[JPRT 109-02-05]
[From the U.S. Government Publishing Office]
OPTIONS TO IMPROVE TAX COMPLIANCE AND
REFORM TAX EXPENDITURES
_____________
PREPARED BY THE STAFF
OF THE
JOINT COMMITTEE ON TAXATION
January 27, 2005
JCS-02-05
Contents
Page
INTRODUCTION AND SUMMARY......................................1
GRASSLEY-BAUCUS REQUEST LETTER................................3
I. TAX PROCEDURE AND ADMINISTRATION...........................4
A. Impose Withholding on Certain Payments Made by Government
Entities...................................................4
B. Require Partial Payments with Submission of Offers-in-
Compromise................................................10
C. Clarify Standards of Scrutiny for Certain Transactions with
Characteristics of Tax Shelters...........................14
II. INDIVIDUAL INCOME TAX....................................31
A. Provide Uniform Treatment for Dependent Care Benefits
(secs. 21 and 129)........................................31
B. Combine Hope and Lifetime Learning Credits and the Above-
the-Line Deduction for Higher Education Expenses (secs.
25A and 222)..............................................35
C. Repeal Exclusion for Qualified Tuition Reductions (sec.
117(d))...................................................44
D. Deny Refundable Child Credit When Section 911 Exclusion is
Elected (sec. 24).........................................47
E. Repeal the Deduction for Interest on Home Equity Indebtedness
(sec. 163)................................................52
F. Limit the Exclusion for Rental Value of a Residence Rented
for Fewer Than 15 Days (sec. 280A)........................57
G. Extend Pro-Rata Basis Allocation Requirement to All
Part-Gift, Part-Sale Transactions (sec. 1011).............59
H. Simplify Taxation of Minor Children (sec. 1)..............62
III. EMPLOYMENT TAXES........................................71
A. Provide Consistent FICA Treatment of Salary Reduction
Amounts (sec. 3121(a))....................................71
B. Conform Calculation of FICA Taxes and SECA Taxes (sec.
1402(a)(12))..............................................74
C. Extend Medicare Payroll Tax to All State and Local
Government Employees (sec. 3121(u)(2))....................80
D. Modify FICA Tax Exception for Students (secs. 3121(b)(10)
and 3306(c)(10))..........................................83
E. Apply Employment Taxes to Sales Incentive Payments Made by
Manufacturers (secs. 3121, 3306, and 3401)................91
F. Modify Determination of Amounts Subject to Employment or
Self-Employment Tax for Partners and S Corporation
Shareholders (sec. 1402)..................................95
IV. PENSIONS AND EMPLOYEE BENEFITS...........................105
A. Conform Definition of Qualified Medical Expenses (secs.
105, 106, 213, 220, and 223).............................105
B. Limit Deduction for Personal Use of Company Aircraft and
Other Entertainment Expenses (sec. 274(e))...............109
C. Limit Deduction for Income Attributable to Property
Transferred in Connection with the Performance of Services
to Amount Included in Income by the Service Provider
(sec. 83)................................................113
D. Payments in Redemption of Stock Held by an ESOP Not
Deductible as Dividends (sec. 404(k))....................117
E. Provide Greater Conformity for Section 403(b) and Section
401(k) Plans (secs. 402(g), 403(b), and 415(c)(3)).......122
F. Extend Early Withdrawal Tax to Eligible Deferred
Compensation Plans of State and Local Governments (sec.
72(t))...................................................130
G. Modify Prohibited Transaction Rules for Individual Retirement
Arrangements (''IRAs'') to Reduce Tax Shelter Transactions
(sec. 4975)..............................................133
H. Repeal Pick-Up Rules for Employee Contributions to State or
Local Governmental Retirement Plans (sec. 414(h))........140
V. CORPORATE AND PARTNERSHIP PROVISIONS.....................145
A. Modify Extraordinary Dividend Rules for Common Stock (sec.
1059)....................................................145
B. Reduce Tax-Indifferent Shareholder's Basis in Stock by
Nontaxed Portion of Extraordinary Dividend (sec. 1059)...148
C. Modify Active Business and Control Requirements for Section
355 Corporate Divisions (sec. 355).......................153
D. Modify Application of Unrelated Business Income Tax to S
Corporation Shareholders (sec. 512)......................159
E. Modify Safe Harbor for Allocation of Nonrecourse Deductions
and Exclude Nonrecourse Liabilities From Outside Basis (secs.
704 and 752).............................................161
F. Modify Adjustment Rules for Basis of Undistributed
Partnership Property (sec. 734)..........................168
G. Treat Guaranteed Payments to Partners as Payments to
Nonpartners (sec. 707)...................................170
VI. INTERNATIONAL PROVISIONS.................................174
A. Amend the Employer-Provided Housing Exclusion and Impose a
Stacking Rule with Respect to Non-Excludable Income
(sec. 911)...............................................174
B. Amend Rules for Determining Corporate Residency (sec.
7701)....................................................178
C. Modify Entity Classification Rules to Reduce Opportunities
for Tax Avoidance (sec. 7701)............................182
D. Adopt a Dividend Exemption System for Foreign Business
Income...................................................186
VII. OTHER BUSINESS PROVISIONS...............................198
A. Disallow Deduction for Interest on Indebtedness Allocable
to Tax-Exempt Obligations (sec. 265).....................198
B. Modify Recapture of Section 197 Amortization (sec. 1245).204
C. Modify Application of Income Forecast Method of Depreciation
(sec. 167)...............................................207
D. Apply Luxury Automobile Limitations to Sport Utility
Vehicles (sec. 280F).....................................210
E. Disallow Deduction for Interest on Debt Allocable to
Tax-Exempt Income of Insurance Companies (secs. 265
and 832).................................................214
F. Eliminate Double Deduction of Mining Exploration and
Development Costs Under the Minimum Tax (sec. 57)........218
VIII. EXEMPT ORGANIZATIONS...................................220
A. Require Five-Year Review of Exempt Status of Public
Charities and Private Foundations and Annual Notice by
Organizations Not Required to File Information Returns
(sec. 508)...............................................220
B. Impose Termination Tax on Conversions of Assets of
Charities (secs. 501, 507, 4941, and 4958)...............230
C. Tax Involvement by Exempt Organizations in Tax-Shelter
Transactions (secs. 6011 and 6707A)......................247
D. Reform Intermediate Sanctions and Extend Certain Reforms
to Private Foundations (secs. 4941 and 4958).............254
E. Increase the Amount of Excise Taxes Imposed on Public
Charities, Social Welfare Organizations, and Private
Foundations (secs. 4941, 4942, 4943, 4944, 4945, and
4958)....................................................270
F. Modify Charitable Deduction for Contributions of Conservation
and Facade Easements (sec. 170)..........................277
G. Limit Charitable Deduction for Contributions of Clothing
and Household Items (sec. 170)...........................288
H. Reform Rules for Charitable Contributions of Property
(sec. 170)...............................................293
I. Require Public Disclosure of Form 990-T and Related
Certification Requirements (secs. 6104 and 6685).........308
J. Expand the Base of the Tax on Private Foundation Net
Investment Income (sec. 4940)............................313
K. Limit Tax-Exempt Status of Fraternal Beneficiary Societies
that Provide Commercial-Type Insurance (sec. 501(c)(8))..319
L. Establish Additional Exemption Standards for Credit
Counseling Organizations (secs. 501(c)(3) and 501(c)(4)).327
IX. TAX-EXEMPT BOND PROVISIONS...............................338
A. Impose Loan and Redemption Requirements on Pooled Financing
Bonds (sec. 149).........................................338
B. Amend Information Reporting Requirements to Include
Interest on Tax-Exempt Bonds (sec. 6049).................346
C. Clarify Limitations on Indian Tribes' Use of Tax-Exempt
Bond Proceeds (sec. 7871)................................350
D. Eliminate Private Payment Test for Stadium Bonds
(sec. 141)...............................................353
E. Require Allocation of Volume Cap to Mortgage Credit
Certificates Based on Allocation of Volume Cap to Mortgage
Bonds (secs. 25 and 143).................................359
F. Eliminate Advance Refunding of Governmental Bonds and
501(c)(3) Bonds (sec. 149(d))............................365
X. EXCISE TAXES.............................................368
A. Modify the Federal Excise Tax on Communications Services
(secs. 4251-4254)........................................368
B. Equalize Alcohol Excise Taxes (secs. 5001, 5041, and 5051).379
C. Subject International Flights with Wholly Domestic Segments
to the Segments Tax (secs. 4261 and 4262)................385
D. Modify the Federal Excise Tax on Sport Fishing Equipment
(secs. 4161 and 4162)....................................388
XI. ESTATE AND GIFT TAXATION.................................392
A. Limit Perpetual Dynasty Trusts (secs. 2631 and 2632).....392
B. Determine Certain Valuation Discounts More Accurately for
Federal Estate and Gift Tax Purposes (secs. 2031, 2512,
and 2624)................................................396
C. Curtail the Use of Lapsing Trust Powers to Inflate the
Gift Tax Annual Exclusion Amount (sec. 2503).............405
D. Provide Reporting for a Consistent Basis Between the
Estate Tax Valuation and the Basis in the Hands of the
Heir (sec. 1014).........................................409
E. Modify Transfer Tax Provisions Applicable to Section 529
Qualified Tuition Accounts (sec. 529)....................412
XII. ESTIMATED REVENUE EFFECTS OF PROPOSALS.................425
INTRODUCTION AND SUMMARY
This report, prepared by the staff of the Joint Committee on Taxation (''Joint Committee
staff''), presents various options to improve tax compliance and reform tax expenditures. This
report is prepared at the request of Senate Finance Committee Chairman Charles Grassley and
Ranking Member Max Baucus. A copy of their letter follows this Introduction and Summary.
This report is an independent work-product of the Joint Committee staff and the options included
in it have not received prior approval by Senator Grassley, Senator Baucus, or their staffs.
As requested by Senators Grassley and Baucus, the report describes a number of
proposals that would reduce the size of the tax gap by curtailing tax shelters, closing unintended
loopholes, and addressing other areas of noncompliance in present law. In addition, the report
contains proposals that would reform certain tax expenditures. Each proposal includes a
description of present law, reasons for change, a description of the proposed change and effective
date, and a discussion of the issues raised by the proposal. The proposals are not ranked or
presented in any order other than by subject-matter.
The proposals contained in the report attempt to reduce noncompliance in several
different ways. Some proposals address the problem by requiring new compliance or reporting
initiatives, revising aspects of the law that have proven to be a source of taxpayer
noncompliance, or increasing penalties. Other proposals address the problem by simplifying the
law or making it more fair.
Among the proposals contained in this report are the following. According to the
National Taxpayer Advocate, noncompliance by self-employed persons accounts for the largest
share of the known tax gap. Prior proposals to curb such noncompliance through required
withholding by the party making payments to the self-employed person have raised concerns
regarding the burden placed upon the party required to withhold. This report contains a proposal
to require withholding on such payments only by government entities. Because such payments
represent a significant part of the economy, the proposal can be expected to improve compliance
to an important extent without burdening private sector payors. The proposal exempts smaller
government entities from the withholding requirement.
The report contains a proposal targeted specifically at tax shelter activity. In addition to
potentially providing unintended tax relief to the participants of the shelter, such activity enlarges
the tax gap by undermining overall respect for the tax system. Prior proposals to restrain such
activity by codifying the 'economic substance' doctrine have been criticized as either removing
too much flexibility from the courts or potentially applying too broadly to many non-tax-shelter
transactions. The proposal contained in this report addresses these concerns by requiring a
higher level of judicial scrutiny only in the case of specific categories of uncommon transactions
which have the characteristics of tax shelters.
Valuation issues, whether in the context of charitable contributions, transfer taxes, or
other situations presented by the tax law, are a common source of noncompliance. The report
contains several proposals to resolve valuation controversies in a simpler and more administrable
way.
The report includes proposals to curb the mismatched taxation of income and related
deductions, a common sheltering technique. In addition, there are proposals addressing the
difficult compliance problem raised by mixed-use property, such as property that provides both
business and personal benefits.
The report also contains several proposals that would carry out a restructuring of different
tax expenditure areas. One example is a proposal that would consolidate three tax benefits
relating to education into a single tax credit for education-related expenses. In general, the
proposed restructurings attempt to simplify the law or permit the Congressional purpose to be
achieved in a more fair or efficient manner.
Finally, the report contains a number of smaller proposals designed to improve
compliance, close loopholes, reform or repeal tax expenditures, end specific tax shelters, and
otherwise prevent unintended consequences.
This report contains proposals that touch on virtually every aspect of the tax law.
Nevertheless, the report is not intended to be comprehensive. The Joint Committee staff
explored and rejected many other ideas as being too difficult to administer or needing further
analysis. As requested by Senators Grassley and Baucus, the Joint Committee staff will continue
to investigate and analyze possible proposals to increase compliance and reform tax
expenditures.
A table at the end of the report contains yearly revenue estimates through fiscal year 2014
of each of the proposals described in the report. With the exception of proposed restructurings of
certain tax expenditures and excise taxes, which have been developed to have a revenue neutral
effect, each of the proposals is estimated to raise revenue. If the proposed restructurings are
viewed as achieving efficiency or other gains, their adoption may provide Congress with the
opportunity to revisit the level of benefit provided or tax imposed.
The revenue estimate of each proposal is determined independent of the other proposals,
and is based on the 2004 CBO baseline. In general, due to time constraints, the absence of
statutory language, and in certain cases, the lack of specificity of certain aspects of some
proposals, the estimates should be viewed as general guidance to the Congress regarding the
likely revenue impact of the proposal. Some estimates may change significantly as a result of
new information, greater specificity of the proposal, and a change to the 2005 CBO baseline.
The proposals are generally assumed to be effective upon date of enactment or, in certain cases,
at some point after date of enactment; for purposes of these estimates, it is assumed that the date
of enactment is October 1, 2005 with no transition relief provided. If any legislation is
developed based on one of these proposals, it may be appropriate to revisit the effective date as
well as the availability of transition relief.
GRASSLEY-BAUCUS REQUEST LETTER
I. TAX PROCEDURE AND ADMINISTRATION
A. Impose Withholding on Certain Payments Made by Government Entities
Present Law
Withholding requirements
The Internal Revenue Code of 1986 (the ''Code) requires employers to withhold income
tax on wages paid to employees, including wages and salaries of employees or elected officials
of Federal, State, and local government units. 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.
Certain nonwage payments also are subject to mandatory or voluntary withholding. For
example:
* Employers are required to withhold FICA and Railroad Retirement taxes from wages
paid to their employees. Withholding rates are generally uniform.
* Payors of pensions are required to withhold from payments made to payees, unless
the payee elects no withholding. Withholding from periodic payments is at variable
rates, parallel to income tax withholding from wages, whereas withholding from
nonperiodic payments is at a flat 10-percent rate.
* A variety of payments (such as interest and dividends) are subject to backup
withholding if the payee has not provided a valid taxpayer identification number
(TIN). Withholding is at a flat rate based on the fourth lowest rate of tax applicable
to single taxpayers. This rate is 28 percent for 2005.
* Certain gambling proceeds are subject to withholding. Withholding is at a flat rate
based on the third lowest rate of tax applicable to single taxpayers. This rate is 25
percent for 2005.
* Voluntary withholding applies to certain Federal payments, such as Social Security
payments. Withholding is at rates specified by Treasury regulations.
* Voluntary withholding applies to unemployment compensation benefits.
Withholding is at a flat 10-percent rate.
* Foreign taxpayers are generally subject to withholding on certain U.S.-source income
which is not effectively connected with the conduct of a U.S. trade or business.
Withholding is at a flat 30-percent rate (14-percent for certain items of income).
Many payments made by government entities are not subject to withholding under
present law. For example, no tax is generally withheld from payments made to workers who are
not classified as employees (i.e., independent contractors).
Information reporting
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. Special information reporting requirements exist for employers required to deduct
and withhold tax from employees' income. In addition, any service 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. Government entities are specifically required
to make an information return, reporting payments to corporations as well as individuals.
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).
Reasons for Change
The lack of a withholding mechanism on nonwage payments leads to substantial
underpayments of tax each year and has long been identified as contributing to the tax gap. For
example, it is estimated that tax compliance for wage earners whose income is subject to
withholding is approximately 99 percent, while compliance for individuals with income not
subject to withholding is significantly less.
Payments made by the Federal government and State and local governments represent a
significant amount of those annual payments that are not subject to withholding. Imposing
withholding on nonwage payments made by the Federal government and State and local
governments would improve taxpayer compliance, reduce the tax gap, and promote fairness.
Requiring withholding on government payments also addresses concerns regarding the poor
compliance records of Federal contractors. For example, a recent Government Accountability
Office (''GAO'') study of Department of Defense and IRS records showed that over 27,000
Federal contractors owed about $3 billion in unpaid taxes as of September 30, 2002.
Description of Proposal
The proposal requires withholding on payments for goods and services made by all
branches of the Federal government and its agencies and all units of State and local
governments, including counties and parishes. Local governments with less than $100 million
of annual expenditures are excluded from the withholding requirement.
The rate of withholding is three percent on all payments, regardless of whether the
payments are for goods or services.
The proposal imposes information reporting requirements on payments that are subject to
withholding under the proposal but are not subject to information reporting under present law.
The proposal does not apply to payments of wages or to any other payment with respect
to which mandatory (e.g., U.S.-source income of foreign taxpayers) or voluntary (e.g.,
unemployment benefits) withholding applies under present law. The proposal also does not
apply to the following: payments of interest; payments for real property; payments to tax-exempt
entities or foreign governments; intragovernmental payments; and payments made pursuant to a
classified or confidential contract (as defined in section 6050M(e)(3)).
Effective Date
The proposal applies to payments made after the first December 31st that is at least six
months after the date of enactment.
Discussion
The withholding of tax on wages has been described as ''the cornerstone of our tax
compliance system for employees.'' Employees who are subject to withholding have little
opportunity to underreport income. Withholding also provides taxpayers with a gradual and
systematic method to pay their taxes. Thus, taxpayers subject to withholding are less likely to
face a large liability at the end of the tax year and have less motivation for underreporting their
income.
In contrast, the absence of withholding on many types of payments has been cited as
contributing to the growing compliance problem. Studies have consistently shown that rates of
noncompliance are considerably higher for taxpayers with income not subject to withholding
than for those taxpayers whose income is subject to withholding. For example, the National
Taxpayer Advocate concluded that the absence of a withholding mechanism on certain nonwage
payments creates several problems, including contributing to the substantial tax gap and
''harming compliant taxpayers because they pay their correct tax liability while others do not.''
This disparate treatment of similarly situated taxpayers undermines respect for the fairness of the
tax system.
Imposing withholding on nonwage payments would increase compliance and facilitate
IRS collection activities by filtering regular tax payments from large numbers of taxpayers
through significantly fewer collection points. In general, the more payments to which
withholding applies, the greater improvement in compliance. However, withholding
requirements also impose burdens on payors. The proposal attempts to balance the goal of
greater compliance with concerns regarding administrative burdens by imposing withholding
only on payments made by Federal, State and most local governments, as well as agencies of
these entities. Because the payments of such entities represent a significant part of the
economy, the proposal may be expected to appreciably improve compliance, while not
burdening private sector payors. To avoid imposing a burden on small entities, local
governments with less than $100 million of annual expenditures are not subject to the proposal.
Although the proposal imposes new administrative requirements on some payors, in
many cases the affected parties will already have procedures in place that can be modified to
accommodate the additional requirements. For example, present law imposes information
reporting requirements on governmental entities. Arguably, the proposal will require only the
expansion of existing information reporting procedures to satisfy the broader withholding
requirement, not the creation of wholly new procedures, in such cases. Similarly, certain Federal
payments to vendors of goods or services are subject to continuous levy authority under present
law. Thus, Federal agencies have existing procedures for deducting and remitting taxes from
payments to businesses and individuals that may be tailored to the requirements of the proposal.
The proposal imposes a flat rate of three percent on all payments, other than the excluded
payments discussed above, regardless of whether the payment is made for goods or services.
The advantages of a flat rate of withholding are that it is simple, easy to verify, and applicable to
all payees. A disadvantage of this approach, however, is that it is likely to cause either
overwithholding or underwithholding for some payees. For example, sellers of goods and
materials are more likely to have overwithholding and, thus, bear more of the burden of a flat
rate because of the lower profit margin on such sales relative to sales of services. Similar
proposals have recommended a higher rate of withholding on payments for the provision of
personal services (where no or minimal goods are provided) than on payments for the provision
of goods only or a mix of goods and services. A variable rate proposal would add additional
complexity, which would have to be weighed against the benefits to be derived from a variable
rate system. In addition, the rate under the proposal is set low enough not to necessitate a second
rate. The conservative three-percent rate under the proposal will limit instances of
overwithholding.
The proposal also addresses inefficiencies in the current Federal levy program. Under
present law, the Federal government has broad authority to levy Federal payments made to
vendors of goods and services, up to 100 percent of certain Federal payments. Although a levy
program should provide an efficient and effective method of collecting unpaid taxes, the Federal
government's levy authority has not proven fully effective. IRS resource constraints have
limited the number of cases referred to the levy program and Federal agencies have not
systematically imposed levies on cases that have been referred. Because withholding, unlike a
levy, is required and relatively simple, the proposal will provide a more effective means of
promoting compliance than the current levy program, which requires numerous administrative
steps to collect unpaid taxes.
Imposing withholding more broadly on non-wage payments throughout the economy
could be expected to generate additional positive effects on compliance and IRS collection
efforts. However, broader withholding requirements would also involve additional
administrative burdens on the private sector and on both payors and payees.
The proposal is estimated to raise approximately $6.4 billion over the fiscal years 2006
through 2014. There is a significant revenue effect in fiscal year 2007 that is largely attributable
to accelerating tax receipts as a result of the withholding requirement. However, the proposal
also has a significant revenue effect over the estimating period that is directly related to the
expected improvement in tax compliance.
B. Require Partial Payments with Submission of Offers-in-Compromise
Present Law
In general
The Federal government may compromise any civil or criminal case arising under the
internal revenue laws. In general, taxpayers initiate this process by making an offer-in-
compromise, which is an offer by the taxpayer to settle an outstanding tax liability for less than
the total amount due. Offers are generally made using Form 656. The IRS currently imposes a
user fee of $150 on most offers, payable upon submission of the offer to the IRS. Taxpayers
may justify their offers on the basis of doubt as to collectibility or liability or on the basis of
effective tax administration. In general, enforcement action is suspended during the period that
the IRS evaluates an offer. In some instances, it may take the IRS 12 to 18 months to evaluate an
offer. Taxpayers are permitted (but not required) to make a deposit with their offer; if the offer
is rejected, the deposit is generally returned to the taxpayer. There are two general categories
of offers-in-compromise.
Lump-sum offers
Taxpayers making lump-sum offers propose to make one lump-sum payment of a
specified dollar amount in settlement of their outstanding liability.
Periodic payment offers
Taxpayers making periodic payment offers propose to make a series of payments over
time (either short-term or long-term) in settlement of their outstanding liability.
Reasons for Change
The offer-in-compromise program is a valuable collection tool; it allows the IRS to
collect a portion of an outstanding tax liability in circumstances in which it may not be possible
or reasonable to expect collection of the entire liability. In general, submission of an offer
indicates that the taxpayer is willing and able to make a partial payment of the taxpayer's
liability. Because of the lengthy review process that the IRS undertakes prior to accepting an
offer, there may be a substantial period of time before the Government actually collects the
amounts the taxpayer is willing to pay. Moreover, experience under present law has shown that
in some cases taxpayers do not make offers in good faith (e.g., by concealing information from
the IRS). Requiring partial payment with the submission of an offer-in-compromise will
preserve the offer program for those cases in which it is appropriate, and will increase fairness
for those taxpayers who pay their taxes in full.
Description of Proposal
In general
The proposal requires that a taxpayer make partial payments to the government while the
taxpayer's offer is being considered by the IRS. These payments are retained by the government
and applied to the taxpayer's outstanding balance, even if the taxpayer's offer is rejected as
inadequate.
Lump-sum offers
The proposal requires that taxpayers make a down payment of 20 percent of the amount
of any lump-sum offer-in-compromise with any application for an offer. A lump-sum offer
includes single payments as well as payments made in five or fewer installments. For example,
if the taxpayer owes the IRS $100,000 and submits an offer-in-compromise of a single payment
of $40,000 to settle this liability in full, the taxpayer must make a down payment of $8,000 when
the taxpayer submits the offer-in-compromise to the IRS. If the IRS rejects an offer as
inadequate and the taxpayer makes a new offer, the taxpayer must make an additional down
payment so that the total of the new down payment and the previous down payment equals 20
percent of the new offer. In the previous example, if the IRS rejects that offer, the $8,000 down
payment is kept by the IRS and applied to the taxpayer's account. If the taxpayer submits a new
offer of $60,000, the taxpayer must make an additional down payment of $4,000 when the
taxpayer submits the new offer to the IRS.
Periodic payment offers
The proposal requires the taxpayer to comply with the taxpayer's own proposed payment
schedule while the offer is being considered. For example, if the taxpayer owes the IRS
$100,000 and submits an offer-in-compromise of $500 per month for five years to fully settle
this liability, the taxpayer would be required to pay $500 when the taxpayer submits the offer-in-
compromise as well as $500 each month thereafter for as long as the IRS is considering the offer.
If the IRS rejects this offer as inadequate, the taxpayer would stop making payments at that time
and enforcement action is permitted. If the taxpayer then submits a higher offer of $600 per
month for five years, the taxpayer would be required to pay $600 when the taxpayer submits the
offer-in-compromise as well as $600 each month thereafter for as long as the IRS is considering
the offer. If the taxpayer does not continue to comply with the taxpayer's own proposed
payment schedule for the entire period the offer is being considered, the offer is considered to be
withdrawn on the date compliance ceases and immediate enforcement action is permitted.
Rules of general applicability
Offers submitted to the IRS that do not comport with the proposed payment requirements
are returned to the taxpayer as unprocessable and immediate enforcement action is permitted.
The taxpayer is permitted to specify how these payments are to be applied. These payment
requirements are separate from, and do not affect, any user fee imposed by the IRS with respect
to offers-in-compromise. The IRS is authorized to establish parallel rules for complex offers that
have both lump-sum and periodic features. If the IRS does not make a decision to reject an offer
within two years of its submission, it is considered accepted for all purposes. The ability of the
IRS to make jeopardy assessments is unaffected by the proposal.
Effective Date
The proposal is effective for offers-in-compromise submitted to the IRS after 60 days
after the date of enactment.
Discussion
An offer-in-compromise is a valuable tool that permits final resolution of disputes over
amounts owed to the government. Agreeing on an appropriate offer may, however, be difficult,
for several reasons. First, the interests of the taxpayer and the government diverge on the issue
of the amount to be paid. Taxpayers prefer to pay as little as possible, whereas the government
wants to maximize its receipts of outstanding liabilities. Second, the interests of the taxpayer
and the government diverge on the issue of the rapidity of payment. In general, taxpayers prefer
to delay payment as long as possible (especially if enforcement actions are held in abeyance),
whereas the government has an interest in receiving payment as soon as possible. Third, there
is also likely to be an imbalance of information. The taxpayer necessarily has complete
information on the taxpayer's own financial information, whereas the government has
incomplete information (which is often information supplied by the taxpayer). While many
taxpayers make an offer in good faith, some are abusing the offer process by concealing
information from the government and by making low-ball offers.
The proposal is designed to accelerate receipts to the government while preserving the
structure of the offer program. Because the proposal calculates the amount of the partial
payment on the basis of the offer that the taxpayer is making, taxpayers should generally be able
to comply with payment terms that they themselves propose. This has several implications.
First, the proposal should not discourage most taxpayers from making offers that would be
comparable to the offers they would make absent the proposal. Second, the proposal should not
impede or further strain the efforts of the IRS in evaluating offers. Third, no special rules are
necessary with respect to offers from low-income taxpayers.
The proposal is also designed to increase collections with respect to offers that the IRS
either rejects or returns. The Taxpayer Advocate's most recent report states: ''The IRS collected
nothing from individual taxpayers in 21 percent of the [offers-in-compromise] that it rejected and
in 37 percent of the [offers-in-compromise] that it returned after acceptance for processing. The
IRS collected nothing from business taxpayers in 46 percent of the [offers-in-compromise] that it
rejected and in 60 percent of the [offers-in-compromise] that it returned after acceptance for
processing.''
C. Clarify Standards of Scrutiny for Certain Transactions
with Characteristics of Tax Shelters
Present Law
In general
The Code provides specific rules regarding the determination of tax liability, including
the amount, timing, source, and character of items of income, gain, loss and deduction. These
rules are designed to provide taxpayers with a degree of certainty as to what their tax liability
will be if they undertake a particular course of action. They also tend to ensure that different
taxpayers will be treated equally, and encounter the same tax liability, if they carry out the same
transaction. From the government's perspective, specific rules generally avoid the need for time-
consuming, case-by-case determinations of tax liability after particular transactions have been
undertaken. In addition to the statutory provisions, courts have developed several doctrines that
can be applied to deny the tax benefits of tax motivated transactions, notwithstanding that the
transaction may satisfy the literal requirements of a specific tax provision. The common-law
doctrines are not entirely distinguishable, and their application to a given set of facts is often
blurred by the courts and the IRS. Although these doctrines serve an important role in the
administration of the tax system, invocation of these doctrines can be seen as at odds with an
objective, ''rule-based'' system of taxation. Nonetheless, courts have applied the doctrines to
deny tax benefits arising from certain transactions.
Economic substance doctrine
In general
A common-law doctrine applied with increasing frequency is the ''economic substance''
doctrine. In general, this doctrine denies tax benefits arising from transactions that do not result
in a meaningful change to the taxpayer's economic position other than a purported reduction in
Federal income tax.
Courts generally deny claimed tax benefits if the transaction that gives rise to those
benefits lacks economic substance independent of tax considerations -- notwithstanding that the
purported activity actually occurred. The Tax Court has described the doctrine as follows:
The tax law . . . requires that the intended transactions have economic substance
separate and distinct from economic benefit achieved solely by tax reduction.
The doctrine of economic substance becomes applicable, and a judicial remedy is
warranted, where a taxpayer seeks to claim tax benefits, unintended by Congress,
by means of transactions that serve no economic purpose other than tax savings.
Business purpose doctrine
Another common law doctrine that overlays and is often considered together with (if not
part and parcel of) the economic substance doctrine is the business purpose doctrine. The
business purpose test is a subjective inquiry into the motives of the taxpayer -- that is, whether
the taxpayer intended the transaction to serve some useful nontax purpose. In making this
determination, some courts have bifurcated a transaction in which independent activities with
nontax objectives have been combined with an unrelated item having only tax-avoidance
objectives in order to disallow the tax benefits of the overall transaction.
Application of the doctrine
There is a lack of uniformity regarding the proper application of the economic substance
doctrine. Some courts apply a conjunctive test that requires a taxpayer to establish the presence
of both economic substance (i.e., the objective component that there be a meaningful change in
the taxpayer's position) and business purpose (i.e., the subjective component that there be a
useful non-tax purpose for the taxpayer's course of action) in order for the transaction to survive
judicial scrutiny. A narrower approach is to conclude that either a business purpose or
economic substance is sufficient. A third approach regards economic substance and business
purpose as 'simply more precise factors to consider'' in determining whether a transaction has
any practical economic effects other than the creation of tax benefits.
Recently, the Court of Federal Claims questioned the continuing viability of the
doctrine. The court also stated that ''the use of the ''economic substance'' doctrine to trump
''mere compliance with the Code'' would violate the separation of powers.'
Nontax economic benefits
There also is a lack of uniformity regarding the type of non-tax economic benefit a
taxpayer must establish in order to satisfy economic substance. Several courts have denied tax
benefits on the grounds that the subject transactions lacked profit potential. In addition, some
courts have applied the economic substance doctrine to disallow tax benefits in transactions in
which a taxpayer was exposed to risk and the transaction had a profit potential, but the court
concluded that the economic risks and profit potential were insignificant when compared to the
tax benefits. Under this analysis, the taxpayer's profit potential must be more than nominal.
Conversely, other courts view the application of the economic substance doctrine as requiring an
objective determination of whether a ''reasonable possibility of profit'' from the transaction
existed apart from the tax benefits. In these cases, in assessing whether a reasonable possibility
of profit exists, it is sufficient if there is a nominal amount of pre-tax profit as measured against
expected net tax benefits.
Financial accounting benefits
In determining whether a taxpayer had a valid business purpose for entering into a
transaction, at least one court has concluded that financial accounting benefits arising from tax
savings do not qualify as a non-tax business purpose. However, based on court decisions that
recognize the importance of financial accounting treatment, taxpayers have asserted that
financial accounting benefits arising from tax savings can satisfy the business purpose test.
Reporting and penalty regimes
As enacted in the American Jobs Creation Act of 2004 (''AJCA''), present law provides
new and strengthened accuracy related penalties with respect to ''reportable transactions'' and
''listed transactions,'' a subset of reportable transactions that includes transactions the IRS views
as tax avoidance transactions.
If listed transactions or other reportable transactions with a significant tax avoidance
purpose are adequately disclosed on the tax return, the accuracy related penalties do not apply if
there was reasonable cause for the understatement and the taxpayer acted in good faith. In the
case of a nondisclosed ''listed transaction,'' the accuracy related penalty is a ''strict liability''
penalty that is imposed notwithstanding the fact that a taxpayer may have had an otherwise
permissible opinion of counsel stating that the taxpayer is believed to be ''more likely than not''
to prevail if the matter is litigated.
The terms ''reportable transaction'' and ''listed transaction'' are defined as transactions
identified by the Treasury department pursuant to regulations. At the present time, ''reportable
transactions'' include certain transactions in which the taxpayer claims a tax credit and has held
property for less than 45 days and certain transactions that produce a book-tax difference, as well
as several other categories of transactions. Those other categories are certain transactions
involving confidentiality requirements, certain transactions involving a fee contingent upon the
taxpayers achieving certain tax benefits, certain transactions producing large losses, and any
listed transaction.
Reasons for Change
Recent tax avoidance transactions have relied upon the interaction of highly technical tax
law provisions to produce tax consequences not contemplated by the Congress. When
successful, taxpayers who engage in these transactions enlarge the tax gap by gaining unintended
tax relief and by undermining overall respect for the tax system.
A strictly rule-based tax system cannot efficiently prescribe the appropriate outcome of
every conceivable transaction that might be devised and is, as a result, incapable of preventing
all unintended consequences. Thus, many courts have long recognized the need to supplement
tax rules with anti-tax avoidance standards, such as the economic substance doctrine, in order to
assure the Congressional purpose is achieved. Application of this doctrine to certain categories
of transactions having the characteristics of tax shelters should be clarified and strengthened in
order to improve its effectiveness at deterring unintended consequences and to promote greater
uniformity.
Description of Proposal
In general
The proposal clarifies and enhances the application of the economic substance doctrine to
certain ''applicable transactions.'' For transactions that are not ''applicable transactions,'' the
proposal does not change present law.
The proposal only applies to cases in which a court determines that the economic
substance doctrine is relevant. The proposal is not intended to change current law standards used
by the courts in determining when to utilize an economic substance analysis, and does not
require a court to make such a determination merely because of the presence of an applicable
transaction. The proposal does not apply to cases in which the taxpayer establishes that the
outcome of the transaction is clearly consistent with all applicable provisions of the Code and the
purposes of such provisions.
Except with respect to the economic substance doctrine as it is applied to applicable
transactions, the provision is not intended to alter or supplant any other common law doctrine,
and is to be considered additive to any such other doctrine.
Draft statutory language of the proposal is set forth following the discussion.
Application of economic substance doctrine to applicable transactions
Under the proposal, in any case in which a court determines that the economic substance
doctrine is relevant to an ''applicable transaction,'' such transaction has economic substance (and
thus satisfies the economic substance doctrine) only if the taxpayer establishes that (1) the
transaction changes in a meaningful way (apart from Federal income tax consequences) the
taxpayer's economic position, and (2) the taxpayer has a substantial nontax purpose for entering
into such transaction. The proposal does not alter the court's ability to aggregate, disaggregate or
otherwise recharacterize a transaction when applying the economic substance doctrine. The
proposal provides a uniform definition of economic substance for applicable transactions, but
does not alter the flexibility of the courts in other respects.
Applicable transactions
The proposal applies the enhanced economic substance doctrine to the following six basic
categories of ''applicable transactions'':
(1) A transaction in which (a) the taxpayer holds offsetting positions which
substantially reduce the risk of loss, and (b) tax benefits would result from
differing tax treatment of the positions;
(2) A transaction which is structured to result in a disparity between basis and fair
market value which creates or increases a loss or reduces a gain;
(3) A transaction which is structured to create or increase a gain in an asset any
portion of which would not be recognized for Federal income tax purposes if the
asset were sold at fair market value by the taxpayer (or a related person);
(4) A transaction which is structured to result in income for Federal income tax
purposes to a tax-indifferent party for any period which is materially in excess of
any economic income to such party with respect to the transaction for such
period;
(5) A transaction in which the taxpayer disposes of property (other than inventory,
receivables, or stock or securities regularly traded on an established securities
market) which the taxpayer held for a period less than 45 days;
(6) A transaction which is structured to result in a deduction or loss which is
otherwise allowable under the Code and which is not allowed for financial
reporting purposes.
Under regulations, the Secretary would have the authority to add or exempt transactions
from the definition of an applicable transaction. A transaction would include a series of
transactions.
Other common law doctrines not affected
Except as specifically provided, the proposal is not to be construed as altering or
supplanting the economic substance doctrine or any other rule of law, and the requirements of
the provision shall be construed as being in addition to such doctrine or any other rule of law.
Effective Date
The proposal applies to transactions entered into on or after the date of enactment of the
proposal.
Discussion
In general
Recent tax avoidance transactions have relied on the interaction of highly technical tax
rules to produce results not intended by the Congress. For example, one such transaction,
described at a recent Senate hearing, involved an attempt to combine the S corporation rules and
those applicable to a special class of tax-exempt entities in order to shelter ordinary business
income from taxation. It is not possible to set forth in advance an appropriate outcome for
every conceivable transaction or uncommon combination of steps that might be devised, nor
would it be efficient for the government to try to do so. For this reason, most courts have long
recognized the need for anti-tax avoidance standards, such as the economic substance doctrine,
to ensure that Congressional objectives are appropriately achieved.
Under current law, the application of the economic substance doctrine among the courts
varies considerably, with one recent court even questioning the viability of the doctrine
altogether. The lack of clarity undermines the prophylactic effect of the doctrine and produces
unfairness. The potential unfairness is compounded by the recent increase in penalties in the
event the IRS finds and challenges a tax shelter transaction and the taxpayer loses in court.
Legislative intrusion into this domain largely dominated by the courts has at least two
potential disadvantages. First, the legislative rule might inadvertently restrict the flexibility of
the courts in resolving disputes on a case-by-case basis. Second, the rule might apply too
broadly, and cause a court (or the IRS) to raise an ''economic substance'' inquiry in common
situations not previously involving the issue.
The proposal attempts to respond to such concerns by limiting its application only to
certain types of transactions having the characteristics of tax shelters, and only if a court
determines the economic substance doctrine is relevant. For these transactions, the proposal
provides that the doctrine requires a conjunctive analysis inquiring into both the nontax
economic effects of the transaction and the taxpayer's purpose for undertaking it. The proposal
is not intended to modify the judicial determination of when to apply the doctrine, and does not
apply to cases in which the taxpayer establishes the outcome of a transaction is clearly consistent
with all applicable rules and Congressional purposes. The proposal does, however, constitute a
legislative determination that the economic substance doctrine has an appropriate role to play in
the tax system.
Proposed clarification of economic substance doctrine for applicable transactions
Conjunctive analysis
Under the proposal, an applicable transaction must satisfy both the objective and
subjective prongs of the economic substance doctrine -- i.e., it must change in a meaningful way
(apart from Federal income tax consequences) the taxpayer's economic position, and the
taxpayer must have a substantial non-tax purpose for entering into such transaction -- in order to
satisfy that doctrine. This clarification eliminates the disparity that exists among the circuits
regarding the application of the doctrine to applicable transactions.
Nontax business purpose
The proposal provides that a taxpayer's non-tax purpose for entering into an applicable
transaction must be ''substantial.'' It is intended that the nontax purpose for the transaction must
bear a reasonable relationship to the taxpayer's normal business operations or investment
activities.
In determining whether a taxpayer has a substantial nontax business purpose, a purpose
of achieving a financial accounting benefit shall not be taken into account if the origin of such
benefit is a reduction of income tax. Under this rule, a transaction that is expected to increase
financial accounting income as a result of generating tax deductions or losses without a
corresponding financial accounting charge (i.e., a permanent book-tax difference) would not be
considered to have a substantial non-tax purpose unless such a purpose exists apart from the
financial accounting benefits.
The proposal retains the present-law ability of the courts to bifurcate a transaction in
which independent activities with nontax objectives are combined with an unrelated item having
only tax-avoidance objectives in order to disallow the tax benefits of the overall transaction.
Meaningful change in the taxpayer's economic position
The proposal requires a meaningful change in the taxpayer's economic position in order
to satisfy a requirement of economic substance. As one example, a transaction is suspect under
this standard if money (or any other asset or liability) moves in a circular manner, such that the
taxpayer's or another party's apparent financial outlay is largely protected from risk and is
reasonably expected to be returned to that party or a related party when the transaction is
complete.
Definitions of applicable transactions
The following illustrates the categories of applicable transactions and is not intended to
be an exhaustive description.
Offsetting positions which substantially reduce the risk of loss
The first type of applicable transaction is one in which the taxpayer holds offsetting
positions which substantially reduce the risk of loss, and tax benefits would result from differing
tax treatment of the positions.
Many of the earlier economic substance decisions involved these types of transactions.
Examples include borrowing to purchase a deferred annuity, borrowing to purchase Treasury
obligations, and commodity straddles. This category generally includes transactions in
which a taxpayer enters into offsetting positions and recognizes a loss without recognizing the
offsetting gain in the same period.
Structured to result in a disparity between basis and fair market value which creates
or increases a loss or reduces a gain
The second type of applicable transaction is one that is structured to result in a disparity
between basis and fair market value which creates or increases a loss or reduces a gain.
One example of this type of transaction is one in which an income interest is separated
from property (''income stripping'') and the taxpayer's basis in the property is not reduced by the
resulting diminution in the property's fair market value. For example, suppose a taxpayer pays
$100 to acquire income-producing property. That price, which acts as the taxpayer's basis for
purposes of determining gain or loss on a subsequent disposition of the property, represents the
fair market value of the property including its expected income stream. The taxpayer then enters
a transaction or series of transactions in which it splits the right to receive all or part of the future
income stream from the basic property right. In one structure, a taxpayer might retain all or
much of the right to the future income (worth $95) and dispose of whatever remains of the initial
''property'' rights (worth only $5). If the taxpayer can allocate all of its $100 basis to the
disposed-of remainder rights, after largely stripping out the income rights, and if this basis
allocation is respected, then the taxpayer will recognize an immediate $95 ''loss'' on the
disposition even though its economic position is unchanged. Although the taxpayer may have
$95x of income in the future from the stream of future income, the time value of the immediate
loss that may be used to shelter other income in the year of sale exceeds the deferred future
income tax on the future income stream.
Some provisions of the Code specifically attempt to prevent this type of result.
However, other similar transactions purport to accomplish similar results in areas outside the
scope of these particular Code provisions. The proposal is intended to clarify that the taxpayer
should not obtain benefits of basis shifting in this type of situation if the enhanced economic
substance test is not satisfied. Such transactions are applicable transactions under the provision.
This category also includes transactions structured to duplicate a built-in loss,
transactions in which a distribution to a taxpayer in effect represents a return of the taxpayer's
investment, and transactions in which basis does not adequately account for the party expected
to pay a liability or obligation of any kind.
Structured to create or increase a gain in any asset any portion of which would not be
recognized if the asset were sold at fair market value by the taxpayer or a related
person
The third type of applicable transaction is one that is structured to create or increase a
gain in any asset any portion of which would not be recognized if the asset were sold at fair
market value by the taxpayer or a related person.
For example, this category includes transactions in which the taxpayer recognizes a loss
or deduction (or a reduced amount of income or gain) that was or is reasonably expected to be
offset by the taxpayer (or a related person) enjoying a corresponding amount of income or gain
that has not been or will not be recognized under section 1032 or that can be eliminated prior to
sale by a liquidation under section 332 that eliminates stock basis, or under any similar provision
that can eliminate gain potential.
Certain transactions described in the Enron Report, including the Tomas and Condor
transactions, would be included in this category. In the Tomas transaction, the taxpayer
contributed low basis but high value depreciable assets, as well as all the stock of another
corporation to a partnership. The other partners (affiliates of Banker's Trust) contributed cash.
The partnership assumed debt and the corporation that the taxpayers contributed received notes
receivable from a Banker's Trust affiliate. Upon the later distribution of the stock out of the
partnership in liquation of the taxpayer's partnership interest, the basis of the distributed stock
was reduced under the tax law to the low basis of the taxpayer's partnership interest. The
partnership made a section 754 election to increase the basis of the depreciable assets it retained.
Although the stock was thus stripped of its basis, the distributee could avoid recognition of any
built-in gain on that stock by liquidating the subsidiary in a tax-free transaction under section
332, with no step down in the basis of the subsidiary's assets under the law at the time of the
transaction. If this transaction were respected, then it would allow permanent avoidance of gain
on the low basis depreciable assets contributed to the partnership. In the Condor transaction,
Enron formed a partnership with the objective of shifting basis from certain Enron stock held by
the partnership to certain depreciable assets. One strategy devised by the taxpayers to avoid any
potential gain recognition in the Enron stock was to utilize section 1032.
Transactions with tax-indifferent parties
The fourth type of applicable transaction is a transaction structured to result in income to
a tax indifferent party for any period, which income is materially in excess of economic income
to such party for such period.
For this purpose, a tax-indifferent party means any person not subject to Federal income
tax, or any person to whom an item would have no substantial impact on its income tax liability.
Examples of persons not subject to Federal income tax include non-U.S. persons, tax-
exempt organizations, or governmental entities (unless they are in fact subject to tax with respect
to the income because, for example, the income is subject to withholding tax at the full statutory
rate, is effectively connected with a U.S. trade or business, or is unrelated business taxable
income). Under appropriate circumstances, a person to whom an item would have no substantial
impact on its income tax liability may also include a person who generally is subject to income
tax, but does not have a tax liability from a transaction because of deductions or credits unrelated
to the transaction (e.g., net operating losses from an unrelated activity). Another example of a
tax-indifferent party would be a person who is generally subject to tax but engages in a
transaction structured to result in that person's realizing taxable income and offsetting such
income with a loss resulting from an increase in basis above fair market value as a result of such
income realization.
One example of this type of applicable transaction would be a financing or other
transaction if the present value of the income inclusions of a tax-indifferent party is substantially
in excess of the anticipated economic returns to that party because the income inclusion is in
effect recovery of the tax-indifferent party's basis. This category also includes transactions that
result in a shifting of basis on account of overstating the income or gain of the tax-indifferent
party, whether because the transaction is in effect a recovery of basis or for other reasons.
Another example is a transaction structured through an entity (such as a pass-through
entity that is an S corporation or real estate investment trust), where income is allocated (but not
distributed) to a tax-indifferent party in excess of the economic gain ultimately provided to such
party. If successful, the remaining investors might obtain economic gain with little or no tax
liability.
This category also would include, for example, the series of transactions in ACM
Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998). In that case ACM Partnership
(''ACM'') purchased Citibank notes and, three weeks later, sold a portion of those notes for cash
and LIBOR notes. Using the ratable basis recovery rules under contingent payment sale
provisions of Temporary Treasury Regulation section 15a.453-1(c), ACM claimed only a portion
of its basis in the sale and allocated the resulting gain to a foreign partner who was not subject to
U.S. tax. Subsequently, ACM redeemed the foreign partner's interest and sold the LIBOR notes
at a loss. ACM allocated the loss to its remaining U.S. partners. Because this series of
transactions resulted in an allocation of gain to a tax-indifferent party (the foreign partner) in
excess of that party's economic gain, the series of transactions in ACM Partnership would be
treated as an applicable transaction under the provision.
Less than 45-day holding period
The fifth category of applicable transaction is one in which the taxpayer disposes of
property (other than inventory, receivables, or stock or securities that are regularly traded on an
established securities market) having held such property for less than 45 days. The holding
period is reduced for periods in which the taxpayer's risk of loss is diminished (e.g. by
purchasing a put option or entering into a short sale with respect to the property).
Present law contains certain specific restrictions relating to a 45-day holding period for
purposes of the dividends received deduction and for the foreign tax credit. The proposal
adopts a similar test to categorize transactions as applicable transactions even though tax benefits
may not otherwise be denied under the specific existing 45-day holding period rules.
Permanent book-tax difference
The sixth category of applicable transaction is one which is structured to result in a
deduction or loss which is otherwise allowable under the Code and which is not allowed for
financial reporting purposes.
Thus, a transaction in which certain amounts are deducted from taxable income for
Federal tax purposes but not for financial accounting purposes is covered by this category. One
example of such a transaction is one in which contingent liabilities are contributed to a
subsidiary corporation, a separate class of high basis stock is created reflecting all or most of the
loss associated with such liabilities, and such stock is sold at a loss while the contributed
liabilities also are expected to produce a second deduction to the taxpayer's consolidated group
when paid.
Other examples are the Steele, Condor, and Teresa transactions described in the Enron
Report, which Enron treated as giving rise to permanent book-tax differences. The Steele
transaction involved another party's transfer of assets (including REMIC residual interests) with
a basis in excess of value to an entity structured as a subsidiary in the Enron affiliated group, and
the creation of a special class of stock for the contributing party, whose basis reflected the loss
inherent in the assets. The transaction was intended to duplicate the loss of the transferor and
allow the duplicate loss also to be taken by the Enron group. The transaction was treated as
generating tax deductions and financial earnings.
In the Condor transaction previously described, Enron's accountants concluded that the
transaction would produce tax deductions without any corresponding financial expense, and that
the tax deductions would therefore generate after-tax financial statement income.
The Teresa transaction involved the creation of a partnership and the transfer of assets
with a low basis and high value. The transaction was structured with the purpose of creating
dividend income that would not be fully taxed, due to the dividends received deduction, but that
would increase partnership basis. The partnership basis ultimately was to be shifted to the
appreciated asset, producing greater depreciation deductions in the future. The transaction was
treated as generating financial statement income.
Treasury Regulations
The proposal provides the Treasury with authority to add or exempt transactions from the
definition of an applicable transaction.
No inference regarding present law
No inference is intended regarding the application of the economic substance doctrine
under present law.
Estimating assumptions
For revenue estimating purposes, the proposal assumes that reporting requirements will
apply to applicable transactions, as well as a strict liability penalty (i.e, reliance on an opinion of
counsel would not protect the taxpayer from penalties if the taxpayer loses in court with respect
to the economic substance doctrine as applied to an applicable transaction).
Statutory draft of proposed new code section
Clarification of Scrutiny for Certain Transactions
(a) IN GENERAL.--Section 7701 is amended by redesignating subsection (n) as
subsection (o) and by inserting after subsection (m) the following subsection:
''(n) CLARIFICATION OF SCRUTINY FOR CERTAIN TRANSACTIONS.--
''(1) IN GENERAL.--In any case in which a court determines that the economic
substance doctrine is relevant for purposes of applying this title to an applicable
transaction, such transaction shall have economic substance only if --
''(A) the transaction changes in a meaningful way (apart from Federal tax effects) the
taxpayer's economic position, and
''(B) the taxpayer has a substantial nontax purpose for entering into the transaction.
''(2) APPLICABLE TRANSACTION.--For purposes of paragraph (1), the term
''applicable transaction'' means a transaction--
''(A) in which--
''(i) the taxpayer holds offsetting positions which substantially reduce the risk of
loss, and
''(ii) tax benefits would result from differing tax treatment of the positions,
''(B) which is structured to result in a disparity between basis and fair market value
which creates or increases a loss or reduces a gain,
''(C) which is structured to create or increase a gain in an asset any portion of which
would not be recognized for Federal income tax purposes if the asset were sold at fair
market value by the taxpayer (or a related person),
''(D) which is structured to result in income for Federal income tax purposes to a tax-
indifferent party for any period which is materially in excess of any economic income
to such party with respect to the transaction for such period,
''(E) in which the taxpayer disposes of property (other than inventory, receivables, or
stock or securities regularly traded on an established securities market) which the
taxpayer held for a period less than 45 days. The rules of section 246(c)(3) and (4)
shall apply in determining holding period for this purpose.
''(F) which is structured to result in a deduction or loss which is otherwise allowable
under this title and which is not allowed for financial reporting purposes, or
''(G) which is specified in regulations prescribed by the Secretary.
The Secretary may by regulations exempt any transaction from the application of
subparagraphs (A) through (F).
'(3) DEFINITIONS AND SPECIAL RULES.--For purposes of this subsection--
''(A) TRANSACTION.--The term ''transaction'' includes a series of transactions.
''(B) EXCEPTION.--Paragraph (1) shall not apply to any transaction if the taxpayer
establishes that the transaction is clearly consistent with all applicable provisions of
this title and the purposes of such provisions.
''(C) NONTAX PURPOSE.-- If a transaction has a purpose of achieving a financial
accounting benefit, such purpose shall not be taken into account in determining
whether the transaction has substantial nontax purpose if the origin of such benefit is
a reduction of income tax.
''(D) COMMON LAW DOCTRINE NOT AFFECTED.--Except as specifically
provided in this subsection, the provisions of this subsection shall not be construed as
altering or supplanting any rule of law, and the requirements of this subsection shall
be construed as being in addition to such rule of the law.
''(E) TAX-INDIFFERENT PARTY.--The term ''tax-indifferent party'' means any
person or entity not subject to tax imposed by subtitle A. A person shall be treated as
a tax-indifferent party with respect to a transaction if the items taken into account
with respect to a transaction have no substantial impact on such person's liability
under subtitle A.''
(b) EFFECTIVE DATE.--The amendments made by this section shall apply to
transactions entered into on or after the date of the enactment of this Act.
II. INDIVIDUAL INCOME TAX
A. Provide Uniform Treatment for Dependent Care Benefits
(secs. 21 and 129)
Present Law
In general
Present law contains two tax benefits for dependent care expenses: the dependent care
credit and the exclusion for employer-provided dependent care expenses. While both provisions
provide tax benefits for similar expenses, the tax benefit available differs under the two
provisions.
Dependent care credit
A taxpayer who maintains a household that includes one or more qualifying individuals
may claim a nonrefundable credit against income tax liability for up to 35 percent of a limited
amount of employment-related dependent care expenses. Eligible employment-related expenses
are limited to $3,000 if there is one qualifying individual or $6,000 if there are two or more
qualifying individuals. Thus, the maximum credit is $1,050 if there is one qualifying individual
and $2,100 if there are two or more qualifying individuals. The applicable dollar limit is
reduced by any amount excluded from income under an employer-provided dependent care
assistance plan. The 35-percent credit rate is reduced, but not below 20 percent, by one
percentage point for each $2,000 (or fraction thereof) of adjusted gross income above $15,000.
Thus, for taxpayers with adjusted gross income of $45,000 or above, the credit rate is 20 percent.
Generally, a qualifying individual is (1) a qualifying child of the taxpayer under the age
of 13 for whom the taxpayer may claim a dependency exemption, or (2) a dependent or spouse
of the taxpayer if the dependent or spouse is physically or mentally incapacitated, and shares the
same principal place of abode with the taxpayer for over one half the year. Married taxpayers
must file a joint return in order to claim the credit. For purposes of the credit, taxpayers who are
legally separated are not considered married. In addition, a taxpayer is not considered married if
he or she files a separate return from his or her spouse, maintains a household which constitutes
the principal place of abode of a qualifying individual for at least half the year, and the
taxpayer's spouse is not a member of such household during the last six months of the year.
For taxable years beginning in 2004 and 2005, the dependent care credit offsets the
alternative minimum tax. For taxable years thereafter, the dependent care credit does not offset
the alternative minimum tax.
Exclusion for employer-provided dependent care
Amounts paid or incurred by an employer for dependent care assistance provided to an
employee generally are excluded from the employee's gross income and wages for employment
tax purposes if the assistance is furnished under a program meeting certain requirements. These
requirements include that the program be described in writing, satisfy certain nondiscrimination
rules, and provide for notification to all eligible employees. The definition of dependent care
expenses eligible for the exclusion is the same as the expenses eligible for the dependent care
credit.
The dependent care exclusion is limited to $5,000 per year (regardless of the number of
qualifying individuals) except that a married taxpayer filing a separate return may exclude only
$2,500. Dependent care expenses excluded from income are not eligible for the dependent care
tax credit.
Reasons for Change
The differing tax provisions for dependent care expenses create inequity in the operation
of the tax laws. While the exclusion generally provides more favorable tax benefits than does
the credit, it is not available to all taxpayers. Thus, individuals not covered by an employer's
dependent care assistance plan may receive a lower tax benefit for the same expenses than an
individual who is covered by such a plan. The differing benefits also add to complexity in the
tax laws for taxpayers who may be eligible for both provisions.
Description of Proposal
The proposal repeals the exclusion for employer-provided dependent care. Thus, under
the proposal, the dependent care credit is the exclusive means for receiving tax benefits for
dependent care expenses.
Effective Date
The proposal is effective with respect to taxable years beginning after date of enactment.
Discussion
The proposal has two primary policy objectives: equity and simplification.
The proposal provides greater equity among similarly situated taxpayers by providing the
same tax benefit for persons with dependent care expenses. Under present law, taxpayers who
are covered under an employer's dependent care plan generally receive greater tax benefits than
other individuals with dependent care expenses.
There are several significant differences between the dependent care credit and the
exclusion for employer-provided dependent care, including the following: (1) the amount of the
tax benefit provided by the exclusion, but not the credit, depends on the tax bracket (income plus
payroll tax rate) of the taxpayer; (2) the amount of benefit provided by the credit, but not the
exclusion, depends on whether the taxpayer has one or two qualifying individuals; (3) the credit
is reduced for persons with incomes above certain levels, whereas the exclusion is not limited
based on income; (4) the credit is not available to married taxpayers who file separate returns,
whereas one-half the maximum exclusion is available to such taxpayers ; (5) the availability of
the exclusion depends on the compensation arrangements of employers; and (6) for taxable years
beginning after 2005, the exclusion will continue to apply in determining alternative minimum
taxable income, but the credit will not offset alternative minimum tax liability of individuals.
The proposal retains the present-law nonrefundable credit approach as the means of
providing a tax benefit for dependent care expenses. A credit is broadly available, treats
similarly situated taxpayers equally, and the value of the benefit is independent of the taxpayer's
rate bracket. Other means of providing tax benefits for dependent care expenses are possible.
For example, an above-the-line deduction would provide similar tax benefits to the exclusion;
like the exclusion, an above-the-line deduction would provide a benefit that varies with the
individual's tax rate and would not affect the taxpayer's eligibility for other tax benefits that vary
based on adjusted gross income. From a theoretical perspective, a deduction may be more
appropriate if dependent care expenses are viewed as affecting taxpayers' overall ability to pay
taxes or as expenses for the production of income. A credit may be more appropriate if a goal of
the tax benefit is to make dependent care expenses more affordable, or to target the benefit more
toward certain taxpayers. If the primary objective of the credit is to lower the price of dependent
care regardless of whether the individual has tax liability, that may suggest that the credit should
be refundable. Refundable credits, however, are administratively complex and potentially more
subject to fraudulent claims that are difficult to recoup.
The proposal also reduces complexity by applying a single set of existing rules for
dependent care expenses.
Taxpayers who currently claim the exclusion for employer-provided dependent care
benefits may face increased tax liability as a result of the proposal. Overall, the greatest tax
impact of the proposal would be on taxpayers who are subject to the alternative minimum tax;
most of the revenue increase from the proposal is attributable to the impact of the alternative
minimum tax beginning in 2006, when the credit will no longer offset minimum tax liability.
B. Combine Hope and Lifetime Learning Credits and the Above-the-Line
Deduction for Higher Education Expenses
(secs. 25A and 222)
Present Law
Hope credit
The Hope credit is a nonrefundable credit of up to $1,500 per student per year for
qualified tuition and related expenses paid for the first two years of the student's post-secondary
education in a degree or certificate program. The Hope credit rate is 100 percent on the first
$1,000 of qualified tuition and related expenses, and 50 percent on the next $1,000 of qualified
tuition and related expenses. The Hope credit that a taxpayer may otherwise claim is phased out
ratably for taxpayers with modified adjusted gross income between $43,000 and $53,000
($87,000 and $107,000 for married taxpayers filing a joint return) for 2005. The first
adjustment to these amounts as a result of inflation is expected in 2006. Thus, for example, an
eligible student who incurs $1,000 of qualified tuition and related expenses is eligible (subject to
the adjusted gross income phaseout) for a $1,000 Hope credit. If an eligible student incurs
$2,000 or more of qualified tuition and related expenses, then he or she is eligible for a $1,500
Hope credit.
The qualified tuition and related expenses must be incurred on behalf of the taxpayer, the
taxpayer's spouse, or a dependent of the taxpayer. The Hope credit is available with respect to
an individual student for two taxable years, provided that the student has not completed the first
two years of post-secondary education before the beginning of the second taxable year.
The Hope credit is available in the taxable year the expenses are paid, subject to the
requirement that the education is furnished to the student during that year or during the first three
months of the next year. Qualified tuition and related expenses paid with the proceeds of a loan
generally are eligible for the Hope credit. The repayment of a loan itself is not a qualified tuition
or related expense.
A taxpayer may claim the Hope credit with respect to an eligible student who is not the
taxpayer or the taxpayer's spouse (e.g., in cases in which the student is the taxpayer's child) only
if the taxpayer claims the student as a dependent for the taxable year for which the credit is
claimed. If a student is claimed as a dependent, the student is not entitled to claim a Hope credit
for that taxable year on the student's own tax return. If a parent (or other taxpayer) claims a
student as a dependent, any qualified tuition and related expenses paid by the student are treated
as paid by the parent (or other taxpayer) for purposes of determining the amount of qualified
tuition and related expenses paid by such parent (or other taxpayer) under the provision. In
addition, for each taxable year, a taxpayer may elect either the Hope credit, the Lifetime
Learning credit (described below), or the section 222 deduction for qualified tuition and related
expenses (described below) with respect to an eligible student.
The Hope credit is available for ''qualified tuition and related expenses,'' which include
tuition and fees (excluding nonacademic fees) required to be paid to an eligible educational
institution as a condition of enrollment or attendance of an eligible student at the institution.
Charges and fees associated with meals, lodging, insurance, transportation, and similar personal,
living, or family expenses are not eligible for the credit. The expenses of education involving
sports, games, or hobbies are not qualified tuition and related expenses unless this education is
part of the student's degree program.
Qualified tuition and related expenses generally include only out-of-pocket expenses.
Qualified tuition and related expenses do not include expenses covered by employer-provided
educational assistance and scholarships that are not required to be included in the gross income
of either the student or the taxpayer claiming the credit. Thus, total qualified tuition and related
expenses are reduced by any scholarship or fellowship grants excludable from gross income
under section 117 and any other tax-free educational benefits received by the student (or the
taxpayer claiming the credit) during the taxable year. The Hope credit is not allowed with
respect to any education expense for which a deduction is claimed under section 162 or any other
section of the Code.
An eligible student for purposes of the Hope credit is an individual who is enrolled in a
degree, certificate, or other program (including a program of study abroad approved for credit by
the institution at which such student is enrolled) leading to a recognized educational credential at
an eligible educational institution. The student must pursue a course of study on at least a half-
time basis. A student is considered to pursue a course of study on at least a half-time basis if the
student carries at least one half the normal full-time work load for the course of study the student
is pursuing for at least one academic period that begins during the taxable year. To be eligible
for the Hope credit, a student must not have been convicted of a Federal or State felony
consisting of the possession or distribution of a controlled substance.
Eligible educational institutions generally are accredited post-secondary educational
institutions offering credit toward a bachelor's degree, an associate's degree, or another
recognized post-secondary credential. Certain proprietary institutions and post-secondary
vocational institutions also are eligible educational institutions. In order to qualify as an eligible
educational institution, an institution must be eligible to participate in Department of Education
student aid programs.
Effective for taxable years beginning after December 31, 2010, the changes to the Hope
credit made by EGTRRA no longer apply. The EGTRRA change scheduled to expire is the
change that permitted a taxpayer to claim a Hope credit in the same year that he or she claimed
an exclusion from an education savings account. Thus, after 2010, a taxpayer cannot claim a
Hope credit in the same year he or she claims an exclusion from an education savings account.
Lifetime Learning credit
Individual taxpayers are allowed to claim a nonrefundable credit, the Lifetime Learning
credit, equal to 20 percent of qualified tuition and related expenses incurred during the taxable
year on behalf of the taxpayer, the taxpayer's spouse, or any dependents. Up to $10,000 of
qualified tuition and related expenses per taxpayer return are eligible for the Lifetime Learning
credit (i.e., the maximum credit per taxpayer return is $2,000). In contrast with the Hope credit,
the maximum credit amount is not indexed for inflation.
In contrast to the Hope credit, a taxpayer may claim the Lifetime Learning credit for an
unlimited number of taxable years. Also in contrast to the Hope credit, the maximum amount of
the Lifetime Learning credit that may be claimed on a taxpayer's return will not vary based on
the number of students in the taxpayer's family ' that is, the Hope credit is computed on a per
student basis, while the Lifetime Learning credit is computed on a family-wide basis. The
Lifetime Learning credit amount that a taxpayer may otherwise claim is phased out ratably for
taxpayers with modified adjusted gross income between $43,000 and $53,000 ($87,000 and
$107,000 for married taxpayers filing a joint return) for 2005. These phaseout ranges are the
same as those for the Hope credit, and are similarly indexed for inflation.
The Lifetime Learning credit is available in the taxable year the expenses are paid,
subject to the requirement that the education is furnished to the student during that year or during
the first three months of the next year. Qualified tuition and related expenses paid with the
proceeds of a loan generally are eligible for the Lifetime Learning credit. As with the Hope
credit, repayment of a loan is not a qualified tuition expense.
As with the Hope credit, a taxpayer may claim the Lifetime Learning credit with respect
to a student who is not the taxpayer or the taxpayer's spouse (e.g., in cases in which the student
is the taxpayer's child) only if the taxpayer claims the student as a dependent for the taxable year
for which the credit is claimed. If a student is claimed as a dependent by the parent or other
taxpayer, the student may not claim the Lifetime Learning credit for that taxable year on the
student's own tax return. If a parent (or other taxpayer) claims a student as a dependent, any
qualified tuition and related expenses paid by the student are treated as paid by the parent (or
other taxpayer) for purposes of the provision.
A taxpayer may claim the Lifetime Learning credit for a taxable year with respect to one
or more students, even though the taxpayer also claims a Hope credit for that same taxable year
with respect to other students. If, for a taxable year, a taxpayer claims a Hope credit with respect
to a student, then the Lifetime Learning credit is not available with respect to that same student
for that year (although the Lifetime Learning credit may be available with respect to that same
student for other taxable years). As with the Hope credit, a taxpayer may not claim the Lifetime
Learning credit and also claim the section 222 deduction for qualified tuition and related
expenses (described below).
As with the Hope credit, the Lifetime Learning credit is available for ''qualified tuition
and related expenses,'' which include tuition and fees (excluding nonacademic fees) required to
be paid to an eligible educational institution as a condition of enrollment or attendance of a
student at the institution. Eligible higher education institutions are defined in the same manner
for purposes of both the Hope and Lifetime Learning credits. Charges and fees associated with
meals, lodging, insurance, transportation, and similar personal, living or family expenses are not
eligible for the credit. The expenses of education involving sports, games, or hobbies are not
qualified tuition expenses unless this education is part of the student's degree program, or the
education is undertaken to acquire or improve the job skills of the student.
In contrast to the Hope credit, qualified tuition and related expenses for purposes of the
Lifetime Learning credit include tuition and fees incurred with respect to undergraduate or
graduate-level courses. Additionally, in contrast to the Hope credit, the eligibility of a student
for the Lifetime Learning credit does not depend on whether the student has been convicted of a
Federal or State felony consisting of the possession or distribution of a controlled substance.
As with the Hope credit, qualified tuition and fees generally include only out-of-pocket
expenses. Qualified tuition and fees do not include expenses covered by employer-provided
educational assistance and scholarships that are not required to be included in the gross income
of either the student or the taxpayer claiming the credit. Thus, total qualified tuition and fees are
reduced by any scholarship or fellowship grants excludable from gross income under section 117
and any other tax-free educational benefits received by the student during the taxable year (such
as employer-provided educational assistance excludable under section 127). The Lifetime
Learning credit is not allowed with respect to any education expense for which a deduction is
claimed under section 162 or any other section of the Code.
Effective for taxable years beginning after December 31, 2010, the changes to the
Lifetime Learning credit made by EGTRRA no longer apply. The EGTRRA change scheduled
to expire is the change that permitted a taxpayer to claim a Lifetime Learning credit in the same
year that he or she claimed an exclusion from an education savings account. Thus, after 2010,
taxpayers cannot claim a Lifetime Learning credit in the same year he or she claims an exclusion
from an education savings account.
Above-the-line deduction for certain higher education expenses
An individual is allowed an above-the-line deduction for qualified tuition and related
expenses for higher education paid by the individual during the taxable year. Qualified tuition
and related expenses are defined in the same manner as for the Hope and Lifetime Learning
credits, and includes tuition and fees 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 institution of higher education for courses of
instruction of such individual at such institution. The expenses must be in connection with
enrollment at an institution of higher education during the taxable year, or with an academic term
beginning during the taxable year or during the first three months of the next taxable year. The
deduction is not available for tuition and related expenses paid for elementary or secondary
education.
For taxable years beginning in 2004 or 2005, the maximum deduction is $4,000 for an
individual whose adjusted gross income for the taxable year does not exceed $65,000 ($130,000
in the case of a joint return), or $2,000 for other individuals whose adjusted gross income does
not exceed $80,000 ($160,000 in the case of a joint return). No deduction is allowed for an
individual whose adjusted gross income exceeds the relevant adjusted gross income limitations,
for a married individual who does not file a joint return, or for an individual with respect to
whom a personal exemption deduction may be claimed by another taxpayer for the taxable year.
The deduction is not available for taxable years beginning after December 31, 2005.
The amount of qualified tuition and related expenses must be reduced by certain
scholarships, educational assistance allowances, and other amounts paid for the benefit of such
individual, and by the amount of such expenses taken into account for purposes of determining
any exclusion from gross income of: (1) income from certain United States Savings Bonds used
to pay higher education tuition and fees; and (2) income from a Coverdell education savings
account. Additionally, such expenses must be reduced by the earnings portion (but not the
return of principal) of distributions from a qualified tuition program if an exclusion under section
529 is claimed with respect to expenses eligible for exclusion under section 222. No deduction
is allowed for any expense for which a deduction is otherwise allowed or with respect to an
individual for whom a Hope credit or Lifetime Learning credit is elected for such taxable year.
Table 1.''Comparison of Certain Education Tax Incentives Available to Individuals Under Present Law
Provision
Tax
Benefit
Dollar Limits on
Amount Eligible for
Tax Benefit
Eligible
Claimants
Eligible
Beneficiaries
Qualified
Education
Expenses
Coordination with
Other Education
Provisions
1. Hope credit
(sec. 25A)
Nonrefundable credit
for qualified tuition
and related expenses
for first two years of
post-secondary
education.
Maximum credit is
$1,500, computed on
a per-student basis.
Credit rate is 100% on
first $1,000 of
qualified expenses
and 50% on next
$1,000 of expenses.
The credit is phased
out ratably for
taxpayers with
modified adjusted
gross income between
$43,000 and $53,000
($87,000 and
$107,000 for married
taxpayers filing a joint
return) for 2005.
Credit may be claimed
by student or by
another taxpayer if the
taxpayer claims the
student as a
dependent.
Eligible student must
be enrolled on at least
a half-time basis and
must not have been
convicted of a Federal
or State felony
involving possession
or distribution of a
controlled substance.
(1) Tuition, except
that tuition is a
qualified
expense with respect
to any course or other
education involving
sports, games, or
hobbies, only if such
course or other
education is part of
the individual's
degree program.
(2) Required fees,
except that required
fees with respect
to any course or other
education involving
sports, games, or
hobbies is included
only if such course or
other education is part
of the individual's
degree program.
Nonacademic fees are
not included.
Hope credit cannot
be claimed with
respect to a student
if either the
Lifetime Learning
credit or the above-
the-line deduction
for higher
education expenses
is claimed for such
student in the same
year.
No credit is allowed
for any expense for
which a deduction
is allowed under
any other provision
of the Code.
2. Lifetime Learning
Credit (''LLC'')
(sec. 25A)
Nonrefundable credit
for qualified tuition
and related expenses
for undergraduate or
graduate courses.
Unlike Hope credit,
LLC is available for
an unlimited number
of years.
Credit rate is 20% of
up to $10,000 of
qualified expenses.
Unlike Hope credit,
LLC is computed on
family-wide basis,
rather than per-student
basis.
The credit is phased
out ratably for
taxpayers with
modified adjusted
gross income between
$43,000 and $53,000
($87,000 and
$107,000 for married
taxpayers filing a joint
return) for 2005.
Same as Hope credit.
No restrictions.
Same as Hope credit,
except that Lifetime
Learning credit also
applies to expenses
for courses related to
sports, games and
hobbies if the course
is taken to acquire or
improve the job skills
of the student.
Lifetime Learning
credit cannot be
claimed with
respect to a student
if either the Hope
credit or the above
the line deduction
for higher
education expenses
is claimed for such
student in the same
year.
No credit is allowed
for any expense for
which a deduction
is allowed under
any other provision
of the Code.
3. Above-the-line
deduction for certain
higher education
expenses (sec. 222)
Above-the-line
deduction for
qualified tuition and
related expenses for
undergraduate or
graduate courses.
For 2004 or 2005, the
maximum deduction
is: (1) $4,000 for an
individual whose
adjusted gross income
for the taxable year
does not exceed
$65,000 ($130,000 in
the case of a joint
return); (2) $2,000 for
other individuals
whose adjusted gross
income does not
exceed $80,000
($160,000 in the case
of a joint return); and
(3) zero for all other
individuals. The
deduction is not
available in 2006 and
thereafter.
Same as Hope credit.
No restrictions.
Same as Hope credit.
Above-the-line
deduction cannot be
claimed with
respect to a student
if either the Hope
credit or the
Lifetime Learning
credit is claimed for
such student in the
same year.
No deduction is
allowed for any
expense for which a
deduction is
allowed under any
other provision of
the Code.
Reasons for Change
Combining the Hope and Lifetime Learning credits and the deduction for higher
education expenses into a single credit for higher education expenses would promote simplicity
in delivering education tax benefits. Additionally, providing such benefits on a per-student
basis, rather than a per tax return basis, would promote greater fairness by allowing the credit to
vary more directly with the number of students in a family.
Description of Proposal
The proposal combines the Hope and Lifetime Learning credits and the above-the-line
deduction for qualified higher education expenses into a single credit. The credit applies on a
per-student basis, as under the Hope credit, and, as under the Lifetime Learning credit, applies to
qualified education expenses for both graduate and undergraduate education without regard to
enrollment status (i.e., halftime or otherwise). The credit equals 25 percent of the first $10,000
dollars of qualified expenses per student. The otherwise allowable aggregate credit per tax
return is phased out by $50 for each $1,000 that adjusted gross income exceeds $70,000
($140,000 if married filing a joint return). The credit is allowed against the alternative minimum
tax.
The credit rate, expense limitation, and phaseout ranges were chosen to create an
approximately revenue neutral proposal over the period 2006-2014 under the assumption that
the baseline includes permanent extension of the above-the-line deduction and extension of
provisions allowing nonrefundable personal credits against the alternative minimum tax. These
assumptions were made for purposes of illustrating a possible credit that provides benefits
comparable to those based on the law in effect for 2005. A revenue estimate of this proposal,
which would be determined relative to present law (and therefore would incorporate the
expiration of all expiring provisions), would not be revenue neutral. In particular, the proposal
does not completely reflect the revenue loss attributable to allowing the credit against the
alternative minimum tax or allowing the credit for those taxpayers phased out of the present-law
Hope and Lifetime Learning Credits, but otherwise eligible for the above-the-line deduction for
higher education expense if the deduction were extended.
The $10,000 expense limit and the phaseout thresholds are the 2006 levels. The expense
limit and the phaseout thresholds are indexed for inflation.
Effective Date
The proposal is effective with respect to taxable years beginning after the date of
enactment.
Discussion
The proposal embodies two principal policy objectives. The first is simplification. The
three present-law benefits are substantially similar in their objectives; combining them into a
single benefit can achieve the same general policy in a less complicated manner. The second
policy objective is to achieve a more equitable benefit by making the benefit apply on a per
student basis rather than a per tax-return basis.
The credit structure (as opposed to a deduction) is adopted, and an income-based
phaseout of the benefit is retained, on the grounds that educational expenses do not warrant a
reduced tax liability as a result of ability-to-pay principles. Rather, the primary function of the
educational benefit is to lower the price of education (accomplished via the credit) to a particular
group in order to encourage pursuit of higher education. The rationale for the credit approach
rather than the deduction suggests that the credit should be refundable, because the rationale for
subsidizing the price of education does not depend on having a tax liability. Nevertheless,
refundable credits are administratively complex and potentially more subject to fraudulent claims
that are difficult to recoup. Additionally, there are Federal programs, such as the Pell Grant
program, that provide direct grants for education to a population that is generally similar to the
population that would be eligible for a refundable credit. Thus, a mechanism already exists to
assist this demographic group, which could be expanded by Congress as necessary.
The proposal does not provide for refundability because Congress has not in the past
permitted refundability with respect to education benefits. The credit structure would readily
permit refundability should Congress desire to provide for it.
The proposal does not include a half-time or greater enrollment requirement on the
grounds that many students from lower-income families cannot afford to attend school on a half-
time or greater basis, either as a result of the expenses of half-time or greater enrollment or as a
result of the greater foregone earnings from reduced employment of the student that a half-time
or greater enrollment requirement would likely entail.
C. Repeal Exclusion for Qualified Tuition Reductions
(sec. 117(d))
Present Law
Qualified tuition reductions
Present law provides an exclusion from gross income and wages for amounts received as
a qualified tuition reduction. In general, a qualified tuition reduction is the amount of any
reduction in tuition provided to employees of qualifying educational organizations for the
education below the graduate level (including primary and secondary school) of the employee
(and the employee's spouse and dependents) at such organizations or other qualifying
educational organizations. A graduate student at a qualifying educational organization who is
engaged in teaching or research activities at the organization may exclude from gross income and
wages any amount received as a qualified tuition reduction even if the education provided is not
below the graduate level.
For a tuition reduction to qualify for the exclusion, the organization must be an
educational organization which normally maintains a regular faculty and curriculum and
normally has a regularly-enrolled body of pupils or students in attendance at the place where its
educational activities are regularly carried on.
A qualified tuition reduction which is provided with respect to a highly compensated
employee qualifies for the exclusion only if it meets certain nondiscrimination rules.
Specifically, the exclusion must be offered on substantially the same terms to each member of a
group of employees which is defined under a reasonable classification established by the
employer which does not discriminate in favor of highly compensated employees. For this
purpose, the term ''highly compensated employee'' means any employee who (1) was a five-
percent owner of the employer at any time during the year or (2) for the preceding year, had
compensation from the employer in excess of $95,000 (for 2005) and if the employer elects, was
in the top-paid group of employees for such year.
The exclusion for qualified tuition reductions generally does not apply to any amount
received by a student that represents payment for teaching, research, or other services by the
student required as a condition for receiving the tuition reduction. Payments for such services
are includible in gross income and wages.
Other tax benefits for education expenses
Present law provides a variety of other tax benefits relating to education. These include:
the Hope tax credit; the Lifetime Learning credit; an above-the-line deduction of up to $4,000 of
higher education expenses; an exclusion of up to $5,250 annually for employer-provided
education assistance; qualified scholarships; section 529 qualified tuition programs; Coverdell
education savings accounts; an exclusion of earnings on education savings bonds; a deduction
for student loan interest; and an exclusion of income for student loan forgiveness.
Reasons for Change
The exclusion for qualified tuition reductions raises fairness concerns because it is
available only to a limited group of taxpayers, as compared to other present-law provisions
which provide tax benefits relating to education much more broadly. Repeal of the provision
would simplify the law and remove a potential source of noncompliance.
Description of Proposal
The proposal repeals the exclusion for qualified tuition reductions. Under the proposal,
such benefits are included in gross income and are treated as wages for employment tax
purposes. Tuition reductions that are includible in income under the proposal would be
eligible for the present-law tax benefits for education expenses, provided the requirements for
such benefits are otherwise satisfied.
Effective Date
The proposal is effective with respect to taxable years beginning after date of enactment.
Discussion
The exclusion for qualified tuition reductions is available only to a limited group of
taxpayers. It is not available to individuals working in fields other than education and, within the
education field, may be available primarily to those working for educational institutions which
have the greatest resources and by employees of the most resource-rich schools within such
institutions because such institutions and schools may be in the best financial position to provide
such benefits.
Although the nondiscrimination rules for qualified tuition reductions require that the
benefits not discriminate in favor of highly compensated employees, these rules may not
adequately prevent the award of these benefits in favor of the more highly compensated,
depending upon how a ''reasonable classification'' of employees is defined. Moreover, the
nondiscrimination rules do not address the limited scope of the provision to benefit only
employees of certain educational organizations.
By comparison to qualified tuition reductions, other provisions under present law provide
tax benefits for education to a much broader segment of taxpayers. If the proposal were adopted,
current beneficiaries of qualified tuition reductions would be entitled to claim benefits under any
of these provisions if they are otherwise eligible.
Qualified tuition reductions are sometimes viewed as a means to promote loyalty on the
part of employees of educational organizations. For example, under present law, such
organizations may subsidize in a tax-free manner the education of an employee's dependents at
the same institution where the employee works. But this rationale may not fully justify the
present-law rules for qualified tuition reductions because these rules also permit a tax-free
subsidy even if the employee's dependent is educated at any other qualifying institution.
The proposal simplifies the law and removes a potential source of noncompliance. For
example, repeal of the provision eliminates the need to determine the appropriate classification
of employees for purposes of applying the nondiscrimination requirement. Repeal also
eliminates the potential confusion of distinguishing between a tax-free tuition reduction received
by a student and taxable compensation received by such student for teaching, research, or other
services.
D. Deny Refundable Child Credit When Section 911 Exclusion is Elected
(sec. 24)
Present Law
Child credit
In general
An individual may claim a $1,000 tax credit for each qualifying child under the age of
17.
The child tax credit is phased-out for individuals with income over certain thresholds.
Specifically, the otherwise allowable child tax credit is reduced by $50 for each $1,000 (or
fraction thereof) of modified 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 length of the phase-out range depends on the number
of qualifying children. For example, the phase-out range for a single individual with one
qualifying child is between $75,000 and $95,000 of modified adjusted gross income. The phase-
out range for a single individual with two qualifying children is between $75,000 and $115,000.
The amount of the tax credit and the phase-out ranges are not adjusted annually for
inflation.
Refundability
For 2005, the child credit is refundable to the extent of 15 percent of the taxpayer's
earned income in excess of $10,900. Families with three or more children are allowed a
refundable credit for the amount by which the taxpayer's social security taxes exceed the
taxpayer's earned income credit, if that amount is greater than the refundable credit based on the
taxpayer's earned income in excess of $10,900 (for 2005). The refundable portion of the child
credit does not constitute income and is not treated as resources for purposes of determining
eligibility or the amount or nature of benefits or assistance under any Federal program or any
State or local program financed with Federal funds. For taxable years beginning after December
31, 2010, the sunset provision of EGTRRA applies to the rule allowing refundable child credits
based on earned income in excess of the threshold.
The definition of ''earned income'' for purposes of the refundable child credit generally
follows that for the earned income credit, which includes (1) wages, salaries, tips and other
employee compensation to the extent includible in gross income, plus (2) net earnings from self-
employment. For purposes of the refundable child credit, earned income also must be taken into
account in computing taxable income in order to be considered earned income for calculating the
refundable child credit.
Earned income credit
In general
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 $2,700 (for 2005). 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.
Section 911
An individual electing to exclude foreign earned income under the provisions of section
911 is not eligible for the EIC.
Foreign earned income exclusion (section 911)
In general
U.S. citizens generally are subject to U.S. income tax on all their income, whether
derived in the United States or elsewhere. U.S. citizens living abroad may be eligible to elect to
exclude from their income for U.S. tax purposes certain foreign earned income and foreign
housing costs, in which case no residual U.S. tax is imposed to the extent of such exclusion.
In order to qualify for these exclusions, an individual must be either: (1) a U.S. citizen who is a
bona fide resident of a foreign country for an uninterrupted period that includes an entire taxable
year; or (2) a U.S. citizen or resident present overseas for 330 days out of any 12-consecutive-
month period. In addition, the taxpayer must have his or her tax home in a foreign country.
Exclusion for compensation
The foreign earned income exclusion generally applies to income earned from sources
outside the United States as compensation for personal services rendered by the taxpayer. The
maximum exclusion amount for foreign earned income is $80,000 per taxable year for 2005 and
thereafter. For taxable years beginning after 2007, the maximum exclusion amount is indexed
for inflation.
Reasons for Change
Present law permits certain high-income taxpayers to receive the refundable child credit,
which is intended for low-income taxpayers.
Description of Proposal
The proposal denies a refundable child credit to anyone claiming the section 911
exclusion.
Effective Date
The proposal is effective with respect to taxable years beginning after the date of
enactment.
Discussion
The refundable child credit is generally intended to apply to working families of
sufficiently low economic income. Under present law, however, because earned income must be
included in gross income in order to be considered earned income for purposes of the EIC and
the refundable child credit, taxpayers working abroad and claiming an exclusion under section
911 are potentially eligible for a refundable child credit if their income is sufficiently high.
Specifically, the refundable credit becomes payable for taxpayers working abroad, and electing
the section 911 exclusion, once the taxpayer's earned income exceeds $90,900 (section 911
exclusion of $80,000 plus the refundable child credit earned income threshold of $10,900 for
2005).
Example 1.''A married U.S. taxpayer with two children who lives and works in a foreign
country with $100,000 of foreign earned income has gross income of only $20,000 as a result of
the $80,000 foreign earned income (section 911) exclusion. The taxpayer is potentially eligible
for up to $2,000 of child credits as a result of having two eligible children. Because the phaseout
of the child credit starts at $110,000 of modified AGI for a married taxpayer filing jointly, the
child credit is not reduced by the phaseout. As a result of other provisions of U.S. tax law
such as the personal exemptions and the standard deduction which collectively exceed
$20,000, taxpayer has no taxable income and thus no U.S. income tax liability to apply the
$2,000 credit towards. However, because the refundable child credit is based on only the portion
of earned income that is included in taxable income, the taxpayer is eligible for a refundable
credit of up to 15 percent of the amount by which such income (in this case $20,000) exceeds
$10,900, or $9,100, for a refundable credit of $1,365 (15 percent of $9,100). Since the taxpayer
was eligible for up to $2,000 in child credits, the taxpayer is able to claim the full refundable
amount of $1,365.
Example 2.''The facts are the same as example 1 except that the taxpayer has $60,000 of
foreign earned income, or $40,000 less income than the taxpayer of example 1. The taxpayer
thus has no gross income for U.S. tax purposes as a result of the $80,000 foreign earned income
(section 911) exclusion. The taxpayer is potentially eligible for up to $2,000 of child credits as a
result of having two eligible children. Because the phaseout of the child credit starts at $110,000
of modified AGI for a married taxpayer filing jointly, the child credit is not reduced by the
phaseout. As a result of having no gross income, the taxpayer has no taxable income and thus no
U.S. income tax liability to apply the $2,000 credit towards. Because the refundable child credit
is based on only the portion of earned income that is included in taxable income for a taxpayer
with fewer than three children, the taxpayer is not eligible for a refundable credit because none
of the earned income is included in taxable income.
Thus, the taxpayer with the lower income is denied the refundable credit, while the
taxpayer with higher income receives a refundable credit. Most observers would agree that
present law, in providing a refundable credit to certain high-income taxpayers, while denying it
to certain lower-income taxpayers, violates generally held principles of equitable tax policy.
Hence, the proposal adopts the EIC rule and prohibits claiming a refundable credit when the
section 911 exclusion is taken.
E. Repeal the Deduction for Interest on Home Equity Indebtedness
(sec. 163)
Present Law
In general
In general, an individual may not deduct personal interest. Personal interest is any
interest other than interest incurred or continued in connection with the conduct of a trade or
business (other than the trade or business of performing services as an employee) or investment
interest. Qualified residence interest, however, is not treated as personal interest and is
deductible subject to limitations. Qualified residence interest means interest on either
acquisition indebtedness or home equity indebtedness.
Acquisition indebtedness
Acquisition indebtedness is indebtedness incurred in acquiring, constructing or
substantially improving any qualified residence of the taxpayer. Acquisition indebtedness is
reduced as payments of principal are made and cannot be increased by refinancing. Thus, for
example, if the taxpayer incurs $200,000 of acquisition indebtedness to acquire his principal
residence and pays down the debt to $150,000, his acquisition indebtedness with respect to the
residence cannot thereafter be increased above $150,000 (except by indebtedness incurred to
substantially improve the residence). Refinanced acquisition debt continues to be treated as
acquisition debt to the extent that the principal amount of the refinancing does not exceed the
principal amount of the acquisition debt immediately before the financing. The indebtedness
must be secured by the qualified residence and is limited to $1 million. Qualified residence
means the taxpayer's principal residence and one other residence of the taxpayer selected to be a
qualified residence.
Home equity indebtedness
Certain home equity indebtedness may give rise to deductible qualified residence interest.
Home equity indebtedness, for this purpose, means debt secured by the taxpayer's principal or
second residence to the extent the aggregate amount of such debt does not exceed the difference
between the total acquisition indebtedness with respect to the residence, and the fair market
value of the residence. The amount of home equity indebtedness on which interest is treated as
deductible qualified residence interest may not exceed $100,000 ($50,000 for married persons
filing a separate return).
Interest on qualifying home equity indebtedness is deductible, regardless of how the
proceeds of the indebtedness are used. A taxpayer and a mortgage company can contract for
the home equity indebtedness loan proceeds to be transferred to the taxpayer either in a lump
sum payment or a series of payments (e.g., a reverse mortgage).
Thus, under present law, the total amount of a taxpayer's home equity indebtedness with
respect to his principal residence and a second residence, when combined with the amount of his
acquisition indebtedness with respect to such residences, may not exceed a $1,100,000 overall
limitation ($550,000, for married persons filing a separate return).
Reasons for Change
The present-law deduction for interest on home equity indebtedness is inconsistent with
the goal of encouraging home ownership while limiting significant disincentives to saving. A
taxpayer may deduct interest on a loan of up to $100,000 secured by his residence that has no
relation to the acquisition or substantial improvement of the residence. This acts as a
disincentive to savings and is unrelated to the purpose of encouraging home ownership. Further,
the present-law home equity indebtedness rules provide inconsistent treatment by allowing
deductible interest for homeowners' consumption spending that is not allowed to similarly
situated non-homeowners.
Description of Proposal
The proposal repeals the deduction for interest on home equity indebtedness.
Effective Date
The proposal is effective for interest paid on debt incurred after the date of enactment.
Interest on home equity indebtedness originally incurred before the date of enactment and
refinanced on or after the date of enactment remains deductible only to the extent of the
outstanding principal of the indebtedness at the time of refinancing.
The following examples illustrate the application of the effective date:
Example 1.''A taxpayer has a home with a fair market value of $500,000 in a taxable year
beginning after the date of enactment. The taxpayer has a first mortgage of $250,000 (at 6.5
percent) which qualifies as an acquisition loan. The taxpayer has a home equity loan of $75,000
(at seven percent) but pays no interest during the year. Both the $250,000 first mortgage and the
$75,000 home equity loan were originally incurred before the effective date. After the date of
enactment, the taxpayer incurs a new home equity loan of $225,000 (at six percent) and pays off
the $75,000 home equity loan. The taxpayer may continue to deduct the interest on the first
mortgage of $250,000 as an acquisition loan and may also deduct one-third of the interest of the
new home equity loan ($75,000/$225,000).
Example 2.''Same facts as above except that the taxpayer did not have an outstanding
home equity loan on the date of enactment. The taxpayer may continue to deduct the interest on
the first mortgage of $250,000 as an acquisition loan, but none of the interest on the new home
equity loan.
Discussion
In general
Encouraging savings is a policy goal reflected throughout the Code. In part for this
reason, personal interest generally is not deductible. Another policy reflected in the Code is the
promotion of home ownership. To promote home ownership, the Code allows a deduction for
qualified residence interest (including interest on home equity indebtedness). Interest on home
equity debt, however, more closely resembles non-deductible personal interest than interest
incurred to purchase a taxpayer's principal or second residence, and therefore the general tax
policy against subsidizing personal debt (other than for homeownership) should apply to home
equity indebtedness. There are three major arguments for eliminating the deduction for home
equity debt: (1) it creates conflicting policies; (2) it causes complexity in the tax law; and (3) it
yields disparate treatment of similarly situated taxpayers.
Conflicting policies
If a tax deduction for personal interest were allowed, it would reduce the effective
interest cost of the indebtedness and thereby encourage individuals to incur such debt. By
generally disallowing a deduction for personal interest, present law discourages personal debt of
individuals and encourages personal saving. Because home equity interest is interest paid on a
personal debt, allowing a deduction for such interest creates an inconsistent policy as between
home equity debt and other personal debt. Further, it is unlikely that the deduction for interest
on home equity debt significantly adds to the present-law incentive to encourage homeownership
because most decisions to purchase a home are unlikely to be affected by the ability to deduct
home equity indebtedness. Also, individuals who currently benefit from the home equity debt
rules have already achieved homeownership and are unlikely to stop being homeowners because
the home equity debt rules are repealed.
Complexity
The present-law rule that home equity interest is only deductible for indebtedness up to
the amount that the fair market value of the home exceeds acquisition indebtedness adds
complexity to the tax law by requiring the homeowner to determine the fair market value of the
home on a periodic basis. This source of complexity is compounded in periods of fluctuating
real estate prices. Repeal of the home equity debt rules would eliminate this source of
complexity.
Further, the present-law home equity debt rules can be manipulated by taxpayers. For
example, many automobile dealerships are willing to accept a security interest in a car buyer's
home without any information about the home's value or whether the home is security for any
other debt in order to provide the individual with an interest deduction under the home equity
debt rules. Dealers may take this interest in the home though a security interest in the car as their
primary security on the debt (often making the home as security for the debt in form only). The
result of this inconsistency can be a perception that the tax rules are unfair as well as complex.
The present-law home equity debt rules have some simplification value in certain
circumstances. Specifically, when the amount of home equity indebtedness incurred as part of a
home refinancing does not exceed $100,000, a taxpayer may not have to allocate interest because
all the interest on the home refinancing is deductible. Unlike present law, the proposal requires a
taxpayer to bifurcate the interest paid on the refinancing debt between the deductible and
nondeductible portions if any home equity debt (other than grandfathered home equity debt) is
incurred as part of a refinancing. Therefore the proposal can result in additional computational
complexity in certain circumstances. However, this potential increase in complexity is small
compared to the reduction in complexity related to valuation that would be effected by the
proposal.
In determining how to characterize interest expense of an individual as, for example,
investment interest (which is deductible within certain limits) or personal interest (which
generally is nondeductible), or deductible qualified residence interest (including home equity
interest), temporary regulations provide rules that essentially adopt a tracing approach. These
tracing rules could be simplified by reducing the number of categories of interest to which they
apply. Denying deductibility for home equity debt rules would simplify the tracing and reduce
complexity.
Disparate treatment of similarly situated taxpayers
Home equity debt is often incurred to finance an individual's personal expenditures, and
not to finance homeownership. Such interest would be nondeductible as personal interest if it
were not incurred with respect to home equity debt. Effectively, present law gives unequal
treatment for otherwise similar interest costs based on whether the debtor owns a home. This
result is inequitable.
The home equity deduction also treats homeowners unequally because the present-law
home equity debt rules favor homeowners with equity in their home versus homeowners with
little or no equity. Therefore, this tax benefit generally is more valuable to homeowners in areas
with price appreciated homes than to homeowners in areas with flat or declining home prices.
Taxpayers may respond to the proposal by incurring or maintaining larger amounts of acquisition
indebtedness. If this occurs, disparate treatment of similarly situated taxpayers may continue.
For example, assume Taxpayer A and Taxpayer B each has $250,000 of savings and no other
debts when they purchase their principal residences for $500,000, respectively. Taxpayer A
incurs $500,000 of acquisition indebtedness and leaves untouched the $250,000 of savings.
Taxpayer B uses the $250,000 of savings as a down payment and incurs $250,000 of acquisition
indebtedness. After these transactions, the two taxpayers are similarly situated with net worths
of $250,000, but Taxpayer A may be able to offset future taxable income with a larger home
mortgage interest deduction. The same situation can arise under present law. Any effort to
address this concern is beyond the scope of this proposal because it involves curtailing the
present-law deduction for acquisition indebtedness.
F. Limit the Exclusion for Rental Value of a Residence
Rented for Fewer Than 15 Days
(sec. 280A)
Present Law
Gross income generally includes all income from whatever source derived, including rent
from real property. Present law provides a de minimis exception to this rule if a dwelling unit is
used during the taxable year by the taxpayer as a residence and is rented for fewer than 15 days
during the taxable year. In this case, the rental income is not included in gross income. No
deductions attributable to such rental use are allowed.
Reasons for Change
The present-law 15-day rule inaccurately measures economic income by excluding rental
income earned by the taxpayer. The amount of the untaxed income can be significant even for
fewer than 15 days' rental. A dollar limitation in conjunction with the 15-day rule would more
accurately function as a de minimis threshold than a rule based exclusively on the rental period.
Description of Proposal
The proposal limits the total exclusion for the rental value of a residence rented fewer
than 15 days to $2,000. Also the proposal allows certain deductions attributable to such rental
use. Specifically, a taxpayer may claim the otherwise allowable deductions attributable to such
rental use (e.g., depreciation) reduced in proportion to the ratio of excludable rental income to
total rental income from the property.
Effective Date
The proposal is effective for taxable years beginning after the date of enactment.
Discussion
The following example illustrates the operation of the proposal:
Taxpayer A rents his residence for fewer than 15 days during the taxable year. The
taxpayer receives $5,000 in rent and has $2,000 of otherwise applicable deductions arising from
such rental use. Under present law, none of the $2,000 is deductible and none of the $5,000 of
rental income is included in gross income. Under the proposal, the allowable amount of the
deduction is reduced by the ratio of excludable gross rental income to total gross rental income
(i.e., $2,000/$5,000). This reduces the otherwise applicable deductions arising from such rental
use by 40 percent from $2,000 to $1,200. After reducing the gross rental income of $5,000 by
the amount of the allowable deductions the taxpayer's net rental income is $3,800. Of this
amount, $2,000 is excludable so the taxpayer has $1,800 of taxable income from the rental of the
residence.
The principal justification for the present-law rule is that it reduces the administrative and
record keeping burden on taxpayers and the IRS by excluding de minimis rental income
attributable to the taxpayer's residence. The fact that there is no dollar limit, however, is
incompatible with the simplification argument underlying the de minimis exception, as rentals of
fewer than 15 days on certain residences can be several thousands of dollars. The exception
should be capped to better fit the de minimis rationale.
Any dollar limitation is arbitrary but an unlimited exception is not justified by the de
minimis rationale. The de minimis exception provides for a less accurate measurement of
income relating to the rental. It does this to alleviate the administrative and recordkeeping
burden on the taxpayer and the IRS. This mismeasurement of income increases as the rental
income rises even though the administrative and recordkeeping burden remains relatively
constant. A dollar limitation would allow Congress to target the de minimis exception to
taxpayers with relatively small amounts of rental income which is more consistent with the de
minimis rationale.
The proposal will increase administrative and recordkeeping burden for those taxpayers
whose rental income exceeds the dollar limitation. Unlike present law, the proposal allows
deductions for such taxpayers and consequently affects the basis in their homes for tax purposes.
The burden of this additional basis calculation, however, is relatively small when weighed
against the more accurate measurement of economic income for such taxpayers achieved by the
proposal.
G. Extend Pro-Rata Basis Allocation Requirement
to All Part-Gift, Part-Sale Transactions
(sec. 1011)
Present Law
A taxpayer that sells property to a charity for a price less than the fair market value
generally must bifurcate the transaction into two parts (one part gift and the other part sale) under
existing bargain sale rules. If a taxpayer makes a bargain sale of property and a charitable
deduction is allowable for the donated portion of the property, then the adjusted basis used to
determine the taxpayer's gain from the sale portion generally is an amount that equals the same
percentage of the property's entire adjusted basis as the percentage that the sales price is of the
fair market value of the property. For example, assume a taxpayer bought 100 shares of stock
for $1,000 and sold those shares to a charity for $5,000 when the fair market value of the shares
was $10,000. The taxpayer's adjusted basis for purposes of determining gain from the sale
portion is $500, which is 50 percent ($5,000 sales price divided by $10,000 fair market value) of
the entire adjusted basis of $1,000. The taxpayer's gain from the sale portion, therefore, is
$4,500, and a charitable deduction of $5,000 '' the amount by which the fair market value
exceeds the sales price '' may be available.
This pro rata basis allocation rule for bargain sales to charities does not apply to part-gift,
part-sale transactions for which a charitable deduction is not permitted. Instead, in determining
the transferor's gain from the sale portion of such a transaction, the entire adjusted basis of the
property transferred is used to offset the sales price. Under this rule, if the taxpayer in the
example described above transferred the stock to his or her child instead of to a charity, the
adjusted basis used to determine the taxpayer's gain from the sale portion would be the entire
adjusted basis of the stock, $1,000, and the taxpayer's gain would be only $4,000. If this basis
rule applies, the transferee's basis generally is the amount paid for the property ($5,000 in the
example) or the transferor's adjusted basis at the time of the transfer ($1,000 in the example),
whichever is greater, plus any increase under section 1015(d) for Federal gift tax paid on the
transfer.
Reasons for Change
In general, when a taxpayer sells part of a larger property, the taxpayer is required to
allocate basis to the portion sold based on that portion's fair market value. Present law
governing bargain sales to charities is consistent with this principle. Present law for other
bargain sales, however, departs from this general rule and allocates the entire basis to the sale
portion, thereby reducing the taxable gain for taxpayers making those sales. As a result, similar
transactions are treated differently.
Description of Proposal
The proposal extends to all part-gift, part-sale transfers the present law pro-rata basis
allocation rule applicable to bargain sales to charities. Consequently, for determining gain from
any bargain sale, the proposal requires a taxpayer to allocate to the sale portion of property an
amount of basis equal to that portion's pro rata share, based on respective fair market values, of
the entire property's adjusted basis.
Under the proposal, the transferee's basis in property acquired in a part-gift, part-sale
transaction is (1) the cost (sales price) of the purchased portion of the property plus (2) the
transferor's basis in the gift portion of the property.
In the example above of a bargain sale to a taxpayer's child, the basis of the stock is
allocated to the portion of the stock sold and the portion transferred as a gift based on the
respective fair market values of the two parts so that the tax result is the same as if the taxpayer
sold 50 shares and made a gift of 50 shares. The taxpayer recognizes a gain of $4,500, not
$4,000 (the present-law result).
Effective Date
The proposal is effective for transfers made on or after the date of enactment.
Discussion
Under the proposal, a taxpayer's taxable gain recognized on any bargain sale equals the
taxpayer's gain that would be recognized on the disposition for fair market value of a portion of
the property. Under present law, by contrast, taxpayers are permitted to shift gain to certain
transferees. A taxpayer may, for example, sell a $100,000 painting for its adjusted basis of
$5,000 and thereby shift the entire $95,000 appreciation in the painting to the transferee. This
shift results in reduced tax liability if the transferee is in a lower tax bracket than the transferor.
Even in the absence of tax rate differences, shifting of gain may create valuable tax deferral.
Present law thus produces different tax results for two economically similar transactions.
A taxpayer may choose to sell a portion of property for its fair market value and then transfer the
remaining part of the property by gift. Alternatively, the taxpayer may choose to sell the entire
property at a bargain price. Under the proposal, the tax treatment of the two transactions is the
same.
Basis allocation is required in a bargain sale to a charity because the charity's subsequent
sale of the property generally will not be taxed to the charity. To reduce the amount of gain that
escapes taxation altogether, therefore, the sale to a charity must result in the proper measurement
of gain. The same policy applies, however, to a bargain sale to a buyer that is not a charity. The
basis allocation rules should measure properly the amount of gain for both parties to any part-
gift, part-sale transaction '' that is, the seller's gain on the initial sale and the buyer's gain on a
subsequent sale.
The proposal may create administrative difficulties when property is hard to value.
Under present law, the purchase price (rather than the fair market value) generally determines the
tax treatment of the transferor or the acquirer's basis in the property acquired if the acquirer is
not a charity. For example, if property with a basis of $50 is transferred for $100 consideration
and is later determined to have been worth $200, the transferor's taxable gain of $50 and the
transferee's basis ($100) will not be affected. Under the proposal, however, the taxpayer may
have reported gain of $50 on the transfer even though he or she should have reported gain of
$75, and the transferee's basis will be adjusted to $125 from $100. Ultimately, the
administrative concerns potentially presented by the proposal as applied to property that is not
readily valued must be weighed against the advantage of taxing a part-gift, part-sale transaction
correctly and not permitting similar transactions to have different tax consequences. If
administrative problems are of sufficient concern, the proposal might be modified to apply only
to readily valued property such as publicly traded stock.
H. Simplify Taxation of Minor Children
(sec. 1)
Present Law
Overview
In general, children are subject to the same income tax filing requirements and tax rules
as other taxpayers, including those applicable to a taxpayer who may be claimed as a dependent
by another taxpayer. For children under age 14, net unearned income (generally investment
income that exceeds a certain amount) is taxed at the parent's rate if the parent's rate is higher
than the child's. This is commonly referred to as the ''kiddie tax.'' In limited circumstances,
generally when a child is under 14 and his or her only income is dividends and interest within a
certain range, a parent may elect to include the child's unearned income on the parent's return.
The application of the kiddie tax may increase (but will not decrease) the amount of tax to be
paid on the child's income. The parental election may cause the aggregate tax to be paid on the
parent's and child's income to be higher than if the parent and child filed separate returns. Filing requirements for children
An unmarried individual eligible to be claimed as a dependent on another taxpayer's
return generally must file an individual income tax return if he or she has: (1) earned income
over $5,000 (for 2005) and no unearned income; (2) unearned income over the minimum
standard deduction amount for dependents ($800 in 2005) and no earned income; or (3) both
earned income and unearned income totaling more than the smaller of (a) $5,000 (for 2005) or
(b) the larger of (i) $800 (for 2005), or (ii) earned income plus $250. Thus, if a dependent
child has less than $800 in gross income, the child does not have to file an individual income tax
return for 2005.
A child who cannot be claimed as a dependent on another person's tax return is subject to
the generally applicable filing requirements. That is, such an individual generally must file a
return if the individual's gross income exceeds the sum of the standard deduction and the
personal exemption amounts applicable to the individual.
Taxation of unearned income of children under 14
Special rules apply to the unearned income of a child who is under age 14. The kiddie
tax applies if: (1) the child has not reached the age of 14 by the close of the taxable year; (2) the
child's unearned income was more than $1,600 (for 2005); and (3) the child is required to file a
return for the year.
For these purposes, unearned income is income other than wages, salaries, professional
fees, or other amounts received as compensation for personal services actually rendered. For
children under age 14, net unearned income (for 2005, generally unearned income over $1,600)
is taxed at the parent's rate if the parent's rate is higher than the child's rate. The remainder of a
child's taxable income (i.e., earned income, plus unearned income up to $1,600 (for 2005), less
the child's standard deduction) is taxed at the child's rates, regardless of whether the kiddie tax
applies to the child. In general, a child is eligible to use the preferential tax rates for qualified
dividends and capital gains.
The kiddie tax applies regardless of the source of the property generating the income or
when the property that gave rise to the income was transferred to or otherwise acquired by the
child. Thus, for example, the kiddie tax may apply to income from property acquired by the
child with compensation derived from the child's personal services, or from property given to the
child by someone other than the child's parent. The kiddie tax applies regardless of whether the
child may be claimed as a dependent on the parent's return.
The kiddie tax is calculated by computing the 'allocable parental tax.'' This involves
adding the net unearned income of the child to the parent's income and then applying the
parent's tax rate. A child's ''net unearned income'' is the child's unearned income less the sum
of (1) the minimum standard deduction allowed to dependents ($800 for 2005), and (2) the
greater of (a) such minimum standard deduction amount or (b) the amount of allowable itemized
deductions that are directly connected with the production of the unearned income. A child's
net unearned income cannot exceed the child's taxable income.
The allocable parental tax equals the hypothetical increase in tax to the parent that results
from adding the child's net unearned income to the parent's taxable income. If a parent has more
than one child subject to the kiddie tax, the net unearned income of all children is combined, and
a single kiddie tax is calculated. Each child is then allocated a proportionate share of the
hypothetical increase, based upon the child's net unearned income relative to the aggregate net
unearned income of all of the parent's children subject to the tax.
Special rules apply to determine which parent's tax return and rate is used to calculate the
kiddie tax. If the parents file a joint return, the allocable parental tax is calculated using the
income reported on the joint return. In the case of parents who are married but file separate
returns, the allocable parental tax is calculated using the income of the parent with the greater
amount of taxable income. In the case of unmarried parents, the child's custodial parent is the
parent whose taxable income is taken into account in determining the child's liability. If the
custodial parent has remarried, the stepparent is treated as the child's other parent. Thus, if the
custodial parent and stepparent file a joint return, the kiddie tax is calculated using that joint
return. If the custodial parent and stepparent file separate returns, the return of the one with the
greater taxable income is used. If the parents are unmarried but lived together all year, the return
of the parent with the greater taxable income is used.
Unless the parent elects to include the child's income on the parent's return (as described
below) the child files a separate return to report the child's income, and items on the parent's
return are not affected by the child's income. The total tax due from a child is the greater of:
(1) the sum of (a) the tax payable by the child on the child's earned income plus (b)
the allocable parental tax on the child's unearned income, or
(2) the tax on the child's income without regard to the kiddie tax provisions.
Thus, application of the kiddie tax will not reduce (but in many cases will increase) a
child's tax liability.
A child's qualifying dividends and capital gains are subject to the preferential tax rates
for such income. Such dividends and capital gains are allocated between the child and the parent
by allocating the $1,600 (for 2005) between such dividends and gains and the child's other
investment income.
Example. ''For 2005, a child who is age 13 has wages of $1,550, and total unearned
income consisting of capital gains, dividends, and interest, of $2,800. The child may be claimed
as a dependent on her parents'' joint return. The child's adjusted gross income is $4,350,
standard deduction is $1,800 (i.e., $1,550 of earned income plus $250), and taxable income is
$2,550. Because the child has unearned income for 2005 exceeding $1,600, the child is subject
to the kiddie tax provisions. The child's net unearned income of $1,200 (i.e., $2,800 less $1,600)
is subject to tax at the parents' rates. The remaining $1,350 of the child's taxable income (i.e.,
the excess of the child's earned income, and unearned income up to $1,600, over the standard
deduction amount) is taxed at the child's rates. The child's capital gains and dividends are
subject to the preferential tax rate for capital gains and qualifying dividends. Because the child
has income other than dividends and interest, the parental election (described below) may not be
made to include the child's unearned income on the parents' return.
Parental election to include child's dividends and interest on parent's return
Under certain circumstances, a parent may elect to report a child's dividends and interest
on the parent's return. If the election is made, the child is treated as having no income for the
year and the child does not have to file a return. The parent makes the election on Form 8814,
''Parents'' Election To Report Child's Interest and Dividends.'' The requirements for the parent's
election are that:
(1) the child has gross income only from interest and dividends (including capital
gains distributions and Alaska Permanent Fund Dividends);
(2) such income is more than the minimum standard deduction amount for
dependents ($800 in 2005) and less than 10 times that amount ($8,000 in 2005);
(3) no estimated tax payments for the year were made in the child's name and
taxpayer identification number;
(4) no backup withholding occurred; and
(5) the child is required to file a return if the parent does not make the election.
