[Description of Revenue Provisions Contained in the President's Fiscal Year 2007 Budget Proposal]
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[JOINT
COMMITTEE PRINT]

 

 

DESCRIPTION
OF REVENUE PROVISIONS 

CONTAINED
IN THE PRESIDENT'S 

FISCAL
YEAR 2007 BUDGET PROPOSAL

 

Prepared
by the Staff 

of the 

JOINT
COMMITTEE ON TAXATION

 

 

 

 

 

 

 

March
2006

 

 

U.S.
Government Printing Office 

Washington:
2006

JCS-1-06

 

 

ï¿½

ï¿½

[JOINT
COMMITTEE PRINT]

 

 

DESCRIPTION
OF REVENUE PROVISIONS 

CONTAINED
IN THE PRESIDENT'S 

FISCAL
YEAR 2007 BUDGET PROPOSAL

 

Prepared
by the Staff 

of the 

JOINT
COMMITTEE ON TAXATION

 

 

 

 

 

March
2006

 

 

U.S.
Government Printing Office 

Washington:
2006

JCS-1-06

 

 

 

 

CONTENTS

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Page

INTRODUCTION.............................................................1

I.
MAKING PERMANENT TAX CUTS ENACTED IN 2001 AND 2003....................2

A.
Permanently Extend Certain Provisions Expiringï¿½
Under EGTRRA and JGTRRA

ï¿½ï¿½
......................................................................2

II TAX
INCENTIVES

Provisions
Related to Savings............................................6

1. Expansion
of tax free savings opportunities...........................6

2.
Consolidation of employer-based savings accounts.....................18

3.
Individual development accounts......................................30

B.
Increase Section 179 Expensing.......................................34

C.
Health Care Provisions...............................................37

1.
Facilitate the growth of HSA-eligible health coverage................37

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

individuals.............................................................51

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

credit..................................................................58

D.
Provisions Relating to Charitable Giving.............................61

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

charitable
contributions................................................61

2.
Expand and increase the enhanced charitable deduction for

contributions
of 

food
inventory..........................................................65

3.
Reform excise tax based on investment income of private foundationsï¿½ï¿½ï¿½ï¿½ï¿½ 71

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

trusts..................................................................75

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

appreciated
............................................................78

6.
Repeal the $150 million limit for qualified 501(c)(3) bonds..........79

7.
Repeal the restrictions on the use of qualified 501(c)(3) bonds

for
residential rental property.........................................81

Eï¿½ Extend the Above-the-Line Deduction for
Qualified Out-of-Pocket

Classroom
Expenses......................................................85

F.
Establish Opportunity Zones..........................................89

G.
Permanently Extend Expensing of Brownfields Remediation Costs........96

H.
Restructure Assistance to New York...................................99

III.SIMPLY
THE TAX LAWS FOR FAMILIES...................................105

A.
Clarify Uniform Definition of Child.................................105

B.
Simplify EIC Eligibility Requirements Regarding Filing Status

Presence
of Children, and Work and Immigrant Status....................111

C.
Reduce Computational Complexity of Refundable

ï¿½Child Tax
Credit......................................................117

 

 

 

 

IV.
PROVISIONS RELATED TO THE EMPLOYER-BASED PENSION SYSTEM............120

A.
Provisions Relating to Cash Balance Plans...........................120

B.
Strengthen Funding for Single-Employer Pension Plans................138

1.
Background and summary..............................................138

2.
Funding and deduction rules.........................................139

3. Form
5500, Schedule B actuarial statement and summary annual

reportï¿½ï¿½ï¿½ï¿½ï¿½ 158

4.
Treatment of grandfathered floor-offset plans.......................163

5. Limitations
on plans funded below target levels.....................165

6.
Eliminate plant shutdown benefitsï¿½ï¿½ï¿½ï¿½ï¿½ 171

7.
Proposals relating to the Pension Benefit Guaranty Corporation

("PBGC")...............................................................174

C.
Reflect Market Interest Rates in Lump-Sum Payments..................186

V. TAX
SHELTERS, ABUSIVE TRANSACTIONS, AND TAX COMPLIANCE..............190

A.
Combat Abusive Foreign Tax Credit Transactions......................190

B.
Modify the Active Trade or Business Test for Certain Corporate

Divisions..............................................................192

C.
Impose Penalties on Charities that Fail to Enforce

Conservation
Easements.................................................198

D.
Eliminate the Special Exclusion from Unrelated Business Taxable

Income
("UBIT") for Gain or Loss on Sale or Exchange of Certain

Brownfield
Properties..................................................201

E.
Limit Related-Party Interest Deductions.............................211

F.
Modify Certain Tax Rules for Qualified Tuition Programs.............214

VI.TAX
ADMINISTRATION PROVISIONS AND UNEMPLOYMENT INSURANCE............223

A. IRS
Restructuring and Reform Act of 1998............................223

1.
Modify section 1203 of the IRS Restructuring and

Reform
Act of 1998.....................................................223

2.
Modifications with respect to frivolous returns and

submissions............................................................226

3. Termination
of installment agreements...............................228

4.
Consolidate review of collection due process cases in the United

States
Tax Court.......................................................230

5.
Office of Chief Counsel review of offers in compromise..............231

B.
Initiate Internal Revenue Service ("IRS") Cost Saving
Measures......233

1.
Allow the Financial Management Service to retain transaction

fees
from levied amounts...............................................233

2.
Expand the authority to require electronic filing by large

businesses
and exempt organizations....................................233

C.
Other Provisions....................................................235

1.
Allow Internal Revenue Service ("IRS") to access information

in the
National 

Directory
of New Hires ("NDNH")........................................235

2.
Extension of IRS authority to fund undercover operations............236

D.
Reduce the Tax Gap..................................................238

1.
Implement standards clarifying when employee leasing companies can be held 

liable
for their clients' Federal employment taxes.....................238

2.
Increased information reporting on payment card transactions........242

3.
Increased information reporting for certain government payments for goods 

and
services...........................................................243

4.
Amend collection due process procedures for employment tax

liabilities............................................................245

5.
Expand the signature requirement and penalty provisions applicable to paid 

preparers..............................................................247

Eï¿½ Strengthen the Financial Integrity of
Unemployment Insurance........249

1.
Reduce improper benefit payments and tax avoidance..................249

2.
Extension of Federal Unemployment Surtax............................251

VII.
MODIFY ENERGY POLICY ACT OF 2005..................................253

A.
Repeal Temporary 15-Year Recovery Period for Natural Gas

Distribution
Lines.....................................................253

B.
Modify Amortization for Certain Geological and Geophysical

Expenditures...........................................................256

VIII.EXPIRING
PROVISIONS...............................................258

A.
Extend Alternative Minimum Tax Relief for Individuals...............258

B.
Permanently Extend the Research and Experimentation

("R&E")
Tax Credit.....................................................261

C.
Extend and Modify the Work Opportunity Tax Credit and

Welfare-to-Work
Tax Credit.............................................278

D.
Extend District of Columbia Homebuyer Tax Credit....................286

E.
Extend Authority to Issue Qualified Zone Academy Bonds..............289

F.
Extend Provisions Permitting Disclosure of Tax Return

Information
Relating to Terrorist Activity.............................294

G.
Permanently Extend and Expand Disclosure of Tax Return

Information
for Administration of Student Loans........................300

H.
Extend Excise Tax on Coal at Current Rates..........................304

I.
Election to Treat Combat Pay as Earned Income for

Purposes
of the Earned Income Credit...................................306

IX.OTHER
PROVISIONS MODIFYING THE INTERNAL REVENUE CODE................308

A.
Extension of the Rate of Rum Excise Tax Cover Over to Puerto

Rico
and Virgin Islands................................................308

B.
Establish Program of User Fees for Certain Services Provided to

the
Alcohol Industry by the Alcohol and Tobacco Tax and Trade

Bureau.................................................................310

ESTIMATED
BUDGET EFFECTS OF THE REVENUE PROVISIONS CONTAINED 

IN THE
PRESIDENT'S FISCAL YEAR 2007 BUDGET PROPOSAL....................314

 

 

 

 

 

INTRODUCTION

This
document,ï¿½ prepared by the staff of the
Joint Committee on Taxation,

provides
a description and analysis of the revenue provisions modifying

the
Internal Revenue Code of 1986 (the "Code") that are contained in the

President's
fiscal year 2007 budget proposal, as submitted to the Congress

on
February 6, 2006.ï¿½ï¿½ 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.ï¿½ï¿½ For each
provision, there is a

description
of present law and the proposal (including effective date), a

reference
to relevant prior budget proposals or recent legislative action,

and an
analysis of policy issues related to the proposal.

 

 

I.ï¿½ï¿½ï¿½ MAKING PERMANENT TAX CUTS ENACTED IN 2001
AND 2003

A.ï¿½ï¿½ï¿½ï¿½ï¿½ Permanently Extend Certain Provisions
Expiringï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ The modifications to the expensing provision
sunset 

for
taxable years beginning after December 31, 2007.ï¿½ The capital gains

and
dividend rate provisions sunset for taxable years beginning after

December
31, 2008.

Expensing
provisions

Section
179 provides that the maximum amount a taxpayer may expense, for

taxable
years beginning in 2003 through 2007, is $100,000 of the cost of

qualifying
property placed in service for the taxable year. In general,

qualifying
property is defined as depreciable tangible personal property

that is
purchased for use in the active conduct of a trade or business.ï¿½ 

Off-the-shelf
computer software placed in service in taxable years

beginning
before 2008 is treated as qualifying property.ï¿½
The $100,000

amount
is reduced (but not below zero) by the amount by which the cost of

qualifying
property placed in service during the taxable year exceeds

$400,000.The
$100,000 and $400,000 amounts are indexed for inflation for

taxable
years beginning after 2003 and before 2008.ï¿½ï¿½


An
expensing election is made under rules prescribed by the Secretary 

(sec.
179(c)(1)).ï¿½ Under Treas. Reg. sec.
1.179-5, applicable to property

placed
in service in taxable years beginning after 2002 and before 2008,

a
taxpayer is permitted to make or revoke an election under section 179

without
the consent of the Commissioner on an amended Federal tax return

for
that taxable year. This amended return must be filed within the time

prescribed
by law for filing an amended return for the taxable year.ï¿½ 

For
taxable years beginning in 2008 and thereafter, an expensing election

may be
revoked only with consent of the Commissioner (sec. 179(c)(2)).

Individual
capital gains rates Under JGTRRA, for taxable years beginning

before
January 1, 2009,generally the maximum rate of tax on net capital

gain of
a non-corporate taxpayer is 15 percent.ï¿½
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.ï¿½ 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.ï¿½
Any gain from the sale or

exchange
of property held more than five years and the holding period for

which
began after December 31, 2000, which would otherwise be taxed at a 20

percent
rate is taxed at an 18-percent rate.

Taxation
of dividends received by individuals

Under
rules enacted in JGTRRA, dividends received by a non-corporate

shareholder
from domestic corporations and qualified foreign corporations

generally
are taxed at the same rates that apply to net capital gain.ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ 

Also,
the proposal permanently extends the provisions of JGTRRA relating

to
expensing,ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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).ï¿½ 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.ï¿½ On
the other hand, some may

argue
that this kind of uncertainty is always present to some degree-with

or
without a sunset provision, taxpayers always face some risk that the

Congress
will change a provision of law relevant to the planning 

of
their affairs.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ 

 

Even if
it is assumed that the sunset provisions will take effect, it is

not
clear how the sunsets would apply to certain provisions.ï¿½ It would be

relatively
simple to apply the EGTRRA sunset to some provisions, such as

the
individual rate reductions.ï¿½ 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.ï¿½ 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.ï¿½ For example, under EGTRRA's
estate tax provisions, a

decedent
dying in 2008 has an exemption equivalent amount of $2 million,

one
dying in 2009 has an exemption equivalent amount of $3.5 million, and

one
dying in 2010 effectively has an infinite exemption but not a complete

"step-up"
in the basis of assets. Thus, the estates of individuals at

certain
wealth levels will incur significant estate tax if they die in

2008,
but none at all if they die in 2009; the estates of individuals at

other
wealth levels will incur significant estate tax if they die in 2009,

but
none at all if they die in 2010.ï¿½ These
discontinuities are not caused 

by the
sunset provisions, but they generate a similar sort of uncertainty and

complexity
for many taxpayers.ï¿½ Similar phase-ins
and phase-outs are found

in
other provisions of EGTRRA and generate complexity and uncertainty,

irrespective
of whether EGTRRA as a whole sunsets or not. In light of

these
issues, some may argue that a more detailed reconsideration of EGTRRA 

or
certain of its provisions would better serve the goal of tax simplification.

 

Beyond
phase-ins and phase-outs, some may argue that EGTRRA included other 

provisions
that increased the complexity of the Code, and that allowing

those
provisions to expire at the end of 2010 (or effectively requiring that

they be
reconsidered before then) may reduce complexity, albeit

potentially
years in the future.ï¿½ Others would argue
that some of 

EGTRRA's
provisions reduced complexity, such as the repeal of the overall

limitation
on itemized deductions and changes relating to the earned income

tax
credit, and that permanently extending these provisions would

contribute
to simplification of the tax laws.

 

Prior
Action

 

A
similar proposal was included in the President's fiscal year 2003, 2004,

2005,
and 2006 budget proposals.

 

 

 

 

II.ï¿½ï¿½ TAX INCENTIVES

A.ï¿½ï¿½ï¿½ï¿½ï¿½ Provisions Related to Savings

1.ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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,ï¿½ to which
both deductible and

nondeductible
contributions may be made,ï¿½ and Roth
IRAs.ï¿½ï¿½ 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.ï¿½ However, 

the
contribution limits for IRAs are coordinated so that the maximum annual 

contribution
that can be made to all of an individual's IRAs is the lesser

of a
certain dollar amount ($4,000 for 2006) or the individual's

compensation.ï¿½ In the case of a married
couple,contributions can be made up

to the
dollar limit for each spouse if the combined compensation of 

the
spouses is at least equal to the contributed amount. An individual who

has
attained age 50 before the end of the taxable year may also make

catch-up
contributions to an IRA.ï¿½ For this
purpose, the dollar limit is

increased
by a certain dollar amount ($1,000 for 2006).ï¿½ï¿½
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.ï¿½ The adjusted gross income phase-out ranges
are:ï¿½ (1) for single

taxpayers,
$50,000 to $60,000; (2) for married taxpayers filing joint

returns,
$75,000 to $85,000 for 2006 and $80,000 to $100,000 for years

after
2006 and (3) for married taxpayers filing separate returns, $0 to

$10,000.ï¿½ If an individual is not an active
participant in an

employer-sponsored
retirement plan, but the individual's spouse is, the 

deduction
is phased out for taxpayers with adjusted gross income between

$150,000
and $160,000.

 

To the
extent an individual cannot or does not make deductible contributions


to an
IRA or contributions to a Roth IRA, the individual may make

nondeductible
contributions to a traditional IRA, subject to the same

limits
as deductible contributions.ï¿½ An
individual who has attained age 50

before
the end of the taxable year may also make nondeductible catch-up 

contributions
to an IRA.

 

An
individual who has attained age 70-ï¿½ prior to the close of a year is

not
permitted to make contributions to a traditional IRA.

