[JPRT 105-4-98]
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[JOINT COMMITTEE PRINT]
DESCRIPTION OF REVENUE PROVISIONS
CONTAINED IN THE PRESIDENT'S
FISCAL YEAR 1999 BUDGET PROPOSAL
__________
Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
[GRAPHIC] [TIFF OMITTED] CONGRESS.#13
FEBRUARY 24, 1998
__________
U.S. GOVERNMENT PRINTING OFFICE
46-548 WASHINGTON : 1998 JCS-4-98
JOINT COMMITTEE ON TAXATION
105th Congress, 2nd Session
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SENATE HOUSE
WILLIAM V. ROTH, Jr., Delaware, BILL ARCHER, Texas,
Chairman Vice Chairman
JOHN H. CHAFEE, Rhode Island PHILIP M. CRANE, Illinois
CHARLES GRASSLEY, Iowa WILLIAM M. THOMAS, California
DANIEL PARTICK MOYNIHAN, New York CHARLES B. RANGEL, New York
MAX BAUCUS, Montana FORTNEY PETE STARK, California
Lindy L. Paull, Chief of Staff
Mary M. Schmitt, Deputy Chief of Staff (Law)
Bernard A. Schmitt, Deputy Chief of Staff (Revenue Analysis)
C O N T E N T S
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Page
Introduction..................................................... 1
I. Provisions Reducing Revenues......................................2
A. Child Care Provisions................................. 2
1. Expand the dependent care tax credit.............. 2
2. Employer tax credit for expenses of supporting
employee child care.............................. 7
B. Energy and Environmental Tax Provisions............... 9
1. Tax credits....................................... 9
a. Tax credit for energy-efficient building
equipment.................................... 9
b. Tax credit for purchase of new energy-
efficient homes.............................. 11
c. Tax credit for high-fuel-economy vehicles..... 11
d. Tax credit for combined heat and power
(``CHP'') systems............................ 12
e. Tax credit for replacement of certain circuit
breaker equipment............................ 14
f. Tax credit for certain perfluorocompound
(``PFC'') and hydrofluorocarbon (``HFC'')
recycling equipment.......................... 14
g. Tax credit for rooftop solar equipment........ 15
h. Extend wind and biomass tax credit............ 16
2. Other provisions.................................. 22
a. Tax treatment of parking and transit benefits. 22
b. Permanent extension of expensing of
environmental remediation costs
(``brownfields'')............................ 23
C. Retirement Savings Provisions......................... 26
1. Access to payroll deduction for retirement
savings.......................................... 26
2. Small business tax credit for retirement plan
start-up expenses................................ 28
3. Simplified pension plan for small business
(``SMART'')...................................... 29
4. Faster vesting for employer matching
contributions.................................... 33
5. Pension ``right to know'' provisions............. 34
6. Simplified method for improving benefits of
nonhighly compensated employees under the safe
harbor for 401(k) plans.......................... 36
7. Simplify definition of highly compensated
employee......................................... 38
8. Simplify benefit limits for multiemployer plans
under section 415................................ 39
9. Simplify full funding limit for multiemployer
plans............................................ 40
10. Eliminate partial termination rules for
multiemployer plans.............................. 42
D. Education Tax Provisions.............................. 43
1. Tax credits for holders of qualified school
modernization bonds and qualified zone academy
bonds............................................ 43
2. Exclusion for employer-provided educational
assistance....................................... 48
3. Eliminate tax on forgiveness of direct student
loans subject to income contingent repayment..... 50
E. Extend Certain Expiring Tax Provisions................ 54
1. Extend the work opportunity tax credit............ 54
2. Extend the welfare-to-work tax credit............. 57
3. Extend the research tax credit.................... 58
4. Extend the deduction provided for contributions of
appreciated stock to private foundations......... 68
F. Miscellaneous Tax Provisions.......................... 71
1. Increase low-income housing tax credit per capita
cap.............................................. 71
2. Extend and modify Puerto Rico tax credit.......... 76
3. Specialized small business investment companies... 80
4. Accelerate and expand incentives available to two
new empowerment zones............................ 82
5. Exempt first $2,000 of severance pay from income
tax.............................................. 88
G. Simplification Provisions............................. 90
1. Optional Self-Employment Contributions Act
(``SECA'') computations.......................... 90
2. Statutory hedging and other rules to ensure
business property is treated as ordinary property 91
3. Clarify rules relating to certain disclaimers..... 96
4. Simplify the foreign tax credit limitation for
dividends from ``10/50'' companies............... 97
5. Interest treatment for dividends paid by certain
regulated investment companies to foreign persons 99
H. Taxpayers' Rights Provisions.......................... 101
1. Suspend collection by levy during refund suit.... 101
2. Suspend collection by levy while offer-in-
compromise is pending............................ 103
3. Suspend collection to permit resolution of
disputes as to liability......................... 104
4. Require district counsel approval of certain
third-party collection activities................ 105
5. Require additional approval of levies on certain
assets........................................... 106
6. Require district counsel review of jeopardy and
termination assessments and jeopardy levies...... 107
7. Require management approval of sales of
perishable goods................................. 107
8. Codify certain fair debt collection practices.... 108
9. Payment of taxes................................. 109
10. Procedures relating to extensions of statute of
limitations by agreement......................... 110
11. Offers-in-compromise............................. 110
12. Ensure availability of installment agreements.... 111
13. Increase superpriority dollar limits............. 112
14. Permit personal delivery of section 6672(b)
notices.......................................... 113
15. Allow taxpayers to quash all third-party
summonses........................................ 114
16. Disclosure of criteria for examination selection. 115
17. Threat of audit prohibited to coerce tip
reporting alternative commitment agreements...... 116
18. Permit service of summonses by mail.............. 117
19. Civil damages for violation of certain bankruptcy
procedures....................................... 117
20. Increase in size of cases permitted on ``small
case'' calendar in the Tax Court................. 118
21. Suspension of statute of limitations on filing
refund claims during periods of disability....... 119
22. Notice of deficiency to specify deadlines for
filing Tax Court petition........................ 120
23. Allow actions for refund with respect to certain
estates which have elected the installment method
of payment....................................... 120
24. Expansion of authority to award costs and certain
fees............................................. 122
25. Expansion of authority to issue taxpayer
assistance orders................................ 123
26. Provide new remedy for third parties who claim
that the IRS has filed an erroneous lien......... 124
27. Allow civil damages for unauthorized collection
actions by persons other than the taxpayer....... 125
28. Suspend collection in certain joint liability
cases............................................ 126
29. Explanation of joint and several liability....... 127
30. Innocent spouse relief........................... 128
31. Elimination of interest differential on
overlapping periods of interest on income tax
overpayments and underpayments................... 130
32. Archive of records of the IRS.................... 131
33. Clarification of authority of Secretary relating
to the making of elections....................... 134
34. Grant IRS broad authority to enter into
cooperative agreements with State tax authorities 134
35. Low-income taxpayer clinics...................... 135
36. Disclosure of field service advice............... 136
II. Provisions Increasing Revenues..................................138
A. Accounting Provisions................................. 138
1. Repeal lower of cost or market inventory
accounting method................................ 138
2. Repeal non-accrual experience method of accounting 140
3. Make certain trade receivables ineligible for
mark-to-market treatment......................... 141
B. Financial Products and Institutions................... 143
1. Defer deduction for interest and original issue
discount on convertible debt..................... 143
2. Disallowance of interest on indebtedness allocable
to tax-exempt obligations of all financial
intermediaries................................... 146
C. Corporate Tax Provisions.............................. 150
1. Eliminate dividends-received deduction for certain
preferred stock.................................. 150
2. Repeal tax-free conversion of larger C
corporations to S corporations................... 152
3. Restrict special net operating loss carryback
rules for specified liability losses............. 155
4. Clarify definition of ``subject to'' liabilities
under section 357(c)............................. 157
D. Insurance Provisions.................................. 160
1. Increase proration percentage for property and
casualty insurance companies..................... 160
2. Capitalization of net premiums for credit life
insurance contracts.............................. 162
3. Modify company-owned life insurance (COLI)
limitations...................................... 165
4. Modify reserve rules for annuity contracts........ 168
5. Tax certain exchanges of insurance contracts and
reallocations of assets within variable insurance
contracts........................................ 170
6. Computation of ``investment in the contract'' for
mortality and expense charges on certain
insurance contracts.............................. 174
E. Estate and Gift Tax Provisions........................ 176
1. Eliminate non-business valuation discounts........ 176
2. Gifts of ``present interests'' in a trust (repeal
``Crummey'' case rule)........................... 180
3. Eliminate gift tax exemption for personal
residence trusts................................. 182
4. Include qualified terminable interest property
(``QTIP'') trust assets in surviving spouse's
estate........................................... 184
F. Foreign Tax Provisions................................ 186
1. Replace sales source rules with activity-based
rule............................................. 186
2. Modify rules relating to foreign oil and gas
extraction income................................ 187
3. Apply ``80/20'' company rules on a group-wide
basis............................................ 190
4. Prescribe regulations regarding foreign built-in
losses........................................... 192
5. Prescribe regulations regarding use of hybrids.... 193
6. Modify foreign office material participation
exception applicable to certain inventory sales.. 197
7. Modify controlled foreign corporation exemption
from U.S. tax on transportation income........... 199
G. Administrative Provisions............................. 201
1. Increase information reporting penalties.......... 201
2. Modify the substantial understatement penalty for
large corporations............................... 203
3. Repeal exemption for withholding on gambling
winnings from bingo and keno in excess of $5,000. 204
4. Modify the deposit requirement for Federal
unemployment (FUTA) taxes........................ 204
5. Clarify and expand mathematical error procedures.. 205
H. Real Estate Investment Trust Provisions............... 207
1. Freeze grandfathered status of stapled or paired-
share REITs...................................... 207
2. Restrict impermissible business indirectly
conducted by REITs............................... 211
3. Modify treatment of closely held REITs............ 212
I. Earned Income Tax Compliance Provisions............... 215
1. Simplification of foster child definition under
the earned income credit......................... 215
2. Clarify the operation of the earned income credit
where more than one taxpayer satisfies the
requirements with respect to the same child...... 216
J. Other Revenue-Increase Provisions..................... 218
1. Repeal percentage depletion for non-fuel minerals
mined on Federal and formerly Federal lands...... 218
2. Modify depreciation method for tax-exempt use
property......................................... 219
3. Impose excise tax on purchase of structured
settlements...................................... 221
4. Reinstate Oil Spill Liability Trust Fund excise
tax.............................................. 223
III.Other Measures Affecting Receipts...............................225
A. Reinstate Superfund Excise Taxes and Corporate
Environmental Income Tax............................. 225
B. Extend Excise Taxes on Gasoline, Diesel Fuel, and
Special Motor Fuels.................................. 226
C. Convert Airport and Airway Trust Fund Excise Taxes to
Cost-Based User Fees to Pay for Federal Aviation
Administration Services.............................. 230
D. Tobacco Legislation................................... 235
E. Other Provisions Affecting Receipts................... 236
1. Expand use of Federal highway monies to include
use for certain ``creative financing'' projects
and for State infrastructure bank programs....... 236
2. Allow Federal housing funds to be used to leverage
tax-exempt bond financed low-income housing
credit projects.................................. 237
3. Employer buy-in (COBRA continuation coverage) for
certain retirees................................. 237
4. Consumer bill of rights and responsibilities...... 238
INTRODUCTION
This pamphlet,1 prepared by the staff of the
Joint Committee on Taxation, provides a description and
analysis of the revenue provisions contained in the President's
Fiscal Year 1999 Budget proposal, as submitted to the Congress
on February 2, 1999. 2 For the revenue provisions,
there is a description of present law and the proposal
(including effective date), a reference to any recent prior
legislative action or budget proposal submission, and some
analysis of related issues. The staff budget estimates of the
President's revenue proposals for fiscal years 1998-2008 will
be a separate document.
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\1\ This pamphlet may be cited as follows: Joint Committee on
Taxation, Description of Revenue Provisions Contained in the
President's Fiscal Year 1999 Budget Proposal (JCS-4-98), February 24,
1998.
\2\ See Department of the Treasury, General Explanations of the
Administration's Revenue Proposals, February 1998. Office of Management
and Budget, Budget of the United States Government, Fiscal Year 1999:
Analytical Perspectives (H. Doc. 105-177, Vol III), pp. 41-77.
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This pamphlet does not include a description of certain
proposed user fees (other than those associated with the
financing of the Airport and Airway Trust Fund) contained in
the President's Fiscal Year 1999 Budget.
I. PROVISIONS REDUCING REVENUES
A. Child Care Provisions
1. Expand the dependent care tax credit
Present Law
In general
A taxpayer who maintains a household which includes one or
more qualifying individuals may claim a nonrefundable credit
against income tax liability for up to 30 percent of a limited
amount of employment-related dependent care expenses (sec. 21).
Eligible employment-related expenses are limited to $2,400 if
there is one qualifying individual or $4,800 if there are two
or more qualifying individuals. Generally, a qualifying
individual is a dependent under the age of 13 or a physically
or mentally incapacitated dependent or spouse. No credit is
allowed for any qualifying individual unless a valid taxpayer
identification number (TIN) has been provided for that
individual. A taxpayer is treated as maintaining a household
for a period if the taxpayer (or the taxpayer's spouse, if
married) provides more than one-half the cost of maintaining
the household for that period.
Employment-related dependent care expenses are expenses for
the care of a qualifying individual incurred to enable the
taxpayer to be gainfully employed, other than expenses incurred
for an overnight camp. For example, amounts paid for the
services of a housekeeper generally qualify if such services
are performed at least partly for the benefit of a qualifying
individual; amounts paid for a chauffeur or gardener do not
qualify.
Expenses that may be taken into account in computing the
credit generally may not exceed an individual's earned income
or, in the case of married taxpayers, the earned income of the
spouse with the lesser earnings. Thus, if one spouse has no
earned income, generally no credit is allowed.
The 30-percent credit rate is reduced, but not below 20
percent, by 1 percentage point for each $2,000 (or fraction
thereof) of adjusted gross income (AGI) above $10,000. Thus,
the credit is never completely phased-out for higher-income
individuals.
Interaction with employer-provided dependent care assistance
For purposes of the dependent care credit, the maximum
amounts of employment-related expenses ($2,400/$4,800) are
reduced to the extent that the taxpayer has received employer-
provided dependent care assistance that is excludable from
gross income (sec. 129). The exclusion for dependent care
assistance is limited to $5,000 per year and does not vary with
the number of children.
Description of Proposal
The proposal would make several changes to the dependent
care tax credit. First, the credit percentage would be
increased to 50 percent for taxpayers with an AGI of $30,000 or
less. For taxpayers with AGI between $30,001 and $59,000, the
credit percentage would be decreased by 1 percent for each
$1,000 of AGI, or fraction thereof, in excess of $30,000. The
credit percentage would be 20 percent for taxpayers with AGI of
$59,001 or greater. Second, under the proposal, an otherwise
qualifying taxpayer would generally qualify for the dependent
care tax credit if the taxpayer resided in the same household
as the qualifying child regardless of whether the taxpayer
contributed over one-half the cost of maintaining the
household. However, in the case of married couple filing
separately, the taxpayer claiming the dependent care tax credit
would still have to satisfy the present-law household
maintenance test to receive the credit. Third, the dollar
amounts of the starting point of the new phase-down range and
the maximum amount of eligible employment-related expenses
would be indexed for inflation.
The present-law reduction of the dependent care credit for
employer-provided dependent care assistance would not be
changed
Effective Date
Generally, the proposal would be effective for taxable
years beginning after December 31, 1998. The starting point of
the phase-down range and the maximum amounts of eligible
employment-related expenses would be indexed for inflation for
taxable years beginning after December 31, 1999.
Prior Action
The House version of the Taxpayer Relief Act of 1997 would
have made two changes relating to the dependent care credit.
These changes were not enacted. First, the child tax credit
would have been reduced by one-half of the dependent care
credit for AGI in excess of $60,000 for married individuals
filing a joint return, $33,000 for heads of households and
single individuals, and $30,000 for married individuals filing
separately. No reduction would have been made with respect to
dependents who were physically or mentally incapable of self-
care. Second, the sum of the child tax credit and the dependent
care credit would have been phased out for taxpayers with
modified AGI in excess of certain thresholds. For these
purposes, modified AGI would have been computed by increasing
the taxpayer's AGI by the amount otherwise excluded from gross
income under Code sections 911, 931, and 933 (relating to the
exclusion of income of U.S. citizens or residents living
abroad, residents of Guam, American Samoa, and the Northern
Mariana Islands, and residents of Puerto Rico, respectively).
For married individuals filing a joint return, the threshold
would have been $110,000. For taxpayers filing as a head of
household or a single individual, the threshold would have been
$75,000. For married taxpayers filing separate returns, the
threshold would have been $55,000.
Analysis
Overview
The proposed expansion of the dependent care tax credit
involves several issues. One issue is the government's role in
encouraging parents (or ``secondary'' workers in childless
couples) to work in the formal workplace versus in the home. A
second issue is the appropriate role of government in providing
financial support for child care. A third issue involves the
increased complexity added by this proposal and the effect of
the phaseout provisions on marginal tax rates. Each of these
issues are discussed in further detail below.
Work outside of the home
One of the many factors influencing the decision as to
whether the second parent in a two-parent household works
outside the home is the tax law. 3 The basic
structure of the graduated income tax may act as a deterrent to
work outside of the home. The reason for this is that the
income tax taxes only labor whose value is formally recognized
through the payment of wages. 4 Work in the home,
though clearly valuable, bears no taxation. One way to see the
potential impact of this bias is to consider the case of a
parent who could work outside the home and earn $10,000. Assume
that in so doing the family would incur $10,000 in child care
expenses. Thus, in this example, the value of the parent's work
inside or outside the home is recognized by the market to have
equal value. 5 From a purely monetary perspective
(ignoring any work-related costs such as getting to work, or
buying clothes for work), this individual should be indifferent
as between working inside or outside the home. The government
also should be indifferent to the choice of where this parent
expends the parent's labor effort, as the economic value is
judged to be the same inside or outside the home. However, the
income tax system taxes the labor of this person in the formal
marketplace, but not the value of the labor if performed in the
home. Thus, of the $10,000 earned in the market place, some
portion would be taxed away, leaving a net wage of less than
$10,000. 6 This parent would be better off by
staying at home and enjoying the full $10,000 value of home
labor without taxation. 7
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\3\ This discussion applies to childless couples as well.
\4\ Barter transactions involving labor services would generally be
subject to income taxation as well.
\5\ A neutral position is taken in this analysis as to whether
actual parents can provide better care for their own children than can
other providers. Thus, since the child care can be obtained in the
marketplace for $10,000 in this example, it is assumed that this is the
economic value of the actual parent doing the same work.
\6\ The tax on ``secondary'' earners may be quite high, as the
first dollar of their earnings are taxed at the highest Federal
marginal tax rate applicable to the earnings of the ``primary'' earning
spouse. Additionally, the earnings will face social security payroll
taxes, and may bear State and local income taxes as well. For further
discussion of this issue, see Joint Committee on Taxation, Present Law
and Background Relating to Proposals to Reduce the Marriage Tax Penalty
(JCX-1-98), January 27, 1998.
\7\ Even with the present lower child care credit, the net wage
would still be lower because of the social security taxes and any
income taxes for which the taxpayer would be liable.
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Because labor in the home bears no taxation, most
economists view the income tax as being biased towards the
provision of home labor, resulting in inefficient distribution
of labor resources. For example, if the person in the above
example could earn $12,000 in work outside the home and pay
$10,000 in child care, work outside the home would be the
efficient choice in the sense that the labor would be applied
where its value is greatest. However, if the $12,000 in labor
resulted in $2,000 or more in additional tax burden, this
individual would be better off by working in the home. The
government could eliminate or reduce this bias in several ways.
First, it could consider taxing the value of ``home
production.'' Most would consider this not feasible for
administrative reasons and unfair. The second alternative would
be to try to eliminate or reduce the burden of taxation on
``secondary'' earners when they do enter the formal labor
force. This approach has been used in the past through the two-
earner deduction (from 1982-1986), which allows a deduction for
some portion of the earnings of the lesser-earning spouse.
8 Another approach, and part of present law, is to
allow a tax credit for child care expenses, provided both
parents (or if unmarried, a single parent) work outside the
home. This latter approach is targeted at single working
parents and two-earner families with children, whereas the two-
earner deduction applied to all two-earner couples regardless
of child care expenses.
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\8\ Joint Committee on Taxation, Present Law and Background
Relating to Proposals to Reduce the Marriage Tax Penalty (JCX-1-98) at
6, January 27, 1998.
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The proposal to expand the dependent care credit would
reduce the tax burden on families that pay for child care
relative to all other taxpayers. Alternatives such as expanding
the child tax credit or the value of personal exemptions for
dependents would target tax relief to all families with
children regardless of the labor choices of the parents.
However, families without sufficient income to owe taxes would
not benefit. If the objective were to further assist all
families with children, including those with insufficient
income to owe taxes, one would need to make the child credit
refundable.
Proponents of the proposal argue that child care costs have
risen substantially, and the dependent care credit needs to be
expanded to reflect this and ensure that children are given
quality care. Opponents would argue that the current credit is
a percentage of expenses, and thus as costs rise so does the
credit. However, to the extent one has reached the cap on
eligible expenses, this would not be true. Furthermore, the
maximum eligible employment-related expenses and the income
levels for the phaseout have not been adjusted for inflation
since 1982 when the amounts of maximum eligible employment-
related expenses were increased. It also could be argued that
the increase is needed to lessen the income tax's bias against
work outside of the home. However, the increase in the number
of two-parent families where both parents work might suggest
that any bias against work outside of the home must have been
mitigated by other forces, such as perhaps increased wages
available for work outside of the home. Others would argue that
the increasing number of two-earner couples with children is
not the result of any reduction in the income tax's bias
against work outside of the home, but rather reflects economic
necessity in many cases.
Opponents of the proposal contend that all families with
children should be given any available tax breaks aimed at
children, regardless of whether they qualify for the dependent
care tax credit. This latter group may cite as support for
their position that the size of the personal exemption for each
dependent is much smaller than it would have been had it been
indexed for inflation in recent decades. In their view, even
with the addition of the child tax credit, the current tax Code
does not adequately account for a family with children's
decreased ability to pay taxes.
It is not clear whether opponents of the proposal also
believe that there should be biases in the income tax in favor
of a parent staying at home with the children. It should be
noted that married couples with children in which both parents
work are often affected by the so-called marriage penalty.
9 Conversely, those for whom one parent stays at
home generally benefit from a ``marriage bonus.'' The proposal
to increase the dependent care credit can be thought of as a
proposal to decrease the marriage penalty for families with
children. 10
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\9\ See Joint Committee on Taxation, Present Law and Background
Relating to Proposals to Reduce the Marriage Tax Penalty (JCX-1-98) at
10, January 27, 1998.
\10\ Married couples with children in which both spouses work and
that receive a marriage bonus would also benefit from the dependent
care proposal.
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Thus, in general, the marriage penalty creates an incentive
for one of the parents to stay at home. Proposals to eliminate
or reduce the marriage penalty that do not also increase the
marriage bonus may imply that there will be greater incentives
for both parents to work outside of the home. For example, the
marriage penalty proposals that would tax the husband and wife
separately at the single schedule, thus eliminating the
marriage penalty, would imply that the stay-at-home parent
would now face a tax liability on any labor income that is
lower than he or she would have faced if the couple were taxed
under the married joint schedule of present law. Hence, this
taxpayer would have a greater incentive to work outside the
home.
The appropriate role of government
Another argument against the proposal is that, by giving an
increased amount of credit based on money spent for child care,
the proposal contributes to a distortion away from other forms
of consumption and an incentive to overspend on child care. A
counter-argument is that there are positive externalities to
quality child care, and thus a distortion that encourages
additional spending on child care is good for society. However,
opponents would counter this argument with a similar argument
that the best quality child care will come from the actual
parents, and thus if there should be any bias in the provision
of child care for reasons of quality it should be a bias
towards parents providing their own child care. Such an
argument is less tenable, however, for single parents for whom
work outside of the home is a necessity. Another response is
that, given the assumption that the government should subsidize
child care, there are better ways to improve availability and
affordability of adequate child care than through the tax code.
It is possible that a direct spending initiative would be more
efficient and administrable.
Complexity and marginal rate issues
Some argue that the increased number (see the discussion of
the employer tax credit for expenses of supporting employee
child care in Part I.A.2., below of this pamphlet) and
complexity of provisions in the tax code for social purposes
(e.g., this proposal) complicates the tax system and undermines
the public's confidence in the fairness of the income tax.
Others respond that tax fairness should sometimes outweigh
simplicity for purposes of the tax Code.
Some argue that the replacement of the maintenance of
household test with a residency test is a significant
simplification. Others respond that taxpayers' compliance
burden will not be significantly reduced because the dependency
requirement which is retained under the proposal requires the
application of a set of rules with a compliance burden similar
to that of the maintenance of household test.
The proposal's modifications relating to the phase-out of
the credit raise the tax policy issue of complexity. By phasing
out the dependent care credit over the $30,000 to $60,000
income range, many more families are likely to be in the phase-
out ranges and thus have their marginal tax rates raised by
this proposal relative to current law, which phases out a
portion of the credit over the income range of $10,000 to
$30,000. The increased number of families required to apply a
phase-out alone is an increase in complexity. Additionally, the
taxpayer's phaseout occurs at a steeper rate than under present
law. Present law has a reduction in the credit rate of 1
percent for each additional $2,000 of AGI in the phase-out
range. This proposal would reduce the credit rate by 1 percent
for each $1,000 of AGI in the phase-out range. The marginal tax
rate implied by the phaseout is thus twice as great as the
marginal tax rate under present law. Under present law, a
taxpayer with maximum eligible expenses of $4,800 will thus
lose $48 in credits for each $2,000 of income in the phase-out
range, which is equivalent to a marginal tax rate increase of
2.4 percentage points ($48/$2,000). Under the proposal,
marginal tax rates would be increased by 4.8 percentage points
($48/$1,000) for those in the phase-out range. Thus, the
dependent care credit could decrease work effort for two
reasons. By increasing marginal tax rates for those in the
phase-out range, the benefit from working is reduced.
Additionally, for most recipients of the credit, after-tax
incomes will have been increased, which would enable the
taxpayer to consume more of all goods, including leisure. A
positive effect on labor supply will exist for those currently
not working, for whom the increased credit might be an
incentive to decide to work outside of the home. 11
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\11\ For further discussion of the impact of this provision on
marginal tax rates and labor supply, see Joint Committee on Taxation,
Present Law and Analysis Relating to Individual Effective Marginal Tax
Rates (JCS-3-98), February 3, 1998.
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2. Employer tax credit for expenses of supporting employee child care
Present Law
Generally, present law does not provide a tax credit to
employers for supporting child care or child care resource and
referral services. 12 An employer, however, may be
able to claim such expenses as deductions for ordinary and
necessary business expenses. Alternatively, the taxpayer may be
required to capitalize the expenses and claim depreciation
deductions over time.
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\12\ An employer may claim the welfare-to-work tax credit on the
eligible wages of certain long-term family assistance recipients. For
purposes of the welfare-to-work credit, eligible wages includes amounts
paid by the employer for dependent care assistance.
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Description of Proposal
Employer tax credit for supporting employee child care
Under the proposal, taxpayers would receive a tax credit
equal to 25 percent of qualified expenses for employee child
care. These expenses would include costs incurred: (1) to
acquire, construct, rehabilitate or expand property that is to
be used as part of a taxpayer's qualified child care facility;
(2) for the operation of a taxpayer's qualified child care
facility, including the costs of training and continuing
education for employees of the child care facility; or (3)
under a contract with a qualified child care facility to
provide child care services to employees of the taxpayer. To be
a qualified child care facility, the principal use of the
facility must be for child care, and the facility must be duly
licensed by the State agency with jurisdiction over its
operations. Also, if the facility is owned or operated by the
taxpayer, at least 30 percent of the children enrolled in the
center (based on an annual average or the enrollment measured
at the beginning of each month) must be children of the
taxpayer's employees. If a taxpayer opens a new facility, it
must meet the 30-percent employee enrollment requirement within
two years of commencing operations. If a new facility failed to
meet this requirement, the credit would be subject to
recapture.
To qualify for the credit, the taxpayer must offer child
care services, either at its own facility or through third
parties, on a basis that does not discriminate in favor of
highly compensated employees.
Employer tax credit for child care resource and referral services
Under the proposal, a taxpayer would be entitled to a tax
credit equal to 10 percent of expenses incurred to provide
employees with child care resource and referral services.
Other rules
A taxpayer's total of these credits would be limited to
$150,000 per year. Any amounts for which the taxpayer may
otherwise claim a tax deduction would be reduced by the amount
of these credits. Similarly, if the credits are taken for
expenses of acquiring, constructing, rehabilitating, or
expanding a facility, the taxpayer's basis in the facility
would be reduced by the amount of the credits.
Effective Date
The credits would be effective for taxable years beginning
after December 31, 1998.
Prior Action
The Senate version of the Taxpayer Relief Act of 1997 would
have provided a temporary tax credit (taxable years 1998
through 2000) equal to 50 percent of an employer's qualified
child care expenses for each taxable year. The maximum credit
allowable would not have exceeded $150,000 per year. This
provision was not included in the final conference agreement of
the Taxpayer Relief Act of 1997.
Analysis
It is argued that providing these tax benefits may
encourage employers to spend more money on child care services
for their employees and that increased quality and quantity of
these services will be the result. On the other hand, less
desirable results may include a windfall tax benefit to
employers who would have engaged in this behavior without
provision of these tax benefits, and a competitive disadvantage
for nonprofit child care providers who cannot take advantage of
these new tax benefits.
Opponents of the proposal argue that adding complexity to
the tax Code can undermine the public's confidence in the
fairness of the tax Code, and that the country's child care
problems and other social policy concerns can be more
efficiently addressed through a spending program than through a
tax credit. Proponents argue that any additional complexity in
the tax law is outweighed by increased fairness. They contend
that present law has not taken into account the changing
demographics of the American workforce and the need to provide
improved child care for the ever increasing numbers of two-
earner families.
B. Energy and Environmental Tax Provisions
1. Tax credits
a. Tax credit for energy-efficient building equipment
Present Law
No income tax credit is provided currently for investment
in energy-efficient building equipment.
A 10-percent energy credit is allowed for the cost of new
property that is equipment (1) that uses solar energy to
generate electricity, to heat or cool a structure, or to
provide solar process heat, or (2) used to produce, distribute,
or use energy derived from a geothermal deposit, but only, in
the case of electricity generated by geothermal power, up to
the electric transmission stage, and which meet performance and
quality standards prescribed by the Secretary of the Treasury
(after consultation with the Secretary of the Energy). Public
utility property does not qualify for the credit (sec. 48B(a)).
A taxpayer may exclude from income the value of any
subsidy provided by a public utility for the purchase or
installation of an energy conservation measure. An energy
conservation measure means any installation or modification
primarily designed to reduce consumption of electricity or
natural gas or to improve the management of energy demand with
respect to a dwelling unit (sec. 136).
Description of Proposal
A credit would be provided for the purchase of certain
types of highly energy-efficient building equipment: fuel
cells, electric heat pump water heaters, advanced natural gas
and residential size electric heat pumps, and advanced central
air conditioners. The credit would equal 20 percent of the
purchase price, subject to a cap. The credit would be
nonrefundable. For businesses, it would be subject to the
limitations on the general business credit and would reduce the
basis of the equipment.
To be eligible for the credit, the specific technologies
would have to meet the following criteria:
Fuel cells generate electricity and heat using an
electrochemical process. To qualify for the credit,
fuel cell technologies would be required to have an
electricity-only generation efficiency greater than 35
percent. Fuel cells with a minimum generating capacity
of 50 kilowatts would be eligible for the credit.
Electric heat pump hot water heaters use electrically
powered vapor compression cycles to extract heat from
air and deliver it to a hot water storage tank.
Qualifying heat pump water heaters would be required to
yield an Energy Factor greater than or equal to 1.7 in
the standard Department of Energy (``DOE'') test
procedure.
Electric heat pumps (``EHP'') use electrically
powered vapor compression cycles to extract heat from
air in one space and deliver it to air in another
space. EHP technologies with a heating efficiency
greater than or equal to 9 HSPF and a cooling
efficiency greater than or equal to 15 SEER would
qualify for the credit.
Natural gas heat pumps use either a gas-absorption
cycle or a gas-driven engine to power the vapor
compression cycle to extract heat from one source and
deliver it to another. Qualifying natural gas heat
pumps would be those with a coefficient of performance
for heating of at least 1.25 and for cooling of at
least 0.70.
Central air conditioners would be required to have
an efficiency equal to or greater than 15 SEER to
qualify for the credit.
Advanced natural gas water heaters use a variety of
mechanisms to increase steady state efficiency and
reduce standby and vent losses. Only natural gas water
heaters with an energy factor of at least 0.80 in DOE
test procedures would qualify for the credit.
Effective Date
The credit would generally be available for final
purchases from unrelated third parties between December 31,
1999, and before January 1, 2004, for use within the United
States. The credit for fuel cells would be available for
purchases after December 31, 1999, and before January 1, 2005.
Prior Action
No prior action.
b. Tax credit for purchase of new energy-efficient homes
Present Law
No deductions or credits are provided currently for the
purchase of energy-efficient new homes.
A taxpayer may exclude from income the value of any
subsidy provided by a public utility for the purchase or
installation of an energy conservation measure. An energy
conservation measure means any installation or modification
primarily designed to reduce consumption of electricity or
natural gas or to improve the management of energy demand with
respect to a dwelling unit (sec. 136).
Description of Proposal
A tax credit of up to $2,000 would be available to
purchasers of highly energy-efficient new homes. To claim the
credit, the taxpayer must use the new home as the taxpayer's
principal residence, and the new home must use at least 50
percent less energy for heating, cooling and hot water than the
Model Energy Code standard for single family residences. The
tax credit would be one percent of the purchase price of the
home up to a maximum credit of $2,000 for eligible homes
purchased in the five-year period beginning January 1, 1999,
and ending December 31, 2003. The credit would be available for
an additional two years, i.e., for homes purchased January 1,
2004, through December 31, 2005, with a maximum credit of
$1,000.
Effective Date
The credit would generally be available for final homes
purchased after December 31, 1998, and before January 1, 2006.
Prior Action
No prior action.
c. Tax credit for high-fuel-economy vehicles
Present Law
A 10-percent tax credit is provided for the cost of a
qualified electric vehicle, up to a maximum credit of $4,000
(sec. 30). A qualified electric vehicle is a motor vehicle that
is powered primarily by an electric motor drawing current from
rechargeable batteries, fuel cells, or other portable sources
of electrical current, the original use of which commences with
the taxpayer, and that is acquired for the use by the taxpayer
and not for resale. The full amount of the credit is available
for purchases prior to 2002. The credit begins to phase down in
2002 and phases out in 2005.
Certain costs of qualified clean-fuel vehicle property may
be expensed and deducted when such property is placed in
service (sec. 179A). Qualified clean-fuel vehicle property
includes motor vehicles that use certain clean-burning fuels
(natural gas, liquefied natural gas, liquefied petroleum gas,
hydrogen, electricity and any other fuel at least 85 percent of
which methanol, ethanol, any other alcohol or ether. The
maximum amount of the deduction is $50,000 for a truck or van
with a gross vehicle weight over 26,000 pounds or a bus with
seating capacities of at least 20 adults; $5,000 in the case of
a truck or van with a gross vehicle weight between 10,000 and
26,000 pounds; and $2,000 in the case of any other motor
vehicle. Qualified electric vehicles do not qualify for the
clean-fuel vehicle deduction. The deduction phases down in the
years 2002 through 2004.
Description of Proposal
The proposal would provide two temporary tax credits for
the purchase of fuel efficient vehicles:
(1) Credit for vehicles with triple the base fuel
economy.--This credit would be $4,000 for each vehicle
that has three times the base fuel economy for its
class. The $4,000 credit would be available for
purchases of qualifying vehicles after December 31,
2002, and before January 1, 2007. The credit amount
would phase down to $3,000 in 2007, $2,000 in 2008, and
$1,000 in 2009, and would phase out in 2010.
(2) Credit for vehicles with twice the base fuel
economy.--This credit would be $3,000 for each vehicle
that has twice the base fuel economy for its class. The
$3,000 credit would be available for purchases of
qualifying vehicles after December 31, 1999, and before
January 1, 2004. The credit amount would phase down to
$2,000 in 2004, $1,000 in 2005, and would phase out in
2006.
These credits would be available for all qualifying light
vehicles, including cars, minivans, sport utility vehicles,
light trucks, and hybrid and electric vehicles. Taxpayers who
claim one of these credits would not be able to claim the
qualified electric vehicle credit or the deduction for clean-
fuel vehicle property for the same vehicle.
Effective Date
The credit would generally be available for vehicles
purchased January 1, 1999, and December 31, 2010.
Prior Action
No prior action.
d. Tax credit for combined heat and power (``CHP'')
systems
Present Law
Combined heat and power (``CHP'') systems are used to
produce electricity and process heat and/or mechanical power
from a single primary energy source. A tax credit is currently
not available for investments in CHP systems.
Depreciation allowances for CHP property vary by asset use
and capacity. Assets employed in the production of electricity
with rated total capacity in excess of 500 kilowatts, or
employed in the production of steam with rated total capacity
in excess of 12,500 pounds per hour, and used by the taxpayer
in an industrial manufacturing process or plant activity (and
not ordinarily available for sale to others), have a general
cost recovery period of 15 years. Electricity or steam
production assets of lesser rated capacity generally are
classified with other manufacturing assets and have cost
recovery periods of five to ten years. Assets used in the steam
power production of electricity for sale, including combustion
turbines operated in a combined cycle with a conventional steam
unit, have a 20-year recovery period. Other turbines and
engines used to produce electricity for sale have a 15-year
recovery period. Assets that are structural components of
buildings have a recovery period of either 39 years (if
nonresidential) or 27.5 years (if residential). For assets with
recovery periods of 10 years or less, the 200-percent declining
balance method may be used to compute depreciation allowances.
The 150-percent declining balance method may be used for assets
with recovery periods of 15 or 20 years. The straight-line
method must be used for buildings and their structural
components.
Description of Proposal
The proposal would establish a 10-percent tax credit for
certain CHP systems with an electrical capacity in excess of 50
kilowatts (or with a capacity to produce mechanical power
equivalent to 50 kilowatts). Investments in qualified CHP
systems that are assigned cost recovery periods of less than 15
years would be eligible for the credit, provided that a 15 year
recovery period and 150-percent declining balance method are
utilized to calculate depreciation allowances. Property placed
in service outside the United States would be ineligible for
the credit.
A qualified CHP system would be defined as equipment used
in the simultaneous or sequential production of electricity,
thermal energy (including heating and cooling and/or mechanical
power), and mechanical power. A qualified CHP system would be
required to produce at least 20 percent of its total useful
energy in the form of both (1) thermal energy, and (2) electric
and/or mechanical power. For CHP systems with an electrical
capacity of 50 megawatts or less, the total energy efficiency
of the system would have to be greater than 60 percent. For
larger systems, the total energy efficiency would have to
exceed 70 percent. For this purpose, total energy efficiency
would be calculated as the sum of the useful electrical,
thermal, and mechanical power produced, measured in Btus,
divided by the lower heating value of the primary energy
supplied. Taxpayers would be required to obtain proper
certification by qualified engineers for meeting the energy
efficiency and percentage-of-energy tests, pursuant to
regulations to be issued by the Secretary of the Treasury.
The credit would be subject to the limitations on the
general business credits. The depreciable basis of qualified
property for which the credit is taken would be reduced by the
amount of the credit. Regulated public utilities claiming the
credit would be required to use a normalization method of
accounting with respect to the credit. Taxpayers using the
credit for CHP systems would not be entitled to any other tax
credit for the same equipment.
Effective Date
The credit would apply to investments in CHP systems
placed in service after December 31, 1998, but before January
1, 2004.
Prior Action
No prior action.
e. Tax credit for replacement of certain circuit breaker
equipment
Present Law
No tax credits are provided currently for the purchase of
large power circuit breakers used in the transmission and
distribution of electricity.
Description of Proposal
A tax credit would be available for the installation of new
power circuit breaker equipment to replace certain older power
circuit breakers. The tax credit would be 10 percent of
qualified investment. To be eligible for the credit, the
replaced power circuit breakers must be dual pressure circuit
breakers that contain sulfur hexaflouride (``SF6''), have a
capacity of at least 115kV, and have been installed by December
31, 1985. The replaced circuit breaker equipment must be
destroyed so as to prevent its further use. The credit would be
subject to the limitations on the general business credit. The
depreciable basis of qualified property for which the credit is
taken would be reduced by the amount of the credit claimed.
Effective Date
The credit would be available for new equipment placed in
service in the five year period beginning January 1, 1999, and
ending December 31, 2003.
Prior Action
No prior action.
f. Tax credit for certain perfluorocompound (``PFC'') and
hydroflurocarbon (``HFC'') recycling equipment
Present Law
No tax credits are provided currently for the purchase of
perfluorocompound (``PFC'') and hydrofluorocarbon (``HFC'')
recycling equipment. Semiconductor manufacturers who install
equipment to recover or recycle PFC and HFC gases used in the
production of semiconductors may depreciate the cost of that
equipment over 5 years.
Description of Proposal
A tax credit would be available for the installation of PFC
and HFC recovery/recycling equipment in semiconductor
manufacturing plants. The tax credit would be 10 percent of
qualified investment. The credit would be subject to the
limitations on the general business credit. The depreciable
basis of qualified property for which the credit is taken would
be reduced by the amount of the credit claimed. Equipment would
qualify for the credit only if it recovers at least 99 percent
of PFCs and HFCs.
Effective Date
The credit would apply to property placed in service after
December 31, 1999, and before January 1, 2004.
Prior Action
No prior action.
g. Tax credit for rooftop solar equipment
Present Law
Nonrefundable business energy tax credits are allowed for
10 percent of the cost of qualified solar and geothermal energy
property (sec. 48(a)). Solar energy property that qualifies for
the credit includes any equipment that uses solar energy to
generate electricity, to heat or cool (or provide hot water for
use in) a structure, or to provide solar process heat.
The business energy tax credits are components of the
general business credit (sec. 38(b)(1)). The business energy
tax credits, when combined with all other components of the
general business credit, generally may not exceed for any
taxable year the excess of the taxpayer's net income tax over
the greater of (1) 25 percent of net regular tax liability
above $25,000 or (2) the tentative minimum tax. For credits
arising in taxable years beginning after December 31, 1997, an
unused general business credit generally may be carried back
one year and carried forward 20 years (sec. 39).
Description of Proposal
A tax credit would be available for purchasers of rooftop
photovoltaic systems and solar water heating systems located on
or adjacent to the building for uses other than heating
swimming pools. The credit would be equal to 15 percent of
qualified investment up to a maximum of $1,000 for solar water
heating systems and $2,000 for rooftop photovoltaic systems.
This credit would be nonrefundable. For businesses, this credit
would be subject to the limitations of the general business
credit. The depreciable basis of the qualified property would
be reduced by the amount of the credit claimed. Taxpayers would
have to choose between the proposed credit and the present
business energy credit for each investment.
Effective Date
The proposal would be effective for equipment placed in
service after December 31, 1998 and before January 1, 2004 for
solar water heating systems, and for equipment placed in
service after December 31, 1998 and before January 1, 2006 for
rooftop photovoltaic systems.
Prior Action
No prior action.
h. Extend wind and biomass tax credit
Present Law
An income tax credit is allowed for the production of
electricity from either qualified wind energy or qualified
``closed-loop'' biomass facilities (sec. 45). The credit is
equal to 1.5 cents (plus adjustments for inflation since 1992)
per kilowatt hour of electricity produced from these qualified
sources during the 10-year period after the facility is placed
in service.
The credit applies to electricity produced by a qualified
wind energy facility placed in service after December 31, 1993,
and before July 1, 1999, and to electricity produced by a
qualified closed-loop biomass facility placed in service after
December 31, 1992, and before July 1, 1999. Closed-loop biomass
is the use of plant matter, where the plants are grown for the
sole purpose of being used to generate electricity. It does not
apply to the use of waste materials (including, but not limited
to, scrap wood, manure, and municipal or agricultural waste).
It also does not apply to taxpayers who use standing timber to
produce electricity. In order to claim the credit, a taxpayer
must own the facility and sell the electricity produced by the
facility to an unrelated party.
The credit for electricity produced from wind or closed-
loop biomass is a component of the general business credit
(sec. 38(b)(1)). This credit, when combined with all other
components of the general business credit, generally may not
exceed for any taxable year the excess of the taxpayer's net
income tax over the greater of (1) 25 percent of net regular
tax liability above $25,000 or (2) the tentative minimum tax.
For credits arising in taxable years beginning after December
31, 1997, an unused general business credit generally may be
carried back one taxable year and carried forward 20 taxable
years.
Description of Proposal
The proposal would extend for five years the placed in
service date for the income tax credit for electricity produced
from wind and closed-loop biomass. Thus, the credit would be
available for qualifying electricity produced from facilities
placed in service before July 1, 2004. As under present law,
the credit would be allowable for a period of ten years after
the facility is placed in service.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
A provision to extend this credit for two years (i.e., for
facilities placed in service before July 1, 2001), was included
in the Senate version of the Taxpayer Relief Act of 1997, but
was not included in the final conference agreement. A provision
to sunset the credit was included in the House version of the
Balanced Budget Act of 1995.
Analysis for a.-h.
General rationale for tax benefits for energy conservation and
pollution abatement
The general rationale for providing tax benefits to energy
conservation and pollution abatement is that there exist
externalities in the consumption or production of certain
goods. An externality exists when, in the consumption or
production of a good, there is a difference between the cost or
benefit to an individual and the cost or benefit to society as
a whole.\13\ When the social costs of consumption exceed the
private costs of consumption, a negative externality exists.
When the social benefits from consumption or production exceed
private benefits, a positive externality is said to exist. When
negative externalities exist, there will be overconsumption of
the good causing the negative externality relative to what
would be socially optimal. When positive externalities exist,
there will be underconsumption or production of the good
producing the positive externality. The reason for the
overconsumption or underconsumption is that private actors will
in general not take into account the effect of their
consumption on others, but only weigh their personal cost and
benefits in their decisions. Thus, they will consume goods up
to the point where their marginal benefit of more consumption
is equal to the marginal cost that they face. But from a social
perspective, consumption should occur up to the point where the
marginal social cost is equal to the marginal social benefit.
Only when there are no externalities will the private actions
lead to the socially optimal level of consumption or
production, because in this case private costs and benefits wil
be equal to social costs and benefits.
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\13\ It should be noted that the social cost or benefit includes
the cost or benefit to the individual actually doing the consuming or
producing.
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Pollution is an example of a negative externality, because
the costs of pollution are borne by society as a whole rather
than solely by the polluters themselves. In the case of
pollution, there are two possible government interventions that
could produce a more socially desirable level of pollution. One
such approach would be to set a tax on the polluting activity
that is equal to the social cost of the pollution. Thus, if
burning a gallon of gasoline results in pollution that
represents a cost to society as a whole of 20 cents, it would
be economically efficient to tax gasoline at 20 cents a gallon.
By so doing, the externality is said to be internalized,
because now the private polluter faces a private cost equal to
the social cost, and the socially optimal amount of consumption
will take place. An alternative approach would be to employ a
system of payments, such as perhaps tax credits, to essentially
pay polluters to reduce pollution. If the payments can be set
in such a way as to yield the right amount of reduction (that
is, without paying for reduction more than the reduction is
valued, or failing to pay for a reduction where the payment
would be less than the value of the pollution reduction), the
socially desirable level of pollution will result.14
The basic difference between these two approaches is a question
of who pays for the pollution reduction. The tax approach
suggests that the right to clean air is paramount to the right
to pollute, as polluters would bear the social costs of their
pollution. The alternative approach suggests that the pollution
reduction costs should be borne by those who receive the
benefit of the reduction.
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\14\ It should be noted that this approach would be unwieldy to
implement, as it would in general require case by case decisions as to
the expenditure of funds to reduce pollution, rather than relying on
market mechanisms once a socially efficient price has been set, as
through the appropriate tax. Also, it can be difficult to measure
pollution reduction, as the base from which the reduction is measured
would necessarily be somewhat arbitrary. As a related matter, a general
policy of paying for pollution reduction could, in theory, lead to
threats to pollute in order to extract the payment.
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In the case of a positive externality, the appropriate
economic policy would be to impose a negative tax (i.e. a
credit) on the consumption or production that produces the
positive externality. By the same logic as above, the
externality becomes internalized, and the private benefits from
consumption become equal to the social benefits, leading to the
socially optimal level of consumption or production.
Targeted investment tax credits
Seven of the President's revenue proposals related to
energy and the environment are targeted investment tax credits
designed to encourage investment in certain assets that reduce
the emissions of gases related to atmospheric
warming.15 The following general analysis of
targeted tax credits is applicable to these proposals.
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\15\ Another credit proposal, a production credit for electricity
produced from wind or biomass, is discussed below.
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As a general matter of economic efficiency, tax credits
designed to influence investment choices should be used only
when it is acknowledged that market-based pricing signals have
led to a lower level of investment in a good than would be
socially optimal. In general, this can occur in a market-based
economy when private investors do not capture the full value of
an investment--that is, when there are positive externalities
to the investment that accrue to third parties who did not bear
any of the costs of the investments.16 For example,
if an individual or corporation can borrow funds at 10 percent
and make an investment that will return 15 percent, they will
generally make that investment. However, if the return were 15
percent, but only 8 percent of that return went to the
investor, and 7 percent to third parties, the investment will
generally not take place, even though the social return (the
sum of the return to the investor and other parties) would
indicate that the investment should be made. In such a
situation, it may be desirable to subsidize the return to the
investor through tax credits or other mechanisms in order that
the investor's return is sufficient to cause the socially
desirable investment to be made. In this example, a credit that
raised the return to the investor to at least 10 percent would
be necessary. Even if the cost of the credit led to tax
increases for the third parties, they would presumably be
better off since they enjoy a 7-percent return from the
investment, and the credit would only need to raise the return
to the investor by 2 percent for him or her to break even.
Thus, even if the third parties would bear the full cost of the
credit, they would, on net, enjoy a 5-percent return to the
investment (7 percent less 2 percent).17
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\16\ Investment in education is often cited as an example where the
social return may exceed the private return, i.e., there are positive
externalities.
\17\ The actual calculation as to whether the credit would improve
economic efficiency should also consider the economic costs imposed to
raise the necessary tax revenues to pay for the credit. Unless taxation
is perfectly efficient (i.e., no distortions are imposed in raising tax
revenue), the costs to society of raising a dollar in public funds will
exceed a dollar. For a discussion of this issue, see Charles Ballard,
John Shoven, and John Whalley, ``General Equilibrium Computations of
the Marginal Welfare Costs of Taxes in the United States,'' American
Economic Review 75, March 1985, pp. 128-38; and Charles Ballard, John
Shoven, and John Whalley, ``The Total Welfare Cost of the United States
Tax System: A General Equilibrium Approach,'' National Tax Journal 38,
June 1985, pp. 125-40.
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There are certain aspects of targeted tax credits that
could impair the efficiency with which they achieve the desired
goal of reduced atmospheric emissions. By targeting only
certain investments, other more cost-effective means of
pollution reduction may be overlooked. Many economists would
argue that the most efficient means of addressing pollution
would be through a direct tax on the pollution-causing
activities, rather than through the indirect approach of
targeted tax credits for certain technologies. By this
approach, the establishment of the economically efficient
prices on pollutants, through taxes, would result in the
socially optimal level of pollution. This would indirectly lead
to the adoption of the technologies favored in the President's
budget, but only if they were in fact the most socially
efficient technologies. In many cases, however, establishing
the right prices on pollution-causing activities through taxes
could be administratively infeasible, and other solutions may
be more appropriate. For example, with respect to the
President's proposal to provide a tax credit for the
replacement of certain circuit breaker equipment because of the
sulfur hexaflouride gas that they can leak, it would likely be
impractical to set a tax on any leaking that occurs and to
monitor the leaking. The President's proposal to provide a tax
credit for their replacement could be the best policy because
of its simplicity.18
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\18\ The same result could be effected through a direct mandate to
replace the equipment, or a sufficiently high tax on the continued use
of the old circuit breakers (as opposed to a tax on the leaking of the
sulfur hexaflouride gas). This, again, is a question of who should bear
the costs of the replacement.
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A second potential inefficiency of investment tax credits
is one of budgetary inefficiency, in the sense that their
budgetary costs could be large relative to the incremental
investment in the targeted activities. The reason for this is
that there will generally have been investment in the
activities eligible for the credit even in the absence of the
credit. Thus, for example, if investors planned to invest a
million dollars in an activity before a 10-percent credit, and
the credit caused the investment to rise $100,000 to $1.1
million because of the credit, then only $100,000 in additional
investment can be attributed to the credit. However, all $1.1
million in investments will be eligible for the 10-percent
credit, at a budgetary cost of $110,000 (10 percent of 1.1
million). Thus, only $100,000 in additional investment would be
undertaken, at a budgetary cost of $110,000. Because there is a
large aggregate amount of investment undertaken without general
investment credits, introducing a general credit would
subsidize much activity that would have taken place
anyway.19
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\19\ For a general discussion of the effects of tax policy on
business fixed investment, see Alan Auerbach and Kevin Hassett, ``Tax
Policy and Business Fixed Investment in the United States,'' Journal of
Public Economics, Vol. 47, No. 2, March 1992.
---------------------------------------------------------------------------
Targeted credits like the President's proposals, on the
other hand, are likely to be more cost effective, from a budget
perspective, in achieving the objective of increased
investment, if only for the reason that a government would
likely not consider their use if there were already extensive
investment in a given area.20 Thus, investment that
would take place anyhow is not subsidized, because there
presumably is not much of such investment taking place. The
presumption behind the targeted tax credits in the President's
budget proposals is that there is not sufficient investment in
the targeted areas because the alternative and more emissions-
producing investments are less costly to the investor. Hence, a
tax credit would be necessary to equalize costs and encourage
investment in the favored activity.
---------------------------------------------------------------------------
\20\ For example, there would be no need for a targeted tax credit
for construction of coffee shops, as most would agree that the
operation of the free market leads to a sufficient number of coffee
shops.
---------------------------------------------------------------------------
A final limitation on the efficiency of the proposed
credits is their restricted availability. The proposed tax
credits come with several limitations beyond their stipulated
dollar limitation. Specifically, they are all nonrefundable and
cannot offset tax liability determined under the AMT. One
proposal, the credit for rooftop solar equipment, has a cap on
the dollar amount of the credit, and thus after the cap is
reached the marginal cost of further investment becomes equal
to the market price again, which is presumed to be inefficient.
The impact of these limitations is to make the credit less
valuable to those without sufficient tax liability to claim the
full credit, for those subject to the AMT, or those who have
reached any cap on the credit. Given the arguments outlined
above as to the rationale for targeted tax credits, it is not
economically efficient to limit their availability based on the
tax status of a possible user of the credit. It can be argued
that, if such social benefits exist and are best achieved
through the tax system, the credit should be both refundable
and available to AMT taxpayers. Some would argue that making
the credits refundable may introduce compliance problems that
would exceed the benefits from encouraging the targeted
activities for the populations lacking sufficient tax liability
to make use of the credit. With respect to the AMT, the
rationale for the limitation is to protect the objective of the
AMT, which is to insure that all taxpayers pay a minimum
(determined by the AMT) amount of tax. Two differing policy
goals thus come in conflict in this instance. Similarly, caps
on the aggregate amount of a credit that a taxpayer may claim
are presumably designed to limit the credit's use out of some
sense of fairness, but again, this conflicts with the goal of
pollution reduction.
A justification for targeted tax credits that has been
offered with respect to some pollution abatement activities,
such as home improvements that would produce energy savings
(installation of energy saving light bulbs or attic insulation,
for example), is that the investment is economically sound at
unsubsidized prices, but that homeowners or business owners are
unaware of the high returns to the investments.21
The argument for targeted tax credits in this case is that they
are needed to raise the awareness of the homeowner, or to lower
the price sufficiently to convince the homeowner that the
investment is worthwhile, even though the investment is in
their interest even without the subsidy. These arguments have
been called into question recently on the grounds that the
returns to the investments have been overstated by
manufacturers, or are achievable only under ideal
circumstances. This view holds that the returns to these
investments are not dissimilar to other investments of similar
risk profile, and that homeowners have not been economically
irrational in their willingness to undertake certain energy
saving investments.22 Of course, to the extent that
there are negative externalities from the private energy
consumption, these households, though making rational private
choices, will not make the most socially beneficial choices
without some form of subsidy.
---------------------------------------------------------------------------
\21\ See Jerry A. Hausman, ``Individual Discount Rates and the
Purchase and Utilization of Energy-Using Durables,'' Bell Journal of
Economics and Management Science, vol. 10, Spring 1979. Hausman's study
concluded that the mean household discount rate for evaluating the
purchase of a more efficient room air conditioner was between 15 and 25
percent in 1975 to 1976. These discount rates generally exceeded
consumer loan rates at that time. In addition, information about the
relative efficiency of different models was available. During this time
period, room air conditioners carried information tags reporting the
energy efficiency and expected operating costs of various models.
\22\ See Gilbert Metcalf and Kevin Hassett, ``Measuring the Energy
Savings from Home Improvement Investments: Evidence from Monthly
Billing Data'', Working paper No. 6074, National Bureau of Economic
Research, June 1997.
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A final justification offered for targeted tax credits in
some instances is to ``jump start'' demand in certain infant
industries in the hopes that over time the price of such goods
will fall as the rewards from competition and scale economies
in production are reaped. However, there is no guarantee that
the infant industry would ultimately become viable without
continued subsidies. This argument is often offered for
production of electric cars--that if the demand is sufficient
the production costs will fall enough to make them ultimately
viable without subsidies. This justification is consistent with
the current proposals in that the credits are available only
for a limited period of time.
Production credit for wind and biomass
The wind and biomass tax credit is different from the other
tax credits in that the credit amount is based on production,
rather than on investment. Some argue that a production credit
provides for a stream of tax benefits, rather than an up-front
lump sum, and that the stream of benefits can help provide
financing for investment projects that would use wind or
biomass facilities. On the other hand, an up-front tax credit
provides more certainty, as the future production credits could
possibly be curtailed by future Congresses. In general,
investors prefer certainty to uncertainty, and thus may
discount the value of future production credits. Another
difference between a production credit and an investment credit
is that the latter provides only a temporary distortion to the
market--once the investment is made, normal competitive market
conditions will prevail and the rational firm will only produce
its end product if it can cover its variable costs. With a
production credit, a firm may actually profitably produce even
though it cannot cover its variable costs in the absence of the
credit. This would generally be considered an economically
inefficient outcome unless there are positive externalities to
the production of the good that exceed the value of the
credit.23 If it is presumed that the electricity
produced from wind or biomass substitutes for electricity
produced from the burning of fossil fuels, economic efficiency
will be improved so long as the credit does not have to be set
so high in order to encourage the alternative production that
it exceeds the value of the positive externality. On the other
hand, by making some production of electricity cheaper, it is
possible that the credit could encourage more electricity
consumption. On net, however, there would be less electricity
produced from fossil fuels.
---------------------------------------------------------------------------
\23\ In the present case, the positive externality is thought to be
pollution abatement. While pollution abatement per se does not occur
from the production of electricity from wind, the presumption is that,
indirectly, pollution is abated because less electricity is produced
from the burning of fossil fuels.
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2. Other provisions
a. Tax treatment of parking and transit benefits
Present Law
Under present law, qualified transportation fringe benefits
provided by an employer are excluded from an employee's gross
income. Qualified transportation fringe benefits include
parking, transit passes, and vanpool benefits. In addition, in
the case of employer-provided parking, no amount is includible
in income of an employee merely because the employer offers the
employee a choice between cash and employer-provided parking.
Transit passes and vanpool benefits are only excludable if
provided in addition to, and not in lieu of, any compensation
otherwise payable to an employee. Under present law, up to $175
per month (for 1998) of employer-provided parking and up to $65
per month (for 1998) of employer-provided transit and vanpool
benefits are excludable from gross income. These dollar amounts
are indexed for inflation.
Description of Proposal
The proposal would permit employers to offer their
employees transit and vanpool benefits in lieu of compensation.
The proposal would also raise the monthly limit on employer-
provided transit and vanpool benefits excludable from gross
income to the limit on employer-provided parking benefits
($175). As under present law, this amount would be indexed for
inflation.
Effective Date
The proposal would be effective for years beginning after
December 31, 1998.
Prior Action
No prior action.
Analysis
The proposal would equalize the tax treatment of employer-
provided transit and vanpool benefits with the tax treatment of
employer-provided parking benefits. This equalization would
appear to eliminate the tax disincentives for providing transit
and vanpool benefits relative to parking benefits. In addition,
it would eliminate possible confusion for employers that
inadvertently structure a transit program that offers cash in
lieu of parking and other transit benefits. In such cases, the
employer may intend the program to qualify for tax exclusion,
but it may result in taxation.
On the other hand, some question whether it is appropriate
to provide a cash election for any transportation benefits, as
this merely allows employees to convert taxable income into
nontaxable income.
The equalization of the tax treatment of transit benefits
and parking benefits is economically desirable in the sense
that it eliminates a distortion that currently favors parking
benefits, and hence driving to work, over transit benefits that
encourage use of public transportation (and the latter is
recognized to be more energy efficient, producing less
pollution per passenger-mile). However, the proposal represents
further subsidies to transportation in general, and thus
encourages more use of transportation over other
goods.24 Such subsidies are only desirable if we
believe that, from a social perspective, expenditures on
transportation have positive externalities. In general, the
opposite view is held, as the burning of fossil fuels in
transportation is a major source of pollution. Furthermore,
additional use of transportation also causes more congestion,
which has a negative impact on all users of the transportation
infrastructure. Such subsidies may encourage people to live
further from their place of work than they otherwise would,
which requires more energy consumption to get to work.
Furthermore, such subsidies encourage the use of cars or public
transportation, both of which use fossil fuels, over more
environmentally friendly forms of transportation such as
walking or bicycling to work, or telecommuting from home, which
do not benefit from any special tax incentives.
---------------------------------------------------------------------------
\24\ An alternative proposal would have been to equalize the
treatment of parking benefits by putting them on the same footing as
transit under current law, rather than the other way around. This would
have represented less of a subsidy to transportation in general.
---------------------------------------------------------------------------
b. Permanent extension of expensing of environmental
remediation costs (``brownfields'')
Present Law
Code section 162 allows a deduction for ordinary and
necessary expenses paid or incurred in carrying on any trade or
business. Treasury regulations provide that the cost of
incidental repairs which neither materially add to the value of
property nor appreciably prolong its life, but keep it in an
ordinarily efficient operating condition, may be deducted
currently as a business expense. Section 263(a)(1) limits the
scope of section 162 by prohibiting a current deduction for
certain capital expenditures. Treasury regulations define
``capital expenditures'' as amounts paid or incurred to
materially add to the value, or substantially prolong the
useful life, of property owned by the taxpayer, or to adapt
property to a new or different use. Amounts paid for repairs
and maintenance do not constitute capital expenditures. The
determination of whether an expense is deductible or
capitalizable is based on the facts and circumstances of each
case.
Under Code section 198, taxpayers can elect to treat
certain environmental remediation expenditures that would
otherwise be chargeable to capital account as deductible in the
year paid or incurred. The deduction applies for both regular
and alternative minimum tax purposes. The expenditure must be
incurred in connection with the abatement or control of
hazardous substances at a qualified contaminated site. In
general, any expenditure for the acquisition of depreciable
property used in connection with the abatement or control of
hazardous substances at a qualified contaminated site does not
constitute a qualified environmental remediation expenditure.
However, depreciation deductions allowable for such property,
which would otherwise be allocated to the site under the
principles set forth in Commissioner v. Idaho Power Co.\25\ and
section 263A, are treated as qualified environmental
remediation expenditures.
---------------------------------------------------------------------------
\25\ Commissioner v. Idaho Power Co., 418 U.S. 1 (1974) (holding
that equipment depreciation allocable to the taxpayer's construction of
capital facilities must be capitalized under section 263(a)(1)).
---------------------------------------------------------------------------
A ``qualified contaminated site'' generally is any property
that: (1) is held for use in a trade or business, for the
production of income, or as inventory; (2) is certified by the
appropriate State environmental agency to be located within a
targeted area; and (3) contains (or potentially contains) a
hazardous substance (so-called ``brownfields''). Targeted areas
are defined as: (1) empowerment zones and enterprise
communities as designated under present law and under the Act
26 (including any supplemental empowerment zone
designated on December 21, 1994); (2) sites announced before
February 1997, as being subject to an Environmental Protection
Agency (``EPA'') Brownfields Pilot; (3) any population census
tract with a poverty rate of 20 percent or more; and (4)
certain industrial and commercial areas that are adjacent to
tracts described in (3) above.
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\26\ Thus, the 22 additional empowerment zones authorized to be
designated under the Taxpayer Relief Act of 1997, as well as the D.C.
Enterprise Zone, are ``targeted areas'' for purposes of this provision.
---------------------------------------------------------------------------
Both urban and rural sites qualify. However, sites that are
identified on the national priorities list under the
Comprehensive Environmental Response, Compensation, and
Liability Act of 1980 (``CERCLA'') cannot qualify as targeted
areas. The chief executive officer of a State, in consultation
with the Administrator of the EPA, was authorized to designate
an appropriate State environmental agency. If no State
environmental agency was so designated within 60 days of the
date of enactment, the Administrator of the EPA was authorized
to designate the appropriate environmental agency for such
State. Hazardous substances generally are defined by reference
to sections 101(14) and 102 of CERCLA, subject to additional
limitations applicable to asbestos and similar substances
within buildings, certain naturally occurring substances such
as radon, and certain other substances released into drinking
water supplies due to deterioration through ordinary use.
In the case of property to which a qualified environmental
remediation expenditure otherwise would have been capitalized,
any deduction allowed under the Act is treated as a
depreciation deduction and the property is treated as section
1245 property. Thus, deductions for qualified environmental
remediation expenditures are subject to recapture as ordinary
income upon sale or other disposition of the property. In
addition, sections 280B (demolition of structures) and 468
(special rules for mining and solid waste reclamation and
closing costs) do not apply to amounts which are treated as
expenses under this provision.
The provision applies only to eligible expenditures paid or
incurred in taxable years ending after August 5, 1997, and
before January 1, 2001.
Description of Proposal
The proposal would eliminate the requirement that
expenditures must be paid or incurred in taxable years ending
before January 1, 2001, to be deductible as eligible
environmental remediation expenditures. Thus, the provision
would become permanent.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
The special expensing for environmental remediation
expenditures was enacted as part of the Taxpayer Relief Act of
1997.
Analysis
The proposal to make permanent the expensing of brownfields
remediation costs would promote the goal of environmental
remediation and remove doubt as to the future deductibility of
remediation expenses. Removing the doubt about deductibility
may be desirable if the present law expiration date is
currently affecting investment planning. For example, the
temporary nature of relief under present law may discourage
projects that require a significant ongoing investment, such as
groundwater clean-up projects. On the other hand, extension of
the provision for a limited period of time would allow
additional time to assess the efficacy of the law, adopted only
recently as part of the Taxpayer Relief act of 1997, prior to
any decision as to its permanency.
The proposal is intended to encourage environmental
remediation, and general business investment, in sites located
in enterprise communities and empowerment zones, the original
EPA Brownfields Pilots, or in census tracts with poverty rates
of 20 percent or more, or certain adjacent tracts. With respect
to environmental remediation, it is not clear that the
restriction to certain areas will lead to the most socially
desirable distribution of environmental remediation. It is
possible that the same dollar amount of expenditures for
remediation in other areas could produce a greater net social
good, and thus the restriction to specific areas diminishes
overall efficiency. On the other hand, property located in a
nonqualifying area may have sufficient intrinsic value so that
environmental remediation will be undertaken absent a special
tax break. With respect to environmental remediation tax
benefits as an incentive for general business investment, it is
possible that the incentive may have the effect of distorting
the location of new investment, rather than increasing
investment overall.\27\ If the new investments are offset by
less investment in neighboring, but not qualifying, areas, the
neighboring communities could suffer. On the other hand, the
increased investment in the qualifying areas could have
spillover effects that are beneficial to the neighboring
communities.
---------------------------------------------------------------------------
\27\ For a discussion of the economic effects of enterprise zones,
see Leslie E. Papke, ``What Do We Know About Enterprise Zones,'' in Jim
Poterba, ed., Tax Policy and the Economy, 7 (Cambridge, MA: The MIT
Press), 1993.
---------------------------------------------------------------------------
Further, permanently extending the brownfields provision
raises administrative issues. For example, it is unclear
whether currently qualified zone sites will continue to qualify
after such designation expires, by law, after 10 years.
Similarly, it is unclear whether the application to census
tracts (currently defined by the 1990 census) with poverty
rates of 20 percent or more (or certain adjacent tracts)
applies to tracts that meet such qualifications on (1) August
5, 1997 (the effective date of the original brownfields
legislation), (2) the effective date of this proposal, or (3)
the date of the expenditure.
C. Retirement Savings Provisions
1. Access to payroll deduction for retirement savings
Present Law
Under present law, an employer may establish a payroll
deduction program to help employees save for retirement through
individual retirement arrangements (``IRAs''). Under a payroll
deduction program, an employee may contribute to an IRA by
electing to have the employer withhold amounts from the
employee's paycheck and forward them to the employee's IRA.
Payroll deduction contributions are included in the employee's
wages for the taxable year but the employee may deduct the
contributions on the employee's tax return, subject to the
normal IRA contribution rules.