Only the parent whose return must be used when calculating the kiddie tax may make the
election. The parent includes in income the child's gross income in excess of twice the
minimum standard deduction amount for dependents (i.e., the child's gross income in excess of
$1,600 for 2005). This amount is taxed at the parent's rate. The parent also must report an
additional tax liability equal to the lesser of: (1) $80 (in 2005); or (2) 10 percent of the child's
gross income (including qualifying dividends and capital gain distributions) exceeding the
child's standard deduction ($800 in 2005).
Including the child's income on the parent's return can affect the parent's deductions and
credits that are based on adjusted gross income, as well as income-based phaseouts, limitations,
and floors. In addition, certain deductions that the child would have been entitled to take on
his or her own return are lost. Further, if the child received tax-exempt interest from a private
activity bond, that item is considered a tax preference of the parent for alternative minimum tax
purposes.
In addition, including a child's qualified dividends and capital gain distributions on a
parent's return may increase the tax on a portion of such income. This is because the preferential
tax rates for qualified dividends may be as low as five percent. If the parental election is made,
however, the child's income between the standard deduction amount and the investment income
threshold (i.e., between $800 and $1,600 for 2005) is taxed at 10 percent, even if it consists of
qualified dividends (as defined in section 1(h)(11), including capital gain distributions) that
would have been taxed at a lesser rate if the child had filed his or her own return.
For all of these reasons, a parent making the election may cause an increased tax liability
for the family.
Taxation of compensation for services of children
Compensation for a child's services is considered the gross income of the child, not the
parent, even if the compensation is not received or retained by the child (e.g., it is the parent's
income under local law). If the child's income tax is not paid, however, an assessment against
the child will be considered as also made against the parent to the extent the assessment is
attributable to amounts received for the child's services.
Reasons for Change
The ''kiddie tax'' was enacted to restrict the practice of high-income individuals
transferring income-producing property to their children so that the income would be taxed at
lower rates. This rationale for applying the kiddie tax rules to children under 14 also applies to
older children who have not yet attained the age of majority.
The present-law kiddie tax provisions are complex, and lead to uncertainty about the tax
rate that will apply to a child's unearned income. A main source of complexity is that present
law requires a linkage between the child's return, the parent's return, and if applicable, the
returns of the child's siblings. This linkage increases complexity in the initial filing of the
child's return, and in subsequent filings or proceedings if the return of the child, the parent, or a
sibling is amended or adjusted under audit. The rules are further complicated depending on
whether the child's parents file jointly, separately, are married, unmarried, or remarried. By
simplifying the taxation of minor children, the proposal removes a potential source of
noncompliance.
Description of Proposal
The proposal modifies the kiddie tax provisions by increasing the age of children to
which the kiddie tax provisions apply from under 14 to under 18, unless the child is married or
files as a head of household. The proposal also subjects the child's unearned income in excess of
an exemption amount (initially $2,500, indexed for inflation) to the highest individual income
tax rate applicable to income of that character, rather than to the parent's marginal rate. Under
the proposal, a child's taxable income is first allocated to the excess (if any) of unearned income
over the exemption amount (any such excess is taxed at the highest individual income tax rate
applicable to income of that character), and then to income taxed at the child's tax rates.
Unearned income in excess of the $2,500 amount (adjusted for inflation) is first treated as net
capital gain (to the extent thereof), and then other unearned income. (This allocation rule is
demonstrated by Examples 1 and 2, below).
The proposal eliminates the present-law parental election to include certain unearned
income of a child on a parent's return. Thus, under the proposal, a return is filed for every child
whose income exceeds the filing requirement.
The proposal retains the present-law definitions of earned income and unearned income
(i.e., unearned income is income other than wages, salaries, professional fees, or other amounts
received as compensation for personal services actually rendered). The proposal does not
modify the present-law determination of the amount of the standard deduction of an individual
who may be claimed as a dependent by another taxpayer.
Example 1.''For 2005, a child who is age 17 has wages of $1,550, and total unearned
income of $2,800, consisting of adjusted net capital gain of $2,000 and interest of $800. The
child may be claimed as a dependent on her parents' joint return. Thus, the child's adjusted
gross income is $4,350, the standard deduction is $1,800 (i.e., $1,550 earned income plus $250),
and taxable income is $2,550.
Under the proposal, the child's income is taxed as follows. First, because the child's
unearned income exceeds $2,500, the $300 excess is taxed at the highest tax rate applicable to
income of the same character. Because the excess is first allocated to net capital gain, the full
$300 is treated as net capital gain and is taxed at the 15-percent rate. Of the remaining $2,250 of
taxable income, the remaining $1,700 of the net capital gain is taxed at the child's regular capital
gain rate (five percent) and $550 (taxable income less net capital gain) is taxed at the child's
regular tax rate (10 percent).
Example 2.''The facts are the same as in Example 1, except that the child has no earned
income for the year. Thus, the child's adjusted gross income is $2,800, the standard deduction is
$800, and taxable income is $2,000. As in example 1, the child's unearned exceeds $2,500, and
the $300 excess is allocated to net capital gain and is taxed at the highest tax rate for net capital
gain, or 15 percent. The remaining $1,700 of taxable income is net capital gain and is taxed at
the child's capital gain rate of five percent. The child has no taxable income in excess of net
capital gain, and thus no income is taxed at the child's regular tax rate.
Example 3.''A child under age 18 has wages of $1,550 and unearned income consisting
of net capital gain and interest of $2,400. Under the proposal, the child's adjusted gross income
is $3,950, the standard deduction is $1,800, and taxable income is $2,150. Because the child's
unearned income does not exceed $2,500, all of the child's taxable income is taxed at the child's
rates (including the preferential rates for net capital gain).
Effective Date
The proposal is effective for taxable years beginning after the date of enactment.
Discussion
Elimination of use of parent's return and tax rates
The present-law requirement that net unearned income of a child under age 14 be taxed at
the parent's rates generally requires a preparer of such a child's return to know the tax
circumstances of the child's parents (i.e., filing status, taxable income, and actual tax liability),
and the amount of net unearned income of other children of a parent, in order to determine the
amount of the kiddie tax applicable to the child's unearned income. If the child's parents are
married but file separate returns (including a custodial parent who divorced and remarried), each
parent must know the amount of the taxable income of each parent to determine which parent's
return is to be used to determine the child's tax on unearned income. If a parent's or a sibling's
return is audited and adjusted, the child's return also must be audited and adjusted. Under present law, the preparer's need to know certain tax information of the respective
parents is not eliminated if the parental election is made, because only the parent whose return
must be used when calculating the kiddie tax for the child's return may make the election (i.e.,
the election cannot be made without such information being known by both parents and, if
applicable, their respective tax return preparers). Thus, certain tax information regarding both
parents who file separately must be known, irrespective of whether the child files a separate
return or one of the parents elects to include the child's unearned income on the parent's return.
The need to know certain tax information of the parents (including their marital status)
and of certain siblings is eliminated if the child's unearned income is no longer taxed at the
parent's tax rate. Alternatives include taxing the child's unearned income under the tax rate
schedule applicable to trusts and estates, or under a rate schedule established specifically for
this purpose. The rate schedule used for this purpose should be sufficiently compressed to
discourage tax-motivated shifting of unearned income between a parent and a child. In its fiscal
year 2005 budget, the Administration proposed modifying the kiddie tax by subjecting the
child's earned income, and the first $2,500 (indexed for inflation) of unearned income, to tax at
the child's rates, and unearned income over $2,500 at the highest regular income tax rate for
individuals (or, for dividends and capital gains, the highest dividends or capital gains rate).
The proposal reduces complexity by eliminating the need to calculate net unearned
income and by eliminating the linkage between the various returns. At the same time, it curbs
the tax-motivated shifting of unearned income to minor children by subjecting the child's
unearned income in excess of a specified amount to the highest individual income tax rates
applicable to that character of income.
Increase in age from under 14 to under 18
The present-law kiddie tax provisions apply only if the child is under age 14. Parents
may shift unearned income to children over age 13 without subjecting such income to taxation at
the parent's tax rate. For example, a parent may transfer stock to a custodial account for a child
pursuant to the Uniform Transfer to Minors Act. If the stock is transferred to the child before the
child attains age 14, the annual dividends and other unearned income of the child in excess of
$1,600 (for 2005) are subject to tax at the parent's rate, if higher than the child's rate, for those
taxable years in which the child is under age 14 at the end of the year. Once the child attains age
14, however, the dividends are taxed at the child's rate.
The kiddie tax was enacted to restrict the practice of high-income individuals transferring
income-producing property to their children so that the income would be taxed at lower rates.
When Congress enacted the kiddie tax in 1986, it ''believed that the prior law rules governing the
taxation of minor children provided inappropriate tax incentives to shift income-producing assets
among family members'' and ''concluded that it generally is appropriate to tax the unearned
income of a minor child under age 14 at the parent''s marginal rates.'' To the extent that
parents shift assets to their children, this rationale for applying the kiddie tax rules to children
under 14 also applies to older children who have not yet attained the age of majority. However,
as is the case under present law, the kiddie tax (as modified by the proposal) applies even if the
child's unearned income is derived from assets that were not acquired from a parent. The
likelihood of a child acquiring assets from sources other than a parent potentially increases with
the child's age. Thus, the proposed increase in age could subject more of a child's income from
such assets to tax at rates higher than the child's rates.
Elimination of parental election
The parental election permitted under present law provides two main simplification
benefits. The primary advantage is the ability to report all of the tax liability of the parents and
children together because of the requirement under present law linking the determination of such
liabilities to one another. The election also avoids the need to file multiple tax returns. The
advantage provided by the election under present law may be limited by the fact that it is not
available in all cases in which a child has income and may result in a higher tax liability for the
family, thus forcing taxpayers to make a choice between achieving simplification and paying
more tax.
The proposal permits parents and their children to determine their tax liabilities
independent of one another. Thus, there would no longer be an advantage to making such
determinations on a single return. Allowing a parental election under the proposal would reduce
the number of returns that would have to be filed. However, it is likely that the information and
worksheets needed to report more than one person's tax liability on a single return would be very
similar to the administrative burden required to file multiple returns. In addition, maintaining the
election under the proposal would retain some of the complexities associated with the election,
such as determining on which parent's return to include the child's income.
III. EMPLOYMENT TAXES
A. Provide Consistent FICA Treatment of Salary Reduction Amounts
(sec. 3121(a))
Present Law
Compensation received for services performed as an employee, including benefits
provided to employees, is generally subject to tax as wages under the Federal Insurance
Contributions Act (''FICA''). 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 ($90,000 for
2005). 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.
For FICA tax purposes, ''wages'' generally includes all remuneration for employment
unless a specific exception applies under the FICA rules. The same definition of wages
generally applies for purposes of determining an individual's quarters of coverage for purposes
of eligibility for Social Security benefits and Medicare and for purposes of determining the
amount of an individual's Social Security benefits.
Employer contributions to certain tax-favored retirement plans are excepted from wages
for FICA purposes. However, this exception does not apply to contributions made by salary
reduction. Thus, for FICA purposes, contributions made by salary reduction are treated as
wages. Legislative history indicates that this treatment is intended to assure that salary reduction
amounts are included in the FICA base. Otherwise, individuals could, in effect, control which
portion of their compensation is included in wages for Social Security purposes, which would
make the Social Security system partially elective and undermine the FICA tax base.
Various types of employer-provided benefits are excepted from FICA wages, such as
employer-provided health coverage (including reimbursements for medical expenses), dependent
care assistance, and certain fringe benefits. These types of benefits paid for by salary
reduction under a cafeteria plan (including a flexible spending arrangements or ''FSA'') are also
excepted from FICA wages if the benefits would be excepted from wages without regard to the
cafeteria plan. In addition, qualified transportation fringe benefits are excepted from FICA
even if provided on a salary-reduction basis.
Reasons for Change
Present law provides inconsistent treatment of salary reduction amounts for FICA
purposes. Contributions made to tax-favored retirement plans by salary reduction are wages for
FICA purposes. However, salary reduction amounts used to provide other benefits are excluded
from wages.
Description of Proposal
The proposal provides consistent treatment of salary reduction amounts for FICA
purposes. Specifically, salary reduction amounts used to provide benefits under a cafeteria plan
or to provide qualified transportation fringe benefits are included in FICA wages in a manner
similar to salary reduction contributions to employer-sponsored retirement plans. Such
amounts are also taken into account in determining wages for purposes of determining Social
Security benefits (both eligibility and amount) and Medicare eligibility.
Effective Date
The proposal is effective with respect to wages for services performed in calendar years
beginning after the date of enactment.
Discussion
Under present law, retirement plan contributions made by salary reduction are wages for
FICA purposes. Legislative history reflects the intent to assure that such salary reduction
amounts are included in the FICA tax base and in wages for Social Security purposes in order to
avoid undermining the FICA tax base and making the Social Security system partially elective.
This rationale for the FICA treatment of retirement plan contributions made by salary reduction
applies equally to salary reduction amounts used to provide benefits under a cafeteria plan or
qualified transportation fringe benefits. However, present law provides disparate treatment of
salary reduction amounts by excepting from FICA salary reduction amounts under a cafeteria
plans or to provide qualified transportation fringe benefits. The proposal eliminates this disparity
by treating all salary reduction amounts as FICA wages.
The proposal also provides consistent FICA treatment of amounts paid by employees to
purchase benefits, regardless of whether the benefits are provided through an employer-
sponsored plan. For example, under present law, an employee who cannot purchase health
insurance through his or her employment must pay FICA tax on his or her salary, including any
amounts used to purchase individual health insurance coverage. Under the proposal, similar
FICA treatment applies to salary reduction amounts used to purchase health insurance coverage
through a cafeteria plan.
The proposal has the effect of increasing FICA taxes for some employers and employees,
as well as increasing revenues for the Social Security and Medicare programs. The proposal
also results in additional wages for Social Security and Medicare purposes, which is likely to
increase benefits for some individuals, as well as long-term costs under such programs.
Applying FICA tax consistently to salary reduction amounts may make payroll
processing and employment tax compliance less complicated for some employers.
B. Conform Calculation of FICA Taxes and SECA Taxes
(sec. 1402(a)(12))
Present Law
As part of the financing for Social Security and Medicare benefits, a tax is imposed on
the wages of an individual received with respect to his or her employment under the Federal
Insurance Contributions Act (''FICA''). A similar tax is imposed on self-employment income
under the Self-Employment Contributions Act (''SECA'').
The FICA tax has two components. Under the old-age, survivors, and disability
insurance component (''OASDI''), the rate of tax is 6.2 percent for the employee, and 6.2 percent
for the employer. The amount of wages subject to this component is capped at $90,000 for 2005.
Under the hospital insurance (''HI'') component, the rate is 1.45 percent for the employee and
1.45 percent for the employer. The amount of wages subject to HI taxes is not capped.
Similarly, the SECA tax has two components. Under the OASDI component, the rate of
tax is the combined employer and employee rates under the OASDI portion of FICA, i.e., 12.40
percent. Under the HI component, the rate is the combined employer and employee rate under
the HI portion of FICA, i.e., 2.90 percent. The amount of self-employment tax under the OASDI
is subject to the same limit as under FICA, i.e., this component is capped at $90,000 of self-
employment income (for 2005). The amount of self-employment income subject to HI taxes is
not capped.
For purposes of determining net earnings from self-employment for SECA liability,
taxpayers are permitted a deduction from net earnings from self-employment equal to the
product of the taxpayer's net earnings (determined without regard to this deduction) and one-half
of the sum of the rates for OASDI (12.4 percent) and HI (2.9 percent), i.e., 7.65 percent of net
earnings. This deduction reflects the fact that the FICA rates apply to an employee's wages,
which do not include FICA taxes paid by the employer, whereas a self-employed individual's net
earnings are economically the equivalent of an employee's wages plus the employer share of
FICA taxes. The deduction is intended to provide parity between FICA and SECA taxes.
Self-employed individuals may deduct one-half of self-employment taxes for income tax
purposes.
Reasons for Change
Although the intent of the present-law rules is to provide parity between FICA and SECA
taxes, the deduction allowed under present law in calculating SECA taxes is larger than the
amount needed to make SECA taxes the economic equivalent of FICA taxes. This is because the
calculation of the deduction does not properly reflect the fact that net earnings are inclusive of
SECA taxes. In addition, it does not take into account the fact that wages above the OASDI
wage base are subject to tax only at the hospital insurance rate of 2.9 percent.
Description of Proposal
The proposal modifies the deduction from net earnings from self-employment to make
SECA taxes economically equivalent to FICA taxes. Under the proposal, the deduction is
determined as shown in Table 2.
Table 2.''Calculation of Deduction Allowed in Determining SECA Taxes
If self-employment income is...
Amount of deduction in calculating
SECA base is...
Up to threshold amount1
7.1064 percent of self-employment
earnings.
In excess of threshold amount
7.1064 percent of self-employment
earnings up to the threshold amount,
plus 1.4293 percent of self-employment
earnings in excess of the threshold.
1 Threshold amount is 1.0765 multiplied by the FICA taxable wage base. Threshold amount for 2005 is
$96,885 ($90,000 x 1.0765).
Effective Date
The proposal is effective for taxable years beginning after the date of enactment.
Discussion
The Social Security Act amendments of 1983 attempted to put SECA taxes on the same
economic footing as FICA taxes. This involved applying the same rates of tax for the first
time, and permitting the deduction from self-employment earnings in recognition of the fact that
net earnings include the ''employer share'' of SECA taxes, whereas FICA tax rates apply to
wages exclusive of the employer share of FICA tax.
The deduction is intended to make SECA taxes the economic equivalent of FICA taxes.
The statute, however, permits a deduction equal to 7.65 percent of net earnings determined
without regard to this deduction, whereas the ''employer'' tax of 7.65 percent applies to the
amount determined after this deduction. Hence, the deduction, which represents the employer
side of the SECA tax, is larger than the actual liability for the employer share of the SECA tax.
Thus, for the same economic wage, SECA tax collections are less than FICA tax collections. To
make the SECA tax the economic equivalent of FICA tax, the deduction should instead have
been determined as the deduction amount necessary to yield an amount that when grossed up by
7.65 percent equals the original amount of net earnings.
Beginning in 1991, the permitted deduction deviated further from consistency with FICA
taxes when the taxable wage base with respect to HI taxes was raised (and eventually eliminated
in 1994) but the deduction was not altered to reflect that fact. Rather, the deduction of 7.65
percent of net earnings continued to apply, despite the fact that the deduction with respect to the
OASDI portion (6.2 percent) of the 7.65 percent should conceptually only reflect OASDI taxes
paid up to the taxable wage base and not the entire amount of net earnings. The deduction thus
leads to a taxable wage base that is conceptually too low for HI tax purposes for self-employed
taxpayers with earnings above the OASDI taxable wage base.
While prior to the raising of the HI cap the deduction worked in this same manner, it did
not matter in practice since both OASDI and HI taxes were capped at the same level. Thus the
deduction, though conceptually too high, had no effect on HI collections because if a taxpayer
were above the OASDI taxable wage base, and thus permitted a deduction that was conceptually
too large, he would also have been above the HI taxable wage base after the deduction and thus
HI collections would not have been affected.
This excess deduction has no impact on the OASDI-equivalent portion of the SECA tax
for high-income taxpayers above the OASDI taxable wage base, but it does affect HI collections
when the HI taxable wage base exceeds that of the OASDI taxable wage base.
The proposal described above corrects the inequities of present law. The following
examples illustrate the difference between present law and the proposal.
Example 1.
Wage-earner.''Taxpayer is employed for $25 per hour at a small accounting firm, earning
$50,000 a year for 2,000 hours of work. The taxpayer's employer pays FICA taxes on the entire
amount of the employee's earnings, because the employee earns less than the taxable wage base
of $90,000 for 2005. The employer FICA tax is 7.65 percent of the $50,000, or $3,825. The
employee pays tax at the same rate on the same base, so his tax is also $3,825, for total FICA
taxes paid of $7,650. The taxpayer's true pre-tax compensation is thus $53,825 ($50,000 plus
$3,825, the employer share of FICA). His wages after all FICA taxes is $46,175 ($53,825 -
$7,650).
Self-employed individual.''A self-employed accountant has net-earnings from self-
employment equal to the wage earner's true pre-tax earnings of $53,825. Under present law, the
taxpayer is permitted a deduction from net earnings equal to 7.65 percent of net earnings, or
$4,118 (7.65 percent of $53,825). The SECA tax of 15.3 percent is applied to the net earnings
after this deduction of $49,707 ($53,825 - $4,118), resulting in a SECA tax of $7,605. The self-
employed taxpayer's income after SECA taxes is $46,220 ($53,825 - $7,605).
Thus, for the same economic income, the self-employed taxpayer's SECA tax is $45
($7,650 - $7,605) lower than that of the employee, resulting in self-employed income after
SECA taxes exceeding the employee's comparable income after FICA taxes by the same
amount.
Under the proposal, the deduction from net earnings for the self-employed individual is
adjusted to 7.1064 percent of net earnings, resulting in a deduction of $3,825, and a base for
SECA taxes of $50,000 ($53,825 pre-tax earnings less $3,825 SECA deduction). The SECA tax
base is thus made equivalent to the FICA tax base for taxpayers with the same economic income.
The SECA tax of 15.3 percent multiplied by the $50,000 tax base results in SECA tax liability of
$7,650, the same as the combined employer and employee share of FICA taxes in the case of the
employee.
Example 2.
Wage-earner.''Taxpayer is employed for $100 per hour at a small accounting firm,
earning $200,000 a year for 2,000 hours of work. The taxpayer's employer pays the OASDI
portion (6.2 percent) of the FICA tax on the employee's earnings only up to the taxable wage
base of $90,000 for 2005. The OASDI portion of the employer FICA tax is thus 6.2 percent of
$90,000, or $5,580. The employee pays tax at the same rate on the same base, so his tax is also
$5,580, for total OASDI portion of FICA taxes paid of $11,160. The employer HI portion (1.45
percent) of FICA tax is not capped and thus equals $2,900 (1.45 percent of $200,000). The
employee pays HI tax at the same rate on the same base, so his HI tax is also $2,900, for total HI
portion of FICA taxes of $5,800. FICA taxes for the employer and the employee are thus each
$8,480, for total FICA tax of $16,960. The taxpayer's true pre-tax compensation is thus
$208,480 ($200,000 plus $8,480, the employer share of FICA). His wages after all FICA taxes
is $191,520 ($208,480 - $16,960).
Self-employed individual.''A self-employed accountant has net-earnings from self-
employment equal to the wage earner's true pre-tax earnings of $208,480. Under present law,
the taxpayer is permitted a deduction from net earnings equal to 7.65 percent of net earnings, or
$15,949 (7.65 percent of $208,480). The OASDI portion of the SECA tax (12.4 percent) is
applied to the net earnings after this deduction of $192,531 ($208,480- $15,949), but only up to
the FICA wage base of $90,000, resulting in the OASDI portion of the SECA tax of $11,160.
The HI portion of the SECA tax (2.9 percent) is not capped, and thus equals 2.9 percent of
$192,531, or $5,583. The total SECA tax is thus $16,743, resulting in net income after SECA
tax of 191,737 ($208,480- $16,743).
Thus, for the same economic income, the self-employed taxpayer's SECA tax is $217
($16,960 - $16,743) lower than that of the employee, resulting in self-employed income after
SECA taxes exceeding the employee's comparable income after FICA taxes by the same
amount. Note that the self-employed taxpayer pays the same OASDI tax as the wage earner,
because both taxpayers are above the taxable wage base of $90,000. The entire shortfall occurs
in the HI portion of SECA, as a result of the deduction from net earnings that implicitly assumes
that the self-employed taxpayer pays the OASDI tax on amounts above the taxable wage base.
Under the proposal, the deduction from net earnings for self-employed individuals occurs
in two stages for taxpayers above the taxable wage base. For amounts up to the FICA taxable
wage base increased by 7.65 percent ($90,000 times 1.0765 = $96,885 for 2005), a deduction of
7.1064 percent of earnings is allowed, equaling $6,885 ($96,885 times .071064). For this portion
of the self-employed taxpayer's earnings, the SECA tax base is $90,000 ($96,885 pre-tax
earnings less $6,885 SECA deduction) and the SECA tax is $13,770 ($90,000 x 15.3%). Note
that the deduction equals one half of the SECA tax that will be owed, and equals the FICA tax
that the employer and employee each owe in the case of the wage earner.
The amount of net earnings above $96,885 is $111,595 ($208,480 - $96,885), and is
permitted a deduction of 1.4293 percent of such earnings, or $1,595, prior to collection of HI tax
on amounts above the cap. The HI portion of SECA tax on net earnings amounts above the cap
is thus 2.9 percent of $110,000 ($111,595 - $1,595), or $3,190. Total SECA collections are thus
$13,770, an amount equivalent to the FICA (OASDI and HI) collections up to the taxable wage
base, plus $3,190, representing HI collections on amounts above the taxable wage base, for a
total of $16,960. This amount is equivalent to the amount of FICA taxes collected on the wage
earner with the same economic income.
C. Extend Medicare Payroll Tax to All State and Local Government Employees
(sec. 3121(u)(2))
Present Law and Background
Hospital insurance taxes
As part of the financing for Medicare benefits, a hospital insurance (''HI'') tax is imposed
on the wages of an individual received with respect to his or her employment. One-half the HI
tax is imposed on the employer and one-half on the employee; the tax rate is 1.45 percent for the
employee and 1.45 percent for the employer. The amount of wages subject to HI taxes is not
capped.
Application of HI taxes to State and local government workers
The application of HI taxes to State and local government workers has expanded over
time. Before the enactment of the Consolidated Omnibus Budget Reconciliation Act of 1985
(''COBRA 1985''), State and local government employees were covered for Social Security
and Medicare benefits only if the State and the Secretary of Health and Human Services entered
into a voluntary agreement providing such coverage. In COBRA 1985, Medicare coverage (and
the corresponding HI tax) was extended on a mandatory basis to State and local government
employees hired after March 31, 1986, for services performed after that date. The Omnibus
Budget Reconciliation Act of 1990 extended Medicare coverage and the HI tax to State and
local government employees who are not covered under a retirement system, effective with
respect to services performed after July 1, 1991.
Under present law, State and local government employees are covered by Medicare and
subject to the HI tax with respect to such employment if: (1) the employee was hired after March
31, 1986; or (2) the employee was hired before March 31, 1986, and either (a) there is a
voluntary agreement in effect with the State providing for such coverage or (b) the employee is
not covered by a retirement system. Thus, State and local government workers are not
covered by Medicare or subject to the HI tax if they were hired before March 31, 1986, and they
are not covered by a voluntary agreement and are covered by a retirement plan.
Application of HI taxes to Federal employees
Medicare coverage (and the HI payroll tax) is mandatory for Federal employees.
Reasons for Change
Most workers pay HI taxes during their entire working lives. However, many State and
local government employees are not subject to the HI tax with respect to such employment yet
receive the same Medicare coverage as other workers, either through other employment or
spousal coverage. Expanding the HI tax to all State and local government workers would
increase the equity of the payroll tax system.
Description of Proposal
The proposal extends Medicare coverage on a mandatory basis to all employees of State
and local governments, without regard to their dates of hire or participation in a retirement
system. Such employees and their employers would become liable for the HI tax and the
employees would earn credit toward Medicare eligibility based on their covered earnings.
Effective Date
This proposal is effective with respect to wages for services performed in calendar years
beginning after the date of enactment.
Discussion
Extending the hospital insurance tax to all State and local employees places such
employees in a comparable position to most other workers, who pay the tax during their entire
working lives. Many State and local workers who do not pay the hospital insurance tax
nevertheless are covered by Medicare, either through other employment or spousal coverage. In
the case of State and local government workers who do not otherwise become eligible for
Medicare, the proposal would extend Medicare coverage. This may provide needed health
coverage for affected workers. Extending the tax to all State and local government employees
would also add needed funds to the Hospital Insurance Trust Fund.
Subjecting all State and local government employees to the hospital insurance tax would
increase the employment costs of State and local governments. However, over time, all State
and local government employees will be subject to the hospital insurance tax even if the proposal
is not adopted, as workers hired before April 1, 1986, retire or otherwise leave the employ of the
government, and are replaced with new employees who are subject to the tax. Thus, the proposal
may be viewed as merely accelerating the full effect of prior changes in the law with respect to
imposition of the hospital insurance tax.
Expanding Medicare coverage may increase to some extent costs of the Medicare
program.
D. Modify FICA Tax Exception for Students
(secs. 3121(b)(10) and 3306(c)(10))
Present Law
FICA and FUTA taxes
FICA
Under the Federal Insurance Contributions Act (''FICA''), a tax is imposed on wages paid
with respect to employment. 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 ($90,000 for
2005). 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.
For FICA tax purposes, ''wages'' generally includes all remuneration for employment,
and ''employment'' generally includes all service performed as an employee. However, some
forms of compensation are excepted from the definition of wages, such as employer-provided
health benefits. Similarly, certain types of services, or services performed by certain employees,
are excepted from the definition of employment. Compensation or services that are excepted
from the definition of wages or employment are not subject to FICA tax.
Under the Social Security Act, an individual's wages are credited to the individual's
earnings record for purposes of determining an individual's eligibility for Social Security
benefits and Medicare coverage and for purposes of determining the amount of an individual's
Social Security benefits. Eligibility for Social Security benefits and Medicare coverage is based
in part on credits (referred to as ''quarters of coverage'') received for wages. Up to four quarters
of coverage can be earned for a year, depending on total wages for the year and the amount
needed to earn each quarter of coverage. For 2005, credit for a quarter of coverage is provided
for each $920 of wages, with a maximum of four quarters of coverage for $3,680 in wages.
The Social Security Act provides exceptions to ''wages'' and ''employment'' that parallel
the FICA tax exceptions. Therefore, compensation or services that are not subject to FICA tax
are also not taken into account in determining Social Security benefits.
FUTA
Under the Federal Unemployment Tax Act (''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. Similar to FICA, ''wages'' for FUTA purposes generally includes all remuneration for
employment, and ''employment'' for FUTA purposes generally includes all service performed as
an employee. However, some forms of compensation are excepted from the definition of wages,
and certain types of services, or services performed by certain employees, are excepted from the
definition of employment.
Student exception
An exception from employment for FICA purposes applies in the case of certain services
performed by a student in the employ of a school, college, or university (the ''student
exception''). Specifically, FICA does not apply to services performed by a student who is
enrolled and regularly attending classes at the school, college, or university. A similar exception
applies for FUTA purposes. The legislative history of the FICA exception for students
provides that the exception is intended to apply to situations in which the employment is part-
time or intermittent and the total amount of earnings is only nominal, the payment of tax is
inconsequential and a nuisance, and the related benefit rights are also inconsequential.
The scope of the student exception has been the subject of uncertainty in recent years,
particularly with respect to its application to medical residents. In two cases, courts have held
that the student exception applies to medical residents performing services at a hospital or other
medical facility.
In February 2004, the IRS issued proposed regulations relating to the terms ''school,
college or university'' and ''student'' for purposes of the student exception. The preamble to
the proposed regulations states that guidance is needed to address situations in which the
performance of services and pursuit of a course of study are not separate and distinct activities,
but instead are to some extent intermingled. The IRS issued final regulations on December
21, 2004. The final regulations are applicable for services performed on or after April 1, 2005.
The provisions of the final regulations are discussed in the following sections.
Definition of school, college, or university
Under the regulations, an organization is considered a school, college, or university if:
(1) its primary function is the presentation of formal instruction; (2) it normally maintains a
regular faculty and curriculum; and (3) it normally has a regularly enrolled body of students in
attendance at the place where its educational activities are regularly carried on. This definition
is the same as under the proposed regulations. The preamble to the proposed regulations noted
that organizations (such as hospitals) providing on the job training typically carry on both
noneducational and educational activities and that the primary character of the organization
determines whether it is a school college, or university, not merely whether the organization
carries on some educational activities.
Student status
In general
Under the student exception, FICA does not apply to services performed by a student
who is enrolled and regularly attending classes at the school, college, or university. The
regulations provide that whether an employee has the status of a student is determined based on
the relationship of the employee with the organization employing the employee. In order to
have the status of a student, the employee must perform services for a school, college, or
university at which the student is enrolled and regularly attending classes in pursuit of a course
of study. In addition, the employee's services must be incident to and for the purpose of
pursuing a course of study at the school, college, or university. The regulations provide specific
criteria for applying these requirements.
Enrolled and regularly attending classes
An employee is enrolled within the meaning of the student exception if the employee is
registered for a course or courses creditable toward an educational credential. An educational
credential is a degree, certificate, or other recognized educational credential granted by a school,
college, or university.
For purposes of the ''regularly attending classes'' requirement, a class is an instructional
activity led by a faculty member, or other qualified individual hired by the school, college, or
university, for identified students following an established curriculum. Traditional classroom
activities are not the sole means of satisfying this requirement. For example, research activities
under the supervision of a faculty advisor necessary to complete the requirements for a Ph.D.
degree may constitute classes for this purpose. The frequency of these and similar activities
determines whether the employee may be considered to be regularly attending classes.
Incident to and for the purpose of pursuing a course of study
A course of study is one or more courses the completion of which fulfills the
requirements necessary to receive an educational credential granted by the school, college, or
university. A course of study also includes one or more courses at a school, college, or
university, the completion of which fulfills the requirements necessary for the employee to sit for
an examination required to receive certification by a recognized organization in a field.
Whether an employee's services are incident to and for the purpose of pursuing a course
of study is determined on the basis of the relationship of such employee with the organization for
which such services are performed as an employee. The educational aspect of the relationship,
as compared to the service aspect of the relationship, must be predominant in order for the
employee's services to be incident to and for the purpose of pursuing a course of study.
The educational aspect of the relationship is evaluated based on all the relevant facts and
circumstances related to the educational aspect of the relationship. The service aspect of
relationship is evaluated based on all the facts and circumstances related to the employee's
employment. The evaluation of the service aspect of the relationship is not affected by the fact
that the services performed by the employee may have an educational, instructional, or training
aspect. Except in the case of a full-time employee, whether the educational aspect or service
aspect of the relationship is predominant is determined by considering all the relevant facts and
circumstances.
Full-time employees
The regulations provide that the services of a full-time employee are not incident to and
for the purpose of pursuing a course of study. The determination of whether an employee is a
full-time employee is based on the employer's standards and practices, except that, regardless of
the employer's classification of the employee, an employee whose normal work schedule is 40
hours or more per week is considered a full-time employee.
Relevant factors for employees other than full-time employees
For employees who are not full-time employees, the employee's normal work schedule
and number of hours worked per week are relevant factors in evaluating the service aspect of the
employee's relationship with the employer. As an employee's normal work schedule or actual
number of hours worked approaches 40 hours per week, it is more likely that the service aspect
of the relationship is predominant. The regulations provide that certain other factors suggest that
the service aspect of the relationship is predominant. For example, status as a professional
employee (as defined in the regulations) suggests that the service aspect of the relationship is
predominant, especially if the employee is required to be licensed under State or local law to
work in the field in which the employee performs services. In addition, eligibility for certain
employment benefits suggests that the service aspect of the relationship is predominant.
Administrative safe harbor
In conjunction with the issuance of the final regulations, the IRS has provided a safe
harbor under which half-time undergraduate students and half-time graduate or professional
students enrolled at an institution of higher education are generally eligible for the student
exception. For purposes of the safe harbor, the term ''graduate or professional student'' does
not include a postdoctoral student, postgraduate fellow, medical resident, or medical intern. In
addition, the safe harbor does not apply to full-time employees, professional employees, or
employees who receive or are eligible for certain employment benefits. Employees who are not
eligible for the safe harbor (other than full-time employees) may qualify for the student
exception based on consideration of all the facts and circumstances.
Application of FICA exceptions containing dollar limits
Some FICA exceptions are subject to dollar limits. For example, cash remuneration of
less than a specified amount ($1,400 for 2005) paid to an employee in a year for domestic service
in a private home is exempt from FICA. Similarly, cash remuneration of less than $150 paid
to an employee in a year for agricultural labor may be exempt from FICA. The FICA rules
provide that, in cases in which a FICA exception is subject to a dollar limit, the employer may
withhold the employee share of FICA from payments made to the employee even though, at the
time of payment, the total amount paid to the employee is less than the limit and, thus, may be
exempt from FICA. Otherwise, once the total payments to the employee reach the limit, the
employer must withhold the employee share of FICA that was not withheld from previous
payments, in addition to withholding FICA with respect to current payments. Withholding the
employee share of FICA from payments made before the limit is reached may result in erroneous
withholding; however, it avoids the need to withhold additional FICA amounts once the limit is
reached.
The IRS has established procedures for situations in which FICA taxes are erroneously
withheld from an employee's pay. Under these procedures, the employer generally repays the
employee for the erroneously withheld amount. In addition, if the employer has paid the
erroneously withheld amount to the IRS, the employer may take credit for the amount in
determining future taxes that must be paid to the IRS.
Reasons for Change
As indicated in legislative history, the student exception to FICA is intended to be
narrow, applying to employment that is part-time or intermittent and involves nominal earnings.
However, it appears that the student exception may be viewed by certain taxpayers as applying
more broadly to include situations that are similar to full-time employment. Although recent IRS
regulations help to clarify the scope of the student exception, clear statutory standards would
make the exception more administrable. In addition, the original intent of the exception can be
implemented more effectively through a dollar limit.
Description of Proposal
In general
The proposal codifies the IRS regulations that clarify the scope of the present-law student
exception. In addition, the proposal amends the student exception so that it does not apply to
individuals whose earnings subject to the exception exceed an annual dollar limit. The proposal
also applies for purposes of determining wages for Social Security and Medicare purposes.
Codification of regulations
The proposal codifies the regulations relating to the definition of ''school, college, or
university.'' Thus, the student exception applies to services performed for an organization only
if: (1) its primary function is the presentation of formal instruction; (2) it normally maintains a
regular faculty and curriculum; and (3) it normally has a regularly enrolled body of students in
attendance at the place where its educational activities are regularly carried on.
The proposal also codifies the regulations relating to student status, including whether:
(1) the student is enrolled and regularly attending classes in pursuit of a course of study at the
school, college, or university for which the services are performed; and (2) the services are
incident to and for the purpose of pursuing a course of study at the school, college, or university.
Under the proposal, the Secretary of Treasury has explicit authority to provide rules for
determining student status, including criteria such as those provided in the regulations. Thus, for
example, it is expected that, under the proposal, as under the regulations, services of a full-time
employee are not incident to and for the purpose of pursuing a course of study, so the student
exception does not apply to a full-time employee.
Annual dollar limit
Under the proposal, the student exception applies to an individual for a year only if the
individual's earnings from the school, college, or university are less than the amount needed to
receive a quarter of FICA coverage for the year ($920 for 2005). Thus, if an individual's
earnings exceed the limit, the individual's earnings are subject to FICA, regardless of whether
the individual otherwise meets the requirements for the student exception. If the limit is
exceeded, all of the individual's earnings are subject to FICA, including earnings up to the limit,
thus enabling the individual to receive at least one quarter of coverage for the year.
Under the proposal, the rules and procedures relating to the withholding of the employee
share of FICA that apply under present law in the case of FICA exceptions that are subject to
dollar limits apply also for purposes of the student exception. For example, the employer may
withhold the employee share of FICA from payments made to the employee even though, at the
time of payment, the total amount paid to the employee is less than the limit.
Effective Date
The proposal relating to codification of the regulations is effective on the date of
enactment.
The proposal relating to a dollar limit on the student exception is effective with respect to
wages for services performed in calendar years beginning after the date of enactment.
Discussion
As indicated by its legislative history, the present-law student exception is intended to
apply to situations in which the employment is part-time or intermittent, the total amount of
earnings is only nominal, and the tax involved and the related Social Security benefit rights are
inconsequential. Over time, however, it appears that the exception has been applied to situations
beyond those intended, such as: (1) employees performing services on a full-time or close to
full-time basis; (2) professional services that have an educational component, but that primarily
further the work of the employer rather than the education of the employee; and (3) services
performed in the employ of an organization other than a school, college, or university.
Uncertainty as to the proper scope of the student exception results in part from a lack of
clear standards for applying the exception. The regulations provide standards that enable the IRS
and taxpayers to determine more accurately whether the exception applies. The proposal to
codify the regulations is likely to make the exception more administrable and improve
compliance.
The proposal to apply a dollar limit to the student exception is also consistent with the
original intent of the student exception to apply in situations in which total earnings are nominal
and benefit rights inconsequential. Under the proposal, the exception is limited to students
whose earnings are too small to provide a quarter of coverage for Social Security benefit
purposes. This will relieve employers and employees from having to pay small amounts of
FICA taxes that do not result in a quarter of coverage, while enabling students whose earnings
are high enough to result in at least one quarter of coverage to receive Social Security credit.
The use of a dollar limit also provides a clearer standard for applying the student
exception, which makes the exception easier for the IRS and taxpayers to apply. For example, if
an individual's pay rate and work schedule are such that the individual's earnings will exceed the
limit, it is unnecessary to determine whether the individual's services are performed as an
incident to and for the purpose of pursuing a course of study. Administrative issues may arise as
to the proper FICA treatment of amounts paid to an employee before the limit is reached,
particularly with respect to whether the employer may withhold the employee share of FICA.
The proposal addresses such issues by applying the rules and procedures that apply in similar
situations under present law.
The proposal has the effect of increasing FICA taxes for some employers and employees,
as well as increasing revenues for the Social Security and Medicare programs. The proposal also
results in additional wages for Social Security and Medicare purposes. In many cases, credit for
wages earned while a student will have little, if any, effect on an individual's eligibility for
Social Security benefits or Medicare coverage. However, in some cases, particularly employees
with short work histories, these earnings may establish eligibility for disability or death benefits.
To the extent that the proposal expands eligibility for Social Security benefits or Medicare
coverage, it may also increase the long-term costs of the Social Security and Medicare programs.
In many cases, a school, college, or university provides employment to students in part as
a form of financial aid. In such cases, application of FICA as a result of the proposal may be
viewed as a cutback on an education-related tax benefit. However, legislative history does not
indicate that the student exception is intended as an education-related tax benefit. In addition,
the student exception creates inappropriate disparities in the FICA tax treatment of students
employed by the school, college, or university where they attend classes and students employed
by other employers. The proposal reduces these disparities.
E. Apply Employment Taxes to Sales Incentive Payments
Made by Manufacturers
(secs. 3121, 3306, and 3401)
Present Law
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'').
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 ($90,000 for 2005). 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.
Employment taxes apply to all compensation for employment (including commissions
and other sales incentives) unless an exception applies. Generally all amounts received in
connection with the performance of services are considered compensation, even if paid by a
person other than the person for whom services are performed. In addition, if compensation is
paid to an employee by a person other than the employer, the payor is generally responsible for
complying with the applicable employment tax requirements, regardless of whether an
employment relationship exists between the employee and the payor. In such circumstances,
all compensation paid to the employee, whether paid by the employer or by another person, is
taken into account in applying the OASDI and FUTA wage bases. Thus, a single OASDI or
FUTA wage base applies to all such compensation.
FICA tax does not apply to individuals engaged in a trade or business. Instead, such
individuals are subject to tax under the Self-Employment Compensation Act (''SECA'') on their
net earnings from self-employment (generally defined as income derived from a trade or
business, less the deductions attributable to the trade or business). For SECA purposes, the
term ''trade or business'' generally does not include the performance of services as an
employee. Thus, SECA tax does not apply to compensation paid to an employee.
In various situations, the Internal Revenue Service (''IRS'') has ruled that amounts
received by employees from a person other than the employer as compensation for services for
the employer are wages for employment tax purposes. This position applies, for example, to:
(1) salaries paid by a racing association to race track stewards employed by the state racing
board; (2) a baseball league's receipts from post-season play distributed among players
employed by the teams in the league; and (3) compensation paid by colleges and universities to
athletic contest officials employed by an athletic association. However, IRS guidance has held
that commissions or other sales incentives paid by a manufacturer or distributor (referred to
herein as ''sales incentive payments'') to sales people employed by a dealer are compensation for
services for the manufacturer or distributor, rather than for services for the dealer. IRS
guidance holds that the sales incentive payments are not wages because the sales people are not
employees of the manufacturer or dealer. Thus, the sales incentive payments are includible in
income by the sales people, but are not subject to FICA, FUTA or income tax withholding. The
IRS has also indicated that sales incentive payments are not subject to SECA tax.
Reasons for Change
Under current IRS guidance and practices, sales incentive payments made by
manufacturers or distributors to employees of a dealer are not subject to either FICA or SECA
taxes, even though such payments are compensation for services. Such payments, like other
compensation paid to employees, should be subject to employment taxes.
Description of Proposal
Under the proposal, sales incentives payments made by manufacturers or distributors to
sales people employed by dealers are wages for employment tax purposes, regardless of whether
an employment relationship exists between the sales people and the manufacturers or
distributors. Thus, sales incentive payments are subject to FICA, FUTA, and income tax
withholding, unless an exception applies. Consistent with present law, the manufacturer or
distributor is responsible for complying with applicable employment tax requirements with
respect to sales incentive payments. Also, as under present law, all wages paid to sales people,
including sales incentive payments, are taken into account in applying the OASDI and FUTA
wage bases.
Effective Date
The proposal is effective with respect to sales incentive payments for services performed
in calendar years beginning after the date of enactment.
Discussion
Under present law, amounts received for services performed by an employee from a
person other than the employer are generally treated as wages to the same extent as amounts
received from the employer. Although services performed by sales people who are the
employees of a dealer benefit the manufacturers and distributors of the products sold, treating
sales incentive payments as compensation for services for the manufacturer or distributor creates
an artificial standard that causes inconsistent employment tax results. In effect, by structuring
compensation as payments from a manufacturer or dealer, the parties can determine among
themselves to what extent compensation will be subject to employment taxes. This undermines
the employment tax base.
Sales incentive payments are compensation for services and, therefore, should be subject
either to FICA or SECA taxes. The proposal imposes FICA taxes rather than SECA taxes
because this is consistent with IRS position in other, similar cases, as well as with judicial
precedents. In addition, compliance is greater with respect to payments subject to FICA and
wage withholding than with respect to other payments.
The proposal has the effect of increasing FICA taxes for employees who receive
commissions and other sales incentives from manufacturers or distributors and increasing FICA
and FUTA taxes for the manufacturers or distributors. The proposal also increases revenues for
the Social Security, Medicare, and unemployment programs. The proposal also results in
additional wages for these purposes, which is likely to increase benefits for some individuals, as
well as long-term costs under such programs.
Manufacturers and distributors who pay commissions or other sales incentives are subject
to additional administrative requirements under the proposal, such as withholding FICA and
income taxes from the payments, depositing employment taxes, and filing employment tax
returns. However, manufacturers and distributors who are employers are already subject to these
requirements with respect to other wages.
Under present law, commissions and other sales incentives paid by a manufacturer or
dealer are includible in income, but are not subject to income tax withholding. As a result, an
individual who receives such amounts generally must either adjust the amount of income tax
withheld from his or her wages or pay quarterly estimated taxes. Otherwise, the individual may
have to pay additional taxes when filing his or her return and could be subject to a penalty.
Applying withholding to these amounts is likely to result in better coordination between the
amount of tax withheld and the individual's tax liability, leading to improved compliance.
F. Modify Determination of Amounts Subject to Employment or Self-Employment
Tax for Partners and S Corporation Shareholders
(sec. 1402)
Present Law
In general
As part of the financing for Social Security and Medicare benefits, a tax is imposed on
the wages of an individual received with respect to his or her employment under the Federal
Insurance Contributions Act (the FICA tax). A similar tax is imposed on the net earnings
from self-employment of an individual under the Self-Employment Contributions Act (the SECA
or self-employment tax).
FICA tax
In general
The FICA tax has two components. Under the old-age, survivors, and disability
insurance component (OADSI), the rate of tax is 12.40 percent, half of which is imposed on the
employer, and the other half of which is imposed on the employee. The amount of wages
subject to this component is capped at $90,000 for 2005. Under the hospital insurance
component (HI), the rate is 2.90 percent, also split equally between the employer and the
employee. The amount of wages subject to the HI component of the tax is not capped. The
wages of individuals employed by a business in any form (for example, a C corporation)
generally are subject to the FICA tax.
S corporation shareholders
An S corporation is treated as a pass-through entity for Federal income tax purposes, and
its income generally is taxed to the shareholders. A shareholder of an S corporation who
performs services as an employee of the S corporation is subject to FICA tax on his or her
wages, but generally is not subject to FICA tax on amounts that are not wages (such as
distributions to shareholders). Nevertheless, an S corporation employee is subject to FICA
tax on the amount of his or her reasonable compensation, even though the amount may have
been characterized as other than wages. A significant body of case law has addressed the issue
of whether amounts paid to shareholder-employees of S corporations constitute reasonable
compensation and therefore are wages subject to the FICA tax, or rather, are properly
characterized as another type of income that is not subject to FICA tax.
In cases addressing whether payments to an S corporation shareholder-employee were
wages for services or were corporate distributions, courts have recharacterized a portion of
corporate distributions as wages if the shareholder performing services did not include any
amount as wages. In recent cases involving whether reasonable compensation was paid (not
exclusively in the S corporation context), courts have applied a multi-factor test to determine
reasonable compensation, including such factors as whether the individual's compensation was
comparable to compensation paid at comparable firms. The Seventh Circuit, however, has
adopted an "independent investor" analysis differing from the multi-factor test in that it asks
whether an inactive, independent investor would be willing to compensate the employee as he
was compensated. The independent investor test has been examined and partially adopted in
some other Circuits, changing the analysis under the multi-factor test.
Self-employment tax
In general
The self-employment tax rate has two components. Under the OASDI component, the
rate of tax is 12.40 percent. Under the HI component, the rate is 2.90 percent. The amount
subject to self-employment tax under the OASDI component is capped at $90,000 of self-
employment income (for 2005). However, the amount of self-employment income subject to the
HI component is not capped.
In the case of an individual with self-employment income, the income subject to self-
employment tax is the net earnings from self-employment. This equals the gross income
derived by an individual from any trade or business carried on by the individual, less the
deductions attributable to the trade or business that are allowed under the self-employment tax
rules. Specified types of income or loss are excluded, such as rentals from real estate in certain
circumstances, dividends and interest, and gains or loss from the sale or exchange of a capital
asset or from timber, certain minerals, or other property that is neither inventory nor held
primarily for sale to customers.
Partners (including LLC members)
For an individual who is a partner in a partnership, the net earnings from self-
employment generally include the partner's distributive share (whether or not distributed) of
income or loss from any trade or business carried on by the partnership. This rule applies to
individuals who are general partners. Specified types of income or loss are excluded from net
earnings from self-employment of a partner, such as rentals from real estate in certain
circumstances, dividends and interest, gains or loss from the sale or exchange of a capital asset or
from timber, certain minerals, or other property that is neither inventory nor held primarily for
sale to customers, and retirement payments from the partnership if the partner rendered no
services for the partnership and certain other requirements are met.
A special rule applies for limited partners of a partnership. In determining a limited
partner's net earnings from self-employment, an exclusion is provided for his or her distributive
share of partnership income or loss. The exclusion does not apply with respect to guaranteed
payments to the limited partner for services actually rendered to or on behalf of the partnership to
the extent that those payments are established to be in the nature of remuneration for those
services. This special rule reflects State law at the time it was enacted in 1977, under which
limited partners ordinarily were not permitted to participate in management of the partnership's
activities without losing their limited liability protection. In recent years, State law has been
changing, with the result that individuals who are limited partners under applicable State law
may participate in the management and operations of the partnership without jeopardizing their
limited liability. This change in the State law rules for limited partners parallels the expansion
of limited liability companies.
Limited liability companies are a relatively new form of business entity provided under
State law, in which members generally may participate in the management and operations of the
business, though they are protected from liability for its debts and obligations. Limited liability
companies generally may choose to be classified as partnerships rather than as corporations for
Federal income tax purposes. The owners of a limited liability company that is classified as a
partnership for tax purposes are treated as partners for Federal income tax purposes. However,
under State law, limited liability company owners are not defined as either general partners or
limited partners.
In 1997, the Treasury Department issued proposed regulations defining a limited partner
for purposes of the self-employment tax rules. These regulations provided, among other
things, that an individual is not a limited partner if the individual participates in the partnership
business for more than 500 hours during the taxable year. In response, in the Taxpayer Relief
Act of 1997, the Congress imposed a moratorium on regulations regarding employment taxes of
limited partners. The moratorium provided that any regulations relating to the definition of a
limited partner for self-employment tax purposes could not be issued or effective before July 1,
1998. No regulations have been proposed or finalized since then.
Reasons for Change
The employment tax treatment of partners who are neither limited nor general partners is
uncertain. In particular, owners of a limited liability company may view themselves as
comparable to limited partners, even though they are not limited partners under applicable State
law. This uncertainty makes compliance with the law difficult for taxpayers and administration
of the law difficult for the IRS. The uncertainty in treatment creates an opportunity for abuse by
taxpayers willing to make the argument that they are not subject to any employment tax (FICA
or self-employment), even though this argument is contrary to the spirit and intent of the
employment tax rules. In addition, the increasing ability of individuals who are limited partners
under State law to perform services for the partnership suggests that the limited partner rule is
out of date and should be changed.
It has become increasingly common for individuals who perform services in businesses
that they own to choose the S corporation form to seek to reduce their FICA taxes. S corporation
shareholders may pay themselves wages below the wage cap, while treating the rest of their
compensation as a distribution by the S corporation in their capacity as shareholders. They
may take the position that no part of the S corporation distribution to them as shareholders is
subject to FICA tax. While present law provides that the entire amount of an S corporation
shareholder's reasonable compensation is subject to FICA tax in this situation, enforcement of
this rule by the government may be difficult because it involves factual determinations on a case-
by-case basis.
More broadly, there are significant differences in the employment tax treatment of
individuals who are owners of interests in passthrough entities and who perform services in the
business. S corporation shareholder-employees are treated like other employees (i.e., subject to
FICA), whereas a broader category of income of some partners (other than limited partners) is
subject to self-employment tax. These discontinuities cause taxpayers' choice-of-business form
decisions to be motivated by a desire to avoid or reduce employment tax, rather than by nontax
considerations.
Description of Proposal
Treatment of partners
Under the proposal, the present-law rule for general partners generally applies to any
partner for determining net earnings from self-employment. Thus, all partners are subject to self-
employment tax on their distributive share (whether or not distributed) of partnership income or
loss. As under present law, specified types of income or loss are excluded from net earnings from
self-employment of a partner, such as certain rental income, dividends and interest, certain gains,
and other items. However, under the proposal, in the case of a service partnership, all of the
partner's net income from the partnership is treated as net earnings from self-employment. A
service partnership is a partnership, substantially all of whose activities involve the performance
of services in the fields of health, law, engineering, architecture, accounting, actuarial science,
performing arts, or consulting (similar to sec. 448(d)(2)).
If, however, any partner (regardless of whether he or she is a general partner, limited
partner, or neither a general nor limited partner, such as a limited liability company member)
does not materially participate in the trade or business of the partnership, a special rule provides
that only the partner's reasonable compensation from the partnership is treated as net earnings
from self-employment. Thus, some general partners who would be subject to self-employment
tax on their distributive share of partnership income under present law will be subject to tax only
on reasonable compensation from the partnership under the proposal.
Treatment of S corporation shareholders
Under the proposal, for purposes of employment tax, an S corporation is treated as a
partnership and any shareholders of the S corporation are treated as general partners. Thus, S
corporation shareholders are subject to self-employment tax on their shares of S corporation net
income (whether or not distributed) or loss. As under the present-law self-employment tax rules,
specified types of income or loss are excluded from net earnings from self-employment of a
shareholder, such as certain rental income, dividends and interest, certain gains, and other items.
However, under the proposal, in the case of a service business, all of the shareholder's net
income from the S corporation is treated as net earnings from self-employment. A service S
corporation is one, substantially all of whose activities involve the performance of services in the
fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or
consulting (similar to sec. 448(d)(2)).
If a shareholder does not materially participate in the trade or business activity of the S
corporation, a special rule provides that only reasonable compensation from the S corporation is
treated as net earnings from self-employment.
Effective Date
The proposal is effective for taxable years of partners or S corporation shareholders (as
the case may be) beginning after the date of enactment.
Discussion
Treatment of partners
The proposal changes the self-employment tax treatment of partners to take account of
changes in applicable State law and in business practices. Limited liability companies are
generally treated as partnerships '' and their owners as partners '' for Federal income tax
purposes. Nevertheless, limited liability company owners are neither general nor limited
partners under applicable State law. Applying the present-law self-employment tax rules, which
refer specifically to general and limited partners, to limited liability company owners has raised
difficult questions of interpretation, creating complexity and compliance problems for both
taxpayers and tax administrators. The proposal ends the present-law uncertainty by identifying a
minimum base on which all partners must pay employment tax.
The reference in the self-employment tax rules to ''limited partners'' does not reflect
changes in State limited partnership laws permitting individuals designated as limited partners
under State law to perform management services as well as other services for the partnership.
The present-law rule limiting the amount of self-employment tax of a limited partner to the
amount of guaranteed payments does not treat partners performing services comparably, and
should be conformed to the rule for general partners.
The conceptual premise of the proposal is that the base for the employment and self-
employment tax should be labor income. Historically, the tax has applied to labor income,
relating very roughly to the rules for accruing benefits under the Social Security system, which
requires the individual to perform quarters of labor. The proposal applies this notion more
uniformly than does present law to individuals who perform services for or on behalf of a
passthrough entity in which they own an interest (i.e., a partnership, limited liability company, or
S corporation). The proposal treats such individuals similarly to sole proprietors, as well as
similarly to each other. Not only does this more uniform treatment improve the fairness of the
tax law and increase the internal theoretical consistency of the tax rules, it also tends to improve
tax neutrality by reducing the importance of FICA and self-employment tax differences in
taxpayers' choice of business entity.
Previous proposals in this area have sought greater theoretical purity by proposing a
carve-out from the self-employment tax for income from the business that is from capital rather
than from labor. Under this approach, an attempt is made to determine a reasonable return
from partnership capital, which is excluded from the partner's self-employment income. This
type of approach raises administrability concerns, as rates of return can vary significantly among
different types of businesses, at different times in the life of a business activity, and with
different management of the business, among other factors. By contrast, the proposal (like
present law) generally provides that certain readily identifiable types of income such as
dividends, interest and rents that generally are not labor income are not subject to self-
employment tax. Only in the case of a service business, typically one in which income is
primarily from labor rather than capital, is this rule not applicable under the proposal. The
proposal does eliminate readily identifiable capital income from the self-employment tax base,
but does not require a factual inquiry on a case-by-case basis as to what income of the
partnership may be attributable to capital, and therefore is more predictable and more
administrable than other approaches.
As a means of further isolating labor income of partners that is subject to self-
employment tax, the proposal provides that if a partner does not materially participate in the
trade or business of the partnership, only the partner's reasonable compensation from the
partnership is treated as net earnings from self-employment. Material participation is a
standard that has been frequently applied since its enactment in 1986 as a component of the
passive loss rules (sec. 469). Though it does require a factual inquiry, the standard is well
developed in the section 469 regulations.
Though also a factual inquiry, the question of whether an individual's compensation is
reasonable is one that has been repeatedly addressed in case law. The addition of the
independent investor test used in the Seventh Circuit and partially adopted in some other Circuits
has changed the previously predictable analysis under the multi-factor test applied in many
judicial decisions to determine reasonable compensation. It could be questioned whether the
determination of reasonable compensation has the predictability that is desirable in a legislative
proposal, given the changing analysis among the Circuit courts. However, the proposal looks to
reasonable compensation to determine net earnings from self employment only if the individual
does not materially participate in the trade or business, limiting the situations in which this
standard applies under the proposal.
Treatment of S corporation shareholders
In addition to addressing the issues that relate also to partners (discussed above), the
proposal relating to S corporation shareholders serves the purpose of minimizing present-law
opportunities to avoid the employment tax by recharacterizing wages as some other type of S
corporation distribution. Disparate treatment of wages and other distributions under present law
creates an undesirable incentive for individuals performing services to avoid FICA tax on labor
income, including on the uncapped HI component, by setting up business as an S corporation and
characterizing as wages a small amount of service income below the wage cap, while the rest is
passed through the S corporation to the shareholder-employee free of FICA tax.
The self-employment tax (and the earlier-instituted FICA tax) were originally designed
both to measure Social Security benefit accruals by determining whether individuals earned
income from working, and to collect revenues to fund such benefit accruals. However,
taxpayers' incentives have changed as the wage base and the resulting tax cost to individual
taxpayers of accruing benefits has risen, and the value of Social Security benefits to high-income
taxpayers has become relatively lower as a percentage of income. The motivation of higher-
income taxpayers to avoid the tax was further increased by the elimination of the cap on the HI
component of the tax by the Revenue Reconciliation Act of 1993. Rather than having an
incentive to accrue benefits, taxpayers now have the opposite incentive: to avoid or reduce the
tax cost, which may exceed the value to them of the social insurance benefit. The tax rules are
not currently designed to prevent avoidance, and indeed, may facilitate it because the rules apply
unevenly depending on whether the taxpayer chooses to do business through an S corporation,
partnership, or sole proprietorship. Eliminating this unevenness not only increases the fairness
of the tax as between similarly situated taxpayers, but also is consistent with a purpose to raise
revenue among all workers comparably. Under the proposal, the employment tax rules no longer
skew taxpayers' choice of business entity because of differing FICA and self-employment tax
results. By treating S corporation shareholders who perform services for or on behalf of the S
corporation in the same manner as partners who perform services for or on behalf of the
partnership, the proposal improves the neutrality of the tax law.
The proposal has the effect of applying the self-employment tax collection system to S
corporation shareholder-employees, rather than the withholding regime that applies to them
(along with other employees) under the present-law FICA tax rules. Withholding may be a more
effective and faster collection mechanism than self-assessment as under the self-employment
rules. However, preserving a withholding regime on S corporation shareholder wages, and
imposing self-employment tax only on the portion of the shareholder's distributive share that
exceeds previously taxed wages, would require a mechanism to prevent double-counting from
one taxable year to the next, which could impose additional administrative and recordkeeping
burdens on the S corporation. Further, the detriment of eliminating FICA withholding on S
corporation shareholder employees is offset by the dual benefits under the proposal of improving
tax neutrality and reducing tax avoidance. Therefore, the proposal applies the self-employment
tax rules to S corporation shareholder-employees in the same manner that those rules apply to
partners.
IV. PENSIONS AND EMPLOYEE BENEFITS
A. Conform Definition of Qualified Medical Expenses
(secs. 105, 106, 213, 220, and 223)
Present Law
Itemized deduction for medical expenses
Under present law, expenses for ''medical care'' are deductible as an itemized deduction
to the extent that a taxpayer's aggregate medical expenses exceed 7.5 percent of the taxpayer's
adjusted gross income. For this purpose, ''medical care'' is defined as under section 213(d),
described below, except that expenses for medicines and drugs can be taken into account only if
the medicine or drug is prescribed or is insulin (sec. 213(b)).
Exclusion for amounts received under employer-sponsored accident or health plans
Present law provides that amounts received under an accident or health plan for
employees are excludable from gross income to the extent the amounts are paid directly or
indirectly to the taxpayer to reimburse the taxpayer for expenses incurred by the taxpayer for the
medical care (as defined in sec. 213(d)) of the taxpayer or the taxpayer's spouse or
dependents. Arrangements commonly used by employers to reimburse medical expenses of
their employees (and their spouses and dependents) include health flexible spending
arrangements (''FSAs'') and health reimbursement accounts (''HRAs'').
Health FSAs are typically funded on a salary reduction basis, meaning that employees are
given the option to reduce current compensation and instead have the compensation used to
reimburse the employee for medical expenses. If the health FSA meets certain requirements,
then the compensation that is forgone is not includible in gross income or wages and
reimbursements for medical care (as defined under sec. 213(d)) from the health FSA are
excludable from gross income and wages. Health FSAs are subject to certain requirements,
including rules that require that FSAs have certain characteristics similar to insurance, and that
they not provide deferred compensation. One of these rules is the so-called ''use-it-or-lose-it
rule,'' which provides that any amounts remaining in the health FSA at the end of the year that
are not used to reimburse expenses are forfeited by the employee.
HRAs operate in a manner similar to health FSAs, in that they are an employer-
maintained arrangement that reimburses employees for medical expenses (as defined under sec.
213(d)). Some of the rules applicable to HRAs and health FSAs are similar, e.g., the amounts in
the arrangements can only be used to reimburse medical expenses and not for other purposes.
Some of the rules are different. For example, HRAs cannot be funded on a salary reduction basis,
and amounts remaining at the end of the year are carried forward to be used to reimburse medical
expenses in the next year.
Health savings accounts; Archer medical savings accounts
Present law provides that individuals with a high deductible health plan (and no other
health plan other than a plan that provides certain permitted coverage) may establish a health
savings account (''HSA''). Subject to certain limitations, contributions to an HSA are deductible
above-the-line if made by the individual and are excludable from income if made by the
employer (including contributions made through a cafeteria plan through salary reduction).
Earnings on contributions to an HSA accumulate on a tax-free basis. Distributions from an HSA
that are for qualified medical expenses are excludable from gross income. ''Qualified medical
expenses'' are expenses for medical care (as defined under sec. 213(d)) for the taxpayer and his
or her spouse and dependents (except that health insurance is generally not a qualified medical
expense for HSA purposes).
Archer medical savings accounts (''MSAs'') are similar to, but generally less favorable
than, the more recently enacted HSAs. Like HSAs, Archer MSAs allow contributions to
accumulate earnings on a tax-free basis. Distributions used for medical expenses are excludable
from gross income. The definition of medical expense is similar to that used for HSAs. After
2005, generally no new MSAs may be established.
Definition of medical care
Section 213(d) defines ''medical care'' to mean amounts paid for: (1) the diagnosis, cure,
mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or
function of the body; (2) transportation primarily for and essential to medical care referred to in
(1); (3) qualified long-term care services; and (4) insurance covering medical care referred to in
(1) or (2), or for eligible long-term care premiums for a qualified long-term care insurance
contract. Expenditures for items that are merely beneficial to the general health of an
individual, such as expenditures for vacation or vitamins, are not medical care. Expenditures for
''medicines and drugs'' are medical care. Toiletries (e.g., toothpaste), cosmetics (e.g., face
creams), and sundry items are not ''medicines and drugs'' and amounts expended for such items
are not expenditures for ''medical care.'' In general, cosmetic surgery and similar procedures do
not constitute medical care.
For purposes of the exclusions for reimbursements under employer accident and health
plans and distributions from HSAs, the limitation (applicable to the itemized deduction) that only
prescription medicines or drugs and insulin are taken into account does not apply. Thus, for
example, amounts paid from an FSA, HRA, or HSA to reimburse the employee for
nonprescription drugs, such as nonprescription aspirin, allergy medicine, antacids, or pain
relievers, are excludable from income; however, if the employee paid for such amounts directly
(without such reimbursement), the expenses could not be taken into account in determining the
itemized deduction for medical expenses.
Reasons for Change
Under present law, individuals who work for an employer that has a reimbursement plan
and individuals with an HSA can purchase nonprescription medicines and drugs, such as aspirin,
on a tax-free basis. However, individuals who purchase such items absent such arrangements
must do so on an after-tax basis. Eliminating this disparity would increase the fairness of the
Federal tax system. In addition, the present-law rule for employer plans provides a tax subsidy
for what are routine personal expenses.
Description of Proposal
Under the proposal, the definition of medical expenses for purposes of the tax treatment
of reimbursements from employer-sponsored accident and health plans, HSAs, and MSAs are
conformed to the definition of medical expenses that may be taken into account for purposes of
the itemized deduction for medical expenses. For example, under the proposal, nonprescription
medicines could not be reimbursed through an FSA.
Effective Date
The proposal is effective for expenses paid or incurred in taxable years beginning after
the date of enactment.
Discussion
As described above, present law contains a variety of provisions that provide tax benefits
for medical expenses. The exclusion for employer-provided health benefits is generally justified
on the ground that it encourages employees to prefer health benefits over taxable wages, thereby
increasing the number of individuals with health insurance coverage. A generally stated purpose
for HSAs combined with high deductible plans is to provide an incentive for individuals to be
more cognizant of health care expenses. The policy behind the itemized deduction for medical
expenses is that such expenses generally are not discretionary and that high levels of such
expenses adversely impact the individual's ability to pay taxes. The present-law definition of
''medical care'' for each of these provisions creates inequities in the Federal tax system because
individuals with similar expenses receive differing treatment.
Personal expenses are generally not deductible for Federal income tax purposes.
Providing a tax subsidy for over-the-counter medicines may be likened to providing a deduction
for personal expenses. Such medicines (e.g., aspirin and cough syrup) are often routine purchases
made by most taxpayers. Providing a tax subsidy for the purchase of over-the-counter medicine
is not integral to the policy objectives of the present-law provisions for health expenses, and may
be counter to such policies.
Providing a subsidy for over-the-counter medicines may also result in result in less
compliance, as it may be more difficult to distinguish products that are medical from those that
are not, such as toiletries and products that promote general health. Thus, continuing to
subsidize such expenses may lead more taxpayers to claim tax benefits for such general health
products.
Some argue that certain over-the-counter medicines are, like prescription drugs,
expensive and not routine for most taxpayers. Also, some over-the-counter products, such as
certain allergy medicines and smoking cessation products, were recently available by
prescription only. Some argue that it is appropriate to provide a subsidy for some of these
products.
B. Limit Deduction for Personal Use of Company Aircraft and Other
Entertainment Expenses
(sec. 274(e))
Present Law
In general
Under present law, no deduction is allowed with respect to (1) an activity generally
considered to be entertainment, amusement or recreation, unless the taxpayer establishes that the
item was directly related to (or, in certain cases, associated with) the active conduct of the
taxpayer's trade or business, or (2) a facility (e.g., an airplane) used in connection with such
activity. The Code includes a number of exceptions to the general rule disallowing deductions
of entertainment expenses. Under one exception, the deduction disallowance rule does not apply
to expenses for goods, services, and facilities to the extent that the expenses are reported by the
taxpayer as compensation and wages to an employee. The deduction disallowance rule also
does not apply to expenses paid or incurred by the taxpayer for goods, services, and facilities to
the extent that the expenses are includible in the gross income of a recipient who is not an
employee (e.g., a nonemployee director) as compensation for services rendered or as a prize or
award. The exceptions apply only to the extent that amounts are properly reported by the
company as compensation and wages or otherwise includible in income. In no event can the
amount of the deduction exceed the amount of the actual cost, even if a greater amount is
includible in income.
Except as otherwise provided, gross income includes compensation for services,
including fees, commissions, fringe benefits, and similar items. In general, an employee or other
service provider must include in gross income the amount by which the fair value of a fringe
benefit exceeds the amount paid by the individual. Treasury regulations provide rules regarding
the valuation of fringe benefits, including flights on an employer-provided aircraft. In general,
the value of a non-commercial flight is determined under the base aircraft valuation formula, also
known as the Standard Industry Fare Level formula or ''SIFL''. If the SIFL valuation rules do
not apply, the value of a flight on a company-provided aircraft is generally equal to the amount
that an individual would have to pay in an arm's-length transaction to charter the same or a
comparable aircraft for that period for the same or a comparable flight.
In the context of an employer providing an aircraft to employees for nonbusiness (e.g.,
vacation) flights, the exception for expenses treated as compensation was interpreted in
Sutherland Lumber-Southwest, Inc. v. Commissioner (''Sutherland Lumber'') as not limiting the
company's deduction for operation of the aircraft to the amount of compensation reportable to its
employees, which can result in a deduction many times larger than the amount required to be
included in income. In many cases, the individual including amounts attributable to personal
travel in income directly benefits from the enhanced deduction, resulting in a net deduction for
the personal use of the company aircraft.
Covered employees
The American Jobs Creation Act of 2004 (''AJCA''), modified the exceptions in the
case of covered employees such that the exceptions to the general entertainment expense
disallowance rule for expenses treated as compensation or includible in income apply only to the
extent of the amount of expenses treated as compensation or includible in income of the covered
employee. Thus, Sutherland Lumber was overturned only with respect to covered employees.
Covered employees are individuals who, with respect to an employer or other service recipient,
are subject to the requirements of section 16(a) of the Securities and Exchange Act of 1934, or
would be subject to such requirements if the employer or service recipient were an issuer of
equity securities referred to in section 16(a). Such individuals generally include officers (as
defined by section 16(a)), directors, and 10-percent-or-greater owners of private and publicly-
held companies.
As a result of the enactment of AJCA, in the case of covered employees, no deduction is
allowed with respect to expenses for (1) a nonbusiness activity generally considered to be
entertainment, amusement or recreation, or (2) a facility (e.g., an airplane) used in connection
with such activity to the extent that such expenses exceed the amount treated as compensation or
includible in income to the covered employee. For example, a company's deduction attributable
to aircraft operating costs and other expenses for a covered employee's vacation use of a
company aircraft is limited to the amount reported as compensation to the covered employee.
Reasons for Change
Permitting a business to deduct entertainment benefits provided to its employees in an
amount greater than the compensation reportable to such employees effectively allows taxpayers
to deduct personal expenses, contrary to general income tax principles. Congress curbed this
practice in the AJCA, but only with respect to covered employees. The same rule applicable to
all individuals would prevent the outcome more broadly and would simplify the law, thereby
removing a potential source of noncompliance.
Description of Proposal
Under the proposal, in the case of all individuals, the exceptions to the general
entertainment expense disallowance rule for expenses treated as compensation or includible in
income apply only to the extent of the amount of expenses treated as compensation or includible
in income. Thus, under those exceptions, no deduction is allowed with respect to expenses for
(1) a nonbusiness activity generally considered to be entertainment, amusement or recreation, or
(2) a facility (e.g., an airplane) used in connection with such activity to the extent that such
expenses exceed the amount treated as compensation or includible in income. The proposal is
intended to overturn Sutherland Lumber for all individuals. As under present law, the exceptions
apply only if amounts are properly reported by the company as compensation and wages or
otherwise includible in income.
Effective Date
The proposal is effective for expenses incurred after the date of enactment.
Discussion
Prior to the decision in Sutherland Lumber, many viewed the exceptions to the general
entertainment expense disallowance rule for expenses treated as compensation or includible in
income as a limit on the amount deductible by the employer, rather than as a full exception to the
general entertainment disallowance rule. Others took the position that the deduction was not
limited to the amount of the income inclusion. They contended that any amount of income
inclusion excepted all costs from the entertainment disallowance rule. This issue has received
considerable attention in the context of nonbusiness (e.g., vacation) use of employer-provided
aircraft.
Sutherland Lumber held that the exception is not limited by the amount includible in
income. Some view the decision as contrary to the statutory language and intent. The
Sutherland Lumber holding was also followed in subsequent Tax Court cases. Based on the
holding in Sutherland Lumber, the IRS issued internal guidance explaining the application of the
exception to pass-through entities, such as subchapter S corporations and partnerships.
Allowing S corporations and partnerships to deduct the full cost of an aircraft use can result in an
individual being entitled to a net deduction for the personal use of a company aircraft. While the
individual would have income inclusion as determined under Treasury regulations, the deduction
flowing through the S corporation or partnership to the individual would, in most cases, be
several multiples of the amount required to be included in income (e.g., the deduction could be
ten times the size of the amount of income inclusion). This may result in an unintended
substantial windfall to businesses, especially closely-held businesses, that provide nonbusiness
related entertainment benefits to their employees. As interpreted in this manner, the exception
permits a taxpayer to deduct personal entertainment expenses, contrary to general income tax
principles.
The proposal limits the exception to the entertainment disallowance rule to the amount
includible in the income of the individual. Thus, in the employer-provided aircraft context, the
amount deductible by the company is limited to the amount includible in the income of the
individual. As under present law, the amount of the deduction cannot exceed the actual cost.
Critics of the proposal argue that the deduction should be related to the actual cost to the
company even though the amount includible in income is significantly less. They argue that,
while the use of the aircraft may be of a personal nature, providing the employee the use of the
aircraft is a necessary cost of doing business. A response is that Congress has long held that the
deduction for expenses associated with nonbusiness activities should be strictly limited. For
example, Congress prohibited any deduction for travel expenses for spouses accompanying
employees on business travel even though some may argue that such costs are integral to the
business (e.g., some may argue that allowing executives' families to travel with them allows the
executive to be away from home longer on business-related travel).
AJCA limited the exceptions in the case of covered employees to the extent of the
amount treated as compensation or includible in income. The proposal extends this rule to all
individuals. Having different rules for covered employees and all other individuals creates
unnecessary complexity in complying with the law. Under present law, companies are subject to
different rules for the same activity depending on whether the service provider is a covered
employee. For example, nonbusiness use of a company aircraft by both covered and noncovered
employees would result in two different deduction amounts for the company. It is appropriate to
extend the limiting rule to all individuals.
C. Limit Deduction for Income Attributable to Property Transferred
in Connection with the Performance of Services to Amount
Included in Income by the Service Provider
(sec. 83)
Present Law
Section 83 governs the amount and timing of income and deductions attributable to
transfers of property in connection with the performance of services. If property is transferred in
connection with the performance of services, the person performing the services (the ''service
provider'') generally must recognize income for the taxable year in which the property is first
substantially vested (i.e., transferable or not subject to a substantial risk of forfeiture). The
amount includible in the service provider's income is the excess of the fair market value of the
property over the amount (if any) paid for the property.
A deduction is allowed to the person for whom such services are performed (the ''service
recipient'') equal to the amount ''included'' in gross income under section 83. The deduction is
allowed for the taxable year of the service recipient in which or with which ends the taxable year
for which the amount is included in the service provider's income. Treasury regulations provide
for a deduction by the service recipient equal to the amount included as compensation in the
service provider's gross income under section 83. The preamble to the regulations states that
the ''amount included'' in gross income means the amount reported on an original or amended
return or included in gross income as a result of an IRS audit of the service provider.
The regulations also provide a special rule (sometimes referred to as a safe harbor), under
which the service provider is deemed to have included an amount as compensation in gross
income if the service recipient satisfies the reporting requirements with respect to that amount
(i.e., the amount is reported on a Form W-2 or 1099 issued to the service provider). The
preamble explains that this rule results from the potential difficulty of demonstrating actual
inclusion by the service provider. The regulations thus allow the deduction without requiring
the service recipient to demonstrate actual inclusion by the service provider.
In Venture Funding, LTD., v. Commissioner, the Tax Court considered an employer's
entitlement to a deduction for compensation income attributable to stock transferred to
employees. The employer did not report any compensation income attributable to the transfer on
either Forms W-2 or Forms 1099 issued to the employees, and none of the employees included
any compensation in income as a result of the transfer. The Tax Court interpreted the reference
in the deduction provision of section 83 to the amount ''included'' in the service provider's
income to mean the amount taken into account in determining the tax liability of the service
provider and thus denied the employer a deduction.
The U.S. Court of Federal Claims considered the same issue recently in Robinson v.
United States. The case involved stock transferred to an employee in connection with the
performance of services in 1995. The employer did not initially report any compensation income
attributable to the transfer on either Form W-2 or Form 1099 issued to the employee for 1995,
and the employee did not include any compensation in income as a result of the transfer. In
1998, the employer issued to the employee an amended Form W-2 for 1995, which reflected
compensation income attributable to the transfer of stock and claimed a deduction for 1995 based
on the compensation income. The IRS was in the process of auditing the employee's 1995 tax
return, and the amount of compensation income (if any) to be included in the employee's income
was an open issue. The IRS therefore argued in Robinson that a decision on the employer's
entitlement to a deduction could not be made until the issue of the amount to be included in the
employee's income was resolved. The court stated that the plain meaning of the deduction
provision in section 83 is that an employer is allowed a deduction only to the extent that an equal
amount actually is included in the employee's income. Because the amount to be included in the
employee's income had not been finally determined, the court held that the employer's
entitlement to a deduction was not ripe for decision by the court.
On appeal, the U.S. Court of Appeals for the Federal Circuit rejected the Government's
interpretation that ''included'' means actual inclusion on the service provider's tax return. The
court instead interpreted ''included'' to mean the amount included in gross income as a matter of
law (that is, the amount legally required to be included in the service provider's gross income
under section 83), without regard to the amount, if any, actually included on the service
provider's return or timely reported as compensation for services. The court thus invalidated the
approach in the regulations, which conditions the deduction on either demonstration of the
amount actually included in the service provider's income or timely reporting of the
compensation income by the service recipient.
Reasons for Change
Under section 83, the amount of the deduction to which a service recipient is entitled as a
result of a transfer of property in connection with the performance of services should be the
amount actually included in the service provider's income. This link helps to avoid mismatches
in the amount of income and deductions attributable to such transfers. Because the Robinson
decision eliminates this link, it increases the potential for such mismatches, thus creating tax
administration and compliance issues.
Description of Proposal
The proposal overrides the Robinson decision and reaffirms the clear language of
section 83 that the amount of the deduction allowed with respect to a transfer of property in
connection with the performance of services is determined by reference to the amount actually
included in income by the service provider under section 83. Thus, the proposal allows a
deduction under section 83 equal to the amount of income actually included in the service
provider's income (either on the service provider's tax return or as a result of an audit). The
proposal also provides that an amount is treated as included in the service provider's income if it
is timely reported on the correct IRS form by the service recipient as compensation income of the
service provider, thus retaining the safe harbor provided in Treasury regulations.
Effective Date
The proposal is effective for transfers of property made after the date of enactment. No
inference is intended from the proposal that under present law an amount may be deducted under
section 83 if the amount has not been included in gross income by the service provider or
reported as compensation by the service recipient.
Discussion
Many transactions between taxpayers result in income inclusion for one taxpayer and a
deduction for the other. In some cases, one taxpayer's income or deduction is determined
separately from the other. However, some Code provisions, including section 83, specifically
provide that the timing and amount of one taxpayer's deduction is based on the timing and
amount of the other taxpayer's income. Such a structure helps to avoid mismatches between
income and deductions.
Such mismatches can lead to a tax ''whipsaw'' if the service recipient takes a deduction
for an amount greater than the amount included in income by the service provider. Whipsaw
situations often raise special enforcement difficulties for the IRS. For example, by the time the
mismatch is discovered, the statute of limitations may preclude the IRS from arguing that a
larger amount should have been included in income by the service provider.
Transactions in which consideration is paid in the form of property rather than cash, such
as property transferred in connection with the performance of services, may also cause special
compliance issues because of the need to determine the property's value, particularly if the
property is not publicly traded. When property is transferred in connection with the performance
of services, the service recipient is generally in the best position to know the value of the
property and the amount required to be included in income by the service provider. Proper
reporting by the service recipient of the amount to be included in income by the service provider
also helps to avoid mismatches in the service recipient's deduction and the service provider's
income.
The proposal addresses these issues by specifying that the amount of the service
recipient's deduction is the amount actually included in the service provider's income and
allowing the service recipient to deem the amount to have been included in the service provider's
income if the service recipient has complied with the reporting requirements applicable to the
income. The proposal thus restores the plain reading of section 83 as in effect before Robinson.
D. Payments in Redemption of Stock Held by an ESOP Not Deductible as Dividends
(sec. 404(k))
Present Law
Employee stock ownership plans
An employee stock ownership plan (''ESOP'') is a type of tax-qualified retirement plan
that is designed primarily to invest in employer securities and that meets certain other
requirements. An ESOP is subject to the rules applicable to tax-qualified retirement plans
generally and receives the same tax benefits. That is, employees do not include ESOP benefits in
gross income until the benefits are distributed even though the plan is funded and the benefits are
nonforfeitable. The employer is entitled to a current deduction (within limits) for contributions to
an ESOP even though an employee's income inclusion is deferred.
In addition, ESOPs receive certain benefits not applicable to qualified plans generally.
For example, ESOPs may borrow from related parties to acquire the employer securities held by
the plan. In such cases, the securities acquired with the loan are held in a suspense account in the
plan and allocated to the accounts of plan participants as the loan is repaid. Examples of the
special tax benefits accorded ESOPs include the ability of the employer to deduct contributions
used to repay a loan without regard to the normal limits on deductions and, as discussed in more
detail below, the ability of the employer to deduct certain dividends paid with respect to stock
held by an ESOP.
As is the case with qualified plans generally, ESOP assets are held in a tax-exempt trust
for the exclusive purpose of paying benefits to plan participants and beneficiaries. Upon
termination of employment (or other event as specified in the plan) a plan participant is entitled
to payment of his or her vested account balance. The circumstances giving rise to a distribution
and the specific payment terms are as specified in the plan, subject to applicable qualification
requirements.
Deduction for certain dividends paid on employer securities held in an ESOP
In general, a corporation may not deduct dividends paid to shareholders. A corporation
generally may, however, deduct the amount of ''applicable dividends'' paid in cash by the
corporation with respect to applicable employer securities held by an ESOP. The dividend
deduction is in addition to otherwise allowable deductions for contributions to the ESOP.
An applicable dividend is any dividend which, in accordance with the provisions of the
ESOP is: (1) paid in cash to the ESOP participants; (2) paid to the ESOP and distributed in cash
to participants not later than 90 days after the close of the plan year in which paid; (3) at the
election of the ESOP participants, paid as described in (1) or (2), or paid to the plan and
reinvested in qualifying employer securities; or (4) used to make payments on a loan, the
proceeds of which were used to acquire stock held by the ESOP.
The Secretary of the Treasury may disallow the deduction for any dividends if the
Secretary determines that the dividend constitutes, in substance, the avoidance or evasion of
taxation.
Applicable dividends that are distributed to plan participants are includible in gross
income. Certain rules generally applicable to qualified plan distributions do not apply. Thus, for
example, a distribution of dividends may not be rolled over tax-free to another qualified plan and
the rules prohibiting involuntary cash-outs of benefits do not apply.
Deductibility of payments in redemption or reacquisition of stock held by an ESOP
In general; IRS ruling
Some taxpayers have taken the position that payments in redemption of stock allocated to
participants' accounts and paid to a terminating or retiring participant in partial or full
satisfaction of the plan's obligations to pay benefits are deductible as dividends under section
404(k). The IRS issued a ruling on this issue in 2001, and held that such payments are not
applicable dividends under section 404(k). In reaching its conclusion, the IRS noted that
allowing a deduction for such payments would allow a deduction for amounts that do not
represent economic costs to the employer and would vitiate rights that the plan participants
would otherwise have with respect to the distribution if it were not treated as an applicable
dividend, including the ability to make a tax-free rollover and the protections against involuntary
cash-outs.
Boise Cascade v. United States
In 2003, the same issue was addressed by the Court of Appeals for the Ninth Circuit in
Boise Cascade v. United States. The facts of the case were essentially the same as those
presented in the 2001 IRS ruling. The case involved convertible preferred stock which was
created for and held solely by the ESOP. When a participant in the ESOP terminated
employment, the company automatically redeemed convertible preferred stock equal in value to
the participant's vested account balance. This amount was then paid out pursuant to the terms of
the plan. The Court of Appeals for the Ninth Circuit held that the payments in redemption of
the stock were deductible dividends under section 404(k).
A key element of the court's decision was whether the payments were properly
characterized as dividends. As relevant here, payments in redemption of stock are treated as full
or partial payment in exchange for the stock if the redemption is not essentially equivalent to a
dividend. A redemption is not essentially equivalent to a dividend only if the redemption
results in a ''meaningful reduction of the shareholder's proportionate interest in the company.''
In making this determination, certain attribution rules apply that treat persons as constructively
owning stock held by others. Under these rules, stock owned, directly or indirectly, by or for a
trust (other than a qualified trust, including an ESOP), is owned by its beneficiaries in proportion
to the actuarial interest of such beneficiaries in such trust.
The court said that the question of whether the redemption payments were dividends
depended on whether the ESOP trust or the participants owned the stock when the redemption
payments were made. The parties stipulated that, if the participants were deemed to own the
stock, the redemption resulted in a meaningful reduction in the participants' interests and
therefore could not be considered a dividend. The parties also stipulated that if the ESOP were
the owner, then the redemptions did not result in a meaningful reduction in the ESOP's interest
and could be characterized as dividends.
The court said that under the attribution rules applicable to determining whether a
redemption is treated as an exchange or a distribution, unlike stock owned by other types of
trusts, stock owned by a tax-exempt employees' trust is not considered owned by its
beneficiaries. Further, the court said, under general trust principles, the ESOP participants in this
case did not beneficially own the stock. Therefore, according to the court, for purposes of the
rules for taxing distributions of property by corporations, the ESOP trust, not the participants,
owned the company stock held by the ESOP when the redemption payments were made. Thus,
as stipulated by the parties, a meaningful reduction in the trust's proportionate interest in the
corporation did not occur and the payments were dividends which were deductible by the
company as ''applicable dividends.''
IRS response
In a Chief Counsel notice issued after the decision in Boise, the IRS reiterated its
position that redemption payments of the type involved in the case are not deductible, and stated
that the decision in Boise Cascade is incorrect and that deductions for amounts paid to redeem
stock held by ESOPs should continue to be denied in jurisdictions outside the Ninth Circuit. The
notice states that in many cases, a redemption payment will not meet the definition of a dividend
(even if the ESOP is treated as the owner of the stock). In addition, it expands on the IRS
reasoning for its position and notes that to treat the payments in question as deductible dividends
would duplicate the earlier deduction the employer was allowed with respect to contributions to
the plan and would undermine important employee rights that would otherwise apply to a
distribution of benefits from the plan, such as the ability to rollover the distribution and thereby
keep it in a tax-favored vehicle for future use.
Reasons for Change
Redemption payments like those involved in Boise Cascade are not the economic
equivalent of a dividend. Treating the trustee of the ESOP as the sole shareholder caused the
transaction to be misidentified as a dividend despite the fact that the transaction clearly had
economic consequences to the individual plan participants which were inconsistent with those of
a dividend. To allow a deduction for such payments would allow an employer a deduction for a
transaction which is not a dividend and therefore was not intended to qualify for deduction.
Finally, allowing a deduction for these types of redemption payments would circumvent the
deduction limitations applicable to ESOPs and could have an adverse impact on plan participants
because they would lose substantial rights, such as the ability to make a tax-free rollover.
Description of Proposal
The proposal provides that, for purposes of determining whether an amount is deductible
as a dividend under section 404(k), each ESOP participant is treated as the direct owner of any
shares allocated to his or her account.
Effective Date
The proposal is effective for payments made after the date of enactment. No inference is
intended from the proposal that payments affected by the proposal are deductible under present
law.
Discussion
The deduction for certain dividends paid with stock held by an ESOP is an exception to
the generally applicable rule that dividends are not deductible. The deduction is generally
thought to encourage the establishment of ESOPs by employers and thereby extend the benefits
of stock ownership to employees.
The rule in Boise Cascade would expand the dividend deduction to payments that are not
economically dividends. As noted above, a payment in redemption of stock is not a dividend if
the payment results in a meaningful reduction in the shareholder's interest. If the ESOP is
viewed as the owner of the stock, rather than the plan participants, in many cases any redemption
of stock would be viewed as a dividend, even though the interests of individual ESOP
participants have changed substantially. For example, as was the case in Boise Cascade, it is
common for ESOPs to hold convertible preferred stock of a type that is created specifically for
the ESOP and that is not held by other shareholders. In such cases, the employer corporation
could redeem substantial amounts of stock, but the ESOP would still hold 100 percent of the
outstanding stock of that class. Depending on the terms and conditions of the stock of that class,
it is possible that there would not be a meaningful reduction in the interest of the ESOP. From
each individual participant's perspective, however, there has been a significant change in
interest. The situation in Boise would not be atypical, in that the participant has no interest in the
corporation after the redemption. While in some contexts it may be appropriate to treat an ESOP
or other qualified retirement plan as a single shareholder, in this context, this treatment obscures
the true nature of the transaction.
Allowing a deduction for redemption payments of the type in Boise undermines the rules
relating to deductions for contributions to qualified retirement plans. Subject to certain
limitations, employers are entitled to a deduction for contributions to a qualified retirement plan,
including an ESOP. Because contributions are deductible, no deduction is allowed upon
subsequent distributions of plan benefits to participants. Treating the redemption payments as
deductible dividends allows the employer a deduction both for contributions to the plan as well
as for distributions from the plan.
E. Provide Greater Conformity for Section 403(b) and Section 401(k) Plans
(secs. 402(g), 403(b), and 415(c)(3))
Present Law
In general
Present law permits tax-deferred savings through salary reduction under certain
employer-sponsored retirement plans, including qualified cash or deferred arrangements
(''section 401(k) plans'') and tax-sheltered annuity plans (''section 403(b) plans''). Taxable
employers are entitled to a current deduction for salary reduction contributions, while employees
who make salary reduction contributions generally do not include such contributions or the
earnings on the contributions in gross income until such amounts are distributed. Permitting
employees to make tax-deferred contributions is intended to encourage retirement income
savings.
Section 401(k) plans
A section 401(k) plan is a type of defined contribution retirement plan. Section 401(k)
plans are subject to the rules generally applicable to defined contribution plans. In addition,
special rules apply to such arrangements.
Under a section 401(k) plan, an employee may elect to have its employer make payments
on a pre-tax basis as contributions to a defined contribution plan on the employee's behalf, or to
the employee directly in cash. Contributions to the plan made at the election of the employee are
called elective deferrals. Employee contributions to a section 401(k) plan may also be made on
an after-tax basis if the plan provides for them.
A section 401(k) plan may also provide for employer contributions. 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 elective deferrals. Matching contributions are employer contributions that
are made only if the employee makes elective deferrals. Depending on the type of defined
contribution plan and the plan terms, employer nonelective contributions and matching
contributions may be required or may be discretionary on the part of the employer.
Section 403(b) plans
Section 403(b) plans are another form of employer-based retirement plan that provide the
same tax benefits as section 401(k) plans. 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).
Employers may contribute to section 403(b) plans on behalf of their employees, and
employees may make elective deferrals. Employee contributions to a section 403(b) plan may
also be made on an after-tax basis if the plan provides for them. Additionally, a section 403(b)
plan may provide for employer nonelective and matching contributions.
Conformity of the general rules for section 401(k) and section 403(b) plans
Historically, some of the rules relating to section 401(k) and section 403(b) plans have
been the same and some have been different. In many cases, these differences have been due to
differences in traditional practices with respect to 403(b) plans. Over time, the trend has been to
conform the rules by applying the rules applicable to 401(k) plans to 403(b) arrangements.
Under present law, these plans generally operate in a similar fashion. For example, employer
contributions and employee elective deferrals to section 401(k) and section 403(b) plans are not
includible in participants' income. After-tax employee contributions are included in the
employee's income for the year the contributions are made. Distributions from such plans
generally are includible in gross income in the year paid or distributed, except to the extent an
amount distributed represents a return of a participant's after-tax contributions (i.e., basis).
As another example, participants' elective deferrals to section 401(k) and section 403(b)
plans generally may not be distributed prior to the occurrence of one or more specified events,
including severance from employment, death, disability, attainment of age 59-� , or hardship.
Early distributions from section 401(k) and section 403(b) plans generally are subject to an
additional 10-percent early withdrawal tax unless an exception applies. In addition, minimum
distribution rules apply to both section 401(k) and section 403(b) plans. Under these rules,
distribution of minimum benefits generally must begin no later than the required beginning
date.
Recent changes in the law further illustrate the process of conformity. For example,
under prior law, contributions to 403(b) plans were limited by an exclusion allowance, which
generally provided that the maximum contribution for a year was equal to 20 percent of the
employee's includible compensation, multiplied by the employee's years of service, minus
excludable contributions for prior years under qualified plans, tax-sheltered annuities, or section
457 plans of the employer. The Economic Growth and Tax Relief Reconciliation Act of 2001
(''EGTRRA'') eliminated the exclusion allowance for years beginning after 2001 and generally
applied to 403(b) plans the limits applicable to contributions under 401(k) plans (as well as other
tax-qualified plans).
Additionally, many of the nondiscrimination rules applicable to section 401(k) plans also
apply to section 403(b) plans, including the minimum coverage requirements, the general
prohibition against discrimination in contributions or benefits, the limit on annual compensation,
the minimum participation requirements, and the special nondiscrimination test applicable to
employer matching contributions and after-tax employee contributions to such plans.
Notwithstanding the conformity of many rules, present law contains some special rules
for section 403(b) plans.
Special definition of compensation under limit on annual additions
For purposes of the limit on annual additions, compensation generally means the taxable
compensation of the employee for the year, plus elective deferrals and similar salary reduction
contributions. However, under a special definition of ''includible compensation'' applicable to
section 403(b) plans, an employee may be treated as if receiving compensation for up to five
years after termination of employment. Under this rule, the limit on annual additions is based
on the participant's compensation for the last year of service before termination of
employment. As a result, contributions to a section 403(b) plan may continue to be made for
former employees for up to five years.
Additional elective deferrals
The maximum annual amount of elective deferrals that an individual can make to a
section 401(k) or section 403(b) plan is $14,000 (for 2005). If elective deferral contributions
are made to both a section 401(k) and a section 403(b) plan for the same employee, a single limit
applies to the contributions under both plans. Additionally, an individual who has attained age
50 before the end of the taxable year may also make ''catch-up contributions'' to section 401(k)
and section 403(b) plans. As a result, the limit on elective deferrals is increased for an individual
who has attained age 50 by $4,000 (for 2005).
Under a special rule for section 403(b) plans, employees who have completed 15 years of
service with certain organizations may make additional elective deferrals of up to the lesser of:
(1) $3,000; (2) $15,000, reduced by amounts deferred in prior years; or (3) the excess of $5,000
multiplied by the number of years of service of the employee over deferrals to the plan in prior
years. The organizations include educational organizations, hospital, home health service
agencies, health and welfare service agencies, churches, or convention of churches.
Under the proposed regulations relating to section 403(b) plans, for participants who
are eligible to make both additional deferrals under the special rule for section 403(b) plans and
catch-up contributions, contributions are treated first as additional deferrals under the special
section 403(b) rule and then as amounts contributed as catch-up contributions, to the extent any
catch-up contributions exceed the special section 403(b) rule amount. For example, assume a
participant is eligible to make both types of contributions and that the maximum additional
deferral which the participant may make for 2005 under the special section 403(b) rule is $3,000.
Under the proposed regulation, the maximum total elective deferral contribution that the
participant may make for 2005 is $21,000. This is the sum of the basic limit on elective
deferrals, $14,000 (for 2005), plus the $3,000 additional deferral under the special section 403(b)
rule, plus a catch-up contribution of $4,000 (for 2005).
Special nondiscrimination test for elective deferrals
A special nondiscrimination rule applies to elective deferrals under section 403(b) plans.
The rule is referred to as the ''universal availability rule.'' Under the universal availability rule,
all employees generally must be eligible to make elective deferrals of more than $200 if any
employee may elect to have the employer make such contributions to the plan. This rule is
intended to ensure the eligibility of all employees to make elective deferrals under a section
403(b) plan.
In contrast, the nondiscrimination test applicable to elective deferrals under a section
401(k) plan compares the actual levels of elective deferrals made by employees. The test is
called the actual deferral percentage test or the ''ADP'' test. The ADP test is designed to
ensure the level of elective deferral contributions under the plan is not weighted too heavily in
favor of compensated employees (''HCEs'') The ADP test compares the actual deferral
percentages (''ADPs'') of the HCE group and the nonhighly compensated employee (''NHCE'')
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 HCE group for the current
plan year is either (1) not more than 125 percent of the ADP of the NHCE group for the prior
plan year, or (2) not more than 200 percent of the ADP of the NHCE group for the prior plan
year and not more than two percentage points greater than the ADP of the NHCE group for the
prior plan year. Alternatively, a section 401(k) plan may be deemed to satisfy the ADP test if it
meets the requirements of a safe harbor. If the ADP test for a plan year is not satisfied, the
plan will technically no longer be qualified. However, the regulations provide measures for
correcting failures of the ADP test, including distributing the amount of elective deferrals (and
allocable income) by HCEs which cause the plan to fail the test.
Reasons for Change
Although many of the rules for section 401(k) and 403(b) plans have been conformed
over time, special rules for section 403(b) plans still exist under present law. Present law rules
for section 403(b) plans relating to the definition of includible compensation, additional elective
deferrals, and universal availability are inequitable and create complexity in many cases. The
proposal provides greater conformity of the rules for section 401(k) and section 403(b) plans by
eliminating these special rules.
Description of Proposal
The proposal further conforms the rules for section 401(k) and section 403(b) plans by
eliminating some of the special rules applicable to section 403(b) plans.
Under the proposal, the definition of compensation applicable to section 403(b) plans for
purpose of the limit on annual additions is conformed to the definition of compensation
applicable to defined contribution plans generally, including section 401(k) plans. The special
rule permitting contributions to a section 403(b) plan for an employee for up to five years after
termination of employment is eliminated.
The proposal eliminates the special rule for section 403(b) plans which permits
employees who have completed 15 years of service with certain employers to make additional
elective deferrals.
The proposal applies the ADP test to elective deferrals under section 403(b) plans.
The universal availability rule is eliminated.
Effective Date
The proposal is effective for plan years beginning after the date of enactment.
Discussion
Conform definition of compensation and eliminate additional elective deferrals
Allowing contributions to section 403(b) plans for up to five years after termination of
employment and the rule permitting additional elective deferrals to section 403(b) plans for
employees who have completed 15 years of service with certain organizations gives certain
employees an advantage in building retirement savings which participants in section 401(k) plans
(and, in the case of the 15-year rule, other section 403(b) plans) do not have. The proposal
provides equity between the different types of plans by adopting the rules applicable to section
401(k) plans. The 401(k) plan rules are more widely applicable under present law as there is
greater coverage under those plans than under 403(b) annuities.
These special rules arguably offer a ''catch-up'' benefit to employees of certain types of
organizations who may be viewed as low-paid relative to employees of other types of
organizations. However, present law allows participants in section 403(b) plans and other plans,
including section 401(k) plans, who have attained age 50 before the end of the taxable year to
make catch-up contributions. In addition, retirement savings are generally intended to replace
compensation received while an individual is working. The rule allowing contributions based on
assumed compensation after termination of employment is inconsistent with this policy
objective.
The special rules for section 403(b) plans add complexity to the tax system. For
example, for purposes of the special five-year rule, it may be difficult for employers to track data
relating to employees who have terminated employment. In addition, monitoring whether
individuals' elective deferrals exceed the overall limit for purposes of the rule permitting
additional elective deferrals may also present a significant recordkeeping burden. The special
rules also make comparing plans more difficult for employers, thus adding complexity to an
employer's decision as to what type of plan to adopt. Further, these special rules may create
confusion for employees. Employees may not understand variations in the limits on elective
deferrals which can result from the rule permitting additional elective deferrals. Such confusion
may result in overall decreased participation.
Nondiscrimination testing
The universal availability rule is a general requirement which ensures that all employees
are given the opportunity to make elective deferrals under a section 403(b) plan if any employee
can make elective deferrals. However, even if the rule is satisfied, the actual levels of
contributions made to the plan may favor highly compensated employees. The ADP test, on the
other hand, is designed to ensure that benefits provided under a plan are not weighted too heavily
in favor of highly compensated employees by testing actual deferrals made under the plan. Like
other nondiscrimination rules, the ADP test reflects the concern that lower-income individuals
typically save less than higher-income individuals. These same concerns apply to section 403(b)
plans as well as section 401(k) plans. The ADP test is viewed by many as better enforcing the
goals of nondiscrimination. While a universal availability rule ensures that all employees are
offered the opportunity to make elective deferrals, it does not ensure that contributions are
actually made. In contrast, testing of actual deferrals ensures that contributions are actually
made for rank-and-file employees, as well as highly compensated employees.
The universal availability test is easier to administer than the ADP test, and imposing the
ADP test on 403(b) plans will increase administrative burdens for those plans. However, these
administrative burdens are not likely to be greater than those imposed on employers with section
401(k) plans. Employers who make matching contributions to 403(b) plans and thus are
applying the special nondiscrimination test for those contributions, already have arrangements in
place which may be able to be modified to accommodate ADP testing. Also, employers who
wish to avoid testing may take advantage of the safe harbor methods of satisfying the ADP tests.
F. Extend Early Withdrawal Tax to Eligible Deferred Compensation Plans
of State and Local Governments
(sec. 72(t))
Present Law
Early withdrawal tax
In general, a distribution from a tax-favored retirement arrangement is includible in gross
income in the year it is paid under the rules relating to taxation of annuities, unless the amount
distributed represents the individual's investment in the contract (i.e., basis). Special rules of
inclusion and exclusion apply in the case of Roth IRAs, distributions that are rolled over into
another tax-favored retirement arrangement, distributions of employer securities, and certain
other situations.
Taxable distributions made before age 59-�, death, or disability are generally subject to
an additional 10-percent income tax unless an exception applies. This early withdrawal tax
applies to all taxable distributions from tax-favored retirement arrangements, except distributions
from an eligible retirement plan of a tax-exempt or State or local government employer (a
''section 457 plan''). Thus, the early withdrawal tax applies to taxable distributions from
qualified retirement plans and annuities, tax-sheltered annuities (sec. 403(b)), and both
traditional and Roth IRAs.
A number of exceptions apply to the early withdrawal tax, depending on the specific type
of arrangement from which the distribution is made. In the case of a qualified retirement plan,
exceptions (in addition to the exceptions for death and disability) include distributions that are:
(1) part of a series of substantially equal periodic payments (not less frequently than annually)
made for the life (or life expectancy) of the employee or the joint lives (or life expectancies) of
the employee and his or her designated beneficiary; or (2) made to an employee after separation
from service after attainment of age 55.
Section 457 plans
Among the various types of tax-favored retirement plans under present law are eligible
deferred compensation plans under section 457. A section 457 plan is a plan that is maintained
by a State or local government or a tax-exempt organization and that meets certain
requirements. In the case of a governmental section 457 plan, compensation deferred under the
plan is not includible in gross income until paid and, in the case of a section 457 plan of a tax-
exempt organization, compensation deferred under the plan is not includible in gross income
until paid or made available. Section 457 applies both to arrangements that permit employees
to elect whether to defer compensation or receive it currently and those that do not permit such
an election; many section 457 plans take an elective deferral approach.
Over time, the rules relating to section 457 plans of State and local governments and of
tax-exempt entities have diverged. Presently, section 457 plans of State and local governments
operate in many cases similar to section 401(k) or other qualified retirement plans and some of
the rules relating to governmental section 457 plans mirror those relating to qualified retirement
plans. For example, assets under a governmental section 457 plan are required to be placed in a
trust for the exclusive benefit of plan participants, similar to the requirements applicable to
qualified retirement plans. In contrast, section 457 plans of tax-exempt organizations (like
nonqualified deferred compensation plans of private companies) cannot be funded. As another
example, the general rule for taxation of distributions from governmental section 457 plans (i.e.,
that amounts are not taxable until paid) parallels the rule applicable to qualified plans, whereas
the rule applicable to distributions from 457 plans of tax-exempt employers does not. In
addition, rollovers between governmental section 457 plans and other tax-favored retirement
arrangements are permitted (subject to certain separate accounting requirements), whereas
rollovers between 457 plans of tax-exempt employers and other types of plans are not.
Reasons for Change
The early withdrawal tax reflects the concern that the tax incentives for retirement
savings are inappropriate unless the savings generally are not diverted to nonretirement uses.
The early withdrawal tax discourages early withdrawals and also recaptures a measure of the tax
benefits that have been provided. Governmental section 457 plans currently provide benefits
similar to those under qualified retirement plans, thus, the same rationale for applying the early
withdrawal tax to qualified retirement plans applies to governmental section 457 plans.
Description of Proposal
Under the proposal, the early withdrawal tax applicable to qualified retirement plans is
extended to section 457 plans of State and local governments.
Effective Date
The proposal is effective for distributions in taxable years beginning after the date of
enactment.
Discussion
The proposal would provide parity between the treatment of qualified retirement plans
and governmental section 457 plans with respect to the early withdrawal tax. This change is
consistent with other recent changes to governmental section 457 plans, including the addition of
the requirement that the trust be funded and the taxation of distributions. As is the case with
qualified plans, imposition of the early withdrawal tax may prevent erosion of governmental 457
plan benefits prior to when they are needed for retirement by the individuals.
The proposal would also be a step toward simplification with respect to rollovers between
governmental section 457 plans and other types of arrangements, by eliminating a reason for the
separate accounting requirement.
Imposition of the early withdrawal tax will increase the tax liability of plan participants to
whom the tax applies compared with present law to the extent that participants take early
withdrawals. In some cases, however, the early withdrawal tax may serve as an incentive to
leave benefits in the section 457 plan until a later date, thus serving the purpose of the tax.
G. Modify Prohibited Transaction Rules for Individual Retirement
Arrangements (''IRAs'') to Reduce Tax Shelter Transactions
(sec. 4975)
Present Law
Roth IRAs
Individuals with adjusted gross income below certain levels may make nondeductible
contributions to Roth IRAs. The maximum annual contribution that may be made to a Roth
IRA is the lesser of a certain dollar amount ($4,000 for 2005) 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 ($500 for 2005).
The contribution limit is reduced to the extent an individual makes contributions to any
other IRA for the same taxable year. In the case of married individuals, 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. Unlike the case with traditional IRAs, contributions to a Roth IRA
may be made even after the account owner has attained age 70-�.
Amounts held in a Roth IRA which are withdrawn as qualified distributions are not
includible in income. 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-�, 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. The amount which is includible in income is
also subject to an additional 10-percent early withdrawal tax unless the withdrawal made after
attainment of age 59-� is due to death or disability, is made in the form of certain periodic
payments or another exception to the tax applies.
Traditional IRAs
Annual contributions to traditional IRAs are subject to the same dollar limit ($4,000 for
2005) as contributions to Roth IRAs. As under the rules relating to Roth IRAs, an annual
contribution of up to the dollar limit for each spouse may be made to a traditional IRA provided
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 a traditional IRA up to a certain dollar amount ($500 for 2005).
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 for taxpayers
with adjusted gross income over certain levels. 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 70-� 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. Additionally, amounts
withdrawn prior to attainment of age 59-� (''early withdrawals'') from a traditional IRA
generally are subject to the same additional 10-percent early withdrawal tax applicable to taxable
distributions from a Roth IRA unless an exception applies.
Prohibited transactions
The Code prohibits certain transactions between certain tax-preferred retirement plans
and a disqualified person. Traditional and Roth IRAs are subject to the prohibited transaction
rules.
Under the Code, if a prohibited transaction occurs, the disqualified person is subject to a
two-tier excise tax. The first level tax is 15 percent of the amount involved in the transaction.
The second level tax is imposed if the prohibited transaction is not corrected within a certain
period and is 100 percent of the amount involved. Amount involved generally means the greater
of the amount of money and the fair market value of the other property given or the amount of
money and the fair market value of the other property received.
Prohibited transactions include certain direct or indirect transactions between a plan and a
disqualified person: (1) the sale, exchange, or leasing of property; (2) the lending of money or
other extension of credit; and (3) the furnishing of goods, services or facilities. Prohibited
transactions also include any direct or indirect: (1) transfer to, or use by or for the benefit of a
disqualified person of the income or assets of the plan; (2) in the case of a fiduciary, an act that
deals with the plan's income or assets for the fiduciary's own interest or account; and (3) the
receipt by a fiduciary of any consideration for the fiduciary's own personal account from any
party dealing with the plan in connection with a transaction involving the income or assets of the
plan.
In general, ''disqualified person'' means: (1) a fiduciary; (2) a person providing services
to the plan; (3) an employer any of whose employees are covered by the plan; (4) an employee
organization any of whose members are covered by the plan; (5) a direct or indirect owner of a
specified interest in such an employer or employee organization; (6) a member of the family of
an individual which meets certain definitions of a disqualified person; (7) a corporation,
partnership, or trust or estate of which (or in which) a specified interest is owned by certain other
disqualified persons; (8) offers and directors (or individuals having powers or responsibilities
similar to those of officers or directors), 10-percent or more shareholders, or highly compensated
employees (earning 10 percent or more of the yearly wages of the employer) of certain other
disqualified persons; or (9) a 10-percent or more (in capital or profits) partner or joint venturer of
certain other disqualified persons.
