[JPRT 109-3-05]
[From the U.S. Government Publishing Office]
[JOINT COMMITTEE PRINT]
DESCRIPTION OF REVENUE PROVISIONS CONTAINED IN THE PRESIDENT'S
FISCAL YEAR 2006 BUDGET PROPOSAL
Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
March 2005
U.S. Government Printing Office
Washington: 2005
JCS-3-05
[JOINT COMMITTEE PRINT]
DESCRIPTION OF REVENUE PROVISIONS
CONTAINED IN THE PRESIDENT'S
FISCAL YEAR 2006 BUDGET PROPOSAL
Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION
March 2005
U.S. Government Printing Office
Washington: 2005
JCS-3-05
JOINT COMMITTEE ON TAXATION
109TH CONGRESS 1st SESSION
________
HOUSE SENATE
WILLIAM M. THOMAS, California, CHARLES E. GRASSLEY, Iowa,
Chairman Vice Chairman
E. CLAY SHAW, Jr., Florida ORRIN G. HATCH, Utah
NANCY L. JOHNSON, Connecticut TRENT LOTT, Mississippi
CHARLES B. RANGEL, New York MAX BAUCUS, Montana
FORTNEY PETE STARK, California JOHN D. ROCKEFELLER IV,
West Virginia
George K. Yin, Chief of Staff
Bernard A. Schmitt, Deputy Chief of Staff
Thomas A. Barthold, Deputy Chief of Staff
CONTENTS
Page
INTRODUCTION....................................................... 1
I. MAKING PERMANENT TAX CUTS ENACTED IN 2001 AND 2003.............. 2
A.Permanently Extend Certain Provisions Expiring Under EGTRRA
and JGTRRA........................................................ 2
II. TAX INCENTIVES................................................ 6
A. Provisions Related to Savings................................. 6
1. Expansion of tax-free savings opportunities................... 6
2. Consolidation of employer-based savings accounts............. 19
3. Individual development accounts.............................. 31
B. Health Care Provisions ...................................... 35
1. Refundable tax credit for the purchase of health insurance... 35
2. Provide an above-the-line deduction for certain high
deductible insuranc premiums................................. 44
3. Provide a refundable tax credit for contributions of small
employers to employee health savings accounts ("HSAs")....... 51
4. Modify the refundable credit for health insurance costs of
eligible individuals......................................... 57
5. Expand human clinical trial expenses qualifying for the
orphan drug tax credit....................................... 65
C. Provisions Relating to Charitable Giving..................... 67
1. Permit tax-free withdrawals from individual retirement
arrangements for charitable contributions.................... 67
2. Expand and increase the enhanced charitable deduction for
contributions of food inventory.............................. 71
3. Reform excise tax based on investment income of private
foundations.................................................. 76
4. Modify tax on unrelated business taxable income of charitable
remainder trusts............................................. 81
5. Modify the basis adjustment to stock of S corporations
contributing appreciated property............................ 84
6. Repeal the $150 million limit for qualified 501(c)(3)
bonds........................................................ 85
7. Repeal the restrictions on the use of qualified 501(c)(3)
bonds for residential rental property........................ 87
D. Extend, Increase, and Expand the Above-the-Line Deduction
for Qualified Out-of-Pocket Classroom Expenses............... 91
E. Exclude from Income of Individuals the Value of
Employer-Provided Computers, Software, and Peripherals........95
F. Establish Opportunity Zones.................................. 98
G. Provide Tax Relief for Federal Emergency Management
Agency Hazard Mitigation Assistance Programs................ 105
H. Provide a Tax Credit for Developers of Affordable
Single-Family Housing....................................... 108
I. Environment and Conservation Related Provisions............. 114
1. Permanently extend expensing of brownfields remediation
costs....................................................... 114
2. Exclude 50 percent of gains from the sale of property for
conservation purposes...................................... 116
J. Energy Provisions........................................... 123
1. Extend and modify the tax credit for producing electricity
from certain sources........................................ 123
2. Provide a tax credit for residential solar energy systems... 127
3. Modify the tax treatment of nuclear decommissioning
funds....................................................... 129
4. Provide a tax credit for purchase of the certain hybrid
and fuel cell vehicles ..................................... 133
5. Provide a tax credit for combined heat and power property... 137
K. Restructure Assistance to New York.......................... 144
III. SIMPLY THE TAX LAWS FOR FAMILIES............................ 151
A. Repeal Phase-Out for Adoption Provisions.................... 151
B. Clarify Eligibility of Siblings and Other Family Members
for Child-Related Tax Benefits.............................. 153
IV. PROVISIONS RELATED TO THE EMPLOYER-BASED PENSION SYSTEM..... 158
A. Provisions Relating to Cash Balance Plans................... 158
B. Strengthen Funding for Single-Employer Pension Plans........ 176
1. Background and summary...................................... 176
2. Funding and deduction rules................................. 177
3. Form 5500, Schedule B actuarial statement and summary
annual report............................................... 197
4. Treatment of grandfathered floor-offset plans............... 202
5. Limitations on plans funded below target levels............. 203
6 Eliminate shutdown benefits................................. 209
7. Proposals relating to the Pension Benefit Guaranty
Corporation ("PBGC")........................................ 212
C. Reflect Market Interest Rates in Lump-Sum Payments ......... 227
V. TAX SHELTERS, ABUSIVE TRANSACTIONS, AND TAX COMPLIANC.E..... 231
A Combat Abusive Foreign Tax Credit Transactions.............. 231
B. Modify the Active Trade or Business Test for Certain
Corporate Divisions......................................... 233
C. Impose Penalties on Charities that Fail to Enforce
Conservation Easements...................................... 239
D. Eliminate the Special Exclusion from Unrelated Business
Taxable Income ("UBIT") for Gain or Loss on Sale or Exchange
of Certain Brownfield Properties............................ 242
E. Apply an Excise Tax to Amounts Received Under Certain Life
Insurance Contracts......................................... 252
F. Limit Related-Party Interest Deductions..................... 257
G. Modify Certain Tax Rules for Qualified Tuition Program.s.... 260
VI. TAX ADMINISTRATION PROVISIONS AND UNEMPLOYMENT
INSURANCE................................................... 269
A. IRS Restructuring and Reform Act of 1998.................... 269
1. Modify section 1203 of the IRS Restructuring and Reform
Act of 1998................................................. 269
2. Modifications with respect to frivolous returns and
submissions................................................. 273
3. Termination of installment agreements....................... 275
4. Consolidate review of collection due process cases in
the Tax Court............................................... 276
5. Office of Chief Counsel review of offers-in-compromise...... 278
B. Initiate Internal Revenue Service (``IRS'') Cost Saving
Measures.................................................... 280
1. Allow the Financial Management Service to retain transaction
fees from levied amounts ................................... 280
2. Extend the due date for electronically-filed tax returns
and expand the authority to require electronic filing by
large businesses and exempt organizations................... 280
C. Other Provisions............................................ 284
1. Allow Internal Revenue Service ("IRS") to access information
in the National Directory of New Hires ("NDNH")............. 284
2. Extension of authority for undercover operations............ 285
D. Strengthen the Financial Integrity of Unemployment
Insurance................................................... 287
VII. REAUTHORIZE FUNDING FOR THE HIGHWAY TRUST FUND.............. 290
A. Extend Excise Taxes Deposited in the Highway Trust Fund..... 290
B. Allow Tax-Exempt Financing for Private Highway Projects
and Rail-Truck Transfer Facilities.......................... 293
VIII. EXPIRING PROVISIONS....................................... 296
A. Permanently Extend the Research and Experimentation
("R&E") Tax Credit.......................................... 296
B. Permanently Extend and Expand Disclosure of Tax Return
Information for Administration of Student Loans............. 312
C. Extend and Modify the Work Opportunity Tax Credit and
Welfare-to-Work Tax Credit.................................. 317
D. Extend District of Columbia Homebuyer Tax Credit............ 324
E. Extend Authority to Issue Qualified Zone
Academy Bonds............................................... 327
F. Extend Deduction for Corporate Donations of Computer
Technology.................................................. 332
G. Extend Provisions Permitting Disclosure of Tax Return
Information Relating to Terrorist Activity.................. 336
H. Extend Excise Taxes Deposited in the Leaking Underground
Storage Tank ("LUST") Trust Fund............................ 341
I. Extend Excise Tax on Coal at Current Rates.................. 343
IX. OTHER PROVISIONS MODIFYING THE INTERNAL REVENUE CODE........ 345
A. Election to Treat Combat Pay as Earned Income for Purposes
of the Earned Income Credit................................. 345
B. Expand Protection for Members of the Armed Forces........... 347
C. Extension of the Rate of Rum Excise Tax Cover Over
to Puerto Rico and Virgin Islands........................... 350
ESTIMATED BUDGET EFFECTS OF THE REVENUE PROVISIONS CONTAINED
IN THE PRESIDENT'S YEAR 2006 BUDGET PROPOSAL..................... 352
INTRODUCTION
This document, prepared by the staff of the Joint Committee on
Taxation, provides a description and analysis of the revenue
provisions modifying the Internal Revenue Code of 1986 (the "Code")
that are contained in the President's fiscal year 2006 budget
proposal, as submitted to the Congress on February 7, 2005.
The document generally follows the order of the proposals as included
in the Department of the Treasury's explanation of the President's
budget proposal. For each provision, there is a description of
present law and the proposal (including effective date), an analysis
of policy issues related to the proposal, and a reference to
relevant prior budget proposals or recent legislative action.
I. MAKING PERMANENT TAX CUTS ENACTED IN 2001 AND 2003
A. Permanently Extend Certain Provisions Expiring Under EGTRRA
and JGTRRA
Present Law
The Economic Growth and Tax Relief Reconciliation Act of 2001
("EGTRRA")
The Economic Growth and Tax Relief Reconciliation Act of 2001
("EGTRRA") made a number of changes to the Federal tax laws,
including reducing individual tax rates, repealing the estate tax,
increasing and expanding various child-related credits, providing tax
relief to married couples, providing additional education-related
tax incentives, increasing and expanding various pension and
retirement-saving incentives, and providing individuals relief
relating to the alternative minimum tax. However, in order to
comply with reconciliation procedures under the Congressional Budget
Act of 1974, EGTRRA included a "sunset" provision, pursuant to which
the provisions of the Act expire at the end of 2010. Specifically,
EGTRRA's provisions do not apply for taxable, plan, or limitation
years beginning after December 31, 2010, or to estates of decedents
dying after, or gifts or generation-skipping transfers made after,
December 31, 2010.
EGTRRA provides that, as of the effective date of the sunset,
both the Code and the Employee Retirement Income Security Act of
1974 ("ERISA") will be applied as though EGTRRA had never been
enacted. For example, the estate tax, which EGTRRA repeals for
decedents dying in 2010, will return as to decedents dying after
2010, in pre-EGTRRA form, without the various interim changes made
by the Act (e.g., the rate reductions and exemption equivalent
amount increases applicable to decedents dying before 2010).
Similarly, the top individual marginal income tax rate, which EGTRRA
reduced to 35 percent will return to its pre-EGTRRA level of 39.6
percent in 2011 under present law. Likewise beginning in 2011,
all other provisions of the Code and ERISA will be applied as
though the relevant provisions of EGTRRA had never been enacted.
The Jobs and Growth Tax Relief Reconciliation Act of 2003
("JGTRRA")
In general
The Jobs and Growth Tax Relief Reconciliation Act of 2003
("JGTRRA") changed the expensing of certain depreciable business
assets, individual capital gains tax rates and the tax
rates on dividends received by individuals. The expensing
provision sunsets for taxable years beginning after December 31,
2007. The capital gains and dividend provisions sunset for taxable
years beginning after December 31, 2008.
Expensing provisions
JGTRRA provides that the maximum dollar amount that may be deducted
as an expense under section 179 is increased to $100,000 (and
indexed for inflation) for property placed in service in taxable
years beginning before 2008. In addition, for purposes of the
phase-out of the deductible amount, the pre-JGTRRA $200,000 amount
at which the phase-out begins is increased to $400,000 (and indexed
for inflation) for property placed in service in taxable years
beginning before 2008. The provision also includes off-the-shelf
computer software placed in service in a taxable year beginning
before 2008 as qualifying property. With respect to taxable
years beginning before 2008, the provision permits taxpayers to
revoke expensing elections on amended returns without the consent
of the Commissioner.
+Individual capital gains rates
Under JGTRRA, for taxable years beginning before January 1, 2009,
generally the maximum rate of tax on net capital gain of a
non-corporate taxpayer is 15 percent. In addition, any net capital
gain which otherwise would have been taxed at a 10- or 15-percent
rate generally is taxed at a five-percent rate (zero for taxable
years beginning after 2007). For taxable years beginning after
December 31, 2008, generally the rates on net capital gain are 20
percent and 10 percent, respectively. Any gain from the sale or
exchange of property held more than five years that would otherwise
be taxed at the 10 percent rate is taxed at an eight percent rate.
Any gain from the sale or exchange of property held more than five
years and the holding period for which began after December 31,
2000, which would otherwise be taxed at a 20 percent rate is
taxed at an 18-percent rate.
Taxation of dividends received by individuals
Under JGTRRA, dividends received by a non-corporate shareholder from
domestic corporations and qualified foreign corporations generally
are taxed at the same rates that apply to net capital gain.
Thus, dividends received by an individual, estate, or trust are
taxed at rates of five (zero for taxable years beginning after 2007)
and 15 percent. This treatment applies to taxable years beginning
before January 1, 2009. For taxable years beginning after
December 31, 2008, dividends received by a non-corporate shareholder
are taxed at the same rates as ordinary income.
Description of Proposal
The proposal repeals the sunset provisions of EGTRRA and JGTRRA.
Specifically, the proposal permanently extends all provisions of
EGTRRA that expire at the end of 2010. Thus, the estate tax
remains repealed after 2010, and the individual rate reductions and
other provisions of the Act that are in effect in 2010 will remain
in place after 2010.
Also, the proposal permanently extends the provisions of JGTRRA
relating to expensing, capital gains, and dividends.
Effective date. -The proposal is effective on the date of enactment.
Analysis
In general
The policy merits of permanently extending the provisions of
EGTRRA and JGTRRA that sunset depend on considerations specific to
each provision. In general, however, advocates of eliminating the
sunset provisions may argue that it was never anticipated that
the sunset actually would be allowed to take effect, and that
eliminating them promptly would promote stability and rationality
in the tax law. In this view, if the sunsets were eliminated, other
rules of EGTRRA and JGTRRA that phase in or phase out provisions
over the immediately preceding years would be made more rational.
On the other hand, others may argue that certain provisions
of EGTRRA and JGTRRA would not have been enacted at all, or would
not have been phased in or phased out in the same manner, if the
sunset provisions had not been included in EGTRRA and JGTRRA,
respectively.
Complexity issues
The present-law sunset provisions of EGTRRA and JGTRRA arguably
contribute to complexity by requiring taxpayers to contend with
(at least) two different possible states of the law in planning
their affairs. For example, under the sunset provision of EGTRRA,
an individual planning his or her estate will face very different
tax regimes depending on whether the individual dies in 2010 (estate
tax repealed) or 2011 (estate tax not repealed). This
``cliff effect''requires taxpayers to plan an estate in such a way
as to be prepared for both contingencies, thereby creating a great
deal of complexity. On the other hand, some may argue that this kind
of uncertainty is always present to some degree � with or without a
sunset provision, taxpayers always face some risk that the Congress
will change a provision of law relevant to the planning of their
affairs. Others may acknowledge this fact, but nevertheless argue
that the sunset provision creates an unusual degree of uncertainty
and complexity as to the areas covered by the Act, because they
consider it unlikely that the sunset will actually go into effect.
In this view, the sunset provision of EGTRRA leaves taxpayers with
less guidance as to the future state of the law than is usually
available, making it difficult to arrange their affairs. In addition
to the complexity created by the need to plan for the sunset,
uncertainty about the timing and details of how the sunset might be
eliminated arguably creates further complexity.
Even if it is assumed that the sunset provisions will take effect
it is not clear how the sunsets would apply to certain provisions.
It would be relatively simple to apply the EGTRRA sunset to some
provisions, such as the individual rate reductions. With respect to
other provisions, however, further guidance would be needed as to
the effect of the sunset. For example, if the Code will be applied
after 2010 as if the Act had never been enacted, then one
possible interpretation of the pension provisions is that
contributions made while EGTRRA was in effect will no longer be
valid, possibly resulting in the disqualification of plans. While
this result was likely not intended, without further guidance
taxpayers may be unsure as to the effect of the sunset.
More broadly, in weighing the overall complexity effects of the
present-law sunsets and the proposed sunset repeal, some would point
out that the sunset provisions are not the only feature of EGTRRA
and JGTRRA that generates "cliff effects" and similar sources of
uncertainty and complexity for taxpayers. For example, under
EGTRRA's estate tax provisions, a decedent dying in 2008 has an
exemption equivalent amount of $2 million, one dying in 2009
has an exemption equivalent amount of $3.5 million, and one dying
in 2010 effectively has an infinite exemption but not a complete
"step-up" in the basis of assets. Thus, the estates of
individuals at certain wealth levels will incur significant estate
tax if they die in 2008, but none at all if they die in 2009; the
estates of individuals at other wealth levels will incur significant
estate tax if they die in 2009, but none at all if they die in 2020.
These discontinuities are not caused by the sunset provisions, but
they generate a similar sort of uncertainty and complexity for many
taxpayers. Similar phase-ins and phase-outs are found in other
provisions of EGTRRA and generate complexity and uncertainty,
irrespective of whether EGTRRA as a whole sunsets or not. In light
of these issues, some may argue that a more detailed reconsideration
of EGTRRA or certain of its provisions would better serve the goal
of tax simplification.
Beyond phase-ins and phase-outs, some may argue that EGTRRA included
other provisions that increased the complexity of the Code, and that
allowing those provisions to expire at the end of 2020 (or
effectively requiring that they be reconsidered before then) may
reduce complexity, albeit potentially years in the future. Others
would argue that some of EGTRRA's provisions reduced complexity, such
as the repeal of the overall limitation on itemized deductions and
changes relating to the earned income tax credit, and that
permanently extending these provisions would contribute to
simplification of the tax laws.
Prior Action
A similar proposal was included in the President's fiscal year 2003,
2004, and 2005 budget proposals.
II. TAX INCENTIVES
A.Provisions Related to Savings
2. Expansion of tax-free savings opportunities
Present Law
In general
Present law provides for a number of vehicles that permit
individuals to save on a tax-favored basis. These savings vehicles
have a variety of purposes, including encouraging saving
for retirement, encouraging saving for particular purposes such as
education or health care, and encouraging saving generally.
The present-law provisions include individual retirement
arrangements, qualified retirement plans and similar
employer-sponsored arrangements, Coverdell education savings
accounts, qualified tuition programs, health savings accounts,
Archer medical savings accounts, annuity contracts, and life
insurance. Certain of these arrangements are discussed in more
detail below.
Individual retirement arrangements ("IRAs")
In general
There are two general types of individual retirement arrangements
("IRAs") under present law: traditional IRAs, to which both
deductible and nondeductible contributions may be made, and Roth
IRAs. The Federal income tax rules regarding each type of IRA
(and IRA contributions) differ.
The maximum annual deductible and nondeductible contributions that
can be made to a traditional IRA and the maximum contribution that
can be made to a Roth IRA by or on behalf of an individual varies
depending on the particular circumstances, including the
individual's income. However, the contribution limits for IRAs
are coordinated so that the maximum annual contribution that can be
made to all of an individual's IRAs is the lesser of a certain
dollar amount ($4,000 for 2005) or the individual's compensation.
In the case of a married couple, Sec. 408
Sec. 229
See 408A
contributions can be made up to the dollar limit for each spouse
if the combined compensation of the spouses is at least equal to
the contributed amount. An individual who has attained age 50
before the end of the taxable year may also make catch-up
contributions to an IRA. As a result, the maximum deduction for
IRA contributions for an individual who has attained age 50 is
increased by a certain dollar amount ($500 for 2005).
Under present law, IRA contributions generally must be made in cash.
Traditional IRAs
An individual may make deductible contributions to a traditional IRA
up to the IRA contribution limit if neither the individual nor the individual's spouse is an active participant in an
employer-sponsored retirement plan. If an individual (or the
individual's spouse) is an active participant in an
employer-sponsored retirement plan, the deduction is phased out for
taxpayers with adjusted gross income over certain levels for the
taxable year. The adjusted gross income phase-out limits for
taxpayers who are active participants in employer-sponsored plans
are as follows.
Table 2.�AGI Phase-Out Range for Deductible IRA Contributions
Single Taxpayers
Taxable years beginning in: Phase-out range
2005 and thereafter........................ 50,000-60,000
Joint Returns
Taxable years beginning in:
Phase-out range
2005 ..................................... 70,000-80,000
2006 .................................... 75,000-85,000
2007 and thereafter....................... 80,000-100,000
The adjusted gross income phase-out range for married taxpayers
filing a separate return is $0 to $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.
To the extent an individual cannot or does not make deductible
contributions to an IRA or contributions to a Roth IRA, the
individual may make nondeductible contributions to a traditional
IRA, subject to the same limits as deductible contributions.
An individual who has attained age 50 before the end of the
taxable year may also make nondeductible catch-up contributions
to an IRA.
An individual who has attained age 70-1/2 prior to the close of a
year is not permitted to make contributions to a traditional IRA.
Amounts held in a traditional IRA are includible in income when
withdrawn, except to the extent the withdrawal is a return of
nondeductible contributions. Early withdrawals from an IRA
generally are subject to an additional 10-percent tax.
That is, includible amounts withdrawn prior to attainment of
age 59 � are subject to an additional 10-percent tax, unless the
withdrawal is due to death or disability, is made in the form of
certain periodic payments, is used to pay medical expenses in excess
of 7.5 percent of adjusted gross income, is used to purchase health
insurance of certain unemployed individuals, is used for higher
education expenses, or is used for first-time homebuyer expenses of
up to $10,000.
Distributions from traditional IRAs generally are required to begin
by the April 1 of the year following the year in which the IRA owner
attains age 70-�. If an IRA owner dies after minimum required
distributions have begun, the remaining interest must be distributed
at least as rapidly as under the minimum distribution method being
used as of the date of death. If the IRA owner dies before minimum distributions have begun, then the entire remaining interest must
generally be distributed within five years of the IRA owner's death.
The five-year rule does not apply if distributions begin within one
year of the IRA owner's death and are payable over the life or life
expectancy of a designated beneficiary. Special rules apply if the
beneficiary of the IRA is the surviving spouse.
Roth IRAs
Individuals with adjusted gross income below certain levels may make nondeductible contributions to a Roth IRA. The maximum annual
contribution that may be made to a Roth IRA is the lesser of a
certain dollar amount ($4,000 for 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. As under
the rules relating to traditional IRAs, a contribution of up to the
dollar limit for each spouse may be made to a Roth IRA provided the
combined compensation of the spouses is at least equal to the
contributed amount. The maximum annual contribution that can be made
to a Roth IRA is phased out for single individuals with adjusted
gross income between $95,000 and $110,000 and for joint filers with
adjusted gross income between $150,000 and $160,000. The adjusted
gross income phase-out range for married taxpayers filing a separate
return is $0 to $10,000. Contributions to a Roth IRA may be
made even after the account owner has attained age 70-�.
Taxpayers with modified adjusted gross income of $100,000 or less
generally may convert a traditional IRA into a Roth IRA. The amount
converted is includible in income as if a withdrawal had been made,
except that the 10-percent early withdrawal tax does not apply.
Married taxpayers who file separate returns cannot convert a
traditional IRA into a Roth IRA.
Amounts held in a Roth IRA that are withdrawn as a qualified
distribution are not includible in income, or subject to the
additional 10-percent tax on early withdrawals. A qualified
distribution is a distribution that (1) is made after the
five-taxable year period beginning with the first taxable year for
which the individual made a contribution to a Roth IRA, and (2) is
made after attainment of age 59-�, on account of death or
disability, or is made for first-time homebuyer expenses of up
to $10,000.
Distributions from a Roth IRA that are not qualified distributions
are includible in income to the extent attributable to earnings.
To determine the amount includible in income, a distribution that is
not a qualified distribution is treated as made in the following
order:
(1) regular Roth IRA contributions; (2) conversion contributions
(on a first-in, first-out basis); and (3) earnings. To the extent
a distribution is treated as made from a conversion contribution,
it is treated as made first from the portion, if any, of the
conversion contribution that was required to be included in income
as a result of the conversion. The amount includible in income
is also subject to the 10-percent early withdrawal tax unless an
exception applies. The same exceptions to the early withdrawal tax
that apply to traditional IRAs apply to Roth IRAs.
Roth IRAs are not subject to the minimum distribution rules during
the IRA owner's lifetime. Roth IRAs are subject to the post-death
minimum distribution rules that apply to traditional IRAs.
Saver's credit
Present law provides a temporary nonrefundable tax credit for
eligible taxpayers for qualified retirement savings contributions.
The maximum annual contribution eligible for the credit is $2,000.
The credit rate depends on the adjusted gross income ("AGI") of the
taxpayer. Taxpayers filing joint returns with AGI of $50,000 or less,
head of household returns of $37,500 or less, and single returns
of $25,000 or less are eligible for the credit. The AGI limits
applicable to single taxpayers apply to married taxpayers filing
separate returns. The credit is in addition to any deduction or
exclusion that would otherwise apply with respect to the
contribution. The credit offsets minimum tax liability as well as
regular tax liability. The credit is available to individuals who
are 18 or over, other than individuals who are full-time students or
claimed as a dependent on another taxpayer's return. The credit is
available with respect to contributions to various types of
retirement savings arrangements, including contributions to a
traditional or Roth IRA.
Coverdell education savings accounts
Present law provides tax-exempt status to Coverdell education
savings accounts, meaning certain trusts or custodial accounts that
are created or organized in the United States exclusively for the
purpose of paying the qualified higher education expenses of a
designated beneficiary. The aggregate annual contributions that can
be made by all contributors to Coverdell education savings accounts
for the same beneficiary is $2,000 per year. In the case of
contributors who are individuals, the maximum contribution limit is
reduced for individuals with adjusted gross income between $95,000
and $110,000 ($190,000 to $220,000 in the case of married taxpayers
filing a joint return). Contributions to a Coverdell education
savings account are not deductible.
Distributions from a Coverdell education savings account are not
includible in the distributee's income to the extent that the
total distribution does not exceed the qualified education expenses
incurred by the beneficiary during the year the distribution is
made. If a distribution from a Coverdell education savings account
exceeds the qualified education expenses incurred by the beneficiary
during the year of the distribution, the portion of the excess
that is treated as earnings generally is subject to income tax and
an additional 10-percent tax. Amounts in a Coverdell education
savings account may be rolled over on a tax-free basis to another
Coverdell education savings account of the same
beneficiary or of a member of the family of that beneficiary.
Qualified tuition programs
Present law provides tax-exempt status to a qualified tuition
program, defined as a program established and maintained by a State
or agency or instrumentality thereof, or by one or more eligible
educational institutions. Under a qualified tuition program, a
person may purchase tuition credits or certificates on behalf of
a designated beneficiary, or in the case of a State program, may
make contributions to an account that is established for the purpose
of meeting qualified higher education expenses of the designated
beneficiary of the account. Contributions to a qualified tuition
program must be made in cash, and the program must have adequate
safeguards to prevent contributions in excess of amounts necessary
to provide for the beneficiary's qualified higher education
expenses. Contributions to a qualified tuition program are not
deductible.Contributions to a qualified tuition program generally
are treatedas a completed gift eligible for the gift tax annual
exclusion.
Distributions from a qualified tuition program are not includible
in the distributee's gross income to the extent that the total
distribution does not exceed the qualified education expenses
incurred by the beneficiary during the year the distribution
is made. If a distribution from a qualified tuition program
exceeds the qualified education expenses incurred by the
beneficiary during the year of the distribution, the portion of the
excess that is treated as earnings generally is subject to income
tax and an additional 10-percent tax. Amounts in a qualified
tuition program may be rolled over on a tax-free basis to another
qualified tuition program for the same beneficiary or for a member
of the family of that beneficiary.
Health savings accounts
Effective for taxable years beginning after December 31, 2003, a
health savings account ("HSA") is a trust or custodial account used
to accumulate funds on a tax-preferred basis to pay for qualified
medical expenses. Within limits, contributions to an HSA made by
or on behalf of an eligible individual are deductible by the
individual. Contributions to an HSA are excludable from income and
employment taxes if made by the individual's employer. Earnings
on amounts in HSAs are not taxable. Distributions from an HSA for
qualified medical expenses are not includible in gross income.
Distributions from an HSA that are not used for qualified
medical expenses are includible in gross income and are subject to
an additional tax of 10 percent, unless the distribution is made
after death, disability, or the individual attains the age of
Medicare eligibility (i.e., age 65).
Eligible individuals for HSAs are individuals who are covered by a
high deductible health plan and no other health plan that is not a
high deductible health plan. A high deductible health plan is a
health plan that has a deductible that is at least $1,000 for
self-only coverage or $2,000 for family coverage (indexed for
inflation) and that has an out-of-pocket expense limit that is no
more than $5,000 in the case of self-only coverage and $10,000 in the
case of family coverage.
The maximum aggregate annual contribution that can be made to an HSA
is the lesser of (1) 100 percent of the annual deductible under the
high deductible health plan, or (2) the maximum deductible permitted
under an Archer MSA high deductible health plan under present
law, as adjusted for inflation. For 2005, the amount of the maximum deductible under an Archer MSA high deductible health plan is $2,650
in the case of self-only coverage and $5,250 in the case of family
coverage. The annual contribution limits are increased for
individuals who have attained age 55 by the end of the taxable year.
In the case of policyholders and covered spouses who are age 55 or
older, the HSA annual contribution limit is greater than the otherwise
applicable limit by $600 in 2005, $700 in 2006, $800 in 2007, $900
in 2008, and $1,000 in 2009 and thereafter.
Archer medical savings accounts ("MSAs")
Like HSAs, an Archer MSA is a tax-exempt trust or custodial account
to which tax-deductible contributions may be made by individuals with
a high deductible health plan. Archer MSAs provide tax benefits
similar to, but generally not as favorable as, those provided by HSAs
for certain individuals covered by high deductible health plans.
The rules relating to Archer MSAs and HSAs are similar. The main
differences include: (1) only self-employed individuals and employees
of small employers are eligible to have an Archer MSA; (2) for MSA
purposes, a high deductible health plan is a health plan with (a) an
annual deductible of at least $1,750 and no more than $2,650 in the
case of self-only coverage and at least $3,500 and no more than
$5,250 in the case of family coverage and (b) maximum out-of pocket
expenses of no more than $3,500 in the case of self-only coverage
and no more than $6,450 in the case of family coverage; and (3) the
additional tax on distributions not used for medical expenses is 15
percent rather than 10 percent.
After 2005, no new contributions can be made to Archer MSAs except
by or on behalf of individuals who previously had Archer MSA
contributions and employees who are employed by a participating
employer.
Description of Proposal
In general
The proposal consolidates traditional and Roth IRAs into a single
type of account, a Retirement Savings Account ("RSA"). The proposal
also creates a new type of account that can be used to save for any
purpose, a Lifetime Savings Account ("LSA").
The tax treatment of both RSAs and LSAs is generally similar to that
of present-law Roth IRAs; that is, contributions are not deductible
and earnings on contributions generally are not taxable when
distributed. The major difference between the tax treatment of LSAs
and RSAs is that all distributions from LSAs are tax free, whereas
tax-free treatment of earnings on amounts in RSAs applies only to
distributions made after age 58 or in the event of death or
disability.
Retirement Savings Accounts
Under the proposal, an individual may make annual contributions to
an RSA up to the lesser of $5,000 or the individual's compensation
for the year. As under present-law rules for IRAs, in the case of a
married couple, contributions of up to the dollar limit may be made
for each spouse, if the combined compensation of both spouses is at
least equal to the total amount contributed for both spouses.
Contributions to an RSA may be made regardless of the
individual's age or adjusted gross income. Contributions to an RSA
may be made only in cash. Contributions to an RSA are taken into
account for purposes of the Saver's credit. Earnings on
contributions accumulate on a tax-free basis.
Qualified distributions from RSAs are excluded from gross income.
Under the proposal, qualified distributions are distributions made
after age 58 or in the event of death or disability.
Distributions from an RSA that are not qualified distributions
are includible in income (to the extent that the distribution
exceeds basis) and subject to a 10-percent additional tax.
As under the present-law rules for Roth IRAs, distributions are
deemed to come from basis first. As under the present-law rules for
Roth IRAs, no minimum distribution rules apply to an
RSA during the RSA owner's lifetime. In addition, married
individuals may roll amounts over from an RSA to a spouse's RSA.
Under the proposal, existing Roth IRAs are renamed RSAs and are
subject to the rules for RSAs. In addition, existing traditional
IRAs may be converted into RSAs . The amount converted is
includible in income (except to the extent it represents a return of nondeductible contributions). No income limits apply to such
conversions. For conversions of traditional IRAs
made before January 1, 2007, the income inclusion may be spread
ratably over four years. For conversions of traditional IRAs made
on or after January 1, 2007, the income that results from
the conversion is included for the year of the conversion.
Under the proposal, existing traditional IRAs that are not converted
to RSAs may not accept new contributions, other than rollovers from
other traditional IRAs or employer-sponsored retirement plans. New
traditional IRAs may be created to accept rollovers from
employer-sponsored retirement plans or other traditional IRAs,
but they cannot accept any other contributions. An individual
may roll an amount over directly from an employer-sponsored
retirement plan to an RSA by including the rollover amount
(excluding basis) in income, similar to a conversion to a Roth
IRA under present law.
Amounts converted to an RSA from a traditional IRA or an Employer
Retirement Savings Account ("ERSA") are subject to a five-year
holding period. If an amount attributable to such a conversion
(other than amounts attributable to a Roth-type account in an ERSA)
is distributed from the RSA before the end of the five-year period
starting with the year of the conversion or, if earlier, the date on
which the individual attains age 58, becomes disabled, or dies, an
additional 10-percent tax applies to the entire amount.
The five-year period is determined separately for each conversion distribution. To determine the amount attributable to a conversion,
a distribution is treated as made in the following order:
(1) regular RSA contributions; (2) conversion contributions
(on a first-in, first-out basis); and (3) earnings. To the extent a
distribution is treated as made from a conversion contribution, it
is treated as made first from the portion, if any, of the
conversion contribution that was required to be included in income
as a result of the conversion.
Lifetime Savings Accounts
Under the proposal, an individual may make nondeductible
contributions to an LSA of up to $5,000 annually, regardless of the individual's age, compensation, or adjusted gross income.
Additionally, individuals other than the LSA owner may make
contributions to an LSA. The contribution limit applies to all LSAs
in an individual's name, rather than to the individuals making the
contributions. Thus, contributors may make annual contributions of
up to $5,000 each to the LSAs of other individuals but total
contributions to the LSAs of any one individual may not exceed
$5,000 per year. Contributions to LSAs may be made only in cash.
Contributions to an LSA are not taken into account for purposes of
the Saver's credit. Earnings on contributions accumulate on a
tax-free basis.
All distributions from an individual's LSA are excludable from
income, regardless of the individual's age or the use of the
distribution. As under the present-law rules for Roth IRAs, no
minimum distribution rules apply to an LSA during the LSA owner's
lifetime. In addition, married individuals may roll amounts over
from an LSA to a spouse's LSA.
Control over an LSA in a minor's name is to be exercised exclusively
for the benefit of the minor by the minor's parent or legal guardian
acting in that capacity until the minor reaches the age of majority (determined under applicable state law).
Taxpayers may convert balances in Coverdell education savings
accounts and qualified tuition programs to LSA balances on a
tax-free basis before January 1, 2007, subject to certain
limitations. An amount may be rolled over to an individual's LSA
only if the individual was the beneficiary of the Coverdell education
savings account or qualified tuition program as of December 31, 2004.
The amount that can be rolled over to an LSA from a Coverdell
education savings account is limited to the sum of: (1) the amount
in the Coverdell education savings account as of December 31, 2004;
and (2) any contributions to and earnings on the account for 2005.
The amount that can be rolled over to an LSA from a qualified
tuition program is limited to the sum of: (1) the lesser of $50,000
or amount in the qualified tuition program as of December 31, 2004;
and (2) any contributions to and earnings on the qualified tuition
program for 2005. The total amount rolled over to an individual's
LSAs that is attributable to 2005 contributions for the individual
to Coverdell education savings accounts and qualified tuition
programs cannot exceed $5,000 (plus any earnings on such
contributions).
Under the proposal, qualified tuition programs continue to exist as
separate arrangements, but may be offered in the form of an LSA.
For example, State agencies that administer qualified tuition
programs may offer LSAs with the same investment options that are
available under the qualified tuition program. The annual limit on
LSA contributions apply to such an LSA, but the additional reporting
requirements applicable to qualified tuition programs under present
law do not apply and distributions for purposes other than education
are not subject to Federal tax.
Effective date
The proposal is effective on January 1, 2006.
Analysis
In general
The proposal is intended to accommodate taxpayers' changing
circumstances over time by providing a new account that taxpayers
may use for tax-favored saving over their entire lifetimes, with no restrictions on withdrawals. The proposal also provides a new
account for individual retirement savings with fewer restrictions
on eligibility than present-law IRAs. The proposal is intended to
simplify saving by permitting the consolidation of existing savings
accounts into these accounts and allowing individuals to make
contributions to the new accounts with no limitations based on age
or income level.
By providing additional tax incentives for saving, the proposal
intends to encourage additional saving generally. By providing
a tax-favored savings account with no restrictions on withdrawals,
the proposal intends to encourage additional saving in particular by
those who are reluctant to take advantage of existing tax-preferred
savings accounts because of withdrawal restrictions. Some argue that
the national saving rate is too low, and that this is due in part
to the bias of the present-law income tax structure against saving
and in favor of current consumption.
By providing tax incentives for saving - specifically, removing the
tax on the return to saving-the present-law income tax structure can
be modified to function more like a consumption tax. Proponents of
such tax incentives argue that saving will increase if the return to
saving is not reduced by taxes. Others have argued that saving has
not necessarily increased as a result of existing tax incentives for
savings. Some have argued that much existing savings have merely
been shifted into tax-favored accounts, and thus do not represent
new saving. Also, it may be advantageous to borrow in order to
fund tax-favored saving vehicles. To the extent that borrowing
occurs to fund these accounts, no net saving occurs. Ideally, saving
incentives should apply only to net new saving, in order to avoid
windfall gains to existing savings. However, measuring net saving
would be difficult in practice.
Others have argued that increasing the return to savings (by not
taxing earnings) might cause some taxpayers actually to save less,
as a higher return to savings means that less saving is necessary to
achieve a "target" level of savings at some point in the future.
From an economic perspective, both LSAs and RSAs receive tax
treatment generally equivalent to Roth IRAs. While the taxpayer
does not deduct contributions to LSAs, tax is never paid on the income
earned on the investment. The same is generally true for RSAs as long
as amounts are withdrawn in qualified distributions. However, while
LSAs and RSAs receive similar tax treatment to Roth IRAs, the
maximum allowable annual contribution is greater than the amount of contributions currently permitted to Roth IRAs. The increase in the
amounts that may be contributed to tax-preferred savings accounts
provides a tax incentive for further saving for those who have
already contributed the maximum to existing tax-favored savings
accounts. However, for taxpayers not already contributing the
maximum amounts, the new accounts provide no additional economic
inducement to save, except to the extent that the LSAs provide
withdrawal flexibility relative to existing retirement savings
vehicles' age restrictions. Opponents of proposals to increase
tax-favored saving thus argue that the only beneficiaries are
likely to be wealthy taxpayers with existing savings that will
be shifted to the tax-favored accounts, since most taxpayers have
not taken full advantage of existing saving incentives.
RSAs also replace traditional IRAs and thereby eliminate taxpayers'
ability to make deductible contributions. From an economic
perspective, RSAs receive tax treatment generally equivalent to
traditional IRAs to which deductible contributions are made.
However, some would argue that the upfront deduction provides a
greater psychological inducement to save, and that the elimination
of traditional IRAs may reduce saving by those who would have been
able to make deductible contributions.
Taxpayers may convert balances under Coverdell education savings
accounts and qualified tuition programs into LSAs on a tax-free
basis before January 1, 2007. Under the proposal, existing balances
in Coverdell education savings accounts and existing balances in
qualified tuition programs (up to $50,000) may be converted to
LSA balances with no income tax consequences. This means that pretax
earnings accumulated on Coverdell education savings accounts and
qualified tuition program balances that are converted to LSAs may
be withdrawn and spent for purposes other than education without the
income tax consequences applicable to Coverdell education savings
account and qualified tuition program distributions that are used
for nonqualifying expenses. Conversion allows the consolidation of
saving into a single vehicle for simplification purposes. However,
there is some scope for abuse of this conversion option. A taxpayer
with sufficient resources may effect such a conversion simply to
shift more saving into tax-favored accounts. For example, a
taxpayer could transfer $50,000 from an existing qualified tuition
program into an LSA, and then reinvest a different $50,000 into the
qualified tuition program.
The tax treatment of contributions under qualified retirement plans
is essentially the same as that of traditional IRAs to which
deductible contributions are made. However, the limits on
contributions to qualified plans are much higher than the IRA
contribution limits, so that qualified plans provide for a greater
accumulation of funds on a tax-favored basis. A policy rationale for
permitting greater accumulation under qualified plans than IRAs
is that the tax benefits for qualified plans encourage employers to
provide benefits for a broad group of their employees. This
reduces the need for public assistance and reduces pressure on the
social security system.
Some argue that offering LSAs and RSAs will reduce the incentive for
small business owners to maintain qualified retirement plans for
themselves and their employees. A business owner can generally
contribute more to a qualified plan than the contributions that may
be made to LSAs and RSAs, but only if comparable contributions are
made by or on behalf of rank-and-file employees. The business owner
must therefore successfully encourage rank-and-file employees to
contribute to the plan or, in many cases, make matching or
nonelective contributions for rank-and-file employees. The
opportunity to contribute $5,000 annually to both an LSA and an RSA
for both the business owner and his or her spouse, without regard
to adjusted gross income or contributions for rank-and-file
employees, may be a more attractive alternative to maintaining a
qualified retirement plan. Others argue that many employers
(including small employers) offer qualified retirement plans
to attract and retain high-quality employees and will continue to do
so. Some raise concerns that, as a substitute for a qualified
retirement plan, an employer could selectively choose to pay
additional compensation only to highly compensated employees in the
form of contributions to LSAs and RSAs. This may undermine the
principle of promoting savings for rank-and-file employees.
Thus, some argue that the proposal may reduce qualified retirement
plan coverage, particularly in the case of small businesses.
Whether any reduced coverage would result in an overall reduction
of retirement security would depend, in part, on the extent to which
individuals who are not covered by a qualified retirement plan
instead contribute to the new savings vehicles.
Complexity
The proposal has elements that may both increase and decrease tax
law complexity. On one hand, the proposal provides new savings
options to individuals, which may increase complexity to the extent
that taxpayers open new LSAs and RSAs without consolidating existing
tax-preferred savings into such accounts. In addition, although the
proposal relating to RSAs generally precludes future contributions
to traditional IRAs, the proposal relating to LSAs does not preclude
future contributions to present-law tax-favored arrangements for
certain purposes, such as Coverdell education savings accounts,
qualified tuition programs, and health savings accounts. On the
other hand, the proposal may decrease complexity by permitting
consolidation of tax-favored savings accounts.
Additionally, with respect to future saving, in one respect choices
are made easier by the elimination of the need to decide whether to
make deductible or nondeductible IRA contributions for those
taxpayers eligible to contribute to both. However,
employer-sponsored qualified retirement plans generally receive the
same tax treatment as traditional IRAs to which deductible
contributions are made (i.e., contributions are not taxable, but
distributions are). Therefore, the increased availability of
Roth-type savings vehicles, in terms of eligibility to make
contributions and higher contribution limits, is likely to mean that
many more taxpayers will face a choice of how to balance their
savings between deductible and nondeductible savings vehicles.
Nonetheless, the ability to make contributions to LSAs and RSAs
without limitations based on age or income level, the uniform tax
treatment of all contributions to LSAs and RSAs, and the lack of
restrictions on LSA withdrawals, are likely to decrease complexity.
Prior Action
The President's fiscal year 2005 budget proposals included a similar
proposal. The President's fiscal year 2004 budget proposals
included a similar proposal; among the differences are that in the
fiscal year 2004 proposal, the annual dollar limit on contributions
to RSAs or to LSAs was $7,500.
2. Consolidation of employer-based savings accounts
Present Law
In general
A plan of deferred compensation that meets the qualification
standards of the Code (a qualified retirement plan) is accorded
special tax treatment under present law. Employees do not include
contributions in gross income until amounts are distributed, even
though the arrangement is funded and benefits are nonforfeitable.
In the case of a taxable employer, the employer is entitled to a
current deduction (within limits) for contributions even though the
contributions are not currently included in an employee's income. Contributions to a qualified plan (and earnings thereon) are held
in a tax-exempt trust.
Qualified retirement plans may permit both employees and employers
to make contributions to the plan. Under a qualified cash or
deferred arrangement (i.e., a section 401(k) plan), employees may
elect to make pretax contributions to a plan. Such contributions
are referred to as elective deferrals. Employees may also make
after-tax contributions to a qualified retirement plan. Employer
contributions consist of two types: nonelective contributions and
matching contributions. Nonelective contributions are employer
contributions that are made without regard to whether the employee
makes pretax or after-tax contributions. Matching contributions are
employer contributions that are made only if the employee makes
contributions.
Present law imposes a number of requirements on qualified retirement
plans that must be satisfied in order for the plan to be qualified
and for the favorable tax treatment to apply. These requirements
include nondiscrimination rules that are intended to ensure that a
qualified retirement plan covers a broad group of employees.
Certain of these rules are discussed in more detail, below.
Qualified retirement plans are broadly classified into two
categories, defined benefit pension plans and defined contribution
plans, based on the nature of the benefits provided. Under a defined
benefit plan, benefits are determined under a plan formula,
generally based on compensation and years of service. Benefits under
defined contribution plans are based solely on the contributions (and
earnings thereon) allocated to separate accounts maintained for each
plan participant.
In addition to qualified section 401(k) plans, present law provides
for other types of employer-sponsored plans to which pretax employee
elective contributions can be made. Many of these arrangements are
not qualified retirement plans, but receive the same tax-favored
treatment as qualified retirement plans. The rules applicable to
each type of arrangement vary.
These arrangements include SIMPLE section 401(k) plans,
tax-sheltered annuity plans ("section 403(b) plans"), governmental
eligible deferred compensation plans ("section 457 plans"),
SIMPLE IRAs, and salary-reduction simplified employee pensions
("SARSEPs").
Limits on contributions to qualified defined contribution plans
The annual additions under a defined contribution plan with respect
to each plan participant cannot exceed the lesser of (1) 100 percent
of the participant's compensation or (2) a dollar amount, indexed
for inflation ($42,000 for 2005). Annual additions are the sum of
employer contributions, employee contributions, and forfeitures with
respect to an individual under all defined contribution plans of the
same employer.
Nondiscrimination requirements applicable to qualified retirement
plans
The nondiscrimination requirements are designed to ensure that
qualified retirement plans benefit an employer's rank-and-file
employees as well as highly compensated employees. Under a general
nondiscrimination requirement, the contributions or benefits
provided under a qualified retirement plan must not discriminate
in favor of highly compensated employees.
Treasury regulations provide detailed and exclusive rules for
determining whether a plan satisfies the general nondiscrimination
rules. Under the regulations, the amount of contributions or
benefits provided under the plan and the benefits, rights and
features offered under the plan must be tested.
Treasury regulations provide three general approaches to testing the
amount of nonelective contributions provided under a defined
contribution plan: (1) design-based safe harbors; (2) a general
test; and (3) cross-testing. Elective deferrals, matching
contributions, and after-tax employee contributions are subject to
separate testing as described below.
Qualified cash or deferred arrangements (section 401(k) plans)
In general
Section 401(k) plans are subject to the rules generally applicable
to qualified defined contribution plans. In addition, special
rules apply.
As described above, an employee may make elective deferrals to a
section 401(k) plan. The maximum annual amount of elective deferrals
that can be made by an individual is $14,000 for 2005. An individual
who has attained age 50 before the end of the taxable year may also
make catch-up contributions to a section 401(k) plan. As a result,
the limit on elective deferrals is increased for an individual who
has attained age 50 by $4,000 for 2005. An employee's elective
deferrals must be fully vested.
Special nondiscrimination tests
A special nondiscrimination test applies to elective deferrals under
a section 401(k) plan, called the actual deferral percentage test or
the "ADP" test. The ADP test compares the actual deferral
percentages ("ADPs") of the highly compensated employee group and
the nonhighly compensated employee group. The ADP for each group
generally is the average of the deferral percentages separately
calculated for the employees in the group who are eligible to make
elective deferrals for all or a portion of the relevant plan year.
Each eligible employee's deferral percentage generally is the
employee's elective deferrals for the year divided by the employee's
compensation for the year.
The plan generally satisfies the ADP test if the ADP of the highly
compensated employee group for the current plan year is either
(1) not more than 125 percent of the ADP of the nonhighly
compensated employee group for the prior plan year, or (2) not more
than 200 percent of the ADP of the nonhighly compensated employee
group for the prior plan year and not more than two percentage
points greater than the ADP of the nonhighly compensated employee
group for the prior plan year.
Under a safe harbor, a section 401(k) plan is deemed to satisfy the
special nondiscrimination test if the plan satisfies one of two
contribution requirements and satisfies a notice requirement
(a "safe harbor section 401(k) plan"). A plan satisfies the
contribution requirement under the safe harbor rule if the employer
either (1) satisfies a matching contribution requirement or
(2) makes a nonelective contribution to a defined contribution plan
of at least three percent of an employee's compensation on behalf of
each nonhighly compensated employee who is eligible to participate
in the arrangement.
A plan satisfies the matching contribution requirement if, under the
arrangement: (1) the employer makes a matching contribution on
behalf of each nonhighly compensated employee that is equal to (a)
100 percent of the employee's elective deferrals up to three percent
of compensation and (b) 50 percent of the employee's elective
deferrals from three to five percent of compensation; and (2) the
rate of match with respect to any elective deferrals for highly
compensated employees is not greater than the rate of match for
nonhighly compensated employees. Alternatively, the matching
contribution requirement is met if (1) the rate of matching
contribution does not increase as the rate of an employee's elective
deferrals increases, and (2) the aggregate amount of matching
contributions at such rate of employee elective deferral is at least
equal to the aggregate amount of matching contributions that would
be made if matching contributions were made on the basis of the
percentages described in the preceding formula. A plan does not
meet the contributions requirement if the rate of matching
contribution with respect to any rate of elective deferral of a
highly compensated employee is greater than the rate of matching
contribution with respect to the same rate of elective deferral of a
nonhighly compensated employee.
Nondiscrimination tests for matching contributions and after-tax
employee contributions
Employer matching contributions and after-tax employee contributions
are also subject to a special annual nondiscrimination test, the
"ACP test". The ACP test compares the actual contribution
percentages ("ACPs") of the highly compensated employee group and
the nonhighly compensated employee group. The ACP for each group
generally is the average of the contribution percentages separately
calculated for the employees in the group who are eligible to make
after-tax employee contributions or who are eligible for an
allocation of matching contributions for all or a portion of the
relevant plan year. Each eligible employee's contribution
percentage generally is the employee's aggregate after-tax employee
contributions and matching contributions for the year divided by the
employee's compensation for the year.
The plan generally satisfies the ACP test if the ACP of the highly
compensated employee group for the current plan year is either (1)
not more than 125 percent of the ACP of the nonhighly compensated
employee group for the prior plan year, or (2) not more than 200
percent of the ACP of the nonhighly compensated employee group for
the prior plan year and not more than two percentage points greater
than the ACP of the nonhighly compensated employee group for the
prior plan year.
A safe harbor section 401(k) plan is deemed to satisfy the ACP test
with respect to matching contributions, provided that (1) matching
contributions are not provided with respect to elective deferrals or
after-tax employee contributions in excess of six percent of
compensation, (2) the rate of matching contribution does not increase
as the rate of an employee's elective deferrals or after-tax
contributions increases, and (3) the rate of matching contribution
with respect to any rate of elective deferral or after-tax employee
contribution of a highly compensated employee is no greater than the
rate of matching contribution with respect to the same rate of
deferral or contribution of a nonhighly compensated employee.
Tax-sheltered annuities (section 403(b) plans)
Section 403(b) plans are another form of employer-based retirement
plan that provide the same tax benefits as qualified retirement
plans. Employers may contribute to such plans on behalf of their
employees, and employees may make elective deferrals.
Section 403(b) plans may be maintained only by (1) tax-exempt
charitable organizations, and (2) educational institutions of State
or local governments (including public schools). Some of the rules
that apply to section 403(b) plans are similar to rules applicable
to qualified retirement plans.
Contributions to a section 403(b) plan are generally subject to the
same contribution limits applicable to qualified defined
contribution plans, including the special limits for elective
deferrals (and catch-up contributions) under a section 401(k) plan.
If contributions are made to both a qualified defined contribution
plan and a section 403(b) plan for the same employee, a single limit
applies to the contributions under both plans. Special contribution
limits apply to certain employees under a section 403(b) plan
maintained by a church. In addition, additional elective deferrals
are permitted under a plan maintained by an educational
organization, hospital, home health service agency, health and
welfare service agency, church or convention of churches in the
case of employees who have completed 15 years of service.
Section 403(b) plans are generally subject to the minimum coverage
and general nondiscrimination rules that apply to qualified defined
contribution plans. In addition, employer matching contributions
and after-tax employee contributions are subject to the ACP test.
However, pretax contributions made by an employee under a salary
reduction agreement (i.e., contributions that are comparable to
elective deferrals under a section 401(k) plan) are not subject to
nondiscrimination rules similar to those applicable to section
401(k) plans. Instead, all employees generally must be eligible to
make salary reduction contributions. Certain employees may be
disregarded for purposes of this rule.
Eligible deferred compensation plans of State and local governments
(section 457 plans)
Compensation deferred under a section 457 plan of a State or local
governmental employer is includible in income when paid. The
maximum annual deferral under such a plan generally is the lesser
of (1) $14,000 for 2005 (increasing to $15,000 for 2006) or (2) 100
percent of compensation. A special, higher limit applies for the
last three years before a participant reaches normal retirement age
(the "section 457 catch-up limit"). In the case of a section 457
plan of a governmental employer, a participant who has attained age
50 before the end of the taxable year may also make catch-up
contributions up to a limit of $4,000 for 2005 (increasing to $5,000
by 2006), unless a higher section 457 catch-up limit applies.
Only contributions to section 457 plans are taken into account in
applying these limits; contributions made to a qualified retirement
plan or section 403(b) plan for an employee do not affect the amount
that may be contributed to a section 457 plan for that employee.
SIMPLE retirement plans
Under present law, a small business that employs fewer than 100
employees can establish a simplified retirement plan called the
savings incentive match plan for employees ("SIMPLE") retirement
plan. A SIMPLE plan can be either an individual retirement
arrangement for each employee (a "SIMPLE IRA") or part of a section
401(k) plan (a "SIMPLE section 401(k) plan").
A SIMPLE retirement plan allows employees to make elective
deferrals, subject to a limit of $10,000 for 2005. An individual
who has attained age 50 before the end of the taxable year may also
make catch-up contributions to a SIMPLE plan up to a limit of $2,000
for 2005 (increasing to $2,500 for 2006).
Employer contributions to a SIMPLE plan must satisfy one of two
contribution formulas. Under the matching contribution formula, the
employer generally is required to match employee elective
contributions on a dollar-for-dollar basis up to three percent
of the employee's compensation. Under a special rule applicable
only to SIMPLE IRAs, the employer can elect a lower percentage
matching contribution for all employees (but not less than one
percent of each employee's compensation). In addition, a lower
percentage cannot be elected for more than two out of any five
years. Alternatively, for any year, an employer is permitted to
elect, in lieu of making matching contributions, to make a two
percent of compensation nonelective contribution on behalf of each
eligible employee with at least $5,000 in compensation for such year,
whether or not the employee makes an elective contribution.
No contributions other than employee elective contributions,
required employer matching contributions or employer nonelective
contributions can be made to a SIMPLE plan and the employer may not
maintain any other plan. All contributions to an employee's SIMPLE
account must be fully vested.
In the case of a SIMPLE IRA, the group of eligible employees
generally must include any employee who has received at least $5,000
in compensation from the employer in any two preceding years and is
reasonably expected to receive $5,000 in the current year. A SIMPLE
IRA is not subject to the nondiscrimination rules generally
applicable to qualified retirement plans. In the case of a SIMPLE
section 401(k) plan, the group of employees eligible to participate
must satisfy the minimum coverage requirements generally applicable
to qualified retirement plans. A SIMPLE section 401(k) plan does
not have to satisfy the ADP or ACP test and is not subject to the
top-heavy rules. The other qualified retirement plan rules generally
apply.
Salary reduction simplified employee pensions ("SARSEPs")
A simplified employee pension ("SEP") is an IRA to which employers
may make contributions up to the limits applicable to defined
contribution plans. All contributions must be fully vested. Any
employee must be eligible to participate in the SEP if the employee
(1) has attained age 21, (2) has performed services for the employer
during at least three of the immediately preceding five years, and
(3) received at least $450 (for 2005) in compensation from the
employer for the year. Contributions to a SEP generally must bear a
uniform relationship to compensation. For this purpose permitted
disparity may be taken into account.
Effective for taxable years beginning before January 1, 1997,
certain employers with no more than 25 employees could maintain a
salary reduction SEP (a "SARSEP") under which employees could make
elective deferrals. The SARSEP rules were generally repealed with
the adoption of SIMPLE plans. However, contributions may continue
to be made to SARSEPs that were established before 1997. Salary
reduction contributions to a SARSEP are subject to the same limit
that applies to elective deferrals under a section 401(k) plan
($14,000 for 2005, increasing to $15,000 for 2006). An individual
who has attained age 50 before the end of the taxable year may also
make catch-up contributions to a SARSEP up to a limit of $2,000
for 2005 (increasing to $2,500 for 2006).
Designated Roth contributions
There are two general types of individual retirement arrangements
("IRAs") under present and prior law: traditional IRAs, to which
both deductible and nondeductible contributions may be made, and
Roth IRAs. Individuals with adjusted gross income below certain
levels generally may make nondeductible contributions to a Roth
IRA. Amounts held in a Roth IRA that are withdrawn as a qualified
distribution are not includible in income, nor subject to the
additional 10-percent tax on early withdrawals. A qualified
distribution is a distribution that (1) is made after the
five-taxable year period beginning with the first taxable
year for which the individual made a contribution to a Roth IRA,
and (2) is made after attainment of age 59-�, is made on account of
death or disability, or is a qualified special purpose distribution
(i.e., for first-time homebuyer expenses of up to $10,000). A
distribution from a Roth IRA that is not a qualified distribution is includible in income to the extent attributable to earnings, and is
subject to the 10-percent tax on early withdrawals (unless an
exception applies).
Beginning in 2006, a section 401(k) plan or a section 403(b) plan is
permitted to include a "qualified Roth contribution program" that
permits a participant to elect to have all or a portion of the
participant's elective deferrals under the plan treated as
designated Roth contributions. Designated Roth contributions are
elective deferrals that the participant designates (at such time
and in such manner as the Secretary may prescribe) as not excludable
from the participant's gross income. The annual dollar limit on a
participant's designated Roth contributions is the same as the limit
on elective deferrals, reduced by the participant's elective
deferrals that the participant does not designate as designated Roth
contributions. Designated Roth contributions are treated as any
other elective deferral for certain purposes, including the
nondiscrimination requirements applicable to section 401(k) plans.
A qualified distribution from a participant's designated Roth
contributions account is not includible in the participant's gross
income. A qualified distribution is a distribution that is made
after the end of a specified nonexclusion period and that is (1)
made on or after the date on which the participant attains age 59-�,
(2) made to a beneficiary (or to the estate of the participant) on
or after the death of the participant, or (3) attributable to the participant's being disabled.
Description of Proposal
In general
Under the proposal, the various present-law employer-sponsored
retirement arrangements under which individual accounts are
maintained for employees and employees may make contributions are
consolidated into a single type of arrangement called an employer
retirement savings account (an "ERSA"). An ERSA is available to all
employers and is subject to simplified qualification requirements.
Employer Retirement Savings Accounts
In general
The rules applicable to ERSAs generally follow the present-law rules
for section 401(k) plans with certain modifications. Existing
section 401(k) plans and thrift plans are renamed ERSAs and continue
to operate under the new rules. Existing section 403(b) plans,
governmental eligible section 457 plans, SARSEPs, and SIMPLE IRAs
and SIMPLE section 401(k) plans may be renamed ERSAs and operate
under the new rules. Alternatively, such arrangements may continue
to be maintained in their current form, but may not accept any new
employee deferrals or after-tax contributions after December 31,
2006.
Types of contributions and treatment of distributions
An ERSA may provide for an employee to make pretax elective
contributions and catch-up contributions up to the present-law
limits applicable to a section 401(k) plan, that is, a limit of
$14,000 for elective deferrals made in 2005 (increasing to $15,000
for 2006) and a limit of $4,000 for catch-up contributions in 2005
(increasing to $5,000 for 2006). An ERSA may also allow an employee
to designate his or her elective contributions as Roth contributions
or to make other after-tax employee contributions. An ERSA may also
provide for matching contributions and nonelective contributions.
Total annual contributions to an ERSA for an employee (including
employee and employer contributions) may not exceed the present-law
limit of the lesser of 100 percent of compensation or $42,000 (as
indexed for future years).
Distributions from an ERSA of after-tax employee contributions
(including Roth contributions) and qualified distributions of
earnings on Roth contributions are not includible in income. All
other distributions are includible in income.
Nondiscrimination requirements
The present-law ADP and ACP tests are replaced with a single
nondiscrimination test. If the average contribution percentage for
nonhighly compensated employees is six percent or less, the average
contribution percentage for highly compensated employees cannot
exceed 200 percent of the nonhighly compensated employees' average
contribution percentage. If the average contribution percentage for
nonhighly compensated employees exceeds six percent, the
nondiscrimination test is met. For this purpose, a "contribution
percentage" is calculated for each employee as the sum of employee
pretax and after-tax contributions, employer matching contributions,
and qualified nonelective contributions made for the employee,
divided by the employee's compensation.
A design-based safe harbor is available for an ERSA to satisfy the
nondiscrimination test. Similar to the section 401(k) safe harbor
under present law, under the ERSA safe harbor, the plan must be
designed to provide all eligible nonhighly compensated employees
with either (1) a fully vested nonelective contribution of at least
three percent of compensation, or (2) fully vested matching
contributions of at least three percent of compensation, determined
under one of two formulas. The ERSA safe harbor provides new
formulas for determining required matching contributions. Under the
first formula, matching contributions must be made at a rate of 50
percent of an employee's elective contributions up to six percent
of the employee's compensation. Alternatively, matching
contributions may be made under any other formula under which the
rate of matching contribution does not increase as the rate of an
employee's elective contributions increases, and the aggregate
amount of matching contributions at such rate of elective
contribution is at least equal to the aggregate amount of matching
contributions that would be made if matching contributions were
made on the basis of the percentages described in the first formula.
In addition, the rate of matching contribution with respect to any
rate of elective contribution cannot be higher for a highly
compensated employee than for a nonhighly compensated employee.
A plan sponsored by a State or local government is not subject to the
nondiscrimination requirements. In addition, a plan sponsored by an
organization exempt from tax under section 501(c)(3) is not subject
to the ERSA nondiscrimination tests (unless the plan permits after-tax
or matching contributions), but must permit all employees of the
organization to participate.
Special rule for small employers.
Under the proposal, an employer that employed 10 or fewer employees
with compensation of at least $5,000 in the prior year is able to
offer an ERSA in the form of custodial accounts for employees
(similar to a present-law IRA), provided the employer's
contributions satisfy the ERSA design-based safe harbor described
above. The option of using custodial accounts under the proposal
provides annual reporting relief for small employers as well as
relief from most fiduciary requirements under the Employee
Retirement Income Security Act of 1974 ("ERISA") under
circumstances similar to the relief provided to sponsors of SIMPLE
IRAs under present law.
Effective date
The proposal is effective for years beginning after December 31,
2005.
Analysis
In general
An employer's decision to establish or continue a retirement plan
for employees is voluntary. The Federal tax laws provide favorable
tax treatment for certain employer-sponsored retirement plans in
order to further retirement income policy by encouraging the
establishment and continuance of plans that provide broad coverage,
including rank-and-file employees. On the other hand, tax policy is
concerned also with the level of tax subsidy provided to retirement
plans. Thus, the tax law limits the total amount that may be
provided to any one employee under a tax-favored retirement plan
and includes strict nondiscrimination rules to prevent highly
compensated employees from receiving a disproportionate amount of
the tax subsidy provided with respect to employer-sponsored
retirement plans.
The rules governing employer-sponsored retirement plans,
particularly the nondiscrimination rules, are generally regarded
as complex. Some have argued that this complexity deters employers
from establishing qualified retirement plans or causes employers to
terminate such plans. Others assert that the complexity of the
rules governing employer-sponsored retirement plans is a necessary
byproduct of attempts to ensure that retirement benefits are
delivered to more than just the most highly compensated employees of
an employer and to provide employers, particularly large employers,
with the flexibility needed to recognize differences in the way that
employers do business and differences in workforces.
Analysis of ERSA proposal
General nondiscrimination test
The special nondiscrimination rules for 401(k) plans are designed
to ensure that nonhighly compensated employees, as well as highly
compensated employees, receive benefits under the plan. The
nondiscrimination rules give employers an incentive to make the plan
attractive to lower- and middle-income employees (e.g., by providing
a match or qualified nonelective contributions) and to undertake
efforts to enroll such employees, because the greater the
participation by such employees, the more highly compensated
employees can contribute to the plan.
Some argue that the present-law nondiscrimination rules are
unnecessarily complex and discourage employers from maintaining
retirement plans. By reducing the complexity associated with ADP
and ACP testing and reducing the related compliance costs associated
with a plan, the proposal arguably makes employers more likely to
offer retirement plans, thus increasing coverage and participation.
Others argue that the present-law section 401(k) safe harbor
already provides a simplified method of satisfying the
nondiscrimination requirements without the need to run the ADP and
ACP tests. Some also point out that the proposal allows a greater
differential in the contribution rates for highly and nonhighly
compensated employees under an ERSA than the present-law rules for
section 401(k) plans. They argue that this weakens the
nondiscrimination rules by enabling employers to provide greater
contributions to highly paid employees than under present law
without a corresponding increase in contributions for rank-
and-file employees. They also argue that the proposal reduces the
incentive for employers to encourage nonhighly compensated employees
to participate in the plan, which could result in lower
contributions for rank-and-file employees. On the other hand,
others believe that allowing contributions to favor highly paid
employees more than under present law is appropriate in order
to encourage employers to maintain plans that benefit rank-and-file
employees.
ERSA safe harbor
The present-law safe harbors for elective deferrals and matching
contributions were designed to achieve the same objectives as the
special nondiscrimination tests for these amounts, but in a
simplified manner. The alternative of a nonelective contribution of
three percent ensures a minimum benefit for all employees covered by
the plan, while the alternative of matching contributions at a
higher rate (up to four percent) was believed to be sufficient
incentive to induce participation by nonhighly compensated
employees. It was also hoped that the safe harbors would reduce
the complexities associated with qualified plans, and induce more
employers to adopt retirement plans for their employees.
To the extent that the ERSA safe harbor requires an employee's
elective deferrals to be matched at only a 50 percent rate and
requires a total of only three percent in matching contributions,
some argue that the proposal not only weakens the matching
contribution alternative under the safe harbor, but also makes
that alternative clearly less expensive for the employer than the
nonelective contribution alternative, thereby reducing the incentive
for an employer to provide nonelective contributions. In addition,
because, as under the present-law safe harbor, the matching
contribution alternative is satisfied by offering matching
contributions (without regard to the amount actually provided to
nonhighly compensated employees), some argue that employers may no
longer have a financial incentive to encourage employees to
participate. This may reduce participation by rank-and-file
employees. The argument may also be made that the matching
contribution requirement under the ERSA safe harbor is less
rigorous than the matching contribution requirement that applies to
a SIMPLE plan under present law, even though an ERSA is not subject
to the limitations on SIMPLE arrangements (i.e.,
contributions are subject to lower limits and SIMPLEs are available
only to small employers). On the other hand, some believe that the
present law safe harbor for section 401(k) plans has failed to
provide an adequate incentive for employers to offer retirement
plans to their employees and further incentive is needed. Some
argue that the proposal makes the safe harbor more attractive for
employers, especially small employers, and will thus increase
coverage and participation.
Consolidation of various types of employer-sponsored plans
One of the sources of complexity in the present-law rules relating
to employer-sponsored retirement plans is the existence of numerous
vehicles with similar purposes but different rules.
Thus, employers desiring to adopt a retirement plan must determine
which vehicles are available to that employer and which of the
various vehicles available it wishes to adopt. This determination
may entail a costly and time-consuming analysis and comparison of a
number of different types of plans. By providing only one type of
defined contribution plan to which employee contributions may be
made, i.e., an ERSA, the proposal makes it easier for employers
to determine whether to adopt a plan and what type of plan to
provide. Having a single type of plan may also make it easier for
employees to understand their retirement benefits, particularly
when employees change jobs.
On the other hand, many employers already have plans and are
familiar with the present-law rules applicable to their plans.
Converting a present-law arrangement to an ERSA will involve
administrative costs, which some employers may not view as
commensurate with simplification benefits.
Many view the different rules for different types of plans as
largely historical in nature and as adding complexity without serving
an overriding policy objective. On the other hand, some argue that
the differences in the rules serve different employment objectives
and policies of different types of employers.
Some may be concerned that the proposal, in combination with the
proposals for expanded individual savings opportunities (i.e.,
Lifetime Savings Accounts and Retirement Savings Accounts), will
further reduce the incentive for small employers to offer retirement
plans to their employees. Although higher contributions may be made
to an employer-sponsored retirement plan than to these other
arrangements, comparable contributions must be made by or on behalf
of rank-and-file employees. The opportunity to contribute $5,000 a
year to both a Lifetime Savings Account and a Retirement Savings
Account for both the business owner and his or her spouse, without
regard to adjusted gross income or contributions for rank-and-file
employees, may be a more attractive alternative to maintaining a
qualified retirement plan. On the other hand, the excludability of
ERSA contributions and the availability of the ERSA safe harbor,
coupled with the higher contribution levels permitted under a
qualified plan, may be viewed as providing an adequate incentive for
a small employer to establish an ERSA.
Prior Action
The President's fiscal years 2004 and 2005 budget proposals included
similar proposals. In addition, the President's fiscal year 2004
budget included several proposals to simplify the rules for defined
contribution plans generally.
3. Individual development accounts
Present Law
Individual development accounts were first authorized by the
Personal Work and Responsibility Act of 1996. In 1998, the Assets
for Independence Act established a five-year $125 million
demonstration program to permit certain eligible individuals to open
and make contributions to an individual development account.
Contributions by an individual to an individual development account
do not receive a tax preference but are matched by contributions
from a State program, a participating nonprofit organization, or
other "qualified entity." The IRS has ruled that matching
contributions by a qualified entity are a gift and not taxable to
the account owner. The qualified entity chooses a matching rate,
which must be between 50 and 400 percent. Withdrawals from
individual development account can be made for certain higher
education expenses, a first home purchase, or small business
capitalization expenses. Matching contributions (and earnings
thereon) typically are held separately from the individuals'
contributions (and earnings thereon) and must be paid directly
to a mortgage provider, educational institution, or business
capitalization account at a financial institution. The Department
of Health and Human Services administers the individual development
account program.
Description of Proposal
The proposal provides a nonrefundable tax credit for a qualified
entity (i.e., qualified financial institutions, qualified nonprofit
organizations, and qualified Indian tribes) that has an individual
development account program in a taxable year. The tax credit
equals the amount of matching contributions made by the eligible
entity under the program (up to $500 per account per year) plus $50
for each individual development account maintained during the year
under the program. Except in the first year that each account is
open, the $50 credit is available only for accounts with a balance
of more than $100 at year-end. The amount of the credit is adjusted
for inflation after 2007. The $500 amount is rounded to the nearest
multiple of twenty dollars. The $50 amount is rounded to the
nearest multiple of five dollars. No deduction or other credit is
available with respect to the amount of matching funds taken into
account in determining the credit.
The credit applies with respect to the first 900,000 individual
development accounts opened after December 31, 2006 and before
January 1, 2012, and with respect to matching funds for participant
contributions that are made after December 31, 2006, and before
January 1, 2014.
Nonstudent U.S. citizens or legal residents between
the ages of 18 and 60 (inclusive) who are not dependents of a
taxpayer and who meet certain income requirements are eligible to
open and contribute to an individual development account. The
income limit is modified adjusted gross income of $20,000 for single
filers, $40,000 for joint filers, and $30,000 for head-of-household
filers. Eligibility in a taxable year is based on the previous
year's modified adjusted gross income and circumstances (e.g.,
status as a student). Modified adjusted gross income is adjusted
gross income, plus certain items that are not includible in gross
income. The proposal does not specify which items are to be added.
The income limits are adjusted for inflation after 2007.
This amount is rounded to the nearest multiple of 50 dollars.
Under the proposal, an individual development account must:
(1) be owned by the eligible individual for whom the account was
established; (2) consist only of cash contributions; (3) be held by
a person authorized to be a trustee of any individual retirement
account under section 408(a)(2)); and (4) not commingle account
assets with other property (except in a common trust fund or common
investment fund). These requirements must be reflected in the
written governing instrument creating the account. The entity
establishing the program is required to maintain separate accounts
for the individual's contributions (and earnings therein)
and matching funds and earnings thereon. Contributions to
individual development accounts by individuals are not deductible
and earnings thereon are taxable to the account holder. Matching
contributions and earnings thereon are not taxable to the account
holder.
The proposal permits individuals to withdraw amounts from an
individual development account for qualified expenses of the account
owner, owner's spouse, or dependents. Withdrawals other than for
qualified expenses ("nonqualified" withdrawals) may not be made
from the portion of the accounts attributable to the matching
contributions before the account owner attains age 61. In addition, nonqualified withdrawals from the portion of the account
attributable to the individual contributions may result in
forfeiture of some or all of the amounts attributable to matching
contributions. Qualified expenses include: (1) qualified higher
education expenses (as generally defined in section 529(e)(3);
(2) first-time homebuyer costs (as generally provided in section 72
(t)(8); (3) business capitalization or expansion costs
(expenditures made pursuant to a business plan that has been
approved by the financial institution, nonprofit, or Indian tribe);
(4) rollovers of the balance of the account (including the
parallel account) to another individual development account for the
benefit of the same owner; and (5) final distributions in the case
of a deceased account owner. Withdrawals for qualified home and
business capitalization expenses must be paid directly to another
financial institution. Withdrawals for qualified educational
expenses must be paid directly to the educational institution.
Such withdrawals generally are not permitted until the account owner
completes a financial education course offered by a qualified
financial institution, qualified nonprofit organization, qualified
Indian tribe or governmental entity. The Secretary of the Treasury
(the "Secretary") is required to establish minimum standards for
such courses. Withdrawals for nonqualified expenses may result in
the account owner's forfeiture of some amount of matching
funds.
The qualified entity administering the individual development
account program is generally required to make quarterly payments of
matching funds on a dollar-for-dollar basis for the first $500
contributed by the account owner in a taxable year. This dollar
amount is adjusted for inflation after 2007. Matching funds may be
provided also by State, local, or private sources.
Balances of the individual development account and parallel account
are reported annually to the account owner. If an account owner
ceases to meet eligibility requirements, matching funds generally
are not contributed during the period of ineligibility.
Any amount withdrawn from a parallel account is not includible in
an eligible individual's gross income or the account sponsor's gross
income.
Qualified entities administering a qualified program are required to
report to the Secretary that the program is administered in accordance
with legal requirements. If the Secretary determines that the
program is not so operated, the Secretary has the power to terminate
the program. Qualified entities also are required to report
annually to the Secretary information about: (1) the number of
individuals making contributions to individual development accounts;
(2) the amounts contributed by such individuals; (3) the amount of
matching funds contributed; (4) the amount of funds withdrawn and
for what purpose; (5) balance information; and (6) any other
information that the Secretary deems necessary.
The Secretary is authorized to prescribe necessary regulations,
including rules to permit individual development account program
sponsors to verify eligibility of individuals seeking to open
accounts. The Secretary is also authorized to provide rules to
recapture credits claimed with respect to individuals who forfeit
matching funds.
Effective date.�The proposal is effective for taxable years ending
after December 31, 2006, and beginning before January 1, 2014.
Analysis
Policy issues
The proposal is intended to encourage individuals to save by
providing a subsidy to saving. Proponents argue that many
individuals have sufficiently low income that saving is difficult,
and that the subsidy will help these individuals to accumulate
savings, as well as to become more financially literate through the
programs required to be provided by the eligible entities that may
offer IDAs.
Opponents may argue that the generosity of the subsidy, which
provides an immediate 100 percent return to the individual's
contribution, makes the program more like an income transfer program
and does not provide a realistic picture of the normal returns to
saving. Others note that the cap on the number of accounts to which
the credit applies creates the potential for unequal tax treatment
of similarly situated individuals, and may effectively allow
financial and other eligible institutions to pick and choose among
potential beneficiaries of the individual development account
program. Additionally, individuals without ready access to eligible
institutions are disadvantaged with respect to the ability to
benefit under the proposal.
Complexity issues
In general, adding a new credit to the tax law will tend to increase
the complexity of the tax law and will require additional Treasury
or other Governmental resources to be devoted to administration of
the provisions and to enforcement activities. The individual
development account proposal requires additional record keeping by
financial institutions benefiting from the credit and also by account
holders. The annual reporting requirements of the individual
development account program will increase the paperwork burden on
individuals and financial institutions utilizing the provision.
Arguably, the proposal will also add complexity in that it will
increase the number of savings incentives in the tax law, each with
different requirements. Some might argue that consolidation of these
incentives will serve to simplify tax law and tax administration.
Prior Action
Similar proposals were included in the President's fiscal year
2002, 2003, 2004, and 2005 budget proposals.
H.R. 7, the "Community Solutions Act of 2001," as passed by the
House of Representatives on July 19, 2001, included a similar
proposal.
B. Health Care Provisions
1. Refundable tax credit for the purchase of health insurance
Present Law
In general
Present law contains a number of provisions dealing with the Federal
tax treatment of health expenses and health insurance coverage.
The tax treatment of health insurance expenses depends on whether a
taxpayer is covered under a health plan paid for by an employer,
whether an individual has self-employment income, or whether an
individual itemizes deductions and has medical expenses that exceed
a certain threshold. The tax benefits available with respect to
health care expenses also depends on the type of coverage.
Exclusion for employer-provided coverage
In general, employer contributions to an accident or health plan
are excludable from an employee's gross income (and wages for
employment tax purposes). This exclusion generally applies to
coverage provided to employees (including former employees) and
their spouses, dependents, and survivors. Benefits paid under
employer-provided accident or health plans are also generally
excludable from income to the extent they are reimbursements for
medical care. If certain requirements are satisfied,
employer-provided accident or health coverage offered under a
cafeteria plan is also excludable from an employee's gross income
and wages. A cafeteria plan allows employees to choose between cash
and certain nontaxable benefits, including health coverage. Through
the use of a cafeteria plan, employees can pay for health coverage
on a salary reduction basis.
Present law provides for two general employer-provided arrangements
that can be used to pay for or reimburse medical expenses of
employees on a tax-favored basis: flexible spending arrangements
("FSAs") and health reimbursement arrangements ("HRAs").
While these arrangements provide similar tax benefits (i.e.,
the amounts paid under the arrangements for medical care are
excludable from gross income and wages for employment tax purposes),
they are subject to different rules. A main distinguishing feature
between the two arrangements is that while FSAs are generally
part of a cafeteria plan and contributions to FSAs are made on a
salary reduction basis, HRAs cannot be part of a cafeteria plan
and contributions cannot be made on a salary-reduction basis.
In addition, amounts in an HRA may be used to purchase insurance as
well as to reimburse expenses not covered by insurance, while
amounts in an FSA cannot be used for insurance, but are used to pay
for expenses not coverage by insurance.
Deduction for health insurance expenses of self-employed individuals
The exclusion for employer-provided health coverage does not apply
to self-employed individuals. However, under present law,
self-employed individuals (i.e., sole proprietors or partners in a
partnership) are entitled to deduct 100 percent of the amount paid
for health insurance for themselves and their spouse and dependents
for income tax purposes.
Itemized deduction for medical expenses
Under present law, individuals who itemize deductions may deduct
amounts paid during the taxable year for health insurance (to the
extent not reimbursed by insurance or otherwise) for the taxpayer,
the taxpayer's spouse, and dependents, only to the extent that the
taxpayer's total medical expenses, including health insurance
premiums, exceeds 7.5 percent of the taxpayer's adjusted gross
income.
Health care tax credit
Under the Trade Adjustment Assistance Reform Act of 2002, certain
individuals are eligible for the health coverage tax credit
("HCTC"). The HCTC is a refundable tax credit for 65 percent of the
cost of qualified health coverage paid by an eligible individual.
In general, eligible individuals are individuals receiving a trade
adjustment allowance (and individuals who would be eligible to
receive such an allowance but for the fact that they had not
exhausted their regular unemployment benefits), individuals eligible
for the alternative trade adjustment assistance program, and
individuals over age 55 and receiving pension benefits from the
Pension Benefit Guaranty Corporation. The credit is available for
"qualified health insurance," which includes certain employer-based
insurance, certain State-based insurance, and in some cases,
insurance purchased in the individual market. The credit is
available on an advance basis through a program established by the
Secretary.
Health savings accounts
In general
The Medicare Prescription Drug, Improvement, and Modernization Act
of 2003 allows individuals with a high deductible health plan
(and no other health plan other than a plan that provides certain
permitted coverage) to establish a health savings account ("HSA").
An HSA is a tax-exempt trust or custodial account. In general, HSAs
provide tax-favored treatment for current medical expenses as well
as the ability to save on a tax-favored basis for future medical
expenses.
Eligible individuals
Eligible individuals for HSAs are individuals who are covered by a
high deductible health plan and no other health plan that is not a
high deductible health plan and which provides coverage for any
benefit which is covered under the high deductible health plan.
Individuals entitled to benefits under Medicare are not eligible to
make contributions to an HSA. Eligible individuals do not include
individuals who may be claimed as a dependent on another person's
tax return. An individual with other coverage in addition to a
high deductible health plan is still eligible for an HSA if such
other coverage is certain permitted insurance or permitted coverage.
A high deductible health plan is a health plan that has a deductible
for 2005 that is at least $1,000 for self-only coverage or $2,000 for
family coverage and that has an out-of-pocket expense limit that is
no more than $5,100 in the case of self-only coverage and $12,000 in
the case of family coverage. A plan is not a high deductible
health plan if substantially all of the coverage is for permitted
coverage or coverage that may be provided by permitted insurance, as
described above. A plan does not fail to be a high deductible health
plan by reason of failing to have a deductible for preventive care.
Tax treatment of and limits on contributions
Contributions to an HSA by or on behalf of an eligible individual
are deductible (within limits) in determining adjusted gross income
(i.e., "above-the-line") of the individual. In addition, employer
contributions to HSAs (including salary reduction contributions made
through a cafeteria plan) are excludable from gross income and wages
for employment tax purposes. The maximum aggregate annual
contribution that can be made to an HSA is the lesser of (1) 100
percent of the annual deductible under the high deductible health
plan, or (2) the maximum deductible permitted under an Archer MSA
high deductible health plan under present law, as adjusted for
inflation. For 2005, the amount of the maximum deductible under an
Archer MSA high deductible health plan is $2,650 in the case of
self-only coverage and $5,250 in the case of family coverage.
The annual contribution limits are increased for individuals who
have attained age 55 by the end of the taxable year. In the case
of policyholders and covered spouses who are age 55 or older, the
HSA annual contribution limit is greater than the otherwise
applicable limit by $600 in 2005, $700 in 2006, $800 in 2007, $900
in 2008, and $1,000 in 2009 and thereafter.
An excise tax applies to contributions in excess of the maximum
contribution amount for the HSA. If an employer makes contributions
to employees' HSAs, the employer must make available comparable
contributions on behalf of all employees with comparable coverage
during the same period.
Taxation of distributions
Distributions from an HSA for qualified medical expenses of the
individual and his or her spouse or dependents generally are
excludable from gross income. Qualified medical expenses generally
are defined as under section 213(d). Qualified medical expenses do
not include expenses for insurance other than for (1) long-term care
insurance, (2) premiums for health coverage during any period of
continuation coverage required by Federal law, (3) premiums for
health care coverage while an individual is receiving unemployment
compensation under Federal or State law, or (4) in the case of an
account beneficiary who has attained the age of Medicare
eligibility, health insurance premiums for Medicare, other than
premiums for Medigap policies. Such qualified health insurance
premiums include, for example, Medicare Part A and Part B
premiums, Medicare HMO premiums, and the employee share of premiums
for employer-sponsored health insurance including employer-sponsored
retiree health insurance.
For purposes of determining the itemized deduction for medical
expenses, distributions from an HSA for qualified medical expenses
are not treated as expenses paid for medical care under section
213. Distributions from an HSA that are not for qualified medical
expenses are includible in gross income. Distributions includible
in gross income are also subject to an additional 10-percent tax
unless made after death, disability, or the individual attains the
age of Medicare eligibility (i.e., age 65).
Archer MSAs
Like HSAs, an Archer MSA is a tax-exempt trust or custodial account
to which tax-deductible contributions may be made by individuals
with a high deductible health plan. Archer MSAs provide tax
benefits similar to, but generally not as favorable as, those
provided by HSAs for certain individuals covered by high deductible
health plans.
The rules relating to Archer MSAs and HSAs are similar. The main
differences include: (1) only self-employed individuals and
employees of small employers are eligible to have an Archer MSA;
(2) for MSA purposes, a high deductible health plan is a health plan
with (a) an annual deductible of at least $1,750 and no more than
$2,650 in the case of self-only coverage and at least $3,500 and no
more than $5,250 in the case of family coverage and (b) maximum
out-of pocket expenses of no more than $3,500 in the case of
self-only coverage and no more than $6,450 in the case of family
coverage; (3) higher contributions may be made to HSAs, and (4)
the additional tax on distributions not used for medical expenses
is 15 percent rather than 10 percent.
After 2005, no new contributions can be made to Archer MSAs except
by or on behalf of individuals who previously had Archer MSA
contributions and employees who are employed by a participating
employer.
Description of Proposal
The proposal provides a refundable tax credit for health insurance
("health insurance tax credit" or "HITC") purchased by individuals
who are under age 65 and do not participate in a public or
employer-provided health plan. The maximum annual amount of the
credit is 90 percent of premiums, up to a maximum premium of $1,111
per adult and $556 per child (for up to two children). These dollar
amounts are indexed in accordance with the medical care component
of the Consumer Price Index based on all-urban consumers. Thus, the
maximum annual credit (prior to any indexing of the premium limits)
is $1,000 per adult and $500 per child (up to two children), for a
total possible maximum credit of $3,000 per tax return.
The 90 percent credit rate is phased-down for higher income
taxpayers. Individual taxpayers filing a single return with no
dependents and modified adjusted gross income of $15,000 or less are
eligible for the maximum credit rate of 90 percent. The credit
percentage for individuals filing a single return with no dependents
is phased-down ratably from 90 percent to 50 percent for modified
adjusted gross income between $15,000 and $20,000, and phased-out
completely at modified adjusted gross income of $30,000.
Other taxpayers with modified adjusted gross income up to $25,000
are eligible for the maximum credit rate of 90 percent. The credit
percentage is phased-out ratably for modified adjusted gross income
between $25,000 and $40,000 if the policy covers only one adult,
and for modified adjusted gross income between $25,000 and $60,000
if the policy (or policies) covers more than one adult.
Taxpayers may not claim the present-law HCTC and this credit for
the same coverage period. In addition, taxpayers may not claim
the HITC for the same period as they claim the above-the-line
deduction for high deductible health plan premiums included in the
President's fiscal year 2005 budget proposal.
If the health insurance purchased by an individual qualifies as a
high deductible health plan under the HSA rules, the individual may
elect to have 30 percent of the credit contributed in a special HSA
(or in a special account in the individual's HSA). The rules
applicable to HSAs would apply to the special HSA (or special
account), except that withdrawals that exceed qualified medical
expenses would be subject to a tax equal to 100 percent of the
amount withdrawn. The 30-percent credit would be counted toward
the HSA contribution limit.
The credit can be claimed on the individual's tax return or on an
advanced basis, as part of the premium payment process, by reducing
the premium amount paid to the insurer. After implementation of the
advanced payment option, the benefit of the credit will be available
at the time that the individual purchases health insurance, rather
than later when the individual files his or her tax return the
following year. Health insurers will be reimbursed by the
Department of the Treasury for the amount of the credit.
Eligibility for the advanced credit option is based on the
individual's prior year return and there is no reconciliation on
the current year return.
Policies eligible for the credit have to meet certain requirements,
including coverage for high medical expenses. Qualifying health
insurance can be purchased through the non-group insurance market,
private purchasing groups, State-sponsored insurance purchase
pools, and State high-risk pools.
At the option of States, after December 31, 2006, the credit can be
used by certain individuals not otherwise eligible for public health
insurance programs to buy into privately contracted State-sponsored
purchasing groups (such as Medicaid or SCHIP purchasing pools for
private insurance or State government employee programs for States
in which Medicaid or SCHIP does not contract with private plans).
States can provide additional contributions to individuals who
purchase insurance through such purchasing groups. The maximum
State contribution is $2,000 per adult (for up to two adults) for
individuals with incomes up to 133 percent of the poverty level.
The maximum State contribution is phased-down ratably, reaching
$500 per adult at 200 percent of the poverty level. Individuals with
income above 200 percent of the poverty level are not eligible for
a State contribution. States are not allowed to offer any other
explicit or implicit cross subsidies.
Effective date.--The credit is effective for taxable years beginning
after December 31, 2005. The advanced payment option is to be
available beginning July 1, 2007.
Analysis
Policy issues
In general
The proposal is intended to provide an incentive to uninsured
individuals to purchase health insurance by providing assistance
in paying premiums. Proponents of the proposal argue that the
proposal will enable low-income individuals to purchase health
insurance, thereby reducing the number of uninsured individuals.
Opponents of the credit argue that it is not sufficient to make
insurance affordable for many individuals and thus would not be
utilized by many uninsured. For example, the credit may not
improve the opportunity for coverage in the individual market for
the elderly and individuals with chronic health problems if
coverage is too expensive, even with the credit. In addition,
opponents of the credit question whether the amount of the credit
will be sufficient to allow many low-income individuals, regardless
of age or health status, to purchase adequate health insurance
coverage. They argue that the credit is too low to allow
individuals to purchase a policy other than a very minimal policy,
and that those most likely to benefit from the credit will be
insurers. Proponents counter that the credit level is sufficient,
and that individuals who purchase insurance as a result of the
credit will be better off than they would be without insurance.
Some opponents are also concerned about the focus of the credit
on insurance purchased in the individual market. They believe the
individual market does not presently offer sufficient protections
to purchasers, and that any credit for the purchase of coverage in
the individual market should only be adopted if accompanied by
market reforms that ensure such protection.
The proposal addresses some of the present-law differences in tax
treatment between employer-subsidized health insurance and insurance
purchased by individuals. Critics of the proposal argue that
providing a credit for the purchase of health insurance undermines
the current employment-based health insurance system by encouraging
healthier individuals who can obtain less expensive coverage in the
individual market to leave the employee pool, thus increasing the
cost of insurance for the employees remaining in the pool.
Further, some argue that the existence of the tax credit could
cause some employers to not offer health benefits for their
employees. This could cause the insurance market to turn into
a predominantly individual market, which could result in an increase
in the cost of health coverage for some individuals.
Others argue that the design of the credit will not cause employees
to leave employers' plans, as the credit is targeted to low-income
individuals who are less likely to have employer-provided health
insurance. Additionally, the subsidy rate is phased out as income
increases and there is a cap on the premium eligible for the subsidy.
Because of the limit on the number of children per family eligible
for the credit, families with more than two children will receive a
smaller benefit under the proposal. For example, a married couple
with two children could be eligible for a credit up to $3,000, while
a single parent with three children could be eligible for a maximum
credit of only $2,000.