The legislative history of the Taxpayer Relief Act of 1997
provides that employers that choose not to sponsor a retirement
plan should be encouraged to set up a payroll deduction system
to help employees save for retirement by making payroll
deduction contributions to their IRAs. The Secretary of
Treasury is encouraged to continue his efforts to publicize the
availability of these payroll deduction IRAs.
Under present law, an IRA payroll deduction program may be
exempt from the provisions of Title I of (the Employer
Retirement Income Security Act of 1974, as amended (``ERISA''),
which include reporting and disclosure and fiduciary
requirements. In general, ERISA regulations provide an
exception from the provisions of Title I of ERISA for an IRA
payroll deduction program in which the employer merely
withholds amounts from the employee's paycheck and forwards
them to the employee's IRA. A payroll deduction program may be
subject to Title I of ERISA if, for example, an employer makes
contributions to the program or an employer receives more than
reasonable compensation for services rendered in connection
with payroll deductions.
Description of Proposal
Under the proposal, contributions of up to $2,000 made to
an IRA through payroll deduction generally would be excluded
from an employee's income and, accordingly, would not be
reported as income on the employee's Form W-2. However, the
amounts would be subject to employment taxes and would be
reported as a contributions to an IRA on the employee's W-2. In
the event the amounts would not have been deductible had the
employee contributed directly to an IRA, the employee would be
required to include the amounts in income on the employee's tax
return.
Effective Date
The proposal would be effective for years beginning after
December 31, 1998.
Prior Action
No prior action.
Analysis
The proposal is intended to encourage employers to offer
payroll deduction programs to their employees and encourage
employees to save for retirement. While present law permits
such payroll deductions, the proposal is designed to make it
more attractive (and more widely utilized) by providing
employees with a convenient way to obtain the tax benefit for
IRA contributions that will eliminate the need for many
employees to report the contributions on their tax returns and
enable some employees to use simpler tax forms. The proposal
does not increase the present-law benefit of making
contributions to an IRA.
It is not clear whether the proposal will have the desired
effect. Increased IRA participation may not result because
there is no change in the economic incentive to make IRA
contributions. On the other hand, by increasing the convenience
of making contributions, some taxpayers may participate who
would not otherwise participate and more taxpayers may begin to
save on a regular basis. Oppositely, some analysts have noted
that under present law many IRA contributions are not made
until immediately prior to the date the taxpayer files his or
her tax return. Such taxpayer may not be motivated by the long-
term economic benefits of an IRA, but rather by a short-term
desire to affect the immediate consequence of tax filing. The
proposal may or may not affect the psychology of such
taxpayers.
For the proposal to be effective, employers must create
payroll deduction programs. In order to do so, employers may
have to revise current payroll systems. Employers may not be
willing to incur the costs of establishing and maintaining a
payroll deduction program. The proposal does not create a
direct economic incentive for employers to incur such costs. On
the other hand, if employees find the payroll deduction program
attractive and know such payroll options are available
elsewhere, employers may find it to their benefit to extend
this payroll deduction option to their employees. In addition,
the proposal does not address certain fiduciary issues under
the present-law ERISA rules. Without some modification,
employers may be unwilling to establish payroll deduction plans
out of concern that they will be considered plan
fiduciaries.\28\
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\28\ The Administration has indicated that the Department of Labor
will address fiduciary issues relating to payroll deduction IRAs.
---------------------------------------------------------------------------
The exclusion provided by the proposal may be confusing for
some employees (e.g., employees who simultaneously participate
in a qualified plan and who have AGI in excess of $50,000).
They may mistakenly believe they are entitled to the exclusion
when they are not because of the IRA deduction income phase-out
rules. In addition, some employees could mistakenly claim both
the exclusion and the deduction on their return.
2. Small business tax credit for retirement plan start-up expenses
Present Law
Under present law, the costs incurred by an employer
related to the establishment and maintenance of a retirement
plan (e.g., payroll system changes, investment vehicle set-up
fees, consulting fees, etc.) generally are deductible by the
employer as an ordinary and necessary expense in carrying on a
trade or business.
Description of Proposal
The proposal would provide a three-year tax credit, in lieu
of a deduction, for 50 percent of the administrative and
retirement-education expenses for any small business that
adopts a new qualified defined benefit or defined contribution
plan (including a section 401(k) plan), SIMPLE plan, simplified
employee pension (``SEP''), or payroll deduction IRA
arrangement. The credit would apply to 50 percent of the first
$2,000 in administrative and retirement-education expenses for
the plan or arrangement for the first year of the plan or
arrangement and 50 percent of the first $1,000 of
administrative and retirement-education expenses for each of
the second and third years.
The credit would be available to employers that did not
employ, in the preceding year, more than 100 employees with
compensation in excess of $5,000, but only if the employer did
not have a retirement plan or payroll deduction IRA arrangement
during any part of 1997. In order for an employer to get the
credit, the plan would have to cover at least two individuals.
In addition, if the credit is for the cost of a payroll
deduction IRA arrangement, the arrangement would have to be
made available to all employees of the employer who have worked
with the employer for at least three months.
The small business tax credit would be treated as a general
business credit and the standard carry forward and backward
rules would apply.
Effective Date
The credit would be effective beginning in the year of
enactment and would be available only for plans established on
or before December 31, 2000. For example, if an eligible
employer adopted a plan in the year 2000, the credit would be
available for the years 2000, 2001, and 2002.
Prior Action
No prior action.
Analysis
Establishing and maintaining a qualified plan involves
employer administrative costs both for initial start-up of the
plan and for on-going operation of the plan. These expenses
generally are deductible to the employer as a cost of doing
business. The cost of these expenses to the employer is reduced
by the tax deduction. Thus, for costs incurred or $C, the net,
after-tax cost is $C(1-t) where t is the employer's marginal
tax rate. The employer's tax rate may be either the applicable
corporate tax rate or individual marginal tax rate, depending
on the form in which the employer does business (e.g., as a C
corporation or a sole proprietor). Under the proposal, a 50-
percent credit could be claimed for eligible costs in lieu of
the deduction. Thus for qualifying costs, C, the net cost to
the employer would be C(1-0.5) or (.5)C. The proposal would
reduce the cost of establishing a plan by the difference
between the employer's marginal tax rate and 50 percent
multiplied by up to $2,000 in the first year or by up to $1,000
in the second or third years. At most the cost reduction would
be $700 (the difference between the lowest marginal tax rate of
15 percent and the proposed credit rate of 50 percent
multiplied by $2,000) in the first year and $350 for the second
and third years. The additional cost saving under the proposal
compared to present law could be as little as $208 in the first
year and $104 dollars in the second and third years. For a
taxpayer in the 39.6-percent marginal income tax bracket.
By reducing costs, providing a tax credit for the costs
associated with establishing a retirement plan may promote the
adoption of such plans by small businesses. On the other hand,
it is unclear whether the magnitude of the cost saving provided
by the proposed tax credit will provide sufficient additional
incentive for small businesses to establish plans. In some
cases the credit may be inefficient because it may be claimed
by employers who would have established a plan in any event.
3. Simplified pension plan for small business (``SMART'')
Present Law
Any employer, including a small employer, may adopt a
qualified plan for its employees. In addition, present law
contains some special plans designed specifically for small
employers. Present law provides for a simplified retirement
plan for small business employers called the savings incentive
match plan for employees (``SIMPLE'') retirement plan. A SIMPLE
plan can be either an individual retirement arrangement
(``IRA'') for each employee or part of a qualified cash or
deferred arrangement (``401(k) plan''). SIMPLE plans can be
adopted by employers who employ 100 or fewer employees who
received at least $5,000 in compensation and who do not
maintain another employer-sponsored retirement plan. Under a
SIMPLE retirement plan, employees can elect to make pre-tax
deferrals of up to $6,000 per year. Employers are required to
make either a matching contribution of up to 3 percent of the
employee's compensation or, alternatively, the employer can
elect to make a lower percentage contribution on behalf of all
eligible employees. Employees are 100 percent vested in all
contributions made to their accounts. A SIMPLE retirement plan
cannot be a defined benefit plan.
Alternatively, small business employers may offer their
employees a simplified employee pension (``SEP''). SEPs are
employer-sponsored plans under which employer contributions are
made to individual retirement arrangements (``IRAs'')
established by the employees. Contributions under a SEP
generally must bear a uniform relationship to the compensation
of each employee covered under the SEP (e.g., each employee
receives a contribution to the employee's IRA equal to 5
percent of the employee's compensation for the year).
Description of Proposal
In general
The proposal would create a new simplified pension plan for
small business employers called the Secure Money Annuity or
Retirement Trust (``SMART'') Plan. The SMART Plan would combine
the features of both a defined benefit plan and a defined
contribution plan. As is the case with qualified retirement
plans, contributions to the SMART Plan would be excludable from
income, earnings would accumulate tax-free, and distributions
would be subject to income tax (unless rolled over).
Employer and employee eligibility and vesting
The SMART Plan could be adopted by an employer who (1)
employs 100 or fewer employees who received at least $5,000 in
compensation in the prior year, (2) is not a professional
service employer (i.e., an employer substantially all of the
activities of which involve the performance of services in the
fields of health, law, engineering, architecture, accounting,
actuarial services, performing arts, or consulting), and (3)
has not maintained a defined benefit pension plan or money
purchase pension plan within the preceding five years. All
employees who have completed two years of service with at least
$5,000 in compensation and who are reasonably expected to
receive $5,000 in compensation in the current year would
participate in the SMART Plan. An employee's benefit would be
100 percent vested at all times.
Benefits and funding
SMART Plans would provide a fully funded minimum defined
benefit. Each year the employee participates, the employee
would earn a minimum annual benefit at retirement equal to 1
percent or 2 percent of compensation for that year. For
example, if an employee participates for 25 years in a SMART
Plan, and the employer had elected a 2 percent benefit, and the
employee's average salary over the entire period was $50,000,
the employee would accrue a minimum benefit of $25,000 per year
at age 65. An employer could elect, for each of the first 5
years the SMART Plan is in existence, to provide all employees
with a benefit equal to 3 percent of compensation. The maximum
compensation that could be taken into account for a year would
be $100,000 (indexed for inflation). Each year the employer
would be required to contribute an amount on behalf of each
participant sufficient to provide the annual benefit accrued
for that year payable at age 65, using specified actuarial
assumptions (including a 5 percent annual interest rate).
Funding would be provided either through a SMART Plan
individual retirement annuity (``SMART Annuity'') or through a
trust (``SMART Trust''). In the case of a SMART Trust, each
employee would have an account to which actual investment
returns would be credited. If a participant's account balance
were less than the total of past employer contributions
credited with 5 percent interest per year, the employer would
be required to make up the shortfall. If the investment returns
exceed the 5 percent assumption, the employee would be entitled
to the larger account balance. In the case of a SMART Annuity,
each year the employer would be required to contribute the
amount necessary to purchase an annuity that provides the
benefit accrual for that year on a guaranteed basis.
The required contributions would be deductible under the
rules applicable to qualified defined benefit plans. An excise
tax would apply if the employer failed to make the required
contributions for a year.
Distributions
No distributions would be allowed from a SMART Plan prior
to the employee's attainment of age 65, except in the event of
death or disability, or where the account balance of a
terminated employee does not exceed $5,000. However, an
employer could allow a terminated employee who has not yet
attained age 65 to directly transfer the individual's account
balance from a SMART Trust to either a SMART Annuity or a
special individual retirement account (``SMART Account'') that
is subject to the same distribution restrictions as the SMART
Trust. If a terminated employee's account balance did not
exceed $5,000, the SMART Plan would be allowed to make a
cashout of the account balance. The employee would be allowed
to transfer such distribution tax-free to a SMART Annuity, a
SMART Account, or a regular IRA.
SMART Plans would be subject to the qualified joint and
survivor annuity rules that apply to qualified defined benefit
plans. Lump sum payments also could be made available. In
addition, an employer could allow the transfer of a terminated
employee's account balance from SMART Trust to either a SMART
Annuity or a SMART Account.
Distributions from SMART Plans would be subject to tax
under the present-law rules applicable to qualified plans. A
20-percent additional tax would be imposed for violating the
pre-age 65 distribution restrictions under a SMART Annuity or
SMART Account.
PBGC guarantee and premiums
The minimum guaranteed benefit under the SMART Trust would
be guaranteed by the Pension Benefit Guarantee Corporation
(``PBGC''). Reduced PBGC premiums would apply to the SMART
Trust. Neither the PBGC guarantee, nor PBGC premiums, would
apply to the SMART Annuity or SMART Account.
Nondiscrimination requirements and benefit limitations
SMART Plans would not be subject to the nondiscrimination
or top-heavy rules applicable to qualified retirement plans.
SMART Plans also would not be subject to the limitations on
benefits under qualified plans. However, if an employer
maintained a SMART Plan, and then terminated it and established
a qualified defined benefit plan, the SMART Plan accruals would
be taken into account for purposes of the limitations
applicable to the defined benefit plan.
Other rules
Other plans maintained by the employer.--An employer that
maintained a SMART Plan could not maintain additional tax-
qualified plans, other than a SIMPLE plan, a 401(k) plan, or a
403(b) tax-sheltered annuity plan under which the only
contributions that are permitted are elective contributions and
matching contributions that are not greater than those provided
for under the design-based safe harbor for 401(k) plans.
Reporting and disclosure.--SMART Plans would be subject to
simplified reporting requirements.
Employee contributions.--No employee contributions would be
permitted to a SMART Plan.
IRS model.--The IRS would be directed to issue model SMART
Plan provisions or a model SMART Plan document. Vendors and
employers would have the option of using their own documents
instead of the models.
Coordination with IRA deduction rules.--SMART Plans would
be treated as qualified plans for purposes of the IRA deduction
phase-out rules. Thus, employees who participated in a SMART
Plan and had modified adjusted gross income in excess of the
applicable thresholds would be phased out of making deductible
IRA contributions. This rule currently applies to SEPs and
SIMPLE Plans.
Calendar plan year.--The plan year for all SMART Plans
would be the calendar year, which would be used in applying
SMART Plan contribution limits, eligibility, and other
requirements.
Effective Date
The proposal would be effective for calendar years
beginning after 1998.
Prior Action
A similar proposal (H.R. 1656) was introduced in the House
in 1997.
Analysis
Under present law, small businesses have many options
available for providing retirement benefits for their
employees, including establishing SIMPLE plans and SEPs not
available to larger employers. Nevertheless, retirement plan
coverage is lower among smaller employers. There may be a
number of reasons for such lower coverage. Some believe the
retirement plan coverage for small business employers continues
to be inadequate. They argue that the limits are not sufficient
to induce owners to establish a plan because the owners will
not be able to receive as high a retirement benefit as they
would like. Others point out that the limits are high enough to
allow significant retirement benefits (the lesser of $130,000
per year or 100 percent of compensation), and that there are
other causes for the low small employer plan coverage, such as
the administrative burdens and costs, and the unpredictability
of funding requirements associated with defined benefit plans
that may inhibit small business employers from adopting and
maintaining such plans. It also may be that the costs of
contributing to a plan are too high for small employers.
Providing small business employers with an additional option
for providing retirement benefits for their employees, the
SMART Plan may provide greater benefits for employees while
reducing the costs of establishing and maintaining a retirement
plan. However, there is an issue concerning which employees
will actually benefit from participating in a SMART Plan.
Because the SMART Plan benefits are based on a formula that
takes into account a participant's age and years of service
with the employer who established the SMART Plan, those older
employees with long service records will receive the greatest
benefits. In many cases, the older employees with the longest
service records will be the higher paid employees. Generally,
younger employees with shorter service records would receive a
greater benefit under a defined contribution plan, SIMPLE or
SEP.
4. Faster vesting for employer matching contributions
Present Law
Under present law, a participant's employer-provided
benefits under a qualified plan must either be fully vested
after the participant has completed 5 years of service, or must
become vested in increments of 20 percent for each year
beginning after 3 years of service, with full vesting after the
participant completes 7 years of service. If a plan is a ``top-
heavy plan'', employer contributions either must be fully
vested after the participant has completed 3 years of service,
or must become vested in increments of 20 percent for each year
beginning after 2 years of service, with full vesting after the
participant completes 6 years of service. Employer matching
contributions on behalf of a participant under a section 401(k)
plan are generally subject to these vesting rules. However,
employer matching contributions that are treated as elective
contributions for purposes of the actual deferral percentage
test under section 401(k) (``qualified matching
contributions'') must be fully vested immediately.
Description of Proposal
Under the proposal, employer matching contributions under
401(k) plans (or other qualified plans) would be required
either to be fully vested after an employee has completed 3
years of service, or to become vested in increments of 20
percent for each year beginning after the employee has
completed 2 years of service, with full vesting after the
employee has completed 6 years of service. Qualified matching
contributions used to satisfy the 401(k) actual deferral
percentage test would continue to be fully vested immediately,
as under present law.
Effective Date
The proposal would be effective for plan years beginning
after December 31, 1998, with an (unspecified) extended
effective date for plans maintained pursuant to a collective
bargaining agreement.
Prior Action
No prior action.
Analysis
The popularity and importance of 401(k) plans has grown
substantially over the years. Employers often choose to
contribute to 401(k) plans by matching the salary reduction
contributions made by employees. The general justification for
accelerating the vesting of employer matching contributions
focuses on the mobile nature of today's workforce and the
substantial risk that many participants will leave employment
before fully vesting in employer matching contributions.
Shortening the vesting period is consistent with encouraging
retirement savings, proponents argue.
Opponents may counter that in some cases accelerating the
vesting schedule of employer matching contributions may reduce
overall retirement savings by making plans more expensive for
some employers. Because matching contributions that are
forfeited are used by some employers to reduce the
contributions of the employer in subsequent years, these
employers may find that the shorter vesting period increases
their plan costs. This could cause employers to eliminate or
reduce the matching contribution. Reductions in matching
contributions may in turn reduce employee participation in
401(k) plans, because employer matching contributions are a
significant feature of plans that for many employees may
provide the economic incentive to participate in the plan.
Employers may use vesting schedules that are not immediate
to promote longer job attachment from employees that may enable
the employer and employee to reap benefits of job specific
training the employee may have received when initially employed
by the employer. Reducing the time to full vesting may cause
the employer to make changes in other forms of compensation or
to reduce training to balance against whatever costs
accelerated vesting may create.
5. Pension ``right to know'' provisions
Present Law
Spouse's right to know distribution information
In general, a qualified pension plan is required to provide
automatic survivor benefits for married participants. In the
case of a married participant who commences distribution of
retirement benefits, the benefit must be distributed in the
form of a qualified joint and survivor annuity. A qualified
joint and survivor annuity distributes the retirement benefit
over the life of the participant and continues to pay at least
one-half of the benefit amount to the surviving spouse
following the participant's death. In the case of a married
participant who dies prior to the commencement of retirement
benefits, the surviving spouse must be provided with a
qualified preretirement survivor annuity. A qualified
preretirement survivor annuity provides the surviving spouse
with a benefit that is not less than what would have been paid
under the survivor portion of the qualified joint and survivor
annuity. Certain defined contribution plans, (such as profit
sharing and 401(k) plans) are not required to provide these
survivor annuities provided certain conditions are satisfied,
including that the spouse be the beneficiary of the
participant's entire account balance.
Plans subject to the survivor annuity requirements may
permit participants to waive the right to receive these
annuities provided certain conditions are satisfied. In
general, these conditions include (1) providing the participant
with a written explanation of the terms and conditions of the
survivor annuity, (2) the right to make, and the effect of, a
waiver of the annuity, (3) the rights of the spouse to waive
the survivor annuity, and (4) the right of the participant to
revoke the waiver. In addition, the spouse must provide a
written consent to the waiver, witnessed by a plan
representative or a notary public, which acknowledges the
effect of the waiver.
Election periods and right to know employer contribution formula
Under present law, there are certain nondiscrimination
tests that apply to contributions made to 401(k) plans. In
general, the actual deferral percentage (``ADP'') test applies
to the elective contributions of all employees under the plan
and the average contribution percentage (``ACP'') test applies
to employer matching and after-tax employee contributions. The
ADP test is satisfied if the average percentage of elective
contributions for highly compensated employees does not exceed
the average percentage of elective contributions for nonhighly
compensated employees by a specified percentage. The ACP test
is similar but it tests the average contribution percentages of
the highly compensated employees and nonhighly compensated
employees.
As an alternative to annual testing under the ADP and ACP
tests, the Small Business Job Protection Act of 1996 provides
two alternative ``design-based'' 401(k) safe harbors, effective
beginning in 1999. If the employees are provided a specified
matching contribution (or a specified nonelective
contribution), the employer can avoid all ADP and ACP testing
of employee elective contributions and employer matching
contributions. There are similar safe-harbor designs under the
SIMPLE plan and the SIMPLE 401(k) plan. Under the SIMPLE plans,
employees must be provided annual 60-day election periods and
notification tied to those election periods. Unlike the SIMPLE
plans, for 401(k) plans using the safe harbor designs there are
no specific requirements that prescribe the length and
frequency of the election period or that tie the timing of the
notice describing employee rights and obligations under the
plan.
Description of Proposal
Spouse's right to know distribution information
The proposal would provide that when an explanation of a
plan's survivor benefits is provided to participants, a copy of
the explanation would be required to be provided to the
participant's spouse. If the last known mailing address of the
participant and spouse is the same, then the explanation and a
copy of the explanation can be provided in a single mailing
addressed to the participant and the spouse.
Election periods and right to know employer contribution formula
The proposal would require employers who use one of the
safe harbor designs to avoid ADP and ACP testing to provide
notice and contribution opportunities comparable to those
provided under SIMPLE plans. Thus, employees would have to be
offered an opportunity to elect to make contributions (or
modify a prior election) during a 60-day period before the
beginning of each year and a 60-day period when they first
become eligible. In addition, the present law requirement that
employers provide employees with notice of their rights to make
contributions and notice of the safe harbor contributions
formula the employer is currently using (in order to notify
employees of their rights and obligations) would be modified to
require the notice within a reasonable period of time before
the 60-day periods begin rather than before the beginning of
the year.
Effective Date
The proposals would be effective for years beginning after
December 31, 1998.
Prior Action
No prior action.
Analysis
The pension right to know proposals would add two new plan
administration requirements. In one case, additional
information must be provided to spouses of plan participants
and in the other case employees must be provided specified
notice and election periods when an employer chooses to use the
401(k) safe harbors. In both cases, it can be argued that the
requirements are necessary so that the individuals affected
understand their rights and have the opportunity to make
informed decisions regarding their benefit entitlements. On the
other hand, the proposals may add to the costs of sponsoring a
plan.
6. Simplified method for improving benefits of nonhighly compensated
employees under the safe harbor for 401(k) plans
Present Law
Under present law, special nondiscrimination tests apply to
contributions made to 401(k) plans. In general, the actual
deferral percentage (``ADP'') test applies to the elective
contributions of all employees under the plan and the average
contribution percentage (``ACP'') test applies to employer
matching and after-tax employee contributions. The ADP test is
satisfied if the average percentage of elective contributions
for highly compensated employees does not exceed the average
percentage of elective contributions for nonhighly compensated
employees by more than a specified percentage. The ACP test is
similar but it tests the average contribution percentages
(i.e., employer matching and after-tax employee contributions)
of the highly compensated employees and nonhighly compensated
employees.
As an alternative to annual testing under the ADP and ACP
tests, the Small Business Job Protection Act of 1996 provides
two alternative ``design-based'' 401(k) safe harbors, effective
beginning in 1999. Under the safe harbor, if the employees are
provided a specified matching contribution or a specified
nonelective contribution, ADP and ACP testing of employee
elective contributions and employer matching contributions is
not required. Under the matching contribution safe harbor, the
employer would have to make nonelective contributions of at
least three percent of compensation for each nonhighly
compensated employee eligible to participate in the plan.
Alternatively, under the other safe harbor, the employer would
have to make a 100 percent matching contribution on an
employee's elective contributions up to the first 3 percent of
compensation and a matching contribution of at least 50 percent
on the employee's elective contributions up to the next 2
percent of compensation.
Description of Proposal
The proposal would modify the section 401(k) matching
formula safe harbor by requiring that, in addition to the
matching contribution, employers would have to make a
contribution of one percent of compensation for each eligible
nonhighly compensated employee, regardless of whether the
employee makes elective contributions.
Effective Date
The proposal would be effective for years beginning after
December 31, 1998, when the 401(k) designed-based safe harbors
become effective.
Prior Action
No prior action.
Analysis
The special nondiscrimination rules for 401(k) plans are
designed to ensure that nonhighly compensated employees, as
well as highly compensated employees, actually receive benefits
under the plan. The nondiscrimination rules give employers an
incentive to make the plan attractive to lower- and middle-
income employees (e.g., by providing a match) and to undertake
efforts to enroll such employees, because the greater the
participation by such employees, the more highly compensated
employees can contribute to the plan.
The design-based safe harbors were designed to achieve the
same objectives as the special nondiscrimination rules, but in
a simplified manner. The nonelective safe harbor ensures a
minimum benefit for employees covered by the plan, and it was
believed that the required employer match would be sufficient
incentive to induce participation by nonhighly compensated
employees. It was also hoped that the design-based safe harbors
would reduce the complexities associated with qualified plans,
and induce more employers to adopt retirement plans for their
employees.
Some are concerned that the safe harbors will not have the
intended effect, but instead will result in less participation
by rank-and-file employees, in part because employers will no
longer have a financial incentive to encourage employees to
participate.
Requiring employers who use the section 401(k) matching
formula safe harbor to make an additional one percent
nonelective contribution for each eligible nonhighly
compensated employee, whether or not the employee makes
elective contributions to the plan, will provide a minimum
benefit for employees covered in the plan and also may
encourage more employees to contribute to the plan and help
ensure that lower- and middle-income employees receive some
benefits. On the other hand, some argue that the purpose of the
safe harbor formulas is to encourage more employers to sponsor
401(k) plans by eliminating the costs associated with annual
testing. Adding a required employer contribution increases
costs to employers and may impede the establishment of
retirement plans. Some also believe that it is inappropriate to
require a contribution to a 401(k) plan if employees do not
make any elective deferrals. Under this view, retirement
savings is a shared obligation of the employer and employee.
7. Simplify definition of highly compensated employee
Present Law
Under present law, an employee is treated as highly
compensated if the employee (1) was a 5-percent owner of the
employer at any time during the year or the preceding year or
(2) either (a) had compensation for the preceding year in
excess of $80,000 (indexed for inflation) or (b) at the
election of the employer had compensation for the preceding
year in excess of $80,000 (indexed for inflation) and was in
the top 20 percent of employees by compensation for such year.
Description of Proposal
The proposal would eliminate the top-paid group election
from the definition of highly compensated employee. Under the
new definition, an employee would be treated as a highly
compensated employee if the employee (1) was a 5-percent owner
of the employer at any time during the year or the preceding
year, or (2) for the preceding year, had compensation in excess
of $80,000 (indexed for inflation).
Effective Date
The proposal would be effective for years beginning after
December 31, 1998.
Prior Action
No prior action.
Analysis
The proposal would further simplify the definition of
highly compensated employee by eliminating the top-paid group
election. Permitting elections that may vary from year to year
increases complexity as employers that may benefit from the
election may feel it necessary to run tests under both options.
In addition, by use of the election, it is possible for
employees earning very high compensation (in excess of $80,000)
to be treated as nonhighly compensated for testing purposes if
the employer has a sufficient percentage of high-paid employees
in its workforce (i.e., if employees earning more than $80,000
are in the top paid 20 percent of employees). This would allow
some employers to effectively eliminate benefits for low- and
moderate-wage workers without violating the nondiscrimination
rules. The proposal may help ensure that the simplified
definition of highly compensated employee better reflects the
purpose of promoting meaningful benefits for low- and moderate-
wage workers, not only the high paid. On the other hand, some
would argue that the greater flexibility provided to employers
under present law is appropriate. Without the flexibility in
testing, some employers may reduce plan benefits or choose to
terminate plans, reducing aggregate pension coverage and
potentially reducing aggregate retirement saving.
8. Simplify benefit limits for multiemployer plans under section 415
Present Law
In general, under present law, annual benefits under a
defined benefit pension plan are limited to the lesser of
$130,000 (for 1998) or 100 percent of average compensation for
the 3 highest years. Reductions in these limits are generally
required if the employee has fewer than10 years of service or
plan participation. If benefits under a defined benefit plan begin
before social security retirement age, the dollar limit must be
actuarially reduced to compensate for the early commencement.
Description of Proposal
Under the proposal, the 100-percent-of-compensation limit
on defined benefit plan benefits would not apply to
multiemployer plans. In addition, certain survivor and
disability benefits payable under multiemployer plans would be
exempt from the adjustments for early commencement of benefits
and for participation and service of less than 10 years.
Effective Date
The proposal would be effective for years beginning after
December 31, 1998.
Prior Action
The proposal was included in the Administration's 1995
Pension Simplification Proposal,\29\ in the Small Business Job
Protection Act of 1996 as passed by the Senate, and in the
Taxpayer Relief Act of 1997 as passed by the Senate.
---------------------------------------------------------------------------
\29\ See Department of the Treasury, Department of Labor, General
Explanation of the Administration's Pension Simplification Proposal
(September 1995).
---------------------------------------------------------------------------
Analysis
The limits on benefits under qualified plans were designed
to limit the tax benefits and revenue loss associated with such
plans, while still ensuring that adequate retirement benefits
could be provided. The 100-percent-of-compensation limitation
reflects Congressional judgment that a replacement rate of 100-
percent-of-compensation is an adequate retirement benefit.
The stated rationale for the proposal is that the qualified
plan limitations present significant administrative problems
for many multiemployer plans which base benefits on years of
credited service not compensation. In addition, it is argued
that the 100-percent of compensation rule produces an
artificially low limit for employees in certain industries,
such as building and construction, where wages vary
significantly from year to year.
Others argue that the limits on benefits under qualified
plans create administrative problems for all plan sponsors, and
that these problems are no greater for multiemployer plans than
for any other plan. In addition, it is argued that there is no
justification for higher benefit limitations for multiemployer
plans, as persons affected by these limits are not all
participants in multiemployer plans. Providing a special rule
for such plans would merely create inequities among plan
participants based upon the type of plan in which they are a
participant. For example, many individuals work in industries
where wages may vary significantly from year to year, but not
all of those employees are participants in multiemployer plans.
To the extent that the qualified plan limits are deemed to
inappropriately reduce benefits in such (or similar cases), it
is argued that it would be more equitable to provide an across
the board rule that is not based upon the type of plan. If it
is believed that a 100-percent of compensation limitation is
not appropriate, it is not clear why only participants in
multiemployer plans should receive the benefit of a higher
limit.
9. Simplify full funding limit for multiemployer plans
Present Law
Under present law, employer deductions for contributions to
a defined benefit pension plan cannot exceed the full funding
limit. In general, the full funding limit is the lesser of a
plan's accrued liability and 150 percent of current liability.
The 150 percent of current liability limit is scheduled to
increase gradually, beginning in 1999, until it is 170 percent
in 2005 and thereafter.
Defined benefit pension plans are required to have an
actuarial valuation no less frequently than annually.
Description of Proposal
Under the proposal, the current liability full funding
limit would not apply to multiemployer plans. In addition, such
plans would be required to have an actuarial valuation at least
once every three years. Changes would be made to the
corresponding provisions of title I of the Employee Retirement
Income Security Act of 1974, as amended.
Effective Date
The proposal would be effective for years beginning after
December 31, 1998.
Prior Action
The proposal was included in the Administration's 1995
Pension Simplification Proposal.\30\
---------------------------------------------------------------------------
\30\ Ibid.
---------------------------------------------------------------------------
Analysis
The current liability full funding limit was enacted as a
balance between differing policy objectives. On one hand is the
concern that defined benefit pension plans should be funded so
as to provide adequate benefit security for plan participants.
On the other hand is the concern that employers should not be
entitled to make excessive contributions to a defined benefit
pension plan to fund liabilities that it has not yet incurred.
Such use of a defined benefit plan was believed to be
equivalent to a tax-free savings account for future
liabilities, and inconsistent generally with the treatment of
unaccrued liabilities under the Internal Revenue Code. The
current liability full funding limit was increased in the
Taxpayer Relief Act of 1997 because the Congress believed that
the 150-percent limit unduly restricted funding of defined
benefit pension plans.
Proponents of the proposal argue that employers have no
incentive to make excess contributions to a multiemployer plan,
because the amount an employer contributes to the plan is set
by a collective bargaining agreement and a particular
employer's contributions are not set aside to pay benefits
solely to the employees of that employer.
Others would argue that it is inappropriate to provide
special rules based on the type of plan. While many
multiemployer plans restrict the ability of the employer to
obtain reversions of excess plan assets on termination of the
plan, not all do, so that an employer may still have an
incentive to fund unincurred liabilities in order to obtain tax
benefits. Also, many plans that are not multiemployer plans
restrict the ability of employers to obtain excess assets,
limiting any incentive to make excess contributions.
Others argue that the proposal should be extended to all
collectively bargained plans (i.e., including single-employer
plans).
10. Eliminate partial termination rules for multiemployer plans
Present Law
Under present law, tax-qualified plans are required to
provide that plan benefits become 100 percent vested (to the
extent funded) upon the termination or partial termination of a
plan. Whether a partial termination has occurred in a
particular situation is generally based on all the facts and
circumstances. Situations that can result in a partial
termination include, for example, the exclusion from the plan
of a group of employees previously covered under the plan due
to a plan amendment or termination of employment by the
employer. In addition, if a defined benefit plan stops or
reduces future benefit accruals under the plan, a partial
termination of the plan is deemed to occur if, as a result of
the cessation or reduction in accruals a potential reversion to
the employer or employers maintaining the plan is created or
increased. If no such reversion is created or increased, a
partial termination is not deemed to occur; however, a partial
termination may be found to have taken place under the
generally applicable rule.
Description of Proposal
The requirement that plan participants must be 100-percent
vested upon partial termination of a plan would be repealed
with respect to multiemployer plans.
Effective Date
The proposal would be effective with respect to partial
terminations that begin after December 31, 1998.
Prior Action
The proposal was included in the Administration's 1995
Pension Simplification Proposal and in the Taxpayer Relief Act
of 1997 as passed by the Senate.\31\
---------------------------------------------------------------------------
\31\ Ibid.
---------------------------------------------------------------------------
Analysis
The partial termination rules help to protect the benefits
of plan participants in circumstances that do not give rise to
a complete termination. In some cases, the partial termination
rules prevent avoidance of the rule requiring vesting upon
complete termination.
Proponents of the proposal argue that the partial
termination rules are not necessary to protect multiemployer
plan participants in the case of terminations due to reductions
in force, because the multiemployer plan structure itself
provides protections. That is, participation in the plan is not
tied to employment with a particular employer, so that an
individual who terminates employment with one employer may
continue participation in the plan if the individual is
employed by an employer participating in the plan.
Others question whether the plan structure will protect
participants in the same manner as the partial termination
rules. There is no assurance that an individual will continue
participation in the plan after an event that would give rise
to a partial termination. In addition, others argue that the
multiemployer plan structure provides no special protection if
the partial termination is due to a plan amendment regarding
eligibility or due to cessation or reduction of accruals under
a defined benefit pension plan.
D. Education Tax Provisions
1. Tax credits for holders of qualified school modernization bonds and
qualified zone academy bonds
Present Law
Tax-exempt bonds
Interest on State and local governmental bonds generally is
excluded from gross income for Federal income tax purposes if
the proceeds of the bonds are used to finance direct activities
of these governmental units, including the financing of public
schools (sec. 103).
Qualified zone academy bonds
Certain financial institutions (i.e., banks, insurance
companies, and corporations actively engaged in the business of
lending money) that hold ``qualified zone academy bonds'' are
entitled to a nonrefundable tax credit in an amount equal to a
credit rate (set monthly by the Treasury Department) multiplied
by the face amount of the bond (sec. 1397E). The credit rate
applies to all such bonds issued in each month. A taxpayer
holding a qualified zone academy bond on the credit allowance
date (i.e., each one-year anniversary of the issuance of the
bond) is entitled to a credit. The credit is includible in
gross income (as if it were an interest payment on the bond),
and may be claimed against regular income tax and AMT
liability.
The Treasury Department will set the credit rate each month
at a rate estimated to allow issuance of qualified zone academy
bonds without discount and without interest cost to the issuer.
The maximum term of the bond issued in a given month also is
determined by the Treasury Department, so that the present
value of the obligation to repay the bond is 50 percent of the
face value of the bond. Such present value will be determined
using as a discount rate the average annual interest rate of
tax-exempt obligations with a term of 10 years or more issued
during the month.
``Qualified zone academy bonds'' are defined as any bond
issued by a State or local government, provided that (1) at
least 95 percent of the proceeds are used for the purpose of
renovating, providing equipment to, developing course materials
for use at, or training teachers and other school personnel in
a ``qualified zone academy'' and (2) private entities have
promised to contribute to the qualified zone academy certain
equipment, technical assistance or training, employee services,
or other property or services with a value equal to at least 10
percent of the bond proceeds.
A school is a ``qualified zone academy'' if (1) the school
is a public school that provides education and training below
the college level, (2) the school operates a special academic
program in cooperation with businesses to enhance the academic
curriculum and increase graduation and employment rates, and
(3) either (a) the school is located in an empowerment zone or
enterprise community (including empowerment zones designated or
authorized to be designated\32\), or (b) it is reasonably
expected that at least 35 percent of the students at the school
will be eligible for free or reduced-cost lunches under the
school lunch program established under the National School
Lunch Act.
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\32\ Pursuant to the Omnibus Budget Reconciliation Act of 1993
(OBRA 1993), the Secretaries of the Department of Housing and Urban
Development (HUD) and the Department of Agriculture designated a total
of nine empowerment zones and 95 enterprise communities on December 21,
1994 (sec. 1391). Designated empowerment zones and enterprise
communities were required to satisfy certain eligibility criteria,
including specified poverty rates and population and geographic size
limitations (sec. 1392). The Code provides special tax incentives for
certain business activities conducted in empowerment zones and
enterprise communities (secs. 1394, 1396, and 1397A). In addition, the
Taxpayer Relief Act of 1997 provides for the designation of 22
additional empowerment zones (secs. 1391(b)(2) and 1391(g)).
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A total of $400 million of ``qualified zone academy bonds''
may be issued in each of 1998 and 1999. The $400 million
aggregate bond cap will be allocated each year to the States
according to their respective populations of individuals below
the poverty line.\33\ Each State, in turn, will allocate the
credit to qualified zone academies within such State. A State
may carry over any unused allocation into subsequent years.
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\33\ See Rev. Proc. 98-9, which sets forth the maximum face amount
of qualified zone academy bonds that may be issued for each State
during 1998; IRS Proposed Rules (REG-119449-97), which provides
guidance to holders and issuers of qualified zone academy bonds.
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Description of Proposal
Qualified zone academy bonds
The proposal would increase the aggregate bond cap for
qualified zone academy bonds for 1999 from $400 million to $1.4
billion. In addition, the proposal would authorize the issuance
of an additional $1.4 billion of qualified zone academy bonds
for 2000. As under present law, the aggregate bond cap would be
allocated to the States according to their respective
populations of individuals below the poverty line, and States
could carry over unused allocations into subsequent years.
The proposal also would expand the list of permissible uses
of proceeds of qualified zone academy bonds to include new
school construction. Moreover, the proposal would set the
maximum term of qualified zone academy bonds at 15 years.
Qualified school modernization bonds
Under the proposal, State and local governments would be
able to issue ``qualified school modernization bonds'' to fund
the construction or rehabilitation of public schools. Similar
to the tax benefits available to holders of qualified zone
academy bonds, the holders of qualified school modernization
bonds would receive annual Federal income tax credits in lieu
of interest payments. Because the proposed credits would
compensate the holder for lending money, such credits would be
treated as payments of interest for Federal income tax purposes
and, accordingly, would be included in the holder's gross
income. As with qualified zone academy bonds, the ``credit
rate'' for qualified school modernization bonds would be set by
the Secretary of the Treasury so that, on average, such bonds
would be issued without interest, discount, or premium. The
maximum term of the bonds would be 15 years.
In contrast to qualified zone academy bonds, any person
(and not only financial institutions) holding a qualified
school modernization bond would be able to claim a tax credit
under the proposal. Information returns would be required to be
provided to the holders of qualified school modernization bonds
and to the IRS with respect to the tax credits related to such
bonds.
A total of $9.7 billion of qualified school modernization
bonds could be issued in each of 1999 and 2000, to be allocated
among the States. Half of this annual $9.7 billion cap would be
allocated among the 100 school districts with the largest
number of low-income children.34 The remaining half
of the annual cap would be divided among the States and Puerto
Rico in proportion to their shares of Federal assistance under
the Basic Grant Formula (contained in Title I of the Elementary
and Secondary Education Act of 1965), adjusted for amounts
allocated to the 100 school districts with the largest number
of low-income children.35 A State, possession, or
eligible school district would be permitted to carry forward
any unused portion of its allocation until September 30, 2003.
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\34\ The cap would be allocated among the 100 districts based on
the amounts of Federal assistance each district receives under the
Basic Grant Formula for Title I of the Elementary and Secondary
Education Act of 1965. This assistance is based primarily upon the
number of low- income children residing in the district, with an
adjustment for differences in per-pupil expenditures.
\35\ A small portion of the total cap would be set aside for each
possession (other than Puerto Rico) based on its share of the total
U.S. poverty population. The relative shares of assistance provided
under the Basic Grant Formula would be determined by the Secretary of
the Treasury based on the most recent data available from the
Department of Education on November 1 of the year prior to the year for
which the allocation of authority to issue qualified school
modernization bonds is made.
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Under the proposal, a bond would be treated as a qualified
school modernization bond only if the following three
requirements are satisfied: (1) the Department of Education
approves the construction plan of the State or eligible school
district, which plan must (a) demonstrate that a comprehensive
survey has been undertaken of the construction and renovation
needs in the jurisdiction, and (b) describe how the
jurisdiction will assure that bond proceeds are used as
proposed; (2) the State or local governmental entity issuing
the bond receives an allocation for the bond from the State
educational agency or eligible school district; and (3) at
least 95 percent of the bond proceeds must be used to construct
or rehabilitate public school facilities.36 In
contrast to qualified zone academy bonds, the proposed
qualified school modernization bonds would not be subject to a
requirement that private businesses contribute a specified
amount of goods or services to the local school district.
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\36\ In determining whether this third requirement is satisfied,
taxpayers may rely on principles used to determine satisfaction of
similar requirements with respect to tax-exempt obligations.
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Effective Date
The provisions regarding qualified school modernization
bonds would be effective for such bonds issued in 1999 and 2000
(and such bonds issued prior to September 30, 2003, with
respect to unused allocations carried forward from 1999 or
2000). The provisions regarding qualified zone academy bonds
would be effective for such bonds issued in 1999 and 2000 (and
such bonds issued thereafter with respect to unused
allocations).
Prior Action
The credit for certain holders of qualified zone academy
bonds (sec. 1397E) was enacted as part of the Taxpayer Relief
Act of 1997.
Analysis
The President's proposals to expand the allocation for (and
permissible uses of) zone academy bonds and to establish school
modernization bonds would subsidize a portion of the costs of
new investment in public school infrastructure and, in certain
qualified areas, equipment and teacher training. By subsidizing
such costs, it is possible that additional investment will take
place relative to investment that would take place in the
absence of the subsidy. If no additional investment takes place
than would otherwise, the subsidy would merely represent a
transfer of funds from the Federal Government to State and
local governments. This would enable the State and local
governments to spend the savings on other government functions
or to reduce taxes.37 In this event, the stated
objective of the proposals would not be achieved. If the
subsidy is successful at encouraging new investment, the
quality of education could be improved.
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\37\ Most economic studies have found that when additional funding
is made available to localities from outside sources, there is indeed
an increase in public spending (this is known as the ``fly-paper''
effect, as the funding tends to ``stick'' where it is applied). The
additional spending is not dollar for dollar, however, implying that
there is some reduction of local taxes to offset the outside funding.
See Harvey Rosen, Public Finance, Second Ed., 1988, p.530 for a
discussion of this issue.
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To be eligible for the qualified zone academy bonds, State
and local governments also must obtain private business
contributions to the qualified zone academy in amounts equal to
at least 10 percent of the bond proceeds. Such a requirement
further lowers the costs to State and local governments of a
successful zone academy bond issue, relative to the amount of
funds that are made available for the qualified zone academy.
However, the requirement also makes it more difficult to obtain
the subsidy from the Federal Government, as private support
needs to be obtained. The requirement may make it more likely
that a successful bond issue will represent new, incremental
investment in qualified zone academies. On the other hand, it
is not certain that this would be the case, since private
businesses already could donate to schools if they were so
motivated. It is possible that the federal subsidy could be
viewed as a ``matching grant'', motivating more private giving.
However, it would remain possible that State and local
governments could receive additional private contributions and
obtain the Federal subsidy and yet not invest any more funds in
public education than they would have otherwise. The proposed
school modernization bonds do not carry the requirement that
private financing also be found.
Though called a tax credit, the Federal subsidy for the
zone academy bonds and the proposed school modernization bonds
is equivalent to the Federal Government directly paying the
interest on a taxable bond issue on behalf of the State or
local government that benefits from the bond
proceeds.38 To see this, consider any taxable bond
that bears an interest rate of 10 percent. A thousand dollar
bond would thus produce an interest payment of $100 annually.
The owner of the bond that receives this payment would receive
a net payment of $100 less the taxes owed on that interest. If
the taxpayer were in the 28-percent Federal tax bracket, such
taxpayer would receive $72 after Federal taxes. Regardless of
whether the State government or the Federal Government pays the
interest, the taxpayer receives the same net of tax return of
$72. In the case of zone academy bonds and the proposed school
modernization bonds, no formal interest is paid by the Federal
Government. Rather, a tax credit of $100 is allowed to be taken
by the holder of the bond. In general, a $100 tax credit would
be worth $100 to a taxpayer, provided that the taxpayer had at
least $100 in tax liability. However, for the zone academy
bonds and the proposed school modernization bonds, the $100
credit also has to be claimed as income. Claiming an additional
$100 in income, though no income is actually realized, costs a
taxpayer in the 28-percent tax bracket an additional $28 in
income taxes, payable to the Federal Government. With the $100
tax credit that is ultimately claimed, the taxpayer nets $72 on
the bond. The Federal Government loses $100 on the credit, but
recoups $28 of that by the requirement that it be included in
income, for a net cost of $72, which is exactly the net return
to the taxpayer. If the Federal Government had simply agreed to
pay the interest on behalf of the State or local government,
both the Federal Government and the bondholder/taxpayer would
be in the same situation as previously. The Federal Government
would make outlays of $100 in interest payments, but would
recoup $28 of that in tax receipts, for a net budgetary cost of
$72, as before. Similarly, the bondholder/taxpayer would
receive a taxable $100 in interest, and would owe $28 in taxes,
for a net gain of $72, as before. The State and local
government would also be in the same situation in both cases.
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\38\ This is true provided that the taxpayer faces tax liability of
at least the amount of the credit. Without sufficient tax liability,
the proposed tax credit arrangement would not be as advantageous.
Presumably, only taxpayers who anticipate having sufficient tax
liability to be offset by the proposed credit would hold these bonds.
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The proposed tax credit arrangement to subsidize public
school investment, as opposed to the equivalent direct interest
payment by the Federal Government on behalf of the State or
locality, raises some questions of administrative efficiencies
and tax complexity. Because potential purchasers of the bonds
must educate themselves as to whether the bonds qualify for the
credit, certain ``information costs'' are imposed on the buyer.
Additionally, since the determination as to whether the bond is
qualified for the credit ultimately rests with the Federal
Government, additional risk is imposed on the investor relative
to a Federal agreement to directly make the interest payments
to the bondholders on behalf of the State or locality that
issues the bond. For these reasons, and the fact that the bonds
will be less liquid than comparable Federal
obligations,39 the Treasury Department has decided
that the zone academy bonds under the proposal will pay a
credit rate that is 110 percent of the long-term applicable
Federal rate (AFR).40 Since the Federal Government
must ultimately determine the eligibility of the bonds for the
credit, it would appear that an otherwise equivalent direct
spending program where the Federal Government promises upfront
to pay the interest would remove some information costs to the
bondholder as well as the risk of buying a bond that could
ultimately be deemed to not qualify for the credit. The bonds
would then presumably bear a lower interest rate, which would
reduce the effective costs of the program to the Federal
Government. Additionally, the direct payment of interest would
involve less complexity in administering the income tax, as the
interest could simply be reported as any other taxable
interest. Finally, the tax credit implies that non-taxable
entities could not take advantage of the bonds to assist school
investment. In the case of a direct payment of interest, non-
profits would be able to take advantage of the bonds.
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\39\ There is also more risk that the principal will not be repaid,
since investors consider the credit risk of States and localities to be
greater than that of the Federal Government.
\40\ The proposed school modernization bonds credit rate would be
set by the Secretary of the Treasury so that, on average, the bonds
could be issued without interest, discount, or premium. That rate has
not yet been established.
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2. Exclusion for employer-provided educational assistance
Present Law
Under present law (Code sec. 127), an employee's gross
income and wages do not include amounts paid or incurred by the
employer for educational assistance provided to the employee if
such amounts are paid or incurred pursuant to an educational
assistance program that meets certain requirements. This
exclusion is limited to $5,250 of educational assistance with
respect to an individual during a calendar year. In the absence
of the exclusion, educational assistance is excludable from
income only if it is related to the employee's current job. The
exclusion applies with respect to undergraduate courses
beginning before June 1, 2000. The exclusion does not apply to
graduate level courses beginning after June 30, 1996.
Description of Proposal
The proposal would expand the exclusion for employer-paid
educational assistance to graduate education, and extend the
exclusion (as applied to both graduate and undergraduate
education) through May 2001.
Effective Date
The proposal to extend the exclusion for undergraduate
courses would be effective for courses beginning before June 1,
2001. The exclusion with respect to graduate-level courses
would be effective for courses beginning after June 30, 1998
and before June 1, 2001.
Prior Action
A similar proposal to extend the exclusion to graduate-
level courses was included in the President's fiscal year 1997
budget proposal and in the 1997 Senate bill.
Analysis
The exclusion for employer-provided educational assistance
programs is aimed at increasing the levels of education and
training in the workforce. The exclusion also reduces
complexity in the tax laws. Employer-provided educational
assistance benefits may serve as a substitute for cash wages
(or other types of fringe benefits) in the overall employment
compensation package. Because of their favorable tax treatment,
benefits received in this form are less costly than cash wages
in terms of the after-tax cost of compensation to the employee.
Present-law section 127 serves to subsidize the provision
of education and could lead to larger expenditures on education
for workers than would otherwise occur. This extra incentive
for education may be desirable if some of the benefits of an
individual's education accrue to society at large through the
creation of a better-educated populace or workforce, i.e.,
assuming that education creates ``positive externalities.'' In
that case, absent the subsidy, individuals would underinvest in
education (relative to the socially desirable level) because
they would not take into account the benefits that others
indirectly receive. To the extent that expenditures on
education represent purely personal consumption, a subsidy
would lead to overconsumption of education.41
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\41\ For a broader discussion of social and private benefits from
education and an analysis of subsidies to education, see Joint
Committee on Taxation, Analysis of Proposed Tax Incentives for Higher
Education (JCS-3-97), March 4, 1997, pp.19-23.
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Because present-law section 127 provides an exclusion from
gross income for certain employer-provided education benefits,
the value of this exclusion in terms of tax savings is greater
for those taxpayers with higher marginal tax rates. Thus,
higher-paid individuals, individuals with working spouses, or
individuals with other sources of income may be able to receive
larger tax benefits than their fellow workers. Section 127 does
not apply, however, to programs under which educational
benefits are provided only to highly compensated employees.
In general, in the absence of section 127, the value of
employer-provided education is excludable from income only if
the education relates directly to the taxpayer's current job.
If the education would qualify the taxpayer for a new trade or
business, however, then the value of the education generally
would be treated as part of the employee's taxable
compensation. Under this rule, higher-income, higher-skilled
individuals may be more able to justify education as related to
their current job because of the breadth of their current
training and responsibilities. For example, a lawyer or
professor may find more courses of study directly related to
his or her current job and not qualifying him or her for a new
trade than would a clerk.
The section 127 exclusion for employer-provided educational
assistance may counteract this effect by making the exclusion
widely available. Proponents argue that the exclusion is
primarily useful to non-highly compensated employees to improve
their competitive position in the work force. In practice,
however, the scant evidence available seems to indicate that
those individuals receiving employer-provided educational
assistance are somewhat more likely to be higher-paid
workers.42 The amount of the education benefits
provided by an employer also appears to be positively
correlated with the income of the recipient worker. Such
evidence is consistent with the observation that, in practice,
the exclusion is more valuable to those individuals in higher
marginal tax brackets. A reformulation of the incentive as an
inclusion of the value of benefits into income in conjunction
with a tax credit could make the value of the benefit more even
across recipients subject to different marginal tax
brackets.43
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\42\ See, for example, Coopers & Lybrand, ``Section 127 Employee
Educational Assistance: Who Benefits? At What Cost?,'' June 1989, p.
15, and Steven R. Aleman, ``Employer Education Assistance: A Profile of
Recipients, Their Educational Pursuits, and Employers,'' CRS Report,
89-33 EPW, January 10, 1989, p. 9.
\43\ If the credit were nonrefundable, then to the extent that a
taxpayer reduces his or her tax liability to zero, he or she may not be
able to receive the full value of the credit.
---------------------------------------------------------------------------
Reinstating the exclusion for graduate-level employer-
provided educational assistance may enable more individuals to
seek higher education. Some argue that greater levels of higher
education are important to having a highly trained and
competitive workforce, while others argue that the tax benefits
from extending the exclusion to graduate-level education will
accrue mainly to higher-paid workers. Others would argue that
it would be desirable to extend the exclusion to graduate-level
education, but that limiting the exclusion in this manner is
appropriate given budgetary constraints.
In addition to furthering education objectives, the
exclusion for employer-provided educational assistance may
reduce tax-law complexity. In the absence of the exclusion,
employers and employees must make a determination of whether
the exclusion is job-related. This determination is highly
factual in nature, and can lead to disputes between taxpayers
and the IRS, who may come to different conclusions based on the
same facts. The exclusion eliminates the need to make this
determination.
The exclusion for employer-provided education has always
been enacted on a temporary basis. It has been extended
frequently, and often retroactively. The past experience of
allowing the exclusion to expire and subsequently retroactively
extending it has created burdens for employers and employees.
Employees may have difficulty planning for their educational
goals if they do not know whether their tax bills will
increase. Employers have administrative problems determining
the appropriate way to report and withhold on educational
benefits each time the exclusion expires before it is extended.
Providing greater certainty by further extending the exclusion
may reduce administrative burdens and complexity, as well as
enable individuals to better plan for their educational costs.
3. Eliminate tax on forgiveness of direct student loans subject to
income contingent repayment
Present Law
Code section 108(f)
In the case of an individual, gross income subject to
Federal income tax does not include any amount from the
forgiveness (in whole or in part) of certain student loans,
provided that the forgiveness is contingent on the student's
working for a certain period of time in certain professions for
any of a broad class of employers (sec. 108(f)).
Student loans eligible for this special rule must be made
to an individual to assist the individual in attending an
educational institution that normally maintains a regular
faculty and curriculum and normally has a regularly enrolled
body of students in attendance at the place where its education
activities are regularly carried on. Loan proceeds may be used
not only for tuition and required fees, but also to cover room
and board expenses (in contrast to tax free scholarships under
section 117, which are limited to tuition and required fees).
The loan must be made by (1) the United States (or an
instrumentality or agency thereof), (2) a State (or any
political subdivision thereof), (3) certain tax-exempt public
benefit corporations that control a State, county, or municipal
hospital and whose employees have been deemed to be public
employees under State law, or (4) an educational organization
that originally received the funds from which the loan was made
from the United States, a State, or a tax-exempt public benefit
corporation. In addition, an individual's gross income does not
include amounts from the forgiveness of loans made by
educational organizations (and certain tax- exempt
organizations in the case of refinancing loans) out of private,
nongovernmental funds if the proceeds of such loans are used to
pay costs of attendance at an educational institution or to
refinance outstanding student loans 44 and the
student is not employed by the lender organization. In the case
of loans made or refinanced by educational organizations (as
well as refinancing loans made by certain tax-exempt
organizations) out of private funds, the student's work must
fulfill a public service requirement.45 The student
must work in an occupation or area with unmet needs and such
work must be performed for or under the direction of a tax-
exempt charitable organization or a governmental entity.
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\44\ A technical correction is required to clarify that gross
income does not include amounts from the forgiveness of loans made by
educational organizations and certain tax-exempt organizations to
refinance any existing student loan (and not just loans made by
educational organizations). A provision to this effect is included in
Title VI (sec. 604(e)) of H.R. 2676, the Tax Technical Corrections Act
of 1997, as passed by the House on November 5, 1997.
\45\ A technical correction is required to clarify that refinancing
loans made by educational organizations and certain tax-exempt
organizations must be made pursuant to a program of the refinancing
organization (e.g., school or private foundation) that requires the
student to fulfill a public service work requirement. A provision to
this effect is included in Title VI (sec. 604(e)) of H.R. 2676, the Tax
Technical Corrections Act of 1997, as passed by the House on November
5, 1997.
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Federal Direct Loan Program; income-contingent repayment option
A major change in the delivery of Federal student loans
occurred in 1993. The Student Loan Reform Act (SLRA), part of
the Omnibus Budget Reconciliation Act of 1993, converted the
Federal Family Education Loans (FFEL), which were made by
private lenders and guaranteed by the Federal Government, into
direct loans made by the Federal Government to students through
their schools (the William D. Ford Direct Loan
Program).46 The Direct Loan Program began in
academic year 1994-95 and was to be phased in, with at least 60
percent of all student loan volume to be direct loans by the
1998-1999 academic year.
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\46\ For a comprehensive description of the Federal Direct Loan
program, see U.S. Library of Congress, Congressional Research Service,
``The Federal Direct Student Loan Program,'' CRS Report for Congress
No. 95-110 EPW, by Margot A. Schenet (Washington, D.C.) updated October
16, 1996.
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Federal Direct Loans include Federal Direct Stafford/Ford
Loans (subsidized and unsubsidized), Federal Direct PLUS loans,
and Federal Direct Consolidation loans. The SLRA requires that
the Secretary of Education offer four alternative repayment
options for direct loan borrowers: standard, graduated,
extended, and income-contingent. However, the income-contingent
option is not available to Direct PLUS borrowers. If the
borrower does not choose arepayment plan, the Secretary may
choose one, but may not choose the income-contingent repayment
option.47 Borrowers are allowed to change repayment plans at
any time.
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\47\ Defaulted borrowers of direct or guaranteed loans may also be
required to repay through an income-contingent plan for a minimum
period.
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Under the income-contingent repayment option, a borrower
must make annual payments for a period of up to 25 years based
on the amount of the borrower's Direct Loan (or Direct
Consolidated Loan), adjusted gross income (AGI) during the
repayment period, and family size.48 Generally, a
borrower's monthly loan payment is capped at 20 percent of
discretionary income (AGI minus the poverty level adjusted for
family size).49 If the loan is not repaid in full at
the end of a 25-year period, the remaining debt is canceled by
the Secretary of Education. There is no community or public
service requirement.
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\48\ The Department of Education revised the regulations governing
the income-contingent repayment option, effective July 1, 1996. See
Federal Register, December 1, 1995, pp. 61819-61828.
\49\ If the monthly amount paid by a borrower does not equal the
accrued interest on the loan, the unpaid interest is added to the
principal amount. This is called ``negative amortization.'' Under the
income-contingent repayment plan, the principal amount cannot increase
to more than 110 percent of the original loan; additional unpaid
interest continues to accrue, but is not capitalized.
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Description of Proposal
The exclusion would be expanded to cover forgiveness of
direct student loans made through the William D. Ford Federal
Direct Loan Program where loan repayment and forgiveness are
contingent on the borrower's income level.
Effective Date
The proposal would be effective for loan cancellations
after December 31, 1998.
Prior Action
The proposal was included in the President's fiscal year
1998 budget proposal, as well as in the House and Senate
versions of the Taxpayer Relief Act of 1997. The proposal was,
however, dropped in conference.
Analysis
There are three types of expenditures incurred by students
in connection with their education: (1) direct payment of
tuition; (2) payment via implicit transfers received from
governments or private persons; and (3) forgone wages. The
present-law income tax generally treats direct payments of
tuition as consumption, neither deductible nor amortizable. By
not including the implicit transfers from governments or
private persons in the income of the student, present law
offers the equivalent of expensing of those expenditures
undertaken on behalf of the student by governments and private
persons. This treatment that is the equivalent of expensing
also is provided for direct transfers to students in the form
of qualified scholarships excludable from income. Similarly,
because forgone wages are never earned, the implicit
expenditure incurred by students forgoing present earnings also
receives expensing under the present-law income
tax.50
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\50\ For a more complete discussion of education expenses under a
theoretical income tax and the present-law income tax prior to changes
made in the 1997 Act, see Joint Committee on Taxation, Analysis of
Proposed Tax Incentives for Higher Education (JCS-3-97), March 4, 1997,
pp.19-23.
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The Federal Government could help a student finance his or
her tuition and fees by making a loan to the student or
granting a scholarship to the student. In neither case are the
funds received by the student includable in taxable income.
Economically, a subsequent forgiveness of the loan converts the
original loan into a scholarship. Thus, as noted above,
exempting a scholarship or forgiving a loan is equivalent to
permitting a deduction for tuition paid.
While section 117 generally excludes scholarships from
income to the extent it is used for qualified tuition and
related expenses regardless of the recipient's income level,
certain other education tax benefits are subject to expenditure
and income limitations. For example, The HOPE credit limits
expenditures that qualify for tax benefit to $2,000 annually
(indexed for inflation after the year 2000) and the Lifetime
Learning credit limits expenditures that qualify for tax
benefit to $5,000 annually ($10,000 beginning in
2003).51 In addition, the HOPE and Lifetime Learning
credits are limited to taxpayers with modified adjusted gross
incomes of $50,000 ($100,000 for joint filers) or less. No
comparable expenditure or income limitations would apply to
individuals who benefit from loan forgiveness under the
proposal. For example, the expenditure limitation contained in
section 117 would not apply; thus, the provision could permit
students to exclude from income amounts in excess of qualified
tuition and related expenses that would have been excludable
under section 117 had the loan constituted a scholarship when
initially made. However, it could be argued that expenditure
limits are not necessary because the Federal Direct Loan
program includes restrictions on the annual amount that a
student may borrow, and that income limitations are unnecessary
because an individual who has not repaid an income contingent
loan in full after 25 years generally would be a lower-income
individual throughout most of that 25-year period.
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\51\ For a more complete description of the HOPE and Lifetime
Learning credits, see Joint Committee on Taxation, General Explanation
of Tax Legislation Enacted in 1997 (JCS-23-97), December 17, 1997, pp.
11-20.
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In addition, expanding section 108(f) to cover forgiveness
of Federal Direct Loans for which the income-contingent
repayment option is elected does not appear to be consistent
with the conceptual framework of 108(f). There is no explicit
or implicit public service requirement for cancellation of a
Federal Direct Loan under the income-contingent repayment
option. Rather, the only preconditions are a low AGI and the
passage of 25 years.
As of May 1, 1996, 15 percent of the Direct Loan borrowers
in repayment had selected the income-contingent
option.52 Among those who choose the income-
contingent repayment option, the Department of Education has
estimated that slightly less than 12 percent of borrowers will
fail to repay their loans in full within 25 years and, thus,
will have the unpaid amount of their loans discharged at the
end of the 25-year period.53 In this regard, it is
important to note that the primary revenue effects associated
with this provision would not commence until 2019-25 years
after the program originated in 1994.
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\52\ The Federal Direct Student Loan Program, p.12. The Department
of Education estimates that approximately 60 percent of borrowers will
be in a repayment plan other than the standard 10-year repayment plan.
\53\ See Federal Register, September 20, 1995, p. 48849.
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E. Extend Certain Expiring Tax Provisions
1. Extend the work opportunity tax credit
Present Law
The work opportunity tax credit (``WOTC'') is available on
an elective basis for employers hiring individuals from one or
more of eight targeted groups. The credit generally is equal to
a percentage of qualified wages. The credit percentage is 25
percent for employment of at least 120 hours but less than 400
hours and 40 percent for employment of 400 hours or more.
Qualified wages consist of wages attributable to service
rendered by a member of a targeted group during the one-year
period beginning with the day the individual begins work for
the employer. For a vocational rehabilitation referral,
however, the period begins on the day the individual begins
work for the employer on or after the beginning of the
individual's vocational rehabilitation plan as under prior law.
Generally, no more than $6,000 of wages during the first
year of employment is permitted to be taken into account with
respect to any individual. Thus, the maximum credit per
individual is $2,400. With respect to qualified summer youth
employees, the maximum credit is 40 percent of up to $3,000 of
qualified first-year wages, for a maximum credit of $1,200. The
credit expires for wages paid to, or incurred with respect to,
qualified individuals who begin work for the employer after
June 30, 1998.
The deduction for wages is reduced by the amount of the
credit.
Description of Proposal
The proposal would extend the WOTC for 22 months (through
April 30, 2000).
Effective Date
The proposal would be effective for wages paid to, or
incurred with respect to, qualified individuals who begin work
for the employer after June 30, 1998 and before May 1, 2000.
Prior Action
The Taxpayer Relief Act of 1997 provided for several
modifications to the WOTC and extended the credit for wages
paid to, or incurred with respect to, qualified individuals who
begin work for the employer before July 1, 1998.
Analysis
Overview
The WOTC is intended to increase the employment and
earnings of targeted group members. The credit is made
available to employers as an incentive to hire members of the
targeted groups. To the extent the value of the credit is
passed on from employers to employees, the wages of target
group employees will be higher than they would be in the
absence of the credit.54
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\54\ For individuals with productivity to employers lower than the
minimum wage, the credit may result in these individuals being hired
and paid the minimum wage. For these cases, it would be clear that the
credit resulted in the worker receiving a higher wage than would have
been received in the absence of the credit (e.g., zero).
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The basic rationale for the WOTC is that employers will not
hire certain individuals without a subsidy because either the
individuals are stigmatized (e.g., convicted felons) or the
current productivity of the individuals is below the prevailing
wage rate. Where particular groups of individuals suffer
reduced evaluations of work potential due to membership in one
of the targeted groups, the credit may provide employers with a
monetary offset for the lower perceived work potential. In
these cases, employers may be encouraged to hire individuals
from the targeted groups, and then make an evaluation of the
individual's work potential in the context of the work
environment, rather than from the job application. Where the
current productivity of individuals is currently below the
prevailing wage rate, on-the-job-training may provide
individuals with skills that will enhance their productivity.
In these situations, the WOTC provides employers with a
monetary incentive to bear the costs of training members of
targeted groups and providing them with job-related skills
which may increase the chances of these individuals being hired
in unsubsidized jobs. Both situations encourage employment of
members of the targeted groups, and may act to increase wages
for those hired as a result of the credit.
As discussed below, the evidence is mixed on whether the
rationales for the credit are supported by economic data. The
information presented is intended to provide a structured way
to determine if employers and employees respond to the
existence of the credit in the desired manner.
Efficiency of the credit
The credit provides employers with a subsidy for hiring
members of targeted groups. For example, assume that a worker
eligible for the credit is paid an hourly wage of w and works
2,000 hours during the year. The worker is eligible for the
full credit (40 percent of the first $6,000 of wages), and the
firm will receive a $2,400 credit against its income taxes and
reduce its deduction for wages by $2,400. Assuming the firm
faces the full 34-percent corporate income tax rate, the cost
of hiring the credit-eligible worker is lower than the cost of
hiring a credit-ineligible worker for 2,000 hours at the same
hourly wage w by 2,400(1-.34) = $1,584.55 This
$1,584 amount would be constant for all workers unless the wage
(w) changed in response to whether or not the individual was a
member of a targeted group. If the wage rate does not change in
response to credit eligibility, the WOTC subsidy is larger in
percentage terms for lower wage workers. If w rises in response
to the credit, it is uncertain how much of the subsidy remains
with the employer, and therefore the size of the WOTC subsidy
to employers is uncertain.
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\55\ The after-tax cost of hiring this credit eligible worker would
be ((2,000)(w)-2,400)(1-.34) dollars. This example does not include the
costs to the employer for payroll taxes (e.g., Social security,
Medicare and unemployment taxes) and any applicable fringe benefits.
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To the extent the WOTC subsidy flows through to the workers
eligible for the credit in the form of higher wages, the
incentive for eligible individuals to enter the paid labor
market may increase. Since many members of the targeted groups
receive governmental assistance (e.g., Temporary Assistance for
Needy Families or food stamps), and these benefits are phased
out as income increases, these individuals potentially face a
very high marginal tax rate on additional earnings. Increased
wages resulting from the WOTC may be viewed as a partial offset
to these high marginal tax rates. In addition, it may be the
case that even if the credit has little effect on observed
wages, credit-eligible individuals may have increased earnings
due to increased employment.
The structure of the WOTC (the 40-percent credit rate for
the first $6,000 of qualified wages) appears to lend itself to
the potential of employers churning employees who are eligible
for the credit. This could be accomplished by firing employees
after they earn $6,000 in wages and replacing them with other
WOTC-eligible employees. If training costs are high relative to
the size of the credit, it may not be in the interest of an
employer to churn such employees in order to maximize the
amount of credit claimed. Empirical research in this area has
not found an explicit connection between employee turnover and
utilization of WOTC's predecessor, the Targeted Jobs Tax Credit
(``TJTC'').56
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\56\ See, for example, Macro Systems, Inc., Final Report of the
Effect of the Targeted Jobs Tax Credit Program on Employers, U.S.