Under this definition, disqualified persons include corporations of which 50 percent or
more of: (1) the combined voting power of all classes of stock entitled to vote; or (2) the total
value of shares of all classes of stock of such corporation, is owned directly or indirectly, or held
by certain other disqualified persons. Thus, for example, a corporation 50 percent of the
voting stock of which is owned by a plan is a disqualified person with respect to that plan.
Additionally, for purposes of the definition of disqualified person, a fiduciary includes
any person who: (1) exercises any authority or control respecting management or disposition of
the plan's assets; (2) renders investment advice for a fee or other compensation with respect to
any plan moneys or property, or has the authority or responsibility to do so; or (3) has any
discretionary authority or responsibility in the administration of the plan. Thus, for example,
an IRA owner with authority to control the investment of the assets in the IRA (a ''self-directed
IRA'') is a fiduciary, and therefore, a disqualified person under the prohibited transactions rules.
Swanson v. Commissioner
In Swanson v. Commissioner, the taxpayer, the sole shareholder of an S corporation
(''S Corp.'') arranged in 1985 for the organization of a C corporation (''C Corp.'') and became its
director and president. C Corp. provided services to S Corp. in exchange for fees. Also in 1985,
the taxpayer established a self-directed IRA and directed its trustee to execute a subscription
agreement for 100 percent (2,500 shares) of C Corp.'s original issue stock. The taxpayer
subsequently directed the payment of $593,602 in dividends on C Corp. stock during 1986-1988.
The IRS viewed the transaction as an arrangement to avoid statutory limits on annual
contributions to an IRA. In Swanson, the IRS argued that a prohibited transaction occurred when
C Corp.'s stock was acquired by the IRA. According to the IRS, the stock acquisition was
prohibited under the rule prohibiting the sale, exchange or leasing of property between a plan and
a disqualified person. The Tax Court disagreed, concluding that C Corp. was not a
disqualified person with respect to the IRA because, at the time the shares were issued to the
IRA, C Corp. was without shares or shareholders and thus, did not fit within the definition of a
disqualified person under which certain share ownership levels by other disqualified persons is
determinative of a corporation's disqualified person status. Accordingly, the court concluded,
the issuance of C Corp. shares and the distribution of dividends on those shares to the IRA was
not a prohibited sale or exchange, or leasing of any property between a plan and a disqualified
person.
The IRS also asked the court to consider whether the payment of dividends by C Corp. to
the IRA involved self-dealing by a fiduciary in violation of the prohibited transaction rules. The
Tax Court concluded that the payment of dividends by C Corp. to the IRA was not prohibited
self-dealing by a disqualified person, in this case, a fiduciary, because the taxpayer did not deal
for his own benefit or account. The court reasoned that the dividends did not become income of
the IRA until they were issued to the IRA. Thus, the taxpayer's direction of the dividend
payment was not prohibited self-dealing with respect to the IRA. The court also concluded that
the taxpayer realized a benefit from the dividends only in his capacity as IRA beneficiary, which
is not considered a prohibited transaction.
The Tax Court did not address whether the Swanson transaction violated any other
prohibited transaction rules. Some taxpayers have relied on Swanson as the basis for similar
transactions that attempt to avoid the IRA contribution limits and obtain tax-free returns. A
November 2003 newspaper article described a transaction in which an individual contributed
$2,000 to a Roth IRA, which purchased a newly-created C corporation. Shares which the
individual owned in another corporation were transferred to the C corporation. The C
corporation later sold the shares for $1.5 million, which was placed in the Roth IRA. Swanson
was cited as supporting the legality of the transaction.
Treasury guidance on Roth IRA shelters
In Notice 2004-8, the Treasury Department announced that certain transactions involving
Roth IRAs are tax avoidance transactions and identified these transactions (''Roth IRA shelters'')
as listed transactions. A listed transaction is a transaction that is the same as or substantially
similar to one of the types of transactions that the IRS: (1) has determined to be a tax avoidance
transaction; and (2) identified by notice, regulation, or other form of published guidance as a
listed transaction. Listed transactions must be disclosed on a tax return and may result in
adverse tax consequences.
According to the Notice, a Roth IRA shelter involves: (1) an individual who owns an
existing business such as a corporation or sole proprietorship (the ''Business''); (2) a Roth IRA
that is maintained for the individual; and (3) a corporation all the original-issue shares of which
are acquired by the Roth IRA (the ''Roth IRA Corporation''). The Roth IRA Corporation
provides services to the Business in exchange for fees. The Roth IRA Corporation then
distributes dividends on its shares to the Roth IRA. The Notice states that a Roth IRA shelter is a
type of transaction that is used to avoid the limitations on contributions to Roth IRAs. The IRS intends to challenge Roth IRA shelter arrangements on several grounds,
according to the Notice. In the Notice, the IRS said that in appropriate cases, it may assert that
the substance of the transaction is that the amount of the value shifted from the Business to the
Roth IRA Corporation is a payment to the individual, followed by a contribution by the
individual to the Roth IRA and a contribution by the Roth IRA to the Roth IRA Corporation.
Additionally, under its authority to allocate gross income, deductions, credits or allowances
among persons owned or controlled directly or indirectly by the same interests, if such allocation
is necessary to prevent evasion of taxes or clearly to reflect income, the IRS may also require
that the income be allocated from the Roth IRA Corporation to the individual, business, or other
entities under the control of the individual. The IRS may also take the position that these
arrangements give rise to one or more prohibited transactions between a Roth IRA and a
disqualified person. The IRS may also impose an excise tax on excess contributions to Roth
IRAs.
Reasons for Change
The Roth IRA shelter and transactions like those in Swanson are tax avoidance schemes
designed to avoid the annual limits on contributions to IRAs and to shelter income. In doing so,
these arrangements artificially shift taxable income away from the IRA owner or from an entity
controlled by the IRA owner to the IRA, a tax-exempt entity.
Description of Proposal
The proposal expands the definition of disqualified person under the prohibited
transaction rules. Under the proposal, entities established by IRA owners are disqualified
persons for purposes of the prohibited transaction rules. The proposal also makes all IRA
owners disqualified persons under the prohibited transaction rules.
Effective Date
The proposal is effective for transactions on or after the date of enactment.
Discussion
The Roth IRA shelter and transactions like those in Swanson are designed to avoid the
annual limits on contributions to IRAs through indirect contributions. These transactions shift
value to an individual's IRA through one or more business entities controlled by the individual.
Because the individual controls the business entity, the individual is in the position to shift
otherwise taxable income or value away from it, often in a transaction that may create a
deduction for the business entity. In doing so, the individual artificially shifts taxable income
away from the business entity into the IRA. In other words, the transaction shifts income that
would be currently taxable (e.g., to the IRA owner) to the IRA. In reality, the value shifted from
the business entity is an indirect payment through an entity established by an individual, to the
IRA for the benefit of the individual. The payment accumulates tax-free in the IRA and, if held
in a Roth IRA, may generate tax-free distributions.
The prohibited transaction rules are intended to prevent persons with close relationships
to plans, including IRAs, from using those relationships to enrich themselves at the expense of
plan participants and beneficiaries. By making entities established by IRA owners disqualified
persons, the proposal prevents IRA owners from using such an entity to sidestep the annual
limits on contributions to IRAs by shifting value from the entity to the IRA. Additionally, by
making all IRA owners disqualified persons (and not just owners of self-directed IRAs because
of their status as fiduciaries) the proposal makes the prohibited transaction rules applicable to all
IRAs on a more consistent basis.
H. Repeal Pick-Up Rules for Employee Contributions to
State or Local Governmental Retirement Plans
(sec. 414(h))
Present Law
Taxation of contributions to qualified retirement plans
Contributions to qualified retirement plans generally fall into three categories: employer
contributions, employee contributions, and elective deferrals. Generally, the type or types of
contributions made to a plan is determined by the terms of the plan.
Employer contributions to a qualified retirement plan are not includible in an employee's
income at the time of contribution and are not wages for purposes of tax under the Federal
Insurance Contributions Act (''FICA''). Employee contributions are generally made on an
after-tax basis, that is, they are included in income at the time of contribution. Employee
contributions are also generally wages for FICA tax purposes.
An amount contributed to a qualified retirement plan at the election of an employee is
generally treated as an employee contribution and thus is includible in income. However, a
defined contribution plan may include a qualified cash-or-deferred arrangement (referred to as a
''401(k)'' plan) under which employees may elect whether to receive certain amounts in cash or
to have them contributed to the plan on a pretax basis (referred to as ''elective deferrals'').
Elective deferrals are subject to certain rules. For example, elective deferrals must be fully
vested and may not exceed an annual limit ($14,000 for 2005). Elective deferrals are not
includible in income at the time of contribution; however, they are wages for FICA tax purposes.
A distribution of benefits from a qualified retirement plan generally is includible in gross
income in the year it is paid or distributed, except to the extent the amount distributed represents
a return of the employee's after-tax contributions (i.e., basis).
Special rules for State and local governmental plans
Some defined benefit pension plans require employee contributions. In many cases,
governmental employees are required to participate in and contribute to a defined benefit pension
plan as a condition of employment. In such cases, the required employee contributions are
generally withheld from employees' salaries. In some cases, a governmental plan may cover
employees of different governmental entities. For example, a plan established by a State may
cover employees of various State agencies or employees of the State and of local governments
within the State. In such cases, the plan may provide employers with the option of paying
required employee contributions on behalf of their employees, rather than withholding the
required contributions from employees' salaries.
Under a special rule, in the case of a plan maintained by a State or local government, if
contributions are designated as employee contributions, but the State or local governmental
employer ''picks up'' (i.e., pays) the contributions, contributions so picked up (''pick-up
contributions'') are treated as employer contributions. As a result of being treated as employer
contributions, pick-up contributions are not includible in employees' income at the time of
contribution.
Legislative history indicates that the pick-up rules were intended to apply to situations in
which amounts are designated as employee contributions under a State or local governmental
plan, but the governmental employer pays all or a part of the employee's contribution without
withholding the amount from the employee's salary. In this situation, the portion of the
contribution that is ''picked up'' by the government was viewed as, in substance, an employer
contribution for Federal tax purposes, even though designated as an employee contribution for
purposes of State law.
IRS guidance has applied pick-up treatment in situations in which employees' salaries are
reduced by the amount of the contribution as long as individual employees are not given the
option of choosing to receive amounts directly instead of having them paid by the employer to
the plan. The IRS has issued numerous private letter rulings to taxpayers that deal with the
application of the pick-up rules to particular arrangements. Many of these rulings apply pick-up
treatment to employee contributions to a State or local governmental pension plan that are
required as a condition of employment and withheld from employees' salary. The IRS also has
ruled favorably on arrangements that allow individual employees to make an irrevocable election
to have contributions made to a plan on their behalf by payroll deduction if a State statute or
similar provision provides that the contributions are being paid by the employer in lieu of
contributions by the employee. The rulings conclude that, in these circumstances, the
employee does not have the option of receiving the amounts directly and that pick-up treatment
applies.
Although pick-up contributions are treated as employer contributions for income tax
purposes, pick-up contributions made pursuant to a salary reduction agreement are wages for
FICA tax purposes. However, compensation of State and local government employees who
are covered by a qualified retirement plan may be generally exempt from FICA tax.
Reasons for Change
The pick-up rules result in inconsistent tax treatment of employee contributions to
qualified retirement plans. Employee contributions made to plans maintained by private
employers or by the Federal government are includible in income. However, the pickup rules
allow employee contributions to State and local governmental plans to be made on a pretax basis.
In many cases, inconsistent treatment applies also for FICA tax purposes. These inconsistencies
cause inequity in the tax system.
Description of Proposal
Under the proposal, the pick-up rules are repealed. Accordingly, contributions to a State
or local government plan that are designated as employee contributions under the plan are treated
as employee contributions for Federal tax purposes. Thus, such contributions are includible in
income and are wages for FICA purposes.
Effective Date
The proposal applies to employee contributions made in taxable years beginning after the
date of enactment.
Discussion
The pick-up rules provide a special tax benefit for contributions made by State and local
government employees that is not available to contributions made by employees of private
employers or employees of the Federal government. Moreover, application of the pickup rules to
employee contributions to defined contribution plans could be a means of avoiding the
requirements applicable to elective deferrals. In conforming the treatment of contributions made
by State and local government employees to the treatment of contributions made by other
employees, the proposal furthers consistency in the tax system.
The pickup rules also lead to complexity, both with respect to whether contributions are
eligible for pick-up treatment (as evidenced by the number of IRS rulings in this area) and
particularly with respect to whether pickup contributions are made pursuant to a salary
arrangement and are thus subject to FICA tax. Under the proposal, the designation of
contributions as employee contributions under the terms of the plan determines the status of the
contributions for Federal tax purposes. As a result, the need to make a separate determination
of the character of the contributions for income or FICA tax purposes is eliminated.
Repeal of the pick-up rules may have the effect of increasing income taxes for
participants in some State or local government plans with respect to employee contributions that
are no longer eligible for pick-up treatment and thus are includible in income. Alternatively,
some State and local governmental employers may choose to redesign their plans so that
contributions that are currently designated as employee contributions are instead treated as
employer contributions. In that case, such employer contributions would not be includible in
employees' income or wages for FICA purposes.
In the case of employee contributions that are includible in income under the proposal,
after-tax treatment of such contributions results in basis, so that a corresponding portion of the
plan distributions made to participants is treated as a nontaxable return of basis. The need to
determine the portion of a distribution that is includible in income may add complexity for
participants. However, this information is generally required to be provided on the tax
statements (Form 1099-R) that a qualified retirement plan provides to participants. To the extent
that the portion of a distribution that is includible in income is reported on the Form 1099-R,
participants would not have to make this determination themselves.
The proposal may add administrative complexity for some qualified retirement plans by
creating the need to keep records on after-tax employee contributions. However, because pick-
up contributions are employee contributions under the plan and may therefore receive special
treatment under the plan, some plans may already keep such records.
The proposal may have the effect of increasing FICA taxes for some employers and
employees (subject to the ability of State and local governmental employers to redesign their
plans as discussed above), as well as increasing revenues for the Social Security and Medicare
programs. Similarly, the proposal may result in additional wages for Social Security and
Medicare purposes, which would be likely to increase benefits for some individuals, as well as
long-term costs under such programs.
V. CORPORATE AND PARTNERSHIP PROVISIONS
A. Modify Extraordinary Dividend Rules for Common Stock
(sec. 1059)
Present Law
A corporation that receives a dividend from another corporation is entitled to at least a 70
percent dividends received deduction if holding period requirements are met. Thus the
maximum rate on such a dividend is 10.5 percent (35 percent, the maximum corporate tax rate,
times the 30 percent of the dividend that is taxable.) Under section 1059, if the dividend is an
''extraordinary'' dividend (as defined), the recipient corporation must reduce its basis in the
dividend paying stock by an amount equal to the ''nontaxed'' portion of the dividend (the amount
of the dividends received deduction with respect to the dividend).
A dividend received by an individual generally is taxed at a maximum rate of 15 percent.
If a dividend received by an individual is an ''extraordinary'' dividend, any loss on the stock is
treated as a long term capital loss to the extent of the dividend. Thus, the loss will reduce the
individual's net long-term capital gain (if any) before reducing the net short-term capital gain.
An extraordinary dividend is generally defined to include any dividend that (1) is paid
within two years of the purchase of the stock and (2) exceeds 10 percent of the taxpayer's
adjusted basis in the stock (five percent in the case of preferred stock). If the aggregate of all
dividends received within a year exceeds 20 percent of a taxpayer's adjusted basis, then such
dividends are also extraordinary dividends.
All dividends received by the taxpayer that have ex-dividend dates within the same
period of 85 days are aggregated to apply the 10-percent test or five percent of preferred stock.
If the taxpayer establishes to the satisfaction of the Secretary the fair market value of the
stock as of the day before the ex-dividend date, then the taxpayer can use such fair market value
in lieu of adjusted basis for purposes of applying the 10 percent and other thresholds.
Reasons for Change
Present law is intended to prevent ''dividend stripping'' transactions. In such transactions,
a taxpayer purchases stock prior to a very large dividend for a price that reflects the expectation
of the dividend, receives the dividend, and then sells the stock for a loss after the dividend, at a
price that reflects the reduction in value following the payment. If the dividend is taxed at a rate
lower than the rate imposed on income that can be sheltered by the loss, and if the basis of stock
is not reduced by any portion of the dividend received, tax benefit can result without any true
economic loss to the stockholder.
Present law unnecessarily allows dividend stripping transactions to occur on some very
large dividends, due to the 10-percent threshold for dividends with respect to common stock.
Description of Proposal
The proposal reduces the threshold for extraordinary dividends on common stock from 10
percent of the adjusted basis of the stock to five percent of such adjusted basis. As under present
law, the taxpayer can elect to use fair market value on the day before the ex-dividend date if such
fair market value is established to the satisfaction of the Secretary.
Effective Date
The proposal is effective for distributions on or after the date of enactment.
Discussion
Stock basis reduction under section 1059 is generally appropriate if a taxpayer has
purchased stock within a relatively short time prior to a dividend. In such a case, the
shareholder could be viewed as having purchased two assets: first, a ''right to dividend value''
and second, the remaining value of the stock. The basis reduction after the dividend leaves the
taxpayer with the proper remaining basis in the stock.
However, basis reduction may be too complicated in the case of purchases and sales of
stock that capture, in the interim, regular quarterly dividends. Thus, present law applies the basis
reduction rule only to certain purchases and sales where ''extraordinary'' dividends are involved,
and does not attempt to apply the rule to regular quarterly dividends.
Nevertheless, the definition of ''extraordinary'' dividends is arguably too narrow, since it
seems to exclude dividends that many would consider ''extraordinary.'' In the case of common
stock, only if all dividends aggregated within an 85 day period exceed 10 percent of the adjusted
basis of the stock (or the fair market value of the stock, if the taxpayer elects uses that measure
instead) is the dividend considered ''extraordinary,'' unless the dividends over a full year
aggregate to greater than 20 percent of the adjusted basis (or fair market value) of the stock. Yet
a quarterly dividend equal to 10 percent of the higher or basis or fair market value of stock is a
significant dividend.
There is increasing evidence that, as a result of the reduction of taxes on dividends and
possibly for other reasons, corporations have increased their dividend payouts. However, even
with the increased payouts, annual dividend yields are still well below 10 percent. In 2004,
there were only a handful of companies that had dividend yields above 10 percent. For most of
the companies paying dividends, the dividend payments on the ex-dividend date were below five
percent of the market price.
Under the proposal, the annual rate on common stock dividends would be modified to
substitute a five percent of basis or fair market value test for the current 10-percent test.
B. Reduce Tax-Indifferent Shareholder's Basis in Stock by
Nontaxed Portion of Extraordinary Dividend
(sec. 1059)
Present Law
In general
A shareholder generally is not required to reduce its basis in stock upon the receipt of a
dividend on that stock. This rule applies to ordinary dividends as well as redemptions of stock
that are treated as dividends.
In the case of a dividend resulting from a redemption of stock, ''proper adjustment'' of the
basis of the shares of stock outstanding after the redemption is made to account for the basis of
the redeemed shares. Treasury regulations provide three examples illustrating a proper
adjustment. In one example, a husband owns half the stock of a corporation, and his wife owns
the other half. The corporation redeems all of the stock owned directly by the husband. Under
the constructive ownership rules applicable in determining whether the redemption is treated as a
dividend, the husband is considered to own the stock owned by his wife. As a result, the
husband's interest in the corporation has not been reduced and the redemption is treated as a
dividend distribution. The example concludes that after the redemption the basis of the shares of
stock owned by the wife includes the basis of the stock held by the husband before the
redemption.
Basis reduction rules
In certain situations, the general rule that a dividend distribution does not require basis
reduction is superseded by more targeted rules. Under section 1059, if a corporate shareholder
receives an extraordinary dividend and has not held the stock for more than two years before the
dividend was announced (and in certain other circumstances), the corporation generally is
required to reduce its basis in the stock with respect to which the dividend is paid. A dividend on
common stock generally is an extraordinary dividend if the amount of the dividend is at least 10
percent of the taxpayer's adjusted basis in the stock. Certain dividends resulting from
redemptions of stock are treated as extraordinary dividends, and basis adjustment is required
without regard to the redeemed corporate shareholder's holding period in its redeemed stock.
These dividends are those resulting from: (1) a partial liquidation; (2) a non-pro-rata redemption;
(3) the application of a rule attributing stock of a corporation to the party holding an option on
that stock (the ''option rule''); or (4) the application of section 304, relating to redemptions
through the use of related corporations. If a dividend is extraordinary and basis reduction is
required, the amount of the reduction is the amount of the nontaxed portion of the dividend,
which effectively is the amount of the dividends received deduction allowed with respect to the
stock (for example, 70 percent of the dividend in the case of a dividend on portfolio stock).
The basis reduction rule was intended to prevent dividend stripping -- the acquisition of
stock shortly before the ex-dividend date, the receipt of a dividend with respect to which the
dividends received deduction is allowed, and the sale of the stock after satisfying the holding
period requirement for the dividends received deduction. In the absence of a rule requiring
basis reduction, dividend stripping generally would produce (1) short-term capital loss in an
amount equal to the full amount of the dividend -- because on payment of a dividend the price of
a share of stock generally declines by the amount of the dividend -- and (2) taxable income only
for the portion of the dividend for which the dividends received deduction was not available.
Basis reduction generally is not required when the taxation of a dividend payment is
reduced or eliminated for a reason other than the dividends received deduction -- when, for
example, the shareholder receiving the dividend is a foreign person or a tax-exempt organization.
Basis-shifting transactions
Certain features of present law arguably permit basis-shifting transactions that generate
tax losses. Those features of present law are the following. First, as described above, a
redemption can be treated as a dividend because of the application of the option rule. Second,
although a redemption treated as a dividend because of the option rule is an extraordinary
dividend, the shareholder's basis in the redeemed shares is not reduced if the dividend is taxed at
a reduced or zero rate for a reason other than the dividends received deduction. Third, foreign
persons generally are not subject to U.S. tax on dividends paid by foreign corporations and often
are subject to reduced treaty withholding rates on dividends paid by U.S. corporations. Fourth,
under Treasury regulations described above, if an amount received in a stock redemption is
treated as a dividend, basis shifts to shares not redeemed.
The following is an example of a transaction in which taxpayers have taken the position
that basis in stock shifts from a shareholder that has its stock redeemed to a nonredeemed
shareholder. A foreign corporation is wholly owned by two shareholders. One shareholder is a
U.S. person, and the other is a foreign corporation. The foreign corporate shareholder also owns
an option to acquire the stock owned by the U.S. person. The foreign shareholder has all its
stock redeemed, but, because of the option rule, the redemption is treated as a dividend. Because
the redeemed shareholder and the redeeming corporation are foreign, the redeemed shareholder
is not subject to U.S. taxation on the dividend distribution. The U.S. shareholder takes the
position that under Treasury regulations its basis in its stock is increased by the basis of the
stock redeemed from the other shareholder. The U.S. shareholder subsequently sells its stock
and claims a loss. In 2001 the IRS issued a notice that this basis-shifting transaction was a listed
transaction. The Treasury Department issued proposed regulations that would make the tax
treatment of this transaction less favorable by suspending the loss in certain circumstances.
Reasons for Change
The existing extraordinary dividend rules require basis reduction if a dividend payment is
not taxed in full because of the dividends received deduction. This basis reduction is intended to
prevent the taxation of the dividend at a low rate with a corresponding capital loss allowable at a
higher rate. However, these rules do not apply if a dividend payment is partly or entirely exempt
from U.S. taxation for reasons other than the dividends received deduction. Consequently, in
certain redemptions that are treated as dividends but are not subject to full U.S. taxation, tax
basis is preserved and may be shifted to a shareholder whose stock is not redeemed. This
shifting of basis may be from a tax-indifferent shareholder -- a foreign person or tax-exempt
organization -- to a taxable shareholder. If the shift is to a taxable shareholder, that shareholder
can use the additional basis to generate a tax loss on a subsequent disposition of the stock to
which the basis has been shifted. Thus, the combination of failing to reduce basis by the
nontaxed portion of an extraordinary dividend and the shifting of tax basis to a taxable person
creates a taxable loss without corresponding taxable income. This result is contrary to the
purpose of the extraordinary dividend rules.
Description of Proposal
The proposal provides that for purposes of the extraordinary dividend rules, the nontaxed
portion of a dividend includes the amount of a dividend received by a shareholder to the extent
the shareholder is not subject to current U.S. taxation. Shareholders not subject to current U.S.
taxation (for example, foreign persons or tax-exempt organizations such as section 501(c)
nonprofit organizations) generally are required to reduce their basis in stock of a corporation
upon receiving an extraordinary dividend from that corporation to the extent the dividend is not
subject to current U.S. taxation. The holding period rules governing this basis reduction are the
same as under present law: In general, basis reduction is required if the shareholder has not
owned the stock on which an extraordinary dividend is paid for more than two years before the
dividend announcement date, but this holding period requirement does not apply to redemptions
treated as extraordinary dividends without regard to holding period.
If a treaty between the United States and a foreign country reduces (but does not fully
exempt) U.S. tax imposed on a dividend (and the dividend is not otherwise subject to U.S. tax),
the proposal provides that the nontaxed portion of a dividend is determined based on the amount
of the dividend multiplied by a fraction, the numerator of which is the tax rate applicable without
reference to the treaty less the tax rate applicable under the treaty, and the denominator of which
is the tax rate applicable without reference to the treaty. For example, if a foreign person with a
stock basis in a U.S. corporation of $100 receives an extraordinary dividend of $100 that is
subject to a 15-percent reduced withholding rate under a tax treaty, the foreign person is required
to reduce its stock basis by 50 percent of the dividend (the 15-percent reduction from the 30-
percent withholding tax, divided by 30 percent), or $50.
For these purposes the nontaxed portion of a dividend does not include dividends that are
currently subject to U.S. tax, such as dividends that are subject to the full 30-percent U.S.
withholding tax or to the unrelated business income tax, or the portion of dividends received by a
controlled foreign corporation or passive foreign investment company that are currently included
in a U.S. shareholder's taxable income. Thus, those dividends generally do not cause a reduction
in stock basis in a corporation.
Effective Date
The proposal is effective for distributions on or after the date of enactment.
Discussion
The proposal is based on two related principles. First, the theory of the extraordinary
dividend rules supports a revision of those rules. Second, because the existing extraordinary
dividend rules permit excess basis to remain in stock after certain dividend payments, those rules
allow improper basis shifting. Each of these principles is discussed below.
The basis reduction for extraordinary dividends under the proposal is consistent with the
theory of section 1059. If a dividend payment on a share of stock is likely to result in the
distribution of earnings and profits not attributable to the earnings that accrued on that share
while it was held by the shareholder, the payment represents a return of the shareholder's
investment in the stock. Similarly, a non-pro-rata redemption treated as a dividend or a
redemption treated as a dividend because of the option rule likely results, in part, in the return of
a shareholder's investment rather than in the distribution of earnings attributable to the redeemed
stock. As a result, in the absence of a rule mandating basis reduction, basis in the shares on
which a dividend is paid, and basis that is shifted to non-redeemed shares in a redemption, is
likely to be too high. This is equally true whether the dividend is not fully subject to tax by
reason of the dividends received deduction or a taxpayer's exemption from tax.
Gaps in the existing extraordinary dividend rules lead to improper basis shifting from one
shareholder to another. The basis shifting is improper for two related reasons. First, the basis
that is shifted is basis that should have been eliminated under the policy of the extraordinary
dividend rules described above. Second, because certain redemption transactions in which basis
shifts result (but for the operation of the option rule) in the termination of a redeemed
shareholder's interest in the redeeming corporation, arguably the redemption should not be
accorded dividend treatment and the redeemed shareholder's basis in its stock should not be
permitted to shift under Treasury regulations. In fact, in Notice 2001-45 the IRS announced its
intention to attack basis-shifting transactions by (1) treating the redemption as a sale rather than a
dividend distribution under the prearranged plan principles of Zenz v. Quinlavan or (2)
disallowing as not ''proper'' any basis shift under the existing Treasury regulations.
It might be argued that mandatory basis reduction for extraordinary dividends received by
shareholders not subject to current U.S. taxation will inappropriately affect legitimate business
transactions. In this view the general principle of basis preservation should not be violated
absent evidence that a particular transaction is abusive. One response to this argument is
discussed above: if a dividend is untaxed or partially taxed and does not represent a distribution
of earnings attributable to the stock on which the dividend is paid, the theory of the extraordinary
dividend rules supports departure from the general principle of basis preservation. In addition,
for a shareholder not subject to U.S. taxation, basis preservation for U.S. tax purposes generally
is unnecessary and therefore should yield to the goal of preventing the use of that basis to create
allowable losses for U.S. taxpayers.
C. Modify Active Business and Control Requirements for
Section 355 Corporate Divisions
(sec. 355)
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. 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.
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 business
test''). 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 that are engaged in the
active conduct of a trade or business.
In determining whether a corporation is directly engaged in an active trade or business
that satisfies the requirement, old IRS guidelines for advance ruling purposes required that the
value of the gross assets of the trade or business being relied on must ordinarily constitute at
least five percent of the total fair market value of the gross assets of the corporation directly
conducting the trade or business. More recently, the IRS has suspended this specific rule in
connection with its general administrative practice of moving IRS resources away from advance
rulings on factual aspects of section 355 transactions in general.
Another requirement for tax-free treatment under section 355 is that the distributed
subsidiary must, immediately prior to the distribution, be under the ''control'' of the parent, as
defined in section 368(c). That section defines ''control'' as ownership of stock possessing at
least 80 percent of the total combined voting power of all classes of stock entitled to vote and at
least 80 percent of the total number of shares of all other classes of stock of the corporation.
This section 355 definition of ''control'' is the definition generally used for purposes of the tax
provisions that deal with corporate reorganizations and certain other restructurings.
This ''control'' definition differs from the definition that governs for purposes of
determining whether corporations are sufficiently related that they are eligible to file a
consolidated return. That definition, contained in section 1504(a)(1)(B), requires ownership of
stock possessing at least 80 percent of the vote and 80 percent of the value of the subsidiary.
Nonvoting preferred stock that does not participate in corporate growth to any significant extent
is not counted as stock for this purpose.
Reasons for Change
The original purpose of section 355 was to permit the tax free separation of a single
enterprise involving different active businesses, which separation is in the nature of a
rearrangement of existing business among existing shareholders. Section 355 should be confined
more closely to this purpose by limiting its use in the case of transactions that more closely
resemble ''sales'' of a business due to the presence of large amounts of cash or the lack of
continuing participating equity ownership by the same shareholders.
Description of Proposal
To satisfy the active business test of section 355, the proposal requires at least 50 percent
of the gross assets of each of the parent corporation and the distributed subsidiary to have been
used in the active conduct of one or more trades or businesses.
For this purpose, the active business test is applied by reference to the relevant affiliated
group rather than on a single corporation basis. For the parent distributing corporation, the
relevant affiliated group consists of the distributing corporation as the common parent and all
corporations affiliated with the distributing corporation through stock ownership described in
section 1504(a)(1)(B) (regardless of whether the corporations are otherwise includible
corporations under section 1504(b)), immediately after the distribution. The relevant affiliated
group for a controlled distributed subsidiary corporation is determined in a similar manner (with
the controlled corporation as the common parent).
In addition, the same control test used for this new active business test is used to
determine whether a distributed corporation was controlled by the parent immediately prior to a
corporate division. Thus, the parent corporation is required to own stock possessing at least 80
percent of the voting power and 80 percent of the value of a controlled corporation (excluding
certain nonvoting preferred stock that does not participate significantly in corporate growth) in
order for the controlled corporation to be treated as a corporation eligible for a tax free corporate
division, or as a corporation whose active business assets are counted in determining whether
sufficient active business assets are retained in each of the parent and the subsidiary distributed
group.
Effective Date
The proposal is effective for distributions on or after the date of enactment.
Discussion
The purpose of section 355 is to permit existing shareholders to separate existing
businesses for good 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. A number of problems
with section 355 have emerged.
Present law has arguably permitted the use of section 355 to separate out a relatively
small business together with a very large proportion of cash. Recent press reports have referred
to these transactions as ''cash-rich'' tax-free corporate divisions. For example, 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 could provide some limit to the proportion of cash that
can be distributed in such transactions.
Present law requires the active business test generally to be applied at the level of the
particular single corporation that is the distributing parent or the distributed subsidiary, without
general regard to the level of active business assets in any subsidiary corporations of such top tier
corporations. Application of the rule only at that level may in part have contributed to the
administrative approach of requiring only a relatively small amount of active business assets.
At the same time, present law differentiates between a holding company structure
(where ''substantially all'' the holding company assets must be stock or securities of corporations
engaged in the active conduct of a trade or business) and a structure in which the parent
corporation itself conducts an active business (even though only five percent of the corporate
assets might be devoted to that business). For example, a parent holding company that owned
five subsidiaries of equal value might fail the active business test if four of its five subsidiaries
conducted an active business and 100 percent of the value of each of those subsidiaries consisted
of active business assets, but the fifth subsidiary held only investment assets. If all of these
enterprises had existed within a single corporate shall, the old five percent active business asset
test would easily have been satisfied. These rules produce unnecessary complexity and resulting
inefficiency. Tax planning is often required to reposition active business assets prior to a section
355 transaction, to satisfy the active business test (for example, by liquidating a small active
business into the parent corporation of what had been a holding company chain). Allowing the
active business test to be applied with reference to an entire chain of controlled corporations can
alleviate this complexity and can also make it easier to satisfy the proposed new 50-percent
standard for active business.
Using a control test for section 355 purposes that requires 80 percent ownership of both
the vote and the growth equity value of a subsidiary also advances the purpose of treating
controlled entities as one in this context.
Present law can permit a large percentage of participating growth equity to be held
outside the group. For example, a parent corporation that owns 80 percent of both the vote and
value of a subsidiary corporation may cause that subsidiary to issue an amount of stock to
outsiders so long as the outsiders do not obtain 50 percent or more of the value of the
subsidiary, while leaving 80 percent of the voting power with the parent corporation. The parent
can extract this cash from the subsidiary prior to the section 355 spin-off. Although more than 20
percent in value of new stock can similarly be issued under the proposal, such stock would have
to be nonvoting preferred stock that does not participate to any significant extent in corporate
growth '' a type of stock that the consolidated return control rules view as similar to debt.
The 50-percent active business aspect of the proposal could be criticized as not going far
enough, since at least 50 percent of assets can still be mere investment assets or cash.
Consideration could be given to raising the threshold higher, for example, to an 80-percent active
business asset requirement. 80 percent is the present law requirement for favorable tax treatment
of investments in certain small business corporations.
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 is arguable that corporate business purposes might require large amounts of cash or
other investment assets to prepare for upcoming business needs. However, if half the entire value
of the entity can be cash or other investment assets, this would appear to be a significant leeway
for such events.
Finally, although the distributed cash does remain in corporate solution, it may be very
accessible to the shareholder even without a further distribution. The divisive transaction has
occurred that has changed the shareholder's investment by separating the cash from the assets in
which it 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 in comparison to its investment assets.
D. Modify Application of Unrelated Business Income Tax
to S Corporation Shareholders
(sec. 512)
Present Law
In general, an S corporation is not subject to corporate-level income tax on its items of
income and loss. Instead, an S corporation passes through its items of income and loss to its
shareholders. The shareholders take into account separately their shares of these items on their
individual income tax returns.
A small business corporation may elect to be an S corporation with the consent of all its
shareholders, and may terminate its election with the consent of shareholders holding more than
50 percent of the stock. A ''small business corporation'' generally is defined as a domestic
corporation which has (1) no more than 100 shareholders, all of whom are U. S. individuals,
certain types of trusts, estates, charitable organizations, qualified retirement plans, and IRAs
holding certain bank stock, and (2) only one class of stock.
If a qualified tax-exempt entity (other than an employee stock ownership plan) holds
stock in an S corporation, the interest held is treated as an interest in an unrelated trade or
business, and the entity's share of the S corporation's items of income, loss, or deduction, and
gain or loss on the disposition of the S corporation stock, are taken into account in computing
unrelated business taxable income.
Reasons for Change
The S corporation rules were designed to require that all income of the corporation be
subject to tax at the shareholder level. This purpose should be carried out by making sure that all
S corporation shareholders, including tax-exempt entities, must pay tax on their share of income
from the S corporation.
Description of Proposal
Under the proposal, a tax-exempt entity (other than an employee ownership plan) is a
permissible shareholder of an S corporation only if it is subject to tax on its share of S
corporation income. Thus, for example, an organization whose income would otherwise be tax-
exempt under section 115 (relating to income derived from essential government function) must
pay the unrelated business income tax on its share of S corporation income or not qualify as a
permissible shareholder of the S corporation.
Also, the unrelated business taxable income of a tax-exempt entity holding S corporation
stock will not be less than the amount of such income taking into account only the S corporation
items. In other words, losses from non-S corporation sources cannot offset income from S
corporations.
Effective Date
The proposal applies to taxable years beginning after date of enactment.
Discussion
In 1996, when Congress allowed certain tax-exempt entities to be shareholders in an S
corporation, Congress stated ''the provisions of subchapter S were enacted in 1958, and
substantially modified in 1982 on the premise that all income of the S corporation would be
subject to a shareholder-level tax. The underlying premise allows the rules governing S
corporations to be relatively simple (in contrast, for example, to the partnership rules of
subchapter K) because of the lack of concern about ''transferring'' income to non-taxpaying
persons. Consistent with this underlying premise of subchapter S, the proposal treats all income
flowing through to a tax-exempt shareholder, and gains and loss from the disposition of the
stock, as unrelated business taxable income.''
Notwithstanding the intent of the 1996 legislation to treat all S corporation income
allocated to a tax-exempt entity as unrelated business taxable income, there nevertheless may be
certain income that is not subject to tax. The IRS has listed as a tax avoidance transaction, the
use of certain tax-exempt entities, claiming that their allocated taxable income from an S
corporation is not subject to the tax on unrelated business income, to shift income to the tax-
exempt entity. The proposal solidifies the intent of Congress that all income of the S
corporation be subject to tax.
Since losses of tax-exempt organizations may be created by misallocation of deductions
between exempt and non-exempt income of the entity, the limitation on the use of losses of tax-
exempt entities to offset S corporation income is proposed.
E. Modify Safe Harbor for Allocation of Nonrecourse Deductions and Exclude
Nonrecourse Liabilities From Outside Basis
(secs. 704 and 752)
Present Law
In general, the income, gain, loss, deduction, or credit of a partnership must be allocated
among the partners in accordance with the partnership agreement. If, however, the allocation
in the partnership agreement does not have substantial economic effect (or there is no partnership
agreement), then a partner's distributive share of income, gain, loss, deduction, or credit must be
determined in accordance with the partner's interest in the partnership.
An allocation has substantial economic effect if the allocation has (1) economic effect
that is (2) substantial. In order for an allocation to have economic effect, generally the
partnership must properly maintain capital accounts, liquidate in accordance with positive capital
accounts, and a partner with a deficit capital account on liquidation must be unconditionally
obligated to restore the deficit. An alternative test for economic effect is provided if a partner
is not unconditionally obligated to restore a deficit capital account on liquidation. Under the
alternative test, an allocation may not create a deficit capital account or increase a deficit beyond
what the partner has agreed to restore. An allocation is substantial if there is a reasonable
possibility that the allocation will affect substantially the dollar amounts to be received by the
partners from the partnership, independent of tax consequences.
The term ''partner's interest in the partnership'' refers to the manner in which the partners
have agreed to share the economic benefit or burden corresponding to the income, gain, loss,
deduction, or credit that is allocated. It is determined by taking into account all facts and
circumstances relating to the economic arrangement of the partners including: (1) the partners''
relative contributions to the partnership; (2) interests of the partners in economic profits and
losses (if different from their interests in taxable income or loss); (3) interests of the partners in
cash flow and other nonliquidating distributions; and (4) partners'' rights to distributions of
capital upon liquidation. A rebuttable presumption provides that all partners'' interests are
presumed to be equal (determined on a per capita basis).
A partnership may incur a liability (referred to as a ''nonrecourse liability'') for which no
partner (or related person) bears the economic risk of loss. Partnership property may or may not
secure the liability. For example, a partnership may purchase a building using nonrecourse
financing for which the building secures the debt, or an entity such as a limited liability company
(''LLC'') may simply borrow money in which no property secures the borrowing and the
members of the LLC have limited liability under State law. Allocations of deductions
attributable to partnership nonrecourse liabilities (referred to as ''nonrecourse deductions'')
cannot have economic effect because the lender, rather than the partners, bears the economic cost
attributable to the deductions. In addition, allocations of the gain (referred to as ''partnership
minimum gain'') that would be realized if the property securing the debt were disposed of for no
consideration other than full satisfaction of the liability cannot have economic effect because
these allocations do not reflect any economic gain but merely constitute a recapture of the
nonrecourse deductions. As a result, Treasury regulations require that nonrecourse deductions be
allocated in accordance with the partners' interests in the partnership and partnership minimum
gain be allocated to the partners that were allocated the nonrecourse deductions. The amount of
nonrecourse deductions for a partnership taxable year generally equals the net increase in
partnership minimum gain during the year. The amount of partnership minimum gain is
determined by first computing for each partnership nonrecourse liability any gain the partnership
would realize if it disposed of the property subject to that liability for no consideration other than
full satisfaction of the liability, and then aggregating the separately computed gains.
The regulations contain a four-prong safe harbor that, if satisfied, deems allocations of
nonrecourse deductions to be in accordance with the partners' interests in the partnership. In
order to meet the safe harbor, the following four requirements must be met: (1) the primary or
alternate test for economic effect must be met throughout the full term of the partnership; (2)
nonrecourse deductions must be allocated in a manner that is reasonably consistent with
allocations that have substantial economic effect of some other significant partnership item
attributable to the property securing the nonrecourse liabilities; (3) the partnership agreement
contains a minimum gain chargeback provision (i.e., if there is a net decrease in partnership
minimum gain, each partner must be allocated income and gain equal to its share of the net
decrease in partnership minimum gain): and (4) all other material allocations and capital account
adjustments under the partnership agreement are recognized under section 704(b).
In the preamble to the regulations, the Treasury acknowledged that a partnership may
have a liability that is not secured by any property, is recourse to the partnership as an entity, and
with respect to which no partner bears the economic risk of loss (i.e., an exculpatory liability).
As noted, an exculpatory liability is treated as a nonrecourse liability. The calculation of
partnership minimum gain is difficult in the case of an exculpatory liability because the liability
is not secured by specific property and the adjusted bases of partnership property may fluctuate.
As a result, the Treasury has not prescribed precise rules for exculpatory liabilities and states that
taxpayers should treat allocations attributable to exculpatory liabilities in a manner that reflects
the principles of section 704(b).
A partner's basis in a partnership interest (the ''outside basis''), is treated as including the
partner's share of the partnership's liabilities. Outside basis includes the partner's share of
recourse liabilities as well as nonrecourse liabilities. A partner's share of a partnership recourse
liability is the portion of that liability, if any, for which the partner or a related person bears the
economic risk of loss. A partner's share of the nonrecourse liabilities of a partnership includes
that partner's share of partnership minimum gain. To the extent that partnership nonrecourse
liabilities exceed partnership minimum gain, the excess is allocated among the partners in
accordance with the partner's share of partnership profits, taking into account all facts and
circumstances relating to the economic relationship of the partners.
Reasons for Change
Present law with respect to the allocation of nonrecourse deductions is ineffective in
requiring taxpayers to allocate nonrecourse deductions in a manner consistent with their overall
economic arrangement. This issue has become more serious as a result of the dramatic increase
in the use of LLCs which has occurred since the nonrecourse deduction rules were originally
promulgated. Partners have significant flexibility to allocate nonrecourse deductions in a tax-
motivated manner which is inconsistent with their overall economic arrangement. Because the
allocation of nonrecourse deductions is generally free of any non-tax economic consequences,
partnerships may use such allocations to shift taxable income from one partner to another in a
manner which reduces the tax liability of the partners in the aggregate. Further restrictions on
the allocation and utilization of nonrecourse deductions are necessary to curtail certain forms of
tax-motivated allocations.
Description of Proposal
In general
Under the proposal, the present-law rules for nonrecourse deductions are generally
maintained; however, the second prong of the present-law safe harbor (requiring allocations to be
reasonably consistent with the allocation of some other significant item) is modified to provide
certainty to partnerships and partners while also reducing the potential for abuses that may be
available under the current safe harbor. In addition, the proposal recognizes that some
nonrecourse liabilities may not be secured by any partnership property (e.g., exculpatory
liabilities). As a result, the new safe harbor, unlike the present-law four-prong safe harbor, is
applicable to nonrecourse deductions attributable to nonrecourse liabilities that are secured by
partnership property as well as those that are unsecured. In addition, the proposal provides that
nonrecourse liabilities of a partnership are excluded from a partner's outside basis.
Under the proposal, nonrecourse deductions must still, as a general rule, be allocated in
accordance with the partners' interests in the partnership. Nonrecourse deductions are defined as
under present law to include items of loss, deduction, or section 705(a)(2)(B) expenditures
attributable to nonrecourse liabilities of the partnership. A nonrecourse liability refers to a
partnership liability for which no partner (or related person) bears the economic risk of loss. As
a result, under the proposal, nonrecourse deductions may arise from exculpatory liabilities,
which may be common in entities such as limited liability companies, and may also arise in the
more traditional sense from nonrecourse liabilities that are secured by partnership property (e.g.,
nonrecourse liability secured by a building owned by the partnership).
Modification of safe harbor
Under the proposal, the first, third, and fourth prongs of the current regulatory safe harbor
for allocations of nonrecourse deductions are retained. The second prong, however, is modified.
As under current law, partnerships must satisfy all four prongs in order to be able to rely on the
safe harbor.
Under the new second prong, if the aggregate capital account balances and recourse
liabilities of the partnership constitute at least 20 percent of the total capitalization of the
partnership at the time the nonrecourse liability arises (using book values), then the partners may
allocate nonrecourse deductions in accordance with the relative capital account balances of the
partners. Alternatively, if there is a reasonable expectation of significant residual (or catch-all)
profits, then the partners may allocate the nonrecourse deductions in accordance with the residual
profit sharing arrangement of the partners. In addition, any allocation arrangement which falls
between relative capital account percentages and residual profit sharing percentages is acceptable
if the required minimum capitalization and residual profit sharing expectation are both met.
Nonrecourse liabilities excluded from outside basis
In addition to the safe harbor modification, the proposal provides that nonrecourse
liabilities of the partnership are excluded from a partner's outside basis. As a result, a partner's
outside basis would only be increased by contributions of money or property, distributive shares
of income, gain, and tax-exempt income, and a portion of any recourse liability of the
partnership.
Effective Date
The modified safe harbor proposal is effective for partnership taxable years beginning
after the date of enactment. The proposal to exclude nonrecourse liabilities from outside basis is
effective for nonrecourse liabilities incurred after date of enactment.
Discussion
In general
The four-part safe harbor in the regulations does not adequately restrict allocations of
nonrecourse deductions to arrangements that are consistent with the partners' overall economic
arrangement (i.e., partners' interests in the partnership). In particular, the requirement that the
allocation of nonrecourse deductions be reasonably consistent with some significant item
attributable to the partnership property that secures the liability has not been effective in
restricting allocations to the partners' overall economic arrangement. Some partnerships have
provided for a special allocation of a significant partnership item to support the allocation of the
nonrecourse deduction. In addition, requiring the allocation of nonrecourse deductions to merely
be reasonably consistent (as opposed to identical) with some significant item has led some
partnerships to believe that a fairly wide range is permissible.
The regulations do not specifically address deductions attributable to exculpatory
liabilities. With the increasing popularity of LLCs coupled with the greater limited liability
protection given to all types of partners in both general and limited partnerships, there is an
increasing need to provide clear guidance for the tax treatment of deductions attributable to
exculpatory liabilities. The proposal retains the general guidance that deductions attributable to
exculpatory liabilities need to be allocated in accordance with the partners' interests in the
partnership. But the proposal also provides a new safe harbor that, if satisfied, deems allocations
to be in accordance with the partners' interest in the partnership.
Modified safe harbor
Under the proposal, the modified safe harbor may be satisfied if the allocations are made
in accordance with relative capital account balances at the time the nonrecourse liability arises.
However, the relative capital account method may only be used if the capital accounts and
recourse liabilities are at least 20 percent of the total capitalization of the partnership. For
example, assume A contributes $5,000 and B contributes $15,000 to partnership AB, which
purchases an office building (its only asset) for $100,000. The balance of the purchase price
($80,000) is financed through nonrecourse debt. The aggregate capital accounts represent 20
percent of the total capitalization of the partnership. As a result, the partnership may allocate the
nonrecourse deductions 25 percent to A and 75 percent to B and meet the safe harbor.
Alternatively, if partnership AB expects to have significant residual profits at the time the
nonrecourse liability arises, then it may allocate the nonrecourse deductions in accordance with
the partners' residual profit sharing ratio. Assume the residual profit sharing ratio is 50 percent
to A and 50 percent to B. Under the safe harbor, partnership AB may allocate the nonrecourse
deductions in a 50/50 sharing ratio. If both the 20 percent capitalization rule and the residual
profits expectation rule are met, partnership AB may allocate the nonrecourse deductions in any
ratio between 50/50 and 25/75. Assuming the other prongs of the safe harbor are also met, the
allocation will be deemed to be in accordance with the partners' interest in the partnership.
Partnerships whose capital accounts and recourse liabilities do not constitute at least 20
percent of the total capitalization and that do not reasonably expect to have significant residual
profits are not eligible for the safe harbor. It is appropriate to deny a safe harbor in such cases
because partnerships whose partners have proportionately less at risk are more likely to be used
in tax motivated transactions. Under the general rule of the proposal, their allocations of
nonrecourse deductions must be consistent with the partners' interests in the partnership, and it is
anticipated that such partnerships will allocate nonrecourse deductions consistent with the most
likely allocation of marginal profits (i.e., the last dollar of reasonably expected profits) unless
such allocation is not reflective of the partners' interests in the partnership.
Nonrecourse liabilities excluded from outside basis
While the proposed modification to the safe harbor should be more effective than present
law in requiring partners to allocate nonrecourse deductions in a manner consistent with their
overall economic arrangement, it will not prevent all potential abuses. Thus, the exclusion of
nonrecourse liabilities from partners' outside basis functions as a backstop which should prevent
the most serious abuses, in which a partner with no economic risk at all is allocated nonrecourse
deductions. Because a partner may not deduct allocated losses in excess of its outside basis, the
proposal assures that partners benefit from the allocation of nonrecourse deductions only to the
extent that they bear economic risk with respect to capital contributions, recourse liabilities, or
undistributed partnership income. As under present law, any nonrecourse deductions allocated to
a partner with insufficient outside basis are suspended and become deductible only when the
partner's outside basis is increased to a sufficient amount.
In addition to its role in preventing abuses, this proposal brings the tax treatment of
partners closer to the tax treatment of S corporation shareholders. In an S corporation, liabilities
of the S corporation to persons other than the S corporation shareholders usually have no effect
on the shareholders' adjusted bases for their stock or debt claims against the S corporation.
Under the proposal, a similar result is achieved for partners in a partnership with respect to
nonrecourse liabilities. A partner is still able to include in its outside basis its share of a recourse
liability, defined as a partnership liability for which one or more partners bear the economic risk
of loss. A partner's share of a recourse liability equals that portion of the liability for which
that partner bears the economic risk of loss. A liability may be part recourse and part
nonrecourse in which case only the recourse portion may be included in a partner's outside basis
to the extent the partner bears the economic risk of loss for the liability.
The proposal has the additional benefit of allowing recourse liabilities to be included in a
partner's outside basis without regard to whether the recourse liability is treated as such because
a partner loaned the money to the partnership or whether a partner guaranteed the partnership
liability. In the S corporation context, there has been much confusion and litigation with respect
to the distinction between a liability of the S corporation guaranteed by a shareholder and a
liability of the S corporation to a shareholder. In the former case, the liability is not included as
part of a shareholder's debt claim against the corporation while in the latter case the shareholder
includes the liability as part of its debt claim. The advantage of inclusion in debt claim is that the
shareholder is able to deduct a greater amount of losses flowing through the S corporation to the
shareholder.
Under the proposal, no distinction is made between a liability of the partnership
guaranteed by a partner and a liability of the partnership to a partner. To the extent a partner
bears the economic risk of loss for the liability, however arising, then the partner includes the
recourse liability in its outside basis. As a result, the proposal has some similarity to the rules for
S corporations (i.e., no inclusion of nonrecourse liabilities in outside basis) while eliminating a
perceived weakness of the S corporation regime (i.e., distinguishing between guaranteed debt
and shareholder debt).
The proposal is consistent with the holding of the Supreme Court in Crane v.
Commissioner while at the same time acknowledging the increasing adoption of the entity
theory of partnership law. A partnership that purchases property using nonrecourse financing
includes the nonrecourse debt in its basis in the property. The partnership will compute its
depreciation deductions using a basis that includes the nonrecourse debt. The partners are,
however, treated as separate from the partnership for purposes of the nonrecourse liability, which
represents economic reality. The nonrecourse creditor's remedy in the event of partnership
default is limited solely to one or more assets of the partnership, and the partners are not
personally liable for the liability under State law or under the contractual terms of the debt (or
both). The proposal serves to minimize the flexibility partners may have to allocate deductions
relating to debt for which no partner bears the economic risk of loss.
Finally, if the outside basis restrictions prove effective in preventing abuses, it may
eventually be possible to modify or replace the existing allocation restrictions, resulting in
significant simplification benefits for partners and partnerships.
F. Modify Adjustment Rules for Basis of Undistributed Partnership Property
(sec. 734)
Present Law
Present law provides that the basis of partnership property is to be adjusted as the result
of a distribution of property if the partnership has so elected under section 754, or if there is a
substantial basis reduction with respect to the property distributed (i.e., a basis reduction in
excess of $250,000). If adjustments are made, the basis of partnership property is to be
increased by any gain recognized to the distributee partner, and also to the extent the distributed
property had an adjusted basis to the partnership greater than the basis attributed to the property
in the hands of the distributee. The basis of partnership property is decreased by any loss
recognized to the distributee partner, and also to the extent the distributed property had an
adjusted basis to the partnership that is less than the basis attributed to the property in the hands
of the distributee.
Reasons for Change
The measurement of the basis adjustment is inaccurate in some cases under present law.
The amount of the adjustment does not consistently keep the amount of unrealized partnership
gain or loss unchanged with respect to the remaining partnership interests in a partnership,
following a distribution of property when basis adjustments are made to partnership property.
The adjustment should reflect the difference between the partnership's adjusted basis in the
property distributed, and the reduction in the distributee partner's share of the adjusted basis of
partnership property. This would more accurately adjust for basis that is shifted to or away from
the partnership (and remaining partners) as a result of the property distribution.
Description of Proposal
The method of making the adjustment to remaining partnership property after a
distribution of property, when the adjustments are made under section 734, is changed to reflect
the difference between the basis to the partnership of the distributed property and the reduction
which occurs in the distributee partner's proportionate share of the adjusted basis of the
partnership property.
Effective Date
The proposal applies to distributions made after the date of enactment.
Discussion
The rules contained in section 734(b) are intended to permit a partnership to maintain the
same adjusted basis for partnership property in the aggregate, as is represented by the aggregate
of the adjusted bases of all the partnership interests. However, because this relationship may
already have become distorted before the partnership made the election under section 754 (or
makes a distribution involving a substantial basis reduction), increasing the basis of partnership
property by the amount of gain recognized to the distributee partner or the excess of the basis of
the partnership property over the amount of the basis assigned to it in the hands of the distributee
may not give the correct result, if upward adjustments are required. Similarly, adjustments for
losses or the excess of the basis of a property in the hands of the distributee over the basis to the
partnership may not give the correct result, if downward adjustments in the basis of partnership
property are required. A more accurate result can be obtained by making an adjustment in the
manner recommended by the proposal. Further, the proposal would conform the operation of
section 734(b) to that of the similar provision in section 743(b), which provides for an
adjustment to the basis of partnership property following the transfer of a partnership interest.
The problem involved can be illustrated by the following examples.
Example 1.''Assume that the assets of the equal partnership ABD had a basis of $9,000
and a fair market value of $15,000. D, who recently purchased his interest in the partnership
from C for $5,000 has a $5,000 basis for his partnership interest. A and B each has a basis for
his partnership interest of $3,000. Under present law, if a $5,000 cash distribution is made by
the partnership to either A or B in liquidation of its partnership interest, the partnership would be
entitled to an upward adjustment of $2,000 to the basis of the remaining partnership assets.
However, a similar distribution to D would result in no adjustment. Under the proposal, there
would be a $2,000 upward adjustment regardless of which partner received the distribution.
Example 2.''Assume that the assets of the equal partnership ABD had a basis of $9,000
and a fair market value of $6,000. D, who recently purchased his interest in the partnership from
C for $2,000 has a $2,000 basis for his partnership interest. A and B each has a basis for his
partnership interest of $3,000. Under present law, if a $2,000 cash distribution is made by the
partnership to either A or B in liquidation of its partnership interest, the partnership would be
required to make a downward adjustment of $1,000 to the basis of the remaining partnership
assets. However, a similar distribution to D would result in no adjustment. Under the proposal,
there would by a $1,000 downward adjustment regardless of which partner received the
distribution.
G. Treat Guaranteed Payments to Partners as Payments to Nonpartners
(sec. 707)
Present Law
In general
Under present law, a partner's treatment of items of income, gain, loss, deduction, and
credit arising in respect of the partnership depends on several factors.
In general, a partner includes on its own Federal income tax return its distributive share
of items of partnership income, gain, loss, deduction, or credit. A partner''s distributive share of
an item is determined under the partnership agreement. The allocations provided in the
partnership agreement will be respected if the allocations have substantial economic effect or are
in accordance with the economic interests of the partners. Generally, allocations of partnership
tax items are treated as having substantial economic effect if the partnership maintains capital
accounts for its partners in accordance with regulations, distributions are made in accordance
with the capital accounts, and any partners with a deficit balance in its capital account must make
a capital contribution upon liquidation of its interest in the partnership.
Generally, under timing rules applicable to partnership items, the items are included in
income for the taxable year of the partner in which the partnership's taxable year ends.
Guaranteed payments
If a partner receives a payment that is determined without regard to the income of the
partnership, the payment is considered a guaranteed payment rather than a distributive share of
partnership income. This provision was adopted in 1954 to clarify the situation in which the
amount of the payment exceeded the net income of the partnership and would have resulted in
the payment being out of the capital of the partners rather than from partnership income. The
1954 treatment of guaranteed payments as different from a distributive share of partnership
income provided the relatively narrow clarification that such payments are includable in the
partner's income (not treated as a return of capital).
The rules for guaranteed payments provide that a partner receiving a guaranteed payment
is treated as a third party (rather than as a partner), but only for purposes of income inclusion by
the partner (sec. 61) and deduction of the payment by the partnership (sec. 162(a), subject to
capitalization requirements of section 263).
The partnership deducts guaranteed payments in determining partnership income.
Present law provides a specific rule that matches the timing of inclusion of guaranteed payments
and the deduction of such payments by the partnership. The timing rule is that guaranteed
payments are included in gross income in the taxable year of the partner that ends within, or ends
at the same time as, the taxable year of the partnership in which the partnership deducts the
payment.
Payments made to a partner in a nonpartner capacity
A partner who engages in a transaction with a partnership, other than in its capacity as a
partner, is treated as if it was not a member of the partnership with respect to the transaction.
This rule applies both to performance of services for a partnership by a partner, and transfers
(including indirect transfers) of property between the partnership and the partner. Thus, the
partnership and the partner are treated in the same manner as if the transaction were between the
partnership and a third party.
The partnership is allowed a deduction with respect to a nonpartner payment in
accordance with its method of accounting (provided capitalization rules do not apply); the
partnership may deduct such a payment to a cash-basis partner no earlier than the day that the
amount is includible in the partner's income. The partner includes the payment in income in
accordance with its own method of accounting (provided exclusion rules do not apply). For
example, a cash method partner generally includes the payment upon receipt; an accrual method
partner generally includes the amount when the right to the payment accrues. These timing rules
differ from the timing rule for inclusion and deduction of guaranteed payments.
Reasons for Change
The statutory distinction between guaranteed payments and nonpartner payments may
have little continuing purpose. Eliminating the distinction between the two sets of rules would
conform the income and deduction timing rules applicable to all payments to partners that are not
based on partnership net income to the more generally applicable timing rules applicable to other
taxpayers, and would eliminate opportunities for manipulation of the tax rules and provide
simplification benefits.
Description of Proposal
Under the proposal, all compensation for services or use of capital that is not based on the
net income (or an item of net income) of the partnership is treated as arising from a transaction
between a partnership and a nonpartner. Under the proposal, the income and deduction timing
rule for guaranteed payments is repealed and such payments are subject to the income and
deduction timing rules for nonpartner payments. In determining whether an amount is a
nonpartner payment, the proposal applies a standard of whether the amount is determined by
reference to net income (or an item of net income) of the partnership, in lieu of the present-law
standard of whether the partner is acting in its capacity as a partner. Thus, the proposal clarifies
the treatment of all payments made to a partner that are not determined by reference to the net
income of the partnership.
Effective Date
The proposal applies to taxable years beginning after the date of enactment.
Discussion
The present-law rules relating to guaranteed payments and nonpartner payments give rise
to confusion, uncertainty and needless complexity in several respects. The treatment of
guaranteed payments as nonpartner payments only for income inclusion and deduction purposes,
but not for other tax purposes, has given rise to conflicting regulatory and judicial interpretations.
The difference in the timing rules for deduction and income inclusion with respect to the two
types of payments is confusing and may create opportunities for manipulation of the tax law.
Further, there is uncertainty as to the scope of the application of the nonpartner payment rules of
section 707(a) because it may be unclear whether a partner is acting in its capacity as a partner.
Both guaranteed payments for capital, and guaranteed payments for services, have counterparts
in the section 707(a) rules for nonpartner payments. Several commentators have questioned the
continued viability of a concept of guaranteed payments separate from the concept of payments
treated as made to a partner in a nonpartner capacity.
Eliminating the guaranteed payment rules would eliminate the confusion resulting from
third-party status for some purposes and distributive share status for other purposes, as well as
the confusion arising from the application of two sets of income and deduction timing rules to
payments to partners. Choosing the more generally applicable timing rules applicable to
nonpartner payments, rather than the partnership-specific rule for guaranteed payments that is
provided under present law, promotes neutrality in the tax law as between comparably situated
taxpayers.
The proposal would apply to all payments made to a partner that are not determined by
reference to the net income of the partnership, rather than requiring a factual inquiry as to
whether a partner is acting in its capacity as a partner with respect to the payment. A net income
test would in many circumstances require a simpler factual determination than would the
present-law test relating to the partner's capacity as a partner.
VI. INTERNATIONAL PROVISIONS
A. Amend the Employer-Provided Housing Exclusion and Impose a Stacking Rule
with Respect to Non-Excludable Income
(sec. 911)
Present Law
In general
U.S. citizens generally are subject to U.S. income tax on all their income, whether
derived in the United States or elsewhere. A U.S. citizen who earns income in a foreign country
also may be taxed on such income by that foreign country. The United States generally cedes the
primary right to tax income derived by a U.S. citizen from sources outside the United States to
the foreign country where such income is derived. Accordingly, a credit against the U.S. income
tax imposed on foreign source income is generally available for foreign taxes paid on that
income, to the extent of the U.S. tax otherwise owed on such income. If the foreign income tax
rate is lower than the U.S. income tax rate, then the United States generally provides a credit up
to the amount of the foreign tax and imposes a residual tax to the extent of the difference.
U.S. citizens living abroad may be eligible to exclude from their income for U.S. tax
purposes certain foreign earned income and foreign housing costs, in which case no residual U.S.
tax is imposed to the extent of such exclusion, regardless of the foreign tax paid on such income
(if any). In order to qualify for these exclusions, an individual must be either: (1) a U.S. citizen
who is a bona fide resident of a foreign country for an uninterrupted period that includes an
entire taxable year; or (2) a U.S. citizen or resident present overseas for 330 days out of any
12-consecutive-month period. In addition, the individual must have his or her tax home in a
foreign country.
Exclusion for compensation
The foreign earned income exclusion generally applies to income earned from sources
outside the United States as compensation for personal services rendered by the taxpayer. The
maximum exclusion amount for foreign earned income is $80,000 per taxable year for 2005 and
thereafter. For taxable years beginning after 2007, the maximum exclusion amount is indexed
for inflation.
Exclusion for housing costs
The amount of the employer-provided housing exclusion is equal to the excess of the
taxpayer's ''housing expenses'' over a base housing amount. The term ''housing expenses''
means the reasonable expenses paid or incurred during the taxable year with respect to the
taxpayer's housing in the foreign country. The term includes expenses attributable to housing,
such as utilities and insurance, but does not include interest and taxes, which are separately
deductible. If the taxpayer maintains a second household outside the United States for a spouse
or dependents who do not reside with the taxpayer because of adverse living conditions, then the
housing expenses of the second household are also eligible for exclusion. Under present law, the
base housing amount is 16 percent of the annual salary earned by a GS-14, Step 1, U.S.
government employee. For 2005, this salary is $76,193 and thus the current base housing
amount is $12,190.
In the case of housing costs that are not paid or reimbursed by the taxpayer's employer,
the amount that would be excludible is treated instead as a deduction.
Exclusion limitation amounts
The combined foreign earned income exclusion and housing cost exclusion may not
exceed the taxpayer's total foreign earned income for the taxable year. The taxpayer's foreign
tax credit is reduced by the amount of such credit that is attributable to excluded income.
Reasons for Change
Under present law, an individual working abroad has the potential to exclude significant
amounts of housing benefits. The employer-provided housing exclusion is equal to the excess of
an individual's housing expenses over a base amount, but substantial amounts above the base
may be excluded from income because the exclusion is limited to ''reasonable housing
expenses,'' which allows for generous interpretation by the taxpayer. The proposal would
establish an objective cap to determine ''reasonable housing expenses.'' The proposal would also
tie the employer-provided housing exclusion to the foreign earned income cap to bring the two
exclusions into conformity.
Under present law, individuals working abroad can also benefit from being subject to low
income tax rates on their non-excludible income. The taxable income of section 911
beneficiaries is subject to rates that ordinarily are applicable to taxpayers with substantially less
economic income. The proposal would impose a stacking rule that requires individuals with
section 911 benefits to stack their taxable income after their section 911 exclusion amounts,
thereby subjecting such individuals to the same rates applicable to individuals living and
working in the United States who have the same amount of economic income.
Description of Proposal
Exclusion for compensation
The foreign earned income exclusion remains capped at $80,000 per annum, but is
indexed for inflation every year instead of only taxable years after 2007.
Exclusion for housing costs
The employer-provided housing exclusion is modified by tying it to the foreign earned
income cap and applying an objective standard to the term ''reasonable housing expenses.''
Under the proposal, the base housing amount used to calculate the employer-provided
housing exclusion is set at 16 percent of the foreign earned income exclusion cap, instead of 16
percent of the GS-14, Step 1 amount. As under present law, amounts below the base housing
amount would be subject to U.S. tax because the base housing amount represents an estimate of
expenditures that taxpayers would incur on housing regardless of whether they were relocated
abroad. For 2005, the proposed base housing amount is $12,800 (=$80,000 x .16).
Employer-provided housing amounts in excess of the base housing amount are excluded
from U.S. tax, but under the proposal such amounts are limited to 30 percent of the $80,000
(indexed for inflation). The proposal applies an objective standard to determine ''reasonable
housing expenses.'' The Department of Housing and Urban Development (''HUD'') considers
maximum affordable housing to be 30 percent of an individual's annual income. For 2005, the
proposed maximum housing exclusion is therefore $11,200 (= ($80,000 x .30) - ($80,000 x .16)).
Stacking rule
Under present law, a taxpayer with excludable income under section 911 is subject to tax
on the taxpayer's other income, after deductions, starting in the lowest tax rate bracket. Under
the proposal, the taxpayer's other income, after deductions, is stacked on top of the section 911
exclusion amounts to arrive at the appropriate tax bracket. Thus, the income exempt under
section 911, while not taxed in the United States, is still considered in determining the section
911 beneficiary's appropriate tax rate bracket under the U.S. progressive rate schedule.
Effective Date
The proposal is effective for taxable years beginning after date of enactment.
Discussion
Housing allowance
As opposed to present law, the proposal establishes an objective standard for excludable
housing costs. Under present law, the employer-provided housing exclusion is provided for
expenses above the base amount and capped at ''reasonable housing expenses.'' As the HUD
standard for maximum affordable housing, the 30-percent cap imposes an objective upper-limit
on what is considered ''reasonable housing expenses.'' A criticism of this approach may be that
the objective cap does not account for the possibility that housing expenses in some foreign
locales may exceed costs of housing in the United States. Thus, it may be appropriate to include
some type of cost-of-housing adjustment factor to take into account the disparate cost of housing
around the world. While the proposal does not include a cost-of-housing adjustment factor, the
$80,000 amount used to cap employer-provided housing is more beneficial than using the
median wage and salary amount for a family of four. Median wages and salaries for a family of
four (married filing jointly with two dependents) was $56,085, as reported by taxpayers on Form
1040, in 2002. Thus, using $80,000 for the employer-provided housing calculation is generous
in comparison to using wages and salaries for the median family.
The employer-provided housing exclusion is also tied to the foreign earned income cap.
Thus, the housing exclusion is calculated by taking $80,000, indexed per annum, and applying a
16 percent floor and 30 percent cap. The foreign earned income exclusion cap is the threshold
set by Congress to determine the amount of foreign earnings exempt from U.S. tax. Tying the
employer-provided housing exclusion to the foreign earned income exclusion cap brings the two
exclusions into conformity.
The modifications to the exclusion for employer-provided housing costs may reduce the
current tax benefit provided to certain individuals under section 911. Income not eligible for the
housing exclusion under the proposal would be treated the same as income earned by U.S.
citizens living in the United States; U.S. citizens living abroad would be taxed on their
worldwide income and a foreign tax credit would be allowed for foreign taxes paid. U.S.
citizens living in countries that have tax rates higher than those in the United States would
generally still not owe U.S. tax on the portion of their foreign earned income no longer eligible
for section 911, because such taxes would be covered by the foreign tax credit. U.S. citizens
living in countries that have tax rates lower than the United States would generally be made
worse off relative to present law because the United States would impose a residual tax on the
portion of their foreign earned income no longer eligible for section 911.
Stacking rule
Under present law, taxpayers with excludable income as a result of section 911 are taxed
on any taxable income at rates that ordinarily are applicable only to taxpayers with substantially
less economic income. The proposed stacking rule corrects this situation by subjecting taxpayers
with section 911 excludable income to the same rates applicable to taxpayers with the same
amount of economic income but who live and work only in the United States. For example,
consider a taxpayer who has an $80,000 foreign earned income exclusion under section 911, a
$10,000 employer-provided housing exclusion under section 911, $35,000 of other gross income,
and $20,000 in deductions (including standard or itemized deductions and/or personal
exemptions). The taxpayer has $90,000 in exclusions under section 911 and $15,000 of other
income (after deductions). Under present law, the $15,000 of other income is taxed starting in
the lowest rate bracket. Under the proposal, the $15,000 of other income is stacked after the
$90,000 section 911 exclusion amounts. Therefore, under the proposal, the $15,000 of other
income is taxed in the rate bracket that corresponds with $105,000. The proposed stacking rule
is also applicable for purposes of the alternative minimum tax.
In cases where the excludable foreign income is subject to foreign taxes, the stacking rule
prevents taxpayers from benefiting twice from graduated rate structures, once in the foreign
country in the determination of the foreign tax liability on their foreign income, and again in the
United States in the determination of their U.S. tax liability on any other income. Under the
proposal, taxpayers can avoid the stacking rule by forgoing utilization of section 911 altogether
and simply claiming a foreign tax credit for any foreign taxes paid.
B. Amend Rules for Determining Corporate Residency
(sec. 7701)
Present Law
The U.S. tax treatment of a multinational corporate group depends significantly on
whether the top-tier ''parent'' corporation of the group is domestic or foreign. For purposes of
U.S. tax law, a corporation is treated as domestic if it is incorporated under the laws of the
United States or of any State. All other corporations (i.e., those incorporated under the laws of
foreign countries) are treated as foreign. Thus, place of incorporation determines whether a
corporation is treated as domestic or foreign for purposes of U.S. tax law, irrespective of other
factors that might be thought to bear on a corporation's ''nationality,'' such as the location of the
corporation's management activities, employees, business assets, operations, revenue sources,
the exchanges on which the corporation's stock is traded, or the residence of the corporation's
shareholders. Only domestic corporations are subject to tax on a worldwide basis. Foreign
corporations are taxed only on income that has sufficient nexus in the United States.
Until recently, a U.S. parent corporation could reincorporate in a foreign jurisdiction, and
this reincorporation could be respected for U.S. tax purposes, even in cases in which the
reincorporation had no significant non-tax purpose or effect, and the corporate group had no
significant business presence in the new country of incorporation. These transactions were
commonly referred to as ''inversion'' transactions, and they could produce a variety of tax
benefits, including the removal of a group's foreign operations from U.S. taxing jurisdiction and
the reduction of U.S. tax on U.S.-source income through earnings-stripping transactions (e.g.,
large payments of interest from a U.S. subsidiary to the new foreign parent).
The American Jobs Creation Act of 2004 (''AJCA'') included provisions designed to
curtail inversion transactions. Most significantly, section 801 of AJCA added section 7874 to the
Code, which denies the intended tax benefits of a typical inversion transaction by deeming the
new top-tier foreign corporation to be a domestic corporation for all Federal tax purposes. This
sanction generally applies to a transaction in which, pursuant to a plan or a series of related
transactions: (1) a U.S. corporation becomes a subsidiary of a foreign-incorporated entity or
otherwise transfers substantially all of its properties to such an entity in a transaction completed
after March 4, 2003; (2) the former shareholders of the U.S. corporation hold (by reason of
holding stock in the U.S. corporation) 80 percent or more (by vote or value) of the stock of the
foreign-incorporated entity after the transaction; and (3) the foreign-incorporated entity,
considered together with all companies connected to it by a chain of greater than 50-percent
ownership (i.e., the ''expanded affiliated group''), does not have substantial business activities in
the entity's country of incorporation, compared to the total worldwide business activities of the
expanded affiliated group.
While AJCA created an exception to the place-of-incorporation test for determining
corporate residency in cases involving defined inversion transactions, AJCA left that test in place
with respect to all other cases. Thus, newly incorporated businesses, as well as businesses that
completed inversion transactions prior to the effective date of the AJCA rules, remain subject to
the place-of-incorporation rule as before.
Reasons for Change
The present-law test of determining corporate residency based solely on where the
company is incorporated is artificial, and allows certain foreign corporations that are
economically similar or identical to U.S. corporations to avoid being taxed like U.S.
corporations. Determining corporate residency based on the location of the corporation's
management activities would be a more meaningful standard.
AJCA included provisions that should curtail inversion transactions. In passing these
provisions, the Congress addressed the most glaring deficiencies of the present-law place-of-
incorporation test. However, ACJA's effective date permanently grandfathered most known
inverted structures already in place. AJCA also did not address newly incorporated entities that
establish corporate charters in a foreign jurisdiction, fail to establish substantial presence
overseas, and effectively manage their business from within the United States, thereby achieving
tax results similar to those achieved by pre-existing companies via inversion. However, in fall
2004, the Senate ratified a U.S.-Netherlands tax treaty protocol (the ''Dutch protocol''), which
included a substantial presence test that looks to primary place of management and control to
determine corporate residency. Revising the general U.S. corporate residency rules to test for
primary place of management and control would produce a more meaningful test than that of
present law and would present a comprehensive response to the problem identified and addressed
by the Congress in 2004. Description of Proposal
The proposal would be an overlay on present law, as amended by AJCA. Under the
proposal, if a company is incorporated in the United States, it is still considered a domestic
corporation and does not have to look any further to determine its residence. For publicly traded
foreign-incorporated entities, however, the proposal adds new rules that look to a corporation's
primary place of management and control.
Under the proposal, a company's residence is based on the location of its primary place
of management and control. A corporation's primary place of management and control is where
the executive officers and senior management of the corporation exercise day-to-day
responsibility for the strategic, financial and operational policy decision making for the company
(including direct and indirect subsidiaries).
In determining which individuals are considered executive officers and senior
management employees, the decision-making activities of all executive officers and senior
management employees are taken into account. Under a centralized management structure, these
employees would generally be those individuals who have executive officer positions and report
to the corporate headquarters office. However, some companies may operate under a more
decentralized management structure, where many strategic policy decisions are delegated to
individuals who are directors of subsidiary companies. In this situation, individuals who are not
executive officers and senior management employees of the corporate headquarters may be
carrying on the strategic, financial and operational policy decisions for the company. The
decision-making activities of these individuals are taken into consideration in determining the
company's residence.
Effective Date
The proposal is effective for taxable years beginning at least two years after the date of
enactment, in order to allow affected companies sufficient time to complete any necessary
restructuring.
Discussion
The proposal retains present law but adds new rules with respect to publicly traded
foreign-incorporated companies that are managed and controlled in the United States. Under
present law, corporate residency is determined by place of incorporation. Thus, companies can
avoid U.S. taxation on a worldwide basis by merely incorporating in a foreign jurisdiction. The
proposal applies a more meaningful corporate residency test by requiring that a publicly traded
foreign-incorporated company be treated as resident in the United States if it is managed and
controlled in the United States.
The proposal determines corporate residence based on the location of the company's
primary place of management and control. The proposal differs from the traditional management
and control concept, defined by other countries as the location where the board of directors
meets. The weakness in adopting the traditional management and control concept is that the
board of directors is generally required to meet no more than a few times a year. Thus, a
company could operate the majority of its business from the United States and meet the
traditional management and control requirement simply by holding its board meetings in the
foreign country a couple times a year.
The day-to-day management of a business is more difficult to manipulate. Moving the
management of a company generally requires the physical relocation of top executives and their
families to an office in a foreign jurisdiction. It also requires the movement of support staff and
administrative functions that are normally performed at the corporate headquarters office.
The concept of primary place of management and control is similar to the substantial
presence test included in the recently ratified Dutch protocol. The substantial presence test in the
Dutch protocol tests for corporate residence based on the location of the headquarters offices and
senior management employees. The proposal does not adopt all aspects of the substantial
presence test used in the Dutch protocol because some aspects lack relevance outside the treaty
context.
Under present law, the corporate residency rules are easy to administer because
determining residency is a bright line test. Under the proposal, corporate residency is based on a
facts and circumstances test. The new rules would require the IRS to gather data on foreign
incorporated entities to ascertain whether they have a substantial presence in the United States.
Not only does this require an increase in the IRS's resources, but it also raises issues for foreign
incorporated entities with respect to how they conduct business in the United States.
While the argument can be made that the new rules compromise the clarity and
consistency of current law, the benefits related to preserving the U.S. tax base may offset these
concerns. The new rules provide objective standards for companies that incorporate in the
United States, but when a foreign company takes the position that it is not incorporated here,
these rules allow the United States to test for management and control by looking at where the
executive decision-making of the company is being conducted. In view of the high threshold of
activity required under the proposal, only publicly traded foreign-incorporated companies that
are effectively headquartered in the United States will need to contend with the new rules. Close
cases should be few, thus limiting the scope of any problems relating to uncertainty and
administrability.
C. Modify Entity Classification Rules to Reduce Opportunities for Tax Avoidance
(sec. 7701)
Present Law
In order to apply the various substantive rules of the Code to transactions involving
business entities, the entities first must be classified, typically as corporations, partnerships, or
branches. The classification of a business entity carries significant Federal tax consequences.
For example, corporations generally are subject to tax at the entity level, whereas partnerships
and branches generally are not. Transactions between a branch and its owner generally are
disregarded for Federal tax purposes (including the anti-deferral rules of subpart F), subject to
several important exceptions.
Prior to 1997, entity classification for Federal tax purposes was determined on the basis
of a multi-factor test provided in regulations issued under section 7701 of the Code. In
distinguishing between a corporation and a partnership, these regulations set forth four
characteristics indicative of status as a corporation: continuity of life, centralization of
management, limited liability, and free transferability of interests. If a business entity possessed
three or more of these characteristics, then it was treated as a corporation; if it possessed two or
fewer, then it was treated as a partnership. Thus, in order to achieve characterization as a
partnership under this system, taxpayers needed to arrange the governing instruments of an entity
in such a way as to eliminate two of these corporate characteristics. For example, a taxpayer
desiring partnership classification for an entity might include transferability restrictions and
dissolution provisions in order to eliminate the corporate characteristics of free transferability
and continuity of life. Partnerships also needed to have at least two members, as the term
suggests.
Since January 1, 1997, new entity classification regulations have been in effect that
generally allow taxpayers simply to elect the desired classification for many types of entities,
including certain limited-liability entities that are available under the laws of many foreign
jurisdictions. These regulations are commonly referred to as the ''check the box'' regulations.
The ''check the box'' regulations generally eliminate the need for modifications to the terms of
governing documents in order to secure a particular entity classification, and they make it
possible for a taxpayer to elect branch treatment for a single-member limited-liability entity, thus
enabling the taxpayer to achieve both flow-through taxation and limited liability with respect to a
foreign entity without adding a second member. These entities are often referred to as
''disregarded entities,'' or ''tax nothings.''
Reasons for Change
It has been widely observed that the ''check the box'' regulations, while producing some
simplification benefits with respect to both domestic and foreign entities, also have created some
unintended tax-avoidance opportunities as applied to foreign entities. In particular, it appears
that the availability of single-member disregarded entities has rendered it easy in many cases to
avoid current taxation under subpart F.
Description of Proposal
Under the proposal, an organization must be treated as a corporation for Federal tax
purposes if the organization: (1) is a separate business entity organized under foreign law; and
(2) has only a single member. This proposal overrides any contrary result that may have been
obtained under the current entity classification regulations. In all other respects, those
regulations remain in force.
If a branch, local office, or other organization does not rise to the level of a separate
business entity (e.g., if it is not established as a separate legal entity under the relevant local law),
then the branch, office, or organization is not subject to this proposal, and thus is not treated as a
corporation for Federal tax purposes.
Domestic business entities and non-single-member foreign business entities are generally
not subject to the proposal and thus remain eligible for elective entity classification to the extent
so eligible under the current regulations. However, the Treasury Secretary may issue regulations
extending the application of this provision to: (1) a non-single-member foreign business entity, in
cases in which a membership interest is issued to a person related to another member, with a
principal purpose of preventing the entity from being classified as a corporation under the
provision; or (2) a domestic business entity that has a CFC as its sole member.
Effective Date
The provision applies to taxable years beginning one year or more after the date of
enactment.
Discussion
As noted above, although the ''check the box'' regulations have produced some
simplification benefits with respect to both domestic and foreign entities, the regulations also
have created some unintended tax-avoidance opportunities as applied to foreign entities. In
particular, it appears that the availability of single-member disregarded entities has facilitated the
avoidance of current taxation under subpart F in situations in which subpart F normally would
apply.
For example, payments of interest, dividends, rent, and royalties between CFCs often
generate subpart F income, but similar payments between a disregarded entity and a CFC do not,
even if the disregarded entity is treated as a separate corporation under applicable foreign tax
law, and thus may be deducting the payment for foreign tax purposes. In these cases, commonly
referred to as ''hybrid branch arrangements,'' the ability to avoid subpart F may combine with
favorable results under foreign tax law to distort investment decisions, arguably making it more
attractive in some cases to locate investments abroad than in the United States. Ensuring that
these transactions are taxed under subpart F could both correct the misallocation of capital away
from the United States and raise additional revenue. On the other hand, some would argue that
this sort of inconsistent treatment of a transaction by the countries concerned is an inevitable
result of cross-border activity in a world with diverse tax systems, that the appropriate U.S. tax
treatment of a transaction should not depend on the results that a taxpayer might be able to
achieve under foreign tax law, and that capital import neutrality is promoted by allowing these
transactions to avoid taxation under subpart F. Regardless of whether these particular tax
results are viewed with approval or disapproval, hybrid branch arrangements illustrate well how
a ''check the box'' election may be used to secure tax results that would have appeared difficult
or impossible to achieve under the current statutory subpart F rules.
While hybrid branch arrangements are perhaps the first and best-known example of how
a ''check the box'' election can be used to circumvent subpart F, other similar uses for the
election have been found. For example, the sale of stock of an operating company by a CFC
generally would give rise to subpart F income, but if an election to disregard the company is in
effect, then the transaction may be treated as a sale of operating assets, thus avoiding the creation
of subpart F income. As in the case of hybrid branch arrangements, a mere election, with no
non-tax economic effect, may transform what would have been subpart F income into an item
exempt from subpart F.
While a certain degree of electivity already prevailed as a practical matter under the pre-
1997 entity classification rules, and tax results similar to those described above may have been
attainable under some circumstances before 1997, the expressly elective approach of the current
regulations has removed some frictions that may have acted as a brake on some of the tax
planning involving the classification of entities. In particular, the ability to disregard single-
member foreign business entities may have impaired the intended functioning of subpart F in
some respects.
The proposal strikes a balance between the goal of simplification and the policies
reflected in the substantive provisions of the Code by generally retaining the elective approach of
the current entity classification regulations, but providing that single-member business entities
organized under foreign law must be treated as corporations for Federal tax purposes. This
approach will not prevent every arrangement that might be thought to be abusive, as not all
abuses require the use of a separate disregarded entity, but the approach will render it
considerably more difficult in many cases for taxpayers to use the entity classification rules to
frustrate the intent of the international tax provisions of the Code. A wide range of potentially
abusive transactions that are currently disregarded for purposes of the substantive rules of the
Code would be ''regarded'' under the proposal, thereby providing a greater opportunity to apply
and adjust those rules in an appropriate manner, whether that be to allow or to disallow a
particular tax result.
While the overall structuring flexibility available to taxpayers under this approach is
considerably less than what prevails under the current entity classification regulations, it is
generally still greater than the flexibility that prevailed before 1997. Because this approach
would have the effect of upsetting taxpayer expectations that have developed over the last
several years of experience with the current regulations, the proposal includes a delayed effective
date, in order to enable taxpayers to restructure arrangements that were established in reliance on
the current regulations.
D. Adopt a Dividend Exemption System for Foreign Business Income
Present Law
''Worldwide'' vs. ''territorial'' taxation of business income
The tax systems of the world generally reflect two basic approaches to the taxation of
cross-border business income, often referred to as ''worldwide'' and ''territorial'' approaches.
Under a pure worldwide tax system, resident corporations are taxable on their worldwide
income, regardless of source, and the potential double taxation arising from overlapping source-
country and residence-country taxing jurisdiction is mitigated by allowing a foreign tax credit.
In contrast, under a pure territorial tax system, a country taxes only income derived within its
borders, irrespective of the residence of the taxpayer. Thus, foreign-source income earned by a
resident corporation is exempt from tax under a pure territorial tax system.
Each type of system may be said to promote a particular conception of economic
efficiency. A pure worldwide tax system promotes capital export neutrality, a norm that holds
that tax considerations should not influence a taxpayer's decision of whether to invest at home or
abroad. Under a pure worldwide tax system, the after-tax return to an otherwise equivalent
investment does not depend on whether the investment is made at home or abroad, since in either
case the income from the investment generally will be subject to tax at the residence-country
rate. Thus, investment-location decisions are governed by business considerations, instead of by
tax law. A pure territorial system, on the other hand, promotes capital import neutrality, a norm
that holds that all investment within a particular source country should be treated the same,
regardless of the residence of the investor. Thus, if a residence country adopts a pure territorial
system, residents of that country, when investing abroad in a particular source jurisdiction, will
not receive a lower after-tax return than other investors by virtue of their country of residence.
In a world with diverse tax systems and rates, it is impossible fully to achieve both capital
import neutrality and capital export neutrality at the same time. For example, suppose a source
country offers a lower tax rate on a particular investment than the U.S. rate on a similar
investment in the United States. Capital export neutrality would dictate that the United States
impose a residual residence-based tax on the foreign investment at a level sufficient to make a
U.S. investor indifferent on an after-tax basis between the two investment locations; however,
doing so would violate capital import neutrality, as a U.S. investor in the source country would
earn a lower after-tax rate of return compared to non-U.S. investors in the same source country,
to the extent that such investors' residence countries did not assert a similar residual tax on the
income. As long as different countries maintain different tax systems and rates, the two goals
will remain in tension with each other.
The tax systems of all large, industrialized countries may be said to reflect varying
compromises between these competing goals. Accordingly, no large, industrialized country
employs a pure worldwide or pure territorial system. Existing systems may be accurately
characterized as predominantly worldwide or territorial, but all systems share at least some
features of both the worldwide and territorial approaches. Thus, systems commonly described as
''worldwide'' in fact include many territorial-type elements that promote capital import neutrality,
such as indefinite deferral of tax on most types of foreign business income earned through
foreign subsidiaries in the case of the United States. Similarly, systems commonly described as
''territorial'' include many worldwide-type features that promote capital export neutrality, such as
residence-country taxation of passive income earned through foreign subsidiaries in lower-tax
countries.
Many countries tax resident corporations on a predominantly territorial basis by
exempting dividends received from foreign subsidiaries from residence-country tax. This
exemption typically applies only where the parent company's ownership in the subsidiary
exceeds a certain threshold (commonly five to 10 percent), and the exemption may be total or
partial (e.g., only 95 percent, or 60 percent, of qualifying dividends might be exempted, as a
proxy for disallowing expenses allocable to exempt income). A number of restrictions generally
apply, in order to limit the exemption to certain categories of income (e.g., active business
income) and to address concerns about shifting income to lower-tax countries in order to avoid
tax. These exemption systems generally do impose tax on foreign-source royalties and portfolio-
type income.
The U.S. system: worldwide, deferral-based taxation of foreign business income
The United States employs a ''worldwide'' tax system, under which domestic corporations
generally are taxed on all income, whether derived in the United States or abroad. Income
earned by a domestic parent corporation from foreign operations conducted by foreign corporate
subsidiaries generally is subject to U.S. tax when the income is distributed as a dividend to the
domestic corporation. Until such repatriation, the U.S. tax on such income generally is deferred,
and U.S. tax is imposed on such income when repatriated.
However, under anti-deferral rules, the domestic parent corporation may be taxed on a
current basis in the United States with respect to certain categories of passive or highly mobile
income earned by its foreign subsidiaries, regardless of whether the income has been distributed
as a dividend to the domestic parent corporation. The main anti-deferral provisions in this
context are the controlled foreign corporation (''CFC'') rules of subpart F and the passive
foreign investment company (''PFIC'') rules.
A foreign tax credit generally is available to offset, in whole or in part, the U.S. tax owed
on foreign-source income, whether earned directly by the domestic corporation, repatriated as a
dividend from a foreign subsidiary, or included in income under the anti-deferral rules. The
foreign tax credit generally is limited to the U.S. tax liability on a taxpayer's foreign-source
income, in order to ensure that the credit serves its purpose of mitigating double taxation of
foreign-source income without offsetting the U.S. tax on U.S.-source income.
The foreign tax credit limitation is applied separately to different types of foreign-source
income, in order to reduce the extent to which excess foreign taxes paid in a high-tax foreign
jurisdiction can be ''cross-credited'' against the residual U.S. tax on low-taxed foreign-source
income. For example, if a taxpayer pays foreign tax at an effective rate of 40 percent on certain
active income earned in a high-tax jurisdiction, and pays little or no foreign tax on certain
passive income earned in a low-tax jurisdiction, then the earning of the untaxed (or low-tax)
passive income could expand the taxpayer's ability to claim a credit for the otherwise
uncreditable excess foreign taxes paid to the high-tax jurisdiction, by increasing the foreign tax
credit limitation without increasing the amount of foreign taxes paid. This sort of cross-crediting
is constrained by rules that require the computation of the foreign tax credit limitation on a
category-by-category basis. Thus, in the example above, the rules would place the passive
income and the active income into separate limitation categories, and the low-tax passive income
would not be allowed to increase the foreign tax credit limitation applicable to the credits arising
from the high-tax active income. A significant degree of cross-crediting may be achieved within
a single limitation category, however. For example, a high-tax dividend from a CFC and a low-
tax royalty from another CFC may both fall into the general limitation category, with the result
that potential excess credits associated with the dividend effectively may reduce the residual U.S.
tax owed with respect to the royalty.
Reasons for Change
It has long been recognized that the worldwide, deferral-based system of present law
distorts business decisions in a number of ways. By establishing repatriation as the system's
principal taxable event, the worldwide, deferral-based system creates incentives in many cases to
redeploy foreign earnings abroad instead of in the United States, thereby distorting corporate
cash-management and financing decisions. At the same time, basing the system on repatriation
renders the payment of U.S. tax on foreign-source business income substantially elective in
many cases, because repatriation itself is elective. By maintaining deferral indefinitely, a
taxpayer may achieve a result that is economically equivalent to 100-percent exemption of
income, with no corresponding disallowance of expenses allocable to the exempt income,
provided that the taxpayer does not repatriate the earnings or run afoul of subpart F or other anti-
deferral rules. In addition, taxpayers that repatriate high-tax earnings may be able to use
excess foreign tax credits arising from these repatriations to offset the U.S. tax on lower-tax
items of foreign-source income, such as royalties received for the use of intangible property in a
low-tax country.
For these reasons, in many cases, the present-law ''worldwide'' system actually may yield
results that are more favorable to the taxpayer than the results available in similar circumstances
under the ''territorial'' exemption systems used by many U.S. trading partners, as these systems
generally fully tax foreign-source royalties and portfolio-type income, and often exempt less than
100 percent of a dividend received from a subsidiary, as a proxy for disallowing expenses
allocable to the exempt income. At the same time, however, the potential for taxation under the
U.S. system by reason of either repatriation or application of the highly complex U.S. anti-
deferral rules arguably forces U.S.-based multinationals to contend with a greater degree of
complexity, and to engage in a greater degree of tax-distorted business planning, than many of
their foreign-based counterparts resident in countries with exemption systems.
The present-law system thus creates a sort of paradox of defects: on the one hand, the
system allows tax results so favorable to taxpayers in many instances as to call into question
whether it adequately serves the purposes of promoting capital export neutrality or raising
revenue; on the other hand, even as it allows these results, the system arguably imposes on
taxpayers a greater degree of complexity and distortion of economic decision making than that
faced by taxpayers based in countries with exemption systems, arguably impairing capital import
neutrality in some cases.
The Congress recognized and addressed some of these problems in AJCA, but significant
problems remain. Replacing the worldwide, deferral-based system with a dividend exemption
system arguably would mitigate many of these remaining problems, while generally moving the
system further in the direction charted by the Congress in 2004.
Description of Proposal
Overview
Under the proposed dividend exemption system, income earned abroad by foreign
subsidiaries of U.S. parent corporations would fall into one of two categories: (1) passive and
other highly mobile income, which would be taxed to the U.S. parent on a current basis under
subpart F; or (2) all other income--i.e., active, less-mobile income not subject to subpart F--
which would be exempt from U.S. tax and thus could be repatriated free of any tax impediment.
The deferral and repatriation tax at the heart of the present-law system would be eliminated, and
the foreign tax credit system would serve a more limited function than it does under present law.
CFC-parent dividends exempt from tax
A U.S. corporation that holds 10 percent or more of the stock of a CFC would exclude
from income 100 percent of the dividends received from the CFC. This exclusion would be
mandatory, and no foreign tax credits would arise with respect to foreign taxes attributable to the
excluded dividend income (including both corporate-level income taxes and dividend
withholding taxes). In addition, a special rule would provide that no subpart F inclusions would
be created as a dividend moves up a chain of CFCs, to the extent that the dividend is attributable
to a 10 percent or greater direct or indirect interest in the dividend-paying CFC owned by the
U.S. parent. This rule would ensure that dividends could be repatriated from lower-tier CFCs
without losing the benefit of dividend exemption, and it also would make it easier to redeploy
CFC earnings in different foreign jurisdictions without triggering subpart F, thus promoting
neutrality as to the decision of how to dispose of CFC earnings.
Under the dividend exemption system, CFC earnings would constitute a predominantly
tax-exempt stream of income for the U.S. parent corporation. Accordingly, deductions for
interest and certain other expenses incurred by the U.S. corporation would be disallowed to the
extent allocable to exempt (non-subpart-F ) CFC earnings. These allocations would be made as
the earnings are generated, as opposed to when they are distributed. Thus, for expense allocation
purposes, CFC earnings would be treated as giving rise to foreign-source income as they are
earned.
Interest expense would first be allocated between U.S. and foreign-source income under
rules similar to those of present law, including the interest allocation changes made by AJCA.
The amount of interest expense allocated to foreign-source income under these rules then would
be further allocated between exempt CFC earnings and other foreign-source income on a pro rata
basis, based on assets. Research and experimentation expenses would first be allocated between
U.S. and foreign-source income under rules similar to those of present law. The amount of
research and experimentation expenses allocated to foreign-source income then would be further
allocated first to taxable royalties and similar payments (e.g., cost-sharing or royalty-like sale
payments) to the extent thereof, then to CFC earnings to the extent thereof (with this amount
divided on a pro rata basis between exempt CFC earnings and non-exempt CFC earnings), and
then finally to other foreign-source income. General and administrative expenses would be
allocated to exempt CFC earnings in the same proportion that exempt CFC earnings of the group
bears to overall earnings of the group. Other expenses, such as stewardship expenses, may be
directly allocable to exempt CFC earnings in some cases. With respect to all of these categories
of expenses, as under present law, it will be necessary for the Treasury Department to provide
detailed expense allocation rules by regulation.
Other foreign-source income fully taxed
Non-dividend payments from the CFC to the U.S. corporation (e.g., interest, royalties,
service fees, income from intercompany sales) would be fully subject to tax, and this tax
generally would not be offset by cross-crediting as it often is under present law. In addition,
dividends from non-CFCs, or from CFCs with respect to which the U.S. corporation is not at
least a 10-percent shareholder, would be fully subject to tax.
Anti-avoidance rules retained
Subpart F would be retained in its current form. Thus, notwithstanding the general rule
of dividend exemption, a U.S. corporation that holds a 10-percent or greater stake in a CFC
would still face current income inclusion when the CFC earns certain types of passive or highly
mobile income. As under present law, a subpart F inclusion would carry with it a credit for any
foreign taxes associated with the subpart F income. The PFIC rules also would be retained in
their current form.
Treatment of gain or loss on sale of CFC stock
A U.S. corporation's gain on the sale of CFC stock would be excluded from income to
the extent of undistributed exempt earnings. Any excess of gain over this amount would be
taxable, even though some of this gain may relate to appreciation of assets that would have
generated exempt income. Deductions for losses on the sale of CFC stock would be
disallowed.
Foreign branches
Foreign branch income would be exempt to the same extent as it would be if earned by a
CFC, under rules that would treat foreign trades or businesses conducted directly by a U.S.
corporation as CFCs for all Federal tax purposes. Thus, subpart F would apply to branch
operations, branch losses would not flow directly onto a U.S. corporation's tax return, and
transactions between the U.S. corporation and the foreign branch would be subject to the full
range of rules dealing with intercompany transactions. Except as provided in regulations, all
trades or businesses conducted predominantly within the same country would be treated as a
single CFC for this purpose. The Treasury Secretary would be given regulatory authority to
issue the rules necessary to place branches and CFCs on an equal footing for these purposes.
Transition and collateral issues
Transition
The exemption system would apply only with respect to CFC earnings generated after the
effective date, thus requiring ongoing separate tracking of earnings pools. With respect to pre-
effective-date earnings, the present-law system would continue to apply in all respects.
Dividends would be treated as coming first from exempt, post-effective-date earnings and then
from pre-effective-date earnings.
Collateral change to subpart F
The deemed-repatriation rules of section 956 would be repealed, as these rules are merely
a backstop to the present-law repatriation tax, which would be eliminated under the proposed
system. (However, as indicated above, these and all other relevant rules of present law would
continue to apply to pre-effective-date earnings.)
Collateral changes to the foreign tax credit
The foreign tax credit would remain in place with respect to: (1) income that is included
on a current basis under the subpart F or PFIC rules; and (2) other foreign-source income that is
not eligible for exemption (e.g., dividends received on a portfolio investment in a foreign
corporation, foreign-source royalty income earned directly by the U.S. corporation).
The indirect foreign tax credit of section 902 would be repealed, except insofar as it
applies to subpart F inclusions. This rule would eliminate the indirect foreign tax credit for
noncontrolled section 902 corporations (''10-50 companies''). A foreign tax credit generally
would remain available with respect to withholding taxes imposed on dividends received from
10-50 companies, as these dividends generally would remain subject to U.S. tax under the
proposal. However, a U.S. corporation would be allowed to elect to treat its investment in a 10-
50 company as an investment in a CFC for Federal tax purposes, thus rendering the investment
both eligible for dividend exemption and subject to subpart F. Thus, the U.S. corporation
effectively would choose between treating the 10-50 investment as a portfolio-type investment or
as a direct, CFC-type investment.
The separate limitation categories of section 904 would be repealed, and thus the foreign
tax credit limitation would apply on an overall basis. By removing most foreign business income
from the foreign tax credit system altogether, most high-tax foreign-source income would be
removed from the computation, greatly reducing the potential for cross-crediting relative to
present law. Under these conditions, it would no longer be necessary to apply the limitation on a
separate-category basis.
No change would be made to the export source rule under section 863(b), but the benefits
of this rule would be significantly reduced or eliminated in most cases, in view of the narrowed
scope of the foreign tax credit and the likelihood that most taxpayers will be in excess-limitation
positions under the new system (because most high-tax foreign income will be exempted, leaving
mostly low-tax or untaxed foreign-source income in the foreign tax credit system).
Treaties
The proposed system would require the renegotiation of existing income tax treaties,
which are premised on the assumption that the United States will continue to operate a
worldwide tax system. For example, existing treaties generally require the United States to allow
foreign tax credits for foreign corporate income taxes and dividend withholding taxes under
certain circumstances. These treaties would have to be revised to reflect the conversion from a
credit mechanism to an exemption mechanism.
Effective Date
The proposal is generally effective for taxable years of foreign corporations beginning
after the date of enactment, and for taxable years of U.S. shareholders with or within which such
taxable years of such foreign corporations end. The rules dealing with foreign branches are
effective for taxable years of U.S. corporations beginning after the date of enactment.
Discussion
As described above, the present-law deferral system arguably imposes on taxpayers a
greater degree of complexity and distortion of economic decision making than that faced by
taxpayers based in countries with exemption systems, arguably impairing capital import
neutrality in some cases. At the same time, the system allows tax results so favorable to
taxpayers in many instances as to call into question whether it adequately serves the purposes of
promoting capital export neutrality or raising revenue. Although the Congress recognized and
addressed some of these problems in AJCA, significant problems remain. Replacing the
worldwide, deferral-based system with a dividend exemption system arguably would mitigate
many of these remaining problems, while generally moving the system further in the direction
charted by the Congress in 2004.
For example, recognizing that deferral-based taxation created an impediment to
repatriating certain foreign earnings, the Congress in 2004 provided a temporary window during
which foreign earnings could be repatriated at a reduced rate of tax. This legislation reduced the
tax impediment to repatriating existing earnings, but as a temporary provision, it left this
impediment in place with respect to future earnings. Indeed, to the extent that taxpayers may
expect the provision to be adopted again as a fiscal stimulus response to a future downturn, they
may be even less likely to repatriate earnings at full tax cost after the temporary window than
they were before the window. Adopting a dividend exemption system would remove the
repatriation disincentive permanently, in a manner generally consistent with steps that the
Congress has already taken on a temporary basis.
More broadly, the Congress made a number of changes to the international tax provisions
of the Code that will promote greater capital import neutrality. Most significantly in this regard,
the foreign tax credit rules were amended in a number of ways in order to reduce the burden on
U.S. taxpayers of the foreign tax credit limitation. More limited changes were made outside
the foreign tax credit area, but these changes also generally moved the system in the direction of
greater capital import neutrality. Adopting a dividend exemption system would further
promote capital import neutrality in many cases, as U.S. corporations no longer would need to
contend with the possibility of residual U.S. taxation with respect to most types of foreign
business income. Adopting a dividend exemption system also would specifically promote the
Congress's demonstrated goal of further simplifying the foreign tax credit regime, as the regime
would be rendered inapplicable to most foreign business income, which would simply be exempt
from U.S. tax under the system. Application of the foreign tax credit regime on a more limited
basis would reduce the amount of income and activity subject to these complex rules, and would
allow further simplifying changes to be made to them, including the elimination of separate
limitation categories.
While the Congress made sweeping changes to the foreign tax credit regime in 2004, the
Congress made no similarly sweeping changes with respect to the anti-deferral regimes. The
complexity of these regimes, the distortions that they produce, and their diminishing
effectiveness in promoting capital export neutrality are all problems that remain to be solved.
The seriousness of these problems, and the appropriateness of various possible solutions, are not
significantly affected by moving to a dividend exemption system. Under either type of system,
effective regimes are needed to prevent the avoidance of tax through shifting income into low-
tax jurisdictions, without unduly interfering with the operation of nontax-motivated business
structures. Accordingly, the desirability of various proposals that the Congress may wish to
consider in this area is largely independent of the question of whether to adopt a dividend
exemption system or to retain the present-law worldwide, deferral-based system--in either case,
certain categories of passive or highly mobile foreign income must be defined and subjected to
immediate U.S. tax.
Although moving from the present-law system to a dividend exemption system broadly
promotes capital import neutrality, such a move also should serve to promote capital export
neutrality in a few respects. For example, in cases in which indefinite deferral and cross-
crediting of high-tax dividends with low-tax royalties may produce results more advantageous to
a taxpayer than the results available under a typical dividend exemption system, capital export
neutrality may be improved by shifting to dividend exemption. In addition, the disallowance of
deductions for interest and overhead expenses allocable to exempt income may have the effect of
promoting capital export neutrality, although this effect would be offset to some extent by
exemption itself.
Thus, like any other system, the proposed system would result in a compromise between
these two efficiency norms, but arguably a better compromise, involving less complexity and
fewer distortions than the present-law system. On the other hand, the continued need for
provisions like subpart F and the inter-company pricing rules means that significant complexity
will remain, and the transition from the present-law system to the proposed system will create
significant complexities of its own.
Some have expressed a concern that switching from a deferral system to an exemption
system might cause U.S. investment to flow out of the United States and into lower-tax
countries, because permanent exemption is thought to be significantly more attractive than the
deferral available under present law. While such an incentive may arise in certain circumstances,
there is little evidence that this would generally be the case. First, as discussed above, the
indefinite deferral available under present law is in many cases no worse a tax result for
taxpayers than the tax results available under a dividend exemption system. Second, as long as
the exemption system maintains anti-avoidance provisions of present law, such as subpart F and
the transfer pricing rules of sections 482 and 367(d), problems of tax avoidance should be similar
under both types of system. Third, the disallowance of deductions for expenses allocable to
exempt income should serve as a brake on any incentive to move investments and activities
offshore, as the exemption achieved by such a shift may come at a cost of greater deduction
disallowance.
Economists who have studied how moving to a dividend exemption system might affect
the location incentives of U.S. corporations find no definitive evidence that incentives would be
significantly changed. Two recent studies examine how the incentive to invest in low-tax
locations abroad would be affected if the United States were to move to a dividend exemption
system similar to the one described here. In both studies, the authors consider dividend
exemption systems that impose allocation rules similar to those of present law so that some
portion of deductions for interest and overhead expenses incurred by the U.S. parent company
and allocated to exempt foreign income are disallowed as deductions from U.S. taxable income.
One study concludes that under dividend exemption, the effective tax rate on U.S. investment in
low-tax locations would actually increase relative to the system in place prior to AJCA.
Although active foreign business income would avoid U.S. residual taxation, the loss of the
ability to shield U.S. tax on foreign royalties through cross-crediting and to claim deductions for
overhead and interest expense at home (or in other high-tax locations) results in higher tax
burdens in low-tax locations. The second study presents hypothetical effective tax rates for
incremental investment by a U.S. taxpayer in a low-tax subsidiary abroad under the U.S. tax
system in place prior to AJCA and under dividend exemption with expense allocation rules.
This study also finds that the tax burden of investing in low-tax countries may increase under
dividend exemption. In addition, the study uses two other approaches to investigate how
location decisions may change under dividend exemption: a comparison of foreign direct
investment patterns for the United States and for two countries which exempt dividends received
from foreign affiliates resident in countries with which they have tax treaties (Germany and
Canada) and an empirical analysis of the extent to which residual U.S. taxes on low-tax foreign
earnings impact the location decisions of U.S. corporations. Neither approach yielded results
that would suggest that location decisions would be significantly altered if the United States were
to exempt dividends from residence country taxation.
VII. OTHER BUSINESS PROVISIONS
A. Disallow Deduction for Interest on Indebtedness
Allocable to Tax-Exempt Obligations
(sec. 265)
Present Law
In general
Present law disallows a deduction for interest on indebtedness incurred or continued to
purchase or carry obligations the interest on which is exempt from tax (tax-exempt
obligations). This rule applies to tax-exempt obligations held by individual and corporate
taxpayers. The rule also applies to certain cases in which a taxpayer incurs or carries
indebtedness and a related person acquires or holds tax-exempt obligations. There are two
methods for determining the amount of the disallowance. One method, which applies to all
taxpayers other than financial corporations or dealers in tax-exempt obligations, asks whether a
taxpayer's borrowing can be traced to its holding of exempt obligations. A second method,
which applies to financial corporations and dealers in exempt obligations, disallows interest
deductions based on the percentage of a taxpayer's assets comprised of exempt obligations.
The interest expense disallowance rules are intended to prevent taxpayers from engaging
in tax arbitrage by deducting interest on indebtedness that is used to purchase tax-exempt
obligations.
Rules for nonfinancial corporations
General rules
Under IRS rules, for every taxpayer other than a financial corporation or a dealer in
tax-exempt obligations, an interest deduction generally is disallowed only if the taxpayer has a
purpose of using borrowed funds to purchase or carry tax-exempt obligations (the ''tracing rule'').
This purpose may be established by direct or circumstantial evidence.
Direct evidence of a purpose to purchase tax-exempt obligations exists if the proceeds of
indebtedness are used for and are directly traceable to the purchase of tax-exempt obligations.
Direct evidence of a purpose to carry tax-exempt obligations exists if tax-exempt obligations are
used as collateral for indebtedness. In the absence of direct evidence, the interest disallowance
rule applies only if the totality of facts and circumstances supports a reasonable inference that the
purpose to purchase or carry tax-exempt obligations exists. In general terms, the tracing rule
applies only if the facts and circumstances establish a sufficiently direct relationship between the
borrowing and the investment in tax-exempt obligations.
Two-percent de minimis exception
Under IRS rules, an interest deduction generally is not disallowed to an individual if
during the taxable year the average adjusted basis of the individual's tax-exempt obligations is
two percent or less of the average adjusted basis of the individual's portfolio investments and
trade or business assets. For a corporation an interest deduction generally is not disallowed if the
average adjusted basis of the corporation's tax-exempt obligations is two percent or less of the
average adjusted basis of all assets held in the active conduct of the corporation's trade or
business. These two-percent safe harbors do not apply to dealers in tax-exempt obligations or to
financial institutions.
Interest on installment sales to State and local governments
If a corporation holds tax-exempt obligations (installment obligations, for example)
acquired in the ordinary course of its business in payment for services performed for, or goods
supplied to, State or local governments, and if those obligations are nonsalable, the interest
deduction disallowance rule generally does not apply. The theory underlying this rule is that a
corporation holding tax-exempt obligations in these circumstances has not incurred or carried
indebtedness for the purpose of acquiring those obligations.