 

Amounts
held in a traditional IRA are includible in income when withdrawn,

except
to the extent the withdrawal is a return of nondeductible

contributions.ï¿½ Early withdrawals from an IRA generally are
subject to an

additional
10-percent tax.ï¿½ï¿½ 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.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.ï¿½ The five-year rule
does not apply if

distributions
begin within one year of the IRA owner's death and are

payable
over the life or life expectancy of a designated beneficiary. 

Special
rules apply if the beneficiary of the IRA is the surviving spouse.

 

Roth
IRAs

 

Individuals
with adjusted gross income below certain levels may make

nondeductible
contributions to a Roth IRA. The maximum annual contribution

that
may be made to a Roth IRA is the lesser of a certain dollar amount

($4,000
for 2006) or the individual's compensation for the year.ï¿½ An

individual
who has attained age 50 before the end of the taxable year may

also
make catch-up contributions to a Roth IRA up to a certain dollar

amount
($1,000 for 2006).

 

The
contribution limit is reduced to the extent an individual makes

contributions
to any other IRA for the same taxable year.ï¿½
As under the 

rules
relating to traditional IRAs, a contribution of up to the dollar

limit
for each spouse may be made to a Roth IRA provided the combined

compensation
of the spouses is at least equal to the contributed amount.

The
maximum annual contribution that can be made to a Roth IRA is phased

out for
taxpayers with adjusted gross income over certain levels for the

taxable
year.ï¿½ The adjusted gross income
phase-out ranges are:ï¿½ (1) for 

single
taxpayers, $95,000 to $110,000; (2) for married taxpayers filing 

joint
returns, $150,000 to $160,000; and (3) for married taxpayers filing

separate
returns, $0 to $10,000.ï¿½ 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, except for married 

taxpayers
filing separate returns The amount converted is includible in

income
as if a withdrawal had been made, except that the 10-percent early

withdrawal
tax does not apply.

 

Amounts
held in a Roth IRA that are withdrawn as a qualified distribution

are not
includible in income, or subject to the additional 10-percent tax

on
early withdrawals. A qualified distribution is a distribution that (1)

is made
after the five-taxable year period beginning with the first taxable

year
for which the individual made a contribution to a Roth IRA, and (2) is 

made
after attainment of age 59-ï¿½, on account of death or disability, or is

made
for first-time homebuyer expenses of up to $10,000.

 

Distributions
from a Roth IRA that are not qualified distributions are

includible
in income to the extent attributable to earnings.ï¿½ To determine

the
amount includible in income, a distribution that is not a qualified

distribution
is treated as made in the following order:ï¿½


(1)
regular Roth IRA contributions; (2) conversion contributions (on a 

first
in, first out basis); and (3) earnings.ï¿½
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.ï¿½ The amount includible in income is also
subject to the

10-percent
early withdrawal tax unless an exception applies.ï¿½ 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.ï¿½ 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.ï¿½ï¿½ The maximum

annual
contribution eligible for the credit is $2,000.ï¿½ The credit rate

depends
on the adjusted gross income ("AGI") of the taxpayer.ï¿½ 

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.ï¿½ The AGI limits
applicable to single taxpayers

apply
to married taxpayers filing separate returns.ï¿½
The credit is in

addition
to any deduction or exclusion that would otherwise apply with

respect
to the contribution.ï¿½ The credit offsets
minimum tax liability as

well as
regular tax liability.ï¿½ 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.ï¿½
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.ï¿½ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½
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.ï¿½ Contributions to a qualified tuition program


are not
deductible.ï¿½ Contributions to a
qualified tuition program

generally
are treated as a completed gift eligible for the gift tax annual

exclusion.


 

Distributions
from a qualified tuition program are not includible in the

distributee's
gross income to the extent that the total distribution does

not
exceed the qualified education expenses incurred by the beneficiary

during
the year the distribution is made.ï¿½ 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.ï¿½ Amounts in a
qualified tuition program 

may be
rolled over on a tax-free basis to another qualified tuition

program
for the same beneficiary or for a member of the family of that

beneficiary.


 

Health
savings accounts

 

A
health savings account ("HSA") is a trust or custodial account used
to

accumulate
funds on a tax-preferred basis to pay for qualified medical

expenses.ï¿½ï¿½ 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.ï¿½ Distributions from an HSA
that are not used for qualified

medical
expenses are includible in gross income and are 

subject
to an additional 10 percent-tax unless the distribution is made

after
death, disability, or the individual attains the age of Medicare

eligibility
(i.e., age 65). 

 

Eligible
individuals for HSAs are individuals who are covered by a high

deductible
health plan and no other health plan that is not a high

deductible
health plan.ï¿½ A high deductible health
plan is a health plan

that
has a deductible that is at least $1,050 for self-only coverage or 

$2,100
for family coverage (for 2006) and that has an out-of-pocket expense

limit
that is no more than $5,250 in the case of self-only coverage and

$10,500
in the case of family coverage (for 2006).

 

The
maximum aggregate annual contribution that can be made to an HSA is

the
lesser of (1) 100 percent of the annual deductible under the high

deductible
health plan, or (2) the maximum deductible permitted under an

Archer
MSA high deductible health plan under present law, as adjusted for 

inflation.ï¿½ For 2006, the amount of the maximum
deductible under an Archer 

MSA
high deductible health plan is $2,700 in the case of self-only coverage

and
$5,450 in the case of family coverage.ï¿½
The annual contribution limits

are
increased for individuals who have attained age 55 by the end of the

taxable
year.ï¿½ In the case of policyholders and
covered spouses 

who are
age 55 or older, the HSA annual contribution limit is greater than

the
otherwise applicable limit by $700 in 2006, $800 in 2007, $900 in 2008,

and
$1,000 in 2009 and thereafter.Archer medical savings accounts
("MSAs")

Like
HSAs, an Archer MSA is a tax-exempt trust or custodial account to which

tax-deductible
contributions may be made by individuals with a high

deductible
health plan

 

Archer
MSAs provide ta x benefits similar to, but generally not as

favorable
as, those provided by HSAs for certain individuals covered by

high deductible
health plans. The rules relating to Archer MSAs and HSAs

are
similar.ï¿½ The main differences
include:(1) only self-employed

individuals
and employees of small employers are eligible to have an 

Archer
MSA; (2) for MSA purposes, a high deductible plan is a health plan

with
(a) an annual deductible of at least $1,800 and no more than $2,700 in

the
case of individual coverage and at least $3,650 and no more than $5,450

in the
case of family coverage (for 2006), and (b) maximum out-of-pocket

expenses
of no more than $3,650 in the case of individual coverage 

and no
more than $6,650 in the case of family coverage (for 2006); and (3)

the
additional tax on distributions not used for medical expenses is 15

percent
rather than 10 percent After 2005, no new contributions can be made

to
Archer MSAs except by or on behalf of individuals who previously had

Archer
MSA contributions and employees who are employed by a participating

employer.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of
Proposal

 

In general

 

The
proposal consolidates traditional and Roth IRAs into a single type of

account,
a Retirement Savings Account ("RSA").ï¿½ 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.ï¿½ The major difference between the tax
treatment of LSAs and

RSAs is
that all distributions from LSAs are tax free, whereas tax-free

treatment
of earnings on amounts in RSAs applies only to distributions

made
after age 58 or in the event of death or disability.

 

Retirement
Savings Accounts

 

Under
the proposal, an individual may make annual nondeductible

contributions
to an RSA of up to the lesser of $5,000 or the individual's

compensation
for the year.ï¿½ 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.ï¿½ Contributions to an RSA may be made only in
cash.ï¿½ Contributions

to an
RSA are taken into account for purposes of the Saver's credit.ï¿½ 

Earnings
on contributions accumulate on a tax-free basis.

 

Qualified
distributions from RSAs are excluded from gross income.ï¿½ 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.ï¿½
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 .ï¿½ The amount converted is
includible in income (except to the 

extent
it represents a return of nondeductible contributions).ï¿½ No income 

limits
apply to such conversions.ï¿½ For
conversions of traditional IRAs 

made
before January 1, 2008, the income inclusion may be spread ratably

over
four years.ï¿½ For conversions of
traditional IRAs made on or after 

January
1, 2008, the income that results from the conversion is included 

for the
year of the conversion.

 

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.ï¿½
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.ï¿½ 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.ï¿½ 

 

Amounts
converted to an RSA from a traditional IRA or an Employer Retirement 

Savings
Account ("ERSA")ï¿½ are subject
to a five-year holding period.ï¿½ If an

amount
attributable to such a conversion (other than an amount attributable

to a
Roth-type account in an ERSA) is distributed from the RSA before the

end of
the five-year period starting with the year of the conversion or, if

earlier,
the date on which the individual attains age 58, becomes disabled,

or
dies, an additional 10-percent tax applies to the entire amount.ï¿½ 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.ï¿½ 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.ï¿½ The contribution

limit
applies to all LSAs in an individual's name, rather than to the

individuals
making the contributions.ï¿½ 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.ï¿½ Contributions to LSAs may be
made only in cash.ï¿½ 

Contributions
to an LSA are not taken into account for purposes of the

Saver's
credit.ï¿½ 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.ï¿½ As

under
the present-law rules for Roth IRAs, no minimum distribution rules

apply
to an LSA during the LSA owner's lifetime.ï¿½
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, 2008, subject to certain limitations.ï¿½
An amount may be rolled

over to
an individual's LSA only if the individual was the beneficiary of

the
Coverdell education savings account or qualified tuition program as of 

December
31, 2005.ï¿½ The amount that can be rolled
over to an LSA from a 

Coverdell
education savings account is limited to the sum of:ï¿½ (1) the

amount
in the Coverdell education savings account as of December 31, 2005;

and (2)
any contributions to and earnings on the account for 

2006.ï¿½ The amount that can be rolled over to an LSA
from a qualified

tuition
program is limited to the sum of:ï¿½ (1)
the lesser of $50,000 or

amount
in the qualified tuition program as of December 31, 2005; and

(2) any
contributions to and earnings on the qualified tuition program 

for 2006.ï¿½ The total amount rolled over to an
individual's LSA that is

attributable
to 2006 contributions for the individual to Coverdell

education
savings accounts and qualified tuition programs cannot exceed

$5,000
(plus any earnings on such contributions).


Under
the proposal, qualified tuition programs continue to exist as

separate
arrangements, but may be offered in the form of an LSA. 

For
example, State agencies that administer qualified tuition programs may

offer
LSAs with the same investment options that are available under the 

qualified
tuition program.ï¿½ 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

.ï¿½ 

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

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 

By
providing tax incentives for saving - specifically, removing the tax on

the
return to savings - the present-law income tax structure can be

modified
to function more like a consumption tax. Proponents of such tax

incentives
argue that saving will increase if the return to savings is not 

reduced
by taxes.ï¿½ Others have argued that
saving has not necessarily

increased
as a result of existing tax incentives for savings.ï¿½ Some have

argued
that much existing savings have merely been shifted into

tax-favored
accounts, and thus do not represent new saving.ï¿½ 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.ï¿½ Ideally,

saving
incentives should apply only to net new saving, in order to avoid

windfall
gains to existing savings.ï¿½
However,measuring net new saving would

be
difficult in practice.

 

Others
have argued that increasing the return to savings (by not taxing

earnings)
might cause some taxpayers actually to save less, as a higher

return
to savings means that less saving is necessary to achieve a "target"

level
of savings at some point in the future.

 

From an
economic perspective, both LSAs and RSAs receive tax treatment

generally
equivalent to Roth IRAs.ï¿½ 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.ï¿½
However, while LSAs and

RSAs
receive tax treatment similar to Roth IRAs, the maximum allowable 

annual
contribution is greater than the 

amount
of contributions currently permitted to Roth IRAs.ï¿½ 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.ï¿½ 

However,
for taxpayers not already contributing the maximum amounts, 

the new
accounts provide no additional economic inducement to save, except 

to the
extent that LSAs provide withdrawal flexibility relative to existing 

retirement
savings vehicles' age restrictions.Opponents of proposals to 

increase
tax-favored saving thus argue that the only beneficiaries are 

likely
to be wealthy taxpayers with existing savings that will be shifted 

to the
tax-favored accounts, since most taxpayers have not taken full 

advantage
of existing saving incentives.

 

RSAs
also replace traditional IRAs and thereby eliminate taxpayers' ability

to make
deductible contributions.ï¿½ From an
economic perspective, RSAs 

receive
tax treatment generally equivalent to traditional IRAs to which 

deductible
contributions are made.ï¿½ï¿½ However, some
argue that the upfront 

deduction
provides a greater psychological inducement to save, and that 

the
elimination of traditional IRAs may reduce saving by those who would 

have
been able to make deductible contributions.

 

Taxpayers
may convert balances under Coverdell education savings accounts 

and
qualified tuition programs into LSAs on a tax-free basis before 

January
1, 2008.ï¿½ 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.ï¿½ 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.ï¿½
Conversion allows the consolidation 

of
saving into a single vehicle for simplification purposes.ï¿½ However, 

there
is some scope for abuse of this conversion option.ï¿½ A taxpayer with 

sufficient
resources may effect such a conversion simply to shift more 

saving
into tax-favored accounts.ï¿½ For example,
a taxpayer could transfer 

$50,000
from an existing qualified tuition program into an LSA, thus 

insulating
already accumulated earnings from tax, regardless 

of
whether they are used for education expenses, and then reinvest a

different
$50,000 into the qualified tuition program.

 

The tax
treatment of contributions under qualified retirement plans is 

essentially
the same as that of traditional IRAs to which deductible 

contributions
are made.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ In addition,
the ability to make pretax 

contributions
to an employer-sponsored plan is attractive to many 

individuals.ï¿½ 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.ï¿½ This may undermine
the principle of 

promoting
savings for rank-and-file employees. 

 

Thus,
some argue that the proposal may reduce qualified retirement plan 

coverage,particularly
in the case of small businesses. Whether any reduced 

coverage
would result in an overall reduction of retirement security would 

depend,
in part, on the extent to which individuals who are not covered by 

a
qualified retirement plan instead contribute to the new saving vehicles.ï¿½ 

 

Complexity


 

The
proposal has elements that may both increase and decrease tax law 

complexity.
On one hand, the proposal provides new saving options to 

individuals,
which may increase complexity to the extent that taxpayers 

open
new LSAs and RSAs without consolidating existing tax-preferred savings 

into
such accounts. In addition, although the proposal relating to RSAs 

generally
precludes future contributions to traditional IRAs, the proposal 

relating
to LSAs does not preclude future contributions to present-law 

tax-favored
arrangements for certain purposes, such as Coverdell education 

savings
accounts, qualified tuition programs, and health savings 

accounts.ï¿½ On the other hand, the proposal may decrease
complexity by 

permitting
consolidation of tax-favored savings accounts.ï¿½


 

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.ï¿½ 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).ï¿½ 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.ï¿½ 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. 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

A
similar proposal was included in the President's fiscal year 2005 and 

2006
budget proposals.ï¿½ The President's
fiscal year 2004 budget proposal 

included
a similar proposal; among the differences is that, in the fiscal 

year
2004 proposal, the annual dollar limit on contributions to RSAs or 

to LSAs
was $7,500.