Department of Labor, 1986.
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Job creation
The number of jobs created by the WOTC is certainly less
than the number of certifications. To the extent employers
substitute WOTC-eligible individuals for other potential
workers, there is no net increase in jobs created. This could
be viewed as merely a shift in employment opportunities from
one group to another. However, this substitution of credit-
eligible workers for others may not be socially undesirable.
For example, it might be considered an acceptable trade-off for
a targeted group member to displace a secondary earner from a
well-to-do family (e.g., a spouse or student working part-
time).
In addition, windfall gains to employers or employees may
accrue when the WOTC is received for workers that the firm
would have hired even in the absence of the credit. When
windfall gains are received, no additional employment has been
generated by the credit.Empirical research on the employment
gains from the TJTC has indicated that only a small portion of the
TJTC-eligible population found employment because of the program. One
study indicates that net new job creation was between 5 and 30 percent
of the total certifications. This finding is consistent with some
additional employment as a result of the TJTC program, but with
considerable uncertainty as to the exact magnitude.57
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\57\ Macro Systems, Inc., Impact Study of the Implementation and
Use of the Targeted Jobs Tax Credit: Overview and Summary, U.S.
Department of Labor, 1986.
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A necessary condition for the credit to be an effective
employment incentive is that firms incorporate WOTC eligibility
into their hiring decisions. This could be done by determining
credit eligibility for each potential employee or by making a
concerted effort to hire individuals from segments of the
population likely to include members of targeted groups.
Studies examining this issue through the TJTC found that some
employers made such efforts, while other employers did little
to determine eligibility for the TJTC prior to the decision to
hire an individual.58 In these latter cases, the
TJTC provided a cash benefit to the firm, without affecting the
decision to hire a particular worker.
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\58\ For example, see U.S. General Accounting Office, Targeted Jobs
Tax Credit: Employer Actions to Recruit, Hire, and Retain Eligible
Workers Vary (GAO-HRD 91-33), February 1991.
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2. Extend the welfare-to-work tax credit
Present Law
The Code provides to employers a tax credit on the first
$20,000 of eligible wages paid to qualified long-term family
assistance (AFDC or its successor program) recipients during
the first two years of employment. The credit is 35 percent of
the first $10,000 of eligible wages in the first year of
employment and 50 percent of the first $10,000 of eligible
wages in the second year of employment. The maximum credit is
$8,500 per qualified employee.
Qualified long-term family assistance recipients are: (1)
members of a family that has received family assistance for at
least 18 consecutive months ending on the hiring date; (2)
members of a family that has received family assistance for a
total of at least 18 months (whether or not consecutive) after
the date of enactment of this credit if they are hired within 2
years after the date that the 18-month total is reached; and
(3) members of a family who are no longer eligible for family
assistance because of either Federal or State time limits, if
they are hired within 2 years after the Federal or State time
limits made the family ineligible for family assistance.
Eligible wages include cash wages paid to an employee plus
amounts paid by the employer for the following: (1) educational
assistance excludable under a section 127 program (or that
would be excludable but for the expiration of sec. 127); (2)
health plan coverage for the employee, but not more than the
applicable premium defined under section 4980B(f)(4); and (3)
dependent care assistance excludable under section 129.
The welfare-to-work tax credit is effective for wages paid
or incurred to a qualified individual who begins work for an
employer on or after January 1, 1998 and before May 1, 1999.
Description of Proposal
The welfare-to-work tax credit would be extended for one
year, so that the credit would be available for eligible
individuals who begin work before May 1, 2000.
Effective Date
The proposal would be effective for wages paid to or
incurred with respect to, qualified individuals who begin work
for an employer after April 30, 1998 and before May 1, 2000.
Prior Action
The welfare-to-work tax credit was proposed in the
President's fiscal year 1998 budget proposal and enacted in the
Taxpayer Relief Act of 1997.
Analysis
Proponents argue that an extension of the welfare-to-work
tax credit will encourage employers to hire, invest in
training, and provide certain benefits and more permanent
employment, to longer term welfare recipients. Opponents argue
that tax credits to employers for hiring certain classes of
individuals do not increase overall employment and may
disadvantage other deserving job applicants. There are also
concerns about the efficiency of tax credits as an incentive to
potential employees to enter the job market as well as an
incentive for employers to retain such employees after they no
longer qualify for the tax credit (e.g., replacing an employee
whose wages no longer qualify for the tax credit with another
employee whose wages do qualify). For a more detailed
discussion of these issues, refer to the analysis section of
the extension of the work opportunity tax credit in Part I.
E.1., above, of this pamphlet.
3. Extend the research tax credit
Present Law
General rule
Section 41 provides for a research tax credit equal to 20
percent of the amount by which a taxpayer's qualified research
expenditures for a taxable year exceeded its base amount for
that year. The research tax credit is scheduled to expire and
generally will not apply to amounts paid or incurred after June
30, 1998.59
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\59\ A special termination rule applies under section 41(h)(1) for
taxpayers that elected to be subject to the alternative incremental
research credit regime for their first taxable year beginning after
June 30, 1996, and before July 1, 1997.
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A 20-percent research tax credit also applied to the excess
of (1) 100 percent of corporate cash expenditures (including
grants or contributions) paid for basic research conducted by
universities (and certain nonprofit scientific research
organizations) over (2) the sum of (a) the greater of two
minimum basic research floors plus (b) an amount reflecting any
decrease in nonresearch giving to universities by the
corporation as compared to such giving during a fixed-base
period, as adjusted for inflation. This separate credit
computation is commonly referred to as the ``university basic
research credit'' (see sec. 41(e)).
Computation of allowable credit
Except for certain university basic research payments made
by corporations, the research tax credit applies only to the
extent that the taxpayer's qualified research expenditures for
the current taxable year exceed its base amount. The base
amount for the current year generally is computed by
multiplying the taxpayer's ``fixed-base percentage'' by the
average amount of the taxpayer's gross receipts for the four
preceding years. If a taxpayer both incurred qualified research
expenditures and had gross receipts during each of at least
three years from 1984 through 1988, then its ``fixed-base
percentage'' is the ratio that its total qualified research
expenditures for the 1984-1988 period bears to its total gross
receipts for that period (subject to a maximum ratio of .16).
All other taxpayers (so-called ``start-up firms'') are assigned
a fixed-base percentage of 3 percent.60
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\60\ The Small Business Job Protection Act of 1996 expanded the
definition of ``start-up firms'' under section 41(c)(3)(B)(I) to
include any firm if the first taxable year in which such firm had both
gross receipts and qualified research expenses began after 1983.
A special rule (enacted in 1993) is designed to gradually recompute
a start-up firm's fixed-base percentage based on its actual research
experience. Under this special rule, a start-up firm will be assigned a
fixed-base percentage of 3 percent for each of its first five taxable
years after 1993 in which it incurs qualified research expenditures. In
the event that the research credit is extended beyond the scheduled
expiration date, a start-up firm's fixed-base percentage for its sixth
through tenth taxable years after 1993 in which it incurs qualified
research expenditures will be a phased-in ratio based on its actual
research experience. For all subsequent taxable years, the taxpayer's
fixed-base percentage will be its actual ratio of qualified research
expenditures to gross receipts for any five years selected by the
taxpayer from its fifth through tenth taxable years after 1993 (sec.
41(c)(3)(B)).
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In computing the credit, a taxpayer's base amount may not
be less than 50 percent of its current-year qualified research
expenditures.
To prevent artificial increases in research expenditures by
shifting expenditures among commonly controlled or otherwise
related entities, a special aggregation rule provides that all
members of the same controlled group of corporations are
treated as a single taxpayer (sec. 41(f)(1)). Special rules
apply for computing the credit when a major portion of a
business changes hands, under which qualified research
expenditures and gross receipts for periods prior to the change
of ownership of a trade or business are treated as transferred
with the trade or business that gave rise to those expenditures
and receipts for purposes of recomputing a taxpayer's fixed-
base percentage (sec. 41(f)(3)).
Alternative incremental research credit regime
Taxpayers are allowed to elect an alternative incremental
research credit regime. If a taxpayer elects to be subject to
this alternative regime, the taxpayer is assigned a three-
tiered fixed-base percentage (that is lower than the fixed-base
percentage otherwise applicable under present law) and the
credit rate likewise is reduced. Under the alternative credit
regime, a credit rate of 1.65 percent applies to the extent
that a taxpayer's current-year research expenses exceed a base
amount computed by using a fixed-base percentage of 1 percent
(i.e., the base amount equals 1 percent of the taxpayer's
average gross receipts for the four preceding years) but do not
exceed a base amount computed by using a fixed-base percentage
of 1.5 percent. A credit rate of 2.2 percent applies to the
extent that a taxpayer's current-year research expenses exceed
a base amount computed by using a fixed-base percentage of 1.5
percent but do not exceed a base amount computed by using a
fixed-base percentage of 2 percent. A credit rate of 2.75
percent applies to the extent that a taxpayer's current-year
research expenses exceed a base amount computed by using a
fixed-base percentage of 2 percent. An election to be subject
to this alternative incremental credit regime may be made for
any taxable year beginning after June 30, 1996, and such an
election applies to that taxable year and all subsequent years
unless revoked with the consent of the Secretary of the
Treasury.
Eligible expenditures
Qualified research expenditures eligible for the research
tax credit consist of: (1) ``in-house'' expenses of the
taxpayer for wages and supplies attributable to qualified
research; (2) certain time-sharing costs for computer use in
qualified research; and (3) 65 percent of amounts paid by the
taxpayer for qualified research conducted on the taxpayer's
behalf (so-called ``contract research expenses'').61
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\61\ Under a special rule enacted as part of the Small Business Job
Protection Act of 1996, 75 percent of amounts paid to a research
consortium for qualified research is treated as qualified research
expenses eligible for the research credit (rather than 65 percent under
the general rule under section 41(b)(3) governing contract research
expenses) if (1) such research consortium is a tax-exempt organization
that is described in section 501(c)(3) (other than a private
foundation) or section 501(c)(6) and is organized and operated
primarily to conduct scientific research, and (2) such qualified
research is conducted by the consortium on behalf of the taxpayer and
one or more persons not related to the taxpayer.
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To be eligible for the credit, the research must not only
satisfy the requirements of present-law section 174 (described
below) but must be undertaken for the purpose of discovering
information that is technological in nature, the application of
which is intended to be useful in the development of a new or
improved business component of the taxpayer, and must pertain
to functional aspects, performance, reliability, or quality of
a business component. Research does not qualify for the credit
if substantially all of the activities relate to style, taste,
cosmetic, or seasonal design factors (sec. 41(d)(3)). In
addition, research does not qualify for the credit if conducted
after the beginning of commercial production of the business
component, if related to the adaptation of an existing business
component to a particular customer's requirements, if related
to the duplication of an existing business component from a
physical examination of the component itself or certain other
information, or if related to certain efficiency surveys,
market research or development, or routine quality control
(sec. 41(d)(4)).
Expenditures attributable to research that is conducted
outside the United States do not enter into the credit
computation. In addition, the credit is not available for
research in the social sciences, arts, or humanities, nor is it
available for research to the extent funded by any grant,
contract, or otherwise by another person (or governmental
entity).
Relation to deduction
Under section 174, taxpayers may elect to deduct currently
the amount of certain research or experimental expenditures
incurred in connection with a trade or business,
notwithstanding the general rule that business expenses to
develop or create an asset that has a useful life extending
beyond the current year must be capitalized. However,
deductions allowed to a taxpayer under section 174 (or any
other section) are reduced by an amount equal to 100 percent of
the taxpayer's research tax credit determined for the taxable
year. Taxpayers may alternatively elect to claim a reduced
research tax credit amount under section 41 in lieu of reducing
deductions otherwise allowed (sec. 280C(c)(3)).
Description of Proposal
The research tax credit would be extended for twelve
months--i.e., for the period July 1, 1998, through June 30,
1999.
Effective Date
The proposal would be effective for qualified research
expenditures paid or incurred during the period July 1, 1998,
through June 30, 1999.
Prior Action
The research tax credit initially was enacted in the
Economic Recovery Tax Act of 1981 as a credit equal to 25
percent of the excess of qualified research expenses incurred
in the current taxable year over the average of qualified
research expenses incurred in the prior three taxable years.
The research tax credit was modified in the Tax Reform Act of
1986, which (1) extended the credit through December 31, 1988,
(2) reduced the credit rate to 20 percent, (3) tightened the
definition of qualified research expenses eligible for the
credit, and (4) enacted the separate, university basic research
credit.
The Technical and Miscellaneous Revenue Act of 1988 (``1988
Act'') extended the research tax credit for one additional
year, through December 31, 1989. The 1988 Act also reduced the
deduction allowed under section 174 (or any other section) for
qualified research expenses by an amount equal to 50 percent of
the research tax credit determined for the year.
The Omnibus Budget Reconciliation Act of 1989 (``1989
Act'') effectively extended the research credit for nine months
(by prorating qualified expenses incurred before January 1,
1991). The 1989 Act also modified the method for calculating a
taxpayer's base amount (i.e., by substituting the present-law
method which uses a fixed-base percentage for the prior-law
moving base which was calculated by reference to the taxpayer's
average research expenses incurred in the preceding three
taxable years). The 1989 Act further reduced the deduction
allowed under section 174 (or any other section) for qualified
research expenses by an amount equal to 100 percent of the
research tax credit determined for the year.
The Omnibus Budget Reconciliation Act of 1990 extended the
research tax credit through December 31, 1991 (and repealed the
special rule to prorate qualified expenses incurred before
January 1, 1991).
The Tax Extension Act of 1991 extended the research tax
credit for six months (i.e., for qualified expenses incurred
through June 30, 1992).
The Omnibus Budget Reconciliation Act of 1993 (``1993
Act'') extended the research tax credit for three years--i.e.,
retroactively from July 1, 1992 through June 30, 1995. The 1993
Act also provided a special rule for start-up firms, so that
the fixed-base ratio of such firms eventually will be computed
by reference to their actual research experience (see footnote
60 supra).
Although the research tax credit expired during the period
July 1, 1995, through June 30, 1996, the Small Business Job
Protection Act of 1996 (``1996 Act'') extended the credit for
the period July 1, 1996, through May 31, 1997 (with a special
11-month extension for taxpayers that elect to be subject to
the alternative incremental research credit regime). In
addition, the 1996 Act expanded the definition of ``start-up
firms'' under section 41(c)(3)(B)(I), enacted a special rule
for certain research consortia payments under section
41(b)(3)(C), and provided that taxpayers may elect an
alternative research credit regime (under which the taxpayer is
assigned a three-tiered fixed-base percentage that is lower
than the fixed-base percentage otherwise applicable and the
credit rate likewise is reduced) for the taxpayer's first
taxable year beginning after June 30, 1996, and before July 1,
1997.
The Taxpayer Relief Act of 1997 (``1997 Act'') extended the
research credit for 13 months--i.e., generally for the period
June 1, 1997, through June 30, 1998. The 1997 Act also provided
that taxpayers are permitted to elect the alternative
incremental research credit regime for any taxable year
beginning after June 30, 1996 (and such election will apply to
that taxable year and all subsequent taxable years unless
revoked with the consent of the Secretary of the Treasury).
Analysis
Overview
Technological development is an important component of
economic growth. However, while an individual business may find
it profitable to undertake some research, it may not find it
profitable to invest in research as much as it otherwise might
because it is difficult to capture the full benefits from the
research and prevent such benefits from being used by
competitors. In general, businesses acting in their own self-
interest will not necessarily invest in research to the extent
that would be consistent with the best interests of the overall
economy. This is because costly scientific and technological
advances made by one firm are cheaply copied by its
competitors. Research is one of the areas where there is a
consensus among economists that government intervention in the
marketplace can improve overall economic efficiency. \62\
However, this does not mean that increased tax benefits or more
government spending for research always will improve economic
efficiency. It is possible to decrease economic efficiency by
spending too much on research. It is difficult to determine
whether, at the present levels of government subsidies for
research, further government spending on research or additional
tax benefits for research would increase or decrease overall
economic efficiency. There is some evidence that the current
level of research undertaken in the United States, and
worldwide, is too little to maximize society's well-being. \63\
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\62\ This conclusion does not depend upon whether the basic tax
regime is an income tax or a consumption tax.
\63\ See Zvi Griliches, ``The Search for R&D Spillovers,'' National
Bureau of Economic Research, Working Paper No. 3768, 1991 and M. Ishaq
Nadiri, ``Innovations and Technological Spillovers,'' National Bureau
of Economic Research, Working Paper No. 4423, 1993. These papers
suggest that the rate of return to privately funded research
expenditures is high compared to that in physical capital and the
social rate of return exceeds the private rate of return.
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If it is believed that too little research is being
undertaken, a tax subsidy is one method of offsetting the
private-market bias against research, so that research projects
undertaken approach the optimal level. Among the other policies
employed by the Federal Government to increase the aggregate
level of research activities are direct spending and grants,
favorable anti-trust rules, and patent protection. The effect
of tax policy on research activity is largely uncertain because
there is relatively little evidence about the responsiveness of
research to changes in taxes and other factors affecting its
price. To the extent that research activities are responsive to
the price of research activities, the research and
experimentation tax credit should increase research activities
beyond what they otherwise would be. However, the present-law
treatment of research expenditures does create certain
complexities and compliance costs.
The scope of present-law tax expenditures on research activities
The tax expenditure related to the research and
experimentation tax credit is estimated to be $1.6 billion for
1998. The related tax expenditure for expensing of research and
development expenditures is estimated to be $2.6 billion for
1998 growing to $3.4 billion for 2002. \64\ As noted above, the
Federal Government also directly subsidizes research
activities. For example, in fiscal 1997 the National Science
Foundation made $2.2 billion in grants, subsidies, and
contributions to research activities and the Department of
Defense financed $2.1 billion in advanced technology
development. \65\
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\64\ Joint Committee on Taxation, Estimates of Federal Tax
Expenditures for Fiscal Years 1998-2002 (JCS-22-97), December 15, 1997,
p.18.
\65\ Office of Management and Budget, Budget of the United States
Government, Fiscal Year 1999, Appendix, pp. 996 and 275.
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Tables 1 and 2 present data for 1993 on those industries
that utilized the research tax credit and the distribution of
the credit claimants by firm size. Three quarters of the
research tax credits claimed are claimed by taxpayers whose
primary activity is manufacturing. Nearly two- thirds of the
credits claimed are claimed by large firms (assets of $500
million or more). Nevertheless, as Table 2 documents, a large
number of small firms are engaged in research and are able to
claim the research tax credit.
Table 1.--Percentage Distribution of Firms Claiming Research Tax Credit
and of Amount of Credit Claimed by Sector, 1993
------------------------------------------------------------------------
Number of Credit
Sector firms claimed
(percent) (percent)
------------------------------------------------------------------------
Agriculture, Forestry and Fishing................. (\1\) (\1\)
Mining............................................ (\1\) (\1\)
Construction...................................... 0.7 0.4
Manufacturing..................................... 58.0 75.2
Transportation, Communication, and Public
Utilities........................................ 1.4 8.1
Wholesale and Retail Trade........................ 9.1 2.6
Finance, Insurance, and Real Estate............... 1.5 1.3
Services.......................................... 28.3 12.0
------------------------------------------------------------------------
\1\ Data undisclosed to protect taxpayer confidentiality.
Source: Joint Committee on Taxation (JCT) calculations from Internal
Revenue Service, Statistics of Income data.
Table 2.--Percentage Distribution of Firms Claiming Research Tax Credit
and of Amount of Credit Claimed by Firm Size, 1993
------------------------------------------------------------------------
Number of Credit
Asset size (dollars) firms claimed
(percent) (percent)
------------------------------------------------------------------------
0................................................. 0.6 0.2
1--100,000........................................ 13.4 0.4
100,000--250,000.................................. 6.0 0.5
250,000--500,000.................................. 10.2 0.9
500,000--1 million................................ 14.6 1.4
1 million--10 million............................. 32.7 7.9
10 million--50 million............................ 12.2 8.5
50 million--100 million........................... 2.8 4.2
100 million--250 million.......................... 2.4 5.0
250 million--500 million.......................... 1.4 6.0
500 million and over.............................. 3.7 64.9
------------------------------------------------------------------------
Source: JCT calculations from Internal Revenue Service, Statistics of
Income data.
Incremental tax credits
For a tax credit to be effective in increasing a taxpayer's
research expenditures it is not necessary to provide that
credit for all the taxpayer's research expenditures. By
limiting the credit to expenditures above a base amount,
incremental tax credits attempt to target the tax incentives
where they will have the most effect on taxpayer behavior.
Suppose, for example, a taxpayer is considering two
potential research projects: Project A will generate cash flow
with a present value of $105 and Project B will generate cash
flow with present value of $95. Suppose that the cost of
investing in each of these projects is $100. Without any tax
incentives, the taxpayer will find it profitable to invest in
Project A and will not invest in Project B.
Consider now the situation where a 10-percent ``flat
credit'' applies to all research expenditures incurred. In the
case of Project A, the credit effectively reduces the cost to
$90. This increases profitability, but does not change behavior
with respect to that project, since it would have been
undertaken in any event. However, because the cost of Project B
also is reduced to $90, this previously neglected project (with
a present value of $95) would now be profitable. Thus, the tax
credit would affect behavior only with respect to this marginal
project.
Incremental credits attempt not to reward projects which
would have been undertaken in any event and to target
incentives to marginal projects. To the extent this is
possible, incremental credits have the potential to be far more
effective per dollar of revenue cost than flat credits in
inducing taxpayers to increase qualified expenditures.
66 Unfortunately, it is nearly impossible as a
practical matter to determine which particular projects would
be undertaken without a credit and to provide credits only to
other projects. In practice, almost all incremental credit
proposals rely on some measure of the taxpayer's previous
experience as a proxy for a taxpayer's total qualified
expenditures in the absence of a credit. This is referred to as
the credit's ``base amount.'' Tax credits are provided only for
amounts above this base amount.
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\66\ In the example above, if an incremental credit were properly
targeted, the Government could spend the same $20 in credit dollars and
induce the taxpayer to undertake a marginal project so long as its
expected cash flow exceeded $80.
---------------------------------------------------------------------------
Since a taxpayer's calculated base amount is only an
approximation of what would have been spent in the absence of a
credit, in practice, the credit may be less effective per
dollar of revenue cost than it otherwise might be in increasing
expenditures. If the calculated base amount is too low, the
credit is awarded to projects that would have been undertaken
even in the absence of a credit. If, on the other hand, the
calculated base amount is too high, then there is no incentive
for projects that actually are on the margin.
Nevertheless, the incentive effects of incremental credits
per dollar of revenue loss can be many times larger than those
of a flat credit. However, in comparing a flat credit to an
incremental credit, there are other factors that also deserve
consideration. A flat credit generally has lower administrative
and compliance costs than does an incremental credit. Probably
more important, however, is the potential misallocation of
resources and unfair competition that could result as firms
with qualified expenditures determined to be above their base
amount receive credit dollars, while other firms with qualified
expenditures considered below their base amount receive no
credit.
The responsiveness of research expenditures to tax incentives
Like any other commodity, the amount of research
expenditures that a firm wishes to incur generally is expected
to respond positively to a reduction in the price paid by the
firm. Economists often refer to this responsiveness in terms of
``price elasticity,'' which is measured as the ratio of the
percentage change in quantity to a percentage change in price.
For example, if demand for a product increases by five percent
as a result of a 10-percent decline in price paid by the
purchaser, that commodity is said to have a price elasticity of
demand of 0.5.67 One way of reducing the price paid
by a buyer for a commodity is to grant a tax credit upon
purchase. A tax credit of 10 percent (if it is refundable or
immediately usable by the taxpayer against current tax
liability) is equivalent to a 10-percent price reduction. If
the commodity granted a 10-percent tax credit has an elasticity
of 0.5, the amount consumed will increase by five percent.
Thus, if a flat research tax credit were provided at a 10-
percent rate, and research expenditures had a price elasticity
of 0.5, the credit would increase aggregate research spending
by five percent.68
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\67\ For simplicity, this analysis assumes that the product in
question can be supplied at the same cost despite any increase in
demand (i.e., the supply is perfectly elastic). This assumption may not
be valid, particularly over short periods of time, and particularly
when the commodity--such as research scientists and engineers--is in
short supply.
\68\ It is important to note that not all research expenditures
need be subject to a price reduction to have this effect. Only the
expenditures which would not have been undertaken otherwise--so called
marginal research expenditures--need be subject to the credit to have a
positive incentive effect.
---------------------------------------------------------------------------
Despite the central role of the measurement of the price
elasticity of research activities, there is little empirical
evidence on this subject. What evidence exists generally
indicates that the price elasticity for research is
substantially less than one. For example, one survey of the
literature reached the following conclusion:
In summary, most of the models have estimated long-
run price elasticities of demand for R&D on the order
of -0.2 and -0.5. . . . However, all of the
measurements are prone to aggregation problems and
measurement errors in explanatory
variables.69
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\69\ Charles River Associates, An Assessment of Options for
Restructuring the R&D Tax Credit to Reduce Dilution of its Marginal
Incentive (final report prepared for the National Science Foundation),
February, 1985, p. G-14.
Although most analysts agree that there is substantial
uncertainty in these estimates, the general consensus when
assumptions are made with respect to research expenditures is
that the price elasticity of research is less than 1.0 and may
be less than 0.5.\70\ Apparently there have been no specific
studies of the effectiveness of the university basic research
tax credit.
---------------------------------------------------------------------------
\70\ In a 1983 study, the Treasury Department used an elasticity of
.92 as its upper range estimate of the price elasticity of R&D, but
noted that the author of the unpublished study from which this estimate
was taken conceded that the estimate might be biased upward. See,
Department of the Treasury, The Impact of Section 861-8 Regulation on
Research and Development, p. 23. As stated in the text, although there
is uncertainty, most analysts believe the elasticity is considerable
smaller. For example, the General Accounting Office summarizes: ``These
studies, the best available evidence, indicate that spending on R&E is
not very responsive to price reductions. Most of the elasticity
estimates fall in the range of -0.2 and -0.5. . . . Since it is
commonly recognized that all of the estimates are subject to error, we
used a range of elasticity estimates to compute a range of estimates of
the credit's impact.'' See, The Research Tax Credit Has Stimulated Some
Additional Research Spending (GAO/GGD-89-114), September 1989, p. 23.
Similarly, Edwin Mansfield concludes: ``While our knowledge of the
price elasticity of demand for R&D is far from adequate, the best
available estimates suggest that it is rather low, perhaps about 0.3.''
See, ``The R&D Tax Credit and Other Technology Policy Issues,''
American Economic Review, Vol. 76, no. 2, May 1986, p. 191. More recent
empirical analyses have estimated higher elasticity estimates. One
recent empirical analysis of the research credit has estimated a short-
run price elasticity of 0.8 and a long-run price elasticity of 2.0. The
author of this study notes that the long-run estimate should be viewed
with caution for several technical reasons. In addition, the data
utilized for the study cover the period 1980 through 1991, containing
only two years under the revised credit structure. This makes it
empirically difficult to distinguish short-run and long-run effects,
particularly as it may take firms some time to fully appreciate the
incentive structure of the revised credit. See, Bronwyn H. Hall, ``R&D
Tax Policy During the 1980s: Success or Failure?'' in James M. Poterba
(ed.), Tax Policy and the Economy, 7, pp. 1-35 (Cambridge: The MIT
Press, 1993). Another recent study examined the post-1986 growth of
research expenditures by 40 U.S.-based multinationals and found price
elasticities between 1.2 and 1.8. However, including an additional 76
firms, that had initially been excluded because they had been involved
in merger activity, the estimated elasticities fell by half. See, James
R. Hines, Jr., ``On the Sensitivity of R&D to Delicate Tax Changes: The
Behavior of U.S. Multinationals in the 1980s'' in Alberto Giovannini,
R. Glenn Hubbard, and Joel Slemrod (eds.), Studies in International
Taxation, (Chicago: University of Chicago Press 1993). Also see M.
Ishaq Nadiri and Theofanis P. Mamuneas, ``R&D Tax Incentives and
Manufacturing-Sector R&D Expenditures,'' in James M. Poterba, editor,
Borderline Case: International Tax Policy, Corporate Research and
Development, and Investment, (Washington, D.C.: National Academy
Press), 1997. While their study concludes that one dollar of research
tax credit produces 95 cents of research, they note that time series
empirical work is clouded by poor measures of the price deflators used
to convert nominal research expenditures to real expenditures.
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Other issues related to the research and experimentation credit
Perhaps the greatest criticism of the research and
experimentation tax credit among taxpayers regards its
temporary nature. Research projects frequently span years. If a
taxpayer considers an incremental research project, the lack of
certainty regarding the availability of future credits
increases the financial risk of the expenditure. A credit of
longer duration may more successfully induce additional
research than would a temporary credit, even if the temporary
credit is periodically renewed.
An incremental credit does not provide an incentive for all
firms undertaking qualified research expenditures. Many firms
have current-year qualified expenditures below the base amount.
These firms receive no tax credit and have an effective rate of
credit of zero. Although there is no revenue cost associated
with firms with qualified expenditures below base, there may be
a distortion in the allocation of resources as a result of
these uneven incentives.
If a firm has no current tax liability, or if the firm is
subject to the alternative minimum tax (AMT) or the general
business credit limitation, the research credit must be carried
forward for use against future-year tax liabilities. The
inability to use a tax credit immediately reduces its value
according to the length of time between when it actually is
earned and the time it actually is used to reduce tax
liability.\71\
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\71\ As with any tax credit that is carried forward, its full
incentive effect could be restored, absent other limitations, by
allowing the credit to accumulate interest that is paid by the Treasury
to the taxpayer when the credit ultimately is utilized.
---------------------------------------------------------------------------
Under present law, firms with research expenditures
substantially in excess of their base amount may be subject to
the 50-percent limitation. In general, although these firms
receive the largest amount of credit when measured as a
percentage of their total qualified research expenditures,
their marginal effective rate of credit is exactly one half of
the statutory credit rate of 20 percent (i.e., firms on the
base limitation effectively are governed by a 10-percent credit
rate).
Although the statutory rate of the research credit is
currently 20 percent, it is likely that the average marginal
effective rate may be substantially below 20 percent.
Reasonable assumptions about the frequency that firms are
subject to various limitations discussed above yields estimates
of an average effective rate of credit between 25 and 40
percent below the statutory rate i.e., between 12 and 15
percent.\72\
---------------------------------------------------------------------------
\72\ For a more complete discussion of this point see Joint
Committee on Taxation, Description and Analysis of Tax Provisions
Expiring in 1992 (JCS-2-92), January 27, 1992, pp. 65-66.
---------------------------------------------------------------------------
Since sales growth over a long time frame will rarely track
research growth, it can be expected that over time each firm's
base will ``drift'' from the firm's actual current qualified
research expenditures. Therefore, increasingly over time there
will be a larger number of firms either substantially above or
below their calculated base. This could gradually create an
undesirable situation where many firms receive no credit and
have no reasonable prospect of ever receiving a credit, while
other firms receive large credits (despite the 50-percent base
limitation). Thus, over time, it can be expected that, for
those firms eligible for the credit, the average marginal
effective rate of credit will decline while the revenue cost to
the Federal Government increases.
Administrative and compliance burdens also result from the
present-law research tax credit. The General Accounting Office
(``GAO'') has testified that the research tax credit is
difficult for the IRS to administer. The GAO reports that the
IRS view is that it is ``required to make difficult technical
judgments in audits concerning whether research was directed to
produce truly innovative products or processes.'' While the IRS
employs engineers in such audits, the companies engaged in the
research typically employ personnel with greater technical
expertise and, as would be expected, personnel with greater
expertise regarding the intended application of the specific
research conducted by the company under audit. Such audits
create a burden for both the IRS and taxpayers. The credit
generally requires taxpayers to maintain records more detailed
than those necessary to support the deduction of research
expenses under section 174.\73\
---------------------------------------------------------------------------
\73\ Natwar M. Gandhi, Associate Director Tax Policy and
Administration Issues, General Government Division, U.S. General
Accounting Office, ``Testimony before the Subcommittee on Taxation and
Internal Revenue Service Oversight,'' Committee on Finance, United
States Senate, April 3, 1995.
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4. Extend the deduction provided for contributions of appreciated stock
to private foundations
Present Law
In computing taxable income, a taxpayer who itemizes
deductions generally is allowed to deduct the fair market value
of property contributed to a charitable organization.\74\
However, in the case of a charitable contribution of short-term
gain, inventory, or other ordinary income property, the amount
of the deduction generally is limited to the taxpayer's basis
in the property. In the case of a charitable contribution of
tangible personal property, the deduction is limited to the
taxpayer's basis in such property if the use by the recipient
charitable organization is unrelated to the organization's tax-
exempt purpose.\75\
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\74\ The amount of the deduction allowable for a taxable year with
respect to a charitable contribution may be reduced depending on the
type of property contributed, the type of charitable organization to
which the property is contributed, and the income of the taxpayer
(secs. 170(b) and 170(e)).
\75\ As part of the Omnibus Budget Reconciliation Act of 1993,
Congress eliminated the treatment of contributions of appreciated
property (real, personal, and intangible) as a tax preference for
alternative minimum tax (AMT) purposes. Thus, if a taxpayer makes a
gift to charity of property (other than short-term gain, inventory, or
other ordinary income property, or gifts to private foundations) that
is real property, intangible property, or tangible personal property
the use of which is related to the donee's tax-exempt purpose, the
taxpayer is allowed to claim the same fair-market-value deduction for
both regular tax and AMT purposes (subject to present-law percentage
limitations).
---------------------------------------------------------------------------
In cases involving contributions to a private foundation
(other than certain private operating foundations), the amount
of the deduction is limited to the taxpayer's basis in the
property. However, under a special rule contained in section
170(e)(5), taxpayers are allowed a deduction equal to the fair
market value of ``qualified appreciated stock'' contributed to
a private foundation prior to June 30, 1998. Qualified
appreciated stock is defined as publicly traded stock which is
capital gain property. The fair-market-value deduction for
qualified appreciated stock donations applies only to the
extent that total donations made by the donor to private
foundations of stock in a particular corporation did not exceed
10 percent of the outstanding stock of that corporation. For
this purpose, an individual is treated as making all
contributions that were made by any member of the individual's
family.
Description of Proposal
The proposal would extend the the special rule contained in
section 170(e)(5) for one year--for contributions of qualified
appreciated stock made to private foundations during the period
July 1, 1998, through June 30, 1999.
Effective Date
The proposal would be effective for contributions of
qualified appreciated stock to private foundations made during
the period July 1, 1998, through June 30, 1999.
Prior Action
The special rule contained in section 170(e)(5), which was
originally enacted in 1984, expired January 1, 1995. The Small
Business Job Protection Act of 1996 reinstated the rule for 11
months--for contributions of qualified appreciated stock made
to private foundations during the period July 1, 1996, through
May 31, 1997. The Taxpayer Relief Act of 1997 extended the
special rule for the period June 1, 1997, through June 30,
1998.
Analysis
Any tax deduction or credit reduces the price of an
activity that receives the tax incentive. For example, for a
taxpayer in the 31 percent tax bracket, a $100 cash gift to
charity reduces the taxpayer's taxable income by $100 and
thereby reduces tax liability by $31. As a consequence, the
$100 cash gift to charity reduces the taxpayer's after-tax
income by only $69. Economists would say that the ``price of
giving'' $100 cash to charity is $69. With gifts of appreciated
property, if a fair market value deduction is allowed (while
the accrued appreciation is not included in income), the price
of giving $100 worth of appreciated property is as low as
$40.40.\76\
---------------------------------------------------------------------------
\76\ This assumes that the taxpayer is in the highest statutory
rate bracket and the property has a basis of zero and is computed as
follows: $100 minus $20 (tax avoided from non-recognition of built-in
capital gain) minus $39.60 (tax saved from deduction for fair market
value). This ``price of giving'' figure assumes that the taxpayer would
sell the appreciated property (and pay tax on the built-in gain) in the
same year of the donation if the property were not given to charity.
However, a higher ``price of giving'' would be derived if it is assumed
that, had the taxpayer not donated the property, he would have retained
the asset until death (and obtained a step-up in basis) or obtained
benefits of deferral of tax by selling the asset in a later year.
---------------------------------------------------------------------------
In principle, a lower price of giving should result in more
charitable giving. The amount of charitable giving that results
from lowering the price of giving determines the efficiency of
the tax deductions. If taxpayers do not increase their
charitable giving significantly in response to a charitable
contribution deduction, the revenue lost to the government
because of the tax incentive may exceed the benefits of
additional contributions that flow to charitable organizations
as a result of the deduction.
Economists have not reached a consensus as to whether the
deduction for charitable donations is efficient in the sense
that the cost to the government in lost revenue is more than
offset by additional funds flowing to charitable organizations.
The economics literature generally does not specifically
address gifts of appreciated property. Moreover, these studies
do not include the possibility of the substitutability between
lifetime giving and gifts made at death. Substantial tax
savings are available to owners of appreciated property if they
bequeath such property to qualified charitable organizations.
Even if the general rule for donating appreciated property
discourages current giving, such giving may not be lost
permanently to charitable organizations, but merely may be
converted into gifts at death. However, if a policy goal is to
speed the donation of such gifts, there may be additional
benefits to inducing gifts prior to death.
The aggregate data on charitable donations also present a
mixed picture of the effect of tax deductions on gifts of
appreciated property. Although gifts of appreciated property
substantially declined after enactment of the Tax Reform Act of
1986, the total value of gifts to charity has continued to grow
since that time, despite the fact that the reduction in
marginal tax rates should have reduced the incentive to give.
Thus, to the extent that gifts of appreciated property have
declined, the decline has been largely offset by increases in
cash gifts.
There are, however, a number of limitations on charitable
contributions contained in the Internal Revenue Code. For
instance, a taxpayer's deduction for a taxable year for gifts
of appreciated property to public charities cannot exceed 30
percent of the taxpayer's adjusted gross income (20 percent if
the donee is a private foundation).
There is another dimension to efficiency. Receipt of gifts
of cash by charitable organizations is more efficient, because
a cash gift permits the donee to avoid the transaction costs
involved should it wish to convert the appreciated property to
cash. Moreover, gifts of appreciated property instead of cash
create administrative costs. Cash donations do not require
appraisals, generally increase taxpayer compliance, and reduce
the burden on the IRS of monitoring the accuracy of valuation
of gifts of appreciated property.
F. Miscellaneous Tax Provisions
1. Increase low-income housing tax credit per capita cap
Present Law
A tax credit, claimed over a 10-year period is allowed for
the cost of rental housing occupied by tenants having incomes
below specified levels. The credit generally has a present
value of 70 percent (new construction) or 30 percent (existing
housing and most housing also receiving other Federal
subsidies) of qualified costs.
Generally, the tax credits available for projects in the
first year of the 10-year period are subject to annual per-
State limitations of $1.25 per capita. Credits that remain
unallocated by States after prescribed periods are reallocated
to other States through a ``national pool.'' The $1.25 per
capita cap was set in 1986 with the inception of the tax
credit.
Description of Proposal
The $1.25 per capita cap would be increased to $1.75 per
capita.
Effective Date
The proposal would be effective for calendar years
beginning after December 31, 1998.
Prior Action
The low-income housing tax credit was enacted as part of
the Tax Reform Act of 1986. It was extended several times, and
was made permanent by the Omnibus Budget Reconciliation Act of
1993. The House version of the Balanced Budget Act of 1995
would have repealed the low-income housing tax credit after
1997.
Analysis
Demand subsidies versus supply subsidies
As is the case with direct expenditures, the tax system may
be used to improve housing opportunities for low-income
families either by subsidizing rental payments (increasing
demand) or by subsidizing construction and rehabilitation of
low-income housing units (increasing supply).
The provision of Federal Section 8 housing vouchers is an
example of a demand subsidy. The exclusion of the value of such
vouchers from taxable income is an example of a demand subsidy
in the Internal Revenue Code. By subsidizing a portion of rent
payments, these vouchers may enable beneficiaries to rent more
or better housing than they might otherwise be able to afford.
The low-income housing credit is an example of a supply
subsidy. By offering a subsidy worth 70 percent (in present
value) of construction costs, the credit is designed to induce
investors to provide housing to low-income tenants, or a better
quality of housing, than otherwise would be available.
A demand subsidy can improve the housing opportunities of a
low-income family by increasing the family's ability to pay for
more or higher quality housing. In the short run, an increase
in the demand for housing, however, may increase rents as
families bid against one another for available housing.
Consequently, while a family who receives the subsidy may
benefit by being able to afford more or better housing, the
resulting increase in market rents may reduce the well-being of
other families. In the long run, investors should supply
additional housing because higher rents increase the income of
owners of existing rental housing, and therefore may be
expected to make rental housing a more attractive investment.
This should ameliorate the short-term increase in market rents
and expand availability of low-income housing.
A supply subsidy can improve the housing opportunities of a
low-income family by increasing the available supply of housing
from which the family may choose. Generally, a supply subsidy
increases the investor's return to investment in rental
housing. An increased after-tax return should induce investors
to provide more rental housing. As the supply of rental housing
increases, the market rents investors charge should decline as
investors compete to attract tenants to their properties.
Consequently, not only could qualifying low-income families
benefit from an increased supply of housing, but other renters
could also benefit. In addition, owners of existing housing may
experience declines in income or declines in property values as
rents fall.
Efficiency of demand and supply subsidies
In principle, demand and supply subsidies of equal size
should lead to equal changes in improved housing opportunities.
There is debate as to the accuracy of this theory in practice.
Some argue that both direct expenditures and tax subsidies for
rental payments may not increase housing consumption dollar for
dollar. One study of the Federal Section 8 Existing Housing
Program suggests that, for every $100 of rent subsidy, a
typical family increases its expenditure on housing by $22 and
increases its expenditure on other goods by $78.\77\ While the
additional $78 spent on other goods certainly benefits the
family receiving the voucher, the $100 rent subsidy does not
increase their housing expenditures by $100.
---------------------------------------------------------------------------
\77\ See, W. Reeder, ``The Benefits and Costs of the Section 8
Existing Housing Program,'' Journal of Public Economics, 26, 1985.
---------------------------------------------------------------------------
Also, one study of government-subsidized housing starts
between 1961 and 1977 suggests that as many as 85 percent of
the government-subsidized housing starts may have merely
displaced unsubsidized housing starts.\78\ This figure is based
on both moderate- and low-income housing starts, and therefore
may overstate the potential inefficiency of tax subsidies
solely for low-income housing. Displacement is more likely to
occur when the subsidy is directed at projects the private
market would have produced anyway. Thus, if relatively small
private market activity exists for low-income housing, a supply
subsidy is more likely to produce a net gain in available low-
income housing units because the subsidy is less likely to
displace otherwise planned activity.
---------------------------------------------------------------------------
\78\ M. Murray, ``Subsidized and Unsubsidized Housing Starts: 1961-
1977,'' The Review of Economics and Statistics, 65, November 1983.
---------------------------------------------------------------------------
The theory of subsidizing demand assumes that, by providing
low-income families with more spending power, their increase in
demand for housing will ultimately lead to more or better
housing being available in the market. However, if the supply
of housing to these families does not respond to the higher
market prices that rent subsidies ultimately cause, the result
will be that all existing housing costs more, the low-income
tenants will have no better living conditions than before, and
other tenants will face higher rents.\79\ The benefit of the
subsidy will accrue primarily to the property owners because of
the higher rents.
---------------------------------------------------------------------------
\79\ For example, supply may not respond to price changes if there
exist construction, zoning, or other restrictions on the creation of
additional housing units.
---------------------------------------------------------------------------
Supply subsidy programs can suffer from similar
inefficiencies. For example, some developers who built low-
income rental units before enactment of the low-income housing
credit, may now find that the projects qualify for the credit.
That is, the subsidized project may displace what otherwise
would have been an unsubsidized project with no net gain in
number of low-income housing units. If this is the case, the
tax expenditure of the credit will result in little or no
benefit except to the extent that the credit's targeting rules
may force the developer to serve lower-income individuals than
otherwise would have been the case. In addition, by depressing
rents the supply subsidy may displace privately supplied
housing.
Efficiency of tax subsidies
Some believe that tax-based supply subsidies do not produce
significant displacement within the low-income housing market
because low-income housing is unprofitable and the private
market would not otherwise build new housing for low-income
individuals. In this view, tax-subsidized low-income housing
starts would not displace unsubsidized low-income housing
starts. However, the bulk of the stock of low-income housing
consists of older, physically depreciated properties which once
may have served a different clientele. Subsidies to new
construction could make it no longer economic to convert some
of these older properties to low-income use, thereby displacing
potential low-income units.
The tax subsidy for low-income housing construction also
could displace construction of other housing. Constructing
rental housing requires specialized resources. A tax subsidy
may induce these resources to be devoted to the construction of
low-income housing rather than other housing. If most of the
existing low-income housing stock had originally been built to
serve non-low-income individuals, a tax subsidy to newly
constructed low-income housing could displace some privately
supplied low-income housing in the long run.
Supply subsidies for low-income housing may be subject to
some additional inefficiencies. Much of the low-income housing
stock consists of older structures. Subsidies to new
construction may provide for units with more amenities or units
of a higher quality than low-income individuals would be
willing to pay for if given an equivalent amount of funds. That
is, rather than have $100 spent on a newly constructed
apartment, a low-income family may prefer to have consumed part
of that $100 in increased food and clothing. In this sense, the
supply subsidy may provide an inefficiently large quantity of
housing services from the point of view of how consumers would
choose to allocate their resources. However, to the extent that
maintenance of a certain standard of housing provides benefits
to the community, the subsidy may enhance efficiency. If the
supply subsidy involves fixed costs, such as the cost of
obtaining a credit allocation under the low-income housing
credit, a bias may be created towards large projects in order
to amortize the fixed cost across a larger number of units.
This may create an inefficient bias in favor of large projects.
On the other hand, the construction and rehabilitation costs
per unit may be less for large projects than for small
projects. Lastly, unlike demand subsidies which permit the
beneficiary to seek housing in any geographic location, supply
subsidies may lead to housing being located in areas which, for
example, are farther from places of employment than the
beneficiary would otherwise choose. In this example, some of
benefit of the supply subsidy may be dissipated through
increased transportation cost.
Targeting the benefits of tax subsidies
A supply subsidy to housing will be spent on housing;
although, as discussed above, it may not result in a dollar-
for-dollar increase in total housing spending. To insure that
the housing, once built, serves low-income families, income and
rent limitations for tenants must be imposed as is the case for
demand subsidies. While an income limit may be more effective
in targeting the benefit of the housing to lower income levels
than would an unrestricted market, it may best serve only those
families at or near the income limit.
If, as with the low-income housing credit, rents are
restricted to a percentage of targeted income, the benefits of
the subsidy may not accrue equally to all low-income families.
Those with incomes beneath the target level may pay a greater
proportion of their income in rent than does a family with a
greater income. On the other hand, to the extent that any new,
subsidy-induced housing draws in only the targeted low-income
families with the highest qualifying incomes it should open
units in the privately provided low-income housing stock for
others.
Even though the subsidy may be directly spent on housing,
targeting the supply subsidy, unlike a demand subsidy, does not
necessarily result in targeting the benefit of the subsidy to
recipient tenants. Not all of the subsidy will result in net
additions to the housing stock. The principle of a supply
subsidy is to induce the producer to provide something he or
she otherwise would not. Thus, to induce the producer to
provide the benefit of improved housing to low-income families,
the subsidy must provide benefit to the producer.
Targeting tax incentives according to income can result in
creating high implicit marginal tax rates. For example, if rent
subsidies are limited to families below the poverty line, when
a family is able to increase its income to the point of
crossing the poverty threshold the family may lose its rent
subsidy. The loss of rent subsidy is not unlike a high rate of
taxation on the family's additional income. The same may occur
with supply subsidies. With the low-income housing credit, the
percentage of units serving low-income families is the criteria
for receiving the credit. Again, the marginal tax rate on a
dollar of income at the low-income threshold may be very high
for prospective tenants.
Data relating to the low-income housing credit
Comprehensive data from tax returns concerning the low-
income housing tax credit currently are unavailable. However,
Table 3, below, presents data from a survey of State credit
allocating agencies.
Table 3.--Allocation of the Low-Income Housing Credit, 1987-1995
----------------------------------------------------------------------------------------------------------------
Percentage
Years Authority Allocated allocated
(millions) (millions) (percent)
----------------------------------------------------------------------------------------------------------------
1987............................................................ $313.1 $62.9 20.1
1988............................................................ 311.5 209.8 67.4
1989............................................................ 314.2 307.2 97.8
1990............................................................ 317.7 206.4 65.0
1991 \1\........................................................ 497.3 400.6 80.6
1992 \1\........................................................ 476.8 332.7 70.0
1993 \1\........................................................ 546.4 322.7 70.0
1994 \1\........................................................ 523.7 424.7 77.7
1995 \1\........................................................ 432.6 410.9 95.0
----------------------------------------------------------------------------------------------------------------
\1\ Increased authority includes credits unallocated from prior years carried over to the current year.
Source: Survey of State allocating agencies conducted by National Council of State Housing Associations (1996).
Table 3 does not reflect actual units of low-income housing
placed in service, but rather only allocations of the credit to
proposed projects. Some of these allocations will be carried
forward to projects placed in service in future years. As such,
these data do not necessarily reflect the magnitude of the
Federal tax expenditure from the low-income housing credit. The
staff of the Joint Committee on Taxation (``Joint Committee
staff'') estimates that the fiscal year 1998 tax expenditure
resulting from the low-income credit will total $3.2
billion.80 This estimate would include revenue lost
to the Federal Government from buildings placed in service in
the 10 years prior to 1998. Table 1 shows a high rate of credit
allocations in recent years.
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\80\ Joint Committee on Taxation, Estimates of Federal Tax
Expenditures for Fiscal Years 1998-2002 (JCS-22-97), December 15, 1997,
p. 21.
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A Department of Housing and Urban Development study has
attempted to measure the costs and benefits of the low-income
housing credit compared to that of the Federal Section 8
housing voucher program.81 This study attempts to
compare the costs of providing a family with an identical unit
of housing, using either a voucher or the low-income housing
credit. The study concludes that on average the low-income
housing credit provides the same unit of housing as would the
voucher at two and one half times greater cost than the voucher
program. However, this study does not attempt to measure the
effect of the voucher on raising the general level of rents,
nor the effect of the low-income housing credit on lowering the
general level of rents. The preceding analysis has suggested
that both of these effects may be important. In addition, as
utilization of the credit has risen, the capital raised per
credit dollar has increased. This, too, would reduce the
measured cost of providing housing using the low-income credit.
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\81\ U.S. Department of Housing and Urban Development, Evaluation
of the Low-Income Housing Tax Credit: Final Report, February 1991.
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Increasing State credit allocations
The dollar value of the State allocation of $1.25 per
capita was set in the 1986 Act and has not been revised. Low-
income housing advocates observe that because the credit amount
is not indexed, inflation has reduced its real value since the
dollar amounts were set in 1986. The Gross Domestic Product
(``GDP'') price deflator for residential fixed investment
measures 38.1 percent price inflation between 1986 and the
third quarter of 1997. Had the per capita credit allocation
been indexed for inflation, using this index, the value of the
credit today would be approximately $1.73.82 While
not indexing for inflation, present law does provide for annual
adjustments to the State credit allocation authority based on
current population estimates. Because the need for low- income
housing can be expected to correlate with population, the
annual credit limitation already is adjusted to reflect
changing needs.
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\82\ Most Code provisions are indexed to the Consumer Price Index
(``CPI''). Over this same period, cumulative inflation as measured by
the CPI was approximately 47 percent. Indexing the $1.25 to the CPI
would have produced a value of approximately $1.84 today.
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The revenue consequences estimated by the Joint Committee
staff of increasing the per capita limitation understate the
long-run revenue cost to the Federal Government. This occurs
because the Joint Committee staff reports revenue effects only
for the 10-year budget period. Because the credit for a project
may be claimed for 10 years, only the total revenue loss
related to those projects placed in service in the first year
are reflected fully in the Joint Committee staff's 10-year
estimate. The revenue loss increases geometrically throughout
the budget period as additional credit authority is granted by
the States and all projects placed in service after the first
year of the budget period produce revenue losses in years
beyond the 10-year budget period.
2. Extend and modify Puerto Rico tax credit
Present Law
The Small Business Job Protection Act of 1996 generally
repealed the Puerto Rico and possession tax credit. However,
certain domestic corporations that had active business
operations in Puerto Rico or another U.S. possession on October
13, 1995 may continue to claim credits under section 936 or
section 30A for a ten-year transition period. Such credits
apply to possession business income, which is derived from the
active conduct of a trade or business within a U.S. possession
or from the sale or exchange of substantially all of the assets
that were used in such a trade or business. In contrast to the
foreign tax credit, the Puerto Rico and possession tax credit
is granted whether or not the corporation pays income tax to
the possession.
One of two alternative limitations is applicable to the
amount of the credit attributable to possession business
income. Under the economic activity limit, the amount of the
credit with respect to such income cannot exceed the sum of a
portion of the taxpayer's wage and fringe benefit expenses and
depreciation allowances (plus, in certain cases, possession
income taxes); beginning in 2002, the income eligible for the
credit computed under this limit generally is subject to a cap
based on the corporation's pre-1996 possession business income.
Under the alternative limit, the amount of the credit is
limited to the applicable percentage (40 percent for 1998 and
thereafter) of the credit that would otherwise be allowable
with respect to possession business income; beginning in 1998,
the income eligible for the credit computed under this limit
generally is subject to a cap based on the corporation's pre-
1996 possession business income. Special rules apply in
computing the credit with respect to operations in Guam,
American Samoa, and the Commonwealth of the Northern Mariana
Islands. The credit is eliminated for taxable years beginning
after December 31, 2005.
Description of Proposal
The proposal would modify the credit computed under the
economic activity limit with respect to operations in Puerto
Rico only. First, the proposal would eliminate the December 31,
2005 termination date with respect to such credit. Second, the
proposal would eliminate the income cap with respect to such
credit. Third, the proposal would eliminate the limitation that
applies the credit only to certain corporations with pre-
existing operations in Puerto Rico; accordingly, under the
proposal the credit computed under the economic activity limit
would beavailable with respect to corporations with new
operations in Puerto Rico. The proposal would not modify the credit
computed under the economic activity limit with respect to operations
in possessions other than Puerto Rico. The proposal also would not
modify the credit computed under the alternative limit with respect to
operations in Puerto Rico or other possessions.
Effective Date
The proposal would apply to taxable years beginning after
December 31, 1998.
Prior Action
The proposal (with an effective date of one year earlier)
was included in the President's fiscal year 1998 budget
proposal.
Analysis
When the Puerto Rico and possession tax credit was repealed
in 1996, the Congress expressed its concern that the tax
benefits provided by the credit were enjoyed by only the
relatively small number of U.S. corporations that operate in
the possessions and that the tax cost of the benefits provided
to these possessions corporations was borne by all U.S.
taxpayers. In light of the then current budget constraints, the
Congress believed that the continuation of the tax exemption
provided to corporations pursuant to the Puerto Rico and
possession tax credit was no longer appropriate.
The proposal to extend and modify the credit computed under
the economic activity limit is intended to provide an incentive
for job creation and economic activity in Puerto Rico. In this
regard, it should be noted that the Puerto Rican government
itself has enacted a package of incentives effective January 1,
1998 designed to attract business investment in Puerto Rico.
This proposal should be analyzed in light of these local
initiatives which have just gone into force; issues to be
considered include whether additional federal tax incentives
are necessary or appropriate and whether the proposed credit
would interact efficiently with the particular local incentives
already in place.
In 1996, the unemployment rate averaged 14 percent in
Puerto Rico. By comparison, the United States's unemployment
rate averaged 5.4 percent in 1996 and the State with the
highest average unemployment rate, New Mexico, averaged 8.1
percent unemployment. 83 The incomes of individuals
and families are lower in Puerto Rico than in the United
States. In the last year for which comparable data are
available, 1989, the median family income in the United States
was $35,225 and the median family income in Puerto Rico was
$9,988. For 1989, the lowest median household income among the
States was $26,159 in Alabama. 84 In 1996, per
capita GDP in Puerto Rico was $8,104 while per capita GDP for
the United States was $28,784. 85 It has been these,
or comparable, facts that have motivated efforts to encourage
economic development in Puerto Rico.
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\83\ The unemployment rate in the District of Columbia averaged 8.5
percent in 1996. Source: Bureau of the Census, U.S. Department of
Commerce, Statistical Abstract of the United States, 1997.
\84\ Ibid. The data are drawn from the 1990 Census. Comparison of
the income figures reported for Puerto Rico or the United States to the
figure for Alabama should be made with some caution as the Alabama
figure reports household income rather than family income. For 1989,
median household income in the United States was $35,526 and in Puerto
Rico median household income was $8,895. U.S. Department of Commerce,
Bureau of the Census, 1990 Census of Population, Social and Economic
Characteristics, Puerto Rico, p. 42.
\85\ Ibid.
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The credit computed under the economic activity limit as
provided in section 30A reduces the Federal income tax burden
on economic activity located in Puerto Rico. By reducing the
Federal income tax burden, the credit may make it attractive
for a business to locate in Puerto Rico, even if the costs of
operation or transportation to or from the United States would
otherwise make such an undertaking unprofitable. As such, the
credit is a deliberate attempt to distort taxpayer behavior.
Generally, distortions of taxpayer behavior, such as those that
distort decisions regarding investment, labor choice, or choice
of business location reduce overall well-being by not putting
labor and capital resources to their highest and best use.
However, proponents of the credit argue that such a distortion
of choice may increase aggregate economic welfare because
Puerto Rico has so many underutilized resources, as evidenced
by its chronic high unemployment rate.
Some also have suggested that the credit may offset
partially certain other distortions that exist in the Puerto
Rican economy. For example, some have suggested that the
application of the Federal minimum wage, which generally has
been chosen based on the circumstances of the States, to Puerto
Rico may contribute to Puerto Rico's relatively high
unemployment rate. Others have suggested that the cost of
investment funds to Puerto Rican businesses may be higher than
is dictated by the actual risk of those investments. If this is
the case, there may be an imperfect capital market. The credit,
as it applies to wages and capital, may partially offset a
distortion created by the minimum wage or a capital market
imperfection.
The proposal would extend the credit computed under the
economic activity limit with respect to operations in Puerto
Rico to new business operations in Puerto Rico, would eliminate
the present-law cap on the economic activity credit, and would
make the economic activity credit permanent. The credit
computed under the economic activity limit is based loosely on
the value added by a business that occurs within a qualifying
Puerto Rican facility. That is, the credit is based upon
compensation paid to employees in Puerto Rico and upon tangible
personal property located in Puerto Rico. Proponents of the
credit note that this design does not bias a business's choice
of production between more labor intensive or more capital
intensive methods and thus should not promote an inefficient
use of resources in production. 86 Proponents
further observe that the economic activity credit under section
30A is based upon the labor employed in Puerto Rico and the
equipment located within Puerto Rico which add value to the
good or service produced, not the cost of raw materials, land,
intangibles, interest, or other expenses. Thus, they argue that
the credit directly targets underemployed resources within
Puerto Rico.
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\86\ The income-based credit of prior law was criticized for
encouraging intangible capital intensive business development rather
than business development of any type. See the discussion in Department
of the Treasury, The Operation and Effect of the Possessions
Corporation System of Taxation, Sixth Report, March 1989.
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The economic activity credit only has been available to
taxpayers since 1994. There have been no studies of its
efficacy to date. However, the tax credit can never be fully
efficient. The credit would be available to any business
locating in Puerto Rico, regardless of whether the business
would have chosen to locate in Puerto Rico in the absence of
the credit for other business reasons. Thus, as with most tax
benefits designed to change economic decisions, in some cases,
the Federal government will lose revenue even when there has
been no change in taxpayer behavior.
Use of a tightly defined tax benefit as a business
development tool may limit Federal Government funds available
for other development initiatives that might foster business
development in Puerto Rico. For example, a lack of
infrastructure such as roads or waste water treatment
facilities may forestall certain business investments. It is
difficult for tax credits to address those sorts of business
development initiatives. More generally, one might question the
efficacy of using tax benefits in lieu of direct spending to
foster economic development. Direct subsidies could be made to
certain businesses to encourage location in Puerto Rico and the
subsidies could be tailored to the specific circumstance of the
business. A tax credit operates as an open-ended entitlement to
any business that is eligible to claim the credit. On the other
hand, unlike direct subsidies, under such a credit the marginal
investment decisions are left to the private sector rather than
being made by government officials.
3. Specialized small business investment companies
Present Law
Under present law, a taxpayer may elect to roll over
without payment of tax any capital gain realized upon the sale
of publicly-traded securities where the taxpayer uses the
proceeds from the sale to purchase common stock in a
specialized small business investment company (``SSBIC'')
within 60 days of the sale of the securities. The maximum
amount of gain that an individual may roll over under this
provision for a taxable year is limited to the lesser of (1)
$50,000 or (2) $500,000 reduced by any gain previously excluded
under this provision. For corporations, these limits are
$250,000 and $1 million.
In addition, under present law, an individual may exclude
50 percent of the gain 87 from the sale of
qualifying small business stock held more than five years. An
SSBIC is automatically deemed to satisfy the active business
requirement which a corporation must satisfy to qualify their
stock for the exclusion.
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\87\ The portion of the capital gain included in income is subject
to a maximum regular tax rate of 28 percent, and 42 percent of the
excluded gain is a minimum tax preference.
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For purposes of these provisions, an SSBIC means any
partnership or corporation that is licensed by the Small
Business Administration under section 301(d) of the Small
Business Investment Act of 1958 (as in effect on May 13, 1993).
SSBICs make long-term loans to, or equity investments in, small
businesses owned by persons who are socially or economically
disadvantaged.
Description of Proposal
Under the proposal, the tax-free rollover provision would
be expanded by (1) extending the 60-day period to 180 days, (2)
making preferred stock (as well as common stock) in an SSBIC an
eligible investment, and (3) increasing the lifetime caps to
$750,000 in the case of an individual and to $2 million in the
case of a corporation, and repealing the annual caps.
The proposal also would provide that an SSBIC that is
organized as a corporation may convert to a partnership without
imposition of a tax to either the corporation or its
shareholders, by transferring its assets to a partnership in
which it holds at least an 80-percent interest and then
liquidating. The transaction must take place within 180 days of
enactment of the proposal. The partnership would be liable for
a tax on any ``built-in'' gain in the assets transferred by the
corporation at the time of the conversion.
Finally, the 50-percent exclusion for gain on the sale of
qualifying small business stock would be increased to 60
percent where the corporation was an SSBIC (or involving the
sale in a pass-through entity holding an interest in an SSBIC).
Effective Date
The proposal would be effective for sales after date of
enactment.
Prior Action
No prior action.
Analysis
The proposal would make investments in SSBICs more
attractive by providing tax advantages of deferral and lower
capital gains taxes. Present law, and the proposal, attempt to
distort taxpayer investment decisions by increasing the net,
after-tax, return to investments in SSBICs compared to other
assets. Economists argue that distortions in capital markets
lead to reduced economic growth. In an efficient capital
market, market values indicate sectors of the economy where
investment funds are most needed. Artificially diverting
investment funds in one direction or another results in certain
investments that offer a lower rate of return being funded in
lieu of certain other investments that offer a higher rate of
return. The net outcome is a reduction in national income below
that which would otherwise be achieved. Proponents of the
proposal argue that capital markets are not fully efficient. In
particular, they argue that a bias exists against funding
business ventures undertaken by persons who are socially or
economically disadvantaged.
Generally, the cost of capital is greater for small
businesses than for larger businesses. That is, investors
demand a greater rate of return on their investment in smaller
businesses than in larger businesses. The higher cost of
capital may take the form of higher interest rates charged on
business loans or a larger percentage of equity ownership per
dollar invested. A higher cost of capital does not imply that
capital markets are inefficient. The cost of capital reflects
investors' perceptions of risk and the higher failure rates
among small business ventures. There has been little study of
whether the cost of capital to small businesses, regardless of
the economic or social background of the entrepreneur, is ``too
high'' when the risk of business failure is taken into account.
Proponents of the proposal argue that, even if the higher
cost of capital to such businesses is not the result of
inefficiency of the capital market, an important social goal
can be achieved by helping more persons who are socially or
economically disadvantaged gain entrepreneurial experience.
Opponents observe that, under present law, that objective is
addressed by the Small Business Administration's subsidized
loan program and present-law Code sections 1045 and 1202. They
note that the proposal would not lower the cost of capital for
all small businesses or for all small businesses organized by
persons who are socially or economically disadvantaged, only
those businesses that receive some of their financing through
an SSBIC. Other investors do not receive these tax benefits
even if they make substantial investments in business ventures
organized by persons who are socially or economically
disadvantaged. They argue there is a loss of efficiency from
funneling a tax benefit to entrepreneurs through only one type
of investment fund pool. In the near term, some of the tax
benefit may accrue to current owners of SSBICs rather than to
entrepreneurs as taxpayers seeking to take advantage of the
proposal bid up the price of shares of existing SSBICs.
Proponents note that over the longer term, as more funds flow
into SSBICs and as new SSBICs are formed, there will be a
larger pool of funds available to qualified entrepreneurs and
those entrepreneurs will receive the benefits of a lower cost
of capital.
4. Accelerate and expand incentives available to two new empowerment
zones
Present Law
Designated zones and communities
Zones and communities designated under OBRA 1993
Pursuant to the Omnibus Budget Reconciliation Act of 1993
(``OBRA 1993''), the Secretaries of the Department of Housing
and Urban Development (HUD) and the Department of Agriculture
designated a total of nine empowerment zones and 95 enterprise
communities on December 21, 1994. As required by law, six
empowerment zones are located in urban areas and three
empowerment zones are located in rural areas.88 Of
the enterprise communities, 65 are located in urban areas and
30 are located in rural areas (sec. 1391). Designated
empowerment zones and enterprise communities were required to
satisfy certain eligibility criteria, including specified
poverty rates and population and geographic size limitations
(sec. 1392).
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\88\ The six designated urban empowerment zones are located in New
York City, Chicago, Atlanta, Detroit, Baltimore, and Philadelphia-
Camden (New Jersey). The three designated rural empowerment zones are
located in Kentucky Highlands (Clinton, Jackson, and Wayne counties,
Kentucky), Mid-Delta Mississippi (Bolivar, Holmes, Humphreys, Leflore
counties, Mississippi), and Rio Grande Valley Texas (Cameron, Hidalgo,
Starr, and Willacy counties, Texas).
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The following tax incentives are available for certain
businesses located in empowerment zones: (1) a 20-percent wage
credit for the first $15,000 of wages paid to a zone resident
who works in the zone; (2) an additional $20,000 of section 179
expensing for ``qualified zone property'' placed in service by
an ``enterprise zone business'' (accordingly, certain
businesses operating in empowerment zones are allowed up to
$38,500 of expensing for 1998); (3) special tax-exempt
financing for certain zone facilities (described in more detail
below); and (4) the so-called ``brownfields'' tax incentive,
which allows taxpayers to expense (rather than capitalize)
certain environmental remediation expenditures.89
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\89\ The environmental remediation expenditure must be incurred in
connection with the abatement or control of hazardous substances at a
qualified contaminated site, generally meaning any property that (1) is
held for use in a trade or business, for the production of income, or
as inventory; (2) is certified by the appropriate State environmental
agency to be located within a targeted area; and (3) contains (or
potentially contains) a hazardous substance. Targeted areas include:
(1) empowerment zones and enterprise communities as designated under
OBRA 1993 and the 1997 Act (including any supplemental empowerment zone
designated on December 21, 1994); (2) sites announced before February
1997, as being an Environmental Protection Agency (EPA) Brownfields
Pilot; (3) any population census tract with a poverty rate of 20
percent or more; and (4) certain industrial and commercial areas that
are adjacent to tracts described in (3) above. The ``brownfields''
provision (enacted in the Taxpayer Relief Act of 1997) applies to
eligible expenditures incurred in taxable years ending after August 5,
1997, and before January 1, 2001.
The President's budget proposal would make the brownfields
incentive permanent (See Part I.B.2.b., above).
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The 95 enterprise communities are eligible for the special
tax-exempt financing benefits and ``brownfields'' tax
incentive, but not the other tax incentives (i.e., the wage
credit and additional sec. 179 expensing) available in the
empowerment zones. In addition to these tax incentives, OBRA
1993 provided that Federal grants would be made to designated
empowerment zones and enterprise communities.
The tax incentives (other than the ``brownfields''
incentive) for empowerment zones and enterprise communities
generally will be available during the period that the
designation remains in effect, i.e., the 10-year period of 1995
through 2004.
Additional zones designated under 1997 Act
Two additional urban zones with same tax incentives as
previously designated empowerment zones.--Pursuant to the
Taxpayer Relief Act of 1997 (``1997 Act''), the Secretary of
HUD designated two additional empowerment zones located in
Cleveland and Los Angeles (thereby increasing to eight the
total number of empowerment zones located in urban areas) with
respect to which apply the same tax incentives (i.e., the wage
credit, additional expensing, special tax-exempt financing, and
brownfields incentive) as are available within the empowerment
zones authorized by OBRA 1993.90 The two additional
empowerment zones located in Cleveland and Los Angeles were
subject to the same eligibility criteria under section 1392
that applied to the original six urban empowerment
zones.91
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\90\ The wage credit available in the two new urban empowerment
zones is modified slightly to provide that the credit rate will be 20
percent for calendar years 2000-2004, 15 percent for calendar year
2005, 10 percent for calendar year 2006, and 5 percent for calendar
2007. No wage credit will be available in the two new urban empowerment
zones after 2007.
\91\ In order to permit designation of these two additional
empowerment zones, the 1997 Act increased the aggregate population cap
applicable to urban empowerment zones from 750,000 to a cap of one
million aggregate population for the eight urban empowerment zones.