Rules for financial corporations and dealers in tax-exempt obligations
A financial institution generally is denied a deduction for that portion of its interest
expense (not otherwise allocable to tax-exempt obligations) that equals the ratio of the financial
institution's average adjusted basis of tax-exempt obligations acquired after August 7, 1986 to
the average adjusted basis of all the taxpayer's assets (the ''pro-rata rule''). In the case of an
obligation of an issuer that reasonably expects not to issue more than $10 million in tax-exempt
obligations within a calendar year (a ''qualified small issuer''), the general pro-rata rule does not
apply. Instead, only 20 percent of the interest allocable to the tax-exempt obligations of a
qualified small issuer is disallowed. The special rule for qualified small issuers also applies to
certain aggregated issuances of tax-exempt obligations in which more than one governmental
entity receives benefits.
A rule similar to the pro-rata rule applies to dealers in tax-exempt obligations, but there is
no exception for qualified small issuers, and the 20-percent disallowance rule does not apply.
Reasons for Change
The tracing rule requires an inquiry into a taxpayer's intent in borrowing. A taxpayer's
deduction for the interest expense of borrowing is subject to the tracing rule only if the taxpayer
intends to use the proceeds of the borrowing to buy or carry tax-exempt obligations. Because
intent is difficult to determine, and because a firm's funds are fungible, the tracing rule has
proven difficult to administer and easy to avoid. In particular, related corporations have avoided
the tracing rule by engaging in borrowing through one corporation and the holding of exempt
obligations by another corporation. Moreover, the two-percent de minimis exception provides a
safe harbor for a certain amount of tax arbitrage.
Description of Proposal
The proposal extends to all corporations (other than insurance companies) the pro-rata
rule applicable to financial institutions under present law. Accordingly, except in limited
circumstances (described below), the proposal repeals the tracing rule, and it repeals the two-
percent de minimis exception provided by IRS guidance. The proposal retains the present-law
scope of the qualified small issuer exception. The proposal retains the present-law exception for
interest on installment sales to State and local governments and extends the exception to
taxpayers that become subject to the pro-rata rule under this proposal.
The proposal applies the pro-rata rule to related persons by treating (1) all members of
the same affiliated group as one taxpayer and (2) any interest in a partnership held by the
taxpayer as a direct ownership interest by the taxpayer in its allocable share of partnership assets
and liabilities. In addition, the proposal applies the present-law tracing rule to all other related
persons by treating those persons and the taxpayer as a single entity. For example, if one
taxpayer borrows with the purpose that a related person will hold tax-exempt obligations (and the
taxpayer and related person are not members of an affiliated group), the tracing rule applies to
the taxpayer's borrowing.
Effective Date
The proposal is effective for taxable years beginning on or after the date of enactment.
Discussion
The proposal reflects the fact that money is fungible and, therefore, all debt of the
taxpayer finances its proportionate share of all of the taxpayer's assets, including tax-exempt
obligations. The proposal offers at least two specific advantages over present law. First, because
the proposal replaces a subjective inquiry into the taxpayer's purpose for borrowing (that is, the
tracing rule) with an objective formulary rule (that is, the pro-rata rule), the proposal is easier
than present law for the IRS and taxpayers to apply. Second, the proposal more effectively
prevents taxpayers from avoiding interest deduction disallowance through the use of related
parties.
As a general matter, curtailing the amount of debt capital available for the purchase of
tax-exempt obligations requires issuers of those obligations to pay higher yields to attract
purchasers -- in particular, purchasers for whom the tax exemption is less valuable than it is to
taxpayers subject to the highest marginal tax rate. Consequently, disallowing interest expense
deductions for leveraged purchases of tax-exempt obligations may erode the subsidy to State and
local governments provided by tax-exempt obligations, and strengthening the rules could further
reduce the subsidy by increasing those governments' borrowing costs.
There are three related responses to this argument. First, without the interest
disallowance rules, tax arbitrage would be permitted. Analysts note that unrestricted arbitrage
opportunities should make the implicit subsidy of tax-exempt bond finance fully efficient in the
sense that the revenue loss of the Federal government would exactly equal the reduced interest
cost of the State or local issuer. However, given the uniqueness of many tax-exempt bond
issues, the practice of private placement without competitive bidding, and several other factors,
some doubt that full efficiency of the subsidy to interest cost would ever be achieved. If full
efficiency is not attained, opportunities for tax arbitrage remain. Many observers view arbitrage
transactions in which tax deductions support the earning of wholly or partially exempt income by
profitable corporations and high-income individual taxpayers (both high marginal tax rate
taxpayers) as corrosive to voluntary compliance and respect for the fairness of the Code, even if
those taxpayers, at the margin, are not materially better off than if they had not engaged in tax
arbitrage transactions. Any such arbitrage creates revenue loss to the Federal government.
Second, although arbitrage intended to be curbed by the proposal exists under present law,
strengthening the interest expense disallowance rule might not raise borrowing costs
significantly. At least one study suggests that most non-financial corporations do not hold debt
and tax-exempt bonds simultaneously or do so at a level below the two-percent de minimis
exception described above. Thus, any change in demand for tax-exempt bonds that results
from the proposal may have little (if any) effect on the price and yields of tax-exempt bonds.
Third, if the impact on State and local governments is minimal, this impact might be outweighed
by the advantages of replacing a subjective rule (that is, the tracing rule) that has proven
avoidable and difficult to apply with an objective rule (that is, the pro-rata rule) that is less
avoidable and easier to apply.
Extending the pro-rata rule to all corporations may increase the compliance burden by
forcing corporations, including firms with small holdings of tax-exempt bonds, to engage in
annual calculations of the proportion of their assets represented by exempt obligations. On the
other hand, the two-percent de minimis exception and the difficulty of applying the tracing rule
permit corporations under present law to engage in tax arbitrage, albeit on a limited scale. The
pro-rata rule will prevent this arbitrage.
The proposal neither extends to non-financial corporations nor repeals the qualified small
issuer exception. The present law exception is intended to ensure that small borrowers do not
face additional obstacles to debt financing due to the insignificant volume of their issuances.
The exception allows qualified small issuers, which may not have access to State bond banks, to
borrow funds directly from financial institutions without the application of the interest
disallowance rule. Nonfinancial corporations do not participate in small issuances to the same
extent as financial institutions.
The proposal retains the present-law exception for interest on installment sales to State
and local governments and extends it to taxpayers that become subject to the pro-rata rule under
this proposal. A taxpayer that makes an installment sale to a State or local government might
have outstanding borrowings and therefore may be engaged in the arbitrage that the pro rata rule
generally is intended to prevent. The taxpayer in this situation, however, is holding an
installment obligation as payment for services, not for investment. Although the pro-rata rule
generally does not inquire into a taxpayer's purposes in borrowing and in holding exempt
obligations, lack of investment intent makes the installment sale context fundamentally different
from the ordinary holding of exempt obligations. Consequently, an exception from the pro-rata
rule is appropriate.
B. Modify Recapture of Section 197 Amortization
(sec. 1245)
Present Law
Taxpayers are entitled to recover the cost of amortizable section 197 intangibles using the
straight-line method of amortization over a uniform life of fifteen years. With certain
exceptions, amortizable section 197 intangibles generally are purchased intangibles held by a
taxpayer in the conduct of a business.
Gain on the sale of depreciable property must be recaptured as ordinary income to the
extent of depreciation deductions previously claimed, and the recapture amount is computed
separately for each item of property. Section 197 intangibles, because they are treated as
property of a character subject to the allowance for depreciation, are subject to these recapture
rules.
Reasons for Change
Under present law, it is difficult for the IRS to ensure that taxpayers recognize the
appropriate amount of ordinary income recapture when multiple intangible assets are sold as part
of a single transaction. Because ordinary income is recaptured only to the extent of ordinary
deductions previously claimed with respect to each individual asset, taxpayers have an incentive
to allocate less of the sales proceeds to intangible assets with respect to which significant
amortization deductions have been claimed. Congress enacted section 197 to reduce
controversies between taxpayers and the IRS with respect to acquisition of intangible assets,
but the potential for controversy remains with respect to the subsequent disposition of section
197 intangibles.
Description of Proposal
Under the proposal, if multiple section 197 intangibles are sold (or otherwise disposed of)
in a single transaction or series of transactions, the seller must calculate recapture as if all of the
section 197 intangibles were a single asset. Thus, any gain on the sale (or other disposition) of
the intangibles is recaptured as ordinary income to the extent of ordinary depreciation deductions
previously claimed on any of the section 197 intangibles. The proposal applies regardless of
whether the intangibles were acquired as part of the same acquisition.
If the sale transaction includes an intangible whose adjusted basis exceeds its fair market
value, such intangible is not subject to recapture and is excluded from this aggregate calculation.
The loss on such intangible continues to be permitted to the extent it is permitted under present
law.
Effective Date
The proposal is effective for dispositions of property after the date of enactment.
Discussion
Section 197 was enacted in 1993 to minimize disputes regarding the proper treatment of
acquired intangible assets by creating a uniform method and period for cost recovery. Where a
taxpayer acquires multiple intangible assets as part of a single acquisition of a trade or business,
the uniform 15-year amortization period minimizes the incentive for taxpayers or the IRS to
manipulate or challenge the valuation of (or allocation of basis among) the various intangible
assets. However, upon disposition of multiple intangible assets, the sales price allocation affects
the amount of recapture. Because income is recaptured only to the extent of deductions
previously claimed with respect to each individual asset, taxpayers have an incentive under
present law to allocate less sales proceeds to intangible assets with respect to which significant
amortization deductions have been claimed.
The following example illustrates present law and the proposal:
Example.''In year 1, a taxpayer acquires two section 197 intangible assets for a
total of $45. Asset A is assigned a cost basis of $15 and asset B is assigned a cost
basis of $30. The allocation is irrelevant for amortization purposes, as the
taxpayer will be entitled to a total of $3 per year ($45 divided by 15 years).
In year 6, the basis of A is $10 and the basis of B is $20. Taxpayer sells the assets
for an aggregate sale price of $45, resulting in gain of $15. The character of this
gain depends on the recapture amount, which depends in turn on the relative sales
prices of the individual assets. Taxpayer has claimed $5 of amortization, and
therefore has $5 of recapture potential, with respect to A. Taxpayer has claimed
$10 of amortization, and therefore has $10 of recapture potential, with respect to
B.
Under present law, if the sale proceeds are allocated $15 to A and $30 to B, the
gain on assets A and B will be $5 and $10, respectively. These amounts match
the recapture potential for each asset, so the full amount of the gain will be
recaptured as ordinary income. However, if the sale proceeds instead are
allocated $25 to A and $20 to B, the full $15 gain will be recognized with respect
to A, and only $5 (full recapture potential with respect to A) will be recaptured as
ordinary income. The remaining $10 of gain attributable to A will be treated as
capital gain. No gain (and thus no recapture) will be recognized with respect to
Asset B, and only $5 of the $15 recapture potential is recognized. This distinction
creates an incentive to manipulate the sales price allocation and increases the
potential for disputes, which is the specific circumstance Congress sought to
eliminate with the enactment of section 197.
Under the proposal, the taxpayer calculates recapture as if assets A and B were a
single asset. For purposes of the calculation, the proceeds are $45 and the gain is
$15. Because a total of $15 of amortization has been claimed with respect to
assets A and B, the full $15 gain is recaptured as ordinary income.
This issue is similar to the one addressed by present-law section 197(f)(1), which
disallows a loss on any section 197 intangible if any other section 197 intangible acquired as part
of the same acquisition is retained. While section 197(f)(1) can sometimes operate to defer real
economic losses, it eliminates the potential for disputes over valuation issues. Similarly, the
policy of section 197 is best served by eliminating the significance of the allocation of basis (and
sale proceeds) among individual intangible assets with respect to recapture.
Like section 197 itself, the proposal will not entirely eliminate the controversies in this
area. Specifically, valuation of intangible assets could still be controversial (as it is under
present law) with respect to whether an individual intangible asset is sold at a loss and, therefore,
not subject to the recapture provisions. However, applying the proposal to intangibles sold at a
loss would create an opportunity for taxpayers to circumvent the recapture rules by combining
gain and loss properties in a single transaction to avoid recapture on the gain intangibles. The
proposal serves to eliminate controversies in situations where it is clear that all assets have
appreciated in value relative to their adjusted bases.
A possible alternative approach would require taxpayers to calculate recapture as if the
sale proceeds were allocated such that the gain on each asset was proportional to each asset's
recapture potential. Thus, for recapture purposes only, intangibles with respect to which the
taxpayer had taken the most amortization deductions would be allocated an amount of proceeds
resulting in the greatest gain. The primary benefit of this alternative approach is that it is more
effective in eliminating disputes between the IRS and taxpayers because it applies to all
intangibles, regardless of whether sold at a gain or a loss. However, the proposal is simpler, is
consistent with present-law section 197(f)(1), and does not require taxpayers to calculate
recapture on the basis of an allocation which may be different from the one agreed to by the
parties to the transaction.
C. Modify Application of Income Forecast Method of Depreciation
(sec. 167)
Present Law
The cost of motion picture films, sound recordings, copyrights, books, and patents are
eligible to be recovered using the income forecast method of depreciation. Under the income
forecast method, a property's depreciation deduction for a taxable year is determined by
multiplying the adjusted basis of the property by a fraction, the numerator of which is the gross
income generated by the property during the year, and the denominator of which is the total
forecasted or estimated gross income expected to be generated prior to the close of the tenth
taxable year after the year the property was placed in service. Any costs that are not recovered
by the end of the tenth taxable year after the property was placed in service may be taken into
account as depreciation in such year. In general, the adjusted basis of property that may be taken
into account under the income forecast method only includes amounts that satisfy the economic
performance standard of section 461(h). An exception to this rule applies to participations and
residuals.
Under the American Jobs Creation Act of 2004 (''AJCA''), solely for purposes of
computing the allowable deduction for property under the income forecast method of
depreciation, participations and residuals may be included in the adjusted basis of the property
beginning in the year such property is placed in service (even if economic performance has not
yet occurred) if such participations and residuals relate to income to be derived from the property
before the close of the tenth taxable year following the year the property is placed in service.
For this purpose, participations and residuals are defined as costs the amount of which, by
contract, varies with the amount of income earned in connection with such property.
Alternatively, rather than accounting for participations and residuals as a cost of the
property under the income forecast method of depreciation, the taxpayer may deduct those
payments as they are paid, consistent with the Associated Patentees decision. This may be
done on a property-by-property basis and must be applied consistently with respect to a given
property thereafter.
The inclusion of participations and residuals in adjusted basis beginning in the year the
property is placed in service applies only for purposes of calculating the allowable depreciation
deduction under the income forecast method. For all other purposes, the general basis rules of
sections 1011 and 1016 apply. Thus, in calculating the adjusted basis for determining gain or
loss on the sale of an income forecast property, participations and residuals are treated as
increasing the taxpayer's basis only when such items are properly taken into account under the
taxpayer's method of accounting.
Reasons for Change
In some cases, the present-law rule relating to participations and residuals allows
taxpayers to deduct costs before they have been paid or incurred. This is because the basis used
for calculating the income forecast deduction can differ from the property's actual adjusted basis.
Taxpayers should not be permitted to deduct costs prior to the time such costs are paid or
incurred, under principles of economic performance that are generally applicable in determining
the timing of deductions.
Description of Proposal
Under the proposal, depreciation deductions under the income forecast method would be
disallowed to the extent that they would cause the adjusted basis for purposes of determining
gain or loss on sale to become negative. Any disallowed deductions will effectively be carried
over by operation of the income forecast formula in subsequent years.
Effective Date
The proposal is effective for property placed in service after the date of enactment.
Discussion
The present-law rule permitting the inclusion of participations and residuals in basis
when the property is placed in service generally is appropriate because the income to which the
participations and residuals relate is included in the denominator of the formula. Effectively, one
must use this ''hypothetical basis'' rather than the actual basis (for gain or loss purposes) in order
for the formula to work correctly. However, the result becomes inappropriate when the income
forecast depreciation deductions exceed the actual adjusted basis of the property (used to
determine gain or loss) because taxpayers should not be permitted to deduct costs prior to the
time the costs are paid or incurred by the taxpayer. The proposal attempts to prevent this result.
The operation of the proposal is illustrated in the following example:
Example.''A taxpayer creates a film with negative costs (i.e., production costs) of
$100. The expected revenue stream over each of the next five years is: $300, $40,
$40, $10, and $10, respectively, for a total of $400 expected revenue. The
taxpayer is contractually obligated to pay participations equal to 80 percent of all
revenue from the film in excess of $350. Thus, the taxpayer expects to pay a total
of $40 of participations over the course of years three through five. Accordingly,
the taxpayer uses a basis of $140 for purposes of its income forecast calculation.
For year one, under present law, the taxpayer's income forecast calculation is $140
multiplied by (300/400), which equals $105. However, under the proposal the deductible
amount is limited to $100 of deductions in year one because economic performance has
occurred only with respect to the first $100 of ''hypothetical basis'' used in the
calculation. Because the taxpayer's adjusted basis in the film is reduced only by the $100
allowable deduction, the disallowed $5 is carried over by operation of the income
forecast formula to subsequent years.
The proposal allows taxpayers to use the ''hypothetical basis'' to determine their tentative
income forecast deduction as under present law, but disallows the tentative deduction to the
extent it would cause the taxpayer's true adjusted basis in the property to go below zero. The
disallowed amount is allowed in a future year when the true adjusted basis would not be reduced
below zero, when the taxpayer has paid or incurred the costs and included them in basis,
consistent with principles of economic performance.
D. Apply Luxury Automobile Limitations to Sport Utility Vehicles
(sec. 280F)
Present Law
A taxpayer is allowed to recover, through annual depreciation deductions, the cost of
certain property used in a trade or business or for the production of income. The amount of the
depreciation deduction allowed with respect to tangible property for a taxable year is determined
under the modified accelerated cost recovery system (''MACRS''). Under MACRS, passenger
automobiles generally are recovered over five years.
In lieu of depreciation, a taxpayer with a sufficiently small amount of annual investment
may elect to expense such investment under section 179. The Jobs and Growth Tax Relief
Reconciliation Act of 2003 (''JGTRRA'') increased the amount a taxpayer may deduct, for
taxable years beginning in 2003 through 2005, to $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.
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 American
Jobs Creation Act of 2004 (''AJCA'') extends the temporary $100,000/$400,000 modifications
to section 179 through 2007. Prior to the enactment of JGTRRA (and 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.
However, section 280F(a) limits the annual cost recovery deduction with respect to
certain passenger automobiles. This limitation is commonly referred to as the ''luxury
automobile depreciation limitation.'' For passenger automobiles placed in service in 2004 and
for which the additional first-year depreciation deduction under section 168(k) is not claimed, the
maximum amount of allowable depreciation is $2,960 for the year in which the vehicle is placed
in service, $4,800 for the second year, $2,850 for the third year, and $1,675 for the fourth and
later years. This limitation applies to the aggregate deduction provided under present law for
depreciation and section 179 expensing.
In general, if a taxpayer does not elect the additional first-year depreciation deduction
under 168(k), the calculated MACRS depreciation deductions for a vehicle placed in service in
2004 are less than the luxury automobile depreciation limitations if the vehicle costs less than
$14,540. Thus, the limitations reduce the taxpayer''s cost recovery deduction for such a vehicle
only if the taxpayer is eligible for section 179 expensing of the cost of the vehicle. Whether a
taxpayer purchasing a car for more than $14,540 is limited under present law depends upon the
taxpayer's percentage of business use of the vehicle.
For purposes of the luxury automobile depreciation limitation, passenger automobiles are
defined broadly to include any 4-wheeled vehicles that are manufactured primarily for use on
public streets, roads, and highways and which are rated at 6,000 pounds unloaded gross vehicle
weight or less. In the case of a truck or a van, the luxury automobile depreciation limitation
applies to vehicles that are rated at 6,000 pounds gross vehicle weight or less. Under regulatory
authority, certain trucks and vans are exempted as ''qualified nonpersonal use vehicles.'' These
vehicles are exempted by reason that the design of the vehicle suggests such vehicle is not likely
to be used more than a de minimis amount for personal uses. Sport utility vehicles (''SUVs'')
are treated as trucks for the purpose of applying the section 280F(a) limitation.
In addition to extending the increased expensing limits of JGTRRA, the AJCA limits the
deduction under section 179 for certain vehicles not subject to section 280F to $25,000 (the
''section 179 expensing limitation''). This provision applies generally to sport utility vehicles
rated between 6,000 pounds and 14,000 pounds gross vehicle weight, but does not apply to any
vehicle which has seating for nine individuals behind the driver's seat or a cargo area that is at
least six feet long.
Reasons for Change
As Congress acknowledged in enacting AJCA, certain vehicles not subject to the luxury
automobile depreciation limitations contain features which are not necessary for purposes of
conducting business. While Congress restricted the ability of certain sport utility vehicles to
qualify for the expanded expensing provisions of section 179, such vehicles remain exempt from
the luxury automobile depreciation limitation and are therefore accorded more favorable
treatment than are luxury sedans, sport utility vehicles, and pickup trucks weighing less than
6,000 pounds. Because the luxury automobile depreciation limitation and the section 179
expensing limitation appear to have the same rationale, it is appropriate to apply the luxury
automobile depreciation limitation to the class of vehicles targeted by the section 179 expensing
limitation.
When the luxury automobile limits were enacted, new car sales included far fewer trucks
and vans than today, and those vehicles were more likely to be used in the operation of a
business. Now, nearly half of all new vehicle sales are not automobiles, and many more of the
larger vehicles are purchased as personal-use vehicles than they were previously. For these
reasons, it is no longer appropriate to assume that the purchase of these larger vehicles is a likely
indicator of 100 percent business use. Thus, an extension of the luxury automobile limits to
these larger vehicles is appropriate.
Description of Proposal
Under the proposal, all vehicles subject to either the present-law luxury automobile
depreciation limitation or to the present-law section 179 expensing limitation for certain sport
utility vehicles are made subject to the luxury automobile limitation. Because the luxury
automobile depreciation limitation is more restrictive than the treatment under the present-law
section 179 expensing limitation for sport utility vehicles, the expensing limitation is repealed.
Effective Date
The proposal is effective for property placed in service after the date of enactment.
Discussion
The Congress has identified two classes of business-use vehicles that have characteristics
and features that are not necessary for the conduct of a taxpayer's business. However, under
present law, the more stringent luxury automobile depreciation limitation is applied to one class
(e.g., an expensive luxury sedan) and the less stringent section 179 expensing limitation is
applied to the other class (e.g., an expensive large SUV). Because the two limitations appear to
have the same rationale, tax neutrality calls for applying the same rule to both classes of vehicles.
To apply different rules to the different classes would favor the purchase of one vehicle over
another. The non-neutrality also may influence producers to design certain vehicles to be
heavier, thereby sacrificing some fuel economy, compared to a design they might have chosen in
the absence of the disparate tax treatment.
Because it favors certain vehicles over others, some may view present law as unfair. If
one taxpayer purchases an SUV weighing 5,700 pounds while another taxpayer purchases an
SUV weighing 6,200 pounds, they presently receive disparate treatment under the income tax.
On the other hand, these two taxpayers may not be equally situated if one taxpayer truly needed
the heavier vehicle, perhaps because the taxpayer requires a heavier suspension for his vehicle.
Because section 280F(a) provides slower cost recovery, the proposal would increase the
user cost of heavier SUVs, even if used 100 percent for business purposes, compared to present
law. This likely would reduce the sale of heavier SUVs; however, if a vehicle is necessary for
the taxpayer's business, the taxpayer may still choose to purchase a heavy SUV or another
vehicle. Aggregate vehicle sales may be only modestly reduced.
The proposal, like present law, may suffer from taking a broad view of what constitutes a
''luxury'' vehicle. The MACRS cost recovery generally allows an investment in cars and light
trucks to be recovered over five years. The calculated MACRS depreciation deductions will
exceed the luxury automobile depreciation limitations for any 100 percent business use
passenger automobile whose cost exceeds $14,540. One can interpret section 280F(a) as
implying that $14,540 constitutes the maximum pure-business investment element of a vehicle,
with any excess cost reflecting a luxury element which provides personal comfort and utility but
is not necessary for business use. Some may deem the $14,540 price as not indicative of
''luxury'' in today's vehicle market. However, such an observation would argue for broader
reform, but would not argue for including some vehicles above the specified price threshold
while excluding other vehicles above that threshold. A broader revenue neutral reform could
increase the price threshold while subjecting all vehicles costing greater than the threshold to
section 280F(a).
Under the proposal, the luxury automobile depreciation limitation continues to apply to
any vehicle that is currently subject to the limitation under present law. In addition, the
limitation is expanded to apply to sport utility vehicles rated at 14,000 pounds gross vehicle
weight or less. The present-law exceptions (currently in section 179) continue to be provided for
any vehicle which has seating for nine individuals behind the driver's seat or a cargo area that is
at least six feet long. This design-based exception is consistent with the reasoning behind the
exceptions for certain trucks and vans from section 280F(a) granted by the Secretary under
present law.
E. Disallow Deduction for Interest on Debt Allocable to
Tax-Exempt Income of Insurance Companies
(secs. 265 and 832)
Present Law
In general
No deduction is allowed for interest on debt incurred or continued to purchase or carry
obligations, the interest on which is exempt from tax (sec. 265(a)(2)). This rule applies to both
individuals and corporations, and incorporates a tracing notion.
In the case of financial institutions, a pro-rata interest deduction disallowance rule
applies. Under that rule, no deduction is allowed for the portion of the taxpayer's interest
expense that is allocable to tax-exempt interest, based on the ratio of the adjusted basis of the
taxpayer's tax-exempt obligations to the adjusted basis of all its assets (sec. 265(b)). An
exception to the pro-rata disallowance rule applies in the case of tax-exempt obligations of a
qualified small issuer.
Insurance companies
In general
The rules of subchapter L determine the income of life insurance companies (sec. 801 et
seq.) and property and casualty insurance companies (sec. 831 et seq.) Under these rules,
different pro-rata interest deduction disallowance rules apply to life insurance companies and to
property and casualty companies.
Life insurance companies
A life insurance company is subject to tax on its life insurance company taxable income
(''LICTI''). LICTI is life insurance gross income reduced by life insurance deductions. A life
insurance company includes in gross income any net decrease in reserves, and deducts a net
increase in reserves. Methods for determining reserves for tax purposes generally are based on
reserves prescribed by the National Association of Insurance Commissioners for purposes of
financial reporting under State regulatory rules.
Because deductible reserves might be viewed as being funded proportionately out of
taxable and tax-exempt income, the net increase and net decrease in reserves are computed by
reducing the ending balance of the reserve items by a portion of tax-exempt interest (sec.
807(b)(2)(B) and (b)(1)(B)). Similarly, a life insurance company is allowed a dividends-received
deduction for intercorporate dividends from nonaffiliates only in proportion to the company's
share of such dividends (secs. 805(a)(4), 812). Fully deductible dividends from affiliates are
excluded from the application of this proration formula (so long as such dividends are not
themselves distributions from tax-exempt interest or from dividend income that would not be
fully deductible if received directly by the taxpayer). In addition, the proration rule includes in
prorated amounts the increase for the taxable year in policy cash values of life insurance policies
and annuity and endowment contracts owned by the company (the inside buildup on which is not
taxed).
In recent years, life insurers have not owned significant amounts of tax-exempt
obligations.
Property and casualty insurance companies
The taxable income of a property and casualty insurance company is determined as the
sum of its underwriting income and investment income (as well as gains and other income
items), reduced by allowable deductions (sec. 832). Underwriting income means premiums
earned during the taxable year less losses incurred and expenses incurred.
In calculating its reserve for losses incurred, a property and casualty insurance company
must reduce the amount of losses incurred by 15 percent of: (1) the insurer's tax-exempt interest,
(2) the deductible portion of dividends received (with special rules for dividends from affiliates),
and (3) the increase for the taxable year in the cash value of life insurance, endowment or
annuity contracts the company owns (sec. 832(b)(5)).
This 15-percent proration requirement was enacted in 1986. The reason the provision
was adopted was Congress' belief that ''it is not appropriate to fund loss reserves on a fully
deductible basis out of income which may be, in whole or in part, exempt from tax. The amount
of the reserves that is deductible should be reduced by a portion of such tax-exempt income to
reflect the fact that reserves are generally funded in part from tax-exempt interest or from wholly
or partially deductible dividends.''
In recent years, property and casualty insurers have owned about 10-14 percent of
outstanding tax-exempt obligations.
Reasons for Change
The 15-percent proration rule applicable to untaxed income of property and casualty
insurance companies does not effectively limit the companies' ability to engage in tax arbitrage.
Applying a rule similar to the rule for other types of financial intermediaries would improve
neutrality of the tax law by treating more financial intermediaries similarly, and would more
effectively limit tax arbitrage.
Description of Proposal
The proposal extends to property and casualty insurers the pro-rata interest disallowance
rule that applies to financial institutions under present law section 265(b). As under the present-
law rules for insurers, however, the proposal applies not only with respect to tax-exempt interest,
but also with respect to the untaxed portion of dividends received and insurance inside buildup.
Thus, in lieu of the current 15-percent proration rule, a property and casualty insurer would be
allowed no deduction for the portion of its interest expense that is allocable to: (1) the insurer's
tax-exempt interest, (2) the deductible portion of dividends received (with special rules for
dividends from affiliates), and (3) the increase for the taxable year in the cash value of life
insurance, endowment or annuity contracts the company owns. The portion of the deduction for
interest expense that is subject to the proposal is determined by the ratio of the adjusted basis of
the taxpayer's tax-exempt obligations, dividend-paying stock and unborrowed policy cash values
to the adjusted basis of all its assets. The proposal does not change the tax treatment of life
insurers.
Effective Date
The proposal is effective for investments acquired on or after the date of enactment.
Discussion
The premise of the proposal is that interest deduction limitation rules based on fungibility
of money should be applied to all corporate taxpayers in a similar manner, to the extent practical.
In particular, the arbitrary 15-percent rule currently applicable to property and casualty insurers
should be replaced by the more accurate allocation rule of section 265(b) that uses the taxpayer's
asset bases to determine the portion of interest costs that finance untaxed income. Because life
insurers already are subject to an interest limitation rule (based on investment income) that is
specific to life insurance products that pay policyholder dividends and interest (which property
and casualty insurance products generally do not), extending the 265(b) rule to life insurers may
not be necessary.
The proposal arguably imposes a greater administrative and recordkeeping burden on
property and casualty insurers by substituting a percentage based on the ratio of adjusted bases of
assets for the present-law flat 15-percent rate. However, business taxpayers usually know the
adjusted bases of their assets. Further, the proposal simplifies tax administration by applying the
same rules to all (or most) taxpayers, and provides a more accurate measurement of taxable
income by the use of relative asset basis for determining what portion of interest costs are
financing untaxed income in lieu of a flat percentage.
A narrower proposal could be limited to interest on tax-exempt obligations as under
section 265(b), both for conformity with other taxpayers subject to 265(b), and to facilitate the
application of the interest deduction limitation in the case of related parties (some of which
might not be property and casualty insurers). However, there may be little difference among
types of untaxed income for purposes of applying an interest deduction limitation based on
fungibility, particularly when no such distinction among types of untaxed income is made for
property and casualty insurers under their present-law interest limitation rule.
Because it would be less attractive under the proposal than under current law for property
and casualty insurance companies to hold tax-exempt debt, the borrowing costs to State and local
governments may rise. As described previously in this report, unrestricted arbitrage
opportunities should make the subsidy of tax-exempt bond financing more efficient. That
subsidy, however, may never be fully efficient, and arbitrage opportunities may remain. This
arbitrage may harm voluntary compliance and creates revenue loss to the Federal government.
F. Eliminate Double Deduction of Mining Exploration and Development
Costs Under the Minimum Tax
(sec. 57)
Present Law
Under present law, mining development costs are expensed in computing taxable income,
unless either the deferred expense method is elected under section 616(b) or 10-year
amortization is elected under section 59(e). In addition, a taxpayer may elect to expense mining
exploration costs under section 617 or amortize the costs over a 10-year period under section
59(e). Also, a deduction for depletion is allowed with respect to mines. One method of
computing the allowance for depletion is the percentage method that is based on the income of
the mining property and is not limited by the adjusted basis of the property.
In determining alternative minimum taxable income (''AMTI'') mining exploration and
development costs with respect to a mine are required to be capitalized and amortized over a 10-
year period, unless the deferred expense method is elected under section 616(b). In addition,
the deduction for percentage depletion is limited to the adjusted basis of the property at the end
of the taxable year (without regard to the depletion deduction for the year).
Under the rules, notwithstanding the adjusted basis limitation on percentage depletion, a
taxpayer may deduct more than 100 percent of its exploration and development costs in
computing AMTI. For example, assume a taxpayer incurs $1 million in development costs in
2005 with respect to a mine that has a zero basis and that the deferred expense method is not
elected. Also, assume that the deduction for percentage depletion (without regard to the basis
limitation) for 2005 is $900,000. Under present law, in computing AMTI, the taxpayer is
allowed to deduct $100,000 per year in development costs for each of the 10 taxable years
beginning in 2005, and, in addition, is allowed to deduct percentage depletion of $900,000 in
2005, for a total of $1.9 million in deductions.
Reasons for Change
The double deduction of the same expenses in computing alternative minimum taxable
income should not be permitted.
Description of Proposal
The deduction for depletion under the alternative minimum tax is amended by excluding
from the adjusted basis of any mining property, the amount of mining exploration and
development costs that may be allowed as a deduction to the taxpayer in computing AMTI in a
future taxable year.
In the example described above, the $1 million development costs will be amortized over
a 10-year period and no amount will be allowed as a deduction for depletion in computing
AMTI.
Effective Date
The proposal applies to taxable years beginning after the date of enactment.
Discussion
The 10-year amortization requirement was enacted in 1986 to better measure the
economic income from mineral properties. However, because percentage depletion (not in
excess of adjusted basis) is also allowed in computing AMTI, the failure to coordinate the two
provisions improperly allows a deduction in excess of costs incurred.
VIII. EXEMPT ORGANIZATIONS
A. Require Five-Year Review of Exempt Status of Public Charities
and Private Foundations and Annual Notice by Organizations
Not Required to File Information Returns
(sec. 508)
Present Law
Application for tax exemption
Section 501(c)(3) organizations (with certain exceptions) are required to seek formal
recognition of tax-exempt status by filing an application with the IRS (Form 1023). In response
to the application, the IRS issues a determination letter or ruling either recognizing the applicant
as tax-exempt or not. Certain organizations are not required to apply for recognition of tax-
exempt status in order to qualify as tax-exempt under section 501(c)(3) but may do so. These
organizations include churches, certain church-related organizations, organizations (other than
private foundations) the gross receipts of which in each taxable year are normally not more than
$5,000, and organizations (other than private foundations) subordinate to another tax-exempt
organization that are covered by a group exemption letter.
A favorable determination by the IRS on an application for recognition of tax-exempt
status will be retroactive to the date that the section 501(c)(3) organization was created if it files
a completed Form 1023 within 15 months from the end of the month it was formed. If the
organization does not file Form 1023 or files a late application, it will not be treated as tax-
exempt under section 501(c)(3) for any period prior to the filing of an application for recognition
of tax exemption. Contributions to section 501(c)(3) organizations that are subject to the
requirement that the organization apply for recognition of tax-exempt status generally are not
deductible from income, gift, or estate tax until the organization receives a determination letter
from the IRS.
Information required on Form 1023 includes, but is not limited to: (1) a detailed
statement of actual and proposed activities; (2) compensation and financial information
regarding officers, directors, trustees, employees, and independent contractors; (3) a statement of
revenues and expenses for the current year and the three preceding years (or for the years of the
organization's existence, if less than four years); (4) a balance sheet for the current year; (5) a
description of anticipated receipts and contemplated expenditures; (6) a copy of the articles of
incorporation, trust document, or other organizational or enabling document; (7) organization
bylaws (if any); and (8) information about previously filed Federal income tax and exempt
organization returns, if applicable. The IRS revised the Form 1023 in October 2004.
A favorable determination letter issued by the IRS will state that the application for
recognition of tax exemption and supporting documents establish that the organization
submitting the application meets the requirements of section 501(c)(3) and will classify (as either
an adverse or definitive ruling) the organization as either a public charity or a private foundation.
Review of exempt status
An organization that has received a favorable tax-exemption determination from the IRS
generally may continue to rely on the determination as long as ''there are no substantial changes
in the organization''s character, purposes or methods of operation.'' There is no mandated,
periodic procedure to review an organization's continuing qualification for exemption.
Organizations that are classified as public charities (or as private operating foundations)
and not as private nonoperating foundations may cease to satisfy the conditions that entitled the
organization to such status. The IRS makes an initial determination of public charity or private
foundation status (either a definitive ruling, or an advance ruling generally effective for five
years and then reviewed again by the IRS) that is subsequently monitored by the IRS through
annual return filings. The IRS periodically announces in the Internal Revenue Bulletin a list of
organizations that have failed to establish, or have been unable to maintain, their status as public
charities or as private operating foundations, and that become private nonoperating foundations.
If the IRS denies an organization's application for recognition of exemption under section
501(c)(3), the organization may seek a declaratory judgment regarding its tax status. Prior to
utilizing the declaratory judgment procedure, the organization must have exhausted all
administrative remedies available to it within the IRS.
Revocation (and suspension) of exempt status
A ruling or determination letter concluding that an organization is exempt from tax may
be revoked or modified by: (1) notice from the IRS to the organization to which the ruling or
determination letter was originally issued; (2) enactment of legislation or ratification of a tax
treaty; (3) a decision of the United States Supreme Court; (4) issuance of temporary or final
Regulations by the Treasury Department; or (5) issuance of a revenue ruling, a revenue
procedure, or other statement in the Internal Revenue Bulletin. An organization's tax
exemption will not be terminated if it becomes inactive for a time so long as the organization
does not cease to be a legal entity under the laws of the State in which it is organized.
The IRS generally issues a letter revoking recognition of an organization's tax-exempt
status only after: (1) conducting an examination of the organization; (2) issuing a letter to the
organization proposing revocation; and (3) allowing the organization to exhaust the
administrative appeal rights that follow the issuance of the proposed revocation letter. In the
case of a section 501(c)(3) organization, the revocation letter immediately is subject to judicial
review under the declaratory judgment procedures of section 7428. To sustain a revocation of
tax-exempt status under section 7428, the IRS must demonstrate that the organization no longer
is entitled to exemption.
Upon revocation of tax-exemption or change in the classification of an organization (e.g.,
from public charity to private foundation status), the IRS publishes an announcement of such
revocation or change in the Internal Revenue Bulletin. Contributions made to organizations
by donors who are unaware of the revocation or change in status ordinarily will be deductible if
made on or before the date of publication of the announcement.
The IRS may suspend the tax-exempt status of an organization for any period during
which an organization is designated or identified by U.S. authorities as a terrorist organization or
supporter of terrorism. Such an organization also is ineligible to apply for tax exemption. The
period of suspension runs from the date the organization is first designated or identified to the
date when all designations or identifications with respect to the organization have been rescinded
pursuant to the law or Executive order under which the designation or identification was made.
During the period of suspension, no deduction is allowed for any contribution to a terrorist
organization.
Information returns
In general, organizations exempt from Federal income tax under section 501(a) are
required to file an annual information return with the IRS. Under present law, the information
return requirement does not apply to several categories of exempt organizations. Organizations
exempt from the filing requirement include organizations (other than private foundations), the
gross receipts of which in each taxable year normally are not more than $25,000. Also
exempt from the requirement are churches, their integrated auxiliaries, and conventions or
associations of churches; the exclusively religious activities of any religious order; section
501(c)(1) instrumentalities of the United States; section 501(c)(21) trusts; an interchurch
organization of local units of a church; certain mission societies; certain church-affiliated
elementary and high schools; certain State institutions whose income is excluded from gross
income under section 115; certain governmental units and affiliates of governmental units; and
other organizations that the IRS has relieved from the filing requirement pursuant to its statutory
discretionary authority.
Reasons for Change
Five-year review
Organizations determined by the Secretary to be described in section 501(c)(3) generally
are exempt from taxation and are eligible to receive tax-deductible contributions. These twin
benefits are provided on the condition that the organization at all times is organized and operated
exclusively for exempt purposes. In general, because these benefits can be substantial,
exemption often is granted based on scant evidence of an organization's actual operations, and
organizations change over time, it is appropriate periodically to review the exempt status of
section 501(c)(3) organizations.
Under present law, tax exemption initially is granted to an organization, often newly
formed, based on information provided by the organization regarding its plans for future
operations, including detailed information about planned activities, future fundraising
expectations, compensation arrangements with insiders, estimated budgets, and relationships
with other entities. Though such information is highly relevant to making a determination of
whether an organization is described in section 501(c)(3), the exemption application typically is
a document based on an organization's aspirations and intentions, and not measured by an
organization's experience. Despite these limitations, however, the exemption application forms
the basis of an organization's claim to exempt status, and once exemption is granted, it rarely is
reviewed or revoked.
As a practical matter, the initial exemption application has become the only procedure
through which an organization must justify its claim to tax exemption. Although many section
501(c)(3) organizations are required to report annually to the IRS regarding the organization's
activities for the year, the annual information return is designed more to provide data and less to
explore the seminal question of whether the organization remains exempt. No established
mechanism exists to hold an organization to account for statements made in the initial exemption
application, or gives an organization the opportunity to explain how promises have been kept,
how aspirations have been adjusted (often appropriately) to reflect changes in plans and
expectations, or how goals have been met as the organization develops. In addition, because the
risk of loss of exemption is remote and in general the level of enforcement by the IRS and State
officials is low, organizations do not have the threat of a significant sanction to encourage
accurate information reporting or overall compliance.
Annual notice for organizations not filing information returns
The present-law exemption from the annual information return filing requirement for
small organizations serves two main purposes. Generally, the exemption is intended to relieve
small organizations of the burden of a detailed annual filing and to lessen the administrative
burden on the Secretary of collecting and maintaining data for such small organizations when the
potential benefit of doing so, compared to the resources required, is slight. As a result, however,
the Secretary is not able to maintain a record of the continuing existence of such organizations
and the public is unable easily to obtain basic information about the organization, such as the
organization's current address. The absence of a record is especially problematic for charitable
organizations. Although the Secretary publishes the names of organizations to which charitable
contributions may be made, if an organization is not required to file with the Secretary and alert
the Secretary of its termination, the Secretary does not know when to omit the organization from
its list of names.
Description of Proposal
Five-year review
The proposal requires that every five years, each organization described in section
501(c)(3), other than churches, must file with the Secretary such information as would enable the
Secretary to determine whether the organization continues to be organized and operated
exclusively for exempt purposes and whether the original determination letter should remain in
effect (or be modified or revoked). The five-year review filing is required to be made publicly
available and to be filed electronically. Failure to satisfy the five-year review filing requirement
results in loss of tax-exempt status, effective as of the first day of the taxable period beginning
after expiration of the five-year review filing deadline.
The Secretary is not required to take action or make any determination with respect to a
five-year review filing. Similar to the filing of a Form 990, under the proposal the Secretary has
discretion to review any filing and is permitted to revoke tax-exempt status retroactively or
prospectively, as warranted by the facts and circumstances, if a review undertaken by the
Secretary concludes that the organization is not entitled to exemption. The Secretary also may
determine based on an examination of the filing that certain activities of an organization are
subject to the unrelated business income tax or that excise taxes should apply to certain
transactions or activities. If the Secretary conducts an examination of a five-year review filing
and determines that the organization continues to be organized and operated for purposes
described in section 501(c)(3), the Secretary is not required to issue a new determination letter.
Organizations that file the five-year review may continue to rely on their existing determination
letter unless informed otherwise by the Secretary.
Information to be filed as part of a five-year review filing include the organization's
current articles of incorporation and by-laws or governing instruments; a description of related
party transactions entered into by the organization over the previous five-year period (and
expected to be entered into over the subsequent five-year period); a detailed narrative about the
organization's prior, current, and contemplated operations and practices and how such operations
and practices differ from those described in the initial application for exemption (or most recent
five-year filing); a description of the prior, current, and contemplated trade or business activities
of the organization and whether and how such activities are related to the organization's exempt
purposes; a summary of the organization's compensation of management and senior employees
for the previous five-year period; the organization's financial statements; a description of the
organization's material changes during the prior five-year period; and such additional
information as the Secretary may require. Private nonoperating foundations are required to show
the percentage over five years of qualifying distributions that are administrative expenses for
purposes of meeting the payout requirement of section 4942 and to compare for each year in the
five-year period the amount expended on grant-related administrative costs and the amounts
expended to recipients as grants for exempt purposes.
Annual notice for organizations not filing information returns
The proposal requires that organizations that are excused from filing an information
return by reason of normally having gross receipts below a certain specified amount (generally,
under $25,000) shall furnish to the Secretary annually a notice containing the legal name of
the organization, any name under which the organization operates or does business, the
organization's mailing address and Internet web site address (if any), the organization's taxpayer
identification number, the name and address of a principal officer, and evidence of the
organization's continuing basis for its exemption from the generally applicable information
return filing requirements. Upon such organization's termination of existence, the organization
is required to furnish notice of such termination. Notices would be required to be made publicly
available by the Secretary and by the organization.
Under the proposal, if an organization fails to provide the required annual notice for three
consecutive years, the organization's tax-exempt status is automatically revoked. In addition, if
an organization that is required to file an annual information return under section 6033(a) (e.g., a
Form 990) fails to file such an information return for three consecutive years, the organization's
tax-exempt status is automatically revoked. If an organization fails to meet its filing obligation
to the IRS for three consecutive years in cases where the organization is subject to the
information return filing requirement in one or more years during a three-year period and also is
subject to the notice requirement for one or more years during the same three-year period, the
organization's tax-exempt status is automatically revoked. An organization may not challenge
under the Code's declaratory judgment procedures a revocation of tax-exemption made
pursuant to the provision. There is no monetary penalty for failure to file the notice. The
proposal does not affect an organization's obligation under present law to file required
information returns or existing penalties for failure to file such returns.
A revocation of exempt status under the proposal is effective from the date that the
Secretary determines was the last day the organization could have timely filed the third required
information return or notice. To again be recognized as tax-exempt, the organization must apply
to the Secretary for recognition of tax exemption, irrespective of whether the organization was
required to make an application for recognition of tax-exemption in order to gain tax exemption
originally.
If upon application for tax-exempt status after a revocation under the proposal, the
organization shows to the satisfaction of the Secretary reasonable cause for failing to file each of
the required annual notices or returns, the organization's tax-exempt status may, in the discretion
of the Secretary, be reinstated retroactive to the date of revocation.
Effective Date
Five-year review
The proposal is effective for organizations receiving favorable exempt status
determinations within the ten years prior to, on, or after the date of enactment. The first five-
year review filings would commence in calendar year 2007. The Secretary has the discretion to
determine the due date for the first five-year review of all organizations subject to the proposal.
Annual notice for small organizations not filing information returns
The proposal is effective for notices and returns with respect to annual periods beginning
after the date of enactment.
Discussion
Five-year review
The purpose of the five-year review filing is to convert the initial exemption application
from a one-time review of an organization's exempt purposes to the first installment in an
ongoing process whereby an organization described in section 501(c)(3) describes its current and
planned activities every five years and explains why such activities are consistent with the goals
and requirements of section 501(c)(3). Like other filings of section 501(c)(3) organizations, e.g.,
the original exemption application and annual information returns, the five-year review filing
would be publicly available. In general, public availability enables oversight by the public and
by State officials of whether an organization meets its exempt purposes, whether contributions
are being spent appropriately, and whether State laws, such as charitable solicitation laws, are
being observed.
A systematic five-year review process would provide the Secretary and the public with
updated information regarding the basis for an organization's exemption, and the ongoing
organizational structure and operations of an organization. The proposal recognizes that the
Secretary does not have the resources to make a new determination with respect to every
organization, or even necessarily to review a high percentage of five-year filings. Thus, the
proposal does not require that the Secretary take any action with respect to a five-year review
filing. However, the five-year review filing will be a public document subject to public scrutiny
and oversight, the Secretary has the discretion to conduct an audit of exempt status based on the
information provided in a five-year review filing, and the process of submitting a five-year
review filing should have a salutary effect on an organization's annual compliance efforts and
also would require an organization to articulate and reveal for scrutiny the basis for its continued
exemption from tax.
Certain information required in the five-year review should be of particular use for
enforcement purposes, including enforcement by State officials. Five-year summaries of
compensation data of senior officers and directors should provide the Secretary, the States, and
the public with an easy reference to the compensation practices of the organization over time. A
five-year review of related-party transactions should highlight whether an organization has a
history of entering into transactions with insiders and whether such transactions should be
subject to greater scrutiny, including intermediate sanctions or self-dealing excise taxes. A
description every five years of an organization's trade and business activities should provide the
Secretary, the States, and the public with a clearer sense of the extent of commercial activity
engaged in by an organization and provide a better ability for assessment of whether such
activity is related to exempt purposes or subject to the unrelated business income tax. Regarding
private nonoperating foundations, five-year reports regarding administrative expenses as a
percentage of qualifying distributions and comparative data regarding grant-related
administrative expenses and grants made for exempt purposes should help identify foundations
that may not be operating efficiently, or that are claiming as qualifying distributions
unreasonable and unnecessary administrative expenses.
Once successfully implemented, the five-year review should provide a new source of data
for information about types of charitable organizations as well as the overall charitable sector.
Because the filings are publicly available, it will be easier for nongovernmental oversight
organizations (as well as the IRS) to collect, analyze, and disseminate data about charitable
organizations. Public oversight will not be solely dependent on a year-by-year analysis and
comparison of the Form 990 or 990-PF, but would be enhanced by the ability to look to five-year
review filings to assess an organization's performance and activities over time.
In general, the Secretary has the discretion to determine the manner of filing the five-year
review. For example, the review could take the form of a special ''Form 990-5 Year,'' which
would include the information regularly required by the annual information return plus an
additional schedule of information relevant to the five-year review. The form is required to be
filed electronically in order to facilitate access for the Secretary, State officials, and the public.
If the five-year filing were made as a separate schedule to the Form 990, the five-year review
would not result in new forms being filed with the Secretary, although the Form 990 would be
longer in years when the five-year filing was required.
The five-year review need not be overly burdensome on organizations. Although it
requires filing of additional information, such a filing is infrequent and the information required
should be readily available to the organization. Small organizations that are exempted from
annual return filing requirements are subject to the five-year review filing and so would have to
provide additional information of a nature not currently provided. However, in general, the
smaller the organization the easier the form should be to complete, and any burden should be
minimized by the filing's infrequency. Irrespective of any relative burden on the organization,
the information is fundamental to the organization's status as an organization exempt from tax
and to which deductible contributions can be made. Some might argue that the Secretary and the
public have a right to know such information and that a five-year filing is a reasonable burden to
impose for the privilege of tax exemption as a charity.
The proposal is effective for organizations that receive favorable determinations of
exempt status within the ten-year period prior to, on, or after the date of enactment. Some might
argue that the proposal should apply beyond ten years and cover all existing organizations that
have favorable determinations. However, a five-year review filing for all organizations could
entail significant additional costs on the IRS as compared to review of organizations recognized
as exempt over the past ten years. Some might argue that any such additional cost is largely
transitional, however, and that once the process for five-year review is successfully
implemented, the IRS will be in a better position than presently to enhance compliance and
efficiency through its data collection and reporting. Arguably, however, the need for a five-year
review filing is most important for more recently formed organizations and less important for
organizations with a more established existence. In addition, covering organizations recognized
as exempt over the past ten years captures much of the recent significant growth of section
501(c)(3) organizations (and the exempt sector). For example, in fiscal year 1995, the IRS listed
626,226 section 501(c)(3) organizations. For fiscal year 2003, the number had grown to
964,418, or an increase of 338,192, and a growth rate of 54 percent over nine years.
Annual notice for small organizations not filing information returns
The proposal requires that exempt organizations that do not have to file an annual
information return by virtue of the amount of their gross receipts file with the Secretary a simple,
short annual notice. Under the proposal, the list presently maintained by the Secretary of active
organizations to which charitable deductions could be made could regularly be updated, omitting
the names of organizations that cease to file a notice or that notify the Secretary of their
termination. The proposal thus addresses the problem under present law of taxpayers relying on
an incomplete and inaccurate list.
The annual notice need be no longer than a single page. The burden and cost are
intended to be modest. No monetary penalty applies for failure to file the notice and so would
not place a financial burden on small organizations. The public availability of the notice also
would enable the public to know how to contact an organization and would inform the public
that the organization was active and in compliance with a basic filing obligation. The sanction of
loss of exempt status for failure to file the notice for three consecutive years is also applied to
organizations that fail to file an information return for three consecutive years to ensure equitable
treatment among exempt organizations.
B. Impose Termination Tax on Conversions of Assets of Charities
(secs. 501, 507, 4941, and 4958)
Present Law
In general
Nonprofit organizations described in section 501(c), including charitable and educational
organizations, may seek to convert their assets for use by a taxable entity that is organized and
operated for profit. Such a conversion may take one of many forms, including a sale of assets, a
joint venture, or a reorganization of the entity for Federal tax or State law purposes. In recent
years, the conversion of public charities, especially of hospitals and other health care providers,
has resulted in significant amounts of charitable assets being converted to for-profit uses.
Many conversion transactions are subject to State nonprofit corporation or charitable trust
laws, as well as Federal tax laws applicable to charitable organizations. Provided that the
converting charity receives fair market value for its assets, pays no more than reasonable
compensation for services rendered in connection with the transaction, and takes appropriate
steps to assure that its assets (including conversion transaction proceeds) remain dedicated to
charitable purposes, conversion transactions may be completed in a manner that is consistent
with the organization's charitable mission and the tax subsidies provided by the Federal
government. In general, no Federal income tax is collected with respect to conversion
transactions, either because they are structured to constitute tax-free reorganizations or joint
ventures involving the charity, or as taxable transactions the gain from which is not subject to the
unrelated business income tax.
Exemption requirements and related provisions
Exemption requirements for charities
Organizations described in section 501(c)(3) (generally ''charitable organizations'' or
''charities'') generally are exempt from Federal income tax and are eligible to receive tax-
deductible contributions. A charitable organization must be organized and operate exclusively to
further one or more tax-exempt purposes constituting the basis of its tax exemption. Section
501(c)(3) organizations are classified either as ''public charities'' or ''private foundations.'' A
charitable organization may lose its exemption for a various reasons, including failure to operate
exclusively for exempt purposes, impermissible private inurement or private benefit, political
campaign activities, and substantial nonexempt business or lobbying activities.
Dedication of assets to charitable purposes
An organization is not organized exclusively for exempt purposes (and thus may be
denied or lose exempt status) unless its assets are dedicated to an exempt purpose. A
charitable organization's assets will be considered dedicated to an exempt purpose if, upon
dissolution, such assets would, by reason of a provision in the organization's articles or by
operation of law, be distributed for one or more exempt purposes, or to the Federal government,
or to a State or local government, for a public purpose, or would be distributed by a court to
another organization to be used in such manner as in the judgment of the court will best
accomplish the general purposes for which the dissolved organization was organized. The IRS
takes the position that a charitable organization's articles of organization must contain a
dissolution clause that satisfies these requirements, unless the organization is organized under a
State law that satisfies the dissolution provisions of Treasury Regulations section 1.501(c)(3)-
1(b)(4).
Intermediate sanctions (excess benefit transaction tax)
The Code imposes excise taxes on excess benefit transactions between disqualified
persons and public charities. An excess benefit transaction generally is a transaction in which
an economic benefit is provided by a public charity directly or indirectly to or for the use of a
disqualified person, if the value of the economic benefit provided exceeds the value of the
consideration (including the performance of services) received for providing such benefit. The
tax generally does not apply to fixed payments made by a public charity to a disqualified person
pursuant to a binding written contract between the organization and a person who was not a
disqualified person immediately before entering into the contract (the ''initial contract
exception'').
Under present law, a disqualified person is any person in a position to exercise substantial
influence over the affairs of the public charity at any time in the five-year period before the
excess benefit transaction occurred. Persons holding certain powers, responsibilities, or
interests (e.g., officers, directors, or trustees) are considered to be in a position to exercise
substantial influence over the affairs of the public charity.
An excess benefit transaction tax is imposed on the disqualified person and, in certain
cases, on the organization managers, but is not imposed on the public charity. An initial tax of
25 percent of the excess benefit amount is imposed on the disqualified person that receives the
excess benefit. An additional tax on the disqualified person of 200 percent of the excess benefit
applies if the violation is not corrected within a specified period of time. A tax of 10 percent of
the excess benefit (not to exceed $10,000 with respect to any excess benefit transaction) is
imposed on an organization manager that knowingly participated in the excess benefit
transaction, if the manager's participation was willful and not due to reasonable cause, and if the
initial tax was imposed on the disqualified person.
Private foundation termination tax
In general, section 507 imposes a tax on the voluntary or involuntary termination of the
status of an organization as a private foundation unless such organization transfers its net assets
to, or begins to operate as, a public charity. Section 507 does not apply to the conversion or
liquidation of public charities. The section 507 termination tax generally is equal to the
aggregate tax benefit resulting from the organization's status as a charitable organization
(including the entire period the organization was exempt as a charitable organization), not to
exceed the value of the net assets of the foundation. The tax also applies in certain cases
involving willful repeated acts or failures to act, or a willful and flagrant act or failure to act, that
gives rise to liability for excise taxes under the private foundation rules. Under present law, the aggregate tax benefit equals the sum of: (1) aggregate increases in
tax that would have been imposed with respect to all substantial contributors to the foundation if
deductions for charitable contributions made by the substantial contributors to the foundation had
been disallowed; (2) the aggregate increases in Federal income tax that would have been
imposed with respect to the foundation if it had not been exempt; and (3) interest on such tax
increases, determined from the dates on which the taxes would have been due and payable, to the
date on which the organization ceases to be a private foundation. The value of the net assets of
the foundation is determined as of the first day on which action is taken by the organization
which culminates in its ceasing to be a private foundation, or the date on which it ceases to be a
private foundation, whichever value is higher.
The Secretary may abate the unpaid portion of the tax if the private foundation distributes
all of its net assets to one or more public charities or governmental units, or in certain cases if
corrective action has been taken pursuant to State law to insure that the assets of the private
foundation are preserved for charitable purposes.
In enacting section 507, ''Congress concluded that foundations should not receive
substantial and continuing tax benefits in exchange for the promise of the use of the assets
involved for educational, charitable, religious, etc., purposes but avoid the carrying out of these
responsibilities.'' There is no indication whether the focus of the Congress in 1969 on private
foundation abuses meant that applying the termination tax to public charities was not considered
at that time.
Application of Federal tax law to conversion transactions
There are a variety of structures used to effect conversion transactions. If a conversion is
structured as a sale, lease, or other transfer of assets, the transferring exempt organization may
remain in existence and continue to use the transaction proceeds to further charitable purposes,
or may form a new charity to use the proceeds for charitable purposes. If a conversion is
structured as a merger or change in form of the corporation under State law, the charity ceases to
exist as a nonprofit organization, and a new charity may be established to receive and hold the
assets to be used to further charitable purposes.
Conversion transactions must be structured in a manner that is consistent with the
organizational requirements of an exempt organization, including that the organization's assets
are dedicated to an exempt purpose. Conversion transactions generally involve a realization
event for Federal income tax purposes, although a converting charitable organization often does
not recognize income on the conversion transaction.
The sale or other transfer by a public charity of its assets to a for-profit entity for less than
fair market value may justify revocation of the charity's exempt status through the private
inurement doctrine (for insider transactions), or through the private benefit doctrine (for non-
insider transactions). However, ''[i]n practice, revocation of tax-exempt status, with or without
the imposition of [excess benefit transaction] excise taxes, would occur only when the
organization no longer operates as a charitable organization.'' Thus, under present law, an
arrangement between a charity and its acquirer arguably would have to be found to be so unfair
to the charity that the organization cannot be regarded as operating in a charitable manner in
order to revoke exemption based on the particular transaction. In addition, a conversion
agreement between a charity and an acquiring party might not be subject to the section 4958
excess benefit transaction tax, either because the transaction is not with insiders of the
organization, or because the agreement fits within the initial contract exception. If the circumstances of a transaction are determined to warrant revocation of exempt
status of the participating charity, present law provides no clear rules to determine what the tax
consequences of revocation are in a particular case. There is no provision in the tax law for the
voluntary termination or conversion of exempt status, and the tax consequences in the event an
organization's exempt status is revoked can be unclear. The dedication of assets requirement
''does not, in a literal sense, ''prevent'' an individual from doing anything.''
Reasons for Change
Conversion transactions raise concerns that: (1) charitable assets may be transferred to
for-profit companies for less than fair market value; (2) excessive compensation and severance
amounts are paid to officers, directors, and employees of the charity or the acquiring for-profit
entity; and (3) the charity's assets will not be used for their intended charitable purposes
following the completion of the transaction. Opportunities for such abuses are greatest in
situations where officers, directors, and employees of the charity enter into relationships with the
acquiring entity that put them in a position of influence over the affairs of the acquirer. Such
conflicts of interest may make it difficult to ensure that the best interests of the charitable
beneficiaries are protected, and that the charity's assets remain dedicated for charitable purposes.
The large number of conversion transactions over recent years involving the conversion of
charitable assets to for-profit uses raises serious questions about the ability of the IRS to enforce
the Federal tax law requirement that a public charity's assets be perpetually dedicated to
charitable purposes. Strict enforcement of this requirement may be accomplished through a
termination tax, similar to the present-law termination tax on private foundations, imposed on all
charitable organizations that liquidate or engage in certain major transactions without dedicating
the entire value of their assets to charitable purposes.
Description of Proposal
Overview
The proposal modifies present law to improve the Federal Government's ability to
enforce the requirement that a charitable organization's assets remain dedicated to charitable
purposes by imposing a termination tax on the liquidation or conversion of a charitable
organization. The termination tax equals the value of the organization's net assets that are not
dedicated to charitable purposes after the liquidation or conversion transaction. No termination
tax is due if following the transaction the entire pre-transaction value of the charity's net assets
remains dedicated to charitable purposes. As is described below, the termination tax may not be
collected from assets that are dedicated to charitable purposes.
The proposal applies to public charities and to private foundations, and thus eliminates
the present-law aggregate tax benefit limit contained in section 507. In the case of private
foundations, the proposed termination tax applies to voluntary or involuntary terminations
(within the meaning of present-law section 507, including willful repeated acts or failures to act,
or a willful and flagrant act or failure to act, that gives rise to liability for tax under Chapter
42), as well as to conversion or liquidation transactions (as defined by this proposal). The
proposed termination tax also applies to a public charity if there have been either willful repeated
acts or failures to act, or a willful and flagrant act or failure to act, that gives rise to liability for
Chapter 42 taxes, which includes sections 4955 (tax on political expenditures) and 4958 (tax on
excess benefit transactions).
The proposal generally defines a conversion transaction by reference to present-law
section 280G principles pertaining to changes in ownership or control of an organization or a
substantial portion of its assets. In order to assure that fair consideration is paid in these
transactions, the proposal extends the section 4958 excess benefit transaction tax rules (in the
case of a public charity) or section 4941 self-dealing rules (in the case of a private foundation) to
an acquirer of the charity's assets in a conversion or liquidation transaction, if persons who are
disqualified persons of the charitable organization are in a position to exercise substantial
influence over the affairs of the acquirer at the time of or after the transaction, including as
officers, directors, or employees of the acquirer. The proposal provides for enhanced disclosure
and substantiation of liquidation and conversion transactions by requiring that the parties to such
a transaction provide the IRS with written notice of a conversion or liquidation of the charity,
and by implementing qualified appraiser and appraisal requirements for such transactions.
Definition of conversion and liquidation transactions
The proposal defines a conversion transaction as a change in the ownership or control of
a charity, or in the ownership of a substantial portion of the assets of a charity, directly or
indirectly, in either a single transaction or a series of transactions, in which a person or persons
other than a charitable organization or governmental unit obtains ownership or control. Forms
of a conversion transaction include, for example, an asset sale, a merger, a transfer of assets to a
subsidiary, a change in corporate form under State law, a transfer of assets to a joint venture, or a
long-term lease or similar transaction pursuant to which the charity has transferred the benefits
and burdens of ownership of its assets.
In general, the proposal uses present-law section 280G principles to determine if a
conversion of the charity has occurred. Under the proposal, a change in ownership of a
charitable corporation occurs on the date that: (1) any one person (other than a charitable
organization or a government), or more than one person acting as a group, acquires ownership of
stock or membership interests of the corporation that, together with stock or membership
interests held by such person or group, causes the person or group to own 50 percent or more of
the total fair market value or total voting power of the stock or membership interests of such
corporation; or (2) the corporation ceases to be organized and operated as a nonprofit corporation
under State law. In the case of a trust or unincorporated charity, a change of ownership is
determined by reference to beneficial interests rather than to stock, and a change of ownership
occurs if the trust or unincorporated entity ceases to be organized and operated for nonprofit
purposes under State law.
Under the proposal, a change in the control of a corporation, trust, or unincorporated
charity occurs on the date that: (1) any one person (other than a charitable organization or a
government), or more than one person acting as a group, acquires the authority to appoint, elect,
or replace at least 50 percent of the members of the corporation's board of directors or of the
trustees; or (2) the organization amends its articles of organization or other governing
instruments to eliminate the requirement that upon dissolution its assets be distributed to a
charity or a government for charitable or public purposes.
A change in the ownership of a substantial portion of the assets of a charity (whether a
corporation, trust, or unincorporated charity) occurs on the date that any one person (other than a
charitable organization or a government), or more than one person acting as a group, acquires
assets from the charity that have a total gross fair market value of at least one-third of the total
gross fair market value of all of the assets of the charity immediately prior to such acquisition.
For this purpose, gross fair market value means the value of the assets without regard to any
liabilities associated with such assets. For example, a change in the ownership of a substantial
portion of a charity's assets could be in the form of the acquisition of a subsidiary of the charity,
a merger of the charity with and into another entity, or a sale of assets (whether exempt purpose,
investment, or trade or business assets) by the charity.
Under the proposal, the term liquidation has the same meaning that it has under present
law. In general, a status of liquidation exists when the corporation ''ceases to be a going concern
and its activities are merely for the purpose of winding up its affairs, paying its debts, and
distributing any remaining balance to its shareholders.''
The proposal does not apply to liquidations or changes of ownership or control of taxable
nonprofit organizations, or organizations exempt from Federal income tax under a provision
other than section 501(c)(3). Further, the proposal does not apply to a charity's change in status
from a public charity to a private foundation, or from a private foundation to a public charity.
Imposition of termination tax on liquidations and conversions
The proposal imposes a termination tax on conversions and liquidations of public
charities and private foundations, including the transfer of assets from a charity to an
organization that is exempt other than as a charity (e.g., a social welfare organization described
in section 501(c)(4)). Under the proposal, a charity is subject to a tax equal to the excess of the
value of its net assets over the value of its net assets that remain dedicated to charitable purposes
following the transaction. The value of the net assets of the organization is determined at
whichever time such value is higher: (1) the first day on which action is taken by the
organization that culminates in a conversion or liquidation of the organization; or (2) the date of
the conversion or liquidation of the organization. If the amount of the termination tax exceeds
the net asset value of the organization immediately after the transaction, the termination tax may
not be collected from assets that are dedicated to charitable purposes. The proposal permits the
tax to be abated to the extent that assets are subsequently dedicated to charitable purposes,
through retention by or distribution to a charitable organization for charitable purposes, or by
distribution to a government for public purposes. The proposal does not modify present law with
respect to the transferee liability of a transferee of property of an organization subject to the
termination tax.
Expansion of intermediate sanctions and self-dealing rules
Treat acquirers as disqualified persons for excess benefit transaction and self-dealing
taxes
To assure that an acquirer of a public charity's assets pays fair market value for the assets
acquired pursuant to a conversion or liquidation in cases involving conflicts of interest between
the charity and the acquirer, the proposal provides that an acquiring person other than a
charitable organization or a governmental unit is a disqualified person for purposes of applying
section 4958 to the transaction, if at any time during the five-year period beginning on the date of
the transaction persons who were disqualified persons of the public charity (at the time of the
conversion or liquidation transaction) are in a position to exercise substantial influence over the
affairs of the acquirer, including as officers, directors, or employees of the acquirer. The
proposal provides that the present-law initial contract exception is not available to such an
acquirer with respect to the acquisition. Under the proposal, such an acquirer is subject to the
present-law 25-percent excise tax on an excess benefit it receives from the transaction, and the
additional 200-percent tax if the excess benefit transaction is not corrected. In addition, the
charity's managers who participate in such a transaction are subject to the ten-percent excise tax
on organization managers.
Under the proposal, whether disqualified persons of the public charity have substantial
influence over the affairs of the acquirer is determined under present-law section 4958 principles.
In general, this includes a person who has or shares authority to control or determine a
substantial portion of the acquirer's capital expenditures, operating budget, or compensation for
employees, or manages a discrete segment or activity of the acquirer that represents a substantial
portion of the activities, assets, income, or expenses of the acquirer, as compared to the
organization as a whole.
Under the proposal, the present-law section 4941 self-dealing rules continue to apply to
transactions involving a private foundation, and may prohibit certain types of conversion
transactions involving private foundations (e.g., if the acquirer is a disqualified person with
respect to the foundation). The proposal extends the self-dealing rules to conversion or
liquidation transactions if at any time during the five-year period beginning on the date of the
conversion or liquidation, persons who were disqualified persons of the private foundation (at the
time of the conversion or liquidation) are in a position to exercise substantial influence over the
affairs of the acquirer (as described above).Excess benefit transaction and self-dealing rules for disqualified persons of the
charity who have a relationship with the acquirer
Under the proposal, the excess benefit transaction tax rules (in the case of a public
charity) or the section 4941 self dealing rules (in the case of a private foundation) apply to
compensation, severance arrangements, and other transactions involving disqualified persons of
the charity (determined as of the time of the conversion or liquidation) who at any time during
the five-year period beginning on the date of the conversion or liquidation transaction have a
relationship with the acquirer that would cause the person to be a disqualified person if the
acquirer were treated as a charity to which section 4958 or section 4941 applies. For example, a
transaction between the acquirer and an officer or director of a public charity who becomes an
officer or director of the acquirer at any time within five years following the transaction is
subject to section 4958.
Notice and reporting requirements
The proposal imposes notice and reporting requirements on the charity and the acquiring
person with respect to certain events relating to the conversion or liquidation. These events
include: (1) entering into a letter of intent or a definitive agreement to convert or liquidate the
charity; (2) adoption of a conversion or liquidation plan by the charity; (3) adoption of or
agreement to any material changes to such a letter, agreement or plan; and (4) filing or receipt of
a filing relating to the commencement of State administrative or judicial proceedings with
respect to a conversion or liquidation transaction involving the charity.
The required information, which must be reported to the IRS within 10 days of the
relevant event, includes: (1) a description of the transaction and all minutes of the governing
bodies of the organizations pertaining to the transaction; (2) a description of any consideration to
be paid (cash, notes, property, stock of acquirer, assumption of liabilities, etc.) by or to the
charity, and of any severance arrangements, stock and stock rights or other equity agreements,
and officer and employee compensation arrangements entered into in connection with the
transaction; (3) copies of any appraisals, fairness opinions (including with respect to any stock,
stock rights, or other equity rights provided as consideration in the transaction), material
transactional documents, severance arrangements, stock and stock rights or other equity
agreements, and officer and employee compensation arrangements entered into in connection
with the transaction; and (4) a summary of any Federal, State, or local regulatory review and
approval processes applicable to the transaction. The proposal authorizes the IRS to recover its
reasonable costs of reviewing the conversion or liquidation transaction.
Tolling or extension of limitations period
Under the proposal, if the required notice and reporting requirements are not fulfilled
within the required time frame, the statute of limitations period is suspended with respect to the
assessment and collection of the termination tax and applicable excess benefit transaction and
self dealing taxes, until the proposal's notice and reporting requirements are satisfied. In
addition, the limitations period with respect to a conversion or liquidation transaction is extended
for an additional five years to enforce the five-year lookback rules for purposes of determining
whether disqualified persons who are in a position to exercise substantial influence over the
acquirer subject the acquirer and such persons to section 4941 or section 4958 with respect to the
conversion or liquidation and other transactions entered into during such five-year period.
Appraiser and appraisal requirements
The proposal establishes qualified appraiser and appraisal requirements for conversion
and liquidation transactions. A charity is required to obtain a qualified appraisal of the fair
market value of the charity's assets from an independent qualified appraiser, determined as of
two dates: (1) the first day on which action is taken by the organization with respect to the
conversion or liquidation transaction; and (2) the date of the conversion or liquidation
transaction. Similarly, each party that acquires ownership or control of the charity, or all or a
substantial portion of the assets of the charity, must obtain its own qualified appraisal from a
different qualified appraiser that is not a related party to any other qualified appraiser with
respect to the transaction of the fair market value of the assets or property it acquired pursuant to
the transaction. Each qualified appraisal must state that the appraisal was performed with the
understanding of the appraiser and the party for whom the appraisal was performed that the
appraised values will be reviewed by the IRS for purposes of determining the applicability of the
termination tax, section 4941 or section 4958 (whichever is applicable), and the private
inurement and private benefit prohibitions.
Under the proposal, a qualified appraiser is an individual who affirms: (1) that the fair
market value of the subject property has been determined in accordance with generally accepted
appraisal standards; (2) with respect to the specific property and transaction type, that he or she:
(a) has successfully completed educational coursework, including for continuing education
credits, in generally accepted appraisal practices, principles, concepts, methodologies, and ethics
from a recognized provider of such courses; or has earned an appraisal designation from a
recognized organization that teaches, tests, and provides continuing education to its members in
valuation; and (b) regularly performs appraisals for which he or she receives compensation and
has a minimum of two years experience in doing so; and (3) has not been subject to disbarment
from practice before the IRS by the Secretary pursuant to 31 U.S.C. section 330(c).
Examples
Example 1.''Public charity (PC) enters into an agreement with several other public
charities, pursuant to which each of the charities transfers a portion of its intellectual property to
a partnership in exchange for a partnership interest. No persons other than public charities
participate in the joint venture. The transfer of intellectual property by some of the charitable
participants constitutes more than one-third of the gross value of the organization's assets. Each
of the charities continues to dedicate its assets, including its partnership interest, to charitable
purposes.
Under the proposal, the arrangement does not constitute a conversion transaction,
because charitable organizations retain ownership and control of the joint venture. The result is
the same whether the joint venture is treated for Federal tax purposes as an association taxed as a
corporation, or as a partnership. Example 2.''PC sells all of its assets with a value of $100 million to a for-profit entity
(FP) for $100 million, and dedicates $100 million to charitable purposes.
Under the proposal, the sale of all of PC's assets to FP is a conversion transaction
(change in ownership of assets) that PC and FP must report to the IRS. Each of PC and FP must
obtain a qualified appraisal from qualified appraisers with respect to the value of PC's assets.
Because PC receives fair market value for the asset transfer, and dedicates the entire fair market
value to charitable purposes following the transaction, there is no termination tax imposed on
PC. The results are the same if the transaction is structured as a State law merger of PC with and
into FP (a change of ownership of assets), or a change in corporate form under State law (a
change in ownership), and FP contributes $100 million to a newly formed charity. Example 3.''PC sells all of its assets with a value of $100 million to FP for $100 million,
but only dedicates $80 million of the sales proceeds to charitable purposes.
Under the proposal, the sale of all of PC's assets to FP is a conversion transaction
(change in ownership of assets) that PC and FP must report to the IRS. Each of PC and FP must
obtain a qualified appraisal from a qualified appraiser with respect to the value of PC's assets.
Because PC failed to dedicate the entire fair market value of its assets for charitable purposes,
there is a termination tax of $20 million imposed on the transaction, the portion of the value that
was not dedicated to charitable purposes. The tax may not be recovered from PC's assets that
are dedicated to charitable purposes, or from FP (which paid fair market value for the acquired
assets). All or a portion of the termination tax may be recovered through enforcement of the
excess benefit transaction tax provisions, however, if the $20 million not dedicated to charitable
purposes was paid to disqualified persons and corrected by repayment of the excess benefit to
PC. In addition, the termination tax may be recovered from a charity's claim under State law
against its officers or directors for breach of duty as an officer or director, if proceeds awarded
under the claim are not dedicated to charitable purposes. Example 4.''PC sells all of its assets with a value of $100 million to FP for $80 million,
and dedicates the $80 million proceeds to charitable purposes.
Under the proposal, the sale of all of PC's assets to FP is a conversion transaction
(change in ownership of assets) that PC and FP must report to the IRS. Each of PC and FP must
obtain a qualified appraisal from a qualified appraiser with respect to the value of PC's assets.
PC is liable for a termination tax of $20 million (the value of the assets that was not dedicated to
charitable purposes). However, the $20 million termination tax may not be recovered from the
assets that remain dedicated to charitable purposes. If FP is a disqualified person as the acquirer
of PC's assets (whether because of a relationship that existed prior to the transaction or by virtue
of disqualified persons of PC being in a position to exercise substantial influence over the affairs
of FP after the transaction), FP is subject to the section 4958 excess benefit transaction taxes,
because PC did not receive fair market value for the asset transfer. The termination tax may be
collected from PC as a result of a correction by FP of the excess benefit transaction, or from FP
under transferee liability principles, if applicable.
Example 5.''PC transfers 40 percent of the gross fair market value of its assets to a joint
venture (JV) in which PC and FP each owns a 50 percent ownership interest. The fair market
value of PC's interest in JV equals the fair market value of the assets transferred by PC to JV.
JV is a partnership for Federal income tax purposes.
PC's transfer of assets to JV constitutes a conversion (change in ownership of a
substantial portion of assets) because more than one-third of PC's assets were transferred to an
entity other than a charity or a government. (This would be the result whether PC owned a
minority or a majority interest in JV.) PC and JV must satisfy the reporting requirements
applicable to the transaction. Each of PC and JV must obtain a qualified appraisal from a
qualified appraiser with respect to the value of PC's assets transferred to JV, and of PC's interest
in JV. Because PC received fair market value in exchange for the transferred assets, neither JV
nor FP is liable for a section 4958 excess benefit transaction tax. Provided that PC continues to
dedicate all of its assets (including its interest in JV) to charitable purposes, the transaction is not
subject to a termination tax.
Example 6.''PC is a nonstock, nonmembership, nonprofit corporation governed by a self-
perpetuating board of directors. FP obtains the authority to elect, appoint, or remove 50 percent
of the members of PC's board.
FP's obtaining authority to elect, appoint, or remove 50 percent of PC's board constitutes
a conversion transaction (change in control) that PC and FP must report to the IRS. Each of PC
and FP must obtain a qualified appraisal from a qualified appraiser with respect to the value of
PC's assets, and FP must obtain a qualified appraisal of the value of FP's rights to alter PC's
board composition. Provided that all of PC's assets remain dedicated to charitable purposes, PC
is not liable for a termination tax on the transaction.
Example 7.''PC amends its articles of organization to eliminate the requirement that,
upon dissolution, its assets will be distributed to a charity or to a government for charitable or
public purposes.
The amendment of PC's articles of organization to eliminate the dedication of assets
requirement constitutes a conversion (change of control) of the organization that must be
reported to the IRS. PC must obtain a qualified appraisal from an independent qualified
appraiser with respect to the value of PC's assets. PC is subject to a termination tax equal to the
entire value of its net assets if no assets are transferred to a charity or government.
Effective Date
The proposal is effective for liquidations or conversion transactions that occur after the
date of enactment.
Discussion
Extending a termination tax to all charities to enforce the dedication of assets requirement
The proposal extends a modified version of the present-law section 507 tax on private
foundation terminations to conversion and liquidation transactions. This approach strictly
enforces the asset dedication requirement by imposing a tax on the net assets of the charity, even
if greater in amount than the aggregate tax benefit, that do not remain dedicated to charitable
purposes. The rationale for strictly enforcing the dedication of assets requirement is that strict
enforcement is necessary to protect the public's interest in seeing that the entire value of its
contributions is used for charitable purposes. The dedication of assets requirement is the
linchpin of exempt status law for charities, with doctrines such as private inurement, private
benefit, and intermediate sanctions and self-dealing providing additional mechanisms to buttress
the requirement by protecting against misuse of charitable assets. A termination tax that strictly
enforces the dedication of assets requirement is consistent with State charitable trust and
nonprofit corporation statutes which contain similar requirements.
Some might argue that extension of a termination tax to public charities inappropriately
interferes with the authority of State officials to oversee these transactions. Under this view, it
might be argued that present-law private inurement and private benefit prohibitions adequately
address the Federal tax law concerns applicable to these transactions, and that many States have
adopted conversion statutes in recent years to give State officials additional enforcement
authority. A number of practical limitations, however, impair the ability of the IRS and the
States to ensure perpetual dedication of assets to charitable uses. First, the private inurement
prohibition does not ensure that a public charity's assets will be used for charitable purposes in
non-insider contexts. Second, the private benefit doctrine is not clearly defined and is difficult to
administer. Third, the proliferation of conversion transactions and the varying State responses to
such transactions demonstrate that there is no uniform national standard that is being applied to
protect the charitable assets of the nation's public charities. A public charity in New York is
subject to the same Federal dedication of assets requirement as a public charity in California, and
whether one or the other's assets remains dedicated to charitable purposes is both a Federal and a
State concern. Under the present regime, however, the Federal government effectively has
delegated enforcement of a Federal tax law requirement to the various States, resulting in non-
uniform enforcement of this important basis for exemption as a public charity.
The proposal modifies the termination tax with respect to private foundations to be
consistent with that proposed for public charities. Some might argue that Congress enacted the
section 507 tax to address a specific type of abuse, and determined at that time that this could be
accomplished by taking away the tax benefits that were provided to those who formed the private
foundation. However, the dedication of assets requirement applies to all charities, and the basic
rationale for strictly enforcing the requirement (rather than limiting it to an aggregate tax benefit)
applies equally to public charities and private foundations. As is the case under present law, the
proposal imposes the termination tax on private foundations in certain cases involving willful
and flagrant acts or failure to act, or willful repeated acts or failures to act, and extends the
termination tax to public charities in similar circumstances.
Some commentators have advocated the imposition of an ''exit tax'' on conversion
transactions, determined by applying a tax rate to the value of the assets involved in the
transaction, without regard to whether fair market value is received by the converting nonprofit
entity or the use of the proceeds. This approach would not assure the dedication of the
charity's assets to charitable purposes, and in some cases could divert assets from the charitable
sector to the Federal government by imposing a tax even if the entire value of the charity's assets
were dedicated to charitable purposes. Others might argue that a better approach would be to
extend the section 507 tax on private foundation terminations to conversions or liquidations of
public charities, and retain the present-law measure of the tax based on the aggregate tax benefit
(not to exceed the net assets of the charity). However, if a charity becomes free to use its assets
without regard to furthering charitable purposes merely by transferring its assets to another
person and paying an exit tax or a termination tax equal to the tax benefits previously provided to
the organization and its donors, the requirement that upon dissolution the charity's assets be
distributed for charitable or public purposes arguably is nothing more than an unenforceable
promise.
Expansion of intermediate sanctions rules
It is important that a charity receive fair market value in all conversion or liquidation
transactions, whether the acquirer is related or unrelated to the charity. In general, the tax law
assumes that unrelated persons (including charities) will bargain at arm's length and that each
will adequately protect its own interests. If the charity and the acquirer are unrelated, and are
free to engage in good faith negotiations to arrive at a fair market value consideration for the
charity because the acquirer is not in a position to substantially influence the affairs of the
charity, the doctrines of transferee liability (applicable to the transferee of assets) and State law
breach of duty (applicable to the charity's officers and directors) should adequately protect
against the risk that a charity will receive less than fair market value consideration from its
unrelated acquirer, and there should be no need to treat the acquirer as a disqualified person
under such circumstances. However, in those instances that involve a financial or other
relationship between the charity and the acquirer, or an overlap of officers, directors, or other
employees of the charity and the acquirer, conflicts of interest may arise that make it difficult to
assure that a charity's interests will be protected in the conversion or liquidation transaction. For
this reason, the proposal treats certain acquirers as disqualified persons for purposes of the
intermediate sanctions and self-dealing rules, even if the acquirer did not have a relationship with
the charity prior to engaging in the conversion transaction. Acquirers treated as disqualified
persons include those who are treated as such under present-law, and acquirers for which
disqualified persons of the charity (determined at the time of the conversion or liquidation
transaction) are at any time during the five-year period beginning on the date of the conversion in
a position to exercise substantial influence over the affairs of the acquirer. Also, in such cases,
transactions between either the acquirer or the charity and such disqualified persons with
substantial influence over the affairs of the acquirer are subject to the excess benefits transaction
tax or self-dealing provisions during such five year period.
Definition of conversion transactions
The definition of conversion must be broad enough to encompass the various kinds of
transactions in which charitable assets cease to be dedicated to charitable purposes. For
example, some have reported that nonprofit organizations have used leases and other structures
that transfer beneficial (but not legal) ownership of their assets to for-profit entities in order to
avoid running afoul of State laws prohibiting or limiting the disposition of assets to a non-
charity. Further, although the focus of many reports has been on the conversion of nonprofits
into for-profit entities, the dedication of assets requirement should not be circumvented by
converting into another nonprofit entity that is not subject to the requirement, such as an exempt
social welfare organization or a taxable nonprofit corporation, or by liquidating and distributing
assets to such an entity. Accordingly, the proposal defines conversion broadly to include any
change in ownership or control pursuant to which charitable assets are no longer subject to a
requirement that they be dedicated in perpetuity to charitable purposes, and extends the proposed
rules to liquidations of charities.
Under the proposal, a conversion through an asset transfer occurs whenever at least one
third of the gross fair market value of the charity's total assets has been transferred other than to
another charity or a government. This is consistent with the one-third standard used for section
280G purposes.
Notice and reporting requirements
Under present law, an exempt organization generally does not notify the IRS of a
liquidation or material transaction, such as a conversion, until it files its Form 990 for the year
during which the liquidation or transaction occurred. This provides the IRS no opportunity to
review the transaction before or soon after it is completed. Under the proposal, a charity is
required to notify the IRS of certain events at various stages of the conversion or liquidation
process. The notice requirements are intended to provide the IRS a meaningful opportunity to
review the proposed transaction for compliance with Federal tax laws, including the proposed
termination tax, and the modified intermediate sanctions and self-dealing rules. By suspending
the statute of limitations with respect to imposition of these taxes until all notice and reporting
requirements are satisfied, the IRS is provided a better opportunity to enforce the laws after
completion of the transaction.
Appraisal requirements
Under the proposal, a proper determination of the fair market value of a charity's assets is
critical in conversion and liquidation cases, including for purposes of determining the amounts of
the potential termination and excess benefits transaction or self-dealing taxes. Accordingly, the
proposal establishes qualified appraiser and qualified appraisal requirements that apply to both
the charity and the acquirer of the charity's assets. The requirement of separate appraisals as of
both the conversion or liquidation date and the first day on which action is taken by the
organization with respect to the transaction might be viewed by some as onerous, but generally
should not result in substantial additional costs unless there have been significant changes in the
composition of assets during the interim, in which case they are justified to reflect such changes
and to determine the potential termination tax amount (i.e., as is the case under present-law
section 507, the greater of the values of net assets as of the two dates).
C. Tax Involvement by Exempt Organizations in Tax-Shelter Transactions
(secs. 6011 and 6707A)
Present Law
Disclosure of listed and other reportable transactions by taxpayers
Present law provides that a taxpayer that participates in a reportable transaction
(including a listed transaction) and who is required to file a tax return must attach to its return a
disclosure statement in the form prescribed by the Secretary. For this purpose, the term
taxpayer includes any person, including an individual, trust, estate, partnership, association,
company, or corporation.
Under existing regulations, a reportable transaction includes a listed transaction and five
other categories of transactions: (1) confidential transactions, which are transactions offered to a
taxpayer under conditions of confidentiality and for which the taxpayer has paid an advisor a
minimum fee; (2) transactions with contractual protection, which include transactions for which
the taxpayer or a related party has the right to a full or partial refund of fees if all or part of the
intended tax consequences from the transaction are not sustained, or for which fees are
contingent on the taxpayer's realization of tax benefits from the transaction; (3) loss transactions,
which are transactions resulting in the taxpayer claiming a loss under section 165 that exceeds
certain thresholds, depending upon the type of taxpayer; (4) transactions with a significant book-
tax difference; and (5) transactions involving a brief asset holding period. A listed transaction
means a reportable transaction which is the same as, or substantially similar to, a transaction
specifically identified by the Secretary as a tax avoidance transaction for purposes of section
6011 (relating to the filing of returns and statements), and identified by notice, regulation, or
other form of published guidance as a listed transaction. The fact that a transaction is a
reportable transaction does not affect the legal determination of whether the taxpayer's treatment
of the transaction is proper. Present law authorizes the Secretary to define reportable
transaction on the basis of such transaction being of a type which the Secretary determines as
having a potential for tax avoidance or evasion.
Treasury regulations provide guidance regarding the determination of when a taxpayer
participates in a transaction for these purposes. A taxpayer has participated in a listed
transaction if the taxpayer's tax return reflects tax consequences or a tax strategy described in the
published guidance that lists the transaction, or if the taxpayer knows or has reason to know that
the taxpayer's tax benefits are derived directly or indirectly from tax consequences or a tax
strategy described in published guidance that lists a transaction. A taxpayer has participated in a
confidential transaction if the taxpayer's tax return reflects a tax benefit from the transaction and
the taxpayer's disclosure of the tax treatment or tax structure of the transaction is limited under
conditions of confidentiality. A taxpayer has participated in a transaction with contractual
protection if the taxpayer's tax return reflects a tax benefit from the transaction, and the taxpayer
has the right to the full or partial refund of fees or the fees are contingent. Present law provides a penalty for any person who fails to include on any return or
statement any required information with respect to a reportable transaction. The penalty
applies without regard to whether the transaction ultimately results in an understatement of tax,
and applies in addition to any other penalty that may be imposed.
The penalty for failing to disclose a reportable transaction is $10,000 in the case of a
natural person and $50,000 in any other case. The amount is increased to $100,000 and
$200,000, respectively, if the failure is with respect to a listed transaction. The penalty cannot be
waived with respect to a listed transaction. As to reportable transactions, the IRS Commissioner
may rescind all or a portion of the penalty if rescission would promote compliance with the tax
laws and effective tax administration.
Disclosure of listed and other reportable transactions by material advisors
Present law requires each material advisor with respect to any reportable transaction
(including any listed transaction) to timely file an information return with the Secretary (in such
form and manner as the Secretary may prescribe). The information return must include (1)
information identifying and describing the transaction, (2) information describing any potential
tax benefits expected to result from the transaction, and (3) such other information as the
Secretary may prescribe. The return must be filed by the date specified by the Secretary.
A ''material advisor'' means any person (1) who provides material aid, assistance, or
advice with respect to organizing, managing, promoting, selling, implementing, insuring, or
carrying out any reportable transaction, and (2) who directly or indirectly derives gross income
in excess of $250,000 ($50,000 in the case of a reportable transaction substantially all of the tax
benefits from which are provided to natural persons) or such other amount as may be prescribed
by the Secretary for such advice or assistance.
The Secretary may prescribe regulations which provide (1) that only one material advisor
is required to file an information return in cases in which two or more material advisors would
otherwise be required to file information returns with respect to a particular reportable
transaction, (2) exemptions from the requirements of this section, and (3) other rules as may be
necessary or appropriate to carry out the purposes of this section.
Present law imposes a penalty on any material advisor who fails to timely file an
information return, or who files a false or incomplete information return, with respect to a
reportable transaction (including a listed transaction). The amount of the penalty is $50,000.
If the penalty is with respect to a listed transaction, the amount of the penalty is increased to the
greater of (1) $200,000, or (2) 50 percent of the gross income derived by such person with
respect to aid, assistance, or advice which is provided with respect to the transaction before the
date the information return that includes the transaction is filed. An intentional failure or act by a
material advisor with respect to the requirement to disclose a listed transaction increases the
penalty to 75 percent of the gross income derived from the transaction.
The penalty cannot be waived with respect to a listed transaction. As to reportable
transactions, the IRS Commissioner can rescind all or a portion of the penalty if rescission would
promote compliance with the tax laws and effective tax administration.
Reasons for Change
Many tax exempt organizations are accorded special tax status because they are
organized and operated to further public purposes or other policy objectives (e.g., charitable
purposes, social welfare purposes, promotion of retirement savings). Certain others obtain
exempt status because they are in effect conduits used to achieve the objectives of their
members, and thus an entity level tax is not appropriate. Regardless of the policy rationale for
providing exempt status to an organization, the exemption from tax generally is limited to
income derived from those activities that substantially further the basis for exemption. Because
tax exemption is a valuable financial benefit, exempt organizations have become attractive
targets to serve as accommodation parties for taxpayers in various tax-motivated transactions.
Such transactions involving exempt organizations contribute to the erosion of the tax base by
improperly extending the benefit of exemption to other taxpayers, including with respect to
transactions that serve no material purpose for the taxable party to the transaction other than to
avoid tax. Although recent shelter legislation addressed many tax shelter abuses, such legislation
does not prevent certain abuses that might be perpetrated by using exempt organizations as
accommodation parties.
Description of Proposal
In general
In general, under the proposal, many tax-exempt entities are subject to penalties for
participating in a prohibited tax shelter transaction as accommodation parties. A prohibited tax
shelter transaction is a transaction that the Secretary determines is a listed transaction (as defined
in section 6707A(c)(2)) or a reportable transaction that is a confidential transaction or a
transaction with contractual protection (as defined by the Secretary in regulations). The proposal
also provides that an exempt organization that participates in a reportable transaction (including
a listed transaction) in order to shelter from tax the organization's own tax liability (e.g., the
unrelated business income tax) is subject to the present-law rules (sec. 6707A and sec. 6011)
pertaining to disclosure of such transactions.
The proposal generally applies to all tax-exempt organizations and entities, including
charitable and other organizations described in section 501(c) (other than instrumentalities of the
United States, i.e., section 501(c)(1) organizations), State and local governments, Indian tribal
governments, and tax qualified pension plans, individual retirement arrangements (''IRAs''), and
similar tax-favored savings arrangements (such as Coverdell education savings accounts, health
savings accounts, and qualified tuition plans).
Entity level tax
Under the proposal, if a tax-exempt entity participates in a transaction, knowing or with
reason to know that the transaction is a prohibited tax shelter transaction, the entity is subject to a
tax of 100 percent of the entity's net income (after taking into account any income tax imposed
with respect to the transaction) that is attributable to the entity's participation in the prohibited
transaction. If the entity is eligible to receive deductible contributions, the Secretary may
suspend such eligibility with respect to the income tax for one year. The entity level tax does not
apply to tax qualified pension plans, IRAs, and similar tax-favored savings arrangements (such
as Coverdell education savings accounts, health savings accounts, and qualified tuition plans).
In addition, if a transaction is not a tax shelter prohibited transaction at the time a tax-
exempt entity participates in the transaction, but the transaction subsequently is determined by
the Secretary to be a prohibited tax shelter transaction (a ''subsequently prohibited tax shelter
transaction''), the entity must pay an excise tax at the highest unrelated business taxable income
rate on any income that is properly allocable to the transaction after the time the transaction
becomes prohibited. The Secretary has the authority to provide guidance regarding the
determination of the allocation of net income of a tax-exempt entity that is attributable to a
transaction to various periods, including before and after the listing of the transaction.
Disclosure of participation in prohibited tax shelter transactions
A person who fails to include information with respect to a prohibited tax shelter
transaction on any return or statement as required by the Secretary must pay a penalty of $10,000
in the case of a natural person or $50,000 in any other case. In addition, the proposal requires
that a party to a prohibited tax shelter transaction that is not a tax-exempt entity disclose to the
tax-exempt entity that the transaction is a reportable transaction. Failure to make such disclosure
is subject to the penalties described above.
The proposal requires disclosure by a tax-exempt entity to the IRS of its participation in a
prohibited tax shelter transaction and disclosure of other known parties to the transaction if the
tax-exempt entity knows that such transaction is a reportable transaction. The penalty for failure
to disclose is imposed on the entity (or entity manager, in the case of qualified pension plans and
similar tax favored retirement arrangements) at $100 per day the failure continues, not to exceed
$50,000. If any person fails to comply with a demand for payment by the Secretary of such
penalty, such person or persons shall pay a penalty of $10 per day (beginning on the date of the
failure to comply) not to exceed $1,000 per reportable transaction.
Penalty on entity managers
A tax of $20,000 is imposed on each entity manager that approves a tax-exempt entity's
participation in a prohibited tax shelter transaction, knowing or with reason to know that the
transaction is a prohibited tax shelter transaction. No more than $200,000 of tax in the aggregate
may be imposed with respect to a prohibited tax shelter transaction. An entity manager is
defined as the person with authority or responsibility similar to that exercised by an officer,
director, or trustee of an organization, except: (1) in the case of an entity described in section
501(c)(3) or (c)(4), an entity manager is an organization manager as defined in section
4958(f)(2), and (2) in the case of tax qualified pension plans, IRAs, and similar tax-favored
savings arrangements (such as Coverdell education savings accounts, health savings accounts,
and qualified tuition plans), an entity manager is the person responsible for causing the entity to
participate in the prohibited tax shelter transaction.
Effective Date
The proposal generally is effective for transactions that are prohibited after the date of
enactment, except that no tax applies with respect to income that is properly allocable to the
period ending on the date that is 90 days after the date of enactment. The effective date for
disclosure obligations and penalties for failure to disclose is returns and statements the due date
of which is after the date of enactment.
Discussion
The proposal provides that exempt organizations and exempt organization managers are
subject to tax for participation as an accommodation party in prohibited tax shelter transactions.
The purpose of the proposal is not to collect the taxes imposed, but to provide a strong deterrent
that will prevent exempt organizations from participating as accommodation parties in
transactions known to be abusive, and to be cautious about entering into transactions that could
be considered abusive. The proposal broadly defines exempt organization for this purpose to
include organizations described in section 501(c) (other than instrumentalities of the Federal
government), State and local governments, Indian tribal governments, qualified plans and trusts,
and certain other entities exempt from Federal income tax. The proposal treats listed and
substantially similar transactions, as well as two types of other reportable transactions generally
regarded as similar to a listed transaction (confidential transactions and contractual protection
transactions) equally.
Some argue that it is inappropriate to impose substantive sanctions with respect to
transactions that have not yet been tested in court. However, listed transactions are now being
used (or considered for use) in other contexts to impose substantive standards, such as
determining whether an auditing firm is independent with respect to a client for which it
provided an opinion regarding a listed or certain reportable transactions, or for limited Circular
230 purposes to determine whether an opinion is a ''covered opinion.'' Some might argue that
the proposal should not provide the IRS and the Treasury with the discretion to determine which
transactions will result in a tax on an exempt organization and its managers. Indeed, the
Treasury has delisted certain transactions after it determined that the potential for abuse was less
than first thought. Others might argue, however, that the listing process is sufficiently rigorous
to identify only those transactions that have the greatest potential to erode the tax base, that the
Treasury and IRS will not abuse its discretion, and that it is appropriate to compel a participating
exempt organization to disgorge its profits from such transactions.
The proposal distinguishes between cases where the transaction was listed or reportable
at the time it was entered into, and transactions that subsequently become listed or reportable, by
providing for a lesser rate of tax in the case of subsequently prohibited tax shelter transactions.
Some argue, however, that an organization should not pay any tax for participating in a
transaction that was not a prohibited tax shelter transaction at the time of the organization's
initial participation because the organization managers would have no way of knowing that
participation in the transaction would subject the organization to tax, and may raise questions
regarding due process issues. Others argue that the tax is a necessary deterrent to discourage
organization managers from entering into potentially suspect transactions. Others also argue that
it is appropriate to impose a tax on the income attributable to the time after the transaction is
determined to be a prohibited tax shelter transaction because, once such a determination is made,
the income should not be considered as related to the organization's exempt purposes and should
be taxed as unrelated business income, regardless of whether the organization regularly engages
in such types of transactions.
Some argue that the proposal should apply more broadly to all tax-motivated transactions
which serve no business or exempt purpose of the participating exempt organization. However,
extending the proposal to cover such tax-motivated transactions would introduce substantial
uncertainty regarding which transactions ultimately would be subject to the proposal. Using
listed and certain reportable transactions as the standard provides a clear line to delineate which
transactions are subject to the proposed sanctions, without having to examine the subjective
motivations and intentions of the parties to the transaction.
Some argue that determining net income may be difficult for some of these transactions,
and that organizations will have an incentive to allocate exempt function expenses to such
activities, or offset such income by unrelated business losses, to reduce the amount of tax. In
many cases, the income of the organization should be relatively easy to determine (the gross
accommodation fee less transaction costs, such as legal fees). In addition, the proposal could be
modified to disallow the use of other losses to offset such income (similar to the separate
proposal regarding exempt organizations that hold stock in an S corporation).
D. Reform Intermediate Sanctions and Extend Certain
Reforms to Private Foundations
(secs. 4941 and 4958)
Present Law
In general
The Code imposes excise taxes on excess benefit transactions between disqualified
persons and charitable organizations (other than private foundations) or social welfare
organizations (as described in section 501(c)(4)). An excess benefit transaction generally is a
transaction in which an economic benefit is provided by a charitable or social welfare
organization directly or indirectly to or for the use of a disqualified person if the value of the
economic benefit provided exceeds the value of the consideration (including the performance of
services) received for providing such benefit. The excise tax is imposed on any such excess.
The Code also imposes excise taxes on acts of self-dealing between a disqualified person
and a private foundation. In general, self-dealing transactions between a private foundation and
a disqualified person include: (1) a sale or exchange, or leasing, of property; (2) lending of
money or other extension of credit; (3) the furnishing of goods, services, or facilities between a
private foundation and a disqualified person,; (4) the transfer to, or use by or for the benefit of, a
disqualified person of the income or assets of the private foundation; and (5) certain payments of
money or property to a government official. Taxes are imposed on the very act of self-
dealing, irrespective of whether fair market value is paid (except for the payment of
compensation, which is permitted at fair market value). The tax is imposed on the entire amount
involved in the transaction (except for the payment of compensation, with respect to which the
tax is imposed on the excess compensation).
The intermediate sanctions regime is modeled on the present-law self-dealing excise tax
regime applicable to private foundations, though the two regimes have significant differences.
The primary difference is that the intermediate sanctions regime permits insider transactions to
occur so long as fair market value is paid, whereas the private foundation self-dealing regime
generally prohibits self-dealing transactions altogether. Thus, the intermediate sanctions regime
is much more permissive than the self-dealing regime.
Legislative background
Prior to enactment of the current private foundation self-dealing rules in 1969,
foundations generally were permitted to engage in certain self-dealing transactions so long as
arm's length standards were followed by the foundation and the insider. Sanctions were imposed
if arm's length standards were not followed. However, Congress significantly tightened the rules
in 1969 in part because arm's length standards proved difficult to enforce. The pre-1969 self-
dealing regime is similar in approach to today's excess benefit transaction rules for public
charities, i.e., self-dealing transactions are permitted so long as fair market value is received by
the public charity.
The excess benefit transaction rules were enacted in 1996 to provide a sanction short of
revocation of tax exemption, an ''intermediate'' sanction, for abusive self-dealing transactions
(i.e., private inurement) between an organization insider and the organization. Prior to
enactment of the excess benefit transaction rules, there was no sanction in the Code on
organization insiders or disqualified persons for engaging in self-dealing transactions with
respect to a public charity. Congress determined that under prior law the chances of the IRS
finding cases of private inurement and of revoking the organization's exemption because of the
bad actions of a few were slim, and that an intermediate sanction was appropriate. The Secretary
issued proposed regulations with respect to excess benefit transactions in January 2001 and final
regulations in January 2002.
Intermediate sanctions regime
Rebuttable presumption of reasonableness
Under the intermediate sanctions rules, in certain cases, an exempt organization may
avail itself of a rebuttable presumption with respect to compensation arrangements and property
transfers. Payments under a compensation arrangement are presumed to be reasonable, and a
transfer of property, or the right to use property, is presumed to be at fair market value, if: (1) the
arrangement or terms of transfer are approved in advance by an authorized body of the
organization (as defined below) composed entirely of individuals who do not have a conflict of
interest with respect to the arrangement or transfer; (2) the authorized body obtained and relied
upon appropriate data as to comparability prior to making its determination; and (3) the
authorized body adequately documented the basis for its determination concurrently with making
that determination. If these requirements are satisfied, the IRS may overcome the presumption
of reasonableness if it develops sufficient contrary evidence to rebut the probative value of the
comparability data relied upon by the authorized body.
An authorized body is defined as: (1) the governing body of the organization; (2) a
committee of the governing body, which may be composed of any individuals permitted under
State law to serve on such a committee, to the extent that the committee is permitted by State law
to act on behalf of the governing body; or (3) to the extent permitted by State law, other parties
authorized by the governing body of the organization to act on its behalf by following procedures
specified by the governing body in approving compensation arrangements or property
transfers.
In general, an authorized body has appropriate data as to comparability if, given the
knowledge and expertise of its members, it has information sufficient to determine whether the
arrangement is reasonable in its entirety or the transfer is at fair market value. In the case of
compensation, relevant information includes, but is not limited to, compensation levels paid by
similarly situated organizations, both taxable and tax-exempt, for functionally comparable
positions; the availability of similar services in the geographic area of the applicable tax-exempt
organization; current compensation surveys compiled by independent firms; and actual written
offers from similar institutions competing for the services of the disqualified person. In the case
of property, relevant information includes, but is not limited to, current independent appraisals of
the value of all property to be transferred, and offers received as part of an open and competitive
bidding process. For organizations with annual gross receipts (including contributions) of less
than $1 million reviewing compensation arrangements, the authorized body is considered to have
appropriate data as to comparability if it has data on compensation paid by three comparable
organizations in the same or similar communities for similar services. There is no inference with
respect to whether circumstances falling outside this safe harbor will meet the requirement with
respect to the collection of appropriate data.
In general, for a decision to be documented adequately, the written or electronic records
of the authorized body must note: (1) the terms of the transaction that was approved and the date
it was approved; (2) the members of the authorized body who were present during debate on the
transaction that was approved and those who voted on it; (3) the comparability data obtained and
relied upon by the authorized body and how the data was obtained; and (4) any actions taken
with respect to consideration of the transaction by anyone who is otherwise a member of the
authorized body but who had a conflict of interest with respect to the transaction.
Amount of the excise tax
The excess benefit tax is imposed on the disqualified person and, in certain cases, on the
organization's managers, but is not imposed on the exempt organization. This follows the
structure for the private foundation self-dealing tax, which imposes a tax on disqualified persons
and private foundation managers, but not the private foundation.
An initial tax of 25 percent of the excess benefit amount is imposed on the disqualified
person that receives the excess benefit. An additional tax on the disqualified person of 200
percent of the excess benefit applies if the violation is not corrected. A tax of 10 percent of the
excess benefit (not to exceed $10,000 with respect to any excess benefit transaction) is imposed
on an organization manager who knowingly participated in the excess benefit transaction, if the
manager's participation was willful and not due to reasonable cause, and if the initial tax was
imposed on the disqualified person. If more than one person is liable for the tax on
disqualified persons or on management, all such persons are jointly and severally liable for the
tax.
Standard for knowing violations
A manager participates in a transaction knowingly only if the manager: (1) has actual
knowledge of sufficient facts so that, based solely upon those facts, such transaction would be an
excess benefit transaction; (2) is aware that such a transaction under these circumstances may
violate the provisions of Federal tax law governing excess benefit transactions; and (3)
negligently fails to make reasonable attempts to ascertain whether the transaction is an excess
benefit transaction, or the manager is in fact aware that it is such a transaction. Similar
standards apply to foundation managers for purposes of imposition of the excise tax on private
foundation managers for knowing participation in an act of self-dealing. The burden of proof in
a Tax Court proceeding as to whether an organization manager (or foundation manager) acted
knowingly is on the Secretary.
Knowing does not mean having a reason to know. However, evidence tending to show
that an organization manager has reason to know of a particular fact or particular rule is relevant
in determining whether the manager had actual knowledge of such a fact or rule. Thus, for
example, evidence tending to show that a manager has reason to know of sufficient facts so that,
based solely upon such facts, a transaction would be an excess benefit transaction is relevant in
determining whether the manager has actual knowledge of such facts.
Participation by an organization manager is willful if it is voluntary, conscious, and
intentional. No motive to avoid the restrictions of the law or the incurrence of any tax is
necessary to make the participation willful. Participation by an organization manager is not
willful if the manager does not know that the transaction in which the manager is participating is
an excess benefit transaction. An organization manager's participation is due to reasonable
cause if the manager has exercised responsibility on behalf of the organization with ordinary
business care and prudence. Similar standards of willfulness and reasonable cause apply to
foundation managers for purposes of imposition of tax on the manager for knowing participation
in an act of self-dealing.
Special rules
An organization manager's reliance on professional advice generally means that the
manager has not knowingly participated in an excess benefit transaction. Under Treasury
regulations, an organization manager's participation in a transaction ordinarily is not considered
knowing, even though the transaction subsequently is held to be an excess benefit transaction, to
the extent that, after full disclosure of the factual situation to an appropriate professional, the
organization manager relies on a reasoned written opinion of that professional with respect to
elements of the transaction within the professional's expertise. A written opinion is considered
as reasoned even though it reaches a conclusion that is subsequently determined to be incorrect
so long as the opinion addresses itself to the facts and the applicable standards. A written
opinion is not considered to be reasoned if it does nothing more than recite the facts and express
a conclusion. The absence of a written opinion of an appropriate professional with respect to a
transaction does not, by itself, give rise to any inference that an organization manager
participated in the transaction knowingly.
Appropriate professionals on whose written opinion an organization manager may rely,
are: (1) legal counsel, including in-house counsel; (2) certified public accountants or accounting
firms with expertise regarding the relevant tax law matters; and (3) independent valuation
experts who hold themselves out to the public as appraisers or compensation consultants,
perform the relevant valuations on a regular basis, are qualified to make valuations of the type of
property or services involved, and include in the written opinion a certification that the three
preceding requirements are met. A similar special rule for private foundation managers,
provided in the context of self-dealing, permits reliance only on advice of counsel and not on
other persons.
An organization manager's participation in a transaction ordinarily is not considered
knowing even though the transaction subsequently is held to be an excess benefit transaction, if
an appropriate authorized body that approved the transaction meets the requirements of the
rebuttable presumption of reasonableness with respect to the transaction.
Initial contract exception for excess benefit transactions
Under Treasury Regulations, the tax on excess benefit transactions does not apply to
fixed payments made by an organization to a disqualified person pursuant to a binding written
contract between the organization and a person who was not a disqualified person immediately
before entering into the contract (the ''initial contract exception''). For purposes of the initial
contract exception, a fixed payment is an amount of cash or other property specified in the
contract, or determined by a fixed formula specified in the contract, which is to be paid or
transferred in exchange for the provision of specified services or property. For example, if a public charity hires a chief financial officer by entering into a five-year
contract with an individual who was not a disqualified person immediately prior to entering into
the contract, and the contract provides for a fixed annual salary, payable in monthly installments,
the excess benefit tax does not apply to the individual's compensation under the contract.
Accordingly, under the regulations, it is unnecessary to evaluate whether any portion of the
compensation paid to the individual pursuant to the five-year contract is an excess benefit
transaction.
There is no similar exception for the private foundation self-dealing tax.
Reasons for Change
The intermediate sanctions regime was enacted in 1996 to provide a sanction short of
revocation of tax-exemption in cases where the assets of a public charity or social welfare
organization are used to benefit insiders. Since the enactment of intermediate sanctions,
however, there continue to be reports of abuses by insiders and managers of public charities, as
well as by private foundations. Compensation packages, loans, sales of property to insiders, joint
ventures, conversions, and other transactions, increasingly are raising questions about the extent
to which excess benefits are being provided to insiders of exempt organizations. Transactions
with insiders create widespread opportunities for abuse, especially when the determination of
whether a transaction passes muster depends upon a subjective determination of fair market
value or reasonableness of compensation. Given the practical difficulties of enforcing valuation
questions, the continued report of abuses, and the critical importance of ensuring that charitable
assets are not used for private purposes, the proposal addresses specific aspects of the
intermediate sanctions regime that impede enforcement and extends certain of these reforms to
the self-dealing regime applicable to private foundations.
