[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 ï¿½ 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.ï¿½AGI 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 ï¿½ are subject to an additional 10-percent tax, unless the 
withdrawal is due to death or disability, is made in the form of 
certain periodic payments, is used to pay medical expenses in excess 
of 7.5 percent of adjusted gross income, is used to purchase health 
insurance of certain unemployed individuals, is used for higher 
education expenses, or is used for first-time homebuyer expenses of 
up to $10,000. 
 
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-ï¿½.  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-ï¿½. 
 
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-ï¿½, on account of death or 
disability, or is made for first-time homebuyer expenses of up 
to $10,000. 
 
Distributions from a Roth IRA that are not qualified distributions 
are includible in income to the extent attributable to earnings.  
To determine the amount includible in income, a distribution that is 
not a qualified distribution is treated as made in the following 
order: 
(1) regular Roth IRA contributions; (2) conversion contributions 
(on a first-in, first-out basis); and (3) earnings.  To the extent 
a distribution is treated as made from a conversion contribution, 
it is treated as made first from the portion, if any, of the 
conversion contribution that was required to be included in income 
as a result of the conversion.  The amount includible in income 
is also subject to the 10-percent early withdrawal tax unless an 
exception applies.  The same exceptions to the early withdrawal tax 
that apply to traditional IRAs apply to Roth IRAs. 
 
Roth IRAs are not subject to the minimum distribution rules during 
the IRA owner's lifetime.  Roth IRAs are subject to the post-death 
minimum distribution rules that apply to traditional IRAs. 
 
Saver's credit 
 
Present law provides a temporary nonrefundable tax credit for 
eligible taxpayers for qualified retirement savings contributions. 
The maximum annual contribution eligible for the credit is $2,000. 
The credit rate depends on the adjusted gross income ("AGI") of the 
taxpayer. Taxpayers filing joint returns with AGI of $50,000 or less, 
head of household returns of $37,500 or less, and single returns 
of $25,000 or less are eligible for the credit. The AGI limits 
applicable to single taxpayers apply to married taxpayers filing 
separate returns.  The credit is in addition to any deduction or 
exclusion that would otherwise apply with respect to the 
contribution.  The credit offsets minimum tax liability as well as 
regular tax liability.  The credit is available to individuals who 
are 18 or over, other than individuals who are full-time students or 
claimed as a dependent on another taxpayer's return.  The credit is 
available with respect to contributions to various types of 
retirement savings arrangements, including contributions to a 
traditional or Roth IRA. 
 
Coverdell education savings accounts 
 
Present law provides tax-exempt status to Coverdell education 
savings accounts, meaning certain trusts or custodial accounts that 
are created or organized in the United States exclusively for the 
purpose of paying the qualified higher education expenses of a 
designated beneficiary. The aggregate annual contributions that can 
be made by all contributors to Coverdell education savings accounts 
for the same beneficiary is $2,000 per year.  In the case of 
contributors who are individuals, the maximum contribution limit is 
reduced for individuals with adjusted gross income between $95,000 
and $110,000 ($190,000 to $220,000 in the case of married taxpayers 
filing a joint return).  Contributions to a Coverdell education 
savings account are not deductible. 
 
Distributions from a Coverdell education savings account are not 
includible in the distributee's income to the extent that the 
total distribution does not exceed the qualified 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-ï¿½, is made on account of 
death or disability, or is a qualified special purpose distribution 
(i.e., for first-time homebuyer expenses of up to $10,000).  A 
distribution from a 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-ï¿½, 
(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.ï¿½The 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.ï¿½The 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-ï¿½. 
 
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-ï¿½, or 
(2) to a split-interest entity on or after the date the IRA owner 
attains age 59-ï¿½.  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-ï¿½ 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 ï¿½ B ï¿½ t(Y ï¿½ 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.ï¿½The 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.ï¿½The 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.ï¿½The 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.ï¿½The 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 zonesï¿½30 in urban areas and 10 in 
rural areasï¿½that 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.ï¿½The 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.ï¿½The 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.ï¿½The 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.ï¿½The 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 investmentï¿½that 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 carsï¿½that 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 marketï¿½once 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.ï¿½The 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 8ï¿½ months after the end of the plan year. 
 If the contribution is made by such due date, the contribution is 
treated as if it were made on the last day of the plan year. 

In the case of a plan with a funded current liability percentage of 
less than 100 percent for the preceding plan year, estimated 
contributions for the current plan year must be made in quarterly 
installments during the current plan year.   The amount of each 
required installment is 25 percent of the lesser of (1) 90 
percent of the amount required to be contributed for the 
current plan year or (2) 100 percent of the amount required 
to be contributed for the preceding plan year. 

Funding waivers

Within limits, the IRS is permitted to waive all or a portion of the 
contributions required under the minimum funding standard for a 
plan year.   A waiver may be granted if the employer (or employers) 
responsible for the contribution could not make the required 

____________________
/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-ï¿½ months after the end of the plan 
year.  However, quarterly contributions are required to be made 
during a plan year if, for the preceding plan year, the plan's 
funding target exceeded the market value of the plan's assets, 
determined as of the valuation date for the preceding plan year. 

A contribution made after the valuation date for a plan year is 
credited against the minimum required contribution for the plan year 
based on its present value as of the valuation date for the plan 

_____________________
/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.ï¿½The 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 faï¿½ade easements.  
Qualified conservation contributions are not subject to the 
"partial interest" rule, which generally denies deductions for 
charitable contributions of partial interests in property.  
Accordingly, qualified conservation contributions are contributions 
of partial interests that are eligible for a fair market value 
deduction. 

A qualified conservation contribution is a contribution of a 
qualified real property interest to a qualified organization 
exclusively for conservation purposes.  A qualified real property 
interest is defined as: (1) the entire interest of the donor other 
than a qualified mineral interest; (2) a remainder interest; or 
(3) a restriction (granted in perpetuity) on the use that may be 
made of the real property.   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 59ï¿½ 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. ï¿½  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 ï¿½ 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.ï¿½For 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.ï¿½In 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.ï¿½The 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.ï¿½20

/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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