Some argue that the objective of the proposal to increase health
insurance would be better served under a direct spending program,
especially because the credit is refundable and does not require
that the individual pay tax. Those opponents to the credit argue
that expanding public programs would be a better alternative because
such expansion would make health insurance coverage more affordable
and accessible. On the other hand, a spending program may provide
less individual choice of health insurance options.
Advanced payment mechanism
The advanced payment feature of the credit raises numerous issues.
The main argument in favor of providing the credit on an advanced
basis is that many of the intended recipients might not be able to
purchase insurance without the advanced credit. Because advancing
the credit merely changes the timing of payment and does not reduce
the cost of insurance (except for the time value of money),
this argument is best understood not as making the insurance
affordable, as is often stated, but rather in making it available
to those who would not otherwise be able to arrange the financing
to pay for the insurance in advance of receiving the credit.
Given the target population of the credit, it might reasonably be
argued that for many potential users of the credit, other financing
mechanisms, such as credit cards, loans from relatives or friends,
personal savings, etc., would not be available, or would not be
used even if available, and the best way to encourage individuals
to buy insurance would be to provide the credit in advance, at the
time of purchase of the insurance.
Some argue that the mechanism for delivering the credit on an advanced
basis is not effective. For example, basing eligibility on the prior
year's income raises issues. Using prior year information may make
the advanced payment option easier to administer, however, using
the prior year data and not requiring reconciliation means that the
credit will in some cases not reach those intended to receive it.
For example, individuals can have low income in the current
year when they need assistance in purchasing health insurance,
but prior year income that is too high to qualify for the advanced
payment of the credit. Such individuals are not eligible to
receive the credit on the advanced basis and in many cases,
because of their decreased income, will remain uninsured.
Some argue that the advanced payment mechanism of the proposal is
flawed because an individual could receive the credit as an advanced
payment based on the prior year's income, even though ineligible for
the credit because of the current year's income. Because there is
no reconciliation required on the current year return, such
individual is not required to repay the amount of the advanced payment
of the credit to the government. For example, a recently graduated
student could have current year income of over $100,000, but prior
year income of less than $15,000 because the individual was in
school on a full-time basis. Such individual could be entitled to
the $1,000 advanced payment of the credit even though the current
year income exceeds the credit income limitation. Thus, using prior
year income may result in inefficiency regarding delivery of the
credit to the intended target population.
Using current year data or requiring reconciliation would reduce
this problem. Using current year data could, however, create other
issues, such as complicating the mechanics of the advanced payment
system and enforcement issues. For example, it may be difficult in
some cases to collect the additional tax owed by people who
erroneously claimed the advance credit. Experience with the earned
income credit shows that this could be the case.
The fact that the tax credit is refundable could lead to fraud and
abuse by taxpayers, as it may be difficult for the IRS to
successfully enforce against taxpayers claiming the credit even
though ineligible. Similar to the earned income credit, it would
be difficult for the IRS to timely detect fraudulent refunds issued
to taxpayers.
Complexity issues
Creating a new tax credit adds complexity to the Code. By providing
additional options to individuals, the proposal may increase
complexity because individuals will have to determine which option
is best for them. A new tax credit will increase complexity in IRS
forms and instructions, by requiring new lines on several tax forms
and additional information in instructions regarding the tax credit.
The new credit would also require IRS programming modifications.
Taxpayers covered by high-deductibles plans that are not part of a
public or employer-provided plan will need to calculate their tax
liability twice to determine whether the proposed credit exceeds the
value of the alternative premium deduction (as provided in the
President's fiscal year 2006 budget proposal).
Additionally, the credit adds new phase-outs to the numerous
existing phase-outs in the Code, which increases complexity.
The advanced payment aspect of the credit also adds additional
complexity to the Code. Taxpayers would have to use different income
amounts to calculate the credit depending whether the credit is
claimed on an advanced basis or on the current year tax return.
The proposal may also increase complexity for insurance companies
by adding administrative burdens with respect to the advanced
payment of the credit. Health insurers would be required to
provide information statements to taxpayers receiving the credit
on an advanced payment basis and to the IRS, including the policy
number, the policy premium, and that the policy meets the requirements
for a qualified policy.
Prior Action
Substantially similar proposals were included in the President's
fiscal year 2002, 2003, 2004, and 2005 budget proposals.
2. Provide an above-the-line deduction for certain high deductible
insurance premiums
Present Law
In general
Present law contains a number of provisions dealing with the Federal
tax treatment of health expenses and health insurance coverage.
The tax treatment of health insurance expenses depends on whether a
taxpayer is covered under a health plan paid for by an employer,
whether an individual has self-employment income, or whether an
individual itemizes deductions and has medical expenses that exceed
a certain threshold. The tax benefits available with respect to
health care expenses also depends on the type of coverage.
Exclusion for employer-provided coverage
In general, employer contributions to an accident or health plan
are excludable from an employee's gross income (and wages for
employment tax purposes). This exclusion generally applies to
coverage provided to employees (including former employees) and
their spouses, dependents, and survivors. Benefits paid under
employer-provided accident or health plans are also generally
excludable from income to the extent they are reimbursements for
medical care. If certain requirements are satisfied,
employer-provided accident or health coverage offered under a
cafeteria plan is also excludable from an employee's gross income
and wages. A cafeteria plan allows employees to choose between
cash and certain nontaxable benefits, including health coverage.
Through the use of a cafeteria plan, employees can pay for
health coverage on a salary reduction basis.
Present law provides for two general employer-provided arrangements
that can be used to pay for or reimburse medical expenses of
employees on a tax-favored basis: flexible spending
arrangements ("FSAs") and health reimbursement arrangements
("HRAs"). While these arrangements provide similar tax benefits
(i.e., the amounts paid under the arrangements for medical care
are excludable from gross income and wages for employment tax
purposes), they are subject to different rules. A main
distinguishing feature between the two arrangements is that
while FSAs are generally part of a cafeteria plan and contributions
to FSAs are made on a salary reduction basis, HRAs cannot be part
_____________________
/66/ Secs. 106, 3121(a)(2), and 3306(b)(2).
/67/ Sec. 105. In the case of a self-insured medical reimbursement
arrangement, the exclusion applies to highly compensated employees
only if certain nondiscrimination rules are satisfied. Sec. 105(h).
Medical care is defined as under section 213(d) and generally
includes amounts paid for qualified long-term care insurance and
services.
/68/ Secs. 125, 3121(a)(5)(G), and 3306(b)(5)(G). Long-term care
insurance and services may not be provided through a cafeteria plan.
of a cafeteria plan and contributions cannot be made on a
salary-reduction basis. In addition, amounts in an HRA may be
used to purchase insurance as well as to reimburse expenses not
covered by insurance, while amounts in an FSA cannot be
used for insurance, but are used to pay for expenses not coverage
by insurance.
Deduction for health insurance expenses of self-employed individuals
The exclusion for employer-provided health coverage does not apply
to self-employed individuals. However, under present law,
self-employed individuals (i.e., sole proprietors or partners in a
partnership) are entitled to deduct 100 percent of the amount paid
for health insurance for themselves and their spouse and dependents
for income tax purposes.
Itemized deduction for medical expenses
Under present law, individuals who itemize deductions may deduct
amounts paid during the taxable year for health insurance (to the
extent not reimbursed by insurance or otherwise) for the taxpayer,
the taxpayer's spouse, and dependents, only to the extent that the
taxpayer's total medical expenses, including health insurance
premiums, exceeds 7.5 percent of the taxpayer's adjusted gross
income.
Health care tax credit
Under the Trade Adjustment Assistance Reform Act of 2002, certain
individuals are eligible for the health coverage tax credit
("HCTC"). The HCTC is a refundable tax credit for 65 percent of the
cost of qualified health coverage paid by an eligible individual.
In general, eligible individuals are individuals receiving a trade
adjustment allowance (and individuals who would be eligible to
receive such an allowance but for the fact that they had not
exhausted their regular unemployment benefits), individuals eligible
for the alternative trade adjustment assistance program, and
individuals over age 55 and receiving pension benefits from the
Pension Benefit Guaranty Corporation. The credit is available for
"qualified health insurance," which includes certain employer-based
insurance, certain State-based insurance, and in some cases,
insurance purchased in the individual market. The credit is
available on an advance basis through a program established by
the Secretary.
______________________
/69/ Notice 2002-45, 2002-28 I.R.B. 93 (July 15, 2002); Rev. Rul.
2002-41, 2002-28 I.R.B. 75 (July 15, 2002).
/70/ Self-employed individuals include more than two-percent
shareholders of S corporations who are treated as partners for
purposes of fringe benefit rules pursuant to section 1372.
/71/ Sec. 162(l). The deduction does not apply for self-employment
tax (SECA) purposes.
/72/ Sec. 213. The adjusted gross income percentage is 10 percent
for purposes of the alternative minimum tax. Sec. 56(b)(1)(B).
/73/ Pub. L. No. 107-210, secs. 201(a), 202 and 203 (2002).
Health savings accounts
In general
The Medicare Prescription Drug, Improvement, and Modernization Act
of 2003 allows individuals with a high deductible health plan (and
no other health plan other than a plan that provides certain
permitted coverage) to establish a health savings account ("HSA").
An HSA is a tax-exempt trust or custodial account. In general,
HSAs provide tax-favored treatment for current medical expenses as
well as the ability to save on a tax-favored basis for future
medical expenses.
Eligible individuals
Eligible individuals for HSAs are individuals who are covered by
a high deductible health plan and no other health plan that is not
a high deductible health plan and which provides coverage for any
benefit which is covered under the high deductible health plan.
Individuals entitled to benefits under Medicare are not eligible to
make contributions to an HSA. Eligible individuals do not include
individuals who may be claimed as a dependent on another person's
tax return. An individual with other coverage in addition to a
high deductible health plan is still eligible for an HSA if such
other coverage is certain permitted insurance or permitted coverage.
A high deductible health plan is a health plan that has a deductible
for 2005 that is at least $1,000 for self-only coverage or $2,000
for family coverage and that has an out-of-pocket expense limit that
is no more than $5,100 in the case of self-only coverage and $12,000
in the case of family coverage. A plan is not a high deductible
health plan if substantially all of the coverage is for permitted
coverage or coverage that may be provided by permitted insurance, as
described above. A plan does not fail to be a high deductible
health plan by reason of failing to have a deductible for preventive
care.
Tax treatment of and limits on contributions
Contributions to an HSA by or on behalf of an eligible individual
are deductible (within limits) in determining adjusted gross income
(i.e., "above-the-line") of the individual. In addition, employer contributions to HSAs (including salary reduction contributions made
____________________
/74/ Pub. L. No. 108-173 (2003).
/75/ Permitted insurance is: (1) insurance if substantially all of
the coverage provided under such insurance relates to (a)
liabilities incurred under worker's compensation law, (b) tort
liabilities, (c) liabilities relating to ownership or use of
property (e.g., auto insurance), or (d) such other similar
liabilities as the Secretary may prescribe by regulations; (2)
insurance for a specified disease or illness; and (3) insurance that
provides a fixed payment for hospitalization.
Permitted coverage is coverage (whether provided through insurance
or otherwise) for accidents, disability, dental care, vision care,
or long-term care.
/76/ The limits are indexed for inflation.
through a cafeteria plan) are excludable from gross income and wages
for employment tax purposes. The maximum aggregate annual
contribution that can be made to an HSA is the lesser of (1) 100
percent of the annual deductible under the high deductible health
plan, or (2) the maximum deductible permitted under an Archer MSA
high deductible health plan under present law, as adjusted for
inflation. For 2005, the amount of the maximum deductible under
an Archer MSA high deductible health plan is $2,650 in the case of
self-only coverage and $5,250 in the case of family coverage.
The annual contribution limits are increased for individuals who
have attained age 55 by the end of the taxable year. In the case
of policyholders and covered spouses who are age 55 or older, the
HSA annual contribution limit is greater than the otherwise
applicable limit by $600 in 2005, $700 in 2006, $800 in 2007,
$900 in 2008, and $1,000 in 2009 and thereafter.
An excise tax applies to contributions in excess of the maximum
contribution amount for the HSA. If an employer makes contributions
to employees' HSAs, the employer must make available comparable
contributions on behalf of all employees with comparable coverage
during the same period.
Taxation of distributions
Distributions from an HSA for qualified medical expenses of the
individual and his or her spouse or dependents generally are
excludable from gross income. Qualified medical expenses generally
are defined as under section 213(d). Qualified medical expenses
do not include expenses for insurance other than for (1) long-term
care insurance, (2) premiums for health coverage during any period
of continuation coverage required by Federal law, (3) premiums for
health care coverage while an individual is receiving unemployment compensation under Federal or State law, or (4) in the case of an
account beneficiary who has attained the age of Medicare
eligibility, health insurance premiums for Medicare, other than
premiums for Medigap policies. Such qualified health insurance
premiums include, for example, Medicare Part A and Part B
premiums, Medicare HMO premiums, and the employee share of premiums
for employer sponsored health insurance including employer-sponsored
retiree health insurance.
For purposes of determining the itemized deduction for medical
expenses, distributions from an HSA for qualified medical expenses
are not treated as expenses paid for medical care under section 213.
Distributions from an HSA that are not for qualified medical
expenses are includible in gross income. Distributions includible
in gross income are also subject to an additional 10-percent tax
unless made after death, disability, or the individual attains the
age of Medicare eligibility (i.e., age 65).
Archer MSAs
Like HSAs, an Archer MSA is a tax-exempt trust or custodial account
to which tax-deductible contributions may be made by individuals with
a high deductible health plan. Archer MSAs provide tax benefits
similar to, but generally not as favorable as, those provided by
HSAs for certain individuals covered by high deductible health
plans.
The rules relating to Archer MSAs and HSAs are similar. The main
differences include: (1) only self-employed individuals and
employees of small employers are eligible to have an Archer MSA;
(2) for MSA purposes, a high deductible health plan is a health plan
with (a) an annual deductible of at least $1,750 and no more than
$2,650 in the case of self-only coverage and at least $3,500 and no
more than $5,250 in the case of family coverage and (b) maximum
out-of pocket expenses of no more than $3,500 in the case of
self-only coverage and no more than $6,450 in the case of family
coverage; (4) the contribution limits for HSAs are higher than
for MSAs; and (4) the additional tax on distributions not used
for medical expenses is 15 percent rather than 10 percent.
After 2005, no new contributions can be made to Archer MSAs except
by or on behalf of individuals who previously had Archer MSA
contributions and employees who are employed by a participating
employer.
Description of Proposal
The proposal provides an above-the-line deduction for high
deductible health insurance premiums for individuals who contribute
to an HSA. As under the present-law rules relating to HSA
eligibility, an individual does not qualify for the deduction
if the individual is covered by any health plan other than the high
deductible plan for which the deduction is claimed, except for
certain permitted coverage. The deduction is only allowed for
insurance purchased in the individual insurance market and is not
allowed for individuals covered by employer plans or public plans.
Additionally, the deduction is not allowed to an individual claiming
the present-law HCTC or the proposed refundable tax credit for the
purchase of health insurance included in the President's fiscal
year 2006 budget proposal.
Effective date.--The proposal is effective for taxable years beginning
after December 31, 2005.
Analysis
Policy issues
The proposal is intended to provide an incentive for individuals to
purchase high deductible health plans in connection with the use
of HSAs. Allowing a deduction for premiums of high deductible
health plans provides a subsidy for the purchase of such plans,
thus making them more affordable. The proposal raises both health
policy issues and tax policy issues.
Proponents believe that the use of high deductible health plans
promotes responsible health policy. Proponents argue that the use
of high deductible health plans (together with HSAs) will encourage
cost consciousness and result in better decision-making with respect
to health care expenses because such plans make individuals more
aware of their health care expenses.
Critics argue that it is inappropriate to favor high deductible
health plans. Critics argue that providing a preference for the
purchase of high deductible health insurance purchased in the
individual market undermines the current group-based health
insurance system by encouraging healthier individuals who can obtain
less expensive coverage in the individual market to leave the
employee pool, thus increasing the cost of insurance for the
employees remaining in the pool.
Critics also argue that any health cost reductions hoped for due to
the use of high deductible health plans are undermined by the
availability of HSAs, which allow for the payment of the first dollar
of health expenses on a tax-favored basis.
Critics have concerns with favoring any insurance purchased in the
individual market. Some argue that favoring plans purchased in the
individual market and excluding employer plans may cause some
employers to not offer health benefits for their employees if they
feel that significant tax incentives exist in the individual
market. Critics argue that this could cause the insurance market
to turn into a predominantly individual market, which could result
in an increase in the cost of health coverage for some individuals.
Critics argue that individuals who are unable to obtain coverage
in the individual market will be greatly disadvantaged by the
proposal. Critics are also concerned about the focus of the
deduction on insurance purchased in the individual market because
they believe the individual market does not presently offer
sufficient protections to purchasers, and that any tax incentive for
the purchase of coverage in the individual market should only be
adopted if accompanied by reforms (e.g., guaranteed issue).
Proponents also argue that the proposal will reduce the number
of uninsured individuals. Many uninsured individuals may purchase
high deductible health plans given the tax advantages of HSAs and
the deduction under the proposal. Others argue that because the
proposal is limited to a certain type of plan, it may have a minimal
effect on reducing the number of uninsured. Some may argue that
those who are uninsured because they cannot afford coverage still
may not have sufficient resources to afford a high deductible plan
even on a tax-subsidized basis. Other younger healthier uninsured
individuals who can afford health insurance may choose to
continue to remain uninsured even with the tax incentive.
Some criticize the proposal as providing a targeted subsidy for one
type of insurance product for which there has been a weak market,
rather than directly addressing the social policy issue of the
rising cost of health care and number of uninsured individuals.
On the other hand, some point out that Congress has already
provided subsidies to high deductible health plans through the tax
law (i.e., HSAs) to encourage people to use such plans and save for
health expenses, and that this proposal is consistent with the policy
already expressed by Congress.
Proponents argue that the proposal will reduce the inequities under
present law regarding the tax treatment of health insurance
expenses. Proponents argue that providing a deduction for high
deductible health plans will level the playing field for those who
are not self-employed or do not have employer-provided coverage.
While the proposal addresses some of the present-law differences in
the tax treatment between employer-subsidized health insurance and
insurance purchased by individuals, critics argue that it is not
appropriate for a tax subsidy for the purchase of insurance to be
limited to one particular type of plan. Critics argue that limiting
the subsidy to high deductible health plans will further contribute
to the inequitable tax treatment of health expenses and may actually
increase inequities by providing, in connection with HSAs, a very
generous subsidy for one particular type of plan.
Some argue that the present-law differences in the tax treatment
between employer-subsidized health insurance and insurance purchased
by individuals could be more equitably addressed by limiting the
exclusion for employer-provided health coverage. Others question
whether an exclusion for employer-provided health expenses should
exist, as such preference leads to a tax system which is not neutral
with respect to similar expenses. Some argue that a tax preference
should exist only to the extent extraordinary medical expenses affect
an individual's ability to pay and that this is already sufficiently
addressed with the present-law itemized deduction (to the extent
of 7.5 percent of adjusted gross income) for medical expenses.
Even if one agrees that high deductible health plans are preferable
from a health policy perspective and should be tax-favored, some
argue that inequities will result because the proposal is narrowly
targeted. For example, because the proposal is limited to insurance
purchased in the individual market, an individual participating in
a group high-deductible plan could not qualify for the deduction
even if the employee pays 100 percent of the cost of coverage.
While the proposal provides that the deduction is not allowed for
individuals covered by employer plans, it is unclear what
specifically constitutes an employer plan. For example, an employee
could have a high deductible health plan purchased in the individual
market, a portion of the cost of which is paid by the employer.
It is unclear whether such plan would qualify for the deduction.
Complexity issues
Conditioning the deduction on making a contribution to an HSA adds
complexity to the proposal compared to providing a deduction without
such a requirement. In addition, the requirement is easily
satisfied, raising questions as to whether the additional complexity
serves any policy function. For example, an individual could
contribute as little as $1 to an HSA and be eligible for the
deduction.
By providing additional options to individuals, the proposal may
increase transactional complexity because individuals will have to
determine which option is best for them.
Individuals eligible for the proposed refundable tax credit for
health insurance will have to determine which option is best for
them because such individuals are not eligible for both the credit
and the deduction. Employees will also have to determine whether it
is better to remain in employer plans or to purchase a policy in
the individual market.
Creating a new tax deduction will necessitate a new line on the Form
1040 and additional information in instructions regarding the
deduction. The new deduction may also require IRS programming
modifications.
Prior Action
A similar proposal was included in the President's fiscal year
2005 budget proposal.
3. Provide a refundable tax credit for contributions of small
employers to employee health savings accounts ("HSAs")
Present Law
In general
Present law contains a number of provisions dealing with the Federal
tax treatment of health expenses and health insurance coverage.
The tax treatment of health insurance expenses of an individual
depends on whether the individual is covered under a health plan
paid for by an employer, has self-employment income, or itemizes
deductions and has medical expenses that exceed a certain threshold.
The tax benefits available with respect to health care expenses
also depends on the type of coverage.
Exclusion for employer-provided coverage
In general, employer contributions to an accident or health plan
are excludable from an employee's gross income (and wages for
employment tax purposes). This exclusion generally applies to
coverage provided to employees (including former employees) and
their spouses, dependents, and survivors. Benefits paid under
employer-provided accident or health plans are also generally
excludable from income to the extent they are reimbursements
for medical care. If certain requirements are satisfied,
employer-provided accident or health coverage offered under a
cafeteria plan is also excludable from an employee's gross income
and wages. A cafeteria plan allows employees to choose between
cash and certain nontaxable benefits, including health coverage.
Through the use of a cafeteria plan, employees can pay for health
coverage on a salary reduction basis.
Present law provides for two general employer-provided arrangements
that can be used to pay for or reimburse medical expenses of
employees on a tax-favored basis: flexible spending arrangements
("FSAs") and health reimbursement arrangements ("HRAs"). While
these arrangements provide similar tax benefits (i.e., the amounts
paid under the arrangements for medical care are excludable from
gross income and wages for employment tax purposes), they are
subject to different rules. A main distinguishing feature betweent
the two arrangements is that while FSAs are generally part of a
cafeteria plan and contributions to FSAs are made on a salary
reduction basis, HRAs cannot be part of a cafeteria plan and
_________________
/78/ Secs. 106, 3121(a)(2), and 3306(b)(2).
/79/ Sec. 105. In the case of a self-insured medical reimbursement
arrangement, the exclusion applies to highly compensated employees
only if certain nondiscrimination rules are satisfied.
Sec. 105(h). Medical care is defined as under section 213(d) and
generally includes amounts paid for qualified long-term care
insurance and services.
/80/ Secs. 125, 3121(a)(5)(G), and 3306(b)(5)(G). Long-term care insurance and services may not be provided through a cafeteria plan.
contributions cannot be made on a salary-reduction basis.
In addition, amounts in an HRA may be used to purchase insurance
as well as to reimburse expenses not covered by insurance, while
amounts in an FSA cannot be used for insurance, but are used to
pay for expenses not coverage by insurance.
Employer contributions for accident or health coverage,
including contributions to an HRA and contributions made through
a cafeteria plan, are generally deductible to the employer
as a compensation expense.
Deduction for health insurance expenses of self-employed individuals
The exclusion for employer-provided health coverage does not apply
to self-employed individuals. However, under present law,
self-employed individuals (i.e., sole proprietors or partners in a
partnership) are entitled to deduct 100 percent of the amount paid
for health insurance for themselves and their spouse and dependents
for income tax purposes.
Itemized deduction for medical expenses
Under present law, individuals who itemize deductions may deduct
amounts paid during the taxable year for health insurance (to the
extent not reimbursed by insurance or otherwise) for the taxpayer,
the taxpayer's spouse, and dependents, only to the extent that the
taxpayer's total medical expenses, including health insurance
premiums, exceeds 7.5 percent of the taxpayer's adjusted gross
income.
Health care tax credit
Under the Trade Adjustment Assistance Reform Act of 2002, certain
individuals are eligible for the health coverage tax credit
("HCTC"). The HCTC is a refundable tax credit for 65 percent of the
cost of qualified health coverage paid by an eligible individual.
In general, eligible individuals are individuals receiving a trade
adjustment allowance (and individuals who would be eligible to
receive such an allowance but for the fact that they had not
exhausted their regular unemployment benefits), individuals eligible
for the alternative trade adjustment assistance program, and
individuals over age 55 and receiving pension benefits from the
Pension Benefit Guaranty Corporation. The credit is available for
__________________
/81/ Notice 2002-45, 2002-28 I.R.B. 93 (July 15, 2002); Rev. Rul.
2002-41, 2002-28 I.R.B. 75 (July 15, 2002).
/82/ Self-employed individuals include more than two-percent
shareholders of S corporations who are treated as partners for
purposes of fringe benefit rules pursuant to section 1372.
/83/ Sec. 162(l). The deduction does not apply for self-employment
tax (SECA) purposes.
/84/ Sec. 213. The adjusted gross income percentage is 10 percent
for purposes of the alternative minimum tax. Sec. 56(b)(1)(B).
/85/ Pub. L. No. 107-210, secs. 201(a), 202 and 203 (2002).
"qualified health insurance," which includes certain employer-based
insurance, certain State-based insurance, and in some cases,
insurance purchased in the individual market. The credit is
available on an advance basis through a program established by
the Secretary.
Health savings accounts
In general
The Medicare Prescription Drug, Improvement, and Modernization Act
of 2003 allows individuals with a high deductible health plan
(and no other health plan other than a plan that provides certain
permitted coverage) to establish a health savings account ("HSA").
An HSA is a tax-exempt trust or custodial account. In general,
]HSAs provide tax-favored treatment for current medical expenses as
well as the ability to save on a tax-favored basis for future
medical expenses.
Eligible individuals
Eligible individuals for HSAs are individuals who are covered by a
high deductible health plan and no other health plan that is not
a high deductible health plan and which provides coverage for any
benefit which is covered under the high deductible health plan.
Individuals entitled to benefits under Medicare are not eligible
to make contributions to an HSA. Eligible individuals do not
include individuals who may be claimed as a dependent on another
person's tax return. An individual with other coverage in addition
to a high deductible health plan is still eligible for an HSA if
such other coverage is certain permitted insurance or permitted
coverage.
A high deductible health plan is a health plan that has a
deductible, for 2005, that is at least $1,000 for self-only coverage
or $2,000 for family coverage and that has an out-of-pocket expense
limit that is no more than $5,100 in the case of self-only coverage
and $12,000 in the case of family coverage. A plan is not a high
deductible health plan if substantially all of the coverage is for
permitted coverage or coverage that may be provided by permitted
insurance, as described above. A plan does not fail to be a high
deductible health plan by reason of failing to have a deductible
for preventive care.
Tax treatment of and limits on contributions
Contributions to an HSA by or on behalf of an eligible individual
are deductible (within limits) in determining adjusted gross
income (i.e., "above-the-line") of the individual. In addition,
employer contributions to HSAs (including salary reduction
contributions made through a cafeteria plan) are excludable from
gross income and wages for employment tax purposes.
The maximum aggregate annual contribution that can be made to an
HSA is the lesser of (1) 100 percent of the annual deductible under
the high deductible health plan, or (2) the maximum deductible
permitted under an Archer MSA high deductible health plan under
present law, as adjusted for inflation. For 2005, the amount of
the maximum deductible under an Archer MSA high deductible health
plan is $2,650 in the case of self-only coverage and $5,250 in the
case of family coverage. The annual contribution limits are
increased for individuals who have attained age 55 by the end of
the taxable year. In the case of policyholders and covered spouses
who are age 55 or older, the HSA annual contribution limit is
greater than the otherwise applicable limit by $600 in 2005, $700
in 2006, $800 in 2007, $900 in 2008, and $1,000 in 2009
and thereafter.
Employer contributions to an HSA are generally deductible by the
employer as compensation expense.
An excise tax applies to contributions in excess of the maximum
contribution amount for the HSA. If an employer makes contributions
to employees' HSAs, the employer must make available comparable
contributions on behalf of all employees with comparable coverage
during the same period.
Taxation of distributions
Distributions from an HSA for qualified medical expenses of the
individual and his or her spouse or dependents generally are
excludable from gross income. Qualified medical expenses generally
are defined as under section 213(d). Qualified medical expenses do
not include expenses for insurance other than for (1) long-term care
insurance, (2) premiums for health coverage during any period of
continuation coverage required by Federal law, (3) premiums for
health care coverage while an individual is receiving unemployment
compensation under Federal or State law, or (4) in the case of
an account beneficiary who has attained the age of Medicare
eligibility, health insurance premiums for Medicare, other
than premiums for Medigap policies. Such qualified health insurance
premiums include, for example, Medicare Part A and Part B
premiums, Medicare HMO premiums, and the employee share of premiums
for employer-sponsored health insurance including employer-sponsored
retiree health insurance.
For purposes of determining the itemized deduction for medical
expenses, distributions from an HSA for qualified medical expenses
are not treated as expenses paid for medical care under section 213.
Distributions from an HSA that are not for qualified medical
expenses are includible in gross income. Distributions includible
in gross income are also subject to an additional 10-percent tax
unless made after death, disability, or the individual attains the
age of Medicare eligibility (i.e., age 65).
Archer MSAs
Like HSAs, an Archer MSA is a tax-exempt trust or custodial account
to which tax-deductible contributions may be made by individuals
with a high deductible health plan. Archer MSAs provide tax benefits
similar to, but generally not as favorable as, those provided by
HSAs for certain individuals covered by high deductible health plans.
The rules relating to Archer MSAs and HSAs are similar. The main
differences include: (1) only self-employed individuals and
employees of small employers are eligible to have an Archer MSA; (2)
for MSA purposes, a high deductible health plan is a health plan
with (a) an annual deductible of at least $1,750 and no more than
$2,650 in the case of self-only coverage and at least $3,500 and no
more than $5,250 in the case of family coverage and (b) maximum
out-of pocket expenses of no more than $3,500 in the case of
self-only coverage and no more than $6,450 in the case of family
coverage; (3) the contribution limits for HSAs are higher than
that for MSAs, and (4) the additional tax on distributions not used
for medical expenses is 15 percent rather than 10 percent.
After 2005, no new contributions can be made to Archer MSAs except
by or on behalf of individuals who previously had Archer MSA
contributions and employees who are employed by a participating
employer.
Description of Proposal
The proposal provides a refundable tax credit to small employers
for contributions made to the HSAs of employees. A small employer
is defined as an employer that normally employs fewer than 100
employees on a typical business day. Governmental and
not-for-profit employers do not qualify for the credit.
The credit applies to 100 percent of contributions made by the small
employer, up to a maximum annual credit amount of $200 for
contributions on behalf of an individual with single coverage and
$500 for an individual with family coverage. In order to receive the
credit, the employer is required to maintain a high deductible
health plan (as defined under the HSA rules) accessible to all
employees. The employer is not required to make contributions
toward employee premiums for the health plan.
The tax credit is not includible in income and is not subject to the
general business tax credit rules. The employer is not entitled to
a deduction for the amount reimbursed by the credit.
The amount of the employer contribution to an HSA for which the
credit is claimed must be maintained in a special HSA or within a
special account in the employee's HSA. The rules applicable to HSAs
apply to the special HSA (or special account), except that
withdrawals that exceed qualified medical expenses are subject to a
tax of 100 percent of the amount of the withdrawal.
___________________
/89/ The deductible and out-of-pocket expenses dollar amounts are
for 2005. These amounts are indexed for inflation in $50 increments.
Sole proprietors, partners, and S corporation shareholders are
eligible for the credit if their business is a small employer and the
business provides the same HSA contributions to all employees who
have the same type of coverage or has no employees. Self-employed
individuals are not entitled to a deduction for the amount
reimbursed by the credit. The credit is pro-rated if eligible
coverage is held for less than 12 months.
Effective date.--The proposal is effective for taxable years
beginning after December 31, 2005.
Analysis
The stated intent of the proposal is to encourage small employers
to offer coverage and contribute toward the health care of their
employees. The proposal is aimed at HSAs, because of their link to
high deductible plans, which the proponents of the proposal believe
may encourage more cost consciousness with respect to health care.
The proposal's emphasis on HSAs and high deductible policies raises
issues similar to those raised by other aspects of the budget
proposal (i.e., the above-the-line deduction for the cost of high
deductible health plans and the health insurance tax credit) as to
whether it is appropriate to favor such insurance over other types
of insurance. As discussed further above, while some argue that
such insurance is preferable to an individual having no insurance and
may result in greater cost awareness, others question whether such
insurance is appropriate and question whether it provides adequate
protections.
Although the proposal is framed in terms of a credit for small
employers, the ultimate effect of the proposal is on employees of
such employers. Particularly given the refundable nature of the
credit, the employer may be viewed as a conduit for delivery of a
subsidy to employees of small employers.
While employer-provided health coverage is generally lower among
employees of small firms compared to employees of larger firms, some
argue that a proposal providing a subsidy for employees of small
firms is not well targeted. They argue that it would be more
appropriate to provide subsidies for health care costs based on
income (or wealth) or other factors that may better reflect need.
To the extent that employees of small employers are considered an
appropriate target group, the proposal does not provide the subsidy
to all employees of small employers. In particular, by denying a
similar subsidy for employees of small not-for-profit or
governmental entities, the proposal arguably discriminates against
individuals who work for such employers.
The proposal does not provide a subsidy for the purchase of health
insurance itself. It may be argued that making insurance more
affordable is addressed by other aspects of the budget proposals,
specifically the proposed health insurance tax credit and the
above-the-line deduction for high deductible plan premiums.
However, this proposal may force some employees to choose between
this credit and the above-the-line deduction or health insurance
tax credit. This is because the deduction and health insurance
credit are not available with respect to group coverage. However,
in order to claim the small employer credit, the employee must
purchase the health insurance offered by the small employer.
For many employees, taking the value of the above-the-line
deduction or the health insurance credit will be more valuable
than the credit for HSA contributions received through a small
employer.
Prior Action
No prior action.
4. Modify the refundable credit for health insurance costs of
eligible individuals
Present Law
Refundable health insurance credit: in general
Under the Trade Act of 2002, in the case of taxpayers who are
eligible individuals, a refundable tax credit is provided for 65
percent of the taxpayer's expenses for qualified health insurance of
the taxpayer and qualifying family members for each eligible
coverage month beginning in the taxable year. The credit is
commonly referred to as the health coverage tax credit ("HCTC").
The credit is available only with respect to amounts paid by the
taxpayer.
Qualifying family members are the taxpayer's spouse and
any dependent of the taxpayer with respect to whom the taxpayer is
entitled to claim a dependency exemption. Any individual who has
other specified coverage is not a qualifying family member.
Persons eligible for the credit
Eligibility for the credit is determined on a monthly basis.
In general, an eligible coverage month is any month if, as of the
first day of the month, the taxpayer (1) is an eligible individual,
(2) is covered by qualified health insurance, (3) does not have
other specified coverage, and (4) is not imprisoned under Federal,
State, or local authority. In the case of a joint return, the
eligibility requirements are met if at least one spouse satisfies
the requirements. An eligible month must begin after November
4,2002.
An eligible individual is an individual who is (1) an eligible TAA
recipient, (2) an eligible alternative TAA recipient, and (3) an
eligible PBGC pension recipient.
An individual is an eligible TAA recipient during any month if the
individual (1) is receiving for any day of such month a trade
adjustment allowance or who would be eligible to receive such an
allowance but for the requirement that the individual exhaust
unemployment benefits before being eligible to receive an allowance
_____________________
/90/ Pub. L. No. 107-210 (2002).
/91/ This date is 90 days after the date of enactment of the Trade
Act of 2002, which was August 6, 2002.
/92/ Part I of subchapter B, or subchapter D, of chapter 2 of title
II of the Trade Act of 1974.
and (2) with respect to such allowance, is covered under a
certification issued under subchapter A or D of chapter 2 of title
II of the Trade Act of 1974. An individual is treated as an
eligible TAA recipient during the first month that such individual
would otherwise cease to be an eligible TAA recipient.
An individual is an eligible alternative TAA recipient during any
month if the individual (1) is a worker described in section
246(a)(3)(B) of the Trade Act of 1974 who is participating in the
program established under section 246(a)(1) of such Act, and (2) is
receiving a benefit for such month under section 246(a)(2) of
such Act. An individual is treated as an eligible alternative TAA
recipient during the first month that such individual would
otherwise cease to be an eligible TAA recipient.
An individual is a PBGC pension recipient for any month if he or she
(1) is age 55 or over as of the first day of the month, and (2) is
receiving a benefit any portion of which is paid by the Pension
Benefit Guaranty Corporation (the "PBGC"). The IRS has interpreted
the definition of PBGC pension recipient to also include certain
alternative recipients and recipients who have received certain
lump-sum payments on or after August 6, 2002.
An otherwise eligible taxpayer is not eligible for the credit for a
month if, as of the first day of the month the individual has other
specified coverage. Other specified coverage is (1) coverage under
any insurance which constitutes medical care (except for insurance
substantially all of the coverage of which is for excepted
benefits) maintained by an employer (or former employer) if at
least 50 percent of the cost of the coverage is paid by an employer
(or former employer) of the individual or his or her spouse or (2)
coverage under certain governmental health programs. A rule
aggregating plans of the same employer applies in determining
_____________________
/93/ Excepted benefits are: (1) coverage only for accident or
disability income or any combination thereof; (2) coverage issued
as a supplement to liability insurance; (3) liability insurance,
including general liability insurance and automobile liability
insurance; (4) worker's compensation or similar insurance; (5)
automobile medical payment insurance; (6) credit-only insurance;
(7) coverage for on-site medical clinics; (8) other insurance
coverage similar to the coverages in (1)-(7) specified in
regulations under which benefits for medical care are secondary or
incidental to other insurance benefits; (9) limited scope dental or
vision benefits; (10) benefits for long-term care, nursing home
care, home health care, community-based care, or any combination
thereof; and (11) other benefits similar to those in (9) and (10)
as specified in regulations; (12) coverage only for a specified
disease or illness; (13) hospital indemnity or other fixed indemnity
insurance; and (14) Medicare supplemental insurance.
/94/ An amount is considered paid by the employer if it is
excludable from income. Thus, for example, amounts paid for health
coverage on a salary reduction basis under an employer plan are
considered paid by the employer.
/95/ Specifically, an individual is not eligible for the credit if,
as of the first day of the month, the individual is (1) entitled to
benefits under Medicare Part A, enrolled in Medicare Part B, or
enrolled in Medicaid or SCHIP, (2) enrolled in a health benefits
plan under the Federal Employees Health Benefit Plan, or (3)
entitled to receive benefits under chapter 55 of title 10 of
whether the employer pays at least 50 percent of the cost of
coverage. A person is not an eligible individual if he or she may
be claimed as a dependent on another person's tax return. A special
rule applies with respect to alternative TAA recipients. For
eligible alternative TAA recipients, an individual has other
specified coverage if the individual is (1) eligible for coverage
under any qualified health insurance (other than coverage under a
COBRA continuation provision, State-based continuation coverage,
or coverage through certain State arrangements) under which at
least 50 percent of the cost of coverage is paid or incurred by an
employer of the taxpayer or the taxpayer's spouse or (2) covered
under any such qualified health insurance under which any portion
of the cost of coverage is paid or incurred by an employer of the
taxpayer or the taxpayer's spouse.
Qualified health insurance
Qualified health insurance eligible for the credit is: (1) COBRA
continuation coverage; (2) State-based continuation coverage
provided by the State under a State law that requires such
coverage; (3) coverage offered through a qualified State high
risk pool; (4) coverage under a health insurance program offered
to State employees or a comparable program; (5) coverage
through an arrangement entered into by a State and a group health
plan, an issuer of health insurance coverage, an administrator,
or an employer; (6) coverage offered through a State arrangement
with a private sector health care coverage purchasing pool; (7)
coverage under a State-operated health plan that does not receive
any Federal financial participation; (8) coverage under a group
health plan that is available through the employment of the
eligible individual's spouse; and (9) coverage under individual
health insurance if the eligible individual was covered
under individual health insurance during the entire 30-day period
that ends on the date the individual became separated from the
employment which qualified the individual for the TAA
allowance, the benefit for an eligible alternative TAA recipient,
or a pension benefit from the PBGC, whichever applies.
Qualified health insurance does not include any State-based
coverage (i.e., coverage described in (2)-(8) in the preceding
paragraph), unless the State has elected to have such coverage
treated as qualified health insurance and such coverage meets
certain requirements. Such State coverage must provide that each
qualifying individual is guaranteed enrollment if the individual
_____________________
the United States Code (relating to military personnel). An
individual is not considered to be enrolled in Medicaid solely by
reason of receiving immunizations.
/96/ For this purpose, "individual health insurance" means any
insurance which constitutes medical care offered to individuals
other than in connection with a group health plan. Such term
does not include Federal- or State-based health insurance coverage.
/97/ For guidance on how a State elects a health program to be
qualified health insurance for purposes of the credit, see Rev.
Proc. 2004-12, 2004-9 I.R.B. 1.
pays the premium for enrollment or provides a qualified health
insurance costs eligibility certificate and pays the remainder
of the premium. In addition, the State-based coverage cannot
impose any pre-existing condition limitation with respect to
qualifying individuals. State-based coverage cannot require a
qualifying individual to pay a premium or contribution that is
greater than the premium or contribution for a similarly situated
individual who is not a qualified individual. Finally, benefits
under the State-based coverage must be the same as (or
substantially similar to) benefits provided to similarly situated
individuals who are not qualifying individuals. A qualifying
individual is an eligible individual who seeks to enroll in the
State-based coverage and who has aggregate periods of creditable
coverage of three months or longer, does not have other specified
coverage, and who is not imprisoned. A qualifying individual also
includes qualified family members of such an eligible individual.
Qualified health insurance does not include coverage under a
flexible spending or similar arrangement or any insurance if
substantially all of the coverage is of excepted benefits.
Other rules
Amounts taken into account in determining the credit may not be
taken into account in determining the amount allowable under the
itemized deduction for medical expenses or the deduction for health
insurance expenses of self-employed individuals. Amounts
distributed from a medical savings account or health savings
account are not eligible for the credit. The amount of the credit
available through filing a tax return is reduced by any credit
received on an advance basis. Married taxpayers filing separate
returns are eligible for the credit; however, if both spouses are
eligible individuals and the spouses file a separate return, then
the spouse of the taxpayer is not a qualifying family member.
The Secretary of the Treasury is authorized to prescribe such
regulations and other guidance as may be necessary or appropriate
to carry out the provision.
Advance payment of refundable health insurance credit; reporting
requirements
The credit is payable on an advance basis (i.e., prior to the filing
of the taxpayer's return). The disclosure of return information of
certified individuals to providers of health insurance information
is permitted to the extent necessary to carry out the advance
payment mechanism. The Code does not specify the items of return
information that are to be disclosed, nor does it provide for the
disclosure of such information to contractors of the health
insurance providers authorized to receive such information.
Advance payment of the credit has been available since
August 1, 2003. To the extent that disclosures to persons not
authorized under the statute are necessary a consent mechanism
has been employed. The signature block of the registration form for
the credit states "By signing, I also agree to allow the IRS to
share my eligibility status and payment information with my health
plan administrator." Applicants are required to give such consent
in applying for the credit.
Any person who receives payments during a calendar year for qualified
health insurance and claims a reimbursement for an advance credit
______________________
/98/ Creditable coverage is determined under the Health Care Portability and
Accountability Act (Code sec. 9801(c)).
amount is required to file an information return with respect to
each individual from whom such payments were received or for whom
such a reimbursement is claimed.
Description of Proposal
The President's proposal modifies the health coverage tax credit
in several ways.
The proposal modifies the requirement that State-based coverage not
impose pre-existing condition limitations. The proposal allows
State-based coverage to impose a modified pre-existing condition
restriction similar to the rules under the Health Insurance
Portability and Accountability Act of 1996 ("HIPAA").
The pre-existing condition exclusion can be imposed for a period of
up to 12 months, but must be reduced by the length of the eligible
individual's creditable coverage, as of the date the individual
applies for the State-based coverage. The exclusion must relate
to a condition (whether physical or mental), regardless of the cause
of the condition, for which medical advice, diagnosis, care, or
treatment was recommended or received within the 6-month period
ending on the date the individual seeks to enroll in the coverage.
The exclusion cannot be an exclusion described in Code section
(801(d) (relating to exclusions not applicable to certain newborns,
certain adopted children, or pregnancy).
The proposal also allows spouses of eligible individuals to claim
the credit even after the eligible individual becomes entitled to
Medicare, provided that the spouse (1) is at least age 55;
(2) is covered by qualified health insurance, the premium of which
is paid by the taxpayer; (3) does not have other specific coverage;
and (4) is not imprisoned under Federal, State, or local
authority.
The proposal also makes other changes to the credit. Under the
proposal, individuals who elect to receive one-time lump sum
payments from the PBGC and certain alternative PBGC payees are
eligible for the credit.
The proposal provides that the Commonwealths of Puerto Rico and the
Northern Mariana Islands, American Samoa, Guam, and the U.S. Virgin
islands are deemed to be States for purposes of the State-based
coverage rules.
In addition, the proposal allows disclosure of certain information
necessary to carry out the advance payment program to contractors of
providers of health insurance and provides that providers of health
insurance include employers and administrators of health plans.
Additionally, under the proposal, State continuation coverage
provided under State law automatically qualifies as qualified health
insurance, as Federally-mandated COBRA continuation coverage,
without having to meet the requirements relating to State-based
qualified coverage.
The proposal also changes the definition of other specified coverage
for eligible alternative TAA recipients by removing the special rule
that applies only to alternative TAA recipients.
Effective date.�The proposal modifying the requirement that there be
no imposition of a pre-existing condition exclusion is effective for
eligible individuals applying for coverage after December 31, 2005.
The proposal relating to spouses of HCTC-eligible individuals is
effective for taxable years beginning after December 31, 2005. The
remaining proposals are effective as if included in the Trade Act
of 2002.
Analysis
In general
The HCTC was enacted to assist certain individuals in paying for
qualified health insurance. The various aspects of the proposal
will make the credit available to more individuals. Some aspects
of the proposal may be considered clarifications of present law
based on current IRS administrative positions.
Pre-existing condition exclusion
The proposal modifies the requirement for State-based coverage that
there be no imposition of a pre-existing condition exclusion.
Proponents argue that this change is necessary to allow States not
currently offering qualified health insurance to be able to offer
qualified insurance. Many States argue that it is difficult to
implement qualifying State-based coverage with the present-law
requirement that there be no imposition of a pre-existing condition
exclusion. Others argue that modification of the no imposition of
preexisting conditions exclusion eliminates an important consumer
protection afforded under State-based coverage.
Proponents counter that the modified requirement under the proposal,
coupled with the other consumer protections, including guaranteed
issue, provides sufficient protections, especially in the case of
States where the alternative would be no qualifying State-based
coverage. Critics argue that if State-based coverage must satisfy
the present-law requirement, States will eventually produce a
qualifying option which will allow its citizens access to the credit
while maintaining the protection. They argue that since the vast
majority of States have been able to produce a qualifying option
under the present-law requirements, the few States that have not
offered qualified insurance should not be afforded a less stringent
rule.
Spouses of eligible individuals entitled to Medicare
The proposal allows spouses of eligible individuals to claim the
credit when the eligible individual becomes entitled to Medicare,
provided that the spouse (1) is at least age 55; (2) is covered by
qualified health insurance, the premium of which is paid by the
taxpayer; (3) does not have other specified coverage; and (4) is
not imprisoned under Federal, State or local authority.
Under present law, once an otherwise eligible individual is entitled
to benefits under Medicare, the spouse of the individual is no
longer eligible for the credit, even if the spouse if not entitled
to benefits under Medicare.
Not allowing the credit to the spouses of Medicare-eligible
individuals can result in many spouses dropping coverage once the
eligible individual becomes entitled to Medicare and becoming
uninsured. The proposal is intended to prevent such result.
Eligible individuals
Under the proposal, individuals who elect to receive one-time
lump-sum payments from the PBGC are eligible for the credit. While
the IRS has interpreted the credit as applying to individuals who
receive a one-time lump sum from the PBGC and certain alternative
PBGC payees, clarifying statutorily that such individuals are
eligible individuals will simplify administration of the credit.
Many believe that individuals who receive a one-time lump-sum
pension payment in lieu of an annuity should not be ineligible for
the credit simply because they are not receiving payments on a
monthly basis. In general, lump-sum payments are only received if
the value of the benefit is $5,000 or less. Given the relatively
small amount of the payments, most agree that requiring participants
to take an annuity in order to qualify for the credit is not
desirable.
The proposal also provides that certain alternative PBGC payees are
eligible for the credit. In general, alternative PBGC payees
include alternative payees under a qualified domestic relations
order and beneficiaries of deceased employees who are receiving
payments from the PBGC. Many believe that fairness requires that
such individuals should be treated as eligible PBGC pension
recipients.
Certain commonwealths and possessions
The proposal providing that the Commonwealths of Puerto Rico and the
Northern Mariana Islands, American Samoa, Guam, and the U.S. Virgin
islands are deemed to be States for purposes of the State-based
coverage rules allows such possessions and commonwealths to elect a
State-based coverage option, which will allow residents greater access
to the credit. Under present law, if an individual meets the
definition of an eligible individual, residents of the possessions
and commonwealths may be eligible for the credit; however, because
the possession or commonwealth in which they live is not able to
offer qualified health insurance, such individuals are generally
unable to access the credit. The proposal would allow certain
possessions and commonwealths to offer qualified health insurance.
Proponents argue that since the credit is targeted to specific
groups of individuals (i.e., individuals receiving benefits under
TAA or from the PBGC), residents of such commonwealths and
possessions who are eligible individuals should not be denied the
credit because their residence cannot offer a qualified State-based
option.
While residents of the possessions and commonwealths are U.S.
citizens, special tax rules apply. Some question whether it is
appropriate to provide a refundable health tax credit to residents of
possessions and commonwealths who may never pay U.S. tax.
Certain other tax credits are not available to such individuals.
For example, the earned income credit and child tax credit are
generally not available to such residents.
____________________________
/90/ There is an exception for those on American Samoa who are U.S.
nationals.
/100/ The refundable child tax credit is available to residents of
the possessions if the individual has three of more qualifying
children and pays FICA or SECA taxes.
Expanded disclosure
The proposal allows disclosure of certain information necessary to
carry out the advance payment program to contractors of providers of
health insurance and provides that providers of health insurance
include employers and administrators of health plans. Proponents
argue that modifying the disclosure provisions is necessary to make
the advance payment program administrable. The proposal would
eliminate uncertainty regarding disclosures permitted for purposes
of the credit. Under present law, disclosure is permitted only to
providers of health insurance. Proponents argue that in order to
facilitate operation of the advance payment program it is necessary
that disclosure of certain information be permitted to employers and
administrators of health plans and to contractors of providers of
health insurance.
Since advance payment of the credit became available August 1, 2003,
a consent mechanism has been used to the extent that disclosures not
technically permitted under the statute are necessary. Proponents
argue that clarifying the disclosure provisions statutorily would
simplify administration of the credit.
Many believe that taxpayer information should be highly safeguarded
and that any expansion of the disclosure rules should be as narrow
as possible. For example, some argue that, given the breadth of the
present-law statute, the use of contractors could expand
significantly the risk of unauthorized disclosure of sensitive
information. Some argue that if present law were narrowed to the
discrete items relating to the health program, such risk would be
diminished. Others argue that items such as taxpayer identification
numbers and health insurance membership are commonly obtained by the
health plans and are not as sensitive as other return information.
State continuation coverage
The proposal providing that State continuation coverage
automatically qualifies as qualified health insurance results in
removing certain State-based coverage requirements from State
continuation coverage. These requirements include guaranteed issue,
no imposition of preexisting conditions (as modified by this
proposal), nondiscriminatory premiums and similar benefits.
Proponents argue that many States lack qualified State-based
coverage and allowing State continuation coverage to automatically
qualify would allow more individuals access to the credit.
Proponents also argue that since State continuation coverage is
similar to COBRA continuation, which is not subject to the
State-based coverage requirements, it is appropriate to waive
such requirements for State continuation coverage. Proponents
argue that it is inappropriate for the State-based coverage
requirements to apply to State continuation coverage as certain
rules applicable to State continuation coverage are inconsistent
with such requirements.
Critics argue that it is extremely important for individuals to
have the protections relating to guaranteed issue, preexisting
conditions, nondiscriminatory premiums and similar benefits.
They argue that if the applicable requirements are waived,
individuals will lose valuable rights with respect to their health
care. In addition, opponents argue that if State continuation
coverage automatically meets the requirements for qualified health
insurance, States will be less inclined to work towards producing a
qualifying option that includes the otherwise applicable
requirements. Critics of the proposal argue that if all State-based
coverage must satisfy the requirements, States will eventually
produce a qualifying option which will allow its citizens access to
the credit while retaining the important consumer protections.
This change is viewed by critics as a substantive change from
what was originally intended, rather than a clarification of present
law.
Other specified coverage of alternative TAA recipients
The proposal also changes the definition of other specified coverage
for eligible alternative TAA recipients by removing the special rule
that applies only to alternative TAA recipients, which results in
applying the same definition of other specified coverage to all
eligible individuals. Under the proposal, for all eligible
individuals, specified coverage would include coverage under a health
plan maintained by an employer (except for insurance substantially
all of which is for excepted benefits) than pays at least 50 percent
of the cost of coverage and certain governmental health programs.
Proponents argue that the proposal would reduce complexity in
administering the credit, as similar rules would apply to all
individuals. Some argue that despite the complexity in having
different rules, the special rule for alternative TAA recipients
should be retained.
Prior Action
Several components of the proposal were included in the President's
fiscal year 2005 budget proposal.
5. Expand human clinical trial expenses qualifying for the orphan
drug tax credit
Present Law
Taxpayers may claim a 50-percent credit for expenses related to
human clinical testing of drugs for the treatment of certain rare
diseases and conditions, generally those that afflict less
than 200,000 persons in the United States. Qualifying expenses are
those paid or incurred by the taxpayer after the date on which
the drug is designated as a potential treatment for a rare disease
or disorder by the Food and Drug Administration ("FDA") in
accordance with section 526 of the Federal Food, Drug, and
Cosmetic Act.
Description of Proposal
The proposal expands qualifying expenses to include those expenses
related to human clinical testing paid or incurred after the date on
which the taxpayer files an application with the FDA for designation
of the drug under section 526 of the Federal Food, Drug, and
Cosmetic Act as a potential treatment for a rare disease or
disorder, if certain conditions are met. Under the proposal,
qualifying expenses include those expenses paid or incurred after
the date on which the taxpayer files an application with the FDA
for designation as a potential treatment for a rare disease or disorder
if the drug receives FDS designation before the due date (including
extensions) for filing the tax return for the taxable year in which
the application was filed with the FDA. As under present law, the
credit may only be claimed for such expenses related to drugs
designated as a potential treatment for a rare disease or disorder
by the FDA in accordance with section 526 of such Act.
Effective date.--The provision is effective for qualified
expenditures incurred after December 31, 2004.
Analysis
Approval for human clinical testing and designation as a potential
treatment for a rare disease or disorder require separate reviews
within the FDA. As a result, in some cases, a taxpayer may be
permitted to begin human clinical testing prior to a drug being
designated as a potential treatment for a rare disease or disorder.
If the taxpayer delays human clinical testing in order to obtain the
benefits of the orphan drug tax credit, which currently may be
claimed only for expenses incurred after the drug is designated as
a potential treatment for a rare disease or disorder, valuable time
will have been lost and Congress's original intent in enacting the
orphan drug tax credit will have been partially thwarted.
For those cases where the process of filing an application and
receiving designation as a potential treatment for a rare disease or
disorder occurs sufficiently expeditiously to fall entirely within
the taxpayer's taxable year plus permitted filing extension, the
proposal removes the potential financial benefit from delaying
clinical testing. While such an outcome may well describe most
applications, in some cases, particularly for applications filed
near the close of a taxpayer's taxable year, there may be some
uncertainty that designation will be made in a timely manner.
In such a case, the taxpayer is in the same position as present
law and may choose to delay filing the appropriate application
until the beginning of his next taxable year.
The FDA is required to approve drugs for human clinical testing.
Such approval creates a unique starting point from which human
clinical testing expenses can be measured. An alternative proposal
would be to expand qualifying expenses to include those expenses
paid or incurred after the date on which the taxpayer files an
application with FDA for designation of the drug as a potential
treatment for a rare disease or disorder, regardless of whether
the designation is approved during the taxable year in which the
application is filed. Such an alternative proposal would provide
more certainty to the taxpayer regarding clinical expenses eligible
for the credit. However, unlike the current proposal, such an
alternative may create the additional taxpayer burden of requiring
the taxpayer to file an amended return to claim credit for
qualifying costs related to expenses incurred in a taxable year
prior to designation.
The staff of the Joint Committee on Taxation recommended a change
similar to the current proposal as part of its 2001 simplification
study.
Prior Action
An identical proposal was part of the President's fiscal year 2005
budget proposal. A similar proposal was part of the President's
fiscal year 2004 budget proposal.
___________________
/101/ Joint Committee on Taxation, Study of the Overall State of
the Federal Tax System and Recommendations for Simplification,
Pursuant to Section 8022(3)(b) of the Internal Revenue Code of 1986,
Vol. II (JCS-3-01), April 2001, at 310.
C. Provisions Relating to Charitable Giving
1. Permit tax-free withdrawals from individual retirement
arrangements for charitable contributions
Present Law
In general
If an amount withdrawn from a traditional individual retirement
arrangement ("IRA") or a Roth IRA is donated to a charitable
organization, the rules relating to the tax treatment of withdrawals
from IRAs apply, and the charitable contribution is subject to the
normally applicable limitations on deductibility of such
contributions.
Charitable contributions
In computing taxable income, an individual taxpayer who itemizes
deductions generally is allowed to deduct the amount of cash and up
to the fair market value of property contributed to an organization
described in section 170(c), including charities and Federal, State,
and local governmental entities. The deduction also is allowed for
purposes of calculating alternative minimum taxable income.
The amount of the deduction allowable for a taxable year with
respect to a charitable contribution of property may be reduced
depending on the type of property contributed, the type of charitable
organization to which the property is contributed, and the income of
the taxpayer.
A payment to a charity (regardless of whether it is termed a
"contribution") in exchange for which the donor receives an economic
benefit is not deductible, except to the extent that the donor can
demonstrate that the payment exceeds the fair market value of the
benefit received from the charity. To facilitate distinguishing
charitable contributions from purchases of goods or services from
charities, present law provides that no charitable contribution
deduction is allowed for a separate contribution of $250 or more
unless the donor obtains a contemporaneous written acknowledgement of
the contribution from the charity indicating whether the charity
provided any good or service (and an estimate of the value of any
such good or service) to the taxpayer in consideration for the
contribution. In addition, present law requires that any charity
that receives a contribution exceeding $75 made partly as a gift
and partly as consideration for goods or services furnished by the
charity (a "quid pro quo" contribution) is required to inform the
contributor in writing of an estimate of the value of the goods
or services furnished by the charity and that only the portion
n exceeding the value of the goods or services is deductible as a
charitable contribution.
_____________________
/102/ Secs. 170(b) and (c).
/103/ Sec. 170(f)(8).
/104/ Sec. 6115.
Under present law, total deductible contributions of an individual
taxpayer to public charities, private operating foundations, and
certain types of private nonoperating foundations may not exceed 50
percent of the taxpayer's contribution base, which is the taxpayer's
adjusted gross income for a taxable year (disregarding any net
operating loss carryback). To the extent a taxpayer has not
exceeded the 50-percent limitation, (1) contributions of capital
gain property to public charities generally may be deducted up to 30
percent of the taxpayer's contribution base; (2) contributions of
cash to private foundations and certain other charitable
organizations generally may be deducted up to 30 percent of the
taxpayer's contribution base; and (3) contributions of capital gain
property to private foundations and certain other charitable
organizations generally may be deducted up to 20 percent of the
taxpayer's contribution base.
Contributions by individuals in excess of the 50-percent, 30-percent,
and 20-percent limits may be carried over and deducted over the next
five taxable years, subject to the relevant percentage limitations
on the deduction in each of those years.
In addition to the percentage limitations imposed specifically on
charitable contributions, present law imposes an overall limitation
on most itemized deductions, including charitable contribution
deductions, for taxpayers with adjusted gross income in excess of a
threshold amount, which is indexed annually for inflation. The
threshold amount for 2005 is $145,950 ($72,975 for married
individuals filing separate returns). For those deductions that
are subject to the limit, the total amount of itemized deductions is
reduced by three percent of adjusted gross income over the threshold
amount, but not by more than 80 percent of itemized deductions
subject to the limit. Beginning in 2006, the Economic Growth and
Tax Relief Reconciliation Act of 2001 phases out the overall
limitation on itemized deductions for all taxpayers. The overall
limitation on itemized deductions is reduced by one-third in taxable
years beginning in 2006 and 2007, and by two-thirds in taxable years
beginning in 2008 and 2009. The overall limitation on itemized
deductions is eliminated for taxable years beginning after
December 31, 2009; however, this elimination of the limitation
sunsets on December 31, 2010.
In general, a charitable deduction is not allowed for income, estate,
or gift tax purposes if the donor transfers an interest in property
to a charity (e.g., a remainder) while also either retaining an
interest in that property (e.g., an income interest) or transferring
an interest in that property to a noncharity for less than full and
adequate consideration. Exceptions to this general rule are
provided for, among other interests, remainder interests in
charitable remainder annuity trusts, charitable remainder unitrusts,
and pooled income funds, and present interests in the form of a
guaranteed annuity or a fixed percentage of the annual value of the
property. For such interests, a charitable deduction is allowed
to the extent of the present value of the interest designated for a
charitable organization.
___________________
/105/ Secs. 170(f), 2055(e)(2), and 2522(c)(2).
/106/ Sec. 170(f)(2).
IRA rules
Within limits, individuals may make deductible and nondeductible
contributions to a traditional IRA. Amounts in a traditional IRA
are includible in income when withdrawn (except to the extent the
withdrawal represents a return of nondeductible contributions).
Individuals also may make nondeductible contributions to a Roth
IRA. Qualified withdrawals from a Roth IRA are excludable from gross
income. Withdrawals from a Roth IRA that are not qualified
withdrawals are includible in gross income to the extent
attributable to earnings. Includible amounts withdrawn from a
traditional IRA or a Roth IRA before attainment of age 59--are
subject to an additional 10-percent early withdrawal tax, unless
an exception applies.
If an individual has made nondeductible contributions to a
traditional IRA, a portion of each distribution from an IRA is
nontaxable, until the total amount of nondeductible contributions
has been received. In general, the amount of a distribution that
is nontaxable is determined by multiplying the amount of the
distribution by the ratio of the remaining nondeductible
contributions to the account balance. In making the calculation,
all traditional IRAs of an individual are treated as a single
IRA, all distributions during any taxable year are treated as a
single distribution, and the value of the contract, income on the
contract, and investment in the contract are computed as of the
close of the calendar year.
In the case of a distribution from a Roth IRA that is not a
qualified distribution, in determining the portion of the
distribution attributable to earnings, contributions and
distributions are deemed to be distributed in the following
order: (1) regular Roth IRA contributions; (2) taxable conversion
contributions; (3) nontaxable conversion contributions; and
(4) earnings. In determining the amount of taxable distributions
from a Roth IRA, all Roth IRA distributions in the same taxable
year are treated as a single distribution, all regular Roth IRA
contributions for a year are treated as a single contribution, and
all conversion contributions during the year are treated as a
single contribution.
Traditional IRAs are subject to minimum distribution rules, under
which distributions from the IRA must generally begin by the April 1
of the calendar year following the year in which the IRA owner
attains age 70.
Traditional and Roth IRAs are subject to post-death minimum
distribution rules that require that distributions upon the death
of the IRA owner must begin by a certain time.
Description of Proposal
The proposal provides an exclusion from gross income for otherwise
taxable IRA withdrawals from a traditional or a Roth IRA for
distributions to a qualified charitable organization. The exclusion
does not apply to indirect gifts to a charity through a split
interest entity, such as a charitable remainder trust, a pooled
income fund, or a charitable gift annuity. The exclusion is
available for distributions made on or after the date the IRA owner
_____________________
/107/ Conversion contributions refer to conversions of amounts in a
traditional IRA to Roth IRA.
attains age 65 and applies only to the extent the individual does
not receive any benefit in exchange for the transfer.
Amounts transferred directly from the IRA to the qualified
charitable organization are treated as a distribution for purposes
of the minimum distribution rules applicable to IRAs.
No charitable contribution deduction is allowed with respect to any
amount that is excluded from income under this provision. Amounts
transferred from the IRA to the qualified organization that would
not be taxable if transferred directly to the individual, such as
a qualified distribution from a Roth IRA or the return of
nondeductible contributions from a traditional IRA, are subject
to the present law charitable contribution deduction rules.
Effective date.--The proposal is effective for distributions made
after the date of enactment.
Analysis
Policy issues
In general, the proposal is intended to enable IRA owners to give a
portion of their IRA assets to charity without being subject to the
charitable contribution percentage limitations or the overall
limitation on itemized deductions. Present law requires an IRA owner
to take the IRA distribution into income, give the money to a
qualified charity, and then claim a deduction for the gift.
However, the deduction is subject to the percentage limitations of
section 170 and to the overall limit on itemized deductions.
The proposal will avoid these limitations and therefore might
encourage additional charitable giving by increasing the tax benefit
of the donation for those who would not be able to fully deduct the
donation by reason of the present-law limitations. However, some
argue that the proposal merely avoids present-law limitations on
charitable contributions that will be made in any event and will
not encourage additional giving.
Further, some question the appropriateness of limiting the tax
benefits of the provision to IRA owners. That is, if the limits on
charitable deductions are determined to be undesirable, they should
be removed for all taxpayers, not only those that are able to make
charitable contributions through an IRA. In addition, the proposal
will alter present law and give IRA owners a tax benefit for
charitable contributions even if they do not itemize deductions.
For example, under present law, a taxpayer who takes the standard
deduction cannot claim a charitable contribution deduction; however,
under the proposal, a taxpayer can both claim the standard deduction
and benefit from the exclusion. It might be beneficial for taxpayers
who itemize their deductions but have a significant amount of
charitable deductions to make their charitable contributions through
the IRA and then claim the standard deduction.
In addition, some argue that the proposal inappropriately will
encourage IRA owners to use retirement monies for nonretirement
purposes (by making such use easier and providing greater tax
benefits in some cases). To the extent that the proposal will spur
additional gifts by circumventing the percentage limitations, IRA
owners may spend more of their retirement money for nonretirement
purposes than under present law. Some also argue that, in the early
years of retirement, an individual might not accurately assess his
or her long-term retirement income needs. For example, the
individual might not make adequate provision for health care or
long-term care costs later in life. Some therefore argue that IRA
distributions to charity should be permitted, if at all, only after
age 70.
Complexity issues
The proposal adds complexity to the tax law by creating an
additional set of rules applicable to charitable donations.
Taxpayers who own IRAs and make such donations will need to review
two sets of rules in order to determine which applies to them and
which is the most advantageous. The proposal may increase the
complexity of making charitable contributions because individuals
who are able and wish to take advantage of the tax benefits provided
by the proposal will need to make the donation through the IRA rather
than directly. The proposal also may increase complexity in tax
planning as the proposal might make it beneficial for some taxpayers
to take the standard deduction and make all charitable contributions
through their IRAs.
In some cases, taxpayers may need to apply both sets of rules to a
single contribution from an IRA. This will occur if the IRA
distribution includes both taxable amounts (which would be subject
to the rules in the proposal) and nontaxable amounts (which would be
subject to the present-law rules). As discussed above, the effect
of the proposal is to eliminate certain present-law limits on
charitable deductions for IRA owners. A simpler approach is to
eliminate such limits with respect to all charitable contributions.
Providing a single rule for charitable contributions would make the
charitable deduction rules easier to understand for all taxpayers
making such contributions.
Prior Action
A similar proposal was included in the President's fiscal years 2004
and 2005 budget proposals. The President's fiscal years 2002 and
2003 budget proposals included a similar proposal, except that the
exclusion would have applied to distributions made on or after the
date the IRA owner attained age 59-�.
In the 108th Congress, S. 476, the "CARE Act of 2003," as agreed to
by the Senate on April 9, 2003, included a similar provision that
would have provided an exclusion for an otherwise taxable
distribution from an IRA that was made (1) directly to a charitable
organization on or after the date the IRA owner attains age 70-�, or
(2) to a split-interest entity on or after the date the IRA owner
attains age 59-�. H.R. 7, the "Charitable Giving Act of 2003," as
passed by the House of Representatives on September 17, 2003,
included a similar provision, except the H.R. 7 provision would have
applied to distributions made directly to a charitable organization
or to a split-interest entity only on or after the date the IRA
owner reaches age 70-� and the exclusion would not have applied to
distributions from SIMPLE IRAs or simplified employee pensions.
2. Expand and increase the enhanced charitable deduction for
contributions of food inventory
Present Law
Under present law, a taxpayer's deduction for charitable
contributions of inventory generally is limited to the taxpayer's
basis (typically, cost) in the inventory. However, for certain
contributions of inventory, C corporations may claim an enhanced
deduction equal to the lesser of (1) the taxpayer's basis in the
contributed property plus one-half of the property's appreciated
value (i.e., basis plus one-half of fair market value in excess of
basis) or (2) two times basis.
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) (other than a
private nonoperating foundation), and the donee must (1) use the
property consistent with the donee's exempt purpose solely for the
care of the ill, the needy, or infants, (2) not transfer the
property in exchange for money, other property, or services, and
(3) provide the taxpayer a written statement that the donee's use of
the property will be consistent with such requirements. In the case
of contributed property subject to the Federal Food, Drug, and
Cosmetic Act, the property must satisfy the applicable requirements
of such Act on the date of transfer and for 180 days prior to
the transfer.
To claim the enhanced deduction, the taxpayer must establish that
the fair market value of the donated item exceeds basis. The
valuation of food inventory has been the subject of ongoing disputes
between taxpayers and the IRS. In one case, the Tax Court held that
the value of surplus bread inventory donated to charity was the full
retail price of the bread rather than half the retail price, as the
IRS asserted.
Description of Proposal
Under the proposal, the enhanced deduction for donations of food
inventory is increased to the lesser of (1) fair market value, or
(2) two times the taxpayer's basis in the contributed inventory.
In addition, any taxpayer engaged in a trade or business, whether or
not a C corporation, is eligible to claim an enhanced deduction for
donations of food inventory. The deduction for donations by S
corporations and noncorporate taxpayers is limited to 10 percent of
the net income from the associated trade or business. The proposal
provides a special rule that would permit certain taxpayers with a
zero or low basis in the food donation (e.g., taxpayers that
use the cash method of accounting for purchases and sales, and
taxpayers that are not required to capitalize indirect costs) to
assume a basis equal to 25 percent of the food's fair market value.
In such cases, the allowable charitable deduction will equal 50
percent of the food's fair market value. The enhanced deduction for
food inventory will be available only for food that qualifies as
"apparently wholesome food" (defined as food that is intended for
human consumption that meets all quality and labeling standards
imposed by Federal, State, and local laws and regulations even
though the food may not be readily marketable due to appearance,
age, freshness, grade, size, surplus, or other conditions). The
proposal provides that the fair market value of apparently wholesome
food that cannot or will not be sold solely due to internal
standards of the taxpayer or lack of market would be determined by
taking into account the price at which the same or substantially the
same food items (taking into account both type and quality) are sold
by the taxpayer at the time of the contribution or, if not so sold
at such time, in the recent past.
______________________
/108/ Sec. 170(e)(3).
/109/ Lucky Stores Inc. v. Commissioner, 105 T.C. 420 (1995).
Effective date.--The proposal is effective for taxable years
beginning after December 31, 2004.
Analysis
Policy issues
In the absence of the enhanced deduction of present law, if the
taxpayer were to dispose of excess inventory by dumping the excess
food in a garbage dumpster, the taxpayer generally could claim the
purchase price of the inventory (the taxpayer's basis in the
property) as an expense against his or her gross income. In the
absence of the enhanced deduction of present law, if the taxpayer
were to donate the excess food inventory to a charitable
organization that maintains a food bank, the taxpayer generally
would be able to claim a charitable deduction equal to the
taxpayer's basis in the food inventory (subject to certain limits on
charitable contributions). Viewed from the taxpayer's profit
motive, the taxpayer would be indifferent between donating the food
or dumping the food in a garbage dumpster. If the taxpayer must
incur cost to deliver the food to the charity that maintains the
food bank, the taxpayer would not find it in his or her financial
interest to donate the excess food inventory to the food bank.
The enhanced deduction creates an incentive for the taxpayer to
contribute excess food inventory to charitable organizations that
provide hunger relief.
In general, the proposal is intended to give businesses greater
incentive to contribute food to those in need. By increasing the
value of the enhanced deduction, up to the fair market value of the
food, and by clarifying the definition of fair market value, the
proposal is intended to encourage more businesses to donate more
food to charitable organizations that provide hunger relief.
However, some argue that if the intended policy is to support food
programs for the needy, it would be more direct and efficient to
provide a direct government subsidy instead of making a tax
expenditure through the tax system, which may result in abuse and
cannot be monitored under the annual budgetary process. On the
other hand, proponents of the proposal likely would argue that a
government program would be less effective in identifying the needy
and overseeing delivery of the food than would the proposal.
More specifically, critics argue that the definition of fair market
value under the proposal is too generous because it may permit
taxpayers to claim as fair market value the full retail price of
food that was no longer fresh when donated. If so, taxpayers might
be better off contributing the food to charity than by selling the
food in the ordinary course of their business. For example,
assume a taxpayer whose income is taxed at the highest corporate
income tax rate of 35 percent has purchased an avocado for $0.75.
The taxpayer previously could have sold the avocado for $1.35, but
now could only sell the avocado for $0.30. If the taxpayer sold the
avocado for $0.30, the taxpayer would incur a loss of $0.45 ($0.75
basis minus $0.30 sales revenue) on the sale.
Because the loss on the sale of the avocado reduces the taxpayer's
____________________
/110/ See generally Louis Alan Talley, "Charitable Contributions
of Food Inventory: Proposals for Change Under the 'Community
Solutions Act of 2001,'" Congressional Research Service Report for
Congress (August 23, 2001).
taxable income, the taxpayer's tax liability would decline by
approximately $0.16 ($0.45 multiplied by 35 percent), so the net
loss from the sale in terms of after-tax income would be $0.29.
If, alternatively, the taxpayer had donated the avocado to the local
food bank, and under the proposal were allowed to claim a deduction
for the previous fair market value of $1.35, the taxpayer's taxable
income would be reduced by $1.35 resulting in a reduction in tax
liability of approximately $0.47 ($1.35 multiplied by 35 percent).
However, the taxpayer originally purchased the avocado for $0.75
and, as the avocado is donated, this expense cannot be deducted as a
cost of goods sold. By donating the avocado, the taxpayer's net loss
on the avocado is $0.28 (the $0.47 in income tax reduction minus the
cost of acquiring the avocado, $0.75). Under the proposal, the
taxpayer loses less on the avocado by donating the avocado to
charity than by selling the avocado.
This possible outcome is a result of permitting a deduction for a
value that the taxpayer may not be able to achieve in the market.
Whether sold or donated, the taxpayer incurred a cost to acquire the
good. When a good is donated, it creates "revenue" for the taxpayer
by reducing his or her taxes otherwise due. When the value deducted
exceeds the revenue potential of an actual sale, the tax savings
from the charitable deduction can exceed the sales revenue from a
sale. While such an outcome is possible, in practice it may not be
the norm. In part because the proposal limits the enhanced
deduction to the lesser of the measure of fair market value or twice
the taxpayer's basis, it can only be more profitable to donate food
than to sell food if the taxpayer would otherwise be selling the
food to be donated at a loss. In general, it depends upon the
amount by which the deduction claimed exceeds the taxpayer's basis
in the food relative to the extent of the loss the taxpayer would
incur from a sale.
_____________________
/111/ In general, it is never more profitable to donate food than to
sell food unless the taxpayer is permitted to deduct a value other
than the current fair market value of the food. To see this:
let Y denote the taxpayer's pre-tax income from all other business
activity;
let B denote the taxpayer's acquisition cost (basis) of the item
to be donated;
let a represent the percentage by which the permitted deduction
exceeds the taxpayer's basis, that is aB equals the value of the
deduction permitted;
let B equal the current market value as a percentage of the
taxpayer's basis in the item, that is the revenue that could be
attained from sale is BB;
and let t denote the taxpayer's marginal tax rate.
Further assume that B < 1 < a, that is, at the current market value
the taxpayer would be selling at a loss, but previously the taxpayer
could sell at a profit.
The taxpayer's after-tax income from sale of the item is
(Y + BB -- B)(1-t).
Under the proposal, the taxpayer's after-tax income from contribution
of the item is Y � B � t(Y � aB). For the case in which the
permitted deduction would exceed twice the
In addition, to the extent the proposal would subsidize food
disposal, companies producing food may take less care in managing
their inventories and might have less incentive to sell aging food
by lowering prices, knowing that doing so might also reduce the
value of an eventual deduction. Critics also argue that the
proposal would in effect provide a deduction for the value of
services, which are not otherwise deductible, because in some
cases, services are built into the fair market value of food.
Complexity issues
The proposal has elements that may both add to and reduce complexity
of the charitable contribution deduction rules. Under present law,
the general rule is that charitable gifts of inventory provide the
donor with a deduction in the amount of the donor's basis in the
inventory. The Code currently contains several exceptions: a special
rule for contributions of inventory that is used by the donee solely
for the care of the ill, the needy, or infants, a special rule for
contributions of scientific property used for research, and a
special rule for contributions of computer technology and equipment
used for educational purposes. Each special rule has distinct
requirements. The proposal would add another special rule, with
its own distinct requirements, thereby increasing the complexity of
an already complex section of the Code. The proposal also could
decrease complexity, however, because it would provide a definition
of fair market value. Under current law, valuation of food
____________________
taxpayer's basis, the taxpayer's after-tax income from contribution
of the item is Y -- B --1(Y -- 2B0.
It is more profitable to donate the item than to sell it when the
following inequality is satisfied.
(1) (Y + B-- B)(1-t) < Y -- B -- t(Y -- aB).
This inequality reduces to:
(2) B/(B + (a-1)) < t.
Whether it is more profitable to donate food than to sell food
depends upon the extent to which the food would be sold at a loss
(B) relative to the extent of the loss plus the extent to which the
permitted deduction exceeds the taxpayer's basis (a-1), compared to the taxpayer's marginal tax rate. Because under present law, the
marginal tax rate is 0.35, equation (2) identifies conditions on the
extent of loss and the permitted deduction that could create a
situation where a charitable contribution produces a smaller loss
than would a market sale, such as the example in the text. In the
case where the taxpayer's deduction would be limited to twice basis,
it is possible to show that for a marginal tax rate of 35 percent,
the current market value of the item to be donated must be less
than 53.8 percent of the taxpayer's basis in the item, that is,
<0.538.
/112/ See Martin A. Sullivan, "Economic Analysis: Can Bush Fight
Hunger With a Tax Break?," Tax Notes, vol. 94, February 11, 2002,
at 671.
inventory has been a disputed issue between taxpayers and the IRS
and a cause of uncertainty for taxpayers when claiming the deduction.
Another interpretative issue could arise in deciding whether the
contributed food is "substantially" the same as other food items sold
by the taxpayer for purposes of determining fair market value of
the food.
Taxpayers who contribute food inventory must consider multiple
factors to ensure that they deduct the permitted amount (and no more
than the permitted amount) with respect to contributed food.
Taxpayers who are required to maintain inventories for their food
purchases must compare the fair market value of the contributed food
with the basis of the food (and twice the basis of the food), and
coordinate the resulting contribution deduction with the
determination of cost of goods sold. Taxpayers who are not
required to maintain inventories for their food purchases generally
will have a zero or low basis in the contributed food, but are
permitted to use a deemed basis rule that provides such taxpayers
a contribution deduction equal to 50 percent of the food's fair
market value. Taxpayers who are not required to maintain
inventories need not coordinate cost of goods sold deductions or
inventory adjustments with contribution deductions, and are not
required to recapture the previously expensed costs associated with
the contributed food.
Prior Action
The President's fiscal year 2003, 2004 and 2005 budget proposals
contained a similar proposal.
3. Reform excise tax based on investment income of private
foundations
Present Law
Under section 4940(a) of the Code, private foundations that are
recognized as exempt from Federal income tax under section 501(a) of
the Code are subject to a two-percent excise tax on their net
investment income. Private foundations that are not exempt from
tax, such as certain charitable trusts, also are subject to an
excise tax, under section 4940(b).
Net investment income generally includes interest, dividends, rents,
royalties, and capital gain net income, and is reduced by expenses
incurred to earn this income. The two-percent rate of tax is
reduced to one-percent in any year in which a foundation exceeds the
average historical level of its charitable distributions.
Specifically, the excise tax rate is reduced if the foundation's
qualifying distributions (generally, amounts paid to accomplish
exempt purposes) equals or exceeds the sum of (1) the amount of
the foundation's assets for the taxable year multiplied by the
average percentage of the foundation's qualifying distributions over
the five taxable years immediately preceding the taxable year in
question, and (2) one percent of the net investment income of the
____________________
/113/ Such taxpayers must remove the amount of the contribution
deduction for the contributed food inventory from opening inventory,
and do not treat the removal as a part of cost of goods sold. IRS
Publication 526, Charitable Contributions, at 7-8.
/114/ Sec. 4942(g).
foundation for the taxable year. In addition, the foundation cannot
have been subject to tax in any of the five preceding years for
failure to meet minimum qualifying distribution requirements.
The tax on taxable private foundations under section 4940(b) is
equal to the excess of the sum of the excise tax that would have
been imposed under section 4940(a) if the foundation was tax exempt
and the amount of the unrelated business income tax that would have
been imposed if the foundation were tax exempt, over the income tax
imposed on the foundation under subtitle A of the Code. Exempt
operating foundations are exempt from the section 4940 tax.
Nonoperating private foundations are required to make a minimum
amount of qualifying distributions each year to avoid tax under
section 4942. The minimum amount of qualifying distributions a
foundation has to make to avoid tax under section 4942 is reduced by
the amount of section 4940 excise taxes paid.
Description of Proposal
The proposal replaces the two rates of excise tax on private
foundations with a single rate of tax and sets the rate at one
percent. Thus, under the proposal, a tax-exempt private foundation
is subject to tax on one percent of its net investment income. A
taxable private foundation is subject to tax on the excess of the
sum of the one percent excise tax and the amount of the unrelated
business income tax (both calculated as if the foundation were
tax-exempt) over the income tax imposed on the foundation. The
proposal repeals the special one-percent excise tax for private
foundations that exceed their historical level of qualifying
distributions.
Effective date.�The proposal is effective for taxable years
beginning after December 31, 2004.
Analysis
The proposal has the effect of increasing the required minimum
charitable payout for private foundations that pay the excise tax at
the two-percent rate. This may result in increased charitable
distributions for private foundations that pay only the minimum in
charitable distributions under present law. For example, if a
foundation is subject to the two-percent excise tax on net investment
income, the foundation reduces the amount of required charitable
distributions by the amount of excise tax paid. Because the
proposal decreases the amount of excise tax paid on net investment
income for such foundations, the proposal increases such foundations'
required minimum amount of charitable distributions by an amount
equal to one percent of the foundation's net investment income.
Thus, the proposal results in an increase of charitable
distributions in the case of foundations paying the two-percent rate
and distributing no greater than the required minimum under present
law. Foundations paying the two-percent rate that exceed the
required minimum under present law generally would not have to
increase their charitable distributions as a result of the proposal.
Although the required minimum amount of charitable distributions
would increase for such foundations, such foundations already make
distributions exceeding the minimum and so generally would not have
to increase charitable distributions as a result of the proposal
(except to the extent that the increase in the required minimum
amount was greater than the excess of a private foundation's
charitable distributions over the required minimum amount of present
law). However, a reduction in the excise tax rate from 2 percent to
1 percent may result in increased charitable distributions to the
extent that a foundation decides to pay out the amount that otherwise
would be paid in tax for charitable purposes.
The proposal also eliminates the present-law two-tier tax structure.
Some have suggested that the two-tier excise tax is an incentive for
foundations to increase the amounts they distribute to charities.
Critics of the present-law two-tier excise tax have criticized the
efficiency of the excise tax as an incentive to increase payout
rates. First, critics note, the reduction in excise tax depends
only upon an increase in the foundation's rate of distributions to
charities, not on the size of the increase in the rate of
distributions. Thus, a large increase in distributions is rewarded
by the same reduction in excise tax rate as is a small increase in
distributions. There is no extra incentive to make a substantial
increase in distributions rather than a quite modest increase in
distributions.
In addition, critics assert that, under a number of circumstances,
the present-law two-tier excise tax can create a disincentive for
foundations to increase charitable distributions substantially.
In order to take advantage of the one-percent excise tax rate, a
private foundation must increase its rate of charitable
distributions in the current year above that which prevailed in the
preceding five years. Whether the present-law two-tier excise tax
creates an incentive or disincentive to increased payout rates
depends, in part, on whether the foundation currently is subject to
the one-percent tax rate or the two-percent tax rate. Because modest
increases in payout rates qualify a foundation for the one-percent
tax rate, some analysts suggest that a foundation may be able to
manage its distributions actively so that the foundation qualifies
for the one-percent tax rate without substantially increasing its
payout rate. For a foundation subject to the one-percent rate in
the current year, an increased payout in any year becomes part
of the computation to determine eligibility for the one-percent rate
in future years. Thus, under the present-law formula, the foundation
can trigger the two-percent excise tax rate by increasing the payout
amount in a particular year because increased payouts make it more
difficult for the foundation to qualify for the one-percent rate in
subsequent years, and it increases the possibility that the
foundation will become subject to the two-percent tax rate.
Consequently, over time, the one-percent rate provides a disincentive
for increasing charitable distributions.
On the other hand, for a foundation currently subject to the
one-percent excise tax rate and also making charitable distributions
at a rate above the minimum required amount, the present-law two-tier
excise tax can create a disincentive for foundations to reduce their
payout rate. A reduction in payout rate in the future would reduce
the foundation's five-year moving average, thereby increasing the
likelihood the foundation's net investment income is taxed at the
two-percent rate, rather than the one-percent rate.
For a foundation currently subject to the excise tax at the
two-percent rate, an increase in payout may qualify the foundation
for the one-percent excise tax rate. If the increase does qualify
the foundation for the one-percent rate, and the foundation
maintains the same payout for the subsequent four years, the
foundation generally will be eligible for the one-percent tax rate
in each of the five years. Hence the reduced tax rate can create an
incentive to increase payout rates. However, even in the case of a
two-percent excise tax paying foundation, the present-law two-tier
excise tax can create a disincentive for a foundation to increase
charitable distributions substantially in any one year compared to a
strategy of slowly increasing payouts over several years.
For example, consider a foundation which has had a payout rate of
5.0 percent for several years. Suppose the foundation is
considering increasing its payout rate. Consider two possible
strategies: increase the payout rate to 8.0 percent in the current
year followed by rates of 5.5 percent thereafter; or gradually
increase the payout rate by increments of one-tenth of one percent
annually for five years. While a substantial increase in any one
year may qualify the foundation for the one-percent tax rate,
subsequent year payout rates of 5.5 percent would fail to qualify
the foundation for the one- percent tax rate. Thus, under the first
option, the foundation would pay the one-percent tax rate for one
year and be a two-percent tax rate payor subsequently. Under the
second option, the foundation would qualify for the one-percent rate
in each year. However, total payouts are greater under the first
option.
In summary, the incentive effects of the present-law two-tier excise
tax depend upon the situation in which the foundation finds itself
in the current year. In 1999, 42 percent of foundations were
one-percent tax rate payors and 58 percent were two-percent rate
payors. Among large foundations (assets of $50 million or greater)
58 percent were one-percent rate payors and 42 percent were
two-percent rate payors. A number of analysts suggest the optimal
tax strategy for a private foundation is to choose a target rate of
disbursement, maintain that rate in all years, and never fall below
the target in any year.
Critics of the present-law excise tax structure observe that the
median payout rate of large nonoperating private foundations
(foundations with total assets of $50 million or more) was 5.1
or 5.0 percent in each year from 1991 through 1995 and was 5.0
percent in 1999. The median payout rates for foundations with
assets between $10 million and $50 million declined annually from
5.4 percent in 1990 to 5.1 percent in 1995 and 1999. Similarly, the
median payout rates for foundations with assets between $100,000
and $1 million declined from 6.7 percent in 1990 to 5.5 percent in
1995 and 5.4 percent in 1999. Critics of the present-law excise
tax structure argue that these data suggest that the excise tax
structure is not encouraging any noticeable increase in payout
rates.
The proposal reduces complexity for private foundations by replacing
the two-tier tax on net investment income with a one-tier tax.
Under the proposal, private foundations do not have to allocate
resources to figuring which tier of the tax would be applicable or
to planning the optimum payout rate. The proposal also would make
compliance easier for private foundations, as they would not have to
compute a five-year average of charitable distributions on the
information return they file each year.
Prior Action
The President's fiscal year 2003, 2004, and 2005 budget proposals
included a similar proposal.
The President's fiscal year 2001 budget proposal included a similar
proposal, but would have reduced the rate of tax to 1.25 percent.
H.R. 7, the "Charitable Giving Act of 2003," as passed by the House
of Representatives on September 17, 2003, included a similar
proposal.
4. Modify tax on unrelated business taxable income of charitable
remainder trusts
Present Law
A charitable remainder annuity trust is a trust that is required to
pay, at least annually, a fixed dollar amount of at least five
percent of the initial value of the trust to a noncharity for the
life of an individual or for a period of 20 years or less, with the
remainder passing to charity. A charitable remainder unitrust is a
trust that generally is required to pay, at least annually, a fixed
percentage of at least five percent of the fair market value of the
trust's assets determined at least annually to a noncharity for the
life of an individual or for a period 20 years or less, with the
remainder passing to charity.
A trust does not qualify as a charitable remainder annuity trust if
the annuity for a year is greater than 50 percent of the initial
fair market value of the trust's assets. A trust does not qualify
as a charitable remainder unitrust if the percentage of assets that
are required to be distributed at least annually is greater than
50 percent. A trust does not qualify as a charitable remainder
annuity trust or a charitable remainder unitrust unless the value
of the remainder interest in the trust is at least 10 percent of the
value of the assets contributed to the trust.
Distributions from a charitable remainder annuity trust or
charitable remainder unitrust are treated in the following order
as: (1) ordinary income to the extent of the trust's current and
previously undistributed ordinary income for the trust's year in
which the distribution occurred; (2) capital gains to the extent of
the trust's current capital gain and previously undistributed
capital gain for the trust's year in which the distribution
occurred; (3) other income (e.g., tax-exempt income) to the extent
of the trust's current and previously undistributed other income
for the trust's year in which the distribution occurred; and
(4) corpus.
In general, distributions to the extent they are characterized as
income are includible in the income of the beneficiary for the year
that the annuity or unitrust amount is required to be distributed
even though the annuity or unitrust amount is not distributed until
after the close of the trust's taxable year.
Charitable remainder annuity trusts and charitable remainder
unitrusts are exempt from Federal income tax for a tax year unless
the trust has any unrelated business taxable income for the year.
Unrelated business taxable income includes certain debt financed
income. A charitable remainder trust that loses exemption from
income tax for a taxable year is taxed as a regular complex trust.
As such, the trust is allowed a deduction in computing taxable
income for amounts required to be distributed in a taxable year,
not to exceed the amount of the trust's distributable net income for
the year.
Description of Proposal
The proposal imposes a 100-percent excise tax on the unrelated
business taxable income of a charitable remainder trust. This
replaces the present-law rule that removes the income tax exemption
of a charitable remainder trust for any year in which the trust has
any unrelated business taxable income. Under the proposal, the tax
is treated as paid from corpus. The unrelated business taxable
income is considered income of the trust for purposes of determining
the character of the distribution made to the beneficiary.
Effective date.�The proposal is effective for taxable years
beginning after December 31, 2004, regardless of when the trust was
created.