Description of Proposal
Modify the rebuttable presumption of reasonableness
Eliminate rebuttable presumption and establish due diligence procedures that apply to
public charities and private foundations
The proposal eliminates the rebuttable presumption of reasonableness contained in the
intermediate sanctions regulations. Under the proposal, the procedures that presently provide an
organization with a presumption of reasonableness (i.e., advance approval by an authorized
body, reliance upon data as to comparability, and adequate and concurrent documentation)
generally will establish instead that an organization has performed the minimum standards of due
diligence with respect to an arrangement or transfer involving a disqualified person. Satisfaction
of these minimum standards will not result in any presumption, of reasonableness or otherwise.
In addition, the proposal extends such minimum standards of due diligence to transactions
between private foundations and disqualified persons for purposes of the self-dealing rules (sec.
4941).
Under the proposal, section 501(c)(3) organizations (including public charities and
private foundations) and section 501(c)(4) organizations are required to disclose whether such
minimum standards of due diligence are satisfied with respect to any transactions potentially
subject to the intermediate sanctions or self-dealing rules. If such standards are not adhered to,
the organization is required to disclose the procedures, if any, that were adopted to ensure that no
excess benefit was provided. Use of information not provided in the minimum due diligence
standards, or use of alternative procedures, do not establish a presumption of unreasonableness,
but do place an additional burden on the organization to explain the procedures used and the data
relied upon to approve a transaction.
Entity level tax on public charities, private foundations, and social welfare
organizations
Under the proposal, if an initial tax is imposed on a disqualified person under the
intermediate sanctions rules or on a self-dealer under the self-dealing rules, the organization
is subject to an excise tax equal to, in the case of a public charity or a social welfare
organization, 10 percent of the excess benefit and, in the case of a private foundation, 2.5 percent
of the amount involved (increased to 10 percent of the amount involved with respect to the
payment of compensation). No tax on the organization is imposed if the organization establishes
to the satisfaction of the Secretary that the organization operated consistent with the minimum
standards of due diligence (described above) with respect to the transaction resulting in the
imposition of tax. The tax is not otherwise subject to abatement, i.e., the tax applies even if the
excess benefit transaction is corrected.
Eliminate certain special rules for knowing behavior by organization and foundation
managers
The proposal eliminates the special rule that provides that an organization manager's or
foundation manager's participation ordinarily is not ''knowing'' for purposes of the intermediate
sanctions and self-dealing excise taxes if the manager relied on professional advice. Although
the proposal eliminates the special rule, whether an organization or foundation manager relies on
professional advice is a relevant consideration in determining whether an organization or
foundation manager knowingly participated in an excess benefit or self-dealing transaction.
The proposal also eliminates the special rule that provides that an organization manager
ordinarily does not act knowingly for purposes of the excess benefit excise tax if the organization
has met the requirements of the rebuttable presumption procedure.
Modify initial contract exception
The proposal modifies the initial contract exception for purposes of the intermediate
sanctions rules. Under the proposal, an initial contract between an organization described in
section 501(c)(3) or (c)(4) and a person who was not a disqualified person immediately prior to
entering into the initial contract is subject to the intermediate sanctions rules if such person
would become a disqualified person upon (a) entering into the contract, or (b) under the terms of
the initial contract, at any time within two years of the time the contract is entered into. The
proposal applies to all payments under the initial contract, whether fixed or otherwise, and
irrespective of whether the disqualified person is a disqualified person for the first two years of
the initial contract. For example, the initial employment contract between a public charity and
an individual who, upon entering into the contract, becomes the chief financial officer of the
charity, is subject to the intermediate sanctions rules even if such person was not a disqualified
person immediately before the contract was entered into.
Effective Date
The proposal is effective for taxable years beginning after the date of enactment.
Discussion
Modify rebuttable presumption of reasonableness
The rebuttable presumption of reasonableness is intended to be an incentive for
organizations to adopt procedures that, if followed, will protect against the occurrence of an
excess benefit transaction. Thus, for the presumption to be available, transactions must be
approved by an independent body, appropriate data must be relied on, and the body's decision
must be properly substantiated. Once the standards for the presumption of reasonableness have
been met, the burden is on the Secretary to develop ''sufficient contrary evidence to rebut the
probative value of the comparability data relied upon by the authorized body.'' In general,
under a presumption of reasonableness approach, the tax law places confidence in the integrity of
the procedures (and the persons using the procedures) to produce reasonable results.
The issue addressed by the proposal is whether use of such procedures should shift the
burden of proof away from the organization manager and the disqualified person and to the
Secretary. There appear to be no reasons to depart from normal tax rules by providing special
treatment for organization managers and disqualified persons. Shifting the burden of proof to the
Secretary may undermine the effectiveness of the intermediate sanctions regime by emphasizing
process instead of substance, with the result that organization managers and insiders may be able
to use the process to reach a desired result with impunity. Thus, the proposal eliminates the
presumption of reasonableness.
Nonetheless, the procedures that create a rebuttable presumption of reasonableness are
laudable. The proposal continues to encourage use of such procedures, described under the
proposal as minimum standards of due diligence, by imposing a tax on the organization equal to
10 percent of the excess benefit provided if the organization fails to use the procedures with
respect to an excess benefit transaction upon which tax is imposed on the disqualified person. In
addition, organizations that do not use the procedures are required generally to disclose what
steps the organization takes to ensure that inurement does not occur. Thus, in general, the
proposal is intended to strengthen the hand of the IRS in excess benefit transactions by placing
the burden of proof on organization managers and disqualified persons, while still requiring use
of the prophylactic procedures.
Some might argue that it is too soon to conclude that the rebuttable presumption of
reasonableness should be modified because the Treasury Regulations were finalized only
relatively recently (January 2002). Although the final regulations are recent, the rebuttable
presumption has been a penumbral part of the rules since the 1996 enactment. More importantly,
as a threshold matter, the tax system arguably should not rely primarily on the use of procedures,
often implemented by self-interested parties, to enforce a penalty excise tax regime intended to
deter misconduct by insiders. The very issue for which the burden is shifted by the presumption
is in many, if not most, cases valuation, a subject with inherent subjectivity. Independently
prepared appraisals or compensation studies may reach a result that the IRS believes is
unreasonable, but proving unreasonableness can be difficult. Thus, the IRS already faces a high
hurdle on the issue of valuation, even prior to assuming the burden of proof established by the
presumption of reasonableness.
It can be argued that the effect of the presumption is to take the IRS out of the substantive
issue entirely because, as a practical matter, examining agents will focus not on whether too
much compensation is paid, or whether fair market value is provided in a property transaction,
but instead will look to whether appropriate procedures were followed. If the procedures were
followed, the agent knows success on the merits is unlikely because the IRS will have to
overcome a presumption of reasonableness in favor of the taxpayer. Under such circumstances,
agents often will abandon the issue. Thus, for the IRS to have a realistic chance at success in
overcoming the present-law presumption of reasonableness, the excess benefit provided must
manifestly be unreasonable.
Some might suggest, however, that the main benefit of the rebuttable presumption of
reasonableness is that it provides certainty, both to organization managers and insiders, and to
the IRS. Without the presumption, some might claim that organizations will have no reassurance
that their dealings with insiders will not fall prey to an overzealous IRS agent; and, that
organization managers need the security the presumption provides in order to conduct the
organization's affairs without the constant threat of an intermediate sanction. Some might also
say that the IRS benefits as well because the IRS can focus less on the resource intensive and
sometimes futile issue of valuation and more on the straightforward issue of process.
Abandoning the rebuttable presumption of reasonableness likely will result in the loss of
some certainty on the part of organization managers and other insiders. The question is whether
providing such certainty overrides the purpose of the intermediate sanctions regime. The
premise of the regime was to provide an effective alternative to revocation of exemption, i.e., a
threat that would deter private inurement. However, the rebuttable presumption of
reasonableness undermines that threat by placing control of the substantive issue '' whether a
benefit is excessive '' in the hands of organization managers and insiders. Such persons may
satisfy the technical requirements of the procedure in order to immunize themselves against
sanctions, but nevertheless reach the desired substantive result. In short, the certainty provided
by the rebuttable presumption of reasonableness generally is a certainty that a sanction will not
be imposed.
It is noted that even after the proposed elimination of the rebuttable presumption of
reasonableness, the intermediate sanctions regime is more liberal than the regime that applies to
self-dealing transactions by private foundations. Private foundations simply are barred from
entering into certain transactions with insiders, regardless of whether fair value is paid (with the
exception of compensation, with respect to which only excessive compensation is barred).
Following the private foundation model, one reform approach for intermediate sanctions would
be to replace the intermediate sanctions regime with the stricter private foundation self-dealing
rules. Such an approach is simple in that it treats as suspect most insider transactions, and also
has the benefit of virtually eliminating the need to value transactions (except in the case of
compensation). However, some might argue that to the extent the intermediate sanctions regime
is imperfect, adoption of a per se rule against fair market value transactions would severely affect
the ability of public charities to enter into many below-market transactions that substantially
benefit the charity and directly further its charitable purposes. To address this concern, an
alternative would be to ban insider transactions, as under the private foundation self-dealing
rules, unless a benefit is provided to the charitable organization at or below fair market value.
Unlike an approach that would apply some or all of the private foundation self-dealing
rules to public charities and social welfare organizations, the proposed elimination of the
rebuttable presumption of reasonableness does not alter the basic policy of the intermediate
sanctions regime, i.e., fair market value transactions still are permitted. The proposal also gives
the IRS more authority to enforce the regime and thus provides a stronger deterrent to self-
dealing and private inurement than under present law. If the presumption of reasonableness
becomes further entrenched in the law, it could undermine the ability of the IRS to enforce the
intermediate sanctions rules to such an extent that Congress might be forced to revisit (as it did
for private foundations in 1969) whether arm's length standards must be replaced by per se
prohibitions.
Impose entity level tax for failure to use minimum due diligence procedures
Under the proposal, an entity level tax is imposed on organizations that do not use the
minimum procedures of due diligence (known under present law as the procedures that provide a
rebuttable presumption of reasonableness) with respect to a transaction that is an excess benefit
transaction. Such a tax provides a direct incentive for an organization to adopt the prophylactic
procedures.
Some might argue that a tax on the organization is unfair to the charitable (or other)
beneficiaries, who must bear the brunt of the tax. Taxes should be paid, some might say, only by
the perpetrators of the transaction. However, holding the organization harmless for condoning
an excess benefit transaction, as under present law, does not provide the organization with any
incentive to prevent an excess benefit transaction from occurring. An entity level tax on a matter
over which the organization generally has control gives the organization a role in preventing
inurement, and provides an intermediate sanction on the organization, instead of just on
organization insiders, that is short of revocation of the organization's exempt status. It is
reasonable to expect the organization to require procedures that satisfy the minimum due
diligence standards, and tax it for failing to do so if its insiders (because of the absence of the
procedures) are allowed to benefit improperly from dealing with the organization.
Arguably, an entity level tax should apply to all excess benefit transactions regardless of
whether the minimum due diligence procedures are used. Without such a tax, a member of the
Board of Directors (or other insider) who does not benefit from an excess benefit transaction but
who knows the person who does benefit, might ignore such a transaction because the
organization itself is not at risk. Such obliging conduct by some insiders might change if the
entity were subject to tax. Although the entity level tax could be applied more broadly, the
proposal limits application of the tax to situations where the organization can be held directly
responsible, i.e., the failure of the organization to establish the prophylactic procedures. Such a
tax generally is consistent with the policy supporting entity level taxes on foundations for not
meeting minimum payout requirements, for having excess business holdings, for investments
that jeopardize charitable purposes, and for taxable expenditures. All such taxes are imposed
on conduct over which the foundation generally has control or responsibility as an entity.
Extend minimum due diligence procedures and entity level tax to private foundations
In addition to eliminating the rebuttable presumption of reasonableness, the proposal
extends the mandated use of the minimum standards of due diligence and the entity level tax
imposed for failures to use such procedures to self-dealing transactions by private foundations.
In general, the intermediate sanctions regime and the private foundation self-dealing regime
should be consistent unless there is a clear policy rationale in favor of a distinction. Requiring
the use of certain procedures to prevent against self-dealing transactions, if recommended for use
by public charities, also should be used by private foundations. The entity level tax, in this case,
is an enforcement mechanism for the use of the procedures, and also should apply to private
foundations.
Rate of entity-level tax
With respect to the intermediate sanctions regime, the proposed rate of the entity-level
tax is 10 percent of the excess benefit provided. The proposed 10 percent rate is equal to twice
the rate applicable under present-law to private foundations for excess business holdings and
jeopardizing investments, and is equal to the present law rate on private foundations for taxable
expenditures. Thus, the 10 percent rate is comparable to entity-level taxes provided under
present law.
With respect to the private foundation self-dealing regime, the proposed rate of the entity
level tax generally is 2.5 percent. This rate is substantially less than the 10 percent rate proposed
for purposes of intermediate sanctions because the base of the tax for self-dealing purposes
generally is the entire amount of the transaction, as compared to just the excess amount paid as is
the case for excess benefit transactions. Thus, a lower rate of tax is warranted for private
foundations.
A 10 percent rate of tax on private foundations, however, is proposed with respect to the
payment of compensation. For compensation arrangements, the tax base is the same under both
regimes, i.e., the excess amount paid, and thus the proposed rate of tax on compensation self-
dealing and excess benefit transactions -- ten percent -- also is the same.
Revise special rules for knowing behavior by organization managers
Under present law, an organization manager is subject to intermediate sanctions only if
the organization manager knowingly participated in an excess benefit transaction. Similarly, a
private foundation manager is subject to an excise tax for self-dealing only if the foundation
manager's participation in the act is knowing.
The knowing standard is a high threshold in both cases. Knowing conduct, for this
purpose, requires actual knowledge of sufficient facts that would constitute an excess benefit or
self-dealing transaction, awareness that the transaction may violate Federal law, and negligent
failure to make reasonable attempts to determine whether a transaction is an excess benefit
transaction or an act of self-dealing (or actual awareness that a transaction is an excess benefit or
self-dealing transaction). Knowing conduct must be willful, meaning that it must be voluntary,
conscious, and intentional. The burden of proof to show knowing conduct in the Tax Court is
placed specifically on the Secretary. In addition, an organization or foundation manager is not
subject to tax if the manager acted with reasonable cause, i.e., the manager exercised
responsibility on behalf of the organization with ordinary business care and prudence.
The standard for knowing conduct is high because, in general, there is a belief that
managers of exempt organizations should be subject to tax only in cases where it is clear that a
manager truly is culpable. A standard less than knowing, such as reason to know, or negligence,
might deter qualified individuals from serving as managers of charitable or social welfare
organizations for fear that a tax would be imposed unfairly. However, to be an effective
deterrent to errant behavior, there must be at least a realistic possibility that the tax will be
imposed and upheld. The regulatory special rules that are layered on top of the already rigorous
statutory standards of knowing conduct described above may unnecessarily excuse an
organization or foundation manager from imposition of tax in cases where the manager has the
requisite knowledge.
With respect to excess benefit transactions, the proposal eliminates the special rules that
conduct ordinarily is not knowing if the organization manager relied on the advice of an
appropriate professional or that the organization satisfied the procedures required for the
rebuttable presumption of reasonableness. In effect, the reliance on professional advice special
rule permits a manager to delegate his or her judgment to a professional -- whether it be legal
counsel, a certified public accountant, or an independent valuation expert -- who may be under
pressure from a culpable organization manager to reach a certain result. Under the proposal,
instead of providing a special rule, reliance on professional advice that a transaction is not an
excess benefit transaction generally would be a favorable factor showing that the organization
manager did not know the transaction provided an excess benefit. Reliance on sound
professional advice therefore is still encouraged, but such reliance does not provide the
organization manager with a special rule.
Some might argue that the reliance on professional advice special rule is a long-standing
regulatory rule, variations of which are provided to private foundation managers for purposes of
the excise taxes with respect to self-dealing, jeopardizing business investments, and taxable
expenditures. Thus, some might say that in promulgating regulations on excess benefit
transactions, the Treasury merely extended similar protections to organization managers and that
it would not be fair to give private foundation managers greater protection than public charity
and social welfare organization managers. However, the proposal also eliminates the special rule
with respect to self-dealing by private foundation managers, and for similar reasons, i.e., the
statutory standard for knowing behavior is sufficiently high without a special rule that
immunizes culpable conduct.
It is noted that the reliance on professional advice special rule for foundation managers is
narrower than that provided for organization managers in that reliance is permitted only on the
advice of legal counsel, and not on certified public accountants or independent valuation experts.
Thus, the possibilities for abuse of the special rule are less in the private foundation self-dealing
context because fewer types of professional judgment may be relied upon, e.g., a compensation
consultant's determination of reasonable compensation may not be relied upon by a foundation
manager for purposes of the special rule. Nevertheless, responsibility for whether private
inurement knowingly is facilitated by a foundation (or organization) manager should rest
ultimately on the manager's own knowledge and conduct, and not on whether a manager seeks
outside advice.
The proposal also eliminates the special rule that is provided an organization manager if
the organization acts pursuant to the rebuttable presumption procedure. In general, the original
logic behind the special rule -- that a transaction earning the presumption of reasonableness
should protect an organization manager from tax -- no longer applies when considered in
conjunction with the proposal to eliminate the presumption of reasonableness. Thus, without a
presumption of reasonable conduct by the organization, there should not be a presumption of
unknowing conduct by an organization manager. Even if the presumption of reasonableness is
retained in present law, the special rule arguably still should be eliminated because the standard
of knowing is sufficiently rigorous without the special rule, and also because a person's
knowledge of bad conduct should not be immunized just because the organization took steps, yet
failed, to protect against an excess benefit transaction occurring.
Modify initial contract exception
An initial contract exception was not provided in the statute, the legislative history, or the
proposed Treasury regulations. After the issuance of the proposed regulations, the United States
Court of Appeals for the Seventh Circuit issued its decision in United Cancer Council, Inc. v.
Commissioner of Internal Revenue Service. The transactions at issue in that case were
conducted prior to the effective date of the intermediate sanctions rules. Nonetheless, in that
case the court concluded that prohibited private inurement under section 501(c)(3) cannot result
from a contractual relationship negotiated at arm's length with a party having no prior
relationship with the exempt organization, regardless of the relative bargaining strength of the
parties or resultant control over the exempt organization created by the terms of the contract.
Based on this decision and on comments received by the Secretary, the subsequent temporary
and final regulations issued by the Secretary created the initial contract exception that removed
from scrutiny certain fixed payments made pursuant to an initial contract between a third party
and the exempt organization.
Some would argue that the initial contract exception is needed because it is unfair and
unnecessary to apply intermediate sanctions to an initial contract between an organization and a
person who does not yet have the legal authority to exercise substantial influence over the affairs
of the organization, even if that person becomes a disqualified person by virtue of entering into
the contract. Some would assert that until the contract is executed, the organization and the third
party are conducting negotiations at arm's length and that the organization is not under the
control of the third party. However, in cases where the organization is contracting with a person
who will have the capacity to exercise control or substantial influence over the organization upon
entering into the contract, it is questionable whether an organization generally can conduct
negotiations entirely at arm's length and free of the influence of the third party. Although
organizations have a financial incentive and legal obligation to protect their own interests in such
cases, they often are under intense pressure (e.g., due to fear of losing the individual to
competitors or of creating tension and hostility between the organization and an individual who
will be critical to the organization's success) to negotiate contractual terms that may result in an
excess benefit being provided to the third party.
Allowing initial contracts to escape the scrutiny of the intermediate sanction provisions
permits an organization to provide a substantial excess benefit to a third party without any real
threat of a sanction to a party to the transaction or to the organization managers. The initial
contract exception encourages long-term contracts by removing all fixed compensation paid
under the contract from excise tax exposure for its organization managers (and for the
disqualified person), no matter how long the term of the contract. (For example, an organization
might enter into a five-year contract rather than a two-year contract to assure that the first five
years of compensation paid to a new officer escape scrutiny. If a two-year contract were used,
only the first two years would avoid scrutiny). The initial contract exception also encourages
structuring the compensation arrangement as fixed payments, rather than as performance-based
variable payments that allow for the subsequent discretion of the organization, even if a
performance-based structure would best serve the interests of the organization.
E. Increase the Amount of Excise Taxes Imposed on Public Charities,
Social Welfare Organizations, and Private Foundations
(secs. 4941, 4942, 4943, 4944, 4945, and 4958)
Present Law
Public charities and social welfare organizations
The Code imposes excise taxes on excess benefit transactions between disqualified
persons (as defined in section 4958(f)) and charitable organizations (other than private
foundations) or social welfare organizations (as described in section 501(c)(4)). An excess
benefit transaction generally is a transaction in which an economic benefit is provided by a
charitable or social welfare organization directly or indirectly to or for the use of a disqualified
person, if the value of the economic benefit provided exceeds the value of the consideration
(including the performance of services) received for providing such benefit.
The excess benefit tax is imposed on the disqualified person and, in certain cases, on the
organization manager, but is not imposed on the exempt organization. An initial tax of 25
percent of the excess benefit amount is imposed on the disqualified person that receives the
excess benefit. An additional tax on the disqualified person of 200 percent of the excess benefit
applies if the violation is not corrected. A tax of 10 percent of the excess benefit (not to exceed
$10,000 with respect to any excess benefit transaction) is imposed on an organization manager
that knowingly participated in the excess benefit transaction, if the manager's participation was
willful and not due to reasonable cause, and if the initial tax was imposed on the disqualified
person. If more than one person is liable for the tax on disqualified persons or on
management, all such persons are jointly and severally liable for the tax.
Private foundations
Self-dealing by private foundations
Excise taxes are imposed on acts of self-dealing between a disqualified person (as
defined in section 4946) and a private foundation. In general, self-dealing transactions are any
direct or indirect: (1) sale or exchange, or leasing, of property between a private foundation and a
disqualified person, including transfers of property subject to a mortgage or lien that the private
foundation assumes or that was put on the property by the disqualified person within 10 years of
the transfer; (2) lending of money or other extension of credit between a private foundation and a
disqualified person, except for no-interest loans by a disqualified person, the proceeds of which
are used exclusively for charitable purposes; (3) the furnishing of goods, services, or facilities
between a private foundation and a disqualified person, unless the goods, services, or facilities
are (i) functionally related to the foundation's exempt purposes and are provided to or by the
foundation on the same basis as provided by the foundation or disqualified person to the general
public, (ii) reasonable and necessary to performing exempt purposes and not excessive, or (iii)
provided by disqualified person without charge; (4) the transfer to, or use by or for the benefit of,
a disqualified person of the income or assets of the private foundation, unless the use or benefit is
de minimis; and (5) certain payments of money or property to a government official. Leases
provided by a disqualified person without charge to a private foundation, even if the foundation
pays for maintenance, are permitted.
An initial tax of five percent of the amount involved with respect to an act of self-dealing
is imposed on any disqualified person (other than a foundation manager acting only as such) who
participates in the act of self-dealing. If such a tax is imposed, a 2.5-percent tax of the amount
involved is imposed on a foundation manager who participated in the act of self-dealing knowing
it was such an act (and such participation was not willful and was due to reasonable cause) up to
$10,000 per act. Such initial taxes may not be abated. Such initial taxes are imposed for each
year in the taxable period, which begins on the date the act of self-dealing occurs and ends on the
earliest of the date of mailing of a notice of deficiency for the tax, the date on which the tax is
assessed, or the date on which correction of the act of self-dealing is completed. A government
official (as defined in section 4946(c)) is subject to such initial tax only if the official participates
in the act of self-dealing knowing it is such an act. If the act of self-dealing is not corrected, a
tax of 200 percent of the amount involved is imposed on the disqualified person and a tax of 50
percent of the amount involved (up to $10,000 per act) is imposed on a foundation manager who
refused to agree to correcting the act of self-dealing. Such additional taxes are subject to
abatement.
Tax on failure to distribute income
Private nonoperating foundations are required to pay out a minimum amount each year as
qualifying distributions. In general, a qualifying distribution is an amount paid to accomplish
one or more of the organization's exempt purposes, including reasonable and necessary
administrative expenses. Failure to pay out the minimum results in an initial excise tax on the
foundation of 15 percent of the undistributed amount. An additional tax of 100 percent of the
undistributed amount applies if an initial tax is imposed and the required distributions have not
been made by the end of the applicable taxable period. A foundation may include as a
qualifying distribution the salaries, occupancy expenses, travel costs, and other reasonable and
necessary administrative expenses that the foundation incurs in operating a grant program. A
qualifying distribution also includes any amount paid to acquire an asset used (or held for use)
directly in carrying out one or more of the organization's exempt purposes and certain amounts
set-aside for exempt purposes. Private operating foundations are not subject to the payout
requirements.
Tax on excess business holdings
Private foundations are subject to tax on excess business holdings. In general, a
private foundation is permitted to hold 20 percent of the voting stock in a corporation, reduced
by the amount of voting stock held by all disqualified persons (as defined in section 4946). If it
is established that no disqualified person has effective control of the corporation, a private
foundation and disqualified persons together may own up to 35 percent of the voting stock of a
corporation. A private foundation shall not be treated as having excess business holdings in any
corporation if it owns (together with certain other related private foundations) not more than two
percent of the voting stock and not more than two percent in value of all outstanding shares of all
classes of stock in that corporation. Similar rules apply with respect to holdings in a partnership
(''profits interest'' is substituted for ''voting stock'' and ''capital interest'' for ''nonvoting stock'')
and to other unincorporated enterprises (by substituting ''beneficial interest'' for ''voting stock'').
Private foundations are not permitted to have holdings in a proprietorship. Foundations
generally have a five-year period to dispose of excess business holdings (acquired other than by
purchase) without being subject to tax. This five-year period may be extended an additional
five years in limited circumstances.
The initial tax is equal to five percent of the value of the excess business holdings held
during the foundation's applicable taxable year. An additional tax is imposed if an initial tax is
imposed and at the close of the applicable taxable period, the foundation continues to hold excess
business holdings. The amount of the additional tax is equal to 200 percent of such holdings.
Tax on jeopardizing investments
Private foundations and foundation managers are subject to tax on investments that
jeopardize the foundation's charitable purpose. In general, an initial tax of five percent of the
amount of the investment applies to the foundation and to foundation managers who participated
in the making of the investment knowing that it jeopardized the carrying out of the foundation's
exempt purposes. The initial tax on foundation managers may not exceed $5,000 per investment.
If the investment is not removed from jeopardy (e.g., sold or otherwise disposed of), an
additional tax of 25 percent of the amount of the investment is imposed on the foundation and
five percent of the amount of the investment on a foundation manager who refused to agree to
removing the investment from jeopardy. The additional tax on foundation managers may not
exceed $10,000 per investment. An investment, the primary purpose of which is to accomplish a
charitable purpose and no significant purpose of which is the production of income or the
appreciation of property, is not considered a jeopardizing investment.
Tax on taxable expenditures
Certain expenditures of private foundations are subject to tax. In general, taxable
expenditures are expenses: (1) for lobbying; (2) to influence the outcome of a public election or
carry on a voter registration drive (unless certain requirements are met); (3) as a grant to an
individual for travel, study, or similar purposes unless made pursuant to procedures approved by
the Secretary; (4) as a grant to an organization that is not a public charity or exempt operating
foundation unless the foundation exercises expenditure responsibility with respect to the grant;
or (5) for any non-charitable purpose. For each taxable expenditure, a tax is imposed on the
foundation of 10 percent of the amount of the expenditure, and an additional tax of 100 percent is
imposed on the foundation if the expenditure is not corrected. A tax of 2.5 percent of the
expenditure (up to $5,000) also is imposed on a foundation manager who agrees to making a
taxable expenditure knowing that it is a taxable expenditure. An additional tax of 50 percent of
the amount of the expenditure (up to $10,000) is imposed on a foundation manager who refuses
to agree to correction of such expenditure.
Reasons for Change
The Tax Reform Act of 1969 introduced the present-law regime of excise taxes that is
applicable to certain actions of private foundations (self-dealing, failure to distribute income,
excess business holdings, jeopardizing investments, and taxable expenditures). The amount of
such taxes has not been changed since. The excise taxes were established to provide strong
deterrents to foundations, and in some cases foundation managers, from engaging in abusive or
disapproved transactions. In the years following passage of the 1969 Act, the IRS closely
monitored the conduct of private foundations, and in 1990 the Treasury Department concluded
that foundations were largely a compliant sector. In subsequent years, however, audits of
foundations and other section 501(c)(3) organizations generally has fallen significantly. For
example, the audit rate of private foundation returns for 1985 was several times the audit rate of
such returns during 2002 and 2003. With such a decreased enforcement presence, there is an
increased likelihood that private foundations are not as compliant as reported by the Treasury
Department in 1990 and that the current excise tax rates, which have not increased in 35 years,
are not providing a sufficient deterrent. Thus, the proposal generally recommends that the
initial taxes, and the dollar amount limitations on foundation manager liability, be doubled.
Description of Proposal
Self-dealing and excess benefit transaction initial taxes and dollar limitations
For acts of self-dealing other than the payment of compensation by a private foundation
to a disqualified person, the proposal increases the initial tax on the self-dealer from five percent
of the amount involved to 10 percent of the amount involved. For acts of self-dealing regarding
the payment of compensation by a private foundation to a disqualified person, the proposal
increases the initial tax on the self-dealer from five percent of the amount involved (none of
which is subject to abatement) to 25 percent of the amount involved (15 percent of which is
subject to abatement). The proposal increases the initial tax on foundation managers from 2.5
percent of the amount involved to five percent of the amount involved and increases the dollar
limitation on the amount of the initial and additional taxes on foundation managers per act of
self-dealing from $10,000 per act to $20,000 per act. Similarly, the proposal doubles the dollar
limitation on organization managers of public charities and social welfare organizations for
participation in excess benefit transactions from $10,000 per transaction to $20,000 per
transaction.
Failure to distribute income, excess business holdings, jeopardizing investments, and
taxable expenditures
The proposal doubles the amounts of the initial taxes and the dollar limitations on
foundation managers with respect to the private foundation excise taxes on the failure to
distribute income, excess business holdings, jeopardizing investments, and taxable expenditures.
Specifically, for the failure to distribute income, the initial tax on the foundation is
increased from 15 percent of the undistributed amount to 30 percent of the undistributed amount.
For excess business holdings, the initial tax on excess business holdings is increased from
five percent of the value of such holdings to 10 percent of such value.
For jeopardizing investments, the initial tax of five percent of the amount of the
investment that is imposed on the foundation and on foundation managers is increased to 10
percent of the amount of the investment. The dollar limitation on the initial tax on foundation
managers of $5,000 per investment is increased to $10,000 and the dollar limitation on the
additional tax on foundation managers of $10,000 per investment is increased to $20,000.
For taxable expenditures, the initial tax on the foundation is increased from 10 percent of
the amount of the expenditure to 20 percent, the initial tax on the foundation manager is
increased from 2.5 percent of the amount of the expenditure to five percent, the dollar limitation
on the initial tax on foundation managers is increased from $5,000 to $10,000, and the dollar
limitation on the additional tax on foundation managers is increased from $10,000 to $20,000.
Effective Date
The proposal is effective for taxable years beginning after the date of enactment.
Discussion
In general, the proposal doubles the amount of excise taxes with respect to certain
activities by private foundations and private foundation managers and increases the dollar
limitations applicable to excise taxes on public charity, private foundation, and social welfare
organization managers. Excise tax regimes that penalize certain conduct generally are effective
if there is the right combination of a punitive sanction and the threat that the sanction will be
enforced. Because of the general decrease in enforcement activities for charitable organizations,
the proposal increases the amount of the sanction in order to impose an additional deterrent to
prohibited behavior.
With respect to the payment of compensation by a private foundation to a self-dealer, the
proposal increases the initial tax from five percent to 25 percent. The increase to 25 percent is
intended to provide partial conformity with the intermediate sanctions regime, which taxes the
disqualified person at the rate of 25 percent of the excess benefit provided. Such conformity is
warranted with respect to the payment of compensation and not to other acts of self-dealing
because the tax base is the same under both regimes for payment of compensation, i.e., the
excess compensation paid. Substantially similar acts (payment of excess compensation)
generally should not be subject to different excise tax rates.
The proposal does not completely conform the two excise tax regimes with respect to the
payment of compensation because the proposal preserves, in part, the stricter private foundation
rule that no abatement is provided for initial taxes on the self-dealer. Thus, the proposal provides
that up to 15 percent of the tax is subject to abatement (i.e., the present law initial tax of five
percent of the amount involved, none of which is subject to abatement, is doubled, and in
addition, a tax of 15 percent tax may be imposed, which is subject to abatement).
The dollar limitations applicable to organization managers and private foundation
managers are increased from $10,000 per act to $20,000 per act (or in some cases, from $5,000
per act to $10,000 per act). Higher penalties are warranted to provide an even greater deterrent
to knowing participation in an excess benefit transaction, act of self-dealing, or the making of a
jeopardizing investment or taxable expenditure.
F. Modify Charitable Deduction for Contributions of
Conservation and Facade Easements
(sec. 170)
Present Law
In general
Section 170(h) provides special rules that apply to charitable contributions of qualified
conservation contributions, which include conservation easements and facade easements.
Qualified conservation contributions are not subject to the ''partial interest'' rule, which generally
bars 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. 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. A contribution is not deductible if it
accomplishes a permitted conservation purpose while also destroying other significant
conservation interests.
Valuation of conservation restrictions
Valuation standards
The value of a conservation restriction granted in perpetuity generally is determined
under the ''before and after approach.'' Such approach provides that the fair market value of the
restriction is equal to the difference (if any) between the fair market value of the property the
restriction encumbers before the restriction is granted and the fair market value of the
encumbered property after the restriction is granted. Courts generally apply this standard by
looking at the objective uses of the property. At least one court, however, has examined the
subjective intentions of the contributing taxpayer to apply this standard.
If the granting of a perpetual restriction has the effect of increasing the value of any other
property owned by the donor or a related person, the amount of the charitable deduction for the
conservation contribution is to be reduced by the amount of the increase in the value of the other
property. In addition, the donor is to reduce the amount of the charitable deduction by the
amount of financial or economic benefits that the donor or a related person receives or can
reasonably be expected to receive as a result of the contribution. If such benefits are greater
than those that will inure to the general public from the transfer, no deduction is allowed. In
those instances where the grant of a conservation restriction has no material effect on the value
of the property, or serves to enhance, rather than reduce, the value of the property, no deduction
is allowed.
Valuation-related penalties
Present law imposes accuracy-related penalties on a taxpayer in cases involving a
substantial valuation misstatement or gross valuation misstatement relating to an underpayment
of income tax. For this purpose, a substantial valuation misstatement generally means a value
claimed that is at least twice the amount determined to be the correct value, and a gross valuation
misstatement generally means a value claimed that is at least four times the amount determined
to be the correct value. Present law does not impose substantial or gross valuation
misstatement penalties on an appraiser that conducted an appraisal that was used by a taxpayer to
support the value claimed on the taxpayer's return. However, the Secretary may disqualify an
appraiser from practicing before the IRS under certain circumstances.
Conservation purposes
Public recreation or education
Under Treasury Regulations, a donation satisfies the conservation purpose of
preservation of land areas for recreation or education if there is substantial and regular use of the
property by the general public. There is no requirement that the preservation of the land area
be made pursuant to a governmental policy or that the area be certified by a governmental unit as
worthy of conservation efforts.
Protection of a significant habitat or ecosystem
Treasury Regulations provide that the donation of a qualified real property interest to
protect a significant natural habitat in which a fish, wildlife, plant community, or similar
ecosystem normally lives will satisfy the conservation purpose requirement. Whether a
donation satisfies the conservation purpose requirement generally depends on the type of animal
or plant life that exists on the property being protected. If a property is a habitat for any
endangered species of plant or animal life, a restriction protecting that habitat likely satisfies the
conservation purpose requirement. Administrative rulings provide that if a particular species has
been identified as unique to a particular place or is approaching an endangered or other protected
status, protection of the habitat will suffice.
Preservation of open space
A conservation purpose includes the preservation of open space (including farmland and
forest land) where such preservation will yield a significant public benefit and is (1) for the
scenic enjoyment of the general public; or (2) pursuant to a clearly delineated Federal, State, or
local government conservation policy. Scenic enjoyment is evaluated by considering all
pertinent facts and circumstances germane to the contribution. The factors identified in the
regulations include the compatibility of the land use with other land in the vicinity, the degree of
contrast and variety provided by the visual scene, the harmonious variety of shapes and textures,
and the consistency of the proposed scenic view with a methodical State scenic identification
program.
Treasury Regulations provide that the purpose of preserving open space pursuant to a
clearly delineated government policy is satisfied by donations that further a specific conservation
purpose identified by public representatives. A general declaration of conservation goals by a
single official or legislative body is not sufficient, although the government policy need not be a
certification program that identifies particular lots or small parcels of individually owned
property. For example, a governmental program according preferential tax assessment or
preferential zoning for certain property deemed worthy of protection for conservation purposes
constitutes a significant commitment by a government, and accordingly satisfies the requisite
standard.
Preservation of historic property
Section 170(h) defines conservation purpose to include the preservation of an historically
important land area or a certified historic structure. For this purpose, a structure means any
structure, whether or not it is depreciable, and, accordingly, easements on private residences may
qualify under this provision. If restrictions to preserve a building or land area within a
registered historic district permit future development on the site, a deduction will be allowed
only if the terms of the restrictions require that such development conform with appropriate
local, State, or Federal standards for construction or rehabilitation within the district.
The IRS and the courts have held that a facade easement may constitute a qualifying
conservation contribution. In general, a facade easement is a restriction the purpose of which
is to preserve certain architectural, historic, and cultural features of the facade, or front, of a
building. The terms of a facade easement might permit the property owner to make alterations to
the facade of the structure if the owner obtains consent from the qualified organization that holds
the easement.
Reasons for Change
Charitable deductions of qualified conservation contributions, including conservation and
facade easements, present serious policy and compliance issues. Valuation is especially
problematic because the measure of the deduction (i.e., generally the difference in fair market
value before and after placing the restriction on the property) is highly speculative, considering
that, in general, there is no market and thus no comparable sales data for such easements. In
many instances, present law does not require that the preservation or protection of conservation
be pursuant to a clearly delineated governmental conservation policy, only requiring such a
policy in cases of open space preservation if the preservation is not for the scenic enjoyment of
the general public. As a result, taxpayers and donee organizations have considerable flexibility
to determine the conservation purpose served by an easement or other restriction, enabling
taxpayers to claim substantial charitable deductions for conservation easements that arguably do
not serve a significant conservation purpose.
Description of Proposal
In general
The proposal eliminates the charitable contribution deduction with respect to facade and
conservation easements relating to personal residence properties, substantially reduces the
deduction for all other qualified conservation contributions, and imposes new standards on
appraisals and appraisers regarding the valuation of such contributions.
Facade easements with respect to certified historic structures
Personal residences
The proposal disallows a charitable contribution deduction for a contribution of a facade
easement relating to a certified historic structure that recently has been or is being used, or is
reasonably expected to be used, by the donor or a family member of the donor as a personal
residence (principal or otherwise). The proposal does not modify the present-law definition of
certified historic structure.
All other certified historic structures
The proposal limits the charitable contribution deduction that may be allowed with
respect to a facade easement relating to a certified historic structure that is not being used (and is
not reasonably expected to be used) as a personal residence to the lesser of (1) five percent of the
fair market value of the structure (determined without regard to the facade easement); or (2) 33
percent of the value of the facade easement. This rule applies to any certified historic structure
not used or reasonably expected to be used as a personal residence by the donor or a family
member of the donor, including commercial buildings, rental properties, and properties held for
investment. The proposal provides that if a charitable deduction is allowed with respect to a
facade easement for a property that is subsequently converted to a residence of the donor or a
member of the donor's family, the deduction is subject to recapture by the donor in the year of
conversion, at the declining rate of 10 percent per year beginning in the third year after the
contribution (e.g., a conversion in the first two years following the contribution results in a 100
percent recapture of the deduction, a conversion in the third year is subject to a 90 percent
recapture, and a conversion in the twelfth year results in no recapture), plus interest. Donors are
required to report any such conversion to the IRS and to the donee or other organization that
owns the easement or restriction.
Other conservation easements and restrictions
In general
Under the proposal, a contribution of a qualified real property interest for: (1) the
preservation of land areas for outdoor recreation by, or the education of, the general public; (2)
the protection of a relatively natural habitat of fish, wildlife, or plants, or a similar ecosystem; or
(3) the preservation of open space (including farmland and forest land) that yields a significant
public benefit; is exclusively for conservation purposes only if the preservation or protection is
pursuant to a clearly delineated Federal, State, or local governmental conservation policy. For
this purpose, the determination of whether preservation or protection is pursuant to a clearly
delineated governmental policy is to be made in accordance with present-law standards
applicable to open space preservation, meaning that the preservation or protection must further a
specific, identified conservation project. The proposal does not modify the present-law
conservation purpose standards relating to the preservation of an historically important land area
or certified historic structure.
The proposal provides that the amount of the charitable deduction for a qualified real
property interest (excluding facade easements, which are described above) is reduced from 100
percent to 33 percent of the fair market value of such contributed interest. The proposal provides
for a disallowance of 67 percent of the value of the easement (as claimed by the taxpayer, or
where applicable, as determined to be the correct amount pursuant to an IRS examination or by
litigation), with no limitation on the deduction based on a percentage of the value of the
underlying property.
Personal residence use
A qualified real property interest is not considered as contributed exclusively for a
conservation purpose if the donor (or a family member of the donor) has a right to use all or a
portion of the real property as a personal residence (principal or otherwise) at any time after the
contribution. Thus, under the proposal, no deduction is allowed for a contribution of a
conservation easement if the donor or a family member may use all or a portion of the
underlying real property as a residence at any time after the contribution. If a donor (or family
member of the donor) uses such property as a residence after a contribution deduction has been
taken, such use is treated as a conversion to residential use that is subject to the recapture rules
described above for facade easement conversions.
Appraiser and appraisal requirements
Substantiation and valuation
Taxpayers are required, as under present law, to substantiate any reduction in value of the
underlying property resulting from the easement, and to substantiate that any such reduction
supports the amount claimed as a charitable deduction. Any required appraisal is subject to the
proposed appraisal and appraisal standards that are described below.
The proposal modifies the definition of a qualified appraiser for purposes of appraisals of
qualified conservation contributions with a claimed value above $5,000. Under the proposal, a
qualified appraiser is an individual who affirms: (1) that the fair market value of the subject
property has been determined in accordance with generally accepted appraisal standards; (2) with
respect to the specific property and transaction type, that he or she: (a) has successfully
completed educational coursework, including courses for continuing education credits, in
generally accepted appraisal practices, principles, concepts, methodologies, and ethics from a
recognized provider of such courses; or has earned an appraisal designation from a recognized
organization that teaches, tests, and provides continuing education to its members in valuation;
and (b) regularly performs appraisals for which he or she receives compensation and has a
minimum of two years experience in doing so; and (3) has not been subject to disbarment from
practice before the IRS by the Secretary pursuant to 31 U.S.C. section 330(c). Effective Date
The proposal is effective for contributions made in taxable years beginning after the date
of enactment. Discussion
In general
The charitable deduction available for qualified conservation contributions depends
largely upon an accurate measure of the value of the contribution, and the promotion of a
conservation purpose that provides a substantial benefit to the public. Inaccurate valuations
result in improper deduction amounts. Absence of a meaningful conservation purpose means
that a tax benefit has been provided that exceeds any public benefit to be derived from the
conservation contribution. Valuation difficulties and conservation purpose issues are especially
problematic in the case of a contribution of a partial interest in property, such as easements,
because the donor both relinquishes and retains rights and value relating to the underlying
property.
Whenever possible, tax incentives should be targeted to those persons who are most
likely to modify their behavior in substantial part because of the provision of the tax benefit.
Otherwise, providing such benefits constitutes a windfall rather than an incentive. The present
charitable deduction regime for qualified conservation contributions provides a windfall to those
taxpayers who grant an easement or other restriction to a qualified organization if the activity or
use restricted by the easement or restriction likely would never occur. For example, a person
who purchases a residence in a historic district that has homes that were designed and
constructed in a particular period and with a particular architectural style generally does not
acquire the home with the intention of altering the exterior of the building in a manner that
would be inconsistent with the neighboring structures. Similarly, a person who acquires real
property located by a nature preserve often is attracted to the area because of the preserve, and in
such cases would not alter or use the acquired property for a purpose that would impede or
contravene such preservation efforts.
The ability of a donor of a qualified conservation contribution to use the retained property
after the contribution of the partial interest often makes it difficult to determine whether a
significant public benefit or conservation purpose is served by the contribution. For example, if
a donor is able to continue to use real property as a residence after the contribution is made, the
donor may benefit economically and in other ways from making the contribution, and the extent
of the public benefit and conservation purpose may be diminished by such use. Such personal
use cases involve competing public and private interests, as well as subjectivity regarding
valuation of the contributed partial interest, that are not efficiently addressed in a context where
proper valuations are expensive and the IRS lacks the expertise or resources to assess
conservation purposes.
Some might argue that there is no need to limit the deduction for qualified conservation
contributions because the issues are mostly valuation-based and should be addressed by
increased enforcement and by imposing additional standards on appraisers and appraisals.
Although present law should operate to deny a deduction to those donors whose property value is
enhanced as a result of the restriction, or to reduce the deduction if the donor claims a deduction
in excess of the actual reduction in value (e.g., if local ordinances or other restrictions are already
in place to limit the owner's use or alteration of the property), it is difficult for the IRS to identify
and challenge such cases. The present-law regime creates significant administrative obstacles
for the IRS with respect to easements, including the cost of conducting appraisals that are
required to properly measure the value of the restriction under the ''before and after approach,''
and the ongoing need to monitor the easements for compliance given that they are to be enforced
in perpetuity. It also is difficult to determine the extent to which the conservation or preservation
benefit (which often is tenuous and speculative) exceeds the economic and other benefits the
donor derives from the contribution. The task becomes especially difficult where, as appears to
be the case with respect to facade easements, many appraisers are using ''rules of thumb'' rather
than objective appraisals to value the contributions. This practice makes it virtually certain that
many appraised values are incorrect, and would necessitate a review by the IRS of many such
contributions to assure the correct value is used in most cases.
Facade easements and conservation easements where property is used as a residence
Contributions of fa�ade easements generally can be expected to reduce the value of the
property owner's interest in the underlying structure in those areas where no local ordinances or
other restrictions are already in place to prohibit the use or alteration of the property. However,
there potentially is no limit to the varieties of local land ordinances, zoning requirements, and
other types of legal restrictions on an owner's use or alteration of a structure throughout the
United States. Thus, an appraiser and the IRS must examine the particular local restrictions
already in place with respect to the underlying property in order to accurately measure the value
of the contributed facade easement. This makes it difficult and costly to determine the extent to
which a particular facade easement affects the value of the underlying property. In addition,
weighing competing public and private benefits when the underlying property is the donor's
residence is inherently more difficult than when the underlying property is to be used for
investment or commercial purposes. Accordingly, the proposal disallows a charitable deduction
for any qualified conservation contribution of a facade easement if the structure may be used by
the donor or the donor's family as a personal residence. Thus, the proposal eliminates the need
to assess valuation, conservation benefits, and private benefits with respect to a large group of
transactions that often provide questionable or limited public benefits.
For the same reasons applicable to fa�ade easements, the proposal eliminates the
deduction for all conservation easements relating to property to be used by the donor or donor's
family as a personal residence.
Other facade easements
With respect to facade easements relating to a certified historic structure to be used other
than as a personal residence of the donor or donor's family, the proposal limits the deduction to
the lesser of five percent of the fair market value of the property or 33 percent of the value of the
easement. In general, property held for business or investment purposes is not subject to the
same concerns of competing public and private benefits applicable to property used as a personal
residence. However, significant valuation concerns justify a cap on the deduction amount for
contributions of such other properties. The proposed cap of 33 percent of the value of the
easement goes directly to valuation abuses pertaining to easements. The additional cap of five
percent of the value of the unencumbered property is imposed because, in general, the nature of a
property restriction on the front of a structure should be a fairly low percentage of the value of
the entire property.
Other conservation easements
Present law attempts to incorporate a public benefit or conservation purpose standard into
each of the different types of qualifying conservation contributions. However, the standards vary
for the different types of contributions, and in many cases a deduction may be available even if
no substantial public benefit or conservation purpose is demonstrated. The present-law standards
for recreation by or education of the general public, for protection of an environmental system,
and for open space easements that are not made pursuant to a clearly delineated governmental
policy, arguably are so broad that the IRS effectively has no basis to challenge contributions
claimed to have been made for such purposes. A significant public benefit and conservation
purpose may be best demonstrated when a contribution promotes preservation or protection that
is pursuant to a clearly delineated governmental conservation policy. Accordingly, the proposal
extends this standard, presently applicable only to certain open space preservation cases, to all
other qualified conservation contributions (excluding historically important land areas and
certified historic structures, which have independent but similar provisions). Although some
might argue that extension of this requirement to such contributions will deter contributions for
such purposes, the status quo in essence permits the donor and the donee, the two parties with the
greatest incentive to reach such a conclusion, to determine that a conservation purpose is served.
Under these circumstances, there is no practical limit to the types or quantities of land areas that
may be treated by taxpayers as contributed for public education or recreation, for the protection
of environmental systems, or for scenic enjoyment of the general public, and no assurance that
such contributed properties promote conservation and provide a public benefit commensurate
with the tax expenditure.
Imposing a more meaningful conservation purpose requirement for most qualified
conservation contributions should isolate the primary tax problem in many cases to one of
valuation. To address the valuation concern, the proposal limits the deduction for conservation
easements (other than facade easements and personal residence properties) to 33 percent of the
value of the easement. The proposal does not eliminate the deduction in these cases, because
doing so would be a significant change in policy that arguably should be made only if there is a
strong case that such contributions pose the same valuation and private benefit concerns that
formed the basis of the proposal to eliminate the deduction with respect to personal residence
properties.
Unlike the proposal for facade easements pertaining to commercial and investment
properties, the proposal does not impose an additional deduction limitation based on a percentage
of the value of the underlying property. Such a limitation would not adequately take into
account the wide range of restrictions an owner may place on the underlying property, and could
discourage those contributions which provide the most significant conservation benefits. Some
might argue that the proposed disallowance percentage is arbitrary, or that other disallowance
percentages should be used. Similar disallowance provisions are used for other purposes relating
to difficult ''mixed-use'' properties or expenditures, such as the 50-percent test for business use
of listed property (sec. 280F(b)), and the 50-percent disallowance of meal and entertainment
expenses (sec. 274(n)). Others might argue that the proposal does not eliminate the need for
appraisals, but only reduces the effect of erroneous valuations at the expense of reduced
deductions for those who comply with the tax laws.
There are possible alternative ways to address the valuation and conservation purpose
concerns pertaining to qualified conservation contributions. For example, a cap could be
imposed on the amount of the deduction that may be claimed, a floor below which no deduction
is available (and above which only the excess may be deducted) could be imposed, or a
combination of a cap and floor could be imposed. The cap alternative often would reduce the
amount of the deduction, but in time could become treated by taxpayers as a ''safe harbor'' within
which deductions would not be challenged. Although the latter concern could be addressed by
using a low specified dollar amount cap, a cap that is too low would effectively eliminate the
incentive to make contributions that provide significant conservation benefits. Imposing a floor
also would disallow many deductions, but might discourage relatively small contributions and
increase the incentive to overvalue properties. The combination of a cap and a floor would
disallow small contribution deductions and potentially a significant portion of large
contributions.
Appraisal requirements and penalties for erroneous valuations
Under the proposal, a proper determination of the fair market value of a contribution of a
conservation or facade easement remains critical in many cases. The proposal attempts to
address valuation difficulties by establishing qualified appraiser requirements with respect to
contributions exceeding $5,000. Appraiser standards should eliminate some valuation problems
that arise under present law, but could make the appraisal process more expensive.
The proposal does not explicitly provide that penalties be imposed on appraisers who
overvalue qualified conservation contributions, because of concerns regarding the potential
unfairness to an appraiser of imposing penalties based on an overvaluation the amount of which
will be determined in a proceeding in which the appraiser is not a party, and for which there is no
assurance that the interests of the taxpayer and the appraiser will be aligned. Imposition of
appraiser penalties in material overvaluation cases might be appropriate if these concerns can be
addressed.
G. Limit Charitable Deduction for Contributions of
Clothing and Household Items
(sec. 170)
Present Law
Deductibility of charitable contributions
In general
In computing taxable income, a taxpayer who itemizes deductions generally is allowed to
deduct the amount of cash and the fair market value of property contributed to an organization
described in section 501(c)(3) or to a Federal, State, or local governmental entity. The amount
of the deduction allowable for a taxable year with respect to a charitable contribution of property
may be reduced or limited depending on the type of property contributed, the type of charitable
organization to which the property is contributed, and the income of the taxpayer. In general,
more generous charitable contribution deduction rules apply to gifts made to public charities than
to gifts made to private foundations. Within certain limitations, donors also are entitled to
deduct their contributions to section 501(c)(3) organizations for Federal estate and gift tax
purposes.
Contributions of property
The amount of the deduction for charitable contributions of capital gain property
generally equals the fair market value of the contributed property on the date of the contribution.
Capital gain property means any capital asset or property used in the taxpayer's trade or business
the sale of which at its fair market value, at the time of contribution, would have resulted in gain
that would have been long-term capital gain. Contributions of capital gain property are subject
to different percentage limitations than other contributions of property.
For certain contributions of property, the deductible amount is reduced from the fair
market value of the contributed property by the amount of any gain, generally resulting in a
deduction equal to the taxpayer's basis. This rule applies to contributions of: (1) ordinary
income property, e.g., property that, at the time of contribution, would not have resulted in long-
term capital gain if the property was sold by the taxpayer on the contribution date; (2) tangible
personal property that is used by the donee in a manner unrelated to the donee's exempt (or
governmental) purpose; and (3) property to or for the use of a private foundation (other than a
foundation defined in section 170(b)(1)(E)).
Charitable contributions of clothing and household items are subject to the tangible
personal property rule (number (2) above) if the property is not used to further the donee's
exempt purpose. In general, however, the value of clothing and household items is less than the
taxpayer's basis in such property, with the result that taxpayers generally deduct the fair market
value of such contributions, regardless of whether the property is used for exempt or unrelated
purposes by the donee.
In general, if the total charitable deduction claimed for non-cash property exceeds $500,
the taxpayer must file Form 8283 (Noncash Charitable Contributions) with the IRS. In general,
taxpayers are required to obtain a qualified appraisal for donated property with a value of $5,000
or more, and to attach an appraisal summary to the tax return.
Vehicles and Intellectual Property '' American Jobs Creation Act
The American Jobs Creation Act (''AJCA'') established new rules for charitable
contributions of qualified vehicles and qualified intellectual property. A deduction for a
contribution of a qualified vehicle with a claimed value in excess of $500 generally may not
exceed the gross proceeds received by the donee upon the sale of the vehicle. If the donee does
not sell the vehicle or performs a significant intervening use or material improvement of the
vehicle prior to sale, the deduction generally is the fair market value of the vehicle at the time of
the contribution. The deduction for a charitable contribution of qualified intellectual property
generally is the donor's basis in the property (or fair market value, if less). The donor is eligible
for additional charitable deductions in certain future years based on the net income received by
or accrued to the donee that is properly allocable to the contributed intellectual property.
Reasons for Change
Clothing and household items are tangible personal property that typically are loss
property, with the result that a fair market value deduction (rather than a deduction equal to
basis, if greater) is available for contributions of such items. Often of low value, clothing and
household items typically do not meet the threshold for which an appraisal is required ($5,000),
meaning that for most of such items, the value is arrived at solely by a determination of the
taxpayer. In general, there is no objective method for determining the value of used clothing and
household items, with the result that overvaluations are likely to occur. In many cases
overvaluations may not be deliberate, but may be based on taxpayer misunderstanding, or may
arise for example, because an item, while not having a high fair market value, has sentimental
value to the taxpayer. In some cases, an item may be of very low value and would have been
disposed of by the taxpayer if not for the possibility of a deduction. Present law also encourages
deliberate overvaluations by aggressive and even moderately aggressive taxpayers, because there
is a remote likelihood of challenge by the IRS except in egregious or random cases. Some
taxpayers may overvalue items on the assumption that other taxpayers do, that those taxpayers
will not be caught by the IRS, and that it is therefore ''fair'' to overvalue.
Description of Proposal
Under the proposal, the income tax deduction for charitable contributions of clothing and
household items made to organizations eligible to receive deductible contributions (i.e.,
organizations described in section 170(c)) is limited to $500 per taxable year (regardless of filing
status) for the aggregate of all such contributions made by the taxpayer. No carryover of such
contributions over $500 is allowed. As under present law, the deduction for a particular item
may not exceed fair market value and the taxpayer must retain records to substantiate the
deduction. The proposal does not apply to contributions by corporations (other than closely held
or personal service corporations). The proposal applies to new and used items. Household items
include furniture, furnishings, electronics, appliances, linens, and other similar items. Food is
not considered a household item. Paintings, antiques, and other objects of art, jewelry and gems,
and collections are excluded from the proposal. A collection must be something given for use or
sale as a collection and generally must have value independent of its component parts.
Effective Date
The proposal is effective for contributions made in taxable years beginning after the date
of enactment.
Discussion
The proposal limits the aggregate amount that a taxpayer may deduct for charitable
contributions of clothing and household items to $500 per year (regardless of filing status), with
no provision for a carryover of amounts in excess of $500. The proposed aggregate taxpayer cap
attempts to limit the extent of the overvaluation problem, yet still provides a reasonable
deduction amount for those who make such contributions. Five hundred dollars is the amount
above which information reporting is triggered under present law, thus a $500 limit minimizes
the filing burdens of taxpayers and donee organizations. However, the number could be adjusted
higher or lower.
Some might argue that the deduction for clothing and household items should be
eliminated entirely, in part on grounds that such property is difficult to value and such
contribution deductions are difficult for the IRS to enforce, but also for the reason that taxpayers
that contribute such property do not need a tax incentive to make the contribution. Under this
argument, taxpayers will continue to donate old clothes and other items because they no longer
have a use for the items and want them to be used by a person in need. On the other hand, some
might argue that the tax incentive in many cases encourages people to take the extra step of
delivering their used personal items to a suitable donee organization rather than merely throwing
them away, or giving them to a friend or relative, and thus that a deduction for such items should
be retained, if limited.
An aggregate limitation on the deduction retains the deduction and so continues to
provide an incentive to make the donation. The limitation also limits the effect of excessive
overvaluation abuses and, at the margin, is not likely to deter someone from increasing the
number of items given in a year. However, the proposal could in some cases postpone
contributions in an amount in excess of $500 to another year, and in cases where the value of a
single item significantly exceeds $500, donors may decide not to make the contribution.
Some might argue that an exception should be provided for contributions made for
purposes of disaster relief. Often, at the onset of a disaster, an outpouring of support and
sympathy prompts people to contribute time, money, and property such as clothing and other
household items to disaster relief organizations (including governmental entities). Although
many donee organizations often prefer to receive cash rather than used property in such cases,
some might argue that the $500 limitation might result in fewer contributions of clothing and
household items to the detriment of victims of a disaster. However, others argue that donations
made as a response to a disaster are often made entirely without consideration of any tax
incentive. Perhaps more than in any other context, people give in such situations from a pure
motive of care and sympathy for fellow human beings in immediate need of assistance, and do
not need the tax laws to encourage such gifts. Under this view, the aggregate limitation on
clothing and household items should not materially affect giving in disaster relief situations, and
thus an exception to the limitation for disaster relief purposes is not necessary.
Under the proposal, household items do not include antiques, jewelry, or collections.
Antiques, jewelry, and collections generally are of a different kind of property than used
clothing, electronics, or other household goods, and have an intrinsic value. It is not intended
that under the proposal a person could describe an assemblage of, for example, a child's stuffed
animals as a ''collection.'' Rather, a collection is something given for use or sale as a collection
and generally must have value independent of its component parts. Although there is a risk that
an exception for antiques, jewelry, or collections will encourage taxpayers to attempt to
circumvent the limitation by, for example, labeling plastic jewelry as jewelry not subject to the
limit, or an old dining room table as an ''antique,'' any such claim would be subject to reporting
on the Form 8283 and generally would require that a taxpayer potentially misreport twice: once
in classifying the property, and again in determining a value. In any event, the Treasury likely
would have to develop guidance on the definition of such items, especially collections.
H. Reform Rules for Charitable Contributions of Property
(sec. 170)
Present Law
Deductibility of charitable contributions
In general
In computing taxable income, a taxpayer who itemizes deductions generally is allowed to
deduct the amount of cash and the fair market value of property contributed to an organization
described in section 501(c)(3) or to a Federal, State, or local governmental entity. The amount
of the deduction allowable for a taxable year with respect to a charitable contribution of property
may be reduced or limited depending on the type of property contributed, the type of charitable
organization to which the property is contributed, and the income of the taxpayer. In general,
more generous charitable contribution deduction rules apply to gifts made to public charities than
to gifts made to private foundations. Within certain limitations, donors also are entitled to
deduct their contributions to section 501(c)(3) organizations for Federal estate and gift tax
purposes. By contrast, contributions to nongovernmental, non-charitable tax-exempt
organizations generally are not deductible by the donor, though such organizations are eligible
for the exemption from Federal income tax with respect to such donations.
In general, if a donor receives a benefit or quid pro quo in return for a contribution, any
charitable contribution deduction is reduced by the amount of the benefit received. For
contributions of $250 or more, no charitable contribution deduction is allowed unless the donee
organization provides a contemporaneous written acknowledgement of the contribution that
describes and provides a good faith estimate of the value of any goods or services provided by
the donee organization in exchange for the contribution.
Contributions of property
The amount of the deduction for charitable contributions of capital gain property
generally equals the fair market value of the contributed property on the date of the contribution.
Capital gain property means any capital asset, or property used in the taxpayer's trade or
business, the sale of which at its fair market value, at the time of contribution, would have
resulted in gain that would have been long-term capital gain. Contributions of capital gain
property are subject to different percentage limitations than other contributions of property.
For certain contributions of property, the deductible amount is reduced from the fair
market value of the contributed property by the amount of any gain, generally resulting in a
deduction equal to the taxpayer's basis. This rule applies to contributions of: (1) ordinary
income property, e.g., property that, at the time of contribution, would not have resulted in long-
term capital gain if the property was sold by the taxpayer on the contribution date; (2) tangible
personal property that is used by the donee in a manner unrelated to the donee's exempt (or
governmental) purpose; and (3) property to or for the use of a private foundation (other than a
foundation defined in section 170(b)(1)(E)).
In general, a charitable contribution deduction is allowed only for contributions of the
donor's entire interest in the contributed property, and not for contributions of a partial
interest. If a taxpayer sells property to a charitable organization for less than the property's
fair market value, the amount of any charitable contribution deduction is determined in
accordance with the bargain sale rules. If a taxpayer pays more than fair market value for
property acquired from a charitable organization, the excess above fair market value may be
deductible assuming that the donor intended to make a gift of such excess.
In general, if the total charitable deduction claimed for non-cash property exceeds $500,
the taxpayer must file IRS Form 8283 (Noncash Charitable Contributions) with the IRS. C
corporations (other than personal service corporations and closely-held corporations) are
required to file Form 8283 only if the deduction claimed exceeds $5,000. Information required
on the Form 8283 includes, among other things, a description of the property, the appraised fair
market value (if an appraisal is required), the donor's basis in the property, how the donor
acquired the property, a declaration by the appraiser regarding the appraiser's general
qualifications, an acknowledgement by the donee that it is eligible to receive deductible
contributions, and an indication by the donee whether the property is intended for an unrelated
use. If a donee organization sells, exchanges, or otherwise disposes of contributed property with
a claimed value over $5,000 (other than publicly traded securities) within two years of the
property's receipt, the donee is required to file a return (Form 8282), and furnish a copy of the
return to the donor, showing the name, address, and taxpayer identification number of the donor,
a description of the property, the date of the contribution, the amount received on the disposition,
and the date of the disposition.
Taxpayers are required to obtain a qualified appraisal for donated property with a value
of $5,000 or more, and to attach an appraisal summary to the tax return. In the case of
contributions of art valued at $20,000 or more, taxpayers are required to attach the appraisal to
the tax return. Under Treasury regulations, a qualified appraisal means an appraisal document
that, among other things: (1) relates to an appraisal that is made not earlier than 60 days prior to
the date of contribution of the appraised property and not later than the due date (including
extensions) of the return on which a deduction is first claimed under section 170; (2) is
prepared, signed, and dated by a qualified appraiser; (3) includes (a) a description of the property
appraised; (b) the fair market value of such property on the date of contribution and the specific
basis for the valuation; (c) a statement that such appraisal was prepared for income tax purposes;
(d) the qualifications of the qualified appraiser; and (e) the signature and taxpayer identification
number of such appraiser; and (4) does not involve an appraisal fee that violates certain
prescribed rules.
Vehicles and Intellectual Property '' American Jobs Creation Act
The American Jobs Creation Act (''AJCA'') established new rules for charitable
contributions of qualified vehicles and qualified intellectual property. A deduction for a
contribution of a qualified vehicle with a claimed value in excess of $500 generally may not
exceed the gross proceeds received by the donee upon the sale of the vehicle. If the donee does
not sell the vehicle or performs a significant intervening use or material improvement of the
vehicle prior to sale, the deduction generally is the fair market value of the vehicle at the time of
the contribution. The deduction for a charitable contribution of qualified intellectual property
generally is the donor's basis in the property (or fair market value, if less). The donor is eligible
for additional charitable deductions in certain future years based on the net income received by
or accrued to the donee that is properly allocable to the contributed intellectual property.
Reasons for Change
The determination of fair market value creates a significant opportunity for error or abuse
by taxpayers making charitable contributions of property. To the extent that taxpayers claim
inflated valuations that are not corrected by the IRS, the Treasury loses revenue that should be
collected under present law because charitable contribution deductions are greater than are
warranted. Whether due to mistake, incompetence, misunderstanding of the law or facts, or
efforts to evade taxes, valuation misstatements are common.
In addition, valuation is a difficult and resource intensive issue for the IRS to identify,
audit, and litigate. The IRS must determine which values are suspect, prepare its own appraisal
of the questioned property, and persuade a court that the IRS's value, and not the taxpayer's, is
correct. Such hurdles often mean, as a practical matter, that attacking valuation misstatements in
the charitable contribution context is not a high priority for the IRS because the probable revenue
collected does not compare favorably with the resource cost (at least when compared to other tax
compliance areas).
Another contributing factor to problems in this area is that unlike in an arm's length
negotiation to arrive at a price between unrelated parties, for a charitable contribution the
interests of a donor and a donee organization are not adverse. A donee organization has no
incentive to question a donor's inflated value because there is no countervailing tax consequence
to the donee if a donor inflates the value of contributed property, i.e., the donee generally does
not pay tax on the receipt of the contribution or a subsequent disposition of the contributed
property. Some donees may even directly or indirectly support an inflated value in order to
secure a desired gift. Such circumstances cause the valuation of property in the charitable
contribution context to be a particularly difficult determination.
Apart from the issues of valuation and enforcement, the fair market value deduction for
property contributions raises separate policy questions. The fair market value deduction for
property generally places gifts of cash and gifts of property on an equal footing. A primary goal
of the charitable deduction, however, should be to encourage gifts that are most useful to a
charitable organization, and should not be to encourage gifts that entail significant diversion of
resources from the charitable mission or that require a charity to incur substantial transaction
costs. Cash, publicly traded securities, and arguably property that can be used directly in
substantial furtherance of exempt purposes meet this standard. Other gifts of property generally
do not and so need not be as favored.
Description of Proposal
Option 1
Under Option 1, the deduction for charitable contributions of property (including capital
gain property) is the donor's basis in the property or, if less, the fair market value of the property.
Thus, the proposal generally extends the ''basis not to exceed fair market value'' rule presently
applicable to contributions of certain tangible personal property to all in-kind property. The
proposal does not apply to charitable contributions of publicly traded securities, which continue
to be eligible for a fair market value deduction.
The proposal does not apply to qualified intellectual property (as defined in section
170(m)(9)), a qualified vehicle (as defined in section 170(f)(12)(E)), or a qualified conservation
contribution (as defined in section 170(h)(1)). The proposal also does not apply to charitable
contributions that meet the requirements of sections 170(e)(3), (e)(4), or (e)(6), i.e., contributions
eligible for an enhanced deduction.
The information return requirement imposed on a donee organization upon a disposition
of contributed property (Form 8282, sec. 6050L) is eliminated under Option 1.
Option 2
In general
Option 2 follows the general rule of Option 1 (i.e., basis not to exceed fair market value),
with an exception for contributions of property to be used to substantially further exempt
purposes (''exempt use'' property). Like Option 1, Option 2 retains a fair market value deduction
for publicly traded securities, and does not apply to contributions of qualified intellectual
property, qualified vehicles, or contributions eligible for an enhanced deduction.
Unlike Option 1, for charitable contributions of exempt use capital gain property, Option
2 retains the present-law fair market value deduction. In addition, for exempt use property with a
claimed value of more than $500 that the donee identifies as exempt use property on the Form
8283, the proposal generally provides for a reduced tax benefit to the donor if such property is
disposed of by the organization within three years of the contribution.
The information return requirement imposed on a donee organization upon a disposition
of contributed property (Form 8282, sec. 6050L) is eliminated for property that is identified by
the donee organization on the Form 8283 as not intended for use in substantial furtherance of an
exempt purpose (''nonexempt use'' property), but is retained and expanded for exempt use
property.
The revenue effect of Option 2 is not estimated in the revenue table include in this Report
due to insufficient data at this time for such an estimate.
Reduction of tax benefit upon subsequent disposition of exempt use property
Under Option 2, with respect to exempt use property for which a deduction of more than
$500 is claimed, and which is identified as exempt use property by the donee organization on the
Form 8283, present law rules generally apply except that, if the donee organization disposes of
such property within three years of the contribution date, the property is deemed to be
nonexempt use property with the result that the deductible amount with respect to such property
is adjusted, as follows. If the disposition occurs in the same taxable year of the donor as the
contribution date, the donor's deduction generally is basis (or if less, the fair market value), and
no subsequent adjustment is required. If the disposition occurs in a subsequent year, the donor
must include as ordinary income for its taxable year in which the disposition occurs an amount
equal to the excess (if any) of (i) the amount of the deduction previously claimed by the donor as
a charitable contribution with respect to such property, over (ii) the donor's basis in such
property at the time of the contribution. The donee's use of proceeds from the disposition of
property in a manner that furthers exempt purposes is not an exempt use.
Upon a disposition of exempt use property subject to the recapture tax, a donor is not
required to adjust the deductible amount from the amount claimed if the donee organization
certifies to the Secretary, by written statement signed under penalties of perjury by an officer of
the organization, that the property disposed of was used for a significant intervening exempt use.
The certification must explain the use of the property and how such use substantially furthered
the purpose or function that constitutes the organization's basis for exemption. The organization
must furnish a copy of the certification to the donor (as part of the present-law requirement to
furnish the Form 8282 to the donor).
Reporting for exempt use property
In addition to the present-law requirement that the donee organization identify on the
Form 8283 whether property for which an amount of more than $500 is claimed is exempt use
property, Option 2 requires that the donee explain the intended use of such property. A penalty
of $1,000 applies to any person that agrees to identify property as exempt use property while
having a reason to know that the property is not intended for such use. A penalty of $10,000
applies to a person that identifies property as exempt use property knowing that it is not intended
for such use.
The proposal modifies the present-law information return requirements that apply upon
the sale of contributed property by a charitable organization (Form 8282, sec. 6050L). For
property identified by the donee organization on the Form 8283 as exempt use property, the
return requirement is extended to dispositions made within three years after receipt (from two
years) and to property for which an amount of more than $500 is claimed (as compared to the
present-law amount of more than $5,000). The donee organization also must provide, in addition
to the information already required to be provided on the return, a description of the donee's use
of the property, a statement of whether the property was used to substantially further exempt
purposes, a certification of such use (described above), and if such certification is provided, a
statement of whether a copy of the certification was provided to the donor of the property.
Effective Date
The proposal is effective for contributions made in taxable years beginning after the date
of enactment.
Discussion
In general
Options 1 and 2 eliminate the value-based deduction for certain charitable contributions
of property because of both valuation issues and independent policy concerns. Retaining the fair
market value deduction while attempting to improve the method for determining value is not
adequate because a system based on appraisals and other estimates of value will continue to be
open to abuse and costly to administer properly. Reducing the fair market value deduction, for
example, by providing that the deduction is a certain percentage of fair market value, would
address valuation abuses in part by reducing the amount of the deduction, but would retain the
need for fair market value determinations and their enforcement. Elimination of the value-based
deduction is preferable to either approach because it eliminates the need for estimates of value, is
easy to enforce, and by disfavoring property contributions generally, promotes contributions that
a charitable organization needs most: cash, publicly traded securities (which present no valuation
problem and are easily converted to cash), and arguably, property that substantially furthers
exempt purposes. Providing for a basis deduction instead of a fair market value deduction
already is the general rule for tangible personal property not intended for exempt purposes and
for contributions to private nonoperating foundations. Thus, the proposal extends this general
rule to other property contributions. Some contributions affected by the basis rule of the
proposal include contributions of the following types of appreciated property: closely held stock;
partnership interests; other securities that are not publicly traded; land; and, under Option 1 but
not Option 2, property for use to further exempt purposes. To the extent any of such listed
property is for exempt purposes, the fair market value deduction is preserved under Option 2.
Option 1: Deduction for property contributions is the lesser of basis or fair market value
Option 1 provides that for contributions of property that is not excepted by Option 1, the
deduction is basis, or if less, fair market value. This is the rule under present law for charitable
contributions to nonoperating private foundations and for charitable contributions of nonexempt
use tangible personal property. Thus, Option 1 generally extends the nonexempt use tangible
personal property rule to all property not excepted by the proposal.
In general, the proposal is a simple and effective solution to overvaluation of property.
The rule is easy to apply, requiring that the taxpayer substantiate its basis in the property. By
providing a basis deduction for appreciated property instead of a fair market value deduction (or
a deduction based on a percentage of fair market value) the proposal eliminates the need to rely
on appraisals or other means of determining value for all such property. The proposal also
reduces the filing burden on donee organizations by eliminating the present-law information
return requirement with respect to property disposed of by the donee within two years of
contribution. Under Option 1, the return requirement is no longer necessary because the IRS
does not need to track the disposition amount of property for which a basis deduction is
claimed.
Option 1 preserves the fair market value deduction for loss property. Taxpayers would
still have an incentive to overvalue any loss property they contribute, although a taxpayer might
be better off (as under present law) selling the property, recognizing the loss (if available for tax
purposes), and donating the sales proceeds. Nevertheless, short of introducing significant
complexity by basing the deduction for loss property on the disposition amount and taxing the
donee organization on the gain upon disposition (similar to an approach discussed below), or
eliminating the deduction for hard-to-value property entirely, there is no simple comprehensive
solution to this problem. In some cases, overvaluation of loss property may best be addressed
through adoption of special rules for certain types of loss property, e.g., the new rules enacted by
the AJCA for vehicles, which use the selling price as a proxy for value. Another example is to
adopt a special rule, such as the aggregate cap proposed in this Report for contributions of
clothing and household items, which are another type of commonly contributed loss property.
The proposal is likely to reduce the amount of contributions of hard-to-value property. In
general, donors would be better off selling the property instead of contributing it, paying tax at
long term capital gain rates, and contributing (and deducting) all or a portion of the after-tax
proceeds to charity. In such a case, the charity might receive less from a donor, but such a
shortfall is at least partially offset because the charity would not have any transaction costs
associated with disposing of the property. A larger question, however, is whether any loss in
fundraising outweighs the loss to the Treasury from excess deductions based on overvalued
property, the cost to enforce correct valuations, and the damage to the tax system from generally
tolerating taxpayers that claim deductions to which they are not entitled.
There also is a question of whether the tax system should encourage charitable
contributions of property. Gifts most useful to charity are cash, gifts readily convertible to cash
(like publicly traded securities), and gifts of property a charity can use to substantially further
charitable programs. Other property contributions generally divert a charity's resources from
its charitable mission and toward soliciting and disposing of such contributions. Accordingly,
reasons independent of valuation difficulties may support discouraging hard-to-value property
contributions.
Option 2: Fair market value deduction for exempt use property, with recapture tax on
certain dispositions by donee
Option 2 follows Option 1 except that the fair market value deduction generally is
preserved for contributions of exempt use property (in addition to publicly traded securities).
This is similar to the present law rule providing for a fair market value deduction for
contributions of tangible personal property for an exempt use, or a basis deduction if for another
use. Thus, the proposal generally retains the tangible personal property rule and extends it to
contributions of other property susceptible for use in exempt purposes, such as land, interests in
land, and buildings, which under Option 1 receive a basis deduction.
As noted above, contributions generally most useful to charities are cash, property easily
convertible to cash, and property that can be used to substantially further charitable programs.
Providing an incentive for exempt use property may be viewed as efficient because the charity
will not have to expend resources separately to acquire the good. In addition, some types of
property, such as artwork, are unique, and some would argue, accessible to charity only because
of the fair market value deduction. However, preserving the incentive to make charitable
contributions of exempt use property retains the valuation difficulty and introduces the
complexity of a recapture tax to prevent misclassification, as compared to Option 1. The
complexity is minimized, however, because a determination of exempt or nonexempt use already
is required under present law on the Form 8283, though because of the recapture tax the
consequences of such a determination would be greater under Option 2. Some would argue that
providing an incentive for exempt use property is unfair to donors who contribute nonexempt use
property of equal value but who receive a basis deduction, and that the incentive is not necessary
to ensure that unique property be contributed to charity because charities that truly want such
property will acquire it by other means.
Under Option 2, a recapture tax applies if exempt use property is disposed of by the
donee organization within three years of the contribution date. The recapture tax does not apply,
however, if the donee organization certifies to the Secretary under penalties of perjury a
significant intervening exempt use of the contributed property. The recapture tax is intended to
provide the donor with a net deduction equal to the deduction the donor would have received if
the property had been correctly identified as nonexempt use property at the time of contribution,
that is, the donor's basis. Option 2 treats a sale or other disposition of exempt use property as
evidence that the property was not used substantially to further exempt purposes, and therefore
that an adjustment to the donor's deduction is warranted (assuming the donee does not certify as
to a significant intervening exempt use).
Option 2 also provides for a penalty of $1,000 on any person who identifies property as
exempt use property with reason to know that such property is not intended for an exempt use
and a penalty of $10,000 on any person who identifies property as exempt use property with
actual knowledge that such property is not intended for an exempt use. The penalties are
designed to ensure that donee organizations and their managers assume responsibility for how
contributed property is identified and to deter intentional misclassification of property deemed to
enable the donor to take the generally more favorable deduction provided for exempt use
property.
The recapture tax will result in some additional reporting by the donee organization. The
donee will have to report dispositions for property with a claimed value of more than $500 over a
three-year period as compared to present law which requires reporting dispositions of property
with a claimed value of more than $5,000 over a two-year period. This increase in reporting
should be offset by the elimination of such reporting for property identified as nonexempt use
property. To minimize the overall reporting and compliance burden, the recapture tax does not
apply to exempt use property with a claimed value of $500 or less. For such property, a fair
market value deduction generally is available and rules similar to the present-law rule for
contributions of tangible personal property apply, i.e., donors will have to determine whether the
property is exempt use property.
As an illustration of the recapture tax, assume at the time of contribution that the value of
the property is $100 and the donor's basis is $60. The donee organization identifies the property
as exempt use property, but sells the property two years later and does not provide a certification
of a significant intervening exempt use. In such a case, the donor takes a $100 ordinary income
deduction in the year of contribution but has ordinary income recapture in the year of sale of $40
(the difference between the fair market value at the time of contribution and the donor's basis)
with a resulting net deduction of $60, or the donor's basis. If the sale occurred in the year that is
the same taxable year of the donor as the contribution date, the donor would take a $60 deduction
(basis) for that year. As another example, assume that at the time of contribution the value of the
property is $100, the donor's basis is $140, and the donee sells the property two years later for
$120 without an exempt use certification. The donor takes a deduction of $100 in the year of
contribution and has no additional income with respect to the contribution in the year of sale
(because the $100 initial deduction does not exceed the donor's basis of $140).
Other possible approaches to property contributions
Strengthen present-law appraiser and appraisal rules
Present law attempts to address valuation concerns by requiring appraisals of contributed
property for which a deduction of more than $5,000 is claimed. Appraisals must be conducted
by a qualified appraiser, who is defined as a person who holds himself or herself out to the public
as an appraiser or performs appraisals on a regular basis, is qualified to make appraisals of the
type of property being valued (as determined by the appraiser's background, experience,
education, and membership, if any, in professional appraisal associations), is independent, and
understands that an intentionally false or fraudulent overstatement of the value of the appraised
property may subject the appraiser to civil penalties. Although professional organizations
exist that educate, train, and certify appraisers, and the appraisal community has developed some
uniform standards applicable to appraising many types of property, the tax law does not require
that a qualified appraiser meet any objective professional qualifications or adhere to any specific
appraisal standards.
Accordingly, one approach to address overvaluation would be to tighten the definition of
a qualified appraiser explicitly to require certain professional qualifications of appraisers, that
appraisals conform to generally accepted uniform appraisal guidelines, and provide that an
appraiser subject to disbarment from practice before the IRS may not qualify. The IRS could be
charged with enforcing specific appraisal standards for different types of property and with
publishing a list of necessary qualifications of qualified appraisers. In addition, the penalty
structure could be strengthened so that appraisers, in addition to donors, are penalized for
valuation misstatements, with increasing penalties for multiple violations. Taxpayers could be
required to pay a fee for a review appraisal by the IRS prior to a gift of highly valued property.
Strengthening the appraisal regime generally is sensible, and reforms such as those
suggested above should be considered; however, as an answer to the issues raised by valuation,
tightening appraisal standards and penalties for appraisers does not address the main problem.
The very practical difficulty of the IRS finding and enforcing valuation misstatements would
remain, as would the incentive to overstate valuations. Under present law there are plausible
methods of valuing even the most difficult to value property, but not every appraiser will follow
such methods, legitimate disputes will arise about which method is appropriate, and there will be
multiple acceptable ways of application and interpretation of a given method to the particular
property being valued. In addition, as estimates of value, appraisals inherently involve the
judgment of a person who is hired and compensated by the taxpayer and who, no matter how
independent or capable of ignoring the reality that the appraiser's economic interests are aligned
with the taxpayer's interests, understands the difficulties presented by the tax system to the
successful challenge of an appraisal.
Provide that the donor's deduction for nonexempt use property generally is equal to
the disposition amount and tax donee on the gain upon disposition
Another approach would be to provide that for property contributions a donor would take
an initial deduction of the donor's basis (or if less, fair market value), and the donor would be
eligible for an additional charitable contribution deduction in the year the contributed property is
disposed of by the donee. The additional deduction would equal the excess (if any) of the
disposition amount over the amount of the initial deduction. This approach would not apply to
publicly traded securities or to property that is intended for use to substantially further the
donee organization's exempt purpose.
Such an approach would preserve the fair market value-based deduction by using as
determinative of fair market value the disposition amount. The donor might not receive the
entire amount of the deduction initially as under present law, but assuming the property is
disposed of by the donee shortly after receipt, the timing of the donor's full deduction would not
differ significantly, if at all, from present law. Use of the disposition amount as determinative of
fair market value would eliminate the need for appraisals and their inherent uncertainty. To the
extent that donors receive less as a deduction under this proposal (after taking into account any
additional deduction) than under present law, the difference (the amount by which the disposition
amount is less than the appraised amount used by the taxpayer) arguably would be equal to the
amount by which the appraisal overvalued the property.
One significant issue under this approach would be that of post-contribution appreciation
or depreciation in the property. Because the additional deduction would be based on the
disposition amount, the donor would receive the benefit of an increase in value of the
property. Thus, if property worth $100 on the date of contribution (with a donor's basis of
$50) increased in value to $500 on the date of its sale five years later, the donor would reap the
benefit with an additional deduction in the year of sale of $450, which is $350 more than the
donor would receive under present law (not taking into account the time value of money). Some
would view this as a windfall to the donor, because the amount of the deduction significantly
differs from the value of the property when contributed. One solution would be to impose a time
limit to the additional deduction, e.g., no additional deduction would be available for dispositions
more than three years after receipt. However, even a three-year time period could create
significant windfalls to the donor and to the fisc. A shorter period, e.g., six months, arguably
would not give the donee organization enough time to dispose of the property and, in certain
cases, could force sales of property in nonoptimal market conditions.
To more fully counter the issue of post-contribution appreciation, this approach could, in
addition to a time limit on additional deductions, provide for a tax on gain at the time of
disposition at the highest unrelated business taxable income tax rate, payable by the donee.
The donor would still reap the benefit of post-contribution appreciation in the form of an
additional charitable deduction (but not beyond the time limit), but the Treasury generally would
not be worse off because the gain in the property would be fully taxed. Such a tax could be
justified as a tax on the donee organization's unrelated activity of accepting, preparing for sale,
and selling property for which the organization had no exempt use. Alternatively, an excise
tax on the gross disposition proceeds could be used, which would reduce administrative
complexity associated with tracking gain on the property.
An anti-abuse rule would be required to cover the possibility of a double deduction in the
case of a part-gift part sale. For example, assume that a donor gives property to charity (e.g., a
compact disc) that is worth $15 and the donor has a basis of $15. The charity sells the compact
disc for $100 as part of a membership fundraising drive. Without an anti-abuse rule, the
disposition amount could be viewed as $100 providing the donor of the disc with a $100
deduction, while the buyer of the disc takes a deduction of $85 (because the purchase of property
valued at $15 for $100 could be viewed as a charitable contribution of $85). An anti-abuse rule
might provide that a donee organization, in disposing of contributed property, either (1) inform
the donor that no portion of the disposition amount is deductible as a charitable contribution; or
(2) inform the donor that the disposition amount with respect to the property is $X and the
remainder paid by the buyer of the property may be deductible by the buyer as a charitable
contribution. In general, donees would have an incentive to establish a disposition amount for
this purpose at or close to the fair market value of the property. If the donee sets the amount too
low, the original donor would be displeased. If the donee sets the amount too high, there might
be fewer buyers (due to reduced contribution deductions for buyers) and the donee would have
more gain on which to pay the proposed unrelated business income tax. Donees that did not
want to put a value on property would have the option of informing prospective purchasers that
no part of the purchase is deductible as a contribution. To avoid the complexities presented by
low value gifts generally, the proposal also could exempt property with a claimed value of $500
or less.
In sum, under this approach, if the donee organization disposes of nonexempt use
property within a certain time period, the donor's deduction (as adjusted) generally would equal
the disposition amount. If the donee organization disposes of nonexempt use property after
expiration of the time period, no additional charitable deduction would be available to the donor
(the donor's deduction would equal the lesser of basis or fair market value, determined at the
contribution date). For all dispositions of nonexempt use property, the donee might pay
unrelated business income tax on the gain. Additional reporting requirements would be required.
This approach would introduce significant complexity for contributions of property. The
approach preserves the fair market value deduction by using the disposition amount as the proxy
for value and as determinative of the donor's deduction. As a result, however, the deduction for
many charitable contributions of nonexempt use property would take years to determine, and
donees would be required to track dispositions of property for the duration of the time period,
which is a significantly greater burden than under present law.
Eliminate, in whole or in part, the charitable contribution deduction for property
The simplest alternative would be to eliminate, in whole or in part, the charitable
contribution deduction for in-kind property. The main argument in support of such an approach
is that the Code should provide incentives only for contributions of cash because cash is of most
use to charity, presents no valuation questions, and generally has no transaction costs associated
with it. To the extent publicly traded securities or exempt use property should be encouraged, a
fair market value deduction could be retained for such property. This approach would
discourage much systematic and institutionalized fundraising. Donors with property to
contribute would be encouraged to dispose of the property and give all or a portion of the
disposition amount to charity. Such a proposal has the benefit of being simple. Some might
argue, however, that donors of property should at least recover their basis in appreciated property
and to deny a basis deduction is unfair.
I. Require Public Disclosure of Form 990-T and
Related Certification Requirements
(secs. 6104 and 6685)
Present Law
In general, an organization described in section 501(c) or (d) is required to make
available for public inspection a copy of its annual information return (Form 990) and exemption
application materials. A penalty may be imposed on any person who does not make an
organization's annual returns or exemption application materials available for public inspection.
The penalty amount is $20 for each day during which a failure occurs. If more than one person
fails to comply, each person is jointly and severally liable for the full amount of the penalty. The
maximum penalty that may be imposed on all persons for any one annual return is $10,000.
There is no maximum penalty amount for failing to make exemption application materials
available for public inspection. Any person who willfully fails to comply with the public
inspection requirements is subject to an additional penalty of $5,000.
These requirements do not apply to an organization's annual return for unrelated business
income tax (Form 990-T).
Reasons for Change
Although exempt organizations are required to file their unrelated business income tax
returns with the IRS, the public does not have access to information pertaining to an
organization's unrelated business activities that is included in the IRS returns. Public disclosure
of nonproprietary trade or business information would provide the public an opportunity to
review the extent and type of unrelated business activities an organization conducts, enabling the
public to assess all of the activities being conducted by organizations it supports through tax-
deductible charitable contributions or through the tax exemption. In addition, more complete
and accurate reporting of unrelated business activities conducted by large organizations would be
improved by requiring independent auditors or counsel to make certain certifications regarding
their review of such organizations' unrelated and other activities.
Description of Proposal
Require public availability of Form 990-T
The proposal extends the present-law public inspection and disclosure requirements and
penalties applicable to the Form 990 to an organization's Form 990-T. The proposal provides
that certain information may be withheld by the organization from public disclosure and
inspection if public availability would adversely affect the organization, similar to the
information that may be withheld under present law with respect to applications for tax
exemption and the Form 990 (e.g., information relating to a trade secret, patent, process, style of
work, or apparatus, of the organization, if the Secretary determines that public disclosure of such
information would adversely affect the organization). The proposal applies to all organizations
required to file a Form 990-T with respect to its unrelated business income.
Require a UBIT certification for certain large organizations
Organizations that normally have annual total gross revenues (including contributions
and grants, program service revenue, investment income, and revenues from an unrelated trade
or business or other sources) or gross assets of at least $10 million must include with its Form
990 and Form 990-T filings (if any) a certification by an independent auditor or by independent
counsel that the organization's filings accurately reflect the unrelated business income tax
liability of the organization for the taxable year.
The certification must attest that the independent auditor or counsel with respect to the
taxable year that is the subject of the return:
(1) has reviewed the trades and businesses of the organization, the organization's
sources of investment income, and the organization's sources of program service
revenues, and determined that the reporting and descriptions of such items as
contained in the Form 990 and, where applicable, Form 990-T, are complete and
accurate;
(2) has determined that the organization's expense allocations between exempt,
unrelated business income activities, and other activities used to determine the
organization's unrelated business income tax comply with the requirements set
forth in Treasury Regulations section 1.512(a)-1;
(3) has or has not reviewed or provided a tax opinion regarding the organization's
treatment of income or an activity under the unrelated business income tax
rules;
(4) has or does not have knowledge that the organization: (a) participated in a
transaction that is a listed transaction (as defined in section 6707A), or a
confidential transaction or a transaction with contractual protection (as defined in
Treasury Regulations issued under section 6011); or (b) received a fee or other
amounts from another party to such a transaction in exchange for participating in
such transaction during the taxable year; and
(5) has or does not have knowledge that the organization participated in a transaction
that is a reportable transaction within the meaning of section 6707A with respect
to the organization, that has not been disclosed by the organization to the IRS.
Failure to satisfy the certification requirement results in a penalty, imposed on the
organization, of one half of one percent (0.5 percent) of the organization's total gross revenues
for the taxable year, excluding revenues from contributions and grants.
Effective Date
The proposal applies to returns filed after the date of enactment.
Discussion
Public availability of Form 990-T
Present law requires public disclosure of certain information pertaining to an exempt
organization's annual information return and exemption application materials. Public access to
such information promotes transparency and accountability with respect to an organization's
exempt activities, but generally does not provide any meaningful information about the
organization's unrelated activities. The purpose of the proposal is to require comparable public
disclosure for all of an exempt organization's activities, not just those treated by the organization
as an exempt activity. Public review of certain information pertaining to an organization's
commercial activities reasonably could be expected to provide an additional safeguard that the
organization's unrelated activities comply with applicable tax laws and that the profits derived
from such activities remain dedicated to its exempt purposes. To protect against public
disclosure of certain proprietary information that could harm the organization, the proposal
provides an exception to public disclosure of such information.
Some might argue that an exempt organization should not be required to disclose to the
public any tax information that it would not be required to disclose if it were a for-profit business
or other taxpayer. Subjecting an exempt organization to public disclosure of information
pertaining to its unrelated trades or businesses arguably puts the organization in a less favorable
position than a taxable party that conducts the same or a comparable activity. Under present law,
however, exempt organizations already are required to disclose certain information with respect
to its annual information returns and application for exemption, because Congress determined
that transparency and public access were important safeguards related to the tax benefits
provided to such organizations. The proposal is consistent with the notion that an exempt
organization should be subject to a heightened standard of care with respect to its reporting and
tax obligations because of its special treatment under the tax laws. The fact that an organization
may pay tax on income from an activity does not lessen the public's need to have available to it
certain information regarding the organization's activities. Some might argue that the
justification for public access to information is even greater with respect to commercial activities
of the organization, because such activities might be more likely to raise issues with respect to
private inurement, private benefit, excess benefit transactions, and other matters that may affect
the organization's exempt status. Further, the tax laws should not permit an organization to
avoid making available to the public certain information regarding its activities by choosing to
treat the activity as an unrelated trade or business, instead of as an exempt activity, regardless of
whether the activity generates income subject to the tax.
UBIT certification for certain large organizations
Exempt organizations often do not provide any meaningful disclosure regarding unrelated
trade or business income or unrelated activities in the financial reports they make available to the
public. This appears to result from the absence of any special financial reporting rules requiring
the disclosure of a nonprofit organization's unrelated business income tax or unrelated activities
in such reports. The extent to which an exempt organization conducts activities that do or
potentially could subject the organization to Federal income tax affects the organization's
financial strength and viability, and thus its ability to carry out its exempt mission. In addition,
some members of the public might benefit from improved information regarding an
organization's nonexempt activities when making decisions whether to provide financial and
other support to such organization.
The proposal attempts to promote more complete and accurate reporting of unrelated
business activities and income by requiring that large organizations (defined as those with annual
gross revenues or assets of at least $10 million) obtain certain reviews and certifications from
independent auditors or counsel with respect to its activities. In addition, the proposal requires
the certifying auditor or counsel to attest to whether it has knowledge regarding whether the
organization has participated in or derived income from listed or reportable transactions. To
encourage compliance with the certification requirement, the proposal imposes a penalty for
failure to satisfy the certification requirements. The amount of the penalty varies with the
amount of the organization's revenues (excluding grants and contributions that are clearly related
to the organization's exempt purposes), and should be substantial enough to encourage
compliance without being unduly harsh. For example, under the proposal, an organization that
has $10 million of annual revenues (regardless of sources) and that fails to satisfy the
certification requirements is liable for a penalty of up to $50,000, depending on the amount of its
revenues other than from contributions and grants. The organization would not be subject to the
penalty if all of its revenues were from contributions and grants.
Based on information relating to reporting year 2000, approximately six percent of public
charities had total assets of at least ten million dollars, and approximately five percent of all
public charities had total revenues of at least that amount. Limiting the certification
requirement to organizations with revenues or assets of at least ten million dollars excludes the
vast majority of charities from the certification requirement, but imposes the requirement on
those organizations with the bulk of the total assets and revenues of all public charities.
Although the measure of the penalty that is imposed for failing to satisfy the certification
requirement is based on revenues (not assets), the certification requirement also applies to large
asset-based organizations with relatively small revenues, in order to expand the scope of review
by outside counsel or auditors. The proposal could be modified to base the penalty on a
percentage of revenues or assets, if that is considered appropriate to increase the level of
compliance.
The proposal requires the organization to provide the certification with both its Form 990
and Form 990-T filings, in order to increase the availability of the information to the public, and
to subject the organization to the certification requirement even if a Form 990-T is not filed with
respect to its unrelated trade or business activities.
J. Expand the Base of the Tax on Private Foundation Net Investment Income
(sec. 4940)
Present Law
In general
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) based on net
investment income and unrelated business income. The two-percent rate of tax is reduced to
one-percent if certain requirements are met in a taxable year. Unlike certain other excise taxes
imposed on private foundations, the tax based on investment income does not result from a
violation of substantive law by the private foundation; it is solely an excise tax.
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 were
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.
Congress enacted section 4940 in 1969 as part of a package of new excise taxes
applicable to private foundations. The legislative history to section 4940 shows different
approaches to the tax in the House and Senate. The House viewed the tax as both an income tax
and a ''user fee'' that would finance the government's oversight of exempt organizations and
proposed a rate of 7.5 percent on net investment income. The Senate favored an ''audit-fee
tax'' based on a percentage of the fair market value of a foundation's assets, and not an income
tax. Under the Senate's view, the level of tax should be set at a rate incident to the cost of
supervision and the tax should not be understood as withdrawal of the income tax exemption.
The bill reported from conference was a compromise: the rate of tax was lowered to four-percent
and the tax was not treated as an income tax or based on the value of a foundation's assets, but
was defined as an excise tax on net investment income. In 1978, the rate was lowered to two
percent in part because Congress determined that the tax was raising more than twice the revenue
needed to finance the IRS's oversight of exempt organizations. Also in 1978, Congress added
''payments with respect to securities loans'' to the definition of gross investment income.
Amounts collected pursuant to the tax based on investment income are not earmarked for
use in administering the tax law for tax-exempt organizations.
Net Investment Income
Internal Revenue Code
In general, net investment income is defined as the amount by which the sum of gross
investment income and capital gain net income exceeds the deductions relating to the production
of gross investment income.
Gross investment income is the gross amount of income from interest, dividends, rents,
payments with respect to securities loans, and royalties. Gross investment income does not
include any income that is included in computing a foundation's unrelated business taxable
income.
Capital gain net income takes into account only gains and losses from the sale or other
disposition of property used for the production of interest, dividends, rents, and royalties, and
property used for the production of income included in computing the unrelated business income
tax (except to the extent the gain or loss is taken into account for purposes of such tax). Losses
from sales or other dispositions of property are allowed only to the extent of gains from such
sales or other dispositions, and no capital loss carryovers are allowed.
Treasury Regulations and case law
The Treasury regulations elaborate on the Code definition of net investment income. The
regulations cite items of investment income listed in the Code, and in addition clarify that net
investment income includes interest, dividends, rents, and royalties derived from all sources,
including from assets devoted to charitable activities. For example, interest received on a student
loan is includible in the gross investment income of a foundation making the loan.
The regulations further provide that gross investment income includes certain items of
investment income that are described in the unrelated business income tax regulations. Such
additional items include payments with respect to securities loans (an item added to the Code in
1978), annuities, income from notional principal contracts, and other substantially similar
income from ordinary and routine investments to the extent determined by the Commissioner.
These latter three categories of income are not enumerated as net investment income in the Code.
The Treasury regulations also elaborate on the Code definition of capital gain net income.
The regulations provide that the only capital gains and losses that are taken into account are (1)
gains and losses from the sale or other disposition of property held by a private foundation for
investment purposes (other than program related investments), and (2) property used for the
production of income included in computing the unrelated business income tax (except to the
extent the gain or loss is taken into account for purposes of such tax).
This definition of capital gain net income builds on the definition provided in the Code
by providing an exception for gain and loss from program related investments and by stating, in
addition, that ''gains and losses from the sale or other disposition of property used for the exempt
purposes of the private foundation are excluded.'' As an example, the regulations provide
that gain or loss on the sale of buildings used for the foundation's exempt activities are not taken
into account for purposes of the section 4940 tax. If a foundation uses exempt income for
exempt purposes and (other than incidentally) for investment purposes, then the portion of the
gain or loss received upon sale or other disposition that is allocable to the investment use is taken
into account for purposes of the tax.
The regulations further provide that ''property shall be treated as held for investment
purposes even though such property is disposed of by the foundation immediately upon its
receipt, if it is property of a type which generally produces interest, dividends, rents, royalties, or
capital gains through appreciation (for example, rental real estate, stock, bonds, mineral interest,
mortgages, and securities).''
This regulation has been challenged in the courts. The regulation says that property is
treated as held for investment purposes if it is of a type that ''generally produces'' certain types of
income. By contrast, the Code provides that the property be ''used'' to produce such income. In
Zemurray Foundation v. United States, the taxpayer foundation challenged the Treasury's
attempt to tax under section 4940 capital gain on the sale of timber property. The taxpayer
asserted that the property was not actually used to produce investment income, and that the
Treasury Regulation was invalid because the regulation would subject to tax property that is of a
type that could generally be used to produce investment income. On this issue, the court upheld
the Treasury regulation, reasoning that the regulation's use of the phrase ''generally used,''
though permitting taxation ''so long as the property sold is usable to produce the applicable types
of income, regardless of whether the property is actually used to produce income or not'' was not
unreasonable or plainly inconsistent with the statute. However, on remand to the district
court, the district court concluded that the timber property at issue, though a type of property
generally used to produce investment income, was not susceptible for such use. Thus, the
district court concluded that the Treasury could not tax the gain under this portion of the
regulation.
The question then turned to the taxpayer's second challenge to the regulation. At issue
was the meaning of the regulatory phrase ''capital gains through appreciation.'' The regulation
provides that if property is of a type that generally produces capital gains through appreciation,
then the gain is subject to tax. The Treasury argued that the timber property at issue, although
held by the court not to be property (in this case) susceptible for use to produce interest,
dividends, rents, or royalties, still was held by the taxpayer to produce capital gain through
appreciation and therefore the gain should be subject to tax under the regulation.
On this issue, the court held for the taxpayer, reasoning that the language of the Code
clearly is limited to certain gains and losses, e.g., the court cited the Code language providing
that ''there shall be taken into account only gains and losses from the sale or other disposition of
property used for the production of interest, dividends, rents, and royalties . . . .'' The court
noted that ''capital gains through appreciation'' is not enumerated in the statute. The court used
as an example a jade figurine held by a foundation. Jade figurines do not generally produce
interest, dividends, rents, or royalties, but gain on the sale of such a figurine would be taxable
under the ''capital gains through appreciation'' standard, yet such standard does not appear in the
statute. After Zemurray, the Treasury generally conceded this issue.
With respect to capital losses, the Code provides that carryovers are not permitted,
whereas the regulations state that neither carryovers nor carrybacks are permitted.
Application of Zemurray to the Code and the regulations
Applying the Zemurray case to the Code and regulations results in a general principle for
purposes of present law: private foundations are subject to tax under section 4940 only on the
items of income and only on gains and losses specifically enumerated therein. Under this
principle, private foundations generally are not subject to the section 4940 tax on other
substantially similar types of income from ordinary and routine investments, notwithstanding
Treasury regulations to the contrary. In addition, the regulations provide that gain or loss from
the sale or other disposition of assets used for exempt purposes, with specific reference to
program-related investments, is excluded. The Code provides for no such blanket exclusion;
thus, under the language of the Code and the reasoning of Zemurray, if a foundation provided
office space at below market rent to a charitable organization for use in the organization's
exempt purposes, gain on the sale of the building by the foundation should be subject to the
section 4940 tax despite the Treasury regulations.
In addition, under the logic of Zemurray, capital loss carrybacks arguably are permitted,
notwithstanding Treasury regulations to the contrary, because the Code mentions only a bar on
use of carryovers and says nothing about carrybacks.
Reasons for Change
The Zemurray case casts doubt on the application of the tax on net investment income of
private foundations beyond the facts of that case. As a result, it is not clear under present law
whether income from certain investments is subject to tax. The proposal clarifies the scope of
the section 4940 tax.
Description of Proposal
The proposal amends the definition of gross investment income to include certain items
of income not presently enumerated in the Code but identified in Treasury regulations, namely,
income from notional principal contracts, annuities, and other substantially similar income from
ordinary and routine investments. In addition, the capital gains and losses subject to the tax are
modified to include capital gains from appreciation, including capital gains and losses from the
sale or other disposition of assets used to further an exempt purpose.
The proposal provides that there are no carrybacks of losses from sales or other
dispositions of property.
Effective Date
The proposal is effective for taxable years beginning after the date of enactment.
Discussion
The proposal takes into account the reasoning of the Zemurray case that the section 4940
tax applies only to the items of income and to capital gains and losses that are specifically
provided in the Code. Thus, the proposal broadens the Code definition of gross investment
income to include other items of investment income that are listed in the Treasury regulations.
By doing so, the proposal protects the tax base by providing certainty for taxpayers and
administrators that income from annuities, notional principal contracts, and other substantially
similar income from ordinary and routine investments are subject to the tax.
The proposal overrides the Treasury regulations to the extent that the regulations provide
that capital gain from the sale or other disposition of assets used to further exempt purposes is
not subject to the tax. Some might argue that subjecting such gain to tax is inconsistent with the
reason for the tax, which is to tax purely investment type income, and not program-related
income. But, the present-law definition of gross investment income subjects to tax any
investment type income, even if the income is from a related activity. The Treasury regulations
explicitly confirm this interpretation, and provide that the interest on a student loan, although
program-related income, is includible in gross investment income. Given that program-related
gross investment income is subject to the tax, consistency argues for subjecting to the tax the
gain or loss on the sale or disposition of property that generates program-related income.
In addition, the proposal expands the definition of capital gain net income to include all
capital gains and losses through appreciation. Arguably, capital gains through appreciation are
similar to capital gains on property held for the production of investment income such as
dividends in that the property generally is used or held for investment purposes. Extending the
tax to include all capital gain through appreciation produces neutrality in the treatment of
investment assets, and is consistent with the Treasury's original interpretation of the statute.
The proposal provides that capital loss carrybacks should not be permitted, consistent
with existing Treasury regulations.
The tax on the net investment income of private foundations originally was intended as a
fee to fund administration of exempt organizations generally. However, there is no evidence that
revenues from the tax affects in any way the amount that is appropriated to the IRS for
administration of programs related to exempt organizations. Thus, the original reason for the tax
is not present, and arguably, the tax could be eliminated. However, ensuring that the tax is
applied evenly among private foundations and does not impose undue administrative burdens on
taxpayers and the IRS is an important consideration when a tax is imposed. Assuming that the
tax on net investment income continues in force, the proposal is intended to rationalize
application of the tax.
K. Limit Tax-Exempt Status of Fraternal Beneficiary Societies that
Provide Commercial-Type Insurance
(sec. 501(c)(8))
Present Law
Fraternal beneficiary societies
A fraternal beneficiary society, order, or association is entitled to tax-exempt status if it
operates under the lodge system or for the exclusive benefit of the members of a fraternity itself
operating under the lodge system, and provides for the payment of life, sick, accident, or other
benefits to the members of such society, order, or association or their dependents (sec.
501(c)(8)). Operating under the lodge system generally means carrying on activities under a
form of organization that comprises local branches, chartered by a parent organization and
largely self-governing, called lodges, chapters, or the like. Separately organized insurance
branches of fraternal societies need not operate under the lodge system, but must provide
permissible benefits exclusively to members of a lodge system. The IRS reported 79,390
fraternal beneficiary societies in its master file for its fiscal year 2003.
Fraternal beneficiary societies were first exempted from Federal income taxation under
the Tariff Act of 1909, which provided that fraternal beneficiary societies, orders, or associations
operating under the lodge system, and providing for the payment of life, sick, accident and other
benefits to the members, were exempt. The Revenue Act of 1913 extended the exemption to
organizations operating for the exclusive benefit of the members of a fraternity itself operating
under the lodge system. The early societies provided members on an informal basis relief
during sickness and unemployment and at death, with fraternal life insurance (i.e., the providing
of death benefits on a more formal basis) appearing in the mid-nineteenth century. The
provision of sickness and accident insurance developed later. The IRS takes the position that
life, sick, accident, and other benefits encompasses those benefits that provide insurance against
the risk of loss of earning power.
In general, the term ''fraternal'' applies to an organization whose members have adopted
the same, or a very similar calling, avocation, or profession, and who for that reason have banded
together to aid and assist one another and to promote a common cause. A fraternal beneficiary
society does not serve a fraternal purpose unless its members engage in fraternal activities.
Rituals, ceremonies, social activities, and the performance of civic, benevolent, or charitable
functions may serve to establish a fraternal purpose. As between fraternal purposes and the
provision of benefits, fraternal purposes need not predominate. It is sufficient if both the
fraternal and benefit features are present, although an organization whose fraternal features are
so insubstantial as to make it indistinguishable from an ordinary insurance company does not
qualify for exemption under section 501(c)(8).
Fraternal beneficiary societies described in section 501(c)(8) generally provide three
types of services or benefits: insurance, fraternal, and charitable. Fraternal activities, by
definition, benefit only members. Charitable activities of fraternal organizations may provide
significant benefits to members and to non-members. A fraternal beneficiary society may
engage in non-fraternal activities or provide non-fraternal benefits, but such activities and
benefits may be taxable as unrelated business income activities, or result in the organization's
loss of exempt status unless the organization remains primarily engaged in fraternal activities
and its benefits are primarily fraternal benefits.
There were approximately 98 tax-exempt fraternal beneficiary societies in 1999 with
assets of approximately $1 million or more, with one such society having assets of
approximately $21 billion. The six largest organizations at that time held $57.8 billion, or 87
percent, of the $66.0 billion total assets of the 98 societies, with the largest organization
having life insurance contracts in force with a face amount of $88 billion, and premium income
of approximately $600 million from life insurance, $826 million from annuities, and $158
million from accident and health insurance.
More recently, 86 of the largest fraternal beneficiary societies reported life insurance in
force of $306.5 billion, life insurance issued during 2003 of $23.8 billion, and premiums and
consideration from life, annuities, and accident and health during 2003 of $7.6 billion.
Following the merger of several of the largest fraternal beneficiary societies, the largest tax-
exempt fraternal beneficiary society had assets of $62.5 billion in 2004.
Although the membership eligibility requirements for these organizations vary, the
common bond or cause that has served as the traditional fraternal purpose (i.e., the same, or a
very similar calling, avocation, or profession, causing persons to band together to aid and assist
one another and to promote a common cause) has eroded and become tenuous. The largest such
organization, Thrivent Financial for Lutherans, requires that a member ''demonstrate a Lutheran
connection,'' either by being a Lutheran or by being a non-Lutheran who satisfies certain
affiliation requirements with respect to a Lutheran organization (including Thrivent). Thrivent's
membership application lists 12 different statuses that entitle a person to membership in the
organization. Another such organization permits a person to become a member if the person is
of the requisite Norwegian or Nordic status by ''descent, marriage, or interest/affiliation.''
Many such organizations, it appears, establish membership based upon the purchase of the
insurance product, and extend fraternal benefits to those persons who become members by virtue
of purchasing the insurance contract.
Insurance activities of certain tax-exempt organizations
An organization described in section 501(c)(3) or (4) (generally including charities and
social welfare organizations) is exempt from tax only if no substantial part of its activities
consists of providing commercial-type insurance (sec. 501(m)). Commercial-type insurance
does not include (1) insurance provided at substantially below cost to a class of charitable
recipients, (2) incidental health insurance provided by a health maintenance organization
(HMO), (3) certain property or casualty insurance or retirement or welfare benefits provided by a
church or convention or association of churches, or (4) charitable gift annuities. Legislative
history refers to case law in defining ''no substantial part.'' This rule was enacted because
Congress was concerned that exempt charitable and social welfare organizations
that engage in insurance activities are engaged in an activity whose nature and
scope is inherently commercial rather than charitable; hence, tax-exempt status is
inappropriate. Congress believed that the tax-exempt status of organizations
engaged in insurance activities provided an unfair competitive advantage to these
organizations. Congress further believed that the provision of insurance at a price
sufficient to cover the costs of insurance generally constitutes an activity that is
commercial. In addition, the availability of tax-exempt status under prior law
allowed some large insurance entities to compete directly with commercial
insurance companies.
The commercial-type insurance provision was enacted in 1986 as part of the legislation
that subjected Blue Cross and Blue Shield organizations to taxation as if they were stock
insurance companies (sec. 833).
