[JPRT 109-1-06]
[From the U.S. Government Publishing Office]




[JOINT COMMITTEE PRINT]
 
DESCRIPTION OF REVENUE PROVISIONS 
CONTAINED IN THE PRESIDENT'S 
FISCAL YEAR 2007 BUDGET PROPOSAL

Prepared by the Staff 
of the 
JOINT COMMITTEE ON TAXATION







March 2006


U.S. Government Printing Office 
Washington: 2006
JCS-1-06




[JOINT COMMITTEE PRINT]


DESCRIPTION OF REVENUE PROVISIONS 
CONTAINED IN THE PRESIDENT'S 
FISCAL YEAR 2007 BUDGET PROPOSAL

Prepared by the Staff 
of the 
JOINT COMMITTEE ON TAXATION





March 2006


U.S. Government Printing Office 
Washington: 2006
JCS-1-06




CONTENTS
								        Page
INTRODUCTION.............................................................1
I. MAKING PERMANENT TAX CUTS ENACTED IN 2001 AND 2003....................2
A. Permanently Extend Certain Provisions Expiring  Under EGTRRA and JGTRRA
   ......................................................................2
II TAX INCENTIVES
Provisions Related to Savings............................................6
1. Expansion of tax free savings opportunities...........................6
2. Consolidation of employer-based savings accounts.....................18
3. Individual development accounts......................................30
B. Increase Section 179 Expensing.......................................34
C. Health Care Provisions...............................................37
1. Facilitate the growth of HSA-eligible health coverage................37
2. Modify the refundable credit for health insurance costs of eligible
individuals.............................................................51
3. Expand human clinical trial expenses qualifying for the orphan drug tax
credit..................................................................58
D. Provisions Relating to Charitable Giving.............................61
1. Permit tax-free withdrawals from individual retirement arrangements for 
charitable contributions................................................61
2. Expand and increase the enhanced charitable deduction for
contributions of 
food inventory..........................................................65
3. Reform excise tax based on investment income of private foundations	71
4. Modify tax on unrelated business taxable income of charitable remainder
trusts..................................................................75
5. Modify the basis adjustment to stock of S corporations contributing
appreciated ............................................................78
6. Repeal the $150 million limit for qualified 501(c)(3) bonds..........79
7. Repeal the restrictions on the use of qualified 501(c)(3) bonds
for residential rental property.........................................81
E  Extend the Above-the-Line Deduction for Qualified Out-of-Pocket
Classroom Expenses......................................................85
F. Establish Opportunity Zones..........................................89
G. Permanently Extend Expensing of Brownfields Remediation Costs........96
H. Restructure Assistance to New York...................................99
III.SIMPLY THE TAX LAWS FOR FAMILIES...................................105
A. Clarify Uniform Definition of Child.................................105
B. Simplify EIC Eligibility Requirements Regarding Filing Status
Presence of Children, and Work and Immigrant Status....................111
C. Reduce Computational Complexity of Refundable
 Child Tax Credit......................................................117




IV. PROVISIONS RELATED TO THE EMPLOYER-BASED PENSION SYSTEM............120
A. Provisions Relating to Cash Balance Plans...........................120
B. Strengthen Funding for Single-Employer Pension Plans................138
1. Background and summary..............................................138
2. Funding and deduction rules.........................................139
3. Form 5500, Schedule B actuarial statement and summary annual
report	158
4. Treatment of grandfathered floor-offset plans.......................163
5. Limitations on plans funded below target levels.....................165
6. Eliminate plant shutdown benefits	171
7. Proposals relating to the Pension Benefit Guaranty Corporation
("PBGC")...............................................................174
C. Reflect Market Interest Rates in Lump-Sum Payments..................186
V. TAX SHELTERS, ABUSIVE TRANSACTIONS, AND TAX COMPLIANCE..............190
A. Combat Abusive Foreign Tax Credit Transactions......................190
B. Modify the Active Trade or Business Test for Certain Corporate
Divisions..............................................................192
C. Impose Penalties on Charities that Fail to Enforce
Conservation Easements.................................................198
D. Eliminate the Special Exclusion from Unrelated Business Taxable
Income ("UBIT") for Gain or Loss on Sale or Exchange of Certain
Brownfield Properties..................................................201
E. Limit Related-Party Interest Deductions.............................211
F. Modify Certain Tax Rules for Qualified Tuition Programs.............214
VI.TAX ADMINISTRATION PROVISIONS AND UNEMPLOYMENT INSURANCE............223
A. IRS Restructuring and Reform Act of 1998............................223
1. Modify section 1203 of the IRS Restructuring and
Reform Act of 1998.....................................................223
2. Modifications with respect to frivolous returns and
submissions............................................................226
3. Termination of installment agreements...............................228
4. Consolidate review of collection due process cases in the United
States Tax Court.......................................................230
5. Office of Chief Counsel review of offers in compromise..............231
B. Initiate Internal Revenue Service ("IRS") Cost Saving Measures......233
1. Allow the Financial Management Service to retain transaction
fees from levied amounts...............................................233
2. Expand the authority to require electronic filing by large
businesses and exempt organizations....................................233
C. Other Provisions....................................................235
1. Allow Internal Revenue Service ("IRS") to access information
in the National 
Directory of New Hires ("NDNH")........................................235
2. Extension of IRS authority to fund undercover operations............236
D. Reduce the Tax Gap..................................................238
1. Implement standards clarifying when employee leasing companies can be held 
liable for their clients' Federal employment taxes.....................238
2. Increased information reporting on payment card transactions........242
3. Increased information reporting for certain government payments for goods 
and services...........................................................243
4. Amend collection due process procedures for employment tax
liabilities............................................................245
5. Expand the signature requirement and penalty provisions applicable to paid 
preparers..............................................................247
E  Strengthen the Financial Integrity of Unemployment Insurance........249
1. Reduce improper benefit payments and tax avoidance..................249
2. Extension of Federal Unemployment Surtax............................251
VII. MODIFY ENERGY POLICY ACT OF 2005..................................253
A. Repeal Temporary 15-Year Recovery Period for Natural Gas
Distribution Lines.....................................................253
B. Modify Amortization for Certain Geological and Geophysical
Expenditures...........................................................256
VIII.EXPIRING PROVISIONS...............................................258
A. Extend Alternative Minimum Tax Relief for Individuals...............258
B. Permanently Extend the Research and Experimentation
("R&E") Tax Credit.....................................................261
C. Extend and Modify the Work Opportunity Tax Credit and
Welfare-to-Work Tax Credit.............................................278
D. Extend District of Columbia Homebuyer Tax Credit....................286
E. Extend Authority to Issue Qualified Zone Academy Bonds..............289
F. Extend Provisions Permitting Disclosure of Tax Return
Information Relating to Terrorist Activity.............................294
G. Permanently Extend and Expand Disclosure of Tax Return
Information for Administration of Student Loans........................300
H. Extend Excise Tax on Coal at Current Rates..........................304
I. Election to Treat Combat Pay as Earned Income for
Purposes of the Earned Income Credit...................................306
IX.OTHER PROVISIONS MODIFYING THE INTERNAL REVENUE CODE................308
A. Extension of the Rate of Rum Excise Tax Cover Over to Puerto
Rico and Virgin Islands................................................308
B. Establish Program of User Fees for Certain Services Provided to
the Alcohol Industry by the Alcohol and Tobacco Tax and Trade
Bureau.................................................................310
ESTIMATED BUDGET EFFECTS OF THE REVENUE PROVISIONS CONTAINED 
IN THE PRESIDENT'S FISCAL YEAR 2007 BUDGET PROPOSAL....................314





INTRODUCTION
This document,  prepared by the staff of the Joint Committee on Taxation,
provides a description and analysis of the revenue provisions modifying 
the Internal Revenue Code of 1986 (the "Code") that are contained in the 
President's fiscal year 2007 budget proposal, as submitted to the Congress
on February 6, 2006.   The document generally follows the order of the 
proposals as included in the Department of the Treasury's explanation of 
the President's budget proposal.   For each provision, there is a 
description of present law and the proposal (including effective date), 
a reference to relevant prior budget proposals or recent legislative 
action, and an analysis of policy issues related to the proposal. 


I.	MAKING PERMANENT TAX CUTS ENACTED IN 2001 AND 2003 
A.	Permanently Extend Certain Provisions Expiring  
                       Under EGTRRA and JGTRRA 
                             Present Law 
                             
The Economic Growth and Tax Relief Reconciliation Act of 2001
 ("EGTRRA") The Economic Growth and Tax Relief Reconciliation Act 
of 2001 ("EGTRRA") made a number of changes to the Federal tax 
laws, including reducing individual tax rates, repealing the 
estate tax, increasing and expanding various child-related 
credits, providing tax relief to married couples, providing 
additional education-related tax incentives, increasing and 
expanding various pension and retirement-saving incentives, 
and providing individuals relief relating to the alternative 
minimum tax.  However, in order to comply with reconciliation 
procedures under the Congressional Budget Act of 1974, EGTRRA 
included a "sunset" provision, pursuant to which the provisions 
of the Act expire at the end of 2010.  Specifically, EGTRRA's 
provisions do not apply for taxable, plan, or limitation years 
beginning after December 31, 2010, or to estates of decedents 
dying after, or gifts or generation-skipping transfers made 
after, December 31, 2010.

EGTRRA provides that, as of the effective date of the sunset, 
both the Code and the Employee Retirement Income Security Act 
of 1974 ("ERISA") will be applied as though EGTRRA had never 
been enacted.  For example,  the estate tax, which EGTRRA 
repeals for decedents dying in 2010, will return as to 
decedents dying after 2010, in pre-EGTRRA form, without the 
various interim changes made by the Act (e.g., the rate 
reductions and exemption equivalent amount increases applicable 
to decedents dying before 2010). Similarly, the top individual 
marginal income tax rate, which EGTRRA reduced to 35 percent 
will return to its pre-EGTRRA level of 39.6 percent 
in 2011 under present law.  Likewise beginning in 2011, 
all other provisions of the Code and ERISA will be applied as 
though the relevant provisions of EGTRRA had never been enacted. 

The Jobs and Growth Tax Relief Reconciliation Act of 2003 ("JGTRRA") 

In general

The Jobs and Growth Tax Relief Reconciliation Act of 2003 ("JGTRRA") 
changed the expensing of certain depreciable business assets, 
individual capital gains tax rates and the tax rates on dividends 
received by individuals.  The modifications to the expensing 
provision sunset for taxable years beginning after 
December 31, 2007.  The capital gains and dividend rate provisions 
sunset for taxable years beginning after December 31, 2008. 

Expensing provisions 

Section 179 provides that the maximum amount a taxpayer may 
expense, for taxable years beginning in 2003 through 2007, is 
$100,000 of the cost of qualifying property placed in service 
for the taxable year. In general, qualifying property is 
defined as depreciable tangible personal property that is 
purchased for use in the active conduct of a trade or business. 
Off-the-shelf computer software placed in service in taxable years 
beginning before 2008 is treated as qualifying property.  
The $100,000 amount is reduced (but not below zero) by the amount 
by which the cost of qualifying property placed in service during 
the taxable year exceeds $400,000.The $100,000 and $400,000 
amounts are indexed for inflation for taxable years beginning 
after 2003 and before 2008.  

An expensing election is made under rules prescribed by the Secretary 
(sec. 179(c)(1)).  Under Treas. Reg. sec. 1.179-5, applicable to 
property placed in service in taxable years beginning after 2002 and 
before 2008, a taxpayer is permitted to make or revoke an election 
under section 179 without the consent of the Commissioner on an 
amended Federal tax return for that taxable year. This amended 
return must be filed within the time prescribed by law for filing 
an amended return for the taxable year. For taxable years beginning 
in 2008 and thereafter, an expensing election may be revoked only 
with consent of the Commissioner (sec. 179(c)(2)). 

Individual capital gains rates 

Under JGTRRA, for taxable years beginning before January 1, 2009,
generally the maximum rate of tax on net capital 
gain of a non-corporate taxpayer is 15 percent.  In addition, 
any net capital gain which otherwise would have been taxed at a 
10- or 15-percent rate generally is taxed at a five-percent rate 
(zero for taxable years beginning after 2007). For taxable years 
beginning after December 31, 2008, generally the rates on net 
capital gain are 20 percent and 10 percent, respectively.  
Any gain from the sale or exchange of property held more than 
five years that would otherwise be taxed at the 10 percent rate 
is taxed at an eight percent rate.  Any gain from the sale or 
exchange of property held more than five years and the holding 
period for which began after December 31, 2000, which would 
otherwise be taxed at a 20 percent rate is taxed at an 
18-percent rate. 

Taxation of dividends received by individuals 

Under rules enacted in JGTRRA, dividends received by a non-corporate 
shareholder from domestic corporations and qualified foreign 
corporations generally are taxed at the same rates that apply to 
net capital gain.  Thus, dividends received by an individual, 
estate, or trust are taxed at rates of five (zero for taxable 
years beginning after 2007) and 15 percent.  This treatment 
applies to taxable years beginning before January 1, 2009. 

For taxable years beginning after December 31, 2008,
dividends received by a non-corporate shareholder are taxed at 
the same rates as ordinary income. 


                       Description of Proposal

The proposal repeals the sunset provisions of EGTRRA and JGTRRA. 

Specifically, the proposal permanently extends all provisions of 
EGTRRA that expire at the end of 2010.  Thus, the estate tax 


remains repealed after 2010, and the individual rate reductions 
and other provisions of the Act that are in effect in 2010 will 
remain in place after 2010.\4\  

Also, the proposal permanently extends the provisions of JGTRRA 
relating to expensing,\5\  capital gains, and dividends. 

Effective date.The proposal is effective on the date of enactment. 


                             Analysis

In general

The policy merits of permanently extending the provisions of EGTRRA 
and JGTRRA that sunset depend on considerations specific to each 
provision. In general, however, advocates of eliminating the sunset 
provisions may argue that it was never anticipated that the sunset 
actually would be allowed to take effect, and that eliminating them 
promptly would promote stability and rationality in the tax law.  
In this view, if the sunsets were eliminated, other rules of EGTRRA 
and JGTRRA that phase in or phase out provisions over the 
immediately preceding years would be made more rational.  On the 
other hand, others may argue that certain provisions 
of EGTRRA and JGTRRA would not have been enacted at all, or would 
not have been phased in or phased out in the same manner, if the 
sunset provisions had not been included in EGTRRA and JGTRRA, 
respectively. 


COMPLEXITY ISSUES

The present-law sunset provisions of EGTRRA and JGTRRA arguably 
contribute to complexity by requiring taxpayers to contend with 
(at least) two different possible states of the law in planning 
their affairs.  For example, under the sunset provision of 
EGTRRA, an individual planning his or her estate will face very 
different tax regimes depending on whether the individual dies 
in 2010 (estate tax repealed) or 2011 (estate tax not repealed). 
This "cliff effect" requires taxpayers to plan an estate in such 
a way as to be prepared for both contingencies, thereby creating 
a great deal of complexity.  On the other hand, some may 
argue that this kind of uncertainty is always present to some 
degree-with or without a sunset provision, taxpayers always 
face some risk that the Congress will change a provision of 
law relevant to the planning of their affairs.  Others may 
acknowledge this fact, but nevertheless argue that the sunset 
provision creates an unusual degree of uncertainty and complexity 
as to the areas covered by the Act, because they consider 

it unlikely that the sunset will actually go into effect.  
In this view, the sunset provision of EGTRRA leaves taxpayers 
with less guidance as to the future state of the 

----------------------------

   \4\ However, certain provisions expire separately under the 
   Act before the end of 2010.  For example, the increased AMT 
   exemption amounts expire after 2005, and thus is unaffected 
   by the proposal. 

    \5\ The President's fiscal 2007 budget proposal includes a 
    separate proposal to increase the $100,000 and $400,000 
    amounts under section 179 to $200,000 and $800,000, 
    respectively.  That proposal is described in section II. B. 
    of this document. 


law than is usually available, making it difficult 
to arrange their affairs.  In addition to the complexity created by 
the need to plan for the sunset, uncertainty about the timing and 
details of how the sunset might be eliminated arguably creates 
further complexity.  

Even if it is assumed that the sunset provisions will take effect, 
it is not clear how the sunsets would apply to certain provisions. 
It would be relatively simple to apply the EGTRRA sunset to some 
provisions, such as the individual rate reductions.  With respect 
to other provisions, however, further guidance would be needed as 
to the effect of the sunset. For example, if the Code will be 
applied after 2010 as if the Act had never been enacted, then one 
possible interpretation of the pension provisions is that 
contributions made while EGTRRA was in effect will no longer be 
valid, possibly resulting in the disqualification of plans.  
While this result was likely not intended, without further guidance 
taxpayers may be unsure as to the effect of the sunset. 

More broadly, in weighing the overall complexity effects of the 
present-law sunsets and the proposed sunset repeal, some would point 
out that the sunset provisions are not the only feature of EGTRRA 
and JGTRRA that generates "cliff effects" and similar sources of 
uncertainty and complexity for taxpayers.  For example, under 
EGTRRA's estate tax provisions, a decedent dying in 2008 has an 
exemption equivalent amount of $2 million, one dying in 2009 has 
an exemption equivalent amount of $3.5 million, and 
one dying in 2010 effectively has an infinite exemption but not 
a complete "step-up" in the basis of assets. Thus, the estates of 
individuals at certain wealth levels will incur significant estate 
tax if they die in 2008, but none at all if they die in 2009; the 
estates of individuals at other wealth levels will incur significant 
estate tax if they die in 2009, but none at all if they die in 2010. 
These discontinuities are not caused by the sunset provisions, but 
they generate a similar sort of uncertainty and complexity for many 
taxpayers.  Similar phase-ins and phase-outs are found in other 
provisions of EGTRRA and generate complexity and uncertainty, 
irrespective of whether EGTRRA as a whole sunsets or not. In light of 
these issues, some may argue that a more detailed reconsideration of 
EGTRRA or certain of its provisions would better serve the goal of 
tax simplification. 

Beyond phase-ins and phase-outs, some may argue that EGTRRA included 
other provisions that increased the complexity of the Code, and that 
allowing those provisions to expire at the end of 2010 (or 
effectively requiring that they be reconsidered before then) may 
reduce complexity, albeit potentially years in the future.  Others 
would argue that some of EGTRRA's provisions reduced complexity, 
such as the repeal of the overall limitation on itemized deductions 
and changes relating to the earned income tax credit, and that 
permanently extending these provisions would contribute to 
simplification of the tax laws. 

                             Prior Action

A similar proposal was included in the President's fiscal year 2003, 
2004, 2005, and 2006 budget proposals. 




II.	TAX INCENTIVES
A.	Provisions Related to Savings
1.	Expansion of tax free savings opportunities

Present Law

In general

Present law provides for a number of vehicles that permit individuals 
to save on a tax-favored basis.  These savings vehicles have a variety 
of purposes, including encouraging saving for retirement, encouraging 
saving for particular purposes such as education or health care, and 
encouraging saving generally. 

The present-law provisions include individual retirement 
arrangements, qualified retirement plans and similar employer-sponsored 
arrangements, Coverdell education savings accounts, qualified tuition 
programs, health savings accounts, Archer medical savings accounts, 
annuity contracts, and life insurance.  Certain of these arrangements 
are discussed in more detail below. 

Individual retirement arrangements ("IRAs") 

In general

There are two general types of individual retirement arrangements 
("IRAs") under present law: traditional IRAs,  to which both 
deductible and nondeductible contributions may be made,  and Roth 
IRAs.   The Federal income tax rules regarding each type of IRA 
(and IRA contributions) differ. 

The maximum annual deductible and nondeductible contributions that 
can be made to a traditional IRA and the maximum contribution that 
can be made to a Roth IRA by or on behalf of an individual varies 
depending on the particular circumstances, including the 
individual's income.  However, the contribution limits for IRAs are 
 coordinated so that the maximum annual contribution that can be made 
to all of an individual's IRAs is the lesser of a certain dollar 
amount ($4,000 for 2006) or the individual's compensation.  In the 
case of a married couple,contributions can be made up to the dollar 
limit for each spouse if the combined compensation of the spouses is 
at least equal to the contributed amount. An individual who 
has attained age 50 before the end of the taxable year may also make 
catch-up contributions to an IRA.  For this 

----------------------------------

   \6\ Sec. 408.
   \7\ Sec. 219.
   \8\ Sec. 408A.



purpose, the dollar limit is 
increased by a certain dollar amount ($1,000 for 2006).   IRA 
contributions generally must be made in cash.

Traditional IRAs

An individual may make deductible contributions to a traditional IRA 
up to the IRA contribution limit if neither the individual nor the 
individual's spouse is an active participant in an employer-sponsored 
retirement plan. If an individual (or the individual's spouse) is an 
active participant in an employer-sponsored retirement plan, the 
deduction is phased out fortaxpayers with adjusted gross income over 
certain levels for the taxable year.  The adjusted gross income 
phase-out ranges are:  (1) for single taxpayers, $50,000 to $60,000; 
(2) for married taxpayers filing joint returns, $75,000 to $85,000 
for 2006 and $80,000 to $100,000 for years after 2006 and (3) for 
married taxpayers filing separate returns, $0 to $10,000.  If an 
individual is not an active participant in an employer-sponsored 
retirement plan, but the individual's spouse is, the deduction is 
phased out for taxpayers with adjusted gross income between 
$150,000 and $160,000. 

To the extent an individual cannot or does not make deductible 
contributions to an IRA or contributions to a Roth IRA, the 
individual may make nondeductible contributions to a traditional 
IRA, subject to the same limits as deductible contributions.  An 
individual who has attained age 50 before the end of the taxable 
year may also make nondeductible catch-up contributions to an IRA. 

An individual who has attained age 70-ï¿½ prior to the close of a 
year is not permitted to make contributions to a traditional IRA. 

Amounts held in a traditional IRA are includible in income when withdrawn, 
except to the extent the withdrawal is a return of nondeductible 
contributions.  Early withdrawals from an IRA generally are subject to an 
additional 10-percent tax.   That is, includible amounts withdrawn prior 
to attainment of age 59-ï¿½ are subject to an additional 10-percent tax, 
unless the withdrawal is due to death or disability, is made in the form 
of certain periodic payments, is used to pay medical expenses in excess of 
7.5 percent of adjusted gross income, is used to purchase health insurance 
of certain unemployed individuals, is used for higher education expenses, 
or is used for first-time homebuyer expenses of up to $10,000. 


  /9/ Under the Economic Growth and Tax Relief Reconciliation Act of 2001 
   ("EGTRRA"), the dollar limit on IRA contributions increases to $5,000 
   in 2008, with indexing for inflation thereafter, and the catch-up limit 
   is indexed for inflation for years after 2006. The provisions of EGTRRA 
   generally do not apply for years beginning after December 31, 2010.  As 
   a result, the dollar limit on annual IRA contributions is $2,000 for  
   years after 2010, and catch-ups contributions are not permitted.  A  
   proposal to make the EGTRRA provisions that expire on December 31, 
   2010, permanent is discussed in Part I of this document. 
   
   /10/ Sec, 72(t). 

Distributions from traditional IRAs generally are required to begin 
by the April 1 of the year following the year in which the IRA owner 
attains age 70.  If an IRA owner dies after minimum required 
distributions have begun, the remaining interest must be distributed 
at least as rapidly as under the minimum distribution method being 
used as of the date of death. If the IRA owner dies before minimum 
 distributions have begun, then the entire remaining interest must 
generally be distributed within five years of the IRA owner's death.
  The five-year rule does not apply if distributions begin within 
one year of the IRA owner's death and are payable over the life or 
life expectancy of a designated beneficiary. Special rules apply if 
the beneficiary of the IRA is the surviving spouse. 

Roth IRAs

Individuals with adjusted gross income below certain levels may make 
nondeductible contributions to a Roth IRA. The maximum annual 
contribution that may be made to a Roth IRA is the lesser of a 
certain dollar amount ($4,000 for 2006) or the individual's 
compensation for the year.  An individual who has attained age 50 
before the end of the taxable year may also make catch-up 
contributions to a Roth IRA up to a certain dollar amount ($1,000 
for 2006). 

The contribution limit is reduced to the extent an individual makes 
contributions to any other IRA for the same taxable year.  As under the 
rules relating to traditional IRAs, a contribution of up to the dollar 
limit for each spouse may be made to a Roth IRA provided the combined 
compensation of the spouses is at least equal to the contributed amount. 
The maximum annual contribution that can be made to a Roth IRA is phased 
out for taxpayers with adjusted gross income over certain levels for the 
taxable year.  The adjusted gross income phase-out ranges are:  (1) for  
single taxpayers, $95,000 to $110,000; (2) for married taxpayers filing 
joint returns, $150,000 to $160,000; and (3) for married taxpayers filing 
separate returns, $0 to $10,000.  Contributions to a Roth IRA may be made 
even after the account owner has attained age 70. 

Taxpayers with modified adjusted gross income of $100,000 or less 
generally may convert a traditional IRA into a Roth IRA, except for 
married taxpayers filing separate returns The amount converted is 
includible in income as if a withdrawal had been made, except that 
the 10-percent early withdrawal tax does not apply. 

Amounts held in a Roth IRA that are withdrawn as a qualified 
distribution are not includible in income, or subject to the 
additional 10-percent tax on early withdrawals. A qualified 
distribution is a distribution that (1) is made after the 
five-taxable year period beginning with the first taxable 
year for which the individual made a contribution to a Roth 
IRA, and (2) is made after attainment of age 59-ï¿½, on account 
of death or disability, or is made for first-time homebuyer 
expenses of up to $10,000. 

Distributions from a Roth IRA that are not qualified distributions are 
includible in income to the extent attributable to earnings. To determine 
the amount includible in income, a distribution that is not a qualified 
distribution is treated as made in the following order:  
(1) regular Roth IRA contributions; (2) conversion contributions (on a 
first in, first out basis); and (3) earnings.  To the extent a 
distribution is treated as made from a conversion contribution, it is 
treated as made first from the portion, if any, of the conversion 
contribution that was required to be included in income as a result 
of the conversion.  The amount includible in income is also subject to 
the 10-percent early withdrawal tax unless an exception applies.  The 
same exceptions to the early withdrawal tax that apply to traditional 
IRAs apply to Roth IRAs. 

Roth IRAs are not subject to the minimum distribution rules during 
the IRA owner's lifetime.  Roth IRAs are subject to the post-death 
minimum distribution rules that apply to traditional IRAs. 

Saver's credit

Present law provides a temporary nonrefundable tax credit for eligible 
taxpayers for qualified retirement savings contributions.   The maximum 
annual contribution eligible for the credit is $2,000.  The credit rate 
depends on the adjusted gross income ("AGI") of the taxpayer.  
Taxpayers filing joint returns with AGI of $50,000 or less, head of 
household returns of $37,500 or less, and single returns of $25,000 or 
less are eligible for the credit.  The AGI limits applicable to single 
taxpayers apply to married taxpayers filing separate returns.  The 
credit is in addition to any deduction or exclusion that would 
otherwise apply with respect to the contribution.  The credit offsets 
minimum tax liability as well as regular tax liability.  The credit is 
available to individuals who are 18 or over, other than individuals 
who are full-time students or claimed as a dependent on another 
taxpayer's return.  The credit is available with respect to 
contributions to various types of retirement savings arrangements, 
including contributions to a traditional or Roth IRA. 

Coverdell education savings accounts 

Present law provides tax-exempt status to Coverdell education savings 
accounts, meaning certain trusts or custodial accounts that are created 
or organized in the United States exclusively for the purpose of 
paying the qualified higher education expenses of a designated 
beneficiary.  The aggregate annual contributions that can be made 
by all contributors to Coverdell education savings accounts for the 
same beneficiary is $2,000 per year.  In the case of contributors 
who are individuals, the maximum contribution limit is reduced for 
individuals with adjusted gross income between $95,000 and $110,000 
($190,000 to $220,000 in the case of married taxpayers filing a 
joint return). Contributions to a Coverdell education savings 
account are not deductible. 

Distributions from a Coverdell education savings account are not 
includible in the distributee's income to the extent that the 
total distribution does not exceed the qualified 

----------------------------
 /11/ Sec. 25B.  The Saver's credit does not apply to taxable year 
  beginning after December 31, 2006. 
   
 /12/ Sec. 530. 
   
 /13/ The present-law contribution limit and the adjusted gross income 
   levels are subject to the general sunset provision of EGTRRA.  
Thus, for  example, the limit on annual contributions to a Coverdell 
education  savings account is $500 after 2010. 


education expenses incurred by the beneficiary during the year the 
distribution is made.  If a distribution from a Coverdell education 
savings account exceeds the qualified education expenses incurred by 
the beneficiary during the year of the distribution, 
the portion of the excess that is treated as earnings generally is 
subject to income tax and an additional 10-percent tax Amounts in a 
Coverdell education savings account may be rolled over on a tax-free 
basis to another Coverdell education savings account of the same 
beneficiary or of a member of the family of that beneficiary. 

Qualified tuition programs 

Present law provides tax-exempt status to a qualified tuition program, 
defined as a program established and maintained by a State or agency or 
instrumentality thereof, or by one or more eligible educational 
institutions. Under a qualified tuition program, a person may 
purchase tuition credits or certificates on behalf of a designated 
beneficiary, or in the case of a State program, may make contributions 
to an account that is established for the purpose of meeting 
qualified higher education expenses of the designated beneficiary of 
the account.  Contributions to a qualified 
tuition program must be made in cash, and the program must have 
adequate safeguards to prevent contributions in excess of amounts 
necessary to provide for the beneficiary's qualified higher 
education expenses.  Contributions to a qualified tuition program 
are not deductible.  Contributions to a qualified tuition program 
generally are treated as a completed gift eligible for the gift 
tax annual exclusion. 

Distributions from a qualified tuition program are not includible 
in the distributee's gross income to the extent that the total 
distribution does not exceed the qualified education expenses 
incurred by the beneficiary during the year the distribution is 
made.  If a distribution from a qualified tuition program exceeds 
the qualified education expenses incurred by the beneficiary 
during the year of the distribution, the portion of the 
excess that is treated as earnings generally is subject to income 
tax and an additional 10-percent tax.  Amounts in a qualified 
tuition program may be rolled over on a tax-free basis to another 
qualified tuition program for the same beneficiary or for a member 
of the family of that beneficiary. 

Health savings accounts

A health savings account ("HSA") is a trust or custodial account used to 
accumulate funds on a tax-preferred basis to pay for qualified medical 
expenses.   Within limits,contributions to an HSA made by or on behalf of 
an eligible individual are deductible by the individual. 
Contributions to an HSA are excludable from income and employment taxes if 

---------------------
 \14\ A proposal relating to qualilfied tuition programs is discussed in 
 Part V.F. of this document. 

 \15\ Sec. 529. The general sunset provision of EGTRRA applies to certain 
 aspects of the rules for qualified tuition programs, including tuition 
 programs maintaineed by one or more eligible educational institutions 
 (which may be private institutions).  Thus, for example, after 2010 a 
 qualified tuition program may be established and maintainedd only by 
 a State or agency or instrumentality thereof. 

 \16\ Sec. 223.

made by the individual's employer. Earnings on amounts in HSAs are not 
taxable. Distributions from an HSA for qualified medical expenses are not 
includible in gross income. Distributions from an HSA that are not used for 
qualified medical expenses are includible in gross income and are 
subject to an additional 10 percent-tax unless the distribution is made 
after death, disability, or the individual attains the age of Medicare 
eligibility (i.e., age 65).  

Eligible individuals for HSAs are individuals who are covered by a high 
deductible health plan and no other health plan that is not a high 
deductible health plan.  A high deductible health plan is a health plan 
that has a deductible that is at least $1,050 for self-only coverage or 
$2,100 for family coverage (for 2006) and that has an out-of-pocket 
expense limit that is no more than $5,250 in the case of self-only 
coverage and $10,500 in the case of family coverage (for 2006). 

The maximum aggregate annual contribution that can be made to an HSA 
is the lesser of (1) 100 percent of the annual deductible under the 
high deductible health plan, or (2) the maximum deductible permitted 
under an Archer MSA high deductible health plan under present law, as 
 adjusted for inflation.  

For 2006, the amount of the maximum deductible under an Archer 
MSA high deductible health plan is $2,700 in the case of self-only 
coverage and $5,450 in the case of family coverage.  The annual 
contribution limits are increased for individuals who have attained 
age 55 by the end of the taxable year.  In the case of policyholders 
and covered spouses who are age 55 or older, the HSA annual 
contribution limit is greater than the otherwise applicable limit 
by $700 in 2006, $800 in 2007, $900 in 2008, and $1,000 in 2009 and 
thereafter. 

Archer medical savings accounts ("MSAs") 

Like HSAs, an Archer MSA is a tax-exempt trust or custodial account 
to which tax-deductible contributions may be made by individuals 
with a high deductible health plan Archer MSAs provide ta x benefits 
similar to, but generally not as favorable as, those provided by 
HSAs for certain individuals covered by high deductible health 
plans.

The rules relating to Archer MSAs and HSAsare similar.  The 
main differences include:(1) only self-employed individuals and 
employees of small employers are eligible to have an Archer MSA; 
(2) for MSA purposes, a high deductible plan is a 
health planwith (a) an annual deductible of at least $1,800 and no 
more than $2,700 in the case of individual coverage and at least 
$3,650 and no more than $5,450 in the case of family coverage 
(for 2006), and (b) maximum out-of-pocket expenses of no more than 
$3,650 in the case of individual coverage and no more than $6,650 
in the case of family coverage (for 2006) ; and (3) the additional 
tax on distributions not used for medical expenses is 15 percent 
rather than 10 percent.

After 2005, no new contributions can be made 
to Archer MSAs except by or on behalf of individuals who previously 
had Archer MSA contributions and employees who are employed by a 
participating employer. 

-----------------------

 \17\ Sec. 220


                        Description of Proposal

In general

The proposal consolidates traditional and Roth IRAs into a single 
type of account, a Retirement Savings Account ("RSA").  The proposal 
also creates a new type of account that can be used to save for 
any purpose, a Lifetime Savings Account ("LSA"). 

The tax treatment of both RSAs and LSAs is generally 
similar to that of present-law Roth IRAs; that is, contributions are 
not deductible and earnings on contributions generally are not 
taxable when distributed.  The major difference between the tax 
treatment of LSAs and RSAs is that all distributions from LSAs are 
tax free, whereas tax-free treatment of earnings on amounts in RSAs 
applies only to distributions made after age 58 or in the event of 
death or disability. 

Retirement Savings Accounts 

Under the proposal, an individual may make annual nondeductible 
contributions to an RSA of up to the lesser of $5,000 or the individual's 
compensation for the year.  As under present-law rules for IRAs, in the 
case of a married couple, contributions of up to the dollar limit may be 
made for each spouse if the combined compensation of both spouses is at 
least equal to the total amount contributed for both spouses. 
Contributions to an RSA may be made regardless of the individual's 
age or adjusted gross income.  Contributions to an RSA may be made 
only in cash.  Contributions to an RSA are taken into account for 
purposes of the Saver's credit.  

Earnings on contributions accumulate on a tax-free basis. 

Qualified distributions from RSAs are excluded from gross income.  
Under the proposal, qualified distributions are distributions made 
after age 58 or in the event of death or disability. Distributions 
from an RSA that are not qualified distributions are includible in 
income (to the extent that the distribution exceeds basis) and 
subject to a 10-percent additional tax. 
As under the present-law rules for Roth IRAs, distributions are 
deemed to come from basis first. 

As under the present-law rules for Roth IRAs, no minimum distribution 
rules apply to an RSA during the RSA owner's lifetime.  In addition, 
married individuals may roll amounts over from an RSA to a spouse's 
RSA. 

Under the proposal, existing Roth IRAs are renamed RSAs and are 
subject to the rules for RSAs. In addition, existing traditional 
IRAs may be converted into RSAs .  The amount converted is 
includible in income (except to the extent it represents a return 
of nondeductible contributions).  No income limits apply to such 
conversions.  For conversions of traditional IRAs made before 
January 1, 2008, the income inclusion may be spread ratably 
over four years.  For conversions of traditional IRAs made on or 
after January 1, 2008, the income that results from the 
conversion is included for the year of the conversion. 


---------------------------

  \18\ The contribution limit is indexd for inflation.
  
  
Under the proposal, existing traditional IRAs that are not converted to 
RSAs may not accept new contributions, other than rollovers from other 
traditional IRAs or employer-sponsored retirement plans.  New traditional 
IRAs may be created to accept rollovers from employer-sponsored retirement 
plans or other traditional IRAs, but they cannot accept any other 
contributions.  An individual may roll an amount over directly from an 
employer-sponsored retirement plan to an RSA by including the rollover 
amount (excluding basis) in income, similar to a conversion to a Roth IRA 
under present law.  

Amounts converted to an RSA from a traditional IRA or an Employer 
Retirement Savings Account ("ERSA")  are subject to a five-year 
holding period.  If an amount attributable to such a conversion 
(other than an amount attributable to a Roth-type account in an ERSA) 
is distributed from the RSA before the end of the five-year period 
starting with the year of the conversion or, if 
earlier, the date on which the individual attains age 58, becomes 
disabled, or dies, an additional 10-percent tax applies to the 
entire amount.  The five-year period is determined separately for 
each conversion distribution. 

To determine the amount attributable to a conversion, a distribution is 
treated as made in the following order: (1) regular RSA contributions;(2) 
conversion contributions (on a first in, first out basis); and 
(3) earnings.  To the extent a distribution is treated as made from a 
conversion contribution, it is treated as made first from the portion, if 
any, of the conversion contribution that was required to be included in 
income as a result of the conversion. 

Lifetime Savings Accounts 

Under the proposal, an individual may make nondeductible contributions to 
an LSA of up to $5,000 annually, regardless of the individual's age, 
compensation, or adjusted gross income. Additionally, individuals other 
than the LSA owner may make contributions to an LSA.  The contribution 
limit applies to all LSAs in an individual's name, rather than to the 
individuals making the contributions.  Thus, contributors may make annual 
contributions of up to $5,000 each to the LSAs of other individuals but 
total contributions to the LSAs of any one individual may not exceed 
$5,000 per year.  Contributions to LSAs may be made only in cash.  
Contributions to an LSA are not taken into account for purposes of the
Saver's credit.  Earnings on contributions accumulate on a tax-free 
basis. 

All distributions from an individual's LSA are excludable from income, 
regardless of the individual's age or the use of the distribution.  As 
under the present-law rules for Roth IRAs, no minimum distribution rules 
apply to an LSA during the LSA owner's lifetime.  In addition, 
married individuals may roll amounts over from an LSA to a spouse's LSA. 

Control over an LSA in a minor's name is to be exercised exclusively for 
the benefit of the minor by the minor's parent or legal guardian acting 
in that capacity until the minor reaches the age of majority (determined 
under applicable state law). 

----------------------------------
 \19\ The proposal relating to ERSAs is dicussed in Par II.A.2. of this 
 document. 
  
  \20\ Total contributions to an LSA for a year may not exceed $5,000, 
  regardless of whether any distributions are taken from the LSA during 
  the year.  The contribution limit is indexed for inflation. 
  

Taxpayers may convert balances in Coverdell education savings accounts 
 and qualified tuition programs to LSA balances on a tax-free basis before 
January 1, 2008, subject to certain limitations.  An amount may be rolled 
over to an individual's LSA only if the individual was the beneficiary of 
the Coverdell education savings account or qualified tuition program as of 
December 31, 2005.  The amount that can be rolled over to an LSA from a 
Coverdell education savings account is limited to the sum of:  (1) the 
amount in the Coverdell education savings account as of December 31, 
2005; and (2) any contributions to and earnings on the account for 
2006.  The amount that can be rolled over to an LSA from a qualified 
tuition program is limited to the sum of:  (1) the lesser of $50,000 or 
amount in the qualified tuition program as of December 31, 2005; and 
(2) any contributions to and earnings on the qualified tuition program 
for 2006.  The total amount rolled over to an individual's LSA that is 
attributable to 2006 contributions for the individual to Coverdell 
education savings accounts and qualified tuition programs cannot exceed 
$5,000 (plus any earnings on such contributions). 

Under the proposal, qualified tuition programs continue to exist as 
separate arrangements, but may be offered in the form of an LSA. 
For example, State agencies that administer qualified tuition 
programs may offer LSAs with the same investment options that are 
available under the qualified tuition program.  The annual limit 
on LSA contributions apply to such an LSA, but the additional 
reporting requirements applicable to 
qualified tuition programs under present law do not apply and 
distributions for purposes other than education are not subject 
to Federal tax .  

Effective date.-The proposal is effective on January 1, 2007. 

                                 Analysis
In general

The proposal is intended to accommodate taxpayers' changing 
circumstances over time by providing a new account that taxpayers 
may use for tax-favored saving over their entire lifetimes, with 
no restrictions on withdrawals. 
The proposal also provides a new account for individual retirement 
savings with fewer restrictions on eligibility than present-law 
IRAs.  The proposal is intended to simplify saving by permitting the 
consolidation of existing savings accounts into these accounts and 
allowing individuals to make contributions to the new accounts 
with no limitations based on age or income level. 

By providing additional tax incentives for saving, the proposal 
intends to encourage additional saving generally.  By providing a 
tax-favored savings account with no restrictions on withdrawals, 
the proposal intends to encourage additional saving in particular 
by those who are reluctant to take advantage of existing 
tax-preferred savings accounts because of withdrawal restrictions. 

--------------------

 /21/ State tax law and qualified tuition program investment options may 
 provide incentives for savings used for educational purposes.

 /22/ The Treasury Department expects that, beginning with the 2007 
filing  season for individual imcome tax returns, taxpayers will be 
able to direct  that a portion of their refunds be deposited into an 
LSA or RSA. 



Some argue that the national saving rate is too 
low, and that this is due in part to the bias of the present-law income 
tax structure against saving and in favor of current consumption.  
By providing tax incentives for saving - specifically, removing the 
tax on the return to savings - the present-law income tax structure 
can be modified to function more like a consumption tax. Proponents 
of such tax incentives argue that saving will increase if the return 
to savings is not reduced by taxes.  Others have argued that saving 
has not necessarily increased as a result of existing tax incentives 
for savings.  Some have argued that much existing savings have merely 
been shifted into tax-favored accounts, and thus do not represent 
new saving.  Also, it may be advantageous to borrow in order to 
fund tax-favored saving vehicles. 

To the extent that borrowing occurs to fund these accounts, no net 
saving occurs.  Ideally,saving incentives should apply only to net 
new saving, in order to avoid windfall gains to existing savings. 
 However,measuring net new saving would be difficult in practice. 


Others have argued that increasing the return to savings (by not 
taxing earnings) might cause some taxpayers actually to save less, 
as a higher return to savings means that less saving is necessary 
to achieve a "target" level of savings at some point in the future. 

From an economic perspective, both LSAs and RSAs receive tax treatment 
generally equivalent to Roth IRAs.  While the taxpayer does not deduct 
contributions to LSAs, tax is never paid on the income earned on the 
investment. The same is generally true for RSAs as long as 
amounts are withdrawn in qualified distributions.  However, while LSAs 
and RSAs receive tax treatment similar to Roth IRAs, the maximum allowable 
annual contribution is greater than the  amount of contributions currently 
permitted to Roth IRAs.  The increase in the amounts that may be 
contributed to tax-preferred savings accounts provides a tax incentive 
for further saving for those who have already contributed the maximum 
to existing tax-favored savings accounts. However, for taxpayers not 
already contributing the maximum amounts, the new accounts provide 
no additional economic inducement to save, except to the extent that 
LSAs provide withdrawal flexibility relative to existing retirement 
savings vehicles' age restrictions.Opponents of proposals to increase 
tax-favored saving thus argue that the only beneficiaries are likely 
to be wealthy taxpayers with existing savings that will be shifted 
to the tax-favored accounts, since most taxpayers have not taken 
full advantage of existing saving incentives. 

--------------------------

  /23/ Unlike present-law IRAs an LSA does not require that contributions 
  be no greater than compensation. Under the proposal, regardless of 
income, an individual may make nondeductible annual contributions to an 
LSA of up  $5,000.  To the extent an individual makes contributions to 
his or her  own LSA that exceed his or her income, then the amounts 
transferred in  excess of income must represent a transfer of assets 
from existing savings and not ne savings from forgoing current 
consumption.  Additionally, individuals other than the LSA owner may 
contributions to  an LSA. 

 /24/ Some argue that contributions to deductible IRAs declined 
substantially after 1986 for taxpayers whose eligibility to 
contribute to   deductible IRAs was not affected by the income-related
limits introduced in 1986 because financial institutions cut back on 
promoting  contributions as a result of the general limits on 
deductibility. 
  Thus, they would argue, universally available tax-preferred 
accounts such as LSAs and RSAs will increase saving at all income 
levels. 


RSAs also replace traditional IRAs and thereby eliminate taxpayers' 
ability to make deductible contributions.  From an economic 
perspective, RSAs receive tax treatment generally equivalent to 
traditional IRAs to which deductible contributions are made.   
However, some argue that the upfront deduction provides a 
greater psychological inducement to save, and that 
the elimination of traditional IRAs may reduce saving by 
those who would have been able to make deductible contributions. 

Taxpayers may convert balances under Coverdell education savings 
accounts and qualified tuition programs into LSAs on a tax-free 
basis before January 1, 2008.  Under the proposal, existing 
balances in Coverdell education savings accounts and existing 
balances in qualified tuition programs (up to $50,000) may be 
converted to LSA balances with no income 
tax consequences.  This means that pretax earnings accumulated on 
Coverdell education savings accounts and qualified tuition program 
balances that are converted to LSAs may be withdrawn and spent for 
purposes other than education without the income tax consequences 
applicable to Coverdell education savings account and qualified 
tuition program distributions that are used for nonqualifying 
expenses.  Conversion allows the consolidation of saving into a 
single vehicle for simplification purposes.  However, 
there is some scope for abuse of this conversion option.  A 
taxpayer with sufficient resources may effect such a conversion 
simply to shift more saving into tax-favored accounts.  For 
example, a taxpayer could transfer $50,000 from an existing 
qualified tuition program into an LSA, thus 
insulating already accumulated earnings from tax, regardless 
of whether they are used for education expenses, and then 
reinvest a different $50,000 into the qualified tuition program. 

The tax treatment of contributions under qualified retirement plans 
is essentially the same as that of traditional IRAs to which 
deductible contributions are made.  However, the limits on 
contributions to qualified plans are much higher than the IRA 
contribution limits, so that qualified plans provide for a 
greater accumulation of funds on a tax-favored basis. 

A policy rationale for permitting greater accumulation under qualified 
plans than IRAs is that the tax benefits for qualified plans encourage 
employers to provide benefits for a broad group of their employees.  
This reduces the need for public assistance and reduces pressure on 
the social security system. 

Some argue that offering LSAs and RSAs will reduce the incentive for 
small business owners to maintain qualified retirement plans for 
themselves and their employees.  A business owner can generally 
contribute more to a qualified plan than the contributions that 
may be made to LSAs and RSAs, but only if comparable contributions 
are made by or on behalf of rank-and-file employees.  The business 
owner must therefore successfully encourage rank-and-file employees 
to contribute to the plan or, in many cases, make 
matching or nonelective contributions for rank-and-file employees. 

----------------------------
\25\  Whether an RSA and a traditional IRA to which deductible 
contributions are made are in fact economically equivalent depends 
on the difference between the taxpayer's marginal tax rate in the 
year contributions are made and the marginal tax rate in the year 
IRA funds are withdrawn.  When marginal rates decrease over time 
(because tax rates change generally or taxpayers fall into lower 
tax brackets), a traditional IRA to which deductible contributions 
 are made is more advantageous than an RSA because the traditional 
IRA permits taxpayer to defer payment of tax until rates are lower.
 When marginal tax rates increase over time, an RSA is more 
advantageous. 

contributions for rank-and-file employees. The opportunity to 
contribute $5,000 annually to both an LSA and an RSA for both the 
business owner and his or her spouse, without regard to adjusted 
gross income or contributions for rank-and-file employees, may be 
a more attractive alternative to maintaining a qualified retirement 
plan.  Others argue that many employers (including small employers) 
offer qualified retirement plans to attract and retain high-quality 
employees and will continue to do so.  In addition, the ability to 
make pretax contributions to an employer-sponsored plan is attractive 
to many individuals.  Some raise concerns that, as a substitute for 
a qualified retirement plan, an employer could selectively choose to 
pay additional compensation only to highly compensated employees in 
the form of contributions to LSAs and RSAs.  This may undermine 
the principle of promoting savings for rank-and-file employees. 

Thus, some argue that the proposal may reduce qualified retirement 
plan coverage,particularly in the case of small businesses. Whether 
any reduced coverage would result in an overall reduction of 
retirement security would depend, in part, on the extent to which 
individuals who are not covered by a qualified retirement plan 
instead contribute to the new saving vehicles.  

Complexity 

The proposal has elements that may both increase and decrease tax law 
complexity. On one hand, the proposal provides new saving options to 
individuals, which may increase complexity to the extent that 
taxpayers open new LSAs and RSAs without consolidating existing 
tax-preferred savings into such accounts. In addition, although the 
proposal relating to RSAs generally precludes future contributions 
to traditional IRAs, the proposal relating to LSAs does not preclude 
future contributions to present-law tax-favored arrangements for 
certain purposes, such as Coverdell education savings accounts, 
qualified tuition programs, and health savings accounts.  On the 
other hand, the proposal may decrease complexity by 
permitting consolidation of tax-favored savings accounts.  

Additionally, with respect to future saving, in one respect choices 
are made easier by the elimination of the need to decide whether to 
make deductible or nondeductible IRA contributions for those 
taxpayers eligible to contribute to both.  However, employer-sponsored 
qualified retirement plans generally receive the same tax treatment 
as traditional IRAs to which deductible contributions are made (i.e., 
 contributions are not taxable, but distributions are).  Therefore, 
the increased availability of Roth-type savings vehicles, in terms of 
 eligibility to make contributions and higher contribution limits, 
is likely to mean that many more taxpayers will face a choice of how 
to balance their savings between deductible and nondeductible 
savings vehicles.  Nonetheless, the ability to make contributions 
to LSAs and RSAs without limitations based on age or income level, 
the uniform tax treatment of all contributions to LSAs 
and RSAs, and the lack of restrictions on LSA withdrawals, are 
likely to decrease complexity. 

                                 Prior Action
                                 
A similar proposal was included in the President's fiscal year 2005 
and 2006 budget proposals.  The President's fiscal year 2004 budget 
proposal included a similar proposal; among the differences is that, 
in the fiscal year 2004 proposal, the annual dollar limit on 
contributions to RSAs or to LSAs was $7,500. 


2.  Consolidation of employer-based savings accounts

                               Present Law
                               
In general

A plan of deferred compensation that meets the qualification 
standards of the Code (a qualified retirement plan) is accorded 
special tax treatment under present law.  Employees do not include 
 contributions in gross income until amounts are distributed, even 
though the arrangement is funded and benefits are nonforfeitable.  
In the case of a taxable employer, the employer is entitled to a 
current deduction (within limits) for contributions even though the 
contributions are not currently included in an employee's income. 
Contributions to a qualified plan, and earnings thereon, are held 
in a tax-exempt trust. 

Qualified retirement plans may permit both employees and employers 
to make contributions to the plan.  Under a qualified cash or 
deferred arrangement (i.e., a "section 401(k)" plan), employees may 
elect to make pretax contributions to a plan.  Such contributions 
are referred to as elective deferrals.  Employees may also make 
after-tax contributions to a qualified retirement plan.  Employer 
contributions consist of two types:  nonelective contributions and 
matching contributions.  Nonelective contributions are employer 
contributions that are made without regard to whether the employee 
makes pretax or after-tax contributions. Matching contributions are 
employer contributions that are made only if the employee makes 
contributions. 

Present law imposes a number of requirements on qualified retirement 
plans that must be satisfied in order for the plan to be qualified 
and for favorable tax treatment to apply.  These requirements include 
nondiscrimination rules that are intended to ensure that a qualified 
retirement plan covers a broad group of employees. Certain of these 
rules are discussed in more detail below. 

Qualified retirement plans are broadly classified into two 
categories, defined benefit pension plans and defined contribution 
plans, based on the nature of the benefits provided. Under a defined 
benefit pension plan, benefits are determined under a plan formula, 
generally based on compensation and years of service.  Benefits 
under defined contribution plans are based solely on the 
contributions, and earnings thereon, allocated to separate accounts 
maintained for plan participants. 

In addition to qualified section 401(k) plans, present law provides 
for other types of employer-sponsored plans to which pretax employee 
elective contributions can be made.  Many of these arrangements are 
not qualified retirement plans, but receive the same tax-favored 
treatment as qualified retirement plans.  The rules applicable to 
each type of arrangement vary. These arrangements include SIMPLE 
section 401(k) plans, tax sheltered annuity plans ("section 403(b)" 
plans),  governmental eligible deferred compensation plans ("section 
457" plans), SIMPLE IRAs,  and salary-reduction simplified employee 
pensions ("SARSEPs"). 

Limits on contributions to qualified defined contribution plans

The annual additions under a defined contribution plan with respect to 
each plan participant cannot exceed the lesser of (1) 100 percent of the 
participant's compensation or (2) a dollar amount, indexed for inflation 
($44,000 for 2006).  Annual additions are the sum of employer 
contributions, employee contributions, and forfeitures with respect to 
an individual under all defined contribution plans of the same 
employer. 

Nondiscrimination requirements applicable to qualified retirement plans 

The nondiscrimination requirements are designed to ensure that qualified 
retirement plans benefit an employer's rank-and-file employees as well as 
highly compensated employees. Under a general nondiscrimination 
requirement, the contributions or benefits provided under a qualified 
retirement plan must not discriminate in favor of highly compensated 
employees. Treasury regulations provide detailed and exclusive rules for 
determining whether a plan satisfies the general nondiscrimination rules.
Under the regulations, the amount of contributions or benefits provided 
under the plan and the benefits, rights and features offered under the 
plan must be tested.

Treasury regulations provide three general approaches to testing the 
amount of nonelective contributions provided under a defined contribution 
plan:  (1) design-based safe harbors; (2) a general test; and 
(3) cross-testing.  Elective deferrals, matching contributions, and 
after-tax employee contributions are subject to separate testing as 
described below. 


------------------------
  \26\ Sec. 403(b). 
   
   \27\ Sec. 457. 
   
   \28\ Sec. 408(p). 
   
   \29\ Sec. 408(k). 
   
   \30\ Elective deferrals are treated as employer contributions for 
   this purpose.
   
   \31\ For purposes of the nondiscrimination requirements, an employee 
    is    treated as highly compensated if the employee (1) was a 
    five-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  $100,000 (for 2006) or (b) at the 
    election of the  employer had  compensation for the preceding year 
    in excess of  $100,000 (for 2006) and was in the top 20 percent of 
    employees by compensation for such year (sec. 414(q)). A nonhighly 
    compensated employee is an employee other than a highly compensated 
    employee. 
   
   \32\ Sec. 401(a)(4). A qualified retirement plan of a State or local 
   governmental employer is not subject to the nondiscrimination 
   requirements. 
   
   \33\ See Treas. Reg. sec. 1.401(a)(4)-1. 
   
   \34\ See Treas. Reg. sec. 1.401(a)(4)-2(b) and (c) and sec. 
   1.401(a)(4)-8(b). 
   

Qualified cash or deferred arrangements (section 401(k)plans) 

In general 

Section 401(k) plans are subject to the rules generally applicable to 
qualified defined contribution plans.  In addition, special rules apply. 
As described above, an employee may make elective deferrals to a section 
401(k) plan. The maximum annual amount of elective deferrals that can be 
made by an individual is $15,000 (for 2006).  An individual who has 
attained age 50 before the end of the taxable year may also make catch-up 
contributions to a section 401(k) plan.  As a result, the dollar limit on 
elective deferrals is increased for an individual who has attained age 50 
by $5,000 (for 2006).  An employee's elective deferrals must be fully 
vested. 

Special nondiscrimination tests 

A special nondiscrimination test applies to elective deferrals under a 
section 401(k) plan, called the actual deferral percentage test 
(the "ADP" test).   The ADP test compares the actual deferral percentages 
("ADPs") of the highly compensated employee group and the nonhighly 
compensated employee group.  The ADP for each group generally is the 
average of the deferral percentages separately calculated for the 
employees in the group who are eligible to make elective deferrals for 
all or a portion of the relevant plan year.  Each eligible employee's 
deferral percentage generally is the employee's elective deferrals for 
the year divided by the employee's compensation for the year. 

The plan generally satisfies the ADP test if the ADP of the highly 
compensated employee group for the current plan year is either (1) not 
more than 125 percent of the ADP of the nonhighly compensated employee 
group for the prior plan year, or (2) not more than 200 percent 
of the ADP of the nonhighly compensated employee group for the prior plan 
year and not more than two percentage points greater than the ADP of the 
nonhighly compensated employee group for the prior plan year. 

Under a safe harbor, a section 401(k) plan is deemed to satisfy the 
special nondiscrimination test if the plan satisfies one of two 
contribution requirements and satisfies a notice requirement (a "safe 
harbor" section 401(k) plan).   A plan satisfies the contribution 

-----------------------

 /35/  Except for certain grandfathered plans, a State or local 
 governmental employer may not maintain a section 401(k) plan. 

  /36/ The Economic Growth and Tax Relief Reconciliation Act of 2001 
("EGTRRA") increased many of the limits applicable to employer-sponsored 
retirement plans and provided for catch-up contributions, generally 
effective for years beginning after December 31, 2001.  The provisions of 
EGTRRA generally do not apply for years beginning after December 31, 2010. 

   /37/ Sec. 401(k)(3). 
   
   /38/ Sec. 401(k)(12). 

requirement under the safe harbor rule if the employer either 
(1) satisfies a matching contribution requirement or (2) makes a 
nonelective contribution to a defined contribution plan of at least 
three percent of an employee's compensation on behalf of each nonhighly 
compensated employee who is eligible to participate in the arrangement. 

A plan satisfies the matching contribution requirement if, under the 
arrangement:  (1) the employer makes a matching contribution on behalf of 
each nonhighly compensated employee that is equal to (a) 100 percent of 
the employee's elective deferrals up to three percent of compensation and 
(b) 50 percent of the employee's elective deferrals from three to five 
percent of compensation; and (2) the rate of match with respect to any 
elective deferrals for highly compensated employees is not greater than 
the rate of match for nonhighly compensated employees. Alternatively, the 
matching contribution requirement is met if (1) the rate of matching 
contribution does not increase as the rate of an employee's elective 
deferrals increases,and (2) the aggregate amount of matching 
contributions at such rate of employee elective deferral is at least 
equal to the aggregate amount of matching contributions that would be 
made if matching contributions were made on the basis of the 
percentages described in the preceding formula. A plan does not meet 
the contributions requirement if the rate of matching contribution with 
respect to any rate of elective deferral of a highly compensated 
employee is greater than the rate of matching contribution with respect 
to the same rate of elective deferral of a nonhighly compensated 
employee. 

Nondiscrimination tests for matching contributions and after-tax 
employee contributions 

Employer matching contributions and after-tax employee contributions 
are also subject to a special annual nondiscrimination test (the 
"ACP test"). The ACP test compares the actual contribution 
percentages ("ACPs") of the highly compensated employee group and 
the nonhighly compensated employee group.  The ACP for each group 
generally is the average of the contribution percentages separately 
calculated for the employees in the group who are eligible to make 
after-tax employee contributions or who are eligible for an 
allocation of matching contributions for all or a portion of the 
relevant plan year.  Each eligible employee's contribution 
percentage generally is the employee's aggregate after-tax employee 
contributions and matching contributions for the year divided by the 
employee's compensation for the year. 

The plan generally satisfies the ACP test if the ACP of the highly 
compensated employee group for the current plan year is either (1) not 
more than 125 percent of the ACP of the nonhighly compensated employee 
group for the prior plan year, or (2) not more than 200 percent of the 
ACP of the nonhighly compensated employee group for the prior plan year 
and not more than two percentage points greater than the ACP of the 
nonhighly compensated employee group for the prior plan year. 

A safe harbor section 401(k) plan is deemed to satisfy the ACP test with 
respect to matching contributions, provided that (1) matching 
contributions are not provided with respect to elective deferrals or 
after-tax employee contributions in excess of six percent of compensation, 

----------------------

 /39/ Sec. 401(m).

(2) the rate of matching contribution does not increase as the rate of 
an employee's elective deferrals or after-tax contributions increases, 
and (3) the rate of matching contribution with respect to any rate of 
elective deferral or after-tax employee contribution of a highly 
compensated employee is no greater than the rate of matching 
contribution with respect to the same rate of deferral or contribution 
of a nonhighly compensated employee. 

Tax-sheltered annuities (section 403(b) plans) 

Section 403(b) plans are another form of employer-based retirement 
plan that provide the same tax benefits as qualified retirement plans.  
Employers may contribute to such plans on behalf of their employees, and 
employees may make elective deferrals.  Section 403(b) plans may be 
maintained only by (1) tax-exempt charitable organizations, and (2) 
educational institutions of State or local governments (including public 
schools).  Many of the rules that apply to section 403(b) plans are 
similar to the rules applicable to qualified retirement plans, 
including section 401(k) plans.  

Contributions to a section 403(b) plan are generally subject to the 
same contribution limits applicable to qualified defined contribution 
plans,including the special limits for elective deferrals and catch-up 
contributions under a section 401(k) plan. If contributions are made 
to both a qualified defined contribution plan and a section 403(b) 
plan for the same employee, a single limit applies to the contributions 
under both plans.  Special contribution limits apply to certain 
employees under a section 403(b) plan maintained by a church.  In 
addition, additional elective deferrals are permitted under a plan 
maintained by an educational organization, hospital,home health service 
agency, health and welfare service agency, church, or convention or 
association of churches in the case of employees who have completed 
15 years of service. 

Section 403(b) plans are generally subject to the minimum coverage 
and general nondiscrimination rules that apply to qualified defined 
contribution plans.  In addition, employer matching contributions and 
after-tax employee contributions are subject to the ACP test.  
However, pretax contributions made by an employee under a salary 
reduction agreement (i.e., elective deferrals) are not subject to 
 nondiscrimination rules similar to those applicable to elective 
deferrals under section 401(k) plans. Instead, all employees 
generally must be eligible to make salary reduction contributions.  
Certain employees may be disregarded for purposes of this rule. 


------------------------

/40/  For proposals to provide greater conformity between section 
403(b)  and section 401(k) plans,see Joint Committee on Taxation, 
Options to  Improve Tax Compliance and Reform Tax Expenditures 
(JCS-02-05),  January 27, 2005, Part IV.E, at 122-129. 

 /41/ The EGTRRA sunset applies to the contribution limits applicable 
to  section 403(b) plans. 

 /42/  As in the case of a qualified retirement plan, a section 403(b) 
  plan of a State or local governmental employer is not subject to the 
  nondiscrimination rules. 


Eligible deferred compensation plans of State and local governments 
(section 457 plans) 

Compensation deferred under a section 457 plan of a State or local 
governmental employer is includible in income when paid.   The maximum 
annual deferral under such a plan generally is the lesser of (1) 
$15,000 (for 2006) or (2) 100 percent of compensation.  A special, 
higher limit applies for the last three years before a participant 
reaches normal retirement age (the "section 457 catch-up limit").  
In the case of a section 457 plan of a governmental employer, a 
participant who has attained age 50 before the end of the taxable 
year may also make catch-up contributions up to a limit of $5,000 
(for 2006), unless a higher section 457 catch-up limit applies.\44\ 
 Only contributions to section 457 plans are taken into account in 
applying these limits; contributions made to a qualified retirement 
plan or section 403(b) plan for an employee do not affect the amount 
that may be contributed to a section 457 plan for that employee. 

SIMPLE retirement plans

Under present law, a small business that employs fewer than 100 
employees can establish a simplified retirement plan called the 
savings incentive match plan for employees ("SIMPLE") retirement 
plan.  A SIMPLE plan can be either an individual retirement 
arrangement for each employee (a "SIMPLE IRA") or part of a section 
401(k) plan (a "SIMPLE section 401(k)" plan). 

A SIMPLE retirement plan allows employees to make elective deferrals, 
subject to a limit of $10,000 (for 2006).  An individual who has 
attained age 50 before the end of the taxable year may also make 
catch-up contributions to a SIMPLE plan up to a limit of $2,500 
(for 2006). \45\

Employer contributions to a SIMPLE plan must satisfy one of two 
contribution formulas. Under the matching contribution formula, the 
employer generally is required to match employee elective contributions 
on a dollar-for-dollar basis up to three percent of the employee's 
compensation.  Under a special rule applicable only to SIMPLE IRAs, the 
employer can elect a lower percentage matching contribution for all 
employees (but not less than one percent of each employee's 
compensation). In addition, a lower percentage cannot be elected for 
more than two out of any five years.  Alternatively, for any year, 
an employer is permitted to elect, in lieu of making matching 
contributions, to make a two percent of compensation nonelective 
contribution on behalf of each eligible employee with at least 
$5,000 in compensation for such year, whether or not the employee 
makes an elective contribution. 

No contributions other than employee elective contributions, 
required employer matching contributions or employer nonelective 
contributions can be made to a SIMPLE plan and the employer may not 
maintain any other plan. 

--------------------------
 /43/ Section 457 applies also to deferred compensation plans to 
tax-exempt entities. Those plans are not affected by the proposal; 
only the rules for governmental section 457 plans are relevant for 
purposes of this discussion. 

 /44/ The EGTRRA sunset applies to the contribution limits applicable 
to section 457 plans. 

 /45/ The EGTRRA sunset applies to the contribution limits applicable 
to SIMPLE plans. 


All contributions to an employee's SIMPLE account must be fully vested. 

In the case of a SIMPLE IRA, the group of eligible employees generally 
must include any employee who has received at least $5,000 in 
compensation from the employer in any two preceding years and is 
reasonably expected to receive $5,000 in the current year.  
A SIMPLE IRA is not subject to the nondiscrimination rules generally 
applicable to qualified retirement plans.  In the case of a SIMPLE 
section 401(k) plan, the group of employees eligible to participate 
must satisfy the minimum coverage requirements generally applicable 
to qualified retirement plans.  A SIMPLE section 401(k) plan does 
not have to satisfy the ADP or ACP test and is not subject to the 
top-heavy rules. The other qualified retirement plan rules generally 
apply. 

Salary reduction simplified employee pensions (SARSEPs) 

A simplified employee pension ("SEP") is an IRA to which employers 
may make contributions up to the limits applicable to defined 
contribution plans. All contributions must be fully vested.  Any 
employee must be eligible to participate in the SEP if the employee 
(1) has attained age 21, (2) has performed services for the 
employer during at least three of the immediately preceding five 
years, and (3) received at least $450 (for 2006) in compensation 
from the employer for the year. Contributions to a SEP generally 
must bear a uniform relationship to compensation 

Effective for taxable years beginning before January 1, 1997, certain 
employers with no more than 25 employees could maintain a SARSEP 
(i.e., a salary reduction SARSEP) under which employees could make 
elective deferrals. The SARSEP rules were generally repealed with 
the adoption of SIMPLE plans.  However, contributions may continue 
to be made to SARSEPs that were established before 1997.  Salary 
reduction contributions to a SARSEP are subject to the same limit 
that applies to elective deferrals under a section 401(k) plan 
($15,000 for 2006).  An individual who has attained age 50 before 
the end of the taxable year may also make catch-up contributions to 
a SARSEP up to a limit of $5,000 (for 2006). 

Designated Roth contributions

There are two general types of individual retirement arrangements 
("IRAs") under present and prior law:  traditional IRAs, to which 
both deductible and nondeductible contributions may be made, and 
Roth IRAs.  Individuals with adjusted gross income below certain 
levels generally may make nondeductible contributions to a Roth 
IRA.  Amounts held in a Roth IRA that are withdrawn as a qualified 
distribution are not includible in income, nor subject to the 
additional 10-percent tax on early withdrawals. 

A qualified distribution is a distribution that (1) is made after 
the five-taxable year period beginning with the first taxable 
year for which the individual made a contribution to a Roth IRA, 
and (2) is made after attainment of age 59-ï¿½, is made on account 
of death or disability, or is a qualified special purpose 
distribution (i.e., for first-time homebuyer expenses of up to 
$10,000).  A distribution from a 


-----------------------
 /46/ The EGTRRA sunset appllies to the contribution limits 
applicable to  SARSEPs. 


Roth IRA that is not a qualified distribution is includible in income 
to the extent attributable to earnings, and is subject to the 
10-percent tax on early withdrawals (unless an exception applies). 

Beginning in 2006, a section 401(k) plan or a section 403(b) plan is 
permitted to include a "qualified Roth contribution program" that 
permits a participant to elect to have all or a portion of the 
participant's elective deferrals under the plan treated as designated 
Roth contributions. Designated Roth contributions are elective 
deferrals that the participant designates (at such time and in such 
manner as the Secretary may prescribe) as not excludable from the 
 participant's gross income.  The annual dollar limit on a 
participant's designated Roth contributions is the same as the limit 
on elective deferrals, reduced by the participant's elective 
deferrals that the participant does not designate as designated 
Roth contributions. Designated Roth contributions are treated as 
any other elective deferral for certain purposes, including the 
nondiscrimination requirements applicable to section 401(k) plans. 

A qualified distribution from a participant's designated Roth 
contributions account is not includible in the participant's gross 
income.  A qualified distribution is a distribution that is made 
after the end of a specified nonexclusion period and that is (1) 
made on or after the date on which the participant attains age 59-, 
(2) made to a beneficiary (or to the estate of the participant) on 
or after the death of the participant, or (3) attributable to the 
participant's being disabled. 


                            Description of Proposal

In general

Under the proposal, the various present-law employer-sponsored 
retirement arrangements under which individual accounts are 
maintained for employees and employees may make contributions are 
consolidated into a single type of arrangement called an employer 
retirement savings account (an "ERSA"). 
An ERSA is available to all employers and is subject to simplified 
qualification requirements.

Employer Retirement Savings Accounts

In general

The rules applicable to ERSAs generally follow the present-law rules 
for section 401(k) plans with certain modifications.  Existing 
section 401(k) plans and thrift plans are renamed ERSAs and continue 
to operate under the new rules.  Existing section 403(b) plans, 
governmental section 457 plans, SARSEPs, and SIMPLE IRAs and SIMPLE 
section 401(k) plans may be renamed ERSAs and operate under the new 
rules.  Alternatively, such arrangements


--------------------
 /47/ The EGTRRA sunset applies to the ability to make designated Roth 
 contributions to a section 401(k) or 403(b) plan. 


may continue to be maintained in their current form, but may not accept 
any new employee deferrals or after-tax contributions after 
December 31, 2007. 

Types of contributions and treatment of distributions

An ERSA may provide for an employee to make pretax elective contributions 
and catch-up contributions up to the present-law limits applicable to a 
section 401(k) plan, that is, a limit of $15,000 for elective deferrals 
and $5,000 for catch-up contributions (as indexed for future years).  
An ERSA may also allow an employee to designate his or her elective 
contributions as Roth contributions or to make other after-tax employee 
contributions.  An ERSA may also provide for matching contributions and 
nonelective contributions.  Total annual contributions to an ERSA for an 
employee (i.e., employee and employer contributions, including elective 
deferrals) may not exceed the present-law limit of the lesser of 100 
percent of compensation or $44,000 (as indexed for future years). 

Distributions from an ERSA of after-tax employee contributions 
(including Roth contributions) and qualified distributions of 
earnings on Roth contributions are not includible in income.  
All other distributions are includible in income. 


Nondiscrimination requirements

The present-law ADP and ACP tests are replaced with a single 
nondiscrimination test.  If the average contribution percentage for 
nonhighly compensated employees is six percent or less,the average 
contribution percentage for highly compensated employees cannot 
exceed 200 percent of the nonhighly compensated employees' average 
contribution percentage.  If the average contribution percentage for 
nonhighly compensated employees exceeds six percent, the 
nondiscrimination test is met.  For this purpose, a "contribution 
percentage" is calculated for each employee as the sum of employee 
pretax and after-tax contributions, employer matching 
contributions, and qualified nonelective contributions 
made for the employee, divided by the employee's compensation.

A design-based safe harbor is available for an ERSA to satisfy the 
nondiscrimination test. Similar to the section 401(k) safe harbor under 
present law, under the ERSA safe harbor, the plan must be designed to 
provide all eligible nonhighly compensated employees with either (1) a 
fully vested nonelective contribution of at least three percent of 
compensation, or (2) fully vested matching contributions of at least 
three percent of compensation, determined under one of two 
formulas.  The ERSA safe harbor provides new formulas for determining 
required matching contributions.  Under the first formula, matching 
contributions must be made at a rate of 50 percent of an employee's 
elective contributions up to six percent of the employee's 
compensation.  Alternatively, matching contributions may be made 
under any other formula under which the rate of matching 
contribution does not increase as the rate of an employee's 
elective contributions increases, and the aggregate amount of 
matching contributions at such rate of elective contribution is 
at least equal to the aggregate amount of matching contributions 
that would be made if matching contributions were made on the basis 
of the percentages described in the first formula.  In addition, the 
rate of matching contribution with respect to any rate of 


---------------------
/48/ Special transition rules ae to be provided for plans maintained 
pursuant to collective bargaining agreements and for plans sponsored 
by State and local governments. 

elective contribution cannot be higher for a highly compensated 
employee than for a nonhighly compensated employee. 

A plan sponsored by a State or local government is not subject to the 
nondiscrimination requirements.  In addition, a plan sponsored by an 
organization exempt from tax under section 501(c)(3) is not subject 
to the ERSA nondiscrimination tests (unless the plan permits 
after-tax or matching contributions), but must permit all employees 
of the organization to participate. 


Special rule for small employers 

Under the proposal, an employer that employed 10 or fewer employees 
with compensation of at least $5,000 in the prior year is able to 
offer an ERSA in the form of custodial accounts for employees 
(similar to a present law IRA), provided the employer's 
contributions satisfy the ERSA design based safe harbor described 
above.  The option of using custodial accounts under the proposal 
provides annual reporting relief for small employers as well as 
relief from most fiduciary requirements under the Employee 
Retirement Income Security Act of 1974 ("ERISA") under circumstances 
similar to the relief provided to sponsors of SIMPLE IRAs under 
present law. 

Effective date.-The proposal is effective for years beginning after 
December 31, 2006. 

                                  Analysis

In general

An employer's decision to establish or continue a retirement plan for 
employees is voluntary.  The Federal tax laws provide favorable tax 
treatment for certain employer-sponsored retirement plans in order to 
further retirement income policy by encouraging the establishment 
and continuance of plans that provide broad coverage, including 
rank-and-file employees.  On the other hand, tax policy is concerned also 
with the level of tax subsidy provided to retirement plans. Thus,the tax 
law limits the total amount that may be provided to any one employee under 
a tax favored retirement plan and includes strict nondiscrimination rules 
to prevent highly compensated employees from receiving a disproportionate 
amount of the tax subsidy provided with respect to employer-sponsored 
retirement plans.

The rules governing employer-sponsored retirement plans, particularly the 
nondiscrimination rules, are generally regarded as complex.  Some have 
argued that this complexity deters employers from establishing qualified 
retirement plans or causes employers to terminate such plans.  Others 
assert that the complexity of the rules governing employer-sponsored 

---------------------
/49/ For a detailed discussion of complexity issues related to
 retirement savings, see, Joint Committee on Taxation, Study of the 
Overall State of the Federal Tax System and Recommendations for 
implification, Pursuant to Section 8022(3)(B) of the Internal Revenue 
Code of 1986 (JCS-3-01), April 2001. 

retirement plans is a necessary byproduct of attempts to ensure that 
retirement benefits are delivered to more than just the most highly 
compensated employees of an employer and to provide employers, 
particularly large employers, with the flexibility needed to recognize 
differences in the way that employers do business and differences in 
workforces. 


Analysis of ERSA proposal

General nondiscrimination test.

The special nondiscrimination rules for 401(k) plans are designed to 
ensure that nonhighly compensated employees, as well as highly compensated 
employees, 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 or qualified nonelective 
contributions) 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.  

Some argue that the present-law nondiscrimination rules are 
unnecessarily complex and discourage employers from maintaining 
retirement plans.  By reducing the complexity associated with ADP 
and ACP testing and reducing the related compliance costs associated 
with a plan, the proposal arguably makes employers more likely to 
offer retirement plans, thus increasing coverage and participation.  
Others argue that the present-law section 401(k) safe harbor already 
provides a simplified method of satisfying the nondiscrimination 
requirements without the need to run the ADP and ACP tests. Some 
also point out that the proposal allows a greater differential 
in the contribution rates for highly and nonhighly compensated 
employees under an ERSA than the present law rules for section 
401(k) plans. They argue that this weakens the nondiscrimination 
rules by enabling employers to provide greater contributions to 
highly paid employees than under present law without a corresponding 
increase in contributions for rank- and-file employees. They also 
argue that the proposal reduces the incentivefor employers to 
encourage nonhighly compensated employees to participate in the 
plan, which could result in lower contributions for rank-and-file 
employees.  On the other hand, others believe that allowing 
contributions to favor highly paid employees more than under 
present law is appropriate in order to encourage employers to 
maintain plans that benefit rank-and-file employees. 

ERSA safe harbor

The present law safe harbors for elective deferrals and matching 
contributions were designed to achieve the same objectives as the 
special nondiscrimination tests for these amounts, but in a 
simplified manner.  The alternative of a nonelective contribution of 
three percent ensures a minimum benefit for all employees covered by 
the plan, while the alternative of matching contributions at a 
higher rate (up to four percent) was believed to be sufficient 
incentive to induce participation by nonhighly compensated 
employees.  It was also hoped that the safe harbors would reduce 
the complexities associated with qualified plans, and induce more 
employers to adopt retirement plans for their employees. 

To the extent that the ERSA safe harbor requires an employee's 
elective deferrals to be matched at only a 50 percent rate and 
requires a total of only three percent in matching contributions, 
some argue that the proposal not only weakens the matching 
contribution alternative under the safe harbor, but also makes that 
 alternative clearly less expensive for the employer than the 
nonelective contribution alternative, thereby reducing the incentive 
for an employer to provide nonelective contributions. 
In addition, because, as under the present-law safe harbor, the 
matching contribution alternative is satisfied by offering matching 
 contributions (without regard to the amount actually provided to 
nonhighly compensated employees), some argue that employers may no 
longer have a financial incentive to encourage employees to 
participate.  This may reduce participation by rank-and-file 
employees.  The argument may also be made that the matching 
contribution requirement under the ERSA safe harbor is less rigorous 
than the matching contribution requirement that applies to a SIMPLE 
plan under present law,even though an ERSA is not subject to the 
limitations on SIMPLE arrangements (i.e.,contributions are 
subject to lower limits and SIMPLEs are available only to small 
employers).  On the other hand, some believe that the present-law 
safe harbor for section 401(k) plans has failed to provide an adequate 
 incentive for employers to offer retirement plans to their employees 
and further incentive is needed.  Some argue that the proposal makes 
the safe harbor more attractive for employers, especially small 
employers, and will thus increase coverage and participation.  

Consolidation of various types of employer-sponsored plans 

One of the sources of complexity in the present-law rules relating to 
employer-sponsored retirement plans is the existence of numerous vehicles 
with similar purposes but different rules.  Thus, employers desiring to 
adopt a retirement plan must determine which vehicles are available 
to that employer and which of the various vehicles available it wishes 
to adopt.  This determination may entail a costly and time-consuming 
analysis and comparison of a number of different types of plans. By 
providing only one type of defined contribution plan to which employee 
 contributions may be made, i.e., an ERSA, the proposal makes it 
easier for employers to determine whether to adopt a plan and what 
type of plan to provide. Having a single type of plan may also make 
it easier for employees to understand their retirement benefits, 
particularly when employees change jobs. 

On the other hand, many employers already have plans and are 
familiar with the present-law rules applicable to their plans. 
Converting a present-law arrangement to an ERSA will involve 
administrative costs, which some employers may not view as 
commensurate with simplification benefits. 

Many view the different rules for different types of plans as largely 
historical in nature and as adding complexity without serving an 
overriding policy objective.  On the other hand, some argue that the 
 differences in 

-----------------------------
 /50/  This issue is discussed in Joint Committee on Taxation, Study 
of the Overall State of the Federal Tax System and Recommendations for 
 Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue 
 Code of 1986 (JCS-3-01), April 2001, at Vol. II, Part III.A.1 (General 
 simplification issues, at 149-150) and Part III.C.5 (Sources of 
Complexity,  at 186), and in Joint Committee on Taxation, Options to 
Improve Tax  Compliance and Reform Tax Expenditures (JCS-02-05), 
Jan. 2005, Part IV.E,  at 122-129. 

the rules serve different employment objectives and policies of 
different types of employers. 

Some may be concerned that the proposal, in combination with the 
proposals for expanded individual savings opportunities (i.e., 
Lifetime Savings Accounts and Retirement Savings Accounts), will 
further reduce the incentive for small employers to offer 
retirement plans to their employees. Although higher contributions 
may be made to an employer-sponsored retirement plan than to these 
other arrangements, comparable contributions must be made by or on 
behalf of rank-and-file employees. The opportunity to contribute 
$5,000 a year to both a Lifetime Savings Account and a 
Retirement Savings Account for both the business owner and 
his or her spouse, without regard to adjusted gross income or 
contributions for rank-and-file employees, may be a more attractive 
 alternative to maintaining a qualified retirement plan.  On the 
other hand, the excludability of ERSA contributions and the 
availability of the ERSA safe harbor, coupled with the higher 
contribution levels permitted under a qualified plan, may be 
viewed as providing an adequate incentive for a small employer to 
establish an ERSA. 

                                  Prior Action
                                  
A similar proposal was included in the President's fiscal year 2004, 
2005, and 2006 budget proposals.  The President's fiscal year 2004 
budget proposal also included several proposals to simplify the 
rules for defined contribution plans generally 

3.  Individual development accounts 

                                     Present Law
                                     
Individual development accounts were first authorized by the 
Personal Work and Responsibility Act of 1996.  In 1998, the Assets 
for Independence Act established a five-year $125 million 
demonstration program to permit certain eligible individuals to open 
and make contributions to an individual development account. 
Contributions by an individual to an individual development account 
do not receive a tax preference but are matched by contributions 
from a State program, a participating nonprofit organization, 
or other "qualified entity."  The IRS has ruled that matching 
contributions by a qualified entity are a gift and not taxable to 
the account owner.\52\ The qualified entity chooses a matching 
rate, which must be between 50 and 400 percent.  Withdrawals from 
individual development account can be made for certain higher 
education expenses, a first home purchase, or small business 
capitalization expenses. Matching contributions (and earnings 
thereon) typically are held separately from the individuals' 
contributions (and earnings thereon) and must be paid directly to 
a mortgage provider, educational institution, or business 
capitalization account at a financial institution. The Department 
of Health and Human Services administers the individual development 
account program. 

-------------------------
   /51/ The proposals relating to Lifetime Savings Accounts and 
Retirement Savings Accounts are discussed in Part II.A.1. of this 
document. 
  
   /52/ Rev. Rul. 99-44, 1999-2 C.B. 549. 
   

                       Description of Proposal
                                
The proposal provides a nonrefundable tax credit for a qualified 
entity (i.e., qualified financial institutions, qualified nonprofit 
 organizations, and qualified Indian tribes)  that has an individual 
 development account program in a taxable year.  The tax credit 
equals the amount of matching contributions made by the eligible 
entity under the program (up to $500 per account per year) plus $50 
for each individual development account maintained during the year 
under the program. Except in the first year that each account is 
open, the $50 credit is available only for accounts with a balance 
of more than $100 at year-end.  The amount of the credit is adjusted 
for inflation after 2008. The $500 amount is rounded to the nearest 
multiple of twenty dollars.  The $50 amount is rounded to the nearest 
multiple of five dollars. No deduction or other credit is available 
with respect to the amount of matching funds taken into account 
in determining the credit. 

The credit applies with respect to the first 900,000 individual 
development accounts opened after December 31, 2007 and before 
January 1, 2013, and with respect to matching funds for participant 
 contributions that are made after December 31, 2007, and before 
January 1, 2015. 

Nonstudent U.S. citizens or legal residents between the ages of 18 
and 60 (inclusive) who are not dependents of a taxpayer and who meet 
certain income requirements are eligible to open and contribute to an 
individual development account.  The income limit is modified 
adjusted gross income of $20,000 for single filers, $40,000 for 
joint filers, and $30,000 for head-of-household filers.   Eligibility 
in a taxable year is based on the previous year's modified adjusted 
gross income and circumstances (e.g., status as a student).  Modified 
adjusted gross income is adjusted gross income, plus certain items 
that are not includible in gross income. The proposal does not 
specify which items are to be added.  The income limits are adjusted 
for inflation after 2007.  This amount is rounded to the nearest 
multiple of 50 dollars. 

Under the proposal, an individual development account must: (1) be 
owned by the eligible individual for whom the account was 
established; (2) consist only of cash contributions; (3) be held 
by a person authorized to be a trustee of any individual retirement 
account under section 408(a)(2)); and (4) not commingle account 
assets with other property (except in a common trust fund or common 
investment fund).  These requirements must be reflected in the 
written governing instrument creating the account.  The entity 
establishing the program is required to maintain separate accounts 
for the individual's contributions (and earnings therein) and 
matching funds and earnings thereon. 

Contributions to individual development accounts by individuals are 
not deductible and earnings thereon are taxable to the account holder. 
Matching contributions and earnings thereon are not taxable to the 
account holder. 

------------------------------
 /53/ If the qualified entity is tax-exempt, other persons may claim 
the credit as provided for in Treasury regulations. 

 /54/  Married taxpayers filing separate returns are not eligible to 
open an IDA or to receive matching funds for an IDA that is already 
open. 
   

The proposal permits individuals to withdraw amounts from an individual 
development account for qualified expenses of the account owner, 
owner's spouse, or dependents. Withdrawals other than for qualified 
expenses ("nonqualified" withdrawals) may not be made from the portion
of the accounts attributable to the matching contributions before the 
account owner attains age 61.  In addition, nonqualified withdrawals 
from the portion of the account attributable to the individual 
contributions may result in forfeiture of some or all of the amounts 
attributable to matching contributions.  Qualified expenses 
include: (1) qualified higher education expenses (as generally 
defined in section 529(e)(3); (2) first-time homebuyer costs 
(as generally provided in section 72 (t)(8); (3) business 
capitalization or expansion costs (expenditures made pursuant 
to a business plan that has been approved by the financial institution, 
nonprofit, or Indian tribe); (4) rollovers of the balance of the 
account (including the parallel account) to another individual 
development account for the benefit of the same owner; and (5) final 
 distributions in the case of a deceased account owner. Withdrawals 
for qualified home and business capitalization expenses must be paid 
directly to another financial institution. Withdrawals for qualified 
 educational expenses must be paid directly to the educational 
institution. Such withdrawals generally are not permitted until the 
account owner completes a financial education course offered by a 
qualified financial institution, qualified nonprofit organization, 
qualified Indian tribe or governmental entity.  
The Secretary of the Treasury (the "Secretary") is required to 
establish minimum standards for such courses.  Withdrawals for 
nonqualified expenses may result in the account owner's forfeiture 
of some amount of matching funds. 