Analysis
The proposal is intended to produce a better result than present law
for trusts that have only small or inadvertent amounts of unrelated
business taxable income. The present-law rule that any amount of
unrelated business taxable income results in loss of tax-exemption
for the year discourages trusts from making investments that might
generate insignificant (or inadvertent) unrelated business taxable
income. A loss of exemption could be particularly punitive in a
year in which a trust sells, for example, the assets that originally
funded the trust and does not distribute the proceeds. The proposal
avoids this result by requiring a trust to pay the amount of the
unrelated business taxable income as an excise tax but does not
require the trust to pay tax on all of its other income for the
year. In addition, the proposal is helpful to trusts that receive
unrelated business taxable income as a result of a change in the
status of the entity in which trust assets are invested. However,
the proposal also may enable trusts to choose to make certain
investments that have small amounts of unrelated business income that
are and some may argue should be discouraged by present law.
For example, investments in rental property may generate a small
amount of unrelated business taxable income from fees for services
provided to tenants. Such investments may be unattractive for
charitable remainder trusts under present law because the unrelated
income causes the trust to lose exemption. Under the proposal,
however, a rental property owner might have an incentive to
contribute the rental property to a charitable remainder trust
(of which the owner was beneficiary) to shelter the rental income
from tax (to the extent the rental income exceeds the unitrust
amount or annuity payment). Some argue that charitable remainder
trusts should not be encouraged to make such investments.
The proposal also is intended to be a more effective deterrent than
present law to prevent charitable remainder trusts from investing in
assets that generate large amounts of unrelated business taxable
income. Although present law requires that a charitable remainder
trust become a taxable trust for a year in which the trust has
unrelated business taxable income, a charitable remainder trust
nevertheless may invest in assets that produce significant unrelated
business income but pay tax only on the trust's undistributed income.
This is because, as a taxable trust, the trust may take a deduction
for distributions of income that are taxable to the beneficiaries.
(To the extent the trust pays tax, trust assets are depleted to the
detriment of the charitable beneficiary.) Thus, proponents argue
that the proposal better deters trusts from making investments that
generate significant unrelated business taxable income because the
100 percent excise tax would be prohibitive. On the other hand,
some question whether such a deterrent is the right policy in cases
where a trustee determines that investment in assets that produce
unrelated business taxable income will increase the (after tax)
rate of return to the trust (and thus inure to the benefit of the
charitable remainderman).
The proposal provides that unrelated business taxable income is
treated as ordinary income to the trust and taxes are paid from
corpus. Thus, the proposal treats the trust beneficiary the same
as under present law, that is, distributions of the unrelated
business income are taxed as ordinary income to the beneficiary.
As result, the proposed rule in effect taxes the unrelated business
income twice, once as an excise tax (at a 100-percent rate), and
again when distributed. (Double taxation presently exists to the
extent that the trust's income from all sources exceeds the amount
distributed to the beneficiary during a year in which the trust is
not exempt from income tax.) Proponents of the proposal would argue
that double taxation is not a concern because the excise tax is
intended as a penalty for incurring unrelated business income.
Proponents also would argue that although an alternative approach,
for example, to tax the unrelated business income as an excise tax
but not again when distributed, would avoid any perceived double
taxation of the unrelated income, such an alternative would have
undesired effects. Proponents would argue that if unrelated income
is not taxed when distributed, a trust might have a strong incentive
to invest in assets that produce unrelated income in order to convey
a benefit to the beneficiary that is not available under present law
(capital gain income or tax-free return of corpus instead of
ordinary income). In addition, proponents would note, the
charitable remainderman's interest would be diminished to the extent
a trust invested significantly in unrelated business income producing
assets.
The proposal simplifies the operation of charitable remainder trusts
in that a trust with a small amount of unrelated business taxable
income does not lose its tax exemption and therefore does not need
to file income tax returns and compute its taxable income as if it
were a taxable trust. This has the effect of not discouraging
trustees to make investments that might entail having a small amount
of unrelated business taxable income.
Prior Action
A similar proposal was included in the President's fiscal year 2003,
2004, and 2005 budget proposals.
H.R. 7, the "Community Giving Act of 2003," as passed by the House
of Representatives on September 17, 2003, included a similar
provision, except that unrelated business income would be excluded
from the determination of (1) the value of a charitable remainder
unitrust's assets, (2) the amount of charitable remainder unitrust
income for purposes of determining the unitrust's required
distributions, and (3) the effect on the income character of any
distributions to beneficiaries by a charitable remainder annuity
trust or charitable remainder unitrust.
S. 476, The "CARE Act of 2003," as agreed to by the Senate on
April 9, 2003, contained a similar proposal.
5. Modify the basis adjustment to stock of S corporations
contributing appreciated property
Present Law
Under present law, a shareholder of an S corporation takes into
account, in determining its own income tax liability, its pro rata
share of any charitable contribution of money or other property made
by the corporation. A shareholder of an S corporation reduces the
basis in the stock of the S corporation by the amount of the
charitable contribution that flows through to the shareholder.
In the case of a contribution of appreciated property, the stock
basis is reduced by the full amount of the contribution. As a
result, when the stock is sold, the shareholder may lose the benefit
of the charitable contribution deduction for the amount of any
appreciation in the asset contributed.
Description of Proposal
The proposal allows a shareholder in an S corporation to increase the
basis of the S corporation stock by an amount equal to the excess of
the charitable contribution deduction that flows through to the
shareholder over the shareholder's pro-rata share of the adjusted
basis of the property contributed.
Effective date.�The proposal applies to taxable years beginning after
December 31, 2004.
Analysis
The proposal preserves the benefit of providing a charitable
contribution deduction for contributions of property by an S
corporation with a fair market value in excess of its adjusted basis
by limiting the reduction in the shareholder's basis in S corporation
stock to the proportionate share of the adjusted basis of the
contributed property. Under the proposal, the treatment of
contributions of appreciated property made by an S corporation is
similar to the treatment of contributions made by a partnership.
The net reduction in basis of stock by the amount of the adjusted
basis of contributed property rather than the fair market value will
have little effect on tax law complexity.
Prior Action
The President's fiscal year 2003, 2004, and 2005 budget proposals
contained a similar proposal.
H.R. 7, the "Charitable Giving Act of 2003," as passed by the House
of Representatives on September 17, 2003, included a similar
proposal.
S. 476, The "CARE Act of 2003," as agreed to by the Senate on
April 4, 2003, contained a similar proposal.
6. Repeal the $150 million limit for qualified 501(c)(3) bonds
Present Law
Interest on State or local government bonds generally is excluded
from income if the bonds are issued to finance activities carried out
and paid for with revenues of these governments. Interest on bonds
issued by these governments to finance activities of other persons,
e.g., private activity bonds, is taxable unless a specific exception
is provided in the Code. One such exception is for private activity
bonds issued to finance activities of private, charitable
organizations described in section 501(c)(3) ("section 501(c)(3)
organizations") if the activities do not constitute an unrelated
trade or business.
Section 501(c)(3) organizations are treated as private persons;
thus, bonds for their use may only be issued as private activity
"qualified 501(c)(3) bonds," subject to the restrictions of section
145. Prior to the Taxpayer Relief Act of 1997 (the "1997 Act"),
the most significant of these restrictions limited the amount of
outstanding bonds from which a section 501(c)(3) organization could
benefit to $150 million. In applying this "$150 million limit," all
section 501(c)(3) organizations under common management or control
were treated as a single organization. The limit did not apply to
bonds for hospital facilities, defined to include only acute care,
primarily inpatient, organizations.
The "1997 Act" repealed the $150 million limit for bonds issued after
the date of enactment (August 5, 1997), to finance capital
expenditures incurred after such date.
Description of Proposal
The proposal repeals the $150 million limit for qualified 501(c)(3)
bonds in its entirety.
Effective date.--The proposal is effective for bonds issued after the
date of enactment.
Analysis
Because the 1997 Act provision applies only to bonds issued with
respect to capital expenditures incurred after August 5, 1997, the
$150 million limit continues to govern the issuance of other
non-hospital qualified 501(c)(3) bonds (e.g., advance refunding
bonds with respect to capital expenditures incurred on or before
such date, new-money bonds for capital expenditures incurred on or
before such date, or new-money bonds for working capital
expenditures). Thus, there are two rules governing qualified
501(c)(3) bonds for capital expenditures. The application of a
particular rule depends on whether the capital expenditures were
incurred on or before or after the date the 1997 Act was enacted.
As noted above, the $150 million volume limit continues to apply
to qualified 501(c)(3) bonds for capital expenditures incurred on
or before August 5, 1997. (Typically, these will be advance
refunding bonds). The limit also continues to apply to bonds more
than five percent of the net proceeds of which finance or refinance
working capital expenditures (i.e., operating expenses). The limit
does not apply to bonds to finance capital expenditures incurred
after that date. The Senate Finance Committee report states that the
purpose of the repeal of the $150 million limit was to correct the
disadvantage the limit placed on 501(c)(3) organizations relative
to substantially identical governmental institutions:
The Committee believes a distinguishing feature of American
society is the singular degree to which the United States maintains
a private, non-profit sector of private higher education and other
charitable institutions in the public service.
The Committee believes it is important to assist these private
institutions in their advancement of the public good. The Committee
finds particularly inappropriate the restrictions of present law
which place these section 501(c)(3) organizations at a financial
disadvantage relative to substantially identical governmental
institutions. For example, a public university generally has
unlimited access to tax-exempt bond financing, while a private,
non-profit university is subject to a $150 million limitation on
outstanding bonds from which it may benefit. The Committee is
concerned that this and other restrictions inhibit the ability of
America's private, non-profit institutions to modernize their
educational facilities.
The Committee believes the tax-exempt bond rules should treat more
equally State and local governments and those private organizations
which are engaged in similar actions advancing the public good.
Although the conference report on the 1997 Act noted the continued
applicability of the $150 million limitation to refunding and
new-money bonds, no reason was given for retaining the rule.
Thus, it appears that eliminating the discrepancy between
pre-August 5, 1997, and post-August 5, 1997, capital expenditures
would not violate the policy underlying the repeal of the $150
million limitation. Some may argue that the $150 million volume
limit should continue to apply to qualified 501(c)(3) bonds more
than five percent of the net proceeds of which finance or refinance
working capital expenditures (i.e., operating expenses). Unlike
bond proceeds financing capital expenditures, bond proceeds
financing working capital expenditures are not directly used to
modernize educational facilities, but are used to finance operating
expenses. Proponents may respond that Congress intended to
eliminate the disparity between 501(c)(3) organizations and
substantially identical governmental institutions in the 1997 Act
and this only can be achieved by complete repeal of the $150
million.
Prior Action
A similar proposal was included in the President's fiscal year 2004
and 2005 budget proposals.
7. Repeal the restrictions on the use of qualified 501(c)(3) bonds for residential rental property
Present Law
In general
Interest on State or local government bonds is tax-exempt when the
proceeds of the bonds are used to finance activities carried out by
or paid for by those governmental units. Interest on bonds issued
by State or local governments acting as conduit borrowers for
private businesses is taxable unless a specific exception is
included in the Code. One such exception allows tax-exempt bonds to
be issued to finance activities of non-profit organizations
described in Code section 501(c)(3) ("qualified 501(c)(3) bonds").
For a bond to be a qualified 501(c)(3) bond, the bond must meet
certain general requirements. The property that is to be provided
by the net proceeds of the issue must be owned by a 501(c)(3)
organization, or by a government unit. In addition, a bond failing
both a modified private business use test and a modified private
security or payment test would not be a qualified 501(c)(3) bond.
Under the modified private business use test at least 95 percent of
the net proceeds of the bond must be used by a 501(c)(3)
organization in furtherance of its exempt purpose. Under a modified
private security or payment test, the debt service on not more
than 5 percent of the net proceeds of the bond issue can be
(1) secured by an interest in property, or payments in respect of
property, used by a 501(c)(3) organization in furtherance of an
unrelated trade or business or by a private user, or (2) derived
from payments in respect of property, or borrowed money, used by a
501(c)(3) organization in furtherance of an unrelated trade or
business or by a private user.
Qualified 501(c)(3) bonds are not subject to (1) the State volume
limitations, (2) the land and existing property limitations, (3) the
treatment of interest as a preference item for purposes of the
alternative minimum tax and (4) the prohibition on advance
refundings.
Qualified residential rental projects
In general
The Code provides that a bond which is part of an issue shall
not be a qualified 501(c)(3) bond if any portion of the net proceeds
of the issue are to be used directly or indirectly to provide
residential rental property for family units (sec. 145(d)(1)).
Exceptions to this rule are provided for facilities that meet the
low-income tenant qualification rules for qualified residential
rental rojects financed with exempt facility private activity bonds,
or are new or substantially rehabilitated (sec. 142(d) and
145(d)(2)).
Acquisition of existing property
Qualified 501(c)(3) bonds issued to acquire existing residential
rental property that is not substantially rehabilitated must meet
certain low-income tenant qualification rules. Section 142(d) sets
forth those rules. Section 142(d) requires for the qualified
project period (generally 15 years) that (1) at least 20 percent of
the housing units must be occupied by tenants having incomes of 50
percent or less of area median income or (2) 40 percent of the
housing units in the project must be occupied by tenants having
incomes of 60 percent or less of the area median income.
New construction or substantial rehabilitation
In the case of a "qualified residential rental project" that
consists of new construction or substantial rehabilitation,
qualified 501(c)(3) bonds are not required to meet the low-income
tenant qualification rules that otherwise would be applicable.
Description of Proposal
The proposal repeals the low-income tenant qualification and
substantial rehabilitation rules for the acquisition of existing
property with qualified 501(c)(3) bonds.
Effective date.--The proposal is effective for bonds issued after
the date of enactment.
Analysis
The current low-income tenant rules to qualified 501(c)(3) bonds
resulted from Congressional concern that qualified 501(c)(3) bonds
were being used in lieu of exempt facility bonds to avoid the
low-income tenant rules applicable to exempt facility bonds.
The Ways and Means Committee report noted:
The Committee has become aware that, since enactment of the Tax
Reform Act of 1986, many persons have sought to avoid the rules
requiring that, to qualify for tax-exempt financing, residential
rental property serve low-income tenants to a degree not previously
required. The most common proposals for accomplishing this result
have been to use qualified 501(c)(3) or governmental bonds to
finance rental housing. Frequently, the proposals have involved the
mere churning of "burned-out" tax shelters with the current
developers remaining as project operators under management contracts
producing similar returns to those they received in the past.
The committee finds it anomalous that section 501(c)(3)
organizations-charities-would attempt in these or any other
circumstances to finance with tax-exempt bonds rental housing
projects that serve a more affluent population group than those
permitted to be served by projects that qualify for tax-exempt
exempt-facility bond financing.
In conference, the applicability of the low-income tenant rules was
limited to the acquisition of existing property. It has been argued
that the disparity in the treatment of existing facilities versus
new facilities causes complexity. Some degree of simplification
might be achieved through the elimination of the low-income tenant
rules. Nonetheless, some might argue that the concerns that
prompted the application of the low-income tenant rules to existing
property would once again arise upon removal of these limitations.
There have been reports that there is a shortage of affordable
rental housing. By removing the restrictions on existing property,
some might argue that charities would not be inclined to serve
low-income tenants to the same degree. Proponents of the
restrictions might argue that charities, in particular, should
provide affordable housing to low-income persons as part of their
charitable mission to serve the poor and distressed.
Others might argue that an affordable housing shortage is not
widespread and that such issues would be better addressed through
efforts to directly assist low-income persons rather than by
imposing restrictions on the property acquired by the charity.
Further, because qualified 501(c)(3) bonds are to be used to
further the exempt purposes of the charity, there is a limit on
the extent the charity can operate like a commercial enterprise.
As noted above, the interest on qualified 501(c)(3) bonds is exempt
from tax, and is not a preference for purpose of the alternative
minimum tax. Unlike some other private activity bonds, qualified
501(c)(3) bonds are not subject to the State volume limitations and
therefore, do not have to compete with other private activity bond
projects for an allocation from the State.
Proponents of the restrictions might argue that the restrictions
are not unreasonable given the preferential status of qualified
501(c)(3) bonds and the fact that such charities could be viewed as
helping alleviate a burden on government to benefit those most in
need.
Prior Action
A similar proposal was included in the President's fiscal year 2004
and 2005 budget proposals.
D. Extend, Increase, and Expand the Above-the-Line Deduction for
Qualified Out-of-Pocket Classroom Expenses
Present Law
Deduction for out-of-pocket classroom expenses incurred by teachers
and other educators
In general, ordinary and necessary business expenses are deductible
(sec. 162). However, in general, unreimbursed employee business
expenses are deductible only as an itemized deduction and only to
the extent that the individual's total miscellaneous deductions
(including employee business expenses) exceed two percent of
adjusted gross income. An individual's otherwise allowable itemized
deductions may be further limited by the overall limitation on
itemized deductions, which reduces itemized deductions for taxpayers
with adjusted gross income in excess of $145,950 (for 2005).
In addition, miscellaneous itemized deductions are not allowable
under the alternative minimum tax.
Certain expenses of eligible educators are allowed an above-the-line
deduction. Specifically, for taxable years beginning prior to
January 1, 2006, an above-the-line deduction is allowed for up to
$250 annually of expenses paid or incurred by an eligible educator
for books, supplies (other than nonathletic supplies for courses of
instruction in health or physical education), computer equipment
(including related software and services) and other equipment, and
supplementary materials used by the eligible educator in the
classroom. To be eligible for this deduction, the expenses must
be otherwise deductible under 162 as a trade or business expense.
A deduction is allowed only to the extent the amount of expenses
exceeds the amount excludable from income under section 135
(relating to education savings bonds), 529(c)(1) (relating to
qualified tuition programs), and section 530(d)(2) (relating to
Coverdell education savings accounts).
An eligible educator is a kindergarten through grade 12 teacher,
instructor, counselor, principal, or aide in a school for at least
900 hours during a school year. A school means any school which
provides elementary education or secondary education, as determined
under State law.
The above-the-line deduction for eligible educators is not allowed
for taxable years beginning after December 31, 2005.
General rules regarding education expenses
An individual taxpayer generally may not deduct the education and
training expenses of the taxpayer or the taxpayer's dependents.
However, a deduction for education expenses generally is allowed
under section 162 if the education or training (1) maintains or
improves a skill required in a trade or business currently engaged
in by the taxpayer, or (2) meets the express requirements of the
taxpayer's employer, or requirements of applicable law or
regulations, imposed as a condition of continued employment.
Education expenses are not deductible if they relate to certain
minimum educational requirements or to education or training that
enables a taxpayer to begin working in a new trade or business.
An individual is allowed an above-the-line deduction for qualified
tuition and related expenses for higher education paid by the
individual during a taxable year that are required for the
enrollment or attendance of the taxpayer, the taxpayer's spouse,
or any dependent of the taxpayer with respect to whom the taxpayer
may claim a personal exemption, at an eligible educational
institution of higher education for courses of instruction of such
individual at such institution.
Unreimbursed educational expenses incurred by employees
In the case of an employee, education expenses (if not reimbursed by
the employer) may be claimed as an itemized deduction only if such
expenses meet the above-described criteria for deductibility under
section 162 and only to the extent that the expenses, along with
other miscellaneous itemized deductions, exceed two percent of the
taxpayer's adjusted gross income. Itemized deductions subject to
the two-percent floor are not deductible for minimum tax purposes.
In addition, present law imposes a reduction on most itemized
deductions, including the employee business expense deduction,
for taxpayers with adjusted gross income in excess of a threshold
amount, which is indexed annually for inflation. The threshold
amount for 2005 is $145,950 ($72,975 for married individuals
filing separate returns). For those deductions that are subject
to the limit, the total amount of itemized deductions is reduced
by three percent of adjusted gross income over the threshold amount,
but not by more than 80 percent of itemized deductions subject
to the limit. Beginning in 2006, the Economic Growth and Tax
Relief Reconciliation Act of 2001 phases-out the overall limitation
on itemized deductions for all taxpayers. The overall limitation on
itemized deductions is reduced by one-third in taxable years
beginning in 2006 and 2007, and by two-thirds in taxable years
beginning in 2008 and 2009.
The overall limitation on itemized deductions is eliminated for
taxable years beginning after December 31, 2009, although this
elimination of the limitation sunsets on December 31, 2010.
Contributions to a school may be eligible for a charitable
contribution deduction under section 170. A contribution that
qualifies both as a business expense and a charitable contribution
may be deducted only as one or the other, but not both.
Description of Proposal
The present-law provision would be made permanent and the maximum
deduction increased to $400. As under current law, the provision
would apply to teachers and other school personnel employed by
public entities, charter schools or private schools (as determined
under state law). The current-law 900-hour rule would be clarified
to refer to a school year ending during the taxable year. Eligible, unreimbursed expenses would be expanded to include teacher
_______________
/141/ Sec. 222.
/142/ A separate proposal contained in the President's fiscal year
2006 budget permanently extends the elimination of the overall
limitation on itemized deductions after 2010 (I.A.,above).
training expenses related to current teaching positions.
Neither travel nor lodging expenses nor expenditures related to
religious instruction or activities would be eligible. Expenses
claimed as an above-the-line deduction could not be claimed as an
itemized deduction or taken into account in determining any other
tax benefit such as Hope or lifetime learning credits. Taxpayers
would be required to retain receipts for eligible expenditures along
with a certification from a principal or other school official that
the expenditures qualified. The proposal would be effective for
expenses incurred in taxable years beginning after December 31,
2005.
Effective date.--The proposal is effective for expenses incurred in
taxable years beginning after December 31, 2005.
Analysis
Policy issues
The proposal and the present-law section 62 above-the-line deduction
attempt to make fully deductible many of the legitimate business
expenses of eligible schoolteachers. As described below, and absent
an above-the-line deduction, the expenses might otherwise be
deductible except for the two-percent floor that applies to
miscellaneous itemized deductions. Some have observed that the
two-percent floor increases pressure to enact above-the-line
deductions on an expense-by-expense basis. In addition to increasing complexity, the expense-by-expense approach is not fair to other
taxpayers with legitimate business expenses that remain subject to
the two-percent floor. For example, emergency response professionals
incur similar unreimbursed expenses related to their employment, a
deduction for which also has been separately proposed.
The proposal expands the present-law above-the-line deduction for
eligible educators by increasing the maximum deduction from $250 to
$400, thereby making additional legitimate business expenses
deductible. As is the case with the present-law above-the-line
deduction, the proposal presents compliance issues. One reason
the two-percent floor was introduced was to reduce the administrative
burden on the IRS to monitor compliance with small deductions.
Some argue that any proposal that circumvents the two-percent floor
will encourage cheating. Others argue that although cheating is a
risk, the risk is the same for similarly situated taxpayers
(e.g., independent contractors or taxpayers with trade or business
income) who are not subject to the two-percent floor on similar
expenses.
Complexity issues
Three provisions of present law restrict the ability of teachers to
deduct as itemized deductions those expenses covered by the
proposal: (1) the two-percent floor on itemized deductions;
(2) the overall limitation on itemized deductions; and (3) the
alternative minimum tax. The staff of the Joint Committee on
Taxation has previously identified these provisions as sources
___________________
/143/ See the conference report to H.R. 1836, the "Economic Growth
and Tax Relief Reconciliation Act of 2001," H. Rep. No. 107-84, at
169-70 (2001).
of complexity and has recommended that such provisions be repealed.
These provisions do not apply to eligible expenses under the
proposal. While repealing these provisions for all taxpayers
reduces the complexity of the Federal tax laws, effectively
repealing these provisions only for certain taxpayers (such as
teachers and other eligible educators) likely increases complexity.
Some may view the present-law above-the-line deduction and the
proposal as increasing simplification by providing for deductibility
of certain expenses without regard to the present-law restrictions
applicable to itemized deductions and the alternative minimum tax.
However, several elements of the proposal and the present-law
above-the-line deduction increase complexity.
The proposal and present-law above-the-line deduction may increase
recordkeeping requirements for certain taxpayers. Taxpayers wishing
to take advantage of the above-the-line deduction are required to
keep records, even if they were not otherwise required to do so
because their expenses were not deductible as a result of the
2-percent floor for itemized deductions. In general, enactment of
additional above-the-line deductions for specific expenses
undermines the concept of the standard deduction, which exists in
part to simplify the tax code by eliminating the need for many
taxpayers to keep track of specific expenses.
The proposal and the present-law above-the-line deduction do not
completely eliminate the need to apply the present-law rules
regarding itemized deductions. For example, a teacher with expenses
in excess of the $400 cap under the proposal or with other
miscellaneous itemized deductions may need to compute tax liability
under the present-law itemized deduction rules as well as under the
proposal. In addition, the proposal does not cover all classroom
expenses, but only those that meet the particular requirements of
the proposal. Expenses that do not meet those requirements remain
subject to the present-law rules. Similarly, some expenses may
either be deductible under the proposal or used for tax benefits
under other provisions. For example, certain teacher education
expenses may be deductible under the proposal or used for a Hope or
Lifetime Learning credit. Taxpayers with such expenses need to
determine tax liability in more than one way in order to determine
which provisions result in the lowest tax liability. In addition,
overlapping provisions increase the likelihood that some taxpayers
inadvertently claim more than one tax benefit with respect to the
same expense.
Prior Action
Similar proposals were contained in the President's fiscal year
2003, 2004, and 2005 budget proposals. A similar provision relating
only to the extension of the availability of the deduction was
contained in the Working Families Tax Relief Act of 2004.
_______________
/144/ See Joint Committee on Taxation, Study of the Overall State
of the Federal Tax System and Recommendations for Simplification,
Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986,
Volume II, 15, 88, at 118 (JCS-3-01), April 2001.
/145/ Pub. Law. No 108-311. sec. 307 (2004).
E. Exclude from Income of Individuals the Value of Employer-Provided
Computers, Software, and Peripherals
Present Law
The value of computers, software, or other office equipment provided
by an employer for use in the home of an employee is generally
excludable from income as a working condition fringe benefit to the
extent the equipment is used to perform work for the employer
(sec. 132). The value of such equipment is includible in income to
the extent the equipment is used for personal purposes. If such
equipment is used for both personal and business purposes, then a
portion of the value may be excluded from income.
In general, employee business expenses are deductible as an itemized
deduction, but only to the extent such expenses and other
miscellaneous itemized deductions exceed two percent of adjusted
gross income. Impairment-related work expenses are not subject to
this two-percent floor. Impairment-related work expenses are
expenses: (1) of a handicapped individual for attendant care
services at the individual's place of employment and other expenses
in connection with such place of employment which are necessary for
such individual to be able to work; and (2) that are trade or
business expenses (sec. 162). For these purposes, a handicapped
individual means an individual who has a physical or mental
disability (including but not limited to blindness or deafness)
which for such individual constitutes or results in a functional
limitation to employment or who has any physical or mental
impairment (including, but not limited to, a sight or hearing
impairment) which substantially limits one or more major life
activities of such individual.
Description of Proposal
The proposal provides an exclusion from income for the value of any
computers, software or other office equipment provided to an
individual by that individual's employer. The exclusion is limited
to equipment necessary for the individual to perform work for the
employer at home but is not limited to business use of such
equipment. Therefore, the exclusion applies to all use of such
equipment, including use by the employee for personal purposes or to
carry on a trade or business other than working as an employee of
the employer. However, in order to qualify for the exclusion, the
employee is required to make substantial use of the equipment to
perform work for the employer.
If the employer provided the employee with the use of the equipment
at the end of its useful life, the proposal also deems the value of
such use to be zero for tax purposes.
Effective date.�The proposal is effective for taxable years
beginning after December 31, 2005.
Analysis
Complexity issues
One purpose of the proposal may be a simplification purpose, that
is, to reduce record keeping for employees to whom an employer
provides office equipment. The proposal eliminates the need to keep
track of personal versus business use of covered equipment.
However, the proposal gives rise to new tax law complexity because
it would add a new factual determination ("substantial" business
use) as a criterion for the tax benefit it provides.
The proposal does not specify what constitutes "substantial"
business use for these purposes. Because any standard for making
this determination involves a factual inquiry, the proposal
increases the complexity of tax administration by increasing the
likelihood of factual disputes and litigation.
Policy issues
Under normal income tax principles, if an employer pays an employee
cash, the cash is taxable as income to the employee regardless of
whether the employee uses the cash to purchase a computer and
software for personal use or whether the employee purchases other
consumer goods for personal consumption. Thus, under normal income
tax principles, when an employer provides any item of value to an
employee, the value of the good or service provided to the employee
should be included in the taxable income of the employee, because
the provision of the good or service is a form of compensation.
The proposal excludes the value of computer hardware and software
provided to certain employees for personal use from the taxable
income of the employees.
If certain forms of compensation are not taxed to the employee, the
employer is indifferent (the employer's outlay is deductible as
compensation regardless of whether in cash or in kind), but the
employee will find the untaxed forms of compensation more valuable.
For example, if a taxpayer in the 15-percent income tax bracket
sought to purchase a $1,000 computer system, the taxpayer would have
to earn $1,176 in income in order to have the $1,000 after-tax
income sufficient to purchase the computer system. If the employer
can provide the computer system to the employee and the value of the
system is excluded from the employee's taxable income, it is
equivalent to the employee receiving a 15-percent discount on the
price of the computer system. Alternatively, it is equivalent to
the employee having received an additional $176 in compensation.
More generally, for a taxpayer whose marginal income tax rate is t,
if the employer can provide the computer system to the employee and
the value of the system is excluded from the employee's taxable
income, it is equivalent to the employee receiving a t-percent
discount on the price of the computer system or, alternatively, it
is equivalent to the employee having received an additional 1/(1-t)
percentage increase in compensation. Generally, if the price of a
good declines, consumers purchase more of the good.
In this context, this could result in employees seeking more
compensation in the form of untaxed computer goods and services and
less in the form of taxable compensation.
Exempting certain forms of compensation from taxable income also has
the potential create economic inefficiencies. Because certain
employees do not bear the full cost of computer hardware and
software, some employees may purchase more computer hardware and
software than they need. By favoring computers, the proposal favors
certain methods of enabling employees (those based on computer
applications) over others. As a result, other strategies that could
raise the well being of employees may be forgone.
Prior Action
A similar proposal was included in the President's fiscal year 2002,
2003, 2004, and 2005 budget proposals.
F. Establish Opportunity Zones
Present Law
In general
The Internal Revenue Code contains various incentives to encourage
the development of economically distressed areas, including
incentives for businesses located in empowerment zones, enterprise
communities and renewal communities, the new markets tax credit, the
work opportunity tax credit, and the welfare-to-work tax credit.
Empowerment zones
There are currently 40 empowerment zones�30 in urban areas and 10 in
rural areas�that have been designated through a competitive
application process. State and local governments nominated
distressed geographic areas, which were selected on the strength of
their strategic plans for economic and social revitalization. The
urban areas were designated by the Secretary of the Department of
Housing and Urban Development. The rural areas were designated by
the Secretary of the Department of Agriculture. Designations of
empowerment zones will remain in effect until December 31, 2009.
Incentives for businesses in empowerment zones include (1) a
20-percent wage credit for qualifying wages, (2) additional expensing
for qualified zone property, (3) tax-exempt financing for certain
qualifying zone facilities, (4) deferral of capital gains on sales
and reinvestment in empowerment zone assets, and (5) exclusion of 60
percent (rather than 50 percent) of the gain on the sale of
qualified small business stock held more than 5 years.
The wage credit provides a 20 percent subsidy on the first $15,000
of annual wages paid to residents of empowerment zones by businesses
located in these communities, if substantially all of the employee's
services are performed within the zone. The credit is not available
for wages taken into account in determining the work opportunity tax
credit.
Enterprise zone businesses are allowed to expense the cost of
certain qualified zone property (which, among other requirements,
must be used in the active conduct of a qualified business in an
empowerment zone) up to an additional $35,000 above the amounts
generally available under section 179. In addition, only 50
percent of the cost of such qualified zone property counts toward
the limitation under which section 179 deductions are reduced to
the extent the cost of section 179 property exceeds a specified
amount.
Qualified enterprise zone businesses are eligible to apply for
tax-exempt financing (empowerment zone facility bonds) for qualified
zone property. These empowerment zone facility bonds do not count
______________________
/146/ Section 179 provides that, in place of depreciation, certain
taxpayers, typically small businesses, may elect to deduct up to
$100,000 of the cost of section 179 property placed in service each
year. In general, section 179 property is defined as depreciable
tangible personal property that is purchased for use in the active
conduct of a trade or business.
against state private activity bond limits, instead a limit is
placed upon each zone, depending on population and whether the zone
is in an urban or rural area.
Enterprise communities
Current law authorized the designation of 95 enterprise communities,
65 in urban areas and 30 in rural areas. Qualified businesses in
these communities were entitled to similar favorable tax-exempt
financing benefits as those in empowerment zones. Designations of
enterprise communities were made in 1994 and remained in effect
through 2004. Many enterprise communities have since been
re-designated as part of an empowerment zone or a renewal community.
Renewal communities
The Community Renewal Tax Relief Act of 2000 authorized 40 renewal
communities, at least 12 of which must be in rural areas. Forty
renewal communities have been chosen through a competitive
application process similar to that used for empowerment zones. The
40 communities were designated by the Department of Housing and
Urban Development in 2002 and that designation continues through
2009.
Renewal community tax benefits include: (1) a 15-percent wage
credit for qualifying wages; (2) additional section 179 expensing
for qualified renewal property; (3) a commercial revitalization
deduction; and (4) an exclusion for capital gains on qualified
community assets held more than five years.
The wage credit and increased section 179 expensing operate in a
similar fashion as in empowerment zones. The primary difference is
that the wage credit is smaller, equal to 15 percent for the first
$10,000 of wages.
The commercial revitalization deduction applies to certain
nonresidential real property or other property functionally related
to nonresidential real property. A taxpayer may elect to either:
(1) deduct one-half of any qualified revitalization expenditures
that would otherwise be capitalized for any qualified revitalization
building in the tax year the building is placed in service; or
(2) amortize all such expenditures ratably over a 120-month period
beginning with the month the building is placed in service. A
qualified revitalization building is any nonresidential building and
its structural components placed in service by the taxpayer in a
renewal community. If the building is new, the original use of the
building must begin with the taxpayer. If the building is not new,
the taxpayer must substantially rehabilitate the building and then
place it in service. The total amount of qualified revitalization
expenditures for any building cannot be more than the smaller of $10
million or the amount allocated to the building by the commercial
revitalization agency for the state in which the building is
located. A $12 million cap on allowed commercial revitalization
expenditures is placed on each renewal community annually.
New markets tax credit
The new markets tax credit provides a tax credit to investors who
make "qualified equity investments" in privately-managed investment
vehicles called "community development entities," or "CDEs." The
CDEs must apply for and receive an allocation of tax credit
authority from the Treasury Department and must use substantially
all of the proceeds of the qualified equity investments to make
qualified low-income community investments. One type of qualified
low-income community investment is an investment in a qualified
active low-income community business. In general, a "qualified
active low-income community business" is any corporation (including
a nonprofit corporation), partnership or proprietorship that meets
the following requirements: ?
At least 50 percent of the gross income of the business is
derived from the active conduct of a qualified business
within a low-income community (as defined in section 45D(e)).
For this purpose, a "qualified business" generally does not
include (1) the rental of real property other than
substantially improved nonresidential property; (2) the
development or holding of intangibles for sale or license;
(3) the operation of a private or commercial golf course,
country club, massage parlor, hot tub facility, suntan
facility, racetrack or other facility used for gambling,
or a liquor store; or (4) farming if the value of the
taxpayer's assets used in the business exceeds $500,000.
At least 40 percent of the use of the tangible property of
the business is within a low-income community.
At least 40 percent of the services performed for the
business by its employees are performed in a low-income
community.
Collectibles (other than collectibles held primarily for
sale to customers in the ordinary course of business)
constitute less than five percent of the assets of the
business.
Nonqualified financial property (which includes debt
instruments with a term in excess of 18 months) comprises
less than five percent of the assets of the business.
A portion of a business may be tested separately for qualification
as a qualified active low-income community business.
Work opportunity and welfare-to-work tax credits
Employers may be entitled to a work opportunity tax credit or a
welfare-to-work tax credit for certain wages paid to eligible
employees.
Description of Proposal
In general
The proposal creates forty opportunity zones, 28 in urban areas and
12 in rural areas. The zone designation and corresponding
incentives for these 40 zones are in effect from January 1, 2006,
to December 31, 2015. As described below, the tax incentives
applicable to opportunity zones include: (1) an exclusion of 25
percent of taxable income for opportunity zone businesses with
average annual gross receipts of $5 million or less; (2) additional
section 179 expensing for opportunity zone businesses;
(3) a commercial revitalization deduction; and (4) a wage credit
for businesses that employ opportunity zone residents within the
zone.
Selection of opportunity zones
The Secretary of Commerce selects opportunity zones through a
competitive process. A county, city or other general purpose
political subdivision of a state (a "local government") is eligible
to nominate an area for opportunity zone status if the local
government is designated by the Secretary of Commerce as a
"Community in Transition." Two or more contiguous local governments
designated as Communities in Transition may submit a joint
application.
A local government may be designated as a Community in Transition if
it has experienced the following: (1) a loss of at least three
percent of its manufacturing establishments from 1993 to 2003 (urban
areas must have had at least 100 manufacturing establishments in
1993); (2) a loss of at least three percent of its retail
establishments from 1993 to 2003; and (3) a loss of at least 20
percent of its manufacturing jobs from 1993 to 2003.
Local governments not making the original Community in Transition
list may appeal to the Secretary of Commerce. Other factors
demonstrating a loss of economic base within the local government
may be considered in the appeal.
Applicants for opportunity zone status have to develop and submit a
"Community Transition Plan" and a "Statement of Economic
Transition." The Community Transition Plan must set concrete,
measurable goals for reducing local regulatory and tax barriers to
construction, residential development and business creation.
Communities that have already worked to address these issues receive
credit for recent improvements. The Statement of Economic
Transition must demonstrate that the local community's economic
base is in transition, as indicated by a declining job base and
labor force, and other measures, during the past decade.
In evaluating applications, the Secretary of Commerce may consider
other factors, including: (1) changes in unemployment rates, poverty
rates, household income, homeownership and labor force
participation; (2) the educational attainment and average age of the
population; and (3) for urban areas, the number of mass layoffs
occurring in the area's vicinity over the previous decade.
The majority of a nominated area must be located within the boundary
of one or more local governments designated as a Community in
Transition. A nominated area would have to have a continuous
boundary (that is, an area must be a single area; it cannot be
comprised of two or more separate areas) and may not exceed 20
square miles if an urban area or 1,000 square miles if a rural area.
A nominated urban area must include a portion of at least one local
government jurisdiction with a population of at least 50,000. The
population of a nominated urban area may not exceed the lesser of:
(1) 200,000; or (2) the greater of 50,000 or ten percent of the
population of the most populous city in the nominated area. A
nominated rural area must have a population of at least 1,000 and no
more than 30,000.
"Rural area" is defined as any area that is (1) outside of a
metropolitan statistical area (within the meaning of section
143(k)(2)(B)) or (2) determined by the Secretary of Commerce,
after consultation with the Secretary of Agriculture, to be a
rural area. "Urban area" is defined as any area that is not a rural
area.
Empowerment zones and renewal communities are eligible to apply for opportunity zone status, but are required to relinquish their current
status and benefits once selected. Opportunity zone benefits for
converted empowerment zones and renewal communities expire on
December 31, 2009. The selection of empowerment zones or renewal
communities to convert to opportunity zones is based on the same
criteria that apply to other communities, but does not count against
the limitation of 40 new opportunity zones.
Enterprise communities are also eligible to apply for opportunity
zone status. Aside from automatically being eligible to apply,
enterprise communities are treated as other areas that do not belong
to either an empowerment zone or a renewal community once selected:
benefits are in effect for 10 years and the selection of an
enterprise community as an opportunity zone counts against the limit
of 40 new opportunity zones.
Reporting requirements identifying construction, residential
development, job creation, and other positive economic results apply
to opportunity zones.
Tax incentives applicable to opportunity zones
Exclusion of 25 percent of taxable income for certain opportunity
zone businesses
A business is allowed to exclude 25 percent of its taxable income if
(1) it qualified as an "opportunity zone business" and (2) it
satisfied a $5 million gross receipts test. The definition of
an opportunity zone business is based on the definition of a
"qualified active low-income community business" for purposes of
the new markets tax credit, treating opportunity zones as low-income
communities. However, a nonprofit corporation does not qualify for
treatment as an opportunity zone business. In addition, a portion
of a business may not be tested separately for qualification as an
opportunity zone business. The $5 million gross receipts test is
satisfied if the average annual gross receipts of the business for
the three-taxable-year period ending with the prior taxable year
does not exceed $5 million. Rules similar to the rules of section
448(c) apply.
Additional section 179 expensing
An opportunity zone business is allowed to expense the cost of
section 179 property that is qualified zone property, up to an
additional $100,000 above the amounts generally available under
section 179. In addition, only 50 percent of the cost of such
qualified zone property counts toward the limitation under which
section 179 deductions are reduced to the extent the cost of
section 179 property exceeds a specified amount.
Commercial revitalization deduction
A commercial revitalization deduction is available for opportunity
zones in a manner similar to the deduction for renewal communities.
A $12 million annual cap on these deductions applies to each
opportunity zone.
Wage credit
Individuals who live and work in an opportunity zone constitute a
new target group with respect to wages earned within the zone under
a combined work opportunity tax credit and welfare-to-work tax
credit, as proposed by the President under a separate proposal.
Other benefits for opportunity zones
Individuals, organizations, and governments within an opportunity
zone receive priority designation when applying for new markets tax
credits and the following other federal programs: 21st Century
After-school, Early Reading First, and Striving Readers funding;
Community Based Job Training Grants; Community Development Block
Grants, Economic Development Administration grants, and HOME
Funding; and USDA Telecommunications Loans, Distance Learning and
Telemedicine grants, and Broadband loans.
Analysis
The proposal is designed to provide tax benefits to local areas with
declines in manufacturing employment and other reductions of the
local economic base. In particular, the proposal encourages the
development and growth of small businesses within local areas
designated as Communities in Transition.
The tax benefits are available to "Communities in Transition," which
are defined as communities that have suffered declines in
manufacturing and retail industries. The proposal may thus have the
effect of providing incentives to communities negatively affected by
increased international trade. Economic theory provides that
international trade generates net benefits to a nation's economy,
but that those benefits are unevenly distributed among sectors
within the economy. However, the existence of net benefits suggests
that sufficient national resources should exist to compensate fully
those sectors hurt by trade. The proposal is consistent with the
aims of this policy of compensation.
Opponents of the proposal might argue that the proposal extends tax
benefits not only to communities that have suffered a decline in
manufacturing and retail establishments but also to neighboring,
prospering communities. This is because the proposal requires only
that a majority of an opportunity zone consist of territory located
in a Community in Transition. Thus, tax benefits may potentially be
allocated to individuals and businesses whose activities may not
significantly contribute to economic development in the Community
in Transition.
Some observers have noted that a challenge to full utilization of
existing local development tax incentives (such as empowerment zones)
is the ever-growing menu of zones and tax benefits. Local officials
have a difficult time explaining complicated sets of policies to
businesses. The proposal adds to the list of benefits in the form of
a 25-percent taxable income exclusion, which is available for
opportunity zones but not for other similar targeted areas.
Critics of existing empowerment zones and renewal communities
policies argue that for full utilization of such tax benefits to be
achieved, there needs to be increased funding of programs educating
individuals and business of the benefits of existing tax incentives.
Allowing the conversion of existing zones to opportunity zones
offers an opportunity consolidate and simplify tax benefits for
distressed economic areas. However, the incentive for existing
empowerment zones and renewal communities to convert to opportunity
zone status is reduced by the early termination date. Further,
the differences in the set of tax incentives available to the
various zones may reduce the incentive of local government officials
to request conversion. Such officials have developed expertise
and development plans based on the existing set of tax benefits.
The gross receipts test for a qualified opportunity zone business
creates a "cliff" with respect to this tax benefit. Businesses who
find themselves marginally in excess of the three-year moving-average
cease to qualify for the income exclusion. Thus, this formulation
of the income exclusion unfairly distinguishes between similarly
situated businesses and offers an incentive for abuse. However,
this formulation of the taxable income exclusion focuses the tax
benefit to small businesses.
Further, as is the case with other tax incentives for
economically-distressed areas, some observers note that the tax
benefits may do little to encourage new development. Hence, such
incentives may primarily benefit existing businesses while producing
little new growth. Indeed, the establishment of local tax
incentives may have the effect of distorting the location of new
investment, rather than increasing investment overall. If the new
investments are offset by less investment in neighboring, but not
qualifying areas, the neighboring communities could suffer. On
the other hand, the increased investment in the qualifying areas
could have spillover effects that are beneficial to the neighboring
communities.
Prior Action
No prior action.
_____________
/147/ For a discussion of the economic effects of targeting economic
activity to specific geographic areas, see Leslie E. Papke, "What Do
We Know About Enterprise Zones," in James M. Poterba, ed., Tax
Policy and the Economy, vol. 7 (Cambridge, MA: The MIT Press), 1993.
G. Provide Tax Relief for Federal Emergency Management Agency
Hazard Mitigation Assistance Programs
Present Law
Gross income includes all income from whatever source derived unless
a specific exception applies.
Gross income does not include amounts received by individuals as
qualified disaster relief payments. Qualified disaster relief
payments include amounts (1) to reimburse or pay reasonable and
necessary personal, family, living, or funeral expenses incurred as
a result of a qualified disaster; (2) to reimburse or pay reasonable
and necessary expenses incurred for the repair or rehabilitation of
a personal residence to the extent need is attributable to a
qualified disaster; (3) by a person engaged in the furnishing or
sale of transportation by reason of the death or personal injuries
as a result of a qualified disaster, and (4) amounts paid by a
Federal, State, or local government, or agency or instrumentality
thereof, in connection with a qualified disaster in order to
promote the general welfare.
In addition to providing grants in the aftermath of a natural
disaster, the Federal Emergency Management Agency ("FEMA") of the
Department of Homeland Security conducts disaster mitigation
assistance programs to provide grants through State and local
governments for businesses and individuals to mitigate potential
damage from future natural disasters. For example, grants may fund
modifications to structures (e.g., homes or businesses) or may be
used to purchase property located in disaster prone areas.
There is no specific exclusion from gross income for amounts
received pursuant to FEMA mitigation grants. FEMA provides these
grants through State and local governments to mitigate potential
damage from future natural hazards. The existing statutory
exclusion under present law for qualified disaster relief payments
only applies to amounts received by individuals as a result of a
disaster that has occurred.
If certain requirements are met, section 1033 provides that if
property is compulsory or involuntarily converted and replaced
within a certain period (generally two years), there is deferral
of gain recognition. In general, the cost basis in the replacement
property is the carry-over basis in the converted property
(decreased by the amount of any money or loss and increased by the
amount of any gain recognized on the conversion).
____________________
/148/ Sec. 139.
/149/ See IRS Chief Counsel Memorandum 200431012
(June 29, 2004), which concluded that foundation elevations provided
through payments made directly or indirectly from FEMA mitigation
grants are includible in gross income of property owners. Various
types of disaster payments made to individuals have been excluded
from gross income administratively under a general welfare
exception. The general welfare exception does not apply to disaster
mitigation payments.
In the case of the sale or exchange of a principal residence,
current law allows an exclusion of up to $250,000 ($500,000 in the
case of a joint return) if the property was used as the taxpayer's
principal residence for two or more years during the five-year
period ending on the date of the sale or exchange.
Description of Proposal
The proposal provides an exclusion from gross income for certain
amounts received as FEMA disaster mitigation grants. Under the
proposal, if FEMA pays the cost of improving property pursuant to a
mitigation assistance program (e.g., retrofitting or elevating), the
cost of such improvement is excluded from gross income. However,
under the proposal, there is no increase in the owner's cost basis
in the property. The proposal also provides that a business that
receives a tax-free mitigation grant and uses the grant to purchase
or repair property cannot claim a deduction for those expenses.
The exclusion does not apply to payments from FEMA in connection
with the acquisition, through a mitigation assistance program, of
property located in a disaster or hazard area. However, if a
property is sold or disposed to implement hazard mitigation, such
sale or disposition is treated as an involuntary conversion under
section 1033.
Effective date.--The proposal is generally effective for mitigation
assistance received after December 31, 2004. The proposal provides
Treasury administrative authority to provide retroactive relief.
Analysis
The proposal provides an exclusion from gross income for amounts
received as FEMA disaster mitigation payments. Amounts excludable
under the proposal include amounts received directly or indirectly
as payment or benefit by a property owner for hazard mitigation with
respect to property pursuant to the Robert T. Stafford Disaster
Relief and Emergency Assistance Act or the National Flood Insurance
Act. Payments are made pursuant to the Flood Mitigation Assistance
Program, the Pre-Disaster Mitigation Program, and the Hazard
Mitigation Grant Program.
Some believe that requiring FEMA mitigation grants to be included in
income is a deterrent for individuals and business to participate
in disaster mitigation programs. Some participants may not have the
cash necessary to pay the tax imposed on the benefits provided by
the mitigation grants. The proposal is intended to remove this
potential impediment to participation in the programs. Because
successful mitigation can be more cost effective for the Federal
government that repair after the occurrence of a disaster, many
believe that allowing an exclusion for payments made to mitigation
program participants translates into net benefits for the government.
Payments can be made, for example, to elevate a home located in an
area prone to floods. Under the proposal, the homeowner is not
required to include the value of the improvement in income.
The proposal provides that there is no increase in an owner's
cost basis for amounts received pursuant to a mitigation assistance
program that are excluded from income. Thus, if the property is
later sold, any gain resulting from the mitigation assistance would
be taxable, subject to any exclusion otherwise available (e.g., the
exclusion under section 121 of gain from the sale of a principal
residence). A reduced tax rate would apply for any amounts
includible in income in excess of any exclusion otherwise available.
The proposal provides that a business that receives a tax-free
mitigation grant and uses the grant to purchase or repair property
cannot claim a deduction for those expenses. It may be appropriate
to apply this denial of double benefit rule on a broader basis,
rather than limiting it only to businesses.
FEMA mitigation payments can also be made to acquire property
located in a disaster area. Under the proposal, amounts received for
the sale or disposition of properties for the purposes of hazard
mitigation are not eligible for the income exclusion. However, if
a property is sold or disposed to implement hazard mitigation, such
sale or disposition is treated as an involuntary conversion, under
section 1033 of the Internal Revenue Code. Thus, under the
proposal, if property is sold by a taxpayer through a FEMA disaster
mitigation program and the taxpayer replaces the property within the
period specified under present law in the case of an involuntary
conversion (i.e., generally two years), instead of including the
compensation in gross income, the taxpayer has carry-over cost basis
in the replacement property. Proponents view this result as more
appropriate compared with allowing an exclusion for payments made to
acquire property located in a disaster area. Others argue that
allowing involuntary conversion treatment is inappropriate, as there
are many other cases in which the government acquires private
property and involuntary conversion treatment is not available.
Many view an exclusion for FEMA mitigation payments similar to the
exclusion provided under the Code for qualified disaster relief
payments. They argue that since an exclusion applies to payments
made to victims after a qualified disaster, it is also appropriate
to allow an exclusion for payments made to mitigate future disaster
damage.
The proposal provides Treasury administrative authority to provide
retroactive tax relief. The extent of the retroactive relief is
unclear. For example, it is unclear whether the proposal
contemplates waiving the statute of limitations or if any
retroactive relief provided by Treasury would apply only to open
taxable years. Retroactivity promotes complexity and adds additional
burdens for both taxpayers and the IRS.
Prior Action
No prior action.
H. Provide a Tax Credit for Developers of Affordable
Single-Family Housing
Present Law
The low-income housing tax credit (the "LIHC") may be claimed over a
10-year period for the cost of rental housing occupied by tenants
having incomes below specified levels. The credit percentage for
newly constructed or substantially rehabilitated housing that is not
Federally subsidized is adjusted monthly by the Internal Revenue
Service so that the 10 annual installments have a present value of
70 percent of the total qualified expenditures. The credit
percentage for new substantially rehabilitated housing that is
Federally subsidized and for existing housing that is substantially rehabilitated is calculated to have a present value of 30 percent
qualified expenditures. The aggregate credit authority provided
annually to each State is $1.75 per resident, except in the case of
projects that also receive financing with proceeds of tax-exempt
bonds issued subject to the private activity bond volume limit and
certain carry-over amounts. The $1.75 per resident cap is indexed
for inflation.
Description of Proposal
The proposal creates a single-family housing tax credit. Pursuant
to a plan of allocation, State or local housing credit agencies will
award first-year credits to new or rehabilitated housing units
comprising a project for the development of single-family housing in
census tracts with medium incomes of 80 percent or less of the
greater of area or statewide median income or areas of chronic
economic distress designated within five years prior to allocation.
Eligible taxpayers generally are the developer or investor
partnership owning the qualified housing unit immediately prior to
the date of sale to a qualified buyer. The maximum credit for each
unit cannot exceed the present value of 50-percent of the eligible
basis of that housing unit. Rules similar to the present-law rules
for the LIHC determine eligible basis for this credit. Neither land
nor existing structures are included in eligible basis for purposes
of this credit. Units in rehabilitated structures qualify for the
credit only if rehabilitation expenditures exceeded $25,000. This
credit is claimed over the five-year period beginning the later of
the date of sale of the unit to a qualified buyer or the date a
certificate of occupancy for that unit is issued.
A qualified buyer means an individual with income of 80 percent
(70 percent for families with less than three members) or less of
area median income. A qualified buyer will not have to be a
first-time homebuyer.
Similar to the present-law low-income rental housing tax credit, this
credit provides the greater of $1.90 per capita or $2.180 million of
tax credit authority annually to each State beginning in calendar
year 2006. These amounts are indexed for inflation. Each State
(or local government) allocates its credit authority to the
qualified developers or investor partnerships that own the housing
unit immediately prior to the date of sale to a qualified buyer
(or, if later, the date a certificate of occupancy was issued).
Units in condominiums and cooperatives are treated as single-family
housing for purposes of the credit. Credits allocated to a housing
unit will revert to the allocating agency unless expenditures equal
to at least 10 percent of the total reasonably expected qualifying
costs with respect to that housing unit were expended during the
first six months after the allocation. Rules similar to the
present-law LIHC rules will apply regarding plans on allocations,
credit carryforwards, credit returns and a national pool of unused
allocations.
The qualified developers or investor partnerships will claim the
credit for the five years after the qualified property is sold to a
qualified buyer. However, no credit is allowed with respect to a
housing unit unless that unit was sold within the one-year period
beginning on the date a certificate of occupancy was issued with
regard to that unit. Rules similar to the present-law LIHC rules
apply to determination of eligible basis, present value calculations
and reporting requirements.
A qualified homebuyer (not the developer or investor partnership) is
subject to recapture if the qualified homebuyer (or subsequent
buyer) sells to a non-qualified buyer within three years of the
initial sale of the qualified unit. The recapture tax is the lesser
of: (1) 80 percent of the gain upon resale, or (2) a recapture
amount. The recapture amount equals one half the gain resulting
from the resale, reduced by 1/36th of that value for each month
between the initial sale and the sale to the nonqualified buyer.
If a housing unit for which any credit was claimed is converted to
rental property within the initial three-year period, then no
deductions for depreciation or property taxes can be claimed with
respect to such unit for the balance of that three-year period. The
proposal does not provide how the qualified homebuyer (or subsequent
buyer) will ascertain the recapture amount for their housing unit.
Effective date.�The proposal is effective for first-year credit
allocations beginning in calendar year 2006.
Analysis
Complexity issues
The proposal adds to complexity in the tax law by creating a new tax
credit with numerous detailed rules and significant record keeping
requirements for both the taxpayer claiming the credit and
subsequent homebuyers. This new credit, like the low-income rental
housing credit upon which it is based, will be inherently complex
and detailed, and will require significant additional paperwork by
taxpayers. The proposal will require the creation of additional tax
forms and will require the Internal Revenue Service to devote
resources to the administration and enforcement of the rules under
the proposal. Also, a system to identify qualified buyers and
advertise qualified properties for sale to such buyers will need
to be developed. This proposal may give rise to an increase in the
number of individual taxpayers requiring third-party assistance in
preparing their tax returns. The factual inquiries necessitated
by the annual State credit authority cap, the per-unit expenditure
requirements, the certification of buyer income levels, the time
limits on subsequent sales, and the recapture rules applicable
to homebuyers, will tend to lead to additional disputes, including
litigation, between the IRS and taxpayers. In addition, adding a
new incentive to home ownership without coordinating with
present-law incentives (such as the low-income housing credit),
which have a similar policy goal but have somewhat different
requirements, will cause a proliferation of similar provisions,
adding to tax law complexity.
Policy issues
Families with incomes less than the median income family are less
often homeowners than are families with incomes above the median
income. While many factors determine a family's decision to rent
rather than own their own home, the price of a home creates two
important financial factors that, at least temporarily, persuade
families with incomes less than the median income to choose to rent
rather than buy. First, the greater the price of a home, the
greater the required down payment, and families generally must
accumulate funds for the down payment. Second, the greater the
price of a home, the greater the monthly mortgage payment, and both
lenders and prudent buyers generally limit monthly housing expenses
by reference to a percentage of current income. In summary, lower
housing prices will make it easier for families with incomes less
than the median income to accumulate funds for a down payment and to
qualify for a mortgage based upon their current income.
Supply and demand in the local housing market, determine the price
of available homes. An important factor in determining the market
price is the cost of developing new properties or renovating old
properties. A developer's expenses in the provision of housing can
be thought of as consisting of two components: (1) the cost of the
land; and (2) the cost of construction. The proposal will provide
a developer a credit against his income tax liability related to
qualified construction expenses for housing sold to a qualified
homebuyer whose family income is 80 percent or less of area median
income (70 percent or less for families comprised of one, two, or
three individuals). In a sale to a qualifying homebuyer, the credit
has the effect of subsidizing construction costs. As a consequence,
the developer may be able to offer housing for sale to a qualifying
homebuyer at a lower price than the developer's costs, or the local
housing market, might warrant. The tax credit may enable the
developer to earn an after-tax rate of return comparable or greater
to that the developer would have earned had the same housing been
sold to a non-qualifying homebuyer or would have earned had the
developer built other housing to be sold to a non-qualifying
homebuyer in the same local housing market.
The statutory incidence of the proposal provides that the taxpayer
developing the qualifying property claims the tax benefit. However,
in a market economy the economic incidence can differ from the
statutory incidence. All of the benefit can accrue to a buyer of the
property in the form of reduction in purchase price (compared to an
otherwise comparable home offered by a developer who has not
received an allocation of the proposed tax credits) equal to the
full present value of the tax credits the developer/seller may
claim under the proposal. Alternatively, there may be no change in
__________________
/150/ The proposal will determine the present value of the tax
credits as provided under present-law Code section 42 (the
low-income housing credit). The present value calculation
prescribed in subsection 42(b) was based on a marginal income tax
rate applicable to the highest income taxpayers of 28 percent.
Subsequent changes in the marginal income tax rate structure,
including changes enacted as part of the Economic Growth and Tax
Relief Reconciliation Act of 2001, have established marginal income
tax rates other than 28 percent to be applicable to the highest
income taxpayers. Thus, the present value calculation of the
proposal may not reflect the actual present value to the taxpayer.
purchase price (compared to an otherwise comparable home offered by
a developer who has not received an allocation of the proposed tax
credits), in which case the entire economic benefit of the tax
credits will accrue to the developer/seller claiming the credits
under the proposal. Generally, the more responsive purchasers are
to changes in the market price, the greater will be the proportion
of the economic incidence of a tax benefit that accrues to the
seller. The more responsive sellers are to changes in the market
price, the greater will be the proportion of the economic incidence
of a tax benefit that accrues to the purchaser. For example, if
there are relatively few properties of a comparable type and it is
difficult to obtain land or building permits to build more such
properties, the more likely it will be that qualifying homebuyers
bid against one another for a property. By bidding up the sales
price of the property, more of the economic benefit of the tax
credit accrues to the seller. On the other hand, if there are
relatively few qualified buyers, but there are several potential
developers who have credit allocations and can easily supply
housing for sale, the developers may compete against each other
to sell to a qualifying buyer by lowering the price they charge
to such buyers. By lowering the price of the property under
competitive pressure, more of the economic benefit of the tax
credit accrues to the buyer.
Because of the diversity in market conditions of different local
housing markets, it is not possible to predict whether buyers or
sellers are likely to be the primary economic beneficiary of the
proposed tax credit. The proposal requires that the credit may
only be claimed for sales that occur within one year of the
property being certified for occupancy. The time limit may exert
pressure on developers to reduce the price of the property in order
to sell it before the one-year period expires. On the other hand,
the limit on the number of properties on which the credit may be
claimed may impose a supply constraint. Potential qualifying
buyers can bid against one another, keeping the sales price higher
than it otherwise might be. Even if the economic beneficiary were
to be the developer, the developer may only claim the credit if a
family with an income of less than 80 percent of the area median
income is the purchaser. Therefore, even if such a family did not
receive a substantial price discount, if the developer sold to such
a family, rather than a non-qualifying family, the goal of
increasing home ownership by families with incomes less than 80
percent of the area median income may have been advanced.
The proposal defines qualifying buyers by reference to their annual
income at the time of purchase. As noted above, a lower proportion
of families with incomes less than area median income are
homeowners than are families with incomes above the area median
income. It is also the case that families headed by individuals
30 years old or younger are more likely to have incomes less than
the area median income than are families headed by individuals over
30 years of age. This arises because most individuals' earning
power increases with experience and job tenure. As the family's
earners age, the family is more able to accumulate funds for a down
payment and have sufficient monthly income to qualify for a mortgage
on a home. Data on homeownership by age are consistent with this
scenario. In 2003, the percentage of household owner-occupiers
__________________
/151/ Economists measure the responsiveness to demand and supply to
price changes by reference to the "price elasticity of demand" and
the "price elasticity of supply." The greater the price elasticity
of demand relative to the price elasticity of supply, the greater
the economic incidence falls to the benefit of sellers. The greater
the price elasticity of supply relative to the price elasticity of
demand, the greater the economic incidence falls to the benefit of
the buyer.
among households headed by an individual less than 35 years old was
42.2 percent. The percentage of household owner-occupiers among
households headed by an individual 35 to 44 years old was 68.3
percent. The percentage of household owner-occupiers among
households headed by an individual 65 years old or older was 80.5
percent. By targeting the credit based on annual income, the
proposal may provide benefit to two distinct types of families.
The proposal provides benefit both to those families whose income,
year-in, year-out falls below 80 percent of area median and who,
consequently, may otherwise always find down payment and monthly
mortgage servicing requirements a hurdle to homeownership.
The proposal also will provide a benefit to families whose income
growth will permit them to own a home without assistance as the
family's income grows through time. For such families the proposal
may only accelerate their ultimate status as a homeowner.
Some observers may find some unfairness in the proposal's definition
of qualifying family. Under the proposal, the Smith family, whose
income is less than 80 percent of the area median income, and the
Jones family, whose income is above 80 percent of the area median
income, can bid on the same property. If the Smith family offered
$95,000 for the property and the Jones family offered $100,000,
under the proposal, the Smith's offer can dominate the Jones's
offer on an after-tax basis to the seller. The Smith and Jones
families can have very similar incomes. A modest raise may have
pushed the Jones family above the qualifying income threshold and
thereby denied the Jones family the opportunity to acquire the home
or it may require the Jones family to offer even more if they hope
to acquire the home.
Some opponents of the proposal question the necessity of providing
additional benefits to homeownership. They note that homeownership
rates are above 67 percent and homeownership receives preferential
treatment under the present income tax as mortgage interest, home
equity interest, and property tax payments are deductible expenses
and that for many taxpayers any capital gain on the income from the
sale of a principal residence is excluded from income.
In addition, they note that, under present law, States may issue
qualified mortgage bonds and qualified mortgage credit certificates
to lower the mortgage costs of middle and lower-middle income
families who seek to acquire a home. That is, the qualified
mortgage bond program and the qualified mortgage credit certificate
program generally target the financial needs of the same population.
Proponents of efforts to increase homeownership observe that
homeownership helps support strong, vital communities and
participatory democracy. In particular, they observe, the quality
of life in distressed neighborhoods can be improved by increasing
homeownership. In such neighborhoods the costs of renovation or new
construction may exceed the current market value of housing in such
neighborhoods and a State allocation mechanism for the proposed
credits may be able to direct qualifying investments to such areas
where the social return to homeownership is particularly large.
_______________________
/152/ U.S. Department of Commerce, Economics and Statistics
Administration, Statistical Abstract of the United States:
2004-2005.
/153/ In 2003, of 105.9 million occupied housing units nationwide,
72.3 million, or 68.2 percent were owner-occupied. U.S. Department
of Commerce, Economics and Statistics Administration, Statistical
Abstract of the United States: 2004- 2005.
Prior Action
A similar proposal was included in the President's fiscal year 2002,
2003, 2004, and 2005 budget proposals.
I. Environment and Conservation Related Provisions
1. Permanently extend expensing of brownfields remediation costs
Present Law
Code section 162 allows a deduction for ordinary and necessary
expenses paid or incurred in carrying on any trade or business.
Treasury regulations provide that the cost of incidental repairs
that neither materially add to the value of property nor
appreciably prolong its life, but keep it in an ordinarily
efficient operating condition, may be deducted currently as a
business expense. Section 263(a)(1) limits the scope of section
162 by prohibiting a current deduction for certain capital
expenditures. Treasury regulations define "capital expenditures"
as amounts paid or incurred to materially add to the value, or
substantially prolong the useful life, of property owned by the
taxpayer, or to adapt property to a new or different use. Amounts
paid for repairs and maintenance do not constitute capital
expenditures. The determination of whether an expense is
deductible or capitalizable is based on the facts and circumstances
of each case.
Under Code section 198, taxpayers can elect to treat certain
environmental remediation expenditures that would otherwise be
chargeable to capital account as deductible in the year paid or
incurred. The deduction applies for both regular and alternative
minimum tax purposes. The expenditure must be incurred in connection
with the abatement or control of hazardous substances at a
qualified contaminated site. In general, any expenditure for the
acquisition of depreciable property used in connection with the
abatement or control of hazardous substances at a qualified
contaminated site does not constitute a qualified environmental
remediation expenditure. However, depreciation deductions
allowable for such property, which would otherwise be allocated to
the site under the principles set forth in Commissioner v. Idaho
Power Co. and section 263A, are treated as qualified environmental
remediation expenditures.
A "qualified contaminated site" (a so-called "brownfield") generally
is any property that is held for use in a trade or business, for
the production of income, or as inventory and is certified by the
appropriate State environmental agency to be an area at or on which
there has been a release (or threat of release) or disposal of a
hazardous substance. Both urban and rural property may qualify.
However, sites that are identified on the national priorities list
under the Comprehensive Environmental Response, Compensation, and
Liability Act of 1980 ("CERCLA") cannot qualify as targeted areas.
Hazardous substances generally are defined by reference to sections
101(14) and 102 of CERCLA, subject to additional limitations
applicable to asbestos and similar substances within buildings,
certain naturally occurring substances such as radon, and certain
other substances released into drinking water supplies due to
deterioration through ordinary use.
_____________________
/154/ Commissioner v. Idaho Power Co., 418 U.S. 1 (1974) (holding
that equipment depreciation allocable to the taxpayer's construction
of capital facilities must be capitalized under section 263(a)(1)).
In the case of property to which a qualified environmental
remediation expenditure otherwise would have been capitalized,
any deduction allowed under section 198 is treated as a depreciation
deduction and the property is treated as section 1245 property.
Thus, deductions for qualified environmental remediation
expenditures are subject to recapture as ordinary income upon a
sale or other disposition of the property. In addition, sections
280B (demolition of structures) and 468 (special rules for mining
and solid waste reclamation and closing costs) do not apply to
amounts that are treated as expenses under this provision.
Eligible expenditures are those paid or incurred before
January 1, 2006.
Description of Proposal
The proposal eliminates the requirement that expenditures must be
paid or incurred before January 1, 2006, to be deductible as
eligible environmental remediation expenditures. Thus, the provision
becomes permanent.
Effective date.�The proposal is effective on the date of enactment.
Analysis
Policy issues
The proposal to make permanent the expensing of brownfields
remediation costs would promote the goal of environmental
remediation and remove doubt as to the future deductibility of
remediation expenses. Removing the doubt about deductibility may
be desirable if the present-law expiration date is currently
affecting investment planning. For example, the temporary nature
of relief under present law may discourage projects that require a
significant ongoing investment, such as groundwater clean-up
projects. On the other hand, extension of the provision for a
limited period of time would allow additional time to assess the
efficacy of the law, adopted only recently as part of the Taxpayer
Relief Act of 1997, prior to any decision as to its permanency.
The proposal is intended to encourage environmental remediation,
and general business investment, at contaminated sites. With
respect to environmental remediation tax benefits as an incentive
for general business investment, it is possible that the incentive
may have the effect of distorting the location of new investment,
rather than increasing investment overall. If the new investments
are offset by less investment in neighboring, but not qualifying,
areas, the neighboring communities could suffer. On the other hand,
the increased investment in the qualifying areas could have
spillover effects that are beneficial to the neighboring
communities.
____________________
/155/ For a discussion of the economic effects of targeting economic
activity to specific geographic areas, see Leslie E. Papke, "What Do
We Know About Enterprise Zones," in James M. Poterba, ed., Tax
Policy and the Economy, vol. 7 (Cambridge, MA: The MIT Press), 1993.
Complexity issues
By making the present law provision permanent, the proposal may
simplify tax planning and investment planning by taxpayers by
providing more certainty. However, in general, the proposal would
treat expenditures at certain geographic locations differently from
otherwise identical expenditures at other geographic locations.
Such distinctions generally require additional record keeping on the
part of taxpayers and more complex tax return filings.
Concomitantly, such distinctions increase the difficulty of IRS
audits.
Prior Action
Proposals to make section 198 permanent were included in the
President's fiscal year 1999, 2000, 2001, 2002, 2003, 2004, and
2005 budget proposals.
2. Exclude 50 percent of gains from the sale of property for
conservation purposes
Present Law
Income tax treatment of dispositions of land
Capital gains treatment
In general, gain or loss reflected in the value of an asset is
recognized for income tax purposes at the time the taxpayer
disposes of the property. On the sale or exchange of capital
assets held for more than one year, gain generally is taxed to
an individual taxpayer at a maximum marginal rate of 15 percent.
However, gain attributable to real estate depreciation deductions
that were previously claimed against ordinary income is taxed at a
maximum marginal rate of 25 percent. Losses from the sale or
exchange of capital assets are deductible only to the extent of the
gains from the sale or exchange of other capital assets, plus, in
the case of individuals, $3,000.
Land is a capital asset, unless it is held primarily for sale to
customers in the ordinary course of the taxpayer's trade or
business, or it is used in the taxpayer's trade or business. In
addition, if the gains from property, including land, used in a
taxpayer's trade or business exceed the losses from such property,
the gains and losses are treated as capital gains.
Deferral of gain or loss
Several provisions allow a taxpayer to defer gain when property,
including land, is disposed of. For example, gain or loss is
deferred if land held for investment or business use is exchanged
for property of a like kind (generally defined to include other real
estate) (sec. 1031). Likewise, gain is deferred if land is condemned
and replaced with other property of a like kind (sec. 1033(g)).
Income tax provisions relating to contributions of capital gain
property and qualified conservation interests
Charitable contributions generally
In general, a deduction is permitted for charitable contributions,
subject to certain limitations that depend on the type of taxpayer,
the property contributed, and the donee organization. The amount of
deduction generally equals the fair market value of the contributed
property on the date of the contribution. Charitable deductions
are provided for income, estate, and gift tax purposes (secs. 170,
2055, and 2522 respectively).
In general, in any taxable year, charitable contributions by a
corporation are not deductible to the extent the aggregate
contributions exceed 10 percent of the corporation's taxable income
computed without regard to net operating or capital loss carrybacks.
For individuals, the amount deductible generally is a percentage of
the taxpayer's contribution base, which is the taxpayer's adjusted
gross income computed without regard to any net operating loss
carryback. The applicable percentage of the contribution base
varies depending on the type of donee organization and property
contributed.
Gifts of certain types of property interests are subject to special
restrictions, either as to the amount deductible or as to the types
of property interests for which a deduction is permitted.
For example, a contribution of less than the donor's entire
interest in property generally is not allowable as a charitable
deduction unless the gift takes the form of an interest in a
unitrust, annuity trust, or a pooled income fund.
Capital gain property
Capital gain property is property, which if sold at 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 to a qualified charity are deductible at fair market
value within certain limitations. Contributions of capital gain
property to charitable organizations described in section 170(b)
(1)(A) (e.g., public charities, private foundations other than
private non-operating foundations, and certain governmental units)
generally are deductible up to 30 percent of the taxpayer's
contribution base. Contributions of capital gain property to
charitable organizations described in section 170(b)(1)(B) (e.g.,
private non-operating foundations) are deductible up to 20 percent
of the taxpayer's contribution base.
For purposes of determining whether a taxpayer's aggregate
charitable contributions in a taxable year exceed the applicable
percentage limitation, contributions of capital gain property are
taken into account after other charitable contributions.
Contributions of capital gain property that exceed the percentage
limitation may be carried forward for five years.
Qualified conservation contributions
Qualified conservation contributions are not subject to the "partial
interest" rule, which generally bars deductions for charitable
contributions of partial interests in property. 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 a historically important land area or a certified
historic structure.
Qualified conservation contributions of capital gain property are
subject to the same limitations and carryforward rules applicable to
other charitable contributions of capital gain property.
Description of Proposal
The proposal provides that a taxpayer may exclude from income 50
percent of the gain realized from the sale of land (or an interest
in land or water) to a qualified conservation organization for
conservation purposes. The income not excluded is taxed as capital
gain eligible for the alternative rate schedule of present law.
The exclusion is computed without regard to improvements.
To be eligible for the exclusion, the taxpayer or a member of the
taxpayer's family has to have owned the property for the three
years immediately preceding the date of the sale. The taxpayer is
not eligible for the exclusion in the case of property sold pursuant
to a condemnation order, but the taxpayer is eligible for the
exclusion in the case of property sold in response to the threat or
imminence of a condemnation order.
A qualified conservation organization is either a governmental unit
or a charity that is a qualified organization under present-law
section 170(h)(3) and that is organized and operated primarily for
conservation purposes. Conservation purposes include the
preservation of land areas for outdoor recreation by, or the
education of, the general public; the protection of a relatively
natural habitat of fish, wildlife, or plants, or similar ecosystem;
or the preservation of open space where the preservation is for the
scenic enjoyment of the general public or pursuant to a clearly
delineated Federal, State, or local governmental conservation policy.
The buyer must provide a written statement representing that it is a
qualified conservation organization and that it intends to hold the
property exclusively for conservation purposes and not to transfer
it for valuable consideration other than to a qualified
conservation organization in a transaction that would qualify under
the proposal if the qualified conservation organization
(i.e., the buyer in the transaction that is the subject of the written statement) were a taxable person.
Sales of partial interests in property also qualify if the sale
meets the present law standards for qualified conservation
contributions of partial interests within the meaning of section
170(h).
To prevent abuse, significant penalties are imposed on any
subsequent transfer or use of the property other than exclusively
for conservation purposes, or on any subsequent removal of a
conservation restriction contained in an instrument of conveyance of
the property. Sales of the property under the proposal at a price
that is less than the fair market value of property qualify as
bargain sales, but only to the extent that the proceeds of the
sale, net of capital gains taxes under this provision, are lower
than the after-tax proceeds that would have resulted if the
property had been sold at fair market value and the seller had paid
tax on the full amount of the resulting gain.
Effective date.--The proposal is effective for sales occurring on or
after January 1, 2006, and before January 1, 2009.
Analysis
Policy issues
In general, for sales of real estate, the maximum tax rate applied
to capital gain income (excluding improvements) is 15 percent for
taxpayers who would otherwise be in the 25 percent, 28 percent, 33
percent, and 35 percent ordinary income tax brackets. If such a
taxpayer sold conservation property to a qualifying conservation
organization, after the 50-percent exclusion, the effective tax
rate on the gain income would be 7.5 percent. Per $1,000 of
gain, the proposal could produce a benefit of up to $75 if the
taxpayer were to sell to a qualifying conservation organization
rather than to another person offering the same purchase price.
The proposal seeks to increase sales of conservation property to
qualifying conservation organizations by making it possible for
the seller to reap a higher after-tax return by selling property
to the qualifying conservation organization than by selling to a
non-qualifying buyer.
___________________________
/156/ See Sec. 1011(b) and Treas. Reg. sec. 1.1011-2.
/157/ Under present law, the maximum tax rate applied to capital
gain income for taxpayers in the 10 and 15-percent income tax
brackets is five percent (zero percent after 2007).
/158/ In the case of a taxpayer otherwise in the 10-percent or
15-percent marginal income tax bracket, the result of the combination
of the exclusion and the alternative five-percent tax rate on
income from capital gain is an effective tax rate of 2.5 percent on
the gain.
/159/ In the case of a taxpayer otherwise in the 10-percent or
15-percent marginal income tax brackets, per $1,000 of gain, the
proposal could produce a benefit of up to $25 if the taxpayer were
to sell to a qualifying conservation organization rather than to
another person offering the same purchase price.
The simple calculations above may suggest that the seller would
reap the full benefit of the lower effective tax rate. However,
qualifying conservation organizations, recognizing that their
purchase of property can qualify a taxpayer for a lower effective
tax rate (a higher after-tax return) may bid less than they
otherwise might knowing that the highest offer may not be selected
by a taxpayer who is informed of the tax benefits of the lower bid.
In this sense, the proposal is equivalent to the Federal government
partially subsidizing the purchase of conservation property selected
by the qualifying conservation organization. From the calculations
above, by lowering the effective tax rate, the Federal government
would be effectively contributing as much as 7.5 percent of the
purchase price of the property.
The extent to which the benefit of the proposed exclusion accrues to
the taxpayer selling the property or to the qualifying conservation
organization purchasing the property depends upon the demand for the
property and the extent to which other similar properties also are
offered for sale. If one qualifying conservation organization is
bidding against other persons for a property, in general one might
expect that the qualifying conservation organization might be able
to derive a substantial portion of the benefit of the lower
effective tax rate. While the persons who are not qualifying
conservation organizations would bid based on what they believe the
market value of the property to be, the qualifying conservation
could bid less, and as demonstrated above, the seller could find it
in his or her interest to accept the lower bid of the qualifying
conservation organization. To receive the entire benefit of the
lower effective tax rate, the qualifying conservation organization
would have to know the tax position of the seller (see discussion of
complexity below). In practice, such knowledge would not be
available to the qualifying conservation organization and
conservative bidding would result in the qualifying conservation
organization deriving less than the full benefit.
On the other hand, if several qualifying conservation organizations
bid against each other on the same property, as they compete with
price offers they would transfer most of the benefit from the
exclusion to the taxpayer selling the property.
The incentive effects of the proposal decrease as the capital gains
tax rate decreases for the selling taxpayer, as is the case for
many taxpayers as a result of the JGTRRA capital gain rate
reductions.
__________________
/160/ The percentages in the text assume that the taxpayer selling
the property has a zero basis in the property. Thus, the
percentages in the text represent an upper bound on the Federal
government's effective share of the purchase price. In the case of
property sold by a taxpayer otherwise in the 10- or 15-percent
marginal income tax brackets, the comparable percentages would be
lower.
Complexity issues
In its report, the staff of the Joint Committee on Taxation
identified the taxation of income from capital gains as an area of
complexity in the individual income tax. The staff of the Joint
Committee on Taxation has identified nine different categories of
capital gain, often with multiple rates of tax applying within each
category depending upon the taxpayer's circumstance.
Present law requires a holding period of one year or more for a
taxpayer to avail him or herself of the benefit of the alternative
tax rates applicable to capital gain income. The proposal layers
an exclusion for the sale of certain assets on top of the present law alternative rate schedule. The proposal would create a new
three-year holding period requirement. This would require
additional computation, instructions, and a longer form for
individuals who recognize gains that qualify for the exclusion of
the proposal and also have other gain income. While relatively few
taxpayers would recognize qualifying gains in any one year, those
axpayers who recognize other capital gain income will have a more
complex form to work through.
By its design, the proposal makes economic decisions more complicated
as a taxpayer's net rate of return to the sale of property would
depend upon the buyer's identity as well as the buyer's purchase
offer. In theory, if the proposal were to have the desired
incentive effect, the taxpayer would weigh the offer price of a
qualifying conservation organization against competing offers from
other persons by calculating his or her after-tax position. Such
calculations are more complex than comparing the dollar purchase
offers of competing buyers.
From the buyer's side, if the qualifying conservation organization
were to attempt to utilize the proposal to its benefit by offering
a lower price to the seller, the organization would have to
make estimates, or consult with the seller, regarding the seller's
tax position for the year of the sale. This would include
researching whether the seller's effective rate of tax may be less
than 7.5 percent. As accurate estimates might be crucial to
submitting a winning offer for qualifying property, the qualifying
conservation organization, in principle, would need to have
information about the financial affairs of the seller. Such an
offer strategy is a more information intensive process than typical
real estate transactions.
The proposal imposes an additional paperwork and record keeping
burden on the qualifying conservation organization and the selling
taxpayer. The qualifying conservation organization must provide
certification to the taxpayer selling the property that the sale and
purchase is a qualifying conservation transaction. The selling
taxpayer must retain this certification in order to claim the
exclusion. Presumably, a separate reporting requirement would
be established for the buyer and or seller to notify the IRS of
a qualifying sale. As the holding period of potentially qualifying
property is satisfied by reference to the taxpayer's family, rather
than solely by reference to the taxpayer's ownership of the
property, in some cases documentation from other persons also would
be required.
____________________
/161/ Joint Committee on Taxation, Study of the Overall State of the
Federal Tax System and Recommendations for Simplification, Pursuant
to Section 8022(3)(B) of the Internal Revenue Code of 1986, Volume
II, at 97-108, (JCS-3-01), April 2001.
The proposal also imposes additional complexity and record keeping
burdens on the qualifying conservation organization because of the
potential penalties that may be imposed for subsequent transfers or
uses of the property that do not satisfy the conservation
requirements. The organization likely will be required to retain
records that demonstrate compliance with the proposal's
requirements and to notify the IRS if any impermissible change in
use takes place with respect to the property. The IRS will have to
modify its forms and instructions to provide for the imposition of
the penalties in such cases. The application of modified
bargain-sale rules to qualified conservation sales at a price less
than fair market value also increases complexity for the buyer and
seller of the property.
Prior Action
A similar proposal was included in the President's fiscal year 2002
and 2003 budget proposals, which included less detail regarding the
penalty and bargain-sale provisions, and in the President's fiscal
year 2004 and 2005 budget proposals.
A similar proposal was included in section 107 of S. 476, the "CARE
Act of 2003," passed by the Senate on April 9, 2003, which would
exclude 25 percent of long-term capital gain on certain sales or
exchanges to eligible entities for conservation purposes.
J. Energy Provisions
1. Extend and modify the tax credit for producing electricity from
certain sources
Present Law
In general
An income tax credit is allowed for the production of electricity
from qualified facilities (sec. 45). Qualified facilities comprise
wind energy facilities, "closed-loop" biomass facilities,
open-loop biomass (including agricultural livestock waste nutrients)
facilities, geothermal energy facilities, solar energy facilities,
small irrigation power facilities, landfill gas facilities, and
trash combustion facilities. In addition, an income tax credit is
allowed for the production of refined coal.
Credit amounts and credit period
In general
The base amount of the credit is 1.5 cents per kilowatt hour
(indexed for inflation) of electricity produced. The amount of the
credit was 1.8 cents per kilowatt hour for 2004. A taxpayer may
claim credit for the 10-year period commencing with the date the
qualified facility is placed in service. The credit is reduced
for grants, tax-exempt bonds, subsidized energy financing, and other
credits. The amount of credit a taxpayer may claim is phased out as
the market price of electricity (refined coal in the case of
refined coal) exceeds certain threshold levels.
______________________
/162/ The Energy Policy Act of 1992 created section 45 as a
production credit for electricity produced from wind and closed-loop
biomass for production from certain facilities placed in service
before July 1, 1999. The Ticket to Work and Work Incentives
Improvement Act of 1999 added poultry waste as a qualifying energy
source, extended the placed in service date through December 31,
2001, and made certain modifications to the requirements of
qualifying wind facilities. The Job Creation and Worker Assistance
Act of 2002 extended the placed in service date through December
31, 2003. The Working Families Tax Relief Act of 2004 extended the
generally applicable placed in service date for wind facilities,
closed-loop biomass facilities, and poultry waste facilities through
December 31, 2005. a The American Jobs Creation Act of 2004 ("AJCA")
modified the provision to add as qualified facilities open-loop
biomass (including agricultural livestock waste nutrients),
geothermal energy, solar energy, small irrigation power, and
municipal solid waste (both landfill gas and trash combustion
facilities). The definition of agricultural livestock waste
nutrients subsumes poultry waste, so the AJCA repealed,
prospectively, poultry waste facilities as a separate category of
qualified facility. The AJCA defined refined coal as a qualifying
resource eligible for credit. The AJCA also made other
modifications.
Reduced credit amounts and credit periods
In the case of open-loop biomass facilities (including agricultural
livestock waste nutrient facilities), geothermal energy facilities,
solar energy facilities, small irrigation power facilities,
landfill gas facilities, and trash combustion facilities,
the 10-year credit period is reduced to five years commencing on
the date the facility is placed in service. In general, for eligible
pre-existing facilities and other facilities placed in service
prior to January 1, 2005, the credit period commences on January 1,
2005. In the case of a closed-loop biomass facility modified to
co-fire with coal, to co-fire with other biomass, or to co-fire with
coal and other biomass, the credit period begins no earlier than
October 22, 2004.
In the case of open-loop biomass facilities (including agricultural
livestock waste nutrient facilities), small irrigation power,
landfill gas facilities, and trash combustion facilities, the
otherwise allowable credit amount is 0.75 cent per kilowatt hour,
indexed for inflation measured after 1992.
Credit applicable to refined coal
The amount of the credit for refined coal is $4.375 per ton (also
indexed for inflation after 2002 and would have equaled $5.350 per
ton for 2004).
Other limitations on credit claimants and credit amounts
In general, in order to claim the credit, a taxpayer must own the
qualified facility and sell the electricity produced by the facility
(or refined coal in the case of refined coal) to an unrelated
party. A lessee or operator may claim the credit in lieu of the
owner of the qualifying facility in the case of qualifying open-loop
biomass facilities originally placed in service on or before the
date of enactment and in the case of a closed-loop biomass
facilities modified to co-fire with coal, to co-fire with other
biomass, or to co-fire with coal and other biomass. In the case of
poultry waste facility, the taxpayer may claim the credit as a
lessee or operator of a facility owned by a governmental unit.
For all qualifying facilities, other than closed-loop biomass
facilities modified to co-fire with coal, to co-fire with other
biomass, or to co-fire with coal and other biomass, the amount of
credit a taxpayer may claim is reduced by reason of grants,
tax-exempt bonds, subsidized energy financing, and other credits,
but the reduction cannot exceed 50 percent of the otherwise
allowable credit. In the case of closed-loop biomass facilities
modified to co-fire with coal, to co-fire with other biomass, or to
co-fire with coal and other biomass, there is no reduction in
credit by reason of grants, tax-exempt bonds, subsidized energy
financing, and other credits.
The credit for electricity produced from wind, closed-loop biomass,
or poultry waste is a component of the general business credit
(sec. 38(b)(8)).
A taxpayer's tentative minimum tax is treated as being zero for
purposes of determining the tax liability limitation with respect
to the section 45 credit for electricity produced from a
facility (placed in service after October 22, 2004) during the
first four years of production beginning on the date the facility
is placed in service.
Qualified facilities
Wind energy facility
A wind energy facility is a facility that uses wind to produce
electricity. To be a qualified facility, a wind energy facility
must be placed in service after December 31, 1993, and before
January 1, 2006.
Closed-loop biomass facility
A closed-loop biomass facility is a facility that uses any organic
material from a plant which is planted exclusively for the purpose
of being used at a qualifying facility to produce
electricity. In addition, a facility can be a closed-loop biomass
facility if it is a facility that is modified to use closed-loop
biomass to co-fire with coal, with other biomass, or with both coal
and other biomass, but only if the modification is approved under
the Biomass Power for Rural Development Programs or is part of a
pilot project of the Commodity Credit Corporation.
To be a qualified facility, a closed-loop biomass facility must be
placed in service after December 31, 1992, and before January 1,
2006. In the case of a facility using closed-loop biomass but also
co-firing the closed-loop biomass with coal, other biomass, or coal
and other biomass, a qualified facility must be originally placed
in service and modified to co-fire the closed-loop biomass at any
time before January 1, 2006.
Open-loop biomass (including agricultural livestock waste
nutrients) facility
An open-loop biomass facility is a facility using open-loop biomass
(including agricultural livestock waste nutrients) to produce
electricity. Open-loop biomass is defined as any solid,
nonhazardous, cellulosic waste material which is segregated from
other waste materials and which is derived from any of
forest-related resources, solid wood waste materials, or
agricultural sources. Eligible forest-related resources are mill
residues, other than spent chemicals from pulp manufacturing,
precommercial thinnings, slash, and brush. Solid wood waste
materials include waste pallets, crates, dunnage, manufacturing
and construction wood wastes (other than pressure-treated,
chemically-treated, or painted wood wastes), and landscape or
right-of-way tree trimmings. Agricultural sources include orchard
tree crops, vineyard, grain, legumes, sugar, and other crop
by-products or residues. However, qualifying open-loop biomass
does not include municipal solid waste (garbage), gas derived
from biodegradation of solid waste, or paper that is commonly
recycled. In addition, open-loop biomass does not include
closed-loop biomass or any biomass burned in conjunction with fossil
fuel (cofiring) beyond such fossil fuel required for start up and
flame stabilization.
Agricultural livestock waste nutrients are defined as agricultural
livestock manure and litter, including bedding material for the
disposition of manure.
To be a qualified facility, an open-loop biomass facility must be
placed in service after October 22, 2004 and before January 1, 2006,
in the case of facility using agricultural livestock waste
nutrients and must be placed in service at any time prior to
January 1, 2006 in the case of a facility using other open-loop
biomass.
Geothermal facility
A geothermal facility is a facility that uses geothermal energy to
produce electricity. Geothermal energy is energy derived from a
geothermal deposit which is a geothermal reservoir consisting of
natural heat which is stored in rocks or in an aqueous liquid or
vapor (whether or not under pressure). To be a qualified
facility, a geothermal facility must be placed in service after the
date of enactment and before January 1, 2006.
Solar facility
A solar facility is a facility that uses solar energy to produce
electricity. To be a qualified facility, a solar facility must be
placed in service after the date of enactment and before January 1,
2006.
Small irrigation facility
A small irrigation power facility is a facility that generates
electric power through an irrigation system canal or ditch without
any dam or impoundment of water. The installed capacity of a
qualified facility is not less than 150 kilowatts and less than
five megawatts. To be a qualified facility, a small irrigation
facility must be originally placed in service after the date of
enactment and before January 1, 2006.
Landfill gas facility
A landfill gas facility is a facility that uses landfill gas to
produce electricity. Landfill gas is defined as methane gas
derived from the biodegradation of municipal solid waste. To be
a qualified facility, a landfill gas facility must be placed in
service after October 22, 2004 and before January 1, 2006.
Trash combustion facility
Trash combustion facilities are facilities that burn municipal solid
waste (garbage) to produce steam to drive a turbine for the
production of electricity. To be a qualified facility, a trash
combustion facility must be placed in service after October 22, 2004
and before January 1, 2006.
Refined coal facility
A qualifying refined coal facility is a facility producing refined
coal that is placed in service after the date of enactment and
before January 1, 2009. Refined coal is a qualifying
liquid, gaseous, or solid synthetic fuel produced from coal
(including lignite) or high-carbon fly ash, including such fuel
used as a feedstock. A qualifying fuel is a fuel that when burned
emits 20 percent less nitrogen oxides and either SO2 or mercury than
the burning of feedstock coal or comparable coal predominantly
available in the marketplace as of January 1, 2003, and if the
fuel sells at prices at least 50 percent greater than the prices
of the feedstock coal or comparable coal. In addition, to be
qualified refined coal the fuel must be sold by the taxpayer
with the reasonable expectation that it will be used for the
primary purpose of producing steam.
Description of Proposal
The proposal extends the placed in service date for facilities
that produce electricity from wind, closed-loop biomass, open-loop
biomass (other than agricultural waste nutrients), and landfill gas
to include electricity from those facilities placed in service
before January 1, 2008. The proposal does not extend the placed in
service date for facilities that produce electricity from
agricultural waste nutrient facilities, geothermal facilities, solar
power facilities, small irrigation facilities, or trash combustion
facilities.