 

 

2.ï¿½ï¿½ï¿½ï¿½ï¿½ Consolidation of employer-based savings
accounts

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½

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.ï¿½ Employees do not include
contributions in gross income 

until
amounts are distributed, even though the arrangement is funded and 

benefits
are nonforfeitable.ï¿½ 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.ï¿½ 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.ï¿½ Under a qualified cash or
deferred arrangement 

(i.e.,
a "section 401(k)" plan), employees may elect to make pretax 

contributions
to a plan.ï¿½ Such contributions are
referred to as elective 

deferrals.ï¿½ Employees may also make after-tax contributions
to a qualified 

retirement
plan.ï¿½ Employer contributions consist of
two types:ï¿½ nonelective 

contributions
and matching contributions.ï¿½ Nonelective
contributions are 

employer
contributions that are made without regard to whether 

the
employee makes pretax or after-tax contributions.ï¿½ 

Matching
contributions are employer contributions that are made only if 

the
employee makes contributions. 

 

Present
law imposes a number of requirements on qualified retirement plans 

that
must be satisfied in order for the plan to be qualified and for 

favorable
tax treatment to apply.ï¿½ These
requirements include 

nondiscrimination
rules that are intended to ensure that a qualified 

retirement
plan covers a broad group of employees. Certain of these rules 

are
discussed in more detail below.

 

Qualified
retirement plans are broadly classified into two categories, 

defined
benefit pension plans and defined contribution plans, based on the 

nature
of the benefits provided. Under a defined benefit pension plan, 

benefits
are determined under a plan formula, generally 

based
on compensation and years of service.ï¿½
Benefits under defined 

contribution
plans are based solely on the contributions, and earnings 

thereon,
allocated to separate accounts maintained for plan participants.

 

In
addition to qualified section 401(k) plans, present law provides for 

other
types of employer-sponsored plans to which pretax employee elective 

contributions
can be made.ï¿½ Many of these arrangements
are not qualified 

retirement
plans, but receive the same tax-favored treatment as qualified 

retirement
plans.ï¿½ 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),ï¿½
governmental eligible deferred 

compensation
plans ("section 457" plans), SIMPLE IRAs,ï¿½ and 

salary-reduction
simplified employee pensions ("SARSEPs"). 

 

Limits
on contributions to qualified defined contribution plans

 

The
annual additions under a defined contribution plan with respect to 

each
plan participant cannot exceed the lesser of (1) 100 percent of the 

participant's
compensation or (2) a dollar amount, indexed for inflation 

($44,000
for 2006).ï¿½ 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:ï¿½ (1) design-based safe harbors; (2) a general
test; and 

(3)
cross-testing.ï¿½ 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.ï¿½ In
addition, special rules apply.

As
described above, an employee may make elective deferrals to a section 

401(k)
plan. The maximum annual amount of elective deferrals that can be 

made by
an individual is $15,000 (for 2006).ï¿½ 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.ï¿½ As a result,
the dollar limit on 

elective
deferrals is increased for an individual who has attained age 50

by
$5,000 (for 2006).ï¿½ An employee's
elective deferrals must be fully 

vested.

 

Special
nondiscrimination tests 

 

A
special nondiscrimination test applies to elective deferrals under a 

section
401(k) plan, called the actual deferral percentage test 

(the
"ADP" test).ï¿½ï¿½ The ADP test
compares the actual deferral percentages 

("ADPs")
of the highly compensated employee group and the nonhighly 

compensated
employee group.ï¿½ 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.ï¿½
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).ï¿½ï¿½ 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:ï¿½ (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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 

Employers
may contribute to such plans on behalf of their employees, and 

employees
may make elective deferrals.ï¿½ 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).ï¿½ Many of the rules that apply to section
403(b) plans are 

similar
to the rules applicable to qualified retirement plans, 

including
section 401(k) plans.ï¿½ 

 

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.ï¿½ Special contribution limits apply to certain
employees under a 

section
403(b) plan maintained by a church.ï¿½ In
addition, additional 

elective
deferrals are permitted under a plan maintained by an educational 

organization,
hospital,home health service agency, health and welfare 

service
agency, church, or convention or association of churches in the 

case of
employees who have completed 15 years of service.

 

Section
403(b) plans are generally subject to the minimum coverage and 

general
nondiscrimination rules that apply to qualified defined 

contribution
plans.ï¿½ In addition, employer matching
contributions and 

after-tax
employee contributions are subject to the ACP test.ï¿½ 

However,
pretax contributions made by an employee under a salary reduction 

agreement
(i.e., elective deferrals) are not subject to nondiscrimination 

rules
similar to those applicable to elective deferrals under section 

401(k)
plans. Instead, all employees generally must be eligible 

to make
salary reduction contributions.ï¿½ 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.ï¿½ï¿½
The maximum 

annual
deferral under such a plan generally is the lesser of (1) $15,000 

(for
2006) or (2) 100 percent of compensation.ï¿½
A special, higher limit 

applies
for the last three years before a participant reaches normal 

retirement
age (the "section 457 catch-up limit").ï¿½ In the case of a 

section
457 plan of a governmental employer, a participant who has attained 

age 50
before the end of the taxable year may also make catch-up 

contributions
up to a limit of $5,000 (for 2006), unless a higher section 

457
catch-up limit applies.ï¿½ï¿½ 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.ï¿½ A SIMPLE plan can be 

either
an individual retirement arrangement for each employee 

(a
"SIMPLE IRA") or part of a section 401(k) plan (a "SIMPLE
section 

401(k)"
plan). 

 

A
SIMPLE retirement plan allows employees to make elective deferrals, 

subject
to a limit of $10,000 (for 2006).ï¿½ An
individual who has attained 

age 50
before the end of the taxable year may also make catch-up 

contributions
to a SIMPLE plan up to a limit of $2,500 (for 2006). 

 

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.ï¿½ 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.ï¿½ 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.ï¿½ A SIMPLE
IRA is not subject to the 

nondiscrimination
rules generally applicable to qualified retirement 

plans.ï¿½ 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.ï¿½ 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.ï¿½
Any employee must be 

eligible
to participate in the SEP if the employee (1) has 

attained
age 21, (2) has performed services for the employer during 

at
least three of the immediately preceding five years, and (3) received 

at
least $450 (for 2006) in compensation from the employer for the year.

Contributions
to a SEP generally must bear a uniform relationship to 

compensation


 

Effective
for taxable years beginning before January 1, 1997, certain 

employers
with no more than 25 employees could maintain a SARSEP (i.e., a 

salary
reduction SARSEP) under which employees could make elective 

deferrals.
The SARSEP rules were generally repealed with the adoption of 

SIMPLE
plans.ï¿½ However, contributions may
continue to be made to SARSEPs 

that
were established before 1997.ï¿½ Salary
reduction contributions to a 

SARSEP
are subject to the same limit that applies to elective deferrals 

under a
section 401(k) plan ($15,000 for 2006).ï¿½
An individual who has 

attained
age 50 before the end of the taxable year may also make catch-up 

contributions
to a SARSEP up to a limit of $5,000 (for 2006).

 

Designated
Roth contributions

 

There
are two general types of individual retirement arrangements ("IRAs") 

under
present and prior law:ï¿½ traditional
IRAs, to which both deductible 

and
nondeductible contributions may be made, and Roth IRAs.ï¿½ Individuals 

with
adjusted gross income below certain levels generally may make 

nondeductible
contributions to a Roth IRA.ï¿½ 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).ï¿½ 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.ï¿½ï¿½ 

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.ï¿½ 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.ï¿½ 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.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½Description 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.ï¿½
Existing section 401(k) 

plans
and thrift plans are renamed ERSAs and continue to operate under the 

new
rules.ï¿½ Existing section 403(b) plans,
governmental section 457 plans, 

SARSEPs,
and SIMPLE IRAs and SIMPLE section 401(k) plans may be renamed 

ERSAs
and operate under the new rules.ï¿½
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, 2007. 

 

Types
of contributions and treatment of distributions

 

An ERSA
may provide for an employee to make pretax elective contributions

and
catch-up contributions up to the present-law limits applicable to a 

section
401(k) plan, that is, a limit of $15,000 for elective deferrals 

and
$5,000 for catch-up contributions (as indexed for future years).ï¿½ 

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.ï¿½ An ERSA may also provide for matching
contributions and 

nonelective
contributions.ï¿½ Total annual
contributions to an ERSA for an

employee
(i.e., employee and employer contributions, including elective

deferrals)
may not exceed the present-law limit of the lesser of 100 

percent
of compensation or $44,000 (as indexed for future years).

 

Distributions
from an ERSA of after-tax employee contributions (including

Roth contributions)
and qualified distributions of earnings on Roth 

contributions
are not includible in income.ï¿½ All other
distributions are 

includible
in income. 

 

Nondiscrimination
requirements

 

The
present-law ADP and ACP tests are replaced with a single 

nondiscrimination
test.ï¿½ 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.ï¿½ If the average contribution percentage for
nonhighly 

compensated
employees exceeds six percent, the nondiscrimination test is 

met.ï¿½ 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.ï¿½ The ERSA safe harbor provides new formulas
for determining 

required
matching contributions.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ The option of
using custodial accounts under 

the
proposal provides annual reporting relief for small employers as 

well as
relief from most fiduciary requirements under the Employee 

Retirement
Income Security Act of 1974 ("ERISA") under circumstances 

similar
to the relief provided to sponsors of SIMPLE IRAs under present law.

 

Effective
date.-The proposal is effective for years beginning after 

December
31, 2006.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Analysis

 

In
general

 

An
employer's decision to establish or continue a retirement plan for 

employees
is voluntary.ï¿½ 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.ï¿½ On the other hand, tax
policy is concerned also 

with
the level of tax subsidy provided to retirement plans.ï¿½ 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.ï¿½ï¿½
Some have 

argued
that this complexity deters employers from establishing qualified 

retirement
plans or causes employers to terminate such plans.ï¿½ 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.ï¿½ 

 

Some argue
that the present-law nondiscrimination rules are unnecessarily 

complex
and discourage employers from maintaining retirement plans.ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½
This may reduce 

participation
by rank-and-file employees.ï¿½ 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).ï¿½ 

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.ï¿½ Some argue
that the proposal makes the 

safe
harbor more attractive for employers, especially small employers, and 

will
thus increase coverage and participation.ï¿½


 

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.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

A
similar proposal was included in the President's fiscal year 2004, 2005,

and
2006 budget proposals.ï¿½ The President's
fiscal year 2004 budget 

proposal
also included several proposals to simplify the rules for defined 

contribution
plans generally

 

3.ï¿½ Individual development accounts

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present
Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

Individual
development accounts were first authorized by the Personal Work 

and
Responsibility Act of 1996.ï¿½ 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."ï¿½ The
IRS has ruled that matching contributions

by a
qualified entity are a gift and not taxable to the account owner.ï¿½ï¿½ 

The
qualified entity chooses a matching rate, which must be between 50 and 

400
percent.ï¿½ 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.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of
Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

The
proposal provides a nonrefundable tax credit for a qualified entity 

(i.e.,
qualified financial institutions, qualified nonprofit organizations, 

and
qualified Indian tribes)ï¿½ that has an
individual development account 

program
in a taxable year.ï¿½ 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.ï¿½
The amount of the

credit
is adjusted for inflation after 2008. The $500 amount is rounded 

to the
nearest multiple of twenty dollars.ï¿½ The
$50 amount is rounded to 

the
nearest multiple of five dollars. No deduction or other credit is 

available
with respect to the amount of matching funds taken into account

in
determining the credit.

 

The
credit applies with respect to the first 900,000 individual development

accounts
opened after December 31, 2007 and before January 1, 2013, and 

with
respect to matching funds for participant contributions that are made 

after
December 31, 2007, and before January 1, 2015.

 

Nonstudent
U.S. citizens or legal residents between the ages of 18 and 60

(inclusive)
who are not dependents of a taxpayer and who meet certain 

income
requirements are eligible to open and contribute to an individual 

development
account.ï¿½ 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.ï¿½ï¿½ Eligibility in a taxable year
is based on the 

previous
year's modified adjusted gross income and circumstances (e.g., 

status
as a student).ï¿½ 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.ï¿½
The income limits 

are
adjusted for inflation after 2007.ï¿½ This
amount is rounded to the 

nearest
multiple of 50 dollars.

 

Under
the proposal, an individual development account must:ï¿½ (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).ï¿½ These 

requirements
must be reflected in the written governing instrument 

creating
the account.ï¿½ 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.ï¿½ 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.ï¿½ Qualified expenses
include:ï¿½ (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.ï¿½


The
Secretary of the Treasury (the "Secretary") is required to establish 

minimum
standards for such courses.ï¿½ Withdrawals
for nonqualified 

expenses
may result in the account owner's forfeiture of some amount of 

matching
funds.

 

The
qualified entity administering the individual development account 

program
is generally required to make quarterly payments of matching funds 

on a
dollar-for-dollar basis for the first $500 contributed by the account 

owner
in a taxable year. This dollar amount is adjusted for inflation after 

2008.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½
The Secretary is also

authorized
to provide rules to recapture credits claimed with respect to 

individuals
who forfeit matching funds.

 

Effective
date.-- The proposal is effective for taxable years ending after 

December
31,2007, and beginning before January 1, 2015.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½

Policy
issues

 

The
proposal is intended to encourage individuals to save by providing a 

subsidy
to saving.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ The individual
development account proposal

requires
additional record keeping by financial institutions benefiting 

from
the credit and also by account holders.ï¿½
The annual reporting 

requirements
of the individual development account program will increase 

the
paperwork burden on individuals and financial institutions utilizing 

the
provision.ï¿½ 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.ï¿½ Some might argue that
consolidation of these 

incentives
will serve to simplify tax law and tax administration.

ï¿½ï¿½ 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior
Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

Similar
proposals were included in the President's fiscal year 2002, 2003,

2004,
2005,and 2006 budget proposals.

 

 

B.ï¿½ Increase Section 179 Expensing

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

In lieu
of depreciation, a taxpayer with a sufficiently small amount of 

annual
investment may elect to deduct (or "expense") such costs.ï¿½ Present 

law
provides that the maximum amount a taxpayer may expense, for taxable 

years
beginning in 2003 through 2007, is $100,000 of the cost of qualifying 

property
placed in service for the taxable year. Additional section 179

incentives
are provided with respect to a qualified property used by a 

business
in the New York Liberty Zone (sec. 1400L(f)), an empowerment zone 

(sec.
1397A), a renewal community (sec. 1400J), or the Gulf Opportunity 

Zone
(sec. 1400N(e)). In general, qualifying property is defined as 

depreciable
tangible personal property that is purchased for use in the 

active
conduct of a trade or business. Off-the-shelf computer software 

placed
in service in taxable years beginning before 2008 is treated as 

qualifying
property.ï¿½ 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.ï¿½ The
$100,000 and $400,000 

amounts
are indexed for inflation for taxable years beginning after 2003

and
before 2008.

 

For
taxable years beginning in 2008 and thereafter, a taxpayer with a 

sufficiently
small amount of annual investment may elect to deduct up to 

$25,000
of the cost of qualifying property placed in service for the 

taxable
year.ï¿½ The $25,000 amount is reduced
(but not below zero) by the 

amount
by which the cost of qualifying property placed in service during 

the
taxable year exceeds $200,000.

 

The
amount eligible to be expensed for a taxable year may not exceed the

taxable
income for a taxable year that is derived from the active conduct 

of a
trade or business (determined without regard to this provision).ï¿½ 

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).ï¿½ No general
business credit under 

section
38 is allowed with respect to any amount for which a deduction is 

allowed
under section 179.