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The two additional empowerment zones located in Cleveland
and Los Angeles were designated by the Secretary of HUD on
January 31, 1997. However, a special rule provides that the
designations of these two additional empowerment zones will not
take effect until January 1, 2000 (and generally will remain in
effect for 10 years).
20 additional urban and rural empowerment zones.--The 1997
Act also authorizes the Secretaries of HUD and Agriculture to
designate an additional 20 empowerment zones (no more than 15
in urban areas and no more than five in rural
areas).92 With respect to these additional
empowerment zones, the present-law eligibility criteria are
expanded slightly in comparison to the eligibility criteria
provided for by OBRA 1993. First, the general square mileage
limitations (i.e., 20 square miles for urban areas and 1,000
square miles for rural areas) are expanded to allow the
empowerment zones to include an additional 2,000 acres. This
additional acreage, which could be developed for commercial or
industrial purposes, is not subject to the poverty rate
criteria and may be divided among up to three noncontiguous
parcels. In addition, the general requirement that at least
half of the nominated area consist of census tracts with
poverty rates of 35 percent or more does not apply to the 20
additional empowerment zones. However, under present-law
section 1392(a)(4), at least 90 percent of the census tracts
within a nominated area must have a poverty rate of 25 percent
or more, and the remaining census tracts must have a poverty
rate of 20 percent or more.93 For this purpose,
census tracts with populations under 2,000 are treated as
satisfying the 25-percent poverty rate criteria if (1) at least
75 percent of the tract was zoned for commercial or industrial
use, and (2) the tract is contiguous to one or more other
tracts that actually have a poverty rate of 25 percent or
more.94
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\92\ In contrast to OBRA 1993, areas located within Indian
reservations are eligible for designation as one of the additional 20
empowerment zones under the 1997 Act.
\93\ In lieu of the poverty criteria, outmigration may be taken
into account in designating one rural empowerment zone.
\94\ A special rule enacted as part of the 1997 Act modifies the
present-law empowerment zone and enterprise community designation
criteria so that any zones or communities designated in the future in
the States of Alaska or Hawaii will not be subject to the general size
limitations, nor will such zones or communities be subject to the
general poverty-rate criteria. Instead, nominated areas in either State
will be eligible for designation as an empowerment zone or enterprise
community if, for each census tract or block group within such area, at
least 20 percent of the families have incomes which are 50 percent or
less of the State-wide median family income. Such zones and communities
will be subject to the population limitations under present-law section
1392(a)(1).
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Within the 20 additional empowerment zones, qualified
``enterprise zone businesses'' are eligible to receive up to
$20,000 of additional section 179 expensing 95 and
to utilize special tax-exempt financing benefits. The
``brownfields'' tax incentive (described above) also is
available within all designated empowerment zones. However,
businesses within the 20 additional empowerment zones are not
eligible to receive the present-law wage credit available
within the 11 other designated empowerment zones (i.e., the
wage credit is available only within in the nine zones
designated under OBRA 1993 and the two urban zones designated
under the 1997 Act that are eligible for the same tax
incentives as are available in the nine zones designated under
OBRA 1993).
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\95\ However, the additional section 179 expensing is not available
within the additional 2,000 acres allowed to be included under the 1997
Act within an empowerment zone.
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The 20 additional empowerment zones are required to be
designated before 1999, and the designations generally will
remain in effect for 10 years.96
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\96\ In addition, the 1997 Act also provides for special tax
incentives (some of which are modeled after the empowerment zone tax
incentives) for the District of Columbia.
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Definition of ``qualified zone property''
Present-law section 1397C defines ``qualified zone
property'' as depreciable tangible property (including
buildings), provided that: (1) the property is acquired by the
taxpayer (from an unrelated party) after the zone or community
designation took effect; (2) the original use of the property
in the zone or community commences with the taxpayer; and (3)
substantially all of the use of the property is in the zone or
community and is in the active conduct of a qualified business
by the taxpayer in the zone or community. In the case of
property which is substantially renovated by the taxpayer,
however, the property need not be acquired by the taxpayer
after zone or community designation or originally used by the
taxpayer within the zone or community if, during any 24-month
period after zone or community designation, the additions to
the taxpayer's basis in the property exceed 100 percent of the
taxpayer's basis in the property at the beginning of the
period, or $5,000 (whichever is greater).
Definition of ``enterprise zone business''
Present-law section 1397B defines the term ``enterprise
zone business'' as a corporation or partnership (or
proprietorship) if for the taxable year: (1) every trade or
business of the corporation or partnership is the active
conduct of a qualified business within an empowerment zone or
enterprise community 97; (2) at least 50 percent
98 of the total gross income is derived from the
active conduct of a ``qualified business'' within a zone or
community; (3) a substantial portion of the business's tangible
property is used within a zone or community; (4) a substantial
portion of the business's intangible property is used in the
active conduct of such business; (5) a substantial portion of
the services performed by employees are performed within a zone
or community; (6) at least 35 percent of the employees are
residents of the zone or community; and (7) less than five
percent of the average of the aggregate unadjusted bases of the
property owned by the business is attributable to (a) certain
financial property, or (b) collectibles not held primarily for
sale to customers in the ordinary course of an active trade or
business.
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\97\ A qualified proprietorship is not required to meet the
requirement that the sole trade or business of the proprietor is the
active conduct of a qualified business within the empowerment zone or
enterprise community.
\98\ The 1997 Act reduced this threshold from 80 percent (as
enacted in OBRA 1993) to 50 percent.
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A ``qualified business'' is defined as any trade or
business other than a trade or business that consists
predominantly of the development or holding of intangibles for
sale or license.99 In addition, the leasing of real
property that is located within the empowerment zone or
community to others is treated as a qualified business only if
(1) the leased property is not residential property, and (2) at
least 50 percent of the gross rental income from the real
property is from enterprise zone businesses.100 The
rental of tangible personal property to others is not a
qualified business unless at least 50 percent of the rental of
such property is by enterprise zone businesses or by residents
of an empowerment zone or enterprise community.
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\99\ Also, a qualified business does not include certain facilities
described in section 144(c)(6)(B)(e.g., massage parlor, hot tub
facility, or liquor store) or certain large farms.
\100\ The 1997 Act provides that the lessor of property may rely on
a lessee's certification that such lessee is an enterprise zone
business.
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Tax-exempt financing rules
Tax-exempt private activity bonds may be issued to finance
certain facilities in empowerment zones and enterprise
communities. These bonds, along with most private activity
bonds, are subject to an annual private activity bond State
volume cap equal to $50 per resident of each State, or (if
greater) $150 million per State. However, a special rule
(enacted in the 1997 Act) provides that certain ``new
empowerment zone facility bonds'' issued for qualified
enterprise zone businesses in the 20 additional empowerment
zones are not subject to the State private activity bond volume
caps or the special limits on issue size generally applicable
to qualified enterprise zone facility bonds under section
1394(c).101
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\101\ The maximum amount of ``new empowerment zone facility bonds''
that can be issued is limited to $60 million per rual zone, $130
million per urban zone with a population of less than 100,000, and $230
million per urban zone with a population of 100,000 or more. ``New
empowerment zone facility bonds'' may not be issued with respect to the
two urban empowerment zones to be designated under the 1997 Act within
which will apply the same tax incentives as apply to the empowerment
zones authorized by OBRA 1993.
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Qualified enterprise zone facility bonds are bonds 95
percent or more of the net proceeds of which are used to
finance (1) ``qualified zone property'' (as defined above
102) the principal user of which is an ``enterprise
zone business'' (also defined above 103), or (2)
functionally related and subordinate land located in the
empowerment zone or enterprise community.104 These
bonds may only be issued while an empowerment zone or
enterprise community designation is in effect.
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\102\ A special rule (enacted in the 1997 Act) relaxes the
rehabilitation requirement for financing existing property with
qualified enterprise zone facility bonds. In the case of property which
is substantially renovated by the taxpayer, the property need not be
acquired by the taxpayer after zone or community designation and need
not be originally used by the taxpayer within the zone if, during any
24-month period after zone or community designation, the additions to
the taxpayer's basis in the property exceed 15 percent of the
taxpayer's basis at the beginning of the period, or $5,000 (whichever
is greater).
\103\ For purposes of the tax-exempt financing rules, an
``enterprise zone business'' also includes a business located in a zone
or community which would qualify as an enterprise zone business if it
were separately incorporated.
A special rule (enacted in the 1997 Act) waives the requirements of
an enterprise zone business (other than the requirement that at least
35 percent of the business' employees be residents of the zone or
community) for all years after a prescribed testing period equal to the
first three taxable years after the startup period.
\104\ A special rule (enacted in the 1997 Act) waives until the end
of a ``startup period'' the requirement that 95 percent or more of the
proceeds of bond issue be used by a qualified enterprise zone business.
With respect to each property, the startup period would end at the
beginning of the first taxable year beginning more than two years after
the later of (1) the date of the bond issue financing such property, or
(2) the date the property was placed in service (but in no event more
than three years after the date of bond issuance). This waiver is
available only if, at the beginning of the startup period, there is a
reasonable expectation that the use by a qualified enterprise zone
business will be satisfied at the end of the startup period and the
business makes bona fide efforts to satisfy the enterprise zone
business definition.
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The aggregate face amount of all qualified enterprise zone
bonds for each qualified enterprise zone business may not
exceed $3 million per zone or community. In addition, total
qualified enterprise zone bond financing for each principal
user of these bonds may not exceed $20 million for all zones
and communities.
Description of Proposal
The proposal would accelerate from January 1, 2000, to
January 1, 1999, the effective date for designation of the two
additional empowerment zones located in Cleveland and Los
Angeles with respect to which will apply the same tax
incentives as are available within the nine empowerment zones
authorized by OBRA 1993. Under the proposal, the wage credit
would be available in these two empowerment zones for 10 years.
The credit rate for the wage credit would be 20 percent for
calendar years 1999-2005, 15 percent for calendar year 2006, 10
percent for calendar year 2007, and 5 percent for calendar year
2008.
Effective Date
The proposal would be effective on January 1, 1999.
Prior Action
OBRA 1993 authorized the designation of nine empowerment
zones and 95 enterprise communities. The Secretaries of HUD and
the Department of Agriculture designated such empowerment zones
and enterprise communities on December 21, 1994, and such
designations generally will remain in effect through December
31, 2004.
The 1997 Act authorized the designation of two additional
empowerment zones, with respect to which will apply the same
tax incentives as are available within the empowerment zones
authorized by OBRA 1993. Pursuant to this authorization, areas
located in Cleveland and Los Angeles were designated as
empowerment zones on January 31, 1998, but such designations
will not take effect until January 1, 2000. The 1997 Act also
authorizes the designation of an additional 20 empowerment
zones (with different eligibility criteria and tax incentives
compared to the empowerment zones designated under OBRA 1993).
These additional 20 empowerment zones have not yet been
designated.
Analysis
Pursuant to the 1997 Act, areas located in Cleveland and
Los Angeles have been designated as empowerment zones. With
respect to these areas, the Administration's proposal would
permit qualifying businesses to claim wage credits, expense
additional capital investments under section 179, to benefit
from special tax-exempt financing, and to expense certain
environmental remediation expenses for expenses incurred during
the 10-year period 1999 through 2008, rather than the 10-year
period 2000 through 2009.105 The proposal does not
change materially any of the tax benefits (other than adding
two more years during which the wage credit will be available),
but rather the time period for which such tax benefits may be
claimed. However, by changing the time period for which tax
benefits may be claimed, the value of those benefits may be
altered for taxpayers in different situations.
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\105\ Expensing of qualified environmental remediation expenditures
within the zones may be claimed only through 2000 under present law. In
a separate proposal, the President's budget would make permanent the
expensing of qualified environmental remediation expenditures. (See
Part I.B.2.b., above.)
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The tax benefits for empowerment zones are designed to
facilitate community economic renewal by encouraging existing
businesses to remain and expand in the designated empowerment
zone, by encouraging new businesses to locate within the
empowerment zone, and by encouraging the employment of zone
residents within the zone. By accelerating the availability of
tax benefits, existing businesses located within the
empowerment zone will be able to claim tax benefits almost
immediately. The reduction in capital costs or employment costs
may enable certain existing businesses which might otherwise
have closed or moved from the zone to remain profitable in
their current location. Because present law delays the tax
benefits for Cleveland and Los Angeles, the present value of
the entire 10-year stream of potential tax benefits is reduced.
Such a reduction may mean that certain existing businesses will
find it more profitable to operate elsewhere. Similarly,
because the empowerment zones located in Cleveland and Los
Angeles were designated on January 31, 1998, community leaders
could advertise that Federal tax benefits will be available in
the future to businesses that relocate to within the zone.
However, a business that is currently considering a relocation
would find it less attractive to have to wait until the year
2000 to claim the promised tax benefits than to be able to
begin claiming the tax benefits in 1999. By accelerating the
period during which tax benefits may be claimed, certain
businesses will find the tax benefits more attractive, and this
could induce such businesses to remain, locate, or expand
within the zone.
On the other hand, by accelerating the period during which
tax benefits may be claimed, certain businesses may find the
tax benefits less attractive. Many investment plans, whether
they be for expansion of an existing business within the zone,
the relocation of a business to within the zone, or the
creation of a new business, require substantial lead time
before investment expenses are incurred or employees are hired.
For example, commencement of operations for a qualifying
business may take one year or more between the initial planning
decisions, the procurement of necessary permits, and the
placement in service of business property. In such a case, by
accelerating the period during which a business may claim
additional expensing under section 179 to the years 1999
through 2008 rather than the years 2000 through 2009, a
business considering an investment to commence operations in
2002 may find that, under the proposal, it may claim additional
expensing for only seven years, rather than eight years under
present law. If the subsidy offered by the additional expensing
under section 179 is critical to the decision to invest in this
business, the loss of one year's worth of subsidy could affect
investment decisions. 106 More generally, community
leaders could find it advantageous to have the lead time
provided under present law to coordinate State and local
redevelopment efforts with those that will be forthcoming from
the private sector in response to future availability of
Federal tax benefits.
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\106\ Because the proposal would add two years during which the
wage credit would be available within the Cleveland and Los Angeles
empowerment zones, all businesses that relocate to such zones prior to
January 1, 2009, would be better off under the proposal than under
present law with respect to the wage credit, despite the proposed one-
year acceleration of the effective date of the designation of such
zones.
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5. Exempt first $2,000 of severance pay from income tax
Present Law
Under present law, severance payments are includible in
gross income.
Description of Proposal
Under the proposal, up to $2,000 of certain severance
payments would be excludable from the income of the recipient.
The exclusion would apply to payments received by an individual
who was separated from service in connection with a reduction
in the employer's work force. The exclusion would not be
available if the individual becomes employed within 6 months of
the separation from service at a compensation level that is 95
percent of the compensation the individual received before the
separation from service. The exclusion would not apply if the
total severance payments received by the individual exceed
$125,000.
Effective Date
The proposal would be effective for severance pay received
in taxable years beginning after December 31, 1998, and before
January 1, 2004.
Prior Action
No prior action.
Analysis
The proposals lacks specificity in certain respects. For
example, the proposal does not define a ``reduction in the
employer's work force.'' Without an adequate definition, almost
any termination of employment could be construed as in
connection with a reduction in the employer's work force,
meaning that up to $2,000 of any payments made upon termination
of employment would be excludable from income. While the
proposal was not intended to be interpreted so broadly,
additional details would be necessary to determine the breadth
and impact of the proposal. The proposal also does not define
``severance payments,'' so it is unclear whether the proposal
is intended to be limited to certain types of payments received
upon a separation from service, or only some payments. The
definition is important not only in determining what payments
qualify for the exclusion, but also in determining whether any
payments qualify because the $125,000 cap is exceeded.
It is also not entirely clear from the proposal whether the
exclusion is a one-time exclusion, an annual exclusion, or
whether it applies separately to each qualifying separation
from service of the individual.
The stated rationale for the proposal is that the tax on
severance payments places an additional burden on displaced
workers, especially if the worker is separated from service
because of a reduction in work force, in which case it may be
difficult for the worker to find new, comparable employment.
Some would agree that it is appropriate to provide tax relief
for individuals in such circumstances. However, others would
argue that the proposal does not provide relief for all persons
in similar circumstances. For example, some would argue that
relief would be even more necessary in cases in which severance
payments are not provided by the employer, and that a more fair
approach to providing relief for displaced workers would be to
provide that some portion of unemployment benefits are
excludable from income. Others would argue that there is no
clear rationale for distinguishing separations from service in
connection with a reduction in the work force from other
separations--the hardship on the individual may be just as
great in other circumstances. Some would also argue that the
proposal is not well-targeted because it provides tax relief
for individuals who are not in financial distress as a result
of the separation from service. The limit on the exclusion to
cases in which the payments are less than $125,000, is one way
of addressing this concern, as is the restriction that the
exclusion does not apply if comparable employment is attained
within 6 months. Other methods would also be possible, but
would also add complexity to the proposal. The 6-month rule may
itself add some complexity, because the new employment may
occur in a tax year other than the one in which the payments
were received and after the individual's tax return for the
year of payment had been filed. It is unclear in those cases
how the individual would correct the error, e.g., would the
individual file an amended return?
G. Simplification Provisions
1. Optional Self-Employment Contribution Act (``SECA'') computations
Present Law
The Self-Employment Contributions Act (``SECA'') imposes
taxes on net earnings from self-employment to provide social
security and Medicare coverage to self-employed individuals.
The maximum amount of earnings subject to the SECA tax is
coordinated with, and is set at the same level as, the maximum
level of wages and salaries subject to FICA taxes ($68,400 for
OASDI taxes in 1998 and indexed annually, and without limit for
the Hospital Insurance tax). Special rules allow certain self-
employed individuals to continue to maintain social security
coverage during a period of low income. The method applicable
to farmers is slightly more favorable than the method
applicable to other self-employed individuals.
A farmer may increase his or her self-employment income,
for purposes of obtaining social security coverage, by
reporting two-thirds of the first $2,400 of gross income as net
earnings from self-employment, i.e., the optional amount of net
earnings from self-employment would not exceed $1,600. There is
no limit on the number of times a farmer may use this method.
The optional method for nonfarm income is similar, also
permitting two-thirds of the first $2,400 of gross income to be
treated as self-employment income. However, the optional
nonfarm method may not be used more than five times by any
individual, and may only be used if the taxpayer had net
earnings from self-employment of $400 or more in at least two
of the three years immediately preceding the year in which the
optional method is elected.
In general, to receive benefits, including Disability
Insurance Benefits, under the Social Security Act, a worker
must have a minimum number of quarters of coverage. A minimum
amount of wages or self-employment income must be reported to
obtain a quarter of coverage. A maximum of four quarters of
coverage may be obtained each year. In 1978, the amount of
earnings required to obtain a quarter of coverage began
increasing each year. Starting in 1994, a farmer could obtain
only two quarters of coverage under the optional method
applicable to farmers.
Description of Proposal
The proposal would combine the farm and nonfarm optional
methods into a single combined optional method applicable to
all self-employed workers under which self-employment income
for SECA tax purposes would be two-thirds of the first $2,400
of gross income. A self-employed individual could elect to use
the optional method an unlimited number of times. If it is
used, it would have to be applied to all self-employment
earnings for the year, both farm and nonfarm. As under present
law, the $2,400 amount would not be increased for inflation.
Effective Date
The proposal would be effective for taxable years beginning
after December 31, 1998.
Prior Action
The proposal was included in the Administration's 1997
simplification proposals. 107 A similar proposal was
also included in the Taxpayer Relief Act of 1997, as passed by
the House. However, that provision would also have initially
increased the $2,400 limit to the amount that would provide for
four quarters of coverage in 1998, and increased the limit
thereafter as the earnings requirement for quarters of coverage
increases under the Social Security Act. That provision would
also have provided that the optional method could not be
elected retroactively on an amended return.
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\107\ See Department of the Treasury, Taxpayer Bill of Rights 3 and
Tax Simplification Proposals (April 1997).
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Analysis
Approximately 48,000 taxpayers use one of the optional
methods. The proposal would simplify SECA calculations for
those who use the optional method.
The present-law optional farm method is more advantageous
than the nonfarm method. The proposal would eliminate
inequities between the two methods.
Some argue that the proposal should be expanded to increase
the $2,400 limit so that the optional method will continue to
fulfill its original purpose of allowing self-employed
individuals to earn full quarters of coverage.
Also, some argue that taxpayers should not be able to make
an election on a retroactive basis, just as insurance cannot be
purchased after the occurrence of an insurable event. On the
other hand, some argue that not permitting the election on an
amended return may unduly penalize taxpayers who mistakenly do
not claim the election when they first file their return.
2. Statutory hedging and other rules to ensure business property is
treated as ordinary property
Present Law
Capital gain treatment applies to gain on the sale or
exchange of a capital asset. Capital assets include property
other than (1) stock in trade or other types of assets
includible in inventory, (2) property used in a trade or
business that is real property or property subject to
depreciation, (3) accounts or notes receivable acquired in the
ordinary course of a trade or business, or (4) certain
copyrights (or similar property) and U.S. government
publications. Gain or loss on such assets generally is treated
as ordinary, rather than capital, gain or loss. Certain other
Code sections also treat gains or losses as ordinary, such as
the gains or losses of a securities or commodities trader or
dealer that are subject to ``mark-to-market'' accounting (sec.
475). Other Code sections treat certain assets as giving rise
to capital gain or loss.
Under case law in a number of Federal courts prior to 1988,
business hedges generally were treated as giving rise to
ordinary, rather than capital, gain or loss. In 1988, the U.S.
Supreme Court rejected this interpretation in Arkansas Best v.
Commissioner, 485 U.S. 212 (1988), which, relying on the
statutory definition of a capital asset described above, held
that a loss realized on a sale of stock was capital even though
the stock was purchased for a business, rather than an
investment, purpose.
In 1993, the Department of the Treasury issued temporary
regulations, which were finalized in 1994, that require
ordinary character treatment for most business hedges and
provide timing rules requiring that gains or losses on hedging
transactions be taken into account in a manner that matches the
income or loss from the hedged item or items. The regulations
apply to hedges that meet a standard of ``risk reduction'' with
respect to ordinary property held (or to be held) or certain
liabilities incurred (or to be incurred) by the taxpayer and
that meet certain identification and other requirements (Treas.
reg. sec. 1.1221-2).
Under the straddle rules, when a taxpayer realizes a loss
on one offsetting position in actively-traded personal
property, the taxpayer generally can deduct this loss only to
the extent the loss exceeds the unrecognized gain in the other
positions in the straddle (sec. 1092). The straddle rules
generally do not apply to positions in stock. However, the
straddle rules apply to straddles where one of the positions is
stock and at least one of the offsetting positions is either
(1) an option with respect to such stock or substantially
identical stock or securities or (2) a position with respect to
substantially similar or related property (other than stock) as
defined in Treasury regulations. In addition, the straddle
rules apply to stock of a corporation formed or availed of to
take positions in personal property which offset positions
taken by any shareholder.
Description of Proposal
The proposal would add three categories to the list of
assets gain or loss on which is treated as ordinary (sec.
1221). The new categories would be: (1) derivative contracts
entered into by derivative dealers; (2) supplies of a type
regularly used by the taxpayer in the provision of services or
the production of ordinary property; and (3) hedging
transactions.
In defining a hedging transaction, the proposal would
generally codify the approach taken by the Treasury
regulations, but would modify the rules to some extent. The
``risk reduction'' standard of the regulations would be
broadened to one of ``risk management'' with respect to
ordinary property held (or to be held) or certain liabilities
incurred (or to be incurred). As under the Treasury
regulations, the transaction would have to be identified as a
hedge of specified property. If a transaction was improperly
identified as a hedging transaction, losses would retain their
usual character (i.e., usually capital), but gains would be
ordinary. If a hedging transaction was not identified (and
there was no reasonable basis for that failure), gains would be
ordinary but losses would retain their non-hedging character.
The proposal would provide an exclusive list of assets the
gains and losses which would receive ordinary character
treatment; other rationales for ordinary treatment generally
would not be allowed. The Treasury Department would be given
authority to apply these rules to related parties.
As under current Treasury regulations, the proposal would
require that the timing of income, gain, deduction or loss from
hedging transactions must reasonably match the income, gain,
deduction or loss from the items being hedged. In addition,
under the proposal, taxpayers could, to the extent provided in
Treasury regulations, elect the application of these timing
rules for certain transactions that would otherwise be subject
to loss deferral under the straddle rules. The proposal would
repeal the exception from the straddle rules for stock.
Finally, the Treasury Department would be given the authority
to treat the offsetting positions in a straddle on an
integrated basis.
Effective Date
The proposal would be generally effective after the date of
enactment. The identification requirements for hedging
transactions would be effective 60 days after the date of
enactment. The Treasury would be given the authority to issue
regulations applying treatment similar to that provided in the
proposal to transactions entered into prior to the effective
date.
Prior Action
A similar proposal was included in the President's tax
simplification proposals released in April 1997.
Analysis
The proposal's additions to the list of assets that give
rise to ordinary gain and loss would to some extent be a
clarification of present law. Hedging transactions have long
been treated as ordinary under the case law and, more recently,
under Treasury regulations. Gains on derivative contracts
referencing interest rates, equity or foreign currencies
recognized by a dealer in such contracts are treated as
ordinary under the ``mark-to-market'' rules (sec. 475(c)(2) and
(d)(3)). One addition the proposal would make to the ordinary
list would be gains on commodities derivative contracts
recognized by a dealer in such contracts. Some would argue that
this addition is justifiable in order to eliminate the
disparity between commodities derivatives dealers and dealers
in other derivative contracts, whose gains are treated as
ordinary as described above. The other addition that the
proposal would make to the list of ordinary assets is supplies
used in the provision of services or the production of ordinary
property. An example would be a sale of excess jet fuel by an
airline, which is treated as giving rise to capital gain under
present law. Advocates of this addition would argue that such
supplies are so closely related to the taxpayer's business that
ordinary character should apply. Indeed, if the fuel were used
rather than sold by the airline, it would give rise to an
ordinary deduction. In addition, hedges of such items generally
are treated as ordinary in character under present law, giving
rise to a potential character mismatch, e.g. ordinary gain on
the hedging transaction with a capital loss on the fuel sale
that cannot be used to offset it (Treas. reg. sec. 1.1221-
2(c)(5)(ii)). However, opponents would argue that not all
business-related income is ordinary in character and, thus,
that the proposal would only create other disparities. For
example, under present law, a special regime applies to gains
and losses from property used in a trade or business that is
either real property or depreciable property held for more than
one year (sec. 1231). The effect of these rules generally is to
treat a taxpayer's net amount of gain in any year from these
items as long-term capital gain, but any net losses as ordinary
losses.
The proposal with respect to the definition of hedging
transactions is largely a codification of the current Treasury
regulations, with the expansion of the regulations' definition
of hedging transactions to cover transactions that involve
``risk management''. As noted above, the Treasury regulations
were issued in response to the U.S. Supreme Court's decision in
Arkansas Best, which narrowed the definition of hedging allowed
by some Federal courts and resulted in confusion in the
business community as to what types of business hedges would
receive tax hedging treatment. The regulations adopted a more
expansive standard than Arkansas Best, with the result that
more types of business hedging practices can now be treated as
hedges for character and timing purposes, and the regulations
have generally been well received by the business community.
Thus, codifying the regulations would serve to validate the
Treasury regulations, as well as to assure businesses that the
current regime for hedges will be available for some time. They
would also prevent taxpayers from taking aggressive positions
that transactions that are not described in the proposal
qualify as hedges.
The principal change that the proposal would make in the
hedging definition is the replacement of the regulations'
requirement that a hedging transaction result in ``risk
reduction'' with respect to the hedged item with a broader
``risk management'' standard. This is a change that is arguably
not within the Treasury's authority to adopt by regulations.
The parameters of the ``risk management'' standard are not
clear in the proposal, yielding the possibility that the
proposal could result in essentially speculative transactions
obtaining the favorable character and timing benefits of
hedging transactions. However, advocates of the proposal would
point to some common types of business hedging transactions
that arguably do not meet a ``risk reduction'' standard. One
example frequently cited is a fixed-rate debt instrument hedged
with a floating rate hedging instrument. A fixed-rate debt
instrument bears little interest-rate risk, and thus the
transaction would arguably not meet the ``risk reduction''
standard (cf. Treas. reg. sec. 1.1221-2(c)(1)(ii)(B)). However,
businesses frequently enter into transactions hedging such
instruments in order to obtain the benefits of floating
interest rates, and such transactions should meet a ``risk
management'' standard. There have been also reports of tax
controversies over the present law ``risk reduction'' standard
that should be reduced by the proposal. Finally, advocates of
the proposal would point out that the expansiveness of the
``risk management'' standard would be limited by identification
requirement of the present Treasury regulations that would be
codified by the proposal. Under that requirement, in order to
obtain hedging character and timing treatment, the taxpayer
must identify the hedging position in its own records on the
day that the position is acquired and must identify the
specific property or liabilities being hedged within 35 days
thereafter (Treas. reg. sec. 1.1221-2(e)). Despite the
potential overbreadth of the ``risk management'' standard,
these identification requirements limit the ability of
taxpayers to utilize the hedging rules for essentially
speculative transactions.
The proposal would generally codify the Treasury
regulations' timing rules for hedges, with the advantages of
codification described above, but would also allow taxpayers to
elect such treatment for non-hedging transactions that are
subject to the straddle rules. Like any election, this one
would be made only by taxpayers who predict that it would
result in a tax savings. Moreover, by adding the election, the
proposal adds complexity to the already complicated rules for
timing of straddle income. The proposal is not clear as to the
priority of the new election and the elections already
available under the straddle rules (Treas. reg. sec. 1092(b)-3T
and 4T) and thus may grant multiple elective tax treatments for
the same transaction. However, advocates of the proposal would
argue that treatment of some transactions under the straddle
rules is too severe. For example, a small loss can be deferred
even where large amounts of gain have been recognized on the
offsetting position because there is also some unrecognized
gain. However, opponents of the proposal would argue that such
problems call for a revision, and hopefully a simplification,
of the straddle rules, not for a new elective treatment. On the
other hand, the hedge timing rules, which the proposal would
allow taxpayers to elect, account for income in an economic
manner--the timing of gains and losses on the hedging
transaction must reasonably match those from the items being
hedged. Advocates of the proposal would also point to the
identification requirement, which would require taxpayers to
elect hedge accounting for a transaction at the time it is
entered into and to follow that treatment whether or not it
proves advantageous. However, the portion of the proposal that
would, in addition to the above rules, grant the Treasury
Department authority to adopt integration treatment for the
positions of a straddle is unclear in scope and should be
clarified.
The repeal of the limited exception from the straddle rules
for stock is arguably consistent with the policy of those
rules, which prevent deduction of losses in situations where a
taxpayer has entered into an offsetting transaction that has
unrecognized gain, until such time as the gain on the
offsetting position is recognized. Advocates of the proposal
would also point out that offsetting stock positions are fully
subject to the constructive sale rules added by the Taxpayer
Relief Act of 1997 (sec. 1259), which have more onerous results
than loss deferral under the straddle rules. However, because
stock is widely held, the repeal of the stock exception would
subject many more taxpayers to the complicated straddle rules.
It must also be pointed out that proposed Treasury regulations
would severely limit the stock exception even if the proposal
is not adopted (Prop. Treas. reg. sec. 1.1092(d)-2).
Finally, the proposal would grant the Treasury Department
regulatory authority to apply the proposal to transactions
entered into prior to the date of enactment. It is difficult to
assess whether it is appropriate to apply rules in a
retroactive manner without knowing what these rules will be. As
an alternative, where Congress intends that the provisions of
the proposal will not change present law, a ``no inference''
statement could be made in the legislative history. However,
this approach would leave ambiguity in the law.
3. Clarify rules relating to certain disclaimers
Present Law
Historically, there must be acceptance of a gift in order
for the gift to be completed under State law and there is no
taxable gift for Federal gift tax purposes unless there is a
completed gift. Most States have rules that provide that, where
there is a disclaimer of a gift, the property passes to the
person who would be entitled to the property had the
disclaiming party died before the purported transfer.
In the Tax Reform Act of 1976, Congress provided a uniform
disclaimer rule (sec. 2518) that specified how and when a
disclaimer must be made in order to be effective for Federal
transfer tax purposes. Under section 2518, a disclaimer is
effective for Federal transfer tax purposes if it is an
irrevocable and unqualified refusal to accept an interest in
property and certain other requirements are satisfied. One of
the requirements is that the disclaimer generally must be made
in writing not later than nine months after the transfer
creating the interest occurs. In order to be a qualified
disclaimer, the disclaiming person must not have accepted the
disclaimed interest or any of its benefits. Section 2518 is not
currently effective for Federal tax purposes other than
transfer taxes (e.g., it is not effective for income tax
purposes).
In 1981, Congress added a rule to section 2518 that allowed
certain transfers of property to be treated as a qualified
disclaimer, even if not a qualified disclaimer under State law.
In order to qualify, these transfer-type disclaimers must be a
written transfer of the disclaimant's ``entire interest in the
property'' to persons who would have received the property had
there been a valid disclaimer under State law (sec.
2518(c)(3)). Like other disclaimers, the transfer-type
disclaimer generally must be made within nine months of the
transfer creating the interest.
Description of Proposal
The proposal would allow a transfer-type disclaimer of an
``undivided portion'' of the disclaimant transferor's interest
in property to qualify under section 2518. Also, the proposal
would allow a spouse to make a qualified transfer-type
disclaimer where the disclaimed property is transferred to a
trust in which the disclaimant spouse has an interest (e.g., a
credit shelter trust). Further, the proposal would provide that
a qualified disclaimer for transfer tax purposes under section
2518 also would be effective for Federal income tax purposes
(e.g., disclaimers of interests in annuities and income in
respect of a decedent).
Effective Date
The proposal would apply to disclaimers made after the date
of enactment.
Prior Action
The proposal was included in the House version of the
Taxpayer Relief Act of 1997.
Analysis
Under present law, a State-law disclaimer can be a
qualified disclaimer even (1) where it is only a partial
disclaimer of the property interest, or (2) where the
disclaimant spouse retains an interest in the property. In
contrast, it is currently unclear whether a transfer-type
disclaimer can qualify under similar circumstances. Thus, in
order to equalize the treatment of State-law disclaimers and
transfer-type disclaimers, it may be appropriate to allow a
transfer-type disclaimer of an undivided portion of property or
a transfer-type disclaimer where the disclaimant spouse has
retained an interest in the property to be treated as a
qualified disclaimer for transfer tax purposes.
The present-law rules pertaining to qualified disclaimers,
as set forth in section 2518, are effective for Federal
transfer tax purposes but not Federal income tax purposes. If a
disclaimer satisfies the requirements for a qualified
disclaimer under present law, it may be appropriate to allow
the disclaimer to be effective for Federal income tax purposes
as well as Federal transfer tax purposes. It should be noted,
however, that allowing disclaimers to be effective for Federal
income tax purposes would override the general assignment of
income concepts in that area.
4. Simplify the foreign tax credit limitation for dividends from ``10/
50'' companies
Present Law
U.S. persons may credit foreign taxes against U.S. tax on
foreign-source income. The amount of foreign tax credits that
may be claimed in a year is subject to a limitation that
prevents taxpayers from using foreign tax credits to offset
U.S. tax on U.S.-source income. Separate limitations are
applied to specific categories of income.
Special foreign tax credit limitations apply in the case of
dividends received from a foreign corporation in which the
taxpayer owns at least 10 percent of the stock by vote and
which is not a controlled foreign corporation (a so-called
``10/50 company'').108 Dividends paid by a 10/50
company in taxable years beginning before January 1, 2003 are
subject to a separate foreign tax credit limitation for each
10/50 company. Dividends paid by a 10/50 company that is not a
passive foreign investment company in taxable years beginning
after December 31, 2002, out of earnings and profits
accumulated in taxable years beginning before January 1, 2003,
are subject to a single foreign tax credit limitation for all
10/50 companies (other than passive foreign investment
companies). Dividends paid by a 10/50 company that is a passive
foreign investment company out of earnings and profits
accumulated in taxable years beginning before January 1, 2003
continue to be subject to a separate foreign tax credit
limitation for each such 10/50 company. Dividends paid by a 10/
50 company in taxable years beginning after December 31, 2002,
out of earnings and profits accumulated in taxable years after
December 31, 2002, are treated as income in a foreign tax
credit limitation category in proportion to the ratio of the
earnings and profits attributable to income in such foreign tax
credit limitation category to the total earnings and profits (a
so-called ``look-through'' approach). For these purposes,
distributions are treated as made from the most recently
accumulated earnings and profits. Regulatory authority is
granted to provide rules regarding the treatment of
distributions out of earnings and profits for periods prior to
the taxpayer's acquisition of such stock.
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\108\ A controlled foreign corporation in which the taxpayer owns
at least 10% of the stock by vote is treated as a 10/50 company with
respect to any distribution out of earnings and profits for periods
when it was not a controlled foreign corporation.
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Description of Proposal
The proposal would simplify the application of the foreign
tax credit limitation by applying the look-through approach
immediately to all dividends paid by a 10/50 company,
regardless of the year in which the earnings and profits out of
which the dividend is paid were accumulated. The proposal would
broaden the regulatory authority to provide rules regarding the
treatment of distributions out of earnings and profits for
periods prior to the taxpayer's acquisition of the stock,
specifically including rules to disregard both pre-acquisition
earnings and profits and foreign taxes, in appropriate
circumstances.
Effective Date
The proposal would be effective for taxable years beginning
after December 31, 1997.
Prior Action
The proposal would modify the effective date of a provision
included in the Taxpayer Relief Act of 1997 (the ``1997 Act'').
Analysis
The proposal would eliminate the single-basket limitation
approach for dividends from 10/50 companies, and would
accelerate the application of the look-through approach for
dividends from such companies for foreign tax credit limitation
purposes. It is argued that the current rules for dividends
from 10/50 companies will result in complexity and compliance
burdens for taxpayers. For instance, dividends paid by a 10/50
company in taxable years beginning after December 31, 2002 will
be subject to the concurrent application of both the single-
basket approach (for pre-2003 earnings and profits) and the
look-through approach (for post-2002 earnings and profits). In
light of the delayed effective date for the look-through
provision included in the 1997 Act, the 1997 Act's application
of the look-through approach only to post-effective date
earnings and profits was necessary to avoid affecting the
timing of distributions before the effective date. The
provision included in the 1997 Act was aimed at reducing the
bias against U.S. participation in foreign joint ventures and
foreign investment by U.S. companies through affiliates that
are not majority-owned. In this regard, the proposal to
accelerate the application of the look-through approach would
be consistent with this objective.
Under present law, regulatory authority is granted to
provide rules regarding the treatment of distributions out of
earnings and profits for periods prior to the taxpayer's
acquisition of the stock of a 10/50 company. The proposal would
broaden such regulatory authority to include rules to disregard
(upon distributions from a 10/50 company) both pre-acquisition
earnings and profits and foreign taxes, in appropriate
circumstances. Under such an approach, in appropriate cases, a
shareholder of a 10/50 company would not be entitled to a
foreign tax credit with respect to distributions from that
company out of pre-acquisition earnings and profits, but also
would not be required to include such distributions in its
income. Such an approach may provide administrative
simplification in cases where it would be difficult for a
minority shareholder to reconstruct the historical records of
an acquired company. Such an approach also may be appropriate
in certain cases where a taxpayer enters into transactions
effectively to ``purchase'' foreign tax credits that can be
used to reduce the taxpayer's U.S. residual taxes on other
foreign-source income. However, this concept of disregarding
earnings and profits and taxes is inconsistent with the general
treatment of distributions from acquired corporations for
foreign tax credit purposes.
5. Interest treatment for dividends paid by certain regulated
investment companies to foreign persons
Present Law
A regulated investment company (``RIC'') is a domestic
corporation that, at all times during the taxable year, is
registered under the Investment Company Act of 1940 as a
management company or as a unit investment trust, or has
elected to be treated as a business development company under
that Act (sec. 851(a)).
In addition, to qualify as a RIC, a corporation must elect
such status and must satisfy certain tests (sec. 851(b)). These
tests include a requirement that the corporation derive at
least 90 percent of its gross income from dividends, interest,
payments with respect to certain securities loans, and gains on
the sale or other disposition of stock or securities or foreign
currencies or other income derived with respect to its business
of investment in such stock, securities, or currencies.
Generally, a RIC pays no income tax because it is permitted
a deduction for dividends paid to its shareholders in computing
its taxable income. Dividends paid by a RIC generally are
includible in income by its shareholders as dividends, but the
character of certain income items of the RIC may be passed
through to shareholders receiving the dividend. A RIC generally
may pass through to its shareholders the character of its long-
term capital gains by designating a dividend it pays as a
capital gain dividend to the extent that the RIC has net
capital gain. A RIC generally also can pass through to its
shareholders the character of its tax-exempt interest from
State and municipal bonds, but only if, at the close of each
quarter of its taxable year, at least 50 percent of the value
of the total assets of the RIC consists of these obligations.
Under the Code, a 30-percent tax, collected by withholding,
generally is imposed on the gross amount of certain U.S.-source
income, such as interest and dividends, of nonresident alien
individuals and foreign corporations (collectively, ``foreign
persons''). Dividends paid by a RIC generally are treated as
dividends for withholding tax purposes, subject to the
exceptions noted above. This 30-percent withholding tax may be
reduced or eliminated pursuant to an applicable income tax
treaty. In the case of dividends on portfolio investments, U.S.
income tax treaties commonly provide for a withholding tax at a
rate of at least 15 percent.
An exception from the U.S. 30-percent withholding tax is
provided for so-called ``portfolio interest.'' Portfolio
interest is interest (including original issue discount) which
would be subject to the U.S. withholding tax but for the fact
that specified requirements are met with respect to the
obligation on which the interest is paid and with respect to
the interest recipient. Pursuant to these requirements, in the
case of an obligation that is in registered form, the U.S.
person who otherwise would be required to withhold tax must
receive a statement that the beneficial owner of the obligation
is not a United States person. Alternatively, if the obligation
is not in registered form, it must be ``foreign targeted.'' If
the obligation is issued by a corporation or a partnership, the
recipient of the interest must not have 10 percent or more of
the voting power of the corporation or 10 percent or more of
the capital or profits interest in the partnership. A corporate
recipient of the interest must be neither a controlled foreign
corporation receiving interest from a related person, nor
(unless the obligor is the United States) a bank receiving the
interest on an extension of credit made pursuant to a loan
agreement entered into in the ordinary course of its trade or
business. Finally, certain contingent interest does not qualify
as portfolio interest.
Description of Proposal
In the case of a RIC that invests substantially all of its
assets in certain debt instruments or cash, the proposal would
treat all dividends paid by the RIC to shareholders who are
foreign persons as interest that qualifies for the ``portfolio
interest'' exception from the U.S. withholding tax. Under the
proposal, the debt instruments taken into account to satisfy
this ``substantially all'' test generally would be limited to
debt instruments of U.S. issuers that would themselves qualify
for the ``portfolio interest'' exception if held by a foreign
person. However, under the proposal, some amount of foreign
debt instruments that are free from foreign tax (pursuant to
the laws of the relevant foreign country) also would be treated
as debt instruments that count toward the ``substantially all''
test.
Effective Date
The proposal would be effective for dividends paid by a RIC
in taxable years beginning after December 31, 1998.
Prior Action
No prior action.
Analysis
The major advantage claimed by advocates of the proposal is
that it would eliminate the disparity in tax treatment between
debt instruments qualifying for the ``portfolio interest''
exception that are held by a foreign person directly and
similar instruments owned indirectly through a RIC. The
proposal may encourage investment by foreign persons in U.S.
debt instruments by making the benefits of the ``portfolio
interest'' exception available to investors who are willing to
invest in such instruments only through a diversified fund.
Expanding demand for U.S. debt instruments could lower
borrowing costs of issuers. It is argued that U.S. RICs are at
a competitive disadvantage as compared with foreign mutual
funds whose home countries do not impose withholding tax on
dividends attributable to income from debt investments. The
proposal would ameliorate this disparate treatment between U.S.
and foreign mutual funds.
Opponents of the proposal would argue that holding an
interest in a RIC that holds debt instruments that qualify for
the ``portfolio interest'' exception is sufficiently different
from holding such instruments directly that the ``portfolio
interest'' exception should not apply in the RIC case. A RIC is
a widely diversified pool of investments, and managers of RICs
have discretion to acquire and dispose of debt instruments in
the pool. Moreover, under the proposal, a portion of the RIC's
assets may be foreign debt instruments, making an investment in
the RIC less analogous to a direct interest in U.S. debt
instruments.
H. Taxpayers' Rights Provisions
1. Suspend collection by levy during refund suit
Present Law
Levy is the IRS's administrative authority to seize a
taxpayer's property to pay the taxpayer's tax liability. The
IRS is entitled to seize a taxpayer's property by levy if the
Federal tax lien has attached to such property. The Federal tax
lien arises automatically where (1) a tax assessment has been
made; (2) the taxpayer has been given notice of the the
assessment stating the amount and demanding payment; and (3)
the taxpayer has failed to pay the amount assessed within ten
days after the notice and demand. The IRS is prohibited from
making a tax assessment (and thus prohibited from collecting
payment) with respect to a tax liability while it is being
contested in Tax Court.109 However, under present
law, the IRS is permitted to assess and collect tax liabilities
during the pendency of a refund suit relating to such tax
liabilities, under the circumstances described below.
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\109\ Code section 6213(a).
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Generally, full payment of the tax at issue is a
prerequisite to a refund suit.110 However, if the
tax is divisible (such as employment taxes or the trust fund
penalty under Code section 6672), the taxpayer need only pay
the tax for the applicable period before filing a refund claim.
Most divisible taxes are not within the Tax Court's
jurisdiction; accordingly, the taxpayer has no pre- payment
forum for contesting such taxes. In the case of divisible
taxes, it is possible that the taxpayer could be properly under
the refund jurisdiction of the district court or the U.S. Court
of Federal Claims and still be subject to collection by levy
with respect to the entire amount of the tax at issue. The
IRS's policy is generally to exercise forbearance with respect
to collection while the refund suit is pending, so long as the
interests of the Government are adequately protected (e.g., by
the filing of a notice of Federal tax lien) and collection is
not in jeopardy.111 Any refunds due the taxpayer may
be credited to the unpaid portion of the liability pending the
outcome of the suit.
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\110\ Flora v. United States, 357 U.S. 63 (1958), aff'd on reh'g,
362 U.S. 145 (1960).
\111\ See, e.g., Internal Revenue Manual (``IRM'') 563(13).2 (May
5, 1993) (setting forth criteria for withholding collection of trust
fund penalties at the taxpayer's request).
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Description of Proposal
This proposal would require the IRS to withhold collection
by levy of liabilities that are the subject of a refund suit
during the pendency of the litigation. This would only apply
when refund suits can be brought without the full payment of
the tax, i.e., in the case of divisible taxes. Collection by
levy would be withheld unless jeopardy exists or the taxpayer
waives the suspension of collection in writing. This proposal
would not affect the IRS's ability to collect other assessments
that are not the subject of the refund suit, to offset refunds,
or to file a notice of Federal tax lien. The statute of
limitations on collection would be stayed for the period during
which the IRS is prohibited from collecting by levy.
Effective Date
The proposal would be effective for refund suits brought
with respect to tax years beginning after December 31, 1998.
Prior Action
No prior action.
Analysis
The decision in a refund suit with respect to divisible
taxes generally determines the liability for all such tax
liability of the taxpayer, not merely for the amounts at issue
in the suit. It may be appropriate that taxpayers who are
litigating a refund action over divisible taxes should be
protected from collection of the full assessed amount, until a
determination of the liability is made, provided that the IRS's
ultimate ability to collect the amount determined by the court
to be properly due is preserved.
2. Suspend collection by levy while offer-in-compromise is pending
Present Law
Section 7122 of the Code permits the IRS to compromise a
taxpayer's tax liability. In general, this occurs when a
taxpayer submits an offer-in-compromise to the IRS. An offer-
in-compromise is a proposal to settle unpaid tax accounts for
less than the full amount of the balance due. They may be
submitted for all types of taxes, as well as interest and
penalties, arising under the Internal Revenue Code. Pursuant to
the IRM, collection normally is withheld during the period an
offer is pending, ``unless it is determined that the offer is a
delaying tactic and collection is in jeopardy.'' 112
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\112\ IRM 57(10)5.1(3) (Sept. 22, 1994).
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Description of Proposal
The proposal would prohibit the IRS from collecting a tax
liability by levy (1) during any period that a taxpayer's
offer-in-compromise for that liability is being processed, (2)
during the 30 days following rejection of an offer, and (3)
during any period in which an appeal of the rejection of an
offer is being considered. Return of an offer-in-compromise as
unprocessable would be considered a rejection for this purpose.
Taxpayers whose offers are either rejected or returned as
unprocessable and who made good faith revisions of their offers
and resubmitted them within 30 days of the rejection or return
would be eligible for a continuous period of relief from
collection by levy. This prohibition on collection by levy
would not apply if the IRS determines that collection is in
jeopardy or that the offer was submitted solely to delay
collection. The proposal would not require the IRS to stop any
levy action that was initiated, or withdraw any lien that was
filed, before the taxpayer submitted an offer in compromise to
the IRS. The proposal would provide that the statute of
limitations on collection would be tolled for the period during
which collection by levy is barred.
Effective Date
The proposal would be effective with respect to taxes
assessed on or after 60 days after the date of enactment.
Prior Action
No prior action.
Analysis
The proposal may increase taxpayers' perception of fairness
in the tax system, in that the proposal will generally prohibit
IRS from utilizing strong collection measures at the same time
the taxpayer is attempting to resolve the issue with the IRS.
3. Suspend collection to permit resolution of disputes as to liability
Present Law
In general, before assessment of a tax deficiency, the IRS
must give notice of such deficiency to the taxpayer, which
provides the taxpayer an opportunity to contest the deficiency
in Tax Court (secs. 6212 and 6213). The notice of deficiency
must be mailed to the taxpayer's last known address (sec.
6212(b)). If the taxpayer fails to file a petition in Tax Court
within 90 days (150 days if the notice is addressed outside the
United States), the IRS may then assess the deficiency (sec.
6213(c)). Once the 90 (or 150) day period has expired, so has
the taxpayer's only opportunity to seek pre-payment judicial
determination of the taxpayer's liability. Under present law,
once a valid assessment is made, the IRS is not required to
suspend collection if the taxpayer claims not to owe the taxes.
The taxpayer has one final opportunity to argue doubt as to
liability. Section 7122 of the Code permits the IRS to
compromise a taxpayer's tax liability. In general, this occurs
when a taxpayer submits an offer-in-compromise to the IRS,
proposing to settle unpaid tax accounts for less than the full
amount of the assessed balance due.113 The
regulations provide that doubt as to liability may be grounds
for the IRS's accepting the taxpayer's offer-in-compromise. The
Code and regulations do not preclude collection of a tax
liability while an offer-in-compromise with respect to that
liability is pending. The regulations provide that collection
may be deferred while an offer-in-compromise is pending, unless
the interests of the United States are
jeopardized.114 The Internal Revenue Manual directs
employees to advise taxpayers that ``collection normally will
be withheld unless it is determined that the offer is a
delaying tactic and collection is in jeopardy.'' 115
Collection is ordinarily barred, pursuant to the parties''
agreement, if an offer-in-compromise is accepted.
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\113\ Treas. Reg. sec. 301.7122-1(a).
\114\ Treas. Reg. sec. 301.7122-1(d)(2).
\115\ IRM 57(10)5.1(3) (Sept. 22, 1994).
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Description of Proposal
This proposal would permit an individual taxpayer to
request that collection be suspended temporarily with regard to
an income tax liability that is assessed based upon a statutory
notice of deficiency that the taxpayer failed to receive or to
which the taxpayer failed to respond. The IRS would suspend
collection for a 60-day period, during which the taxpayer may
dispute the merits of the underlying assessment. The 60-day
period would be extended in appropriate cases where progress is
being made in resolving the liability. Collection by refund
offset and jeopardy levies would be exempted. The statute of
limitations on collection would be stayed while the taxpayer's
claim is pending. The proposal also would not affect the IRS's
ability to file a notice of Federal tax lien.
Effective Date
The proposal would be effective for taxes assessed with
respect to taxable years beginning after December 31, 1998.
Prior Action
No prior action.
Analysis
This proposal may ease the burden on taxpayers with a
colorable dispute as to liability who were unable to have a
hearing in Tax Court because they failed to receive or respond
to a proper statutory notice of deficiency. Proponents of the
proposal argue that if such a taxpayer is making a legitimate
effort to resolve a tax liability through an offer-in-
compromise, and the interests of the United States are
adequately protected, it would be appropriate to preclude
enforced collection of the liability. In conjunction with the
proposal to suspend collection by levy while an offer-in-
compromise is pending, this proposal would restrict IRS
collection measures while the taxpayer is attempting to resolve
the issue with the IRS.
4. Require district counsel approval of certain third-party collection
activities
Present Law
The Code authorizes the IRS to levy upon all non-exempt
property and rights to property belonging to the taxpayer (sec.
6331(a)). In some cases, property belonging to the taxpayer may
be nominally held in a name other than the taxpayer's. For
example, if a corporation would be treated as the alter ego of
an individual taxpayer under common law principles, the IRS may
treat the corporation's assets as those of the taxpayer and can
properly take administrative collection action against those
assets. Similarly, it is sometimes possible to show that
property held in the name of a third party individual is being
held in a nominal or representative capacity for a taxpayer
(such as, for example, in the case of a fraudulent conveyance).
In such situations, IRS policy is to require written advice by
District Counsel as to the need for a supplemental assessment,
a new notice and demand, and the language to be incorporated in
the notices of lien and levy on such property. However,
District Counsel approval is not presently required before a
notice of Federal tax lien can be filed in connection with
property held by a nominee, transferee, or alter ego of the
taxpayer, or before the seizure of property to which a Federal
tax lien attaches but which is presently neither owned by the
taxpayer nor titled in the name of the taxpayer.
Description of Proposal
The proposal would require IRS District Counsel approval
before a notice of Federal tax lien can be filed or levy is
made in connection with property held by a nominee, transferee,
or alter ego of the taxpayer. District Counsel approval would
be required before the IRS seizes property encumbered by a
Federal tax lien if the property is presently neither owned nor
titled in the name of the taxpayer. The only exception would be
in jeopardy situations. If District Counsel's approval was not
obtained, the property-owner would be entitled to obtain
release of the lien or levy, and, if the IRS failed to make
such release, to appeal first to the Collections Appeals
process and then to the U.S. District Court.
Effective Date
The proposal would be effective with respect to taxes
assessed after the date of enactment.
Prior Action
No prior action.
Analysis
The determination of whether property held in the hands of
a third party belongs to the taxpayer often involves difficult
legal issues. It may be argued that District Counsel review of
these issues before the IRS takes collection action against
such property will insure that third party property seizures
are legally sound, thus improving the public's perception of
the IRS.
5. Require additional approval of levies on certain assets
Present Law
In general, the IRS may collect taxes by levy on the
property and rights to property of the taxpayer. A number of
statutory restrictions apply. One of these is that a levy is
allowed on a taxpayer's principal residence only if a District
Director or Assistant District Director of the IRS personally
approve in writing of the levy (except in cases of jeopardy).
Description of Proposal
The proposal would expand these approval requirements to
also apply to levies on non-governmental pensions and on the
cash value of life insurance policies. The proposal would also
provide for administrative and judicial remedies if appropriate
approval were not obtained.
Effective Date
The proposal would be effective with respect to taxes
assessed after the date of enactment.
Prior Action
No prior action.
Analysis
Taxpayers may find it beneficial to have these approval
requirements extended to these additional items, in that doing
so will help ensure more careful consideration of the
appropriateness of the levy in the taxpayer's situation.
6. Require district counsel review of jeopardy and termination
assessments and jeopardy levies
Present Law
The Code provides special procedures that allow the IRS to
make jeopardy assessments or termination assessments in certain
extraordinary circumstances, such as if the taxpayer is leaving
or removing property from the United States (sec. 6851), or if
assessment or collection would be jeopardized by delay (secs.
6861 and 6862). In jeopardy situations, a levy may also be made
without the 30 days' notice of intent to levy that is
ordinarily required by section 6331(d)(2). The Code and
regulations do not presently require District Counsel to review
jeopardy assessments, termination assessments, or jeopardy
levies, although the Internal Revenue Manual does require
District Counsel review before such actions and it is current
practice to make such a review.116 The IRS bears the
burden of proof with respect to the reasonableness of a
jeopardy or termination assessment or a jeopardy levy (sec.
7429(g)).
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\116\ IRM (CCDM) (34)(12)25.
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Description of Proposal
The proposal would require IRS District Counsel review and
approval before the IRS could make a jeopardy assessment, a
termination assessment, or a jeopardy levy. If District
Counsel's approval was not obtained, the taxpayer would be
entitled to obtain abatement of the assessment or release of
the levy, and, if the IRS failed to offer such relief, to
appeal first to the Collections Appeals process and then to the
U.S. District Court.
Effective Date
The proposal would be effective with respect to taxes
assessed after the date of enactment.
Prior Action
No prior action.
Analysis
Seizure of property without the notice periods generally
required by the Code is a serious matter that should not be
undertaken without adequate safeguards for the property rights
of the taxpayer. Determination of whether a jeopardy situation
exists justifying immediate collection often involves difficult
legal issues. District Counsel review prior to collection
action may help protect taxpayers' property rights.
7. Require management approval of sales of perishable goods
Present Law
If the IRS seizes property that (1) is liable to perish,
(2) is liable to become greatly reduced in price or value by
keeping, or (3) cannot be kept without great expense, special
rules apply (sec. 6336). First, the IRS must appraise the value
of the property. Next, the IRS must give the owner the
opportunity to pay (or give bond for) the appraised amount. If
the owner does so, the property must be returned to the owner.
If the owner does not do so, the IRS conducts a public sale of
the property as soon as practicable. The IRS Manual (``IRM'')
117 permits IRS district directors to delegate the
authority to approve a sale to group managers.
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\117\ IRM Part V, chapter 5600, 56(14)5.
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Description of Proposal
The proposal would require approval by the IRS district
director or assistant district director before the sale of
perishable goods. If these provisions are not followed,
taxpayers could sue for civil damages for unauthorized
collection actions (sec. 7433). Taxpayers would be permitted to
waive the requirement of approval.\118\ The proposal would also
clarify what a perishable good is.\119\
---------------------------------------------------------------------------
\118\ It is anticipated that owners would consider doing so when
time is of the essence and an immediate sale was in the owner's best
interests.
\119\ The proposal does not specifiy the natue of the
clarification.
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Effective Date
The proposal would be effective with respect to taxes
assessed after the date of enactment.
Prior Action
No prior action.
Analysis
Taxpayers may find it beneficial to have these approval
requirements applied to sales of perishable goods, in that
doing so will help ensure more careful consideration of the
appropriateness of all elements of the sale.
8. Codify certain fair debt collection practices
Present Law
The Fair Debt Collection Practices Act \120\ provides a
number of rules relating to debt collection practices. Among
these are restrictions on communication with the consumer, such
as a general prohibition on telephone calls outside the hours
of 8:00 a.m. to 9:00 p.m. local time,\121\ and prohibitions on
harassing or abusing the consumer.\122\ In general, these
provisions do not apply to the Federal Government.\123\ These
provisions relating to communication with the consumer and
prohibiting harassing or abusing the consumer have been applied
to the IRS through the appropriations process.\124\
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\120\ 15 U.S.C. 1692.
\121\ 15 U.S.C. 1692c.(a).
\122\ 15 U.S.C. 1692d.
\123\ 15 U.S.C. 1692a.(6)(c).
\124\ Section 104 of the Fiscal Year 1998 Treasury Department
Appropriations Act.
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Description of Proposal
The proposal would make the restrictions relating to
communication with the consumer and the prohibitions on
harassing or abusing the consumer applicable to the IRS by
incorporating these provisions into the Internal Revenue Code.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
The 1998 Treasury Department Appropriations Act requires
that the IRS follow these restrictions.
Analysis
Placing these restrictions in the Code may improve the
general awareness of these restrictions and emphasize their
importance.
9. Payment of taxes
Present Law
The Code provides that it is lawful for the Secretary to
accept checks or money orders as payment for taxes, to the
extent and under the conditions provided in regulations
prescribed by the Secretary (sec. 6311). Those regulations
\125\ state that checks or money orders should be made payable
to the Internal Revenue Service.
---------------------------------------------------------------------------
\125\ Treas. Reg. Sec. 301.6311-1(a)(1).
---------------------------------------------------------------------------
Description of Proposal
The proposal would require the Secretary or his delegate to
establish such rules, regulations, and procedures as are
necessary to allow payment of taxes by check or money order to
be made payable to the United States Treasury.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
The proposal is contained in section 374 of H.R. 2676 (the
``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997.
Analysis
The proponents believe that it is more appropriate that
checks be made payable to the United States Treasury rather
than the Internal Revenue Service. They argue that it may
improve the public's perception of the IRS by raising awareness
that the IRS is merely the collector of revenue for the Federal
Government.
10. Procedures relating to extensions of statute of limitations by
agreement
Present Law
The statute of limitations within which the IRS may assess
additional taxes is generally three years from the date a
return is filed (sec. 6501).\126\ Prior to the expiration of
the statute of limitations, both the taxpayer and the IRS may
agree in writing to extend the statute, using Form 872 or 872-
A. An extension may be for either a specified period or an
indefinite period. The statute of limitations within which a
tax may be collected after assessment is 10 years after
assessment (sec. 6502). Prior to the expiration of the statute
of limitations, both the taxpayer and the IRS may agree in
writing to extend the statute, using Form 900.
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\126\ For this purpose, a return filed before the due date is
considered to be filed on the due date.
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Description of Proposal
The proposal would require that, on each occasion on which
the taxpayer is requested by the IRS to extend the statute of
limitations, the IRS must notify the taxpayer of the taxpayer's
right to refuse to extend the statute of limitations or to
limit the extension to particular issues.
Effective Date
The proposal would apply to requests to extend the statute
of limitations made after the date of enactment.
Prior Action
The proposal is contained in section 345 of H.R. 2676 (the
``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997.
Analysis
The proponents believe that taxpayers should be fully
informed of their rights with respect to the statute of
limitations.
11. Offers-in-compromise
Present Law
Section 7122 of the Code permits the IRS to compromise a
taxpayer's tax liability. In general, this occurs when a
taxpayer submits an offer-in-compromise to the IRS. An offer-
in- compromise is a proposal to settle unpaid tax accounts for
less than the full amount of the assessed balance due. An
offer-in-compromise may be submitted for all types of taxes, as
well as interest and penalties, arising under the Internal
Revenue Code.
Taxpayers submit an offer-in-compromise on Form 656. There
are two bases on which an offer can be made. The first is doubt
as to the liability for the amount owed. The second is doubt as
to the taxpayer's ability fully to pay the amount owed. An
application can be made on either or both of these grounds.
Taxpayers are required to submit background information to the
IRS substantiating their application. If they are applying on
the basis of doubt as to the taxpayer's ability fully to pay
the amount owed, the taxpayer must complete a financial
disclosure form enumerating assets and liabilities.
As part of an offer-in-compromise made on the basis of
doubt as to ability fully to pay, taxpayers must agree to
comply with all provisions of the Internal Revenue Code
relating to filing returns and paying taxes for five years from
the date the IRS accepts the offer. Failure to observe this
requirement permits the IRS to begin immediate collection
actions for the original amount of the liability.
Description of Proposal
The proposal would require the IRS to develop and publish
schedules of national and local allowances designed to provide
taxpayers entering into an offer-in-compromise with adequate
means to provide for basic living expenses.
Effective Date
The materials required by this provision would be required
to be published as soon as practicable, but no later than 180
days after the date of enactment.
Prior Action
The proposal is contained in section 346 of H.R. 2676 (the
``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997. (That
section of the House bill also contains additional provisions
relating to offers-in-compromise.)
Analysis
In determining whether there is doubt as to the taxpayer's
ability fully to pay the amount owed, the proponents believe
that the Secretary should take into consideration a taxpayer's
need to provide for the basic living expenses of his or her
family, based on the cost of living in the taxpayer's locality.
12. Ensure availability of installment agreements
Present Law
Section 6159 of the Code authorizes the IRS to enter into
written agreements with any taxpayer under which the taxpayer
is allowed to pay taxes owed, as well as interest and
penalties, in installment payments if the IRS determines that
doing so will facilitate collection of the amounts owed. An
installment agreement does not reduce the amount of taxes,
interest, or penalties owed; it does, however, provide for a
longer period during which payments may be made during which
other IRS enforcement actions (such as levies or seizures) are
held in abeyance. Many taxpayers can request an installment
agreement by filing form 9465. This form is relatively simple
and does not require the submission of detailed financial
statements. The IRS in most instances readily approves these
requests if the amounts involved are not large (in general,
below $10,000) and if the taxpayer has filed tax returns on
time in the past. Some taxpayers are required to submit
background information to the IRS substantiating their
application. If the request for an installment agreement is
approved by the IRS, a user fee of $43 is charged.\127\ This
user fee is in addition to the tax, interest, and penalties
that are owed.
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\127\ This user fee is imposed pursuant to 31 U.S.C. 9701. See T.D.
8589 (February 14, 1995).
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Description of Proposal
The proposal would require the Secretary to enter an
installment agreement, at the taxpayer's option, if:
(1) the liability is $10,000 or less;
(2) within the previous 5 years, the taxpayer has not
failed to file or to pay, nor entered an installment agreement
under this provision;
(3) if requested by the Secretary, the taxpayer submits
financial statements that demonstrate an inability to pay the
tax due in full;
(4) the installment agreement provides for full payment of
the liability within 3 years, with installment payments made by
direct debit of the taxpayer's bank account;
(5) the taxpayer extends the statute of limitations on
collection during the term of the agreement; and (6) the
taxpayer agrees to continue to comply with the tax laws and the
terms of the agreement for the period (up to 3 years) that the
agreement is in place.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
Several elements of the proposal essentially codify current
IRS Manual provisions relating to installment agreements.
Analysis
Taxpayers may consider it helpful to have statutory
assurance of their right to an installment agreement.
13. Increase superpriority dollar limits
Present Law
The Federal tax lien attaches to all property and rights in
property of the taxpayer, if the taxpayer fails to pay the
assessed tax liability after notice and demand (sec. 6321).
However, the Federal tax lien is not valid as to certain
``superpriority'' interests as defined in section 6323(b).
Two of these interests are limited by a specific dollar
amount. Under section 6323(b)(4), purchasers of personal
property at a casual sale are presently protected against a
Federal tax lien attached to such property to the extent the
sale is for less than $250. Section 6323(b)(7) provides
protection to mechanic's lienors with respect to the repairs or
improvements made to owner- occupied personal residences, but
only to the extent that the contract for repair or improvement
is for not more than $1,000.
In addition, a superpriority is granted under section
6323(b)(10) to banks and building and loan associations which
make passbook loans to their customers, provided that those
institutions retain the passbooks in their possession until the
loan is completely paid off.
Description of Proposal
The proposal would increase the dollar limit in section
6323(b)(4) for purchasers at a casual sale from $250 to $1,000,
and it would increase the dollar limit in section 6323(b)(7)
from $1,000 to $5,000 for mechanics lienors providing home
improvement work for owner-occupied personal residences. The
proposal would index these amounts for inflation. The proposal
also would clarify section 6323(b)(10) to reflect present
banking practices, where a passbook-type loan may be made even
though an actual passbook is not used.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
No prior action.
Analysis
The dollar limits on the superpriority amounts have not
been increased for decades and do not reflect present prices or
values. Similarly, the passbook loan requirement does not
reflect present banking practices, in which an actual passbook
is not used.. If the policy behind the creation of
superpriority interests is still valid, then increasing the
limits would be appropriate, as the protection provided by
present law is not effective because it is so limited.
14. Permit personal delivery of section 6672(b) notices
Present Law
Any person who is required to collect, truthfully account
for, and pay over any tax imposed by the Internal Revenue Code
who willfully fails to do so is liable for a penalty equal to
the amount of the tax (Sec. 6672(a)). Before the IRS may assess
any such ``100 percent penalty,'' it must mail a written
preliminary notice informing the person of the proposed penalty
to that person's last known address. The mailing of such notice
must precede any notice and demand for payment of the penalty
by at least 60 days. The statute of limitations shall not
expire before the date 90 days after the date in which the
notice was mailed. These restrictions do not apply if the
Secretary finds the collection of the penalty is in jeopardy.
Description of Proposal
The proposal would permit personal delivery, as an
alternative to delivery by mail, of a preliminary notice that
the IRS intends to assess a 100 percent penalty.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
The requirement that such preliminary notices be mailed to
the person's last known address was added in 1996 by the
Taxpayer Bill of Rights 2 (P.L. 104-168).
Analysis
A penalty under section 6672 may be assessed where a
``responsible person'' willfully fails to remit Federal income
tax withholding, social security and health insurance taxes. A
``responsible person'' includes the employer and certain
employees of the employer who have control over the use of
corporate funds. An individual identified by the IRS as a
responsible person is permitted an administrative appeal on the
question of responsibility.
At the time Congress added the requirement that the
preliminary notice of intention to assess a penalty under
section 6672 be mailed, it was concerned that some employees
may not be fully aware of their personal liability under
section 6672 and believed that the IRS could make additional
efforts to assist the public in understanding its
responsibilities.\128\
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\128\ See Joint Committee on Taxation, General Explanation of Tax
Legislation Encated in the 104th Congress (JCS-12-96), December 18,
1996, pp. 38-39.