In addition, the proposal permits taxpayers to claim a credit at
60 percent of the otherwise allowable credit for electricity
produced from open-loop biomass (0.45 cents per kilowatt-hour before
adjustment for inflation indexing) for electricity produced from
open-loop biomass (other than agricultural waste nutrients)
co-fired in coal plants during the three-year period January 1,
2006 through December 31, 2008.
Effective date.�The proposal is effective on the date of enactment.
Analysis
See the general discussion following the description of the proposed
tax credit for combined heat and power property, below.
Prior Action
The President's fiscal year 2005, 2004 and 2003 budgets proposed
a similar proposal to the current proposal. The President's fiscal
year 2001 and 2002 budgets also proposed extending and modifying
the categories of facilities that would qualify for the production
credit under section 45.
2. Provide a tax credit for residential solar energy systems
Present Law
A nonrefundable, 10-percent business energy credit is allowed for
the cost of new property that is equipment (1) that uses solar
energy to generate electricity, to heat or cool a structure, or to
provide solar process heat, or (2) used to produce, distribute, or
use energy derived from a geothermal deposit, but only, in the
case of electricity generated by geothermal power, up to the
electric transmission stage.
The business energy tax credits are components of the general
business credit (sec. 38(b)(1)). The business energy tax credits,
when combined with all other components of the general business
credit, generally may not exceed for any taxable year the excess of
_________________
/163/ The extended placed in service date also will apply to the
date of modification of facilities modified to co-fire closed-loop
biomass with coal, other biomass, or both coal and other biomass.
the taxpayer's net income tax over the greater of (1) 25 percent
of net regular tax liability above $25,000 or (2) the tentative
minimum tax. For credits arising in taxable years beginning after
December 31, 1997, an unused general business credit generally may
be carried back one year and carried forward 20 years (sec. 39).
A taxpayer may exclude from income the value of any subsidy provided
by a public utility for the purchase or installation of an energy
conservation measure. An energy conservation measure means any
installation or modification primarily designed to reduce
consumption of electricity or natural gas or to improve the
management of energy demand with respect to a dwelling unit
(sec. 136).
There is no present-law personal tax credit for residential solar
energy property.
Description of Proposal
The proposal provides a tax credit for the purchase of photovoltaic
equipment and solar water heating equipment for use in a dwelling
unit that is used by the taxpayer as a residence.
Equipment would qualify for the credit only if is used exclusively
for purposes other than heating swimming pools. The credit is equal
to 15 percent of qualified investment up to a cumulative maximum of
$2,000 for solar water heating systems and $2,000 for rooftop
photovoltaic systems. This credit is nonrefundable.
Effective date.--The credit applies to equipment placed in service
after December 31, 2004 and before January 1, 2008 for solar water
heating systems and after December 31, 2004 and before January 1,
2010 for photovoltaic systems.
Analysis
See general discussion following the description of the proposed
tax credit for combined heat and power property, below.
Prior Action
Similar proposals were contained in the President's fiscal year
1999-2005 budget proposals.
A similar provision was contained in H.R. 4520, the "Jumpstart Our
Business Strength Act, as amended and passed by the Senate on July
15, 2004, and in S. 1637, the "Jumpstart Our Business Strength Act,
as passed by the Senate on May 11, 2004.
The conference agreement to H.R. 6, "The Energy Policy Act of 2003,"
as passed by the House of Representatives on November 18, 2003
contained a similar provision. Similar provisions are contained in
Division D of H.R. 6, the "Energy Tax Policy Act of 2003," as passed
by the House of Representatives on April 11, 2003, and in Division H
of H.R. 6, the "Energy Tax Incentives Act of 2003" as amended and
passed by the Senate on July 31, 2003.
Similar provisions were also contained in Division C of H.R. 4, the
"Energy Tax Policy Act of 2001," as passed by the House of
Representatives on August 2, 2001, and in Division H of H.R. 4,
"The Energy Tax Incentives Act of 2002," as amended and passed by
the Senate on April 25, 2002.
3. Modify the tax treatment of nuclear decommissioning funds
Present Law
Overview
Special rules dealing with nuclear decommissioning reserve funds
were adopted by Congress in the Deficit Reduction Act of 1984
("1984 Act"), when tax issues regarding the time value of money
were addressed generally. Under general tax accounting rules, a
deduction for accrual basis taxpayers is deferred until there is
economic performance for the item for which the deduction is
claimed. However, the 1984 Act contains an exception under which a
taxpayer responsible for nuclear powerplant decommissioning may
elect to deduct contributions made to a qualified nuclear
decommissioning fund for future decommissioning costs. Taxpayers
who do not elect this provision are subject to general tax
accounting rules.
Qualified nuclear decommissioning fund
A qualified nuclear decommissioning fund (a "qualified fund") is a
segregated fund established by a taxpayer that is used exclusively
for the payment of decommissioning costs, taxes on fund income,
management costs of the fund, and for making investments. The
income of the fund is taxed at a reduced rate of 20 percent for
taxable years beginning after December 31, 1995.
Contributions to a qualified fund are deductible in the year made
to the extent that these amounts were collected as part of the cost
of service to ratepayers (the "cost of service requirement").
Funds withdrawn by the taxpayer to pay for decommissioning costs
are included in the taxpayer's income, but the taxpayer also is
entitled to a deduction for decommissioning costs as economic
performance for such costs occurs.
Accumulations in a qualified fund are limited to the amount required
to fund decommissioning costs of a nuclear powerplant for the period
during which the qualified fund is in existence (generally post-1983
decommissioning costs of a nuclear powerplant). For this purpose,
decommissioning costs are considered to accrue ratably over a
_______________
/164/ As originally enacted in 1984, a qualified fund paid tax on
its earnings at the top corporate rate and, as a result, there was
no present-value tax benefit of making deductible contributions to
a qualified fund. Also, as originally enacted, the funds in the
trust could be invested only in certain low risk investments.
Subsequent amendments to the provision have reduced the rate of tax
on a qualified fund to 20 percent and removed the restrictions on
the types of permitted investments that a qualified fund can make.
/165/ Taxpayers are required to include in gross income customer
charges for decommissioning costs (sec. 88).
nuclear powerplant's estimated useful life. In order to prevent
accumulations of funds over the remaining life of a nuclear
powerplant in excess of those required to pay future decommissioning
costs of such nuclear powerplant and to ensure that contributions to
a qualified fund are not deducted more rapidly than level funding
(taking into account an appropriate discount rate), taxpayers must
obtain a ruling from the IRS to establish the maximum annual
contribution that may be made to a qualified fund (the "ruling
amount"). In certain instances (e.g., change in estimates), a
taxpayer is required to obtain a new ruling amount to reflect
updated information.
A qualified fund may be transferred in connection with the sale,
exchange or other transfer of the nuclear powerplant to which it
relates. If the transferee is a regulated public utility
and meets certain other requirements, the transfer will be treated
as a nontaxable transaction. No gain or loss will be recognized
on the transfer of the qualified fund and the transferee will
take the transferor's basis in the fund. The transferee is
required to obtain a new ruling amount from the IRS or accept a
discretionary determination by the IRS.
Nonqualified nuclear decommissioning funds
Federal and State regulators may require utilities to set aside
funds for nuclear decommissioning costs in excess of the amount
allowed as a deductible contribution to a qualified fund.
In addition, taxpayers may have set aside funds prior to the
effective date of the qualified fund rules. The treatment of
amounts set aside for decommissioning costs prior to 1984 varies.
Some taxpayers may have received no tax benefit while others may
have deducted such amounts or excluded such amounts from income.
Since 1984, taxpayers have been required to include in gross
income customer charges for decommissioning costs (sec. 88), and a
deduction has not been allowed for amounts set aside to pay for
decommissioning costs except through the use of a qualified fund.
Income earned in a nonqualified fund is taxable to the fund's owner
as it is earned.
Description of Proposal
Repeal of cost of service requirement
The proposal repeals the cost of service requirement for deductible
contributions to a nuclear decommissioning fund. Thus, all
taxpayers, including unregulated taxpayers, would be allowed a
deduction for amounts contributed to a qualified fund.
Exception to ruling amount for certain decommissioning costs
The proposal also permits taxpayers to make contributions to a
qualified fund in excess of the maximum annual contribution amount
(IRS ruling amount) up to an amount that equals the present value
_____________________
/166/ Treas. Reg. sec. 1.468A-6.
/167/ Treas. Reg. sec. 1.468A-6(f).
/168/ These funds are generally referred to as ``nonqualified funds.''
of the amount required to fund the nuclear powerplant's pre-1984
decommissioning costs to which the qualified fund relates. Any
amount transferred to the qualified fund that has not previously
been deducted or excluded from gross income is allowed as a
deduction over the remaining useful life of the nuclear
powerplant. If a qualified fund that has received amounts under
this rule is transferred to another person, that person will be
entitled to the deduction at the same time and in the same manner
as the transferor. Accordingly, if the transferor was not subject
to tax and thus unable to use the deduction, then the transferee
will similarly not be able to utilize the deduction. Amounts
contributed (and the earnings on such amounts) under these rules
would not be taken into account in determining the ruling amount
for the qualified fund.
Clarify treatment of transfers of qualified funds and deductibility
of decommissioning costs
The proposal clarifies the Federal income tax treatment of the
transfer of a qualified fund. No gain or loss would be recognized
to the transferor or the transferee as a result of the transfer
of a qualified fund in connection with the transfer of the power
plant with respect to which such fund was established. In
addition, the proposal provides that all nuclear decommissioning
costs are deductible when paid.
Contributions to a qualified fund after useful life of powerplant
The proposal also allows deductible contributions to a qualified
fund subsequent to the end of a nuclear powerplant's estimated
useful life. Such payments are permitted to the extent they do not
cause the assets of the qualified fund to exceed the present value
of the taxpayer's allocable share (current or former) of the
nuclear decommissioning costs of such nuclear powerplant.
Effective date
The proposal is effective for taxable years beginning after
December 31, 2004.
Analysis
Policy issues
The cost of service limitation on the amount of deductible
contributions to a qualified nuclear decommissioning fund reflects
the regulatory environment that existed when the legislation was
originally enacted in 1984 and all taxable entities producing
nuclear power were subject to rate regulation. More recently, the
process of deregulating the electric power industry has begun at
both the Federal and state level. Proponents of the proposal argue
that the present-law limitation is outdated, and that the rules
relating to deductible contributions to nuclear decommissioning
funds should be modernized to reflect industry deregulation.
The process of deregulation takes different forms in different
jurisdictions. A jurisdiction may choose to eliminate rate
regulation and allow rates to be set by the market instead of the
public utility commission. Although such market rates may include
an element compensating a generator of nuclear power for its
anticipated decommissioning costs, there is no regulatory cost
of service amount against which to measure a deductible
contribution. A line charge or other fee could be imposed by a
State or local government or a public utility commission to ensure
that adequate funds will be available for decommissioning, but
there is no assurance that this will be the case. The taxpayer
generating the electricity may not be the same as the taxpayer
distributing it. In those cases, the use of line charges and
other customer based fees as a vehicle to satisfy the requirement
that deductible contributions not exceed cost of service may not
be successful.
The exception allowing a taxpayer responsible for nuclear power
plant decommissioning to deduct contributions to a qualified
nuclear decommissioning fund for future payment costs was enacted
in Congress' belief that the establishment of segregated reserve
funds for paying future nuclear decommissioning costs was of
national importance. If deregulation continues, the deduction of
such contributions may be prevented unless the cost of service
limitation is repealed. The loss of deductibility may reduce the
amount of funds available for decommissioning in the future.
In addition, the proposal allows taxpayers to transfer to a
qualified fund decommissioning costs for the period prior to the
qualified fund's existence (generally pre-1984 decommissioning
costs of a nuclear powerplant). Proponents of this aspect of the
proposal argue that it provides equal treatment to all
decommissioning costs and provides an incentive for taxpayers to
ensure that sufficient funds are being reserved for decommissioning
costs. However, some may argue that safeguards are already in place
that require funds to be available for decommissioning and that
this aspect of the proposal merely reduces the effective tax rate
on earnings associated with the reserved funds. Finally,
clarifying the treatment of transfers of qualified funds removes a
tax barrier that may be hindering taxpayers from fulfilling
various policy goals of electricity deregulation.
Complexity issues
Many aspects of the proposal provide clarification to issues that
would simplify the administration of the present-law provision and
likely reduce the cost of complying with the tax law and minimize
disputes between taxpayers and the IRS.
Prior Action
A similar proposal was included in the President's fiscal year 2003,
2004, and 2005 budget proposals. Similar proposals were also
included in section 1328 of the Conference Report to H.R. 6, the "
Energy Policy Act of 2003," and section 855 of the Senate Amendment
to H.R. 4520, the "American Jobs Creation Act of 2004."
____________________
/169/ Joint Committee on Taxation, General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984, p. 270.
4. Provide a tax credit for purchase of the certain hybrid and
fuel cell vehicles
Present Law
Credit for qualified electric vehicles
A 10-percent tax credit is provided for the cost of a qualified
electric vehicle, up to a maximum credit of $4,000. A qualified
electric vehicle generally is a motor vehicle that is powered
primarily by an electric motor drawing current from rechargeable
batteries, fuel cells, or other portable sources of electrical
current. The full amount of the credit is available for purchases
prior to 2006. The credit is reduced to 25 percent of the
otherwise allowable amount for purchases in 2006, and is
unavailable for purchases after December 31, 2006.
Deduction for qualified clean-fuel vehicle property
Qualified clean-fuel vehicles
Certain costs of qualified clean-fuel vehicle may be expensed and
deducted when such property is placed in service. Qualified
clean-fuel vehicle property includes motor vehicles that use
certain clean-burning fuels (natural gas, liquefied natural gas,
liquefied petroleum gas, hydrogen, electricity and any other fuel
at least 85 percent of which is methanol, ethanol, any other
alcohol or ether). The Secretary has determined that certain
hybrid (gas-electric) vehicles are qualified clean-fuel vehicles.
The maximum amount of the deduction is $50,000 for a truck or van
with a gross vehicle weight over 26,000 pounds or a bus with
seating capacities of at least 20 adults; $5,000 in the case of a
truck or van with a gross vehicle weight between 10,000 and 26,000
pounds; and $2,000 in the case of any other motor vehicle. The
deduction allowable for purchases of vehicles in 2006 is 25 percent
of the otherwise allowable amount, and is unavailable for purchases
after December 31, 2006.
Refueling property
Clean-fuel vehicle refueling property comprises property for the
storage or dispensing of a clean-burning fuel, if the storage or
dispensing is the point at which the fuel is delivered into the fuel
tank of a motor vehicle. Clean-fuel vehicle refueling property
also includes property for the recharging of electric vehicles, but
only if the property is located at a point where the electric
vehicle is recharged. Up to $100,000 of such property at each
location owned by the taxpayer may be expensed with respect to that
location. Expensing for clean-fuel vehicle refueling property is
unavailable for expenditures after December 31, 2006.
_______________________
/170/ Code sections 30 and 179A were enacted as part of the Energy
Policy Act of 1992 and were extended by the Job Creation and Worker
Assistance Act of 2002.
Description of Proposal
In general
The proposal provides a tax credit for the purchase of a qualified
hybrid vehicle or fuel cell vehicle purchased after December 31,
2004, and before January 1, 2009, for a hybrid vehicle and after
December 31, 2004, and before January 1, 2013, for a fuel cell
vehicle. The credits are available for all qualifying light
vehicles including cars, minivans, sport utility vehicles, and
light trucks. Taxpayers are eligible for only one of the credits
per vehicle and taxpayers who claim either credit are not eligible
for the qualified electric vehicle credit or the deduction for
clean-fuel vehicles for the same vehicle. For business taxpayers
the credit is part of the general business credit and the taxpayer
will reduce his or her basis in the vehicle by the amount of the
credit. A qualifying vehicle must meet all applicable regulatory
requirements for safety and air pollutants.
Hybrid vehicles
A qualifying hybrid vehicle is a motor vehicle that draws propulsion
energy from on-board sources of stored energy which include both an
internal combustion engine or heat engine using combustible fuel
and a rechargeable energy storage system (e.g., batteries). The
amount of credit for the purchase of a hybrid vehicle is the sum
of two components, a base credit amount that varies with the amount
of power available from the rechargeable storage system and a fuel
economy credit amount that varies with the rated fuel economy of
the vehicle compared to a 2000 model year standard. Table 2,
below, shows the proposed base credit amounts.
Table 2.--Hybrid Vehicle Base Credit Amount Dependent Upon the
Power Available from the Rechargeable Energy Storage System As a
Percentage of the Vehicles Maximum Available Power
[Graphics not available in Tiff Format]
For these purposes, a vehicle's power available from its
rechargeable energy storage system as a percentage of maximum
available power is calculated as the maximum value available from
the battery or other energy storage device during a standard power
test, divided by the sum of the battery or other energy storage
device and the SAE net power of the heat engine.
Table 3, below, shows the proposed additional fuel economy credit
available to hybrid vehicles whose fuel economy exceeds that of a
base fuel economy. For these purposes the base fuel economy is the
2000 model year city fuel economy rating for vehicles of various
weight classes (see below).
Table 3.--Additional Fuel Economy Credit for Hybrid Vehicles
[Graphics not Available in Tiff Format]
Fuel cell vehicles
A qualifying fuel cell vehicle is a motor vehicle
that is propelled by power derived from one or more cells that
convert chemical energy directly into electricity by combining
oxygen with hydrogen fuel which is stored on board the vehicle and
may or may not require reformation prior to use. The amount of
credit for the purchase of a fuel cell vehicle is $4,000 plus an
additional credit determined by the rated fuel economy of the vehicle
compared to a base fuel economy. For these purposes the base fuel
economy is the 2000 model year city fuel economy rating for vehicles
of various weight classes (see below). Table 4, below, shows the
proposed credits for qualifying fuel cell vehicles.
Table 4.--Additional Fuel Economy Credit for Fuel Cell Vehicles
[Graphics not Available in Tiff Format]
Effective date.--The proposal is effective for vehicles purchased
after December 31, 2004.
Base fuel economy
The base fuel economy is the 2000 model year city fuel economy for
vehicle
Analysis
See the general discussion following the description of the proposed
tax credit for combined heat and power property, below.
Prior Action
The President's fiscal year 2003, 2004, and 2005 budget proposals
contained a similar proposal to the current proposal (identical
except for effective dates). The President's fiscal year
1999, 2000, 2001, and 2002 budget proposals proposed creating a
credit for electric and hybrid vehicles.
5. Provide a tax credit for combined heat and power property
Present Law
A nonrefundable, 10-percent business energy credit is allowed for
the cost of new property that is equipment (1) that uses solar
energy to generate electricity, to heat or cool a structure, or to
provide solar process heat, or (2) used to produce, distribute, or
use energy derived from a geothermal deposit, but only, in the
case of electricity generated by geothermal power, up to the
electric transmission stage.
The business energy tax credits are components of the general
business credit (sec. 38(b)(1)). The business energy tax credits,
when combined with all other components of the general business
credit, generally may not exceed for any taxable year the excess
of the taxpayer's net income tax over the greater of (1) 25 percent
of net regular tax liability above $25,000 or (2) the tentative
minimum tax. For credits arising in taxable years beginning after
December 31, 1997, an unused general business credit generally may
be carried back one year and carried forward 20 years (sec. 39).
A taxpayer may exclude from income the value of any subsidy provided
by a public utility for the purchase or installation of an energy
conservation measure. An energy conservation measure means any
installation or modification primarily designed to reduce
consumption of electricity or natural gas or to improve the
management of energy demand with respect to a dwelling unit
(sec. 136).
There is no present-law credit for combined heat and power ("CHP")
property.
Description of Proposal
The proposal would establish a 10-percent investment credit for
qualified CHP systems with an electrical capacity in excess of 50
kilowatts or with a capacity to produce mechanical power in excess
of 67 horsepower (or an equivalent combination of electrical and
mechanical energy capacities). CHP property is defined as property
comprising a system that uses the same energy source for the
simultaneous or sequential generation of (1) electricity or
mechanical shaft power (or both) and (2) steam or other forms of
useful thermal energy (including heating and cooling applications).
A qualified CHP system is required to produce at least 20 percent of
its total useful energy in the form of thermal energy and at least
20 percent of its total useful energy in the form of electrical or
mechanical power (or a combination thereof) and would also be
required to satisfy an energy-efficiency standard. For CHP systems
with an electrical capacity in excess of 50 megawatts (or a
mechanical energy capacity in excess of 67,000 horsepower), the
total energy efficiency of the system would have to exceed 70
percent. For smaller systems, the total energy efficiency would have
to exceed 60 percent. For this purpose, total energy efficiency
is calculated as the sum of the useful electrical, thermal, and
mechanical power produced by the system at normal operating rates,
measured on a Btu basis, divided by the lower heating value of
the primary fuel source for the system. The eligibility of
qualified CHP property is verified under regulations prescribed
by the Secretary of the Treasury.
Qualified CHP assets that are assigned cost recovery periods of less
than 15 years are eligible for the credit, but only if the taxpayer
elects to treat such property as having a 22-year class life. Thus,
for such property, regular tax depreciation allowances are
calculated using a 15-year recovery period and the 150 percent
declining balance method.
The credit is treated as an energy credit under the investment
credit component of the section 38 general business credit, and is
subject to the rules and limitations governing that credit.
Taxpayers using the credit for CHP equipment would not be entitled
to any other tax credit for the same equipment.
Effective date.�The credit would apply to property placed in
service after December 31, 2004 and before January 1, 2010.
Analysis
See general discussion immediately below.
Prior Action
A similar proposal was contained in the President's fiscal year 2000
through 2005 budget proposals.
A similar provision was contained in H.R. 4520, the "Jumpstart Our
Business Strength Act, as amended and passed by the Senate on July
15, 2004, and in S. 1637, the "Jumpstart Our Business Strength Act,
as passed by the Senate on May 11, 2004.
The conference agreement to H.R. 6, "The Energy Policy Act of 2003,"
as passed by the House of Representatives on November 18, 2003,
contained a similar provision. Similar provisions are contained in
Division D of H.R. 6, the "Energy Tax Policy Act of 2003," as
passed by the House of Representatives on April 11, 2003, and in
Division H of H.R. 6, the "Energy Tax Incentives Act of 2003" as
amended and passed by the Senate on July 31, 2003.
Similar provisions were also contained in Division C of H.R. 4, the
"Energy Tax Policy Act of 2001," as passed by the House of
Representatives on August 2, 2001, and in Division H of H.R. 4,
"The Energy Tax Incentives Act of 2002," as amended and passed by
the Senate on April 25, 2002.
Analysis for 1, 2, 4, and 5.
General rationale for tax benefits for energy conservation and
pollution abatement
The general rationale for providing tax benefits to energy
conservation and pollution abatement is that there exist
externalities in the consumption or production of certain goods.
An externality exists when, in the consumption or production of a
good, there is a difference between the cost or benefit to an
individual and the cost or benefit to society as a whole. When
the social costs of consumption exceed the private costs of
consumption, a negative externality exists. When the social
benefits from consumption or production exceed private benefits, a
positive externality exists. When negative externalities exist,
there will be over-consumption of the good causing the negative
externality relative to what would be socially optimal. When
positive externalities exist, there will be under consumption or
production of the good producing the positive externality. The
reason for the over consumption or under consumption is that
private actors will in general not take into account the effect of
their consumption on others, but only weigh their personal cost and
benefits in their decisions. Thus, they will consume goods up
to the point where their marginal benefit of more consumption is
equal to the marginal cost that they face. But from a social
perspective, consumption should occur up to the point where the
marginal social cost is equal to the marginal social benefit.
Only when there are no externalities will the private actions lead
to the socially optimal level of consumption or production, because
in this case private costs and benefits will be equal to social
costs and benefits. Pollution is an example of a negative
externality, because the costs of pollution are borne
by society as a whole rather than solely by the polluters
themselves. In the case of pollution, there are two possible
government interventions that could produce a more socially
desirable level of pollution. One such approach would be to set a
tax on the polluting activity that is equal to the social cost
of the pollution. Thus, if burning a gallon of gasoline results
in pollution that represents a cost to society as a whole of 20
cents, it would be economically efficient to tax gasoline at 20
cents a gallon. By so doing, the externality is said to be
internalized, because now the private polluter faces a private
cost equal to the social cost, and the socially optimal amount
of consumption will take place. An alternative approach would be
to employ a system of payments, such as perhaps tax credits, to
essentially pay polluters to reduce pollution. If the payments
can be set in such a way as to yield the right amount of
reduction (that is, without paying for reduction more than the
reduction is valued, or failing to pay for a reduction where the
payment would be less than the value of the pollution reduction),
the socially desirable level of pollution will result. The basic
difference between these two approaches is a question of who
pays for the pollution reduction. The tax approach suggests that
the right to clean air is paramount to the right to pollute, as
polluters would bear the social costs of their pollution. The
alternative approach suggests that the pollution reduction costs
should be borne by those who receive the benefit of the reduction.
In the case of a positive externality, the appropriate economic
policy would be to impose a negative tax (i.e., a credit) on the
consumption or production that produces the positive
externality. By the same logic as above, the externality becomes
internalized, and the private benefits from consumption become
equal to the social benefits, leading to the socially optimal
level of consumption or production.
Targeted investment tax credits
Three of the proposals related to energy and the environment
(residential solar, combined heat and power, and hybrid vehicles)
are targeted investment tax credits designed to encourage
investment in certain assets that reduce the consumption of
conventional fuels and that reduce the emissions of gases related
to atmospheric warming and other pollutants. The following
general analysis of targeted investment tax credits is applicable
to these proposals.
As a general matter of economic efficiency, tax credits designed
to influence investment choices should be used only when it is
acknowledged that market-based pricing signals have led to a lower
level of investment in a good than would be socially optimal. In
general, this can occur in a market-based economy when private
investors do not capture the full value of an investment�that is,
when there are positive externalities to the investment that accrue
to third parties who did not bear any of the costs of the
investments. For example, if an individual or corporation can
borrow funds at 10 percent and make an investment that will return
15 percent, they will generally make that investment. However, if
the return were 15 percent, but only eight percent of that return
went to the investor, and seven percent to third parties, the
investment will generally not take place, even though the social
return (the sum of the return to the investor and other parties)
would indicate that the investment should be made.
In such a situation, it may be desirable to subsidize the return
to the investor through tax credits or other mechanisms in order
that the investor's return is sufficient to cause the
socially desirable investment to be made. In this example, a
credit that raised the return to the investor to at least 10
percent would be necessary. Even if the cost of the credit led
to tax increases for the third parties, they would presumably be
better off since they enjoy a seven-percent return from the
investment, and the credit would only need to raise the return to
the investor by two percent for him or her to break even. Thus,
even if the third parties would bear the full cost of the credit,
they would, on net, enjoy a five-percent return to the investment
(seven percent less two percent).
There are certain aspects of targeted tax credits that could impair
the efficiency with which they achieve the desired goal of reduced
atmospheric emissions. By targeting only certain investments, other
more cost-effective means of pollution reduction may be overlooked.
Many economists would argue that the most efficient means of
addressing pollution would be through a direct tax on the
pollution-causing activities, rather than through the indirect
approach of targeted tax credits for certain technologies. By this
approach, the establishment of the economically efficient prices
on pollutants, through taxes, would result in the socially optimal
level of pollution. This would indirectly lead to the adoption of
the types of technologies favored in the President's budget, but
only if they were in fact the most socially efficient technologies.
In many cases, however, establishing the right prices on
pollution-causing activities through taxes could be administratively
infeasible, and other solutions such as targeted credits may be
more appropriate.
A second potential inefficiency of investment tax credits is one of
budgetary inefficiency, in the sense that their budgetary costs
could be large relative to the incremental investment in the
targeted activities. The reason for this is that there will
generally have been investment in the activities eligible for the
credit even in the absence of the credit. Thus, for example, if
investors planned to invest a million dollars in an activity
before a 10-percent credit, and the credit caused the investment
to rise $100,000 to $1.1 million because of the credit, then only
$100,000 in additional investment can be attributed to the credit.
However, all $1.1 million in investments will be eligible for the
10-percent credit, at a budgetary cost of $110,000 (10 percent of
1.1 million). Thus, only $100,000 in additional investment would
be undertaken, at a budgetary cost of $110,000. Because there is
a large aggregate amount of investment undertaken without general
investment credits, introducing a general credit would subsidize
much activity that would have taken place anyway.
Targeted credits like the above proposals, on the other hand, are
likely to be more cost effective, from a budget perspective, in
achieving the objective of increased investment, if only for the
reason that a government would likely not consider their use if
there were already extensive investment in a given area. Thus,
not much investment that would take place anyhow is subsidized,
because there presumably is not much of such investment taking
place. The presumption behind these targeted tax credits is that
there is not sufficient investment in the targeted areas because
the alternative and more emissions-producing investments are less
costly to the investor. Hence, a tax credit would be necessary to
reduce costs and encourage investment in the favored activity.
A final limitation on the efficiency of the proposed credits is
their restricted availability. The proposed tax credits come with
several limitations beyond their stipulated dollar limitation.
Specifically, they are nonrefundable and cannot be used to offset
tax liability determined under the AMT. The credit for solar
equipment has a cap on the dollar amount of the credit, and thus
after the cap is reached the marginal cost of further investment
becomes equal to the market price again, which is presumed to be
inefficient. The impact of these limitations is to make the
credit less valuable to those without sufficient tax liability to
claim the full credit, for those subject to the AMT, or those who
have reached any cap on the credit. Given the arguments outlined
above as to the rationale for targeted tax credits, it is not
economically efficient to limit their availability based on the
tax status of a possible user of the credit. It can be argued that,
if such social benefits exist and are best achieved through the
tax system, the credit should be both refundable and available
to AMT taxpayers. Some would argue that making the credits
refundable may introduce compliance problems that would exceed the
benefits from encouraging the targeted activities for the
populations lacking sufficient tax liability to make use of the
credit. With respect to the AMT, the rationale for the limitation
is to protect the objective of the AMT, which is to insure that all
taxpayers pay a minimum (determined by the AMT) amount of tax.
Two differing policy goals thus come in conflict in this instance.
Similarly, caps on the aggregate amount of a credit that a taxpayer
may claim are presumably designed to limitthe credit's use out
of some sense of fairness, but again, this conflicts with the goal
of pollution reduction.
A justification for targeted tax credits that has been offered with
respect to some pollution abatement activities, such as home
improvements that would produce energy savings (installation of
energy saving light bulbs or attic insulation, for example), is
that the investment is economically sound at unsubsidized prices,
but that homeowners or business owners are unaware of the high
returns to the investments. The argument for targeted tax credits
in this case is that they are needed to raise the awareness of the
homeowner, or to lower the price sufficiently to convince the
homeowner that the investment is worthwhile, even though the
investment is in their interest even without the subsidy. These
arguments have been called into question recently on the grounds
that the returns to the investments have been overstated by
manufacturers, or are achievable only under ideal circumstances.
This view holds that the returns to these investments are not
dissimilar to other investments of similar risk profile, and
that homeowners have not been economically irrational in their
willingness to undertake certain energy saving investments.
Of course, to the extent that there are negative externalities
from the private energy consumption, these households, though
making rational private choices, will not make the most socially
beneficial choices without some form of subsidy.
A final justification offered for targeted tax credits in some
instances is to "jump start" demand in certain infant industries
in the hopes that over time the price of such goods will fall as
the rewards from competition and scale economies in production
are reaped. However, there is no guarantee that the infant
industry would ultimately become viable without continued
subsidies. This argument is often offered for production of
electric cars�that if the demand is sufficient the production costs
will fall enough to make them ultimately viable without subsidies.
This justification is consistent with the current proposals in that
the credits are available only for a limited period of time.
Production tax credits
One of the proposals related to energy and the environment
(the credit for electricity produced from wind, biomass, and
landfill gas) is a production tax credit. This type of credit
differs from an investment tax credit in that the credit amount
is based on production, rather than on investment. Some argue
that a production credit provides for a stream of tax benefits,
rather than an up-front lump sum, and that the stream of benefits
can help provide financing for investment projects. On the other
hand, an up-front tax credit provides more certainty, as the
future production credits could possibly be curtailed by future
Congresses. In general, investors prefer certainty to uncertainty,
and thus may discount the value of future production credits.
Another difference between a production credit and an investment
credit is that the latter provides only a temporary distortion to
the market�once the investment is made, normal competitive market
conditions will prevail and the rational firm will only produce
its end product if it can cover its variable costs. With a
production credit, a firm may actually profitably produce even
though it cannot cover its variable costs in the absence of the
credit. This would generally be considered an economically
inefficient outcome unless there are positive externalities to the
production of the good that exceed the value of the credit. In the
case of electricity produced from wind or biomass, if it is
presumed that the electricity produced from these sources
substitutes for electricity produced from the burning of fossil
fuels, economic efficiency will be improved so long as the credit
does not have to be set so high in order to encourage the
alternative production that it exceeds the value of the positive
externality. On the other hand, by making some production of
electricity cheaper, it is possible that the credit could encourage
more electricity consumption. On net, however, there would be less
electricity produced from fossil fuels.
With respect to the increase in the credit rate for open-loop
biomass, the basic issues are the same as those outlined above for
any tax benefit for energy conservation or pollution abatement.
To justify the credit on economic grounds, the positive
externalities from the burning of biomass for the production of
electricity must outweigh the costs of the tax subsidy. One
positive externality is similar to that of wind power production,
namely the reduction in electricity production from the more
environmentally damaging coal. Another consideration with the
waste products is whether their current disposal is harmful to the
environment. If so, an additional positive externality may exist
from discouraging such disposal. If the disposal is harmful to
the environment and is a partial justification for the credit,
then ideally the credit amount should vary for each biomass waste
product if their present disposal varies in its harm to the
environment. A single credit rate would be justified if the
negative externalities are of a similar magnitude, or if
administrative considerations would make multiple credit rates
problematic.
Complexity issues
Each of the President's proposals in the area of energy production
and conservation can be expected to increase the complexity of tax
law. Though the effect of each provision, or even all provisions
collectively, on tax law complexity may be small, they would all
add to complexity merely by providing new tax benefits not
previously available. Taxpayers considering using these provisions
would need to consider the impact of additional tax factors in
making investment decisions, and taxpayers that actually utilize
the provisions will need to educate themselves as to the rules
of the provisions, as well as fill out the necessary forms to
claim the tax benefits. Taxpayers constrained by the AMT or by the nonrefundability of the credit would face additional complications
in determining the value of the various credits to them, which
would further complicate their investment choices.
In general, the proposal related to the production tax credits
adds less complexity in the aggregate as it is mainly an extension
of present law, and there are relatively few taxpayers in a
position to claim such benefits. The personal credits, such
as those for solar equipment and hybrid vehicles, add more
aggregate complexity as they would be new credits. Many taxpayers
would be able to avail themselves of the credit and the credits
could induce millions more to at least consider purchasing hybrid
vehicles or solar equipment as a result of the credit.
K. Restructure Assistance to New York
Present Law
In general
Present law includes a number of incentives to invest in property
located in the New York Liberty Zone ("NYLZ"), which is the area
located on or south of Canal Street, East Broadway (east of its
intersection with Canal Street), or Grand Street (east of its
intersection with East Broadway) in the Borough of Manhattan in
the City of New York, New York. These incentives were enacted
following the terrorist attack in New York City on September 11,
2001.
Special depreciation allowance for qualified New York Liberty Zone
property
Section 1400L(b) allows an additional first-year depreciation
deduction equal to 30 percent of the adjusted basis of qualified
NYLZ property. In order to qualify, property generally must be
placed in service on or before December 31, 2006 (December 31, 2009
in the case of nonresidential real property and residential rental
property).
The additional first-year depreciation deduction is allowed for
both regular tax and alternative minimum tax purposes
for the taxable year in which the property is placed in service.
A taxpayer is allowed to elect out of the additional first-year
depreciation for any class of property for any taxable year.
In order for property to qualify for the additional first-year
depreciation deduction, it must meet all of the following
requirements. First, the property must be property to which the
general rules of the Modified Accelerated Cost Recovery System
("MACRS") apply with (1) an applicable recovery period of 20
years or less, (2) water utility property (as defined in section
168(e)(5)), (3) certain nonresidential real property and
residential rental property, or (4) computer software other than
computer software covered by section 197. A special rule
precludes the additional first-year depreciation under this
provision for (1) qualified NYLZ leasehold improvement property
________________
/172/ In addition to the NYLZ provisions described above, other
NYLZ incentives are provided: (1) $8 billion of tax-exempt private
activity bond financing for certain nonresidential real property,
residential rental property and public utility property is authorized
to be issued after March 9, 2002, and before January 1, 2010; and
(2) $9 billion of additional tax-exempt advance refunding bonds is
available after March 9, 2002, and before January 1, 2006, with
respect to certain State or local bonds outstanding on September
11, 2001.
/173/ The amount of the additional first-year depreciation deduction
is not affected by a short taxable year.
/174/ A special rule precludes the additional first-year depreciation
deduction for property that is required to be depreciated under the
alternative depreciation system of MACRS.
and (2) property eligible for the additional first-year
depreciation deduction under section 168(k) (i.e., property is
eligible for only one 30 percent additional first-year
depreciation). Second, substantially all of the use of such
property must be in the NYLZ. Third, the original use of the
property in the NYLZ must commence with the taxpayer on or after
September 11, 2001. Finally, the property must be acquired by
purchase by the taxpayer after September 10, 2001 and placed in
service on or before December 31, 2006. For qualifying
nonresidential real property and residential rental property the
property must be placed in service on or before December 31, 2009
in lieu of December 31, 2006. Property will not qualify if a
binding written contract for the acquisition of such property
was in effect before September 11, 2001.
Nonresidential real property and residential rental property is
eligible for the additional first-year depreciation only to the
extent such property rehabilitates real property damaged, or
replaces real property destroyed or condemned as a result of the
terrorist attacks of September 11, 2001.
Property that is manufactured, constructed, or produced by the
taxpayer for use by the taxpayer qualifies for the additional
first-year depreciation deduction if the taxpayer begins the
manufacture, construction, or production of the property after
September 10, 2001, and the property is placed in service on or
before December 31, 2006 (and all other requirements are
met). Property that is manufactured, constructed, or produced
for the taxpayer by another person under a contract that is entered
into prior to the manufacture, construction, or production of the
property is considered to be manufactured, constructed, or produced
by the taxpayer.
Depreciation of New York Liberty Zone leasehold improvements
Generally, depreciation allowances for improvements made on leased
property are determined under MACRS, even if the MACRS recovery
period assigned to the property is longer than the term of the
lease. This rule applies regardless of whether the lessor or the
____________________
/175/ Qualified NYLZ leasehold improvement property is defined in
another provision. Leasehold improvements that do not satisfy the
r0equirements to be treated as "qualified NYLZ leasehold improvement
property" maybe eligible for the 30 percent additional first-year
depreciation deduction (assuming all other conditions are met).
/176/ For purposes of this provision, purchase is defined as under
section 179(d).
/177/ Property is not precluded from qualifying for the additional
first-year depreciation merely because a binding written contract
to acquire a component of the property is in effect prior to
September 11, 2001.
/178/ December 31, 2009 with respect to qualified nonresidential
real property and residential rental property.
/179/ Sec. 168(i)(8). The Tax Reform Act of 1986 modified the
Accelerated Cost Recovery System ("ACRS") to institute MACRS.
Prior to the adoption of ACRS by the Economic Recovery Tax Act of
1981, taxpayers were allowed to depreciate the various
lessee places the leasehold improvements in service. If a leasehold
improvement constitutes an addition or improvement to
nonresidential real property already placed in service, the
improvement generally is depreciated using the straight-line
method over a 39-year recovery period, beginning in the month
the addition or improvement is placed in service.
A special rule exists for qualified NYLZ leasehold improvement
property, which is recovered over five years using the
straight-line method. The term qualified NYLZ leasehold
improvement property means property defined in section 168(e)
(6) that is acquired and placed in service after September 10,
2001, and before January 1, 2007 (and not subject to a binding
contract on September 10, 2001), in the NYLZ. For purposes of
the alternative depreciation system, the property is assigned
a nine-year recovery period. A taxpayer may elect out of
the 5-year (and 9-year) recovery period for qualified NYLZ
leasehold improvement property.
Increased section 179 expensing for qualified New York Liberty
Zone property
In lieu of depreciation, a taxpayer with a sufficiently small
amount of annual investment may elect to deduct the cost of
qualifying property. For taxable years beginning in 2003 through
2007, a taxpayer may deduct up to $100,000 of the cost of
qualifying property placed in service for the taxable year.
In general, qualifying property for this purpose is defined as
depreciable tangible personal property (and certain computer
software) that is purchased for use in the active conduct of a
trade or business. The $100,000 amount is reduced (but not below
zero) by the amount by which the cost of qualifying property placed
in service during the taxable year exceeds $400,000.
The $100,000 and $400,000 amounts are indexed for inflation.
For taxable years beginning in 2008 and thereafter, a taxpayer
with a sufficiently small amount of annual investment may elect
to deduct up to $25,000 of the cost of qualifying property placed
in service for the taxable year. The $25,000 amount is reduced
(but not below zero) by the amount by which the cost of qualifying
____________________
components of a building as separate assets with separate useful
lives. The use of component depreciation was repealed upon the
adoption of ACRS. The Tax Reform Act of 1986 also denied the use of
component depreciation under MACRS.
/180/ Former sections 168(f)(6) and 178 provided that, in certain
circumstances, a lessee could recover the cost of leasehold
improvements made over the remaining term of the lease.
The Tax Reform Act of 1986 repealed these provisions.
/181/ Secs. 168(b)(3), (c), (d)(2), and (i)(6). If the improvement
is characterized as tangible personal property, ACRS or MACRS
depreciation is calculated using the shorter recovery periods,
accelerated methods, and conventions applicable to such property.
The determination of whether improvements are characterized as
tangible personal property or as nonresidential real property often
depends on whether or not the improvements constitute a "structural
component" of a building (as defined by Treas. Reg. sec. 1.48-1
(e)(1)). See, e.g., Metro National Corp v. Commissioner, 52 TCM
(CCH) 1440 (1987); King Radio Corp Inc. v. U.S., 486 F.2d 1091
(10th Cir. 1973); Mallinckrodt, Inc. v. Commissioner, 778 F.2d 402
(8th Cir. 1985) (with respect to various leasehold improvements).
property placed in service during the taxable year exceeds $200,000.
In general, qualifying property for this purpose is defined as
depreciable tangible personal property that is purchased for use in
the active conduct of a trade or business.
The amount eligible to be expensed for a taxable year may not exceed
the taxable income for a taxable year that is derived from the
active conduct of a trade or business (determined without regard to
this provision). Any amount that is not allowed as a deduction
because of the taxable income limitation may be carried forward to
succeeding taxable years (subject to similar limitations).
No general business credit under section 38 is allowed with respect
to any amount for which a deduction is allowed under section 179.
The amount a taxpayer can deduct under section 179 is increased for
qualifying property used in the NYLZ. Specifically, the maximum
dollar amount that may be deducted under section 179 is increased
by the lesser of (1) $35,000 or (2) the cost of qualifying property
placed in service during the taxable year. This amount is in
addition to the amount otherwise deductible under section 179.
Qualifying property for purposes of the NYLZ provision means
section 179 property purchased and placed in service by the
taxpayer after September 10, 2001 and before January 1, 2007,
where (1) substantially all of the use of such property is in
the NYLZ in the active conduct of a trade or business by the
taxpayer in the NYLZ, and (2) the original use of which in the
NYLZ commences with the taxpayer after September 10, 2001.
The phase-out range for the section 179 deduction attributable to
NYLZ property is applied by taking into account only 50 percent of
the cost of NYLZ property that is section 179 property. Also,
no general business credit under section 38 is allowed with respect
to any amount for which a deduction is allowed under section 179.
The provision is effective for property placed in service after
September 10, 2001 and before January 1, 2007.
Extended replacement period for New York Liberty Zone involuntary
conversions
A taxpayer may elect not to recognize gain with respect to property
that is involuntarily converted if the taxpayer acquires within an
applicable period (the "replacement period") property similar or
related in service or use (section 1033). If the taxpayer does not
replace the converted property with property similar or related in
service or use, then gain generally is recognized. If the taxpayer
elects to apply the rules of section 1033, gain on the converted
property is recognized only to the extent that the amount realized
on the conversion exceeds the cost of the replacement property.
In general, the replacement period begins with the date of the
_____________________
/182/ As defined in sec. 179(d)(1).
/183/ See Rev. Proc. 2002-33, 2002-20 I.R.B. 963 (May 20, 2002),
for procedures on claiming the increased section 179 expensing
deduction by taxpayers who filed their tax returns
before June 1, 2002.
disposition of the converted property and ends two years after
the close of the first taxable year in which any part of the gain
upon conversion is realized. The replacement period is extended
to three years if the converted property is real property held for the productive use in a trade or business or for investment.
The replacement period is extended to five years with respect to
property that was involuntarily converted within the NYLZ as a
result of the terrorist attacks that occurred on September 11, 2001.
However, the five-year period is available only if substantially all
of the use of the replacement property is in New York City. In all
other cases, the present-law replacement period rules continue to
apply.
Description of Proposal
Repeal of certain NYLZ incentives
The proposal repeals the four NYLZ incentives relating to the
additional first-year depreciation allowance of 30 percent, the
five-year depreciation of leasehold improvements, the additional
section 179 expensing, and the extended replacement period for
involuntary conversions.
Effective date.--The proposal is effective on the date of enactment,
with an exception for property subject to a written binding contract
in effect on the date of enactment which is placed in service prior
to the original sunset dates under present law. The extended
replacement period for involuntarily converted property ends on
the earlier of (1) the date of enactment or (2) the last
day of the five-year period specified in the Jobs Creation
and Worker Assistance Act of 2002 ("JCWAA").
Credit for certain payments of New York State and New York City
The proposal provides a Federal tax credit only for New York State
and New York City, allowable against any payment by the State or
City to the Federal government required under a provision of the
Internal Revenue Code other than the provisions relating to payments
of excise taxes, FICA, SECA, or OASDI amounts. For example, the
credit is allowable against payments of Federal income tax withheld
with respect to State or City employees.
The amount of the credit may not exceed the lesser of (1) $200
million per year (divided equally between the State and the City)
for calendar years after 2005, until a cumulative total of
____________________
/184/ Section 1033(a)(2)(B).
/185/ Section 1033(g)(4).
/186/ The proposal does not change the present-law rules relating
to certain NYLZ private activity bond financing and additional
advance refunding bonds.
/187/ Pub. Law No. 107-147, sec. 301 (2002).
$2 billion is reached, or (2) expenditures for the calendar year
by the State or City, respectively, relating to the construction
or improvement of transportation infrastructure in or connecting to
the New York Liberty Zone. Any amount of unused credit below the
$200 million annual limit is carried forward to the following year,
and expenditures that exceed the $200 million annual limit are
carried forward and subtracted from the $200 million annual limit
in the following year.
Treasury guidance is to be provided to ensure that the expenditures
satisfy the intended purposes. The amount of the credit would be
treated as State and local funds for purposes of any Federal
program.
Effective date.--The proposal is effective for calendar years after
2005.
Analysis
The proposal is based on the premise that some of the tax benefits
provided by the present-law incentive provisions will not be usable
in the form in which they were originally provided, and that they
should be replaced with other benefits which would have a greater
impact on the recovery and continued development in the NYLZ.
The proposal reflects a preference for subsidizing transportation
infrastructure rather than buildings and other private property.
Even to the extent that the incentive provisions can be used by
taxpayers in their present-law form, they are arguably unnecessary
to spur investment in the NYLZ because investment would occur in
the area even without special tax incentives.
On the other hand, the effectiveness of the present-law NYLZ
incentives may not yet be determinable because insufficient time
has passed since they were enacted. Furthermore, repeal
of the provisions prior to their scheduled expiration could be
unfair to any taxpayers who have begun, in reliance upon the
incentive provisions, to implement long-term plans the status of
which requires them to continue with planned investments despite
the absence of a written binding contract. Opponents may also
object to the replacement of a benefit for private taxpayers with
a cash grant to governmental entities, or the replacement of an
incentive for investment in private property with an incentive
for investment in public infrastructure.
The proposal could be criticized as creating an inefficient method
for delivering a Federal transportation infrastructure subsidy to
New York State and New York City. Further, because neither New
York City nor New York State is subject to Federal income tax
itself, administration of the Federal tax law is made needlessly
complex by the creation of a credit against payment of withheld
income tax of these governmental entities' employees. Providing
a transportation infrastructure subsidy as a direct grant outside
of the tax law would be more consistent with simplification of the
tax law and administrative efficiency.
Prior Action
The NYLZ incentives were enacted as part of JCWAA. In 2003, the
Senate amendment to H.R. 2, the Jobs and Growth Tax Relief
Reconciliation Act of 2003, would have permitted property purchased
by another member of the taxpayer's affiliated group (in lieu of the
taxpayer) to be treated as replacement property for purposes of the
__________________
/188/ The affiliated group rule would have applied only with
respect to the replacement of NYLZ property.
/189/ H.R. Conf. Rep. No. 108-126, at 220-221 (2003).
provision. The provision was not included in the conference
agreement.
III. SIMPLY THE TAX LAWS FOR FAMILIES
A. Repeal Phase-Out for Adoption Provisions
Present Law
Tax credit
A maximum nonrefundable credit of $10,630 per eligible child is
allowed for qualified adoption expenses paid or incurred by the
taxpayer for 2005. This amount is adjusted for inflation annually.
An eligible child is an individual (1) who has not attained age 18
or (2) who is physically or mentally incapable of caring for him or
herself.
Qualified adoption expenses are reasonable and necessary adoption
fees, court costs, attorneys' fees, and other expenses that are
directly related to the legal adoption of an eligible child. All
reasonable and necessary expenses required by a State as a
condition of adoption are qualified adoption expenses. Generally,
a taxpayer is not eligible for the adoption credit in the
year that qualified adoption expenses are paid or incurred by
the taxpayer, but rather in the next taxable year. An exception
is provided for qualified adoption expenses paid or incurred in the
year the adoption becomes final.
In the case of a special needs child, the adoption expenses taken
into account are increased by the excess, if any, of $10,630 over
actual qualified adoption expenses otherwise taken into account for
that special needs child. A special needs child is an eligible
child who also meets other requirements. Specifically, a special
needs child must be a citizen or resident of the United States
which the State has determined: (1) cannot or should not be
returned to the home of the birth parents, and (2) has a specific
factor or condition because of which the child cannot be placed
with adoptive parents without adoption assistance.
Exclusion from income
Present law provides a maximum $10,630 exclusion from the gross
income of an employee for qualified adoption expenses (as defined
above) paid by the employer. This amount is adjusted for inflation
annually. The $10,630 limit is a per-child limit, not an annual
limitation.
In the case of a special needs adoption, the amount of adoption
expenses taken into account in determining the exclusion for
employer-provided adoption assistance is increased by the excess,
if any, of $10,630 over the amount of the aggregate adoption
expenses otherwise taken into account for that special needs child.
Phaseout of credit and exclusion
The otherwise allowable credit and exclusion for 2004 is phased out
ratably for taxpayers with adjusted gross income (AGI) above
$159,450, and is fully phased out at $199,450 of modified AGI.
These amounts are adjusted for inflation annually. For purposes
of the phaseout of the credit, AGI is computed by increasing the
taxpayer's AGI by the amount otherwise excluded from gross income
under Code sections 911, 931, or 933 (relating to the exclusion of
income of U.S. citizens or residents living abroad; residents of Guam, American Samoa, and the Northern Mariana Islands, and residents of
Puerto Rico, respectively).
For purposes of the phaseout of the exclusion, AGI is determined
without regard to the adoption exclusion and the deductions under
sections 199, 221, 222 (relating to income attributable to
domestic production, interest on educational loans, and qualified
tuition and related expenses and is increased by the amount
otherwise excluded from gross income under Code sections 911, 931,
or 933 (relating to the exclusion of income of U.S. citizens or
residents living abroad; residents of Guam, American Samoa, and
the Northern Mariana Islands, and residents of Puerto Rico,
respectively).
Description of Proposal
The proposal repeals the income phase-outs of the adoption credit
and the exclusion for qualified adoption expenses.
Effective date.�The proposal is effective for taxable years
beginning after December 31, 2005.
Analysis
Repeal of the phase-outs of the adoption credit and of the
exclusion of adoption assistance simplifies the tax system for
those claiming the credit or exclusion. Removing the phase-outs
reduces the uncertainty as to whether a taxpayer is eligible for
the credit or exclusion, and simplifies preparation of tax returns
for those who adopt children. Additionally, for taxpayers beyond
the phase-out range (no credit or exclusion allowed) or in the
phase-out range (credit or exclusion limited), the repeal of the
phase-outs creates, or increases, a financial incentive to adopt
children. Opponents of repeal may argue that it is appropriate to
restrict the benefits of the credit or exclusion such that the
highest income taxpayers, who can afford to adopt without
additional assistance, do not receive a tax reduction as a result
of adopting children.
Prior Action
A similar proposal was included in the President's fiscal year 2004
and 2005 budget proposals.
__________________
/190/ For a complete discussion of policy issues with regard to the
elimination of phase-outs, see Joint Committee on Taxation, Study
of the Overall State of the Federal Tax System and Recommendations
for Simplification, Pursuant to Section 8022(3)(B) of the Internal
Revenue Code of 1986, Volume II, at 79-91 (JCS-3-01), April 2001.
This study includes recommendations to repeal many phase-outs,
including the phaseout relating to the adoption credit and
exclusion.
B. Clarify Eligibility of Siblings and Other Family Members
for Child-Related Tax Benefits
Present Law
Uniform definition of qualifying child
In general
Present law provides a uniform definition of qualifying child (the
"uniform definition") for purposes of the dependency exemption, the
child credit, the earned income credit, the dependent care credit,
and head of household filing status. A taxpayer generally may
claim an individual who does not meet the uniform definition
(with respect to any taxpayer) as a dependent if the dependency
requirements are satisfied. The uniform definition generally does
not modify other parameters of each tax benefit (e.g., the earned
income requirements of the earned income credit) or the rules for
determining whether individuals other than children of the taxpayer
qualify for each tax benefit.
Under the uniform definition, in general, a child is a qualifying
child of a taxpayer if the child satisfies each of three tests:
(1) the child has the same principal place of abode as the taxpayer
for more than one half the taxable year; (2) the child has a
specified relationship to the taxpayer; and (3) the child has not
yet attained a specified age. A tie-breaking rule applies if more
than one taxpayer claims a child as a qualifying child.
The support and gross income tests for determining whether an
individual is a dependent generally do not apply to a child who
meets the requirements of the uniform definition.
Residency test
Under the uniform definition's residency test, a child must have
the same principal place of abode as the taxpayer for more than one
half of the taxable year. As was the case under prior law,
temporary absences due to special circumstances, including absences
due to illness, education, business, vacation, or military service,
are not treated as absences.
Relationship test
In order to be a qualifying child, the child must be the taxpayer's
son, daughter, stepson, stepdaughter, brother, sister, stepbrother,
stepsister, or a descendant of any such individual. For purposes
of determining whether an adopted child is treated as a child by
blood, an adopted child means an individual who is legally adopted
by the taxpayer, or an individual who is lawfully placed with the
taxpayer for legal adoption by the taxpayer. A foster child who is
placed with the taxpayer by an authorized placement agency or by
judgment, decree, or other order of any court of competent
jurisdiction is treated as the taxpayer's child.
Age test
The age test varies depending upon the tax benefit involved. In
general, a child must be under age 19 (or under age 24 in the case
of a full-time student) in order to be a qualifying child.
In general, no age limit applies with respect to individuals who
are totally and permanently disabled within the meaning of section
22(e)(3) at any time during the calendar year. A child must be
under age 13 (if he or she is not disabled) for purposes of the
dependent care credit, and under age 17 (whether or not disabled)
for purposes of the child credit.
Children who support themselves
A child who provides over one half of his or her own support
generally is not considered a qualifying child of another
taxpayer. However, a child who provides over one half of his
or her own support may constitute a qualifying child of another
taxpayer for purposes of the earned income credit.
Tie-breaking rules
If a child would be a qualifying child with respect to more than
one individual (e.g., a child lives with his or her mother and
grandmother in the same residence) and more than one person claims
a benefit with respect to that child, then the following
"tie-breaking" rules apply. First, if only one of the individuals
claiming the child as a qualifying child is the child's parent,
the child is deemed the qualifying child of the parent. Second,
if both parents claim the child and the parents do not file a
joint return, then the child is deemed a qualifying child first
with respect to the parent with whom the child resides for the
longest period of time, and second with respect to the parent with
the highest adjusted gross income. Third, if the child's parents
do not claim the child, then the child is deemed a qualifying
child with respect to the claimant with the highest adjusted gross
income.
Interaction with other rules
Taxpayers generally may claim an individual who does not meet the
uniform definition with respect to any taxpayer as a dependent if
the dependency requirements (including the gross income and support
tests) are satisfied. Thus, for example, a taxpayer may claim a
parent as a dependent if the taxpayer provides more than one half
of the support of the parent and the parent's gross income is less
than the personal exemption amount. As another example, a
grandparent may claim a dependency exemption with respect to a
grandson who does not reside with any taxpayer for over one half
the year, if the grandparent provides more than one half of
the support of the grandson and the grandson's gross income is less
than the personal exemption amount.
Citizenship and residency
Children who are U.S. citizens living abroad or non-U.S. citizens
living in Canada or Mexico may qualify as a qualifying child, as is
the case under the dependency tests. A legally adopted child who
does not satisfy the residency or citizenship requirement may
nevertheless qualify as a qualifying child (provided other
________________
/191/ Individuals who satisfy the present-law dependency tests and
who are not qualifying children are referred to as "qualifying
relatives".
applicable requirements are met) if (1) the child's principal place
of abode is the taxpayer's home and (2) the taxpayer is a citizen or
national of the United States.
Children of divorced or legally separated parents
A custodial parent may release the claim to a dependency exemption
(and, therefore, the child credit) to a noncustodial parent.
Thus, custodial waivers that are in place and effective on the
date of enactment will continue to be effective after the date of
enactment if they continue to satisfy the waiver rule.
In addition, the custodial waiver rule applies for purposes of the
dependency exemption (and, therefore, the child credit) for decrees
of divorce or separate maintenance or written separation agreements
that become effective after the date of enactment.
The custodial waiver rules do not affect eligibility with respect
to children of divorced or legally separated parents for purposes
of the earned income credit, the dependent care credit, and head
of household filing status.
If a waiver is made, the waiver applies for purposes of determining
whether a child meets the definition of a qualifying child or a
qualifying relative under section 152(c) or 152(d) as amended by
the provision. While the definition of qualifying child is
generally uniform, for purposes of the earned income credit, head
of household status, and the dependent care credit, the uniform
definition is made without regard to the waiver provision.
Thus, a waiver that applies for the dependency exemption will
also apply for the child credit, and the waiver will not
apply for purposes of the other provisions.
Other provisions
A taxpayer identification number for a child be provided on the
taxpayer's return. For purposes of the earned income credit, a
qualifying child is required to have a social security number that
is valid for employment in the United States (that is, the child
must be a U.S. citizen, permanent resident, or have a certain
type of temporary visa).
Earned income credit
The earned income credit is a refundable tax credit available to
certain lower-income individuals. Generally, the amount of an
individual's allowable earned income credit is dependent on the
individual's earned income, adjusted gross income and the number
of qualifying children
An individual who is a qualifying child of another individual is
not eligible to claim the earned income credit. Thus, in certain
cases a taxpayer caring for a younger sibling in a home with no
parents would be ineligible to claim the earned income credit based
solely on the fact that the taxpayer is a qualifying child of the
younger sibling if the taxpayer meets the age, relationship and
residency tests.
_________________
/192/ See secs. 2(b)(1)(A)(i) and 32(c)(3)(A) and sec. 21(e)(5).
Description of Proposal
Limit definition of qualifying child
The proposal adds a new requirement to the uniform definition.
Specifically, it provides that an individual who otherwise
satisfies the definition of a qualifying individual for purposes
of the uniform definition is not treated a qualifying child unless
he or she is either: (1) younger than the individual claiming him
or her as a qualifying child or (2) permanently and totally
disabled.
Restrict qualifying child tax benefits to child's parent
The proposal provides that if a parent resides with a qualifying
child for more than half the taxable year then only the parent can
claim the child as a qualifying child. However, the parent could
allow another member of the household to claim the qualifying child
if the other individual: (1) has a higher AGI for the taxable year;
and (2) otherwise is eligible to claim the qualifying child.
Effective date
The proposal is effective for taxable years beginning after
December 31, 2004.
Analysis
In general
The proposed changes to the uniform definition are intended to
restore eligibility for the earned income credit to certain
lower-income siblings while eliminating a tax planning opportunity
for more affluent families. As discussed below, each element of
the proposal would achieve its intended result. However, the
proposal would also constitute the third change in the earned
income credit eligibility requirements since 2001. The earned
income credit eligibility requirements were changed by Economic
Growth and Tax Relief Reconciliation Act of 2001 and the Working
Families Tax Relief Act of 2004. Beneficiaries of the earned
income credit are more likely to be less sophisticated than other
taxpayers. For this reason, changes to the uniform definition may
adversely affect the ability of lower income individuals to
understand their eligibility for child-related benefits such as
the earned income credit. This is particularly important in an area
that has a history of high taxpayer error rates.
Limit definition of qualifying child
The proposal is intended to restore eligibility for the earned
income credit to certain individuals. It applies to certain working
lower-income siblings with respect to their siblings
where no other taxpayers reside in the household. Under present
law, such siblings would be ineligible for the earned income credit
to the extent they could each be the qualifying child of the
other. For example, a 20-year-old woman who is a full-time student
and the legal guardian of her 15-year-old brother would be unable
to claim him as her qualifying child. It can be argued that denying
the earned income credit in such a case was an unintended consequence
of the enactment of a uniform definition. Further, the earned
income credit arguably is intended to provide assistance in this
kind of situation.
One situation that would not benefit from the proposal would be a
circumstance where a younger sibling is supporting an older sibling.
Such a situation may arise, for example, where a younger sibling is
working but the older sibling is a full-time student. The proposal
could have addressed this circumstance and restored eligibility for
the earned income credit to this group by denying status as a
qualifying child to siblings with lower incomes rather than to
siblings that are younger.
Restrict qualifying child tax benefits to child's parent
Under certain fact patterns (e.g., certain multi-generational
families), where more than one taxpayer within a family can claim
a qualifying child for certain tax benefits, the members of the
family may arrange to maximize their tax benefits. This planning
opportunity was available in the case of the earned income credit
before the enactment of the uniform definition in 2004. The
enactment of the uniform definition potentially expanded this
planning opportunity to other child-related tax benefits. For
example, if a grandparent, parent, and child share the same
household, under present law the grandparent and parent can decide
which of them should claim the qualifying child in order to
maximize tax benefits. If the parent earns $40,000 a year and
the grandparent $20,000, it may be more advantageous for the
grandparent to claim the qualifying child in order to receive the
earned income credit, which the parent is ineligible for due to his
level of earnings. Under the proposal, the grandparent could not
claim the qualifying child because his adjusted gross income is
less than that of the parent.
The uniform definition has another, arguably unintended consequence.
In certain fact patterns, the uniform definition extends tax
benefits to certain families who otherwise would not qualify (e.g.
when the parents' income exceeds otherwise applicable income
levels) or increases benefits to certain qualifying families.
For example, it may be possible in certain circumstances and
financially advantageous for the family as a whole, for parents to
forgo claiming a child as a qualifying child so that an older child
living at home may claim such child as a qualifying child.
This would be most advantageous in circumstances in which the
parents have income above the phaseout limits for the child credit
or where the older sibling becomes eligible for the earned income
credit by claiming the younger sibling as a qualifying child.
Under the circumstances described above, the uniform definition
provides a tax planning opportunity for families that are more
affluent and arguably less in need of a tax benefit. The proposal
addresses these situations by limiting the ability of a non-parent
to claim a child as a qualifying child when the child lives with
his or her parents for over half the year.
Prior Action
No prior action.
IV. PROVISIONS RELATED TO THE EMPLOYER-BASED PENSION SYSTEM
A. Provisions Relating to Cash Balance Plans
Present Law
Overview
Types of qualified plans in general
Qualified retirement plans are broadly classified into two
categories, defined benefit pension plans and defined contributions
plans, based on the nature of the benefits provided. In some cases,
the qualification requirements apply differently depending on
whether a plan is a defined benefit pension plan or a defined
contribution plan.
Under a defined benefit pension plan, benefits are determined under
a plan formula, generally based on compensation and years of
service. For example, a defined benefit pension plan might provide
an annual retirement benefit of two percent of final average
compensation multiplied by total years of service completed by
an employee. Benefits under a defined benefit pension plan are
funded by the general assets of the trust established under the
plan; individual accounts are not maintained for employees
participating in the plan.
Employer contributions to a defined benefit pension plan are subject
to minimum funding requirements under the Internal Revenue Code
and the Employee Retirement Income Security Act of 1974 ("ERISA")
to ensure that plan assets are sufficient to pay the benefits under
the plan.
An employer is generally subject to an excise tax for a failure to
make required contributions.
Benefits under a defined benefit pension plan are guaranteed
(within limits) by the Pension Benefit Guaranty Corporation
("PBGC"). Benefits under defined contribution plans are based
solely on the contributions (and earnings thereon) allocated to
separate accounts maintained for each plan participant.
Profit-sharing plans and qualified cash or deferred arrangements
(commonly called "401(k) plans" after the section of the Internal
Revenue Code regulating such plans) are examples of defined
contribution plans.
Cash balance plans
A "hybrid" plan is a plan that combines the features of a defined
benefit pension plan and a defined contribution plan. In recent
years, more employers have adopted cash balance plans (and other
hybrid plans).
A cash balance plan is a defined benefit pension plan with benefits
resembling the benefits associated with defined contribution plans.
Under a cash balance plan, benefits are defined by reference to a
hypothetical account balance. An employee's hypothetical account
balance is determined by reference to hypothetical annual
allocations to the account ("pay credits") (e.g., a certain
percentage of the employee's compensation for the year) and
hypothetical earnings on the account ("interest credits").
The method of determining interest credits under a cash balance
plan is specified in the plan. Under one common plan design,
interest credits are determined in the form of hypothetical
interest on the account at a rate specified in the plan or based
on a specified market index, such as the rate of interest on
certain Treasury securities. Alternatively, interest credits are
sometimes based on hypothetical assets held in the account,
similar to earnings on an account under a defined contribution
plan, which are based on the assets held in the account.
Cash balance plans are generally designed so that, when a
participant receives a pay credit for a year of service, the
participant also receives the right to future interest on the pay
credit, regardless of whether the participant continues employment
(referred to as "front-loaded" interest credits). That is, the
participant's hypothetical account continues to be credited with
interest after the participant stops working for the employer.
As a result, if an employee terminates employment and defers
distribution to a later date, interest credits will continue to be
credited to that employee's hypothetical account. Some early cash
balance plans provided interest credits only while participants'
remained employed (referred to as "back-loaded" interest credits).
That is, a participant's hypothetical account was not credited with
interest after the participant stopped working for the employer.
Overview of qualification issues with respect to cash balance
plans
Cash balance plans are subject to the qualification requirements
applicable to defined benefit pension plans generally. However,
because such plans have features of both defined benefit pension
plans and defined contributions plans, questions arise as to the
proper application of the qualification requirements to such plans.
Some issues arise if a defined benefit pension plan with a
traditional defined benefit formula is converted to a cash balance
plan formula, while others arise with respect to all cash balance
plans. Issues that commonly arise include: (1) in the case of a
conversion to a cash balance plan formula, the application of the
rule prohibiting a cutback in accrued benefits; (2) the proper
method for determining lump-sum distributions; and (3) the
application of the age discrimination rules. These rules are
discussed below.
___________________
/193/ The assets of the cash balance plan may or may not include the
assets or investments on which interest credits are based. As in
the case of other defined benefit pension plans, a plan fiduciary
is responsible for making investment decisions with respect to cash
balance plan assets.
/194/ The conversion of a defined benefit pension plan to a cash
balance plan generally means that the plan is amended to change the
formula for accruing benefits from a traditional defined benefit
formula to a cash balance formula. In such cases, the plan with
the old formula and the plan as amended with the new formula are
sometimes referred to as different plans, even though legally
there is not a separate new plan.
/195/ Sec. 411(d)(6); ERISA sec. 204(g).
/196/ Sec. 417(e); ERISA sec. 205(g).
/197/ Sec. 411(b)(1)(G) and (H); ERISA sec. 204(b)(1)(G) and (H);
Age Discrimination in Employment Act ("ADEA"), 29 U.S.C. 623(i).
Other issues have been raised in connection with cash balance plans,
including the proper method for applying the accrual rules.
There is little guidance under present law with respect to many of
the issues raised by cash balance conversions. In 1999, the IRS
imposed a moratorium on determination letters for cash balance
conversions pending clarification of applicable legal requirements.
Under the moratorium, all determination letter requests regarding
converted cash balance plans are sent to the National Office for
review; however, the National Office is not currently acting on
these plans.
Benefit accrual requirements
Several of the requirements that apply to qualified retirement plans
relate to a participant's accrued benefit. For example, the
vesting requirements apply with respect to a participant's accrued
benefit. In addition, as discussed below, a plan amendment may not
have the effect of reducing a participant's accrued benefit.
In the case of a defined benefit pension plan, a participant's
accrued benefit is generally the accrued benefit determined under
the plan, expressed in the form of an annuity commencing at normal
retirement age.
The accrued benefit to which a participant is entitled under a
defined benefit pension plan must be determined under a method
(referred as the plan's accrual method) that satisfies one of
three accrual rules. These rules relate to the pattern in which
a participant's normal retirement benefit (i.e., the benefit
payable at normal retirement age under the plan's benefit formula)
accrues over the participant's years of service, so that benefit
accruals are not "back-loaded" (i.e., delayed until years of
service close to attainment of normal retirement age).
A participant's accrued benefit under a cash balance plan is
determined by converting the participant's hypothetical account
balance at normal retirement age to an actuarially equivalent
annuity. Under a plan providing front-loaded interest credits,
benefits attributable to future interest credits on a pay credit
become part of the participant's accrued benefit when the
participant receives the pay credit. Thus, for purposes of
determining the accrued benefit, the participant's hypothetical
account balance includes projected future pay credits for the
period until normal retirement age. This has the effect of
front-loading benefit accruals.
__________________
/198/ Sec. 411(b); ERISA sec. 204(b).
/199/ Announcement 2003-1, 2003-2 I.R.B. 281.
/200/ Id.
/201/ Sec. 411(b); ERISA sec. 204(b).
/202/ Sec. 411(a)(7). If a plan does not provide an accrued
benefit in the form of an annuity commencing at normal retirement
age, the accrued benefit is an annuity commencing at normal
retirement age that is the actuarial equivalent of the accrued
benefit determined under the plan. Treas. Reg. sec.
1.411(a)-7(a)(1)(ii).
Under a plan providing back-loaded interest credits, benefits
attributable to interest credits do not accrue until the interest
credits are credited to the employee's account. Thus, as a
participant's account balance grows over time, the amount of
interest credited to the account increases, with a resulting
increase in the participant's accrued benefit. The IRS has
indicated that plans that provide back-loaded interest credit
typically will not satisfy any of the accrual rules.
Protection of accrued benefits; "wearaway" under cash balance plans
In general
The Code generally prohibits an employer from amending a plan's
benefit formula to reduce benefits that have already accrued (the
"anticutback rule"). For this purpose, an amendment is treated as
reducing accrued benefits if it has the effect of eliminating or
reducing an early retirement benefit or a retirement-type subsidy
or of eliminating an optional form of benefit.
The anticutback rule applies in the context of cash balance plan
conversions. Because of this rule, after conversion to a cash
balance formula, a plan must provide employees at least with
the normal retirement benefit that he or she had accrued before
the conversion, as well as with any early retirement benefits or
other optional forms of benefit provided before the conversion.
However, the plan may determine benefits for years following the
conversion in a variety of ways, while still satisfying the
anticutback rule. Common plan designs are discussed below.
Wearaway (or "greater of" approach)
Upon a conversion to a cash balance plan, participants are generally
given an opening account balance. The pay and interest credits
provided under the plan are then added to this opening account
balance. The opening account balance may be determined in a
variety of ways and is generally a question of plan design. For
example, an employer may create an opening account balance that is
designed to approximate the benefit a participant would have had,
based on the participant's compensation and years of service, if
the cash balance formula had been in effect in prior years. As
another example, an employer may convert the preconversion accrued
benefit into a lump-sum amount and establish this amount as the
opening account balance.
Depending on the interest and mortality assumptions used, this
lump-sum amount may or may not equal the actuarial present value of
the participant's accrued benefit as of the date of conversion,
determined using the statutory interest and mortality assumptions
required in determining minimum lump-sum benefits (as discussed
below).
____________________
/203/ Notice 96-8, 1996-1 C.B. 359.
/204/ Sec. 411(d)(6); ERISA sec. 204(g). The provisions do not,
however, protect benefits that have not yet accrued but would have
in the future if the plan's benefit formula had not changed.
/205/ Sec. 411(d)(6)(B); ERISA sec. 204(g)(2).
Under the wearaway approach, the participant's protected benefit
(i.e., the preconversion accrued benefit) is compared to the normal
retirement benefit that is provided by the account balance (plus pay
and interest credits), and the participant does not earn any new
benefits until the new benefit exceeds the protected accrued
benefit. That is, the participant's benefit is the greater of the
preconversion accrued benefit and the benefit provided by the cash
balance account. Because of this effect, plans with a wearaway are
also referred to as using the "greater of" method of calculating
benefits. For example, suppose the value of the protected accrued
benefit is $40,000, and the opening account balance under the cash
balance formula provides a normal retirement benefit of $35,000.
The participant will not earn any new benefits until the
hypothetical balance under the cash balance formula increases to
the extent that it provides a normal retirement benefit exceeding
$40,000. Plan design can greatly affect the length of any wearaway
period.
No wearaway (or "sum of " approach)
Under a plan without a wearaway, a participant's benefit under the
cash balance plan consists of the sum of (1) the benefit accrued
before conversion plus (2) benefits under the cash balance formula
for years of service after the conversion. This approach is more
favorable to plan participants than the wearaway approach because
they earn additional benefits under the new plan formula
immediately. This approach is also sometimes referred to as the "
A + B" method, where A is the protected benefit and B is the benefit
under the cash balance formula.
Grandfathering
For older and longer-service participants, benefits under a cash
balance formula may be lower than the benefits a participant may
have expected to receive under the traditional defined benefit
formula (the "old" formula). The employer might therefore provide
some type of "grandfather" to participants already in the plan or
to older or longer-service employees. For example, the participants
might be given a choice between the old formula and the cash balance
formula for future benefit accruals, or, in the case or a final
average pay plan, the plan may stop crediting service under the old
formula, but continue to apply post-conversion pay increases, so
the employee's preconversion benefit increases with post-conversion
pay increases. This approach goes beyond merely preserving the
benefit protected by the anticutback rule.
________________________________
/206/ This description applies to normal retirement benefits.
Others issues may arise with respect to early retirement benefits.
For example, a plan might have provided a subsidized early
retirement benefit must still be provided with respect to the
preconversion accrued benefit. However, the plan is not required
to provide a subsidized early retirement benefit with respect to
benefits that accrue after the conversion.
/207/ This is sometimes the reduction in benefits that is referred
to in connection with cash balance conversions, i.e., reduction in
expected benefits, not accrued benefits.
Age discrimination
In general
The Code prohibits any reduction in the rate of a participant's
benefit accrual (or the cessation of accruals) under a defined
benefit pension plan because of the attainment of any age.
Parallel requirements exist in ERISA and the Age Discrimination in
Employment Act ("ADEA").
These provisions do not necessarily prohibit all benefit formulas
under which a reduction in accruals is correlated with participants'
age in some manner. Thus, for example, a plan may limit the total
amount of benefits, or may limit the years of service or
participation considered in determining benefits.
In general terms, an age discrimination issue arises as a result of
front-loaded interest credits under cash balance plans because
there is a longer time for interest credits to accrue on
hypothetical contributions to the account of a younger participant.
For example, a $1,000 hypothetical contribution made when a plan
participant is age 30 will be worth more at normal retirement age
(e.g., age 65) and thus provide a higher annuity benefit at normal
retirement age than the same contribution made on behalf of an older
participant closer to normal retirement age. This age
discrimination issue is not limited to cash balance plan
conversions, but arises with respect to cash balance plans generally.
Proposed Treasury regulations
In December 2002, the Treasury Department issued proposed regulations
relating to the application of age discrimination prohibitions to
defined benefit pension plans, including special rules for cash
balance plans. The proposed regulations provided guidance on how
__________________________
/208/ Sec. 411(b)(1)(H). Similarly, a defined contribution plan is
prohibited from reducing the rate at which amounts are allocated to
a participant's account (or ceasing allocations) because of the
attainment of any age.
/209/ ERISA sec 204(b)(1)(H); ADEA 29 U.S.C. Code sec 623(i)
/210/ Sec.411(b)(1)(H)(ii); ERISA sec. 204(b)(1)(H)(ii)
/211/ Other age discrimination issues may also arise in connection
with cash balance plan conversions, dep;einding in part on how the
conversion is made, such as whether the plan has a ``wearaway''.
However, the recent focus of age discrimination has related to the
basic cash balance plan design.
/212/ 67 Fed. Reg. 76123 (December 11, 2002) Prop. Treas. Reg
sec 1.411(b)-2. The proposed regulations were issued after
consideration of comments on regulations proposed in the 1988.53
Fed. Reg. 11876 (April 11, 1988).
to determine the rate of benefit accrual under a defined benefit
pension plan or rate of allocation under a defined contribution
plan.
Under the proposed regulations, subject to certain requirements,
a cash balance formula that provides all participants with the same
rate of pay credit and front-loaded interest credits generally does
not violate the prohibition on age discrimination. In the case of
a plan that is converted to a cash balance plan, the conversion
generally must be accomplished in one of two ways in order to use
the special rule. That is, in general, the converted plan must
either: (1) determine each participant's benefit as not less than
the sum of the participant's benefits accrued under the traditional
defined benefit pension plan formula and the cash balance formula;
or (2) establish each participant's opening account balance as an
amount not less than the actuarial present value of the
participant's prior accrued benefit, using reasonable actuarial
assumptions. The proposed regulations also allow a converted plan
to continue to apply the traditional defined benefit formula to
some participants.
Section 205 of the Consolidated Appropriations Act, 2004 (the "2004
Appropriations Act"), enacted January 24, 2004, provides that
none of the funds made available in the 2004 Appropriations Act
may be used by the Secretary of the Treasury, or his designee, to
issue any rule or regulation implementing the proposed Treasury
regulations or any regulation reaching similar results. The 2004
Appropriations Act also required the Secretary of the Treasury
within 180 days of enactment to present to Congress a legislative
proposal for providing transition relief for older and
longer-service participants affected by conversions of their
employers' traditional pension plans to cash balance plans.
On June 15, 2004, the Treasury Department and the IRS announced
the withdrawal of the proposed age discrimination regulations
including the special rules on cash balance plans and cash balance
conversions. According to the Announcement, "[t]his will provide
Congress an opportunity to review and consider the Administration's
legislative proposal and to address cash balance and other hybrid
plan issues through legislation." Treasury and the IRS that
announced they do not intend to issue guidance on compliance with
the age discrimination rules for cash balance plans, cash balance
_______________________
/213/ The proposed regulations also addressed a number of other
issues, including nondiscrimination testing for cash balance plans
under section 401(a)(4). In April 2003, the Treasury Department
announced it would withdraw the portion of proposed regulations
relating to nondiscrimination testing because the regulations might
make it difficult for employers to provide transition relief to
participants upon conversions. Announcement 2003-22,2002-17 I.R.B
846 (April 28, 2003).
/214/ Pub. L. No. 108-199 (2004)
/215/ The Treasury Department complied with this requirement by
including its cash balance proposal in the President's fiscal year
2005 budget proposal.
/216/ Announcement 2004-57, 2004-27 I.R.B. 15 (June 15, 2004)
/217/ Id.
conversions, or other hybrid plans or hybrid plan conversions while
the issues are under consideration by Congress. As previously
discussed, Treasury and the IRS also announced that they do not
intend to process the technical advice cases pending with the
National Office while cash balance issues are under consideration
by Congress.
Case law
In response to employers' decisions to implement or convert to cash
balance plans, several class action lawsuits have been brought by
employees claiming that age discrimination requirements have been
violated. Three Federal district court cases have addressed
whether cash balance plans violate the age discrimination rules.
In Eaton v. Onan, a case of first impression, the court held that
a cash balance plan did not violate the prohibition on reducing the
rate of benefit accrual because of age. Under the plan,
participants received pay credits for each year of service as well
as front-loaded interest credits. The court examined how the rate
of an employee's benefit accrual was determined and found that the
_____________________
/218/ Other decisions discussing the age discrimination issue do
not directly address the issue, but are based on procedural errors
or only discuss the issue as dicta. In Campbell v. BankBoston,
N.A., 206 F. Supp. 2d 70 (D. Mass. 2002), aff'd, 327 F.3d 1
(1st Cir. 2003), a district held that when the participant was
credited with what he had accrued under the plan up to the date of
conversion to a cash balance plan, the conversion did not show
any intentional age discrimination. At the appeals court, the
participant raised an additional claim that cash balance plan was
age discriminatory under ERISA. Because the argument was not
timely raised before the district court, it was waived. However,
because the appeals court considered this a serious claim, it
discussed the issue, principally citing the Eaton v. Onan decision.
While the BankBoston decision is often cited for the position
that cash balance plans are not age discriminatory, the appeals
court did not actually resolve the ERISA age discrimination issue.
In Godinez v. CBS Corp., 2003 U.S. App. LEXIS 23923 (9th Cir. Nov.
21, 2003), the appeals court upheld the district court's
determination that the plaintiffs failed to make a prima facie case
of discrimination since they could not show any disproportionate
impact on older employees or offer statistical evidence
demonstrating an age correlation (the older workers earned a
larger pension benefit than similarly situated younger workers).
In Engers v. AT&T, 2000 U.S. Dist. LEXIS 10937 (D.N.J. June 29,
2000), in dismissing a claim of deliberate discrimination under
the ADEA relating to the treatment of participants, the district
court held that the plaintiff's claim that AT&T's cash balance plan
violated ERISA and the ADEA's age discrimination requirements could
proceed to trial.
/219/ 117 F. Supp 2d 812 (S.D. Ind. 2000)
/220/ The plaintiffs also raised an issue regarding whether the
lump-sum payments violating age discrimination requirements. The
court held that the defendants were entitled to summary judgment
on that issue.
statute does not require that the rate of benefit accrual be
measured solely in terms of change in the value of an annuity
payable at normal retirement age. The court found that requiring
the rate of benefit accrual to be measured in such way would produce
a result inconsistent with the goal of the pension age
discrimination provisions. The court found that in the case of a
cash balance plan, the rate of benefit accrual should be defined as
the change in the employee's cash balance account from one year to
the next, thus determining that the cash balance plan was not age
discriminatory.
After the proposed Treasury regulations were issued, a Federal
district court in Cooper v. IBM Personal Pension Plan held that
cash balance formulas are inherently age discriminatory because
identical interest credits necessarily buy a smaller age annuity at
normal retirement age for older workers than for younger workers
due to the time value of money. The court interpreted "rate of
benefit accrual" as referring to an employee's age 65 annual
benefit (i.e., annuity payable at normal retirement age) and the
rate at which the age 65 annual benefit accrues. The court held
that the interest credits must be valued as an age 65 annuity, so
that interest credits would always be more valuable to a younger
employee as opposed to an older employee, thus violating the
prohibition on reducing the rate of benefit accrual because of age.
More recently, the U.S. District Court for the District of
Maryland followed Eaton v. Onan and rejected the argument that cash
balance plans are age discriminatory in Tootle v. ARISC Inc.
The court held that in examining the age discrimination issue,
benefit accrual should be should be measured by examining the rate
at which amounts are allocated and the changes in a participant's
account balance over time. According to the court, accrued
benefit should be calculated under ERISA's provisions for defined
contribution plans, rather than in terms of an age-65 annuity, as
required for defined benefit plans.
Calculating minimum lump-sum distributions
Defined benefit pension plans are required to provide benefits in
the form of a life annuity commencing at a participant's normal
retirement age. If the plan permits benefits to be paid in certain
other forms, such as a lump-sum distribution, the alternative form
of benefit cannot be less than the present value of the life
annuity payable at normal retirement age, determined using certain
statutorily prescribed interest and mortality assumptions.
Although a participant's benefit under a cash balance plan is
described in terms of a hypothetical account balance, like other
defined benefit pension plans, a cash balance plan is required to
____________________
/221/ 274 F. Supp. 2d 1010 (S.D. III. 2003)
/222/ Tootle v. ARINC, Inc., et al., 2004 U.S. Dist. LEXIS 10629
(June 10, 2004).
/223/ In Tootle, transition credits were provided on terms more
favorable to older workers when the plan was converted to a cash
balance plans, and the participant received a higher benefit under
the cash balance plan than he would have received under the
traditional defined benefit pension plan.
/224/ Sec. 401(a)(11); ERISA sec. 205.
provide benefits in the form of an annuity payable at normal
retirement age. Most cash balance plans are designed to permit
lump-sum distributions of the participant's hypothetical account
balance upon termination of employment. As is the case with
defined benefit pension plans generally, such a lump-sum amount
is required to be the actuarial equivalent to the annuity payable
at normal retirement age, determined using the statutory interest
and mortality assumptions.
IRS Notice 96-8 provides that determination of an employee's
minimum lump sum under a cash balance plan that provides for
front-loaded interest credits is calculated by: (1) projecting
the participant's hypothetical account balance to normal retirement
age by crediting future interest credits, the right to which has
already accrued; (2) converting the projected account balance to
an actuarially equivalent life annuity payable at normal retirement
age, using the interest and mortality assumptions specified in the
plan; and (3) determining the present value of the annuity (i.e.,
the lump-sum value) using the statutory interest and mortality
assumptions.
A difference in the rate of interest credits provided under the
plan, which is used to project the account balance forward to
normal retirement age, and the statutory rate used to determine the
lump-sum value (i.e., present value) of the accrued benefit will
cause a discrepancy between the value of the minimum lump-sum and
the employee's hypothetical account balance. In particular, if
the plan's interest crediting rate is higher than the statutory
interest rate, then the resulting lump-sum amount will be greater
than the hypothetical account balance. This result is sometimes
referred to as "whipsaw." Several Federal appellate courts have
addressed the calculation of lump-sum distributions under cash
balance plans and have all followed the approach as described in
IRS Notice 96-8.
Description Proposal
In general
The proposal provides rules for conversions of defined benefit
pension plans to cash balance plans, applying the age
discrimination requirements to cash balance plans, and determining
_________________________
/225/ Secs. III B. and C of Notice 96-8.
/226/ Berger V. Xerox Corp. Retirement Income Guarantee Plan. 338
F.3d 755 (7th Cir. 2003); Esden v. Bank of Boston, 229 F.3d 154
(2d Cir. 20000, cert. dismissed, 531 U.S. 1061 (2001); Lyons v.
Georgia Pacific Salaried Employees Retirement Plan, 221 F.3d 1235
(11th Cir. 2000) cert. denied, 532 U.S. 967 (2001); and West v. AK
Steel Corps. Retirement Accumulation Plan, 2004 U.S. Dist LEXIS
9224 (S.D. Ohio April 8, 2004). Additonally, under Esden, if
participants accrue interest credits under a cahs balance plan at an
interest rate that is higher than the interest assumptions prescribed
by the Code of determining the present value of the annuity, the
interest credits must be reflected in the projection of the
participant's hypothetical account balance to normal retirement age
in order to avoid violating the Code's prohibition against
forfeitures.
minimum lump-sum distributions from cash balance plans. The proposal
makes conforming amendments to applicable rules under ERISA and ADEA.
Conversions to cash balance plans; wearaway
Under the proposal, for the first five years following the
conversion of a traditional defined benefit pension plan to a cash
balance plan, the benefits earned by any participant in the cash
balance plan who was a participant in the traditional plan must be
at least as valuable as the benefits the participant would have
earned under the traditional plan had the conversion not occurred.
Additionally, wearaway of normal and early retirement benefits in
connection with a conversion to a cash balance plan is prohibited.
Failure to follow these requirements will not result in
disqualification of the plan. However, a 100-percent excise payable
by the plan sponsor will be imposed on any difference between
required benefits and the benefits actually provided under a plan
which has been converted to a cash balance formula. The amount of
the excise tax cannot exceed the plan's surplus assets at the time
of the conversion or the plan sponsor's taxable income, whichever is
greater. The excise tax does not apply if participants are given a
choice between the traditional defined benefit pension plan formula
and the cash balance formula or if current participants are
"grandfathered," i.e., permitted to continue to earn benefits under
the traditional formula rather than the cash balance formula.
Age discrimination
Under the proposal, a cash balance plan satisfies age
discrimination requirements if it provides pay credits for older
participants that are not less than the pay credits for younger
participants (in the same manner as under a defined contribution
plan). Additionally, certain transition approaches used in
conversions, such as preserving the value of early retirement
subsidies, do not violate the age discrimination or other
qualification rules. The proposal provides similar rules for other
types of hybrid plans and for conversions from traditional defined
benefit pension plans to other types of hybrid plans.
Calculating lump-sum distributions
The proposal permits the value of a lump-sum distribution to be
determined as the amount of a participant's hypothetical account
balance under a cash balance plan as long as the plan does not
provide interest credits in excess of a market rate of return.
The Secretary of the Treasury is authorized to provide safe
harbors for market rates of return and to prescribe appropriate
conditions regarding the calculation of plan distributions.
_________________
/227/ A proposal to change the interest rate used to determine
minimum lump-sum values is discussed in Part IV. C.
Effective date
The proposal is effective prospectively. No inference is intended
as to the status of cash balance plans or cash balance conversions
under present law.
Analysis
In general
Issues relating to cash balance plans raise broader issues
relating to the defined benefit pension plan system and retirement
income security, as discussed below. The proposal addresses certain
issues relating to cash balance plans, with three stated objectives:
(1) to ensure fairness for older workers in cash balance
conversions, (2) to protect the defined benefit pension plan
system by clarifying the status of cash balance plans, and (3)
removing the effective ceiling on interest credits in cash balance
plans due to the way lump-sum benefits are calculated. Specific
issues arise with respect to each part of the proposal. In
addition, because the proposal is effective only prospectively,
there will be continued uncertainty as to the legal status of cash
balance plans created or converted before the date of enactment.
Retirement income security and cash balance plans
Helping to ensure that individuals have retirement income security
is the major objective of the U.S. private pension system. The
system is a voluntary system, relying heavily on tax incentives in
order to encourage employers to establish qualified retirement plans
for their employees. Although qualified plans are subject to a
variety of legal requirements, employers generally may choose
whether or not to adopt a qualified plan, the type of plan to
adopt, the level of benefits to be provided, and many other plan
features.
Over time, there has been a decline in defined benefit pension plan
coverage compared to coverage under defined contribution plans.
This has caused some to be concerned about a possible decline in
retirement income security, and has focused attention on both
defined contribution plans and defined benefit pension plans.
Issues of retirement income security with respect to both
types of plans have been the subject of recent Congressional
hearings.
Traditional defined benefit pension plans are viewed by many
as providing greater retirement income security than defined
contribution plans. This is primarily because such plans
provide a specific promised benefit. Employers bear the risk
of investment loss; if plan contributions plus earnings are
insufficient to provide promised benefits, the employer is
responsible for making up the difference. Within certain
limits, most defined benefit pension plan benefits are guaranteed
by the PBGC. Investments of defined benefit pension plan assets
are subject to ERISA's fiduciary rules and limitations on the
amount of plan assets that may be invested in stock of the
employer. In addition, defined benefit pension plans are
subject to certain spousal benefit requirements that do not
apply to most defined contribution plans. That is, defined
benefit plans are required to provide benefits in the form
of a joint and survivor annuity, unless the participant and
spouse consent to another form of benefit.
In contrast, defined contribution plans do not promise a specific
benefit, but instead pay the value of the participant's account.
The plan participant bears the risk of investment loss.