At the time that this rule was enacted, Congress also directed the Treasury Department to
conduct a study of organizations described in section 501(c)(8) that received gross annual
insurance premiums in excess of $25 million for 1984. The Treasury study, published in
1993, found that "the insurance activities of fraternal benefit societies are income-producing
activities that are similar in nature and scope to that provided by taxable commercial insurers.
While there are some distinctions, the insurance policies of fraternal benefit societies appear to
serve the same markets as those served by commercial insurers." With respect to the rationale
for tax exemption of fraternal beneficiary societies, the Treasury report stated, ''[f]raternal
benefit societies provide three types of services: insurance, charitable and fraternal. The
insurance activities of the fraternal benefit societies are similar to activities of commercial
insurers and, therefore, do not appear to have significant benefits that have been used in other
contexts to justify tax exemption. The significant external benefits from charitable services, the
redistributive nature of some fraternal services, and the use of the conduit organization form for
providing fraternal services may, however, justify continuation of tax exemption for these [non-
insurance] activities of fraternal benefit societies.''
Reasons for Change
Fraternal beneficiary societies that provide insurance are engaged in an activity whose
nature and scope is inherently commercial rather than fraternal in nature. The tax-exempt status
of fraternal beneficiary societies providing commercial-type insurance gives them an unfair
competitive advantage. Tax-exempt status for such activities is inappropriate.
Description of Proposal
Under the proposal, a fraternal beneficiary society, order, or association is exempt from
tax as an organization described in section 501(c)(8) only if no substantial part of its activities
consists of providing commercial-type insurance. For this purpose, no substantial part has the
same meaning as under the present-law rule, and commercial-type insurance generally is any
insurance of a type provided by insurance companies (including annuities). An organization
that is treated as not exempt from tax under the proposal is subject to tax as if it were an
insurance company, including with respect to its fraternal and other activities. In the case of an
organization that is exempt from tax under the proposal, the activity of providing commercial-
type insurance is treated as an unrelated trade or business, but is taxed under the rules relating to
insurance companies with respect to such activity, rather than under the unrelated business
income tax rules generally applicable to exempt organizations.
Effective Date
The proposal is effective for taxable years beginning after the date of enactment.
Discussion
Congress has recognized that providing commercial-type insurance is a commercial
business activity, and that providing tax-exempt status for organizations that engage in insurance
activities provides an unfair competitive advantage to these organizations. Therefore, tax-
exempt status is not appropriate for an organization unless no substantial part of its activities
consists of providing commercial-type insurance. This is especially the case when the rationale
for providing the exemption for an organization (i.e., that the organization provides benefits
exclusively to members that share a common, fraternal bond) has been eroded, and fraternal
features are incidental to the insurance activity such that the organization is indistinguishable
from a taxable insurance company.
Some might argue that Congress intended to provide tax-exempt status to the insurance
activities of fraternal beneficiary societies, as evidenced by the statutory language referring to the
payment of life, sick, accident, or other benefits to the members by such organizations, while
commercial insurers were subject to income tax under a separate statutory regime also
established by Congress. Under this view, changing the treatment of the insurance activities of
fraternal beneficiary societies would violate the intent of Congress in making them tax-exempt,
and is not appropriate.
On the other hand, it can be said that the commercial-type insurance marketed by tax-
exempt fraternal beneficiary societies has grown substantially since the time such organizations
were originally provided tax exemption in the early part of the last century. The nature of the
commercial insurance business has changed, and the Federal income tax treatment of other
organizations providing commercial insurance has evolved to reflect such changes. These
major changes may justify a reexamination of the original rationale for exempting fraternal
beneficiary societies' insurance activities.
The original fraternal purpose of the organization has been lost if it can effectively
provide insurance to any person. This is the result when membership in the organization carries
with it little benefit from or obligation to the fraternal organization or other members, other than
that which is derived from the insured member being required to pay the insurance premiums
pertaining to the insurance product. It might be argued that in many cases, the connection
between fraternal beneficiary societies and the insurance benefits they provide has changed from
a fraternal society making insurance protection available for its fraternal members, to persons
becoming members of a fraternal organization because they purchase insurance products from
the organization. Put another way, the common bond or cause that once justified making
insurance benefits available to members on an exempt basis has been replaced by a common
bond resulting from the fact that many individuals otherwise lacking a common bond have
chosen to purchase an insurance product from the same organization. Congress implicitly
acknowledged these changes when, in 1986, it requested the Treasury study ''so that Congress
may consider the recommendations and take such action regarding the tax treatment of fraternal
beneficiary societies engaged in insurance activities as is appropriate.''
It could be argued that the fraternal and charitable activities of a fraternal beneficiary
organization are funded or financially made possible by receipts from the organization's
insurance activity, and therefore are inextricably linked to the insurance activity so that
continued tax-exempt status for these organizations would be appropriate. If any taxation were
appropriate, imposition of unrelated business income tax on the insurance business activity
income arguably is all that is required to address the point that such activities are commercial in
nature.
The proposal does provide that the activity of providing commercial-type insurance is
treated as an unrelated trade or business taxed under the insurance company tax rules, if the
insurance activity does not constitute a substantial part of the organization's activities. In those
cases where the insurance activity is a substantial part of the organization's overall activities,
however, merely imposing an unrelated business income tax on the insurance activity does not
adequately address the fundamental nature of the organization as a commercial insurance
company. Further, if the non-insurance activities of the organization may be conducted
separately, those activities may continue to benefit from tax-exempt status under section
501(c)(10) and the proposal.
No size limit or maximum revenue or asset cap is imposed on the insurance activities of
fraternal beneficiary societies under present law. The largest organization reported assets of
$62.5 billion in 2004, with the largest of these organizations increasing in asset size by 38
percent from 1999 to 2003. The exemption with respect to commercial insurance activities of
other large insurers was revoked in 1986, and fraternally organized insurers are the only
significant remaining group of tax-exempt insurers with no significant limitation on the size of
its insurance activities.
Several tax rules permit tax exemption or reduced taxation for some types of insurers
considered small. It may be argued that Congress has evinced an intent not to impose full
income taxation on small insurers, and that taxing the insurance activities of some smaller
fraternal beneficiary societies would violate that intent. However, the proposal does not contain
any special rule or continuation of exempt status for small fraternal insurers. Historically,
exempt status has been provided only for small property and casualty insurers under section
501(c)(15), not for life insurers. The rationale for providing exempt status to small property
and casualty insurers -- that they represented a pooling of risks on a small scale, frequently for
farmers in a small region or in a county with respect to farming risks like hailstorms -- does not
apply to life insurance products or insurers. Indeed, insurance generally requires both risk
shifting and risk distribution, which generally require a large pool of mortality or morbidity risks
in the case of life insurance products; the larger the pool, the more efficiently the risks can be
assessed and priced. Some might argue that providing a small insurer exception under such
circumstances could promote underwriting inefficiencies in the life insurance industry.
Under the proposal, no inference is intended regarding the meaning of commercial-type
insurance for purposes of section 501(m), as it applies to section 501(c)(3) or (c)(4)
organizations.
L. Establish Additional Exemption Standards for Credit Counseling Organizations
(secs. 501(c)(3) and 501(c)(4))
Present Law
Under present law, a credit counseling organization may be exempt as a charitable or
educational organization described in section 501(c)(3), or as a social welfare organization
described in section 501(c)(4). The IRS has issued two revenue rulings holding that certain
credit counseling organizations are exempt as charitable or educational organizations or as social
welfare organizations.
In Revenue Ruling 65-299, an organization whose purpose was to assist families and
individuals with financial problems, and help reduce the incidence of personal bankruptcy, was
determined to be a social welfare organization described in section 501(c)(4). The organization
counseled people in financial difficulties, advised applicants on payment of debts, and negotiated
with creditors and set up debt repayment plans. The organization did not restrict its services to
the poor, made no charge for counseling services, and made a nominal charge for certain services
to cover postage and supplies. For financial support, the organization relied on voluntary
contributions from local businesses, lending agencies, and labor unions.
In Revenue Ruling 69-441, the IRS ruled an organization was a charitable or
educational organization exempt under section 501(c)(3) by virtue of aiding low-income people
who had financial problems and providing education to the public. The organization in that
ruling had two functions: (1) educating the public on personal money management, such as
budgeting, buying practices, and the sound use of consumer credit through the use of films,
speakers, and publications; and (2) providing individual counseling to low-income individuals
and families without charge. As part of its counseling activities, the organization established
debt management plans for clients who required such services, at no charge to the clients. The
organization was supported by contributions primarily from creditors, and its board of directors
was comprised of representatives from religious organizations, civic groups, labor unions,
business groups, and educational institutions.
In 1976, the IRS denied exempt status to an organization, Consumer Credit Counseling
Service of Alabama, whose activities were distinguishable from those in Revenue Ruling 69-441
in that (1) it did not restrict its services to the poor, and (2) it charged a nominal fee for its debt
management plans. The organization provided free information to the general public through
the use of speakers, films, and publications on the subjects of budgeting, buying practices, and
the use of consumer credit. It also provided counseling to debt-distressed individuals, not
necessarily poor or low-income, and provided debt management plans at the cost of $10 per
month, which was waived in cases of financial hardship. Its debt management activities were a
relatively small part of its overall activities. The district court determined the organization
qualified as charitable and educational within section 501(c)(3), finding the debt management
plans to be an integral part of the agency's counseling function, and that its debt management
activities were incidental to its principal functions, as only approximately 12 percent of the
counselors' time was applied to such programs and the charge for the service was nominal. The
court also considered the facts that the agency was publicly supported, and that it had a board
dominated by members of the general public, as factors indicating a charitable operation.
A recent estimate shows the number of credit counseling organizations increased from
approximately 200 in 1990 to over 1,000 in 2002. During the period from 1994 to late 2003,
1,215 credit counseling organizations applied to the IRS for tax exempt status under section
501(c)(3), including 810 during 2000 to 2003. The IRS has recognized more than 850 credit
counseling organizations as tax exempt under section 501(c)(3). Few credit counseling
organizations have sought section 501(c)(4) status, and the IRS reports it has not seen any
significant increase in the number or activity of such organizations operating as social welfare
organizations. As of late 2003, there were 872 active tax-exempt credit counseling agencies
operating in the United States.
A credit counseling organization described in section 501(c)(3) is exempt from certain
Federal and State consumer protection laws that provide exemptions for organizations described
therein. Some believe that these exclusions from Federal and State regulation may be a
primary motivation for the recent increase in the number of organizations seeking and obtaining
exempt status under section 501(c)(3). Such regulatory exemptions generally are not available
for social welfare organizations described in section 501(c)(4).
Congress recently conducted hearings investigating the activities of credit counseling
organizations under various consumer protection laws, such as the Federal Trade Commission
Act. In addition, the IRS has commenced a broad examination and compliance program with
respect to the credit counseling industry, pursuant to which the IRS has initiated audits of 50
credit counseling organizations, including nine of the 15 largest in terms of gross receipts.
Reasons for Change
An entire industry of credit counseling, credit repair, and debt management and debt
consolidation has emerged over the past 30 years, with much of this activity conducted by
nonprofit organizations that initially received favorable exempt status determinations from the
IRS. During this period, judicial decisions relaxed exemption standards for credit counseling
organizations claiming exempt status, ultimately resulting in many organizations conducting
substantial activities that are not directly related to the charitable and educational purposes that
initially formed the rationale for providing exemption from Federal income tax. Activities
such as debt management plan and credit repair services test, and in many instances cross, the
boundaries of what should be permissible activity for a charitable, educational, or social welfare
organization. Although the IRS recently has dedicated substantial resources to address these
organizations, and believes that it can make strong legal challenges to the exempt status of many
of such organizations under present law, legislation to establish exemption standards tailored
to the peculiar aspects of the industry would provide greater certainty that further erosion of
exemption standards does not occur, and strengthen enforcement of Federal and State consumer
protection laws by limiting exemption from those laws to those organizations that satisfy stricter
tax-exemption standards.
Description of Proposal
Additional requirements applicable to all credit counseling organizations
Under the proposal, a nonprofit credit counseling agency or other nonprofit organization
that provides credit counseling, debt management, and similar services, is eligible for exemption
from income tax only as a charitable or educational organization under section 501(c)(3), or as a
social welfare organization under section 501(c)(4). The proposal provides additional
requirements that must be satisfied by a credit counseling organization in order to be an
organization described in section 501(c)(3) or (c)(4). The proposed requirements supplement,
rather than replace, the present-law requirements generally applicable to all organizations
described in section 501(c)(3) or (c)(4).
Under the proposal, a nonprofit credit counseling agency is eligible for exempt status as
an organization described in section 501(c)(3) or (c)(4) only if it is organized and operated in
accordance with the following requirements:
(1) it at all times conducts as its primary activities (a) providing educational
information to the general public on budgeting, personal finance, financial
literacy, saving and spending practices, and the sound use of consumer credit; (b)
assisting individuals and families with financial problems by providing them
counseling tailored to their specific needs and circumstances; or (c) any
combination of such activities;
(2) it makes no loans to debtors, does not negotiate to make loans on behalf of
debtors, and provides no credit repair services (i.e., services for the purpose of
improving any consumer's credit record, credit history, or credit rating);
(3) it may not refuse to provide counseling services to a consumer due to inability to
pay or to qualify for debt management plan enrollment, or because of a
consumer's unwillingness to enroll in a debt management plan;
(4) it limits any debt management plan services to individuals or families for whom a
debt management plan reasonably is determined to be the most appropriate means
to relieve financial distress;
(5) it establishes and implements a fee policy to require that any fees charged to a
consumer for its services are reasonable, and prohibits charging any fee based in
whole or in part on a percentage of the consumer's debt, the consumer's payments
to be made pursuant to a debt management plan, or on projected or actual savings
to the consumer resulting from enrolling in a debt management plan;
(6) it at all times has a board of directors or other governing body (a) that is
controlled by persons who represent the broad interests of the public, such as
public officials acting in their capacities as such, persons having special
knowledge or expertise in credit or financial education, and community leaders;
and (b) not more than 20 percent of the voting power of which is vested in
persons who are employed by the agency or who will benefit financially, directly
or indirectly, from the agency's activities (other than through the receipt of
reasonable directors' fees or the repayment of consumer debt to creditors other
than the credit counseling agency or its affiliates);
(7) it receives no compensation for providing referrals to others for services to be
provided to consumers, and pays no compensation to others for obtaining referrals
of consumers; and
(8) it is not related to a person that is in the business of lending money or that
provides debt management, credit repair, payment processing, and similar
services. For this purpose, a person is treated as related to another person if (1)
such person bears a relationship to such other person described in section 267(b)
(determined without regard to paragraph (9) thereof), or section 707(b)(1),
determined by substituting ''25 percent'' for ''50 percent'' each place it appears
therein, and (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.
Additional requirements for charitable or educational organizations
Under the proposal, a credit counseling agency is exempt as a charitable or educational
organization under section 501(c)(3) only if, in addition to satisfying the above requirements, it
is organized and operated such that (1) it charges no fees (other than nominal fees) for services
provided to low-income individuals and families and for credit counseling or educational
services, and waives any fees if payment of such fees would work a financial hardship; (2) it
does not solicit voluntary contributions from its clients during the initial counseling process or
while the client is receiving services from the agency; (3) the provision of debt management plan
services to a consumer is in connection with providing counseling and education services to such
consumer; (4) the aggregate of the agency's debt management plan services (measured by time,
resources, effort expended by the agency, and any other factors prescribed by the Secretary)
during the four-year period that includes the agency's current taxable year and the immediately
preceding three taxable years does not exceed 10 percent of the agency's total activities during
such four-year period; and (5) it satisfies all other requirements of section 501(c)(3).
Additional requirements for social welfare organizations
Under the proposal, a nonprofit credit counseling agency is eligible for exempt status as
an organization described in section 501(c)(4) only if, in addition to satisfying the above
requirements applicable to such organizations, it is organized and operated such that: (1) it
charges no fees (other than nominal fees) for its credit counseling and educational services, and
waives any fees if payment of such fees would work a financial hardship; and (2) satisfies the
other requirements of section 501(c)(4).
A comparison of the proposal's requirements for the two types of organizations, and to
present law, is contained in the following table.
Table 3.''Comparison of Proposed and Present Law
Description of
Activity or
Requirement
Present Law
Standards
Proposed (c)(3)
Standards
Proposed (c)(4)
Standards
Counseling and
education activities
Legally required, but
such activities have
diminished in practice
as the industry has
changed
Education and
counseling must be
primary activity
Education and
counseling must be
primary activity
Extent of debt
management plan
(DMP) activities
permitted
No clear standards
DMP services for a
consumer must be in
connection with
counseling and
education provided to
such consumer, and
limited to those for
whom a DMP is the
most appropriate
means to relieve
distress; agency's
aggregate DMP
activities cannot
exceed 10% of total
activities for rolling
four-year period
(based on time,
resources, effort)
DMP services for a
consumer must be
limited to those for
whom a DMP is the
most appropriate
means to relieve
distress; DMP
activities cannot be
primary activity
Credit repair activities
permitted to be
performed
Probably limited to
insubstantial
activities, but no clear
standards
Prohibited
Prohibited
Lending and loan
negotiation activities
that are permitted
No clear standards
Prohibited
Prohibited
Services and fees for
poor or low-income
persons
No clear standards
Exemption is not
dependent upon
providing services to
low-income persons;
may not refuse to
provide counseling
services to a
consumer unwilling to
pay, must charge no
or nominal fees for
education and
counseling services
for low-income
persons, and must
waive any fees for any
service that would
work a hardship
Exemption is not
dependent upon
providing services to
low-income persons;
may not refuse to
provide counseling
services to a
consumer unwilling to
pay, and must waive
any fees for any
service that would
work a hardship; may
charge more than
nominal fees to low-
income persons
Overall fee policy
No clear standards
Required to have a fee
policy that any fee
that may be charged
must be reasonable in
relation to the services
provided; certain fee
arrangements are
prohibited
Required to have a fee
policy that any fee
that may be charged
must be reasonable in
relation to the services
provided; certain fee
arrangements are
prohibited
Fees that may be
charged for
counseling and
education
No clear standards
No more than nominal
fees may be charged
for such services
No more than nominal
fees may be charged
for such services
Fees that may be
charged for debt
management services
No clear standards
No more than nominal
fees may be charged
for such services if
provided to low
income persons
Fees must be
reasonable in relation
to the services
provided
Fees that may be
charged for credit
repair services
No clear standards,
but such fees probably
constitute unrelated
business income
None permitted; such
activities are
prohibited
None permitted; such
activities are
prohibited
Compensation for
referrals
No clear standards
Cannot pay or receive
compensation for
referrals of consumers
Cannot pay or receive
compensation for
referrals of consumers
Board composition
requirements
No special rules
Board must be
controlled by persons
who represent the
broad public interest,
and no more than 20%
of its members may
be persons who
directly or indirectly
receive financial
benefits from the
organization's
activities
Board must be
controlled by persons
who represent the
broad public interest,
and no more than 20%
of its members may
be persons who
directly or indirectly
receive financial
benefits from the
organization's
activities
Related party rules
(lending of money,
payment processing,
debt management,
other services)
No special rules
Organization cannot
be related to a lender
of money, or to a
provider of payment
processing, debt
management, or
similar services
Organization cannot
be related to a lender
of money, or to a
provider of payment
processing, debt
management, or
similar services
Effective Date
The proposal is effective for taxable years beginning after the date of enactment,
regardless of when the organization was formed or received a determination letter that it was an
exempt organization.
Discussion
The primary rationale of the proposal is that judicial interpretations of the application of
generally applicable exempt organization law to credit counseling organizations have eroded the
meaning of charitable and educational in this industry, which ultimately led to the
commercialization of an industry that is largely operated in nonprofit form. An overly expansive
definition of ''charitable or educational'' with respect to credit counseling organizations means
that some organizations have improperly avoided paying Federal income tax on their income and
activities. In addition, and perhaps equally important, such organizations have escaped Federal
and State consumer protection regulation under the erroneous assumption that Federal tax-
exempt status has provided sufficient regulatory oversight to identify and address misconduct
and mismanagement, thereby eliminating the need for non-tax regulation of such organizations.
The Congressional hearings and IRS compliance and enforcement efforts have reported
numerous areas of abuse in the industry, many of which implicate Federal tax exemption
policy. Many credit counseling organizations now conduct as their primary activity, and
derive most of their revenues from, debt management planning and other activities that are at
best only tangentially related to the counseling and educational missions they purport to serve.
Relationships with for-profit entities, many of which were established by organizers and
managers of the credit counseling organization, reportedly have siphoned off commercial profits
of the exempt organization to the for-profit entity, and then been used to pay significant salaries
and dividends to the for-profit's employees and owners. Many organizations have been charging
consumers substantial fees for services, in some cases based on potential savings a consumer
might derive from being placed on a debt management plan, with some initial advance fees
equaling the entire first month's payment under the plan. Boards of directors often do not
represent the communities the organizations are supposed to serve.
The proposal's additional organizational and operational requirements are designed to
address these reported areas of abuse and concern. The proposal subjects both types of exempt
organizations (charitable or educational and social welfare) to many of the same requirements,
but makes certain distinctions with respect to the fees that may be charged by each to low-
income persons, and the extent to which an organization may conduct debt management plan
activities. More stringent requirements for charitable or educational organizations apply because
such status generally has heightened standards when compared with social welfare organizations
described in section 501(c)(4).
The material aspects of the proposal are consistent with the legal and factual conclusions
reached by the IRS in its legal memorandum released in July 2004. In that memorandum, the
IRS concluded that many credit counseling organizations do not qualify for exemption under
section 501(c)(3) because of operation for a substantial nonexempt purpose, substantial private
benefit, and private inurement. The memorandum stated that the marketing of debt management
plans is ''by far the most substantial activity'' of many organizations the IRS has reviewed. The
proposal addresses debt management plans by imposing strict fee limits on the amount
consumers may be charged for such services, and limiting the amount of such activities that
may be conducted on an ongoing basis (i.e., no more than 10 percent of total activities if a
charitable or educational organization, no more than 50 percent if a social welfare organization).
The 10-percent limit applicable to charitable and educational organizations comports with the
traditional levels of such activity before the dramatic growth in the industry.
Two areas discussed in the IRS memorandum are not explicitly addressed in the proposal.
First, the memorandum concluded that if debt management plan activity of an organization is
insubstantial, income from such activities should be examined on a case by case basis to
determine whether such income should be taxed as unrelated business income. The proposal
does not modify the treatment of debt management plan income as unrelated business income,
and relies on present law to determine whether an organization's income from such activities
should be taxed. Thus, under the proposal, an organization that conducts its debt management
activities in accordance with the proposed requirements could be subject to the unrelated
business income tax on none, some or all of its income (if any) derived from such activities,
depending upon its facts and circumstances. Second, the IRS noted that service arrangements
between a credit counseling organization and unrelated organizations could raise private benefit
issues. The proposal addresses related party service arrangements by prohibiting them, but does
not explicitly limit or prohibit such arrangements with unrelated service providers. Although
service arrangements with unrelated providers may raise private benefit issues, the proposal
relies upon the generally applicable private benefit doctrine to address such arrangements.
Similar unrelated business income tax and private benefit concerns exist throughout the exempt
organization sector, and arguably any reforms in these two areas should be applied more broadly
across the exempt sector. The proposal attempts to address those areas that have contributed to
the erosion of exemption standards in the credit counseling industry.
Some might argue that the proposal unfairly targets a particular industry, and that the
exempt status rules for credit counseling organizations should be the same as for other types of
exempt organizations. However, the Code contains various special exemption standards for a
particular type of industry or organization. For example, the Code provides special exemption
standards for cooperative hospital service organizations (sec. 501(e)), cooperative service
organizations of operating educational organizations (sec. 501(f)), certain amateur sports
organizations (sec. 501(j)), certain child care organizations (sec. 501(k)), and charitable risk
pools (sec. 501(n)), in order to be treated as a charitable organization described in section
501(c)(3). Further, some might argue that imposing supplemental exemption standards on the
credit counseling industry is appropriate where, as is the case here: (1) the nontax regulation of
an entire industry is dependent upon whether the organization is exempt as a charitable or
exempt organization; (2) systematic abuses have been reported by Congress and the IRS with
respect to much of the industry; and (3) prior attempts by the IRS to prevent erosion of
traditional exempt standards were rejected by the courts.
IX. TAX-EXEMPT BOND PROVISIONS
A. Impose Loan and Redemption Requirements on Pooled Financing Bonds
(sec. 149)
Present Law
In general
Section 103 generally provides that gross income does not include interest received on
State or local bonds. State and local bonds are classified generally as either governmental
bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are
primarily used to finance governmental facilities or the debt is repaid with governmental funds.
Private activity bonds are bonds in which the State or local government serves as a conduit
providing financing to nongovernmental persons (e.g., private businesses or individuals). To
qualify for the tax exemption, the Code imposes requirements that apply to all State and local
bonds. Arbitrage restrictions, for example, limit the ability of issuers to profit from investment
of tax-exempt bond proceeds. In addition, the exclusion from income for State and local bonds
does not apply to private activity bonds, unless the bonds are issued for certain permitted
purposes. The Code also imposes requirements that only apply to specific types of bond issues.
For instance, pooled financing bonds (defined below) are not tax-exempt unless the issuer meets
certain requirements regarding the expected use of proceeds.
Pooled financing bond restrictions
At times, State or local bonds are issued to provide financing for the benefit of a third
party (a ''conduit borrower''). Pooled financing bonds are issues in which the proceeds are used
to make or finance loans to two or more conduit borrowers, unless the conduit loans are to be
used to finance a single project. The Code imposes several requirements on pooled financing
bonds if more than $5 million of proceeds are expected to be used to make loans to conduit
borrowers. For purposes of these rules, a pooled financing bond does not include certain private
activity bonds.
A pooled financing bond is not tax-exempt unless the issuer reasonably expects that at
least 95 percent of the net proceeds will be lent to ultimate borrowers by the end of the third year
after the date of issue. The term ''net proceeds'' is defined to mean the proceeds of the issue less
the following amounts: (1) proceeds used to finance issuance costs; (2) proceeds necessary to
pay interest on the bonds during a three-year period; and (3) amounts in reasonably required
reserves.
An increase in interest rates or anticipated changes in Federal income tax laws may not
be used as a basis for the issuer's reasonable expectations regarding the lending of proceeds to
borrowers. Moreover, the legislative history to the pooled financing provision states the
''investment of bond proceeds in guaranteed investment contracts which do not permit significant
draw downs to originate loans during the three-year period will be prima facie evidence that the
reasonable expectations test is not satisfied.'' An issuer's past experience regarding loan
origination is a criterion upon which the reasonableness of the issuer's expectations can be
based. As an additional requirement for tax exemption, all legal and underwriting costs
associated with the issuance of pooled financing bonds may not be contingent and must be
substantially paid within 180 days of the date of issuance.
Arbitrage restrictions on tax-exempt bonds
To prevent the issuance of more Federally subsidized tax-exempt bonds than necessary;
the tax exemption for State and local bonds does not apply to any arbitrage bond. 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. 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 (''arbitrage rebate'').
The Code contains several exceptions to the arbitrage rebate requirement, including an
exception for bonds issued by small governments (the ''small issuer exception''). For this
purpose, small governments are defined as general purpose governmental units that issue no
more than $5 million of tax-exempt governmental bonds in a calendar year.
Pooled financing bonds are subject to the arbitrage restrictions that apply to all tax-
exempt bonds, including arbitrage rebate. Under certain circumstances, however, small
governments may issue pooled financing bonds without those bonds counting towards the
determination of whether the issuer qualifies for the small issuer exception to arbitrage rebate. In
the case of a pooled financing bond where the ultimate borrowers are governmental units with
general taxing powers not subordinate to the issuer of the pooled bond, the pooled bond does not
count against the issuer's $5 million limitation, provided the issuer is not a borrower from the
pooled bond. However, the issuer of the pooled financing bond remains subject to the
arbitrage rebate requirement for unloaned proceeds.
Reasons for Change
A number of pooled financing bonds have been issued recently under which few or no
loans were made to conduit borrowers from bond proceeds. A common feature of these
transactions is the use of non-binding demand surveys that fail to adequately identify potential
borrowers or evaluate current financing needs. Many of these transactions involve large
issuances by small local governments that receive a fee to act as the issuer of the pooled
financing. Because these local governments do not borrow proceeds from the pool, present law
permits them to issue pooled financing bonds without those bonds counting towards the
determination of whether they qualify for the small issuer exception to arbitrage rebate. These
transactions result in greater issuance of tax-exempt bonds than necessary to finance current
governmental activities, diminishing the utility and value of the tax subsidy.
Description of Proposal
In general
The proposal imposes new requirements on pooled financing bonds as a condition of tax-
exemption. First, the proposal imposes a written loan commitment requirement to restrict the
issuance of pooled bonds where potential borrowers have not been identified (''blind pools'').
Second, in addition to the current three-year expectations requirement, the issuer must
reasonably expect that at least 50 percent of the net proceeds of the pooled bond will be lent to
borrowers one year after the date of issue. Third, the proposal requires the redemption of
outstanding bonds with proceeds that are not loaned to borrowers within the expected loan
origination periods. Finally, the proposal eliminates the rule allowing an issuer of pooled
financing bonds to disregard the pooled bonds for purposes of determining whether the issuer
qualifies for the small issuer exception to rebate.
Borrower identification
Under the proposal, interest on a pooled financing bond is tax exempt only if the issuer
obtains written commitments with ultimate borrowers for loans equal to at least 50 percent of the
net proceeds of the pooled bond prior to issuance. For purposes of the proposal, a loan
commitment exists only if: (a) the issuer is committed to lend bond proceeds to the borrower
identified in the commitment, and (b) the borrower has applied for, and agreed to execute, a loan
in an amount certain to finance a specifically identified project and, as part of that application,
has paid a nonrefundable commitment fee in an amount that is commensurate with fees
customarily paid for similar loan commitments.
Loan origination expectations
The proposal imposes new reasonable expectations requirements for loan originations.
The issuer must expect that at least 50 percent of the net proceeds of the pooled bond will be lent
to ultimate borrowers one year after the date of issue. This is in addition to the present-law
requirement that at least 95 percent of the net proceeds will be lent to ultimate borrowers by the
end of the third year after the date of issue.
Redemption requirement
Under the proposal, if bond proceeds are not loaned to borrowers within prescribed
periods, outstanding bonds equal to the amount of proceeds that were not loaned within the
required period must be redeemed in the following six months. This effectively imposes an
actual loan origination requirement in addition to the reasonable expectations tests. The bond
redemption requirement applies with respect to excess proceeds that are unoriginated as of
expiration of the one-year and three-year loan origination periods. For example, if an amount
equal to 45 percent of the net proceeds of an issue are used to make loans to ultimate borrowers
as of one year after the bonds are issued, an amount equal to five percent of the net proceeds of
the issue is no longer available for lending and must be used to redeem bonds within the
following six-month period. Similarly, if only 85 percent of the net proceeds of the issue are
used to make qualifying loans (or to redeem bonds) as of three years after the bonds are issued,
10 percent of the remaining net proceeds is no longer available for lending and must be used to
redeem bonds within the following six months.
Small issuer exception
The proposal eliminates the rule disregarding pooled financing bonds from the issuer's
$5,000,000 annual limitation for purposes of the small issuer exception to arbitrage rebate.
Effective Date
The proposal is effective for bonds issued after the date of enactment.
Discussion
The Code excludes interest on State and local government bonds from tax to enable these
governments to finance their activities at a lower cost than that provided in the taxable debt
market. The underlying premise of this exemption is that tax-subsidized borrowing will be
limited to amounts for which actual and immediate financing requirements are demonstrated,
either for direct governmental activities or for those statutorily enumerated private activities for
which tax-exemption is permitted. Issuing more bonds and issuing bonds earlier than what is
otherwise necessary to accomplish the governmental purpose of the borrowing have the effect of
overburdening the tax-exempt bond market and diminishing the value of the subsidy.
Pooled financing bonds raise special concerns because such bonds generally are not
issued to meet the financing requirements of the issuer, but of the borrowers from the pool who
may or may not be identified at the time of issuance. Thus, if a prospective issuer of a pooled
financing bond fails to adequately evaluate the level of demand and likelihood of participation
for potential borrowers from the pool, such a financing may result in greater and/or earlier
issuance of tax-exempt bonds than necessary to meet current financing needs.
Congress previously addressed concerns relating to pooled financing bonds when it
added section 149(f) to the Code as part of the Technical and Miscellaneous Act of 1988.
Section 149(f) was a response to the increased issuance of tax-exempt bonds in cases in which no
immediate financing requirements were demonstrated. Congress found that, in many cases,
pooled financing bonds were issued not to meet current financing needs of identified borrowers,
but rather to ''lock-in'' low interest rates. This issuance of tax-exempt bonds without an
expectation of using proceeds for a current governmental purpose was viewed as an
inappropriate use of the subsidy. Congress stated that tax-exempt bonds should be issued only
when the proceeds are needed to finance a legitimate purpose and, even then, only for relatively
current financing needs. Section 149(f) reflects that intent by prohibiting the issuance of tax-
exempt pooled financing bonds without reasonable expectations that 95 percent of net proceeds
will be used to make loans to conduit borrowers within three years.
Although not included in the final provision, the original House bill that led to the
enactment of section 149(f) would have required identification of borrowers from pooled
financings as a condition of tax-exemption. This was intended to address findings that pool-
bond arrangements were frequently issued based on demand surveys, rather than written loan
commitments. Demand surveys are conducted in advance of issuance of pooled financing bonds
to indicate a potential demand for loans, but typically do not bind potential borrowers or lenders.
The House Committee on Ways and Means noted that the failure to identify and bind borrowers
through written loan commitments contributed to the overissuance of pooled financing bonds.
The borrower identification requirement was not included in section 149(f), but the Conference
Report states that the Treasury Department is to monitor blind pools to assure conformity with
pooled financing restrictions.
The present-law restrictions on pooled financing bonds have not eliminated concerns
associated with this financing method. As publicly reported, examinations conducted by both
IRS and State regulators have revealed a number of instances where pooled financing bonds
were issued but few or no loans were made from bond proceeds. For example, a Florida General
Auditor report released in 2003 studied eight tax-exempt pooled bond issuances and found that in
seven of the eight deals approximately 91 percent of the bond proceeds had not been loaned.
The IRS also has been examining pooled financings since the mid-1990s. During that time, it
has examined numerous pooled financing transactions where only small percentages of bond
proceeds were loaned to borrowers. The IRS has stated that it would continue to devote
significant resources to address concerns with pooled financings, focusing its efforts on those
transactions where few loans were made and where participants received large fees.
A common characteristic of those transactions in which few loans were made is the use
of non-binding demand surveys to justify issue size. In many cases, it was found that issuers
relied on demand surveys that made only a minimal effort to evaluate the likelihood of
participation of potential borrowers or to identify projects requiring financing. Demand surveys
conducted in this manner are likely to overestimate financing needs, resulting in excessive
issuance of pooled financing bonds. Identifying borrowers by obtaining binding loan
commitments prior to issuance will eliminate many of the sizing problems caused by faulty
demand surveys. While increased enforcement efforts or the adoption of objective standards for
conducting demand surveys may improve issuers' expectations, issuing bonds primarily on the
basis of non-binding surveys is less likely to accurately measure current financing needs than
written loan commitments that are accompanied by a nonrefundable commitment fee.
Imposing pre-issuance administrative requirements, such as written loan commitments,
may increase the costs of issuance and, therefore, reduce the economic benefits of issuing bonds
on a pooled basis. However, a loan commitment requirement does not impose new costs, but
simply shifts the timing of those costs from post-issuance to pre-issuance. Furthermore, the
continued issuance of pooled financing bonds in which issuers are unable to demonstrate an
immediate financing need warrants restrictions on blind pools. On the other hand, there may be
circumstances when it is impractical for issuers to obtain loan commitments from all potential
borrowers prior to issuance. For example, many pooled financings are issued through State bond
pools that issue bonds more frequently than small local governments. The largest programs may
issue bonds ten or more times each year. In these cases, requiring written loan commitments
from all borrowers prior to issuance may prove burdensome. Therefore, to provide issuers
continued flexibility when sizing bond issues while simultaneously addressing the concerns
raised by blind pools, the proposal requires loan commitments equal to at least 50 percent of the
net proceeds of the issue.
The proposal also imposes new expectations requirements for loan originations. In
addition to the present-law 95 percent requirement, the issuer must expect that at least 50 percent
of the net proceeds of the pooled bond will be lent to ultimate borrowers one year after the date
of issue. Because pooled bonds provide financing for multiple projects, all on different
timetables, a one-year origination requirement will restrict borrowers' access to pooled
financings, create a need for smaller, more frequent issuances, and may reduce the savings that
borrowers realize through pooled financings. However, this requirement will limit the period
that bond proceeds remain unspent and will provide additional assurance that pooled financing
bonds are only issued for relatively current financing needs. Moreover, curbing excessive
issuances will lessen the overall burden on the tax-exempt market, which will ultimately
decrease local governments' borrowing costs.
Although written loan commitments and additional reasonable expectations requirements
will curtail excessive issuances, these requirements will not eliminate all concerns with pooled
financing bonds. For example, there will be many reasons why a prospective borrower might
ultimately decide not to, or be unable to, borrow from a pool despite submitting a ''binding'' loan
commitment. Assuming substitute borrowers are not found in such a case, there will be greater
issuance of tax-exempt bonds than necessary, even though the issuer's expectations were
reasonable at the time of issuance. Furthermore, identifying borrowers without imposing a time
limit for originating loans does not address concerns with respect to bonds that are issued earlier
than necessary. Thus, the proposal requires the redemption of outstanding bonds with proceeds
that are not loaned to borrowers within the one-year or three-year loan origination periods.
The redemption requirements might be criticized on the grounds that they do not provide
the flexibility needed when pooled bonds are issued to finance the projects of multiple
borrowers. In general, mandatory redemption requirements may cause a need for more frequent
issuances of pooled bonds, which will either increase borrowers' costs or simply deny some
small governments access to pooled funds. Redemption requirements, however, will provide
additional assurance that pooled financing bonds are only issued for current financing needs and
will remain outstanding for the minimum period necessary to meet those needs. In addition, the
proposal addresses the issue of flexibility by requiring the redemption of only those proceeds that
are required to be loaned within the specified origination periods. Therefore, if 45 percent of the
net proceeds of an issue are used to make loans to ultimate borrowers as of one year after the
bonds are issued, only five percent of the net proceeds of the issue must be used to redeem bonds
within the following six-month period and the remaining proceeds may continue to be used to
originate loans within the three-year origination period.
Finally, the proposal requires issuers to count pooled financing bonds towards the $5
million small issuer limitation for rebate purposes. Many of the larger pooled financing bonds
where few or no loans were made were issued by small local governments that received a fee to
act as the pool issuer. In addition to the receipt of compensation, a local government is willing to
issue pooled bonds because doing so generally does not impact whether the issuer qualifies for
the small issuer exception to arbitrage rebate. Eliminating the rule allowing an issuer to
disregard pooled financing bonds for purposes of qualifying for the small issuer exception will
remove some of the incentive to issuing pooled bonds at the local level where there is generally
less oversight of such financings. In the short term, the proposal may reduce small
governments' access to pooled funds; particularly in States that do not issue pooled bonds, as
certain local governments will no longer issue pool bonds. However, pooled financing bonds
will still be available to small governments, both as issuers and borrowers. The proposal does
not prevent local governments from issuing pooled bonds; rather it limits the ability of a local
government to act merely as an accommodation party when issuing pooled bonds and forces
issuers to consider their own financing needs before engaging in these transactions.
B. Amend Information Reporting Requirements to Include
Interest on Tax-Exempt Bonds
(sec. 6049)
Present Law
Tax-exempt bonds
Generally, gross income does not include interest on State or local bonds. State and
local bonds are classified generally as either governmental bonds or private activity bonds.
Governmental bonds are bonds the proceeds of which are primarily used to finance
governmental facilities or the debt is repaid with governmental funds. Private activity bonds are
bonds in which the State or local government serves as a conduit providing financing to
nongovernmental persons (e.g., private businesses or individuals). The exclusion from income
for State and local bonds does not apply to private activity bonds, unless the bonds are issued for
certain purposes (''qualified private activity bonds'') permitted by the Code.
Tax-exempt interest reporting by taxpayers
The Code provides that every person required to file a return must report the amount of
tax-exempt interest received or accrued during any taxable year. There are a number of
reasons why the amount of tax-exempt interest received is relevant to determining tax liability
despite the general exclusion from income. For example, the interest income from qualified
private activity bonds (other than qualified 501(c)(3) bonds) issued after August 7, 1986, is a
preference item for purposes of calculating the alternative minimum tax (''AMT''). Tax-
exempt interest also is relevant for determining eligibility for the earned income credit (the
''EIC'') and the amount of Social Security benefits includable in gross income. Moreover,
determining includable Social Security benefits is necessary for calculating either adjusted or
modified adjusted gross income under several Code sections. Thus, the amount of tax-exempt
interest paid to taxpayers is germane to these provisions as well.
Information reporting by payors
The Code generally requires every person who makes payments of interest aggregating
$10 or more or receives payments of interest as a nominee and who makes payments aggregating
$10 or more to file an information return setting forth the amount of interest payments for the
calendar year and the name, address, and TIN of the person to whom interest is paid.
Treasury regulations prescribe the form and manner for filing interest payment information
returns. Penalties are imposed for failures to file interest payment information returns or payee
statements. Treasury Regulations also impose recordkeeping requirements on any person
required to file information returns. The Code excludes interest paid on tax-exempt bonds
from the interest payment reporting requirements.
Tax-exempt bond enforcement
The IRS begins examinations of tax-exempt bonds at the issuer level, rather than through
the examination of individual bondholders. This is done largely as a matter of administrative
convenience because the issuer of tax-exempt bonds is more likely to have information with
respect to the transaction. However, if the IRS makes a determination that interest on a bond
sold as tax-exempt is taxable, bondholders, not issuers, are the parties whose tax liability is
affected.
Reasons for Change
Although generally exempt from tax, the amount of interest received on tax-exempt
bonds is pertinent to a number of tax determinations, including AMT liability, taxable Social
Security benefits, and eligibility for the EIC. For this reason, under present law, taxpayers are
required to report the amount of tax-exempt interest received during the taxable year. Issuers of
tax-exempt bonds, however, are not required to file information returns identifying the recipients
of interest payments. The lack of a reporting requirement for interest payments on qualified
private activity bonds may lead to incorrect reporting and erroneous calculations of tax liability
by individual taxpayers.
Moreover, the lack of a reporting requirement increases the administrative burdens
confronted by the IRS in the examination of tax-exempt bonds. Individual bondholders, rather
than issuers, are the parties whose tax liability is affected by the determination that a bond issued
as tax-exempt is taxable. The IRS may have to invest significant resources in learning the names
of the bondholders whose liability is affected by such a determination. Most issuers contract
with a third-party to make interest payments to bondholders. Present law requires the IRS to
begin judicial proceedings to obtain bondholder names from third parties.
Description of Proposal
Option 1
Under the proposal, issuers of tax-exempt bonds are required to file information returns
identifying the amount of interest payments in a calendar year and the name, address, and TIN of
the person to whom interest is paid. The recordkeeping requirement imposed on issuers as
persons required to file information returns may be satisfied by contracting with a third party to
maintain the necessary information at the time bonds are issued.
Option 2
An alternative proposal is to require the production of payee information from the issuer
of any tax-exempt bond upon request of the IRS. Similar to the first option, the proposal permits
issuers to satisfy the requirement by contracting with a third party to maintain and provide the
necessary records.
Under either option, penalty provisions for failure to file correct information returns
and for failure to furnish correct payee statements, would be amended to apply to interest on
tax-exempt bonds.
Effective Date
The proposal is effective for bonds issued after the date of enactment.
Discussion
The first option requires issuers to report annually the names, addresses, and TINs of
payees and the amount of interest paid on tax-exempt bonds. Present law requires taxpayers to
report the amount of tax-exempt interest received during the taxable year, but issuers of tax-
exempt obligations are not required to file information returns with respect to interest paid. The
proposal ensures that taxpayers have sufficient information to meet present-law reporting
requirements. In addition, as discussed above, the amount of tax-exempt interest received is
important to a number of tax determinations. Providing taxpayers with this information will
reduce erroneous reporting and enhance tax compliance. Although the proposal imposes a new
administrative requirement and cost on issuers of State and local bonds, issuers or their agents
are currently required to know the holders of outstanding bonds in order to make scheduled
interest payments. Therefore, the reporting requirement should not be unduly burdensome or
costly. Moreover, imposing information reporting requirements on State and local governments
is not novel. State and local governments generally are required to make information returns
with respect to taxable payments. The administrative burden imposed on State and local
governments by the proposal should be no greater than that imposed by present-law reporting
requirements for other types of payments. The burden is not disproportionate to the benefit State
and local governments receive in the form of the Federal tax exemption for State and local
bonds.
The information return requirement of the proposal subjects issuers to present-law
recordkeeping requirements for such information. To lessen the administrative burdens imposed
on issuers, the proposal permits issuers to satisfy the recordkeeping requirement by contracting
with a third party to maintain the necessary records.
Rather than filing payee information returns on an annual basis, the second option is to
require issuers of all State and local bonds to maintain interest payee information for production
upon request of the IRS. Requiring issuers of tax-exempt bonds to maintain information
regarding interest payments (i.e., payee names, addresses, TINs, and amount of interest received)
and produce that information upon request of the IRS, will lessen the administrative burdens
confronted by the IRS in the examination of tax-exempt bond transactions. This additional
recordkeeping requirement may create a burden on some issuers. In addition, the burden is
likely to be greatest for small issuers with fewer resources to implement recordkeeping controls.
However, issuers or parties acting on their behalf must know the identity of bondholders to make
scheduled interest payments. Further, as with the first option, the proposal will lessen the
administrative burden by permitting issuers to satisfy the requirement by contracting with a third
party to maintain the necessary records and produce them upon request by the IRS.
Either an information reporting requirement or information production requirement will
require a penalty regime to ensure compliance. The penalty provisions for failure to file correct
information returns and for failure to furnish correct payee statements could be amended to apply
to tax-exempt bonds under either alternative.
C. Clarify Limitations on Indian Tribes' Use of Tax-Exempt Bond Proceeds
(sec. 7871)
Present Law
Under present law, gross income does not include interest on State or local bonds.
State and local bonds are classified generally as either governmental bonds or private activity
bonds. Governmental bonds are bonds the proceeds of which are primarily used to finance
governmental facilities or the debt is repaid with governmental funds. Private activity bonds are
bonds in which the State or local government serves as a conduit providing financing to
nongovernmental persons. For these purposes, the term ''nongovernmental person'' includes the
Federal government and all other individuals and entities other than States or local
governments. Interest on private activity bonds is taxable, unless the bonds are issued for
certain purposes permitted by the Code and other requirements are met.
In many cases, State or local bonds are issued to provide financing to a third party (a
''conduit borrowing''). In a conduit borrowing, a State or local government issues bonds and
loans the proceeds to a conduit borrower who then repays the loan in such amounts, and at such
times to allow the issuer to make debt service payments on the bonds.
Although not States or subdivisions of States, Indian tribal governments are provided
with a tax status similar to State and local governments for specified purposes under the Code.
Among the purposes for which a tribal government is treated as a State is the issuance of tax-
exempt bonds. However, bonds issued by tribal governments are subject to limitations not
imposed on State and local government issuers. Tribal governments are authorized to issue tax-
exempt bonds only if substantially all of the proceeds are used for essential governmental
functions or certain manufacturing facilities.
Reasons for Change
Indian tribal governments may only issue tax-exempt bonds to finance essential
governmental functions or certain manufacturing facilities. Despite this limitation, there have
been reports of transactions in which State or local governments issued tax-exempt bonds as a
conduit borrowing and loaned the proceeds to Indian tribes to finance the construction of
gambling casinos. The transactions reportedly ranged in size from $10 million to over $300
million. These transactions were promoted as tax-exempt because legal opinions were
provided concluding that the restrictions on bonds financing the activities of tribal governments
do not apply where the tribe is the conduit (rather than direct) borrower of bond proceeds.
Moreover, the use of conduit borrowings have been promoted as a method for avoiding the
essential governmental function requirement for bonds issued by Indian tribal governments.
Description of Proposal
Under the proposal, section 7871, which allows Indian tribes to finance projects with tax-
exempt bonds subject to certain limitations, is amended to clarify that it applies whether an
Indian tribal government is a conduit borrower or an issuer of tax-exempt bonds.
Effective Date
The proposal is effective for bonds issued after the date of enactment.
Discussion
In 1982, Congress passed the Indian Tribal Government Tax Status Act (the ''Act'')
adding section 7871 to the Code and permitting tribal governments to issue tax-exempt bonds for
limited purposes. Prior to the Act, the IRS had taken the position that obligations issued by a
tribal government were not tax exempt under section 103, in part, because tribes exercise their
authority by virtue of Federal rather than State authority. Congress, however, recognized that
many tribal governments have financing needs and perform governmental functions similar to
State and local governments and, thus, should have the ability to issue tax-exempt bonds to
finance certain governmental functions. The legislative history to the Act indicates that tribal
governments' authority to issue bonds should be limited to the financing of essential
governmental functions such as ''schools, streets, and sewers.'' Moreover, the legislative
history clearly states that tribal governments are prohibited from issuing all types of private
activity bonds.
As part of the Omnibus Budget Reconciliation Act of 1987 (''OBRA 1987''), Congress
amended section 7871 to expressly provide that tribal governments' authority to issue tax-
exempt bonds is limited to the financing of activities ''customarily performed by State and local
governments with general taxing powers.'' The additional restrictions were in response to
concerns that tribal government bonds were being issued for purposes that were commercial,
rather than governmental in nature. The legislative history to OBRA 1987 provides both an
explanation of the concerns Congress was addressing and clarification of tribal governments'
authority to issue bonds:
Issuance of bonds to finance commercial or industrial facilities (e.g., private rental
housing, cement factories, or mirror factories) which bonds technically may not
be private activity bonds is not included within the scope of the essential
governmental function exception . . . [T]he committee wishes to stress that only
those activities that are customarily financed with governmental bonds (e.g.,
schools, roads, government buildings, etc.) are intended to be within the scope of
this exception, notwithstanding that isolated instances of a State or local
government issuing bonds for another activity may occur.
Section 7871 places clear limitations on the ability of Indian tribes to issue tax-exempt
bonds and the conduit financing transactions discussed above are attempts to circumvent present
law. Thus, the proposal clarifies that the essential governmental function requirements of section
7871 apply whether an Indian tribal government is a direct issuer of tax-exempt bonds or a
conduit borrower of bond proceeds. The proposal ensures that Indian tribes cannot use tax-
exempt conduit financing for activities that cannot be directly financed with tax-exempt bonds
issued by an Indian tribe.
In some cases, Indian tribes may borrow funds at a lower rate through a conduit
borrowing than if they were to issue bonds directly. Therefore, the proposal has no impact on
the ability of Indian tribes to enter into legitimate conduit borrowing transactions with States or
local governments. Rather, the proposal simply clarifies the intent of Congress and provides that
Indian tribes must use the proceeds of tax-exempt bonds in the same manner whether they are
direct issuers of such bonds or conduit borrowers.
D. Eliminate Private Payment Test for Stadium Bonds
(sec. 141)
Present Law
In general
Under present law, gross income does not include interest on State or local bonds. State
and local bonds are classified generally as either governmental bonds or private activity bonds.
Governmental bonds are bonds the proceeds of which are primarily used to finance
governmental functions or the debt is repaid with governmental funds. Private activity bonds are
bonds in which the State or local government serves as a conduit providing financing to
nongovernmental persons (e.g., private businesses or individuals). The exclusion from income
for State and local bonds does not apply to private activity bonds, unless the bonds are issued for
certain purposes (''qualified private activity bonds'') permitted by the Code and other Code
requirements are met.
Private activity bond tests
In general
The Code defines a private activity bond as any bond that satisfies (1) the private
business use test and the private security or payment test (''the private business test''); or (2) ''the
private loan financing test.''
Two-part private business test
Under the private business test, a bond is a private activity bond if it is part of an issue in
which:
(1) More than 10 percent of the proceeds of the issue (including use of the bond-
financed property) are to be used in the trade or business of any person other
than a governmental unit (''private business use test''); and
(2) More than 10 percent of the payment of principal or interest on the issue is,
directly or indirectly, secured by (a) property used or to be used for a private
business use or (b) to be derived from payments in respect of property, or
borrowed money, used or to be used for a private business use (''private
payment test'').
A bond is not a private activity bond unless both parts of the private business test (i.e., the
private business use test and the private payment test) are met.
A contract between a private management or other service company and a governmental
unit to operate bond-financed governmental facilities may result in private business use
depending on the terms of the contract. In general, a management contract gives rise to
private business use if the compensation under the contract is based on net profits. Contracts for
service incidental to the facility's primary functions, such as janitorial, office equipment repair
and similar services, are not considered management contracts. Certain contracts involving
hospital-admitting privileges, operation of public utility property, and expense reimbursements
are not treated as management contracts.
For purposes of the private payment test, both direct and indirect payments made by any
private person treated as using the financed property are taken into account. Payments by a
person for the use of proceeds generally do not include payments for ordinary and necessary
expenses (within the meaning of section 162) attributable to the operation and maintenance of
financed property.
Private loan financing test
A bond issue satisfies the private loan financing test if proceeds exceeding the lesser of
$5 million or five percent of such proceeds are used directly or indirectly to finance loans to one
or more nongovernmental persons.
Types of qualified private activity bonds
The list of activities that may be financed with qualified private activity bonds has
increased to 20 from the 12 originally defined by the Revenue and Expenditure Control Act of
1968. Under present law, a qualified private activity bond is a qualified mortgage, veterans'
mortgage, small issue, student loan, redevelopment, 501(c)(3), or exempt facility bond. To
qualify as an exempt facility bond, 95 percent of the net proceeds must be used to finance: (1)
airports; (2) docks and wharves; (3) mass commuting facilities; (4) high-speed intercity rail
facilities; (5) facilities for the furnishing of water; (6) sewage facilities; (7) solid waste disposal
facilities; (8) hazardous waste disposal facilities; (9) qualified residential rental projects; (10)
facilities for the local furnishing of electric energy or gas; (11) local district heating or cooling
facilities; (12) environmental enhancements of hydroelectric generating facilities; (13) qualified
public educational facilities; or (14) qualified green building and sustainable design projects.
Reasons for Change
In 1986, Congress eliminated a provision expressly allowing tax-exempt financing for
sports facilities. Nevertheless, professional sports facilities continue to be financed with tax-
exempt bonds despite the fact that privately owned sports teams are the primary (if not
exclusive) users of such facilities. This is because present law permits the use of tax-exempt
bond proceeds for private activities if either part of the two-part private business test is not met.
In the case of bond-financed professional sports facilities, issuers have intentionally structured
the tax-exempt bond issuance and related transactions to fail the private payment test. In most of
these transactions, the professional sports team is not required to pay for more than a small
portion of its use of the sports facility. As a result, the private payment test is not met and the
bonds financing the facility are not treated as private activity bonds, despite the existence of
substantial private business use.
Description of Proposal
The proposal eliminates the private payment test for professional sports facilities. Under
the proposal, bonds issued to finance a professional sports facility are taxable private activity
bonds if more than 10 percent of the proceeds of the issue (including use of the bond-financed
property) are to be used in the trade or business of any person other than a governmental unit,
regardless of the amount of private security or private payments received with respect to such
use. A professional sports facility is defined as real property or related improvements used, in
whole or in part, for professional sports. Use for professional sports includes any use by a
nongovernmental person for sports exhibitions, games, or training which generates monetary
benefit.
Effective Date
The proposal is effective for bonds issued after the date of enactment.
Discussion
As part of the Tax Reform Act of 1986 (the ''1986 Act''), Congress adopted the private
activity bond rules in response to concerns that a significant amount of proceeds from
governmental bonds were being used to finance private activities. The issuance of tax-exempt
bonds to finance private activities was viewed as an inefficient use of the Federal subsidy that
increased the cost of financing traditional government activities. Therefore, Congress
expressed its intent to restrict the diversion of governmental bond proceeds for private purposes
not specifically authorized to receive tax-exempt financing.
Present law, however, permits tax-exempt financing of facilities primarily used by private
persons if bonds fail either prong of the private business test; the private business use test or the
private payment test. By requiring that both the use and payment tests be met before a bond is
a taxable private activity bond, Congress effectively authorized the issuance of tax-exempt bonds
to finance private activities in situations in which the taxpayers, rather than private parties, are
the obligors on the debt. As a result, present law permits the use of bond proceeds for private
activities that Congress has not specifically approved to benefit from the indirect Federal subsidy
provided through tax exemption.
For example, prior to the 1986 Act, the Code expressly allowed tax-exempt financing for
sports facilities. The 1986 Act discontinued this express authority by eliminating a provision
that treated sports facilities as exempt activities eligible for tax-exempt financing.
Municipalities, however, continue to subsidize sports facilities using tax-exempt bonds. This is
because stadiums qualify for tax-exempt financing under present law even if the bonds providing
such financing exceed either the 10 percent private business use test or the 10 percent private
payment test, but not both. Use by a professional sports team almost always will cause the
private business use test to be met, so a stadium bond (to be tax-exempt) must be structured so
that debt service is primarily paid from sources other than stadium revenues or other private
payments. Because only one prong of the private business test is satisfied in such cases, the
bonds are not treated as private activity bonds. In effect, present law virtually requires that if a
stadium is to be financed with tax-exempt bonds, a municipality must enter an arrangement
granting a professional sports team use of the stadium at terms substantially more favorable than
market value.
The proposal addresses the ability of municipalities to transfer the benefits of tax-exempt
financing to professional sports teams by eliminating the private payment test for the financing
of professional sports facilities. Under the proposal, bonds issued to finance a professional
sports facility are private activity bonds if more than 10 percent of the proceeds of the issue are
to be used in the trade or business of any person other than a governmental unit, without regard
to whether the bonds were secured by private payments. Arguably, the proposal is simply
corrective because Congress previously eliminated the provision allowing sports facilities to be
treated as exempt activities and, thus, intended to disallow the tax-exempt financing of such
facilities. However, the 1986 Act has no express prohibition on financing sports facilities with
tax-exempt governmental bonds. Thus, whether such prohibition was contemplated and intended
by the elimination of the prior-law authorization for sports facilities financings may be subject to
interpretation. In adopting the two-part private business test, it might be argued that Congress
intended to allow tax-exempt financing for any facility, including stadiums, provided the private
activity bond limitations are followed.
On the other hand, sports facility financings are anomalous; the relative scarcity of
professional sports teams enables team owners to convince State and local officials to pledge
public funds (e.g., through tax-exempt financing) either to lure teams to an area or to entice them
to stay. Present law encourages these arrangements by requiring the repayment of bonds to
derive from sources other than the sports facility or the professional team if such a facility is to
be financed with tax-exempt obligations. By offering tax-exempt financing, however, State and
local governments use the Federal subsidy to compete with other municipalities for professional
sports teams. Moreover, pledging public funds to the repayment of tax-exempt bonds not only
permits issuers to avoid the restrictions on private business use, but also causes more of the
benefit of tax-exempt financing to be transferred to private parties in these transactions, a result
that is inconsistent with the purpose of the subsidy.
With respect to governmental bonds, present law generally permits State and local
governments to determine the types of projects for which tax-exempt financing is appropriate.
By prohibiting a particular type of facility, the proposal imposes some restrictions on the ability
of States and local governments to make these independent determinations. Nevertheless, the tax
exemption for State and local bonds represents a Federal subsidy. There are numerous examples
in the Code of circumstances in which Congress determined it appropriate to limit the subsidy.
The limitation imposed by the proposal is appropriate because it prevents tax-exempt financing
of one type of facility, professional sports facilities, for which there is generally substantial
private business use. Finally, the proposal does not prevent States and local governments from
subsidizing sports facilities through the use of public funds; it merely prevents the use of the
Federal subsidy in such cases.
The transfer of tax-exempt financing benefits to private parties is not unique to stadium
bonds and, thus, the private payment test could be eliminated for all bonds. Tax-exempt
governmental bonds are issued to finance a variety of privately used facilities including,
corporate industrial parks and parking garages. Similar to stadium financings, bonds financing
these privately used facilities typically may be structured to fail the private payment test. As
discussed above, the ability to finance private activities with tax-exempt governmental bonds
reduces the efficiency and equity of the Federal subsidy. In addition to transferring the benefit of
the subsidy to private parties, tax-exempt financing for private activities increases the volume of
tax-exempt bonds and, thus, increases the cost of financing essential governmental services.
Although specified activities may be financed under the qualified private activity bond rules,
Congress expressed its intent that tax-exempt bonds for private persons should be limited, to the
extent possible, to activities for which financing specifically has been approved. Eliminating the
private payment test for all bonds would limit the ability of State and local officials to divert
governmental bond proceeds to private activities and improve the efficiency of the subsidy.
Conversely, the current two-part private business test provides State and local
governments with flexibility to finance unspecified facilities if they make a determination to
subsidize the facilities with public payments. For example, State and local governments often
utilize the skills of private businesses to assist in the provision of government services by
entering into public-private partnerships. Public-private partnerships are entered either because
the issuer does not customarily provide the services offered by the arrangement or the issuer can
achieve cost savings through the use of a private provider. Moreover, a number of facilities are
used simultaneously by both private parties and the public, which raises difficult questions as to
the measurement of the private business use of such facilities. Under present law, public-private
facilities that serve a legitimate governmental purpose can be structured to fail the private
payment test, thus, eliminating the question whether the privately used portion of a facility would
cause bonds to be taxable. Although many of these concerns could be addressed through private
use allocation rules, existing rules would need to be reexamined, and possibly new rules adopted
if a one-part private business test were implemented for all tax-exempt bonds. The current
proposal is limited to professional sports facilities because it reflects Congressional intent to
restrict the tax-exempt financing of such facilities, and because sports facilities have been
identified as one type of facility primarily used by private businesses.
E. Require Allocation of Volume Cap to Mortgage Credit Certificates Based
on Allocation of Volume Cap to Mortgage Bonds
(secs. 25 and 143)
Present Law
In general
Under present law, gross income does not include interest on State or local bonds. State
and local bonds are classified generally as either governmental bonds or private activity bonds.
Governmental bonds are bonds the proceeds of which are primarily used to finance
governmental functions or the debt is repaid with governmental funds. Private activity bonds are
bonds in which the State or local government serves as a conduit providing financing to
nongovernmental persons (e.g., private businesses or individuals). The exclusion from income
for State and local bonds does not apply to private activity bonds, unless the bonds are issued for
certain permitted purposes (''qualified private activity bonds'').
Qualified mortgage bonds
The definition of a qualified private activity bond includes a qualified mortgage bond.
Qualified mortgage bonds are issued to make mortgage loans to qualified mortgagors for the
purchase, improvement or, rehabilitation of owner-occupied residences. Typically, these bonds
are issued by State or local housing agencies that use the proceeds either to purchase or originate
mortgage loans at below market rates. The debt service on qualified mortgage bonds and other
administrative costs generally are repaid from mortgage payments from individuals who receive
loans from the bond proceeds, investment income from bond proceeds, and fees that may be
charged to program participants (i.e., lenders, developers, and mortgagors).
The Code imposes several limitations on qualified mortgage bonds which include income
limitations for homebuyers, purchase price limitations for the home financed with bond
proceeds, and a requirement that the homebuyer not have an ownership interest in a principal
residence in the preceding three years (the ''first time homebuyer'' requirement). Generally the
mortgagor's family income cannot exceed 115 percent of the applicable median family income.
Adjustments are made for targeted area residences, for areas that have high housing costs in
relation to income, and for family size. Further, 95 percent or more of the net proceeds of
qualified mortgage bonds must be used to finance residences for first-time homebuyers.
Exceptions are made for financing of targeted area residences, qualified home improvement
loans, and qualified rehabilitation loans.
A residence financed with qualified mortgage bonds may not have a purchase price in
excess of 90 percent of the average area purchase price for that residence. Adjustments are made
for targeted area residences and the number of families for which a residence is designed. A
targeted area residence is one located in either (1) a census tract in which at least 70 percent of
the families have an income which is 80 percent or less of the state-wide median income or (2)
an area of chronic economic distress. For targeted area residences, the income requirement is
satisfied when no more than one-third of the targeted area loans are made without regard to any
income limits and the remainder of the targeted area mortgages are made to mortgagors whose
family income is 140 percent or less of the applicable median family income. The first time
homebuyer requirement does not apply to targeted area residences. In addition, the purchase
price limitation is raised from 90 percent to 110 percent of the average area purchase price for
targeted area residences.
Part or all of the interest subsidy provided by qualified mortgage bonds is recaptured if
the borrower experiences substantial increases in income and disposes of the subsidized
residence within nine years after purchase.
The Code also contains special arbitrage rules that permit issuers of qualified mortgage
bonds to recover issuance and program costs. Generally, tax-exempt bond proceeds may not be
invested in investments that exceed the bond yield by more than one-eighth of one percentage
point (.125 percent). However, qualified mortgage bond proceeds may be invested in mortgages
with an effective interest rate that does not exceed the bond yield by more than one and one-
eighth percentage points (1.125 percent).
Volume cap for qualified mortgage bonds
The amount of qualified private activity bonds that can be issued annually by all
authorized issuers in a State is limited by the State's ceiling. A State's ceiling is allocated among
the authorized issuers within a State to determine the maximum amount of qualified private
activity bonds that each authority is permitted to issue in a calendar year (''volume cap''). Most
qualified private activity bonds, including qualified mortgage bonds, are subject to volume cap
limitations. Most States have set up agencies or programs for allocating volume cap. If an
issuing authority's volume cap for a calendar year exceeds the aggregate amount of tax-exempt
private activity bonds issued during the year, the authority may elect to treat all (or any portion)
of the excess as a carryforward for one or more carryforward purposes. The issuing authority is
required to identify the purpose for which the carryforward is elected and specify the portion of
the carryforward which is to be used for that purpose. The Code defines ''carryforward purpose''
to mean four different purposes, including issuing qualified mortgage bonds or mortgage credit
certificates. Carryforwards are valid for three years.
Mortgage credit certificates
Qualified governmental units can elect to exchange all or a portion of their qualified
mortgage bond authority for authority to issue mortgage credit certificates (''MCCs''). MCCs
entitle homebuyers to a nonrefundable income tax credit for a specified percentage of interest
paid on mortgage loans on their principal residences. The tax credit provided by the MCC may
be carried-forward for three years. Once issued, a MCC generally remains in effect as long as
the residence being financed is the certificate-recipient's principal residence. MCCs generally
are subject to the same eligibility and targeted area requirements as qualified mortgage bonds.
Each MCC is required to represent a credit for at least 10 percent (but not more than 50
percent) of interest paid or incurred during the taxable year on qualifying mortgage indebtedness.
The actual dollar amount of an MCC depends on the amount of qualifying interest paid during
any particular year and the applicable certificate credit percentage. If the credit percentage
exceeds 20 percent, however, the dollar amount of the credit received by the taxpayer for any
year may not exceed $2,000. The three-year carry-forward is not permitted for amounts in
excess of the $2,000. The recapture rules for qualified mortgage bonds also apply to MCCs if
the homeowner experiences substantial increases in income and disposes of the subsidized
residence within nine years after purchase.
When a homebuyer receives an MCC, the homebuyer's deduction for interest on the
qualifying indebtedness is reduced by the amount of the credit. For example, a homebuyer
receiving a 50-percent credit, and making $4,000 of qualifying mortgage interest payments in a
given year, would receive a $2,000 credit and a deduction for the remaining $2,000 of interest
payments.
The aggregate amount of MCCs distributed by an electing issuer cannot exceed 25
percent of the volume of qualified mortgage bond authority exchanged by the State or local
government for authority to issue MCCs. For example, a State that was authorized to issue $200
million of qualified mortgage bonds, and that elected to exchange $100 million of that bond
authority, could distribute an aggregate amount of MCCs equal to $25 million.
Reasons for Change
MCCs provide a more efficient and stable mechanism for delivering the tax subsidy to
potential homebuyers than qualified mortgage bonds. Despite this, the program is not widely
used. For example, in 2002, $4.6 billion of qualified mortgage bonds were issued, representing
about 15 percent of States' private activity bond volume, compared to $356.2 million of MCCs,
representing about one percent of 2002 private activity bond capacity. The efficiencies that
may be achieved through increased use of MCCs warrant requiring issuers to dedicate a portion
of bond authority to the issuance of MCCs.
Description of Proposal
The proposal requires State and local issuing authorities to dedicate volume cap to the
issuance of MCCs in an amount that would permit the issuance of one dollar of MCCs for every
four dollars of qualified mortgage bonds issued. Issuers are still required to exchange bond
authority for MCC authority at present law rates. To illustrate, the proposal requires an issuer
that has received an allocation of volume cap to issue $200 million of qualified mortgage bonds
to allocate $100 million of that bond authority to the issuance of $25 million of MCCs (based on
the present-law rate of exchange). Therefore, under the proposal, the issuer is permitted to issue
$100 million of qualified mortgage bonds and $25 million of MCCs.
The second element of the proposal is to raise the dollar limitation on the maximum
annual credit that may be claimed when the MCC rate is greater than 20 percent from $2,000 to
$3,000. This makes the MCC program more usable for homebuyers.
Effective Date
The proposal requiring issuers to dedicate a portion of volume cap to the issuance of
MCCs based on the amount of volume cap allocated to qualified mortgage bonds is effective for
allocations made after the first December 31st that is at least six months after the date of
enactment.
The proposal to increase the maximum annual credit is effective for elections to issue
MCCs made after the date of enactment.
Discussion
The primary purpose for the subsidy for qualified mortgage bonds, mortgage assistance
to lower-income homebuyers, has not been efficiently and effectively achieved. Much of the
benefit of the subsidy provided by qualified mortgage bonds accrues to the bondholders and pays
the administrative costs of running the programs.
In 1984, Congress provided States and localities the alternative of distributing MCCs in
lieu of issuing a specified amount of mortgage bonds. Congress indicated that the nature of tax-
exempt financing makes it difficult to target the subsidy provided by qualified mortgage bonds to
those most in need of housing assistance. This is because qualified mortgage bonds spread the
subsidy between the homebuyer, bondholders, issuers, and other financial parties to the
transaction.
MCCs, in contrast, are allocated by State or local housing agencies and do not require
access to debt or equity markets. Typically, homebuyers receive credits directly from State or
local housing agencies after qualifying for a mortgage from a conventional lender. The holder of
the MCC takes a tax credit for a specified percentage of home mortgage interest paid during the
taxable year. In this way, MCCs direct the full subsidy to homebuyers. Thus, MCCs may
provide State and local issuing authorities greater flexibility in targeting the subsidy to those
individuals who are most in need. The MCC also provides a more uniform subsidy for all
homeowners. For example, low-income homeowners are less likely to itemize deductions.
Increased use of MCCs would also extend the subsidy to those homeowners who currently use
the standard deduction and do not benefit from the mortgage interest deduction.
Despite the benefits MCCs can provide, the program generally is underutilized.
Relatively small amounts of MCCs are issued compared to the volume of qualified mortgage
bonds that are issued for single-family housing. For example, MCC issuances in 2002
represented just one percent of States' private activity bond capacity, whereas qualified mortgage
bond issuances represented about 15 percent of private activity bond capacity in that year. One
reason for the disparity in volume is that issuers are required to exchange mortgage bond
authority for the authority to issue MCCs. Issuers may be reluctant to forgo the opportunity to
issue qualified mortgage bonds because they have the ability to defray the costs of issuing such
bonds and administering mortgage programs through the arbitrage permitted under present law.
There is no similar method for issuers to recover the costs of issuing MCCs and, thus, issuers
bear the administrative costs of issuing MCCs in lieu of qualified mortgage bonds.
However, the costs associated with issuing MCCs are low compared to issuing qualified
mortgage bonds. MCCs do not require access to the credit markets and provide a fairly simple
alternative to the complex and expensive process (e.g., underwriter's costs and counsel fees) of
issuing bonds. In addition, MCCs arguably provide a more stable delivery of the tax subsidy.
The decision to issue qualified mortgage bonds is interest rate sensitive. Housing finance
agencies typically are willing to issue qualified mortgage bonds when interest rates plus
permitted arbitrage allow sufficient earnings to recover the costs of issuing the bonds and
administering the mortgage program. In contrast, MCCs, lacking the arbitrage potential of
qualified mortgage bonds, are less sensitive to interest rate changes and would provide a more
predictable method for delivering the subsidy. The issuance history of some States demonstrates
that MCCs provide a viable alternative to the issuance of qualified mortgage bonds, despite the
lack of a mechanism for recovering costs. For example, California allocated nearly $700 million
of qualified private activity bond authority to single-family housing programs in 2003 and nearly
38 percent of that was allocated to issuing MCCs. In 2002, approximately 30 percent of the
bond authority that California allocated to single-family programs was allocated to MCCs.
The experience in California suggests that MCCs are a workable alternative to qualified
mortgage bonds.
Because MCCs can deliver the same amount of subsidy, if not more, to targeted
individuals than qualified mortgage bonds (for example, issuers can adjust the credit rate on
MCCs to provide more or less of a subsidy, depending on the targeted individuals), it is more
efficient to require issuers to dedicate a portion of their bond authority to the issuance of MCCs
in relation to the amount of authority allocated to qualified mortgage bonds. Increased use of
MCCs will provide a more uniform subsidy for homebuyers and will reduce the spreading of the
subsidy to other financial parties. Increased use of MCCs also will provide a more stable method
for delivering the subsidy to homebuyers in interest rate environments where qualified mortgage
bonds would not be economically viable.
To make MCCs more usable for homebuyers, the proposal also raises the dollar
limitation on the maximum annual credit that may be claimed from $2,000 to $3,000. The
$2,000 cap has not been raised since the MCC program was adopted in 1984. Since that time,
housing prices have increased significantly and the Treasury recently revised the average area
purchase price safe-harbors to reflect this increase. Raising the dollar limitation will make it
more likely for holders, even those purchasing homes in areas with lower average purchase
prices, to receive something closer to the full amount of the credit when the credit rate exceeds
20 percent.
F. Eliminate Advance Refunding of Governmental Bonds and 501(c)(3) Bonds
(sec. 149(d))
Present Law
Section 103 generally provides that gross income does not include interest received on
State or local bonds. State and local bonds are classified generally as either governmental bonds
or private activity bonds. Governmental bonds are bonds the proceeds of which are primarily
used to finance governmental facilities or the debt is repaid with governmental funds. Private
activity bonds are bonds in which the State or local government serves as a conduit providing
financing to nongovernmental persons (e.g., private businesses or individuals). Bonds issued
to finance the activities of charitable organizations described in section 501(c)(3) (''qualified
501(c)(3) bonds'') are one type of private activity bond. The exclusion from income for interest
on State and local bonds only applies if certain Code requirements are met.
A refunding bond is defined as any bond used to pay principal, interest, or redemption
price on a prior bond issue (the refunded bond). The Code contains different rules for ''current''
as opposed to advance refunding bonds. A current refunding occurs when the refunded bond is
redeemed within 90 days of issuance of the refunding bonds. Conversely, a bond is classified as
an advance refunding if it is issued more than 90 days before the redemption of the refunded
bond. Proceeds of advance refunding bonds are generally invested in an escrow account and
held until a future date when the refunded bond may be redeemed.
Although there is no statutory limitation on the number of times that tax-exempt bonds
may be currently refunded, the Code limits advance refundings. Generally, governmental bonds
and qualified 501(c)(3) bonds may be advance refunded one time. Private activity bonds,
other than qualified 501(c)(3) bonds, may not be advance refunded at all. Furthermore, in the
case of an advance refunding bond that results in interest savings (e.g., a high interest rate to low
interest rate refunding), the refunded bond must be redeemed on the first call date 90 days after
the issuance of the refunding bond that results in debt service savings (the ''first call
requirement'').
Reasons for Change
Advance refunding bonds represent an inefficient subsidy from the Federal government
to State and local governments and section 501(c)(3) organizations because they result in two or
more issues of tax-exempt bonds outstanding simultaneously for the financing of a single
activity. For example, if tax-exempt bonds are issued to finance a building and a second issue of
tax-exempt bonds is issued to advance refund the first bonds, the Federal government bears a
revenue loss on both issues of bonds, resulting in a double subsidy for the same building.
Providing multiple subsidies for a single activity also increases the volume of outstanding tax-
exempt bonds, thus increasing borrowing costs on other issuers of tax-exempt debt.
Description of Proposal
The proposal eliminates advance refundings of governmental bonds and 501(c)(3) bonds.
Effective Date
The proposal is effective for the advance refunding of bonds issued after the date of
enactment. This would permit advance refunding of bonds outstanding on the date of enactment
under present law limitations.
Discussion
Typically, the issuer of a tax-exempt bond uses an advance refunding (or current
refunding) to take advantage of market interest rates that are lower than the interest rate
prevailing when the refunded bond was issued. An advance refunding allows the issuer to lock-
in lower interest expense during a period when the refunded bond cannot be redeemed prior to
maturity.
From the Federal government's perspective, the primary concern with advance refunding
bonds is that it results in two or more issues of tax-exempt bonds outstanding with respect to a
single facility (e.g., the construction of a city hall). Because the proceeds of advance refunding
bonds are invested in an escrow account until the refunded debt may be redeemed, an ''[a]dvance
refunding results in multiple issues of bonds outstanding simultaneously and thereby results in
multiple indirect Federal subsidies attributable to tax-exempt financing for a single activity.''
The ability to issue tax-exempt advance refunding bonds also subsidizes the call
protection that issuers of State and local bonds typically provide. For example, some of the
factors that impact the interest cost on a bond issue are the credit rating, the years to maturity,
and the presence or absence of a call provision. An issuer's interest costs are generally lower
when bonds are issued with call protection, which is a defined period that a bond cannot be
redeemed. This is because an investor typically will accept a lower interest rate if that interest
rate is guaranteed for the call protection period. Long-term fixed rate tax-exempt bonds are
commonly issued with a ''no call'' period extending ten years from the date of issue. During that
no-call period, it is not possible to do a current refunding and the ability to do an advance
refunding on a tax-exempt basis may prove valuable to the issuer should interest rates decline.
Taxpayers, however, bear the cost when call provisions provided by issuers result in longer
periods in which two issues of tax-exempt bonds remain outstanding simultaneously.
Congress eliminated advance refundings for most private activity bonds based on the
rationale that they are inefficient and increase borrowing costs on other issuers of tax-exempt
debt. Present law permits one advance refunding of governmental bonds and qualified
501(c)(3) bonds. Elimination of the remaining category of tax-exempt advance refunding bonds
will equalize the treatment for all tax-exempt bonds. The proposal also lessens the volume of
outstanding tax-exempt bonds, thus, making the subsidy of tax-exemption generally more
efficient.
State and local government finance officers have argued that advance refundings provide
a valuable and frequently used financing tool for most municipal issuers. While it is true that
issuers may achieve interest rate savings under the current rules, these interest rate savings are
not without cost to the general taxpayer. The interest subsidy created through tax exemption
costs the Federal government and other issuers when multiple sets of bond are outstanding for
the same facility. As a result of the proposal, issuers also may allow themselves greater
flexibility to currently refund bonds by reducing the length of call protection provided when
bonds are originally issued.
The proposal is effective for the advance refunding of bonds issued after the date of
enactment. Bonds that are currently outstanding are likely to have been structured with the
expectation they could be advance refunded at a later date. Thus, the proposal allows issuers to
advance refund bonds outstanding on the date of enactment under present law limitations.
X. EXCISE TAXES
A. Modify the Federal Excise Tax on Communications Services
(secs. 4251-4254)
Present Law
In general
A three-percent Federal excise tax is imposed on amounts paid for communications
services (sec. 4251). Communications services are defined as ''local telephone service,'' ''toll
telephone service,'' and ''teletypewriter exchange service.'' The person paying for the service
(i.e., the consumer) is liable for payment of the tax. Service providers are required to collect the
tax; however, if a consumer refuses to pay, the service provider is not liable for the tax and is not
subject to penalty for failure to collect if reasonable efforts to collect have been made. Instead,
the service provider must report the delinquent consumer's name and address to the IRS, which
then must attempt to collect the tax.
Local telephone service is defined as the provision of voice-quality telephone access to a
local telephone system that provides access to substantially all persons having telephone stations
constituting a part of the local system.
Toll telephone service is defined as voice quality communication for which (1) there is a
toll charge that varies with the distance and elapsed transmission time of each individual call and
payment for which occurs in the United States, or (2) a service (such as a wide area telephone
service, or ''WATS'') which, for a periodic charge (determined as a flat amount or upon the basis
of total elapsed transmission time), entitles the subscriber to an unlimited number of telephone
calls to or from an area outside the subscriber's local system area.
Special rules, enacted in 1997, apply to the sale of ''prepaid telephone cards.'' These
cards are subject to tax when a telecommunications carrier sells them to a non-
telecommunications carrier (rather than when communication services are provided to the
consumer). The base to which the tax is applied is the face amount of the card.
Exemptions
Present law provides for the following exemptions:
* Public coin-operated service from the tax on local telephone service, and to the extent
that the charge is less than 25 cents, from the toll telephone service tax.
* Service for the collection of news by the public press, news ticker, or radio
broadcasting services (providing a news service as part of or similar to that of the
public press), from the toll telephone service tax. (Local telephone service provided
to the press is subject to tax.)
* Private communication service for which a separate charge is made, from the local
telephone service tax.
* Service provided to international organizations and the American National Red Cross.
* Toll telephone service provided to members of the Armed Services who are stationed
in combat zones.
* Certain toll telephone service to common carriers (i.e., public transportation
companies), telephone or telegraph companies, or radio broadcasting stations or
networks in the conduct of these businesses.
* Installation charges (including wires, poles, switchboards, or other equipment).
* Telephone service provided to non-profit hospitals.
* Telephone service provided to State and local governments.
* Telephone service provided to nonprofit educational organizations.
* Telephone service provided to the government of the United States.
Private communications services exclusion
The exclusion for private communications services was added by the Excise Tax
Reduction Act of 1965 in order to equalize the tax treatment of internal local communications
systems, such as a private branch exchange system, purchased by businesses, and similar
services leased to businesses by telephone companies. Prior to 1965, leased systems were
subject to tax if they could access a local telephone exchange, whereas purchased systems were
not taxed. Equalization of treatment was achieved by exempting leased systems from tax.
Equipment purchased by businesses for long distance internal communications is free of tax, just
as local systems are.
Toll telephone service controversy
As stated above, toll telephone service is defined as voice quality communication for
which (1) there is a toll charge that varies with the distance and elapsed transmission time of
each individual call and payment for which occurs in the United States, or (2) a service (such as
a wide area telephone service, or ''WATS'') which, for a periodic charge (determined as a flat
amount or upon the basis of total elapsed transmission time), entitles the subscriber to an
unlimited number of telephone calls to or from an area outside the subscriber's local system area.
In a series of recent cases, the IRS has had only limited success in sustaining the tax on
toll telephone services where the charges for such services are assessed on an individual call
basis and do not vary in amount with both elapsed transmission time and distance. The
conjunctive (time and distance) requirement of present law is not literally met by charges for toll
telephone services that vary solely by elapsed transmission time. On August 9, 2004, the IRS
issued Notice 2004-57 confirming that it ''will continue to assess and collect the tax under
section 4251 on all taxable communications services, including those communications services
similar to those at issue in the cases.''
Overview of history of the Federal communications excise tax
The first Federal excise tax on telephone service was enacted in 1898 to help finance the
Spanish-American War. That tax was repealed in 1902 and was not re-enacted until World War
I required additional revenues. The World War I telephone tax was repealed in 1924 and was re-
enacted in 1932. All of these initial telephone taxes applied only to toll (long distance) service.
In 1941, prior to the advent of World War II, the tax was extended to general local service.
A Federal excise tax on telephone service has been in effect in every year since 1941,
despite enactment of periodic legislation to repeal or phase out the tax. In the Excise Tax
Reduction Act of 1965, Congress scheduled a phase-out, beginning with a reduction in the then
10-percent rate for both local and toll service to three percent after 1965. Additional
reductions of one percentage point per year were scheduled thereafter until there would have
been no tax effective on January 1, 1969. However, the scheduled reductions were repealed in
1966 (effective April 1, 1966), and the 10-percent rate was re-instated. A delayed phase-out
schedule was enacted in 1968, to begin in 1970. This phase-out schedule also was postponed,
with a one-percentage point per year phase-out finally going into effect on January 1, 1973.
In 1973, the tax rate declined from 10 percent to nine percent as the first step in this
phase-out, which was to be completed beginning in 1982. However, the Omnibus Reconciliation
Act of 1980 delayed the repeal by one year (until 1983); and the Economic Recovery Tax Act of
1981 further delayed repeal for two additional years. After reaching a rate of one percent, the
rate was increased again to three percent in 1983, and after being extended at that rate several
times, the three-percent rate was made permanent by the Revenue Reconciliation Act of 1990.
Reasons for Change
The present communications excise tax provisions were enacted before the development
of most modern technology -- the growth of computers and new electronic means of
communication. The proliferation of wireless communications technology and the Internet, and
in particular broadband access, has blurred the lines between ''data'' and ''voice'' and between the
functions of transmission and application. Consequently, service providers have found it
increasingly difficult to determine which services are taxable communications services and
which are nontaxable information services.
The basis for the toll (long distance) telephone tax has not kept up in many instances with
the many ways that long distance services are charged today. For example, long distance calling
plans may be purchased now by paying a fixed monthly fee for a limited (or even an unlimited)
number of minutes usable nationwide. In addition, both local and long distance telephone
services may be bundled together or with nontaxable services, including data (e.g., text
messaging, or wireless internet).
The exclusion for private communication services has also been overtaken by new
technologies and marketing practices. It is possible for larger businesses to purchase telephone
equipment (including private lines or microwave relays in some cases) and thereby significantly
reduce their communications costs by reducing their tax liability relative to the tax paid for
similar services by smaller businesses and individuals who must contract with third parties for
identical services. In addition, private communications systems or services partially or wholly
excluded from the telephone tax can be used to facilitate long distance services.
Description of Proposal
In general
The proposal is presented below as three options. Option 3 represents a more
fundamental change to the tax than Option 2, which in turn represents a more fundamental
change than Option 1. Each of the options assumes that the current three-percent rate is applied
to the relevant tax base.
Option 1: Modify the definitions of toll and local telephone services
Under this option, the communications excise tax is imposed upon both local and non-
local (long distance) voice telephone services, regardless of whether the charges are fixed or vary
with distance, elapsed transmission time, both, or some other criteria. Definitions are clarified to
remove any distinction between the calculation of taxes on local and long distance telephone
services, and to clarify that the tax is intended to apply to landline and wireless (including
satellite) voice communications services.
Option 1 contemplates no additional changes to the communications excise tax
provisions. No view is expressed regarding whether VOIP is a taxable communications service
or a nontaxable information service.
Option 2: Modernize the excise tax on voice communications services
Option 2 incorporates the changes to the tax under Option 1 and makes further changes to
the law. Under Option 2, a voice communications service is taxable regardless of its technical
form. For example, the tax applies to voice communications services using landlines, analog and
digital wireless, satellite and VOIP, or any combination. It is not necessary that the voice
communications service provide the capability to access the public switched telephone network
(required under present law) to be taxable.
In general, a service component is classified as a taxable communications service if the
primary purpose of the service component is the transmission of real-time voice
communications. The content of the communications or the capability for generating, acquiring
storing, transforming, processing, retrieving, utilizing, or making information available via
communications, is not a taxable communications service. For example, a service in which a
caller dials a ''1-900'' number for the purpose of receiving information is a nontaxable
information service. However, the underlying telephone service provided to the information
services provider by the communications provider is a taxable communications service.
To avoid controversy, certain service components are expressly classified as taxable
communications services: enhanced voice service features, such as conference calling, three-
way calling, call forwarding, caller ID and voice mail services, as well as other ancillary services
taxable under present law. Directory listings (whether ''white pages'' or ''yellow pages''),
however, are classified as information services. Provision of a ''regular'' phone line or circuit
that may be used for facsimile, for teletypewriter, or for connection to a ''dial-up'' Internet access
provider is treated as a taxable communications service unless the line or circuit cannot be used
for real-time voice communications. Provision of broadband (where the amount for such service
is separately itemized from VOIP) or dial-up Internet access service (where not connected to the
public switched telephone network) is not taxable.
The billing and bundling rules generally remain as under present law. However, to be
excluded or exempted from the communications excise tax, a nontaxable service component
must be separately stated on the customer's bill. The Treasury Department is granted the
regulatory authority to determine if the communications component of a service is de minimis, if
an offered service constitutes a service component, and if a service component is a
communications service or an information service.
Option 2 modifies certain present-law exemptions. Present-law exemptions for the press,
common carriers (e.g., trucking companies), and radio broadcasting stations and networks are
expanded to cover all communications excise taxes (rather than only taxes on toll telephone
services). Separately itemized service components provided by one communications provider
to another communications provider are exempt from excise tax to the extent that the recipient
uses such services to provide services to its customers. The exemption for public coin-operated
service is modified such that such calls are exempted to the extent of the minimum amount
charged by the coin-phone service for a local call. The rest of the exemptions (except for private
communications services) are unchanged.
The private communication services exclusion is significantly modified. Under Option 2,
the exclusion continues to apply as under present law, but is geographically limited to taxable
communications either (a) within a Core Based Statistical Area, or (b) within one building or
between buildings located on a contiguous plot of land. Rules similar to the rules of the Mobile
Communications Sourcing Act are applicable to cross-border services.
Option 3: Expand the tax base to all voice and data communications
Option 3 incorporates the changes to the tax under Option 2 (including changes to the tax
under Option 1) and makes further changes to the law. Under Option 3, the communications
excise tax base is generally expanded to include all data communications services to end-users.
The taxable base includes local and long distance voice services, VOIP, analog and digital
cellular and satellite telephone services, cable and satellite television services (to the extent the
charge is for communications), broadband and dial-up Internet access services, paging services,
and other data communications services.
In general, a service component is classified as a communications service if the primary
purpose of the service component is the transmission of communications, as contrasted with the
content of the communications or the capability for generating, acquiring, storing, transforming,
processing, retrieving, utilizing, or making information available via communications. The
billing and bundling rules are similar to those of Option 2. For example, cable and satellite
television is considered to consist of a taxable communications service component bundled with
a nontaxable information (content) component.
Unlike Option 2, communications capacity (''bandwidth'') is taxable, whether provided,
for example, as a service, as a lease, or as the sale of ''lit'' (activated) fiber optic cable or installed
''dark'' (inactivated) fiber.
Effective Date
Option 1 of the proposal is effective for services rendered after the date of enactment.
Option 2 or 3 of the proposal is effective for services rendered on or after the first day of the first
calendar quarter beginning 60 days after the date of enactment.
No inference is intended as to the treatment of any issues or controversies arising under
present law.
Discussion
Overview
There is no compelling policy argument for imposing taxes on communications services.
Indeed, in 1987 the Department of the Treasury recommended letting the tax expire. Any
excise tax distorts consumer decisions, and taxing new services and new technologies makes
them more expensive, and, therefore, may slow their development. The last significant
revision of the tax occurred in 1965. Consequently, many of the rules are now so obsolete due to
intervening developments in technology and marketing that, in many cases, they either fail to
capture many services that traditionally were seen as within the scope of the communications tax
or they capture those services unevenly.
On the other hand, the excise tax on communications services raises a significant amount
of revenue. According to the IRS, the communications excise tax raised approximately $5.8
billion in 2003. Assuming that the communications excise tax continues in force, however,
the policies of fairness and efficiency require that the tax apply as consistently as possible to
similar services with as little administrative costs as possible.
Option 1
This option involves making only limited changes to certain tax rules and is targeted to
resolve a particular set of controversies that currently place the administration and collection of
the communications tax on toll telephone service in substantial doubt. Option 1 will end the
controversy regarding the dual requirements of elapsed transmission time and distance, and
should eliminate other uncertainties regarding the application of the present-law definition of toll
telephone services by more closely conforming such definition to the range of current industry
billing practices. Option 1 does not address other current major issues, for example, issues
relating to access to the local telephone system, private communications services, and the full or
mixed use of new technologies such as VOIP. However, it might be possible to selectively
address these or other discrete issues within the scope of an expanded Option 1, by adding
selected features from Option 2.
Many of the arguments advanced by those who believe the tax should be repealed are
also arguments against Option 1. Future controversies will almost certainly develop as
technologies are developed and implemented and the market changes. Since these changes are
occurring now, Option 1 is likely to be only a short-run measure.
Option 2
This option is based on the premise that the current communications tax on voice services
can be adapted to the technology and the markets of the early 21st century. Option 2 attempts to
resolve current controversies such as the time/distance controversy and the coverage of services
provided through multiple technologies, including VOIP. In addition, the option recognizes that
the broad exclusion for private communications services, the requirement of access to the local
telephone system, and the application of certain exemptions solely to toll (long distance) services
no longer operate efficiently and equitably in light of technical developments and the practical
difficulties in distinguishing between local and long distance services.
At the same time, Option 2 does not tax data, Internet access, and bandwidth, and
therefore does not ''tax the Internet.'' In addition to the voice/data dichotomy, distinctions are
drawn between communications services and information services. While such distinctions may
generally parallel regulatory distinctions, they may not follow them in a particular case.
Similarly, cross-border rules are adapted from the Federal law specifying the apportionment
methodology for mobile communications for State and local consumption tax purposes.
Option 2 also recognizes that service providers may bundle their customer offerings in a
variety of ways. Such bundling may be functional in nature, such as voice accompanied by and
integrated with data, or the bundling may be in the nature of marketing or discounts (e.g., a
nontaxable data service ''thrown in for free'' when taxable voice service is purchased). The
Treasury Department is given the authority to make the necessary determinations regarding these
very fact-specific issues.
Option 2 may not be a complete solution to the problems inherent in present law. It does
not address technological changes and practices that may make certain nontaxable data services a
close substitute for taxable voice services. It therefore tends to favor such data services over
voice services, and therefore may inhibit the growth of taxable voice services relative to
nontaxable data services. While this distinction also exists under present law, its impact may
grow significantly in the future.
Option 3
This option is based on the premise that taxation of voice services and not data and
internet services creates an economic distortion. Voice and data are becoming interchangeable
and integrated parts of modern communications. For example, cellular phones send and receive
text messages and may access the Internet as well as transmit and receive voice communications.
Cellular phones are being manufactured that may operate using VOIP through ''Wi-Fi'' access,
as well as through more traditional means. As voice phone service migrates to using Internet
protocol, there may be no way to distinguish ''packets'' of voice and ''packets'' of data. It is also
expected that users will integrate their Internet data and voice applications. Consequently, both
data and voice are taxable services under this option.
Extending the tax to all communications requires taxing Internet access, bandwidth
capacity, and the transmission of cable and satellite television, as these are close substitute means
for delivery of information and other content. This will make the distinction between
communications services (including data) and information services increasingly important.
While it may be relatively simple at this time for a cable company to apportion its revenue
between the transport of information and the information itself, it may become more difficult as
technology develops. In addition, the resale exemption is intended to prevent double taxation of
the communications component of services.
While Option 3 will still leave distortions in the market between communications
services and other goods and services, Option 3, unlike Option 2, should minimize or eliminate
distortion in the markets for different communications services.
B. Equalize Alcohol Excise Taxes
(secs. 5001, 5041, and 5051)
Present Law
In general
Separate excise taxes are imposed on distilled spirits, wine, and beer. Both the tax rates
and the volumetric measures on which the taxes are imposed differ depending on the type of
beverage.
Distilled spirits
Distilled spirits produced in or imported into the United States are taxed at the rate of
$13.50 per proof gallon. The Code defines a proof gallon as a United States gallon of proof
spirits, or the alcoholic equivalent thereof. Generally, a proof gallon is a U.S. liquid gallon
consisting of 50 percent alcohol. Wines containing more than 24 percent alcohol by volume
are taxed as distilled spirits.
Wine
Wine produced or imported into the United States is taxed at the following rates per wine
gallon:
Wine (sec. 5041)
Still wines --
No more than 14 percent alcohol
More than 14 percent but not
more than 21 percent alcohol
More than 21 percent but not
more than 24 percent alcohol
More than 24 percent alcohol
Hard apple cider
$1.07 per wine gallon
$1.57 per wine gallon
$3.15 per wine gallon
Taxed at the distilled spirits rate
$0.226 per wine gallon
Sparkling wines --
Champagne and other naturally
sparkling wines
Artificially carbonated wines
$3.40 per wine gallon
$3.30 per wine gallon
A ''wine gallon'' means a United States gallon of liquid measure equivalent to the volume
of 231 cubic inches. On lesser quantities, the tax is paid proportionately.
Beer
Beer brewed, produced, and removed for consumption or sale in the United States, or
imported, is taxed at a rate of $18.00 per barrel (31 gallons). The $18 per barrel rate equals
approximately 58 cents per gallon. Generally, beer is a fermented beverage containing one-half
of one percent or more of alcohol by volume, brewed or produced from malt, wholly or in part,
or from any substitute therefor.
Credit for wine content and for flavors content
Present law includes a tax credit (''the section 5010 credit'') that reduces the distilled
spirits tax rate for the alcohol content of a final product that is derived from the alcohol in wine
or a flavor added to the product. For example, 40 percent of the alcohol in a final distilled spirits
product may be derived from a wine content and 60 percent from the original distilled spirits.
Under section 5010, the wine portion would be taxed at $1.07 per wine gallon and the distilled
spirits portion at $13.50 per proof gallon.
Reasons for Change
On a per ounce basis, distilled spirits are taxed at roughly 21 cents per ounce of alcohol,
still wines at 8 cents per ounce of alcohol (assuming an average alcohol content of 12 percent),
and beer at 10 cents per ounce of alcohol (assuming alcohol content of 4.5 percent). The
differential rates for alcohol products influence production decisions, as producers try to take
advantage of the lower wine and beer rates. This in turn has led to compliance problems
involving the section 5010 credit, and controversy over the proper tax classification of certain
beverages.
Description of Proposal
The proposal imposes a uniform tax based on the alcohol content contained in the
product. The rate of tax is based on proof gallon. Because the rate of tax would not depend on
the source of the alcohol, the section 5010 credit is eliminated. The proposal taxes all alcohol at
$8.40 per proof gallon. It is estimated that this rate would produce a revenue neutral effect when
compared with present law.
As under present law, domestic wineries having aggregate annual production not
exceeding 250,000 gallons are entitled to a tax credit equal to 90 cents per gallon on the first
100,000 gallons of wine (other than champagne and other sparkling wines) removed in a
calendar year. In a manner similar to present law, for domestic brewers producing less than two
million barrels of beer during the calendar year, the proposal imposes a reduced rate of tax on the
first 60,000 barrels of beer removed each year.
The tables below compare the rates under present law and the proposal by using proof
gallons as the standard measure for all alcohol, and also by using present law standards of
measurement (i.e. proof gallon, wine gallon, and barrel).
Per Proof Gallon Comparison
Alcohol Beverage
Present Law Equivalent
Per Proof Gallon Rate
Proposed Rate
Beer
(assuming 4.5-percent average
alcohol content)
$6 per proof gallon
$8.40 per proof gallon
Wine
(12-percent alcohol by content)
$4.46 per proof gallon
$8.40 per proof gallon
Wine
(14-percent alcohol by content)
$5.41 per proof gallon
$8.40 per proof gallon
Champagne and other sparkling
wines (assuming 12-percent
alcohol by content)
$14.17 per proof gallon
$8.40 per proof gallon
Distilled Spirits
$13.50 per proof gallon
$8.40 per proof gallon
Per Present Law Standards of Measure
Alcohol Beverage
Present Law
Statutory
Under the Proposal
Comparable to Statutory Rate
Beer
(assuming 4.5-percent average
alcohol content)
$18 per beer barrel
$23.44 per barrel
Wine
(12-percent alcohol by content)
$1.07 per wine gallon
$2.02 per wine gallon
Wine
(14-percent alcohol by content)
$1.57 per wine gallon
$2.44 per wine gallon
Champagne and other sparkling
wines (assuming 12-percent
alcohol by content)
$3.40 per wine gallon
$2.02 per wine gallon
Distilled Spirits
$13.50 per proof gallon
$8.40 per proof gallon
Effective Date
The proposal is effective on the first day of the first quarter beginning 60 days after the
date of enactment.
Discussion
Wine, beer, and distilled spirits are taxed because they contain alcohol. There is no tax
policy reason for taxing alcoholic beverages differently based on whether it is a distilled spirit,
wine, or beer.
Some may argue that the proposal unfairly penalizes beer and wine by substantially
increasing the rate of tax on such products, while lowering the rates for distilled spirits. As a
matter of chemical composition, alcohol remains alcohol regardless of whether it is produced
through fermentation alone or fermentation followed by distillation. The difference in products
results from the concentration of alcohol in the product rather than a difference in chemical
composition. Further, if the rationale for the tax on alcohol, often referred to as a ''sin'' tax, is to
recognize the costs to society associated with alcohol-related accidents and crimes, no alcoholic
beverage should be thought of as deserving better treatment over other forms of alcohol.
However, the proposal does preserve the incentives for small producers. These incentives may
be viewed as intended to encourage small businesses to enter the industry. On the other hand, as
under present law, the rate differential may continue to encourage large producers to try to
structure their businesses to qualify for rates for which they are ineligible.
Present law's lack of neutrality as to alcohol type affects consumer choice and distorts
production decisions. For example, there has been controversy over the proper classification of
flavored malt beverages, in which the base of the beverage is made from fermented malts so as to
obtain the tax rate applicable to beer, but as much as 95 percent of the alcohol content comes
from a distilled spirit. The distilled spirit is used as a ''flavor,'' and there is no requirement that
the resulting product taste, or retain the characteristics of, a traditional beer although it is taxed
like one. In addition, the wine industry has developed ''stripped down'' and neutral wines that
are produced only for purposes of blending with distilled spirits in order to obtain the section
5010 credit. For purposes of claiming the section 5010 credit, there is no requirement that the
"wine" be produced from any particular type of fruit, or that wine coloring or that wine flavoring
be evident in the distilled spirits product. It is understood that some of the "wine" with respect to
which the credit currently is claimed is produced from table grapes, oranges, and grapefruits
(which are not ordinarily used to produce wine) and that, in some cases, the wine is filtered to
eliminate both color and flavoring. Thus, the resulting product does not resemble ''wine'' as
typically consumed, but nonetheless is used to take advantage of the section 5010 credit.
Because all alcohol is taxed the same under the proposal, there would no longer be a need
for the section 5010 credit. The GAO has noted that the section 5010 credit creates
administrative problems, and that generally, Treasury's Alcohol and Tobacco Tax and Trade
Bureau (''TTB'') is unable to verify compliance with the requirements for this credit without
extensive investigation.
Present law allows wines to fall within specific ranges (for example, between 14 and 21
percent alcohol). The proposal requires a more precise measurement of the alcohol content in
the wine. Because alcohol content may vary from batch to batch, the proposal may require more
testing and effort on the part of wineries to correct the alcohol content of their wines. Brewers
may make similar arguments. However, such testing already occurs, and therefore, additional
testing, to the extent required, is not overly burdensome. Small brewers may not have the on-
site equipment to accurately test the alcohol content of their beers, and such equipment may be
expensive to acquire, but off-site testing facilities do exist for such purposes.
C. Subject International Flights with Wholly Domestic Segments to the Segments Tax
(secs. 4261 and 4262)
Present Law
Domestic air transportation
Most domestic air passenger transportation is subject to a two-part excise tax. First,
the Code imposes a tax at the rate of 7.5 percent of the amount paid for taxable transportation.
Second, the Code imposes a flight segment tax of $3 (indexed annually for inflation) for each
domestic segment of taxable transportation. The segment tax is $3.20 per segment that begins
during 2005.
A flight segment is defined as transportation involving a single take-off and a single
landing. For example, travel from New York to San Francisco, with an intermediate stop in
Chicago, consists of two flight segments (without regard to whether the passenger changes
aircraft in Chicago).
Taxable transportation is transportation that meets one of the following tests:
(1) It begins or ends in either the United States or at any place in Canada or Mexico
not more than 225 miles from the nearest point on the continental United States
boundary (the ''225-mile zone''), or
(2) It is directly or indirectly from one port or station in the United States to another
port or station in the United States, but only if it is not a part of uninterrupted
international air transportation.
''Uninterrupted international air transportation'' means transportation entirely by air that
does not begin and end in the United States or in the 225-mile zone if there is not more than a
12-hour scheduled interval between arrival and departure at any station in the United States.
Under these rules, a passenger traveling on separate domestic segments integral to international
travel is exempt from the domestic passenger taxes on those segments if the stopover time at any
point within the United States does not exceed 12 hours. Instead such flights are subject to the
tax on international flights, discussed below.
International air transportation
International flights are subject to a tax of $12.00 per arrival or departure in lieu of the
taxes imposed on domestic air passenger transportation. The tax rate is indexed for inflation
annually, effective on each January 1. In 2005, the tax on international air transportation is
$14.10 for each arrival and departure in the United States. As noted above, international air
transportation includes certain purely domestic transportation that is associated with an
international journey (''uninterrupted international air transportation''). The international air
transportation tax does not apply if all the transportation is subject to the 7.5 percent tax
discussed above.
Reason for Change
Although an international flight may have wholly domestic segments, and utilize the
same airport flight control resources as a purely domestic flight, such segments are exempt from
the domestic segment tax.
Description of Proposal
The proposal imposes the segment tax on the domestic segments of an international
flight. Under the proposal, transportation to a point outside the United States would not be
subject to the segment tax from the last port or station in the United States. For example, a
person purchasing a ticket in Washington, D.C. to fly to Paris via New York, would pay no
segment tax on the part of the transportation from New York to Paris. The $3.20 segment tax
would apply to the segment from Washington, D.C. to New York. The $14.10 international air
transportation tax would continue to apply. Such flights would continue to be exempt from the
7.5-percent tax.
Effective Date
The proposal is effective for transportation beginning on or after the first day of the first
quarter beginning 60 days after the date of enactment.
Discussion
Taxes on air transportation support the Federal Airport and Airway Trust Fund.
Expenditures from the fund support the Federal Aviation Administration (''FAA''). Among other
principal duties, the FAA regulates civil aviation and air traffic control. More than half of the
agency's budget is devoted to expenditures for aviation safety. Although an international
flight with a purely domestic segment (Baltimore to Miami to Jamaica for example) requires the
same FAA air traffic control resources as a solely domestic flight (Baltimore to Miami), the
international flight is exempt from the domestic passenger taxes, paying only the international
passenger tax. Calculating the 7.5 percent tax on a flight that is partially taxable and partially
exempt adds complexity. However, the same cannot be said for the $3.20 segment tax, which is
not based on the value of the ticket but is calculated based on takeoffs and landings within the
United States.
Imposing the segment tax on international flights may be viewed as penalizing the carrier
that makes stops within the United States as compared with one that offers nonstop international
flights. However, by taking off and landing within the United States, the carrier making
additional stops within the United States utilizes more FAA resources than a nonstop flight. In
addition, there is inequity in that a passenger flying from Paris to New York to Washington D.C.
pays no segment tax, while a passenger that boards the same plane in New York will pay a
domestic segment tax on the same flight.
D. Modify the Federal Excise Tax on Sport Fishing Equipment
(secs. 4161 and 4162)
Present Law
Under present law, an ad valorem excise tax is imposed on the sale by the manufacturer,
producer, or importer of specified sport fishing equipment. The general rate for this tax is 10
percent; the rate is reduced to three percent for electric outboard boat motors and fishing tackle
boxes. Taxable sport fishing equipment is defined as: fishing rods and poles (and component
parts therefor); fishing reels; fly fishing lines; other fishing lines not over 130 pounds test;
fishing spears; spear guns; spear tips; tackle items (including leaders, artificial lures, artificial
baits, artificial flies, fishing hooks, bobbers, sinkers, snaps, drayles, and swivels); fish stringers;
creels; bags, baskets, and other containers designed to hold fish; portable bait containers; fishing
vests; landing nets; gaff hooks; fishing hook disgorgers; dressing for fishing lines and artificial
flies; fishing tip-ups and tilts; fishing rod belts; fishing rodholders; fishing harnesses; fish
fighting chairs; fishing outriggers; fishing downriggers; and electric outboard boat motors.
Parts or accessories that are sold on or in connection with taxable articles are also treated as
taxable.
Revenues from the excise tax on sport fishing equipment are deposited in the Sport Fish
Restoration Account (the ''Account'') of the Aquatic Resources Trust Fund (the ''Fund''). Monies
in the Account are spent, subject to an existing permanent appropriation, to support Federal-State
sport fish enhancement and restoration and coastal wetlands protection and restoration
programs.
Reasons for Change
The excise tax on sport fishing equipment is complex and creates administrative burdens
for both taxpayers and the IRS. In part, this is due to the large number of items subject to the
tax. In addition, many of the items subject to the tax have close nontaxable substitutes, leading
to highly factual determinations as to whether a particular item is or is not subject to the tax and
to disputes between taxpayers and the IRS. The existence of close nontaxable substitutes also
leads to erosion of the tax base as taxpayers shift from taxable items to nontaxable items and to
competitive problems for manufacturers of items with close nontaxable substitutes. Narrowing
the tax base with an accompanying increase in the tax rate should improve tax administration and
compliance, provide more stable funding for the Account and Fund, and reduce competitive
problems.
Description of Proposal
Under the proposal, the excise tax on sport fishing equipment is imposed only on fishing
rods, poles, and reels. As under present law, parts or accessories that are sold on or in
connection with taxable articles are also treated as taxable. To maintain the current level of
revenue generated by the tax, the rate of tax imposed on taxable articles is adjusted to 21 percent.
Effective Date
The proposal is effective for articles sold by the manufacturer, producer, or importer on
or after the first day of the first calendar quarter beginning 60 days after the date of enactment.
Discussion
The underlying policy of the sport fishing equipment excise tax is to link the tax burden
with beneficiaries of specific Federal programs. Thus, under present law, the funding
mechanism for sport fishing-related purposes follows this ''benefit principle'' by imposing tax on
equipment used by fishermen, directing relevant tax collections to the Account, and authorizing
relevant expenditures from the Account for sport fishing purposes.
Present law takes a relatively broad view of which items should be burdened with
generating relevant tax collections. However, issues have arisen with several items included in
the tax base. For example, the AJCA reduced the tax burden on fishing tackle boxes and
eliminated the tax on sonar devices used to find fish in order to reduce disparities where similar
products were taxed differently. The rationale for lowering the rate of excise tax on tackle boxes
to three percent under the Act was that nontaxable tool boxes may be used in lieu of taxable
tackle boxes. The rationale for removing sonar fish finders from the list of taxable sport
fishing equipment was that most types of these devices were already exempt from tax, while
others were taxed, depending on their technology. Competitiveness and fairness issues have
also been raised regarding other taxable sport fishing equipment items or components with close
nontaxable substitutes or with alternative nontaxable uses. For example, a bait bucket, a taxable
item, may contain a small marine life aeration system that is not taxable when sold separately as
a fish tank aerator.
Present law's attempt to tax nearly all identifiable items of fishing equipment leads to
unnecessary administrative complexity for taxpayers and for the Government. Enforcement of
taxes on numerous items requires a significant amount of Government resources for relatively
small amounts of revenue. Requiring taxpayers and the IRS to make highly factual
determinations as to which similar-use items are subject to the excise tax and which are not adds
unwarranted complexity and controversy to the tax system. In addition, some have raised
concerns that further attempts to equalize treatment of similar-use items through piecemeal tax
exemption or reduced tax rates could negatively impact the stability of funding for the Account
and the Fund.
To simplify the tax on sport fishing equipment, the proposal limits taxable items to
fishing rods, poles, and reels. Fishing rods, poles, and reels are used by almost all persons
engaged in sport fishing and such equipment does not have alternative uses or close substitutes.
In addition, taxes on these items currently comprise between 45 and 50 percent of the total
collected excise taxes on sport fishing equipment. To maintain revenue and the Account at
current levels, the proposal increases the tax rate on these items. By adopting a tax base for
items for which there are not close substitutes, the proposal may more closely match the burdens
of the tax with the benefits of the use of funds in the Account. Tax administration and
compliance should be improved by narrowing the tax base to a limited number of equipment
types. Narrowing the tax base with an accompanying increase in the tax rate should also provide
more stable funding for the Account and the Fund and minimize opportunities for future
controversies and base erosion.