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The IRS and the Treasury Department have expressed concern
that the requirement that preliminary notices be mailed leads
to unnecessary disputes over whether the notice was properly
addressed or received. The IRS and the Treasury Department have
also suggested that if the preliminary notice could be
personally delivered it could afford an additional opportunity
to resolve disputes in these cases at an earlier stage.
In requiring the preliminary notice to be mailed, Congress
insured that the person to whom the notice was addressed would
have an opportunity to consider the issue of personal liability
for the penalty before being required to respond. Personal
delivery should not change this, since the 60-day waiting
period between the mailing or personal delivery of the notice
and the assessment of any penalty would continue to apply.
15. Allow taxpayers to quash all third-party summonses
Present Law
When the IRS issues a summons to a ``third-party record
keeper'' relating to the business transactions or affairs of a
taxpayer, section 7609 requires that notice of the summons be
given to the taxpayer within three days by certified or
registered mail. The taxpayer is thereafter given up to 23 days
to begin a court proceeding to quash the summons. If the
taxpayer does so, third-party record keepers are prohibited
from complying with the summons until the court rules on the
taxpayer's petition to quash, but the statute of limitations
for assessment and collection with respect to the taxpayer is
stayed during the pendency of such a proceeding. Third-party
record keepers are generally persons who hold financial
information about the taxpayer, such as banks, brokers,
attorneys, and accountants.
Description of Proposal
The proposal would generally expand the current ``third-
party record keeper'' procedures to apply to all summonses
issued to persons other than the taxpayer. Thus, the taxpayer
whose liability is being investigated would receive notice of
the summons and would be entitled to bring an action in the
appropriate U.S. District Court to quash the summons, although
(as under the current third-party record keeper provision) the
statute of limitations on assessment and collection would be
stayed pending the litigation, and certain kinds of summonses
specified under current law would not be subject to these
requirements.
Effective Date
The proposal would be effective for summonses served after
the date of enactment.
Prior Action
No prior action.
Analysis
A taxpayer should have notice when the IRS utilizes its
summons power to gather information in an effort to determine
the taxpayer's liability. A taxpayer should be able to
challenge all such efforts where appropriate, and not just
those situations where the IRS is attempting to recover records
related to the taxpayer from a specially-defined third party.
Allowing a taxpayer to challenge all third party summons will
also eliminate unnecessary disputes between taxpayers, third
parties and the IRS as to whether a summonsed third party is a
record keeper.
16. Disclosure of criteria for examination selection
Present Law
The IRS examines Federal tax returns to determine the
correct liability of taxpayers. The IRS selects returns to be
audited in a number of ways, such as through a computerized
classification system (known as the discriminant function
(``DIF'') system).
Description of Proposal
The proposal would require that IRS add to Publication 1
(``Your Rights as a Taxpayer'') a statement which sets forth in
simple and nontechnical terms the criteria and procedures for
selecting taxpayers for examination. The statement must not
include any information the disclosure of which would be
detrimental to law enforcement. The statement must specify the
general procedures used by the IRS, including whether taxpayers
are selected for examination on the basis of information in the
media or from informants. Drafts of the statement or proposed
revisions to the statement would be required to be submitted to
the House Committee on Ways and Means, the Senate Committee on
Finance, and the Joint Committee on Taxation.
Effective Date
The addition to Publication 1 would be required to be made
not later than 180 days after the date of enactment.
Prior Action
The proposal is contained in section 353 of H.R. 2676 (the
``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997.
Analysis
The proponents believe that it is important that taxpayers
understand the reasons they may be selected for examination.
17. Threat of audit prohibited to coerce tip reporting alternative
commitment agreements
Present Law
Restaurants may enter into Tip Reporting Alternative
Commitment (``TRAC'') agreements. A restaurant entering into a
TRAC agreement is obligated to educate its employees on their
tip reporting obligations, to institute formal tip reporting
procedures, to fulfill all filing and record keeping
requirements, and to pay and deposit taxes. In return, the IRS
agrees to base the restaurant's liability for employment taxes
solely on reported tips and any unreported tips discovered
during an IRS audit of an employee.
Description of Proposal
The proposal would require the IRS to instruct its
employees that they may not threaten to audit any taxpayer in
an attempt to coerce the taxpayer to enter into a TRAC
agreement.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
The proposal is contained in section 349 of H.R. 2676 (the
``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997.
Analysis
The proponents believe that it is inappropriate for the
Secretary to use the threat of an IRS audit to induce
participation in voluntary programs.
18. Permit service of summonses by mail
Present Law
Section 7603 requires that a summons shall be served ``by
an attested copy delivered in hand to the person to whom it is
directed or left at his last and usual place of abode.'' By
contrast, if a third-party recordkeeper summons is served,
section 7609 permits the IRS to give the taxpayer notice of the
summons via certified or registered mail. Moreover, Rule 4 of
the Federal Rules of Civil Procedure permits service of process
by mail even in summons enforcement proceedings.
Description of Proposal
The proposal would permit the IRS the option to serve all
summonses in person or by mail.
Effective Date
The provision would be effective for summonses served after
the date of enactment.
Prior Action
No prior action.
Analysis
The proposal would conform the general service of summons
procedures to the procedures applicable to third party
recordkeeper summonses and to the service of process
requirements of the Federal Rules of Civil Procedure.
Many IRS summonses are used to obtain financial data from
large corporate financial institutions, such as banks and
brokers. Under present law, IRS officials must appear
personally and serve the summons on an officer of the
corporation designated to receive service of process. This
unnecessarily disruptive intrusion could be avoided were the
mails used as an option.
19. Civil damages for violation of certain bankruptcy procedures
Present Law
A taxpayer may sue the United States for up to $1 million
of civil damages caused by an officer or employee of the IRS
who recklessly or intentionally disregards provisions of the
Internal Revenue Code or Treasury regulations in connection
with the collection of Federal tax with respect to the
taxpayer.
Description of Proposal
The proposal would provide for up to $1 million in civil
damages caused by an officer or employee of the IRS who
willfully disregards provisions of the Bankruptcy Code relating
to automatic stays or discharges. No person is entitled to seek
civil damages in a court of law unless he first exhausts his
administrative remedies.
Effective Date
The proposal would be effective with respect to actions of
officers or employees of the IRS occurring after the date of
enactment.
Prior Action
No prior action.
Analysis
The proponents believe that taxpayers should also be able
to recover economic damages they incur as a result of a willful
violation by an officer or employee of the IRS of these
provisions of the Bankruptcy Code.
20. Increase in size of cases permitted on small case calendar in the
Tax Court
Present Law
Taxpayers may choose to contest many tax disputes in the
Tax Court. Special small case procedures apply to disputes
involving $10,000 or less, if the taxpayer chooses to utilize
these procedures (and the Tax Court concurs).
Description of Proposal
The proposal would increase the cap for small case
treatment from $10,000 to $25,000.
Effective Date
The proposal would apply to proceedings commenced after the
date of enactment.
Prior Action
The proposal is contained in section 313 of H.R. 2676 (the
``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997.
Analysis
The proponents believe that use of the small case
procedures should be expanded.
21. Suspension of statute of limitations on filing refund claims during
periods of disability
Present Law
In general, a taxpayer must file a refund claim within
three years of the filing of the return or within two years of
the payment of the tax, whichever period expires later (if no
return is filed, the two-year limit applies) (sec. 6511(a)). A
refund claim that is not filed within these time periods is
rejected as untimely.
There is no explicit statutory rule providing for equitable
tolling of the statute of limitations. Several courts have
considered whether equitable tolling implicitly exists. The
First, Third, Fourth, and Eleventh Circuits have rejected
equitable tolling with respect to tax refund claims. The Ninth
Circuit has permitted equitable tolling. However, the U.S.
Supreme Court has reversed the Ninth Circuit in U.S. v.
Brockamp \129\, holding that Congress did not intend the
equitable tolling doctrine to apply to the statutory
limitations of section 6511 on the filing of tax refund claims.
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\129\ 117 S. Ct. 849 (1997), reversing 67 F. 3d 260 and 70 F. 3d
120.
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Description of Proposal
The proposal would permit equitable tolling of the statute
of limitations for refund claims of an individual taxpayer
during any period of the individual's life in which he or she
is unable to manage his or her financial affairs by reason of a
medically determinable physical or mental impairment that can
be expected to result in death or to last for a continuous
period of not less than 12 months. Proof of the existence of
the impairment must be furnished in the form and manner
required by the Secretary. Tolling would not apply during
periods in which the taxpayer's spouse or another person is
authorized to act on the taxpayer's behalf in financial
matters.
Effective Date
The proposal would apply to taxable years ending after the
date of enactment.
Prior Action
The proposal (with a different effective date) is contained
in section 322 of H.R. 2676 (the ``Internal Revenue Service
Restructuring and Reform Act of 1997''), as passed by the House
on November 5, 1997.
Analysis
The proponents believe that, in cases of severe disability,
equitable tolling should be considered in the application of
the statutory limitations on the filing of tax refund claims.
22. Notice of deficiency to specify deadlines for filing Tax Court
petition
Present Law
Taxpayers must file a petition with the Tax Court within 90
days after the deficiency notice is mailed (150 days if the
person is outside the United States) (sec. 6213). If the
petition is not filed within that time period, the Tax Court
does not have jurisdiction to consider the petition.
Description of Proposal
The proposal would require that the IRS include on each
deficiency notice the date determined by the IRS as the last
day on which the taxpayer may file a petition with the Tax
Court. The last day on which a taxpayer who is outside the
United States may file a petition with the Tax Court would be
shown as an alternative. The proposal would provide that a
petition filed with the Tax Court by this date shall be treated
as timely filed.
Effective Date
The proposal would apply to notices mailed after December
31, 1998.
Prior Action
The proposal is contained in section 347 of H.R. 2676 (the
``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997.
Analysis
Proponents of the proposal believe that taxpayers should
receive assistance in determining the time period within which
they must file a petition in the Tax Court and that taxpayers
should be able to rely on the computation of that period by the
IRS. Computation of the time period may be difficult for some
taxpayers and the consequences of missing the filing deadline
are severe (loss of the ability to litigate in a prepayment
forum).
23. Allow actions for refund with respect to certain estates which have
elected the installment method of payment
Present Law
In general, the U.S. Court of Federal Claims and the U.S.
district courts have jurisdiction over suits for the refund of
taxes, as long as full payment of the assessed tax liability
has been made. Flora v. United States, 357 U.S. 63 (1958),
aff'd on reh'g, 362 U.S. 145 (1960). Under Code section 6166,
if certain conditions are met, the executor of a decedent's
estate may elect to pay the estate tax attributable to certain
closely-held businesses over a 14-year period. Courts have held
that U.S. district courts and the U.S. Court of Federal Claims
do not have jurisdiction over claims for refunds by taxpayers
deferring estate tax payments pursuant to section 6166 unless
the entire estate tax liability has been paid (i.e., timely
payment of the installments due prior to the bringing of an
action is not sufficient to invoke jurisdiction). See, e.g.,
Rocovich v. United States, 933 F.2d 991 (Fed. Cir. 1991),
Abruzzo v. United States, 24 Ct. Cl. 668 (1991). A provision in
the Taxpayer Relief Act of 1997, however, provides limited
authority to the U.S. Tax Court to provide declaratory
judgments regarding initial or continuing eligibility for
deferral under section 6166.
Description of Proposal
The proposal would grant the U.S. Court of Federal Claims
and the U.S. district courts jurisdiction to determine the
correct amount of estate tax liability (or refund) in actions
brought by taxpayers deferring estate tax payments under
section 6166, as long certain conditions are met. In order to
qualify for the proposal, the estate must have made an election
pursuant to section 6166, fully paid each installment of
principal and/or interest due before the date the suit is filed
(as long as one or more installments are not yet due), and no
portion of the payments due may have been accelerated. The
proposal further would provide that once a final judgment has
been entered by a district court or the U.S. Court of Federal
Claims, the IRS would not be permitted to collect any amount
disallowed by the court, and any amounts paid by the taxpayer
in excess of the amount the court finds to be currently due and
payable would be refunded to the taxpayer. Lastly, the proposal
would provide that the two-year statute of limitations for
filing a refund action would be suspended during the pendency
of any action brought by a taxpayer pursuant to section 7479
for a declaratory judgment as to an estate's eligibility for
section 6166.
Effective Date
The proposal would be effective for claims for refunds
filed after the date of enactment.
Prior Action
The proposal is contained in H.R. 2676 (the ``Internal
Revenue Service Restructuring and Reform Act of 1997''), as
passed by the House on November 5, 1997.
Analysis
Present-law section 6166 allows taxpayers to defer payment
of estate taxes attributable to certain closely-held
businesses, and pay such taxes over a 14-year period. Section
6166 was enacted to address the liquidity problems of estates
holding farms and closely held businesses, so that such
businesses need not be liquidated in order to pay estate taxes.
Where an installment election has been made under 6166,
taxpayers may have limited access to judicial review of the
amount of estate tax liability before the entire estate tax
liability has been paid. If a dispute arises as to the amount
of estate taxes due with respect to the closely-held business,
taxpayers may be required to pay the full amount of estate
taxes the IRS asserts as being owed for the full 14-year period
in order to obtain judicial review of the IRS determination,
which could cause the potential liquidation of the assets and
frustrate the purpose behind the installment provisions of
section 6166. In addition, where installment payments are being
made over a 14-year period, the two-year statute of limitations
for filing refund claims could operate to bar refunds with
respect to payments made more than two years prior to the date
the refund action is filed.
The proposal is intended to equalize access to the courts
between taxpayers who are required to pay their full estate tax
liability at one time with those taxpayers who are deferring
payments under section 6166, as long as such taxpayers are
current with respect to their installment payments. To ensure
that taxpayers deferring payments under 6166 are not provided
with greater access to the courts than taxpayers who have not
made such an election, and to ensure that the proposal would
operate as intended, possible modifications to the
Administration proposal have been suggested. Under these
proposed modifications, in order to commence suit: (1) the
estate must have paid all non-6166-related estate taxes due (in
addition to any 6166 installments due before the date the suit
is filed), (2) there must be no suits for declaratory judgment
pursuant to section 7479 pending, (3) there must be no
outstanding deficiency notices against the estate, and (4) the
taxpayer must continue to make any installment payments that
come due while the lawsuit is pending.
24. Expansion of authority to award costs and certain fees
Present Law
Any person who substantially prevails in any action by or
against the United States in connection with the determination,
collection, or refund of any tax, interest, or penalty may be
awarded reasonable administrative costs incurred before the IRS
and reasonable litigation costs incurred in connection with any
court proceeding. In general, only an individual whose net
worth does not exceed $2 million is eligible for an award, and
only a corporation or partnership whose net worth does not
exceed $7 million is eligible for an award.
Reasonable litigation costs include reasonable fees paid or
incurred for the services of attorneys, except that the
attorney's fees will not be reimbursed at a rate in excess of
$110 per hour (indexed for inflation) unless the court
determines that a special factor, such as the limited
availability of qualified attorneys for the proceeding,
justifies a higher rate. Awards of reasonable litigation costs
and reasonable administrative costs cannot exceed amounts paid
or incurred.
Once a taxpayer has substantially prevailed over the IRS in
a tax dispute, the IRS has the burden of proof to establish
that it was substantially justified in maintaining its position
against the taxpayer. A rebuttable presumption exists that
provides that the position of the United States is not
considered to be substantially justified if the IRS did not
follow in the administrative proceeding (1) its published
regulations, revenue rulings, revenue procedures, information
releases, notices, or announcements, or (2) a private letter
ruling, determination letter, or technical advice memorandum
issued to the taxpayer.
Description of Proposal
The proposal would permit the award of attorney's fees (in
amounts up to the statutory limit determined to be appropriate)
to specified persons who represent for no more than a nominal
fee a taxpayer who is a prevailing party.
Effective Date
The proposal would apply to costs incurred and services
performed after the date of enactment.
Prior Action
The proposal is contained in section 311 of H.R. 2676 (the
``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997. (That
section of the House bill also contains additional provisions
relating to attorney's fees.)
Analysis
The proponents believe that the pro bono publicum
representation of taxpayers should be encouraged and the value
of the legal services rendered in these situations should be
recognized. Where the IRS takes positions that are not
substantially justified, it should not be relieved of its
obligation to bear reasonable administrative and litigation
costs because representation was provided the taxpayer on a pro
bono basis.
25. Expansion of authority to issue taxpayer assistance orders
Present Law
Taxpayers can request that the Taxpayer Advocate in the
Internal Revenue Service (``IRS'') issue a taxpayer assistance
order (``TAO'') if they are suffering or about to suffer a
significant hardship as a result of the manner in which the
internal revenue laws are being administered (sec. 7811). A TAO
may require the IRS to release property of the taxpayer that
has been levied upon, or to cease any action, take any action
as permitted by law, or refrain from taking any action with
respect to the taxpayer.
Description of Proposal
The proposal would provide that in determining whether to
issue a TAO, the Taxpayer Advocate shall consider, among
others, the following four factors: (1) whether there is an
immediate threat of adverse action; (2) whether there has been
an unreasonable delay in resolving the taxpayer's account
problems; (3) whether the taxpayer will have to pay significant
costs (including fees for professional representation) if
relief is not granted; and (4) whether the taxpayer will suffer
irreparable injury, or a long-term adverse impact, if relief is
not granted.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
A substantially similar proposal is contained in section
342 of H.R. 2676 (the ``Internal Revenue Service Restructuring
and Reform Act of 1997''), as passed by the House on November
5, 1997.
Analysis
The proponents believe that these factors should generally
be considered by the Taxpayer Advocate in determining whether a
taxpayer assistance order should be issued.
26. Provide new remedy for third parties who claim that the IRS has
filed an erroneous lien
Present Law
Prior to 1995, the provisions governing jurisdiction over
refund suits had generally been interpreted to apply only if an
action was brought by the taxpayer against whom tax was
assessed. Remedies for third parties from whom tax was
collected (rather than assessed) were found in other provisions
of the Internal Revenue Code. The Supreme Court held in
Williams v. United States, 115 S.Ct. 1611 (1995), however, that
a third party who paid another person's tax under protest to
remove a lien on the third party's property could bring a
refund suit, because she had no other adequate administrative
or judicial remedy. In Williams, the IRS had filed a nominee
lien against property that was owned by the taxpayer's former
spouse and that was under a contract for sale. In order to
complete the sale, the former spouse paid the amount of the
lien under protest, and then sued in district court to recover
the amount paid. The Supreme Court held that parties who are
forced to pay another's tax under duress could bring a refund
suit, because no other judicial remedy was adequate.
Description of Proposal
The proposal would create an administrative procedure
similar to the wrongful levy remedy for third parties in
section 7426. Under this procedure, a record owner of property
against which a Federal tax lien had been filed could obtain a
certificate of discharge of property from the lien as a matter
of right. The third party would be required to apply to the
Secretary of the Treasury for such a certificate and either to
deposit cash or to furnish a bond sufficient to protect the
lien interest of the United States. Although the Secretary
would determine the amount of the bond necessary to protect the
Government's lien interest, if this procedure was followed the
Secretary would have no discretion to refuse to issue a
certificate of discharge, thus curing the defect in this remedy
that the Supreme Court found in Williams. A certificate of
discharge of property from a lien issued pursuant to the
procedure would enable the record owner to sell the property
free and clear of the Federal tax lien in all circumstances.
The proposal also would authorize the refund of all or part of
the amount deposited, plus interest at the same rate that would
be made on an overpayment of tax by the taxpayer, or the
release of all or part of the bond, if the Secretary otherwise
satisfies the tax liability or determines that the United
States does not have a lien interest or has a lesser lien
interest than the amount initially determined.
The proposal would also establish a judicial cause of
action for third parties challenging a lien that is similar to
the wrongful levy remedy in section 7426. The period within
which such an action must be commenced would be a short period
(120 days) to ensure an early resolution of the parties'
interests. The statute of limitations on collecting from the
taxpayer would be stayed while a third party challenged a lien
in court under these procedures. Upon conclusion of the
litigation, the IRS would be authorized to apply the deposit or
bond to the assessed liability and to refund to the third party
any amount in excess of the liability, plus interest, or to
release the bond. Actions to quiet title under 28 U.S.C.
Sec. 2410 would still be available to persons who did not seek
the expedited review permitted under the new statutory
procedure.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
No prior action.
Analysis
The Williams decision left many important questions
unresolved, such as: which class of third parties have
standing; what administrative procedure is required before
litigation; the applicable statutes of limitations; the IRS's
authority to pay interest on such a refund; and how to prevent
expiration of the collection period on the taxpayer while the
third party from whom the tax was collected challenges the IRS.
In order to avoid prolonged uncertainty in this area, it may be
appropriate to resolve these questions by statute rather than
through litigation.
27. Allow civil damages for unauthorized collection actions by persons
other than the taxpayer
Present Law
A taxpayer may sue the United States for up to $1 million
of civil damages caused by an officer or employee of the IRS
who recklessly or intentionally disregards provisions of the
Internal Revenue Code or Treasury regulations in connection
with the collection of Federal tax with respect to the
taxpayer.
Description of Proposal
The proposal would provide that persons other than the
taxpayer may sue for civil damages for unauthorized collection
actions.
Effective Date
The proposal would be effective with respect to action of
officers or employees of the IRS occurring after the date of
enactment.
Analysis
Proponents argue that anyone should be able to recover
economic damages they incur as a result of unauthorized
collection actions.
28. Suspend collection in certain joint liability cases
Present Law
In general, spouses who file a joint tax return are each
fully responsible for the full tax liability. However, both
spouses need not join in contesting such liability in the Tax
Court. Thus, it is possible for one spouse to file a petition
in Tax Court while the other spouse does not. The IRS may not
assess the tax liability or take collection action against the
spouse who has filed the petition in Tax Court, until the Tax
Court decision is final (sec. 6213(a)). However, there are no
provisions in the Code or the regulations that prohibit
administrative collection action against a nonpetitioning
spouse during the pendency of the Tax Court. In general, the
IRS is authorized to assess and commence collection action
against the nonpetitioning spouse after the expiration of the
90 (or 150) day period in section 6213(c). The IRS's policy is
generally to forbear from administrative collection until the
Tax Court renders its decision on the liability.\130\
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\130\ IRS Policy Statement P-5-16.
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Under certain circumstances, collection action may be
appropriate even during the pendency of the Tax Court action.
Collection is appropriate if the amount of the assessment is
not being contested in the Tax Court, such as when the
petitioning spouse is seeking relief solely as an innocent
spouse. Collection may also be appropriate when the interests
of the IRS are likely to be jeopardized by forbearance, such as
when the nonpetitioning spouse intends to file a bankruptcy
petition or leave the United States.
Description of Proposal
When a married couple's joint return is the subject of a
Tax Court proceeding, the proposal would require the IRS to
withhold collection by levy against a nonpetitioning spouse
during the pendency of a Tax Court proceeding involving the
other spouse. This would treat the nonpetitioning spouse the
same as the petitioning spouse in most situations. Certain
exceptions would be provided, including in jeopardy situations,
when the taxpayer waives this protection (i.e., agrees to the
collection action), or for some other, limited but automatic
kinds of collection activity, such as automatic refund offset,
filing of protective notices of Federal tax lien, or in certain
other circumstances. The statute of limitations on assessment
and collection would be stayed for the period during which
collection is barred. In general, if there is a final decision
that reduces the proposed assessment against the petitioning
spouse, the assessment against the nonpetitioning spouse would
likewise be reduced. The proposal would not affect the IRS's
ability to collect other liabilities or assessments that are
not the subject of the Tax Court proceeding.
Effective Date
The proposal would be effective for taxes assessed with
respect to taxable years beginning after December 31, 1998.
Prior Action
No prior action.
Analysis
A nonpetitioning spouse should generally receive the same
protection against IRS collection action as the spouse who has
filed a petition in Tax Court contesting a proposed deficiency.
The stay of collection protects nonpetitioning taxpayers from
premature deprivation of their property, before the
adjudication of the joint and several liability. This proposal
generally complements the proposal on innocent spouse relief.
29. Explanation of joint and several liability
Present Law
In general, spouses who file a joint tax return are each
fully responsible for the accuracy of the tax return and for
the full liability. This is true even though only one spouse
may have earned the wages or income which is shown on the
return. This is ``joint and several'' liability. Spouses who
wish to avoid joint and several liability may file as a married
person filing separately. Special rules apply in the case of
innocent spouses pursuant to section 6013(e).
Description of Proposal
The proposal would require that, no later than 180 days
after the date of enactment, the IRS must establish procedures
clearly to alert married taxpayers of their joint and several
liability on all appropriate tax publications and instructions.
Effective Date
The proposal would require that the procedures be
established as soon as practicable, but no later than 180 days
after the date of enactment.
Prior Action
The proposal is contained in section 351 of H.R. 2676 (the
``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997.
Analysis
The proposal would assist married taxpayers need in clearly
understanding the legal implications of signing a joint return;
it is appropriate for the IRS to provide the information
necessary for that understanding.
30. Innocent spouse relief
Present Law
Spouses who file a joint tax return are each fully
responsible for the accuracy of the return and for the full tax
liability. This is true even though only one spouse may have
earned the wages or income which is shown on the return. This
is ``joint and several'' liability. A spouse who wishes to
avoid joint liability may file as a ``married person filing
separately.'
Relief from liability for tax, interest and penalties is
available for ``innocent spouses'' in certain limited
circumstances. To qualify for such relief, the innocent spouse
must establish: (1) that a joint return was made; (2) that an
understatement of tax, which exceeds the greater of $500 or a
specified percentage of the innocent spouse's adjusted gross
income for the preadjustment (most recent) year, is
attributable to a grossly erroneous item 131 of the
other spouse; (3) that in signing the return, the innocent
spouse did not know, and had no reason to know, that there was
an understatement of tax; and (4) that taking into account all
the facts and circumstances, it is inequitable to hold the
innocent spouse liable for the deficiency in tax. The specified
percentage of adjusted gross income is 10 percent if adjusted
gross income is $20,000 or less. Otherwise, the specified
percentage is 25 percent.
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\131\ Grossly erroneous items include items of gross income that
are omitted from reported income and claims of deductions, credits, or
basis in an amount for which there is no basis in fact or lwa (Code
sec. 6013(e)(2)).
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It is unclear under present law whether a court may grant
partial innocent spouse relief. The Ninth Circuit Court of
Appeals in Wiksell v. Commissioner 132 has allowed
partial innocent spouse relief where the spouse did not know,
and had no reason to know, the magnitude of the understatement
of tax, even though the spouse knew that the return may have
included some understatement.
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\132\ 90 F.3d 1459 (9th Cir. 1997).
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The proper forum for contesting a denial by the Secretary
of innocent spouse relief is determined by whether an
underpayment is asserted or the taxpayer is seeking a refund of
overpaid taxes. Accordingly, the Tax Court may not have
jurisdiction to review all denials of innocent spouse relief.
No form is currently provided to assist taxpayers in
applying for innocent spouse relief.
Description of Proposal
The proposal generally would make innocent spouse status
easier to obtain. The proposal would eliminate all of the
understatement thresholds and requires only that the
understatement of tax be attributable to an erroneous (and not
just a grossly erroneous) item of the other spouse. The
proposal would also make parallel the innocent spouse rules
applicable in community property States and common law States.
The proposal would provide that the Tax Court has
jurisdiction to review any denial (or failure to rule) by the
Secretary regarding an application for innocent spouse relief.
The Tax Court may order refunds as appropriate where it
determines the spouse qualifies for relief and an overpayment
exists as a result of the innocent spouse qualifying for such
relief. The taxpayer must file his or her petition for review
with the Tax Court during the 90-day period that begins on the
earlier of (1) 6 months after the date the taxpayer filed his
or her claim for innocent spouse relief with the Secretary or
(2) the date a notice denying innocent spouse relief was mailed
by the Secretary. Except for termination and jeopardy
assessments (secs. 6851, 6861), the Secretary would not be
permitted to levy or proceed in court to collect any tax from a
taxpayer claiming innocent spouse status with regard to such
tax until the expiration of the 90-day period in which such
taxpayer may petition the Tax Court or, if the Tax Court
considers such petition, before the decision of the Tax Court
has become final. The running of the statute of limitations
would be suspended in such situations with respect to the
spouse claiming innocent spouse status.
The proposal would also require the Secretary of the
Treasury to develop a separate form with instructions for
taxpayers to use in applying for innocent spouse relief within
180 days from the date of enactment.
Effective Date
The proposal would be effective for understatements with
respect to taxable years beginning after the date of enactment.
An innocent spouse seeking relief under this proposal must
claim innocent spouse status with regard to any assessment not
later than two years after the date of such assessment.
Prior Action
A similar proposal is contained in section 321 of H.R. 2676
(the ``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997.
Analysis
The proponents are concerned that the innocent spouse
provisions of present law are inadequate. The proponents
believe it is inappropriate to limit innocent spouse relief
only to the most egregious cases where the understatement is
large and the tax position taken is grossly erroneous. The
proponents also believe that all taxpayers should have access
to the Tax Court in resolving disputes concerning their status
as an innocent spouse. Finally, the proponents believe that
taxpayers need to be better informed of their right to apply
for innocent spouse relief in appropriate cases and that the
IRS is the best source of that information.
31. Elimination of interest differential on overlapping periods of
interest on income tax overpayments and underpayments
Present Law
A taxpayer that underpays its taxes is required to pay
interest on the underpayment at a rate equal to the Federal
short-term interest rate plus three percentage points. A
special ``hot interest'' rate equal to the Federal short-term
interest rate plus five percentage points applies in the case
of certain large corporate underpayments.
A taxpayer that overpays its taxes receives interest on the
overpayment at a rate equal to the Federal short-term interest
rate plus two percentage points. In the case of corporate
overpayments in excess of $10,000, this is reduced to the
Federal short-term interest rate plus one-half of a percentage
point.
If a taxpayer has an underpayment of tax from one year and
an overpayment of tax from a different year that are
outstanding at the same time, the IRS will typically offset the
overpayment against the underpayment and apply the appropriate
interest to the resulting net underpayment or overpayment.
However, if either the underpayment or overpayment have been
satisfied, the IRS will not typically offset the two amounts,
but rather will assess or credit interest on the full
underpayment or overpayment at the underpayment or overpayment
rate. This has the effect of assessing the underpayment at the
higher underpayment rate and crediting the overpayment at the
lower overpayment rate. This results in the taxpayer being
assessed a net interest charge, even if the amounts of the
overpayment and underpayment are the same.
The Secretary has the authority to credit the amount of any
overpayment against any liability under the Code (sec. 6402).
Congress has previously directed the Internal Revenue Service
to consider procedures for ``netting'' overpayments and
underpayments and, to the extent a portion of tax due is
satisfied by a credit of an overpayment, not impose interest.
133
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\133\ Pursuant to TBOR2 (1996), the Secretary conducted a study of
the manner in which the IRS has implemented the netting of interest on
overpaymetns and underpayments and the policy and administrative
implications of global netting. The legislative history to the General
Agreement on Trade and Tariffs (GATT) (1994) stated that the Secretary
should implement the most comprehensive crediting procedures that are
consistent with sound administrative practice, and should do so as
rapidly as is practicable. A similar statment was included in the
Conference Report to the Omnibus Budget Reconciliation Act of 1990.
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Description of Proposal
The proposal would establish a net interest rate of zero on
equivalent amounts of overpayment and underpayment of income
tax that exist for any period, provided that the taxpayer
reasonably identifies and establishes an appropriate situation
for netting before the statute of limitations for filing a
claim for refund for any of the periods involved has expired.
Each overpayment and underpayment is to be considered only once
in determining whether equivalent amounts of overpayment and
underpayment exist. The special rules that increase the
interest rate paid on large corporate underpayments and
decrease the interest rate received on corporate underpayments
in excess of $10,000 would not prevent the application of the
net zero rate. The proposal would apply to income taxes.
Effective Date
The proposal would apply prospectively, to periods of
overlapping mutual indebtedness that occur after the date of
enactment.
Prior Action
A similar proposal is contained in section 331 of H.R. 2676
(the ``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997.
Analysis
The proponents believe that taxpayers should be charged
interest only on the amount they actually owe, taking into
account overpayments and underpayments from all open years.
32. Archive of records of the IRS
Present Law
The IRS is obligated to transfer agency records to the
National Archives and Records Administration (``NARA'') for
retention or disposal. The IRS is also obligated to protect
confidential taxpayer records from disclosure. These two
obligations have created conflict between NARA and the IRS.
Under present law, the IRS determines whether records contain
taxpayer information. Once the IRS has made that determination,
NARA is not permitted to examine those records. NARA has
expressed concern that the IRS may be using the disclosure
prohibition to improperly conceal agency records with
historical significance.
IRS obligation to archive records
The IRS, like all other Federal agencies, must create,
maintain, and preserve agency records in accordance with
section 3101 of title 44 of the United States Code. NARA is the
Government agency responsible for overseeing the management of
the records of the Federal government.134 Federal
agencies are required to deposit significant and historical
records with NARA.135 The head of each Federal
agency must also establish safeguards against the removal or
loss of records.136
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\134\ 44 U.S.C. sec. 2904
\135\ 5 U.S.C. sec. 552a(b)(6),
\136\ 44 U.S.C. sec. 3105.
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Authority of NARA
NARA is authorized, under the Federal Records Act, to
establish standards for the selective retention of records of
continuing value.137 NARA has the statutory
authority to inspect records management practices of Federal
agencies and to make recommendations for
improvement.138 The head of each Federal agency must
submit to NARA a list of records to be destroyed and a schedule
for such destruction.139 NARA examines the list to
determine if any of the records on the list have sufficient
administrative, legal research, or other value to warrant their
continued preservation. In many cases, the description of the
record on the list is sufficient for NARA to make the
determination. For example, NARA does not need to inspect
Presidential tax returns to determine that they have historical
value and should be retained. In some cases, NARA may find it
helpful to examine a particular record. NARA has general
authority to inspect records solely for the purpose of making
recommendations for the improvement of records management
practices.140 However, tax returns and return
information can only be disclosed under the authority provided
in section 6103 of the Internal Revenue Code. There is no
exception to the disclosure prohibition for records management
inspection by NARA.141
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\137\ 44 U.S.C. sec. 2905.
\138\ 44 U.S.C. sec. 2904(c)(7).
\139\ 44 U.S.C. sec. 3303.
\140\ 44 U.S.C. 2906.
\141\ American Friends Service Committee v. Webster, 720 F.wd 29
(D.C. Cir. 1983).
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NARA is also responsible for the custody, use and
withdrawal of records transferred to it.142
Statutory provisions that restrict public access to the records
in the hands of the agency from which the records were
transferred also apply to NARA. Thus, if a confidential record,
such as a Presidential tax return, is transferred to NARA for
archival storage, NARA is not permitted to disclose it. In
general, the application of such restrictions to records in the
hands of NARA expire after the records have been in existence
for 30 years.143 The issue of whether the specific
disclosure prohibition of section 6103 takes precedence over
the general 30-year expiration of restrictions generally
applicable to records in the hands of NARA has not been
addressed by a court, but an informal advisory opinion from the
Office of Legal Counsel of the Attorney General concluded that
the 30-year expiration provision would not reach records
subject to section 6103.144
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\142\ 44 U.S.C. sec. 2108.
\143\ 44 U.S.C. sec. 2108.
\144\ Department of Justice, Office of Legal Counsel, Memorandum to
Richard K. Willard, Assistant Attorney General (Civil Division)
(February 27, 1986).
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Confidentiality requirements
The IRS must preserve the confidentiality of taxpayer
information contained in Federal income tax returns. Such
information may not be disclosed except as authorized under
Code section 6103. Section 6103 was substantially revised in
1976 to address Congress' concern that tax information was
being used by Federal agencies in pursuit of objectives
unrelated to administration and enforcement of the tax laws.
Congress believed that the wide-spread use of tax information
by agencies other than the IRS could adversely affect the
willingness of taxpayers to comply voluntarily with the tax
laws and could undermine the country's self-assessment tax
system.145 Section 6103 does not authorize the
disclosure of confidential return information to NARA.
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\145\ S. Rept. 94-938, p. 317 (1976).
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Section 6103 restricts the disclosure of returns and return
information only. Return means any tax or information return,
declaration of estimated tax, or claim for refund, including
schedules and attachments thereto, filed with the IRS. Return
information includes the taxpayer's name; nature and source or
amount of income; and whether the taxpayer's return is under
investigation. Section 6103(b)(2) provides that ``nothing in
any other provision of law shall be construed to require the
disclosure of standards used or to be used for the selection of
returns for examination, or data used or to be used for
determining such standards, if the Secretary determines that
such disclosure will seriously impair assessment, collection,
or enforcement under the internal revenue laws.'' Section 6103
does not restrict the disclosure of other records required to
be maintained by the IRS, such as records documenting agency
policy, programs and activities, and agency histories. Such
records are required to be made available to the public under
the Freedom of Information Act (``FOIA'').146
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\146\ FOIA does not require disclosure of records of information
that would frustrate law enforcement efforts. 5 U.S.C. sec. 552(b)(7).
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The Internal Revenue Code prohibits disclosure of tax
returns and return information, except to the extent
specifically authorized by the Internal Revenue Code (sec.
6103). Unauthorized disclosure is a felony punishable by a fine
not exceeding $5,000 or imprisonment of not more than five
years, or both (sec. 7213). An action for civil damages also
may be brought for unauthorized disclosure (sec. 7431).
Description of Proposal
The proposal would provide an exception to the disclosure
rules to require IRS to disclose IRS records to officers or
employees of NARA, upon written request from the Archivist, for
purposes of the appraisal of such records for destruction or
retention. The present-law prohibitions on and penalties for
disclosure of tax information would generally apply to NARA.
Effective Date
The proposal would be effective for requests made by the
Archivist after the date of enactment.
Prior Action
The proposal is contained in section 373 of H.R. 2676 (the
``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997.
Analysis
The proponents believe that it is appropriate to permit
disclosure to NARA for purposes of scheduling records for
destruction or retention, while at the same time preserving the
confidentiality of taxpayer information in those documents.
33. Clarification of authority of Secretary relating to the making of
elections
Present Law
Except as otherwise provided, elections provided by the
Code are to be made in such manner as the Secretary shall by
regulations or forms prescribe.
Description of Proposal
The proposal would clarify that, except as otherwise
provided, the Secretary may prescribe the manner of making of
any election by any reasonable means.
Effective Date
The proposal would be effective as of the date of
enactment.
Prior Action
The proposal is contained in section 375 of H.R. 2676 (the
``Internal Revenue Service Restructuring and Reform Act of
1997''), as passed by the House on November 5, 1997.
Analysis
The proposal would eliminate any confusion over the type of
guidance in which the Secretary may prescribe the manner of
making any election.
34. Grant IRS broad authority to enter into cooperative agreements with
State tax authorities
Present Law
The IRS is generally not authorized to provide services to
non-Federal agencies even if the cost is reimbursed (62 Comp.
Gen. 323,335 (1983)).
Most taxpayers reside in States with an income tax and,
therefore, must file both Federal and State income tax returns
each year. Each return is separately prepared, with the State
return often requiring information taken directly from the
Federal return.
Description of Proposal
The proposal would provide that the IRS is authorized to
enter into cooperative agreements with State tax authorities to
enhance joint tax administration. These agreements may include
(1) joint filing of Federal and State income tax returns, (2)
joint processing of these returns, and (3) joint collection of
taxes (other than Federal income taxes).
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
The proposal was included in the Tax Simplification and
Technical Corrections Act of 1993 (H.R. 3419), as passed by the
House in 1994, but was not enacted.
Analysis
Permitting the IRS to enter into agreements that are
designed to promote efficiency through joint tax administration
programs with States could reduce the burden on taxpayers
because much of the same information could be used by both
Governments.
For example, the burden on taxpayers could be significantly
reduced through joint electronic filing of tax returns, whereby
a taxpayer electronically transmits both Federal and State
returns to one location. Joint Federal and State electronic
filing could simplify and shorten return preparation time for
taxpayers. Also, State governments could benefit from reduced
processing costs, while the IRS could benefit from the
potential increase in taxpayers who would elect to file
electronically because they would be able to fulfill both their
Federal and State obligations simultaneously.
35. Low-income taxpayer clinics
Present Law
There are no provisions in present law providing for
assistance to clinics that assist low- income taxpayers.
Description of Proposal
The proposal would authorize the Legal Services Corporation
to make matching grants for the development, expansion, or
continuation of certain low-income taxpayer clinics. Eligible
clinics would be those that charge no more than a nominal fee
to either represent low-income taxpayers in controversies with
the IRS or provide tax information to individuals for whom
English is a second language. The term ``clinic'' would include
(1) a clinical program at an accredited law school in which
students represent low-income taxpayers, and (2) an
organization exempt from tax under Code section 501(c) which
either represents low-income taxpayers or provides referral to
qualified representatives.
A clinic would be treated as representing low-income
taxpayers if at least 90 percent of the taxpayers represented
by the clinic have incomes which do not exceed 250 percent of
the poverty level and amounts in controversy of $25,000 or
less.
The aggregate amount of grants to be awarded each year
would be limited to $3,000,000. No taxpayer clinic could
receive more than $100,000 per year. The clinic must provide
matching funds on a dollar-for-dollar basis. Matching funds may
include the allocable portion of both the salary (including
fringe benefits) of individuals performing services for the
clinic and clinic equipment costs, but not general
institutional overhead.
The following criteria would be required to be considered
in making awards: (1) number of taxpayers served by the clinic,
including the number of taxpayers in the geographical area for
whom English is a second language; (2) the existence of other
taxpayer clinics serving the same population; (3) the quality
of the program; and (4) alternative funding sources available
to the clinic.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
A substantially similar proposal is contained in section
361 of H.R. 2676 (the ``Internal Revenue Service Restructuring
and Reform Act of 1997''), as passed by the House on November
5, 1997.
Analysis
The proponents believe that the provision of tax services
by accredited nominal fee clinics to low-income individuals and
those for whom English is a second language will improve
compliance with the Federal tax laws and should be encouraged.
36. Disclosure of field service advice
Present Law
Field service advice memoranda are documents prepared by
IRS national office attorneys for use by IRS district counsel
attorneys. Because field service advice memoranda apply legal
principles to the facts of a particular case, they generally
contain confidential taxpayer information. In Tax Analysts v.
IRS,147 the court held that the Freedom of
Information Act requires field service advice memoranda issued
by the National Office of the Chief Counsel of the Internal
Revenue Service to field personnel to be open to public
inspection. Section 6103 of the Code prohibits the disclosure
of tax return information. Statutory procedures do not
currently exist for insuring taxpayer privacy while allowing
the public inspection of field service advice memoranda.
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\147\ 117 F.3d 607 (D.C. Cir. 1997).
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Description of Proposal
The proposal would provide that field service advice
memoranda are return information in their entirety, which would
prohibit their disclosure. The proposal would also provide a
structured mechanism 148 for public inspection of
field service advice memoranda, subject to a redaction process
similar to that applicable to written determinations under
section 6110. This would permit the taxpayer whose liability is
the subject of the field service advice memorandum to
participate in the process of assessing what information should
not be disclosed.
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\148\ Details concerning the operation of this mechanism are not
specified.
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Effective Date
The proposal would be effective on the date of enactment.
It would also apply to those memoranda that were the subject of
the lawsuit on a specifically scheduled basis.
Prior Action
No prior action.
Analysis
Some might view the proposal as providing an appropriate
resolution to issues currently outstanding in the litigation
over disclosure of these memoranda. Others might view the
proposal as providing a result that is more restrictive (in
terms of providing disclosure) than the result reached in the
litigation.
II. PROVISIONS INCREASING REVENUE
A. Accounting Provisions
1. Repeal lower of cost or market inventory accounting method
Present Law
A taxpayer that sells goods in the active conduct of its
trade or business generally must maintain inventory records in
order to determine the cost of goods it sold during the taxable
period. Cost of goods sold generally is determined by adding
the taxpayer's inventory at the beginning of the period to
purchases made during the period and subtracting from that sum
the taxpayer's inventory at the end of the period.
Because of the difficulty of accounting for inventory on an
item-by-item basis, taxpayers often use conventions that assume
certain item or cost flows. Among these conventions are the
``first-in-first-out'' (``FIFO'') method which assumes that the
items in ending inventory are those most recently acquired by
the taxpayer, and the ``last-in-first-out'' (``LIFO'') method
which assumes that the items in ending inventory are those
earliest acquired by the taxpayer.
Treasury regulations provide that taxpayers that maintain
inventories under the FIFO method may determine the value of
ending inventory under a (1) cost method or (2) ``lower of cost
or market'' (``LCM'') method (Treas. reg. sec. 1.471-2(c)).
Under the LCM method, the value of ending inventory is written
down if its market value is less than its cost. Similarly,
under the subnormal goods method, any goods that are unsalable
at normal prices or unusable in the normal way because of
damage, imperfections, shop wear, changes of style, odd or
broken lots, or other similar causes, may be written down to
net selling price. The subnormal goods method may be used in
conjunction with either the cost method or LCM.
Retail merchants may use the ``retail method'' in valuing
ending inventory. Under the retail method, the total of the
retail selling prices of goods on hand at year end is reduced
to approximate cost by deducting an amount that represents the
gross profit embedded in the retail prices. The amount of the
reduction generally is determined by multiplying the retail
price of goods available at yearend by a fraction, the
numerator of which is the cost of goods available for sale
during the year and the denominator of which is the total
retail selling prices of the goods available for sale during
the year, with adjustments for mark-ups and mark-downs (Treas.
reg. sec. 1.471-8(a)). Under certain conditions, a taxpayer
using the FIFO method may determine the approximate cost or
market of inventory by not taking into account retail price
mark-downs for the goods available for sale during the year,
even though such mark-downs are reflected in the retail selling
prices of the goods of goods on hand at year end (Treas. reg.
sec. 1.471-8(d)). As a result, such taxpayer may write down the
value of inventory below both its cost and its market value.
Description of Proposal
The proposal would repeal the LCM method and the subnormal
goods method. Appropriate wash-sale rules would be provided.
The proposal would not apply to taxpayers with average annual
gross receipts over a three-year period of $5 million or less.
Effective Date
The proposal would be effective for taxable years beginning
after the date of enactment. Any section 481(a) adjustment
required to be taken into account pursuant to the change of
method of accounting under the proposal would be taken into
account ratably over a four taxable year period beginning with
the first taxable year the taxpayer is required to change its
method of accounting.
Prior Action
The proposal is substantially similar to a provision that
had been reported favorably by the Senate Committee on Finance
in conjunction with the passage of the General Agreement on
Tariffs and Trade, but was not included in the final
legislation as passed by the Congress in 1994. The proposal is
identical to a provision contained in the President's budget
proposals for fiscal years 1997 and 1998.
Analysis
Under present law, income or loss generally is not
recognized until it is realized. In the case of a taxpayer that
sells goods, income or loss generally is realized and
recognized when the goods are sold or exchanged. The LCM and
subnormal goods inventory methods of present law represent
exceptions to the realization principle by allowing the
recognition of losses without a sale or exchange. In addition,
these methods are one-sided in that they allow the recognition
of losses, but not gains, even if the items of inventory
recover their value in a subsequent year.
In general, the LCM and subnormal goods inventory methods
have been long-accepted as generally accepted accounting
principles (``GAAP'') applicable to the preparation of
financial statements and have been allowed by Treasury
regulations for tax purposes since 1918. However, the mechanics
of the tax rules differ from the mechanics of the financial
accounting rules. Moreover, the conservatism principle of GAAP
requires the application of the LCM and subnormal goods methods
so that the balance sheets of dealers in goods are not
overstated relative to realizable values. There is no analog to
the conservatism principle under the Federal income tax.
The repeal of the LCM method may cause some taxpayers to
change their methods of accounting for inventory to the LIFO
method. The LIFO method generally is considered to be a more
complicated method of accounting than is the FIFO method and
often results in less taxable income. Despite this potential
tax saving, many taxpayers are deterred from using the LIFO
method because of the present-law requirement that the LIFO
method must also be used for financial statement purposes, thus
reducing financial accounting income.
2. Repeal non-accrual experience method of accounting
Present Law
An accrual method taxpayer generally must recognize income
when all events have occurred that fix the right to its receipt
and its amount can be determined with reasonable accuracy. An
accrual method taxpayer may deduct the amount of any receivable
that was previously included in income if the receivable
becomes worthless during the year.
Accrual method service providers are provided an exception
to these general rules. Under the exception, a taxpayer using
an accrual method with respect to amounts to be received for
the performance of services is not required to accrue any
portion of such amounts which (on the basis of experience) will
not be collected (``non-accrual experience method''). This
exception applies as long as the taxpayer does not charge
interest or a penalty for failure to timely pay on such
amounts.
Description of Proposal
Under the proposal, the non-accrual experience method would
be repealed.
Effective Date
The proposal generally would be effective for taxable years
ending after the date of enactment. Any required section 481(a)
adjustment would be taken into account ratably over a four-year
period.
Prior Action
The non-accrual experience method of accounting was enacted
by the Tax Reform Act of 1986, which repealed the bad debt
reserve method of accounting and required certain taxpayers to
use an accrual method of accounting.
Analysis
The principal argument made for repeal of the non-accrual
experience method is that it allows accrual method service
providers the equivalent of a bad debt reserve, which is not
available to other accrual method taxpayers. Opponents of the
use of bad debt reserves argue that such reserves allow
deductions for bad debts to be taken prior to the time they
actually occur. The more favorable regime for service debts
under the non-accrual experience method has also given rise to
controversies over what constitutes a service (as opposed, for
example, to selling property or issuing a loan).
On the other hand, the non-accrual experience method allows
an accrual method service provider to avoid the recognition of
income that, on the basis of experience, it expects it will
never collect. This moderates the disparity in treatment
between accrual method service providers and service providers
using the cash method of accounting, who generally are not
required to recognize income from the performance of services
prior to receipt of payment. Most large entities in other lines
of business are required to use the accrual method of
accounting, either because their inventories are a material
income producing factor or they are corporations with gross
receipts in excess of $5,000,000. Service providers, however,
are frequently organized as partnerships of individuals or as
qualified personal service corporations, eligible to use the
cash method of accounting. It may be appropriate to continue to
allow accrual basis service providers the use of the non-
accrual experience method to avoid the disparity of treatment
between accrual and cash method competitors that could
otherwise result.
While the non-accrual experience method does provide a
benefit that is not available to accrual basis sellers of
goods, this difference may be appropriate. Sellers of goods may
be able to mitigate their bad debt losses by recovering the
goods themselves. This option is not available to service
providers.
3. Make certain trade receivables ineligible for mark-to-market
treatment
Present Law
In general, dealers in securities are required to use a
mark-to-market method of accounting for securities (sec. 475).
Exceptions to the mark-to-market rule are provided for
securities held for investment, certain debt instruments and
obligations to acquire debt instruments and certain securities
that hedge securities. A dealer in securities is a taxpayer who
regularly purchases securities from or sells securities to
customers in the ordinary course of a trade or business, or who
regularly offers to enter into, assume, offset, assign, or
otherwise terminate positions in certain types of securities
with customers in the ordinary course of a trade or business. A
security includes (1) a share of stock, (2) an interest in a
widely held or publicly traded partnership or trust, (3) an
evidence of indebtedness, (4) an interest rate, currency, or
equity notional principal contract, (5) an evidence of an
interest in, or derivative financial instrument in, any of the
foregoing securities, or any currency, including any option,
forward contract, short position, or similar financial
instrument in such a security or currency, or (6) a position
that is an identified hedge with respect to any of the
foregoing securities.
Treasury regulations provide that if a taxpayer would be a
dealer in securities only because of its purchases and sales of
debt instruments that, at the time of purchase or sale, are
customer paper with respect to either the taxpayer or a
corporation that is a member of the same consolidated group,
the taxpayer will not normally be treated as a dealer in
securities. However, the regulations allow such a taxpayer to
elect out of this exception to dealer status (the ``Customer
paper election'').\149\ For this purpose, a debt instrument is
customer paper with respect to a person if: (1) the person's
principal activity is selling nonfinancial goods or providing
nonfinancial services; (2) the debt instrument was issued by
the purchaser of the goods or services at the time of the
purchase of those goods and services in order to finance the
purchase; and (3) at all times since the debt instrument was
issued, it has been held either by the person selling those
goods or services or by a corporation that is a member of the
same consolidated group as that person.
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\149\ Treas. reg. sec. 1.475(c)-1(b), issued Decenber 23, 1996.
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Description of Proposal
The proposal would provide that certain trade receivables
would not be eligible for mark-to-market treatment, whether the
taxpayer is a securities dealer required to use mark-to-market
treatment or elects such treatment under the Treasury
regulation. The trade receivables that would be excluded would
include non-interest bearing receivables, and account, note and
trade receivables unrelated to an active business of a
securities dealer. The proposal would specify that no inference
is intended as to the treatment of such receivables under
present law and would also grant the Treasury regulatory
authority to carry out the purposes of the proposal.
Effective Date
The proposal generally would be effective for taxable years
ending after the date of enactment.
Prior Action
The mark-to-market method of section 475 was enacted by the
Omnibus Budget Reconciliation Act of 1993.
Analysis
Advocates of the proposal to exclude certain receivables
from ``mark-to-market'' treatment would argue that it is
necessary to prevent what is in effect a deduction for bad debt
reserves, through the deduction of losses in value of the
taxpayer's receivables and that Congress did not intend mark-
to-market treatment to reintroduce a bad debt reserve
deduction. However, it is not clear that a mark-to-market
method is equivalent to a bad debt reserve method. A bad debt
reserve method generally attempts to measure the extent to
which a creditor will or will not collect the face amount of
its accounts receivable.\150\ Such collections often are
primarily dependent upon the creditworthiness of the debtors. A
mark-to-market method of accounting attempts to measure the
fair market value of a creditor's accounts receivable. Such
value is dependent upon a number of factors, including the
creditworthiness of the debtors, the interest rate and other
terms borne by the receivables, and the marketability of the
receivables.
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\150\ Under some bad debt reserve methods, this amount may be
determined by reference to the taxpayer's bad debt experience in
previous years.
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As a demonstration of the differences between a mark-to-
market method and a bad debt reserve method, consider the
following two examples. Assume a taxpayer sells goods, on
credit, during the taxable year to a variety of debtors, some
of whom are of risky creditworthiness. In order to compensate
for these potential bad debts, the accounts receivable bear a
relatively high rate of interest. Under a mark-to-market
method, this pool of accounts receivable could be valued at or
near their face values, resulting in little or no deductible
loss (the fact that some receivables will not be collected is
offset by the fact that others will generate above-market
interest returns). Under a bad debt reserve method, the
taxpayer generally would be allowed a deduction to reflect the
fact that a portion of its accounts receivable will not be
paid. In this example, a bad debt reserve method would result
in a larger deduction during the taxable year than a mark-to-
market method. Consider another example. Assume a taxpayer
sells goods, on credit, to the Federal Government during the
taxable year and that these accounts receivable do not bear
interest. Under a ``mark-to-market'' method, this pool of
accounts receivable would be valued below their face values,
resulting in a deductible loss (the present value of even the
most secure non-interest bearing loan is less than its face
value). Under a bad debt reserve method, the taxpayer generally
would not be allowed a deduction because the likelihood of its
accounts receivable not being paid is, at best, remote. In this
example, a mark-to-market method would result in a larger
deduction during the taxable year than a bad debt reserve
method.
Mark-to-market treatment to allow deductions with respect
to receivables has probably been facilitated by the ``customer
paper election'' provided by the recent Treasury regulations.
Thus, opponents of the proposal might argue that a regulatory
rather than a legislative solution is appropriate. However,
even without the customer paper election, taxpayers that
regularly acquire receivables in transactions with customers
may argue that they are entitled to mark-to-market treatment
under present law. The proposal adds simplification in that
certain non-traded receivables will not have to be valued. The
major argument against the exception of certain receivables
from the mark-to-market regime is that mark-to-market always
provides a more accurate reflection of the income derived from
an asset, even if it produces losses. On the other hand,
Congress, in 1993, applied the mark-to-market method to a
discrete class of taxpayers and financial instruments
(securities of security dealers); thus, it is appropriate to
further clarify the limits of the application of the method by
explicitly excluding certain accounts receivable.
B. Financial Products and Institutions
1. Defer interest deduction on certain convertible debt
Present Law
If a financial instrument qualifies as a debt instrument,
the issuer of the instrument may deduct stated interest as it
economically accrues. In addition, if the instrument is issued
at a discount, the issuer may deduct original issue discount
(``OID'') as it economically accrues, even though the OID may
not be paid until the instrument matures. The holder of a debt
instrument includes stated interest under its regular method of
accounting and OID as it economically accrues.
In the case of a debt instrument that is convertible into
the stock of the issuer or a related party, an issuer generally
may deduct accrued interest and OID up until the time of the
conversion, even if the accrued interest and OID is never paid
because the instrument is converted.
Description of Proposal
The proposal would defer interest deductions for accrued
stated interest and OID on convertible debt until such time as
the interest is paid. For this purpose, payment would not
include: (1) the conversion of the debt into equity of the
issuer or a related person (as determined under secs. 267(b)
and 707(b)) or (2) the payment of cash or other property in an
amount that is determined by reference to the value of such
equity. Convertible debt would include debt: (1) exchangeable
for the stock of the issuer or a related party, (2) with cash-
settlement conversion features, or (3) issued with warrants (or
similar instruments) as part of an investment unit in which the
debt instrument may be used to satisfy the exercise price of
the warrant. Convertible debt would not include debt that is
``convertible'' solely because a fixed payment of principal or
interest could be converted by the holder into equity of the
issuer or a related party having a value equal to the amount of
such principal or interest. Holders of convertible debt would
continue to include the interest on such instruments in gross
income as under present law.
Effective Date
The proposal would be effective for convertible debt issued
on or after the date of first committee action.
Prior Action
The proposal was included in the President's fiscal year
1998 budget proposal.
Analysis
The manner in which the proposal would operate may be
illustrated in one context by examining its effect upon the tax
treatment of instruments commonly known as liquid yield option
notes (``LYONs'').\151\ A LYON generally is an instrument that
is issued at a discount and is convertible into a fixed number
of shares of the issuer, regardless of the amount of original
issue discount (``OID'') accrued as of the date of conversion.
The conversion option usually is in the hands of the holder,
although a LYON may be structured to allow the issuer to ``cash
out'' the instrument at certain fixed dates for its issue price
plus accrued OID. If the LYON is not converted into equity at
maturity, the holder receives the stated redemption price at
maturity (i.e., the issue price plus accrued OID). A LYON is
convertible into a fixed number of shares of issuer stock
regardless of the amount of accrued OID and does not provide
interim interest payments to holders. Thus, a LYON could be
viewed as providing the holder both a discount debt instrument
and an option to purchase stock at a price equal to the
maturity value of the debt. If the stock has risen in value
from the date of issuance to the maturity date to an amount
that is greater than the stated redemption price at maturity of
the OID debt, the holder will exercise the option to acquire
stock by surrendering the debt. If the stock has not
sufficiently risen in value, the holder will cash in the debt
and let the option lapse.
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\151\ Other convertible debt instruments may have features similar
to LYONs and may be issued or traded under different names or acronyms.
The reference to ``LYONs'' in this discussion is intended to be a
reference to any other similar instruments.
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As a simplified example, assume ABC Co. issues a LYON that
will mature in five years. The LYON provides that, at maturity,
the holder has the option of receiving $100 cash or one share
of ABC Co. stock. The LYONs are issued for $70 per instrument
at time that the ABC Co. stock is trading for less than $70 a
share. Thus, at the end of five years, the holder of the LYON
has the following choices: (1) if ABC Co. stock is trading at
less than $100 a share, the holder will take the $100 cash, but
(2) if ABC Co. stock is trading at more than $100 a share, the
holder will take the stock. Because the holder is guaranteed to
receive at least $100 in value at maturity, present law allows
the issuer (and requires the holder) to accrue $30 of OID as
interest over the five-year term of the instrument.
The structure of LYONs raises several tax issues. The first
is whether the conversion feature of a LYON is sufficiently
equity-like to characterize the LYON as equity instead of debt.
Under present law, issuers of LYONS deduct (and the holders
include in income) the amount of OID as interest as it accrues.
A second issue is whether it is appropriate to accrue OID on an
instrument when it is unclear whether such instrument
(including the accrued OID) will be paid in cash or property
other than stock. The proposal provides answers to these two
issues by applying a ``wait and see'' approach, that is, OID on
a LYON is not deductible unless and until the amount of OID is
paid in cash. In this way, the proposal defers the
determination of whether a LYON is debt or equity until
maturity. This approach is consistent with present-law section
163(e)(5) that provides that a portion of the OID of applicable
high-yield debt instruments is not deductible until paid.
Opponents of the proposal would argue that the
determination of whether an instrument is debt or equity should
be made at its issuance and, at issuance, a LYON has more debt-
like features than equity-like features. They would further
point out that the holder of a LYON is guaranteed to receive at
maturity at least the amount of the OID and that present law
properly allows issuers to accrue such amount over time.
Opponents of the proposal also would argue that under present
law, taxpayers are allowed deductions when stock is issued for
deductible expenses (or taxpayers can issue stock to the public
and use the cash to pay deductible expenses) and that the
issuance of stock for accrued interest is no different. They
further claim that issuers can achieve results that are similar
(or better) than the present law treatment of a LYON by issuing
callable OID indebtedness and options or warrants as separate
instruments and that the tax law should not discourage the
efficient combination of the two types of instruments. However,
if the two instruments truly trade separately, it is not clear
that they are economically equivalent to a LYON. Finally,
opponents would argue that it is unfair and contrary to the
present-law OID rules to require holders of LYONS to accrue OID
in income while deferring or denying related OID deductions to
issuers. Again, under present law, holders of applicable high-
yield debt instruments are required to include OID in income as
it accrues, while OID deductions of issuers of such instruments
are deferred or denied.
2. Disallowance of interest on indebtedness allocable to tax-exempt
obligations of all financial intermediaries
Present Law
In general
Present law disallows a deduction for interest on
indebtedness incurred or continued to purchase or carry
obligations the interest on which is not subject to tax (tax-
exempt obligations) (sec. 265). This rule applies to tax-exempt
obligations held by individual and corporate taxpayers. The
rule also applies to certain cases in which a taxpayer incurs
or continues indebtedness and a related person acquires or
holds tax-exempt obligations. \152\
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\152\ Section 7701(f) (as enacted in the Deficit Reduction Act of
1984 (sec. 53(c) of Public Law 98-369)) provides that the Treasury
Secretary shall prescribe such regulations as may be necessary or
appropriate to prevent the avoidance of any income tax rules which deal
with linking of borrowing to investment or diminish risk through the
use of related persons, pass-through entities, or other intermediaries.
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Application to non-financial corporations
In Rev. Proc. 72-18, 1972-1 C.B. 740, the IRS provided
guidelines for application of the disallowance provision to
individuals, dealers in tax-exempt obligations, other business
enterprises, and banks in certain situations. Under Rev. Proc.
72-18, a deduction is disallowed only when indebtedness is
incurred or continued for the purpose of purchasing or carrying
tax-exempt obligations.
This purpose may be established either by direct or
circumstantial evidence. Direct evidence of a purpose to
purchase or carry tax-exempt obligations exists when the
proceeds of indebtedness are directly traceable to the purchase
of tax-exempt obligations or when such obligations are used as
collateral for indebtedness. In the absence of direct evidence,
a deduction is disallowed only if the totality of facts and
circumstances establishes a sufficiently direct relationship
between the borrowing and the investment in tax-exempt
obligations.
Two-percent de minimis exception.--In the case of an
individual, interest on indebtedness which is not directly
traceable to tax-exempt obligations is not disallowed if during
the taxable year the average adjusted basis of the tax-exempt
obligations does not exceed 2 percent of the average adjusted
basis of the individual's portfolio investments and trade or
business assets. In the case of a corporation other than a
financial institution or a dealer in tax-exempt obligations,
interest on indebtedness which is not directly traceable to
tax-exempt obligations is not disallowed if during the taxable
year the average adjusted basis of the tax-exempt obligations
does not exceed 2 percent of the average adjusted basis of all
assets held in the active conduct of the trade or business.
These safe harbors are inapplicable to financial institutions
and dealers in tax-exempt obligations.
Interest on installment sales to State and local
governments.--If a taxpayer sells property to a State or local
government in exchange for an installment obligation, interest
on the obligation may be exempt from tax. Present law has been
interpreted to not disallow interest on a taxpayer's
indebtedness if the taxpayer acquires nonsaleable tax-exempt
obligations in the ordinary course of business in payment for
services performed for, or goods supplied to, State or local
governments.\153\
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\153\ R.B. George Machinery Co., 26 B.T.A. 594 (1932) acq. C.B. XI-
2, 4; Rev. Proc. 72-18, as modified by Rev. Proc. 87-53, 1987-2 C.B.
669.
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Application to financial institutions
In the case of a financial institution, the allocation of
the interest expense of the financial institution (which is not
otherwise allocable to tax-exempt obligations) is based on the
ratio of the average adjusted basis of the tax-exempt
obligations acquired after August 7, 1986, to the average
adjusted basis of all assets of the taxpayer (Code sec. 265).
For this purpose, a financial institution is (1) a person who
accepts deposits from the public in the ordinary course of the
taxpayer's business that is subject to Federal or State
supervision as a financial institution or (2) a foreign
corporation which has a banking business in the United States.
In the case of an obligation of an issuer which reasonably
anticipates to issue not more than $10 million of tax- exempt
obligations (other than certain private activity bonds) within
a calendar year (hereinafter the ``small issuer exception''),
only 20 percent of the interest allocable to such tax-exempt
obligations is disallowed (Code sec. 291(a)(3)).
Treatment of securities dealers
A pro rata disallowance rule, similar to the rule
applicable to financial institutions, applies to dealers in
tax-exempt obligations, but there is no small issuer exception,
and the 2-percent de minimis exception does not apply (Rev.
Proc. 72-18). Securities dealers are allowed, however, to
exclude from the pro rata disallowance rule interest on
borrowings that they can prove by tracing were incurred or
continued for a purpose other than purchasing or carrying tax-
exempt obligations.
Treatment of insurance companies
Present law provides that a life insurance company's
deduction for additions to reserves is reduced by a portion of
the company's income that is not subject to current tax
(generally, tax-exempt interest, deductible intercorporate
dividends, and the increase in certain insurance policy cash
values) (secs. 807 and 812). The portion by which the life
insurance company's reserve deduction is reduced is related to
its earnings rate. Similarly, in the case of property and
casualty insurance companies, the deduction for losses incurred
is reduced by a percentage (15 percent) of (1) the insurer's
tax-exempt interest, (2) the deductible portion of dividends
received (with special rules for dividends from affiliates),
and (3) the increase for the taxable year in the cash value of
life insurance, endowment or annuity contracts (sec.
832(b)(5)(B)). If the amount of this reduction exceeds the
amount otherwise deductible as losses incurred, the excess is
includible in the property and casualty insurer's income.
Description of Proposal
The Administration proposal would extend to all persons
engaged in the active conduct of banking, financing, or similar
business (such as securities dealers and other financial
intermediaries) the rule that applies to financial institutions
that disallows interest deductions of a taxpayer (that are not
otherwise disallowed as allocable under present law to tax-
exempt obligations) in the same proportion as the average basis
of its tax-exempt obligations bears to the average basis of all
of the taxpayer's assets. The proposal would not extend the $10
million small-issuer exception to taxpayers which are not
financial institutions. The proposal would not apply to
insurance companies.
Effective Date
The proposal would be effective for taxable years beginning
after date of enactment with respect to obligations acquired on
or after the date of committee action.
Prior Action
Section 10116 of the Omnibus Budget Reconciliation Act of
1987 as reported by the House Committee on the Budget would
have disallowed a deduction for interest on indebtedness
allocable to tax-exempt installment obligations. In addition,
that section would have reduced the non-statutory two-percent
de minimis test to the lesser of $1 million or two-percent of
the taxpayer's adjusted basis of all of the taxpayer's assets.
That bill passed the House, but the provision disallowing a
deduction for interest allocable to tax-exempt obligations was
subsequently deleted in conference.
The Administration made similar proposals in 1995 and 1997
except that the proposed extension of the interest disallowance
rule would have applied to all corporations, not just financial
intermediaries. In addition the prior proposal would not have
applied to nonsaleable tax-exempt debt acquired by a
corporation in the ordinary course of business in payment for
goods or services sold to a State or local government. Like the
present proposal, the prior proposal would not have applied to
an insurance company. Finally, the prior proposal would have
applied the interest disallowance provision to all related
persons (within the meaning of sec. 267(f)).
Analysis
Premise of proposal
Taxpayers generally are allowed to deduct the amount of
interest expense paid or accrued within the taxable year (Code
sec. 163(a)). However, present law disallows the deduction of
interest expense on indebtedness incurred to purchase or carry
tax-exempt obligations (Code sec. 265(a)(2)). The purpose of
this disallowance rule is to prevent the tax arbitrage that
would otherwise occur if taxpayers could borrow money and
deduct any resulting interest expense while excluding from
gross income interest income on State or local obligations
financed with that borrowing. If unrestricted, tax arbitrage
could create an unlimited transfer of funds from the Treasury
to State and local treasuries. Moreover, the transfer of funds
generally is inefficient in that the Federal tax revenue lost
generally exceeds the arbitrage profit earned by State and
local governments.
Present law provides more favorable rules on the
disallowance of interest expense or reserve deductions
allocable to tax-exempt bonds to certain types of financial
intermediaries (e.g., property and casualty insurance and
finance companies) than other types of financial intermediaries
with whom they compete (e.g., banks). If one accepts the
premise that all money is fungible and that debt of the
taxpayer finances its proportionate share of all of the
taxpayer's assets including tax-exempt bonds, a proportional
disallowance rule theoretically should apply to all taxpayers.
The Administration proposal to apply a proportional
disallowance rule to all financial intermediaries is based on
the notion that similar taxpayers should be taxed similarly.