Benefits provided by defined contribution plans are not guaranteed
by the PBGC. The extent to which ERISA's fiduciary rules apply
to a defined contribution plan depends on the particular
plan structure; in many cases defined contribution plans allow
plan participants to direct the investment of their accounts, in
which case more limited fiduciary protections apply than in the
case of defined benefit pension plans. ERISA's limitations on the
amount of plan assets that may be invested in employer stock
generally do not apply to defined contribution plans. In addition,
under most defined contribution plans, the spouse has only the
right to be named the beneficiary of the amount (if any) remaining
upon the death of the employee.
Cash balance plans have become an increasing prevalent plan design
and, as well, an increasing element in discussions regarding
retirement income security and the future of the defined benefit
plan system.
During the 1990s, conversions of traditional defined benefit pension
plans to cash balance formulas were common among mid- to large-size
employers. There was considerable media attention regarding such
conversions, particularly in cases in which the plan contained a
"wearaway" or in which older or longer-service employees close to
retirement were denied the opportunity to continue to accrue
benefits under the old plan formula. While perhaps complying
with the law, such plan designs were viewed by many as unfair
to certain participants. There was concern that some employers
were adversely affecting participants in order to reduce costs.
There was also concern that participants might not understand
the effect of the conversion on their benefits (including future
benefits the participant may have accrued under the old
formula).
Since then, cash balance plans have continued to be popular.
While certain legal issues have remained, employers have continued
to adopt cash balance plans. In many cases, employers have
structured conversions to avoid or minimize potential adverse
effects on older and longer-service employees.
Attention again focused on cash balance plans following the decision
in IBM, which held that cash balance formulas violate the age
discrimination rules. This case applies not only to conversions,
but to all cash balance plans. This decision has called into
question whether cash balance plans are a permitted form of pension
benefit. The decision has resulted in uncertainty for those
employers that currently offer cash balance plans and employees
who are participants in such plans. It has also focused attention
on the future of defined benefit pension plans and the role that
cash balance play within the overall pension system.
Many view preserving cash balance plans as a means of preserving the
defined benefit pension plan system, and as an important step in
helping to ensure retirement income security.
_____________________
/228/ These concerns led to the enactment of the present-law notice
requirements regarding future reductions in benefit accurals. Sec.
4980F and ERISA sec. 204(h).
Many who hold this view argue that cash balance plans are more
beneficial to many employees than a traditional defined benefit
pension plan and should be a permitted plan design option.
Unlike traditional defined benefit pension plans, which tend to
benefit long-service participants who remain with a company until
retirement, cash balance plans often benefit shorter service, more
mobile workers. Cash balance plans also provide a more portable
benefit than the traditional defined benefit pension plan. Thus,
cash balance plans may be popular in industries or markets in which
workers are relatively mobile or among groups of workers who go
in and out of the workforce. Some participants also find cash
balance plans easier to understand than a traditional defined
benefit pension plan because their benefit is described in terms
of an account balance.
Cash balance plans may be attractive to employers for various
reasons. The adoption of a cash balance plan may enable employers
to better manage pension liabilities. Some employers are concerned
about the level of contributions that may be required to fund
traditional defined benefit pension plans, especially because the
required contributions may fluctuate over time. They argue that a
cash balance plan design does not result in such unpredictable
funding obligations.
On the other hand, some are concerned that cash balance plans are
primarily adopted by employers who wish to cut costs and reduce
future benefits. They argue that reductions in benefits are not as
obvious with a conversion to a cash balance plan compared to plan
changes within the traditional defined benefit pension plan
structure. Even with the present-law requirements relating to
notices of reductions in future benefit accruals, it is argued that
plan participants do not understand how to compare cash balance
benefits with traditional defined benefit pension plan benefits and
that many employees mistakenly think that the cash balance
formula, expressed as an account balance, provides comparable
benefits when it does not. It is also argued that cash balance
plans inherently discriminate against longer service older workers,
and thus should not be encouraged as a plan design.
It is countered that if employers wish to reduce benefits, or
eliminate benefits altogether, they could do so within the
traditional defined benefit pension plan structure. Moreover, some
argue, employers generally sponsor qualified retirement plans
voluntarily. While tax incentives encourage employers to establish
and maintain such plans, they are not required to do so. It is
argued that the flexibility allowed by employers by cash balance
plans enables employers to continue a defined benefit pension plan,
as well as in many cases also provide a defined contribution plan,
thus enhancing retirement income security.
__________________
/229/ Others argue that a more appropriate question is whether
workers are better off under a cash balance plan or no defined
benefit pension plan. They argue that defined benefit pension
plan coverage is falling and that the traditional defined benefit
pension plan continues to be a less and less viable and attractive
option for many employers. Some view cash balance plans as a more
likely design for the future and, if cash balance plans are not
allowed to continue, defined benefit plan coverage will continue
to decline, which will erode retirement income security.
Some also note that cash balance plans, while legally defined
benefit pension plans, operate in a way that does not deliver
the full protections of a traditional defined benefit pension
plan. For example, many traditional defined benefit pension
plans do not offer lump-sum distributions. In contrast, cash
balance plans typically do. While some argue that this increases
portability of benefits, others argue that cash balance plans
discourage annuity benefits, which may erode retirement income
security and may undermine spousal rights.
Some also comment that the risk of investment loss borne by
employers, and the protections against such losses for employees,
are fundamentally different in cash balance plans than in
traditional defined benefit pension plans. In the case of a
traditional defined benefit plan, the plan formula promises a
specific benefit payable at normal retirement age. The employer
bears the risk that plan assets will not be sufficient to provide
the promised benefits and generally must make up investment
losses. Rather than providing a specified benefit, a cash
balance plan specifies interest credits. This design may reduce
the employer's risk that plan assets will underperform compared to
the interest credits provided under the plan, while giving
the employer the benefit of greater than expected investment
performance.
Some argue that, under certain cash balance plans designs, plan
participants face investment risk similar to the risk under defined
contribution plans. For example, this risk may exist to the extent
that the hypothetical account balance in a cash balance plan is
subject to investment losses and well as investment gains. While
many cash balance plans are designed to protect against loss in
value, others argue that it is permissible to tie interest credits
to hypothetical investments that may incur losses. In that case, a
decline in the value of a participant's hypothetical account
balance may result in a decline in the participant's accrued
benefit. Some argue that such declines are inconsistent with
the basic concept of a defined benefit pension plan, i.e., a plan
that provides a specified benefit to participants, in contrast to a
defined contribution plan under which participants bear the risk of
loss. They argue that cash balance plan designs under which
participants bear the risk of investment loss (even if only on
hypothetical investments) should not be permitted.
Some argue that to the extent proposals relating to cash balance
plans are motivated by concerns about retirement income security
that other proposals to address such concerns should also be
considered. For example, some argue that addressing issues with
respect to funding of traditional defined benefit pension plans
would help make such plans more attractive to employers on an
on-going basis. Some also argue that it may be appropriate to
consider whether changes to the rules relating to defined
contribution plans should be considered to enable such plans to
provide greater retirement income security.
Conversions to cash balance plans; wearaway
The proposal is intended to ensure fairness for older workers in
conversions of traditional defined benefit pension plans to cash
balance plans. It provides rules relating to the benefits
accrued by participants in defined benefit pension plans which are
converted to cash balance plans. The proposal provides greater
protection for longer-service participants than is currently
required under the present-law rules prohibiting cut backs in
accrued benefits.
By requiring that the benefits earned by a participant for the
first five years following a conversion must be at least as valuable
as the benefits the participant would have earned under the
traditional plan had the conversion not occurred, participants in
the plan who are close to retirement age are better protected
against disadvantages of converting to a cash balance plan.
Further, by prohibiting wearaway in a conversion to a cash balance
plan with respect to the benefits of such participants, possible
adverse effects on older and longer-service participants will be
reduced.
On the other hand, some argue that the proposal does not go far
enough in ensuring that older and longer service employees will
not be disadvantaged. Some argue that all plan participants, or
at least participants who have attained a certain age or number of
years of service, should automatically be given the greater of
benefits under the old plan formula or under the new plan formula.
Others argue that any such additional requirement would cause
employer qualified retirement plan costs to increase, and could
cause employers to reduce benefits further or terminate existing
plans. They argue that the proposal provides an appropriate balance
between concerns about older workers and the need to provide
flexibility to employers in order to maintain the voluntary pension
system.
Some argue that the 100-percent excise tax on any difference between
required benefits and the benefits actually provided under a plan
which has been converted to a cash balance formula is sufficient to
encourage compliance with the proposal. However, others argue that
limiting the amount of the excise tax to the plan's surplus assets
at the time of the conversion or the plan sponsor's taxable income,
whichever is greater, will allow plan sponsors to manipulate
the timing of a conversion so that the requirements of the proposal
can be avoided without imposition of the excise tax. They argue
that absent the potential for plan disqualification, the efficacy
of the proposal is diminished, or even eliminated.
Some argue that the proposal provides appropriate flexibility to
employers and additional safeguards for employees, by allowing
employers to avoid the excise tax by grandfathering participants
under the old formula or giving employees a choice between the old
and new formula. On the other hand, some point out that giving
employees options increases complexity for plan participants, and
that many participants may not adequately understand the differences
between the new plan formula and the old plan formula.
These concerns may be addressed, at least to some extent, by
requiring that participants receive sufficient information to make an
informed decision. As mentioned above, others would go further,
and require that at least some employees be automatically given the
greater of the two formulas. This would avoid the need for
elections, and the possibility that an employee may unwittingly
choose an option that is clearly worse than the old plan formula.
On the other hand, some view such a requirement as unduly
restricting employers options in plan design.
Age discrimination
By providing that cash balance plans satisfy the age discrimination
rules if the plan provides pay credits for older participants that
are not less than the pay credits for younger participants, the
proposal provides certainty in this regard. Some have argued that
if such certainty is not provided, employers will be disinclined to
offer defined benefit pension plans, including cash balance plans,
to their employees. By reducing uncertainty as to how cash balance
plans can meet age discrimination requirements, some would argue
that employers will be more likely to sponsor (or continue to
sponsor) defined benefit pension plans, including cash balance plans.
The age discrimination issue results from the effect of front-loaded
interest credits, under which a participant receiving a pay credit
also receives the right to future interest on the pay credit,
regardless of whether the participant continues employment.
Front-loaded interest credits cause benefits to accrue more
quickly, which is generally viewed as advantageous to participants,
especially participants who leave employment after a short period
of service. However, some argue that front-loaded pay credits
inherently favor younger participants and are thus age inherently
discriminatory. They believe that for this, and other reasons,
cash balance plans should not be permitted.
Calculating lump-sum distributions
The proposal is intended to eliminate situations in which the
amount of a minimum lump-sum distribution required from a cash
balance plan is greater than a participant's hypothetical account
balance because the plan's interest crediting rate is higher than
the statutory interest rate. The proposal departs from the analysis
set out in IRS Notice 96-8 and followed by several Federal courts
that have considered this issue.
Proponents argue that the cases are based on IRS rulings that
pre-date the prevalence of cash balance plans and that apply rules
that are inappropriate in a cash balance context. Further, they
argue that, as a result of the present-law rules, employers have
reduced the rate of interest credits under cash balance plans, thus
reducing benefits for participants. The proposal avoids this result
and thus, it is argued, will benefit plan participants by
encouraging employers to use a higher rate of return than the
statutorily-prescribed rate.
Others note that, for purposes of satisfying the accrual rules,
benefits attributable to front-loaded interest credits are treated
as part of the accrued benefit. They argue that, if benefits
attributable to front-loaded interest credits are part of the
accrued benefit, such benefits should be reflected in determining
the minimum value of lump-sum distributions as required under
present law. To the extent that a participant's hypothetical
account balance is less than such minimum lump-sum value, a
participant who receives a distribution of the hypothetical account
balance has not received the full value of his or her accrued
benefit. They argue that such a result is inconsistent with the
protections provided by the vesting and accrual rules.
In order for the proposal to apply, the plan must not use interest
credits in excess of a market rate of return, and the Secretary is
to provide safe harbors as to what is a market rate. This aspect
of the proposal raises issues as to how to determine a market rate
of return. Recent discussions over what constitutes an appropriate
replacement for the interest rate on 30-year Treasury obligations
for purposes related to defined benefit pension plans reflects the
degree of complexity which may be involved in prescribing such safe
harbors. The effects of the proposal on plan benefits, and the ease
with which the proposal can be implemented by employers, understood
by employees, and administered by the IRS will depend in large part
on the ability to determine measures of market rates of returns.
Some argue that because so much depends on what is a market rate
of return under the proposal, it would be more appropriate to
provide statutory guidance on this issue, rather than leave the
issue for the Secretary to resolve.
Complexity
As a result of its study of Enron Corporation, performed at the
direction of the Senate Committee on Finance, the staff of the
Joint Committee on Taxation ("Joint Committee staff") found that
the lack of guidance with respect to cash balance plan conversions
and cash balance plans generally creates uncertainty for employers
and employees. The Joint Committee staff recommended that clear
rules for such plans should be adopted in the near future.
The budget proposals help to reduce uncertainty with respect to cash
balance plans by addressing certain issues that frequently arise
with respect to cash balance plans. However, the proposals do not
address all issues with respect to such plans. In addition, certain
aspects of the proposals need further clarification, or may add
some additional complexities. For example, additional clarification
is needed with respect to types of transition approaches in
conversions that do not violate age discrimination or other
qualification rules, allowing participants to choose between a
traditional defined benefit formula and cash balance formula in
order to avoid the 100-percent excise tax, and the determination of
a market rate of return for purposes of calculating
lump-sum distributions.
Prior Action
An identical proposal was included in the President's fiscal year
2005 budget proposal.
__________________________
/230/ Joint Committee on Taxation, Report of Investigation of Enron
Corporation and Related Entities Regarding Federal Tax and
Compensation Issues, and Policy Recommendations (JCS-3-030, February
2003, at 487.
B. Strengthen Funding for Single-Employer Pension Plans
1. Background and summary
Helping to assure that individuals have retirement income security
is the major objective of the U.S. private pension system. Federal
law attempts to further this goal in various ways. The Code
provides tax-favored treatment for employer-sponsored qualified
retirement plans. ERISA applies many of the same requirements as
the Code and provides employees with the means of pursuing their
rights.
Defined benefit pension plans are considered by many to provide
greater retirement income security than defined contribution plans.
Factors that contribute to this view include the fact that such
plans offer a specified benefit payable as an annuity for life,
the employer bears the risk of investment loss, and benefits are
guaranteed (within limits) by the PBGC in the event the plan
terminates and plan assets are not sufficient to pay promised
benefits. The minimum funding rules are designed to promote
retirement income security by helping to assure that plan assets
will be sufficient to pay promised benefits when due. If plans
are not adequately funded by the employer, then the benefits
promised under the plan may not be paid in full; In particular,
if a plan terminates and the assets are not sufficient to pay
benefits, participants may not receive the full value of the
benefits due, even with the PBGC guarantee.
The minimum funding rules have been the focus of much attention
in recent years. On one hand, attention has focused on the
increase in required contributions under the deficit reduction
contribution rules, caused in part by the combination of low
interest rates that have increased the value of plan liabilities
and market declines that have decreased the value of plan assets.
Some view this combination as a temporary situation that has
artificially increased the extent of pension plan underfunding.
On the other hand, attention has focused also on large, severely
underfunded plans maintained by insolvent employers that have
terminated with resulting benefit losses to employees and increases
in PBGC liabilities. Some therefore believe the present-law funding
rules are inadequate. Many believe that resolution of funding
issues is essential to the long-term viability of the defined
benefit pension system.
As of September 30, 2004, the PBGC reported a total deficit of
$23.5 billion, more than double the 2003 fiscal year end deficit
of $11.5 billion. The PBGC's deficit is the amount by which its
liabilities exceed its assets. The PBGC has noted that its
financial state is a cause for concern.
__________________
/231/ Additional information about the Administration's proposals
relating to funding and the Pension Benefit Guaranty Corporation is
available on the Department of Labor's website at:
www.dol.gov/ebsa/pensionreform.html
/232/ Many believe that resolution of the uncertanity surrounding cash
balance plans is also essential to the long-term viability of the
defined benefit pension system, as discussed more fully in connection
with the Administration's proposal relating to cash balance plans in
Part IV. A.
/233/ A variety of estimates and assumption are used by the PBGC in
evaluating the present value of its liability for future benefits,
including assumptions about future plan terminations. According to
concern. The Government Accountability Office (``GAO'') has
placed the PBGC on its high risk list. Although the PBGC is a
Federal agency, it does not receive financing from general
revenues. Instead, the PBGC is funded by assets in terminated
plans, amounts recovered from employers who terminate undefended
plans, preminums paid with respect to plans covered by the PBGC
insurance program, and investment earnings. Underfunding of defined
benefit pension plans presents a risk to PBGG preminum payors,
who may have to pay for the unfunded liabilities of terminating
plans, and plan participants, who may lose benefits if a plan
terminates (even with the PBGC guarantee).
The President's budget contains a series of proposals designed to
strengthen funding levels in defined benefit pension plans and
ability of the PBGC to provide guaranteed benefits. These
proposals consist of: (1) changes to the funding rules to measure
a plan's funding status more accurately and to require faster
funding of shortfalls, along with increased deduction limits to
encourage additional contributions (as discussed above); (2) more
accurate and timely reporting of funding status; (3) elimination
of a grandfather rule that allows certain plans to exceed the limits
on investments in employer securities and real property;
(4) restrictions on benefit increases and accelerated distributions
that result in increases in unfunded liabilities; (5) a prohibition
on providing shutdown benefits; and (6) redesign of the PBGC
premium structure, limits on the PBGC guarantee when an employer
enters bankruptcy, and enabling the PBGC to perfect a lien for
required contributions against the assets of an employer in
bankruptcy.
2. Funding and deduction rules
Present Law
In general
Defined benefit pension plans are subject to minimum funding
requirements. The minimum funding requirements are designed to
ensure that plan assets are sufficient to pay plan benefits when
due. The amount of contributions required for a plan year under
the minimum funding rules is generally the amount needed to fund
benefits earned during that year plus that year's portion of other
liabilities that are amortized over a period of years, such as
benefits resulting from a grant of past service credit. The
amount of required annual contributions is determined under
_______________________
to the PBGC, this present value is particularly sensitive to changes
in the underlying estimates and assumptions; changes in estimates and
assumptions could materially change the present value of its
liability for future benefits.
/234/ Sec. 412; ERISA secs. 301-308. The minimum funding rules do
not a apply to governmental plans or to church plans, except church
plans with respect to which an election has been made to have various
requrements, including trhe funding requirements, apply to the plan.
In some respects, teh funding rules applicable to multiemployer plans
differ from the rules applicable to singel-employer plans. In
addition, special rules apply to certain plans funded exclusively by
the purchase of individual insurance contracts (referred to as
``insurance contract'' plans).
number of acceptable actuarial cost methods. Additional
contributions are required under the deficit reduction contribution
rules in the case of certain underfunded plans. No contribution is
required under the minimum funding rules in excess of the full
funding limit (described below).
An employer sponsoring a defined benefit pension plan generally may
deduct amounts contributed to a defined benefit pension plan to
satisfy the minimum funding requirements for a plan year.
In addition, contributions in excess of the amount needed to
satisfy the minimum funding requirements may be deductible, subject
to certain limits.
General minimum funding rules
Funding methods and general concepts
A defined benefit pension plan is required to use an acceptable
actuarial cost method to determine the elements included in its
funding standard account for a year. Generally, an actuarial cost
method breaks up the cost of benefits under the plan into annual
charges consisting of two elements for each plan year. These
elements are referred to as: (1) normal cost; and (2) supplemental
cost.
The plan's normal cost for a plan year generally represents the cost
of future benefits allocated to the year by the funding method used
by the plan for current employees and, under some funding methods,
for separated employees. Specifically, it is the amount actuarially
determined that would be required as a contribution by the employer
for the plan year in order to maintain the plan if the plan had been
in effect from the beginning of service of the included employees
and if the costs for prior years had been paid, and all assumptions
as to interest, mortality, time of payment, etc., had been
fulfilled. The normal cost will be funded by future contributions
to the plan: (1) in level dollar amounts; (2) as a uniform
percentage of payroll; (3) as a uniform amount per unit of service
(e.g., $1 per hour); or (4) on the basis of the actuarial present
values of benefits considered accruing in particular plan years.
The supplemental cost for a plan year is the cost of future benefits
that would not be met by future normal costs, future employee
contributions, or plan assets. The most common supplemental cost
is that attributable to past service liability, which represents the
cost of future benefits under the plan: (1) on the date the plan
is first effective; or (2) on the date a plan amendment increasing
plan benefits is first effective. Other supplemental costs may be
attributable to net experience losses, changes in actuarial
assumptions, and amounts necessary to make up funding deficiencies
for which a waiver was obtained. Supplemental costs must be
amortized (i.e., recognized for funding purposes) over a specified
number of years, depending on the source. For example, the cost
attributable to a past service liability is generally amortized
over 30 years.
Normal costs and supplemental costs under a plan are computed on the
basis of an actuarial valuation of the assets and liabilities of a
plan. An actuarial valuation is generally required annually and is
made as of a date within the plan year or within one month before
the beginning of the plan year. However, a valuation date within
the preceding plan year may be used if, as of that date, the value
of the plan's assets is at least 100 percent of the plan's current
liability (i.e., the present value of benefit liabilities under the
plan, as described below).
For funding purposes, the actuarial value of plan assets is
generally used, rather than fair market value. The actuarial value
of plan assets is the value determined under an actuarial valuation
method that takes into account fair market value and meets certain
other requirements. The use of an actuarial valuation method allows
appreciation or depreciation in the market value of plan assets to
be recognized gradually over several plan years.
In applying the funding rules, all costs, liabilities, interest
rates, and other factors are required to be determined on the basis
of actuarial assumptions and methods: (1) each of which is
reasonable individually; or (2) which result, in the aggregate, in
a total plan contribution equivalent to a contribution that would
be obtained if each assumption were reasonable. In addition, the
assumptions are required to reflect the actuary's best estimate of
experience under the plan.
Funding standard account
As an administrative aid in the application of the funding
requirements, a defined benefit pension plan is required to maintain
a special account called a "funding standard account" to which
specified charges and credits are made for each plan year, including
a charge for normal cost and credits for contributions to the plan.
Other credits or charges or credits may apply as a result of
decreases or increases in past service liability as a result of
plan amendments (discussed above) or (as discussed below)
experience gains or losses, gains or losses resulting from a change
in actuarial assumptions, or a waiver of minimum required
contributions.
In determining plan funding under an actuarial cost method, a
plan's actuary generally makes certain assumptions regarding the
future experience of a plan. These assumptions typically involve
rates of interest, mortality, disability, salary increases, and
other factors affecting the value of assets and liabilities. If
the plan's actual unfunded liabilities are less than those
anticipated by the actuary on the basis of these assumptions, then
the excess is an experience gain. If the actual unfunded
liabilities are greater than those anticipated, then the difference
is an experience loss. Experience gains and losses for a year are
generally amortized as credits or charges to the funding standard
account over five years.
If the actuarial assumptions used for funding a plan are revised
and, under the new assumptions, the accrued liability of a plan is
less than the accrued liability computed under the previous
assumptions, the decrease is a gain from changes in actuarial
assumptions. If the new assumptions result in an increase in the
accrued liability, the plan has a loss from changes in actuarial
assumptions. The accrued liability of a plan is the actuarial
present value of projected pension benefits under the plan that
will not be funded by future contributions to meet normal cost or
_____________
/235/ Present law also provides for the use of an ``alternative''
funding standard account, which has rarely been used.
future employee contributions. The gain or loss for a year from
changes in actuarial assumptions is amortized as credits or charges
to the funding standard account over ten years.
If minimum required contributions are waived (as discussed below),
the waived amount is credited to the funding standard account.
The waived amount is then amortized over a period of five years,
beginning with the year following the year in which the waiver is
granted. Each year, the funding standard account is charged with
the amortization amount for that year unless the plan becomes fully
funded.
If, as of the close of the plan year, charges to the funding
standard account exceed credits to the account, then the excess is
referred to as an "accumulated funding deficiency." For example,
if the balance of charges to the funding standard account of a plan
for a year would be $200,000 without any contributions, then a
minimum contribution equal to that amount would be required to meet
the minimum funding standard for the year to prevent an accumulated
funding deficiency.
If, as of the close of a plan year, the account reflects credits at
least equal to charges, the plan is generally treated as meeting
the minimum funding standard for the year. Thus, as a general
rule, the minimum contribution for a plan year is determined as
the amount by which the charges to the account would exceed credits
to the account if no contribution were made to the plan. If credits
to the funding standard account exceed charges, a "credit balance"
results. The amount of the credit balance, increased with interest,
can be used to reduce future required contributions. A credit
balance may result, for example, if contributions in excess of
minimum required contributions are made or if investment returns
on plan assets are more favorable than assumed.
Additional contributions for underfunded plans
Under special funding rules (referred to as the "deficit reduction
contribution" rules), an additional contribution to a plan is
generally required if the plan's funded current liability percentage
is less than 90 percent. A plan's "funded current liability
percentage" is the actuarial value of plan assets as a percentage
of the plan's current liability. In general, a plan's current
liability means all liabilities to employees and their beneficiaries
under the plan, determined on a present-value basis.
________________
/236/ The deficit reduction contribution rules apply to single-
employer plans with no more than 100 participants on any day in the
preceding plan year. Single-employer plans with more than 100 but
not more than 150 participants are generally subject to lower
contribution requirements under these rules.
/237/ Under an alternative test, a plan is not subject to the deficit
reduction contribution rules for a plan year if (1) the plan's funded
current liability percentage for the plan year is at least 80 percent,
and (2) the plan's funded current liability percentage was at least 90
percent for each of the two immediately preceding plan years or each of
the second and third immediately preceding plan years.
The amount of the additional contribution required under the deficit
reduction contribution rules is the sum of two amounts: (1) the
excess, if any, of (a) the deficit reduction contribution (as
described below), over (b) the contribution required under the
normal funding rules; and (2) the amount (if any) required with
respect to unpredictable contingent event benefits. The amount
of the additional contribution cannot exceed the amount needed
to increase the plan's funded current liability percentage to
100 percent. The amount of the additional contribution is applied
as a charge to the funding standard account.
The deficit reduction contribution is the sum of (1) the "unfunded
old liability amount," (2) the "unfunded new liability amount," and
(3) the expected increase in current liability due to benefits
accruing during the plan year. The "unfunded old liability
amount" is the amount needed to amortize certain unfunded
liabilities under 1987 and 1994 transition rules. The "unfunded
new liability amount" is the applicable percentage of the plan's
unfunded new liability. Unfunded new liability generally means
the unfunded current liability of the plan (i.e., the amount by
which the plan's current liability exceeds the actuarial value of
]plan assets), but determined without regard to certain
liabilities (such as the plan's unfunded old liability and
unpredictable contingent event benefits). The applicable
percentage is generally 30 percent, but decreases by .40 of one
percentage point for each percentage point by which the plan's
funded current liability percentage exceeds 60 percent. For
example, if a plan's funded current liability percentage is 85
percent (i.e., it exceeds 60 percent by 25 percentage points),
the applicable percentage is 20 percent (30 percent minus 10
percentage points (25 multiplied by .4)).
A plan may provide for unpredictable contingent event benefits,
which are benefits that depend on contingencies that are not
reliably and reasonably predictable, such as facility shutdowns or
reductions in workforce. The value of any unpredictable contingent
event benefit is not considered in determining additional
contributions until the event has occurred. The event on which an unpredictable contingent event benefit is contingent is generally not considered to have occurred until all events on which the benefit
is contingent have occurred.
Required interest rate and mortality table
Specific interest rate and mortality assumptions must be used in
determining a plan's current liability for purposes of the special
funding rule. For plans years beginning before January 1, 2004, the
interest rate used to determine a plan's current liability must be
within a permissible range of the weighted average of the interest
rates on 30-year Treasury securities for the four-year period
ending on the last day before the plan year begins. The
permissible range is generally from 90 percent to 105 percent
(120 percent for plan years beginning in 2002 or 2003). The
_____________________
/238/ If the Secretary of the Treasury prescribes a new mortality
table to be used in determining current liability, as described
below, the deficit reduction contribution may include an additional
amount.
/239/ The weighting used for this purpose is 40 percent, 30 percent,
20 percent and 10 percent, starting with the most recent year in the
four-year period. Notice 88-73, 1988-2 C.B. 383.
interest rate used under the plan generally must be consistent
with the assumptions which reflect the purchase rates which would
be used by insurance companies to satisfy the liabilities under
the plan.
Under the Pension Funding Equity Act of 2004 ("PFEA 2004"), a
special interest rate applies in determining current liability
for plan years beginning in 2004 or 2005. For these years, the
interest rate used must be within a permissible range of the
weighted average of the rates of interest on amounts invested
conservatively in long-term investment-grade corporate bonds during
the four-year period ending on the last day before the plan year
begins. The permissible range for these years is from 90 percent
to 100 percent. The interest rate is to be determined by the
Secretary of the Treasury on the basis of two or more indices
that are selected periodically by the Secretary and are in the
top three quality levels available.
The Secretary of the Treasury is required to prescribe mortality
tables and to periodically review (at least every five years) and
update such tables to reflect the actuarial experience of
pension plans and projected trends in such experience. The
Secretary of the Treasury has required the use of the 1983
Group Annuity Mortality Table.
--------------------
/240/ If the Secretary of the Treasury determines that the lowest
permissble interest rate in this range is unreasonably high, the
Secretary may prescribe a lower rate, but not less than 80 percent of
the weighted average of the 30-year Treasury rate.
/241/ Sec. 412(b)(5)(B)(iii)(II); ERISA sec. 302(b)(5)(B)(iii)(II).
Under Notices 90-11, 1990-1 C.B. 319, the interest rates in the
permissible range are deemed to be consistent with the assumptions
reflecting the purchase rates that would be used by insurance
companies to satisfy the liabilities under the plan.
/242/ Pub. L. No. 108-218 (2004)
/243/ In addition, udner PFEA 2004, if certain requirements are met,
reduced contributions under the deficit reduction contribution rules
apply for plan years beginning after December 27, 2003, and before
December 28, 2005, in the case of plans maintained by commercial
passenger airlines, employers primarily engaged in the production or
manufacture of a steel mill product or in the processing of iron ore
pellets, or a certain labor organization.
/244/ Sec. 412(1)(7)(C)(ii); ERISA sec. 302(d)(7)(C)(ii).
/245/ Rev. Rul. 95-28, 1995-1 C.B. 74. The IRS and the Treasury
Department have announced that they are undertaking a review of the
applicable mortality table and have requested comments on related
issues, such as how mortality trends should be reflected. Notice
2003-62, 2003-38 I.R.B. 576; Announcement 2000-7, 2000-I C.B. 586
Other rules
Full funding limitation
No contributions are required under the minimum funding rules in
excess of the full funding limitation. In 2004 and thereafter,
the full funding limitation is the excess, if any, of (1) the
accrued liability under the plan (including normal cost), over (2)
the lesser of (a) the market value of plan assets or (b) the
actuarial value of plan assets. However, the full funding
limitation may not be less than the excess, if any, of 90 percent
of the plan's current liability (including the current liability
normal cost) over the actuarial value of plan assets. In general,
current liability is all liabilities to plan participants and
beneficiaries accrued to date, whereas the accrued liability under
the full funding limitation may be based on projected future
benefits, including future salary increases.
Timing of plan contributions
In general, plan contributions required to satisfy the funding
rules must be made within 8� months after the end of the plan year.
If the contribution is made by such due date, the contribution is
treated as if it were made on the last day of the plan year.
In the case of a plan with a funded current liability percentage of
less than 100 percent for the preceding plan year, estimated
contributions for the current plan year must be made in quarterly
installments during the current plan year. The amount of each
required installment is 25 percent of the lesser of (1) 90
percent of the amount required to be contributed for the
current plan year or (2) 100 percent of the amount required
to be contributed for the preceding plan year.
Funding waivers
Within limits, the IRS is permitted to waive all or a portion of the
contributions required under the minimum funding standard for a
plan year. A waiver may be granted if the employer (or employers)
responsible for the contribution could not make the required
____________________
/246/ For plan years beginning before 2004, the full funding
limitation was generally defined as the excess, if any, of (1)
the lesser of (a) the accrued liability under the plan
(including normal cost) or (b) a percentage (170 percent for 2003)
of the plan's current liability (including the curent liability
normal cost), over (2) the lesser of (a) the market value of plan
assets or (b) the acturial value of plan assets, but in no case less
than the excess, if any, of 90 percent of the plan's current
liability over the acturial value of plan assets. Under the Economic
Growth and Tax Relief Reconciliation Act of 2001 (``EGTRRA''), the
full funding limitation based on 170 percent of current liability is
repeated for plan years beginning in 2004 and thereafter. The
provisions of EGTERRA genrally do not apply for years beginning
after December 31, 2010.
/247/ Sec. 412(m); ERISAA sec. 302(e)
/248/ Sec. 412(d); ERISA sec. 303. Under similar rules, the
amortization period applicable to losses may also be extended.
contribution without temporary substantial business hardship and if
requiring the contribution would be adverse to the interests of
plan participants in the aggregate. Generally, no more than
three waivers may be granted within any period of 15 consecutive
plan years.
The IRS is authorized to require security to be granted as a
condition of granting a waiver of the minimum funding standard if
the sum of the plan's accumulated funding deficiency and the balance
of any outstanding waived funding deficiencies exceeds $1 million.
Failure to make required contributions
An employer is generally subject to an excise tax if it fails to
make minimum required contributions and fails to obtain a waiver
from the IRS. The excise tax is 10 percent of the amount of the
funding deficiency. In addition, a tax of 100 percent may be
imposed if the funding deficiency is not corrected within a
certain period.
If the total of the contributions the employer fails to make (plus
interest) exceeds $1 million and the plan's funded current liability
percentage is less than 100 percent, a lien arises in favor of the
plan with respect to all property of the employer and the members
of the employer's controlled group. The amount of the lien is the
total amount of the missed contributions (plus interest).
Reversions of defined benefit pension plan assets
Defined benefit pension plan assets generally may not revert to an
employer before termination of the plan and the satisfaction of
all plan liabilities. In addition, the plan must provide for the
reversion. A reversion prior to plan termination may result in
disqualification of the plan and may constitute a prohibited
transaction. Certain limitations and procedural requirements apply
to a reversion upon plan termination. Any assets that revert to the
employer upon plan termination are includible in the gross income of
the employer and subject to an excise tax. The excise tax rate is
generally 20 percent, but increases to 50 percent if the employer
does make contributions to a replacement plan or make certain
benefit increases. Upon plan termination, the accrued benefits of
all plan participants are required to be fully vested.
If certain requirements are satisfied, a qualified transfer of
excess assets of a defined benefit pension plan may be made to a
separate account within the plan in order to fund retiree health
benefits. Excess assets generally means the excess, if any, of
the value of the plan's assets over the greater of (1) the accrued
__________________
/249/ Sec. 4971 An excise tax applies also if a quarterly installment
is less than the amount required to cover the plan's liquidity
shortfall.
/250/ Sec. 4980.
/251/ sec. 420.
/252/ The value of plan assets for this purpose is the lesser of
fair market value or acturarial value.
liability under the plan (including normal cost) or (2) 125 percent
of the plan's current liability. No transfer after December 31,
2013, is a qualified transfer.
Deductions for contributions
Employer contributions to qualified retirement plans are deductible,
subject to certain limits. In the case of a defined benefit pension
plan, the employer generally may deduct the greater of: (1) the
amount necessary to satisfy the minimum funding requirement of the
plan for the year; or (2) the amount of the plan's normal cost for t
he year plus the amount necessary to amortize certain unfunded
liabilities over 10 years, but limited to the full funding
limitation for the year.
The maximum amount of deductible contributions is generally not less
than the plan's unfunded current liability. For purposes of
determining the maximum amount of deductible contributions, an
employer may elect to disregard the temporary interest rate change
under PFEA 2004. In such a case, the interest rate used in
determining current liability for deduction purposes must be within
the permissible range (90 to 105 percent) of the weighted average of
the interest rates on 30-year Treasury securities for the preceding
four-year period.
Subject to certain exceptions, an employer that makes nondeductible
contributions to a plan is subject to an excise tax equal to 10
percent of the amount of the nondeductible contributions for the
year.
Description of Proposal
In general
In the case of single-employer plans, the proposal repeals the
present-law funding rules and provides a new set of rules for
determining minimum required contributions. Under the proposal,
the minimum required contribution to a defined benefit pension plan
for a plan year is generally the sum of two amounts: (1) the
payments required to amortize over seven years the amount by which
_________________________
/253/ Sec. 404(a)(1).
/254/ Sec. 404(a)(1)(D). In the case of a plan that terminates during
the year, the maximum deductible amount is generally not less than
the amount needed to make the plan assets sufficient to fund benefit
liabilities as defined for purposes of the PBGC termination insurance
program (sometimes referred to as ``termination liability'').
/255/ Sec. 4972.
/256/ The proposal does not change the funding rules applicable to
multiemployer plans or insurance contract plans. Covernmental plans
church plans continue to be exempt from the funding rules to the
extent provided under present law.
/257/ As discussed below, different payments may be required with
respect to amortization bases established for different years.
the plan's funding target exceeds the market value of the plan
assets; and (2) the plan's normal cost for the plan year.
The plan's funding target is generally the present value of benefits
earned as of the beginning of the plan year. The plan's normal
cost is generally the present value of benefits expected to be
earned during the plan year. Under the proposal, present value is
determined using interest rates drawn from a corporate bond yield
curve and a mortality table prescribed by the Secretary of Treasury.
However, other assumptions used to determine the plan's
funding target and normal cost depend on the financial status of
the employer.
The proposal also changes the limit on deductible contributions.
Determination of funding target and normal cost.
In general
In general, under the proposal, the funding target and normal cost
for a plan are the plan's "ongoing liability" and "ongoing" normal
cost. However, in the case of a plan maintained by a financially
weak plan sponsor, the funding target and normal cost for the plan
are the plan's "at-risk liability" and "at-risk" normal cost.
Different actuarial assumptions apply in determining ongoing or
at-risk liability and normal cost.
Ongoing liability and ongoing normal cost
A plan's ongoing liability for a plan year is the present value of
future payments expected to be made from the plan to provide
benefits earned as of the beginning of the plan year.
Benefits taken into account for this purpose include early
retirement benefits and similar benefits that participants will
become entitled to as a result of future service, to the extent
such benefits are attributable to benefits accrued as of the
beginning of the plan year.
For purposes of determining a plan's ongoing liability, the present
value of benefits is determined by discounting future expected
payments under the plan using a corporate bond yield curve, as
described below. Future expected benefit payments under the plan
are determined using a mortality table prescribed by the Secretary
of Treasury. The proposal generally does not require other
specified assumptions to be used in determining ongoing liability.
However, other assumptions, such as the rate of turnover among
participants and early and normal retirement rates, must be
actuarially reasonable based on experience for the plan (or other
relevant historical experience if there is no experience for the
plan). In addition, a reasonable assumption as to future benefits
that will be paid in the form of a lump sum must be used.
Ongoing normal cost for a plan year is the present value of future
payments expected to be made from the plan to provide benefits that
accrue during the plan year. Benefits that accrue during the plan
year include any benefit accruals that result from compensation
increases during the plan year that are applied to previous years
of service, such as under a plan that bases benefits on final
average compensation. Ongoing normal cost is determined using the
same actuarial assumptions used to determine ongoing liability.
At-risk liability and at-risk normal cost
A plan's at-risk liability for a plan year is also the present value
of future payments expected to be made from the plan to provide
benefits earned as of the beginning of the plan year, determined
using a corporate bond yield curve and a mortality table prescribed
by the Secretary of Treasury. However, certain specified additional
assumptions must be used in determining at-risk liability.
Specifically, at-risk liability must be determined by assuming that
participants retire at the earliest retirement age permitted under
the plan and that benefits are paid in the form of a lump sum (or
in whatever form permitted under the plan results in the largest
present value). In addition, at-risk liability includes an
additional amount, referred to as a loading factor. The loading
factor is $700 per plan participant plus four percent of the amount
of the plan's at-risk liability, as determined without regard to
the loading factor.
At-risk normal cost is the present value of future payments expected
to be made from the plan to provide benefits that accrue during the
plan year, determined using the same actuarial assumptions used to
determine at-risk liability, including a loading factor of four
percent of the amount of the plan's at-risk normal cost, as
determined without regard to the loading factor.
Financially weak status
Financially weak status applies if, as of the plan's valuation date,
any plan sponsor has senior unsecured debt that is rated as not
being investment grade by each nationally recognized rating
organization that has issued a credit rating for the debt.
Alternatively, if no plan sponsor has senior unsecured debt that
is rated, financially weak status applies if all of the nationally
recognized statistical rating organizations that have made an issuer
credit rating for any plan sponsor have rated the sponsor as less
than investment grade. However, financially weak status does not
apply if any significant member of the plan sponsor's controlled
group has senior unsecured debt that is rated as investment grade,
regardless of whether that controlled group member is a plan sponsor
of the plan.
Special rules apply in the case of plan sponsors that have neither
unsecured debt that is rated nor an issuer credit rating. Such a
_____________________
/259/ These additional assumptions are intended to reflect behavior
that may occur when the financial health of the plan sponsor
deteriorates.
/260/ The loading factor is intended to reflect the cost of
purchasing group annuity contracts in the case of termination of the
plan.
plan sponsor is automatically treated as not being financially weak,
provided that the total number of participants covered by defined
benefit pension plans maintained by the sponsor is less than 500.
If the total number of participants covered by defined benefit
pension plans maintained by such a plan sponsor is 500 or more,
whether the plan sponsor is financially weak is determined under
regulations. It is expected that, under such regulations,
financially weak status will be determined based on financial
measures, such as whether the ratio of long-term debt to equity for
the plan sponsor's controlled group is 1.5 or more. For this
purpose, debt is expected to include the unfunded at-risk liability
of any plans maintained by the plan sponsor, and equity is expected
to be based on: (1) fair market value in the case of a privately
held company; or (2) market capitalization in the case of a company,
the stock of which is publicly traded.
If a plan sponsor becomes financially weak during a plan year, any
resulting change in the plan's funding target (i.e., from ongoing
liability to at-risk liability) and normal cost (i.e., from ongoing
normal cost to at-risk normal cost) is phased in ratably over a
five-year period beginning with the plan year following the year in
which the plan sponsor becomes financially weak. This rule applies
if a plan sponsor becomes financially weak either before or after
enactment of the proposal, and the five-year phase-in period is
determined without regard to whether any of the relevant years
occurred before enactment of the proposal. If a plan sponsor's
financial status changes during a plan year so that it is no
longer financially weak, the plan's ongoing liability is the
applicable funding target for the next plan year.
Interest rate based on corporate bond yield curve and transition
rule
The funding target and normal cost applicable to a plan are
determined using a series of interest rates drawn from a yield curve
for high-quality zero-coupon corporate bonds ("corporate bond yield
curve"). That is, the interest rates used to determine the present
value of payments expected to be made under the plan reflect the
interest rates for corporate bonds maturing at the times when the
payments are expected to be made. The corporate bond yield curve
is to be issued monthly by the Secretary of Treasury, based on the
interest rates (averaged over 90 business days) for high-quality
corporate bonds (i.e., bonds rated AA) with varying maturities.
A special method of calculating a plan's funding target applies for
plan years beginning in 2006 and 2007. For those years, the plan's
funding target is the weighted average of: (1) the plan's funding
target (i.e., ongoing or at-risk liability, as applicable)
determined using a corporate bond yield curve; and (2) the plan's
funding target determined using the "transition" interest rate.
The transition interest rate is the interest rate that would apply
if the statutory interest rate applicable in determining current
liability for plan years beginning in 2005 continued to apply for
plan years beginning in 2006 and 2007. That is, the interest rate
___________________
/262/ Typically, higher interest rates apply to bonds of longer
durations, and lower interest rates apply to bonds of shorter
durations. It is therefore expected that higher interest rates will
generally apply in determining the present value of payments
expected to be made further in the future, and lower interest rates
will generally apply in determining the present value of payments
expected to be made in the nearer future.
used must be within a permissible range (from 90 to 100 percent)
of the weighted average of the rates of interest on amounts
invested conservatively in long-term investment-grade corporate
bonds during the four-year period ending on the last day before
the plan year begins. For plan years beginning in 2006, a weighting
factor of 2/3 applies to the plan's funding target determined using
the transition interest rate, and a weighting factor of 1/3 applies
to the plan's funding target determined using a corporate bond
yield curve. For plan years beginning in 2007, the respective
weighting factors are 1/3 and 2/3.
A similar method applies in determining a plan's normal cost (i.e.,
ongoing or at-risk normal cost, as applicable) for plan years
beginning in 2006 and 2007.
Valuation date
Under the proposal, a plan's funding target (i.e., ongoing or
at-risk liability, as applicable), the plan's normal cost (i.e.,
ongoing or at-risk normal cost, as applicable), the market
value of the plan's assets, and the minimum required contribution
for a plan year are determined as of the valuation date for the
plan year. If a plan has more than 100 participants, the plan's
valuation date must be the first day of the plan year. If the
plan has 100 or fewer participants, the plan's valuation date may
be any day in the plan year.
If a plan's valuation date is after the first day of the plan year,
benefits accruing between the first day of the plan year and the
valuation date are disregarded in determining the plan's funding
target for the plan year. In addition, in determining the market
value of plan assets as of the valuation date, any contribution
made to the plan for the current plan year is disregarded
and any contribution to be made to the plan for the prior year that
has not yet been made is included in plan assets as a contribution
receivable. For plan years beginning in 2007 or later, the present
value of the contribution receivable is included in plan assets,
and present value is determined using the average effective
interest rate that applied in determining the plan's funding target
for the prior plan year.
Minimum required contributions
Under the proposal, the minimum contribution required to be made to a
plan for a plan year is generally the sum of: (1) the plan's normal
cost for the plan year (i.e., ongoing or at-risk normal cost, as
applicable); and (2) the payments required (as described below) to
amortize the amount by which the plan's funding target for the
plan year (i.e., ongoing or at-risk liability, as applicable)
exceeds the market value of plan assets.
Under the proposal, if the plan's funding target for the plan year
beginning in 2006 exceeds the market value of the plan's assets for
that year, an initial amortization base is established in the amount
of the shortfall. Payments are then required in the amount needed
to amortize the initial amortization base over seven years, starting
with the plan year beginning in 2006. The required amortization
___________________________
/263/ Such benefits are taken into account in determining the plan's
normal cost for the plan year.
/264/ The present-law rules permitting the waiver of the minimum
funding requirements continue to apply.
payments are determined on a level basis, using the applicable
interest rates under the corporate bond yield curve.
For each subsequent plan year, the plan's funding target is compared
with the sum of: (1) the market value of the plan's assets; and
(2) the present value of any future required amortization payments
(determined using the applicable interest rates under the corporate
bond yield curve). If the plan's funding target exceeds that
sum, an additional amortization base is established in the amount
of the shortfall, and payments are required in the amount needed
to amortize the additional amortization base over seven years.
If, for a plan year, the sum of the market value of plan assets
and the present value of any future required amortization payments
exceeds the plan's funding target, no additional amortization base
is established for that plan year.
All required amortization payments generally must be made over the
applicable seven-year period. However, if, for a plan year, the
market value of the plan's assets is at least equal to the plan's
funding target, any existing amortization bases are eliminated and
no amortization payments are required.
If no amortization payments are required for a plan year, the
minimum required contribution for the plan year is based solely
on the plan's normal cost. Specifically, the minimum required
contribution is the plan's normal cost, reduced by the amount
(if any) by which the market value of the plan's assets exceeds
the plan's funding target. Accordingly, no contribution is required
for a plan year if the market value of the plan's assets is at least
equal to the sum of the plan's funding target and the plan's normal
cost for the plan year.
A contribution in excess of the minimum required contribution does
not create a credit balance that can be used to offset minimum
required contributions for later years. However, contributions in
excess of the minimum (and income thereon) increase plan assets,
which may have the effect of accelerating the elimination of
amortization bases or of reducing contributions required with
respect to normal cost.
Timing rules for contributions
As under present law, contributions required for a plan year
generally must be made within 8-� months after the end of the plan
year. However, quarterly contributions are required to be made
during a plan year if, for the preceding plan year, the plan's
funding target exceeded the market value of the plan's assets,
determined as of the valuation date for the preceding plan year.
A contribution made after the valuation date for a plan year is
credited against the minimum required contribution for the plan year
based on its present value as of the valuation date for the plan
_____________________
/265/ Under the proposal, the present-law rules permitting the
extension of amortization periods are repealed with respect to
single-employer plans.
year. Present value is determined by discounting the contribution
from the date the contribution is actually made to the valuation
date, using the average effective interest rate applicable in
determining the plan's funding target for the plan year.
Maximum deductible contributions
Under the proposal, the limit on deductible contributions for a year
is generally the amount by which the sum of the plan's funding
target, the plan's normal cost, and the plan's cushion amount
exceeds the market value of the plan's assets. The plan's cushion
amount is the sum of: (1) 30 percent of the plan's funding target;
and (2) the amount by which the plan's funding target and normal
cost would increase if they were determined by taking into account
expected future salary increases for participants (or, in the case
of a plan under which previously accrued benefits are not based on
compensation, expected future benefit increases, based on average
increases for the previous six years). The increase in the plan's
funding target and normal cost as a result of taking into account
expected future salary or benefit increases is determined by
applying the expected salary or benefit increase with respect to participants'service as of the valuation date for the plan year.
For this purpose, the dollar limits on benefits and on compensation
that apply for the plan year are used.
In addition, the limit on deductible contributions for a year is not
less than the sum of: (1) the plan's at-risk normal cost for the
year; and (2) the amount by which the plan's at-risk liability for
the year exceeds the market value of the plan's assets. For this
purpose, at-risk liability and at-risk normal cost are used
regardless of the financial status of the plan sponsor.
Present-law rules permitting an employer to deduct a contribution
made within the time for filing its tax return for a taxable year
continue to apply.
Effective date
The proposal is effective for plan years beginning after December
31, 2005.
Analysis
General policy issues relating to the funding and deduction rules
for defined benefit pension plans
The funding rules are a cornerstone of the defined benefit pension
plan system and, over time, have been a frequent source of
discussion and change. Proposals relating to the funding rules
involve balancing competing policy interests.
The present-law minimum funding rules recognize that pension
benefits are generally long-term liabilities that can be funded over
a period of time. On the other hand, benefit liabilities are
accelerated when a plan terminates before all benefits have been
paid, as many plans do, and the deficit reduction contribution
rules to some extent reflect the amount that would be needed to
provide benefits if the plan terminated. Some argue that if
minimum funding requirements are too stringent, funds may be
unnecessarily diverted from the employer's other business needs and
may cause financial problems for the business, thus jeopardizing the
future of not just the employees' retirement benefits, but also
their jobs. This suggestion tends to arise during a period of
economic downturn, either generally or in a particular industry.
Some also argue that overly stringent funding requirements may
discourage the establishment or continuation of defined benefit
pension plans.
The limits on deductible contributions, the excise tax on
nondeductible contributions, and the rules relating to reversions
of defined benefit pension plan assets have as a major objective
preventing the use of defined benefit pension plans as a tax-favored
funding mechanism for the business needs of the employer. They
also serve to limit the tax expenditure associated with defined
benefit pension plans. Some argue that if the maximum limits on
plan funding are too low, then benefit security will be
jeopardized. They argue that employers need flexibility to make
greater contributions when possible, in order to ensure adequate
funding in years in which the business may not be as profitable.
Others note that such flexibility is available as a result of the
increases in the deduction limits under EGTRRA, but the full effect
of the increases may not be apparent yet because of recent economic
conditions. With respect to reversions, some argue that if
restrictions on reversions are too strict, employers may be
discouraged from making contributions in excess of the required
minimums.
The desire to achieve the proper balance between these competing
policy objectives has resulted in a variety of legislative changes
to address the concerns arising at particular times. For example,
the Omnibus Budget Reconciliation Act of 1987 made comprehensive
changes to the minimum funding rules (including enactment of the
deficit reduction contribution rules) prompted by concerns regarding
the solvency of the defined benefit pension plan system. That Act
also added the current liability full funding limit. Legislation
enacted in 1990 allowed employers access to excess assets in defined
benefit pension plans in order to pay retiree health liabilities.
The Retirement Protection Act of 1994 again made comprehensive
changes to the funding rules. Recent changes to the funding rules
have focused on increasing the maximum deductible contribution, and
on the interest rate that must be used to calculate required
contributions. For example, EGTRRA increased the current liability
full funding limit and then repealed the current liability full
funding limit for 2004 and thereafter.
General analysis of the funding and deduction proposal
The proposed changes to the funding rules reflect the view that the
present-law rules are ineffective in assuring that plans are
adequately funded. For example, the valuation methods and
amortization periods applicable under present law may have the
effect of disguising a plan's true funding status. In some cases,
these factors result in artificial credit balances that can be used
to reduce required contributions. Thus, employers may fully comply
with the present-law funding rules, yet still have plans that are
substantially underfunded. In general, the proposal is intended to
more accurately measure the unfunded liability of a plan and
accelerate the rate at which contributions are made to fund that
liability.
Under the proposal, a plan's funding status is measured by reference
to the present value of plan liabilities, using a current interest
rate, and the market value of plan assets. This approach is
intended to provide a more accurate and up-to-date picture of the
plan's financial condition. On the other hand, some point out that
most plans are long-term arrangements and a measurement of assets
and liabilities as of a particular date does not necessarily provide an
accurate picture of the plan's status. Some are also concerned that
elimination of the averaging and smoothing rules that apply under
present law may result in increased volatility of required
contributions. They also note that the present-law averaging and
smoothing rules allow employers to know in advance that higher
plan contributions will be required, thereby providing some
predictability in required contributions. They suggest that, by
making required contributions more volatile and unpredictable, the
proposal may discourage employers from continuing to maintain plans
and thus may harm, rather than strengthen, the defined benefit
pension plan system.
The proposal applies a more rigorous funding target in the case of
a plan maintained by a financially weak employer. Under the
proposal, financially weak status is generally based on a rating
of the employer's debt as below investment grade by nationally
recognized rating organizations. In some cases, financially weak
status is determined in accordance with standards to be established
under regulations. Some argue that credit ratings are simply not a
reliable indicator of whether a plan will terminate on an
underfunded basis. They note that many businesses with below
investment grade ratings continue to operate and to maintain a
defined benefit pension plan. Some also suggest that the
possibility of greater required contributions could itself drive
down an employer's credit rating. Some also express concern that,
in some cases, Treasury and the IRS would be responsible for
determining financial status.
If a plan terminates, in addition to the cost of benefits, costs are
incurred to purchase annuity contracts to provide the benefits due
under the plan. In addition, an economic decline in a business may
cause employees to retire earlier and to take benefits in the form
of a lump sum. The proposal requires these factors to be reflected
in the determination of a plan's funding target in the case of a
financially weak employer. This approach has the effect of
increasing such liabilities and required contributions. Some view
this approach as appropriate in order to reduce the financial risk
posed by underfunded plans maintained by financially weak employers.
Others argue that requiring such employers to make even greater
required contributions may increase the risk that the plan will
terminate on an underfunded basis.
Under the proposal, the changes to the deduction limits are intended
to allow employers to make higher contributions when funds are
available, thus improving the plan's funding status
and reducing the contributions that may be required during a
downturn in business. However, some argue that the elimination of
the credit balance concept (which limits the ability to reduce
future required contributions by additional contributions made in
the past) undercuts the incentive to make additional contributions.
In addition, some employers may have made additional contributions
and generated credit balances as part of a planned funding strategy
and elimination of existing credit balances may be viewed as
disruptive. Some suggest that credit balances should be adjusted to
reflect changes in plan asset values, but not eliminated. On the
other hand, with respect to the proposed increase in the deduction
limits, some note that, currently, most employers do not make
contributions up to the present-law deduction limits.
They suggest that raising the limits will primarily benefit employers
who want to use the plan as a source of tax-free savings to provide
funds for other purposes.
The present-law funding rules are complex, in part because they
essentially consist of two sets of rules - the general rules that
determine required contributions on an ongoing basis and the deficit
reduction contribution rules that determine required contributions
on a present-value basis. The proposal replaces these rules with a
single set of rules, which reduces complexity. In addition, the
methods used to determine minimum required contributions under the
proposal are less complex than the present-law rules involving the
funding standard account and various amortization periods and
valuation methods.
Background relating to interest rate used to measure pension
liabilities
Recent attention has focused on the issue of the rate of interest
used to determine the present value of benefits under defined
benefit pension plans for purposes of the plan's current liability
(and hence the amount of contributions required under the funding
rules) and the minimum amount of lump-sum benefits under the plan.
For plan funding purposes, the use of a lower interest rate in
determining current liability results in a higher present value of
the benefits and larger contributions required to fund those
benefits. Alternatively, the use of a higher interest rate results
in a lower present value of future liabilities and therefore lower
required contributions.
Under present law, the theoretical basis for the interest rate to be
used to determine the present value of pension plan benefits for
funding purposes is an interest rate that would be used
in setting the price for private annuity contracts that provide
similar benefits. Some studies have shown that it is not
practicable to identify such a rate accurately because of variation
in the manner in which prices of private annuity contracts are
determined. As a result, the interest rate used to value pension
benefits is intended to approximate the rate used in pricing annuity
contracts. Some have described this standard as a rate comparable
to the rate earned on a conservatively invested portfolio of assets.
Under present law, the interest rate used to determine current
liability (and minimum lump-sum benefits) has been based on the
interest rate on 30-year Treasury obligations. The interest rate
issue has received attention recently in part because the Treasury
Department stopped issuing 30-year obligations. As a result, there
is no longer a 30-year Treasury interest rate, and statutory changes
are necessary to reflect this. In addition, some have argued that
the 30-year Treasury rate has been too low compared to annuity
rates, resulting in inappropriately high levels of minimum funding
requirements on employers that are not necessary to maintain
appropriate retirement income security.
_____________________________
/266/ A proposal to use a corporate bond yield curve in determining
minimum lump-sum benefits is discussed in Part IV.C.
/267/ In practice, the price of an annuity contact encompasses not
only an interest rate factors, such as the costs of servicing the
contract and recordkeeping. Under present law, the interest used for
determining current liability is intended to embody all of these
factors. See H.R. Rpt. No. 100-495, at 868 (1987).
/268/ As discussed above, temporary increases in the permissible
interest rate for purposes of determining current liability were
enacted in 2002 and 2004.
Analysis of interest-rate proposal
Under the proposal, the rate of interest on 30-year Treasury
securities is replaced with the rare of interest on high-quality
corporate bonds for purposes of determining the present value of
plan benefits for purposes of determining minimum required
contributions. Initiallym the interest ratre used is based on a
weighted average of the yields on high-quality long-term corporate
bonds. After a transition period, the proposal provides for the use
of a series of interest rates drawn from timing of benefits payments
expected to be made from the plan.
Some believe that, compared with the rate of interest on 30-year
Treasury securities, an interest rate based on long-term corporate
bonds better approximates the rate that would be used in determining
the cost of settling pension liabilities, i.e., by purchasing
annuity contracts to provide the benefits due under the plan.
However, the proposal reflects the view that use of an interest
rate based solely on long-term corporate bonds is inappropriate,
and rather that multiple interest rates should be used to reflect
the varying times when benefits become payable under a plan, because
of, for example, different expected retirement dates of employees.
The rationale for this approach is that interest rates differ
depending, in part, on the term of an obligation. Because plan
liabilities may be payable both in the short term and the long
term, this approach would determine the present value of these
liabilities with multiple interest rates, chosen to match the times
at which the benefits are payable under the plan.
Some have raised concerns that a yield-curve approach is more
complicated than the use of a single rate, particularly for smaller
plans. Some have suggested that this could have the effect of
increasing administrative costs associated with maintaining a
defined benefit pension plan (and, in some cases, required
contributions) and discourage the continuation and establishment of
such plans. Some also question whether using a yield curve would
result in such increased accuracy as to justify the complexity.
Some have suggested that the use of a single rate, such as the
long-term corporate bond rate, with an appropriate adjustment
factor can produce results similar to the use of a yield curve,
but much more simply.
Others have responded to these concerns by suggesting that, although
a single interest rate is used to determine required contributions
under the present-law funding rules, a yield-curve approach is
commonly used for other purposes, such as corporate finance. Some
also note that the determination of plan liabilities already
involves the application of complicated actuarial concepts and the
proposal does not add significant complexity. They argue moreover
that any additional complexity is outweighed by the importance of
measuring pension liabilities accurately, including the timing of
benefit payments from the plan. In addition, it has been suggested
that simplified methods (such as the use of a single composite rate)
can be provided for smaller plans.
______________________
/269/ Some also argue that the interest rate used to funding purposes
should be based on the expected return on plan investments, rather
than on annuity purchase rates.
Some have questioned whether it is possible to construct a yield
curve of corporate bond rates that is appropriate for measuring
pension liabilities. They suggest that, for example, corporate
bonds of certain durations that are available on the market are too
limited to provide a reliable basis for constructing a yield curve.
Some have also suggested that the proposal may be intended to
encourage employers to invest plan assets more heavily in bonds,
rather than in equities. Although, over time, returns on equity
investments are expected to be higher than bond returns, equity
investments are also subject to greater value changes, which can
lead to volatility in plan asset values, which in turn may
increase unfunded liabilities and minimum required contributions.
Thus, investments in bonds may reduce volatility in the value of
plan assets and in required contributions. Some argue that, to
the extent plan assets are invested more heavily in bonds in order
to reduce volatility in plan assets, the long term return on such
plan might be lower than that achieved with an alternative portfolio
invested less heavily in bonds, thus requiring greater employer
contributions over time to meet plan liabilities. However,
employers today face similar issues in the management of pension
plans under the existing funding rules.
The proposal also eliminates the four year averaging period used to
determine the interest rate applicable for purposes of determining
current liability under present law. Some have suggested that such
an averaging period is necessary to prevent rapid interest rate
changes from causing corresponding changes in the value of pension
liabilities, which in turn may result in volatility in the amount of
minimum required contributions. The use of a yield curve, however,
should to some extent mitigate volatility relative to the use of a
single rate, as short and long term interest rates fluctuate to
differing degrees and do not necessarily even move in the same
direction. Others believe that the interest rate used to value
pension liabilities should be designed to measure those
liabilities as accurately as possible and that volatility in
required contributions should be addressed through modifications
to the funding and deduction rules. However, some argue that the
proposal fails to address such volatility.
Prior Action
The President's fiscal year 2005 budget proposal included a proposal
to use a yield curve of interest rates on corporate bonds in
determining current liability for plan years beginning after
December 31, 2007, with a phase-in for plan years beginning after
December 31, 2005, and before January 1, 2008.
The National Employee Savings and Trust Equity Guarantee Act of
2004 ("NESTEG"), as reported by the Senate Committee on Finance on
May 14, 2004, included a provision under which a yield curve of
interest rates on corporate bonds is used in determining current
liability for plan years beginning after December 31, 2010, with a
phase-in for plan years beginning after December 31, 2006, and before
January 1, 2011. NESTEG also contained a provision under which the
limit on deductible contributions to a defined benefit pension plan
is not less than the excess (if any) of: (1) 130 percent of the
plan's current liability; over (2) the value of plan assets.
3. Form 5500, Schedule B actuarial statement and summary annual
report
Present Law
Form 5500 and Schedule B actuarial statement
A plan administrator of a pension, annuity, stock bonus,
profit-sharing or other funded plan of deferred compensation
generally must file with the Secretary of the Treasury an annual
return for each plan year containing certain information with
respect to the qualification, financial condition, and operation
of the plan. Title I of ERISA also may require the plan
administrator to file annual reports concerning the plan with the
Department of Labor and the Pension Benefit Guaranty Corporation
("PBGC"). The plan administrator must use the Form 5500 series as
the format for the required annual return. The Form 5500 series
annual return/report, which consists of a primary form and
various schedules, includes the information required to be filed
with all three agencies. The plan administrator satisfies the
reporting requirement with respect to each agency by filing the
Form 5500 series annual return/report with the Department of
Labor, which forwards the form to the Internal Revenue Service and
the PBGC.
Certain schedules must be filed with the Form 5500. Schedule B must
be filed by most defined benefit pension plans (i.e., the
requirement applies to all plans subject to the minimum funding
standard) and includes actuarial information of the plan.
Information required in the actuarial report includes (1) a
description of the funding method and actuarial assumptions used
to determine costs under the plan; (2) a certification of the
contribution necessary to reduce the accumulated funding deficiency
to zero; (3) a statement that the report is complete and accurate
and that the requirements relating to reasonable actuarial
assumptions have been met; (4) other information as may be
necessary to fully and fairly disclose the actuarial position of
the plan; and (5) such other information as the Secretary may
prescribe.
The Form 5500 is due by the last day of the seventh month following
the close of the plan year. The due date may be extended up to two
and one-half months.
Upon written request, a participant must be provided with a copy of
the full annual report. Copies of filed Form 5500s are available
for public examination at the U.S. Department of Labor. As
discussed below, the plan administrator must automatically provide
participants with a summary of the annual report. A plan
administrator is also required to furnish participants with other
notices and information about the plan.
Summary annual report
ERISA requires that plans furnish a summary annual report of the
Form 5500 to plan participants and beneficiaries. The summary
annual report must include a statement whether contributions were
_____________________________
/270/ Treas. Reg. sec. 301.6058-1(a).
/271/ Code sec. 6059.
made to keep the plan funded in accordance with minimum funding
requirements, or whether contributions were not made and the amount
of the deficit. The current value of plan assets is also required
to be disclosed. The summary annual report must be furnished
within nine months after the close of the plan year. If an
extension applies for the Form 5500, the summary annual report must
be provided within two months after the extended due date. A plan
administrator who fails to provide a summary annual report to a
participant within 30 days of the participant making request for
the report may be liable to the participant for a civil penalty of
up to $100 a day from the date of the failure.
Participant notice of underfunding
Plan administrators of plans required to pay variable rate premiums
to the PBGC are required to provide notice to plan participants and
beneficiaries of the plan's funding status and the limits on the
PBGC's guaranty should the plan terminate while underfunded.
The notice is generally due no later than two months after the
filing deadline for the Form 5500 for the previous plan year and
may be distributed with the plan's summary annual report.
Disclosure of certain plan actuarial and company financial
information Certain plan sponsors are required to annually provide
the PBGC with records, documents, or other information that the
PBGC specifies as necessary to determine the liabilities and assets
of the plan. The sponsor must also provide copies of audited
financial statements, and such other information as the PBGC may
prescribe. The disclosure is required on a controlled-group basis.
Plan subject to this requirement include single-employer plans if
(1) the aggregate unfunded vested benefits at the end of the
preceding plan year of plans maintained by the contributing sponsor
and members of its controlled group exceed $50,000,000; (2) the
condition for imposing a lien for missed plan contribution
exceeding $1 million have been met with respect to any member of
the controlled group; or (3) minimum funding waivers in excess
of $1 million have been granted with respect to any plan maintained
by a member of the controlled group and any portion is still
outstanding.
In general, the contents of annual reports, statement, and other
documents filed with the Department of Labor under the reporting
and disclosure provisions of ERISA are generally public information
that must be made available for public inspection. Information or
documentary materials submitted to the PBGC pursuant to ERISA
section 4010 is exempt from disclosure under the Freedom of
Information Act ("FOIA") and no such information or documentary
materials may be made public, except as may be relevant to an
administrative or judicial action or proceeding.
_________________
/272/ ERISA sec. 4011.
/273/ ERISA sec. 4010.
Description of Proposal
Form 5500, Schedule B actuarial statement
Under the proposal, a plan's ongoing liability, at-risk liability
(regardless of whether the employer is financially weak), and the
market value of the plan assets are required to be reported in the
actuarial report (i.e., the Schedule B) filed with the plan's
annual report. The proposal applies to all PBGC-covered,
single-employer defined benefit pension plans.
In addition, if quarterly contributions are required with respect
to a plan covering more than 100 participants (i.e., a plan that
has assets less than the funding target as of the prior valuation
date), the deadline for the actuarial report is accelerated. The
actuarial report is due on the 15th day of the second month
following the close of the plan year (February 15 for calendar
year plans). If any contribution is subsequently made for the plan
year, the additional contribution is required to be reflected in an
amended Schedule B to be filed with the Form 5500.
Summary annual report
Under the proposal, the summary annual report provided to
participants is required to include information on the funding
status of the plan for each of the last three years. The funding
status is required to be shown as a percentage based on the ratio
of the plan's assets to its funding target. Information on the
employer's financial status and on the PBGC benefit guarantee must
also be provided. The proposal replaces the requirement of notice
to participants of underfunding with the summary annual report
disclosure.
The summary annual report must be provided to participants no later
than 15 days after the due date for filing the plan's annual
report. A plan administrator that fails to provide a summary annual
report on a timely basis is subject to a penalty.
Public disclosure of certain PBGC filings
The proposal eliminates the nondisclosure rules of section 4010(c)
of ERISA, which exempt certain information filed with the PBGC from
disclosure under FOIA. Under the proposal, information and
documentation filed with the PBGC pursuant to ERISA section 4010
___________________
/274/ As previously discussed, for a plan sponsor that is not
financially weak, the funding target is the plan's ongoing liabilty.
For a plan sponsor that is financially weak, the funding target is
the plan's at-risk liability. Ongoing liability and at-risk
liability are previously discussed in detail. In general, a plan's
ongoing liability for a plan year is the present value of future
payments expected to be made from the plan to provide benefits
earned as of the beginning of the plan year. At risk liability is
based on the same benefits and assumptions as ongoing liability,
except that the valuation of those benefits would require the use
of certain actuarial assumptions to reflect the concept that a plan
maintained by a financially weak plan sponsor may be more likely
to pay benefits on an accelerated basis or to terminate its plan.
/275/ ERISA sec. 4011.
can be made available to the public, except for confidential trade
secrets and commercial or financial information under FOIA.
Effective date
The proposal is effective for plan years beginning in 2006. The
proposal relating to elimination of the nondisclosure rules is
effective with respect to filings made under section 4010
of ERISA on or after 30 days after date of enactment.
Analysis
In general
The proposal is intended to provide more detailed and timely
information to plan participants, government agencies, and the
public regarding the financial status of pension plans and their
sponsors and to make such information publicly available.
Participants should be adequately and timely informed about their
retirement benefits. Many believe that the asset and liability
measures under current law do not provide an accurate and meaningful
measure to participants of a plan's funding status. They believe
that present law does not require adequate disclosure about a plan's
funding status and does not provide enough advance warning to
participants of underfunding. Some believe that current law
results in disclosures being made too late, resulting in
participants not being timely informed of the plan status.
Form 5500, Schedule B actuarial statement
The proposal requires the Schedule B actuarial statement filed with
the Form 5500 of all single-employer defined benefit pension plans to
include the market value of the plan's assets, ongoing liability, and
at-risk liability. This will provide participants greater
information regarding the financial position of their pension plans,
including the increased liability that will result if the financial
condition of the plan sponsor deteriorates. Some argue that if a
plan sponsor is not financially weak, the Form 5500 should only be
required to include the liability applicable to the plan (i.e.,
ongoing liability), rather than both ongoing and at-risk liability.
The proposal accelerates the deadline for filing of the Schedule B
actuarial report in the case of plans that cover more than 100
participants and are subject to the requirement to make quarterly
contributions to the 15th day of the second month following the close
of the plan year. In the case of a calendar year plan, the due date
is February 15. Proponents argue that this will provide timely
information on the financial situation of defined benefit pension
plans. Others may argue that the accelerated deadline does not
provide enough time for completion of the actuarial statement.
In the case of plans covering more than 100 participants, the
funding proposal previously discussed requires the valuation date
to be the first day of the plan year. In such case, the valuation
date will be more than one year before the actuarial statement
is due.
Summary annual report
The proposal requires the summary annual report to include a
presentation of the funding status of the plan for each of the last
three years. The funding status must be shown as a percentage based
on the ratio of the plan's assets to its funding target. Proponents
believe that requiring disclosure of the plan's funding target, along
with a comparison of that liability to the market value of assets,
will provide participants more accurate and useful information on
the financial status of the plan. The proposal also requires the
summary annual report to include information on the company's
financial health and on the PBGC guarantee. The proposal is unclear
as to what information would be required to show the company's
financial health.
The proposal requires that the summary annual report be provided to
participants and beneficiaries by 15 days after the filing date for
the Form 5500. A penalty is imposed for failure to furnish a
summary annual report in a timely manner. Specific information
regarding the penalty is unclear. The proposal eliminates the
participant notice requirement under section 4011, as the proposal
assumes that the summary annual report disclosure will provide more
accurate timely information.
Public disclosure of certain PBGC filings
Eliminating the nondisclosure rules of ERISA section 4010(c) allows
all information filed with the PBGC pursuant to section 4010 to be
available to the public, with the exception of confidential trade
secrets and commercial or financial information under FOIA. By
eliminating the nondisclosure rule, the proposal is intended to
provide more public information on the financial status of pension
plans and plan sponsors. The proposal is intended to provide
greater information to participants so that they know when their
plan is underfunded or when the plan sponsor's financial condition
may impair the ability of the company to maintain or fund the plan.
Under the proposal, information disclosed to the PBGC generally is
subject to the present-law FOIA provisions. FOIA provides that
commercial or financial information that is required to be submitted
to the Government is protected from disclosure if it is privileged or
confidential. Some argue that FOIA's commercial and financial
information exception provides adequate protection for confidential
business information. Others believe that certain financial
information outside of the scope of the exception should remain
confidential.
Public availably of financial information will allow participants
more transparency as to the true financial picture of their
pensions. The proposal is similar to certain securities laws
which require public disclosure of material financial information.
Proponents argue that public disclosure of financial information
results in greater scrutiny and accountability without requiring the
draining of government resources. Some consider public disclosure
to be a securities law issue, rather than a pension law issue.
Others are concerned that shortfalls in the PBGC insurance program
could ultimately become taxpayers' responsibility, so that public
disclosure under the pension laws is appropriate.
Some argue that greater public availability is inappropriate as some
participants may not have the financial sophistication to
appropriately evaluate such information. They also argue that
___________________
/276/ The exception for trade secrets and commerical or financial
information also applies for purposes of the Code rule allowing
public inspection of written determinations. Sec. 6110(c)(4).
because the pension system is voluntary, additional requirements on
plans and plan sponsors, particularly small employers, may result
in some sponsors discontinuing plan sponsorship.
Prior Action
No prior action.
4. Treatment of grandfathered floor-offset plans
Present Law
ERISA generally prohibits defined benefit pension plans from
acquiring employer securities or employer real property if, after
the acquisition, more than 10 percent of the assets of the plan
would be invested in employer securities or employer real property.
This 10-percent limitation generally does not apply to most defined
contribution plans.
A floor-offset arrangement is an arrangement under which benefits
payable to a participant under a defined benefit pension plan are
reduced by benefits under a defined contribution plan. The defined
benefit pension plan provides the "floor" or minimum benefit which
is offset or reduced by the annuitized benefit under the defined
contribution plan.
Pursuant to the Pension Protection Act of 1987, the 10-percent
limitation on the acquisition of employer securities and employer
real property applies to a defined contribution plan that is part of
a floor-offset arrangement, unless the floor-offset arrangement was established on or before December 17, 1987. Thus, for floor-offset
plans established after that date, the 10-percent limit applies on
an aggregated basis to the combined assets of the defined benefit
pension plan and the defined contribution plan that form the
arrangement.
An employee stock ownership plan (an "ESOP") is an individual
account plan that is designed to invest primarily in employer
securities and which meets certain other requirements.
ESOPs are not subject to the 10-percent limit on the acquisition
of employer securities, unless the ESOP is part of a floor-offset
arrangement.
Description of Proposal
The exception to the 10-percent limit on holding employer securities
and employer real property for plans established on or before
December 17, 1987, is eliminated. Floor-offset arrangements affected
by the proposal are required to reduce their holdings of employer
_________________
/277/ ERISA sec. 407.
/278/ ERISA uses the term ``individual account plan'' to refer to
defined contribution plans. Money purchase pension plans (a type of
defined contribution plan) are subjevt to the 10-percent limitation
unless the plan was established before ERISA. Special rules apply
with respect to certain plans to which effective deferrals are made.
real property and employer securities to no more than 10 percent
of the combined assets of both plans over a period of seven
years. The requirement to dispose of such property will be phased
in pursuant to regulations.
Effective date.�The proposal is effective for plan years beginning
after 2005.
Analysis
The present-law 10-percent limit on holding employer securities and
real property reflects the concern that assets in defined benefit
plans should be adequately diversified and that allowing such plans
to hold significant amounts of assets that rely on the financial
status of the employer creates a greater risk that the plan will
become underfunded in the event of employer financial distress and
that benefits under the plan will become the obligation of the
PBGC. The potential problems with such arrangements are illustrated
by the recent experience with Enron Corporation, which maintained
a grandfathered floor-offset arrangement. The proposal addresses
this concern by eliminating the grandfather for such arrangements.
Thus, all floor-offset plans will be subject to the same rules
under the proposal. The proposal recognizes that it may take some
time for a plan to dispose of affected property by allowing a
seven-year period for plans to comply.
5. Limitations on plans funded below target levels
Present Law
In general
Under present law, various restrictions may apply to benefit
increases and distributions from a defined benefit pension plan,
depending on the funding status of the plan.
Funding waivers
Within limits, the IRS is permitted to waive all or a portion of
the contributions required under the minimum funding standard for
a plan year. A waiver may be granted if the employer
(or employers) responsible for the contribution could not make
the required contribution without temporary substantial business
hardship and if requiring the contribution would be adverse to the
interests of plan participants in the aggregate. Generally, no
more than three waivers may be granted within any period of 15
consecutive plan years.
_______________________
/279/ Enron's floor-offset plan and related issues are discussed in
Joint Committee on Taxation, Report of Investigation of Enron
Corporation and Related Entities Regarding Federal Tax and
Compensation Issues, and Policy Recommendations (JCS-3-03), February
2003, at 458-75.
/280/ Code sec. 412(d); ERISA sec. 303.
If a funding waiver is in effect for a plan, subject to certain
exceptions, no plan amendment may be adopted that increases the
liabilities of the plan by reason of any increase in benefits, any
change in the accrual of benefits, or any change in the rate at
which benefits vest under the plan.
Security for certain plan amendments
If a plan amendment increasing current liability is adopted and the
plan's funded current liability percentage is less than 60 percent
(taking into account the effect of the amendment, but disregarding
any unamortized unfunded old liability), the employer and members
of the employer's controlled group must provide security in favor
of the plan. The amount of security required is the excess of:
(1) the lesser of (a) the amount by which the plan's assets are
less than 60 percent of current liability, taking into account the
benefit increase, or (b) the amount of the benefit increase and
prior benefit increases after December 22, 1987, over (2) $10
million. The amendment is not effective until the security is
provided.
The security must be in the form of a bond, cash, certain U.S.
government obligations, or such other form as is satisfactory to
the Secretary of the Treasury and the parties involved. The security
is released after the funded liability of the plan reaches 60
percent.
Prohibition on benefit increases during bankruptcy
Subject to certain exceptions, if an employer maintaining a plan
(other than a multiemployer plan) is involved in bankruptcy
proceedings, no plan amendment may be adopted that increases the
liabilities of the plan by reason of any increase in benefits, any
change in the accrual of benefits, or any change in the rate at
which benefits vest under the plan.
Liquidity shortfalls
In the case of a plan with a funded current liability percentage of
less than 100 percent for the preceding plan year, estimated
contributions for the current plan year must be made in quarterly
installments during the current plan year. If quarterly
contributions are required with respect to a plan, the amount of a
quarterly installment must also be sufficient to cover any shortfall
in the plan's liquid assets (a "liquidity shortfall"). In general,
a plan has a liquidity shortfall for a quarter if the plan's liquid
assets (such as cash and marketable securities) are less than a
certain amount (generally determined by reference to disbursements
from the plan in the preceding 12 months).
If a quarterly installment is less than the amount required to
cover the plan's liquidity shortfall, limits apply to the benefits
that can be paid from a plan during the period of underpayment.
During that period, the plan may not make: (a) any payment in
excess of the monthly amount paid under a single life annuity
(plus any social security supplement provided under the plan) in
the case of a participant or beneficiary whose annuity starting
date occurs during the period; (b) any payment for the purchase
_______________
/281/ Sec. 401(a)(29).
of an irrevocable commitment from an insurer to pay benefits (e.g.,
an annuity contract); or (c) any other payment specified by the
Secretary of the Treasury by regulations.
Nonqualified deferred compensation
Qualified retirement plans, including defined benefit pension plans,
receive tax-favored treatment under the Code. A deferred
compensation arrangement that is not eligible for tax-favored
treatment is generally referred to as a nonqualified deferred
compensation arrangement. In general, a nonqualified deferred
compensation arrangement is exempt from the requirements of ERISA
only if it is maintained primarily for the purpose of providing
deferred compensation for a select group of management or highly
compensated employees. As a result, nonqualified deferred
compensation arrangements generally cover only higher paid
employees, such as executives.
Nonqualified deferred compensation arrangements may be merely
unfunded contractual arrangements, or the employer may establish
a trust to hold assets from which nonqualified deferred compensation
payments will be made. In some cases, even though trust assets
are generally not available for purposes other than to provide
nonqualified deferred compensation, the terms of the trust provide
that the assets are subject to the claims of the employer's
creditors in the case of insolvency or bankruptcy. Such an
arrangement is referred to as a "rabbi" trust, based on an IRS
ruling issued with respect to such an arrangement covering a rabbi.
Description of Proposal
Restrictions on benefit increases
Under the proposal, the present-law rule prohibiting amendments that
increase benefits while the employer is in bankruptcy continues to
apply. The present-law rule requiring security for amendments that
increase benefits and result in a funded current liability
percentage of less than 60 percent is replaced with a new rule.
Under the new rule, if the plan's funding percentage (i.e., the
market value of the plan's assets as a percentage of the plan's
funding target, determined as of the plan's valuation date) does
not exceed 80 percent, any amendment increasing benefits is
prohibited unless, in addition to the otherwise required minimum
contribution, the employer contributes the amount of the increase
in the plan's funding target attributable to the amendment. If the
plan's funding percentage exceeds 80 percent, but was less than 100
percent for the preceding plan year, an amendment that increases
benefits and reduces the plan's funding percentage to less than 80
percent is prohibited unless, in addition to the otherwise required
minimum contribution, the employer contributes the lesser of: (1)
the amount of the increase in the plan's funding target attributable
to the amendment; or (2) the amount needed to increase the plan's
funding percentage to 80 percent. If the plan's funding
percentage is at least 100 percent, amendments increasing benefits
are not restricted. In addition, the restrictions do not apply for
the first five years after a plan is established.
__________________
/282/ Rules governing nonqualified deferred compensation arrangements
are contained in Code section 409A.
Restrictions on distributions and accruals
Under the proposal, the restrictions on distributions during a
period of a liquidity shortfall continue to apply (i.e., only
annuity payments are permitted). In addition, such restrictions
apply if: (1) the plan's percentage does not exceed 60 percent;
or (2) in the case of a financially weak employer, the plan's
funding percentage does not exceed 80 percent. In addition, no
benefit accruals are permitted if: (1) the employer is financially
weak and the plan's funding percentage does not exceed 60 percent
(i.e., theplan is "severely underfunded"); or (2) the employer is
in bankruptcy and the plan's funding percentage is less than
100 percent.
Prohibition on funding nonqualified deferred compensation
Under the proposal, if a financially weak employer maintains a
severely underfunded plan, ERISA prohibits the funding of
nonqualified deferred compensation for top executives of the
employer's controlled group (or any former employee who was a
top executive at the time of termination of employment). The
proposal also prohibits any funding of executive compensation
that occurs within six months before or after the termination of
a plan, the assets of which are less than the amount needed to
provide all benefits due under the plan. For this purpose,
funding includes the use of an arrangement such as a rabbi trust,
insurance contract, or other mechanism that limits immediate
access to resources of the employer by the employer or by
creditors. However, the prohibition on funding nonqualified
deferred compensation does not apply for the first five years
after a plan is established.
Under the proposal, an employer maintaining a severely underfunded
or terminating plan must notify fiduciaries of the plan if any
prohibited funding of a nonqualified deferred compensation
arrangements occurs. The proposal provides plan fiduciaries with
the right to examine the employer's books and records to ascertain
whether the employer has met its obligation in this regard.
Under the proposal, a plan has a cause of action under ERISA against
any top executive whose nonqualified deferred compensation
arrangement is funded during a period when funding is prohibited.
The proposal permits the plan to recover the funded amount plus
attorney's fees. Plan fiduciaries have the duty to take reasonable
steps to pursue the cause of action provided under the proposal.
Timing rules for restrictions
Under the proposal, certain presumptions apply in determining
whether restrictions apply with respect to a plan, subject to
certifications provided by the plan actuary. If a plan was subject
to a restriction for the preceding year, the plan's funding
percentage is presumed not to have improved in the current year
until the plan actuary certifies that the plan's funding percentage
for the current year is such that the restriction does not apply.
If a plan was not subject to a restriction for the preceding year,
but its funding percentage did not exceed the restriction threshold
by more than 10 percentage points, the plan's funding percentage is
presumed to be reduced by 10 percentage points as of the first day
of the fourth month of the current plan year. As a result, the
restriction applies as of that day and until the plan actuary
certifies that the plan's funding percentage for the current year
is such that the restriction does not apply. In any other case,
if an actuarial certification is not made by the first day of the
tenth month of the plan year, as of that day the plan's funding
percentage is presumed not to exceed 60 percent for purposes of
the restrictions.
If the employer maintaining a plan enters bankruptcy, the plan's
funding percentage is presumed to be less than the plan's funding
target. As a result, no benefit accruals are permitted until the
plan actuary certifies that the plan's funding percentage is at
least 100 percent.
For purposes of the timing rules, the actuary's certification must
be based on information available at the time of the certification
regarding the market value of the plan's assets and the actuary's
best estimate of the plan's funding target as of the valuation date
for the current plan year. If the actuary determines that the
plan's funding percentage using the plan's actual funding target
causes a change in the application of restrictions, the actuary must
notify the plan administrator of the change.
Notice to participants
If a restriction applies with respect to a plan (including a plan
maintained by an employer that enters bankruptcy), the plan
administrator must provide notice of the restriction to affected
participants within a reasonable time after the date the restriction
applies (or, to the extent provided by the Secretary of Labor, a
reasonable period of time before the restriction applies).
Notice must also be provided within a reasonable period of time
after the date the restriction ceases to apply. A plan
administrator that fails to provide the required notice is subject
to a penalty. The Secretary of Labor is authorized to prescribe
regulations relating to the form, content, and timing of the notice.
Restoration of benefits
If restrictions on distributions and accruals apply with respect to
plan, distributions and accruals may resume in a subsequent plan year
only by a plan amendment. Such an amendment may be adopted at any
time after the first valuation date as of which the plan's funding
percentage exceeds the applicable threshold, subject to applicable
restrictions on plan amendments that increase benefits. In
addition, benefits provided under the amendment are subject to the
phase-in of the PBGC guarantee of benefit increases.
Effective date
The proposals are generally effective for plan years beginning after
December 31, 2006. In the case of a plan maintained pursuant to a
collective bargaining agreement in effect on the date of enactment,
the proposals are not effective before the first plan year beginning
after the earlier of: (1) the date the collective bargaining
agreement terminates (determined without regard to any extension
thereof); or (2) December 31, 2008.
Analysis
Underfunded plans, particularly those maintained by employers
experiencing financial problems, pose the risk that the plan will
terminate and the employer will be unable to provide the additional
assets needed to provide the benefits due under the plan (a distress
termination).
In some cases, because of the limit on the PBGC benefit guarantee,
employees bear the cost of underfunding through the loss of
benefits. In addition, the PBGC bears the cost of the shortfall
to the extent needed to provide guaranteed benefits.
Providing benefit increases under an unfunded plan increases these
costs. In addition, the payment of lump sums and similar forms of
benefit to some participants drain assets from the plan, thus
increasing the cost to the PBGC and other participants. Cases have
also arisen in which assets were used to provide nonqualified
deferred compensation to corporate executives shortly before
bankruptcy and the termination of an underfunded plan covering rank
and file employees. The proposal is intended to address these
situations by restricting benefit increases, lump sums and similar
forms of distribution, and the funding of nonqualified deferred
compensation in the case of underfunded plans. Under the proposal,
the extent of the restrictions depends on the funding status of the
plan and, in some cases, whether the employer is financially
weak or has entered bankruptcy.
Some view such restrictions as an appropriate means of limiting the
risk presented by underfunded plans. Others may consider some of
the restrictions (such as the restriction on lump sums) as unfairly
penalizing plan participants and potentially disrupting their
retirement income arrangements. Some also suggest that the prospect
of being unable to receive lump-sum distributions may itself cause
employees to elect lump sums while they are still available, thus
triggering a drain on plan assets. On the other hand, some consider
it unfair to allow participants to rely on benefits that might never
be paid and to favor some participants over others.
With respect to the restriction on funding nonqualified deferred
compensation, some may consider it inappropriate to target assets
used for that particular purpose without targeting assets used for
other purposes. Some also argue that companies in financial
difficulty should be able to use competitive compensation methods,
including funding methods under which assets will be available to
creditors in the event of bankruptcy or insolvency, such as a rabbi
trust. Others believe that such funding methods provide executives
with the opportunity to cash out their nonqualified deferred
compensation before an employer enters bankruptcy, thus giving
executives an unfair advantage over rank-and-file participants.
Some may also consider it inappropriate to allow a plan to bring
action against the executive rather than against the employer.
On the other hand, the proposal applies only in the case of a
"top" executive. Although the concept of top executive is not
defined, it suggests that the proposal is aimed at company officials
who have the authority to decide whether to adequately fund the
employer's defined benefit pension plan or instead to fund
nonqualified deferred compensation benefits.
Prior Action
The President's fiscal year 2005 budget proposal included a
proposal to restrict benefit accruals and distributions from
certain underfunded plans.
The National Employee Savings and Trust Equity Guarantee Act of
2004, as reported by the Senate Committee on Finance on May 14, 2004,
included a provision to restrict benefit increases, benefit
accruals, and distributions from financially distressed plans.
6. Eliminate shutdown benefits
Present Law
Unpredictable contingent event benefits
A plan may provide for unpredictable contingent event benefits,
which are benefits that depend on contingencies that are not
reliably and reasonably predictable, such as facility shutdowns or
reductions in workforce. Under present law, unpredictable
contingent event benefits generally are not taken into account
for funding purposes until the event has occurred.
Early retirement benefits
Under present law, defined benefit pension plans are not permitted
to provide "layoff" benefits (i.e., severance benefits). However,
defined benefit pension plans may provide subsidized early
retirement benefits, including early retirement window benefits.
Prohibition on reductions in accrued benefits
An amendment of a qualified retirement plan may not decrease the
accrued benefit of a plan participant. This restriction is
sometimes referred to as the "anticutback" rule and applies to
benefits that have already accrued. In general, an amendment may
reduce the amount of future benefit accruals, provided that, in the
case of a significant reduction in the rate of future benefit
accrual, certain notice requirements are met.
For purposes of the anticutback rule, an amendment is also treated
as reducing an accrued benefit if, with respect to benefits accrued
before the amendment is adopted, the amendment has the effect of
either (1) eliminating or reducing an early retirement benefit or a
retirement-type subsidy, or (2) except as provided by Treasury
regulations, eliminating an optional form of benefit.
Generally, courts have held that unpredictable contingent event
benefits are protected by the anticutback rule. Additionally,
______________
/283/ Treas. Reg. sec. 1.401-1(b)(1)(i).
/284/ Treas. Reg secs. 1.401(a)(4)-3(f)(4) and 1.411(a)-7(c).
/285/ Sec. 411(d)(6). Section 204(g) of ERISA provides similar rules
for ERISA-covered plans.
/286/ See Bellas v. CBS. Inc., 221 F. 3d 517 (3rd Cir. 2000), cert.
denied, 531 U.S. 1104 (2001) (involuntary separation benefit is both
an early retirement benefit and a retirement-tupe subsidy to the
extent it provides for the payment of normal retirement benefits that
continue beyond normal retirement age); Richardson v. Pension Plan of
Bethlehem Steel Corp., 67 F.3d 1462 (9th Cir, 1996), modified,
112 F.3d 982 (9th Cir. 1997) (shutdown benefit is a retirement-type
subsidy protected under anticutback rule, opinion
under proposed Treasury regulations, if an unpredictable
contingent event benefit is a retirement-type subsidy, the benefits
cannot be reduced or eliminated with respect to service prior to the
applicable amendment date without violating anticutback rule.
