[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]
IMPACT OF COMPLEXITY IN THE TAX CODE ON INDIVIDUAL TAXPAYERS AND SMALL
BUSINESSES
=======================================================================
HEARING
before the
SUBCOMMITTEE ON OVERSIGHT
of the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
FIRST SESSION
__________
MAY 25, 1999
__________
Serial 106-83
__________
Printed for the use of the Committee on Ways and Means
U.S. GOVERNMENT PRINTING OFFICE
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_______________________________________________________________________
For sale by the U.S. Government Printing Office
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20402
COMMITTEE ON WAYS AND MEANS
BILL ARCHER, Texas, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
BILL THOMAS, California FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York SANDER M. LEVIN, Michigan
WALLY HERGER, California BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana JIM McDERMOTT, Washington
DAVE CAMP, Michigan GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota JOHN LEWIS, Georgia
JIM NUSSLE, Iowa RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania KAREN L. THURMAN, Florida
WES WATKINS, Oklahoma LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
A.L. Singleton, Chief of Staff
Janice Mays, Minority Chief Counsel
______
Subcommittee on Oversight
AMO HOUGHTON, New York, Chairman
ROB PORTMAN, Ohio WILLIAM J. COYNE, Pennsylvania
JENNIFER DUNN, Washington MICHAEL R. McNULTY, New York
WES WATKINS, Oklahoma JIM McDERMOTT, Washington
JERRY WELLER, Illinois JOHN LEWIS, Georgia
KENNY HULSHOF, Missouri RICHARD E. NEAL, Massachusetts
J.D. HAYWORTH, Arizona
SCOTT McINNIS, Colorado
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C O N T E N T S
__________
Page
Advisory of May 18, 1999, announcing the hearing................. 2
WITNESSES
Internal Revenue Service, W. Val Oveson, National Taxpayer
Advocate....................................................... 12
______
American Bar Association, Stefan F. Tucker....................... 35
American Institute of Certified Public Accountants, David A.
Lifson......................................................... 52
KPMG LLP, Harry L. Gutman........................................ 70
National Federation of Independent Business, and Southern Pan
Services Company, Gerry P. Harkins............................. 75
National Tax Association, and Urban Institute, C. Eugene Steuerle 80
New York State Society of Certified Public Accountants, and
Mengel, Metzger, Barr & Co., LLP, P. Gerard Sokolski........... 23
Williams-Keepers CPA's LLP, Stephen B. Smith..................... 28
SUBMISSIONS FOR THE RECORD
American Network of Community Options and Resources, Annandale,
VA, statement.................................................. 98
Associated General Contractors of America, statement............. 100
Bond, Hon. Christopher S. ``Kit,'' a United States Senator from
the State of Missouri, statement............................... 103
Kleczka, Hon. Gerald D., a Representative in Congress from the
State of Wisconsin, statement.................................. 107
National Association of Home Builders, statement................. 108
National Conference of CPA Practitioners, Lake Success, NY,
Steven Greenberg, letter....................................... 111
Washington Counsel, P.C., LaBrenda Garrett-Nelson, and Robert J.
Leonard, statement............................................. 113
IMPACT OF COMPLEXITY IN THE TAX CODE ON INDIVIDUAL TAXPAYERS AND SMALL
BUSINESSES
----------
TUESDAY, MAY 25, 1999
House of Representatives,
Committee on Ways and Means,
Subcommittees on Oversight,
Washington, DC.
The Subcommittee met, pursuant to notice, at 2:06 p.m., in
room 1100, Longworth House Office Building, Hon. Amo Houghton
(Chairman of the Subcommittee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE
COMMITTEE
ON WAYS
AND
MEANS
SUBCOMMITTEE ON OVERSIGHT
CONTACT: (202) 225-7601
FOR IMMEDIATE RELEASE
May 18, 1999
No. OV-7
Houghton Announces Hearing on
the Impact of Complexity in the Tax Code
on Individual Taxpayers and Small Businesses
Congressman Amo Houghton (R-NY), Chairman, Subcommittee on
Oversight of the Committee on Ways and Means, today announced that the
Subcommittee will hold a hearing on the impact of complexity in the tax
code for individual taxpayers and small businesses. The hearing will
take place on Tuesday, May 25, 1999, in the main Committee hearing
room, 1100 Longworth House Office Building, beginning at 2 p.m.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from invited witnesses only.
Witnesses will include representatives of the U.S. Department of the
Treasury, the Office of the Taxpayer Advocate, tax professional
organizations, and individual tax practitioners. However, any
individual or organization not scheduled for an oral appearance may
submit a written statement for consideration by the Committee and for
inclusion in the printed record of the hearing.
BACKGROUND:
When the Federal income tax system was established in 1913, the
legislation was only 19 pages long. Today, the Internal Revenue Code
covers 2,300 pages, not counting regulations. The resulting compliance
burden for taxpayers is enormous, especially for lower- and middle-
income taxpayers and small businesses.
Many studies have documented the impact of complexity. For example,
one study showed that U.S. taxpayers spent more than five billion hours
preparing tax returns with compliance costs of more than $200 billion
in 1998. Two-thirds of compliance costs were borne by small businesses.
Another study has shown that some small businesses pay more than seven
dollars in compliance costs for every dollar they pay in taxes.
Because of the problems caused by the complexity of the current tax
code, there are several efforts in Congress to replace the tax code.
However, in the interim, simplification of the most complex provisions
of the Code may help to reduce significantly the burden on individual
taxpayers and small businesses.
In announcing the hearing, Chairman Houghton stated: ``Sixty-six
percent of respondents in a recent Associated Press poll said that the
Federal tax system is too complicated. The same poll showed that over
half of those surveyed, 56 percent, pay someone else to complete their
returns. When you consider that only 30 percent of taxpayers itemize,
that is a good number of people who are paying someone else to fill out
their income tax forms. Something is wrong when so many taxpayers with
relatively straightforward returns lack confidence in their ability to
fill them out.''
FOCUS OF THE HEARING:
The Subcommittee will review current tax law to identify the impact
of complexity, along with a number of proposals to simplify the tax
code.
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Chairman Houghton [presiding]. Ladies and gentlemen, I
think we will begin the hearing if we could.
Val, it is nice to have you here.
I would like to make a statement, and then I know Mr. Neal
would like to make one and then Mr. Coyne would also.
Anyway, Mr. Albert Einstein once remarked, ``the hardest
thing in the world to understand is the income tax.'' And in
trying to prepare his own return, he said, ``This is too
difficult for a mathematician. It takes a philosopher.'' So
these troubling words were spoken long before the enactment of
what is named the individual Alternative Minimum Tax. The AMT
is computed on Form 6251. And it is a baffling calculation of
adjustments and preferences.
They were also spoken long before the notorious Schedule D,
which you have here. This schedule is used to calculate capital
gains and losses, a form which is 2 pages and 54 lines long.
According to the IRS, it takes an average of 6 hours and 41
minutes to fill out schedule D. It is required even if a
taxpayer receives as little as $10 in capital gains income from
a mutual fund.
The whole process began many years ago with a simple
constitutional amendment. And it consisted of 32 words and here
they are: ``The Congress shall have the power to lay and
collect taxes on incomes, from whatever source derived, without
apportionment among the several States, and without regard to
any census or enumeration.'' Incidentally, the Revenue Act of
1913, which enacted the income tax, was 15 pages long.
Now, here is a copy of the Internal Revenue Code and it is
printed on very, very thin paper. It covers over 2,300 pages
and the regulations springing from this particular code fill,
obviously, many volumes. The court cases--I am told--would fill
a whole library.
As we all know, our tax system is unique. It relies on
voluntary compliance with our tax laws. Now they must be
intelligible. No one should have to skip a day of work to
complete any tax form, nor should 56 percent of taxpayers have
to pay someone else to complete their returns.
Two of my Subcommittee Colleagues, Mr. Coyne and Mr. Neal,
have introduced bills to help simplify the Tax Code. Mr.
Portman, sitting on my right, has introduced a bill to simplify
the pension provisions of tax law. He also helped bring about
enactment last year of key changes in the way we consider tax
legislation in order to help reduce complexity. Today, I will
be introducing a tax simplification bill as well.
Now, we have a great deal of talent and many good ideas
springing from this Subcommittee and its staff. Today's
witnesses have some important thoughts to share with us as
well. But before calling on the first witness, I would like to
yield to our Ranking Democrat, Mr. Neal, for his opening
statement.
Mr. Neal. Thank you, Mr. Chairman. I have a brief opening
statement. I want to thank you for holding this hearing to
address some of the complexities of the Federal Income Tax
Code, especially for individual taxpayers. And I certainly want
to compliment you on the bill you are introducing that contains
a series of proposals to make life easier for average
taxpayers. I also want to note the key role of Mr. Coyne, our
Ranking Member, in efforts to change and to simplify the
current method of taxing capital gains. His is a common sense
approach that I hope we can all share in the appropriate
moment.
As you know, my bill, H.R. 1420, eliminates about 200 lines
from individual tax forms, work sheets, and schedules. It does
this in essentially a revenue-neutral manner and without moving
money between economic income groups. Other members have other
ideas about simplification, such as Mr. Hulshof's SAVE Act. Mr.
Chairman, this hearing can be an important step forward in the
effort to reform the Federal income tax by raising simplicity
to a competing value with all the other things we want to
accomplish.
The income tax code will always be complex because we live
in a complex society with a complex economy. To achieve
fairness, our Tax Code must mirror that economic reality. But
for those who do not engage in complex transactions, who have,
indeed, a simple economic life, then the Tax Code should also
mirror that reality.
In this instance, fairness means simplicity and, to that
end, a taxpayer should not have to fill out dozens of lines
simply because they received a small capital gains
distribution. Nor should a taxpayer have to worry about
alternative minimum tax because they want to take the child
care credit or the education credits. Nor should those credits
be cut back after we have promised them to the American people.
Lifting at least these two burdens would go a long way toward
helping taxpayers.
But that is just the least that we can do. We can also
accomplish by direct means that which we are now accomplishing
by indirect means. I think of the phaseouts of the personal
exemption and itemized deductions as examples of needless
paperwork. But how to jump start this process of simplification
is a question that I am struggling with and certainly would
welcome suggestions from other members of this panel. That is
the critical role that we play today: how to jump start this
process.
Simplification is like the weather, everybody talks about
it, but nobody does anything. To put it in this context,
simplification is an idea that everybody supports and, during
normal times, is low enough on everyone's list so that it never
quite gets done. I have concluded that it will be all but
impossible to find the revenue by the means we normally apply
to offset the cost of significant simplification. While the
budget surplus is coming, it seems to have already been spent
two or three times on ideas of differing merit, but which have
significant political support behind them.
We could develop a series of small revenue raisers and
dedicate the revenue to tax simplification. But the CQ Daily
Monitor laid that notion to rest yesterday by pointing out that
the tax and trade bills that are currently moving all use many
of the same offsets to fund different bills. A simplification
package is bound to lose out in such a game.
Again, I have concluded that the only realistic chance a
major simplification bill has of being enacted is to be
revenue-neutral as a free-standing proposal. That is why my
bill is essentially revenue-neutral and, in fact, all three
titles to the bill are revenue-neutral in and of themselves. I
have also come to the conclusion that simplification cannot
move money between economic income groups because that may be
seen as a back-door way of advancing the agenda of one
political party or the other. That is why my bill upholds the
principle that those who benefit from simplification ought to
pay for it to keep the focus purely on simplification.
I, for one, seriously doubt that a major tax cut is going
to make it into law this year. But if it does, a major
simplification title would fit nicely into that package. But if
it doesn't, a major simplification package might be even more
attractive because it would be a real accomplishment in an era
of diminishing accomplishments for both parties.
In conclusion, Mr. Chairman, I hope this hearing will
produce a number of technical suggestions to improve our
efforts to date, but I also hope today is the first step toward
bringing some well-
deserved simplification to the American people. And I would
close on a note that I offer in the middle of my statement, and
that is I think the broader question for all of us today is how
do we jump start this process.
Chairman Houghton. Thanks very much, Mr. Neal. Mr. Coyne.
Mr. Coyne. Thank you, Mr. Chairman. I apologize for being
late. I knew, however, that the minority party's position was
going to be strongly upheld by the very distinguished gentleman
from Massachusetts. So, with that, I would like to just submit
my statement for the record.
[The prepared statement follows:]
Statement of Hon. William J. Coyne, a Representative in Congress from
the
State of Pennsylvania
Mr. Chairman, I want to thank you for holding today's hearing on a
topic that is a source of concern for millions of Americans--
simplification of our tax laws.
At nearly 2300 pages, with hundreds of forms and publications, the
Federal Tax Code confuses and intimidates most Americans. They fear the
consequences of making a mistake and dread the prospect of spending
hours or days preparing their returns.
The debate on fundamental tax reform appears to be one which will
continue indefinitely. Therefore, we must proceed to simplify the Tax
Code wherever and whenever we can. We should start with the provisions
which affect the greatest number of individual taxpayers and which are
unnecessarily complex.
There are several proposals that the Subcommittee will hear about
today. These are proposals that have bi-partisan support in the
Congress and great appeal to the taxpaying public.
I have introduced H.R. 1407, the Capital Gains Tax Simplification
Act of 1999. This bill would simplify capital gains calculations for
all taxpayers and provide a modest capital gains tax reduction for
most. I have attached for the record a copy of my recent ``Dear
Colleague'' on H.R. 1407, as well as a copy of the current Schedule D,
a tax form which millions of taxpayers would no longer need to fill out
under my bill.
Importantly, H.R. 1407 would be revenue neutral. Simplification
proposals which cost millions or billions in lost revenues are
politically attractive. However, given the fiscal constraints facing
this Congress, it is doubly important that simplification proposals
have small--or even better--positive fiscal impacts.
I also support Congressman Neal's simplification bill, H.R. 1420,
the Individual Tax Simplification Act of 1999. This bill incorporates
capital gains simplification and significant alternative minimum tax
relief, along with other reforms.
I understand that you, Mr. Chairman, are introducing tax
simplification legislation, and I look forward to working with you and
the other Members of the Subcommittee to make tax simplification a
reality.
Today's hearing will provide an excellent forum for discussing
individual and small business tax simplification proposals. I thank
each of the witnesses for participating in this hearing.
Congress of the United States
Washington, DC, April 15, 1999.
Re: Capital Gains Tax Simplification
Dear Colleague:
As you know, the 1997 Taxpayer Relief Act has resulted in a
significant increase in complexity for ordinary taxpayers with capital
gains. We urge you to become a cosponsor of H.R. 1407, the Capital
Gains Tax Simplification Act of 1999, which would simplify the
calculation of the individual capital gains tax.
The current capital gains tax schedule and the underlying rules for
taxation of capital gains are unnecessarily complex, as illustrated by
the attached 1998 Schedule D, Capital Gains and Losses. The IRS
estimates that these provisions will force taxpayers (with more than
four sales) to spend, on average, more than 6 hours and 41 minutes
filling out these forms (over 3 hours more than in 1994).
Unfortunately, the problem will only get worse in the coming years as
two additional tax rate categories established by the Taxpayer Relief
Act of 1997 take effect in tax years 2001 and 2006. In addition,
increasingly large numbers of taxpayers will have to fill out this
complex schedule twice--once for the regular tax and once for the
alternative minimum tax.
The complexity of the current law may fall hardest on mutual fund
investors, many of whom are low- and middle-income taxpayers, because
they now are required in all cases to fill out Schedule D to report
capital gain distributions from their mutual fund. It has been
estimated that nearly half of all U.S. households now own mutual funds.
Under H.R. 1407, taxpayers whose only capital gains come from mutual
funds would not have to fill out even a simplified capital gains
schedule. They would simply total up their capital gains distributions,
figure out what 62 percent of that total would be, and then write that
amount on the appropriate line of their tax return form.
Some have also asserted that the current law's complexity was due
to the previous 18-month holding period requirement (repealed by the
IRS Restructuring and Reform Act). That is not correct. The repeal of
the 18-month holding period requirement did not eliminate one line of
Schedule D since the various capital gains tax rates will remain.
The bill that we have introduced would substitute a simple 38-
percent capital gains exclusion for the confusing array of five capital
gains tax rates provided in the 1997 Act. It also would permit
individuals selling real estate to receive the full benefit of the
capital gains tax reduction. We have not received a revenue estimate
for H.R. 1407 yet, but the Joint Committee on Taxation determined that
an identical bill last year would have raised $600 million over a 10-
year period.
H.R. 1407 would simplify the computation of capital gains taxes for
all individual taxpayers. In addition, more than 98 percent of
individual taxpayers would be eligible for modest capital gains tax
reductions. Many of the remaining 2 percent of taxpayers could also
receive modest tax reductions under this bill. The following chart
shows the impact of this legislation on capital gains tax rates.
----------------------------------------------------------------------------------------------------------------
Rate Under Current Law Rate Under
------------------------------------------------------------------------------------------------ Proposed
Legislation
----------------
Assets Held All Capital
More than 12 Real Estate Collectibles Assets (Other
Rate Bracket (No. of Taxpayers in Bracket) Months and Not Depreciation Held At Least Than
Collectibles or Recapture Gain 12 Months Collectibles)
Recapture Gain Held More Than
12 Months
----------------------------------------------------------------------------------------------------------------
15 percent (61.58 million).................. 10 15 15 9.3
28 percent (24.0 million)................... 20 25 28 17.36
31 percent (2.3 million).................... 20 25 28 19.22
36 percent (1.0 million).................... 20 25 28 22.32
39.6 percent (0.5 million).................. 20 25 28 24.55
----------------------------------------------------------------------------------------------------------------
If you have any questions about this legislation or if you desire
to be a cosponsor, please feel free to contact Matt Dinkel at extension
5-2301.
Sincerely,
Robert T. Matsui
Member of Congress.
William J. Coyne
Member of Congress.
[GRAPHIC] [TIFF OMITTED] T7314.001
[GRAPHIC] [TIFF OMITTED] T7314.002
Chairman Houghton. Thank you very much. Mr. Portman.
Mr. Portman. Mr. Chairman, I will be brief. I just want to
congratulate you for shining the light on the issue of
complexity. We have spent a year with the IRS Commission
looking at the inner workings of the IRS and figuring out how
to change the mission of the IRS, which was discussed at length
by Commissioner Rossotti this morning. But at the end of the
day, there was a consensus among all commissioners, and it was
actually a consensus that was formulated in terms of specific
recommendations, that we needed to simplify the Tax Code if the
IRS is truly going to be the kind of taxpayer service
organization that we all hoped for. So this does not just
affect the taxpayer, Mr. Chairman, as you know, it affects the
administration of taxes and I commend you for your proposal
today and for holding a hearing today.
The pension reforms are also another example where we can
move forward with regard to simplification and almost everyone
on this Subcommittee is now working toward that goal on the
legislation and I think this is, indeed, a good first step.
Short of fundamental tax reform, we need to figure out ways to
get under the hood as another great philosopher, not Einstein,
said at one point. Get under the hood and figure out how to
change aspects of our Tax Code to make it simpler for both the
taxpayer and the tax administration. I commend you for having
the hearing.
Chairman Houghton. Who was that? Henry Ford.
Mr. Portman. H. Ross Perot. [Laughter.]
Chairman Houghton. Thanks, Mr. Portman. Mrs. Dunn.
Ms. Dunn. Mr. Chairman, thank you very much. I applaud you
for holding this hearing. As I go home to my districts and
speak to the people I represent in town hall meetings or in
other meetings, they ask first and foremost that we do
something to effectively simplify the Tax Code. Those of us who
believe in tax relief would really like the first step of that
to be tax simplification. And so I think the fact that you are
holding this hearing today and that we are hearing from
organizations that have to deal with the complicated Tax Code
and also from our very able new taxpayer advocate, that speaks
very well of your oversight capabilities and I think we are
going to do a lot in this hearing. Thank you.
Chairman Houghton. Thanks, Ms. Dunn. Mr. Watkins.
Mr. Watkins. Thank you, Mr. Chairman, again, for your work
and the Committee's work. And I still have got a couple of
comments. One about the national taxpayer advocate. I utilized
their assistance a couple of different times and they have been
a great help in getting focused on a problem that was hard for
our office to be able to get that done and that has been a
great help.
Second, I guess about the overall tax, I think all of us
would like to have, you know, tax simplification, but I have
always felt like our national priority should dictate our tax
policy. And, you know, is a domestic food basket important for
this country? And, if we do, we have got to have the incentives
to produce in this country a domestic food basket. Is a
domestic oil supply important to the national security of this
country? If it is, then we have got to have the type of
incentives that let us produce the energy and the oil
production for this country in order to have that.
So as we look at trying to say how we simplify, there are
certain things that we have got to have incentives to produce,
so I am one who feels that very strongly that we have got to
have those kind of economic impacts if we are going to have a
future we want here in this country and, especially, in that
global competitive world.
Chairman Houghton. Thank you, Mr. Watkins.
Now, I would like to call our first witness, the Honorable
W. Val Oveson, Taxpayer Advocate. Val, again, great to have you
here.
STATEMENT OF W. VAL OVESON, NATIONAL TAXPAYER ADVOCATE,
INTERNAL REVENUE SERVICE
Mr. Oveson. Thank you very much, Mr. Chairman and
distinguished Members of the Subcommittee. I am pleased to be
with you once again and very pleased to be addressing this very
critical, important topic of simplification and, on the
converse side, complexity of the Tax Code.
Complexity, in my opinion, is the No. 1 problem facing the
American taxpayer and the tax administrators in the Government
in general. It is not just one-sided. All of us are dealing
with this complexity problem.
I use several factors as my basis for saying that it is the
No. 1 problem--it popped up in my annual report this year, as I
testified earlier this year to you and had done in that report
for the 2 years running that had been presented to you.
Analyzing the cases that come up from the field is one of the
sources of identification that complexity is the No. 1 problem.
Actually, the casework that we deal with, as well as surveys of
taxpayers, tax practitioners, and small business groups that we
conducted over the last year and a half, also tell us that it
is a No. 1 problem. Surveys of our own taxpayer advocates in
the field and their feelings of the work that they have
conducted also identify it as the No. 1 problem.
As is written in my testimony, which I have submitted for
the record, my opinion is that the following three issues are
the most critical components of this complexity that, if you
want to address, you need to solve. No. 1 is the frequency and
the number of tax law changes. No. 2 is targeted tax relief for
groups of taxpayers, including income phaseouts on deductions.
And No. 3 is the alternative minimum tax.
Now let me go briefly into these areas. In the last 10
years, there have been 6,500 changes in the tax law in 61
bills. In the last 2 years alone, there have been approximately
1,260 changes of individual code sections. It is difficult for
taxpayers to understand why the law changes so much and for
them to assimilate it and to understand why; it is hard for
them to deal with it.
Programming changes into the brittle computer system at the
IRS is extremely expensive and fraught with risks in getting it
right. The magnitude of the changes makes it hard to convey the
changes to the taxpayer in forms and publications and the
communications effort gets more and more difficult every day at
the IRS. And it is difficult to train employees and the service
level suffers. And I might add training the private sector, not
only the taxpayers, but tax practitioners is also a major,
major problem. For those reasons, again, the frequency and
number of tax law changes, I rate as No. 1.
Second is targeted relief for groups of taxpayers,
including income phaseouts. These would be items such as the
child care credit, the adoption credit, educational credits
that are on top of other credits that are very similar. There
are different qualifications for each of these credits. There
are definitions that sound similar but they are really not and
they are different among the credits, making it more
complicated and difficult to sort through them. And then the
income phaseouts are different and complicated in each of these
areas.
I want you to know and understand that I am not commenting
on the merits of the policy issues surrounding these issues.
You need to sort through those policy issues. What I am telling
you is that these are the areas that, in my opinion, are
creating complication in the tax law.
Third is the alternative minimum tax. Again, you are well
familiar with this issue of requiring taxpayers to actually
compute their tax under two separate systems and to evaluate
the two against each other. It is not indexed. AMT is affecting
more and more people every day as more credits in the system
come into play.
In conclusion, don't change the laws so much. If you are
going to change the laws, make sure that they are actually less
complex and not more complex. Thank you very much.
[The prepared statement follows:]
Statement of W. Val Oveson, National Taxpayer Advocate,
Internal Revenue Service
Mr. Chairman and Distinguished Members of the Subcommittee: I am
pleased to appear before this Subcommittee to address the subject of
the complexity of the tax law. As you know, my role is to be the voice
of the taxpayer and the advocate of a more equitable and balanced
approach to tax administration. As my FY 1998 Annual Report to Congress
describes, complexity of the tax laws is the number one problem facing
taxpayers. This conclusion is supported by those groups directly
impacted by such complexity--individual and small business taxpayers,
tax practitioners and professional associations and IRS Field Taxpayer
Advocates. I take great hope in the fact that Congress, by inviting the
panelists you will have before you today for hearings like this, is
acknowledging the problems complexity is causing and is prepared to
help America's taxpayers. I am here today to lend my hand in easing
that burden.
I. Frequency and Number of Changes to Tax Law
As I just suggested, I believe that Congress is serious about
wanting to reduce the complexity of the tax laws. Section 4022 of RRA
98, which calls for complexity studies to be conducted by the IRS and
the Joint Committee on Taxation, is a good place to start. As I
mentioned last month before the Senate Finance Committee, I am
confident that the two studies the law mandates will identify for the
Congress and Federal tax administrators specific sources of complexity.
The Commissioner's study will provide you empirical data on how
existing law affects taxpayers and a window into how the tax laws you
pass get translated into what the public experiences. I continue to be
optimistic that you can use the information to reduce existing
complexity. The study by the Joint Committee on Taxation will estimate
the ``complexity factor'' of legislation and what that means to
taxpayers. I hope that you can use that information to affect what I
believe to be the single most complicating factor in tax
administration--the frequency and number of changes to the tax laws.
In 1986, Congress drastically changed the tax laws by enacting the
Tax Reform Act (TRA 86). The goal of TRA 86 was to create a simpler,
fairer and more efficient tax system. In TRA 86, Congress made
approximately 1850 separate amendments to the Internal Revenue Code. It
reduced the number of tax brackets, modified the standard deduction and
made many other changes that greatly reduced complexity.
Since TRA 86 and ending in 1998, Congress made approximately 6,500
changes to Title 26 in 61 different pieces of legislation. In fact, the
Taxpayer Relief Act of 1997 and RRA 98 alone made 1,260 changes to the
tax code. The magnitude of the changes made by those two pieces of
legislation resulted in revisions of at least 100 separate IRS forms.
This translates into additional burden for taxpayers in several
significant ways. First, it is difficult for taxpayers to understand
why the law changes so much. As Ben Franklin said, ``Nothing is certain
but death and taxes.'' Taxpayers may not necessarily like the certainty
of paying taxes, but certainty and familiarity at least lead to an
understanding of expectations. An uncertain tax system leads to
cynicism and unintentional noncompliance. Second, programming the
changes into brittle computer systems is expensive and fraught with
risks. Third, the magnitude of the changes, particularly recently,
makes it hard for the IRS to convey those changes most effectively to
taxpayers. The nature of changes can be difficult for the IRS to
explain simply enough in forms, instructions and publications for
taxpayers. The frequency of the changes means that IRS publishes
guidance reacting largely to the most pressing issues, such as those
for the next filing season, resulting in fewer resources to address
longer standing questions. Finally, such frequent changes make it
difficult for the IRS to adequately train its employees, which inhibits
the service IRS employees can provide to taxpayers. Every taxpayer has
a right to expect that, in every encounter with an IRS employee,
whether it is a phone call asking a question about how to fill out a
return or a meeting with a revenue agent in an audit, the employee
understands the current tax laws and has the skills to apply the laws
to the facts and circumstances of that taxpayer. When our employees do
not understand the complex and frequent changes to the laws, we cannot
explain the laws to the taxpayer. Failing to understand the law results
in frustration on both ends.
For example, TRA 97 changed the law regarding capital gains. It
lowered the rates, but it provided different brackets based on the type
of property and the length of the holding period. There are 10 percent,
20 percent, 25 percent and 28 percent brackets. It resulted in the IRS
completely overhauling Schedule D and in a marked increase in the
amount of time and information required to complete that schedule. As a
matter of fact, the burden estimate for the 1998 Schedule D is 6 hours
and 41 minutes. These changes also resulted in a great deal of
frustration for taxpayers who had difficulty calculating their capital
gains and could not get through when calling the IRS for help. What
could make things even more confusing is that this will become even
more complicated in the relatively near future. A new 8 percent rate
becomes effective in 2001 for capital gains on assets held longer than
five years, that otherwise would have been subject to the 10 percent
rate. Also in 2001, yet another rate--18 percent--will apply to capital
gains otherwise subject to the current 20 percent rate with respect to
assets held longer than five years.
Cumulatively, the changes over the last 13 years, but particularly
TRA 97 and RRA 98, have greatly increased complexity. In conjunction
with the complexity studies, I hope that you will simplify the tax
code. If not, then I suggest that you can alleviate the burden of
complexity on taxpayers, practitioners and tax administrators, as well
as our tax system, by not changing the tax laws so frequently.
II. Targeted Relief for Groups of Taxpayers
Frequency and number of changes to the laws are obviously not the
only causes of complexity in the tax code. I believe that targeted
relief or incentives for groups of taxpayers significantly adds to the
complexity of the tax law and the difficulty these taxpayers have in
understanding and complying with the law. As I did before the Senate
Finance Committee, I would like to take a moment to point out that I am
not commenting on the merits of the policy reasons for targeted relief.
Those in a position to make policy decisions may conclude that a
certain subsidy is best or most simply delivered through the tax code.
My goal here, like the RRA 98 studies, is to point out where the laws
cause problems for taxpayers.
Recently, the Administration and Congress enacted into law many
credits to help families, such as the child tax credit, the adoption
credit and the education credits. These are in addition to the already-
existing credits such as the child and dependent care credit, the
credit for the elderly and the earned income tax credit. While these
credits have resulted in lower taxes for taxpayers, they have also
increased the complications these same taxpayers experience. Some of
these credits sound like they involve similar concepts, but the tax law
has defined them differently. For example, the definition of a
``qualifying child'' or ``qualifying individual,'' used to determine
eligibility to claim the child and dependent care tax credit, the child
tax credit and the earned income tax credit, is different in each case.
So, taxpayers who sit down to prepare their returns must fill out
different worksheets or schedules and look to different instructions
each time they claim similar sounding credits to determine which
definition applies and whether their circumstances meet the
requirements in every situation.
Further, the interaction of these targeted provisions, with each
other and with those currently existing, creates a great deal of
complexity. The credits mentioned above must be claimed in a specific
order. In addition, the child tax credit, adoption credit, the
education credits and the earned income tax credit are each subject to
different income phase outs. These phase outs are equivalent to
marginal rate increases and require a taxpayer to perform additional
calculations on a separate worksheet, rather than simply entering a
standard credit amount on a tax form. The combination of these credits,
along with exemptions and deductions, can also cause unintended
consequences for taxpayers if they become subject to the Alternative
Minimum Tax (AMT).
I am not suggesting that we should or should not employ targeted
relief or incentives. Rather, I am advising you that certain
legislation increases the complexity of the tax laws and the burden on
taxpayers and the system. You must weigh the desire for simplicity
against the policy reasons for the legislation. Going forward, you can
help to reduce complexity by harmonizing the provisions to the extent
possible. In this way, you can take steps to minimize the burden
taxpayers experience in taking advantage of relief they expect from the
laws that you passed.
III. Other Issues
I am certain that the other panels today will discuss some very
specific areas in which you can reduce complexity and proposals to
accomplish that result. I would like to take this opportunity to
mention very briefly a couple of places in the tax code that could
benefit from your attention.
Based on several articles this past filing season, I think the AMT
is probably one of the most discussed and least understood areas in the
tax code with good reason for both. Taxpayers that Congress never
intended to subject to the AMT are and will increasingly be required to
calculate the AMT. That means having to calculate taxes twice, once
under the standard rules and once under the AMT rules, which requires
taxpayers to understand the basics of the two regimes. Considering that
taxpayers can be intimidated by preparing their returns under the one,
more common, set of rules, I cannot imagine that subjecting more of
them to the AMT will increase their comfort or compliance level.
I also believe that the penalty and interest regimes are
unnecessarily complex and, as a result, misunderstood by taxpayers.
With regard to the complexity of the regimes, I hope that the RRA 98
studies will provide you an important tool in improving interest and
penalty administration. With regard to taxpayers' understanding of the
interest provisions, I think the RRA 98 provision requiring the IRS,
beginning in 2001, to provide taxpayers with interest computations and
Internal Revenue Code citations imposing the interest will help
taxpayers better comprehend their tax situations.
Conclusion
Mr. Chairman, it is important that we continue to discuss our tax
laws and the effect of our laws on taxpayers. It is my hope that you
will carry through the difficult task of reducing complexity. If not, I
recommend that you not add to the complexity and slow down the
frequency of change to the tax laws.
Chairman Houghton. Thank you, Mr. Oveson. I would like to
ask one question, and then I will turn it over to the rest of
the members of the panel. You know, we constantly get tripped
up on who does what. I have said this to Mr. Rosotti at times.
Why don't you do this? Why don't you do that? And he said,
``Well, that is a policy issue; it is not mine.'' I am trying
to work out the mechanics and the structure of the IRS. But, I
just wonder whether the Internal Revenue Service, just taking
this meeting as a key, couldn't do an awful lot through the
administrative function, rather than waiting for the change in
the law.
Mr. Oveson. Well, first of all, there are many things that
the IRS can do and many of those things are being addressed.
But none of that can compensate for the tax law that you
described, Mr. Chairman, in your opening remarks. It is
essential if we are going to get simplification, that we get
true simplification in the code.
But there are things that the IRS can do and let me mention
a couple. Forms and publications. Again, we need to make those
as simple and as clear in plain English as possible and a
project has been underway for some time to do that. By the way,
the issue popping up as about the third or fourth most serious
problem is clarity of the forms and letters that go out to
taxpayers. So there is a lot more that we can do with forms and
letters and publications.
With customer service, there is a lot that we have done
and, interestingly, have we gone too far with customer service?
I think not, but there are those that would say that we have.
But, certainly in the customer service area, there is more that
we can do to help people, taxpayers, negotiate the tax system.
So, yes, there is more that needs to be done, but we really
need your help in simplifying the code to make that really
meaningful.
Chairman Houghton. I will ask you a question. You don't
have to answer this if it is too sensitive for you, but I want
to ask it anyway. Prior to the State of the Union, does the
President ever ask the Internal Revenue Service to come in?
When he talked about the 28 tax credits that he had, did he
ever say to you, you know, I would like to do this and I think
it is going to reduce--or is this something that is really
handled at the Treasury level?
Mr. Oveson. I don't know. He didn't ever ask me and I have
no knowledge of whether he asked the Commissioner or others at
the IRS.
Chairman Houghton. All right. Thanks. Mr. Coyne.
Mr. Coyne. Thank you, Mr. Chairman. Mr. Oveson, with the
tax laws getting more complicated with each year that passes
by, what comments do you have about the Taxpayer Relief Act of
1997 now that we have had a year or so of experience with it?
Mr. Oveson. Again, I have commented in my testimony and I
would comment again that the targeted credits are a
complicating factor in the code. Again, the policy decisions of
why you do credits of that type versus something else is
something you need to work out in the policy side of the
business between you and the Treasury and the White House. But
it complicates the code.
Mr. Coyne. Is that the only offering that you could give
from that particular Act?
Mr. Oveson. I think that is pretty strong, actually. There
were approximately 1,260 changes between the 2 years. There
were just a lot of changes and a lot of complications and we
hear that through the casework. We hear it through
practitioners and then the other work that we do in the field.
Mr. Coyne. What complexity problems has the current tax
return season yielded that you would be concerned about? The
one that just has passed, for individual taxpayers?
Mr. Oveson. The biggest complication I see from this past
tax season is the sheer size and momentum of the changes of the
bill that passed last summer. Again, much of that bill--I would
say most of that bill--was taxpayer friendly and provided
additional rights to taxpayers. Since you would have to say
that was good, I would say it was good. I think it was a great
piece of legislation. But you can't escape the fact that there
was a lot of change and a lot to assimilate, certainly within
the IRS. We are reeling and struggling to train employees, to
change the systems, and to get all of the features that were in
that bill implemented and get them working. And I think the
same would be true from the outside.
Mr. Coyne. On the EITC issue, given the fact that both
practitioners and taxpayers have had trouble calculating the
earned income tax credit, do you have any recommendations in
that area?
Mr. Oveson. Yes. The report to Congress that I presented in
December has about four suggestions on the EITC. The top two:
One is really a refund offset issue that the earned income tax
credit should not be subject to offset by other debts. In a
hardship kind of basis, we see that issue come up a lot. The
other one that we see on EITC is the top wage-earner issue
where only the top wage-earner in a household can be eligible
for the credit. And we recommended that that be changed. And we
have also recommended that you change the definition of
qualifying individual and make that consistent with the
exemption. That causes a lot of confusion as people are trying
to claim the credit and comply with the law.
Mr. Coyne. Thank you.
Chairman Houghton. Thanks, Mr. Coyne. Mr. Portman.
Mr. Portman. Thanks, Mr. Chairman. Let me look back to the
report language from the IRS Restructuring and Reform Act which
just passed last summer, as you say. With regard to Mr.
Houghton's earlier question to follow up on that, I think what
Chairman Houghton was getting at is the sense that we want to
have an independent view from the IRS on our process of
developing tax legislation. And he took it a step further by
saying, wouldn't it be great if the President actually
consulted with his Internal Revenue Service before coming out
with the Administration proposals, whether it was attractive
new tax credits or other changes in the law that added
complexity.
And I guess all I can say is that, under this law, we made
two requirements. One was that there be a new complexity
analysis done by the Joint Tax Committee as legislation is
considered by this Committee or by the Finance Committee. We
are waiting this year to see how that is going to work. I know
Joint Tax is hard at work on it. And I would hope that the IRS,
as intended in the law, would work with the Joint Tax Committee
in providing input to the Joint Tax Committee as to the burden
on the system. But that is new and that is a complexity
analysis that will bear fruit even next month and the month
after as we get into tax writing with this Committee. There you
have a role to play because you, I hope, will be givin input to
the IRS, as taxpayer advocate, which then will go into the
process.
Second is that there is a new requirement, as you know,
that the IRS send us, in addition to your report, an IRS report
every year. And that report is regarding sources of complexity
in the administration and the Federal tax laws. And then we
would list all the factors and take them into account,
including many of the things you take into account: frequently
asked questions and so on. And there, again, I hope that you
will provide input that you are getting.
My point is that this new law we passed last summer is
intended to reduce complexity prospectively. And it comes out
of the commission's work of over a year's worth of effort
looking at this and deciding that, if you are really going to
have the tax laws work, you have got to reduce the complexity.
There is also in the report language, though, this Sense of
Congress that the IRS should provide the Congress--and I am
reading the report language here--``with an independent view of
tax administration.'' And I guess part of what my frustration
has been in my short time here in the last 6 years is that we
often get an administration position and we don't get an IRS
position on tax complexity.
And I would just pose the question to you, do you feel as
though your input going into the system, whether it is to the
IRS and then to the Joint Tax Committee or directly from the
IRS to the Congress in terms of these two reports or in your
report to us, do you feel as though you are able to give us an
independent, unvarnished, apolitical, non-tax ideology or tax
policy view as to administration? Do you feel comfortable
giving us that input and do you feel as though you are giving
adequate input?
Mr. Oveson. To answer your question directly, yes I do. And
the fact that I would be here today talking about the
alternative minimum tax as directly as I am is, I think, a
testament to that independence and to that directness.
Mr. Portman. And talking about the EITC takes some courage
also.
Mr. Oveson. Yes.
Mr. Portman. Although some of your suggestions would
broaden the EITC in an area where we have already got a
tremendous amount of mispayment and some would say fraud.
Mr. Oveson. Thank you. One of my concerns with the EITC is
that it is there. It is in the law. And we see taxpayers that
would qualify that are being excluded from it. And that our
position, as you have put into the statute, is to look at the
taxpayers point of view with EITC and not, necessarily, from
the compliance point of view.
On the other issues, we do have the study internally within
the IRS, on complexity and I will be a player. I will be on the
Committee. I will be working with them and advising the group
that is working on complexity within the IRS. I will be a
contributor to it.
With regard to the Joint Committee work, I look forward to
the outcome of that work and, hopefully, it will be extremely
valuable to you as you evaluate proposals against that
complexity analysis. And I would be happy to help any way you
or the Joint Committee would like.
Mr. Portman. Thank you. Thank you, Val.
Chairman Houghton. Thank you, Mr. Portman. Mr. Neal.
Mr. Neal. Thank you, Mr. Chairman. In your written
statement, you raised the question of AMT and you suggest that
you can't imagine subjecting more and more taxpayers to the AMT
will increase ``their comfort or compliance level.'' The most
immediate problem is the nonrefundable credits and the AMT.
Would you be willing to give us a better idea about your
thoughts of what will happen to compliance and taxpayer
frustration in general if we don't fix the problem with AMT and
nonrefunable credits?
Mr. Oveson. That is a bit speculative. The question asks
for a speculative answer. My personal opinion is that, as the
law gets more complex, people choose to drop out of the system,
to not comply, because it is so complex, out of frustration or
out of other kinds of feelings. And that it is not conducive to
good tax compliance to have the law get more and more complex.
And this alternative minimum tax, as you suggest, is an area
that kind of creeps up and grabs people by the back of the neck
and creates a lot of anger.
Mr. Neal. Well, as you know, my legislation would collapse
the three phaseout ranges for the adoption, education, and
child credits into one phaseout range. Do you think that is a
useful suggestion?
Mr. Oveson. I have read your proposals and your bill, and,
in general, the simplification that it would create, I think,
would be great.
Mr. Neal. Thank you. Thanks, Mr. Chairman.
Chairman Houghton. Thanks, Mr. Neal. Mr. Watkins.
Mr. Watkins. Thank you. The third line on your testimony,
you basically said, you know, you see yourself as your role
would be to be the voice of the taxpayer and the advocate of
more equitable and balanced approach to tax administration. Do
you see that more in policy or do you see that more dealing
with the compliances that the taxpayers run into?