While uniform treatment may not be appropriate among all
taxpayers, there arguably should be uniform treatment among
taxpayers that compete against each other.
Scope of proposal
The scope of the proposal is not entirely clear since it
applies to persons in the active conduct of businesses
``similar'' to ``banking'', ``financing,'' ``securities
dealers'' and ``other financial intermediaries.'' For example,
is a retailer who sells appliances or furniture on an
installment method in a financing business and, therefore,
subject to the proposed rule? Is any retailer who issues its
own credit card (e.g., Sears, Macy's, J.C. Penney's, Firestone,
etc.) subject to the proposed rule?
Effect of proposal
The primary effect of the proposal would be to disallow the
2-percent de minimis exception and the installment sale
exception to taxpayers covered by the proposal.
Repeal of 2-percent de minimis exception.--The
Administration proposal to adopt a pro rata rule would repeal
the 2-percent de minimis exception for those taxpayers covered
by the proposal. Some proponents of the Administration proposal
accept the premise that money is fungible and, accordingly,
would disallow interest deductions on a pro rata basis (e.g.,
in the same proportion as the taxpayer's average basis in its
tax-exempt obligations bears to the average basis of its total
assets). These proponents argue that the proposed pro rata
allocation of indebtedness among assets (in the manner
prescribed for financial institutions) has the additional
administrative benefit, for taxpayers that own more tax-exempt
bonds than the 2 percent de minimis amount, of avoiding the
difficult and often subjective inquiry of when indebtedness is
incurred or continued to purchase or carry tax-exempt
obligations.
Opponents of the Administration proposal argue that the
proposal would have the effect of raising the financing costs
for State or local governments. Opponents also note that the de
minimis exception avoids the complexity of complying with the
proposed pro rata rule. Lastly, opponents note that there is no
policy justification for repealing the de minimis exception for
financial intermediaries, but not individuals.
Repeal of the installment sale exception.--The
Administration proposal to adopt a pro rata rule also would
repeal the installment sales exception for those taxpayers
covered by the proposal. Opponents of the proposal believe that
the present exception for debt arising from installment sales
to State and local governments should be retained because such
debt often is incurred by governments for acquisition of
property that could not easily be financed through debt issued
in the public debt markets because of the size of the
government or the asset acquisition.
The exemption from the pro rata rule for insurance
companies is justified on the grounds that present law already
adjusts the deduction for additions to an insurance company's
reserves for its tax-exempt income.
C. Corporate Tax Provisions
1. Eliminate dividends-received deduction for certain preferred stock
Present Law
A corporate taxpayer is entitled to a deduction of 70
percent of the dividends it receives from a domestic
corporation. The percentage deduction is generally increased to
80 percent if the taxpayer owns at least 20 percent (by vote
and value) of the stock of the dividend-paying corporation, and
to 100 percent for ``qualifying dividends,'' which generally
are from members of the same affiliated group as the taxpayer.
The dividends-received deduction is disallowed if the
taxpayer has held the stock for 45 days or less during the 90-
day period beginning on the date that is 45 days before the
date on which such share becomes ex-dividend with respect to
such dividend. In the case of certain preferred stock, the
dividends received deduction is disallowed if the taxpayer has
held the stock for 90 days or less during the 180-day period
beginning on the date which is 90 days before the date on which
such share becomes ex-dividend with respect to such dividend.
The holding period generally does not include any period during
which the taxpayer has a right or obligation to sell the stock,
or is otherwise protected from the risk of loss otherwise
inherent in the ownership of an equity interest. If an
instrument was treated as stock for tax purposes, but provided
for payment of a fixed amount on a specified maturity date and
afforded holders the rights of creditors to enforce such
payment, the Internal Revenue Service has ruled that no
dividends-received deduction would be allowed for distributions
on the instrument.154
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\154\ See Rev. Rul. 94-28, 1994-1 C.B. 86.
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The Taxpayer Relief Act of 1997 amended sections 351, 354,
355, 356 and 1036 to treat ``nonqualified preferred stock'' as
boot in corporate transactions, subject to certain exceptions.
Nonqualified preferred stock is defined in section 351(g) as
preferred stock that does not participate (through a conversion
privilege or otherwise) in corporate growth to any significant
extent, if (1) the holder has the right to require the issuer
or a related person to redeem or purchase the stock, (2) the
issuer or a related person is required to redeem or purchase
the stock, (3) the issuer or a related person has the right to
redeem or purchase the stock and, as of the issue date, it is
more likely than not that such right will be exercised, or (4)
the dividend rate on the stock varies in whole or in part
(directly or indirectly) with reference to interest rates,
commodity prices, or similar indices, regardless of whether
such varying rate is provided as an express term of the stock
(as in the case of adjustable rate stock) or as a practical
result of other aspects of the stock (as in the case of auction
rate stock). For this purpose, clauses (1), (2), and (3) apply
if the right or obligation may be exercised within 20 years of
the issue date and is not subject to a contingency which, as of
the issue date, makes remote the likelihood of the redemption
or purchase.
Description of Proposal
Except in the case of ``qualifying dividends,'' the
dividends-received deduction would be eliminated for dividends
on nonqualified preferred stock (as defined in section 351(g)).
No inference regarding the present-law tax treatment of the
above-described stock is intended by this proposal.
Effective Date
The proposal would apply to stock issued after the date of
enactment.
Prior Action
A substantially similar proposal was included in the
President's fiscal year 1998 budget proposal.
Analysis
This proposal extends the denial of the dividends-received
deduction to preferred stock that is treated as taxable
consideration (or ``boot'') in certain otherwise non-taxable
corporate reorganizations and restructurings.
It is arguable that stock with the particular
characteristics identified in the proposal is sufficiently free
from risk and from participation in corporate growth that it
should be treated as debt for certain purposes, including
denial of the dividends received deduction. Many of the types
of stock described in the proposal are traditionally marketed
to corporate investors (or can be tailored or designed for
corporate investors) to take advantage of the dividends
received deduction. As one example, a corporation may structure
a disposition of a subsidiary taking back this type of
preferred stock. The transferor might transform what may be
essentially sales proceeds into deductible dividends, based on
the future earnings of the former subsidiary corporation after
principal ownership has been transferred to others. Features
such as puts and calls effectively determine the period within
which total payment is expected to occur.
Similarly, so called ``auction rate'' preferred stock has a
mechanism to reset the dividend rate on the stock so that it
tracks changes in interest rates over the term of the
instrument, thus diminishing any risk that the ``principal''
amount of the stock would change if interest rates changed.
Although it is theoretically possible (and it has sometimes
occurred) that an auction will ``fail'' (i.e., that a dividend
rate will not be achieved in the auction that maintains the
full value of principal of the investment), this has occurred
extremely rarely in actual practice. Investors may view such
stock as similar to a floating rate debt instrument.
In addition to section 351(g) which treats the type of
stock addressed here as ``boot'' for purposes of certain
otherwise tax-free transactions, the Code in various places
treats certain non-participating preferred stock differently
from other stock. For example, ceterain preferred stock that
does not participate to any significant extent in corporate
growth does not count as stock ownership in determining whether
two corporations are sufficiently related to file consolidated
returns; also such stock does not count in determining whether
there has been a change of ownership that would trigger the
loss limitation rules of Code section 382.
On the other hand, some argue that a relatively low level
of risk and participation in growth, or expectation of
termination of the instrument at a particular time, should not
be factors governing the availability of the dividends received
deduction. Furthermore, it is argued that if this type of
instrument is viewed as sufficiently debt-like, then it should
be classified as debt for all tax purposes, rather than merely
subjected to several detrimental non-stock consequences.
2. Repeal tax-free conversion of larger C corporations to S
corporations
Present Law
The income of a corporation described in subchapter C of
the Internal Revenue Code (a ``C corporation'') is subject to
corporate-level tax when the income is earned and individual-
level tax when the income is distributed. The income of a
corporation described in subchapter S of the Internal Revenue
Code (an ``S corporation'') generally is subject to individual-
level, but not corporate-level, tax when the income is earned.
The income of an S corporation generally is not subject to tax
when it is distributed to the shareholders. The tax treatment
of an S corporation is similar to the treatment of a
partnership or sole proprietorship.
The liquidation of a subchapter C corporation generally is
a taxable event to both the corporation and its shareholders.
Corporate gain is measured by the difference between the fair
market values and the adjusted bases of the corporation's
assets. The shareholder gain is measured by the difference
between the value of the assets distributed and the
shareholder's adjusted basis in his or her stock. The
conversion of a C corporation into a partnership or sole
proprietorship is treated as the liquidation of the
corporation.
The conversion from C to S corporation status (or the
merger of a C corporation into an S corporation) generally is
not a taxable event to either the corporation or its
shareholders.
Present law provides rules designed to limit the potential
for C corporations to avoid the recognition of corporate-level
gain on shifting appreciated assets by converting to S
corporation status prior to the recognition of such gains.
Specifically, an S corporation is subject to a tax computed by
applying the highest marginal corporate tax rate to the lesser
of (1) the S corporation's recognized built-in gain or (2) the
amount that would be taxable income if such corporation was not
an S corporation (sec. 1374). For this purpose, a recognized
built-in gain generally is any gain the S corporation
recognizes from the disposition of any asset within a 10-year
recognition period after the conversion from C corporation
status, or any income that is properly taken into account
during the recognition period that is attributable to prior
periods. However, a gain is not a recognized built-in gain if
the taxpayer can establish that the asset was not held by the
corporation on the date of conversion or to the extent the gain
exceeds the amount of gain that would have been recognized on
such date. In addition, the cumulative amount of recognized
built-in gain that an S corporation must take into account may
not exceed the amount by which the fair market value of the
corporation's assets exceeds the aggregated adjusted basis of
such assets on the date of conversion from C corporation
status. Finally, net operating loss or tax credit carryovers
from years in which the corporation was a C corporation may
reduce or eliminate the tax on recognized built-in gain.
The amount of built-in gain that is subject to corporate-
level tax also flows through to the shareholders of the S
corporation as an item of income subject to individual-level
tax. The amount of tax paid by the S corporation on built-in
gain flows through to the shareholders as an item of loss that
is deductible against such built-in gain income on the
individual level.
Description of Proposal
The proposal would repeal section 1374 for large S
corporations. A C-to-S corporation conversion (whether by a C
corporation electing S corporation status or by a C corporation
merging into an S corporation) would be treated as a
liquidation of the C corporation followed by a contribution of
the assets to an S corporation by the recipient shareholders.
Thus, the proposal would require immediate gain recognition by
both the corporation (with respect to its appreciated assets)
and its shareholders (with respect to their stock) upon the
conversion to S corporation status.
For this purpose, a large S corporation is one with a value
of more than $5 million at the time of conversion. The value of
the corporation would be the fair market value of all the stock
of the corporation on the date of conversion.
In addition, the Internal Revenue Service would revise
Notice 88-19 155 to conform to the proposed
amendment to section 1374, with an effective date similar to
the statutory proposal. As a result, the conversion of a large
C corporation to a regulated investment company (``RIC'') or a
real estate investment trust (``REIT'') would result in
immediate recognition by the C corporation of the net built-in
gain in its assets.
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\155\ Notice 88-19, 1988-1 C.B. 486, allows C corporations that
become RICs or REITs to be subject to rules similar to those of section
1374, rather than being subject to the rules applicable to complete
liquidations.
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Effective Date
The proposal generally would be effective for subchapter S
elections that become effective for taxable years beginning
after January 1, 1999. Thus, C corporations would continue to
be permitted to elect S corporation status effective for
taxable years beginning in 1998 or on January 1, 1999. The
proposal would apply to acquisitions (e.g., the merger of a C
corporation into an existing S corporation) after December 31,
1998.
Prior Action
Similar proposals were included in the President's budget
proposals for the fiscal years 1997 and 1998.
Analysis
The conversion of a C corporation to an S corporation may
be viewed as the constructive liquidation of the C corporation
because the corporation has changed from taxable status to
passthrough status. The proposal would conform the tax
treatment of such constructive liquidation to the tax treatment
of an actual liquidation. Thus, the proposal would conform the
treatment of the conversion from C corporation status to
passthrough entity status where the passthrough entity is an S
corporation with the present-law treatment where the
passthrough entity is a partnership or a sole proprietorship.
The proposal would eliminate some of the complexity of
subchapter S under present law.156 The rules that
trace C corporation built-in gain and C corporation earnings
and profits generally would become unnecessary. In addition,
the rules imposing corporate tax and the possible loss of S
corporation status after the conversion due to excessive
passive income also could be eliminated. However, these complex
rules would continue to apply to small converting C
corporations and it could be argued that these businesses are
the least able to handle complexity.
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\156\ A similar proposal was included in a letter to House Ways and
Means Chairman Dan Rostenkowski from Ronald A. Pearlman, Chief of Staff
of the Joint Committee on Taxation, recommending several simplification
proposals. See, Committee on Ways and Means, Written Proposals on Tax
Simplification, (WMCP 101-27), May 25, 1990, p 24.
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The proposal would create some complexity, as it would
require the valuation of C corporation stock to determine if
the $5 million threshold has been exceeded and C corporation
assets for purposes of determining the amount of gain on the
constructive liquidation. However, valuations theoretically are
required under present law because of the need to determine
whether corporate tax may be due under the built-in gain
tracing rules; it is possible that taxpayers may not perform
the valuations for all assets in all cases, particularly if
they believe that there is no aggregate net built-in gain, or
if there is a possibility that built-in gain assets may not be
disposed of within the present-law tracing period. It should be
noted that the $5 million threshold creates a ``cliff'' where
corporations valued at $5 million or less are not subject to
tax while corporations valued at greater than $5 million would
be subject to full taxation. It appears that rules would be
required to address step transactions designed to avoid the
proposal (e.g., where a series of C corporations, each under
the $5 million cap, merge into an S corporation; or where a
large C corporation divides into multiple entities so that some
or all of the entities are under the $5 million cap). Another
issue under the proposal is whether the stock of the
corporation is to be valued immediately before the conversion
(i.e., as C corporation stock subject to two levels of tax) or
immediately after the conversion (i.e., as S corporation stock,
subject to one level of tax).
The proposal would create significant shareholder and
corporate liquidity concerns for large C corporations planning
on converting to S corporation status. Current businesses that
organized as C corporations may have done so in anticipation of
converting at a relatively low tax cost in the future. Not
applying the proposal until taxable years beginning after
January 1, 1999, addresses some, but not all, of these
concerns.
Finally, the proposal raises significant policy issues
regarding the integrity of the separate corporation tax as
opposed to integrating the corporate and individual tax
regimes. More acutely, the proposal raises issues regarding the
need for the continued existence of subchapter S in light of
other developments. Recent IRS rulings with respect to the
various State limited liability companies and the ``check-the-
box'' Treasury regulations 157 have significantly
expanded the availability of pass-through tax treatment for
entities that accord their investors limited legal liability.
These developments, coupled with the restrictive rules of
subchapter S,158 have decreased the desirability of
the subchapter S election for newly-formed entities. This
proposal would decrease the desirability of the subchapter S
election for existing C corporations. Thus, if the proposal
were enacted, the primary application of subchapter S would be
limited to existing S corporations and small converting
corporations. At that point, one may question whether it is
desirable to have a whole separate passthrough regime in the
Code that pertains to a limited number of taxpayers. Any repeal
of subchapter S would require rules providing for the treatment
of existing S corporations.159
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\157\ Treas. reg. secs. 301.7701-1, -2, and -3, issued in final
form on December 17, 1996.
\158\ For example, only domestic corporations with simple capital
and limited ownership structures may elect to be S corporations.
\159\ See, for example, the letter of July 25, 1995, from Leslie B.
Samuels, Assistant Treasury Secretary (Tax Policy) to Senator Orrin
Hatch, suggesting possible legislative proposals to allow S
corporations to elect partnership status or to apply the check-the-box
regulations to S corporations.
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3. Restrict special net operating loss carryback rules for specified
liability losses
Present Law
Under present law, that portion of a net operating loss
that qualifies as a ``specified liability loss'' may be carried
back 10 years rather than being limited to the general two-year
carryback period. A specified liability loss includes amounts
allowable as a deduction with respect to product liability, and
also certain liabilities that arise under Federal or State law
or out of any tort of the taxpayer. In the case of a liability
arising out of a Federal or State law, the act (or failure to
act) giving rise to the liability must occur at least 3 years
before the beginning of the taxable year. In the case of a
liability arising out of a tort, the liability must arise out
of a series of actions (or failures to act) over an extended
period of time a substantial portion of which occurred at least
3 years before the beginning of the taxable year. A specified
liability loss cannot exceed the amount of the net operating
loss, and is only available to taxpayers that used an accrual
method throughout the period that the acts (or failures to act)
giving rise to the liability occurred.
Description of Proposal
Under the proposal, specified liability losses would be
defined and limited to include (in addition to product
liability losses) only amounts allowable as a deduction that
are attributable to a liability that arises under Federal or
State law for reclamation of land, decommissioning of a nuclear
power plant (or any unit thereof), dismantlement of an offshore
oil drilling platform, remediation of environmental
contamination, or payments arising under a workers'
compensation statute, if the act (or failure to act) giving
rise to such liability occurs at least 3 years before the
beginning of the taxable year. No inference regarding the
interpretation of the specified liability loss carryback rules
under current law would be intended by this proposal.
Effective Date
The proposal would be effective for taxable years beginning
after the date of enactment.
Prior Action
No prior action.
Analysis
A taxpayer is required to determine and report the taxable
income recognized in each taxable year, regardless of whether
the taxable year matches the natural business cycle of the
taxpayer or whether transactions have occurred which span
several years. This is known as the ``annual accounting
concept.'' Thus, deductions claimed in the current taxable year
may relate to, and be properly matched with, income reported in
a different taxable year. In recognition of the restrictions of
the annual accounting concept, present law allows taxpayers
with net operating losses to carry such losses back to the
preceding two taxable years or carried forward to the
succeeding 20 years. In addition, present law allows a 10-year
carryback of that portion of a net operating loss that relates
to certain specified liabilities to the extent these
liabilities arose as a result of acts or failures to act that
occurred more than three years ago.
The proper interpretation of the specified liability loss
provisions has been the subject of controversy. Although the
legislative history suggests that these specified liability
loss rules were provided to apply to certain liabilities for
which a deduction is deferred as a result of the economic
performance rules of section 461(h),160 many
taxpayers have not limited their claimed specified liability
losses to such deductions. In addition, many taxpayers have
interpreted the 3-year requirement and the requirement that the
liability arises out of a Federal or State law in a broad
manner and the IRS has announced that it will contest many such
claims. (See, e.g., Notice 97-36, 1997-26 I.R.B. 6, June 1,
1997.) For example, taxpayers have claimed that accounting fees
paid for annual compliance with SEC and ERISA auditing and
reporting requirements can be carried back 10 years as
specified liability losses on the ground that the taxpayer
first became subject to the laws imposing such reporting
requirements more than 3 years prior to the year of the current
annual expenditures. Taxpayers have also asserted that
accounting fees paid in connection with an IRS audit can be
carried back 10 years as specified liability losses. In a
recent decision, Sealy Corp. v. Commissioner, 107 T.C. 177
(1996), the Tax Court upheld the IRS position rejecting a 10-
year carryback for such claims; however the court did not
specify the boundaries of the 10-year carryback provision. It
is also possible that taxpayers may continue to take and
litigate positions such as those in the Sealy Corp. case even
on similar facts, seeking to obtain other interpretations in
other courts.
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\160\ H. Rept. 98-861, 98th Cong., 2d Sess. 871 (1984).
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The proposal would lessen similar controversies by
providing a definitive list of items for which the 10-year
carryback is available. It may be argued that the proposal may
result in a mismatch between income and expense to the extent a
currently deductible liability relates to previously recognized
income and the liability is not listed under the proposal.
However, proponents of the proposal argue that section 172(f)
was originally intended as a relief provision narrowly targeted
to certain liabilities for which a deduction is deferred as a
result of the economic performance rules of section 461(h), and
that narrowing the provision to a limited class of liabilities
does not frustrate the original Congressional intent.
4. Clarify definition of ``subject to'' liabilities under section
357(c)
Present Law
Present law provides that the transferor of property
recognizes no gain or loss if the property is exchanged solely
for qualified stock in a controlled corporation (sec. 351).
Code section 357(c) provides that the transferor generally
recognizes gain to the extent that the sum of the liabilities
assumed by the controlled corporation and the liabilities to
which the transferred property is subject exceeds the
transferor's basis in the transferred property. If the
transferred property is ``subject to'' a liability, Treasury
regulations have indicated that the amount of the liability is
included in the calculation regardless of whether the
underlying liability is assumed by the controlled corporation.
Treas. Reg. sec. 1.357-2(a).
The gain recognition rule of section 357(c) is applied
separately to each transferor in a section 351 exchange.
The basis of the property in the hands of the controlled
corporation equals the transferor's basis in such property,
increased by the amount of gain recognized by the transferor,
including section 357(c) gain.
Section 357(c) also applies to reorganizations described in
section 368(a)(1)(D).
Description of Proposal
The proposal would eliminate any distinction between the
assumption of the liability and the acquisition of an asset
subject to a liability. Instead, the extent to which a
liability (including a nonrecourse liability) would be treated
as assumed for Federal income tax purposes in connection with a
transfer of property would be determined on the basis of all
the facts and circumstances. Thus, for example, a transferee
would not be treated as assuming a liability if the transferor
indemnifies the transferee against the possibility of
foreclosure. Similarly, the fact that a lender retains a
security interest in property securing a recourse liability
would not cause the transferee to be treated as assuming the
liability if the transferor remains solely liable on the
indebtedness without a right of contribution against the
transferee. In general, if nonrecourse indebtedness is secured
by more than one asset, and any assets securing the
indebtedness are transferred subject to the indebtedness
without any indemnity agreements, then for all Federal income
tax purposes the transferee would be treated as assuming an
allocable portion of the liability based upon the relative fair
market values (determined without regard to section 7701(g)) of
the assets securing the liability. The proposal would authorize
the Secretary of the Treasury to issue regulations to carry out
the purposes of this proposal, including anti-abuse rules.
No inference regarding the tax treatment under current law
would be intended by this proposal.
Effective Date
The proposal would apply to transfers after the date of
first committee action.
Prior Action
No prior action
Analysis
In general, a taxpayer recognizes income when he or she is
relieved of a liability. Thus, if a taxpayer transfers an asset
to a corporation, and the corporation assumes a liability of
the taxpayer in an amount greater than the taxpayer's basis in
the asset, present law treats the taxpayer as having sold the
asset for an amount equal to the relieved liability. Similar
rules apply if an asset is transferred subject to a liability.
Present law does not clearly define what ``transferred
subject to a liability'' means. If the transferor has cross-
collateralized a liability with several assets, it has been
asserted that each of those assets is literally ``subject to''
the entire amount of the liability, even where the transferor
has not been relieved of the liability. A number of cases have
applied section 357(c) in a manner or with language suggesting
that it is not necessary to consider whether, as a practical
matter, the transferor has been relieved of the transferred
liability. For example in Rosen v. Commissioner,\161\ the Tax
Court stated that ``. . . there is no requirement in section
357(c)(1) that the transferor be relieved of liability.
Similarly, in Owen v. Commissioner,162 the Ninth
Circuit Court of Appeals rejected a claim by the taxpayers that
the concept of assets ``subject to'' liabilities only applies
to non-recourse liabilities, and stated that continuing
personal liability for the loans secured by the transferred
equipment was irrelevant.
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\161\ 62 T.C. 11, 19 (1974), affd. without published opinion 515
F.2d 507 (3d Cir. 1975).
\162\ 881 F.2d 832 (9th Cir. 1989).
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In Lessinger v. Commissioner,163 on the other
hand, the Second Circuit Court of Appeals construed the
language of section 357(c) to avoid imposing gain recognition
on the taxpayer where the taxpayer contributed his own
promissory note in the amount of the excess of the transferred
liabilities over the basis of the transferred assets.
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\163\ 872 F.2d 519 (2d Cir. 1989).
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As a result of this uncertainty in present law, some
taxpayers may be reluctant to engage in legitimate transactions
or may restructure them, while others may attempt to structure
transactions to take advantage of different interpretations.
For example, a taxpayer who has cross-collateralized a
liability with assets that the taxpayer now, for valid business
reasons, wants to contribute to one or more corporations, may
structure the transaction in a manner seeking to take the
position that some case law supports non-recognition, or may
contribute additional assets with basis sufficient to avoid
gain recognition under any of the case law, or may seek to
obtain a release of the transferred assets from the lender. It
may be difficult or expensive for a taxpayer to obtain such a
release.
On the other hand, taxpayers not concerned about current
gain recognition (for example, due to losses, credits or status
as a non-taxable entity) may attempt to structure transactions
to take advantage of different interpretations. For example,
assume that transferor A has borrowed $100,000 on a recourse
basis, secured by two assets. A transfers one asset with a
basis of $20,000 and a fair market value of $50,000 to a
controlled domestic corporation, X. Under the literal language
of section 357(c), it may be argued that A would recognize
$80,000 of gain on the transfer, and X would hold the asset at
a basis of $100,000 (A's original basis of $20,000 plus $80,000
recognized gain). If A is a foreign person or a tax-exempt
entity or in the position to use expiring loss or credit
carryovers to offset the gain, X can obtain a stepped-up basis
in the asset without a tax cost to A. X can benefit from this
stepped-up basis by increased depreciation deductions or
reduced gain on the future sale of the asset.
The proposal is intended to ensure that 357(c) will operate
in a manner that reflects the economics of the transaction.
While it may be argued that factual uncertainty will remain
because this approach involves a facts and circumstances test,
it can also be argued that the proposal will increase the legal
certainty and reduce the potential for results that do not
conform to the economic reality of the extent of actual relief
from liability (if any) that has occurred in a transfer.
D. Insurance Provisions
1. Increase proration percentage for property and casualty insurance
companies
Present Law
The taxable income of a property and casualty insurance
company is determined as the sum of its underwriting income and
investment income (as well as gains and other income items),
reduced by allowable deductions. Underwriting income means
premiums earned during the taxable year less losses incurred
and expenses incurred. In calculating its reserve for losses
incurred, a property and casualty insurance company must reduce
the amount of losses incurred by 15 percent of (1) the
insurer's tax-exempt interest, (2) the deductible portion of
dividends received (with special rules for dividends from
affiliates), and (3) the increase for the taxable year in the
cash value of life insurance, endowment or annuity contracts.
This 15-percent proration requirement was enacted in 1986.
The reason the provision was adopted was Congress' belief that
``it is not appropriate to fund loss reserves on a fully
deductible basis out of income which may be, in whole or in
part, exempt from tax. The amount of the reserves that is
deductible should be reduced by a portion of such tax-exempt
income to reflect the fact that reserves are generally funded
in part from tax-exempt interest or from wholly or partially
deductible dividends.'' \164\ In 1997, the provision was
modified to take into account the increase for a taxable year
in the cash value of certain insurance contracts.\165\
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\164\ H. Rept. 99-426, Report of the Committee on Ways and Means on
H.R. 3838, The Tax Reform Act of 1985 (99th Cong., 1st Sess.,), 670.
\165\ P.L. 105-34, The Taxpayer Relief Act of 1997, section 1084.
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Description of Proposal
The proposal would increase the proration percentage
applicable to a property and casualty insurance company from 15
percent to 30 percent.
Effective Date
The proposal would be effective for taxable years beginning
after the date of enactment with respect to investments
acquired on or after the date of first committee action.
Prior Action
No prior action.
Analysis
The proposal relates to the effect of the 15 percent
proration percentage of present law on the funding of
deductible loss reserves by means of income that may be, in
whole or in part, exempt from tax. In 1996, property and
casualty insurers held between 13 and 14 percent of all tax-
exempt debt outstanding,\166\ and about 21 percent of these
companies' financial assets were invested in tax-exempt
debt.\167\ Proponents of the proposal interpret this as
evidence that property and casualty insurers continue to find
tax-exempt debt more profitable than otherwise comparable
taxable debt. A taxpayer generally is likely to buy a tax-
exempt security rather than an otherwise equivalent taxable
security if the interest rate paid on the tax-exempt security
is greater than the after-tax yield from the taxable
security.\168\ The 15-percent proration requirement of present
law has the effect of imposing tax on interest paid by a tax-
exempt bond at an effective marginal tax rate equal to 15
percent of the taxpayer's statutory marginal tax rate.
Proponents of the proposal argue that the 15 percent rate could
be increased to a rate that reduces but does not eliminate the
use of tax-preferred income to fund deductible reserves.\169\
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\166\ Federal Reserve Board, Flow of Funds Accounts, Flows and
Outstandings, second quarter 1997.
\167\ Ibid.
\168\ Mathematically, it is more profitable to hold a tax-exempt
security paying an interest rate, rte, than a taxable
security of comparable risk and maturity paying an interest rate, r, if
rte>r(1-t),
where t is the taxpayer's marginal tax rate.
\169\ By reducing the deduction for increases in reserves by 15
percent of the taxpayer's tax-exempt interest earnings, the taxpayer's
taxable income is increased by 15 percent of the taxpayer's tax-exempt
interest earnings. Thus, the 15-percent proration requirement has the
effect of imposing tax on the interest paid by a tax-exempt bond at an
effective marginal tax rate equal to (.15)t, where t is the
taxpayer's marginal tax rate. One effect of creating an effective tax
on the interest earned from a tax-exempt bond is that a property and
casualty insurer would only find holding the tax-exempt bond more
profitable than holding an otherwise comparable taxable bond when
rte(1-(.15)t)>r(1-t). This is equivalent to:
rte>r{(1-t)/(1-(.15)t)}.
If the statutory marginal tax rate of the property and casualty
insurer were 35 percent, then it would be profitable to purchase tax-
exempt debt in lieu of taxable debt when rte>(.686)r. Under
the proposal, it would be profitable to purchase tax-exempt debt in
lieu of taxable debt when rte>(.726)r.
Because the tax-exempt debt offers yields less than that of
otherwise comparable taxable debt, some analysts maintain that a holder
of tax-exempt debt already pays an ``implicit tax'' by accepting a
lower, albeit tax free, yield. This implicit tax can be measured as the
yield spread between the tax-exempt debt and the otherwise comparable
taxable security. In this sense the taxpayer's true effective marginal
tax rate to holding tax-exempt debt would be the implicit tax rate plus
(.15)t. However, in considering the ``implicit'' tax, one must
recognize that this implicit tax is not paid to the Federal Government,
but rather is received by the issuer of the tax-exempt debt in the form
of a lower borrowing cost.
---------------------------------------------------------------------------
It is also argued that banks and life insurance companies
(which also maintain reserves, increases in which are
deductible for Federal income tax purposes), are subject to
more effective proration rules that generally prevent them from
funding reserve deductions with tax-preferred income. Present
law may promote unequal treatment of competitors in the
financial service sectors and the proposal would reduce any
such unequal treatment, it is argued.
Critics of the proposal could respond that property and
casualty insurance may be a sufficiently different business
from that of other financial service providers that the
disparate treatment of tax-exempt securities across the
financial services industry does not create any unfair
competitive advantage for one sector over another. The proposal
alternatively could be criticized because it would still
provide property and casualty insurers with more favorable
proration rules than currently apply to banks and life
insurance companies.
Critics of the proposal note that by reducing the effective
yield received by property and casualty insurers on their
holdings of tax-exempt debt, the proposal can reduce the demand
for tax-exempt bonds by this industry. As noted above, property
and casualty insurers are large holders of tax-exempt bonds. A
reduction in demand for these securities by the property and
casualty insurers may lead to an increase in borrowing costs
for State and local governments. Even a small increase in the
interest cost to tax-exempt finance could create a substantial
increase in the aggregate financial cost of debt-financed
public works projects to State and local governments.
On the other hand, it could be said that the proration rate
under the proposal is low enough so that there would be no such
reduction in demand. Depending on yield spreads between tax-
exempt and taxable securities, a modest increase in the
proration percentage may only reduce the profit of the property
and casualty insurers without changing the underlying advantage
those taxpayers find in holding tax-exempt rather than taxable
debt.
More broadly, it is said that the present tax rules provide
an inefficient subsidy for borrowing by State and local
governments. The interest rate subsidy provided to State and
local governments by the ability to issue tax-exempt bonds
cannot efficiently pass the full value of the revenue lost to
the Federal Government to the issuer. The Federal income tax
has graduated marginal tax rates. Thus, $100 of interest income
forgone by a taxpayer in the 31-percent bracket costs the
Federal Government $31, while the same amount of interest
income forgone by a taxpayer in the 28-percent bracket costs
the Federal Government $28. Consequently, if a taxpayer in the
28-percent bracket finds it profitable to hold a tax-exempt
security, a taxpayer in the 31-percent bracket will find it
even more profitable.\170\ This conclusion implies that the
Federal Government loses more in revenue than an issuer of tax-
exempt debt gains in reduced interest payments, illustrating
the inefficiency of this subsidy.
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\170\ As explained above, a taxpayer generally finds it more
profitable to buy a tax-exempt security rather than an otherwise
equivalent taxable security if the interest rate paid by the tax-exempt
security, rte, is greater than the after-tax yield from the
taxable security, r(1-t), where t is the taxpayer's marginal tax rate
and r is the yield on the taxable security.
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2. Capitalization of net premiums for credit life insurance contracts
Present Law
Insurance companies are required to capitalize policy
acquisition expenses and amortize them on a straight-line
basis, generally over a period of 120 months \171\ beginning
with the first month in the second half of the taxable year.
Policy acquisition expenses required to be capitalized and
amortized are determined, for any taxable year, for each
category of specified insurance contracts, as a percentage of
the net premiums for the taxable year on specified insurance
contracts in that category. The percentages for each of the
categories are as follows:
---------------------------------------------------------------------------
\171\ A special rule permits a 60-month amortization period for
certain small companies.
------------------------------------------------------------------------
Percent
------------------------------------------------------------------------
Annuities.................................................... 1.75
Group life................................................... 2.05
Other life (including noncancellable or guaranteed renewable
accident and health)........................................ 7.70
------------------------------------------------------------------------
Group credit life insurance policy acquisition expenses
fall within the ``group life'' category,\172\ even though the
actual expenses are substantially higher than 2.05 percent of
net premiums for the contracts.
---------------------------------------------------------------------------
\172\ See Recommendations of the Committee on Finance for purposes
of the Reconciliation Bill provided for in H. Con. Res. 310 (101st
Cong., 2d Sess.) (``Finance Committee Report''), 136 Cong. Rec. S 15693
(Oct. 18. 1990).
---------------------------------------------------------------------------
Regulatory authority is provided to the Treasury Department
to provide a separate category for a type of insurance
contract, with a separate percentage applicable to the
category, under certain circumstances. The authority may be
exercised if the Treasury Department determines that the
deferral of policy acquisition expenses for the type of
contract which would otherwise result under the provision is
substantially greater than the deferral of acquisition expenses
that would have resulted if actual acquisition expenses
(including indirect expenses) and the actual useful life of the
contract had been used. In making this determination, Congress
intended that the amount of a reserve for a contract not be
taken into account.\173\ If the authority is exercised, the
Treasury Department is required to adjust the percentage that
would otherwise have applied to the category that included the
type of contract, so that the exercise of the authority does
not result in a decrease in the amount of revenue received by
reason of the amortization provision for any fiscal year.
---------------------------------------------------------------------------
\173\ See H. Rept. 101-964, Conference Report to accompany H.R.
5835, Omnibus Budget Reconciliation Act of 1990 (101st Cong., 2d
Sess.), 1066, 1070.
---------------------------------------------------------------------------
Description of Proposal
The proposal would require insurance companies to
capitalize and amortize 7.7 percent of net premiums for the
taxable year with respect to all credit life insurance (whether
or not it is group credit life insurance), not 2.05 percent.
Effective Date
The proposal would be effective for taxable years beginning
after the date of enactment.
Prior Action
No prior action.
Analysis
The provision requiring insurance companies to capitalize
and amortize policy acquisition expenses was enacted in 1990 to
correct prior-law mismeasurement of the income of insurance
companies. Policy acquisition expenses arise in connection with
acquiring a stream of premium and investment income that is
earned over a period well beyond the year the expenses are
incurred. It is a well-established principle of the tax law
that costs of acquiring an asset with a useful life beyond the
taxable year are amortized over the life of the asset. Congress
adopted a ``proxy'' approach designed to approximate the
expenses for each year that are attributable to new and renewed
insurance contracts in each of several broad categories of
business. While this approach does not measure actual
acquisition expenses, Congress believed that the advantage of
adopting a theoretically correct approach was outweighed by the
administrative simplicity of the proxy approach.\174\
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\174\ Finance Committee Report, supra, at S 15961.
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It could be argued that Congress specifically intended
group credit life insurance to come within the ``group life''
category, and that therefore it would not be appropriate to
change the amortization percentage applicable to it. Similarly,
it could be argued that because Congress believed that the
levels of amortizable amounts would in most cases, understate
actual acquisition expenses,\175\ it is not now necessary to
revise the percentage applicable to credit life insurance.
---------------------------------------------------------------------------
\175\ Ibid.
---------------------------------------------------------------------------
On the other hand, the level of actual policy acquisition
expenses for credit life insurance is substantially higher than
either 2.05 percent or 7.7 percent. Because the actual expenses
are relatively high, it can be argued that it is more accurate
to place credit life insurance in the highest-percentage
category, even though such insurance may be group insurance. It
is also argued that Congress may not have been aware, at the
time group credit life insurance was included in the ``group
life'' category, that policy acquisition expenses for credit
life insurance were ordinarily rather high.
It also could be argued that even though credit life
insurance has relatively high actual acquisition expenses, the
contracts tend to have a relatively short duration and
therefore the present value of the deduction for these expenses
is lower than if the contracts remained in effect for a long
period. Therefore, it is argued, the contracts should remain in
the 2.05 percent category. On the other hand, the present value
of the deduction for acquisition expenses is actually higher
than even the highest percentage category, advocates for the
proposal argue. Further, they argue, credit life insurance is
often reinsured with small companies eligible for the more
favorable 60-month amortization period, and consequently the
present value of the deduction for acquisition expenses in such
a case is greater.
The Treasury Department has regulatory authority to create
an additional category of contract (provided it adjusts the
category from which the contract was drawn so that there is no
decrease in revenue from the provision), as noted above. Some
may argue that this may suggest that legislation might not be
required to change the capitalization percentage applicable to
credit life insurance. On the other hand, it could be said that
determining the proper percentage for the new category of
contract and making the correct adjustment to its former
category might be viewed as a judgment that is best left to
Congress. Some might argue that the requirement that
adjustments to the categories be balanced by an offsetting
adjustment indicates that Congress viewed unfavorably any
administrative change to the categories, making legislation the
preferred means for any change to the categories.
3. Modify company-owned life insurance (COLI) limitations
Present Law
Exclusion of inside buildup and amounts received by reason of death
No Federal income tax generally is imposed on a
policyholder with respect to the earnings under a life
insurance contract (``inside buildup'').\176\ Further, an
exclusion from Federal income tax is provided for amounts
received under a life insurance contract paid by reason of the
death of the insured (sec. 101(a)).
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\176\ This favorable tax treatment is available only if the
policyholder has an insurable interest in the insured when the contract
is issued and if the life insurance contract meets certain requirements
designed to limit the investment character of the contract (sec. 7702).
Distributions from a life insurance contract (other than a modified
endowment contract) that are made prior to the death of the insured
generally are includable in income, to the extent that the amounts
distributed exceed the taxpayer's investment in the contract; such
distributions generally are treated first as a tax-free recovery of the
investment in the contract, and then as income (sec. 72(e)). In the
case of a modified endowment contract, however, in general,
distributions are treated as income first, loans are treated as
distributions (i.e., income rather than basis recovery first), and an
additional 10 percent tax is imposed on the income portion of
distributions made before age 59\1/2\ and in certain other
circumstances (secs. 72(e) and (v)). A modified endowment contract is a
life insurance contract that does not meet a statutory ``7-pay'' test,
i.e., generally is funded more rapidly than 7 annual level premiums
(sec. 7702A). Certain amounts received under a life insurance contract
on the life of a terminally or chronically ill individual, and certain
amounts paid for the sale or assignment to a viatical settlement
provider of a life insurance contract on the life of a terminally ill
or chronically ill individual, are treated as excludable as if paid by
reason of the death of the insured (sec. 101(g)).
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Interest deduction disallowance
Generally, no deduction is allowed for interest paid or
accrued on any indebtedness with respect to one or more life
insurance contracts or annuity or endowment contracts owned by
the taxpayer covering any individual (the ``COLI'' rules).
An exception to this interest disallowance rule is provided
for interest on indebtedness with respect to life insurance
policies covering up to 20 key persons. A key person is an
individual who is either an officer or a 20-percent owner of
the taxpayer. The number of individuals that can be treated as
key persons may not exceed the greater of (1) 5 individuals, or
(2) the lesser of 5 percent of the total number of officers and
employees of the taxpayer, or 20 individuals. For determining
who is a 20-percent owner, all members of a controlled group
are treated as one taxpayer. Interest paid or accrued on debt
with respect to a contract covering a key person is deductible
only to the extent the rate of interest does not exceed Moody's
Corporate Bond Yield Average--Monthly Average Corporates for
each month beginning after December 31, 1995, that interest is
paid or accrued.
This rule was enacted in 1996.
Pro rata disallowance of interest on debt to fund life insurance
In addition, in the case of a taxpayer other than a natural
person, no deduction is allowed for the portion of the
taxpayer's interest expense that is allocable to unborrowed
policy cash surrender values with respect to any life insurance
policy or annuity or endowment contract issued after June 8,
1997. Interest expense is allocable to unborrowed policy cash
values based on the ratio of (1) the taxpayer's average
unborrowed policy cash values of life insurance policies, and
annuity and endowment contracts, issued after June 8, 1997, to
(2) the sum of (a) in the case of assets that are life
insurance policies or annuity or endowment contracts, the
average unborrowed policy cash values, and (b) in the case of
other assets, the average adjusted bases for all such other
assets of the taxpayer.
An exception is provided for any policy or contract
177 owned by an entity engaged in a trade or
business, which covers one individual who (at the time first
insured under the policy or contract ) is (1) a 20-percent
owner of the entity, or (2) an individual (who is not a 20-
percent owner) who is an officer, director or employee of the
trade or business. The exception for 20- percent owners also
applies in the case of a joint-life policy or contract under
which the sole insureds are a 20-percent owner and the spouse
of the 20-percent owner. A joint-life contract under which the
sole insureds are a 20-percent owner and his or her spouse is
the only type of policy or contract with more than one insured
that comes within the exception. Any policy or contract that is
not subject to the pro rata interest disallowance rule by
reason of this exception (for 20-percent owners, their spouses,
employees, officers and directors), or by reason of the
exception for an annuity contract to which section 72(u)
applies, is not taken into account in applying the ratio to
determine the portion of the taxpayer's interest expense that
is allocable to unborrowed policy cash values.
---------------------------------------------------------------------------
\177\ It was intended that if coverage for each insured individual
under a master contract is treated as a separate contract for purposes
of sections 817(h), 7702, and 7702A of the Code, then coverage for each
such insured individual is treated as a separate contract, for purposes
of the exception to the pro rata interest disallowance rule for a
policy or contract covering an individual who is a 20-percent owner,
employee, officer or director of the trade or business as the time
first covered. A master contract does not include any contract if the
contract (or any insurance coverage provided under the contract) is a
group life insurance contract within the meaning of Code section
848(e)(2). No inference was intended that coverage provided under a
master contract, for each such insured individual, is not treated as a
separate contract for each such individual for other purposes under
present law. A technical correction may be needed so that the statute
reflects this intent. See Title VI of H.R. 2676, the Tax Technical
Corrections Act of 1997, as passed by the House on November 5, 1997.
---------------------------------------------------------------------------
This rule was enacted in 1997.
Description of Proposal
The proposal would eliminate the exception under the pro
rata disallowance rule for employees, officers and directors.
The exception for 20-percent owners would be retained, however.
Effective Date
The proposal would be effective for taxable years beginning
after the date of enactment.
Prior Action
No prior action.
Analysis
The proposal is directed to an aspect of the issue
addressed by Congress in 1996 and 1997: the issue of borrowing
against life insurance contracts to achieve tax arbitrage.
Businesses that own life insurance on employees and borrow from
a third-party lender or from the public may still be able to
achieve tax arbitrage by deducting interest that funds the tax-
free inside buildup on the life insurance (or the tax-deferred
inside buildup of annuity and endowment contracts). This
continued opportunity for tax arbitrage results from the
exception under the pro rata interest deduction limitation for
insurance covering employees and others, it is argued.
Businesses have been able to substitute third-party debt for
debt that would have been subject to the 1996 Act limitations
on interest deductibility with respect to insurance on
employees. This tax arbitrage opportunity may be utilized by
financial intermediation businesses, which may have a
relatively large amount of debt in the ordinary course of
business. Thus, it is argued, the exception should be repealed.
It can be argued, however, that retaining an exception from
the pro rata interest disallowance rule for employees,
officers, and directors is important for small businesses.
Small businesses might argue that they need access to cash, in
particular the cash value of life insurance on key employees,
and that it would be inappropriate to reduce the tax subsidy
stemming from the exception in their case. They might also
argue that the proposal should be more targeted, perhaps to
financial intermediaries or to large employers, or should
provide for a narrower employee exception structured like the
20-key-person exception under the 1996 legislation, so as to
address the tax arbitrage concern without negatively impacting
their cash needs. On the other hand, it could be countered that
in most cases the cash needs of small businesses have already
been addressed by the proposal's continuation of the exception
for 20-percent owners. In addition, it can be argued that
insuring the lives of key employees can be accomplished by
purchasing term life insurance, which is not affected by the
proposal, and that cash needs can be addressed without the
purchase of cash value life insurance.
Opponents might also argue that the proposed effective date
may be too harsh. The proposal would limit the deduction for
interest even in the case of insurance contracts that were
purchased before the effective date, with no explicit phase-in
rule. By contrast, the 1996 COLI limitations provided a phase-
in rule, and the 1997 COLI limitations generally applied only
to contracts issued after the effective date. On the other
hand, it could be argued that purchasers of COLI that would be
impacted by the proposal were aware of Congress' concern about
tax arbitrage through leveraging life insurance because of the
1996 and 1997 legislative activity in the area. It could be
said that recent COLI purchasers in particular assumed the risk
of further Congressional action on leveraged life insurance
products, as well as those whose contractual arrangements
include provisions to ``unwind'' the transaction in the event
unfavorable tax rules are enacted. Further, arguably the
effective date for the proposal merely puts COLI purchasers
with non-traceable third party debt in the same position they
would have been in had they been subject to the phase-in rules
under the 1996 legislation, which is fully phased in by 1999.
4. Modify reserve rules for annuity contracts
Present Law
A life insurance company is subject to tax on its life
insurance company taxable income (LICTI) (sec. 801). LICTI is
life insurance gross income reduced by life insurance
deductions. For this purpose, a life insurance company includes
in gross income any net decrease in reserves, and deducts a net
increase in reserves.
A decrease in reserves arises if (1) the opening balance
for reserve items exceeds (2) the closing balance for the
reserve items (reduced by certain adjustments). An increase in
reserves arises if (1) the closing balance for reserve items
(reduced by certain adjustments) exceeds (2) the opening
balance for the reserve items.
In determining reserves, a life insurance company takes
into account the life insurance reserves (among other items).
Life insurance reserves for any contract are the greater of the
net surrender value of the contract or the reserve determined
using the tax reserve method, but in no event may the reserve
for any contract at any time exceed the amount set forth in the
annual statement (sec. 807). No additional reserve deduction is
allowed for deficiency reserves (sec. 807(c)(3)(C)).
In the case of an annuity contract, the tax reserve method
means the Commissioners' Annuities Reserve Valuation Method
prescribed by the National Association of Insurance
Commissioners (NAIC) 178 which is in effect on the
date of the issuance of the contract (CARVM) (sec.
807(d)(3)(B)(ii)).
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\178\ In general, the NAIC promulgates guidelines relating to
accounting for insurance products for purposes of the insurer's annual
statement, which generally is filed with the State in which the insurer
is subject to State regulation.
---------------------------------------------------------------------------
Present law provides for a 10-year spread of the reserve
amount that arises in the event of a change in the basis for
determining reserves (807(f)).
On June 11, 1997, the NAIC Life Insurance (A) Committee
adopted Actuarial Guideline XXXIII Determining CARVM Reserves
for Annuity Contracts with Elective Benefits (NAIC Guideline
33).
NAIC Guideline 33 states that industry practices and
methods of reserving under CARVM for some annuity contracts
have not been found to be consistent, ranging from relatively
low reserves based on cash surrender value to higher reserves
representing the greatest actuarial present value of future
benefits under the contract. NAIC Guideline 33 provides
generally that the ultimate policy reserve must be sufficient
to fund the greatest present value of all potential benefits,
both guaranteed elective and non-elective benefits under the
contract.
NAIC Guideline 33 states that it is effective on December
31, 1998, affecting all contracts issued on or after January 1,
1981. The NAIC Guideline also states that its purpose is ``to
codify the basic interpretation of CARVM and does not
constitute a change of method or basis from any previously used
method . . .'' (NAIC Guideline at page 3).
In 1997, the NAIC also adopted Actuarial Guideline XXXIV,
Variable Annuity Minimum Guaranteed Death Benefit Reserves
(NAIC Guideline 34), interpreting the standards for the
valuation of reserves for ``minimum guaranteed death benefits''
provided in variable annuity contracts. NAIC Guideline 34
requires that reserves for these benefits be determined
assuming an immediate drop in the values of the assets
supporting the variable annuity contract, followed by a
subsequent recovery at a net assumed return until the maturity
of the contract. NAIC Guideline 34 also provides mortality
tables that assume increased longevity of individuals, to be
used in determining reserves for contracts with these benefits.
NAIC Guideline 34 states that it is effective for all contracts
issued on or after January 1, 1981.
Description of Proposal
Under the proposal, reserves for any annuity contract with
a cash surrender value would equal the lesser of the CARVM
reserve for the contract or the contract's adjusted account
value. The proposal would retain the rule of present law that
in no event may the reserve for any contract at any time exceed
the amount set forth in the annual statement.
For purposes of the proposal, the adjusted account value
for a contract would equal the net cash surrender value for the
contract, plus a percentage of the net surrender value for the
contract. The percentage would be 5.5 percent in the taxable
year in which the contract is issued, 5.0 percent in the second
year, 4.0 in the third year, 3.0 in the fourth year, 2.5
percent in the fifth year, 1.5 percent in the sixth year, 0.5
percent in the seventh year, and 0 percent in the eighth and
all succeeding years.
Effective Date
The proposal would be effective for taxable years ending on
or after the date of enactment.
Prior Action
No prior action.
Analysis
In general, an important purpose of ``statutory
accounting,'' the method of accounting used by insurers in
reporting to State insurance regulators, is to maintain the
solvency of insurers so that they have the funds to pay future
benefits under insurance contracts. This method has been
characterized as conservative, generally taking account of
deductions and losses relatively early and taking income items
into account relatively late. If an important goal of an income
tax system is the accurate measurement of income, the
accounting method used for tax purposes should be less
conservative than a method whose goal is company solvency.
Acceleration of losses and deductions (including reserve
deductions) that may be appropriate for regulatory purposes
results in understatement of income for tax purposes, it is
argued.
Although present-law tax rules for life insurance companies
are based in part on ``statutory accounting'' methods that the
companies utilize under non-tax regulation, the rationale for
this may be in part that the advantage of increased accuracy in
measuring income is outweighed by the advantage of
administrative convenience for insurers. However, it is argued,
when the disparity between a normative tax accounting method
and ``statutory accounting'' rules becomes too great, accuracy
dictates a divergence from the statutory accounting rule
theretofore in use for tax purposes. For example, in 1987
Congress modified the interest rate to be used by life
insurance companies in computing reserves so as to take into
account the greater of the applicable Federal interest rate or
the prevailing State assumed rate. At that time, Congress
stated that ``the interest rate applied by State insurance
regulators may not reflect current market trends, and is likely
to be selected with a view towards maintaining insurance
company solvency (a regulatory goal) rather than accurately
measuring income of the company (a tax goal).'' 179
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\179\ H. Rept. 100-391, Report of the Committee on the Budget,
House of Representatives, to accompany H.R. 3545, The Omnibus Budget
Reconciliation Act of 1987 (100th Cong., 1st Sess.), 1106.
---------------------------------------------------------------------------
The effective date of the proposal could be criticized as
needlessly broad, in that the proposal applies to reserves for
all contracts, whenever issued, starting in taxable years after
enactment. Application to previously issued contracts arguably
may not be needed, because the scope of the application of NAIC
Guidelines 33 and 34 for tax purposes is not clear. For
example, although NAIC Guidelines 33 and 34 say that they apply
to contracts issued on or after January 1, 1981, perhaps this
retroactivity applies for State regulatory purposes but not for
Federal tax purposes, because the tax law utilizes the CARVM in
effect when the contract is issued. Further, although NAIC
Guideline 33 states that it is not a change in basis for
determining reserves, that assertion is not necessarily
controlling for purposes of the Federal tax law. If NAIC
Guidelines 33 and 34 were to apply to any company that was
using cash surrender value reserves or otherwise computing
reserves less conservatively that would be required under the
Guidelines, it could be said that the company would have to
spread the change in reserves over a 10-year period under the
present-law rule of section 807(f). In addition, to the extent
that the Guidelines would require companies to maintain
deficiency reserves, they are not deductible under present law.
Additional issues may also arise as to the extent to which NAIC
Guidelines 33 and 34 apply for tax purposes.
5. Tax certain exchanges of insurance contracts and reallocations of
assets within variable insurance contracts
Present Law
Gain or loss realized from the sale or other disposition of
property generally is subject to tax under present law. The
gain from a sale or other disposition of property is the excess
of the amount realized on the disposition over the adjusted
basis of the property. The loss from a sale or other
disposition of property is the excess of the adjusted basis
(for determining loss) over the amount realized (sec. 1001).
Gain or loss realized on some transactions is accorded non-
recognition treatment under special rules. A special rule
resembling other nontaxable exchange rules for like-kind
property was enacted in 1954. This rule provides that no gain
or loss is recognized on the exchange of certain insurance
contracts for other insurance contracts. No gain or loss
generally is recognized on the exchange of: (1) a life
insurance contract for a life insurance, endowment or annuity
contract; (2) an endowment contract for an endowment contract
(provided regular payments begin no later than under the
exchanged contract) or an annuity contract; or (3) an annuity
contract for an annuity contract (sec. 1035).
Additional special rules apply to variable life insurance
and variable annuity contracts (sec. 817). A variable life
insurance contract generally is a life insurance contract under
which the amount of the death benefit (or the period of
coverage) is adjusted on the basis of the investment return and
the market value of the segregated asset account maintained
with respect to the contract. A variable annuity contract
generally is an annuity contract under which the amounts paid
in, or the amount paid out, reflect the investment return and
the market value of the segregated asset account maintained
with respect to the contract. In order for a variable life
insurance or annuity contract to meet the definition of a life
insurance contract (including an annuity contract), and to be
eligible for favorable tax rules on distributions under the
contract, for any calendar quarter period, the segregated asset
account with respect to the contract generally must be
adequately diversified (sec. 817(h)).179a
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\179a\ In addition, the policyholder may not exercise excessive
control over the investments. See Rev. Rul. 81-225, 1981-2 C.B. 12;
Christofferson v. U.S., 749 F.2d 651 (8th Cir. 1984), cert. denied, 473
U.S. 905 (1985); Rev. Rul. 82-54, 1982-1 C.B. 11.
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The segregated asset accounts for a variable contract may
be invested in a variety of investment funds. A variable life
insurance or variable annuity contract often gives the holder
the option to reallocate assets under the contract among these
investment choices, and the practice has developed that no
current taxation is imposed if no distribution is made under
the contract at the time. In addition, a variable life
insurance contract or variable annuity contract may be
exchanged for another contract, as described above, without
current taxation. Under these special rules, the holder of a
variable life insurance or annuity contract may be able to
dispose of one or more investment properties and re-invest in
different investment properties without current taxation of the
gain or loss realized on the disposition.
A variable life insurance contract otherwise has the same
tax treatment to the holder as a life insurance contract that
is not variable. Generally, an exclusion from Federal income
tax is provided for amounts received under a life insurance
contract paid by reason of the death of the insured (sec.
101(a)). Further, no Federal income tax generally is imposed on
a policyholder with respect to the earnings under a life
insurance contract (``inside buildup''). Distributions from a
life insurance contract (other than a modified endowment
contract) that are made prior to the death of the insured
generally are includible in income only to the extent that the
amounts distributed exceed the taxpayer's investment in the
contract. Such distributions generally are treated first as a
tax-free recovery of the investment in the contract, and then
as income (sec. 72(e)). Present law provides a definition of
life insurance designed to limit the investment orientation of
the contract (sec. 7702). However, no dollar limit is imposed
on the amount that may be paid into a life insurance contract
for Federal income tax purposes.
Similarly, a deferred annuity that is a variable contract
otherwise has the same tax treatment to the holder as a
deferred annuity that is not variable. Generally, no Federal
income tax is imposed on a deferred annuity contract holder who
is a natural person with respect to the earnings on the
contract (inside buildup) in the absence of a distribution
under the contract. Annuity distributions generally are treated
as partially excludable under an ``exclusion ratio'' (the ratio
of the investment in the contract to the expected return under
the contract as of that date) (sec. 72(b)). Other distributions
(which for this purpose include loans) are treated as income
first, then as a tax-free return of the investment on the
contract (sec. 72(e)). An additional 10 percent tax is imposed
on the income portion of distributions made before age 59-1/2,
and in certain other circumstances (sec. 72(q)). An annuity
contract must provide for certain required distributions where
the holder dies before the entire interest in the contract has
been distributed (sec. 72(s)). No dollar limit is imposed on
the amount that may be paid into an annuity contract (that is
not a pension plan contract) for Federal income tax purposes.
Description of Proposal
Under the proposal, tax-free treatment for an exchange of
any life insurance, endowment or annuity contract for any
variable contract would be repealed. Further, tax-free
treatment for an exchange for any variable contract for any
life insurance, endowment, or annuity contract would be
repealed. The proposal also provides that each reallocation of
assets among investment options within a variable annuity
contract (such as a separate account mutual fund) or to the
insurance company's general account under the terms of a
variable contract would be treated as an exchange to which tax-
free treatment does not apply.
Effective Date
The proposal would apply to contracts issued after the date
of first committee action. Reallocation of assets after that
date under the terms of an existing variable contract that was
issued on or before that date would not be subject to the
proposal. However, in the case of a material change to a
contract originally issued before the date of first committee
action, the contract would be treated as a new contract. Thus,
the proposal would apply to any exchange of the new contract
for another contract at any time after the material change. In
addition, the proposal would apply to any reallocation of
assets under the new contract at any time after the material
change.
Prior Action
No prior action.
Analysis
The proposal is based on the premise that reallocations of
assets within variable contracts, as well as exchanges of the
contracts themselves, are sufficiently similar to exchanges of
investment assets that ordinarily are subject to current
taxation, that these exchanges should be subject to current
taxation as well. If a taxpayer invests in a mutual fund, or a
particular stock or bond, for example, and then disposes of the
fund, the stock or the bond, gain or loss is recognized. If
fairness dictates that similarly situated taxpayers should be
subject to similar tax treatment, then wrapping the investment
in a variable life insurance or annuity contract should not
produce different tax results. Congress gave credence to this
view in an analogous situation when it modified the tax
treatment of ``swap funds'' in the Taxpayer Relief Act of 1997.
In that Act, Congress limited the ability of taxpayers to
contribute certain types of investment assets to a pool of
other investment assets and diversify or otherwise change the
nature of its investments without recognition of gain or loss
on the transaction. By analogy, it can be argued that
reallocation of assets within a variable contract and exchanges
of variable contracts represent transactions that are more
properly treated as taxable exchanges.
Opponents argue that variable life insurance and variable
annuity contracts, while not strictly pension or retirement
vehicles, serve an important function in encouraging savings by
individuals. They assert that the tax benefits of tax-free
reallocations of assets and exchanges of the contracts should
be retained in order to continue this incentive. On the other
hand, it could be argued that Congress has already provided
targeted incentives for retirement savings in the form of tax-
favored treatment for qualified pension plans, section 401(k)
plans, SIMPLE plans, and a variety of individual retirement
account (``IRA'') provisions. In addition, it is argued that
these provisions are subject to dollar caps, as well as other
restrictions, whereas contributions and benefits under life
insurance and annuity contracts generally are not. It is argued
that additional tax incentives for savings should be
deliberated by Congress rather than evolving through the
modification of insurance products, the tax treatment of which
was determined long before variable contracts were introduced
in the marketplace. Further, as a savings incentive, tax-
favored treatment for variable life insurance and variable
annuity contracts is arguably extremely inefficient, because of
the relatively high fees and transaction costs of such vehicles
compared to purchases of mutual funds or other securities.
Opponents of the proposal also argue that, perhaps
unintentionally, the proposal destroys the market for variable
life insurance and annuity contracts, because individuals will
no longer choose to purchase them if the holder may not select
at will from an array of investment options depending on
current market conditions. It can be countered that limiting
tax-free exchanges and reallocations of assets within variable
contracts still leaves such contracts more tax-favored than
non-insurance vehicles such as mutual funds or direct ownership
of stocks, securities or bonds. The proposal, it is argued,
would not eliminate the tax deferral or the favorable tax
treatment on annuity distributions under the exclusion ratio.
Also, the proposal would not eliminate the tax- favored
treatment of distributions, such as partial surrenders, under
life insurance contracts generally as tax-free return of the
investment in the contract first. Nor would the proposal
eliminate the opportunity to withdraw the cash surrender value
as a loan, and then receive the balance tax-free as a death
benefit. It is also argued that the proposal would not affect
the market for variable life insurance and annuity contracts in
which the purchaser expects to buy and hold for the long term
without changing the type of investment.
6. Computation of ``investment in the contract'' for mortality and
expense charges on certain insurance contracts
Present Law
An exclusion from Federal income tax is provided for
amounts received under a life insurance contract paid by reason
of the death of the insured (sec. 101(a)). Further, no Federal
income tax generally is imposed on a policyholder with respect
to the earnings under a life insurance contract (``inside
buildup'').
This favorable tax treatment is available only if the
policyholder has an insurable interest in the insured when the
contract is issued and if the life insurance contract meets
certain requirements designed to limit the investment character
of the contract (sec. 7702). Among other requirements,
mortality charges must be reasonable mortality charges which
meet the requirements (if any) prescribed in Treasury
regulations and which (except as provided in regulations) do
not exceed the mortality charges specified in the prevailing
commissioners' standard tables as of the time the contract is
issued. Similarly, expense charges must be reasonable and must
be charges which (on the basis of the company's experience, if
any, with respect to similar contracts) are reasonably expected
to be actually paid.
Distributions from a life insurance contract (other than a
modified endowment contract) that are made prior to the death
of the insured generally are includible in income, to the
extent that the amounts distributed exceed the taxpayer's
investment in the contract. Such distributions generally are
treated first as a tax-free recovery of the investment in the
contract, and then as income (sec. 72(e)).
In the case of a modified endowment contract, however, in
general, distributions are treated as income first, loans are
treated as distributions (i.e., income rather than basis
recovery first), and an additional 10-percent tax is imposed on
the income portion of distributions made before age 59\1/2\ and
in certain other circumstances (secs. 72(e) and (v)). A
modified endowment contract is a life insurance contract that
does not meet a statutory ``7-pay'' test, i.e., generally is
funded more rapidly than 7 annual level premiums (sec. 7702A).
The requirements that mortality and expense charges be
reasonable also apply to modified endowment contracts.
Generally, no Federal income tax is imposed on a deferred
annuity contract holder who is a natural person with respect to
the earnings on the contract (inside buildup) in the absence of
a distribution under the contract. Annuity distributions
generally are treated as partially excludable under an
``exclusion ratio'' (the ratio of the investment in the
contract to the expected return under the contract as of that
date) (sec. 72(b)). Other distributions (which for this purpose
include loans) are treated as income first, then as a tax-free
return of the investment on the contract (sec. 72(e)). An
additional 10-percent tax is imposed on the income portion of
distributions made before age 59\1/2\, and in certain other
circumstances (sec. 72(q)). An annuity contract must provide
for certain required distributions where the holder dies before
the entire interest in the contract has been distributed (sec.
72(s)).
Investment in the contract means the aggregate amount of
premiums or other consideration paid for the contract to date
reduced by the aggregate amount received under the contract
that was excludable from income (sec. 72(e)(6)), for purposes
of the distribution rules. These rules do not provide that the
investment in the contract is reduced by the portion of the
premium paid that is used to pay mortality charges or expense
charges. These charges can include the cost of term insurance
protection for the current period, or, in the case of a
deferred annuity contract, the cost of a payout option such the
right to purchase a life annuity at guaranteed rates.
Description of Proposal
The proposal would modify the definition of investment in
the contract for purposes of the distribution rules with
respect to life insurance and annuity contracts.
For a life insurance contract, investment in the contract
(as defined under present law) would be reduced by the
mortality charges that are taken into account for purposes of
Code section 7702. Investment in the contract would also be
reduced by appropriate expense charges, to the extent provided
in regulations (or other guidance promulgated by the Treasury
Department).
For an annuity contract (other than an immediate annuity
described in section 72(u)(4)), the investment in the contract
(as defined under present law) would be reduced by the
contract's assumed mortality and expense charges. These assumed
charges would be defined as the contract's average cash value
during the year multiplied by 1.25 percent. In the event that
the contract holder used accumulated funds in the contract to
exercise a particular payout option such as the right to
purchase a life annuity at guaranteed rates, then the assumed
mortality and expense charges associated with that option would
be added to the investment in the contract at that time.
Effective Date
The proposal would be effective for contracts issued after
the date of first committee action.
Prior Action
No prior action.
Analysis
The proposal is based on the premise of tax policy that
amounts paid for current expenses should not be included in the
basis of an asset. A life insurance contract that has a cash
value can be viewed as divisible into two portions: a portion
providing current term insurance protection and a cash value
portion. The cost of the term insurance portion represents a
current expense for a benefit--insurance protection--that does
not last beyond the term. The cash value portion, by contrast,
has continued value. Thus, because investment in the contract
is equivalent to the basis for the contract (for purposes of
section 72), the investment in the contract for a life
insurance or annuity contract should not include amounts that
represent current expenses, such as mortality charges for term
insurance coverage for the current period and associated
expense charges. It is also argued that the investment in the
contract should not include the cost of any payout options that
are still contingent and have not been exercised by the holder.
If investment in the contract is overstated by including
the amount of current mortality and associated expenses, then
the amount of any distribution from a life insurance or annuity
contract that is taxable is measurably understated. This
understatement of income would arise whether the contract is a
modified endowment contract, with respect to which income is
taxed before return of basis, or is a life insurance contract
eligible for the more favorable distribution rules permitting
recoupment of basis before the income is taxed, or is an
annuity contract subject to the income- first rule on non-
annuity distributions.
On the other hand, it could be argued that the proposal,
while increasing the accuracy of the tax law, also increases
its complexity by requiring an additional calculation with
respect to distributions from life insurance or annuity
contracts. Nevertheless, insurance companies already keep track
of prior distributions for purposes of computing the investment
in the contract, as well as mortality and expense charges, and
frequently provide this information to policyholders on an
annual basis, so it could be argued that there is not a
significant additional record-keeping or reporting burden. It
could also be argued that the incremental improvement in
accuracy of the tax rules does not outweigh the disadvantage of
disrupting present practices and present-law tax treatment for
the numerous contracts that would be affected by the proposal.
E. Estate and Gift Tax Provisions
1. Eliminate non-business valuation discounts
Present Law
Generally, for Federal transfer tax purposes, the value of
property is its fair market value, i.e., the price at which the
property would change hands between a willing buyer and a
willing seller, neither being under any compulsion to buy or
sell and both having reasonable knowledge of relevant facts. In
valuing a fractional interest in a non-publicly traded entity,
taxpayers routinely claim discounts for factors such as
minority ownership or lack of marketability. The concept of
such valuation discounts is based upon the principle that a
willing buyer would not pay a willing seller a proportionate
share of the value of the entire business when purchasing a
minority interest in a non-publicly traded business, because
the buyer may not have the power to manage or control the
operations of the business, and may not be able to readily sell
his or her interest.
In the family estate planning area, a common planning
technique is for an individual to contribute marketable assets
to a family limited partnership or limited liability company
and make gifts of minority interests in the entity to other
family members. In valuing such gifts for transfer tax
purposes, taxpayers often claim large discounts on the
valuation of these gifts.
Description of Proposal
The proposal would eliminate valuation discounts except as
they apply to active businesses. Interests in entities would be
required to be valued for transfer tax purposes at a
proportional share of the net asset value of the entity to the
extent that the entity holds readily marketable assets
(including cash, cash equivalents, foreign currency, publicly
traded securities, real property, annuities, royalty-producing
assets, non-income producing property such as art or
collectibles, commodities, options and swaps) at the time of
the gift or death. To the extent the entity conducts an active
business, the reasonable working capital needs of the business
would be treated as part of the active business (i.e., not
subject to the limits on valuation discounts). No inference is
intended as to the propriety of these discounts under present
law.
Effective Date
The proposal would be effective for transfers made after
the date of enactment.
Prior Action
No prior action.
Analysis
It is well established that discounts may be appropriate in
valuing minority interests in business entities. See, e.g.,
Estate of Andrews, 79 T.C. 938 (1982). Generally, these
discounts take the form of minority discounts and lack of
marketability discounts. A minority discount reflects a
decreased value due to the fact that a minority shareholder (or
partner) may have little ability to control or participate in
the management of the business, or to compel liquidation of the
business or payment of distributions. The IRS has stated that
minority discounts even may be appropriate in cases where the
transferred interest, when aggregated with interests held by
family members, is part of a controlling interest. See Rev.