The proposed regulations, which apply prospectively only, apply
this result regardless of whether the contingent event which
triggers the payment of the benefit has or has not occurred before
the amendment. Thus, under the proposed regulations, protection of
unpredictable contingent event benefits which provide
retirement-type subsidies is required even before a triggering
contingency occurs.
PBGC benefit guarantee
Within certain limits, the PBGC guarantees any retirement benefit
that was vested on the date of plan termination (other than
benefits that vest solely on account of the termination), and
any survivor or disability benefit that was owed or was in payment
status at the date of plan termination. Generally only that part
of the retirement benefit that is payable in monthly installments
(rather than, for example, lump sum benefits payable to encourage
early retirement) is guaranteed.
Retirement benefits that begin before normal retirement age are
guaranteed, provided they meet the other conditions of guarantee
(such as that, before the date the plan terminates, the participant
had satisfied the conditions of the plan necessary to establish the
right to receive the benefit other than application for the
benefit). Contingent benefits (for example, early retirement
benefits provided only if a plant shuts down) are guaranteed only
if the triggering event occurs before plan termination.
Description of Proposal
Prohibition on providing unpredictable contingent event benefits
Under the proposal, plans are not permitted to provide benefits
which are payable upon a plant shutdown or any similar
unpredictable contingent event as determined under regulations.
_____________________
withdrawn and modified because court later found plan amendment not
valid); Harms v. Cavenham Forest Industries, Inc., 984 F.2d 686
(5th Cir.), cert. denied, 510 U.S. 944 (1993) (involuntary separation
benefit is a retirement-type benefit protected under the anticutback
rule); and Arenda v. ABB Power T&D Company, Inc., 2003 U.S. Dist
LEXIS 13166 (S.D. Ind. July 2003) (plant shutdown benefit is a
retirement-type susidy protected by the anticutback rule because
the benefit continues beyond normal retirement age and the amount of
the benefit exceeds the actuarially reduced normal retirement
benefit); but see ROss V. Pension Plan for Hourly Employees of SKF
Industries, Inc., 847 F. 2d 329 (6th Cir. 1988) (plant shutdown
benefti is not a retirement-type subsidy)
/287/ Prop. Treas. Reg. sec. 1.411(d0-3(b).
/288/ ERISA sec. 4022(a)
/289/ ERISA sec. 4022(b) and (c).
A plan which contains such a benefit is required to eliminate the
benefit, but only with respect to an event which occurs after the
effective date. Such a plan amendment is deemed not to violate
the anticutback rule.
Effective date.--The prohibition on providing unpredictable
contingent event benefits generally is effective for plan years
beginning in 2007. In the case of a collective bargaining agreement
which provided for an unpredictable contingent event benefit on
February 1, 2005, the prohibition on unpredictable contingent event
benefits is not effective before the end of the term of that
agreement (without regard any to extension of the agreement) or, if
earlier, the first plan year beginning in 2008.
Elimination of PBGC guarantee
The proposal amends the guarantee provisions of Title IV of ERISA to
provide that the PBGC guarantee does not apply to benefits that are
payable upon a plant shutdown or any similar contingent event.
Effective date.--The elimination of the PBGC guarantee is effective
for benefits that become payable as a result of a plant shutdown or
similar contingent event that occurs after February 1, 2005.
Analysis
Benefits for plant shutdowns and similar unpredictable contingent
events and the PBGC guarantee of such benefits present many issues,
including the lack of funding of the benefits and their nature as
retirement or severance-type benefits. These issues are relevant
with respect to the proposals to eliminate such benefits and the
PBGC guarantee.
Unlike most benefits under a defined benefit pension plan, shutdown
benefits may be predictable only a short while before the shutdown
occurs, to the extent that they can be predicted at all. On the
other hand, some shutdowns may be the result of business decisions.
Notwithstanding, under the funding rules, a plan's liabilities for
shutdown benefits generally remain unfunded until the triggering
contingency occurs. After the contingency occurs, the liabilities
may be funded over a period of years. In some cases, contingencies
may be followed by the employer's insolvency, making it difficult
for employers to fully fund the triggered benefits. Additionally,
the departure of employees from the company may follow a shutdown or
other contingency. Many such employees may take distributions from
the plan, thereby draining assets from the plan. If the plan
later terminates, assets might not be sufficient to provide the
benefits due other plan participants. In addition, the PBGC may
be left with increased unfunded liabilities as a consequence of the
shutdown and the related benefits. Thus, shutdown benefits may
significantly increase the underfunding taken on by the PBGC. Some
argue that liabilities for such benefits make up a significant
percentage of PBGC losses.
Some view shutdown benefits as severance-type benefits which should
not be provided under a retirement plan. Shutdown benefits may,
however, be considered a variety of subsidized early retirement
benefits, similar to early retirement window benefits which are
provided as an incentive for employees to voluntarily terminate
employment. Some believe that it is appropriate for a defined
benefit pension plan to provide such benefits to employees whose
employment is involuntarily terminated. They argue that concerns
about the effect of such benefits on funding status and PBGC
liability can be addressed by providing rules under which these
benefits are taken into account in determining required
contributions and limiting the PBGC guarantee, rather than
prohibiting plans from providing the benefits.
Others argue that shutdown benefits which are promised to
participants under the terms of a plan should be guaranteed by the
PBGC like any other benefits under the plan. Shutdown benefits may
represent a significant portion of a participant's benefits under
a plan. Moreover, unlike some other types of benefits subject to
contingent events, shutdown benefits may be intertwined with the
employer's financial well-being. Some feel that eliminating the
PBGC guarantee applicable to shutdown benefits might further
disadvantage plan participants who are experiencing the effects
of their employer's troubled financial status. As an alternative,
some suggest that rather than eliminating the PBGC guarantee, the
occurrence of an event giving rise to unpredictable contingent
event benefits could be treated as a plan amendment, so that the
PBGC guarantee of such benefits is phased in over five years.
Prior Action
No prior action.
7. Propsals relating to the Pension Benefit Guaranty Corporation
("PBGC")
(a) Premiums that reflect plan risk
Present Law
In general
The minimum funding requirements permit an employer to fund defined
benefit pension plan benefits over a period of time. Thus, it is
possible that a plan may be terminated at a time when plan assets
are not sufficient to provide all benefits accrued by employees
under the plan. In order to protect plan participants from losing
retirement benefits in such circumstances, the PBGC, a corporation
within the Department of Labor, was created in 1974 under ERISA to
provide an insurance program for benefits under most defined benefit
pension plans maintained by private employers. According to the
PBGC, as of September 30, 2004, about 34.6 million participants in
more than 29,600 single-employer defined benefit pension plans were
insured under its programs.
_____________________
/290/ The PBGC termination insurance program does not cover plans of
professional service employers that have fewer than 25 participants.
/291/ The PBGC also reported that about 9.8 million participants in
approximately 1, 600 multiemployer plans were insured under the its
programs. Pension Benefit Guaranty Corporation Performance and
Accountabilty Report, Fiscal Year 2004 (Nov. 15, 2004).
Premiums paid to the PBGC
In general
The PBGC is funded by assets in terminated plans, amounts recovered
from employers who terminate underfunded plans, premiums paid with
respect to covered plans, and investment earnings.
Single-employer plans
All covered single-employer plans are required to pay a flat
per-participant premium and underfunded plans are subject to an
additional variable premium based on the level of underfunding.
As originally enacted in ERISA, covered plans were annually required
to pay a flat premium to the PBGC of $1 per plan participant.
The annual flat-rate per-participant premium has been increased
several times since the enactment of ERISA and, since 1991, has
been $19 per participant.
Under the Pension Protection Act, additional PBGC premiums are
imposed on certain plans for plan years beginning after December
31, 1987. In the case of an underfunded plan, additional premiums
are required in the amount of $9 per $1,000 of unfunded vested
benefits (the amount which would be the unfunded current liability
if only vested benefits were taken into account and if benefits were
valued at the variable premium interest rate). These premiums are
referred to as "variable rate premiums." No variable-rate premium
is imposed for a year if contributions to the plan for the prior
year were at least equal to the full funding limit for that year.
In determining the amount of unfunded vested benefits, the interest
rate used is generally 85 percent of the interest rate on 30-year
Treasury securities for the month preceding the month in which the
plan year begins (100 percent of the interest rate on 30-year
Treasury securities for plan years beginning in 2002 and 2003).
Under the Pension Funding Equity Act of 2004, in determining the
amount of unfunded vested benefits for PBGC variable rate premium
purposes for plan years beginning after December 31, 2003, and
before January 1, 2006, the interest rate used is 85 percent of the
annual rate of interest determined by the Secretary of the Treasury
on amounts invested conservatively in long-term investment-grade
corporate bonds for the month preceding the month in which the plan
year begins.
___________________
/292 ERISA sec. 4006(a).
/293/ Pub. L. No. 100-203 (1987)
/294/ If variable rate premiums are required to be paid, the plan
administrator generally must provide notice to plan participants of
the plan's funding status and the limits on the PBGC benefit
guarantee if the plan terminates while underfunded.
/295/ Pub. L. No. 108-218(2004).
Interest on premium payments
If any premium required to be paid to the PBGC is not paid by the
last date prescribed for a payment, interest on the amount of such
premium is charged at the rate imposed on underpayment, nonpayment,
or extensions of time for payment of tax for the period from such
date to the date paid. The PBGC is not authorized to pay interest
on premium overpayments.
Description of Proposal
Under the proposal, the single-employer flat-rate premium is
increased to $30 starting in 2007 and is indexed annually
thereafter based on the Average Wage Index (i.e., the index of
the rate of growth of average wages, which is used to adjust the
contributions and benefits base under the Social Security Act).
Variable rate premiums are replaced by risk-based premiums, which
are charged to all plans with assets less than their funding target
(i.e., ongoing liability or at-risk liability, depending on the
financial status of the plan sponsor). The risk-based premium is
set by the PBGC (and adjusted by the PBGC) are computed based on
forecasts of the PBGC's expected claims and future financial
condition. The premium rate per dollar of underfunding is uniform
for all plans. A plan with a financially-weak sponsor is required
to pay premiums for each dollar of unfunded at-risk liability,
while a financially-healthy sponsor is required to pay premiums
for each dollar of unfunded ongoing liability. The full-funding
exception is eliminated so that all underfunded plans are required
to pay risk-based premiums. The proposal authorizes the PBGC
to pay interest on premium overpayments.
Effective date.--The proposal is effective for plan years beginning
on or after January 1, 2006.
_____________________
/296/ Sec. 6601.
/297/ ERISA sec. 4007(b)
/298/ For a plan sponsr that is not financially weak, the funding
target is the plan's ongoing liability. For a plan sponsor that is
financially weak, teh funding target generally is the plan's at-risk
liability. Ononging liability and at-risk liability are discussed in
proposal relating to the funding and deduction rules in Part IV.B.2.
In general, a plan's ongoing liabiity for a plan year is the present
value of future pauments expected to be made from the plan to provide
benefits earned as of the beginning of the plan uear. At-risk
liability is baded on the same benefits and assumptions as ongoing
liability, except that the valuation of those benefits would require
the use of certain actuarial assumptions to reflect the concept that a
plan mainted by a financially weak plan sponsor may be more likely to
pay benefits on an accelerated basis or to terminate its plan.
Analysis
In general
ERISA requires the pension insurance system to be self-financed, i.e.,
it is not funded by general revenues. The PBGC's principal sources of
revenue are premiums collected from PBGC-covered plans, assets assumed
from terminated plans, collection of employer liability payments due
under ERISA, and investment income.
The proposal is intended to address problems which are attributed to
the current premium structure, including the failure of the
present-law premium structure to adequately reflect the risk that an
underfunded plan will be terminated, thus shifting costs from
financially-troubled companies with underfunded plans to healthy
companies with well-funded plans. The premium structure under the
proposal is intended to more accurately reflect the exposure that
certain defined benefit pension plans present to the pension
insurance system. The proposal is also intended to provide
increased premium revenue. Premium revenue under the current
system is described by the Administration as inadequate to cover
expected claims.
As mentioned above, the PBGC premium proposal is one part of the
President's overall proposal to increase defined benefit pension
plan security. Some argue that the proposed increased flat-rate
premium and risk-based premiums may not comprise the most
appropriate combination of modifications for alleviating current
problems. For example, the proposed increase in the flat-rate
premium may be construed as burdening employers which have
consistently fully funded their plans with making up for the funding
shortfalls of underfunded plans. A more modest increase in
premiums may be viewed by some as more fair. Moreover, some feel
that the proposal may not solve the problems associated with
underfunding of defined benefit pension plans and pension security
in general. They believe that the solution may instead be
modifications to the funding rules. This is because PBGC premiums
may not benefit plan participants to the same extent that funding
plans does. Some argue that better funding rules should be enacted
and the effects of those rules should be determined before
significant premium increases are adopted.
Moreover, if premium increases are viewed as too high by employers,
a possible consequence of premium increases may be the freezing of
plans by companies which would otherwise maintain ongoing plans.
Because sponsoring a retirement plan for employees is voluntary,
if the burden of sponsoring a plan becomes too onerous, in part
because burdensome premium payments are required, more companies may
freeze or terminate defined benefit pension plans. Further,
___________________________
/299/ See ``Pension Benefit Guaranty Corporation Performance and
Accountability Report, Fiscal Year 2004 '' (Nov. 15, 2004), at 16.
/300/ Testimony of Ann L. Combs, Assistant Secretary of Labor, before
the Committee on Finance, United States Senate (March 1, 2005),
at 16.
companies considering whether to establish a defined benefit pension
plan may be discouraged from doing so by increased premium costs.
Increase in flat-rate premiums
The proposed increase in the flat-rate premium is intended to
reflect wage growth since 1991, when the present-law $19 premium
was enacted. This premium increase reflects the idea that the
PBGC benefit guarantee has continued to grow with wages since 1991,
and the premiums should reflect this increase. The proposed
increase in the flat-rate premium reflects a concern that premiums
for all covered plans are currently too low.
The proposed premium increase is likely to raise the cost of
sponsoring a defined benefit pension plan. As discussed above,
whether employers continue to sponsor defined benefit pension plans
may be influenced by this increase. Some feel that a more modest
increase in the flat-rate premium is a more appropriate alternative
to the proposed increase. This, in conjunction with more frequent
Congressional review of the premium rate, it is argued, may be a
more appropriate way of responding to the conditions affecting
defined benefit pension plans.
Indexing of flat-rate premium
Indexing the flat-rate premium using the Average Wage Index is
intended to reflect increases in the levels of guaranteed benefits.
Increases in wages may affect the level of guaranteed benefits both
because the dollar limit on the PBGC guarantee is indexed by
reference to wages and because benefits under defined benefit
pension plans generally increase as participants' pay increases.
For example, benefits are often based on career average or final
average pay, or, in the case of a plan which provides a flat rate
of benefit, the benefit rate tends to be increased when wage rates
are increased. Thus, some feel that the indexing under the proposal
is an appropriate means of ensuring a logical correlation between
increases in the PBGC's potential liabilities and the revenue it
takes in.
Others feel that automatic increases resulting from the indexing of
the flat-rate premium diminish the correlation of premiums to the
PBGC's actual program costs. Automatic increases resulting from
indexing may not reflect the conditions faced by the PBGC. Some
believe that under the proposal, premiums may not be as low as
possible, representing significant costs to employers.
Risk-based premiums
The present-law variable rate premium is intended to reflect the
greater potential risk of exposure from underfunded plans. The
variable rate premium is also believed to provide an incentive to
plan sponsors to better fund their plans.
The current premium structure is described by the Administration as
resulting in the shifting of costs from financially-troubled
companies to those with well-funded plans owing to the
overdependence on flat-rate premiums and lack of appropriate
risk-based premiums. The proposed risk-based premiums are intended
to better correlate with the risk a plan poses to the pension
insurance system because they are based on a better measure of
underfunding and reflect the financial condition of the plan
sponsor's controlled group. The periodic adjustment of premium rates
based on the PBGC's expected claims and future financial condition,
is intended to more accurately reflect the cost of the PBGC program
by providing the funds necessary to meet expected future claims and
to retire PBGC's deficit over a reasonable time period.
Some express concerns, however, that the proposed risk-based premiums
would make financially unstable employers, and those in bankruptcy,
liable for substantial premium increases if their plans are not fully
funded. An increase in premiums may be a source of volatility and
burden for companies struggling to recover from financial hardships.
These issues are similar to the issues raised with respect to
basing funding requirements on the financial condition of the
employer and are discussed in more detail above.
Additionally, some feel that it is not appropriate for the PBGC to
set and adjust the risk-based premium, based on forecasts of its
expected claims and future financial condition. It may be viewed as
more appropriate for the adjustment of risk-based premiums to be
subject to Congressional action.
Under the proposal, the risk-based premium is payable even if a plan
is at the full funding limit. According to the PBGC, some of the
companies maintaining plans that have resulted in the largest claims
against the PBGC insurance fund have not been required to pay a
variable rate premium because they were at the full funding limit.
Imposing the risk-based premium on plans that are at the full
funding limit will subject more plans to the premium compared to
the present-law variable rate premium. The present-law exception
for plans at the full funding limit reflects concerns that it may
be unfair to impose the premium on employers making contributions
up to certain levels, even if the plan remains underfunded. Under
the proposal, contributions to eliminate underfunding are fully
deductible, so that an employer may avoid the risk-based premium
by making sufficient contributions to eliminate underfunding. In
some cases, the amount of contributions required to eliminate
underfunding could be substantial.
Interest on premium overpayments
Some believe that premium payers should receive interest on premium
overpayment amounts that are owed to them. Others feel that it is
inappropriate for the PBGC to pay interest and that providing for
such interest may further impair the financial condition of the
PBGC. Some argue that interest may not be appropriate in some
cases, depending on how the overpayment arose.
____________________
/302/ Testimony of Bradley D. Belt, Executive Director, Pension
Benefit Guarantee Corporation, before the Committee on Finance,
United States Senate (March 1, 2005) at 15.
Prior Action
No prior action.
(b) Freeze benefit guarantee when contributing sponsor enters
bankruptcy
Present Law
Termination of single-employer defined benefit pension plans
In general
An employer may voluntarily terminate a single-employer plan only
in a standard termination or a distress termination. The
participants and the PBGC must be provided notice of the intent to
terminate. The PBGC may also involuntarily terminate a plan (that
is, the termination is not voluntary on the part of the employer).
Standard terminations
A standard termination is permitted only if plan assets are
sufficient to cover benefit liabilities. Generally, benefit
liabilities equal all benefits earned to date by plan participants,
including vested and nonvested benefits (which automatically become
vested at the time of termination), and including certain early
retirement supplements and subsidies. Benefit liabilities may also
include certain contingent benefits (for example, early
retirement subsidies). If assets are sufficient to cover benefit
liabilities (and other termination requirements, such as notice to
employees, have not been violated), the plan distributes benefits
to o participants. The plan provides for the benefit payments it
owes by purchasing annuity contracts from an insurance company, or
otherwise providing for the payment of benefits, for example, by
providing the benefits in lump-sum distributions.
If certain requirements are satisfied, and the plan so provides,
assets in excess of the amounts necessary to cover benefit
liabilities may be recovered by the employer in an asset reversion.
Reversions are subject to an excise tax, described above.
________________________
/303/ ERISA sec. 4041.
/304/ Id.
/305/ ERISA sec. 4001(a)(16).
Distress terminations and involuntary terminations by the PBGC
Distress terminations
If assets in a defined benefit pension plan are not sufficient to
cover benefit liabilities, the employer may not terminate the plan
unless the employer meets one of four criteria necessary for a
``distress'' termination:
The contributing sponsor, and every member of the controlled
group of which the sponsor is a member, is being liquidated in
bankruptcy or any similar Federal law or other similar State
insolvency proceedings;
The contributing sponsor and every member of the sponsor's
controlled group is being reorganized in bankruptcy or similar
State proceeding;
The PBGC determines that termination is necessary to allow the
employer to pay its debts when due; or
The PBGC determines that termination is necessary to avoid
unreasonably burdensome pension costs caused solely by a decline
in the employer's work force.
These requirements, added by the Single Employer Pension Plan
Amendments Act of 1986 and modified by the Pension Protection Act
of 1987 and the Retirement Protection Act of 1994, are designed
to ensure that the liabilities of an underfunded plan remain the
responsibility of the employer, rather than of the PBGC, unless
the employer meets strict standards of financial need indicating
genuine inability to continue funding the plan.
Involuntary terminations by the PBGC
The PBGC may institute proceedings to terminate a plan if it
determines that the plan in question has not met the minimum
funding standards, will be unable to pay benefits when due,
has a substantial owner who has received a distribution greater
than $10,000 (other than by reason of death) while the plan has
unfunded nonforfeitable benefits, or may reasonably be expected to
increase PBGC's long-run loss unreasonably. The PBGC must institute
proceedings to terminate a plan if the plan is unable to pay
benefits that are currently due.
_________________________
/306/ ERISA sec. 4041.
/307/ Pub. L. No. 99-272 (1986).
/308/ Pub. L. No. 100-203 (1987).
/309/ Pub L. No. 103-465 (1994).
Asset allocation
ERISA contains rules for allocating the assets of a single-employer
plan when the plan terminates. Plan assets available to pay for
benefits under a terminating plan include all plan assets remaining
after subtracting all liabilities (other than liabilities for future
benefit payments), paid or payable from plan assets under the
provisions of the plan. On termination, the plan administrator must
allocate plan assets available to pay for benefits under the plan
in the manner prescribed by ERISA. In general, plan assets
available to pay for benefits under the plan are allocated to six
priority categories. If the plan has sufficient assets to pay for
all benefits in a particular priority category, the remaining
assets are allocated to the next lower priority category.
This process is repeated until all benefits in the priority
category are provided or until all available plan assets have been
allocated.
Guaranteed benefits
Single-employer plans
When an underfunded plan terminates, the amount of benefits that the
PBGC will pay depends on legal limits, asset allocation, and recovery
on the PBGC's employer liability claim. The PBGC guarantee applies
to "basic benefits." Basic benefits generally are benefits accrued
before a plan terminates, including (1) benefits at normal
retirement age; (2) most early retirement benefits; (3) disability
benefits for disabilities that occurred before the plan was
terminated; and (4) certain benefits for survivors of plan
participants. Generally only that part of the retirement benefit
that is payable in monthly installments (rather than, for example,
lump-sum benefits payable to encourage early retirement) is
guaranteed.
Retirement benefits that begin before normal retirement age are
guaranteed, provided they meet the other conditions of guarantee
(such as that before the date the plan terminates, the participant
had satisfied the conditions of the plan necessary to establish the
right to receive the benefit other than application for the
benefit). Contingent benefits (for example, subsidized early
retirement benefits) are guaranteed only if the triggering event
occurs before plan termination.
For plans terminating in 2005, the maximum guaranteed benefit for an
individual retiring at age 65 is $3,698.86 per month or $44,386.32
per year. The dollar limit is indexed annually for inflation. The
guaranteed amount is reduced for benefits starting before age 65.
In the case of a plan or a plan amendment that has been in effect
for less than five years before a plan termination, the amount
guaranteed is phased in by 20 percent a year.
Description of Proposal
Under the proposal, the amount of guaranteed benefits payable by
the PBGC is frozen when a contributing sponsor enters bankruptcy or
a similar proceeding. The freeze continues for two years after the
sponsor emerges from bankruptcy. If the plan terminates during the
contributing sponsor's bankruptcy or within two years after the
sponsor emerges from bankruptcy, the amount of guaranteed benefits
payable by the PBGC is determined based on plan provisions, salary,
service, and the guarantee in effect on the date the employer
entered bankruptcy.
The priority among participants for purposes of allocating plan
assets and employer recoveries to non-guaranteed benefits in the
event of plan termination is determined as of the date the sponsor
enters bankruptcy or a similar proceeding.
The administrator of a plan for which guarantees are frozen is
required to notify plan participants about the limitations on
benefit guarantees, and potential receipt of non-guaranteed
benefits in a termination on account of the bankruptcy.
Effective date.--The proposal is effective with respect to Federal
bankruptcy or similar proceedings or arrangements for the benefit
of creditors which are initiated on or after the date that is 30
days after enactment.
Analysis
A recent report of the Government Accountability Office said that
the termination of large, underfunded defined benefit pension
plans of bankruptcy firms in troubled industries has been the major
cause of the PBGC's single employer program's worsening net
financial position. The PBGC estimates that financially-weak
___________________
assets in the terminating plan, participants may receive more than
the amount guaranteed by PBGC.
Special rules limit the guaranteed benefits of individuals who
are substantial owners covered by a plans whose benefits have not
been increased by reason of any plan amendment. A substantial owner
generally is an individual who: (1) owns the entire interest in an
unincorporated trade or business; (2) in the case of a partnership,
is a partner who owns, directly or indirectly, more than 10 percent
of either the capital interest or the profits interest in the
partnership; (3) in the case of a corporation, owns, directly or
indirectly, more than 10 percent in value of either the voting stock
of the corporation or all the stock of the corporation; or (4) at any
time with the preceding 60 months was a substantial owner under the
plan. ERISA sec. 4022(b)(5).
/315/ The phase in does not apply if the benefit is less than $20
per month.
firms, particularly in the airline industry, sponsor plans with
over $35 billion in unfunded benefits.
A PBGC-insured defined benefit pension plan may be terminated
during the pendency of the plan sponsor's bankruptcy. During
bankruptcy, plan assets may be diminished because the plan sponsor's
ability to make contributions to the plan may be compromised.
Additionally, distributions to participants during bankruptcy may
decrease plan assets. The PBGC's losses attributable to paying
guaranteed benefits which are unfunded may worsen if plan assets
are decreased during bankruptcy. In cases where assets of a plan
which is terminated are not sufficient to cover benefit
liabilities, the PBGC is required to pay benefits within
prescribed limits to participants. Any increases in
PBGC-guaranteed benefit amounts apply to benefits under a plan until
it is terminated.
Using the date a plan sponsor enters bankruptcy as the determinative
date for freezing the amount of guaranteed benefits and setting the
priority for purposes of plan asset allocation and employer
recoveries of non-guaranteed benefits may decrease the PBGC's
losses forunfunded guaranteed benefits. Some feel that the date a
plan sponsor files a bankruptcy petition is the appropriate measure
for setting PBGC-guaranteed benefit levels and priorities for asset
allocations. Using this date, it is argued, would more effectively
and appropriately limit the PBGC's exposure for unfunded
liabilities. Drains on plan assets and increases in unfunded
liabilities which may arise during the period after the bankruptcy
petition is filed and before termination of the plan may no longer
result in disproportionate losses for the PBGC. For these same
reasons, some argue that the bankruptcy filing date is the
appropriate date for allocating assets to priority categories.
On the other hand, freezing the amount of PBGC-guaranteed benefits
on the date a plan sponsor enters bankruptcy and maintaining the
freeze for two years after the plan sponsor emerges from bankruptcy
may be viewed as unfair to plan participants. Plan sponsors may be
in bankruptcy for years; an additional two years may exacerbate
the negative impact on plan participants. The guaranteed benefits
paid by the PBGC to participants whose plans are terminated already
may be considerably lower than the benefits they were promised
under the plan terms under present law. Freezing the level of
benefits provided by the PBGC as of the date of the bankruptcy
petition may further harm participants.
Prior Action
No prior action.
________________________
/316/ GAO, High-risk Series: An Update, GAO-05-207 (Washington,
D.C.; January 2005).
/317/ Id.
(c) Allow PBGC to perfect liens in bankruptcy for missed required
pension contributions
Present Law
Funding rules
The Code and the ERISA impose both minimum funding requirements with
respect to defined benefit pension plans. Under the minimum
funding rules, the amount of contributions required for a plan year
("minimum required contributions") is generally the plan's normal
cost for the year (i.e., the cost of benefits allocated to the year
under the plan's funding method) plus that year's portion of other
liabilities that are amortized over a period of years, such as
benefits resulting from a grant of past service credit. In general,
] plan contributions required to satisfy the funding rules must be
made within 8-1/2 months after the end of the plan year. If the
contribution is made by such due date, the contribution is treated
as if it were made on the last day of the plan year.
A plan with a funded current liability percentage of less than 100
percent for the preceding plan year must make estimated contributions
for the current plan year in quarterly installments ("installment
payments") during the current plan year. A plan's "funded current
liability percentage" is the actuarial value of plan assets (i.e.,
the average fair market value over a period of years) as a
percentage of the plan's current liability. In general, a plan's
current liability means all liabilities to employees and their
beneficiaries under the plan.
PBGC liens for missed contributions
Under certain conditions, if an employer fails to timely make a
required installment payment or minimum required contribution to a
defined benefit pension plan (other than a multiemployer plan), a
lien automatically arises in favor of the plan. For such a lien
to arise, (1) the plan's current liability percentage must be less
than 100 percent for the plan year; (2) the plan must be covered by
the PBGC termination insurance program; (3) the installment payment
minimum required contribution was not made before the due date for
the contribution; and (4) the unpaid balance of the installment
payments or required minimum contributions (including interest),
when added to the aggregate unpaid balance of all preceding
installment payments or minimum required contributions which were
not paid before the due date (including interest) exceeds
$1,000,000.
The lien is upon all property and rights to property, whether real
or personal, belonging to the employer or a member of the
employer's controlled group. The amount of the lien is equal
_________________________________
/318/ Code sec. 412; ERISA sec. 302.
/319/ Code sec. 412(n); ERISA sec. 302(1).
/320/ The term ``controlled group'' means any group treated as a
single employer under subsection (b), (c), (m) or (o) of Code
section 414.
____________________
to the aggregate unpaid balance of required contributions (including
interest) for plan years beginning after 1987 and for which payment
has not been made before the due date for the installment payment or
required minimum contribution.
The lien arises after the due date for which the installment payment
or minimum required contribution is not made and continues through
the end of the plan year in which such liabilities
exceed $1,000,000. The PBGC may perfect and enforce such a lien,
or such a lien may be perfected and enforced at the direction of
the PBGC by the contributing sponsor or any member of the controlled
group of the contributing sponsor.
Bankruptcy rules affecting liens for missed contributions
Automatic stays
Federal bankruptcy law provides for provides for an automatic stay
against certain actions by creditors once a bankruptcy petition is
filed. The automatic stay prevents the commencement or
continuation of actions against the debtor or the debtor's property
and applies to all entities, including governmental entities.
The automatic stay protects the debtor's property against attempts
to create, perfect, or enforce liens against it, including liens
which arise solely by force of a statute on specified
circumstances or conditions ("statutory liens"). The automatic
stay generally remains in effect, absent modification or termination
by the court, until the earliest of (1) the time the case is
closed; (2) the time the case is dismissed; or (3) the time a
discharge is granted or denied.
The automatic stay applies to PBGC liens for missed contributions.
Lien avoidance powers
Federal bankruptcy law allows a bankruptcy trustee to avoid
statutory liens that are not perfected or enforceable against a
hypothetical bona fide purchaser as of the date of the bankruptcy
________________
/321/ When a creditor has taken the required steps to perfect a lien
that lien is senior to any liens that arise subsequent to the
perfection, An unperfected lien is valid between the debtor and the
creditor, but in the context of a bankruptcy proceeding, an
unperfected lien can be avoided in bankruptcy. State law generally
applies to perfection of liens. A lien generally may be perfected
in various ways, including by filing or recording with various
government offices.
/322/ 11 U.S.C. sec. 362 (2005).
/323/ 11 U.S.C. sec. 101(38)(2005).
/324/ The bankruptcy trustee is the representative of trhe debtor's
estate. The estate is generally is comprised of the legal or
equitable interests of the debtor as of the filing of the petition
for bankruptcy. See 11 U.S.C., secs. 323 and 541 (2005).
petition is filed. This power generally allows a bankruptcy
trustee to avoid liens for missed contributions which are not
perfected by the PBGC at the time a bankruptcy petition is filed.
Description of Proposal
The proposal amends Federal bankruptcy law to provide an exemption
from the automatic stay under Federal bankruptcy law to allow the
creation and perfection of PBGC liens for missed contributions
against a plan sponsor and controlled group members. The proposal
also provides an exemption for PBGC liens for missed contributions
from the lien avoidance provisions of Federal bankruptcy law.
Effective date.--The proposal is effective with respect to
initiations of Federal bankruptcy or similar proceedings on or
after the date 30 days after enactment.
Analysis
Federal bankruptcy law allows a debtor to preserve some of its
assets and discharges the debtor's legal obligation to pay certain
debts. In many cases, bankruptcy allows a debtor the chance to
cure its financial ills and continue in business. The automatic
stay, a fundamental feature of the protections afforded a debtor
under Federal bankruptcy law, provides the debtor relief from
collection efforts by creditors and protects the bankruptcy estate
from being depleted and from seizures of property before the
bankruptcy trustee has marshaled and distributed the debtor's
assets. The lien avoidance provisions under Federal bankruptcy
law grant special protections to the debtor in certain cases,
allowing a bankruptcy trustee to avoid creditor's claims.
Like other creditors, the PBGC is subject to these provisions as
they apply to a plan sponsor which has petitioned for bankruptcy.
It may be argued that that the automatic stay and lien avoidance
provisions of Federal bankruptcy law unfairly allow employers to
escape liability for required contributions to defined benefit
pension plans. The PBGC may be adversely affected as a result.
An employer with significant aggregate unpaid required installment
payments or minimum required contributions may avoid its funding
obligations as to the missed contributions during the pendency of a
bankruptcy proceeding. If a plan terminates while the employer is
in bankruptcy, the PBGC may experiences losses on account of its
inability to perfect liens for missed contributions and the lien
avoidance rules which may allow the trustee to avoid the PBGC lien.
Some feel that that the PBGC lien for missed contributions should
not be made ineffective by a plan sponsor's entering bankruptcy
notwithstanding whether it has been perfected. In many cases, an
employer's liability for unpaid contributions later become unfunded
_______________
325 11 U.S.C. sec. 545(2) (2005). Statutory liens may also be
avoided to the extent that the lien first becomes effective against
the debtor: (1) when a bankruptcy case is commenced; (2) when an
insolvency proceeding other than under bankruptcy law is commenced;
(3) when a custodian is appointed or authorized to take or takes
possessions; (4) when the debtor becomes insolvent; (5) when the
debtor's financial condition fails to meet a specified standard; or
(6) at the time of an execution against property of the debtor
levied at the instance of an entity other than the holder of such
statutory lien. 11 U.S.C. sec. 545(1) (2005).
liabilities which are taken on by the PBGC once the plan is
terminated.
On the other hand, the automatic stay and lien avoidance provisions
assist in preserving Federal bankruptcy law's distributional scheme
for distributing the debtors' assets. These provisions generally
allow the trustee to take stock of the debtor's property interests
so as to be apprised of the various rights and interests involved
without the threat of immediate estate dismemberment by zealous
creditors. Additionally, they prevent creditors from gaining
preference, forestall the depletion of a debtor's assets, and
avoid interference with or disruption of the administration of the
bankruptcy estate in an orderly liquidation or reorganization.
It may be argued that exempting PBGC liens for missed contributions
from these provisions would interfere with these fundamental
principles of Federal bankruptcy law and may ultimately harm the
interests of defined benefit pension plan participants, for
example, by making it more difficult for the employer to emerge
from bankruptcy.
Some feel that a more appropriate solution to obstacles the PBGC
encounters when a plan sponsor enters bankruptcy is to modify the
non-bankruptcy laws which affect PBGC's financial position,
including the funding rules.
Prior Action
No prior action.
C. Reflect Market Interest Rates in Lump-Sum Payments
Present law
Accrued benefits under a defined benefit pension plan generally must
be paid in the form of an annuity for the life of the participant
unless the participant consents to a distribution in another form.
Defined benefit pension plans generally provide that a participant
may choose among other forms of benefit offered under the plan,
such as a lump-sum distribution. These optional forms of benefit
generally must be actuarially equivalent to the life annuity benefit
payable to the participant.
A defined benefit pension plan must specify the actuarial
assumptions that will be used in determining optional forms of
benefit under the plan in a manner that precludes employer
discretion in the assumptions to be used. For example, a plan may
specify that a variable interest rate will be used in determining
actuarial equivalent forms of benefit, but may not give the
employer discretion to choose the interest rate.
Statutory assumptions must be used in determining the minimum value
of certain optional forms of benefit, such as a lump sum. That is,
the lump sum payable under the plan may not be less than the amount
of the lump sum that is actuarially equivalent to the life annuity
payable to the participant, determined using the statutory
assumptions. The statutory assumptions consist of an applicable
mortality table (as published by the IRS) and an applicable interest
rate.
The applicable interest rate is the annual interest rate on 30-year
Treasury securities, determined as of the time that is permitted
under regulations. The regulations provide various options for
determining the interest rate to be used under the plan, such as
the period for which the interest rate will remain constant
("stability period") and the use of averaging.
Annual benefits payable under a defined benefit pension plan
generally may not exceed the lesser of (1) 100 percent of average
compensation, or (2) $170,000 (for 2005). The dollar limit
generally applies to a benefit payable in the form of a straight
life annuity. If the benefit is not in the form of a straight life
annuity (e.g., a lump sum), the benefit generally is adjusted to an
equivalent straight life annuity. For purposes of adjusting a
benefit in a form that is subject to the minimum value rules, such
as a lump-sum benefit, the interest rate used generally must be not
less than the greater of: (1) the rate applicable in determining
minimum lump sums, i.e., the interest rate on 30-year Treasury
securities; or (2) the interest rate specified in the plan.
In the case of plan years beginning in 2004 or 2005, the interest
rate used must be not less than the greater of: (1) 5.5 percent; or
(2) the interest rate specified in the plan.
___________________
/326/ Code sec. 417(e)(3); ERISA sec. 205(g)(3).
/327/ Code sec. 415(b).
Description of Proposal
The proposal changes the interest rate used to calculate lump sums
payable from a defined benefit pension plan.
For plan years beginning in 2005 and 2006, the proposal does not
change the law relating to the determination of minimum lump sums
from defined benefit pension plans (i.e., minimum lump-sum values
are determined using the rate of interest on 30-year Treasury
securities). Beginning in 2009, the proposal provides that minimum
lump-sum values are to be calculated using rates drawn from the
zero-coupon corporate bond yield curve. Under the proposal, the
yield curve is to be issued monthly by the Secretary of Treasury
and based on the interest rates (averaged over 90 business days)
for high quality corporate bonds with varying maturities. Thus,
the interest rate that applies depends upon how many years in the
future a participant's annuity payment will be made. Typically,
a higher interest applies for payments made further out in the
future.
For distributions in 2007 and 2008, lump-sum values are determined
as the weighted average of two values: (1) the value of the lump
sum determined under the methodology under present law (the "old"
methodology); and (2) the value of the lump sum determined using
the methodology applicable for 2009 and thereafter (the "new"
methodology). For distributions in 2007, the weighting factor is 2/3
for the lump-sum value determined under the old methodology
and 1/3 for the lump-sum value determined under the new
methodology. For distributions in 2008, the weighting factors are
reversed.
Analysis
As previously discussed, recent attention has focused on the issue
of the rate of interest used to determine the present value of
benefits under defined benefit pension plans for purposes of the
plan's current liability and the amount of lump-sum benefits under
the plan. Under present law, the interest rate used for valuing
lump-sum benefits is based on the interest rate on 30-year Treasury
obligations. The interest rate issue has received attention
recently in part because the Treasury Department stopped issuing
30-year obligations. As a result, there is no longer a 30-year
Treasury interest rate (the interest rate for the Treasury bond
due on February 15, 2031, is used), and statutory changes are
necessary to reflect this. In addition, as discussed below,
concerns have been raised that the 30-year Treasury rate was too
low compared to annuity purchase rates and therefore caused
inappropriate results.
Because minimum lump-sum distributions are calculated as the present
value of future benefits, the interest rate used to calculate this
present value will affect the value of the lump-sum benefit.
Specifically, the use of a lower interest rate results in larger
lump-sum benefits; the use of a higher interest rate results in
lower lump-sum benefits.
_______________
/328/ The President's proposal relating to the interest rate to be
used to determine a plan's liability is discussed in Part IV.B.2.
Some have argued that the 30-year Treasury rate has been so low as
to make lump-sum benefits disproportionately large in comparison
with a life annuity benefit payable under the plan, thus providing
an incentive for employees to take benefits in a lump sum rather
than in the form of a life annuity. Some argue that lump sums
should not be favored as a form of benefit because they can cause a
cash drain on the plan. In addition, an annuity assures the
individual of an income stream during retirement years, which may
not be available in the case of a lump-sum payment, depending on
what use the individual makes of the payment (e.g., whether the
individual spends the lump sum currently or uses the funds to
purchase an annuity).
Under the proposal, the rate of interest on 30-year Treasury
securities is replaced with the rate of interest on high-quality
corporate bonds for purposes of determining a plan's minimum
lump-sum values. In determining lump-sum values, the proposal
provides for the use of a series of interest rates drawn from a
yield curve of high-quality zero-coupon bonds with various
maturities, selected to match the timing of benefit payments
expected to be made from the plan.
Some have raised concerns that a yield-curve approach is more
complicated than the use of a single rate, particularly for
purposes of determining lump-sum distributions. Others argue
that it is unlikely that use of a yield curve would introduce new
complexities for plan administrators, as the most complicated
aspect of determining the present value of a plan's future
liabilities is the determination of the magnitude and timing of
future liabilities themselves, which is not affected by the
proposal. Once the future stream of liabilities is projected,
the difference in difficulty between discounting using one rate
for each year, or discounting with varying rates
(i.e., the yield curve), is trivial.
Some believe that the same rate should be used for determining the
plan's current liability and amount of lump-sum benefits under the
plan, while others argue that the use of different rates may be
appropriate. Even though the 30-year Treasury rate is used for
both purposes under present law, different averaging periods
apply. The interest rates used for the two purposes at any
particular time are not necessarily the same.
The proposal includes a transition period so that employees who are
expecting to retire in the near future are not subject to a change
in the expected amount of their lump sum. While most agree that a
transition period is necessary, views differ on the appropriate
length of the transition period.
The proposal does not directly change the rules under section 415 for
the limitations on annual benefits. As discussed above, in applying
these limitations to lump-sum benefits, the interest rate that must
be used must be not less than the greater of (1) the interest rate
used in determining minimum lump sums, or (2) the interest rate
used in the plan. Because section 415 refers to the rate
applicable in determining minimum lump sums, the proposal to change
the rate used for minimum lump-sum purposes would automatically
apply for purposes of applying the limits on benefits to lump
sums. In addition, many plans use the applicable rate under
___________________
/329/ For 2004 and 2005, 5.5 percent is used in lieu of the interest
rate used in determining minimum lump sums. However, the proposal is
not effective until after such years.
section 417(e) to determine lump-sum benefits. In such a case, the
proposal to use a corporate bond yield curve in determining minimum
lump sums has the effect of also making the corporate bond yield
curve the rate used in the plan. Thus, the proposal indirectly
affects the computation of the annual limit on benefits.
Prior Action
A similar proposal was included in the President's fiscal year 2005
budget proposal.
The National Employee Savings and Trust Equity Guarantee Act of 2004
("NESTEG"), as reported by the Senate Committee on Finance on May
14, 2004, included a provision relating to the interest rate used to
determine minimum lump-sum benefits. Under that provision, for
plan years beginning in 2007 through 2010, a phase-in yield curve
method generally applies in determining the amount of a benefit in a
form that is subject to the minimum value rules, such as a lump-sum
benefit. The yield curve is based on interest rates on high-quality
corporate bonds. For plan years beginning after 2010, the yield
curve method generally applies in determining the amount of a
benefit in a form that is subject to the minimum value rules.
V. TAX SHELTERS, ABUSIVE TRANSACTIONS, AND TAX COMPLIANCE
A.Combat Abusive Foreign Tax Credit Transactions
Present Law
The United States employs a "worldwide" tax system, under which
residents generally are taxed on all income, whether derived in the
United States or abroad. In order to mitigate the possibility of
double taxation arising from overlapping claims of the United States
and a source country to tax the same item of income, the United
States provides a credit for foreign income taxes paid or accrued,
subject to several conditions and limitations.
For purposes of the foreign tax credit, regulations provide that a
foreign tax is treated as being paid by "the person on whom foreign
law imposes legal liability for such tax." Thus, for example, if
a U.S. corporation owns an interest in a foreign partnership, the
U.S. corporation can claim foreign tax credits for the tax that is
imposed on it as a partner in the foreign entity. This would be
true under the regulations even if the U.S. corporation elected to
treat the foreign entity as a corporation for U.S. tax purposes.
In such a case, if the foreign entity does not meet the definition
of a controlled foreign corporation or does not generate income
that is subject to current inclusion under the rules of subpart F,
the income generated by the foreign entity might never be reported
on a U.S. return, and yet the U.S. corporation might take the
position that it can claim credits for taxes imposed on that
income. This is one example of how a taxpayer might attempt to
separate foreign taxes from the related foreign income, and thereby
attempt to claim a foreign tax credit under circumstances in which
there is no threat of double taxation.
Description of Proposal
The proposal provides regulatory authority for the Treasury
Department to address transactions that involve the inappropriate
separation of foreign taxes from the related foreign income in cases
in which taxes are imposed on any person in respect of income of an
entity. Regulations issued pursuant to this authority could provide
for the disallowance of a credit for all or a portion of the foreign
taxes, or for the allocation of the foreign taxes among the
participants in the transaction in a manner more consistent with the
economics of the transaction.
Effective date.--The proposal generally is effective after the date
of enactment.
Analysis
The proposal expands existing regulatory authority to facilitate
efforts on the part of the Treasury Department and the IRS to address
abusive transactions involving foreign tax credits. The proposal
gives the Treasury Department broad authority to stop foreign tax
credit abuses, but the proposal does not identify in great detail
the scope of transactions that would be covered.
___________________
/330/ Treas. Reg. sec. 1.901-2(f)(l)
/331/ Sec, e.g., Notices 2004_19 and 2004-20, 2004-11 I.R.B. I.
The effectiveness of these rules would depend on the degree to which
the Treasury Department provides greater detail with respect to the
scope of transactions covered and the means by which these
transactions would be curtailed.
Prior Action
This proposal was included in H.R. 4520, the American Jobs Creation
Act of 2004, as passed by the Senate. The proposal was not included
in AJCA as enacted.
This proposal also was included in the President's fiscal year 2005
budget proposal.
B. Modify the Active Trade or Business Test for Certain Corporate
Divisions
Present Law
A corporation generally is required to recognize gain on the
distribution of property (including stock of a subsidiary) to its
shareholders as if the corporation had sold such property for its
fair market value. In addition, the shareholders receiving the
distributed property are ordinarily treated as receiving a dividend
of the value of the distribution (to the extent of the distributing
corporation's earnings and profits), or capital gain in the case of
a stock buyback that significantly reduces the shareholder's
interest in the parent corporation.
An exception to these rules applies if the distribution of the
stock of a controlled corporation satisfies the requirements of
section 355 of the Code. If all the requirements are satisfied,
there is no tax to the distributing corporation or to the
shareholders on the distribution. If the requirements are
satisfied, section 355 provides tax-free treatment both to pro-rata
distributions of stock of a subsidiary to the parent's shareholders
and also to non-pro-rata distributions, in which the former parent
company shareholders own the distributed and former parent
corporations in different proportions after the transaction.
In these cases, one or more former parent shareholders not only
may own the resulting corporations in different proportions after
the transaction than their ownership in the parent prior to the
transaction, but also might terminate any stock relationship in
one or the other of the corporations.
One requirement to qualify for tax-free treatment under section
355 is that both the distributing corporation and the controlled
corporation must be engaged immediately after the distribution in
the active conduct of a trade or business that has been conducted
for at least five years and was not acquired in a taxable
transaction during that period (the "active trade or
business test"). For this purpose, a corporation is engaged in
the active conduct of a trade or business only if (1) the
corporation is directly engaged in the active conduct of a
trade or business, or (2) the corporation is not directly engaged
in an active business, but substantially all its assets consist of
stock and securities of one or more corporations that it controls
immediately after the distribution, each of which is engaged in the
active conduct of a trade or business.
________________
/332/ Secs. 311(b) and 336.
/333/ Secs. 301 and 302.
/334/ Secs. 355(b). Certain taxable acquisitions that are considered
expansions of an existing active trade or business are not as the
taxable acquisition of a business for purposes of the rules. Treas.
Reg. sec 1.355-3(b)(3)(ii) and sec. 1.355-3(c), Examples (7) and (8).
/335/ Sec. 355(b)(2)(A). The IRS takes the position for advance
ruling purposes that the second statutory test requires that at least
90 percent of the fair market value of the corporation's gross assets
consist of stock and securities of a 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.
There is no statutory requirement that a certain percentage of the
distributing or controlled corporation's assets be used in the
conduct of an active trade or business in order for the active
trade or business test to be satisfied.
In determining for advance ruling purposes whether a corporation is
directly engaged in an active trade or business that satisfies
the requirement, prior IRS guidelines required that the fair market
value of the gross assets of the active trade or business
ordinarily must constitute at least five percent of the total
fair market value of the gross assets of the corporation. The IRS
recently suspended this specific rule in connection with its
general administrative practice of devoting fewer IRS resources
to advance rulings on factual aspects of section 355 transactions.
Description of Proposal
Under the proposal, in order for a corporation to satisfy the active
trade or business test in the case of a non-pro-rata distribution,
as of the date of the distribution at least 50 percent of its
assets, by value, must be used or held for use in a trade or
business that satisfies the active trade or business test.
Effective Date
No effective date for the proposal is specified in the President's
budget proposal. For revenue estimating purposes, the staff of
the Joint Committee on Taxation has assumed the provision to be
effective for distributions made on or after the date of enactment.
Analysis
The purpose of section 355 is to permit existing shareholders to
separate existing businesses for valid business purposes without
immediate tax consequences. Absent section 355, a corporate
distribution of property (including stock of a subsidiary) to
shareholders would be a taxable event both to the distributing
corporation and to the shareholders.
Present law arguably has permitted taxpayers to use section 355 as
a vehicle to make, in effect, tax- free distributions of large
amounts of cash by combining a relatively small business with such
cash in a distributed corporation. Recent press reports have
referred to these transactions as "cash-rich" tax-free corporate
divisions. For example, the addition of a relatively small
___________________
/336/ The ruling guidelines also provided the possibility that IRS
might rule the active trade or business test was satisfied if the
trades or businesses relief upon were not ``de minimis'' compared
with the other assets or activities of the corporation and its
subsidiaries. Rev. Proc. 2003-3, sec. 4.01(30), 2003-1 I.R.B. 113.
/377/ Rev. Proc. 2003-48, 2003-29 I.R. B. 86.
/338/ 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 susidiary's 29 percent interest in Clorox. Other reported
transactons were undertaken by Janus Capital Group and DST Systems,
Inc. (with cash representing 89 percent of the value of the
business to an otherwise cash stock redemption transaction can
convert an essentially cash stock buyback, which would have been
taxed to the recipient shareholder, into a tax-free transaction for the recipient shareholder. Increasing the active business asset
requirement to a level such as 50 percent in the case of a
non-pro-rata distribution could provide some limit to the
proportion of cash that can be distributed in such transactions.
The 50-percent active trade or business test of the proposal could
be criticized as inadequate to accomplish its policy objectives,
since the proposal still permits at least 50 percent of assets to
be mere investment assets or cash that are neither used nor held
for use in the active conduct of a trade or business.
Consideration could be given to increasing the threshold above
50 percent. For example, present law requires that 80 percent of
gross assets by value be "used" in the active conduct of one or
more qualified trades or businesses for favorable tax
treatment of investments in certain small business corporations,
with specific statutory definitions of what is considered "use" for
this purpose.
_________________________
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 Captial Group's Cash Rich
Split-Off,'' Corporaate Taxation, (November-December 2003) at 39
Robert S. Berstein, ``KeySpan Corp's Cash-Rich Split Off,''
Corporate Taxation, (September-October 2004) at 38. Robert Willens,
``Split End,'' 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.001-11899)
(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).
/339/ The proposal does not explicity define the situations in which
various types of assets could qualify under the test as ``used or
held for use '' in an active trade or business. Thus, it is unclear
whether or to what extent, the proposal categorically would preclude
investment assets or cash from being considered such assetsl. See
additional discussion of these issues in the following text.
/340/ Secs. 1202(c)(2), 1202(e)(1)(A), and 1045(b). For purposes of
this 80-percent test, the statute expressly provides that assets are
treated as used in the active conduct of a trade or business if they
are held as part of the reasonably requried working capital needs of
a qualified trade or business or if they are held for investment or
are reasonably expected to be used within two years to finance
research and experimentation in a qualified trade or business or
increases in working capital needs of a qualified trade or business.
However, for periods after the corporation has been in existence for
at least two years, no more than 50 percent of the assets of the
corporation can qualify as used in the active conduct of a trade or
business by reason of these provisions. Sec. 1202(e)(6).
In some cases, it is possible that an active trade or business might
require large amounts of cash or other investment assets to prepare
for upcoming business needs. The proposal does appear to give some
leeway for such situations by permitting assets "held for use" in
the active conduct of a trade or business to count towards the
50-percent requirement. While the intended scope of this "held for
use" standard is not entirely clear, it is possible that it would
be interpreted at least to cover working capital needs of the
business and possibly broader expansion or other needs. The test
might also be interpreted to provide the necessary flexibility to
address, for example, situations involving financial institutions
or insurance companies that might hold significant investment-type
assets as part of their business. Specific clarification of the
intended scope of the phrase could be desirable, both from the
viewpoint of the government and of taxpayers. On the one hand,
expressly stating any limitations might provide a more
administrable limit on the extent to which a taxpayer can assert
possible expansion or other potential plans to justify a very high
percentage of cash or investment assets. On the other hand,
even if that phrase is limited in any way to provide greater
certainty, from the taxpayer's point of view there would appear to
be significant leeway for additional cash and investment assets,
since half the entire value of the entity can consist of cash or
other assets that are neither used nor held for use in the active
conduct or a trade or business.
Some may argue that any significant absolute cut-off test might
prove inflexible in accommodating situations where corporations
legitimately need to equalize values to shareholders in a division
of business assets. However, if cash in excess of 50 percent of the
assets transferred is necessary to equalize values, the question
arises whether such an amount of cash should be allowed to be
transferred tax-free. A corporation could distribute the excess cash
prior to the division if necessary, keeping the basic business
division tax-free but causing a taxable event to shareholders who
are being economically cashed out in part in connection with the
business division.
It also might be argued that in corporate divisions such as those
affected by the proposal, the distributed cash or investment assets
remain in corporate solution and thus have not been paid directly
to the shareholder. However, in such situations, the value of such
cash or investment assets may be very accessible to the shareholder
even without a further distribution. A divisive transaction has
occurred that has qualitatively changed the shareholder's investment
by separating the cash from the assets in which the shareholder had
previously invested. Such a transaction may allow the shareholder
indirectly to obtain the value of the cash in the separated
corporation, by borrowing against stock that carries little
business risk.
Similarly, it could be argued that as long as the assets in
question have a carryover basis in the hands of the corporation, it
is not necessary to impose a tax at the time of distribution of
the corporate stock. However, a corporation generally is not
permitted to sell assets to another corporation at carryover basis
without tax; nor is a corporation generally permitted to distribute
stock of a subsidiary without tax (absent the application of
section 355). Moreover, section 355 provides tax-free treatment to
both the corporation and the shareholders, so no tax is paid even
though there has been a readjustment of the shareholders'
investment.
The proposal applies only to non-pro-rata distributions and does
not change the present law active business requirement for pro-rata
tax-free corporate divisions in which each existing shareholder of
the parent receives an interest in each of the resulting separate
corporations that is the same proportionate interest as the interest
held in the parent corporation. Consideration should be given to
whether such a disparity in treatment could result in pro-rata
transactions structured to meet the old law requirements,
followed by additional steps to achieve a result similar to the
current cash-rich stock redemption transactions. In general, it
would appear that any outright sales of stock for cash among
shareholders, or other subsequent stock repurchases by the
corporation following a pro-rata spin off, would either be taxable
as an outright cash sale or would again be subject to the
non-pro-rata rules of the proposal if structured as a corporate
division. However, general anti-abuse rules might be desirable
to prevent the use of partnerships or other arrangements to
restructure the benefits and burdens of stock ownership among
the shareholders after a pro-rata distribution. At the same
time, consideration should be given to whether there may be
situations where the definition of "non-pro rata" requires
clarification, such as cases involving distributions with respect
to different classes of stock, or cases where some small
shareholders might be able to receive cash in lieu of stock.
Applying the new "active business" test only to non-pro-rata
distributions might still permit some pro-rata transactions to
occur that largely isolate cash or investment assets in one
entity and risky business assets in the other, thus significantly
changing the nature of the shareholders' holdings after the
transaction. The limited application of the proposal does include
the specific type of transaction that has attracted recent press
attention as the "cash rich" redemption type division. Arguably,
however, applying the new rule to all tax-free corporate divisions
could provide greater consistency. Separating corporate assets to
enable shareholders to have an interest in at least one corporation
with a large proportion of cash or non-business investment assets
could be considered contrary to the purpose of section 355 because
such a transaction may effect a change in the shareholders'
investment more similar to the distribution of a dividend than to a
restructuring of business holdings.
If the proposal were adopted, consideration might also be given to
expanding the manner of its application so that the 50-percent
active trade or business test would apply to each of the
distributing and distributed corporation affiliated groups
immediately after the transaction, rather than solely on a
corporation by corporation basis. This could provide some additional
structural flexibility to situations involving holding companies in
a chain of entities and could reduce the complexity and possible
difficulty of meeting the new 50-percent standard on the basis only
of the parent distributing or distributed corporation.
_____________________
/341/ Tax free treatment under section 355 does not apply to a
transaction that is used principally as a ``device'' for the
distribution of earnings and profits. Sec. 355(a)(1)(B). The
statute does not contain any absolute percentage threshold of
nonbusiness assets that is forbidden under this test. It could be
undesirable and possibly suggestive of a more liberal rule in
pro-rata cases to establish a specific threshold for non-pro-rata
transactions while allowing a continuing unspecified threshold
situation.
/342/ 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
Prior Action
No prior action.
_______________________
Code of 1986 (JCS-3-01), April 2001, Vol. II at 251-252. Such a
proposal was also contained in section 304 of the Senate amendment
to H.R. 4250 (but was not adopted in the American Jobs Creation Act
of 2004, which was the final enacted version of that legislation).
See H.R. Rep 108-755, 108th Cong. (2004) at 361-362 .
C. Impose Penalties on Charities that Fail to Enforce Conservation
Easements
Present Law
Section 170(h) provides special rules that apply to charitable
contributions of qualified conservation contributions, which
include conservation easements and fa�ade easements.
Qualified conservation contributions are not subject to the
"partial interest" rule, which generally denies deductions for
charitable contributions of partial interests in property.
Accordingly, qualified conservation contributions are contributions
of partial interests that are eligible for a fair market value
deduction.
A qualified conservation contribution is a contribution of a
qualified real property interest to a qualified organization
exclusively for conservation purposes. A qualified real property
interest is defined as: (1) the entire interest of the donor other
than a qualified mineral interest; (2) a remainder interest; or
(3) a restriction (granted in perpetuity) on the use that may be
made of the real property. 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.
Description of Proposal
The Administration's proposal imposes "significant" penalties on
any charity that removes or fails to enforce a conservation
restriction for which a charitable contribution deduction was
claimed, or transfers such an easement without ensuring that the
conservation purposes will be protected in perpetuity. The
_____________________
/343/ 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).
/344/ Treas. Reg. sec. 1.170A-14(e)(2).
/345/ Id.
amount of the penalty is determined based on the value of the
conservation restriction shown on the appraisal summary provided
to the charity by the donor.
Under the proposal, the Secretary is authorized to waive the
penalty in certain cases, such as if it is established to the
satisfaction of the Secretary that, due to an unexpected change in
the conditions surrounding the real property, retention of the
restriction is impossible or impractical, the charity receives an
amount that reflects the fair market value of the easement, and the
proceeds are used by the charity in furtherance of conservation
purposes. The Secretary also is authorized to require such
additional reporting as may be necessary or appropriate to ensure
that the conservation purposes are protected in perpetuity.
Effective date.--The proposal is effective for taxable years
beginning after December 31, 2004.
Analysis
The proposal addresses the concern that charitable contributions of
conservation restrictions, which are required to be in perpetuity,
are being removed, or are being transferred without securing the
conservation purpose. The proposal's solution to the problem is
to impose penalties on the charity in such cases.
The intended scope of the proposal is not clear. The proposal
applies to "removals," which some might argue includes significant
modifications to conservation restrictions. A fair reading of the
proposal would impose taxes in a case where a conservation
restriction that prohibits development on 100 acres of property is
modified after the contribution to prohibit development on only 50
of the acres. Although the conservation restriction is not removed
in its entirety, a portion of the restriction is removed,
constituting a "removal" for purposes of the proposal. Some might
argue, however, that if modifications to conservation restrictions
are penalized, certain non significant modifications, such as for
mistake or clarity, or de minimus modifications, should not be
penalized, and that determining whether a modification is
significant introduces administrative complexity. On the other
hand, some might argue that any such complexity could be overcome
and that a proposal that is directed to enforcing the perpetuity
requirement and that does not address significant modifications
to property restrictions is not sufficient.
The suggested penalty of the proposal is "based on the value of the
conservation restriction shown on the appraisal summary provided
to the charity by the donor." The amount of the penalty is not
clear. Under this standard, the penalty could be any percentage
of such value. Some might argue that the penalty should recapture
the tax benefit to the donor, and thus should equal the value of
the conservation restriction that is removed or transferred times
the highest applicable tax rate of the donor at the time of the
contribution, plus interest. Others might argue that the penalty
should equal such amount, plus an additional amount to penalize the
charity for removing or transferring the easement. In either case,
knowing the highest applicable tax rate of the donor may be
difficult; thus in the alternative, a rate could be established by
law. In addition, arguably the penalty also should take into account
the present value of the restriction. For example, the removal or
transfer of the restriction could occur many years after the
donation and in such a case, a penalty based on the value of the
restriction at the time of the donation would not recover the tax
benefit unless the present value is taken into account.
If the proposal applies to modifications of restrictions, however,
a penalty based on recapture of the tax benefit presents additional
complexity, in that a before and after appraisal would be required
tow determine the effect of the modification on the value of the
property. For modifications, a better approach might be to impose
as a penalty an established percentage (perhaps using the same
percentage established for removals and transfers) times the value
of the restriction (taking into account present value). Although
such a penalty would recover more than the tax benefit, the excess
above such benefit could be viewed as the additional penalty amount,
mentioned above, that is imposed on the charity for permitting
the modification. Alternatively, some might argue that the penalty
need not recover the tax benefit, but should just be sufficiently
high to deter the donee organization from removing the restriction.
The proposal provides the Secretary the authority to require
additional reporting to ensure that conservation purposes are
protected in perpetuity. Some might argue that such authority
should specifically require a notification mechanism whereby a
charity is required to inform the Secretary of modifications,
removals, or transfers of conservation restrictions. Some might
argue that notification is an important element of enforcement
of the perpetuity requirement, and if made publicly available,
would inform interested members of the public. Others might argue
that a mere notification requirement would not accomplish much
because charities that are subject to the penalty would not have
an incentive honestly to notify the Secretary in any event.
The proposal applies not only to removals and transfers of
conservation restrictions, but also to "failures to enforce" a
conservation restriction. It is not clear what will constitute a
failure for this purpose. A penalty could be triggered, for
example, if a landowner violates the terms of a conservation
restriction, and (i) the charity was aware of such violation
before it occurred, (ii) the charity should have been aware of
such violation, or (iii) the charity failed to take remedial
measures after learning of such violation. In addition, in the
case of a failure to enforce, the amount of the penalty is not
clear. Arguably, as is the case with modifications of
restrictions, if the violation is only with respect to certain
terms of a restriction, calculating recovery of the tax benefit
is complex. In addition, some would argue that any penalty for
failure to enforce a conservation restriction also should be
accompanied by a means of requiring that charities show the
Secretary as part of their annual information return filings
that sufficient amounts have been set aside for enforcement of
conservation restrictions and that the charity has in place a
program regularly to monitor property restrictions.
The proposal imposes penalties on charities and not on other
qualified organizations that are eligible to accept qualified
conservation contributions, such as governmental entities. Some
would argue that a penalty also should be imposed on such
entities, irrespective of their governmental status.
Prior Action
No prior action.
D. Eliminate the Special Exclusion from Unrelated Business Taxable
Income ("UBIT") for Gain or Loss on Sale or Exchange of Certain
Brownfield Properties
Present Law
In general
In general, an organization that is otherwise exempt from Federal
income tax is taxed on income from a trade or business regularly
carried on that is not substantially related to the organization's
exempt purposes. Gains or losses from the sale, exchange, or
other disposition of property, other than stock in trade,
inventory, or property held primarily for sale to customers in
the ordinary course of a trade or business, generally are
excluded from unrelated business taxable income. Gains or losses
are treated as unrelated business taxable income, however, if
derived from "debt-financed property." Debt-financed property
generally means any property that is held to produce income and
with respect to which there is acquisition indebtedness at any time
during the taxable year.
In general, income of a tax-exempt organization that is produced by
debt-financed property is treated as unrelated business income in
proportion to the acquisition indebtedness on the income-producing
property. Acquisition indebtedness generally means the amount of
unpaid indebtedness incurred by an organization to acquire or
improve the property and indebtedness that would not have been
incurred but for the acquisition or improvement of the property.
Acquisition indebtedness does not include: (1) certain indebtedness
incurred in the performance or exercise of a purpose or function
constituting the basis of the organization's exemption; (2)
obligations to pay certain types of annuities; (3) an obligation,
to the extent it is insured by the Federal Housing Administration,
to finance the purchase, rehabilitation, or construction of
housing for low and moderate income persons; or (4) indebtedness
incurred by certain qualified organizations to acquire or improve
real property.
Special rules apply in the case of an exempt organization that owns
a partnership interest in a partnership that holds debt-financed
property. An exempt organization's share of partnership income
that is derived from debt-financed property generally is taxed
as debt-financed income unless an exception provides otherwise.
Exclusion for sale, exchange, or other disposition of brownfield
property
Present law provides an exclusion from unrelated business taxable
income for the gain or loss from the qualified sale, exchange, or
other disposition of a qualifying brownfield property by an
eligible taxpayer. The exclusion from unrelated business taxable
income generally is available to an exempt organization that
acquires, remediates, and disposes of the qualifying brownfield
property. In addition, there is an exception from the debt-financed
property rules for such properties.
In order to qualify for the exclusions from unrelated business
income and the debt-financed property rules, the eligible taxpayer
is required to: (a) acquire from an unrelated person real property
that constitutes a qualifying brownfield property; (b) pay or incur
a minimum level of eligible remediation expenditures with respect
to the property; and (c) transfer the remediated site to an
unrelated person in a transaction that constitutes a sale, exchange,
or other disposition for purposes of Federal income tax law.
Qualifying brownfield properties
The exclusion from unrelated business taxable income applies only
to real property that constitutes a qualifying brownfield property.
A qualifying brownfield property means real property that is
certified, before the taxpayer incurs any eligible remediation
expenditures (other than to obtain a Phase I environmental site
assessment), by an appropriate State agency (within the meaning of
section 198(c)(4)) in the State in which the property is located
as a brownfield site within the meaning of section 101(39) of the
Comprehensive Environmental Response, Compensation, and Liability
Act of 1980 (CERCLA). The taxpayer's request for certification
must include a sworn statement of the taxpayer and supporting
documentation of the presence of a hazardous substance, pollutant,
or contaminant on the property that is complicating the expansion,
redevelopment, or reuse of the property given the property's
reasonably anticipated future land uses or capacity for uses of the
property (including a Phase I environmental site assessment and,
if applicable, evidence of the property's presence on a local,
State, or Federal list of brownfields or contaminated property) and
other environmental assessments prepared or obtained by the taxpayer.
Eligible taxpayer
An eligible taxpayer with respect to a qualifying brownfield
property is an organization exempt from tax under section 501(a)
that acquired such property from an unrelated person and
paid or incurred a minimum amount of eligible remediation
expenditures with respect to such property. The exempt organization
(or the qualifying partnership of which it is a partner) is
required to pay or incur eligible remediation expenditures with
respect to a qualifying brownfield property in an amount that
exceeds the greater of: (a) $550,000; or (b) 12 percent of the fair
market value of the property at the time such property is acquired
by the taxpayer, determined as if the property were not
contaminated.
An eligible taxpayer does not include an organization that is:
(1) potentially liable under section 107 of CERCLA with respect to
the property; (2) affiliated with any other person that is
potentially liable thereunder through any direct or indirect
familial relationship or any contractual, corporate, or financial
relationship (other than a contractual, corporate, or financial
relationship that is created by the instruments by which title to a
_________________________
/346/ A person is related to another person if (1) such person bears
a relationship to such other person that is described in section
267(b) (determined without regard to paragraph (9), or section
707(b)(1), determined by substituting 25 percent for 50 percent each
place it appears therein; or (2) if such other person is a nonprofit
organization, if such person controls directly or indirectly more
than 25 percent of the governing body of such organization.
qualifying brownfield property is conveyed or financed by a contract
of sale of goods or services); or (3) the result of a reorganization
of a business entity which was so potentially liable.
Qualified sale, exchange, or other disposition
A sale, exchange, or other disposition of a qualifying brownfield
property shall be considered as qualified if such property is
transferred by the eligible taxpayer to an unrelated person, and
within one year of such transfer the taxpayer has received a
certification (a "remediation certification") from the Environmental
Protection Agency or an appropriate State agency (within the
meaning of section 198(c)(4)) in the State in which the property
is located that, as a result of the taxpayer's remediation
actions, such property would not be treated as a qualifying
brownfield property in the hands of the transferee. A taxpayer's
request for a remediation certification shall be made no later
than the date of the transfer and shall include a sworn statement
by the taxpayer certifying that: (1) remedial actions that comply
with all applicable or relevant and appropriate requirements
(consistent with section 121(d) of CERCLA) have been substantially
completed, such that there are no hazardous substances, pollutants
or contaminants that complicate the expansion, redevelopment, or
reuse of the property given the property's reasonably anticipated
future land uses or capacity for uses of the property; (2) the
reasonably anticipated future land uses or capacity for uses of
the property are more economically productive or environmentally
beneficial than the uses of the property in existence on the date
the property was certified as a qualifying brownfield property;
(3) a remediation plan has been implemented to bring the property
in compliance with all applicable local, State, and Federal
environmental laws, regulations, and standards and to ensure that
remediation protects human health and the environment; (4) the
remediation plan, including any physical improvements required to
remediate the property, is either complete or substantially complete,
and if substantially complete, sufficient monitoring, funding,
institutional controls, and financial assurances have been put in
________________________
/347/ In general, a person is potentially liable under section 107 of
CEARCLSA if; (1) if is the owner and operator of a vessel or
facility; (2) at the time of disposal of any hazardous substance it
owned or operated any facility at which such hazardous substances
were disposed of; (3) by contract, agreement, or otherwise it arranged
for disposal or treatment, or arranged with a trasnporter for
transport for disposal or treatment, of hazardous substances owned or
possessed by such pesoin, by any other party or entity, at any
facility or incineration vessel owoned or operated by another party
or entity and containing such hazardous substances; or (4) it accepts
or accepted any hazardous substances for transport to disposal or
treatment facilities, incineration vessels or sites selected by such
person, from which there is a release, or a threatened release which
causes the incurrence of response costs, of hazardous substance. 42
U.S.C. sec. 9607(a) (2004) .
/348/ For this purpose, use of the property as a landfill or other
hazardous waste facility shall not be considered more economically
productive or environmentally beneficial.
/349/ For these purposes, substantial completion means any necessary
physical construction is complete, all immediate threats have been
eliminated, and all long-term threats are under control.
place to ensure the complete remediation of the site in accordance
with the remediation plan as soon as is reasonably practicable
after the disposition of the property by the taxpayer; and (5)
public notice and the opportunity for comment on the request for
certification (in the same form and manner as required for public
participation required under section 117(a) of CERCLA (as in
effect on the date of enactment of the provision)) was completed
before the date of such request. Public notice shall include, at a
minimum, publication in a major local newspaper of general
circulation.
A copy of each of the requests for certification that the property
was a brownfield site, and that it would no longer be a qualifying
brownfield property in the hands of the transferee, shall be
included in the tax return of the eligible taxpayer (and, where
applicable, of the qualifying partnership) for the taxable year
during which the transfer occurs.
Eligible remediation expenditures
Eligible remediation expenditures means, with respect to any
qualifying brownfield property: (1) expenditures that are paid or
incurred by the taxpayer to an unrelated person to obtain a Phase I
environmental site assessment of the property; (2) amounts paid or
incurred by the taxpayer after receipt of the certification that
the property is a qualifying brownfield property for goods and
services necessary to obtain the remediation certification; and
(3) expenditures to obtain remediation cost-cap or stop-loss
coverage, re-opener or regulatory action coverage, or similar
coverage under environmental insurance policies, or to obtain
financial guarantees required to manage the remediation and
monitoring of the property. Eligible remediation expenditures
include expenditures to (1) manage, remove, control, contain,
abate, or otherwise remediate a hazardous substance, pollutant, or
contaminant on the property; (2) obtain a Phase II environmental
site assessment of the property, including any expenditure to
monitor, sample, study, assess, or otherwise evaluate the release,
threat of release, or presence of a hazardous substance,
pollutant, or contaminant on the property, or (3) obtain
environmental regulatory certifications and approvals required to
manage the remediation and monitoring of the hazardous substance,
pollutant, or contaminant on the property. Eligible remediation
expenditures do not include (1) any portion of the purchase price
paid or incurred by the eligible taxpayer to acquire the qualifying
brownfield property; (2) environmental insurance costs paid or
incurred to obtain legal defense coverage, owner/operator liability
coverage, lender liability coverage, professional liability
coverage, or similar types of coverage; (3) any amount paid or
___________________
/350/ Cleanup cost-cap or stop-loss coverage is coverage that places
an upper limit on the costs of cleanup that the insured may have to
pay. Re-opener or regulatory action regulatory action coverage is
coverage for cost associated with any future governmebt actions that
require further site cleanup, including costs associated with the
loss of use of site improvements.
/351/ For this purpose, professional liability insurance is coverage
for errors and omissions by public and private parties dealing with
or managing contaminated land issues, and includes coverage under
policies referred to as owner-controlled insurance. Owner/operator
liability coverage is coverage for those parties that own the site
or conduct business or engage in cleanup
incurred to the extent such amount is reimbursed, funded or
otherwise subsidized by: (a) grants provided by the United
States, a State, or a political subdivision of a State for use in
connection with the property; (b) proceeds of an issue of State or
local government obligations used to provide financing for the
property, the interest of which is exempt from tax under section
103; or (c) subsidized financing provided (directly or indirectly)
under a Federal, State, or local program in connection with the
property; or (4) any expenditure paid or incurred before the date of
enactment of the proposal.
Qualified gain or loss
In general, the exempt organization's gain or loss from the sale,
exchange, or other disposition of a qualifying brownfield property
is excluded from unrelated business taxable income. Income, gain,
or loss from other transfers is not excluded. The amount of gain
or loss excluded from unrelated business taxable income is not
limited to or based upon the increase or decrease in value of the
property that is attributable to the taxpayer's expenditure of
eligible remediation expenditures. The exclusion does not apply to
an amount treated as gain that is ordinary income with respect to
section 1245 or section 1250 property, including any amount
deducted as a section 198 expense that is subject to the recapture
rules of section 198(e), if the taxpayer had deducted such amount
in the computation of its unrelated business taxable income.
Special rules for qualifying partnerships
In general
In the case of a tax-exempt organization that is a partner of a
qualifying partnership that acquires, remediates, and disposes of a
qualifying brownfield property, the exclusion applies to the
tax-exempt partner's distributive share of the qualifying
partnership's gain or loss from the disposition of the property.
_________________
operations on the site. Legal defense coverage is coverage for
lawsuits associated with liability claims against the insured made
by enforcement agencies or third parties, including by private
parties
/352/ The Secretary of the Treasury is authorized to issue guidance
regarding the treatment of government provided funds for purposes of
determining eligible remdediation expenditures.
/353/ For example, rent income from leasing the property does not
qualify under the proposal.
/354/ Depreciation or section 198 amounts that the taxpayer had not
used to determine its unrelated business taxable income are not
treated as gain that is ordinary income under sections 1245 or 1250
(secs. I.1245-2(a)(8) and 1.1250-2(d)(6)), and are not recognized as
gain or ordinary income upon the sale, exchange, or disposition of
the property. Thus, an exempt organization would not be entitled to
a double benefit resulting from a section 198 expense deduction and
the proposed exclusion from gain with respect to any amounts it
deducts under section 198.
A qualifying partnership is a partnership that (1) has a partnership
agreement that satisfies the requirements of section 514(c)(9)
(B)(vi) at all times beginning on the date of the first
certification received by the partnership that one of its
properties is a qualifying brownfield property; (2) satisfies the
requirements of the proposal if such requirements are applied to
the partnership (rather than to the eligible taxpayer that is a
partner of the partnership); and (3) is not an organization that
would be prevented from constituting an eligible taxpayer by
reason of it or an affiliate being potentially liable under CERCLA
with respect to the property.
The exclusion is available to a tax-exempt organization with respect
to a particular property acquired, remediated, and disposed of by a
qualifying partnership only if the exempt organization is a partner
of the partnership at all times during the period beginning on the
date of the first certification received by the partnership that
one of its properties is a qualifying brownfield property, and
ending on the date of the disposition of the property by the
partnership.
The Secretary is required to prescribe such regulations as are
necessary to prevent abuse of the requirements of the provision,
including abuse through the use of special allocations of gains or
losses, or changes in ownership of partnership interests held by
eligible taxpayers.
Certifications and multiple property elections
If the property is acquired and remediated by a qualifying
partnership of which the exempt organization is a partner, it is
intended that the certification as to status as a qualified
brownfield property and the remediation certification will be
obtained by the qualifying partnership, rather than by the
tax-exempt partner, and that both the eligible taxpayer and the
qualifying partnership will be required to make available such
copies of the certifications to the IRS. Any elections or
revocations regarding the application of the eligible remediation
expenditure rules to multiple properties (as described below)
acquired, remediated, and disposed of by a qualifying partnership
must be made by the partnership. A tax-exempt partner is bound
by an election made by the qualifying partnership of which it is
a partner.
Special rules for multiple properties
The eligible remediation expenditure determinations generally are
made on a property-by-property basis. An exempt organization (or
a qualifying partnership of which the exempt organization is a
partner) that acquires, remediates, and disposes of multiple
qualifying brownfield properties, however, may elect to make the
eligible remediation expenditure determinations on a
multiple-property basis. In the case of such an election, the
taxpayer satisfies the eligible remediation expenditures test with
____________________
/355/ The exclusion do not apply to a tax-exempt partner's gain or
loss from the tax-exempt partner's sale, exchange, or other
dispositon of its partnership interest. Such transactions continue
to be governed by present-law.
/356/ A tax-exempt partner is subject to tax on gain previously
excluded by the partner (plus interest) if a property subsequently
becomes ineligible for exclusion under the qualifying partnership's
multiple-property election.
respect to all qualifying brownfield properties acquired during the
election period if the average of the eligible remediation
expenditures for all such properties exceeds the greater of:
(a) $550,000; or (b) 12 percent of the average of the fair market
value of the properties, determined as of the dates they were
acquired by the taxpayer and as if they were not contaminated.
If the eligible taxpayer elects to make the eligible remediation
expenditure determination on a multiple property basis, then the
election shall apply to all qualifying sales, exchanges, or other
dispositions of qualifying brownfield properties the acquisition
and transfer of which occur during the period for which the election
remains in effect.
An acquiring taxpayer makes a multiple-property election with its
timely filed tax return (including extensions) for the first taxable
year for which it intends to have the election apply. A timely
filed election is effective as of the first day of the taxable year
of the return in which the election is included or a later day in
such taxable year selected by the taxpayer. An election remains
effective until the earliest of a date selected by the taxpayer,
the date which is eight years after the effective date of the
election, the effective date of a revocation of the election, or,
in the case of a partnership, the date of the termination of the
partnership.
A taxpayer may revoke a multiple-property election by filing a
statement of revocation with a timely filed tax return (including
extensions). A revocation is effective as of the first day of the
taxable year of the return in which the revocation is included or a
later day in such taxable year selected by the eligible taxpayer or
qualifying partnership. Once a taxpayer revokes the election, the
taxpayer is ineligible to make another multiple-property election
with respect to any qualifying brownfield property subject to the
revoked election.
Debt-financed property
Debt-financed property, as defined by section 514(b), does not
include any property the gain or loss from the sale, exchange, or
other disposition of which is excluded by reason of the provisions
of the proposal that exclude such gain or loss from computing the
gross income of any unrelated trade or business of the taxpayer.
Thus, gain or loss from the sale, exchange, or other disposition
of a qualifying brownfield property that otherwise satisfies the
requirements of the provision is not taxed as unrelated business
taxable income merely because the taxpayer incurred debt to acquire
or improve the site.
Termination date
The Code provides for a termination date of December 31, 2009, by
applying to gain or loss on the sale, exchange, or other disposition
of property that is acquired by the eligible taxpayer or qualifying
partnership during the period beginning January 1, 2005, and ending
December 31, 2009. Property acquired during the five-year
acquisition period need not be disposed of by the termination date
in order to qualify for the exclusion. For purposes of the multiple
property election, gain or loss on property acquired after
December 31, 2009, is not eligible for the exclusion from unrelated
business taxable income, although properties acquired
after the termination date (but during the election period) are
included for purposes of determining average eligible
remediation expenditures.
Description of Proposal
The proposal eliminates the special exclusion from unrelated
business income and the debt-financed property rules.
Effective date.--The proposal is retroactive to January 1, 2005.
Analysis
The proposal repeals the recently enacted exclusion for gains from
the disposition of remediated brownfield property from unrelated
business income tax rules, citing administrative and policy
concerns.
Administrative concerns
The proposal states that the exclusion adds significant new
complexity to the Code and would be difficult to administer. By
any measure, the exclusion is complicated; and the exclusion's
complexity presents several administrative challenges. In general,
although the policy of the proposal is simple -- exempt entities
should not be deterred by unrelated business income tax rules from
investing in contaminated properties for the purposes of
remediating the property prior to sale -- the exclusion
mechanically is complex in order to prevent abuse and because of
the difficult and technical nature of the problem being addressed.
The question raised by the proposal essentially is whether such
requisite complexity makes the exclusion too difficult to administer
and thus, ineffective policy at best, and a potentially abusive
provision at worst.
Although the proposal does not cite specific administrative
concerns, there are several aspects of the proposal that might be
at issue. For example, the exclusion requires that remediation
expenses on brownfield property be incurred in an amount that
exceeds the greater of $550,000 or 12 percent of the fair market
value of the property determined at the time the property is
acquired and as if the property were not contaminated. Such a
determination of value may be difficult for the IRS to enforce,
with the effect of making the $550,000 component of the test a
ceiling and not a floor for required remediation expenses. Also,
the remediation expense test may be applied on a
property-by-property basis or, by an election, on a multiple
property basis. Under the multiple property test, in general,
all the remediation expenses and noncontaminated values of
properties acquired within an eight-year period are taken into
account. Because the election period potentially is eight years,
and tens or hundreds of properties could be sold during such time,
it could be difficult for the IRS to determine whether
bona fide remediation expenses were made with respect to each
property or what the respective noncontaminated values of the
properties are.
Another area of concern for the IRS might be that the exclusion
is not extended to certain persons that are potentially liable under
CERCLA with respect to the acquired property. This may require the
IRS to make determinations under environmental laws, which may
prove difficult. The exclusion also requires the taxpayer to
provide the IRS with copies of certifications that the property
was, prior to remediation, a qualified brownfield property and
that, at the time of disposition, the property no longer is a
brownfield property. Although the IRS is not involved in the
certification process (the EPA and State agencies generally are
responsible for issuing such certifications), the IRS must maintain
the certifications, perhaps for many years, and examine them in
order to test the validity of the exclusion.
A significant administrative concern also might be determining
whether an expense is an eligible remediation expense, which is a
matter of critical importance to the policy supporting the
exclusion. The definition of an eligible expense is detailed and
descriptive, but not precise. Given the complexity of the
definition, it likely will be resource intensive and difficult for
the IRS to challenge a taxpayer's accounting of remediation
expenses.
Another complicating factor is that qualified property may have
gain that is excludable because of the special rules and gain that
is not excludable, such as rental income from the property.
The exclusion also does not apply to an amount treated as gain that
is ordinary income with respect to section 1245 or section 1250
property, including certain section 198 expenses.
Although these rules are clear, it may nonetheless be difficult for
the IRS to administer in the context of a provision that excludes
some kinds of gain and taxes others.
The exclusion also has special rules for partnerships (which likely
is the vehicle that will often be utilized for purposes of the
exclusion), which require, among other things that the Secretary
issue regulations to prevent abuse, including abuse through the use
of special allocations of gains or losses or changes in ownership
of partnership interests held by eligible taxpayers.
The exclusion also contains a related-party rule and a recapture
provision, which contribute to the administrative complexity of
the exclusion. By virtue of the proposal to repeal the exclusion,
the President has concluded, albeit without identifying specific
areas of concern, that the administrative complexity engendered by
the exclusion outweighs any policy benefits that may result from
the exclusion. Some might argue that the exclusion should be given
time to see whether it proves as complicated to administer as it
appears. Others might agree that the self-evident complexity of
the conclusion warrants repeal.
Policy concerns
The President expresses the concern that the exclusion is not
sufficiently targeted because it excludes from unrelated business
income all of the gain from the disposition of qualified
property, irrespective of whether the gain is attributable to
remediation by the taxpayer. Under this view, arguably the
exclusion should be provided only to gain that results from
remediation activity, and permitting the exclusion of gain resulting
from nonremediation-related property development provides an
unwarranted windfall to the taxpayer. Some might argue that the
proposal is broad by design in order to encourage the development
of contaminated sites, because without the benefit of exclusion for
]all of a property's gain, taxpayers will not have a sufficient
incentive to acquire and remediate contaminated property.
Nevertheless, the multiple property election of the proposal may
permit taxpayers to acquire a brownfieldsite where little
remediation is required, significantly develop the property, and
sell the property without paying tax on the gain so long as the
average expenses over all the properties meet the requirements of
the multiple property election. Even so, some might argue that it
is too soon to determine whether the exclusion is overbroad, as the
exclusion has not yet been utilized.
Prior Action
No prior action.
E. Apply an Excise Tax to Amounts Received Under Certain
Life Insurance Contracts
Present Law and Background
Amounts received under a life insurance contract
Amounts received under a life insurance contract paid by reason of
the death of the insured are not includible in gross income for
Federal tax purposes. No Federal income tax generally is imposed
on a policyholder with respect to the earnings under a life
insurance contract (inside buildup).
Distributions from a life insurance contract (other than a modified
endowment contract) that are made prior to the death of the insured
generally are includible in income to the extent that the amounts
distributed exceed the taxpayer's investment in the contract (i.e.,
basis). Such distributions generally are treated first as a
tax-free recovery of basis, and then as income.
Transfers for value
Although the general rule is that gross income does not include
amounts received under a life insurance contract paid by reason of
the death of the insured, a limitation on this exclusion is provided
in the case of transfers for value. If a life insurance contract
(or an interest in the contract) is transferred for valuable
consideration, the amount excluded from income is limited to
the actual value of the consideration plus the premiums and
other amounts subsequently paid by the acquiror of the contract.
_________________________
/359/ Sec. 101(a)
/360/ This favorable tax treatment is available only if a life
insurance contract meets certain requirements designed to limit the
investment character of the contract (sec. 7702).
/361/ Sec. 72(e). In the case of a modified endowment contract,
however, in general, distributions are treated as income first, loans
are treated as distribution (i.e., income rather than basis recover
first), and an additional 10-percent tax is imposed on the income
portion of distributions made before age 59� and in certain other
circumstances (secs. 72(e) and (v)). A modified endowment contract
is a life insurance contract that does not meet statutory ``7-pay''
test, i.e., generally is funded more rapidly than seven annual level
premiums (sec. 7702A).
/362/ Section 101(a)(2). The transfer-for-value rule does not apply,
however, in the case of a transfer in which the life insurance
contract (or interest in the contract) transferred has a basis in the
hands of the transferee that is determined by reference to the
transferor's basis. Similarly, the transfer-for-value rule generally
does not apply if the transfer is between certain parties
(specifically, if the transfer is to the insured, a partner of the
insured, a partnership in which the insured is a partner, or
corporation in which the insured is a shareholder or officer).
Tax treatment of charitable organizations and donors
Present law generally provides tax-exempt status for charitable,
educational and certain other organizations, no part of the net
earnings of which inures to the benefit of any private shareholder
or individual, and which meet certain other requirements.
Governmental entities, including some educational organizations,
are exempt from tax on income under other tax rules providing that
gross income does not include income derived from the exercise of
any essential governmental function and accruing to a State or any
political subdivision thereof.
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 for exclusively public purposes.
State-law insurable interest rules
State laws generally provide that the owner of a life insurance
contract must have an insurable interest in the insured person when
the life insurance contract is issued. Insurable interest
requirements generally reflect a social policy against gambling on
the life of an individual for profit, and some insurable interest
laws have incorporated a notion that the owner of the life insurance
contract should have an interest in the continued life of the
insured person.
State laws vary as to the insurable interest of a charitable
organization in the life of any individual. Some State laws
provide that a charitable organization meeting the requirements of
section 501(c)(3) of the Code is treated as having an insurable
interest in the life of any donor, or, in other States, in the
life of any individual who consents (whether or not the individual
________________________
/363/ Section 501(c)(3).
/364/ Section 115
/365/ Section 170.
/360/ See, e.g., S. Leimberg and A. Gibbons, COLI, BOLI, TOLI and
Insurable Interests, 28 Est. Plan. 333 (July 2001) (describing the
development of insurable interest rules under 18th-century English
law). See also testimony of J.J. McNabb before the Senate Finance
Committee, ``Hearings on Charity Oversight and Reforn: Keeping Bad
Things from Happening to Good Charities, '' Committee Print, 108th
Cong., 2d Sess., June 22, 2004.
/367/ See, e.g., Mass. Gen. Laws Ann. ch. 175 sec. 123A(2) (West
2005); Iowa Code Ann. sec. 511.39 (West 2004) (``a person who, when,
purchasing a life insurance policy, makes a donation to the
charitable organization the beneficiary of all or a part of the
proceeds of the policy ...).
is a donor). Other States' insurable interest rules permit the
purchase of a life insurance contract even though the person
paying the consideration has no insurable interest in the life of
the person insured if a charitable, benevolent, educational or
religious institution is designated irrevocably as the beneficiary.
Transactions involving charities and non-charities acquiring life
insurance
Recently, there has been an increase in transactions involving the
acquisition of life insurance contracts using arrangements in which
both charities and private investors have an interest in the
contract. The charity has an insurable interest in the insured
individuals, either because they are donors, because they consent,
]or otherwise under applicable State insurable interest rules.
Private investors provide capital used to fund the purchase of the
life insurance contracts. Both the private investors and the
charity have an interest in the life insurance contracts, directly
or indirectly, through the use of trusts, partnerships, or other
arrangements for sharing the rights to the life insurance
contracts. Both the charity and the private investors receive cash
amounts in connection with the investment in the life insurance
while the life insurance is in force or as the insured individuals
die.
Description of Proposal
The proposal imposes an excise tax on any payment received by a
person under a life insurance contract (whether a death benefit,
dividend, withdrawal, loan, or surrender payment), if both a charity
and a non-charity have ever had a direct or indirect interest in
the contract. For this purpose, an indirect interest includes an
interest in an entity that holds an interest in the life insurance
contract. The excise tax is imposed on such a payment received by
any person, whether a charity or a non-charity, and is imposed
without regard to the income tax treatment of the payment. The
rate of the excise tax under the proposal is 25 percent.
No Federal income tax deduction is permitted for the excise tax
payable under the proposal. The amount of the excise tax payable
under the proposal is not included in the investment in the
contract.
Exceptions to the application of the excise tax apply under the
proposal. The excise tax does not apply if each non-charity with
a direct or indirect interest in the life insurance contract
has an insurable interest in the insured independent of the
_____________________
/368/ See, e.g., Cal. Ins. Code sec. 10110.1(f) (West 2005); 40 Pa.