The qualified entity administering the individual development account 
program is generally required to make quarterly payments of matching 
funds on a dollar-for-dollar basis for the first $500 contributed by 
the account owner in a taxable year. This dollar amount is adjusted 
for inflation after 2008.  Matching funds may be provided also by 
State, local, or private sources Balances of the individual 
development account and parallel account are reported annually to the 
account owner. If an account owner ceases to meet eligibility 
requirements, matching funds generally are not contributed 
during the period of ineligibility.  Any amount withdrawn from a 
parallel account is not includible in an eligible individual's gross 
income or the account sponsor's gross income. 

Qualified entities administering a qualified program are required to 
report to the Secretary that the program is administered in 
accordance with legal requirements.  If the Secretary determines 
that the program is not so operated, the Secretary has the power to 
terminate the program. Qualified entities also are required to 
report annually to the Secretary information about: (1) the number 
of individuals making contributions to individual 
development accounts; (2) the amounts contributed by such 
individuals; (3) the amount of matching funds contributed; (4) the 
amount of funds withdrawn and for what purpose; (5) balance 
information; and (6) any other information that the Secretary deems 
necessary. 

The Secretary is authorized to prescribe necessary regulations, 
including rules to permit individual development account program 
sponsors to verify eligibility of individuals seeking to open 
accounts.  The Secretary is also authorized to provide rules to 
recapture credits claimed with respect to individuals who forfeit 
matching funds. 

Effective date.-- The proposal is effective for taxable years ending 
after December 31,2007, and beginning before January 1, 2015. 


                               Analysis

Policy issues

The proposal is intended to encourage individuals to save by providing a 
subsidy to saving.  Proponents argue that many individuals have 
sufficiently low income that saving is difficult, and that the subsidy 
will help these individuals to accumulate savings, as well as to 
become more financially literate through the programs required to 
be provided by the eligible entities that may offer IDAs. 

Opponents may argue that the generosity of the subsidy, which provides 
an immediate 100 percent return to the individual's contribution, 
makes the program more like an income transfer program and does not 
provide a realistic picture of the normal returns to saving.  Others 
note that the cap on the number of accounts to which the credit 
applies creates the potential for unequal tax treatment of similarly 
situated individuals, and may effectively allow financial and other 
eligible institutions to pick and choose among potential 
beneficiaries of the individual development account program.  
Additionally, individuals without ready access to eligible 
institutions are disadvantaged with respect to the ability to 
benefit under the proposal. 

Complexity issues 

In general, adding a new credit to the tax law will tend to increase the 
complexity of the tax law and will require additional Treasury or other 
Governmental resources to be devoted to administration of the provisions 
and to enforcement activities.  The individual development account 
proposal requires additional record keeping by financial institutions 
 benefiting from the credit and also by account holders.  The annual 
reporting requirements of the individual development account program 
will increase the paperwork burden on individuals and financial 
institutions utilizing the provision.  Arguably, the proposal will 
also add complexity in that it will increase the number of savings 
incentives in the tax law, each with different requirements.  Some 
might argue that consolidation of these incentives will serve to 
simplify tax law and tax administration. 


                                     Prior Action
                                     
Similar proposals were included in the President's fiscal year 2002, 
2003, 2004, 2005,and 2006 budget proposals. 


B.  Increase Section 179 Expensing

                                  Present Law
                                    
In lieu of depreciation, a taxpayer with a sufficiently small amount of 
annual investment may elect to deduct (or "expense") such costs.  
Present law provides that the maximum amount a taxpayer may expense, 
for taxable years beginning in 2003 through 2007, is $100,000 of the 
cost of qualifying property placed in service for the taxable year. 
Additional section 179 incentives are provided with respect to a 
qualified property used by a business in the New York Liberty Zone 
(sec. 1400L(f)), an empowerment zone (sec. 1397A), a renewal 
community (sec. 1400J), or the Gulf Opportunity 
Zone (sec. 1400N(e)). In general, qualifying property is defined as 
depreciable tangible personal property that is purchased for use in the 
active conduct of a trade or business. Off-the-shelf computer software 
placed in service in taxable years beginning before 2008 is treated as 
qualifying property.  The $100,000 amount is reduced (but not below 
zero) by the amount by which the cost of qualifying property placed 
in service during the taxable year exceeds $400,000.  The $100,000 
and $400,000 amounts are indexed for inflation for taxable years 
beginning after 2003 and before 2008. 

For taxable years beginning in 2008 and thereafter, a taxpayer with a 
sufficiently small amount of annual investment may elect to deduct up to 
$25,000 of the cost of qualifying property placed in service for the 
taxable year.  The $25,000 amount is reduced (but not below zero) by the 
amount by which the cost of qualifying property placed in service during 
the taxable year exceeds $200,000. 

The amount eligible to be expensed for a taxable year may not exceed 
the taxable income for a taxable year that is derived from the active 
conduct of a trade or business (determined without regard to this 
provision).  Any amount that is not allowed as a deduction because 
of the taxable income limitation may be carried forward to succeeding 
taxable years (subject to similar limitations).  No general business 
credit under section 38 is allowed with respect to any amount for 
which a deduction is allowed under section 179. 

An expensing election is made under rules prescribed by the Secretary 
(sec. 179(c)(1)). Under Treas. Reg. sec. 1.179-5, applicable to property 
placed in service in taxable years beginning after 2002 and before 2008, 
a taxpayer is permitted to make or revoke an election under section 179 
without the consent of the Commissioner on an amended Federal tax return 
for that taxable year.  This amended return must be filed within the time 
prescribed by law for filing an amended return for the taxable year. 
For taxable years beginning in 2008 and thereafter, an expensing election 
may be revoked only with consent of the Commissioner (sec. 179(c)(2)). 


                           Description of Proposal
                           
The proposal increases permanently the amount a taxpayer may deduct 
under section 179.  The proposal provides that the maximum amount a 
taxpayer may expense, for taxable years beginning after 2006, is 
$200,000 of the cost of qualifying property placed in service for 
the taxable year.  The $200,000 amount is reduced (but not below 
zero) by the amount by which the cost of qualifying property placed 
in service during the taxable year exceeds $800,000.  

The President's fiscal 2007 budget proposal separately proposes 
permanent extension of the temporary provisions of section 179 
that are in effect for taxable years beginning before 2008 \55\. 
That proposal,which is treated as underlying the increased dollar 
amounts of this proposal, provides that the section 179 dollar 
limit amounts continued to be indexed for inflation for taxable 
years beginning after 2007. In addition, off-the-shelf computer 
software is treated as qualifying property. Further, a taxpayer is 
permitted to make or revoke an election for a taxable year under 
section 179 without the consent of the Commissioner on an amended 
Federal tax return for that taxable year.  That proposal is 
effective for taxable years beginning after 2007.

Effective date.--The proposal to increase the section 179 amounts to 
$200,000 and $800,000 is effective for taxable years beginning after 
2006. 


                                    Analysis
                                    
The proposal would lower the after-tax cost of capital expenditures made 
by eligible businesses by permitting the immediate deduction of the full 
amount of the capital expenditure (i.e., expensing), rather than 
depreciation of the expenditure over a series of years.  With a lower 
cost of capital, it is argued that eligible businesses will invest in 
more equipment and employ more workers, thus serving to stimulate 
economic growth in the United States. 

Expensing of capital expenditures is the appropriate treatment if the 
objective is to tax consumption, because expensing effectively eliminates 
tax on the normal returns to the marginal investment opportunity. \56\If 
the objective is to tax income, then depreciation deductions should 
coincide with the economic depreciation of the asset in order to 
measure economic income accurately.  A depreciation system more 
generous than economic depreciation, but less generous than full 
expensing, results in an effective tax rate on the income from 
capital that is less than the statutory tax rate, but still positive. 

In addition to promoting investment, advocates of expensing assert that 
increased expensing eliminates depreciation recordkeeping requirements 

---------------------
 /55/ See section I.A. of this document for the description of the 
 President's fiscal 2007 budget proposal permanently to extend those 
rules  of section 179 that are currently in effect for taxable years 
beginning  before 2008. 

 /56/ To see this, consider an investment of $100 that yields the 
normal return in the following year, assumed to be 10-percent pre-tax 
return,  resulting in $110 (this example assumes no remaining basis 
for simplicity). 

 If the tax rate is 50 percent, expensing of the $100 investment 
yields a $50 reduction in tax liability, meanig the after-tax cost 
to the taxpayer  for the $100 investment is $50  The $110 return in 
the following year  results in a $55 tax, and thus a $55 after-tax 
return.  Thus, the after-tax rate if return on the investment is 10 
percent ($55-$50,divided by $50), the same as the spre-tax rate of 
return, and the pesent value of tax  liability, discounted at the 
normal rate of return, is zero. While an investment that realized a 
return in excess of the normal return would  also have the same 
pre-tax rate of return as after-tax rate of return, the return in 
excess of hte normal return would bear the statutory rate of tax and 
the present value of tax liability would be greater than zero. 
 It should be noted that when a deduction for interest on 
debt-financed  investment is taken along with expensing, the 
effective rate of tax on  the normal return to such investment 
turns negative. 


with respect to expensed property.  Under the proposal, Federal 
income tax accounting would be simplified by increasing the portion 
of capital costs that are expensed in one taxable year and 
concomitantly reducing those that are recovered through depreciation 
over a series of years.  It could be argued that the simplification 
benefit of expensing is not fully realized, however, so long as 
property is partially depreciated, or so long as some but not all 
of the taxpayer's property that is eligible for cost recovery is 
expensed; the taxpayer must still keep records for that property 
that is subject to depreciation over a period of years. 

Increasing the present-law $400,000 phaseout threshold amount to 
$800,000 can have the effect of generally permitting larger 
businesses to obtain the tax benefit of expensing.  Some may argue 
that this result is inconsistent with the idea of limiting expensing 
to small businesses, as under the present-law provision.  They might 
 alternatively argue that in an income tax system, expanding the 
availability of expensing is not appropriate because it results in 
broader income mismeasurement.  On the other hand, it could be 
argued that there is no rationale for limiting expensing to 
businesses below a particular size or with capital expenditures below 
a certain level. 

An advantage of making the increase in the expensing amounts 
permanent is that it reduces uncertainty with respect to the tax 
treatment of future investment, thus permitting taxpayers to plan 
capital expenditures with greater focus on the underlying economics 
of the investments, and less focus on tax-motivated timing of 
investment. Removing tax-motivated distortions in the timing of 
investment may promote more efficient allocation of economic 
resources.  On the other hand, legislative changes to the expensing 
rules (principally temporary increases in the amount that 
can be expensed) have been frequent in the past decade, and there is 
nothing to suggest that additional legislative changes would not be 
made to the expensing rules, whether the current expensing rules were 
permanent or temporary.  Additionally, to the extent that the 
rationale for the original increase in the amounts that may be expensed 
was to provide a counter-cyclical short-term economic stimulus, it 
can be argued that it is important that such provisions in fact be 
temporary.  If there is uncertainty that a provision providing 
temporary tax relief may not ultimately be temporary, it can be 
argued that the stimulative effect of the provision is compromised 
because the taxpayer need not act within the originally specified 
time frame of the provision in order to get the tax benefits from 
the provision. 

                                   Prior Action
                                   
H.R. 4297, as passed by the House (the "Tax Relief Extension 
Reconciliation Act of 2005"), extends the present-law section temporary 
 section 179 rules for an additional two years (through taxable years 
 beginning before 2010). 

H.R. 4297, as amended by the Senate (the "Tax Relief Act of 2005"), also 
extends the present-law section temporary section 179 rules for an 
additional two years (through taxable years beginning before 2010). 


                          C.  Health Care Provisions
                             
1.  Facilitate the growth of HSA-eligible health coverage


                                  Present Law
                                                                      
In general

Present law contains a number of provisions dealing with the Federal 
tax treatment of health expenses and health insurance coverage.  
The tax treatment of health insurance expenses depends on whether a 
taxpayer is covered under a health plan paid for by an employer, 
whether an individual has self-employment income, or whether an 
individual itemizes deductions and has medical expenses that exceed 
 a certain threshold. The tax benefits available with respect to 
health care expenses also depends on the type of coverage. 

Exclusion for employer-provided coverage 

In general, employer contributions to an accident or health plan are 
excludable from an employee's gross income (and wages for employment 
tax purposes).\57\  This exclusion generally applies to coverage 
provided to employees (including former employees) and their spouses,
dependents, and survivors. Benefits paid under employer- 
provided accident or health plans are also generally excludable from 
income to the  extent they are reimbursements for medical care.\58\ 
If certain requirements are satisfied, employer-provided accident 
or health coverage offered under a cafeteria plan is also excludable 
from an employee's gross income and wages.\59\  A cafeteria plan 
allows employees to choose between cash and certain nontaxable 
benefits, including health coverage.  Through the use of a cafeteria 
plan, employees can pay for health coverage on a salary reduction 
basis. 

Present law provides for two general employer-provided arrangements 
that can be used to pay for or reimburse medical expenses of employees 
on a tax-favored basis: flexible spending arrangements ("FSAs") and 
health reimbursement arrangements ("HRAs").  While these arrangements 
provide similar tax benefits (i.e., the amounts paid under the 
arrangements for medical care are excludable from gross income and 
wages for employment tax purposes), they are subject to different 
rules.  A main distinguishing feature between the two arrangements 
is that while FSAs are generally part of a cafeteria plan and 
contributions to FSAs are made on a salary 

-------------------
/57/ Secs. 106, 312(a)(2), and 3306(b)(2). 

/58/ Sec. 105. In the case of a self-insured medical reimbursemet 
arrangement, the exclusion applies to highly compensated employees 
only if certain non-discrimination rules are satisfed. Sec. 105(h). 
Medical care is defined as under section 213(d) and generally 
includes amounts paid for qualifed long-term care insurance and 
services. 

/59/ Secs. 125, 3121(a)(5)(G), and 3306(b)(5)(G). Long-term care 
insurance and services may not be provided through a cafeteria plan. 

reduction basis,\60\ HRAs cannot be part of a cafeteria plan and 
contributions cannot be made on a salary reduction basis.  In addition, 
 amounts in an HRA may be used to purchase insurance as well as to 
reimburse expenses not covered by insurance, while amounts in an FSA 
cannot be used for insurance, but are used to pay for expenses not 
coverage by insurance.  Moreover, the ability to carry over unused 
amounts from one year to the next is different. 
An FSA may provide that amounts remaining as of the end of the year 
may be used to reimburse expenses incurred within 2-1/2 months of the 
end of the year.  Under an HRA, however, unused amounts generally may 
be carried forward into the next year.  The different treatment for 
unused amounts stems from the statutory rule that provides that 
cafeteria plans, including salary reduction FSAs, generally may not 
provide for deferred compensation.\61\ 

Deduction for health insurance expenses of self-employed individuals

The exclusion for employer-provided health coverage does not apply to 
self-employed individuals.  However, under present law, self-employed 
individuals (i.e., sole proprietors or partners in a partnership)\62\ 
are entitled to deduct 100 percent of the amount paid for health 
insurance for themselves and their spouse and dependents for income 
tax purposes.\63\ 

Itemized deduction for medical expenses

Under present law, individuals who itemize deductions may deduct 
amounts paid during the taxable year for health insurance (to the 
extent not reimbursed by insurance or otherwise) for the taxpayer, 
the taxpayer's spouse, and dependents, only to the extent that the 
taxpayer's total medical expenses, including health insurance 
premiums, exceeds 7.5 percent of the taxpayer's adjusted gross 
income.\64\ 

Health care tax credit

Under the Trade Adjustment Assistance Reform Act of 2002,\65\  certain 
individuals are eligible for the health coverage tax credit ("HCTC").  
The HCTC is a refundable tax credit for 65 percent of the cost of 
qualified health coverage paid by an eligible individual.  In general, 
eligible individuals are individuals receiving a trade adjustment 
allowance(and individuals who would be eligible to receive such an
allowance but for the fact that they had not exhausted their

--------------------

/60/ Notice 2002-45,2002-28 I.R.B. 93 (July 15,20020; Rev.Rul, 
 2002-41, 2002-28 I.R.B. 75 (July 15, 2002). 

/61/ Sec.125(d)(2).

/62/ Self-employed individuals include more than two-percent 
shareholdes of S corporations who are treated as partners for 
purposes of fringe benefit rules pursuant to section 1372. 

/63/ Sec. 162(1). The deduction does not apply for self-employment 
tax (SECA) purposes. 

/64/ Sec. 213. The adjusted gross income percentages is 10 percent for 
purposes of the alternate minumum tax. Sec. 56(b)(1)(B). 

/65/ Pub. L. No. 107-210, secs.201(a),202 and 203 (2002). 


regular unemployment benefits), individuals eligible for the 
alternative trade adjustment assistance program, and individuals 
over age 55 and receiving pension benefits from the Pension Benefit 
Guaranty Corporation. The credit is available for "qualified 
health insurance," which includes certain employer-based insurance, 
certain State-based insurance, and in some cases, insurance 
purchased in the individual market.  The credit is available on an 
advance basis through a program established by the Secretary. 

Health savings accounts

In general 

The Medicare Prescription Drug, Improvement, and Modernization Act of 
2003\66\ allows individuals with a high deductible health plan (and no 
other health plan other than a plan that provides certain permitted 
coverage) to establish a health savings account ("HSA").\67\   An HSA 
is a tax-exempt trust or custodial account. In general, HSAs provide 
tax-favored treatment for current medical expenses as well as the 
ability to save on a tax-favored basis for future medical expenses. 

Eligible individuals 

Eligible individuals for HSAs are individuals who are covered by a 
high deductible health plan and no other health plan that is not a 
high deductible health plan and which provides coverage for any 
benefit which is covered under the high deductible health plan.  
Individuals entitled to benefits under Medicare are not eligible to 
make contributions to an HSA.  An individual with other coverage in 
addition to a high deductible health plan is still eligible for an 
HSA if such other coverage is certain permitted insurance or 
permitted coverage. 

A high deductible health plan is a health plan that has a deductible 
for 2006 that is at least $1,050 for self-only coverage or $2,100 
for family coverage and that has an out-of-pocket expense limit that 
is no more than $5,250 in the case of self-only coverage and $10,500 
in the case of family coverage.   A plan is not a high deductible 
health plan if substantially all of the coverage is for permitted 
coverage or coverage that may be provided by permitted insurance, as 
described above.  A plan does not fail to be a high deductible 
health plan by reason of failing to have a deductible for preventive 
care. 

Tax treatment of and limits on contributions

Contributions to an HSA by or on behalf of an eligible individual 
are deductible (within limits) in determining adjusted gross income 
(i.e., "above-the-line") of the individual.  In addition, employer 
 contributions to HSAs (including salary reduction contributions 
made through a cafeteria plan) are excludable from gross income and 
wages for employment tax purposes.  The maximum aggregate annual 
contribution that can be made to an HSA is the lesser of (1) 100 
percent of the annual deductible under the high deductible health 
plan, or (2) (for 2006) $2,700 in the case of self-only coverage and 
$5,450 in the case of family coverage. The annual contribution 
limits are increased for individuals who have attained
age 55 by the end of the taxable year. In the case of policyholders 
and covered spouses who are age 55 or older, the HSA annual 
contribution limit is greater than the otherwise applicable limit by 
$700 in 2006, $800 in 2007, $900 in 2008, and $1,000 in 2009 and 
thereafter. 

An excise tax applies to contributions in excess of the maximum 
contribution amount for the HSA.  If an employer makes contributions 
to employees' HSAs, the employer must make available comparable 
contributions on behalf of all employees with comparable coverage 
during the same period.  

Taxation of distributions

Distributions from an HSA for qualified medical expenses of the 
individual and his or her spouse or dependents generally are 
excludable from gross income.  Qualified medical expenses generally 
are defined as under section 213(d). Qualified medical expenses do 
not include expenses for insurance other than for (1) long-term care 
 insurance, (2) premiums for health coverage during any period of 
continuation coverage required by Federal law, (3) premiums for 
health care coverage while an individual is receiving unemployment 
compensation under Federal or State law, or (4) in the case of an 
account beneficiary who has attained the age of Medicare 
eligibility, health insurance premiums for Medicare, other than 
premiums for Medigap policies  Such qualified health insurance premiums 
 include, for example, Medicare Part A and Part B premiums, Medicare 
HMO premiums, and the employee share of premiums for employer- 
sponsored health insurance including employer-sponsored retiree health 
insurance.

For purposes of determining the itemized deduction for medical expenses, 
distributions from an HSA for qualified medical expenses are not treated 
as expenses paid for medical care under section 213.  Distributions from 
an HSA that are not for qualified medical expenses are includible in 
gross income.  Distributions includible in gross income are also subject 
to an additional 10-percent tax unless made after death, disability, or 
the individual attains the age of Medicare eligibility (i.e., age 65).

Archer MSAs

Like HSAs, an Archer MSA is a tax-exempt trust or custodial account to 
which tax-deductible contributions may be made by individuals with a high 
deductible health plan.\70\  Archer MSAs provide tax benefits similar to,
but generally not as favorable as, those provided by HSAs for certain 
individuals covered by high deductible health plans. 

The rules relating to Archer MSAs and HSAs are similar.  The main 
differences include: (1) only self-employed individuals and employees of 
small employers are eligible to have an Archer MSA; (2) for MSA 
purposes, a high deductible health plan is a health plan with (a) an 
annual deductible of at least $1,800 and no more than $2,700 in the 
case of self-only coverage and at least $3,650 and no more than $5,450 
in the case of family coverage and (b) maximum out-of pocket 
expenses of no more than $3,650 in the case of self-only coverage and 
no more than $6,650 in the case of family coverage;\71\ (3) higher 
 contributions may be made to HSAs, and (4) the additional tax on 
 distributions not used for medical expenses is 15 percent rather 
than 10 percent. 

After 2005, no new contributions can be made to Archer MSAs except by 
or on behalf of individuals who previously had Archer MSA 
contributions and employees who are employed by a participating 
employer. 


                            Description of Proposal
In general

The proposal has four elements: (1) provide an above-the-line 
deduction and refundable income tax credit for the purchase of 
HSA-eligible non-group coverage to offset employment taxes; (2) 
increase the amounts that can be contributed to HSAs and provide a 
refundable income tax credit to offset employment taxes on HSA 
contributions not made by an employer; 
(3) provide a refundable tax credit to lower income individuals for 
the purchase of HSA-eligible health coverage; and (4) make other 
changes to HSAs to facilitate their formation and administration. 


Above-the-line deduction and income tax credit for the purchase of 
HSA-eligible non-group coverage

Above-the-line deduction

The proposal provides an above-the-line deduction for insurance premiums 
that meet the definition of a high deductible health plan under the rules 
relating to HSAs.  The deduction is only allowed for insurance purchased 
in the individual insurance market. As under the present-law 

---------------------
\70\ Sec. 220.

\71\ The deductible and out-of-pocket expenses dollar amounts are for 
2006.  These amounts are indexed for inflation in $50 increments. 


rules relating to HSA eligibility, an individual does not qualify for 
the deduction if the individual is covered by any health plan other 
than the high deductible plan for which the deduction is claimed, 
except for certain permitted coverage.  The deduction is not allowed 
for individuals covered by employer plans  or public plans.  
Additionally, the deduction is not allowed to an individual claiming 
the present-law HCTC or the proposed refundable health insurance tax 
credit ("HITC") included in the President's fiscal year 2007 budget 
proposal. The deduction is not allowed for amounts paid from an HSA. 
An individual may not claim both the deduction for health insurance 
expenses of self-employed individuals and this proposed deduction 
for the same premiums. 


Refundable credit

In addition to the above-the-line deduction for HSA-eligible premiums, 
individuals who purchase insurance eligible for the proposed deduction 
are entitled to a refundable credit equal to the lesser of (1) 15.3 
percent of the high deductible health plan premium or (2) 15.3 percent 
of the individual's wages subject to employment taxes.  If the taxpayer 
has wages above the Social Security wage base, the credit rate would 
be lower to account for the lower rate of employment taxes on wages 
above the cap.  The credit would not apply to amounts paid with 
HSA funds. 

Increase in HSA contribution limit; refundable income tax credit to 
offset employment taxes on HSA contributions not made by an employer 
The maximum annual HSA contribution is increased to the out-of-pocket 
limit for a participant's high deductible health plan (i.e., for 2006, 
$5,250 for self-only coverage and $10,500 for family coverage).  
The maximum contribution is pro rated for the number of months in the 
year that the individual is an eligible individual with coverage by 
the high deductible health plan. 

As under present law, a special rule applies for determining HSA 
contributions by married individuals with family high deductible health 
plan coverage.  If one spouse has family coverage, both spouses are 
generally treated as having family coverage. If both spouses have 
family coverage, the coverage with the lowest bona fide out-of-pocket 
amount determines the maximum annual HSA contribution by the couple. 
The maximum annual HSA contribution based on the family high 
deductible health plan coverage is divided between the spouses 
equally unless they agree on a different division, which can include 
 allocating the entire contribution to one spouse.  If one spouse has 
family coverage that is not high deductible health plan coverage, 
neither spouse may contribute to an HSA unless the non-high 
deductible health plan does not cover both spouses. 

-----------------------
\72\ While the proposal provides that the deduction (and the credit, 
described below) is not allowed for individuals covered by employer 
 plan. For example, an employee could have a high deductible  health 
plan purchased in the individual market, a portion of the cost of 
which is paid by the employer.  It is unclear whether such plan 
would qualify for the deduction. 


Where married couples have non-overlapping coverage, they would be 
allowed to "stack" the separate maximum contributions up to the 
out-of-pocket maximum allowed for a family high deductible health 
plan to determine the amount of the contribution.  The contributions 
to each spouse's HSA would remain subject to that spouse's respective 
HSA contribution limit.  Family high deductible health plan coverage 
that only covers a single eligible individual is treated as self-only 
coverage for purposes of determining the maximum HSA contribution.  
Thus, if there is only a single eligible individual covered by a 
family high deductible health plan, the maximum HSA contribution is 
capped at the out-of- pocket maximum for self-only plan.  With 
respect to catch up contributions, if both spouses are 
eligible individuals, both spouses will be allowed to contribute the 
contributions to a single HSA owned by one spouse. 

In addition, in the case of HSA contributions made by an individual 
(rather than the individual's employer), the individual is entitled 
to a refundable credit equal to a percentage of such contributions to 
offset the employment taxes on the contributions.  The credit is the 
lesser of (1) 15.3 percent of the contributions to the HSA, or (2) 
15.3 percent of wages subject to employment taxes.  If the taxpayer 
has wages above the Social Security wage cap, the credit would be 
lower to account for the lower employment tax rate on wages above 
the cap.  If the taxpayer is also eligible for a credit for high 
deductible health plan premium payments, the OASDI portion of the 
employment tax in the above calculation would be limited by the 
combined amount by which the applicable high deductible health 
plan premium payments and applicable HSA contributions exceed the 
amount of wages above the OASDI cap.  In order to recapture the 
credit relating to employment taxes for contributions that are 
not used for medical expenses, the additional tax on nonmedical 
distributions would be increased to 30 percent, with a 15-percent 
rate on nonmedical distributions after death, disability or 
attaining the age for Medicare eligibility. 

Refundable tax credit for lower income individuals for the purchase of 
HSA-eligible health coverage

The proposal provides a refundable tax credit ("health insurance tax 
credit" or "HITC") for the cost of an HSA-eligible high deductible health 
plan purchased by individuals who are under age 65 and who do not 
participate in a public or employer-provided health plan.  The maximum 
annual amount of the credit is 90 percent of premiums, up to a maximum 
premium of $1,111 in the case of a policy covering only one adult, only 
one child, or only two or more children; $2,222 for a policy or policies 
covering two adults or one adult and one or more children; and $3,333 
for a policy or policies covering two adults plus one or more 
children. This dollar amount is indexed in accordance with the 
medical care component of the Consumer Price Index based on all-urban 
 consumers.  Thus, the maximum annual credit (prior to any indexing 
of the premium limit) is $3,000 per tax return (for three or more 
covered individuals).  The maximum credit rate is phased out for 
higher income taxpayers as described below. 

The 90 percent credit rate is phased-down for higher income taxpayers. 
Individual taxpayers filing a single return with no dependents and 
modified adjusted gross income of $15,000 or less are eligible for 
the maximum credit rate of 90 percent.  The credit percentage for 
individuals filing a single return with no dependents is phased-down 
ratably from 90 percent to 50 percent for modified adjusted gross 
income between $15,000 and $20,000, and phased-out completely at 
modified adjusted gross income of $30,000.  

Other taxpayers with modified adjusted gross income up to $25,000 are 
eligible for the maximum credit rate of 90 percent.  The credit 
percentage is phased-out ratably for modified adjusted gross income 
between $25,000 and $40,000 if the policy covers only one person, and 
for modified adjusted gross income between $25,000 and $60,000 if the 
policy (or policies) covers more than one person. 

Taxpayers may not claim the present-law HCTC and this credit for 
the same coverage period.  In addition, taxpayers may not claim the 
HITC for the same period as they claim the above-the-line deduction 
for high deductible health plan premiums included in the President's 
fiscal year 2007 budget proposal. 

The credit can be claimed on the individual's tax return or, beginning 
in 2008, on an advanced basis, as part of the premium payment process, 
by reducing the premium amount paid to the insurer. Health insurers 
will be reimbursed by the Department of the Treasury for the amount 
of the credit. Eligibility for the advanced credit option is based on 
the  individual's prior year return and there is no reconciliation on 
the current year return. 

Qualifying health insurance can be purchased through the individual 
insurance market, private purchasing groups, State-sponsored insurance 
purchase pools, and State high-risk pools. At the option of States, after 
December 31, 2007, the credit can be used by certain individuals 
not otherwise eligible for public health insurance programs to buy into 
privately contracted State-sponsored purchasing groups (such as Medicaid 
or SCHIP purchasing pools for private insurance or State government 
employee programs for States in which Medicaid or SCHIP does 
not contract with private plans).  States can provide additional 
contributions to individuals who purchase insurance through such 
purchasing groups.  The maximum State contribution is $2,000 
per adult (for up to two adults) for individuals with incomes up to 133 
percent of the poverty level.  The maximum State contribution is 
phased-down ratably, reaching $500 per adult at 200 percent of the 
poverty level.  Individuals with income above 200 percent of the 
poverty level are not eligible for a State contribution.  States are 
not allowed to offer any other explicit or implicit cross subsidies. 

Other changes relating to HSAs

For purposes of HSAs, qualified medical expenses include any medical 
expense incurred on or after the first day of HSA-eligible coverage for a 
year, regardless of whether the HSA had been established when the expense 
was incurred. The HSA has to be established no later than the date for 
filing the individual's tax return for the year, determined without 
regard to extensions. 

Qualified medical expenses that can be reimbursed by an HSA are 
expanded to include the premiums for the purchase of HSA-eligible 
plans through the individual market. 

Employers are allowed to contribute existing HRA balances to the 
HSAs of employees who would be eligible individuals but for the HRA 
coverage. The contributions of the HRA balances are not taken into 
account for purposes of the comparability rules, or the annual 
maximum HSA contributions.  Only HRAs existing on the date of 
enactment qualify for the transfer and only contributions of HRA 
balances made in prior taxable years beginning one year after the 
date of enactment are covered. 

Contributions to HSAs on behalf of employees who are chronically 
ill or employees who have spouses or dependents who are chronically 
ill are excluded from the comparability rules to the extend the 
contributions exceed the comparable contributions for other employees. 

Effective date.-The proposals are effective for taxable years beginning 
after December 31, 2006.  The advanced payment option for the 
refundable credit for low-income individuals is to be available 
beginning in 2008. 


                              Analysis
In general

The proposal increases incentives for individuals to purchase high 
deductible health plans and contribute to HSAs.  The proposal raises 
both tax and health policy issues.  The proposal is intended to 
increase equity in the tax laws by providing more similar tax 
treatment for employer-provided group insurance, individually 
purchased insurance, and out-of-pocket health spending. The proposal 
is intended to create a more market-oriented and consumer driven 
health care system, with a view toward making health care more 
affordable and accessible.  There is substantial disagreement among 
analysts as to whether the proposal will achieve the stated goals, or 
will have an adverse effect on the affordability, accessibility, and 
quality of health care coverage. 

Issues under present law

The appropriateness of the present-law Federal tax treatment of 
health expenses has been the subject of discussion over time from 
both tax and health policy perspectives.  The exclusion for 
employer-provided health care is typically a focal point of such 
discussions.  The exclusion represents a departure from the normal 
income tax principle that compensation should be included in 
income, and has consistently been one of the largest three tax 
expenditure items.\73\ 

The present-law favorable tax treatment of employer-provided health 
coverage has generally been justified on the grounds that it encourages 
employees to prefer health coverage over taxable compensation, thereby 
increasing health insurance coverage and reducing the number of uninsured.
Employees in employer-provided health plans not only receive a tax 
subsidy, but may also benefit from group rates which may make coverage 
more affordable. From this perspective, the exclusion may be said to be 
effective.  For 2005, approximately 90 million policyholders are 
estimated to have employer-provided health coverage.\74\


------------------

/73/ For Federal Fiscal years 2005-2009, the tax expenditure for the 
exclusion of employer contributions for health care, health insurance 
premiums, and long-term are insurance premiums is estimated to be
$493.7 billion. Joint Committee on Taxation, Estimates of Federal
Tax Expenditures for Fiscal Years 2005-2009 (JCS-1-05), 
January 12, 2005. 

/74/ The policy may cover more than one individual, e.g., the 
policyholder and his or her family. 


Nevertheless, the present-law rules have been the subject of a number of 
criticisms.  One criticism is that present law is inequitable because 
health expenses are not treated consistently. Some argue that this 
inequity provides the worst treatment in some cases for those who 
need the tax benefit the most, because many individuals who face the 
highest insurance rates also receive no tax subsidy for the purchase 
of such insurance.  

The most favorable tax treatment under present law generally is 
provided to individuals who are in an employer plan.\75\  Such 
individuals may exclude from income and wages employer-provided 
health insurance and, depending on the employer's plan, may also 
exclude from income amounts expended for medical care not covered by 
insurance.  Self-employed individuals receive the next 
most favorable treatment, and may deduct 100 percent of the cost of 
their health insurance. Individuals who are not self employed and 
pay for their own health insurance receive the least favorable tax 
treatment; such individuals may deduct the cost of health insurance 
only to the extent that aggregate medical expenses exceed 7.5 percent 
of adjusted gross income and only if they itemize deductions. In the 
case of individuals covered by a high deductible health plan, the 
recently-enacted provisions relating to HSAs alter this comparison to 
some extent; however, those with employer coverage still have the 
highest potential tax benefit.\76\ 

From a health policy perspective, the exclusion for employer-provided 
health care has been criticized as contributing to higher health costs 
because individuals are not faced with the full cost of health care. 
That is, the cost of insurance or out-of-pocket expenses paid by the 
individual is reduced by the tax benefit received, effectively reducing 
the price of health care relative to other goods.

---------------------
/75/  The refundable HCTC provides a greater tax benefit than the exclusion. 
However, the credit is available to only limited classes of taxpayers.  
Less than one-half million taxpayers per year are estimated to be eligible
for the credit.  For a comparison of the value of health tax benefits for
individuals covered under a plan that is not a high deduction plan and for
individuals covered under a high deductible plan, see Joint Committee on 
Taxation, Present Law and Analysis Relating to the Tax Treatment of Health 
Care Expenses (JCX-12-06) March 6, 2006, tables 2 and 3, at p. 13-14.

/76/ With an HSA, both self-employed individuals and those with 
employer-provided coverage receive a tax benefit for the purchase of the 
health insurance as well as a tax benefit for out-of-pocket expenses 
(through the HSA).  However, in some circumstances, an employee could, in
addition, have an FSA or HRA that provides coverage for additional expenses
on a tax-free basis.  Thus, for example, an employer plan could provide 
that the cost of a high deductible plan is paid by the employer and could
also allow an FSA that provides certain limited coverage, e.g., for dental
or vision benefits.  In addition, under Treasury guidance, the individual 
could also have an FSA or HRA in certain other situations, such as an 
FSA or HRA that pays expenses in excess of the deductible under the high
deductible plan.  In such cases, the individual could also have an HSA to
which deductible contributions could be made.  A self-employed individual,
in contrast, would not have the opportunity to have an FSA or HRA.  
Individuals (other than self-employed individuals) who purchase a high 
deductible plan may make deductible contributions to an HSA, but would not 
receive a subsidy for the purchase of the insurance unless aggregate 
medical expenses exceed the adjusted gross income threshold.  There is not
always a clear distinction between out-of-pocket expenses and expenses 
covered by insurance, because insurance policies differ.  That is, some 
insurance policies will cover expenses that are out-of-pocket expenses
other policies.



In addition, some argue that the unlimited exclusion for 
employer-provided coverage leads to very generous insurance 
coverage, which further contributes to increases in health 
costs because individuals are not as likely to question medical 
treatments to the extent the cost is paid by a third party through 
insurance.  

The present-law rules for HSAs were designed to provide an incentive 
to purchase high deductible plans, thereby shifting more routine 
medical costs from the third-party payor system to the individual. 
Proponents of HSAs argue that this will cause individuals to be 
more conscious of health care costs, which will ultimately lower 
the cost of health care generally.  

Under present law, HSAs provide at a minimum a tax benefit that is 
equivalent to an above-the-line deduction for medical expenses, up to 
the annual cap on contributions to the HSA.  To the extent that the 
taxpayer is able to fund the HSA well in advance of the medical 
expenses, the HSA provides the ability to save for medical expenses 
on a pre-tax basis. If the funds in the HSA are not used for medical 
expenses, they may be withdrawn subject to income tax and, prior to 
age 65, a 10-percent additional income tax.  This feature provides 
a tax benefit similar to that provided under a deductible IRA.  
Further issues relating to HSAs are discussed below. 

Issues relating to the proposal

The proposal addresses the gap in the present-law treatment of health 
expenses by providing a tax subsidy for individuals who are not self 
employed and who purchase health coverage in the individual market. 
Under present law, such individuals receive no tax subsidy 
(except perhaps for the itemized deduction),  whereas under the 
proposal such individuals are entitled either to a refundable credit 
or a deduction (plus a refundable credit to approximate FICA taxes) 
for the purchase of a high deductible health plan.  In addition, 
the proposal enhances the tax benefits of HSA contributions by 
increasing the amount of the maximum contribution and adding a 
refundable tax credit to approximate FICA taxes on contributions not 
made by an employer. 

A key issue that arises under the proposal is its focus on providing a 
subsidy specifically for high deductible health insurance in the individual 
market  (and HSAs).  Proponents of the proposal believe that the use of 

----------------------
/77/ Specifically, because of the income tax exclusion, a dollar of 
consumption of tax favored health care actually costs the taxpayer only 
$(1-t), where t is the tax rate of the individual.  In other words, 
the taxpayer is able to convert $(1-t) dollars of after-tax income 
into $1 of health consumption.  The last column of Tables 2 and 3 
reports the value of the tax subsidy as a percentage of the total 
health costs. 

/78/ Discussions relating inequities of the present-law rules 
typically do not iunclude the itemized deduction for medical expenses 
in excess of 7.5 percent of adjusted gross income. This is because 
that deduction is generally viewed as havcing a different policy 
rationale than the other present-law provisions.  While the other 
provisions are generally intended to provide subsidies in various 
ways of the purchase of health care, the policy behind the itemized 
deduction is that medical expenses in excess of a certain amount 
generally are naot discretionary and that high levels of such 
expenses adversely impact an individual's ability to pay taxes. 

/79/ The definition of what insurance qualifies under the proposal 
is not clear in all cses.  For example, it is not clear whether an 
employee who participates in a high deductible plan of the employer 


high deductible plans promotes responsible health policy by making 
individuals more conscious of their health care costs because fewer 
expenses are paid by a third party insurer. This, in turn, is 
anticipated to reduce overall health care costs.  Some proponents of 
such proposals believe that many current health insurance policies 
cover routine medical expenses and that the tax laws should provide 
a subsidy only for insurance for unpredictable medical expenses.  

Those who do not favor providing additional tax benefits for high 
deductible plans are concerned that such plans are likely to be more 
attractive to healthier individuals, with the result that adverse 
selection will occur which will erode the group market and result in 
higher insurance costs for individuals with greater health risks. 
This may occur because when insurance is priced on a group basis, 
individuals with lower health  risks in effect subsidize higher risk 
individuals. Tax-favored high deductible plans are likely to be more 
attractive to lower risk individuals.  If they leave the pool, 
however, the average cost increases for those remaining. This, in 
turn, may cause more lower risk individuals to leave the pool, with a 
concomitant rise in cost for those remaining. 

Some argue that this effect, while likely to occur with any increased 
subsidy for high deductible plans, is likely to be worse under the 
proposal because the proposal only subsidizes high deductible 
insurance purchased in the individual market and does not subsidize 
group insurance. 

There is also disagreement regarding the effects of high deductible 
plans (and HSAs) on health care costs.  As noted above, a basic premise 
underlying high deductible plans is that individuals will make wiser 
choices if faced with the cost of medical treatments and that this will 
reduce health care costs overall. On the other hand, some note that the 
existence of the HSA itself may undermine the goal of making individuals 
more conscious of heath care costs because it provides a subsidy for the 
first dollar of medical expenses.  Thus, medical expenses not covered by 
the high deductible plan receive a tax subsidy, even though they are not 
covered by insurance.  Others are concerned that even if individuals do 
spend less on health costs with a high deductible plan, this may not 
necessarily result in better health outcomes or a long-term reduction 
in costs.  For example, it is noted that it may be very difficult for 
an individual to determine whether a particular medical procedure is 
in fact needed, and that some individuals will forgo needed care if 
it is not covered by insurance, with the possibility that longer-term 
medical costs increase. 

As noted above, to the extent that amounts in HSAs are not used for 
current medical expenses, HSAs provide a tax benefit similar to that 
of an IRA. HSA proponents argue that this feature may help contribute 
to lowering  medical costs by in effect rewarding lower spending on 
medical care.  Others argue that this feature operates to make HSAs 
primarily attractive to higher income individuals who can afford to 
self insure for the higher deductible under the high deductible plan 
and who are primarily interested 

--------------------
(so that premiums are calculated on a group basis) and who pays for 100 
percent of the premium is eligible for the tax benefits provided by the 
proposal.

 /80/ The issue of adverse selection is discussed in greater detail in 
Joint Committee on Taxation,Present Law and Analysis Relating to the Tax 
Treatment of Health Care Expenses (JCX-12-06) March 6,2006, tables 2 and 
 3, at p. 16-17 and 20-21.

in a tax-favored savings vehicle.  It is argued that the increase in the 
contribution limits under the proposal will make it even more likely that 
an HSA is used in this way by higher income individuals. On the other hand, 
the proposed increase in the additional tax on distributions that are not 
for medical purposes could make the savings aspects of HSAs less 
attractive for individuals who do not expect to have health costs in the 
future (including in retirement). 

The proposed refundable credit for lower income individuals is 
intended to provide an incentive to uninsured individuals to purchase 
health insurance by providing assistance in paying premiums.  Apart from 
the general issues relating to high deductible plans discussed above, 
a key issue with respect to this credit is whether the amount of the 
credit is sufficient to enable low-income individuals to purchase health 
 insurance.  This depends on the cost of insurance that is available 
in the individual market, which may vary depending on the 
characteristics of the individual, e.g., whether the individual is 
at higher risk from a health standpoint. Some argue that a credit 
for the cost of high deductible insurance alone will not be a 
benefit to many lower-income individuals, particularly those with 
chronic illnesses and recurring medical costs, because it will be 
difficult for them to pay the out-of-pocket expenses required under 
a high deductible plan. 

The advanced payment feature of the credit is designed to assist intended 
recipients who might not be able to purchase insurance without the 
advanced credit.  Because advancing the credit merely changes the timing 
of payment and does not reduce the cost of insurance (except for the time 
value of money), this argument is best understood not as making the 
insurance affordable, as is often stated, but rather in making it
 available to those who would not otherwise be able to arrange the 
financing to pay for the insurance in advance of receiving the credit. 
Given the target population of the credit, it might reasonably be 
argued that for many potential users of the credit, other financing 
mechanisms, such as credit cards, loans from relatives or friends, 
personal savings, etc., would not be available, or would not be used 
even if available, and the best way to encourage individuals to buy 
insurance would be to provide the credit in advance, at the time of 
purchase of the insurance. 

In order to make the advance payment system more workable, the proposal 
uses prior year income information, and does not require reconciliation 
based on current year information. The trade off for this is that in some 
cases the credit will be provided on an advance basis to those with current 
incomes well in excess of the income limits for the credit.  In other
cases, individuals will have a current need for the credit on an advance 
basis, but will not be eligible (e.g., if current year income is 
substantially less than prior year income). 

Experience with refundable credits under present law indicates that such 
credits may lead to fraud and abuse by taxpayers, as it may be difficult 
for the IRS to ensure that all taxpayers who claim the credit are in fact 
eligible.  This effect could be reduced to the extent that an advance 
payment system works efficiently and makes payments directly to insurers 
or others providing bona fide coverage.  The experience with the 
present-law HCTC may provide some indication of how an advance 

---------------------

/81/ This issue may also arise under proposed refundable credits designed 
to offset FICA taxes.



payment mechanism may operate; however, that credit is significantly 
narrower in scope than the proposed credit. 

The multiplicity of the provisions, as well as the varying requirements 
for each one will add complexity for taxpayers and the IRS.  By providing 
additional options to individuals, the proposal may increase complexity 
because individuals will have to determine which option is best for them.
For example, individuals eligible for the proposed refundable tax credit 
for health insurance will have to determine which option is best for them 
because such individuals are not eligible for both the credit and a 
deduction.  Employees will also have to determine whether it is better to 
remain in employer plans or to purchase a policy in the individual market. 

Creating a new tax deduction and new credits will necessitate new lines on 
the Form 1040 and additional information in instructions regarding the new 
provisions.  The new provisions may also require IRS programming 
modifications.

Additionally, the credit for lower-income individuals adds 
new phase-outs to the numerous existing phase-outs in the Code, which 
increases complexity.\82\ The advanced payment aspect of the credit 
also adds additional complexity to the Code. Taxpayers would have to use 
different income amounts to calculate the credit depending whether the 
credit is claimed on an advanced basis or on the current year tax return. 
The proposal may also increase complexity for insurance companies by
 adding administrative burdens with respect to the advanced payment of 
the credit. Health insurers would be required to provide information 
 statements to taxpayers receiving the credit on an advanced payment 
basis and to the IRS, including the policy number, the policy premium, 
and that the policy meets the requirements for a qualified policy. 

Requiring reporting by health insurers and employers could be helpful in 
enforcing other aspects of the proposal, e.g., in ensuring that a taxpayer 
who takes the above-the-line deduction is in fact covered by a high 
deductible plan.  While any such reporting requirements would be likely to 
increase compliance, they would also increase administrative burdens on 
the part of those subject to the requirements. 

                               Prior Action
   
Proposals similar to the above-the-line deduction were included in the 
President's fiscal year 2005 and 2006 budget proposals.  Proposals similar 
to the refundable credit for lower-income individuals were included in the 
President's fiscal year 2002, 2003, 2004, 2005, and 2006 budget proposals. 

-------------------
\82\ For a discussion of issues relating to income phase-outs, see Joint 
Committee on Taxation, Study of the Overall State of the Federal Tax System 
and Recommendations for Simplification, Pursuant to Section 8022(3)(B) 
of the Internal Revenue Code of 1986(JCS-3-01), April 2001, Volume II at 
79.



2.  Modify the refundable credit for health insurance costs of eligible 
individuals

                                    Present Law
                                    
Refundable health insurance credit: in general 

Under the Trade Act of 2002,\83\ in the case of taxpayers who are eligible 
individuals, a refundable tax credit is provided for 65 percent of the 
taxpayer's expenses for qualified health insurance of the taxpayer and 
qualifying family members for each eligible coverage month beginning in 
the taxable year. The credit is commonly referred to as the health 
coverage tax credit ("HCTC"). The credit is available only with respect 
to amounts paid by the taxpayer. The credit is available on an advance 
basis. 

Qualifying family members are the taxpayer's spouse and any dependent of 
the taxpayer with respect to whom the taxpayer is entitled to claim a 
dependency exemption.  Any individual who has other specified coverage is 
not a qualifying family member. 

Persons eligible for the credit

Eligibility for the credit is determined on a monthly basis. In general, 
an eligible coverage month is any month if, as of the first day of the 
month, the taxpayer (1) is an eligible individual, (2) is covered by 
qualified health insurance, (3) does not have other specified 
coverage, and (4) is not imprisoned under Federal, State, or local 
authority.  In the case of a joint return, the eligibility requirements 
are met if at least one spouse satisfies the requirements.  An eligible 
month must begin after November 4, 2002.\84\ 

An eligible individual is an individual who is (1) an eligible TAA 
recipient, (2) an eligible alternative TAA recipient, and (3) an 
eligible PBGC pension recipient. 

An individual is an eligible TAA recipient during any month if the 
individual (1) is receiving for any day of such month a trade adjustment 
allowance  or who would be eligible to receive such an allowance but for 
the requirement that the individual exhaust unemployment benefits before 
being eligible to receive an allowance and (2) with respect to such 
allowance, is covered under a certification issued under subchapter A or 
D of chapter 2 of title II of the Trade Act of 1974.  An individual is 
treated as an eligible TAA recipient during the first month that 
such individual would otherwise cease to be an eligible TAA recipient. 

An individual is an eligible alternative TAA recipient during any month 
if the individual (1) is a worker described in section 246(a)(3)(B) of 
the Trade Act of 1974 who is participating in the program established 
under 

----------------------
/83/ Pub. L. No. 107-210 (2002). 

/84/ This date is 90 days after the date of enactment of the Trade Act 
of 2002, which was August 6, 2002. 

/85/ Part I of subchapter B, or subchapter D, of chapter 2 of title II 
of the Trade Act of 1974. 


section 246(a)(1) of such Act, and (2) is receiving a benefit for 
such month under section 246(a)(2) of such Act.  An individual is treated 
as an eligible alternative TAA recipient during the first month that such 
individual would otherwise cease to be an eligible TAA recipient. 

An individual is a PBGC pension recipient for any month if he or she 
(1) is age 55 or over as of the first day of the month, and (2) is 
receiving a benefit any portion of which is paid by the Pension Benefit 
Guaranty Corporation (the "PBGC").  The IRS has interpreted the 
definition of PBGC pension recipient to also include certain 
alternative recipients and recipients who have received certain 
lump-sum payments on or after August 6, 2002. 

An otherwise eligible taxpayer is not eligible for the credit for a 
month if, as of the first day of the month, the individual has other 
specified coverage.  Other specified coverage is (1) coverage under 
any insurance which constitutes medical care (except for insurance 
 substantially all of the coverage of which is for excepted 
benefits)\86\ maintained by an employer (or former employer) if at 
least 50 percent of the cost of the coverage is paid by an employer 
 (or former employer)\87\ of the individual or his or her spouse or 
(2) coverage under certain governmental health programs.\88\  
A rule aggregating plans of the same employer applies in determining 
whether the employer pays at least 50 percent of the cost of
coverage. A person is not an eligible individual if he or she may be 
claimed as a dependent on another person's tax return. A special rule 
applies with respect to alternative TAA recipients.  For eligible 
alternative TAA recipients, an individual has other specified coverage if 
the individual is (1) eligible for coverage under any qualified health 
insurance (other than coverage under a COBRA continuation provision, 
State-based continuation coverage, or coverage through certain State 

---------------------
\86\ Excepted benefits are: (1) coverage only for accident or disability 
income or any combination thereof; (2) coverage issued as a supplement to 
liability insurance; (3) liability insurance, including general liability 
insurance and automobile liability insurance; (4) worker's compensation or 
similar insurance; (5) automobile medical payment insurance; 
(6) credit-only insurance; (7) coverage for on-site medical clinics; 
(8)other insurance coverage similar to the coverages in (1)-(7) 
specified in regulations under which benefits for medical care are 
secondary or incidental to other insurance benefits; (9) limited scope 
dental or vision benefits; (10) benefits for long-term care, nursing 
home care, home health care, community-based care, or any combination 
thereof; and (11) other benefits similar to those in (9) and (10) as 
specified in regulations; (12) coverage only for a specified disease or 
 illness; (13) hospital indemnity or other fixed indemnity insurance; 
and (14) Medicare supplemental insurance. 

\87\ An amount is considered paid by the employer if it is 
excludable from income.  Thus, for example, amounts paid for health 
coverage on a salary reduction basis under an employer plan are 
considered paid by the employer 

\88\ Specifically, an individual is not eligible for the
credit if, as of the first day of the month, the individual is (1) 
entitled to benefits under Medicare Part A, enrolled in Medicare 
Part B, or enrolled in Medicaid or SCHIP, (2) enrolled in a health 
benefits plan under the Federal Employees Health Benefit Plan, or 
(3) entitled to receive benefits under chapter 55 of title 10 of 
the United States Code (relating to military personnel).  An 
individual is not considered to be enrolled in Medicaid solely by 
reason of receiving immunizations. 


arrangements) under which at least 50 percent of the cost of coverage is 
paid or incurred by an employer of the taxpayer or the taxpayer's spouse 
or (2) covered under any such qualified health insurance under which any 
portion of the cost of coverage is paid or incurred by an employer of the 
taxpayer or the taxpayer's spouse. 

Qualified health insurance

Qualified health insurance eligible for the credit is: (1) COBRA 
continuation coverage; (2) State-based continuation coverage provided by 
the State under a State law that requires such coverage; (3) coverage 
offered through a qualified State high risk pool; (4) coverage under a 
health insurance program offered to State employees or a comparable 
program; (5) coverage through an arrangement entered into by a State andï¿½20
a group health plan, an issuer of health insurance coverage, an 
administrator, or an employer; (6) coverage offered through a State 
arrangement with a private sector health care coverage purchasing pool; 
(7) coverage under a State-operated health plan that does not receive any 
Federal financial participation; (8) coverage under a group health plan 
that is available through the employment of the eligible individual's 
spouse; and (9) coverage under individual health insurance if the eligible 
individual was covered under individual health insurance during the entire 
30-day period that ends on the date the individual became separated from 
the employment which qualified the individual for the TAA allowance, the 
benefit for an eligible alternative TAA recipient, or a pension benefit 
from the PBGC, whichever applies.\89\ 

Qualified health insurance does not include any State-based coverage 
(i.e., coverage described in (2)-(8) in the preceding paragraph), unless 
the State has elected to have such coverage treated as qualified health 
insurance and such coverage meets certain requirements.\90\  Such State 
coverage must provide that each qualifying individual is guaranteed 
enrollment if the individual pays the premium for enrollment or 
provides a qualified health insurance costs eligibility certificate and 
pays the remainder of the premium.  In addition, the State-based coverage 
cannot impose any pre-existing condition limitation with respect to 
qualifying individuals.  State-based coverage cannot require a qualifying 
individual to pay a premium or contribution that is greater than the 
premium or contribution for a similarly situated individual who is not a
qualified individual.  Finally, benefits under the State-based coverage 
must be the same as (or substantially similar to) benefits provided to 
similarly situated individuals who are not qualifying individuals.  A 
qualifying individual is an eligible individual who seeks to enroll 
in the State-based coverage and who has aggregate periods of creditable 
coverage  of three months or longer, does not have other specified 
coverage, and who is not imprisoned.   A qualifying individual also 
includes qualified family members of such an eligible individual.


--------------------------------
/89/ For this purpose, "individual health insurance" means any insurance 
which constitutes medical care offered to individuals other than in 
connection with a group  health plan.  Such item does noit include 
Federal-or-State-based health insurance coverage.

/90/ For guidance on how a State elects a health program to be qualifed 
health insurance or purposes of the creit, see Rev. Proc. 2004-12, 2004-9 
I.R.B. 1.

/91/ Credible coverage is determined under the Health Insurance 
Portability and Accountability Act (Code sec.980(c)). 


Qualified health insurance does not include coverage under a flexible 
spending or similar arrangement or any insurance if substantially all of 
the coverage is of excepted benefits. 

Other rules

Amounts taken into account in determining the credit may not be taken 
into account in determining the amount allowable under the itemized 
deduction for medical expenses or the deduction for health insurance 
expenses of self-employed individuals.  Amounts distributed from a 
medical savings account or health savings account are not eligible 
for the credit.  The amount of the credit available through filing a 
tax return is reduced by any credit received on an advance basis.  
Married taxpayers filing separate returns are eligible for the 
credit; however, if both spouses are eligible individuals and the 
spouses file a separate return, then the spouse of the taxpayer is 
not a qualifying family member. 

The Secretary of the Treasury is authorized to prescribe such 
regulations and other guidance as may be necessary or appropriate 
to carry out the provision. 

Health Insurance Portability and Accountability Act of 1996 ("HIPAA") 

HIPAA imposed a number of requirements with respect to health coverage 
that are designed to provide protections to health plan participants. 
Among other things, HIPAA generally provides that a pre-existing 
condition exclusion may be imposed only if:  (1) the exclusion 
relates to a condition (whether physical or mental), regardless of 
the cause of the condition, for which medical advice, diagnosis, 
care, or treatment was recommended or received with the 6-month 
period ending on the enrollment date; (2) the exclusion extends for 
a period of not more than 12 months after the enrollment date; and 
(3) the period of any pre-existing condition exclusion is reduced 
by the length of the aggregate of the periods of creditable 
coverage (if any) applicable to the participant as of the enrollment 
date. In general terms, creditable coverage includes health care 
coverage without a gap of more than 63 days.  Special limitations 
apply to exclusions in the case of newborns, adopted children, and 
pregnancy. 

                        Description of Proposal
                        
In general

The President's proposal modifies the health coverage tax credit in 
several ways. 

Pre-existing condition exclusion for State-based coverage 

The proposal modifies the requirement that State-based coverage not 
impose pre-existing condition limitations.  The proposal allows 
State-based coverage to impose a modified pre-existing condition 
restriction similar to the HIPAA rules.  The pre-existing condition 
exclusion can be imposed for a period of up to 12 months, but must 
be reduced by the length of the eligible individual's creditable 
coverage, as of the date the individual applies for the State-based 
coverage.  The exclusion must relate to a condition (whether 
physical or mental), regardless of the cause of the condition, for 
which medical advice, diagnosis, care, or treatment was recommended 
or received within the 6-month period ending on the date the 
individual seeks to enroll in the coverage.  The present-law HIPAA 
provisions relating to newborns, adopted children, and pregnancy 
apply. 

Spouses of eligible individuals entitled to Medicare

The proposal also allows spouses of eligible individuals to claim the 
credit even after the eligible individual becomes entitled to Medicare, 
provided that the spouse (1) is at least age 55; (2) is covered by 
qualified health insurance, the premium of which is paid by the 
taxpayer; (3) does not have other specific coverage; and (4) is not 
imprisoned under Federal, State, or local authority. 

Other modifications

The proposal also makes other changes to the credit.  Under the 
proposal, individuals who elect to receive one-time lump sum payments 
from the PBGC and certain alternative PBGC payees are eligible for 
the credit. 

The proposal provides that the Commonwealths of Puerto Rico and the 
Northern Mariana Islands, and American Samoa, Guam, and the U.S. Virgin 
Islands are deemed to be States for purposes of the State-based coverage 
rules.

Additionally, under the proposal, State continuation coverage provided 
under State law automatically qualifies as qualified health insurance, as 
Federally-mandated COBRA continuation coverage, without having to 
meet the requirements relating to State-based qualified coverage. 

The proposal also changes the definition of other specified coverage 
for eligible alternative TAA recipients by removing the special rule 
that applies only to alternative TAA recipients. 

Effective date.-The proposal modifying the requirement that there be 
no imposition of a pre-existing condition exclusion is effective for 
eligible individuals applying for coverage after December 31, 2006.  
The proposal relating to spouses of HCTC-eligible individuals is 
effective for taxable years beginning after December 31, 2006.  The 
remaining proposals are effective as if included in the Trade Act of 
2002. 

                             Analysis
In general

The HCTC was enacted to assist certain individuals in paying for 
qualified health insurance.  The various aspects of the proposal are 
intended to make the credit available to more individuals.  Some 
aspects of the proposal may be considered clarifications of present 
law based on current IRS administrative positions. 

Pre-existing condition exclusion for State-based coverage 

The pre-existing condition provisions of present law have been noted 
by some as a barrier to greater participation in the HCTC system by 
States.  The proposal is intended to result in greater plan 
participation.  According to the IRS, for the 2005 tax year, 40 
States (including the District of Columbia) had made available at 
least one State-based option (other than State-based continuation 
coverage).  Nine States had available only State-based continuation 
coverage, and two States did not have any State-based coverage option. 

Proponents argue that the change is necessary to allow States not 
currently offering qualified health insurance to be able to offer 
qualified insurance. Many States argue that it is difficult to 
implement qualifying State-based coverage with the present-law 
requirement that there be no imposition of a pre-existing 
condition exclusion.  Others argue that the proposed modification 
would eliminate an important consumer protection afforded 
under State-based coverage.  Proponents counter that the modified 
requirement under the proposal, coupled with the other consumer 
protections, including guaranteed issue, provides sufficient 
protections, especially in the case of States where the alternative 
would be no qualifying State-based coverage.  Critics argue that 
if State-based coverage must satisfy the present-law requirement, 
States will eventually produce a qualifying option which will allow 
its citizens access to the credit while maintaining the protection. 
 They argue that since the vast majority of States have been able 
to produce a qualifying option under the present-law requirements, 
the few States that have not offered qualified insurance should 
not be afforded a less stringent rule. 

Spouses of eligible individuals entitled to Medicare

Under present law, once an otherwise eligible individual is entitled 
to benefits under Medicare, the spouse of the individual is no longer 
eligible for the HCTC, even if the spouse is not entitled to 
benefits under Medicare (i.e., is younger). In such cases, loss of 
the credit may result in loss of health care coverage.  The proposal 
is intended to prevent such a result. 

Eligible individuals

Under the proposal, individuals who elect to receive one-time lump-sum 
payments from the PBGC are eligible for the credit.  While the IRS has 
interpreted the credit as applying to individuals who receive a 
one-time lump sum from the PBGC and certain alternative PBGC payees, 
 clarifying statutorily that such individuals are eligible 
individuals will simplify administration of the credit.  Many believe 
that individuals who receive a one-time lump-sum pension payment in 
lieu of an annuity should not be ineligible for the credit simply 
because they are not receiving payments on a monthly basis.  
In general, lump-sum payments are only received if the value of the 
benefit is $5,000 or less.  Given the relatively small amount of the 
payments, most agree that requiring participants to take an annuity 
in order to qualify for the credit is not desirable.  

The proposal also provides that certain alternative PBGC payees are 
eligible for the credit.  In general, alternative PBGC payees include 
alternative payees under a qualified domestic relations order and 
beneficiaries of deceased employees who are receiving payments 
from the PBGC.  Many believe that fairness requires that such 
individuals should be treated as eligible PBGC pension recipients. 

Certain commonwealths and possessions 

Under present law, if an individual meets the definition of an eligible 
individual, residents of the possessions and commonwealths may be 
eligible for the credit; however, because the possession or 
commonwealth in which they live is not able to offer qualified health 
 insurance, such individuals may be unable to access the credit.  
The proposal would allow certain possessions and commonwealths to 
offer qualified health  insurance on the same basis as States. 
Proponents argue that since the credit is targeted to specific groups 
of individuals (i.e., individuals receiving benefits under TAA or from 
the PBGC), residents of such commonwealths and possessions who are 
eligible individuals should not be denied the credit because their 
residence cannot offer a  qualified State-based option. 

While residents of the possessions and commonwealths are U.S. 
citizens,\92\ special tax rules apply.  Some question whether it 
is appropriate to provide a refundable health tax credit to 
residents of possessions and commonwealths who may never pay U.S. 
tax.  Certain other tax credits are not available to such 
individuals.  For example, the earned income credit and child tax 
credit are generally not available to such residents.\93\ 

State continuation coverage 

The proposal providing that State continuation coverage automatically 
qualifies as qualified health insurance results in removing certain 
State-based coverage requirements from State continuation coverage.  
These requirements include guaranteed issue, no imposition of 
pre-existing conditions (as modified by this proposal), 
nondiscriminatory premiums and similar benefits. Proponents argue 
that many States lack qualified State-based coverage and allowing 
State continuation coverage to automatically qualify would allow 
more individuals access to the credit.  Proponents also argue that 
since State continuation coverage is similar to COBRA continuation, 
which is not subject to the State-based coverage requirements, it 
is appropriate to waive such requirements for State continuation 
coverage.  Proponents argue that it is inappropriate for the 
State-based coverage requirements to apply to State continuation 
coverage as certain rules applicable to State continuation coverage 
are inconsistent with such requirements. 

Critics argue that it is extremely important for individuals to have 
the protections relating to guaranteed issue, pre-existing conditions, 
nondiscriminatory premiums and similar benefits.They argue that if the 
applicable requirements are waived, individuals will lose valuable 
rights with respect to their health care.  In addition, opponents 
argue that if State continuation coverage automatically meets the 
requirements for qualified health insurance, States will be less 
inclined

---------------------
\92\ There is an exception for those on American Samoa who are 
U.S. nationals.

\93\ The refundable child tax credit is available to residents 
of the possessions if the individual has three or more qualifying 
children and pays FICA or SECA taxes. 


to work towards producing a qualifying option that includes the 
otherwise applicable requirements.  Critics of the proposal argue 
that if all State-based coverage must satisfy the requirements, 
States will eventually produce a qualifying option which will 
allow its citizens access to the credit while retaining the 
important consumer protections.  This change is viewed by critics 
as a substantive change from what was originally intended, 
rather than a clarification of present law. 

Other specified coverage of alternative TAA recipients 

The proposal also changes the definition of other specified coverage 
for eligible alternative TAA recipients by removing the special rule 
that applies only to alternative TAA recipients, which results in 
applying the same definition of other specified coverage to all 
eligible individuals. Under the proposal, for all eligible 
individuals, specified coverage would include coverage under a 
health plan maintained by an employer (except for insurance 
substantially all of which is for excepted benefits) than pays 
at least 50 percent of the cost of coverage and certain 
governmental health programs.  Proponents argue that the 
proposal would reduce complexity in administering the credit, as 
similar rules would apply to all individuals.  
Some argue that despite the complexity in having different rules, the 
special rule for alternative TAA recipients should be retained. 


                                Prior Action
                                    
A similar proposal was included in the President's fiscal year 2006 
budget proposal.  Several components of the proposal were included 
in the President's fiscal year 2005 budget proposal. 

3. Expand human clinical trial expenses qualifying for the orphan drug 
tax credit 

                                 Present Law

Taxpayers may claim a 50-percent credit for expenses related to human 
clinical testing of drugs for the treatment of certain rare diseases and 
conditions, generally those that afflict less than 200,000 persons in the 
United States.  Qualifying expenses are those paid or incurred by the 
taxpayer after the date on which the drug is designated as a potential 
treatment for a rare disease or disorder by the Food and Drug 
Administration ("FDA") in accordance with section 526 of the 
Federal Food, Drug, and Cosmetic Act.

                             Description of Proposal
                                 
The proposal expands qualifying expenses to include those expenses 
related to human clinical testing paid or incurred after the date on 
which the taxpayer files an application with the FDA for designation 
of the drug under section 526 of the Federal Food, Drug, and Cosmetic 
Act as a potential treatment for a rare disease or disorder, if 
certain conditions are met.  Under the proposal, qualifying expenses 
include those expenses paid or incurred after the date on which the 
taxpayer files an application with the FDA for designation as a 
potential treatment for a rare disease or disorder if the drug 
receives FDA designation before the due date (including extensions) 
for filing the tax return for the taxable year in which the 
application was filed with the FDA.  As under present law, 
the credit may only be claimed for such expenses related to drugs 
designated as a potential treatment for a rare disease or disorder 
by the FDA in accordance with section 526 of such Act. 

Effective date.--The provision is effective for qualified expenditures 
incurred after December 31, 2005.

                                 Analysis
                                    
Approval for human clinical testing and designation as a potential 
treatment for a rare disease or disorder require separate reviews within 
the FDA.  As a result, in some cases, a taxpayer may be permitted to 
begin human clinical testing prior to a drug being designated as a 
potential treatment for a rare disease or disorder.  If the taxpayer 
delays human clinical testing in order to obtain the benefits of the 
orphan drug tax credit, which currently may be claimed only for 
expenses incurred after the drug is designated as a potential 
treatment for a rare disease or disorder, valuable time will have 
been lost and Congress's original intent in enacting the orphan drug 
tax credit will have been partially thwarted. 

For those cases where the process of filing an application and receiving 
designation as a potential treatment for a rare disease or disorder occurs 
sufficiently expeditiously to fall entirely within the taxpayer's taxable 
year plus permitted filing extension, the proposal removes the 
potential financial benefit from delaying clinical testing.  While such 
an outcome may well describe most applications, in some cases,
 particularly for applications filed near the close of a taxpayer's 
taxable year, there may be some uncertainty that designation will be 
made in a timely manner. In such a case, the taxpayer is in the same 
position as present law and may choose to delay filing the appropriate 
 application until the beginning of his next taxable year. 

The FDA is required to approve drugs for human clinical testing.  Such 
approval creates a unique starting point from which human clinical 
testing expenses can be measured.  An alternative proposal would be 
to expand qualifying expenses to include those expenses paid or 
incurred after the date on which the taxpayer files an application 
with FDA for designation of the drug as a potential treatment for a 
rare disease or disorder, regardless of whether the designation is 
approved during the taxable year in which the application is filed.  
Such an alternative proposal would provide more certainty to the 
taxpayer regarding clinical expenses eligible for the credit.  
However, unlike the current proposal, such an alternative may 
create the additional taxpayer burden of requiring the taxpayer to 
file an amended return to claim credit for qualifying costs related 
to expenses incurred in a taxable year prior to designation. 

The staff of the Joint Committee on Taxation recommended a change 
similar to the current proposal as part of its 2001 simplification 
study.\94\ 



-------------------------
\94\ Joint Committee on Taxation, Study of the Overall State of the 
Federal Tax System and Recommendations for Simplification, Pursuant 
to Section 8022(3)(b) of the Internal Revenue Code of 1986, Vol. 
II(JCS-3-01), April 2001, p.310. 



                                 Prior Action

An identical proposal was part of the President's fiscal year 2005 
and 2006 budget proposals.  A similar proposal was part of the 
President's fiscal year 2004 budget proposal 


D.  Provisions Relating to Charitable Giving

1.  Permit tax-free withdrawals from individual retirement arrangements 
for charitable contributions 

                                Present Law
                                  
In general

If an amount withdrawn from a traditional individual retirement 
arrangement ("IRA") or a Roth IRA is donated to a charitable 
organization, the rules relating to the tax treatment of withdrawals 
from IRAs apply, and the charitable contribution is subject to the 
normally applicable limitations on deductibility of such 
contributions. 

Charitable contributions

In computing taxable income, an individual taxpayer who itemizes 
deductions generally is allowed to deduct the amount of cash and up 
to the fair market value of property contributed to an organization 
described in section 170(c), including charities and Federal, State, 
and local governmental entities.  The deduction also is allowed for 
purposes of calculating alternative minimum taxable income.  

The amount of the deduction allowable for a taxable year with respect 
to a charitable contribution of property 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.\95\ 

A taxpayer who takes the standard deduction (i.e., who does not 
itemize deductions) may not take a separate deduction for charitable 
contributions.\96\ 

A payment to a charity (regardless of whether it is termed a 
"contribution") in exchange for which the donor receives an economic 
benefit is not deductible, except to the extent that the donor can 
demonstrate, among other things, that the payment exceeds the fair 
market value of the benefit received from the charity.  To facilitate 
distinguishing charitable contributions from purchases of goods or 
services from charities, present law provides that no charitable 
contribution deduction is allowed for a separate contribution of 
$250 or more unless the donor obtains a contemporaneous written 
acknowledgement of the contribution from the charity indicating 
whether the charity provided any good or service (and an estimate 
of the value of any such good or service) to the taxpayer in 
consideration for the contribution.  In addition, present law 
requires that any charity that receives a contribution exceeding 
$75 made partly as a gift and partly as consideration for goods 
or services furnished by the charity (a "quid pro quo" 

-----------------------
\95\ Secs. 170(b) and (c).

\96\ Sec. 170(a).

\97\ Sec. 170(f)(8).


contribution) is required to inform the contributor in writing of an 
estimate of the value of the goods or services furnished by the charity 
and that only the portion exceeding the value of the goods or services 
is deductible as a charitable contribution.\98\ 

Under present law, total deductible contributions of an individual 
taxpayer to public charities, private operating foundations, and 
certain types of private nonoperating foundations may not exceed 50 
percent of the taxpayer's contribution base, which is the taxpayer's 
adjusted gross income for a taxable year (disregarding any net 
operating loss carryback).  To the extent a taxpayer has not exceeded 
the 50-percent limitation, (1) contributions of capital gain property 
to public charities generally may be deducted up to 30 percent of 
the taxpayer's contribution base; (2) contributions of cash to 
private foundations and certain other charitable organizations 
generally may be deducted up to 30 percent of the taxpayer's 
contribution base; and (3) contributions of capital gain 
property to private foundations and certain other charitable 
organizations generally may be deducted up to 20 percent of the 
taxpayer's contribution base. 

Contributions by individuals in excess of the 50-percent, 30-percent, 
and 20-percent limits may be carried over and deducted over the next 
five taxable years, subject to the relevant percentage limitations 
on the deduction in each of those years. 

In addition to the percentage limitations imposed specifically on 
charitable contributions, present law imposes an overall limitation on 
most itemized deductions, including charitable contribution deductions, 
for taxpayers with adjusted gross income in excess of a threshold amount,
which is indexed annually for inflation. The threshold amount for 2006 is 
$150,500 ($75,250 for married individuals filing separate returns). 
For those deductions that are subject to the limit, the total amount of
itemized deductions is reduced by three percent of adjusted gross 
income over the threshold amount, but not by more than 80 percent of 
itemized deductions subject to the limit.  Beginning in 2006, the 
overall limitation on itemized deductions phases out for all 
taxpayers. The overall limitation on itemized deductions is reduced 
by one-third in taxable years beginning in 2006 or 2007, and by 
two-thirds in taxable years beginning in 2008 or 2009. The overall 
limitation on itemized deductions is eliminated for taxable years 
beginning after December 31, 2009; however, this elimination of the 
limitation sunsets on December 31,2010. 

In general, a charitable deduction is not allowed for income, 
estate, or gift tax purposes if the donor transfers an interest in 
property to a charity (e.g., a remainder) while also either 
retaining an interest in that property (e.g., an income 
interest) or transferring an interest in that property to a 
noncharity for less than full and adequate consideration.\99\ 
 Exceptions to this general rule are provided for, among other 
interests, remainder interests in charitable remainder annuity 
trusts, charitable remainder unitrusts, and pooled income funds, and 
present interests in the form of a guaranteed annuity or a fixed 
percentage of the annual value of the property.\100\   For 

----------------
\98\ Sec 6115.

\99\ Secs. 170(f),2055(e)(2), and 2522(c)(2)

\100\ Sec. 170(f)(2).


such interests,a charitable deduction generally is allowed to the 
extent of the present value of the interest designated for a 
charitable organization. 

IRA rules

Within limits, individuals may make deductible and nondeductible 
contributions to a traditional IRA.  Amounts in a traditional IRA are 
includible in income when withdrawn (except to the extent the withdrawal 
represents a return of nondeductible contributions).  Individuals also 
may make nondeductible contributions to a Roth IRA.  Qualified 
withdrawals from a Roth IRA are excludable from gross income.  
Withdrawals from a Roth IRA that are not qualified withdrawals are 
includible in gross income to the extent attributable to earnings.  
Includible amounts withdrawn from a traditional IRA or a Roth IRA 
before attainment of age 59-1/2 are subject to an additional 
10-percent early withdrawal tax, unless an exception applies.  
Under present law, minimum distributions are required 
to be made from tax-forward retirement arrangements, including IRAs. 
Minimum required distributions from a traditional IRA must generally 
begin by the April 1 of the calendar year following the year in 
which the IRA owner attains age 70-1/2. \101\

If an individual has made nondeductible contributions to a 
traditional IRA, a portion of each distribution from an IRA is 
nontaxable until the total amount of nondeductible contributions 
has been received.  In general, the amount of a distribution that 
 is nontaxable is determined by multiplying the amount of the 
distribution by the ratio of the remaining nondeductible 
contributions to the account balance.  In making the calculation, 
all traditional IRAs of an individual are treated as a single IRA, 
all distributions during any taxable year are treated as a single  
distribution, and the value of the contract, income on the 
contract, and investment in the contract are computed as of the 
close of the calendar year. 

In the case of a distribution from a Roth IRA that is not a qualified 
distribution, in determining the portion of the distribution 
attributable to earnings, contributions and distributions are deemed 
to be distributed in the following order: (1) regular Roth IRA 
contributions; (2) taxable conversion contributions;\102\ 
(3) nontaxable conversion contributions; and (4) earnings.  
In determining the amount of taxable distributions from 
a Roth IRA, all Roth IRA distributions in the same taxable year 
are treated as a single distribution, all regular Roth IRA 
contributions for a year are treated as a single contribution, 
and all conversion contributions during the year are treated as 
a single contribution. 


                            Description of Proposal
                                   
The proposal provides an exclusion from gross income for otherwise 
taxable IRA withdrawals from a traditional or a Roth IRA for 
distributions to a qualified charitable organization.  The exclusion 
 does not apply to indirect gifts to a charity through a split 
interest 

-----------------
\101\ Minimum distribution rules also apply to the case of distribution 
after the death of a traditional or Roth ITA owner. 

\102\ Conversion contributions refer to conversions of amounts in a 
traditional IRA to a Roth IRA. 


entity, such as a charitable remainder trust, a pooled income fund, 
or a charitable gift annuity.  The exclusion is available for 
distributions made after the date the IRA owner attains age 65 and 
applies only to the extent the individual does not receive any 
benefit in exchange for the transfer. Amounts transferred directly 
from the IRA to the qualified charitable organization are treated 
as a distribution for purposes of the minimum distribution rules 
applicable to IRAs.  No charitable contribution 
deduction is allowed with respect to any amount that is excluded from 
income under this provision.  Amounts transferred from the IRA to the 
qualified charitable organization that would not be taxable if 
transferred directly to the individual, such as a qualified 
distribution from a Roth IRA or the return of nondeductible 
contributions from a traditional IRA, are subject to the present 
law charitable contribution deduction rules. 

Effective date. The proposal is effective for distributions made after 
the date of enactment. 


                                    Analysis
                                         
Policy issues

In general, the proposal is intended to enable IRA owners to give a 
portion of their IRA assets to charity without being subject to the 
charitable contribution percentage limitations or the overall 
limitation on itemized  deductions.  Present law requires an IRA 
owner to take the IRA distribution into income, give the money to a 
qualified charity, and then claim a deduction for the gift.  However, 
the deduction is subject to the percentage limitations of section 
170 and to the overall limit on itemized deductions. The proposal 
will allow an IRA owner to avoid these limitations and therefore 
might encourage additional charitable giving by increasing 
the tax benefit of the donation for those who would not be able 
to fully deduct the donation by reason of the present-law 
limitations.  However,some argue that the proposal merely avoids 
present-law limitations on charitable contributions that will be 
made in any event and will not encourage additional giving. 

Further, some question the appropriateness of limiting the tax 
benefits of the provision to IRA owners.  That is, if the limits 
on charitable deductions are determined to be undesirable, they 
should be removed for all taxpayers, not only those that are able 
to make charitable contributions through an IRA.  In addition, 
the proposal will alter present law and give IRA owners a tax 
benefit for charitable contributions even if they do not 
itemize deductions.  For example, under present law, a taxpayer who 
takes the standard deduction cannot claim a charitable contribution 
deduction; however, under the proposal, a taxpayer can both claim 
the standard deduction and benefit from the exclusion.  Therefore, 
under the proposal, it might be beneficial for taxpayers who itemize 
their deductions but have a significant amount of charitable 
deductions to make their charitable contributions through the IRA 
and then claim the standard deduction. 

In addition, some argue that the proposal will inappropriately 
encourage IRA owners to use retirement monies for nonretirement 
purposes (by making such use easier and providing greater tax 
benefits in some cases). To the extent that the proposal will 
spur additional gifts by circumventing the percentage limitations, 
IRA owners may spend more of their retirement money for nonretirement 
purposes than under present law.  Some also argue that, in the early 
years of retirement, an individual might not accurately assess his 
or her long-term retirement income needs.  For example, the 
individual might not make adequate provision for health care or 
long-term care costs later in life.  Some therefore argue that IRA 
distributions to charity should be permitted, if at all, only after 
age 70. 

Complexity issues

The proposal adds complexity to the tax law by creating an additional 
set of rules applicable to charitable contributions.  Taxpayers who 
own IRAs and make such contributions will need to review two sets 
of rules in order to determine which applies to them and which is 
the most advantageous.  The proposal may increase the complexity of 
making charitable contributions because individuals who are able and 
wish to take advantage of the tax benefits provided by the proposal 
will need to make the contribution through the IRA rather than 
directly. The proposal also may increase complexity in tax planning 
as the proposal might make it beneficial for some taxpayers to take 
the standard deduction and make all charitable contributions through 
their IRAs. 

In some cases, taxpayers may need to apply both sets of rules to a 
single contribution from an IRA. This will occur if the IRA 
distribution includes both taxable amounts (which would be subject 
to the rules in the proposal) and nontaxable amounts (which would 
be subject to the present-law rules). As discussed above, the effect 
of the proposal is to eliminate certain present-law limits on 
charitable deductions for IRA owners.  A simpler approach is to 
eliminate such limits with respect to all charitable contributions.  
Providing a single rule for charitable contributions 
would make the charitable deduction rules easier to understand for all 
taxpayers making such contributions. 

                                 Prior Action
                                 
A similar proposal was included in the President's fiscal years 
2004, 2005, and 2006 budget proposals.  The President's fiscal years 
2002 and 2003 budget proposals included a similar proposal, except 
that the exclusion would have applied to distributions made on or 
after the date the IRA owner attained age 59-1/2. 

H.R. 4297, as amended by the Senate (the "Tax Relief Act of 2005"), 
includes a similar provision that would have provided an exclusion 
for an otherwise taxable distribution from an IRA that was made (1) 
directly to a charitable organization on or after the date the IRA 
owner attains age 70-ï¿½, or (2) to a split interest entity on or 
after the date the IRA owner attains age  59-1/2 . 

2.  Expand and increase the enhanced charitable deduction for 
contributions of food inventory 

                               Present Law
                                   
Under present law, a taxpayer's deduction for charitable contributions 
of inventory generally is limited to the taxpayer's basis (typically, 
cost) in the inventory, or if less the fair market value of the 
inventory.  For certain contributions of inventory, C corporations may 
claim an enhanced deduction equal to the lesser of (1) basis plus 
one-half of the item's appreciation (i.e., basis plus one half of 
fair market value in excess of basis) or (2) two times basis 
(sec. 170(e)(3)).  In general, a C corporation's charitable contribution 
deductions for a year may not exceed 10 percent of the corporation's 
taxable income (sec. 170(b)(2)). To be eligible for the enhanced 
deduction, the contributed property generally must be inventory of 
the taxpayer, contributed to a charitable organization described in 
section 501(c)(3) (except for private nonoperating foundations), 
and the donee must (1) use the property consistent with the donee's 
exempt purpose solely for the care of the ill, the needy, or 
infants, (2) not transfer the property in exchange for money, 
other property, or services, and (3) provide the taxpayer a written 
statement that the donee's use of the property will be consistent with 
such requirements.  In the case of contributed property subject to 
the Federal Food, Drug, and Cosmetic Act, the property must satisfy the 
applicable requirements of such Act on the date of transfer and for 
180 days prior to the transfer.

A donor making a charitable contribution of inventory must make a 
corresponding adjustment to the cost of goods sold by decreasing the cost 
of goods sold by the lesser of the fair market value of the property or 
the donor's basis with respect to the inventory (Treas. Reg. 
sec.1.170A-4A(c)(3)).  Accordingly, if the allowable charitable deduction 
for inventory is the fair market value of the inventory, the donor reduces 
its cost of goods sold by such value,with the result that the difference 
between the fair market value and the donor's basis may still be 
recovered by the donor other than as a charitable contribution. 

To use the enhanced deduction, the taxpayer must establish that the fair 
market value of the donated item exceeds basis.The valuation of food 
inventory has been the subject of disputes between taxpayers and the 
IRS. \103\ 

Under the Katrina Emergency Tax Relief Act of 2005, any taxpayer, whether 
or not a C corporation, engaged in a trade or business is eligible to 
claim the enhanced deduction for certain donations made after 
August 28, 2005, and before January 1, 2006, of food inventory.  For 
taxpayers other than C corporations, the total deduction for donations 
of food inventory in a taxable year generally may not exceed 10 percent 
of the taxpayer's net income for such taxable year from all sole  
proprietorships, S corporations, or partnerships (or other entity that 
is not a C corporation) from which contributions of "apparently 
wholesome food" are made.  "Apparently wholesome food" is defined as 
food intended for human consumption that meets all quality and labeling 
standards imposed by Federal, State, and local laws and regulations 
even though the food may not be readily marketable due to appearance, 
age, freshness, grade, size, surplus, or other conditions.\104\  


----------------------

\103\ Lucky Stores Inc. v. Commissioner,105 T.C.420 (1995)(holding that 
the value of surplus bread inventory donated to charity was the full 
retail price of te bread rather than half the retail price, as the IRS 
 asserted).

\104\ The Katrina Emergency Tax Relief Act of 2005 defines "apparently 
wholesome food" as that term is defined under the Bill Emerson Good 
Samaritan Food Donation Act. 42U.S.C.A. see 1791. 