 

An
expensing election is made under rules prescribed by the Secretary 

(sec.
179(c)(1)). Under Treas. Reg. sec. 1.179-5, applicable to property 

placed
in service in taxable years beginning after 2002 and before 2008, a 

taxpayer
is permitted to make or revoke an election under section 179 

without
the consent of the Commissioner on an amended Federal tax return 

for
that taxable year.ï¿½ This amended return
must be filed within the time 

prescribed
by law for filing an amended return for the taxable year.

For
taxable years beginning in 2008 and thereafter, an expensing election 

may be
revoked only with consent of the Commissioner (sec. 179(c)(2)).

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of
Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

The
proposal increases permanently the amount a taxpayer may deduct under

section
179.ï¿½ The proposal provides that the
maximum amount a taxpayer may 

expense,
for taxable years beginning after 2006, is $200,000 of the cost 

of
qualifying property placed in service for the taxable year.ï¿½ The 

$200,000
amount is reduced (but not below zero) by the amount by which the 

cost of
qualifying property placed in service during the taxable year 

exceeds
$800,000.ï¿½ The President's fiscal 2007
budget proposal separately 

proposes
permanent extension of the temporary provisions of section 179 

that
are in effect for taxable years beginning before 2008.ï¿½ That proposal,

which
is treated as underlying the increased dollar amounts of this 

proposal,
provides that the section 179 dollar limit amounts continued to

be
indexed for inflation for taxable years beginning after 2007. In 

addition,
off-the-shelf computer software is treated as qualifying property.

Further,
a taxpayer is permitted to make or revoke an election for a

taxable
year under section 179 without the consent of the Commissioner on

an
amended Federal tax return for that taxable year.ï¿½ That proposal is 

effective
for taxable years beginning after 2007.

 

Effective
date.--The proposal to increase the section 179 amounts to

$200,000
and $800,000 is effective for taxable years beginning after 2006.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

The
proposal would lower the after-tax cost of capital expenditures made by

eligible
businesses by permitting the immediate deduction of the full 

amount
of the capital expenditure (i.e., expensing), rather than 

depreciation
of the expenditure over a series of years.ï¿½
With a lower cost

of
capital, it is argued that eligible businesses will invest in more 

equipment
and employ more workers, thus serving to stimulate economic 

growth
in the United States.

 

Expensing
of capital expenditures is the appropriate treatment if the 

objective
is to tax consumption, because expensing effectively eliminates 

tax on
the normal returns to the marginal investment opportunity. If the 

objective
is to tax income, then depreciation deductions should coincide 

with
the economic depreciation of the asset in order to measure economic 

income
accurately.ï¿½ A depreciation system more
generous than economic 

depreciation,
but less generous than full expensing, results in an 

effective
tax rate on the income from capital that is less than the 

statutory
tax rate, but still positive. 

 

In
addition to promoting investment, advocates of expensing assert that 

increased
expensing eliminates depreciation recordkeeping requirements 

with
respect to expensed property.ï¿½ Under the
proposal, Federal income tax

accounting
would be simplified by increasing the portion of capital costs 

that
are expensed in one taxable year and concomitantly reducing those 

that
are recovered through depreciation over a series of years.ï¿½ It could

be
argued that the simplification benefit of expensing is not fully 

realized,
however, so long as property is partially depreciated, or so 

long as
some but not all of the taxpayer's property that is eligible for

cost
recovery is expensed; the taxpayer must still keep records for that 

property
that is subject to depreciation over a period of years.

 

Increasing
the present-law $400,000 phaseout threshold amount to $800,000

can
have the effect of generally permitting larger businesses to obtain the

tax
benefit of expensing.ï¿½ Some may argue
that this result is inconsistent 

with
the idea of limiting expensing to small businesses, as under the 

present-law
provision.ï¿½ They might alternatively
argue that in an income 

tax
system, expanding the availability of expensing is not appropriate 

because
it results in broader income mismeasurement.ï¿½
On the other hand,

it
could be argued that there is no rationale for limiting expensing to

businesses
below a particular size or with capital expenditures below a 

certain
level.

 

An
advantage of making the increase in the expensing amounts permanent is 

that it
reduces uncertainty with respect to the tax treatment of future 

investment,
thus permitting taxpayers to plan capital expenditures with 

greater
focus on the underlying economics of the investments, and less 

focus
on tax-motivated timing of investment. Removing tax-motivated 

distortions
in the timing of investment may promote more efficient 

allocation
of economic resources.ï¿½ On the other
hand, legislative changes

to the
expensing rules (principally temporary increases in the amount that

can be
expensed) have been frequent in the past decade, and there is 

nothing
to suggest that additional legislative changes would not be made

to the
expensing rules, whether the current expensing rules were permanent

or
temporary.ï¿½ Additionally, to the extent
that the rationale for the 

original
increase in the amounts that may be expensed was to provide a 

counter-cyclical
short-term economic stimulus, it can be argued that it is

important
that such provisions in fact be temporary.ï¿½
If there is 

uncertainty
that a provision providing temporary tax relief may not 

ultimately
be temporary, it can be argued that the stimulative effect 

of the
provision is compromised because the taxpayer need not act within 

the
originally specified time frame of the provision in order to get the

tax
benefits from the provision.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior
Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

H.R.
4297, as passed by the House (the "Tax Relief Extension Reconciliation

Act of
2005"), extends the present-law section temporary section 179 rules

for an
additional two years (through taxable years beginning before 2010).

 

H.R.
4297, as amended by the Senate (the "Tax Relief Act of 2005"), also 

extends
the present-law section temporary section 179 rules for an 

additional
two years (through taxable years beginning before 2010).

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ C.ï¿½ Health Care Provisions

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

1.ï¿½ Facilitate the growth of HSA-eligible health
coverage

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½Present Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

In
general

 

Present
law contains a number of provisions dealing with the Federal tax

treatment
of health expenses and health insurance coverage.ï¿½ 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.ï¿½ 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).ï¿½ 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.ï¿½ A 

cafeteria
plan allows employees to choose between cash and certain 

nontaxable
benefits, including health coverage.ï¿½
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").ï¿½ 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.ï¿½ 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.ï¿½ï¿½
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.ï¿½ Moreover, the 

ability
to carry over unused amounts from one year to the next is different.

An FSA
may provide that amounts remaining as of the end of the year may 

be used
to reimburse expenses incurred within 2-ï¿½ months of the end of the 

year.ï¿½ Under an HRA, however, unused amounts
generally may be carried 

forward
into the next year.ï¿½ The different
treatment for unused amounts 

stems
from the statutory rule that provides that cafeteria plans, 

including
salary reduction FSAs, generally may not provide for deferred

compensation.


 

Deduction
for health insurance expenses of self-employed individuals

 

The
exclusion for employer-provided health coverage does not apply to 

self-employed
individuals.ï¿½ 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,ï¿½ certain 

individuals
are eligible for the health coverage tax credit ("HCTC").ï¿½ 

The
HCTC is a refundable tax credit for 65 percent of the cost of 

qualified
health coverage paid by an eligible individual.ï¿½ 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.ï¿½
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").ï¿½ï¿½
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.ï¿½
Individuals 

entitled
to benefits under Medicare are not eligible to make contributions

to an
HSA.ï¿½ An individual with other coverage
in addition to a high 

deductible
health plan is still eligible for an HSA if such other coverage 

is
certain permitted insurance or permitted coverage. 

 

A high
deductible health plan is a health plan that has a deductible for 

2006
that is at least $1,050 for self-only coverage or $2,100 for family 

coverage
and that has an out-of-pocket expense limit that is no more than 

$5,250
in the case of self-only coverage and $10,500 in the case of family

coverage.ï¿½ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ The maximum aggregate annual contribution
that can be made to

an HSA
is the lesser of (1) 100 percent of the annual deductible under 

the
high deductible health plan, or (2) (for 2006) $2,700 in the case of

self-only
coverage and $5,450 in the case of family coverage. The 

annual
contribution limits are increased for individuals who have attained

age 55
by the end of the taxable year. In the case of policyholders and 

covered
spouses who are age 55 or older, the HSA annual contribution limit 

is
greater than the otherwise applicable limit by $700 in 2006, 

$800 in
2007, $900 in 2008, and $1,000 in 2009 and thereafter.

An
excise tax applies to contributions in excess of the maximum 

contribution
amount for the HSA.ï¿½ 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. ï¿½

 

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.ï¿½ 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 policiesï¿½ 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.ï¿½ Distributions from 

an HSA
that are not for qualified medical expenses are includible in 

gross
income.ï¿½ 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.ï¿½ The main 

differences
include: (1) only self-employed individuals and employees of

small
employers are eligible to have an Archer MSA; (2) for MSA purposes,

a high
deductible health plan is a health plan with (a) an annual 

deductible
of at least $1,800 and no more than $2,700 in the case of 

self-only
coverage and at least $3,650 and no more than $5,450 in the case 

of
family coverage and (b) maximum out-of pocket expenses of no more than 

$3,650
in the case of self-only coverage and no more than $6,650 in the 

case of
family coverage; (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.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of
Proposal

In
general

 

The
proposal has four elements: (1) provide an above-the-line deduction and

refundable
income tax credit for the purchase of HSA-eligible non-group 

coverage
to offset employment taxes; (2) increase the amounts that can be 

contributed
to HSAs and provide a refundable income tax credit to offset 

employment
taxes on HSA contributions not made by an employer; 

(3)
provide a refundable tax credit to lower income individuals for the 

purchase
of HSA-eligible health coverage; and (4) make other changes to 

HSAs to
facilitate their formation and administration.

 

Above-the-line
deduction and income tax credit for the purchase of 

HSA-eligible
non-group coverage

 

Above-the-line
deduction

 

The
proposal provides an above-the-line deduction for insurance premiums 

that
meet the definition of a high deductible health plan under the rules 

relating
to HSAs.ï¿½ The deduction is only allowed
for insurance purchased 

in the
individual insurance market. 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.ï¿½ The deduction is
not allowed for individuals

covered
by employer plansï¿½ or public plans.ï¿½ Additionally, the deduction 

is not
allowed to an individual claiming the present-law HCTC or the 

proposed
refundable health insurance tax credit ("HITC") included in the 

President's
fiscal year 2007 budget proposal. The deduction is not allowed 

for
amounts paid from an HSA. An individual may not claim both the 

deduction
for health insurance expenses of self-employed individuals and

this
proposed deduction for the same premiums.

 

Refundable
credit

 

In
addition to the above-the-line deduction for HSA-eligible premiums,

individuals
who purchase insurance eligible for the proposed deduction are

entitled
to a refundable credit equal to the lesser of (1) 15.3 percent of 

the
high deductible health plan premium or (2) 15.3 percent of the 

individual's
wages subject to employment taxes.ï¿½ If
the taxpayer has 

wages
above the Social Security wage base, the credit rate would be lower 

to
account for the lower rate of employment taxes on wages above the cap.ï¿½ 

The
credit would not apply to amounts paid with HSA funds.

 

Increase
in HSA contribution limit; refundable income tax credit to offset

employment
taxes on HSA contributions not made by an employer

 

The
maximum annual HSA contribution is increased to the out-of-pocket limit

for a
participant's high deductible health plan (i.e., for 2006, $5,250 

for
self-only coverage and $10,500 for family coverage).ï¿½ The maximum 

contribution
is pro rated for the number of months in the year that the 

individual
is an eligible individual with coverage by the high deductible 

health
plan.

 

As
under present law, a special rule applies for determining HSA 

contributions
by married individuals with family high deductible health 

plan
coverage.ï¿½ If one spouse has family
coverage, both spouses are generally 

treated
as having family coverage. If both spouses have family coverage,

the
coverage with the lowest bona fide out-of-pocket amount determines the 

maximum
annual HSA contribution by the couple. The maximum annual HSA 

contribution
based on the family high deductible health plan coverage is

divided
between the spouses equally unless they agree on a different

division,
which can include allocating the entire contribution to one 

spouse.ï¿½ If one spouse has family coverage that is
not high deductible 

health
plan coverage, neither spouse may contribute to an HSA unless the 

non-high
deductible health plan does not cover both spouses.

 

Where
married couples have non-overlapping coverage, they would be allowed 

to
"stack" the separate maximum contributions up to the out-of-pocket 

maximum
allowed for a family high deductible health plan to determine the 

amount
of the contribution.ï¿½ The contributions
to each spouse's HSA would 

remain
subject to that spouse's respective HSA contribution limit.ï¿½ Family 

high
deductible health plan coverage that only covers a single eligible 

individual
is treated as self-only coverage for purposes of determining the

maximum
HSA contribution.ï¿½ Thus, if there is
only a single eligible 

individual
covered by a family high deductible health plan, the maximum 

HSA
contribution is capped at the out-of- pocket maximum for self-only 

plan.ï¿½ With respect to catch up contributions, if
both spouses are 

eligible
individuals, both spouses will be allowed to contribute the 

contributions
to a single HSA owned by one spouse.

 

In
addition, in the case of HSA contributions made by an individual (rather

than
the individual's employer), the individual is entitled to a 

refundable
credit equal to a percentage of such contributions to offset the

employment
taxes on the contributions.ï¿½ The credit
is the lesser of 

(1)
15.3 percent of the contributions to the HSA, or (2) 15.3 percent of 

wages
subject to employment taxes.ï¿½ If the
taxpayer has wages above the 

Social
Security wage cap, the credit would be lower to account for the 

lower
employment tax rate on wages above the cap.ï¿½
If the taxpayer is also 

eligible
for a credit for high deductible health plan premium payments, the 

OASDI
portion of the employment tax in the above calculation would be 

limited
by the combined amount by which the applicable high deductible 

health
plan premium payments and applicable HSA contributions exceed the 

amount
of wages above the OASDI cap.ï¿½ In order
to recapture the credit 

relating
to employment taxes for contributions that are not used for 

medical
expenses, the additional tax on nonmedical distributions would be

increased
to 30 percent, with a 15-percent rate on nonmedical 

distributions
after death, disability or attaining the age for 

Medicare
eligibility

.

Refundable
tax credit for lower income individuals for the purchase of 

HSA-eligible
health coverage

 

The
proposal provides a refundable tax credit ("health insurance tax 

credit"
or "HITC") for the cost of an HSA-eligible high deductible health 

plan
purchased by individuals who are under age 65 and who do not 

participate
in a public or employer-provided health plan.ï¿½
The maximum 

annual
amount of the credit is 90 percent of premiums, up to a maximum 

premium
of $1,111 in the case of a policy covering only one adult, only one

child,
or only two or more children; $2,222 for a policy or policies 

covering
two adults or one adult and one or more children; and $3,333 for a

policy
or policies covering two adults plus one or more children. This 

dollar
amount is indexed in accordance with the medical care component of

the
Consumer Price Index based on all-urban consumers.ï¿½ Thus, the maximum

annual
credit (prior to any indexing of the premium limit) is $3,000 per 

tax
return (for three or more covered individuals).ï¿½ The maximum credit 

rate is
phased out for higher income taxpayers as described below.

 

The 90
percent credit rate is phased-down for higher income taxpayers.

Individual
taxpayers filing a single return with no dependents and modified

adjusted
gross income of $15,000 or less are eligible for the maximum 

credit
rate of 90 percent.ï¿½ 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.ï¿½ 

 

Other
taxpayers with modified adjusted gross income up to $25,000 are 

eligible
for the maximum credit rate of 90 percent.ï¿½
The credit percentage

is
phased-out ratably for modified adjusted gross income between $25,000

and
$40,000 if the policy covers only one person, and for modified 

adjusted
gross income between $25,000 and $60,000 if the policy (or policies) 

covers
more than one person. Taxpayers may not claim the present-law HCTC

and
this credit for the same coverage period.ï¿½
In addition, taxpayers may

not
claim the HITC for the same period as they claim the above-the-line 

deduction
for high deductible health plan premiums included in the 

President's
fiscal year 2007 budget proposal.