Many of the other items that are taxed under present law, and that would be exempt under
the proposal, are not used as widely by all sport fishermen and their use may tend to increase
with the income of the fishermen. As a result, some may argue that the proposal requires lower
income sport fishermen to bear the burden of a larger share of the overall tax on fishing
equipment than they do under present law. However, the tax under the proposal remains a
proportional tax, with purchasers of more expensive rods, poles, and reels paying more tax than
purchasers of less expensive equipment.
XI. ESTATE AND GIFT TAXATION
A. Limit Perpetual Dynasty Trusts
(secs. 2631 and 2632)
Present Law
In general, present law imposes transfer taxes that are designed to tax transfers once each
generation. These taxes are in the form of a gift tax for lifetime transfers, an estate tax for death
time transfers, and a generation skipping transfer tax for transfers to persons more than one
generation younger than the transferor. A generation skipping tax is imposed on all transfers,
whether directly or indirectly, to ''skip persons.'' A skip person includes a person who is two or
more generations below the generation of the transferor or a trust, if all the interests are held by
skip persons. The transferor generally is the individual who transfers property in a transaction
that is subject to Federal estate or gift tax. Transfers that are subject to the generation skipping
tax are direct skips (e.g., a transfer from a grandparent to a grandchild), taxable distributions
(e.g., a distribution of income or corpus to a grandchild from a trust created by a grandparent),
and taxable terminations (e.g., the death of a grandchild who was a beneficiary of a trust created
by a grandparent).
Present law provides for a lifetime per-transferor exemption from the generation skipping
transfer tax. The amount of the generation skipping transfer tax exemption is $1,500,000 for
generation skipping transfers made in 2005, $2,000,000 for generation skipping transfers made
in 2006, 2007, or 2008, and $3,500,000 for generation skipping transfers made in 2009. In the
case of a generation skipping trust, the exemption applies to distributions from, or terminations
of interests in, that fraction of the trust that the portion of the exemption that is allocated to the
trust bears to the value of trust's assets at its creation. Thus, if a generation skipping trust is
created with $1.5 million and $1.5 million of the creator's generation skipping transfer tax
exemption is allocated to that trust, no generation skipping transfer tax ever is imposed on any
distributions from, or termination of interests in, that trust regardless of the number of
generations of the trust's beneficiaries that are skipped.
Many States limit the length of time that assets can be held in trust for the benefit of
beneficiaries who were not alive at the time of the creation of the trust. This limitation is
generally referred to as the rule against perpetuities. The rule against perpetuities was a
judicially created rule of English common law. In many cases, States adopted the rule against
perpetuities when they adopted British common law as their basic law. The rule has been
criticized as being inconsistent with the present capital market system, and because of its
complexity and resulting uncertainty of application. In order to alleviate this uncertainty, some
States have adopted the Uniform Statutory Rule Against Perpetuities. Under that uniform
statute, ''trust settlors may elect to create either a trust measured by lives in being at the creation
of the trust plus 21 years or trust measured by ninety-years.'' Other States have either
repealed the rule against perpetuities, or provided an ability to opt out of the rule. In a State
without a mandatory rule against perpetuities, it is possible to transfer assets to a trust created in
that State, to which the transferor's generation skipping tax exemption has been allocated. The
trust assets may grow for a potentially unlimited period of time without being subject to any
transfer tax. Because of their potential long life and potential for substantial accumulation, such
trusts generally are called ''perpetual dynasty trusts.''
Reasons for Change
Perpetual dynasty trusts are inconsistent with the uniform structure of the estate and gift
taxes to impose a transfer tax once every generation. In addition, perpetual dynasty trusts deny
equal treatment of all taxpayers because such trusts can only be established in the States that
have repealed the mandatory rule against perpetuities.
Description of Proposal
The proposal prohibits the allocation of the generation skipping tax exemption to a
''perpetual dynasty trust,'' except to the extent that the trust provides for distributions to
beneficiaries in the generations of the transferor's children or grandchildren. Under the proposal,
the generation-skipping tax exemption effectively is limited to an exemption of a skip of one
generation. A ''perpetual dynasty trust'' is defined as a trust whose situs (place of creation) is a
State that either (1) has repealed the rule against perpetuities, (2) allows the creator of a trust to
elect to be exempt from the rule against perpetuities and the creator so elects, or (3) has modified
its rule against perpetuities to permit creation of interests for individuals more than three
generations younger than the interest's creator. If the situs of a trust is moved from a State that
has retained the rule against perpetuities to a State that has repealed the rule against perpetuities,
the inclusion ratio thereafter will be changed to one.
Effective Date
The proposal is effective for transfers made after the date of enactment.
Discussion
As Congress stated both when it originally imposed a tax on generation skipping transfers
in 1976 and again when it revised the generation skipping tax in 1986, the purpose of imposing
gift, estate and generation skipping tax was ''not only to raise revenue, but to do so in a manner
that has as nearly as possible a uniform effect.'' Similarly, the Congress stated that it
''believed that the tax law should basically be neutral and that there should be no tax advantage
available in setting up trusts.'' The imposition of a generation skipping tax was believed
necessary to achieve the uniformity of imposing a transfer tax once every generation. A $1
million exemption from the generation skipping tax originally was provided when the generation
skipping tax was revised in 1986. The size of the generation-skipping transfer tax exemption
was increased beginning in 2002 to be equal to the amount of effective exemption for estate and
gift taxes. Thus, the exemption from the generation skipping transfer tax is scheduled to increase
to $3.5 million by 2009. When Congress originally enacted a tax on generation skipping
transfers, it noted that ''[m]ost States have a rule against perpetuities which limits the duration of
a trust.''
Since that time, a number of States have either repealed the rule against perpetuities or
provided an ability to opt out of such limitations. Thus, it is possible to transfer a relatively
large initial amount of assets to a trust created in such States and to which the transferor's entire
generation skipping tax exemption has been allocated. Potentially unlimited growth in the trust
assets may occur, while the assets are not subject to any transfer tax even though the trust's
beneficiaries have changed many generations. These ''perpetual dynasty trusts'' can be used to
frustrate the uniform application of transfer tax that was envisioned when the generation
skipping tax was enacted. This lack of uniformity is compounded by the fact that perpetual
dynasty trusts can be created only in the limited number of States that have repealed or modified
the rule against perpetuities.
The proposal would result in greater uniformity by limiting exemption from the
generation skipping transfer tax for perpetual dynasty trusts. The proposal is consistent both with
the purpose of enacting a generation skipping transfer tax, and with the operation of the present
transfer tax system, which generally imposes a tax once every generation by limiting the amount
of assets that can be placed beyond the present-law transfer taxes. The proposal also is
consistent with the generation skipping tax exemption, in that it permits an exemption from the
generation skipping transfer tax for transfers to the transferor's grandchildren. The proposal
avoids the possible constitutional limitations of alternative proposals to limit the transfer tax
advantage of perpetual dynasty trusts (e.g., impose an ad valorem tax every set number of years
on perpetual dynasty trusts). In addition, the proposal is consistent with the purposes of the rule
against perpetuities to prevent perpetuation of wealth disparities, promote alienability of
property, and make property productive. The proposal does not prevent an individual from
creating a trust in a State that has repealed the rule against perpetuities. Thus, the proposal does
not prevent the creation of a trust in a State if that State otherwise would be the best State in
which to create a trust. The proposal does, however, eliminate a Federal transfer tax advantage
for creating a trust in a State that has repealed the rule against perpetuities.
B. Determine Certain Valuation Discounts More Accurately for
Federal Estate and Gift Tax Purposes
(secs. 2031, 2512, and 2624)
Present Law
In general
The value of property subject to transfer taxes is the fair market value of the property
being transferred on the date of transfer. The fair market value is the price at which the
property would change hands between a willing buyer and a willing seller, neither being under
any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
If actual sales prices and bona fide bid and asked prices are lacking, the fair market value
of stock in a closely held business is determined by looking to various factors including: the
company's net worth; its prospective earning power and dividend-paying capacity; the goodwill
of the business; the economic outlook in the nation and in the particular industry; the company's
position in the industry and its management; the degree of control of the business represented by
the block of stock to be valued; and the values of securities of corporations engaged in the same
or similar lines of businesses.
Discounts
In general
Courts and the IRS have recognized that for various reasons interests in an entity (shares
in a corporation or interests in a partnership, for instance) may be worth less than the owner's
proportionate share of the value of the entity's assets. For example, the value of a 50-percent
shareholder's stock might differ from the value of 50 percent of the assets owned by the
corporation in which the stock is held. Some (but not all) of the valuation discounts used under
present law are discussed below. In many cases courts apply more than one discount. The
theories of some discounts overlap, and court decisions sometimes blur the distinctions between
those discounts.
Minority (or lack of control) discount
Numerous courts and the IRS have recognized that shares of stock or other ownership
interests in a closely-held business entity that represent a minority interest are usually worth less
than a proportionate share of the value of the assets of the entity. Minority discounts arise
from a division of control because the holder of a minority interest cannot control the ongoing
direction of the business entity, the timing and amount of income distributed by the entity to its
owners, or the liquidation of its assets. Minority discounts often result in reductions in the value
of transferred property from 15 percent to 40 percent.
Marketability (or illiquidity) discount
Recognizing that closely held stock and partnership interests often are less attractive to
investors and have fewer potential purchasers than publicly traded stock, courts and the IRS
grant discounts to reflect the illiquidity of such interests. Courts sometimes combine
marketability and minority discounts into a single discount, but the discounts reflect different
concerns. Whereas the minority discount compensates for lack of control over an interest, the
marketability discount compensates for the limitations upon free exit inherent in interests for
which no public market exists. The marketability discount may be appropriate whether valuing a
controlling or a minority ownership interest. Generally, the size of the marketability discount
is reduced as the donor's or decedent's control of the corporation or partnership increases.
However, the discount has been applied to a 100-percent ownership interest in a closely-held
corporation. Marketability discounts often result in reductions in the value of transferred
property of 20 to 30 percent in addition to any applicable minority discount. Marketability
discounts often are created by placing assets in a limited partnership. Marketability discounts
created through the use of a limited partnership permit the donee or legatee to recreate value by
liquidating the partnership or having a partner's interest redeemed by the partnership.
Fragmentation (or fractional interest) discount
Fragmentation discounts are similar to minority discounts. This discount arises from the
lack of control inherent in joint ownership of an asset (e.g., a gift of an undivided fractional
interest in real estate). Fragmentation discounts often result in reductions in the value of
transferred property of 15 to 60 percent.
Investment company discount
The investment company discount arises because the market values of closed-end mutual
funds and investment companies often are less than the net asset values of those funds and
companies. These discounts can be as high as 50 percent and may overlap with the marketability
discount.
Reasons for Change
Under present law, valuation discounts can significantly reduce the estate and gift tax
values of transferred property. Minority and marketability discounts in particular often create
substantial reductions in value. In some cases these reductions in value for estate and gift tax
purposes do not accurately reflect value. For example, a taxpayer may make gifts to a child of
minority interests in property and claim lack-of-control discounts under the gift tax even though
the taxpayer or the taxpayer's child controls the property being transferred. A taxpayer also may
contribute marketable property such as publicly-traded stock to a partnership (such as a family
limited partnership) or other entity that he or she controls and, when interests in that entity are
transferred through the estate, claim marketability discounts even though the heirs may be able to
liquidate the entity and recover the full value by accessing the underlying assets directly.
Description of Proposal
In general
The proposal provides rules for determining the value of property for Federal transfer tax
purposes. These rules limit the availability of minority and marketability discounts. In certain
situations the proposal also may have an effect on other discounts such as the investment
company discount and the fragmentation discount. The property interests to which the proposal
applies include shares of stock of a corporation, interests in a partnership or limited liability
company, and other similar interests in a business or investment entity or in an asset. The
proposal has two parts, aggregation rules and a look-through rule. Under the proposal, step
transaction principles are used to determine whether two or more transfers are treated as a single
transfer. Moreover, any interest in an asset owned by the spouse of a transferor or transferee is
considered as owned by the transferor or transferee.
The aggregation and look-through rules described below generally apply to all gifts made
during life without consideration, transfers at death, generation-skipping events, and any transfer
of an asset by gift for an amount of consideration less than the value determined under those
rules. The rules described below are not intended, however, to change the principles of present
law concerning whether transfers made in the ordinary course of business are, or are not, treated
as gifts.
Aggregation rules
Basic aggregation rule
Under the proposal, the value for Federal estate, gift, and generation-skipping transfer tax
purposes of any asset transferred by a transferor (a donor or decedent) generally is a pro-rata
share of the fair market value of the entire interest in the asset owned by the transferor just before
the transfer (the ''basic aggregation rule'').
Example 1.''Mother owns 80 percent of the interests in a limited liability company
(''LLC''). LLC's value is $100,000, and Mother's 80-percent interest has a value of
$80,000. Mother makes related gifts of 20-percent interests to each of her two
children. Under the proposal, the value of each 20-percent interest for transfer tax
purposes is one-quarter (20/80) of the value of Mother's 80-percent interest, or
$20,000. Because this value is a pro-rata share of the value of Mother's controlling
interest, the value does not reflect a minority discount.
Example 2.''Mother owns a 40-percent interest in LLC. The value of this 40-percent
interest is $32,000, reflecting a 20-percent minority discount. Mother dies. This 40-
percent interest passes through Mother's estate in equal shares to two children who
did not previously own any interests in the LLC. Under the proposal, the value of
each 20-percent share for transfer tax purposes is $16,000, one-half (20/40) of
Mother's interest at death.
Transferee aggregation rule
A special rule applies if a donor or a decedent's estate does not own a controlling interest
in an asset just before a transfer of all or a portion of the asset to a donee or heir and, in the hands
of the donee or heir, the transferred asset is part of a controlling interest. In that case, the estate,
gift, and generation-skipping transfer tax value of the asset transferred is a pro-rata share of the
fair market value of the entire interest in the asset owned by the donee or heir (not by the
transferor) after taking into account the gift or bequest (the ''transferee aggregation rule'').
Example 3.''The facts follow those in Examples 1 and 2 except that instead of making
gifts and bequests to different children, Mother transfers interests in LLC only to one
child. Thus, during her life Mother makes a single gift of a 40-percent interest to one
child. After application of the basic aggregation rule, this gift has a value of $40,000,
one half (40/80) of the value of Mother's entire 80-percent interest. At the time of
her death, assume that an 80-percent interest in the LLC is still worth $80,000, but
that Mother's remaining 40-percent interest is worth only $32,000, reflecting a
minority discount. After application of the transferee aggregation rule, the 40-percent
interest transferred to the child has a value of $40,000, one-half the $80,000 value of
child's 80-percent interest after the bequest. Because the child has a controlling
interest after the transfer, the value of the bequest for transfer tax purposes does not
incorporate a minority discount.
Look-through rule
If, after application of the aggregation rules described above, a transferred interest in an
entity is part of a controlling interest owned (before the transfer) by the transferor or (after the
transfer) by the transferee, a look-through rule may apply to determine the value of that
transferred interest. Under the look-through rule, if at least one-third of the entity's assets (by
value) consists of marketable assets, the value of a transferred interest in that entity for Federal
estate, gift, and generation-skipping transfer tax purposes is the sum of (1) the net value of the
entity's marketable assets allocable to that transferred interest and (2) the value of the
transferor's interest in the entity attributable to nonmarketable assets. Marketable assets include
cash, bank accounts, certificates of deposit, money market accounts, commercial paper, U.S. and
foreign treasury obligations and bonds, corporate obligations and bonds, precious metals or
commodities, and publicly traded instruments. Marketable assets do not include assets that are
part of an active lending or financing business.
If the look-through rule applies, the effect is to deny a marketability discount to the extent
the entity holds marketable assets. In all cases in which the look-through rule applies, no
minority discount is permitted because a condition of the look-through rule is that the transferred
interest must be part of a controlling interest either before or after the transfer.
Example 4.''At her death, Aunt owns 80 percent of the interests in an LLC whose
assets have a total value of $1 million. The LLC owns publicly-traded stock worth
$600,000, real estate worth $200,000, and a laundromat business worth $200,000.
Aunt's 80-percent interest in LLC passes through her estate to Niece. If it is assumed
that a marketability discount, if available, is 25 percent, then under the proposal the
estate tax value of this 80-percent interest is $720,000, computed in the following
manner. Because 60 percent of the value of LLC's assets is represented by
marketable assets (the publicly-traded stock) and because Aunt owns a controlling
interest before the transfer, the look-through rule applies. The $720,000 value thus
equals (1) 80 percent of the value of the publicly-traded stock, or $480,000 ($600,000
x 80 percent), plus (2) the value of Aunt's interest in the entity attributable to the real
estate and laundromat business, or $240,000 (80 percent of $300,000 (with the
$300,000 representing the value of the laundromat business and real estate after
taking into account a 25-percent marketability discount)).
Example 5.''The facts are the same as in Example 4, except that the laundromat
business is worth $1.2 million. The total value of LLC's assets is $2 million.
Consequently, the value of the marketable assets equals only 30 percent of the value
of the LLC, and the look-through rule does not apply. The estate tax value of this 80-
percent interest is $1.2 million, which equals 80 percent of the value of the LLC (80
percent x $2 million = $1.6 million), less a 25-percent marketability discount
($400,000). No minority discount is available because the 80-percent interest is a
controlling interest.
Example 6.''The facts are the same as in Example 4, except that Aunt owns only a 10-
percent interest in the LLC and Niece does not own any interest in it before she
inherits her Aunt's interest. Accordingly, the look-through rule does not apply
because the 10-percent interest is not part of a controlling interest either before or
after the transfer. Therefore, a minority discount is available. Assume the minority
discount is 20 percent. The value of the 10-percent interest is therefore $60,000,
which equals 10 percent of the value of the LLC ($100,000), less (1) a 20-percent
minority discount ($20,000) and (2) a 25-percent marketability discount ($20,000)
computed after application of the minority discount (that is, 25 percent of $80,000,
the value remaining after taking into account the minority discount).
Effective Date
The proposal applies to transfers occurring and estates of decedents dying on or after the
date of enactment.
Discussion
The proposal responds to the frequent use of family limited partnerships (''FLPs'') and
LLCs to create minority and marketability discounts. In a common planning technique, a
taxpayer forms an FLP or LLC, contributes to that entity marketable securities, real estate, and
other assets, and makes gifts of noncontrolling interests in the entity. At death, the taxpayer
owns only a noncontrolling interest in the FLP or LLC (rather than the underlying assets). Under
present law the gifts made during life may qualify for minority and marketability discounts, and
the estate tax value of the taxpayer's interest in the FLP or LLC also may be substantially
reduced by those discounts. The proposal seeks to curb the use of this strategy frequently
employed to manufacture discounts that do not reflect the economics of the transfers during life
and after death. More broadly, the proposal attempts to reduce the inefficiency caused by the
creation of complicated structures that serve only to shelter value from taxation.
The proposed aggregation and look-through rules restrict a taxpayer's ability to claim
minority and marketability discounts in certain situations in which those discounts do not
accurately reflect the value of the property interests transferred. In general, the basic aggregation
rule of the proposal determines the existence of a minority discount by taking into account the
entire interest held by the transferor just before the transfer. This is because the focus of the
estate and gift tax should be on the amount a transfer depletes the value of the transferor's
holdings. Thus, no minority interest should apply if the transferor holds a controlling interest in
the property just before the transfer. Although inconsistent with this theory, the transferee
aggregation rule is proposed to prevent the strategic sequencing of multiple gifts made to the
same donee. The aggregate value of a series of lifetime and testamentary gifts made by one
donor to the same donee should not depend upon the order in which controlling and non-
controlling interests are transferred to the donee.
The proposed look-through rule addresses abusive situations in which a marketability
discount is inappropriate. If an entity whose interests are nonmarketable holds marketable
assets, a marketability discount for an interest in the entity results in the undervaluing of the
interest if the owner has a controlling interest in the entity and can easily access the marketable
assets.
The proposal does not eliminate minority and marketability discounts in other contexts in
which facts generally support those discounts. If, for example, neither the transferor nor the
transferee owns a controlling interest in an entity, the estate and gift tax value of an interest in
that entity may be determined by taking into account the lack of control. Similarly, where an
entity's value primarily is attributable to nonmarketable assets, the estate and gift tax value of an
interest in that entity may reflect that illiquidity.
The proposal is similar to, but refines, several previous legislative proposals. First, the
basic aggregation rule is similar to a proposal made by the Treasury Department in 1984 as part
of a broad report on tax reform. The 1984 proposal, however, based the value of transferred
property on the transferor's highest level of ownership after taking into account prior gifts. This
tracing of ownership backward through all gifts made by a transferor during his or her lifetime
would create significant administrative difficulties. The proposed basic aggregation rule,
therefore, looks only to the transferor's ownership interest just before the transfer. To eliminate
the advantage of strategic sequencing of gifts to the same donee, the proposal adds a donee
aggregation rule. Second, the look-through rule is similar to the approach taken in the Fiscal
Year 2000 Administration Budget Proposal. That proposal would have required an interest in
an entity to be valued at a proportionate share of the net asset value of the entity to the extent the
entity held non-business assets. The proposal's look-through rule is narrower than the earlier
Treasury proposal, on the theory that in certain cases it may be inappropriate to look through an
interest in an entity if the entity primarily holds non-marketable assets. Third, the proposal
incorporates spousal attribution but does not include a broader family attribution approach taken
by various legislative proposals. The proposal does not take this broader approach because it is
not correct to assume that individuals always will cooperate with one another merely because
they are related. Any proposal involving family attribution could include an exception based on
family hostility, but that exception could entail significant administrative difficulties and might
yield unintended incentive effects.
C. Curtail the Use of Lapsing Trust Powers to Inflate the Gift
Tax Annual Exclusion Amount
(sec. 2503)
Present Law
Under present law, gift tax is imposed on transfers of property by gift, subject to several
exceptions. One major exception is the gift tax annual exclusion of section 2503(b). Under this
exclusion, a donor can transfer up to $11,000 of property to each of an unlimited number of
donees without incurring gift tax on such transfers. In order to qualify for the exclusion, the
property interests transferred must be present interests, as opposed to future interests (such as
remainders). In addition, spouses are allowed to ''split'' gifts for purposes of applying the
exclusion. For example, at both spouses' election, a $22,000 gift from one spouse to a third
person could be treated as being made equally by both spouses, and thus would be sheltered
entirely by the spouses' combined annual exclusion amounts.
Gifts in trust are treated as made to the trust beneficiaries for purposes of applying the
annual exclusion. Accordingly, if the trust beneficiaries have no right to present enjoyment of
the transferred property, the annual exclusion will not apply, as no present interest will have been
transferred. However, the courts and the IRS have long agreed that a temporary right of
withdrawal of trust property on the part of a beneficiary may serve to create a present interest,
thus qualifying such a gift for the annual exclusion. This result obtains even if the right of
withdrawal is of short duration, and even if all parties involved expect that the right will not be
exercised, and thus the beneficiary will not actually ''enjoy'' the transferred property on a current
basis as a practical matter. For example, a married couple may establish a trust for the benefit
of their minor child, and the general terms of the trust may allow distributions to the child only
upon reaching age 25. This couple nevertheless can transfer $22,000 per year to the trust, fully
sheltered by the annual exclusion, as long as the child is given a temporary power to demand
distribution of each new amount transferred into the trust, even if it is highly improbable that the
power will be exercised. These powers, and these arrangements in general, are referred to as
''Crummey powers,'' and ''Crummey trusts'' (so named after a court case upholding one such
arrangement).
While Crummey powers may be used in connection with simple transfers of cash or any
other kind of asset into a trust, use of the powers is particularly common in the case of life
insurance trusts. In these arrangements, a trust owns the life insurance policy, the insured makes
periodic payments into the trust for the purpose of covering the premiums, and the trust
beneficiaries are given Crummey powers with respect to these periodic payments, in order to
ensure that the payments qualify as transfers of present interests eligible for the gift tax annual
exclusion.
In recent years, taxpayers have used Crummey powers to achieve benefits extending
beyond the conversion of future interests into present interests. Specifically, taxpayers have
taken the position that the holder of the Crummey power need not even be a vested beneficiary
of the trust, which creates the possibility of using multiple annual exclusions (one for each
Crummey power holder) for what ultimately will be a gift to a single donee, as a practical matter.
The Tax Court has sustained this position.
Reasons for Change
Recent arrangements involving Crummey powers have extended the ''present interest''
concept far beyond what the Congress likely contemplated in enacting the gift tax annual
exclusion, resulting in significant erosion of the transfer-tax base.
Description of Proposal
In general
The proposal sets forth three options that the Congress may wish to consider for
improving the tax treatment of Crummey powers.
Option 1
Under the first option, for purposes of determining the applicability of the annual
exclusion, a holder of a Crummey power is not treated as the donee with respect to an amount
transferred into trust unless such holder is also a direct, noncontingent beneficiary of the trust.
The Treasury Secretary is given regulatory authority to disregard other Crummey powers in
cases in which the holder of a power is given a relatively small vested interest in a trust, with a
principal purpose of avoiding the application of this provision. This option is designed simply to
prevent taxpayers from claiming multiple annual exclusions in connection with gifts that are
intended and arranged to accrue to a single person.
Option 2
Under the second option, for purposes of determining the applicability of the annual
exclusion, powers to demand the distribution of trust property are taken into account only if they
cannot lapse during the holder's lifetime. This option effectively eliminates Crummey powers as
a tax planning tool.
Option 3
Under the third option, for purposes of determining the applicability of the annual
exclusion, powers to demand the distribution of trust property are taken into account only if: (1)
there is no arrangement or understanding to the effect that the powers will not be exercised; and
(2) there exists at the time of the creation of such powers a meaningful possibility that they will
be exercised. This option requires a facts-and-circumstances analysis of every Crummey power
and disregards those that are found to be essentially lacking in substance. In view of the
prevalence of Crummey powers that essentially lack substance, the practical effect of this option
would be to eliminate Crummey powers as a planning tool in a wide range of cases.
Effective Date
The first option is effective for transfers made after the date of enactment.
The second and third options are effective for transfers made to trusts that are established
after the date of enactment.
Discussion
In general
Crummey arrangements are often essentially shams, and yet they are for the most part
respected for gift tax purposes. While it is arguably troubling for any arrangement essentially
lacking in substance to be given credence for any purpose under the tax law, it nevertheless may
be appropriate to distinguish among various uses of Crummey powers. In many cases, even
though the Crummey power is essentially a sham, the results may be considered unobjectionable,
as the powers may be used simply to provide somewhat greater flexibility in making a gift in
trust to a single person without running afoul of the present-interest constraint. In other cases,
the results may be considered more objectionable, such as when the powers are used to claim
multiple annual exclusions in connection with gifts that are intended and arranged to accrue to a
single person.
Option 1
If Crummey powers held by individuals with no significant interest in the underlying
trust assets are respected for purposes of determining the annual exclusion, then taxpayers are
effectively free to mint multiple annual exclusions for what is in substance a gift through the
trust to a single beneficiary. This power to mint exclusions is limited only by the number of
friends and relatives that a donor can find and can trust not to exercise the withdrawal right
during its brief existence. The use of Crummey powers for this purpose is an abuse of the annual
exclusion and may cause significant erosion of the transfer tax base. By requiring a Crummey
power holder to be a significant, vested beneficiary of the underlying trust, the first option would
curtail this abuse of Crummey powers. At the same time, this option would preserve the
availability of the powers for the more limited purpose of allowing a donor to place practical
constraints on a donee's enjoyment of a gift without running afoul of the present-interest
limitation. This option would not affect standard life insurance trusts. Because this option
narrowly targets abusive applications of Crummey powers, it is effective for transfers made after
the date of enactment, regardless of whether the trust already existed prior to enactment.
Option 2
Crummey powers arguably have eviscerated the present-interest requirement. This
requirement was originally designed to protect the integrity of the per-donee annual exclusion
amount under the gift tax. As the Cristofani case illustrates, if an exclusion amount is allowed to
attach to an interest that lapses, then it becomes possible for the benefit of the gift shielded by the
exclusion ultimately to inure to some other person, resulting in an inappropriate multiplication of
the exclusion amount. Narrowly targeted anti-abuse rules that leave Crummey powers basically
intact--like the first option above--may leave open some avenues of abuse. The second option
ensures that the benefit of a gift will inure only to the holder of a withdrawal power, by
respecting that power for tax purposes only if it never lapses. On the other hand, as noted above,
Crummey powers are well-established tools widely used for the purpose of making a gift in trust
to a single person without running afoul of the present-interest constraint. Eliminating the
powers could force a large number of individuals to revisit their family financial plans, although
this problem would be mitigated significantly by grandfathering transfers made to existing trusts.
Option 3
Some may argue that Crummey powers are objectionable only insofar as they are
effectively shams. According to this view, the case law on this subject is problematic only
because it allows ''wink and a nod'' arrangements to dictate tax results, with little analysis of the
surrounding facts and circumstances. It would arguably be inappropriate to disregard a lapsing
withdrawal power that might actually be exercised as a practical matter, thus making the second
option too aggressive according to this view. In such a case, possession of the power actually is
tantamount to ownership of a present interest in property. The IRS and the courts are equipped
to examine the substance of these arrangements, and doing so arguably would lead to
appropriate, commonsense results: illusory powers would be given no tax effect, and real powers
would be given tax effect. As a practical matter, if such a rule were applied vigorously, it would
eliminate most common Crummey arrangements, as such arrangements generally involve powers
that are not expected to be exercised. Thus, like the second option above, this option could force
a large number of individuals to revisit their family financial plans (and thus, this option also
would grandfather transfers to existing trusts). This option would present the administrative and
compliance difficulties common to all rules that require facts-and-circumstances determinations.
D. Provide Reporting for a Consistent Basis Between the Estate
Tax Valuation and the Basis in the Hands of the Heir
(sec. 1014)
Present Law
The value of an asset for purposes of the estate tax is the fair market value at the time of
death or at the alternate valuation date. The basis of property acquired from a decedent is the fair
market value of the property at the time of the decedent's death or alternate valuation date, if
elected by the executor. Under regulations, the fair market value of the property at the date of
the decedent's death (or alternate date) is deemed to be its value as appraised for estate tax
purposes. However, the value of property as reported on the decedent's estate tax return
provides only a rebuttable presumption of the property's basis in the hands of the heir. Unless
the heir is estopped by his or her previous actions or statements with regard to the estate tax
valuation, the heir may rebut the use of the estate's valuation as his or her basis by clear and
convincing evidence. The heir is free to rebut the presumption in two situations: (1) the heir has
not used the estate tax value for tax purposes, the IRS has not relied on the heir's representations,
and the statute of limitations on assessments has not barred adjustments; and (2) the heir does not
have a special relationship to the estate which imposes a duty of consistency.
For property acquired by gift, the basis of the property in the hands of the donee
generally is same as it was in the hands of the donor. However, for the purpose of determining
loss on subsequent sale, the basis of property in the hands of the donee is the lesser of the
donor's basis or the fair market value of the property at the time of the gift.
Reasons for Change
Providing an heir with fair market value information gives the heir records to improve
reporting of income upon future realization of gain. Providing the IRS with the same
information would better enable the IRS to challenge inappropriate attempts to underreport gain
upon a subsequent realization of that gain.
Description of Proposal
The proposal requires that for any property acquired as a bequest from an estate which
has a Federal estate tax liability, the executor is required to provide the heir and the IRS with a
statement of the value of the asset reported for estate tax purposes. The value so reported is
binding on the heir as his or her basis for the purpose of computing future gain or loss as
provided under present law. The proposal does not apply to items of income in respect of a
decedent or property that the executor of the decedent's estate sells.
Effective Date
The proposal is effective for transfers from estates for which the estate tax return is filed
after the date of enactment.
Discussion
Under present law, generally the incentive exists for an executor to offer conservative
estimates of the value of assets in an estate. For the purpose of determining gain or loss on an
inherited asset, generally the heir would prefer a higher basis. The government is potentially
whipsawed by inconsistent valuations. For example, the IRS has ruled that while value as
appraised for estate tax purposes provides a presumptive value for the basis of inherited property
in the hands of a beneficiary, such estate tax valuation generally is not conclusive. In a case
discussed in a technical advice memorandum, at the time of the decedent's death the taxpayer
owned stock in two closely held corporations. On audit, the IRS proposed a higher value for the
stock than the value the executor provided on the estate tax return. The estate subsequently
argued for a lower valuation and the IRS agreed to an amount in between the two parties' initial
valuations. Following a redemption of the inherited stock from the beneficiary, the beneficiary
(in an amended return for the taxable year of redemption) claimed a basis in the stock that was
higher than both the original estate tax return value and the agreed upon value.
Underlying the rebuttable presumption rule set forth in the technical advice memorandum
is the theory that a taxpayer should not be estopped from claiming a basis different from the
value determined by an executor for estate tax purposes where the taxpayer did not participate in
the executor's determination or benefit from it. This theory represents an application of an
estoppel principle that is used outside the context of the estate tax. Where, however, a taxpayer
succeeds in presenting clear and convincing evidence of a higher basis than the value used for
estate tax purposes, this principle conflicts with one rationale for the section 1014 basis step-up
rule. Some analysts argue that the step-up of an asset's basis at death is an appropriate
adjustment to prevent property transferred at death from being subject to both Federal income tax
and estate tax. If the basis in the hands of the heir exceeds the value used for estate tax
purposes, an exemption from income tax in excess of the appreciation in decedent's hands has
been implicitly created. By helping to ensure consistency in value for estate and income tax
purposes, the proposal at least mitigates the whipsawing of the government that may occur under
present law.
In general, in the computation of capital gain or loss, establishing basis in property is a
problem area for taxpayers and the IRS, because the basis in the property only becomes
important for determining tax liability when the asset is sold, often many years after the asset is
acquired. Taxpayers may lose records in the interim. The difficulty would be particularly acute
where the taxpayer did not purchase the asset in question and thereby would have no records
(e.g., receipts or other purchase documentation) to begin with. Thus, another rationale for the
basis step-up rule of present law section 1014 is to provide administrative simplicity for the heir
and the IRS because the heir's fair market value basis will potentially already have been
determined for estate tax purposes. The proposal achieves this administrative advantage by
having basis reported at the time an asset is bequeathed, thereby establishing a record
comparable to purchase documentation. Present law arguably fails to achieve this advantage,
both because the executor is not required to report the estate tax value to the heir, and because
the heir is not required in all cases to use such value in determining basis.
Under the proposal there would be instances in which the value of an asset reported by an
executor to an heir differs from the ultimate value of the asset used for estate tax purposes. For
example, if the IRS challenges an estate valuation and prevails, the executor will have reported
to the heir a valuation that is ''too low'' and the heir may arguably be overtaxed on a subsequent
sale of the asset. This same problem exists under present law to the extent the initially reported
estate tax value is presumptively the heir's basis. To provide complete consistency between
estate tax valuation and basis in the hands of an heir may be impractical as ultimate
determination of value for estate tax purposes may depend upon litigation and an heir may sell an
asset before the determination of value for estate tax purposes.
By requiring the value of an asset reported for estate tax purposes to be reported and used
by the heir in determining basis, however, the proposal has the salutary effect of encouraging a
more realistic value determination in the first instance. This salutary effect would be lost if there
were a relief mechanism for heirs and estates (and recoupment for the government) if the basis
used by heirs differs from the fair market value ultimately determined for estate tax purposes.
Thus, the proposal does not contain any such relief mechanism.
E. Modify Transfer Tax Provisions Applicable to
Section 529 Qualified Tuition Accounts
(sec. 529)
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. 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''). 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'').
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
on behalf 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 look to for decisions,
recordkeeping, and reporting with respect to the account or contract. The person or persons who
make the contributions to the account need not be the same person who is regarded as the
account owner. 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. 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, without the consent of the designated beneficiary. As a result, in many
qualified tuition programs, neither the contributor nor the designated beneficiary has legally
enforceable protections designed to assure that the account will be used to provide education or
other benefits to the designated beneficiary.
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 account 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. 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.
Generally applicable transfer tax provisions
A gift tax is imposed on lifetime transfers and an estate tax is imposed on transfers at
death. A taxpayer may exclude $11,000 (for 2005) of gifts made to any one donee during a
calendar year. The annual exclusion does not apply to gifts of future interests (e.g., reversions or
remainders). Married individuals may treat gifts made to any one donee as having been made
one-half by such donor and one-half by his or her spouse, effectively allowing a married couple
to exclude $22,000 (for 2005) of gifts made to any one donee during a calendar year.
The gift tax applies to a transfer by way of gift whether the transfer is in trust or
otherwise, whether the gift is direct or indirect, and whether the property is real or personal,
tangible or intangible. If a trustee has a beneficial interest in trust property, a transfer of the
property by the trustee is not a taxable transfer if it is made pursuant to a fiduciary power the
exercise or nonexercise of which is limited by a reasonably fixed or ascertainable standard which
is set forth in the trust instrument. For example, a power to distribute corpus for the education of
the beneficiary generally is a power limited by such a standard, whereas a power to distribute
corpus for the happiness of the beneficiary is not.
For estate tax purposes, the value of the decedent's gross estate includes the value of all
property to the extent of the decedent's interest therein at the time of his or her death,
including the value of certain interests in property transferred by the decedent during his or her
life (sections 2035 through 2038), and special kinds of property and powers held by the decedent
or on the life of the decedent (sections 2039 through 2042, including powers of appointment
governed by section 2041). For example, section 2036 provides for the inclusion of
transferred property with respect to which the decedent retained the income or the power to
designate who shall enjoy the income of the property, and section 2038 provides for the inclusion
of transferred property if the decedent had at the time of his or her death the power to change the
beneficial enjoyment of the property.
A generation-skipping transfer (''GST'') tax generally is imposed on transfers, either
directly or through a trust or similar arrangement, to a ''skip person'' (i.e., a beneficiary in a
generation more than one generation below that of the transferor). In general, if an outright gift
is not subject to gift tax because of application of the gift tax annual exclusion, then it will not be
subject to GST tax.
Absent the specific transfer tax provisions of section 529, the generally applicable gift,
GST, and estate tax provisions would apply to qualified tuition accounts.
Income tax treatment of qualified tuition accounts
A qualified tuition program, including a savings account or a prepaid tuition contract
established thereunder, generally is exempt from income tax. 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. If a distribution is not used to
pay qualified higher education expenses, the earnings portion of the distribution is subject to
Federal income tax, 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.
Gift and GST tax treatment of qualified tuition accounts
Section 529 modifies the generally applicable gift and GST tax provisions that otherwise
would apply to qualified tuition accounts. 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. Such contributions qualify for the per-donee
annual gift tax exclusion, and, to the extent of such exclusions, also are exempt from the GST
tax. A contributor may contribute 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.
A distribution from a qualified tuition account or prepaid tuition contract generally is not
subject to gift tax or GST tax. Those taxes apply, however, to a change of designated beneficiary
if the new designated beneficiary is in a generation below that of the former beneficiary or is not
a member of the family of the former beneficiary.
Estate tax treatment of qualified tuition accounts
Section 529 modifies the generally applicable estate tax provisions that otherwise would
apply to qualified tuition accounts. Qualified tuition program account balances or prepaid
tuition benefits generally are excluded from the gross estate of any individual. Amounts
distributed on account of the death of the designated beneficiary, however, are includible in the
designated beneficiary's gross estate. If a contributor elected the special five-year allocation rule
for gift tax annual exclusion purposes, any amounts contributed by the contributor 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.
Reasons for Change
Present law regarding the transfer tax treatment of section 529 accounts is unclear in
many situations, and in other situations imposes transfer taxes in a manner that is inconsistent
with otherwise applicable transfer tax provisions. In addition, the present-law section 529
transfer tax rules do not adequately reflect the structural changes that have occurred to qualified
tuition programs over the past few years, many of which have been designed to provide
maximum flexibility to the program's account owners, rather than assure that account funds will
be used to fund educational expenses of a designated beneficiary.
Description of Proposal
Modify special transfer tax provisions of section 529
In general
The proposal modifies the special transfer tax (gift, GST, and estate tax) provisions of
present-law section 529, and generally subjects qualified tuition accounts to otherwise applicable
transfer tax provisions. In general, a contribution to a qualified tuition account is not treated as a
completed gift, and is includible in the estate of the contributor or account owner, unless the
terms governing the account satisfy certain requirements. The proposal defines an account
owner as the person whom the program administrator may look to for decisions, recordkeeping,
and reporting with respect to the qualified tuition account. The present-law income tax rules
applicable to qualified tuition accounts do not change.
Contributions treated as completed gifts to designated beneficiary
Under the proposal, an amount contributed to a qualified tuition account is treated as a
completed gift of a present interest to the designated beneficiary (and becomes includible in the
estate of the designated beneficiary) at the time of the contribution only if: (1) the designated
beneficiary is living at the time the account is established; (2) only the designated beneficiary
may terminate the account or change the designated beneficiary during the designated
beneficiary's lifetime, and such termination or change of beneficiary may not occur prior to the
designated beneficiary's attaining age 18, receiving a high school diploma, or becoming learning
disabled; (3) if the designated beneficiary dies before attaining age 18, the personal
representative of the deceased beneficiary may designate a successor designated beneficiary who
is a member of the family (and of the same generation as) the designated beneficiary, or
terminate the account; and (4) a distribution upon termination of the account may be made to or
for the benefit of a person (including to an educational institution) other than the designated
beneficiary only if (a) such other person is irrevocably designated at the time the contract is
executed, or is a member of the family of (and in the same generation as) the designated
beneficiary, and is a person other than the contributor and account owner; and (b) such
distribution may be made only if the designated beneficiary dies, becomes learning disabled,
certifies that the designated beneficiary has reached the age of 18 and will not attend a college or
university, has received a scholarship in an amount equal to or greater than the amount of the
distribution, or certifies that the account balance or prepaid benefit exceeds the designated
beneficiary's actual educational expenses. If such conditions are satisfied, then the contribution
is treated as a completed gift of a present interest by the contributor (whether the account owner
or a person other than the account owner) to the designated beneficiary, the contributor may elect
to take the contribution into account as a gift ratably over the five-year period beginning with the
year of the contribution, and no further transfer tax consequences apply upon a change of
account owner, a change of designated beneficiary, or a distribution from the account.
Example.''Mother establishes a qualified tuition account and designates her living child
(Child) as the designated beneficiary. The account's terms provide that Mother is the account
owner, but that only Child may terminate the account or change the designated beneficiary, and
that any distribution other than to or for the benefit of Child must satisfy the other conditions
described above. Mother makes a $55,000 contribution to the account in Year 1. In Year 5, a
distribution of $25,000 is made from the account for Child's benefit and paid to an eligible
educational institution. Under the proposal, Mother's contribution is treated as a completed gift
of a present interest by Mother to Child in Year 1, and Mother may elect to treat the gift as made
ratably over the five-year period (i.e., $11,000 per year) beginning with Year 1. If Child's
grandparent (Grandfather), rather than Mother, makes the contribution to the account, then
Grandfather is treated as making the completed gift to Child and may elect the application of the
special five-year rule. The distribution in Year 5 is not a transfer for transfer tax purposes. Amounts treated as includible in estate of account owner
In those circumstances involving qualified tuition accounts that do not satisfy the
requirements described above, a completed gift to the designated beneficiary does not occur until
an amount is distributed from the qualified tuition account to or for the benefit of the designated
beneficiary. In such cases, the transfer tax consequences of a contribution to a qualified tuition
account depend upon whether the contribution is made by the account owner or by a person other
than the account owner. Contributions made by the account owner are not a completed gift and
remain includible in the account owner's estate. Contributions made by a person other than the
account owner are governed by generally applicable transfer tax principles, and may constitute a
completed gift of a present interest to the account owner at the time of the contribution that
become includible in the account owner's estate. A completed gift of a present interest by the
account owner occurs at the time an amount is distributed from the account to or for the benefit
of a person other than the account owner (e.g., the designated beneficiary), whether for
educational or other purposes. In these cases, a change of account owner is a completed gift to
the new account owner (not eligible for the special five-year rule), but a change of designated
beneficiary is not a completed gift.
Example.''Mother establishes a qualified tuition account and designates her living child
(Child) as the designated beneficiary. The account's terms provide that Mother is the account
owner, and that Mother may terminate the account, change the designated beneficiary, and direct
that a distribution be made other than to or for the benefit of Child. Mother makes a $55,000
contribution to the account in Year 1. In Year 5, a distribution of $25,000 is made from the
account for Child's benefit and paid to an eligible educational institution. Under the proposal,
Mother's contribution in Year 1 is not a completed gift by Mother to Child, and the account
remains includible in Mother's estate. If Child's grandparent (Grandfather), rather than Mother,
makes the contribution to the account, Grandfather is treated as making a completed gift of a
present interest to Mother (rather than to Child), and Grandfather may not elect the application of
the special five-year rule. The $25,000 distribution from the account for the benefit of Child
constitutes a completed gift of a present interest by Mother to Child (not eligible for the special
five-year rule) at the time of the distribution, and may be excludable as a qualified transfer
within the meaning of section 2503(e)(2) if paid for Child's tuition.
Effective Date
The proposal applies to contributions (and earnings thereon) made in taxable years
beginning after the date of enactment. The proposal does not apply to contributions made on or
before the effective date (and earnings thereon). Separate accounting of such contributions is
required.
Discussion
Recent changes in qualified tuition account program design
Present-law section 529 is unclear with respect to the transfer tax consequences of certain
events pertaining to qualified tuition accounts, imposes transfer taxes in a manner that is
inconsistent with otherwise applicable transfer tax principles, and creates opportunities for abuse
by taxpayers who may establish such accounts with no intention of providing education benefits
to others. In addition, present-law section 529 affords taxpayers who establish qualified tuition
accounts a combination of income tax and transfer tax benefits that is more favorable than those
available for other tax-favored accounts, such as individual retirement accounts and health
savings accounts. Although other tax-favored accounts obtain income tax benefits similar to
those available for section 529 accounts, qualified tuition accounts are unusual in that section
529 permits a taxpayer to avoid estate, gift and GST taxes even if (as is the case in many
qualified tuition programs) the taxpayer effectively retains control of the qualified tuition
account.
Section 529 was enacted in 1996. Since then, qualified tuition programs have
increased significantly, both in the number of accounts and aggregate funds, with more than $35
billion invested in such programs as of early 2004. Some have estimated the number of
section 529 accounts at approximately five million, and program assets soon approaching $50
billion. Others have predicted that total assets in qualified tuition programs will reach $300
billion by 2010.
In 1986, the State of Michigan adopted the first prepaid tuition program in the United
States. The Michigan prepaid tuition program prohibited the account owner from changing
the designated beneficiary, and limited the ability of the account owner to use the funds other
than for the beneficiary's education expenses. The current Michigan prepaid tuition program
retains these restrictions. Under the current Michigan prepaid tuition program, only a student
who is at least 18 years of age or has obtained a high school diploma may terminate a prepaid
tuition account and compel a distribution of the account balance. A parent or purchaser of the
prepaid contract may not terminate the account for any reason other than if the student has died
or has become learning disabled. If the student reaches age 18 or receives a high school
diploma, the student has the option of transferring the account to an immediate family member or
terminating the account to obtain a refund paid to a refund designee established at the time the
account was established. A student who receives a scholarship or other type of tuition
assistance may receive the excess account funds not needed to pay for the student's educational
expenses. Use of the prepaid tuition account for other purposes is not permitted under the
program.
As of January 2004, there were 17 State prepaid tuition programs, and 51 State savings
programs. Few qualified tuition programs impose requirements designed to meaningfully
restrict beneficiary changes or limit use of the account or contract to qualified higher education
expenses. Present-law section 529 provides the same transfer tax outcomes for all qualified
tuition accounts, without regard to the rights and controls retained by the contributor or account
owner. The proposal provides for uniform transfer tax treatment for all plans that satisfy the
proposed requirements that treat a contribution as a completed gift of a present interest. The
transfer tax consequences for accounts established under programs that do not satisfy the
proposed requirements would depend upon the particular terms and restrictions applicable to the
account.
The Administration's Fiscal Year 2005 Budget included a proposal to modify certain of
the rules regarding qualified tuition accounts. The explanation of the Administration's proposal
stated that ''[c]urrent law regarding the transfer tax treatment of section 529 accounts is unclear
and in some situations imposes tax in a manner inconsistent with generally applicable transfer
tax provisions'' In addition, the lack of any limits on who can be named a [designated
beneficiary] creates opportunities for the unintended and inappropriate use of section 529 plans.
For example, taxpayers may seek to use section 529 accounts as retirement accounts, with all the
tax benefits but none of the restrictions and requirements of qualified retirement accounts, or to
avoid gift and GST taxes by changing the [designated beneficiary] of existing section 529
accounts.'' The Administration stated that the law ''should be clarified to provide taxpayers
with certainty as to the tax consequences of a transfer and to eliminate the inappropriate
imposition of transfer taxes.''
Subjecting qualified tuition accounts to generally applicable transfer tax provisions would
reduce the potential for abuse by taxpayers who establish such accounts with no intention of
ultimately providing education benefits to other persons, and would put qualified tuition
accounts on a more level playing field with other tax incentive vehicles such as IRAs, while
retaining the substantial income tax benefits provided by the present-law section 529 provisions
for qualified tuition accounts. Under the proposal, a taxpayer could treat the contribution of
amounts to a qualified tuition account as a completed gift, excludable from his or her estate, only
if he or she relinquished control over the use and enjoyment of the account. Other potential
solutions offered to prevent abuse of the accounts, such as imposing aggregate quantitative per-
contributor or per-beneficiary limits on contributions or account balances, would be difficult to
administer because they would require coordination of recordkeeping and reporting by the
various State-sponsored and private qualified tuition programs. In addition, the present-law
provisions cannot be made consistent with generally applicable transfer tax principles without
materially altering the structural design of most qualified tuition programs.
Transfer tax deficiencies of present-law section 529
Section 529 does not explicitly address the transfer tax consequences of certain events
that are commonplace under existing qualified tuition programs. For example, section 529 does
not address the transfer tax consequences of a change of account owners of a qualified tuition
account. It is unclear whether a change of account owner is to be regarded as a completed gift of
a present interest from the former account owner to the new account owner, or as having no tax
consequences because a completed gift had been made to the designated beneficiary. Further,
section 529 does not identify which party is responsible for payment of the transfer tax when it is
imposed (i.e., in instances involving a change of designated beneficiary to a person who is in a
generation lower than the former beneficiary). In such cases, it is not clear whether the gift tax
should be imposed on the former designated beneficiary, the original contributor, the account
owner, or perhaps on the account. This lack of clarity creates complexity for taxpayers in
arranging their affairs, and for the IRS in attempting to administer the present-law rules.
In addition, section 529 departs from otherwise generally applicable transfer tax
principles in at least five ways. First, present-law section 529 treats a contribution to a qualified
tuition account as a completed gift of a present interest to the designated beneficiary, 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 vested in the account owner. Second, a change of designated beneficiary to a new
beneficiary who is in a generation lower than the former beneficiary constitutes a taxable gift,
even though the new designated beneficiary would not, under otherwise applicable transfer tax
principles, be regarded as receiving a completed gift. Third, an account owner is not required to
include in the account owner's estate the amount held in a qualified tuition account, even if the
account owner possesses at his or her death the right to withdraw funds for the benefit of
someone other than the designated beneficiary or to change the designated beneficiary.
Fourth, a distribution from a qualified tuition account is not treated as a taxable gift unless the
distributee is of a generation lower than the designated beneficiary. Fifth, 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 account.
For example, under present-law section 529, a taxpayer might establish 20 separate
qualified tuition accounts for 20 separate designated beneficiaries, and immediately deposit
$55,000 in each account. By doing so, the taxpayer may treat the full amount of each
contribution as a completed gift to the designated beneficiary, elect the section 529 five-year
annual exclusion treatment for each of the contributions, and exclude the entire $1.1 million (up
to $2.2 million under gift-splitting) from estate, gift, and GST taxes. Under present law, the
taxpayer may be the account owner with respect to each of these accounts, which under many
qualified tuition programs permits the taxpayer to control the account through changes in the
designated beneficiary and the withdrawal of funds for any purpose. The taxpayer has avoided
the imposition of the estate, gift, and GST taxes even if the account ultimately is not used for
education purposes. The taxpayer also may avoid imposition of the GST by designating
beneficiaries who are in generations more than one generation below the generation of the
taxpayer. Because section 529 imposes no restrictions on the identity or number of persons for
whom qualified tuition accounts may be established, or to which contributions may be made, it
has been suggested that the literal application of section 529 could permit a closely-held business
employer to establish qualified tuition accounts for each of its employees, and later change the
beneficiaries of the accounts to a single individual, without incurring transfer taxes on the
transfers to the accounts.
Some might argue that the proposal effectively eliminates transfer tax benefits for most
qualified tuition programs, and that retention of the special transfer tax principles of present law
is desirable to encourage savings for educational purposes. Others might argue that the proposal
does not go far enough to maximize the likelihood that the account ultimately is used for
educational purposes, and would endorse the imposition of an excise tax (in addition to the
present-law additional 10-percent tax) in cases where monies are withdrawn for noneducational
purposes. Such an excise tax might be limited to cases where the withdrawal is for the benefit of
someone other than the initial designated beneficiary, because in such cases additional transfer
tax benefits (such as through generation skipping) might have been derived from the
arrangement.
XII. ESTIMATED REVENUE EFFECTS OF PROPOSALS
National Taxpayer Advocate, 2003 Annual Report to Congress, Publication 2104 (Rev.
12-2003), at iv.
Sec. 3401(c).
Secs. 3401 and 3402.
Secs. 3121 and 3231.
Sec. 3405.
Sec. 3406.
Sec. 3402(q).
Sec. 3402(p)(1).
Sec. 3402(p)(2).
Secs. 1441 and 1442.
Sec. 6041(a).
Sec. 6051(a).
Sec. 6041A.
Sec. 6041A(d)(3)(A).
Sec. 6050M.
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 estimated size of the annual net tax gap (i.e., the gross tax gap
reduced by the taxes eventually collected) is about $255 billion. National Taxpayer Advocate,
2004 Annual Report to Congress, Publication 2104 (Rev. 12-2004), at 211.
For example, self-employed individuals whose income is subject to neither
withholding nor to information reporting are estimated to report only 36 percent of their income.
National Taxpayer Advocate, 2003 Annual Report to Congress, Publication 2104 (Rev. 12-
2003), at 265.
U.S. General Accounting Office, Financial Management: Some DOD Contractors
Abuse the Federal Tax System with Little Consequence, GAO-04-95 (February 2004).
Thus, the proposal does not apply, for example, to welfare and other types of public
assistance payments.
Multistate agencies also would be covered by the terms of the proposal.
The proposal does not exclude payments that are potentially subject to backup
withholding under section 3406. If, however, payments are actually being withheld under
backup withholding, withholding under the proposal does not apply. The purpose of the backup
withholding system is to decrease noncompliance by ensuring taxpayers provide valid taxpayer
identification numbers. Backup withholding only applies when a taxpayer has failed to furnish a
taxpayer identification number and the taxpayer has either a history of underreporting or has
failed to certify that backup withholding is not applicable. Thus, payments potentially subject to
backup withholding, but for which amounts are not actually being withheld, are not of the type
excluded from the proposal.
GAO Testimony before the Committee on Small Business, House of Representatives,
Tax Administration, Improving Independent Contractor Compliance with Tax Laws, GAO/T-
GGD-94-194, August 4, 1994.
See GAO Report to Congressional Requesters, Tax Administration, Approaches for
Improving Independent Contractor Compliance, GAO/GGD-92-108, July 1992, at 4.
GAO Report to the Chairman, Subcommittee on Oversight, Committee on Ways and
Means, House of Representatives, Tax Administration: Tax Compliance of Nonwage Earners,
GAO/GGD-96-165, August 1996, at 12.
National Taxpayer Advocate, 2003 Annual Report to Congress, Publication 2104
(Rev. 12-2003), p. 265; see also National Taxpayer Advocate, 2004 Annual Report to Congress,
Publication 2104 (Rev. 12-2004), at 484.
The combined payments for goods and services by Federal, State, and local
governments represent between six and seven percent of gross domestic product in any year,
with approximately one-third of this amount attributable to purchases of goods and services by
the Federal government. See Bureau of Economic Analysis, U.S. Department of Commerce,
National Income and Product Accounts Tables, Tables 1.1.5 and 3.10.5 (December 22, 2004).
Sec. 6331(h).
National Taxpayer Advocate, 2003 Annual Report to Congress, Publication 2104
(Rev. 12-2003), at 265.
Sec. 6331(h), as amended by Pub. L. No. 108-357 (2004).
U.S. General Accounting Office, Tax Administration: Federal Payment Levy Program
Measure, Performance, and Equity Can Be Improved, GAO-03-356 (March 6, 2003).
Id.
The National Taxpayer Advocate generally recommended withholding by all payors
on non-wage payments. National Taxpayer Advocate, 2003 Annual Report to Congress,
Publication 2104 (Rev. 12-2003); see also National Taxpayer Advocate, 2004 Annual Report to
Congress, Publication 2104 (Rev. 12-2004), at 484.
Sec. 7122.
Olsen v. United States, 326 F. Supp.2d 184 (D. Mass. June 16, 2004).
The IRS categorizes payment plans with more specificity, which is generally not
significant for purposes of the proposal. See Form 656, Offer-in-Compromise, page 6 of
instruction booklet (revised July 2004).
While the government has an interest in receiving payment as soon as possible, it also
has an interest in receiving the maximum appropriate amount, and these two interests conflict.
Reviewing an offer (to establish that the government is receiving the maximum appropriate
amount) generally takes a significant period of time. Most offers are made because of doubt as
to collectibility; in other words, the taxpayer asserts that its resources are inadequate to pay the
government in full. To evaluate the veracity of the taxpayer's assertions, the IRS must in many
instances consider in detail the resources available to the taxpayer. This requires a very fact-
intensive process, which can require significant time to complete. In addition, the evaluation of
how those resources should be deployed to satisfy the taxpayer's obligation to the government
(as well as the taxpayer's other obligations) requires both time and sound judgment.
National Taxpayer Advocate, 2004 Annual Report to Congress (December 31, 2004),
at 311, citing a recent IRS study.
See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), aff'g 73
T.C.M. (CCH) 2189 (1997), cert. denied 526 U.S. 1017 (1999).
Closely related doctrines also applied by the courts (sometimes interchangeable with
the economic substance doctrine) include the ''sham transaction doctrine'' and the ''business
purpose doctrine.'' See, e.g., Knetsch v. United States, 364 U.S. 361 (1960) (denying interest
deductions on a ''sham transaction'' the only purpose of which was to create the deductions).
ACM Partnership v. Commissioner, 73 T.C.M. at 2215.
ACM Partnership v. Commissioner, 157 F.3d at 256 n.48.
''The casebooks are glutted with [economic substance] tests. Many such tests
proliferate because they give the comforting illusion of consistency and precision. They often
obscure rather than clarify.'' Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988).
See, e.g., Pasternak v. Commissioner, 990 F.2d 893, 898 (6th Cir. 1993) (''The
threshold question is whether the transaction has economic substance. If the answer is yes, the
question becomes whether the taxpayer was motivated by profit to participate in the
transaction'').
See, e.g., Rice's Toyota World v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985)
(''To treat a transaction as a sham, the court must find that the taxpayer was motivated by no
business purposes other than obtaining tax benefits in entering the transaction, and, second, that
the transaction has no economic substance because no reasonable possibility of a profit exists.'').
As noted earlier, the economic substance doctrine and the sham transaction doctrine are similar
and sometimes are applied interchangeably. For a more detailed discussion of the sham
transaction doctrine, see, Joint Committee on Taxation, Study of Present-Law Penalty and
Interest Provisions as Required by Section 3801 of the Internal Revenue Service Restructuring
and Reform Act of 1998 (including Provisions Relating to Corporate Tax Shelters), (JCS-3-99) at
182.
See, e.g., ACM Partnership v. Commissioner, 157 F.3d at 247; Sacks v.
Commissioner, 69 F.3d 982, 985 (9th Cir. 1995) (''Instead, the consideration of business purpose
and economic substance are simply more precise factors to consider . . . . We have repeatedly
and carefully noted that this formulation cannot be used as a ''rigid two-step analysis'''').
Coltec Industries, Inc. v. United States, 62 Fed. Cl. 716 (2004) (slip opinion at 123-
124). The court also found, however, that the doctrine was satisfied in that case. Id. at 128.
Id. at 128.
See, e.g., Knetsch, 364 U.S. at 361; Goldstein v. Commissioner, 364 F.2d 734 (2d Cir.
1966) (holding that an unprofitable, leveraged acquisition of Treasury bills, and accompanying
prepaid interest deduction, lacked economic substance).
See, e.g., Goldstein v. Commissioner, 364 F.2d at 739-40 (disallowing deduction even
though taxpayer had a possibility of small gain or loss by owning Treasury bills); Sheldon v.
Commissioner, 94 T.C. 738, 768 (1990) (stating that ''potential for gain . . . is infinitesimally
nominal and vastly insignificant when considered in comparison with the claimed deductions'').
See, e.g., Rice's Toyota World v. Commissioner, 752 F.2d at 94 (the economic
substance inquiry requires an objective determination of whether a reasonable possibility of
profit from the transaction existed apart from tax benefits); Compaq Computer Corp. v.
Commissioner, 277 F.3d at 781 (applied the same test, citing Rice's Toyota World); IES
Industries v. United States, 253 F.3d 350, 354 (8th Cir. 2001).
See, American Electric Power, Inc. v. U.S., 136 F. Supp. 2d 762, 791-92 (S.D. Ohio
2001).
See, e.g., Joint Committee on Taxation, Report of Investigation of Enron Corporation
and Related Entities Regarding Federal Tax and Compensation Issues, and Policy
Recommendations (JSC-3-03) February, 2003 (''Enron Report''), Volume III at C-93, 289. Enron
Corporation relied on Frank Lyon Co. v. United States, 435 U.S. 561, 577-78 (1978), and
Newman v. Commissioner, 902 F.2d 159, 163 (2d Cir. 1990) to argue that financial accounting
benefits arising from tax savings constitutes a good business purpose.
In order to satisfy these requirements there must have been substantial authority for
the taxpayer's position and the taxpayer must have reasonably believed that the claimed
treatment was more likely than not the proper treatment. A taxpayer may not rely on a tax
opinion that is issued by a ''disqualified advisor'' (in general, an advisor with certain
relationships to the transaction) and may not rely on any tax opinion that is a ''disqualified
opinion'' that does not meet certain standards. Sec. 6662A.
Sec. 6662A. In the case of a nondisclosed reportable transaction that is not listed but
that has a significant purpose of evading or avoiding Federal income tax, the IRS may waive the
accuracy related penalty only if the Commissioner determines that such waiver will enhance
compliance and tax administration.
Sec. 6707A(c). Reportable transactions are described at Treasury Regulation section
1.6011-4(b). See also Notice 2004-80, 2004-50 I.R.B. 963, modifying the definitions of
reportable transactions. Listed transactions are described in Notice 2004-67, 2004-41 I.R.B. 600.
The rules of section 246(c)(3) and 246(c)(4), regarding the computation of holding
period, apply for this purpose.
See description of ''SC2'' transaction, Appendix B of the report, ''U.S. Tax Shelter
Industry: The Role of Accounts, Lawyers, and Financial Professionals,'' Minority Staff of the
Permanent Subcommittee on Investigations, Senate Committee on Government Affairs (released
in conjunction with Hearings on November 18 and 20, 2003).
See, e.g., Treas. Reg. sec. 1.269-2(b) (stating that a distortion of tax liability indicating
the principal purpose of tax evasion or avoidance might be evidenced by the fact that ''the
transaction was not undertaken for reasons germane to the conduct of the business of the
taxpayer''). Similarly, in ACM Partnership v. Commissioner, 73 T.C.M. (CCH) 2189 (1997), the
court stated:
Key to [the determination of whether a transaction has economic substance] is
that the transaction must be rationally related to a useful nontax purpose that is
plausible in light of the taxpayer's conduct and useful in light of the taxpayer's
economic situation and intentions. Both the utility of the stated purpose and the
rationality of the means chosen to effectuate it must be evaluated in accordance
with commercial practices in the relevant industry.
The tax deductions or losses need not arise in the year the financial accounting benefit
is recognized but may, for example, be expected to occur in some future year. Statement of
Financial Accounting Standards No. 109 (''FAS 109'') in some cases permits the recognition of
financial accounting benefits prior to the period in which the tax benefits are recognized for
income tax purposes.
Claiming that a financial accounting benefit constitutes a substantial non-tax business
purpose fails to consider the origin of the accounting benefit (i.e., reduction of taxes) and
significantly diminishes the purpose for having a substantial non-tax purpose requirement. See,
e.g., American Electric Power, Inc. v. U.S., 136 F. Supp. 2d 762, 791-92 (S.D. Ohio, 2001)
(''AEP's intended use of the cash flows generated by the [corporate-owned life insurance] plan is
irrelevant to the subjective prong of the economic substance analysis. If a legitimate business
purpose for the use of the tax savings ''were sufficient to breathe substance into a transaction
whose only purpose was to reduce taxes, [then] every sham tax-shelter device might succeed'
citing Winn-Dixie v. Commissioner, 113 T.C. 254, 287 (1999)).
See, e.g., ACM Partnership v. Commissioner, 157 F.3d at 256, n.48.
See, e.g., Knetsch v. United States, 364 U.S. 361 (1960).
See, e.g., Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966); Sheldon v.
Commissioner, 94 T.C. 738 (1990).
See, e.g., Yosha v. Commissioner, 861 F.2d 494 (7th Cir. 1988).
See, e.g., Rev. Rul. 2000-12, 2000-1 C.B. 744 (bull/bear); Notice 2002-65, 2002-2
C.B. 690 (pass-through entity straddle).
The mere fact that a purchased asset loses value with a resulting disparity between
basis and fair market value would not be covered since, without more, this alone is not a
transaction ''structured to result'' in a disparity between basis and fair market value.
For example, section 1232B (the predecessor of current Code section 1286) was
enacted in 1982 to address ''coupon stripping'' transactions with debt instruments. See H.R.
Conf. Rep. No. 97-760, 97th Cong., 2d Sess. 554-555(1982); S. Rep. No. 97-494, 97th Cong., 2d
Sess. 215-18 (1982). Section 305(e) applies to analogous transactions that involve stripping
dividends from preferred stock. These sections were further expanded in the American Jobs
Creation Act of 2004, 108th Cong. Sec. 831 (2004), to apply to certain stripped interests in bond
and preferred stock funds. Secs. 1286(f) and 305(e)(7).
For example, similar techniques have been used with rent payments on long-term
leases. In many situations, unlike the case with stripped bonds or stripped preferred stock, the
future value of the stripped property is uncertain. For this reason, the particular preventive
approach of section 1286 would be more difficult to apply. As another example, see Notice
2003-55, 2003-34 I.R.B. 35 (lease stripping).
See, e.g., Notice 2001-17, 2001-1 C.B. 730 (contingent liabilities); see also the Tanya
and Valor transactions described in the Enron Report; Vol. I, at 118-135, Black & Decker
Corporation v. United States, 340 F. Supp. 2d 621 (D. Md. 2004); and Coltec Industries, Inc. v.
United States, 62 Fed. Cl. 716 (2004). The enactment of Section 358(h) has addressed similar
transactions. However, any other transactions not covered by section 358(h) but structured to
duplicate losses would also be applicable transactions. The American Jobs Creation Act of 2004,
108th Cong. Secs. 833 and 836 (2004), also added certain explicit statutory limitations on the
ability to import or duplicate certain built-in losses.
See, e.g., Notice 2000-60, 2000-2 C.B. 568 (stock compensation transfers) and Castle
Harbour v. United States, 342 F. Supp. 2d 94 (D.Conn. 2004). See also Notice 97-21, 1997-1
C.B. 407 (step-down preferred). The ''step-down'' preferred investment transaction described in
that notice has since been addressed in Treasury Regulations section 1.7701(l)-3. However,
these and other transactions involving recovery of investment would be applicable transactions.
See, e.g., Notice 2002-21, 2002-1 C.B. 730 (inflated basis); Notice 2001-17, 2001-1
C.B. 730 (contingent liability); Notice 2000-44, 2000-2 C.B. 255 (son of boss); Notice 99-59,
1999-2 C.B. 761 (boss).
See Enron Report, Vol. I, at 189-221. See also the Tammy I and Tammy II
transactions, Enron Report, Vol. I, at 221-41.
The subsequent enactment of section 732(f) shut down the specific Tomas structure of
transaction. However, that transaction and any similar transactions not affected by that section
would be applicable transactions.
Other examples could include situations where any reduction in a tax loss or tax credit
carryover would not be expected to have a substantial impact on tax liability, due to the amount
and timing of such reduction and the taxpayer's otherwise reasonably expected use of such loss
or credit carryover.
See, e.g., Notice 97-21, 1997-1 C.B. 407 (step-down preferred). The Apache
transaction described in the Enron Report, Vol. I, at 242-60 is also an applicable transaction
under this category, as is the transaction in Castle Harbour v. United States, 342 F. Supp. 2d 94
(D.Conn. 2004).
See, e.g., Notice 2001-45, 2001-2 C.B. 129 (basis shifting).
See description of ''SC2'' transaction, Appendix B of the report entitled ''U.S. Tax
Shelter Industry: The Role of Accountants, Lawyers, and Financial Professionals,'' Minority
Staff of the Permanent Subcommittee on Investigations, Senate Committee on Government
Affairs, (released in conjunction with Hearings on November 18 and 20, 2003). Or the
remaining investors might attempt to use a loss remaining in the entity. See, e.g., Notice 2002-
65, 2002-2 C.B. 690. Similar transactions have also been addressed in Rev. Rul. 2004-4, 2004-6
I.R.B. 414 and Temp. Reg. sec. 1.409(p) '' IT.
The rules of section 246(c)(3) and (4) apply in determining holding period.
Secs. 246(c)(1)(A) and 901(k)(3).
It is intended that the Treasury Department will identify and except from this category
certain transactions producing a permanent book-tax difference, such as the claiming by a
corporation of a tax deduction upon the exercise of nonqualified stock options granted by the
corporation, absent factors indicating that the transaction was a sham or used in conjunction with
other technical provisions to obtain an inappropriate result.
See, e.g., Notice 2001-17, 2001-1 C.B. 730, and see Tanya and Valor transactions
described in the Enron Report, Vol. I, at 118-135.
See Enron Report, Vol. I, at 135-46. See also the Cochise transaction, Enron Report,
Vol. I, at 147-164.
See Enron Report, Vol. I, at 208-21.
See Enron Report, Vol. I, at 165-80.
Sec. 21.
The expenses cannot exceed the earned income of the taxpayer (or, in the case of
married taxpayers, the earned income of the spouse with the lowest earned income).
A qualifying child is determined by reference to the uniform definition of qualifying
child enacted by Congress in 2004, effective for taxable years beginning after December 31,
2004. Secs. 21(b)(1)(A) and 152(a)(1) (as amended by The Working Families Tax Relief Act of
2004, Pub. L. No. 108-311, secs. 201 and 203). In general, a qualifying child means, with
respect to a taxpayer for a taxable year, an individual who: (1) is a son, daughter, stepson,
stepdaughter, adopted child, eligible foster child, brother, sister, stepbrother, or stepsister of the
taxpayer, or a descendant of any such individual; (2) shares the same principal place of abode as
the taxpayer for more than half the taxable year; (3) meets certain age requirements or is
permanently and totally disabled; and (4) has not provided over one half of his or her own
support during the year. Sec. 152(c) (as amended by the Act).
Secs. 129 and 3121(a)(18).
The value of dependent care provided by an employer (e.g., day care provided on-site
by an employer to employees without charge) is includible in gross income and wages under the
proposal. The amount of employer-provided dependent care included in gross income is eligible
for the credit.
Denying the credit to married individuals filing separate returns serves as a way to
prevent avoidance of the income phaseout of the credit by splitting income between the spouses.
As part of the 2001 simplification report, the Joint Committee staff previously noted
that, in general, the exclusion is less complex than the credit. In that report, the Joint Committee
staff generally recommended conforming the credit to the exclusion by having a single dollar
amount of expenses that can be taken into account that does not depend on the number of
children, eliminating the income phasedown of the credit, and allowing married taxpayers filing
a separate return to claim one half the credit. 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 67-8. Other
considerations in addition to simplification have resulted in a different proposal here. The
current proposal also achieves simplification by eliminating the primary source of the
complexity, the existence of two provisions with similar policy goals yet differing requirements.
Sec. 25A. The Hope credit generally may not be claimed against a taxpayer's
alternative minimum tax liability. However, the credit may be claimed against a taxpayer's
alternative minimum tax liability for taxable years beginning prior to January 1, 2006.
The adjusted gross income phase-out ranges are indexed for inflation. Also, each of
the $1,000 amounts of qualified tuition and related expenses to which the 100-percent credit rate
and 50 percent credit rate apply are indexed for inflation, with the amount rounded down to the
next lowest multiple of $100.
Sec. 25A. The Lifetime Learning credit generally may not be claimed against a
taxpayer's alternative minimum tax liability. However, the credit may be claimed against a
taxpayer's alternative minimum tax liability for taxable years beginning prior to January 1, 2006.
As explained above, the Hope credit is available only with respect to the first two
years of a student's undergraduate education.
Sec. 222.
The deduction generally is not available for expenses with respect to a course or
education involving sports, games, or hobbies, and is not available for student activity fees,
athletic fees, insurance expenses, or other expenses unrelated to an individual's academic course
of instruction.
Secs. 222(d)(1) and 25A(g)(2).
Sec. 222(c). These reductions are the same as those that apply to the Hope and
Lifetime Learning credits.
The complexity of the present-law rules was previously noted by the staff of the Joint
Committee on Taxation in the 2001 simplification study. The proposal here is similar to the
recommendation in the simplification study. 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 122, 126-30.
The proposal is not revenue neutral on a year-by-year basis.
Further simplification could be achieved across other tax benefits for education. For
example, separately, the President's Fiscal Year 2005 budget proposal and the staff of the Joint
Committee on Taxation have recommended that the definition of qualified education expenses be
conformed more generally across provisions of the Code. See Office of Management and
Budget, Budget of the United States Government, Fiscal Year 2005; and, 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 122-26.
Secs. 117(d) and 3121(a)(20).
Certain other individuals may also be treated as employees for purposes of this rule,
including retired and disabled employees and surviving spouses of employees.
Sec. 117(d)(2)(B).
Sec. 414(q). This is the same definition used for purpose of the nondiscrimination
rules applicable to qualified retirement plans.
Some of these provisions apply to higher education, while others also apply to
elementary and secondary education. For example, the Coverdell education savings accounts
may be used to provide for primary and secondary education on a tax-favored basis. A proposal
to combine the above-the-line deduction, the Hope credit and the Lifetime Learning credit is
described in Part II.B., of the report.
Tuition reductions are also excludable from income and wages if they qualify: (1) as a
working condition fringe benefit (sec. 132(d)), i.e., if the cost of the education would be
deductible as a business expense paid by the employee; or (2) for the exclusion for employer-
provided education assistance (sec. 127). In many cases, the section 127 exclusion will not
apply, because that exclusion applies to education provided to the employee, but not to the
employee's spouse or dependents.
Reasonable classification is a concept that also applies with respect to the
nondiscrimination rules applicable to qualified retirement plans. The IRS has noted that the
reasonable classification rule applies differently to qualified tuition reductions than to qualified
retirement plans. See, e.g., Priv. Ltr. Ruls. 200137041 (June 20, 2001) and 9710022 (December
6, 1996).
Sec. 24. The credit reverts to $500 in taxable years beginning after December 31,
2010, under the sunset provision of EGTRRA. A qualifying child is determined by reference to
the uniform definition of qualifying child enacted by Congress in 2004, effective for taxable
years beginning after December 31, 2004. Secs. 21(b)(1)(A) and 152(a)(1) (as amended by The
Working Families Tax Relief Act of 2004, Pub. L. No. 108-311, secs. 201 and 203). In general,
a qualifying child means, with respect to a taxpayer for a taxable year, an individual who: (1) is a
son, daughter, stepson, stepdaughter, adopted child, eligible foster child, brother, sister,
stepbrother, or stepsister of the taxpayer, or a descendant of any such individual; (2) shares the
same principal place of abode as the taxpayer for more than half the taxable year; (3) meets
certain age requirements or is permanently and totally disabled; and (4) has not provided over
one half of his or her own support during the year. Sec. 152(c) (as amended by the Act).
Modified adjusted gross income is the taxpayer's total gross income plus certain
amounts excluded from gross income (e.g., excluded income of U.S. citizens or residents living
abroad (sec. 911); residents of American Samoa and the Northern Mariana Islands (sec. 931);
and residents of Puerto Rico (sec. 933)).
The $10,900 amount is indexed for inflation.
Sec. 32.
Sec. 911.
Only U.S. citizens may qualify under the bona fide residence test. However, resident
aliens of the United States who are citizens of foreign countries that have a treaty with the United
States may qualify for section 911 exclusions under the bona fide residence test by application of
a nondiscrimination provision.
The phaseout of the child credit applies regardless of whether the child credit is used
to offset regular tax liability or is a refundable child credit.
The taxpayer would have two personal exemptions and two dependent exemptions at
$3,200 each for a total of $12,800, and a standard deduction of $10,000, for total exemptions and
deductions of $22,800.
If the taxpayer had only one child, the calculation for the refundable credit would still
yield a potentially refundable credit of $1,365, but the actual refundable credit would have been
limited to $1,000 as that is the maximum credit allowable for a taxpayer with one child.
Sec. 163(h)(1).
Sec. 163(h)(2)(D) and (h)(3).
The $100,000 limitation on home equity indebtedness was enacted by the Revenue
Act of 1987. The Tax Reform Act of 1986 had previously limited the deductibility of personal
interest. The exception in the Tax Reform Act of 1986 for qualified residence interest allowed a
deduction for interest on a loan secured by a principal or second residence up to the sum of the
amount of the cost of the residence plus the amount of qualified medical expenses and qualified
educational expenses (not in excess of the fair market value of the residence).
Examples of such personal expenditures include health costs and education expenses
for the taxpayer's family members or any other personal expenses.
The deduction for interest on home equity indebtedness may conflict with the goal of
homeownership if taxpayers are encouraged to incur unsustainable levels of debt.
Treas. Reg. sec. 1.163-8T (1987).
Taxpayer A may also have more taxable income as a result of the return on the
$250,000 of savings than Taxpayer B.
Sec. 1011(b).
Treas. Reg. sec. 1.1001-1(e).
Treas. Reg. sec. 1.1015-4(a). For determining loss, however, the transferee's basis is
limited to the fair market value of the property at the time of the transfer.
Treas. Reg. sec. 1.61-6(a).
Sec. 6012(a)(1)(C). Other filing requirements apply to dependents who are married,
elderly, or blind. See Internal Revenue Service, Publication 929, Tax Rules for Children and
Dependents (2004), at 2, Table 1.
A taxpayer generally need not file a return if he or she has gross income in an amount
less than the standard deduction (and, if allowable to the taxpayer, the personal exemption
amount). An individual who may be claimed as a dependent of another taxpayer is not eligible
to claim the personal exemption for himself or herself. Sec. 151(d)(2). For taxable years
beginning in 2005, the standard deduction amount for an individual who may be claimed as a
dependent by another taxpayer may not exceed the greater of $800 or the sum of $250 and the
individual's earned income.
Sec. 1(g).
Sec. 1(g)(4) and sec. 911(d)(2).
Sec. 1(h).
Sec. 1(g)(4).
Sec. 1(g)(5); Internal Revenue Service, Publication 929, Tax Rules for Children and
Dependents (2004), at 6.
The child must attach to the return Form 8615, Tax for Children Under Age 14 With
Investment Income of More Than $1,600 (2004).
IRS Publication 929, Tax Rules for Children and Dependents (2004), at 8 (referring
to Instructions to Form 8814, Child's Qualified Dividends and Capital Gain Distributions
Worksheet, to divide the $1,600 base amount between the child's qualified dividends, capital
gain distributions, and other interest and dividend income).
This example is based on the illustrated example contained in IRS Publication 929,
Tax Rules for Children and Dependents (2004) at 16-23. The amount of unearned income of a
minor child taxed at the parent's rates is the same for both 2004 and 2005 (i.e., over $1,600).
Id. at 7.
Id.
Id.
Sec. 1(g)(7)(B).
Internal Revenue Service, Publication 929, Tax Rules for Children and Dependents
(2004), at 7.
Sec. 73(a).
Sec. 6201(c).
The complexity of the present-law rules was previously noted by the staff of the Joint
Committee on Taxation in the 2001 simplification study. 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 144.
For this purpose net capital gain includes qualified dividend income. See sec.
1(h)(11).
This alternative was recommended by the staff of the Joint Committee in its 2001
simplification study, and has been endorsed by others. 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 147.
Although both the present proposal and the simplification study proposal promote simplification,
the present proposal reduces the number of rates that would apply to a child's unearned income,
which should reduce complexity and provide taxpayers greater certainty with respect to the
taxation of income subject to the kiddie tax.
Department of the Treasury, General Explanations of the Administration's Fiscal
Year 2005 Revenue Proposals, February 2004, at 91-92. As described above, the tax applies more broadly to include unearned income on
property owned by the child, regardless of how or when the child acquired the property.
Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986
(JCS-10-87), May 4, 1987, at 1253.
Secs. 3101-3128. FICA tax applies separately from income tax. Therefore, certain
types of compensation may be: (1) excluded from income for income tax purposes, but subject
to FICA tax; or (2) includible in income for income tax purposes, but exempt from FICA tax.
Definitions similar to the FICA definition of wages apply also for purposes of taxes
applicable to compensation under the Railroad Retirement Tax Act (''RRTA'') (secs. 3201-3241)
and to wages under the Federal Unemployment Tax Act (''FUTA'') (secs. 3301-3311). However,
a lower wage base applies for purposes of Tier 2 tax under RRTA ($66,900 for 2005) and for
purposes of FUTA ($7,000).
For 2005, the amount of wages required for a quarter of coverage is $920, or $3,680
for four quarters of coverage for the year.
Sec. 3121(a)(5)(A) (qualified retirement plans), (C) (simplified employee pensions),
(D) (tax-sheltered annuities), and (H) (SIMPLE IRAs). Employer contributions to these plans
are also excluded from income for income tax purposes.
Sec. 3121(a)(5)(C), (D), and (H) and (v)(1). For income tax purposes, contributions
made to these retirement plans by salary reduction are treated as employer contributions and are
excluded from income.
S. Rep. No. 98-23, at 40 (1983). Legislative history also provides that treating salary
reduction contributions to employer-sponsored plans as FICA wages is consistent with the
treatment of individual contributions to an individual retirement account (''IRA''). Individuals
may make IRA contributions based on their compensation income. Although such contributions
may be deductible for income tax purposes (subject to limitations), the FICA rules do not
provide an exemption for IRA contributions.
Sec. 3121(a)(2), (18), and (20). These benefits are also excluded from income for
income tax purposes.
Sec. 3121(a)(5)(G). These benefits are also excluded from income for income tax
purposes when provided under a cafeteria plan.
The proposal applies also for purposes of the RRTA definition of compensation and
the FUTA definition of wages.
Legislative history regarding the application of FICA to salary reduction
contributions to an employer-sponsored retirement plan indicates the intent of treating such
contributions in a manner consistent with IRA contributions.
In the case of employees whose other wages equal or exceed the OASDI wage base,
only HI tax applies to the additional wages that result under the proposal.
Sec. 3101.
Sec. 1402(a)(12).
Sec. 164(f).
The conference report to the Social Security Amendments of 1983 (H. Rep. No. 98-
47, p. 146) states:
''b. Effective in 1990 and thereafter, the credit would terminate and be replaced
with a system designed to achieve parity between employees and the self-
employed. Under this system:
1. The base of the self-employment tax would be adjusted downward to reflect
the fact that employees do not pay FICA tax on the value of the employer's
FICA tax.
2. A deduction would be allowed for income tax purposes for half of SECA
liability, to allow for the fact that employees do not pay income tax on the
value of the employer's FICA tax.''
For example, a self-employed taxpayer with $100 in net earnings is, under present
law, permitted a deduction of $7.65, resulting in a SECA tax base of $92.35. The SECA tax on
that base is $14.13 (15.3 percent of $92.35). Half of that, or $7.065, represents the employer
share of SECA. Note however that the deduction permitted ($7.65), which is intended to
represent the employer share of the tax, exceeds the employer share actually paid.
Technically, the deviation from economic equivalence of FICA and SECA taxes due
to the problem just described does not occur until net earnings from self-employment after the
proper deduction for the employer share of tax exceeds the OASDI taxable wage base. The
proposal as described accounts for this.
The proposal has the effect of increasing SECA taxes for some individuals, as well as
increasing revenues for the Social Security and Medicare Trust Funds. The proposal may also
result in additional earnings for Social Security and Medicare purposes, which is likely to
increase benefits for some individuals, as well as long-term costs under such programs.
In the examples, amounts are rounded to the nearest dollar.
HI taxes are imposed under the Federal Insurance Contributions Act (''FICA''). As
part of the financing for Social Security benefits, FICA taxes also include an old-age, survivors,
and disability insurance (''OASDI'') component. The OASDI rate of tax is 6.2 percent for the
employee, and 6.2 percent for the employer. The amount of wages subject to the OASDI portion
of FICA taxes is capped at $90,000 (for 2005).
Pub. L. No. 99-272.
For purposes of this rule, an individual is considered to be hired after March 31, 1986,
if the individual was performing substantial and regular services for the employer before April 1,
1986, the individual is a bona fide employee of the employer on March 31, 1986, and the
individual's employment relationship with the employer was not terminated after March 31,
1986. These rules are generally referred to as the ''continuous employment'' requirement. Sec.
3121(u)(2)(C).
Pub. L. No. 101-508.
Sec. 3121(b)(7)(F). Certain classes of State and local employees are exempt from the
hospital insurance tax, such as certain election workers. The rules relating to Social Security
coverage for State and local workers are different from the rules relating to Medicare and the
hospital insurance tax. Under present law, State and local government workers are covered by
Social Security (and subject to the corresponding taxes) if they are covered under a voluntary
agreement with the State to be covered or if they are not members of a public retirement system.
The proposal does not affect the exemptions for certain classes of employees, such as
election workers.
Secs. 3101-3128.
The employer is required to withhold the employee's share of FICA taxes from wages
paid to the employee. Sec. 3102(a).
Secs. 3301-3311.
Sec. 3121(b)(10). The exception also applies to services performed as a student in the
employ of an organization that is organized and operated exclusively for the benefit of, to
perform the functions of, or to carry out the purposes of the school, college, or university, if the
organization is operated, supervised or controlled by or in connection with such school, college,
or university.
Sec. 3306(c)(10)(B). In addition, under section 3121(b)(2), a FICA exception applies
to domestic service performed in a local college club or local chapter of a college fraternity or
sorority by a student who is enrolled and regularly attending classes at a school, college, or
university.
H.R. Rep. No. 76-728, at 17-18 (1939); S. Rep. No. 76-734, at 19 (1939).
See State of Minnesota v. Apfel, 151 F. 3d 742 (8th Cir. 1998), aff'g, 1997 U.S. Dist.
LEXIS 7506 (D. Minn. 1997), and U.S. v. Mayo Foundation, 282 F. Supp. 2d 997 (D. Minn.
2003). Compare U.S. v. Mount Sinai Medical Center, No. 02-22715-CIV (S.D. Fla. filed
January 19, 2005) (holding that, as a matter of law, medical residents are not students who are
exempt from FICA tax).
69 Fed. Reg. 8604 (proposed February 25, 2004).
Id. at 8605.
69 Fed. Reg. 76404 (December 21, 2004). The regulations include provisions
applicable for purposes of the other student exceptions under FICA and FUTA.
Treas. Reg. sec. 31.3121(b)(10)-2(b). The regulations also refer to
section 170(b)(1)(A)(ii) (relating to educational organizations) and the regulations thereunder.
Treas. Reg. sec. 31.3121(b)(10)-2(d).
Rev. Proc. 2005-11, 2005-02 I.R.B. 1. Safe harbor guidance under Rev. Proc. 98-16,
1998-1 C.B. 403, applies for periods before the new regulations apply.
Sec. 3121(a)(7)(B).
Sec. 3121(a)(8)(B).
See sec. 3102(a) and Treas. Reg. sec. 31.3102-1(b).
See Treas. Reg. sec. 31.6402(a)-2.
The proposal applies also for purposes of the other student exceptions under FICA
and FUTA and for purposes of coverage under the Social Security Act.
No inference is intended that the regulations are inconsistent with the student
exception under present law.
As under present law, the student exception may also apply to services performed as a
student in the employ of an organization that is organized and operated exclusively for the
benefit of, to perform the functions of, or to carry out the purposes of the school, college, or
university, if the organization is operated, supervised or controlled by or in connection with such
school, college, or university.
Secs. 3101-3128 (FICA), 3301-3311 (FUTA), and 3401-3404 (income tax
withholding).
See, e.g., Treas. Reg. sec. 1.61-2T(a)(5) (fringe benefits treated as provided by the
person for whom services performed, regardless of whether actually provided by that person) and
Treas. reg. sec. 1.83-6(d) (rules for transfers of property by a shareholder to an employee of a
corporation in consideration of services performed for the corporation).
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); and 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).
See, e.g., Cencast Services, L.P., v. United States, 62 Fed. Cl. 159 (2004).
Secs. 1401-1403.
Sec. 1402(c)(2).
See, respectively, Rev. Rul. 73-253, 1973-1 C.B. 414; Rev. Rul. 57-456, 1957-2 C.B.
629; and Rev. Rul. 57-119, 1957-1 C.B. 331.
Rev. Rul. 70-337, 1970-1 C.B. 191, and Rev. Rul. 70-331, 1970-1 C.B. 15. In the
facts of these rulings, the manufacturer or distributor makes the sales incentive payments under
an agreement with, or with the consent of, the dealer. In addition, Rev. Rul. 70-337 states that
the sales people are hired by the dealers.
Compare Rev. Rul. 66-162, 1966-1 C.B. 234, holding that commissions paid by a
concessionaire of a leased department in a department store to sales people employed by the
store are wages because the sales people are employees of both the store and the concessionaire.
See IRS Publication 3204, Automotive Manufacturers' Incentive Program (Rev. 3-
2002).
Authorities for this approach are cited in footnotes 199 and 203.
The increase in compliance as a result of tax withholding is discussed in detail in Part
I.A. of this Report.
See Chapter 21 of the Code.
Sec. 1401.
Secs. 3101 and 3111.
Though unrelated to the FICA tax, present law provides that an S corporation is
treated as a partnership and a two-percent shareholder is treated as a partner, for purposes of
applying rules relating to employee fringe benefits. Sec. 1372.
See, e.g., Renewed Focus on S Corp. Officer Compensation, AICPA Tax Division''s S
Corporation Taxation Technical Resource Panel, Tax Advisor, May 2004, at 280.
Radtke v. U.S., 895 F.2d 1196 (7th Cir. 1990); Spicer Accounting, Inc. v. U.S., 918
F.2d 90 (9th Cir. 1990); see also, e.g., Joseph M. Grey Public Accountant, P.C., v. U.S., 119 T.C.
121 (2002), aff'd, 93 Fed. Appx. 473, 3d Cir., April 7, 2004, and Nu-Look Design, Inc. v.
Comm'r, 356 F.2d 290 (3d Cir. 2004), in which an officer and sole shareholder of an S
corporation argued unsuccessfully that he had no wages and that he received payments in his
capacity as shareholder or as loans, rather than as wages subject to employment tax.
See, e.g., Haffner's Service Stations, Inc. v. Commissioner, 326 F.3d 1 (1st Cir.
2003).
Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999).
In Metro Leasing and Dev. Corp. v. Commissioner, (9th Cir. 2004) at 10-11, the
Ninth Circuit court noted that it is helpful to consider the perspective of an independent investor,
and pointed to other Circuits that apply the multi-factor test through the lens of the independent
investor test, citing RAPCO Inc. v. Commissioner, 85 F.3d 950 (2d Cir. 1996).
For purposes of determining net earnings from self-employment, taxpayers are
permitted a deduction from net earnings from self-employment equal to the product of the
taxpayer's net earnings (determined without regard to this deduction) and one-half of the sum of
the rates for OASDI (12.4 percent) and HI (2.9 percent), i.e., 7.65 percent of net earnings. This
deduction reflects the fact that the FICA rates apply to an employee's wages, which do not
include FICA taxes paid by the employer, whereas a self-employed individual's net earnings are
economically the equivalent of an employee's wages plus the employer share of FICA taxes.
The deduction is intended to provide parity between FICA and SECA taxes. See the separate
proposal relating to conforming the calculation of FICA and SECA taxes, elsewhere in this
document. In addition, self-employed individuals may deduct one-half of self-employment taxes
for income tax purposes (sec. 164(f)).
Sec. 1402(a)(13). For this purpose, limited partner status is determined under State
law.
Social Security Amendments of 1977 (Pub. L. No. 95-216). The exclusion of limited
partners from the self-employment tax (except with respect to guaranteed payments for services)
reflects the perception at that time that the value of accruing benefits under the Social Security
system outweighed the tax cost, and that limited partnerships were used for investment rather
than for service businesses. See Patricia E. Dilley, Breaking the Glass Slipper - Reflections on
the Self-Employment Tax, 54 Tax Law. 65 (Fall 2000), at note 91.
See, e.g., Revised Uniform Limted Partnership Act (2001), sec. 303, providing, ''[a]n
obligation of a limited partnership, whether arising in contract, tort, or otherwise, is not the
obligation of a limited parter. A limited partner is not personally liabile, directly or indidirectly,
by way of contribution or otherwise, for an oblgation of the limited partnersip solely by reason
of being a limited partner, even if the limited partner participates in the mamagement and control
of the limited partnership.''
Prop. Treas. Reg. sec. 1.1402(a)-2 (January 13, 1997).
Because the HI tax has no wage cap, this approach may be viewed as a tax planning
opportunity with respect to HI tax even at higher wage levels.
See Dilley, Breaking the Glass Slipper - Reflections on the Self-Employment Tax, at
note 18. Benefit accruals have historically been tied to performance of labor (quarters of
service), but the amount of FICA taxes collected does not necessarily relate to the individual's
Social Security benefits.
For some individuals, the proposal has the effect of increasing the amount of earnings
subject to employment tax. In the case of individuals whose earnings equal or exceed the
OASDI wage base, only HI tax applies to the additional earnings that result under the proposal.
The AICPA has proposed this type of approach to modernize the self-employment tax
reference to limited partners in section 1402(a)(13). See Letter of David A. Lifson, Chair, Tax
Executive Committee of AICPA, to the Honorable William V. Roth, Chairman, Senate
Committee on Finance, dated June 22, 2000, enclosing such a recommendation originally made
by letter dated July 6, 1999. The AICPA proposal would provide that if the partner works less
than a minimum number of hours in the partnership's business, none of his income would be
treated as subject to the self-employment tax. The AICPA proposal would provide that a limited
liability company owner's income would be treated as subject to the self-employment tax, except
for a defined rate of return on his capital in the partnership.
Alternatively, this approach might specify a definition for a reasonable rate of return
on capital. It could be based, for example, on a percentage or multiple of the applicable Federal
rate, as defined under present law. While this approach may conceptually take account of a
partner's return on capital, it may not represent the simplest and most direct approach, nor would
it be accurate in most cases.
Present law does not provide this rule for general partners. Under the proposal,
however, in the case of a general partner who does not materially participate in the partnership's
trade or business, only his or her reasonable compensation from the partnership is included in net
earnings from self-employment. Such a general partner may be subject to a lower self-
employment tax under the proposal than under present law.
These regulations provide several bright-line tests for material participation,
including, for example, a test based on the number of hours the individual works in the business
activity. Rules in the section 469 regulations providing that a limited partner is deemed not to
materially participate in the partnership's business would not apply for purposes of the proposal.
See the present law description, above.
Reasonable compensation has also been suggested as a standard for determining the
net earnings from self-employment of all limited partners and LLC members, but the
administrative concerns with the standard could make this approach less attractive than the more
mechanical approach taken under the proposal.
See Dilley, Breaking the Glass Slipper - Reflections on the Self-Employment Tax, at
note 23-30.
Because eligibility for hospital insurance under Medicare is based on an individual's
quarters of coverage, not the amount of the individual's wages, paying HI tax on higher wages
does not increase the individual's Medicare benefits.
For some individuals, the proposal has the effect of increasing the amount of earnings
subject to employment tax. In the case of individuals whose earnings equal or exceed the
OASDI wage base, only HI tax applies to the additional earnings that result under the proposal.
Only expenses that are not reimbursed by insurance or otherwise may be taken into
account for purposes of the deduction. For purposes of the alternative minimum tax, the adjusted
gross income threshold is 10 percent, rather than 7.5 percent.
This exclusion does not apply to amounts attributable to (and not in excess of)
deductions allowed under section 213 for any prior taxable year.
Sec. 213(d). The amount of long-term care premiums that may be taken into account
for purposes of the itemized deduction is subject to a dollar limit based on the age of the covered
individual.
Sec. 274(a).
Sec. 274(e)(2). See below for a discussion of the recent modification of this rule for
certain individuals.
Sec. 274(e)(9).
Treas. Reg. sec. 1.61-21.
Treas. Reg. sec. 1.61-21(g).
Treas. Reg. sec. 1.61-21(b)(6).
Sutherland Lumber-Southwest, Inc. v. Comissioner., 114 T.C. 197 (2000), aff'd, 255
F.3d 495 (8th Cir. 2001), acq., AOD 2002-02 (February 11, 2002).
Pub. L. No. 108-357, sec. 907.
An officer is defined as the president, principal financial officer, principal accounting
officer (or, if there is no such accounting officer, the controller), any vice-president in charge of
a principal business unit, division or function (such as sales, administration or finance), any other
officer who performs a policy-making function, or any other person who performs similar
policy-making functions.
Midland Financial Co. v. Commissioner, T.C. Memo 2001-203; National Bancorp of
Alaska, Inc. v. Commissioner, T.C. Memo 2001-202.
Chief Counsel Advice 200344008.
Sec. 83(a).
Under section 83(b), even if the property is not vested at the time of transfer, the
service provider may nevertheless elect within 30 days of the transfer to recognize income for
the taxable year of the transfer. The service provider makes an election by filing with the IRS a
written statement that includes the fair market value of the property at the time of transfer and
the amount (if any) paid for the property. The service provider must also provide a copy of the
statement to the service recipient.
Sec. 83(h).
Treas. Reg. sec. 1.83-6(a)(1).
60 Fed. Reg. 36995, 36996 (July 19, 1995).
Treas. Reg. sec. 1.83-6(a)(2). For purposes of the safe harbor, whether the service
recipient satisfies the reporting requirements is determined without regard to the exception from
the reporting requirements that generally applies to payments to corporations (currently at Treas.
Reg. sec. 1.6041-3(p)), i.e., reporting of payments to a corporation is required in order to meet
the safe harbor.
60 Fed. Reg. 36995, 36996 (July 19, 1995).
110 T.C. 236 (1998), aff'd per curiam, 198 F. 3d 248 (6th Cir. 1999).
Under Treasury regulations in effect for the year in question, an employer could take
a deduction for the amount ''includible'' in an employee's income as compensation under
section 83 (rather than the amount actually included), but only if the employer withheld income
tax attributable to the compensation income. The employer in Venture Funding had not met the
income tax withholding requirement and thus was not entitled to a deduction under the
regulations. As described in the text, current Treasury regulations do not condition the deduction
on withholding if the amount of compensation is properly reported.
52 Fed. Cl. 725 (2002), rev'd by 335 F.3d 1365 (Fed. Cir. 2003).
Although the stock was not substantially vested at the time of transfer, the employee
elected to apply section 83(b) at that time. However, the employee took the position that he had
paid fair market value for the stock ($2 million) and that no compensation income for 1995
resulted from the transfer. The employer learned of the employee's election in 1998 and claimed
a deduction for 1995 for compensation income based on a stock value of more than $20 million.
Because the employer in Robinson was an S corporation, the deduction affected the tax liability
of the employer's shareholders, who were the plaintiffs in the case.
Robinson v. United States, 335 F.3d 1365 (Fed. Cir. 2003), cert. denied, 72 U.S.L.W.
3446 (U.S. January 12, 2004). The Robinson decision is binding in the U.S. Court of Federal
Claims, a court of national jurisdiction in which taxpayers may bring suits over tax issues. The
Robinson decision therefore has nationwide applicability.
As under present law, the exception to the reporting requirements for payments to
corporations does not apply for this purpose.
Sec. 404(k). Applicable employer securities are, with respect to any dividend,
employer securities which are held by an ESOP which is maintained by the corporation paying
the dividend or any other corporation in the same controlled group on the record date for such
dividend.
Sec. 404(k)(2). In the case of dividends paid with respect to stock allocated to
participants' account that are used to repay a loan, the deduction is not available unless the plan
provides that employer securities with a fair market value of not less than the amount of the
dividend are allocated to the participant for the year.
Rev. Rul. 2001-6, 2001-1 C.B. 491. The IRS also found that, regardless of whether
the payments were deductible under section 404(k), the payments were not deductible under
section 162(k), which denies a deduction for any amount paid or incurred by a corporation in
connection with the reacquisition of its stock or the stock of a related person.
The case involved the 1989 taxable year.
The plan provided that the stock could be redeemed either in the form of cash or
common stock, at the election of Boise Cascade. The payments in question were all made in the
form of cash.
Sec. 302(b).
United States v. Davis, 397 U.S. 301 (1970). Small changes in a shareholder's
interest have been found to be a meaningful reduction. See, e.g., Rev. Rul. 76-385, 1976-2 C.B.
92 (reduction from .0001118 percent to .0001081 percent is meaningful).
Sec. 318(a)(2)(B)(i).
The court also concluded that section 162(k) did not preclude the deduction. During
the year at issue in Boise, section 162(k) applied to expenses in connection with the
''redemption'' of stock. The section was modified to apply to expenses in connection with the
''reaquisition'' of stock in the Small Business Job Protection Act of 1996, effective for amounts
paid or incurred after September 13, 1995, in taxable years ending after such date.
CC-2004-038 (October 1, 2004).
The notice also concludes that section 162(k) denies the deduction.
As noted above, the court in Boise Cascade also found that section 162(k) did not
deny the deduction. Because the proposal provides that there is no deduction for the
reacquisition payments, the applicability of 162(k) does not arise under the proposal. No
inference is intended whether, under present law, deduction of these amounts is permitted under
section 162(k).
Present law provides for several other types of elective deferral arrangements,
including savings incentive match plan for employees (''SIMPLE'') section 401(k) plans,
employer-sponsored SIMPLE IRAs, salary reduction simplified employee pension plans, and
eligible deferred compensation plans of State or local governments or tax-exempt organizations
under section 457. The proposal does not affect these types of elective deferral arrangements.
Legally, a ''section 401(k) plan'' is not a separate type of plan, but is an arrangement
that is part of a qualified profit-sharing, stock bonus or pre-ERISA money purchase plan. In the
Code, section 401(k) plans are referred to as ''qualified cash or deferred arrangements.'' The
term ''section 401(k) plan'' is commonly used to refer to qualified cash or deferred arrangements
and that term is used here for simplicity.
State and local governments may not maintain 401(k) plans, but can maintain similar
arrangements, unless the plan was in existence before May 6, 1986. Many governmental 457
plans operate in a manner similar to section 401(k) plans.
Proposed regulations reflecting these and other changes to the rules for section 403(b)
plans were issued on November 16, 2004. 69 Fed. Reg. 67065 (November 16, 2004). The
regulations are proposed to be generally applicable to plan years beginning after December 31,
2005.
Secs. 401(k)(2)(B) and 403(b)(11). Under a special rule for section 401(k) plans,
elective deferrals may also be distributed upon the termination of a plan in certain cases. Sec.
401(k)(10).
The exceptions from the additional 10-percent early withdrawal tax include when the
distribution is due to death or disability, is made in the form of certain periodic payments, is
made to an employee after separation from service after attainment of age 55, or is used to pay
medical expenses in excess of 7.5 percent of adjusted gross income. Sec. 72(t).
The required beginning date generally is April 1 of the calendar year following the
later of the calendar year in which the participant (1) attains age 70-� or (2) retires.
Sec. 403(b)(12).
Secs. 403(b)(3) and 415(c)(3)(E).
This special rule codified a position taken by the Internal Revenue Service in private
letter rulings which permitted post-retirement contributions to section 403(b) plans. Priv. Ltr.
Ruls. 9625043 (March 26, 1996) and 9233030 (May 19, 1992).
EGTRRA increased many of the limits applicable to employer-sponsored retirement
plans, generally effective for years beginning after December 31, 2001. Under EGTRRA, the
dollar limit on elective deferrals increases to $15,000 for 2006. After 2006, the limit is adjusted
for inflation in $500 increments. The provisions of EGTRRA generally do not apply for years
beginning after December 31, 2010.
The additional amount permitted for catch-up contributions increases to $5,000 for
2006. After 2006, the limit is adjusted for inflation in $500 increments. The catch-up
contribution provisions are subject to the general sunset provision of EGTRRA.
Sec. 402(g)(8).
69 Fed. Reg. 67075 (November 15, 2004).
See Prop. Treas. Reg. sec. 1.403(b)-4(c)(4), Ex. 4 (69 Fed. Reg. 67089).
Sec. 401(k)(3).
''Highly compensated employee'' means any employee who (1) was a five-percent
owner of the employer at any time during the year or (2) for the preceding year, had
compensation from the employer in excess of $95,000 (for 2005) and if the employer elects, was
in the top-paid group of employees for such year. Sec. 414(q).
Under the safe harbor, a section 401(k) plan is deemed to satisfy the ADP test if the
plan satisfies one of two contribution requirements and a notice requirement. A plan satisfies the
contribution 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. Sec. 401(k)(12).
Treas. Reg. secs. 1.401(k)-1(f)(1)(i)-(ii) and 1.410(b)-7(c)(3).
As under present law, State and local government employers are not subject to the
ADP test under the proposal.
To the extent that it is desirable to encourage tax-favored savings after retirement,
that goal could be accomplished in a more equitable manner, e.g., through the use of widely
available tax-savings vehicles.
The exclusion allowance was a cumulative limit over all years of service, such that
some of the special rules that require tracking of cumulative contributions under section 403(b)
plans are consistent with that limit, but are no longer appropriate now that section 403(b) plans
are subject to the limit on annual deferrals and limit on annual additions.
The tension between retirement policy objectives (such as ensuring that plans benefit
rank and file employee as well as highly compensated employees) and administrative burdens is
a common theme with respect to retirement plans, particularly given the voluntary nature of the
retirement plan system. Retirement policy often involves balancing concerns that rules are
adequate to protect policy interests with concerns that if the rules are too onerous, some
employers may elect not to maintain plans.
A similar early withdrawal tax also applies to deferred annuities (sec. 72(q)) and
modified endowment contracts (sec. 72(v)).
Section 457 does not apply to a plan maintained by a church or a church-controlled
organization. Sec. 457(e)(13).
Sec. 457(a).
Sec. 457(g).
Sec. 408A.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (''EGTRRA'')
increased the dollar limit on IRA contributions to $4,000 for 2005 through 2007 and $5,000 for
2008. After 2008, the limit is adjusted for inflation in $500 increments. The provisions of
EGTRRA generally do not apply for years beginning after December 31, 2010. Thus, the dollar
limit on annual IRA contributions returns to $2,000 in 2011.
Under EGTRRA, the additional amount permitted for catch-up contributions to an
IRA is $500 for 2005 and $1,000 for 2006 and thereafter. As a result of the general sunset
provision of EGTRRA, catch-up contributions are not permitted after 2010.
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 the dollar limit or the
individual's compensation for the year.
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) contributions attributable to conversions of traditional IRAs (on a first-in, first-out basis); and
(3) earnings.
Sec. 72(t).
Sec. 408.
For 2005, the deduction phase-out ranges are as follows: (1) for single taxpayers, the
range is $50,000-$60,000; (2) for married taxpayers filing jointly, the range is $70,000-$80,000;
and (3) for married taxpayers filing a separate return, the range is $0-$10,000. If the 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.
Sec. 72(t).
Sec. 4975.
The prohibited transaction rules under the Code also apply to other tax-favored
savings vehicles, including qualified retirement plans, health savings accounts (sec. 223),
medical savings accounts (sec. 220), and Coverdell education savings accounts (sec. 530).
Under ERISA, similar prohibited transaction rules apply to employer-sponsored retirement plans
and welfare benefit plans. In general, IRAs are not subject to ERISA. The prohibited
transaction rules under the Code and ERISA do not apply to governmental plans or church plans.
Sec. 4975(a)-(b).
Sec. 4975(f)(4).
Sec. 4975(e)(2)(G).
Sec. 4975(e)(2)(A).
106 T.C. 76 (1996).
Sec. 4975(c)(1)(A).
Sec. 4975(e)(2)(G).
''The Secret Life of a Retirement Account'', New York Times, November 11, 2003,
section C, page 1.
Notice 2004-8, 2004-4 I.R.B. 333 (January 26, 2004).
Treas. Reg. sec. 1.6011-4(b)(2).
Sec. 482.
Sec. 4973.
The proposal would also apply to other tax-favored arrangements to which the IRA
prohibited transaction rules apply.
Secs. 3101-3128. 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 ($90,000 for 2005).
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.
A State or local governmental employer may not maintain a 401(k) plan unless it
maintained a 401(k) plan before May 6, 1986. However, other arrangements similar to 401(k)
plans are available to State and local governmental employers, such as eligible deferred
compensation plans (section 457).
A governmental plan may also allow an employee to purchase additional service
credit (such as credit for military service) by making additional employee contributions.
Sec. 414(h)(2).
See H.R. Rep. No. 93-807, at 145 (1974).
See, e.g., Rev. Rul. 81-36, 1981-1 C.B. 255. (The employer must also specify that
the contributions are being paid by the employer in lieu of contributions by the employee.)
Compare Rev. Rul. 81-35, 1981-1 C.B. 255, which denies pick-up treatment to contributions
made pursuant to an individual employment agreement under which the employer contributes a
certain percentage of the employee's salary to the State's pension plan on behalf of the
employee.
See, e.g., Priv. Ltr. Rul. 200423040 (March 9, 2004) (employees may elect whether to
participate in a defined benefit pension plan that requires employee contributions) and Priv. Ltr.
Rul. 200317034 (October 10, 2002) (employees may elect to have contributions made to a
defined benefit pension plan by payroll reduction to purchase additional service credit). In
addition, under Priv. Ltr. Rul. 200317024 (September 30, 2002), pick-up treatment applies to
contributions made to a defined contribution plan at the election of employees. This ruling
suggests that the pick-up rules may be used to make pretax employee contributions to a defined
contribution plan without complying with the rules applicable to elective deferrals.
Sec. 3121(v)(1)(B). For this purpose, salary reduction agreement includes any
arrangement in which there is a reduction in the employee's salary in connection with the
employer's contribution of a corresponding amount to a pension plan on the employee's behalf,
regardless of whether the employee approves or chooses participation in the plan or whether
participation is mandatory. See H.R. Rep. No. 98-861, at 1415 (1984), and State of New Mexico
v. Shalala, 153 F.3d 1160 (10th Cir. 1998).
Sec. 3121(b)(7)(F).
In the case of changes to the rules for qualified retirement plans, a delayed effective
date is often provided with respect to governmental plans in order to provide sufficient time for
making necessary plan amendments. If the proposal is adopted, it may be appropriate to
consider whether a delayed effective should apply.
Designation of contributions as employee contributions under a State or local
government plan generally has significance under the terms of the plan (and under State or local
law). For example, the plan might subject benefits attributable to employer contributions to a
vesting requirement, but provide that benefits attributable to employee contributions are
immediately vested. Similarly, the plan may include special distribution terms applicable only to
employee contributions. The fact that the designation of contributions as employee contributions
has significance under the plan (and under State or local law) provides further support for
treating them as employee contributions for Federal tax purposes.