Cons. Stat. Ann. sec 40-512 (2004); Fla. Stat. Ann. sec. 27.404 (2)
(2004); Mich. Comp. Laws Ann. sec. 500.2212 (West 2004).
/369/ Or, Rev. Stat sec. 743.030 (2003); Del. Code Ann. Tit. 18,
sec. 2705(a) (2004).
/370/ Davis, Wendy, ``Death-Pool Donations,'' Trusts and Estates,
May 2004, 55; Francis, Theo, ``Tax May Thwart Investment Plans
Enlisting Charities, '' Wall St. J., Feb. 8, 2005, A-10.
charity's interest. The excise tax does not apply if the
non-charity's sole interest in the life insurance contract is as a
named beneficiary. Treasury regulatory authority is provided under
the proposal to provide exceptions to the application of the excise
tax based on specified factors including (1) whether the transaction
is at arms' length, (2) the relative economic benefits to the
charity as compared to the non-charity participants in the
arrangement, and (3) the likelihood of abuse. Treasury regulatory
]authority is also provided to prevent avoidance of the provision,
including through the use of intermediaries.
Effective date.--The proposal is effective for amounts received
under a life insurance contract entered into after February 7, 2005.
Analysis
The proposal reflects a concern that arrangements in which both
charities and private investors have an interest in life insurance
contracts may accord unintended Federal tax benefits to the private
investors. The charity may effectively be renting out its insurable
interest in individuals in whom the private investors have no
insurable interest, making available a tax-favored life insurance
investment that would not otherwise be available. Alternatively,
the arrangement could be viewed as an inappropriate sharing of the
charity's tax-exempt status with private persons.
The generous scope of a charity's insurable interest in the lives
of a broad class of individuals under many States' laws facilitates
private investment in life insurance together with a charity in
situations in which the private investment without the charity's
involvement would violate insurable interest rules. Although
insurable interest rules are a matter of State, not Federal, law,
an indirect consequence of the broad insurable interest rules for
charities is a broadened availability of Federal-tax-favored
investments in life insurance that may be inconsistent with the
rationale for the favorable tax rules for life insurance. The
rationale for favorable tax treatment of life insurance has been
described as encouraging breadwinners to provide for their
dependents financially in the event of the breadwinners' untimely
death. Arguably, this rationale cannot support the growth of pools
of insured individuals who have no relation to the private investors
funding the purchase of life insurance contracts on those
individuals. The use of pools of insured individuals may also
violate the original purpose of insurable interest laws to prevent
dead pools and prohibit betting on individuals' deaths for profit.
Alternatively, the use of a charity's insurable interest under State
law could be viewed as an inappropriate sharing of the charity's
tax-exempt status with private persons. The renting out of State-law
insurable interests that are based on the entity's status as a
charity for Federal tax purposes is tantamount to using the
charity's favored Federal tax status for private gain, it may
be argued. This type of arrangement is inconsistent with the
Federal tax law requirement that a charity be operated exclusively
for charitable purposes. An excise tax on such transactions that
is applicable both to the charity and to the investors, as provided
under the proposal, can be seen as an intermediate sanction, short
of revocation of the charity's tax-exempt status.
Nevertheless, charities that are short of cash may find that the
joint investment in life insurance with cash-rich private investors
generates needed revenue and funds the continuation of charitable
activities. Even though the charities share the death benefits or
other proceeds under the life insurance contracts with private
investors, the arrangement may provide a source of cash to a
charity that might not otherwise be available. It could be argued
that the social benefit of increasing the flow of funds to charities
outweighs both the social detriment of permitting investments in
what some characterize as dead pools and the tax policy concern of
spreading the tax benefit of life insurance beyond its intended
function.
Some arrangements in which both charities and non-charities have an
interest in the same life insurance contracts may not involve
shifting the tax-favored treatment of life insurance from charities
to private investors. For example, some of these transactions are
conducted through partnerships, from which payments to the private
investors take the form of taxable guaranteed payments or other
taxable payments. In these transactions, the purchase of life
insurance on individuals in which the charity has an insurable
interest is funded by annuity contracts purchased with capital
contributed by the private investors. In such transactions,
arbitrage is achieved not by relying on tax-free payments to the
private investors, but rather, by relying on pricing differentials
arising from differing mortality assumptions under the annuity
contracts and the life insurance contracts. Nevertheless, in
these arrangements, the charity may still be characterized as
renting out an insurable interest in an individual in whom the
private investor would not have an insurable interest, absent the
charity's participation in the transaction.
It could be argued that the present-law transfer-for-value rules
should serve to prevent the shifting of tax benefits from a charity
with an insurable interest in insured individuals to private
investors. However, in the transactions, the acquisition of the
contract may be structured in such a way that there is no transfer
of the life insurance contract subsequent to its original purchase.
It could, however, be argued that application of general
principles of tax law such as the sham transaction doctrine,
economic substance, or form over substance, should cause the
transaction to be characterized as a transfer for value.
Prior Action
No prior action.
F. Limit Related-Party Interest Deductions
Present Law
A U.S. corporation with a foreign parent may reduce the U.S. tax on
its U.S.-source income through the payment of deductible amounts
such as interest, rents, royalties, and management service fees to
the foreign parent or other foreign affiliates that are not subject
to U.S. tax on the receipt of such payments. Although foreign
corporations generally are subject to a gross-basis U.S. tax at a
flat 30-percent rate on the receipt of such payments, this tax may
be reduced or eliminated under an applicable income tax treaty.
Consequently, foreign-owned U.S. corporations may use certain
treaties to facilitate earnings stripping transactions without
having their deductions offset by U.S. withholding taxes.
Generally, present law limits the ability of corporations to reduce
the U.S. tax on their U.S.-source income through earnings stripping
transactions. Section 163(j) generally disallows a deduction for so
called "disqualified interest" paid or accrued by a corporation in
a taxable year, if two threshold tests are satisfied: the payor's
debt-to-equity ratio exceeds 1.5 to 1 (the so-called "safe harbor");
and the payor's net interest expense exceeds 50 percent of
its "adjusted taxable income" (generally taxable income computed
without regard to deductions for net interest expense, net operating
losses, and depreciation, amortization, and depletion).
Disqualified interest includes interest paid or accrued to:
(1) related parties when no Federal income tax is imposed with
respect to such interest; or (2) unrelated parties in certain
instances in which a related party guarantees the debt
("guaranteed debt"). Interest amounts disallowed under these rules
can be carried forward indefinitely. In addition, any excess
limitation (i.e., the excess, if any, of 50 percent of the adjusted
taxable income of the payor over the payor's net interest expense)
can be carried forward three years.
Under section 424 of the American Jobs Creation Act of 2004
("AJCA"), the Treasury Secretary is required to submit to the
Congress a report examining the effectiveness of the
earnings stripping provisions of present law. This report is due
no later than June 30, 2005.
Description of Proposal
The proposal eliminates the safe harbor and the excess limitation
carryforward of present law. In addition, the proposal reduces the
present-law threshold of 50 percent of adjusted taxable income to
25 percent with respect to interest on related-party debt.
With respect to interest on guaranteed debt, the present-law
threshold of 50 percent of adjusted taxable income is retained.
The carryforward of disallowed interest is limited to 10 years.
_________________________
/371/ For example, it appearss that the U.S.-Barbados income tax
treaty was often used to facilitate earnings stripping arrangements.
That treaty was amended in 2004 to make it less amenable to such use.
It is possible, however, that other treaties in the U.S. network might
be used for similar purposes. For a discussion of this issue, see
Joint Committee on Taxation, Explanation of Proposed Protocol to the
Income Tax Treaty Between the United States and Barbardos (JCX-55-04),
September 16, 2004, 12-20, 22.
The Treasury Department also indicates that the study required under
AJCA is underway, and that the report of this study may include
further recommendations in this area.
Effective date.--The proposal is effective on the date of first
committee action.
Analysis
Recent inversion transactions led some to question the efficacy
of the present-law earnings stripping rules. In some cases, it
appeared that the earnings stripping benefit achieved when a U.S.
corporation paid deductible amounts to its new foreign parent or
other foreign affiliates constituted the primary intended tax
benefit of the inversion transaction, which should not have been
the case if the earnings stripping rules had been functioning
properly. By eliminating the debt-equity safe harbor, reducing
the adjusted taxable income threshold from 50 percent to 25
percent for interest on related-party debt, limiting the
carryforward of disallowed interest to 10 years, and eliminating
the carryforward of excess limitation, the proposal would
significantly strengthen rules that have proven ineffective in
preventing certain recent earnings stripping arrangements.
On the other hand, some may view the proposal as unnecessary and
overbroad, arguing that there is no empirical evidence of a
significant earnings stripping problem outside the context
of inversion transactions. Under this view, the recently enacted
anti-inversion rules of section 7874, combined with recent treaty
developments (mainly the 2004 protocol to the U.S.-Barbados income
tax treaty), should constitute a sufficient response to any
earnings stripping problem that might have existed. Proponents of
the proposal may respond that, although recent legislative and
treaty developments have removed some significant opportunities for
earnings stripping, other opportunities may remain, and thus
erosion of the U.S. tax base will continue until the statutory
earnings stripping rules themselves are strengthened.
Some may take the view that the proposal does not go far enough in
curtailing earnings stripping. While the proposal would have the
effect of further limiting the ability of taxpayers to erode the
U.S. tax base through earnings stripping transactions involving
interest, the proposal does not address earnings stripping
transactions involving the payment of deductible amounts other than
______________________
/372/ Sec, e.g., Department of the Treasury, General Explanations of
the Administration's Fiscal Year 2004 Revenue Proposals, February
2003, 104 (``Under current law, opportunities are available to
reduce inappropriately the U.S. tax on income erarned from U.S.
operations through the use of foreign related-party debt.
Tightening the rules of section 163(j) is necessary to eliminate
these inappropriate income-reduction opportunities.''); Department of
the Treasury, Office of Tax Policy, Corporate Inversion Transactions;
Tax Policy Implications, May 17, 2002, Part VII.A (``Treasury
study'') (``The prevalent use of foreign related-party debt in
inversion transactions is evidence that [the rules of section 163
(j)] should be revisited'').
/373/ See, e.g., Treasury study, Part VII A; Joint Committee on
Taxation, Background and Description of Present-Law Rules and
Proposals Relating to Corporate Inversion Transactions (JCX-52-02),
June 5, 2002, 3-4.
interest (e.g., rents, royalties, and service fees), or the payment
of deductible amounts by taxpayers other than corporations. These
transactions also may erode the U.S. tax base, and thus it may be
argued that a more comprehensive response to earnings stripping is
needed. Indeed, as opportunities for stripping earnings in the
form of interest are reduced, taxpayers may find it increasingly
attractive to strip earnings through other means. Proponents of
the proposal may respond that earnings stripping is much more
readily achieved through the use of debt than through other means,
and that there is insufficient evidence to suggest that these
other forms of stripping warrant a new legislative response.
Finally, some may argue that further action in this area should be
deferred until the Treasury Department completes its study and
submits its report to the Congress. It is hoped that this report
will provide new data and analysis that will further inform the
discussion in this area.
Prior Action
H.R. 2896, the "American Jobs Creation Act of 2003," as passed by
the House Committee on Ways and Means in 2003, contained a similar
proposal. No such proposal was included in AJCA as enacted in 2004.
The same proposal was included in the President's fiscal year 2005
budget proposal. The President's fiscal year 2004 budget proposal
contained a different earnings stripping proposal that changed
present law by modifying the safe harbor provision, reducing the
adjusted taxable income threshold, adding a new disallowance
provision based on a comparison of domestic to worldwide
indebtedness, and limiting carryovers.
G. Modify Certain Tax Rules for Qualified Tuition Programs
Present Law
Overview
Section 529 provides specified income tax and transfer tax rules
for the treatment of accounts and contracts established under
qualified tuition programs. 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"). Under both types of qualified
tuition programs, a contributor establishes an account for the
benefit of a particular designated beneficiary to provide for that
beneficiary's higher education expenses.
For this purpose, qualified higher education expenses means
tuition, fees, books, supplies, and equipment required for the
enrollment or attendance of a designated beneficiary at an eligible
educational institution, and expenses for special needs services
in the case of a special needs beneficiary that are incurred in
connection with such enrollment or attendance. Qualified higher
education expenses generally also include room and board for
students who are enrolled at least half-time.
In general, prepaid tuition contracts and tuition savings accounts
established under a qualified tuition program involve prepayments
or contributions made by one or more individuals for the benefit
of a designated beneficiary, with decisions with respect to the
contract or account to be made by an individual who is not the
designated beneficiary. Qualified tuition accounts or contracts
generally require the designation of a person (generally referred
________________________
/374/ 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.
/375/ Sec. 529(b)(1)(A).
/376/ Sec. 529(b)(1)(A).
/377/ Sec. 529(e)(3)(A).
/376/ Sec. 529(e)(3)(B).
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 established for a designated beneficiary. The person or
persons who make the contributions to the account need not be the
same person who is regarded as the account owner for purposes of
administering the account. Under many qualified tuition programs,
the account owner generally has control over the account or
contract, including the ability to change designated beneficiaries
and to withdraw funds at any time and for any purpose. Thus, in
practice, qualified tuition accounts or contracts generally
involve a contributor, a designated beneficiary, an account owner
(who oftentimes is not the contributor or the designated
beneficiary), and an administrator of the account or contract.
Under present law, section 529 does not establish eligibility
requirements for designated beneficiaries. Accordingly, a
beneficiary of any age may be named as a designated beneficiary.
Special considerations generally apply to accounts that are funded
by amounts subject to Uniform Gifts to Minors Act ("UGMA") or
Uniform Transfers to Minors Act ("UTMA") laws.
Section 529 does not provide for any quantitative limits on the
amount of contributions, account balances, or prepaid tuition
benefits relating to a qualified tuition account, other than to
require that the program provide adequate safeguards to prevent
contributions on behalf of a designated beneficiary in excess of
those necessary to provide for the qualified higher education
expenses of the beneficiary. Many qualified tuition programs
impose limits on the maximum amount of contributions that may be
made, or account balances that may accrue, for the benefit of a
designated beneficiary under that program.
Under present law, contributions to a qualified tuition account
must be made in cash. A qualified tuition program may not permit
any contributor to, or designated beneficiary under, the program
to directly or indirectly direct the investment of any
contributions (or earnings thereon), and must provide separate
account must be made in cash. A qualified tuition program may not
permit any contributor to, or designated beneficiary under, the
program to directly or indirectly direct the investment of any
contributions (or earnings thereon), and must provide separate
accounting for each designated beneficiary. A qualified tuition
_____________________
/379/ Section 529 refers to contributorss and designated
beneficiaries, but does not define or otherwise refer to the term
account owner, which is a commonly used term amoung qualifed tuition
programs.
/380/ Sec. 529(b)(6).
/381/ For example, a qualified tuition program might provide that
contributions to all accounts established for the benefit of a
particular designated beneficiary under that program may not exceed
a specified limit (e.g., $250.000), or that the maximum account
balance for all accounts established for the benefit of a particular
designated beneficiary under that program may not exceed a specified
limit. In the case of prepaid tuition contracts, the limit might be
expressed in terms of a maximum number of semesters.
/382/ Sec. 529(b)(2).
/383/ Sec. 529(b)(4).
/384/ Sec. 529(b)(3).
tuition program may not allow any interest in an account or contract
(or any portion thereof) to be used as security for a loan.
Special rules apply to coordinate qualified tuition programs with
other education benefits, including Coverdell education savings
accounts, the HOPE credit, and the lifetime learning credit.
Income tax treatment
A qualified tuition program, including a savings account or a
prepaid tuition contract established thereunder, generally is
exempt from income tax, although it is subject to the tax on
unrelated business income. 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.
_________________________
/385/ Sec. 529(b)(5).
/386/ Sec. 529(e)(3)(B)(v) and (vi).
/387/ Sec. 529(a). An interest in a qualified tuition account is not
treated as debt for purposes of t he debt-financed property rules.
Sec. 529(e)(4).
/388/ Sec. 529(c)(3)(B). Any benefit furnished to a designed
beneficiary under a qualified tuition account is treated as a
distribution to the benefciary for these purposes. Sec. 529(c)(3)(B)
(iv).
/389/ Sec. 529(c)(3)(A) and (B)(ii).
/390/ Sec. 529(c)(6).
/391/ Sec. 529(c)(3)(C)(ii). For this purpose. ``member of family''
means, with respect to a designated beneficiary: (1) the spouse of
such beneficiary; (2) an individual who bears a relationship to such
beneficiary which is described in paragraphs (1) though (8) of
section 152(a)(i.e., with respect to the beneficiary, a son,
daughter, or a descendant of either; a stepson or stepdaughter; a
sibling or stepsibling; a father, mother, or ancestor of either; a
stepfather or stepmother; a son or daughter of a brother or sister; a
brother or sister of a father or mother; and a son-in-law,
daughter-in-law, father-in-law, mother-in-law, brother-in-law, or
sister-in-law), or the spouse of any such individual; and (3) the
first cousin of such beneficiary. Sec. 529(e)(2).
Gift and generation-skipping transfer (GST) tax treatment
A contribution to a qualified tuition account (or with respect to a
prepaid tuition contract) is treated as a completed gift of a
present interest from the contributor to the designated beneficiary.
Such contributions qualify for the per-donee annual gift tax
exclusion ($11,000 for 2005), and, to the extent of such exclusions,
also are exempt from the generation-skipping transfer (GST) tax.
A contributor may contribute in a single year up to five times the
per-donee annual gift tax exclusion amount to a qualified tuition
account and, for gift tax and GST tax purposes, treat the
contribution as having been made ratably over the five-year period
beginning with the calendar year in which the contribution is made.
A distribution from a qualified tuition account or prepaid tuition
contract generally is not subject to gift tax or GST tax. Those
taxes may apply, however, to a change of designated beneficiary if
the new designated beneficiary is in a generation below that of the
old beneficiary or if the new beneficiary is not a member of the
family of the old beneficiary.
Estate tax treatment
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 the contributor elected the
special five-year allocation rule for gift tax annual exclusion
purposes, any amounts contributed that are allocable to the years
within the five-year period remaining after the year of the
contributor's death are includible in the contributor's gross
estate.
Powers of appointment
Special income tax and transfer tax rules apply to instances where
a person holds a power of appointment or certain other powers with
respect to property. In general, a power of appointment includes
all powers which are in substance and effect powers of appointment
______________________
/392/ Sec. 529(c)(2)(A).
/393/ Sec. 529(c)(2)(B).
/394/ Sec. 529(c)(5)(A).
/395/ Sec. 529(c)(5)(B).
/396/ Sec. 529(c)(4)(B).
/398/ Sec. 529(c)(4)(C).
regardless of the nomenclature used in creating the power and
regardless of local property law connotations, and may include, for
example, the power to consume or appropriate the property, or to
affect the beneficial enjoyment of principal or income through a
power to revoke, alter or amend the terms of the instrument (such
as changing the designated beneficiary of property).
The nature of the power held by a person affects whether the holder
of the power is taxed on the income on the property, and whether
the property subject to the power is treated as includible within
the estate of the holder of the power or is subject to gift tax.
Description of Proposal
Overview
The proposal modifies certain income tax, gift tax,
generation-skipping transfer tax, and estate tax rules with respect
to changes in designated beneficiaries of qualified tuition
accounts.
The proposal modifies the present-law provisions regarding the
imposition of the 10-percent additional tax, and imposes new excise
taxes on amounts that are used other than for qualified higher
education expenses.
Changes in designated beneficiaries
The proposal modifies present law by providing that a change in the
designated beneficiary of a qualified tuition account does not
cause the imposition of gift tax or GST tax, regardless of whether
the new designated beneficiary is in a generation below that of the
former designated beneficiary. The proposal also provides that
gift tax and GST tax is not imposed even if the new designated
beneficiary is not a member of the family of the old beneficiary.
The proposal modifies the income tax treatment of a change in a
designated beneficiary to provide that a change of designated
beneficiary to a new eligible designated beneficiary who is not a
member of the family of the old beneficiary is not treated as a
distribution for income tax purposes.
The proposal provides that upon the death of a designated
beneficiary, the account is to be distributed to the estate of the
designated beneficiary, thereby triggering potential income tax and
estate tax consequences, unless a new eligible designated
beneficiary is named in a timely manner or the contributor
withdraws the funds from the account. The designated beneficiary's
gross estate would include only amounts (if any) paid to the estate
or pursuant to the designated beneficiary's general power of
appointment.
__________________________
/399/ Sec. 20.2041-1(b)(1). See also secs. 674, 2041, and 2514.
/400/ Powers of appointment are often classified as ``general powers
of appointment'' or as ``limited'' or ``special'' powers of
appointment.
/401/ This change is proposed in order to be consistent with the
objective of imposing no taxes on a change of designated beneficiary
so long as the new beneficiary is an eligible designated beneficiary
and the funds are not used for nonqualified purposes.
Rules applicable to contributors; account administrators
Under the proposal, each section 529 account may have only one
contributor. A section 529 program is permitted to accept
contributions to a section 529 account only from the account
contributor (or the contributor's irrevocable trust) and, to the extent provided by the Secretary, from other persons in a de minimis amount.
As under present law, the contributor to a section 529 account is
permitted to withdraw funds from the account during the
contributor's lifetime, subject to income tax on the income portion
of the withdrawal. An additional tax applies to the income portion
of a withdrawal unless the withdrawal is due to the designated
beneficiary's death, disability, receipt of a scholarship or
attendance at a U.S. military academy. Under the proposal, the
amount of the additional tax is generally 10 percent and is
increased to 20 percent if the withdrawal occurs more than 20 years
after the account was originally created.
Under the proposal, the contributor may name another person to
administer the account (the "account administrator"). The
account administrator would have no beneficial interest in the
account. The account administrator would be permitted to change
the designated beneficiary "from time to time". Neither the
account administrator nor the administrator's spouse could be
or become a designated beneficiary, except as provided by the
Secretary.
Imposition of excise tax on nonqualifying distributions
The proposal retains the present-law income tax treatment of
distributions from a qualified tuition account that are used for
qualified higher education expenses. Such distributions are not
subject to income tax, regardless of the distributee's identity.
As under present law, distributions used for purposes other than
qualified higher education expenses are subject to income tax on
the earnings portion of the distribution. Further, the proposal
imposes additional excise taxes with respect to distributions that
are used other than for qualified higher education expenses if the
distribution is made to someone other than the contributor or the
initial designated beneficiary. Nonqualified distributions in
excess of $50,000 but less than or equal to $150,000 (computed on a
cumulative basis for each designated beneficiary, including for this
purpose the entire amount of the distribution, not just earnings)
are subject to a new excise tax imposed at the rate of 35 percent.
Nonqualified distributions in excess of $150,000 (computed on a
cumulative basis for each designated beneficiary, including for
this purpose the entire amount of the distribution, not just
earnings) are subject to an excise tax imposed at the rate of
50 percent. The excise tax is payable from the account and is
required to be withheld by the program administrator.
Changes in reporting requirements
The proposal modifies the reporting requirements applicable to
qualified tuition accounts. For example, new reporting requirements
would be established to facilitate the administration of excise tax
withholding by administrators. Such requirements might include
certifications provided by designated beneficiaries to
administrators of qualified tuition programs, so that administrators
may withhold appropriate amounts of excise taxes with respect to
distributions used other than for qualified higher education
expenses.
Grant of regulatory authority to Treasury
The proposal grants the Secretary of the Treasury broad regulatory
authority to ensure that qualified tuition accounts are used in a
manner consistent with Congressional intent.
Effective dates
The proposal generally is effective for qualified tuition accounts
(including savings accounts and prepaid tuition contracts)
established after the date of enactment of the proposal, including
prepaid tuition contracts if additional prepaid tuition benefits
are purchased on or after the date of enactment of the proposal.
The proposal does not apply to qualified tuition savings accounts
that are in existence on the date of enactment unless an election is
made to be covered by the new rules. No additional contributions to
savings accounts in existence on the date of enactment of the
proposal would be permitted without such election.
The modified reporting requirements apply after the date of
enactment of the proposal to all qualified tuition accounts
(including savings accounts and prepaid tuition contracts).
Analysis
Overview
The President's budget proposal addresses certain transfer tax
anomalies with regard to changes in designated beneficiaries by
providing that a change of beneficiary to another eligible
beneficiary does not constitute a transfer for gift or
generation-skipping transfer tax purposes or a distribution for
income tax purposes. In addition, by requiring that no person other
than a designated beneficiary possess any beneficial interest in
a qualified tuition account, the proposal attempts to more closely
align the gift tax treatment of contributions to qualified tuition
accounts (i.e., a completed gift of a present interest to the
designated beneficiary) with the treatment of contributions under
generally applicable transfer tax principles. The proposal addresses
potential abuses of qualified tuition accounts by establishing
eligibility rules for designated beneficiaries, and imposing an
excise tax on distributions that are not used for qualified higher
education expenses and increasing the additional tax on
nonqualified withdrawals by the contributor more than 20 years
after the creation of the account.
Section 529 transfer tax treatment and generally applicable
transfer tax provisions
Overview
Certain aspects of present-law section 529 depart from otherwise
generally applicable transfer tax principles. For example, present
law treats a contribution to a qualified tuition account as a
__________________________
/402/ In cases where an existing account or contract is subject to
the newe rules, the entire account or conrracr is subject tothe new
rules, not just that portion of the account or contract that relates
to contributions made, or prepaid benefits acquired, after the date
of enactment.
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.
Absent section 529, such contributions generally would not be
treated as completed gifts to the designated beneficiary under otherwise applicable transfer tax principles. Further, present-law section
529 does not address the transfer tax consequences of a change of
account owners of a qualified tuition account.
Treatment of changes of designated beneficiaries
Under present-law section 529, a change of designated beneficiary to
a beneficiary who is in a generation lower than the former
beneficiary (or who is not a family member of the former beneficiary)
constitutes a taxable gift, even though the new designated
beneficiary would, under otherwise applicable transfer tax
principles, be regarded as not receiving a completed gift.
Further, present-law section 529 does not identify which party is
responsible for payment of the transfer tax when it is imposed in
such instances. Also, under present-law section 529, there is
no express requirement that the multiple annual present interest
exclusion is available only if there is a present intent to allow
the designated beneficiary to receive the benefits of the qualified
tuition program.
Present law also has different change-of-beneficiary rules for
income tax and transfer tax purposes. A change of beneficiary to a
person who is not a member of the same family as the old beneficiary
is treated as a distribution for income tax purposes, regardless of
whether the new beneficiary is in a lower generation than the
former beneficiary. Under present law, a change of beneficiary to a
person who is in a lower generation than the former beneficiary is
treated as a transfer for transfer tax purposes, regardless of
whether the new beneficiary is of the same family as the former
beneficiary.
The proposal eliminates these disparities and provides that a
change of beneficiary will not be treated as a distribution or
transfer.
________________________
/403/ Sec. 529(c)(2).
/404/ Under otherwise applicable transfer tax principles, the
designated beneficiary's lack of control over the qualified tuition
account generally would cause the beneficiary's interest in the
account to be regarded as a future interest, and any completed gift
of a present interest would be regarded as having been made from the
contributor to the account owner (rather than to the designated
beneficiary). In cases where the contributor and the account owner
are the same person, no gift would take place under generally
applicable transfer tax principles.
/405/ A change of account owner might be regarded as a completed gift
of a present interest from the old account owner to the new account
owner, or as having no tax consequences because a comleted gift had
been made to the designated beneficiary.
Because the proposal expands the class of permissible successor
designated beneficiaries without the imposition of any income or
transfer taxes, individuals interested in establishing a qualified
tuition account as a means to fund qualified higher education
expenses for their children, relatives, or others, might view these
changes as being a liberalization and simplification of existing
law.
Potential abuses addressed by the proposal
The proposal attempts to discourage substantial multi-generational
accumulations of qualified tuition account assets by imposing new
excise taxes on distributions that are ultimately used other than
for qualified higher education expenses. The proposed excise tax is
imposed only if an actual distribution occurs and the distributed
amounts are not used for qualified higher education expenses. The
excise tax does not apply if a distribution is made to the estate
of a deceased designated beneficiary, or to a designated beneficiary
on account of the designated beneficiary's disability, receipt
of a scholarship, or attendance at a military academy. Excise taxes
on the entire amount of a distribution that exceeds certain
cumulative thresholds, including on both the principal and earnings
components, would be imposed. Such excise taxes are intended to
serve as deterrents to using the funds other than for qualified
higher education expenses. However, the excise taxes are not imposed
unless an actual or deemed distribution occurs, and thus would not be
imposed so long as the funds are maintained in a qualified tuition
account that continues to be held for the benefit of an eligible
designated beneficiary. The proposal does not impose a specific
deadline by which time the funds must be used for education
expenses or become subject to income, excise, and transfer taxes.
Some may argue that this proposal does not go far enough to deter
(or in fact may create an opportunity to achieve) substantial
multi-generational accumulations of qualified tuition account
assets, and that a better approach would be to impose caps on the
amounts that can be contributed to such accounts, or on the length
of time that such assets can be held. Enforcing such caps,
however, would impose significant administrative burdens on
administrators, taxpayers, and the IRS. Others may argue that the
present-law requirement that the account or contract provide
adequate safeguards to prevent contributions on behalf of a designated
beneficiary in excess of those necessary to provide for the
qualified higher education expenses of the beneficiary, combined
with the maximum contribution or account balance limits established
by many of the various qualified tuition programs, adequately
address any concerns that such accounts might be used to improperly
accumulate assets for purposes other than providing for qualified
higher education expenses of the designated beneficiary. Others
may counter that program-imposed limits are applied only on a
per-State basis, and further, that the ability of an individual to
establish accounts for an unlimited number of designated
beneficiaries means there are no effective limits under present
law.
Prior Action
A similar proposal was contained in the President's fiscal year
2005 budget proposal.
VI. TAX ADMINISTRATION PROVISIONS AND UNEMPLOYMENT INSURANCE
A. IRS Restructuring and Reform Act of 1998
1. Modify section 1203 of the IRS Restructuring and Reform Act of
1998
Present Law
Section 1203 of the IRS Restructuring and Reform Act of 1998
requires the IRS to terminate an employee for certain proven
violations committed by the employee in connection with the
performance of official duties. The violations include:
(1) willful failure to obtain the required approval signatures on
documents authorizing the seizure of a taxpayer's home, personal
belongings, or business assets; (2) providing a false statement
under oath material to a matter involving a taxpayer; (3) with
respect to a taxpayer, taxpayer representative, or other IRS
employee, the violation of any right under the U.S. Constitution,
or any civil right established under titles VI or VII of the Civil
Rights Act of 1964, title IX of the Educational Amendments of
1972, the Age Discrimination in Employment Act of 1967, the Age
Discrimination Act of 1975, sections 501 or 504 of the
Rehabilitation Act of 1973 and title I of the Americans with
Disabilities Act of 1990; (4) falsifying or destroying documents
to conceal mistakes made by any employee with respect to a matter
involving a taxpayer or a taxpayer representative; (5) assault
or battery on a taxpayer or other IRS employee, but only if there
is a criminal conviction or a final judgment by a court in a
civil case, with respect to the assault or battery; (6) violations
of the Internal Revenue Code, Treasury Regulations, or policies of
the IRS (including the Internal Revenue Manual) for the purpose of
retaliating or harassing a taxpayer or other IRS employee;
(7) willful misuse of section 6103 for the purpose of concealing
data from a Congressional inquiry; (8) willful failure to file any
tax return required under the Code on or before the due date
(including extensions) unless failure is due to reasonable cause;
(9) willful understatement of Federal tax liability, unless such
understatement is due to reasonable cause; and (10) threatening
to audit a taxpayer for the purpose of extracting personal gain
or benefit.
Section 1203 also provides non-delegable authority to the
Commissioner to determine that mitigating factors exist, that, in
the Commissioner's sole discretion, mitigate against terminating
the employee. The Commissioner, in his sole discretion, may
establish a procedure to determine whether an individual should be
referred for such a determination by the Commissioner.
Description of Proposal
The proposal removes the following from the list of violations
requiring termination: (1) the late filing of refund returns; and
(2) employee versus employee acts. The proposal also adds
unauthorized inspection of returns and return information to the
list of violations. Additionally, the proposal requires the
Commissioner to establish guidelines outlining specific penalties,
up to and including termination, for specific types of wrongful
conduct covered by section 1203 of the IRS Restructuring and Reform
Act of 1998. The Commissioner retains the non-delegable authority
to determine whether mitigating factors support a personnel action
other than that specified in the guidelines for a covered
violation.
Effective date.--The proposal is effective on the date of enactment.
Analysis
Policy issues
Late filing of refund returns
The proposal has the effect of treating IRS employees more like
individuals employed by any other employer, with respect to late
filing of refund returns. Late filing generally is not grounds
for termination by most employers. In addition, late filing of
refund return is generally not subject to penalty under the Code.
Proponents of the proposal relating to late filings may argue that
late filings of refund return is not the type of serious conduct
for which the severe penalties imposed by the IRS Restructuring
and Reform Act should apply. Others may argue that IRS employees,
as the enforcers of the country's tax laws, should be held to a
higher standard and be required to timely file all income tax
returns.
Employee vs. employee allegation
Advocates of removing employee versus employee conduct from the list
of grounds for IRS employee termination may argue that allegations
of willful conduct by IRS employees against other IRS employees can
be addressed by existing administrative and statutory procedures.
Other means, such as the Whistleblower Protection Act, negotiated
grievance processes, and civil rights laws, exist to address
employee complaints and appeals. Moreover, it is argued that under
present-law rules, parallel investigative and adjudicative
functions for addressing employee complaints and appeals are
confusing to employees and burdensome for the IRS.
Proponents also believe that it is appropriate to remove employee
versus employee conduct from the list of section 1203 violations
because, unlike other section 1203 violations, such conduct does
not violate taxpayer protections. On the other hand, opponents may
point out that Congress believed it appropriate to include such
conduct in the statutory list of grounds for IRS employee
termination. They may argue that including employee versus
employee conduct in the section 1203 violation list benefits tax
administration. Another issue to consider is the extent to which
the inclusion of employee versus employee conduct on the list of
section 1203 violations deters inappropriate behavior (by reducing
the likelihood of real employee versus employee actions) or
increases inappropriate behavior (by increasing the number of
allegations of inappropriate behavior against other employees for
purposes of intimidation, harassment, or retribution).
Unauthorized inspection of returns
Advocates of the proposal argue that unauthorized inspection of tax
returns and return information is a serious act of misconduct that
should be included in the list of violations subject to termination,
as unauthorized inspection is as serious as the other taxpayer
______________________
/406/ The refund claim must be filed prior to the expiration of the
applicable statue of limitation for the taxpayer to receive the
refund.
rights protections covered by section 1203. Code section 7213A
already makes the unauthorized inspection of returns and return
information illegal, with violations punishable by fine,
imprisonment, and discharge from employment. Even though
unauthorized inspection is punishable under a separate law, it is
argued that extending section 1203 coverage to unauthorized
inspection will strengthen the IRS' power to discipline without
the penalty being overturned.
On the other hand, opponents of this part of the proposal may point
out that most violations of Code section 7213A are not prosecuted,
but employees are subject to discipline based on administrative
determination. The IRS policy has been to propose termination of
employment in cases of unauthorized inspection, but in a number of
recent cases, arbitrators and the Merit Systems Protection Board
have overturned the IRS' determination to terminate employees for
such violations.
Advocates may also argue that adding unauthorized inspection of
returns to the list of section 1203 violations will prevent
overturning of the IRS' determination of the level of appropriate
employee punishment. Some might question whether it is appropriate
to use an internal administrative process to achieve a result that
the IRS states that it has been unable to achieve through judicial
or external administrative processes. In addition, adding
unauthorized inspection of returns to the list of section 1203
violations could add to the fear of IRS employees that they will be
subject to unfounded allegations and lose their jobs as a result,
which might deter fair enforcement of the tax laws.
The position taken by the IRS with respect to this part of the
proposal can be criticized as inconsistent with its position on the
employee versus employee allegations piece of the proposal.
The IRS argues that employee versus employee conduct should be
removed from the list of section 1203 violations because such
conduct can be addressed by existing administrative and statutory
procedures, while at the same time argues that unauthorized
inspection of returns should be added to the list of violations
even though it is punishable under a separate law. Some might view
these positions as inconsistent.
While the proposal makes unauthorized inspection (which is a
misdemeanor) a section 1203 violation, it does not make
unauthorized disclosure (which is a felony under Code section
7213) a section 1203 violation. Arguably, more damage can be done
by disclosing sensitive tax information to a third party than by
looking at a return out of curiosity. Thus, the proposal can be
criticized as lacking the proper focus.
Penalty guidelines
Some are concerned that the IRS' ability to administer the tax
laws efficiently is hampered by a fear among employees that they
will be subject to false allegations and possibly lose their jobs.
Proponents of the proposal requiring the IRS to publish detailed
guidelines argue that these guidelines are needed to provide notice
to IRS employees of the most likely punishment that will result from
specific violations. They believe that the certainty provided by
specific guidelines would improve IRS employee morale and enhance
the fundamental fairness of the statute.
Others argue that since Congress intended for the section 1203
violations to warrant termination, it is not appropriate to allow
the IRS to determine a lesser level of punishment.
Additionally, they argue that the claim that penalty guidelines are
necessary is inconsistent with the proposal to remove from the list
the two violations that are said to most often warrant punishment
other than that required under section 1203 (late filed refund
returns and employee versus employee allegations).
Complexity issues
The proposal has elements that may both increase and decrease
complexity. The IRS must review and investigate every allegation
of a section 1203 violation. Removing late filing of refund
returns and employee versus employee conduct from the list of
section 1203 violations may make it easier for the IRS to
administer section 1203, as there would be fewer types of
allegations that would require section 1203 review and
investigation. Similarly, adding unauthorized inspection of returns
to the list of violations may complicate IRS administration, as
there would likely be an increase in the number of 1203 violations
requiring IRS review and investigation. Additionally, because
unauthorized inspection of returns violations under Code section
7213A are currently subject to discipline based on administrative
determination by the IRS, adding such violations to the list of
section 1203 violations would require the IRS to change current
practice and follow section 1203 procedures instead.
Additional penalty guidelines may also either increase or decrease
complexity. Additional guidelines may increase complexity by
creating more rules for the IRS to establish and follow. The
guidelines would also have to be periodically updated to ensure
that punishments for specific violations continue to be
appropriate. On the other hand, additional penalty guidelines may
decrease complexity by providing clarity as to specific punishments
for specific employee violations, which may enhance the IRS'
effectiveness in administering section 1203.
Prior Action
An identical proposal was included in the President's fiscal year
2003, 2004, and 2005 budget proposals. An identical proposal
was contained in the "Taxpayer Protection and IRS Accountability Act
of 2003," as passed by the House of Representatives on June 19,
2003. A substantially similar proposal was contained in the "Tax
Administration Good Government Act of 2004," as passed by the Senate
on May 19, 2004.
__________________
/407/ The original provisions were enacted in the IRS Restructuring
and Reform Act of
2. Modifications with respect to frivolous returns and submissions
Present Law
The Code provides that an individual who files a frivolous income
tax return is subject to a penalty of $500 imposed by the IRS (sec.
6702). The Code also permits the Tax Court to impose a penalty
of up to $25,000 if a taxpayer has instituted or maintained
proceedings primarily for delay or if the taxpayer's position in
the proceeding is frivolous or groundless (sec. 6673(a)).
Description of Proposal
The proposal modifies this IRS-imposed penalty by increasing the
amount of the penalty to $5,000 for frivolous income tax returns.
The proposal also modifies present law with respect to certain
submissions that raise frivolous arguments or that are intended to
delay or impede tax administration. The submissions to which this
provision applies are: (1) requests for a collection due process
hearing; (2) installment agreements; and (3) offers-in-compromise.
First, the proposal permits the IRS to dismiss such requests.
Second, the proposal permits the IRS to impose a penalty of $5,000
for repeat behavior or failing to withdraw the request after being
given an opportunity to do so.
The proposal permits the IRS to maintain administrative records
of frivolous submissions by taxpayers. The proposal also requires
that this designation be removed after a reasonable period of time
if the taxpayer makes no further frivolous submissions to the IRS.
The proposal requires the IRS to publish (at least annually) a list
of positions, arguments, requests, and proposals determined to be
frivolous for purposes of these provisions.
Effective date.--The proposal is effective for submissions made on
or after the date of enactment.
___________________
/408/ Because the Tax Court is the only pre-payment forum available
to taxpayers, it handles the majority of cases brought by individuals
contesting their tax liability. As a result, it also deals with most
of the frivolous, groundless, or dilatory arguments raised in tax
cases.
/409/ It is unclear how this portion of the proposal is intended to
interact with the statutory prohibition on the designation of
taxpayers by the IRS as ``illegal tax protestors (or any similar
designation)'' (sec. 3707 of the Internal Revenue Service
Restructing and Reform Act of 1998; P.L. 105-206 (July 22, 1998)).
Analysis
In general
Genuinely frivolous returns and submissions are those that raise
arguments that have been repeatedly rejected by the courts.
Dealing with genuinely frivolous returns and submissions consumes
resources at the IRS and in the courts that can better be utilized
in resolving legitimate disputes with taxpayers. Accordingly, the
proposals may improve the overall functioning of the tax system and
improve the level of service provided to taxpayers who do not
raise these frivolous arguments.
Some may question why this IRS-imposed penalty should be applied
only to individuals instead of applying it to all taxpayers who
raise frivolous arguments. Expanding the scope of the penalty to
cover all taxpayers would treat similarly situated taxpayers who
raise identical arguments in the same manner, which would promote
fairness in the tax system. Similarly, some may question why this
penalty should apply only to income tax returns and not to all
other types of returns, such as employment tax and excise tax
returns. Applying this penalty to all taxpayers and all types of
tax returns would make this IRS-imposed penalty more parallel to
the Tax Court penalty, where these constraints do not apply.
Complexity issues
Increasing the amount of an existing penalty arguably would have no
impact on tax law complexity. It could be argued that the
procedural changes made by the proposal, taken as a whole, would
simplify tax administration by speeding the disposition of
frivolous submissions, despite the fact that some elements of the
proposals (such as the requirement to publish a list of frivolous
positions) may entail increased administrative burdens.
Prior Action
A substantially similar proposal was included in the President's
fiscal year 2003 budget proposal. A substantially similar
proposal was included in the President's fiscal year 2004 and
2005 budget proposals. A substantially similar proposal was
contained in the "Taxpayer Protection and IRS Accountability Act
of 2003," as passed by the House of Representatives on
June 19, 2003. A substantially similar proposal was contained in
the "Tax Administration Good Government Act of 2004," as passed
by the Senate on May 19, 2004.
______________________
/410/ The fiscal year 2003 budget proposal also applied to taxpayer
assistance orders and applied to all types of tax returns, not just
income tax returns.
/411/ The fiscal year 2004 and 2005 budget proposals applied to all
types of tax returns, not just income tax returns.
3. Termination of installment agreements
Present Law
The Code authorizes the IRS to enter into written agreements with
any taxpayer under which the taxpayer is allowed to pay taxes owed,
as well as interest and penalties, in installment payments, if the
IRS determines that doing so will facilitate collection of the
amounts owed (sec. 6159). An installment agreement does not reduce
the amount of taxes, interest, or penalties owed. Generally,
during the period installment payments are being made, other IRS
enforcement actions (such as levies or seizures) with respect to
the taxes included in that agreement are held in abeyance.
Under present law, the IRS is permitted to terminate an installment
agreement only if: (1) the taxpayer fails to pay an installment at
the time the payment is due; (2) the taxpayer fails to pay any
other tax liability at the time when such liability is due; (3) the
taxpayer fails to provide a financial condition update as required
by the IRS; (4) the taxpayer provides inadequate or incomplete
information when applying for an installment agreement; (5) there
has been a significant change in the financial condition of the
taxpayer; or (6) the collection of the tax is in jeopardy.
Description of Proposal
The proposal grants the IRS authority to terminate an installment
agreement when a taxpayer fails to timely make a required Federal
tax deposit or fails to timely file a tax return (including
extensions). The termination could occur even if the taxpayer
remained current with payments under the installment agreement.
Effective date.--The proposal is effective for failures occurring
on or after the date of enactment.
Analysis
The proposal may lead to some additional complexity in the
administration of installment agreements. For example, taxpayers
might not understand why their installment agreement is being
terminated, leading to additional phone calls to the IRS.
In addition, the proposal would require that additional explanatory
information be provided to taxpayers, which will increase
complexity. It might be possible to reduce this increase in
complexity by implementing these termination procedures in a manner
as parallel as possible to the similar termination procedures
________________
/412/ Sec. 6159(b).
/413/ Failure to timely make a required Federal tax deposit is not
considered to be a failure to pay any other tax liability at the
time such liability is due under section 6159(b)(4)(B) because
liability for tax generally does not accrue until the end of the
taxable period, and deposits are required to be made prior to that
date (sec. 6302).
for offers in compromise. It may also be beneficial to permit
the reinstatement of terminated installment agreements for
reasonable cause, parallel to the procedures applicable to offers
in compromise.
The proposal reflects the policy determination that taxpayers who
are permitted to pay their tax obligations through an installment
agreement should also be required to remain current with their other
Federal tax obligations. Some might be concerned that this does not
take into account the benefits of making continued installment
payments. A key benefit to the government of continued installment
payments is that the government continues to receive payments,
whereas if the installment agreement is terminated payments under
that agreement stop. Some might note that termination of the
installment agreement permits the IRS to begin immediate collection
actions, such as reinstating liens and levies, which could increase
government receipts. In the past several years, however, there
has been a significant decline in IRS' enforced collection
activities, so that others might respond that terminating
installment agreements might not lead to increased receipts to the
government, in that the cessation of receipts due to termination of
installment agreements may outweigh increases in receipts through
additional enforcement activities.
The proposal is effective for failures occurring on or after the
date of enactment. Some may question whether it is fair to
taxpayers who are currently in an installment agreement to terminate
those agreements.
Prior Action
An identical proposal was included in the President's fiscal year
2003, 2004, and 2005 budget proposals. An identical proposal was
contained in the "Tax Administration Good Government Act of 2004,"
as passed by the Senate on May 19, 2004.
4. Consolidate review of collection due process cases in the Tax
Court
Present Law
In general, the IRS is required to notify taxpayers that they have
a right to a fair and impartial hearing before levy may be made on
any property or right to property (sec. 6330(a)). Similar rules
apply with respect to liens (sec. 6320). The hearing is held by
an impartial officer from the IRS Office of Appeals, who is
required to issue a determination with respect to the issues raised
by the taxpayer at the hearing. The taxpayer is entitled to appeal
that determination to a court. That appeal must be brought to the
United States Tax Court, unless the Tax Court does not have
jurisdiction over the underlying tax liability. If that is the
case, then the appeal must be brought in the district court of the
United States (sec. 6330(d)). Special rules apply if the taxpayer
files the appeal in the incorrect court.
The United States Tax Court is established under Article I of the
United States Constitution and is a court of limited jurisdiction.
__________________
/414/ Sec. 7441
Description of Proposal
The proposal consolidates all judicial review of these collection
due process determinations in the United States Tax Court.
Effective date.--The proposal applies to IRS Office of Appeals
determinations made after the date of enactment.
Analysis
Because the Tax Court is a court of limited jurisdiction, it does
not have jurisdiction over all of the taxes (such as, for example,
most excise taxes) that could be at issue in collection due process
cases. The judicial appeals structure of present law was designed
in recognition of these jurisdictional limitations; all appeals
must be brought in the Tax Court unless that court does not
have jurisdiction over the underlying tax liability. Accordingly,
the proposal would give the Tax Court jurisdiction over issues
arising from a collection due process hearing, while the Tax Court
will not have jurisdiction over an identical issue arising in a
different context.
The proposal would provide simplification benefits to taxpayers and
to the IRS by requiring that all appeals be brought in the Tax
Court, because doing so will eliminate confusion over which court
is the proper venue for an appeal and will significantly reduce the
period of time before judicial review.
Some believe that present law "entitles a taxpayer patently seeking
delay to achieve his goal by refiling in the District Court."
The proposal would provide simplification benefits by eliminating
this opportunity for delay.
Prior Action
A substantially similar proposal was included in the President's
fiscal year 2003 and 2004 budget proposals. An identical proposal
was included in the President's fiscal year 2005 budget proposal.
An identical proposal was contained in the "Tax Administration
Good Government Act of 2004," as passed by the Senate on May 19, 2004
___________________
/415/ Sec. 7442
/416/ This reduction is attributable to the elimination of time
periods built into the judicial reveiw process to permit the refiling
of appeals that have been filed with the wrong court.
/417/ Nestor v. Commissioner, 118 T.C. No. 10 (February 19, 2002),
concurring opinion by Judge Beghe.
/418/ There was a slight difference in the effective dates of those
proposals.
The right to a hearing and judicial review of the determinations
made at these hearings were enacted in the IRS Restructuring and
Reform Act of 1998.
5. Office of Chief Counsel review of offers-in-compromise
Present Law
The IRS has the authority to settle a tax debt pursuant to an
offer-in-compromise. IRS regulations provide that such offers can
be accepted if the taxpayer is unable to pay the full amount of
the tax liability and it is doubtful that the tax, interest, and
penalties can be collected or there is doubt as to the validity of
the actual tax liability. Amounts of $50,000 or more can
only be accepted if the reasons for the acceptance are documented
in detail and supported by a written opinion from the IRS Chief
Counsel (sec. 7122).
Description of Proposal
The proposal repeals the requirement that an offer-in-compromise of
$50,000 or more must be supported by a written opinion from the
Office of Chief Counsel. The Secretary must establish standards
for determining when a written opinion is required with respect
to a compromise.
Effective date.--The proposal applies to offers-in-compromise
submitted or pending on or after the date of enactment.
Analysis
Repealing the requirement that an offer-in-compromise of $50,000 or
more be supported by a written opinion from the Office of Chief
Counsel will simplify the administration of the offer-in-compromise
provisions by the IRS. Repealing this requirement also would
increase the level of discretionary authority that the IRS may
exercise, which may lead to increasingly inconsistent results among
similarly situated taxpayers. Some may believe that Chief Counsel
review is appropriate for all offers-in-compromise above specified
dollar thresholds, similar to the review of large refund cases by
the Joint Committee on Taxation.
Prior Action
An identical proposal was included in the President's fiscal year
2003, 2004, and 2005 budget proposals. An identical proposal was
contained in the "Taxpayer Protection and IRS Accountability Act of
2003," as passed by the House of Representatives on June 19, 2003.
_____________________
/419/ Sec. 340(b) of P.L. 105-206 (July 22, 1998).
/420/ Sec. 6405. The threshold for Joint Committee review is
currently $2 million.
An identical proposal was contained in the "Tax Administration Good
Government Act of 2004," as passed by the Senate on May 19, 2004.
The $50,000 threshold was raised from $500 in 1996.
_________________
/421/ Sec. 503 of the Taxpayer Bill of Rights 2 (P.L. 104-168;
July 30, 1996).
B. Initiate Internal Revenue Service ("IRS") Cost Saving Measures
1. Allow the Financial Management Service to retain transaction
fees from levied amounts
Present Law
To facilitate the collection of tax, the IRS can generally levy
upon all property and rights to property of a taxpayer (sec. 6331).
With respect to specified types of recurring payments, the IRS may
impose a continuous levy of up to 15 percent of each payment, which
generally continues in effect until the liability is paid (sec.
6331(h)). Continuous levies imposed by the IRS on specified
Federal payments are administered by the Financial Management
Service (FMS) of the Department of the Treasury. FMS is generally
responsible for making most non-defense related Federal payments.
FMS is required to charge the IRS for the costs of developing
and operating this continuous levy program. The IRS pays these FMS
charges out of its appropriations.
Description of Proposal
The proposal allows FMS to retain a portion of the levied funds as
payment of these FMS fees. The amount credited to the taxpayer's
account would not, however, be reduced by this fee.
Effective date.--The provision is effective on the date of
enactment.
Analysis
Proponents believe that altering the bookkeeping structure of these
costs will provide for cost savings to the government.
Prior Action
An identical proposal was included in the President's fiscal year
2005 budget proposal. An identical proposal was contained in the
"Taxpayer Protection and IRS Accountability Act of 2003," as passed
by the House of Representatives on June 19, 2003. An identical
proposal was contained in the "Tax Administration Good Government
Act of 2004," as passed by the Senate on May 19, 2004.
2. Extend the due date for electronically-filed tax returns and
expand the authority to require electronic filing by large
businesses and exempt organizations
Present Law
Extend the due date for electronically filed tax returns
In general, individuals must file their income tax returns and pay
the full amount owed by April 15 (sec. 6072(a)). This deadline
applies regardless of the method the taxpayer may choose to submit
the tax return to the IRS. The Secretary may grant reasonable
extensions of time for filing returns, but in general the time for
paying tax may not be extended (sec. 6081(a)). Failure to file or
pay on a timely basis may subject the taxpayer to interest and
penalties.
Expand the authority to require electronic filing
The Code authorizes the IRS to issue regulations specifying which
returns must be filed electronically. There are several
limitations on this authority. First, it can only apply to persons
required to file at least 250 returns during the year. Second,
the IRS is prohibited from requiring that income tax returns of
individuals, estates, and trusts be submitted in any format other
than paper (although these returns may by choice be filed
electronically).
Description of Proposal
Extend the due date for electronically filed tax returns
The proposal extends the due date for filing and paying individual
income taxes to April 30 provided that the taxpayer files the
return electronically and pays the entire balance due electronically
by that date. The due date for filing by any other method or for
filing electronically but paying the balance due by non-electronic
means is not changed.
Effective date.--The proposal is effective for taxable years
beginning after December 31, 2005; these returns will be filed in
2007.
Expand the authority to require electronic filing
The proposal expands the authority of the IRS to require businesses
(including corporations, partnerships, and other business entities)
and exempt organizations to file their returns electronically.
The proposal statutorily lowers the number of returns that trigger
the requirement to file electronically from 250 to "a minimum at a
high enough level to avoid imposing an undue burden on taxpayers."
Taxpayers required to file electronically but who fail to do so
would be subject to a monetary penalty, which could be waived for
reasonable cause.
Effective date.--The proposal is effective for taxable years
beginning after December 31, 2005; these returns will be filed in
2007.
Analysis
Extend the due date for electronically filed tax returns
In general, the goal of the proposal is to reduce the administrative
burdens on the IRS by encouraging more taxpayers to file and pay
electronically. In particular, extending the date by which payment
must be made could provide encouragement to file electronically to a
significant number of filers of balance due returns, some of which
__________________________
/422/ Sec. 6011(c).
/423/ Partnerships with more than 100 partners are required to file
electronically.
/424/ Treasury General Explanations, p.131.
are very complex. The proposal is, however, unlikely to cause a
substantial increase in electronic filing for returns due a refund
(which already constitute the vast majority of electronically filed
returns) because one of the primary reasons those taxpayers
file electronically is to receive their refunds more rapidly; a
further extension of time to file contravenes that reason. The
proposal would also reduce the administrative burdens on individual
taxpayers to the extent that they prepare the tax return
electronically but file a paper return by encouraging those
individuals to file their returns electronically. The proposal
could, in addition, encourage return preparers to file
electronically, in that it will give the preparers additional time
to prepare the returns.
Taxpayers must both file and pay electronically in order to receive
the benefit of the proposed extension of time. There are currently
three electronic mechanisms for paying the balance due with the
return: (1) credit card; (2) electronic funds withdrawal; or (3)
the Electronic Federal Tax Payment System (EFTPS). Credit card
providers charge a convenience fee in addition to the amount of
tax due, which may deter some individuals from paying the balance
due electronically by credit card.
Another factor that may deter significant numbers of individuals
from availing themselves of the extended Federal due date is
whether States and local governments that impose income taxes
provide parallel extensions of time to file. If they do not, and
if the State or local income tax requires completion of the Federal
return first (which many but not all do), taxpayers in those
jurisdictions may not be able to avail themselves of the extended
due date for Federal returns.
Although the proposal may in many instances reduce administrative
burdens, having two different Federal filing deadlines could be
considered to increase complexity. It would, for example, require
explaining two filing deadlines, which is likely to be more complex
than explaining one. Another factor that could affect complexity
is whether all tax forms (or only some tax forms) will be eligible
for electronic filing by the time the proposal becomes effective.
__________________
/425/ As an alternative, taxpayers could increase their wage
withholding or estimated tax payments so as not to have a balance
due with the return.
/426/ This permits the IRS to withdraw the amount owed from the
taxpayer's bank account electronically, it is not offered as an
option when a paper return is filed. Taxpayers who file on paper
are told in the instructions that they may pay by check or credit
card; they are not told of the option to paying via EFTPS.
/427/ This system, now used almost entirely by business taxpayers
(principally to deposit payroll taxes), also accommodates
individuals paying a balance due on their individual income tax
returns or making estimated tax payments.
/428/ The fee generally amounts to several percent of the total
amount of taxes charged.
For the current tax filing season, many (but not all) tax forms are
eligible for electronic filing. If some forms cannot be filed
electronically, taxpayers required to file those forms will be
ineligible for this extension of time to file and pay. This could
mean that taxpayers with especially complicated returns will be
ineligible for this extension. If taxpayers are unaware in advance
of their ineligibility to file electronically, ineligible taxpayers
(erroneously believing they were eligible) might delay the filing
of their returns until after April 15 intending to take advantage of
this extension of time, then discover they are in fact ineligible
and consequently inadvertently file late returns (owing interest
and penalties).
Expand the authority to require electronic filing
The Congress set a goal for the IRS to have 80 percent of tax
returns filed electronically by 2007. The overwhelming majority
of tax returns are already prepared electronically. Thus, expanding
the scope of returns that are required to be filed electronically
may be viewed as both helping the IRS to meet the 80 percent goal
set by the Congress and improving tax administration.
Prior Action
Extend the due date for electronically filed tax returns
A similar proposal was included in the President's fiscal year 2003
budget proposal. An identical proposal was included in the
President's fiscal year 2004 and 2005 budget proposals. A similar
proposal was contained in the "Taxpayer Protection and IRS
Accountability Act of 2003," as passed by the House of
Representatives on June 19, 2003.
Expand the authority to require electronic filing
A similar proposal was contained in the "Tax Administration Good
Government Act of 2004," as passed by the Senate on May 19, 2004.
__________________
/429/ See IRS Publication 1345A, Filing Season Supplement for
Authorized IRS E-File Providers, pp. 20-1 (December 2004).
C. Other Provisions
1. Allow Internal Revenue Service ("IRS") to access information in
the National Directory of New Hires ("NDNH")
Present Law
The Office of Child Support Enforcement of the Department of Health
and Human Services ("HHS") maintains the National Directory of New
Hires (NDNH), which is a database that contains: newly-hired
employee data from Form W-4; quarterly wage data from state and
federal employment security agencies; and unemployment benefit data
from state unemployment insurance agencies. The NDNH was created to
help state child support enforcement agencies enforce obligations of
parents across state lines.
Under current provisions of the Social Security Act, the IRS may
obtain data from the NDNH, but only for the purpose of administering
the Earned Income Tax Credit (EIC) and verifying a taxpayer's
employment that is reported on a tax return.
Under various state laws, the IRS may negotiate for access to
employment and unemployment data directly from state agencies that
maintain these data. Generally, the IRS obtains employment and
unemployment data less frequently than quarterly, and there are
significant internal costs of preparing these data for use.
Description of Proposal
The proposal amends the Social Security Act to allow the IRS access
to NDNH data for general tax administration purposes, including
data matching, verification of taxpayer claims during return
processing, preparation of substitute returns for non-compliant
taxpayers, and identification of levy sources.
Effective date.--The proposal is effective upon enactment.
Analysis
The proposal could enhance tax administration by providing the IRS
with a more efficient method to obtain taxpayer data. Obtaining
taxpayer data from a centralized source such as the NDNH, rather
than from separate State agencies, should increase the productivity
of the IRS by reducing the amount of IRS resources dedicated to
obtaining and processing such data. Some may argue that allowing
the IRS to access the NDNH for general tax administration purposes
infringes on individual privacy and extends the use of the database
beyond that which was originally intended; to enable state child
support enforcement agencies to be more effective in locating
noncustodial parents. On the other hand, data obtained by the IRS
from the NDNH is protected by existing disclosure law. Thus,
the proposal does not reduce the current levels of taxpayer privacy.
Prior Action
No prior action
2. Extension of authority for undercover operations
Present Law
IRS undercover operations are statutorily exempt from the
generally applicable restrictions controlling the use of Government
funds (which generally provide that all receipts must be deposited
in the general fund of the Treasury and all expenses be paid out of
appropriated funds). In general, the Code permits the IRS to
"churn" the income earned by an undercover operation to pay
additional expenses incurred in the undercover operation, through
2005. The IRS is required to conduct a detailed financial audit of
large undercover operations in which the IRS is churning funds and
to provide an annual audit report to the Congress on all such large
undercover operations.
Description of Proposal
The proposal extends this authority through December 31, 2010.
Analysis
Some believe the extension of this authority is appropriate because
they believe that it assists the fight against terrorism. Some also
believe that it is appropriate for IRS to have this authority
because other law enforcement agencies have churning authority.
Others, however, point to the four and a half year gap during which
the provision had lapsed as evidence that this authority is not
essential to the operation of the IRS. However, it is difficult to
show what investigative opportunities were lost due to the lack of
churning authority during that period.
Some believe that extension is inappropriate because the provision
may provide incentives to continue undercover operations for
extended periods of time. IRS data for fiscal years 2002,
2003, and 2004 reveal that a total of approximately $748,000 was
churned while only $6,700 was deposited in the general fund of
the Treasury due to the cessation of undercover operations.
Prior Action
The provision was originally enacted in The Anti-Drug Abuse Act of
1988. The exemption originally expired on December 31, 1989, and
was extended by the Comprehensive Crime Control Act of 1990 to
December 31, 1991. There followed a gap of approximately
four and a half years during which the provision had lapsed. In
the Taxpayer Bill of Rights II, the authority to churn funds from
undercover operations was extended for five years, through 2000.
The Community Renewal Tax Relief Act of 2000 extended the authority
of the IRS to "churn" the income earned from undercover operations
for an additional five years, through 2005.
_____________________
/431/ Sec. 7601(c) of Pub. L. 100-690 (Nov. 18, 1988).
/432/ Sec. 3301 of Pub. L. 101-647 (Nov. 29, 1990) .
/433/ The Ways and Means Committee Report stated: ``The committee
believes that it is appropriate to extend this provision for two
additional years, to provide additional time to evalute its
effectiveness.'' Rept. 101-681, Part 2, p.5 (September 10, 1990).
/434/ Sec. 1205 of Pub. L. 104-168 (July 30, 1996).
/435/ The Ways and Means Committee Report stated: ``Many other law
enforcement agencies have churning authority. It is appropriate for
IRS to have this authority as well.'' Rept. 104-506, p.47 (March 28,
1996). The Senate passed the House bill without alteration.
/436/ Pub. L. 106-554.
D. Strengthen the Financial Integrity of Unemployment Insurance
Present Law
The Federal Unemployment Tax Act ("FUTA") imposes a 6.2-percent
gross tax rate on the first $7,000 paid annually by covered
employers to each employee. Employers in States with programs
approved by the Federal Government and with no delinquent Federal
loans may credit 5.4 percentage points against the 6.2 percent tax
rate, making the net Federal unemployment tax rate 0.8 percent.
Because all States have approved programs, 0.8 percent is the
Federal tax rate that generally applies. The net Federal
unemployment tax revenue finances the administration of the
unemployment system, half of the Federal-State extended benefits
program, and a Federal account for State loans. Also, additional
distributions ("Reed Act distributions") may be made to the States,
if the balance of the Federal unemployment trust funds exceeds
certain statutory ceilings. The States use Reed Act distributions
to finance their regular State programs (which are mainly funded
with State unemployment taxes) and the other half of the
Federal-State extended benefits program.
State Unemployment Insurance taxes are deposited into the State's
Federal Unemployment Insurance Trust Fund and are used by the state
to pay unemployment benefits. State recoveries of overpayments of
Unemployment Insurance benefits must be similarly deposited and
used exclusively to pay unemployment benefits. While States may
enact penalties for overpayments, amounts collected as penalties or
interest on benefit overpayments may be treated as general receipts
by the States.
Under present law, all States operate experience rating systems.
Under these systems an employer's State unemployment tax rate is
based on the amount of unemployment benefits paid to the employer's
former employees. Generally, the more unemployment benefits paid to
former employees, the higher the State unemployment tax rates.
Description of Proposal
The proposal provides States with an incentive to recover
unemployment benefit overpayments, and delinquent employer taxes.
The proposal allows States to redirect up to five percent of
overpayment recoveries to additional enforcement activity. The
proposal requires States to impose a 15 percent penalty on
recipients of fraudulent overpayments; the penalty would be used
exclusively for additional enforcement activity.
Under the proposal, States also are required to take overpayments
resulting from employer fault into account for purposes of the
employer's experience rating account, even if the overpayment is
later recovered. In certain circumstances relating to fraudulent
overpayments or delinquent employer taxes, States are permitted to
employ private collection agencies to retain a portion of such
overpayments or delinquent taxes collected.
Finally, the proposal provides that the Secretary of the Treasury,
upon request of a State, will reduce any income tax refund owed to
a benefit recipient when that recipient owes a benefit
overpayment to the requesting State.
Effective date.--The proposal is effective on January 1, 2006.
Analysis
States' abilities to reduce unemployment benefit overpayments and
increase overpayment recoveries are limited by funding. In
addition, the present-law requirement that States redeposit
recoveries of overpayments to the Federal Unemployment Insurance
Trust Fund creates a disincentive for States to increase enforcement
activity. Permitting States to redirect five percent of overpayment
recoveries to additional enforcement activity provides States with
additional resources to detect and recover overpayments. The
proposal also deters noncompliance by imposing a 15 percent penalty
on fraudulent overpayments and provides States additional resources
by requiring penalty proceeds to be used exclusively for enforcement
activity.
However, the proposal does not provide a definition of what will be
considered fraudulent. The lack of a uniform definition of a
fraudulent overpayment may result in disparate treatment of
individuals in different States. In addition, there is a question
as to whether the Federal government can ensure that amounts
redirected from the Federal Unemployment Insurance Trust Fund are
used exclusively for enforcement purposes.
The proposal also requires States to take overpayments resulting
from employer fault into account for purposes of the employer's
experience rating, even if the overpayment is later recovered.
Proponents may argue this will decrease overpayments resulting
from employer error. In addition, for employers with high error
rates, the proposal ensures that the employer's State unemployment
taxes are set at a level commensurate with the amount of
unemployment benefits expected to be paid to the former employees
of that employer. On the other hand, the proposal does not provide
a definition of what will be considered employer fault. Without
providing the States criteria for making this determination, there
are issues regarding the administrability of such a standard.
The proposal permitting States to employ private collection agencies
to retain a portion of certain fraudulent overpayments or delinquent
employer taxes collected may permit States to more efficiently
allocate resources to enforcement activities. The proposal does
not, however, describe the circumstances when private collection
agencies will be allowed to retain a portion of taxes collected and
some may question whether it is appropriate to compensate such
agencies based on the success in collecting taxes that are due.
There are administrability issues regarding the proposal requiring
the Secretary to reduce any income tax refund owed to an
unemployment benefit recipient when that recipient owes a
overpayment to a State requesting offset. Present law provides
States a limited right of offset with respect to legally
enforceable State income tax obligations. Present law also
establishes the priority of State income tax obligations relative
to other liabilities. The proposal neither defines
how the IRS will determine whether unemployment overpayments are
legally owed to a State nor describes the relative priority of
such offsets. Clarification of these elements is necessary to
implement the proposal. Finally, some may question whether it
is appropriate to provide States an offset right in non-income
tax cases, thus, expanding the circumstances in which the Federal
government acts a collection agent for the States.
Prior Action
No prior action
VII. REAUTHORIZE FUNDING FOR THE HIGHWAY TRUST FUND
A. Extend Excise Taxes Deposited in the Highway Trust Fund
Present Law
In general
Six separate excise taxes are imposed to finance the Federal
Highway Trust Fund program. Three of these taxes are imposed on
highway motor fuels. The remaining three are a retail sales tax on
heavy highway vehicles, a manufacturers' excise tax on heavy vehicle
tires, and an annual use tax on heavy vehicles. The six taxes are
summarized below.
Highway motor fuels taxes
The Highway Trust Fund motor fuels tax rates are as follows:
Gasoline 18.3 cents per gallon
Diesel fuel and kerosene 24.3 cents per gallon
Special motor fuels 18.3 cents per gallon generally
____________________
/437/ Secs. 4081(a)(2)(A)(i), 4081(a)(2)(A)(iii), 4041(a)(3), and
4041(m).
/438/ The statutory rate of certain special motor fuels is determined
on an energy equivalent basis, as follows:
[Graphics not Available in Tiff Format]
See secs. 4041(a)(2), 4041(a)(3) and 4041(m).
The compressed natural gas tax rate is eqivalent only to 4.3 cents
per gallon of the rate imposed on gasoline and other special motor
fuels rather than the full 18.3--cents-per-gallon rate. The tax
rate for the other special motor fuels is equivalent to the full
18.3-cents-per-gallon gasoline and special motor fules tax rate.
Except for 4.3 cents per gallon of the Highway Trust Fund fuels tax
Some of these fuels also are subject to an additional
Except for 4.3 cents per gallon of the Highway Trust Fund fuels tax
rates, and a portion of the tax on certain special motor fuels, all
of these taxes are scheduled to expire after September 30, 2005.
The 4.3-cents-per-gallon portion of the fuels tax rates is
permanent.
Non-fuel Highway Trust Fund excise taxes
In addition to the highway motor fuels excise tax revenues, the
Highway Trust Fund receives revenues produced by three excise taxes
imposed exclusively on heavy highway vehicles or tires. These
taxes are:
A 12-percent excise tax imposed on the first retail sale of
heavy highway vehicles, tractors, and trailers (generally,
trucks having a gross vehicle weight in excess of 33,000 pounds
and trailers having such a weight in excess of 26,000 pounds)
(sec. 4051);
An excise tax imposed on highway tires with a rated load
capacity exceeding 3,500 pounds, generally at a rate of 9.45
cents per 10 pounds of excess (sec. 4071(a)); and
An annual use tax imposed on highway vehicles having a taxable
gross weight of 55,000 pounds or more (sec. 4481). (The
maximum rate for this tax is $550 per year, imposed on vehicles
having a taxable gross weight over 75,000 pounds.) The taxes on
heavy highway vehicles and tires are scheduled to expire on
September 30, 2005. The use tax applies only to uses before
October 1, 2005.
Description of Proposal
The proposal would extend the motor fuel taxes and all three
non-fuel excise taxes at their current rates through September 30,
2011.
Analysis
The President's FY06 Budget has proposed a spending level of $283.9
billion for the Highway Trust Fund reauthorization period FY 2004
through 2009. Ninety percent of Highway Trust Fund revenue comes
from the motor fuel taxes. An extension of the current taxes
dedicated to the Highway Trust Fund would continue to provide a
significant funding source for highway programs.
The current mix of Highway Trust fund taxes reflects an attempt to
assign tax burdens in relation to assumed damage to the highways done
by the various industry segments. However, some may argue that the
current rates do not reflect a proportionate cost allocation.
As an example, in 2002, the Government Accountability Office noted
a Federal Highway Administration report that heavy trucks (weighing
over 55,000 pounds) cause a disproportionate amount of damage to
the nation's highways and, because the use tax is capped at $550,
such trucks have not paid a corresponding share for the cost of
the pavement damage they cause.
In addition, some might argue that the non-fuel taxes supporting
the Highway Trust Fund generate a relatively small amount of
revenue, but require the IRS to devote significant resources
to enforce. For example, the use tax subjects a large number
of taxpayers to the tax for relatively small amounts, which might
be viewed as an inefficient use of the IRS resources to enforce.
The 12-percent retail sales tax is imposed on the first retail
sale of the tractor, truck, or trailer. The term first retail sale
includes the first sale of a "remanufactured vehicle". Whether
modifications to a vehicle constitute a "repair" or the manufacture
of a new (remanufactured) vehicle involves significant factual
determinations and is the subject of frequent disputes between the
IRS and taxpayers. Thus, opponents of an extension may argue that
the highly factual determinations in the application of the truck
tax, and the large number of taxpayers subject to the use tax as
compared with the revenue generated from the tax, result in an
inefficient use of IRS resources in the enforcement of such taxes
and weigh against extension of these taxes. On the other hand, the
needs of the highway program continue to grow and since these
industry segments make significant use of the nations highways,
it is appropriate to continue to have these users contribute to
the maintenance and improvement of the highway system.
Prior Action
The Highway Trust Fund Taxes were last extended in 1998 as part
of the Transportation Equity Act for the 21st Century (TEA-21).
In the 108th Congress, H.R. 3550 (as passed by the House) would
have extended these taxes through September 30, 2011. H.R. 3550
(as amended and passed by the Senate) would have extended these
taxes through September 30, 2009.
B. Allow Tax-Exempt Financing for Private Highway Projects
and Rail-Truck Transfer Facilities
Present Law
Interest on bonds issued by States or local governments to finance
activities of those governmental units is excluded from tax
(sec. 103). In addition, interest on certain bonds ("private
activity bonds") issued by States or local governments acting as
conduits to provide financing for private businesses or
individuals is excluded from income if the purpose of the borrowing
is specifically approved in the Internal Revenue Code (sec. 141).
Approved private activities for which States or local governments
may provide tax-exempt financing include transportation facilities
such as airports, ports, mass commuting facilities, and certain
high-speed intercity rail facilities. High-speed intercity rail
facilities eligible for tax-exempt financing include land, rail,
and stations (but not rolling stock) for fixed guideway rail
transportation of passengers and their baggage using vehicles
that are reasonably expected to operate at speeds in excess of 150
miles per hour between scheduled stops.
Description of Proposal
Two new categories of exempt facility bonds would be authorized to
finance highway facilities and surface freight transfer facilities.
Issuance of the bonds would not be subject to the general private
activity bond volume cap, but rather would be subject to a separate
volume limitation of $15 billion in the aggregate. The Secretary
of Transportation would allocate the $15 billion of authority among
eligible projects.
Highway facilities eligible for financing under the program would
consist of any surface transportation project eligible for Federal
assistance under Title 23 of the United States Code, or any project
for an international bridge or tunnel for which an international
entity authorized under Federal or State law is responsible.
Surface freight transfer facilities would consist of facilities for
the transfer of freight from truck to rail or rail to truck,
including any temporary storage facilities directly related to
those transfers. Examples of eligible surface freight transfer
facilities would include cranes, loading docks and
computer-controlled equipment that are integral to such freight
transfers. Examples of non-qualifying facilities would include
lodging, retail, industrial or manufacturing facilities.
Effective date--The proposal is effective for bonds issued after
date of enactment.
Analysis
Surface freight transfer facilities
Present law provides that private activity bonds may be issued for
dock facilities and airport facilities. Dock and airport facilities
eligible for private activity bonds include cranes and equipment
integral to the loading and unloading of ships and planes and
enabling the transfer of that cargo to other modes of transport.
The proposal generally would treat rail and truck cargo exchanges
comparably to ship to truck or rail exchanges.
Improved cargo transfers improve cargo delivery and reduce
transportation costs, creating benefits for all consumers. The
providers of truck and rail transportation services are
private businesses. Generally, if there are cost-reducing
efficiencies that can be achieved, a profit opportunity is created
and private businesses will make investments to achieve these
efficiencies. For example, private railroads invest in facilities
and equipment to facilitate the transfer of freight from truck to
rail and back to truck to provide so-called "piggyback" service.
If the necessary investment to achieve a given level of cost
reduction is too great for private business to achieve a reasonable
rate of return on investment, the investment usually is not in the
public's interest as the benefit to the consuming public is
insufficient to justify the investment.
However, some observe that current freight handling facilities may
promote the consumption of additional fuels and result in pollution,
imposing costs not borne directly by consumers in the price of
delivered goods. A reduction in pollution may justify subsidies
to the investment in freight handling facilities beyond that which
would be provided by private business in the absence of such subsidies.
The ability to finance capital and operating costs with tax-exempt
bonds may substantially reduce the cost of debt finance. To
illustrate, assume the interest rate on taxable debt is 10 percent.
If an investor in the 35 percent marginal income tax bracket
purchased a taxable debt instrument, his after tax rate of return
would be the 10 percent interest less a tax of 35 percent on the
interest received for a net return of 6.5 percent. If as an
alternative this investor could purchase a tax-exempt bond, all
other things such as credit worthiness being equal, he would earn a
better after tax return by accepting any tax-exempt yield greater
than 6.5 percent. In the market, the yield spread between a
tax-exempt bond and comparable taxable bond is determined by the
marginal buyer of the bonds; in today's market, yield spreads are
generally less than 20 percent. Because the yield spread arises
from forgone tax revenue, economists say that tax-exempt finance
creates an implicit subsidy to the issuer. However, with many
investors in different tax brackets, the loss of Federal receipts is
________________________
/442/ More generally, if trhe investor's marginal tax rate is t and
the taxable bond yields r, the investor is indifferent between a
tax-exempt yield, r, and (l-t)r.
/443/ For example, while not comparable in security, market trading
recently has priced 30-year U.S. Treasuries (due in 26 years) to
have a yield to maturity of approximately 4.68 percent. Prices for
an index of long-term tax-exempt bonds have produced a yield to
maturity of approximately 4.35 percent. See The Bond Buyer,
February 23, 2005. Again ignoring differences in risk or other
non-tax characterictics of the securities, the yield spread implies
that an investor with a marginal tax rate of approximately 7 percents
would be indifferent between the Treasury bond and the average
high-quality quality tax-exempt bond. Thus, under preent market
conditions, yield spreads on long-term bonds are so narrow that
almost all taxpayers investing in those instruments should prefer
tax-exempt bonds. Viewed another way, almost the entire Federal
subsidy to these bonds geos to bondholders (rather than State of
local government issuers, or the private persons repaying the debt
in the case of private activity bonds) under these market conditions.
greater than the reduction in the tax-exempt issuers' interest
saving. The difference accrues to investors in tax brackets
higher than those that would be implied by the yield spread between
taxable and tax exempt bonds.
International bridges and tunnels
The proposal permits private activity bonds to be issued for
international bridges or tunnels for which an international entity
authorized under Federal or State law is responsible. Proponents of
the proposal might argue that a private entity might be able to
more effectively and efficiently manage such structures. In
addition, having a private entity own the structure may provide
additional capital for maintenance and upkeep. On the other hand,
opponents might argue that the benefit from such international
projects does not justify the decrease in Federal revenues that
would result from the proposal.
Prior Action
On February 12, 2004, the Senate passed a similar proposal as part
of S. 1072, the "Safe, Accountable, Flexible and Efficient
Transportation Equity Act of 2004."
_____________________
/444/ The Federal income tax has graduated marginal tax rates. Thus,
$100 of interest income forgone to taxpayer in the 33-percent bracket
costs Federal Government $33, while the same amount of interest income
forgone to a taxpayer in the 25-percent bracket costs the Federal
Government $25. If a taxpayer in the 25-percent bracket finds at
profitable to hold a tax-exempt security, a taxpayer in the
33-percent bracket will find it even more profitable. This
conclusion implies that the Federal Government will lose more in
revenue than the tax-exempt issuer gains in reduced interest
payments.
VIII. EXPIRING PROVISIONS
A. Permanently Extend the Research and Experimentation
("R&E") Tax Credit
Present Law
General rule
Section 41 provides for a research tax credit equal to 20 percent
of the amount by which a taxpayer's qualified research expenses for
a taxable year exceed its base amount for that year. The research
tax credit is scheduled to expire and generally will not apply to
amounts paid or incurred after December 31, 2005.
_____________________
/445/ The research tax credit initially was enacted to the Economic
Recovery Tax Act of 1981 as credit equal to 25 percent of the excess
of qualified research expenses incurred in the current taxable year
over the average of qualified research expenses incurred in the prior
three taxable years. The research tax credit was modified in the
Tax Reform Act of 1986, which (1) extended the credit through
December 31, 1988, (2) reduced the credit rate to 20 percent,
(3) tightened the definition of qualified resarch expenses eligible
for the credit, and (4) enacted the separate university basic
research credit.
The Technical and Miscellaneous Revenue Act of 1988 (``1988 Act'')
extended the research tax credit for one additional year, through
December 31, 1989. The 1988 Act also reduced the deduction allowed
under section 174 (or any other section) for qualified research
expenses by an amount equal to 50 percent of the research tax credit
determined for the year.
The Omnibus Budget Reconciliation Act of 1989 (``1989 Act'') extended
the research tax credit for one additional year, through December 31,
1989. The 1988 ASct also reduced the deduction allowed under section
174 (or any other section) for qualified research expenses by an
amount equal to 100 percent of the research tax credit determined for
the year.
The Omnibus Budget Reconciliation Act of 1990 extended the research
tax credit through December 31, 1991 (and repealed the special rule
to prorate qualified expenses incurred before January 1, 1991).
The Tax Extension Act of 1991 extended the research tax credit for
six months (i.e., for qualified expenses incurred through June 30,
1992).
The Omnibus Budget Reconciliation Act of 1993 (``1993 Act'') extended
the research tax credit for three years--i.e., retroactively from
July 1, 1992 through June 30, 1995. The 1993 Act
A 20-percent research tax credit also applies to the excess of
(1) 100 percent of corporate cash expenses (including grants or
contributions) paid for basic research conducted by universities
(and certain nonprofit scientific research organizations) over
(2) the sum of (a) the greater of two minimum basic research floors
plus (b) an amount reflecting any decrease in nonresearch giving to
universities by the corporation as compared to such giving during
a fixed-base period, as adjusted for inflation. This separate
credit computation is commonly referred to as the university
basic research credit (see sec. 41(e)).
Computation of allowable credit
Except for certain university basic research payments made by
corporations, the research tax credit applies only to the extent
that the taxpayer's qualified research expenses for the current
taxable year exceed its base amount. The base amount for the
current yeargenerally is computed by multiplying the taxpayer's
fixed-base percentage by the average amount of the taxpayer's
gross receipts for the four preceding years. If a taxpayer
__________________
also provided a special rule for start-up firms, so that the
fixed-base ratio of such firms eventually will be computed by
reference to their actual research experience.
Although the research tax credit expired during the period July 1,
1995, through June 30 1996, the Small Business Job Protection Act
of 1996 (``1996 Act'') extended the credit for the period July 1,
1996, through May 31, 1997 (with a special 11-month extension for
taxpayers that elect to be subject to the alternative incremental
research credit regime). In addition, the 1996 Act expanded the
definition of start-up firms under section 41(b)(3)(C), and provided
that taxpayers may elect an alternative research credit regime
under which the taxpayer is assigned a three-tiered fixed-base
percentage that is lower than the fixed-base percentage otherwise
applicable and the credit rate likewise is reduced) for the
taxpayer's first taxable year beginning after June 30, 1996, and
before July 1, 1997.
The Taxpayer Relief Act of 1997 ("1997 Act") extended the research
credit for 13 months--i.e., generally for the period June 1, 1997,
through June 30, 1998. The 1997 Act also provided that taxpayers
are permitted to elect the alternative incremental research credit
regime for any taxable year beginning after June 30, 1996 (and
such election will apply to that taxable year and all subsequent
taxable years unless revoked with the consent of the Secretary of
the Treasury). The Tax and Trade Relief Extension Act of 1998
extended the research credit for 12 months, i.e., through June 30,
1999.
The Ticket to Work and Work Incentives Improvement Act of 1999
added poultry waste as a qualifying energy source, extended the
placed in service date through December 31, 2001, and made
certain modifications to the requirements of qualifying wind
facilities. The Job Creation and Worker Assistance Act of 2002
extended the placed in service date through December 31, 2003.
The Working Families Tax Relief Act of 2004 extended the generally
applicable placed in service date for wind facilities, closed-loop
biomass facilities, and poultry waste facilities through
December 31, 2005.
both incurred qualified research expenses and had gross receipts
during each of at least three years from 1984 through 1988, then
its fixed-base percentage is the ratio that its total qualified
research expenses for the 1984-1988 period bears to its total gross
receipts for that period (subject to a maximum fixed-base percentage
of 16 percent). All other taxpayers (so-called start-up firms) are
assigned a fixed-base percentage of three percent.
In computing the credit, a taxpayer's base amount may not be less
than 50 percent of its current-year qualified research expenses.
To prevent artificial increases in research expenditures by
shifting expenditures among commonly controlled or otherwise related
entities, a special aggregation rule provides that all members of
the same controlled group of corporations are treated as a single
taxpayer (sec. 41(f)(1)). Under regulations prescribed by the
Secretary, special rules apply for computing the credit when a major
portion of a trade or business (or unit thereof) changes hands,
under which qualified research expenses and gross receipts for
periods prior to the change of ownership of a trade or business are
treated as transferred with the trade or business that gave rise to
those expenses and receipts for purposes of recomputing a taxpayer's
fixed-base percentage (sec. 41(f)(3)).
Alternative incremental research credit regime
Taxpayers are allowed to elect an alternative incremental research
credit regime. If a taxpayer elects to be subject to this
alternative regime, the taxpayer is assigned a three-tiered
fixed-base percentage (that is lower than the fixed-base percentage
otherwise applicable under present law) and the credit rate
likewise is reduced. Under the alternative incremental credit
regime, a credit rate of 2.65 percent applies to the extent that a
taxpayer's current-year research expenses exceed a base amount
computed by using a fixed-base percentage of one percent (i.e.,
the base amount equals one percent of the taxpayer's average gross
receipts for the four preceding years) but do not exceed a base
__________________________
/446/ The Small Business Job Protection Act of 1996 expanded the
definition of start-up firms under section 41(c)(3)(B)(i) to include
any firm if the first taxable year in which such firm had both
gross receipts and qualified research expenses began after 1983.
A special rule (enacted in 1993) is designed to gradually recompute
a start-up firm's fixed-base percentage based on its actual research
experience. Under this special rule, a start-up firm will be
assigned a fixed-base percentage of three percent for each of its
first five taxable years after 1993 in which it incurs qualified
research expenses. In the event that the research credit is
extended beyond the scheduled expiration date, a start-up firm's
fixed-base percentage for its sixth through tenth taxable years
after 1993 in which it incurs qualified research expenses will be a
phased-in ratio based on its actual research experience. For all
subsequent taxable years, the taxpayer's fixed-base percentage will
be its actual ratio of qualified research expenses to gross
receipts for any five years selected by the taxpayer from its fifth
through tenth taxable years after 1993 (sec. 41(c)(3)(B)).
/447/ Sec. 41(c)(4).
amount computed by using a fixed-base percentage of 1.5 percent.
A credit rate of 3.2 percent applies to the extent that a taxpayer's
current-year research expenses exceed a base amount computed by
using a fixed-base percentage of 1.5 percent but do not exceed a
base amount computed by using a fixed-base percentage of two
percent. A credit rate of 3.75 percent applies to the extent that
a taxpayer's current-year research expenses exceed a base amount
computed by using a fixed-base percentage of two percent. An
election to be subject to this alternative incremental credit
regime may be made for any taxable year beginning after June 30,
1996, and such an election applies to that taxable year and all
subsequent years unless revoked with the consent of the Secretary
of the Treasury.
Eligible expenses
Qualified research expenses eligible for the research tax credit
consist of: (1) in-house expenses of the taxpayer for wages and
supplies attributable to qualified research; (2) certain
time-sharing costs for computer use in qualified research; and
(3) 65 percent of amounts paid or incurred by the taxpayer to
certain other persons for qualified research conducted on the
taxpayer's behalf (so-called contract research expenses).
To be eligible for the credit, the research must not only satisfy
the requirements of present-law section 174 (described below) but
must be undertaken for the purpose of discovering information that
is technological in nature, the application of which is intended to
be useful in the development of a new or improved business
component of the taxpayer, and substantially all of the activities
of which must constitute elements of a process of experimentation
for functional aspects, performance, reliability, or quality of a
business component. Research does not qualify for the credit if
substantially all of the activities relate to style, taste,
cosmetic, or seasonal design factors (sec. 41(d)(3)). In addition,
research does not qualify for the credit: (1) if conducted after
the beginning of commercial production of the business component;
(2) if related to the adaptation of an existing business component
to a particular customer's requirements; (3) if related to the
duplication of an existing business component from a physical
examination of the component itself or certain other information;
or (4) if related to certain efficiency surveys, management
function or technique, market research, market testing, or
market development, routine data collection or routine quality
control (sec. 41(d)(4)). Research does not qualify for the credit
if it is conducted outside the United States, Puerto Rico, or any
U.S. possession.
___________________________
/448/ Under a special rule enacted as part of the Small Business
Job Protection Act of 1996, 75 percent of amounts paid to a research
consortium for qualified research is treated as qualified
research expenses eligible for the research credit (rather than 65
percent under the general rule under section 41(b)(3) governing
contract research expenses) if (1) such research consortium is a
tax-exempt organization that is described in section 501(c)(3)
(other than a private foundation) or section 501(c)(6) and is
organized and operated primarily to conduct scientific research,
and (2) such qualified research is conducted by the consortium on
behalf of the taxpayer and one or more persons not related to the
taxpayer. Sec. 41(b)(3)(C).
Relation to deduction
Under section 174, taxpayers may elect to deduct currently the
amount of certain research or experimental expenditures paid or
incurred in connection with a trade or business, notwithstanding the
general rule that business expenses to develop or create an asset
that has a useful life extending beyond the current year must be
capitalized. However, deductions allowed to a taxpayer under
section 174 (or any other section) are reduced by an amount equal
to 100 percent of the taxpayer's research tax credit determined
for the taxable year (Sec. 280C(c)). Taxpayers may alternatively
elect to claim a reduced research tax credit amount (13 percent)
under section 41 in lieu of reducing deductions otherwise allowed
(sec. 280C(c)(3)).
Description of Proposal
The research tax credit is made permanent.
Effective date.--The proposal is effective on the date of
enactment.
Analysis
Overview
Technological development is an important component of economic
growth. However, while an individual business may find it
profitable to undertake some research, it may not find it profitable
to invest in research as much as it otherwise might because it is
difficult to capture the full benefits from the research and
prevent such benefits from being used by competitors. In general,
businesses acting in their own self-interest will not necessarily
invest in research to the extent that would be consistent with
the best interests of the overall economy. This is because costly
scientific and technological advances made by one firm are cheaply
copied by its competitors. Research is one of the areas where there
is a consensus among economists that government intervention in
the marketplace can improve overall economic efficiency. However,
this does not mean that increased tax benefits or more government
spending for research always will improve economic efficiency.
It is possible to decrease economic efficiency by spending too much
on research. However, there is evidence that the current level
of research undertaken in the United States, and worldwide, is
too little to maximize society's well-being. Nevertheless, even
if there were agreement that additional subsidies for research
________________________
/449/ Taxpayers may elect 10-year amortization of certain research
expenditures allowable as a deduction under section 174(a). Secs.
174(f)(2) and 59(e).
/450/ This conclusion does not depend upon whether the basic tax
regime is an income tax or a consumption tax.
/451/ See Zvi Griliches, "The Search for R&D Spillovers,"
Scandinavian Journal of Economics, vol. XCIV, (1992), M. Ishaq
Nadiri, "Innovations and Technological Spillovers," National Bureau
of Economic Research, Working Paper No. 4423, 1993, and Bronwyn
Hall, "The Private and Social Returns to Research and Development,"
in Bruce Smith and Claude
are warranted as a general matter, misallocation of research dollars
across competing sectors of the economy could diminish economic
efficiency. It is difficult to determine whether, at the present
levels and allocation of government subsidies for research, further
government spending on research or additional tax benefits for
research would increase or decrease overall economic efficiency.
If it is believed that too little research is being undertaken, a
tax subsidy is one method of offsetting the private-market bias
against research, so that research projects undertaken approach
the optimal level. Among the other policies employed by the
Federal Government to increase the aggregate level of research
activities are direct spending and grants, favorable anti-trust
rules, and patent protection. The effect of tax policy on research
activity is largely uncertain because there is relatively little
consensus regarding magnitude of the responsiveness of research to
changes in taxes and other factors affecting its price. To the
extent that research activities are responsive to the price of
research activities, the research and experimentation tax credit
should increase research activities beyond what they otherwise
would be. However, the present-law treatment of research
expenditures does create certain complexities and compliance
costs.