 

The
credit can be claimed on the individual's tax return or, beginning in

2008,
on an advanced basis, as part of the premium payment process, by

reducing
the premium amount paid to the insurer. Health insurers will be 

reimbursed
by the Department of the Treasury for the amount of the credit.

Eligibility
for the advanced credit option is based on the individual's prior 

year
return and there is no reconciliation on the current year return.

 

Qualifying
health insurance can be purchased through the individual 

insurance
market, private purchasing groups, State-sponsored insurance 

purchase
pools, and State high-risk pools. At the option of States, after 

December
31, 2007, the credit can be used by certain individuals 

not
otherwise eligible for public health insurance programs to buy into 

privately
contracted State-sponsored purchasing groups (such as Medicaid 

or
SCHIP purchasing pools for private insurance or State government 

employee
programs for States in which Medicaid or SCHIP does 

not
contract with private plans).ï¿½ States
can provide additional 

contributions
to individuals who purchase insurance through such 

purchasing
groups.ï¿½ 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.ï¿½ The maximum State
contribution is 

phased-down
ratably, reaching $500 per adult at 200 percent of the poverty

level.ï¿½ Individuals with income above 200 percent of
the poverty level are 

not
eligible for a State contribution.ï¿½
States are not allowed to offer

any
other explicit or implicit cross subsidies.

 

Other
changes relating to HSAs

 

For
purposes of HSAs, qualified medical expenses include any medical

expense
incurred on or after the first day of HSA-eligible coverage for a 

year,
regardless of whether the HSA had been established when the expense 

was
incurred. The HSA has to be established no later than the date for 

filing
the individual's tax return for the year, determined without regard

to
extensions.

 

Qualified
medical expenses that can be reimbursed by an HSA are expanded

to
include the premiums for the purchase of HSA-eligible plans through the 

individual
market.

 

Employers
are allowed to contribute existing HRA balances to the HSAs of

employees
who would be eligible individuals but for the HRA coverage. The 

contributions
of the HRA balances are not taken into account for purposes 

of the
comparability rules, or the annual maximum HSA contributions.ï¿½ Only 

HRAs
existing on the date of enactment qualify for the transfer and only 

contributions
of HRA balances made in prior taxable years beginning one

year
after the date of enactment are covered.

 

Contributions
to HSAs on behalf of employees who are chronically ill or

employees
who have spouses or dependents who are chronically ill are 

excluded
from the comparability rules to the extend the contributions 

exceed
the comparable contributions for other employees.

 

Effective
date.-The proposals are effective for taxable years beginning

after
December 31, 2006.ï¿½ The advanced payment
option for the refundable

credit
for low-income individuals is to be available beginning in 2008.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½Analysis

In
general

 

The
proposal increases incentives for individuals to purchase high 

deductible
health plans and contribute to HSAs.ï¿½
The proposal raises both 

tax and
health policy issues.ï¿½ The proposal is
intended to increase equity

in the
tax laws by providing more similar tax treatment for employer-

provided
group insurance, individually purchased insurance, and 

out-of-pocket
health spending. The proposal is intended to create a more

market-oriented
and consumer driven health care system, with a view toward 

making
health care more affordable and accessible.ï¿½
There is substantial 

disagreement
among analysts as to whether the proposal will achieve the 

stated
goals, or will have an adverse effect on the affordability, 

accessibility,
and quality of health care coverage.

 

Issues
under present law

 

The
appropriateness of the present-law Federal tax treatment of health

expenses
has been the subject of discussion over time from both tax and 

health
policy perspectives.ï¿½ The exclusion for
employer-provided health 

care is
typically a focal point of such discussions.ï¿½
The exclusion 

represents
a departure from the normal income tax principle that 

compensation
should be included in income, and has consistently been one

of the
largest three tax expenditure items.

 

The
present-law favorable tax treatment of employer-provided health 

coverage
has generally been justified on the grounds that it encourages 

employees
to prefer health coverage over taxable compensation, thereby 

increasing
health insurance coverage and reducing the number of uninsured.

Employees
in employer-provided health plans not only receive a tax 

subsidy,
but may also benefit from group rates which may make coverage 

more
affordable. From this perspective, the exclusion may be said to be 

effective.ï¿½ For 2005, approximately 90 million
policyholders are estimated

to have
employer-provided health coverage.

 

Nevertheless,
the present-law rules have been the subject of a number of

criticisms.ï¿½ One criticism is that present law is
inequitable because 

health
expenses are not treated consistently. Some argue that this inequity

provides
the worst treatment in some cases for those who need the tax 

benefit
the most, because many individuals who face the highest insurance 

rates
also receive no tax subsidy for the purchase of such insurance.ï¿½ 

 

The
most favorable tax treatment under present law generally is provided to

individuals
who are in an employer plan.ï¿½ Such
individuals may exclude from

income
and wages employer-provided health insurance and, depending on the 

employer's
plan, may also exclude from income amounts expended for medical 

care
not covered by insurance.ï¿½ Self-employed
individuals receive the next 

most
favorable treatment, and may deduct 100 percent of the cost of 

their
health insurance. Individuals who are not self employed and pay for

their
own health insurance receive the least favorable tax treatment; such 

individuals
may deduct the cost of health insurance only to the extent that 

aggregate
medical expenses exceed 7.5 percent of adjusted gross income 

and
only if they itemize deductions. In the case of individuals covered by 

a high
deductible health plan, the recently-enacted provisions relating to

HSAs
alter this comparison to some extent; however, those with employer 

coverage
still have the highest potential tax benefit. 

 

From a
health policy perspective, the exclusion for employer-provided 

health
care has been criticized as contributing to higher health costs 

because
individuals are not faced with the full cost of health care. 

That
is, the cost of insurance or out-of-pocket expenses paid by the 

individual
is reduced by the tax benefit received, effectively reducing 

the
price of health care relative to other goods. In addition, some argue 

that
the unlimited exclusion for employer-provided coverage leads to very 

generous
insurance coverage, which further contributes to increases in 

health
costs because individuals are not as likely to question medical 

treatments
to the extent the cost is paid by a third party through 

insurance.ï¿½ 

 

The
present-law rules for HSAs were designed to provide an incentive to

purchase
high deductible plans, thereby shifting more routine medical costs


from
the third-party payor system to the individual. Proponents of HSAs 

argue
that this will cause individuals to be more conscious of health care 

costs,
which will ultimately lower the cost of health care generally.ï¿½ 

Under
present law, HSAs provide at a minimum a tax benefit that is 

equivalent
to an above-the-line deduction for medical expenses, up to the

annual
cap on contributions to the HSA.ï¿½ To the
extent that the taxpayer

is able
to fund the HSA well in advance of the medical expenses, the 

HSA
provides the ability to save for medical expenses on a pre-tax basis.

If the
funds in the HSA are not used for medical expenses, they may be 

withdrawn
subject to income tax and, prior to age 65, a 10-percent 

additional
income tax.ï¿½ This feature provides a tax
benefit similar to 

that
provided under a deductible IRA.ï¿½
Further issues relating to HSAs are

discussed
below.

 

Issues
relating to the proposal

 

The
proposal addresses the gap in the present-law treatment of health 

expenses
by providing a tax subsidy for individuals who are not self 

employed
and who purchase health coverage in the individual market. 

Under
present law, such individuals receive no tax subsidy 

(except
perhaps for the itemized deduction),ï¿½
whereas under the proposal

such
individuals are entitled either to a refundable credit or a deduction

(plus a
refundable credit to approximate FICA taxes) for the purchase of a 

high
deductible health plan.ï¿½ In addition,
the proposal enhances the tax 

benefits
of HSA contributions by increasing the amount of the maximum 

contribution
and adding a refundable tax credit to approximate FICA taxes 

on
contributions not made by an employer.

 

A key
issue that arises under the proposal is its focus on providing a 

subsidy
specifically for high deductible health insurance in the individual

marketï¿½ (and HSAs).ï¿½
Proponents of the proposal believe that the use of 

high
deductible plans promotes responsible health policy by making

individuals
more conscious of their health care costs because fewer

expenses
are paid by a third party insurer. This, in turn, is anticipated

to
reduce overall health care costs.ï¿½ Some
proponents of such proposals 

believe
that many current health insurance policies cover routine 

medical
expenses and that the tax laws should provide a subsidy only for

insurance
for unpredictable medical expenses.ï¿½ 

 

Those
who do not favor providing additional tax benefits for high 

deductible
plans are concerned that such plans are likely to be more 

attractive
to healthier individuals, with the result that adverse selection

will
occur which will erode the group market and result in higher insurance

costs
for individuals with greater health risks. This may occur because

when
insurance is priced on a group basis, individuals with lower health 

risks
in effect subsidize higher risk individuals. Tax-favored high 

deductible
plans are likely to be more attractive to lower risk 

individuals.ï¿½ If they leave the pool, however, the average
cost increases

for
those remaining. This, in turn, may cause more lower risk individuals

to
leave the pool, with a concomitant rise in cost for those remaining. 

Some
argue that this effect, while likely to occur with any increased 

subsidy
for high deductible plans, is likely to be worse under the 

proposal
because the proposal only subsidizes high deductible insurance 

purchased
in the individual market and does not subsidize group insurance.

 

There
is also disagreement regarding the effects of high deductible plans

(and
HSAs) on health care costs.ï¿½ As noted
above, a basic premise 

underlying
high deductible plans is that individuals will make wiser 

choices
if faced with the cost of medical treatments and that this will 

reduce
health care costs overall. On the other hand, some note that the 

existence
of the HSA itself may undermine the goal of making individuals

more
conscious of heath care costs because it provides a subsidy for the

first
dollar of medical expenses.ï¿½ Thus,
medical expenses not covered by

the
high deductible plan receive a tax subsidy, even though they are not

covered
by insurance.ï¿½ Others are concerned that
even if individuals do 

spend
less on health costs with a high deductible plan, this may not 

necessarily
result in better health outcomes or a long-term reduction 

in
costs.ï¿½ For example, it is noted that it
may be very difficult for an

individual
to determine whether a particular medical procedure is in fact

needed,
and that some individuals will forgo needed care if it is not 

covered
by insurance, with the possibility that longer-term 

medical
costs increase.

 

As
noted above, to the extent that amounts in HSAs are not used for current

medical
expenses, HSAs provide a tax benefit similar to that of an IRA.

HSA
proponents argue that this feature may help contribute to lowering 

medical
costs by in effect rewarding lower spending on medical care.ï¿½ 

Others
argue that this feature operates to make HSAs primarily attractive

to
higher income individuals who can afford to self insure for the higher 

deductible
under the high deductible plan and who are primarily interested

in a
tax-favored savings vehicle.ï¿½ It is
argued that the increase in the 

contribution
limits under the proposal will make it even more likely that 

an HSA
is used in this way by higher income individuals. On the other hand,

the
proposed increase in the additional tax on distributions that are not 

for
medical purposes could make the savings aspects of HSAs less attractive

for
individuals who do not expect to have health costs in the future

(including
in retirement). The proposed refundable credit for lower income

individuals
is intended to provide an incentive to uninsured individuals to

purchase
health insurance by providing assistance in paying 

premiums.ï¿½ Apart from the general issues relating to
high deductible plans

discussed
above, a key issue with respect to this credit is whether the 

amount
of the credit is sufficient to enable low-income individuals to 

purchase
health insurance.ï¿½ This depends on the
cost of insurance that 

is
available in the individual market, which may vary depending on the 

characteristics
of the individual, e.g., whether the individual is at 

higher
risk from a health standpoint.ï¿½ Some
argue that a credit for the 

cost of
high deductible insurance alone will not be a benefit to many 

lower-income
individuals, particularly those with chronic illnesses and 

recurring
medical costs, because it will be difficult for them to pay the 

out-of-pocket
expenses required under a high deductible plan.

 

The
advanced payment feature of the credit is designed to assist intended

recipients
who might not be able to purchase insurance without the 

advanced
credit.ï¿½ Because advancing the credit
merely changes the timing 

of
payment and does not reduce the cost of insurance (except for the time 

value
of money), this argument is best understood not as making the 

insurance
affordable, as is often stated, but rather in making it available

to
those who would not otherwise be able to arrange the financing to pay 

for the
insurance in advance of receiving the credit. Given the target 

population
of the credit, it might reasonably be argued that for many 

potential
users of the credit, other financing mechanisms, such as credit 

cards,
loans from relatives or friends, personal savings, etc., would not

be
available, or would not be used even if available, and the best way to

encourage
individuals to buy insurance would be to provide the credit in 

advance,
at the time of purchase of the insurance.

 

In
order to make the advance payment system more workable, the proposal 

uses
prior year income information, and does not require reconciliation 

based
on current year information. The trade off for this is that in some 

cases
the credit will be provided on an advance basis to those with current 

incomes
well in excess of the income limits for the credit.ï¿½ In other

cases,
individuals will have a current need for the credit on an advance 

basis,
but will not be eligible (e.g., if current year income is substantially

less
than prior year income). 

 

Experience
with refundable credits under present law indicates that such 

credits
may lead to fraud and abuse by taxpayers, as it may be difficult 

for the
IRS to ensure that all taxpayers who claim the credit are in fact 

eligible.ï¿½ This effect could be reduced to the extent
that an advance 

payment
system works efficiently and makes payments directly to insurers 

or
others providing bona fide coverage.ï¿½
The experience with the 

present-law
HCTC may provide some indication of how an advance payment 

mechanism
may operate; however, that credit is significantly narrower in 

scope
than the proposed credit.

 

The
multiplicity of the provisions, as well as the varying requirements 

for
each one will add complexity for taxpayers and the IRS.ï¿½ By providing 

additional
options to individuals, the proposal may increase complexity 

because
individuals will have to determine which option is best for them.

For
example, individuals eligible for the proposed refundable tax credit 

for
health insurance will have to determine which option is best for them 

because
such individuals are not eligible for both the credit and a 

deduction.ï¿½ Employees will also have to determine
whether it is better to 

remain
in employer plans or to purchase a policy in the individual market.

 

Creating
a new tax deduction and new credits will necessitate new lines on 

the
Form 1040 and additional information in instructions regarding the new 

provisions.ï¿½ The new provisions may also require IRS
programming 

modifications.ï¿½ Additionally, the credit for lower-income
individuals 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.ï¿½ The 

proposal
may also increase complexity for insurance companies by adding 

administrative
burdens with respect to the advanced payment of the credit.

Health
insurers would be required to provide information statements to 

taxpayers
receiving the credit on an advanced payment basis and to the IRS, 

including
the policy number, the policy premium, and that the policy meets 

the
requirements for a qualified policy.

 

Requiring
reporting by health insurers and employers could be helpful in

enforcing
other aspects of the proposal, e.g., in ensuring that a taxpayer 

who
takes the above-the-line deduction is in fact covered by a high 

deductible
plan.ï¿½ While any such reporting
requirements would be likely to 

increase
compliance, they would also increase administrative burdens on 


the
part of those subject to the requirements. 

 

Prior
Action

 

Proposals
similar to the above-the-line deduction were included in the

President's
fiscal year 2005 and 2006 budget proposals.ï¿½
Proposals similar 

to the
refundable credit for lower-income individuals were included in the 

President's
fiscal year 2002, 2003, 2004, 2005, and 2006 budget proposals.