Mr. Oveson. I see it more with the administration of the
tax law and the day-to-day field work that we have got
taxpayers out there working in every area of the country and
every State----
Mr. Watkins. I am glad to hear you say that because I think
that is where many of us need help out there. As I said in my
opening statement, I have turned to the taxpayer advocacy group
a couple of times and they have been able to be on the ground
and been able to intercede in working with giving some
confidence in working with the IRS with some of the problems
that they have had and I have felt like it was really a plus in
that area. And I know we have a lot of changes, you know, as we
go about looking at the tax policy and I know the great one we
would like to have would be sort of simplified that one could
probably do their own taxes. And I don't know that if we will
ever see that.
But, again, I have stated, you know, as I have tried to
analyze it and reflect on it, I think our national priorities
shouldn't dictate our tax priorities. And I don't know how we
maintain certain positions economically around the world,
especially in this competitive global economy we are in unless
we have certain incentives in place.
And that is like a national food basket for this country.
Food is important and we need to have the kind of tax policies
that make it feasible to do so. In the same way as we look at
the national security and the need of energy, we have got to
have tax incentives to produce the type of oil production that
quantity and all that we need to have, especially when you see,
if we analyze our national policy as we deal with Kosovo and
all concerning oil embargoes and the other things that has
turned against us, we are going to find that we are in a world
of hurt, literally.
So I think we have to look at our priorities and say, what
are our incentives? What is necessary for us to have that
national security and what do we have to have in the way of
trying to secure the future for our children and our
grandchildren? So I appreciate your being on the ground and
your groups trying to help many of the families out there and
individuals and small businesses that are running into
complication. I think it is a great assistance. Thank you.
Chairman Houghton. Thanks very much. Mr. Weller.
Mr. Weller. Thank you, Mr. Chairman. And, Mr. Oveson, thank
you for your testimony. And I am glad to see you here today. I
represent the southside of Chicago and the south suburbs and
whether I am at a union hall or the VFW or the local coffee
shop or a grain elevator in some of the rural areas I
represent, everyone complains about their taxes are too high,
but they also complain about how they are too complicated, too
unfair, they are frustrated that over half of them tell me they
have to hire someone else to do their taxes. They are afraid of
being audited if someone else doesn't fill out their tax forms.
But they really focus on the unfairness of the Tax Code and
the complexity of the Tax Code is part of the unfairness. But
they are frustrated that the Tax Code unfairly treats married
working couples. They are frustrated that the Tax Code unfairly
treats family farms and family businesses because of the estate
tax. They are frustrated that the alternative minimum tax is
now goring middle-class working families. They are frustrated
that senior citizens who want to work longer after the age of
65 are stuck with the work penalty, the earnings limit, which
confiscates much of their social security benefits. And the
self-employed are also frustrated that the big corporations can
deduct 100 percent of their health insurance premiums, but the
little guys and the little gals that are self-employed can't.
And Jennifer Dunn and I have put together a package of what
we call tax simplification that addresses the unfairness in
these areas as a solution, not only of lowering the tax burden,
but also to address the complexity of the code by simplifying
the unfair aspects of the code. And I would like to focus on a
couple of these just to ask your perspective. Particularly the
marrieds tax penalty which I consider to be the most unfair
complication in the Tax Code which affects 21 million married
working couples who pay an average of $1,400 more in higher
taxes just because they are married.
Do you consider, you know, the consequences of our Tax Code
where our joint filers pay higher taxes, joint filers with an
identical income pay higher taxes than two single filers,
perhaps living together, with identical incomes--that married
couple pays $1,400 more--do you consider that fair?
Mr. Oveson. Boy, you put it to me so directly. The fairness
issue of the marriage penalty, I think, cuts both ways and
certainly there are some that get caught one way and some that
get caught the other way and I think that is a policy issue
that you need to grapple with. There are certainly some
complexity issues related to the marriage penalty, but I don't
think it is a clear-cut complexity issue.
Mr. Weller. So you really feel that, for 21 million couples
that pay $1,400 more, it is not really unfair that they do?
Now, as a taxpayer advocate, I would think that you would want
them treated more fairly.
Mr. Oveson. If you fixed it in that direction, you are
going to have a whole group of other taxpayers that are going
to go the other direction, depending on how you fix that issue.
Mr. Weller. Well, if you have a man and woman with
identical incomes who are living together, have the same
household income as a married couple, should the married couple
pay more in taxes just because they are married?
Mr. Oveson. And that is a policy issue that I am not going
to comment on.
Mr. Weller. All righty. Well, I certainly believe it is
unfair and I know 21 million couples, 42 million people, who do
and certainly feel our Tax Code should be marriage neutral so
that you should not pay more just because you are married,
under our Tax Code. And, you know, the CPAs were before us a
year ago and we were talking about the marriage tax penalty in
testimony and they pointed out that, you know, once you get
beyond the marriage tax penalty, the big one that exists for
joint filers, that there are 63 other marriage tax penalties.
And most of them are the result of the so-called targeted tax
cuts.
Mr. Oveson. Yes.
Mr. Weller. You know, where there is various means testing
and so forth and the means testing is never double for joint
filers what it is for single filers. Do you feel that it would
help simplify the code if we eliminated those 63 different
marriage penalties----
Mr. Oveson. Yes.
Mr. Weller [continuing]. So that joint filers would be able
to earn twice as much as single filers?
Mr. Oveson. Definitely.
Mr. Weller. Well, how about for the larger marriage tax
penalty for joint filers? Do you feel it would simplify the
code if joint filers would be able to earn twice as much as a
single filer with the same burden as two single filers?
Mr. Oveson. Again, my concern with your question is that
there are some tax policy elements to your question and to the
issue. There are some simplification issues. And it is hard to
separate those out. And, certainly, the deal with the phaseouts
and the credits and the others would be extremely helpful in
solving the complexity issue. Again, there are some tax policy
questions implicit in all that I would prefer not to get into.
Mr. Weller. Well, I would like to work with you. I think it
is really wrong that under our Tax Code our society's most
basic institution is punished by our Tax Code and I believe one
of the best ways we can help families is to simplify the code
by eliminating that unfair aspect called the marriage tax
penalty. Thank you, Mr. Chairman.
Chairman Houghton. Thank you very much. I would like to
just ask a final question, unless other people have continued
questions. These are not up-to-date figures, but a few years
ago, we had a regional meeting of the Oversight Committee, when
Mr. Pickle was chairman of it, and I think we figured at that
time that it cost something like $400 billion for people to
make out their taxes. I mean, it was that expensive.
So, I look at your testimony here and you talk about the
frequency and the number of the changes to the tax laws.
Suppose we froze that for 1 year--had no changes. The same
thing as far target relief for groups of taxpayers. There would
be no credits, no exemptions, and no deduction changes at all.
We would do the same thing as far as the alternative minimum
tax is concerned. What sort of impact would this have on the
country?
I mean, you obviously wrote this thing and you have a sort
of a composite view. Tell me how you feel about it.
Mr. Oveson. I think in a large view of the situation, that
it would be helpful to have a multi-year commitment not to
change the Tax Code. You would have to forego some solutions:
the marriage-tax penalty, the alternative minimum tax, other
kinds of issues that you feel would help simplify the code. You
would have to forego those. But the impact that that would have
on the taxpayers themselves, certainly the impact that it would
have within the IRS, particularly during these times when we
are rebuilding and redoing the computer systems and having to,
as Commissioner Rosotti explained earlier today and has said
many times, redesign and rebuild the home while you are living
in it; it is even worse when you talk about redesigning an
airplane while you are flying it. While you are making these
changes, it is extremely difficult and fraught with risk.
So my suggestion, No. 1, less changes, less frequent
changes to the Tax Code, was implying just what you suggested
here, that there would be some tremendous benefits in freezing
that for a period of time.
Chairman Houghton. Well, I think that there are two
categories--the internal and the external. Internal, obviously
it helps the IRS, you know, in terms of the transition in using
your new computer system and trying to get more electronic
filing and things like that. But what does it do for the
ordinary American? Suppose you did this, which you suggest,
what would it do, in a year, if that happened?
Mr. Oveson. I think the longer you do it, the more benefits
there are. In a year, certainly all of the tax software vendors
won't have to scramble to do that, although they may lose some
market in terms of making the changes and selling them. But,
from what I hear from practitioners and having been one in the
past, there is just a lot of things you don't catch as you go
through and it is difficult and you have got to go really
scramble to learn the changes that go on. And there would be a
benefit throughout the economy, throughout the taxpaying world
to not having the level of changes that we have had recently.
Chairman Houghton. OK. Mr. Coyne, have you got any
questions?
Mr. Coyne. No, Mr. Chairman.
Chairman Houghton. And, Mr. Weller, have you got any other?
Mr. Weller. No.
Chairman Houghton. Well, Val, let me ask if you have some
thoughts on this as a followup to your statement; you might
want to send them along to us. You talk about this multi-year
program. Some of the impacts it would have inside, specifically
stating those things which you do for the ordinary taxpayer. I
think it would be an interesting followup to this meeting if
you could do that. And thank you. Thank you very much.
Mr. Oveson. Thank you.
Chairman Houghton. We certainly appreciate your not only
being here, but also the wonderful work you are doing.
All right. Now we have the tax practitioner panel. Mr.
Gerard Sokolski, who is a CPA partner in a firm in the great
city of Rochester, New York, and Stephen B. Smith, who is a
general partner in a CPA firm in Columbia, Missouri. Would you
please come to the stand. OK, good. Thank you.
Gentlemen, how are you? Good to have you here.
Mr. Sokolski, would you like to start with your testimony?
STATEMENT OF P. GERARD SOKOLSKI, CPA, TAX PARTNER, MENGEL,
METZGER, BARR & CO., LLP, ROCHESTER, NY; ON BEHALF OF NEW YORK
STATE SOCIETY OF CERTIFIED PUBLIC ACCOUNTANTS
Mr. Sokolski. Certainly. Thank you. Good afternoon, Mr.
Chairman, and Members of the Oversight Subcommittee. I am Gerry
Sokolski, CPA, a tax partner with the regional upstate New York
firm of Mengel, Metzger, Barr, and Company and, as of June 1, I
will be president-elect of the New York State Society of CPAs.
I am honored to testify before you today on tax simplification.
My written testimony contains several points which I will not
be able to address in the time allotted. I therefore
respectfully request that my written testimony be admitted to
the record.
Let me first offer my opinion as to the chief causes of
unnecessary complexity. If we face those causes, stare at them
eyeball-to-eyeball, perhaps we can take some steps to eliminate
unnecessary complexity in the future.
Ladies and gentlemen, in the words of Pogo, ``I have met
the enemy and they is us.'' By they, I mean taxpayers and tax
advisers who obtain special provisions for their clients. They
include legislative staff, many of whom are fresh out of school
and have never worked out there in the real world. And, with
utmost respect, they also means you. I know that you all have
very busy schedules, but sometimes the tax laws look as though
you haven't thought them through sufficiently. Perhaps it is
unreasonable to expect legislators to understand their
legislation in this complex society. Still a key element of tax
law draftsmanship, going back to Adam Smith, is that tax law
should be understandable.
Now on to specifics. Recent changes to the IRA rules have
made this area extremely complicated. The complexity results
from many different phaseouts applicable to the IRAs. Not just
IRA phaseouts need reform. In 1998, child credits, tuition tax
credits, and education loan interest deductions dramatically
highlighted the problem with the so-called middle income
phaseouts. Who would have thought that a young married couple
just out of school and making $37,500 each would not be able to
deduct student loan interest because their combined income was
too high? I suggest that you use a uniform phaseout schedule
that kicks in at a higher income level if phaseout is necessary
at all. This would make the tax system simpler, if not more
palatable.
Also needing reform are the minimum distribution rules from
qualified retirement plans. The current rules were designed in
the early 1960's. In the 1990's, they are hurting the working
elderly and also widows. They feel they may need more money in
their accounts later in their lives. Also the unisex tables
used to compute minimum distributions discriminate against
women because of their higher life expectancy.
Capital gains rules are another area of unnecessary
complexity. In 1996, the schedule D was a single page with 19
lines. Taxpayers whose only capital gains came from mutual fund
dividends reported their gains on the first page of form 1040
and were excused from filing schedule D. No longer. After the
1997 Taxpayer Relief Act, schedule D ballooned to 54 lines on 2
pages.
Now on to the AMT. The AMT is now taxing taxpayers whom it
was never intended to affect. One of my colleagues faxed me a
startling example. It involves a divorced mother of two who
received $102,000 of alimony and had AGI of $108,000. She paid
nearly $7,800 of additional tax due to AMT because $14,000 of
mostly real estate taxes and $10,000 of home mortgage interest
was not deductible for AMT purposes.
This also highlights that AMT discriminates against
taxpayers in high-tax States such as New York and California.
Personally, I would like to see you repeal the AMT. But if you
cannot, our written testimony suggests a number of reforms you
should explore.
Another area of unnecessary and unexpected complexity is
the so-called kiddie tax. Often kiddie tax situations require
the running and rerunning of a family's tax returns to arrive
at the correct tax.
I sincerely thank you for the opportunity to testify here
today. It is an experience I will always cherish. Let me end by
reminding you of one of Adam Smith's four maxims of taxation:
Certainty. Specifically, Smith advised the tax which each
individual is bound to pay ought to be certain and not
arbitrary. The time of payment, the manner of payment, the
quantity to be paid ought all to be clear and plain to the
contributor and to every other person. If we regain that sense
that taxes need to be clear and plain to every contributor, tax
complexity will never be an issue. Thank you.
[The prepared statement follows:]
Statement of P. Gerard Sokolski, CPA, Tax Partner Mengel, Metzger, Barr
& Co., LLP, Rochester, New York; on Behalf of New York State Society of
Certified Public Accountants
Good afternoon, Mr. Chairman and distinguished members of the
Oversight Subcommittee. I am P. Gerard Sokolski, CPA, a tax partner
with the regional CPA firm of Mengel, Metzger, Barr & Co. LLP, which
has four offices in upstate New York. Also, as of June 1, I will be the
President-Elect of the New York State Society of Certified Public
Accountants. The NYSSCPA represents more than 31,000 CPAs, who
collectively serve literally millions of taxpayers, ranging from
individuals and corner grocery stores to multinational
megacorporations. My firm serves a variety of individual and small
business clients in central and western New York State.
I am honored to testify before you today to give you a
practitioner's views on the complexity of the Internal Revenue Code and
the hardships it imposes on individual taxpayers and small businesses.
Although many areas are too complex and require simplification, I will
limit my comments today to six issues:
Tax-advantaged savings accounts,
Phase-outs,
Retirement plan distribution reform,
Capital gains and the Schedule D,
Alternative minimum tax, and
The ``kiddie tax''.
It is no wonder that Americans are burdened with an overly complex
tax law. There have been significant tax-law changes in eight of the
last 14 years--1986, 1987, 1988, 1989, 1990, 1993, 1996 and 1997. The
1997 Taxpayer Relief Act alone contains
36 retroactive changes,
114 changes effective August 5, 1997,
69 changes effective January 1, 1998, and five changes
effective thereafter,
285 new Code sections, and
824 Internal Revenue Code amendments.
Because of the average taxpayer's inability to understand the
requirements of the tax laws as interpreted in the tax forms, many are
forced to pay a tax preparer to help them meet their tax obligations.
This may be appropriate for wealthier taxpayers for whom tax advice is
a necessary part of their financial planning, but I am hard-pressed to
justify tax rules that also create a need for lower-income taxpayers to
hire paid preparers.
Before turning to specific instances of tax complexity, let me
offer my opinion as to the chief causes of unnecessary complexity. If
we face those chief causes--stare at them eyeball to eyeball--perhaps
we can take some steps to eliminate unnecessary complexity in the
future.
Ladies and gentlemen, in the words of Pogo, ``I have met the enemy
and they is us!'' By ``they'' I mean that the causes of complexity
include taxpayers and tax advisors who obtain special provisions for
their clients. ``They'' includes legislative staff, many of whom are
fresh out of school or have never worked ``out there'' in the real
world. Some staff members latch on to trendy economic theories and
craft statutes that are simply impractical. And, with utmost respect,
``they'' also means you. I know that you all have very busy schedules,
but sometimes the tax laws look as though you haven't thought them
through sufficiently. Perhaps it is unreasonable to expect legislators
to understand their legislation in this complex society.
Still, I submit to you that a key element to tax-law draftsmanship
going back to the days of Adam Smith is that tax law should be
understandable. If it is unreasonable to expect you to understand your
own work product, how much more unreasonable is it to expect the
average taxpayer to understand it?
Now to specifics.
Tax-Advantaged Savings Accounts
We are very supportive of tax-advantaged savings accounts.
Nevertheless, recent changes to the IRA rules have made this area
extremely complicated. In 1998, individual taxpayers could choose from
among the
Traditional IRA
Spousal IRA
Nondeductible IRA
The Roth IRA
The Education IRA (EDIRA)
The SEP IRA, and
The Simple IRA.
Availability of many of these phase out as incomes rise. But the
phase-outs are not consistent. For instance, the income phase-out
ranges from $30,000 to $40,000 for a single taxpayer in a traditional
IRA to $150,000 to $160,000 for joint return filers for a spousal IRA
where the spouse is not covered by a qualified plan. The nondeductible
IRA has no income phase-out range at all. The phase-out range for the
Roth IRA is between $95,000 and $110,000 for a single taxpayer and
$150,000 and $160,000 for joint filers. The same phase-out rules apply
for the Education IRA.
Perhaps a little uniformity is in order.
While discussing the area of retirement saving choices, I would be
remiss if I did not mention the complexity of Keogh plans. These are
the retirement plans for the self-employed. Because an algebraic
formula must be used to calculate the maximum Keogh contribution, an
individual owning an unincorporated business and filing a Schedule C is
generally not capable of calculating his or her own self-employed
contribution deduction. Thank goodness for computers!
With all of the current effort to save the Social Security program,
it makes sense to encourage taxpayers to put more into retirement
plans. In the case of the self-employed individual, the deduction
should be a straight percentage of the individual's Schedule C income.
An individual owner of a corporation merely has to multiply his or her
salary by a maximum percentage to determine his or her annual
deduction. Why not the self-employed?
You can also encourage additional contributions to IRAs if you
eliminate or raise the income phase-out ranges. But please make them
uniform throughout the various IRA vehicles.
Phase-Outs
It is not just IRA phase-outs that cry out for reform. This past
year child credits, tuition tax credits and education loan interest
deductions dramatically highlighted the problem with so-called middle-
income phase-outs. Numerous middle class taxpayers who thought Congress
had done something for them with the Taxpayer Relief Act of 1997 were
disappointed, some even angry, to find out that the credits or
deduction didn't apply to them. Who would have thought that a young
married couple just out of school and making $37,500 each would not be
able to deduct student loan interest because their combined income was
too high? Presumably the intended effect was to show middle-income
families that their member in Congress cared about them. The actual
effect for many was disillusionment and even anger. My suggestion would
be to use uniform phase-out schedules that kick in at a higher income
level, if phase-out is necessary at all. This would make the tax system
simpler if not palatable
Retirement Plan Distribution Reform
Another area that needs simplification and reform is Internal
Revenue Code section 401(a)(9), which governs distributions from
qualified retirement plans. Where do you come up with numbers like
59\1/2\ and 70\1/2\? These are the respective ages at which qualified
plan distributions may begin and must begin.
I need to digress a moment and talk about half-years. I always
assumed that \1/2\-year increments are the result of congressional
compromise. They also pop up, for instance, in the depreciation rules,
where the cost of certain buildings must be recovered over 31\1/2\
years. Talk about unnecessary complexity! Ladies and gentlemen, please
stay away from 6-month increments in your compromise discussions.
The current qualified plan distribution rules were first designed
in the early 1960s. In the 1990s they are hurting the elderly who want
or have to work past the traditional retirement age and also widows and
widowers. With ever-greater life expectancies, it is worrisome to the
elderly to require minimum distributions. They feel they may need the
money later in their lives. Also, the tables used to compute minimum
distributions are unisex tables. Because women have a higher life
expectancy, their minimum required distributions are higher than they
should be to match their life expectancies.
This area of the tax law is both overly complex and past its prime
demographically.
Capital Gains and Schedule D
The capital gains rules are another area of unnecessary complexity.
In 1996, the Form 1040, Schedule D, was a single page with 19 lines.
Taxpayers whose only capital gains transactions came from mutual fund
dividends were even excused from filing a Schedule D and could report
their mutual funds capital gain on page 1 of the Form 1040. No longer!
After the 1997 Taxpayer ``Relief '' Act, Schedule D ballooned to 54
lines on two pages. The form became very confusing to the average
taxpayer, not only because of the variety of tax rates--10%, 20%, 25%,
and 28%--but also because it is sometimes so hard to determine what
assets qualify for each of these rates.
Alternative Minimum Tax (AMT)
We have two federal income tax systems, the regular tax and the
alternative minimum tax, or AMT. Theoretically, the AMT is very similar
to the flat tax one hears touted in tax policy circles. What makes the
AMT so complicated, however, is its need to interface with the regular
tax.
The individual AMT is now taxing taxpayers whom it was never
intended to affect. Among the most important reasons for this is that
tax brackets and exemptions are not indexed for the AMT as they are for
the regular income tax. Furthermore, some important credits are either
directly or effectively not allowed against the AMT.\1\
---------------------------------------------------------------------------
\1\ Congress passed legislation last year allowing these credits
against the AMT for 1998 only, creating the need to extend this
palliative in future years. The legislative technique of annual
extenders is very unfortunate. An extender bill introduces unnecessary
uncertainty into the tax law and significantly increases tax compliance
costs when the extender bill is passed late and taxpayers have to file
amended returns. We strongly discourage you from resorting to short-
term extenders.
---------------------------------------------------------------------------
In my firm we had several cases during the past filing season where
taxpayers with adjusted gross incomes below $100,000 were subject to
the AMT. Many taxpayers are not sophisticated in tax matters and have
no idea that they may be subject to the AMT. It is easy to understand
why many taxpayers fail to notice their AMT obligations when filing
their return--it is so unexpected.
The disallowance of certain itemized deductions in the calculation
of the AMT is another AMT feature that surprises taxpayers in the
middle-income group. For AMT purposes, taxpayers lose itemized
deductions, which are already reduced by the 3% AGI adjustment as well
as the 2% miscellaneous deduction floor. Furthermore, medical expenses
are disallowed to the extent that they do not exceed 10% of AGI. Under
the regular tax, medical expenses are permitted to the extent they
exceed 7\1/2\% of AGI. One of my colleagues faxed me a startling
example. It involves a divorced mother of two who received $102,000 of
alimony and had an AGI of $108,000. She paid nearly $7,800 of
additional tax due to the AMT because $14,000 of state tax\2\ and
$10,000 of home mortgage interest was not deductible for AMT purposes.
---------------------------------------------------------------------------
\2\ $12,426 of real estate taxes and $1,619 of state income taxes.
All numbers used in the example above are rounded.
---------------------------------------------------------------------------
I should also note that the AMT is rather unfair to taxpayers in
high tax states such as New York and California. Taxpayers with the
same AGI often will pay AMT if they live in high-tax states, but not
trigger the AMT if they live in low-tax states.
Small businesses are also adversely affected by the Alternative
Minimum Tax. One component of the AMT calculation, the ACE adjustment,
requires the calculation of depreciation three different ways. Small
business taxpayers who are not subject to the alternative tax must
still make this calculation because a negative ACE adjustment could be
of benefit to them in future years if they become subject to the
Alternative Minimum Tax. Although the ACE adjustment for depreciation
has been eliminated prospectively, those with assets placed in service
prior to the enactment of that legislation are still required to
calculate the ACE adjustment depreciation.
Recommendations for Change in the AMT
The easiest way to eliminate the complexity of the Alternative
Minimum Tax would be to repeal it. I understand this is a very
political issue and is much easier said than done. However, if
repealing the AMT is not a possibility, there are several changes that
can be made to the individual Alternative Minimum Tax that would help
reduce its complexity. These include the following:
Index the AMT brackets and exemption amounts.
Eliminate any add-back of itemized deductions and personal
exemptions in calculating alternative minimum taxable income.
Permanently allow certain regular tax credits as credits
against the AMT.
Exclude low- and middle-income taxpayers from being
subject to the AMT by providing an exemption when adjusted gross income
(AGI) is less than $100,000 (indexed).
Small business relief from the Alternative Minimum Tax could be
accomplished by eliminating the ACE calculation completely and
increasing the corporate exemption from AMT to eliminate small
businesses under an indexed dollar amount of annual sales (higher than
the current exemption).
The ``Kiddie Tax''
The ``kiddie tax'' was enacted to keep parents from shifting income
to lower-tax children. It was passed along with several other measures
to curtail this practice, including the elimination of ``Clifford
trusts'' and the prohibition against a child taking a full personal
exemption while the parents take the dependency deduction. The lowering
of the top tax bracket also reduced the incentive to shift income. I
believe the kiddie tax was overkill and these other provisions were
sufficient to curtail abuse.
In any event the kiddie tax is very complicated, requiring the
running and rerunning of a family's tax return to arrive at the correct
tax. Also, it is not designed quite correctly and can result in a
higher tax than if the income were kept with the parent. Two examples
in which this occurs are where the parents have capital losses while
the children have capital gains and where the parents have investment
interest limitations.
Administrative Reforms
We would also like to suggest two administrative reforms that would
greatly simplify representation of individuals and small businesses.
First interim extensions (July 15 for partnerships and trusts and
August for individuals) should be eliminated and the initial extensions
should be for six months. And second, powers of attorney are a
perennial source of irritation in relations between the IRS and the
practitioner community. Consideration should be given to a ``check the
box'' power of attorney or ``tax information authorization,'' whereby
the taxpayer can check a box on the tax return at the time of filing
giving the IRS permission to discuss the contents of the tax return
with the preparer who has signed the tax return.
Conclusion
I sincerely thank you for the opportunity to testify here today. It
is an experience I will always cherish. Let me end by reminding you of
one of Adam Smith's four ``maxims'' of taxation--certainty.
Specifically, Smith advised, ``The tax which each individual is bound
to pay ought to be certain, and not arbitrary. The time of payment, the
manner of payment, the quantity to be paid ought all to be clear and
plain to the contributor, and to every other person.'' This is good
advice as you move to amend the Internal Revenue Code. If we regain the
sense that taxes need to be ``clear and plain to every contributor,''
tax complexity will never be an issue.
Chairman Houghton. Thanks very much, Mr. Sokolski.
Mr. Smith.
STATEMENT OF STEPHEN B. SMITH, CPA, GENERAL PARTNER, WILLIAMS-
KEEPERS CPA'S LLP, COLUMBIA, MISSOURI
Mr. Smith. Thank you, Mr. Chairman. Mr. Chairman and
Members of this distinguished Subcommittee, I am Stephen B.
Smith. I am a practicing CPA from Columbia, Missouri. And I
appear before you today with observations from the viewpoint of
a practitioner with 30 years experience in the field of
taxation.
Before drawing your attention to a few aspects of my
prepared testimony and at the risk of appearing to curry favor,
I would like to refer to the chairman's Tax Simplification and
Burden Reduction Act. I did not have the benefit of the
chairman's May 12 statement concerning that Act when I prepared
my testimony prior to going on vacation. In summary, and
without exception, it is an excellent start on the road to tax
simplification. I believe it does not go far enough in the
alternative minimum tax area, however.
Referring to my prepared statement, I draw your attention
to the fact that my comments are divided into two areas: those
requiring statutory changes, the logical province of this
Subcommittee, and those requiring administrative action.
Dealing first with what I perceive to be the largest
problem and, perhaps, somewhat repeatedly, the alternative
minimum tax needs to be repealed outright. As I recall, this
tax was conceived 20 years ago as a political reaction to a
very limited number of high-income individuals who paid no
income tax. It was instituted in order to collect taxes on
fewer than 500 returns out of something on the order now of
about 90 million returns that would be filed. It is to be
repealed outright, as I said.
However, it traps more taxpayers each succeeding year and
thereby generates revenue, the ability to repeal it in a
revenue-neutral environment gets successively difficult. I am
reminded of the commercial, one of the punchlines of which was
you can pay me now or you can pay me later, but every year it
gets to be more expensive to consider repealing this. This is a
stealth tax. It is a parallel tax universe with significant
impact and almost no ability to be predicted with any degree of
certainty and economy of effort.
Few taxpayers can describe it at all. A substantial number
of tax professionals such as Mr. Sokolski and I cannot
accurately describe it. And I would throw myself into that
group also. If it is politically impossible to abolish it
outright, the bare minimum changes should be to exempt State
and local income taxes from the calculations and to index the
brackets for change.
The cumulative effects of complexity affect all of us.
Although each individual rule may be capable of explanation,
the cumulative effect of many different provisions, each
requiring a unique understanding of income levels, facts, and
circumstances to which they do apply, they don't apply, or they
might apply causes many taxpayers to simply give up any attempt
at preparing their own returns. This failure to prepare their
own return produces a citizenry which is more removed from the
tax laws of our country and more removed, more importantly,
from the details of their own finances. Both are detrimental to
our society.
The current code is so complex that many taxpayers are
suspicious that someone else is gaining an unknown advantage on
them. The result of this is a compensation for the perceived
inequity and voluntary compliance goes down. This is a
euphemism for the process whereby individual taxpayers don't
report income or overstate deductions in order to decrease the
amount of tax paid and, therefore, be fair. Even ignoring
fairness completely, we believe that a significant minority of
taxpayers' actions are influenced by alternating attacks of
greed and fear. And with few or no IRS field audits to worry
about, fear is the less dominant concern and compliance goes
down.
A simplified filing process would be greatly to the
advantage of all. The perceived complexity unnecessarily scares
millions of taxpayers into hiring others to prepare a return
which should be easy to self-prepare and the exclusion of a de
minimis amount of interest and dividends from taxation, such as
those that have been proposed on more than one occasion, would
serve to remove many returns from the realm of the paid
preparer.
Although I prefer the chairman's proposal for capital
gains, the Coyne-Matsui Capital Gains Tax Simplification Bill
would also solve the problem. And many parts of Mr. Neal's
Individual Tax Simplification Act of 1999 addressed complexity
which need attention. Thank you for the privilege of appearing
before you today and I would be pleased to answer any questions
you might have.
[The prepared statement follows:]
Statement of Stephen B. Smith, CPA, General Partner, Williams-Keeper
CPA's LLP, Columbia, Missouri
Introductory Comments
Mr. Chairman, and members of this distinguished subcommittee: My
name is Stephen B. Smith, and I am a general partner in Williams-
Keepers CPA's LLP. Our firm is located in Mid-Missouri and encompasses
the talents and efforts of more than 80 of my colleagues in our three
offices. We assist over two thousand clients in their dealings with
various taxing authorities. I am not notable for any historic interest
in tax policy or lobbying for or against specific Internal Revenue Code
changes. My comments are contributed as ``observations from the
Heartland.''
Speaking personally from the perspective of thirty years of tax
practice I have seen the Internal Revenue Code become increasingly
complex, more expensive to comply with and viewed as unfair in many
material aspects. The disdain of many taxpayers for the societal
engineering which permeates the tax law is palpable. In addition, with
reduced personal contact between taxpayers and the Internal Revenue
Service, many taxpayers now view compliance as a lottery; and,
voluntary compliance has declined. Many have no faith in the system and
believe it to be inherently unfair. The significant majority of high-
income taxpayers have never had an IRS field audit.
To be viewed as fair, we believe any tax system must be:
1. Uniform
2. Understandable
3. Administered impartially
4. Reasonable in relation to the income of the payer
5. Not unduly burdensome with which to comply
At the moment, we believe only #3 would be generally acclaimed to
be present. Our experiences with the vast bulk of Internal Revenue
Service employees prove them to be dedicated to their jobs. Many of
them feel they do not have adequate support or adequate tools to do
their job, but they do the best they can. There clearly is room for
improvement and we refer below to some of the most-needed areas based
on our day-to-day experiences.
We firmly believe a small group of trained tax practitioners could
materially simplify the Internal Revenue Code, on a revenue-neutral
basis, if exempted from the lobbying process. The Alternative Minimum
Tax solution, referred to below, might require an exemption from the
charge to make all changes on a revenue-neutral basis. I have divided
my comments below into two areas: first, those requiring legislative
change; second, those requiring administrative action alone.
Suggestions for Internal Revenue Code Changes
Repeal or drastically amend the Alternative Minimum Tax (AMT). This
tax was conceived twenty years ago as a political reaction to a very
limited number of high income individuals who paid no income tax. My
recollection is that it was instituted in order to collect taxes on
fewer than 500 returns. Originally designed to apply to a handful of
wealthy taxpayers, it can reasonably be expected to apply to millions
of taxpayers in the very near future. It ought to be repealed outright.
However, it traps more taxpayers each succeeding year and thereby
generates revenue. The ability to repeal it in a ``revenue-neutral''
environment gets more difficult each year. It is, practically speaking,
impossible to determine without an unreasonable effort. Generally the
only time the true amount of AMT tax can be calculated, if indeed it
can be calculated at all, is annually during the tax preparation
process. It is a ``stealth'' tax. It is a parallel tax universe with
significant impact and almost no ability to be predicted with any
degree of certainty and economy of effort. Few taxpayers can describe
it at all. A substantial number of professional tax practitioners
cannot accurately describe it. It would be far preferable, nationally,
for the tax to be wiped out and to allow a relatively few persons to
pay no tax at all than to cause the pain and suffering on the scale it
currently produces. The AMT may be the single most unknown or
unexpected tax and strikes taxpayers in many cases solely because of
their state of residence. High-tax-state taxpayers are thus treated
differently, nationally, solely because of the tax burden of a
political subdivision below the Federal level. If it is politically
impossible to abolish the tax, the minimum changes should be to exempt
state and local income taxes from the calculations and index the
brackets for inflation.
Change underpayment rules for the individual estimated tax safe
harbor. For many years the underpayment of individual income tax safe
harbor rules provided a simple test permitting 100 percent of the prior
year's tax liability to serve as a safe harbor for avoiding penalties
for failure to ``quarterly'' pay enough income tax. As a revenue-
raising measure the safe harbor was initially raised for several years,
then subsequently structured to fluctuate up and down over a period of
years, again solely as a revenue-balancing measure. The old rule was
simple, effective and economical to compute and follow. The new rules
are unduly complicated and for many taxpayers very expensive to
compute. The new rules do not, in the end, change the amount of the
tax. In many cases taxpayers are required to make elaborate
calculations as many as three times a year. A return to the original
safe harbor would be a significant simplification for many taxpayers
who do not otherwise have complex returns, but have incomes which
fluctuate from year to year.
Coordinate phaseout rules. Different rules for phaseouts should be
coordinated. The lack of coordination among phaseouts that apply to
different provisions should be remedied. Recent years have produced a
plethora of ``targeted'' credits and special provisions that are phased
in or out at different levels of income. Although the various levels
may well have been set at different times based on fiscal cost
estimates, the lack of a small group of homogenous rules for
determining phase-in or phase-out produces a degree of complexity that
cannot be overemphasized. Breaking phaseouts into two or three
categories and applying uniform rules to each category would ease the
ability to increase the utilization of all credits and phaseouts.
Reverse the effects of cumulative complexity. Although each
individual rule may be capable of explanation, the cumulative effect of
many different provisions, each requiring unique understanding of the
income levels, facts and circumstances to which they apply, or don't
apply, causes many taxpayers to simply give up any attempt at preparing
their own returns. This failure to prepare their own return produces a
citizenry which is more removed from the tax laws of our country and
more removed from the details of their own finances. Both are
detrimental to our society. The current Internal Revenue Code can be
analogized to a family home which has been much remodeled over the
years. Each successive remodeling ``chopped up'' the house into smaller
and smaller unique spaces. Moving about the house increased in
difficulty. New owners ``gut'' the house, opening it up, restoring the
simplicity and beauty which was originally present. The current
Internal Revenue Code needs new owners, statesmen who are prepared to
withstand the lobbyists' incessant pressure, in order to return the tax
code to a system which once again is sufficiently comprehensible as to
inspire confidence and permit an economical system of self-assessment
with a high degree of compliance. The Code is currently so complex that
many taxpayers are suspicious that ``someone else'' is gaining an
unknown advantage on them. In order to compensate for the perceived
inequity, voluntary compliance goes down. This is a polite euphemism
for the process whereby income is not reported and/or deductions are
increased in order to cause the tax amount to be less, and, therefore,
``fair.'' Even ignoring fairness completely, we believe a significant
minority of taxpayers' actions are influenced by alternating attacks of
``greed'' and ``fear.'' With few or no IRS field audits to worry about,
fear is the less dominant concern. Compliance goes down.
Increase the number of taxpayers qualifying for a simplified filing
process. An additional goal should be to remove taxpayers from the
complexities of the filing process, to the maximum extent possible.
Perceived complexity unnecessarily scares millions of taxpayers into
hiring others to prepare a tax return which should be easy to self-
prepare. Many taxpayers have only Forms W-2 and a relatively small
amount of interest or dividends to report. The inclusion of the
interest or dividend statements frequently causes an outside preparer
to be engaged. In many cases, that is unnecessary. The exclusion of a
de minimis amount of interest and dividends from taxation, such as
proposed by The Savings Advancement and Enhancement Act, would serve to
remove many returns from the realm of the paid preparer and at the same
time encourage savings and investment.
The ``marriage penalty.'' Those sections of the Code which produce
a marriage penalty should be repealed and a married couple should be
treated no worse than two single individuals who cohabit. Although this
is a policy issue, computer software currently available at mass-market
prices provides a diagnostic which alerts the user to the fact that a
Married Filing Separately status may save a married couple money. Since
this diagnostic is generated only after the completion of a MFJ return,
the inefficiencies of dividing and re-entering information to capture
the savings possible in MFS are notorious. The Marriage Penalty should
be eliminated and two married individuals should individually be
treated on a par with single individuals.
Suggestions for Administrative Changes Within the IRS
Filing by electronic means. The current process which permits the
filing of tax returns by telephone for simpler returns should be
expanded. Filing using the Internet, email and other electronic media
should be developed and implemented as quickly as possible. In
addition, sufficient taxpayer education should be undertaken in order
to inform the public about the availability of alternatives to mailed
paper forms.
The IRS budget. Reverse the erosion of the IRS budget. Incredibly,
as tax returns have grown exponentially more complicated, the IRS has
constantly reduced face-to-face taxpayer contact opportunities, closed
IRS offices and consolidated IRS personnel in increasingly isolated
surroundings and generally removed the human factor from the tax
collection process. Although this can and does reduce the nominal costs
of collection, the toll it exacts in the form of expenses for hired
professional help, confusion about tax law, reduced compliance and
other more intangible detriments reduce the efficiencies claimed. Most
taxpayers are not trained tax professionals. There is a significant
need for increased opportunities for face-to-face contact with IRS
professionals. Most individuals are visual learners. We need help in
understanding that which we cannot understand. Telephone contacts will
not replace human interaction for many of those taxpayers most in need
of special assistance.
Increase investment in technology. As tax practitioners one of the
greatest hindrances we face is the lack of good technology on the part
of the IRS when we need to interact with them concerning a taxpayer's
account. At the present time we believe that IRS accounts are updated
on a weekly basis to reflect changes in a taxpayer's account. In a
virtual Windows World we are forced to deal with a system based on
Worse-Than-DOS computers and accounts that are only updated weekly.
Powers of Attorney which permit a CPA to represent a client are
regularly unable to be documented online, requiring a continuous stream
of faxes in order to document our ability to speak for the taxpayer as
we wind our way through the telephone maze. We are respectful of the
needs to secure privacy, but the current system is inadequate for
telephone contacts. Lengthy lag times following contact between the
taxpayer (or his/her professional representative) and inclusion of any
results in the IRS database guarantees significant confusion about
whether a particular telephone or mail contact actually accomplished
the promised results. This generates additional correspondence/contacts
which further degrade efficiency. Increased reliance on other forms of
electronic communications such as email as a substitute for taxpayer
contact should be investigated and implemented at the earliest possible
date. In addition, the IRS should consider adopting that portion of the
airlines' reservations database technology which permits each IRS
employee who deals with an account to record substantial detail as to
the steps taken. Frequently repeated contacts are necessary because
telephonic contacts are not documented or not capable of being
documented. Subsequent contacts then re-commence from ``square one.''
Errors in overpayments. The number of tax overpayments applied to
future tax periods which are refunded in error appear to be out of
proportion to the expected number of such errors. In addition, it is
clear that IRS computers do not adequately capture information on Form
2210 pertaining to the exceptions from penalty for underpayment of
estimated tax utilizing annualization of income over 3, 5 and 8-month
periods. This failure generates notices of penalty which should never
be generated based on the information filed with the return.
Thank you for the opportunity to provide perspective on these
matters.
Chairman Houghton. Thank you, gentlemen, very much. We have
to vote now, so let us try to go through the questions--I will
hold off on my questions--and see whether we can do this so you
won't have to wait. Then we will have a recess and go back to
the next panel.
Mr. Coyne.
Mr. Coyne. No, Mr. Chairman.
Chairman Houghton. No questions. Mr. Neal.
Mr. Neal. Thank you, Mr. Chairman.
Mr. Smith, you touched upon it in your testimony. You spoke
about a growing complexity of the Tax Code and the disgusting
reaction from your clients. Would you elaborate on that a bit
more?
Mr. Smith. I think the disgust comes from the fact that
several of us have alluded today. The code should not be beyond
the province of an average American. It doesn't mean that every
single one of our citizens should be able to understand it
completely, but certainly the average American should be able
to understand how to prepare their own income taxes.
When they cannot and they can do nothing about it, they
have only one reaction left and that is frustration. That is
the last avenue. I can't fight it and I can't flee it. And,
unfortunately, some of them don't flow it very well, either.
Mr. Neal. Thank you. Thanks, Mr. Chairman.
Chairman Houghton. Mr. Weller.
Mr. Weller. Thank you, Mr. Chairman. And, Mr. Smith, I
would like to direct my question to you. By the way, you have a
fine representative in Kenny Hulshof, my seatmate here. He does
a great job as a Member of this Committee.
You had, in your testimony, of course you focused as all of
us are today, on the need to simplify the code and the
taxpayers' frustration and you as a tax practitioner with the
complications in the Tax Code. Over the last few years in
particular, there has been the desire by some to focus every
time there is a new initiative to provide tax relief, to target
it. And I once had a gentleman say, you know what targeted tax
cut means? That means very few get very little. And, as a
result of that, you know, the various targeted tax relief that
has been adopted by Congress and the initiative of the White
House in the last few years has created quite a few targeted
tax cuts.
What, from a general standpoint, in your view as a tax
practitioner, how has this made your job more difficult? Or has
it made it more easy, having so-called targeted tax cuts?