                           Description of Proposal

Under the proposal, the enhanced deduction for donations of food 
inventory s increased to the lesser of (1) fair market value, or 
(2) two times the taxpayer's basis in the contributed inventory.  
In addition, any taxpayer engaged in a trade or business, whether 
or not a C corporation, is eligible to claim an enhanced deduction 
for donations of food inventory. The deduction for donations by S 
corporations and noncorporate taxpayers is limited to 10 percent 
of the net income from the associated trade or business.  The 
proposal provides a special rule that would permit certain 
taxpayers with a zero or low basis in the food donation (e.g., 
taxpayers that use the cash method of accounting for purchases and 
sales, and taxpayers that are not required to capitalize indirect 
costs) to assume a basis equal to 25 percent of the food's fair 
market value.  In such cases, the allowable charitable deduction 
will equal 50 percent of the food's fair market value.  The enhanced 
deduction for food inventory will be available only for food that 
qualifies as "apparently wholesome food" (defined as food that is 
intended for human consumption that meets all quality and labeling 
standards imposed by Federal, State, and local laws and regulations 
even though the food may not be readily marketable due to 
appearance, age freshness, grade, size, surplus, or other conditions).  
The proposal provides that the fair market value of apparently wholesome 
food that cannot or will not be sold solely due to internal 
standards of the taxpayer or lack of market would be determined by 
taking into account the price at which the same or substantially the 
same food items (taking into account both type and quality) are sold 
by the taxpayer at the time of the contribution or, if not so sold 
at such time, in the recent past. 

Effective date.--The proposal is effective for taxable years beginning 
after December 31,2005.

                                 Analysis
Policy issues

In the absence of the enhanced deduction of present law, if the taxpayer 
were to dispose of excess inventory by dumping the excess food in a 
garbage dumpster, the taxpayer generally could claim the purchase 
price of the inventory (the taxpayer's basis in the property) as an 
expense against his or her gross income. In the absence of the enhanced 
 deduction of present law, if the taxpayer were to donate the excess 
food inventory to a charitable organization that maintains a food 
bank, the taxpayer generally would be able to claim a charitable 
deduction equal to the taxpayer's basis in the food inventory 
(subject to certain limits on charitable contributions). Viewed 
from the taxpayer's profit motive, the taxpayer would be indifferent 
between donating the food or dumping the food in a garbage dumpster. 
 If the taxpayer must incur cost to deliver the food to the charity 
that maintains the food bank, the taxpayer would not find it 
in his or her financial interest to donate the excess food inventory 
to the food bank.  The enhanced deduction creates an incentive for the 
taxpayer to contribute excess food inventory to charitable 
organizations that provide hunger relief. 

In general, the proposal is intended to give businesses greater 
incentive to contribute food to those in need.  By increasing the 
value of the enhanced deduction, up to the fair market value of the 
food, and by clarifying the definition of fair market value, the 
proposal is intended to encourage more businesses to donate more 
food to charitable organizations that provide hunger relief.  However,
some  argue that if the intended policy is to support food programs 
for the needy, it would be more direct and efficient to provide a 
direct government subsidy instead of making a tax expenditure 
through the tax system, which may result in abuse 
and cannot be monitored under the annual budgetary process. 
 On the other hand, proponents of the proposal likely would argue 
that a government program would be less effective in identifying 
the needy and overseeing delivery of the food than would the 
proposal.\105\ 

More specifically, critics argue that the definition of fair market value 
under the proposal is too generous because it may permit taxpayers to 
claim as fair market value the full retail price of food that was no 
longer fresh when donated.  If so, taxpayers might be better off 
contributing the food to charity than by selling the food in the 
ordinary course of their business.  For example, assume a taxpayer 
whose income is taxed at the highest corporate income tax rate of 
35 percent has purchased an avocado for $0.75.  The taxpayer 
previously could have sold the avocado for $1.35, but now could only 
sell the avocado for $0.30.  If the taxpayer sold the avocado for 
$0.30,the taxpayer would incur a loss of $0.45 ($0.75 basis minus 
$0.30 sales revenue) on the sale. Because the loss on the sale of 
the avocado reduces the taxpayer's taxable income, the taxpayer's 
tax liability would decline by approximately $0.16 ($0.45 multiplied 
by 35 percent), so the net loss from the sale in terms of after-tax 
income would be $0.29.  If, alternatively, the taxpayer had donated 
the avocado to the local food bank, and under the proposal were 
allowed to claim a deduction for the previous fair market value 
of $1.35, the taxpayer's taxable income would be reduced by $1.35 
resulting in a reduction in tax liability of approximately $0.47 
($1.35 multiplied by 35 percent). However, the taxpayer originally 
purchased the avocado for $0.75 and, as the avocado is donated, this 
expense cannot be deducted as a cost of goods sold.  By donating the 
avocado, the taxpayer's net loss on the avocado is $0.28 
(the $0.47 in income tax reduction minus the cost of acquiring the 
avocado, $0.75). Under the proposal, the taxpayer loses less on the 
avocado by donating the avocado to charity than by selling the 
avocado.  

This possible outcome is a result of permitting a deduction for a value 
that the taxpayer may not be able to achieve in the market.  Whether sold 
or donated, the taxpayer incurred a cost to acquire the good. When a 
good is donated, it creates "revenue" for the taxpayer by reducing his 
or her taxes otherwise due.  When the value deducted exceeds the revenue 
potential of an actual sale, the tax savings from the charitable 
deduction can exceed the sales revenue from a sale. While such an 
outcome is possible, in practice it may not be the norm.  In part 
because the proposal limits the enhanced deduction to the lesser of the 
measure of fair market value  or twice the taxpayer's basis, it can 
only be more profitable to donate food than to sell food if the 
taxpayer would otherwise be selling the food to be donated at a loss. 
 In general, it depends upon the 

----------------------
\105\ See generally Louis Alan Talley, "Charitable  Contributions of Food 
Inventory: Proposals for Change Under the 'Community Solutions Act 2001," 
Congressional Research Service Report for Congress (August 23, 2001). 


amount by which the deduction claimed exceeds the taxpayer's basis in the 
food relative to the extent of the loss the taxpayer would incur from 
a sale.\106\ 



In addition, to the extent the proposal would subsidize food disposal, 
companies producing food may take less care in managing their inventories 
and might have less incentive to sell aging food by lowering prices, 
knowing that doing so might also reduce the value of an 

------------------------------
\106\ In general, it is never more profitabl to donate food than to sell 
food unless the taxpayer is permitted to deduct a value greater than the 
current fair market value of the food.  To see this: 

        let Y denote the taxpayer's pre-tax income from all other business 
        activity;

	let B denote the taxpayer's acquisition cost (basis) of the item 
	to be donated;
	
	let a represent the percentage by which the permitted deduction 
        exceeds the taxpayer's basis, that is aB equals the value of the 
        deduction permitted; 
        
	let  equal the current market value as a percentage of the 
	taxpayer's basis in the item, that is the revenue that could be 
	attained from sale is B;
	

and let t denote the taxpayer's marginal tax rate. 
Further assume that  < 1 < a, that is, at the current market value the 
taxpayer would be selling at a loss, but previously the taxpayer could 
sell at a profit. The taxpayer's after-tax income from sale of the 
item is (Y + B 
- B)(1-t). 

Under the proposal, the taxpayer's after-tax income from contribution of 
the item is Y - B - t(Y - aB).  For the case in which the permitted 
deduction would exceed twice the taxpayer's basis, the taxpayer's 
after-tax income from contribution of the item is Y - B - t(Y - 2B). 
It is more profitable to donate the item than to sell it when the 
following inequality is satisfied. 
(1)    (Y + B - B)(1-t) < Y - B - t(Y - aB). 
This inequality reduces to:
(2)    /( + (a-1)) < t. 


Whether it is more profitable to donate food than to sell food depends 
upon the extent to which the food would be sold at a loss ( ) relative 
 to the extent of the loss plus the extent to which the permitted 
deduction exceeds the taxpayer's basis (a-1), compared to the taxpayer's 
marginal tax rate.  Because under present law, the marginal tax rate is 
0.35, equation (2) identifies conditions on the extent of loss and 
the permitted deduction that could create a situation where a 
charitable contribution produces a smaller loss than would a market 
 sale, such as the example in the text.  In the case where the 
taxpayer's deduction would be limited to twice basis, it is possible 
to show that for a marginal tax rate of 35 percent, the current market 
value of the item to be donated must be less than 53.8 percent of the 
taxpayer's basis in the item, that is, <0.538. 


eventual deduction.\107\ Critics also argue that the proposal would in 
effect provide a deduction for the value of services, which are not 
otherwise deductible, because in some cases, services are built into the 
fair market value of food. 

Complexity issues

The proposal has elements that may both add to and reduce complexity of 
the charitable contribution deduction rules. Under present law, the 
general rule is that charitable gifts of inventory provide the donor 
with a deduction in the amount of the donor's basis in the inventory. 
The Code currently contains several exceptions: a special rule for 
contributions of inventory that is used by the donee solely for the 
care of the ill, the needy, or infants, a special rule for 
contributions of scientific property used for research, and a special 
rule for contributions of computer technology and equipment used 
for educational purposes. Each special rule has distinct 
requirements.  The proposal would add another special rule, with 
its own distinct requirements, thereby increasing the complexity 
of an already complex section of the Code.  The proposal also could 
decrease complexity, however, because it would provide a definition 
of fair market value.  Under current law, valuation of food 
inventory has been a disputed issue between taxpayers and the IRS 
and a cause of uncertainty for taxpayers when claiming the 
deduction. Another interpretative issue could arise in deciding 
whether the contributed food is "substantially" the same as other 
food items sold by the taxpayer for purposes of determining fair 
market value of the food. 

Taxpayers who contribute food inventory must consider multiple 
factors to ensure that they deduct the permitted amount (and no 
more than the permitted amount) with respect to contributed 
food.  Taxpayers who are required to maintain inventories for 
their food purchases must compare the fair market value of the 
contributed food with the basis of the food (and twice the basis 
of the food), and coordinate the resulting contribution deduction 
with the determination of cost of goods sold.   Taxpayers who are 
not required to maintain inventories for their food purchases 
generally will have a zero or low basis in the contributed food, 
but are permitted to use a deemed basis rule that provides such 
taxpayers a contribution deduction equal to 50 percent of the 
food's fair market value.  Taxpayers who are not required to 
maintain inventories need not coordinate cost of goods sold 
deductions or inventory adjustments with contribution 
deductions, and are not required to recapture the previously 
expensed costs associated with the contributed food.   

                                 Prior Action
                                     
The President's fiscal year 2003, 2004, 2005, and 2006 budget 
proposals contained a similar proposal.  

--------------------------
\107\ See Martin A. Sullivan,"Economic Analysis: Can Bush Fight 
Hunger With a Tax Break?," Tax Notes, vol,94, February 11, 2002, 
p.671. 

\108\ Such taxpayers must remove the amount of the contribution 
deduction for the contributed food inventory from opening 
inventory, and do not treat the removal a spart of cost of 
goods sold.  IRS Publication 526, Charitable Contributions, pp.7-8. 



3.  Reform excise tax based on investment income of private foundations 

                              Present Law
                                  
Under section 4940(a) of the Code, private foundations that are 
recognized as exempt from Federal income tax under section 501(a) of 
the Code are subject to a two-percent excise tax on their net 
investment income. Private foundations that are not exempt from tax, 
such as certain charitable trusts, also are subject to an excise 
tax, under section 4940(b).  Net investment income generally 
includes interest, dividends, rents, royalties, and capital gain 
net income, and is reduced by expenses incurred to earn this 
income. The two-percent rate of tax is reduced to one-percent 
in any year in which a foundation exceeds the average historical 
level of its charitable distributions.  Specifically, the excise 
tax rate is reduced if the foundation's qualifying distributions 
(generally, amounts paid to accomplish exempt purposes)\109\ equal 
or exceed the sum of (1) the amount of the foundation's assets for 
the taxable year multiplied by the average percentage of the 
foundation's qualifying distributions over the five taxable years 
immediately preceding the taxable year in question, and (2) one 
percent of the net investment income of the foundation for the 
taxable year.\110\ In addition, the foundation cannot have been 
subject to tax in any of the five preceding years for failure to 
meet minimum qualifying distribution requirements.\111\ 

The tax on taxable private foundations under section 4940(b) is 
equal to the excess of the sum of the excise tax that would have 
been imposed under section 4940(a) if the foundation was tax 
exempt and the amount of the unrelated business income tax that 
would have been imposed if the foundation were tax exempt, over 
the income tax imposed on the foundation under subtitle A of the 
Code.  Exempt operating foundations are exempt from the section 
4940 tax.\112\ 

Nonoperating private foundations are required to make a minimum 
amount of qualifying distributions each year to avoid tax under 
section 4942. The minimum amount of qualifying distributions a 
foundation has to make to avoid tax under section 4942 is reduced 
by the amount of section 4940 excise taxes paid.\113\ 

--------------------

\109\ Sec. 4942(g).

\110\ Sec. 4940(e)

\111\ Sec. 4942.

\112\ Sec. 4940(d)(1).  Exempt operating foundations generally include 
organizations such as museums or libraries that devote their assets to 
operating charitable programs but have difficulty meeting the 
"public support" tests necessary not to be classified as a private 
foundation.  To be an exempt operating foundation, an organization 
must: (1) be an operating foundation (as defined in section 
4942(j)(3)); (2) be publicly supported for at least 10 taxable years; 
(3) have a governing body no more than 25 percent of whom are 
disqualified persons and that is broadly representative of the 
general public; and (4) have no officers who are disqualified 
persons.  Sec. 4940(d)(2). 

\113\ Sec. 4942(d)(2).






                            Description of Proposal

The proposal replaces the two rates of excise tax on private 
foundations with a single rate of tax and sets the rate at one 
percent. Thus, under the proposal, a tax-exempt private foundation 
is subject to tax on one percent of its net investment income.  
A taxable private foundation is subject to tax on the excess of 
the sum of the one percent excise tax and the amount 
of the unrelated business income tax (both calculated as if the 
foundation were tax-exempt) over the income tax imposed on the 
foundation. The proposal repeals the special one-percent excise 
tax for private foundations that exceed their historical level of 
qualifying distributions. 

Effective date.--The proposal is effective for taxable years beginning 
after December 31, 2005. 


                                  Analysis
                                      
The proposal has the effect of increasing the required minimum 
charitable payout for private foundations that pay the excise tax at 
the two-percent rate.   This may result in increased charitable 
distributions for private foundations that pay only the minimum in 
charitable distributions under present law. For example, if a 
foundation is subject to the two-percent excise tax on net investment 
income, the foundation reduces the amount of required charitable 
distributions by the amount of excise tax paid. 
Because the proposal decreases the amount of excise tax paid on net 
investment income for such foundations, the proposal increases such 
foundations' required minimum amount of charitable distributions by an 
amount equal to one percent of the foundation's net investment income. 
Thus, the proposal results in an increase of required charitable 
distributions in the case of foundations paying the two-percent rate and 
distributing no greater than the required minimum under present law. 
Foundations paying the two-percent rate that exceed the required minimum 
under present law generally would not have to increase their charitable 
distributions as a result of the proposal. Although the required minimum 
amount of charitable distributions would increase for such foundations, 
such foundations already make distributions exceeding the minimum and so 
generally would not have to increase charitable distributions as a result 
of the proposal (except to the extent that the increase in the required 
minimum amount was greater than the excess of a private foundation's 
charitable distributions over the required minimum amount of present 
law). However, a reduction in the excise tax rate from 2 percent to 1 
percent may result in increased charitable distributions to the extent 
that a foundation decides to pay out the amount that otherwise would 
be paid in tax for charitable purposes. 

The proposal also eliminates the present-law two-tier tax structure. 
 Some have suggested that the two-tier excise tax is an incentive 
for foundations 

------------------
\114\ Operating foundations are not subject to the minimum 
charitable payout rules.  Sec.4942(a)(1).

\115\ The proposal does not, however, increase the total amount required 
to be paid out for charitable and tace purposes; rather, by reducing the 
rate of tax, the proposal decreases the amount of the pay out that may 
be satisfied through payment of tax.

to increase the amounts they distribute to charities.\116\  Critics of 
the present-law two-tier excise tax have criticized the efficiency of 
the excise tax as an incentive to increase payout rates.  First, 
critics note, the reduction in excise tax depends only upon an 
increase in the foundation's rate of distributions to charities, not 
on the size of the increase in the rate of distributions.  Thus, a 
large increase in distributions is rewarded by the same reduction in 
excise tax rate as is a small increase in distributions. There is no 
extra incentive to make a substantial increase in distributions 
rather than a quite modest increase in distributions.

In addition, critics assert that, under a number of circumstances, the 
present-law two-tier excise tax can create a disincentive for foundations 
to increase charitable distributions substantially.\117\ In order to 
take advantage of the one-percent excise tax rate, a private foundation 
must increase its rate of charitable distributions in the current year 
above that which prevailed in the preceding five years. Whether the 
present-law two-tier excise tax creates an incentive or disincentive 
to increased payout rates depends, in part, on whether the foundation 
 currently is subject to the one-percent tax rate or the two-percent 
tax rate.  Because modest increases in payout rates qualify a 
foundation for the one-percent tax rate, some analysts suggest 
that a foundation may be able to manage its distributions actively so 
that the foundation qualifies for the one-percent tax rate without 
 substantially increasing its payout rate.\118\ For a foundation 
subject to the one-percent rate in the current year, an 
increased payout in any year becomes part of the computation to 
determine eligibility for the one-percent rate in future years. 
Thus, under the present-law formula, the foundation can trigger 
the two-percent excise tax rate by increasing the payout amount 
in a particular year because increased payouts make it more difficult 
for the foundation to qualify for the one-percent rate in subsequent 
years, and it increases the possibility that the foundation will 
become subject to the two-percent tax rate. 
Consequently, over time, the one-percent rate provides a disincentive 
for increasing charitable distributions. 

On the other hand, for a foundation currently subject to the one-percent 
excise tax rate and also making charitable distributions at a rate above 
the minimum required amount, the present-law two-tier excise tax can 
create a disincentive for foundations to reduce their payout rate. A 
reduction in payout rate in the future would reduce the foundation's 

------------------
\116\ In general, foundations that make only the minimum amount of 
charitable distributions and seek to minimize total payouts have no 
incentive to decrease their rate of excise tax because such a decrease 
would result in an increase in the required minimum amount of 
charitable distributions, thus making no difference to the total 
payout of the private foundation. 

\117\ See C. Eugene Steuerle and Martin A. Sullivan, "Toward More 
Simple and Effective Giving: Reforming the Tax Rules for Charitable 
 Contributions and Charitable Organizations," American Journal of 
Tax Policy, 12, Fall 1995, at 399-447. 

\118\ For example, if over a 10-year period the foundation increased 
its payout rate from the minimum 5.00 percent to 5.01 percent, to 
5.02 percent, up to 5.10 percent, the foundation generally would 
qualify for the one-percent excise tax rate throughout the 10-year 
period. 

five-year moving average, thereby increasing the likelihood the 
foundation's net investment income is taxed at the two-percent rate, 
rather than the one-percent rate.\119\ 

For a foundation currently subject to the excise tax at the 
two-percent rate, an increase in payout may qualify the foundation 
for the one-percent excise tax rate. If the increase does qualify 
the foundation for the one-percent rate, and the foundation maintains 
the same payout for the subsequent four years, the foundation 
generally will be eligible for the one-percent tax rate in each of 
the five years. Hence the reduced tax rate can create an incentive 
to increase payout rates. However, even in the case of a two-percent 
excise tax paying foundation, the present-law two-tier excise tax 
can create a disincentive for a foundation to increase 
charitable distributions substantially in any one year compared to 
a strategy of slowly increasing payouts over several years. For 
example, consider a foundation which has had a payout rate of 5.0 
percent for several years. Suppose the foundation is considering 
increasing its payout rate. Consider two possible strategies: 
increase the payout rate to 8.0 percent in the current year 
followed by rates of 5.5 percent thereafter; or gradually increase 
the payout rate by increments of one-tenth of one percent annually 
for five years. While a substantial increase in any one 
year may qualify the foundation for the one-percent tax rate, 
 subsequent year payout rates of 5.5 percent would fail to qualify 
the foundation for the one- percent tax rate.\120\  Thus, under the 
first option, the foundation would pay the one-percent tax rate for 
one year and be a two-percent tax rate payor subsequently. Under 
the second option, the foundation would qualify for the one-percent 
rate in each year.  However, total payouts are greater under the 
first option. 

In summary, the incentive effects of the present-law two-tier excise 
tax depend upon the situation in which the foundation finds itself 
in the current year. In 2001, 51.6 percent of foundations were 
one-percent tax rate payors and 48.4 percent were two-percent rate 
 payors.Among large foundations (assets of $50 million or greater) 
71.5 percent were \one-percent rate payors and 28.5 percent were 
two-percent rate payors. A number of analysts suggest the optimal 
tax strategy for a private foundation is to choose a target rate of 
 disbursement, maintain that rate in all years, and never fall below 
the target in any year. 

Critics of the present-law excise tax structure observe that the median 
payout rate of large nonoperating private foundations (foundations with 
total assets of $50 million or more) was 5.1 or 5.0 percent in each year 
from 1991 through 1995 and was 5.0 percent in 1999.\123\  However,the 


----------------------
\123\ See Figure I in Paul Arnsberger, "Private Foundations and 
Charitable Trusts, 1995," Internal Revenue Service, Statistics of 
Income Bulletin, 18, Winter 1998-1999 at 73 and Figure I in Melissa 
Ludlum, "Domestic Private Foundations and Charitable Trusts, 1999," 
Internal Revenue Service, Statistics of Income Bulletin, 22, Fall 
2002 at 148. 

\124\ See Figure J in Melissa Ludlum, "Domestic Private Foundations 
and Charitable Trusts, 2001," Internal Revenue Service, Statistics of 
Income Bulletin, 24, Fall 2004 at 153. 

\125\ See Figure I in Paul Arnsberger, "Private Foundations and 
Charitable Trusts, 1995," Internal Revenue Service, Statistics of 
Income Bulletin, 18, Winter 1998-1999 at 73 and Figure I in 
Melissa Ludlum, "Domestic Private Foundations and Charitable 
Trusts, 1999," Internal Revenue Service, Statistics of Income 
Bulletin, 22, Fall 2002 at 148. 

\126\ See Figure J in Melissa Ludlum, "Domestic Private Foundations 
and Charitable Trusts,2001," Internal Revenue Service, Statistics 
of Income Bulletin, 24, Fall 2004 at 153. 


payout rate for such foundations increased to 5.5 percent in 2001. 
The median payout rates for foundations with assets between $10 
million and $50 million declined annually from 5.4 percent in 1990 
to 5.1 percent in 1995 and 1999.  Similarly, the median payout 
rates for foundations with assets between $100,000 and $1 million 
declined from 6.7 percent in 1990 to 5.5 percent in 1995 and 5.4 
percent in 1999  but increased to 6.2 percent in 2001. 

The proposal reduces complexity for private foundations by 
replacing the two-tier tax on net investment income with a 
one-tier tax.  Under the proposal, private foundations do not 
have to allocate resources to figuring which tier of the tax 
would be applicable or to planning the optimum payout 
rate.  The proposal also would make compliance easier for private 
foundations, as they would not have to compute a five-year average of 
charitable distributions on the information return they file each year. 


                               Prior Action
                                      
The President's fiscal year 2003, 2004, 2005, and 2006 budget 
proposals included a similar proposal. 

The President's fiscal year 2001 budget proposal included a similar 
proposal, but would have reduced the rate of tax to 1.25 percent. 

4. Modify tax on unrelated business taxable income of charitable 
remainder trusts 

                               Present Law
                                      
A charitable remainder annuity trust is a trust that is required to 
pay, at least annually, a fixed dollar amount of at least five 
percent of the initial value of the trust to a noncharity for the 
life of an individual or for a period of 20 years or less, with the 
remainder passing to charity.
A charitable remainder unitrust is a trust that generally is required to 
pay, at least annually, a fixed percentage of at least five percent of 
the fair market value of the trust's assets determined at least 
annually to a noncharity for the life of an individual or for a period 
20 years or less, with the remainder passing to charity. 

A trust does not qualify as a charitable remainder annuity trust if 
the annuity for a year is greater than 50 percent of the initial fair 
market value of the trust's assets.  A trust does not qualify as a 
charitable remainder unitrust if the percentage of assets that are 
required to be distributed at least annually is greater than 50 
percent.  A trust does not qualify as a charitable remainder annuity 
trust or a charitable remainder unitrust unless the value of the 
remainder interest in the trust is at least 10 percent of the value 
of the assets contributed to the trust. 

Distributions from a charitable remainder annuity trust or charitable 
remainder unitrust are treated in the following order as: (1) ordinary 
income to the extent of the trust's current and previously undistributed 
ordinary income for the trust's year in which the distribution occurred; 
(2) capital gains to the extent of the trust's current capital gain and 
previously undistributed capital gain for the trust's year in which the 
distribution occurred; (3) other income (e.g., tax-exempt income) to the 
extent of the trust's current and previously undistributed other income 
for the trust's year in which the distribution occurred; and (4) corpus. 

In general, distributions to the extent they are characterized as income 
are includible in the income of the beneficiary for the year that the 
annuity or unitrust amount is required to be distributed even though the 
annuity or unitrust amount is not distributed until after the close of 
the trust's taxable year. 

Charitable remainder annuity trusts and charitable remainder unitrusts 
are exempt from Federal income tax for a tax year unless the trust has 
any unrelated business taxable income for the year.  Unrelated business 
taxable income includes certain debt financed income.  A charitable 
remainder trust that loses exemption from income tax for a taxable 
year is taxed as a regular complex trust.  As such, the trust is 
allowed a deduction in computing taxable income for amounts required 
to be distributed in a taxable year, not to exceed the amount of the 
trust's distributable net income for the year. 


                         Description of Proposal
                                 
The proposal imposes a 100-percent excise tax on the unrelated business 
taxable income of a charitable remainder trust.  This replaces the 
present-law rule that removes the income tax exemption of a charitable 
remainder trust for any year in which the trust has any unrelated 
business taxable income. Under the proposal, the tax is treated as paid 
from corpus. The unrelated business taxable income is considered income 
of the trust for purposes of determining the character of the 
distribution made to the beneficiary. 

Effective date.--The proposal is effective for taxable years beginning 
after December 31,2005, regardless of when the trust was created. 


                                 Analysis
                                        
The proposal is intended to produce a better result than present law for 
trusts that have only small or inadvertent amounts of unrelated business 
taxable income.  The present-law rule that any amount of unrelated 
business taxable income results in loss of tax-exemption for the year 
discourages trusts from making investments that might generate 
insignificant (or inadvertent) unrelated business taxable income. A loss
of exemption could be particularly punitive in a year in which a trust 
sells, for example, the assets that originally funded the trust and does 
not distribute the proceeds.  The proposal avoids this result by 
requiring a trust to pay the amount of the unrelated business taxable 
income as an excise tax but does not require the trust to pay tax on 
all of its other income for the year.  In addition, the proposal is 
helpful to trusts that receive unrelated business taxable income as 
a result of a change in the status of the entity in which trust assets 
are invested.  However, the proposal also may enable trusts to choose 
to make certain investments that have small amounts of unrelated 
business income that are and some may argue should be discouraged 
by present law. For example, investments in rental property may 
generate a small amount of unrelated business taxable 
income from fees for services provided to tenants. Such investments 
may be unattractive for charitable remainder trusts under present 
law because the unrelated income causes the trust to lose exemption. 
 Under the proposal, however, a rental property owner might have an 
incentive to contribute the rental property to a charitable remainder 
trust (of which the owner was beneficiary) to shelter the rental 
income from tax (to the extent the rental income exceeds the unitrust 
amount or annuity payment). Some argue that charitable remainder 
trusts should not be encouraged to make such investments. 

The proposal also is intended to be a more effective deterrent than 
present law to prevent charitable remainder trusts from investing in 
assets that generate large amounts of unrelated business taxable 
income.  Although present law requires that a charitable remainder 
trust become a taxable trust for a year in which the trust has 
unrelated business taxable income, a charitable remainder trust 
nevertheless may invest in assets that produce significant 
unrelated business income but pay tax only on the trust's 
undistributed income. This is because, as a taxable trust,the 
trust may take a deduction for distributions of income that are 
taxable to the beneficiaries. To the extent the trust pays tax, 
trust assets are depleted to the detriment of the charitable 
beneficiary. Thus, proponents argue that the proposal better deters 
trusts from making investments that generate significant unrelated 
business taxable income because the 100 percent excise tax would 
be prohibitive.  On the other hand, some question whether such a 
deterrent is the right policy in cases where a trustee determines 
that investment in assets that produce unrelated business taxable 
income will increase the (after tax) rate of return to the trust 
(and thus inure to the benefit of the charitable remainderman). 

The proposal provides that unrelated business taxable income is 
treated as ordinary income to the trust and taxes are paid from 
corpus. Thus, the proposal treats the trust beneficiary the same 
as under present law, that is, distributions of the unrelated 
business income are taxed as ordinary income to the beneficiary. 
 As a result, the proposed rule in effect taxes the unrelated 
business income twice, once as an excise tax (at a 100-percent 
rate), and again when distributed.  Double taxation presently 
exists to the extent that the trust's income from all sources 
exceeds the amount distributed to the beneficiary during a year 
in which the trust is not exempt from income tax.  Proponents of 
the proposal would argue that double taxation is not a concern 
because the excise tax is intended as a penalty for incurring 
unrelated business income.  Proponents also would argue that 
although an alternative approach, for example, to tax the 
unrelated business income as an excise tax but not again when 
distributed, would avoid any perceived double taxation of the 
unrelated income, such an alternative would have undesired 
effects.  Proponents would argue that if unrelated income is 
not taxed when distributed, a trust might have a strong 
incentive to invest in assets that produce unrelated income 
in order to convey a benefit to the beneficiary that is not 
available under present law (capital gain income or tax-free 
return of corpus instead of ordinary income).  In addition, 
proponents would note, the charitable remainderman's interest 
would be diminished to the extent a trust invested 
significantly in unrelated business income producing assets. 

The proposal simplifies the operation of charitable remainder 
trusts in that a trust with a small amount of unrelated business 
taxable income does not lose its tax exemption and therefore does 
not need to file income tax returns and compute its taxable 
income as if it were a taxable trust.  This has the effect of not 
discouraging trustees to make investments that might entail 
having a small amount of unrelated business taxable income. 

                                 Prior Action
                                 
A similar proposal was included in the President's fiscal year 2003, 
2004, 2005, and 2006 budget proposals. 

5.  Modify the basis adjustment to stock of S corporations 
contributing appreciated property

                                   Present Law
                                   
Under present law, a shareholder of an S corporation takes into account, 
in determining its own income tax liability, its pro rata share of any 
charitable contribution of money or other property made by the 
corporation. A shareholder of an S corporation reduces the basis in 
the stock of the S corporation by the amount of the charitable 
contribution that flows through to the shareholder. 

In the case of a contribution of appreciated property, the stock basis 
is reduced by the full amount of the contribution.  As a result, when 
the stock is sold, the shareholder may lose the benefit of the 
charitable contribution deduction for the amount of any appreciation 
in the asset contributed. 



--------------------------
\130\ Sec. 1366(a)(1)(A).

\131\ Sec.. 1367(a)(2)(B).



                         Description of Proposal
                               
The proposal allows a shareholder in an S corporation to increase the 
basis of the S corporation stock by an amount equal to the excess of the 
charitable contribution deduction that flows through to the shareholder 
over the shareholder's pro-rata share of the adjusted basis of the 
property contributed.\132\ 

Effective date.--The proposal applies to taxable years beginning after 
December 31, 2005.

                                Analysis 
                                       
The proposal preserves the benefit of providing a charitable 
contribution deduction for contributions of property by an S 
corporation with a fair market value in excess of its adjusted 
basis by limiting the reduction in the shareholder's basis in S 
corporation stock to the proportionate share of the adjusted basis 
of the contributed property. Under the proposal, the treatment of 
contributions of appreciated property made by an S corporation is 
similar to the treatment of contributions made by a partnership. 

The net reduction in basis of stock by the amount of the adjusted 
basis of contributed property rather than the fair market value 
will have little effect on tax law complexity. 

                                  Prior Action
                                     
A similar proposal was included in the President's fiscal year 2003, 
2004, 2005, and 2006 budget proposals. 

H.R. 4297 as amended by the Senate (the "Tax Relief Act of 2005") 
contains a similar proposal. 

6.  Repeal the $150 million limit for qualified 501(c)(3) bonds 


                              Present Law
                                     
Interest on State or local government bonds generally is excluded from 
income if the bonds are issued to finance activities carried out and paid 
for with revenues of these governments.  Interest on bonds issued by these 
governments to finance activities of other persons, e.g., private activity 
bonds, is taxable unless a specific exception is provided in the Code. 
One such exception is for private activity bonds issued to finance 
activities of private, charitable organizations described in section 
501(c) (3) ("section 501(c)(3) organizations") if the activities do not 
constitute an unrelated trade or business. 

Section 501(c)(3) organizations are treated as private persons; thus, 
bonds for their use may only be issued as private activity "qualified 
501(c) (3) bonds," subject to the restrictions of 

----------------------
\132\ See Rev. Rul.96-11 (1996-1 C.B. 140) for a similar rule 
applicable to contributions made by a partnership. 


section 145.  Prior to the Taxpayer Relief Act of 1997 
(the "1997 Act"), the most significant of these restrictions 
limited the amount of outstanding bonds from which a section 
501(c)(3) organization could benefit to $150 million.  In applying 
this "$150 million limit," all section 501(c)(3) organizations 
under common management or control were treated as a single 
organization.  The limit did not apply to bonds for hospital 
facilities, defined to include only acute care, primarily inpatient, 
organizations. 

The "1997 Act" repealed the $150 million limit for bonds issued after 
the date of enactment (August 5, 1997), to finance capital 
expenditures incurred after such date. 

                              Description of Proposal
                                
The proposal repeals the $150 million limit for qualified 501(c)(3) 
bonds in its entirety. 

Effective date.--The proposal is effective for bonds issued after 
the date of enactment. 

                              Analysis

Because the 1997 Act provision applies only to bonds issued with 
respect to capital expenditures incurred after August 5, 1997, 
the $150 million limit continues to govern the issuance of other 
non-hospital qualified 501(c)(3) bonds (e.g., advance refunding 
bonds with respect to capital expenditures incurred on or before 
such date, new-money bonds for capital expenditures incurred on 
or before such date, or new-money bonds for working capital 
expenditures).  Thus, there are two rules governing 
qualified 501(c)(3) bonds for capital expenditures.  The 
application of a particular rule depends on whether the capital 
expenditures were incurred on or before or after the date the 1997 
Act was enacted. 

As noted above, the $150 million volume limit continues to apply to 
qualified 501(c)(3) bonds for capital expenditures incurred on or 
before August 5, 1997.  (Typically, these will be advance refunding 
bonds).  The limit also continues to apply to bonds more than five 
percent of the net proceeds of which finance or refinance working 
capital expenditures (i.e., operating expenses).  The limit does 
not apply to bonds to finance capital expenditures incurred after 
that date.  The Senate Finance Committee report states that the 
purpose of the repeal of the $150 million limit was to correct the 
 disadvantage the limit placed on 501(c) (3) organizations relative 
to substantially identical governmental institutions: The Committee 
believes a distinguishing feature of American society is the 
singular degree to which the United States maintains a private, 
non-profit sector of private higher education and other charitable 
institutions in the public service.  

The Committee believes it is important to assist these private 
institutions in their advancement of the public good.  The Committee 
finds particularly inappropriate the restrictions of present law 
which place these section 501(c)(3) organizations at a financial 
disadvantage relative to substantially identical governmental 
institutions.  For example, a public university generally has 
unlimited access to tax-exempt bond financing, while a private, 
non-profit university is subject to a $150 million limitation on 
outstanding bonds from which it may benefit. 

The Committee is concerned that this and other restrictions inhibit 
the ability of America's private, non-profit institutions to 
modernize their educational facilities.  The Committee believes the 
tax-exempt bond rules should treat more equally State and local 
governments and those private organizations which are engaged in 
similar actions advancing the public good. 

Although the conference report on the 1997 Act noted the continued 
applicability of the $150 million limitation to refunding and new-money 
bonds, no reason was given for retaining the rule. Thus, it appears that 
eliminating the discrepancy between pre-August 5, 1997, and post-August 
5, 1997, capital expenditures would not violate the policy underlying 
the repeal of the $150 million limitation.  Some may argue that the 
$150 million volume limit should continue to apply to qualified 
501(c)(3) bonds more than five percent of the net proceeds of which 
finance or refinance working capital expenditures (i.e., operating 
expenses).  Unlike bond proceeds financing capital expenditures, 
bond proceeds financing working capital expenditures are not 
directly used to modernize educational facilities, but are used to 
finance operating expenses Proponents may respond that Congress 
intended to eliminate the disparity between 501(c)(3) organizations 
and substantially identical governmental institutions in the 
1997 Act and this only can be achieved by complete repeal of the $150 
million

                              Prior Action
                              
A similar proposal was included in the President's fiscal year 2004, 
2005, and 2006 budget proposals. 

7. Repeal the restrictions on the use of qualified 501(c)(3) bonds for 
residential rental property


                               Present Law
                               
In general

Interest on State or local government bonds is tax-exempt when the 
proceeds of the bonds are used to finance activities carried out by 
or paid for by those governmental units.  Interest on bonds issued by 
State or local governments acting as conduit borrowers for private 
businesses is taxable unless a specific exception is included in the 
Code.  One such exception allows tax-exempt bonds to be issued to 
finance activities of non-profit organizations described in Code 
section 501(c)(3) ("qualified 501(c)(3) bonds"). 

For a bond to be a qualified 501(c)(3) bond, the bond must meet certain 
general requirements.  The property that is to be provided by the net 
proceeds of the issue must be owned by a 501(c)(3) organization, or by a 
government unit.  In addition, a bond failing both a modified private 
business use test and a modified private security or payment test would 
not be a qualified 501(c)(3) bond.  Under the modified private 
business use test at least 95 percent of the net proceeds of the bond 
must be used by a 501(c)(3) organization in furtherance of its exempt 

--------------------
\133\ S. Rep. 105-33 (June 20, 1997), aat 24-25. 

\134\ H. Rep. 105-220 (July 30, 1997), at 372-373. 


purpose. Under amodified private security or payment test, the debt 
service on not more than 5 percent of the net proceeds of the bond 
issue can be (1) secured by an interest in property, or payments in 
respect of property, used by a 501(c)(3) organization in furtherance 
of an unrelated trade or business or by a private user, or (2) 
derived from payments in respect of property, or borrowed money, 
used by a 501(c)(3) organization in furtherance of an unrelated 
trade or business or by a private user. 

Qualified 501(c)(3) bonds are not subject to (1) the State volume 
limitations, (2) the land and existing property limitations, (3) the 
treatment of interest as a preference item for purposes of the 
alternative minimum tax and (4) the prohibition on advance refundings. 

Qualified residential rental projects

In general

The Code provides that a bond which is part of an issue shall not be a 
qualified 501(c)(3) bond if any portion of the net proceeds of the issue 
are to be used directly or indirectly to provide residential rental 
property for family units (sec. 145(d)(1)). Exceptions to this rule are 
provided for facilities that meet the low-income tenant qualification 
rules for qualified residential rental projects financed with exempt 
facility private activity bonds,\135\  or are new or substantially 
rehabilitated (sec. 142(d) and 145(d)(2)). 

Acquisition of existing property 

Qualified 501(c)(3) bonds issued to acquire existing residential 
rental property that is not substantially rehabilitated must meet 
certain low-income tenant qualification rules.  Section 142(d) 
sets forth those rules.  Section 142(d) requires for the qualified 
project period (generally 15 years) that (1) at least 20 percent 
of the housing units must be occupied by tenants having incomes 
of 50 percent or less of area median income or (2) 40 percent of 
the housing units in the project must be occupied by tenants 
having incomes of 60 percent or less of the area median 
income. 

New construction or substantial rehabilitation 

In the case of a "qualified residential rental project" that consists 
of new construction or substantial rehabilitation, qualified 501(c)(3) 
bonds are not required to meet the low-income tenant qualification 
rules that otherwise would be applicable. 

                          Description of Proposal
                          
The proposal repeals the low-income tenant qualification and 
substantial rehabilitation rules for the acquisition of existing 
property with qualified 501(c)(3) bonds. 


----------------------
\135\ Section 142(a)(7) describes an exempt facility bond as any bond 
issued as part of an issue of bonds if 95 percent or more of the net 
proceeds of the issue are to be used to provide qualified residential 
rental projects. 



Effective date.--The proposal is effective for bonds issued after the 
date of enactment. 

                                 Analysis
                                 
The current low-income tenant rules to qualified 501(c)(3) bonds 
resulted from Congressional concern that qualified 501(c)(3) bonds 
were being used in lieu of exempt facility bonds to avoid the 
low-income tenant rules applicable to exempt facility bonds.  
The Ways and Means Committee report noted: 

The Committee has become aware that, since enactment of the Tax 
Reform Act of 1986, many persons have sought to avoid the rules 
requiring that, to qualify for tax-exempt financing, residential 
rental property serve low-income tenants to a degree not previously 
required. The most common proposals for accomplishing this result 
have been to use qualified 501(c)(3) or governmental bonds to 
finance rental housing. Frequently, the proposals have involved the 
mere churning of "burned-out" tax shelters with the current 
developers remaining as project operators under management contracts 
producing similar returns to those they received in the past. The 
committee finds it anomalous that section 501(c)(3) 
organizations-charities-would attempt in these or any other 
circumstances to finance with tax-exempt bonds rental housing 
projects that serve a more affluent population group than those 
permitted to be served by projects that qualify for tax-exempt 
exempt-facility bond financing.\136\ 

In conference, the applicability of the low-income tenant rules was 
limited to the acquisition of existing property.\137\  It has been 
argued that the disparity in the treatment of existing facilities 
versus new facilities causes complexity. Some degree of 
simplification might be achieved through the elimination of the 
low-income tenant rules.Nonetheless, some might argue that the 
concerns that prompted the application of the low-income tenant 
rules to existing property would once again arise upon removal of 
these limitations. 

There have been reports that there is a shortage of affordable rental 
housing.  By removing the restrictions on existing property, some 
might argue that charities would not be inclined to serve low-income 
tenants to the same degree.  Proponents of the restrictions might 
argue that charities, in particular, should provide affordable 
housing to low-income persons as part of their charitable mission 
to serve the poor and distressed. 

Others might argue that an affordable housing shortage is not 
widespread and that such issues would be better addressed through 
efforts to directly assist low-income persons rather than by 
imposing restrictions on the property acquired by the charity. 
Further, because qualified 

--------------------
/136/ H.R. Rep. No. 100-795 at 585 (1988).  The report also noted: 
"The press has reported housing industry representatives stating 
publicly that a primary attraction of some housing financed with 
governmental and qualified 501(c)(3) bonds is that the low-icome 
tenant requirements and State volume caps applicable to for-profit 
developers do not apply." ld. 

/137/ H.R. Conf. Rep. 100-1104, vol.II ar 126 (1988). 



501(c)(3) bonds are to be used to further the exempt purposes of the 
charity, there is a limit on the extent the charity can operate like a 
commercial enterprise. 

As noted above, the interest on qualified 501(c)(3) bonds is exempt 
from tax, and is not a preference for purpose of the alternative 
minimum tax. Unlike some other private activity bonds, qualified 
501(c)(3) bonds are not subject to the State volume limitations 
and therefore, do not have to compete with other private activity 
bond projects for an allocation from the State. Proponents of the 
restrictions might argue that the restrictions are not unreasonable 
given the preferential status of qualified 501(c)(3) bonds and the 
fact that such charities could be viewed as helping alleviate a 
burden on government to benefit those most in need. 


                            Prior Action
                                  
A similar proposal was included in the President's fiscal year 2004, 
2005, and 2006 budget proposals. 


E.  Extend the Above-the-Line Deduction for 
Qualified Out-of-Pocket Classroom Expenses 

                                      Present Law
                                      
Deduction for out-of-pocket classroom expenses incurred by teachers and 
other educators 

In general, ordinary and necessary business expenses are deductible 
(sec. 162).  However, in general, unreimbursed employee business 
expenses are deductible only as an itemized deduction and only to 
the extent that the individual's total miscellaneous deductions 
(including employee business expenses) exceed two percent of 
adjusted gross income. An individual's otherwise allowable itemized 
deductions may be further limited by the overall limitation on 
itemized deductions, which reduces itemized deductions for taxpayers 
with adjusted gross income in excess of $150,500 (for 2006). In 
addition, miscellaneous itemized deductions are not allowable under 
the alternative minimum tax. 

Certain expenses of eligible educators are allowed an above-the-line 
deduction. Specifically,for taxable years beginning prior to 
January 1, 2006, an above-the-line deduction is allowed for up to 
$250 annually of expenses paid or incurred by an eligible educator 
for books, supplies (other than nonathletic supplies for courses of 
instruction in health or physical education), computer equipment 
(including related software and services) and other equipment, and 
supplementary materials used by the eligible educator in the 
classroom.  To be eligible for this deduction, the expenses must 
be otherwise deductible under 162 as a trade or business expense. 
 A deduction is allowed only to the extent the amount of expenses 
exceeds the amount excludable from income under section 135 
(relating to education savings bonds), 529(c)(1) (relating to 
qualified tuition programs), and section 530(d)(2) 
(relating to Coverdell education savings accounts). 

An eligible educator is a kindergarten through grade 12 teacher, 
instructor, counselor,principal, or aide in a school for at least 
900 hours during a school year.  A school means any school 
which provides elementary education or secondary education, as 
determined under State law.The above-the-line deduction for 
eligible educators is not allowed for taxable years beginning 
after December 31, 2005. 

General rules regarding education expenses 

An individual taxpayer generally may not deduct the education and 
training expenses of the taxpayer or the taxpayer's dependents.  
However, a deduction for education expenses generally is allowed 
under section 162 if the education or training (1) maintains or 
improves a skill required in a trade or business currently engaged 
in by the taxpayer, or (2) meets the express requirements of the 
taxpayer's employer, or requirements of applicable law or 
regulations, imposed as a condition of continued 
employment.\138\  Education expenses are not deductible 

------------------
\138\ Treas. Reg. sec.11.162-5.


if they relate to certain minimum educational requirements or to 
education or training that enables a taxpayer to begin working in a 
new trade or business.  

An individual is allowed an above-the-line deduction for qualified 
tuition and related expenses for higher education paid by the 
individual during a taxable year that are required for the enrollment 
or attendance of the taxpayer, the taxpayer's spouse, or any 
dependent of the taxpayer with respect to whom the taxpayer may 
claim a personal exemption, at an eligible educational institution 
of higher education for courses of instruction of such individual 
at such institution. \139\   

Unreimbursed educational expenses incurred by employees 

In the case of an employee, education expenses (if not reimbursed by 
the employer) may be claimed as an itemized deduction only if such 
expenses meet the above-described criteria for deductibility under 
section 162 and only to the extent that the expenses, along with 
other miscellaneous itemized deductions, exceed two percent of 
the taxpayer's adjusted gross income.  Itemized deductions 
subject to the two-percent floor are not deductible for minimum 
tax purposes.  In addition, present law imposes a reduction on 
most itemized deductions, including the employee business expense 
deduction, for taxpayers with adjusted gross income in excess of 
a threshold amount, which is indexed annually for inflation.  
\The threshold amount for 2005 is $150,500 ($75,250 for married 
individuals filing separate returns).  For those deductions that 
are subject to the limit, the total amount of itemized deductions 
is reduced by three percent of adjusted gross income over the 
threshold amount, but not by more than 80 percent of itemized 
deductions subject to the limit. Beginning in 2006 , EGTRRA phases 
out the overall limitation on itemized deductions for all 
taxpayers.  The overall limitation on itemized deductions is 
reduced by one-third in taxable years beginning in 2006 and 
2007, and by two-thirds in taxable years beginning in 2008 and 
2009.  The overall limitation on itemized deductions is eliminated 
for taxable years beginning after December 31, 2009, although 
this elimination of the limitation sunsets on 
December 31, 2010.\140\ 

Contributions to a school may be eligible for a charitable 
contribution deduction under section 170.  A contribution that 
qualifies both as a business expense and a charitable contribution 
may be deducted only as one or the other, but not both. 

                          Description of Proposal 
                          
The present-law provision would be made permanent. 

Effective date.--The proposal is effective for expenses incurred in 
taxable years beginning after December 31, 2005. 

---------------------------
\139\ Sec.222. 

\140\ A separate proposal contained in the President's fiscal  year 
2007 budget permanently extends the elimination of the overall 
limitation on itemized deductions after 2010 (I.A., above). 


                                   Analysis
                                   
Policy issues

The present-law section 62 above-the-line deduction attempts to make 
fully deductible many of the legitimate business expenses of eligible 
schoolteachers.  As described below, and absent an above-the-line 
deduction, the expenses might otherwise be deductible except for the 
two-percent floor that applies to miscellaneous itemized deductions. 
Some have observed that the two-percent floor increases pressure to 
enact above-the-line deductions on an expense-by-expense basis.  
In addition to increasing complexity, the expense-by-expense 
approach is not fair to other taxpayers with legitimate business 
expenses that remain subject to the two-percent floor.  Extending 
the present-law above-the-line deduction presents compliance 
issues.  One reason the two-percent floor was introduced was to 
reduce the administrative burden on the IRS to monitor 
compliance with small deductions. Some argue that any proposal 
that circumvents the two-percent floor will encourage cheating.  
Others argue that although cheating is a risk, the risk is the 
same for similarly situated taxpayers (e.g., independent contractors 
or taxpayers with trade or business income) who are not subject to 
the two-percent floor on similar expenses. 

Complexity issues 

Three provisions of present law restrict the ability of teachers to 
deduct as itemized deductions those expenses covered by the proposal: 
 (1) the two-percent floor on itemized deductions; (2) the overall 
limitation on itemized deductions; and (3) the alternative minimum 
tax. The staff of the Joint Committee on Taxation has previously 
identified these provisions as sources of complexity and has 
recommended that such provisions be repealed.\141\ These provisions 
do not apply to eligible expenses under the proposal. While 
repealing these provisions for all taxpayers reduces 
the complexity of the Federal tax laws, effectively repealing these 
provisions only for certain taxpayers (such as teachers and other 
eligible educators) likely increases complexity. 

Some may view extending the present-law above-the-line deduction as 
increasing simplification by providing for deductibility of certain 
expenses without regard to the present-law restrictions applicable to 
itemized deductions and the alternative minimum tax.   However, 
extending the present-law above-the-line deduction may increase 
complexity because of the increased recordkeeping requirements.  
Taxpayers wishing to take advantage of the above-the-line deduction 
are required to keep records, even if they were not otherwise 
required to do so because their expenses were not deductible as a 
result of the 2-percent floor for itemized deductions. In general, 
enactment of additional above-the-line deductions for specific 
expenses undermines the concept of the standard deduction, which 
exists in part to simplify the tax code by eliminating the need for 
many taxpayers to keep track of specific expenses. 


----------------------
/141/ See Joint Committee on Taxation, Study of the Overall State of the 
Federal Tax System and Recommendations for Simplification, Pursuant to 
Section 8022(3)(B) of the Internal Revenue Code of 1986, Volume II, 15, 
88, at 118 (JCS-310), April 2001. 


                             Prior Action
                             
                             
Similar proposals were contained in the President's fiscal year 2003, 
2004 , 2005, and 2006 budget proposals. 

A similar provision in H.R. 4297, as passed by the House (the 
"Tax Relief Extension Reconciliation Act of 2005"), extends the 
present-law provision for one year.  A similar provision in H.R. 
4297, as amended by the Senate (the "Tax Relief Act of 2005"), 
extends the present-law provision for one year. 


                       F.  Establish Opportunity Zones 
                        
                                   Present Law 

In general

The Internal Revenue Code contains various incentives to encourage 
the development of economically distressed areas, including 
incentives for businesses located in empowerment zones, enterprise 
communities and renewal communities, the new markets tax credit, the 
work opportunity tax credit, and the welfare-to-work tax credit. 

Empowerment zones

There are currently 40 empowerment zones--30 in urban areas and 10 in 
rural areas--that have been designated through a competitive 
application process. State and local governments nominated distressed 
geographic areas, which were selected on the strength of their 
strategic plans for economic and social revitalization. The urban 
areas were designated by the Secretary of the Department of Housing 
and Urban Development. The rural areas were designated by the 
Secretary of the Department of Agriculture. Designations of 
empowerment zones will remain in effect until December 31, 2009. 

Incentives for businesses in empowerment zones include (1) a 
20-percent wage credit for qualifying wages, (2) additional expensing 
for qualified zone property, (3) tax-exempt financing for certain 
qualifying zone facilities, (4) deferral of capital gains on sales 
and reinvestment in empowerment zone assets, and (5) exclusion of 60 
percent (rather than 50 percent) of the gain on the sale of qualified 
small business stock held more than 5 years. 

The wage credit provides a 20 percent subsidy on the first $15,000 of 
annual wages paid to residents of empowerment zones by businesses 
located in these communities, if substantially all of the employee's 
services are performed within the zone. The credit is not available 
for wages taken into account in determining the work opportunity tax 
credit. 

Enterprise zone businesses are allowed to expense the cost of certain 
qualified zone property (which, among other requirements, must be used 
in the active conduct of a qualified business in an empowerment zone) 
up to an additional $35,000 above the amounts generally available 
under section 179. In addition, only 50 percent of the cost of such 
qualified zone property counts toward the limitation under which 
section 179 deductions are reduced to the extent the cost of section 
179 property exceeds a specified amount. 

Qualified enterprise zone businesses are eligible to apply for 
tax-exempt financing (empowerment zone facility bonds) for qualified 
zone property. These empowerment zone 

--------------------
\142\ Section 179 provides that,in place of depreciation, certain 
taxpayers, typically small business, may elect to deduct up to $100,000 
of the cost of section 179 property placed in service each year.  In 
general, section 179 property is defined as depreciable tangible 
personal property that is purchased for use in the active conduct of 
a trade or business. 


facility bonds do not count against state private activity bond limits,
instead a limit is placed upon each zone, depending on population and 
whether the zone is in an urban or rural area. 

Enterprise communities 

Current law authorized the designation of 95 enterprise communities, 
65 in urban areas and 30 in rural areas. Qualified businesses in these 
communities were entitled to similar favorable tax-exempt financing 
benefits as those in empowerment zones. Designations of enterprise 
communities were made in 1994 and remained in effect through 2004. 
Many enterprise communities have since been re-designated as part 
of an empowerment zone or a renewal community. 

Renewal communities

The Community Renewal Tax Relief Act of 2000 authorized 40 renewal 
communities, at least 12 of which must be in rural areas. Forty 
renewal communities have been chosen through a competitive 
application process similar to that used for empowerment zones. 
The 40 communities were designated by the Department of Housing 
and Urban Development in 2002 and that designation continues 
through 2009. 

Renewal community tax benefits include: (1) a 15-percent wage credit 
for qualifying wages; (2) additional section 179 expensing for 
qualified renewal property; (3) a commercial revitalization 
deduction; and (4) an exclusion for capital gains on qualified 
community assets held more than five years. 

The wage credit and increased section 179 expensing operate in a 
similar fashion as in empowerment zones. The primary difference is 
that the wage credit is smaller, equal to 15 percent for the first 
$10,000 of wages. 

The commercial revitalization deduction applies to certain 
nonresidential real property or other property functionally related 
to nonresidential real property. A taxpayer may elect to either: (1) 
deduct one-half of any qualified revitalization expenditures that 
would otherwise be capitalized for any qualified revitalization 
building in the tax year the building is placed in service; or 
(2) amortize all such expenditures ratably over a 120-month period 
beginning with the month the building is placed in service. A 
qualified revitalization building is any nonresidential building 
and its structural components placed in service by the taxpayer in 
a renewal community. If the building is new, the original use of 
the building must begin with the taxpayer. If the building 
is not new, the taxpayer must substantially rehabilitate the 
building and then place it in service. The total amount of 
qualified revitalization expenditures for any building cannot be 
more than the smaller of $10 million or the amount allocated to 
the building by the commercial revitalization agency for the state 
in which the building is located. A $12 million cap on allowed 
commercial revitalization expenditures is placed on each renewal 
community annually. 

New markets tax credit 

The new markets tax credit provides a tax credit to investors who 
make "qualified equity investments" in privately-managed investment 
vehicles called "community development entities," or "CDEs." The CDEs 
must apply for and receive an allocation of tax credit authority from 
the Treasury Department and must use substantially all of the proceeds 
of the qualified equity investments to make qualified low-income 
community investments. One type of qualified low-income community 
investment is an investment in a qualified active low-income community
business. In general, a "qualified active low-income community 
business" is any corporation (including a nonprofit corporation), 
partnership or proprietorship that meets the following requirements: 
At least 50 percent of the gross income of the business is derived 
from the active conduct of a qualified business within a low-income 
community (as defined in section 45D(e)). For this purpose, a 
"qualified business" generally does not include (1) the rental of 
real property other than substantially improved nonresidential 
property; (2) the development or holding of intangibles for sale 
or license; (3) the operation of a private or commercial golf 
course, country club, massage parlor, hot tub facility, suntan 
facility, racetrack or other facility used for gambling, 
or a liquor store; or (4) farming if the value of the taxpayer's 
assets used in the business exceeds $500,000. 

At least 40 percent of the use of the tangible property of the 
business is within a low-income community. 

At least 40 percent of the services performed for the business by its 
employees are performed in a low-income community. 

Collectibles (other than collectibles held primarily for sale to 
customers in the ordinary course of business) constitute less than 
five percent of the assets of the business. 

Nonqualified financial property (which includes debt instruments with 
a term in excess of 18 months) comprises less than five percent of 
the assets of the business. 

A portion of a business may be tested separately for 
qualification as a qualified active low-income community business. 

Work opportunity and welfare-to-work tax credits 

Employers may be entitled to a work opportunity tax credit or a 
welfare-to-work tax credit for certain wages paid to eligible 
employees. 



                          Description of Proposal
In general

The proposal creates 20 opportunity zones, 14 in urban areas and 6 
in rural areas.  The zone designation and corresponding incentives 
for these 20 zones are in effect from January 1,2007, to 
December 31, 2016.  As described below, the tax incentives 
applicable to opportunity zones include: (1) an exclusion of 25 
percent of taxable income for opportunity zone businesses with 
average annual gross receipts of $5 million or less; (2) additional 
section 179 expensing for opportunity zone businesses; 
(3) a commercial revitalization deduction; and (4) a wage credit for 
businesses that employ opportunity zone residents within the zone. 

Selection of opportunity zones 

The Secretary of Commerce selects opportunity zones through a 
competitive process. A county, city or other general purpose 
political  subdivision of a state (a "local government") is eligible 
to nominate an area for opportunity zone status if the local 
government is designated by the Secretary of Commerce as a "Community 
in Transition."  Two or more contiguous local governments designated 
as Communities in Transition may submit a joint application. 

A local government may be designated as a Community in Transition if 
it has experienced the following: (1) a loss of at least three percent 
of its manufacturing establishments from 1993 to 2003 (urban areas 
must have had at least 100 manufacturing establishments in 1993); 
(2) a loss of at least three percent of its retail establishments 
from 1993 to 2003; and (3) a loss of at least 20 percent of its 
manufacturing jobs from 1993 to 2003. 

Local governments not making the original Community in Transition 
list may appeal to the Secretary of Commerce.  Other factors 
demonstrating a loss of economic base within the local government 
may be considered in the appeal. 

Applicants for opportunity zone status have to develop and submit a 
"Community Transition Plan" and a "Statement of Economic Transition." 
The Community Transition Plan must set concrete, measurable goals 
for reducing local regulatory and tax barriers to construction, 
residential development and business creation.  Communities that have 
already worked to address these issues receive credit for recent 
improvements.  The Statement of Economic Transition must demonstrate 
that the local community's economic base is in transition, as 
indicated by a declining job base and labor force, and other 
measures, during the past decade. 

In evaluating applications, the Secretary of Commerce may consider 
other factors, including: (1) changes in unemployment rates, poverty 
rates, household income, homeownership and labor force participation; 
(2) the educational attainment and average age of the population; 
and (3) for urban areas, the number of mass layoffs occurring in the 
area's vicinity over the previous decade. 

The majority of a nominated area must be located within the boundary 
of one or more local governments designated as a Community in 
Transition. A nominated area would have to have a continuous 
boundary (that is, an area must be a single area; it cannot be 
comprised of two or more separate areas) and may not exceed 20 
square miles if an urban area or 1,000 square miles if a rural area. 

A nominated urban area must include a portion of at least one local 
government jurisdiction with a population of at least 50,000. The 
population of a nominated urban area may not exceed the lesser of: 
(1) 200,000; or (2) the greater of 50,000 or ten percent of the 
population of the most populous city in the nominated area.  A 
nominated rural area must have a population of at least 1,000 and 
no more than 30,000. 

"Rural area" is defined as any area that is (1) outside of a 
metropolitan statistical area (within the meaning of section 143(k)
(2)(B)) or (2) determined by the Secretary of Commerce,after 
consultation with the Secretary of Agriculture, to be a rural area. 
 "Urban area" is defined as any area that is not a rural area. 

Empowerment zones and renewal communities are eligible to apply for 
opportunity zone status, but are required to relinquish their current 
status and benefits once selected.  Opportunity zone benefits for 
converted empowerment zones and renewal communities expire on 
December 31, 2009.  The selection of empowerment zones or renewal 
communities to convert to opportunity zones is based on the same 
criteria that apply to other communities, but does not count against 
the limitation of 20 new opportunity zones. 

Previously designated enterprise communities are also eligible to 
apply for opportunity zone status.  Aside from automatically being 
eligible to apply, enterprise communities are treated as other areas 
that do not belong to either an empowerment zone or a renewal 
community once selected: benefits are in effect for 10 years and the 
selection of an enterprise community as an opportunity zone counts 
against the limit of 20 new opportunity zones. 

Reporting requirements identifying construction, residential 
development, job creation, and other positive economic results 
apply to opportunity zones. 

Tax incentives applicable to opportunity zones 

Exclusion of 25 percent of taxable income for certain opportunity zone 
businesses 

A business is allowed to exclude 25 percent of its taxable income if 
(1) it qualified as an "opportunity zone business" and (2) it satisfied 
a $5 million gross receipts test. The definition of an opportunity 
zone business is based on the definition of a "qualified active 
low-income community business" for purposes of the new markets tax 
credit, treating opportunity zones as low-income communities.  
However, a nonprofit corporation does not qualify for treatment as 
an opportunity zone business.  In addition, a portion of a business 
may not be tested separately for qualification as an opportunity 
zone business. The $5 million gross receipts test is satisfied 
if the average annual gross receipts of the business for the 
three-taxable-year period ending with the prior taxable year does not 
exceed $5 million.  Rules similar to the rules of section 448(c) 
apply. 

Additional section 179 expensing 

An opportunity zone business is allowed to expense the cost of section 
179 property that is qualified zone property, up to an additional 
$100,000  above the amounts generally available under section 179.  
In addition, only 50 percent of the cost of such qualified zone 
property counts toward the limitation under which section 179 
deductions are reduced to the extent the cost of section 179 property 
exceeds a specified amount. 

Commercial revitalization deduction 

A commercial revitalization deduction is available for opportunity 
zones in a manner similar to the deduction for renewal communities. 
A $12 million annual cap on these deductions applies to each 
opportunity zone. 

Wage credit

Individuals who live and work in an opportunity zone constitute a new 
target group with respect to wages earned within the zone under a 
combined work opportunity tax credit and welfare-to-work tax credit, 
as proposed by the President under a separate proposal. 

 Other benefits for opportunity zones 

Individuals, organizations, and governments within an opportunity zone 
receive priority designation when applying for new markets tax credits 
and the following other Federal programs: 21st Century After-school, 
Early Reading First, and Striving Readers funding; Community Based 
Job Training Grants; Community Development Block Grants,Economic 
Development Administration grants, and HOME Funding; and USDA 
Telecommunications Loans, Distance Learning and Telemedicine grants, 
and Broadband loans. 

                               Analysis 

The proposal is designed to provide tax benefits to local areas with 
declines in manufacturing employment and other reductions of the local 
economic base. In particular, the proposal encourages the development 
and growth of small businesses within local areas designated as 
Communities in Transition. 

The tax benefits are available to "Communities in Transition," which 
are defined as communities that have suffered declines 
in manufacturing and retail industries.  The proposal may thus have 
the effect of providing incentives to communities negatively affected 
by increased international trade.  Economic theory provides that 
international trade generates net benefits to a nation's economy, but 
that those benefits are unevenly distributed among sectors within the 
economy.  However, the existence of net benefits suggests that 
sufficient national resources should exist to compensate fully those 
sectors hurt by trade.  The proposal is consistent with the aims of 
this policy of compensation. 

Opponents of the proposal might argue that the proposal extends tax 
benefits not only to communities that have suffered a decline in 
manufacturing and retail establishments but also to neighboring, 
prospering communities.  This is because the proposal requires only 
that a majority of an opportunity zone consist of territory located 
in a Community in Transition.  Thus, tax benefits may potentially be 
allocated to individuals and businesses whose activities may not 
significantly contribute to economic development in the Community in 
 Transition. 

Some observers have noted that a challenge to full utilization of 
existing local development tax incentives (such as empowerment zones) 
is the ever-growing menu of zones and tax benefits. Local officials 
have a difficult time explaining complicated sets of policies to 
businesses. 

The proposal adds to the list of benefits in the form of a 25-percent 
taxable income exclusion, which is available for opportunity zones but 
not for other similar targeted areas.Critics of existing empowerment 
zones and renewal communities policies argue that for full utilization 
of such tax benefits to be achieved, there needs to be increased 
funding of programs educating individuals and business of the benefits 
of existing tax incentives. 

Allowing the conversion of existing zones to opportunity zones offers 
an opportunity consolidate and simplify tax benefits for distressed 
economic areas.   However, the incentive for existing empowerment 
zones and renewal communities to convert to opportunity zone status 
is reduced by the early termination date.  Further, the differences 
in the set of tax incentives available to the various zones may 
reduce the incentive of local government officials to request 
conversion.  Such officials have developed expertise and development 
plans based on the existing set of tax benefits. 

The gross receipts test for a qualified opportunity zone business 
creates a "cliff" with respect to this tax benefit.  Businesses who 
find themselves marginally in excess of the three-year moving-average 
cease to qualify for the income exclusion.  Thus, this formulation 
of the income exclusion unfairly distinguishes between similarly 
situated businesses and offers an incentive for abuse.  However, 
this formulation of the taxable income exclusion focuses the tax 
benefit to small businesses. 

Further, as is the case with other tax incentives for 
economically-distressed areas, some observers note that the tax 
benefits may do little to encourage new development.  Hence, such 
incentives may primarily benefit existing businesses while 
producing little new growth. 

Indeed, the establishment of local tax incentives may have the 
effect of distorting the location of new investment, rather than 
increasing investment overall.\143\  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. 

                               Prior Action
                               
The President's fiscal year 2006 budget proposal included a similar 
proposal (proposing twice as many new opportunity zones as proposed 
here). 
















--------------------
\143\ For a discuxsion of the economic effects of targeting economic 
activity to specific geographic areas, see Leslie E. Papke, "What Do 
We Know About Enterprise Zones," in James M. Poterba, ed., Tax 
Policy and the Economy, vol.7 (Cambridge, MA: The MIT Press), 1993. 







G.  Permanently Extend Expensing of Brownfields Remediation Costs 


                            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 
that 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.  and section 263A, are treated 
as qualified environmental remediation expenditures. 

A "qualified contaminated site" (a so-called "brownfield") generally 
is any property that is held for use in a trade or business, for the 
production of income, or as inventory and is certified by the 
appropriate State environmental agency to be an area at or on which 
there has been a release (or threat of release) or disposal of a 
hazardous substance. Both urban and rural property may 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. 
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 section 198 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 

-------------------------
\144\ Commissioner v. Idaho Power Co., 418 U.S. 1(1974)(holding that 
equipment depreciation allocable to the taxpayer's construction of 
capital facilites must be capitalizeed under section 263(a)(1)). 


income upon a 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 that are treated as expenses under this provision. 

Eligible expenditures are generally those paid or incurred before 
January 1, 2006. 

The Gulf Opportunity Zone Act of 2005 added section 1400N(g) to the 
Code, which extended for two years (through December 31, 2007) the 
expensing of environmental remediation expenditures paid or incurred 
to abate contamination at qualified contaminated sites located in the 
Gulf Opportunity Zone; in addition, for sites within the Gulf 
Opportunity Zone section 1400N(g) broadens the definition of 
hazardous substance to include petroleum products (defined by 
reference to section 4612(a)(3)). 



                        Description of Proposal

The proposal eliminates the requirement that expenditures must be 
paid or incurred before January 1, 2006, to be deductible as 
eligible environmental remediation expenditures.Thus, the provision 
(including the special provision under section 1400N(g) which 
includes petroleum products within the definition of hazardous 
substance, but only within the Gulf Opportunity Zone) becomes 
permanent. 

Effective date.--The proposal is effective on the date of enactment. 


                                Analysis
                                        
Policy issues

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, at contaminated sites. 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.\145\ If the new investments are 
offset by less investment in neighboring, but not qualifying, areas, 
the 
-----------------------
\145\ For a discussion of the economic effects of targeting economic 
activity to specific geographic areas, see Leslie E. Papke, "What Do 
We Know About Enterprise Zones," in James M. Poterba, ed, Tax Policy and 
the Economy, vol. 7(Cambridge,MA: The MIT Press), 1993. 



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. 


Complexity issues 


By making the present law provision permanent, the proposal may 
simplify tax planning and investment planning by taxpayers by 
providing more certainty.  However, in general, the proposal would 
treat expenditures at certain geographic locations differently from 
otherwise identical expenditures at other geographic locations. 
Such distinctions generally require additional record keeping on 
the part of taxpayers and more complex tax return filings. 
Concomitantly, such distinctions increase the difficulty of IRS audits. 


                               Prior Action
                               
Proposals to make section 198 permanent were included in the 
President's fiscal year 1999, 2000, 2001, 2002, 2003, 2004, 2005, 
and 2006 budget proposals.H.R. 4297, as passed by the House 
(the "Tax Relief Extension Reconciliation Act of 2005"), extends 
section 198 expensing for two years (through December 31, 2007), 
and also broadens the definition of hazardous substance to include 
petroleum products (defined by reference to section 4612(a)(3)). 
 H.R. 4297, as amended by the Senate (the "Tax Relief Act of 
2005"), includes the same provision. 



                  H.  Restructure Assistance to New York 


                                    Present Law 
In general

Present law includes a number of incentives to invest in property 
located in the New York Liberty Zone ("NYLZ"), which is the area 
located on or south of Canal Street, East Broadway (east of its 
intersection with Canal Street), or Grand Street (east of its 
intersection with East Broadway) in the Borough of Manhattan in 
the City of New York, New York. These incentives were enacted 
following the terrorist attack in New York City on September 11,2001. 

Special depreciation allowance for qualified New York Liberty Zone 
property 

Section 1400L(b) allows an additional first-year depreciation 
deduction equal to 30 percent of the adjusted basis of qualified 
NYLZ property.  In order to qualify, property generally must be 
placed in service on or before December 31, 2006 (December 31, 2009 
in the case of nonresidential real property and residential rental 
property).  

The additional first-year depreciation deduction is allowed for both 
regular tax and alternative minimum tax purposes for the taxable year in 
which the property is placed in service.  A taxpayer is allowed to elect 
out of the additional first-year depreciation for any class of property 
for any taxable year. 

In order for property to qualify for the additional first-year 
depreciation deduction, it must meet all of the following 
requirements. First, the property must be property to which the 
general rules of the Modified Accelerated Cost Recovery System 
("MACRS")\148\  apply with (1) an applicable recovery period of 
20 years or less,(2) water utility property (as defined in section 
168(e)(5)), (3) certain nonresidential real property and residential 
rental property, or (4) computer software other than computer 
software covered by section 197.  A special rule precludes the 
additional first-year depreciation under this provision for (1) 
qualified NYLZ 





----------------------------

\146\  In addition to the NYLZ provisions described above, other NYLZ 
incentives are provided; (1)$8 billion of tax-exempt private activity 
bond financing for certain nonresidential real property, residential 
rental property and public utility property is authorized to be 
issued after March 9,2002, and before January 1, 2010; and (2) $9 
bilion of additional tax-exempt advance refunding bonds is available 
after March 9, 2002, and before January 1, 2006, with respect to 
certain State or local bonds outstanding on September 11, 2001. 

\147\ The amount of the additional first-year depreciation deduction 
is not affected by a short taxable year. 

\148\ A special rule precludes the additional first-year depreciation 
deduction for property that is required to be depreciated under the 
alternative depreciation system of MACRS. 



leasehold improvement property\149\  and (2) property eligible for 
the additional first-year depreciation deduction under section 
168(k) (i.e., property is eligible for only one 30 percent additional 
first-year depreciation).  Second, substantially all of the use 
of such property must be in the NYLZ. Third, the original use of 
the property in the NYLZ must commence with the taxpayer on or after 
September 11, 2001.  Finally, the property must be acquired by 
purchase by the taxpayer after September 10, 2001 and placed in 
service on or before December 31, 2006.  For qualifying 
nonresidential real property and residential rental property 
the property must be placed in service on or before December 31, 2009 
in lieu of December 31, 2006.  Property will not qualify if a 
binding written contract for the acquisition of such property was 
in effect before September 11, 2001.\151\ 

Nonresidential real property and residential rental property is eligible 
for the additional first-year depreciation only to the extent such 
property rehabilitates real property damaged, or replaces real property 
destroyed or condemned as a result of the terrorist attacks of 
September 11, 2001. 

Property that is manufactured, constructed, or produced by the 
taxpayer for use by the taxpayer qualifies for the additional 
first-year depreciation deduction if the taxpayer begins the 
manufacture, construction, or production of the property after 
September 10, 2001, and the property is placed in service on or 
before December 31, 2006  (and all other requirements are met). 
Property that is manufactured, constructed, or produced for the 
taxpayer by another person under a contract that is entered into 
prior to the manufacture, construction, or production of the 
property is considered to be manufactured, constructed, or produced 
by the taxpayer. 

Depreciation of New York Liberty Zone leasehold improvements 

Generally, depreciation allowances for improvements made on leased 
property are determined under MACRS, even if the MACRS recovery period 
assigned to the property is longer than the term of the lease.\153\ 

--------------------------
\149\ Quality NYLZ leasehold improvement property is defined in another 
provision. Leasehold improvements that do not satisfy the requirements 
to be treated as "qualified NYLZ leasehold improvement property" maybe 
eligible for the 30 percent additional first-year depreciation 
deducation (assuming all other conditions are met). 


\150\ For purposes of this provision, purchase is defined as under 
section 179(d). 

\151\ Property is not precluded from qualifying for the additional 
first-year depreciation merely because a binding written contract to 
acquire a component of the property is in effect pror to September 
11,2001. 

\152\ December 31, 2009 with respect to qualified nonresidential 
real property and residential rental property. 

\153\ Sec, 168(i)(8). The Tax Reform Act of 1986 modified the 
Accelerated Cost Recovery System ("ACRS"} to institute MACRS.  
Prior to the adoption of ACRS by the Economic Recovery Tax Act of 
1981, taxpayers were allowed to depreciate the various components 
of a building as separate lessee places the leasehold improvements 
in service.\154\ If a leasehold improvement constitutes an addition 
or improvement to nonresidential real property already placed in 
service, the improvement generally is depreciated sing the 
straight-line method over a 39-year recovery period, beginning in 
the month the addition or improvement is placed in service.\155\ 


A special rule exists for qualified NYLZ leasehold improvement property, 
which is recovered over five years using the straight-line method. The 
term qualified NYLZ leasehold improvement property means property 
defined in section 168(e)(6) that is acquired and placed in service 
after September 10, 2001, and before January 1, 2007 (and not subject 
to a binding contract on September 10, 2001), in the NYLZ.  For 
purposes of the alternative depreciation system, the property is 
assigned a nine-year recovery period. A taxpayer may elect out of the 
5-year (and 9-year) recovery period for qualified NYLZ leasehold 
improvement property. 

Increased section 179 expensing for qualified New York Liberty Zone 
property

In lieu of depreciation, a taxpayer with a sufficiently small amount of 
annual investment may elect to deduct the cost of qualifying property. 
For taxable years beginning in 2003 through 2007, a taxpayer may 
deduct up to $100,000 of the cost of qualifying property placed in 
service for the taxable year.  In general, qualifying property for 
this purpose is defined as depreciable tangible personal property 
(and certain computer software) that is purchased for use in the active 
conduct of a trade or business. The $100,000 amount is reduced (but 
not below zero) by the amount by which the cost of qualifying property 
placed in service during the taxable year exceeds $400,000.  The 
$100,000 and $400,000 amounts are indexed for inflation. 

For taxable years beginning in 2008 and thereafter, a taxpayer with a 
sufficiently small amount of annual investment may elect to deduct up 
to $25,000 of the cost of qualifying property placed in service for 
the taxable year.  The $25,000 amount is reduced (but not below zero) 
by the amount by which the cost of qualifying property placed in 
service during the taxable year exceeds $200,000.  In general, 
qualifying property for this purpose is defined as depreciable 
tangible personal property that is purchased for use in the active 
conduct of a trade or business. 


--------------------
separate useful lives. The use of component depreciation was repealed 
upon the adoption of ACRS.  The Tax Return Act of 1986 also denied the 
use of component depeciation under MACRS. 

\154\ Former sections 168(f)(6) and 178 provided that, in certain 
circumstances,a lessee could recover the cost of leasehold improvements 
made over the remaining term of the lease.  The Tax Reform Act of 1986 
repealed these provisions.  

\155\ Secs. 168(b)(3), (c), (d)(2), and (i)(6). If the improvement 
is characterized as tangible personal property, ACRS or MACRS 
depreciation is calculated using the shorter recovery periods, 
accelerated methods, and conventions applicable to such 
property. The determination of whether improvements are characterized 
as tangible personal property or as nonresidential real property 
often depends on whether or not the improvements constitute a 
"structural component" of a building (as defined by Treas. Reg. 
sec. 1.48-1(e)(1)).  See, e.g., Metro National Corp v. Commissioner, 
52 TCM (CCH) 1440 (1987); King Radio Corp Inc. v. U.S., 486 F.2d 1091 
(10th Cir. 1973); Mallinckrodt, Inc. v.Commissioner, 778 F. 2d 402 
(8th Cir. 1985) (with respect to various leasehold improvements). 


The amount eligible to be expensed for a taxable year may not exceed 
the taxable income for a taxable year that is derived from the active 
conduct of a trade or business (determined without regard to this 
provision). Any amount that is not allowed as a deduction because of 
the taxable income limitation may be carried forward to succeeding 
taxable years (subject to similar limitations).  No general business 
credit under section 38 is allowed with respect to any amount for 
which a deduction is allowed under section 179. 

The amount a taxpayer can deduct under section 179 is increased for 
qualifying property used in the NYLZ.  Specifically, the maximum dollar 
amount that may be deducted under section 179 is increased by the lesser 
of (1) $35,000 or (2) the cost of qualifying property placed 
in service during the taxable year.  This amount is in addition to the 
amount otherwise deductible under section 179. 

Qualifying property for purposes of the NYLZ provision means section 
179\156\ property  purchased and placed in service by the taxpayer 
after September 10, 2001 and before January 1,2007, where 
(1) substantially all of the use of such property is in the NYLZ in 
the active conduct of a trade or business by the taxpayer in the 
NYLZ, and (2) the original use of which in the NYLZ commences with 
the taxpayer after September 10, 2001. \157\ 

The phase-out range for the section 179 deduction attributable to 
NYLZ property is applied by taking into account only 50 percent of 
the cost of NYLZ property that is section 179 property.  Also, no 
general business credit under section 38 is allowed with respect 
to any amount for which a deduction is allowed under section 179. 

The provision is effective for property placed in service after 
September 10, 2001 and before January 1, 2007. 

Extended replacement period for New York Liberty Zone involuntary 
conversions 

A taxpayer may elect not to recognize gain with respect to property 
that is involuntarily converted if the taxpayer acquires within an 
applicable period (the "replacement period") property similar or 
related in service or use (section 1033).  If the taxpayer does 
not replace the converted property with property similar or related 
in service or use, then gain generally is recognized.  If the 
taxpayer elects to apply the rules of section 1033, gain on the 
converted property is recognized only to the extent that the amount 
realized on the conversion exceeds the cost of the replacement 
property.  In general, the replacement period begins with the 
date of the disposition of the converted property and ends two years 
after the close of the first taxable year in which any part of the 
gain upon conversion is realized. The replacement period is extended 

----------------
\156\ As defined in sec.179(d)(1).

\157\ See Rev. Proc. 2002-33, 2002-20 I.R.B. 963 (May 20,2002), for 
procedures on claiming the increased section 179 expensing deduction 
by taxpayers who filed their tax returns before June 1, 2002. 

\158\ Section 1033(a)(2)(B). 

to three years if the converted property is real property held for the 
productive use in a trade or business or for investment.\159\ 

The replacement period is extended to five years with respect to 
property that was involuntarily converted within the NYLZ as a result 
of the terrorist attacks that occurred on September 11, 2001.  
However, the five-year period is available only if substantially 
all of the use of the replacement property is in New York City.  
In all other cases, the present-law replacement period rules 
continue to apply. 

                          Description of Proposal
                                     
Repeal of certain NYLZ incentives 

The proposal repeals the four NYLZ incentives relating to the 
additional first-year depreciation allowance of 30 percent, the 
five-year depreciation of leasehold improvements, the additional 
section 179 expensing, and the extended replacement period for 
involuntary conversions.\160\ 

Effective date.--The proposal is effective on the date of enactment, 
with an exception for property subject to a written binding contract 
in effect on the date of enactment which is placed in service prior 
to the original sunset dates under present law. The extended 
replacement period for involuntarily converted property ends on the 
earlier of (1) the date of enactment or (2) the last day of the 
five-year period specified in the Jobs Creation and Worker Assistance 
Act of 2002 ("JCWAA").\161\ 

Credit for certain payments of New York State and New York City 

The proposal provides a Federal tax credit only for New York State 
and New York City,allowable against any payment by the State or City 
to the Federal Government required under a provision of the Internal 
Revenue Code other than the provisions relating to payments of 
excise taxes, FICA, SECA, or OASDI amounts. For example, the credit 
is allowable against payments of Federal income tax withheld with 
respect to State or City employees.  

The amount of the credit may not exceed the lesser of (1) $200 
million per year (divided equally between the State and the City) 
for calendar years after 2006, until a cumulative total of $2 
billion is reached, or (2) expenditures for the calendar year by 
the State or City, respectively, relating to the construction or 
improvement of transportation infrastructure in or connecting to 
the New York Liberty Zone. Any amount of unused credit below the 
$200 million annual limit is carried forward to the following 
year, and expenditures that exceed the $200 million annual 
limit are carried forward and subtracted from the $200 million 
annual limit in the following year.  

Treasury guidance is to be provided to ensure that the expenditures 
satisfy the intended purposes. The amount of the credit would be 
treated as State and local funds for purposes of any Federal program. 

Effective date.--The proposal is effective for calendar years after 
2006. 


                                  Analysis
                                    
The proposal is based on the premise that some of the tax benefits 
provided by the present-law incentive provisions will not be usable 
in the form in which they were originally provided, and that they 
should be replaced with other benefits which would have a greater 
impact on the recovery and continued development in the NYLZ.  The 
proposal reflects a preference for subsidizing transportation 
infrastructure rather than buildings and other private property.  
Even to the extent that the incentive provisions can be used by 
taxpayers in their present-law form,they are arguably unnecessary 
to spur investment in the NYLZ because investment would occur in 
the area even without special tax incentives. 

On the other hand, the effectiveness of the present-law NYLZ 
incentives may not yet be determinable because insufficient time 
has passed since they were enacted.  Furthermore, repeal of the 
provisions prior to their scheduled expiration could be unfair to 
any taxpayers who have begun, in reliance upon the incentive 
provisions, to implement long-term plans the status of which 
requires them to continue with planned investments despite the 
absence of a written binding contract.  Opponents may also object 
to the replacement of a benefit for private taxpayers with 
a cash grant to governmental entities, or the replacement of an 
incentive for investment in private property with an incentive 
for investment in public infrastructure. 

The proposal could be criticized as creating an inefficient method for 
delivering a Federal transportation infrastructure subsidy to New York 
State and New York City.  Further, because neither New York City nor 
New York State is subject to Federal income tax itself, 
administration of the Federal tax law is made needlessly complex by 
the creation of a credit against payment of withheld income tax of 
these governmental entities' employees.  Providing a transportation 
infrastructure subsidy as a direct grant outside of the tax law would 
be more consistent with simplification of the tax law and 
administrative efficiency. 


                              Prior Action
                              
A similar proposal was included in the President's fiscal year 2006 
budget proposals. 


 III. SIMPLY THE TAX LAWS FOR FAMILIES 

A. Clarify Uniform Definition of Child 

                              Present Law 
                                       
Uniform definition of qualifying child 

In general

Present law provides a uniform definition of qualifying child (the 
"uniform definition") for purposes of the dependency exemption, the 
child credit, the earned income credit, the dependent care credit, 
and head of household filing status.  A taxpayer generally may 
claim an individual who does not meet the uniform definition (with 
respect to any taxpayer) as a dependent if the dependency 
requirements are satisfied.  The uniform definition generally does 
not modify other parameters of each tax benefit (e.g., the earned 
income requirements of the earned income credit) or the rules for 
determining whether individuals other than children of the taxpayer 
qualify for each tax benefit. 

Under the uniform definition, in general, a child is a qualifying 
child of a taxpayer if the child satisfies each of three tests: 
(1) the child has the same principal place of abode as the taxpayer 
for more than one half the taxable year; (2) the child has a 
specified relationship to the taxpayer; and (3) the child has not 
yet attained a specified age. A tie-breaking rule applies if more 
than one taxpayer claims a child as a qualifying child. 

The support and gross income tests for determining whether an 
individual is a dependent generally do not apply to a child who 
meets the requirements of the uniform definition. 

Residency test

Under the uniform definition's residency test, a child must have the 
same principal place of abode as the taxpayer for more than one half 
of the taxable year.  As was the case under prior law, temporary 
absences due to special circumstances, including absences due to 
illness, education, business, vacation, or military service, are 
not treated as absences.  

Relationship test

In order to be a qualifying child, the child must be the taxpayer's 
son, daughter, stepson, stepdaughter, brother, sister, stepbrother, 
stepsister, or a descendant of any such individual.  For purposes of 
determining whether an adopted child is treated as a child by blood, 
an adopted child means an individual who is legally adopted by the 
taxpayer, or an individual who is lawfully placed with the taxpayer 
for legal adoption by the taxpayer. A foster child who is placed with 
the taxpayer by an authorized placement agency or by judgment, decree, 
or other order of any court of competent jurisdiction is treated as the 
taxpayer's child. 

Age test

The age test varies depending upon the tax benefit involved. 
In general, a child must be under age 19 (or under age 24 in the 
case of a full-time student) in order to be a qualifying child. 
In general, no age limit applies with respect to individuals who 
are totally and permanently disabled within the meaning of section 
22(e)(3) at any time during the calendar year. 
A child must be under age 13 (if he or she is not disabled) 
for purposes of the dependent care credit,and under age 17 (whether 
or not disabled) for purposes of the child credit. 