2.ï¿½ Modify the refundable credit for health
insurance costs of eligible

individuals

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present
Law

ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½

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. The credit is available on an advance basis.

Qualifying
family members are the taxpayer's spouse and any dependent of

the
taxpayer with respect to whom the taxpayer is entitled to claim a 

dependency
exemption.ï¿½ 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.ï¿½ In the case of a joint return, the
eligibility requirements 

are met
if at least one spouse satisfies the requirements.ï¿½ 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 

allowanceï¿½ or who would be eligible to receive such an
allowance but for 

the
requirement that the individual exhaust unemployment benefits before 

being
eligible to receive an allowance and (2) with respect to such 

allowance,
is covered under a certification issued under subchapter A or

D of chapter
2 of title II of the Trade Act of 1974.ï¿½
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.ï¿½
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").ï¿½ 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.ï¿½ 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 employerï¿½ (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 

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.ï¿½ 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.ï¿½
Such State 

coverage
must provide that each qualifying individual is guaranteed 

enrollment
if the individual pays the premium for enrollment or 

provides
a qualified health insurance costs eligibility certificate and 

pays
the remainder of the premium.ï¿½ In
addition, the State-based coverage 

cannot
impose any pre-existing condition limitation with respect to 

qualifying
individuals.ï¿½ 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.ï¿½ 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.ï¿½ A 

qualifying
individual is an eligible individual who seeks to enroll 

in the
State-based coverage and who has aggregate periods of creditable 

coverageï¿½ of three months or longer, does not have
other specified 

coverage,
and who is not imprisoned.ï¿½ï¿½ 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.ï¿½ Amounts distributed from a
medical savings 

account
or health savings account are not eligible for the credit.ï¿½ The 

amount
of the credit available through filing a tax return is reduced by 

any
credit received on an advance basis.ï¿½
Married taxpayers filing 

separate
returns are eligible for the credit; however, if both spouses are 

eligible
individuals and the spouses file a separate return, then the 

spouse
of the taxpayer is not a qualifying family member.

 

The
Secretary of the Treasury is authorized to prescribe such regulations 

and
other guidance as may be necessary or appropriate to carry out the 

provision.

 

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

 

HIPAA
imposed a number of requirements with respect to health coverage 

that
are designed to provide protections to health plan participants.ï¿½ 

Among
other things, HIPAA generally provides that a pre-existing condition

exclusion
may be imposed only if:ï¿½ (1) the exclusion
relates to a condition

(whether
physical or mental), regardless of the cause of the condition, 

for
which medical advice, diagnosis, care, or treatment was recommended or

received
with the 6-month period ending on the enrollment date; (2) the 

exclusion
extends for a period of not more than 12 months after the 

enrollment
date; and (3) the period of any pre-existing condition exclusion

is
reduced by the length of the aggregate of the periods of creditable 

coverage
(if any) applicable to the participant as of the enrollment date.

In
general terms, creditable coverage includes health care coverage without

a gap
of more than 63 days.ï¿½ Special
limitations apply to exclusions in 

the
case of newborns, adopted children, and pregnancy.

 

ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½Description of Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

In
general

 

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

ways.

 

Pre-existing
condition exclusion for State-based coverage

 

The
proposal modifies the requirement that State-based coverage not impose 

pre-existing
condition limitations.ï¿½ The proposal
allows State-based 

coverage
to impose a modified pre-existing condition restriction similar 

to the
HIPAA rules.ï¿½ 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.ï¿½ 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.ï¿½ The
present-law HIPAA 

provisions
relating to newborns, adopted children, and pregnancy apply.

 

Spouses
of eligible individuals entitled to Medicare

 

The
proposal also allows spouses of eligible individuals to claim the 

credit
even after the eligible individual becomes entitled to Medicare, 

provided
that the spouse (1) is at least age 55; (2) is covered by 

qualified
health insurance, the premium of which is paid by the taxpayer; 

(3)
does not have other specific coverage; and (4) is not imprisoned under

Federal,
State, or local authority.

 

Other
modifications

 

The
proposal also makes other changes to the credit.ï¿½ Under the proposal,

individuals
who elect to receive one-time lump sum payments from the PBGC

and
certain alternative PBGC payees are eligible for the credit.

 

The
proposal provides that the Commonwealths of Puerto Rico and the

Northern
Mariana Islands, and American Samoa, Guam, and the U.S. Virgin

Islands
are deemed to be States for purposes of the State-based coverage 

rules.

 

Additionally,
under the proposal, State continuation coverage provided 

under
State law automatically qualifies as qualified health insurance, as

Federally-mandated
COBRA continuation coverage, without having to meet the

requirements
relating to State-based qualified coverage.

 

The
proposal also changes the definition of other specified coverage for 

eligible
alternative TAA recipients by removing the special rule that 

applies
only to alternative TAA recipients.

 

Effective
date.-The proposal modifying the requirement that there be no 

imposition
of a pre-existing condition exclusion is effective for eligible 

individuals
applying for coverage after December 31, 2006.ï¿½
The proposal 

relating
to spouses of HCTC-eligible individuals is effective for taxable 

years
beginning after December 31, 2006.ï¿½ The
remaining proposals are 

effective
as if included in the Trade Act of 2002.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½
Analysis

In
general

 

The
HCTC was enacted to assist certain individuals in paying for qualified

health
insurance.ï¿½ The various aspects of the
proposal are intended to make

the
credit available to more individuals.ï¿½
Some aspects of the proposal may 

be
considered clarifications of present law based on current IRS 

administrative
positions.

 

Pre-existing
condition exclusion for State-based coverage

 

The
pre-existing condition provisions of present law have been noted by some

as a
barrier to greater participation in the HCTC system by States.ï¿½ The 

proposal
is intended to result in greater plan participation.ï¿½ According to

the
IRS, for the 2005 tax year, 40 States (including the District of 

Columbia)
had made available at least one State-based option (other than

State-based
continuation coverage).ï¿½ Nine States had
available only 

State-based
continuation coverage, and two States did not have any 

State-based
coverage option.

 

Proponents
argue that the change is necessary to allow States not currently

offering
qualified health insurance to be able to offer qualified insurance.

Many
States argue that it is difficult to implement qualifying State-based

coverage
with the present-law requirement that there be no imposition of a 

pre-existing
condition exclusion.ï¿½ Others argue that
the proposed 

modification
would eliminate an important consumer protection afforded 

under
State-based coverage.ï¿½ 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.ï¿½ 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.ï¿½ They
argue that since the vast

majority
of States have been able to produce a qualifying option under the

present-law
requirements, the few States that have not offered qualified 

insurance
should not be afforded a less stringent rule.

 

Spouses
of eligible individuals entitled to Medicare

 

Under
present law, once an otherwise eligible individual is entitled to 

benefits
under Medicare, the spouse of the individual is no longer eligible

for the
HCTC, even if the spouse is not entitled to benefits under Medicare

(i.e.,
is younger). In such cases, loss of the credit may result in loss of

health
care coverage.ï¿½ The proposal is intended
to prevent such a result.

 

Eligible
individuals

 

Under
the proposal, individuals who elect to receive one-time lump-sum 

payments
from the PBGC are eligible for the credit.ï¿½
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.ï¿½ 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.ï¿½ In general, lump-sum
payments are only received if

the
value of the benefit is $5,000 or less.ï¿½
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.ï¿½ 

 

The
proposal also provides that certain alternative PBGC payees are 

eligible
for the credit.ï¿½ 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.ï¿½ Many believe that fairness
requires that such individuals

should
be treated as eligible PBGC pension recipients.

 

Certain
commonwealths and possessions

 

Under
present law, if an individual meets the definition of an eligible

individual,
residents of the possessions and commonwealths may be eligible 

for the
credit; however, because the possession or commonwealth in which 

they
live is not able to offer qualified health insurance, such individuals

may be
unable to access the credit.ï¿½ The
proposal would allow certain 

possessions
and commonwealths to offer qualified health insurance on the 

same
basis as States. Proponents argue that since the credit is targeted 

to
specific groups of individuals (i.e., individuals receiving benefits 

under
TAA or from the PBGC), residents of such commonwealths and 

possessions
who are eligible individuals should not be denied the credit 

because
their residence cannot offer a qualified State-based option.

 

While
residents of the possessions and commonwealths are U.S. citizens,

special
tax rules apply.ï¿½ 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.ï¿½ Certain
other tax credits are 

not
available to such individuals.ï¿½ For
example, the earned income credit 

and
child tax credit are generally not available to such residents.

 

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.ï¿½ 

These
requirements include guaranteed issue, no imposition of pre-existing

conditions
(as modified by this proposal), nondiscriminatory premiums and 

similar
benefits. Proponents argue that many States lack qualified 

State-based
coverage and allowing State continuation coverage to 

automatically
qualify would allow more individuals access to the 

credit.ï¿½ 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.ï¿½ Proponents argue
that it is 

inappropriate
for the State-based coverage requirements to apply to State 

continuation
coverage as certain rules applicable to State continuation

coverage
are inconsistent with such requirements.

 

Critics
argue that it is extremely important for individuals to have the 

protections
relating to guaranteed issue, pre-existing conditions, 

nondiscriminatory
premiums and similar benefits.They argue that if the 

applicable
requirements are waived, individuals will lose valuable rights 

with
respect to their health care.ï¿½ 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.ï¿½ 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.ï¿½
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.ï¿½ Proponents argue that the proposal would
reduce complexity in 

administering
the credit, as similar rules would apply to all individuals.ï¿½ 

Some
argue that despite the complexity in having different rules, the 

special
rule for alternative TAA recipients should be retained.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½Prior Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

A
similar proposal was included in the President's fiscal year 2006 budget

proposal.ï¿½ Several components of the proposal were
included in the 

President's
fiscal year 2005 budget proposal. 

 

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

tax
credit 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ 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.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description
of Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½

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.ï¿½ Under the proposal, qualifying
expenses include those expenses 

paid or
incurred after the date on which the taxpayer files an application 

with
the FDA for designation as a potential treatment for a rare 

disease
or disorder if the drug receives FDA designation before the due

date
(including extensions) for filing the tax return for the taxable year

in
which the application was filed with the FDA.ï¿½
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.ï¿½The provision is effective for qualified expenditures 

incurred
after December 31, 2005.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

Approval
for human clinical testing and designation as a potential 


treatment
for a rare disease or disorder require separate reviews within 

the
FDA.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ Such 

approval
creates a unique starting point from which human clinical testing

expenses
can be measured.ï¿½ 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.ï¿½ Such an
alternative proposal would 

provide
more certainty to the taxpayer regarding clinical expenses 

eligible
for the credit.ï¿½ 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. 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½Prior Action

 

An
identical proposal was part of the President's fiscal year 2005 and 2006

budget
proposals.ï¿½ A similar proposal was part
of the President's fiscal 

year
2004 budget proposal

 

D.ï¿½ Provisions Relating to Charitable Giving

 

1.ï¿½ Permit tax-free withdrawals from individual
retirement arrangements for 

charitable
contributions 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½ The deduction also is allowed for purposes
of calculating 

alternative
minimum taxable income.ï¿½ 

 

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 taxpayer
who takes the standard deduction (i.e., who does not itemize

deductions)
may not take a separate deduction for charitable contributions.

 

A
payment to a charity (regardless of whether it is termed a

"contribution")
in exchange for which the donor receives an economic 

benefit
is not deductible, except to the extent that the donor can 

demonstrate,
among other things, that the payment exceeds the fair market

value
of the benefit received from the charity.ï¿½
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.ï¿½ 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

exceeding
the value of the goods or services is deductible as a charitable

contribution.


 

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).ï¿½ To the extent a taxpayer has not exceeded
the 50-percent 

limitation,
(1) contributions of capital gain property to public charities 

generally
may be deducted up to 30 percent of the taxpayer's contribution base; 

(2)
contributions of cash to private foundations and certain other 

charitable
organizations generally may be deducted up to 30 percent of the

taxpayer's
contribution base; and (3) contributions of capital gain 

property
to private foundations and certain other charitable 

organizations
generally may be deducted up to 20 percent of the taxpayer's

contribution
base.

 

Contributions
by individuals in excess of the 50-percent, 30-percent, and 

20-percent
limits may be carried over and deducted over the next five 

taxable
years, subject to the relevant percentage limitations on the 

deduction
in each of those years.

 

In
addition to the percentage limitations imposed specifically on 

charitable
contributions, present law imposes an overall limitation on 

most
itemized deductions, including charitable contribution deductions,

for
taxpayers with adjusted gross income in excess of a threshold amount,

which
is indexed annually for inflation. The threshold amount for 2006 is 

$150,500
($75,250 for married individuals filing separate returns). 

For
those deductions that are subject to the limit, the total amount of

itemized
deductions is reduced by three percent of adjusted gross 

income
over the threshold amount, but not by more than 80 percent of 

itemized
deductions subject to the limit.ï¿½
Beginning in 2006, the overall

limitation
on itemized deductions phases out for all taxpayers. The overall

limitation
on itemized deductions is reduced by one-third in taxable years 

beginning
in 2006 or 2007, and by two-thirds in taxable years beginning in

2008 or
2009. The overall limitation on itemized deductions is eliminated 

for
taxable years beginning after December 31, 2009; however, this 

elimination
of the limitation sunsets on December 31,2010.

 

In
general, a charitable deduction is not allowed for income, estate, or

gift
tax purposes if the donor transfers an interest in property to a 

charity
(e.g., a remainder) while also either retaining an interest in 

that
property (e.g., an income interest) or transferring an interest in 

that
property to a noncharity for less than full and adequate 

consideration.ï¿½ 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.ï¿½ï¿½
For such interests,

a
charitable deduction generally is allowed to the extent of the present

value
of the interest designated for a charitable organization.

 

IRA
rules

 

Within
limits, individuals may make deductible and nondeductible 

contributions
to a traditional IRA.ï¿½ Amounts in a
traditional IRA are 

includible
in income when withdrawn (except to the extent the withdrawal 

represents
a return of nondeductible contributions).ï¿½
Individuals also 

may
make nondeductible contributions to a Roth IRA.ï¿½ Qualified withdrawals

from a
Roth IRA are excludable from gross income.ï¿½
Withdrawals from a Roth

IRA
that are not qualified withdrawals are includible in gross income to

the
extent attributable to earnings.ï¿½
Includible amounts withdrawn from a 

traditional
IRA or a Roth IRA before attainment of age 59-ï¿½ are 

subject
to an additional 10-percent early withdrawal tax, unless an 

exception
applies.ï¿½ Under present law, minimum
distributions are required

to be
made from tax-forward retirement arrangements, including IRAs.

Minimum
required distributions from a traditional IRA must generally begin

by the
April 1 of the calendar year following the year in which the IRA 

owner
attains age 70-ï¿½. 

 

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.ï¿½ 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.ï¿½ 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.ï¿½ 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.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description
of Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½ 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.ï¿½ The exclusion is available for distributions
made after the date

the IRA
owner attains age 65 and applies only to the extent the individual 

does
not receive any benefit in exchange for the transfer. Amounts 

transferred
directly from the IRA to the qualified charitable organization

are
treated as a distribution for purposes of the minimum distribution 

rules
applicable to IRAs.ï¿½ No charitable
contribution deduction is allowed 

with
respect to any amount that is excluded from income under 

this
provision.ï¿½ Amounts transferred from the
IRA to the qualified 

charitable
organization that would not be taxable if transferred directly

to the
individual, such as a qualified distribution from a Roth IRA or the

return
of nondeductible contributions from a traditional IRA, are subject

to the
present law charitable contribution deduction rules.