The present-law FICA standard depends on the facts and circumstances and is
sometimes a source of confusion. In eliminating a distinction based on whether contributions are
made pursuant to a salary reduction agreement, the proposal may lead to increased FICA tax
compliance.
Secs. 243 and 246.
Sec. 1(h)(1), 1(h)(3), 1(h)(11) and 1(h)(11)(D).
Sec. 1059
As one example, the very large dividend that Microsoft declared in 2004 would not
have been an extraordinary dividend if its amount had been only slightly reduced. See Robert
Willens, ''Microsoft''s Special Distribution - The Verdict is In'' 17 Tax & Accounting Issue 135
(November 16, 2004).
Jeff Opdyke, ''Tax Cut, Shareholder Pressure Stoke Surge in Stock Dividends,'' Wall
Street Journal online, (January 18, 2005).
A redemption is a payment by a corporation to acquire stock from a shareholder. A
payment in redemption of a shareholder's stock generally produces sale treatment and therefore
capital gain or loss to that shareholder, but a redemption is treated as a dividend if it does not
satisfy one of several criteria that generally seek to determine whether a shareholder's
proportionate interest in the distributing corporation has been meaningfully reduced. Sec. 302.
Treas. Reg. sec. 1.302-2(c).
Id., Example 3.
Deficit Reduction Act of 1984, S. Prt. 98-169, Vol. 1, at 172 (April 2, 1984).
Treas. Reg. sec. 1.302-2(c).
IRS Notice 2001-45, 2001-2 C.B. 129.
Prop. Treas. Reg. sec. 1.302-5.
213 F.2d 914 (6th Cir. 1954).
The American Bar Association Section of Taxation's Committee on Corporate Tax
suggested the same attacks but recommended the withdrawal, for policy and administrability
reasons, of the specific approach proposed in Prop. Treas. Reg. sec. 1.302-5. Richard A. Shaw,
Comments Concerning Proposed Regulations Providing Guidance Regarding the Treatment of
Unutilized Basis of Stock Redeemed in Certain Transactions (August 2003).
Sec. 355(b).
Sec. 355(b)(2)(A). The IRS takes the position that the 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 controlled corporation that is engaged in the active conduct of a trade or 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.
Rev. Proc. 2003-3, sec. 4.01(30), 2003-1 I.R.B. 113.
Rev. Proc. 2003-48, 2003-29 I.R.B. 86.
Secs. 355(a)(1)(A) and 368(c).
Such nonvoting preferred stock is considered economically more similar to debt for
purposes of considering whether the parent controls the subsidiary for consolidated return
purposes.
Foreign corporations, insurance companies, and certain other types of corporations
are not eligible to file consolidated tax returns with other corporations. However, these
exceptions would not apply under the proposal for section 355 purposes, if the relevant stock
ownership requirement is met.
A similar proposal addressing the group to which the present law active business test
is applied was contained in the Joint Tax Committee Staff Simplification recommendations 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, Vol. II at 251-252 and in section 304 of the Senate
amendment to H.R. 4520 (but was not adopted in the final version of that legislation). See H.R.
Rep. 108-755, 108th Cong. (2004) at 361-362.
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, ''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).
In this case, only 80 percent of the holding company's assets would consist of stock
of corporations engaged in an active trade or business. The IRS ruling guidelines have required a
90 percent threshold to satisfy the special holding company rule that ''substantially all'' of the
holding company's assets be stock of companies engaged in an active trade or business.
The Treasury Department in the past has proposed that such an 80 percent of vote and
value test be used for all tax-free reorganization provisions of the Code. See, General
Explanations of the Administration's Fiscal Year 2001 Revenue Proposals, Department of the
Treasury, at 148 (February 2000). That proposal was not adopted. Use of such a test does
require greater testing of the relative values of different classes of stock than does present law, in
order to determine whether 80 percent of the total value of shares (in addition to 80 percent of
the vote) has been acquired. While the new test might arguably prove somewhat complex in the
case of an acquisitive transaction, it could be less difficult to apply in the case of a distribution
from a preexisting control situation where the parent has already owned the required 80 percent
of vote and value. Using such a test in section 355 for all purposes (rather than merely for the
active business test) would provide consistency within that provision as revised.
A separate provision of section 355 would tax the parent in an otherwise tax-free
distribution of a subsidiary as if it had sold the distributed subsidiary, if 50 percent or more of the
value (or vote) of the subsidiary is acquired by new shareholders as part of a plan related to the
spin off. Sec. 355(e).
Secs. 1202(c)(2), 1202(e)(1)(A), and 1045(b).
Sec. 512(e). However, the income of certain municipal qualified retirement plans
may be exempt from tax as income derived from the exercise of an essential government
function (sec. 115).
The proposal does not apply to employee stock ownership plans as Congress has
enacted special rules in this area.
Proper adjustments to net operating loss carryovers will be made to the extent losses
are not allowed to offset S corporation income.
Small Business Job Protection Act of 1996, S. Rpt. No. 104-281, at 61 (June 18,
1996).
Notice 2004-30, 2004-17 I. R. B. 828 (April 1, 2004).
Sec. 704(a).
Sec. 704(b).
Treas. Reg. sec. 1.704-1(b)(2)(i).
Treas. Reg. sec. 1.704-1(b)(2)(ii)(b).
Treas. Reg. sec. 1.704-1(b)(2)(ii)(d).
Treas. Reg. sec. 1.704-1(b)(2)(iii).
Treas. Reg. sec. 1.704-1(b)(3).
Treas. Reg. sec. 1.704-1(b)(3).
Limited liability companies are generally taxed as partnerships.
Treas. Reg. sec. 1.704-2(b)(1).
Treas. Reg. sec. 1.704-2(c).
Treas. Reg. sec. 1.704-2(d).
Treas. Reg. sec. 1.704-2(e).
T.D. 8385, 1992-1 C.B. 199, 203.
Sec. 752.
Treas. Reg. sec. 1.752-2(a).
Treas. Reg. sec. 1.752-3(a). For this purpose, the partnership generally must take into
account any allocations which would be required under section 704(c) if the partnership
minimum gain were recognized.
Treas. Reg. sec. 1.752-3(a)(3).
Section 705(a)(2)(B) generally requires that the adjusted basis of a partner's interest
in a partnership be reduced by permanently nondeductible expenses.
Secs. 1366 and 1367.
Treas. Reg. sec. 1.752-1(a)(1).
Treas. Reg. sec. 1.752-2(a).
331 U.S. 1 (1947).
Sec. 734.
This proposal has been recommended by the Advisory Group on Subchapter K of the
Internal Revenue Code of 1954 to the Subcommittee on Internal Revenue Taxation of the House
Ways and Means Committee (December 30, 1957); the Section of Taxation of the American Bar
Association (Recommendation #1974-11, 27 Tax Lawyer 876 (1974); and Professor William D.
Andrews, Inside Basis Adjustments and Hot Asset Exchanges in Partnership Distributions, 47
Tax Law Rev. 3 (1991).
Sec. 706(a).
Sec. 707(c).
In 1954, House bill section 707(c) provided a rule with respect to ''guaranteed
salaries'' of a partner. The Ways and Means Committee Report stated, ''[a] partner who renders
services to the partnership for a fixed salary, payable without regard to partnership income, shall
be treated to the extent of such amount like any other employee who is not a partner, and the
partnership shall be allowed a deduction for salary expense. The amount '' shall not be
considered a distributive share of partnership income or gain.'' H.R. Rep. No. 1337, 83d Cong.,
2d Sess., A226-A227. The provision was modified in the Senate to apply to guaranteed
payments for capital as well as for services. S. Rep. No. 1622, 83d Cong., 2d Sess. The
evolution of this rule as included in the law in 1954 has been described this way: ''To
summarize, the genesis of section 707(c) was a desire on the part of the House to obviate the
complexity caused under prior law when compensatory payments to partners exceed partnership
income. As the provision emerged from the Senate, its scope was limited to that necessary to
accomplish this narrow purpose, as redefined by the Senate, and was expanded to include
payments for the use of capital.'' McKee, Nelson & Whitmire, Federal Taxation of Partnerships
and Partners, 13-40, 3d ed. 2004.
Sec. 707(c).
Sec. 706(a); Treas. Reg. sec. 1.707-1(c).
Sec. 707(a).
Sec. 267(a)(2).
See, e.g., L. Steinberg, ''Fun and Games with Guaranteed Payments,'' 57 Tax Lawyer
533 (Winter 2004); S. Banoff, ''Guaranteed Payments for the Use of Capital: Schizophrenia in
Subchapter K,'' 70 Taxes 820 (1992); P. Postlewaite and D. Cameron, ''Twisting Slowly in the
Wind: Guaranteed Payments After the Tax Reform Act of 1984,'' 40 Tax Lawyer 649 (1986).
Several commentators have advocated an approach like that of the proposal, stating that the
''better approach would be to eliminate section 707(c) totally and provide that any payment to a
partner, not determined with regard to partnership income, constitutes a section 707(a) payment.''
P. Postlewaite and J. Pennell, ''JCT's Partnership Tax Proposals '' ''Houston, We Have a
Problem,''' 76 Tax Notes 527, 538 (July 28, 1997); and see W. Brannan, ''The Subchapter K
Reform Act of 1997,'' 76 Tax Notes 121 (April 7, 1997).
Only U.S. citizens may qualify under the bona fide residence test. However, resident
aliens of the United States who are citizens of foreign countries that have a treaty with the United
States may qualify for section 911 exclusions under the bona fide residence test by application of
a nondiscrimination provision.
Sec. 7701(a)(4).
Sec. 7701(a)(5).
Pub. L. No. 108-357.
AJCA also provides for a lesser set of sanctions with respect to a transaction that
would meet the definition of an inversion transaction described above, except that the 80-percent
ownership threshold is not met. In such a case, if at least a 60-percent ownership threshold is
met, then a second set of rules applies to the inversion. Under these rules, the inversion
transaction is respected (i.e., the foreign corporation is treated as foreign), but any applicable
corporate-level ''toll charges'' for establishing the inverted structure are not offset by tax
attributes such as net operating losses or foreign tax credits. AJCA also subjects certain
partnership transactions to the new inversions rules.
Senate Treaty Doc. 108-25.
One such exception is the so-called ''branch rule'' of section 954(d)(2), which
effectively treats branches of controlled foreign corporations as separate corporations for
purposes of the foreign base company sales income rules, under certain circumstances. No
similar ''branch rule'' applies for other purposes of subpart F.
Treas. Reg. sec. 301.7701-2, as in effect prior to 1997.
Treas. Reg. sec. 301.7701-1, et seq.
Persons are considered related for this purpose if they meet a greater-than-50-percent
common-control standard under rules similar to those of section 954(d)(3).
In 1998 the IRS proposed, and then withdrew, regulations that sought to prevent this
particular use of the ''check the box'' regulations. See Notice 98-11, 1998-1 C.B. 433; former
Temp. Treas. Reg. sec. 1.954-9T, adopted in T.D. 8767, 1998-1 C.B. 875; Notice 98-35, 1998-2
C.B. 34. More recently, both the House- and Senate-passed versions of AJCA included a
provision that would have allowed taxpayers to achieve tax results similar to those achieved via
hybrid branch arrangements in connection with payments between two CFCs, thus obviating the
need to establish a hybrid branch, but this provision was not adopted in the final version of
AJCA.
See, e.g., Dover Corp. v. Commissioner, 122 T.C. 324 (2004).
Under section 412 of AJCA, certain sales of partnership interests by controlled
foreign corporations no longer give rise to subpart F income. AJCA did not extend a similar
approach to the sale of stock by a controlled foreign corporation, which still gives rise to subpart
F income.
These systems are often referred to as ''participation exemption'' systems.
Secs. 951-964.
Secs. 1291-1298.
Secs. 901, 902, 960, and 1291(g).
Secs. 901 and 904.
Sec. 904(d). The American Jobs Creation Act of 2004 (''AJCA'') generally reduced
the number of these categories from nine to two, effective in 2007. A number of other
provisions of the Code and treaties have the effect of creating additional separate limitation
categories in specific circumstances.
See sec. 904(d)(3) (providing for look-through treatment of dividends, interest, rents,
and royalties received from CFCs).
In addition, in some cases taxpayers may enter into transactions that are substantially
equivalent to repatriations economically, but that are intended to escape taxation as such.
Section 956 imposes limits on this practice with respect to many of the nearest repatriation
equivalents.
Sec. 401 of AJCA.
Sec. 864(f).
Allocating gain between appreciation of assets that produce exempt income and those
that produce non-exempt income, while perhaps attractive in theory, would be highly complex
and would introduce difficult issues of valuation into the system.
See AJCA secs. 401 (interest allocation), 402 (overall domestic loss), 403
(noncontrolled sec. 902 corporations), 404 (reduction of number of separate limitation
categories), 406 (treatment of deemed royalties), and 417 (extension of carryover period). These
changes promote capital import neutrality in the long run, as they reduce the U.S. residence-
country tax burden imposed on the cross-border income of U.S. taxpayers. More directly, these
changes also may be viewed as promoting capital export neutrality, because they reduce the
impact of the foreign tax credit limitation. The foreign tax credit limitation, while necessary to
preserve full U.S. taxing jurisdiction with respect to U.S.-source income, impairs capital export
neutrality by allowing investments in high-tax foreign jurisdictions to be subjected to a greater
aggregate tax burden than comparable investments in the United States.
See, e.g., AJCA secs. 407 (dealer exceptions to deemed repatriation rules), 412
(subpart F treatment of CFC sales of partnership interests), 414 (subpart F treatment of
commodities transactions), 415 (subpart F treatment of aircraft leasing and shipping income),
and 416 (subpart F active financing exception).
There are several proposals dealing with subpart F that the Congress may wish to
consider, either in conjunction with this proposal or as freestanding proposals. One such
proposal would be to limit taxpayers'' ability to use disregarded entities to avoid what would
traditionally have been subpart F income, as described in Part VI.C. of this Report. Other
possible proposals include repeal of the foreign base company sales and services income rules,
which arguably are outmoded and distort business decision making, and yet appear to be
ineffective as a practical matter in promoting capital export neutrality and reinforcing the transfer
pricing rules. Another possible proposal would be to make permanent the active financing
exception of sections 954(h) and (i) and 953(e), in order to promote greater certainty and stability
in the tax law.
Even if a dividend exemption system is not adopted, some would favor allocating
certain expenses to CFC earnings and deferring deductions for the expenses so allocable during
the period that the U.S. tax on the CFC earnings is deferred.
See, e.g., Michael J. Graetz and Paul W. Oosterhuis, ''Structuring an Exemption
System for Foreign Income of U.S. Corporations,'' National Tax Journal, Vol. LIV, No. 4,
(December 2001) (illustrating that moving to a dividend exemption system could provide an
opportunity for simplification, but that many of the sources of complexity encountered under
present law would remain).
To the extent that permanent exemption is more favorable than the indefinite-but-
restricted deferral available under present law, an exemption system may place somewhat more
pressure on some of these rules, thus making it somewhat more important to remedy existing
defects in the design and administration of those rules.
Harry Grubert and John Mutti, Taxing International Business Income: Dividend
Exemption versus the Current System, Washington, D.C., American Enterprise Institute (2001)
(''Grubert and Mutti''); and Rosanne Altshuler and Harry Grubert, ''Where Will They Go if We
Go Territorial'' Dividend Exemption and the Location Decisions of U.S. Multinational
Corporations,'' National Tax Journal, Vol. LIV, No. 4 (December 2001) (''Altshuler and
Grubert'').
Grubert and Mutti.
Altshuler and Grubert.
Some economic research has focused on the impact of home country tax systems on
foreign direct investment in the United States. The conclusions from this literature are mixed.
Joel Slemrod uses time-series data to compare the responsiveness to U.S. corporate tax rates of
foreign direct investment from exemption and ''worldwide'' countries. Joel Slemrod, ''Tax
Effects on Foreign Direct Investment: Evidence from a Cross-Country Comparison,'' in Taxation
in the Global Economy, edited by Assaf Razin and Joel Slemrod, Chicago, University of Chicago
Press, 1990. The study does not uncover a difference between the two groups of countries.
James R. Hines, Jr. examines whether the sensitivity of manufacturing foreign direct investment
to State income tax rates varies across exemption and ''worldwide'' countries. James R. Hines,
Jr., ''Altered States: Taxes and the Location of Foreign Direct Investment in America,'' American
Economic Review, 86, No. 5, December, 1996. The study finds that foreign direct investment
from exemption countries is more responsive to differences in State income tax rates. Although
relevant, these papers do not examine the experience of U.S. corporations and how location
incentives may change under the dividend exemption proposal described here and the current
system.
Sec. 265.
Section 7701(f) provides that the Secretary of the Treasury will prescribe regulations
necessary or appropriate to prevent the avoidance of any income tax rules that deal with the use
of related persons, pass-through entities, or other intermediaries in (1) the linking of borrowing
to investment or (2) diminishing risks. See H Enterprises Int'l, Inc. v. Commissioner, T.C.M.
1998-97, aff'd. 183 F.3d 907 (8th Cir. 1999) (Code section 265(a)(2) applied where a subsidiary
borrowed funds on behalf of a parent and the parent used the funds to buy, among other
investments, tax-exempt securities).
Rev. Proc. 72-18, 1972-1 C.B. 740.
Rev. Proc. 72-18, as modified by Rev. Proc. 87-53, 1987-2 C.B. 669.
Sec. 265(b).
Secs. 265(b)(3) and 291(a)(3).
Sec. 265(b)(3)(C)(iii).
Rev. Proc. 72-18, sec. 5.
The proposal adopts the definition of affiliated group found in present law section
1563(a).
The proposal defines related persons by reference to section 267(f)(1).
If the taxpayer and the related person are members of an affiliated group, they are
treated as a single taxpayer under the proposal, and the pro-rata rule applies.
In recent guidance, the IRS and Treasury Department have expressed concern over
multi-party financing arrangements that avoid the application of section 265. See Rev. Rul.
2004-47, 2004-21 I.R.B. 941 (borrowing and investing by dealer and non-dealer members of
affiliated group); Priv. Ltr. Rul. 200428027 (March 26, 2004) (borrowing and investing by
subsidiary of bank); Announcement 2004-44, 2004-21 I.R.B. 957 (request for comments
regarding the scope of possible proposed regulations under section 7701(f) to address the
application of section 265(a)(2) (and section 246A) in transactions involving related parties); 69
F.R. 25535 (May 7, 2004) (proposed amendments to Treas. Reg. secs. 1.265-2 and 1.1502-13
addressing situations in which one member of a consolidated group borrows funds that another
member had borrowed from a nonmember and uses those funds to purchase tax-exempt
obligations). For recent guidance involving ownership of tax-exempt obligations by investment
subsidiaries of banks, see Tech. Adv. Mem. 200434021 (March 12, 2004) and Tech. Adv. Mem.
200434029 (March 26, 2004).
Merle Erickson, Austan Goolsbee, and Edward Maydew, ''How Prevalent is Tax
Arbitrage'' Evidence from the Market for Municipal Bonds,'' National Tax Journal, 56 (June
2003).
The Joint Committee staff previously recommended that the qualified small issuer
exception should be eliminated. 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 Federal Tax System (JCS-3-01), April 2001. For the reasons described in the
accompanying text, this proposal does not include that recommendation.
Sec. 197(a).
Sec. 197(c).
Sec. 1245.
Sec. 197(f)(7).
See H.R. Rep. No. 103-111 at 760 (1993).
See sec. 197(f)(1), which disallows the loss if any other section 197 intangibles
acquired as part of the same acquisition are retained.
AJCA also grants authority to the Treasury Department to prescribe appropriate
adjustments to the basis of property (and the look-back method) to reflect the treatment of
participations and residuals under the provision.
Associated Patentees, Inc. v. Commissioner, 4 T.C. 979 (1945).
For example, in the case of participations or residuals to which section 404(a)(5) or
section 404(b)(1) applies, such participations or residuals would not increase the taxpayer's basis
until the amount is included in the gross income of the participant.
It is possible that Treasury may address this issue when regulations are issued under
AJCA. See sec. 167(g)(7)(E).
Pub. L. No. 108-27, sec. 202 (2003).
Pub. L. No. 108-357, sec. 910 (2004).
Rev. Proc. 2004-20, 2004-13 I.R.B. 642. The 2005 amounts have not yet been
released by the IRS.
Sec. 280F(d)(5). Exceptions are provided for any ambulance, hearse, or any vehicle
used by the taxpayer directly in the trade or business of transporting persons or property for
compensation or hire.
Temp. Treas. Reg. sec. 1.274-5T(k). Examples of exempted trucks include flatbed
trucks, refrigerated trucks, and delivery trucks with seating only for the driver.
See S. Rep. No. 108-192, at 195 (2004).
Temp. Treas. Reg. sec. 1.274-5T(k) grants the exemption to ''any vehicle which, by
reason of its nature (i.e., design), is not likely to be used more than a de minimis amount for
personal purposes.''
The portion is referred to in the statute as the ''policyholders'' share' of tax-exempt
interest; this term originates with the notion that a share of the assets of the company really
belongs to the policyholders. The policyholders' share is the excess of 100 percent over the
portion determined as the ''company's share' under section 812. In general, the company's share
is that percentage that reflects the investment income of the company for the taxable year,
reduced by policyholder dividends, policy interest credited to policyholders, and a portion of
investment expenses.
H.R. Rep. No. 99-426, 670.
See Part VII.A. of this Report, ''Disallow Deduction for Interest on Indebtedness
Allocable to Tax-Exempt Obligations.''
Sec. 56(a)(2).
Sec. 57(a)(1).
If the taxpayer elects the deferred expense method under section 616(b) or 10-year
amortization under section 59(e), the deduction for depletion will remain zero.
Pursuant to Treas. Reg. sec. 301.9100-2(a)(2)(iv), organizations are allowed an
automatic 12-month extension as long as the application for recognition of tax exemption is filed
within the extended, i.e., 27-month, period. The IRS also may grant an extension beyond the 27-
month period if the organization is able to establish that it acted reasonably and in good faith and
that granting relief will not prejudice the interests of the government. Treas. Reg. secs.
301.9100-1 and 301.9100-3.
Treas. Reg. sec. 1.508-1(a)(1).
Sec. 508(d)(2)(B). Contributions made prior to receipt of a favorable determination
letter may be deductible prior to the organization's receipt of such favorable determination letter
if the organization has timely filed its application to be recognized as tax-exempt. Treas. Reg.
secs. 1.508-1(a) and 1.508-2(b)(1)(i)(b).
Treas. Reg. sec. 1.501(a)-1(a)(2).
Sec. 7428.
Rev. Proc. 90-27, 1990-1 C.B. 514; IRS Pub. No. 557, Tax-Exempt Status for Your
Organization (May 2003) at 4-5.
Rev. Proc. 82-39, 1982-2 C.B. 759.
Sec. 501(p) (enacted by Pub. L. No. 108-121, sec. 108(a), effective for designations
made before, on, or after November 11, 2003).
Sec. 6033(a)(1). Temporary Treasury Regulations effective January 12, 2005, require
that exempt organizations that file at least 250 returns (of any type, including Forms 1099) a
calendar year and with assets of at least $100 million file the Form 990 electronically for taxable
years ending on or after December 31, 2005, reduced to $10 million in assets for taxable years
ending on or after December 31, 2006. Private foundations and charitable trusts meeting the 250
return requirement are required to file the Form 990-PF electronically for taxable years ending
on or after December 31, 2006. Temp. Treas. Reg. sec. 301.6033-4T.
Sec. 6033(a)(2); Treas. Reg. sec. 1.6033-2(a)(2)(i); Treas. Reg. sec. 1.6033-2(g)(1).
Sec. 6033(a)(2)(A)(ii) provides a $5,000 annual gross receipts exception from the annual
reporting requirements for certain exempt organizations. In Announcement 82-88, 1982-25
I.R.B. 23, the IRS exercised its discretionary authority under section 6033 to increase the gross
receipts exception to $25,000, and enlarge the category of exempt organizations that are not
required to file Form 990.
The proposal does apply to integrated auxiliaries and conventions or associations of
churches.
An exception could be made for failure due to reasonable cause and not to willful
neglect. Revocation due to failure to satisfy the five-year review filing requirement is not subject
to the declaratory judgment provisions of section 7428.
The annual notice proposal does not apply to organizations exempted from the filing
requirement on other grounds, for example, churches, their integrated auxiliaries, and
conventions or associations of churches; the exclusively religious activities of any religious
order; section 501(c)(1) instrumentalities of the United States; section 501(c)(21) trusts; an
interchurch organization of local units of a church; certain mission societies; certain church-
affiliated elementary and high schools; certain state institutions whose income is excluded from
gross income under section 115; certain governmental units and affiliates of governmental units;
and other organizations that the IRS has relieved from the filing requirement pursuant to its
statutory discretionary authority.
Sec. 7428.
Tax-Exempt Organizations and Other Entities Listed on the Exempt Organization
Business Master File, by Type of Organization and Internal Revenue Code Section, Fiscal Years
2000-2003 and Fiscal Years 1995-1998, 2003 IRS Data Book, Excel ver. 4, March 2004 and
1998 IRS Data Book, Excel ver. 4, September 2000.
A similar proposal was passed by the Senate on April 9, 2003, as section 207 of S.
476. The staff of the Joint Committee on Taxation recommended the adoption of a similar
proposal. Joint Committee on Taxation, Study of Present-Law Taxpayer Confidentiality and
Disclosure Provisions as Required by Section 3802 of the Internal Revenue Service
Restructuring and Reform Act of 1998, Volume II: Study of Disclosure Provisions Relating to
Tax-Exempt Organizations (JCS-1-00), January 28, 2000, at 98.
Conversion transactions are sometimes used to provide organizations access to equity
markets, and advocates of conversion transactions claim additional advantages of: (1) cost
reduction due to efficiency and enhanced bargaining power with respect to providers of services
or goods to the organization; (2) greater accountability to consumers and enhancement of
consumer choices; (3) providing a means to offer stock options, restricted stock, and other long-
term incentives to management; and (4) avoiding the limiting effects of certain tax rules (such as
the treatment of commercial-type insurance under section 501(m)) and fear of regulatory
changes. Frances R. Hill and Douglas M. Mancino, ''Taxation of Exempt Organizations,''
sec. 30.01 (2002).
Sec. 509(a). The phrase ''public charity'' is not defined in the Code, but generally
refers to a charitable organization described in section 501(c)(3) that is not a private foundation.
In general, private foundations are subject to special rules (such as reporting requirements, excise
tax rules, and charitable deduction limitations) that do not apply to public charities.
Treas. Reg. sec. 1.501(c)(3)-1(b)(4).
Id.
Rev. Proc. 82-2, 1982-1 C.B. 367 (providing which State nonprofit corporation
statutes satisfy the dissolution provision, and explaining the application of the provision to inter
vivos charitable trusts, testamentary charitable trusts, and unincorporated nonprofit associations).
See also Rev. Proc. 2003-12, 2003-1 C.B. 316. The IRS provided a sample dissolution provision
that may be used by charitable organizations to satisfy this provision. It reads: ''[u]pon
dissolution of [this organization], assets shall be distributed for one or more exempt purposes
within the meaning of section 501(c)(3) of the Internal Revenue Code, or corresponding section
of any future Federal tax code, or shall be distributed to the Federal government, or to a state or
local government, for a public purpose.'' Rev. Proc. 82-2, 1982-1 C.B. 367.
Sec. 4958. The excess benefit transaction tax is commonly referred to as
''intermediate sanctions,'' because it imposes penalties generally considered to be less punitive
than revocation of the organization's exempt status. The tax also applies to transactions between
disqualified persons and social welfare organizations (as described in section 501(c)(4)).
Treas. Reg. sec. 53.4958-4(a)(3).
Sec. 4958(f)(1). A disqualified person also includes certain family members of such
a person, and certain entities that satisfy a control test with respect to such persons.
Sec. 507(a)(2).
Id. at 56.
Frances R. Hill and Douglas M. Mancino, ''Taxation of Exempt Organizations,'' sec.
30.02[4][d] (2002) (change in form under State law might be treated as a tax-free recapitalization
under section 368(a)(1)(E) or disregarded entirely; merger might be treated as a tax-free
reorganization; other transfers might be viewed as a sale of assets by the charity, with exclusions
of gain or loss from unrelated business income as a transaction that furthers the charity's exempt
purpose, or as gain or loss from the sale, exchange, or other disposition of assets that is
excludable under section 512(b)(5)). See, e.g., Priv. Ltr. Rul. 200434028 (charity that transfers
all of its student loan notes to a taxable corporate subsidiary in exchange for stock in the
subsidiary will not recognize unrelated business income on the transfer of the assets, upon
receipt of dividends, or on a subsequent redemption or sale of the stock, as it constitutes ''a one
time sale of the principal asset'').
H.R. Rep. No. 104-506, 59, n.15 (legislative history to the intermediate sanctions
rules). See also Caracci v. Commissioner, 118 T.C. 379 (2002) (certain insider transactions
warranted imposition of the section 4958 excise taxes but did not justify revocation of exempt
status).
Bruce R. Hopkins, ''The Law of Tax-Exempt Organizations,'' sec. 33.3(b) (8th ed.
2003).
Id. at sec. 33.3(b), note 71 (8th ed. 2003).
Evelyn Brody, ''Whose Public'' Parochialism and Paternalism in State Charity Law
Enforcement,'' 79 Indiana Law Journal 937, 962-63 (Fall 2004) (''[c]ommunities have been
worrying about behind-closed-doors sales of nonprofit hospital assets: the community might be
short-changed either in the amount paid for the assets (and hence the funds available for future
charity) or in the quality and price of future for-profit hospital services. Some also suspect
conflicts of interest on the part of the nonprofit's trustees and officers, who might receive
positions either in the new hospital management or the resulting foundations.''); Terry Roth
Reicher, ''Assuring Competent Oversight to Hospital Conversion Transactions'', 52 Baylor Law
Review 83, 91-92 (Winter 2000) (major objections to conversion transactions stemmed from
undervaluation of the nonprofit with the resultant underfunding of the charity, the channeling of
sales proceeds back to the for-profit purchaser, restrictions on the surviving charity's ability to
function as a charity after the transaction, and improper inducements to board members).
Chapter 42 refers to the excise taxes imposed under sections 4940 through 4963.
For this purpose, a governmental unit is defined in the same manner as under section
507 (i.e., an organization described in section 170(b)(1)(A) (other than in clauses (vii) and (viii)).
This includes the Federal government, State and local governments, and certain Indian tribal
governments treated as a State or local government for this purpose. Secs. 507(b)(1)(A),
170(b)(1)(A)(v), 170(c)(1), and 7871(a).
Treas. Reg. sec. 1.332-2(c).
E.g., Blue Cross and Blue Shield organizations described in section 833. Congress
addressed the treatment of such organizations in 1986 by treating them similar to taxable
insurance companies and providing special rules for such organizations. Sec. 1012(c)(3) of the
Tax Reform Act of 1986, Pub. L. No. 99-514.
Under section 6901 and the substantive doctrine of transferee liability, a transferee of
property of a taxpayer may succeed to the transferor's Federal tax liability under certain
circumstances. In general, however, a transferee of property is not liable for the tax liability of
the transferor if the transferee pays adequate consideration for the transferred property.
As is the case under present-law section 4958, a ''person'' includes an individual,
trust, estate, partnership, association, company, or corporation. Sec. 7701(1).
A separate proposal in this publication modifies the initial contract exception for
more general purposes. See Part VIII.D. of this report, ''Reform Intermediate Sanctions and
Extend Certain Reforms to Private Foundations.''
Treas. Reg. sec. 53.4958-3(e).
The officer or director also would be a disqualified person with respect to the public
charity, and thus subject to section 4958 with respect to transactions between such person and the
charity, during this five-year period. Sec. 4958(f)(1). Thus, under the proposal, the disqualified
person would be required to deal fairly with both the charity and the acquirer to avoid excess
benefit transaction tax liability.
An alternative to recovery of actual reasonable costs might be to require filing parties
to pay a user fee to cover the costs of IRS review of conversion and liquidation transactions.
31 U.S.C. sec. 330(c) (after notice and opportunity for a hearing to any appraiser with
respect to whom a penalty for aiding and abetting understatement of tax liability has been
assessed, the Secretary may provide that appraisals by such appraiser shall not have any
probative effect in any administrative proceeding before the Treasury or the IRS, and bar such
appraiser from presenting evidence or testimony in any such proceeding).
David Villar Patton, ''The Queen, the Attorney General, and the Modern Charitable
Fiduciary: A Historical Perspective on Charitable Enforcement Reform,'' 11 Journal of Law &
Public Policy 131, 164-65 (Spring 2000) (stating that critics of charitable enforcement by State
Attorneys General assert that they are politically influenced, suffer from a lack of funds and
staff, and have an overwhelming case load resulting in insufficient and ineffective regulation of
charitable fiduciaries).
E.g., John D. Columbo, ''A Proposal for an Exit Tax on Nonprofit Conversion
Transactions,'' 23 Iowa Journal of Corporate Law 779 (Summer 1998).
In those instances where the acquirer is not treated as a disqualified person with
respect to the conversion transaction, the acquirer will not be subject to an excess benefits
transaction tax, and generally will not be liable for any portion of a termination tax imposed on
the charity unless the acquirer is liable as a transferee under transferee liability principles. If the
charity's officers and directors did not uphold their State law duties as officers and directors to
protect the charity's assets, in some cases the charity or the State Attorney General (on behalf of
the charity) might be able to assert a claim for damages against the officers or directors who
breached their duty.
Terry Roth Reicher, ''Assuring Competent Oversight to Hospital Conversion
Transactions,'' 52 Baylor Law Review 83, note 21 (Winter 2000).
The proposal should prevent the use of multiple step conversions to achieve a
conversion of charitable assets to for-profit uses, such as through a conversion to a social welfare
organization followed by a sale by the social welfare organization of the formerly charitable
assets to a for-profit entity.
Treas. Reg. sec. 1.6011-4(a).
Sec. 7701(a)(1); Treas. Reg. sec. 1.6011-4(c)(1).
Treas. Reg. sec. 1.6011-4(b).
Sec. 6707A(c)(2); Treas. Reg. sec. 1.6011-4(b)(2).
Treas. Reg. sec. 1.6011-4(a).
Sec. 6707A(c)(1).
Treas. Reg. sec. 1.6011-4(c)(3).
Sec. 6707A, as added by the American Jobs Creation Act of 2004, Pub. L. No. 108-
357, sec. 811(a).
Sec. 6707(a), as added by the American Jobs Creation Act of 2004, Pub. L. No. 108-
357, sec. 816(a).
Sec. 6707(b)(1).
Sec. 6707(c).
Sec. 6707(b).
On December 14, 2004, the Public Company Accounting Oversight Board
(''PCAOB'') unanimously approved proposed ethics and auditor independence rules to limit the
ability of accounting firms to provide certain aggressive tax planning services to their public
clients. Proposed Rule 3522 provides that a public accounting firm will lose its independence
from an audit client if the accounting firm provides services related to planning or opining on the
tax consequences of a listed or confidential transaction under Treasury Regulations. In addition,
the proposed rule provides that a firm is not independent if it provides its client services
regarding planning or opining on transactions based on an aggressive interpretation of applicable
tax laws and regulations.
31 C.F.R. Part 10, sec. 10.35(b)(2)(i) (a covered opinion includes written advice by a
practitioner concerning one or more Federal tax issues arising from ''a transaction that is the
same as or substantially similar to a transaction that, at the time the advice is rendered, the
Internal Revenue Service has determined to be a tax avoidance transaction and identified by
published guidance as a listed transaction'' under Treas. Reg. sec. 1.6011-4(b)(2)). A practitioner
who provides a covered opinion must comply with standards of practice of Circular 230,
including certain requirements with respect to factual matters, relating the law to the facts, and
evaluating significant Federal tax issues.
See Part V.D. of this report, ''Modify Application of Unrelated Business Income Tax
to S Corporation Shareholders.''
Sec. 4958. The excess benefit transaction tax commonly is referred to as
''intermediate sanctions.''
Sec. 4941.
Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1969,
December 3, 1970, at 30 (''Arm's-length standards have proved to require disproportionately
great enforcement efforts, resulting in sporadic and uncertain effectiveness of the provisions. . . .
Also the Congress concluded that compliance with arm's length standards often does not in itself
prevent the use of a private foundation to improperly benefit those who control the foundation.'').
Treas. Reg. sec. 53.4958-6(a). See also H. Rep. No. 506, 104th Congress, 2d Sess.
(1996), 53, 56-7.
Treas. Reg. sec. 53.4958-6(b).
Treas. Reg. sec. 53.4958-6(c)(1)(i).
Treas. Reg. sec. 53.4958-6(c)(2)(i).
Treas. Reg. sec. 53.4958-6(c)(2)(ii).
Treas. Reg. sec. 53.4958-6(c)(3).
Sec. 4958(d)(2). Taxes imposed may be abated if certain conditions are met. Secs.
4961 and 4962.
Sec. 4958(d)(1).
Treas. Reg. sec. 53.4958-1(d)(4)(i); Treas. Reg. sec. 53.4941(b)(3). Similar rules
apply to private foundations with respect to jeopardizing business investments (sec. 4944) and
taxable expenditures (sec. 4945). Treas. Reg. sec. 53.4944-1(b)(2); Treas. Reg. sec. 53.4945-
1(a)(2)(iii).
Sec. 7454(b).
Treas. Reg. sec. 53.4958-1(d)(4)(ii).
Id.
Treas. Reg. sec. 53.4958-1(d)(5). A similar standard applies to foundation managers
for purposes of the self-dealing rules (sec. 4941) and taxable expenditures (sec. 4945). Treas.
Reg. sec. 53.4941(b)(4); Treas. Reg. sec. 53.4945-1(a)(2)(iv).
Treas. Reg. sec. 53.4958-1(d)(6).
A similar standard applies to foundation managers for purposes of taxable
expenditures. Treas. Reg. sec. 53.4945-1(a)(2)(v).
Treas. Reg. sec. 53.4958-1(d)(4)(iii).
Treas. Reg. sec. 53.4941(a)-1(b)(6). A similar special rule for foundation managers
provided for purposes of taxable expenditures (sec. 4945) permits reliance only on advice of
counsel and not on other persons. Treas. Reg. sec. 53.4945-1(a)(2)(vi). A similar special rule
for foundation managers provided for purposes of the excise tax on jeopardizing investments
(sec. 4944) permits reliance on advice of legal counsel and qualified investment counsel. Treas.
Reg. sec. 53.4944-1(b)(2)(v).
Treas. Reg. sec. 53.4958-1(d)(4)(iv).
Treas. Reg. sec. 53.4958-4(a)(3).
Treas. Reg. sec. 53.4958-4(a)(3)(vii), Example (1).
Press reports frequently highlight questions of the reasonableness of compensation
paid to charity executives, and other insider transactions. For example, the Washington Post in
May 2003, published a series of articles raising questions about practices by The Nature
Conservancy, including executive compensation, loans to employees, and purchases and sales of
land from and by trustees or other insiders. For a description of such concerns in the case of
conversion transactions, see Part VIII.B. of this report, ''Impose Termination Tax on Conversions
of Assets of Charities.'' Part VIII.L. of this report, ''Establish Additional Exemption Standards
for Credit Counseling Organizations,'' describes practices in the credit counseling industry
whereby organization insiders profit from self-dealing. (The proposal with respect to credit
counseling organizations primarily addresses exemption standards, and not the application of
intermediate sanctions to insider transactions.)
Sec. 4958(a)(1).
Sec. 4941(a)(1).
The rebuttable presumption of reasonableness does not have a statutory basis. The
presumption appears to have originated as a proposal by the American Bar Association in
hearings before the Ways & Means Oversight Subcommittee on public charity abuses in 1993.
See U.S. Department of the Treasury's Proposals to Improve Compliance by Tax-Exempt
Organizations: Hearing before the Subcommittee on Oversight of the Committee on Ways and
Means House of Representatives, 103rd Cong., Serial 103-72, at 47. At the same hearing, the
Treasury Department introduced its intermediate sanctions proposal. Id. at 20. The Treasury
proposal did not contain a rebuttable presumption of reasonableness. Rather, the Treasury
emphasized that certain actions taken by an organization, e.g., approval by an independent board,
generally would ''weigh in favor of a finding of reasonableness''. Id. at 21 (''The weight to be
given to this factor would depend on the circumstances''). The Treasury noted that:
Determinations of the reasonableness of compensation would be made in
accordance with the procedures that govern the resolution of any factual question
involved in the application of a tax rule. Therefore, taxpayers who disagree with
an IRS determination of unreasonableness would have recourse to the normal
review procedures, including, as necessary, administrative appeals and judicial
proceedings.
The law eventually enacted by Congress largely followed the Treasury proposal. However, the
legislative history to the provision outlined the rebuttable presumption of reasonableness in terms
substantially similar to the American Bar Association proposal. The legislative history then
provided the underpinning for the rebuttable presumption of reasonableness, which became part
of the Treasury regulations. H. Rep. No. 506, 104th Cong., 2d Sess. (1996), 53, 56-7.
Treas. Reg. sec. 53.4958-6(b).
Secs. 4942-4945.
Part VIII.E. of this report, ''Increase the Amounts of Excise Taxes Imposed on Public
Charities, Social Welfare Organizations, and Private Foundations,'' proposes doubling the rates
of these taxes. If such proposal is adopted, the 10 percent entity-level tax described here would
be equal to the tax rate applicable to foundations for excess business holdings and jeopardizing
investments, and half the rate with respect to taxable expenditures.
Secs. 4941, 4944, and 4945.
The proposal does not recommend elimination of the reliance on counsel special rule
for purposes of the taxes on jeopardizing investments and taxable expenditures. Seeking the
advice of investment or legal counsel for purposes of making an investment for the foundation,
or seeking the advice of legal counsel to determine whether an expense of the foundation is a
taxable expenditure are different types of inquiries than seeking professional advice with respect
to self-dealing transactions. It is in the very nature of self-dealing that a manager's duties are
highest and where personal responsibility is paramount.
165 F.3d 1173 (7th Cir. 1999), rev''ing and remanding 109 T.C. 326 (1997).
The legislative history to section 4958 states that ''[i]n practice, revocation of tax-
exempt status, with or without the imposition of excise taxes, would occur only when the
organization no longer operates as a charitable organization.'' H. Rept. No. 104-506, 59, n.15.
Thus, under present law, an initial contract likely would have to be found to be so unfair to the
exempt organization that the organization cannot be regarded as operating in a charitable manner
before any sanction would be imposed.
Sec. 4958. The excess benefit transaction tax is commonly referred to as
''intermediate sanctions,'' because it imposes penalties generally considered to be less punitive
than revocation of the organization's exempt status.
Sec. 4958(d)(2). Taxes imposed may be abated if certain conditions are met. Secs.
4961 and 4962.
Sec. 4958(d)(1).
Sec. 4941.
Sec. 4962(b).
Sec. 4961.
Sec. 4942(g)(1)(A).
Sec. 4942(a) and (b). Taxes imposed may be abated if certain conditions are met.
Secs. 4961 and 4962.
Sec. 4942(g)(1)(B) and 4942(g)(2). In general, an organization is permitted to adjust
the distributable amount in those cases where distributions during the five preceding years have
exceeded the payout requirements. Sec. 4942(i).
Sec. 4943. Taxes imposed may be abated if certain conditions are met. Secs. 4961
and 4962.
Sec. 4943(c)(6).
Sec. 4943(c)(7).
Sec. 4944. Taxes imposed may be abated if certain conditions are met. Secs. 4961
and 4962.
Sec. 4944(c).
Sec. 4945. Taxes imposed may be abated if certain conditions are met. Secs. 4961
and 4962.
In general, expenditure responsibility requires that a foundation make all reasonable
efforts and establish reasonable procedures to ensure that the grant is spent solely for the purpose
for which it was made, to obtain reports from the grantee on the expenditure of the grant, and to
make reports to the Secretary regarding such expenditures. Sec. 4945(h).
Internal Revenue Service, ''Private Foundation Grant-Making Administrative
Expenses Study'' (January 1990).
Based on IRS Statistics of Income, it appears that between 60,000 and 75,000 annual
information returns were filed by private foundations for each of the taxable years examined
during 2002 and 2003. Less than 150 of such returns were examined by the IRS during each of
those years (approximately 0.3 percent). The number of such returns filed for 1985, the year that
was the subject of the IRS compliance study, was approximately 31,000. The IRS examined 882
private foundation returns for the study (approximately 2.8 percent of returns filed). Id. at
Appendix A.
A recent series of reports in the Boston Globe highlight many brazen abuses by
private foundation managers. See, e.g., Boston Globe, ''Some officers of charities steer assets to
selves'' (October 9, 2003); Boston Globe, ''Foundation's sale of nonprofit hospital a windfall for
administrator'' (October 9, 2003); Boston Globe, ''Charity money funding perks'' (November 9,
2003); Boston Globe, ''Costly furnishings come at charities'' expense'' (November 9, 2003);
Boston Globe, ''The trustees' perk that keeps on giving'' (November 9, 2003); Boston Globe,
''Foundations veer into business'' (December 3, 2003); Boston Globe, ''Philanthropist's millions
enrich family retainers'' (December 21, 2003); Boston Globe, ''Foundation's tax returns left
unchecked'' (December 29, 2003).
The tax base for other acts of self-dealing by private foundations generally is the
entire amount of a transaction. The tax base for purposes of intermediate sanctions, by contrast,
is always the excess above fair market value.
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).
Treas. Reg. sec. 1.170A-14(e)(2).
Treas. Reg. sec. 1.170A-14(e)(2).
Treas. Reg. sec. 1.170A-14(h)(3).
McLennan v. U.S., 24 Cl. Ct. 102 (1991) (highest and best use refers to ''the most
profitable and probable use'' of the property; although the property could be subdivided into
eight parcels, the taxpayer's ''strong aversion to development'' meant that a valuation based on
an assumption of subdividing the entire property was ''untenable'' and ''directly contradicts
[taxpayers''] clear intention to preserve their land from development;'' found that the reasonable
and probable use of the property was as an undivided country estate, not as a subdivision, and
that the easement did not affect the highest and best use of the land).
Treas. Reg. sec. 1.170A-14(h)(3)(i).
Id.
Id.
Treas. Reg. sec. 1.170A-14(h)(3)(ii).
Secs. 6662(b)(3) and 6662(h).
Sec. 6662(e) and 6662(h).
31 U.S.C. sec. 330(c) (after notice and opportunity for a hearing to any appraiser with
respect to whom a penalty for aiding and abetting understatement of tax liability has been
assessed, the Secretary may provide that appraisals by such appraiser shall not have any
probative effect in any administrative proceeding before the Treasury or the IRS, and bar such
appraiser from presenting evidence or testimony in any such proceeding).
Treas. Reg. sec. 1.170A-14(d)(2)(i).
Treas. Reg. sec. 1.170A-14(d)(3)(i).
Treas. Reg. sec. 1.170A-14(d)(4)(i).
Treas. Reg. sec. 1.170A-14(d)(4)(iii).
Id.
Id.
The conservation purpose standard for historically important land is that the area be:
(1) an independently significant land area including any related historic resources that meets the
National Register Criteria for Evaluation; (2) an area within a registered historic district
including any buildings on the land areas that can reasonably be considered as contributing to the
significance of the district; and (3) an area (including related historic resources) adjacent to a
property listed individually in the National Register of Historic Places (but not within a
registered historic district) in a case where the physical or environmental features of the land area
contribute to the historic or cultural integrity of the property. Treas. Reg. sec. 1.170A-
14(d)(5)(ii).
Treas. Reg. sec. 1.170A-14(d)(5)(iii).
Treas. Reg. sec. 1.170A-14(d)(5)(i).
Hillborn v. Commissioner, 85 T.C. 677 (1985) (holding the fair market value of a
facade donation generally is determined by applying the ''before and after'' valuation approach);
Richmond v. U.S., 699 F. Supp. 578 (E.D. La. 1988); Priv. Ltr. Rul. 199933029 (May 24, 1999)
(ruling that a preservation and conservation easement relating to the facade and certain interior
portions of a fraternity house was a qualified conservation contribution).
Treas. Reg. sec. 1.170A-14(d)(4)(iii).
31 U.S.C. sec. 330(c) (after notice and opportunity for a hearing to any appraiser with
respect to whom a penalty for aiding and abetting understatement of tax liability has been
assessed, the Secretary may provide that appraisals by such appraiser shall not have any
probative effect in any administrative proceeding before the Treasury or the IRS, and bar such
appraiser from presenting evidence or testimony in any such proceeding).
The deduction also is allowed for purposes of calculating alternative minimum
taxable income.
Secs. 170(b) and 170(e).
For certain contributions of inventory and other property, C corporations may claim
an enhanced deduction equal to the lesser of (1) basis plus one-half of the item's appreciated
value (i.e., basis plus one half of fair market value in excess of basis) or (2) two times basis.
Secs. 170(e)(3), 170(e)(4), and 170(e)(6).
Sec. 170(f)(12).
Secs. 170(e)(1)(B)(iii) and 170(m).
Contributions of clothing and household items present a similar problem to that
recently addressed by Congress in the AJCA with respect to contributions of vehicles. As with
vehicles under prior law, donors may deduct the fair market value of clothing and household
items irrespective of the use by the donee because the value of such items typically is less than
the donor's basis. However, the approach Congress took with vehicles, generally limiting the
deduction to the sales price of the vehicle, is not appropriate for clothing and household items.
Such items often may not be sold by the donee organization, in which case a rule limiting the
deduction to sales proceeds would not address most contributions. To the extent donee
organizations sell contributed clothing and household items, reporting the sales price to the donor
for purposes of determining the deductible amount would be impracticable.
The rules for contributions of such items are, however, affected by the proposal in
Part VIII.H. of this report, ''Reform Rules for Charitable Contributions of NonCash Property.''
The deduction also is allowed for purposes of calculating alternative minimum
taxable income.
Secs. 170(b) and 170(e).
Exceptions to the general rule of non-deductibility include certain gifts made to a
veterans' organization or to a domestic fraternal society. In addition, contributions to certain
nonprofit cemetery companies are deductible for Federal income tax purposes, but generally are
not deductible for Federal estate and gift tax purposes. Secs. 170(c)(3), 170(c)(4), 170(c)(5),
2055(a)(3), 2055(a)(4), 2106(a)(2)(A)(iii), 2522(a)(3), and 2522(a)(4).
Sec. 170(f)(8).
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 appreciated value (i.e., basis
plus one half of fair market value in excess of basis) or (2) two times basis. Sec. 170(e)(3). 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 and 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.
A similar enhanced deduction is available for contributions of scientific property and equipment
(sec. 170(e)(4)) and for contributions of computer technology used for educational purposes
made in taxable years beginning before January 1, 2006 (sec. 170(e)(6)).
Sec. 170(f)(3).
Sec. 1011(b) and Treas. Reg. sec. 1.1011-2.
Sec. 6050L(a)(1).
Pub. L. No. 98-369, sec. 155(a)(1) through (6) (1984) (providing that not later than
December 31, 1984, the Secretary shall prescribe regulations requiring an individual, a closely
held corporation, or a personal service corporation claiming a charitable deduction for property
(other than publicly traded securities) to obtain a qualified appraisal of the property contributed
and attach an appraisal summary to the taxpayer's return if the claimed value of such property
(plus the claimed value of all similar items of property donated to one or more donees) exceeds
$5,000).
In the case of a deduction first claimed or reported on an amended return, the deadline
is the date on which the amended return is filed.
Treas. Reg. sec. 1.170A-13(c)(3).
Sec. 170(f)(12).
Sec. 170(e)(1)(B)(iii) and 170(m).
Publicly traded securities are defined as securities for which (as of the date of the
contribution) market quotations are readily available on an established securities market. See
sec. 6050L(a)(2)(B).
Congress recently enacted special rules for contributions of qualified vehicles and
intellectual property, which are tailored to the circumstances pertaining to such property
contributions. Thus, such contributions are excepted from Option 1 and Option 2. See Part
VIII.F. of this report, ''Modify Charitable Deduction for Contributions of Conservation and
Facade Easements,'' for a proposal to change the charitable deduction rules for qualified
conservation contributions. If the present-law special rules for qualified conservation
contributions are not separately addressed, Option 1 could be modified to apply to such
contributions. The merits of applying Option 1 to qualified conservation contributions are not
discussed in this report. See Part VIII.G. of this report, ''Limit Charitable Deduction for
Contributions of Clothing and Household Items,'' for a proposal on the treatment of contributions
of clothing and household items.
Because they are not excepted from Option 2, qualified conservation contributions
generally would receive the same deduction as under current law (fair market value) because
such contributions generally are exempt use property. See Part VIII.F. of this report, ''Modify
Charitable Deduction for Contributions of Conservation and Facade Easements,'' for a proposal
to change the charitable deduction rules for qualified conservation contributions.
Under present law, the donor's deduction generally is the fair market value of the
property. There are exceptions for contributions to private nonoperating foundations and for
contributions of tangible personal property not intended to further exempt purposes. The
deduction for such contributions generally is the donor's basis or, if less, fair market value.
Option 2 does not change the rules for contributions to nonoperating foundations.
Present-law rules continue to apply to any contribution of exempt use property for
which a deduction of $500 or less is claimed.
The disposition proceeds are regarded as relevant to a determination of fair market
value.
Other present-law penalties also may apply, such as the penalty for aiding and
abetting the understatement of tax liability under section 6701.
Much of the discussion regarding Option 1 also is applicable to Option 2, as the two
Options are largely identical except with respect to the treatment of exempt use property.
Option 1 eliminates the return requirement with respect to all property, including loss
property. Ideally, returns should continue to be required for dispositions of contributed loss
property because donors claim a fair market value deduction for such property and the IRS could
benefit from comparing the disposition amount to the amount claimed as a deduction. However,
requiring an information return for dispositions of loss property but not for appreciated property
could be confusing for donees, and the potential for abusive valuations is limited in such cases
because in no event is the taxpayer allowed to claim a deduction in excess of the taxpayer's basis
in the property.
See Part VIII.G. of this report, ''Limit Charitable Deduction for Contributions of
Clothing and Household Items.''
Option 2 preserves the fair market value deduction for exempt use property.
Independent of Option 2, the recapture tax could be applied to enforce the present-law
rule for contributions of tangible personal property. Under present law, the fair market value
deduction may be claimed for such contributions. However, if the donee does not so use the
property, there is no automatic recapture of the donor's deduction. Recapture may occur under
present law if the IRS audits the taxpayer and the taxpayer cannot show, for example, that at the
time of the contribution, it is reasonable to anticipate that the property will not be put to an
unrelated use by the donee. Treas. Reg. sec. 1.170A-4(b)(3)(ii).
If the donee organization certifies as to the property's exempt use and thus the
recapture tax does not apply, the disposition amount could still inform the Treasury as to whether
an appraised amount for the property, and thus the donor's fair market value-based deduction,
was reasonable.
For property with a claimed value of $500 or less, information reporting, such as
whether property is exempt use property, generally is not required. It would be possible to
require that a donee make a determination of use of the property on the substantiation required
under present law for contributions of property with a value of $250 or more (sec. 170(f)(8)).
The AJCA recently amended the law generally to require that C corporations obtain
an appraisal in such cases.
Treas. Reg. sec. 1.170A-13(c)(5)(i).
Under present law, appraisers generally are subject to penalties only for aiding and
abetting the understatement of tax liability (sec. 6701), but not for providing an appraisal that is
determined to be a valuation misstatement under section 6662.
If the property is disposed of on a date within the same taxable year of the donor as
the contribution date, the deduction would equal the disposition amount and no additional
deduction would be available. If the property was disposed of for less than the taxpayer's basis,
the deduction would be adjusted downward.
The approach could carve out qualified intellectual property, or qualified vehicles,
which have newly enacted special rules.
Exempt use property by definition is unlikely to be sold or otherwise disposed of by
the organization. Thus, if such an approach applied to exempt use property, additional
deductions generally would not be available for contributions of such property with the
untenable result that property used for exempt purposes would be disfavored as compared to
property not so used. A separate proposal therefore would be required to address overvaluations
of exempt use property (perhaps similar to that discussed in Option 2).
The donor also would receive the detriment of any post-contribution decrease in
value.
The donee would use the donor's basis in the property as reported by the donor on the
Form 8283. Such an approach might prohibit a donee from claiming any loss with respect to the
property.
Although the tax could apply only to post-contribution appreciation and not the entire
appreciation in the property, imposing tax only on post-contribution appreciation would still
require a determination of fair market value at the time of contribution and thus would not
eliminate the need for appraisals.
Taxing donee organizations on the gain realized from the disposition of nonexempt
use property could have the salutary effect of encouraging donees that regularly accept
nonexempt use property for disposition to better negotiate fundraising contracts with third
parties, and discouraging donee organizations from engaging in fundraising practices that
provide substantial benefits to non-exempt third parties because such practices, considering the
tax effects to the donee, might not be worth it.
Sec. 6104(d).
Sec. 6685.
Treas. Reg. sec. 301.6104(d)-1(b)(4)(ii).
A similar proposal was recommended by the Joint Committee staff in its earlier study
of disclosure relating to tax-exempt organizations. See Study of Present-Law Taxpayer
Confidentiality and Disclosure Provisions as Required by Section 3802 of the Internal Revenue
Service Restructuring and Reform Act of 1998, Volume II: Study of Disclosure Provisions
Relating to Tax-Exempt Organizations, Prepared by the Staff of the Joint Committee on
Taxation, 93 (JCS-1-00), January 28, 2000.
If the certifying party has provided or reviewed such an opinion, it also must include
a description of the material facts regarding the income or activity that was the subject of such
opinion.
Under present law, for example, an organization might conduct an activity that
generates a loss or a small amount of income, and avoid public disclosure regarding such activity
by choosing to treat it as an unrelated business activity (with little or no tax cost) rather than as
an exempt activity.
IRS Publication 1136, Statistics of Income Bulletin, Fall 2003, Volume 23, Number 2,
at 123.
The 13,967 public charities with total assets of at least ten million dollars had 88
percent of the total assets and total fund balances of all such charities, and 80 percent of the total
revenues of all such organizations. The 10,296 public charities with revenues of at least ten
million dollars had 79 percent of total assets, 78 percent of total fund balances, and 81 percent of
total revenues, of all such organizations. The proposal also would apply to approximately nine
thousand private foundations with total assets of at least $10 million. IRS Publication 1136,
Statistics of Income Bulletin, Fall 2003, Volume 23, Number 2, at 140.
See sec. 4947(a)(1).
Sec. 4940(e).
H. Rep. No. 413 (Part 1) at 19 (1969).
S. Rep. No. 552 at 27 (1969).
H.R. Conf. Rep. No. 782 at 278 (1969).
S. Rep. No. 1263, 95th Cong., 2d Sess. 218 (1978).
Sec. 4940(c)(1). Net investment income also is determined by applying section 103
(generally providing an exclusion for interest on certain State and local bonds) and section 265
(generally disallowing the deduction for interest and certain other expenses with respect to tax-
exempt income). Sec. 4940(c)(5).
Sec. 4940(c)(2).
Sec. 4940(c)(4).
Treas. Reg. sec. 53.4940-1(d)(1).
Id.
Treas. Reg. sec. 1.512-1(a)(1).
Treas. Reg. sec. 53.4940-1(f)(1).
Id.
Zemurray Foundation v. United States, 687 F.2d 97, 100 (5th Cir. 1982).
Zemurray Foundation v. United States, 53 A.F.T.R. 2d (RIA) 842 (E. D. La. 1983).
Zemurray Foundation v. United States, 755 F.2d 404 (5th Cir. 1985), 413 (citing Code
sec. 4940(c)(4)(A).
General Counsel Memorandum 39538 (July 23, 1986).
Treas. Reg. sec. 53.4940-1(f)(3).
See also the example in Treas. Reg. sec. 53.4940-1(f)(1).
The staff of the Joint Committee on Taxation recommended elimination of the tax in
2001 on the ground that elimination would simplify the tax law and could be justified because
the original reason for the tax no longer existed. 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
459.
According to trade association literature, ''most fraternal benefit societies were
founded more than a century ago to provide a sense of community to new Americans. These
societies supported religious, educational and patriotic activities, with fraternal life insurance
often providing the only means of support for a family following the death of the primary wage
earner.'' National Fraternal Congress of America, 1998 Activity Report of the Fraternal Benefit
System.
Treas. Reg. sec. 1.501(c)(8)-1.
Rev. Rul. 73-192, 1973-1 C.B. 224.
IRS Data Book, FY 2003, Publication 55b. Fraternal societies operating under the
lodge system but that do not, in addition to their fraternal activities, provide for the payment of
life, sick, accident and other benefits, may be entitled to exemption under section 501(c)(10).
The IRS reported 22,576 such organizations in its master file for fiscal year 2003. Id.
Section 38 of the Tariff Act of August 5, 1909, 36 Stat. 113 (1909).
Pub. L. No. 63-6, sec. II(G)(a), 38 Stat. 172 (1913).
Priv. Ltr. Rul. 9523027 (citing D. Gregg, Life and Health Insurance Handbook, 276
(3rd ed. 1973)).
General Counsel Memorandum 38312 (March 12, 1980). ''Other benefits'' includes a
legal defense fund for charges of misconduct arising from employment (Rev. Rul. 84-48, 1984-1
C.B. 133), an orphanage for surviving children of deceased members (Rev. Rul. 84-49, 1984-1
C.B. 134), and annuities (General Counsel Memorandum 39575 (November 18, 1986)).
National Union v. Marlow, 74 F. 775, 778-79 (8th Cir. 1896).
Rev. Rul. 73-165, 1973-1 C.B. 224.
General Counsel Memorandum 34607 (September 13, 1971).
Report to the Congress on Fraternal Benefit Societies, Department of the Treasury,
Jan. 1993, 12.
General Counsel Memorandum 38312 (March 20, 1980).
1999 Statistics of Fraternal Benefit Societies: Five-Year Summary, National Fraternal
Congress of America (July 2000), at 3-4.
1999 Statistics of Fraternal Benefit Societies: Five-Year Summary, National Fraternal
Congress of America (July 2000), at 3-4. These same six organizations reported assets totaling
approximately $80 billion in their publicly available annual reports for 2003, an increase of
approximately 38 percent from 1999.
Id. at 6.
2003 Statistics of Fraternal Benefit Societies, National Fraternal Congress of America
(July 2004), at 11-12.
Fraternal Face-Off, Best's Review, April 2004, 85; Investors Put Their Faith In
Funds Tied To Religion, Wall Street Journal (December 19, 2002).
Thrivent Financial for Lutherans, Family Membership Application, available at
www.thrivent.com/joinus/options.html. Membership is open to a current or former member of a
Lutheran congregation who professes to be a Lutheran, an associate member of a Lutheran
congregation listed on the congregation's membership roster, individuals who have varying
family or employment relationships with Thrivent or Lutheran organizations, certain students or
graduates of Lutheran educational organizations, residents of a Lutheran nursing home or care
center, certain co-owners of Lutheran-owned businesses, a beneficiary of a Thrivent annuity or
life insurance contract who uses the proceeds to purchase a Thrivent annuity or insurance
contract or to fund a settlement option, and an individual who gifts a Thrivent annuity or
insurance contract to a Lutheran organization that is the owner or irrevocable beneficiary. Each
person submitting an application for membership with Thrivent is required to certify that he or
she supports the mission of Thrivent, which is as ''a faith-based membership organization called
to improve the quality of life of our members, their families and their communities by providing
unparalleled solutions that focus on financial security, wellness and caring for others.''
Sons of Norway, Membership Application, available at
www.sofn.com/joinus/Signup.html.
E.g., Woodmen of the World/Omaha Woodmen Life Insurance Society, Membership
Opportunities, available at www.woodmen.com/about/fratmem.cfm (''[b]y purchasing a
Woodmen insurance or annuity certificate, you become a Woodmen member and are eligible to
receive Woodmen's many member benefits, and enjoy the social and community activities of
your local lodge'').
Present law also provides tax-exempt status or reduced tax for some types of
insurance business that falls below certain dollar thresholds. The rule of section 501(c)(15)
permits certain small property and casualty insurers to be tax-exempt if their premiums do not
exceed $600,000 and other requirements are satisfied. Other rules generally permit certain
taxable property and casualty insurers to elect to be taxed only on taxable investment income if
their premiums do not exceed $1.2 million (sec. 831(b)).
General Explanation of the Tax Reform Act of 1986, Joint Committee on Taxation,
JCS-10-87 (May 4, 1987), 585, citing Haswell v. U.S., 500 F.2d 1133 (Ct. Cl. 1974), Seasongood
v. Commissioner, 227 F.2d 907 (6th Cir. 1955). The case law provides that under five percent of
time and effort is no substantial part of an organization''s activities, and 16 percent of an
organization's expenditures is beyond the meaning of no substantial part.
Id. at 584.
Pub. L. No. 99-514, sec. 1012(c)(2).
Report to the Congress on Fraternal Benefit Societies, Department of the Treasury,
Jan. 1993, 2.
Id. at 12.
As recently as 1983, commercial insurance companies were not subject to Federal
income tax on a substantial part of their income, but the tax rules were reformed in 1984. As
noted above, Congress eliminated the tax exemption for Blue Cross and Blue Shield
organizations in 1986, on the basis that such organizations were providing commercial-type
insurance in competition with other insurance companies from which they could not be
distinguished.
General Explanation of the Tax Reform Act of 1986, Joint Committee on Taxation,
JCS-10-87 (May 4, 1987), at 586.
The exemption rule of section 501(c)(15) for property and casualty insurers with
gross receipts below $600,000, and the reduced tax base for property and casualty insurers with
net (or direct) written premiums below $1.2 million are described in the present law section,
above.
The section 501(c)(15) rule was modified in 2004 (sec. 206, Pub. L. No. 108-218).
An early version of the section 501(c)(15) exemption provided that exempt organizations
included ''[f]armers'' or other mutual hail, cyclone or fire insurance companies, mutual ditch or
irrigation companies, mutual or cooperative telephone companies, or like organizations of a
purely local character, the income of which consists solely of assessments, dues, and fees
collected from members for the sole purpose of meeting expenses.'' Pub. L. No. 65-254, sec. 231
(10) (1919). Later, dollar limits were imposed on premiums received; section 101(11) of the
1939 Code provided that exempt organizations included ''[m]utual insurance companies or
associations other than life or marine (including interinsurers and reciprocal underwriters) if the
gross amount received during the taxable year from interest, dividends, rents, and premiums
(including deposits and assessments) does not exceed $75,000.''
Rev. Rul. 65-299, 1965-2 C.B. 165.
Rev. Rul. 69-441, 1969-2 C.B. 115.
Debt management plans are debt payment arrangements, including debt consolidation
arrangements, entered into by a debtor and one or more of the debtor's creditors, generally
structured to reduce the amount of a debtor's regular ongoing payment by modifying the interest
rate, minimum payment, maturity or other terms of the debt. Such plans frequently are promoted
as a means for a debtor to restructure debt without filing for bankruptcy.
Consumer Credit Counseling Service of Alabama, Inc. v. U.S., 44 A.F.T.R. 2d (RIA)
5122 (D.D.C. 1978). The case involved 24 agencies throughout the United States.
See also, Credit Counseling Centers of Oklahoma, Inc., v. U.S., 45 A.F.T.R. 2d (RIA)
1401 (D.D.C. 1979) (holding the same on virtually identical facts).
Opening Statement of The Honorable Max Sandlin, Hearing on Non-Profit Credit
Counseling Organizations, House Ways and Means Committee, Subcommittee on Oversight
(November 20, 2003).
United States Senate Permanent Subcommittee on Investigations, Committee on
Governmental Affairs, Profiteering in a Non-Profit Industry: Abusive Practices in Credit
Counseling, Report Prepared by the Majority & Minority Staffs of the Permanent Subcommittee
on Investigations and Released in Conjunction with the Permanent Subcommittee Investigations''
Hearing on March 24, 2004, p. 3 (citing letter dated December 18, 2003, to the Subcommittee
from IRS Commissioner Everson).
Testimony of Commissioner Mark Everson before the House Ways and Means
Committee, Subcommittee on Oversight (November 20, 2003).
Testimony of Commissioner Mark Everson before the House Ways and Means
Committee, Subcommittee on Oversight (November 20, 2003).
United States Senate Permanent Subcommittee on Investigations, Committee on
Governmental Affairs, Profiteering in a Non-Profit Industry: Abusive Practices in Credit
Counseling, Report Prepared by the Majority & Minority Staffs of the Permanent Subcommittee
on Investigations and Released in Conjunction with the Permanent Subcommittee Investigations''
Hearing on March 24, 2004, at 3 (citing letter dated December 18, 2003 to the Subcommittee
from IRS Commissioner Everson).
E.g., The Credit Repair Organizations Act, 15 U.S.C. section 1679 et seq., effective
April 1, 1997 (imposing restrictions on credit repair organizations that are enforced by the
Federal Trade Commission, including forbidding the making of untrue or misleading statements
and forbidding advance payments; section 501(c)(3) organizations are explicitly exempt from
such regulation). Testimony of Commissioner Mark Everson before the House Ways and Means
Committee, Subcommittee on Oversight (November 20, 2003) (California's consumer
protections laws that impose strict standards on credit service organizations and the credit repair
industry do not apply to nonprofit organizations that have received a final determination from the
IRS that they are exempt from tax under section 501(c)(3) and are not private foundations).
Testimony of Commissioner Mark Everson before the House Ways and Means
Committee, Subcommittee on Oversight (November 20, 2003).
United States Senate Permanent Subcommittee on Investigations, Committee on
Governmental Affairs, Profiteering in a Non-Profit Industry: Abusive Practices in Credit
Counseling, Report Prepared by the Majority & Minority Staffs of the Permanent Subcommittee
on Investigations and Released in Conjunction with the Permanent Subcommittee Investigations''
Hearing on March 24, 2004.
15 U.S.C. sec. 45(a) (prohibiting unfair and deceptive acts or practices in or affecting
commerce; although the Federal Trade Commission generally lacks jurisdiction to enforce
consumer protection laws against bona fide nonprofit organizations, it may assert jurisdiction
over a nonprofit, including a credit counseling organization, if it demonstrates the organization is
organized to carry on business for profit, is a mere instrumentality of a for-profit entity, or
operates through a common enterprise with one or more for-profit entities).
United States Senate Permanent Subcommittee on Investigations, Committee on
Governmental Affairs, Profiteering in a Non-Profit Industry: Abusive Practices in Credit
Counseling, Report Prepared by the Majority & Minority Staffs of the Permanent Subcommittee
on Investigations and Released in Conjunction with the Permanent Subcommittee Investigations''
Hearing on March 24, 2004, at 31.
See, e.g., Testimony of Commissioner Mark Everson before the House Ways and
Means Committee, Subcommittee on Oversight (November 20, 2003) (''In recent years, the
Service has seen an increase in applications for tax exempt status from organizations intending to
provide credit counseling services. Among the more recent applicants, we are finding credit
counseling organizations that vary from the model approved in the earlier rulings and court
cases. We are seeing organizations whose principal activity is selling and administering debt
management plans. '' The individual budget assistance and public education programs that
formed the original basis for exemption under section 501(c)(3) have changed'').
The IRS released a legal memorandum (ILM 200431023) (July 13, 2004), in which it
concluded that many credit counseling organizations do not qualify for exemption under section
501(c)(3) because of operation for a substantial nonexempt purpose, substantial private benefit,
and private inurement.
E.g., Testimony of Commissioner Mark Everson before the House Ways and Means
Committee, Subcommittee on Oversight (November 20, 2003) (''Often the board of directors is
not representative of the community and may be related by family or business ties to the for-
profit entities that service and market the debt management plans.'' ' ''The organizations are
supported by fees from customers and from credit card companies, and the fees are much higher
than those in the rulings or court cases.' '' Finally, it does not appear that significant counseling
or education is being provided'').
Credit Counseling Agencies, ILM 200431023 (July 13, 2004).
For all such organizations, the proposal prohibits charging any fee based in whole or
in part on a percentage of the consumer's debt, the consumer's payments to be made pursuant to
a debt management plan, or on projected or actual savings to the consumer resulting from
enrolling in a debt management plan. For an organization described in section 501(c)(3), no
more than nominal fees may be charged for such services if provided to low-income persons. In
all cases, debt management service fees must be waived if they would work a financial hardship.
If it is determined that additional requirements should be put in place for service
arrangements with unrelated providers, perhaps principles similar to those employed in the
management contract rules used to determine private use of tax-exempt bond financed facilities
could be employed. Rev. Proc. 97-13, 1997-1 C.B. 632, as modified by Rev. Proc. 2001-39,
2001-2 C.B. 38 (addressing types of fee arrangements and other contractual terms that may be
used in such management services arrangements without violating the private use requirement).
Sec. 103.
Sec. 141.
Treas. Reg. sec. 1.150-1(b).
Sec. 149(f)(4)(B).
Sec. 149(f)(2)(C).
H.R. Rep. No.100-1104, at 123 (1988).
Secs. 103(a) and 103(b)(2).
The $5 million limit is increased to $15 million if at least $10 million of the bonds are
used to finance public schools.
Sec. 148(f)(4)(D)(ii)(II).
Treas. Reg. sec. 1.148-8(d)(1).
See Susanna Duff Barnett, ''Tax Enforcement: Florida Health Agency Settles Over
Pooled Bond Issues,'' The Bond Buyer, (October 26, 2004), at 5.
Pub. L. No. 100-647 (1988).
H.R. Rep. No. 100-795, at 447 (1988).
H.R. 4333 (1988).
H.R. Rep. No. 100-795, at 446 (1988).
H.R. Rep. No. 100-1104, at 123 (1988).
See State of Florida Auditor General, Local Government Bond Pools, Report No. 03-
187, (May 22, 2003). The report also noted that the participants to these transactions received
significant fees, despite the fact that few of the proceeds were used for public purposes. The
Florida report did not, however, address potential tax issues raised by either the failure to make
loans or the amount of fees received by participants.
See Susanna Duff Barnett, ''Tax Enforcement: Florida Health Agency Settles Over
Pooled Bond Issues,'' The Bond Buyer, (October 26, 2004), at 5.
See State of Florida Auditor General, Local Government Bond Pools, Report No. 03-
187, at 31.
Sec. 103.
Secs. 103(b)(1) and 141.
Sec. 6012(d).
Sec. 57(a)(5). Special rules apply to exclude refundings of bonds issued before
August 8, 1986, and certain bonds issued before September 1, 1986.
Sec. 32(i).
Sec. 86.
See secs. 135, 219, and 221.
The taxpayer's identification number, generally, for individuals is the taxpayer's
Social Security number. Sec. 7701(a)(41).
Sec. 6049.
Secs. 6721 and 6722.
Treas. Reg. sec. 1.6001-1(a).
Sec. 6049.
Sec. 7609(f) (relating to requirements for a ''John Doe'' summons).
Sec. 6721.
Sec. 6722.
See secs. 6041A and 6049.
Sec. 103.
Sec. 141(b)(6); Treas. Reg. sec. 1.141-1(b).
Secs. 103(b)(1) and 141.
Sec. 7871.
Sec. 7871(c).
See Susanna Duff Barnett, ''$145.5M Cabazon Deal Under Scrutiny, IRS Steps Up
Probe of Indian Tribes,'' The Bond Buyer, (August 6, 2004), at 1.
Pub. L. No. 97-473, sec. 202(a) (1983).
Rev. Rul. 68-231, 1968-1 C.B. 48
S. Rep. No. 97-646 (1982).
H.R. Rep. No. 97-984, at 16-17 (1982).
Sec. 7871(e).
H.R. Rep. No. 100-391, at 1139 (1987). OBRA 1987 also amended section 7871 to
permit limited issuance of tribal bonds for manufacturing activities.
Section 7701(f) may also provide the Secretary authority to issue regulations
addressing the substance of these transactions.
Sec. 141.
The 10-percent private business test is reduced to five percent in the case of private
business uses (and payments with respect to such uses) that are unrelated to any governmental
use being financed by the issue.
Treas. Reg. sec. 1.141-3(b)(4).
Treas. Reg. sec. 1.141-4(c)(3).
Pub. L. No. 90-364, sec. 107.
Sec. 141(e).
Transitional rules may be necessary for facilities approved for financing on the date
of enactment but for which bonds had yet to be issued.
S. Rep. No. 99-313, at 826 (1986).
H.R. Rep. No. 99-426, at 514 (1985); S. Rep. 99-313, at 825-26 (1986).
The original House bill that led to the 1986 Act would have repealed the ten percent
security or payment test, leaving only the ten percent use test. H.R. Rep. No. 99-426, at 520
(1985).
Pub. L. No. 99-514 (1986).
This may be accomplished by securing the repayment of the bonds with generally
applicable taxes, which, under Treas. Reg. Sec. 1.141-4(e), are not taken into account for
purposes of the private security or payment test.
There is also no loan to a private person in these transactions that would meet the
private loan financing test.
Secs. 103(b)(1) and 141.
Sec. 143(a).
Sec. 146(f)(5).
Sec. 25(c)(2).
Sec. 25(i).
See Susanna Duff Barnett, ''Carryforward Cap Record: States Keep $18.4B of Private
Activity Authority,'' The Bond Buyer (May 26, 2004), at 1.
H.R. Rep. No. 98-432, at 360 (1983).
California Debt Limit Allocation Committee, Estimated Public Benefits, Single-
Family Housing Program Pool, Summary 2003.
California Debt Limit Allocation Committee, Estimated Public Benefits, Single-
Family Housing Program Pool, Summary 2002.
Rev. Proc. 2004-18, 2004-9 I.R.B. 529.
Sec. 141.
Sec. 149(d)(5).
Sec. 149(d)(3). Bonds issued before 1986 and pursuant to certain transition rules
contained in the Tax Reform Act of 1986 may be advance refunded more than one time in
certain cases.
Sec. 149(d)(2).
Sec. 149(d)(3)(A)(iii) and (B); Treas. Reg. sec. 1.149(d)-1(f)(3). A ''call'' provision
provides the issuer of a bond with the right to redeem the bond prior to the stated maturity.
This is unlike refinancing a home mortgage loan where the original loan is retired at
the time of the refinancing.
Either a current or advance refunding may also be used to remove covenants
associated with a refunded bond.
S. Rep. No. 99-313, at 828 (1986).
See H.R. Rep. No. 99-426, at 518 (''The ability to advance refund certain types of
bonds under present law encourages tax-exempt borrowers to agree to covenants and other terms
that other borrowers would reject'').
H.R. Rep. No. 99-426, at 518 (1985).
''Teletypewriter exchange service'' refers to a data system that provides access from a
teletypewriter or other data station to a teletypewriter exchange system and the privilege of
intercommunication by that station with substantially all persons having teletypewriter or other
data stations in the same exchange system. While it is understood that the system to which the
definition was initially intended to apply is no longer in use, the definition may fit other services
provided now or that may be provided in the future.
In general, the amount of tax is based on the sum of charges for taxable services
included in the bill. If the person who renders the bill groups individual items for purposes of
rendering the bill and computing the tax, then the tax base with respect to each such group is the
sum of all items within that group. The tax on any remaining items not included in any such
group is based on the charge for each item separately.
The access to substantially all persons having telephone stations constituting a part of
the local system is sometimes referred to as access to the public switched telephone network.
If coin-operated toll service is taxable, the tax is computed to the nearest multiple of
five cents.
Private communication service is defined as: (1) service that entitles the customer to
exclusive or priority use of a communication channel or group of channels, or an
intercommunication system for the customer's stations; (2) switching capacity, extension lines
and stations, or other associated services provided in connection with services described in (1);
and (3) channel mileage connecting a telephone outside a local service area with a central office
in the local area.
Unlike the other exemptions, the special treatment for private communication service is
accomplished by means of an exclusion from the definition of local telephone service rather than
as a stated exemption.
Compare Reese Brothers, Inc. v. United States, No. 03-745 (W.D. Pa. Nov. 30, 2004);
National Railroad Passenger Corp. v. United States, 2004 U.S. Dist. LEXIS 18907 (D.D.C.
Sept. 20, 2004); Fortis, Inc. v. United States, 2004 U.S. Dist. LEXIS 18686 (S.D.N.Y. Sept. 16,
2004); and Office Max, Inc. v. United States, 309 F. Supp. 984 (N.D. Ohio 2004), appeal
docketed, No. 04-4009 (6th Cir. Aug. 19, 2004) with American Bankers Insurance Group v.
United States, 308 F. Supp. 1360 (S.D. Fla. 2004) (reading ''and'' disjunctively as ''or'' in the
definition of toll telephone service), appeal docketed, No. 04-10720-EE (11th Cir. February 12,
2004); and Rev. Rul. 79-404, 1979-2 C.B. 382 (finding that a service qualifies as toll telephone
service even though the charge for calls between remote maritime stations and stations in the
United States vary with elapsed transmission time only).
Notice 2004-57, 2004-35 I.R.B. 376. The Notice also stated that persons (taxpayers)
paying for taxable communications services are required to pay the tax to a collecting agent (i.e.,
the service provider). Taxpayers were directed to preserve any claims for overpayment by filing
administrative refund claims with the IRS. In addition, the Treasury Department recently issued
final, temporary, and proposed regulations relating to the obligations of persons that receive
payments for communications services (or air transportation) subject to excise tax when persons
liable for tax refuse to pay. T.D. 9149, 2004-38 I.R.B. 494; REG-163909-02, 2004-38 I.R.B.
499.
At their highest, the tax rates were 15 percent on general local service and 25 percent
on toll service costing more than 24 cents per message. These rates were in effect from 1944
until 1954.
The complications resulting from these developments became evident during the
recent legislative debates relating to the regulation and State and local taxation of Voice Over
Internet Protocol (VOIP) services. See, e.g., VOIP Regulatory Freedom Act of 2004, S. 2281,
108th Cong., 2d Sess. (2004) (introduced April 5, 2004 with restriction on State and local
taxation of VOIP applications; reported out of Committee on Commerce, Science,
Transportation on November 19, 2004 without such restriction); Internet Tax Nondiscrimination
Act, Pub. L. No. 108-435, amending Internet Tax Freedom Act, sec. 1108 (generally permitting
taxation of voice services utilizing Internet protocol), codified as amended at 47 U.S.C. sec. 151
note (2004).
VOIP is the use of software, hardware, or network equipment for real-time two-way or
multidirectional voice communications over the public Internet or a private network utilizing
Internet protocol, or any successor protocol, in whole or in part, to connect users notwithstanding
(i) the underlying transmission technology used to transmit the communications; (ii) whether the
packetizing and depacketizing of the communications occurs at the customer premise or network
level; or (iii) the software, hardware, or network equipment used to connect users. See VOIP
Regulatory Freedom Act of 2004, H.R. 4129, 108th Cong., 2d Sess., sec. 10(a)(6) (2004).
For example, AT&T has claimed that adding an advertisement heard by users when
they dial the main number to make a call using prepaid calling cards transforms the cards from a
communications service subject to certain regulatory fees to an exempt information service. See
Wall Street Journal, January 7, 2005, at A3.
See, e.g., Rev. Rul. 79-405, 1979-2 C.B. 383.
This distinction is generally consistent with 47 U.S.C. 153 (20), which defines an
information service as ''the offering of a capability for generating, acquiring storing,
transforming, processing, retrieving, utilizing, or making information available via
telecommunications.'' However, Options 2 and 3 do not expressly adopt the operative
distinctions between telecommunications services and information services that may currently
exist in the regulatory world. In addition, Options 2 and 3 of this proposal implicitly recognize
that real-time voice communications may be transformed into data form to facilitate some or all
of its physical transmission, and then reconstituted as voice. Such intermediate transformation
should not affect the incidence of excise taxation, which is a tax upon the service received.
This treatment is consistent with present law. See Rev. Rul. 89-84, 1989-1 C.B. 296.
The telephone service that generally enables the caller generally to place the ''1-900'' call (as
well as other calls) is also a taxable communications service.
Voice mail services are generally classified as private communications services under
present law. See Priv. Ltr. Rul. 9006014 (November 7, 1989). Such classification would not
change under the proposal, to the extent such services are provided within the scope of the
private communications services exemption, as modified under the proposal.
White pages directory listings are classified as taxable local telephone services under
present law. Yellow pages listings, however, are classified as nontaxable advertising. See Rev.
Rul. 72-616, 1972-2 C.B. 575.
For example, in the case of a private voice network bundled with a video game, the
Treasury Department might determine that the access to the bundled private voice network is de
minimis because access to a similar, but unbundled, private voice network is available at no
charge.
If Option 2 or 3 is enacted, it may be timely to revisit whether these and other
exemptions are still warranted.
A Core Based Statistical Area is a geographical area containing a recognized
population nucleus and adjacent communities that have a high degree of integration with that
nucleus. See Office of Management and Budget, Standards for Defining Metropolitan and
Micropolitan Statistical Areas, 65 Fed. Reg. 82,228 (2000). Lists of these areas are published
periodically by the Office of Management and Budget, based on information from the Census
Bureau.
Pub. L. No. 106-252 (2000) (codified at 4 U.S.C. secs. 116-126). This legislation
generally relates to the methodology for allocating and apportioning mobile communications
revenue for purposes of State and local taxation.
The communications component of cable and satellite television consists of the
portion of the ''basic'' service provided by the taxpayer attributable to the communications, i.e.,
the capability to access the provider's content. Enhanced features, such as pay-per-view and
''premium'' channels, are not taxable services, but are, instead, incremental information services.
Office of Tax Analysis, U.S. Department of the Treasury, Report to the Congress on
Communication Services Not Subject to Federal Excise Tax (1987). The specific mandate for
the Report in section 8061 of Public Law 99-509, The Omnibus Budget Reconciliation Act of
1986, was to study the various exemptions of the communications excise tax, and to describe a
method under which the tax could be extended to private communications services.
Indeed, some have argued that the costs imposed on society by taxing
telecommunications are quite large in terms of the distortion of choice. See, e.g., Jerry
Hausman, ''Taxation by Telecommunications Regulation,'' National Bureau of Economic
Research, Working Paper No. 6260 (1997).
The Joint Committee staff recommended repealing the tax in its 2001 Simplification
Study. 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), Vol. II at 504-506, April 2001. The primary reason for the
recommendation was the obsolescence of the law due to technological changes. If the tax was
not eliminated, the Study recommended updating the Code to reflect current technology and
granting broad regulatory authority to the Treasury Department to allow it to continually update
the tax base to reflect future technological changes.
This was the total excise tax collected by, or reported to, the IRS in fiscal year 2003.
See IRS, Statistics of Income Bulletin (Fall 2004), Vol. 24, No. 2, Table 21 at 345.
In recognition of the many changes in the communications services industry, on July
19, 2004, IRS and Treasury issued an Advanced Notice of Proposed Rulemaking, in which
comments and suggestions were requested describing the various technologies, services and
methods of transmission currently available for transmitting data and voice communications and
how they should be treated under the communications excise tax rules. See Announcement
2004-61, 2004-29 I.R.B. 67. There is significant doubt, however, whether the IRS and Treasury
have the statutory authority to resolve many of the issues currently arising under those rules.
''Wi-Fi'' is a wireless local area network product through which one may access the
Internet, based on IEEE 802.11 specification.
The terms ''distilled spirits,'' ''alcohol spirits,'' and ''spirits'' mean that substance
known as ethyl alcohol, ethanol, or spirits of wine in any form (including all dilutions and
mixtures thereof from whatever source or by whatever process produced). Sec. 5002(a)(8).
Sec. 5001(a).
Specifically, a United States gallon of proof spirits is a liquid that contains one-half
its volume of ethyl alcohol of a specific gravity of 0.7939 at 60 degrees Fahrenheit (referring to
water at 60 degrees Fahrenheit as unity). For example, 80 proof vodka is 40 percent alcohol by
volume.
Domestic wineries having aggregate annual production not exceeding 250,000
gallons are entitled to a tax credit equal to 90 cents per gallon (the amount of the wine tax
increase enacted in 1990) on the first 100,000 gallons of wine (other than champagne and other
sparkling wines) removed in a calendar year. For hard apple cider production, the amount of the
credit is 5.6 cents per wine gallon. For example, the credit reduces the effective tax rate of $1.07
per wine gallon to $0.17 per wine gallon (the rate that applied before 1990 when the credit was
enacted). The credit is phased out by one percent for each 1,000 gallons produced in excess of
150,000 gallons. The credit has been the subject of a challenge under the General Agreement on
Trade and Tariffs (''GATT''). In addition, Industry Circular No. 2003-7 noted that certain
persons were attempting to use ''alternating proprietorships'' to split the production of one large
proprietor into several smaller businesses in order to take advantage of the credit. An alternating
proprietorship is an arrangement where two or more persons take turns using the physical
premises of a winemaking facility. Alcohol and Tobacco Tax and Trade Bureau, Alternating
Proprietors at Bonded Wine Premises, Industry Circular 2003-7 (December 10, 2003).
Sec. 5041(d).
Sec. 5051. The tax rate is $7 per barrel (approximately 22.6 cents per gallon) on the
first 60,000 barrels of beer removed each year by domestic brewers producing less than two
million barrels of beer during the calendar year. This reduced rate provision was the subject of a
GATT challenge.
The present-law $7-per-barrel tax rate on the first 60,000 barrels of beer removed
each year by domestic brewers producing less than two million barrels of beer during the
calendar year is increased to $12.44 under the proposal. Thus, under the proposal, the rate
applicable to small brewers is $11.00 per barrel lower than the standard rate, as under present
law.
See Congressional Budget Office, Budget Options (March 2003) at 231, noting that a
study reported by the National Institute on Alcohol Abuse and Alcoholism estimated that the
external economic costs of alcohol abuse exceeded $100 billion in 1998.
As noted above, both the small producer credit for wine, and the reduced rate of tax
for small brewers have been the subject of challenges under GATT.
The Alcohol and Tobacco Tax and Trade Bureau (''TTB'') released proposed
regulations that would have taxed flavored malt beverages as spirits. See Alcohol and Tobacco
Tax and Trade Bureau, Notice No. 4, 68 F.R. 14292 (March 24, 2003). To be classified as a
beer, distilled spirit additives would be limited to one-half of one percent or less of the beverage
content and the remaining 99.5 percent of the beverage content must come from the brewing
process for the product to be classified as beer. The TTB proposal attracted significant attention.
Over 15,000 comments were received by the TTB. On January 3, 2005, TTB issued a final rule.
Alcohol and Tobacco Tax and Trade Bureau, TTB T.D.-21, Flavored Malt Beverage and
Related Regulatory Amendments, 70 F.R. 193-237 (January 3, 2005). The final rule adopted a
less stringent standard, allowing up to 49 percent of the alcohol content to come from flavors and
nonbeverage ingredients for beers and malt beverages (''the 51/49 standard''). The final rule is
effective January 3, 2006. TTB noted that it was important for it to act in order to protect both
revenue and the consumer, and to prevent the unlimited use of alcohol derived from distilled
spirits in the production of flavored malt beverages. Although the final TTB rule clarified the
status of flavored malt beverages, by imposing uniform rates for all alcohol, the proposal should
further eliminate a substantial number of disputes over whether or not a beverage falls into a
specific tax category.
General Accounting Office, GAO/GGD-90-123, Alcohol Excise Taxes: Simplifying
Rates Can Enhance Economic and Administrative Efficiency (September 1990). The GAO
report noted that laboratory tests cannot determine the source of the alcohol in a product,
therefore, TTB is required to examine company records to determine exactly what ingredients
were used to make a product. Inspecting records can be complex and time-consuming because
the inspectors must trace the sources of all alcohol used in each beverage. The GAO also noted
that inspectors do not have the authority to inspect distilled spirit plants in other countries, so
TTB is unable to verify that wine or flavors have actually been added to imported products
claiming the credit. Id. at 7-8.
Secs. 4261(a) and 4261(b).
The flight segment component of the tax does not apply to segments to or from
qualified ''rural airports.''
Sec. 4262. Special rules apply for military personnel.
Sec. 4261(c).
For a domestic segment that begins or ends in Alaska or Hawaii, a $7.00 tax applies
only to departures. See Rev. Proc. 2004-71.
The FAA estimated that 63 percent of the agency's budget in FY 2005 will be
required to maintain and improve the agency's safety programs. Federal Aviation
Administration, Budget in Brief - Fiscal Year 2005 at 5. In FY 2004, the agency estimates it
spent slightly more than $6 billion on air traffic services. Federal Aviation Administration,
Administrator's Fact Book (November 2004) at 33.
Sec. 4161(a)(1).
Sec. 4161(a)(2) and (a)(3). Prior to the enactment of section 333 of the American
Jobs Creation Act of 2004 (''AJCA''), Pub. L. No. 108-357, a 10-percent rate applied to fishing
tackle boxes.
Sec. 4162(a).
Sec. 4161(a)(4).
In addition to the excise taxes on sport fishing equipment, certain other amounts are
credited to or deposited in the Account. These amounts are: import duties imposed on fishing
tackle, yachts and pleasure craft under the Harmonized Tariff Schedule of the United States;
excise taxes on gasoline used as a fuel in the nonbusiness use of small-engine outdoor power
equipment, to the extent that such taxes are deposited into the Highway Trust Fund (under
present law, 13.5 cents per gallon of the total 18.3 cents per gallon gasoline excise taxes
collected with respect to such use are deposited into the Highway Trust Fund); excise taxes on
gasoline and special motor fuels used as fuel in motorboats, to the extent that such taxes are
deposited into the Highway Trust Fund (under present law, 13.5 cents per gallon of the total 18.3
cents per gallon gasoline and special motor fuel excise taxes collected with respect to such use
are deposited into the Highway Trust Fund), and are not paid from the Highway Trust Fund into
the Boat Safety Account of the Fund; and interest on investments made with Account funds. See
secs. 9503(c)(4) and (5); 9504(a)(2) and (b); and 9602(b).
AJCA, sec. 333, effective for articles sold by the manufacturer, producer, or importer
after December 31, 2004. See H.R. Rep. No. 108-548, at 171 (2004).
AJCA, sec. 334, effective for articles sold by the manufacturer, producer, or importer
after December 31, 2004. See H.R. Rep. No. 108-548, at 171-172 (2004). Fish finders may also
be used as navigational aids, and some devices used primarily as navigational aids may also be
used to find fish.
The Internal Revenue Service has ruled that aeration systems designed to keep fish
and marine life alive are taxable parts or accessories when sold on or in connection with portable
bait containers. See Tech. Adv. Mem. 200022011 (February 23, 2000). Fish tank aerators,
however, are not taxable. Rev. Rul. 85-150, 1985-2 C.B. 260.
The Joint Committee staff cited the tackle box issue as an example of the complexity
of the sport fishing excise tax, and has previously recommended the elimination of the sport
fishing equipment excise tax. 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), Vol. II, at 499-500, April 2001. This proposal
assumes that Congress wants to maintain the current funding level under a benefit principle.
Every transferor is entitled to a generation skipping tax exemption that may be
allocated to transfers made by the transferor either during the transferor's life or at death. The
amount of the generation skipping transfer tax on a transfer technically is determined by
multiplying the amount transferred by the applicable rate. The applicable rate is the maximum
Federal estate tax rate multiplied by the inclusion ratio. The inclusion ratio is defined in turn as
one minus the applicable fraction. The applicable fraction is a fraction the numerator of which is
the generation skipping transfer exemption allocated to the trust (or the property transferred in a
direct skip) and the denominator of which is the value of the property transferred to the trust (or
involved in the direct skip) reduced by Federal or State estate and death taxes actually recovered
from the trust (or transferred property) and any charitable deduction allowed for Federal estate
and gift tax on the transfer.
Jesse Dukeminier, ''The Uniform Statutory Rule Against Perpetuities and the GST
Tax: New Perils for Practitioners and New Opportunities,'' Real Property Probate & Trust
Journal, 30 (1995) at 185.
Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986
(JCS-10-87), May 4, 1987, at 1263.
Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1976
(JCS-33-76), December 29, 1976, at 565.
Id.
Brian Layman, ''Comment: Perpetual Dynasty Trusts: One of the Most Powerful
Tools in the Estate Planner's Arsenal,'' Akron Law Review, 32 (1999), at 747.
Secs. 2031 (estate tax), 2512 (gift tax), and 2624 (generation-skipping transfer tax).
Fair market value is determined on the date of the gift in the case of the gift tax or on the date of
the decedent's death (or on the alternative valuation date if the executor so elects) in the case of
the estate tax.
Treas. Reg. secs. 20.2031-1(b) and 25.2512-1.
Treas. Reg. secs. 20.2031-2(f)(2) and 25.2512-2(f)(2); Rev. Rul. 59-60, 1959-1 C.B.
237.
Other valuation discounts that courts have recognized include a blockage discount (if
the sale of a block of assets, such as 80 percent of the stock of a public company, would depress
the market for that asset); a key man (thin management) discount (if the value of a business
declines due to the loss of a key manager); and a capital gain (or General Utilities) discount (to
reflect the tax on gain from the eventual sale of assets acquired by gift or held by a corporation).
See Rev. Rul. 93-12, 1993-2 C.B. 202; Propstra v. United States, 680 F.2d 1248 (9th
Cir. 1982); Ward v. Commissioner, 87 T.C. 78 (1986); Estate of Leyman v. Commissioner, 40
T.C. 100 (1963). More recently, a minority discount was allowed even where the total shares
owned by related persons constituted a majority interest. For example, in Estate of Bright v.
United States, 658 F.2d 999 (5th Cir. 1981), the court upheld a minority discount on stock
transferred to a trust even though the other principal shareholder of the corporation was trustee of
the trust and father of its beneficiary.
See David T. Lewis and Andrea Chomakos, The Family Limited Partnership
Deskbook: Forming and Funding FLPs and Other Closely Held Business Entities (ABA
Publishing 2004) at 11.
E.g., Central Trust Co. v. United States, 305 F.2d 393 (Ct. Cl. 1962); Estate of Titus
v. Commissioner, T.C. Memo 1989-466.
Controlling shares in a nonpublic corporation, which do not qualify for a minority
discount, may nonetheless receive a marketability discount because there is no ready private
placement market and because transaction costs would be incurred if the corporation were to
publicly offer its stock.
See, e.g., Estate of Bennett v. Commissioner, T.C. Memo 1993-34, in which the Tax
Court concluded that in determining the discount, the corporate form could not be ignored.
(''Here, we have a real estate management company whose assets are varied and nonliquid. We
think that the corporate form is a quite important consideration here: there is definitely a
difference in owning the assets and liabilities of Fairlawn directly and in owning the stock of
Fairlawn, albeit 100 percent of the stock. We think some discounting is necessary to find a buyer
willing to buy Fairlawn's package of desirable and less desirable properties.'').
There is no established formula to compute the size of a discount. One measure of
the size of a discount, applicable when valuing a controlling interest, is the total cost of
registering securities with the Securities and Exchange Commission, i.e., converting nonliquid
securities into liquid ones. Other factors considered are the size of any costs and the amounts
realizable on a private placement or secondary offering, the opportunity cost of losing access to
the invested funds, and the discounts applied in comparable transactions involving sales of
comparable closely held businesses.
The United States Tax Court has noted that the application of a minority discount and
a marketability discount is multiplicative rather than additive. According to the Court, the
minority discount should be applied first and then the marketability discount should be applied to
that figure. For example, a 20-percent minority discount and a 40-percent marketability discount
should result in a 52-percent discount (20 percent + (40 percent x 80 percent)), not a 60-percent
discount. See Estate of Bailey v. Commissioner, T.C. Memo 2002-152.
Because the holder of a fractional interest in real property has the power to compel
partition (a remedy not available to minority holders of other interests), the discount should
reflect the cost of partition and the value of the interest secured thereby. See Boris I. Bittker &
Lawrence Lokken, Federal Income Taxation of Estates, Gifts, and Trusts, para. 135.3.4 (2d ed.
1993). Courts, however, often apply a minority discount instead. See, e.g., LeFrak v.
Commissioner, T.C. Memo 1993-526.
See, e.g., Estate of Van Loben Sels v. Commissioner, T.C. Memo 1986-501.
For example, the Tax Court in Estate of Folks v. Commissioner, T.C. Memo 1982-43,
granted the taxpayer a 50-percent investment company discount and then applied to the resulting
value a 50-percent marketability discount, resulting in a total discount of 75 percent.
See, e.g., Estate of Anderson v. Commissioner, 8 T.C. 706 (1947), acq. 1947-2 C.B. 1.
For illustrative purposes only, the $80,000 value, and the values described in all
subsequent examples, disregard the possible existence of a control premium. The $80,000 value
also assumes a marketability discount does not apply.
The result is the same even if, just before the gifts, Mother owned only 65 percent of
the LLC and her husband owned 15 percent.
The result for a minority discount is the same as under present law.
For purposes of this proposal, rules similar to those of section 6166(b)(10)(B) apply.
As in all of these examples, the possible existence of a control premium is ignored.
Commentators have referred to this discounting as the ''disappearing wealth''
phenomenon: Wealth disappears from the transfer tax base even though no (or little) economic
actual value is lost. See Mary Louise Fellows & William H. Painter, ''Valuing Close
Corporations for Federal Wealth Transfer Taxes: A Statutory Solution to the Disappearing
Wealth Syndrome,'' 30 Stanford Law Review 895 (1978); James Repetti, ''Minority Discounts:
The Alchemy in Estate and Gift Taxation,'' 50 Tax Law Review (1995); Laura E. Cunningham,
Remember the Alamo: The IRS Needs Ammunition in its Fight Against the FLP, 86 Tax Notes
1461 (2000).
Church v. United States, 85 A.F.T.R. 2d (RIA) 804 (W.D. Tex. 2000), aff'd without
published opinion, 268 F.3d 1063 (5th Cir. 2001), provides a simple example of the creation of
discounts shortly before death. Mrs. Church, who was the mother of the plaintiff and was
suffering from a terminal illness, and her two children together formed a limited partnership. In
exchange for limited partnership interests, Mrs. Church contributed to the partnership her interest
in a Texas ranch (valued at $380,038) together with $1,087,710 in publicly traded securities,
while her two children contributed their undivided interests in the ranch. A corporation owned
equally by the two children was the general partner of the partnership. Two days after the
formation of the partnership, Mrs. Church died. The District Court found that the date-of-death
value of Mrs. Church's limited partnership interest was $617,591, despite the fact that Mrs.
Church transferred assets to the partnership worth $1,467,748 just two days earlier. The court
upheld a 58-percent discount based upon the noncontrolling and illiquid nature of Mrs. Church's
limited partnership interest.
Department of the Treasury, Tax Reform for Fairness, Simplicity, and Economic
Growth, vol. 2, General Explanation of the Treasury Department Proposals (November 1984) at
386-88.
Department of the Treasury, General Explanations of the Administration's Revenue
Proposals (February 1999) at 167. The Fiscal Year 2001 Administration Budget Proposal
included the same proposal. See Department of the Treasury, General Explanations of the
Administration's Fiscal Year 2001 Revenue Proposals (February 2000) at 184-85.
The proposal also bases its application on the existence of marketable assets, not non-
business assets. The definitions of those two terms may differ.
The statute provides an amount of $10,000, adjusted in $1,000 increments for
inflation occurring after 1997. The inflation-adjusted amount for 2005 is $11,000.
See sec. 2513.
See Helvering v. Hutchings, 312 U.S. 393 (1941).
See Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968); Rev. Rul. 73-405, 1973-
2 C.B. 321.
See Estate of Cristofani v. Commissioner, 97 T.C. 74 (1991). Taxpayers still must
exercise some caution in executing this strategy: under section 2514(e), the lapse of a Crummey
power may itself be treated as a taxable gift from the power holder to the beneficiary of such
lapse, but only if the property subject to the lapsed power exceeds the greater of $5,000 or five
percent of the value of trust assets available to satisfy the power. To avoid the application of this
rule, taxpayers either may limit their Crummey powers to $5,000 each, or may fund the
underlying trust with at least $220,000 (such that an $11,000 Crummey power would not exceed
five percent of trust assets).
Treas. Reg. sec. 1.1014-3(a).
Sec. 1015(a).
This preference is especially clear in the case of a spouse of the decedent. That
spouse will not bear the burden of an estate tax on his or her bequest. Other beneficiaries
generally will bear the burden of the estate tax and therefore may have competing preferences.
In Rev. Rul. 54-97, 1954-1 C.B. 113, the IRS concluded, ''Except where the taxpayer
is estopped by his previous actions or statements, such value [the value of the property as
determined for estate tax purposes] is not conclusive but is a presumptive value which may be
rebutted by clear and convincing evidence.''
Tech. Adv. Mem. 199933001 (January 7, 1999).
Compare Ford v. United States, 276 F.2d 17 (Ct. Cl. 1960) (permitting taxpayers for
income tax purposes to use a basis for inherited assets greater than the fair market value reported
for estate tax purposes; two dissenting judges argued that the government was entitled to
recoupment from the taxpayers for previous underpayment of estate taxes based on a lower
property valuation).
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.
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.
For example, a qualified tuition program might provide that contributions to all
accounts established for the benefit of a particular designated beneficiary 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 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.
The principles described in this section are certain of the generally applicable gift,
generation-skipping transfer, and estate tax rules that generally apply to taxpayers to determine
transfer tax consequences. As is described below, the generally applicable transfer tax
provisions are modified by present-law section 529 with respect to qualified tuition accounts.
Treas. Reg. sec. 25.2511-1(a).
Treas. Reg. sec. 25.2511-1(g)(2).
Sec. 2033.
Treas. Reg. sec. 20.2031-1(a).
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).
Sec. 529(c)(3)(A) and (B)(ii).
Sec. 529(c)(6).
Sec. 529(c)(3)(C)(ii). For this purpose, ''member of family'' means, with respect to a
designated beneficiary, the spouse of such beneficiary, or an individual who bears one of the
following relationships to such 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 the first cousin of such beneficiary. Sec. 529(e)(2).
Sec. 529(c)(2) and (5).
Prior to enactment of section 406(a) of the Working Families Tax Relief Act of 2004,
P.L. No. 108-311, a new beneficiary was not explicitly required to be a member of the family of
the former beneficiary in order to avoid imposition of the gift and GST taxes upon a change of
beneficiary. Section 406(a) of the Act amended section 529(c)(5) to provide that gift and GST
taxes are imposed on a change of designated beneficiary unless (1) the new beneficiary is of the
same or a higher generation than the former beneficiary, and (2) the new beneficiary is a member
of the family of the former beneficiary. The amendment made by the Act was effective as if
included in the Taxpayer Relief Act of 1997.
Sec. 529(c)(4).
The proposal contemplates that an account need not provide for irrevocable
designations of distributees at the time the account is established, and may permit changes to the
person designated as entitled to receive a distribution upon termination of the account if the
person is a member of the family (and in the same generation as) the designated beneficiary.
In such a case, no additional gift is treated as made at the time the account is used for
the benefit of the designated beneficiary, whether for educational or other purposes.
In such cases, the special five-year rule is not available to permit the contributor to
treat the gift as made to the account owner ratably over a five-year period, because the benefit of
the five-year rule is limited to those instances where the account is irrevocably dedicated for the
benefit of the designated beneficiary.
At the time of such a distribution, an exclusion from gift tax is available if the
distribution satisfies the requirements of section 2503(e) (i.e., is made as tuition to an educational
organization).
Pub.L. No. 104-188, sec. 1806(a) (effective for tax years ending after August 20,
1996).
Opening Statement of Chairman Michael G. Oxley, House Financial Services
Committee, Subcommittee on Capital Markets, Insurance, and Government Sponsored
Enterprises, Investing for the Future: 529 State Tuition Savings Plans, June 2, 2004.
Statement of Charles Toth on Behalf of The College Savings Foundation and
Securities Industry Association Before the United States Senate Committee on Finance on the
Role of Higher Education Financing in Strengthening U.S. Competitiveness in a Global
Economy, July 22, 2004 (citing Financial Research Corporation, Quarterly Update April 2004,
and reporting that most of the growth in program assets has occurred since 2001, from $8.5
billion at the end of 2001 to over $40 billion in the first quarter of 2004).
Morningstar Investment Research Firm estimates that investors have assets totaling
more than $47 billion in section 529 accounts. Morningstar Testimony to the House Financial
Services Committee, Subcommittee on Capital Markets, Insurance, and Government Sponsored
Enterprises, June 2, 2004.
Opening Statement of Ranking Democratic Member Paul E. Kanjorski, House
Financial Services Committee, Subcommittee on Capital Markets, Insurance, and Government
Sponsored Enterprises, Investing for the Future: 529 State Tuition Savings Plans, June 2, 2004
(citing Financial Research Corporation).
State of Michigan and Michigan Education Trust v. U.S., 40 F.3d 817, 818 (6th Cir.
1994).
Priv. Ltr. Rul. 8825027 (describing the account terms as follows: individual A
contributes amounts to trust to be used to provide educational benefits to B, an irrevocably
designated beneficiary; cash refund of prepaid amount may be made to C, a person irrevocably
designated by A at the time the contract is executed, but only if B dies, is denied admission to a
Michigan public educational institution, or certifies that B has reached the age of 18 and will not
attend a college or university, or if the State program is determined to be actuarially unsound).
A student who is mentally disabled or under 18 years of age must be represented by a
legal guardian.
The refund designee may be the student or another person designated at the time the
account was established. A change of beneficiary of the prepaid tuition account may be
accomplished only through these limited account transfer provisions.
National Association of Student Financial Aid Administrators (NASFAA) State Plan
Summary Chart, available at www.nasfaa.org/PDFs/2002/CSP0202.pdf.
Department of the Treasury, General Explanations of the Administration's Fiscal
Year 2005 Revenue Proposals, February 2005, 136-37.
Id. The Administration's proposal generally would modify certain income tax, gift
tax, generation-skipping transfer tax, and estate tax rules with respect to changes in designated
beneficiaries of qualified tuition accounts, impose new eligibility rules for designated
beneficiaries, require that a qualified tuition account be a custodial arrangement maintained for
the benefit of a designated beneficiary, and impose new excise taxes on amounts that are used
other than for qualified higher education expenses. For a description and analysis of the
Administration's proposal, see Joint Committee on Taxation, Description of Revenue Provisions
Contained in the President's Fiscal Year 2005 Budget Proposal, (JCS-3-04), February 2004,
306-17.
Sec. 529(c)(2).
Absent section 529, such contributions generally would not be treated as completed
gifts to the designated beneficiary under otherwise applicable transfer tax principles. Under
otherwise applicable transfer tax principles, the designated beneficiary's lack of control over the
qualified tuition account generally would 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.
Under otherwise applicable estate tax principles, the account owner generally would
be regarded as possessing rights with respect to the qualified tuition account that cause the
account balance to be includible in the account owner's estate for Federal estate tax purposes.
See, e.g., secs. 2036 and 2038.
Under otherwise applicable principles, such distributions would be a taxable gift by
the account owner unless the account owner has an obligation to provide such benefits (e.g., the
beneficiary is a dependent of the account owner and is obligated to provide education support
under State law) or the distribution is a direct purchase of tuition from the school by the qualified
tuition account (and would be excludable under section 2503(e)). This exclusion for
distributions made to a person who is of a generation of the same generation of the designated
beneficiary seems to apply even if the distribution is used by the designated beneficiary other
than for qualifying educational expenses.
Thus, a contributor may make contributions eligible for multiple $11,000 annual
exclusions by naming multiple beneficiaries of multiple qualified tuition accounts, even if the
contributor has no present intent to allow the named beneficiaries (or any beneficiaries) to
receive any benefits from the accounts.
The taxpayer might deposit $110,000 in each account if he or she is married and
elects with the spouse to gift-split for annual exclusion purposes.
A taxpayer who makes the special five-year ratable allocation annual exclusion
election is required to include a portion of the contribution in his or her estate if he or she dies
within five years of making the contribution.
The distribution of the funds for uses other than qualifying educational expenses will
be subject to income tax, and an additional 10-percent tax, however, on the earnings portion of
the distribution.
Letter from Carlyn S. McCaffrey of the American College of Trust and Estate
Counsel to the Internal Revenue Service, February 25, 2003, Q/A-21 Abusive Situations
(providing a similar example in the employer-employee context, and noting that section 529
might permit a father that owns a business to transfer $1,000,000 gift tax-free to his son through
the use of section 529 accounts initially established for employees, and stating that the College
does not believe that Congress intended to undermine the integrity of the gift tax system by
enacting section 529).