Mr. Smith. First of all, it clearly has not made it more
easy. So we can dispense with that side of it, immediately. And
I am sure Mr. Sokolski would join me in saying that.
Second, targeted tax credits produce two reactions amongst
my clients. One is palpable disdain for societal engineering.
The second is a little more complex. Essentially--and I
address that in my prepared testimony--because if you are going
to have--and that, of course, is a policy decision beyond my
purview--if you are going to have them at all, targeted
legislation should be subjected to phaseouts that are
appropriate for high-income taxpayers, perhaps medium-income
taxpayers, and a low-income group of taxpayers.
And I would urge this Committee to conform the definitions
so that the same definition applies for ``individual'' and
``exemption'' and the other things, for example, in the ITC and
HOPE credit and some of these. And to take the income levels
that they apply and rationalize them so that they all apply at
the same level. And if, in a revenue-neutral environment, you
have to change those amounts a little bit in order to get the
CBO numbers to come out right, then do it.
But there are something like 15 different phaseout levels
and I can go to a book and find them, but I have the book. How
many of the 90-million returns have people that have a book
that is 2 inches thick right at their right hand where they can
go look at it or have some chance of knowing it offhand? They
don't. And they really have no real easy way to get it,
although with the advent of the Internet, I think we are going
to find that some information will, be easier to obtain than it
has been in the past.
Mr. Weller. OK.
Mr. Smith. And in my administrative comments, which I, in
the interest of time, skipped over, I believe the IRS should
clearly be making steps and plans now to utilize the Internet.
It is extremely efficient. It can be dealt with once for a lot
of people and it can be accessed millions of times, at no cost,
as opposed to the rather unsatisfactory telephone contacts that
have to be made now.
Mr. Weller. Thank you. Mr. Chairman, I know Mr. Hulshof
would like to ask questions so I will yield back.
Chairman Houghton. Thanks. Mr. Hulshof.
Mr. Hulshof. Thanks, Mr. Chairman. And let me just say how
much I appreciate you allowing me to invite a constituent here
to provide this testimony. And, Mr. Smith, let me just say, you
need not worry about an attempt to curry favor with the
chairman. Those of us on this side of the dais attempt to do
the same thing on a daily basis, so we welcome you here. Just a
couple of quick questions. And I want to associate myself with
the remarks of Mr. Neal earlier today regarding the SAVE Act.
And you make reference to the fact that many returns would
be removed from the realm of the paid preparer, to paraphrase
your testimony. I think the actual numbers are 7-million
taxpayers would no longer have to file a schedule B tax form if
we were to enact the $200, $400 exclusion, and an additional
10-million taxpayers would be able to file the 1040 EZ form
were we to implement this one change in the Tax Code.
You touched on this briefly, Mr. Smith. I want to give you
a chance to expand just a bit. How well acquainted do you think
that the average American citizen is with his or her finances?
Mr. Smith. I think I have been quoted as saying that many
of them are about as well acquainted with them as the father
salmon is with one of their offspring. Not very, in other
words. [Laughter.]
Mr. Hulshof. And, as a result of that, not to have you run
afoul of members of your profession of certified public
accountants or paid preparers, but, I mean, how does this lack
of acquaintanceship with one's own finances, how does that
affect whether or not you involve a paid preparer?
Mr. Smith. Well, frankly, it causes people to spend money
with us unnecessarily. And, in doing so, many taxpayers take
the position that it is in a box, the old, classic shoe box,
and they hand it to us, at least at my level of practice they
do, and that is sort of the end of it. It is sort of like
putting the body in a bag and shipping it off. And then they
come back and sign the return at the very end. It is a sort of
casual process of dealing with the largest expense that many
people have.
If you think about it, Federal and State taxes are larger
for many people, although not for all, obviously, than any
other expense, including their home. And yet, annually, they
turn over their calculation of that tax to me, a relative
complete stranger. I think many of them would be much better
off to do it themselves. And I am sure my union will have some
chat with me in the locker room afterward.
But, truthfully, for the good of the country, we would be a
lot better off if we got 10 million or 15 million people just
flat out of the system and head some way to turn it into a
telephone filing system or an Internet filing system or, less
acceptably, a mail filing system that is capable of even having
the service match up their very good reports of wages and other
income and then sending me a bill. And I think, hopefully, it
will come to that someday.
Mr. Hulshof. And I think that, probably, Mr. Chairman, is a
good note to end on, recognizing our time is drawing close for
a vote. Thank both of you gentlemen for being here.
Chairman Houghton. Yes. Thanks very much, gentlemen.
Certainly appreciate it.
[Recess.]
Chairman Houghton. We will begin our next panel. We have
Mr. Tucker, chairman of the Section on Taxation of the American
Bar Association; David Lifson, chairman of the Tax Executive
Committee, the American Institute of Certified Public
Accountants in New York; the famous Mr. Harry L. Gutman, a
partner with KPMG; Mr. Gerry Harkins, general manager and owner
and operator of Southern Pan Services Company in Conley,
Georgia; and, Mr. Eugene Steuerle, senior fellow of the Urban
Institute, National Tax Association.
Gentlemen, thanks very much for being here.
Mr. Tucker, would you begin?
STATEMENT OF STEFAN F. TUCKER, CHAIR, SECTION OF TAXATION,
AMERICAN BAR ASSOCIATION
Mr. Tucker. Yes, Sir, Mr. Chairman and Members of the
Subcommittee. My name is Stefan Tucker. I am appearing today in
my capacity as chair of the American Bar Association Section of
Taxation and my testimony is presented on behalf of the Tax
Section. As you probably know, we are comprised of
approximately 18,000 tax lawyers. We are the largest and
broadest-based professional organization of tax lawyers in the
country, and we are the national representatives of the legal
profession with regard to the tax system.
On behalf of the section, I would like to thank the
Chairman and the Members of this Subcommittee for their focus
on eliminating complexity in the Tax Code. Mr. Chairman, we are
looking forward to your introduction of the Tax Simplification
and Burden Reduction Act of 1999 and, frankly, we are quite
pleased that the proposed legislation will include several of
the Tax Section's proposals.
We are also pleased to have read Congressman Neal's Act and
noted that, both as to the AMT and as to a number of other
provisions, you have focused on items that we have focused on.
And, Congressman Coyne, we were pleased to see, has taken a
very careful look with Congressman Matsui at the capital gains
provisions and their complexity. And, finally, Congressman
Portman has looked at the pension and profit sharing
complexities which are, in my mind, extraordinary. And we think
that we really do need to focus on these complexities.
We have said for a long time in the ABA Tax Section, we
have testified during my tenure as chairman of the ABA Tax
Section on complexity and simplification and we believe very
strongly in the same. Now you may wonder why would tax lawyers
want to see simplification? I can tell you that our membership
in the Tax Section has gone down by 10,000 persons over the
last 12 years. Complexity is not something that engenders
confidence in either the taxpayers or the practitioners and we
think that is something to know.
I think it is interesting to see that a number of our
younger members are now specialists in anywhere from three to
six provisions of the entire Internal Revenue Code. Whereas
when I started 36 years ago, we were able to focus on the
Internal Revenue Code as a code. You noted that there is one
thick volume with very thin pages. The regulations are six
volumes with very thin pages and there are virtually no
regulations yet on the 1997 or 1998 legislation. And the more
that we do, the more complex it becomes, the more we enhance
people looking at ways to get around the system and to avoid
the system and that does none of us any good.
Earlier this year, in February, I wrote a letter to
Secretary Rubin with a concern and a great deal of
disappointment that the President's budget proposals had added
a multitude of proposed new tax credits to the income tax
system. And we think that does none of us any good either. So
we were very concerned in that, in particular on phaseouts. And
we really think that, as Congressman Neal said before, you need
to jump start the system of simplification. I learned a long
time ago that a journey of 1,000 miles starts with one small
step. Of course, it was stated by somebody whose political
philosophy may not have been the most desirable, but it still
does start with one small step.
We have a number of specific tax proposals in our written
testimony. We would note that a number of them are the same as
the AICPA and others have noted to you. We have a number of the
same concerns. The first and foremost is the AMT, the
alternative minimum tax. There are at least four significant
tax problems with the AMT. No. 1, it no longer is necessary to
fulfill its original intended purpose.
No. 2, it increasingly affects an unintended class of
taxpayers, middle-class taxpayers who are not engaged in tax
shelter or deferral strategies. As someone said, we started
with a few people who were not paying any tax and we have
broadened to the remainder of the world. It is too complex. It
creates too much of a compliance burden. And a number of the
adjustments and preference items are inappropriate from both a
policy and a technical perspective.
We think you ought to repeal the individual AMT. If you
don't repeal it, we think you need to raise the threshold so
that people below an average AGI, for example, of $200,000 are
not subject to the AMT. Or partially repeal it. We have noted
before, time and again, that itemized deductions create AMT.
Mortgage interest creates AMT. That is a very strange result.
Real estate taxes and State and local income taxes create AMT.
That is not an intended result. We think you ought to focus on
at least, at the very least, indexing, which was never done and
at least would pick up something.
We note there are problems with the phaseout of itemized
deductions and personal exemptions. We concur with what was
said before that people are more interested in eliminating
these hidden taxes and seeing the real tax rates.
And then, finally, there are a number of items in our
specific proposals that have come from our committees and we
would just note three of them to you. One is we think you ought
to repeal the 2 percent floor on miscellaneous itemized
deductions. Second, we think you ought to simplify alternatives
for family status issues. And, third, we think you ought to
simplify subchapter S and maybe even consider, in light of
limited liability companies, eliminating subchapter S and just
recognize that for small business there ought to be a single
tax regime. Thank you.
[The prepared statement follows:]
Statement of Stefan F. Tucker, Chair, Section of Taxation, American
Bar Association
Mr. Chairman and Members of the Subcommittee: My name is Stefan F.
Tucker. I appear before you today in my capacity as Chair of the
American Bar Association Section of Taxation. This testimony is
presented on behalf of the Tax Section. Accordingly, except as
otherwise indicated, it has not been approved by the House of Delegates
or the Board of Governors of the American Bar Association and,
accordingly, should not be construed as representing the policy of the
Association.
As you know, the ABA Tax Section is comprised of approximately
18,000 tax lawyers. As the largest and broadest-based professional
organization of tax lawyers in the country, we serve as the national
representative of the legal profession with regard to the tax system.
We regularly and continuously advise individuals, trusts and estates
and small businesses, as well as exempt organizations and major
national and multi-national corporations. We serve as attorneys in law
firms, as in-house counsel, and as advisors in other, multidisciplinary
practices. Many of the Section's members have served on the staffs of
the Congressional tax-writing Committees, in the Treasury Department
and the Internal Revenue Service, and the Tax Division of the
Department of Justice. Virtually every former Assistant Secretary of
the Treasury for Tax Policy, Commissioner of Internal Revenue, Chief
Counsel of the Internal Revenue Service and Chief of Staff of the Joint
Committee on Taxation is a member of the Section.
The Section appreciates the opportunity to appear before the
Subcommittee today to discuss simplification. On behalf of the Section,
I want to thank the Chairman and the Members of this Subcommittee for
their focus on eliminating complexity in the tax code. We are truly
looking forward to the introduction by the Chairman of The Tax
Simplification and Burden Reduction Act; we are very pleased that the
proposed legislation will include several of the Tax Section's
proposals. As you are aware, we consider the elimination of complexity
to be of the utmost importance, and the Section and its members are
ready, willing and able to work with you in order to accomplish needed
change.
Simplification and Complexity
The ABA and its Tax Section have long been forceful advocates for
simplification of the Internal Revenue Code. In resolutions proposed by
the Tax Section and passed by the full ABA in 1976 and 1985, the ABA
went on record urging tax law simplicity, a broad tax base and lower
tax rates. We have reiterated this position in testimony before the
House Ways and Means and Senate Finance Committees on numerous
occasions.
In recent years, the Code has become more and more complex, as
Congress and various administrations have sought to address difficult
issues, target various tax incentives and raise revenue without
explicit rate increases. As the complexity of the Code has increased,
so has the complexity of the regulations that the IRS and Treasury have
issued interpreting the Code. Moreover, the sheer volume of tax law
changes has made learning and understanding these new provisions
difficult for taxpayers, tax practitioners and Service personnel alike.
The volume of changes, especially recent changes affecting average
taxpayers, has created the impression of instability and unmanageable
tax complexity. This takes a tremendous toll on taxpayer confidence.
This Subcommittee often hears how our tax system relies heavily on the
willingness of the average taxpayer voluntarily to comply with his or
her tax obligations. Members of the Tax Section can attest to the
widespread disaffection among taxpayers with the current Code. The
willingness and ability of taxpayers to keep up with the pace and
complexity of changes is now under serious stress.
Tax law changes are again under discussion. The Tax Section does
not take a position with respect to the wisdom of particular levels of
taxation or of particular broad-based tax reduction proposals. We do
urge, however, that the members of this Subcommittee keep
simplification and avoidance of complexity uppermost in their minds as
any tax reduction packages are fashioned. Tax relief can be delivered
in ways that avoid new, complicated rules, such as phase-outs, multiple
choice elections and highly detailed conditions. While simple, broad-
based tax reductions may not have the cachet of the newer style, more
targeted provisions, they will avoid the layering of new complexity
over old. If Congress chooses to reduce taxes, we urge you to do no
harm.
To this end, I, on behalf of the Tax Section, earlier this year
sent to Secretary Rubin a letter expressing our disappointment that the
President's budget proposes to add a multitude of new tax credits to
the Federal income tax system. Our point in that letter was that,
although each credit taken in isolation could be viewed as meritorious,
that kind of micro-balancing inevitably leads to the type of tax system
that is, in total, overly complex and undeserving of public respect.
Particularly in light of the various, complicated provisions added by
the Taxpayer Relief Act of 1997, Congress and the Administration must
focus on the cumulative impact of all new provisions sought to be
added. We continue to urge that the leaders of the tax legislative
process--including this Subcommittee--resist the accretion of income
tax benefits and penalties that are unrelated to the administrable
measurement of annual taxable income and ability to pay.
My letter to Secretary Rubin also urged that particularly close
scrutiny be given to any proposals that include income phaseouts. These
phaseouts have gained popularity in the last two decades and are
responsible for a significant amount of the complexity imposed on
individual taxpayers. Phaseouts create the effect of a marginal rate
increase as a taxpayer's income moves through the phaseout range, and
the effects of multiple phaseouts on the same taxpayer can create
capricious results. Phaseouts also blunt the intended incentive effect,
because taxpayers cannot predict whether benefits will be available to
them. Phaseouts also play a significant role in the creation of
marriage tax ``penalties,'' and add to the difficulty in addressing
that set of issues. We urge you to resist their continued use in the
enactment of additional tax incentives.
We do not claim to have all the answers. The Tax Section will
continue to point out opportunities to achieve simplification whenever
possible, including several ideas that we will discuss later in this
testimony. However, it is also necessary that we point out that
simplification necessitates hard choices and a willingness to embrace
proposals that are often dull and without passionate political
constituencies. Simplification also requires that easy, politically
popular, proposals be avoided if they would add significant new
complexity. Simplification--and preventing greater complexity--may not
garner political capital or headlines, but it is crucial. It requires
leadership from the Administration and from the tax-writing committees.
To date, simplification has not achieved the commitment that we
believe is required. Too often, other objectives have tended to crowd
simplification out as a priority. We urge the members of this
Subcommittee to adjust this balance by endorsing simplification as a
bedrock principle and communicating that principle to all involved in
the tax-writing process.
To that end, the Congress adopted as part of the IRS Restructuring
and Reform Act of 1998 a procedure to analyze the complexity of
proposals with widespread applicability to individuals or small
business. By means of this complexity analysis, the Joint Committee on
Taxation will call attention to provisions that could result in
substantial increases in complexity, and will suggest ways in which the
goals of those proposals can be achieved in simpler ways. We strongly
support this increased focus on complexity and urge the members of this
Committee, and especially this Subcommittee, to pay heed to the JCT
analyses. Only by raising awareness of problems with proposals before
they become law will Congress make substantial inroads into the
problem.
Specific Proposals
We would now like to address certain specific areas in which the
Tax Section considers the need for simplification immediate. We begin
with the alternative minimum tax, which is an area that we believe
demands the immediate attention of this Congress. As this Subcommittee
is well aware, there is an inherent problem with the individual AMT
which, if not dealt with in one way or another, will result in
approximately 9 million additional taxpayers becoming AMT taxpayers
within the next decade. Many have referred to this problem as a
``ticking time bomb.'' Most of these additional taxpayers are not of
the type envisioned as being subject to the AMT when it was revised in
1986. Moreover, many of these individuals will not even be aware they
are subject to the AMT until completing their returns or, worse,
receiving deficiency notices from the IRS. We are continuing to confer
with our counterparts at the Tax Division of the AICPA concerning our
respective positions on the AMT, and we have found that our two groups
are in accord on the importance of addressing the AMT issue promptly.
We wish to acknowledge the Chairman's understanding of the problems
attendant to the AMT, as reflected in the first three items of his list
of provisions for his proposed legislation, and for his leadership in
seeking to reduce complexity. We are pleased that Congressman Coyne (D-
PA) has introduced a simplification bill. (See H.R. 1407 (106th
Cong.).) We also would like to commend Congressman Neal (D-MA) for his
recognition of the problems that the Tax Section perceives as
associated with the individual AMT and for his proposal to repeal the
personal exemption phaseout and the overall limitation on miscellanous
itemized deductions--an issue which I will discuss in more detail later
in this testimony. (See H.R. 1420 (106th Cong., 1st Session, 1999.)
A. Alternative Minimum Tax
1. Background
Individuals first became subject to an ``add-on'' minimum tax in
1969, enactment of which was precipitated by concerns that some
taxpayers with significant economic income were paying little or no tax
because of excessive investments in tax shelters. This add-on tax
ultimately was repealed and replaced with a minimum tax payable to the
extent that an individual's AMT liability exceeded his or her regular
tax liability. This minimum tax--which eventually morphed into an
entirely separate, parallel, tax system--has been modified several
times since enacted.
The current law version of the minimum tax generally involves
computing AMT liability by multiplying an AMT rate that is lower than
the regular tax rate against a tax base that is broader than the
regular tax base. Subject to year-by-year exceptions that have been
made, most nonrefundable credits cannot be used to reduce AMT
liability. This has the effect of making many credits unavailable to
otherwise eligible individuals in cases where use of the credit would
cause the amount of the regular tax liability to be less than the
tentative AMT liability. The AMT rate brackets are mildly progressive,
but are not indexed for inflation.
The base for the AMT is an individual's alternative minimum taxable
income (AMTI). An individual's AMTI is determined by adding certain
``preference items'' to taxable income (such as tax-exempt interest on
certain private activity bonds and a portion of the amount excluded
from regular taxable income on sales of certain small business stock)
and ``adjusting'' the treatment of certain items to eliminate or reduce
benefits associated with the regular tax treatment of those items. Some
of these adjustments relate to ``business'' type items--such as the
requirement that depreciation be computed for AMT purposes using a
separate system that provides for less accelerated depreciation
deductions than under the regular tax system. Other adjustments are
purely ``personal.'' For example, adjustments for individuals include:
(1) disallowing deductions for State and local taxes; (2) disallowing
medical expenses except to the extent they exceed 10 percent of the
taxpayer's adjusted gross income (AGI), and (3) disallowing standard
deductions and personal exemptions. Other adjustments that affect
individuals relate to investment or employment items. For example, (1)
miscellaneous itemized deductions are not allowed, and (2) the special
regular tax rules relating to incentive stock options (ISOs) are not
allowed. Although an individual is allowed an exemption against his or
her AMTI, the exemption amount is not indexed for inflation.
2. Problems with the AMT
As explained below, we believe that there are at least four
significant problems with the individual AMT.
First, the AMT no longer is necessary to fulfill its intended
purpose. As indicated above, the original AMT was enacted to address
concerns that persons with significant economic income were paying
little or no Federal taxes due to investments in tax shelters. This
reason is no longer compelling in light of numerous changes that have
been made to the Tax Code to specifically limit tax-shelter deductions
and credits. For example, the Tax Reform Act of 1986 expanded the
application of the at-risk rules and enacted rules limiting deductions
and credits for passive activity losses, which greatly reduced shelter
opportunities.
Second, the AMT increasingly is affecting an unintended class of
taxpayers--middle class taxpayers who are not engaged in tax-shelter or
deferral strategies. Studies indicate that the AMT increasingly is
becoming the tax system for middle-income individuals. For example, a
pamphlet prepared last year by the Joint Committee on Taxation
(``JCT'') indicates that, by 2008, 19.7 percent of taxpayers in the
$75,000 to $100,000 bracket will be paying the AMT and that almost 1.75
million AMT returns will be filed by individuals in the $30,000 to
$75,000 bracket. Joint Committee on Taxation, Present Law and Issues
Relating to the Individual Alternative Minimum Tax (``AMT'') (JCX-3-
98), February 2, 1998. Another study indicates that, by 2007, almost 95
percent of the revenue from AMT preferences and adjustments will be
derived from four items that are ``personal'' in nature and are not the
product of any tax planning strategies--the personal exemption, the
standard deduction, state and local taxes, and miscellaneous itemized
deductions. In fact, the same study indicates that, in 1994, the
disallowance of the deduction for state and local taxes accounted for
approximately 47 percent of total AMT preferences; we expect this
percentage is even larger today. Harvey and Tempalski, ``The Individual
AMT: Why It Matters,'' National Tax Journal, Vol. L, No. 3, September
1997. Further, even those individuals who ultimately do not pay any AMT
liability increasingly will lose the benefits of credits that Congress
decided were necessary and appropriate and, in some cases, may have
been targeted to specific classes of taxpayers. For example, the 1998
JCT pamphlet projects that, by 2008, 7.9 million returns will receive
zero or less than the full child care credit due to AMT limitations.
Third, the AMT is too complex and imposes too great a compliance
burden. The existence of the AMT system literally requires all people
to compute their taxes under two different sets of rules--the regular
rules and the AMT rules. Given the complexity associated with the
regular tax system, even a small amount of additional complexity from
an additional tax system may be too much. However, the AMT involves
more than a small amount of additional complexity. Even individuals who
ultimately do not end up paying the AMT have to perform calculations to
determine whether or not they need to pay it or whether they are
restricted in their use of credits. For example, taxpayers trying to
determine whether or not they owe the AMT must complete a 12-line
worksheet first, then a 43-line form (and another 22-lines if they have
long-term capital gains). Further, some of the adjustments (such as
those for depreciation and net operating losses) require the taxpayer
to keep two sets of records, one for regular tax purposes and the other
for AMT purposes so that proper alternative calculations may be made in
the future, even if there is no AMT liability currently. It is no
wonder that many individuals fail to make the statutorily required
calculations, either because they cannot imagine the AMT would apply to
them, or because they simply cannot deal with the excessive complexity.
Fourth, some of the adjustments and preference items are
inappropriate from both a policy and a technical perspective. While
virtually all of the adjustments and preferences can be, and have been,
sharply criticized from a policy standpoint, two adjustments that apply
only to individuals seem particularly inappropriate for technical
reasons as well. Neither the adjustment to disallow miscellaneous
itemized deductions nor the adjustment for ISOs seems supportable from
a policy or technical standpoint. The AMT's main purpose is to blunt
the use of tax shelter or uneconomic deductions incurred to reduce
income tax excessively. The regular tax system permits as a
miscellaneous itemized deduction those expenditures that are employment
related or are clearly related to the production of income or the
management or maintenance of income-producing property. There is no AMT
objective to deny a deduction for the remaining, clearly employment--or
income-related, expenses. Certainly they are not the sort of deductions
that individuals incur as tax-shelter items or ``trump up''
artificially to eliminate income tax.
The AMT system also denies regular tax benefits accorded to
incentive stock options by requiring that the excess of the fair market
value of the stock over the exercise price (i.e., the ``bargain''
element) be included in income in the year the option is exercised.
However, this adjustment improperly taxes the ISO gain at a 28% rate
rather than the top capital gain rate of 20%, the rate applicable under
the regular tax system. There seems no justification for this denial of
capital-gain character of the bargain element now that Congress has
expressed its intention in the Taxpayer Relief Act of 1997 that long-
term capital gain be taxed under the AMT system at no higher rate than
under the regular system.
3. Recommendations
We respectfully suggest that the Subcommittee consider the
following alternatives, which we state in our order of preference.
a. Repeal the Individual AMT. As indicated above, the individual
AMT is no longer necessary to serve its intended purpose and, if kept
in place, will become the regular tax system for more and more
individuals. Further, the additional burdens it imposes are not
justified by a sufficiently clear policy objective and, if left
unchecked, almost certainly will engender further dissatisfaction with
the tax system. We realize that repealing the individual AMT is
expensive and may raise a political problem if repeal is perceived as
aiding people with economic income to avoid paying their fair share of
taxes. However, we respectfully submit that, even though it may be
expensive to repeal the individual AMT in its entirety now, the cost of
repeal will only increase in the future as more people are affected.
Further, it is doubtful that repealing the individual AMT will result
in a significant ``perception'' problem akin to that which precipitated
the enactment of the original add-on tax in 1969, given the reforms to
the Tax Code that have been made in the interim and Congressional
willingness to legislate against shelter transactions in general.
Indeed, we believe there will be a much worse political problem if the
AMT is not repealed and more and more Americans become subject to the
AMT, lose credits to which they otherwise would be entitled, or are
forced to endure the frustration of spending even more time and effort
on filing their income tax returns.
b. Exclude Taxpayers with Average AGI Below a Certain Threshold
from the AMT System Entirely. In the Taxpayer Relief Act of 1987,
Congress struck a blow in favor of simplicity by excluding certain
small corporations from the burden of AMT calculations. This was done
on the basis of the average gross receipts of the corporation for the
prior three years. Applying a similar approach to individuals could
exclude many taxpayers from the individual AMT system while still
retaining much of the revenue. For example, based on income
distribution tables as of 1994, it might be possible to exclude
approximately two-thirds of taxpayers from the AMT system, while
retaining nearly two-thirds of the revenue, by excluding entirely from
the AMT system any individuals whose average AGI for the prior three
years was under $200,000, adjusted for inflation. See Harvey and
Tempalski, Table 3 at p. 463. We emphasize, however, that this approach
alone does not fully respond to the significant substantive problems
with the AMT.
c. Partial Repeal. Another alternative would be to examine each
preference and adjustment item separately and to determine whether it
should be retained in the AMT system. However, in our view, proper
analysis of each item of adjustment and preference would result in the
AMT system being repealed. There is little, if any, justification for
the ``business'' adjustments and preferences, and clearly is no
justification for any of the personal adjustments and preferences.
Still, if full repeal is not possible, major simplification could be
achieved by (1) allowing all credits to reduce the individual's
liability, without regard to the AMT (i.e., making the temporary
measure for 1998 returns permanent); (2) removing most of the
adjustments and preferences, which are mostly ``cats and dogs'' anyway,
while retaining at most the four or five ``core'' items that account
for almost all the revenue; and (3) removing some of these core items
depending upon revenue constraints. As indicated above, however, we
strongly urge the Subcommittee to consider repealing the entire system.
Individual items can be addressed directly under the regular tax rules,
if necessary for revenue purposes.
d. Fix Problems with the Existing Adjustments and Preferences. Even
if Congress decides to retain all or most of the existing preferences
and adjustments for perception or revenue reasons, we recommend that
Congress correct the glaring problems with two preference items that
affect only individuals. First, the denial for AMT purposes of any
deduction for miscellaneous itemized deductions should be repealed. The
regular tax system already denies a deduction for a portion of those
expenses, i.e., the portion equal to two percent of AGI. The remaining
portion is either an employment-related expense or is clearly related
to the production of income or the maintenance of income-producing
property. It cannot be said that these deductions are ``excessive,''
uneconomic or otherwise incurred primarily to reduce income tax. There
is no reason for these items to be denied under the alternative system
when they are sufficiently ``income related'' to be allowed under the
regular tax system. Second, the adjustment for ISO stock should be
modified or eliminated as it inappropriately taxes a portion of the
gain at a rate in excess of the maximum 20% that Congress intended be
applied to long-term capital gain. As noted earlier, because the entire
gain will be treated as capital gain if the stock is held for more than
12 months after the option is exercised, the so-called bargain element
should also be treated as capital gain under the AMT system and taxed
at a top rate of 20%.
e. Index the Rate Brackets and the Exemption Amount. Studies have
shown that indexing the rate brackets and exemption amount would solve
a significant part of the second problem highlighted above--that more
and more people will be affected by the AMT each year. For example, the
above-cited article by Harvey and Tempalski indicates that, if the AMT
exemption, the income level at which the phaseout of the AMT exemption
begins, and the income level at which the AMT marginal rate switches
from 26 to 28 percent were indexed, approximately 8.2 million fewer
taxpayers would be affected by the AMT in 2007 than if nothing were
done. Indexing the parameters of the AMT is less optimal than full
repeal, however, because it will do little to alleviate the compliance
burden associated with the AMT system. That is, people will still have
to make the calculations to determine whether they must pay the AMT or
whether they will lose the benefit of certain credits. For these
reasons, we view indexing as our last choice and as only a partial
response to the problem.
We urge this Subcommittee in the strongest possible terms to solve
the problems with the AMT once and for all. There is universal
acknowledgement that the effects we have described are unintended and
unjustified. It is also acknowledged that the revenue cost associated
with a permanent solution will only increase over time and may
eventually become prohibitive. It would be a travesty if a permanent
solution to the AMT became caught on the merry-go-round of expiring
provisions. A permanent solution should not be deferred merely because
it competes with other, more popular proposals for tax reduction.
B. Phaseout of Itemized Deductions and Personal Exemptions
At the urging of the Tax Section, the American Bar Association
earlier this year adopted a recommendation that the Congress repeal the
phaseout for itemized deductions (the so-called ``Pease provision'')
and the phaseout for personal exemptions (the ``PEP provision''). The
ABA also recommends that the revenue that would be lost by repeal be
made up with explicit rate increases. This would address any revenue
neutrality concern, as well as any concern with respect to the
distributional effects of repeal.
It may be difficult for members of Congress to appreciate the level
of cynicism engendered by these two phaseouts. Countless times,
taxpayers who might not otherwise be troubled by the amount of tax they
are paying have reacted in anger when confronted with the fact that
they have lost--either wholly or partially--their itemized deductions
and personal exemptions. They are no more comforted when told that
these phaseouts should really be viewed as substituting for an explicit
rate increase. Almost without exception, they react by asking why
Congress refuses to impose the additional rate rather than trying to
pull the wool over their eyes.
We have no answer to that question. We take pride in the fact that
the ABA is willing to recommend a simplification proposal funded by a
marginal rate increase on the same taxpayers benefiting from the
simplification. We urge this Subcommittee to give serious consideration
to the ABA's recommendation.
C. Additional Simplification Proposals
Although the alternative minimum tax certainly causes great
complexity in the Code (and its application is much more widespread
than ever envisioned), the Code is replete with numerous other
provisions, the complexity of which are much greater than the perceived
abuse to which the provision was directed or the benefit that was
deemed gained by its addition. Furthermore, the Code contains many
provisions which at the time of enactment may well have been desirable,
but with the passage of time or the enactment of other changes, have
truly become ``deadwood.'' However, despite the lack of utility of such
provisions (whether in a relative or absolute sense) analysis of the
same may well be required either in the preparation of the tax return
or in the consummation of a proposed transaction. The elimination of
such provisions would greatly simplify the law. The following are
examples of such provisions, that when analyzed do not justify their
continuation in the law. Obviously, these are but a few such examples,
and an extensive analysis of the Code would undoubtedly uncover a
legion of the same. We have separated our recommendations into
categories for individual, business, and administrative items.
1. Individual Tax Provisions
a. Simplify Phaseouts. Numerous sections in the Code
provide for the phaseout of benefits from certain deductions or
credits over various ranges of income based on various measures
of the taxpayer's income. There is no consistency among these
phaseouts in either the measure of income, the range of income
over which the phaseouts apply or the method of applying the
phaseouts. Even without the inconsistencies, the phaseouts
cause problems. They add significantly to the length of tax
returns, increase the potential for errors, are difficult to
comprehend, and make it extraordinarily difficult for families
to know whether the benefits the provisions confer will be
available. The inconsistencies exacerbate these problems,
causing inordinate complexity, particularly for taxpayers
attempting to prepare their tax returns manually. Simplicity
would be achieved by (a) eliminating phaseouts altogether, (b)
substituting cliffs for the phaseouts, or (c) providing
consistency in the measure of income, the range of phaseout and
the method of phaseout.
b. Rationalize Estimated Tax Safe Harbors. Section 6654
imposes an interest charge on underpayments by individuals of
estimated income taxes, which generally are paid by self-
employed individuals. This interest charge generally does not
apply if the individual made estimated tax payments equal to
the lesser of (x) 90 percent of the tax actually due for the
year or (y) 100 percent of the tax due for the immediately
prior year. The availability and computation of the prior year
safe harbor has been adjusted regularly by the Congress over
the past decade. Presently, for individuals with adjusted gross
income exceeding $150,000, the prior year safe harbor
percentage increases and decreases from year to year over a
range from 105 to 112 percent. The purpose of these increases
and decreases is to shift revenues from year to year within the
five and ten year budget windows used for estimating the
revenue effects of tax legislation. Congress should determine
an appropriate safe harbor percentage and apply that amount for
all years, avoiding the complexity the increasing and
decreasing percentages bring.
c. Repeal the Two Percent Floor on Miscellaneous Itemized
Deductions. The two percent floor on miscellaneous itemized
deductions contained in Section 67 was enacted as a
simplification measure intended to relieve taxpayers of
recordkeeping burdens and the Internal Revenue Service
(``IRS'') of the burden of auditing deductions insignificant in
amount. Experience indicates that taxpayers continue to keep
records of such expenses to determine deductible amounts in
excess of two percent of adjusted gross income. Moreover, the
existence of the limitation and the need to identify the
deductions to which it applies introduces needless
computational and substantive complexity to the preparation of
tax returns.
d. Increase the Floor for Itemized Deductions for Medical
Expenses and Increase the Personal Exemption Amount for
Taxpayers 65 or Over. A deduction is allowed for medical
expenses in excess of 7.5 percent of adjusted gross income.
Despite the current 7.5 percent floor, which limits the
deduction to extraordinary unreimbursed medical expenses, the
existence of the deduction requires taxpayers to identify
medical as compared to personal expenses and to maintain
detailed records of the former. An increase in the floor to 10
percent of adjusted gross income would reduce the number of
returns claiming the medical expense deduction and alleviate
substantiation and audit verification problems and numerous
definitional issues. An increase in the floor to a catastrophic
level would also likely reduce the number of taxpayers
maintaining medical records. The personal exemption amount for
taxpayers 65 and older could be increased to offset any adverse
effect on elderly taxpayers.
e. Reduce Family Unit Tax Complexity. A number of
provisions make the filing of tax returns and computation of
tax liability particularly complicated for low and moderate
income taxpayers. Certain provisions necessitate the filing of
returns by individuals who would otherwise have no tax
liability and no need to file. The complexity of the
calculations coupled with definitional issues make it extremely
difficult for low and moderate income taxpayers to complete
their returns without paid assistance, which they cannot
afford. These provisions result in a significant number of
adjustments to tax returns, causing considerable administrative
difficulties for the IRS in making the adjustments and
collecting the amounts due. In addition, the adjustments result
in additional liability for interest and penalties on the part
of a group of taxpayers that has difficulty satisfying the tax
liability, let alone additional sums.
f. Earned Income Credit. The Earned Income Credit (EIC)
contained in Section 32 provides a substantial, refundable tax
credit to low income workers, both with and without children.
The EIC, as presently designed, creates several layers of
complexity.
The EIC requires many taxpayers to file a return
whose income would otherwise fall below filing thresholds.
The definition of a ``qualifying child'' under
Section 32(c)(3) differs from the definition of a dependent
child, and treats foster children differently from biological
or adoptive children.
The AGI tie-breaker rule does not resolve the
perceived abuse it targets while its application often
incorrectly denies the credit to people who should be eligible,
insofar as it does not focus on a clear and reasonable
definition of what constitutes a ``household''.
g. Child Credit. The Child Credit, contained in Section 24,
on account of its multiple calculations and ``integration''
with the child and dependent care credit, the earned income
credit, the alternative minimum tax, and social security tax
creates unnecessary complexity for taxpayers who would
otherwise be able to file simple returns.
h. Dependent Care Credit. The Dependent Care Credit,
contained in Section 21, is of limited benefit to low income
working families because it is not refundable. Further, it does
not benefit higher-income working families because the credit
rate caps at relatively low income levels and does not reflect
the true cost of child or dependent care.
i. Nondeductibility of Child Support Payments. The
treatment of child support payments as a nondeductible expense
creates confusion and leads to many noncustodial parents
claiming dependency exemptions for children without obtaining
the required Form 8332. It places the burden on the IRS
administratively to identify and audit such claims, and makes
the dependency exemption an element of horse-trading in
domestic relations disputes, catching taxpayers in a conflict
between state domestic relations orders and Federal income tax
laws. The disparate treatment of alimony and child support adds
the complexity of the tax law to negotiations that are often
difficult and unpleasant.
j. Dependency Definition. The current definition of
``dependent'' under Sections 151 and 152 is confusing and
difficult to administer. In particular, problems arise with
regard to the treatment of (1) children of separated or
divorced spouses; (2) other ``custodians'' of dependent
children; and (3) ``custodians'' of disabled or elderly
individuals. Further, as noted previously, the definition of a
dependent child is not harmonized with the definition of a
``qualifying child'' under the earned income credit, nor is the
concept of ``support'' identical to the concept of
``maintaining a household'' for purposes of head of household
status under Section 2(b). Finally, foster children are treated
differently from biological or adopted children.
k. Simplification Alternatives for Family Status Issues.
Simplification for low and moderate income taxpayers could be
pursued at a macro level, with a wholesale revision of the
provisions intended to provide benefits to this group of
taxpayers, or at a micro level by addressing individual issues
described above. On the macro level, replacing ``head of
household'' status, dependent child exemptions, and the child
credit with one ``mega-'' program that provides the economic
value of these benefits to taxpayers with children, with the
same overall distribution of benefits as under current law
could result in significant simplification for low and moderate
income taxpayers. Definitions would be coordinated with those
utilized in the EIC program. The exemption amount could differ
depending on whether the taxpayer is single or married (or
married filing separately). With this kind of macro revision,
taxpayers would only have to walk through two sets of
coordinated rules--the mega-exemption and the EIC.
On a micro level, the following alternatives address
particular problems and could significantly reduce complexity
in those areas.
Apply one standard for qualification as a
dependent child, qualifying child for purposes of the EIC, and
head of household status (if retained) that equates support
with the cost of maintaining a taxpayer's household and is
based on the child residing in the taxpayer's home for more
than half the tax year. Provide safe harbors for taxpayers
awarded custody by court order or other agreement. (Taxpayers
could check a box signifying the existence of such an order or
agreement.)
Define dependent to include foster children
residing in a home for more than half the tax year. In the case
of a court order or other official ``placement'' of the child
(e.g., by order of the local Department of Social Services, a
child welfare agency, or other placement agency), qualification
could be established by attaching a copy of the order to the
return or checking a box signifying the existence of such an
order. In the case of the informal placement of a foster child,
the taxpayer would have to establish residence for more than
half the tax year.
Equalize the treatment of alimony and child
support by making child support deductible by the payor and
included in income by the payee. This will remove much of the
``gaming'' involved with duplicate claims for dependency
exemptions, the earned income credit and head of household
status, and problems arising from state domestic relations
orders, since it gives taxpayers who pay child support some tax
benefit for their payments. Since dependent exemptions will
only be claimed by custodial parents or other custodial
individuals, nonworking custodial parents will usually not have
to file. Those custodial parents who do file will claim
dependency exemptions and other child-related credits.
Increase the dependency exemption to ensure it
reflects the cost of maintaining a home for a child. An
increase in the amount of the dependency exemption in
conjunction with standard deductions that more accurately
reflect minimum cost of living would reduce the number of
taxpayers who must file returns.
Replace the ``AGI tie-breaker'' rule in the EIC
with a definition of ``household'' that more accurately targets
the perceived abuse of two unmarried taxpayers living together
and gaming the system.
Facilitating or mandating advance EIC payments
through integration of Forms W-4 and W-5 and employee
withholding systems would eliminate the need for many taxpayers
to file returns.
Establish a uniform credit rate for the dependent
care credit and make the credit refundable so it truly benefits
lower income working families.
l. Simplify the Capital Gains Provisions. The capital gains
regime applicable to individuals is frighteningly and
unnecessarily complex. As a result of Congressional
determinations that some assets are worthier of tax benefits
than others and that investment in capital assets should be
encouraged but only if the tax benefits affect revenue some
time in the future, the Code contains a bewildering variety of
rules under which different types of assets are subject to
different rates and the rates applicable to long-term gains
vary depending on the holding period. This system imposes
difficult record-keeping burdens on taxpayers and encourages
taxpayers to try to manipulate the system through investments
in derivatives, short sales, and similar techniques. In
addition, taxpayers holding property acquired before 2001 can
elect to have the property treated as if it had been sold on
the first business day after January 1, 2001, thereby becoming
eligible for the special 18% rate if it is held for another
five years. Determining whether to make this election will
require taxpayers to make economic assumptions and do difficult
present value calculations. While there may be some
justification for each item of fine-tuning in this area, their
cumulative effect has been to create a structure that is
incomprehensible to taxpayers and to the people who prepare
their tax returns.