 

Effective
date.ï¿½ The proposal is effective for
distributions made after

the
date of enactment.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½
Analysis

ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½

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.ï¿½ 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.ï¿½ However, the deduction is
subject to the 

percentage
limitations of section 170 and to the overall limit on itemized 

deductions.
The proposal will allow an IRA owner to avoid these limitations

and
therefore might encourage additional charitable giving by increasing

the tax
benefit of the donation for those who would not be able to fully 

deduct
the donation by reason of the present-law limitations.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½
Therefore, under the proposal,

it
might be beneficial for taxpayers who itemize their deductions but have

a
significant amount of charitable deductions to make their charitable 

contributions
through the IRA and then claim the standard deduction.

 

In
addition, some argue that the proposal will inappropriately encourage

IRA
owners to use retirement monies for nonretirement purposes (by making 

such
use easier and providing greater tax benefits in some cases). To the 

extent
that the proposal will spur additional gifts by circumventing the 

percentage
limitations, IRA owners may spend more of their retirement 

money
for nonretirement purposes than under present law.ï¿½ Some also argue

that,
in the early years of retirement, an individual might not accurately

assess
his or her long-term retirement income needs.ï¿½
For example, the 

individual
might not make adequate provision for health care or 

long-term
care costs later in life.ï¿½ Some
therefore argue that IRA 

distributions
to charity should be permitted, if at all, only after age 70.

 

Complexity
issues

 

The
proposal adds complexity to the tax law by creating an additional set 

of
rules applicable to charitable contributions.ï¿½
Taxpayers who own IRAs 

and
make such contributions will need to review two sets of rules in order

to
determine which applies to them and which is the most advantageous.ï¿½ 

The
proposal may increase the complexity of making charitable 

contributions
because individuals who are able and wish to take advantage

of the
tax benefits provided by the proposal will need to make the 

contribution
through the IRA rather than directly. The proposal also may

increase
complexity in tax planning as the proposal might make it 

beneficial
for some taxpayers to take the standard deduction and make all

charitable
contributions through their IRAs.

 

In some
cases, taxpayers may need to apply both sets of rules to a single 

contribution
from an IRA. This will occur if the IRA distribution includes 

both
taxable amounts (which would be subject to the rules in the proposal) 

and
nontaxable amounts (which would be subject to the present-law rules).

As
discussed above, the effect of the proposal is to eliminate certain 

present-law
limits on charitable deductions for IRA owners.ï¿½ A simpler 

approach
is to eliminate such limits with respect to all charitable 

contributions.ï¿½ Providing a single rule for charitable
contributions 

would
make the charitable deduction rules easier to understand for all

taxpayers
making such contributions.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½Prior Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

A
similar proposal was included in the President's fiscal years 2004, 2005,

and
2006 budget proposals.ï¿½ 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.

 

H.R.
4297, as amended by the Senate (the "Tax Relief Act of 2005"), 

includes
a similar provision that would have provided an exclusion for an

otherwise
taxable distribution from an IRA that was made (1) directly to a 

charitable
organization on or after the date the IRA owner attains age

70-ï¿½,
or (2) to a split interest entity on or after the date the IRA owner

attains
ageï¿½ 59- ï¿½.

 

2.ï¿½ Expand and increase the enhanced charitable
deduction for contributions

of food
inventory

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

Under
present law, a taxpayer's deduction for charitable contributions of 

inventory
generally is limited to the taxpayer's basis (typically, cost) 

in the
inventory, or if less the fair market value of the inventory.ï¿½ 

For
certain contributions of inventory, C corporations may claim an 

enhanced
deduction equal to the lesser of (1) basis plus one-half of the

item's
appreciation (i.e., basis plus one half of fair market value in 

excess
of basis) or (2) two times basis (sec. 170(e)(3)).ï¿½ In general, a

C
corporation's charitable contribution deductions for a year may not 

exceed
10 percent of the corporation's taxable income (sec. 170(b)(2)).

To be
eligible for the enhanced deduction, the contributed property 

generally
must be inventory of the taxpayer, contributed to a charitable 

organization
described in section 501(c)(3) (except for private 

nonoperating
foundations), and the donee must (1) use the property

consistent
with the donee's exempt purpose solely for the care of the ill,

the
needy, or infants, (2) not transfer the property in exchange for money,

other
property, or services, and (3) provide the taxpayer a written 

statement
that the donee's use of the property will be consistent with 

such
requirements.ï¿½ In the case of
contributed property subject to 

the
Federal Food, Drug, and Cosmetic Act, the property must satisfy the

applicable
requirements of such Act on the date of transfer and for 180

days
prior to the transfer.

 

A donor
making a charitable contribution of inventory must make a

corresponding
adjustment to the cost of goods sold by decreasing the cost

of
goods sold by the lesser of the fair market value of the property or 

the
donor's basis with respect to the inventory (Treas. Reg. 

sec.1.170A-4A(c)(3)).ï¿½ Accordingly, if the allowable charitable
deduction

for
inventory is the fair market value of the inventory, the donor reduces

its
cost of goods sold by such value,with the result that the difference

between
the fair market value and the donor's basis may still be recovered

by the
donor other than as a charitable contribution.

 

To use
the enhanced deduction, the taxpayer must establish that the fair

market
value of the donated item exceeds basis.The valuation of food 

inventory
has been the subject of disputes between taxpayers and the IRS. 

Under
the Katrina Emergency Tax Relief Act of 2005, any taxpayer, whether 

or not
a C corporation, engaged in a trade or business is eligible to 

claim
the enhanced deduction for certain donations made after 

August
28, 2005, and before January 1, 2006, of food inventory.ï¿½ For 

taxpayers
other than C corporations, the total deduction for donations 

of food
inventory in a taxable year generally may not exceed 10 percent

of the
taxpayer's net income for such taxable year from all sole 

proprietorships,
S corporations, or partnerships (or other entity that

is not
a C corporation) from which contributions of "apparently wholesome

food"
are made.ï¿½ "Apparently wholesome
food" is defined as food intended 

for
human consumption that meets all quality and labeling standards imposed

by
Federal, State, and local laws and regulations even though the 

food
may not be readily marketable due to appearance, age, freshness, 

grade,
size, surplus, or other conditions. 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ In such cases,

the
allowable charitable deduction will equal 50 percent of the food's 

fair
market value.ï¿½ 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).ï¿½ 

The
proposal provides that the fair market value of apparently wholesome 

food
that cannot or will not be sold solely due to internal 

standards
of the taxpayer or lack of market would be determined by taking

into
account the price at which the same or substantially the same food 

items
(taking into account both type and quality) are sold by the taxpayer 

at the
time of the contribution or, if not so sold at such time, in 

the
recent past.

 

Effective
date.--The proposal is effective for taxable years beginning 

after
December 31,2005.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ If so, taxpayers might be
better off contributing the food

to
charity than by selling the food in the ordinary course of their 

business.ï¿½ 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.ï¿½ The taxpayer previously could
have sold the avocado for 

$1.35,
but now could only sell the avocado for $0.30.ï¿½
If the taxpayer 

sold
the avocado for $0.30,the taxpayer would incur a loss of $0.45 ($0.75

basis
minus $0.30 sales revenue) on the sale. Because the loss on the

sale of
the avocado reduces the taxpayer's taxable income, the taxpayer's 

tax
liability would decline by approximately $0.16 ($0.45 multiplied by 35

percent),
so the net loss from the sale in terms of after-tax income would

be
$0.29.ï¿½ 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.ï¿½ 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.ï¿½ 

 

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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.

 

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.ï¿½ 

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.ï¿½
The proposal would add 

another
special rule, with its own distinct requirements, thereby 

increasing
the complexity of an already complex section of the Code.ï¿½ The

proposal
also could decrease complexity, however, because it would provide

a
definition of fair market value.ï¿½ Under
current law, valuation of food

inventory
has been a disputed issue between taxpayers and the IRS and a 

cause
of uncertainty for taxpayers when claiming the deduction. Another 

interpretative
issue could arise in deciding whether the contributed food

is
"substantially" the same as other food items sold by the taxpayer for

purposes
of determining fair market value of the food.

 

Taxpayers
who contribute food inventory must consider multiple factors to

ensure
that they deduct the permitted amount (and no more than the 

permitted
amount) with respect to contributed food.ï¿½
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.ï¿½ï¿½
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.ï¿½ 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.ï¿½ï¿½ 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior
Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

The
President's fiscal year 2003, 2004, 2005, and 2006 budget proposals

contained
a similar proposal.ï¿½ 

 

 

3.ï¿½ Reform excise tax based on investment income
of private foundations 

ï¿½

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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).ï¿½ 

 

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.ï¿½ Specifically,
the excise tax rate is 

reduced
if the foundation's qualifying distributions (generally, amounts 

paid to
accomplish exempt purposes)ï¿½ equal or
exceed the sum of (1) the 

amount
of the foundation's assets for the taxable year multiplied by the 

average
percentage of the foundation's qualifying distributions over the 

five
taxable years immediately preceding the taxable year in question, and

(2) one
percent of the net investment income of the foundation for the 

taxable
year.ï¿½ï¿½ 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.ï¿½ 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. 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½Description 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.ï¿½ A taxable
private foundation is subject to

tax on
the excess of the sum of the one percent excise tax and the amount

of the
unrelated business income tax (both calculated as if the foundation

were
tax-exempt) over the income tax imposed on the foundation. 

The
proposal repeals the special one-percent excise tax for private

foundations
that exceed their historical level of qualifying distributions.

 

Effective
date.--The proposal is effective for taxable years beginning 

after
December 31, 2005.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½ï¿½ This may result in increased charitable
distributions for private 

foundations
that pay only the minimum in charitable distributions under 

present
law. For example, if a foundation is subject to the two-percent 

excise
tax on net investment income, the foundation reduces the amount of 

required
charitable distributions by the amount of excise tax paid. 

Because
the proposal decreases the amount of excise tax paid on net 

investment
income for such foundations, the proposal increases such 

foundations'
required minimum amount of charitable distributions by an 

amount
equal to one percent of the foundation's net investment income.

Thus,
the proposal results in an increase of required charitable 

distributions
in the case of foundations paying the two-percent rate and

distributing
no greater than the required minimum under present law.

Foundations
paying the two-percent rate that exceed the required minimum 

under
present law generally would not have to increase their charitable 

distributions
as a result of the proposal. Although the required minimum

amount
of charitable distributions would increase for such foundations, 

such
foundations already make distributions exceeding the minimum and so

generally
would not have to increase charitable distributions as a result 

of the
proposal (except to the extent that the increase in the required 

minimum
amount was greater than the excess of a private foundation's 

charitable
distributions over the required minimum amount of present law).

However,
a reduction in the excise tax rate from 2 percent to 1 percent 

may
result in increased charitable distributions to the extent that a 

foundation
decides to pay out the amount that otherwise would 

be paid
in tax for charitable purposes.

 

The
proposal also eliminates the present-law two-tier tax structure.ï¿½ Some

have
suggested that the two-tier excise tax is an incentive for foundations

to
increase the amounts they distribute to charities.ï¿½ Critics of the 

present-law
two-tier excise tax have criticized the efficiency of the 

excise
tax as an incentive to increase payout rates.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ However, total payouts are
greater under the first option.

 

In
summary, the incentive effects of the present-law two-tier excise tax

depend
upon the situation in which the foundation finds itself in the 

current
year. In 2001, 51.6 percent of foundations were one-percent tax 

rate
payors and 48.4 percent were two-percent rate payors.Among large 

foundations
(assets of $50 million or greater) 71.5 percent were 

\one-percent
rate payors and 28.5 percent were two-percent rate payors. A

number
of analysts suggest the optimal tax strategy for a private 

foundation
is to choose a target rate of disbursement, maintain 

that
rate in all years, and never fall below the target in any year. 

 

Critics
of the present-law excise tax structure observe that the median 

payout
rate of large nonoperating private foundations (foundations with

total
assets of $50 million or more) was 5.1 or 5.0 percent in each year

from
1991 through 1995 and was 5.0 percent in 1999.ï¿½
However,the payout 

rate
for such foundations increased to 5.5 percent in 2001. The median

payout
rates for foundations with assets between $10 million and $50 

million
declined annually from 5.4 percent in 1990 to 5.1 percent in 1995

and
1999.ï¿½ 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 1999ï¿½
but increased to 6.2 percent 

in
2001.

 

The
proposal reduces complexity for private foundations by replacing the

two-tier
tax on net investment income with a one-tier tax.ï¿½ 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.ï¿½ 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.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior
Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

The
President's fiscal year 2003, 2004, 2005, and 2006 budget proposals

included
a similar proposal.

 

The
President's fiscal year 2001 budget proposal included a similar

proposal,
but would have reduced the rate of tax to 1.25 percent. 

 

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

trusts 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present
Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½

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.ï¿½ 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.ï¿½
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.ï¿½ Unrelated business 

taxable
income includes certain debt financed income.ï¿½
A charitable 

remainder
trust that loses exemption from income tax for a taxable year is

taxed
as a regular complex trust.ï¿½ 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.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description
of Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

The
proposal imposes a 100-percent excise tax on the unrelated business

taxable
income of a charitable remainder trust.ï¿½
This replaces the 

present-law
rule that removes the income tax exemption of a charitable 

remainder
trust for any year in which the trust has any unrelated business 

taxable
income. Under the proposal, the tax is treated as paid from corpus. 

The
unrelated business taxable income is considered income of the trust 

for
purposes of determining the character of the distribution made to the

beneficiary.

 

Effective
date.--The proposal is effective for taxable years beginning 

after
December 31,2005, regardless of when the trust was created.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½
Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ 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).ï¿½ 

 

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.ï¿½ As a result, the
proposed rule in effect taxes

the
unrelated business income twice, once as an excise tax (at a 

100-percent
rate), and again when distributed.ï¿½
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.ï¿½ 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.ï¿½
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.ï¿½
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).ï¿½ 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.ï¿½ This

has the
effect of not discouraging trustees to make investments that 

might
entail having a small amount of unrelated business taxable income.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½

A
similar proposal was included in the President's fiscal year 2003, 2004,

2005,
and 2006 budget proposals.

 

5.ï¿½ï¿½ï¿½ Modify the basis adjustment to stock of S
corporations 

contributing
appreciated property

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½Present Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½
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.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of
Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

The
proposal allows a shareholder in an S corporation to increase the 

basis
of the S corporation stock by an amount equal to the excess of the 

charitable
contribution deduction that flows through to the shareholder 

over
the shareholder's pro-rata share of the adjusted basis of the 

property
contributed. 

 

Effective
date.--The proposal applies to taxable years beginning after 

December
31, 2005.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½Analysis 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior
Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

A
similar proposal was included in the President's fiscal year 2003, 2004, 

2005,
and 2006 budget proposals.

 

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

a
similar proposal.