Rul. 93-12, 1993-1 C.B. 202. In addition to minority discounts,
an additional valuation discount due to lack of marketability
also may be available to reflect the fact that there is no
ready market for interests in a closely-held entity. It is not
unusual for taxpayers to claim combined discounts of 30 to 50
percent, although taxpayers have claimed discounts of as much
as 60 or 70 percent in some cases. See, e.g., Estate of
Barudin, T.C. Memo. 1996-395 (taxpayer claimed a combined
discount of 67.5 percent; the Tax Court allowed 45 percent).
The appropriate level of discount for any particular business
interest often is the subject of litigation.
The Administration proposal raises two separate issues
relevant to the valuation of assets and the administration of
the estate tax: the appropriateness of minority discounts and
the liquidity of assets. The issue of minority discounts
relates to circumstances where the value of a fractional
holding of an asset may not equal the proportionate market
value of the entire holding. Analysts generally believe that
minority discounts result from the ability of the controlling
owner to dictate the course of future investment, business
strategy, or timing of liquidation of the asset. Not being able
to make such decisions generally makes a minority claim on the
asset less valuable.\180\ The extent of any minority discount
depends upon the facts and circumstances related to the asset.
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\180\ Using the same reasoning, it can be argued that individuals
may be willing to pay more than the proportionate market value of the
entire holding in order to have control (i.e., ``control premiums'').
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An asset's liquidity is its ability to be readily converted
to cash. The issue of liquidity of assets relates to
identifying those assets which are readily tradeable and,
therefore, for which market values are readily ascertainable
without great expense to the asset's owner. While generally
people view passive assets such as stocks and bonds as liquid
assets, not all passive assets are equally liquid, and some
passive assets may be less liquid than active assets. For
example, specialty brokers may be able to more readily generate
offers to purchase a radio station in a major metropolitan
area, than would a financial broker who attempts to generate
offers for the purchase of a bond issued by a small rural
school district.
Although the practice of claiming valuation discounts has
been accepted in valuing active businesses, proponents of the
Administration proposal maintain that it is less clear whether
such discounts are appropriate for entities holding marketable
assets. For example, if an individual contributes his or her
stock portfolio to an entity and transfers interests in the
entity to his or her children, it is questionable that the
stock portfolio is somehow worth less to the family, simply
because its ownership is dispersed among several individuals.
In such circumstances, where the underlying assets remain
readily marketable, proponents may argue that issues of control
are much less important than in the context of making decisions
to manage the operations of an ongoing active business. That
is, the proposal would deem there to be no minority or other
discount in the case of a family enterprise that holds
marketable assets.
Opponents of this approach note that it is inconsistent
with observed market outcomes to claim that a minority discount
cannot exist when the assets in question are liquid. For
example, assume a taxpayer holds a one-third share in a
portfolio of New York Stock Exchange stocks and that her
brother holds the two-third's share. In this circumstance, the
brother would be able to dictate the course of future
investment, investment strategy, and timing of liquidation of
the portfolio. Some may argue that such a circumstance could
reasonably give rise to a minority discount on the value of the
taxpayer's one-third holding even though the underlying assets
are liquid.
In determining how much of a minority discount might be
appropriate with respect to entities holding liquid assets, it
may be helpful to consider the value placed on closed-end
mutual funds. Closed-end mutual funds are traded regularly on
the open market and, among funds that invest in domestic
assets, are almost always traded at a discount from the net
asset value of the underlying assets. The discounts observed in
the marketplace generally are smaller than those often claimed
as minority discounts in valuing transfers of business
interests for estate and gift tax purposes. For example, over
the past six months the discount from net asset value of the
Herzfeld Closed-End Average has ranged between 12 percent and 4
percent of net asset value.\181\ On the other hand, closed-end
mutual funds also may be valued at a premium. While this is
observed infrequently with closed-end mutual funds that invest
in domestic equities, it may make it difficult to arrive at any
generalized conclusions as to the proper valuation of interests
in such entities.
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\181\ The Herzfeld Closed-End Average measures 16 equally-weighted
closed-end funds that invest principally in equities of U.S.
corporations. Barron's Market Week, February 9, 1998, p. 89. As an
average, the Herzfeld Closed-End Average does not reflect the range of
discounts or premiums that may be observed on individual funds.
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The Administration proposal states that valuation discounts
would be denied with respect to entities holding ``readily
marketable assets.'' It is unclear, however, whether the
proposal is actually limited to ``readily marketable assets''
as that term is commonly understood. The examples listed in the
proposal (i.e., cash, cash equivalents, foreign currency,
publicly traded securities, real property, annuities, royalty-
producing assets, non-income producing property such as art or
collectibles, commodities, options and swaps) indicate that the
proposal would apply to most passive assets. However, as noted
above, passive assets are not automatically liquid. The
liquidity of markets is a qualitative concept. While the market
for Treasury securities generally is conceded to be the most
liquid market in the world, there are not generally accepted
ways to measure the relative liquidity of the market for U.S.
Treasury securities to that of pork bellies, to that for
Picassos, to that for real estate in New York city. Observers
note that Picassos are not sold daily and an effort to quickly
convert a Picasso to cash may result in the painting being sold
at a discount to its ``market value.''
To the extent that the Administration proposal is meant to
cover assets such as real estate and art that may not actually
be readily marketable, the arguments that valuation discounts
are inappropriate may not be as applicable.\182\ If the
proposal does not include a ``bright line'' definition of those
assets to be denied valuation discounts, the proposal could
lead to increased taxpayer litigation regarding the standard of
``readily marketable assets.'
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\182\ For example, the Tax Court recently accepted a taxpayer's
expert's valuation allowing a 44 percent combined discount with respect
to the transfer of an undivided one-half interest in timberland, based
on the taxpayer's lack of control and the marketing time and real
estate commission cost involved in selling real property in that
particular market, where the Commissioner's expert admitted that an
undivided one-half interest in real property has a limited market and
that a fractional interest may be discounted, but introduced no
testimony or other evidence to rebut taxpayer's expert's testimony as
to the appropriate level of discount. Estate of Williams, T.C. Memo.
1998-59.
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2. Gifts of ``present interests'' in a trust (repeal the ``Crummey''
case rule)
Present Law
Under present law, the first $10,000 \183\ of gifts of
present interest are excluded from Federal gift tax. Several
courts have held that a donee's power to withdraw annual
additions to the trust during the year in question gave that
donee a present interest in the additions. These withdrawal
powers often are referred to as ``Crummey powers.'' See, e.g.,
D. Clifford Crummey v. Commissioner, 397 F. 2d 82 (9th Cir.
1968). This result has been upheld even where the donee is a
minor or lacks knowledge of his right of withdrawal.
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\183\ The Taxpayer Relief Act of 1997 provided that this amount
will be increased (i.e., indexed) in $1,000 increments for inflation
occurring after 1997.
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In the Crummey case, the holder of the withdrawal power was
the ultimate beneficiary of the trust. In more recent cases,
such as Estate of Cristofani v. Commissioner, 97 T.C. 74
(1991), and Estate of Kohlsaat v. Commissioner, 73 T.C.M. 2732
(1997), the trust agreement was drafted to give withdrawal
rights to individuals who did not have substantial economic
interests in the trust.
Premiums paid by an insured person for a life insurance
policy are considered a taxable gift to the beneficiaries of
the policy if (1) the policy proceeds are payable to
beneficiaries other than the insured's estate, (2) the insured
retains no power to receive the economic benefits in himself or
his estate, (3) the insured retains no power to change the
beneficiaries or their proportionate benefit, and (4) the
insured retained no reversionary interest in the insured or his
estate. Treas. Reg. sec. 25.2511-1(h)(8). The transfer of cash
to an insurance trust is a future interest where the cash is
used to pay premiums on an insurance policy and the income from
the insurance proceeds after the death of the insured is to be
paid to the trust's beneficiary for life. Treas. Reg. sec.
25.2503-3(c), Example (2).
Description of Proposal
The proposal would overrule the Crummey decision by
amending section 2503(b) to apply only to outright gifts of
present interests. Gifts to minors under a uniform act would be
deemed to be outright gifts.
Effective Date
The proposal would be effective for gifts completed after
December 31, 1998.
Analysis
Opponents of the Administration proposal argue that the
principles of the Crummey decision are longstanding. Taxpayers
have made use of Crummey powers to minimize gift taxes with
respect to certain transfers in trust for at least 30 years. On
the other hand, the Administration argues that use of the
Crummey power often is a legal fiction since, typically by
understanding or expectation, it is extremely rare for a
Crummey power to be exercised. The Administration believes that
the continued existence and expansion of the Crummey decision
undermines the statutory requirement that only a gift of a
present interest is eligible for the $10,000 annual gift tax
exclusion.
The legislative history of the annual exclusion indicates
that its size was established to exempt numerous small gifts
and larger wedding and Christmas gifts. That legislative
history \184\ also supports the view that the disallowance of
the annual exclusion for future interests was necessary because
of the need to determine the identity of the donee and the
amount of the gift. Opponents of the Treasury proposal argue
that, in many cases, the existence of a Crummey power does not
make the identity of the donee, or the value of the transfer,
unclear and, therefore, use of Crummey powers is consistent
with the annual exclusion.
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\184\ The Finance Committee report for the Revenue Act of 1932
(Committee Report No. 665 (72d Congress 1st Session)) states as
follows: ``Such exemption, on the one hand, is to obviate the necessity
of keeping account of and reporting numerous small gifts, and, on the
other, to fix the amount sufficiently large to cover in most cases
wedding and Christmas gifts and occasional gifts of relatively small
amounts. The exemption does not apply with respect to a gift to any
donee to whom is given a future interest. The term ``future interest in
property'' refers to any interest or estate, whether vested or
contingent, limited to commence in possession or enjoyment at a future
date. The exemption being available only in so far as the donees are
ascertainable, the denial of the exemption in the case of future
interests is dictated by the apprehended difficulty, in many instances,
of determining the number of eventual donees and the value of their
respective gifts.'' page 41. Identical language is contained in page 29
of Report of the Committee on Ways and Means (Report Number 708, 72d
Cong., 1st Session)
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Proponents of the Treasury proposal argue that application
of the Crummey rule to situations where the withdrawal rights
have been given to individuals who do not have substantial
economic interests in a trust may be more troubling because it
potentially permits an unlimited gift tax exemption through
multiple withdrawal rights given to multiple individuals while
only the intended donee or donees have substantial economic
interests in that trust. In any event, the Treasury proposal
would overrule all uses of Crummey powers, not just these
situations.
Crummey powers frequently are used in conjunction with a
trust whose principal asset is a life insurance policy (called
an ``insurance trust''). These trusts typically first begin
making income payments after the death of the insured from the
insurance proceeds so that interests in such a trust are future
interests. Crummey powers are used so that cash contributions
to the trust by the insured to be used to pay premiums on the
insurance policy will qualify for the annual exclusion. The
proposal's repeal of the Crummey rule would cause such cash
contributions to cease to qualify for the annual exclusion,
resulting in use of the insured's unified credit or payment of
gift tax. If limitations are adopted on the use of Crummey
powers, transitional relief may be appropriate in situations
where the insurance policy is a whole life policy, especially
where the policy has been irrevocably transferred to the trust
and the insured individual is no longer insurable.
3. Eliminate gift tax exemption for personal residence trusts
Present Law
Section 2702 sets forth special valuation rules for
circumstances in which an individual sets up a trust, retaining
a partial interest in the trust and transferring other
interests in the trust to family members. In general, if an
interest in a trust is retained by a grantor when other
interests are transferred to family members, the retained
interest is valued at zero for gift tax purposes unless it is a
qualified annuity interest (a ``GRAT''), unitrust interest (a
``GRUT''), or a remainder interest after a GRAT or a GRUT. A
special exception under section 2702(a)(3)(A)(ii) provides that
the special valuation rules do not apply in the case of
personal residence trusts. In general, a personal residence
trust is a trust ``all the property in which consists of a
residence to be used as a personal residence by persons holding
term interests in such trust.'
Description of Proposal
The proposal would repeal the personal residence exception
of section 2702(a)(3)(A)(ii). If a residence is used to fund a
GRAT or a GRUT, the trust would be required to pay out the
required annuity or unitrust amount; otherwise the grantor's
retained interest would be valued at zero for gift tax
purposes.
Effective Date
The proposal would be effective for transfers in trust
after the date of enactment.
Prior Action
No prior action.
Analysis
The present-law rules pertaining to personal residence
trusts were enacted by Congress in 1990 as a specific statutory
exception to the general rules of section 2702. Personal
residence trusts are commonly used as a tax planning device to
reduce transfer taxes by allowing an individual's home (or
vacation home) to be transferred to his or her heirs at
significant tax savings. For example, an individual may
transfer his primary residence to a trust which provides that
the grantor may continue to live in the house for fifteen
years, at which time the trust assets (i.e., the home) will be
transferred to his children. The grantor may retain a
reversionary interest in the property (i.e., provide that if
the grantor does not survive the trust term, the property would
revert to his estate).\185\ The trust agreement may further
provide that the grantor may continue to live in the home after
the fifteen-year period as long as he makes rental payments to
his children at fair market value. If the requirements for a
personal residence trust are satisfied, the transfer is treated
as a gift of the contingent remainder interest, which generally
has a relatively small value as compared to the full fair
market value of the residence.
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\185\ Reversionary interests commonly are retained so that, if the
grantor dies before the end of the trust term, the property may be left
to the grantor's spouse, thus qualifying for the marital deduction.
Retention of a reversionary interest also has the effect of reducing
the amount of the taxable gift.
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The gift tax is imposed on the fair market value of the
property transferred. In the case of a transfer such as the one
described above, the value of the gift would be determined by
taking the fair market value of the entire property, and
subtracting from it the actuarially determined value of the
grantor's retained income interest and the actuarially
determined value of any contingent reversionary interest
retained by the grantor. The actuarially determined value of
any annuity, interest for life or a term of years, or any
remainder or reversionary interest is based upon tables set
forth by the IRS under section 7520. These tables set forth
valuation rates for each type of interest (e.g., annuity, life
interest, remainder interest) based upon applicable interest
rates and the length of the term.
There are several advantages and disadvantages to the use
of personal residence trusts. First, such trusts allow an
individual to transfer his home to his heirs at a significantly
reduced value for gift tax purposes. In addition, any future
appreciation in the house is not subject to transfer taxes, as
long as the grantor survives the trust term.\186\ Lastly, if
the grantor continues to live in the home after the trust term
has expired, the required rental payments to his heirs will
reduce the size of his estate (and thus his estate taxes) even
further. On the other hand, when a personal residence trust is
utilized, the heirs receive a carryover basis in the residence
rather than having the basis stepped up to its full fair market
value on the date of death, as would be the case if the grantor
held the property until death and transferred it outright to
the heirs at that time. This disadvantage may be alleviated
somewhat, however, by the provision in the Taxpayer Relief Act
of 1997 that potentially exempts up to $500,000 of capital gain
from tax when the home is sold, if the heirs meet the ownership
and residence requirements of that provision.
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\186\ If the grantor dies during the trust term, the full fair
market value of the house at the date of death will be brought back
into his estate under section 2036, regardless of whether the grantor
has retained a reversionary interest in the property. However, the
estate will receive credit for any gift taxes paid (or use of the
unified credit) with respect to the initial transfer to the personal
residence trust.
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The valuation rules of section 2702 are patterned after the
rules set forth in section 2055 for determining whether a
charitable deduction is allowed for split interests in property
where an interest is given to charity. When Congress enacted
section 2055 in 1969, there were concerns that it would be
inappropriate to give a charitable deduction except in cases
where there was some assurance that the interest given to
charity could be properly valued. Types of interests for which
a deduction was allowed included annuities and unitrusts.
Generally, an annuity pays a fixed amount each year while a
unitrust pays out a certain fraction of the value of the trust
annually. Thus, a charitable deduction is allowed in cases
where, for example, an annuity is paid to charity with the
remainder going to an individual, or an annuity is paid to an
individual with the remainder going to charity, or a unitrust
pays out to charity annually with the remainder going to an
individual, or a unitrust pays out to an individual annually
with the remainder going to charity. In addition, a charitable
deduction is allowed for the contribution of a remainder
interest in a personal residence or farm under an exception
provided in section 170(f)(3)(B)(i). These same basic rules
were adopted in valuing non-charitable gifts for purposes of
section 2702.
Proponents of the Administration proposal argue that the
use value of the residence retained by the grantor is a poor
substitute for an annuity or unitrust interest, and that the
actuarial tables overstate the value of the grantor's retained
interest in the house. These conclusions are based in part on
the fact that in a personal residence trust situation, the
grantor ordinarily remains responsible for the insurance,
maintenance and property taxes on the residence, and thus the
true rental value of the house should be less than the fair
market rent. Such proponents also argue that by completely
exempting personal residence trusts from the requirements of
section 2702, personal residence trusts are accorded even more
beneficial treatment than are GRATs, GRUTs, or remainder
interests after a GRAT or a GRUT, because under those
arrangements, it is not possible to reduce the value of the
gift by retaining a contingent reversionary interest.
The Administration proposal does not question whether a
remainder interest in a personal residence can be appropriately
valued for purposes of determining the amount of a charitable
contribution, in that no modification of section 2055 is
proposed. It is unclear how the same basic valuation rules
could produce an acceptable result where a remainder interest
is going to charity, yet an unacceptable result where the
remainder interest is being transferred to private parties.
4. Include qualified terminable interest property (``QTIP'') trust
assets in surviving spouse's estate
Present Law
For estate and gift tax purposes, a marital deduction is
allowed for qualified terminable interest property (QTIP). Such
property generally is included in the surviving spouse's gross
estate. The surviving spouse's estate is entitled to recover
the portion of the estate tax attributable to such inclusion
from the person receiving the property, unless the spouse
directs otherwise by will (sec. 2207A). A marital deduction is
allowed for QTIP passing to a qualifying trust for a spouse
either by gift or by bequest. Under section 2044, the value of
the recipient spouse's estate includes the value of any such
property in which the decedent had a qualifying income interest
for life and a deduction was allowed under the gift or estate
tax.
Description of Proposal
The proposal would provide that if a marital deduction is
allowed with respect to qualified terminable interest property
(QTIP), inclusion is required in the beneficiary spouse's
estate.
Effective Date
The proposal would be effective for decedents (i.e.,
surviving spouses) dying after the date of enactment.
Prior Action
No prior action.
Analysis
Both the gift tax and the estate tax allow an unlimited
deduction for certain amounts transferred from one spouse to
another spouse who is a citizen of the United States.\187\
Under both the gift and estate tax marital deduction,
deductions are not allowed for so-called ``terminable
interests''. Terminable interests generally are created where
an interest in property passes to the spouse and another
interest in the same property passes from the donor or decedent
to some other person for less than full and adequate
consideration. For example, an income interest to the spouse
generally would not qualify for the marital deduction where the
remainder interest is transferred to a third party. Special
rules permit a marital deduction where the surviving spouse has
an income interest if that spouse has a testamentary power of
appointment or the remainder passes to the estate of that
surviving spouse.
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\187\ In addition, a marital deduction is allowed for both gift and
estate tax purposes for transfers to spouses who are not citizens of
the United States if the transfer is to a qualified domestic trust
(QDOT). A qualified domestic trust is a trust which has at least one
trustee that is a U.S. citizen or a domestic corporation and no
distributions of corpus can be made without withholding from those
distributions.
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An exception to the terminable interest rule was provided
when the unlimited marital deduction was provided in 1981.
Under this exception, a marital deduction is allowed for a
transfer to a trust of ``qualified terminable interest
property'' (called ``QTIP'') in which the spouse only has an
income interest, as long as the transferor elects to include
the trust in the spouse's gross estate for Federal estate tax
purposes and subjects to gift tax the property in the QTIP if
the spouse disposes of the income interest.
The purpose and effect of the terminable interest and
qualified terminable interest rules is to permit deferral of
taxation on amounts transferred to spouses that are not
consumed before the death of the second spouse, not to provide
an exemption from estate and gift tax. In some cases, the
estate of the first spouse to die has claimed a marital
deduction as a QTIP and then, after the statute of limitations
for assessing tax on the first estate has elapsed, the estate
of the second spouse to die argues against inclusion in that
second estate due to a technical flaw in the QTIP eligibility
or election in the first estate. Under the proposal, the estate
of the second spouse to die would be required to include
property with respect to which the estate of the first spouse
to die claimed a marital deduction even if there was a
technical flaw in the QTIP eligibility or election in the first
estate.
F. Foreign Tax Provisions
1. Replace sales source rules with activity-based rule
Present Law
U.S. persons are subject to U.S. tax on their worldwide
income. Foreign taxes may be credited against U.S. tax on
foreign-source income of the taxpayer. For purposes of
computing the foreign tax credit, the taxpayer's income from
U.S. sources and from foreign sources must be determined.
Income from the sale or exchange of inventory property that
is produced (in whole or in part) within the United States and
sold or exchanged outside the United States, or produced (in
whole or in part) outside the United States and sold or
exchanged within the United States, is treated as partly from
U.S. sources and partly from foreign sources. Treasury
regulations provide that 50 percent of such income is treated
as attributable to production activities and 50 percent is
treated as attributable to sales activities. Alternatively, the
taxpayer may elect to determine the portion of such income that
is attributable to production activities based upon an
available independent factory price (i.e., the price at which
the taxpayer makes a sale to a wholly independent distributor
in a transaction that reasonably reflects the income earned
from the production activity). With advance permission of the
Internal Revenue Service, the taxpayer instead may elect to
determine the portion of its income attributable to production
activities and the portion attributable to sales activities
based upon its books and records.
The portion of the income that is considered attributable
to production activities generally is sourced based on the
location of the production assets. The portion of the income
that is considered attributable to sales activities generally
is sourced where the sale occurs. Treasury regulations provide
that the place of sale will be presumed to be the United States
if the property is wholly produced in the United States and is
sold for use, consumption, or disposition in the United States.
Specific rules apply for purposes of determining the source
of income from the sale of products derived from natural
resources within the United States and sold outside the United
States or derived from natural resources outside the United
States and sold within the United States.
Description of Proposal
Under the proposal, income from the sale or exchange of
inventory property that is produced in the United States and
sold or exchanged abroad, or produced abroad and sold or
exchanged in the United States, would be apportioned between
production activities and sales activities based on actual
economic activity. The proposal would not modify the rules
regarding the source of income derived from natural resources.
Effective Date
The proposal would apply to taxable years beginning after
the date of enactment.
Prior Action
The proposal was included in the President's fiscal year
1998 budget proposal.
Analysis
The 50/50 source rule of present law may be viewed as
drawing an arbitrary line in determining the portion of income
that is treated as attributable to production activities and
the portion that is treated as attributable to sales
activities. The proposal could be viewed as making this
determination more closely reflect the economic components of
the export sale. Some further argue that the present-law rule
provides a tax benefit only to U.S. exporters that also have
operations in high-tax foreign countries. In many cases, the
income from a taxpayer's export sales is not subject to tax in
the foreign jurisdiction and therefore does not give rise to
foreign tax credits. The present-law treatment of 50 percent of
the income from a taxpayer's export sales of property it
manufactured in the United States as foreign-source income
therefore has the effect of allowing the taxpayer to use excess
foreign tax credits, if any, that arise with respect to other
operations. It is argued that the proposal would prevent what
might be viewed as the inappropriate use of such excess foreign
tax credits.
Others argue that the export benefit provided by the 50/50
source rule of present law is important to the U.S. economy and
should be retained. It is further argued that the rule is
needed to counter-balance various present-law restrictions on
the foreign tax credit that can operate to deny the taxpayer a
credit for foreign taxes paid with respect to foreign
operations, thereby causing the taxpayer to be subject to
double tax on such income. Moreover, the 50/50 source rule of
present law can be viewed as having the advantage of
administrative simplicity; the proposal to apportion income
between the taxpayer's production activities and its sales
activities based on actual economic activity has the potential
to raise complex factual issues similar to those raised under
the section 482 transfer pricing rules that apply in the case
of transactions between related parties.
2. Modify rules relating to foreign oil and gas extraction income
Present Law
U.S. persons are subject to U.S. income tax on their
worldwide income. A credit against U.S. tax on foreign-source
income is allowed for foreign taxes paid or accrued (or deemed
paid). The foreign tax credit is available only for foreign
income, war profits, and excess profits taxes and for certain
taxes imposed in lieu of such taxes. Other foreign levies
generally are treated as deductible expenses only. Treasury
regulations provide detailed rules for determining whether a
foreign levy is a creditable income tax. A levy generally is a
tax if it is a compulsory payment under the authority of a
foreign country to levy taxes and is not compensation for a
specific economic benefit provided by a foreign country. A
taxpayer that is subject to a foreign levy and that also
receives a specific economic benefit from such country is
considered a ``dual-capacity taxpayer.'' Treasury regulations
provide that the portion of a foreign levy paid by a dual-
capacity taxpayer that is considered a tax is determined based
on all the facts and circumstances. Alternatively, under a safe
harbor provided in the regulations, the portion of a foreign
levy paid by a dual-capacity taxpayer that is considered a tax
is determined based on the foreign country's generally
applicable tax or, if the foreign country has no general tax,
the U.S. tax (Treas. Reg. sec. 1.901-2A(e)).
The amount of foreign tax credits that a taxpayer may claim
in a year is subject to a limitation that prevents taxpayers
from using foreign tax credits to offset U.S. tax on U.S.-
source income. The foreign tax credit limitation is calculated
separately for specific categories of income. The amount of
creditable taxes paid or accrued (or deemed paid) in any
taxable year which exceeds the foreign tax credit limitation is
permitted to be carried back two years and carried forward five
years. Under a special limitation, taxes on foreign oil and gas
extraction income are creditable only to the extent that they
do not exceed a specified amount (e.g., 35 percent of such
income in the case of a corporation). For this purpose, foreign
oil and gas extraction income is income derived from foreign
sources from the extraction of minerals from oil or gas wells
or the sale or exchange of assets used by the taxpayer in such
extraction. A taxpayer must have excess limitation under the
special rules applicable to foreign extraction taxes and excess
limitation under the general foreign tax credit provisions in
order to utilize excess foreign oil and gas extraction taxes in
a carryback or carryforward year. A recapture rule applicable
to foreign oil and gas extraction losses treats income that
otherwise would be foreign oil and gas extraction income as
foreign-source income that is not considered oil and gas
extraction income; the taxes on such income retain their
character as foreign oil and gas extraction taxes and continue
to be subject to the special limitation imposed on such taxes.
Description of Proposal
The proposal would deny the foreign tax credit with respect
to all amounts paid or accrued (or deemed paid) to any foreign
country by a dual-capacity taxpayer if the country does not
impose a generally applicable income tax. A dual-capacity
taxpayer would be a person that is subject to a foreign levy
and also receives (or will receive) directly or indirectly a
specific economic benefit from such foreign country. A
generally applicable income tax would be an income tax that is
imposed on income derived from business activities conducted
within that country, provided that the tax has substantial
application (by its terms and in practice) to persons who are
not dual-capacity taxpayers and to persons who are citizens or
residents of the foreign country. If the foreign country
imposes a generally applicable income tax, the foreign tax
credit available to a dual-capacity taxpayer would not exceed
the amount of tax that is paid pursuant to the generally
applicable income tax or that would be paid if the generally
applicable income tax were applicable to the dual-capacity
taxpayer. Amounts for which the foreign tax credit is denied
could constitute deductible expenses. The proposal would not
apply to the extent contrary to any treaty obligation of the
United States.
The proposal would replace the special limitation rules
applicable to foreign oil and gas extraction income with a
separate foreign tax credit limitation under section 904(d)
with respect to foreign oil and gas income. For this purpose,
foreign oil and gas income would include foreign oil and gas
extraction income and foreign oil related income. Foreign oil
related income is income derived from foreign sources from the
processing of minerals extracted from oil or gas wells into
their primary products, the transportation, distribution or
sale of such minerals or primary products, the disposition of
assets used by the taxpayer in one of the foregoing businesses,
or the performance of any other related service. The proposal
would repeal both the special carryover rules applicable to
excess foreign oil and gas extraction taxes and the recapture
rule for foreign oil and gas extraction losses.
Effective Date
The proposal with respect to the treatment of dual-capacity
taxpayers would apply to foreign taxes paid or accrued in
taxable years beginning after the date of enactment. The
proposal with respect to the foreign tax credit limitation
generally would apply to taxable years beginning after the date
of enactment.
Prior Action
The proposal was included in the President's fiscal year
1998 budget proposal. The proposal in the fiscal year 1998
budget proposal also included an additional modification with
respect to the treatment of foreign oil and gas income under
subpart F of the Code which is not included in this proposal.
Analysis
The proposal with respect to the treatment of dual-capacity
taxpayers addresses the distinction between creditable taxes
and non-creditable payments for a specific economic benefit.
The proposal would modify rules currently provided under the
Treasury regulations and would deny a foreign tax credit for
amounts paid by a dual-capacity taxpayer to any foreign country
that does not have a tax that satisfies the definition of a
generally applicable income tax. Thus, neither the present-law
facts and circumstances test nor the present-law safe harbor
based on the U.S. tax rate would apply in determining whether
any portion of a foreign levy constitutes a tax.
Proponents of the proposal argue that the safe harbor of
the present regulations allows taxpayers to claim foreign tax
credits for payments that are more appropriately characterized
as royalty expenses. Opponents of the proposal argue that the
mere fact that a foreign country does not impose a tax that
qualifies under the specific definition of a generally
applicable income tax should not cause all payments to such
country by a dual-capacity taxpayer to be treated as royalties
rather than taxes. Moreover, applying such a rule to dual-
capacity taxpayers could disadvantage them relative to other
persons that are subject to a levy in a country that does not
impose a tax that satisfies the specific definition of a
generally applicable income tax but that do not also receive a
specific economic benefit from such country (e.g., a taxpayer
that is not in a natural resources business); a taxpayer that
is not a dual-capacity taxpayer would not be subject to this
disallowance rule and therefore could continue to claim foreign
tax credits for payments to a foreign country that does not
impose a generally applicable income tax. In addition, issues
necessarily would continue to arise in determining whether a
taxpayer is a dual-capacity taxpayer and whether a foreign
country has a generally applicable income tax.
Under the proposal, a separate foreign tax credit
limitation (or ``basket'') would apply to foreign oil and gas
income, which would include both foreign oil and gas extraction
income and foreign oil related income. In addition, the
present-law special limitation for extraction taxes would be
eliminated. The proposed single basket rule may provide some
simplification by eliminating issues that arise under present
law in distinguishing between income that qualifies as
extraction income and income that qualifies as oil related
income. The proposal also would have the effect of allowing the
foreign taxes on extraction income, which may be imposed at
relatively high rates, to be used to offset the U.S. tax on
foreign oil related income, which may be subject to lower-rate
foreign taxes.
3. Apply ``80/20'' company rules on a group-wide basis
Present Law
In general, U.S.-source interest and dividends paid to
nonresident alien individuals and foreign corporations
(``foreign persons'') that are not effectively connected with a
U.S. trade or business are subject to a U.S. withholding tax on
the gross amount of such income at a rate of 30 percent (secs.
871(a) and 881(a)). The 30-percent withholding tax may be
reduced or eliminated pursuant to an income tax treaty between
the United States and the foreign country where the foreign
person is resident. Furthermore, an exemption from this
withholding tax is provided for certain items of U.S.-source
interest income (e.g., portfolio interest). The United States
generally does not impose withholding tax on foreign-source
interest and dividend payments.
Interest and dividend income generally is sourced in the
country of incorporation of the payor. Thus, interest or
dividends paid by a U.S. corporation to foreign persons
generally are subject to U.S. withholding tax. However, if a
U.S. corporation meets an 80-percent active foreign business
income test (the ``80/20 test''), all or a portion of any
interest or dividends paid by that corporation (a so-called
``80/20 company'') effectively is exempt from U.S. withholding
tax. In general, a U.S. corporation meets the 80/20 test if at
least 80 percent of the gross income of the corporation during
a specified testing period is derived from foreign sources and
is attributable to the active conduct of a trade or business in
a foreign country (or a U.S. possession) by the corporation or
a 50-percent owned subsidiary of the corporation. The testing
period generally is the three-year period preceding the year in
which the interest or dividend is paid.
Interest paid by an 80/20 company is treated as foreign-
source income (and, therefore, exempt from the 30-percent
withholding tax) if paid to unrelated parties. Interest paid by
an80/20 company to related parties is treated as having a
prorated source based on the source of the income of such company
during the three-year testing period (a so-called ``look-through''
approach). Dividends paid by an 80/20 company are treated as wholly or
partially exempt from U.S. withholding tax under a similar look-through
approach based on the source of the income of such company during the
three-year testing period.
Description of Proposal
The proposal would apply the 80/20 test on a group-wide
basis. Therefore, members of a group would be required to
aggregate their gross income for purposes of applying the 80/20
test.
Effective Date
The proposal would apply to interest or dividends paid or
accrued more than 30 days after the date of enactment.
Prior Action
No prior action.
Analysis
The 80/20 test generally is applied based on the gross
income of a ``tested'' U.S. corporation (i.e., the corporation
paying the interest or dividend) during a three-year lookback
period. In some cases this three-year lookback period may be
subject to manipulation and can result in the improper
avoidance of U.S. withholding tax with respect to certain
distributions attributable to the U.S.-source earnings of a
U.S. subsidiary of the payor corporation. For instance,
dividends paid by a ``tested'' U.S. corporation attributable to
the U.S.-source earnings of a U.S. subsidiary of such
corporation can be timed in such a manner that the earnings are
not included in the three-year lookback period. Some assert
that such a dividend timing strategy is not unlike other
dividend timing strategies (or so-called ``rhythm methods''),
such as those previously used to maximize section 902 foreign
tax credits prior to the adoption in 1986 of the pooling
concept for a foreign subsidiary's earnings and profits and
taxes.
The proposal would apply the 80/20 test on a group-wide
basis. As a result, members of a group would be required to
aggregate their gross income for purposes of the 80/20 test. It
is not clear how a ``group'' should be defined for these
purposes. One approach may be to use an affiliated group
concept under principles similar to section 1504. Under such an
approach, the U.S.-source earnings of a wholly-owned U.S.
subsidiary of the payor corporation would be considered in
determining whether payments from the payor corporation (or
from other group members) qualify for the 80/20 company rules.
However, such an approach may be viewed as being overly broad,
and may serve to disqualify from the 80/20 company rules
payments from group members which in fact are attributable to
foreign-source earnings. For instance, interest payments from a
group member to unrelated parties that are attributable to
foreign-source earnings of such group member may not qualify
for the 80/20 company rules if the 80/20 test is applied on
such a group basis. It is argued that the degree to which
earnings of group members would be tainted under such an
approach can be reduced by more narrowly defining the group.
For instance, the group could be defined to include only the
tested U.S. corporation and certain subsidiaries owned by it.
On the other hand, some may argue that a group approach by its
nature may not be sufficiently targeted to the specific timing
issues raised by the three-year lookback rule.
The proposal also may affect U.S. income tax treaties that
contain provisions that incorporate the 80/20 test (e.g., the
U.S.-UK income tax treaty which provides that the reduced rates
of tax on dividends, interest and royalties do not apply to
certain 80/20 companies); the interaction of this proposal with
the affected treaties would require further clarification.
4. Prescribe regulations regarding foreign built-in losses
Present Law
U.S. persons are subject to U.S. tax on their worldwide
income. Foreign persons are subject to U.S. tax, calculated in
the same manner and at the same graduated rates as the U.S. tax
on U.S. persons, on income that is effectively connected with
the conduct of a U.S. trade or business. Foreign persons also
are subject to a U.S. 30-percent withholding tax on the gross
amount of certain U.S.-source income that is not effectively
connected with a U.S. trade or business.
Various rules are aimed at preventing U.S. taxpayers from
transferring appreciated property outside the U.S. taxing
jurisdiction to escape U.S. tax on the built-in gain with
respect to such property. Section 367(a) limits the application
of nonrecognition provisions to corporate reorganizations
involving transfers to foreign corporations. In addition, under
section 864(c)(7), the gain with respect to property that was
used in connection with a U.S. trade or business may be
considered to be effectively connected with a U.S. trade or
business, and therefore subject to U.S. tax, even though the
property is no longer so used at the time of its disposition.
Moreover, section 877 includes rules to limit the ability of
former U.S. citizens to avoid U.S. tax on appreciated property.
The Code does not include analogous provisions specifically
aimed at preventing taxpayers from transferring property with
built-in losses into the U.S. taxing jurisdiction. Such losses
could be used to offset income or gain that otherwise would be
subject to U.S. tax.
Description of Proposal
Under the proposal, the Secretary of the Treasury would be
directed to prescribe regulations to determine the basis of
assets held directly or indirectly by a non-U.S. person and the
amount of built-in deductions with respect to a non-U.S. person
or an entity held directly or indirectly by a non-U.S. person
as may be necessary or appropriate to prevent the avoidance of
tax. No inference would be intended regarding the treatment
under present law of transactions involving losses arising
outside the U.S. taxing jurisdiction.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
No prior action.
Analysis
The proposal is intended to address both transactions in
which taxpayers acquire built-in losses arising outside the
U.S. taxing jurisdiction and transactions in which related
income and loss are generated but the income arises outside the
U.S. taxing jurisdiction. Such losses could be used to reduce
U.S. tax both by U.S. persons and by foreign persons with
operations in the United States. The Administration is
concerned that existing regulatory authority may not provide
the Secretary of the Treasury with sufficient flexibility to
address potential abuses in a comprehensive manner. However,
granting broad regulatory authority to address the use of
built-in foreign losses, without further enumerating the scope
of such authority, may be criticized as creating uncertainty
and providing insufficient guidance to taxpayers making
business decisions. On the other hand, an alternative approach
of requiring basis adjustments in all such cases would provide
greater certainty but could be criticized as inflexible and
unduly harsh. Additional consideration should be given to
identifying the specific circumstances where basis adjustments
may or may not be appropriate.
5. Prescribe regulations regarding use of hybrids
Present Law
Because of differences in U.S. and foreign tax laws, it is
possible for a taxpayer to enter into transactions that are
treated in one manner for U.S. tax purposes and in another
manner for foreign tax purposes. These transactions are
referred to as hybrid transactions. A hybrid transaction may
involve the use of a hybrid entity that is treated as a
corporation for purposes of the tax law of one jurisdiction but
is treated as a branch or partnership for purposes of the tax
law of another jurisdiction. Alternatively, a hybrid
transaction also may involve the use of hybrid securities, such
as a security that is treated as debt or a royalty right in one
jurisdiction but is treated as an equity interest in another
jurisdiction. Moreover, a hybrid transaction may involve
another type of hybrid structure, including a transaction
involving a repurchase agreement arrangement that is
characterized as a loan in one jurisdiction but is
characterized as a non-taxable exchange in another
jurisdiction.
Section 894(c), enacted with the Taxpayer Relief Act of
1997, was aimed at addressing the potential tax-avoidance
opportunity available for foreign persons that invest in the
United States through hybrid entities. Section 894(c) limits
the availability of a reduced rate of withholding tax pursuant
to an income tax treaty in order to prevent tax avoidance.
Under section 894(c), a foreign person is not entitled to a
reduced rate of withholding tax under a treaty with a foreign
country on an item of income derived through an entity that is
treated as a partnership (or is otherwise treated as fiscally
transparent) for U.S. tax purposes if (1) such item is not
treated for purposes of the taxation laws of such foreign
country as an item of income of such person, (2) the foreign
country does not impose tax on an actual distribution of such
item of income from such entity to such person, and (3) the
treaty itself does not contain a provision addressing the
applicability of the treaty in the case of income derived
through a partnership or other fiscally transparent entity. In
addition, the Secretary of the Treasury is authorized to
prescribe regulations to determine, in situations other than
the situation specifically described in the statutory
provision, the extent to which a taxpayer shall not be entitled
to benefits under an income tax treaty of the United States
with respect to any payment received by, or income attributable
to activities of, an entity that is treated as a partnership
for U.S. federal income tax purposes (or is otherwise treated
as fiscally transparent for such purposes) but is treated as
fiscally non-transparent for purposes of the tax laws of the
jurisdiction of residence of the taxpayer.
Section 894(c) addresses a potential tax-avoidance
opportunity for Canadian corporations with U.S. subsidiaries
that arises because of the interaction between the U.S. tax
law, the Canadian tax law, and the income tax treaty between
the United States and Canada. Through the use of a U.S. limited
liability company, which is treated as a partnership (or
otherwise fiscally transparent) for U.S. tax purposes but as a
corporation for Canadian tax purposes, a payment of interest
(which is deductible for U.S. tax purposes) may be converted
into a dividend (which is excludable for Canadian tax
purposes). Accordingly, interest paid by a U.S. subsidiary
through a U.S. limited liability company to a Canadian parent
corporation would be deducted by the U.S. subsidiary for U.S.
tax purposes and would be excluded by the Canadian parent
corporation for Canadian tax purposes; the only tax on such
interest would be a U.S. withholding tax, which could have been
imposed at a reduced rate of 10 percent (rather than the full
statutory rate of 30 percent) pursuant to the income tax treaty
between the United States and Canada. Under section 894(c),
withholding tax is imposed at the full statutory rate of 30
percent in such case.
Notice 98-5, issued on December 23, 1997, addresses among
other things, the treatment of certain hybrid structures under
the foreign tax credit provisions of the Code. The Notice
states that the Treasury Department and the Internal Revenue
Service have concluded that the use of certain hybrid
structures creates the potential for foreign tax credit abuse.
The hybrid structures identified in Notice 98-5 include
transactions that result in the effective duplication of tax
benefits through the use of structures designed to exploit
inconsistencies between U.S. and foreign tax laws (e.g., an
arrangement that generates foreign taxes for which a credit is
given in both the United States and a foreign country for the
same taxes). The Notice states that it is intended that
regulations will be issued to disallow foreign tax credits for
such arrangements in cases where the reasonably expected
economic profit from the transaction is insubstantial compared
to the value of the foreign tax credits expected to be obtained
as a result of the arrangement. In addition, the Notice states
that Treasury and the Internal Revenue Service are considering
various approaches to address structures, such as hybrid entity
structures, intended to create a significant mismatch between
the time foreign taxes are paid or accrued and the time the
foreign-source income giving rise to the relevant foreign tax
liability is recognized for U.S. tax purposes; such approaches
may include either deferring the foreign tax credits until the
taxpayer recognizes the income, or accelerating the income
recognition to the time when the credits are allowed. The
Notice further states that it is intended that regulations will
apply with respect to hybrid arrangements resulting in the
effective duplication of tax benefits for foreign taxes paid or
accrued on or after December 23, 1997 and, in the case of other
hybrid entity structures, no earlier than the date proposed
regulations are issued.
Notice 98-11, issued on January 16, 1998, addresses the
treatment of hybrid branches under the provisions of subpart F
of the Code. The Notice states that the Treasury Department and
the Internal Revenue Service have concluded that the use of
certain hybrid branch arrangements is contrary to the policy
and rules of subpart F. The hybrid branch arrangements
identified in Notice 98-11 are structures that are
characterized for U.S. tax purposes as part of a controlled
foreign corporation (a ``CFC'') but are characterized for
purposes of the tax law of the country in which the CFC is
incorporated as a separate entity. The Notice states that it is
intended that regulations will be issued to prevent the use of
hybrid branch arrangements to reduce foreign tax while avoiding
the corresponding creation of subpart F income; such
regulations will provide that the branch and the CFC will be
treated as separate corporations for purposes of subpart F. The
Notice further states that it is intended that such regulations
will apply to hybrid branch arrangements entered into or
substantially modified on or after January 16, 1998 and, in the
case of arrangements entered into before such date, to all
payments or other transfers made or accrued after June 30,
1998. The Notice also states that similar issues raised under
subpart F by certain partnership or trust arrangements will be
addressed in separate regulations projects.
Description of Proposal
Under the proposal, the Secretary of the Treasury would be
directed to prescribe regulations clarifying the tax
consequences of hybrid transactions. Such regulations would set
forth the appropriate tax results with respect to hybrid
transactions in which the intended results are inconsistent
with the purposes of U.S. tax law or U.S. income tax treaties.
The regulations also would provide that the intended results
will be respected in the case of hybrid transactions in which
the results are not inconsistent with the purposes of U.S. tax
law or treaties. In this regard, the regulations would not deny
the intended tax results solely because the hybrid transaction
involves the inconsistent treatment of entities, items, or
transactions.
Effective Date
The proposal would be effective as of the date of
enactment.
Prior Action
No prior action.
Analysis
The Administration's description of the proposal provides
several examples of specific circumstances where the proposed
regulatory authority may be used. One example involves the use
of hybrid securities to generate interest deductions in the
United States that are viewed as incompatible with the purposes
of a U.S. income treaty. Another example is the use of hybrid
securities that generate original issue discount deductions in
a foreign jurisdiction without corresponding income inclusions
in the United States. A third example involves the use of
hybrid transactions to generate inappropriate foreign tax
credit benefits. However, the proposed regulatory authority is
not limited to these examples.
General principles of income taxation include the principle
of equitable taxation and the principle of efficient taxation.
Some analysts suggest that, in certain cases, hybrid
transactions may compromise both the equity and the efficiency
of the U.S. income tax. Equity requires that similarly situated
taxpayers be treated similarly. The proposal suggests that in
certain circumstances hybrid securities may be used to generate
interest deductions in the United States that generally could
not be claimed by otherwise similar businesses that have not
issued such hybrid securities. In such a circumstance, the net
capital costs of one business might be higher than those of
another because the second business's use of hybrid securities
permits it a tax deduction not available to the first business.
Such an outcome could put the first business at a competitive
disadvantage in the prices it can charge for its product. To
the extent that the only difference between the two businesses
is the hybrid structure, an inequity may be created by the
income tax that would not exist in the market in the absence of
the tax.
Such disparate treatment of different hybrid structures
also might produce market inefficiencies. For example, if
certain businesses or industries are able to use hybrid
structures to reduce their income tax burden compared to that
of other businesses or industries, their after-tax rate of
return will increase. In the capital market, increases in rates
of return act as signals to investors as to where more
investment funds are needed. Investors may respond by making
more investment funds available to these businesses or
industries and less to other businesses or industries. To the
extent changed rates of return are a consequence of the income
tax and not of underlying market conditions, investor decisions
will be distorted. Too little investment monies may go to some
businesses and too much to others. A misallocation of
investment monies can dampen future economic growth.
Hybrid structures might create a further form of
inefficiency in investment. Such structures might increase the
after-foreign-tax earnings of foreign subsidiaries. Because
active foreign subsidiaries are permitted to defer U.S. income
tax on their net foreign earnings, hybrid structures might
create an inefficient incentive for domestic businesses to
locate certain facilities abroad.
Hybrid structures may induce a third type of inefficiency
as well. Creation of hybrid entities or hybrid securities
requires real resources, the time and effort of many
individuals, and other such costs. These resources represent
funds spent to reduce tax liability rather than funds spent to
produce more goods or services for sale to the public.
It may be the case that certain hybrid transactions are
purely a matter of form over substance. On the other hand,
other hybrid transactions may have business purposes in
addition to whatever ancillary tax saving they produce. The
development of such transactions reflects the growing financial
sophistication of world capital markets and the desire to
spread risk efficiently. The ability to divide business claims
more finely than in the old simple distinctions of ``bond'' or
``stock'' generally has improved the efficiency of the
financial markets, allocated risk more efficiently to those
better able to bear risk and, thereby, has reduced the cost of
capital, making possible more investment and greater future
economic growth potential. Moreover, hybrid transactions are
not inherently inequitable. Any business may choose to organize
itself to take advantage of the benefits of these structures.
New innovations in business, be it in management structure or
financial structure, often create an advantage for the
innovator, but such outcomes are not inherently unfair.
The use of hybrid transactions to circumvent provisions of
the U.S. tax law is potentially troublesome. Moreover, the
availability of these transactions may have been exacerbated by
the so-called ``check-the-box'' entity classification
regulations issued in 1996. However, given the numerous types
of hybrid transactions, a broad grant of regulatory authority
to specify the tax consequences of hybrid transactions in
general may not be the most appropriate solution. Granting
broad authority, without further enumerating the reach of the
authority, could create an environment of uncertainty that has
the potential for stifling legitimate business transactions. In
addressing the issues raised by hybrid transactions, additional
consideration should be given to identifying both the specific
circumstances where a hybrid transaction is inconsistent with
the purposes of the U.S. tax law and the appropriate tax
treatment of such transactions. Finally, it should be noted
that the Treasury Department and the Internal Revenue Service
have announced their intention to issue regulations addressing
the treatment of hybrid branches under the subpart F provisions
(Notice 98-11); it is not entirely clear how this proposal for
regulatory authority may interact with that regulation project.
6. Modify foreign office material participation exception applicable to
certain inventory sales
Present Law
Foreign persons are subject to U.S. tax on income that is
effectively connected with the conduct of a U.S. trade or
business; the U.S. tax on such income is calculated in the same
manner and at the same graduated rates as the tax on U.S.
persons (secs. 871(b) and 882). Detailed rules apply for
purposes of determining whether income is treated as
effectively connected with a U.S. trade or business (sec.
864(c)). Under these rules, foreign-source income is treated as
effectively connected with a U.S. trade or business only in
limited circumstances (sec. 864(c)(4)).
Income derived from the sale of personal property other
than inventory property generally is sourced based on the
residence of the seller (sec. 865(a)). Income derived from the
sale of inventory property generally is sourced where the sale
occurs (i.e., where title to the property passes from the
seller to the buyer) (secs. 865(b) and 861(a)(6)). However, a
special rule applies in the case of certain sales by foreign
persons. If a foreign person maintains an office or other fixed
place of business in the United States, income from a sale of
personal property (including inventory property) attributable
to such office or place of business is sourced in the United
States (sec. 865(e)(2)(A)). This special rule does not apply,
however, in the case of inventory property that is sold by the
foreign person for use, disposition or consumption outside the
United States if an office or other fixed place of business of
such person outside the United States materially participated
in the sale (sec. 865(e)(2)(B)). Accordingly, income from the
sale by a foreign person of inventory property attributable to
an office or other fixed place of business of such foreign
person in the United States is sourced based on where the sale
occurs, provided that the inventory property is sold for use
outside the United States and a foreign office or other fixed
place of business of such person materially participated in the
sale. Income that is sourced outside the United States under
this rule is not treated as effectively connected with a U.S.
trade or business.
Description of Proposal
Under the proposal, the foreign office material
participation rule would apply only if an income tax equal to
at least 10 percent of the income from the sale actually is
paid to a foreign country with respect to such income.
Accordingly, income from the sale by a foreign person of
inventory property attributable to an office or other fixed
place of business of such person in the United States would be
sourced in the United States if an income tax of at least 10
percent of the income from the sale is not paid to a foreign
country. Income sourced in the United States under this
proposal would be treated as effectively connected with a U.S.
trade or business conducted by the foreign person.
Effective Date
The proposal would be effective for transactions occurring
on or after the date of enactment.
Prior Action
No prior action.
Analysis
Under present law, a foreign person that maintains an
office in the United States is not subject to U.S. tax on
income derived from sales of inventory property attributable to
such office provided that the property is sold for use outside
the United States and a foreign office materially participated
in the sale. The foreign person is not subject to U.S. tax on
such income even if no foreign country imposes tax on the
income. The proposal would modify this material participation
rule so that it would apply only if an income tax of at least
10 percent is paid to a foreign country with respect to such
income.
The proposal reflects the view that the United States
should not cede its jurisdiction to tax income from sales of
inventory property attributable to an office in the United
States unless the income from such sale is subject to foreign
tax at some minimal level. Under present law, a similar rule
applies in the case of certain sales by a U.S. person of
personal property (other than inventory property) attributable
to an office or other fixed place of business outside the
United States; such income is sourced outside the United
States, but only if a foreign income tax of at least 10 percent
is paid with respect to such income.
7. Modify controlled foreign corporation exemption from U.S. tax on
transportation income
Present Law
The United States generally imposes a 4-percent tax on the
U.S.-source gross transportation income of foreign persons that
is not effectively connected with the foreign person's conduct
of a U.S. trade or business (sec. 887). Foreign persons
generally are subject to U.S. tax at regular graduated rates on
net income, including transportation income, that is
effectively connected with a U.S. trade or business (secs.
871(b) and 882).
Transportation income is any income derived from, or in
connection with, the use (or hiring or leasing for use) of a
vessel or aircraft (or a container used in connection
therewith) or the performance of services directly related to
such use (sec. 863(c)(3)). Income attributable to
transportation that begins and ends in the United States is
treated as derived from sources in the United States (sec.
863(c)(1)). Transportation income attributable to
transportation that either begins or ends (but not both) in the
United States is treated as derived 50 percent from U.S.
sources and 50 percent from foreign sources (sec. 863(c)(2)).
U.S.-source transportation income is treated as effectively
connected with a foreign person's conduct of a U.S. trade or
business only if the foreign person has a fixed place of
business in the United States that is involved in the earning
of such income and substantially all of such income of the
foreign person is attributable to regularly scheduled
transportation (sec. 887(b)(4)).
An exemption from U.S. tax is provided for income derived
by a nonresident alien individual or foreign corporation from
the international operation of a ship or aircraft, provided
that the foreign country in which such individual is resident
or such corporation is organized grants an equivalent exemption
to individual residents of the United States or corporations
organized in the United States (secs. 872(b)(1) and (2) and
883(a)(1) and (2)). In the case of a foreign corporation, this
exemption does not apply if 50 percent or more of the stock of
the foreign corporation by value is owned by individuals who
are not residents of a country that provides such an exemption
unless the foreign corporation satisfies one of two alternative
tests (sec. 883(c)). Under these alternative tests, the
exemption applies to a foreign corporation without regard to
the residence of the corporation's shareholders either if the
foreign corporation is a controlled foreign corporation (a
``CFC'') or if the stock of the corporation is primarily and
regularly traded on an established securities market in the
United States or in a foreign country that provides an
equivalent exemption. Accordingly, the exemption for
transportation income applies to any CFC formed in a country
that provides an equivalent exemption, regardless of whether
the owners of the stock of the CFC are residents of such a
country.
A foreign corporation is a CFC if U.S. persons own more
than 50 percent of the corporation's stock (measured by vote or
by value), taking into account only those U.S. persons that own
at least 10 percent of the stock (measured by vote only) (secs.
957 and 951(b)). For this purpose, a U.S. partnership is
considered a U.S. person (secs. 957(c) and 7701(a)(30)). The
U.S. 10-percent shareholders of a CFC are required to include
in income currently for U.S. tax purposes their pro rata shares
of certain income of the CFC and their pro rata shares of the
CFC's earnings invested in U.S. property (sec. 951).
Description of Proposal
The proposal would modify the provision under which a CFC
organized in a country that provides an equivalent exemption is
eligible for the exemption from U.S. tax for transportation
income without regard to the residence of the shareholders of
the CFC. Under the proposal, a CFC would qualify for this
exemption only if the CFC is more than 50-percent owned by U.S.
shareholders that are individuals or corporations. A CFC that
does not satisfy this test would be eligible for the exemption
for transportation income only if it satisfies either the
requirement as to the residence of its shareholders or the
public trading test of present law.
Effective Date
The proposal would be effective for taxable years beginning
after the date of enactment.
Prior Action
No prior action.
Analysis
The proposal is intended to prevent the use of the CFC test
by foreign persons that are not residents of a country that
grants an equivalent exemption to obtain the benefit of the
exemption from U.S. tax for transportation income. Under
present law, if 50 percent or more of the stock of a foreign
corporation is owned by individuals who are residents of
countries that do not provide an equivalent exemption, such
foreign corporation generally is not eligible for the exemption
from U.S. tax for transportation income (even though the
corporation is itself organized in an equivalent exemption
country). However, if such persons hold the stock of the
foreign corporation through a U.S. partnership, the corporation
will constitute a CFC and therefore under present law will
qualify for the exemption. The proposal would prevent this
result and would permit CFCs to qualify for the exemption from
U.S. tax for transportation income only if U.S. persons subject
to U.S. tax (i.e., individuals or corporations) own more than
50 percent of the stock of the CFC.
The proposal could give rise to double taxation in certain
circumstances. The U.S. 10-percent shareholders of a CFC are
required to include in income currently their pro rata shares
of certain income of the CFC, including certain shipping
income. Under the proposal, a CFC that does not satisfy the
ownership requirements set forth in the proposal would not be
eligible for an exemption from the U.S. 4-percent tax on
transportation income. Thus, income of such a CFC would be
subject to the U.S. 4-percent tax at the CFC-level and also
could be includible in the incomes, and therefore subject to
U.S. tax, of any U.S. 10-percent shareholders. It should be
noted that the same potential for double taxation could occur
under present law in the case of a CFC organized in a foreign
country that does not grant an equivalent exemption.
G. Administrative Provisions
1. Increased information reporting penalties
Present Law
Any person who fails to file a correct information return
with the IRS on or before the prescribed filing date is subject
to a penalty that varies based on when, if at all, the correct
information return is filed. If a person files a correct
information return after the prescribed filing date but on or
before the date that is 30 days after the prescribed filing
date, the penalty is $15 per return, with a maximum penalty of
$75,000 per calendar year. If a person files a correct
information return after the date that is 30 days after the
prescribed filing date but on or before August 1 of that year,
the penalty is $30 per return, with a maximum penalty of
$150,000 per calendar year. If a correct information return is
not filed on or before August 1, the amount of the penalty is
$50 per return, with a maximum penalty of $250,000 per calendar
year.
There is a special rule for de minimis failures to include
the required, correct information. This exception applies to
incorrect information returns that are corrected on or before
August 1. Under the exception, if an information return is
originally filed without all the required information or with
incorrect information and the return is corrected on or before
August 1, then the original return is treated as having been
filed with all of the correct required information. The number
of information returns that may qualify for this exception for
any calendar year is limited to the greater of (1) 10 returns
or (2) one-half of one percent of the total number of
information returns that are required to be filed by the person
during the calendar year.
In addition, there are special, lower maximum levels for
this penalty for small businesses. For this purpose, a small
business is any person having average annual gross receipts for
the most recent three taxable years ending before the calendar
year that do not exceed $5 million. The maximum penalties for
small businesses are: $25,000 (instead of $75,000) if the
failures are corrected on or before 30 days after the
prescribed filing date; $50,000 (instead of $150,000) if the
failures are corrected on or before August 1; and $100,000
(instead of $250,000) if the failures are not corrected on or
before August 1.
If a failure to file a correct information return with the
IRS is due to intentional disregard of the filing requirement,
the penalty for each such failure is generally increased to the
greater of $100 or ten percent of the amount required to be
reported correctly, with no limitation on the maximum penalty
per calendar year (sec. 6721(e)). The increase in the penalty
applies regardless of whether a corrected information return is
filed, the failure is de minimis, or the person subject to the
penalty is a small business.
Description of Proposal
The proposal would increase the penalty for failure to file
information returns correctly on or before August 1 from $50
for each return to the greater of $50 or 5 percent of the
amount required to be reported correctly but not so reported.
The $250,000 maximum penalty for failure to file correct
information returns during any calendar year ($100,000 with
respect to small businesses) would continue to apply under the
proposal.
The proposal also would provide for an exception to this
increase where substantial compliance has occurred. The
proposal would provide that this exception would apply with
respect to a calendar year if the aggregate amount that is
timely and correctly reported for that calendar year is at
least 97 percent of the aggregate amount required to be
reported under that section of the Code for that calendar year.
If this exception applies, the present-law penalty of $50 for
each return would continue to apply.
The proposal would not affect the following provisions of
present law: (1) the reduction in the $50 penalty where
correction is made within a specified period; (2) the exception
for de minimis failures; (3) the lower limitations for persons
with gross receipts of not more than $5,000,000; (4) the
increase in the penalty in cases of intentional disregard of
the filing requirement; (5) the penalty for failure to furnish
correct payee statements under section 6722; (6) the penalty
for failure to comply with other information reporting
requirements under section 6723; and (7) the reasonable cause
and other special rules under section 6724.
Effective Date
The proposal would apply to information returns the due
date for which (without regard to extensions) is more than 90
days after the date of enactment.
Prior Action
The proposal was included in the President's fiscal year
1998 budget proposal.
Analysis
Some of the information returns subject to this proposed
increased penalty report amounts that are income, such as
interest and dividends. Other information returns subject to
this proposed increased penalty report amounts that are gross
proceeds. 188 Imposing the penalty as a percentage
of the amount required to be reported might be viewed as
disproportionately affecting businesses that file information
returns reporting gross proceeds.
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\188\ Gross proceeds reports are useful to indicate that a
potentially income-producing event has occurred, even though the amount
reported on the information return bears no necessary relationship to
the amount of income utlimately reported on the income tax return.
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2. Modify the substantial understatement penalty for large corporations
Present Law
A 20-percent penalty applies to any portion of an
underpayment of income tax required to be shown on a return
that is attributable to a substantial understatement of income
tax. For this purpose, an understatement is considered
``substantial'' if it exceeds the greater of (1) 10 percent of
the tax required to be shown on the return, and (2) $5,000
($10,000 in the case of a corporation other than an S
corporation or a personal holding company). Generally, the
amount of an ``understatement'' of income tax is the excess of
the tax required to be shown on the return, over the tax shown
on the return (reduced by any rebates of tax). The substantial
understatement penalty does not apply if there was a reasonable
cause for the understatement and the taxpayer acted in good
faith with respect to the understatement (the ``reasonable
cause exception''). The determination as to whether the
taxpayer acted with reasonable cause and in good faith is made
on a case-by-case basis, taking into account all pertinent
facts and circumstances.
Description of Proposal
The proposal would treat a corporation's deficiency of more
than $10 million as substantial for purposes of the substantial
understatement penalty, regardless of whether it exceeds 10
percent of the taxpayer's total tax liability.
Effective Date
The proposal would be effective for taxable years beginning
after the date of enactment.
Prior Action
The proposal was included in the President's fiscal year
1998 budget proposal.
Analysis
Opponents might argue that altering the present-law penalty
to make it apply automatically to large corporations might be
viewed as violating the policy basis for this penalty, which is
to punish an understatement that is substantial or material in
the context of the taxpayer's own tax return. Proponents might
respond that a deficiency of more that $10 million is material
in and of itself, regardless of the proportion it represents of
that taxpayer's total tax return.
3. Repeal exemption for withholding on gambling winnings from bingo and
keno in excess of $5,000
Present Law
In general, proceeds from a wagering transaction are
subject to withholding at a rate of 28 percent if the proceeds
exceed $5,000 and are at least 300 times as large as the amount
wagered. The proceeds from a wagering transaction are
determined by subtracting the amount wagered from the amount
received. Any non-monetary proceeds that are received are taken
into account at fair market value.
In the case of sweepstakes, wagering pools, or lotteries,
proceeds from a wager are subject to withholding at a rate of
28 percent if the proceeds exceed $5,000, regardless of the
odds of the wager.
No withholding tax is imposed on winnings from bingo or
keno.
Description of Proposal
The proposal would impose withholding on proceeds from
bingo or keno wagering transactions at a rate of 28 percent if
such proceeds exceed $5,000, regardless of the odds of the
wager.
Effective Date
The proposal would be effective for payments made after the
beginning of the first month that begins at least 10 days after
the date of enactment.
Prior Action
The proposal was included in the President's fiscal year
1998 budget proposal.
Analysis
It is generally believed that imposing withholding on
winnings from bingo and keno will improve tax compliance and
enforcement.
4. Modify the deposit requirement for Federal unemployment (``FUTA'')
taxes
Present Law
If an employer's liability for Federal unemployment
(``FUTA'') taxes is over $100 for any quarter, it must be
deposited by the last day of the first month after the end of
the quarter. Smaller amounts are subject to less frequent
deposit rules.
Description of Proposal
The proposal would require an employer to pay Federal and
State unemployment taxes on a monthly basis in a given year if
the employer's FUTA tax liability in the prior year was $1,100
or more. The deposit with respect to wages paid during a month
would be required to be made by the last day of the following
month. A safe harbor would be provided for the required
deposits for the first two months of each calendar quarter. For
the first month in each quarter, the payment would be required
to be the lesser of 30 percent of the actual FUTA liability for
the quarter or 90 percent of the actual FUTA liability for the
month. The cumulative deposits paid in the first two months of
each quarter would be required to be the lesser of 60 percent
of the actual FUTA liability for the quarter or 90 percent of
the actual FUTA liability for the two months. The employer
would be required to pay the balance of the actual FUTA
liability for each quarter by the last day of the month
following the quarter. States would be required to establish a
monthly deposit mechanism but would be permitted to adopt a
similar safe harbor mechanism for paying State unemployment
taxes.
Effective Date
The proposal would be effective for months beginning after
December 31, 2003.
Prior Action
A substantially similar proposal was included in the
President's fiscal year 1998 budget proposal.
Analysis
Proponents of the proposal argue that the new deposit
requirements will: (1) provide a regular inflow of money to
State funds to offset the regular payment of benefits; and (2)
reduce losses to the Federal unemployment trust funds caused by
employer delinquencies. Opponents respond that the State trust
funds already have sufficient funds for the payment of benefits
and find no evidence that more frequent deposits reduce
employer delinquencies. Further, opponents contend that the
proposal's administrative burden significantly outweighs its
benefits.
5. Clarify and expand mathematical error procedures
Present Law
Taxpayer identification numbers (``TIN''s)
The Internal Revenue Service (``IRS'') may deny a personal
exemption for a taxpayer, the taxpayer's spouse or the
taxpayer's dependents if the taxpayer fails to provide a
correct TIN for each person for whom the taxpayer claims an
exemption. This TIN requirement also indirectly effects other
tax benefits currently conditioned on a taxpayer being able to
claim a personal exemption for a dependent (e.g., head-of-
household filing status and the dependent care credit). Other
tax benefits, including the adoption credit, the child tax
credit, the Hope Scholarship credit and Lifetime Learning
credit, and the earned income credit also have TIN
requirements. For most individuals, their TIN is their Social
Security Number (``SSN''). The mathematical and clerical error
procedure currently applies to the omission of a correct TIN
for purposes of personal exemptions and all of the credits
listed above except for the adoption credit.
Mathematical or clerical errors
The IRS may summarily assess additional tax due as a result
of a mathematical or clerical error without sending the
taxpayer a notice of deficiency and giving the taxpayer an
opportunity to petition the Tax Court. Where the IRS uses the
summary assessment procedure for mathematical or clerical
errors, the taxpayer must be given an explanation of the
asserted error and a period of 60 days to request that the IRS
abate its assessment. The IRS may not proceed to collect the
amount of the assessment until the taxpayer has agreed to it or
has allowed the 60-day period for objecting to expire. If the
taxpayer files a request for abatement of the assessment
specified in the notice, the IRS must abate the assessment. Any
reassessment of the abated amount is subject to the ordinary
deficiency procedures. The request for abatement of the
assessment is the only procedure a taxpayer may use prior to
paying the assessed amount in order to contest an assessment
arising out of a mathematical or clerical error. Once the
assessment is satisfied, however, the taxpayer may file a claim
for refund if he or she believes the assessment was made in
error.
Description of Proposal
The proposal would provide in the application of the
mathematical and clerical error procedure that a correct TIN is
a TIN that was assigned by the Social Security Administration
(or in certain limited cases, the IRS) to the individual
identified on the return. For this purpose the IRS would be
authorized to determine that the individual identified on the
tax return corresponds in every aspect (including, name, age,
date of birth, and SSN) to the individual to whom the TIN is
issued. The IRS would be authorized to use the mathematical and
clerical error procedure to deny eligibility for the dependent
care tax credit, the child tax credit, and the earned income
credit even though a correct TIN has been supplied if the IRS
determines that the statutory age restrictions for eligibility
for any of the respective credits is not satisfied (e.g., the
TIN issued for the child claimed as the basis of the child tax
credit identifies the child as over the age of 17 at the end of
the taxable year).
Effective Date
The proposal would be effective for taxable years ending
after the date of enactment.
Prior Action
The Small Business Job Protection Act of 1996 extended the
mathematical and clerical error procedure to the omission of a
correct TIN for personal exemptions and therefore indirectly to
other tax benefits which are currently conditioned on the
taxpayer being able to claim a personal exemption for a
dependent (e.g., head-of-household status and the dependent
care tax credit). The Taxpayer Relief Act of 1997 extended the
mathematical and clerical error procedure to the omission of a
correct TIN for the child tax credit and the Hope Scholarship
credit and Lifetime Learning tax credits.
Analysis
One argument in favor of the proposal is that treating age
discrepancies as evidence of an incorrect TIN and applying the
mathematical and clerical error procedure will increase
compliance with the Internal Revenue Code. Also, in the case of
the refundable earned income credit, the proposals will reduce
the amount of erroneously large refunds in excess of tax
liability sent to taxpayers and ease the IRS burden in trying
to recoup the erroneous portion of the refund from lower-income
taxpayers. One response to the proposal is that the IRS already
has general regulatory authority to implement it. Others
question whether the IRS has the ability to apply these new
proposals without incorrectly denying tax benefits to some
taxpayers.
H. Real Estate Investment Trust Provisions
1. Freeze grandfathered status of stapled or paired-share REITs
Present Law
In general
A real estate investment trust (``REIT'') is an entity that
receives most of its income from passive real estate related
investments and that essentially receives pass-through
treatment for income that is distributed to shareholders. If an
electing entity meets the qualifications for REIT status, the
portion of its income that is distributed to the investors each
year generally is taxed to the investors without being
subjected to a tax at the REIT level. If an entity qualifies as
a REIT by satisfying the various requirements described below,
the entity is taxable as a corporation on its real estate
investment trust taxable income (``REITTI'') and on certain
other amounts. REITTI is the taxable income of the REIT with
certain adjustments, the most significant of which is a
deduction for dividends paid. The allowance of this deduction
is the mechanism by which the REIT becomes a pass-through
entity for Federal income tax purposes.