Simplification can take several forms. First, different
rates for different types of assets (e.g., collectibles) should
be eliminated. Second, different rates for long-term assets
held for different holding periods should be eliminated; there
is no reason to have a special ultra-low rate for assets held
for more than five years. Third, to assure that any benefit is
extended to all taxpayers regardless of their tax brackets, the
concept of special capital gain rates might be replaced by an
exclusion for a percentage of long-term capital gains.
m. Harmonize and Rationalize Education Incentives. The Code
contains a variety of provisions granting taxpayers educational
incentives. These provisions include education IRAs, the Hope
Credit, the Lifetime Learning Credit, exclusions for employer-
provided educational assistance, and interest deductions on
student loans. The sheer number of alternatives creates
complication. Moreover, the targeting of the provisions makes
them particularly complicated and difficult to comprehend. The
restrictions on their use can mean that taxpayers unexpectedly
find they have lost the benefit of a particular incentive. The
education incentives should be harmonized and rationalized so
that taxpayers have a simple and clear menu of options from
which to choose in planning for educational expenses that
yields predictable results.
n. Eliminate Elections. Many provisions allow taxpayers to
elect special treatment. While some elections are necessary and
appropriate (e.g., election to be treated as an S corporation),
it is often the case that elections and safe harbors, even
those enacted in the name of simplification, increase
complexity. The availability of an election oftentimes requires
taxpayers to make multiple computations to determine the best
result, thereby adding significant complexity. For example, the
various elections available under recently enacted Section 6015
with respect to innocent spouse relief increase planning and
procedural complexity significantly. Likewise, some recent
proposals for eliminating or reducing the so-called marriage
penalty would effectively require married couples to compute
their income twice to determine which approach yielded a lower
tax payment. In lieu of providing multiple approaches to the
same goal, Congress should develop a single legislative
solution to address a specific problem, and should make such a
solution as simple and fair as possible.
o. Increase the Estate and Gift Tax Unified Credit. The
Code requires the estates of decedents with gross estates in
excess of the exclusion amount ($650,000 in 1999) to file
estate tax returns. According to the latest published IRS
statistics (calendar year 1996), approximately 79,346 estate
tax returns were filed that year. Fewer than half of the
returns filed (47.5 percent) reported estates that were subject
to tax. Of those subject to tax, the largest 14 percent of
estates (over $2.5 million gross estate) bore 69 percent of the
total estate tax paid. Conversely, the lowest 86 percent of
gross estates paid only 31 percent of the total estate tax
revenues received ($4.51 billion out of $14.49 billion). In
1997, Congress put in place a gradual phase-up of the exclusion
amount to $1 million in 2006, which will eliminate the filing
requirements for a substantial number of estates otherwise
required to file returns and reduce to zero the tax owed by
many of those estates. An additional increase in the unified
credit (beyond $1 million) would further relieve an additional
significant number of decedents' estates from the burden of
filing returns and paying estate tax without a significant
decrease in Federal revenue. More importantly, such a change
would relieve many such individuals during their lifetimes of
the burden of estate planning oriented almost entirely toward
minimizing their estate tax liability, rather than family and
business succession considerations.
p. Repeal Sections 2032A and 2057. Section 2032A (enacted
in 1976) provides special valuation rules for farms and real
property used in a trade or business. Section 2057 (enacted in
1997) provides a deduction for a limited amount of the value of
a closely held business. The maximum reduction in the value of
a decedent's estate from use of Section 2032A is $750,000; the
maximum deduction under Section 2057 is $675,000 (not taking
into account the interaction with the unified credit). The
limited benefits provided by these Sections, which is limited
to a select group of taxpayers, should be contrasted with the
substantial complexity they produce. In addition to their
statutory and administrative complexity, the provisions
encourage extensive tax planning and invite manipulation of
ownership interests and asset use.
q. Simplify Transfer Tax Valuation of Minority Interests in
Non-Publicly Traded Family-Owned Businesses. Significant
taxpayer planning and government administrative expenses are
incurred when a discount is claimed with respect to the value
of ownership interests in non-publicly traded business
enterprises controlled by a family. Significant simplification
could be achieved if the value of stock in a non-publicly
traded corporation were deemed to be equal to its pro rata
share of all the stock of the same class in such corporation,
unless a different value is established by clear and convincing
evidence. Under this test, all stock held, directly or
indirectly, by an individual or by members of such individual's
family will be treated as held by one person. Similar rules
would apply to ownership interests in other entities.
2. Small Business Tax Provisions
a. Simplify the Minimum Distribution Requirements. Under Section
401(a)(9), qualified retirement plan benefits must be distributed to a
participant or his or her beneficiary(ies) within a prescribed period
of time that is dependent upon a number of variables, including the
identity of the participant's beneficiary(ies) and the circumstances
under which benefits are paid. Section 408(a)(6) extends these
distribution requirements to IRA benefits. The distribution rules in
Section 401(a)(9) complicate the administration of qualified retirement
plans and IRAs, and present conceptual difficulties for participants.
Moreover, although intended to preclude the unreasonable deferral of
benefits, benefits deferred are subject to income taxation upon
eventual distribution and may be subject to estate taxation upon a
participant's death. The provisions of Section 401(a)(9), other than
those dealing with the required beginning date for distribution of
retirement benefits, should be replaced with the incidental death
benefit rule in effect prior to the enactment of the Employee
Retirement Income Security Act of 1974 (hereafter ``ERISA'').
b. Eliminate the Half-Year Age Conventions. Section 401(a)(9)
provides that retirement plan benefits must commence, with respect to
certain employees, by April 1 of the calendar year following that in
which the employee attains 70\1/2\. Section 401(k) states that plan
benefits may not be distributed before certain stated events, including
attainment of age 59\1/2\. Further, Section 72(t) provides that
premature distributions from a qualified retirement plan, including
most in-service distributions occurring before an employee's attainment
of age 59\1/2\, are subject to an additional 10% tax. Changing these
age requirements to age 70 and age 59, respectively, would simplify
plan administration.
c. Repeal or Modify the Top Heavy Rules. Section 416 was enacted to
limit the ability of a plan sponsor to maintain a qualified retirement
plan benefiting primarily the highly paid. Section 416 is both
administratively complex and difficult to understand. Furthermore,
under current law, there are limitations on the compensation with
respect to which qualified retirement plan benefits can be provided,
there are overall limitations on qualified retirement plan benefits,
and non-discrimination requirements limit the ability of sponsors to
adopt benefit formulas favoring the highly paid. Given the other
limitations in the Code, Section 416 adds an unnecessary layer of
complexity to employee plan administration.
If Section 416 is retained, the rule attributing to a participant
stock owned by a member of the participant's family for purposes of
determining whether or not the participant is a key employee should be
eliminated. This change would be consistent with the recent repeal of
the family aggregation rules under Sections 401(a)(17) and 414(q).
d. Replace the Affiliated Service Group and Employee Leasing Rules.
Sections 414(b) and 414(c) treat businesses under common control as a
single employer for purposes of determining whether a retirement plan
maintained by one or more of these businesses qualifies under Section
401. Two other Code provisions adopt an aggregation concept as well.
Specifically, Section 414(m) generally treats all employees of members
of an affiliated service group as though they were employed by a single
employer, and Section 414(n) states that, under certain circumstances,
a so-called leased employee will be deemed to be employed by the person
for whom the employee performs services. No regulations have been
finalized under these provisions. They are difficult to comprehend and
to apply.
Sections 414(m) and 414(n) should be replaced with provisions
explicitly describing and limiting the circumstances under which
employees of businesses that are not under common control must be taken
into account for purposes of determining the qualified status of a
sponsor's retirement plan, and the discretion granted under Section
414(o) to develop different rules should be repealed.
e. Worker Classification. Determining whether a worker is an
employee or independent contractor is a particularly complex
undertaking because it is based on a 20-factor common law test. The
factors are subjective and given to varying interpretations and no
guidance exists on how or whether to weight them. In addition, the
factors are not applicable in all work situations, and, in some work
situations, the factors do not provide a meaningful indication of
whether the worker is an employee or independent contractor. The
consequences of misclassification are significant for both the worker
and employer, including retroactive tax assessments, imposition of
penalties, disqualification of benefit plans, and loss of deductions.
Complexity would be significantly reduced by enactment of an
objective test to replace the subjective 20-factor test and making it
applicable for Federal income tax and ERISA purposes. In the
alternative, changes could be made to reduce the differences between
the tax treatment of employees and independent contractors. Efforts to
make the tax law more neutral with respect to whether a worker is an
employee or independent contractor would reduce the importance of the
worker classification rules because the consequences of
misclassification would be less significant.
f. Expand the Use of the Cash Method of Accounting. Small C
corporations, qualified personal service corporations, sole proprietors
and certain passthrough entities are excepted from the required use of
the accrual method under Section 448. This exception does not cover
more than de minimis amounts of inventory, however, and there are no
specific rules delineating when inventory is de minimis. In addition,
the applicability of the inventory rules, which were written for the
industrial age, is not at all clear for businesses operating in the
information age. For example, it is not clear whether a business
developing software sold via the Internet is required to use an
inventory method. Thus, some businesses cannot easily determine if they
have inventory that requires the use of the accrual method of
accounting. Moreover, many of these businesses otherwise use the cash
method of accounting, so that requiring the use of the accrual method
and the keeping of inventories subjects them to complex rules and
recordkeeping.
Considerable simplification could be achieved by amending Sections
446 and 448 to allow small taxpayers to use the cash method of
accounting. Consistent with Section 448, small taxpayers (even those
with inventory) could be defined as those with average annual gross
receipts in the three prior years of $5 million or less. This rule
would enable small businesses (even those with inventory) to use the
cash method should they find it simpler. This proposal should not
result in taxpayers manipulating their income because such businesses
generally cannot afford to maintain large quantities of inventory on
hand and the inventory levels of small businesses, in particular, would
not be extensive. Further simplification could be achieved by
increasing the Section 448 gross receipts threshold to $10 million.
g. Provide Clear Rules Governing the Capitalization and Expensing
of Costs and Recovery of Capitalized Costs. Although the IRS clearly
stated that the Supreme Court's decision in INDOPCO v. Commissioner,
503 U.S. 79 (1992), did not change fundamental legal principles for
determining whether a particular expense may be deducted or must be
capitalized, nonetheless, since INDOPCO, whether an expense must be
capitalized has become the most contested audit issue for businesses. A
future benefit test derived from the INDOPCO decision has been used by
the IRS to support capitalization of numerous expenditures, many of
which have long been viewed as clearly deductible. Almost any ongoing
business expenditure arguably has some future benefit. The distinction
between an ``incidental'' future benefit, which would not bar deduction
of the expenditure, and a ``more than incidental'' future benefit,
which might require capitalization, generally is neither apparent nor
easy to establish to the satisfaction of parties with differing
objectives. In addition, the administrative burden associated with
maintaining the records necessary to permit the capitalization of
regular and recurring expenditures is significant. Development of
objective, administrable tests governing the deduction of expenses or
the capitalization of categories of expenditures would significantly
reduce controversy, just as the enactment of Section 197 significantly
reduced controversy regarding the amortization of intangible assets.
For example, repair allowance percentages such as those previously
provided under the Class Life Asset Depreciation Range (CLADR) System
would significantly reduce controversy regarding capitalization of
repair expenditures. See Rev. Proc. 83-35, 1983-1 C.B. 745 (CLADR
repair allowance percentages); see alsoSection 263(d) (repair allowance
percentage for railroad rolling stock).
h. Modify the Uniform Capitalization Rules. The uniform
capitalization (``UNICAP'') rules in Section 263A are extraordinarily
complex. Compliance with the UNICAP rules consumes significant taxpayer
resources; yet, for many taxpayers, the UNICAP rules do not result in
capitalization of any significant amounts not capitalized under prior
law. Modification of the UNICAP rules to limit their application to
categories of expenditures not addressed comprehensively under prior
law (e.g., self-constructed assets) or to large taxpayers would reduce
complexity for many taxpayers.
i. Simplify S Corporation Qualification Criteria. The definition of
an ``S corporation'' contained in Section 1361 establishes a number of
qualification criteria. To qualify, the corporation may have only one
class of stock and no more than 75 shareholders. Complex rules provide
that the shareholders must be entirely composed of qualified
individuals or entities. On account of state statutory changes and the
check-the-box Regulations, S corporations are disadvantaged relative to
other limited liability entities, which qualify for a single level of
Federal income taxation without the restrictions. The repeal of many of
the restrictions would simplify the law and prevent inadvertent
disqualifications of S corporation elections.
j. Modify the S Corporation Election Requirement. Section
1362(a)(2) requires all shareholders to consent to an S corporation
election, as well as that the election be made on or before the 15th
day of the third month of the taxable year. There are also election
deadlines for qualified subchapter S subsidiaries and qualified
subchapter S trusts, which adds complexity. Late elections are common
occurrences because taxpayers are unaware of or simply miss the
election deadline. If the election is filed late, Section 1362(b)(5)
permits the IRS to treat the late election as timely if the IRS finds
reasonable cause for the late election. This provision has saved
hundreds of taxpayers from the consequences of a procedural mistake; it
has also generated considerable administrative work for the IRS as is
evidenced by the hundreds of rulings granting relief. The election
deadline was intended to prevent taxpayers from waiting until income
and expenses for the taxable year were known before deciding whether to
make an S corporation election. The differences that exist between the
taxation of S and C corporations are so significant, however, that it
is unlikely a taxpayer's decision over whether to make an S corporation
election would be determined by the events during a single taxable
year. Even if that were the case, it is difficult to understand the
compelling policy reason to require taxpayers to guess at their
financial operations for the year in determining whether to make an S
corporation election at the beginning of the year rather than making an
informed decision. The ability to pass through losses has been
substantially restricted by various provisions of the Code. Thus,
concerns about passing through losses are likely more theoretical than
real. In addition, as a practical matter, taxpayers cannot wait until
the end of the taxable year to make a decision because the need to make
estimated tax payments compels a decision before the date the first
estimated tax payment is due. Thus, the separate filing of the election
itself is a mere procedural requirement leading to frequent procedural
foot faults, but little else.
The most obvious time for the filing of an election is with a
filing that is otherwise required. Significant simplification could be
achieved by requiring the election to be made on the corporation's
timely filed (including extensions) Federal income tax return for the
year of the election. The same rule should apply to the qualified
subchapter S subsidiary and qualified subchapter S trust elections.
k. Repeal or Simplify the Personal Holding Company Rules. The
personal holding company rules were enacted in 1934 to tax the so-
called ``incorporated pocketbook.'' With differentials in the corporate
and individual tax rates, individuals could, for example, place their
investments in a corporation and substantially lower the Federal income
tax paid on income generated by those investments, especially if the
income was held in the corporation and reinvested for a long period of
time. The personal holding company provisions attack this plan by
imposing a surtax on certain types of passive income earned by closely
held corporations that is not distributed (and thus taxed) annually.
Over time, the personal holding company rules have been broadened
to include many closely held corporations, both large and small, with
passive income (whether or not such corporations are, in effect,
``incorporated pocketbooks'') and, thus, may create a trap for the
unwary. In addition, the rules have become very complex and difficult
for the IRS to administer and for taxpayers to comply with, and
sometimes require taxpayers to rearrange asset ownership to comply with
the rules. With maximum corporate and individual rates coming closer
together and the repeal of General Utilities, it is questionable
whether the personal holding company rules should remain in the tax
code at all. Regardless of this debate, however, the rules should be
significantly simplified in order to eliminate the substantial burden
they impose on closely held corporations.
l. Repeal the Collapsible Corporation Provision. Since the repeal
of the General Utilities doctrine in 1986, Section 341--the
``collapsible corporation'' provision--is essentially deadwood. By
definition, a collapsible corporation is a corporation availed of with
a view to a sale of stock before a substantial amount of the corporate
income has been recognized. After 1986, a sale of corporate stock or a
sale of all of a corporation's assets prior to the realization of
corporate income cannot escape corporate taxation. Section 384 assures
that a purchaser of stock of a corporation with built-in gain property
cannot utilize its losses to shelter that gain. Since 1964, a
corporation could escape the rigors of Section 341 by effecting a
Section 341(f) election, i.e., the corporation agrees to recognize gain
on the disposition of subsection (f) assets, notwithstanding any
otherwise applicable non-recognition provisions of the Code. The repeal
of General Utilities renders Section 341(f) redundant. More accurately,
it renders Section 341(a) redundant because no corporate gain can now
escape corporate tax. Since it was that avoidance or potential
avoidance that gave birth to Section 341, it is now deadwood and should
be repealed. Its repeal would result in the interment of the longest
sentence in the Internal Revenue Code--Section 341(e).
m. Simplify the Attribution Rules. The attribution rules throughout
the Code contain myriad distinctions, many of which may have been
reasonably fashioned in light of the particular concern of the
underlying provision. For example, should siblings be included in the
rules? Should the ownership test be 80% or 50%? Whatever the reasons
originally driving the differences among the attribution rules, those
reasons may simply be outweighed by the need to simplify the Code.
Consequently, the attribution rules and the concerns underlying them
should be reexamined in light of concerns about complexity with a view
to harmonizing and standardizing the rules, unless there are truly
compelling reasons to do otherwise. At a minimum, and without
reexamination, it is clear the rules could be simplified by
standardizing whether the percentage is equal to or greater than and
not have both.
n. Simplify the Loss Limitation Rules. The Code contains multiple
rules limiting the availability of a taxpayer claim to use losses.
These include Section 465, which limits the deductibility of losses of
individuals and certain C corporations to the amount at risk--that is,
generally, the amount of the investment that could be lost plus the
taxpayer's personal liability for additional losses; Section 469, which
limits losses incurred in ``passive activities'' Section 704(d), which
limits a partner's distributive share of a partnership's losses to the
partner's basis in the partnership interest; and Section 1366(d), which
limits an S corporation shareholder's loss in similar fashion.
There are numerous limitations and qualifications layered on each
of these rules and definitions, and Sections 465 and 469, in
particular, are extremely complicated and difficult to comprehend.
Section 465 originally applied only to certain types of activities
deemed especially prone to abuse, such as the production and
distribution of films and video tapes, but, in 1978, it was extended to
virtually all other income-producing activities. Since the enactment of
Section 469, Section 465 has become superfluous because there are very
few situations in which a deduction would be denied because of the
applicability of Section 465 that would not also be denied because of
the applicability of Section 469.
Substantial simplification could be achieved by combining,
rationalizing and harmonizing the loss limitation provisions.
o. Simplify Section 355. Section 355 permits a corporation or an
affiliated group of corporations to divide on a tax-free basis into two
or more separate entities with separate businesses. Under Section
355(b)(2)(A), which currently provides an attribution or
``lookthrough'' rule for groups of corporations that operate active
businesses under a holding company, ``substantially all'' of the assets
of the holding company must consist of stock of active controlled
subsidiaries. Under this rule, holding companies that, for very sound
business reasons, own assets other than the stock of active controlled
subsidiaries are required to undertake one or more preliminary (and
costly) reorganizations solely for the purpose of complying with this
provision. Treating members of an affiliated group as a single
corporation for purposes of the active trade or business requirement
will simplify numerous corporate transactions.
p. Simplify the Consolidated Return Rules. Affiliated groups of
corporations can elect to file a single consolidated income tax return.
The dominant theory governing the development of the consolidated
return regulations is that the consolidated group should be treated as
a single entity. As evidenced by the hundreds of pages of regulations
and excruciating detail, this seemingly simple concept has evolved into
one of the most complex and burdensome areas of the tax law. These
rules, which are laced with numerous traps for the unwary, are
virtually incomprehensible, even to experienced tax practitioners if
they do not spend an entire career in the consolidated return area.
With the advent of single-member limited liability companies (LLCs) and
the check-the-box regulations, many companies may be able to avoid or
ameliorate the complexity of the consolidated return rules by simply
inserting single-member LLCs into their corporate structure. For
companies that desire or are required to use a C corporation, however,
the consolidated return rules still present a major stumbling block in
terms of complexity. Accordingly, simplification of the consolidated
return rules would be a major step towards the ultimate goal of
simplifying the tax laws.
q. Simplify the PFIC Rules. In 1997, the passive foreign investment
company (``PFIC'') rules were greatly simplified by the elimination of
the controlled foreign corporation-PFIC overlap and by allowing for a
mark-to-market election for marketable stock. However, a great deal of
complication remains in the PFIC area, suggesting that further
simplification is necessary. Considerable simplification could be
achieved by eliminating the application of the PFIC rules for smaller
investments in foreign companies whose stock is not marketable.
r. Simplify the Foreign Tax Credit Rules. The foreign tax credit
area is subject to significant complication, particularly because of
the nine separate baskets for allocating income and credits set forth
in Section 904(d)(1). Consolidating these baskets for businesses that
are either starting up abroad or that constitute small investments
would provide some relief from the complexity. In addition, treating
the European Union as a single country would eliminate another
complication faced by US taxpayers competing in this newly unified
marketplace. Lastly, the elimination of the alternative minimum tax
credit limitations on the use of foreign tax credits would greatly
simplify this area for all US taxpayers operating abroad without
permitting tax motivated behavior.
s. Simplify the Subpart F Rules. The Subpart F rules present a host
of difficulties in their application. While the rules may be necessary
to prevent tax avoidance by large and sophisticated taxpayers, smaller
taxpayers or smaller foreign investments could be excepted from the
application of these rules, which would greatly simplify the tax
system, without creating the potential for the tax avoidance the rules
were intended to prevent.
t. Clarify Treatment of Check-the-Box Entities for Subpart F
Purposes. Notices 98-11 and 98-35 caused considerable confusion in
planning with respect to international tax matters. Notice 98-35
suggests potential rules that, once implemented, could adversely affect
the use of so-called ``check-the-box'' entities (that is, entities that
are either disregarded or treated as partnerships for Federal income
tax purposes but are treated as taxable entities under local law) in
international transactions. The suggested rules are leaving many
taxpayers with uncertainly in their international planning.
Congressional clarification of what factors should be relevant in
computing ``foreign personal holding company'' income under Subpart F
would greatly simplify the task of international tax compliance.
u. Repeal Section 514(c)(9)(E). In general, income of a tax exempt
organization from debt financed property is treated as unrelated
business taxable income. Debt financed property is defined in Section
514 as income producing property subject to ``acquisition
indebtedness,'' which generally does not include debt incurred to
acquire or improve real property. Section 514(c)(9)(E) (the ``fractions
rule'') provides, in general, that debt of a partnership will not be
treated as acquisition indebtedness if the allocation of income and
loss items to a tax exempt partner cannot result in the share of the
overall taxable income of that organization for any year exceeding the
smallest share of loss that will ever be allocated to that
organization. This provision was enacted to prevent disproportionate
allocations of income to tax exempt partners and disproportionate
allocations of loss items to taxable partners. The provision has become
a trap for the unwary as well as a tremendous source of planning
complexity even for those familiar with it. Anecdotal evidence suggests
that few practitioners understand the provision completely, and almost
no IRS agents or auditors raise it as an issue on audits. Instead,
because of its daunting complexity, it has become a barrier to
legitimate investment in real estate by exempt organizations. At the
same time, other provisions in the tax law (such as the requirement of
substantial economic effect under Section 704(b)) substantially limit
the ability to shift tax benefits among partners. Therefore, Section
514(c)(9)(E) could be repealed without substantial risk of abuse.
3. Administrative Provisions
a. Deposit Penalty. The failure to timely deposit taxes is subject
to penalty, pursuant to Section 6656, in amounts ranging from 2 percent
to 15 percent of the underdeposit, depending on the lateness of the
deposit. The deposit rules are unnecessarily complex and adversely
affect small businesses as they move from one payroll deposit category
to another.
For example, professional corporations may be severely impacted
where their payroll deposit is normally less than $100,000 per pay
period which permits at least semi-weekly deposits (i.e., a three-day
deposit rule). However, at each year end, in order to pay out all, or
almost all, of the corporation's income, bonus compensation
distributions are frequently required. The amount of the bonus
distributions for each employee, a prerequisite to determining
appropriate withholding tax, cannot be ascertained until the annual
books are closed. Closing of the books requires receipts, expenses,
etc. for the last day of the taxable year to be considered. Bonuses
must also be paid by the last day of the taxable year (often December
31) to be tax deductible for such year.
Financial intermediaries generally require at least one day's
advance notice to make electronic federal withholding tax deposits.
Banks and taxpayer businesses are frequently shorthanded at year end
and find it difficult to determine the amount of the Federal tax
deposit due until after the financial intermediaries' cutoff time to
make withholding tax deposits on the next business day. This is
particularly true for taxpayers in the western U.S. time zones. A 2
percent penalty is excessive for a deposit that is only one day late,
particularly where the depositor is normally a semi-weekly depositor
but is required to make a one-day deposit.
Congress recently recognized that the changing of deposit
requirement time frames is a complexity that causes great confusion and
that waiver of the penalty should be permitted for the first change
period. See Section 6656(c)(2)(B). While this solution helps, it does
not fully address the problem. The current provision requires an
administrative waiver request that may be expensive and time consuming
and applies only to the first instance of a problem which by nature is
likely to occur annually. Section 6302 (or the regulations) should be
modified to require next day electronic depositing only in those
instances where next day depositing (i.e., $100,000 or more deposit) is
required of that taxpayer with respect to 10 percent or more of its
deposits. Alternatively, taxpayers could be given a minimum of two days
to make deposits of $250,000 or less.
b. Information Returns. Sections 6041 and 6041A generally require
reporting of all payments made in connection with a trade or business
that exceed $600 per year. The $600 per year has never been adjusted
for inflation. Section 6045(f) now requires reporting of all gross
payments to attorneys (includes law firms and professional
corporations) where the portion constituting the legal fee is unknown
even if the payment is less than $600. Many Form 1099 information
returns from non-financial institutions cannot be processed by the IRS
or do not provide truly useable information. Anecdotal evidence
suggests the information on these information returns may not be used
in examinations of the taxpayers and cannot be reconciled to tax
returns. The reporting threshold should be increased to $5,000 (which
harmonizes with Section 6041A(b)) and adjusted for inflation in full
$1,000 increments.
c. Penalty Reform. The 1998 IRS Restructuring Act instructs both
the Joint Committee on Taxation and the Treasury Department to conduct
separate studies of the penalty and interest provisions of the Code and
to make recommendations for the reform of the same.
The Tax Section believes that reform of the penalty and interest
provisions is appropriate at this time and looks forward to working
with the JCT and Treasury. There are many cases in which the
application of penalty and interest provisions takes on greater
significance to taxpayers than the original tax liability itself. The
Tax Section is concerned that these provisions often catch individuals
unaware, and that the system lacks adequate flexibility to achieve
equitable results. In light of the significant changes being made by
the IRS, the completion of this study and eventual enactment of the
recommendations will be welcome.
The Tax Section has submitted preliminary comments to the staff of
the Joint Committee on Taxation that we hope will be useful in
developing alternatives.
Conclusion
Thank you again for the opportunity to testify at this very
important hearing. We wish you, and concomitantly all individual and
small business taxpayers, success in your endeavors. We would be happy
to work with the Committee and this Subcommittee as legislation is
developed to address the twin tasks of simplification and avoidance of
complexity.
Chairman Houghton. Thank you very much. We are having to
work on our mechanics here because we have another vote. We
will get around to some questions, Mr. Tucker. Thanks very
much.
Mr. Lifson.
STATEMENT OF DAVID A. LIFSON, CHAIR, TAX EXECUTIVE COMMITTEE,
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Mr. Lifson. Mr. Chairman and Members of this Distinguished
Committee, my name is David Lifson and I speak to you
representing over 330,000 certified public accountants, as the
chair of the Tax Executive Committee of the American Institute
of CPAs.
Many of our members provide comprehensive tax services for
all types of taxpayers, including businesses and individuals in
various financial situations. They work daily with the tax
provisions you enact and we are committed to helping make our
tax system as simple yet as fair as possible. These days, the
process of obeying the tax law is more daunting than ever. Our
tax laws are too complicated. The current outcry for tax
simplification is not new. In fact the AICPA has warned
Congress for more than a decade that the tax law is growing so
dense that it threatens to undermine voluntary compliance.
Chairman Houghton, I commend you on your commitment to
reducing the complexity of the tax law. Your Tax Simplification
and Burden Reduction Act represents an excellent starting point
for reducing the tax compliance burden imposed on many
individual taxpayers and small businesses.
In our written statement submitted for the record, we have
included our top 10 list of tax law complexities, designed for
individuals and small businesses. We share concerns about such
areas of law as the individual AMT and the estimated tax safe
harbor. We urge you to place a high tax policy value on tax
simplification and would be pleased to work with you to try to
make your tax legislative proposals as simple and as complete
and as effective as possible.
Complexity has already led to a growing perception by
taxpayers that the tax law is unfair, increased costs in
funding the IRS to administer the tax law, increased taxpayer
compliance costs, and, perhaps, most importantly, undue
interference with business decisionmaking. Our tradition of
voluntary tax compliance and self-assessment is a national
treasure. By and large, our citizens obey the law, but it is
only human to disobey a law if you do not or cannot understand
the rules.
There are various types of simplification, such as
simplification that reduces calculation complexity, like the
earned income credit calculation. Simplification that reduces
the filing burden such as electronic filing. Perhaps most
importantly, simplification that reduces the chances of a
dispute between the Internal Revenue Service and the taxpayer,
such as worker classification reform.
The first two types of simplification are sometimes the
easiest to identify, yet, politically, they may not be the
easiest to address. But they should be the low fruit on the tax
tree that you can see and capture most readily. The last type,
adding certainty to the law and thereby reducing the likelihood
of disputes is the most difficult to effectuate, yet perhaps it
is the most important. Please help us find simplification in
all three areas. Clarifying law that is hard to understand must
be a priority if we are to achieve a simpler system and to
avoid unnecessary taxpayer unrest.
Our written submission offers a start. Inside are the 10
areas that require serious revisions. There are, in fact,
hundreds of areas that could be improved. Because of their
importance, I will simply mention four areas of particular
interest today. I hope you will look into our full explanation
in our submission for the record.
The alternative minimum tax is one of the most complex
parts of the tax system. It should be eliminated or
substantially simplified. The earned income credit has long
been identified as an area in great need of simplification. The
rules are so complex that the targeted taxpayers are often not
always effectively able to claim the credit. Worker
classification issues often paralyze startup businesses with
uncertainty which leads to resentment of the tax system. Until
taxpayers are provided with clear-cut rules by Congress, this
area will continue to provide unintended traps for small
business owners as well as a continuation of the many battles
between the taxpayers and the IRS. Phaseouts should also be
simplified and we have provided you with a comprehensive,
detailed starting point for legislative action.
There is a good bit more detail in my written statement,
both on the items I have mentioned here and in a number of
other areas. We would only ask that you review that statement
carefully. The AICPA thanks you for the opportunity to help. We
want to simplify the system for everyone's benefit.
[The prepared statement follows:]
Statement of David A. Lifson, Chair, Tax Executive Committee, American
Institute of Certified Public Accountants
Mr. Chairman, and members of this distinguished committee: My name
is David A. Lifson, and I am the chair of the Tax Executive Committee
of the American Institute of Certified Public Accountants (AICPA). The
AICPA is the professional association of certified public accountants,
with more than 330,000 members, many of who provide comprehensive tax
services to all types of taxpayers including businesses and
individuals, in various financial situations. Our members work daily
with the tax provisions you enact, and we are committed to helping make
our tax system as simple and fair as possible.
The AICPA has long been an advocate of simplification of the tax
system. The complexity of our tax law has reached the point where many
taxpayers and practitioners believe that it is undermining voluntary
compliance. Frequent change, the lack of deliberation in the
legislative process, and the increasing magnitude and complexity of the
Internal Revenue Code are serious concerns for tax professionals.
Chairman Houghton, I commend you on your commitment to reducing the
complexity of the tax law. The pending Tax Simplification and Burden
Reduction Act represents an excellent starting point for reducing the
tax compliance burden imposed on many individual taxpayers and small
businesses. As you can see from the Top Ten List of Tax Law
Complexities, we share concerns about such areas of law as the
individual alternative minimum tax and the estimated tax safe harbor.
Many of our comments urge simpler solutions, particularly in the
area of the individual alternative minimum tax and the proliferation of
individual credits with complex income phase-out rules for families. We
urge you to place a high tax policy value on tax simplification and
would be pleased to work with you to try to make your tax legislative
proposals as simple and as effective as possible.
There are various types of simplification such as: simplification
that reduces calculation complexity, like the AMT calculation;
simplification that reduces the filing burden, such as electronic
filing; and, simplification that reduces the chances of a dispute
between the Internal Revenue Service and the taxpayer. The first two
types are sometimes the easiest to identify and accomplish--the ``low
fruit'' on the tax tree that you can see and capture most easily. The
last type, adding certainty to the law and thereby reducing the
likelihood of disputes, is the most difficult to effectuate yet,
perhaps, the most important.
Clarifying law that is hard to understand must be a priority if we
are to achieve a simpler system. There are numerous areas of the Code
where this type of simplification is needed. One example is in the area
of worker classification. The AICPA is on record as supporting S.344,
the Independent Contractor Simplification and Relief Act of 1999, which
was introduced by Senator Christopher Bond on February 9, 1999. At this
time we are examining other proposed legislation in this area. It is
our hope that the proper elements can be pulled together so that worker
classification simplification can be accomplished. We welcome the
opportunity to work with legislators and staffs to design an approach
that provides certainty, while balancing the needs of service
recipients and the rights of service providers.
Significant problems arise from the increasing complexity of the
tax law. For example:
a growing number of taxpayers perceive the tax law to be
unfair;
it becomes increasingly more difficult for the Internal
Revenue Service to administer the tax law;
the cost of compliance for all taxpayers is increasing (of
particular concern are the many taxpayers with unsophisticated
financial affairs who are forced to seek professional tax return
preparation assistance); and,
complexity interferes with economic decision making.
The end result is erosion of voluntary compliance. By and large,
our citizens obey the law, but it is only human to disobey a law if you
do not or can not understand the rules. In a recent Associated Press
(AP) poll, 66 percent of the respondents said that the federal tax
system is too complicated. Three years ago, just under one-half of
respondents in a similar AP poll said that the tax system was too
complicated.
The poll also showed that more than half of those surveyed, 56
percent, now pay someone else to prepare their tax returns. This is a
serious indictment of our tax system. When over half our individual
taxpayers have so little comprehension of (or faith in) their tax
system that they have to hire another party to prepare their returns,
something is not right. Consider, too, that only about 30% of
individual returns claim itemized deductions. Thus, a significant
segment of those paying to have returns prepared are standard deduction
filers. The AICPA firmly believes that taxpayers with relatively simple
financial affairs should not have to seek professional preparation
services in order to comply with the tax law.
To maintain a viable voluntary tax system, simplification must have
a prominent position in the tax process. Although it should not take
precedence over revenue and tax policy objectives, simplification must
be an integral part of the tax legislative, regulatory, and
administrative process. While a tax system that is simple for all
taxpayers may never be designed, a ``simpler'' system is attainable,
both through new legislative proposals and a review of existing tax
law.
AICPA Blueprint for Tax Simplification and Complexity Index
The AICPA in the Blueprint for Tax Simplification, issued in 1992,
identified four elements necessary to create a simpler tax system: (1)
a visible constituency to communicate the need for simplification to
Congress and the Administration; (2) identification of guiding
principles for tax simplification; (3) identification of factors that
contribute to complexity to be used in the development of a framework
for analyzing the balance among equity, policy, revenue, and
simplification objectives; and, (4) consideration of simplification at
all stages of the legislative and regulatory process.
The Blueprint also outlined guiding principles in pursuing a
simpler tax law. These are:
the legislative process should consider the objectives of
equity, efficiency and revenue needs, balancing them with
simplification;
once tax policy objectives have been identified,
alternative approaches to implementing the policy should be considered
to provide the simplest possible design and administration;
the long-term benefit of any change made to simplify the
tax law should more than offset any transitory complexity that results
by a change;
the law and regulations should be drafted within a
rational, consistent framework;
there should be a balance between simple general rules and
more complex detailed rules;
the benefit of a provision should be weighed against the
cost of compliance; and
tax rules should build on common industry record keeping
and business practices.
The Blueprint concluded with the identification of the leading
factors that create complexity: the effects of change; subjectivity;
lack of consistent concepts; structural complexity; the effect on
taxpayers not targeted by a particular provision; communication
complexity; computations; complexity of forms; administrative issues;
legal complexity; transactional application and business dynamics;
diffusion of responsibility; inconsistent application of rules; and the
legislative process.
From these factors, the AICPA then developed and released the
Complexity Index. The Index is a tool for measuring complexity factors
to assess the complexity, or simplification, of proposed tax law
changes relative to existing law or competing legislative proposals.
The Index is used by AICPA committees when developing legislative
proposals and comments. Although we understand that complexity is a
multidimensional concept and acknowledge that no single index can
measure complexity in an absolute sense, the AICPA has encouraged
Congressional tax writing committees and staffs to use the same or a
similar index when considering and drafting proposed legislation.
Internal Revenue Service Restructuring and Reform Act of 1998
The AICPA was greatly pleased when many of the concepts and factors
contained in the Blueprint and Index were incorporated into the tax law
complexity analysis mandated by the Internal Revenue Service
Restructuring and Reform Act of 1998.
The Act requires an annual tax law analysis of sources of
complexity in administration of the Federal tax laws to be conducted by
the Commissioner of Internal Revenue. This analysis will draw on such
information as: questions frequently asked by taxpayers; common errors
on tax returns; areas of law which frequently result in disagreements
between taxpayers and the IRS; and areas of law lacking published
guidance.
The Act also requires the Joint Committee on Taxation, in
conjunction with the IRS and the Treasury Department, to develop a
complexity analysis of any proposed legislation that has widespread
applicability to individuals or small business. This analysis will draw
on such information as: an estimate of the number of taxpayers affected
by a provision; the income level of affected taxpayers; the effect of a
proposed change on tax forms and published guidance; any additional
record keeping requirements imposed on taxpayers; and an estimated cost
to taxpayers to comply with the provision.
Now that a framework for analyzing complexity has been established
and tools are being developed to measure a proposal's effect on the
complexity of the law, steps must be taken to ensure that the tools are
used and that the information obtained is formally considered in the
legislative and regulatory process. This final element is critical to
achieving a simpler tax system for many taxpayers.
Recent Legislative Proposals
In recent years, tax legislation has increasingly included complex
thresholds, ceilings, phase-ins, phase-outs, effective dates, and
sunset dates in an effort to provide benefits to numerous specific
groups within the limits of revenue neutrality. For example, the
President's Fiscal Year 2000 Budget tax proposals, as drafted, continue
this trend through numerous, additional targeted credits. While these
credits are well-intentioned, cumulatively they would further weigh
down our tax system with complexity. Many average taxpayers do not
understand the benefits to which they are currently entitled. While it
is still early, we believe that taxpayers will, all too frequently,
omit from their 1998 tax returns some of the benefits intended for
them. In fact the Wall Street Journal just reported on April 12 that
the IRS had discovered that 30,000 filers eligible for the child tax
credit had filled out their tax return wrong. Other taxpayers will be
disappointed to learn that they do not qualify for benefits that they
have heard about because of complex phase-out rules written in fine-
print. Taxpayers will have difficulty in complying, much less planning
for, and this level of complexity.
We understand that delivering politically popular benefits within
budget constraints often results in simplification being sacrificed.
However, the Administration's current proposals are only the
continuation of a growing trend to complicate our tax structure through
targeted benefits. For example, the 1997 Taxpayer Relief Act enacted
the new dependent child credit (up to $400 in 1998 for dependent
children under 17 years of age) that had strong political support from
both political parties. The AICPA opposed the proposal, not on policy
grounds but solely based on simplification of the law. Rather than
introduce a new form, a new set of calculations and a new set of income
phase-outs, a rough equivalent of the desired objective could have been
achieved by increasing the dependency exemption available for children
under 17. Since exemption deductions already phase-out for the wealthy,
the increased amount would not have been available for our most
affluent taxpayers. Obviously, we were politically incorrect. But, we
think we were correct in the context of tax simplification.
The Administration's revenue proposals contain numerous provisions
affecting individuals, such as: a new long-term care credit, a new
disabled workers tax credit, the child and dependent care tax credit
expansion, the employer-provided educational assistance exclusion
extension, a new energy efficient new homes credit, the electric
vehicles credit extension, AMT relief extension, a new D.C. homebuyers
credit, optional self-employment contributions computations, a new
severance pay exemption, a new rental income inclusion, etc. While we
are not commenting on the policy need for these provisions, we note
that Congress must consider the general administrability of these
provisions.
We are very concerned about the increasing complexity of the tax
law as a result of targeted individual tax cuts. The 1997 Taxpayer
Relief Act contained several targeted individual tax cuts that were
first effective for 1998 individual income tax returns. As discussed in
the Wall Street Journal of February 17, 1999, these provisions, while
providing tax relief to certain individuals, have greatly increased the
complexity of the preparation of individual income tax returns. This
increased compliance burden is born mostly by lower income taxpayers
who can least afford the cost of hiring a professional income tax
return preparer.
IRS National Taxpayer Advocate W. Val Oveson, in his first report
to Congress, stated that increasing tax law complexity is imposing
significant compliance and administrative burdens on the IRS and
taxpayers. The report also cited the increasing complexity caused by
the targeted individual tax cuts contained in the 1997 Taxpayer Relief
Act.
The Administration's tax proposals contain 28 new targeted tax
cuts. Many of these provisions have limited applicability; none are
available to high-income taxpayers. Unfortunately, the way these
provisions are drafted with different income limits for each provision,
taxpayers need to make many additional tax calculations just to
determine if they are eligible for the tax benefit. The
Administration's tax proposals will add several additional income
limits to the Internal Revenue Code.
Below are a few examples of provisions in the Administration's tax
proposals that have different phase-out limits:
The long-term care credit and disabled workers tax credit
would be phased out ``by $50 for each $1,000 (or fraction thereof) by
which the taxpayer's modified AGI exceeds'' $110,000 (married filing a
joint return taxpayers), $75,000 (single/head of household), or $55,000
married filing separate.
The first-time D.C. homebuyers credit phases out for
individuals with AGI between $70,000 and $90,000 ($110,000 to $130,000
for joint filers).
The severance pay exemption would not apply if the total
severance payments received exceed $75,000.
The expanded child and dependent care credit proposal
would allow taxpayers the 50 percent credit rate if their AGI is
$300,000 or less, then the credit rate would be reduced by one
percentage point for each additional $1,000 of AGI in excess of
$300,000, and taxpayers with AGI over $59,000 would be eligible for a
20 percent credit rate.
The student loan interest deduction (to which the
President's proposal would eliminate the current 60-month limit) phases
out ratably for single taxpayers with AGI between $40,000 and $55,000
and between $60,000 and $75,000 for married filing a joint return
taxpayers.
This type of law, with so many different phase-out limits, provides
incredible challenges for middle-income taxpayers, in determining how
much of what benefit they are entitled to. We suggest common phase-out
limits among all individual tax provisions in order to target benefits
to one of three uniform groups and simplify the law. Our phase-out
simplification proposal is attached.
Another problem with these targeted tax cuts is that the impact of
the alternative minimum tax (AMT) on these cuts is not adequately
addressed. This is evidenced by the provision in the 1998 IRS
Restructuring and Return Act and the provision in the Administration's
tax proposals that provide temporary relief from the AMT for
individuals qualifying for some of the targeted tax credits. We believe
that the individual alternative minimum tax needs to be simplified; our
proposal is attached.