Children who support themselves  

A child who provides over one half of his or her own support 
generally is not considered a qualifying child of another taxpayer. 
 However, a child who provides over one half of his or her own 
support may constitute a qualifying child of another taxpayer 
for purposes of the earned income credit. 

Tie-breaking rules

If a child would be a qualifying child with respect to more than one 
individual (e.g., a child lives with his or her mother and grandmother 
in the same residence) and more than one person claims a benefit with 
respect to that child, then the following "tie-breaking" rules apply. 
First, if only one of the individuals claiming the child as a 
qualifying child is the child's parent, the child is deemed the 
qualifying child of the parent. Second, if both parents claim the 
child and the parents do not file a joint return, then the child is 
deemed a qualifying child first with respect to the parent with whom 
the child resides for the longest period of time, and second with 
respect to the parent with the highest adjusted gross income.  
Third, if the child's parents do not claim the child, then the child 
is deemed a qualifying child with respect to the claimant with the 
highest adjusted gross income. 

Interaction with other rules

Taxpayers generally may claim an individual who does not meet the 
uniform definition with respect to any taxpayer as a dependent if 
the dependency requirements (including the gross income and support 
tests) are satisfied. 

Thus, for example, a taxpayer may claim a parent as a dependent if 
the taxpayer provides more than one half of the support of the parent 
and the parent's gross income is less than the personal exemption 
amount.  As another example, a grandparent may claim a dependency 
exemption with respect to a grandson who does not reside with any 
taxpayer for over one half the year, if the grandparent provides 
more than one half of the support of the grandson and the grandson's 
gross income is less than the personal exemption amount. 

Citizenship and residency

Children who are U.S. citizens living abroad or non-U.S. citizens 
living in Canada or Mexico may qualify as a qualifying child, as is 
the case under the dependency tests.  A legally adopted child who 
does not satisfy the residency or citizenship requirement may 
nevertheless qualify as a qualifying child (provided other 
applicable requirements are met) if (1) the child's principal place 
of abode is the taxpayer's home and (2) the taxpayer is a citizen 
or national of the United States Children of divorced or legally 
separated parents Generally, a custodial parent may release the 
claim to a dependency exemption (and,therefore, the child credit) 
to a noncustodial parent. If a waiver is made, the waiver applies 
for purposes of determining whether a child meets the definition 
of a qualifying child or a qualifying relative under section 
152(c) or 152(d) as amended by the provision. While the definition 
of qualifying child is generally uniform, for purposes of the 
earned income credit, head of household status, and the dependent 
care credit, the uniform definition is made without regard to 
the waiver provision.  Thus, a waiver that applies for the 
dependency exemption will also apply for the child credit, 
and the waiver will not apply for purposes of the other provisions. 

Other provisions 

A taxpayer identification number for a child must be provided on the 
taxpayer's return.  For purposes of the earned income credit, a 
qualifying child is required to have a social security number that 
is valid for employment in the United States (that is, the child 
must be a U.S. citizen, permanent resident, or have a certain type 
of temporary visa). 

 Earned income credit 

The earned income credit is a refundable tax credit available to 
certain lower-income individuals.  Generally, the amount of an 
individual's allowable earned income credit is dependent on the 
individual's earned income, adjusted gross income and the number 
of qualifying children. 

An individual who is a qualifying child of another individual is not 
eligible to claim the earned income credit.  Thus, in certain cases 
a taxpayer caring for a younger sibling in a home with no parents 
would be ineligible to claim the earned income credit based solely 
on the fact that the taxpayer is a qualifying child of the younger 
sibling if the taxpayer meets the age, relationship and residency 
tests. 

                         Description of Proposal
                              
Limit definition of qualifying child

The proposal adds a new requirement to the uniform definition. 
Specifically, it provides that an individual who otherwise satisfies 
the definition of a qualifying child for purposes of the uniform 
definition is not treated a qualifying child unless he or she is 
either: (1) younger than the individual claiming him or her as a 
qualifying child or (2) permanently and totally disabled.  In 
addition, the proposal provides that an individual who is married 
and files a joint return (unless the return is filed only 
as a claim for a refund) will not be considered a qualifying child 
for child-related tax benefits, including the child tax credit. 

Restrict qualifying child tax benefits to child's parent 

The proposal provides that if a parent resides with a qualifying 
child for more than half the taxable year then only the parent can 
claim the child as a qualifying child.  However, the parent could 
allow another member of the household to claim the qualifying child 
if the other individual: (1) has a higher AGI for the taxable year; 
and (2) otherwise is eligible to claim the qualifying child.  The 
proposal further provides that dependent filers are not eligible 
for child-related tax benefits. 

Effective date.-The proposal is effective for taxable years beginning 
after December 31, 2006. 

                                   Analysis 
                                   
In general

The proposed changes to the uniform definition are intended to restore 
eligibility for the earned income credit to certain lower-income 
siblings while eliminating a tax planning opportunity for more affluent 
families. As discussed below, each element of the proposal would 
achieve its intended result. However, the proposal would also 
constitute the third change in the earned income credit eligibility 
requirements since 2001. The earned income credit eligibility 
requirements were changed by Economic Growth and Tax Relief 
Reconciliation Act of 2001 and the Working Families Tax Relief Act 
of 2004.  Beneficiaries of the earned income credit are more likely 
to be less sophisticated than other taxpayers.  For this reason, 
changes to the uniform definition may adversely affect the ability 
of lower income individuals to understand their eligibility for 
child-related benefits such as the earned income credit.  This is 
particularly important in an area that has a history of high taxpayer 
error rates. 

 Limit definition of qualifying child 

The first part of the proposal is intended to restore eligibility for 
the earned income credit to certain individuals.  It applies to 
certain working lower-income siblings with respect to their siblings 
where no other taxpayers reside in the household.  Under present 
law, such siblings would be ineligible for the earned income credit 
to the extent they could each be the qualifying child of the other. 
 For example, a 20-year-old woman who is a full-time student and the 
legal guardian of her 15-year-old brother would be unable to claim 
him as her qualifying child. It can be argued that denying the earned 
income credit in such a case was an unintended consequence of the 
enactment of a uniform definition.  Further,the earned income credit 
arguably is intended to provide assistance in this kind of situation. 

One situation that would not benefit from the proposal would be a 
circumstance where a younger sibling is supporting an older sibling. 
Such a situation may arise, for example, where a younger sibling is 
working but the older sibling is a full-time student. The proposal 
could have addressed this circumstance and restored eligibility for 
the earned income credit to this group by denying status as a 
qualifying child to siblings with lower incomes rather than to 
siblings that are younger. 

Some child-related tax benefits, such as the dependency exemption, 
are already restricted where an individual is married and files a 
joint return. 

The proposal extends this limitation by excluding all joint filers 
(with a narrow exception for taxpayers who file jointly only as a 
claim for refund) from the uniform definition.  This change would 
affect only a small percentage of filers (such as married teenagers 
filing joint returns) but would reduce complexity by eliminating 
the need to file a special form in cases were a qualifying child 
under the uniform definition is not a dependent. 

Restrict qualifying child tax benefits to child's parent

Under certain fact patterns (e.g., certain multi-generational 
families), where more than one taxpayer within a family can claim 
a qualifying child for certain tax benefits, the members of the 
family may arrange to maximize their tax benefits. This planning 
opportunity was available in the case of the earned income credit 
before the enactment of the uniform definition in 2004.  The 
enactment of the uniform definition potentially expanded this 
planning opportunity to other child-related tax benefits.  For 
example, if a grandparent, parent, and child share the same 
household, under present law the grandparent and parent can decide 
which of them should claim the qualifying child in order to 
maximize tax benefits.  If the parent earns $40,000 a year and 
the grandparent $20,000, it may be more advantageous for the 
grandparent to claim the qualifying child in order to receive 
the earned income credit,which the parent is ineligible for due to 
his level of earnings. Under the proposal, the grandparent could 
not claim the qualifying child because his adjusted gross income 
is less than that of the parent. 

The uniform definition has another, arguably unintended consequence. 
In certain fact patterns, the uniform definition extends tax 
benefits to certain families who otherwise would not qualify (e.g. 
when the parents'income exceeds otherwise applicable income levels) 
or increases benefits to certain qualifying families. For example, 
it may be possible in certain circumstances and financially 
advantageous for the family as a whole, for parents to forgo 
claiming a child as a qualifying child so that an older child living 
at home may claim such child as a qualifying child. 
This would be most advantageous in circumstances in which the 
parents have income above the phaseout limits for the child credit 
or where the older sibling becomes eligible for the earned income 
credit by claiming the younger sibling as a qualifying child. 

Under the circumstances described above, the uniform definition 
provides a tax planning opportunity for families that are more 
affluent and arguably less in need of a tax benefit. The proposal 
addresses these situations by limiting the ability of a non-parent 
to claim a child as a qualifying child when the child lives with 
his or her parents for over half the year. 

The proposal also restricts dependent filers from being eligible for 
child-related tax benefits. The result of this would be to extend the 
limitation already imposed with respect to the dependency exemption to 
other child-related tax benefits. 

                                     Prior Action
                                     
A similar proposal was included in the President's fiscal year 2006 
budget. That proposal, however, did not include the proposal to 
exclude from the definition of qualifying child married individuals 
filing a joint return. In addition, that proposal did not exclude 
dependent filers from child-related tax benefits. 


B. Simplify EIC Eligibility Requirements Regarding Filing Status, 
Presence of Children, and Work and Immigrant Status 


                                  Present Law
                                  
Overview

Low and moderate-income workers may be eligible for the refundable 
earned income credit (EIC). Eligibility for the EIC is based on earned 
income, adjusted gross income investment income, filing status, and 
immigration and work status in the United States. The amount of the 
EIC is based on the presence and number of qualifying children in the 
worker's family, as well as on adjusted gross income and earned income. 

The earned income credit generally equals a specified percentage of 
wages up to a maximum dollar amount. The maximum amount applies over 
a certain income range and then diminishes to zero over a specified 
phaseout range. For taxpayers with earned income (or adjusted gross 
income (AGI)), if greater) in excess of the beginning of the phaseout 
range, the maximum EIC amount is reduced by the phaseout rate 
multiplied by the amount of earned income (or AGI, if greater) in 
excess of the beginning of the phaseout range.  For taxpayers with 
earned income (or AGI, if greater) in excess of the end of the 
phaseout range, no credit is allowed. 

An individual is not eligible for the EIC if the aggregate amount of 
disqualified income of the taxpayer for the taxable year exceeds 
$2,800 (for 2006). This threshold is indexed. Disqualified income 
is the sum of: (1) interest (taxable and tax exempt); (2) dividends; 
(3) net rent and royalty income (if greater than zero);(4) capital 
gains net income; and (5) net passive income (if greater than zero) 
that is not self-employment income. 

The EIC is a refundable credit, meaning that if the amount of the 
credit exceeds the taxpayer's Federal income tax liability, the 
excess is payable to the taxpayer as a direct transfer payment. 
Under an advance payment system, eligible taxpayers may elect to 
receive the credit in their paychecks, rather than waiting to 
claim a refund on their tax return filed by April 15 of the 
following year. 

Filing status

An unmarried individual may claim the EIC if he or she files as a 
single filer or as a head of household.  Married individuals 
generally may not claim the EIC unless they file jointly. An 
exception to the joint return filing requirement applies to certain 
spouses who are separated. Under this exception, a married taxpayer 
who is separated from his or her spouse for the last six months of 
the taxable year shall not be considered as married (and, 
accordingly, may file a return as head of household and claim 
the EIC), provided that the taxpayer maintains a household that 
constitutes the principal place of abode for a dependent child 
(including a son, stepson, daughter, stepdaughter, adopted child, 
or a foster child) for over half the taxable year,\162\ and pays 
over half the cost of maintaining the household in which he or 
she resides with the child during the year. 

Presence of qualifying children and amount of the earned income credit 

The EIC is available to low and moderate-income working taxpayers. 
Three separate schedules apply: one schedule for taxpayers with no 
qualifying children, one schedule for taxpayers with one qualifying 
child, and one schedule for taxpayers with more than one qualifying 
 child.\163\ 

Taxpayers with one qualifying child may claim a credit in 2006 of 34 
percent of their earnings up to $8,080, resulting in a maximum credit 
of $2,747. The maximum credit is available for those with earnings 
between $8,080 and $14,810 ($16,810 if married filing jointly). 
The credit begins to phase down at a rate of 15.98 percent of 
earnings above $14,810 ($16,810 if married filing jointly).  The 
credit is phased down to 0 at $32,001 of earnings ($34,001 if 
married filing jointly). 

Taxpayers with more than one qualifying child may claim a credit in 
2006 of 40 percent of earnings up to $11,340, resulting in a maximum 
credit of $4,536. The maximum credit is available for those with 
earnings between $11,340 and $14,810 ($16,810 if married filing 
jointly).  The credit begins to phase down at a rate of 21.06 percent 
of earnings above $14,810 ($16,810 if married filing jointly).  The 
credit is phased down to $0 at $36,348 of earnings ($38,458 if 
married filing jointly). 

Taxpayers with no qualifying children may claim a credit if they are 
over age 24 and below age 65.  The credit is 7.65 percent of earnings 
up to $5,380, resulting in a maximum credit of $412, for 2006.  The 
maximum is available for those with incomes between $5,380 and $6,740 
($8,740 if married filing jointly).  The credit begins to phase down 
at a rate of 7.65 percent of earnings above $6,740 ($8,740 if married 
filing jointly) resulting in a $0 credit at $12,120 of earnings 
($14,120 if married filing jointly). 

If more than one taxpayer lives with a qualifying child, only one of 
these taxpayers may claim the child for purposes of the EIC.  If 
multiple eligible taxpayers actually claim the same qualifying child, 
then a tiebreaker rule determines which taxpayer is entitled to the 
EIC with respect to the qualifying child.  The eligible taxpayer who 
does not claim the EIC with respect to the qualifying child may not 
claim the EIC for taxpayers without qualifying children. 

Definition of qualifying child

Present law provides a uniform definition of qualifying child (the 
"uniform definition") for purposes of the dependency exemption, the 
child credit, the earned income credit, the dependent care credit, 
and head of household filing status.  The uniform definition 
generally does 

-----------------------
/162/ A foster child must reside with the taxpayer for the entire 
taxable year. 

/163/ All income thresholds are indexed for inflation annually. 



not modify other parameters of each tax benefit (e.g., the earned 
income requirements of the earned income credit) or the rules for 
determining whether individuals other than children of the taxpayer 
qualify for each tax benefit. Under the uniform definition, in 
general, a child is a qualifying child of a taxpayer if the child 
satisfies each of three tests: (1) the child has the same principal 
place of abode as the taxpayer for more than one halfthe taxable year; 
(2) the child has a specified  relationship to the taxpayer; and (3) 
the child has not yet attained a specified age.  A tie-breaking rule 
applies if more than one taxpayer claims a child as a qualifying child. 

Taxpayer identification number requirements 

Individuals are ineligible for the credit if they do not include their 
taxpayer identification number (TIN) and their qualifying child's TIN 
(and, if married, their spouse's TIN) on their tax return.  Solely for 
these purposes and for purposes of the present-law identification test 
for a qualifying child, a TIN is defined as a Social Security number 
issued to an individual by the Social Security Administration other 
than a number issued under section 205(c)(2)(B)(i)(II) (or that 
portion of sec. 205(c) (2)(B)(i)(III) relating to it) of the Social 
Security Act regarding the issuance of a number to an individual 
applying for or receiving federally funded benefits.  If an 
individual fails to provide a correct taxpayer identification number, 
such omission will be treated as a mathematical or clerical error by 
the IRS. 

A taxpayer who resides with a qualifying child may not claim the EIC 
with respect to the qualifying child if such child does not have a 
valid TIN. The taxpayer also is ineligible for the EIC for workers 
without children because he or she resides with a qualifying child. 
 However, if a taxpayer has two or more qualifying children, some of 
whom do not have a valid TIN, the taxpayer may claim the EIC based 
on the number of qualifying children for whom there are valid TINs. 

                            Description of Proposal
                            
Overview

The proposal modifies present law EIC rules by (1) altering the rules 
with respect to EIC claims made by separated spouses;\164\ (2) 
simplifying the rules regarding claiming the EIC for workers without 
children; and (3) changing the taxpayer identification number 
requirements for taxpayers and their qualifying children with 
respect to the EIC. 

Claims by separated spouses

The proposal modifies present law regarding EIC claims made by 
separated spouses. Under the proposal, a married taxpayer who files 
a separate return (as married filing separately) is allowed to claim 
the EIC if he or she lives with a qualifying child for over half the 
 year,provided the taxpayer lives apart from his or her spouse for 
the last six months of the taxable 

------------------------
\164\ Secs. 32(d) and 7703(b) 


year and otherwise satisfies the generally applicable EIC provisions. 
\165\ Under the proposal, a married taxpayer who satisfies these 
requirements, and files as married filing separately,is not required 
to provide over half the cost of maintaining the household in which 
the qualifying child resides. 

Claims for EIC for workers without children 

The proposal modifies the rules for EIC claims made by multiple 
taxpayers residing in the same principal place of abode in which a 
qualifying child resides.  Under the proposal, if multiple taxpayers 
residing in the same principal place of abode are eligible to claim 
the same qualifying child, an otherwise eligible taxpayer may claim 
the EIC for workers without children (maximum credit of $412 for 
2006) even if another taxpayer within the same principal place of 
abode claims the EIC with respect to the qualifying child.  However, 
if unmarried parents reside together with 
their child or children (sons, daughters, stepchildren, adopted children,
or foster children), then one parent may claim the EIC for taxpayers with
qualifying children, but neither parent may claim the EIC for workers 
without children

TIN requirements

The proposal provides that a taxpayer (including his or her spouse, if 
married) must have a Social Security number that is valid for employment 
in the United States (that is, the taxpayer must be a United States 
citizen, permanent resident, or have a certain type of temporary visa that 
allows him to work in the United States). Under the proposal, taxpayers 
who receive Social Security numbers for non-work reasons, such as for 
purposes of receiving Federal benefits or for any other reason, are not 
eligible for the EIC. The proposal also provides that if a qualifying 
child does not have a valid TIN, a taxpayer is eligible to claim the EIC 
for workers without children (maximum credit of $412 for 2006). 

Effective date.--The proposal generally is effective for taxable years 
beginning after December 31, 2006.


                                Analysis
                                
Claims by separated spouses

The proposal eliminates the household maintenance test for a separated
spouse who claims the EIC. Married taxpayers filing separate returns who 
reside with qualifying children may claim the EIC if they live apart from
their spouse for the last half of the year.  As under present law, such a
taxpayer could not file as a head of household unless he or she also 
satisfies a household maintenance test and resides with a dependent child.
This proposal simplifies the determination of whether a separated spouse
is eligible to claim the earned income credit, and increases the number of
separated spouses living with a qualifying child who could claim the 
EIC for taxpayers with qualifying children.

Claims for EIC for workers without children

Some may argue that the proposal to permit a taxpayer to claim the EIC for
taxpayers without qualifying children (maximum of $412 for 2006) in cases 
where the taxpayer has a qualifying child, but another taxpayer claims the 
qualifying child for EIC purposes, has the potential to add administrative 
complexity for both taxpayers and the IRS. Under the proposal, each 
eligible taxpayer has an incentive to calculate his or her taxes under
two alternatives to determine the maximum aggregate EIC available to the 
multiple taxpayers who could claim the qualifying child: one alternative in
which the taxpayer claims the qualifying child for the EIC (and the other
taxpayer claims the EIC for taxpayers without qualifying children), and
one in which the taxpayer claims the EIC without the qualifying child (and
the other taxpayer claims the EIC for taxpayers with a qualifying child). 
Presumably the taxpayers would wish to select that filing combination that
yields the lowest tax cost, or the highest tax benefit, to the parties.  
The proposal provides flexibility to taxpayers so that they are able to 
allocate the qualifying child to a taxpayer in a manner that maximizes the
aggregate earned income credit, and may increase the aggregate credit paid
when compared to present law, but might do so at the cost of increasing 
the complexity of the tax system. Others may argue that the proposal does
not increase selectivity or materially increase complexity, because 
multiple taxpayers who are eligible to claim the same qualifying child for
the EIC currently have an incentive to calculate their taxes under two 
alternatives (each computes the EIC for qualifying children, but not the 
EIC for taxpayers without qualifying children) to yield the lowest tax cost
or the highest tax benefit for the parties.

The proposal's adoption of different rules for unmarried parents than for
other taxpayers who reside with a qualifying child in the same residence 
creates complexity, and places unmarried parents at a disadvantage when 
compared with other types of extended family situations (e.g., a mother 
and grandmother sharing the same principal place of abode with a qualifying
child).

TIN requirements

The proposal permits a taxpayer to claim the EIC for taxpayers without a
qualifying child (maximum credit of $412 for 2006) if the taxpayer has a 
qualifying child who does not have a valid TIN.  The proposal has the
effect of reducing the amount of the lost tax benefit associated 
with failing to satisfy the TIN requirement for a qualifying child. Some
may argue that this is equitable because it treats a taxpayer with a
qualifying child who lacks a valid TIN in the same manner as a taxpayer 
who does not have a qualifying child.  Others may argue that in some cases 
the proposal reduces the incentive for a taxpayer to obtain a valid TIN
for a qualifying child. 

The proposal also requires that taxpayers (including spouses) claiming the
EIC have Social Security numbers that are valid for employment in the 
United States.   This has the effect of denying the EIC to some taxpayers 
who have valid TINs and are currently eligible to claim the credit but who
are not authorized to work in the United States.  Proponents of the 
proposal may argue that individuals who are not authorized to work in the
United States should not be eligible to claim the EIC.

                                  Prior Action

A similar proposal was included in the President's fiscal year 2005 budget.
That proposal, however, required that taxpayers and any qualifying children
have Social Security numbers that were valid for employment in the United
States.

























----------------------
\167\ The proposal does not require that qualifying children have Social
Security numbers authorizing them to work in the United States.





C. Reduce Computational Complexity of Refundable Child Tax Credit

                                Present Law
                                
An individual may claim a tax credit for each qualifying child under the
age of 17.  The amount of the credit per child is $1,000 through 2010.  A
child who is not a citizen, national, or resident of the United States may
not be a qualifying child.

The credit is phased out for individuals with income over certain threshold
amounts. Specifically, the otherwise allowable child tax credit is reduced 
by $50 for each $1,000 (or fraction thereof) of adjusted gross income over
$75,000 for single individuals or heads of households, $110,000 for married
individuals filing joint returns, and $55,000 for married individuals filing
separate returns.

The credit is allowable against the regular tax and the alternative minimum
tax.  To the extent the child credit exceeds the taxpayer's tax liability,
the taxpayer is eligible for a refundable credit (the additional child tax 
credit) equal to 15 percent of earned income in excess of $11,300 (the 
"earned income" formula).  The threshold dollar amount is indexed for 
inflation.

Families with three or more children may determine the additional child 
tax credit using the "alternative formula," if this results in a larger 
credit than determined under the earned income formula.  Under the 
alternative formula, the additional child tax credit can equal the amount
by which the taxpayer's social security taxes exceed the taxpayer's earned
income credit ("EIC"). 

Earned income is defined as the sum of wages, salaries, tips, and other 
taxable employee compensation plus net self-employment earnings. Unlike the
EIC, which also includes the preceding items in its definition of earned
income, the additional child tax credit is based only on earned income to
the extent it is included in computing taxable income.  For example, some 
ministers' parsonage allowances are considered self-employment income, and
thus are considered earned income for purposes of computing the EIC, but
the allowances are excluded from gross income for individual income tax 
purposes, and thus are not considered earned income for purposes of the
additional child tax credit since the income is not included in taxable 
income.

Residents of U.S. possessions (e.g., Puerto Rico) are generally not 
eligible for the refundable child credit, because the earned income formula
is based on earned income to the extent the earned income is included in 
taxable income.  Because residents of possessions are not subject to the 
U.S. income tax on income earned outside the U.S., they are not generally 
eligible for the refundable child credit.  However, the alternative child 
credit formula for taxpayers with three or more children is based on social
security taxes, and thus residents of possessions with three or more 
children are eligible for the refundable child credit if they pay social
security taxes, as do Puerto Ricans on Puerto Rican or U.S. sourced earnings.

                            Description of Proposal

The proposal repeals the alternative formula based on the excess of the 
social security taxes paid over the amount of the EIC.  Thus, the 
additional child tax credit will be based solely on the earned income 
formula, regardless of the number of children in a taxpayer's family.

Also, the proposal eliminates the requirement that earned income be 
included in taxable income for purposes of computing the additional child
tax credit. This conforms the definition of earned income for purposes of
the refundable child credit and the EIC (i.e., earned income for both 
credits equals the sum of wages, salaries, tips, and other taxable 
employee compensation plus net self-employment earnings). Thus, net 
self-employment earnings that are not included in taxable income will be 
included in earned income for purposes the additional child credit.

Finally, the proposal requires taxpayers to reside with a child in the
United States to claim the additional child tax credit. For these purposes,
the principal place of abode for members of the U.S. Armed Forces is 
treated as in the United States for any period the member is stationed 
outside the United States while serving on extended active duty. Extended
active duty includes a call or order to such duty for a period in excess
of 90 days.

Effective date.--The proposal is effective for taxable years beginning 
after December 31,2006.

                               Analysis
                               
A single rule for calculating the refundable child credit will provide
simplification for taxpayers with three or more children who otherwise must
make two separate calculations: the earned income formula and the 
alternative formula. The vast majority of such taxpayers find that 
the alternative formula calculation does not yield a higher credit amount
so its repeal would make the credit calculation simpler without changing 
total benefits. While the vast majority of taxpayers benefit from the 
simplification of this change, taxpayers for whom the alternative 
formula produces the greater benefit would receive a smaller refundable
child credit than that provided by current law.  In general, taxpayers who
find the alternative formula more valuable are: (1) residents of Puerto 
Rico, who do not pay U.S. income taxes and are not eligible to claim 
the EIC, but who may nonetheless may file a U.S. income tax return to 
claim a refundable child credit, and (2) taxpayers in the United States 
who are eligible for the child credit but not eligible to claim the EIC.

Use of the same measure of earned income for both the refundable child
credit and the EIC will provide simplification for all taxpayers claiming
both credits.  While for virtually all taxpayers the two measures of income
yield the same result under present law, the fact that this is not true of
all taxpayers requires additional instructions for all. Taxpayers for whom
the two measures of earned income differ are those who have certain
self-employment earnings, such as a parsonage allowance, that is excluded
from gross income for individual income tax purposes.The President's 
proposal to adopt the EIC definition of earned income for purposes of the 
refundable child credit (that is, to eliminate the requirement that the 
earned income be included in computing taxable income) will expand the 
availability of the refundable child credit to income not subject to the 
individual income tax, which some might view as an undesirable policy
result.  The modified definition would allow Puerto Ricans with fewer than
three children to claim the refundable child credit but for the 
President's proposal that eligibility for the refundable credit be 
conditioned on United States residency (discussed below). 

An alternative proposal that modifies the definition of earned income for
both EIC and refundable child credit purposes to incorporate only such
income that is also includable in gross income would appear to achieve 
similar simplification without affecting the child credit for 
residents of Puerto Rico with children.  The proposal would also treat
employees and the self-employed equivalently in determining both the EIC
and refundable child credit, although it may result in the denial of the
EIC for some EIC eligible parsons with parsonage allowances.

The President's proposal requires taxpayers to reside in the United States
in order to claim the refundable child credit. The principal effect of this
proposal is to prevent the expansion of the refundable child credit to 
residents of Puerto Rico with fewer than three children that would occur
under the President's proposal to conform the earned income 
definition for purposes of the EIC and the refundable child credit.  There
does not appear to be any particular simplification that results from the
proposal other than to prevent Puerto Ricans,who are not required to file
a U.S. income tax return, from filing such a return for the sole 
purpose of claiming a refundable credit.

The President's proposal to require U.S. residency in order to claim a 
refundable child credit would deny the refundable child tax credit to 
certain taxpayers living abroad who may currently claim it. In some cases
this may not be considered desirable, such as in the case of a 
low-income U.S. citizen who works in the U.S. but who happens to live in
Canada or Mexico.  In other cases the result may be viewed as desirable.
For example, a married U.S. taxpayer with two children who lives and works
in a foreign country with $100,000 foreign earned income would have a
gross income of only $20,000 as a result of the $80,000 foreign earned 
income (section 911) exclusion. As a result of other provisions of U.S.
law such as the personal exemptions and child credits, such a taxpayer
would have no U.S. income tax liabilityHowever, because the refundable
child credit is based on only earned income included in taxable 
income, the taxpayer is eligible for a refundable credit of 15 percent
of the amount by which such income (in this case $20,000) exceeds $11,300
, or $8,700, for a refundable credit of $1,305.Under present law, and
under the proposal, the taxpayer is not eligible for the EIC. The policy
for paying a refundable child credit in such a case is questionable, 
especially considering the refundable credit is only payable once the
taxpayer's earned income reaches $91,300 ($80,000 section 911 exclusion 
plus refundable child credit earned income threshold of $11,300).

Another situation where present law leads to a potentially undesirable 
result occurs where a U.S. taxpayer with children living abroad has foreign
tax liability and claims a foreign tax credit.  In some such cases, the 
taxpayer could pay the foreign tax, use the foreign tax credit to eliminate
any U.S. tax liability, and then claim a refundable child credit. 
Under the proposal, the child credit would not be available to such a 
taxpayer.  

                                Prior Action
                                  
A similar proposal was included in the President's fiscal year 2005 budget.





IV. PROVISIONS RELATED TO THE EMPLOYER-BASED PENSION SYSTEM

A.  Provisions Relating to Cash Balance Plans

                                       Present Law
                                       
Overview

Types of qualified plans in general

Qualified retirement plans are broadly classified into two categories, 
defined benefit pension plans and defined contributions plans, based on the
nature of the benefits provided.  In some cases, the qualification 
requirements apply differently depending on whether a plan is a defined 
benefit pension plan or a defined contribution plan.Under a defined benefit
pension plan, benefits are determined under a plan formula, generally based
on compensation and years of service. For example, a defined benefit 
pension plan might provide an annual retirement benefit of two percent of
final average compensation multiplied by total years of service completed 
by an employee.  Benefits under a defined benefit pension plan are funded 
by the general assets of the trust established under the plan; individual 
accounts are not maintained for employees participating in the plan.

Employer contributions to a defined benefit pension plan are subject to
minimum funding requirements under the Internal Revenue Code and the 
Employee Retirement Income Security Act of 1974 ("ERISA") to ensure that plan
assets are sufficient to pay the benefits under the plan.  
An employer is generally subject to an excise tax for a failure to make
required contributions.  Benefits under a defined benefit pension plan are
generally guaranteed (within limits) by the Pension Benefit Guaranty 
Corporation ("PBGC").

Benefits under defined contribution plans are based solely on the 
contributions (and earnings thereon) allocated to separate accounts 
maintained for each plan participant.  Profit sharing plans and qualified 
cash or deferred arrangements (commonly called "401(k) plans" after the 
section of the Internal Revenue Code regulating such plans) are examples of
defined contribution plans.

Cash balance plans

A cash balance plan is a defined benefit pension plan with benefits 
resembling the benefits associated with defined contribution plans. Cash 
balance plans are sometimes referred to as "hybrid" plans because they 
combine features of a defined benefit pension plan and a defined 
contribution plan. Other types of hybrid plans exist as well, such as
pension equity plans.\168\


-------------------
\168\ Under pension equity plans (often called "PEPs"), benefits are
generally described as a percentage of final average pay, with the 
percentage determined on the basis of points received for each year of
service, which are ofgen weighted for older or longer service employees,
Pension equity plans.

Under a cash balance plan, benefits are defined by reference to a 
hypothetical account balance.  An employee's hypothetical account balance
is determined by reference to hypothetical annual allocations to the 
account ("pay credits"), for example, a certain percentage of the 
employee's compensation for the year, and hypothetical earnings on the 
account ("interest credits").

The method of determining interest credits under a cash balance plan is
specified in the plan.  Under one common plan design, interest credits are
determined in the form of hypothetical interest on the account at a rate 
specified in the plan or based on aspecified market index, such as the rate
of interest on certain Treasury securities.  Alternatively, interest 
credits are sometimes based on hypothetical assets held in the account,
similar to earnings on an individual account under a defined contribution
plan, which are based on the assets held in the individual account.\169\ 

Cash balance plans are generally designed so that, when a participant 
receives a pay credit for a year of service, the participant also receives 
the right to future interest on the pay credit, regardless of whether the
participant continues employment (referred to as "front-loaded" interest 
credits).  That is, the participant's hypothetical account continues to be
credited with interest after the participant stops working for the 
employer.  As a result, if an employee terminates employment and defers 
distribution to a later date, interest credits will continue to be 
credited to that employee's hypothetical account.  Some early cash balance
plans provided interest credits only while participants' remained employed
(referred to as "back-loaded" interest credits).  That is, a participant's
hypothetical account was not credited with interest after the participant 
stopped working for the employer.

Overview of qualification issues with respect to cash balance plans

Cash balance plans are subject to the qualification requirements applicable
to defined benefit pension plans generally.  However, because such plans 
have features of both defined benefit pension plans and defined 
contributions plans, questions arise as to the proper application 
of the qualification requirements to such plans.  Some issues arise if a
defined benefit pension plan with a traditional defined benefit formula is
converted to a cash balance plan formula, while others arise with respect 
to all cash balance plans.\170\  Issues that commonly arise include: (1) in 
the case of a conversion to a cash balance plan formula, the application of

-----------------------
commonly provide interest credits for the period between a participant's 
terminiation of employment and commencement of benefits.

\169\The assets of the cash balance plan may or may not include the assets
of investments on which interest credits are based. As in th case of other
defined benefit pension plans, a plan fiduciary is responsible for making
investment decisions with respect to cash balance plan assets.

\170\ The conversion of a defined benefit pension plan to a cash balance
plan generally means that the plan is amended to change the formula for
accruing benefits from a traditional defined benefit formula to a cash
balance forumula.  In such cases, the plan with the old formula and the
plan as amended with the new formula are sometimes referred to as 
different plans, even though legally there is not a separate new
plan.


the rule prohibiting a cutback in accrued benefits;\171\ (2) the proper
method for determining lump-sum distributions;\172\ and (3) the 
application of the age discrimination rules\173\. These rules are discussed
below. Other issues have been raised in connection with cash balance plans,
including the proper method for applying the accrual rules.\174\

There is little guidance under present law with respect to many of the 
issues raised by cash balance conversions.  In 1999, the IRS imposed a 
moratorium on determination letters for cash balance conversions pending 
clarification of applicable legal requirements.\175\ Under the moratorium,
all determination letter requests regarding converted cash balance plans
are sent to the National Office for review; however, the National Office
is not currently acting on these plans.\176\ 

Benefit accrual requirements\177\ 

Several of the requirements that apply to qualified retirement plans relate
to a participant's accrued benefit. For example, the vesting requirements 
apply with respect to a participant's accrued benefit.  In addition, as 
discussed below, a plan amendment may not have the effect of reducing a 
participant's accrued benefit. In the case of a defined benefit pension 
plan, a participant's accrued benefit is generally the accrued benefit 
determined under the plan,expressed in the form of an annuity commencing
at normal retirement age \178\ 

The accrued benefit to which a participant is entitled under a defined 
benefit pension plan must be determined under a method (referred as the 
plan's accrual method) that satisfies one of three accrual rules.  These
rules relate to the pattern in which a participant's normal retirement 
benefit (i.e., the benefit payable at normal retirement age under the 
plan's benefit formula) accrues over the participant's years of service,
so that benefit accruals are not "back-loaded" (i.e., delayed until years 
of service close to attainment of normal retirement age).

-------------------------
\171\ Sec. 411(d)(6);ERISA sec.204(g).

\172\ Sec. 417(e);ERISA sec.205(g).

\173\ Sec.411(b)(1)(G) adn (H); ERISA sec. 204(b)(1)(G) and (H); Age
Discrimination in Employment Act("ADEA"),29U.U.S.C. 623(i).

\174\ Sec.411(b); ERISA sec.204(b)

\175\ Announcement 2003-1, 2003-2 I.R.B. 281.

\176\ Id.


\177\ Sec.411(b);ERISA sec. 204(b).

\178\ Sec. 411(a)(7). If a plan does not provide an accrued benefit in the
form of an annuity commencing at normal retirement age, the accrued benefit
is an annuiaty commencing at normal retirement age that is the actuarial
equivalent of the accrued benefit determined under the plan. Treas.Reg.sec.
1.411(a)-7(a)(1)ii).


A participant's accrued benefit under a cash balance plan is determined 
by converting the participant's hypothetical account balance at normal 
retirement age to an actuarially equivalent annuity. Under a plan 
providing front-loaded interest credits, benefits attributable
to future interest credits on a pay credit become part of the 
participant's accrued benefit when the participant receives the pay credit.
Thus, for purposes of determining the accrued benefit, the participant's
hypothetical account balance includes projected future pay credits for the
period until normal retirement age.  This has the effect of front-loading 
benefit accruals.

Under a plan providing back-loaded interest credits, benefits attributable
to interest credits do not accrue until the interest credits are credited 
to the employee's account.  Thus, as a participant's account balance grows 
over time, the amount of interest credited to the account increases, with a 
resulting increase in the participant's accrued benefit. The IRS has indicated 
that plans that provide back-loaded interest credit typically will not 
satisfy any of the accrual rules.\179\

Protection of accrued benefits; "wearaway" under cash balance plans

In general

The Code generally prohibits an employer from amending a plan's benefit 
formula to reduce benefits that have already accrued (the "anticutback 
rule").\180\  For this purpose, an amendment is treated as reducing accrued 
benefits if it has the effect of eliminating or reducing an early 
retirement benefit or a retirement-type subsidy or of eliminating an 
optional form of benefit provided with respect to benefits that have 
already accrued.\181\

The anticutback rule applies in the context of cash balance plan 
conversions.  Because of this rule, after conversion to a cash balance
formula, a plan must provide employees at least with the normal retirement 
benefit that he or she had accrued before the conversion, as well as with 
any early retirement benefits or other optional forms of benefit provided
with respect to the accrued benefit before the conversion.  However, the
plan may determine benefits for years following the conversion in a variety
of ways, while still satisfying the anticutback rule.  
Common plan designs are discussed below.

Wearaway (or "greater of" approach)

Upon a conversion to a cash balance plan, participants are generally given
an opening account balance.  The pay and interest credits provided under 
the plan are then added to this opening account balance. The opening account 
balance may be determined in a variety of ways and is generally a question 
of plan design.  For example, an employer may create an opening account 
balance that is designed to approximate the benefit a participant would 
have had, based on the participant's compensation and years of service,

-------------------
\179\ Notice 96-8, 1996-1 C.B. 359.

\180\ Sec. 411(d)(6);ERISA sec.204(g). The provisions do not, however,
protect benefits that have not yet accrued byt would accrue in the future
if the plan's benefit formula were not changed.

\181\ Sec. 411(d)(6)(B);ERISA sec.204(g)(2).



if the cash balance formula had been in effect in prior years.  As
another example, an employer may convert the preconversion accrued 
benefit into a lump-sum amount and establish this amount as the opening
account balance. Depending on the interest and mortality assumptions used,
this lump-sum amount may or may not equal the actuarial present value of
the participant's accrued benefit as of the date of conversion, determined
using the statutory interest and mortality assumptions required in 
determining minimum lump-sum distributions (as discussed below).

Under the wearaway approach, the participant's protected benefit (i.e.,the
preconversion accrued benefit) is compared to the normal retirement benefit
that is provided by the account balance (plus pay and interest credits),
and the participant does not earn any new benefits until the new benefit 
exceeds the protected accrued benefit. That is, the participant's benefit
is the greater of the preconversion accrued benefit and the benefit 
provided by the cash balance account.  Because of this effect, plans with a
wearaway are also referred to as using the "greater of" method of 
calculating benefits. For example, suppose the value of the protected
accrued benefit is $40,000, and the opening account balance under the cash
balance formula provides a normal retirement benefit of $35,000. The 
participant will not earn any new benefits until the hypothetical balance
under the cash balance formula increases to the extent that it provides a
normal retirement benefit exceeding $40,000. Plan design can greatly affect
the length of any wearaway period. 

No wearaway (or "sum of " approach)

Under a plan without a wearaway, a participant's benefit under the cash 
balance plan consists of the sum of (1) the benefit accrued before 
conversion, plus (2) benefits under the cash balance formula for years of 
service after the conversion. This approach is more favorable to plan 
participants than the wearaway approach because they earn additional 
benefits under the new plan formula immediately. This approach is also 
sometimes referred to as the "A + B" method, where A is the protected 
benefit and B is the benefit under the cash balance formula.

Grandfathering

For older and longer-service participants, benefits under a cash balance
formula may be lower than the benefits a participant may have expected to
receive under the traditional defined benefit formula (the "old" formula).
The employer might therefore provide some type of "grandfather" to 
participants already covered by the plan or to older or longer-service 
employees.  For example, the old formula might continue to apply to 
participants who were already covered by the plan before the conversion


-------------------
\182\ This descsription aplies to normal retirement benefits. Other issues
may arise with respect to early retirement benefits.  For example, a plan
might have provided a subsidized early retirement benefits before the
conversion.  After the conversion, the subsidized early retirement benefit
must still be provided with respect to the preconversion accrued benefit.
However, the plan is not required toi provide a subsidized early retirement
benefit with respect to benefits that accrue after the converstion.

\183\ This is sometimes the reduction in benefits that is referred to in
connection with cash balance conversions, i.e., a reduction in expected
benefits, not accrued benefits.




such participants might be given a choice between the old formula and the
cash balance formula for future benefit accruals; or,in the case of a final
average pay plan, the plan may stop crediting service under the old 
formula, but continue to apply post-conversion pay increases, so the 
employee's preconversion benefit increases with post-conversion pay 
increases. These approaches go beyond merely preserving the benefit 
protected by the anticutback rule.

Age discrimination

In general

The Code and ERISA prohibit any reduction in the rate of a participant's 
benefit accrual (or the cessation of accruals) under a defined benefit 
pension plan because of the attainment of any age.  A parallel requirement 
applies under the Age Discrimination in Employment Act ("ADEA").  These 
provisions do not necessarily prohibit all benefit formulas under which a 
reduction in accruals is correlated with participants' age in some manner.
Thus, for example, a plan may limit the total amount of benefits, or may 
limit the years of service or participation considered in determining
benefits.\186\


In general terms, an age discrimination issue arises as a result
of front-loaded interest credits under cash balance plans because there is
a longer time for interest credits to accrue on hypothetical contributions
to the account of a younger participant.  For example, a $1,000 
hypothetical contribution made when a plan participant is age 30 will be 
worth more at normal retirement age (e.g., age 65) and thus provide a 
higher annuity benefit at normal retirement age than the same contribution 
made on behalf of an older participant closer to normal retirement age.  
This age discrimination issue is not limited to cash balance plan
conversions,but arises with respect to cash balance plans generally. 

Proposed Treasury regulations

In December 2002, the Treasury Department issued proposed regulations 
relating to the application of age discrimination prohibitions to defined 
benefit pension plans, including special rules for cash balance plans.\188\




-----------------------------
\184\ Code sec. 411(b)(1)(1)(H);ERISA sec.204(b)(1)(H). Similarly, a 
defined contribution plan is prohibited from reducing the rate at
which amounts are allocated to a participant's account for ceasing
allocation) because of the attainment of any age.

\185\ 29 U.S.C. Code sec.623(i).

\186\ Sec.411(b)(1)(H)(ii);ERISA sec.204(b)(1)(H)(ii).

\187\ Other age discrimination issues may also arise in connection with 
cash balance plan conversion, depending in part on how the conversion is
made, such as whether the plan has a "wearaway." However, the recent focus
of age discrimination has related to the basic cash balance plan design.




The proposed regulations provided guidance on how to determine the rate of 
benefit accrual under a defined benefit pension plan or rate of allocation 
under a defined contribution plan.\189\

The proposed regulations provided that an employee's rate of benefit 
accrual for a year under a defined benefit pension plan is generally the
increase in the employee's accrued normal retirement benefit (i.e., the 
benefit payable at normal retirement age) for the plan year.  However, 
the proposed regulations provided a special rule under which an employee's
rate of benefit accrual under a cash balance plan meeting certain 
requirements (an "eligible" cash balance plan) was based on the rate of 
pay credit provided under the plan. Thus, under the proposed regulations, 
an eligible cash balance plan would not violate the prohibition on age 
discrimination solely because pay credits for younger employees earn 
interest credits for a longer period. In order for a plan converted to a
cash balance plan to be an eligible cash balance plan, the regulations 
generally required the conversion to be accomplished in one of two ways.
In general,the converted plan had to either: (1) determine each 
participant's benefit as not less than the sum of the participant's 
benefits accrued under the traditional defined benefit pension plan formula 
and the cash balance formula; or (2) establish each participant's opening
account balance as an amount not less than the actuarial present value of
the participant's prior accrued benefit, using reasonable actuarial 
assumptions. The proposed regulations also allowed a converted plan to 
continue to apply the traditional defined benefit formula to some 
participants.

Section 205 of the Consolidated Appropriations Act, 2004
(the "2004 Appropriations Act"), enacted January 24, 2004, provides that
none of the funds made available in the 2004 Appropriations Act may be used
by the Secretary of the Treasury, or his designee, to issue any 
rule or regulation implementing the proposed Treasury regulations or any
regulation reaching similar results.  The 2004 Appropriations Act also 
required the Secretary of the Treasury within 180 days of enactment to 
present to Congress a legislative proposal for providing transition relief

-------------------------------
\188\ 67 Fed.Reg. 76123 (December 11, 2002). Prop. Treas. Reg. 
sec. 1.411(b)-2.  (The proposed regulations were issued after consideration
of comments on regulations proposed in 1988.  53 Fed. Reg.11876 
(April 11, 1988).)  Treasury had previously discussed the cash balance age
discrimination issue in the preamble to regulations issued in 1991 under 
section 401(a)(4), which provided a safe harbor for cash balance plans 
that provide frontloaded interest credits and meet certain other 
requirements.  The preamble to these regulations stated "[t]he fact that 
interest adjustments through normal retirement age are accrued in the year
of the related hypothetical allocation will not cause a cash balance plan
to fail to satisfy the requirements of section 411(b)(1)(H), relating to 
age-based reductions in the rate at which benefits accrue 
under a plan."  56 Fed. Reg. 47528 (Sept. 19, 1991).
  
\189\ The proposed regulations also addressed a number of other issues,
including nondiscrimination testing for cash balance plans under section
401(a)(4).  In April 2003, the Treasury Department announced it would 
withdraw the portion of proposed regulations relating to nondiscrimination
testing because the regulations might make it difficult for employers to 
provide transition relief to participants upon conversions.  
Announcement 2003-22, 2002-17 I.R.B. 846 (April 28, 
2003).
  
\190\ Pub. L. No. 108-199 (2004). 






for older and longer-service participants affected by conversions of their
employers' traditional pension plans to cash balance plans.\191\

On June 15, 2004, the Treasury Department and the IRS announced the 
withdrawal of the proposed age discrimination regulations including the 
special rules on cash balance plans and cash balance conversions.\192\  
According to the Announcement, "[t]his will provide Congress an 
opportunity to review and consider the Administration's legislative 
proposal and to address cash balance and other hybrid plan issues through
legislation."\193\  Treasury and the IRS announced that they do not intend
to issue guidance on compliance with the age discrimination rules for 
cash balance plans, cash balance conversions, or other hybrid plans or 
hybrid plan conversions while the issues are under consideration by 
Congress.  As previously discussed, Treasury and the IRS also announced 
that they do not intend to process the technical advice cases pending with 
the National Office while cash balance issues are under consideration by 
Congress.

Case law

In response to employers' decisions to implement or convert to cash 
balance plans, several class action lawsuits have been brought by employees 
claiming that age discrimination requirements have been violated. Four 
Federal district court cases have addressed whether cash balance plans 
violate the age discrimination rules.\194\

In Eaton v. Onan,\195\  a case of first impression, the court held that a cash 
balance plan did not violate the prohibition on reducing the rate of 
benefit accrual because of age.  Under the plan,participants received pay 
credits for each year of service as well as front-loaded interest credits.  
The court considered how the rate of an employee's benefit accrual is 
determined for purpose of the age discrimination rules and concluded that
the statute does not require the rate of benefit accrual to be measured 
solely by the value of a participant's annuity payable at normal retirement

----------------------------
\191\ The Treasury Department complied with this requirement by including
its cash balance proposal in the President's fiscal year 2005 budget
proposal.

\192\  Announcement 2004-57, 2004-27 I.R.B. 15.

\193\   Id.


\194\ Other decisions discussing the age discrimination issue do not
directly address the issue, but are based on procedural errors or only 
discuss the issue as dicta.  In Campbell v. BankBoston, 327 F.3d
1(1st Cir. 2003), the plaintiff argued for the first time only on appeal
that the cash balance plan at issue violated the age discrimination rules.
The court therefore held that the issue had been waived and did not 
resolve the issue.  However, the court briefly described the various
arguments involved and the disagreement as to how rate of benefit accrual
should be determined.  While the BankBoston decision is often cited for the
position that cash balance plans are not age discriminatory, the appeals
court did not actually resolve the age discrimination issue.  In Engers
v. AT&T, 2000 U.S. Dist. LEXIS 10937 (D.N.J. June 29, 2000), the court 
dismissed an age discrimination claim based on disparate impact, but ruled
that a claim that AT&T's cash balance plan reduced the rate of benefit 
accrual on account of age in violation of ERISA and the ADEA could proceed
to trial.

\195\ 117 F. Supp. 2d 812 (S.D. Ind. 2000).



age.  The court found that, in the case of a cash balance plan, the rate of
benefit accrual should be defined as the change in the employee's cash 
balance account from one year to the next. The court held that a cash 
balance plan does not violate the prohibition on reducing the rate of 
benefit accrual because of age.

After the proposed Treasury regulations were issued, a Federal district 
court in Cooper v IBM Personal Pension Plan  held that cash balance 
formulas are inherently age discriminatory because identical interest 
credits necessarily buy a smaller age annuity at normal retirement age 
for older workers than for younger workers due to the time value of money.
The court interpreted "rate of benefit accrual" as referring to an 
employee's age 65 annual benefit (i.e.,the annuity payable at normal 
retirement age) and the rate at which the age 65 annual benefit 
accrues. The court held that the interest credits must be valued as an age
65 annuity, so that interest credits would always be more valuable to a 
younger employee as opposed to an older employee, thus violating the 
prohibition on reducing the rate of benefit accrual because of age. 

More recently, the analysis in Eaton v. Onan Corporation has also been 
applied in two other cases, Tootle v. ARINC Inc., and Register v. PNC 
Financial Services Group, Inc.\198\

Calculating minimum lump-sum distributions

Defined benefit pension plans are required to provide benefits in the form
of a life annuity commencing at a participant's normal retirement age.\199\
If the plan permits benefits to be paid in certain other forms, such as a 
lump sum, the alternative form of benefit cannot be less than the present
value of the annuity payable at normal retirement age, determined using 
certain statutorily prescribed interest and mortality assumptions.  

Although a participant's benefit under a cash balance plan is described in
terms of a hypothetical account balance, a cash balance plan (like other
defined benefit pension plans) is required to provide benefits in the form
of an annuity payable at normal retirement age.  Most cash balance plans
are designed to permit lump-sum distributions of the participant's 
hypothetical account balance upon termination of employment.  As is the
case with defined benefit pension plans generally, such a lump-sum amount
is required to be the actuarial equivalent to the annuity payable at 
normal retirement age, determined using the statutory interest and 
mortality assumptions.

IRS Notice 96-8 provides that determination of an employee's minimum 
lump sum under a cash balance plan that provides for 
front-loaded interest credits is calculated by: (1) projecting the 
participant's hypothetical account balance to normal retirement age by
crediting future interest credits, the right to which has already accrued;
(2) converting the projected account balance to an actuarially equivalent

--------------------------
\196\ 274 F. Supp. 2d 1010 (S.D. Ill. 2003).

\197\ 222 F.R.D. 88 (D. Md. 2004).

\198\ No. 04-CV-6097, 2005 WL 3120268 (E.D. Pa. Nov. 21, 2005).

\199\ Sec. 401(a)(11); ERISA sec. 205(a).
   

life annuity payable at normal retirement age, using the interest and
mortality assumptions specified in the plan; and (3) determining the 
present value of the annuity (i.e., the lump-sum value) using the statutory
interest and mortality assumptions.\200\ 

A difference in the rate of interest credits provided under the plan, which
is used to project the account balance forward to normal retirement age, 
and the statutory rate used to determine the minimum lump-sum value (i.e.,
present value) of the accrued benefit will generally cause a discrepancy 
between the value of the minimum lump-sum and the employee's hypothetical 
account balance.  In particular, if the plan's interest crediting rate is
higher than the statutory interest rate, then the resulting lump-sum amount
will generally be greater than the hypothetical account balance.  This 
result is sometimes referred to as "whipsaw."  Several Federal appellate 
courts that have addressed the calculation of lump-sum distributions under
cash balance plans have followed an approach similar to the approach 
described in IRS Notice 96-8.\201\


                             Description of Proposal
                               
In general

The proposal provides rules for conversions of defined benefit pension 
plans to cash balance plans, applying the age discrimination requirements 
to cash balance plans, and determining minimum lump-sum distributions from 
cash balance plans.  The proposal makes conforming amendments to ERISA and
ADEA. 

Conversions to cash balance plans

Under the proposal, for the first five years following the conversion of a
traditional defined benefit pension plan to a cash balance plan, the 
benefits earned by any participant in the cash balance plan who was a 
participant in the traditional plan must be at least as valuable as the 
benefits the participant would have earned under the traditional plan had
the conversion not occurred.  Additionally, wearaway of normal and early 
retirement benefits in connection with a conversion to a cash balance plan
is prohibited.

Failure to follow these requirements will not result in 
disqualification of the plan.  However, a 100-percent excise payable by
the plan sponsor will be imposed on any difference between required 

----------------------
\200\ Secs. III.B. and C of Notice 96-8.

\201\ Berger v. Xerox Corp. Retirement Income Guarantee Plan, 338 F.3d
755 (7th Cir. 2003); Esden v. Bank of Boston, 229 F.3d 154 (2d Cir. 2000),
cert. dismissed, 531 U.S. 1061 (2001); and Lyons v. Georgia Pacific 
Salaried Employees Retirement Plan, 221 F.3d 1235 (11th Cir. 2000), cert.
denied, 532 U.S. 967 (2001).  See also, West v. AK Steel Corp. Retirement 
Accumulation Plan, 2004 U.S. Dist.LEXIS 9224 (S.D. Ohio April 8, 2004).  
Additionally, under Esden, if participants accrue interest credits 
under a cash balance plan at an interest rate that is higher than the 
interest assumptions prescribed by the Code for determining the present 
value of the annuity, the interest credits must be reflected in the 
projection of the participant's hypothetical account balance to normal
retirement age in order to avoid violating the Code's prohibition against
forfeitures.
   


benefits and the benefits actually provided under a plan which has been
converted to a cash balance formula.  The amount of the excise tax cannot
exceed the plan's surplus assets at the time of the conversion or the plan
sponsor's taxable income, whichever is greater.  The excise tax does not 
apply if participants are given a choice between the traditional defined 
benefit pension plan formula and the cash balance formula or if current 
participants are "grandfathered," i.e., permitted to continue to earn 
benefits under the traditional formula rather than the cash balance formula.

Age discrimination

Under the proposal, a cash balance plan satisfies age discrimination 
requirements if it provides pay credits for older participants that are not
less than the pay credits for younger participants (in the same manner as 
under a defined contribution plan).  Additionally, certain transition 
approaches used in conversions, such as preserving the value of early 
retirement subsidies, do not violate the age discrimination or other 
qualification rules.  The proposal provides similar rules for other types
of hybrid plans and for conversions from traditional defined benefit 
pension plans to other types of hybrid plans.

Calculating lump-sum distributions

The proposal permits the value of a lump-sum distribution to be determined
as the amount of a participant's hypothetical account balance under a cash
balance plan as long as the plan does not provide interest credits in 
excess of a market rate of return.\202\  The Secretary of the Treasury is 
authorized to provide safe harbors for market rates of return and to 
prescribe appropriate conditions regarding the calculation of plan 
distributions

Effective date.-The proposal is effective prospectively. No inference is
intended as to the status of cash balance plans or cash balance conversions
under present law.

                                  Analysis
                                  
In general

Issues relating to cash balance plans raise broader issues relating to the
defined benefit pension plan system and retirement income security, as 
discussed below.  The proposal addresses certain issues relating to cash 
balance plans, with three stated objectives:  (1) to ensure fairness for
older workers in cash balance conversions, (2) to protect the defined 
benefit pension plan system by clarifying the status of cash balance 
plans, and (3) to remove the effective ceiling on interest credits in cash
balance plans due to the manner in which lump-sum benefits are calculated.
Specific issues arise with respect to each part of the proposal.  In 
addition, because the proposal is effective only prospectively, there will
be continued uncertainty as to the legal status of cash balance plans 
created or converted before the date of enactment.



-----------------------
\202\ A proposal to change the interest rate used to determine minimum 
lump-sum values is discussed in Part IV.C.



Retirement income security and cash balance plans

Helping to ensure that individuals have retirement income security is the
major objective of the U.S. private pension system.  The system is a 
voluntary system, relying heavily on tax incentives in order to encourage 
employers to establish qualified retirement plans for their employees.  
Although qualified plans are subject to a variety of legal requirements,
employers generally may choose whether or not to adopt a qualified plan, 
the type of plan to adopt, the level of benefits to be provided, and many 
other plan features.

Over time, there has been a decline in defined benefit pension plan 
coverage compared to coverage under defined contribution plans.  This has 
caused some to be concerned about a possible decline in retirement income 
security and has focused attention on both defined contribution plans and 
defined benefit pension plans.  Issues of retirement income security with 
respect to both types of plans have been the subject of recent 
Congressional action.

Traditional defined benefit pension plans are viewed by many as providing 
greater retirement income security than defined contribution plans.  This 
is primarily because such plans provide a specific promised benefit. 
Employers bear the risk of investment loss; if plan contributions plus 
earnings are insufficient to provide promised benefits, the employer is 
responsible for making up the difference.  Within certain limits, most 
defined benefit pension plan benefits are guaranteed by the PBGC.  
Investments of defined benefit pension plan assets are subject to ERISA's
fiduciary rules and limitations on the amount of plan assets that may be 
invested in stock of the employer.  In addition, defined benefit pension 
plans are subject to certain spousal benefit requirements that do not apply
to most defined contribution plans.  That is, defined benefit plans are 
required to provide benefits in the form of a joint and survivor 
annuity unless the participant and spouse consent to another form of 
benefit.  

In contrast, defined contribution plans do not promise a specific
benefit, but instead pay the value of the participant's account. The plan 
participant bears the risk of investment loss.Benefits provided by defined
contribution plans are not guaranteed by the PBGC.  The extent to which 
ERISA's fiduciary rules apply to a defined contribution plan depends on 
the particular plan structure; in many cases defined contribution plans
allow plan participants to direct the investment of their accounts, in 
which case more limited fiduciary protections may apply than in the case
of defined benefit pension plans.  ERISA's limitations on the amount of
plan assets that may be invested in employer stock generally do not apply
to defined contribution plans.  In addition,under most defined contribution
plans, the spouse has only the right to be named the beneficiary of the
amount (if any) remaining upon the death of the employee.

Cash balance plans have become an increasing prevalent plan design and, as
well, an increasing element in discussions regarding retirement income 
security and the future of the defined benefit pension plan system.

During the 1990s, conversions of traditional defined benefit pension plans
to cash balance formulas were common among mid- to large-size employers.
There was considerable media attention regarding such conversions, 
particularly in cases in which the plan contained a "wearaway" or in which
older or longer-service employees close to retirement were denied the 
opportunity to continue to accrue benefits under the old plan formula.
While perhaps complying with the law, such plan designs were viewed by

many as unfair to certain participants. There was concern that some 
employers were adversely affecting participants in order to reduce costs.
There was also concern that participants might not understand the effect
of the conversion on their benefits (including future benefits the
participant may have accrued under the old formula).\203\

Since then, cash balance plans have continued to be popular.  While certain
legal issues have remained, employers have continued to adopt cash balance
plans.  In many cases, employers have structured conversions to avoid or 
minimize potential adverse effects on older and longer-service employees.

Attention again focused on cash balance plans following the IBM decision, 
which found the basic cash balance formula to violate the age
discrimination rules. This case applies not only to conversions, but to all
cash balance plans.  This decision called into question whether cash 
balance plans are a permitted form of pension benefit. Although a previous
case and two subsequent cases have upheld the cash balance plan design, 
continued litigation of this issue has resulted in uncertainty for 
employers that currently offer cash balance plans and employees who 
are participants in such plans.  It has also focused attention on the 
future of defined benefit pension plans and the role that cash balance
plans play within the overall pension system.

Some believe that traditional defined benefit pension plans, and final
average pay formulas under such plans, generally provide greater benefits 
than cash balance plans, particularly because traditional plans often 
provide subsidized early retirement benefits.  Some argue that cash balance 
plans are primarily adopted by employers who wish to cut costs and reduce 
future benefits.  They argue that reductions in benefits are not as obvious
with a conversion to a cash balance plan compared to plan changes within 
the traditional defined benefit pension plan structure.  Even with the 
present-law requirements relating to notices of reductions in future 
benefit accruals, it is argued that plan participants do not understand how
to compare cash balance benefits with traditional defined benefit pension
plan benefits and that many employees mistakenly think that the cash 
balance formula, expressed as an account balance, provides comparable 
benefits when it does not.  It is also argued that cash balance plans 
inherently discriminate against longer-service older workers, and thus 
should not be encouraged as a plan design.


On the other hand, others point out that employers sponsor qualified 
retirement plans voluntarily.  While tax incentives encourage employers to 
establish and maintain such plans, they are not required to do so.  Thus,
if employers wish to reduce future benefits, or eliminate future benefits 
altogether, they may do so and many have. Some view preserving cash balance 
plans as a means of preserving the defined benefit pension plan system and
as an important step in helping to ensure retirement income security.
Cash balance plans may be attractive to employers for various reasons.
The adoption of a cash balance plan may enable employers to better manage
pension liabilities.  Some employers are concerned about the level of



------------------------
\203\ These concerns led to the enactment of the present-law notice 
requirements regarding future reductions in benefit accurals. Sec. 4980F
and ERISA sec.204(h).


contributions that may be required to fund traditional defined benefit 
pension plans, especially because the required contributions may fluctuate
over time.  They argue that a cash balance plan design does not result in 
such unpredictable funding obligations.

Some say that, rather than whether workers are better off with a
traditional defined benefit pension plan than with a cash balance plan,a
more appropriate question is whether workers are better off with a cash 
balance plan or no defined benefit pension plan.  They note that defined 
benefit pension plan coverage is falling and that the traditional defined
benefit pension plan continues to be a less and less viable and attractive
option for many employers. They argue that the flexibility offered by cash 
balance plans enables employers to continue a defined benefit pension plan,
as well as in many cases also provide a defined contribution plan, thus 
enhancing retirement income security.

Some also argue that cash balance plans are more beneficial to many 
employees than a traditional defined benefit pension plan and should be a 
permitted plan design option.  Unlike traditional defined benefit pension 
plans, which tend to benefit long-service participants who remain with a 
company until retirement, cash balance plans often benefit shorter service,
more mobile workers.  Cash balance plans may also provide more portable 
benefits than traditional defined benefit pension plans.  Thus, cash 
balance plans may be popular in industries or markets in which workers are
relatively mobile or among groups of workers who go in and out of the 
workforce.  Some participants also find cash balance plans easier to 
understand than a traditional defined benefit pension plan because their 
benefit is described in terms of an account balance.

However, some note that cash balance plans, while legally defined benefit
pension plans,operate in a way that does not deliver the full protections
of a traditional defined benefit pension plan.  For example, many 
traditional defined benefit pension plans do not offer lump-sum 
distributions.  In contrast,cash balance plans typically do.  While some 
argue that this increases portability of benefits, others argue that cash 
balance plans discourage annuity benefits, which may erode retirement 
income security and may undermine spousal rights.

Some also comment that the risk of investment loss borne by employers, and
the protections against such losses for employees, are fundamentally 
different in cash balance plans than in traditional defined benefit pension
plans.  In the case of a traditional defined benefit plan,the plan formula 
promises a specific benefit payable at normal retirement age.  Although the 
employer may benefit from favorable investment returns by making lower 
contributions, the employer also bears the risk that plan assets will not
be sufficient to provide the promised benefits and generally must make up
investment losses.  Rather than providing a specified benefit, a cash 
balance plan specifies interest credits.  This design may reduce the 
employer's risk that plan assets will underperform compared to the 
interest credits provided under the plan, while still giving the employer
the benefit of greater than expected investment performance.

Some argue that,under certain cash balance plan designs, plan participants
face investment risk similar to the risk under defined contribution plans.
For example, this risk may exist to the extent that the hypothetical 
account balance in a cash balance plan is subject to investment losses and
well as investment gains. While many cash balance plans are designed to 
protect against loss in value, some argue that it is permissible to tie
interest credits to hypothetical investments that may incur losses. In that
case, a decline in the value of a participant's hypothetical account 
balance may result in a decline in the participant's accrued benefit.
Some argue that such declines are inconsistent with the basic concept of a
defined benefit pension plan, i.e.,a plan that provides a specified 
benefit to participants, in contrast to a defined contribution plan under
which participants bear the risk of loss. They argue that cash 
balance plan designs under which participants bear the risk of investment
loss (even if only on hypothetical investments) should not be permitted.

Some argue that, to the extent proposals relating to cash balance plans are
motivated by concerns about retirement income security, other proposals to 
address such concerns should also be considered, including ways to make 
defined benefit pension plans more attractive to employers on an ongoing 
basis.  Some also argue that it may be appropriate to consider whether 
changes to the rules relating to defined contribution plans should be 
considered to enable such plans to provide greater retirement income 
security.

Conversions to cash balance plans; wearaway

The proposal is intended to ensure fairness for older workers in 
conversions of traditional defined benefit pension plans to cash balance 
plans.  It provides rules relating to the benefits accrued by participants
in defined benefit pension plans that are converted to cash balance plans.  
The proposal provides greater protection for longer-service participants 
than is currently required under the present-law rules prohibiting cutbacks
in accrued benefits.

By requiring that the benefits earned by a participant for the first five 
years following a conversion must be at least as valuable as the benefits
the participant would have earned under the traditional plan had the 
conversion not occurred, the proposal protects participants in the plan 
who are close to retirement age against possible disadvantages of 
conversion to a cash balance plan.  Further, prohibiting wearaway in a 
conversion to a cash balance plan with respect to the benefits of such 
participants will reduce possible adverse effects on older and 
longer-service participants. 

Some argue that the proposal does not go far enough in ensuring that older 
and longer service employees will not be disadvantaged.  Some argue that 
all plan participants, or at least participants who have attained a certain
age or number of years of service, should automatically be given the 
greater of benefits under the old plan formula or under the new plan 
formula.  Others argue that any such additional requirement would cause 
employers' qualified retirement plan costs to increase and could cause 
employers to reduce benefits further or terminate existing 
plans.  They argue that the proposal provides an appropriate balance 
between concerns about older workers and the need to provide flexibility
to employers in order to maintain the voluntary pension system.  On the 
other hand, some consider the present-law anticutback rules to provide 
adequate protection for participants and view the proposal as protecting 
employees' expectations of future benefits in a manner that is likely to 
increase employers' costs and discourage employers from continuing to 
offer defined benefit pension plans.

Some argue that the 100-percent excise tax on any difference between 
required benefits and the benefits actually provided under a plan which 
has been converted to a cash balance formula is sufficient to encourage 
compliance with the proposal.  However, others argue that limiting the 
amount of the excise tax to the plan's surplus assets at the time of the 
conversion or the plan sponsor's taxable income, whichever is greater, 
will allow plan sponsors to manipulate the timing of a conversion so that 
the requirements of the proposal can be avoided without imposition of the 
excise tax.  They argue that absent the potential for plan 
disqualification, the efficacy of the proposal is diminished, or even
eliminated. 

Some argue that the proposal provides appropriate flexibility to employers
and additional safeguards for employees, by allowing employers to avoid
the excise tax by grandfathering participants under the old formula or 
giving employees a choice between the old and new formula.  On the other 
hand, some point out that giving employees options increases complexity 
for plan participants, and that many participants may not adequately 
understand the differences between the new plan formula and the old plan 
formula.  These concerns may be addressed, at least to some extent, by 
requiring that participants receive sufficient information to make an 
informed decision.  As mentioned above, others would go further, and 
require that at least some employees be automatically given the greater of
the two formulas.  This would avoid the need for elections, and the 
possibility that an employee may unwittingly choose an option that is
clearly worse than the old plan formula.  On the other hand, some view such
a requirement as unduly restricting employers' options in plan design.

Age discrimination

By providing that cash balance plans satisfy the age discrimination rules
if the plan provides pay credits for older participants that are not less 
than the pay credits for younger participants, the proposal provides 
certainty in this regard.  Some have argued that if such certainty is not 
provided, employers will be disinclined to offer defined benefit pension 
plans, including cash balance plans, to their employees.  Some argue that, 
by reducing uncertainty as to how cash balance plans can meet the age 
discrimination requirements, the proposal will make employers more likely 
to sponsor (or continue to sponsor) defined benefit pension plans, 
including cash balance plans.

The age discrimination issue results from the effect of front-loaded 
interest credits, under which a participant receiving a pay credit also 
receives the right to future interest on the pay credit, regardless of 
whether the participant continues employment.  Front-loaded interest
credits cause benefits to accrue more quickly, which is generally viewed 
as advantageous to participants, especially participants who leave 
employment after a short period of service.  However, some argue that 
front-loaded pay credits inherently favor younger participants and are 
thus inherently age discriminatory.  They believe that for this, and other
reasons, cash balance plans should not be permitted.

Calculating lump-sum distributions

The proposal is intended to eliminate situations in which the amount of a
minimum lump-sum distribution required from a cash balance plan is greater 
than a participant's hypothetical account balance because the plan's 
interest crediting rate is higher than the statutory interest rate. The
proposal departs from the analysis set out in IRS Notice 96-8 and followed
by several Federal courts that have considered this issue.

Proponents argue that the cases are based on IRS rulings that pre-date the 
prevalence of cash balance plans and that apply rules that are 
inappropriate in a cash balance context.  Further, they argue that, as a 
result of the present-law rules, employers have reduced the rate of 
interest credits under cash balance plans, thus reducing benefits for 
participants.  The proposal avoids this result and thus, it is argued, 
will benefit plan participants by encouraging employers to use a 
higher rate of return than the statutorily-prescribed rate.

Others note that, for purposes of satisfying the accrual rules, benefits 
attributable to front-loaded interest credits are treated as part of the 
accrued benefit.  They argue that, if benefits attributable to front-loaded
interest credits are part of the accrued benefit, such benefits should be 
reflected in determining the minimum value of lump-sum distributions as 
required under present law.  To the extent that a participant's 
hypothetical account balance is less than such minimum lump-sum value, a
participant who receives a distribution of the hypothetical account balance
has not received the full value of his or her accrued benefit.  They argue
that such a result is inconsistent with the protections provided by the 
vesting and accrual rules.

In order for the proposal to apply, the plan must not use interest credits 
in excess of a market rate of return, and the Secretary is to provide safe 
harbors as to what is a market rate. This aspect of the proposal raises 
issues as to how to determine a market rate of return. Recent discussions 
over what constitutes an appropriate replacement for the interest rate on 
30-year Treasury obligations for purposes related to defined benefit 
pension plans reflects the degree of complexity which may be involved in 
prescribing such safe harbors.  The effect of the proposal on plan 
benefits, and the ease with which the proposal can be implemented by 
employers, understood by employees, and administered by the IRS will 
depend in large part on the ability to determine measures of market rates 
of return.  Some argue that because so much depends on what is a market 
rate of return under the proposal, it would be more appropriate to provide
statutory guidance on this issue, rather than leave the issue for the 
Secretary to resolve.

Complexity

As a result of its study of Enron Corporation, performed at the direction 
of the Senate Committee on Finance, the staff of the Joint Committee on 
Taxation ("Joint Committee staff") found that the lack of guidance with 
respect to cash balance plan conversions and cash balance plans generally 
creates uncertainty for employers and employees.  The Joint Committee 
staff recommended that clear rules for such plans should be adopted in the
near future.\204\

The budget proposals help to reduce uncertainty with respect to cash 
balance plans by addressing certain issues that frequently arise with 
respect to cash balance plans.  However, the proposals do not address all
issues with respect to such plans.  In addition, certain aspects of the 
proposals need further clarification, or may add some additional 
complexities.  For example, additional clarification is needed with 
respect to types of transition approaches in conversions that do not 
violate age discrimination or other qualification rules, allowing 

----------------
\204\ Joint Committee on Taxation, Report of Investigation of Enron 
Corporation and Related Entities Regarding Federal Tax and Compensation
Issues, and Policy Recommendations (JCS-3-03), February 2003, at Vol. I,
487.



participants to choose between a traditional defined benefit formula and 
cash balance formula in order to avoid the 100-percent excise tax, and the
determination of a market rate of return for purposes of calculating 
lump-sum distributions.

                               Prior Action
                               
An identical proposal was included in the President's fiscal year 2005 and
2006 budget proposals.

H.R. 2830 (the "Pension Protection Act of 2005"), as passed by the House,
and S. 1783, (the "Pension Security and Transparency Act of 2005"), as 
passed by the Senate, both include provisions relating to the application 
of the Code and ERISA to hybrid plans, including cash balance plans.


         B. Strengthen Funding for Single-Employer Pension Plans 

1. Background and summary

Helping to assure that individuals have retirement income security is the 
major objective of the U.S. private pension system.  Federal law attempts 
to further this goal in various ways. The Code provides tax-favored 
treatment for employer-sponsored qualified retirement plans ERISA applies 
many of the same requirements as the Code and provides employees with the 
means of pursuing their rights.

Defined benefit pension plans are considered by many to provide greater 
retirement income security than defined contribution plans.  Factors that 
contribute to this view include the fact that such plans offer a specified 
benefit payable as an annuity for life, the employer bears the risk of 
investment loss, and benefits are guaranteed (within limits) by the PBGC 
in the event the plan terminates and plan assets are not sufficient to pay
promised benefits.  The minimum funding rules are designed to promote 
retirement income security by helping to assure that plan assets will be 
sufficient to pay promised benefits when due. If plans are not adequately 
funded by the employer, then the benefits promised under the plan may not 
be paid in full.  In particular, if a plan terminates and the assets are 
not sufficient to pay benefits, participants may not receive the full value
of the benefits due, even with the PBGC guarantee.

The minimum funding rules have been the focus of much attention in recent 
years.  On one hand, attention has focused on the increase in required 
contributions under the deficit reduction contribution rules, caused in 
part by the combination of low interest rates that have increased the 
value of plan liabilities and market declines that have decreased the 
value of plan assets.  Some view this combination as a temporary situation 
that has artificially increased the extent of pension plan underfunding.
On the other hand, attention has focused also on large, severely 
underfunded plans maintained by insolvent employers that have terminated 
with resulting benefit losses to employees and increases in PBGC 
liabilities.  Some therefore believe the present-law funding rules are
inadequate.  Many believe that resolution of funding issues is essential
to the long-term viability of the defined benefit pension system.\206\

As of September 30, 2005, the PBGC reported a total deficit of $22.8 
billion, a slight improvement from the 2004 fiscal year end deficit of 
$23.5 billion, but almost double the 2003 fiscal year end deficit of $11.5 
billion.  The PBGC's deficit is the amount by which its liabilities 
exceed its assets.\207\  The PBGC has noted that its financial state is a

-----------------------
\205\ Additional information about the Administration's proposals relating
to funding and the Pension Benefit Guaranty Corporation is available on
the Department of Labor's website at www.dol.gov/ebsa/pensionreform.html.

\206\ Many believe that resolution of the uncertainty surrounding cash
balance plans is also essential to the long-term viability of the defined
benefit pension system, as discussed more fully in connection with the 
Administration's proposal relating to cash balance plans in Part IV.A.

\207\  A variety of estimates and assumptions are used by the PBGC in 
evaluating the present value of its liability for future benefits, 
including assumptions about future plan terminations.  According to the


cause for concern.  The Government Accountability Office ("GAO") has placed
the PBGC on its high risk list. Although the PBGC is a Federal agency,
it does not receive financing from general revenues.  Instead, the PBGC is
funded by assets in terminated plans, amounts recovered from employers who 
terminate undefended plans, premiums paid with respect to plans covered by
the PBGC insurance program, and investment earnings. Underfunding of 
defined benefit pension plans presents a risk to PBGC premium payors, who
may have to pay for the unfunded liabilities of terminating plans, and plan
participants, who may lose benefits if a plan terminates (even with the 
PBGC  guarantee). 

The President's budget contains a series of proposals designed to 
strengthen funding levels in defined benefit pension plans and the ability 
of the PBGC to provide guaranteed benefits.  These proposals consist of:  
(1) changes to the funding rules to measure a plan's funding status more 
accurately and to require faster funding of shortfalls, along with 
increased deduction limits to encourage additional contributions; (2) more
accurate and timely reporting of funding status; (3) elimination of a 
grandfather rule that allows certain plans to exceed the limits on 
investments in employer securities and real property; (4) restrictions on
benefit increases and accelerated distributions that result in increases 
in unfunded liabilities; (5) a prohibition on providing shutdown benefits; 
and (6) redesign of the PBGC variable-rate premium structure,limits on the
PBGC guarantee when an employer enters bankruptcy, and enabling the PBGC 
to perfect a lien for required contributions against the assets of an 
employer in bankruptcy.

2. Funding and deduction rules

                                   Present Law
                                   
In general

Defined benefit pension plans are subject to minimum funding requirements.
The minimum funding requirements are designed to ensure that plan assets
are sufficient to pay plan benefits when due. The amount of contributions 
required for a plan year under the minimum funding rules is generally the 
amount needed to fund benefits earned during that year plus that year's 
portion of other liabilities that are amortized over a period of years, 
such as benefits resulting from a grant of past service credit. The amount
of required annual contributions is determined under one of a number of 
acceptable actuarial cost methods.  Additional contributions are required
under the deficit reduction contribution rules in the case of certain 

----------------------
PBGC,this present value is particularly sensitive to changes in the underlying
estimates and assumptions; changes in estimates and assumptions could
materially change the present value of its liability for future benefits

\208\ Sec. 412; ERISA secs. 301-308.  The minimum funding rules do not
apply to governmental plans or to church plans, except church plans with 
respect to which an election has been made to have various requirements, 
including the funding requirements, apply to the plan.  In some respects,
the funding rules applicable to multiemployer plans differ from the rules 
applicable to single-employer plans.  In addition, special rules apply to 
certain plans funded exclusively by the purchase of individual insurance 
contracts (referred to as "insurance contract" plans).


underfunded plans.  No contribution is required under the minimum funding
rules in excess of the full funding limit (described below).An employer 
sponsoring a defined benefit pension plan generally may deduct amounts 
contributed to a defined benefit pension plan to satisfy the minimum 
funding requirements for a plan year.  In addition, contributions in excess
of the amount needed to satisfy the minimum funding requirements may be 
deductible, subject to certain limits 

General minimum funding rules

Funding standard account

As an administrative aid in the application of the funding requirements, a 
defined benefit pension plan is required to maintain a special account 
called a "funding standard account" to which specified charges and credits 
are made for each plan year, including a charge for normal cost and 
credits for contributions to the plan.\209\ Other charges or credits
may apply as a result of decreases or increases in past service liability
as a result of plan amendments, experience gains or losses, gains or
losses resulting from a change in actuarial assumptions, or a waiver of
minimum required contributions.

In determining plan funding under an actuarial cost method, a plan's 
actuary generally makes certain assumptions regarding the future 
experience of a plan.  These assumptions typically involve rates of 
interest, mortality, disability, salary increases, and other factors 
affecting the value of assets and liabilities.  If the plan's actual 
unfunded liabilities are less than those anticipated by the actuary on the
basis of these assumptions, then the excess is an experience gain.  If the
actual unfunded liabilities are greater than those anticipated, then the 
difference is an experience loss.  Experience gains and losses for a year
are generally amortized as credits or charges to the funding standard 
account over five years.

If the actuarial assumptions used for funding a plan are revised and, under
the new assumptions, the accrued liability of a plan is less than the 
accrued liability computed under the previous assumptions, the decrease is
a gain from changes in actuarial assumptions.  If the new assumptions 
result in an increase in the accrued liability, the plan has a loss from 
changes in actuarial assumptions.  The accrued liability of a plan is the 
actuarial present value of projected pension benefits under the plan that 
will not be funded by future contributions to meet normal cost or future 
employee contributions.  The gain or loss for a year from changes in 
actuarial assumptions is amortized as credits or charges to the funding 
standard account over ten years.

If minimum required contributions are waived (as discussed below), the 
waived amount (referred to as a "waived funding deficiency") is credited to
the funding standard account.  The waived funding deficiency is then 
amortized over a period of five years, beginning with the year 
following the year in which the waiver is granted.  Each year, the funding
standard account is charged with the amortization amount for that year 
unless the plan becomes fully funded.

----------------------
\209\ Present law also provides for the use of an "alternatice" funding
standard account, which has rarely been used.


If, as of the close of a plan year, the funding standard account reflects 
credits at least equal to charges, the plan is generally treated as meeting
the minimum funding standard for the year.  If, as of the close of the 
plan year, charges to the funding standard account exceed credits 
to the account, then the excess is referred to as an "accumulated funding
deficiency."  Thus, as a general rule, the minimum contribution for a plan 
year is determined as the amount by which the charges to the funding 
standard account would exceed credits to the account if no contribution 
were made to the plan.  For example, if the balance of charges to the 
funding standard account of a plan for a year would be $200,000 without 
any contributions, then a minimum contribution equal to that amount would
be required to meet the minimum funding standard for the year to prevent an
accumulated funding deficiency.

Credit balances

If credits to the funding standard account exceed charges, a "credit 
balance" results.  A credit balance results, for example, if contributions 
in excess of minimum required contributions are made.  Similarly, a credit 
balance may result from large net experience gains.  The amount of the 
credit balance, increased with interest at the rate used under the plan to 
determine costs, can be used to reduce future required contributions.

Funding methods and general concepts

A defined benefit pension plan is required to use an acceptable actuarial 
cost method to determine the elements included in its funding standard 
account for a year.  Generally, an actuarial cost method breaks up the 
cost of benefits under the plan into annual charges consisting of two 
elements for each plan year. These elements are referred to as: (1) normal
cost; and (2) supplemental cost.

The plan's normal cost for a plan year generally represents the cost of 
future benefits allocated to the year by the funding method used by the 
plan for current employees and, under some funding methods, for separated 
employees.  Specifically, it is the amount actuarially determined that 
would be required as a contribution by the employer for the plan year in 
order to maintain the plan if the plan had been in effect from the 
beginning of service of the included employees and if the costs for prior 
years had been paid, and all assumptions as to interest,
mortality, time of payment, etc., had been fulfilled.  The normal cost will
be funded by future contributions to the plan: (1) in level dollar amounts;
(2) as a uniform percentage of payroll; (3) as a uniform amount per unit of
service (e.g., $1 per hour); or (4) on the basis of the actuarial 
present values of benefits considered accruing in particular plan years.

The supplemental cost for a plan year is the cost of future benefits that 
would not be met by future normal costs, future employee contributions, or
plan assets.  The most common supplemental cost is that attributable to 
past service liability, which represents the cost of future benefits under 
the plan:  (1) on the date the plan is first effective; or (2) on the date 
a plan amendment increasing plan benefits is first effective.  Other 
supplemental costs may be attributable to net experience losses, changes in
actuarial assumptions, and amounts necessary to make up funding 
deficiencies for which a waiver was obtained. Supplemental costs must be 
amortized (i.e., recognized for funding purposes) over a specified number 
of years, depending on the source.  For example, the cost attributable to 
a past service liability is generally amortized over 30 years.

Normal costs and supplemental costs under a plan are computed on the basis 
of an actuarial valuation of the assets and liabilities of a plan.  An 
actuarial valuation is generally required annually and is made as of a 
date within the plan year or within one month before the beginning of the 
plan year.  However, a valuation date within the preceding plan year may be 
used if, as of that date, the value of the plan's assets is at least 100 
percent of the plan's current liability (i.e., the present value of benefit
liabilities under the plan, as described below).

For funding purposes, the actuarial value of plan assets is generally used,
rather than fair market value.  The actuarial value of plan assets is the 
value determined under an actuarial valuation method that takes into 
account fair market value and meets certain other requirements.  
The use of an actuarial valuation method allows appreciation or 
depreciation in the market value of plan assets to be recognized gradually
over several plan years.

In applying the funding rules, all costs, liabilities, interest rates, and
other factors are required to be determined on the basis of actuarial 
assumptions and methods, each of which is reasonable (taking into account 
the experience of the plan and reasonable expectations), or which, in the 
aggregate, result in a total plan contribution equivalent to a contribution
that would be obtained if each assumption and method were reasonable.  In 
addition, the assumptions are required to offer the actuary's best estimate
of anticipated experience under the plan.

Additional contributions for underfunded plans

Under special funding rules (referred to as the "deficit reduction 
contribution" rules),\210\ in the case of a single-employer plan, an 
additional contribution to a plan is generally required if the plan's
funded current liability percentage is less than 90 percent.\211\ A plan's
"funded current liability percentage" is the actuarial value of plan
assets as a percentage of the plan's current liability.\212\ In general,
a plan's current liability means all liabilities to employees and their
beneficiaries under the plan,determined on a present-value basis.

--------------------
\210\ The deficit reduction contribution rules apply to single-employer 
plans, other than single-employer plans with no more than 100 participants
on any day in the preceding plan year.  Single-employer plans with more 
than 100 but not more than 150 participants are generally subject to lower 
contribution requirements under these rules.
   
\211\ Under an alternative test, a plan is not subject to the deficit 
reduction contribution rules for a plan year if (1) the plan's funded 
current liability percentage for the plan year is at least 80 percent, and
(2) the plan's funded current liability percentage was at least 90 percent
for each of the two immediately preceding plan years or each of the second
and third immediately preceding plan years.
   
\212\ In determining a plan's funded current liability percentage for a
plan year, the value of the plan's assets is generally reduced by the 
amount of any credit balance under the plan's funding standard account.
However, this reduction does not apply in determining the plan's funded 
current liability percentage for purposes of whether an additional charge
is required under the deficit reduction contribution rules.