In general, a REIT must derive its income from passive
sources and not engage in any active trade or business.
Accordingly, in addition to the tax on its REITTI, a 100-
percent tax is imposed on the net income of a REIT from
``prohibited transactions'' (sec. 857(b)(6)). A prohibited
transaction is the sale or other disposition of property held
for sale in the ordinary course of a trade or business other
than certain foreclosure property.
Requirements for REIT status
A REIT must satisfy a number of tests on a year-by-year
basis that relate to the entity's: (1) organizational
structure; (2) source of income; (3) nature of assets; and (4)
distribution of income. These tests are intended to allow pass-
through treatment only if there really is a pooling of
investment arrangement, if the entity's investments are
basically in real estate assets, and if its income is passive
income from real estate investment, as contrasted with income
from the operation of a business involving real estate. In
addition, substantially all of the entity's income must be
passed through to its shareholders on a current basis.
Under the organizational structure tests, a REIT must be
for its entire taxable year a corporation or an unincorporated
trust or association that would be taxable as a domestic
corporation but for the REIT provisions, and must be managed by
one or more trustees (sec. 856(a)). The beneficial ownership of
the entity must be evidenced by transferable shares or
certificates of ownership. Except for the first taxable year
for which an entity elects to be a REIT, the beneficial
ownership of the entity must be held by 100 or more persons.
Under the source-of-income tests, at least 95 percent of
its gross income generally must be derived from rents,
dividends, interest and certain other passive sources. In
addition, at least 75 percent of its income generally must be
from real estate sources, including rents from real property.
For purposes of these tests, rents from real property
generally include charges for services customarily rendered in
connection with the rental of real property, whether or not
such charges are separately stated. Services provided to
tenants are regarded as customary if, in the geographic market
within which the building is located, tenants in buildings that
are of a similar class (for example, luxury apartment
buildings) are customarily provided with the service. Where a
REIT furnishes non-customary services to tenants, amounts
received generally are not treated as qualifying rents unless
the services are furnished through an independent contractor
(sec. 856(d)(2)(C)). In general, an independent contractor is a
person who does not own more than a 35-percent interest in the
REIT (sec. 856(d)(3)(A)), and in which no more than a 35-
percent interest is held by persons with a 35-percent or
greater interest in the REIT (sec. 856(d)(3)(B)).
The requirements relating to the nature of the REIT's
assets includes a rule mandating that, at the close of each
quarter of its taxable year, at least 75 percent of the value
of the entity's assets be invested in real estate assets, cash
and cash items, and government securities (sec. 856(c)(5)(A)).
The income distribution requirement provides generally that
at least 95 percent of a REIT's income (with certain minor
exceptions) must be distributed to shareholders as dividends
(sec. 857(a)).
Stapled REITs
In a stapled REIT structure, both the shares of a REIT and
a C corporation may be traded, often including public trading,
but are subject to a provision that they may not be sold
separately. Thus, the REIT and the C corporation have identical
ownership at all times.
In 1984, Congress became concerned that the net effect of a
separate treatment of an active business stapled to a REIT is
to eliminate the corporate tax on an active business.
Accordingly, Congress adopted Code section 269B in the Deficit
Reduction Act of 1984 (the ``1984 Act''). The provision
relevant to REITs requires that in applying the tests for REIT
status, all stapled entities are treated as one entity (sec.
269B(a)(3)). This provision generally was effective upon
enactment. However, the 1984 Act included grandfather rules,
one of which provided that certain stapled REITs were not
subject to the new provision (sec. 136(a)(2) of the 1984 Act).
The rule provided that the new provision did not apply to a
REIT that was a part of a group of stapled entities if the
group of entities was stapled on June 30, 1983, and included a
REIT on that date.
Description of Proposal
The proposal would limit the tax benefits of the existing
stapled REITs that qualify under the 1984 Act's grandfather
rules. Under the proposal, the general rules treating the REIT
and the stapled C corporation as a single entity for purposes
of the REIT qualification tests (sec. 269B) would be applied to
properties acquired by grandfathered entities on or after the
effective date and activities or services relating to such
properties performed on or after the effective date.
Effective Date
The proposal would be effective as of the date of first
committee action.
Prior Action
No prior action.
Analysis
In a stapled REIT structure, the shares of a REIT are
stapled to a C corporation that operates an active business.
The REIT holds real estate assets used in the C corporation's
business, which it rents to the C corporation. The goal of a
stapled REIT structure is to achieve a single level of tax on
the part of a corporation's income that is attributable to the
return on its real estate assets, often where that corporation
is publicly-traded. A corporation operating a business cannot
itself meet the requirements for REIT status, especially the
rule that at least 95 percent of a REIT's gross income must be
from real property rents and other passive sources (sec.
856(c)(2)). A publicly-traded corporation generally cannot
qualify for pass-through treatment as a partnership (sec.
7704). Thus, absent a stapled REIT or similar structure, all of
the income of a publicly-traded corporation is subject to both
income tax at the corporate level and tax at the shareholder
level when dividends or liquidation proceeds are paid.
For stapled REITs that are grandfathered under the 1984
Act, the structure allows an amount of the C corporation's
income equal to the rent paid to the REIT for assets used in
the C corporation's business to be excluded from corporate-
level taxation. The C corporation claims a deduction for the
rent paid. Although the rental income is taxed to the REIT's
shareholders, who also are the C corporation's shareholders,
the corporate tax on this income has been eliminated.
The 1984 Act generally prevents these benefits by treating
the REIT and the stapled C corporation as one entity for
purposes of the tests for REIT qualification. In many
situations, combining the activities of the C corporation and
the REIT would cause all income attributable to a property to
be treated as other than rents from real property. This could
cause a violation of the 95-percent gross-income test,
resulting in disqualification of the REIT. Thus, the REIT would
be treated as a C corporation.
A small number of stapled REITs which are still in
existence are excepted from the 1984 Act's changes under the
grandfather rule. These entities thus continue to derive the
benefits of the stapled REIT structure that the 1984 Act rules
generally prevent. Recently, some of these grandfathered
stapled REITs have engaged in acquisitions of real estate
assets worth billions of dollars. 189 Moreover, some
of the grandfathered REITs have been acquired by new owners who
have changed their lines of business and vastly increased their
assets. 190
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\189\ ``Hiltons They Aren't; 2 Guys In a Hurry,'' The New York
Times, September 7, 1997, sec. 3, p. 1.
\190\ ``Pavlovian Capitalists; Stapled REITs,'' The Wall Street
Journal, April 17, 1997, p. C1.
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It can be argued that this grandfather rule, like similar
transition rules, was probably provided with the intent of
preventing the application of the new rules to some entities
already in existence, the owners of which had made large
investments based on the assumption that the tax benefits of
the structure would continue to be available. However, it can
be argued that Congress did not intend that the grandfathered
REITs would engage in large-scale acquisitions of assets or
that new owners would acquire the grandfathered REITs in order
to utilize their grandfathered status for different businesses.
Furthermore, the ability of the current grandfathered REITs to
utilize the benefits of their grandfathered status for new
asset acquisitions raises concerns of competitiveness. Because
other publicly traded entities that engage in businesses
involving real estate are taxed as corporations and, thus, are
subject to two levels of tax, they probably must charge higher
prices in order to obtain a comparable economic rate of after-
tax return on their assets.
Particular aspects of the proposal may be criticized. For
example, it may be considered unfair to apply the proposal to
all new properties acquired by grandfathered entities. In
addition, it is not clear what constitutes a ``property'' for
purposes of the proposal. A new parking lot added to an
existing structure would constitute separate property for some
tax purposes (e.g., the depreciation rules). If the concept of
a new property under the proposal is this expansive, the
required allocations of income and activities could be onerous.
Further, the application of the general rules for stapled REITs
(i.e., combining the REIT and the stapled C corporation for
purposes of the REIT qualification tests) only to specific
properties of grandfathered REITs could be viewed as overly
complicated or unfair. The proposal's approach appears to
require a tracing of income to the business conducted by the C
corporation with each new property acquired by the REIT. For
example, such tracing would be required to apply the 95-percent
gross income test to the combined entities. On the other hand,
any complexity arising the proposal is limited to a small
number of taxpayers who derive a benefit not available to other
taxpayers.
Finally, it is unclear whether the proposal would apply to
properties acquired by the REIT prior to the effective date but
leased to the C corporation thereafter.
2. Restrict impermissible businesses indirectly conducted by REITs
Present Law
In general, a real estate investment trust (``REIT'') is an
entity that receives most of its income from passive real
estate related investments and that receives pass-through
treatment for income that is distributed to shareholders. If an
electing entity meets the qualifications for REIT status, the
portion of its income that is distributed to the investors each
year generally is taxed to the investors without being
subjected to tax at the REIT level.
A REIT must satisfy a number of tests on a year-by-year
basis that relate to the entity's: (1) organizational
structure; (2) source of income; (3) nature of assets; and (4)
distribution of income.
To satisfy the REIT asset requirements, at the close of
each quarter of its taxable year, an entity must have at least
75 percent of the value of its assets invested in real estate
assets, cash and cash items, and government securities (sec.
856(c)(5)(A)). Moreover, not more than 25 percent of the value
of the REIT's assets can be invested in securities (other than
government securities and other securities described in the
preceding sentence). The securities of any one issuer may not
comprise more than five percent of the value of a REIT's
assets.
Finally, the REIT may not own more than 10 percent of the
outstanding securities of any one issuer, determined by voting
power (sec. 856(c)(4)(B)).
A REIT is permitted to have a wholly-owned subsidiary
subject to certain restrictions. A REIT's subsidiary is treated
as one with the REIT (sec. 856(i)).
Description of Proposal
The proposal would prohibit a REIT from holding more than
10 percent of the outstanding stock of any one issuer,
determined by either vote or value.
Effective Date
The proposal would be effective with respect to stock
acquired on or after the date of first committee action. Stock
acquired before such date would become subject to the proposal
when the corporation in which stock is owned engages in a trade
or business in which it does not engage on the date of first
committee action or if the corporation acquires substantial new
assets on or after such date.
Prior Action
No prior action.
Analysis
The 10-percent limitation on a REIT's ownership of the
stock of any one issuer arguably is consistent with several
other requirements for REIT status that prevent the REIT from
engaging in an active business, as opposed to passive real
estate investments. If a REIT owns a majority or even a
substantial minority position in a corporation that engages in
an active business, the REIT could in effect conduct an active
business indirectly through such corporation, although the REIT
would be prohibited from conducting such a business directly.
The present-law rule that a REIT may not own more than 10
percent of the voting securities of any one issuer could be
viewed as insufficient to prevent a REIT from having a
substantial interest in an active trade or business. Because
only voting securities are counted, a REIT can own a large
interest in the value and income of a corporation, provided the
REIT has a 10-percent-or-less voting interest. Apparently, some
REITs may have acquired large interests in the income and value
of corporations conducting real estate development or
management businesses, which the REIT could not conduct itself,
by using preferred stock structures that do not violate the
more-than-10-percent voting securities test. In some instances,
the employees and officers of the corporation owned also may be
employees and officers of the REIT. By comparison, other tax
rules that depend on ownership of a threshold level of stock
have adopted a test based on percentage of vote or value
similar to that of the proposal (e.g., secs. 355(d)(4) and
sec.957(a)).
Opponents of the proposal would argue that it adds
complexity and in some cases would cause unfair results.
Because the proposal would prevent a REIT from having a
greater-than-10-percent stock interest by vote or value, it
would be possible that a REIT investing primarily in preferred
stock of a corporation would not violate this test at the time
the stock was acquired, but subsequently would violate it due
to a decline in the corporation's value. Additional complexity
would arise from the requirement of monitoring the value of
shares.
3. Modify treatment of closely held REITs
Present Law
In general, a real estate investment trust (``REIT'') is an
entity that receives most of its income from passive real
estate related investments and that receives pass-through
treatment for income that is distributed to shareholders. If an
electing entity meets the qualifications for REIT status, the
portion of its income that is distributed to the investors each
year generally is taxed to the investors without being
subjected to tax at the REIT level.
A REIT must satisfy a number of tests on a year-by-year
basis that relate to the entity's: (1) organizational
structure; (2) source of income; (3) nature of assets; and (4)
distribution of income.
Under the organizational structure test, except for the
first taxable year for which an entity elects to be a REIT, the
beneficial ownership of the entity must be held by 100 or more
persons. Generally, no more than 50 percent of the value of the
REIT's stock can be owned by five or fewer individuals during
the last half of the taxable year. Certain attribution rules
apply in making this determination.
Description of Proposal
The proposal would impose as an additional requirement for
REIT qualification that no person can own stock of a REIT
possessing more than 50 percent of the combined voting power of
all classes of voting stock or more than 50 percent of the
total value of shares of all classes of stock. For purposes of
determining a person's stock ownership, rules similar to
attribution rules for REIT qualification under present law
would apply (sec. 856(d)(5)).
Effective Date
The proposal would be effective for entities electing REIT
status for taxable years beginning on or after the date of
first committee action.
Prior Action
No prior action.
Analysis
REITs allow individual investors to obtain a single level
of tax on passive real estate investments, often in publicly-
traded entities. Present law requires that ownership interests
must be held by at least 100 persons and that 5 or fewer
individuals cannot own more than 50 percent of the value of the
REIT. These ownership requirements indicate that Congress
intended that REIT benefits not be available to closely-held
entities. A REIT held largely by a single corporation does not
meet this objective of Congress.
It is clear that, under present law, it is unnecessary for
a corporation to establish a separate real estate entity as a
REIT in order to insure that there is a single corporate level
tax. If the separate entity is a corporation, the dividends-
received deduction and the benefits of consolidation can
eliminate a second corporate tax. If the separate entity is a
non-publicly-traded partnership or limited liability company,
only one level of tax is imposed. The REIT rules were enacted
earlier than most of the rules for other pass-through regimes
and lack some of the more sophisticated rules of such regimes
aimed at preventing unwarranted shareholder benefits. For
example, the REIT rules contain no provisions to prevent REIT
shareholders from structuring their interests in order to
divide the income from the REIT's assets among themselves in a
tax-motivated manner (cf. secs. 704(b) and (c) and
1361(b)(1)(D)). Consequently, where REIT status is elected by
an entity with a substantial corporate shareholder, a principal
reason may be to take advantage of deficiencies in the REIT
rules that have been the basis for several recently reported
tax-motivated transactions.
Congress may have believed that improper use of the REIT
rules was limited by the restrictions on REIT ownership. The
100-or-more shareholder requirement, and the rule that no more
than 50 percent of the value of the REIT's stock can be owned
by five or fewer individuals, generally require that REIT stock
be widely held, with the result that it is less likely that
shareholders will be able to agree on a structure designed to
yield tax benefits for certain shareholders. However, present
law does not contain a provision prohibiting ownership of large
amounts of a REIT's stock by one or a few corporations.
Several recent transactions have utilized REITs to obtain
tax benefits for large corporate shareholders. In such
transactions, the requirement that the REIT have 100 or more
shareholders often may be met by having related persons (such
as employees of the majority holder) acquire small amounts of
stock. The most well-known of these has been the so-called
``step-down preferred'' transaction. In such a transaction, the
REIT issues a class of preferred stock that pays
disproportionately high dividends in the REIT's early years and
``steps down'' to disproportionately low dividends in later
years. Such stock may be sold to a tax-exempt entity. One or
more corporate shareholders hold the REIT's common stock and
are in effect compensated for the preferred's dividend rights
in the early years by the right to higher payments on, or
liquidation proceeds with respect to, the common stock after
the preferred dividends ``step down.'' These corporate
shareholders generally fund the high dividends paid to the
preferred shareholders by making deductible rent payments to
the REIT for real property it leases to the corporate
shareholders. 191
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\191\ Cf. IRS Notice 97-21, 1997-11 I.R.B. 9, which denies the
benefits of a step-down preferred transaction based on a conduit
analysis.
---------------------------------------------------------------------------
By preventing a shareholder from owning a greater-than-50-
percent interest in the REIT, the proposal would substantially
reduce the ability of a single shareholder or a small group of
shareholders to utilize a REIT to achieve tax benefits based on
their individual tax situations. However, the proposal may not
prevent such structures entirely. For example, it still might
be possible under the proposal for three corporations to
acquire nearly all of the REIT's shares (with additional small
shareholders to meet the 100-shareholder test).
Opponents of the provision would argue that it adds
complexity and in some cases would prevent legitimate business
transactions. Because the proposal would prevent one
shareholder from having a greater-than-50-percent interest by
vote or value, it would be possible that a shareholder who
initially did not violate this test subsequently may violate it
due to a decline in the REIT's value. Under the proposal, the
REIT apparently would become disqualified at such time.
Similarly, the proposal could prevent a REIT's organizers from
having a single large investor for a temporary period, such as
in preparation for a public offering of the REIT's shares.
Finally, the proposal may be criticized for adding complexity
to the already complex REIT rules. For example, individual
shareholders apparently would be subject to the proposal even
though they also are subject to the present-law rule preventing
five or fewer shareholders from owning 50 percent or more of a
REIT's shares by value.
I. Earned Income Credit Compliance Provisions
1. Simplification of foster child definition under the earned income
credit
Present law
For purposes of the earned income credit (``EIC'),
qualifying children may include foster children who reside with
the taxpayer for a full year, if the taxpayer ``cares for the
foster children as the taxpayer's own children.'' (Code sec.
32(c)(3)(B)(iii)(I)). All EIC qualifying children (including
foster children) must either be under the age of 19 (24 if a
full-time student) or permanently and totally disabled. There
is no requirement that the foster child either be (1) placed in
the household by a foster care agency or (2) a relative of the
taxpayer.
Description of Proposal
For purposes of the EIC, a foster child would be defined as
a child who (1) is cared for by the taxpayer as if he or she
were the taxpayer's own child, and (2) either is the taxpayer's
niece, nephew, or sibling or was placed in the taxpayer's home
by an agency of a State or one of its political subdivisions or
by a tax-exempt child placement agency licensed by a State.
Effective Date
The proposal would be effective for taxable years beginning
after December 31, 1998.
Prior Action
A substantially similar proposal was included in a list of
eight proposals to reduce errors on tax returns with respect to
the EIC released by the Department of the Treasury on April 23,
1997. 192
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\192\ A further discussion of these proposals can be found in the
Joint Committee on Taxation document, Description of the
Administration's Proposals Relating to the Earned Income Credit (JCX-
14-97), May 7, 1997.
---------------------------------------------------------------------------
Analysis
Some advocates of this proposal contend that the element of
present law which requires that a foster child be cared for by
the taxpayer as the taxpayer's own child is open to intentional
noncompliance by some taxpayers. They continue that the
vagueness of this element of present law also creates a
compliance burden on the IRS as well as the taxpayer. They
believe that this proposal would: (1) reduce potential abuse by
tax cheats; (2) prevent unintentional errors by confused
taxpayers; and (3) provide better guidance to the IRS when
investigating questionable EIC claims.
Opponents respond that there are legitimate family living
arrangements (e.g., care for a godchild) where a taxpayer
deserves the EIC because the taxpayer is caring for the foster
child even though that child meets neither the proposed
familial relationship with the taxpayer, nor was formally
placed with the taxpayer by an agency of the State or a tax-
exempt child placement agency licensed by the State. Further,
they contend that this proposal does not reduce any ambiguity
found in present law. Since the EIC requirement that the foster
child be cared for by the taxpayer as the taxpayer's own child
is retained for all foster children, both the IRS and taxpayers
with foster children will still be required to interpret its
meaning.
2. Clarify the operation of the earned income credit where more than
one taxpayer satisfies the requirements with respect to the
same child
Present law
In general
In order to claim the earned income credit (``EIC'), an
individual must be an eligible individual. To be an eligible
individual, an individual must either have a qualifying child
or meet other requirements. In order to claim the EIC without a
qualifying child, an individual must not be a dependent and
must be over age 24 and under age 65.
Qualifying child
A qualifying child must meet a relationship test, an age
test, an identification test, and a residence test. Under the
relationship and age tests, an individual is eligible for the
EIC with respect to another person only if that other person:
(1) is a son, daughter, or adopted child (or a descendent of a
son, daughter, or adopted child); a stepson or stepdaughter; or
a foster child of the taxpayer (a foster child is defined as a
person whom the individual cares for as the individual's child;
it is not necessary to have a placement through a foster care
agency 193); and (2) is under the age of 19 at the
close of the taxable year (or is under the age of 24 at the end
of the taxable year and was a full-time student during the
taxable year), or is permanently and totally disabled. Also, if
the qualifying child is married at the close of the year, the
individual may claim the EIC for that child only if the
individual may also claim that child as a dependent.
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\193\ See discussion in Part II.I.1., above, of this pamphlet
relating to the President's proposal to simplify the foster child
definition under the earned income credit.
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To satisfy the identification test, an individual must
include on their tax return the name, age, and taxpayer
identification number (``TIN'') of each qualifying child.
The residence test requires that a qualifying child must
have the same principal place of abode as the taxpayer for more
than one-half of the taxable year (for the entire taxable year
in the case of a foster child), and that this principal place
of abode must be located in the United States. For purposes of
determining whether a qualifying child meets the residence
test, the principal place of abode shall be treated as in the
United States for any period during which a member of the Armed
Forces is stationed outside the United States while serving on
extended active duty.
Tie-breaker rule
If more than one taxpayer would be treated as an eligible
individual with respect to the same qualifying child for a
taxable year only the individual with the highest modified
adjusted gross income (``modified AGI'') is treated as an
eligible individual with respect to that child. For these
purposes, modified AGI means AGI with certain losses
disregarded and the addition of two items of nontaxable income.
The losses disregarded are: (1) net capital losses (if greater
than zero); (2) net losses from trusts and estates; (3) net
losses from nonbusiness rents and royalties; and (4) 75 percent
of the net losses from businesses, computed separately with
respect to sole proprietorships (other than in farming), sole
proprietorships in farming, and other businesses. The two items
of nontaxable income added to AGI to determine modified AGI
are: (1) tax-exempt interest; and (2) non-taxable distributions
from pensions, annuities, and individual retirement accounts
(but only if not rolled over into similar vehicles during the
applicable rollover period).
Historically, the Internal Revenue Service (``IRS'') has
interpreted this tie-breaker rule to deny the EIC to other
taxpayers meeting the definition of eligible individual
regardless of whether the taxpayer with the highest modified
AGI had claimed the EIC with respect to the child on the
taxpayer's tax return. The Tax Court in Lestrange v.
Commissioner, T.C.M. 1997-428 (1997) held that the tie-breaker
rule does not apply to deny the EIC to a taxpayer unless
another taxpayer actually claimed the EIC with respect to the
child on the taxpayer's return. The Tax Court decision hinged
on the determination that the child was not a qualifying child
with respect to the taxpayer with the highest modified AGI
because the identification test was not met by that taxpayer
with respect to the child. Under this view, because the
taxpayer with the highest modified AGI did not satisfy the
qualifying child requirement, there was not more than one
eligible individual and the tie-breaker rule did not apply.
Description of Proposal
The proposal clarifies that the identification requirement
is a requirement for claiming the EIC, rather than an element
of the definition of ``qualifying child''. Thus, the tie-
breaker rule would apply where more than one individual
otherwise could claim the same child as a qualifying child on
their respective tax returns, regardless of whether the child
is listed on any tax return. A similar change would be made to
the definition of ``eligible individual''. No inference is
intended as to the operation of the tie-breaker rule under
present law.
Effective Date
The proposal would be effective for taxable years beginning
after the date of enactment.
Analysis
Proponents of the clarification believe that it is
necessary to provide the EIC efficiently and appropriately.
They argue that the present-law rules including the residency
test are simpler and more verifiable that the old support test.
194 They continue that the tie-breaker is necessary
in all cases where more than one taxpayer could claim the same
qualifying child, to ensure that only needy taxpayers receive
the EIC. For example, a taxpayer with a qualifying child should
not qualify for the EIC if that taxpayer is sharing a household
with the taxpayer's own higher-income parent. To allow these
taxpayers to essentially elect out of the tie-breaker rule by
failing to claim the child on the return of the higher-income
parent would undermine Congressional intent with regards to the
EIC.
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\194\ The Omnibus Budget Reconciliation Act of 1990 replaced the
old EIC requirement that the taxpayer be eligible to claim a dependency
exemption with the present-law rules. Generally, the dependency
exemption requirement was not satisfied unless the taxpayer could
establish that the taxpayer had provided over one-half of the cost of
maintaining the household which included the child for the year.
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J. Other Revenue-Increase Provisions
1. Repeal percentage depletion for non-fuel minerals mined on Federal
and formerly Federal lands
Present Law
Taxpayers are allowed to deduct a reasonable allowance for
depletion relating to the acquisition and certain related costs
of mines or other hard mineral deposits. The depletion
deduction for any taxable year is calculated under either the
cost depletion method or the percentage depletion method,
whichever results in the greater allowance for depletion for
the year.
Under the cost depletion method, the taxpayer deducts that
portion of the adjusted basis of the property which is equal to
the ratio of the units sold from that property during the
taxable year, to the estimated total units remaining at the
beginning of that year.
Under the percentage depletion method, a deduction is
allowed in each taxable year for a statutory percentage of the
taxpayer's gross income from the property. The statutory
percentage for gold, silver, copper, and iron ore is 15
percent; the statutory percentage for uranium, lead, tin,
nickel, tungsten, zinc, and most other hard rock minerals is 22
percent. The percentage depletion deduction for these minerals
may not exceed 50 percent of the net income from the property
for the taxable year (computed without allowance for
depletion). Percentage depletion is not limited to the
taxpayer's basis in the property; thus, the aggregate amount of
percentage depletion deductions claimed may exceed the amount
expended by the taxpayer to acquire and develop the property.
The Mining Law of 1872 permits U.S. citizens and businesses
to freely prospect for hard rock minerals on Federal lands, and
allows them to mine the land if an economically recoverable
deposit is found. No Federal rents or royalties are imposed
upon the sale of the extracted minerals. A prospecting entity
may establish a claim to an area that it believes may contain a
mineral deposit of value and preserve its right to that claim
by paying an annual holding fee of $100 per claim. Once a
claimed mineral deposit is determined to be economically
recoverable, and at least $500 of development work has been
performed, the claim holder may apply for a ``patent'' to
obtain title to the surface and mineral rights. If approved,
the claimant can obtain full title to the land for $2.50 or
$5.00 per acre.
Description of Proposal
The proposal would repeal the present-law percentage
depletion provisions for non-fuel minerals extracted from any
land where title to the land or the right to extract minerals
from such land was originally obtained pursuant to the
provisions of the Mining Law of 1872.
Effective Date
The proposal would be effective for taxable years beginning
after the date of enactment.
Prior Action
The proposal was included in the President's fiscal year
1997 and 1998 budget proposals.
Analysis
The percentage depletion provisions generally can be viewed
as providing an incentive for mineral production. The Mining
Act of 1872 also provides incentives for mineral production by
allowing claimants to acquire mining rights on Federal lands
for less than fair market value. In cases where a taxpayer has
obtained mining rights relatively inexpensively under the
provisions of the Mining Act of 1872, it can be argued that
such taxpayers should not be entitled to the additional
benefits of the percentage depletion provisions. However, the
Administration proposal would appear to repeal the percentage
depletion provisions not only for taxpayers who acquired their
mining rights directly from the Federal Government under the
Mining Act of 1872, but also for those taxpayers who purchased
such rights from a third party who had obtained the rights
under the Mining Act of 1872. In cases where mining rights have
been transferred to an unrelated party for full value since
being acquired from the Federal Government (and before the
effective date), there is little rationale for denying the
benefits of the percentage depletion provisions to the taxpayer
currently mining the property on the basis that the original
purchaser obtained benefits under the Mining Act of
1872.195
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\195\ The Administration has indicated that it may consider a
transition rule that would address this issue.
---------------------------------------------------------------------------
2. Modify depreciation method for tax-exempt use property
Present Law
Taxpayers are allowed to recover the cost of property used
in a trade or business through annual depreciation deductions.
The depreciation deductions for most tangible property are
determined under the modified Accelerated Cost Recovery System
(``MACRS'') of section 168.196
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\196\ The Tax Reform Act of 1986 installed MACRS as the successor
system to the Accelerated Cost Recovery System (``ACRS''). ACRS
generally provided more generous depreciation allowances than MACRS for
property placed in service after 1980 and before 1987.
---------------------------------------------------------------------------
Under MACRS, depreciation for tangible personal property is
determined using accelerated methods over specified recovery
periods that are generally shorter than the class lives of the
property. Depreciation for real property is determined using
the straight-line method over 27.5 years (for residential real
property) or 39 years (for nonresidential real property). The
class life of real property generally is 40 years, whether or
not the property is residential.
Accelerated depreciation under MACRS generally is
unavailable for property that is (1) used predominantly outside
the United States, (2) financed with tax-exempt bonds, or (3)
leased to a tax-exempt entity (``tax-exempt use property'').
For this purpose, a tax-exempt entity means (1) the United
States, any State or political subdivision thereof, any
possession of the United States, or any agency or
instrumentality of any of the foregoing, (2) any organization
exempt from tax (other than farmer's cooperatives), and (3) any
foreign person or entity. Tax-exempt use property generally is
depreciated using the straight-line method over a period equal
to the greater of (1) the property's class life, or (2) 125
percent of the lease term. 197 Property used
predominantly outside the United States or financed with tax-
exempt bonds generally is depreciated using the straight-line
method over the property's class life.
---------------------------------------------------------------------------
\197\Special exemptions are provide for certain real property,
qualified technological equipment, and property subject to a short-term
lease.
---------------------------------------------------------------------------
The class lives of property are periods that had been
developed by the Treasury Department for purposes of computing
depreciation allowances under prior law. Prior to the enactment
of section 168 in 1981, depreciation deductions generally were
determined based on the taxpayers' estimates of the useful
lives of its depreciable property. Such a ``facts and
circumstances'' system often led to disputes between taxpayers
and the IRS as to the proper period over which depreciation
should be computed. Class lives for different types of property
were developed to give taxpayers safe harbors over which to
depreciate such property.
Description of Proposal
Tax-exempt use property would be depreciated using the
straight-line method over a period equal to 150 percent of the
class life of the property. The proposal would not affect the
depreciation of property other than tax-exempt use property.
Effective Date
The proposal would be effective for property placed in
service after December 31, 1998. The proposal would also be
effective for property that first becomes tax-exempt use
property after December 31, 1998, or becomes subject to a new
lease after that date.
Prior Action
No prior action.
Analysis
Theoretically, depreciation deductions for property would
be most accurately determined by ``economic depreciation.''
Under economic depreciation, property is valued and ``marked-to
market'' on an annual basis and any decrease in value from one
year to the next is allowed as a depreciation deduction.
Economic depreciation generally is conceded to be difficult to
administer due to the case-by-case, annual valuations of each
property that would be required. Because of these
administrative difficulties and in order to provide an
incentive to invest in tangible property, depreciation
deductions generally have been determined under ACRS and MACRS
since 1981. Depreciation allowances under ACRS and MACRS are
determined pursuant to statutorily mandated schedules that
often are more generous than the depreciation allowances
determined under economic depreciation.
The purpose of the special depreciation rules for tax-
exempt use property is to prevent the benefits of accelerated
depreciation from accruing to users of property who do not pay
U.S. income taxes. However, to the extent the class life of a
leased asset is shorter than the economic useful life of the
asset, and because taxpayers have control over the term of a
lease, current law may continue to provide depreciation that is
too rapid compared to economic depreciation. In such cases, the
class lives of all property, including tax-exempt use property
should be extended.
There is no empirical evidence that suggests that the class
lives of all property, or tax- exempt-use property, is too
short. The Treasury Department's Office of Tax Analysis has,
from time-to-time, issued reports on the useful lives of
specific types of property. 198 Some of these
studies have suggested that the present-law class lives are too
short for some types of property, and too long for other types
of property. Pursuant to a provision in the Omnibus Budget
Reconciliation Act of 1988, the Treasury Department may not
change the class lives of property. Such authority had been
granted by the Tax Reform Act of 1986.
---------------------------------------------------------------------------
\198\ See, Department of the Treasury, Report to Congress on the
Depreciation of Clothing Held for Rental, July 1989; Department of the
Treasury, Report to Congress on the Depreciation of Fruit and Nut
Trees, March 1990; Department of the Treasury, Report to Congress on
the Depreciation of Scientific Instruments, March 1990; Department of
the Treasury, Report to Congress on the Depreciation of Horses, March
1990; Department of the Treasury, Report to Congress on the
Depreciation of Business-Use Passenger Cars, April 1991; and Department
of the Treasury, Report to Congress on the Depreciation of Business-Use
Light Trucks, September 1991.
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3. Impose excise tax on purchase of structured settlements
Present Law
Present law provides tax-favored treatment for structured
settlement arrangements for the payment of damages on account
of personal injury or sickness.
Under present law, an exclusion from gross income is
provided for amounts received for agreeing to a qualified
assignment to the extent that the amount received does not
exceed the aggregate cost of any qualified funding asset (sec.
130). A qualified assignment means any assignment of a
liability to make periodic payments as damages (whether by suit
or agreement) on account of a personal injury or sickness (in a
case involving physical injury or physical sickness), provided
the liability is assumed from a person who is a party to the
suit or agreement, and the terms of the assignment satisfy
certain requirements. Generally, these requirements are that
(1) the periodic payments are fixed as to amount and time; (2)
the payments cannot be accelerated, deferred, increased, or
decreased by the recipient; (3) the assignee's obligation is no
greater than that of the assignor; and (4) the payments are
excludable by the recipient under section 104(a)(2) as damages
on account of personal injuries or sickness.
A qualified funding asset means an annuity contract issued
by an insurance company licensed in the U.S., or any obligation
of the United States, provided the annuity contract or
obligation meets statutory requirements. An annuity that is a
qualified funding asset is not subject to the rule requiring
current inclusion of the income on the contract which generally
applies to annuity contract holders that are not natural
persons (e.g., corporations) (sec. 72(u)(3)(C)). In addition,
when the payments on the annuity are received by the structured
settlement company and included in income, the company
generally may deduct the corresponding payments to the injured
person, who, in turn, excludes the payments from his or her
income (sec. 104). Thus, neither the amount received for
agreeing to the qualified assignment of the liability to pay
damages, nor the income on the annuity that funds the liability
to pay damages, generally is subject to tax.
Present law provides that the payments to the injured
person under the qualified assignment cannot be accelerated,
deferred, increased, or decreased by the recipient. Consistent
with these requirements, it is understood that contracts under
structured settlement arrangements generally contain anti-
assignment clauses. It is understood, however, that injured
persons may nonetheless be willing to accept discounted lump
sum payments from certain ``factoring'' companies in exchange
for their payment streams. The tax effect on the parties of
these transactions may not be completely clear under present
law.
Description of Proposal
The proposal would impose an excise tax on any person
acquiring a payment stream under a structured settlement
arrangement. The amount of the excise tax would be 20 percent
of the consideration for acquiring the payment stream. The
excise tax would not be imposed if the acquisition were
pursuant to a court order finding that the extraordinary and
unanticipated needs of the original recipient of the payment
stream render the acquisition desirable.
Effective Date
The proposal would be effective for acquisitions occurring
after the date of enactment. No inference would be intended as
the contractual validity of the acquisition transaction or its
effect on the tax treatment of any party other than the
acquiror.
Prior Action
No prior action.
Analysis
The proposal responds to the social policy concern that
injured persons may not be adequately protected financially in
transactions in which a long-term payment stream is exchanged
for a lump sum. Transfer of the payment stream under a
structured settlement arrangement arguably subverts the purpose
of the structured settlement provisions of the Code to promote
periodic payments for injured persons. The potential for deep
discounting of the value of the payment stream may financially
disadvantage injured persons that the provision was designed,
in part, to protect.
It could be argued that imposing a tax on the acquisition
of the payment stream would only worsen the risk that the
injured person would receive an excessively discounted value
for the payment stream. It is possible that the acquiror may
reduce the consideration even further by the amount of the
excise tax. It can be argued that sellers may not accept such a
deep discount in many cases, however. One possible response to
the concern relating to excessively discounted payments might
be to raise the excise tax to a level that is certain to stop
the transfers (perhaps 100 percent), or to modify the present-
law rules to impose a different penalty on transfer of the
payment stream, such as a rule of current inclusion of the
amount the structured settlement company originally received
for agreeing to the qualified assignment.
It could also be argued that it is not the function of the
tax law to prevent injured persons or their legal
representatives from transferring rights to payment. Arguably,
consumer protection and similar regulation is more properly the
role of the States than of the Federal government. On the other
hand, the tax law already provides an incentive for structured
settlement arrangements, and if practices have evolved that are
inconsistent with its purpose, addressing them should be viewed
as proper.
4. Reinstate Oil Spill Liability Trust Fund excise tax
Present Law
A 5-cents-per-barrel excise tax was imposed before January
1, 1995. Revenues from this tax were deposited in the Oil Spill
Liability Trust Fund. The tax did not apply during any calendar
quarter when the Treasury Department determined that the
unobligated balance in this Trust Fund exceeded $1 billion.
Description of Proposal
The proposal would reinstate the Oil Spill Liability Trust
Fund tax during the period after the date of the proposal's
enactment and before October 1, 2008. The proposal also would
increase the $1 billion limit on the unobligated balance in
this Oil Spill Liability Trust Fund to $5 billion.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
The President's fiscal year 1998 budget proposal included a
similar provision.
Analysis
Some view the Oil Spill Liability Trust Fund excise tax as
a tax on oil producers and consumers to fund an insurance pool
against potential environmental risks that arise from the
transport of petroleum. In this view, the tax is an insurance
premium in a mandated scheme of risk pooling. While the first
liability for damage from an oil spill remains with the owner
of oil, the tax funds a trust fund that may be drawn upon to
meet unrecovered claims that may arise from an oil spill either
upon the high seas or from ruptured domestic pipelines. The tax
and the Trust Fund represent a social insurance scheme with
risks spread across all consumers of petroleum. The analogy to
insurance is imperfect, however. The tax assessed reflects an
imperfect pricing of risks. For example, the prior-law Oil
Spill Liability Trust Fund tax was imposed at the same rate
regardless of whether the importer employed more difficult to
rupture double-hulled or single-hulled tankers.
Proponents of reimposing the Oil Spill Liability Trust Fund
excise tax suggest that the revenues would provide a cushion
for future Trust Fund program activities. However, the
Congressional authorizing committees have not notified the tax-
writing committees of either a shortfall in the amounts
required for currently authorized expenditures or of plans to
expand or extend those authorizations. Opponents of reimposing
the taxes suggest that this action should be undertaken only in
combination with such authorizing legislation.
III. OTHER MEASURES AFFECTING RECEIPTS
A. Reinstate Superfund Excise Taxes and Corporate Environmental Income
Tax
Present Law
Before January 1, 1996, four taxes were imposed to fund the
Hazardous Substance Superfund Trust Fund (``Superfund'')
program:
(1) An excise tax on petroleum and imported refined
products;
(2) An excise tax on certain hazardous chemicals,
imposed at rates that varied from $0.22 to $4.87 per
ton;
(3) An excise tax on imported substances made with
the chemicals subject to the tax in (2), above; and
(4) An income tax on corporations calculated using
the alternative minimum tax rules.
Description of Proposal
The proposal would reinstate the three Superfund excise
taxes during the period after the date of the proposal's
enactment and before October 1, 2008. The corporate
environmental income tax would be reinstated for taxable years
beginning after December 31, 1997, and before January 1, 2009.
Revenues from reinstatement of these taxes would be
deposited in the Superfund Trust Fund.
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
The President's fiscal year 1998 budget proposal included a
similar provision.
Analysis
The Superfund Trust Fund provides for certain environmental
remediation expenses. The prior-law taxes were imposed on
petroleum products, chemical products, and more generally on
large businesses. Thus, the taxes were imposed on those
taxpayers who generally were believed to represent the parties
liable for past environmental damage rather than on taxpayers
perceived to benefit from the expenditure program. Depending on
their incidence, these taxes may inexactly recoup damages from
parties held responsible for past environmental damage. For
example, the burden may fall on the current owners of
enterprises rather than those who were the owners at the time
the damage occurred. On the other hand, to the extent that
taxable products continue to create environmental harm, the
taxes may discourage overuse of such products.
Proponents of reimposing the Superfund excise taxes suggest
that the revenues can provide a cushion for ongoing Superfund
program costs, and that reimposition of these taxes is a
necessary complement to reauthorization and possible
modification of the Superfund program. Opponents suggest that
the taxes should be reimposed only as part of pending program
reform legislation. These persons suggest, in particular, that
proposals to address issues associated with so-called
``retroactive liability'' may require budgetary offsets which
could be provided by reimposing the Superfund taxes as a
component of such authorizing legislation.
B. Extend Excise Taxes on Gasoline, Diesel Fuel, and Special Motor
Fuels
Present Law
Overview
The current highway transportation excise taxes consist of:
(1) taxes on gasoline, diesel fuel, kerosene, and
special motor fuels;
(2) a retail sales tax imposed on trucks and trailers
having gross vehicle weights in excess of prescribed
thresholds;
(3) a tax on manufacturers of tires designed for use
on heavy highway vehicles; and
(4) an annual use tax imposed on trucks and tractors
having taxable gross weights in excess of prescribed
thresholds.
Special motor fuels include liquefied natural gas (``LNG'),
benzol, naphtha, liquefied petroleum gas (e.g., propane),
natural gasoline, and any other liquid (e.g., ethanol and
methanol) other than gasoline or diesel fuel. Compressed
natural gas (``CNG'') also is subject to tax as a special motor
fuel.
With the exception of 4.3 cents per gallon of the motor
fuels excise tax rates, these taxes are scheduled to expire
after September 30, 1999.
Highway motor fuels taxes
The current highway motor fuels excise tax rates are shown
in Table 4.
Table 4.--Federal Highway Trust Fund Motor Fuels Excise Tax Rates, as of
October 1, 1997\1\
[Rates shown in cents per gallon]
------------------------------------------------------------------------
Tax rate
Highway fuel \2\
------------------------------------------------------------------------
Gasoline\3\................................................ 18.3
Diesel fuel \4\............................................ 24.3
Special motor fuels generally.............................. \5\ 18.3
CNG........................................................ \6\ 4.3
------------------------------------------------------------------------
\1\ The rates shown include the 4.3-cents-per-gallon tax rate which is
transferred to the Highway Fund effective on October 1, 1997.
\2\ Effective on October 1, 1997, an additional 0.1-cent-per-gallon rate
was imposed on these motor fuels to finance the Leaking Underground
Storage Tank Trust Fund.
\3\ Gasoline used in motorboats and in certain off-highway recreational
vehicles and small engines is subject to tax in the same manner and at
the same rates as gasoline used in highway vehicles. 6.8 cents per
gallon of the revenues from the tax on gasoline used in these uses is
retained in the General Fund; the remaining 11.5 cents per gallon is
deposited in the Aquatic Resources Trust Fund (motorboat and small
engine gasoline), the Land and Water Conservation Fund ($1 million of
motorboat gasoline tax revenues), and the National Recreational Trails
Trust Fund (the ``Trails Trust Fund'') (off-highway recreational
vehicles). Transfers to these Trust Funds are scheduled to terminate
after September 30, 1998. Transfers to the Trails Trust Fund are
contingent on appropriations occurring from that Trust Fund; to date,
no appropriations have been enacted. Of the 6.8-cents-per-gallon tax,
2.5 cents per gallon is scheduled to expire after September 30, 1999.
The remaining 4.3-cents-per-gallon rate is permanent.
\4\ Kerosene is taxed at the same rate as diesel fuel.
\5\ The rate is 13.6 cents per gallon for propane, 11.9 cents per gallon
for liquefied natural gas, and 11.3 cents per gallon for methanol fuel
from natural gas, in each case based on the relative energy
equivalence of the fuel to gasoline.
\6\ The statutory rate is 48.54 cents per thousand cubic feet (``MCF').
Present law includes numerous exemptions (including partial
exemptions for specified uses of taxable fuels or for specified
fuels) typically for governments or for uses not involving use
of the highway system. Because the gasoline and diesel fuel
taxes generally are imposed before the end use of the fuel is
known, many of these exemptions are realized through refunds to
end users of tax paid by a party that processed the fuel
earlier in the distribution chain. These exempt uses and fuels
include:
(1) Use in State and local government and nonprofit
educational organization vehicles;
(2) Use in buses engaged in transporting students and
employees of schools;
(3) Use in private local mass transit buses having a
seating capacity of at least 20 adults (not including
the driver) when the buses operate under contract with
(or are subsidized by) a State or local governmental
unit;
(4) Use in private intercity buses serving the
general public along scheduled routes (totally exempt
from the gasoline tax and exempt from 17 cents per
gallon of the diesel tax); and
(5) Use in off-highway uses such as farming.
LNG, propane, CNG, and methanol derived from natural gas
are subject to reduced tax rates based on the energy
equivalence of these fuels to gasoline.
Ethanol and methanol derived from renewable sources (e.g.,
biomass) are eligible for income tax benefits (the ``alcohol
fuels credit'') equal to 54 cents per gallon (ethanol) and 60
cents per gallon (methanol). 199 In addition, small
ethanol producers are eligible for a separate 10-cents-per-
gallon credit. 200 The 54-cents-per-gallon ethanol
and 60-cents-per-gallon renewable source methanol tax credits
may be claimed through reduced excise taxes paid on gasoline
and special motor fuels as well as through credits against
income tax. 201
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\199\ The alcohol fuels credit is scheduled to expire after
December 31, 2000, or earlier, if the Highway Fund excise taxes
actually expire before that date.
\200\ The small ethanol producer credit is available on up to 15
million gallons of ethanol produced by persons whose annual production
capacity does not exceed 30 million gallons.
\201\ Authority to claim the ethanol and renewable source methanol
tax benefits through excise tax reductions is scheduled to expire after
September 30, 2000 (or earlier, if the underlying excise taxes actually
expire before September 30, 2000).
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Non-fuel Highway Fund excise taxes
In addition to the highway motor fuels excise tax revenues,
the Highway Fund receives revenues produced by three excise
taxes imposed exclusively on heavy highway vehicles or tires.
These taxes are:
(1) A 12-percent excise tax imposed on the first
retail sale of highway vehicles, tractors, and trailers
(generally, trucks having a gross vehicle weight in
excess of 33,000 pounds and trailers having such a
weight in excess of 26,000 pounds);
(2) An excise tax imposed at graduated rates on
highway tires weighing more than 40 pounds; and
(3) An annual use tax imposed on highway vehicles
having a taxable gross weight of 55,000 pounds or more.
(The maximum rate for this tax is $550 per year,
imposed on vehicles having a taxable gross weight over
75,000 pounds.)
Description of Proposal
The proposal would extend the excise taxes on nonaviation
gasoline, diesel fuel (including kerosene), and special motor
fuels that currently are scheduled to expire after September
30, 1999. (The currently scheduled, March 31, 2005, expiration
date for the Leaking Underground Storage Tank Trust Fund rate
would be retained.)
Effective Date
The proposal would be effective on the date of enactment.
Prior Action
In a separate 1997 proposal, the Administration proposed
extending all of the highway excise taxes through September 30,
2005, a part of legislation to extend Highway Trust Fund
expenditure authorizations.
Analysis
The current structure of highway transportation excise
taxes relies heavily on a 1982 DOT cost allocation study.
202 Average cost allocation is offered as an
equitable way to recover the costs incurred in provision of
highway services. One result of 1982 excise tax changes is that
users of the freight shipping services of heavy trucks bear a
heavier tax than do users of passenger automobiles. The higher
tax rates for trucks (fuel and non-fuel taxes) were imposed in
an attempt to reflect the greater road damages from trucks and
heavy trucks in particular. The structure of these taxes
demonstrates compromises reached to accommodate
administrability of the tax system to the desire to recover
costs equitably. Administrative costs could have been minimized
by relying solely on the fuels excise taxes, but the three
additional excise taxes permit policymakers to distinguish
between heavy cross-country vehicles that burn diesel fuel and
smaller, lighter local delivery vehicles that also burn diesel
fuel. Given this apparent goal, the annual use tax reflects
further compromise with the goal of administrability. The
annual use tax is the same dollar amount whether the truck
drives 5,001 miles or 100,000 miles in the year. Collecting a
tax based on actual miles driven (e.g., a ``weight-distance''
tax) would be more precise, but more difficult to administer.
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\202\ Department of Transportation, Federal Highway Administration,
Final Report on the Federal Highway Cost Allocation Study, Report of
the Secretary of Transportation to the United States Congress Pursuant
to Public Law 95-599, Surface Transportation Assistance Act of 1978
(May 1982).
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Highway Trust Fund taxes are like ``prices'' that highway
users must pay to use the roadways. To promote economic
efficiency, prices should equal society's marginal, or
incremental, cost of providing the service. The extent to which
the current highway transportation excise taxes promote the
efficient use of highway system depends upon the extent to
which these taxes approximate the incremental cost of the
Government's provision of the highway services. 203
In the presence of economies of scale, taxes that reflect
average costs may move the tax (price) further away from
marginal costs, thereby decreasing efficiency. Because these
taxes are set at average rates to apply nationally, the taxes
can never be fully efficient. It is more costly to build and
maintain roads in some geographic locations than in others. For
example, it is less expensive to build highways across flat
rural areas than through mountains or in urban areas.
Similarly, the tax and expenditure policy is unlikely to follow
cost or tax burdens imposed exactly. The excise taxes generally
apply to all motor fuel purchased, while the expenditures
(benefits) are provided only to the users of certain highways.
Any change in the taxes assessed on different highway users may
be expected to change the pattern of use of the highways by the
different users.
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\203\ For a more complete discussion of the issues of efficiency
and equity related to highway taxes see, Joint Committee on Taxation,
Present Law and Background on Transportation Excise Taxes and Trust
Fund Expenditure Programs (JCS-10-96), November 14, 1996.
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A majority of the revenues from the highway excise taxes is
dedicated to the Highway Trust Fund. Part of the fuels tax
revenues finance programs of the Aquatic Resources Trust Fund,
the Land and Water Conservation Fund, and the National
Recreational Trails Trust Fund. Extension of all of the fuels
tax rates and non-fuels highway taxes is necessary as part of
reauthorization of these programs.
The President's budget proposal addresses only extension of
the fuels taxes. In general, under the Budget Enforcement Act,
excise taxes dedicated to trust funds are assumed by the
Congressional Budget Office to be permanent, despite any
statutory expiration dates. A small portion (2.5 cents per
gallon) of the expiring taxes on gasoline blended with ethanol
and on gasoline used in motorboats is retained in the General
Fund. It is understood that the budget proposal addresses only
the fuels taxes because the Office of Management and Budget
economic forecast does not assume these General Fund components
of the fuels tax rates to be permanent. During any period when
the fuels taxes are imposed, the Congressional Budget Office
forecast assumes the entire tax rate (as opposed to just the
11.5-cents-per-gallon Trust Fund component) to be permanent.
Thus, for purposes of Congressional budget scorekeeping, this
proposal has no revenue effect.
C. Convert Airport and Airway Trust Fund Excise Taxes to Cost-Based
User Fees to Pay for Federal Aviation Administration Services
Present Law
Airport and Airway Trust Fund excise taxes with scheduled expiration
dates
Excise taxes are imposed on commercial and noncommercial
\204\ aviation to finance programs administered through the
Airport and Airway Trust Fund (the ``Airport Trust Fund'').
These excise taxes were modified and extended (through
September 30, 2007) by the Taxpayer Relief Act of 1997 (the
``1997 Act''). The following describes the current aviation
excise taxes.
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\204\ Noncommercial aviation is defined to include transportation
that does not involve the carrying of passengers or freight ``for
hire'' (e.g., corporate aircraft transporting corporate employees).
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Commercial air passenger transportation
Commercial passenger air transportation generally is
subject to one of two taxes. First, domestic air passenger
transportation is subject to a tax equal to the total of 7.5
percent of the gross amount paid by the passenger for the
transportation plus a $3 per flight segment tax.\205\ These tax
rates currently are being phased-in, as follows:
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\205\ A flight segment is transportation involving a single take-
off and a single landing.
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October 1, 1997-September 30, 1998: 9 percent of the
fare, plus $1 per domestic flight segment;
October 1, 1998-September 30, 1999: 8 percent of the
fare, plus $2 per domestic flight segment; and
October 1, 1999-December 31, 1999: 7.5 percent of the
fare, plus $2.25 per domestic flight segment.
After December 31, 1999, the ad valorem rate will remain at
7.5 percent. The domestic flight segment component of the tax
will increase to $2.50 (January 1, 2000-December 31, 2000), to
$2.75 (January 1, 2001-December 31, 2001), and to $3 (January
1, 2002-December 31, 2002). On January 1, 2003, and on each
January 1 thereafter, the fixed dollar amount per flight
segment will be indexed annually for inflation occurring after
2001.
Second, commercial air passengers arriving in the United
States from another country or departing the United States for
another country are subject to a $12 tax per arrival or
departure.
Further. amounts paid to air carriers (in cash or in kind)
for the right to award or otherwise distribute free or reduced-
rate air transportation are treated as amounts paid for taxable
air transportation, subject to a 7.5-percent ad valorem rate.
This tax applies to payments, whether made within the United
States or elsewhere, if the rights to transportation for which
payments are made can be used in whole or in part for
transportation that, if purchased directly, would be subject to
either the domestic or international passenger taxes, described
above.
Commercial air cargo transportation
Commercial transportation of cargo by air is subject to a
6.25-percent excise tax.
Noncommercial aviation
Noncommercial aviation is subject to taxes on fuels
consumed. Aviation gasoline is taxed at 15 cents per gallon and
aviation jet fuel is taxed at 17.5 cents per gallon.
Permanent aviation fuels excise tax
In addition to the taxes described above, aviation gasoline
and jet fuel is subject to a permanent 4.3-cents-per-gallon
excise tax rate. Receipts from this tax (since October 1,
1997), like the taxes with scheduled expiration dates, are
deposited in the Airport Trust Fund.
Description of Proposal
The proposal states that legislation to phase out aviation
excise taxes and to replace those taxes with cost-based user
fees will be proposed at a later date. (The budget proposal, as
transmitted, addresses only those taxes that currently are
scheduled to expire after September 30, 2007.) Under the
proposal, the aviation excise taxes would be phased out over
the period fiscal year 1999 through fiscal year 2003 (with the
first reduction on October 1, 1999, and full phase-out on
October 1, 2002). Other details of the proposal have not been
specified.
Prior Action
The proposal is similar to a proposal contained in the
President's fiscal year 1998 budget, for which details were not
submitted to the Congress. The structure and level of aviation
taxes to support the Federal Aviation Administration (the
``FAA'') was addressed in the Taxpayer Relief Act of 1997. That
Act enacted the current excise tax structure, provided that the
taxes with scheduled expiration dates would be imposed through
September 30, 2007, and transferred receipts from the permanent
4.3-cents-per-gallon aviation fuels tax (previously retained in
the General Fund) to the Airport Trust Fund.
Analysis
Because details of the proposal have not been transmitted
to the Congress, it is not possible to comment on specifics;
however, several general issues regarding substitution of user
fees for excise taxes which were raised before the Congress
during consideration of the 1997 Act may be noted.\206\
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\206\ For a more discussion of these issues, see, Joint Committee
on Taxation, Present Law and Background Information on Federal
Transportation Excise Taxes and Trust Fund Expenditure Programs (JCS-
10-96), November 14, 1996.
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Budget Act scorekeeping
The current excise taxes imposed to finance FAA activities
are classified as Federal revenues, with gross receipts from
the taxes being deposited in the Airport Trust Fund. Because of
interactions with the Federal income tax, net revenues to the
Federal Government is less than the gross receipts from these
taxes (i.e., ``net revenues'' equal approximately 75 percent of
gross excises taxes). Spending from the Airport Trust Fund is
classified as discretionary domestic spending, subject to
aggregate annual appropriation limits (``caps'') that apply to
this spending as well as other types of discretionary domestic
spending. These caps most recently were set as part of the 1997
balanced budget agreement. Because spending from the Airport
Trust Fund is subject to the discretionary domestic spending
caps, deposit of amounts in excess of net revenues from these
taxes in the Airport Trust Fund does not impact Federal budget
scorekeeping.
Proponents of changing FAA financing to user fees typically
argue that current spending levels are too low because of the
discretionary spending caps. These persons suggest that, if the
FAA were permitted to impose cost-based user fees, it could
spend the entire amount collected outside of the regular
budgetary process. However, if FAA financing and spending were
restructured using user fees and expenditures not requiring
appropriation, the discretionary domestic spending caps
established by the 1997 balanced budget agreement would have to
be reduced to prevent increases in other programs that might
produce deficit spending. Further, if the user fees were
classified as Federal revenues and the FAA were allowed to
spend more than the net revenues produced (as opposed to the
gross receipts), from a budgetary standpoint, the agency would
be engaged in deficit spending.
Under the current financing and spending structure, Airport
Trust Fund spending levels may be less than net excise tax
revenues. Any excess net revenues received are included in
calculations of the Federal deficit or surplus under the Budget
Enforcement Act. If the excise taxes were repealed, and were
not replaced by similarly treated revenue sources equal at
least to the excess of collections over expenditures, Federal
deficit or surplus calculations would be affected.
Tax vs. fee
Proponents of cost-based user fees suggest that the FAA,
not the Congress, should establish and collect appropriate fees
for the services it provides. These persons suggest that
imposition of fees by the FAA would enable that agency to
operate in a more businesslike manner. However, others point
out that care must be taken to ensure that any FAA-imposed fees
are not legally ``taxes'' because the taxing power cannot
constitutionally be delegated by the Congress.\207\ In general,
a true user fee (which an Executive agency may be authorized to
levy) may be imposed only on the class that directly avails
itself of a governmental program and may be used solely to
finance that program rather than to finance the costs of
Government generally. The amount of the fee charged to any
payor generally may not exceed the costs of providing the
services with respect to which the fee is charged. Fees are not
imposed on the general public; there must be a reasonable
connection between the payors of the fee and the agency or
function receiving the fee. Those paying a fee must have the
choice of not utilizing the governmental service or avoiding
the regulated activity and thereby avoiding the charge. If the
FAA were authorized to establish and collect cost-based user
fees, the fees would have to satisfy these criteria to avoid
being subject to challenge as unconstitutional delegations of
the taxing power. When the Congress modified and extended the
aviation excise taxes in 1997, the FAA was reported to have no
comprehensive cost accounting system upon which it could base
such fees. Further, over 50 percent of FAA costs were
identified in the then most recently conducted cost allocation
study as ``common'' costs to many sectors, requiring allocation
rules. Such allocation rules may be viewed by some as imprecise
and subject to challenge.\208\
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\207\ Article I, Section 8 of the U.S. Constitution includes the
enumerated powers of Congress the ``. . . Power To lay and collect
Taxes, Duties, Imposts, and Excises. . . .''
\208\ See, e.g., Asiana Airlines v. Federal Aviation
Administration, No. 97-135 (D.C. Cir., January 30, 1998), holding that
certain international overflight fees imposed by the FAA based on this
cost allocation study violated a statutory requirement that the fees be
cost-based.
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Cost allocation and Airport and Airway Trust fund excise tax efficiency
Setting taxes or fees on the basis of cost allocation
generally is an attempt to have the tax or fee reflect the
average cost of providing the service. Many view such pricing
as an equitable manner to recover costs. However, cost
allocation as a basis of air transportation excise tax design
may create an economically inefficient tax structure. The
provision of transportation services often requires substantial
capital investments. Fixed costs tend to be large compared with
marginal costs. For example, the construction of a bridge
across the Mississippi River requires a substantial fixed
capital investment. The additional resource costs (wear and
tear) imposed by one additional automobile on an uncongested
bridge, once the bridge has been built, is quite small in
comparison. This means that the provision of many
transportation services is often characterized by ``economies
of scale.'' Provision of a good or service is said to be
characterized by economies of scale when the average cost of
providing the good or service exceeds the marginal cost of
providing that good or service. When this occurs, the average
cost of providing the good or service is falling with each
additional unit of the good or service provided. Economists
proffer setting prices or taxes equal to marginal cost to
obtain economically efficient outcomes. However, in the
presence of substantial economies of scale, the marginal cost
is less than the average cost of providing the transportation
service and the revenues collected from equating taxes to
marginal costs would not cover the full expenditure required to
provide the service. That is, provision of the service may
require a subsidy beyond the revenues provided by the
economically efficient tax.\209\
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\209\ Some argue that the presence of economies of scale justify
Government involvement in certain infrastructure investments. They
argue that when the economies of scale are great, the potential for
cost recovery and profit from market prices may be insufficient for
private providers to undertake the investment, even though provision of
the service would create marginal benefits that exceed marginal costs.
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Cost allocation would set the price or taxes for air
transportation services at rates equal to the average cost of
services. In the presence of substantial economics of scale,
average cost pricing implies that consumers are being charged
prices in excess of marginal resource costs and that less than
the economically efficient level of transportation services are
provided. Indeed, an expansion of services would lead to a
decline in the average cost of the service to each user. If
each user could be charged that lower average price, the price
paid would still exceed the marginal cost of the provision of
the service, all costs would be recovered and net economic
well-being (efficiency) would increase. Thus, the principle of
cost allocation involves a trade-off between economic
efficiency and cost recovery.\210\
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\210\ For a discussion of ways of decreasing the inefficiencies
that arise from diverging from marginal cost pricing while raising
revenue to cover substantial fixed costs, see Congressional Budget
Office, Paying for Highways, Airways and Waterways: How Can Users Be
Charged? May 1992.
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Congressional oversight
The current financing and Airport Trust Fund spending
process involves oversight of at least four Congressional
committees in each House of Congress. Taxes are imposed and
dedicated to the Airport Trust Fund by the tax-writing
committees. Overall expenditure levels for domestic spending
are set by the budget committees. Specific expenditure purposes
are authorized by the House Committee on Transportation and
Infrastructure and the Senate Committee on Commerce, Science
and Transportation. Finally, expenditures are appropriated by
the appropriations committees of each House. Proponents of
changing FAA financing and spending authority as proposed by
the Administration suggest that such extensive Congressional
oversight is unnecessary. At a minimum, the Administration's
proposal could eliminate the oversight roles of the tax-writing
and appropriations committees. Others suggest that the
involvement of multiple Congressional committees promotes
better prioritization of actual FAA spending needs within the
framework of the overall system of Federal revenues and outlays
and a more efficient use of FAA resources.
D. Tobacco Legislation
Present Law and Background
There are no special rules limiting the liability of
manufacturers and sellers of tobacco products. Although the
tobacco industry has agreed to certain voluntary limitations on
its ability to advertise products, the constitutionality of
mandatory limitations has not been established.
A number of States have brought suit against the
manufacturers of tobacco products. These suits generally allege
that the tobacco companies were negligent in that they failed
to exercise reasonable care in the design, manufacture and
marketing of cigarettes and other tobacco products. These suits
further allege that the tobacco companies sold dangerous and
defective products, suppressed technologies that could have
resulted in safer products, and engaged in false advertising,
deceit and fraud. Some of these suits also allege violations of
the Federal Racketeer Influenced and Corrupt Organizations Act
(RICO), Federal anti-trust statutes, and other Federal and
State laws.
The States' suits generally have sought compensation for
the costs attributable to smoking that the litigant States have
incurred through the Medicaid Program, the State's employee
retirement program, the State's employee health insurance
program, and through charity care. These suits generally also
have sought injunctive relief that would prohibit certain types
of marketing of tobacco products, particularly cigarettes and
smokeless tobacco.
Settlements have been filed in three states: Florida;
Mississippi; and Texas.\211\ These settlements provide for the
payment of substantial monetary damages to the States and
require the tobacco companies to fund certain anti-smoking
initiatives and change their marketing practices. The terms of
these settlements may be modified if a proposed nationwide
resolution \212\ advanced by certain tobacco companies and
certain States is enacted.
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\211\ Settlements have been approved by the courts in Florida and
Mississippi, approval is pending in Texas.
\212\ The proposed resolution is memorialized in a document marked
``for settlement discussion purposes only'' and dated June 20, 1997.
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The proposed nationwide resolution provides for the payment
by the tobacco companies to the various States and the Federal
Government of a lump sum payment of $10 billion and base
payments with a face value totaling $358.5 billion over 25
years. The actual amount that would be paid under the proposed
nationwide resolution could be more or less, depending upon
certain factors. In addition, the proposed nationwide
resolution would place significant restrictions on the
marketing and advertising of tobacco products, clarify the
scope of FDA authority over tobacco, and establish nationwide
standards for second-hand smoke.
The proposed nationwide resolution is contingent on the
enactment of Federal legislation that would limit the potential
civil liability of the tobacco companies to private individuals
for the tobacco companies'' past and future conduct. Such
legislation would cap the amount the tobacco companies could be
required to pay as damages in any year, prohibit class action
suits, make certain evidence inadmissible and (with regard to
past conduct of the tobacco companies only) prohibit punitive
damages.
Several bills have been introduced in the 105th Congress
that follow the terms of the proposed nationwide resolution
with certain changes. In addition, other legislation has been
introduced in the 105th Congress that would increase the excise
tax on tobacco products.
Description of Proposal
The President's budget for fiscal year 1999 does not
include a specific proposal related to the treatment of tobacco
products or the proposed settlement. However, the budget does
include ``receipts from tobacco legislation'' of $9.795 billion
in fiscal year 1999, $11.787 billion in 2000, $13.283 billion
in 2001, $14.544 billion in 2002, and $16.085 billion in 2003,
for a five-year total of $65.494 billion.
Prior Action
Excise taxes on tobacco products were last increased in the
Balanced Budget Act of 1997.
E. Other Provisions Affect Receipts
Certain of the outlay proposals contained in the
President's budget result in changes in receipts. These
provisions are as follows:
1. Expand use of Federal highway monies to include use for certain
``creative financing'' projects and for State infrastructure
bank programs
Interest on State and local government bonds is tax-exempt
if the bonds are used to finance activities carried out and
paid for by these governments. Governmentally owned and
maintained highways, transit systems, and rail systems are
eligible for this financing. Interest on bonds issued to
finance activities of private businesses (``private activity
bonds'') is taxable unless a specific exception is included in
the Code. The private business activities for which tax-exempt
bond financing is available do not include privately owned and/
or operated highways (e.g., private toll roads). Tax-exempt
private activity bonds may be issued, subject to certain
limits, to finance mass transit and high-speed intercity rail
facilities (other than rolling stock).
The proposal would authorize the use of Federal highway
monies to provide credit enhancement to certain highway
projects, such as toll roads, transit, and high-speed intercity
rail facilities. The credit enhancement could be provided
through direct loans, letters of credit, or loan guarantees,
each of which could be used to leverage issuance of larger
amounts of tax-exempt bonds. The proposal further would
authorize the use of Federal highway monies for funding of
State infrastructure banks. These banks would serve as
revolving pools of funds for financing of transportation
projects (including leveraged financing and credit
enhancement).
The direct effect of the proposal would be to increase
issuance of long-term tax-exempt bonds by expanding the revenue
sources available to repay (or secure repayment of)
transportation debt.
2. Allow Federal housing funds to be used to leverage tax-exempt bond
financed low-income housing credit projects
Present law provides an income tax credit for low-income
rental housing. In general, the credit is paid over 10 years
and is equal to 70 percent of the basis of newly constructed
low-income housing units. The credit percentage is reduce to 30
percent in the case of existing housing and of housing that
receives other Federal subsidies, including tax-exempt bond
financing. In general, each State annually may allocate credits
equal $1.25 per resident of the State. Credits for low-income
housing projects financed with the proceeds of tax-exempt State
or local government bonds are not subject to this volume limit.
Tax-exempt bonds may be issued to finance activities that
are carried out by and paid for by States and local
governments. Interest on bonds issued by these governments to
finance activities of private businesses (``private activity
bonds'') is taxable unless a specific exception is included in
the Code. One such exception allows issuance of tax-exempt
private activity bonds to finance low-income rental housing,
defined in generally the same manner as under the low-income
housing credit provision. Issuance of most tax-exempt private
activity bonds is subject to annual State volume limits of $50
per resident ($150 million, if greater).
The proposal would allow Federal housing monies to be used
to establish State revolving funds to be used to provide
additional security for repayment of tax-exempt debt.\213\
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\213\ The President's budget proposal includes an unrelated
proposal to increase the State low-income housing credit limit. (See,
discussion in Part I.F.1., above.)
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The proposal can be expected to result in increased
issuance of tax-exempt bonds and in increased utilization of
low-income housing income tax credits, which would be available
without regard to the low-income housing credit volume limit.
3. Employer buy-in (COBRA continuation coverage) for certain retirees
Under the proposal, the termination of retiree health
benefits for retirees age 55 to 64 and their dependents would
become a COBRA qualifying event. Affected retirees would be
eligible to enroll in the health plan of their former employer,
and would be required to pay a premium no greater than 125
percent of the average premium for active employees of the
former employer. The affected retirees would remain eligible
for the COBRA continuation coverage until they reach age 65.
This proposal would have no effect on Federal outlays, because
the cost would be paid by the private sector. However, in many
cases the cost of providing the COBRA coverage would exceed 125
percent of the premium for active employees. The additional
costs would be borne by the former employers providing the
coverage, resulting in a reduction in taxable income. Thus the
proposal would result in an indirect reduction in Federal tax
revenues.
4. Consumer bill of rights and responsibilities
The proposal would require that private health plans
implement a series of consumer protection initiatives,
including enhanced information disclosure, an expansion of the
grievance and appeal process, and enhanced access to specialty
care. These consumer protection initiatives will result in a
small increase in health care costs, and in particular, a small
increase in average premiums for employer-sponsored health
plans. This will result in an increase in employee compensation
paid in nontaxable form, which will result in an indirect
decline in Federal tax revenues.