Finally, much of the complexity in the individual income tax system
is the result of recent efforts to provide meaningful tax relief to
medium and low-income taxpayers. In order to aid simplification, we
believe that Congress should consider alternatives to targeted tax
cuts, including the new ones proposed by the Administration, with
provisions such as the following:
Increased standard deduction.
Increased amount for personal exemptions.
Increasing the taxable income level where the 28 percent
tax and the 31 percent tax rate begins.
Marriage penalty relief.
The AICPA would like to further study the complexity caused by the
proliferation of credits with their complex provisions, and hopes to
provide further specific comments as this legislation progresses.
AICPA Simplification Efforts
Over the years the AICPA has made numerous, regular submissions of
specific tax simplification recommendations. Examples include the
annual release of ``The AICPA Top Ten List of Tax Law Complexities''
and the April 1997 comprehensive package of simplification proposals
which included recommendations to simplify the tax law for individuals,
small businesses, employee benefit taxation, trust and estate taxation,
corporation and shareholder taxation, financial service and product
institutions taxation, and international taxation. The AICPA is once
again initiating a project to develop a comprehensive package of tax
simplification recommendations that we hope to share with this
committee later in the year.
In the meanwhile, our statement below contains the AICPA 1999 Top
Ten List of Tax Laws Complexities that would significantly simplify the
tax law for individuals. We also encourage this committee to consider
alternatives to targeted tax credits and cuts, including an increased
standard deduction, increased personal exemption amount, reduction of
the income level at which current rates apply, and relief from the
marriage penalty.
Specific Simplification Recommendations--Top Ten List of Tax Law
Complexities for Individual Taxpayers and Small Businesses
Simplification of the Individual Alternative Minimum Tax (AMT)
Present Law
Complexity of AMT. The AMT is one of the most complex parts of the
tax system. Each of the adjustments of Internal Revenue Code (IRC)
section 56, and preferences of IRC Section 57, requires computation of
the income or expense item under the separate AMT system. The
supplementary schedules used to compute many of the necessary
adjustments and preferences must be maintained for many years to allow
the computation of future AMT as items turn around.
Generally, the fact that AMT cannot always be calculated directly
from information on the tax return makes the computation extremely
difficult for taxpayers preparing their own returns. This complexity
also calls into question the ability of the Internal Revenue Service to
audit compliance with the AMT. The inclusion of adjustments and
preferences from pass-through entities also contributes to the
complexity of the AMT system.
Effects of the Taxpayer Relief Act of 1997 and AMT on Individual
Taxpayers. If the Administration's budget proposal on temporary AMT
relief expansion is not enacted, several tax credits included in the
Taxpayer Relief Act of 1997 will have a dramatic impact on the number
of individuals who will find themselves subject to the AMT. For many,
this will come as a real surprise and, in all likelihood, will cause
substantial problems for the Internal Revenue Service, which will have
to redirect significant resources to this area in the future to ensure
compliance, educate taxpayers, and handle taxpayer questions. We
believe the Administration's proposal should be for permanent AMT
relief rather than just temporary two-year relief.
Most sophisticated taxpayers understand that there is an
alternative tax system, and that they may sometimes wind up in its
clutches; unsophisticated taxpayers, however, may never have even heard
of the AMT, certainly do not understand it, and do not expect to ever
have to worry about it. Unfortunately, that is changing--and fairly
rapidly--because a number of the more popular items, such as the
education and child credits that were recently enacted, offset only
regular tax and not AMT. While Congress changed the law--for 1998
only--to allow these credits against AMT, it is now faced with the need
to continue revisiting this issue if there is to be continuing relief.
Thus, the question of nonrefundable credits as an AMT offset has joined
the unenvied list of ``expiring provisions'' or ``extenders'' for which
it becomes necessary to continue finding revenues to pay for another
year or two of what should be a matter of simplicity and equity.
Indexing of AMT Brackets and Exemption. Numerous anecdotal examples
now indicate the likelihood that taxpayers with adjusted gross incomes
in the $60,000-$70,000 range (or below) will be subject to AMT in the
next few years. Aside from the fairness issues involved--this is not
the group that the AMT has ever been targeted to hit--we see some
potentially serious compliance and administration problems. Many of
these taxpayers have no idea that they may be subject to the AMT (if,
indeed, they are even aware that there is an AMT). Thus, we anticipate
large numbers of taxpayers not filling out a Form 6251 or paying the
AMT who may be required to do so, thus requiring extra enforcement
efforts on the part of the IRS to make these individuals (most of whom
will otherwise be filing in absolute good faith) aware of their added
tax obligations. Further, IRS notices to these taxpayers assessing the
proper AMT may well be perceived as unfair, subjecting the IRS to
unwarranted criticism that should be directed elsewhere.
Recommended Changes
Due to the increasing complexity, compliance problems, and a
perceived lack of fairness towards the intended target, the AICPA
supports eliminating the individual AMT altogether. These provisions
have been in the law since 1978 (with amendments from time to time),
and substantive changes to the regular tax regime in the past 20 years
have resulted in much of the AMT impact now coming from disallowance of
itemized deductions, with a slowly growing secondary effect from the
failure to index tax brackets and exemptions. Thus, the policy
underpinning of the AMT which was present in 1978 has been greatly
diluted.
While we are concerned with those who have to pay the AMT based
upon mechanical rules that leave a lot to be desired from a policy
perspective, we also note that many non-AMT payers must still be AMT
filers. We would be interested in seeing statistics as to the number of
individual taxpayers who struggle to fill out Form 6251 just to show
they do not have an AMT liability. To fill this form out correctly is
one of the most baffling experiences a taxpayer can go through -not
because the IRS can't design forms (they do a terrific job overall),
but because the law is so incomprehensible it defies being reduced to a
set of easily derived numbers and simple instructions.
For these reasons, and others described above, we believe the
individual AMT is an appropriate candidate for repeal. We do, however,
recognize that there is no simple solution to the AMT problem given the
likely revenue loss to the government. If repeal is not possible,
Congress should consider the following:
1. Increasing and/or indexing the AMT brackets and exemption
amounts.
2. Eliminating itemized deductions and personal exemptions as
adjustments to regular taxable income in arriving at alternative
minimum taxable income (AMTI) (e.g., all--or possibly a percentage of--
itemized deductions would be deductible for AMTI purposes).
A. At the very least, state income taxes should no longer be an
adjustment. There is very little fairness in concluding that a resident
of California, the District of Columbia, or New York should have a
higher likelihood of incurring the AMT than a resident of Texas, solely
for making a choice of state in which to live or work.
3. Eliminating many of the AMT preferences by reducing for all
taxpayers the regular tax benefits of AMT preferences (e.g., require
longer lives for regular tax depreciation).
4. Allowing certain regular tax credits against AMT (e.g., low-
income tax credit, tuition tax credits)--permanently, rather than just
for the next two years.
5. Providing an exemption from AMT for low and middle-income
taxpayers with regular tax AGI of less than $100,000.
6. The impact of AMT in all future tax legislation.
Contribution to Simplification
The fairness goal of the AMT has created hardship and complexity
for many taxpayers who have not used preferences to lower their taxes.
Many of these individuals are not aware of these rules and complete
their return themselves, causing confusion and errors. The 1997 law and
the impact of inflation on indexed tax brackets and the AMT exemption
are causing more lower-income taxpayers to be inadvertently subject to
AMT. Increasing and/or indexing the AMT brackets and exemption
(recommendation 1) would solve this problem.
Under recommendation 2, those individuals who are affected only by
itemized deductions and personal exemption adjustments would no longer
have to compute the AMT. Itemized deductions are already reduced by the
phase out for high income taxpayers, 2 percent AGI miscellaneous
itemized deduction disallowance, 7.5 percent AGI medical expense
disallowance, $100 and 10 percent AGI casualty loss disallowance, and
the 50 percent disallowance for meals and entertainment. Similarly, the
phase out of exemptions already affects high-income taxpayers. It is
also worth noting that because state income taxes vary, taxpayers in
high income tax states may incur AMT solely based on the state in which
they live, while other taxpayers with the same AGI, but who live in
states with lower or no state income taxes, would not pay AMT. This
unintentionally works to the disadvantage of residents of high tax
states.
In addition, under recommendation 3, many of the AMT preferences
could be eliminated by reducing for all taxpayers the regular tax
benefits of present law AMT preferences (e.g., require longer lives for
regular tax depreciation). This would add substantial simplification to
the Code, recordkeeping and tax returns.
Under recommendation 4, those who are allowed regular tax credits,
such as the low income or tuition tax credits, would be allowed to
decrease their AMT liability by the credits. This would increase
simplicity and create fairness. Compliance would also be improved.
Under recommendation 5, fewer taxpayers will be subject to AMT and
its associated problems. By increasing the AMT exemption to exclude low
and middle income taxpayers, the AMT will again be aimed at its
original target--the high-income taxpayer.
In conclusion, we see the AMT as becoming more prevalent and
causing considerable disillusion to many taxpayers whom do not see
themselves as wealthy and who will believe they are being punished
unfairly. The AMT will apply to many taxpayers it was not originally
intended to affect. We believe our proposals offer a wide range of ways
to help address this problem.
Simplification of Earned Income Tax Credit
Present Law
The refundable earned income tax credit (EITC) was enacted in 1975
with the policy goals of providing relief to low-income families from
the regressive effect of social security taxes, and improving work
incentives among this group. According to the IRS, EITC rules affect
almost 15 million individual taxpayers.
Over the last few years, the most common individual tax return
error discovered by the IRS during return processing has been the EITC,
including the failure of eligible taxpayers to claim the EITC, and the
use of the wrong income figures when computing the EITC.
The frequent changes made over the past twenty years contribute
greatly to the credit's high error and noncompliance rates. Some
examples of frequent changes and complexities follow. As part of the
health insurance deduction act that Congress passed in 1995, a new
factor was added to determining eligibility--the amount of interest
(taxable and tax-exempt), dividends, and net rental and royalty income
(if greater than zero) received by a taxpayer, even if total income is
low enough to otherwise warrant eligibility for the EITC. A threshold
of this type of disqualified income was set at $2,350 in 1995, was then
altered as part of the Personal Responsibility and Work Opportunity
Reconciliation Act of 1996 to be $2,200, and goes to $2,300 for 1998.
In addition, in 1996, capital gain net income and net passive income
(if greater than zero) that is not self-employment income were added to
this disqualified income test.
In 1996, the credit computation became even more complicated, with
the introduction of a modified AGI definition for phasing out the
credit, wherein certain types of nontaxable income need to be
considered and certain losses are disregarded. Specifically, nontaxable
items to be included are: tax-exempt interest, and nontaxable
distributions from pensions, annuities, and individual retirement
arrangements (but only if not rolled over into similar vehicles during
the applicable rollover period). The losses that are to be disregarded
are:
net capital losses (if greater than zero);
net losses from trusts and estates;
net losses from non-business rents and royalties; and
50 (changed to 75% in 1997) percent of net losses from
businesses, computed separately with respect to sole proprietorships
(other than in farming), sole proprietorships in farming, and other
businesses--but amounts attributable to business that consist of
performance of services by an individual as an employee are not taken
into account.
In addition to the prior requirement that a taxpayer identification
number (TIN) be supplied for all qualifying children, starting in 1996,
individuals are also required to be authorized to be employed in the
U.S. in order to claim the credit. Failure to provide a correct TIN is
now treated as a mathematical or clerical error.
In 1997, as part of the Taxpayer Relief Act of 1997 (TRA 97), new
restrictions are placed on the availability of the EITC. For example,
taxpayers who improperly claimed the credit in earlier years are denied
the credit for a period of years. If the improper claim was due to
fraud, the disallowance period is ten years after the most recent tax
year for which the final determination is made. If it was due to
reckless or intentional disregard of the rules, the disallowance period
is two tax years after the most recent tax year for which the final
determination was made. Taxpayers who are denied the EITC for any tax
year as a result of tax deficiency procedures must demonstrate
eligibility for the credit and provide additional information to the
IRS in order to claim the credit in any later tax year.
In addition, the 1997 law increases from 50% to 75% the amount of
net losses from carrying on trades or businesses that is disregarded in
determining modified AGI. The 1997 legislation also includes the
following items in determining modified AGI for the credit: tax-exempt
interest received or accrued during the tax year; and non-taxable
distributions from pensions, annuities, or individual retirement plans
(if not rolled over into similar vehicles during the rollover period).
The 1997 law provides that workfare payments are not earned income for
EITC purposes.
The credit has been changed 13 times (1976, 1977, 1978, 1979, 1984,
1986, 1988, 1990, 1993, 1994, 1995, 1996 and 1997) and now is a
nightmare of eligibility tests, requiring a maze of worksheets.
Computation of the credit currently requires the taxpayer to consider 9
eligibility requirements:
the number of qualifying children--taking into account
relationship;
residency test;
age test;
the taxpayer's earned income--taxable and non-taxable;
the taxpayer's AGI;
the taxpayer's modified AGI;
threshold amounts;
phase out rates; and,
varying credit rates.
To claim the credit, the taxpayer may need to complete:
a checklist (containing 9 complicated questions);
a worksheet (which has 10 steps);
another worksheet (if there is self-employment income);
and
a schedule with 6 lines and 2 columns (if qualifying
children are claimed).
For guidance, the taxpayer may refer to 7 pages of instructions
(and 28 pages of IRS Publication 596). The credit is determined by
multiplying the relevant credit rate by the taxpayer's earned income up
to an earned income threshold. The credit is reduced by a phase-out
rate multiplied by the amount of earned income (or AGI, if less) in
excess of the phase-out threshold.
While Congress and the IRS may expect that the AICPA and its
members can comprehend the EITC intricacies and the many pages of
instructions and worksheets, it is unreasonable to expect those
individuals entitled to the credit (who will almost certainly NOT be
expert in tax matters) to deal with this complexity. Even our members,
who tend to calculate the credit for taxpayers as part of their
volunteer work, find this area to be extremely challenging.
Our analysis suggests that most of the EITC complexity arises from
the definitional distinctions in this area. While each departure from
definitions used elsewhere in the Code can be understood in a context
of accomplishing a specific legislative purpose, the sum of all the
definitional variances causes this IRC Section to be unmanageable by
taxpayers and even the IRS. We recognize that many of the additions and
restrictions to the credit over the years were well intended. However,
the rules are so complex that the group of taxpayers to be benefited
finds them incomprehensible and are not effectively able to claim the
credit to which they are entitled.
Recommended Changes
We recommend that Congress adopt the following changes to the EITC.
1. Simplify definitions and the calculation.
2. Define ``earned income'' as taxable wages (Form 1040, line 7)
and self-employment income (Form 1040, line 12).
3. Modify the ``qualifying child'' rules.
A. Replace the ``qualifying child'' definition with the existing
``dependent child'' definition.
B. Increase the incremental amount of credit provided for two
children versus one child.
C. Use the dependency exemption rather than the EITC to provide
benefits relating to children.
4. Combine and expand the denial provision.
A. Deny the credit for taxpayers with: foreign earned income,
alternative minimum tax liability, and AGI that exceeds earned income
by $2,200 or more.
Contribution to Simplification
Instructions and computations would be greatly simplified. The
error rate should be dramatically reduced.
Simplification of Phase-Outs Based on Income Level
Present Law
Numerous sections in the tax law provide for the phase-out of
benefits from certain deductions or credits over various ranges of
income based on various measures of the taxpayer's income. There is
currently no consistency among these phase-outs in either the level of
income, the range of income over which the phase-outs apply, or the
method of applying the phase-outs. Furthermore, the ranges for a
particular phase-out often differ depending on filing status, but even
these differences are not consistent. For example, the traditional IRA
deduction phases out over a different range of income for single filers
than it does for married-joint filers; whereas the $25,000 allowance
for passive losses from rental activities for active participants
phases out over the same range of income for both single and married-
joint filers. Consequently, these phase-outs cause inordinate
complexity, particularly for taxpayers attempting to prepare their tax
returns by hand; and the instructions for applying the phase-outs are
of relatively little help. See the attached Exhibits for a listing of
most current phase-outs, including their respective income
measurements, phase-out ranges (for 1998) and phase-out methods.
Note that currently many the phase-out ranges for married-filing-
separate (MFS) taxpayers are 50 percent of the range for married-
filing-joint (MFJ), while many of the phase-out ranges for single and
head of household (HOH) taxpayers are 75 percent of married-joint. That
causes a marriage penalty when the spouses' incomes are relatively
equal.
Recommended Changes
Simplification could easily be accomplished by eliminating phase-
outs altogether. However, if that is considered either unfair
(simplicity is often at odds with equity) or bad tax policy,
significant simplification can be achieved by creating consistency in
the level of income, the income range of phase-out and the method of
phase-out.
Instead of the approximately 20 different phase-out ranges (shown
in attached Exhibit A), we recommend only three--at levels representing
low, middle, and high income taxpayers.
If there are revenue concerns, the ranges and percentages could be
adjusted, as long as the phase-outs for each income level group (i.e.,
low, middle, high income) stayed consistent across all relevant
provisions. In addition, marriage penalty impact should be considered
in adjusting phase-out ranges for revenue needs.
We propose that all phase-out ranges for MFS taxpayers should be
the same as those for single and HOH taxpayers, which would be 50
percent of the range for MFJ taxpayers.
The benefits that are specifically targeted to low-income
taxpayers, such as the earned income credit, elderly credit, and
dependent care credit, would phase-out under the low-income taxpayer
phase-out range. The benefits that are targeted to low and middle
income taxpayers, such as the traditional IRA deduction and education
loan interest expense deduction, would phase-out under the middle-
income taxpayer phase-out range. Likewise, those benefits that are
targeted not to exceed high income levels, such as the new child
credit, the new education credits and education IRA, and the new Roth
IRA, as well as the existing law AMT exemption, itemized deductions,
personal exemptions, adoption credit and exclusion, series EE bond
exclusion, and section 469 $25,000 rental exclusion and credit, would
phase-out under the high-income taxpayer phase-out range.
Additionally, instead of the differing methods of phase-outs (shown
in attached Exhibit B), the phase-out methodology for all phase-outs
would be the same, such that the benefit phases out evenly over the
phase-out range. Every phase-out should be based on adjusted gross
income (AGI).
Proposed Adjusted Gross Income Level Range for Beginning to End of Phase-Out for Each Filing Status
----------------------------------------------------------------------------------------------------------------
Category of Taxpayer Married Filing Joint Single & HOH & MFS
----------------------------------------------------------------------------------------------------------------
Low-Income.................................................... $15,000-$37,500 $7,500-$18,750
Middle-Income................................................. 60,000-75,000 30,000-37,500
High-Income................................................... 225,000-450,000 112,500-225,000
----------------------------------------------------------------------------------------------------------------
Contribution to Simplification
The current law phase-outs complicate tax returns immensely and
impose marriage penalties. The instructions related to these phase-outs
are difficult to understand and the computations often cannot be done
by the average taxpayer by hand. The differences among the various
phase-out income levels are tremendous. Either the phase-outs should be
eliminated and the same goal accomplished with a lot less complexity by
adjusting rates, or at least the phase-outs should be made applicable
at consistent income levels (only three) and applied to consistent
ranges using a consistent methodology. This would ease the compliance
burden on many individuals. If there were only three ranges and only
one methodology, it would be much easier to recognize when and how a
phase-out applies. Portions of numerous Internal Revenue IRC Sections
could be eliminated. By also making the MFJ phase-out ranges double the
ranges applicable to single individuals, and by making the MFS ranges
the same as single individuals, the marriage penalty associated with
phase-out ranges would be eliminated. (See Exhibit A for selected AGI
phase-out amounts and Exhibit B for current methods of phase-out.)
Eliminate the Marriage Penalty
Present Law
Under the current tax system, a marriage penalty and marriage bonus
exist. The marriage penalty/bonus results when two married individuals
have a greater (penalty) or smaller (bonus) tax liability as compared
to two similarly situated single individuals (i.e., individuals with
the same total incomes). The marriage penalty is likely an unintended
result from prior legislative efforts to be equitable. As each Congress
introduces changes to the Code, complexity and unintended tax effects
often result. There are at least 63 provisions in the Internal Revenue
Code where tax liability depends on whether a taxpayer is married or
single. Most of these differences were created to be fair; to target
benefits to specific taxpayers, or to prevent abuses. Some examples are
the tax rates, standard deduction, and earned income tax credit, as
well as social security benefits taxation, capital loss limits, IRAs,
dependent care credit, child credit, and education tax incentives.
The two major factors that have created the marriage penalty
problems are:
1. The ``stacking of income'' problem, resulting from the different
and progressive tax rate/bracket schedules applicable to different
filing statuses, and
2. Different income thresholds and phase-outs of deductions and
credits for single versus married taxpayers.
The progressive tax rate/bracket schedules impose a higher marginal
tax on combined spousal earnings, as compared to two single persons.
Additionally, the tax brackets for married filing joint are not twice
as wide as the brackets for single taxpayers, and the tax brackets for
married filing separately do not equate to the tax brackets for single
taxpayers. We refer to this phenomenon as the ``stacking of income''
problem and there are a variety of ways to address it.
The second factor contributing to the marriage penalty is the large
number of provisions that phase-out based on income levels that may or
may not differ based on marital/filing status. The TRA 97 significantly
increased the provisions with different phase-outs for different filing
status (i.e., based on joint, single, or married filing separately).
Recommended Changes
The AICPA has been studying this area for many years and
recommends that the marriage penalty be eliminated or reduced.
There are a number of possible approaches to address the
marriage penalty problem.
1. Provide a deduction to reduce the marriage penalty, such
as the two-earner deduction. This would be the simplest
solution to implement, and would eliminate some, but not
necessarily all, of the marriage penalty and could add to
marriage bonuses. It would have to apply for both regular tax
and alternative minimum tax (AMT) and not be subject to an AGI
phase-out to be fully effective.
2. Provide on one return, a separate calculation of each
spouse's taxable income and use one tax rate schedule that
would apply to all individuals. The income and deductions of
each spouse could be allocated in a variety of ways, e.g., by
property ownership, by AGI, by percentage of earned income, 50/
50, or in the parties' discretion. In our opinion,
conceptually, this one-return, separate calculation proposal
could produce the most equitable system. However, any
allocation of income and deductions adds complexity in return
filing and tax administration. The total increase in complexity
will depend on the allocation methods used. Many states that
have an income tax, such as Virginia, use this approach.
3. Provide a tax credit to reduce the marriage penalty.
This would eliminate some, but not necessarily all, of the
penalty and could add to the marriage bonus. It would have to
apply for both regular tax and AMT to be fully effective.
Several considerations would have to be taken into account,
such as the complexity in the calculation, the treatment of
carryovers and carrybacks, and the priority ordering of the
many tax credits that could apply.
4. Adjust/broaden the current rate/bracket schedules
applicable to married individuals. The joint schedule could be
modified to eliminate the marriage penalty (by increasing the
joint brackets to twice the single brackets) or to reduce the
penalty. Another approach would be to conform the married
filing separate and single rate/bracket schedules (such as in
Arizona). This approach would be better than the current system
and could be viewed as elective complexity for those couples
that chose to file separately.
5. Adopt standard phase-outs for three income levels--low,
middle, and high-income taxpayers (rather than the 20 current
levels), and adopt one standard phase-out method. This would
eliminate marriage penalties related to phase-outs, since the
joint amounts would be twice the single ranges, and the phase-
out ranges applicable to married filing separate taxpayers
would be the same as those for single taxpayers.
In addition, there are related tax problems that arise
because of marriage and divorce, and we urge the Committee to
give these matters consideration. For example, the treatment of
carryover tax attribute rules and NOL computations in divorce
situations need modification. We also note that various IRC
regulations (i.e., under IRC Sections 108, 121, 154, 163, 1041,
and 6013) regarding spouses and divorce situations need to be
amended.
This recommendation discusses a number of possible
approaches to address the marriage penalty problem. However,
each of these provisions needs to be thoroughly analyzed in
order to provide the economic, tax, and social benefits that
Congress determines is appropriate. Further, to eliminate
marriage penalties and improve simplification, standard phase-
outs (with joint ranges being twice the single and married
filing separate ranges) for three income levels--low, middle,
and high-income taxpayers (rather than the 20 current levels)--
and one standard phase-out method should be adopted.
Contribution to Simplification
By eliminating or reducing the marriage penalty and marriage bonus,
the tax system would become ``marriage neutral.'' Tax complexities
arising out of marriage and divorce would be reduced and the tax system
would be made more rational and equitable.
Simplification of Employee vs. Independent Contractor
Present Law
The rules relating to classification of a worker as an employee or
independent contractor are unclear. This results in needless confusion
and potentially large tax assessments for businesses that are
attempting to comply with the law.
Recommended Changes
A bill (S. 344 Independent Contractor Simplification and Relief Act
of 1999) simplifying the classification of workers was introduced in
the Senate on February 9, 1999 by Senator Christopher Bond (R-MO). This
bill establishes a safe harbor for businesses classifying workers as
independent contractors when either of the following two criteria are
met:
A worker demonstrates economic and workplace independence
meeting a set of stipulated criteria, and a written agreement exists
between the parties; or
A worker conducts business through a corporation or
limited liability company, the worker does not receive benefits from
the service recipient, and a written agreement exists between the
parties.
At this time the AICPA is examining other proposed legislation in
this area. It is our hope that the proper elements can be pulled
together so that worker classification simplification can be
accomplished through an approach that provides certainty, while
balancing the needs of service recipients and the rights of service
providers.
Contribution to Simplification
Until taxpayers are provided with clear-cut rules by Congress, this
area will continue to provide many uncertainties for small business
owners, as well as a continuation of the many battles between taxpayers
and the Internal Revenue Service. This issue is a top priority of many
small business organizations, including the 1995 White House Conference
on Small Business and the U.S. Chamber of Commerce. Even the Treasury
Department has testified that the 20-factor test, historically used by
the Internal Revenue Service to classify workers, is confusing and does
not yield ``clear, consistent, or even satisfactory answers, and
reasonable persons may differ as to the correct classification.''
Simplification of the Kiddie Tax
Present Law
The 1986 Tax Reform Act introduced the so-called ``kiddie tax''
which taxes the net unearned income of children under the age of 14 at
the parents' tax rate. While at first this seems to be straight-forward
approach, it has evolved into a very complicated calculation. When
first enacted in 1986, there was not a preferential tax rate for
capital gains. The introduction of the maximum 28% (now 20%) capital
gain rate has further complicated the situation. Under certain limited
circumstances, parents can elect to include their children's income on
their return. However, the election in not available for parents of a
child with any earned income, unearned income in excess of $5,000,
capital gains, withholding or estimated tax payments.
Instructions for utilization of Form 8615, ``Tax for Children Under
Age 14 Having Investment Income of More Than $1,200,'' cannot be
contained on the reverse of the form. Instead, the IRS has issued
Publication 929, a 20-page booklet which provides the ``hidden
worksheets'' that allow the taxpayer, or the return preparer, to
calculate the child's taxable income, as well as the tax. In situations
in which there are multiple siblings falling within this provision, the
complexity expands. Similarly, if a child is subject to the AMT,
additional calculations are required. In the overwhelming majority of
situations, the additional tax revenue generated by the ``kiddie tax''
appears to be insignificant when compared to the complexity of the
calculations. Also, the kiddie tax provision only considers the regular
tax of section 1 and not the AMT of section 55. Therefore, the way the
current rules are written, if a parent must pay AMT, the children's
income is still taxed at the parent's regular marginal tax rate, while
the parent is taxed at the AMT rate without taking into account the
child's income or the child's regular tax liability. This results in
taxpayers paying more tax than if the parent and children's income are
both included in the parent's AMT calculation.
Recommended Changes
The linkage of a child's taxable income to parents' and other
siblings' taxable income should be repealed. Income (other than capital
gains) subject to kiddie tax should be taxed at a separate rate
schedule (e.g., fiduciary income tax rates). The child's capital gains
should be taxed at the capital gains rates. The election to include a
child's income on the parent's return should be expanded to allow all
income, regardless of its nature or amount, to be included. The
election could apply whether or not the child has withholding or
estimated payments. There could be a check-off, similar to the current
nominee interest check-off, or column added to the Form 1040 Schedules
B and D so as to indicate whether the item applies to another social
security number, to avoid any matching problems.
Contribution to Simplification
The suggested change would allow children's returns to stand on
their own. Issues regarding missing information on one return,
matrimonial issues, and unintended AMT problems would be eliminated.
The perceived loophole of shifting income to minors would remain closed
since fiduciary income moves to higher tax brackets at significantly
lower income levels than individuals.
Allowing across-the-board inclusion of a child's income on a
parent's return could eliminate many children's returns and their
associated compliance burdens for taxpayers and the government.
Simplification of the Individual Estimated Tax Safe Harbor
Present Law
Individuals with adjusted gross incomes of $150,000 or less may
base their current year estimated taxes on 100 percent of their prior
year tax. As changed by TRA 97, individuals with adjusted gross incomes
in excess of $150,000 may base their current year estimated taxes on a
percentage of their taxes for the prior year as follows:
------------------------------------------------------------------------
Percentage
Current Estimated Tax Year of Prior
Year Tax
------------------------------------------------------------------------
1998........................................................ 100
1999........................................................ 105
2000........................................................ 106
2001........................................................ 106
2002........................................................ 112
2003 and thereafter......................................... 110
------------------------------------------------------------------------
Recommended Changes
The percentage of prior year tax should be 100 percent for all
years.
Contribution to Simplification
In general, the estimated tax rules are complex. Prior to TRA 97,
the provisions for basing individual estimated taxes on their prior
year taxes were straight-forward and simple. To change to different
percentages for different years results in poor tax policy, and adds
needless complexity. By basing all estimates on the same percentage for
all years, such as 100 percent of the prior year tax, the complex
calculations that are made quarterly by taxpayers are reduced and
simplicity and year-by-year consistency is added to the Code.
Simplification of Child Credits
Present Law
Effective for years beginning in 1998, taxpayers can claim
a $400 ($500 in 1999 and later) credit for each qualifying
child. The credit is phased out by $50 for each $1,000 of
adjusted gross income over a threshold amount. The threshold
amounts are $110,000 for married persons filing jointly,
$55,000 for married taxpayers filing separately and $75,000 for
single taxpayers.
The basic child credit is a non-refundable credit that is
limited to the excess of regular tax liability over alternative
minimum tax liability. (A special provision treats alternative
minimum tax as equal to zero for 1998 only.) However, to the
extent that the child credit is disallowed because of other
refundable credits, a portion of the credit is converted into a
supplemental refundable credit. Further, an additional
refundable credit for taxpayers with three or more children is
allowed.
Recommended Changes
We recognize that there is no one solution that will both continue
to target the credit to its intended beneficiaries and limit the cost
associated with its benefits. However, we recommend the following
legislative changes.
1. Replace the three-tier child credit system (basic, supplemental
and additional) with one universal, refundable credit.
2. Consider increasing the credit amount and eliminating the
exemption amount for children eligible for the credit.
3. Change the phase out levels to correspond to one of the three
levels included in the AICPA Phase out Simplification proposal.
4. Make permanent the provision that allows the credit against both
regular and alternative minimum tax.
Contribution to Simplification
The purpose of the child credit is to allow a reduction in tax
liability in excess of that provided by the existing exemption
deduction amount. The use of an additional credit amount rather than a
combined credit and exemption mechanism would allow additional use of
credits to be provided to low income taxpayers without the significant
revenue drain associated with providing benefits to high income
taxpayers.
Combining the three-tier credit into one refundable credit would
eliminate confusing computations for taxpayers with low income. The
current system either fosters a system prone to errors or forces
taxpayers with otherwise simple returns to seek professional advice
whose cost would offset a portion of the benefit of the credit.
Simplification of the Generation Skipping Transfer Tax
Present Law
In 1986, Congress enacted the generation skipping transfer
tax (GST tax), which is imposed on transfers to beneficiaries
more than one generation below the transferor's generation at
the maximum gift and estate tax rate (55%). To determine the
rate applicable to a particular transfer, the 55% rate is
multiplied by the inclusion ratio (a fraction based on the GST
exemption amount allocated to the transfer). A trust with a
zero inclusion ratio is exempt from GST tax. Every individual
is allowed a $1 million GST exemption (indexed for inflation),
that may be allocated to any property subject to estate or gift
tax. Married couples may treat transfers as made one-half by
each spouse, in effect giving them a combined $2 million GST
tax exemption. While direct transfers to grandchildren qualify
for an automatic allocation of the GST exemption, transfers to
a trust do not. If a GST exemption is allocated to a lifetime
transfer to a trust on a timely filed gift tax return, the
portion of the trust protected is generally based on the
property's value at the time of the transfer. However, if the
allocation is not made on a timely filed gift tax return, the
portion of the trust protected is based on the value at the
time of allocation. The planning necessitated by the GST tax
exemption rules is very complex and fraught with traps for
taxpayers and their advisors.
Recommended Changes
We propose the following legislative changes:
1. Extend the automatic GST exemption allocation rule (that
currently applies to direct skips) to transfers in trust where
skips are generally expected. Those taxpayers that do not want
the automatic allocation to apply could elect out.
2. Provide relief for GST tax exemption allocations for
those taxpayers who do not make an election because of an
inadvertent failure to timely file an appropriate return and
for those who demonstrate intent to have a zero inclusion ratio
for a trust (substantial compliance).
3. Provide a trust severance rule.
4. Allow retroactive allocations of GST exemption when
there is an unnatural order of death.
Contribution to Simplification
The following examples demonstrate some of the common
problems faced by taxpayers as a result of the current GST tax
rules:
1. P, a parent, transfers $10,000 a year for 10 years to a
discretionary trust for a child, C, and such descendants of C,
which will terminate and distribute to C when C reaches age 35.
If C dies before attaining age 35, the trust is distributable
to the descendants of C. If C dies before age 35 with issue
when the trust assets are worth $100,000, a taxable termination
occurs. Unless P allocates a GST tax exemption before C dies,
the GST tax would be $55,000.
2. P transfers $1 million of stock to a trust to pay income
to C for life, remainder to P's grandchild, G. If the full $1
million GST exemption is allocated to this transfer on a timely
filed gift tax return, and the stock's value is $5 million at
the time the property passes to G, no GST tax results. However,
if the GST tax exemption is not allocated until the property
has grown to $5 million, a $2.2 million GST tax would result if
the property that passes is still worth $5 million when it
passes to G.
3. P transfers $1 million to a trust to pay income to C
until C's 35th birthday, at which time the trust property will
be paid to C. If C dies before his 35th birthday, the trust
property is paid to C's children. If C dies before attaining
age 35 at a time when the trust property is worth $5 million,
and there was no GST tax exemption allocation before C's death,
there would be no opportunity to allocate such exemption and a
$2.75 million GST tax would be imposed.
4. P transfers $5 million to a trust for the benefit of his
five children. If one child dies, current regulations do not
allow the trust to be severed so that a GST tax exemption can
be allocated to the one-fifth of the trust that will primarily
benefit the deceased child's children. (If five separate trusts
had been created instead of one, this problem could have been
avoided).
Simplification would be achieved by making automatic an
allocation of GST tax exemption to those taxpayers likely to
benefit, rather than requiring taxpayers to elect such an
allocation. The planning necessary to take advantage of the GST
tax exemption allowed by law is overly complex and often leads
to errors by taxpayers. These simplification proposals would
allow some relief to taxpayers that fail to make timely
allocations and allow retroactive allocation in situations
involving an unnatural order of death. In addition, the trust
severance rule would simplify the drafting of trusts and
minimize the need for creating multiple trusts simply for GST
tax planning purposes.
Simplification of Half Year Requirements
Present Law
The Internal Revenue Code uses &;-year age requirements to
allow individual taxpayers to begin to withdraw from their
pension plans without penalty. (Example, distribution must be
made after the taxpayer reaches age 59 &; to avoid penalty).
Recommended Change
Change the Internal Revenue Code by eliminating the various
IRC Sections that use &; year requirements: A) Age 70 &; for
mandatory IRA distributions and B) Age 59 &; for penalty free
retirement plan withdrawals. Instead, use whole years: Age 70
and Age 59.
Contribution to Simplification
Many taxpayers, employers and banks are confused when
calculating this part of the requirement. It would be easier to
remember, calculate and administer, and be more user-friendly
if the ages were changed.
EXHIBIT A--Selected AGI Phase-out Amounts
--------------------------------------------------------------------------------------------------------------------------------------------------------
Current Single & Proposed Single &
IRC Section Provision Ft Nt. Current Joint HOH Current Married/Sep Proposed Joint HOH & MFS
--------------------------------------------------------------------------------------------------------------------------------------------------------
PHASE-OUT LEVELS FOR LOW-INCOME TAXPAYERS
21............... 30 Percent (3).............. $10,000-$20,000 $10,000-$20,000 No credit........... $15,000-$37,500 $7,500-$18,750
Dependent Care
Credit.
22............... Elderly Credit.. (4).............. $10,000-$25,000 $7,500-$17,500
$5,000-$12,500
$15,000-$37,500$7
,500-$18,750
32............... EITC (No Child). (2,3,4).......... $5,570-$10,030 10,030 No credit........... $15,000-$37,500 $7,500-$18,750
32............... EITC (1 Child).. (2,3,4).......... $12,260-$26,473 $12,260-$26,473 No credit........... $15,000-$37,500 $7,500-$18,750
32............... EITC (2 or More (2,3,4).......... $12,260-$30,095 $12,260-$30,095 No credit........... $15,000-$37,500 $7,500-$18,750
Children).
--------------------------------------------------------------------------------------------------------------------------------------------------------
PHASE-OUT LEVELS FOR MIDDLE-INCOME TAXPAYERS
219.............. IRA Deduction w/ (1,7,9).......... $50,000-$60,000 $30,000-$40,000 No deduction........ $60,000-$75,000 $30,000-$37,500
retirement plan.
221.............. Education Loan (1,2,6).......... $60,000-$75,000 $40,000-$55,000 No deduction........ $60,000-$75,000 $30,000-$37,500
Interest Exp..
--------------------------------------------------------------------------------------------------------------------------------------------------------
PHASE-OUT LEVELS FOR HIGH-INCOME TAXPAYERS
24............... Child Credit.... (1,5,6).......... $110,000- $75,000- $55,000-............ $225,000-$450,000 $112,500-$225,000
25A.............. Hope Credit & (1,2,6).......... $80,000-$100,000 $40,000-$50,000 No credit........... $225,000-$450,000 $112,500-$225,000
Lifetm. Lrng.
Cr..
23 & 137......... Adoption Credit/ (1,7)............ $75,000-$115,000 $75,000-$115,000 No benefit.......... $225,000-$450,000 $112,500-$225,000
Exclusion.
55(d)............ AMT Exemption... (1,8)............ $150,000-$330,000 $112,500-$247,500 $75,000-$165,000.... $225,000-$450,000 $112,500-$225,000
68............... Itemized (2).............. $124,500- $124,500- $62,250-............ $225,000-$450,000 $112,500-$225,000
Deduction level.
135.............. EE Bond int. (1,2,7).......... $78,350-$108,350- $52,250-$67,250 No exclusion........ $225,000-$450,000 $112,500-$225,000
Exclusion.
151.............. Personal (2).............. $186,800-$309,300 $124,500-$247,000 $93,400-$154,650.... $225,000-$450,000 $112,500-$225,000
Exemption. HOH$155,650-$278,
150
219-(g)(7)....... IRAw/spouse w/ (1,6,7).......... $150,000-$160,000 Not applicable No deduction........ $225,000-$450,000 $112,500-$225,000
retrmt.plan.
408A............. Roth IRA (1,6)............ $150,000-$160,000 $95,000-$110,000 No deduction........ $225,000-$450,000 $112,500-$225,000
Deduction.
408A............. IRA to Roth IRA (1,6,7).......... $100,000 $100,000 No rollover......... $225,000-$450,000 $112,500-$225,000
Rollover.
469 (i).......... $25,000 Rent (1,7)............ $100,000-$150,000 $100,000-$150,000 $50,000-$75,000..... $225,000-$450,000 $112,500-$225,000
Passive Loss.
469 (i).......... Passive Rehab. (1,7)............ $200,000-$250,000 $200,000-$250,000 $100,000-$125,000... $225,000-$450,000 $112,500-$225,000
Credit.
530.............. Education IRA (1,6)............ $150,000-$160,000 $95,000-$110,000 No deduction........ $225,000-$450,000 $112,500-$225,000
Deduction.
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Modifications to AGI apply; (2) Inflation indexed; (3) Earned income limitations; (4) Low income only; (5) Phase-out range depends on number of
children; (6) Newly enacted in 1997; (7) Also see section 221(b)(2); (8) Phase-out applies to alternative minimum taxable income rather than AGI; (9)
Increases for future years are specifically provided in the statute.
EXHIBIT B--Current Method of Phase-Out
------------------------------------------------------------------------
Current Methodology for
Code Section(s) Tax Provision Phase-outs Application
------------------------------------------------------------------------
21.................... Dependent Care Credit Credit percent reduced
from 30 percent to 20
percent in AGI range
noted by 1 percent
credit for each $2,000
in income
22.................... Elderly Credit....... Credit amount reduced by
excess over AGI range
23 & 137.............. Adoption Credit & Benefit reduced by excess
Exclusion. of modified AGI over
lowest amount noted
divided by 40,000
24.................... Child Credit......... Credit reduced by $50 for
each $1,000 in modified
AGI over lowest amount
divided by 10,000
(single) and 20,000
(joint)
25A................... Education Credits Credits reduced by excess
(Hope/Lifetime of modified AGI over
Learning). lowest amount divided by
10,000 (single) and
20,000 (joint)
32.................... Earned Income Credit. Credit determined by
earned income and AGI
levels
55.................... AMT Exemption........ Exemption reduced by 1/4
of AGI in excess of
lowest amount noted
68.................... Itemized Deductions.. Itemized deductions
reduced by 3 percent of
excess AGI over amount
noted
135................... Series EE Bonds...... Excess of modified AGI
over lowest amount
divided by 15,000
(single), 30,000 (joint)
reduces excludable
amount
151................... Personal Exemption... AGI in excess of lowest
amount, Exemption
divided by 2,500,
rounded to nearest whole
number, multiplied by 2,
equals the percentage
reduction in the
exemption amounts
219................... Traditional IRA w/ Individual retirement
Retiremt. Plan. account (IRA) IRA
limitation ($2,000/
$4,000) reduced by
excess of AGI over
lowest amount noted
divided by $10,000
219(g)(7)............. IRA w/Spouse w/ Deduction for not active
Retiremt. Plan. spouse reduced by excess
of modified AGI over
lowest amount noted
divided by 10,000
221................... Education Loan Deduction reduced by
Interest Expense excess of modified AGI
Deduction. over lowest amount noted
divided by 15,000
408A.................. Roth IRA............. Contribution reduced by
excess of modified AGI
over lowest amount noted
divided by 15,000
(single) and 10,000
(joint)
408A.................. IRA Rollover-Roth IRA Rollover not permitted if
AGI exceeds 100,000 or
if MFS
469(i)................ Passive Loss Rental Benefit reduced by 50
$25,000 Rule. percent of AGI over
lowest amount noted
530................... Education IRA Contribution reduced by
Deduction. excess of modified AGI
over lowest amount noted
divided by 15,000
(single) and 10,000
(joint)
------------------------------------------------------------------------
Chairman Houghton. Thank you very much, Mr. Lifson.