The amount of the additional contribution required under the deficit 
reduction contribution rules is the sum of two amounts: (1) the excess, if
any, of (a) the deficit reduction contribution (as described below), over 
(b) the contribution required under the normal funding rules; and (2) the 
amount (if any) required with respect to unpredictable contingent event 
benefits.  The amount of the additional contribution cannot exceed the 
amount needed to increase the plan's funded current liability percentage 
to 100 percent. The amount of the additional contribution is applied as a 
charge to the funding standard account.

The deficit reduction contribution is the sum of (1) the "unfunded old 
liability amount," (2) the "unfunded new liability amount," and (3) the 
expected increase in current liability due to benefits accruing during the 
plan year.\213\  The "unfunded old liability amount" is the amount 
needed to amortize certain unfunded liabilities under 1987 and 1994 
transition rules.  The "unfunded new liability amount" is the applicable
percentage of the plan's unfunded new liability. Unfunded new liability 
generally means the unfunded current liability of the plan (i.e.,the amount
by which the plan's current liability exceeds the actuarial value of plan
assets), but determined without regard to certain liabilities (such as the
plan's unfunded old liability and unpredictable contingent event benefits)
The applicable percentage is generally 30 percent, but decreases by .40 of 
one percentage point for each percentage point by which the plan's funded 
current liability percentage exceeds 60 percent.  For example, if a plan's
funded current liability percentage is 85 percent (i.e., it exceeds 60 
percent by 25 percentage points), the applicable percentage is 20 percent 
(30 percent minus 10 percentage points (25 multiplied by .4)).\214\

A plan may provide for unpredictable contingent event benefits, which are 
benefits that depend on contingencies that are not reliably and reasonably 
predictable, such as facility shutdowns or reductions in workforce.  The 
value of any unpredictable contingent event benefit is not considered in 
determining additional contributions until the event has occurred. The event 
on which an unpredictable contingent event benefit is contingent is 
generally not considered to have occurred until all events on which the 
benefit is contingent have occurred.

Required interest rate and mortality table 

Specific interest rate and mortality assumptions must be used in 
determining a plan's current liability for purposes of the special funding
rule.  For plans years beginning before January 1, 2004, and after 
December 31,2005, the interest rate used to determine a plan's current 
liability must be within a permissible range of the weighted average\215\
of the interest rates on 30-year Treasury securities for the four-year
period ending on the last day before the plan year begins.The permissible
range is generally from 90 percent to 105 percent (120 percent for plan 

------------------------
\213\ If the Secretary of the Treasury prescribes a new mortality table to
be used in determining current liability, as described below, the deficit 
reduction contribution may include an additional amount.

\214\ In making these computations, the value of the plan's assets is 
reduced by the amount of any credit balance under the plan's funding 
standard account. 

\215\ The weighting used for this purpose is 40 percent, 30 
percent, 20 percent and 10 percent starting with the most recent year
in the four-year period.  Notice 88-73, 1988-2 C.B. 383.
   

years beginning in 2002 or 2003).\216\  The interest rate used under the
plan generally must be consistent with the assumptions which reflect the 
purchase rates which would be used by insurance companies to satisfy the 
liabilities under the plan.\217\

Under the Pension Funding Equity Act of 2004 ("PFEA 2004")\218\,  a special
interest rate applies in determining current liability for plan years 
beginning in 2004 or 2005.\219\  For these years, the interest rate used must 
be within a permissible range of the weighted average of the rates of 
interest on amounts invested conservatively in long term investment-grade 
corporate bonds during the four-year period ending on the last day before 
the plan year begins.  The permissible range for these years is from 90 
percent to 100 percent. The interest rate is to be determined by the 
Secretary of the Treasury on the basis of two or more indices that are 
selected periodically by the Secretary and are in the top 
three quality levels available.

The Secretary of the Treasury is required to prescribe mortality tables and
to periodically review (at least every five years) and update such tables 
to reflect the actuarial experience of pension plans and projected trends
in such experience.\220\  The Secretary of the Treasury has required the use 
of the 1983 Group Annuity Mortality Table.\221\

Other rules

Full funding limitation

No contributions are required under the minimum funding rules in excess of 
the full funding limitation.  The full funding limitation is the excess, 
if any, of (1) the accrued liability under the plan (including normal 
cost), over (2) the lesser of (a) the market value of plan assets

-----------------------
\216\ If the Secretary of the Treasury determines that the lowest 
permissible interest rate in this range is unreasonably high, the Secretary
may prescribe a lower rate, but not less than 80 percent of the weighted 
average of the 30-year Treasury rate.

\217\  Sec. 412(b)(5)(B)(iii)(II); ERISA sec. 302(b)(5)(B)(iii)(II). Under
Notice 90-11, 1990-1 C.B.319, the interest rates in the permissible range 
are deemed to be consistent with the assumptions reflecting the purchase 
rates that would be used by insurance companies to satisfy the liabilities
under the plan

\218\  Pub. L. No. 108-218 (2004).

\219\ In addition, under PFEA 2004, if certain requirements are met, 
reduced contributions under the deficit reduction contribution rules apply
for plan years beginning after December 27, 2003, and before December 28,
2005, in the case of plans maintained by commercial passenger airlines,
employers primarily engaged in the production or manufacture of a steel
mill product or in the processing of iron ore pellets, or a certain labor
organization.

\220\ Sec. 412(l)(7)(C)(ii); ERISA sec. 302(d)(7)(C)(ii).

\221\ Rev. Rul. 95-28, 1995-1 C.B. 74.  Under Prop. Treas. 
Reg. 1.412(l)(7)-1, beginning in 2007, RP-2000 Mortality Tables are used
with improvements in mortality (including future improvements) projected 
to the current year and with separate tables for annuitants and 
nonannuitants.  



or (b)the actuarial value of plan assets.  However, the full funding
limitation may not be less than the excess, if any, of 90 percent of the
plan's current liability (including the current liability normal cost) 
over the actuarial value of plan assets.  In general, current liability
is all liabilities to plan participants and beneficiaries accrued to date, 
whereas the accrued liability under the full funding limitation may be 
based on projected future benefits, including future salary increases.

Timing of plan contributions

In general, plan contributions required to satisfy the funding rules must 
be made within 8ï¿½ months after the end of the plan year.  If the 
contribution is made by such due date, the contribution is treated as if 
it were made on the last day of the plan year.

In the case of a plan with a funded current liability percentage of less 
than 100 percent for the preceding plan year, estimated contributions for 
the current plan year must be made in quarterly installments during the 
current plan year.  The amount of each required installment is 25 percent 
of the lesser of (1) 90 percent of the amount required to be contributed 
for the current plan year or (2) 100 percent of the amount required to be
contributed for the preceding plan year.

Funding waivers

Within limits, the IRS is permitted to waive all or a portion of the 
contributions required under the minimum funding standard for a plan year.
A waiver may be granted if the employer (or employers) responsible for the 
contribution could not make the required contribution without temporary 
substantial business hardship and if requiring the contribution 
would be adverse to the interests of plan participants in the aggregate.
Generally, no more than three waivers may be granted within any period of 
15 consecutive plan years.

The IRS is authorized to require security to be granted as a condition of 
granting a waiver of the minimum funding standard if the sum of the plan's 
accumulated funding deficiency and the balance of any outstanding waived 
funding deficiencies exceeds $1 million.


-----------------------
\222\ For plan years beginning before 2004, the full funding limitation was
generally defined as the excess, if any, of (1) the lesser of (a) the 
accrued liability under the plan (including normal cost) or (b) a 
percentage (170 percent for 2003) of the plan's current liability 
(including the current liability normal cost), over (2) the lesser of (a)
the market value of plan assets or (b) the actuarial value of plan assets,
but in no case less than the excess, if any, of 90 percent of the plan's 
current liability over the actuarial value of plan assets.  Under the 
Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"), the
full funding limitation based on 170 percent of current liability is repealed
for plan years beginning in 2004 and thereafter.  The provisions of EGTRRA 
generally do not apply for years beginning after December 31, 2010.

\223\ Sec. 412(m); ERISA sec. 302(e).

\224\ Sec. 412(d); ERISA sec. 303  Under similar rules, the amortization
period applicable to an unfunded past service liability or loss may also
be extended.


Failure to make required contributions 

An employer is generally subject to an excise tax if it fails to make 
minimum required contributions and fails to obtain a waiver from the IRS.
The excise tax is 10 percent of the amount of the funding deficiency.  
In addition, a tax of 100 percent may be imposed if the funding deficiency 
is not corrected within a certain period.

If the total of the contributions the employer fails to make (plus 
interest) exceeds $1 million and the plan's funded current liability 
percentage is less than 100 percent, a lien arises in favor of the plan 
with respect to all property of the employer and the members of the 
employer's controlled group. The amount of the lien is the total amount of
the missed contributions (plus interest).

Reversions of defined benefit pension plan assets

Defined benefit pension plan assets generally may not revert to an employer
before termination of the plan and the satisfaction of all plan liabilities.
In addition, the plan must provide for the reversion. A reversion prior to 
plan termination may result in disqualification of the plan and may 
constitute a prohibited transaction. Certain limitations and procedural 
requirements apply to a reversion upon plan termination.  Any assets that
revert to the employer upon plan termination are includible in the gross 
income of the employer and subject to an excise tax.  The excise tax rate
is generally 20 percent,but increases to 50 percent if the employer 
does make contributions to a replacement plan or make certain benefit 
increases. Upon plan termination, the accrued benefits of all plan 
participants are required to be fully vested.

If certain requirements are satisfied, a qualified transfer of excess 
assets of a defined benefit pension plan may be made to a separate account 
within the plan in order to fund retiree health benefits.  Excess assets 
generally means the excess, if any, of the value of the plan's assets  over
the greater of (1) the accrued liability under the plan (including
normal cost) or (2) 125 percent of the plan's current liability.  No
transfer after December 31, 2013, is a qualified transfer.

Deductions for contributions

Employer contributions to qualified retirement plans are deductible, 
subject to certain limits.  In the case of a defined benefit pension plan,
the employer generally may deduct the greater of: (1) the amount necessary
to satisfy the minimum funding requirement of the plan for the year; or (2)
the amount of the plan's normal cost for the year plus the amount necessary




to amortize certain unfunded liabilities over 10 years, but limited to the
full funding limitation for the year.\229\

The maximum amount of deductible contributions is generally not less than 
the plan's unfunded current liability.\230\  For this purpose, current 
liability is generally determined using the statutory assumptions used in
determining current liability for funding purposes.  However, for purposes 
of determining the maximum amount of deductible contributions for 2004 and 
2005, an employer may elect to disregard the temporary interest rate change
under PFEA 2004.  In such a case, the interest rate used in determining 
current liability for deduction purposes must be within the permissible 
range (90 to 105 percent) of the weighted average of the interest rates on
30-year Treasury securities for the preceding four-year period.

Subject to certain exceptions, an employer that makes nondeductible 
contributions to a plan is subject to an excise tax equal to 10 percent of
the amount of the nondeductible contributions for the year.\231\

                         Description of Proposal
                           
In general

Under the proposal, the interest rate used in determining current liability
for plan years beginning in 2004 and 2005 is extended to 2006.  Thus, in
determining current liability for plan years beginning in 2006, the 
interest rate used must be within the permissible range (90 to 100 
percent) of the weighted average of the rates of interest on amounts 
invested conservatively in long-term investment-grade corporate bonds 
during the four-year period ending on the last day before the plan year
begins.

In the case of single-employer plans, for plan years beginning after 
December 31, 2006, the proposal repeals the present-law funding rules and 
provides a new set of rules for determining minimum required
contributions.\232\  Under the proposal, the minimum required contribution
to a defined benefit pension plan for a plan year is generally the sum of
two amounts:  (1) the payments\233\  required to amortize over seven years

----------------------
\229\ Sec. 404(a)(1).

\230\ Sec. 404(a)(1)(D). In the case of a plan that terminates during the 
year, the maximum deductible amount is generally not less than the amount 
needed to make the plan assets sufficient to fund benefit liabilities as 
defined for purposes of the PBGC termination insurance program (sometimes 
referred to as "termination liability").

\231\ Sec. 4972.

\232\ The proposal does not change the funding rules applicable to 
multiemployer plans or insurance contract plans.  Governmental plans and 
church plans continue to be exempt from the funding rules to the extent
provided under present law.

\233\ As discussed below, different payments may be required with respect
to amortization bases established for different years.


the amount by which the plan's funding target exceeds the market value of
the plan assets; and (2) the plan's normal cost for the plan year.

The plan's funding target is generally the present value of benefits earned
as of the beginning of the plan year.  The plan's normal cost is generally 
the present value of benefits expected to be earned during the plan year.
Under the proposal, present value is determined using interest rates drawn 
from a corporate bond yield curve and a mortality table prescribed by 
the Secretary of Treasury.   However, other assumptions used to determine
the plan's funding target and normal cost depend on the financial status of
the employer.

The proposal also changes the limit on deductible contributions.

Determination of funding target and normal cost

In general

In general, under the proposal, the funding target and normal cost for a 
plan are the plan's "ongoing liability" and "ongoing" normal cost.  
However, in the case of a plan maintained by a financially weak plan 
sponsor, the funding target and normal cost for the plan are the plan's
"at-risk liability" and "at-risk" normal cost.  Different actuarial 
assumptions apply in determining ongoing or at-risk liability and normal cost.

Ongoing liability and ongoing normal cost

A plan's ongoing liability for a plan year is the present value of future
payments expected to be made from the plan to provide benefits earned as 
of the beginning of the plan year. Benefits taken into account for this 
purpose include early retirement benefits and similar benefits that 
participants will become entitled to as a result of future service, to the
extent such benefits are attributable to benefits accrued as of the 
beginning of the plan year.

For purposes of determining a plan's ongoing liability,the present value of
benefits is determined by discounting future expected payments under the 
plan using a corporate bond yield curve, as described below.  Future 
expected benefit payments under the plan are determined using a mortality
table prescribed by the Secretary of Treasury. The proposal generally does
not require other specified assumptions to be used in determining ongoing 
liability.  However, other assumptions, such as the rate of turnover among
participants and early and normal retirement rates, must be actuarially 
reasonable based on experience for the plan (or other relevant historical 
experience if there is no experience for the plan). In addition, a 
reasonable assumption as to future benefits that will be paid in the form
of a lump sum must be used.

Ongoing normal cost for a plan year is the present value of future payments
expected to be made from the plan to provide benefits that accrue during 
the plan year.  Benefits that accrue during the plan year include any 
benefit accruals that result from compensation increases during

--------------------
\234\ A proposal to use interest rates drawn from a corporagte bond yield
curve in determining benefits subject to the minimum value rules, such as
lump sums, is dicussed in Part IV. C.


the plan year that are applied to previous years of service, such as
under a plan that bases benefits on final average compensation.Ongoing
normal cost is determined using the same actuarial assumptions used to
determine ongoing liability.

At-risk liability and at-risk normal cost

A plan's at-risk liability for a plan year is also the present value of
future payments expected to be made from the plan to provide benefits 
earned as of the beginning of the plan year, determined using a corporate 
bond yield curve and a mortality table prescribed by the Secretary of 
Treasury.  However, certain specified additional assumptions must be used
in determining at-risk liability.  Specifically, at-risk liability must be
determined by assuming that participants retire at the earliest retirement 
age permitted under the plan and that benefits are paid 
in the form of a lump sum (or in whatever form permitted under the plan 
results in the largest present value). In addition, at-risk liability 
includes an additional amount, referred to as a loading factor. The loading
factor is $700 per plan participant plus four percent of the amount of the 
plan's at-risk liability, as determined without regard to the loading
factor 

At-risk normal cost is the present value of future payments expected to be
made from the plan to provide benefits that accrue during the plan year, 
determined using the same actuarial assumptions used to determine at-risk 
liability, including a loading factor of four percent of the amount of the 
plan's at-risk normal cost, as determined without regard to the loading factor. 

Financially weak status 

Financially weak status applies if, as of the plan's valuation date, any 
plan sponsor has senior unsecured debt that is rated as not being 
investment grade by each nationally recognized rating organization that 
has issued a credit rating for the debt. Alternatively, if no plan sponsor 
has senior unsecured debt that is rated, financially weak status applies if
all of the nationally recognized statistical rating organizations that have
made an issuer credit rating for any plan sponsor have rated the sponsor as
less than investment grade.  However, financially weak status does not 
apply if any significant member of the plan sponsor's controlled group has
senior unsecured debt that is rated as investment grade, regardless of 
whether that controlled group member is a plan sponsor of the plan.

Special rules apply in the case of plan sponsors that have neither 
unsecured debt that is rated nor an issuer credit rating.  Such a plan 
sponsor is automatically treated as not being financially weak, provided 
that the total number of participants covered by defined benefit

----------------------
\235\ These additional assumptions are intended to reflect behavior that 
may occur when the financial health of the plan sponsor deteriorates.

\236\ The loading factor is intended to reflect the cost of purchasing
group annuity contrcts in the case of termination of the plan.

\237\ At-risk normal cost does not includde a loading factor of $700 per
plan participant.


pension plans maintained by the sponsor is less than 500.  If  the total 
number of participants covered by defined benefit pension plans maintained 
by such a plan sponsor is 500 or more,whether the plan sponsor is 
financially weak is determined under regulations.  It is expected that, 
under such regulations, financially weak status will be determined based 
on financial measures,such as whether the ratio of long-term debt to equity
for the plan sponsor's controlled group is 1.5 or more. For this purpose, 
debt is expected to include the unfunded at-risk liability of any 
plans maintained by the plan sponsor, and equity is expected to be based
on: (1) fair market value in the case of a privately held company; or (2)
market capitalization in the case of a company, the stock of which is 
publicly traded

If a plan sponsor becomes financially weak during a plan year, any 
resulting change in the plan's funding target (i.e., from ongoing liability
to at-risk liability) and normal cost (i.e., from ongoing normal cost to 
at-risk normal cost) is phased in ratably over a five-year period 
beginning with the plan year following the year in which the plan sponsor
becomes financially weak. This rule applies if a plan sponsor becomes 
financially weak either before or after enactment of the proposal, and the
five-year phase-in period is determined without regard to whether any of 
the relevant years occurred before enactment of the proposal. If a plan 
sponsor's financial status changes during a plan year so that it is no 
longer financially weak, the plan's ongoing liability is the applicable 
funding target for the next plan year.

Interest rate based on corporate bond yield curve and transition rule

The funding target and normal cost applicable to a plan are determined
using a series of interest rates drawn from a yield curve for high-quality
zero-coupon corporate bonds ("corporate bond yield curve").  That is, the
interest rates used to determine the present value of payments expected to
be made under the plan reflect the interest rates for corporate bonds
maturing at the times when the payments are expected to be made. The 
corporate bond yield curve is to be issued monthly by the Secretary of 
Treasury, based on the interest rates (averaged over 90 business days) for
high-quality corporate bonds (i.e., bonds rated AA) with varying 
maturities.

A special method of calculating a plan's funding target applies for plan
years beginning in 2007 and 2008. For those years, the plan's funding 
target is the weighted average of:  (1) the plan's funding target (i.e., 
ongoing or at-risk liability, as applicable) determined using a corporate 
bond yield curve; and (2) the plan's funding target determined using the
"transition" interest rate.  The transition interest rate is the interest
rate that would apply if the statutory interest rate applicable under the 
proposal in determining current liability for plan years beginning in 2006 
continued to apply for plan years beginning in 2007 and 2008.  That is,
the interest rate used must be within a permissible range (from 90 to
100 percent) of the weighted average of the rates of interest on amounts
invested conservatively in long term investment-grade corporate bonds 
during the four-year period ending on the last day before the plan year
begins.For plan years beginning in 2007, a weighting factor of 2/3 
applies to the plan's funding target determined using the transition 

-----------------------
\238\ Typically, higher interest rates apply to bonds of longer durations,
and lower interest rates apply to bonds of shorter durations.  It is 
therefore expected that higher interest rates will generally apply in 
determining the present value of payments expected to be made further in
the future, and lower interest rates will generally apply in determining
the present value of payments expected to be made in the nearer 
future.


interest rate, and a weighting factor of 1/3 applies to the plan's 
funding target determined using a corporate bond yield curve.  For plan
years beginning in 2008, the respective weighting factors are 1/3 and 2/3.

A similar method applies in determining a plan's normal cost (i.e., ongoing
or at-risk normal cost, as applicable) for plan years beginning in 2007 and
2008.

Valuation date

Under the proposal, a plan's funding target (i.e., ongoing or at-risk 
liability, as applicable), the plan's normal cost (i.e., ongoing or at-risk
normal cost, as applicable), the market value of the plan's assets, and 
the minimum required contribution for a plan year are determined 
as of the valuation date for the plan year.  If a plan has more than 100
participants, the plan's valuation date must be the first day of the plan 
year.  If the plan has 100 or fewer participants, the plan's valuation 
date may be any day in the plan year.

If a plan's valuation date is after the first day of the plan year,benefits
accruing between the first day of the plan year and the valuation date are 
disregarded in determining the plan's funding target for the plan year.  
In addition, in determining the market value of plan assets as of the 
valuation date, any contribution made to the plan for the current plan year
is disregarded and any contribution to be made to the plan for the prior 
year that has not yet been made is included in plan assets as a 
contribution receivable. For plan years beginning in 2008 or later, 
the present value of the contribution receivable is included in plan assets,
and present value is determined using the average effective interest rate
that applied in determining the plan's funding target for the prior plan
year.

Minimum required contributions

Under the proposal, the minimum contribution required to be made to a plan 
for a plan year is generally the sum of: (1) the plan's normal cost for 
the plan year (i.e., ongoing or at-risk normal cost, as applicable); and 
(2) the payments required (as described below) to amortize the amount by 
which the plan's funding target for the plan year (i.e., ongoing or at-risk
liability, as applicable) exceeds the market value of plan assets.

Under the proposal, if the plan's funding target for the plan year 
beginning in 2007 exceeds the market value of the plan's assets for that 
year, an initial amortization base is established in the amount of the 
shortfall.  Payments are then required in the amount needed to 
amortize the initial amortization base over seven years, starting with the
plan year beginning in 2007. The required amortization payments are 
determined on a level basis, using the applicable interest rates under the 
corporate bond yield curve.

---------------------
\239\ Such benefits are taken into account in determining the plan's normal
cost for the plan year.

\240\ The present-law rules permintting the waiver of the minimum funding
requirements continue to apply.


For each subsequent plan year, the plan's funding target is compared with
the sum of (1) the market value of the plan's assets; and (2) the present 
value of any future required amortization payments (determined using the 
applicable interest rates under the corporate bond yield curve).  If the 
plan's funding target exceeds that sum, an additional amortization base is 
established in the amount of the shortfall, and payments are required in 
the amount needed to amortize the additional amortization base over seven 
years.  If, for a plan year, the sum of the market value of plan assets 
and the present value of any future required amortization payments 
exceeds the plan's funding target, no additional amortization base is 
established for that plan year.

All required amortization payments generally must be made over the 
applicable seven-year period.   However, if, for a plan year, the market 
value of the plan's assets is at least equal to the plan's funding target,
any existing amortization bases are eliminated and no amortization 
payments are required.

If no amortization payments are required for a plan year,the minimum
required contribution for the plan year is based solely on the plan's 
normal cost.  Specifically, the minimum required contribution is the plan's
normal cost, reduced by the amount (if any) by which the market value of 
the plan's assets exceeds the plan's funding target.  Accordingly, no 
contribution is required for a plan year if the market value of the plan's
assets is at least equal to the sum of the plan's funding target and the 
plan's normal cost for the plan year.

A contribution in excess of the minimum required contribution does not 
create a credit balance that can be used to offset minimum required 
contributions for later years.  However,contributions in excess of the 
minimum (and income thereon) increase plan assets, which may have the 
effect of accelerating the elimination of amortization bases or of reducing
contributions required with respect to normal cost.

Timing rules for contributions

As under present law, contributions required for a plan year generally must
be made within 8-ï¿½ months after the end of the plan year.  However, 
quarterly contributions are required to be made during a plan year if,for 
the preceding plan year, the plan's funding target exceeded the market 
value of the plan's assets, determined as of the valuation date for the 
preceding plan year.

A contribution made after the valuation date for a plan year is credited 
against the minimum required contribution for the plan year based on its 
present value as of the valuation date for the plan year.  Present value is
determined by discounting the contribution from the date the contribution 
is actually made to the valuation date, using the average effective 
interest rate applicable in determining the plan's funding target for the 
plan year.

-----------------------
/241/ Under the proposal, the present-law rules permitting the extension
of amortization periods are repealed with respect to single-employer plans.



Maximum deductible contributions

Under the proposal, the limit on deductible contributions for a year is 
generally the amount by which the sum of the plan's funding target, the 
plan's normal cost, and the plan's cushion amount exceeds the market value
of the plan's assets.  The plan's cushion amount is the sum of:(1) 30 
percent of the plan's funding target; and (2) the amount by which the 
plan's funding target and normal cost would increase if they were 
determined by taking into account expected future salary increases for
participants (or, in the case of a plan under which previously 
accrued benefits are not based on compensation, expected future benefit
increases, based on average increases for the previous six years).  The
increase in the plan's funding target and normal cost as a result of 
taking into account expected future salary or benefit increases is 
determined by applying the expected salary or benefit increase with 
respect to participants' service as of the valuation date for the plan 
year.  For this purpose, the dollar limits on benefits and on compensation
that apply for the plan year are used.

In addition, the limit on deductible contributions for a year is not less
than the sum of (1) the plan's at-risk normal cost for the year; and 
(2) the amount by which the plan's at-risk liability for the year exceeds
the market value of the plan's assets.  For this purpose, at-risk liability 
and at-risk normal cost are used regardless of the financial status of the 
plan sponsor.

Present-law rules permitting an employer to deduct a contribution made 
within the time for filing its tax return for a taxable year continue to
apply.Effective date.-The proposal is effective for plan years beginning 
after December 31,2005.

                                 Analysis
                                 
General policy issues relating to the funding and deduction rules for 
defined benefit pension plans

The funding rules are a cornerstone of the defined benefit pension plan 
system and, over time, have been a frequent source of discussion and 
change.  Proposals relating to the funding rules involve balancing 
competing policy interests.

The present-law minimum funding rules recognize that pension benefits are
generally long-term liabilities that can be funded over a period of time.
On the other hand, benefit liabilities are accelerated when a plan 
terminates before all benefits have been paid, as many plans do, and the 
deficit reduction contribution rules to some extent reflect the amount that 
would be needed to provide benefits if the plan terminated. Some argue 
that if minimum funding requirements are too stringent, funds may be 
unnecessarily diverted from the employer's other business needs and may 
cause financial problems for the business, thus jeopardizing the future of 
not just the employees' retirement benefits, but also their jobs.  This 
suggestion tends to arise during a period of economic downturn, either
generally or in a particular industry.  Some also argue that overly 
stringent funding requirements may discourage the establishment or 
continuation of defined benefit pension plans.

The limits on deductible contributions, the excise tax on nondeductible
contributions, and the rules relating to reversions of defined benefit 
pension plan assets have as a major objective preventing the use of 
defined benefit pension plans as a tax-favored funding mechanism for the 
business needs of the employer.  They also serve to limit the tax 
expenditure associated with defined benefit pension plans.  Some argue that
if the maximum limits on plan funding are too low, then benefit security 
will be jeopardized.  They argue that employers need flexibility to 
make greater contributions when possible, in order to ensure adequate 
funding in years in which the business may not be as profitable.\242\
Others note that such flexibility is available as a result of the 
increases in the deduction limits under EGTRRA, but the full effect of
the increases may not be apparent yet because of recent economic 
conditions.  With respect to reversions, some argue that if restrictions
on reversions are too strict, employers may be discouraged from making
contributions in excess ofthe required minimums

The desire to achieve the proper balance between these competing policy
objectives has resulted in a variety of legislative changes to address the
concerns arising at particular times.  For example, the Omnibus Budget 
Reconciliation Act of 1987 made comprehensive changes to the minimum 
funding rules (including enactment of the deficit reduction contribution 
rules) prompted by concerns regarding the solvency of the defined benefit 
pension plan system.  That Act also added the current liability full 
funding limit.  Legislation enacted in 1990 allowed employers access to 
excess assets in defined benefit pension plans in order to pay retiree 
health liabilities.  The Retirement Protection Act of 1994 again made 
comprehensive changes to the funding rules.  Recent changes to the funding
rules have focused on increasing the maximum deductible contribution and 
on the interest rate that must be used to calculate required 
contributions. For example, EGTRRA increased the current liability full
funding limit and then repealed the current liability full funding limit
for 2004 and thereafter 

General analysis of the funding and deduction proposal

The proposed changes to the funding rules reflect the view that the 
present-law rules are ineffective in assuring that plans are adequately 
funded.  For example, the valuation methods and amortization periods 
applicable under present law may have the effect of disguising a plan's
true funding status.  In some cases, these factors result in artificial 
credit balances that can be used to reduce required contributions.  Thus,
employers may fully comply with the present-law funding rules, yet still 
have plans that are substantially underfunded.  In general, the proposal
is intended to more accurately measure the unfunded liability of a plan and
accelerate the rate at which contributions are made to fund that liability.

Under the proposal, a plan's funding status is measured by reference to the
present value of plan liabilities, using a current interest rate, and the 
market value of plan assets.  This approach is intended to provide a more
accurate and up-to-date picture of the plan's financial condition.  On the
other hand, some point out that most plans are long-term arrangements and a 
measurement of assets and liabilities as of a particular date does not 
necessarily provide an accurate picture of the plan's status.

-------------------
\242\ Some employers may also wish to make additonal contributions to 
improve the funding status of their plans for financiak reporting purposes.


Some are also concerned that elimination of the averaging and smoothing
rules that apply under present law may result in increased volatility of 
required contributions.  They also note that the present-law averaging and
smoothing rules allow employers to know in advance that higher plan 
contributions will be required, thereby providing some predictability in
required contributions.  They suggest that, by making required 
contributions more volatile and unpredictable, the proposal may discourage
employers from continuing to maintain plans and thus may harm, rather than
strengthen, the defined benefit pension plan system.

The proposal applies a more rigorous funding target in the case of a plan
maintained by a financially weak employer.  Under the proposal, financially
weak status is generally based on a rating of the employer's debt as below 
investment grade by nationally recognized rating organizations.  In some 
cases, financially weak status is determined in accordance with standards 
to be established under regulations.  Some argue that credit ratings are 
simply not a reliable indicator of whether a plan will terminate on an 
underfunded basis.  They note that many businesses with below investment
grade ratings continue to operate and to maintain a defined benefit pension
plan.  Some also suggest that the possibility of greater required 
contributions could itself drive down an employer's credit rating.  Some
also express concern that, in some cases, Treasury and the IRS would be 
responsible for determining financial status.

If a plan terminates, in addition to the cost of benefits, costs are 
incurred to purchase annuity contracts to provide the benefits due under
the plan.  In addition, an economic decline in a business may cause 
employees to retire earlier and to take benefits in the form of a lump
sum.  The proposal requires these factors to be reflected in the 
determination of a plan's funding target in the case of a financially 
weak employer.  This approach has the effect of increasing such 
liabilities and required contributions.  Some view this approach as 
appropriate in order to reduce the financial risk posed by underfunded 
plans maintained by financially weak employers.  Others argue that 
requiring such employers to make even greater required contributions may
increase the risk that the plan will terminate on an underfunded basis.

Under the proposal, the changes to the deduction limits are intended to 
allow employers to make higher contributions when funds are available,thus
improving the plan's funding status and reducing the contributions that may
be required during a downturn in business.  However, some argue that the 
elimination of the credit balance concept (which limits the ability to 
reduce future required contributions by additional contributions made in
the past) undercuts the incentive to make additional contributions. In 
addition, some employers may have made additional contributions and 
generated credit balances as part of a planned funding strategy and 
elimination of existing credit balances may be viewed as disruptive. Some
suggest that credit balances should be adjusted to reflect changes in 
plan asset values, but not eliminated.  On the other hand, with respect to
the proposed increase in the deduction limits, some note that,currently, 
most employers do not make contributions up to the present-law deduction
limits.They suggest that raising the limits will primarily benefit
employers who want to use the plan as a source of tax-free savings to
provide funds for other purposes.

The present-law funding rules are complex, in part because they essentially
consist of two sets of rules - the general rules that determine required 
contributions on an ongoing basis and the deficit reduction contribution 
rules that determine required contributions on a present-value 


basis. The proposal replaces these rules with a single set of rules, which
reduces complexity.  In addition, the methods used to determine minimum 
required contributions under the proposal are less complex than the 
present-law rules involving the funding standard account and various 
amortization periods and valuation methods.

Background relating to interest rate used to measure pension liabilities

Recent attention has focused on the issue of the rate of interest used to
determine the present value of benefits under defined benefit pension plans
for purposes of the plan's current liability (and hence the amount of 
contributions required under the funding rules) and the minimum amount of 
lump-sum benefits under the plan.\243\ For plan funding purposes, the 
use of a lower interest rate in determining current liability results in a
higher present value of the benefits and larger contributions required to
fund those benefits.  Alternatively, the use of a higher interest rate
results in a lower present value of future liabilities and therefore lower 
required contributions. 

Under present law, the theoretical basis for the interest rate to be used
to determine the present value of pension plan benefits for funding 
purposes is an interest rate that would be used in setting the price for 
private annuity contracts that provide similar benefits.  Some studies have
shown that it is not practicable to identify such a rate accurately because
of variation in the manner in which prices of private annuity contracts 
are determined.  As a result, the interest rate used to value pension 
benefits is intended to approximate the rate used in pricing annuity 
contracts.\244\ Some have described this standard as a rate comparable
to the rate earned on a conservatively invested portfolio of assets.

Under present law (except for 2004 and 2005), the interest rate used to 
determine current liability (and minimum lump-sum benefits) is based on the
interest rate on 30-year Treasury obligations.  The interest rate issue 
has received attention recently, in part because the Treasury 
Department stopped issuing 30-year obligations in 2001, which meant that
a change to the statutory interest rate was needed.  Because the Treasury 
Department recently resumed the issuance of 30-year obligations, some view
a statutory change as no longer necessary.   However, apart from the 
availability of 30-year Treasury obligations, some have argued that the
30-year Treasury rate has been too low compared to annuity rates, resulting
in inappropriately high levels of minimum funding requirements on employers
that are not necessary to maintain appropriate retirement income
security.\245\ 

--------------------
\243\ A proposal to use a corporate bond yield curve in determining 
minimum lump-sum benefits is discussed in Part IV.C.

\244\ In practice, the price of an annuity contact encompasses not only
an interest rate factor but also other factors, such as the costs of 
servicing the contract and recordkeeping.  Under present law, the interest
rate used for determining current liability is intended to embody all of
these factors.  See H.R.Rpt. No. 100-495, at 868 (1987).

\245\ As discussed above, temporary increases in the permissible interest
rate for purposes of determining current liability were enacted in 2002
and 2004.



Analysis of interest rate proposal

Under the proposal, the rate of interest on 30-year Treasury securities is
replaced with the rate of interest on high quality corporate bonds in 
calculating the present value of plan benefits for purposes of determining 
minimum required contributions.  Initially, the interest rate used is based
on a weighted average of the yields on high-quality long-term corporate 
bonds.  After a transition period, the proposal provides for the use of a
series of interest rates drawn from a yield curve of high-quality 
zero-coupon bonds with various maturities, selected to match the timing of 
benefit payments expected to be made from the plan.

Some believe that, compared with the rate of interest on 30-year Treasury 
securities, an interest rate based on long-term corporate bonds better 
approximates the rate that would be used in determining the cost of settling 
pension liabilities, i.e., by purchasing annuity contracts to provide the 
benefits due under the plan.\246\  However, the proposal reflects the view
that use of an interest rate based solely on long-term corporate bonds is 
inappropriate, and rather that multiple interest rates should be used to 
reflect the varying times when benefits become payable under a plan, 
because of, for example, different expected retirement dates of employees.
The rationale for this approach is that interest rates differ depending, 
in part, on the term of an obligation. Because plan liabilities may be 
payable both in the short term and the long term, this approach would 
determine the present value of these liabilities with multiple interest 
rates, chosen to match the times at which the benefits are payable under 
the plan 

Some have raised concerns that a yield curve approach is more complicated 
than the use of a single rate, particularly for smaller plans.  Some have 
suggested that this could have the effect of increasing administrative costs 
associated with maintaining a defined benefit pension plan (and, in some 
cases, required contributions) and discourage the continuation and 
establishment of such plans.  Some also question whether using a yield 
curve would result in such increased accuracy as to justify the complexity.
Some have suggested that the use of a single rate, such as the long-term 
corporate bond rate, with an appropriate adjustment factor can produce 
results similar to the use of a yield curve, but much more simply.

Others have responded to these concerns by suggesting that, although a 
single interest rate is used to determine required contributions under the
present-law funding rules, a yield curve approach is commonly used for 
other purposes, such as corporate finance.  Some also note that the 
determination of plan liabilities already involves the application of 
complicated actuarial concepts and the proposal does not add significant
complexity.  They argue moreover that any additional complexity is 
outweighed by the importance of measuring pension liabilities 
accurately, including the timing of benefit payments from the plan.  In
addition, it has been suggested that simplified methods (such as the use of
a single composite rate) can be provided for smaller plans.

Some have questioned whether it is possible to construct a yield curve of
corporate bond rates that is appropriate for measuring pension liabilities.
They suggest that, for example,corporate bonds of certain durations that

-------------------
\246\ Some also argue that the interest rate sed  for funding purposes
should be based on the expected return on plan investments, rather than
on annuity purchase rates.



are available on the market are too limited to provide a reliable basis for
constructing a yield curve.  Some have also suggested that the proposal may 
be intended to encourage employers to invest plan assets more heavily in 
bonds, rather than in equities.  Although, over time, returns on equity 
investments are expected to be higher than bond returns, equity investments
are also subject to greater value changes, which can lead to volatility 
in plan asset values, which in turn may increase unfunded liabilities and 
minimum required contributions.  Thus, investments in bonds may reduce 
volatility in the value of plan assets and in required contributions.  
Some argue that, to the extent plan assets are invested more heavily in 
bonds in order to reduce volatility in plan assets, the long term return on
such plan might be lower than that achieved with an alternative portfolio 
invested less heavily in bonds, thus requiring greater employer 
contributions over time to meet plan liabilities.  However, employers 
today face similar issues in the management of pension plans under the 
existing funding rules.

The proposal also eliminates the four-year averaging period used to 
determine the interest rate applicable for purposes of determining current 
liability under present law.  Some have suggested that such an averaging 
period is necessary to prevent rapid interest rate changes from causing 
corresponding changes in the value of pension liabilities, which in turn 
may result in volatility in the amount of minimum required contributions.
The use of a yield curve, however,should to some extent mitigate 
volatility relative to the use of a single rate, as short and long 
term interest rates fluctuate to differing degrees and do not necessarily
even move in the same direction.  Others believe that the interest rate 
used to value pension liabilities should be designed to measure those 
liabilities as accurately as possible and that volatility in required 
contributions should be addressed through modifications to the funding and
deduction rules. However, some argue that the proposal fails to address 
such volatility.

                             Prior Action
                            
A similar proposal was included in the President's fiscal year 2006 budget
proposal.  The President's fiscal year 2005 budget proposal included a 
proposal to use a yield curve of interest rates on corporate bonds in 
determining current liability.

H.R. 2830 (the "Pension Protection Act of 2005"), as passed by the House,
and S. 1783, (the "Pension Security and Transparency Act of 2005"), as 
passed by the Senate, both include provisions relating to the funding and 
deduction rules for single-employer defined benefit pension plans.

3. Form 5500, Schedule B actuarial statement and summary annual report

                              Present Law
                              
Form 5500 and Schedule B actuarial statement

The plan administrator of a qualified retirement plan generally must file 
an annual return with the Secretary of the Treasury, an annual report with 
the Secretary of Labor, and certain information with the Pension Benefit 
Guaranty Corporation ("PBGC").\247\  Form 5500, which consists of

----------------
\247\ Code secs. 6058 and 6059; ERISA secs. 103 and 4065.


a primary form and various schedules, includes the information required to
be filed with all three agencies. The plan administrator satisfies the 
reporting requirement with respect to each agency by filing the Form 5500
with the Department of Labor.

In the case of a defined benefit pension plan,the annual report must 
include an actuarial report (filed on Schedule B of the Form 5500).\248\
The actuarial report must include, for example,information as to the value of 
plan assets, the plan's accrued and current liabilities, expected 
disbursements from the plan for the year, plan contributions, the plan's 
actuarial cost method and actuarial assumptions, and amortization bases 
established in the year.  The report must be signed by an actuary enrolled
to practice before the IRS, Department of Labor and the PBGC.

The Form 5500 is due by the last day of the seventh month following the 
close of the plan year.  The due date may be extended up to two and 
one-half months.  Copies of filed Form 5500s are available for public 
examination at the Department of Labor.

Summary annual report

ERISA requires that plans furnish a summary annual report of the Form 5500
to plan participants and beneficiaries.\249\ The summary annual report must 
include a statement whether contributions were made to keep the plan funded
in accordance with minimum funding requirements, or whether contributions 
were not made and the amount of the deficit. The current value of plan 
assets is also required to be disclosed.  The summary annual report must be 
furnished within nine months after the close of the plan year.  If an 
extension applies for the Form 5500, the summary annual report must be 
provided within two months after the extended due date.  A plan 
administrator who fails to provide a summary annual report to a participant 
within 30 days of the participant making request for the report may be 
liable to the participant for a civil penalty of up to $100 a day from the 
date of the failure.

Participant notice of underfunding

Plan administrators of plans required to pay variable rate premiums to the 
PBGC are required to provide notice to plan participants and beneficiaries 
of the plan's funding status and the limits on the PBGC's guaranty should 
the plan terminate while underfunded.\250\ The notice is generally due no
later than two months after the filing deadline for the Form 5500 for the 
previous plan year and may be distributed with the plan's summary annual
report

----------------------
\248\ Code sec.6059;ERISA sec.103(d).

\249\ ERISA sec.104(b). A participant must also be provided with a copy
of te fll annual report on written request.

\250\ ERISA sec.4011.


Disclosure of certain plan actuarial and company financial information

In certain circumstances, the contributing sponsor of a single-employer 
plan covered by the PBGC (and members of the contributing sponsor's 
controlled group) must provide certain information to the PBGC.  This 
information (referred to as "section 4010 information") includes financial
information with respect to the contributing sponsor (and controlled group
members) and actuarial information with respect to single-employer plans 
maintained by the sponsor (and controlled group members).  This reporting
is required if: (1) the aggregate unfunded vested benefits (determined 
using the interest rate used in determining variable-rate premiums) as of
the end of the preceding plan year under all plans maintained by members of
the controlled group exceed $50 million (disregarding plans with no 
unfunded vested benefits); (2) the conditions for imposition of a lien (i.e
., required contributions totaling more than $1 million have not been 
made) have occurred with respect to an underfunded plan maintained by a 
member of the controlled group; or (3) minimum funding waivers in excess of
$1 million have been granted with respect to a plan maintained by any 
member of the controlled group and any portion of the waived amount is 
still outstanding. The PBGC may assess a penalty for a failure to provide
the required information in the amount of up to $1,000 a day for each day
the failure continues.\252\ 

In general, the contents of annual reports, statement, and other documents 
filed with the Department of Labor under the reporting and disclosure 
provisions of ERISA are generally public information that must be made 
available for public inspection.  Section 4010 information is exempt from 
disclosure under the Freedom of Information Act ("FOIA") and no such 
information or documentary materials may be made public, except as may be
relevant to an administrative or judicial action or proceeding.\253\

                             Description of Proposal

Form 5500, Schedule B actuarial statement

Under the proposal, a plan's ongoing liability, at-risk liability 
(regardless of whether the employer is financially weak),\254\ and the
market value of the plan assets are required to be 

----------------
/251/ ERISA sec. 4010

/252/ ERISA sec. 4071.

/253/ ERISA sec. 4010(c).

/254/ As discussed  connection with the proposal relating to funding rules
for single-employer defined benefit pension plans in Part IV.B.2, for a
plan sponsor that is not financially weak, the funding target is the 
plan's ongoing liability.  For a plan sponsor that is financially weak,
the funding target generally is the plan's at-risk liability.  In general,
a plan's ongoing liability for a plan year is the present value of future 
payments expected to be made from the plan to provide benefits earned as
of the beginning of the plan year.  At-risk liability is based on the same
benefits and assumptions as ongoing liability, except that the valuation of
those benefits would require the use of certain actuarial assumptions 
to reflect the concept that a plan maintained by a financially weak plan
sponsor may be more likely to pay benefits on an accelerated basis or to
terminate its plan.


reported in the actuarial report (i.e., the Schedule B) filed with the
plan's annual report. The proposal applies to all PBGC-covered, 
single-employer defined benefit pension plans.

In addition, if quarterly contributions are required with respect to a
plan covering more than 100 participants (i.e., a plan that has assets
less than the funding target as of the prior valuation date), the deadline
for the actuarial report is accelerated.  The actuarial report is due on 
the 15th day of the second month following the close of the plan year 
(February 15 for calendar year plans).  If any contribution is 
subsequently made for the plan year, the additional contribution is required
to be reflected in an amended Schedule B to be filed with the Form 5500.

Summary annual report

Under the proposal, the summary annual report provided to participants is
required to include information on the funding status of the plan for each 
of the last three years.  The funding status is required to be shown as a 
percentage based on the ratio of the plan's assets to its funding target.
Information on the employer's financial status and on the PBGC benefit 
guarantee must also be provided.  The proposal replaces the requirement of
notice to participants of underfunding\255\ with the summary annual report 
disclosure. 

The summary annual report must be provided to participants no later than 15
days after the due date for filing the plan's annual report.  A plan 
administrator that fails to provide a summary annual report on a timely 
basis is subject to a penalty.

Public disclosure of certain PBGC filings

The proposal eliminates the nondisclosure rules of section 4010(c) of 
ERISA, which exempt section 4010 information from disclosure under FOIA.
Under the proposal, section 4010 information can be made available to the 
public, except for confidential trade secrets and commercial or financial 
information protected under FOIA.

Effective date.-The proposal is effective for plan years beginning in 2006.
The proposal relating to elimination of the nondisclosure rules is effective 
with respect to filings made under section 4010 of ERISA on or after 30 
days after date of enactment.

                                 Analysis
In general

The proposal is intended to provide more detailed and timely information to
plan participants, government agencies, and the public regarding the 
financial status of pension plans and their sponsors and to make such 
information publicly available.  Participants should be adequately and 
timely informed about the security of their retirement benefits.  Many 
believe that the asset and liability measures under current law do not 
provide participants with an accurate and meaningful measure of a plan's
funding status.  They believe that present law does 

------------------
\255\ ERISA sec.4011.


not require adequate disclosure about a plan's funding status and does not
provide enough advance warning to participants of underfunding.  Thus, in
some cases, participants have learned of the extent of a plan's underfunding
only when
the plan terminated on an underfunded basis.  

Form 5500, Schedule B actuarial statement 

The proposal requires the Schedule B actuarial statement filed with the 
Form 5500 of all single-employer defined benefit pension plans to include
the market value of the plan's assets, ongoing liability, and at-risk 
liability.  This will provide participants greater information regarding 
the financial position of their pension plans, including the increased 
liability that will result if the financial condition of the plan sponsor 
deteriorates.  Some argue that if a plan sponsor is not financially weak,
the Form 5500 should only be required to include the liability applicable
to the plan (i.e., ongoing liability), rather than both ongoing and at-risk
liability.

In the case of plans that cover more than 100 participants and are subject
to the quarterly contributions requirement, the proposal accelerates the 
filing deadline for the Schedule B actuarial report to the 15th day of the
second month following the close of the plan year.  Thus, in the case of a 
calendar year plan, the due date is February 15. Proponents argue that this
will provide timely information on the financial situation of defined 
benefit pension plans.  Others may argue that the accelerated deadline does
not provide enough time for completion of the actuarial statement.  In 
the case of plans covering more than 100 participants, the funding 
proposal previously discussed requires the valuation date to be the first
day of the plan year.  In such case, the valuation date will be more than 
one year before the actuarial statement is due.

Summary annual report

The proposal requires the summary annual report to include the funding
status of the plan for each of the last three years.  The funding status 
must be shown as a percentage based on the ratio of the plan's assets to
its funding target.  Proponents believe that requiring disclosure of the 
plan's funding target, along with a comparison of that liability to the 
market value of assets, will provide participants more accurate and useful
information on the financial status of the plan. The proposal also requires
the summary annual report to include information on the company's 
financial health and on the PBGC guarantee.  The proposal is unclear as 
to what information would be required to show the company's financial 
health.

The proposal requires that the summary annual report be provided to 
participants and beneficiaries by 15 days after the filing date for the 
Form 5500.  A penalty is imposed for failure to furnish a summary annual 
report in a timely manner.  Specific information regarding the penalty is 
unclear.  The proposal eliminates the participant notice requirement under
section 4011, as the proposal assumes that the summary annual report 
disclosure will provide more accurate and timely information.

Public disclosure of certain PBGC filings

Eliminating the nondisclosure rules of ERISA section 4010(c) allows section
4010 information to be available to the public, with the exception of 
confidential trade secrets and commercial or financial information 
protected under FOIA.  By eliminating the nondisclosure rule, the proposal 
is intended to provide more public information on the financial status of 
pension plans and plan sponsors.  The proposal is intended to provide 
greater information to participants so that they know when their plan is 
underfunded or when the plan sponsor's financial condition may impair the 
ability of the company to maintain or fund the plan.

Under the proposal,information disclosed to the PBGC generally is subject 
to the present-law FOIA provisions.  FOIA provides that commercial or 
financial information that is required to be submitted to the Government is
protected from disclosure if it is privileged or confidential.   Some argue
that FOIA's commercial and financial information exception provides 
adequate protection for confidential business information. Others believe 
that certain financial information outside of the scope of the exception 
should remain confidential.

Public availability of financial information will allow participants and 
the public more transparency as to the true financial picture of pension 
plans.  The proposal is similar to certain securities laws that require 
public disclosure of material financial information.  Proponents argue 
that public disclosure of financial information results in greater scrutiny
and accountability without requiring the draining of government resources.
Some consider public disclosure to be a securities law issue, rather than a
pension law issue.  Others are concerned that shortfalls in the PBGC 
insurance program could ultimately become taxpayers' responsibility, so
that public disclosure under the pension laws is appropriate. 

Some argue that greater public availability is inappropriate as some 
participants may not have the financial sophistication to appropriately 
evaluate such information.  They also argue that because the pension system
is voluntary, additional requirements on plans and plan sponsors, 
particularly small employers, may result in some sponsors discontinuing
plan sponsorship.

                               Prior Action
                               
A similar proposal was included in the President's fiscal year 2006 budget
proposal.

H.R. 2830 (the "Pension Protection Act of 2005"), as passed by the House, 
and S. 1783,(the "Pension Security and Transparency Act of 2005"), as 
passed by the Senate, both include provisions relating to reporting and 
disclosure requirements with respect to single-employer defined benefit 
pension plans.

4.  Treatment of grandfathered floor-offset plans

                                 Present Law
                                 
ERISA generally prohibits defined benefit pension plans from acquiring
employer securities or employer real property if, after the acquisition, 
more than 10 percent of the assets of the plan would be invested in

-----------------------
\256\ The exception for trade secrets and commerical or financial 
information also applies for purposes of the Code rule allowing public
inspection of written determinations. Sec.6110(c)(4).



employer securities or employer real property.\257\ This 10-percent 
limitation generally does not apply to most defined contribution plans.

A floor offset arrangement is an arrangement under which benefits payable 
to a participant under a defined benefit pension plan are reduced by 
benefits under a defined contribution plan.  The defined benefit pension 
plan provides the "floor" or minimum benefit which is offset or reduced by
the annuitized benefit under the defined contribution plan
\258\

Pursuant to the Pension Protection Act of 1987, the 10-percent limitation 
on the acquisition of employer securities and employer real property 
applies to a defined contribution plan that is part of a floor-offset 
arrangement, unless the floor offset arrangement was established 
on or before December 17, 1987.  Thus, for floor-offset plans established 
after that date, the 10-percent limit applies on an aggregated basis to the
combined assets of the defined benefit pension plan and the defined 
contribution plan that form the arrangement.

An employee stock ownership plan (an "ESOP") is an individual account plan
that is designed to invest primarily in employer securities and which meets
certain other requirements. ESOPs are not subject to the 10-percent limit 
on the acquisition of employer securities, unless the ESOP is part of a 
floor-offset arrangement.

                            Description of Proposal

The exception to the 10-percent limit on holding employer securities and 
employer real property for floor-offset plans established on or before 
December 17, 1987, is eliminated.  Floor-offset arrangements affected by 
the proposal are required to reduce their holdings of employer real 
property and employer securities to no more than 10 percent of the combined
assets of both plans over a period of seven years.  The requirement to 
dispose of such property will be phased in pursuant to regulations.

Effective date.--The proposal is effective for plan years beginning after 
2005

                                  Analysis
                                  
The present-law 10-percent limit on holding employer securities and real 
property reflects the concern that assets in defined benefit plans should 
be adequately diversified and that allowing such plans to hold significant
amounts of assets that rely on the financial status of the employer 
creates a greater risk that the plan will become underfunded in the event 
of employer financial distress and that benefits under the plan will become
the obligation of the PBGC.  The potential problems with such arrangements 
are illustrated by the recent experience with Enron

---------------
\257\ ERISA sec.407.

\258\ ERISA uses te term "individual account plan" to refer to defined
contribution pans. Money purchase pension plans (a type of defined
contribution plan) are subject to the 10-percent limitation unless the plan
was established before ERISA. Special rules apply with respect to certain
plans to which elective deferrals ae made.


Corporation, which maintained a grandfathered floor-offset arrangement.The
proposal Thus, all floor-offset plans will be subject to the same rules 
under the addresses this concern by eliminating the grandfather for such
arrangements proposal.  The proposal recognizes that it may take some time
for a plan to dispose of affected property by allowing a seven-year period 
for plans to comply.

                                 Prior Action
                                 
A similar proposal was included in the President's fiscal year 2006 budget
proposal.

5  Limitations on plans funded below target levels 

                                   Present Law
In general

Under present law, various restrictions may apply to benefit increases and 
distributions from a defined benefit pension plan, depending on the funding 
status of the plan 

Funding waivers

Within limits, the IRS is permitted to waive all or a portion of the 
contributions required under the minimum funding standard for a plan 
year.\260\ A waiver may be granted if the employer (or employersnbn)
responsible for the contribution could not make the required contribution
without temporary substantial business hardship and if requiring the 
contribution would be adverse to the interests of plan participants in the
aggregate. Generally, no more than three waivers may be granted within any
period of 15 consecutive plan years.

If a funding waiver is in effect for a plan, subject to certain exceptions,
no plan amendment may be adopted that increases the liabilities of the plan 
by reason of any increase in benefits, any change in the accrual of 
benefits, or any change in the rate at which benefits vest under the
plan.\261\

Security for certain plan amendments

If a plan amendment increasing current liability is adopted and the plan's
funded current liability percentage is less than 60 percent (taking into 
account the effect of the amendment, but disregarding any unamortized 
unfunded old liability), the employer and members of the employer's 
controlled group must provide security in favor of the plan.  The amount

-----------------
\259\ Enron's floor-offset plan and related issues are discussed in Joint
Committee on Taxation, Report of Investigation of Enron Corporation and
Compensaation Issues, and Policy Recommendations (JCS-3-03), February
2003, at 458-75.

\260\ Code Sec. 412(d);ERISA sec.303.

\261\ Code sec. 412(f);ERISA sec.304(b)(1).



of security required is the excess of:  (1) the lesser of (a) the amount by
which the plan's assets are less than 60 percent of current liability, 
taking into account the benefit increase, or (b) the amount of the 
benefit increase and prior benefit increases after December 22, 1987, over
(2) $10 million  The amendment is not effective until the security is
provided.

The security must be in the form of a bond, cash, certain U.S. government 
obligations, or such other form as is satisfactory to the Secretary of the
Treasury and the parties involved. The security is released after the 
funded liability of the plan reaches 60 percent.

Prohibition on benefit increases during bankruptcy

Subject to certain exceptions, if an employer maintaining a plan (other 
than a multiemployer plan) is involved in bankruptcy proceedings, no plan
amendment may be adopted that increases the liabilities of the plan by 
reason of any increase in benefits, any change in the accrual of benefits,
or any change in the rate at which benefits vest under the plan. 

Liquidity shortfalls

In the case of a plan with a funded current liability percentage of less 
than 100 percent for the preceding plan year, estimated contributions for
the current plan year must be made in quarterly installments during the 
current plan year.  If quarterly contributions are required with 
respect to a plan, the amount of a quarterly installment must also be 
sufficient to cover any shortfall in the plan's liquid assets (a "liquidity
shortfall").   In general, a plan has a liquidity shortfall for a quarter
if the plan's liquid assets (such as cash and marketable securities) are
less than a certain amount (generally determined by reference to 
disbursements from the plan in the preceding 12 months).

If a quarterly installment is less than the amount required to cover the 
plan's liquidity shortfall,limits apply to the benefits that can be paid 
from a plan during the period of underpayment.\264\ During that period,
the plan may not make:  (a) any payment in excess of the monthly amount
paid under a single life annuity (plus any social security supplement 
provided under the plan) in the case of a participant or beneficiary whose
annuity starting date occurs during the period; (b) any payment for the
purchase of an irrevocable commitment from an insurer to pay benefits
(e.g., an annuity contract); or (c) any other payment specified by the
Secretary of the Treasury by regulations.

Nonqualified deferred compensation

Qualified retirement plans, including defined benefit pension plans, 
receive tax-favored treatment under the Code. A deferred compensation 
arrangement that is not eligible for tax-favored treatment is generally 
referred to as a nonqualified deferred compensation 

--------------------
\262\ Code sec. 401(a)(29);ERISA sec.307.

\263\ Code sec. 401(a)(33);ERISA sec.204(i).

\264\ Code sec. 401(a)(32);ERISA sec.206(e)


arrangement.\265\ In general,a nonqualified deferred compensation 
arrangement is exempt from the requirements of ERISA only if it is
maintained primarily for the purpose of providing deferred compensation
for a select group of management or highly compensated employees.  As a
result, nonqualified deferred compensation arrangements generally cover
only higher-paid employees, such as executives.


Nonqualified deferred compensation arrangements may be merely unfunded
contractual arrangements or the employer may establish a trust tohold
assets from which nonqualified deferred compensation payments will be 
made.  In some cases, even though trust assets are generally not available
for purposes other than to provide nonqualified deferred compensation,
the terms of the trust provide that the assets are subject to the claims
of the employer's creditors in the case of insolvency or bankruptcy. Such
an arrangement is referred to as a "rabbi" trust, based on an IRS ruling
issued with respect to such an arrangement covering a rabbi

Amounts deferred under a nonqualified deferred compensation plan for all 
taxable years are currently includible in gross income to the extent not 
subject to a substantial risk of forfeiture and not previously included in
gross income, unless certain requirements are satisfied.\266\  In addition, 
certain arrangements involving assets transferred or set aside to provide
benefits under a nonqualified deferred compensation plan are treated as a
transfer of property in connection with the performance of services, 
resulting in income inclusion.  If the requirements applicable to 
nonqualified deferred compensation plan are not satisfied, in addition
to current income inclusion, interest applies at the underpayment rate 
plus 1 percentage point and the amount required to be included in income
is subject to a 20-percent additional tax.

                             Description of Proposal
                             
Restrictions on benefit increases

Under the proposal, the present-law rule prohibiting amendments that 
increase benefits while the employer is in bankruptcy continues to apply.
The present-law rule requiring security for amendments that increase 
benefits and result in a funded current liability percentage of less 
than 60 percent is replaced with a new rule.  Under the new rule, if the 
plan's funding percentage (i.e., the market value of the plan's assets as
a percentage of the plan's funding target,determined as of the plan's
valuation date) does not exceed 80 percent, any amendment increasing 
benefits is prohibited unless, in addition to the otherwise required 
minimum contribution, the employer contributes the amount of the increase
in the plan's funding target attributable to the amendment.  If the plan's
funding percentage exceeds 80 percent, but was less than 100 percent for
the preceding plan year, an amendment that increases benefits and reduces 
the plan's funding percentage to less than 80 percent is prohibited unless,
in addition to the otherwise required minimum contribution, the employer 
contributes the lesser of: (1) the amount of the increase in the plan's 
funding target attributable to the amendment; or (2) the amount 

------------------
\265\ Rules governing nonqualified deferred compensation arrangements
are contained in Code section 409A.

\266\ Sec. 409A.


needed to increase the plan's funding percentage to 80 percent.If the 
plan's funding percentage is at least 100 percent, amendments increasing 
benefits are not restricted.  In addition, the restrictions do not apply 
for the first five years after a plan is established.

Restrictions on distributions and accruals

Under the proposal, the restrictions on distributions during a period of a
liquidity shortfall continue to apply (i.e., only annuity payments are 
permitted).  In addition, such restrictions apply if: (1) the plan's 
percentage does not exceed 60 percent; (2) in the case of a financially
weak employer, the plan's funding percentage does not exceed 80 percent; 
or (3) the employer is in bankruptcy and the plan's funding percentage is
less than 100 percent.In addition, no benefit accruals are permitted if
: (1) the employer is financially weak and the plan's funding percentage 
does not exceed 60 percent (i.e., the plan is "severely underfunded"); or 
(2) the employer is in bankruptcy and the plan's funding percentage is less
than 100 percent.

Prohibition on funding nonqualified deferred compensation

Under the proposal, if a financially weak employer maintains a severely 
underfunded plan, ERISA prohibits the funding of nonqualified deferred 
compensation for top executives of the employer's controlled group (or any
former employee who was a top executive at the time of termination of 
employment). The proposal also prohibits any funding of executive 
compensation that occurs within six months before or after the termination
of a plan, the assets of which are less than the amount needed to provide
all benefits due under the plan.  For this purpose, funding includes the
use of an arrangement such as a rabbi trust, insurance contract, or other
mechanism that limits immediate access to resources of the employer by the
employer or by creditors.  However, the prohibition on funding nonqualified
deferred compensation does not apply for the first five years after a plan 
is established. 

Under the proposal, an employer maintaining a severely underfunded or 
terminating plan must notify fiduciaries of the plan if any prohibited 
funding of a nonqualified deferred compensation arrangements occurs.  
The proposal provides plan fiduciaries with the right to examine the 
employer's books and records to ascertain whether the employer has met its
obligation in this regard.

Under the proposal, a plan has a cause of action under ERISA against any
top executive whose nonqualified deferred compensation arrangement is 
funded during a period when funding is prohibited.  The proposal permits 
the plan to recover the funded amount plus attorney's fees.  
Plan fiduciaries have the duty to take reasonable steps to pursue the cause
of action provided under the proposal.

Timing rules for restrictions

Under the proposal, certain presumptions apply in determining whether 
restrictions apply with respect to a plan, subject to certifications 
provided by the plan actuary.  If a plan was subject to a restriction for
the preceding year, the plan's funding percentage is presumed not to 
have improved in the current year until the plan actuary certifies that the
plan's funding percentage for the current year is such that the restriction
does not apply.  If a plan was not subject to a restriction for the
preceding year, but its funding percentage did not exceed the restriction 
threshold by more than 10 percentage points, the plan's funding percentage
is presumed to be reduced by 10 percentage points as of the first day of 
the fourth month of the current plan year.  As a result, the restriction 
applies as of that day and until the plan actuary certifies that the 
plan's funding percentage for the current year is such that the restriction
does not apply.  In any other case, if an actuarial certification is not 
made by the first day of the tenth month of the plan year, as of that day 
the plan's funding percentage is presumed not to exceed 60 percent for 
purposes of the restrictions.

If the employer maintaining a plan enters bankruptcy, the plan's funding 
percentage is presumed to be less than the plan's funding target. As a 
result, no benefit accruals are permitted until the plan actuary certifies
that the plan's funding percentage is at least 100 percent

For purposes of the timing rules, the actuary's certification must be 
based on information available at the time of the certification regarding 
the market value of the plan's assets and the actuary's best estimate of
the plan's funding target as of the valuation date for the current plan 
year. If the actuary determines that the plan's funding percentage using 
the plan's actual funding target causes a change in the application of 
restrictions, the actuary must notify the plan administrator of the change.

Notice to participants

If a restriction applies with respect to a plan (including a plan 
maintained by an employer that enters bankruptcy), the plan administrator 
must provide notice of the restriction to affected participants within a 
reasonable time after the date the restriction applies (or, to the extent 
provided by the Secretary of Labor, a reasonable period of time before the
restriction applies) Notice must also be provided within a reasonable 
period of time after the date the restriction ceases to apply.  A plan
administrator that fails to provide the required notice is subject to a 
penalty.  The Secretary of Labor is authorized to prescribe regulations 
relating to the form,content, and timing of the notice.

Restoration of benefits

If restrictions on distributions and accruals apply with respect to plan, 
distributions and accruals may resume in a subsequent plan year only by a 
plan amendment.  Such an amendment may be adopted at any time after the 
first valuation date as of which the plan's funding percentage exceeds 
the applicable threshold, subject to applicable restrictions on plan 
amendments that increase benefits.  In addition, benefits provided under
the amendment are subject to the phase-in of the PBGC guarantee of benefit
increases.

Effective date.-The proposals are generally effective for plan years 
beginning after December 31, 2007.  In the case of a plan maintained 
pursuant to a collective bargaining agreement in effect on the date of 
enactment, the proposals are not effective before the first plan 
year beginning after the earlier of: (1) the date the collective bargaining
agreement terminates (determined without regard to any extension thereof); 
or (2) December 31, 2009.

                                Analysis
                                
Underfunded plans, particularly those maintained by employers experiencing
financial problems, pose the risk that the plan will terminate and the 
employer will be unable to provide the additional assets needed to provide
the benefits due under the plan (a distress termination). In some cases,
because of the limit on the PBGC benefit guarantee, employees bear the cost
of underfunding through the loss of benefits. In addition, the PBGC bears 
the cost of the shortfall to the extent plan assets are insufficient to 
provide guaranteed benefits.

Providing benefit increases under an unfunded plan increases these costs.
In addition, the payment of lump sums and similar forms of benefit to some
participants drains assets from the plan, thus increasing the cost to the 
PBGC and other participants.  Cases have also arisen in which assets were 
used to provide nonqualified deferred compensation to corporate executives 
shortly before bankruptcy and the termination of an underfunded plan 
covering rank and file employees.  The proposal is intended to address 
these situations by restricting benefit increases,lump sums and similar
forms of distribution, and the funding of nonqualified deferred 
compensation in the case of underfunded plans.  Under the proposal, the 
extent of the restrictions depends on the funding status of the plan and, 
in some cases, whether the employer is financially weak or has entered 
bankruptcy.

Some view such restrictions as an appropriate means of limiting the risk
presented by underfunded plans.  Others may consider some of the 
restrictions (such as the restriction on lump sums) as unfairly penalizing 
plan participants and potentially disrupting their retirement income 
arrangements.  Some also suggest that the prospect of being unable to 
receive lump-sum distributions may itself cause employees to elect lump 
sums while they are still available, thus triggering a drain on plan 
assets. On the other hand, some consider it unfair to allow participants 
to rely on benefits that might never be paid and to favor some participants
over others.

With respect to the restriction on funding nonqualified deferred 
compensation, some may consider it inappropriate to target assets
used for that particular purpose without targeting assets used for other 
purposes.  Some also argue that companies in financial difficulty should be
able to use competitive compensation methods, including funding methods
under which assets will be available to creditors in the event of 
bankruptcy or insolvency, such as a rabbi trust.  Others believe that such
funding methods provide executives with the opportunity to cash out their 
nonqualified deferred compensation before an employer enters bankruptcy,
thus giving executives an unfair advantage over rank-and-file participants.
Some may also consider it inappropriate to allow a plan to bring action 
against the executive rather than against the employer.  On the other hand,
the proposal applies only in the case of a "top" executive.  Although the
concept of top executive is not defined, it suggests that the proposal is
aimed at company officials who have the authority to decide whether to 
adequately fund the employer's defined benefit pension plan or instead to 
fund nonqualified deferred compensation benefits.


                            Prior Action

Similar proposals were included in the President's fiscal year 2005 and 
2006 budget proposals.

H.R. 2830 (the "Pension Protection Act of 2005"), as passed by the House, 
and S. 1783, (the "Pension Security and Transparency Act of 2005"), as 
passed by the Senate, both include provisions relating to benefit 
limitations applicable to underfunded single-employer defined benefit 
pension plans.

6.  Eliminate plant shutdown benefits

                                 Present Law
                                    
Unpredictable contingent event benefits

A plan may provide for unpredictable contingent event benefits, which are 
benefits that depend on contingencies other than age, service, 
compensation, death or disability or that are not reliably and reasonably 
predictable as determined by the Secretary.  Some of these benefits are 
commonly referred to as "plant shutdown" benefits.  Under present law, 
unpredictable contingent event benefits generally are not taken into 
account for funding purposes until the event has occurred.

Early retirement benefits

Under present law, defined benefit pension plans are not permitted to 
provide "layoff" benefits (i.e., severance benefits).\267\ However, defined 
benefit pension plans may provide subsidized early retirement benefits, 
including early retirement window benefits.\268\

Prohibition on reductions in accrued benefits

An amendment of a qualified retirement plan may not decrease the accrued 
benefit of a plan participant.  This restriction is sometimes referred to 
as the "anticutback" rule and applies to benefits that have already
accrued.\269\  In general, an amendment may reduce the amount of future
benefit accruals,provided that, in the case of a significant reduction 
in the rate of future benefit accrual, certain notice requirements are met.

For purposes of the anticutback rule, an amendment is also treated as 
reducing an accrued benefit if, with respect to benefits accrued before the
amendment is adopted, the amendment has the effect of either 
(1) eliminating or reducing an early retirement benefit or a 
retirement-type subsidy, or (2) except as provided by Treasury regulations,
eliminating an optional form of benefit.  This protection applies to 
participants who satisfy, either before or after the plan amendment, the
pre-amendment conditions for the benefit, and even if the condition on 
which eligibility for the benefit depends is an unpredictable event such 
as a plan shutdown.\270\ 

PBGC benefit guarantee 

Within certain limits, the PBGC guarantees any retirement benefit that was
vested on the date of plan termination (other than benefits that vest 
solely on account of the termination), and any survivor or disability 
benefit that was owed or was in payment status at the date of plan 
termination.   Generally only that part of the retirement benefit that is
payable in monthly installments (rather than, for example, lump sum 
benefits payable) is guaranteed.\ 272\

Retirement benefits that begin before normal retirement age are guaranteed,
provided they meet the other conditions of guarantee (such as that, before
the date the plan terminates, the participant had satisfied the conditions 
of the plan necessary to establish the right to receive the benefit other 
than application for the benefit). Contingent benefits (for example, 
early retirement benefits provided only if a plant shuts down) are 
guaranteed only if the triggering event occurs before plan termination.

In the case of a plan or a plan amendment that has been in effect for less
than five years before a plan termination, the amount guaranteed is 
phased in by 20 percent a year.

                           Description of Proposal
                           
Prohibition on providing unpredictable contingent event benefits

Under the proposal, plans are not permitted to provide benefits that are 
payable upon a plant shutdown or any similar unpredictable contingent event
as determined under regulations. A plan that contains such a benefit is 
required to eliminate the benefit, but only with respect to an event that
occurs after the effective date.  Such a plan amendment is deemed not to 
violate the anticutback rule.

Effective date.--The prohibition on providing unpredictable contingent 
event benefits generally is effective for plan years beginning in 2008.
In the case of a collective bargaining agreement that provides for an 
unpredictable contingent event benefit on February 1, 2006, the prohibition
on unpredictable contingent event benefits is not effective before the end 
of the term of that agreement (without regard any to extension of the 
agreement) or, if earlier, the first plan year beginning in 2009.

Elimination of PBGC guarantee

The proposal amends the guarantee provisions of Title IV of ERISA to 
provide that the PBGC guarantee does not apply to benefits that are payable
upon a plant shutdown or any similar contingent event.

-----------------
\271\ ERISA sec.4022(a).

\272\ ERISA sec.4022(b) and (c).

Effective date.--The elimination of the PBGC guarantee is effective for 
benefits that become payable as a result of a plant shutdown or similar 
contingent event that occurs after February 1, 2006.



                                  Analysis
                                  
                                      
Benefits for plant shutdowns and similar unpredictable contingent events 
and the PBGC guarantee of such benefits present many issues, including the
lack of funding of the benefits and their nature as retirement or 
severance-type benefits. These issues are relevant with respect to the
proposals to eliminate such benefits and the PBGC guarantee.

Unlike most benefits under a defined benefit pension plan, plant shutdown
benefits may be predictable only a short while before the shutdown occurs,
to the extent that they can be predicted at all.  On the other hand, some 
shutdowns may be the result of business decisions. Notwithstanding, under
the funding rules, a plan's liabilities for plant shutdown benefits 
generally remain unfunded until the triggering contingency occurs.  After
the contingency occurs, the liabilities may be funded over a period of 
years.  In some cases, contingencies may be followed by the employer's 
insolvency, making it difficult for employers to fully fund the triggered 
benefits.  Additionally, the departure of employees from the company may 
follow a shutdown or other contingency.  Many such employees may take 
distributions from the plan,thereby draining assets from the plan.  If
the plan later terminates, assets might not be sufficient to provide the
benefits due other plan participants. In addition, the PBGC may be left 
with increased unfunded liabilities as a consequence of the shutdown and 
the related benefits.  Thus, plant shutdown benefits may significantly 
increase the underfunding taken on by the PBGC. 
Some argue that liabilities for such benefits make up a significant 
percentage of PBGC losses.

Some view plant shutdown benefits as severance-type benefits which should 
not be provided under a retirement plan.  Plant shutdown benefits may, 
however, be considered a variety of subsidized early retirement benefits,
similar to early retirement window benefits which are provided as an 
incentive for employees to voluntarily terminate employment.  Some believe 
that it is appropriate for a defined benefit pension plan to provide such
benefits to employees whose employment is involuntarily terminated.  They
argue that concerns about the effect of such benefits on funding status 
and PBGC liability can be addressed by providing rules under which these
benefits are taken into account in determining required contributions and
limiting the PBGC guarantee, rather than prohibiting plans from providing
the benefits.

Others argue that plant shutdown benefits that are promised to participants
under the terms of a plan should be guaranteed by the PBGC like any other 
benefits under the plan.  Plant shutdown benefits may represent a 
significant portion of a participant's benefits under a plan
Moreover, unlike some other types of benefits subject to contingent events,
plant shutdown benefits may be intertwined with the employer's financial 
well-being.  Some feel that eliminating the PBGC guarantee applicable to 
plant shutdown benefits might further disadvantage plan participants who 
are experiencing the effects of their employer's troubled financial status.
As an alternative, some suggest that, rather than eliminating the PBGC 
guarantee, the occurrence of an event giving rise to unpredictable 
contingent event benefits could be treated as a plan amendment, so that 
the PBGC guarantee of such benefits is phased in over five years.

                                  Prior Action
                                  
A similar proposal was included in the President's fiscal year 2006 budget
proposal.

H.R. 2830 (the "Pension Protection Act of 2005"), as passed by the House, 
and S. 1783,(the "Pension Security and Transparency Act of 2005"), as passed
by the Senate, both include provisions relating to plant shutdown and 
similar benefits provided under single-employer defined benefit pension
plans.
7.  Proposals relating to the Pension Benefit Guaranty Corporation ("PBGC")

(a)  Single-employer plan premiums that reflect risk


                                  Present Law
                                  
In general

The minimum funding requirements permit an employer to fund defined benefit
pension plan benefits over a period of time.  Thus, it is possible that a 
plan may be terminated at a time when plan assets are not sufficient to 
provide all benefits accrued by employees under the plan.  
In order to protect plan participants from losing retirement benefits in
such circumstances, the PBGC, a corporation within the Department of Labor,
was created in 1974 under ERISA to provide an insurance program for 
benefits under most defined benefit pension plans maintained by private 
employers. 

Premiums paid to the PBGC 

The PBGC is funded by assets in terminated plans, amounts recovered from
employers who terminate underfunded plans, premiums paid with respect to 
covered plans, and investment earnings.  Single-employer plans covered by
the PBGC insurance program are required to pay a flat-rate per participant 
premium.  Underfunded plans are subject to an additional variable-rate 
premium based on the level of underfunding.  In addition, as discussed 
below, additional termination premiums apply in certain circumstances if a
plan terminates on an underfunded basis.

Beginning in 1991, the flat-rate premium was $19 per participant.   Under
the Deficit Reduction Act of 2005,  for plan years beginning after 2005, 
the flat-rate premium is increased to $30, with indexing after 2006 based 
on increases in average wages.

In the case of an underfunded plan, variable-rate premiums are required in
the amount of $9 per $1,000 of unfunded vested benefits (the amount which 
would be the unfunded current liability if only vested benefits were taken 
into account and if benefits were valued at the variable premium interest 
rate).   No variable-rate premium is imposed for a year if contributions to
the plan for the prior year were at least equal to the full funding limit 
for that year. 

Under the Deficit Reduction Act of 2005, a new premium generally applies in
the case of certain plan terminations occurring after 2005 and before 2011.
A premium of $1,250 per participant is imposed generally for the year of 
the termination and each of the following 2 years. The premium applies in 
the case of a plan termination by the PBGC or a distress termination due 
to reorganization in bankruptcy, the inability of the employer to pay its 
debts when due, or a determination that a termination is necessary to 
avoid unreasonably burdensome pension costs caused solely by a decline in
the workforce.  In the case of a termination due to reorganization, 
the liability for the premium does not arise until the employer is 
discharged from the reorganization proceeding.  The premium does not apply
with respect to a plan terminated during bankruptcy reorganization 
proceedings pursuant to a bankruptcy filing before October 18, 2005.

Interest on premium payments

If any premium required to be paid to the PBGC is not paid by the last 
date prescribed for a payment, interest on the amount of such premium is 
charged at the rate imposed on underpayment, nonpayment, or extensions of 
time for payment of tax  for the period from such date to the date paid.
The PBGC is not authorized to pay interest on premium overpayments.


                       Description of Proposal
                       
Under the proposal, variable rate premiums are replaced by risk-based 
premiums, which are charged to all plans with assets less than their 
funding target (i.e., ongoing liability or at-risk liability, depending
on the financial status of the plan sponsor).  The risk-based premium is 
set by the PBGC, and adjusted by the PBGC, based on forecasts of the PBGC's
expected claims and future financial condition.  The premium rate per 
dollar of underfunding is uniform for all plans. A plan with a 
financially-weak sponsor is required to pay premiums for each dollar of 
unfunded at-risk liability, while a financially-healthy sponsor is required
to pay premiums for each dollar of unfunded ongoing liability.  The
full-funding exception is eliminated so that all underfunded plans are 
required to pay risk-based premiums.  The proposal also authorizes the PBGC
to pay interest on premium overpayments.

Effective date.-- The proposal is effective for plan years beginning on or
after January 1,2006.

                                Analysis
Risk-based premiums

ERISA requires the pension insurance system to be self-financed, i.e., it 
is not funded by general revenues. The PBGC's principal sources of revenue
are premiums collected from PBGC-covered plans, assets assumed from 
terminated plans, collection of employer liability payments due under ERISA,
and investment income 

The present-law variable rate premium is intended to reflect the greater 
potential risk of exposure from underfunded plans.  The variable rate 
premium is also believed to provide an incentive to plan sponsors to better
fund their plans.  However, the current premium structure is described by 
the Administration as resulting in the shifting of costs from 
financially-troubled companies to healthy companies with adequately-funded 
plans, owing to the overdependence on flat-rate premiums and lack of 
appropriate risk-based premiums.

The proposed risk-based premiums are intended to better correlate with the 
risk a plan poses to the pension insurance system because they are based on
a more accurate measure of underfunding and reflect the financial condition
of the plan sponsor's controlled group.  The periodic adjustment of premium
rates, based on the PBGC's expected claims and future financial condition,
is intended to more accurately reflect the cost of the PBGC program by 
providing the funds necessary to meet expected future claims and to retire 
PBGC's deficit over a reasonable time period.

Some express concerns, however, that the proposed risk-based premiums
would make financially unstable employers, and those in bankruptcy, liable
for substantial premium increases if their plans are not fully funded.
An increase in premiums may be a source of volatility and burden for 
companies struggling to recover from financial hardships. These issues are
similar to the issues raised with respect to basing funding requirements 
on the financial condition of the employer and are discussed in more detail
above

Additionally, some feel that it is not appropriate for the PBGC to set and 
adjust the risk-based premium, based on forecasts of its expected claims 
and future financial condition.  It may be viewed as more appropriate for
the amount of, and increases, in premiums to be determined by Congressional
action. 

The proposal repeals the present-law exception to variable-rate premiums 
for plans at the full funding limit.  According to the PBGC, some of the 
companies maintaining plans that have resulted in the largest claims 
against the PBGC insurance fund have not been required to pay a variable 
rate premium because they were at the full funding limit.\280\ Imposing the 
risk-based premium on all plans, without a full funding limit exception,
will subject more plans to the premium compared to the present-law variable
rate premium.  The present-law exception for plans at the full funding 
limit reflects concerns that it may be unfair to impose the premium on 
employers making contributions as required under the funding rules, even
if the plan remains underfunded.  Under the proposal, contributions to 
eliminate underfunding are fully deductible so that an employer may avoid
the risk-based premium by making sufficient contributions to eliminate 
underfunding.  In some cases, however, the amount of contributions required
to eliminate underfunding could be substantial.

Some raise the concern that variable-rate premium increases, in addition to
the recent increase in flat-rate premiums, may cause more employers to 
freeze their plans.  Because sponsoring a retirement plan for employees is 
voluntary, if the burden of sponsoring a plan becomes too onerous, in part 
because burdensome premium payments are required, more companies may freeze
or terminate defined benefit pension plans.  Further, companies 
considering whether to establish a defined benefit pension plan may be
discouraged from doing so by increased premium costs.

The PBGC premium proposal is one part of the President's overall proposal 
to increase defined benefit pension plan security.  Some feel that improved
funding rules will adequately address underfunding issues and that better 
funding rules should be enacted and the effects of those rules should be 
determined before additional premium increases are adopted.

Interest on premium overpayments

Some believe that premium payers should receive interest on premium 
overpayment amounts that are owed to them.  Others feel that it is 
inappropriate for the PBGC to pay interest and that providing for such 
interest may further impair the financial condition of the PBGC.  
Some argue that interest may not be appropriate in some cases, depending
on how the overpayment arose.  

                                 Prior Action
                                 
A similar proposal was included in the President's fiscal year 2006 budget
proposal.

H.R. 2830 (the "Pension Protection Act of 2005"), as passed by the
House, and S. 1783, (the "Pension Security and Transparency Act of 2005"), 
as passed by the Senate, both include provisions relating to PBGC premiums.



---------------
\280\ Testimony of Bradley D.Belt,Executive Director, Pension Benefir
Guarantee Corporation, before the Committee on Finance, United States
Senate (March 1, 2005) at 15.


(b)  Freeze benefit guarantee when contributing sponsor enters bankruptcy


                                 Present Law
                                 
Termination of single-employer defined benefit pension plans

 In general

An employer may voluntarily terminate a single-employer plan only in a 
standard termination or a distress termination.\281\ The participants
and the PBGC must be provided notice of the intent to terminate. The PBGC
may also involuntarily terminate a plan (that is, the termination is not
voluntary on the part of the employer).

Standard terminations

A standard termination is permitted only if plan assets are sufficient to 
cover benefit liabilities.  Generally, benefit liabilities equal all 
benefits earned to date by plan participants, including vested and 
nonvested benefits (which automatically become vested at the time of 
termination), and including certain early retirement supplements and 
subsidies.  Benefit liabilities may also include certain contingent 
benefits (for example, early retirement subsidies).  
If assets are sufficient to cover benefit liabilities (and other 
termination requirements, such as notice to employees, are met), 
the plan distributes benefits to participants.  The plan provides for 
the benefit payments it owes by purchasing annuity contracts from an 
insurance company, or otherwise providing for the payment of benefits,
for example, by providing the benefits in lump-sum distributions.

If certain requirements are satisfied, and the plan so provides, assets in
excess of the amounts necessary to cover benefit liabilities may be 
recovered by the employer in an asset reversion.  Reversions are generally
subject to an excise tax, described above.

Distress terminations and involuntary terminations by the PBGC

Distress terminations

If assets in a defined benefit pension plan are not sufficient to cover
benefit liabilities, the employer may not terminate the plan unless the
employer meets one of four criteria necessary for a ''distress'' 
termination:

     The contributing sponsor, and every member of the controlled group
     of which the sponsor is a member, is being liquidated in bankruptcy or
     any similar Federal law or other similar State insolvency proceedings;
     
     
--------------------
\281\ERISA sec.4041.

\282\ ld.

\283\ ERISA sec.4001(a)(16)


     The contributing sponsor and every member of the sponsor's controlled
     group is being reorganized in bankruptcy or similar State proceeding;
     
     The PBGC determines that termination is necessary to allow the 
     employer to pay its debts when due; or 
     
     The PBGC determines that termination is necessary to avoid 
     unreasonably burdensome pension costs caused solely by a decline in 
     the employer's work force.
     
These requirements are designed to ensure that the liabilities of an 
underfunded plan remain the responsibility of the employer, rather than of
the PBGC, unless the employer meets strict standards of financial need 
indicating genuine inability to continue funding the plan.

Involuntary terminations by the PBGC

The PBGC may institute proceedings to terminate a plan if it determines 
that the plan in question has not met the minimum funding standards, will 
be unable to pay benefits when due,has a substantial owner who has 
received a distribution greater than $10,000 (other than by reason of 
death) while the plan has unfunded nonforfeitable benefits, or may 
reasonably be expected to increase PBGC's long-run loss unreasonably. 
The PBGC must institute proceedings to terminate a plan if the plan is 
unable to pay benefits that are currently due.

Asset allocation

ERISA contains rules for allocating the assets of a single-employer plan 
when the plan terminates.\285\ Plan assets available to pay for benefits
under a terminating plan include all plan assets remaining after
subtracting all liabilities (other than liabilities for future benefit
payments), paid or payable from plan assets under the provisions of the
plan.  On termination, the plan administrator must allocate plan assets 
available to pay for benefits under the plan in the manner prescribed by
ERISA.  In general, plan assets available to pay for benefits under the 
plan are allocated to six priority categories.\ 286\ If the plan has
sufficient assets to pay for all benefits in a particular priority
category,the remaining assets are allocated to the next lower priority
category. This process is repeated until all benefits in the priority
category are provided or until all available plan assets have been 
allocated.\287\  




----------------------
\284\ ERISA sec.4041.