Scope of research activities in the United States and abroad
In the United States, private for-profit enterprises and
individuals, non-profit organizations, and the public sector
undertake research activities. Total expenditures on research
and development in the United States are large, representing 2.8
percent of gross domestic product in 2002. This rate of
expenditure on research and development exceeds that of the European
Union and the average of all countries that are members of the
Organisation for Economic Co-operation and Development ("OECD"),
but is less than that of Japan. See Figure 1, below. In 2001,
expenditures on research and development in the United States
represented 43.7 percent of all expenditures on research and
development undertaken by OECD countries, were 55 percent greater
than the total expenditures on research and development undertaken
in the European Union, and were more than two and one half times
such expenditures in Japan. Expenditures on research and
development in the United States have grown at an average real
__________________________
Barfield, editors, Technology, R&D and the Economy, (Washington,
D.C.: Brookings Institution Press), 1996, pp. 1-14. These papers
suggest that the rate of return to privately funded research
expenditures is high compared to that in physical capital and the
social rate of return exceeds the private rate of return.
Griliches concludes, "in spite of [many] difficulties, there has
been a significant number of reasonably well-done studies all
pointing in the same direction: R&D spillovers are present, their
magnitude may be quite large, and social rates of return remain
significantly above private rates." Griliches, p. S43.
/452/ Organisation for Economic Co-operation and Development, OECD
Science, Technology and Industry Scoreboard, 2003, (Paris:
Organisation of Economid Co-operation and Development), 2003.
The OECD, measuring in real 1995 dollars, calculates that the United
States spent approximately $253 billion on research and development
in 2001.
/453/ Ibid.
rate of 5.4 percent over the period 1995-2001. This rate of growth
has exceeded that of Japan (2.8 percent), Germany (3.3 percent),
France (2.4 percent for the period 1997-1999), Italy (2.7 percent
for the period 1997-2000), and the United Kingdom, (2.3 percent),
but is less than that of Canada (5.6 percent), Ireland
(7.5 percent), and Spain (6.5 percent).
[Graphics not available in Tiff Format]
Source: OECD, OECD Science, Technology and Industry Scoreboard, 2003.
The scope of present-law tax expenditures on research activities
The tax expenditure related to the research and experimentation tax
credit is estimated to be $4.8 billion for 2005. The related tax
expenditure for expensing of research and development expenditures
was estimated to be $4.0 billion for 2005 growing to $6.3 billion
for 2009. As noted above, the Federal Government also directly
subsidizes research activities. For example, in fiscal 2004, the
National Science Foundation made $4.0 billion in grants, subsidies,
and contributions to research activities, the Department of Defense
financed $11.5 billion in basic research, applied research, and
advanced technology development, and the Department of Energy
financed $0.7 billion in research in high energy physics, $1.0
billion in basic research in the sciences, $0.6 billion in
biological and environmental research, and $197 million for
research in advance scientific computing.
Table 6 and Table 7 present data for 2002 on those industries that
utilized the research tax credit and the distribution of the credit
claimants by firm size. In 2002, more than 15,000 taxpayers claimed
more than $5.8 billion in research tax credits. Taxpayers whose
primary activity is manufacturing claimed two thirds of the
research tax credits claimed. Firms with assets of $50 million or
more claimed nearly 85 percent of the credits claimed.
Nevertheless, as Table 7 documents, a large number of small firms
are engaged in research and were able to claim the research tax
credit.
_______________________-
/456/ Office of Management and Budget, Budget of the United States
Government, Fiscal Year 2006, Appendix, pp. 1081-1085, 295-300 and
395-397.
/457/ The $5.8 billion figure reported for 2002 is not directly
comparable to the $4.8 billion tax expenditure estimate for 2005
reported in the preceding paragraph. The tax expenditure estimate
accounts for the present-law requirement that deductions for
research expenditures be reduced by research credits claimed.
Also, the $5.8 billion figure does not reflect the actual tax
reduction achieved by taxpayers claiming research credits in 2002
as the actual tax reduction will depend upon whether the taxpayer
had operating losses, was subject to the alternative minimum tax,
or other aspects specific to each taxpayer's situation.
Table 6.--Percentage Distribution of Firms Claiming Research Tax
Credit and Percentage of Credit Claimed by Sector, 2002 Industry
[Graphics not available in Tiff Format]
Table 7.--Percentage Distribution of Firms Claiming Research Tax
Credit and of Amount of Credit Claimed by Firm Size, 2002
[Graphics not available in Tiff Format]
Flat or incremental tax credits?
For a tax credit to be effective in increasing a taxpayer's research
expenditures it is not necessary to provide that credit for all the
taxpayer's research expenditures (i.e., a flat credit). By limiting
the credit to expenditures above a base amount, incremental tax
credits attempt to target the tax incentives where they will have
the most effect on taxpayer behavior.
Suppose, for example, a taxpayer is considering two potential
research projects: Project A will generate cash flow with a present
value of $105 and Project B will generate cash flow with a present
value of $95. Suppose that the research cost of investing in each
of these projects is $100. Without any tax incentives, the taxpayer
will find it profitable to invest in Project A and will not invest
in Project B.
Consider now the situation where a 10-percent flat credit applies
to all research expenditures incurred. In the case of Project A,
the credit effectively reduces the cost to $90.
This increases profitability, but does not change behavior with
respect to that project, since it would have been undertaken in
any event. However, because the cost of Project B also is
reduced to $90, this previously neglected project (with a present
value of $95) would now be profitable. Thus, the tax credit would
affect behavior only with respect to this marginal project.
Incremental credits attempt not to reward projects that would have
been undertaken in any event but to target incentives to marginal
projects. To the extent this is possible, incremental credits
have the potential to be far more effective per dollar of revenue
cost than flat credits in inducing taxpayers to increase
qualified expenditures. In the example above, if an incremental
credit were properly targeted, the Government could spend the same
$20 in credit dollars and induce the taxpayer to undertake a
marginal project so long as its expected cash flow exceeded
$80. Unfortunately, it is nearly impossible as a practical
matter to determine which particular projects would be undertaken
without a credit and to provide credits only to other projects.
In practice, almost all incremental credit proposals rely on some
measure of the taxpayer's previous experience as a proxy for a
taxpayer's total qualified expenditures in the absence of a
credit.
This is referred to as the credit's base amount. Tax credits are
provided only for amounts above this base amount. Since a
taxpayer's calculated base amount is only an approximation of what
would have been spent in the absence of a credit, in practice,
the credit may be less effective per dollar of revenue cost than
it otherwise might be in increasing expenditures. If the
calculated base amount is too low, the credit is awarded to
projects that would have been undertaken even in the absence
of a credit. If, on the other hand, the calculated base amount
is too high, then there is no incentive for projects that actually
are on the margin.
Nevertheless, the incentive effects of incremental credits per
dollar of revenue loss can be many times larger than those of a
flat credit. However, in comparing a flat credit to an incremental
credit, there are other factors that also deserve consideration.
A flat credit generally has lower administrative and compliance
costs than does an incremental credit. Probably more important,
however, is the potential misallocation of resources and unfair
competition that could result as firms with qualified expenditures
determined to be above their base amount receive credit dollars,
while other firms with qualified expenditures considered below
their base amount receive no credit.
The responsiveness of research expenditures to tax incentives
Like any other commodity, the amount of research expenditures
that a firm wishes to incur generally is expected to respond
positively to a reduction in the price paid by the firm.
Economists often refer to this responsiveness in terms of price
elasticity, which is measured as the ratio of the percentage change
in quantity to a percentage change in price. For example, if
demand for a product increases by five percent as a result of a
10-percent decline in price paid by the purchaser, that commodity
is said to have a price elasticity of demand of 0.5. One way of
reducing the price paid by a buyer for a commodity is to grant a
tax credit upon purchase. A tax credit of 10 percent (if it is
refundable or immediately usable by the taxpayer against current
tax liability) is equivalent to a 10-percent price reduction.
If the commodity granted a 10-percent tax credit has an elasticity
of 0.5, the amount consumed will increase by five percent. Thus,
if a flat research tax credit were provided at a 10-percent rate,
and research expenditures had a price elasticity of 0.5, the credit
would increase aggregate research spending by five percent.
________________________
/458/ For simplicity, this analysis assumes that the product in
question can be supplied at the same cost despite any increase in
demand (i.e., the supply is perfectly elastic). This assumption may
not be valid, particularly over short periods of time, and
particularly when the commodity--such as research scientists and
engineers--is in short supply.
/459/ It is important to note that not all research expenditures
need be subject to a price reduction to have this effect. Only the
expenditures that would not have been undertaken
Despite the central role of the measurement of the price elasticity
of research activities, the empirical evidence on this subject has
yielded quantitative measures of the response of research spending
to tax incentives. While all published studies report that the
research credit induced increases in research spending, early
evidence generally indicated that the price elasticity for research
is substantially less than one. For example, one early survey of
the literature reached the following conclusion:
In summary, most of the models have estimated long-run price
elasticities of demand for R&D on the order of -0.2 and
-0.5. . . . However, all of the measurements are prone to
aggregation problems and measurement errors in explanatory
variables.
If it took time for taxpayers to learn about the credit and what
sort of expenditures qualified, taxpayers may have only
gradually adjusted their behavior. Such a learning curve might
explain a modest measured behavioral effect.
________________________
otherwise--so called marginal research expenditures--need be subject
to the credit to have a positive incentive effect.
/460/ Charles River Associates, An Assessment of Options for
Restructuring the R&D Tax Credit to Reduce Dilution of its Marginal
Incentive (final report prepared for the National Science
Foundation), February, 1985, p. G-14. The negative coefficient in
the text reflects that a decrease in price results in an increase in
research expenditures. Often, such elasticities are reported
without the negative coefficient, it being understood that there is
an inverse relationship between changes in the "price" of research
and changes in research expenditures.
In a 1983 study, the Treasury Department used an elasticity of 0.92
as its upper range estimate of the price elasticity of R&D, but noted
that the author of the unpublished study from which this estimate was
taken conceded that the estimate might be biased upward. See,
Department of the Treasury, "The Impact of Section 861-8 Regulation
on Research and Development," p. 23. As stated in the text,
although there is uncertainty, most analysts believe the elasticity
is considerable smaller. For example, the General Accounting Office
(now called the Government Accountability Office) summarizes: "These
studies, the best available evidence, indicate that spending on R&E
is not very responsive to price reductions. Most of the elasticity
estimates fall in the range of 0.2 and 0.5. . . . Since it is
commonly recognized that all of the estimates are subject to error,
we used a range of elasticity estimates to compute a range of
estimates of the credit's impact." See, The Research Tax Credit
Has Stimulated Some Additional Research Spending (GAO/GGD-89-114),
September 1989, p. 23. Similarly, Edwin Mansfield concludes: "While
our knowledge of the price elasticity of demand for R&D is far from
adequate, the best available estimates suggest that it is rather
low, perhaps about 0.3." See, "The R&D Tax Credit and Other
Technology Policy Issues," American Economic Review, Vol. 76, no.
2, May 1986, p. 191.
A more recent survey of the literature on the effect of the tax credit suggests a stronger behavioral response, although most analysts agree
that there is substantial uncertainty in these estimates.
[W]ork using US firm-level data all reaches the same conclusion:
the tax price elasticity of total R&D spending during the 1980s is
on the order of unity, maybe higher. � Thus there is little doubt
about the story that the firm-level publicly reported R&D data
tell: the R&D tax credit produces roughly a dollar-for-dollar
increase in reported R&D spending on the margin.
However this survey notes that most of this evidence is not drawn
directly from tax data. For example, effective marginal tax credit
rates are inferred from publicly reported financial data and
may not reflect limitations imposed by operating losses or the
alternative minimum tax. The study notes that because most
___________________
/461/ Bronwyn Hall and John Van Reenen, "How effective are fiscal
incentives for R&D? A review of the evidence," Research Policy,
vol.29, 2000, p. 462. This survey reports that more recent
empirical analyses have estimated higher elasticity estimates.
One recent empirical analysis of the research credit has estimated
a short-run price elasticity of 0.8 and a long-run price elasticity
of 2.0. The author of this study notes that the long-run estimate
should be viewed with caution for several technical reasons.
In addition, the data utilized for the study cover the period 1980
through 1991, containing only two years under the revised credit
structure. This makes it empirically difficult to distinguish
short-run and long-run effects, particularly as it may take firms
some time to fully appreciate the incentive structure of the
revised credit. See, Bronwyn H. Hall, "R&D Tax Policy During the
1980s: Success or Failure?" in James M. Poterba (ed.), Tax Policy
and the Economy, vol. 7, (Cambridge: The MIT Press, 1993), pp.
1-35. Another recent study examined the post-1986 growth of
research expenditures by 40 U.S.-based multinationals and found
price elasticities between 1.2 and 1.8. However, including an
additional 76 firms, that had initially been excluded because
they had been involved in merger activity, the estimated
elasticities fell by half. See, James R. Hines, Jr., "On the
Sensitivity of R&D to Delicate Tax Changes: The Behavior of U.S.
Multinationals in the 1980s" in Alberto Giovannini, R. Glenn
Hubbard, and Joel Slemrod (eds.), Studies in International
Taxation, (Chicago: University of Chicago Press 1993). Also see
M. Ishaq Nadiri and Theofanis P. Mamuneas, "R&D Tax Incentives and
Manufacturing-Sector R&D Expenditures," in James M. Poterba, editor,
Borderline Case: International Tax Policy, Corporate Research and
Development, and Investment, (Washington, D.C.: National Academy
Press), 1997. While their study concludes that one dollar of
research tax credit produces 95 cents of research, they note
that time series empirical work is clouded by poor measures of
the price deflators used to convert nominal research expenditures
to real expenditures.
Other research suggests that many of the elasticity studies may
overstate the efficiency of subsidies to research. Most R&D
spending is for wages and the supply of qualified scientists is
small, particularly in the short run. Subsidies may raise the
wages of scientists, and hence research spending, without increasing
actual research. See Austan Goolsbee, "Does Government R&D Policy
Mainly Benefit Scientists and Engineers?" American Economic Review,
vol. 88, May, 1998, pp. 298-302.
studies rely on "reported research expenditures" that a "relabelling
problem" may exist whereby a preferential tax treatment for an
activity gives firms an incentive to classify expenditures as
qualifying expenditures. If this occurs, reported expenditures
increase in response to the tax incentive by more than the underlying
real economic activity. Thus, reported estimates may overestimate
the true response of research spending to the tax credit.
Apparently there have been no specific studies of the effectiveness
of the university basic research tax credit.
Other policy issues related to the research and experimentation
credit
Perhaps the greatest criticism of the research and experimentation
tax credit among taxpayers regards its temporary nature. Research
projects frequently span years. If a taxpayer considers an
incremental research project, the lack of certainty regarding the
availability of future credits increases the financial risk of
the expenditure. A credit of longer duration may more successfully
induce additional research than would a temporary credit, even if
the temporary credit is periodically renewed.
An incremental credit does not provide an incentive for all firms
undertaking qualified research expenditures. Many firms have
current-year qualified expenditures below the base amount. These
firms receive no tax credit and have an effective rate of credit
of zero. Although there is no revenue cost associated with firms
with qualified expenditures below base, there may be a distortion
in the allocation of resources as a result of these uneven
incentives.
If a firm has no current tax liability, or if the firm is subject
to the alternative minimum tax ("AMT") or the general business
credit limitation, the research credit must be carried forward
for use against future-year tax liabilities. The inability to
use a tax credit immediately reduces its present value according
to the length of time between when it actually is earned and the
time it actually is used to reduce tax liability.
Under present law, firms with research expenditures substantially
in excess of their base amount may be subject to the 50-percent
base amount limitation. In general, although these firms receive
the largest amount of credit when measured as a percentage of
their total qualified research expenses, their marginal effective
rate of credit is exactly one half of the statutory credit rate of
20 percent (i.e., firms subject to the base limitation effectively
are governed by a 10-percent credit rate).
Although the statutory rate of the research credit is currently 20
percent, it is likely that the average marginal effective rate
may be substantially below 20 percent. Reasonable assumptions
_________________________
/462/ Hall and Van Reenen, "How effective are fiscal incentives for
R&D? A review of the evidence," p. 463.
/463/ As with any tax credit that is carried forward, its full
incentive effect could be restored, absent other limitations, by
allowing the credit to accumulate interest that is paid by the
Treasury to the taxpayer when the credit ultimately is utilized.
about the frequency that firms are subject to various limitations
discussed above yield estimates of an average effective rate of
credit between 25 and 40 percent below the statutory rate, i.e.,
between 12 and 15 percent.
Since sales growth over a long time frame will rarely track research
growth, it can be expected that over time each firm's base will
drift from the firm's actual current qualified research
expenditures. Therefore, increasingly over time there will be a
larger number of firms either substantially above or below their
calculated base. This could gradually create an undesirable
situation where many firms receive no credit and have no reasonable
prospect of ever receiving a credit, while other firms receive large
credits (despite the 50-percent base amount limitation). Thus, over
time, it can be expected that, for those firms eligible for the
credit, the average marginal effective rate of credit will decline
while the revenue cost to the Federal Government increases.
Complexity and the research tax credit
Administrative and compliance burdens also result from the
present-law research tax credit. The General Accounting Office
("GAO") has testified that the research tax credit is difficult for
the IRS to administer. The GAO reported that the IRS states that
it is required to make difficult technical judgments in audits
concerning whether research was directed to produce truly innovative
products or processes. While the IRS employs engineers in such
audits, the companies engaged in the research typically employ
personnel with greater technical expertise and, as would be
expected, personnel with greater expertise regarding the intended
application of the specific research conducted by the company under
audit. Such audits create a burden for both the IRS and taxpayers.
The credit generally requires taxpayers to maintain records more
detailed than those necessary to support the deduction of research
expenses under section 174. An executive in a large technology
company has identified the research credit as one of the most
significant areas of complexity for his firm. He summarizes the
problem as follows.
Tax incentives such as the R&D tax credit � typically pose
compliance challenges, because they incorporate tax-only concepts
that may be only tenuously linked to financial accounting principles
or to the classifications used by the company's operational units.
...[I]s what the company calls "research and development" the same
as the "qualified research" eligible for the R&D tax credit
_______________________
/464/ For a more complete discussion of this point see Joint
Committee on Taxation, Description and Analysis of Tax Provisions
Expiring in 1992 (JCS-2-92), January 27, 1992, pp. 65-66.
/465/ Natwar M. Gandhi, Associate Director Tax Policy and
Administration Issues, General Government Division, U.S. General
Accounting Office, "Testimony before the Subcommittee on Taxation
and Internal Revenue Service Oversight," Committee on Finance,
United States Senate, April 3, 1995.
under I.R.C. Section 41? The extent of any deviation in those
terms is in large part the measure of the compliance costs
associated with the tax credit.
Prior Action
The President's fiscal year 2003, 2004, and 2005 budget proposals
contained an identical provision.
_________________
/466/ David R. Seltzer, "Federal Income Tax Compliance Costs:
A Case Study of Hewlett-Packard Company," National Tax Journal,
vol. 50, September 1997, pp. 487-493.
B. Permanently Extend and Expand Disclosure of Tax Return
Information for Administration of Student Loans
Present Law
Income-contingent loan verification program
Present law prohibits the disclosure of returns and return
information, except to the extent specifically authorized by the
Code. An exception is provided for disclosure to the
Department of Education (but not to contractors thereof) of a
taxpayer's filing status, adjusted gross income and identity
information (i.e., name, mailing address, taxpayer identifying
number) to establish an appropriate repayment amount for an
applicable student loan. The Department of Education disclosure
authority is scheduled to expire after December 31, 2005.
An exception to the general rule prohibiting disclosure is also
provided for the disclosure of returns and return information to a
designee of the taxpayer. Because the Department of Education
utilizes contractors for the income-contingent loan verification
program, the Department of Education obtains taxpayer information
by consent under section 6103(c), rather than under the specific
exception. The Department of Treasury has reported that the
Internal Revenue Service processes approximately 100,000 consents
per year for this purpose.
Verifying financial aid applications.
The Higher Education Act of 1998 ("Higher Education Act")
authorized the Department of Education to confirm with the Internal
Revenue Service four discrete items of return information for the
purposes of verifying of student aid applications. The Higher
Education Act, however, did not amend the Code to permit disclosure
for this purpose. Therefore, the disclosure provided by
____________________
/467/ Sec. 6103.
/468/ Sec. 6103(l)(13).
/469/ Pub. L. No. 108-311 (2004).
/470/ Sec. 6103(c).
/471/ Department of Treasury, Report to the Congress on Scope and
Use of Taxpayer Confidentiality and Disclosure Provisions,
Volume I: Study of General Provisions (October 2000) at 91.
/472/ Department of Treasury, General Explanations of the
Administration's Fiscal Year 2004 Revenue Proposals (February
2003), p. 133.
/473/ Pub. L. No. 105-244, sec. 483 (1998).
the Higher Education Act may not be made unless the taxpayer
consents to the disclosure under section 6103(c).
The financial aid application is submitted to the Department of
Education and is then given to a contractor for processing.
Based on the information given, the contractor calculates an
expected family contribution that determines the amount of aid a
student will receive. All Department of Education financial aid
is disbursed directly through schools or various lenders.
The Department of Education requires schools to verify the financial
aid information of 30 percent of the applicants. The applicants
must furnish a copy of their tax returns. The applicants are not
required to obtain copies of tax returns from the IRS or to produce
certified copies. If the information reflected on the student's
copy of the tax return does not match the information on the
financial aid application, the school requires corrective action to
be taken before a student receives the appropriate aid.
The Office of Inspector General of the Department of Education has
reported that, because many applicants are reporting incorrect
information on their financial aid applications, erroneous
overpayments of Federal Pell grants have resulted.
Overpayments of Pell grants and defaulted student loans
For purposes of locating a taxpayer to collect an overpayment of a
Federal Pell grant or to collect payments on a defaulted loan,
the Internal Revenue Service may disclose the taxpayer's mailing
address to the Department of Education. To assist in locating
the defaulting taxpayer, the Department of Education may redisclose
the mailing address to the officers, employees and agents of
certain lenders, States, nonprofit agencies, and educational
institutions whose duties relate to the collection of student
loans.
Safeguard procedures and recordkeeping
Federal and State agencies that receive returns and return
information are required to maintain a standardized system of
permanent records on the use and disclosure of that information.
Maintaining such records is a prerequisite to obtaining and
continuing to obtain returns and return information. Such
agencies must also establish procedures satisfactory to the IRS
for safeguarding the information it receives. The IRS must also
file annual reports with the House Committee on Ways and Means,
the Senate Committee on Finance, and the Joint Committee on
Taxation regarding procedures and safeguards followed by recipients
of return and return information.
____________________
/474/ Sec. 6103(m)(4).
/475/ Id.
/476 Sec. 6103(p)(4).
/477/ Sec. 6103(p)(5).
Description of Proposal
The proposal allows the disclosure to the Department of Education
and its contractors of the adjusted gross income, filing status,
total earnings from employment, Federal income tax liability, type
of return filed and taxpayer identity information for the financial
aid applicant or of the applicant's parents (if the applicant is a
dependent) or spouse (if married). Pursuant to the proposal, the
Department of Education could use the information not only for
establishing a loan repayment amount but also for verifying items
reported by student financial aid applicants and their parents.
The proposal allows the Department of Education to use contractors
to process the information disclosed to the Department of
Education, eliminating the need for consents. It is understood
that the proposal imposes the present-law safeguards applicable to
disclosures to Federal and State agencies on disclosures to the
Department of Education and its contractors.
Effective date.--The proposal is effective with respect to
disclosures made after the date of enactment.
Analysis
Contractors
The proposal permits the disclosure of a taxpayer's return
information to contractors and agents of the Department of
Education, not just to Department of Education employees. Some
might argue that the use of contractors significantly expands the
risk of unauthorized disclosure, particularly when return
information is used by a contractor outside of the recipient
agency. The volume of taxpayer information involved under this
proposal and the disclosure of millions of taxpayer records,
significantly contributes to the risk of unauthorized disclosure.
On the other hand, some might argue that it is appropriate to
permit the disclosure of otherwise confidential tax information to
contractors to ensure the correctness of Federal student aid.
Opponents of the proposal may argue that it is not clear that the
Internal Revenue Service has the resources and computer specialists
to implement and enforce the safeguards that the proposal imposes.
However, proponents of the proposal argue that the proposal
alleviates some of the burden on the Internal Revenue Service by
requiring the Department of Education to monitor its contractors as
a supplement to the safeguard reviews conducted by the Internal
Revenue Service.
Burdens on IRS
In general, the proposal eases the burden on the financial aid
applicant because the applicant will not be required to produce
copies of their tax returns for verification of their financial
aid applications. The proposal arguably provides simplification
for the schools as well, because the schools will no longer be
required to match the information of 30 percent of its applicants.
On the other hand, the proposal tends to increase complexity for
the Internal Revenue Service by requiring it to resolve
discrepancies between tax information and income data on the
financial aid application if the applicant is unable to resolve
the discrepancy with the school.
Income contingent loan verification program
Currently the Department of Education uses consents to obtain tax
information for purposes of its income contingent loan verification
program, and does not rely on the statutory authority to receive
that information without consent. The IRS processes over 100,000
consents for this program. Some might argue that since the specific
statutory authority is not being used, it should not be extended.
Verifying financial aid applications
Congress has expressed a concern about the increasing number of
requests for the disclosure of confidential tax information for
nontax purposes and the effect of such disclosures on voluntary
taxpayer compliance. Some might argue that consensual disclosure
of return information, in which the taxpayer knowingly consents
to the disclosure of his or her return information ("consents"),
is less likely to adversely impact taxpayer compliance than adding
a nonconsensual provision for the disclosure of taxpayer
information. Since the Internal Revenue Service is already
processing consents for the Department of Education, some would
argue that the current practice simply could be extended to
financial aid applications. On the other hand, some might argue
that because present law does not impose restrictions on
redisclosure of return information obtained by consent, the
proposal, which imposes such restrictions, would be preferable.
Critics might argue that the disclosure of sensitive return
information of millions of taxpayers to identify the abuse of a
few does not strike the appropriate balance between the need to know
and the right to privacy. On the other hand, some might argue that
since this financial information is already required to be
submitted as part of the financial aid form, the infringement
on taxpayer privacy is minimal.
_________________________
/478/ S. Prt. No. 103-37 at 54 (1993).
/479/ In its study on the disclosure of return information, the
Department of Treasury noted: "The burden of processing this number
of consents obviously would be reduced if the consents were executed
and transmitted electronically. Accordingly, the Department of
Education has asked to be included in the TDS program." Department
of Treasury, Report to the Congress on Scope and Use of Taxpayer
Confidentiality and Disclosure Provisions, Volume I: Study of
General Provisions (2000) at 92.
/480/The Department of Education seeks access to the return
information of approximately 15 million taxpayers each year.
The Department of Education receives approximately 10 million
applications for student financial assistance each year.
Because roughly half of the applicants are dependents, income
information is needed for both the student and his or her
parents. Thus, verification under this provision could apply to
over 15 million taxpayers each year. It is not clear what
percentage of applicants submit fraudulent financial aid
applications. Id.
Prior Action
Similar proposals were contained in the President's fiscal year 2003,
2004 and 2005 budget proposals.
C. Extend and Modify the Work Opportunity Tax Credit and
Welfare-to-Work Tax Credit
Present Law
Work opportunity tax credit
Targeted groups eligible for the credit
The work opportunity tax credit is available on an elective basis
for employers hiring individuals from one or more of eight targeted
groups. The eight targeted groups are: (1) certain families
eligible to receive benefits under the Temporary Assistance for
Needy Families Program; (2) high-risk youth; (3) qualified
ex-felons; (4) vocational rehabilitation referrals; (5) qualified
summer youth employees; (6) qualified veterans; (7) families
receiving food stamps; and (8) persons receiving certain
Supplemental Security Income (SSI) benefits.
A qualified ex-felon is an individual certified as: (1) having been
convicted of a felony under State or Federal law; (2) being a
member of an economically disadvantaged family; and (3) having a
hiring date within one year of release from prison or conviction.
Qualified wages
Generally, qualified wages are defined as cash wages paid by the
employer to a member of a targeted group. The employer's deduction
for wages is reduced by the amount of the credit.
Calculation of the credit
The credit equals 40 percent (25 percent for employment of 400 hours
or less) of qualified first-year wages. Generally, qualified
first-year wages are qualified wages (not in excess of $6,000)
attributable to service rendered by a member of a targeted group
during the one-year period beginning with the day the individual
began work for the employer. Therefore, the maximum credit per
employee is $2,400 (40 percent of the first $6,000 of qualified
first-year wages). With respect to qualified summer youth
employees, the maximum credit is $1,200 (40 percent of the first
$3,000 of qualified first-year wages).
Minimum employment period
No credit is allowed for qualified wages paid to employees who work
less than 120 hours in the first year of employment.
Coordination of the work opportunity tax credit and the
welfare-to-work tax credit
An employer cannot claim the work opportunity tax credit with
respect to wages of any employee on which the employer claims
the welfare-to-work tax credit.
Other rules
The work opportunity tax credit is not allowed for wages paid to a
relative or dependent of the taxpayer. Similarly wages paid to
replacement workers during a strike or lockout are not eligible for
the work opportunity tax credit. Wages paid to any employee during
any period for which the employer received on-the-job training
program payments with respect to that employee are not eligible for
the work opportunity tax credit. The work opportunity tax credit
generally is not allowed for wages paid to individuals who had
previously been employed by the employer. In addition, many other
technical rules apply.
Expiration date
The work opportunity tax credit is effective for wages paid or
incurred to a qualified individual who begins work for an employer
before January 1, 2006.
Welfare-to-work tax credit
Targeted group eligible for the credit
The welfare-to-work tax credit is available on an elective basis to
employers of qualified long-term family assistance recipients.
Qualified long-term family assistance recipients are: (1) members
of a family that has received family assistance for at least 18
consecutive months ending on the hiring date; (2) members of a
family that has received such family assistance for a total of at
least 18 months (whether or not consecutive) after August 5, 1997
(the date of enactment of the welfare-to-work tax credit) if they
are hired within 2 years after the date that the 18-month total is
reached; and (3) members of a family that is no longer eligible for
family assistance because of either Federal or State time limits,
if they are hired within 2 years after the Federal or State time
limits made the family ineligible for family assistance.
Qualified wages
Qualified wages for purposes of the welfare-to-work tax credit are
defined more broadly than for the work opportunity tax credit.
Unlike the definition of wages for the work opportunity tax credit
which includes simply cash wages, the definition of wages for the
welfare-to-work tax credit includes cash wages paid to an employee
plus amounts paid by the employer for: (1) educational assistance
excludable under a section 127 program (or that would be excludable
but for the expiration of sec. 127); (2) health plan coverage for
the employee, but not more than the applicable premium defined
under section 4980B(f)(4); and (3) dependent care assistance
excludable under section 129. The employer's deduction for wages
is reduced by the amount of the credit.
Calculation of the credit
The welfare-to-work tax credit is available on an elective basis to
employers of qualified long-term family assistance recipients during
the first two years of employment. The maximum credit is 35
percent of the first $10,000 of qualified first-year wages and 50
percent of the first $10,000 of qualified second-year wages.
Qualified first-year wages are defined as qualified wages (not in
excess of $10,000) attributable to service rendered by a member of
the targeted group during the one-year period beginning with the
day the individual began work for the employer. Qualified
second-year wages are defined as qualified wages (not in excess
of $10,000) attributable to service rendered by a member of the
targeted group during the one-year period beginning immediately
after the first year of that individual's employment for the
employer. The maximum credit is $8,500 per qualified employee.
Minimum employment period
No credit is allowed for qualified wages paid to a member of the
targeted group unless they work at least 400 hours or 180 days in
the first year of employment.
Coordination of the work opportunity tax credit and the
welfare-to-work tax credit
An employer cannot claim the work opportunity tax credit with
respect to wages of any employee on which the employer claims the
welfare-to-work tax credit.
Other rules
The welfare-to-work tax credit incorporates directly or by reference
many of these other rules contained on the work opportunity tax
credit.
Expiration date
The welfare-to-work tax credit is effective for wages paid or
incurred to a qualified individual who begins work for an employer
before January 1, 2006.
Description of Proposal
Combined credit
The proposal combines the work opportunity and welfare-to-work tax
credits and extends the combined credit for one year.
Targeted groups eligible for the combined credit
The combined credit is available on an elective basis for employers
hiring individuals from one or more of all nine targeted groups.
The welfare-to-work credit/long-term family assistance recipient is
the ninth targeted group.
The proposal repeals the requirement that a qualified ex-felon be
an individual certified as a member of an economically disadvantaged
family.
Qualified wages
Qualified first-year wages for the eight WOTC categories remain
capped at $6,000 ($3,000 for qualified summer youth employees).
No credit is allowed for second-year wages. In the case of
long-term family assistance recipients the cap is $10,000 for both
qualified first-year wages and qualified second-year wages.
For all targeted groups, the employer's deduction for wages is
reduced by the amount of the credit.
Calculation of the credit
First-year wages.�For the eight WOTC categories, the credit equals
40 percent (25 percent for employment of 400 hours or less) of
qualified first-year wages. Generally, qualified first-year wages
are qualified wages (not in excess of $6,000) attributable to
service rendered by a member of a targeted group during the
one-year period beginning with the day the individual began work
for the employer. Therefore, the maximum credit per employee for
members of any of the eight WOTC targeted groups generally is
$2,400 (40 percent of the first $6,000 of qualified first-year
wages). With respect to qualified summer youth employees, the
maximum credit remains $1,200 (40 percent of the first $3,000 of
qualified first-year wages). For the welfare-to-work/long-term
family assistance recipients, the maximum credit equals $4,000 per
employee (40 percent of $10,000 of wages).
Second year wages.�In the case of long-term family assistance
recipients the maximum credit is $5,000 (50 percent of the first
$10,000 of qualified second-year wages).
Minimum employment period
No credit is allowed for qualified wages paid to employees who work
less than 120 hours in the first year of employment.
Coordination of the work opportunity tax credit and the
welfare-to-work tax credit
Coordination is no longer be necessary once the two credits are
combined
Effective date.--The proposal is effective for wages paid or
incurred to a qualified individual who begins work for an employer
after December 31, 2005 and before January 1, 2007.
Analysis
Overview of policy issues
The WOTC is intended to increase the employment and earnings of
targeted group members. The credit is made available to employers
as an incentive to hire members of the targeted groups. To the
extent the value of the credit is passed on from employers to
employees, the wages of target group employees will be higher than
they would be in the absence of the credit.
The rationale for the WOTC is that employers will not hire certain
individuals without a subsidy, because either the individuals are
stigmatized (e.g., convicted felons) or the current productivity of
-------------------------
/481/ For individuals with productivity to employers lower than the
minimum wage, the credit may result in these individuals being hired
and paid the minimum wage. For these cases, it would be clear that
the credit resulted in the worker receiving a higher wage than
would have been received in the absence of the credit (e.g., zero).
the individuals is below the prevailing wage rate. Where particular
groups of individuals suffer reduced evaluations of work potential
due to membership in one of the targeted groups, the credit may
provide employers with a monetary offset for the lower perceived
work potential. In these cases, employers may be encouraged to
hire individuals from the targeted groups, and then make an
evaluation of the individual's work potential in the context of
the work environment, rather than from the job application.
Where the current productivity of individuals is currently below
the prevailing wage rate, on-the-job-training may provide
individuals with skills that will enhance their productivity.
In these situations, the WOTC provides employers with a monetary
incentive to bear the costs of training members of targeted groups
and providing them with job-related skills which may increase
the chances of these individuals being hired in unsubsidized
jobs. Both situations encourage employment of members of the
targeted groups, and may act to increase wages for those hired
as a result of the credit.
As discussed below, the evidence is mixed on whether the rationales
for the credit are supported by economic data. The information
presented is intended to provide a structured way to determine if
employers and employees respond to the existence of the credit in
the desired manner.
Efficiency of the credit
The credit provides employers with a subsidy for hiring members of
targeted groups. For example, assume that a worker eligible for
the credit is paid an hourly wage of w and works 2,000 hours during
the year. The worker is eligible for the full credit (40 percent
of the first $6,000 of wages), and the firm will receive a $2,400
credit against its income taxes and reduce its deduction for wages
by $2,400. Assuming the firm faces the full 35-percent corporate
income tax rate, the cost of hiring the credit-eligible worker is
lower than the cost of hiring a credit-ineligible worker for 2,000
hours at the same hourly wage w by 2,400 (1-.35) = $1,560.
This $1,560 amount would be constant for all workers unless the
wage (w) changed in response to whether or not the individual was
a member of a targeted group. If the wage rate does not change in
response to credit eligibility, the WOTC subsidy is larger in
percentage terms for lower wage workers. If w rises in response
to the credit, it is uncertain how much of the subsidy remains
with the employer, and therefore the size of the WOTC subsidy to
employers is uncertain.
To the extent the WOTC subsidy flows through to the workers eligible
for the credit in the form of higher wages, the incentive for
eligible individuals to enter the paid labor market may increase.
Since many members of the targeted groups receive governmental
assistance (e.g., Temporary Assistance for Needy Families or food
stamps), and these benefits are phased out as income increases,
these individuals potentially face a very high marginal tax rate
on additional earnings. Increased wages resulting from the WOTC
______________________
/482/ The after-tax cost of hiring this credit eligible worker
would be ((2,000)(w)-2,400)(1-.35) dollars. This example does not
include the costs to the employer for payroll taxes (e.g.,
Social security, Medicare and unemployment taxes) and any
applicable fringe benefits.
may be viewed as a partial offset to these high marginal tax
rates. In addition, it may be the case that even if the credit
has little effect on observed wages, credit-eligible individuals
may have increased earnings due to increased employment.
The structure of the WOTC (the 40-percent credit rate for the first
$6,000 of qualified wages) appears to lend itself to the potential
of employers churning employees who are eligible for the credit.
This could be accomplished by firing employees after they earn
$6,000 in wages and replacing them with other WOTC-eligible
employees. If training costs are high relative to the size of the
credit, it may not be in the interest of an employer to churn such
employees in order to maximize the amount of credit claimed.
Empirical research in this area has not found an explicit
connection between employee turnover and utilization of WOTC's
predecessor, the Targeted Jobs Tax Credit ("TJTC").
Job creation
The number of jobs created by the WOTC is certainly less than the
number of certifications. To the extent employers substitute
WOTC-eligible individuals for other potential workers, there is
no net increase in jobs created. This could be viewed as merely
a shift in employment opportunities from one group to another.
However, this substitution of credit-eligible workers for others
may not be socially undesirable. For example, it might be
considered an acceptable trade-off for a targeted group member
to displace a secondary earner from a well-to-do family (e.g., a
spouse or student working part-time).
In addition, windfall gains to employers or employees may accrue
when the WOTC is received for workers that the firm would have
hired even in the absence of the credit. When windfall gains are
received, no additional employment has been generated by the
credit. Empirical research on the employment gains from the TJTC
has indicated that only a small portion of the TJTC-eligible
population found employment because of the program. One study
indicates that net new job creation was between five and 30
percent of the total certifications. This finding is consistent
with some additional employment as a result of the TJTC program,
but with considerable uncertainty as to the exact magnitude.
A necessary condition for the credit to be an effective employment
incentive is that firms incorporate WOTC eligibility into their
hiring decisions. This could be done by determining credit
eligibility for each potential employee or by making a concerted
effort to hire individuals from segments of the population likely
to include members of targeted groups. Studies examining this
issue through the TJTC found that some employers made such efforts,
__________________________
/483/ See, for example, Macro Systems, Inc., Final Report of the
Effect of the Targeted Jobs Tax Credit Program on Employers, U.S.
Department of Labor, 1986.
/484/ Macro Systems, Inc., Impact Study of the Implementation and
Use of the Targeted Jobs Tax Credit: Overview and Summary, U.S.
Department of Labor, 1986.
while other employers did little to determine eligibility for the
TJTC prior to the decision to hire an individual. In these latter
cases, the TJTC provided a cash benefit to the firm, without
affecting the decision to hire a particular worker.
Complexity issues
Extension of the provision for one year provides some continuity
and simplifies tax planning during that period for taxpayers
and practitioners. Some may argue that a permanent
extension will have a greater stabilizing effect on the tax law.
They point out that temporary expirations, like the current one,
not only complicate tax planning but also deter some taxpayers
from participating in the program. Others who are skeptical of
the efficacy of the WOTC program may argue that not extending
the credit could eliminate a windfall benefit to certain
taxpayers and permanently reduce complexity in the Code.
Prior Action
Separate proposals to extend the two credits without combining them
were included in the President's fiscal year 2002 and 2003 budget
proposals. A similar proposal was included in the President's
fiscal year 2004 and 2005 budget proposals.
____________________
/485/ For example, see U.S. General Accounting Office, Targeted
Jobs Tax Credit: Employer Actions to Recruit, Hire, and Retain
Eligible Workers Vary (GAO-HRD 91-33), February 1991.
/486/ Pub. L. No. 107-147, "The Job Creation and Worker Assistance
Act of 2002," extended the credit for two years.
D. Extend District of Columbia Homebuyer Tax Credit
Present Law
First-time homebuyers of a principal residence in the District of
Columbia are eligible for a nonrefundable tax credit of up to $5,000
of the amount of the purchase price. The $5,000 maximum credit
applies both to individuals and married couples. Married
individuals filing separately can claim a maximum credit of $2,500
each. The credit phases out for individual taxpayers with adjusted
gross income between $70,000 and $90,000 ($110,000-$130,000 for
joint filers). For purposes of eligibility, "first-time homebuyer"
means any individual if such individual did not have a present
ownership interest in a principal residence in the District of
Columbia in the one-year period ending on the date of the purchase
of the residence to which the credit applies. The credit is
scheduled to expire for residences purchased after December 31, 2005.
Description of Proposal
The proposal extends the first-time homebuyer credit for one year,
through December 31, 2006.
Effective date.--The proposal is effective for residences purchased
after December 31, 2005.
Analysis
The D.C. first-time homebuyer credit is intended to encourage home
ownership in the District of Columbia in order to stabilize or
increase its population and thus to improve its tax base.
Recently, home sales in D.C. have reached record levels, and sales
prices have increased. However, this has been equally true in
surrounding communities. It is difficult to know the extent to which
the D.C. homebuyer credit may have been a factor in the surge in
home sales. According to the Treasury Department, the homeownership
rate in the District of Columbia is significantly below the rate
for the neighboring States and the nation as a whole. Arguably,
extending the credit would enhance the District of Columbia's
ability to attract new homeowners and establish a stable
residential base.
A number of policy issues are raised with respect to whether the
D.C. homebuyer credit should be extended. One issue is whether
it is the proper role of the Federal government to distort local
housing markets by favoring the choice of home ownership in one
jurisdiction over another. Favoring home ownership in one area
comes at the expense of home ownership in adjacent areas. Thus, if
the credit stimulates demand in the District of Columbia, this
comes at the expense of demand in other portions of the relevant
housing market, principally the nearby suburbs of Virginia and
Maryland.
To the extent that local jurisdictions vary in their tax rates and
services, individuals purchasing a home may choose to buy in the
jurisdiction that offers them the combination of tax rates and
services and other amenities that they desire. If a jurisdiction
has a low tax rate, some might choose it on that basis. If a
jurisdiction has a high tax rate but offers a high level of
services, some will decide that the high tax rate is worth the
services and will choose to buy in that jurisdiction. If tax rates
are high but services are not correspondingly high, individuals may
avoid such jurisdictions. It is in part this individual freedom to
choose where to live that can promote competition in the provision
of local public services, helping to assure that such services
are provided at reasonable tax rates. If a jurisdiction fails
at providing reasonable services at reasonable tax rates,
individuals might choose to move to other jurisdictions. This may
cause property values in the jurisdiction to fall and, together
with taxpayer departures, may put pressure on the local government
to change its behavior and improve its services. If the Federal
government were to intervene in this market by encouraging the
purchase of a home in one local market over another, competition
among local jurisdictions in the provision of public services
may be undermined.
In the above scenario, however, a dwindling tax base may make it
financially difficult to improve government services. Some argue
that the District of Columbia is in this position and that it needs
Federal assistance to improve the District's revenue base. An
alternative view is that the tax credit could take some of the
pressure off the local government to make necessary
improvements. By improving the local government's tax base
without a commensurate improvement in government services, the
Federal expenditure could encourage a slower transition to better
governance.
Some argue that the credit is appropriate because a number of
factors distinguish the District of Columbia from other cities
or jurisdictions and that competition among the District and
neighboring jurisdictions is constrained by outside factors. For
example, some argue that the credit is a means of compensating
the District for an artificially restricted tax base. While
many residents of the suburbs work in the District and benefit
from certain of its services, the Federal government precludes the
imposition of a "commuter tax," which is used by some other
jurisdictions to tax income earned within the jurisdiction by
workers who reside elsewhere. In addition, some argue that the
District has artificially reduced property, sales, and income tax
revenues because the Federal government is headquartered in the
District. The Federal government makes a payment to the District
to compensate for the forgone revenues, but some argue that the
payment is insufficient. Some also argue that to the extent
migration from the District is a result of a high tax rate and poor
services, it is not entirely within the control of the
______________________
/488/ Other factors may also affect the choice of where to live,
such as closeness to work or family members.
District to fix such problems, because the District government
is not autonomous, but is subject to the control of Congress.
Another issue regarding the D.C. homebuyer credit is how
effectively it achieves its objective. Several factors might
diminish its effectiveness. First, the $5,000 will not reduce the
net cost of homes by $5,000. Some of the $5,000 is likely to be
captured by sellers, as eligible buyers entering the market with
effectively an additional $5,000 to spend will push prices to
levels higher than would otherwise attain. If the supply of
homes for sale is relatively fixed, and potential buyers relatively
plentiful, then the credit will largely evaporate into sellers'
hands through higher prices for homes.
A second reason the credit might not be very effective at boosting
the residential base of the District is that it applies to existing
homes as well as any new homes that are built. Thus, the family that
sells its D.C. home to a credit-eligible buyer must move elsewhere.
To the extent that they sell in order to move outside of the
District of Columbia, there is no gain in D.C. residences.
And, to the extent that the credit caused home prices to rise,
the credit can be seen as an encouragement to sell a home in the
District as much as an encouragement to buy.
Prior Action
A similar proposal was included in the President's fiscal year 2004
and 2005 budget proposals. The 2005 proposal suggested extension
of the credit for two years, through 2005.
E. Extend Authority to Issue Qualified Zone Academy Bonds
Present Law
Tax-exempt bonds
Interest on State and local governmental bonds generally is excluded
from gross income for Federal income tax purposes if the proceeds of
the bonds are used to finance direct activities of these governmental
units or if the bonds are repaid with revenues of the governmental
units. Activities that can be financed with these tax-exempt bonds
include the financing of public schools (sec. 103). An issuer must
file with the IRS certain information about the bonds issued
by them in order for that bond issue to be tax-exempt (sec.
149(e)). Generally, this information return is required to be
filed no later the 15th day of the second month after the close of
the calendar quarter in which the bonds were issued.
The tax exemption for State and local bonds does not apply to any
arbitrage bond (secs. 103(a) and (b)(2)). 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 (sec. 148). In
general, arbitrage profits may be earned only during specified
periods (e.g., defined "temporary periods") before funds are needed
for the purpose of the borrowing or on specified types of
investments (e.g., "reasonably required reserve or replacement
funds"). Subject to limited exceptions, investment profits that
are earned during these periods or on such investments must be
rebated to the Federal Government.
Qualified zone academy bonds
As an alternative to traditional tax-exempt bonds, States and local
governments were given the authority to issue "qualified zone
academy bonds" ("QZABs") (sec. 1397E). A total of $400 million of
qualified zone academy bonds was authorized to be issued annually in
calendar years 1998 through 2005. The $400 million aggregate bond
cap was allocated each year to the States according to their
respective populations of individuals below the poverty line.
Each State, in turn, allocated the credit authority to qualified
zone academies within such State.
Financial institutions that hold qualified zone academy bonds are
entitled to a nonrefundable tax credit in an amount equal to a
credit rate multiplied by the face amount of the bond. A taxpayer
holding a qualified zone academy bond on the credit allowance date
is entitled to a credit. The credit is includable in gross income
(as if it were a taxable interest payment on the bond), and may be
claimed against regular income tax and AMT liability.
The Treasury Department set the credit rate at a rate estimated to
allow issuance of qualified zone academy bonds without discount and
without interest cost to the issuer. The maximum term of the bond
was determined by the Treasury Department, so that the present
value of the obligation to repay the bond was 50 percent of the
face value of the bond.
"Qualified zone academy bonds" are defined as any bond issued by a
State or local government, provided that (1) at least 95 percent of
the proceeds are used for the purpose of renovating, providing
equipment to, developing course materials for use at, or training
teachers and other school personnel in a "qualified zone academy"
and (2) private entities have promised to contribute to the
qualified zone academy certain equipment, technical assistance or
training, employee services, or other property or services with a
value equal to at least 10 percent of the bond proceeds.
A school is a "qualified zone academy" if (1) the school is a
public school that provides education and training below the
college level, (2) the school operates a special academic program
in cooperation with businesses to enhance the academic curriculum
and increase graduation and employment rates, and (3) either (a)
the school is located in an empowerment zone or enterprise
community designated under the Code, or (b) it is reasonably
expected that at least 35 percent of the students at the school
will be eligible for free or reduced-cost lunches under the school
lunch program established under the National School Lunch Act.
Description of Proposal
The proposal authorizes issuance of up to $400 million of qualified
zone academy bonds annually in calendar years 2006 and 2007. For
qualified zone academy bonds issued after the date of enactment, the
proposal requires issuers to report issuance to the IRS in a manner
similar to the information returns required for tax-exempt bonds.
Effective date.�The provision is effective generally for bonds
issued after the date of enactment.
Analysis
Policy issues
The proposal to extend qualified zone academy bonds would subsidize
a portion of the costs of new investment in public school
infrastructure and, in certain qualified areas, equipment and
teacher training. By subsidizing such costs, it is possible that
additional investment will take place relative to investment that
would take place in the absence of the subsidy. If no additional
investment takes place than would otherwise, the subsidy would
merely represent a transfer of funds from the Federal Government to
States and local governments. This would enable States and local
governments to spend the savings on other government functions or
to reduce taxes. In this event, the stated objective of the
proposals would not be achieved.
Though called a tax credit, the Federal subsidy for tax credit
bonds is equivalent to the Federal Government directly paying the
interest on a taxable bond issue on behalf of the State or
/489/ Most economic studies have found that when additional funding
is made available to localities from outside sources, there is
indeed an increase in public spending (this is known as the
"fly-paper" effect, as the funding tends to "stick" where it is
applied). The additional spending is not dollar for dollar,
however, implying that there is some reduction of local taxes to
offset the outside funding. See Harvey Rosen, Public Finance, sixth
ed., 2002, p. 502-503 for a discussion of this issue.
local government that benefits from the bond proceeds. To see
this, consider any taxable bond that bears an interest rate of 10
percent. A thousand dollar bond would thus produce an interest
payment of $100 annually. The owner of the bond that receives this
payment would receive a net payment of $100 less the taxes owed
on that interest. If the taxpayer were in the 28-percent Federal
tax bracket, such taxpayer would receive $72 after Federal taxes.
Regardless of whether the State government or the Federal
Government pays the interest, the taxpayer receives the
same net of tax return of $72. In the case of tax credit bonds, no
formal interest is paid by the Federal Government. Rather, a tax
credit of $100 is allowed to be taken by the holder of the
bond. In general, a $100 tax credit would be worth $100 to a
taxpayer, provided that the taxpayer had at least $100 in tax
liability. However, for tax credit bonds, the $100 credit also
has to be claimed as income. Claiming an additional $100 in income
costs a taxpayer in the 28-percent tax bracket an additional $28
in income taxes, payable to the Federal Government. With the $100
tax credit that is ultimately claimed, the taxpayer nets $72 on the
bond. The Federal Government loses $100 on the credit, but
recoups $28 of that by the requirement that it be included in
income, for a net cost of $72, which is exactly the net return to
the taxpayer. If the Federal Government had simply agreed to pay
the interest on behalf of the State or local government, both the
Federal Government and the bondholder/taxpayer would be in the same
situation. The Federal Government would make outlays of $100 in
interest payments, but would recoup $28 of that in tax receipts,
for a net budgetary cost of $72, as before. Similarly, the bondholder/taxpayer would receive a taxable $100 in interest, and
would owe $28 in taxes, for a net gain of $72, as before. The
State or local government also would be in the same situation in
both cases.
Use of qualified zone academy bonds to subsidize public school
investment raises some questions of administrative efficiencies
and tax complexity (see above). Because potential purchasers of
the zone academy bonds must educate themselves as to whether the
bonds qualify for the credit, certain "information costs" are
imposed on the buyer. Additionally, since the determination as to
whether the bond is qualified for the credit ultimately rests with
the Federal Government, further risk is imposed on the investor.
These information costs and other risks serve to increase the
credit rate and hence the costs to the Federal Government for a
given level of support to the zone academies. For these reasons,
and the fact that tax credit bonds will be less liquid than
Treasury Securities, the bonds would bear a credit rate that is
equal to a measure of the yield on outstanding corporate bonds.
Inefficiency in the program also can be attributed to the fact that
qualified zone academy bonds, unlike interest-bearing State and
local bonds, are not subject to the arbitrage or rebate requirements
of the Code. The ability to earn and retain arbitrage profits
_____________________
/490/ This is true provided that the taxpayer faces tax liability of
at least the amount of the credit. Without sufficient tax
liability, the proposed tax credit arrangement would not be as
advantageous. Presumably, only taxpayers who anticipate having
sufficient tax liability to be offset by the proposed credit would
hold these bonds.
provides an incentive for issuers to issue more bonds and to issue
them earlier than necessary, which increases the cost of the
subsidy. On the other hand, the lack of arbitrage or rebate
requirements for qualified zone academy bonds subsidizes the
repayment of principal on such bonds, as well as other qualified
expenditures, by allowing issuers to invest proceeds at unrestricted
yields and retain the earnings from such investments. Opponents
to the imposition of arbitrage or rebate requirements may argue
that such restrictions will decrease the amount of subsidy
available to assist schools with significant needs, but limited
means through which to satisfy those needs.
The direct payment of interest by the Federal Government on behalf
of States or localities, which was discussed above as being
economically the equivalent of the credit proposal, would involve
less complexity in administering the income tax, as the interest
could simply be reported as any other taxable interest.
Additionally, the tax credit approach implies that non-taxable
entities would only be able to invest in the bonds to assist school
investment through repurchase agreements or by acquiring rights to
repayment of principal if a tax credit bond is stripped. In the
case of a direct payment of interest, by contrast, tax-exempt
organizations would be able to enjoy such benefits.
Complexity issues
A temporary extension provides some stability in the qualified zone
academy bonds program. Certainty that the program would continue
at least temporarily, without further interruption or modification,
arguably would facilitate financial planning by taxpayers during
that period. The uncertainty that results from expiring provisions
may adversely affect the administration of and perhaps the level
of participation in such provisions. For example, a taxpayer may
not be willing to devote the time and effort necessary to satisfy
the complex requirements of a provision that expires shortly.
Similarly, the Internal Revenue Service must make difficult
decisions about the allocation of its limited resources between
permanent and expiring tax provisions.
Some argue that a permanent or long-term extension is necessary to
encourage optimal participation among potential QZAB issuers.
Others respond that the permanent repeal of expiring provisions
such as the QZAB rules that are inherently complex would provide
the same level of certainty for tax planning purposes as a
long-term or permanent extension, and would further reduce the
overall level of complexity in the Code. A related argument is
that programs such as qualified zone academy bonds would be more
efficient if administered as direct expenditure programs rather than
as a part of the tax law.
The proposal's reporting requirements may assist in the monitoring
of the use of these bonds. On the other hand, it will add to
complexity in that it imposes a requirement not previously applied
to qualified zone academy bonds. In addition, the proposal
increases the paperwork burden on issuers in that forms must be
completed and filed with the IRS.
___________________________
/491/ The Treasury Department issued proposed regulations on March
26, 2004 that would require issuers of qualified zone academy
bonds to spend proceeds with due diligence. 69 CFR 15747 (March
26, 2004).
Prior Action
Similar proposals were included in the President's fiscal year
2003, 2004, and 2005 budget proposals.
F. Extend Deduction for Corporate Donations of Computer Technology
Present Law
In the case of a charitable contribution of inventory or other
ordinary-income or short-term capital gain property, the amount of
the charitable deduction generally is limited to the taxpayer's
basis in the property. In the case of a charitable contribution of
tangible personal property, the deduction is limited to the
taxpayer's basis in such property if the use by the recipient
charitable organization is unrelated to the organization's
tax-exempt purpose. In cases involving contributions to a private
foundation (other than certain private operating foundations),
the amount of the deduction is limited to the taxpayer's basis
in the property.
Under present law, a taxpayer's deduction for charitable
contributions of scientific property used for research and for
contributions of computer technology and equipment generally is
limited to the taxpayer's basis (typically, cost) in the property.
However, certain corporations may claim a deduction in excess of
basis for a "qualified research contribution" or a "qualified
computer contribution." This enhanced deduction is 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 minus
basis) or (2) two times basis. The enhanced deduction for qualified
computer contributions expires for any contribution made during
any taxable year beginning after December 31, 2005.
A qualified computer contribution means a charitable contribution
of any computer technology or equipment, which meets standards
of functionality and suitability as established by the Secretary of
the Treasury. The contribution must be to certain educational
organizations or public libraries and made not later than three
years after the taxpayer acquired the property or, if the taxpayer
constructed the property, not later than the date construction of
the property is substantially completed. The original use of the
property must be by the donor or the donee, and in the case of
the donee, must be used substantially for educational purposes
related to the function or purpose of the donee. The property must
fit productively into the donee's education plan. The donee may
not transfer the property in exchange for money, other property, or
services, except for shipping, installation, and transfer costs.
To determine whether property is constructed by the taxpayer,
the rules applicable to qualified research contributions apply.
That is, property is considered constructed by the taxpayer only
if the cost of the parts used in the construction of the property
(other than parts manufactured by the taxpayer or a related person)
__________________
/492/ Sec. 170(e)(1).
/493/ Secs. 170(e)(4) and 170(e)(6).
/494/ If the taxpayer constructed the property and reacquired such
property, the contribution must be within three years of the date
the original construction was substantially completed.
Sec. 170(e)(6)(D)(i).
/495/ This requirement does not apply if the property was reacquired
by the manufacturer and contributed. Sec. 170(e)(6)(D)(ii).
does not exceed 50 percent of the taxpayer's basis in the property.
Contributions may be made to private foundations under certain
conditions.
Description of Proposal
The proposal extends the enhanced deduction to apply to donations
made in taxable years beginning after December 31, 2005 and to
donations made in taxable years beginning before January 1, 2007.
Effective date.--The proposal is effective on the date of
enactment.
Analysis
The enhanced deduction for computer equipment and software is
intended to give businesses greater incentive to contribute
computer equipment and software to educational organizations and
public libraries. In the absence of the enhanced deduction of
present law, if a taxpayer were to dispose of excess inventory by
dumping unneeded computer equipment in a garbage dumpster, the
taxpayer generally could claim the purchase price of the inventory
(the taxpayer's basis in the property) as an expense against the
taxpayer's gross income. In the absence of the enhanced deduction,
if the taxpayer were to donate the unneeded computer equipment to a
school or library, the taxpayer generally would be able to claim a
charitable deduction equal to the taxpayer's basis in the computer
equipment (subject to certain limits on charitable contributions).
From the perspective of the taxpayer's profit motive, the taxpayer
would be indifferent between donating the computer equipment and
dumping the computer equipment in a garbage dumpster. If the
taxpayer must incur costs to deliver the computer equipment to the
school or library, the taxpayer may not find it in the taxpayer's
financial interest to donate the computer equipment to the school
or library. On the other hand, a taxpayer may make a contribution
regardless of any tax benefit because of goodwill generated by the
gift. For example, a company may determine that a contribution of
computers to public libraries will expose potential new buyers to
their products and that such goodwill alone is worth any incremental
costs incurred to deliver the equipment.
Proponents argue that present law helps accelerate the nationwide
adoption of computer technology in education and helps avail more
individuals internet access through their local public library.
Proponents argue that more time is needed to achieve higher levels
of computer access and that it is appropriate to extend the
present-law enhanced deduction to help attain this outcome.
However, some argue that if the intended policy is to promote
adoption of computer technology in education and internet access
via public libraries, it would be more direct and efficient to
provide a direct government subsidy instead of making a tax
expenditure through the tax system, which cannot be monitored under
the annual budgetary process.
The proposal, as does present law, creates complexities for the
taxpayer and the IRS. The enhanced deduction is allowed to the
donor only for equipment that the donee does not trade or sell.
Generally, once the equipment is in the hands of the donee it is
________________________
/496/ Sec, 179(e)(6)(C).
difficult for the donor to monitor the use of the equipment.
Likewise, it is difficult for the IRS to ascertain whether a
claim for an enhanced deduction is valid. Also, the proposal,
as does present law, predicates the enhanced deduction on an
ascertainable fair market value of the computer technology.
With the rapid advances in the field, such determinations are
difficult at times. Computers lose value quickly. However,
third-party tracking of prices for used computer equipment do
exist. In this regard, the limitation to equipment less than
three years old may aid taxpayer compliance and IRS
administration. Nonetheless, because value is uncertain, the
IRS is at a disadvantage in enforcing the provision. To ease
administration and provide greater certainty for taxpayers and
the IRS, the enhanced deduction generally could be based not on
the value of the computer equipment but on the taxpayer's basis
in the equipment and the equipment's age. For example, equipment
one year old or less could receive a deduction of up to twice the
taxpayer's basis; equipment between one and two years old could
receive a deduction of a lesser multiple of the taxpayer's basis;
and equipment two years old or greater could receive a deduction of
an even lesser multiple of the taxpayer's basis. The reduction
in the deduction over time could be justified by the generally
rapid decrease in value of computer equipment over time. The
deduction still would be an enhanced deduction because the
taxpayer would receive more than its basis in the property.
Under such an alternative, the basis multiple would have to be
determined based on information about the markup of new items and
the rate of loss of value over time. However, assuming that the
relationship between value and basis varies over time, the basis
multiple should be adjusted regularly.
Taxpayers who contribute computer equipment from inventory must
consider multiple factors to ensure that they deduct the permitted
amount (and no more than the permitted amount) with respect to
contributed equipment. Taxpayers who are required to maintain
inventories for such items must consider the fair market value
of the contributed equipment, the basis of the equipment (and twice
the basis of the equipment), and the resulting income that would
/497/ The enhanced deduction is equal to the lesser of basis plus
one-half of the item's appreciated value (that is, one-half basis
plus one-half fair market value) or two times basis. The two times
basis limitation is binding only if the fair market value of the
item exceeds three times the item's basis. Thus, a measure of
fair market value always is necessary.
/498/ A recent study concludes that "[n]ot surprisingly, our
empirical results indicate that PCs lose value at a rapid pace.
...[T]he value of a PC declines roughly 50 percent, on average,
with each year of use, implying that a newly installed PC can be
expected to be nearly worthless after five or six years of service.
Mark E. Doms, Wendy E. Dunn, Stephen D. Oliner, and Daniel E. Sichel,
"How Fast Do Personal Computers Depreciate? Concepts and New
Estimates," in James M. Poterba (ed.), Tax Policy and the Economy,
vol. 18, (Cambridge, MA: The MIT Press), 2004
/499/ As under present law, the deduction could not exceed fair
market value.
be realized if the equipment were sold, and coordinate the
resulting contribution deduction with the determination of cost of
goods sold.
Prior Action
An identical proposal was part of the President's fiscal year 2004
and 2005 budgets.
_____________________
/500/ Such taxpayers must remove the amount of the contribution
deduction for the contributed food inventory from opening inventory,
and do not treat the removal as a part of cost of goods sold. IRS
Publication 526, Charitable Contributions, at 7-8.
a
G. Extend Provisions Permitting Disclosure of Tax Return
Information Relating to Terrorist Activity
Present Law
In general
Section 6103 provides that returns and return information may not
be disclosed by the IRS, other Federal employees, State employees,
and certain others having access to the information except as
provided in the Internal Revenue Code. Section 6103 contains a
number of exceptions to this general rule of nondisclosure that
authorize disclosure in specifically identified circumstances
(including nontax criminal investigations) when certain conditions
are satisfied. One of those exceptions is for the disclosure of
return and return information regarding terrorist activity.
Among the disclosures permitted under the Code is disclosure of
returns and return information for purposes of investigating
terrorist incidents, threats, or activities, and for analyzing
intelligence concerning terrorist incidents, threats, or activities.
The term "terrorist incident, threat, or activity" is statutorily
defined to mean an incident, threat, or activity involving an act
of domestic terrorism or international terrorism, as both of those
terms are defined in the USA PATRIOT Act.
In general, returns and taxpayer return information must be
obtained pursuant to an ex parte court order. Return information,
other than taxpayer return information, generally is available upon
a written request meeting specific requirements. No disclosures may
be made under this provision after December 31, 2005.
Disclosure of returns and return information - by ex parte court
order
Ex parte court orders sought by Federal law enforcement and Federal
intelligence agencies
The Code permits, pursuant to an ex parte court order, the
disclosure of returns and return information (including taxpayer
return information ) to certain officers and employees of a
Federal law enforcement agency or Federal intelligence agency.
These officers and employees are required to be personally and
directly engaged in any investigation of, response to, or analysis
of intelligence and counterintelligence information concerning any
terrorist incident, threat, or activity. These officers and
employees are permitted to use this information solely for
their use in the investigation, response, or analysis, and in any
judicial, administrative, or grand jury proceeding, pertaining to
any such terrorist incident, threat, or activity.
_____________________
/501/ 18 U.S.C. 2331 18 U.S.C. 2331.�20
/502/ "Taxpayer return information" is return information that is
filed with, or furnished to, the Secretary by or on behalf of the
taxpayer to whom such return information relates.
The Attorney General, Deputy Attorney General, Associate Attorney
General, an Assistant Attorney General, or a United States attorney,
may authorize the application for the ex parte court order to be
submitted to a Federal district court judge or magistrate. The
Federal district court judge or magistrate would grant the order if
based on the facts submitted he or she determines that: (1) there
is reasonable cause to believe, based upon information believed
to be reliable, that the return or return information may be
relevant to a matter relating to such terrorist incident, threat, or
activity; and (2) the return or return information is sought
exclusively for the use in a Federal investigation, analysis, or
proceeding concerning any terrorist incident, threat, or activity.
Special rule for ex parte court ordered disclosure initiated by the
IRS
If the Secretary of Treasury possesses returns or return
information that may be related to a terrorist incident, threat, or
activity, the Secretary of the Treasury (or his delegate), may on
his own initiative, authorize an application for an ex parte court
order to permit disclosure to Federal law enforcement. In order to
grant the order, the Federal district court judge or magistrate
must determine that there is reasonable cause to believe, based
upon information believed to be reliable, that the return or
return information may be relevant to a matter relating to such
terrorist incident, threat, or activity. The information may be
disclosed only to the extent necessary to apprise the appropriate
Federal law enforcement agency responsible for investigating or
responding to a terrorist incident, threat, or activity and for
officers and employees of that agency to investigate or respond
to such terrorist incident, threat, or activity. Further, use
of the information is limited to use in a Federal investigation,
analysis, or proceeding concerning a terrorist incident, threat,
or activity. Because the Department of Justice represents the
Secretary of the Treasury in Federal district court, the Secretary
is permitted to disclose returns and return information to the
Department of Justice as necessary and solely for the purpose of
obtaining the special IRS ex parte court order.
Disclosure of return information other than by ex parte court order
Disclosure by the IRS without a request
The Code permits the IRS to disclose return information, other than
taxpayer return information, related to a terrorist incident,
threat, or activity to the extent necessary to apprise the
head of the appropriate Federal law enforcement agency responsible
for investigating or responding to such terrorist incident, threat,
or activity. The IRS on its own initiative and without a written
request may make this disclosure. The head of the Federal law
enforcement agency may disclose information to officers and
employees of such agency to the extent necessary to investigate or
respond to such terrorist incident, threat, or activity. A
taxpayer's identity is not treated as taxpayer return information
for this purpose, and may be disclosed under this authority.
Disclosure upon written request of a Federal law enforcement
agency The Code permits the IRS to disclose return information,
other than taxpayer return information, to officers and employees
of Federal law enforcement upon a written request satisfying
certain requirements. A taxpayer's identity is not treated as
taxpayer return information for this purpose and may be disclosed
under this authority. The request must: (1) be made by the head
of the Federal law enforcement agency (or his delegate) involved in
the response to or investigation of terrorist incidents, threats,
or activities, and (2) set forth the specific reason or reasons why
such disclosure may be relevant to a terrorist incident, threat, or
activity. The information is to be disclosed to officers and
employees of the Federal law enforcement agency who would be
personally and directly involved in the response to or investigation
of terrorist incidents, threats, or activities. The information is
to be used by such officers and employees solely for such response
or investigation.
The Code permits the head of a Federal law enforcement agency to
redisclose return information received, in response to the written
request described above, to officers and employees of State and
local law enforcement personally and directly engaged in the
response to or investigation of the terrorist incident, threat,
or activity. The State or local law enforcement agency must be
part of an investigative or response team with the Federal law
enforcement agency for these disclosures to be made.
Disclosure upon request from the Departments of Justice or Treasury
for intelligence analysis of terrorist activity
Upon written request satisfying certain requirements discussed
below, the IRS is to disclose return information (other than
taxpayer return information) to officers and employees of the
Department of Justice, Department of Treasury, and other Federal
intelligence agencies, who are personally and directly engaged in
the collection or analysis of intelligence and counterintelligence
]or investigation concerning terrorist incidents, threats, or
activities. Use of the information is limited to use by such
officers and employees in such investigation, collection,
or analysis. A taxpayer's identity is not treated as taxpayer
return information for this purpose and may be disclosed under this
authority.
The written request is to set forth the specific reasons why the
information to be disclosed is relevant to a terrorist incident,
threat, or activity. The request is to be made by an individual
who is: (1) an officer or employee of the Department of Justice
or the Department of Treasury, (2) appointed by the President with
the advice and consent of the Senate, and (3) responsible for
the collection, and analysis of intelligence and counterintelligence
information concerning terrorist incidents, threats, or activities.
The Director of the United States Secret Service also is an
authorized requester under the Act.
Description of Proposal
The proposal extends the disclosure authority relating to terrorist
activities. Under the proposal, no disclosures can be made after
December 31, 2006.
Effective date.--The proposal is effective for disclosures on or
after the date of enactment.
Analysis
The temporary nature of the present-law provision introduces a
degree of uncertainty regarding the disclosure of return information
relating to terrorist activities, i.e., whether the provision will
be the subject of further extensions. There has been no study of
the effectiveness of the provisions.
According to IRS accountings of disclosures made under the authority
of the provisions in calendar year 2002, the IRS reported 39
disclosures to the Federal Bureau of Investigation under the
terrorist activity provisions governing IRS-initiated disclosures
to Federal law enforcement. However, the IRS used its authority
to make disclosures in emergency circumstances to make an
additional 12,236 disclosures to the FBI. The IRS made 25
disclosures to the Department of Justice for purposes of preparing
an application for an ex parte court order to permit the IRS to
initiate an affirmative disclosure of returns and return
information. Pursuant to the ex parte court order authority, 2,215
disclosures were made to U.S. Attorneys in calendar year 2002.
The IRS did not report any terrorist activity disclosures to
Federal intelligence agencies, nor did it report any disclosures
in response to requests from Federal law enforcement agencies for
calendar year 2002.
For calendar year 2003, 1,626 disclosures were made under the
terrorist activity provisions governing IRS disclosures to Federal
law enforcement. Under the ex parte court order authority, 1,724
disclosures were made to U.S. Attorneys in calendar year 2003.
The IRS did not report any disclosures to Federal intelligence
agencies or in response to requests from Federal law enforcement
agencies for calendar year 2003. This limited usage could be an
indication that further extension of the provision is not warranted.
On the other hand, this may not be a significant number of
disclosures to evaluate the effectiveness of the provision. An
additional temporary extension provides additional time to evaluate
the effectiveness of the provision and whether any modifications
need to be implemented to enhance the provision.
Some argue that the terrorist activity disclosure provisions are
duplicative provisions that were already in place for emergency
disclosures and for use in criminal investigations. As noted
above, the IRS used its emergency disclosure authorization to make
disclosures to the Federal Bureau of Investigation concerning
terrorist activity. However, the emergency disclosure
authorization is to be used under circumstances involving an
imminent danger of death or physical injury. In the case of
terrorist activity, it may not be clear whether the danger is
"imminent", which could lead to the misapplication of the emergency
authority and uncertainty as to whether a particular disclosure is
authorized. Thus, the existence of a specific disclosure provision
for terrorist activity information provides clear authority and
direction for making disclosures to combat terrorism.
_____________________
/503/ Joint Committee on Taxation, Revised Disclosure Report for
Public Inspection Pursuant to Internal Revenue Code Section 6103(p)
(3)(c) for Calendar Year 2002 (JCX-29-04), April 6, 2004.
/504/ Joint Committee on Taxation, Disclosure Report for Public
Inspection Pursuant to Internal Revenue Code Section 6103(p)(3)(C) for Calendar Year 2003 (JCX-30-04), April 6, 2004.
The requirements for disclosure of terrorist activity information
are not as stringent as those required for criminal investigations.
For example, the granting of an ex parte order
relating to terrorist activities does not require a finding that
there is reasonable cause to believe that a specific criminal act
has been committed. In cases involving terrorist activity the
judge or magistrate needs to determine that there is reasonable
cause to believe that the return or return information may be
relevant to a matter relating to such terrorist incident, threat or
activity. In addition, unlike the requirements for criminal
investigations, the judge or magistrate does not need to find that
the information cannot be reasonably obtained from another source
before granting the request for an ex parte order for disclosure
relating to terrorist activity. Some argue that the less stringent
requirements facilitate a proactive approach to combating
terrorism.
Prior Action
A similar proposal was included in the President's fiscal year 2005
budget proposals.
H. Extend Excise Taxes Deposited in the Leaking Underground Storage
Tank ("LUST") Trust Fund
Present Law
The Code imposes an excise tax, generally at a rate of 0.1 cents per
gallon, on gasoline, diesel, kerosene, and special motor fuels ,
used on highways, in aviation, on inland waterways and in
diesel-powered trains. The taxes are deposited in the Leaking
Underground Storage Tank ("LUST") Trust Fund. The tax expires on
March 31, 2005.
Description of Proposal
The LUST Trust Fund tax is extended at the current rate through
March 31, 2007.
Analysis
The LUST Trust Fund enables the Environmental Protection Agency and
States to pay the costs of responding to leaking underground storage
tanks when the tank owners fail to do so, or in an emergency
situation, and to oversee LUST cleanup activities by responsible
parties. Thus, an extension of the tax would ensure the
availability of funds for these activities.
On the other hand, some may contend that based on historical
appropriations, the Trust Fund has sufficient funds on hand. At
the end of FY 2004, the LUST Trust Fund's net assets were $2.24
billion. In FY 2004, the LUST tax generated $192.9 million in
revenues, and the fund earned $66.7 million in interest.
Historically, authorized appropriations from the Trust Fund have
ranged from $70 to $76 million. For FY 2003, Congress authorized
appropriations of $72.3 million. For FY 2004, Congress
appropriated approximately $76 million, and in FY 2005, Congress
provided $70 million.
_____________________
/505 The tax does not apply to liquefied petroleum gas liquefied
natural gas. Sec. 4041(d)(1).
/506/ An underground storage tank system ("UST") is a tank and any
underground piping connected to the tank that has at least 10 percent
of its combined volume underground. The Federal UST regulations
apply only to underground tanks and piping storing either petroleum
or certain hazardous substances. According to the Environmental
Protection Agency, the greatest potential hazard from a leaking UST
is that the petroleum or other hazardous substance can seep into the
soil and contaminate groundwater. A leaking UST can also present
other health and environmental risks, including fire and explosion.
U.S. Environmental Protection Agency, Overview of the Federal
Underground Storage Tank Program
http://www.epa.gov/swerust1/overview.htm (visited February 23, 2005).
Proponents of an extension may argue that an extension is justified
because there is a significant backlog of sites requiring remedial
action (129,827). In addition, the discovery of the gasoline
additive methyl tertiary butyl ether ("MTBE") at thousands of LUST
sites is a major concern. Corrective action for leaks that affect
groundwater typically cost from $100,000 to over $1 million,
depending on the extent of contamination. The presence of MTBE can
lead to a substantial increase in cleanup and drinking water
treatment costs. Energy bills from the 108th Congress sought to
broaden the use of Trust Fund monies, increasing Trust Fund
appropriations to clean up MTBE leaks, and adding new leak
prevention and enforcement provisions to the underground storage
tank program. In light of these possible new uses of the
fund, some might argue that past appropriations are not indicative
of the future needs of the LUST Trust Fund program.
Prior Action
]
The Superfund Revenue Act of 1986 created the LUST Trust Fund. The
taxing authority expired in December 1995. Congress reinstated the
tax from October 1, 1997, through March 31, 2005.
____________________
activities for FY2003-FY2005. The mandatory recission amounts
applied for these years were: 0.65% for FY2003; 0.59% for FY2004;
and 0.8% for FY2005.
/508/ This figure is as of September 2004. See U.S. Environmental
Protection Agency, UST Program Facts (February 2005).
/509/ CRS Report at CRS-1.
/510/ U.S. Environmental Protection Agency, Leaking Underground
Storage Tank (LUST)Trust Fund
(visited February 23,
2005).
/511/ Id. MTBE is very water soluble and moves through soil into
water more rapidly than other gasoline components. CRS Report at
CRS-4.
/512/ See e.g. H.R. 6 and S. 2095 (108th Cong.). For a
comprehensive list of bills introduced in the 108th Congress on
this topic see CRS Report at CRS-5-6.
/513/ Pub. L. No. 105-34, sec. 1033 (1997).
I. Extend Excise Tax on Coal at Current Rates
Present Law
A $1.10 per ton excise tax is imposed on coal sold by the producer
from underground mines in the United States. The rate is 55 cents
per ton on coal sold by the producer from surface mining
operations. The tax cannot exceed 4.4 percent of the coal
producer's selling price. No tax is imposed on lignite.
Gross receipts from the excise tax are dedicated to the Black Lung
Disability Trust Fund to finance benefits under the Federal Black
Lung Benefits Act. Currently, the Black Lung Disability Trust Fund
is in a deficit position because previous spending was financed with
interest-bearing advances from the General Fund.
The coal excise tax rates are scheduled to decline to 50 cents per
ton for underground-mined coal and 25 cents per ton for surface-mined
coal (and the cap is scheduled to decline to two percent of the
selling price) for sales after January 1, 2014, or after any earlier
January 1 on which there is no balance of repayable advances from
the Black Lung Disability Trust Fund to the General Fund and no
unpaid interest on such advances.
Description of Proposal
The proposal retains the excise tax on coal at the current rates
until the date on which the Black Lung Disability Trust Fund has
repaid, with interest, all amounts borrowed from the General Fund.
After repayment of the Trust Fund's debt, the reduced rates of $.50
per ton for coal from underground mines and $.25 per ton for coal
from surface mines apply and the tax per ton of coal is capped at
2 percent of the amount for which it is sold by the producer.
Effective date.--The proposal is effective for coal sales after
December 31, 2004.
Analysis
Trust fund financing of benefits was established in 1977 to reduce
reliance on the Treasury and to recover costs from the mining
industry. Claims were much more numerous than expected and it was
difficult to find responsible operators, litigate their challenges
and collect from them. Therefore, deficits were financed with
interest-bearing advances from the General Fund. During each year
of the period 1992-2002, the expenses of the program covered by the
trust fund (benefits, administration and interest) have exceeded
revenues, with an advance from the General Fund making up the
difference and accumulating as a debt. Direct costs (benefits
and administration), however, have been less than revenues.
According to the Congressional Research Service, if it were not
for the interest on the accumulated deficit, the trust fund would
_______________________
/514/ Congressional Research Service, RS21239 The Black Lung
Benefits Program (June 12, 2002) at 6.
be self-supporting: "In effect, the annual advances from the
Treasury are being used to pay back interest to the Treasury, while
the debt has been growing as if with compound interest."
Miners and survivors qualify for benefits from the Fund only if the
miner's mine employment terminated before 1970 or no mine operator
is liable for the payment of benefits. Some might argue that since
the Federal Government has essentially made a loan to itself with a
transfer between funds, the interest component should be forgiven.
Because the class of beneficiaries is dwindling and revenues
currently cover benefits and administrative costs, coal tax revenues
could eventually pay off the bonds if extended at their current
rates.
Based on historical trends, it appears that the trust fund will not
be able to pay off its debt by December 31, 2013. Therefore, it
could be argued that it is appropriate to continue the tax on coal
at the increased rates beyond that expiration date until the debt
is repaid, rather than require that the General Fund provide even
larger advances to the trust fund. On the other hand, since
the tax is not scheduled to be reduced until December 31, 2013, it
could be argued that this proposal to further extend the rates is
premature.
Prior Action
An identical proposal was included in the President's fiscal year
2005 budget proposal.
IX. OTHER PROVISIONS MODIFYING THE INTERNAL REVENUE CODE
A. Election to Treat Combat Pay as Earned Income
for Purposes of the Earned Income Credit
Present Law
Child Credit
Combat pay that is otherwise excluded from gross income under
section 112 is treated as earned income which is taken into
account in computing taxable income for purposes of calculating the
refundable portion of the child credit.
Earned Income Credit
Any taxpayer may elect to treat combat pay that is otherwise
excluded from gross income under section 112 as earned income for
purposes of the earned income credit. This election is available
with respect to any taxable year ending after the date of enactment
and before January 1, 2006.
Effective date.--The proposal would be effective upon enactment.
Description of Proposal
The proposal extends the provision relating to the earned income
credit for one year (through December 31, 2006).
Analysis
The exclusion of combat pay from gross income is intended to
benefit military personnel serving in combat. However, to the
extent that certain tax benefits, such as the child credit and
the earned income credit, may vary based on taxable or earned
income, the exclusion has the potential to increase tax liability.
Including combat pay in gross income for purposes of the refundable
child credit is always advantageous to the taxpayer. However,
including combat pay for purposes of calculating the earned income
credit may either help or hurt the taxpayer, because the credit
both phases in and phases out based on earned income.
If the objective of the present-law rules it to ensure that the
exclusion of combat pay from gross income does not result in an
increase in tax liability, an election to include combat pay in
income for all Code purposes would be sufficient to achieve
that objective. Present law, however, takes a more taxpayer
favorable approach by allowing the tax treatment of combat pay
to vary across Code provisions when such variation is favorable,
and thus present law (1) always treats combat pay as earned income
for purposes of the refundable portion of the child credit, as
that is always the most favorable result because the refundable
child credit can only rise as income rises, and (2) allows the
taxpayer to elect to include combat pay as earned income for
purposes of the EIC (advantageous to the taxpayer depending on the
amount of earned income that would result).
The election to include or exclude combat pay for purposes of the
earned income credit creates complexity. In general, elections
always add complexity, because taxpayers need to calculate their tax
liability in more than one way in order to determine which result is
best for them.
The present-law rules with respect to combat pay treat such pay
differently than other nontaxable compensation for purposes of the
definition of earned income in the refundable child credit and the
earned income credit. For example, under present law, other
nontaxable employee compensation (e.g., elective deferrals such
as salary reduction contributions to 401(k) plans) is not includible
in earned income for these purposes. Allowing combat pay to be
included in earned income creates an inconsistent treatment between
it and other nontaxable employee compensation and arguably creates
inequities between taxpayers who receive combat pay compared to other
types of nontaxable compensation.
Prior Action
No prior action.
B. Expand Protection for Members of the Armed Forces
Present Law
General time limits for filing tax returns
Individuals generally must file their Federal income tax returns by
April 15 of the year following the close of a taxable year. The
Secretary may grant reasonable extensions of time for filing such
returns. Treasury regulations provide an additional automatic
two-month extension (until June 15 for calendar-year individuals)
for United States citizens and residents in military or naval service
on duty on April 15 of the following year (the otherwise applicable
due date of the return) outside the United States. No action is
necessary to apply for this extension, but taxpayers must indicate
on their returns (when filed) that they are claiming this extension.
Unlike most extensions of time to file, this extension applies to
both filing returns and paying the tax due.
Treasury regulations also provide, upon application on the proper
form, an automatic four-month extension (until August 15 for
calendar-year individuals) for any individual timely filing that
form and paying the amount of tax estimated to be due.
In general, individuals must make quarterly estimated tax payments
by April 15, June 15, September 15, and January 15 of the following
taxable year. Wage withholding is considered to be a payment of
estimated taxes.
Suspension of time periods
In general, the period of time for performing various acts under
the Code, such as filing tax returns, paying taxes, or filing a
claim for credit or refund of tax, is suspended for any
individual serving in the Armed Forces of the United States in an
area designated as a "combat zone" during the period of combatant
activities. This suspension of the time period rules also
applies to persons deployed outside the United States away from
the individual's permanent duty station while participating in an
operation designated by the Secretary of Defense as a contingency
operation or that becomes a contingency operation. An individual
who becomes a prisoner of war is considered to continue in active
service and is therefore also eligible for these suspension of time
provisions. The suspension of time also applies to an individual
serving in support of such Armed Forces in the combat zone, such as
Red Cross personnel, accredited correspondents, and civilian
personnel acting under the direction of the Armed Forces in support
of those Forces. The designation of a combat zone must be made by
the President in an Executive Order. The President must also
designate the period of combatant activities in the combat zone
(the starting date and the termination date of combat).
The suspension of time encompasses the period of service in the
combat zone during the period of combatant activities in the zone,
as well as (1) any time of continuous qualified hospitalization
resulting from injury received in the combat zone or (2) time in
missing in action status, plus the next 180 days.
The suspension of time applies to the following acts:
1. Filing any return of income, estate, or gift tax (except
employment and withholding taxes);
2. Payment of any income, estate, or gift tax (except employment
and withholding taxes);
3. Filing a petition with the Tax Court for redetermination of a
deficiency, or for review of a decision rendered by the Tax Court;
4. Allowance of a credit or refund of any tax;
5. Filing a claim for credit or refund of any tax;
6. Bringing suit upon any such claim for credit or refund;
7. Assessment of any tax;
8. Giving or making any notice or demand for the payment of any
tax, or with respect to any liability to the United States in
respect of any tax;
9. Collection of the amount of any liability in respect of any tax;
10. Bringing suit by the United States in respect of any liability
in respect of any tax; and
11. Any other act required or permitted under the internal revenue
laws specified by the Secretary of the Treasury.
Individuals may, if they choose, perform any of these acts during the
period of suspension. Spouses of qualifying individuals are entitled
to the same suspension of time, except that the spouse is ineligible
for this suspension for any taxable year beginning more than two
years after the date of termination of combatant activities in the
combat zone.
__________________
/517/ Two special rules apply to continuous hospitalization inside
the United States. First, the suspension of time provisions based
on continuous hospitalization inside the United States are
applicable only to the hospitalized individual; they are not
applicable to the spouse of such individual. Second, in no event
do the suspension of time provisions based on continuous
hospitalization inside the United States extend beyond five years
from the date the individual returns to the United States. These
two special rules do not apply to continuous hospitalization
outside the United States.
Servicemembers Civil Relief Act
In general, section 510 of the Servicemembers Civil Relief Act
provides that if a servicemember's ability to pay Federal or State
income tax liability falling due before or during military service
is materially affected by military service (whether or not in a
combat zone), collection activities with respect to the tax
liability is deferred for the period of military service and up to
180 days after the servicemember's termination or release from
military service. No interest or penalties accrue on the unpaid
income tax liability during the period of deferment. The statute of
limitations for the collection of the taxes affected by the deferral
is also extended. The deferral does not apply to certain Social
Security taxes.
Description of Proposal
The proposal makes the provisions of section 7508 that are currently
available to members of the Armed Forces in combat zones or
contingency operations applicable to all Armed Forces reservists
and National Guardsmen called to active duty (regardless of the
location of their active duty). Active duty for persons in the
National Guard is defined as being called to active duty by the
President or the Secretary of Defense for a period of more than 30
consecutive days under section 502(f) of Title 32, United States
Code. Accordingly, calls to active duty by a Governor are
ineligible for this expanded provision. Parallel rules apply to
Armed Forces reservists. In addition, training duty is not
considered to be active duty for this purpose.
The proposal extends Section 510 of the Servicemembers Civil Relief
Act to suspend the assessment and collection of any state income tax
liability for all servicemembers (including Armed Forces reservists
]and National Guardsmen) serving in a designated combat zone and for
all other Armed Forces reservists and National Guardsmen called to
active duty.
Effective date.--The proposal would be effective upon enactment.
Analysis
One issue is whether it is appropriate to extend these benefits to
all reservists on active duty (regardless of the location of their
active duty) who may be stationed alongside regular servicemembers
who, if not stationed in a combat zone, do not enjoy these benefits.
The proposal increases administrative complexity for the Internal
Revenue Service. For example, eligibility for the benefits is
dependent upon whether the call to active duty is issued by
the Federal government or a State government. Particularly in cases
where the servicemember's ability to pay is not materially affected,
it is unclear whether this administrative complexity is warranted.
Prior Action
An identical proposal was included in the President's fiscal year
2005 budget proposal.
__________________________
/518/ Publ. L. No. 108-189, (2003).
C. Extension of the Rate of Rum Excise Tax Cover Over to Puerto
Rico and Virgin Islands
Present Law
A $13.50 per proof gallon excise tax is imposed on distilled
spirits produced in or imported (or brought) into the United
States. The excise tax does not apply to distilled spirits
that are exported from the United States, including exports to U.S.
possessions (e.g., Puerto Rico and the Virgin Islands).
The Code provides for cover over (payment) to Puerto Rico and the
Virgin Islands of the excise tax imposed on rum imported (or
brought) into the United States, without regard to the country of
origin. The amount of the cover over is limited under Code
section 7652(f) to $10.50 per proof gallon ($13.25 per proof gallon
during the period July 1, 1999 through December 31, 2005).
Tax amounts attributable to shipments to the United States of rum
produced in Puerto Rico are covered over to Puerto Rico. Tax
amounts attributable to shipments to the United States of rum
produced in the Virgin Islands are covered over to the Virgin
Islands. Tax amounts attributable to shipments to the United States
of rum produced in neither Puerto Rico nor the Virgin Islands are
divided and covered over to the two possessions under a formula.
Amounts covered over to Puerto Rico and the Virgin Islands are
deposited into the treasuries of the two possessions for use as
those possessions determine. All of the amounts covered over
are subject to the limitation.
_____________________
/519/ A proof gallon is a liquid gallon consisting of 50 percent
alcohol. See sec. 5002(a)(10) and (11).
/520/ Sec. 5001(a)(1).
/521/ Secs. 5062(b), 7653(b) and (c).
/522/ Secs. 7652(a)(3), (b)(3), and (e)(1). One percent of the
amount of excise tax collected from imports into the United States
of articles produced in the Virgin Islands is retained by the
United States under section 7652(b)(3).
/523/ The amount covered over is limited to the amount of excise
tax imposed under section 5001(a)(1), if lower than the limits
stated above. Sec. 7652(f)(2).
/524/ Sec. 7652(e)(2).
/525/ Secs. 7652(a)(3), (b)(3), and (e)(1).
Description of Proposal
The proposal extends the $13.25-per-proof-gallon cover over rate
for one additional year, through December 31, 2006.
Effective date.--The proposal is effective for articles brought
into the United States after December 31, 2005.
Analysis
The fiscal needs of Puerto Rico and the Virgin Islands were the
impetus to extend the increased cover over rate to bolster the
Treasuries in those possessions. Rather than rely on rum
consumption in the United States, increased revenue could be
achieved by intergovernmental support through a direct
appropriation. The advantage of a direct appropriation is that it
provides for annual oversight. Some might argue that a cover over
is akin to an entitlement in terms of the annual budget process and
making it permanent ensures a steady flow of revenue. Although the
cover over may provide a more stable revenue stream, it may be more
difficult to administer than a direct appropriation.
Prior Action
The $13.25 per-proof-gallon cover over rate had been scheduled to
expire after December 31, 2003. The President's fiscal year 2004
and 2005 budget proposals included a proposal that extended the
$13.25 per-proof-gallon cover over rate for two additional years,
through December 31, 2005. The Working Families Tax Relief Act of
2004 enacted that proposal into law.
__________________________
/526/ Pub. L. No. 108-311, sec. 305 (2004).
ESTIMATED BUDGET EFFECTS OF THE REVENUE PROVISIONS
CONTAINED IN THE PRESIDENT'S YEAR 2006 BUDGET PROPOSAL
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