Mr. Gutman.
STATEMENT OF HARRY L. GUTMAN, PARTNER, KPMG LLP
Mr. Gutman. Thank you, Mr. Chairman. It is a pleasure to be
sitting as a witness, I must say, as compared to other
capacities I have been here. I appreciate the opportunity to
appear before you and ask that my statement be included in the
record. Before I get to the substance of my remarks, I want to
commend you and Mr. Coyne and Mr. Neal for doing something
tangible in the simplification area. Too often, we have simply
heard words from those who have the responsibility to enact and
administer the tax laws and you have taken some action and put
some concrete proposals on the table and I think you need to be
commended for that. This process, as has been said before, has
to start somewhere.
I wish I had some good advice for Mr. Neal about how to
jump start the process. That is extremely difficult. Revenue-
neutrality is a key component. He has achieved that with his
bill. And while a bill could get out of this committee and pass
the House, unfortunately, as we know, the risk is not here, but
rather on the other side of the Capitol. And, unfortunately, I
think, as a practical matter, until one gets satisfied by what
might happen to a tax bill when it goes over to the Senate, a
free-standing bill is a problem. So I appreciate the
difficulty, but urge you to continue to try to move forward
with this legislation in a free-standing or whatever other
capacity you are able to get it out of the committee and onto
the floor.
Tax complexity causes serious systemic costs. Focusing on
the taxpayer side of the equation, the most obvious is the cost
of
compliance. But complexity also affects planning and certainty.
If complex rules are viewed as unfair or unnecessary, respect
for the system is undermined. And the story doesn't end with
taxpayers, complex rules also affect the administration of the
tax system, requiring more guidance, training, and enforcement.
Understanding that inordinate complexity imposes
unacceptable costs on the system and those who are affected by
it does not, however, provide us with solutions. We are tempted
to say, make the system simple and all our problems will
disappear. But that is not really the case.
Tax simplification is considerably more subtle and tricky
because it means a lot of different things to a lot of
different people. For example, to some, simplification means a
system that is easy to understand. To others, it is a system
that requires little record keeping. To still others, it is a
system that allows for ease of computation and return
preparation. And, finally, to others, simplification means a
system that is easy to administer. In truth, it is all of those
things. But it is important to recognize that achieving
simplification objectives involves real tradeoffs and that
simplification cannot occur in a vacuum. Simplification needs
to take place within the context of creating a tax system that
is, and is perceived as, equitable, neutral, and administrable.
Complexity comes in many different forms and we must
recognize that complex rules are often necessary to deal with
complex transactions undertaken by sophisticated taxpayers.
That complexity is not what we are talking about today. There
are many other forms and sources of complexity that need not
and should not be tolerated and those provisions are the
subject of the bills that are under consideration today.
In addressing the problem, we need to recognize that
complexity often occurs because of the desire to use the Tax
Code to achieve social or political goals rather than simply
collect revenue on an equitable and neutral basis. The history
of the Tax Code is replete with efforts to use the code to
achieve particular objectives and they are the principal
sources, I believe, of the complexity that was identified in a
Joint Committe print prepared for a similar hearing in the
Finance Committee.
Another source of complexity is congressional attempts to
tailor provisions to benefit specific taxpayers. The complexity
of the law is also increased when Congress, for political
expediency, disguises the substance of its legislative changes.
Personal exemption and itemized deduction phaseouts, commonly
known as PEP and Pease are prime examples of this. Mr. Neal's
bill would repeal these provisions and substitute explicit rate
increases. That is to be commended.
Turning to the bills that are under consideration today, I
would like to review very briefly the provisions of H.R. 1407
and H.R. 1420. Title I of H.R. 1420, which is Mr. Neal's bill,
and Chairman Houghton's proposed legislation would permanently
waive the minimum tax limitations on nonrefundable credits and
Mr. Neal's bill would also create a single phaseout range for
the adoption credit, the family credit, and the education
credits. These are sensible provisions and they should be
enacted.
Title II of the bill, which is Mr. Coyne's provision as
well as Mr. Neal's, would replace the present melange of
capital gains provisions with a 38-percent deduction and would
treat gain or loss from the sale of a collectible as short-term
gain. Mr. Houghton's legislation would provide a 50-percent
deduction. Both of these would be simplifying provisions. The
question of the appropriate exclusion amount is a political
issue, but the question of how to compute the tax is not and
these would both be very favorably received.
Title III of Mr. Neal's bill would repeal PEP and Pease and
that makes perfect sense. The provision repealing the
individual minimum tax isn't quite as simple. It is clear that
more taxpayers than ever anticipated will shortly become
subject to the tax unless something is done. Moreover, many
taxpayers who are not ultimately subject to the tax must make
calculations to determine whether the tax applies to them.
These facts argue for some adjustment. Mr. Neal would repeal
the tax. Chairman Houghton would increase the alternative
minimum tax exemption.
As currently structured, the minimum tax does not achieve
the objectives for which it was originally designed. The
passive loss rules have largely eliminated the real and
perceived sheltering and fairness issues that previously
existed. The current minimum tax base does not correspond in
any meaningful way to economic income. Indeed, it is
questionable whether a number of the preferences are
conceptually correct. And, finally, it is shortly going to
affect too many taxpayers. Chairman Houghton's solution limits
the damage. Mr. Neal eliminates the problem. Unless the minimum
tax base is expanded to measure economic income, I prefer Mr.
Neal's solution. No taxpayer should have to bother with the
minimum tax in its current form.
I am pleased to have had the opportunity to share some
ideas with you. And I will be happy to answer any questions.
Thank you.
[The prepared statement follows:]
Statement of Harry L. Gutman, Partner, KPMG LLP
Mr. Chairman and Members of the Subcommittee: I am honored to
appear before the Subcommittee today as an invited witness to discuss
tax simplification for individuals and small businesses, in general,
and the Tax Simplification and Burden Reduction Act that is to be
introduced by Chairman Houghton, H.R. 1407 introduced by Mr. Coyne, and
H.R. 1420 introduced by Mr. Neal, in particular. This statement is made
in my individual capacity and expresses my personal views. Nothing in
this statement should be attributed to KPMG or to any of its clients.
Tax Complexity and Simplification
Inordinate tax complexity creates serious systemic costs. Focusing
on the taxpayer side of the equation, the most obvious is the cost of
compliance. Complex rules and requirements mean that affected taxpayers
need to take more time to understand, prepare, and substantiate tax
returns. Complexity also affects planning and certainty. Time is
required to master the rules so that the consequences of anticipated
acts or transactions can be evaluated. If complex rules are also viewed
as unfair or unnecessary, respect for the system is undermined. But the
story does not end with taxpayers. Complex rules also affect the
administration of the tax system, requiring more guidance, training,
and enforcement.
Understanding that inordinate complexity imposes unacceptable costs
on the system (and those affected by it) does not, however, provide us
with solutions. We are tempted to say, ``Make the system simple and all
our problems will disappear.'' That, however, is not the case. Tax
simplification is a considerably more subtle and tricky topic because
it means different things to different people. For example, to some,
simplification means a tax system that is simple to understand. To
others, it means a system that requires little record keeping. To still
others, it means a system that allows for ease of computation and
return preparation. Finally, to others, tax simplification means a tax
system that is easy to administer. In truth, it is all of these
things--and more.
It is important to recognize that achieving simplification
objectives involves real trade-offs and that simplification cannot
occur in a vacuum. Simplification needs to take place within the
context of creating a tax system that is, and is perceived as,
equitable, neutral, and administerable. An equitable tax system treats
all similarly situated taxpayers the same. A neutral tax system is one
that does not affect economic decisions. A tax system is administerable
if the costs of administering the law and collecting revenue are
comparatively low. Arguably, our tax system is none of the above.
Sources of Current Tax Law Complexity
Complexity comes in many different forms. Complex rules are often
necessary to deal with complex transactions undertaken by sophisticated
taxpayers. They are not the provisions under consideration today. But
there are many other forms and sources of complexity that need not--and
should not--be tolerated, and many of those are addressed by the bills
under consideration today.
In large measure, the complexity we are addressing today is the
result of using the tax code to achieve social or political goals
rather than simply to collect revenue on an equitable and neutral
basis. The principal sources of complexity in our tax system--described
by the Joint Committee on Taxation\1\ as elections provided to
taxpayers, definitional issues that taxpayers must consider, record-
keeping and reporting requirements, limitations on the availability of
tax benefits, and frequent changes in the tax laws--are often the
consequences of congressional attempts to tailor tax provisions to
benefit specific taxpayers.
---------------------------------------------------------------------------
\1\ JCX-18-99, Overview of Present Law and Issues Relating to
Individual Income Taxes, April 14, 1999.
---------------------------------------------------------------------------
The complexity of the tax laws is also increased when Congress, for
political expediency, disguises the substance of its legislative
changes. The personal exemption and itemized deduction phase-outs--
commonly known as ``PEP and Pease''--are prime examples. Rather than
providing explicitly for a marginal rate increase when these provisions
were added in 1990, Congress hid the real nature of these provisions as
rate increases by calling them ``phase-outs.'' Mr. Neal's bill would
repeal these complex provisions and substitute explicit rate increases.
Simplicity Trade-Offs
Attempts to achieve tax simplification require trade-offs. Simple
rules often create inequalities because in real life, there are many
disparate situations that cannot be dealt with by applying simple
rules. Attempts to tailor tax rules to address disparate situations
generally give rise to greater complexity in the system. Thus,
ironically, complex rules generally promote greater equality in a tax
system. The original issue discount rules as applied to zero coupon
bonds held by individuals are a case in point.
The proposal to make all mortgage points paid in connection with a
refinancing currently deductible is designed to add simplicity to the
tax code, but it will result in trade-offs. Current deductibility of
refinancing points would not reflect economic reality and would create
abuse potential that should be addressed statutorily, thus complicating
the proposed simple rules. If mortgage points are paid in connection
with a 10-year refinancing loan, why does it make sense for the points
to be deducted in the first year of the loan, rather than being
allocated to and deducted over the course of the 10-year period? Would
a simple rule of deductibility encourage refinancing, rather than
allowing taxpayers to make refinancing decisions based on their
personal economics? What would stop taxpayers from front-loading
interest or points to obtain an accelerated interest deduction? Is it
not a more sound approach--an approach in line with economic
realities--to apply the costs of the refinancing over the life of the
loan?
Two Areas Where Simplification Is Necessary
The array of education assistance programs now available in the tax
code, from Lifetime Learning credits, to HOPE credits, to Education
IRAs, to prepaid tuition plans and student loan interest deductions,
are hopelessly intertwined, complex, difficult to understand, and
difficult to compute--even for a person who has taken advantage of any
of these programs to attain a good education. No rational individual
could have concocted this scheme. Rather, it is the result of the
political process. The program should be rationalized.
Another prime example of tax law complexity is the earned income
tax credit (EITC). The EITC is, of course, a government subsidy
programs for low-income taxpayers who are gainfully employed. The goal
of the EITC is laudable; however, the complexity of the provisions is
regrettable. Simplification is plainly necessary to reduce the burden
on taxpayers least able to afford the compliance costs.
Recent testimony before the Senate Finance Committee by
representatives of the American Bar Association and the American
Institute of Certified Public Accountants, among others, described many
other instances of tax complexity. These statements, and the bills
under consideration today, suggest that the road to tax simplification
is an incremental one. I agree. It is unreasonable to expect a complete
revision of the Internal Revenue Code--to achieve simplification or
otherwise. Consequently, simplification efforts should be devoted to
identifying major areas of complexity for a large number of taxpayers
and simplifying those provisions. I cited two examples above. The bills
under consideration today identify a number of others. Accordingly, I
now turn to the bills before the Subcommittee.
H.R. 1407 and H.R. 1420
The basic substance of H.R. 1407 is included in Title II of H.R.
1420. Therefore, I will discuss the bills together.
Title I--Simplification Relating to Nonrefundable Personal
Credits
Title I of H.R. 1420, and Chairman Houghton's proposed legislation,
would permanently waive the minimum tax limitations on nonrefundable
credits. H.R. 1420 would also create a single phase-out range for the
adoption credit, the family credit, and the education credits. Both are
sensible provisions and should be enacted.
Title II--Simplification of Capital Gains Tax
Title II would replace the present melange of capital gain
provisions with a 38 percent deduction and would treat gain or loss
from the sale of a collectible as short term. Chairman Houghton's
legislation would provide a 50-percent deduction. The question of the
amount of the preference to be accorded capital gain income is a
political issue. The structure of the preference is not. The complexity
of the current provisions reflects a number of political
accommodations. They make little policy sense when originally adopted,
and they make less sense today. The bills restore simplicity to the
calculation of capital gain income, even if they fail to address the
question of why the preference is required at all.
Title III--Repeal of Certain Hidden Marginal Rate Increases;
Repeal of Individual Minimum Tax
As noted above, Title III of the bill would repeal PEP and Pease
and replace them with a straightforward rate increase. I strongly
support these changes, both from a simplicity and ``truth in
advertising'' perspective. I am not as comfortable with the provision
that increases the floor on itemized deductions for higher income
taxpayers. I never understood the policy justification for the floor in
the first place.
The provision repealing the individual minimum tax is not quite as
simple. It is clear that more taxpayers than ever anticipated will
shortly become subject to the minimum tax unless something is done.
Moreover, many taxpayers who are not ultimately subject to the tax must
make the calculations to determine whether the tax applies to them.
These facts argue for some adjustment. Mr. Neal would repeal the tax.
Chairman Houghton would increase the alternative minimum tax exemption.
What to do about the minimum tax depends in large measure on one's
view of why the tax exists in the first place. Almost 15 years ago, in
1985, I testified about this very issue before the Senate Finance
Committee. The discussion at that time focused on the fact that high-
income taxpayers were able to use tax preferences to reduce
substantially, or even eliminate, their income tax liabilities. At the
1985 hearing, I noted there were three reasons why a minimum tax should
be enacted. The first was revenue. In my testimony, I stated that while
a need for revenue could lead to a search for an alternative source of
tax receipts, this alone was not a compelling reason to adopt a minimum
tax. Moreover, even with revenue as the principal justification for the
tax, the structure of the tax was not provided.
The second reason for a minimum tax dealt with perceptions of
fairness. Because of the existence of tax preference items, different
taxpayers with similar economic income were allowed to pay different
amounts of tax. The use of tax preference items by some taxpayers to
minimize their tax liabilities fostered public resentment, and this
resentment had two notable consequences: a loss of respect for the tax
system; and pressure on the political process to do ``something'' about
the problem. As I said at the time, while it was not perfectly clear
what the ``something'' was, it appeared to be that steps should be
taken to ensure that all taxpayers pay some tax.
The third reason for invoking a minimum tax was to broaden the
income tax base. If broadening the tax base was the ultimate goal, a
minimum tax was the appropriate vehicle. The tax base should
approximate economic income.
I also noted that a minimum tax designed solely to assure that all
taxpayers paid some tax created what I referred to as tax system
``schizophrenia.'' On the one hand, a minimum tax had the effect of
reducing the after-tax value of the preferences that are a part of the
minimum tax base. On the other hand, the congressional objective that
prompted the enactment of the preference in the first place would be
undermined. I asked why the value of the preference should be reduced
when a taxpayer did precisely what Congress intended.
Now, some 15 years later, we return to visit some of the same
issues. As currently structured, the minimum tax does not achieve the
objectives for which it was originally designed. The passive loss rules
have largely eliminated the real and perceived sheltering and fairness
issues I addressed in 1985. The current minimum tax base does not
correspond in any meaningful way to economic income. Indeed, it is
questionable whether a number of the preference items are conceptually
correct. Finally, it will shortly affect too many taxpayers.
Chairman Houghton's solution limits the damage. Mr. Neal eliminates
the problem. Unless the minimum tax base is expanded to measure
economic income, I prefer Mr. Neal's solution. No taxpayer should have
to bother with the minimum tax in its current form.
Tax Simplification and Burden Reduction Act
I have discussed a number of the provisions in Chairman Houghton's
proposed legislation earlier in this statement. In the absence of
legislative language, it is difficult to comment more than generally on
the other proposals. However, I think it makes good sense to simplify
the estimated tax safe harbors and to treat the postmark date as the
filing date for all returns. Further Subchapter'S simplification is
appealing, but the details are critical. The same is true with respect
to reducing record-keeping requirements.
Conclusion
I am pleased to have had the opportunity to share my views on tax
simplification with you. I am prepared to answer any questions you may
have.
Chairman Houghton. Thank you, Mr. Gutman.
Mr. Harkins.
STATEMENT OF GERRY HARKINS, OWNER AND GENERAL MANAGER, SOUTHERN
PAN SERVICES COMPANY, CONLEY, GEORGIA, ON BEHALF OF NATIONAL
FEDERATION OF INDEPENDENT BUSINESS
Mr. Harkins. Thank you, Mr. Chairman, Committee Members. I
am here to speak on behalf of the National Federation of
Independent Business and its 600,000 small business owner
members.
I am the owner and operator of Southern Pan Services
Company in Conley, Georgia. Southern Pan Services was started
in 1987. It is a construction subcontractor specializing in
concrete form work. We employ approximately 400 workers in the
Southeast. I have been an adviser to the Internal Revenue
Service for 9 years as chairman of the Commissioner's Advisory
Group, and as a member of the District Director's Liaison
Committee and as a member of the National Commission on
Restructuring the Internal Revenue Service, of which Mr. Coyne
served ably. I spent a year investigating the Internal Revenue
Service.
I am here today to talk about several things and I would
like to ask that my statement be entered into the record.
First, tax simplification. Small business owners might best be
described as the poster child for tax complexity victims. We
could be compared to the slowest buffalo in the herd and the
IRS as the lion. And, as tough as the IRS code is on everybody
else, it is doubly tough on America's small businessmen and
women. It has been estimated that tax-related paperwork costs
are twice as high for small business, compared to large
business.
About the chairman's bill, Chairman Houghton's bill, the
NFIB has advocated a long list of items that would simplify the
Tax Code for small businesses. I am pleased to say that many of
these items are contained in the Tax Simplification and Burden
Reduction Act proposed by Chairman Houghton. These provisions
include: alternative minimum tax relief, expanded expensing
opportunities, and pension simplification. Other legislation to
be introduced by Congressman Talent also contains many of these
provisions as does legislation introduced by Congressman Neal.
The chairman's proposals regarding AMT are targeted
specifically at small businesses and represent a significant
relief from the AMT. On behalf of small business, I would like
to thank the chairman for including this provision in his bill.
While the NFIB obviously would prefer the outright elimination
of the AMT, which is the Neal approach, the Houghton bill would
address the worst aspects of the tax.
Another pet peeve of small business and all property owners
is the elimination of the death tax. One provision not
addressed by the chairman's bill that would provide significant
relief to small businesses is repeal of the death tax. For a
family business like mine, the death tax is a storm on the
horizon. It threatens everything I have accomplished over the
past 19 years.
Death tax supporters argue that the tax only affects a
small percentage of estates, but the costs are much deeper than
that. I recently completed a series of lengthy meetings with my
attorney and CPA to determine how my estate would be affected
by my death. To my horror, I found out that my heirs would have
to liquidate my business under duress to pay the estate taxes
due upon my death. There is no way to avoid this tax upon a
successful business. In my company's case, we would endanger
the livelihood of all our employees and suppliers. The negative
economic impact goes far beyond the business owner's heirs.
The death tax may provide government revenue in the short-
run but, in the long-run, costs far outweigh the gains. Studies
by the Joint Economic Committee and the Institute for Policy
Innovation show the death tax actually costs the Federal
Government in the long-run. NFIB supports eliminating the death
tax. Two bills have been introduced in the House that we
support. H.R. 8, introduced by Representatives Dunn and Tanner
and H.R. 86, introduced by Representative Cox.
Another area ripe for simplification is the Federal
Unemployment Tax or FUTA. For small businesses, FUTA presents
two problems. First, the rate is too high. Second, employers
are required to pay two unemployment taxes, the Federal tax and
the State tax. That means twice the collection points, twice
the payments, and twice the complexity. NFIB supports reforming
the nation's unemployment system, including cutting the rate
and having just one point of collection. Once again, I am
pleased to see that the chairman and other Members of the
Committee have supported such reforms in the past. This week,
Congressman McInnis plans to introduce legislation to eliminate
the FUTA surtax, which is .2 percent or one-fourth of the tax
and I hope the Committee will support his efforts.
Another area is the clarification of the definition of
independent contractor. I understand the chairman has joined
others in introducing legislation to address the independent
contractor issue. We applaud the chairman for seeking to create
objective standards to define who is and who is not an
independent contractor. At the same time, I understand the
chairman is aware that the NFIB has serious concerns about the
direction this legislation takes. That said, something needs to
be done to create a bright line between employee and an
independent contractor. The current 20 common law factor test
has handcuffed small business for too long. We need an
objective standard that is simple and easily understood.
Mr. Chairman, Committee Members, I thank you for your
attention and for inviting me to be here today. I will answer
any questions.
[The prepared statement follows:]
Statement of Gerry Harkins, Owner and General Manager, Southern Pan
Services Company, Conley, Georgia, on Behalf of National Federation of
Independent Business
Good afternoon. On behalf of the 600,000 members of the National
Federation of Independent Business (NFIB), I appreciate the opportunity
to present the views of small business owners on the subject of tax
simplification.
My name is Gerry Harkins. I am an owner and operator of Southern
Pan Services Company of Conley, Georgia. Southern Pan Services was
started in 1987 and is a construction subcontractor specializing in
concrete formwork. We employ approximately 400 workers in the
Southeast.
I have been an advisor to the IRS for 9 years as Chairman of the
Commissioner's Advisory Group and a member of the District Director's
Liaison Committee. As a member of the Commission on Restructuring the
IRS, I spent a year investigating the Internal Revenue Service.
Tax Simplification
Small business owners might best be described as the poster child
of tax complexity victims. As tough as the IRS Code is on everyone
else, it is doubly tough on America's small businessmen and women. It
has been estimated that the tax-related paperwork costs are twice as
high for a small business compared to a large business.
While economists differ as to the actual cost of compliance,
Professor Joel Slemrod, in testimony before the IRS Restructuring
Commission, very conservatively estimated the cost to the taxpayers of
complying with the current tax code is $75 billion annually. Other
estimates put the cost closer to $200 billion. This is particularly
staggering when compared to the IRS budget of $7.5 billion.
For that reason, NFIB believes the best solution for a fairer,
simpler tax code is to scrap the current code and replace it with one
that promotes investment and savings. This new system must be broad
based. That is our long-term goal and we will continue to work towards
it.
In the short term, however, there are specific tax provisions that
are particularly onerous to small business. I believe addressing these
issues would move us towards the fairer, simpler tax code we would all
like to see. I am pleased to say that many of these items are contained
in the proposed legislation outlined by Chairman Houghton, including
Alternative Minimum Tax Relief, expanded expensing opportunities, and
pension simplification. Other legislation to be introduced by
Congressman Talent also includes many of these provisions.
Eliminate the Death Tax
If you want to simplify the tax code and raise revenues at the same
time, eliminate the death tax? Eliminating the death tax would remove
an enormous source of compliance cost and complexity and remove an
entire Subtitle of the IRS Code all at the same time.
For a family business like mine, the death tax is a storm on the
horizon. It threatens everything I have accomplished over the past
nineteen years. Death tax supporters argue that the tax only affects a
small percentage of estates, but the costs are much deeper than that.
I recently completed a series of lengthy meetings with my attorney
and CPA to determine how my estate would be affected by the death tax.
To my horror, I found out that my heirs would have to liquidate my
business under duress to pay the estate taxes due upon my death. There
is no way to avoid this tax upon a successful business. In my company's
case, we would endanger the livelihood of all our employees and
suppliers. The negative economic effect goes far beyond the business
owner's heirs.
The death tax is bad for family businesses, it is bad for
employees, and if you take the economic and compliance costs into
account, it is bad for the federal government too. The death tax may
provide government revenue in the short run, but the long-run costs far
outweigh the gains. Studies by the Joint Economic Committee and the
Institute for Policy Innovation show the death tax actually costs the
federal government in the long run.
NFIB supports eliminating the death tax. Two bills have been
introduced in the House that we support--HR 8, introduced by
Representatives Dunn and Tanner, and HR 86, introduced by
Representative Cox. Either one of these bills would provide significant
relief to millions of small business owners and dramatically simplify
the IRS Code. I am pleased to see that many members of this panel,
including the Chairman, are cosponsors of one or both of these bills.
Reform Payroll Taxes
Another area ripe for simplification is the federal unemployment
tax, or FUTA. For small business, FUTA presents two problems. First,
the rate is too high. Federal payroll taxes have never been cut--they
only go up. Since their inception, federal payroll taxes--including
FUTA and Social Security taxes--have risen from 2 cents of the first
dollar earned to over 16 cents. This represents an increase of 800
percent.
Second, employers are required to pay two unemployment taxes--the
federal tax and the state tax. That means twice the collection points,
twice the payments, and twice the complexity. Payroll taxes were listed
as the most costly tax in an NFIB tax survey, just ahead of personal
income taxes. And 53 percent of those surveyed said payroll taxes are
less fair or much less fair than business income taxes.
NFIB supports making the following changes to our nation's
unemployment system:
Eliminate the Surtax: The temporary FUTA surtax was put in
place in 1976 in order to repay loans from the federal unemployment
trust fund. Even though this money was fully repaid in 1987, Congress
has extended this temporary tax four times, imposing an annual $1.4
billion tax burden on America's workers and employers. The surtax
should be eliminated. Repeal of the surtax is long overdue.
Cut FUTA Taxes: Even if the surtax is eliminated, FUTA
still collects far more than it needs. FUTA raised $6.1 billion last
year, but only $3.5 billion was spent on FUTA-related expenses. The
rest was used to pay for non-related government programs. Permanent
FUTA taxes should be cut to reflect the lower costs of the program.
Send the Program to the States: The current system is
duplicative and inefficient, costing the federal government, state
governments, and private employers hundreds of millions in unnecessary
administrative costs annually. Unemployment taxes should be collected
by the states alone to eliminate these unnecessary costs.
Once again, I am pleased to note that the Chairman and other
members of this Committee have supported such reforms. This week,
Congressman McInnis plans to introduce legislation to eliminate the
FUTA surtax.
Small Business Expensing
Another positive step taken by Congress recently was to increase
the annual limit on business expensing to $25,000 by the year 2003.
Legislation has been introduced by Congressman English to increase this
limit further, to $60,000.
The purpose of small business expensing is twofold. First, it
simplifies tax calculations--deducting investments immediately is
simpler than depreciating them over a number of years. Second, it
encourages small businesses to invest by reducing their tax liability
and increasing their cash flow.
Personally, I fail to understand why expensing isn't universal.
There is no real revenue loss from expensing--any tax benefit I gain
this year I will lose next year. Meanwhile, the money that I keep this
year goes into the economy and may mean the difference between success
and failure for my business. Long and complex depreciation schedules
don't just add to tax complexity and cost; they are also a tax on
investments.
One way to make Section 179 more effective, aside from increasing
its limits, might be to expand the types of purchases that can be
expensed. Right now, only tangible property like business equipment,
office furniture, and computer hardware can be expensed. Even auto
purchases are subject to a limit. Expanding Section 179 to include
purchases of computer software and other investments like leasehold
improvements would make the section more effective. Once again,
expanded Section 179 expensing is part of the Chairman's proposal, and
it is certainly something NFIB would support.
Clarify the Definition of Independent Contractor
I understand the Chairman has joined others in introducing
legislation to address the Independent Contractor issue. I also
understand the Chairman is aware that NFIB has serious concerns about
the direction of this legislation.
That said, something needs to be done to create a bright line
between an employee and an independent contractor. A recent NFIB
Education Foundation Survey found that the issue of determining an
independent contractor was one of the biggest problems facing small
business today. The current 20 common law factor test has handcuffed
small businesses for too long. We need an objective standard that is
simple and easily understood.
The 1995 White House Conference on Small Business's top
recommendation was to establish a new test based on the following four
criteria: (1) realization of a profit or loss; (2) separate principal
place of business; (3) making services available to the general public;
and (4) paid on a commission basis.
These criteria formed the foundation of legislation introduced in
both the House and the Senate--Senator Bond has a bill in the Senate--
and I encourage the Members of this Committee to use that legislation
as a starting point for resolving this longstanding issue.
Cash vs. Accrual Accounting
Another area related to accounting has to do with shoring up
Section 448 of the IRS Code. Section 448 permits businesses with less
than $5 million in annual revenues to use the cash method of
accounting. While my business is too large to take advantage of this
provision, many small shops in my industry do use it to their
advantage. Cash accounting simply allows a business to only recognize
those revenues it has actually received.
There are two reforms that NFIB would like to see to this
provision. First, the $5 million cap has been in place for some time.
It would be helpful to increase this cap. I believe the Chairman has
proposed to do just that.
Second, the IRS has begun to use other portions of the IRS Code to
undermine Section 448. In some cases, the IRS has disallowed the use of
the cash accounting system for businesses with annual revenues below $5
million because the IRS claims inventory is a material factor in their
business. It is my understanding that the IRS's definition of
``material'' can be extremely imaginative.
Once again, a bright line is needed to ensure that businesses below
the threshold and without extensive inventories can use cash accounting
if they so choose.
Abolish the Alternative Minimum Tax for Individuals
Finally, let me mention the Alternative Minimum Tax. I believe the
individual Alternative Minimum Tax is misnamed. It should be called,
``The Alternative Small Business Tax.'' Take a look at the adjustments
required under the individual AMT. Most of them are targeted at
business-related deductions.
And, like the death tax, the notion that the AMT is a rich
taxpayer's problem is incorrect. According to the Joint Committee on
Taxation, more taxpayers than ever will be subject to the AMT within a
decade, with the largest increase coming from taxpayers earning between
$50,000 and $100,000.
Finally, the AMT has the side effect of hitting small businesses
when they can least afford the bill. If I have a bad year, I'm more
likely to trigger the AMT than when I do well. The AMT literally
``kicks taxpayers when they are down.''
In 1993 and 1997, Congress made numerous reforms to the corporate
AMT to reduce its complexity and cost to certain industries. But many
small businesses file as individuals, not corporations. The NFIB
supports abolishing the individual Alternative Minimum Tax. At the very
least, the existing AMT exemption should be increased and indexed to
shield taxpayers from this onerous tax. Once again, I am pleased to see
that the Chairman has proposed to do just that.
Conclusion
I would like to thank the Chairman for the opportunity to testify
before the Ways and Means Subcommittee on Oversight on the important
issue of tax simplification. I would also like to thank him for taking
on this issue with so much enthusiasm. Adoption of the reforms
mentioned above would be a dramatic victory in the battle of tax
simplification.
Chairman Houghton. All right. Thank you very much. We will
have them questions, Mr. Harkins.
Mr. Steuerle.
STATEMENT OF C. EUGENE STEUERLE, SENIOR FELLOW, URBAN
INSTITUTE, ON BEHALF OF NATIONAL TAX ASSOCIATION
Mr. Steuerle. Mr. Chairman and Members of the Subcommittee,
thank you for the opportunity to testify on tax simplification
on behalf of the National Tax Association. Founded in 1907, NTA
is the leading association of tax professionals dedicated to
advancing the understanding and theory of public finance. The
association will be pleased to assist the Subcommittee in any
discussion of tax simplification.
As has been expressed before, principles of tax law often
conflict. In achieving a balance among principles, however,
almost everyone would agree that simplicity has been given far
too little weight in the legislative process. My
congratulations go out to the Members of this Subcommittee for
their willingness to tackle these problems and, in particular,
to the three of you who have remained, Mr. Houghton, Mr. Coyne,
Mr. Neal, for your special efforts. I realize that you will not
be blinded by the TV lights for your giving attention to this
issue, but I think, nonetheless, it is extremely important.
Needless tax complexity, I believe, serves as one of the
more important barriers to a healthy relationship between a
citizenry and its government. In my testimony, I include
several items of needless tax complexity which I will list very
briefly and then get onto an issue that I think is also equally
important but perhaps has not been given enough attention--and
that is the question of a process that might give simplicity
more attention.
Among the items that I list are: an alternative minimum tax
that treats items such as dependent exemptions as a tax
shelter, thereby threatening to tax millions who were never
meant to be affected; the phaseout after phaseout of such items
as itemized deductions, personal exemptions, and educational
tax breaks, each of which is like a little mini-tax unto
itself; pension and savings incentives that add administrative
costs and perhaps even reduce net saving because of their
multiple rules on withdrawals, penalties, allowing amounts of
exclusion and deduction and so on; a tax treatment of dependent
children that needlessly causes millions of unnecessary tax
returns to be filed; a capital gains tax law with seven
different tax breaks; multiple educational tax breaks that are
poorly coordinated with each other and with direct expenditures
for education; complicated rules for charitable deductions and
charities, including multiple limits on giving and an excise
tax on foundations that actually discourages charitable giving;
child credits and dependent exemptions that could easily be
folded into one; and unnecessarily strict estimated tax rules
that pick up very little revenue for all the complexity they
introduce.
I would like to concentrate, however, the remainder of my
testimony not on particular proposals but on a broader issue. I
believe that the complexity of the tax law is, at its heart, a
failure of process. The process failure could be mitigated
through the adoption of certain procedures that I have
suggested for both the executive branch and Congress. The
purpose of these procedures is simply to grant simplicity a
higher priority in the overall process. I therefore suggest
strong consideration be given to two types of process reforms:
No. 1, those that require periodic reporting on existing law;
and, No. 2, those that would apply to new legislation.
Let me turn first to the possible periodic reports that I
believe would help you in achieving your goal. My first
suggestion is that the Treasury or the Joint Committee on
Taxation should publish a formal study, year after year,
listing tax simplification options. If you don't believe how
important this could be, I invite you only to look at the list
of revenue options and expenditure options put out annually by
the Congressional Budget Office and the attention that those
receive. Or to the tax expenditure list prepared by the
Treasury and the Joint Committee on Taxation. This latter list,
however, is not a list of items for simplification.
Second, the Government Performance and Results Act of 1993
requires a performance plan review that has been extended on a
very embryonic basis to Treasury's tax expenditure budget. Now
Treasury made some very tentative steps there. I believe that
they could be expanded significantly and help you in your
roles. At the same time, I believe there is a fundamental
failure in the IRS administrative structure. Because it is
organized around tax returns and not tax programs under its
jurisdiction, IRS does not prepare analyses of programs and it
takes no responsibility for their success or failure. It is not
surprising, then, that IRS almost always ends up behind the
eight-ball when Congress suddenly decides it wants to examine
the effectiveness of, say, the earned income credit or the
compliance costs imposed upon charities.
I also suggest some procedures for giving simplicity
greater weight in the legislative process. These include
testimony on proposed bills that would always give at least
some attention to witnesses who focus solely on simplification
administrative issues. When the markup of a bill occurs and
when you go to conference, I suggest that at least one person
at the witness table should have the sole assignment of
providing information on administrative aspects of the bill.
Before going to conference, the IRS could also provide mock tax
forms showing exactly what has been wrought from bills. I
actually succeeded in having them do this with one piece of
legislation in 1987 and it did significantly change what was in
the bill, although the bill itself still had major problems.
And, finally, the National Commission on Restructuring the
IRS suggested the tax complexity assessment accompany future
tax changes. Last year, the Joint Committee on Taxation did
prepare a simplification analysis of the House bill at the
request of Chairman Archer, even though it wasn't required that
year. I am hopeful that this Subcommittee will devote some
effort to making sure that these procedures continue to be set
because precedents this year and next year are very important.
Of course, none of these process reforms guarantee that
simplification will occur. Nonetheless, a combination of some
if not all of these procedures, I believe, could serve as a
major deterrent to new sources of unnecessary complexity and as
a spur to further efforts in achieving the types of
simplifications of the Subcommittee that it has fostered today.
Thank you.
[The prepared statement follows:]
Statement of C. Eugene Steuerle, Senior Fellow, Urban Institute; on
behalf of National Tax Association
Mr. Chairman and Members of the Subcommittee: Thank you for the
opportunity to testify on tax simplification on behalf of the National
Tax Association (NTA). Founded in 1907, NTA is the leading association
of tax professionals dedicated to advancing understanding of the theory
and practice of public finance. The Association is the premier forum
for debating complex and controversial public finance issues; testing
new tax theories, practices, and policies; and disseminating impartial,
nonpartisan research of the highest quality. NTA is a tax-exempt
501(c)(3) organization and does not promote any particular tax program
or policy. NTA's diverse membership brings together government,
corporate, academic, and independent tax professionals: a rich mix of
federal and state legislators and administrators; taxpayer
representatives; tax lawyers and accountants; professors, librarians,
and other scholars; and students and interested citizens.
With its long history of exploring tax issues, and its broad
membership, the Association will be pleased to assist the Subcommittee
in its discussion of tax simplification. Most recently, NTA convened
the major national project on taxation of communications and electronic
commerce, which is sorting out issues facing governments, industry, and
users of these services.
Principles of tax law often conflict. For example, taxing all
income on an equal basis is generally considered to promote both a more
efficient and fair tax system, but carried to an extreme it can add to
complexity. In achieving a balance among principles, however, almost
everyone would agree that simplicity has been given far too little
weight in the legislative process. There are many items in the tax law
that add significant complexity with little gain in some other area
like equity or efficiency. Almost no one would introduce many
provisions now in current law, if designing a Code from scratch. Once
there, however, these complexities are hard to remove. My
congratulations go out to the members of this subcommittee who are
willing to tackle these problems.
Complexity creates waste, not merely cost. One must distinguish
between costs that might provide benefits and those that do not. A
transfer of $1 from me to you may cost me $1, but there is an offset in
the $1 that you pick up. Economists often focus on the distortions that
this transaction might bring about, such as changes in behavior.
However, among the most important distortions are the extra time and
effort involved. Joel Slemrod of the National Tax Association has made
special efforts over time to study this issue and has concluded that
administrative costs are significant. If it now costs me $1.10 to
transfer $1 to you--$1 in cash and 10 cents in human resources--then
that 10 cents is lost to society as a whole.
Another cost, although more subtle, may be even more important.
Many people do not mind paying their fair share of the cost of
government, but they highly resent it when they see needless waste--
including waste of their time in filling out an unreasonable number of
forms. They gradually lose respect for government and its functions. I
do not mean to imply that tax complexity is the only, or even the
primary, factor at play in the public's increasing cynicism toward
government--a cynicism that goes well beyond the healthy skepticism
that Americans have always had. But needless tax complexity does serve
as one of the important barriers to a healthy relationship between a
citizenry and its government.
A Few Candidates for Reform
Included among the many items of needless complexity today are the
following:
An alternative minimum tax that treats items such as
dependent exemptions as tax shelters, thereby threatening to tax
millions who were never meant to be affected;
Phase-out after phase-out of such allowances as itemized
deductions, earned income tax credits, personal exemptions, eligibility
for IRAs, eligibility for other saving incentives, eligibility for
educational tax breaks--each of which is like an additional mini-tax
system all to itself;
Pension and saving incentives that add administrative
costs and possibly even reduce net saving by providing different rules
for withdrawals, penalties, Social Security tax treatment, allowable
amounts of exclusion or deduction, and so on;
A tax treatment of dependent children that needlessly
causes millions of unnecessary tax returns to be filed;
A capital gains tax law with at least seven different tax
rates and that requires taxpayers to fill out pages of forms even when
they have only a few dollars of gains;
Multiple educational tax breaks that are poorly
coordinated with each other and with direct educational expenditures,
thus requiring duplicate administration and creating complexity for
students, parents, educators, and the IRS;
Complicated rules for charitable deductions and charities,
including multiple limits on giving as a percent of income and a
perverse excise tax on foundations that actually discourages charitable
giving;
Child credits and dependent exemptions that could easily
be folded into one; and
Unnecessarily strict estimated tax rules that pick up very
little extra revenue for all the complexity they introduce.
In the appendix to this testimony, I elaborate a bit on the first
three of these items. My purpose here, however, is not to go through a
laundry list of provisions in need of reform. Instead, I would like to
concentrate the remainder of my testimony not on particular proposals
but on a broader issue. I believe that the complexity of the tax law is
at its heart a failure of process. This process failure could be
mitigated through the adoption of certain procedures that I have
suggested for both the Executive Branch and Congress. The purpose of
these procedures is simply to grant simplicity a higher priority in the
policy process.
The issue, however, is not whether simplification should receive
the top priority in every tax bill. It should not. There are often
equally important, or more important, principles and issues at stake,
such as financing government activity or providing equal justice to
citizens in equal circumstances. After all, the government doesn't
collect taxes merely to simplify its tax system. The issue, instead, is
that simplification receives too little weight, especially given how
complex the tax system has already become. Indeed, the good news in
this bad news is that there are so many opportunities now for
simplification that only a modest effort is required to ensure that
most new tax enactments achieve net tax simplification.
Process
When I speak of process reform, I refer partly to the fact that no
one in the Executive Branch or in the Congress is responsible for
reporting on the consequences of tax law. I believe the way to
alleviate this situation would be to assign this fiduciary-like
responsibility and to formalize it in some very specific procedures.
Below I list two types of process reforms: (1) those that would involve
periodic reporting on existing law; and (2) those that would apply to
new legislation.
Periodic Reports
My first suggestion is that Treasury or the Joint
Committee on Taxation should publish a formal study year after year
listing tax simplification options. This would be similar to the
package of potential expenditure cuts and tax increases prepared by the
Congressional Budget Office and the tax expenditure list prepared by
Treasury and the Joint Committee on Taxation. I have become convinced
that it is only through the publication of such a list that tax
simplification is liable to get the greater attention it deserves,
especially on an ongoing basis.