\285\ ERISA sec. 4044(a)

\286\ Id.

\287\ The asset allocation rules also appky in standard terminations.


Guaranteed benefits

Single-employer plans

When an underfunded plan terminates, the amount of benefits that the PBGC
will pay depends on legal limits, asset allocation, and recovery on the 
PBGC's employer liability claim. The PBGC guarantee applies to "basic 
benefits."  Basic benefits generally are benefits accrued before a plan 
terminates, including (1) benefits at normal retirement age; (2) most early 
retirement benefits; (3) disability benefits for disabilities that occurred
before the plan was terminated; and (4) certain benefits for survivors of 
plan participants.  Generally only that part of the retirement benefit that
is payable in monthly installments is guaranteed (rather than, for example, 
lump-sum benefits).  

Retirement benefits that begin before normal retirement age are guaranteed,
provided they meet the other conditions of guarantee (such as that, before 
the date the plan terminates, the participant had satisfied the conditions
of the plan necessary to establish the right to receive the benefit other 
than application for the benefit). Contingent benefits (for example, 
subsidized early retirement benefits) are guaranteed only if the triggering
event occurs before plan termination.

For plans terminating in 2006, the maximum guaranteed benefit for an 
individual retiring at age 65 is $3,971.59 per month or $47,659.08 per year.
The dollar limit is indexed annually for inflation.  The guaranteed amount 
is reduced for benefits starting before age 65.  In the case of a plan or a
plan amendment that has been in effect for less than five years before a 
plan termination, the amount guaranteed is phased in by 20 percent a year.



                            Description of Proposal

                            
Under the proposal, certain aspects of the PBGC benefit guarantee are frozen
when a contributing sponsor enters bankruptcy or a similar proceeding. The
freeze continues for two years after the sponsor emerges from bankruptcy.
If the plan terminates during the contributing sponsor's bankruptcy or 
within two years after the sponsor emerges from bankruptcy, the amount 
of guaranteed benefits payable by the PBGC is determined based on plan 
provisions, salary,service, and the guarantee in effect on the date the 
employer entered bankruptcy.  The priority for allocating plan assets and 
employer recoveries to non-guaranteed benefits in the event of plan 
termination is determined as of the date the sponsor enters bankruptcy or a
similar proceeding.

The administrator of a plan for which guarantees are frozen is required to 
notify plan participants about the limitations on benefit guarantees, and 
potential receipt of non-guaranteed benefits in a termination on account of 
the bankruptcy.

Effective date.--The proposal is effective with respect to Federal 
bankruptcy or similar proceedings or arrangements for the benefit of 
creditors which are initiated on or after the date that is 30 days after
enactment.


                                Analysis
                                  
A recent report of the Government Accountability Office said that the 
termination of large, underfunded defined benefit pension plans of
bankruptcy firms in troubled industries has been the major cause of the
PBGC's single employer program's worsening net financial position.\290\

The funded status of a defined benefit pension plan may deteriorate during 
the pendency of the employer's bankruptcy for various reasons.  For 
example, ongoing benefit accruals increase plan liabilities.  The ability 
of the employer to make contributions may be impaired,reducing the amount 
of assets that would be available to pay benefits if contributions
continued. In addition, distributions to participants, especially 
lump-sum distributions, decrease plan assets. Nonetheless, under present
law, the amount of PBGC-guaranteed benefit is not determined until a plan
terminates.Thus, the PBGC's losses attributable to paying unfunded
guaranteed benefits may worsen during bankruptcy.In addition, the rights
of some participants under the priority in which assets are allocated may
be adversely affected by changes that occur during the period that 
bankruptcy proceedings are pending.

Using the date a plan sponsor enters bankruptcy as the determinative date for 
freezing the amount of guaranteed benefits may decrease the PBGC's losses 
for unfunded guaranteed benefits.  This will also provide certainty as to 
priorities in asset allocations. Some feel that the date a plan sponsor 
files a bankruptcy petition is the appropriate measure for setting PBGC-
guaranteed benefit levels and priorities for asset allocations.  
Using this date, it is argued, would more effectively and appropriately 
limit the PBGC's exposure for unfunded liabilities.  Drains on 
plan assets and increases in unfunded liabilities that may occur during the
period after the bankruptcy petition is filed and before termination of 
the plan may no longer result in disproportionate losses for the PBGC.  
For these same reasons, some argue that the bankruptcy 
filing date is the appropriate date for allocating assets to priority
categories. 

On the other hand, freezing the amount of PBGC-guaranteed benefits on the
date a plan sponsor enters bankruptcy and maintaining the freeze for two 
years after the plan sponsor emerges from bankruptcy may be viewed as unfair
to plan participants.  Plan sponsors may be in bankruptcy for years; an 
additional two years may exacerbate the negative impact on plan 
participants.  The guaranteed benefits paid by the PBGC to participants
whose plans are terminated may already be considerably lower than the 
benefits they were promised under the plan terms.  Freezing the level of 
benefits provided by the PBGC as of the date of the bankruptcy 
petition may further harm participants.



------------------------
\290\ GAO, High-risk Series: An Update, GAO-05-207 (Washington,D.C.;January
2005).



                                   Prior Action
                                   
A similar proposal was included in the President's fiscal year 2006 budget
proposal.

S. 1783 (the "Pension Security and Transparency Act of 2005"), as 
passed by the Senate, includes a provision under which certain aspects of 
the PBGC guarantee are determined as of the date a plan sponsor enters 
bankruptcy.

(c)  Allow PBGC to perfect liens in bankruptcy for missed 
required pension contributions


                                 Present Law
                                   
Funding rules

The Code and the ERISA impose minimum funding requirements with respect to
defined benefit pension plans.   Under the minimum funding rules, the 
contribution required for a plan year ("minimum required contribution") is 
generally the plan's normal cost for the year (i.e., the cost of benefits
allocated to the year under the plan's funding method) plus that year's 
portion of other liabilities that are amortized over a period of years, 
such as benefits resulting from a grant of past service credit. In addition,
for single-employer plans covering more than 100 participants and, in 
general, having a funded current liability percentage of less than 90%,
an additional deficit reduction contribution may be required, based on the
sum of:  (1) the expected increase in current liability for benefits 
accruing in the current year; and (2) a percentage of unfunded 
current liability. Minimum required contributions generally must be made
within 8-1/2 months after the end of the plan year.  If the contribution is
made by such due date, the contribution is treated as if it were made on 
the last day of the plan year.

A plan with a funded current liability percentage of less than 100 percent
for the preceding plan year must make estimated contributions for the 
current plan year in quarterly installments ("installment payments") during 
the current plan year.  A plan's "funded current liability percentage" is 
the actuarial value of plan assets (i.e., the average fair market value 
over a period of years) as a percentage of the plan's current liability.
In general, a plan's current liability means all liabilities to employees 
and their beneficiaries under the plan 

PBGC liens for missed contributions

Under certain conditions, if an employer fails to timely make a required
installment payment or minimum required contribution to a defined benefit 
pension plan (other than a multiemployer plan), a lien automatically arises
in favor of the plan.\292\  For such a lien to arise, (1) the 
plan's current liability percentage must be less than 100 percent for the
plan year; (2) the plan must be covered by the PBGC termination insurance
program; (3) the installment payment minimum required contribution was not

-----------------
\291\ Code sec.412;ERISA sec;302

\292\ Code sec 412;ERISA sec.302(f).


made before the due date for the contribution; and (4) the unpaid balance
of the installment payments or required minimum contributions (including 
interest), when added to the aggregate unpaid balance of all preceding
installment payments or minimum required contributions which were not paid 
before the due date (including interest) exceeds $1,000,000.

The lien is upon all property and rights to property, whether real or 
personal, belonging to the employer or a member of the employer's 
controlled group.\293\  The amount of the lien is equal to the aggregate
unpaid balance of required contributions (including interest) for plan
years beginning after 1987 and for which payment has not been made before
the due date for the installment payment or required minimum contribution.  
The lien arises after the due date for which the installment payment or
minimum required contribution is not made and continues through the end of
the plan year in which such liabilities exceed $1,000,000.  The PBGC may 
perfect and enforce such a lien, or such a lien may be perfected and 
enforced at the direction of the PBGC by the contributing sponsor or any
member of the controlled group of the contributing sponsor.\294\ 


Bankruptcy rules affecting liens for missed contributions

Automatic stays

Federal bankruptcy law provides for an automatic stay against certain 
actions by creditors once a bankruptcy petition is filed.\295\ The 
automatic stay prevents the commencement or continuation of actions 
against the debtor or the debtor's property and applies to all entities,
including governmental entities. The automatic stay protects the debtor's
property against attempts to create, perfect, or enforce liens against it, 
including liens which arise solely by force of a statute on specified 
circumstances or conditions ("statutory liens").  The automatic stay 
generally remains in effect, absent modification or termination by the 
court, until the earliest of (1) the time the case is closed; (2) the time
the case is dismissed; or (3) the time a discharge is granted or denied.

The automatic stay applies to PBGC liens for missed contributions. 

----------------------
\293\ The term "controlled group" means any group treated as a single 
employer under subsections (b), (c), (m) or (o) of Code section 414.

\294\ When a creditor has taken the required steps to perfect a lien, that
lien is senior to any liens that arise subsequent to the perfection. An 
unperfected lien is valid between the debtor and the creditor, but in the
context of a bankruptcy proceeding, an unperfected lien may be treated as
behind liens created later in time, but perfected earlier. In addition, an
unperfected lien can be avoided in bankruptcy.  State law generally applies
to perfection of liens. A lien generally may be perfected in various ways, 
including by filing or recording with various government offices.

\295\ 11 U.S.C. sec. 362 (2005).

\296\ 11 U.S.C. sec. 101(53) (2005).
   


Lien avoidance powers Federal bankruptcy law allows a bankruptcy trustee  
to avoid statutory liens that are not perfected or enforceable against a 
hypothetical bona fide purchaser as of the date the bankruptcy petition is
filed.   This power generally allows a bankruptcy trustee to avoid liens 
for missed contributions which are not perfected by the PBGC at the time a
bankruptcy petition is filed.  

                      Description of Proposal

The proposal amends Federal bankruptcy law to provide an exemption from 
the automatic stay under Federal bankruptcy law to allow the creation and 
perfection of PBGC liens for missed contributions against a plan sponsor 
and controlled group members.  The proposal also provides an exemption for
PBGC liens for missed contributions from the lien avoidance provisions of 
Federal bankruptcy law.

Effective date.--The proposal is effective with respect to initiations of
Federal bankruptcy or similar proceedings on or after the date 30 days 
after enactment.

                                  Analysis
                                  
Federal bankruptcy law allows a debtor to preserve some of its assets and 
discharges the debtor's legal obligation to pay certain debts.  In many cases,
bankruptcy law allows a debtor the chance to cure its financial ills and 
continue in business.  The automatic stay, a fundamental feature of the 
protections afforded a debtor under Federal bankruptcy law, provides the 
debtor relief from collection efforts by creditors and protects the bankruptcy
estate from being depleted and from seizures of property before the 
bankruptcy trustee has marshaled and distributed the debtor's assets. The
lien avoidance provisions under Federal bankruptcy law grant special 
protections to the debtor in certain cases, allowing a bankruptcy trustee
to avoid creditor's claims.  Like other creditors, the PBGC is subject to 
these provisions as they apply to a plan sponsor which has petitioned for 
bankruptcy.

It may be argued that the automatic stay and lien avoidance provisions of
Federal bankruptcy law unfairly allow employers to escape liability for 
required contributions to defined benefit pension plans.  The PBGC and plan
participants may be adversely affected as a result An employer with 
significant aggregate unpaid required installment payments or minimum

-------------------------
\297\ The bankruptcy trustee is the representative of the debtor's estate. 
The estate is generally is comprised of the legal or equitable interests of
the debtor as of the filing of the petition for bankruptcy.
See 11 U.S.C. secs. 323 and 541 (2005).

\298\ 11 U.S.C. sec. 545(2) (2005). Statutory liens may also be avoided to
the extent that the lien first becomes effective against the debtor:
(1) when a bankruptcy case is commenced; (2) when an insolvency proceeding
other than under bankruptcy law is commenced; (3) when a custodian is
appointed or authorized to take or takes possession; (4) when the debtor
becomes insolvent; (5) when the debtor's financial condition fails to meet
a specified standard; or (6) at the time of an execution against property
of the debtor levied at the instance of an entity other than the holder of
such statutory lien.  11 U.S.C. sec.545(1) (2005).


required contributions may avoid its funding obligations as to the missed
contributions during the pendency of a bankruptcy proceeding.  If a plan 
terminates while the employer is in bankruptcy, the PBGC may experience 
losses on account of its inability to perfect liens for missed 
contributions and the lien avoidance rules which may allow the trustee to
avoid the PBGC lien.  In addition, plan participants may receive lower 
benefits in that the employer's failure to make contributions results in 
less plan assets.  Some feel that the PBGC lien for missed contributions 
should not be made ineffective by a plan sponsor's entering bankruptcy 
notwithstanding whether it has been perfected.  In many cases, an 
employer's liability for unpaid contributions ultimately leads to unfunded 
liabilities that are taken on by the PBGC once the plan is terminated.

On the other hand, the automatic stay and lien avoidance provisions assist 
in preserving Federal bankruptcy law's distributional scheme for 
distributing the debtors' assets.  These provisions generally allow the 
trustee to take stock of the debtor's property interests so as to be 
apprised of the various rights and interests involved without the threat 
of immediate estate dismemberment by zealous creditors.  Additionally, 
they prevent creditors from gaining preference, forestall the depletion of
a debtor's assets, and avoid interference with or disruption 
of the administration of the bankruptcy estate in an orderly liquidation
or reorganization.  It may be argued that exempting PBGC liens for missed
contributions from these provisions would interfere with these fundamental
principles of Federal bankruptcy law and may ultimately harm the interests
of defined benefit pension plan participants, for example, by making it 
more difficult for the employer to emerge from bankruptcy.

Some feel that a more appropriate solution to obstacles the PBGC encounters
when a plan sponsor enters bankruptcy is to modify the non-bankruptcy laws 
which affect PBGC's financial position, including the funding rules.



                                  Prior Action
                                  
A similar proposal was included in the President's fiscal year 2006 budget
proposal.



C.  Reflect Market Interest Rates in Lump-Sum Payments

                             Present law
                             
Accrued benefits under a defined benefit pension plan generally must be 
paid in the form of an annuity for the life of the participant unless the
participant consents to a distribution in another form.  Defined benefit 
pension plans generally provide that a participant may choose among other 
forms of benefit offered under the plan, such as a lump-sum distribution.
These optional forms of benefit generally must be actuarially equivalent
to the life annuity benefit payable to the participant.

A defined benefit pension plan must specify the actuarial assumptions that
will be used in determining optional forms of benefit under the plan in a 
manner that precludes employer discretion in the assumptions to be used.
For example, a plan may specify that a variable interest rate will be used 
in determining actuarial equivalent forms of benefit, but may not give the 
employer discretion to choose the interest rate.

Statutory assumptions must be used in determining the minimum value of 
certain optional forms of benefit, such as a lump sum.\299\ That is, 
the lump sum payable under the plan may not be less than the amount of
the lump sum that is actuarially equivalent to the life annuity payable to
the participant, determined using the statutory assumptions.The statutory 
assumptions consist of an applicable mortality table (the 1994 Group 
Annuity Reserving Table projected through 2002) and an applicable 
interest rate.

The applicable interest rate is the annual interest rate on 30-year 
Treasury securities, determined as of the time that is permitted under 
regulations.  The regulations provide various options for determining the 
interest rate to be used under the plan, such as the period for which 
the interest rate will remain constant ("stability period") and the use of
averaging.

Annual benefits payable under a defined benefit pension plan generally may
not exceed the lesser of (1) 100 percent of average compensation, or 
(2) $175,000 (for 2006).\300\ The dollar limit generally applies to a
benefit payable in the form of a straight life annuity. If the benefit is
not in the form of a straight life annuity (e.g. a lump sum), the benefit 
generally is adjusted to an equivalent straight life annuity.  For purposes
of adjusting a benefit in a form that is subject to the minimum value rules
, such as a lump-sum benefit, the interest rate used generally must be 
not less than the greater of: (1) the rate applicable in determining 
minimum lump sums, i.e., the interest rate on 30-year Treasury securities;
or (2) the interest rate specified in the plan.  In the case of plan years
beginning in 2004 or 2005, the interest rate used must be not less than the 
greater of: (1) 5.5 percent; or (2) the interest rate specified in the plan

----------------------
\299 Code sec.417(e)(3);ERISA sec.205(g)(3).

\300\ Code sec. 415(b).


                         Description of Proposal

The proposal changes the interest rate used to calculate lump sums payable
from a defined benefit pension plan for plan years beginning in 2008.  
For plan years beginning in 2006 and 2007, the present-law interest rate 
applies in determining minimum lump sums from defined benefit pension plans
, i.e., minimum lump-sum values are determined using the rate of interest 
on 30-year Treasury securities.

For plan years beginning after December 31, 2007, the proposal provides 
that minimum lump-sum values are calculated using rates drawn from a 
zero-coupon corporate bond yield curve.  Under the proposal, the yield 
curve is to be issued monthly by the Secretary of Treasury 
and based on the interest rates (averaged over 90 business days) for high
quality corporate bonds with varying maturities.  Thus, the interest rate
that applies depends upon how many years in the future a participant's 
annuity payment will be made.  Typically, a higher interest applies for 
payments made further out in the future.

For distributions in 2008 and 2009, lump-sum values are determined as the 
weighted average of two values: (1) the value of the lump sum determined 
under the methodology under present law (the "old" methodology); and (2) 
the value of the lump sum determined using the methodology applicable for
2010 and thereafter (the "new" methodology).  For distributions in 2008, 
the weighting factor is 2/3 for the lump-sum value determined under the old
methodology and 1/3 for the lump-sum value determined under the new 
methodology.  For distributions in 2009, the weighting factors are reversed.

Effective date.-The proposal is effective for plan years beginning after
December 31,2007.

                                 Analysis
                                 
As previously discussed, recent attention has focused on the issue of the
rate of interest used to determine the present value of benefits under 
defined benefit pension plans for purposes of the plan's current liability
and the amount of lump-sum benefits under the plan.   Because minimum 
lump-sum distributions are calculated as the present value of future 
benefits, the interest rate used to calculate this present value will 
affect the value of the lump-sum benefit. Specifically, the use of a lower
interest rate results in larger lump-sum benefits; the use of a 
higher interest rate results in lower lump-sum benefits.

Under present law, the interest rate used for valuing lump-sum benefits is 
based on the interest rate on 30-year Treasury obligations.  The interest 
rate issue has received attention recently in part because the Treasury 
Department stopped issuing 30-year obligations in 2001,which meant that a
change to the statutory interest rate was needed.  Because the Treasury 
Department recently resumed the issuance of 30-year obligations, some view
a statutory change as no longer necessary.  However, apart from the

-------------
\301\ The President's proposal relating to the interest rate to be
used to value a plan's liabilities for funding purposes is discussed
in Part IV.B.2.

availability of 30-year Treasury obligations, some have argued that the 
30-year Treasury rate has been inappropriately low, causing lump-sum 
benefits to be disproportionately large in comparison with annuity benefit
payable under the plan. This raises the concern that use of a low interest
rate provides an incentive for employees to take benefits in a lump sum 
rather than in the form of a life annuity.  Annuity distributions are 
generally considered to provide greater retirement income security in that
they assure an individual (and generally the individual's spouse) of an 
income stream for life.  On the other hand, even if a lump-sum distribution
is rolled over to an IRA or other retirement plan, it does not assure a 
lifetime stream of income.  Some also argue that lump sums should not be
favored as a form of benefit because they can cause a cash drain 
on the plan.

Under the proposal, the rate of interest on 30-year Treasury securities is 
replaced with the rate of interest on high quality corporate bonds for 
purposes of determining a plan's minimum lump-sum values.  In determining 
lump-sum values, the proposal provides for the use of a series of interest 
rates drawn from a yield curve of high-quality zero-coupon bonds with various 
maturities, selected to match the timing of benefit payments expected to be 
made from the plan.

Some have raised concerns that a yield curve approach is more complicated 
than the use of a single rate, particularly for purposes of determining 
lump-sum distributions.  Others argue that, once the stream of expected 
future benefit payments is determined, the difference in difficulty 
between discounting using one rate for all payments, or discounting with 
varying rates (i.e., the yield curve), is minor.

Some believe that the same interest rate should be used in valuing a plan's
liabilities for funding purposes and in determining minimum lump-sum
benefits under the plan because to do otherwise would undermine the
accuracy of funding computations.  However, the assumptions used to 
determine other optional forms of benefit under a plan, such as early 
retirement benefits,often differ from the assumptions used to value the
liabilities attributable to those benefits for funding purposes.The 
difference in assumptions does not undermine the accuracy of funding
computations provided that the benefits expected to be paid from the
plan, which form the basis for valuing plan liabilities, are determined
using the assumptions that apply under the plan.\302\ Moreover, even
though, under present law, an interest rate based on 30-year Treasury
securities is used both in valuing plan liabilities for funding purposes
and in determining minimum lump sums, the interest rates actually used
can be very different, for example, because different averaging 
periods apply.

The proposal includes a transition period so that employees who are 
expecting to retire in the near future are not subject to a change in the
expected amount of their lump sum.  While most agree that a transition 
period is necessary, views may differ on the appropriate length of the 
transition period.

The proposal does not directly change the interest rate used in applying
the limitations on benefits to lump-sum distributions.  As discussed above,
in applying these limitations to lump-sum benefits, the interest rate that 
must be used must be not less than the greater of (1) the 

---------------------
\302\ Under the proposal relating to changes in the funding rles, disussed in
Part IV B., lump-sum benefits expected to be paid from a plan are required
to be reflected in valuing plan liabilities.


interest rate used in determining minimum lump sums, or (2) the interest
rate used in the plan. Because this rule uses the rate applicable in 
determining minimum lump sums, the proposal to change the rate used for 
minimum lump-sum purposes would automatically apply for purposes of 
applying this rule. In addition, many plans use the statutory minimum
lump-sum rate to determine lump-sum benefits under the plan.  In such a
case, the proposal to use a corporate bond yield curve in determining
minimum lump sums has the effect of also making the corporate bond yield
curve the rate used in the plan. Thus, the proposal indirectly affects the
computation of the limitations on benefits. 

                                Prior Action
                                    
A similar proposal was included in the President's fiscal year 2005 and 
2006 budget proposals.

Pension Protection Act of 2005, as passed by the House, and Pension 
Security and Transparency Act of 2005, as passed by the Senate, both 
include provisions relating to the determination of minimum lump sums.


























-------------------
\303\ For 2004 and 2005,5.5 percent is used in lieu of the interest rate
used in determining minimum lump sums. However, the proposal is not 
effective until after such years.






V.  TAX SHELTERS, ABUSIVE TRANSACTIONS, AND TAX COMPLIANCE


A.  Combat Abusive Foreign Tax Credit Transactions


                                Present Law
                                
The United States employs a "worldwide" tax system, under which residents
generally are taxed on all income, whether derived in the United States or
abroad.  In order to mitigate the possibility of double taxation arising 
from overlapping claims of the United States and a source country to tax 
the same item of income, the United States provides a credit for foreign
income taxes paid or accrued, subject to several conditions and limitations.

For purposes of the foreign tax credit, regulations provide that a foreign
tax is treated as being paid by "the person on whom foreign law imposes 
legal liability for such tax." Thus,for example, if a U.S. corporation 
owns an interest in a foreign partnership, the U.S. corporation 
can claim foreign tax credits for the tax that is imposed on it as a 
partner in the foreign entity. This would be true under the regulations 
even if the U.S. corporation elected to treat the foreign entity as a 
corporation for U.S. tax purposes.  In such a case, if the foreign entity 
does not meet the definition of a controlled foreign corporation or does 
not generate income that is subject to current inclusion under the rules 
of subpart F, the income generated by the foreign entity might 
never be reported on a U.S. return, and yet the U.S. corporation might
take the position that it can claim credits for taxes imposed on that 
income.  This is one example of how a taxpayer might attempt to separate 
foreign taxes from the related foreign income, and thereby attempt to 
claim a foreign tax credit under circumstances in which there is no threat
of double taxation.

The Treasury Department currently has substantial authority to promulgate
regulations under section 901 and other provisions of the Code to address 
transactions and structures that produce inappropriate foreign tax credit 
results.

                          Description of Proposal
                             
The proposal enhances the regulatory authority of the Treasury Department 
to address transactions that involve the inappropriate separation of 
foreign taxes from the related foreign income in cases in which taxes are 
imposed on any person in respect of income of an entity. Regulations 
issued pursuant to this authority could, for example, provide for the 
disallowance of a credit for all or a portion of the foreign taxes, or for
the allocation of the foreign taxes among the participants in the 
transaction in a manner more consistent with the economics of the 
transaction.

Effective date.--The proposal generally is effective after the date of 
enactment.

                              Analysis
                                     
The proposal clarifies and centralizes existing regulatory authority to 
facilitate efforts on the part of the Treasury Department and the IRS to 
address abusive transactions involving foreign tax credits. This grant of 
regulatory authority would supplement existing authority and thereby 
provide greater flexibility in addressing a wide range of transactions and
structures.  However, the proposal does not identify in great detail the 
scope of transactions that would be covered.  Consequently, the 
effectiveness of these rules would depend on the degree to which the 
Treasury Department provides greater detail with respect to the scope of
transactions covered and the means by which these transactions would be 
curtailed.

                              Prior Action
                                     
An identical proposal was included in the President's fiscal year 2005 and 
2006 budget proposals.

The proposal is also included in H.R. 4297, as amended by the Senate (the 
"Tax Relief Act of 2005").



B.  Modify the Active Trade or Business Test for Certain Corporate Divisions

                               Present Law
                                       
A corporation generally is required to recognize gain on the distribution 
of property (including stock of a subsidiary) to its shareholders as if the
corporation had sold such property for its fair market value.\306\ In 
addition,the shareholders receiving the distributed property are ordinarily
treated as receiving a dividend of the value of the distribution (to the
extent of the distributing corporation's earnings and profits), or 
capital gain in the case of a stock buyback that significantly reduces 
the shareholder's interest in the parent corporation.  

An exception to these rules applies if the distribution of the stock of a
controlled corporation satisfies the requirements of section 355 of the 
Code. If all the requirements are satisfied, there is no tax to the 
distributing corporation or to the shareholders on the distribution. 
If the requirements are satisfied, section 355 provides tax-free treatment
both to pro-rata distributions of stock of a subsidiary to the parent's 
shareholders and also to non-pro-rata distributions, in which the former 
parent company shareholders own the distributed and former parent 
corporations in different proportions after the transaction. In these cases,
one or more former parent shareholders not only may own the resulting 
corporations in different proportions after the transaction than their 
ownership in the parent prior to the transaction, but also might 
terminate any stock relationship in one or the other of the
corporations.\307\

One requirement to qualify for tax-free treatment under section 355 is that
both the distributing corporation and the controlled corporation must be 
engaged immediately after the distribution in the active conduct of a trade
or business that has been conducted for at least five years and was not 
acquired in a taxable transaction during that period (the "active trade
or business test").\308\ For this purpose, a corporation is engaged in the 
active conduct of a trade or business only if (1) the corporation is 
directly engaged in the active conduct of a trade or business, or (2)
the corporation is not directly engaged in an active business, but 
substantially all its assets consist of stock and securities of one or
more corporations that it controls immediately after the distribution,
each of which is engaged in the active conduct of a trade or
business.\309\ 

-----------------------
\306\ Secs.311(b) and 336.

\307\ Secs.301 and 302.

\308\ Sec.355(b). Certain taxable acquisitions that are considered 
expansions of an existing active trade or business are not treated
as the taxable acquisition of a business for purposes of the rules.
Treas. Reg. sec 1.355-3(b)(3)(ii) and sec. 1.355-3(c), Examples (7)
and (8).

\309\ Sec.355(b)(2)(A). The IRS takes te position for advance ruling
purposes that the second statutory test requires that at least 90
percent of the fair market value of the corporation's gross assets
consist of stock and securities of a conrrolled  corporation that is
engaged in the active conduct of a trade of business. Rev.Proc. 96-30,
sec.4.03(5), 1996-1 C.B. 696;Rev. Proc. 77-37, sec.3.04, 1977-2 C.B.568.



There is no statutory requirement that a certain percentage of the 
distributing or controlled corporation's assets be used in the conduct 
of an active trade or business in order for the active trade or business 
test to be satisfied.

In determining for advance ruling purposes whether a corporation is 
directly engaged in an active trade or business that satisfies the 
requirement, prior IRS guidelines required that the fair market value of 
the gross assets of the active trade or business ordinarily must constitute
at least five percent of the total fair market value of the gross assets 
of the corporation. The IRS recently suspended this specific rule in 
connection with its general administrative practice of devoting fewer IRS
resources to advance rulings on factual aspects of section 355 transactions
. 

                            Description of Proposal
                            
Under the proposal, in order for a corporation to satisfy the active trade
or business test in the case of a non-pro-rata distribution, as of the date 
of the distribution at least 50 percent of its assets, by value, must be 
used or held for use in a trade or business that satisfies the active trade 
or business test

Effective date.-No effective date for the proposal is specified in the 
President's budget proposal. For revenue estimating purposes, the staff of 
the Joint Committee on Taxation has assumed the provision to be effective 
for distributions made on or after the date of enactment.

                               Analysis
                                   
The purpose of section 355 is to permit existing shareholders to separate
existing businesses for valid business purposes without immediate tax 
consequences.  Absent section 355,a corporate distribution of property 
(including stock of a subsidiary) to shareholders would be a taxable event 
both to the distributing corporation and to the shareholders.

Present law arguably has permitted taxpayers to use section 355 as a 
vehicle to make, in effect, tax-free distributions of large amounts of 
cash by combining a relatively small business with such cash in a 
distributed corporation.  Recent press reports have referred to these 
transactions as "cash-rich" tax-free corporate divisions.  For example

-----------------
\310\ The ruling guidelines also provided the possibility that the IRS 
might rule the active trade or business test was satisfied if the trades or
businesses relied upon were not "de minimis" compared with the other assets or
activities of the corporation and its subsidiaries. Rev. Proc. 2003-3, 
sec. 4.01(30), 2003-1 I.R.B. 113.

\311\ Rev. Proc. 2003-48, 2003-29 I.R.B. 86.

\312\ In one of the reported recent transactions, the Clorox Company 
distributed $2.1 billion cash and a business worth $740 million to a U.S.
subsidiary of the German company Henkel KGaA in redemption of that 
subsidiary's 29 percent interest in Clorox. Other reported transactions
were undertaken by Janus Capital Group and DST Systems, Inc. (with cash 
representing 89 percent of the value of the distributed corporation);
Houston Exploration Company and KeySpan Corp. (87 percent cash); and 
Liberty Media Corporation and Comcast Corporation (53 percent cash). 
See, e.g., Allan Sloan, "Leading the Way in Loophole Efficiency,
" Washington Post, (October 26, 2004), at E.3;  Robert S. Bernstein,

,
the addition of a relatively small business to an otherwise cash stock 
redemption transaction can convert an essentially cash stock buyback, which
would have been taxed to the recipient shareholder, into a tax-free 
transaction for the recipient shareholder. Increasing the active business
asset requirement to a level such as 50 percent in the case of a 
non-pro-rata distribution could provide some limit to the proportion of 
cash that can be distributed in such transactions.

The 50-percent active trade or business test of the proposal could be 
criticized as inadequate to accomplish its policy objectives, since the 
proposal still permits at least 50 percent of assets to be mere investment 
assets or cash that are neither used nor held for use in the active 
conduct of a trade or business.\313\ Consideration could be given to
The threshold above 50 percent. For example, present law requires that 80 
increasing percent of gross assets by value be "used" in the active
conduct of one or more qualified trades or businesses for favorable tax
treatment of investments in certain small business corporations, with 
specific statutory definitions of what is considered "use" for this
purpose.\314\

In some cases, it is possible that an active trade or business might 
require large amounts of cash or other investment assets to prepare for 
upcoming business needs.  The proposal does appear to give some leeway for 
such situations by permitting assets "held for use" in the active conduct 
of a trade or business to count towards the 50-percent requirement. While
the intended scope of this "held for use" standard is not entirely clear, 
it is possible that it would be interpreted at least to cover working 
capital needs of the business and possibly broader expansion 
or other needs.  The test might also be interpreted to provide the 
necessary flexibility to address, for example, situations involving 
financial institutions or insurance companies that might hold significant
investment-type assets as part of their business. Specific clarification

-----------------------
"Janus Capital Group's Cash Rich Split-Off," Corporate Taxation,
(November-December 2003) at 39; Robert S. Bernstein, "KeySpan Corp.'s
Cash-Rich Split Off," Corporate Taxation, (September-October 2004) at 38.
Robert Willens, "Split Ends," Daily Deal, (August 31, 2004); and 
Richard Morgan "Comcast Exits Liberty Media," Daily Deal, (July 22, 2004).
See also, The Clorox Company Form 8-K SEC File No. 001-07151), 
(October 8, 2004); Janus Capital Group, Inc. Form 8-K (SEC File No 001-
15253) (August 26, 2003); The Houston Exploration Company Form 8-K (SEC
File No. 001-11899) (June 4, 2004); Key Span Corp. Form 8-K (SEC File No.
001-14161 (June 2, 2004); and Liberty Media Corporation Form 8-K (SEC File
No. 001-16615) (July 21, 2004). 

\313\ The proposal does not explicitly define the situations in which 
various types of assets could qualify under the test as "used or held for
use" in an active trade or business.  Thus, it is unclear whether,or to
what extent, the proposal categorically would preclude investment assets or
cash from being considered such assets. See additional discussion of these
issues in the following text.

\314\ Secs. 1202(c)(2), 1202(e)(1)(A), and 1045(b). For purposes of this 
80-percent test, the statute expressly provides that assets are treated as 
used in the active conduct of a trade or business if they are held as part
of the reasonably required working capital needs of a qualified trade or
business or if they are held for investment or are reasonably expected to
be used within two years to finance research and experimentation in a 
qualified trade or business or increases in working capital needs of a
qualified trade or business. However, for periods after the corporation 
has been in existence for at least two years, no more than 50 percent of
the assets of the corporation can qualify as used in the active conduct of
a trade or business by reason of these provisions. Sec. 1202(e)(6).


of the intended scope of the phrase could be desirable, both from the 
viewpoint of the government and of taxpayers.  On the one hand, expressly 
stating any limitations might provide a more administrable limit on the 
extent to which a taxpayer can assert possible expansion or other 
potential plans to justify a very high percentage of cash or investment
assets.  On the other hand even if that phrase is limited in any way to 
provide greater certainty, from the taxpayer's point of view there would 
appear to be significant leeway for additional cash and investment assets,
since half the entire value of the entity can consist of cash or other 
assets that are neither used nor held for use in the active conduct or a 
trade or business

Some may argue that any significant absolute cut-off test might prove 
inflexible in accommodating situations where corporations legitimately need
to equalize values to shareholders in a division of business assets. 
However, if cash in excess of 50 percent of the assets transferred is 
necessary to equalize values, the question arises whether such an amount of 
cash should be allowed to be transferred tax-free. A corporation could 
distribute the excess cash prior to the division if necessary, keeping the
basic business division tax-free but causing a taxable event to 
shareholders who are being economically cashed out in part in connection
with the business division. 

It also might be argued that in corporate divisions such as those affected 
by the proposal, the distributed cash or investment assets remain in 
corporate solution and thus have not been paid directly to the shareholder.
However, in such situations, the value of such cash or investment assets 
may be very accessible to the shareholder even without a further 
distribution.  A divisive transaction has occurred that has qualitatively 
changed the shareholder's investment by separating the cash from the assets
in which the shareholder had previously invested. Such a transaction may 
allow the shareholder indirectly to obtain the value of the cash in the 
separated corporation, by borrowing against stock that carries little 
business risk. 

Similarly, it could be argued that as long as the assets in question have 
a carryover basis in the hands of the corporation, it is not necessary to 
impose a tax at the time of distribution of the corporate stock.  However,
a corporation generally is not permitted to sell assets to another 
corporation at carryover basis without tax; nor is a corporation generally
permitted to distribute stock of a subsidiary without tax (absent the 
application of section 355).  Moreover, section 355 provides tax-free 
treatment to both the corporation and the shareholders, so no tax is paid 
even though there has been a readjustment of the shareholders' investment.   

The proposal applies only to non-pro-rata distributions and does not change
the present law active business requirement for pro-rata tax-free 
corporate divisions in which each existing shareholder of the parent 
receives an interest in each of the resulting separate corporations that is 
the same proportionate interest as the interest held in the parent 
corporation.  Consideration should be given to whether such a disparity in
treatment could result in pro-rata transactions structured to meet the old
law requirements, followed by additional steps to achieve a result 
similar to the current cash-rich stock redemption transactions.  In 
general, it would appear that any outright sales of stock for cash among 
shareholders, or other subsequent stock repurchases by the corporation 
following a pro-rata spin off, would either be taxable as an outright cash
sale or would again be subject to the non-pro-rata rules of the proposal if
structured as a corporate division.  However, general anti-abuse rules 
might be desirable to prevent the use of partnerships or other arrangements
to restructure the benefits and burdens of stock ownership among the 
shareholders after a pro-rata distribution.  At the same time, 
consideration should be given to whether there may be situations where the
definition of "non-pro rata" requires clarification, such as cases 
involving distributions with respect to different classes of stock, or 
cases where some small shareholders might be able to receive cash in lieu
of stock
.    
Applying the new "active business" test only to non-pro-rata distributions 
might still permit some pro-rata transactions to occur that largely isolate
cash or investment assets in one entity and risky business assets in the 
other, thus significantly changing the nature of the shareholders' holdings
after the transaction.  The limited application of the proposal does include 
the specific type of transaction that has attracted recent press attention as
the "cash rich" redemption type division.  Arguably, however, applying the 
new rule to all tax-free corporate divisions could provide greater 
consistency.  Separating corporate assets to enable shareholders to have an
interest in at least one corporation with a large proportion of cash or 
non-business investment assets could be considered contrary to the purpose 
of section 355 because such a transaction may effect a change in the 
shareholders' investment more similar to the distribution of a dividend 
than to a restructuring of business holdings.

If the proposal were adopted,onsideration might also be given to expanding 
the manner of its application so that the 50-percent active trade or 
business test would apply to each of the distributing and distributed 
corporation affiliated groups immediately after the transaction, rather 
than solely on a corporation by corporation basis. This could provide some
additional structural flexibility to situations involving holding companies
in a chain of entities and could reduce the complexity and possible 
difficulty of meeting the new 50-percent standard on the basis only of 
the parent distributing or distributed corporation.

                                 Prior Action
                                       
An identical provision was contained in the President's fiscal year 2006
budget proposal 

The Tax Relief Act of 2005 would deny tax-free treatment under section 
355 if,immediately after the distribution of a controlled corporation, 50
percent of either the vote or value of either the distributing or controlled
corporation is owned by a person that did not previously own 
such a 50 percent interest and that corporation is a "disqualified 
investment company."  The definition of a "disqualified investment company"
requires 75 percent or more of the value of the company to be in cash or 
certain other investment assets (as defined) before the provision applies.
Certain corporate stock and partnership interests are "looked through" for 
this purpose to their underlying assets, and certain securities of such 
entities are disregarded, as are certain assets held for use in the active
and regular conduct of  a lending or finance, banking,or insurance 
businesses, and securities held by a dealer that are marked to market.  


C. Impose Penalties on Charities that Fail to Enforce Conservation Easements

                               Present Law
                               
Section 170(h) provides special rules that apply to qualified conservation 
contributions,which include charitable contributions of conservation 
easements and faï¿½ade easements. Qualified conservation contributions are 
not subject to the "partial interest" rule, which generally denies 
deductions for charitable contributions of partial interests in property.
Accordingly,qualified conservation contributions are contributions of 
partial interests that are eligible for a fair market value deduction.

A qualified conservation contribution is a contribution of a qualified real
property interest to a qualified organization exclusively for conservation
purposes.  A qualified real property interest is defined as: (1) the entire
interest of the donor other than a qualified mineral interest; (2) a 
remainder interest; or (3) a restriction (granted in perpetuity) on the use
that may be made of the real property.\319\ Qualified organizations include 
certain governmental units, public charities that meet certain public 
support tests, and certain supporting organizations. Conservation purposes 
include:  (1) the preservation of land areas for outdoor recreation by, or 
for the education of, the general public; (2) the protection of a 
relatively natural habitat of fish,wildlife, or plants, or similar 
ecosystem; (3) the preservation of open space (including farmland 
and forest land) where such preservation will yield a significant public
benefit and is either for the scenic enjoyment of the general public or 
pursuant to a clearly delineated Federal, State, or local governmental 
conservation policy; and (4) the preservation of an historically important
land area or a certified historic structure.

In general, no deduction is available if the property may be put to a use 
that is inconsistent with the conservation purpose of the gift.\320\ A 
contribution is not deductible if it accomplishes a permitted conservation
purpose while also destroying other significant conservation interests. 


                              Description of Proposal
                              
The Administration's proposal imposes "significant" penalties on any 
charity that removes or fails to enforce a conservation restriction for 
which a charitable contribution deduction was claimed, or transfers such an
easement without ensuring that the conservation purposes will be protected 
in perpetuity.  The amount of the penalty is determined based on the 


----------------------
\319\  Charitable contributions of interests that constitute the taxpayer's
entire interest in the property are not regarded as qualified real property 
interests within the meaning of section 170(h), but instead are subject to
the general rules applicable to charitable contributions of entire interests
of the taxpayer (i.e., generally are deductible at fair market value, 
without regard to satisfaction of the requirements of section 170(h)).
Priv. Ltr. Rul. 8626029 (March 25, 1986).

\320\ Treas. Reg. sec. 1.170A-14(e)(2).

\321\  Id.
   

value of the conservation restriction shown on the appraisal summary 
provided to the charity by the donor 

Under the proposal, the Secretary is authorized to waive the penalty in 
certain cases, such as if it is established to the satisfaction of the 
Secretary that, due to an unexpected change in the conditions surrounding 
the real property, retention of the restriction is impossible or impractical, 
the charity receives an amount that reflects the fair market value of the 
easement, and the proceeds are used by the charity in furtherance of 
conservation purposes.  The Secretary also is authorized to require such 
additional reporting as may be necessary or appropriate to ensure that 
the conservation purposes are protected in perpetuity.

Effective date.--The proposal is effective for taxable years beginning 
after December 31,2005.

                               Analysis
                                   
The proposal addresses the concern that charitable contributions of 
conservation restrictions, which are required to be in perpetuity, are 
being removed, or are being transferred without securing the conservation 
purpose. The proposal's solution to the problem is to impose penalties on 
the charity in such cases.

The intended scope of the proposal is not clear.  The proposal applies to
"removals," which some might argue includes significant modifications to 
conservation restrictions.  A fair reading of the proposal would impose 
taxes in a case where a conservation restriction that prohibits development
on 100 acres of property is modified after the contribution to prohibit 
development on only 50 of the acres.  Although the conservation restriction
is not removed in its entirety, a portion of the restriction is removed, 
constituting a "removal" for purposes of the proposal.  Some might argue, 
however, that if modifications to conservation restrictions are penalized
, certain non significant modifications, such as for mistake or clarity, 
or de minimis modifications, should not be penalized, and that determining 
whether a modification is significant introduces administrative complexity.
On the other hand, some might argue that any such complexity could be 
overcome and that a proposal that is directed to enforcing the 
perpetuity requirement and that does not address significant modifications
to property restrictions is not sufficient.

The suggested penalty of the proposal is "based on the value of the 
conservation restriction shown on the appraisal summary provided to the 
charity by the donor."  The amount of the penalty is not clear.  Under this
standard, the penalty could be any percentage of such value.  Some might 
argue that the penalty should recapture the tax benefit to the donor, and
thus should equal the value of the conservation restriction that is removed
or transferred times the highest applicable tax rate of the donor at the 
time of the contribution, plus interest.  Others might argue that the 
penalty should equal such amount, plus an additional amount to penalize the 
charity for removing or transferring the easement.  In either case, knowing
the highest applicable tax rate of the donor may be difficult; thus in the 
alternative, a rate could be established by law.

In addition, arguably the penalty also should take into account the present
value of the restriction.  For example, the removal or transfer of the 
restriction could occur many years after the donation and in such a case, a
penalty based on the value of the restriction at the time of the donation 
would not recover the tax benefit unless the present value is taken into 
account.  If the proposal applies to modifications of restrictions, however,
a penalty based on recapture of the tax benefit presents additional 
complexity, in that a before and after appraisal would be required to 
determine the effect of the modification on the value of the property. For 
modifications, a better approach might be to impose as a penalty an 
established percentage (perhaps using the same percentage established for 
removals and transfers) times the value of the restriction (taking into 
account present value).  Although such a penalty would recover more than 
the tax benefit, the excess above such benefit could be viewed as the 
additional penalty amount,mentioned above, that is imposed on the charity
for permitting the modification.  Alternatively, some might argue that the
penalty need not recover the tax benefit, but should just be sufficiently 
high to deter the donee organization from removing the restriction.

The proposal provides the Secretary the authority to require additional
reporting to ensure that conservation purposes are protected in perpetuity.
Some might argue that such authority should specifically require a 
notification mechanism whereby a charity is required to inform the 
Secretary of modifications, removals, or transfers of conservation 
restrictions.  Some might argue that notification is an important element
of enforcement of the perpetuity requirement, and if made publicly 
available, would inform interested members of the public.  Others might
argue that a mere notification requirement would not accomplish much 
because charities that are subject to the penalty would not have an 
incentive honestly to notify the Secretary in any event.

The proposal applies not only to removals and transfers of conservation 
restrictions, but also to "failures to enforce" a conservation restriction.
It is not clear what will constitute a failure for this purpose.  A penalty
could be triggered, for example, if a landowner violates the terms of a 
conservation restriction, and (i) the charity was aware of such violation 
before it occurred, (ii) the charity should have been aware of such 
violation, or (iii) the charity failed to take remedial measures after 
learning of such violation.  In addition, in the case of a failure to 
enforce, the amount of the penalty is not clear.  Arguably, as is the case
with modifications of restrictions, if the violation is only with respect 
to certain terms of a restriction, calculating recovery of the tax benefit
is complex.  In addition, some would argue that any penalty for failure to
enforce a conservation restriction also should be accompanied by a means of
requiring that charities show the Secretary as part of their annual 
information return filings that sufficient amounts have been set aside for
enforcement of conservation restrictions and that the charity has 
in place a program regularly to monitor property restrictions.

The proposal imposes penalties on charities and not on other qualified 
organizations that are eligible to accept qualified conservation 
contributions, such as governmental entities.  Some would argue that a 
penalty also should be imposed on such entities, irrespective of their 
governmental status.

                                Prior Action
                                
The President's fiscal year 2006 budget proposal included a similar
proposal.


D.  Eliminate the Special Exclusion from Unrelated Business Taxable  
Income ("UBIT") for Gain or Loss on Sale or Exchange of Certain 
Brownfield Properties 

                                Present Law
In general

In general, an organization that is otherwise exempt from Federal income 
tax is taxed on income from a trade or business regularly carried on that
is not substantially related to the organization's exempt purposes. Gains 
or losses from the sale, exchange, or other disposition of property, other
than stock in trade, inventory, or property held primarily for sale to 
customers in the ordinary course of a trade or business, generally are 
excluded from unrelated business taxable income. Gains or losses are 
treated as unrelated business taxable income, however, if derived from 
"debt-financed property." Debt-financed property generally means any 
property that is held to produce income and with respect to which there is
acquisition indebtedness at any time during the taxable year.  

In general, income of a tax-exempt organization that is produced by 
debt-financed property is treated as unrelated business income in 
proportion to the acquisition indebtedness on the income-producing 
property.  Acquisition indebtedness generally means the amount of unpaid 
indebtedness incurred by an organization to acquire or improve the property
and indebtedness that would not have been incurred but for the acquisition 
or improvement of the property. Acquisition indebtedness does not include: 
(1) certain indebtedness incurred in the performance or exercise of a 
purpose or function constituting the basis of the organization's exemption;
(2) obligations to pay certain types of annuities; (3) an obligation, to 
the extent it is insured by the Federal Housing Administration, to finance 
the purchase, rehabilitation, or construction of housing for low and 
moderate income persons; or (4) indebtedness incurred by certain qualified
organizations to acquire or improve real property.

Special rules apply in the case of an exempt organization that owns a 
partnership interest in a partnership that holds debt-financed property. An 
exempt organization's share of partnership income that is derived from 
debt-financed property generally is taxed as debt-financed income unless an
exception provides otherwise.

Exclusion for sale, exchange, or other disposition of brownfield property

Present law provides an exclusion from unrelated business taxable income 
for the gain or loss from the qualified sale, exchange, or other disposition
of a qualifying brownfield property by an eligible taxpayer.  The exclusion
from unrelated business taxable income generally is available to an exempt 
organization that acquires, remediates, and disposes of the qualifying 
brownfield property. In addition, there is an exception from the 
debt-financed property rules for such properties.  

In order to qualify for the exclusions from unrelated business income and
the debt-financed property rules, the eligible taxpayer is required to:
(a) acquire from an unrelated person real property that constitutes a 
qualifying brownfield property; (b) pay or incur a minimum level 
of eligible remediation expenditures with respect to the property; and (c)
transfer the remediated site to an unrelated person in a transaction that 
constitutes a sale, exchange, or other disposition for purposes of Federal
income tax law.

Qualifying brownfield properties

The exclusion from unrelated business taxable income applies only to real
property that constitutes a qualifying brownfield property.  A qualifying 
brownfield property means real property that is certified, before the 
taxpayer incurs any eligible remediation expenditures (other than to 
obtain a Phase I environmental site assessment), by an appropriate State 
agency (within the meaning of section 198(c)(4)) in the State in which the
property is located as a brownfield site within the meaning of section 
101(39) of the Comprehensive Environmental Response, Compensation, and 
Liability Act of 1980 (CERCLA).  The taxpayer's request for certification 
must include a sworn statement of the taxpayer and supporting 
documentation of the presence of a hazardous substance, pollutant, or 
contaminant on the property that is complicating the expansion, 
redevelopment, or reuse of the property given the property's reasonably
anticipated future land uses or capacity for uses of the property 
(including a Phase I environmental site assessment and, if applicable, 
evidence of the property's presence on a local, State, or Federal 
list of brownfields or contaminated property) and other environmental 
assessments prepared or obtained by the taxpayer. 

Eligible taxpayer

An eligible taxpayer with respect to a qualifying brownfield property is 
an organization exempt from tax under section 501(a) that acquired such 
property from an unrelated person and paid or incurred a minimum amount of 
eligible remediation expenditures with respect to such property.  The 
exempt organization (or the qualifying partnership of which it is a 
partner) is required to pay or incur eligible remediation expenditures 
with respect to a qualifying brownfield property in an amount that exceeds
the greater of: (a) $550,000; or (b) 12 percent of the fair market value 
of the property at the time such property is acquired by the taxpayer,
determined as if the property were not contaminated.

An eligible taxpayer does not include an organization that is: 
(1) potentially liable under section 107 of CERCLA with respect to the 
property; (2) affiliated with any other person that is potentially liable
thereunder through any direct or indirect familial relationship or any 
contractual, corporate, or financial relationship (other than a 
contractual, corporate, or financial relationship that is created by 
the instruments by which title to a qualifying brownfield property 







--------------------
\322\  A person is related to another person if (1) such person bears a 
relationship to such other person that is described in section 267(b)
(determined without regard to paragraph (9)), or section 707(b)(1), 
determined by substituting 25 percent for 50 percent each place it appears
therein; or (2) if such other person is a nonprofit organization, if such
person controls directly or indirectly more than 25 percent of the 
governing body of such organization.  



is conveyed or financed by a contract of sale of goods or services); or
(3) the result of a reorganization of a business entity which was so 
potentially liable. 

Qualified sale, exchange, or other disposition

A sale, exchange, or other disposition of a qualifying brownfield property
shall be considered as qualified if such property is transferred by the 
eligible taxpayer to an unrelated person, and within one year of such 
transfer the taxpayer has received a certification (a "remediation 
certification") from the Environmental Protection Agency or an appropriate
State agency (within the meaning of section 198(c)(4)) in the State in 
which the property is located that, as a result of the taxpayer's 
remediation actions, such property would not be treated as a 
qualifying brownfield property in the hands of the transferee.  A 
taxpayer's request for a remediation certification shall be made no later
than the date of the transfer and shall include a sworn statement by the 
taxpayer certifying that: (1) remedial actions that comply with all 
applicable or relevant and appropriate requirements (consistent with 
section 121(d) of CERCLA) have been substantially completed, such that
there are no hazardous substances, pollutants or contaminants that 
complicate the expansion, redevelopment, or reuse of the property given
the property's reasonably anticipated future land uses or capacity for 
uses of the property; (2) the reasonably anticipated future land uses or
capacity for uses of the property are more economically productive or 
environmentally beneficial than the uses of the property in existence 
on the date the property was certified as a qualifying brownfield 
property;  (3) a remediation plan has been implemented to bring the 
property in compliance with all applicable local, State,and Federal 
environmental laws, regulations, and standards and to ensure that 
remediation protects human health and the environment; (4) the remediation
plan, including any physical improvements required to remediate the 
property, is either complete or substantially complete, and if 
substantially complete,  sufficient monitoring, funding, institutional 
controls, and financial assurances have been put in place to ensure the
complete remediation of the site in accordance with the remediation plan 
as soon as is reasonably practicable after the disposition of the property
by the taxpayer; and (5) public notice and the opportunity for comment on
the request for certification (in the same form and manner as required for
public participation required under section 117(a) of CERCLA (as in effect

--------------------
\323\  In general, a person is potentially liable under section 107 of 
CERCLA if: (1) it is the owner and operator of a vessel or a facility;
(2) at the time of disposal of any hazardous substance it owned or 
operated any facility at which such hazardous substances were disposed of;
(3) by contract, agreement, or  otherwise it arranged for disposal or 
treatment, or arranged with a transporter for transport for disposal or 
treatment, of hazardous substances owned or possessed by such person, by 
any other party or entity, at any facility or incineration vessel owned or
operated by another party or entity and containing such hazardous 
substances; or (4) it accepts or accepted any hazardous substances for 
transport to disposal or treatment facilities, incineration vessels or 
sites selected by such person, from which there is a release, or a 
threatened release which causes the incurrence of response costs, of a
hazardous substance.  42 U.S.C.sec. 9607(a) (2004).
   
   
\324\ For this purpose, use of the property as a landfill or other 
hazardous waste facility shall not be considered more economically 
productive or environmentally beneficial.
   
   
\325\ For these purposes, substantial completion means any necessary 
physical construction is complete, all immediate threats have been 
eliminated, and all long-term threats are under control.


on the date of enactment of the provision)) was completed before the date 
of such request.  Public notice shall include, at a minimum, publication
in a major local newspaper of general circulation. 

A copy of each of the requests for certification that the property was a 
brownfield site, and that it would no longer be a qualifying brownfield 
property in the hands of the transferee, shall be included in the tax 
return of the eligible taxpayer (and, where applicable, of the qualifying
partnership) for the taxable year during which the transfer occurs. 

Eligible remediation expenditures  

Eligible remediation expenditures means, with respect to any qualifying 
brownfield property: (1) expenditures that are paid or incurred by the 
taxpayer to an unrelated person to obtain a Phase I environmental site 
assessment of the property; (2) amounts paid or incurred by the taxpayer 
after receipt of the certification that the property is a qualifying 
brownfield property for goods and services necessary to obtain the 
remediation certification; and (3) expenditures to obtain remediation 
cost-cap or stop-loss coverage, re-opener or regulatory action coverage,
or similar coverage under environmental insurance policies,\326\ or 
to obtain financial guarantees required to manage the remediation and
monitoring of the property. Eligible remediation expenditures include
expenditures to (1) manage, remove, control, contain, abate, or otherwise
remediate a hazardous substance, pollutant, or contaminant on the 
property; (2) obtain a Phase II environmental site assessment of the 
property, including any expenditure to monitor, sample,study, assess, or
otherwise evaluate the release, threat of release, or presence of a 
hazardous substance, pollutant, or contaminant on the property, or (3)
obtain environmental regulatory certifications and approvals required to
manage the remediation and monitoring of the hazardous substance, 
pollutant, or contaminant on the property.  Eligible remediation 
expenditures do not include (1) any portion of the purchase price paid
or incurred by the eligible taxpayer to acquire the qualifying brownfield
property; (2) environmental insurance costs paid or incurred to obtain 
legal defense coverage, owner/operator liability coverage, lender 
liability coverage, professional liability coverage, or similar types of
coverage;\327\ (3) any amount paid or incurred to the extent such amount is
reimbursed, funded or otherwise subsidized by:(a) grants provided by the
United States, a State, or a political subdivision of a State for use in
connection with the property; (b) proceeds of an issue of State or local
government obligations used to provide financing for the property, the 
interest of which is exempt from tax under section 103; or (c) subsidized


-------------------
\326\ Cleanup cost-cap or stop-loss coverage is coverage that places an 
upper limit on the costs of cleanup that the insured may have to pay.  
Re-opener or regulatory action coverage is coverage for costs associated
with any future government actions that require further site cleanup, 
including costs associated with the loss of use of site improvements.

\327\ For this purpose, professional liability insurance is coverage for
errors and omissions by public and private parties dealing with or managing
contaminated land issues, and includes coverage under policies referred to
as owner-controlled insurance.  Owner/operator liability coverage is
coverage for those parties that own the site or conduct business or engage
in cleanup operations on the site.  Legal defense coverage is coverage for
lawsuits associated with liability claims against the insured made by 
enforcement agencies or third parties, including by private parties.



financing provided (directly or indirectly) under a Federal, State, or 
local program in connection with the property; or (4) any expenditure paid
or incurred before the date of enactment of the proposal. 


Qualified gain or loss

In general, the exempt organization's gain or loss from the sale, exchange,
or other disposition of a qualifying brownfield property is excluded from 
unrelated business taxable income.  Income, gain, or loss from other 
transfers is not excluded.\329\  The amount of gain or loss excluded from 
unrelated business taxable income is not limited to or based upon the
increase or decrease in value of the property that is attributable to the
taxpayer's expenditure of eligible remediation expenditures.  The exclusion
does not apply to an amount treated as gain that is ordinary income with 
respect to section 1245 or section 1250 property, including any amount 
deducted as a section 198 expense that is subject to the recapture rules 
of section 198(e), if the taxpayer had deducted such amount in the 
computation of its unrelated business taxable income.\330\

Special rules for qualifying partnerships

In general

In the case of a tax-exempt organization that is a partner of a qualifying
partnership that acquires, remediates, and disposes of a qualifying 
brownfield property, the exclusion applies to the tax-exempt partner's 
distributive share of the qualifying partnership's gain or loss from the 
disposition of the property.\331\  A qualifying partnership is a 
partnership that (1) has a partnership agreement that satisfies the 
requirements of section 514(c)(9)(B)(vi) at all times beginning on the
date of the first certification received by the partnership that one of
its properties is a qualifying brownfield property; (2) satisfies the 
requirements of the proposal if such requirements are applied to the 
partnership (rather than to the eligible taxpayer that is a partner of the
partnership); and (3) is not an organization that would be prevented from 
constituting an eligible taxpayer by reason of it or an affiliate being 
potentially liable under CERCLA with respect to the property.


-----------------------
\328\ The Secretary of the Treasury is authorized to issue guidance 
regarding the treatment of government-provided funds for purposes of 
determining eligible remediation expenditures.

\329\ For example, rent income from leasing the property does not qualify
under the proposal.

\330\  Depreciation or section 198 amounts that the taxpayer had not used
to determine its unrelated business taxable income are not treated as gain
that is ordinary income under sections 1245 or 1250 (secs.1.1245-2(a)(8) 
and 1.1250-2(d)(6)), and are not recognized as gain or ordinary income upon
the sale, exchange, or disposition of the property.  Thus, an exempt 
organization would not be entitled to a double benefit resulting from a 
section 198 expense deduction and the proposed exclusion from gain with 
respect to any amounts it deducts under section 198.

\331\ The exclusions do not apply to a tax-exempt partner's gain or loss
from the tax-exempt partner's sale, exchange, or other disposition of its 
partnership interest.  Such transactions continue to be governed by 
present-law.  
   

The exclusion is available to a tax-exempt organization with respect to a
particular property acquired, remediated, and disposed of by a qualifying
partnership only if the exempt organization is a partner of the partnership
at all times during the period beginning on the date of the first 
certification received by the partnership that one of its properties is a
qualifying brownfield property, and ending on the date of the disposition 
of the property by the partnership.\332\ 

The Secretary is required to prescribe such regulations as are necessary 
to prevent abuse of the requirements of the provision, including abuse 
through the use of special allocations of gains or losses, or changes in 
ownership of partnership interests held by eligible taxpayers.

Certifications and multiple property elections

If the property is acquired and remediated by a qualifying partnership of
which the exempt organization is a partner, it is intended that the 
certification as to status as a qualified brownfield property and the 
remediation certification will be obtained by the qualifying partnership, 
rather than by the tax-exempt partner, and that both the eligible taxpayer 
and the qualifying partnership will be required to make available such 
copies of the certifications to the IRS.  Any elections or revocations 
regarding the application of the eligible remediation expenditure rules to
multiple properties (as described below) acquired, remediated, and disposed 
of by a qualifying partnership must be made by the partnership.  A 
tax-exempt partner is bound by an election made by the qualifying 
partnership of which it is a partner.

Special rules for multiple properties

The eligible remediation expenditure determinations generally are made on a
property-by-property basis.  An exempt organization (or a qualifying 
partnership of which the exempt organization is a partner) that acquires,
remediates, and disposes of multiple qualifying brownfield properties, 
however, may elect to make the eligible remediation expenditure 
determinations on a multiple-property basis.  In the case of such an 
election, the taxpayer satisfies the eligible remediation expenditures 
test with respect to all qualifying brownfield properties acquired during 
the election period if the average of the eligible remediation 
expenditures for all such properties exceeds the greater of: (a) $550,000;
or (b) 12 percent of the average of the fair market value of the properties,
determined as of the dates they were acquired by the taxpayer and as if 
they were not contaminated.  If the eligible taxpayer elects to make the 
eligible remediation expenditure determination on a multiple property 
basis, then the election shall apply to all qualifying sales, exchanges, or
other dispositions of qualifying brownfield properties the acquisition
and transfer of which occur during the period for which the election 
remains in effect.\332\ 




------------------
\332\ A tax-exempt partner is subject to tax on gain previously by the 
partner (plus interest) if a property subsequently becomes ineligible for
exclusion under the qualifying partnership's multiple-property election.



An acquiring taxpayer makes a multiple-property election with its timely
filed tax return (including extensions) for the first taxable year for 
which it intends to have the election apply.  A timely filed election is
effective as of the first day of the taxable year of the return in which
the election is included or a later day in such taxable year selected by
the taxpayer.  An election remains effective until the earliest of a date
selected by the taxpayer, the date which is eight years after the effective
date of the election, the effective date of a revocation of the election,
or, in the case of a partnership, the date of the termination of the 
partnership.

A taxpayer may revoke a multiple-property election by filing a statement of
revocation with a timely filed tax return (including extensions).  A 
revocation is effective as of the first day of the taxable year of the 
return in which the revocation is included or a later day in such taxable 
year selected by the eligible taxpayer or qualifying partnership.  Once a 
taxpayer revokes the election, the taxpayer is ineligible to make another 
multiple-property election with respect to any qualifying brownfield 
property subject to the revoked election.\334\ 

Debt-financed property

Debt-financed property, as defined by section 514(b), does not include any 
property the gain or loss from the sale, exchange, or other disposition of 
which is excluded by reason of the provisions of the proposal that exclude 
such gain or loss from computing the gross income of any unrelated trade or
business of the taxpayer.  Thus, gain or loss from the sale, exchange, or 
other disposition of a qualifying brownfield property that otherwise 
satisfies the requirements of the provision is not taxed as unrelated 
business taxable income merely because the taxpayer incurred debt to 
acquire or improve the site.

Termination date

The Code provides for a termination date of December 31, 2009, by applying
to gain or loss on the sale, exchange, or other disposition of property 
that is acquired by the eligible taxpayer or qualifying partnership during 
the period beginning January 1, 2005, and ending December 31, 2009.  
Property acquired during the five-year acquisition period need not be 
disposed of by the termination date in order to qualify for the exclusion.
For purposes of the multiple property election, gain or loss on property 
acquired after December 31, 2009, is not eligible for the exclusion from 
unrelated business taxable income, although properties acquired 
after the termination date (but during the election period) are included
for purposes of determining average eligible remediation expenditures.

-----------------------
\333\ If the taxpayer fails to satisfy the averaging test for the properties
subject to the election, then the taxpayer  may not apply the exclusion on
a separate property basis with respect to any of such properties.

\334\ A taxpayer is subject to tax on gain previously excluded (plus 
interest) in the event a site subsequently becomes ineligible for gain
exclusion under the multiple-property election.


    
                       Description of Proposal

The proposal eliminates the special exclusion from unrelated business
income and the debt-financed property rules.

Effective date.--The proposal is effective for taxable years beginning after
December 31, 2006.

                              Analysis
                              
The proposal repeals the recently enacted exclusion for gains from the
disposition of remediated brownfield property from unrelated business 
income tax rules, citing administrative and policy concerns.

Administrative concerns

The proposal states that the exclusion adds significant new complexity to
the Code and would be difficult to administer.  By any measure, the 
exclusion is complicated; and the exclusion's complexity presents several
administrative challenges.  In general, although the policy of the proposal
is simple - exempt entities should not be deterred by unrelated business 
income tax rules from investing in contaminated properties for the purposes
of remediating the property prior to sale - the exclusion mechanically is
complex in order to prevent abuse and because of the difficult and 
technical nature of the problem being addressed.  The question raised 
by the proposal essentially is whether such requisite complexity makes the
exclusion too difficult to administer and thus, ineffective policy at best,
and a potentially abusive provision at worst.

Although the proposal does not cite specific administrative concerns, 
there are several aspects of the exclusion that might be at issue.  For 
example, the exclusion requires that remediation expenses on brownfield 
property be incurred in an amount that exceeds the greater of $550,000 or
12 percent of the fair market value of the property determined at the time
the property is acquired and as if the property were not contaminated.
Such a determination of value may be difficult for the IRS to enforce, 
with the effect of making the $550,000 component of the test a ceiling and
not a floor for required remediation expenses.  Also, the remediation 
expense test may be applied on a property-by-property basis or, by an 
election, on a multiple property basis.  Under the multiple property test,
in general, all the remediation expenses and noncontaminated values of 
properties acquired within an eight-year period are taken into account.
Because the election period potentially is eight years, and tens or 
hundreds of properties could be sold during such time, it could be 
difficult for the IRS to determine whether bona fide remediation expenses
were made with respect to each property or what the respective 
noncontaminated values of the properties are.

Another area of concern for the IRS might be that the exclusion is not 
extended to certain persons that are potentially liable under CERCLA with
respect to the acquired property.  This may require the IRS to make 
determinations under environmental laws, which may prove difficult.  The
exclusion also requires the taxpayer to provide the IRS with copies of 
certifications that the property was, prior to remediation, a qualified 
brownfield property and that, at the time of disposition, the property no
longer is a brownfield property.  Although the IRS is not involved in the
certification process (the EPA and State agencies generally are responsible
for issuing such certifications), the IRS must maintain the 
certifications, perhaps for many years, and examine them in order to test
the validity of the exclusion. 

A significant administrative concern also might be determining whether an
expense is an eligible remediation expense, which is a matter of critical 
importance to the policy supporting the exclusion.  The definition of an 
eligible expense is detailed and descriptive, but not precise. Given the
complexity of the definition, it likely will be resource intensive and
difficult for the IRS to challenge a taxpayer's accounting of remediation
expenses.

Another complicating factor is that qualified property may have gain that 
is excludable because of the special rules and gain that is not excludable,
such as rental income from the property.  The exclusion also does not apply
to an amount treated as gain that is ordinary income with respect to 
section 1245 or section 1250 property, including certain section 198 
expenses. Although these rules are clear, it may nonetheless be difficult 
for the IRS to administer in the context of a provision that excludes some
kinds of gain and taxes others.

The exclusion also has special rules for partnerships (which likely is the
vehicle that will often be utilized for purposes of the exclusion), which 
require, among other things that the Secretary issue regulations to prevent
abuse, including abuse through the use of special allocations of gains or 
losses or changes in ownership of partnership interests held by eligible 
taxpayers.  The exclusion also contains a related-party rule and a 
recapture provision, which contribute to the administrative complexity of
the exclusion.

By virtue of the proposal to repeal the exclusion, the President has 
concluded, albeit without identifying specific areas of concern, that the
administrative complexity engendered by the exclusion outweighs any policy 
benefits that may result from the exclusion.  Some might argue that the 
exclusion should be given time to see whether it proves as complicated to 
administer as it appears.  Others might agree that the self-evident 
complexity of the conclusion warrants repeal.

Policy concerns

The President expresses the concern that the exclusion is not sufficiently
targeted because it excludes from unrelated business income all of the 
gain from the disposition of qualified property, irrespective of whether
the gain is attributable to remediation by the taxpayer.  Under this view,
arguably the exclusion should be provided only to gain that results from
remediation activity, and permitting the exclusion of gain resulting from
nonremediation-related property development provides an unwarranted 
windfall to the taxpayer.  Some might argue that the proposal is broad by
design in order to encourage the development of contaminated sites, 
because without the benefit of exclusion for all of a property's gain, 
taxpayers will not have a sufficient incentive to acquire and remediate 
contaminated property.  Nevertheless, the multiple property election of 
the proposal may permit taxpayers to acquire a brownfield site where 
little remediation is required, significantly develop the property, and
sell the property without paying tax on the gain so long as the average 
expenses over all the properties meet the requirements of the multiple
property election.

                             Prior Action
                             
The President's fiscal year 2006 budget proposal included a similar 
proposal.


E.  Limit Related-Party Interest Deductions

                                Present Law
                                
A U.S. corporation with a foreign parent may reduce the U.S. tax on its 
U.S.-source income through the payment of deductible amounts such as 
interest, rents, royalties, and management service fees to the foreign 
parent or other foreign affiliates that are not subject to U.S. tax on the
receipt of such payments.  Although foreign corporations generally are 
subject to a gross-basis U.S. tax at a flat 30-percent rate on the receipt
of such payments, this tax may be reduced or eliminated under an applicable
income tax treaty.  Consequently, foreign-owned U.S.corporations may use 
certain treaties to facilitate earnings stripping transactions without
having their deductions offset by U.S. withholding taxes.\335\

Generally, present law limits the ability of corporations to reduce the 
U.S. tax on their U.S.-source income through earnings stripping 
transactions.  Section 163(j) generally disallows a deduction for so called
"disqualified interest" paid or accrued by a corporation in a taxable year, 
if two threshold tests are satisfied: the payor's debt-to-equity ratio 
exceeds 1.5 to 1 (the so-called "safe harbor"); and the payor's net 
interest expense exceeds 50 percent of its "adjusted taxable income" 
(generally taxable income computed without regard to deductions for net 
interest expense, net operating losses, and depreciation, amortization, and
depletion).  Disqualified interest includes interest paid or accrued to:
(1) related parties when no Federal income tax is imposed with respect to 
such interest; or (2) unrelated parties in certain instances in which a 
related party guarantees the debt ("guaranteed debt").  Interest amounts
disallowed under these rules can be carried forward indefinitely.  In 
addition, any excess limitation (i.e., the excess, if any, of 50 percent 
of the adjusted taxable income of the payor over the payor's net interest 
expense) can be carried forward three years.

Under section 424 of the American Jobs Creation Act of 2004 ("AJCA"), the 
Treasury Secretary is required to submit to the Congress a report examining
the effectiveness of the earnings stripping provisions of present law. 
This report was due no later than June 30, 2005.


                        Description of Proposal
                             
The proposal eliminates the safe harbor and the excess limitation 
carryforward of present law.  In addition, the proposal reduces the 
present-law threshold of 50 percent of adjusted taxable income to 25 
percent with respect to interest on related-party debt. With respect to 
interest on guaranteed debt, the present-law threshold of 50 percent of
adjusted taxable income is retained. The carryforward of disallowed 
interest is limited to 10 years.



-------------------------
\335\ For example, it appears that the U.S.-Barbados income tax treaty was
often used to facilitate earnings stripping arrangements.  That treaty was
amended in 2004 to make it less amenable to such use. It is possible,
however, that other treaties in the U.S. network might be used for similar
purposes. For a discussion of this issue, see Joint Committee on Taxation,
Explanation of Proposed Protocol to the Income Tax Treaty Between the 
United States and Barbados (JCX-55-04), September 16, 2004, 12-20,22.




Effective date.--The proposal is effective on the date of first committee
action.

                               Analysis
                               
Recent inversion transactions led some to question the efficacy of the 
present-law earnings stripping rules.   In some cases, it appeared that the
earnings stripping benefit achieved when a U.S. corporation paid deductible
amounts to its new foreign parent or other foreign affiliates constituted 
the primary intended tax benefit of the inversion transaction, which 
should not have been the case if the earnings stripping rules had been 
functioning properly. By eliminating the debt-equity safe harbor, reducing 
the adjusted taxable income threshold from 50 percent to 25 percent for
interest on related-party debt, limiting the carryforward of disallowed 
interest to 10 years, and eliminating the carryforward of excess limitation,
the proposal would significantly strengthen rules that have proven 
ineffective in preventing certain recent earnings stripping arrangements.
On the other hand, some view the proposal as unnecessary and overbroad, 
arguing that there is no empirical evidence of a significant earnings 
stripping problem outside the context of inversion transactions.  Under
this view, the recently enacted anti-inversion rules of section 7874, 
combined with recent treaty developments (mainly the 2004 protocol to the
U.S.-Barbados income tax treaty), should constitute a sufficient response 
to any earnings stripping problem that might have existed.  Proponents of 
the proposal respond that, although recent legislative and treaty 
developments have removed some significant opportunities for earnings 
stripping, other opportunities may remain, and thus erosion of the U.S.
tax base will continue until the statutory earnings stripping rules 
themselves are strengthened 

Some take the view that the proposal does not go far enough in curtailing 
earnings stripping.  While the proposal would have the effect of further 
limiting the ability of taxpayers to erode the U.S. tax base through 
earnings stripping transactions involving interest, the proposal does not 
address earnings stripping transactions involving the payment of 
deductible amounts other than interest (e.g., rents, royalties, and 
service fees), or the payment of deductible amounts by taxpayers other than
corporations.  These transactions also may erode the U.S. tax base, and 
thus it may be argued that a more comprehensive response to earnings 
stripping is needed. Indeed, as opportunities for stripping earnings in the
form of interest are reduced, taxpayers may find it increasingly attractive 


-------------------
\336\ See, e.g., Department of the Treasury, General Explanations of the 
Administration's Fiscal  Year 2004 Revenue Proposals, February 2003, 104
("Under current law, opportunities are available to  reduce inappropriately
the U.S. tax on income earned from U.S. operations through the use of 
foreign  related-party debt.  Tightening the rules of section 163(j) is
necessary to eliminate these inappropriate  income-reduction 
opportunities."); Department of the Treasury, Office of Tax Policy,
Corporate  Inversion Transactions: Tax Policy Implications, May 17, 2002,
Part VII.A ("Treasury study") ("The  prevalent use of foreign related-party
debt in  inversion transactions is evidence that [the rules of section 
 163(j)] should be revisited").
    
\337\  See, e.g., Treasury study, Part VII.A; Joint Committee on Taxation,
Background and  Description of Present-Law Rules and Proposals Relating to 
Corporate Inversion Transactions (JCX-52- 02), June 5, 2002, 3-4.



to strip earnings through other means.  Proponents of the proposal respond 
that earnings stripping is much more readily achieved through the use of
debt than through other means, and that there is insufficient evidence to 
suggest that these other forms of stripping warrant a new legislative 
response 


Finally, some argue that further action in this area should be deferred 
until the Treasury Department completes its earnings stripping study and 
submits its report of the study to the Congress.  The Treasury Department 
has indicated that the study is underway and that the report may include 
further recommendations in this area, but has not announced when the report
will be released.  It is hoped that this report will provide new data and 
analysis that will further inform the discussion in this area.



                                  Prior Action
                                  
The identical proposal was included in the President's fiscal year 2005 
and 2006 budget proposals.  The President's fiscal year 2004 budget 
proposal contained a different earnings stripping proposal that changed 
present law by modifying the safe harbor provision, reducing the adjusted 
taxable income threshold, adding a new disallowance provision based on a 
comparison of domestic to worldwide indebtedness, and limiting carryovers.




F.  Modify Certain Tax Rules for Qualified Tuition Programs

                               Present Law
                               
Overview

Section 529 provides specified income tax and transfer tax rules for the
treatment of accounts and contracts established under qualified tuition 
programs.\338\ A qualified tuition program is a program established and 
maintained by a State or agency or instrumentality thereof,or by one or
more eligible educational institutions, which satisfies certain 
requirements and under which a person may purchase tuition credits or
certificates on behalf of a designated beneficiary that entitle the 
beneficiary to the waiver or payment of qualified higher education 
expenses of the beneficiary (a "prepaid tuition program").\339\
In the case of a program established and maintained by a State or agency
or instrumentality thereof, a qualified tuition program also includes a 
program under which a person may make contributions to an account 
that is established for the purpose of satisfying the qualified higher
education expenses of the designated beneficiary of the account, provided
it satisfies certain specified requirements (a"savings account
program").\340\  Under both types of qualified tuition programs, a 
contributor establishes an account for the benefit of a particular 
designated beneficiary to provide for that beneficiary's higher education
expenses.  

For this purpose, qualified higher education expenses means tuition, fees,
books,supplies, and equipment required for the enrollment or attendance of
a designated beneficiary at an eligible educational institution, and 
expenses for special needs services in the case of a special 
needs beneficiary that are incurred in connection with such enrollment
or attendance.\341\ Qualified higher education expenses generally also 
include room and board for students who are enrolled at least 
half-time.\342\

In general, prepaid tuition contracts and tuition savings accounts 
established under a qualified tuition program involve prepayments or 
contributions made by one or more individuals for the benefit of a 
designated beneficiary, with decisions with respect to the contract or 
account to be made by an individual who is not the designated beneficiary.
Qualified tuition accounts or contracts generally require the designation 
of a person (generally referred to as an "account owner") whom the program
administrator (oftentimes a third party administrator retained by the 
State or by the educational institution that established the program) may

----------------------------
\338\  For purposes of this description, the term "account" is used 
interchangeably to refer to a prepaid tuition benefit contract or a tuition
savings account established pursuant to a qualified tuition program.

\339\ Sec.529(b)(1)(A).

\340\ Sec.529(b)(1)(A).

\341\ Sec.529(e)(3)(A).

\342\ Sec.529(e)(3)(B).


look to for decisions,recordkeeping, and reporting with respect to the
account established for a designated beneficiary.The person or persons 
who make the contributions to the account need not be the same person 
who is regarded as the account owner for purposes of administering the
account.  Under many qualified tuition programs, the account owner 
generally has control over the account or contract,including the ability
to change designated beneficiaries and to withdraw funds at any time and 
for any purpose.  Thus, in practice, qualified tuition accounts or 
contracts generally involve a contributor, a designated beneficiary, an
account owner (who oftentimes is not the contributor or 
the designated beneficiary), and an administrator of the account or 
contract.\343\ 

Under present law, section 529 does not establish eligibility requirements 
for designated beneficiaries.  Accordingly, a beneficiary of any age may be
named as a designated beneficiary.  Special considerations generally apply 
to accounts that are funded by amounts subject to Uniform Gifts to Minors 
Act ("UGMA") or Uniform Transfers to Minors Act ("UTMA") laws.    

Section 529 does not provide for any quantitative limits on the amount
of contributions, account balances, or prepaid tuition benefits relating to
a qualified tuition account, other than to require that the program provide 
adequate safeguards to prevent contributions on behalf of a designated 
beneficiary in excess of those necessary to provide for the qualified 
higher education expenses of the beneficiary.\344\   Many qualified tuition 
programs impose limits on the maximum amount of contributions that may be
made, or account balances that may accrue, for the benefit of a designated 
beneficiary under that program.\345\

Under present law, contributions to a qualified tuition account must be 
made in cash.\346\  A qualified tuition program may not permit any contributor
to, or designated beneficiary under,the program to directly or indirectly 
direct the investment of any contributions (or earnings thereon),\347\ and 
must provide separate accounting for each designated beneficiary.\348\ A





-----------------------
\343\ Section 529 refers to contributors and designated beneficiaries, but
does not define or otherwise refer to the term account owner, which is a
commonly used term among qualified tuition programs.  

\344\ Sec. 529(b)(6).

\345\ For example, a qualified tuition program might provide that
contributions to all accounts established for the benefit of a particular
designated beneficiary under that program may not exceed a specified limit 
(e.g., $250,000), or that the maximum account balance for all accounts 
established for the benefit of a particular designated beneficiary under 
that program may not exceed a specified limit.  In the case of prepaid 
tuition contracts, the limit might be expressed in terms of a maximum 
number of semesters.

\346\ Sec. 529(b)(2).

\347\ Sec. 529(b)(4).

\348\ Sec. 529(b)(3).



qualified tuition program may not allow any interest in an account or 
contract (or any portion thereof) to be used as security for a loan.\349\

Special rules apply to coordinate qualified tuition programs with other
education benefits,including Coverdell education savings accounts, the 
HOPE credit, and the lifetime learning credit,\350\
. 

Income tax treatment

A qualified tuition program, including a savings account or a prepaid 
tuition contract established thereunder, generally is exempt from income 
tax, although it is subject to the tax on unrelated business income.\351\  
Contributions to a qualified tuition account (or with respect to a 
prepaid tuition contract) are not deductible to the contributor or 
includible in income of the designated beneficiary or account owner.  
Earnings accumulate tax-free until a distribution is made.  If a 
distribution is made to pay qualified higher education expenses, no 
portion of the distribution is subject to income tax.\352\ If a 
distribution is not used to pay qualified higher education expenses,
the earnings portion of the distribution is subject to Federal income
tax,\353\ and a 10-percent additional tax (subject to exceptions for death, 
disability, or the receipt of a scholarship).  A change in the designated
beneficiary of an account or prepaid contract is not treated as a 
distribution for income tax purposes if the new designated beneficiary is a
member of the family of the old beneficiary.\355\ 












------------------------
\349\ Sec. 529(b)(5).

\350\ Sec. 529(c)(3)(B)(v) and (vi).

\351\ Sec. 529(a). An interest in a qualified tuition account is not
treated as debt for purposes of the debt-financed property rules.
Sec. 529(e)(4).

\352\ Sec. 529(c)(3)(B).  Any benefit furnished to a designated beneficiary
under a qualified tuition account is treated as a distribution to the 
beneficiary for these purposes.  Sec. 529(c)(3)(B)(iv).

\353\  Sec. 529(c)(3)(A) and (B)(ii).

\354\  Sec. 529(c)(6).

\355\ Sec. 529(c)(3)(C)(ii).  For this purpose, "member of family" means,
with respect to a designated beneficiary: (1) the spouse of such beneficiary; 
(2) an individual who bears a relationship to such beneficiary which is 
described in paragraphs (1) through (8) of section 152(a) (i.e., with 
respect to the beneficiary, a son, daughter, or a descendant of either; a 
stepson or stepdaughter; a sibling or stepsibling; a father, mother, or 
ancestor of either; a stepfather or stepmother; a son or daughter of a 
brother or sister; a brother or sister of a father or mother; and a 
son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, 
or sister-in-law), or the spouse of any such individual; and (3) the first 
cousin of such beneficiary.  Sec. 529(e)(2).
   

Gift and generation-skipping transfer (GST) tax treatment

A contribution to a qualified tuition account (or with respect to a 
prepaid tuition contract) is treated as a completed gift of a present 
interest from the contributor to the designated beneficiary.\356\   
Such contributions qualify for the per-donee annual gift tax exclusion
($12,000 for 2006), and, to the extent of such exclusions, also are exempt
from the generation-skipping transfer (GST) tax.  A contributor may 
contribute in a single year up to five times the per-donee annual gift tax
exclusion amount to a qualified tuition account and, for gift tax and GST
tax purposes, treat the contribution as having been made ratably over the
five-year period beginning with the calendar year in which the contribution
is made.\357\

A distribution from a qualified tuition account or prepaid tuition contract
generally is not subject to gift tax or GST tax.\358\   Those taxes may apply, 
however, to a change of designated beneficiary if the new designated 
beneficiary is in a generation below that of the old beneficiary 
or if the new beneficiary is not a member of the family of the old 
beneficiary. \359\

Estate tax treatment

Qualified tuition program account balances or prepaid tuition benefits 
generally are excluded from the gross estate of any individual.\360\ Amounts 
distributed on account of the death of the designated beneficiary, however,
are includible in the designated beneficiary's gross estate.   If the 
contributor elected the special five-year allocation rule for gift tax 
annual exclusion purposes, any amounts contributed that are allocable to 
the years within the five-year period remaining after the year of the 
contributor's death are includible in the contributor's gross estate.\362\ 

Powers of appointment

Special income tax and transfer tax rules apply to instances where a person
holds a power of appointment or certain other powers with respect to property.
In general, a power of appointment includes all powers which are in substance 
and effect powers of appointment regardless of the nomenclature used in 
creating the power and regardless of local property law connotations, and may 
include, for example, the power to consume or appropriate the property, 
or to affect the beneficial enjoyment of principal or income through a
power to revoke, alter or amend the terms of the instrument (such as 

------------------
\356\ Sec.529(c)(2)(A).

\357\ Sec.529(c)(2)(B).

\358\ Sec.529(c)(5)(A).

\359\ Sec. 529(c)(5)(B)

\360\ Sec.529(c)(4)(A).

\361\ Sec. 529(c)(4)(B).

\362\ Sec. 529(c)(4)(C) 



changing the designated beneficiary of property).\363\
The nature of the power held by a person affects whether the holder
of the power is taxed on the income on the property, and whether the 
property subject to the power is treated as includible within the estate
of the holder of the power or is subject to gift tax. \364\

Description of Proposal

Overview

The proposal modifies certain income tax, gift tax, generation-skipping 
transfer tax, and estate tax rules with respect to changes in designated 
beneficiaries of qualified tuition accounts. The proposal modifies the 
present-law provisions regarding the imposition of the 10-percent 
additional tax, and imposes new excise taxes on amounts that are used other
than for qualified higher education expenses.

Changes in designated beneficiaries

The proposal modifies present law by providing that a change in the 
designated beneficiary of a qualified tuition account does not cause the
imposition of gift tax or GST tax,regardless of whether the new designated 
beneficiary is in a generation below that of the former designated 
beneficiary.  The proposal also provides that gift tax and GST tax is not
imposed even if the new designated beneficiary is not a member of the 
family of the old beneficiary.  The proposal modifies the income tax 
treatment of a change in a designated beneficiary to provide that a change
of designated beneficiary to a new eligible designated beneficiary who is
not a member of the family of the old beneficiary is not treated as a 
distribution for income tax purposes.\365\ 

The proposal provides that upon the death of a designated beneficiary, the
account is to be distributed to the estate of the designated beneficiary, 
thereby triggering potential income tax and estate tax consequences, unless
a new eligible designated beneficiary is named in a timely manner or the 
contributor withdraws the funds from the account.  The designated 
beneficiary's gross estate would include only amounts (if any) paid to the
estate or pursuant to the designated beneficiary's general power of 
appointment.


Rules applicable to contributors; account administrators

Under the proposal, each section 529 account may have only one contributor
A section 529 program is permitted to accept contributions to a section 
529 account only from the account contributor (or the contributor's

------------------------
\363\ Sec.20.2041-1(b)(1). See also secs.674, 2041, and 2514.

\364\ Powers of appointment are often classified as "general powers
of appointment" or as "limited" or "special" powers of appointment.

\365\ This change is proposed in order to be consistent with the objective
of imposing no taxes on a change of designate beneficiary so long as the
new beneficiary is an eligible designated beneficiary and the funds are
not used for nonqualified purposes.


irrevocable trust) and, to the extent provided by the Secretary, from 
other persons in a de minimis amount.

As under present law, the contributor to a section 529 account is 
permitted to withdraw funds from the account during the contributor's 
lifetime, subject to income tax on the income portion of the withdrawal.
An additional tax applies to the income portion of a withdrawal 
unless the withdrawal is due to the designated beneficiary's death, 
disability, receipt of a scholarship or attendance at a U.S. military 
academy.  Under the proposal, the amount of the additional tax is generally
10 percent and is increased to 20 percent if the withdrawal occurs 
more than 20 years after the account was originally created.

Under the proposal, the contributor may name another person to administer 
the account (the "account administrator"). The account administrator would
have no beneficial interest in the account. The account administrator 
would be permitted to change the designated beneficiary "from time to 
time".Neither the account administrator nor the administrator's spouse 
could be or become a designated beneficiary, except as provided by the 
Secretary.

Imposition of excise tax on nonqualifying distributions

The proposal retains the present-law income tax treatment of distributions
from a qualified tuition account that are used for qualified higher 
education expenses.  Such distributions are not subject to income tax, 
regardless of the distributee's identity.  As under present law, 
distributions used for purposes other than qualified higher education 
expenses are subject to income tax on the earnings portion of the 
distribution.  Further, the proposal imposes additional excise taxes with 
respect to distributions that are used other than for qualified higher 
education expenses if the distribution is made to someone other than the
contributor or the initial designated beneficiary.  Nonqualified 
distributions in excess of $50,000 but less than or equal to $150,000
(computed on a cumulative basis for each designated beneficiary, including 
for this purpose the entire amount of the distribution, not just earnings)
are subject to a new excise tax imposed at the rate of 35 percent.  
Nonqualified distributions in excess of $150,000 (computed on a cumulative 
basis for each designated beneficiary, including for this purpose the 
entire amount of the distribution, not just earnings) are subject to an 
excise tax imposed at the rate of 50 percent.  The excise tax is payable 
from the account and is required to be withheld by the program 
administrator.

Changes in reporting requirements

The proposal modifies the reporting requirements applicable to qualified 
tuition accounts For example, new reporting requirements would be 
established to facilitate the administration of excise tax withholding by 
administrators.  Such requirements might include certifications provided by
designated beneficiaries to administrators of qualified tuition programs, 
so that administrators may withhold appropriate amounts of excise taxes 
with respect to distributions used other than for qualified higher 
education expenses.

Grant of regulatory authority to Treasury

The proposal grants the Secretary of the Treasury broad regulatory 
authority to ensure that qualified tuition accounts are used in a manner 
consistent with Congressional intent 

Effective dates

The proposal generally is effective for qualified tuition accounts 
(including savings accounts and prepaid tuition contracts) established after
the date of enactment of the proposal,including prepaid tuition contracts 
if additional prepaid tuition benefits are purchased on or after the date 
of enactment of the proposal.  The proposal does not apply to qualified 
tuition savings accounts that are in existence on the date of enactment 
unless an election is made to be covered by the new rules.  No additional 
contributions to savings accounts in existence on the date of enactment of
the proposal would be permitted without such election.\366\ 

The modified reporting requirements apply after the date of enactment of 
the proposal to all qualified tuition accounts (including savings accounts 
and prepaid tuition contracts)


                              .Analysis
Overview

The President's budget proposal addresses certain transfer tax anomalies 
with regard to changes in designated beneficiaries by providing that a 
change of beneficiary to another eligible beneficiary does not constitute a
transfer for gift or generation-skipping transfer tax purposes or a
distribution for income tax purposes.  In addition, by requiring that no 
person other than a designated beneficiary possess any beneficial interest
in a qualified tuition account, the proposal attempts to more closely 
align the gift tax treatment of contributions to qualified tuition 
accounts (i.e., a completed gift of a present interest to the designated 
beneficiary) with the treatment of contributions under generally applicable
transfer tax principles. The proposal addresses potential abuses of 
qualified tuition accounts by establishing eligibility rules for designated
beneficiaries, and imposing an excise tax on distributions that are not 
used for qualified higher education expenses and increasing the additional 
tax on nonqualified withdrawals by the contributor more than 20 years after
the creation of the account.

Section 529 transfer tax treatment and generally applicable transfer tax 
provisions

Overview

Certain aspects of present-law section 529 depart from otherwise generally 
applicable transfer tax principles.  For example, present law treats a 
contribution to a qualified tuition account as a completed gift of a 
present interest to the designated beneficiary,\367\ even though in most 
instances, the designated beneficiary possesses no rights to control the 
qualified tuition account or withdraw funds, and such control (including 
the right to change beneficiaries or to withdraw funds, including for the 
benefit of someone other than the designated beneficiary) is



-------------------
\366\ In cases where an existing account or contract is subject to then new
rules, the entire account or contract is subject to the new rules, not
just that portion of the account or contract that relates to contributions
made, or prepaide benefits acquired, after the date of enactment.

\367\ Sec. 529(c)(2).


vested in the account owner. Absent section 529, such contributions
generally would not be treated as completed gifts to the designated 
beneficiary under otherwise applicable transfer tax principles.  Further,
present-law section 529 does not address the transfer tax consequences of a
change of account owners of a qualified tuition account. 

Treatment of changes of designated beneficiaries

Under present-law section 529, a change of designated beneficiary to a 
beneficiary who is in a generation lower than the former beneficiary (or 
who is not a family member of the former beneficiary) constitutes a taxable
gift, even though the new designated beneficiary would, under otherwise 
applicable transfer tax principles, be regarded as not receiving a 
completed gift. Further, present-law section 529 does not identify which
party is responsible for payment of the transfer tax when it is imposed in
such instances.  Also, under present-law section 529, there is no express 
requirement that the multiple annual present interest exclusion is 
available only if there is a present intent to allow the designated 
beneficiary to receive the benefits of the qualified tuition program.

Present law also has different change-of-beneficiary rules for income tax
and transfer tax purposes.  A change of beneficiary to a person who is not
a member of the same family as the old beneficiary is treated as a 
distribution for income tax purposes, regardless of whether the new 
beneficiary is in a lower generation than the former beneficiary.  Under
present law, a change of beneficiary to a person who is in a lower 
generation than the former beneficiary is treated as a transfer for 
transfer tax purposes, regardless of whether the new beneficiary is of
the same family as the former beneficiary. 

The proposal eliminates these disparities and provides that a change of
beneficiary will not be treated as a distribution or transfer.

Because the proposal expands the class of permissible successor designated
beneficiaries without the imposition of any income or transfer taxes, 
individuals interested in establishing a qualified tuition account as a 
means to fund qualified higher education expenses for their children, 
relatives, or others, might view these changes as being a liberalization 
and simplification of existing law.




-----------------------------
\368\ Under otherwise applicable transfer tax principles, the designated
beneficiary's lack of control over the qualified tuition account generally
would cause the beneficiary's interest in the account to be regarded as a 
future interest, and any completed gift of a present interest would be 
regarded as having been made from the contributor to the account owner
(rather than to the designated beneficiary).  In cases where the 
contributor and the account owner are the same person, no gift would take
place under generally applicable transfer tax principles.

\369\  A change of account owner might be regarded as a completed gift of
a present interest from the old account owner to the new account owner, or
as having no tax consequences because a completed gift had been made to 
the designated beneficiary.


Potential abuses addressed by the proposal

The proposal attempts to discourage substantial multi-generational 
accumulations of qualified tuition account assets by imposing new excise 
taxes on distributions that are ultimately used other than for qualified 
higher education expenses.  The proposed excise tax is imposed only if an 
actual distribution occurs and the distributed amounts are not used for 
qualified higher education expenses.  The excise tax does not apply if a
distribution is made to the estate of a deceased designated beneficiary, or
to a designated beneficiary on account of the designated beneficiary's 
disability, receipt of a scholarship, or attendance at a military academy.
Excise taxes on the entire amount of a distribution that exceeds certain 
cumulative thresholds, including on both the principal and earnings 
components, would be imposed.  Such excise taxes are intended to serve as
deterrents to using the funds other than for qualified higher education 
expenses.  However, the excise taxes are not imposed unless an actual or 
deemed distribution occurs, and thus would not be imposed so long as the 
funds are maintained in a qualified tuition account that continues to be 
held for the benefit of an eligible designated beneficiary.  The proposal 
does not impose a specific deadline by which time the funds must be used 
for education expenses or become subject to income, excise, and transfer
taxes.

Some may argue that this proposal does not go far enough to deter (or in
fact may create an opportunity to achieve) substantial multi-generational 
accumulations of qualified tuition account assets, and that a better 
approach would be to impose caps on the amounts that can be contributed to 
such accounts, or on the length of time that such assets can be held. 
Enforcing such caps, however, would impose significant administrative 
burdens on administrators, taxpayers, and the IRS.  Others may argue that
the present-law requirement that the account or contract provide adequate 
safeguards to prevent contributions on behalf of a designated beneficiary
in excess of those necessary to provide for the qualified higher education
expenses of the beneficiary, combined with the maximum contribution or 
account balance limits established by many of the various qualified tuition
programs, adequately address any concerns that such accounts might be used 
to improperly accumulate assets for purposes other than providing for 
qualified higher education expenses of the designated beneficiary.  Others
may counter that program-imposed limits are applied only on a per-State 
basis, and further, that the ability of an individual to establish accounts
for an unlimited number of designated beneficiaries means there are no 
effective limits under present law.

                              Prior Action
                                   
A similar proposal was contained in the President's fiscal year 2005 and 
2006 budget proposals.


VI. TAX ADMINISTRATION PROVISIONS AND UNEMPLOYMENT INSURANCE

A. IRS Restructuring and Reform Act of 1998

1. Modify section 1203 of the IRS Restructuring and Reform Act of 1998

                               Present Law

Section 1203 of the IRS Restructuring and Reform Act of 1998 requires the
IRS to terminate an employee for certain proven violations committed by 
the employee in connection with the performance of official duties. The
violations include: (1) willful failure to obtain the required approval 
signatures on documents authorizing the seizure of a taxpayer's home, 
personal belongings, or business assets; (2) providing a false statement
under oath material to a matter involving a taxpayer; (3)with respect to 
a taxpayer, taxpayer representative, or other IRS employee, the violation
of any right under the U.S. Constitution, or any civil right established 
under titles VI or VII of the Civil Rights Act of 1964, title IX of the
Educational Amendments of 1972, the Age Discrimination in Employment Act
of 1967, the Age Discrimination Act of 1975, sections 501 or 504 of the
Rehabilitation Act of 1973 and title I of the Americans with Disabilities
Act of 1990; (4) falsifying or destroying documents to conceal mistakes 
made by any employee with respect to a matter involving a taxpayer or a
taxpayer representative; (5) assault or battery on a taxpayer or other 
IRS employee, but only if there is a criminal conviction or a final 
judgment by a court in a civil case, with respect to the assault or 
battery; (6) violations of the Internal Revenue Code, Treasury Regulations,
or policies of the IRS (including the Internal Revenue Manual) for the 
purpose of retaliating or harassing a taxpayer or other IRS employee; (7)
willful misuse of section 6103 for the purpose of concealing data from a
Congressional inquiry; (8) willful failure to file any tax return required
under the Code on or before the due date (including extensions) unless
failure is due to reasonable cause; (9) willful understatement of Federal
tax liability, unless such understatement is due to reasonable cause; and
(10) threatening to audit a taxpayer for the purpose of extracting personal
gain or benefit.

Section 1203 also provides non-delegable authority to the Commissioner to 
determine that mitigating factors exist, that, in the Commissioner's sole 
discretion, mitigate against terminating the employee. The Commissioner, 
in his sole discretion, may establish a procedure to determine whether an 
individual should be referred for such a determination by the Commissioner. 

                           Description of Proposal
                            
The proposal removes the following from the list of violations requiring 
termination: (1) the late filing of refund returns; and (2) employee versus
employee acts. The proposal also adds unauthorized inspection of returns
and return information to the list of violations requiring 
termination.  Additionally, the proposal requires the Commissioner to 
establish guidelines outlining specific penalties, up to and including 
termination, for specific types of wrongful conduct covered by section 1203 
of the IRS Restructuring and Reform Act of 1998. The Commissioner retains
the non-delegable authority to determine whether mitigating factors 
support a personnel action other than that specified in the guidelines for
a covered violation.

Effective date.--The proposal is effective on the date of enactment.


                                   Analysis
Policy issues

Late filing of refund returns

The proposal has the effect of treating IRS employees more like individuals
employed by any other employer, with respect to late filing of refund 
returns.  Late filing generally is not grounds for termination by most 
employers.  In addition, late filing of refund returns is generally 
not subject to penalty under the Code.\370\  Proponents of the proposal 
relating to late filings may argue that the late filing of a refund return
is not the type of serious conduct for which the severe penalties imposed 
by the IRS Restructuring and Reform Act should apply.  Others may argue
that IRS employees, as the enforcers of the country's tax laws, should be 
held to a higher standard and be required to timely file all income tax 
returns.

Employee vs. employee allegation 

Advocates of removing employee versus employee conduct from the list of 
grounds for IRS employee termination may argue that allegations of willful 
conduct by IRS employees against other IRS employees can be addressed by 
existing administrative and statutory procedures.  Other means, such as 
the Whistleblower Protection Act, negotiated grievance processes, and civil
rights laws, exist to address employee complaints and appeals.  Moreover,
it is argued that under present-law rules, parallel investigative and 
adjudicative functions for addressing employee complaints and appeals are
confusing to employees and burdensome for the IRS.

Proponents also believe that it is appropriate to remove employee versus
employee conduct from the list of section 1203 violations because, unlike
other section 1203 violations,such conduct does not violate taxpayer 
protections.  On the other hand, opponents may point out that Congress 
believed it appropriate to include such conduct in the statutory list of 
grounds for IRS employee termination. They may argue that including 
employee versus employee conduct in the section 1203 violation list 
benefits tax administration.  Another issue to consider is the extent to
which the inclusion of employee versus employee conduct on the list of 
section 1203 violations deters inappropriate behavior (by reducing the 
likelihood of real employee versus employee actions) or increases 
inappropriate behavior (by increasing the number of allegations of 
inappropriate behavior against other employees for purposes of 
intimidation, harassment, or retribution).

Unauthorized inspection of returns 

Advocates of the proposal argue that unauthorized inspection of tax returns
and return information is a serious act of misconduct that should be 
included in the list of violations subject to termination, as unauthorized 
inspection is as serious as the other taxpayer rights protections 

-----------------------
\370\ The refund claim must be filed prior to the expiration of the 
applicable statute of limitations for the taxpayer otr receive the
refund.


covered by section 1203. Code section 7213A already makes the unauthorized 
inspection of returns and return information illegal, with violations 
punishable by fine, imprisonment, and discharge from employment.  Even 
though unauthorized inspection is punishable under a separate law, it is 
argued that extending section 1203 coverage to unauthorized inspection will
strengthen the IRS' power to discipline without the penalty being 
overturned. 

On the other hand, opponents of this part of the proposal may point out 
that most violations of Code section 7213A are not prosecuted, but 
employees are subject to discipline based on administrative determination.
The IRS policy has been to propose termination of employment in cases of 
unauthorized inspection, but in a number of recent cases, arbitrators and 
the Merit Systems Protection Board have overturned the IRS' determination 
to terminate employees for such violations.

Advocates may also argue that adding unauthorized inspection of returns to 
the list of section 1203 violations will prevent overturning of the IRS' 
determination of the level of appropriate employee punishment.  Some might
question whether it is appropriate to use an internal administrative 
process to achieve a result that the IRS states that it has been unable to 
achieve through judicial or external administrative processes.  In 
addition, adding unauthorized inspection of returns to the list of section
1203 violations could add to the fear of IRS employees that they will be 
subject to unfounded allegations and lose their jobs as a result, which 
might deter fair enforcement of the tax laws.

The position taken by the IRS with respect to this part of the proposal 
can be criticized as inconsistent with its position on the employee versus
employee allegations piece of the proposal.The IRS argues that employee 
versus employee conduct should be removed from the list of section 1203 
violations because such conduct can be addressed by existing administrative
and statutory procedures, while at the same time argues that unauthorized 
inspection of returns should be added to the list of violations even though
it is punishable under a separate law.  Some might view these positions as
inconsistent.

While the proposal makes unauthorized inspection (which is a misdemeanor) a
section 1203 violation, it does not make unauthorized disclosure (which is
a felony under Code section 7213) a section 1203 violation.  Arguably, more
damage can be done by disclosing sensitive tax information to a third party
than by looking at a return out of curiosity.  Thus, the proposal can 
be criticized as lacking the proper focus.

Penalty guidelines

Some are concerned that the IRS' ability to administer the tax laws
efficiently is hampered by a fear among employees that they will be subject
to false allegations and possibly lose their jobs.  Proponents of the 
proposal requiring the IRS to publish detailed guidelines argue 
that these guidelines are needed to provide notice to IRS employees of the
most likely punishment that will result from specific violations.  They 
believe that the certainty provided by specific guidelines would improve 
IRS employee morale and enhance the fundamental fairness 
of the statute.

Others argue that since Congress intended for the section 1203 violations
to warrant termination, it is not appropriate to allow the IRS to determine
a lesser level of punishment.

Additionally, they argue that the claim that penalty guidelines are 
necessary is inconsistent with the proposal to remove from the list the two
violations that are said to most often warrant punishment other than that 
required under section 1203 (late filed refund returns and employee 
versus employee allegations).

Complexity issues

The proposal has elements that may both increase and decrease complexity.
The IRS must review and investigate every allegation of a section 1203 
violation.  Removing late filing of refund returns and employee versus
employee conduct from the list of section 1203 violations 
may make it easier for the IRS to administer section 1203, as there would
be fewer types of allegations that would require section 1203 review and
investigation.  Similarly, adding unauthorized inspection of returns to the
list of violations may complicate IRS administration, as there would likely
be an increase in the number of 1203 violations requiring IRS review and 
investigation.  Additionally, because unauthorized inspection of returns
violations under Code section 7213A are currently subject to discipline 
based on administrative determination by the IRS, adding such violations to
the list of section 1203 violations would require the IRS to change 
current practice and follow section 1203 procedures instead.

Additional penalty guidelines may also either increase or decrease 
complexity. Additional guidelines may increase complexity by creating more 
rules for the IRS to establish and follow.  The guidelines would also have
to be periodically updated to ensure that punishments for specific 
violations continue to be appropriate.  On the other hand, additional
penalty guidelines may decrease complexity by providing clarity as to 
specific punishments for specific employee violations, which may enhance 
the IRS' effectiveness in administering section 1203.


                            Prior Action
                                 
An identical proposal was included in the President's fiscal year 2003, 
2004, 2005, and 2006 budget proposals.

2.  Modifications with respect to frivolous returns and submissions

               
                               Present Law
                                
The Code provides that an individual who files a frivolous income tax 
return is subject to a penalty of $500 imposed by the IRS.\371\ The Code
also permits the Tax Court\372\ to impose a penalty of up to $25,000 if a

--------------------------
\371\ Sec. 6702.

\372\ Because the Tax Court is te only pre-payment forum available to 
taxpayers, it handles the majority of cases brought by individuals 
contesting their tax liability.  As a result, it also deals with most of
the frivolous, groundless, or dilatory arguments raised in tax cases.




taxpayer has instituted or maintained proceedings primarily for delay or
if the taxpayer's position in the proceeding is frivolous or
groundless.\373\


                            Description of Proposal
                            

The proposal modifies this IRS-imposed penalty by increasing the amount of
the penalty to $5,000 for frivolous income tax returns.

The proposal also modifies present law with respect to certain submissions
that raise frivolous arguments or that are intended to delay or impede tax
administration. The submissions to which this provision applies are: (1) 
requests for a collection due process hearing; (2) installment agreements;
and (3) offers-in-compromise. First, the proposal permits the IRS to 
dismiss such requests.  Second, the proposal permits the IRS to impose a
penalty of $5,000 for repeat behavior or failing to withdraw the request 
after being given an opportunity to do so.

The proposal permits the IRS to maintain administrative records of 
frivolous submissions by taxpayers.   The proposal also requires that this
designation be removed after a reasonable period of time if the taxpayer 
makes no further frivolous submissions to the IRS.

The proposal requires the IRS to publish (at least annually) a list of 
positions, arguments, requests, and proposals determined to be frivolous
for purposes of these provisions.

Effective date.--The proposal is effective for submissions made on or 
after the date of enactment.


                            Analysis

In general

Genuinely frivolous returns and submissions are those that raise arguments
that have been repeatedly rejected by the courts.  Dealing with genuinely 
frivolous returns and submissions consumes resources at the IRS and in the
courts that can better be utilized in resolving legitimate disputes with 
taxpayers.  Accordingly, the proposals may improve the overall functioning
of the tax system and improve the level of service provided to taxpayers 
who do not raise these frivolous arguments.

Some may question why this IRS-imposed penalty should be applied only to 
individuals instead of applying it to all taxpayers who raise frivolous 
arguments.  Expanding the scope of the penalty to cover all taxpayers would
treat similarly situated taxpayers who raise identical arguments in the 
same manner, which would promote fairness in the tax system.  Similarly, 

----------------
\373\ Sec. 6673(a).

\374\ It is unclear how this portion of the proposal is intended to
interact with the statutory prohibition on the designation of taxpayers by
the IRS as "illegal tax protesters (or any similar designation)" (sec. 3707
of the Internal Revenue Service Restructuring and Reform Act of 1998; P.L. 
105-206 (July 22, 1998)).



some may question why this penalty should apply only to income tax returns
and not to all other types of returns, such as employment tax and excise 
tax returns.  Applying this penalty to all taxpayers and all types of tax
returns would make this IRS-imposed penalty more parallel to the Tax Court 
penalty, where these constraints do not apply.  

Complexity issues

Increasing the amount of an existing penalty arguably would have no impact
on tax law complexity. It could be argued that the procedural changes made 
by the proposal, taken as a whole, would simplify tax administration by 
speeding the disposition of frivolous submissions, despite the fact that 
some elements of the proposals (such as the requirement to publish a list
of frivolous positions) may entail increased administrative burdens.


                              Prior Action
                              
A substantially similar proposal was included in the President's fiscal 
year 2003, 2004, 2005, and 2006 budget proposals.   

3.  Termination of installment agreements


                               Present Law
                               
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.  Generally, during the period installment payments are 
being made, other IRS enforcement actions (such as levies or seizures) 
with respect to the taxes included in that agreement are held in abeyance.

Under present law, the IRS is permitted to terminate an installment 
agreement only if: (1) the taxpayer fails to pay an installment at the time
the payment is due; (2) the taxpayer fails to pay any other tax liability
at the time when such liability is due; (3) the taxpayer fails to 
provide a financial condition update as required by the IRS; (4) the 
taxpayer provides inadequate or incomplete information when applying for
an installment agreement; (5) there has been a significant change in the
financial condition of the taxpayer; or (6) the collection of the tax is in 
jeopardy.\377\

------------------
\375\ The fiscal year 2004 and 2005 budget proposals applied to all types of
tax returns, not just income tax returns.

\376\ Sec.6159.

\377\ Sec.6159(b).




                         Description of Proposal
                         
The proposal grants the IRS authority to terminate an installment 
agreement when a taxpayer fails to timely make a required Federal tax 
deposit  or fails to timely file a tax return (including extensions).
The termination could occur even if the taxpayer remained current with 
payments under the installment agreement. 

Effective date.--The proposal is effective for failures occurring on or 
after the date of enactment.

                                Analysis
                                
The proposal may lead to some additional complexity in the administration
of installment agreements.  For example, taxpayers might not understand 
why their installment agreement is being terminated, leading to additional
phone calls to the IRS.  In addition, the proposal would require that 
additional explanatory information be provided to taxpayers, which will 
increase complexity.  It might be possible to reduce this increase in 
complexity by implementing these termination procedures in a manner as 
parallel as possible to the similar termination procedures for offers in
compromise.  It may also be beneficial to permit the reinstatement of 
terminated installment agreements for reasonable cause, parallel to the 
procedures applicable to offers in compromise.

The proposal reflects the policy determination that taxpayers who are 
permitted to pay their tax obligations through an installment agreement 
should also be required to remain current with their other Federal tax 
obligations.  Some might be concerned that this does not take into account
the benefits of making continued installment payments.  A key benefit to 
the Federal Government of continued installment payments is that the 
Federal Government continues to receive payments, whereas if the 
installment agreement is terminated payments under that agreement stop.
Some might note that termination of the installment agreement permits the
IRS to begin immediate collection actions, such as reinstating liens and 
levies, which could increase Federal Government receipts.  In the past 
several years, however, there has been a significant decline in IRS' 
enforced collection activities, so that others might respond that 
terminating installment agreements might not lead to increased receipts to
the Federal Government, in that the cessation of receipts due to 
termination of installment agreements may outweigh increases in 
receipts through additional enforcement activities.

The proposal is effective for failures occurring on or after the date of 
enactment.  Some may question whether it is fair to taxpayers who are 
currently in an installment agreement to terminate those agreements.

------------------------
\378\ Failure to timely make a required Federal tax deposit is not 
considered to be a failure to pay any other tax liability at the time such
liability is due under section 6159(b)(4)(B) because liability for tax
generally does not accrue until the end of the taxable period, and deposits
are required to be  made prior to that date (sec.6302).


                                 Prior Action
                                   
An identical proposal was included in the President's fiscal year 2003, 
2004, 2005, and 2006 budget proposals.  

4.  Consolidate review of collection due process cases in the United States
Tax Court 
                            Present Law
                            
In general, the IRS is required to notify taxpayers that they have a right 
to a fair and impartial hearing before levy may be made on any property or 
right to property.   Similar rules apply with respect to liens.\380\  The 
hearing is held by an impartial officer from the IRS Office of Appeals, who
is required to issue a determination with respect to the issues raised by
the taxpayer at the hearing.  The taxpayer is entitled to appeal that 
determination to a court  That appeal must be brought to the United States
Tax Court, unless the Tax Court does not have jurisdiction over the 
underlying tax liability.  If that is the case, then the appeal must be
brought in the district court of the United States.\381\  Special rules
apply if the taxpayer files the appeal in the incorrect court.

The United States Tax Court is established under Article I of the United
States Constitution  and is a court of limited jurisdiction.\383\


                        Description of Proposal

                        
The proposal consolidates all judicial review of these collection due
process determinations in the United States Tax Court.

Effective date.--The proposal applies to IRS Office of Appeals 
determinations made after the date of enactment.

                                 Analysis
                                 
Because the Tax Court is a court of limited jurisdiction, it does not
have jurisdiction over all of the taxes (such as, for example, most excise 
taxes) that could be at issue in collection due process cases.  The 
judicial appeals structure of present law was designed in recognition of
these jurisdictional limitations; all appeals must be brought in the Tax
Court unless that court does not have jurisdiction over the underlying tax
liability.  Accordingly, the proposal would give the Tax Court jurisdiction

--------------------
\379\ Sec. 6330(a).

\380\ Sec. 6320.

\381\ Sec. 6330(d).

\382\ Sec. 7441.

\383\ Sec. 7442.


over issues arising from a collection due process hearing, while the Tax
Court will not have jurisdiction over an identical issue arising in a 
different context.

The proposal would provide simplification benefits to taxpayers and to the
IRS by requiring that all appeals be brought in the Tax Court, because 
doing so will eliminate confusion over which court is the proper venue for
an appeal and will significantly reduce the period of time before judicial
review.\384\

Some believe that present law "entitles a taxpayer patently seeking delay
to achieve his goal by refiling in the District Court."\385\ The proposal
would provide simplification benefits by eliminating this opportunity for
delay.


                              Prior Action
                                    
A substantially similar proposal was included in the President's fiscal 
year 2003 and 2004 budget proposals.\386\  An identical proposal was 
included in the President's fiscal year 2005 and 2006 budget proposals.
The right to a hearing and judicial review of the determinations made at
these hearings were enacted in the IRS Restructuring and Reform Act of 
1998.\387\

5. Office of Chief Counsel review of offers in compromise 

                               Present Law
                               
The IRS has the authority to settle a tax debt pursuant to an offer in 
compromise.  IRS regulations provide that such offers can be accepted if 
the taxpayer is unable to pay the full amount of the tax liability and it
is doubtful that the tax, interest, and penalties can be collected 
or there is doubt as to the validity of the actual tax liability.  Amounts
of $50,000 or more can only be accepted if the reasons for the acceptance 
are documented in detail and supported by a written opinion from the IRS
Chief Counsel.\388\


                              Description of Proposal
                              
The proposal repeals the requirement that an offer-in-compromise of 
$50,000 or more must be supported by a written opinion from the Office of 
Chief Counsel. 

--------------------
\384\ This reductio  is attributable to the elimination of time periods
built into the judicial review process to permit the refiling of appeals
that hace been filed with the wrong court.

\385\ Nestor v Commissioner, 118 T.C. No.10 (February 19,2002), concurring
opinion by Judge Beghe.

\386\ There was a slight difference in the effecrive dates of those 
proposals.

\387\ Sec.3401(b) of P.L.105-206 (July 22,1998).

\388\ Sec. 7122.




The Secretary must establish standards for determining when a written
opinion is required with respect to a compromise.

Effective date.--The proposal applies to offers-in-compromise submitted or
pending on or after the date of enactment.

                                  Analysis
                                     
Repealing the requirement that an offer-in-compromise of $50,000 or more
be supported by a written opinion from the Office of Chief Counsel will 
simplify the administration of the offer-in-compromise provisions by the
IRS.  Repealing this requirement also would increase the level of 
discretionary authority that the IRS may exercise, which may lead to 
increasingly inconsistent results among similarly situated taxpayers. 

Some may believe that Chief Counsel review is appropriate for all offers-in-
compromise above specified dollar thresholds, similar to the review of large 
refund cases by the Joint Committee on Taxation. 

                                  Prior Action
                                  
An identical proposal was included in the President's fiscal year 2003, 
2004, 2005, and 2006 budget proposals.  The $50,000 threshold was raised
from $500 in 1996. 


















------------------
\389\ Sec.6405.  The thresold for Joint Committee review is currently
$2 million.

\390\ Sec.503 of the Taxpayer Bill of Rights 2(P.L.104-168;July 30,1996).



B. Initiate Internal Revenue Service ("IRS") Cost Saving Measures

1. Allow the Financial Management Service to retain transaction fees from 
levied amounts

                                  Present Law
                                  
To facilitate the collection of tax, the IRS can generally levy upon all 
property and rights to property of a taxpayer.\391\ With respect to 
specified types of recurring payments, the IRS may impose a continuous levy
of up to 15 percent of each payment, which generally continues in effect 
until the liability is paid.\392\  Continuous levies imposed by the IRS on 
specified Federal payments are administered by the Financial Management
Service (FMS) of the Department of the Treasury. FMS is generally 
responsible for making most non-defense related Federal payments.  FMS is
required to charge the IRS for the costs of developing and operating this
continuous levy program.  The IRS pays these FMS charges out of its 
appropriations.

                            Description of Proposal
                            
The proposal allows FMS to retain a portion of the levied funds as payment
of these FMS fees.  The amount credited to the taxpayer's account would not,
however, be reduced by this fee.

Effective date.--The provision is effective on the date of enactment.

                                Analysis
                                
Proponents believe that altering the bookkeeping structure of these costs
will provide for cost savings to the Federal Government.

                             Prior Action
                             
An identical proposal was included in the President's fiscal year 2005 and
2006 budget proposals.  

2.  Expand the authority to require electronic filing by large businesses
and exempt organizations

                                 Present Law
                                 
The Code authorizes the IRS to issue regulations specifying which returns
must be filed electronically.   There are several limitations on this 
authority.  First, it can only apply to persons required to file at least
250 returns during the year.\394\  Second, the IRS is prohibited from 

---------------------
\391\ Sec. 6331.

\392\ Sec.6331(h)

\393\ Sec. 6011(e).

\394\ Partnerships with more than 100 partners are required to file
electronically,

requiring that income tax returns of individuals, estates, and trusts be
submitted in any format other than paper (although these returns may by 
choice be filed electronically).


                          Description of Proposal
                          
The proposal expands the authority of the IRS to require businesses 
(including corporations, partnerships, and other business entities) and
exempt organizations to file their returns electronically.  The proposal
statutorily lowers the number of returns that trigger the requirement to 
file electronically from 250 to "a minimum at a high enough level to avoid
imposing an undue burden on taxpayers."   Taxpayers required to file 
electronically but who fail to do so would be subject to a monetary 
penalty, which could be waived for reasonable cause.

Effective date.--The proposal is effective for taxable years beginning 
after December 31,2006; these returns will be filed in 2008.

                                 Analysis
                                 
In general, the goal of the proposal is to reduce the administrative 
burdens on the IRS by providing IRS authority to require more taxpayers to
file electronically.  The Congress set a goal for the IRS to have 80 
percent of tax returns filed electronically by 2007.  The overwhelming 
majority of tax returns are already prepared electronically.  Thus, 
expanding the scope of returns that are required to be filed 
electronically may be viewed as both helping the IRS to meet the 80 
percent goal set by the Congress and improving tax administration.

                                Prior Action
                                
A similar proposal was included in the President's fiscal year 2006 budget
proposal.  
















-------------------
\395\ Treasury General Explanations, p.131.




                            C.  Other Provisions
                            
                            

1.  Allow Internal Revenue Service ("IRS") to access information in the 
National Directory of New Hires ("NDNH")

                                   Present Law
                                   
The Office of Child Support Enforcement of the Department of Health and
Human Services ("HHS") maintains the National Directory of New Hires 
(NDNH), which is a database that contains newly-hired employee data from 
Form W-4, quarterly wage data from State and Federal employment security
agencies, and unemployment benefit data from State unemployment insurance
agencies. The NDNH was created to help State child support enforcement 
agencies enforce obligations of parents across State lines.

Under current provisions of the Social Security Act, the IRS may obtain 
data from the NDNH, but only for the purpose of administering the Earned
Income Tax Credit (EIC) and verifying a taxpayer's employment that is 
reported on a tax return.

Under various State laws, the IRS may negotiate for access to employment
and unemployment data directly from State agencies that maintain these data.
Generally, the IRS obtains such employment and unemployment data less 
frequently than quarterly, and there are significant internal costs of 
preparing these data for use.

                            Description of Proposal
                            
The proposal amends the Social Security Act to allow the IRS access to
NDNH data for general tax administration purposes, including data matching,
verification of taxpayer claims during return processing, preparation of 
substitute returns for non-compliant taxpayers, and identification of levy
sources.  Data obtained by the IRS under the proposal is subject to the 
confidentiality and disclosure rules applicable to taxpayer information

Effective date.--The proposal is effective upon enactment.

                                 Analysis
                                 
The proposal could enhance tax administration by providing the IRS with
a more efficient method to obtain taxpayer data.  Obtaining taxpayer data
from a centralized source such as the NDNH, rather than from separate 
State agencies, should increase the productivity of the IRS by reducing 
the amount of IRS resources dedicated to obtaining and processing such
data. Some may argue that allowing the IRS to access the NDNH for general
tax administration purposes infringes on individual privacy and extends the
use of the database beyond that which was originally intended; to enable 
state child support enforcement agencies to be more effective 
in locating noncustodial parents. On the other hand, data obtained by the
IRS from the NDNH is protected by existing disclosure law. Thus, the 
proposal does not reduce the current levels of taxpayer privacy.

                                Prior Action
                                
An identical proposal was included in the President's fiscal year 2006 
budget proposal.


2. Extension of IRS authority to fund undercover operations

                                 Present Law
                                 
IRS undercover operations are statutorily  exempt from the generally 
applicable restrictions controlling the use of Government funds (which 
generally provide that all receipts must be deposited in the general fund
of the Treasury and all expenses be paid out of appropriated funds). In
general, the Code permits the IRS to use proceeds from an undercover 
operation to pay additional expenses incurred in the undercover operation,
through 2006.  The IRS is required to conduct a detailed financial audit 
of large undercover operations in which the IRS is churning funds and to 
provide an annual audit report to the Congress on all such large 
undercover operations.  

                         Description of Proposal
                         
The proposal extends this authority through December 31, 2011.

                                 Analysis
                                 
Some believe the extension of this authority is appropriate because they
believe that it assists the fight against terrorism.  Some also believe 
that it is appropriate for IRS to have this authority because other law
enforcement agencies have churning authority.  Others, however, point to
the four and a half year gap during which the provision had lapsed as 
evidence that this authority is not essential to the operation of the IRS.
However, it is difficult to show what investigative opportunities were lost
due to the lack of churning authority during that period.
Some believe that extension is inappropriate because the provision may 
provide incentives to continue undercover operations for extended periods 
of time.  IRS data for fiscal years 2002, 2003, and 2004 reveal that a 
total of approximately $748,000 was churned while only $6,700 was deposited
in the general fund of the Treasury due to the cessation of undercover 
operations.

                                 Prior Action
                                 
The provision was originally enacted in The Anti-Drug Abuse Act of 1988.
The exemption originally expired on December 31, 1989, and was extended by
the Comprehensive Crime Control Act of 1990\398\ to December 31, 1991.\399\
There followed a gap of approximately four and a half years during which


----------------------
\396\ Sec. 7608(c).

\397\ Sec. 7061(c) of Pub. L.100-690(Nov 18,1988).

\398\ Sec. 3301 of Pub. L. 191-647 (Nov.29,1990).



the provision had lapsed. In the Taxpayer Bill of Rights II,\400\the
authority to churn funds from undercover operations was extended for five
years, through 2000.\401\ The Community Renewal Tax Relief Act of 2000\402\
extended the authority of the IRS to "churn" the income earned from 
undercover operations for an additional five years, through 2005.  The Gulf 
Opportunity Zone Act of 2005 extended this authority through 2006.\403\ 









-------------------
\399\ The Ways and Means Committee Report stated: "The committee believes 
that it is appropriate to extend this provision for two additional years, 
to provide additional time to evaluate its effectiveness." Rept. 101-681, 
Part 2, p. 5 (September 10, 1990).

\400\ Sec. 1205 of Pub. L. 104-168 (July 30, 1996).


\401\ The Ways and Means Committee Report stated: "Many other law 
enforcement agencies have churning authority.  It is appropriate for IRS to
have this authority as well." Rept. 104-506, p. 47 (March 28, 1996).
The Senate passed the House bill without alteration.

\402\ Pub. L. 106-554.

\403\ Pub. L. 109-135.
    


                          D.  Reduce the Tax Gap

1. Implement standards clarifying when employee leasing companies can 
be held liable for their clients' Federal employment taxes


                                 Present Law
                                   
In general

Employment taxes generally consist of the taxes under the Federal Insurance 
Contributions Act ("FICA"), the tax under the Federal Unemployment Tax Act 
("FUTA"), and the requirement that employers withhold income taxes from 
wages paid to employees ("income tax withholding").\404\

FICA tax consists of two parts: (1) old age, survivor, and disability 
insurance ("OASDI"), which correlates to the Social Security program that
provides monthly benefits after retirement,disability, or death; and (2)
Medicare hospital insurance ("HI"). The OASDI tax rate is 6.2 percent on
both the employee and employer (for a total rate of 12.4 percent). The 
OASDI tax rate applies to wages up to the OASDI wage base ($94,200 
for 2006).  The HI tax rate is 1.45 percent on both the employee and the
employer (for a total rate of 2.9 percent).  Unlike the OASDI tax, the HI
tax is not limited to a specific amount of wages, but applies to all wages.

Under FUTA, employers must pay a tax of 6.2 percent of wages up to the
FUTA wage base of $7,000.  An employer may take a credit against its FUTA
tax liability for contributions to a State unemployment fund and certain 
other amounts.Employers are required to withhold income taxes from wages 
paid to employees.  Withholding rates vary depending on the amount of 
wages paid, the length of the payroll period,and the number of withholding
allowances claimed by the employee.

Wages paid to employees, and FICA and income taxes withheld from the wages,
are required to be reported on employment tax returns and on 
Forms W-2.\405\

Responsibility for employment tax compliance

Employment tax responsibility generally rests with the person who is the 
employer of an employee under a common-law test that has been incorporated
into Treasury regulations.\406\ Under the regulations, an employer-employee 
relationship generally exists if the person for whom services are performed
has the right to control and direct the individual who performs the 
services, not only as to the result to be accomplished by the work, but 
also as to the details and means by which that result is accomplished.
That is, an employee is subject to the will and control of the employer,

-------------------
\404\ Secs. 3101-3128 (FICA), 3301-3311 (FUTA), and 3401-3404 (income tax
withholding).

\405\ Secs. 6011 and 6051.

\406\ Treas. Reg. secs. 31.3121(d)-1(c)(1), 31.3306(i)-1(a), and 
31.3401(c)-1.


not only as to what is to be done, but also as to how it is to be done.
It is not necessary that the employer actually control the manner in which
the services are performed, rather it is sufficient that the employer have
a right to control.  Whether the requisite control exists is determined on
the basis of all the relevant facts and circumstances.  The test of whether 
an employer-employee relationship exists often arises in determining 
whether a worker is an employee or an independent contractor.  However,
the same test applies in determining whether a worker is an employee of
one person or another.\407\

In some cases, a person other than the common-law employer (a "third 
party") may be liable for employment taxes. For example, if wages are paid 
to an employee by a third party and the third party, rather than the 
employer, has control of the payment of the wages, the third party 
is the statutory employer responsible for complying with applicable 
employment tax requirements.\408\  In addition, an employer may designate a
reporting agent to be responsible for FICA tax and income tax withholding
compliance,\409\ including filing employment tax returns and issuing 
Forms W-2 to employees.  In that case, the reporting agent and the employer
are jointly and severally liable for compliance.\411\ 

Employee leasing arrangements

Under an employee leasing arrangement, a leasing company provides workers
("leased employees") to perform services in the businesses of the leasing 
company's clients.\412\  In many cases, before the leasing arrangement is

--------------
\407\ Issues relating to the classification of workers as employees or
independent contractors are discussed in Joint Committee on Taxation, Study
of the Overall State of the Federal Tax System and Recommendations for 
Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code
of 1986 (JCS-3-01), April 2001, at Vol. II, Part XV.A, at 539-550.

 \408\ Sec. 3401(d)(1) (for purposes of income tax withholding, if the 
employer does not have control of the payment of wages, the person having 
control of the payment of such wages is treated as the employer); Otte v.
United States, 419 U.S. 43 (1974) (the person who has the control of the 
payment of wages is treated as the employer for purposes of withholding 
the employee's share of FICA from wages); In re Armadillo Corporation, 561
F.2d 1382 (10th Cir. 1977), and In re The Laub Baking Company v.United 
States, 642 F.2d 196 (6th Cir. 1981) (the person who has control of the 
payment of wages is the employer for purposes of the employer's share of 
FICA and FUTA).  The mere fact that wages are paid by a person other than
the employer does not necessarily mean that the payor has control of the 
payment of the wages.  Rather, control depends on the facts and 
circumstances.  See, e.g., Consolidated Flooring Services v. United States
, 38 Fed. Cl. 450 (1997), and Winstead v. United States, 109 F. 2d 989
(4th Cir. 1997).

\409\ The designated reporting agent rules do not apply for purposes of
FUTA compliance.

\410\ Sec. 3504. Form 2678 is used to designate a reporting agent.

\411\ For administrative convenience, an employer may also use a
payroll service to handle payroll and employment tax filings on its
behalf, but the employer, not the payroll service, continues to be 
responsible for employment taxt compliance.

\412\ Employee leasing companies are somtimes referred to as professional
employer organizations or "PEOs"


entered into, the leased employees already work for the client's business 
as employees of the client. Under the terms of a typical leasing 
arrangement,the leasing company is assumed to be the employer of the leased
employees and is responsible for paying the leased employees and the 
related employment tax compliance.  The client typically pays the leasing 
company a fee based on payroll costs plus an additional amount.
In many cases, leased employees are legally the employees of the client
and the client is legally responsible for employment tax compliance. 
Nonetheless, clients generally rely on the leasing company for employment 
tax compliance (without designating the leasing company as a payroll agent)
and often take the position that the leased employees are employees of the
leasing company.

                         Description of Proposal
                         
The proposal contemplates the establishment of standards for holding 
employee leasing companies jointly and severally liable with their clients
for Federal employment taxes and for holding employee leasing companies 
solely liable for such taxes if they meet specified requirements.  Details
of the proposal have not yet been provided

Effective date.-The proposal is effective for employment tax returns filed
with respect to wages paid on or after January 1, 2007.


                                   Analysis
                                   
In the absence of a detailed proposal, the following analysis discusses 
general issues relating to employee leasing companies and employment taxes.

The IRS estimates that the portion of the 2001 tax gap attributable to 
FICA and FUTA taxes is $15 billion.\414\  An additional portion of the tax
gap is attributable to income taxes due on unreported wages. The proposal
is aimed at narrowing the tax gap attributable to employment taxes.

In an employee leasing arrangement, clients typically rely on the leasing
company to comply with the applicable employment tax requirements, 
regardless of whether legal responsibility for employment taxes rests with
the leasing company or with the client.  In addition, if a leasing company
files employment tax returns and pays employment taxes, absent an audit,
the IRS generally has no way of knowing whether the leasing company or the
client is the employer, or even that a leasing arrangement exists.  
Moreover, in situations in which neither the leasing company nor the client
complies with the applicable employment tax requirements, it may be 
difficult to determine which party is liable for employment taxes.
Uncertainty as to who is liable for employment taxes in an employee leasing
arrangement may mean that, as a practical matter, no one is held liable. 
Providing clear rules for determining who is liable for employment 
taxes in employee leasing arrangements would address those issues and could
improve compliance.

Some believe that leasing companies offer a greater likelihood of 
employment tax compliance than can be expected from clients (particularly 
clients that are small businesses) on an individual basis.  On the other 
hand, the payroll of a leasing company typically includes the payroll for 
employees leased to many client businesses, as well as payroll for 
employees working directly for the leasing company. Accordingly, failure of
a leasing company to comply may result in noncompliance on a larger scale 
than the level of noncompliance that would otherwise occur among client 
businesses.  Rules for holding leasing companies solely liable for 
employment taxes should therefore include adequate standards and procedural
safeguards to assure that the leasing company will in fact comply.

Some argue that existing rules, such as the designated payroll agent rules,
are sufficient to permit leasing companies to assume employment tax 
responsibility and that the need for rules under which only the leasing 
company is liable is really a marketing issue for leasing companies, 
rather than a true compliance issue.  On the other hand, leasing companies
argue that, in addition to improving employment tax compliance with respect
to clients, they also often provide leased employees with employee benefits
that cannot be provided by their smaller clients.

To the extent that the proposal provides clear standards for determining 
whether a leasing company, its clients, or both, are liable for employment 
taxes, without the need to determine which is the employer of the leased 
employees or which has control of the payment of wages, it may reduce the 
complexity related to employment tax compliance. On the other hand, 
allowing a leasing company to be solely liable for employment taxes may 
require complicated rules and procedures.  In addition, employer status is
relevant for employment tax purposes other than compliance.  For example,
employment tax exceptions for certain services or compensation may 
depend on the type of employer, such as agricultural employers.  In 
addition, certain aspects of the FUTA rules are based on an employer's
liability for contributions to a State unemployment system.   Similarly,
certain income tax credits are available to employers, such as the credit
for a portion of employer social security taxes paid with respect to cash
tips.  Application of these provisions may therefore be more difficult if 
a leasing company is the person handling employment tax compliance rather
than the client businesses.

                                 Prior Action
                                 
No prior action.






-------------------------
\415\ As noted above, the designated payroll agent rules do not apply for
FUTA purposes.




2  Increased information reporting on payment card transactions


                                 Present Law
                                 
Present law imposes a variety of information reporting requirements that 
enable the IRS to verify the correctness of taxpayers' returns. For example,
every person engaged in a trade or business generally is required to file 
information returns for each calendar year for payments of $600 or more 
made in the course of the payor's trade or business.  By regulation, 
payments to corporations generally are excepted from this requirement.
Certain payments subject to information reporting also are subject to 
backup withholding if the payee has not provided a valid taxpayer 
identification number ("TIN"), or if the IRS determines that there has
been payee underreporting and notice has been provided to the taxpayer with
respect to that underreporting. 

                        Description of Proposal
                               
The proposal provides the Secretary with authority to promulgate 
regulations requiring issuers of credit cards and debit cards to report to
the IRS annually the aggregate reimbursement payments made to merchants in
a calendar year.  The proposal also requires backup withholding on 
reimbursement payments made to merchants in the event that a merchant 
payee fails to provide a TIN, if the IRS notifies the payor that the TIN
furnished by the payee is incorrect, or in the event of payee 
underreporting.  Under the proposal, the Secretary is expected to exclude 
certain categories of merchant payees, such as corporations, and certain 
categories of payments from the reporting and backup withholding 
requirements.

Effective date.-The proposal is effective for payments made by payment card
issuers on or after January 1, 2007.

                                   Analysis
                                      
Requiring issuers of payment cards (credit cards and debit cards) to 
annually report to the IRS the aggregate reimbursement payments made to 
merchants, and to impose backup withholding in certain cases on such
payments,could be expected to generate additional positive effects on 
compliance and IRS collection efforts. In general, income that is subject
to information reporting and withholding is less likely to be underreported.
In contrast, the absence of information reporting or withholding on many 
types of payments results in underreporting and contributes to the tax gap.
In general, the more payments to which information reporting and/or 
withholding applies, the greater improvement in compliance.  While some 
consider it inappropriate to single out payment card reimbursements made to
merchants for additional information reporting, others respond that 
reporting is appropriate in this instance because of the large amount of 
income derived by businesses from payment card transactions and because the 
unreported income of businesses represents a significant part of the tax 
gap.  Information reporting for payment card reimbursements would also help







--------------------
\416\ Sec. 6041(a).

\417\ The tax gap is the amount of tax that is imposed by law for a given
tax year but is not paid voluntarily and timely.



the IRS focus its audit resources on taxpayers who are more likely to have 
unreported income.

Although the proposal can be expected to increase tax compliance, the 
extent of the increase will depend on the details of the reporting 
requirements and any exceptions, which have not yet been specified.  For 
example, the proposal is not expected to apply to reimbursement payments to
corporations, which suggests that it is more likely to apply to payments to
small businesses rather than to larger businesses.  Thus, the proposal 
could have the effect of discouraging small businesses from accepting 
payment cards, which could reduce the compliance benefit of the proposal.
Moreover, the proposal does not provide a definition for "merchant," so 
issues arise as to the scope of the proposal, for example, whether it 
applies to service providers that accept payment cards, as well as to 
retail businesses.  Clarification of these issues is necessary to implement
the proposal.

Finally, imposing additional information reporting and withholding 
requirements will increase the paperwork burden on financial institutions 
subject to the provision.  The extent of the increase in burden and any 
associated costs will depend on the details of the proposal.  Any 
additional burden will be lessened to the extent that the proposal relies
on existing information gathering systems.


                                Prior Action
                                
No prior action.

3. Increased information reporting for certain government payments for 
goods and services.

                                Present Law
                                
Present law imposes numerous information reporting requirements that enable
the Internal Revenue Service ("IRS") to verify the correctness of 
taxpayers' returns.  For example,every person engaged in a trade or 
business generally is required to file information returns for each 
calendar year for payments of $600 or more made in the course of the 
payor's trade or business.\418\  By regulation, payments to corporations 
generally are excepted from this requirement.  Certain payments subject to
information reporting also are subject to backup withholding if the payee 
has not provided a valid taxpayer identification number ("TIN"), or if the
IRS determines that there has been payee underreporting and notice has been
provided to the taxpayer with respect to that underreporting.  Special 
information reporting requirements exist for employers required to deduct 
and withhold tax from employees' income.\419\  In addition, any service






----------------
\418\ Sec. 6041(a).

\419\ Sec. 6051(a)



recipient engaged in a trade or business and paying for services is 
required to make a return according to regulations when the aggregate of
payments is $600 or more.\420\ 


Government entities also are required to make an information return, 
reporting payments for services to corporations as well as 
individuals.\421\  Moreover, the head of every Federal executive agency
that enters into certain contracts must file an information return 
reporting the contractor's name, address, TIN, date of contract action,
amount to be paid to the contractor, and any other information required
by Forms 8596 (Information Return for Federal Contracts) and 8596A
(Quarterly Transmittal of Information Returns for Federal Contracts).\422\



                           Description of Proposal
                              
The proposal provides the Secretary with authority to promulgate 
regulations requiring information reporting on all non-wage payments by 
Federal, State and local governments to procure property and services. 
The proposal also requires backup withholding on such payments in the event
that the payee fails to provide a TIN, or if the IRS notifies the payor 
that the TIN furnished by the payee is incorrect, or in the event of payee
underreporting.  Under the proposal,the Secretary is expected to exclude 
certain categories of payments from the information reporting and backup 
withholding requirements, including payments of interest, payments for 
real property, payments to tax-exempt entities or foreign governments, 
intergovernmental payments, and payments made pursuant to a classified or
confidential contract. 

Effective date.-The proposal is effective for payments made by Federal, 
State and local governments to procure property and services on or after
January 1, 2007.

                                  Analysis
                                     
The proposal could have a positive impact on compliance with the tax laws
by requiring additional information reporting and backup withholding on 
certain non-wage payments.  In general, the more payments to which 
information reporting and withholding applies, the greater improvement in 
compliance.  However, the extent to which the proposal improves compliance 
depends on details which have not been specified, such as the scope of 
payments subject to the proposal and any exceptions.  For example, under 
present law, government entities are required to report payments to a 
service provider when the aggregate of payments to such service provider 
is $600 or more.  The proposal does not specify whether a similar dollar 
threshold would apply to payments subject to the reporting requirements.
Because the extent to which the proposal expands upon present-law 
requirements is unclear, it is difficult to fully assess the relative 
benefits and detriments of the proposal.





---------------
\420\ Sec. 6041A.

\421\ Sec. 6041A(d)(3)(A)

\422\ Sec. 6050M.



Imposing additional information reporting requirements also will impose new
costs on payors. The extent of any new burden and associated costs will 
depend on the details of the proposal.  In general, new burdens will be 
lessened to the extent the proposal relies on procedures already in place.
For example, present law imposes information reporting requirements on 
governmental entities.  Arguably, the proposal only will require the 
expansion of existing procedures to satisfy the broader requirements under
the proposal, not the creation of wholly new procedures.  Similarly, 
certain Federal payments to vendors of goods or services are subject to 
continuous levy authority under present law.  Thus, government entities are
likely to have existing procedures for deducting and remitting taxes from
payments to businesses and individuals that may be tailored to the specific
requirements of the proposal.

Some might consider it inappropriate to single out payments by Federal, 
State and local governments for additional information reporting, rather 
than expanding the reporting requirements for all payors.  Proponents 
respond that additional information reporting is appropriate in this 
instance because unreported income received by government contractors 
represents an important part of the tax gap.


                                  Prior Action
                                  
No prior action.

4.  Amend collection due process procedures for employment tax liabilities

                                  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.  A Federal tax lien arises automatically where (1) a tax 
assessment has been made, (2) the taxpayer has been given notice of the
assessment stating the amount and demanding payment, and (3) the taxpayer 
has failed to pay the amount assessed within 10 days after the notice and
demand.

In general, the IRS is required to notify taxpayers that they have a right
to a fair and impartial collection due process ("CDP") hearing before levy 
may be made on any property or right to property.   Similar rules apply 
with respect to notices of tax liens, although the right to a hearing 
arises only on the filing of a notice.\426\ The CDP hearing is held by an 
impartial officer from the IRS Office of Appeals, who is required to issue
a determination with respect to the issues raised by the taxpayer at the


------------------
\423\ Sec.6331(b).

\424\ The tax gap is the amount of tax that is imposed by law for a given
tax year but is not paid voluntarily and timely.

\425\ Sec. 6330(a)

\425\ Sec. 6320.




hearing.  The taxpayer is entitled to appeal that determination 
to a court.  Under present law, taxpayers are not entitled to a pre-levy
CDP hearing if a levy is issued to collect a Federal tax liability from a
State tax refund or if collection of the Federal tax is in jeopardy.  
However, levies related to State tax refunds or jeopardy determinations
are subject to post-levy review through the CDP hearing process.

Employment taxes generally consist of the taxes under the Federal 
Insurance Contributions Act ("FICA"), the tax under the Federal 
Unemployment Tax Act ("FUTA"), and the requirement that employers withhold
income taxes from wages paid to employees ("income tax withholding").
Income tax withholding rates vary depending on the amount of wages 
paid, the length of the payroll period, and the number of withholding 
allowances claimed by the employee.

                             Description of Proposal
                             
Under the proposal, levies issued to collect Federal employment taxes are 
excepted from the pre-levy CDP hearing requirement.  Thus, taxpayers would 
not have a right to a CDP hearing before a levy is issued to collect 
employment taxes.  As with the current procedures applicable to 
levies issued to collect a Federal tax liability from State tax refunds,
the taxpayer would be provided an opportunity for a hearing within a 
reasonable period of time after the levy  Collection by levy would be 
allowed to continue during the CDP proceedings.

Effective date.-The proposal is effective for levies issued on or after 
January 1, 2007.

                                 Analysis
                                 
Congress enacted the CDP hearing procedures to afford taxpayers adequate 
notice of collection activity and a meaningful hearing before the IRS 
deprives them of their property.  By permitting the IRS to seize property 
prior to the CDP hearing, the proposal may increase the burden on taxpayers
with employment tax liabilities who are legitimately seeking alternatives
to IRS forced collection through levy.  Opponents of the proposal argue 
that if such a taxpayer is making a legitimate effort to resolve a tax 
liability, and the interests of the United States are adequately protected,
it would be appropriate to preclude enforced collection of the liability.

On the other hand, proponents argue that taxpayers frequently abuse the CDP
procedures by raising frivolous arguments simply for the purpose of 
delaying or evading collection of tax. Moreover, proponents argue that the
opportunity to delay collection of employment tax liabilities presents a 
greater risk to the government than delay may present in other contexts 
because employment tax liabilities continue to increase as ongoing wage 
payments are made to employees.  In addition, much of an employer's 
employment tax liability consists of FICA tax and income tax withheld from
employees' wages and held in trust for the government by the employer.  
Others respond that the opportunity to use the present-law rules in 
unintended ways to delay or defeat the collection process is not unique to

---------------------
\427\ secs. 3101-3128 (FICA), 3301-3311 (FUTA), and 3401-3404 (income tax
withholdings). FICA taxes consist of an employer share and an employee
share, which the employer withholds from employees' wages.


taxpayers with employment tax liabilities.  In addition, opponents argue 
that it is unnecessary to provide special rules for employment tax 
liabilities because present law permits the IRS to levy property prior to
providing the CDP  hearing if collection of the tax is in jeopardy.



                                   Prior Action
                                   
No prior action.


5.  Expand the signature requirement and penalty provisions applicable to
paid preparers

                                     Present Law
                                     
An income tax return preparer is defined as any person who prepares for 
compensation,or who employs other people to prepare for compensation, all 
or a substantial portion of an income tax return or claim for refund.\428\  
Under present law, the definition of an income tax return preparer does not 
include a person preparing non-income tax returns, such as estate and 
gift, excise, or employment tax returns.

Income tax return preparers are required to sign and include their taxpayer
identification numbers on income tax returns and income return-related 
documents prepared for compensation. Penalties are imposed on any income 
tax return preparer who, in connection with the preparation of an income 
tax return, fails to (1) furnish a copy of a return or claim for refund to 
the taxpayer, (2) sign the return or claim for refund, (3) furnish his or
her identifying number, (4) retain a copy of the completed return or a 
list of the taxpayers for whom a return was prepared, (5) file a correct 
information return, and (6) comply with certain due diligence requirements
in determining a taxpayer's eligibility for the earned income credit.\429\ 
The penalty is $50 for each failure and the total penalties imposed for any
single type of failure for any calendar year are limited to $25,000.

Under present law, income tax return preparers also are subject to a 
penalty of $250 with respect to any return if a portion of an 
understatement of tax liability is due to a position for which there was
not a realistic possibility of success on the merits, the preparer knew or 
reasonably should have known of the position, and the position was not 
disclosed or was frivolous.\430\ In addition, present law imposes a 
penalty on income tax return preparers of $1,000 with respect to a tax 
return if a portion of an understatement of tax liability is due to a
willful attempt to understate liability or to reckless or intentional 
disregard of rules or regulations.\431\ 




------------------
\429\ Sec. 7701(a)(36)(A).

\429\ Sec. 6695.

\430\ Sec. 6694(a).

\431\ Sec. 6694(b).



                      Description of Proposal
                      
The proposal expands preparer identification and penalty provisions to
non-income tax returns (such as estate and gift, employment tax, and excise
tax returns) and non-income tax return-related documents prepared for 
compensation.  The proposal also subjects paid preparers to penalties for 
preparing non-income tax return-related documents that contain false,
incomplete, or misleading information or contain frivolous positions that 
delay collection.

Effective date.-The proposal is effective for returns filed on or after 
January 1, 2007.

                              Analysis
                              
Penalties for the failure to comply with tax laws are a necessary component
of any tax system if broad compliance is to be expected.  The present-law 
penalties that apply to income tax return preparers serve to establish and 
validate the standards of behavior set forth by the tax laws themselves, as
well as to prevent specific departures from and enforce such laws.  The 
proposal to expand present-law penalties for income tax return preparers to
paid preparers of all types of tax returns and documents may enhance 
compliance by imposing on non-income tax return preparers the same or 
similar requirements that apply to income tax return preparers.  In 
addition, the proposal may achieve a measure of uniformity and promote 
fairness in the tax system by treating similarly situated individuals in 
the same manner.  However, the extent to which the proposal improves the 
overall functioning of the tax system depends on details which have not 
been specified, such as the definition of a "non-income tax return 
preparer" and whether such preparers will be subject to the same standards
as income tax return preparers for purposes of imposing penalties for 
submitting false, incomplete, misleading, or frivolous returns.

                                Prior Action
                                
No prior action.


E.  Strengthen the Financial Integrity of Unemployment Insurance

1.  Reduce improper benefit payments and tax avoidance

                                Present Law
                                
The Federal Unemployment Tax Act ("FUTA") imposes a 6.2-percent gross tax 
rate on the first $7,000 paid annually by covered employers to each 
employee.  Employers in States with programs approved by the Federal 
Government and with no delinquent Federal loans may credit 5.4 percentage 
points against the 6.2 percent tax rate, making the net Federal 
unemployment tax rate 0.8 percent.  Because all States have approved 
programs, 0.8 percent is the Federal tax rate that generally applies. 
The net Federal unemployment tax revenue finances the administration of 
the unemployment system, half of the Federal-State extended benefits 
program, and a Federal account for State loans.  Also, additional 
distributions ("Reed Act distributions") may be made to the States, if the
balance of the Federal unemployment trust funds exceeds certain statutory 
ceilings.  The States use Reed Act distributions to finance their regular
State programs (which are mainly funded with State unemployment taxes) and
the other half of the Federal-State extended benefits program.

State Unemployment Insurance taxes are deposited into the State's Federal 
Unemployment Insurance Trust Fund and are used by the State to pay 
unemployment benefits. State recoveries of overpayments of unemployment 
insurance benefits must be similarly deposited and used exclusively to pay
unemployment benefits.  While States may enact penalties for overpayments, 
amounts collected as penalties or interest on benefit overpayments may be 
treated as general receipts by the States.

Under present law, all States operate experience rating systems.  Under 
these systems an employer's State unemployment tax rate is based on the 
amount of unemployment benefits paid to the employer's former employees.
Generally, the more unemployment benefits paid to former employees, the 
higher the State unemployment tax rates.

The Office of Child Support Enforcement of the Department of Health and
Human Services ("HHS") maintains the National Directory of New Hires 
("NDNH"), which is a database that contains newly-hired employee data from
Form W-4, quarterly wage data from State and Federal employment security 
agencies, and unemployment benefit data from state unemployment insurance 
agencies.  The NDNH was created to help state child support enforcement 
agencies enforce obligations of parents across state lines.



                         Description of Proposal
                         
The proposal provides States with an incentive to recover unemployment
benefit overpayments, and delinquent employer taxes.  The proposal allows 
States to redirect up to five percent of overpayment recoveries to 
additional enforcement activity.  The proposal requires States to impose a
15 percent penalty on recipients of fraudulent overpayments; the penalty 
would be used exclusively for additional enforcement activity.

Under the proposal, States are prohibited from relieving an employer of 
benefit charges due to a benefit overpayment if the employer had caused the 
overpayment.  In certain circumstances relating to fraudulent overpayments
or delinquent employer taxes, States are permitted to employ private 
collection agencies to retain a portion (up to 25 percent) of such 
overpayments or delinquent taxes collected.  In addition, the proposal
provides that the Secretary of the Treasury, upon request of a State, will
reduce any income tax refund owed to a benefit recipient when that 
recipient owes a benefit overpayment to the requesting State.

The proposal requires employers to report the starting date of employment
for all new hires to the NDNH.  Finally, the proposal authorizes the 
Secretary of Labor to waive certain requirements to allow states to conduct
Demonstration Projects geared to reemployment of individuals eligible for 
unemployment benefits.

Effective date.--The proposal is effective on the date of enactment.


                                Analysis

States' abilities to reduce unemployment benefit overpayments and increase
overpayment recoveries are limited by funding. In addition, the present-law
requirement that States redeposit recoveries of overpayments to the Federal
Unemployment Insurance Trust Fund creates a relative disincentive for 
States to increase enforcement activity.  Permitting States to redirect 
five percent of overpayment recoveries to additional enforcement activity 
provides States with additional resources to detect and recover 
overpayments.  The proposal also deters noncompliance by imposing a 15 
percent penalty on fraudulent overpayments and provides States additional
resources by requiring penalty proceeds to be used exclusively for 
enforcement activity.  However, the proposal does not provide a definition
of what will be considered fraudulent.  The lack of a uniform definition of
a fraudulent overpayment may result in disparate treatment of individuals 
in different States.  In addition, there is a question as to whether the 
Federal Government can ensure that amounts redirected from the Federal 
Unemployment Insurance Trust Fund are used exclusively for State 
enforcement purposes.

The proposal also prohibits States from relieving employers of benefit 
charges due to a benefit overpayment if the employer caused the overpayment.
Proponents may argue this will decrease overpayments resulting from 
employer error.  In addition, the proposal ensures that employers with high
error rates bear the burden of additional costs associated with such errors.  
On the other hand, the proposal does not provide a definition of what will
be considered employer fault. Without providing the States criteria for 
making this determination, there are issues regarding the administrability
of such a standard.

The proposal permitting States to employ private collection agencies to 
retain a portion of certain fraudulent overpayments or delinquent employer 
taxes collected may permit States to more efficiently allocate resources to
enforcement activities.  The proposal does not, however, describe the 
circumstances when private collection agencies will be allowed to retain a
portion of taxes collected and some may question whether it is appropriate 
to compensate such agencies based on the success in collecting taxes that
are due.

There are administrability issues regarding the proposal requiring the 
Secretary to reduce any income tax refund owed to an unemployment benefit 
recipient when that recipient owes a overpayment to a State requesting 
offset.  Present law provides States a limited right of offset with respect
to legally enforceable State income tax obligations.  Present law also 
establishes the priority of State income tax obligations relative to other
liabilities.  The proposal neither defines how the IRS will determine 
whether unemployment overpayments are legally owed to a State nor describes
the relative priority of such offsets. Clarification of these issues is 
necessary to implement this element of the proposal.  Finally, some may 
question whether it is appropriate to provide States an offset right in 
non-income tax cases, thus, expanding the circumstances in which the 
Federal Government acts a collection agent for the States.

Proponents may argue that the proposal requiring employers to report the
starting date of employment for all new hires to the NDNH will reduce 
unemployment benefit overpayments.  Obtaining taxpayer data from a 
centralized source such as the NDNH, rather than from separate 
State agencies, should increase the efficiency of enforcement efforts.
Some may argue, however, that allowing States to access the NDNH for 
administering unemployment benefits extends the use of the database beyond
that which was originally intended; to enable state child support 
enforcement agencies to be more effective in locating noncustodial parents.

                               Prior Action
                               
A similar proposal was included in the President's fiscal year 2006 budget
proposal.

2.  Extension of Federal Unemployment Surtax

                                Present Law
                                  
The Federal Unemployment Tax Act (FUTA) imposes a 6.2 percent gross tax
rate on the first $7,000 paid annually by covered employers to each 
employee.  Employers in States with programs approved by the Federal 
Government and with no delinquent Federal loans may credit 5.4 percentage 
points against the 6.2 percent tax rate, making the minimum, net Federal 
unemployment tax rate 0.8 percent.  Since all States have approved 
programs, 0.8 percent is the Federal tax rate that generally applies.
This Federal revenue finances administration of the unemployment system,
half of the Federal-State extended benefits program, and a Federal 
account for State loans.  The States use the revenue turned back to them by
the 5.4 percent credit to finance their regular State programs and half of 
the Federal-State extended benefits program.

In 1976, Congress passed a temporary surtax of 0.2 percent of taxable wages
to be added to the permanent FUTA tax rate.  Thus, the current 0.8 percent 
FUTA tax rate has two components: a permanent tax rate of 0.6 percent, and
a temporary surtax rate of 0.2 percent.  The temporary surtax subsequently 
has been extended through 2007.

                             Description of Proposal
                             

The proposal extends the temporary surtax rate through December 31, 2012.

Effective date.-The proposal is effective for labor performed on or after
January 1, 2008.

                                     Analysis
                                     
The proposal reflects the belief that a surtax extension is needed in 
order to increase funds for the Federal Unemployment Trust Fund to provide 
a cushion against future Trust Fund expenditures.  The monies retained in 
the Federal Unemployment Account of the Federal Unemployment Trust Fund can
then be used to make loans to the 53 State Unemployment Compensation 
benefit accounts as needed.

An argument against the proposal is that an extension is not necessary at 
this time because Federal Unemployment Trust Fund projected revenues are 
sufficient to cover projected expenditures for the next several years. 
Some argue that the proposal is simply an attempt to improve the unified 
Federal budget by collecting the surtax for five additional years.

   
                                Prior Action
                                   
No prior action.




VII.   MODIFY ENERGY POLICY ACT OF 2005

A.  Repeal Temporary 15-Year Recovery Period for Natural Gas Distribution
Lines

                                Present Law
                                
The applicable recovery period for assets placed in service under the 
Modified Accelerated Cost Recovery System is based on the "class life of 
the property."  Except where provided specifically by statute, the class 
lives of assets placed in service after 1986 are generally set forth in 
Revenue Procedure 87-56.\432\  In the Revenue Procedure, natural gas 
distribution pipelines are assigned a 20-year recovery period and a class
life of 35 years.  However, natural gas distribution pipelines the original
use of which commences with the taxpayer after April 11,2005, and which are
placed in service before January 1, 2011 are assigned a statutory 15-year 
recovery period.\433\ 

                           Description of Proposal
                           
Under the proposal, the temporary 15-year recovery period for natural gas
distribution lines is repealed for property placed in service after 
December 31, 2006.  Thus, under the proposal, all natural gas distribution 
lines placed in service after December 31, 2006 are assigned a recovery period
of 20 years and a class life of 35 years.

                                   Analysis
                                     
The temporary reduced recovery period for natural gas distribution lines
under present law encourages investment in such property by reducing the 
present-value after-tax cost of investment. In considering the shorter 
recovery period, the Senate Committee on Finance and the House Ways and 
Means Committee each cited an aging energy infrastructure and a desire to 
encourage investment in energy property:

"The Committee recognizes the importance of modernizing our aging energy
infrastructure to meet the demands of the twenty-first century, and the
Committee also recognizes that both short-term and long-term solutions are
required to meet this challenge.  The Committee understands that investment
in our energy infrastructure has not kept pace with the nation's needs. In
light of this,the Committee believes it is appropriate to reduce the 
recovery period for investment in certain energy infrastructure property
to encourage investment in such property."\434\

-------------------------
\432\ 1987-2 CX.B.674(as clarified and modified by Rev. Proc.88-22,1998-I
C.B. 785).

\433\ Sec. 168(e)(3)(E)(viii).

\434\ Sec H.R. Rep. No. 108-67, at 51 (2003) and S, Rep, No,108-54, at 58
(2003). Sec.168(e)(3)(E)(viii) was enacted as part of the Energy Policy
Act of 2005 (Pub. L.No. 109-58), While neither tax committee filed a 
committee report witih respect to the Energy Policy Act of 2005, a
substantially identifical provision to sec,168(e)(E)(viii) was passed by 
both the House and the Senate in 2003. The quoted text appears in each of


However, supporters of the proposal to repeal the reduced recovery period
argue that the nation's energy policy should be focused not just on 
modernization but on increased energy supply, and that incentives for 
investment should therefore be offered to suppliers rather than 
distributors. This argument suggests that the reduced recovery period
should be repealed in favor of incentives for energy production and energy
efficiency.

Proponents also argue that the shorter recovery period unfairly benefits 
gas utilities over competitors such as electric utilities.\435\ This
argument raises two primary questions. The first question is whether it is
accurate that the 15-year and 20-year recovery periods for gas utilities
and electric utilities, respectively, favor investment in gas distribution
lines over electric distribution lines.  The second question is, if so, 
whether there is a policy justification for doing so.

The first question is one of neutrality, and requires analysis of the 
economic lives of the properties whose recovery periods are being compared.
Conforming the recovery period of a property as closely as possible to the 
economic life of the property results in a more accurate measure of 
economic income derived from such property. Additionally, to the extent 
that the depreciation schedules of other property are designed to 
accurately measure economic depreciation, a depreciation schedule for an
asset class that deviates from economic depreciation may distort investment
decisions. If the depreciation schedule provides for faster cost recovery 
than economic depreciation, an incentive is created to invest in such 
assets relative to other assets.  Similarly, if the depreciation schedule 
provides for slower cost recovery than economic depreciation, a 
disincentive to invest in such assets is created.  If the depreciation 
schedules uniformly match economic depreciation, the depreciation system
will be generally neutral as to the choice of investment across asset 
classes.  Such neutrality promotes economically efficient investment 
choices by helping to insure that investments with the highest post-tax 
return (the return that the investor cares about) are also those with the
highest pre-tax return (the measure of the value of the investment to 
society).  Thus, the 15-year recovery period for gas distribution 
lines creates an advantage for gas distributors over electric utilities
only if it is shorter than the economic life of the gas distribution lines
to a greater degree than the 20-year recovery period for electric utility 
lines is shorter than their economic life.  

The relationship between the economic lives of gas distribution lines and 
electric utility lines is unclear and would require an empirical study to 
determine.  As part of the Tax and Trade Relief Extension Act of 1998,\436\
Congress directed the Secretary of the Treasury to conduct a study of 

-----------------
the cited committee reports under the heading "Reasons for Change."

\435\ While high voltage electric transmission lines are also assigned a
15-year recovery period, the lower voltage lines which go into individual
homes are recovered over 20 years.  No such distinction exists with 
respect to the depreciable life of gas lines; thus, gas lines which 
serve individual homes and businesses are eligible for the 15-year 
recovery period under present law.

\436\ Division J of the Omnibus Consolidated and Emergency Supplemental
Appropriations Act,H.R. 4328, Pub. L. No. 105-206 (1999).



recovery periods and depreciation methods, in part due to concerns that 
present-law depreciation rules may create competitive disadvantages such
as the one which could be asserted with respect to gas and electric 
utilities.\437\   In the resulting report, Treasury cited time, cost, and 
difficulty as reasons not to address the recovery periods of specific 
assets as part of a study of the overall depreciation system:

"Resolution of the issue of how well the current recovery periods and
methods reflect useful lives and economic depreciation rates would involve 
detailed empirical studies and years of analysis.  In addition, the data 
required for this analysis would be costly and difficult to obtain."\438\ 

While the time, cost, and difficulty of empirically studying the economic 
lives of all assets makes doing so impractical, addressing individual 
assets such as those used in the electric and gas utility industries would
be feasible.\439\ 

The question of whether a policy justification exists for providing an
incentive to invest in gas distribution lines rather than 
electric utility lines is primarily one of efficiency.  On one hand, it 
could be argued that such an incentive is inappropriate policy because it 
reduces the efficiency of the market, making it less likely to steer 
consumption decisions toward the least expensive energy sources.  However,
it could also be argued that an incentive to invest in gas distribution
lines overcomes an existing market inefficiency.  While certain household
appliances and systems can be operated using gas or electric energy, many 
others require only electricity (e.g., a microwave oven).  Thus, electric
utilities are likely to be offered to every residential consumer while not
all of those consumers are also offered the option of natural gas. An 
incentive to invest in gas distribution lines may result in more customers
having the option to choose between gas and electric energy, allowing them 
to efficiently choose household appliances according to cost and 
performance.  This would also promote increased competition 
among energy sources, forcing producers and distributors to become more 
efficient.

                                  Prior Action
                                  
No prior action.








---------------------
\437\ The Congress also cited improper measurement of income and 
inefficient allocation of investment capital as concerns.  See Joint 
Committee on Taxation, General Explanation of Tax Legislation Enacted in
1998 (JCS-6-98), November 24, 1998, at 279.

\438\ Department of the Treasury, Report to The Congress on Depreciation
Recovery Methods and Periods, July 2000, at 1.

\439\ During the years 1989 through 1991 the now-defunct Depreciation 
Analysis Division of Treasury's Office of Tax Analysis completed a number
of property-specific reports which included the results of such studies.
A summary of these reports can be found in the Treasury report.
See id. at 123.



B.  Modify Amortization for Certain Geological and Geophysical Expenditures


                                    Present Law
                                    
Geological and geophysical expenditures ("G&G costs") are costs incurred by
a taxpayer for the purpose of obtaining and accumulating data that will 
serve as the basis for the acquisition and retention of mineral properties 
by taxpayers exploring for minerals.  G&G costs incurred in connection with
oil and gas exploration in the United States may be amortized over two 
years (sec. 167(h)).  In the case of property abandoned during the two year 
period, no abandonment loss deduction for G&G costs is allowed. G&G costs
associated with abandoned property continue to be recovered over the 
two-year amortization period.

                            Description of Proposal
                               
The proposal establishes a five-year amortization period for G&G costs 
incurred in connection with oil and gas exploration in the United States.
The five-year amortization period applies even if the property to which 
the G&G costs relate is abandoned, and any remaining unamortized G&G costs
associated with the abandoned property are recovered over the remainder of
the five-year period. 

Effective date.--The proposal is effective for G&G costs paid or incurred
in taxable years beginning after December 31, 2006.

                                 Analysis
                                      
Prior to the enactment of the two-year amortization period for G&G costs
such costs were treated as capital expenditures deductible over the useful
life of the property to which they related.  In the event the G&G costs 
associated with a particular area of interest did not result in the 
acquisition or retention of property, the entire amount of the G&G costs 
allocable to the area of interest was deductible as a loss under section
165 for the taxable year in which such area of interest was abandoned as a 
potential source of mineral production.

As part of the Energy Policy Act of 2005, the amortization period for G&G
costs was fixed at two years, regardless of whether such costs resulted in
the acquisition or abandonment of any property.  While this simplified the 
process for recovering G&G costs, it also had the result of extending the 
recovery period for G&G costs associated with abandoned property.  On 
average, however, the two-year amortization period accelerated the 
recovery of G&G costs. Having a more rapid recovery period was intended to
foster increased exploration for sources of oil and natural gas within the 
United States. 

Extending the recovery period for domestic G&G costs from two to five 
years increases the after-tax costs associated with oil and gas exploration 
in the United States and thus reduces the incentive to engage in such 
activities.  Proponents of the proposal believe that high energy prices are 
already providing sufficient incentives for companies to invest in oil 
and gas exploration. While a five year amortization period may more 
closely match the useful life of property acquired for mineral production
as a result of the geological and geophysical expenditures, the longer 
amortization period also increases the difference between the assumed 
life of the asset for tax purposes versus its actual economic life, in 
cases where property is abandoned.

                                 Prior Action
                                    
The Tax Relief Act of 2005 contains a provision that would require certain 
large integrated oil companies to amortize their G&G costs over the useful 
life of the property to which those costs relate.


VIII.	EXPIRING PROVISIONS

A.  Extend Alternative Minimum Tax Relief for Individuals

     
                                 Present Law
                                 
The alternative minimum tax is the amount by which the tentative minimum 
tax exceeds the regular income tax.  An individual's tentative minimum tax 
is the sum of (1) 26 percent of so much of the taxable excess as does not 
exceed $175,000 ($87,500 in the case of a married individual filing a 
separate return) and (2) 28 percent of the remaining taxable excess. The 
taxable excess is so much of the alternative minimum taxable income 
("AMTI") as exceeds the exemption amount. The maximum tax rates on net
capital gain and dividends used in computing the regular tax are used in
computing the tentative minimum tax.  AMTI is the individual's taxable 
income adjusted to take account of specified preferences and adjustments.

The exemption amount is: (1) $45,000 ($58,000 for taxable years beginning 
after 2002 and before 2006) in the case of married individuals filing a 
joint return and surviving spouses; (2) $33,750 ($40,250 for taxable years
beginning before 2006) in the case of other unmarried individuals; (3)
$22,500 ($29,000 for taxable years beginning after 2002 and before 2006)
in the case of married individuals filing a separate return; and 
(4) $22,500 in the case of an estate or trust. The exemption amount is 
phased out by an amount equal to 25 percent of the amount by which the 
individual's AMTI exceeds (1) $150,000 in the case of married individuals
filing a joint return and surviving spouses, (2) $112,500 in the case of 
other unmarried individuals, and (3) $75,000 in the case of married 
individuals filing separate returns, an estate, or a trust. These 
amounts are not indexed for inflation.

Present law provides for certain nonrefundable personal tax credits (i.e.,
the dependent care credit, the credit for the elderly and disabled, the
adoption credit, the child tax credit, the credit for interest on certain
home mortgages, the HOPE Scholarship and Lifetime Learning credits, the 
credit for savers, the credit for certain nonbusiness energy property, the
credit for residential energy efficient property, and the D.C. first-time 
homebuyer credit).   In addition, the Energy Tax Incentives Act of 2005 
enacted, effective for 2006, nonrefundable tax credits for alternative 
motor vehicles, and alternative motor vehicle refueling property. 

For taxable years beginning in 2005, the nonrefundable personal credits
are allowed to the extent of the full amount of the individual's regular 
tax and alternative minimum tax.

For taxable years beginning after 2005, the nonrefundable personal credits
(other than the adoption credit, child credit and saver's credit) are 
allowed only to the extent that the individual's regular income tax
liability exceeds the individual's tentative minimum tax, determined 

----------------------------
\440\ The portion of these credits relating to personal user property is 
subject to the same tax liability limitation as the nonrefundable personal
tax credits (other than the adoption credit, child credit, and saver's
credit).


without regard to the minimum tax foreign tax credit. The adoption credit,
child credit, and saver's credit are allowed to the full extent of the 
individual's regular tax and alternative minimum tax.\441\



                           Description of Proposal 
                               
The proposal extends the higher individual AMT exemption amounts ($58,000, 
$40,250,and $29,000) through 2006.

For 2006, the proposal allows an individual to offset the entire regular 
tax liability and alternative minimum tax liability by the nonrefundable 
personal credits

Effective date.-The proposal is effective for taxable years beginning in
2006.

                                  Analysis
                                  
Allowing the nonrefundable personal credits to offset the regular tax and
alternative minimum tax, and increasing the exemption amounts results in 
significant simplification.  Substantially fewer taxpayers need to complete
the alternative minimum tax form (Form 6251), and the forms and worksheets 
relating to the various credits can be simplified.\442\


Congress, in legislation relating to expiring provisions in recent years,
has determined that allowing these credits to fully offset the regular tax
and alternative minimum tax does not undermine the policy of the individual
alternative minimum tax and promotes the important social policies 
underlying each of the credits.

Congress also has temporarily increased the exemption amount in recent 
years to limit the impact of the AMT.

The following example compares the effect of not extending minimum tax 
relief with the effect of the proposal extending minimum tax relief:

Example.--Assume in 2006, a married couple has an adjusted gross income of
$80,000, they do not itemize deductions, and they have four dependent 
children, two of whom are eligible for the child tax credit and two of 
whom are eligible for a combined $3,000 HOPE Scholarship 
credit.  The couple's net tax liability (without and with an extension) is
shown in Table 1



--------------------
\441\ The rule applicable to the adoption credit, child credit, and 
savers' credit is subject to the EGTRRA sunset.

\442\ For a recommendation that the repeal of the individual alternative
minimum tax will result in significant tax simplification, see Study of the
Overall State of the Federal Tax System and Recommendations Pursuant to 
Section 8022(3)(B) of the Internal Revenue Code of 1986, Volume II: 
Recommendations of the Staff of the Joint Committee on Taxation to Simplify
the Federal Tax System, p.2.




GRAPHICS NOT AVAILABLE IN ITFF FORMAT

Table 1. Comparison of Individual Tax Liability, Without 
and With Extension of Rules, 2006


                          
                          Prior Action
                          
A similar proposal was included in the President's fiscal year 2004 and 
2005 budget proposals.

H.R. 4297, as passed by the House (the "Tax Relief Extension Reconciliation
Act of 2005") and H.R. 4297, as amended by the Senate (the "Tax Relief Act
of 2005"), both extend the use of the nonrefundable personal credits against
the AMT for 2006.