Note, by the way, that the tax expenditure list is not sufficient
for this purpose. Among the many reasons are that not all tax
expenditures are complex, or more complex than direct expenditures. The
purpose of the tax expenditure list is not to provide ideas for
simplification, but to give tax programs a budgetary weight that is
equivalent to the expenditure programs that they might replace.
Some simplification options can be taken from Joint Committee on
Taxation studies such as its recent overviews of individual income tax
provisions on April 14, 1999 and of employer-sponsored retirement plans
on March 22, 1999. The Treasury often makes some suggestions each year,
especially at budget time. However, one should not discount the
importance of assembling, packaging, and reissuing a much more
comprehensive list on a regular basis.
The Government Performance and Results Act of 1993
requires a performance plan review that has been extended on an
embryonic basis to Treasury's tax expenditure budget. Treasury has made
some very tentative steps here, although it complains about the lack of
data (see comment below on IRS structural defects). While it would be
foolish to think that Treasury could study each of these programs
adequately each year--Congress continually mandates studies without
providing the resources to back up the mandate--a cycle could be
established that would lead to periodic review of each of them.
At the same time, I believe there is a fundamental failure
in IRS administrative structure that leads to the Treasury complaints
about inadequate information. Indirectly it also leads to some of IRS'
internal problems in managing itself. That defect is the failure of the
IRS to partially organize itself on a programmatic basis. IRS organizes
itself by tax return category, not by the programs under its
administration. Therefore, it prepares few analyses of these programs
and takes no responsibility for their success or failure. Only
indirectly do we find out about these programs, as when IRS measures
error rates by line item on returns. It is not surprising, then, that
IRS almost always ends up behind the 8-ball when Congress suddenly
decides it wants to examine the effectiveness of, say, the Earned
Income Tax Credit, the tax exclusion for employer-provided health
insurance, or the compliance costs imposed upon charities.
IRS sometimes excuses itself because it is in charge of
administration, whereas Treasury and the White House are in charge of
policy. While I am not unsympathetic with this argument, I still
believe it is inadequate. No one can properly administer a program
unless they understand how target-efficient it is and can analyze the
costs of administration for both the government and their customer from
a programmatic perspective. IRS does not have to make final judgment;
it does have responsibility for better development and dissemination of
the information it acquires in administering programs.
IRS is also scared to put out reports on administrative
effectiveness. In reporting on the EITC during the 1990s, for instance,
it has faced the political constraint that both President Bush and
President Clinton favored an increase in the grants made under this
program. Unless a regular schedule of reporting is established, IRS
will fear that the timing of release of any report will appear to be
politically motivated by one side or the other.
Reporting on New Legislation
Here are some methods for giving simplicity greater weight in the
legislative process:
Testimony on proposed bills should always include at least
some witnesses who focus solely on the simplification and
administration issues. Although affected persons should be invited,
some of these witnesses should not represent anyone with a significant
stake in the outcome.
When the markup of a bill occurs, one individual at the
witness table should have the sole assignment of providing information
on the administrative aspects of the bill. This individual might be
from the IRS, the Treasury's Office of Tax Policy, or the Joint
Committee on Taxation, but the assignment must be separated from other
issues so as to ensure that simplification concerns are not ignored.
Before going to conference, the IRS should produce mock
tax forms showing exactly what has been wrought from bills produced in
both houses. Changes in number of users of forms and line items should
also be provided, when possible.
In conference committee, one person at the witness table
should be held responsible for providing information only on the
simplification aspects of the bills from both parts of Congress.
The National Commission on Restructuring the IRS suggested
that a tax complexity assessment accompany future tax changes. If
interpreted in too legalistic a fashion, the requirement may be hard to
implement, but the spirit of the suggestion could be met in a variety
of ways. Last year the Joint Committee on Taxation prepared a
simplification analysis of a House bill at the request of Chairman
Archer, even though it was not required for that year. I am hopeful
that this subcommittee will devote some effort to making sure the right
precedents continue to be set and to guaranteeing that these analyses
are given significant weight in future legislative efforts.
Of course, none of these process reforms guarantee that
simplification will occur. Nor, as I noted at the beginning of my
testimony, should simplification be the only factor under
consideration. Nonetheless, a combination of some, if not all, of these
procedures could serve as a major deterrent to new sources of
unnecessary complexity and as a spur toward achieving the types of
simplifications sought by this subcommittee.
APPENDIX
Three Major Areas of Complexity
Alternative Minimum Tax
Many efforts at reforming the AMT deal with the failure to
index the system over time, so that more and more taxpayers
would not be forced to pay this tax. Under current law, for
instance, many married couples with two children, average
income, and no more deductions than their state and local taxes
are scheduled to pay AMT in the future. As their income and
state and local taxes--which are counted as preference items--
grow with normal inflation and economy-wide growth, these
taxpayers are less likely to be excluded from the AMT. But
while a reform that indexes the AMT is worthwhile, it still
ignores whether or not the tax makes sense, whether its base
includes items that should not be subject to taxation, and
whether the administrative hassle and complexity are worth the
trouble in the first place.
A few of the preference items in the AMT have attributes
associated with preferential treatment, such as generous
depletion allowances or the tax exemption for interest received
on private activity bonds. In those cases the taxpayer may be
excluding from taxable income a significant portion of real
income received. But most of these items are not large in terms
of alternative minimum tax collections. Other items included at
different times, such as an alternative depreciation schedule,
are more debatable since they seem to deny to some taxpayers
even those deductions that would be allowed if economic income
were calculated accurately. Some of these provisions are
enormously complex, as well, for they require the taxpayer to
keep multiple records for years under alternative methods of
calculation.
There is little excuse for inclusion of items that are
legitimate deductions reflecting a lower ability to pay tax.
The standard deduction allowed to nonitemizers is treated as a
preference item under the AMT. So also are extraordinary and
legitimate work expenses when deducted as miscellaneous
itemized deductions. The inclusion of personal exemptions as a
preference item implies Congress believes that a dependency
exemption is not an appropriate adjustment to ability to pay
tax, but instead accords the taxpayer special treatment. In
effect, for AMT purposes, the law implies that a family of four
has the same ability to pay tax as a family of two with equal
income.
Finally, there are those items that under some theories
might not be deductions under an income tax, but under other
theories are quite reasonable. It is inconsistent and arbitrary
to try to tax them through an AMT. These include state and
local tax deductions and those few medical deductions allowed
for regular tax, but not minimum tax, purposes. If there is a
rationale for further limiting these deductions, it should be
applied directly in the normal income tax, not through the more
complex AMT.
Tax System after Tax System & the High Implicit Marginal Tax
Rates
In recent decades the tax and expenditure laws have
witnessed the establishment of one new tax system after
another. These tax systems derive from attempts to cut back or
pare various ``benefits'' as income increases. As one
consequence, they create a strange tax rate schedule with a
number of side effects such as rising and increasing marriage
penalties on individuals.
The difficulty is that the tax systems are created in
happenstance manner. They derive from nothing more than a
glance at what might look politically salable when each part of
a bill is up for adoption. For example, child credits are meant
to apply to the middle class, so they will at least be limited
for those with incomes of, say, $75,000 or $110,000 or more.
Yet almost every one of these phase-outs has its own set of
rates, base, and phase-out region. Should one of these income
taxes apply at one level and the next at a very different
level? Maybe, but no rationale is or has been provided.
Moreover, granting some benefit at high income levels is not
necessarily regressive if those individuals have more than paid
for the benefit with their taxes.
Meanwhile, there are now multiple tax systems implicit in
expenditure programs as well. Consider all the possible
interactions among the following: a federal income tax, a state
income tax, the phaseout of an earned income tax credit,
phaseouts of the benefits of nontaxation of social security
income, phaseouts of personal exemptions, phase-ins of limits
on itemized deductions, phase-ins of alternative minimum taxes,
phaseouts of existing higher educational benefits like Pell
grants, and phaseouts of various welfare benefits like
Temporary Assistance to Needy Families, food stamps,
Supplemental Security Income, and various forms of housing
subsidies.
For low and moderate income taxpayers--the primary group
for which simplified filing at one time seemed possible--earned
income tax credits, child credits, dependent care deductions,
educational credits, and presidential campaign check-offs,
among others, have been added to returns. Unlike the
traditional personal exemption and standard deduction, these
various provisions often require additional information by the
taxpayer. Whatever their other merits, therefore, they have
complicated filing significantly. To top matters off, the IRS
has discovered that many of the errors in EITC filing and other
allowances are related to claiming children incorrectly,
especially when the parents of children are separated,
divorced, or never married. To deal with this problem, the IRS
has sought additional information from taxpayers to verify
their eligibility for different allowances related to children.
Most of the allowances for low and average income
individuals, ranging from the EITC to child credits and
dependent exemptions, could be combined or simplified
significantly, even if some variations had to be eliminated.
For example, there's little reason that the personal exemptions
for dependents couldn't be folded into the child credit.
Pension and Saving Plan Simplification
The number of rules and regulations applying to pension and
saving plans is overwhelming (see attached table). This derives
from an extraordinary number of so-called saving and retirement
incentives in the tax code, each with its own separate limits,
exceptions, and requirements on both individual taxpayers and
employers. The consequent complexity reduces the net rate of
return available to saving, in part because of the very large
expenditure of time and paid labor that must be employed to
interpret, administer, and seek to understand this universe.
Thus, the issue is not whether there should be rules
regarding eligible deposits, discrimination among employees,
penalties for withdrawals, and so on, but whether there needs
to be so many inconsistent rules and regulations across so many
different plans.
One type of reform does not address how many incentives
might be offered, but, whatever their number, seeks to apply a
more common set of rules on as many of them as possible. For
example, there might be a single, common limit on deductible
contributions for all types of employer-provided plans and a
common income eligibility standard for individual plan options
such as individual retirement accounts. The limit might be
expressed simply as a dollar amount, rather than as percent of
income. For withdrawals, a common but limited set of exceptions
might be established, and a common penalty for early withdrawal
might be applied. A simple standard could be adopted as to
whether contributions are subject to social security tax or
not.
More complicated to design, but highly desirable, would be
a simpler rule or set of rules regarding when plans
``discriminate'' against lower-paid workers in a firm. A second
approach to simplification would reduce the number of
retirement and saving options. Do we need both traditional IRAs
and Roth IRAs, both profit-sharing and employee stock option
plans, both money purchase and profit-sharing plans, both
401(k) and 403(b) plans? My feeling is that the gains from
these differentiations are small, if any, and the costs of
administration are almost inevitably higher than any gains.
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Chairman Houghton. Thank you very much, Mr. Steuerle.
Let me ask, is there anybody from the Internal Revenue
Service in the audience? Interesting--with all this testimony.
Well, I will be their advocate.
It is very difficult to separate tax reduction from tax
reform because you get all tangled up here. We are, however,
really interested in the simplification issue. I mean, as we
looked at the numbers, the No. 1 target for simplification was
the AMT; it has just spread like an octopus far beyond the
boundaries of what was intended.
If you take a look at it--and I have just gotten the
figures from Mac of our staff here--that over 10 years, this
would cost $135 billion. It starts off at a $7 billion rate and
ends up, in the 10th year, at a $27 billion rate. Now you can
say, well, if those are the numbers, you better get at it
pretty soon or it is going to strangle you. But are there any
adjustments we can make? I am looking at it from the practical
standpoint. We don't have a lot of money to play with, and
there is the great concept of a 10-percent across-the-board tax
cut out there. We are not going to do that.
Yet, at the same time, there are so many things we can do.
What--and several of you listed 10 issues--what are those
things we can do? I don't mean to be cheap about this thing--
but what are the things we could do right now, and you could
say to the leadership of the House, this thing is not going to
cost us an arm and a leg. It will help the taxpayers
tremendously. It will be a first cut in terms of overall
simplification. What do you think are those things? Now, Hank,
you mentioned compliance. What could we do in that area,
without talking about billions and billions and billions of
dollars?
Mr. Gutman. Well, I think, Mr. Chairman, Mr. Neal said his
bill was revenue-neutral. There is the start. If what we are
worried about is cost, there is something on the table that has
got revenue-neutrality and achieves enormous simplification. It
has got elements that are in your bill as well. Capital gains
is a mess. The AMT, as everyone has pointed out, is reaching
into an area where it was never intended to be. And if the
revenue raisers which Mr. Neal has proposed are acceptable,
that ought to work.
I have a little bit of doubt about increasing the floor
under itemized deductions from 2 percent to 4 percent. I never
understood, as a policy matter, why the floor was enacted in
the first place. I do understand the pragmatics.
You eliminate a huge amount of complexity with the
elimination of Pease and PEP, the elimination of the
alternative minimum tax and the rationalization of the capital
gains structure.
A second area, which may end up actually raising some
money, depending upon how you do it, is rationalization of the
education credits. The educational assistance programs that are
in the code came in at different times with different
objectives. They are impossible to figure out and you may be
able to move them around, get some money and achieve
significant simplification. So I think those are areas to focus
on because people have already begun to focus on them.
Chairman Houghton. Right now. Mr. Neal, have you got a
comment? Because I would like to end it at any time, gentlemen.
But why don't you go ahead, Rich.
Mr. Neal. I would like to ask the other panelists about PEP
and Pease since Mr. Gutman raised it and then I would like to
come back to him with a specific question. The other----
Mr. Steuerle. I was around then although I would like to
claim that I am not fully responsible for the complications. I
was coordinator of Treasury's study when we first put forward
tax reform in 1984 to 1986 and PEPs and Pease ended up to be
the result of a back-door attempt to basically hide tax rate
increases by creating what then was called a bubble which----
Mr. Neal. So you were part of it?
Mr. Steuerle [continuing]. Meant your rate went up and then
went down, but then leveled out. That bubble was not actually
in the original Treasury proposal. It provided a way of saying
``We cut rates,'' but then raise them on the side. As a
professional in the tax field, I don't like hidden taxes and,
therefore, I don't like PEPs and Pease. I would much prefer to
put them in the rate schedule. I realize, however, that that
causes considerable political consternation; that is, if hidden
rates are all right, but direct rates aren't, then there is a
real problem. But, for the most part, these phase-outs are
nothing more than back-door rate increases. Outside of some
slight differences across families, you could work them into a
rate schedule, if you want to create a bubble in the rate
schedule, but it would be explicit.
Mr. Neal. The others? Would you like to comment on that?
Mr. Tucker. The Tax Section has pointed out a number of
times that we would far prefer to see rates raised than do it
the indirect way through PEP and Pease and AMT and other
phaseouts that come in and come out. We think that, No. 1, is
really simplicity. No. 2, we understand it is politically
difficult, but it is also very difficult to explain to our
clients who are in the 39.6 bracket they think, when in
actuality they are in the 42 percent bracket in most
circumstances and we get a lot of anger. We get a lot of, you
know, you are not helping me. You are telling me something I
don't want to hear. And we think it ought to recognized. That
that truly would be simplification.
Mr. Neal. Mr. Gutman, yes, I know it is not a topic that we
were to focus on today, but corporate tax shelters, the
Treasury's approach. Do you have a comment?
Mr. Gutman. Well, that is an interesting question, Mr.
Neal. I guess from a congressional perspective, one of the
things that I would have thought you and Chairman Houghton and
others would want to focus on is the extent to which the
Treasury proposals represent a shift of legislative authority
from you to the Internal Revenue Service and the Treasury. That
is something I would have thought would be of some concern to
you, particularly given the IRS restructuring legislation which
in large measure was directed to limiting the scope of
authority that the Internal Revenue Service has to exercise
power over taxpayers. From an institutional viewpoint, this is
an issue that you ought at least to think about.
From the point of view of practitioners, I think the
Treasury proposals raise a number of issues. The first is
simply the ambiguity of the proposals. That is a consequence, I
think, of the attempt to create a one-size-fits-all rule. And,
if nothing else has emerged from the debate so far, it ought to
be clear that there is little consensus about the kinds of
transactions that fall within the rule. And so, I think, one of
the things that needs to be addressed is an attempt to make
clear that we know what it is we are talking about.
The second part of the Treasury proposals goes to what I
call proportionality. Does the punishment fit the crime? The
Treasury proposals impose strict liability penalty on taxpayers
without regard to the nature of the advice they have received
in connection with a transaction. And it is strict liability
for transactions that are undefined. That is a big problem. If
the motive for the imposition of strict liability is a
perception that people aren't getting straight advice, then I
think you should deal with the question of what kind of advice
is required. But a no-fault penalty when it is not clear to
what the penalty is going to apply, and when the Internal
Revenue Service and the Treasury are the ones who define the
scope of the penalty, seems to me to be problematic.
And finally, there is, a very practical side to this. There
will be an awful lot of power bestowed on the IRS in the audit
process by these kinds of proposals and that is something, too,
that you have evidenced concern about in the past. No matter
how much people say that this won't happen, the fact of the
matter is that agents who are armed with these kinds of weapons
will use them to extract concessions from taxpayers. I think
you ought to be concerned about that.
Mr. Neal. Mr. Lifson. Mr. Lifson, you were nodding in the
affirmative. Do you want to comment, too?
Mr. Lifson. I would say that what petrifies the American
Institute of CPAs is the effect of this legislation on a whole
broad class of unintended participants, which are small
business people and bestowing IRS agents with this extra level
of authority absolutely petrifies us. On a second layer, the
idea that it is a good idea to make a law that is fuzzy and
nobody knows where they stand so they stand way back from the
line, isn't consistent with our view of American justice.
Mr. Neal. Thank you, Mr. Chairman.
Chairman Houghton. Yes. Mr. Harkins. You run a business and
you are concerned about a variety of things--the death tax and
the independent contractor. Talk a little bit about those
things.
Mr. Harkins. Yes, Sir. The estate tax, death tax as we
prefer to call it, is probably the most unfair tax there is. If
a man works his whole life, pays his taxes, takes his after-tax
income, hangs on to it, when he dies, the government, you know,
sticks out their hand for another 37 to 55 percent of it. You
know, the original intent of the law was to break up I guess
large family monopolies. But I think it has been proven and the
Joint Economic Committee study really made the point that the
estate taxes cost almost $500 billion this century, or 3.2
percent of the stock of capital, reduction in capital in the
country. The cost of compliance is about $23 billion, which is
almost the same amount as the tax takes in. It destroys
families; it destroys farms; it destroys small businesses.
Now that in my opinion is revenue-neutral. Now, I am not in
favor of revenue-neutrality. I am in favor of less taxes being
paid. You know, I think we have a projected surplus in this
country and that surplus means that somebody has paid too much
in taxes. And if somebody has paid too much in taxes, it would
appear to me that the best thing to do would be to find a way
to give some of it back. So I am totally not convinced by any
revenue-neutrality logic.
I would like to see the AMT eliminated because it punishes
small businesses, especially. A lot more than it punishes
anybody else. I just studied the IRS for a year and I worked
with them for 9 years and I don't trust the IRS to make tax
law. Congress needs to make tax law and they need to make it
very specific so it is not subject to interpretation because it
just costs the system a lot of money when you let a bureaucrat
make the law and that is what happens.
Chairman Houghton. What about the independent contractor
issue?
Mr. Harkins. Well, I am concerned about that. Your
legislation, Chairman Houghton, is excellent. When I served as
a delegate to the White House Conference on Small Business in
1995, our No. 1 issue--and there were 2,000 small business
owners from all over the country--and they all agreed that the
No. 1 issue was the independent contractor issue. And what we
said was we needed an objective standard. We were tired of the
IRS interpreting the 20 common law factors. Because if you got,
you know, 11 of them right or maybe you got 19 of them right
and one of them wrong, then you were subject to
reclassification. So there was a lot of uncertainty.
What we said was you need to make it objective. But then
what you need to do is you need to have safe harbors for
industries who have been established and who have thrived on
certain interpretations of that classification. You can't just
throw them to the dogs by allowing the Internal Revenue Service
to write regulations.
And I assure you, if you let the Internal Revenue Service
decide who is an employee and who is an independent contractor,
there will be no independent contractors. They will all be
employees because that is the line of least resistance with the
Internal Revenue Service and it gives them the ability to
collect more revenue which is what their job is. They are going
to maximize revenue to the detriment of the taxpayer.
Chairman Houghton. OK. What--I don't know how you feel
about this, Mr. Neal, but I would like to end up with 4, or 5,
or 10, specific things we can do to start this tax
simplification process. As I mentioned earlier, we have got to
be careful of the money, because we will just run up against a
stone wall here. I have heard a lot of things; we have your
testimony.
I think it might be helpful--I hate to throw more work at
you, but obviously you have invested enough as it is. However,
I would appreciate your giving Mr. Neal and myself, a one-pager
in terms of those specific things that you think are important,
priority-wise, that will go with our report, and then we will
take a look at our respective legislation and see what we can
do together on this thing. I think if there ever was a time to
do something, it is now, while the economy is going
particularly well.
[The information was not available at the time of
printing.]
Mr. Neal. Mr. Chairman, just a quick observation. To have a
Democrat propose eliminating the AMT is a good starting point.
It seems to me that--I have talked with Mr. Archer a couple of
times about this. He is all excited about that aspect of it. I
think our goal is to convince him that there are other aspects
of this that are doable as well.
Chairman Houghton. OK. That is your No. 1. I don't disagree
with it either. Have you got any other comments to make.
Mr. Harkins. Sure. Mr. Chairman, pardon me, but I do have
one issue that I think could be revenue-neutral, as Mr. Neal
would----
Mr. Neal. You were against that a few minutes ago, Mr.
Harkins.
Mr. Harkins. No, but I am just--let me explain this, Sir.
Is the capitalization, increase in capitalization for
businesses? You know, if a business buys a piece of equipment
for $10,000 and they have to depreciate it over 10 years, now
they end up getting $1,000 a year in write-offs for that piece
of equipment over the 10 years. If you let them expense that
piece of equipment in year one, they would get to keep more of
their money, but, in fact, they end up paying the same amount
of tax.
So it really--all it gives them is a break in the first
year, which increases their working capital, which increases
their ability to create jobs and to stimulate the economy, but
yet it costs the Federal Government nothing except you might
say, ``Well, what is the interest on the money that you would
have gotten in the first year versus in the second or third or
fourth?'' But, in my opinion, that is a very simple way of
doing two good things without creating any problems for the
budget process. But perhaps I am naive to think that.
Chairman Houghton. I don't think you are naive, but I do
think we have problems with that. I mean, the whole structure
of the concept of long-term pay-out and short-term is at risk
here. I wish, as a matter of fact, that we had the reverse in
the Federal Government, because you have to expense everything.
It is a cash system rather than an accrual system, and we get
all tangled up in our scabbard on this thing. But let us take
it into account, and if you feel strongly about this, maybe you
can put that into your one-pager.
Mr. Harkins. Yes, Sir. Thank you.
Chairman Houghton. Anything else? Any other comments?
Mr. Tucker. Just, I guess, there are two other items. No.
1, we would ask at the Tax Section of the ABA that, as you
think through these items, that you not add more exceptions and
more complexities and more phaseouts, because we are concerned
that what you may see on the one hand as burden reduction
creates more complexity and not more simplification.
Second, I think if we were to have our most-favored list,
we would certainly focus on the alternative minimum tax and its
elimination.
Chairman Houghton. Right.
Mr. Tucker. But if you can't eliminate it, there are some
major concerns that every taxpayer has, including,
particularly, the loss of itemized deductions and personal
exemptions. Second, is the simplification of long-term capital
gains and short-term capital gains and simplifying the rules. I
mean, adding all the lines as a result of the 1997 Act had
absolutely no benefit for anybody. And, third, we would look at
the ability to eliminate the phaseouts. And I recognize that
they are considered an offset to certain things, but I think
really focusing on maybe rate brackets rather than phaseouts in
a number areas and not just PEP and Pease would be very
important.
Mr. Steuerle. Mr. Chairman, can I also suggest that your
efforts and yours, Mr. Neal, to make a bipartisan bill is
extremely important. It is so much easier. Having served at
Treasury, I can tell you, and perhaps Hank can tell you from
the Joint Committee perspective that it is much more easy, in a
bipartisan context, to pull together staff from different
places to work together and really pull together. There are a
lot of people at Treasury, the Joint Committee, ABA, the ICPA,
National Tax Association, other places, who have no agenda at
all.
They can sit down and they can list items that are on these
lists, on other lists. They can tell you the ones they agree
with. They can say, ``Well, you know, this pushes a little bit
toward simplifying, but we think you might have some equity
concerns.'' With a deliberate bipartisan effort, you could come
up with a longer list and build some momentum.
Just as a trivial example, I have suggested a number of
simplifications in the area of charitable deductions that I
don't think cost revenue. You could add those to the bill. That
might build you a little momentum in the charitable community.
So there are a lot of areas where you could think about
expanding what I think all of us at this table feel is a very,
very commendable process.
Mr. Lifson. You know, from the AICPA's perspective, we also
have a list to further what you are saying, of simplification
ideas that could lead to greater tax compliance. Now if you can
combine simplification with improved tax compliance so that
people pay their taxes more voluntarily than they do now and
move your rate from 86 percent to 87 or 88 percent and attack
people that are not paying the right amount of tax now, then
sometimes your simplification vehicle can be a revenue-positive
item without hurting anybody in the political structure.
Chairman Houghton. Well, I think there are certain,
fundamentals here. I think I can speak for you Rich; we are
really serious about this. I mean, this isn't just a hearing to
have a report and go on; we really are serious and, also, I
think we are serious about doing something important. You know,
time is the most precious thing we have and we ought to use it.
If it is important, it must be bipartisan, because on any big
issue, you know, one party can't do it.
So, gentlemen, thank you very much for your time and your
great thoughtfulness in these reports; I hope to hear from you.
Thank you.
[Whereupon, at 4:25 p.m., the hearing was adjourned.]
[Submissions for the record follow:]
Statement of American Network of Community Options and Resources,
Annandale, VA
Introduction and Overview
This testimony outlines the comments and suggestions of the
American Network of Community Options and Resources (``ANCOR'')
relating to the current complexity of section 131 of the Code of 1986,
as amended (the ``Code''), which provides rules on the tax treatment of
foster care payments received by individual taxpayers.
ANCOR was formed in 1970 to improve the quality of life of persons
with disabilities and their families by coordinating the efforts of
concerned providers of private support services. ANCOR is comprised of
more than 650 organizations from across the United States together
providing community support to more than 150,000 individuals with
disabilities.
ANCOR strongly recommends that section 131 of the Code be amended
to eliminate current law's complexity by uniformly allowing individual
taxpayers to exclude from income the foster care payments they receive
from State and local governmental sources. ANCOR believes that amending
section 131 in this manner would (i) simplify the tax treatment of
foster care payments for individual taxpayers, (ii) eliminate an
impediment to State and local governmental efforts to reduce
bureaucracy and costs for their foster care programs, and (iii) support
State and local governmental efforts to encourage much-needed
individuals to participate in foster care programs.
Description of Current Law and Proposal
Current Law
Section 131 of the Code as it currently exists creates a complex
dichotomy in the tax treatment of individuals who serve as foster care
providers for individuals in foster care under 19 years of age and for
those who provide treatment to individuals in foster care over 19 years
of age. For children under 19 years old, section 131 of the Code
permits individual taxpayers to exclude foster care payments from
taxable income when a government entity or charitable tax-exempt
organization directly places the child and makes the foster care
payments to the provider. For individuals 19 years of age or older,
section 131 allows an individual taxpayer to exclude foster care
payments from taxable income only when a governmental entity makes the
placement and the payment. Thus, an individual's ability to exclude
foster care payments, even if all such payments are derived from
government funds, is linked to the type of agency that places the
individual with the provider.
Proposed Change
Congress should amend section 131 to allow all individuals who
serve as providers of foster care the ability to exclude from income
those foster care payments that they receive from a governmental
source, regardless of whether a governmental entity placed the
individual, provided that a governmental entity has either certified or
licensed the placement agency. Amending section 131 in such a way would
not only simplify the tax treatment of foster care payments and reduce
the administrative burden on the Internal Revenue Service (``IRS''),
but the change would also support the efforts of State and local
governments to address the needs of their communities more effectively.
A. Current law is confusing to taxpayers and to the IRS. As
illustrated by Table 1, incongruent treatment of individual taxpayers
who are foster care providers has created a complex system for
determining when such providers can exclude their foster care payments
from income.
Table 1.--Excludability of Foster Care Payments from Income Under Section 131
----------------------------------------------------------------------------------------------------------------
Age of Foster Care
Placement Agency Payor Individual Payment Excludable?
----------------------------------------------------------------------------------------------------------------
State or political subdivision....... State or political <19 years.............. Yes
subdivision.
State or political subdivision....... State or political 19 years............... Yes
subdivision.
State or political subdivision....... 501(c)(3).............. <19 years.............. Yes
State or political subdivision....... 501(c)(3).............. 19 years............... No
State or political subdivision....... Not 501(c)(3).......... <19 years.............. No
State or political subdivision....... Not 501(c)(3).......... 19 years............... No
Licensed 501(c)(3)................... State or political <19 years.............. Yes
subdivision.
Licensed 501(c)(3)................... State or political 19 years............... No
subdivision.
Licensed 501(c)(3)................... 501(c)(3).............. <19 years.............. Yes
Licensed 501(c)(3)................... 501(c)(3).............. 19 years............... No
Licensed 501(c)(3)................... Not 501(c)(3).......... <19 years.............. No
Licensed 501(c)(3)................... Not 501(c)(3).......... 19 years............... No
Not 501(c)(3)........................ State or political <19 years.............. No
subdivision.
Not 501(c)(3)........................ State or political 19 years............... No
subdivision.
Not 501(c)(3)........................ 501(c)(3).............. <19 years.............. No
Not 501(c)(3)........................ 501(c)(3).............. 19 years............... No
Not 501(c)(3)........................ Not 501(c)(3).......... <19 years.............. No
Not 501(c)(3)........................ Not 501(c)(3).......... 19 years............... No
----------------------------------------------------------------------------------------------------------------
The confusion presented by current law is exemplified by the recent
Tax Court decision in Micorescu v. Commissioner, T.C. Memo 1998-398. In
Micorescu, the court held that an Oregon family providing foster care
services to adults in the family's home could not exclude from income
payments received from the private agency that placed the individuals
with the family. The court reasoned that because the adult individuals
were placed with the family by a private agency rather than by the
State or an agency of the State, those individuals were not ``qualified
foster individuals'' within the meaning of section 131. The court
reached this conclusion even though the organization that placed the
adults in the family's home both contracted with and received funds
from the State of Oregon. Equal treatment of all families providing
foster care services (i) who receive payments from an agency that
operates under a license or certification by a government entity or
(ii) who receive payments directly from a government entity would
reduce the confusion that currently exists. Provider families, like the
family involved in the Micorescu case, would know with certainty
whether they could exclude their income.
Individual taxpayers are not alone in their confusion. Section 131
has proven so confusing that our members have reported many instances
in which IRS officials and experienced certified public accountants and
tax attorneys also have difficulty ascertaining when a payment is
excludable. Our members can site various examples of situations in
which individual providers have been told informally by an IRS official
and/or an experienced tax advisor that their foster care payments were
to be excluded from taxable income, when in fact those payments were
not excludable. Amending section 131 would, therefore, prevent not only
the confusion individuals and their tax advisors have over whether
foster care payments are excludable, but also the confusion experienced
by the IRS officials that are charged with administering the law.
B. Current law fails to support the decisions of State and local
governments. Governmental entities are becoming increasingly reliant on
private agencies to place both children and adults with special needs
in foster care. Governmental entities have found that foster care for
adults with special needs reduces the expense that is usually incurred
when maintaining group homes and institutional settings. In particular,
the National Association of State Directors of Developmental
Disabilities Services has found that over the past several years there
has been a considerable increase in pressure on state agencies to
reduce waiting lists. Additionally, State and local governments often
use outside entities to make case-specific decisions (such as
identification of those individuals who would benefit from foster care
and those providers with whom such individuals should be placed) as a
means of reducing bureaucracy in an already trying situation. Current
law, however, fails to provide the same tax treatment to those
individuals identified by private entities acting under a license or
certification with States, counties and municipalities as is provided
to individuals that are identified directly by the State. Disparate
treatment exists despite the fact that from the governmental entities'
perspectives, the activities are the same. As a result of the
difference in treatment, State and local governments are discouraged
from contracting with private agencies to make placement decisions. The
tax code should support State and local governments that decide to cut
costs, reduce bureaucracy and support individuals with special needs in
their communities through expanding their foster care programs.
C. Current treatment of foster care payments discourages much-
needed individuals from participating in foster care programs. The
confusion created by section 131's complex rules discourages many
potential foster care individuals from participating in these programs.
Despite the fact that individual taxpayers could, under these rules,
offset taxable foster care payments (paid by non-qualified agencies) by
treating expenditures made on behalf of a foster individual as a
business expense deductions, such deductions are permitted only if the
families maintain detailed expense records. Accordingly, otherwise
willing providers are discouraged from accepting foster individuals
placed by non-qualified agencies, because such providers are forced to
endure the time and inconvenience associated with keeping extensive
records. The result is a smaller pool of available, qualified and
willing providers and a growing pool of individuals with special needs
for whom group housing or institutional living is inappropriate.
Amending section 131 as suggested would help address the increasing
demand for providers of foster care services.
D. Legislation introduced this year would remedy these problems.
Bills were introduced in the House (H.R. 1194) and in the Senate (S.
670) that propose to simplify the current rules under section 131 for
individuals receiving foster care payments. These bills would allow
individual providers to exclude from income foster care payments
received, regardless of the age of the individual in foster care and
the type of entity that placed that individual. The exclusion would
apply only if either (i) a state or local government or (ii) a
``qualified foster care placement agency'' made the foster care
payments. Such payments would have to be made pursuant to a foster care
program of such governmental entity. Further, to be qualified, a foster
care placement entity would have to be licensed or certified by a state
or local government to make foster care payments to providers of foster
care.
Conclusion
ANCOR recommends amending section 131 of the Internal Revenue Code
so that all governmental foster care payments received by individual
taxpayer providers are treated the same. If enacted, current law's
confusing and unfair tax rules would no longer discourage much-needed
individual providers from participating in foster care programs.
Amending section 131 in this fashion also will support State and local
governments in their efforts to reduce bureaucracy and cut costs,
provide more alternatives to institutionalization, while simplifying
tax administrative burdens.
Statement of Associated General Contractors of America (AGC)
The Associated General Contractors of America (AGC) is pleased to
provide the House Ways and Means Subcommittee on Oversight with this
written statement on the ``Impact of Complexity in the Tax Code on
Individual Taxpayers and Small Businesses.'' AGC is the nation's
largest and oldest construction trade association, founded in 1918. AGC
represents more than 33,000 firms, including 7,500 of America's leading
general contracting firms. AGC's general contractor members have more
than 25,000 industry firms associated with them through a network of
101 AGC chapters. AGC member firms are engaged in the construction of
the nation's commercial buildings, factories, warehouses, highways,
bridges, airports, waterworks facilities, waste treatment facilities,
dams, water conservation projects, defense facilities, multi-family
housing projects, site preparation, and utilities installation for
housing developments.
While AGC's membership is diverse, the majority of AGC firms are
closely-held businesses. AGC member firms are 94% closely-held, 81% are
owned by fewer than four persons, and over 80% are small businesses
with an average construction project size under $5 million.
AGC supports tax simplification for general contractors in the
following complex tax areas:
Lookback Method of Accounting
AGC supports efforts in Congress to eliminate the burdensome
lookback method of accounting for long-term construction contracts.
The 1986 Tax Act extensively revised the methods of accounting
available for long-term contracts, including enactment of a provision
mandating the use of the lookback method for all long-term contracts
accounted for on the percentage of completion method of accounting
(PCM). The lookback method of accounting was adopted to address abuses
in the application of the PCM in other industries that have long-term
contracts spanning many years. The lookback method essentially requires
a construction contractor to file amended tax returns each year for
every prior year in which a currently completed contract was in
progress. It also requires similar amendments for every year in which
post completion changes occur. The difference between the theoretical
taxes that would have been due if all facts were known in the year the
contract was entered into, and the taxes actually paid in prior years,
is calculated. Interest is then calculated on this change in prior-year
tax liabilities. The lookback method does not result in any change in
total tax liability. It does result in an interest adjustment based on
this theoretical change in tax liabilities.
The lookback method is exceedingly complex. It imposes tremendous
compliance and administrative burdens on construction contractors. The
lookback method diverts valuable time, labor, and resources of
construction financial and accounting professionals from worthwhile
functions. The lookback method is exceedingly burdensome for all
construction contractors, but it poses special problems for smaller
contractors that have to hire outside accounting experts in order to
calculate lookback.
The Taxpayer Relief Act of 1997 attempted to address this issue by
providing an election to forego application of the lookback method if
the estimated gross profit recognized in each contract falls within 10
percent of the retroactively determined gross profit for each year the
contract was in progress. However, this provision provides no relief
from the paperwork burden. Election to apply this provision requires
most of the above calculations as well as additional calculations in
order to determine whether each contract falls within this 10 percent
variance in each prior year.
The lookback method is an overwhelming burden for both small and
large contractors. Further, many contractors receive refunds of
interest, which, in AGC's estimation, makes this a revenue loser for
the Department of Treasury.
Percentage of Completion Method of Accounting
The Tax Reform Act of 1986 revised the long-term contract
accounting rules for contractors. These rules--contained in Section 460
of the Internal Revenue Code--place unfair burdens on smaller
contractors and should be modified by Congress to account for inflation
growth since 1986.
In 1986, Congress enacted changes to the Internal Revenue Code
(Section 460) requiring contractors to use the percentage of completion
accounting method for reporting taxable income from long-term
contracts. Long-term contracts are contracts for the manufacturing,
building, installation, or construction of property that are not
completed within the tax year in which they are entered into. The
percentage of completion method requires contractors to calculate what
percentage of the contract is complete in a tax year and then pay taxes
on that percentage. Prior to the 1986 change, a contractor could pay
taxes on their income from a long-term contract when the contract was
completed.
The 1986 tax law change was intended to prevent large contractors
from deferring taxes for years on large contracts. Congress created an
exception to Section 460 for smaller contractors. Those contractors
whose contracts will be completed within two years of the contract
commencement date, and whose average annual gross receipts for the
three tax years preceding the tax year the contract is entered into do
not exceed $10 million, are exempt from the percentage of completion
requirements.
Unfortunately, the $10 million threshold was not indexed for
inflation. Today, more and more small contractors are crossing this
threshold and are being forced into the burdensome and costly
percentage of completion method. Congress clearly recognized the burden
this change places on smaller contractors forced to switch to the
percentage-of-completion method. AGC advocates that the $10 million
exemption be updated to account for inflation since 1986.
Cash Method of Accounting
AGC recognizes the cash method of accounting as a legitimate
accounting method for small contractors that adhere closely to the
Internal Revenue Code. AGC advocates clarifying that construction
materials are not ``merchandise'' or ``an income producing factor,''
updating the small business exemption and mitigating unreasonable
retroactive penalties. AGC strongly supports legislation by Chairman
Houghton to update the threshold for cash accounting to $10 million.
AGC also supports legislation by Chairman Jim Talent of the Small
Business Committee to clarify that businesses under $5 million can use
the cash method regardless of IRS inventory or merchandise tests.
For small contractors, the cash method of accounting is the most
practical method because it recognizes income and expenses when the
cash is actually paid to the company or by the company. The accrual
method requires recognition of income before the cash is received; that
is, income is recognized when the right to the money arises even though
it may never ultimately be received. Under the accrual method, the
company is required, in effect, to pay taxes with money it doesn't
have, which can be quite a burden for small contractors. The IRS has
long favored the accrual method over the cash method, with little
thought of small businesses that often find the accrual method a
financial burden.
Although I.R.C. Sec. 448 places limitations on the use of the cash
method of accounting, a specific exception is provided for entities
with average annual gross receipts of $5 million or less for three
previous taxable years. Accordingly, small contractors should be able
to use the cash method of accounting. The IRS has largely ignored the
$5 million exception for small contractors and has aggressively sought
to enforce the accrual method on small contractors. The IRS has done so
by requiring contractors to inventory on-site supplies, because the IRS
says that these supplies are an income-producing factor. Once the IRS
requires an inventory to be kept, then a small contractor must switch
to the accrual method and even pay substantial underpayment penalties.
In a nutshell, the IRS is attempting to ignore certain sections of
the Internal Revenue Code which allow the cash method, thus giving the
IRS the luxury of using the method of accounting that most aggressively
accelerates revenue recognition. The IRS position on the cash method
ignores the sections of the Internal Revenue Code specifically allowing
corporations with average annual gross revenues of less than $5 million
to use the cash method of accounting. Regardless of what the Internal
Revenue Code clearly states, the IRS has continued its assault on small
contractors by administratively repealing the $5 million protective
statute.
Alternative Minimum Tax Relief
AGC supports total elimination of the alternative minimum tax.
Short of total elimination, AGC supports legislative relief from the
burdensome calculations required of smaller contractors under the
alternative minimum tax. In this regard, AGC legislation by Chairman
Houghton to increase the AMT gross receipts exemption for small
businesses from $7.5 million to $10 million.
The computation of AMT is administratively complex and inhibits the
formation of capital, including complicating equipment and property
acquisition decisions. The AMT long-term contract adjustment was
enacted to require large contractors to report certain income from
long-term contracts using the percentage-of-completion method (PCM).
The AMT requires contractors with long-term contracts at their fiscal
year end that are not subject to current regular taxation to add back
to regular taxable income the unreported gross profit on the long-term
contracts, and subject the long-term gross profit to an alternative
minimum tax of 20% for corporate taxpayers or 28% for individual
taxpayers. Therefore, a contractor is currently required to make the
difficult and time-consuming cost-to-cost percentage-of-completion
calculations for every long-term contract in progress at the fiscal
end.
The Taxpayer Relief Act of 1997 provided relief for a number of
small contractors from the alternative minimum tax. The Act allowed C
corporations with three-year average gross receipts of $5,000,000 or
less with tax years beginning after December 31, 1996 to be exempt from
the alternative minimum tax. This law allowed these corporate
contractors to grow their business to a three-year average of
$7,500,000 before they would once again become subject to the
alternative minimum tax. However, S corporations and non-corporate
contractors with the same three-year average of gross receipts continue
to remain subject to the alternative minimum tax.
Due to changes in the tax code following 1986, primarily small
contractors are the only taxpayers subject to the AMT long-term
contract adjustment. Small contractor's contracts typically are
completed within one year, so any deferral is realized within the
following year. The tax effect of any deferral cannot be abusive for
small contractors.