H.R. 4096, as passed by the House (the "Stealth Tax Act of 2005"), extends 
the 2005 AMT exemption amounts for 2006 and indexes the amounts for 
inflation.  H.R. 4297, as amended by the Senate (the "Tax Relief Act of
2005"), increases the AMT exemption amounts for 2006 to $62,550 for joint 
returns, to $42,500 for unmarried taxpayers, and to $31,275 for 
separate returns.



B.  Permanently Extend the Research and Experimentation 
("R&E") Tax Credit

                          Present Law
                          
General rule

Prior to January 1, 2006, a taxpayer could claim a research credit equal
to 20 percent of the amount by which the taxpayer's qualified research 
expenses for a taxable year exceeded its base amount for that year.\443\
Thus,the research credit was generally available with respect to 
incremental increases in qualified research.

A 20-percent research tax credit was also available with respect to the
excess of (1) 100 percent of corporate cash expenses (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
e corporation as compared to such giving during a fixed-base period, as 
adjusted for inflation.  This separate credit computation was 
commonly referred to as the university basic research credit (see sec.
41(e)).

Finally, a research credit was available for a taxpayer's expenditures on
research undertaken by an energy research consortium.  This separate credit
computation was commonly referred to as the energy research credit.  
Unlike the other research credits, the energy research credit applied to 
all qualified expenditures, not just those in excess of a base amount.

The research credit, including the university basic research credit and the
energy research credit, expired on December 31, 2005.\444\


----------------
\443\ Sec,41

\444\ Sec.41.
   
   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 te deduction allowed
   



Computation of allowable credit

Except for energy research payments and certain university basic research
payments made by corporations, the research tax credit applied only to the 
extent that the taxpayer's qualified research expenses for the current 
taxable year exceeded its base amount.  The base amount for the current 
year generally was computed by multiplying the taxpayer's fixed-base 
percentage by the average amount of the taxpayer's gross receipts for the
four preceding years.

--------------------------
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.

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). The Tax and Trade Relief 
Extension Act of 1998 extended the research credit for 12 months, i.e.,
through June 30, 1999. 

The Ticket To Work and Work Incentive Improvement Act of 1999 extended the
research credit for five years, through June 30, 2004, increased the rates
of credit under the alternative incremental research credit regime, and 
expanded the definition of research to include research undertaken in Puerto 
Rico and possessions of the United States.

The Working Families Tax Relief Act of 2004 extended the research credit 
through December 31,2005.


If a taxpayer both incurred qualified research expenses and had gross 
receipts during each of at least three years from 1984 through 1988, then
its fixed-base percentage was the ratio that its total qualified research 
expenses for the 1984-1988 period bore to its total gross receipts for that
period (subject to a maximum fixed-base percentage of 16 percent).  All 
other taxpayers (so-called start-up firms) were assigned a fixed-base 
percentage of three percent.

In computing the credit, a taxpayer's base amount could not be less than 
50 percent of its current-year qualified research expenses.

To prevent artificial increases in research expenditures by shifting 
expenditures among commonly controlled or otherwise related entities, a
special aggregation rule provided that all members of the same controlled 
group of corporations were treated as a single taxpayer (sec.41(f)(1)).
Under regulations prescribed by the Secretary, special rules applied for 
computing the credit when a major portion of a trade or business (or unit
thereof) changed hands, under which qualified research expenses and gross
receipts for periods prior to the change of ownership of a trade or 
business were treated as transferred with the trade or business that gave
rise to those expenses and receipts for purposes of recomputing a 
taxpayer's fixed-base percentage (sec41(f)(3)).


Alternative incremental research credit regime


Taxpayers were allowed to elect an alternative incremental research credit
regime.   If a taxpayer elected to be subject to this alternative regime, 
the taxpayer was 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 was reduced.  Under the 
alternative incremental credit regime, a credit rate of 2.65 percent 
applied to the extent that a taxpayer's current-year research 
expenses exceeded a base amount computed by using a fixed-base percentage
of one percent (i.e., the base amount equaled one percent of the taxpayer's
average gross receipts for the four preceding years) but did not exceed a 
base amount computed by using a fixed-base percentage of 1.5 percent.  A 
credit rate of 3.2 percent applied to the extent that a taxpayer's 
current-year research expenses exceeded a base amount computed by using a
fixed-base percentage of 1.5 percent but did not exceed a base amount 
computed by using a fixed-base percentage of two percent.  A credit rate of

---------------------
\445\  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) was 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 would be assigned a fixed-base percentage of three 
percent for each of its first five taxable years after 1993 in which it 
incurs qualified research expenses.  In the event that the research credit
is extended beyond its 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 expenses 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 expenses 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)).


\446\  Sec. 41(c)(4).
    


3.75 percent applied to the extent that a taxpayer's current-year research 
expenses exceeded a base amount computed by using a fixed-base percentage
of two percent.  An election to be subject to this alternative incremental 
credit regime could be made for any taxable year beginning after June 30, 
1996, and such an election applied to that taxable year and all subsequent 
years unless revoked with the consent of the Secretary of the Treasury.

Eligible expenses

Qualified research expenses eligible for the research tax credit consisted 
of:  (1) in-house expenses of the taxpayer for wages and supplies 
attributable of qualified research; (2) certain time-sharing costs for 
computer use in qualified research; and (3) 65 percent of amounts paid or 
incurred by the taxpayer to certain other persons for qualified research 
conducted on the taxpayer's behalf (so-called contract research expenses).
Notwithstanding the limitation for contract research expenses, qualified 
research expenses included 100 percent of amounts paid or incurred by the
taxpayer to an eligible small business, university, or Federal laboratory
for qualified energy research.

To be eligible for the credit, the research did not only have to satisfy 
the requirements of present-law section 174 (described below) but also had 
to be undertaken for the purpose of discovering information that is 
technological in nature, the application of which was intended to 
be useful in the development of a new or improved business component of 
the taxpayer, and substantially all of the activities of which had to 
constitute elements of a process of experimentation for functional aspects.
performance, reliability, or quality of a business component.  Research 
did not qualify for the credit if substantially all of the activities 
related to style, taste, cosmetic, or seasonal design factors (sec. 41
(d)(3)).  In addition, research did not qualify for the credit: (1) if 
conducted after the beginning of commercial production of the 
business component; (2) if related to the adaptation of an existing 
business component to a particular customer's requirements; (3) if related
to the duplication of an existing business component from a physical 
examination of the component itself or certain other information; or 
(4) if related to certain efficiency surveys, management function or 
technique, market research, market testing, or market development, routine
data collection or routine quality control (sec. 41(d)(4)).  Research did
not qualify for the credit if it was conducted outside the United States, 
Puerto Rico, or any U.S. possession.

-----------------------
\447\  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 were 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 was a tax-exempt organization that is described in
section 501(c)(3) (other than a private foundation) or section 501(c)(6) 
and was organized and operated primarily to conduct scientific research,
and (2) such qualified research was conducted by the consortium on behalf
of the taxpayer and one or more persons not related to the 
taxpayer.  Sec. 41(b)(3)(C).




Relation to deduction

Under section 174, taxpayers may elect to deduct currently the amount of 
certain research or experimental expenditures paid or 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.  While the research
credit was in effect, however, deductions allowed to a taxpayer under 
section 174 (or any other section) were reduced by an amount equal to 100
percent of the taxpayer's research tax credit determined for the taxable
year (Sec. 280C(c)).  Taxpayers could alternatively elect to claim a
reduced research tax credit amount (13 percent) under section 41 in lieu of
reducing deductions otherwise allowed (sec. 280C(c)(3)).



                            Description of Proposal
                            
The research tax credit, excluding the energy research credit, is made 
permanent.

Effective date.--The proposal is effective for amounts paid or incurred 
after December 31,2005.

                              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.  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.  However, there is evidence 
that the current level of research undertaken in the United States, and 
worldwide, is too little to maximize society's well-being.\450\ 
Nevertheless, even if there were agreement that additional subsidies for

----------------------
\448\ Taxpayers may elect 10-year amortization of certain research
expenditures allowable as a deduction under section 174(a).
Secs. 174(f)(2) and 59(e).

\449\ This conclusion does not depend upon whether the basic tax regime
is an income tax or a consumption tax.

\450\ See Zvi Griliches, "The Search for R&D Spillovers," Scandinavian
Journal of Economics,vol. XCIV, (1992), M. Ishaq Nadiri, "Innovations and
Technological Spillovers," National Bureau of Economic Research, Working 
Paper No. 4423, 1993, and Bronwyn Hall, "The Private and Social Returns



research are warranted as a general matter, misallocation of research
dollars across competing sectors of the economy could diminish economic 
efficiency. It is difficult to determine whether, at the present levels
and allocation of government subsidies for research, further government
spending on research or additional tax benefits for research would increase
or decrease overall economic efficiency.

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 consensus regarding magnitude of 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 pre-2006 research credit
did create certain complexities and compliance costs.

Scope of research activities in the United States and abroad

In the United States, private for-profit enterprises and individuals,
non-profit organizations, and the public sector undertake research 
activities. Total expenditures on research and development in the United 
States are large, representing 2.6 percent of gross domestic product in 
2003.\451\ This rate of expenditure on research and development exceeds
that of the European Union and the average of all countries that are
members of the Organisation for Economic Co-operation and Development
("OECD"), but is less than that of Japan. See Figure 1, below.  In 2003,
expenditures on research and development in the United States represented
42.1 percent of all expenditures on research and development undertaken by
OECD countries,were 37 percent greater than the total expenditures on
research and development undertaken in the European Union, and were more
than two and one half times such expenditures in Japan.\452\

----------------------
to Research and Development," in Bruce Smith and Claude Barfield, editors,
Technology, R&D and the Economy, (Washington, D.C.: Brookings Institution
Press), 1996, pp. 1-14.  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.  
Griliches concludes, "in spite of [many] difficulties, there has been a 
significant number of reasonably well-done studies all pointing in the same 
direction: R&D spillovers are present, their magnitude may be quite large, 
and social rates of return remain significantly above private rates."  
Griliches, p. S43.

\451\  Organisation for Economic Co-operation and Development, OECD Science,
Technology and Industry Scoreboard, 2005, (Paris:  Organisation for 
Economic Co-operation and Development), 2005. These data represent outlays
by private persons and by governments.  The figures reported in this 
paragraph and Figure 1 do not include the value of tax expenditures, if 
any.  The OECD, measuring in real 1995 dollars, calculates that the United 
States spent approximately $268 billion on research and development in 2003.

\452\ Ibid. While the OECD attempts to present these data on a standardized
basis the cross-country comparisons are not perfect.  For example, the
United States reporting for research spending generally does not include


Expenditures on research and development in the United States have grown at
an average real rate of 2.7 percent over the period 1995-2003. This rate of
growth has exceeded that of France (1.5 percent) and the United Kingdom 
(2.4 percent), and equaled, that of Japan (2.7 percent), but is less than
that of Germany (2.9 percent)Italy (3.8 percent for the period 
1995-2002), Canada (5.0 percent), Ireland (6.7 percent for the period
1995-2002), and Spain (7.4 percent)\453\

Source:
OECD,OECD Science, Technology and Industry Scoreboard, 2005.

Direct expenditures are not the only means by which governments subsidize
research activities.  A number of countries, in addition to the United 
States, provide tax benefits to taxpayers who undertake research 
activities.  The OECD has attempted to quantify the relative value of such
tax benefits in different countries by creating an index that measures the 
total value of tax benefits accorded research activities relative to 
simply permitting the expensing of all qualifying research expenditures.

-----------------
capital expendirure outlays devoted to research while the reporting of some
other countries does include capital expenditures.

\453\ Ibid. The OECD calculates the annual real rate of growth of 
expenditures on research  and development for the period 1995-2003 in the
European Union and in all OECD countries at 3.3 percent and 3.7 percent,
respectively.



Table 2 below, reports the value of this index for selected 
countries.  A value of zero would result if the only tax benefit a country
offered to research activities was the expensing of all qualifying research
expenditures.  Negative values reflect tax benefits less generous than 
expensing.  Positive values reflect tax benefits more generous than 
expensing.  For example, in 2004 in the United States qualifying taxpayers
could expense research expenditures and, in certain circumstances claim the
research and experimentation tax credit.  The resulting index number for 
the United States is 0.066.

Table 2.-Index Number of Tax Benefits for Research Activities 
in Selected Countries, 2005

GRAPHICS NOT AVAILABLE IN TIFF FORMAT


-------------------
\454\ Organisation for Economic Co-operation and development, OECD
Science, Technology and Industry Scoreboard, 2005. (Paris: Organisation
for Economic Co-operation and development), 2005.The index is calculated as
one minus the so-called "B-index." The B-index is equal to the after-tax
cost of an expenditure of one dollar on qualifying research, divided by one
minus the taxpayer marginal tax rate.  Alternatively, the B-index represents
the present value of pre-tax income that is necessary to earn in order to
finance the research activity and earn a positive after-tax profit. 
In practice, construction of the B-index and the index number reported in

Table 2 requires a number of simplifying assumptions.  As a 
consequence, the relative position of the tax benefits of various countries
reported in the table is only 
suggestive.



The scope of tax expenditures aon research activities before the expiration
of the research credit.

The tax expenditure related to the research and experimentation tax credit
is esrimated to be $4.8 billion for 2005. The related tax expenditure for 
expensing of research and development expenditures was estimated to be
$4.0 billion for 2005 growing to $6.3 billion for 2009.\455\ As noted above,
the Federal Government also directly subsidizes research activities. Direct 
government outlays for research have substantially exceeded the annual 
estimated value of the tax expenditure provided by either the research and
experimentation tax credit or the expensing of research and development 
expenditures.  For example, in fiscal 2005, the National Science Foundation
made $3.9 billion in grants, subsidies, and contributions to research 
activities, the Department of Defense financed $11.8 billion\456\ in basic 
research, applied research, and advanced technology development, and the
Department of Energy financed $0.7 billion in research in high energy 
physics, $1.0 billion in basic research in the sciences, $0.6 billion in 
biological and environmental research, and $226 million for research in 
advance scientific computing.  However, such direct government outlays
generally are for directed research on projects selected by the government
The research credit provides a subsidy to any qualified project of an 
eligible taxpayer with no application to a grant-making agency required.
Projects are chosen based on the taxpayer's assessment of future profit
potential.

Table 3 and Table 4 present data for 2003 on those industries that utilized
the research tax credit and the distribution of the credit claimants by 
firm size.  In 2003, more than 15,500 taxpayers claimed more than $5.7 
billion in research tax credits.\458\ Taxpayers whose primary activity is 
manufacturing claimed just over two-thirds of the research tax credits 
claimed.  Firms with assets of $50 million or more claimed nearly 85 
percent of the credits claimed. Nevertheless, as Table 3 documents, a large
number of small firms are engaged in research and were able to claim the
research tax credit.


----------------------
\455\ Joint Committee on Taxation, Estimates of Federal Tax Expenditures
for Fiscal Years 2005-2009 (JCS-1-05), January 12, 2005, p. 30.

\456\ Office of Management and Budget, Budget of the United States
Government, Fiscal Year 2007, Appendix, pp. 294-299.  (Figures include
military and non-military departments.)

\457\ Office of Management and Budget, Budget of the United States 
Government, Fiscal Year 2007, Appendix, pp. 1073-1074, 294-299 and 387-388.


\458\ The $5.7 billion figure reported for 2003 is not directly comparable
to the $4.8 billion tax expenditure estimate for 2005 reported in the 
preceding paragraph.  The tax expenditure estimate accounts for the 
present-law requirement that deductions for research expenditures be 
reduced by research credits claimed.  Also, the $5.7 billion figure does
not reflect the actual tax reduction achieved by taxpayers claiming 
research credits in 2003 as the actual tax reduction will depend upon
whether the taxpayer had operating losses, was subject to the alternative
minimum tax, or other aspects specific to each taxpayer's situation.





Table 3.--Percentage Distribution of Firms Claiming Research Tax Credit 
and Percentage of Credit Claimed by Sector, 2003

GRAPHICS NOT AVAILABLE IN TIFF FORMAT

Table--4 Percentage Distribution of Firms Claiming Research Tax Credit
            and of Amount of Credit Claimed by Firm Size, 2002,
            
            
  GRAPHICS NOT AVAILABLE IN TIFF FORMAT


Flat or 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 (i.e., a flat credit). 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 a present value of $95.  Suppose
that the research 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 that would have been
undertaken in any event but 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. 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. 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.

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.\459\  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.\460\

-----------------------
\459\ 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.

\460\ It is important to note that not all research expenditures need be 
subject to a price reduction to have this effect.  Only the expenditures
that 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, the empirical evidence on this subject has yielded 
quantitative measures of the response of research spending to tax 
incentives.  While all published studies report that the research credit 
induced increases in research spending, early evidence generally indicated
that the price elasticity for research is substantially less than one.  For
example, one early 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.\461\   

If it took time for taxpayers to learn about the credit and what sort of 
expenditures qualified, taxpayers may have only gradually adjusted their 
behavior.  Such a learning curve might explain a modest measured behavioral
effect.

A more recent survey of the literature on the effect of the tax credit 
suggests a stronger behavioral response, although most analysts agree that
there is substantial uncertainty in these estimates.

[W]ork using US firm-level data all reaches the same conclusion:  the tax
price elasticity of total R&D spending during the 1980s is on the order of
unity, maybe higher. --Thus there is little doubt about the story that the
firm-level publicly reported R&D data tell:  the R&D tax credit produces 


--------------------------
\461\ 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.  The negative coefficient in the text reflects that a decrease in
price results in an increase in research expenditures.  Often, such 
elasticities are reported without the negative coefficient, it being 
understood that there is an inverse relationship between changes in the
"price" of research and changes in research expenditures.


  In a 1983 study, the Treasury Department used an elasticity of 0.92 
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 (now called the Government 
Accountability 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.


roughly a dollar-for-dollar increase in reported R&D spending on 
the margin.\462\


However this survey notes that most of this evidence is not drawn directly
from tax data.  For example, effective marginal tax credit rates are 
inferred from publicly reported financial data and may not reflect 
limitations imposed by operating losses or the alternative minimum tax.
The study notes that because most studies rely on "reported research 
expenditures" that a "relabelling problem" may exist whereby a preferential
tax treatment for an activity gives firms an incentive to classify 
expenditures as qualifying expenditures.  If this occurs, reported 
expenditures increase in response to the tax incentive by more than the
underlying real economic activity.  Thus, reported estimates may 
overestimate the true response of research spending to the tax credit.
. 
Apparently there have been no specific studies of the effectiveness of the
university basic research tax credit.



--------------------------
\462\ Bronwyn Hall and John Van Reenen, "How effective are fiscal 
incentives for R&D?  A review of the evidence," Research Policy, vol.29, 
2000, p. 462.  This survey reports that 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, vol. 7, (Cambridge: The MIT
Press, 1993), pp. 1-35.   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.  

Other research suggests that many of the elasticity studies may overstate 
the efficiency of subsidies to research.  Most R&D spending is for wages 
and the supply of qualified scientists is small,particularly in the short 
run.  Subsidies may raise the wages of scientists, and hence research 
spending, without increasing actual research.  See Austan Goolsbee, "Does
Government R&D Policy Mainly Benefit Scientists and Engineers?"  American
Economic Review, vol. 88, May, 1998, pp. 298-302.


\463\ Hall and Van Reenen, "How effective are fiscal incentives for R&D?
A review of the evidence," p. 463.



Other policy 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
465these 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 present value according to the length of time between when it actually
is earned and the time it actually is used to reduce tax liability.\464\ 

Under pre-2006 law, firms with research expenditures substantially in 
excess of their base amount could be subject to the 50-percent base amount 
limitation.  In general, although these firms received the largest amount 
of credit when measured as a percentage of their total qualified research 
expenses, their marginal effective rate of credit was exactly one half of
the statutory credit rate of 20 percent (i.e., firms subject to the base 
limitation effectively are governed by a 10-percent credit rate).

Although the statutory rate of the research credit was 20 percent, it is 
likely that the average marginal effective rate may be substantially below
20 percent.  Reasonable assumptions about the frequency that firms were 
subject to various limitations discussed above yield estimates of an 
average effective rate of credit between 25 and 40 percent below the 
statutory rate, i.e., between 12 and 15 percent.\465\

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, if the 
research credit were made permanent, increasingly over time there would
be a larger number of firms either substantially above or below their 
calculated base.  This could gradually create an undesirable situation

-----------------
\464\ 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.

\465\ 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.



where many firms would receive no credit and have no reasonable 
prospect of ever receiving a credit, while other firms would receive large
credits (despite the 50-percent base amount limitation). Thus, over time,
it can be expected that, for those firms eligible for the credit,
the average marginal effective rate of credit would decline while the 
revenue cost to the Federal Government increased.


As explained above, because costly scientific and technological advances 
made by one firm may often be cheaply copied by its competitors, research 
is one of the areas where there is a consensus among economists that 
government intervention in the marketplace, such as the subsidy of the 
research tax credit, can improve overall economic efficiency. This
rationale suggests that the problem of a socially inadequate amount of
research is not more likely in some industries than in other industries,
but rather it is an economy-wide problem.  The basic economic rationale 
argues that a subsidy to reduce the cost of research should be equally 
applied across all sectors.  As described above, prior to the expiration
of the research credit, the Energy Tax Incentives Act of 2005 had provided
that energy related research undertaken by certain energy research
consortia receive a greater tax subsidy than other research.  Some argue
that it makes the tax subsidy to research inefficient by biasing the choice
of research projects. They argue that an energy related research project 
could be funded by the taxpayer in lieu of some other project that would
offer a higher rate of return absent the more favorable tax credit for the 
energy related project.  In addition, taxpayers may have an incentive to 
enter into such research consortia without the additional tax benefit 
because a research consortia potentially reduces the cost of all 
participants by eliminating duplication of effort.  Proponents of the
differential treatment for energy related research argue that broader 
policy concerns such as promoting energy independence justify creating a
bias in favor of energy related research.  The President's budget proposal
would not extend the special energy credit. It would provide that energy 
related research be treated equivalently to any other proposed research 
under the tax credit.

Complexity and the research tax credit

Administrative and compliance burdens also resulted from the research tax 
credit. The General Accounting Office ("GAO") has testified that the 
research tax credit had been difficult for the IRS to administer.  The GAO 
reported that the IRS states 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.\466\
An executive in a large technology company has identified the research 
credit as one of the most significant areas of complexity for his firm. He 
summarizes the problem as follows.

--------------------------
\466\  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.


Tax incentives such as the R&D tax credit...typically pose compliance 
challenges, because they incorporate tax-only concepts that may be only 
tenuously linked to financial accounting principles or to the 
classifications used by the company's operational units....[I]s what the
company calls "research and development" the same as the "qualified 
research" eligible for the R&D tax credit under I.R.C. Section 41?  The 
extent of any deviation in those terms is in large part the measure of the
compliance costs associated with the tax credit.\467\ 


                                Prior Action
                                  
The President's budget proposals for fiscal years 2003 through 2006 
contained an identical provision.


H.R. 4297, as passed by the House (the "Tax Relief Extension 
Reconciliation Act of 2005"), contains a one year extension of a modified
research credit, effective retroactively to the expiration of the research 
credit under present law.  H.R. 4297, as passed by the Senate ("the Tax 
Relief Act of 2005"), also contains a two year extension of a modified 
research credit.















-------------------------
\467\  David R. Seltzer, "Federal Income Tax Compliance Costs:  A Case
Study of Hewlett-Packard Company," National Tax Journal, vol. 50, 
September 1997, pp. 487-493.








C. Extend and Modify the Work Opportunity Tax Credit 
        and Welfare-to-Work Tax Credit 
        
                          Present Law
                          
Work opportunity tax credit

Targeted groups eligible for the credit

The work opportunity tax credit is available on an elective basis for 
employers hiring individuals from one or more of eight targeted groups.
The eight targeted groups are: (1) certain families eligible to receive 
benefits under the Temporary Assistance for Needy Families Program; (2) 
high-risk youth; (3) qualified ex-felons; (4) vocational rehabilitation 
referrals; (5) qualified summer youth employees; (6) qualified veterans;
(7) families receiving food stamps; and (8) persons receiving certain 
Supplemental Security Income (SSI) benefits.

A qualified ex-felon is an individual certified as: (1) having been 
convicted of a felony under State or Federal law; (2) being a member of an
economically disadvantaged family; and (3) having a hiring date within one 
year of release from prison or conviction.

The Katrina Emergency Tax Relief Act of 2005 created a new category of
Hurricane Katrina employees and provided special rules for their 
eligibility.

Qualified wages

Generally, qualified wages are defined as cash wages paid by the employer
to a member of a targeted group.  The employer's deduction for wages is 
reduced by the amount of the credit 

Calculation of the credit

The credit equals 40 percent (25 percent for employment of 400 hours or
less) of qualified first-year wages. Generally, qualified first-year wages 
are qualified wages (not in excess of $6,000) attributable to service 
rendered by a member of a targeted group during the one-year period 
beginning with the day the individual began work for the employer. 
Therefore, the maximum credit per employee is $2,400 (40 percent of the
first $6,000 of qualified first-year wages).  With respect to qualified 
summer youth employees, the maximum credit is $1,200 (40 percent of the 
first $3,000 of qualified first-year wages).

Minimum employment period

No credit is allowed for qualified wages paid to employees who work less 
than 120 hours in the first year of employment.

Coordination of the work opportunity tax credit and the welfare-to-work
tax credit

An employer cannot claim the work opportunity tax credit with respect to 
wages of any employee on which the employer claims the welfare-to-work tax 
credit.

Other rules

The work opportunity tax credit is not allowed for wages paid to a relative
or dependent of the taxpayer.  Similarly wages paid to replacement workers 
during a strike or lockout are not eligible for the work opportunity tax 
credit.  Wages paid to any employee during any period for which the 
employer received on-the-job training program payments with respect to 
that employee are not eligible for the work opportunity tax credit. The 
work opportunity tax credit generally is not allowed for wages paid to 
individuals who had previously been employed by the employer.  In 
addition, many other technical rules apply.

Expiration date

The work opportunity tax credit is effective for wages paid or incurred to
a qualified individual who begins work for an employer before January
1, 2006. 

Welfare-to-work tax credit

Targeted group eligible for the credit

The welfare-to-work tax credit is available on an elective basis to 
employers of qualified long-term family assistance recipients.  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 such
family assistance for a total of at least 18 months (whether or not 
consecutive) after August 5, 1997 (the date of enactment of the 
welfare-to-work tax credit) if they are hired within 2 years after the 
date that the 18-month total is reached; and (3) members of a family that
is 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.

Qualified wages

Qualified wages for purposes of the welfare-to-work tax credit are defined 
more broadly than for the work opportunity tax credit. Unlike the definition
of wages for the work opportunity tax credit which includes simply cash 
wages, the definition of wages for the welfare-to-work tax 
credit includes cash wages paid to an employee plus amounts paid by the
employer for: (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 employer's deduction for wages is reduced 
by the amount of the credit.

Calculation of the credit

The welfare-to-work tax credit is available on an elective basis to 
employers of qualified long-term family assistance recipients during the 
first two years of employment.  The maximum credit is 35 percent of the 
first $10,000 of qualified first-year wages and 50 percent of the first 
$10,000 of qualified second-year wages. Qualified first-year wages are 
defined as qualified wages (not in excess of $10,000) attributable to 
service rendered by a member of the targeted group during the one-year





period beginning with the day the individual began work for the 
employer.  Qualified second-year wages are defined as qualified wages
(not in excess of $10,000) attributable to service rendered by a member of
the targeted group during the one-year period beginning immediately after 
the first year of that individual's employment for the employer. The 
maximum credit is $8,500 per qualified employee.

Minimum employment period

No credit is allowed for qualified wages paid to a member of the targeted
group unless they work at least 400 hours or 180 days in the first year of
employment.

Coordination of the work opportunity tax credit and the welfare-to-work
tax credit

An employer cannot claim the work opportunity tax credit with respect to
wages of any employee on which the employer claims the welfare-to-work tax
credit.

Other rules

The welfare-to-work tax credit incorporates directly or by reference many 
of these other rules contained on the work opportunity tax credit.

Expiration date 

The welfare-to-work tax credit is effective for wages paid or incurred to
a qualified individual who begins work for an employer before January 1, 2006.

                             Description of Proposal
                             
Combined credit

The proposal combines the work opportunity and welfare-to-work tax credits
and extends the combined credit for one year.

Targeted groups eligible for the combined credit

The combined credit is available for employers hiring individuals from one
or more of all nine targeted groups.  The welfare-to-work credit/long-term 
family assistance recipient is the ninth targeted group.  The special rules 
for Hurricane Katrina employees are unchanged by the proposal.

The proposal repeals the requirement that a qualified ex-felon be an 
individual certified as a member of an economically disadvantaged family.

Qualified wages

Qualified first-year wages for the eight WOTC categories remain capped 
at $6,000 ($3,000 for qualified summer youth employees).  No credit is 
allowed for second-year wages.  In the case of long-term family assistance 
recipients the cap is $10,000 for both qualified first-year wages and 
qualified second-year wages.  For purposes of the combined credit, 
qualified wages are defined as cash wages paid by the employer to a member
of a targeted group (not the broader WWTC definition of wages).  Also, for
all targeted groups, the employer's deduction for wages is reduced by the 
amount of the credit. 

Calculation of the credit

First-year wages.--For the eight WOTC categories, the credit equals 40 
percent (25 percent for employment of 400 hours or less) of qualified 
first-year wages.  Generally, qualified first-year wages are qualified
wages (not in excess of $6,000) attributable to service rendered by a 
member of a targeted group during the one-year period beginning with the
day the individual began work for the employer.  Therefore, the maximum
credit per employee for members of any of the eight WOTC targeted groups
generally is $2,400 (40 percent of the first $6,000 of qualified 
first-year wages). With respect to qualified summer youth employees,the
maximum credit remains $1,200 (40 percent of the first $3,000 of qualified 
first-year wages).  For the welfare-to-work/long-term family assistance 
recipients, the maximum credit equals $4,000 per employee (40 percent of 
$10,000 of wages).

Second-year wages.--In the case of long-term family assistance recipients 
the maximum credit is $5,000 (50 percent of the first $10,000 of qualified 
second-year wages).

Minimum employment period

No credit is allowed for qualified wages paid to employees who work less
than 120 hours in the first year of employment.

Coordination of the work opportunity tax credit and the welfare-to-work 
tax credit. 
Coordination is no longer necessary once the two credits are combined

Effective date.--The proposal is effective for wages paid or incurred to a
qualified individual who begins work for an employer after December 31, 
2005 and before January 1, 2007.

                                   Analysis
                                   
Overview of policy issues

The WOTC and WWTC are intended to increase the employment and earnings of
their targeted group members, respectively.  The credits are made available
to employers as an incentive to hire members of the targeted groups.  To
the extent the value of the credits 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.\468\



--------------------
\468\ 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 



The rationale for the WOTC and WWTC 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 credits 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 and WWTC 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 WOTC 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 WOTC in the desired manner.
A similar analysis may be appropriate for the WWTC.  

Efficiency of the WOTC

The WOTC 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 
35-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-.35) = $1,560.
This $1,560 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.

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.  

-----------------
resulted in the worker receiving a higher wage than would have been 
received in the absence of the credit (e.g., zero).

\469\ The after-tax cost of hiring this credit eligible worker would be 
((2,000)(w)-2,400)(1-.35) 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.



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").\470\ 

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 five
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.\471\

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

---------------------
\470\ 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.

\471\ 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.


employers made such efforts, while other employers did little to determine
eligibility for the TJTC prior to the decision to hire an individual.
In these latter cases, the TJTC provided a cash benefit to the firm, 
without affecting the decision to hire a particular worker.

Complexity issues

Extension of the provisions for one year even in a modified form provides
some continuity (especially in the case of the eight WOTC categories) and 
simplifies tax planning during that period for taxpayers and practitioners.
Some argue that a permanent extension will have a greater stabilizing 
effect on the tax law.  They point out that temporary expirations, like
the current one, not only complicate tax planning but also deter some 
taxpayers from participating in the program.  Others who are skeptical of 
the efficacy of the WOTC and WWTC programs argue that not extending the 
credits could eliminate a windfall benefit to certain taxpayers and 
permanently reduce complexity in the Code.

The partial combining of the WOTC and the WWTC will provide some 
simplification benefits, particularly with respect to limiting the WWTC
to the WOTC cash-only definition of wages.  Allowing the WWTC to use the
WOTC minimum employment periods is likely to provide limited simplification 
since it expands the eligibility for the WWTC.  The failure to fully 
combine the two credits (e.g., by maintaining the larger cap on eligible 
first year wages for the WWTC, and maintaining the second-year benefit 
under the WWTC) essentially means that two separate credits remain in 
effect which limits the simplification benefits under the proposal.

                             Prior Action
                             
Separate proposals to extend the two credits without combining them were
included in the President's fiscal year 2002 and 2003 budget
proposals.\473\  A similar proposal was included in the President's fiscal
year 2004, 2005,and 2006 budget proposals.

Similar provisions are contained in H.R. 4297, "the Tax Relief Extension
Reconciliation Act of 2005" as passed by the House and H.R. 4297, the "Tax 
Relief Act of 2005," as amended by the Senate.

The Tax Relief Extension Reconciliation Act of 2005 as passed by the House
separately extends the work opportunity credit and the welfare-to-work tax
credits for one year (through December 31, 2006).  Also, the House bill 
raises the maximum age limit for the WOTC food stamp recipient category to
include individuals who are at least age 18 but under age 35 on the hiring
date.

-----------------------
\472\  For exampl, 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.

\473\  Publl L. No.107-147, "The Job Creation and Worker Assistance Act of
2002," extended the credits for two years.




The "Tax Relief Act of 2005," as amended by the Senate combines the work
opportunity and welfare-to-work tax credits and extends the combined credit
for one year.  The welfare-to-work credit is repealed.  The combined credit
is available on an elective basis for employers hiring individuals from one
or more of all nine targeted groups.  The nine targeted groups are the 
present-law eight groups with the addition of the welfare-to-work 
credit/long-term family assistance recipient as the ninth targeted group.
Also, the "Tax Relief Act of 2005," as amended by the Senate on 
February 2, 2006: (1) raises the age limit for the high-risk youth category
to include individuals aged 18 but not aged 40 on the hiring date; (2) 
renames the high-risk youth category to be the designated community 
resident category; (3) repeals the requirement that a qualified ex-felon
be an individual certified as a member of an economically disadvantaged 
family; and (4) raises the age limit for the food stamp recipient category
to include individuals aged 18 but not aged 40 on the hiring date.


D. Extend District of Columbia Homebuyer Tax Credit

                           Present Law
                           
First-time homebuyers of a principal residence in the District of Columbia
are eligible for a nonrefundable tax credit of up to $5,000 of the amount 
of the purchase price.  The $5,000 maximum credit applies both to individuals
and married couples.  Married individuals filing separately can claim a
maximum credit of $2,500 each.  The credit phases out for individual 
taxpayers with adjusted gross income between $70,000 and $90,000 
($110,000-$130,000 for joint filers).  For purposes of eligibility,
"first-time homebuyer" means any individual if such individual did not 
have a present ownership interest in a principal residence in the District
of Columbia in the one-year period ending on the date of the purchase of 
the residence to which the credit applies.  The credit expired for 
residences purchased after December 31, 2005.\474\

                              Description of Proposal
                              
The proposal extends the first-time homebuyer credit for one year, through
December 31,2006.  

Effective date.--The proposal is effective for residences purchased after 
December 31, 2005.

                                    Analysis
                                    
The D.C. first-time homebuyer credit is intended to encourage home 
ownership in the District of Columbia in order to stabilize or increase
its population and thus to improve its tax base.  Recently, home sales in 
D.C. have reached record levels, and sales prices have increased.  
However, this has been equally true in surrounding communities.  It is 
difficult to know the extent to which the D.C. homebuyer credit may have
been a factor in the surge in home sales.  

According to the Treasury Department, the homeownership rate in the 
District of Columbia is significantly below the rate for the neighboring 
States and the nation as a whole.  Arguably,extending the credit would 
enhance the District of Columbia's ability to attract new homeowners 
and establish a stable residential base.

A number of policy issues are raised with respect to whether the D.C.
homebuyer credit should be extended.  One issue is whether it is the proper
role of the Federal Government to distort local housing markets by favoring
the choice of home ownership in one jurisdiction over another.  Favoring 
home ownership in one area comes at the expense of home ownership in 
adjacent areas.  Thus, if the credit stimulates demand in the District of
Columbia, this comes at the expense of demand in other portions of the

--------------------
\474\  Sec. 1400C(i).  The District of Columbia first-time homebuyer credit
was enacted as part of the Taxpayer Relief Act of 1997, and was scheduled 
to expire on December 31, 2000.  The Tax Relief Extension Act of 1999 
extended the first-time homebuyer credit for one year, through 
December 31, 2000.  The Community Renewal Tax Relief Act of 2000 extended
the first-time homebuyer credit for two additional years, through 
December 31, 2003.  The Working Families Tax Relief Act of 2004 extended 
the first-time homebuyer credit for two additional years, through
December 31, 2005.
   



relevant housing market, principally the nearby suburbs of Virginia and 
Maryland.   



To the extent that local jurisdictions vary in their tax rates and services,
individuals purchasing a home may choose to buy in the jurisdiction that 
offers them the combination of tax rates and services and other amenities
that they desire.   If a jurisdiction has a low tax rate,some might choose
it on that basis.  If a jurisdiction has a high tax rate but offers a high
level of services, some will decide that the high tax rate is worth the 
services and will choose to buy in that jurisdiction.  If tax rates are
high but services are not correspondingly high, individuals may avoid such
jurisdictions.  It is in part this individual freedom to choose where to 
live that can promote competition in the provision of local public 
services, helping to assure that such services are provided at reasonable
tax rates.  If a jurisdiction fails at providing reasonable services at
reasonable tax rates, individuals might choose to move to other 
jurisdictions.  This may cause property values in the jurisdiction to fall
and, together with taxpayer departures, may put pressure on the local 
government to change its behavior and improve its services. If the Federal 
Government were to intervene in this market by encouraging the purchase of
a home in one local market over another, competition among local 
jurisdictions in the provision of public services may be undermined.

In the above scenario, however, a dwindling tax base may make it 
financially difficult to improve government services.  Some argue that the 
District of Columbia is in this position and that it needs Federal 
assistance to improve the District's revenue base. An alternative view is 
that the tax credit could take some of the pressure off the local 
government to make necessary improvements.  By improving the local 
government's tax base without a commensurate improvement in government 
services, the Federal expenditure could encourage a slower transition to
better governance.

Some argue that the credit is appropriate because a number of factors 
distinguish the District of Columbia from other cities or jurisdictions
and that competition among the District and neighboring jurisdictions is 
constrained by outside factors.  For example, some argue that the 
credit is a means of compensating the District for an artificially 
restricted tax base.  While many residents of the suburbs work in the 
District and benefit from certain of its services, the Federal 
Government precludes the imposition of a "commuter tax," which is used
by some other jurisdictions to tax income earned within the jurisdiction by
workers who reside elsewhere.  In addition, some argue that the District
has artificially reduced property, sales, and income tax revenues because
the Federal Government is headquartered in the District.  The Federal 
Government makes a payment to the District to compensate for the forgone
revenues, but some argue that the payment is insufficient.  Some also argue
that to the extent migration from the District is a result of poor 
services, it is not entirely within the control of the District to fix such
problems, because the District government is not autonomous, but is subject
to the control of Congress.

--------------------
\475\  Other factors may also affect the choice of where to live, such as
closeness to work or family members.



Another issue regarding the D.C. homebuyer credit is how effectively it
achieves its objective.  Several factors might diminish its effectiveness.
First, the $5,000 will not reduce the net cost of homes by $5,000.  Some of 
the $5,000 is likely to be captured by sellers, as eligible 
buyers entering the market with effectively an additional $5,000 to spend
will push prices to levels higher than would otherwise attain.  If the 
supply of homes for sale is relatively fixed, and potential buyers 
relatively plentiful, then the credit will largely evaporate into sellers'
hands through higher prices for homes.

A second reason the credit might not be very effective at boosting the 
residential base of the District is that it applies to existing homes as 
well as any new homes that are built. Thus, the family that sells its
D.C. home to a credit-eligible buyer must move elsewhere.  To the extent 
that they sell in order to move outside of the District of Columbia, there
is no gain in D.C. residences.  And, to the extent that the credit caused 
home prices to rise, the credit can be seen as an encouragement to sell a 
home in the District as much as an encouragement to buy.

                                 Prior Action
                                 
A similar proposal was included in the President's fiscal year 2004, 2005,
and 2006 budget proposals.

H.R. 4297, as passed by the House (the "Tax Relief Extension Reconciliation
Act of 2005") and as amended by the Senate (the "Tax Relief Act of 2005"), 
contains a similar proposal.



E.  Extend Authority to Issue 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 or if the
bonds are repaid with revenues of the governmental units. Activities that 
can be financed with these tax-exempt bonds include the financing of public 
schools.   Issuers must file with the IRS certain information about the 
bonds issued by them in order for interest on those bonds issues to be 
tax-exempt.\477\  Generally, this information return is required to be 
filed no later the 15th day of the second month after the close of the
calendar quarter in which the bonds were issued.

The tax exemption for State and local bonds does not apply to any arbitrage
bond.\478\  An arbitrage bond is defined as any bond that is part of an
issue if any proceeds of the issue are reasonably expected to be used (or 
intentionally are used) to acquire higher yielding investments or to 
replace funds that are used to acquire higher yielding investments.\479\ In
general, arbitrage profits may be earned only during specified periods 
(e.g., defined "temporary periods") before funds are needed for the purpose
of the borrowing or on specified types of investments (e.g.,"reasonably 
required reserve or replacement funds").  Subject to limited exceptions, 
investment profits that are earned during these periods or on such 
investments must be rebated to the Federal Government.

Qualified zone academy bonds

As an alternative to traditional tax-exempt bonds, States and local 
governments were given the authority to issue "qualified zone academy 
bonds".\480\  A total of $400 million of qualified zone academy bonds
was authorized to be issued annually in calendar years 1998 through 2005.  
The $400 million aggregate bond cap was allocated each year to the States
according to their respective populations of individuals below the poverty
line.  Each State, in turn, allocated the credit authority to qualified 
zone academies within such State.

Only certain financial institutions are eligible to hold qualified zone 
academy bonds. Financial institutions that hold qualified zone academy 

------------------
\476\ Sec. 103.

\477\ Sec. 149(e).

\478\ Sec. 103(a) and (b)(2).

\479\ Sec. 148. 

\480\ Sec. 1397E.



bonds are entitled to a nonrefundable tax credit in an amount equal to a
credit rate multiplied by the face amount of the bond.  A taxpayer 
holding a qualified zone academy bond on the credit allowance date is 
entitled to a credit.  The credit is includable in gross income (as if it
were a taxable interest payment on the bond), and may be claimed against 
regular income tax and alternative minimum tax liability.

The Treasury Department set the credit rate 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 was determined 
by the Treasury Department, so that the present value of the obligation to
repay the bond was 50 percent of the face value of the bond.

"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 designated under the Code, 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.

                            Description of Proposal
                            
The proposal authorizes issuance of up to $400 million of qualified zone 
academy bonds in calendar year 2006.  For qualified zone academy bonds 
issued after the date of enactment, the proposal requires issuers to 
report issuance to the IRS in a manner similar to the information returns
required for tax-exempt bonds.

Effective date.--The provision is effective generally for bonds issued 
after the date of enactment.

                                    Analysis 
                                    
Policy issues

The proposal to extend qualified zone academy 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 States and local governments.  This
would enable States and local governments to spend the savings on other
government functions or to reduce taxes.\481\
In this event, the stated objective of the proposal would not be achieved.

Though called a tax credit, the Federal subsidy for tax credit 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.   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 tax credit bonds, no formal interest is paid by the issuer or
the Federal Government.  Rather, a tax credit of $100 is allowed to be 
taken by the holder of the bond on its Federal income tax return.  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 tax credit
bonds, the $100 credit also has to be claimed as income.  Claiming an 
additional $100 in income 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, after taxes.  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.  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 or local government also would be in the same situation
in both cases.

Use of qualified zone academy bonds to subsidize public school investment
raises some questions of administrative efficiencies and tax complexity 
(see below).  Because potential purchasers of the qualified zone academy 
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, further risk is imposed on
the investor.  These information costs and other risks serve to increase 
the credit rate and hence the costs to the Federal Government for a given

------------------
\481\  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, sixth ed., 2002, p. 502-503 for a discussion of this
issue.

\482\ 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.



level of support to the zone academies.  For these reasons, and the fact 
that tax credit bonds will be less liquid than  Treasury securities, the 
bonds would bear a credit rate that is equal to a measure of the yield on
outstanding corporate bonds.

Qualified zone academy bonds, unlike interest-bearing State and local 
bonds, are not subject to the arbitrage or rebate requirements of the 
Code.  The ability to earn and retain arbitrage profits provides an 
incentive for issuers to issue more bonds and to issue them earlier 
than necessary.  As a result, there may be increased delays in the 
expenditure of bond proceeds for approved purposes in order to earn 
greater arbitrage profits.   Further, there are transaction costs, such
as brokers and investment advisor fees, associated with investing to earn
arbitrage, which diverts funds away from the rehabilitation or repair of
a school facility. 

On the other hand, the ability of issuers to invest proceeds at 
unrestricted yields and retain the earnings from such investments, 
increases the subsidy available for qualified expenditures, as well as
the repayment of principal on such bonds, beyond the savings achieved 
through having the issuer's interest costs paid by Federal tax credit.
Opponents of imposition of arbitrage or rebate requirements argue that such
restrictions will decrease the amount of subsidy available to assist 
schools with significant needs, but limited means through which to satisfy 
those needs.  Increasing the subsidy through permitted arbitrage, however,
results in costs to the Federal Government beyond the revenue loss 
associated with providing Federal tax credits.  The lack of arbitrage 
restrictions and rebate also results in foregone tax revenues on the 
arbitrage profits because the issuing entity is tax-exempt.

The direct payment of interest by the Federal Government on behalf of 
States or localities, which was discussed above as being economically the
equivalent of the credit proposal, would involve less complexity in 
administering the income tax, as the interest could simply be reported
as any other taxable interest.  Additionally, the tax credit approach
implies that non-taxable entities would only be able to invest in the
bonds to assist school investment through repurchase agreements or by
acquiring rights to repayment of principal if a tax credit bond is 
stripped.  In the case of a direct payment of interest, by contrast, 
tax-exempt organizations would be able to enjoy such benefits.

Complexity issues

A temporary extension provides some stability in the qualified zone academy
bonds program.  Certainty that the program would continue at least 
temporarily, without further interruption or modification, arguably would 
facilitate financial planning by taxpayers during that period.  The 
uncertainty that results from expiring provisions may adversely affect the 
administration of and perhaps the level of participation in such 
provisions.  For example, a taxpayer may not be willing to devote the time
and effort necessary to satisfy the complex requirements of a provision 
that expires shortly.  Similarly, the Internal Revenue Service 

-------------------
\483\  The Treasury Department issued proposed regulations on 
March 26, 2004 that would require issuers of qualified zone academy bonds
to spend proceeds with due diligence.  REG 121475-03, 69 CFR 15747 
(March 26, 2004).
   

must make difficult decisions about the allocation of its limited resources
between permanent and expiring tax provisions.

Some argue that a permanent or long-term extension is necessary to 
encourage optimal participation among potential qualified zone academy 
bond issuers.  Others respond that the permanent repeal of expiring 
provisions such as the qualified zone academy bond rules that are 
inherently complex would provide the same level of certainty for tax
planning purposes as a long-term or permanent extension, and would further
reduce the overall level of complexity in the Code. A related argument is
that programs such as qualified zone academy bonds would be more efficient
if administered as direct expenditure programs rather than as a part of the
tax law 

The proposal's reporting requirements may assist in the monitoring of the
use of these bonds.  On the other hand, it will add to complexity in that
it imposes a requirement not previously applied to qualified zone academy 
bonds.  In addition, the proposal increases the paperwork burden on issuers
in that forms must be completed and filed with the IRS.


                               Prior Action
                                  
Similar proposals were included in the President's fiscal year 2003, 2004,
2005, and 2006 budget proposals.

H.R. 4297, as passed by the House (the "Tax Relief Extension Reconciliation
Act of 2005"), authorizes up to $400 million of qualified zone academy 
bonds for calendar year 2006.

H.R. 4297, as amended by the Senate (the "Tax Relief Act of 2005"), 
authorizes up to $400 million of qualified zone academy bonds for each of 
calendar years 2006 and 2007.  The Tax Relief Act of 2005 also imposes 
information reporting requirements for qualified zone academy bonds, limits
acceptable private business contributions to cash or cash equivalents, 
requires ratable principal amortization, imposes a five-year expenditure
period in which to spend bond proceeds, and applies the arbitrage rules of
section 148 to these bonds.



F.  Extend Provisions Permitting Disclosure of Tax Return 
Information Relating to Terrorist Activity

                                   Present Law
                                   
In general

Section 6103 provides that returns and return information are confidential
may not be disclosed by the IRS, other Federal employees, State employees,
and certain others having access to the information except as provided in 
the Internal Revenue Code.  A "return" is any tax or information return, 
declaration of estimated tax, or claim for refund required by, or permitted 
under, the Internal Revenue Code, that is filed with the Secretary by, on 
behalf of, or with respect to any person.   Return also includes any 
amendment or supplement thereto, including supporting schedules, 
attachments, or lists which are supplemental to, or part of, the return so
filed.

The definition of "return information" is very broad and includes any 
information gathered by the IRS with respect to a person's liability or 
possible liability under the Internal Revenue Code.   "Taxpayer return 
information" is a subset of return information. Taxpayer return information
is return information filed with or furnished to the IRS by, or on behalf 
of, the taxpayer to whom the information relates.  For example, information
submitted to the IRS by a taxpayer's accountant on behalf of the taxpayer 
is "taxpayer return information."  

Section 6103 contains a number of exceptions to the general rule of 
confidentiality, which permit disclosure in specifically identified 
circumstances  when certain conditions are satisfied.   One of those 
exceptions is for the disclosure of return and return information regarding
terrorist activity.The Code permits the disclosure of returns and return
information for purposes of investigating terrorist incidents, threats, or
activities, and for analyzing intelligence concerning terrorist incidents, 
threats, or activities.  The term "terrorist incident, threat, or activity"
is statutorily defined to mean an incident, threat, or activity involving
an act of domestic terrorism or international terrorism, as both of those
terms are defined in the USA PATRIOT Act.

Return information generally is available Federal law enforcement and 
Federal intelligence agencies upon a written request meeting specific 
requirements. However, a return or information submitted to the IRS by the
taxpayer or on his behalf may only be obtained pursuant to an ex parte
court order.  No disclosures may be made under this provision after 
December 31,2006.

Disclosure of return information other than taxpayer return information

Disclosure by the IRS without a request

The Code permits the IRS to disclose return information, other than 
taxpayer return information, related to a terrorist incident, threat, or 
activity to the extent necessary to apprise the head of the appropriate 
Federal law enforcement agency responsible for investigating or responding 
to such terrorist incident, threat, or activity.\489\ The IRS on its own 
initiative and without a written request may make this disclosure.  The 
head of the Federal law enforcement agency may disclose information to 
officers and employees of such agency to the extent necessary to 
investigate or respond to such terrorist incident, threat, or activity.
A taxpayer's identity is not treated as taxpayer return information for 
this purpose, and may be disclosed under this authority.

Disclosure upon written request of a Federal law enforcement agency

The Code permits the IRS to disclose return information, other than
taxpayer return information, to officers and employees of Federal law

-----------------
\487\ Sec. 6103(c)-(0).

\488\ 18 U.S.C. 2331.

\489\ Sec.6103Ii)(3)(C).


enforcement upon a written request satisfying certain requirements.\490\
A taxpayer's identity is not treated as taxpayer return information for
this purpose and may be disclosed under this authority. The request
must:(1) be made by the head of the Federal law enforcement agency (or his
delegate) involved in the response to or investigation of terrorist 
incidents, 
threats, or activities, and (2) set forth the specific reason or reasons
why such disclosure may be relevant to a terrorist incident, threat, or 
activity.  The information is to be disclosed to officers and employees of
the Federal law enforcement agency who would be personally and directly 
involved in the response to or investigation of terrorist incidents, 
threats, or activities.  The information is to be used by such 
officers and employees solely for such response or investigation.

The Code permits the head of a Federal law enforcement agency to redisclose
return information received, in response to the written request described
above, to officers and employees of State and local law enforcement 
personally and directly engaged in the response to or investigation of the
terrorist incident, threat, or activity.  The State or local law 
enforcement agency must be part of an investigative or response team with
the Federal law enforcement agency for these disclosures to be made.

Disclosure upon request from the Departments of Justice or Treasury for
intelligence analysis of terrorist activity

Upon written request satisfying certain requirements discussed below, the
IRS is to disclose return information (other than taxpayer return 
information) to officers and employees of the Department of Justice, 
Department of Treasury, and other Federal intelligence agencies, who 
are personally and directly engaged in the collection or analysis of 
intelligence and counterintelligence or investigation concerning terrorist
incidents, threats, or activities.\491\  Use of the information is limited
to use by such officers and employees in such investigation, collection, 
or analysis.  A taxpayer's identity is not treated as taxpayer return 
information for this purpose and may be disclosed under this authority.

The written request is to set forth the specific reasons why the 
information to be disclosed is relevant to a terrorist incident, threat,or
activity.  The request is to be made by an individual who is:  (1) an 
officer or employee of the Department of Justice or the Department of 
Treasury,(2) appointed by the President with the advice and consent of the
Senate, and (3) responsible for the collection, and analysis of 
intelligence and counterintelligence information concerning terrorist 
incidents, threats, or activities. The Director of the United States Secret
Service also is an authorized requester.


--------------------
\490\ Sec.6103(i)(7)(A).

\491\ Sec.6103(i)(7)(B)


Disclosure of returns and return information by ex parte court order 

Ex parte court orders sought by Federal law enforcement and Federal 
intelligence agencies

In order to obtain a return or information submitted to the IRS by the 
taxpayer or his representative, court approval must be obtained.\493\ 
The Code permits, pursuant to an ex parte court order, the disclosure of
returns and return information (including taxpayer return information)
to certain officers and employees of a Federal law enforcement agency or
Federal intelligence agency. These officers and employees are required to
be personally and directly engaged in any investigation of, response to,
or analysis of intelligence and counterintelligence information concerning
any terrorist incident, threat, or activity. These officers and employees 
are permitted to use this information solely for their use in the 
investigation, response, or analysis, and in any judicial, administrative, 
or grand jury proceeding, pertaining to any such terrorist incident, 
threat, or activity 

The Attorney General, Deputy Attorney General, Associate Attorney General,
an Assistant Attorney General, or a United States attorney, may authorize
the application for the ex parte court order to be submitted to a Federal 
district court judge or magistrate.  The Federal district court judge or 
magistrate would grant the order if based on the facts submitted he or she 
determines that:  (1) there is reasonable cause to believe, based upon 
information believed to be reliable, that the return or return information
may be relevant to a matter relating to such terrorist incident, threat, or
activity; and (2) the return or return information is sought exclusively
for the use in a Federal investigation, analysis, or proceeding concerning
any terrorist incident, threat, or activity. 

Special rule for ex parte court ordered disclosure initiated by the IRS

If the Secretary of Treasury possesses returns or return information that 
may be related to a terrorist incident, threat, or activity, the Secretary 
of the Treasury (or his delegate), may on his own initiative, authorize an
application for an ex parte court order to permit disclosure to Federal 
law enforcement.\494\  In order to grant the order, the Federal district court
judge or magistrate must determine that there is reasonable cause to 
believe, based upon information believed to be reliable, that the return or
return information may be relevant to a matter relating to such terrorist 
incident, threat, or activity.  The information may be disclosed only to
the extent necessary to apprise the appropriate Federal law enforcement 
agency responsible for investigating or responding to a terrorist incident,
threat, or activity and for officers and employees of that agency 
to investigate or respond to such terrorist incident, threat, or activity.
Further, use of the information is limited to use in a Federal 
investigation, analysis, or proceeding concerning a 

-----------------
\492\ Sec. 6103(i)(7)(C).

\493\ As noted above, an ex parte court order is not necessary to obtain
information gathered from a source other than the taxpayer.

\494\ Sec. 6103(i)(7)(D).




terrorist incident,threat, or activity.  Because the Department of Justice
represents the Secretary of the Treasury in Federal district court, the 
Secretary is permitted to disclose returns and return information to the
Departmentof Justice as necessary and solely for the purpose of obtaining 
the special IRS ex parte court order.



                             Description of Proposal
                             
The proposal extends for one year the disclosure authority relating to 
terrorist activities (through December 31, 2007)

Effective date.--The proposal is effective for disclosures on or after the
date of enactment 

                                Analysis
                                
The temporary nature of the present-law provision introduces a degree
of uncertainty regarding the disclosure of return information relating to
terrorist activities, i.e., whether the provision will be the subject of 
further extensions.   There has been no study of the effectiveness 
of the provisions.

.  
According to IRS accountings of disclosures made under the authority of
the provisions  in calendar year 2002, the IRS reported 39 disclosures to 
the Federal Bureau of Investigation under the terrorist activity 
provisions governing IRS-initiated disclosures to Federal law 
enforcement.\495\  However, the IRS used its authority to make disclosures
in emergency circumstances to make an additional 12,236 disclosures to 
the FBI.  The IRS made 25 disclosures to the Department of Justice for 
purposes of preparing an application for an ex parte court order to permit
the IRS to initiate an affirmative disclosure of returns and return 
information.  Pursuant to the ex parte court order authority, 2,215 
disclosures were made to U.S. Attorneys in calendar year 2002.  The IRS
did not report any terrorist activity disclosures to Federal intelligence
agencies, nor did it report any disclosures in response to requests from 
Federal law enforcement agencies for calendar year 2002.

 For calendar year 2003, 1,626 disclosures were made under the terrorist 
 activity provisions governing IRS disclosures to Federal law enforcement.
 Under the ex parte court order authority, 1,724 disclosures were made to
 U.S. Attorneys in calendar year 2003.  The IRS did not report any 
 disclosures to Federal intelligence agencies or in response to 
 requests from Federal law enforcement agencies for calendar year 2003.\496\

For calendar year 2004, the IRS made 883 disclosures to under the 
provisions permitting disclosure to Federal law enforcement.  Under the
ex parte court order authority, 3,992 disclosures were made to U.S. 
Attorneys in calendar year 2004. Again, for calendar year 2004,


----------------------
\495\ Joint Committee on Taxation, Revised Disclosure Report for Public 
Inspection Pursuant to Internal Revenue Code Section 6103(p)(3)(c) for
Calendar Year 2002(JCX-29-04), April 6, 2004.

\496\ Joint Committee on Taxation, Disclosure Report for Public Inspection
Pursuant to Internal Revenue Code Section 6103(p)(3)(C) for Calendar Uar
2003 (JCX-30-04), April 6, 2004.



the IRS did not report any disclosures to Federal intelligence agencies or
in response to request from Federal law enforcement agencies.  

The fact that the IRS has not reported any responses in connection with
requests by Federal intelligence agencies and Federal law enforcement, may
be an indication that further extension of those provision is not 
warranted.  However, the data does indicate that the IRS is 
using its self-initiated disclosure authority and that U.S. Attorneys are
taking advantage of the ex parte court order provision to obtain returns 
and return information.

Some argue that the terrorist activity disclosure provisions are 
duplicative provisions that were already in place for emergency disclosures
and for use in criminal investigations.  As noted above, the IRS used its 
emergency disclosure authorization to make disclosures to the Federal 
Bureau of Investigation concerning terrorist activity.   However, the 
emergency disclosure authorization is to be used under circumstances 
involving an imminent danger of death or physical injury.  In the case of
terrorist activity, it may not be clear whether the danger is "imminent",
which could lead to the misapplication of the emergency authority and 
uncertainty as to whether a particular disclosure is authorized.  Thus,
the existence of a specific disclosure provision for terrorist activity 
information provides clear authority and direction for making 
disclosures to combat terrorism.

The requirements for disclosure of terrorist activity information are not
as stringent as those required for criminal investigations.  For example, 
the granting of an ex parte order relating to terrorist activities does not
require a finding that there is reasonable cause to believe that a specific
criminal act has been committed.  In cases involving terrorist activity the
judge or magistrate needs to determine that there is reasonable cause to 
believe that the return or return information may be relevant to a matter
relating to such terrorist incident, threat or activity.  In addition, 
unlike the requirements for criminal investigations, the judge or 
magistrate does not need to find that the information cannot be reasonably
obtained from another source before granting the request for an ex parte
order for disclosure relating to terrorist activity.  Some argue that the
less stringent requirements facilitate a proactive approach to combating
terrorism.

                              Prior Action
                              
A similar proposal was included in the President's fiscal years 2004, 
2005, and 2006 budget proposals.










---------------------
\497\  Joint Committee on Taxation, Disclosure Report for Public Inspection
Pursuant to Internal Revenue Code Section 6103(p)(3)(C) for Calendar Year
2004 (JCX-63-05), August 19, 2005.





G.  Permanently Extend and Expand Disclosure of Tax Return Information 
for Administration of Student Loans

                                Present Law
                                
Income-contingent loan verification program

Present law prohibits the disclosure of returns and return information,
except to the extent specifically authorized by the Code.\498\  An 
exception is provided for disclosure to the Department of Education
(but not to contractors thereof) of a taxpayer's filing status, adjusted 
gross income and identity information (i.e., name, mailing address, 
taxpayer identifying number) to establish an appropriate repayment amount
for an applicable student loan.\499\ The Department of Education disclosure
authority is scheduled to expire after December 31, 2006.\500\

An exception to the general rule prohibiting disclosure is also provided 
for the disclosure of returns and return information to a designee of the 
taxpayer.\501\  Because the Department of Education utilizes contractors
for the income-contingent loan verification program, the Department of 
Education obtains taxpayer information by consent under section 6103(c),
rather than under the specific exception.\502\ The Department of Treasury
has reported that the Internal Revenue Service processes approximately
100,000 consents per year for this purpose.\503\

Verifying financial aid applications

The Higher Education Act of 1998 ("Higher Education Act") authorized the
Department of Education to confirm with the Internal Revenue Service four
discrete items of return information for the purposes of verifying of 
student aid applications.\504\  The Higher Education Act, however, did not 
amend the Code to permit disclosure for this purpose. Therefore, the 
disclosure provided by the Higher Education Act may not be made unless
the taxpayer consents to the disclosure pursuant to section 6103(c).

The financial aid application is submitted to the Department of Education
and is then given to a contractor for processing.  Based on the information

-------------------
\498\ Sec. 6103.

\499\ Sec. 6103(l)(13).

\500\ Sec. 6103(l)(13)(D).

\501\ Sec. 6103(c).

\502\ Department of Treasury, Report to the Congress on Scope and Use of
Taxpayer Confidentiality and Disclosure Provisions, Volume I:  Study of
General Provisions (October 2000) at 91.

\503\ Department of Treasury, General Explanations of the Administration's
Fiscal Year 2004 Revenue Proposals (February 2003), p. 133.   Pub. L. 
No. 105-244, sec. 483 (1998).

\504\ Pub. L. No. 105-244, sec. 483 (1998).


given, the contractor calculates an expected family contribution that 
determines the amount of aid a student will receive.  All Department of 
Education financial aid is disbursed directly through schools or various
lenders. 

The Department of Education requires schools to verify the financial aid
information of 30 percent of the applicants.  The applicants must furnish a
copy of their tax returns.  The applicants are not required to obtain 
copies of tax returns from the IRS or to produce certified copies.  If the
information reflected on the student's copy of the tax return does not 
match the information on the financial aid application, the school requires
corrective action to be taken before a student receives the appropriate aid.  

The Office of Inspector General of the Department of Education has reported
that, because many applicants are reporting incorrect information on their
financial aid applications, erroneous overpayments of Federal Pell grants 
have resulted.  

Overpayments of Pell grants and defaulted student loans

For purposes of locating a taxpayer to collect an overpayment of a Federal 
Pell grant or to collect payments on a defaulted loan, the Internal Revenue
Service may disclose the taxpayer's mailing address to the Department of 
Education.\505\  To assist in locating the defaulting taxpayer, the 
Department of Education may redisclose the mailing address to the officers,
employees and agents of certain lenders, States, nonprofit agencies, and 
educational institutions whose duties relate to the collection of student
loans.\506\

Safeguard procedures and recordkeeping

Federal and State agencies that receive returns and return information are
required to maintain a standardized system of permanent records on the use
and disclosure of that information.\507\  Maintaining such records is a 
prerequisite to obtaining and continuing to obtain returns and return 
information.  Such agencies must also establish procedures satisfactory to
the IRS for safeguarding the information it receives.  The IRS must also 
file annual reports with the House Committee on Ways and Means, the Senate 
Committee on Finance, and the Joint Committee on Taxation regarding 
procedures and safeguards followed by recipients of return and return 
information.\508\

                            Description of Proposal
                            
The proposal allows the disclosure to the Department of Education and its
contractors of the adjusted gross income, filing status, total earnings 
from employment, Federal income tax liability, type of return filed and 
taxpayer identity information for the financial aid applicant or of 

----------------------
\505\ Sec.6103(m)(4).

\506\ Id.

\507\ Sec.6103(p)(4).

\508\ Sec. 6103(p)(5).





the applicant's parents (if the applicant is a dependent) or spouse 
(if married).  Pursuant to the proposal, the Department of Education could
use the information not only for establishing a loan repayment amount but 
also for verifying items reported by student financial aid applicants and 
their parents. 

The proposal allows the Department of Education to use contractors to 
process the information disclosed to the Department of Education, 
eliminating the need for consents.  It is understood that the proposal 
imposes the present-law safeguards applicable to disclosures to 
Federal and State agencies on disclosures to the Department of Education
and its contractors.

Effective date.--The proposal is effective with respect to disclosures made
after the date of enactment.

                                   Analysis 
                                   
Contractors

The proposal permits the disclosure of a taxpayer's return information to
contractors and agents of the Department of Education, not just to 
Department of Education employees.  Some might argue that the use of 
contractors significantly expands the risk of unauthorized disclosure, 
particularly when return information is used by a contractor outside of the
recipient agency.  The volume of taxpayer information involved under this 
proposal and the disclosure of millions of taxpayer records, significantly
contributes to the risk of unauthorized disclosure.  On the other hand, 
some might argue that it is appropriate to permit the disclosure of 
otherwise confidential tax information to contractors to ensure the 
correctness of Federal student aid.

Opponents of the proposal may argue that it is not clear that the Internal
Revenue Service has the resources and computer specialists to implement and
enforce the safeguards that the proposal imposes.  However, proponents of
the proposal argue that the proposal alleviates some of the burden on the 
Internal Revenue Service by requiring the Department of Education to 
monitor its contractors as a supplement to the safeguard reviews conducted 
by the Internal Revenue Service.

Burdens on IRS

In general, the proposal eases the burden on the financial aid applicant 
because the applicant will not be required to produce copies of their tax 
returns for verification of their financial aid applications.  The 
proposal arguably provides simplification for the schools as well,because
the schools will no longer be required to match the information of 30 
percent of its applicants.  On the other hand, the proposal tends to 
increase complexity for the Internal Revenue Service by requiring it to
resolve discrepancies between tax information and income data on the 
financial aid application if the applicant is unable to resolve the 
discrepancy with the school.

Income contingent loan verification program

Currently the Department of Education uses consents to obtain tax 
information for purposes of its income contingent loan verification program,
and does not rely on the statutory authority to receive that information 
without consent.  The IRS processes over 100,000 consents for this program.
Some might argue that since the specific statutory authority is not being
used, it should not be extended.  

Verifying financial aid applications

Congress has expressed a concern about the increasing number of requests 
for the disclosure of confidential tax information for nontax purposes and
the effect of such disclosures on voluntary taxpayer compliance.\509\
Some might argue that consensual disclosure of return information,
in which the taxpayer knowingly consents to the disclosure of his or her
return information ("consents"), is less likely to adversely impact 
taxpayer compliance than adding a nonconsensual provision for the 
disclosure of taxpayer information.  Since the Internal Revenue Service
is already processing consents for the Department of Education, some would
argue that the current practice simply could be extended to financial aid 
applications.\510\ On the other hand,some might argue that because present
law does not impose restrictions on redisclosure of return information 
obtained by consent, the proposal, which imposes such restrictions, would
be preferable.

Critics might argue that the disclosure of sensitive return information of
millions\511\  of taxpayers to identify the abuse of a few does not strike
the appropriate balance between the need to know and the right to privacy.
On the other hand, some might argue that since this financial information
is already required to be submitted as part of the financial aid form, the 
infringement on taxpayer privacy is minimal.


                                 Prior Action 
                                 
Similar proposals were contained in the President's fiscal year 2003, 2004,
2005, and 2006 budget proposals.






----------------------
\509\ S. Prt. No. 103-37 at 54 (1993).

\510\ In its study on the disclosure of return information, the Department
of Treasury noted: "The burden of processing this number of consents 
obviously would be reduced if the consents were executed and transmitted 
electronically.  Accordingly, the Department of Education has asked to be 
included in the TDS program."  Department of Treasury, Report to the 
Congress on Scope and Use of Taxpayer Confidentiality and Disclosure 
Provisions, Volume I: Study of General Provisions (2000) at 92.

\511\ The Department of Education seeks access to the return information
of approximately 15 million taxpayers each year. The Department of 
Education receives approximately 10 million applications for student 
financial assistance each year.  Because roughly half of the applicants are 
dependents, income information is needed for both the student and his or
her parents.  Thus, verification under this provision could apply to over
15 million taxpayers each year.  It is not clear what percentage 
of applicants submits fraudulent financial aid applications.  Id.





H.  Extend Excise Tax on Coal at Current Rates


                                  Present Law
                                  
A $1.10 per ton excise tax is imposed on coal sold by the producer from 
underground mines in the United States. The rate is 55 cents per ton on 
coal sold by the producer from surface mining operations. In either case,
the tax cannot exceed 4.4 percent of the coal producer's selling price.  
No tax is imposed on lignite.

Gross receipts from the excise tax are dedicated to the Black Lung 
Disability Trust Fund to finance benefits under the Federal Black Lung 
Benefits Act.  Currently, the Black Lung Disability Trust Fund is in a 
deficit position because previous spending was financed with 
interest-bearing advances from the General Fund. 

The coal excise tax rates are scheduled to decline to 50 cents per ton for
underground-mined coal and 25 cents per ton for surface-mined coal (and 
the cap is scheduled to decline to two percent of the selling price) for 
sales after January 1, 2014, or after any earlier January 1 on 
which there is no balance of repayable advances from the Black Lung 
Disability Trust Fund to the General Fund and no unpaid interest on such
advances.

                          Description of Proposal
                          
The proposal retains the excise tax on coal at the current rates until 
the date on which the Black Lung Disability Trust Fund has repaid, with 
interest, all amounts borrowed from the General Fund.  After repayment of 
the Trust Fund's debt, the reduced rates of $.50 per ton for coal from 
underground mines and $.25 per ton for coal from surface mines would apply
and the tax per ton of coal would be capped at two percent of the amount 
for which it is sold by the producer.

Effective date.--The proposal is effective for coal sales after 
December 31, 2005.

                              Analysis
                                     
Trust fund financing of benefits was established in 1977 to reduce 
reliance on the Treasury and to recover costs from the mining industry.
Claims were much more numerous than expected and it was difficult to find
responsible operators, litigate their challenges and collect from them.
Therefore, deficits were financed with interest-bearing advances from the 
General Fund.  During each year of the period 1992-2002, the expenses of
the program covered by the trust fund (benefits, administration and 
interest) have exceeded revenues, with an advance from the General Fund 
making up the difference and accumulating as a debt.\512\ Direct costs 
(benefits and administration), however, have been less than revenues. 
According to the Congressional Research Service, if it were not for the
interest on the accumulated deficit, the trust fund would

-------------------
\512\  Congressional Research Service, RS21239 The Black Lung Benefits 
Program (June 12, 2002).


be self-supporting:  "In effect, the annual advances from the Treasury are 
being used to pay back interest to the Treasury, while the debt has been
growing as if with compound interest." \513\

Miners and survivors qualify for benefits from the Fund only if the 
miner's mine employment terminated before 1970 or no mine operator is 
liable for the payment of benefits. Some might argue that since the Federal
Government has essentially made a loan to itself with a transfer between 
funds, the interest component should be forgiven.  Because the class of 
beneficiaries is dwindling and revenues currently cover benefits and 
administrative costs, coal tax revenues could eventually pay off the bonds
if extended at their current rates

Based on historical trends, it appears that the trust fund will not be 
able to pay off its debt by December 31, 2013.  Therefore, it could be 
argued that it is appropriate to continue the tax on coal at the increased
rates beyond that expiration date until the debt is repaid, rather than
require that the General Fund provide even larger advances to the trust 
fund.  On the other hand, since the tax is not scheduled to be reduced 
until December 31, 2013, it could be argued that this proposal to further
extend the rates is premature.

                                 Prior Action
                                 
Identical proposals (except for effective date) were included in the 
President's fiscal year 2005 and 2006 budget proposals.




I.  Election to Treat Combat Pay as Earned Income 
for Purposes of the Earned Income Credit

                                  Present Law
                                  
In General

Subject to certain limitations, military compensation earned by members of
the Armed Forces while serving in a combat zone may be excluded from gross
income.  In addition, for up to two years following service in a combat 
zone, military personnel may also exclude compensation earned while 
hospitalized from wounds, disease, or injuries incurred while serving 
in the zone.

Child Credit

Combat pay that is otherwise excluded from gross income under section 112
is treated as earned income which is taken into account in computing 
taxable income for purposes of calculating the refundable portion of the
child credit 

Earned Income Credit

Any taxpayer may elect to treat combat pay that is otherwise excluded from
gross income under section 112 as earned income for purposes of the earned
income credit.  This election is available with respect to any taxable year
ending after the date of enactment and before January 1, 2007.


                          Description of Proposal

The proposal extends the elections to treat combat pay as earned income for
purposes of the earned income credit for one year (through 
December 31, 2007).

Effective date.--Generally, the proposal would be effective after 
December 31, 2006.

                                  Analysis
                                  
The exclusion of combat pay from gross income is intended to benefit 
military personnel serving in combat. However, to the extent that certain
tax benefits, such as the child credit and the earned income credit, may 
vary based on taxable or earned income, the exclusion has the potential to
limit the availability of certain refundable tax credits (i.e. the child 
credit and the earned income credit). Including combat pay in gross income
for purposes of the refundable child credit is always advantageous to the
taxpayer.  However, including combat pay for purposes of calculating




the earned income credit may either help or hurt the taxpayer, because 
the credit both phases in and phases out based on earned income.\514\ 

If the objective of the present-law rules is to ensure that the exclusion
of combat pay from gross income does not result in a net economic detriment
through the elimination of otherwise available refundable credits, an 
election to include combat pay in income for all Code purposes 
would be sufficient to achieve that objective.  Present law, however,
takes a more taxpayer favorable approach by allowing the tax treatment
of combat pay to vary across Code provisions when such variation is 
favorable, and thus present law (1) always treats combat pay as earned 
income for purposes of the refundable portion of the child credit, as that
is always the most favorable result because the refundable child credit 
can only rise as income rises, and (2) allows the taxpayer to elect to 
include combat pay as earned income for purposes of the EIC (advantageous
to the taxpayer depending on the amount of earned income that 
would result). 

The election to include or exclude combat pay for purposes of the earned 
income credit creates complexity. In general, elections always add 
complexity, because taxpayers need to calculate their tax liability in more
than one way in order to determine which result is best for them.

The present-law rules with respect to combat pay treat such pay differently
than other nontaxable compensation for purposes of the definition of earned
income in the refundable child credit and the earned income credit. 
For example, under present law, other nontaxable employee compensation 
(e.g., elective deferrals such as salary reduction contributions to 401(k)
plans) is not includible in earned income for these purposes.  Allowing 
combat pay to be included in earned income creates an inconsistent 
treatment between it and other nontaxable employee compensation and 
arguably creates inequities between taxpayers who receive combat pay 
compared to other types of nontaxable compensation.


                                   Prior Action
                                   
A similar proposal was included in the President's 2006 budget.  That 
proposal extended the earned income credit combat pay election through 
December 31, 2006, and was enacted as part of the Gulf Opportunity Zone Act
of 2005 (Pub. Law 109-135).










------------------
\514\ A similar issue would arise with respect to the child credit, 
because that credit also is phased out based on adjusted gross income.
However, present law addresses this potential adverse effect by including
combat pay only for purposes of calculating the refundable portion of the
credit.



IX.  OTHER PROVISIONS MODIFYING THE INTERNAL REVENUE CODE

A.  Extension of the Rate of Rum Excise Tax Cover Over 
to Puerto Rico and Virgin Islands



                             Present Law
                             
A $13.50 per proof gallon  excise tax is imposed on distilled spirits 
produced in or imported (or brought) into the United States. The excise
tax does not apply to distilled spirits that are exported from the United
States, including exports to U.S. possessions (e.g., Puerto Rico 
and the Virgin Islands).\517\ 

The Code provides for cover over (payment) to Puerto Rico and the Virgin
Islands of the excise tax imposed on rum imported (or brought) into the 
United States, without regard to the country of origin. The amount of the
cover over is limited under Code section 7652(f) to $10.50 per proof 
gallon ($13.25 per proof gallon during the period July 1, 1999 through 
December 31, 2005).\519\ 

Tax amounts attributable to shipments to the United States of rum produced
in Puerto Rico are covered over to Puerto Rico.  Tax amounts attributable
to shipments to the United States of rum produced in the Virgin Islands are
covered over to the Virgin Islands.  Tax amounts attributable to shipments
to the United States of rum produced in neither Puerto Rico nor the Virgin
Islands are divided and covered over to the two possessions under a
formula.\520\   
Amounts covered over to Puerto Rico and the Virgin Islands are deposited 
into the treasuries of the two possessions for use as those possessions 
determine.\521\ All of the amounts covered over are subject to 
the limitation.







---------------------
\515\ A proof gallon is a liquid gallon consisting of 50 percent alcohol.
See sec. 5002(a)(10) and (11).

\516\ Sec. 5001(a)(1).

\517\ Secs. 5062(b), 7653(b) and (c).

\518\ Secs. 7652(a)(3), (b)(3), and (e)(1). One percent of the amount of
excise tax collected from imports into the United States of articles 
produced in the Virgin Islands is retained by the United States under 
section 7652(b)(3).

\519\ The amount covered over is limited to the amount of excise tax 
imposed under section 5001(a)(1), if lower than the limits stated above.
 Sec. 7652(f)(2).

\520\ Sec. 7652(e)(2).

\521\ Secs. 7652(a)(3), (b)(3), and (e)(1).
   

   
   

                         Description of Proposal
                         
The proposal extends the $13.25-per-proof-gallon cover over rate for two
additional years, through December 31, 2007.

Effective date.--The proposal is effective for articles brought into the 
United States after December 31, 2005.


                                 Analysis
                                     
The fiscal needs of Puerto Rico and the Virgin Islands were the impetus to
extend the increased cover over rate to bolster the Treasuries in those 
possessions.  Rather than rely on rum consumption in the United States, 
increased revenue could be achieved by intergovernmental support through a 
direct appropriation. The advantage of a direct appropriation is that it 
provides for annual oversight.  Some argue that a cover over is akin to an
entitlement in terms of the annual budget process and making it permanent 
ensures a steady flow of revenue.  Although the cover over may provide a 
more stable revenue stream, it may be more difficult to administer than
a direct appropriation.  


                                 Prior Action
                                    
The $13.25 per-proof-gallon cover over rate had been scheduled to expire
after December 31, 2003. The President's fiscal year 2004 and 2005 budget 
proposals included a proposal that extended the $13.25 per-proof-gallon 
cover over rate for two additional years, through December 31, 2005.  
The Working Families Tax Relief Act of 2004 enacted that proposal 
into law.\522\ The President's fiscal year 2006 budget proposal included a
proposal that extended the $13.25 per-proof-gallon cover over rate for one
additional year, through December 31, 2006.  H.R. 4388, as passed by the 
House (the "Tax Revision Act of 2005"), would extend the $13.25 cover 
over rate through December 31, 2006.










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\522\ Pub. L. No.108-311, sec.305 (2004).





B.  Establish Program of User Fees for Certain Services Provided to the 
Alcohol Industry by the Alcohol and Tobacco Tax and Trade Bureau


                              Present Law
                                    
The Alcohol and Tobacco Tax and Trade Bureau ("TTB"), under the Secretary
of the Treasury, is responsible for the collection of alcohol, tobacco, 
firearms, and ammunition excise taxes, for ensuring that such products are
labeled, advertised, and marketed in accordance with the law, and for 
administering certain laws and regulations concerning these products.  

TTB issues permits to members of the alcohol industry engaged in the 
business of producing distilled spirits or wine, or importing or 
wholesaling distilled spirits, wine, or malt beverages.\523\ In addition, 
bottlers and importers of these alcoholic beverages must obtain a 
certificate of label approval from TTB prior to bottling or selling its
product in interstate commerce or removing the bottled product 
from customs custody.\524\ TTB also reviews formulas and statements of
process, and performs laboratory tests pursuant to the Federal Alcohol 
Administration Act. For example, formulas are required for distilled 
spirits operations that change the character, composition, class, or type 
of the spirits.  These formulas must be approved by TTB.\525\ TTB does not 
currently charge fees for these services.

Under the Code, manufacturers may claim a drawback of most of the tax for
the use of tax-paid distilled spirits in nonbeverage products.  Currently 
TTB imposes a fee of one dollar per proof gallon to process 
such claims. \526\

The Code authorizes the Secretary to establish a user fee program for
requests to the Internal Revenue Service for ruling letters, opinion 
letters, determination letters, and other similar requests.\527\ The user
fees charged under the IRS program must (1) vary according to categories
(or subcategories) established by the Secretary, (2) be determined after
taking into account the average time for (and difficulty of) complying with 
requests in each category (and subcategory), and (3) be payable 
in advance.\528\











-------------------
\523\ 27 U.S.C. sec. 204.

\524\ 27 U.S.C. sec. 205(e).

\525\ 27 CFR secs. 5.25-5.28.

\526\ Sec. 5134(a).

\527\ Sec. 7528(a). See Rev. Proc. 2006-8, 2006-1 I.R.B. 245.

\528\ Sec. 7528(b).






                     Description of Proposal

The proposal directs the Secretary to establish a program requiring the
payment of certain user fees to TTB. User fees would be required for the 
following categories of services, in no less than the following minimum
amounts:

GRAPHICS NOT AVAILABLE IN TIFF FORMAT


The proposal provides that the amount of fees charged may vary according to
categories (or subcategories) established by the Secretary, after taking 
into account the average time for,and difficulty of, processing such 
requests in each category (and subcategory).  The fees are required to be 
payable in advance.  However, the foregoing rules do not limit the Secretary's 
authority to use any other measures or standards in setting fees as the
Secretary deems appropriate and necessary.  The proposal also provides that,
except for the minimum fees stated in the fee schedule, the Secretary may 
provide for reduced or increased program fees as the Secretary determines
to be appropriate.

-----------------------
\529\  Minimum fees would be in accordance with the minimum fees for the 
appropriate category of services to which the relevant service is similar.



In exercising the authority under this proposal, the normal regulatory 
process of notice,comment, and hearing would not be required.  Instead, the
Secretary is required only to publish a notice of the new fees or 
adjustment to such fees not less than 60 days prior to the effective date 
of such new fees or adjustment.

In addition to the regulatory fees described above, the proposal increases
the fee for processing tax drawback claims of manufacturers of nonbeverage 
products from one dollar to two dollars per proof gallon. 

The fees in excess of one dollar per proof gallon for 
processing the drawback claims and all of the other fees imposed under the
proposal are to be deposited in an Alcohol and Tobacco Regulatory Fund
within the Treasury Department. Amounts in such Fund are authorized to be
appropriated for activities of TTB, and remain available until expended.
However, such amounts must be appropriated to be spent.

Effective date.--The proposal is effective on date of enactment.
The increased fee for processing drawback claims is effective on date of
enactment.  The other fees become effective no sooner than 60 days after
publication of a notice of such fees in the Federal Register.


                               Analysis
                               
Some argue that TTB's regulatory services provide value to the industry
by providing information and assurance to the public that enhances the 
applicant's value, and, therefore, the applicant should pay for these 
benefits, in the same manner as users of IRS ruling services. Others argue
that the primary beneficiary of TTB's regulatory services is the public,
and that Congress should take these expenses into account when 
appropriating general funds for the TTB budget.  Proponents of these 
arguments stress that it is unfair to require taxpayers to pay to apply for
government-mandated approvals, and that it is burdensome on small business
taxpayers.

TTB employs a high percentage of highly educated and technically trained
staff; more than half are analysts, chemists, investigators, and auditors. 
Accordingly, some argue that the cost to TTB of regulatory approval may be
greater than that of some other government agencies. On the other hand, it
is not clear that the current TTB budget is inadequate for TTB to provide 
these services.

The proposal gives the Secretary wide latitude to set the fees without
providing the public an opportunity for notice and comment on whether the 
fee is justified in light of the related expense or its effect on the 
industry.  While the IRS has changed the amounts of user fees 
without formal notice, comment, and hearing procedures,\530\ the IRS user
fees are constrained by the statutory requirements that they shall vary
by category and shall be determined after taking into account the average
time and difficulty of complying with the requests.  The proposal states 
these same requirements with respect to TTB program fees, but only as 
nonbinding permissive guidelines.  Some argue that the lack of binding
statutory standards for these TTB fees (particularly when compared with
the statutory requirements applicable to the IRS), combined 

------------------
\530\ See Rev.Proc. 93-23, 1993-1 CB 538.



with lack of notice, comment, and hearing rulemaking procedures vests
too much discretion in the Secretary.


The drawback fee under section 5134(a) has not been increased in over 50
years, and some argue that the fee should keep up with the agency's 
increase in costs over that time span. On the other hand, some argue that
two dollars per proof gallon is an unreasonably large proportion of the 
entire tax on distilled spirits, i.e., $13.50 per proof gallon.


                              Prior Action
                              
An identical proposal was included in the President's fiscal year 2006
budget proposal




   This document may be cited as follows:  Joint Committee on Taxation,
   Description of Revenue Provisions Contained in the President's Fiscal
   Year 2007 Budget Proposal (JCS-1-06), March 2006.
   See Office of Management and Budget, Budget of the United States
   Government, Fiscal Year 2007: Analytical Perspectives (H. Doc. 109-79,
   Vol. III), at 285-328.   See Department of the Treasury, General 
   Explanations of the Administration's Fiscal Year 2007 Revenue Proposals,
   February 2006.   
   
   
   
   
   
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