Thank you for this opportunity to submit this statement to the Ways
and Means Subcommittee on Oversight.
Statement of Hon. Christopher S. ``Kit'' Bond, a U.S. Senator from the
State of Missouri
Mr. Chairman and Members of the Subcommittee, I am pleased to
submit this statement regarding the need for tax simplification. As the
Chairman of the Senate Committee on Small Business, I am particularly
concerned about the burden our overly complicated tax code places on
small businesses and the self-employed. Over the past several years, my
Committee has focused considerable attention to this issue, most
recently with a hearing on April 12, 1999, to examine the tax filing
and reporting burdens that small-business owners face nearly every day.
What my Committee learned in that hearing was nothing short of
startling. According to the General Accounting Office, a small-business
owner faces more than 200 IRS forms and schedules that could apply in a
given year. While no business will have to file them all, it is a
daunting universe of forms, including more than 8,000 lines, boxes, and
data requirements, which are accompanied by over 700 pages of
instructions.
Even more surprising was that 76% of small-business owners in 1995
(the most recent data available) hired a tax professional to help them
fulfill their tax obligations. When we consider the complexity of the
forms, rules and regulations, no one should be surprised. And these tax
professionals are far from inexpensive. By some estimates, small-
business owners pay more than 5% of their revenues just to comply with
the tax law--five cents out of every dollar to make sure that all of
the records are kept and the forms completed--all before the tax check
is even written. In light of these burdens, I commend the Subcommittee
for addressing this important issue.
While the list of tax provisions crying out for simplification has
grown considerably in recent years, I shall focus on a particularly
troubling and long-standing area of complexity for America's businesses
and entrepreneurs--the status of independent contractors.
A New Business Paradigm
Throughout this decade, there has been an important shift in the
American workplace, with an increasing emphasis on independent business
relationships. The traditional single-employer career is rapidly being
supplanted by independent entrepreneurs who provide specialized
services on an ``as needed'' basis. They seek out individual contracts,
apply their expertise, and move onto the next opportunity, bound only
to their creativity and stamina. The members of this new workforce are
often described as independent contractors, temps, freelancers, self-
employed, home-based businesses, and even free agents. Whatever their
title, they are a rapidly growing segment of our economy and one that
cannot be ignored.
There are a number of reasons for this new business paradigm.
Recent innovations in computer and communication technology have made
the ``virtual'' office a reality and allow many Americans to compete in
marketplaces that a few years ago required huge investments in
equipment and personnel. In addition, many men and women in this
country have turned to home-based business in an effort to spend more
time with their children. By working at home, these families can
benefit from two incomes, while avoiding the added time and expense of
day-care and commuting. Corporate downsizing, glass ceilings, and
company politics, too, contribute to the growth in this sector as many
skilled individuals convert their knowledge and experience from
corporate life into successful enterprises operated on their own.
The rewards of being an independent entrepreneur are also numerous.
The added flexibility and self-reliance of having your own business
provide not only economic rewards but also personal satisfaction. You
are the boss: you set their own hours, develop your own business plans,
and choose your customers and clients. In many ways, this new paradigm
provides the greatest avenue for the entrepreneurial spirit, which has
long been the driving force behind the success of this country.
With these rewards, however, come a number of obstacles, not the
least of which are burdens imposed by the Federal Government. In fact,
the tax laws, and in particular the Internal Revenue Service (IRS), are
frequently cited as the most significant problems for independent
entrepreneurs today. Changes in tax policy must be considered by this
Congress to recognize this new paradigm and ensure that our laws do not
stall the growth and development of this successful sector of our
economy.
Legislative Advances
In the last two Congresses, we have made substantial headway on a
number of tax issues critical to these independent entrepreneurs. In
the Taxpayer Relief Act of 1997, we restored the home-office deduction
putting home-based entrepreneurs on a level-playing field with
storefront businesses. The Small Business Job Protection Act of 1996
and the Taxpayer Relief Act also made some important strides forward on
the unbelievably complex pension rules so that the freelance writer,
home-based webpage designer, and other small businesses have the
opportunity to plan for their retirement as they see fit. Finally, and
arguably most importantly, through several pieces of legislation in the
last four years, we have finally made the self-employed health-
insurance deduction permanent and placed it on a path to full
deductibility by 2003--still four years too long in my view. These
examples are just a few of the tax law changes that are helping men and
women who chose to work as independent entrepreneurs to enjoy a level-
playing field with their larger competitors and still maintain the
flexibility of their independent business lives.
Classification Burdens
Amid this progress, however, one glaring problem still remains
unsolved for this growing segment of the workplace--there are no
simple, clear and objective rules for determining who is an independent
contractor and who is an employee. As the Chairman of the Senate
Committee on Small Business, I have heard from countless small-business
owners who are caught in the environment of fear and confusion that now
surround the classification of workers. This situation is stifling the
entrepreneurial spirit of many small-business owners who find that they
do not have the flexibility to conduct their businesses in a manner
that makes the best economic sense and that serves their personal and
family goals.
The root of this problem is found in the IRS' test for determining
whether a worker is an independent contractor or an employee. Over the
past three decades, the IRS has relied on a 20-factor test based on the
common law to make this determination. On first blush, a 20-factor test
sounds like a reasonable approach--if our home-based webpage designer
demonstrates a majority of the factors, she is an independent
contractor. Not surprisingly, the IRS' test is not that simple. It is a
complex set of extremely subjective criteria with no clear weight
assigned to any of the factors. As a result, small-business taxpayers
are not able to predict which of the 20 factors will be most important
to a particular IRS agent, and finding a certain number of these
factors in any given case does not guarantee the outcome.
To make matters worse, the IRS' determination inevitably occurs two
or three years after the parties have determined in good faith that
they have an independent-contractor relationship. And the consequences
can be devastating. For example, the business that contracts with a
freelance writer is forced to reclassify the writer from an independent
contractor to an employee and must pay the payroll taxes the IRS says
should have been collected in the prior years. Interest and penalties
are also piled on. The result for many small businesses is a tax bill
that bankrupts the company. But that is not the end of the story. The
IRS then goes after the freelance writer, who is now classified as an
employee, and disallows a portion of her business expenses--again
resulting in additional taxes, interest and penalties.
Mr. Chairman, all of us recognize that the IRS is charged with the
duty of collecting federal revenues and enforcing the tax laws. The
problem in this case is that the IRS is using a procedure that is
patently unfair and subjective and one that forces today's independent
entrepreneurs into the business model of the 1950s. The result is that
businesses must spend thousands of dollars on lawyers and accountants
to try to satisfy the IRS' procedures, but with no certainty that the
conclusions will be respected. That is no way for businesses to operate
in today's rapidly changing economy.
For its part, the IRS has adopted a worker-classification training
manual, which according to then-Commissioner Richardson is an ``attempt
to identify, simplify, and clarify the relevant facts that should be
evaluated in order to accurately determine worker classification. . .
.'' While I applaud the agency's efforts to address this issue, the
manual represents one of the most compelling reason for immediate
action. The IRS' training manual is more than 150 pages in length,
riddled with references to court cases and rulings. If it takes that
many pages to teach revenue agents how to ``simplify and clarify'' this
small-business tax issue, I think we can be sure how simple and clear
it is going to seem to the independent day-care provider who is trying
to figure it out on her own.
Independent Contractor Simplification and Relief Act of 1999
In recognition of the new paradigm and the IRS' archaic 20-factor
test, I introduced in the Senate earlier this year S. 344, the
``Independent Contractor Simplification and Relief Act of 1999.'' I
understand that a companion bill will be introduced in this body
shortly. My bill removes the need for so many pages of instruction on
the IRS' 20-factor test by establishing clear rules for classifying
workers based on objective criteria. Under these criteria, if there is
a written agreement between the parties, and if our freelance writer
demonstrates economic independence and independence with respect to the
workplace, based on objective criteria set forth in the bill, she will
be treated as an independent contractor rather than an employee. And
the service recipient will not be treated as an employer. In addition,
individuals who perform services through their own corporation or
limited-liability company will also qualify as independent contractors
as long as there is a written agreement and the individuals provide for
their own benefits.
The safe harbor is simple, straightforward, and final. To take
advantage of it, payments above $600 per year to an individual service
provider must be reported to the IRS, just as is required under current
law. This will help ensure that taxes properly due to the Treasury will
continue to be collected.
The IRS contends that there are millions of independent contractors
who should be classified as employees, which costs the Federal
Government billions of dollars a year. This assertion is plainly
incorrect. Classification of a worker has no cost to the Government.
What costs the Government are taxpayers who do not pay their taxes. The
Independent Contractor Simplification and Relief Act has three
requirements that will improve compliance among independent contractors
using the new rules we propose. First, there must be a written
agreement between the parties--this will put the home-based webpage
designer on notice at the beginning that she is responsible for her own
tax payments. Second, the new rules will not apply if the service
recipient does not comply with the reporting requirements and issue
1099s to individuals who perform services. Third, an independent
contractor operating through his own corporation or limited-liability
company must file all required income and employment tax returns in
order to be protected under the bill.
In the last Congress, concerns were raised that permitting
individuals who provide their services through their own corporation or
limited-liability company to qualify as independent contractors would
lead to abusive situations at the expense of workers who should be
treated as employees. To prevent this option from being abused, I have
added language that limits the number of former employees that a
service recipient may engage as independent contractors under the
incorporation option. This limit will protect against misuse of the
incorporation option while still allowing individuals to start their
own businesses and have a former employer as one of their initial
clients.
Much has also been made of the improperly classified employee who
is denied benefits by the unscrupulous employer. This issue raises two
important points. First, the legislation that I have introduced would
not facilitate this troubling situation. Under the provisions of our
bill, it is highly doubtful that a typical employee, like a janitor,
would qualify as an independent contractor. In reality, this issue
relates to enforcement, which our bill simply makes easier through
clear and objective rules. Second, the issue of benefits, like health
insurance and pension plans, is extremely important to independent
entrepreneurs. But the answer is not to force them to all be employees.
Rather, we should continue to enact legislation like the Small Business
Job Protection Act, the Taxpayer Relief Act, and the tax provisions of
last fall's omnibus appropriations bill, that permit full and immediate
deductibility of health insurance for the self-employed and better
access to retirement savings plans.
Repeal of Section 1706
A special concern of technical-service providers, such as
engineers, designers, drafters, computer programmers, and systems
analysts is section 1706 of the 1986 Tax Reform Act. In certain cases,
Section 1706 precludes businesses engaging individuals in these
professions from applying the reclassification protections under
section 530 of the Revenue Act of 1978. When section 1706 was enacted,
its proponents argued that technical-service workers were less
compliant in paying their taxes. Later examination of this issue by the
Treasury Department found that technical-service workers are in fact
more likely to pay their taxes than most other types of independent
contractors. This revelation underscores the need to repeal section
1706 and level the playing field for individuals in these professions.
In the last two Congresses, proposals to repeal section 1706
enjoyed wide bipartisan support. The Independent Contractor
Simplification and Relief Act is designed to level the playing field
for individuals in these professions by providing the businesses that
engage them with the same protections that businesses using other types
of independent contractors have enjoyed for more than 20 years.
Relief from Retroactive Reclassification
Another major concern of many businesses and independent
entrepreneurs is the issue of reclassification. My bill provides relief
to these taxpayers when the IRS determines that a worker was
misclassified. Under S. 344, if the business and the independent
contractor have a written agreement, if the applicable reporting
requirements were met, and if there was a reasonable basis for the
parties to believe that the worker is an independent contractor, then
an IRS reclassification will only apply prospectively. This provision
gives important peace of mind to small businesses that act in good
faith by removing the unpredictable threat of retroactive
reclassification and substantial interest and penalties.
Mr. Chairman, the Independent Contractor Simplification and Relief
Act is a common-sense measure that answers the urgent plea from
independent entrepreneurs and the businesses that engage them for
fairness and simplicity in the tax law. As we work toward the day when
the entire tax law is based on these principles, we can make a positive
difference today by enacting this legislation.
Troubling Alternatives
Until recently, those that opposed positive improvements like the
Independent Contractor Simplification and Relief Act have mainly
expressed their objections and preferred to maintain the status quo--an
alternative that few have been eager to embrace.
With the introduction of H.R. 1525 by Congressman Kleczka and
Chairman Houghton, a new alternative has been put on the table. While I
am pleased that we now have broader recognition that worker
classification is a problem in need of a solution, I am troubled by the
regressive nature of this bill. From my reading, H.R. 1525 will
rollback the progress we have made in the last 21 years in recognition
of independent entrepreneurs and their contribution to the
unprecedented growth of our economy. Instead, the Federal Government
would dictate business relationships through the tax code--an
alternative that we cannot afford to embrace.
My concerns about this legislation are three-fold. First, as its
title suggests, the bill is intended to ``clarify'' the independent
contractor rules. Regrettably, it accomplishes that objective by
establishing a presumption that everyone is an employee until proven
otherwise. While seemingly simple, such a presumption would abandon all
hope of neutral worker-classification rules and put independent
entrepreneurs at an even greater disadvantage than they are today.
Second, according to the bill's author, all one need do to rebut
the presumption is satisfy ``a simple, easy to understand 3 point
test.'' Upon taking a closer look, an independent entrepreneur like our
home-based webpage designer is likely to be nonplused. One part of the
test is indeed clear cut--she must make her services available to other
customers. A second requirement is more complicated--she must
demonstrate ``entrepreneurial risk.'' The final requirement is the
antithesis of simplicity--she must demonstrate that her client has no
``control'' over the webpage she designs.
Unfortunately for the independent entrepreneur, the bill does not
define what constitutes ``entrepreneurial risk'' or ``control.'' These
two terms are exactly what the IRS' subjective 20-factor test was
designed to determine. But under H.R. 1525, our webpage designer will
no longer be able to rely on the common-law precedents underlying the
20-factor test. Instead, the Treasury Department and the IRS will once
again be permitted to write all the rules and regulations. With the
events leading up to the Revenue Act of 1978, which established the ban
on Treasury and IRS regulations concerning independent contractors, I
have a good idea how fair and unbiased those rules will be for our
independent entrepreneur.
Third, H.R. 1525 repeals section 530 of the Revenue Act of 1978.
For the last two decades this provision has been the only protection
for businesses that utilize independent contractors. It is by no means
a simple test to meet, but it permits small businesses and the
independent contractors they utilize to rely on established industry
practice as a roadmap for classifying their business relationships. By
removing this protection, the value of which Congress reaffirmed with
the 1996 legislative modifications, the bill will put countless
businesses at the mercy of the IRS. With the extraordinary efforts over
the last two years to improve taxpayer rights and IRS' customer
service, do we really want to magnify the environment of fear
surrounding worker classification, let alone expose even more
businesses to huge tax bills at the whim of the IRS?
One final point on H.R. 1525. Buried under the ostensible
simplicity of the bill's requirements is an enormous hidden cost for
small businesses and independent contractors. These individuals will
have to spend more time and hire even more expensive lawyers and
accountants just to sort out all of the undefined terms of the bill,
not to mention the cost of proving that a particular business
relationship meets the bill's strict requirements for recognition of an
independent-contractor relationship. That time and money will not
produce a single job and will contribute nothing to our economy or
society. It is simply time taken away from the business and money
thrown down the drain.
Conclusion
For too long, independent entrepreneurs and the businesses with
which they work have struggled for a neutral tax environment. For an
equally long time, that tax environment has been unfairly and
unnecessarily biased against them. It is well past time that the tax
code embraces one of the fundamental tenets of our country--the free
market. We must allow individuals the freedom to pursue new
opportunities in the ever-changing marketplace through business
relationships that make the best sense for them. Our tax code should
facilitate those opportunities through fair and simple rules that
permit the freelance writer, home-based webpage designer, and every
other independent entrepreneur to pay their taxes without undue
interference from the Government. Trying to force today's dynamic
workforce into a 1950s model serves no one and only stands to stifle
the entrepreneurial spirit in this country and dampen the continued
success of our economy.
Thank you for the opportunity to present my views on this critical
issue for independent entrepreneurs in this country.
Statement of Hon. Gerald D. Kleczka, a Representative in Congress from
the State of Wisconsin
Mr. Chairman, and members of the Subcommittee, I would like to take
this opportunity to discuss H.R. 1525, the Independent Contractor
Clarification Act of 1999. Working on a bipartisan basis, Chairman
Houghton and I recently introduced H.R. 1525. Ten other members of the
Ways and Means Committee joined us as original cosponsors of this
legislation.
The bipartisan spirit of this legislation cannot be underestimated.
Congress has struggled with this issue since 1978. Unfortunately,
legislation introduced in recent years has tended to favor employers
and only served to polarize the debate on this issue. Congressman
Houghton and I have worked with groups representing both employers and
employees for most of the past year to develop H.R. 1525.
The current 20 point test used to determine an individual's
employment classification and the section 530 safe harbor are
burdensome and unworkable. The 20 point test is a series of tests that
provide employers with a general guideline as to how they are supposed
to classify their workers. However, these tests do not provide
employers with a clear definition of who is an independent contractor
and who is an employee. This lack of clarity has led to countless
workers being misclassified.
For example, one of the criteria used in the 20 point test is the
level of training of the worker. Some have interpreted a level of
training to be a college degree while others would argue it is a
person's general work experience. Another criteria is furnishing
significant tools and assets. For a computer programmer, significant
equipment and assets might be an expensive computer system whereas in
the case of a laborer an employer might deem a significant investment
to be some basic tools.
The lack of clarity in the 20 point test has been compounded by the
fact section 530 of the 1978 tax bill has prohibited the Department of
Treasury from writing regulations to clarify the 20 test. Section 530
was intended to be a temporary, one-year solution to a dispute over the
Department of Treasury's efforts to bring about the proper
classification of workers. A few years later, section 530 was made
permanent.
As a result of the lack of clear direction, many businesses have
misclassified their workers as independent contractors. Such
misclassifications have resulted in workers being denied essential
benefits such as health coverage, a retirement plan, or the employer's
share of FICA taxes. Workers who are actual employees and who work at
the direction of and under the supervision of a superior are entitled
to these benefits as part of their employment.
The Independent Contractor Clarification Act would replace the
current 20 point test with a three point test. An individual would be
classified as an independent contractor if the employer does not
control the manner in which the individual completes his or her
assigned tasks; the individual is able to solicit and undertake other
business opportunities; and the individual encounters entrepreneurial
risk. The last point would include the ability of the independent
contractor to generate a profit or bear the risk of financial loss.
Detractors of the legislation have asserted that the three tests in
H.R. 1525 is too vague and do nothing to clarify the employer-employee
relationship. That is a red herring. In fact, other legislation that
has been introduced on this issue would only add to the confusion by
adding a layer of a new tests on top of the 20 point tests.
For example, S. 344, the Independent Contractor Simplification and
Relief Act of 1999 was recently introduced by Senator Bond. S. 344
establishes a set of criteria to help businesses classify their workers
as independent contractors. One of the criteria is whether a person
``has a significant investment in assets.'' As I previously indicated,
the concept of a significant investment in assets is already one of the
most confusing aspects of the current 20 point test. Another criteria
is whether a person ``operates primarily from equipment not supplied by
the service recipient.'' That can hardly be considered a clear, concise
standard. Finally, S. 344 would not allow the Department of Treasury to
provide any clarification to those new tests.
Instead of prolonging the confusion of current law, H.R. 1525 would
move forward. By allowing the Department of Treasury to issue guidance,
further clarification of the three criteria in H.R. 1525 will be
developed. Congress, the Administration, and interested parties will
have ample opportunity to express their views in this process. Congress
will be able to write lengthy report language to specifically direct
the Department of Treasury as to how the tests are to be interpreted.
The issuance of regulations by the Department of Treasury will follow
the established process of issuing proposed regulations, public
hearings and comment on the proposed regulations, and final
regulations.
I would also like to point out that any person who has a statutory
exemption would maintain that exemption under H.R. 1525. For example,
current law says that real estate agents and direct sellers such as
newspaper delivery persons are independent contractors, and they would
maintain that status under the Independent Contractor Clarification
Act.
Finally, H.R. 1525 would give many businesses something they do not
have under current law--protection from retroactive taxes. The single
largest hurdle to employers reclassifying their workers as employees is
the fear the IRS is going to take the reclassification as an admission
of wrongdoing and, as a result, assess retroactive employment taxes.
Under this legislation, the IRS would be prohibited from collecting
back taxes if an employer meets certain criteria.
The effective date of this legislation is January 1, 2001. This is
designed to give businesses a reasonable amount of time to implement
the changes in the independent contractor statutes. Furthermore, any
business that is told to reclassify its workers would have 60 days
after final notification from the IRS to implement the change.
H.R. 1525 is a bipartisan solution to a difficult and longstanding
problem. The Independent Contractor Clarification Act attempts to
balance the interests of employers and their workers. If enacted, this
legislation will provide employers the guidance they need to properly
classify their workers. It will also serve the interests of hard-
working Americans and their families.
Statement of National Association of Home Builders
On behalf of the 197,000 member firms of the National Association
of Home Builders (NAHB), we would like to express our support for
Congressman Amo Houghton convening a hearing on the impact of
complexity in the tax code on individuals and small businesses. This
issue is important to all taxpaying Americans who desire to comply with
the tax code's thousands of confusing rules and regulations while at
the same time operating a business or running a household. This hearing
is both very timely and necessary and NAHB applauds the Chairman on his
efforts.
Cash Method of Accounting
NAHB would like to also support a key provision in the ``Tax
Simplification and Burden Reduction Act'' that is sponsored by
Subcommittee Chairman Amo Houghton. This provision would increase the
gross receipt threshold for the cash method of accounting from $5
million to $10 million. Not only does Representative Houghton believe
that the tax code is forcing far too many small businesses to use the
accrual method instead of the cash method but builders and small
contractors experience this costly and burdensome change annually.
Home builder subcontractors who supply both service and materials
have traditionally used a cash method for tax accounting. The Internal
Revenue Service (IRS) has a long history of enabling small contractors
to use the cash method of computing taxes; however, the IRS has now
begun to enforce a tax court ruling that requires these firms to use an
accrual method of tax accounting. The result has been that some small
firms must pay taxes on income not yet realized or are not allowed to
deduct expenses actually paid. Some of the builders and small
contractors do not have the cash available to pay taxes on funds that
have not been received and these small firms are sometimes forced to
close because of the tax change. The IRS code does allow service
businesses with gross receipts of under $5 million per year to use the
cash method of tax accounting and NAHB would like to extend this
exception to builders and small contractors.
Although NAHB supports the efforts of Congressman Houghton, we
believe it does not go far enough to allow builders and small
contractors as defined by IRS code section 460 to be included within
the scope of service businesses as defined by IRS code section 448 and
we would recommend that the legislation be modified to include this
equitable and necessary change.
Protect and Preserve the Low Income Housing Tax Credit Program
Another issue that has recently become a major problem for NAHB is
the unnecessary and harmful recapture of low income housing tax credits
by the IRS. As many of you know, the low income housing tax credit
program in Internal Revenue Code Section 42 provides a limited amount
of tax credits to each state which in turn is sold to investors in the
open market and the proceeds of which is used to finance the building
and maintenance of low income affordable housing. In order to be
awarded the tax credits, developers of affordable housing must endure a
very costly underwriting process at three different times. Once the
state issues the final amount of tax credits (in the form of an 8609
determination), the developer then sells those credits to investors at
a discount to raise the equity necessary to build the project.
Unfortunately, the IRS in the last couple of years has begun auditing
these affordable housing projects and recalculating the amount of
credit and in some cases recapturing a significant amount of those tax
credits. This is causing the financing arrangements for some existing
low income housing projects to unravel and raising concern in the
industry about the financial security of all projects that have been
built in the last 10 to 12 years. This approach by the IRS is somewhat
akin to a bank recalculating a mortgage to determine whether you meet
the right ratios to qualify for a loan after you have bought the house,
have moved in and are paying monthly on the debt. This violates notions
of fundamental fairness.
The recapture risk by the industry to date has been perceived to be
a risk of non-compliance with the Section 42 rules on occupancy
eligibility for the most part. Many investors have a staff of
compliance monitors as well as contractual reporting requirements for
their LIHTC investments in order to compensate for and reduce this type
of recapture risk. Many developer/builders, whether for-profit or non-
profit, also have increased their on-site and off-site staff that
monitor leasing procedures to assure compliance with the complex rules.
Syndicators and investors have led the way, in cooperation with state
agencies, in promoting additional training and credentialed standards
of competency for LIHTC professionals and also in efforts to reduce the
risk of recapture from program non-compliance, this we applaud and
support.
Developers, syndicators, bond counsel, underwriters' counsel, and
investors implicitly have relied on the state agency determination and
allocation of the credit amount (the 8609). The industry from lenders
to investors, and agencies to developers, has operated on the basis
that they could rely on the amount of the credit on the 8609, unless
there was non-compliance with program requirements. This new risk from
recalculation of a projects eligibility for credits and that the amount
of the eligible basis could be reduced and tax credits recaptured was
not anticipated. This risk for an existing project can apply back three
years from the date of the audit and forward to the end of the 10 year
credit period. The states' final determination (the 8609) has been the
definitive statement of allocated amount for buyers and sellers of
credits. When the IRS is now coming in to redetermine the amount, it
undermines the state agency's obligations imposed by Congress.
In its 1989 amendments to the housing credit program, Congress
imposed on State agencies the burden of determining the appropriate
amount of credit. Congress did not choose the federal pre-approval
method (e.g. HUD administration), nor did they rely on the market alone
and professional opinions (e.g. tax-exempt bonds) to assure that the
developer and investors take the appropriate amount of credit. In our
view, for this housing program there should not be, nor previously was
there perceived to be, an obligation or ``threat'' of recalculation of
the agency's credit allocation. Part of the ``magic'' of the LIHTC
program is that each State determines what kind of projects and how
much federal investment to make in that project. When the IRS
recalculates basis and recaptures tax credits it is second-guessing the
state agency. This over regulation is burdensome and will have a severe
negative impact on the program.
As with so many tax law issues, the IRS could probably recalculate
eligible basis for every project and come up with a different amount
than the state agency. This should not be surprising given the
complexities of tax law and, the plethora of potentially applicable tax
cases, combined with the enormous amount of detail and number of
documents that are amassed for any development project. In this
program, Congress put the calculation burden on the state agency and
the developers of the projects are already incurring the cost of that
obligation in the form of fees to the states. This does not need to be
duplicated.
After the burdensome audit process is concluded, it does not result
in any increased benefit for the LIHTC program. Recaptured credits do
not increase funds for affordable LIHTC housing. A recapture by the IRS
does not return the funds to the states for reallocation and no
increased affordable housing results from a recapture. Audits and
threats of audits and recaptures will reduce the amount of housing
benefit from the already very limited amount of credit available to the
states each year.
Most states do not have enough funds to satisfy the outstanding
need for affordable housing in their area and the method the IRS is
taking regarding the audit process will further impede the flow of
capital to this program. The magic of the LIHTC program is that it
leverages private money to produce affordable housing that reaches a
policy goal set by Congress. Private capital and capital markets,
however, are very sensitive to risks and potential risks. Thus, whether
IRS audits of credit projects are done frequently or infrequently is
irrelevant. When the possible result is the recapture of credits, the
capital markets and potential investors may flee the market based on
the perception of the extent of the risk.
In addition to a slow down or break in capital flows to LIHTC
projects, the prices paid for credits may decline to compensate for the
increased risk of recapture and loss of credit to the investor. When
the discount paid by investors increases and the price for credits
declines, there will be fewer housing units or lesser quality units
built for the same revenue offset to the Treasury.
The affordable housing industry would like to continue to make the
LIHTC program the best and longest lasting affordable housing program
in existence but we need certainty and finality for housing credit
allocations. The objective is to protect and preserve the public-
private partnership that produces section 42 affordable housing for our
communities. The congressional objective is also being achieved which
is to provide low income individuals with an affordable place to live
and ultimately the public benefits through better neighborhoods and
communities.
After discussing this issue with the IRS, it is clear that the only
method to provide certainty regarding the allocations provided by the
states is to address the problem legislatively. As a result, NAHB would
like to work with Congress to develop a legislative proposal that would
protect and preserve the public-private partnership that produces
section 42 affordable housing.
NAHB has developed a legislative proposal that is intended to
eliminate disputes over what is in, or out, of eligible basis for
purposes of calculating the credit allocation for an 8609. The
objectives of the proposals are to: (1) assure certainty for
determining eligible basis and hence credit allocations, (2) protect
existing credit allocations and (3) provide finality in credit
allocations. The concept behind the legislative language is that a
credit allocation is really an equity gap calculation to determine how
many credits are necessary for the financial viability of the project.
The gap calculation needs to be as formulaic as possible, in order to
assure the certainty of the allocation. Allocations should not be at
risk of recapture and lost to the affordable housing stock due to
disputes over what is or is not in eligible basis.
The legislative language will also preserve the existing credit
allocations by preventing the retroactive recalculation of eligible
basis on outstanding allocations. Additionally, the legislation will
help provide finality for future tax credit allocations because
predictability, finality and certainty is what the low income housing
development and investment community needs to continue the effective
public-private partnerships that has built so many affordable housing
projects under Section 42.
NAHB would like Congress to prevent these retroactive recaptures
and allow for certainty and finality in credit allocations by the
states. Credit allocations need to have finality in order to assure a
vibrant, competitive market where investors and developers can rely on
an allocation once it is received. Legislative reform in this area is
necessary to preserve the LIHTC program and continue to ensure that
this program will supply America's affordable housing needs.
Independent Contractor Issue
An additional issue that must be addressed is our opposition to
Congressman Kleczka and Houghton's bill, H.R. 1525, the ``Independent
Contractor Clarification Act.'' NAHB is opposed to this bill for
various reasons. First, this bill will turn back the clock 20 years and
undermine the current law regarding whether an individual is an
independent contractor or an employee. This bill begins with the
statutory presumption that an individual is an employee unless the
parties can prove otherwise. Current law is neutral and does not, in
theory, present a preference either way although, in practice, there is
a bias against independent contractors. By creating a statutory
preference towards employees, Congress would ignore a national policy
that placed the utmost importance and value on independent contractors
and the small businesses that utilize their services.
Secondly, the bill provides a three-prong test to determine
employment status that does not simplify the test but only complicates
it further. The test consists of three elements: the service recipient
must lack control, make their services available to others and have
entrepreneurial risk. Neither ``control'' nor ``entrepreneurial risk''
is defined in the bill. Although the bill repeals the common law test,
the new test would be even more subjective than current law, and would
create even greater uncertainty and confusion because the new test
lacks clear definition and guidance.
Thirdly, the bill repeals Section 530, a safe harbor provision that
allows small businesses and the independent contractors they may engage
to rely on ``long standing industry practice'' as a guide to the
appropriate classification of individuals. H.R. 1525 repeals Section
530 and replaces it with a narrower safe harbor, reliance on
substantial authority. There have been few favorable IRS rulings over
the years that might constitute substantial authority. What makes this
repeal so damaging is that it will return us to an era when the IRS had
the tools, the authority and power to stifle the entrepreneurial spirit
or independent contractors and small businesses and was subject to the
mercy of the enforcers.
What NAHB and other small businesses are looking for is clarity and
surety regarding the classification of the service provider and
protection against retroactive reclassification. A bill S. 344, the
``Independent Contractor Simplification and Relief Act of 1999''
sponsored by Senator Kit Bond does achieve that goal. Please consider
other avenues to address worker classification because H.R. 1525 is not
the answer.
NAHB appreciates your attention to issues of concern to our members
and look forward to changes in the tax code that include some of the
priorities mentioned in this testimony.
National Conference of CPA Practitioners
Lake Success, NY,
June 7, 1999
A.L. Singleton, Chief of Staff
House Ways and Means
U.S. House of Representatives
1102 Longworth House Office Building
Washington, D.C. 20515
Dear Mr. Singleton:
I am writing in response to your advisory concerning the hearing on
the impact of complexity in the tax code.
The National Conference of CPA Practitioners has been in existence
since 1979. The organization is comprised solely of CPA firms in public
practice. The majority of our members represent small to mid-sized
businesses and individual taxpayers. As such, we are in a position to
understand the problems that taxpayers have with the complexities of
the tax code.
Alternative Minimum Tax
The AMT is perhaps the most difficult item for taxpayers to
understand. The perception is that AMT was instituted to thwart the
efforts of rich taxpayers to pay little or no tax. Even tax
professionals have trouble planning for this onerous tax. It is nearly
impossible to prepare a tax projection for a client with a reasonable
degree of accuracy.
Many AMT items are passed through on K-1 Forms from partnerships
and S corporations. In most cases it is not possible to know what the
effect will be until the K-1 is received. Taxpayers can not react on a
timely basis.
Code Section 469 was enacted in 1986 to limit the ability of
taxpayers to use passive losses to offset other income. There are many
other areas of the code that place limitations on deductions. Some
examples are medical expense, investment interest expense, gambling
losses, the 2% floor for miscellaneous deductions and the 3% overall
limit on itemized deductions. It seems that these limitations are
already complex and onerous. The AMT further complicates the ability of
taxpayers to understand what their actual effective deductions will be.
The rules for employee business expenses, coupled with the AMT,
create complexity and discriminatory treatment of some taxpayers. The
employee business expenses are reported on Form 2106 and passed through
to Schedule A. They are not deductible for AMT purposes, even though
there is a valid business purpose for the deduction. Taxpayers that
qualify as statutory employees can deduct their expenses on Schedule C
without any effect for AMT purposes. Most individuals and many
businesses don't understand the statutory employee criteria. Our
committee is aware of cases in which the employee qualified as a
statutory employee and the employer refused to check the proper box on
the W-2 Form. One case involved a large employer. We contacted the home
office in Chicago and were informed that the legal department mandates
a position whereby nobody is a statutory employee. During a mail in
audit, IRS determined that the facts and circumstances indicate that
the taxpayer does qualify. If a large employer can't deal with these
rules, there is no hope of smaller entities reporting properly. As
well, the employee is placed at a tax disadvantage merely because of
his status as an employee. This is an unfair tax policy and should be
rectified.
I recently had to prepare a projection for a client who had
eligible Section 1202 transactions. This provision was enacted to
encourage investment in small businesses. The effective tax rate on
Section 1202 transactions is nominally 14% (50% of the gain taxed at
28%). Because 21% of the gain is added back for AMT, most taxpayers
will not pay the 14% rate. The effective rate including the AMT is
19.88%, which was enacted to keep the rate no more than the ordinary
20% capital gain rate. My projection software does not handle the AMT
on Section 1202 transactions automatically and the analysis required to
make the proper adjustments is onerous. Accordingly, my initial
estimate of how much money to set aside for the income tax on his sale
was understated. In fact, the AMT for this taxpayer was approximately
$130,000. For practical purposes, the people who make these investments
would need to sell their holdings over many years if they wish to avoid
the AMT. As well, the 21% AMT adjustment will expose other income to
AMT that ordinarily would not be. This make the effective rate on the
Section 1202 transaction 28%, which is not consistent with the
intentions of the statute.
I presented the Section 1202 topic as part of a tax update seminar.
Over 500 of our members attended the seminar and most of them did not
understand the nuances of the AMT on Section 1202 transactions. If one
presumes that the CPAs attending seminars are well versed in taxation,
there is little hope of unlicensed tax practitioners being able to work
with these rules. One would doubt that any lay person could understand
them.
Independent Contractor Rules
This issue has been on our legislative agenda for years. The
difficulty of working with the 20 common law tests is well documented.
The Microsoft case should be a clear indication that ordinary taxpayers
can not work with the existing rules. The potential ramifications of a
worker classification error are Draconian. If Congress is unable to
devise a logical approach, taxpayers should be given liberal relief in
correcting errors. We understand the need for IRS to capture the taxes
that many independent contractors do not report. In our experience, the
honest taxpayer that made a good faith attempt to comply is most likely
to be hurt. The true non-compliant taxpayer is likely to be out of the
tax system completely.
We have reviewed several previous bills that were intended to
modify the independent contractor rules. Every bill attempts to place
statutory definitions on the concepts of (a) control, (b) profit
motive, and (c) availability to other entities. While these concepts
may be easier to comply with than the common law tests, they still
leave significant room for interpretation. Taxpayers need clear and
concise criteria that can be assessed without the assistance of a tax
lawyer. It is likely that, as taxpayers find ways to bend new rules,
additional legislation will be required to close the loopholes. Before
long, the new rules will be as complex and burdensome as the old ones.
Congress has always been concerned that employers will coerce
employees to elect independent contractor status. This is a concern has
merit, but the tax code can not solve every social problem. At this
time an employer may pass IRS scrutiny and lose an audit with the
Federal or State Department of Labor. We believe that independent
contractor status should require a written agreement between the
service provider and the service recipient. Perhaps a model agreement
could be developed by statute. If the statutory language were adopted,
there would be a presumption that the arrangement is valid. The IRS
should only have the ability to interfere if undue influence can be
proven.
We are concerned about conflicts between Federal and State laws. We
believe that most states mandate workers compensation coverage for sub-
contractors that don't have their own coverage. Any new Federal
legislation should address this area. It should be mandated that the
service recipient is not required to cover the service provider for
workers compensation if the provider is an independent contractor for
Federal purposes.
Phase Out Tables
Since 1986 Congress has become enamored with phase out tables. An
example of this concept is the phase out of passive losses for rental
real estate losses for income ranges from $100,000 to $150,000. We now
have phase out tables for IRA contributions, Roth IRAs, education
savings bonds, education IRAs, education credits, itemized deductions,
personal deductions, student loan interest, etc., etc. At our seminars
the standing joke is that you need a table to keep track of the tables.
Practitioners who work with the tax code continuously can't remember
all of these tables. When a practitioner attempts to explain these to a
client they usually just give up. The fact is taxpayers just can't deal
with it. Clients may call with a simple question, such as ``should I
fund my IRS as early as possible?'' The practitioner now responds that
it depends on the gross income because of the phase out ranges.
Taxpayers can't plan under this scenario. Some of the decisions must be
made prior to December 31, however they can't determine whether they
qualify until the year is over. Taxpayers that receive K-1 Forms might
not know their AGI until October 15 of the following year because of
extensions. This is unfair and unmanageable.
The reason for phase out ranges in the law is understandable, but
the rules need to be codified. We believe that Congress should develop
a set of phase out ranges that will apply to each filing status
(single, married joint, etc.). These tables should be used for every
area of the code that requires a phase out. In many cases it would make
sense to use the prior year adjusted gross income to make the
calculation. An example is the conversion of an IRA to a Roth IRA.
Conversions are only allowed if AGI is less than $100,000, but the
conversion must be made by December 31. While the law does provide a
remedy to correct invalid conversions, the complexity involved to
correct the conversion creates an additional burden on taxpayers.
Taxpayers are losing confidence in our tax system because they can't
understand the rules.
I wish to thank you for the opportunity to submit our comments. Our
committee welcomes any future opportunity to be involved in the process
of seeking a more fair and equitable tax code. We applaud your efforts.
Respectfully submitted,
Steven Greenberg, CPA
Chair, Tax Policy Committee
Statement of LaBrenda Garrett-Nelson and Robert J. Leonard; on behalf
of Washington Counsel, P.C., Attorneys-at-Law
Washington Counsel, P.C. is a law firm based in the District of
Columbia that represents a variety of clients on tax legislative and
policy issues.
Introduction
As Chairman Houghton stated in his announcement of today's hearing,
``simplification of the most complex provisions of the code may help to
reduce significantly the burden on individual taxpayers and small
businesses.'' In this regard, the provisions that make up the U.S.
international tax regime certainly rank among the most complex
provisions in the Code. This statement sets forth a proposal to reduce
complexity in this area by repealing the little used regime for export
trade corporations (``ETCs''), enacted in 1962 to provide a special
export incentive in the form of deferral of U.S. tax on export trade
income. The rationale for the proposed repeal is that the special
regime for ETCs was, effectively, repealed by the 1986 enactment of the
passive foreign investment company (``PFIC'') rules. At the same time,
the proposal would provide appropriate (and prospective) transition
relief for ETCs that were caught in a bind created by enactment of the
PFIC regime.
I. The Overlap Between the ETC Regime and the PFIC Rules Effectively
Nullified the ETC Rules For Many Corporations
Although the PFIC rules were originally targeted at foreign mutual
funds, the Congress has recognized that the scope of the PFIC statute
was too broad. Thus, for example, the Taxpayer Relief Act of 1997
eliminated the overlap between the PFIC rules and the subpart F regime
for controlled foreign corporations. Similarly, in the 1996 Small
Business Jobs Protection Act, the Congress enacted a technical
correction to clarify that an ETC is excluded from the definition of a
PFIC.
The 1996 technical correction came too late, however, for ETCs that
took the reasonable step of making ``protective'' distributions during
the ten-year period between the creation of the uncertainty caused by
enactment of the PFIC regime and the passage of the 1996 technical
correction. Although U.S. tax on distributed earnings would have been
deferred but for the ETC/PFIC overlap, these ETCs were, effectively,
required to make distributions to protect against the accumulation of
large potential tax liabilities under the PFIC rules. Thus, the PFIC
rules, in effect, repealed the ETC regime.
II. Congressional Precedents for Providing Transition Relief for ETCs
The proposal would simplify the foreign provisions of the tax code
by repealing the ETC regime. When the Congress enacted the Domestic
International Sales Company (``DISC'') rules in 1971, and again when
those rules were replaced with the Foreign Sales Corporation (``FSC'')
rules in 1984, existing ETCs were authorized to remain in operation.
Moreover, ETCs that chose to terminate pursuant to the 1984 enactment
of the FSC regime were permitted to repatriate their undistributed
export trade income as nontaxable PTI.
The Proposal also provides a mechanism for providing prospective
relief to ETCs that were caught in the bind created by the PFIC rules.
Consistent with the transition rule made available in the 1984 FSC
legislation, the proposal would grant prospective relief to ETCs that
made protective distributions after the 1986 enactment of the PFIC
rules. Essentially, future (actual or deemed) distributions would be
treated as derived from PTI, to the extent that pre-enactment
distributions of export trade income were included in a U.S.
shareholder's gross income as a dividend. Note that the proposed
transition relief would provide only ``rough justice,'' because taxes
have already been paid but the proposed relief will occur over time.
Conclusion
Repeal of the ETC provisions would greatly simplify the
international tax provisions of the Code, but such a repeal should be
accompanied by relief for ETCs that were caught in the bind created by
the PFIC rules.