 

6.ï¿½ Repeal the $150 million limit for qualified
501(c)(3) bonds

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present
Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½
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.ï¿½ 

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.ï¿½ 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.ï¿½ In applying

this
"$150 million limit," all section 501(c)(3) organizations under
common

management
or control were treated as a single organization.ï¿½ 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.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of
Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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. 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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).ï¿½ Thus, there are
two rules governing 

qualified
501(c)(3) bonds for capital expenditures.ï¿½
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.ï¿½ (Typically, these will be
advance refunding bonds).ï¿½ 

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).ï¿½ The limit does not
apply to bonds to finance 

capital
expenditures incurred after that date.ï¿½
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.ï¿½ 

 

The Committee
believes it is important to assist these private 

institutions
in their advancement of the public good.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ï¿½
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.ï¿½ 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).ï¿½ 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

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

A
similar proposal was included in the President's fiscal year 2004, 2005,

and
2006 budget proposals.

 

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

residential
rental property

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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 projects financed with exempt 

facility
private activity bonds,ï¿½ 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.ï¿½ Section
142(d) sets forth those 

rules.ï¿½ 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.


 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of
Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

A
similar proposal was included in the President's fiscal year 2004, 2005, 

and
2006 budget proposals.

 

 

E.ï¿½ Extend the Above-the-Line Deduction for 

Qualified
Out-of-Pocket Classroom Expenses

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present
Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

Deduction
for out-of-pocket classroom expenses incurred by teachers and 

other
educators

 

In
general, ordinary and necessary business expenses are deductible 

(sec.
162).ï¿½ However, in general, unreimbursed
employee business expenses 

are
deductible only as an itemized deduction and only to the extent that 

the
individual's total miscellaneous deductions (including employee 

business
expenses) exceed two percent of adjusted gross income. An 

individual's
otherwise allowable itemized deductions may be further limited

by the
overall limitation on itemized deductions, which reduces itemized 

deductions
for taxpayers with adjusted gross income in excess of $150,500

(for
2006). In addition, miscellaneous itemized deductions are not 

allowable
under the alternative minimum tax.

 

Certain
expenses of eligible educators are allowed an above-the-line 

deduction.
Specifically,for taxable years beginning prior to 

January
1, 2006, an above-the-line deduction is allowed for up to $250

annually
of expenses paid or incurred by an eligible educator for books, 

supplies
(other than nonathletic supplies for courses of instruction in 

health
or physical education), computer equipment (including related 

software
and services) and other equipment,and supplementary materials 

used by
the eligible educator in the classroom.ï¿½
To be eligible for 

this
deduction, the expenses must be otherwise deductible under 162 as

a trade
or business expense.ï¿½ï¿½ 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.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ 

 

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.ï¿½ï¿½ 

 

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.ï¿½ Itemized deductions subject to the
two-percent floor are not 

deductible
for minimum tax purposes.ï¿½ 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.ï¿½ The 

threshold
amount for 2005 is $150,500 ($75,250 for married individuals 

filing
separate returns).ï¿½ For those deductions
that are subject to the 

limit,
the total amount of itemized deductions is reduced by three percent

of
adjusted gross income over the threshold amount, but not by more than 

80
percent of itemized deductions subject to the limit. Beginning in 2006

,
EGTRRA phases out the overall limitation on itemized deductions for all

taxpayers.ï¿½ 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.ï¿½
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.ï¿½ 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.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of
Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

The
present-law provision would be made permanent.

 

Effective
date.--The proposal is effective for expenses incurred in taxable

years
beginning after December 31, 2005. 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

Policy
issues

 

The
present-law section 62 above-the-line deduction attempts to make fully

deductible
many of the legitimate business expenses of eligible 

schoolteachers.ï¿½ 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.ï¿½ Some

have
observed that the two-percent floor increases pressure to enact 

above-the-line
deductions on an expense-by-expense basis.ï¿½
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.ï¿½ Extending the present-law
above-the-line deduction 

presents
compliance issues.ï¿½ 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.ï¿½
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:ï¿½ (1) the 

two-percent
floor on itemized deductions; (2) the overall limitation on 

itemized
deductions; and (3) the alternative minimum tax. The staff of the 

Joint
Committee on Taxation has previously identified these provisions as 

sources
of complexity and has recommended that such provisions be repealed.

These
provisions do not apply to eligible expenses under the proposal.ï¿½ 

While
repealing these provisions for all taxpayers reduces the complexity

of the
Federal tax laws, effectively repealing these provisions only for 

certain
taxpayers (such as teachers and other eligible educators) likely 

increases
complexity.

 

Some
may view extending the present-law above-the-line deduction as 

increasing
simplification by providing for deductibility of certain 

expenses
without regard to the present-law restrictions applicable to 

itemized
deductions and the alternative minimum tax.ï¿½ï¿½
However, 

extending
the present-law above-the-line deduction may increase complexity

because
of the increased recordkeeping requirements.ï¿½
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.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

Similar
proposals were contained in the President's fiscal year 2003, 2004

, 2005,
and 2006 budget proposals.

 

A
similar provision in H.R. 4297, as passed by the House (the "Tax Relief 

Extension
Reconciliation Act of 2005"), extends the present-law provision 

for one
year.ï¿½ A similar provision in H.R. 4297,
as amended by the Senate

(the
"Tax Relief Act of 2005"), extends the present-law provision for one

year.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ F.ï¿½ Establish Opportunity Zones

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present Law

 

In
general

 


The
Internal Revenue Code contains various incentives to encourage the 

development
of economically distressed areas, including incentives for 

businesses
located in empowerment zones, enterprise communities and 

renewal
communities, the new markets tax credit, the work opportunity tax

credit,
and the welfare-to-work tax credit. 

 

Empowerment
zones

 

There
are currently 40 empowerment zones--30 in urban areas and 10 in rural

areas--that
have been designated through a competitive application process.

State
and local governments nominated distressed geographic areas, which 

were
selected on the strength of their strategic plans for economic and 

social
revitalization. The urban areas were designated by the Secretary of 

the
Department of Housing and Urban Development. The rural areas were 

designated
by the Secretary of the Department of Agriculture. Designations

of
empowerment zones will remain in effect until December 31, 2009. 

 

Incentives
for businesses in empowerment zones include (1) a 20-percent 

wage
credit for qualifying wages, (2) additional expensing for qualified 

zone
property, (3) tax-exempt financing for certain qualifying zone 

facilities,
(4) deferral of capital gains on sales and reinvestment in 

empowerment
zone assets, and (5) exclusion of 60 percent (rather than 50

percent)
of the gain on the sale of qualified small business stock held

more
than 5 years.

 

The
wage credit provides a 20 percent subsidy on the first $15,000 of

annual
wages paid to residents of empowerment zones by businesses located

in
these communities, if substantially all of the employee's services are 

performed
within the zone. The credit is not available for wages taken 

into
account in determining the work opportunity tax credit.

 

Enterprise
zone businesses are allowed to expense the cost of certain 

qualified
zone property (which, among other requirements, must be used in

the
active conduct of a qualified business in an empowerment zone) up to an

additional
$35,000 above the amounts generally available under section 

179. In
addition, only 50 percent of the cost of such qualified zone 

property
counts toward the limitation under which section 179 deductions

are
reduced to the extent the cost of section 179 property exceeds a 

specified
amount 

 

Qualified
enterprise zone businesses are eligible to apply for tax-exempt

financing
(empowerment zone facility bonds) for qualified zone property.

These
empowerment zone facility bonds do not count 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.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of
Proposal

In
general

 

The
proposal creates 20 opportunity zones, 14 in urban areas and 6 in rural

areas.ï¿½ The zone designation and corresponding
incentives for these 20 

zones
are in effect from January 1,2007, to December 31, 2016.ï¿½ 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."ï¿½ 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.ï¿½ 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."ï¿½ The

Community
Transition Plan must set concrete, measurable goals for reducing

local
regulatory and tax barriers to construction, residential development 

and
business creation.ï¿½ Communities that
have already worked to address 

these
issues receive credit for recent improvements.ï¿½
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.ï¿½
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.ï¿½
"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.ï¿½ Opportunity
zone benefits for converted

empowerment
zones and renewal communities expire on December 31, 2009.ï¿½ 

The
selection of empowerment zones or renewal communities to convert to 

opportunity
zones is based on the same criteria that apply to other 

communities,
but does not count against the limitation of 20 new 

opportunity
zones 

 

Previously
designated enterprise communities are also eligible to apply

for
opportunity zone status.ï¿½ Aside from
automatically being eligible to 

apply,
enterprise communities are treated as other areas that do not belong

to
either an empowerment zone or a renewal community once selected: benefits

are in
effect for 10 years and the selection of an enterprise community as an 

opportunity
zone counts against the limit of 20 new opportunity zones.

 

Reporting
requirements identifying construction, residential development,

job
creation, and other positive economic results apply to opportunity 

zones. 

 

Tax
incentives applicable to opportunity zones 

 

Exclusion
of 25 percent of taxable income for certain opportunity zone

businesses

 

A
business is allowed to exclude 25 percent of its taxable income if (1)

it
qualified as an "opportunity zone business" and (2) it satisfied a $5


million
gross receipts test. The definition of an opportunity zone business

is
based on the definition of a "qualified active low-income community 

business"
for purposes of the new markets tax credit, treating opportunity 

zones
as low-income communities.ï¿½ However, a
nonprofit corporation does 

not
qualify for treatment as an opportunity zone business.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½
The proposal may thus have the 

effect
of providing incentives to communities negatively affected by 

increased
international trade.ï¿½ 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.ï¿½ However, the 

existence
of net benefits suggests that sufficient national resources 

should
exist to compensate fully those sectors hurt by trade.ï¿½ 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.ï¿½ This is because the proposal requires only
that a majority 

of an
opportunity zone consist of territory located in a Community in 

Transition.ï¿½ 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.ï¿½ï¿½ However, the incentive for existing
empowerment zones and renewal 

communities
to convert to opportunity zone status is reduced by the early 

termination
date.ï¿½ 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.ï¿½ 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.ï¿½ Businesses who find themselves

marginally
in excess of the three-year moving-average cease to qualify for 

the
income exclusion.ï¿½ Thus, this
formulation of the income exclusion 

unfairly
distinguishes between similarly situated businesses and offers an 

incentive
for abuse.ï¿½ 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.ï¿½
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.ï¿½ If the new investments are
offset by less investment

in
neighboring, but not qualifying areas, the neighboring communities could 

suffer.ï¿½ On the other hand, the increased investment
in the qualifying

areas
could have spillover effects that are beneficial to the neighboring 

communities.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

The
President's fiscal year 2006 budget proposal included a similar 

proposal
(proposing twice as many new opportunity zones as proposed here).

 

G.ï¿½ Permanently Extend Expensing of Brownfields
Remediation Costs

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

Code
section 162 allows a deduction for ordinary and necessary expenses 

paid or
incurred in carrying on any trade or business.ï¿½
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.ï¿½
Section 263(a)(1) limits the 

scope
of section 162 by prohibiting a current deduction for certain 

capital
expenditures.ï¿½ 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.ï¿½
Amounts paid for repairs

and
maintenance do not constitute capital expenditures.ï¿½ 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.ï¿½ The expenditure 

must be
incurred in connection with the abatement or control of hazardous 

substances
at a qualified contaminated site.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ However, sites that are
identified on the national 

priorities
list under the Comprehensive Environmental Response, 

Compensation,
and Liability Act of 1980 ("CERCLA") cannot qualify as 

targeted
areas. Hazardous substances generally are defined by reference 

to
sections 101(14) and 102 of CERCLA, subject to additional limitations 

applicable
to asbestos and similar substances within buildings, certain 

naturally
occurring substances such as radon, and certain other substances 

released
into drinking water supplies due to deterioration through ordinary

use. In
the case of property to which a qualified environmental 

remediation
expenditure otherwise would have been capitalized, any 

deduction
allowed under section 198 is treated as a depreciation deduction 

and the
property is treated as section 1245 property.ï¿½
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 generally those paid or incurred before 

January
1, 2006 

 

The
Gulf Opportunity Zone Act of 2005 added section 1400N(g) to the 

Code,
which extended for two years (through December 31, 2007) the 

expensing
of environmental remediation expenditures paid or incurred to

abate
contamination at qualified contaminated sites located in the Gulf

Opportunity
Zone; in addition, for sites within the Gulf Opportunity Zone

section
1400N(g) broadens the definition of hazardous substance to include

petroleum
products (defined by reference to section 4612(a)(3)).

 

Description
of Proposal

 

The
proposal eliminates the requirement that expenditures must be paid or

incurred
before January 1, 2006, to be deductible as eligible environmental

remediation
expenditures.Thus, the provision (including the special 

provision
under section 1400N(g) which includes petroleum products within 

the
definition of hazardous substance, but only within the Gulf 

Opportunity
Zone) becomes permanent.

 

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

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½
Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½ Removing the doubt

about
deductibility may be desirable if the present-law expiration date is 

currently
affecting investment planning.ï¿½ 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.

 

Complexity
issues

 

By
making the present law provision permanent, the proposal may simplify

tax
planning and investment planning by taxpayers by providing more 

certainty.ï¿½ 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.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

Proposals
to make section 198 permanent were included in the President's

fiscal
year 1999, 2000, 2001, 2002, 2003, 2004, 2005, and 2006 budget

proposals.H.R.
4297, as passed by the House (the "Tax Relief Extension 

Reconciliation
Act of 2005"), extends section 198 expensing for two years 

(through
December 31, 2007), and also broadens the definition of hazardous 

substance
to include petroleum products (defined by reference to section 

4612(a)(3)).ï¿½ï¿½ H.R. 4297, as amended by the Senate (the
"Tax Relief Act of

2005"),
includes the same provision.

 

H.ï¿½ Restructure Assistance to New York

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ 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).ï¿½


 

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.ï¿½ 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")ï¿½
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.ï¿½ A special rule
precludes the additional 

first-year
depreciation under this provision for (1) qualified NYLZ 

leasehold
improvement propertyï¿½ 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).ï¿½ 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.ï¿½ 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.ï¿½ 

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.ï¿½ 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, 2006ï¿½
(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 lessee places the leasehold

improvements
in service.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ The $25,000 amount is reduced
(but not below zero) by 

the
amount by which the cost of qualifying property placed in service 

during
the taxable year exceeds $200,000.ï¿½ 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.ï¿½ 

 

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).ï¿½ 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).ï¿½ 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.ï¿½
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.ï¿½ This
amount is in addition to the

amount
otherwise deductible under section 179.

 

Qualifying
property for purposes of the NYLZ provision means section 179

propertyï¿½ 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.ï¿½
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).ï¿½ If the taxpayer does
not replace the converted 

property
with property similar or related in service or use, then gain 

generally
is recognized.ï¿½ 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.ï¿½ In general, the replacement
period begins with the

date of
the disposition of the converted property and ends two years after

the
close of the first taxable year in which any part of the gain upon 

conversion
is realized.ï¿½ 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.ï¿½
However, the 

five-year
period is available only if substantially all of the use of the

replacement
property is in New York City.ï¿½ In all
other cases, the 

present-law
replacement period rules continue to apply.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of
Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½ 

 

The
amount of the credit may not exceed the lesser of (1) $200 million per

year
(divided equally between the State and the City) for calendar years 

after
2006, until a cumulative total of $2 billion is reached, or (2) 

expenditures
for the calendar year by the State or City, respectively, 

relating
to the construction or improvement of transportation 

infrastructure
in or connecting to the New York Liberty Zone. Any amount

of
unused credit below the $200 million annual limit is carried forward to

the
following year, and expenditures that exceed the $200 million annual 

limit
are carried forward and subtracted from the $200 million annual limit

in the
following year.ï¿½ 

 

Treasury
guidance is to be provided to ensure that the expenditures satisfy

the
intended purposes. The amount of the credit would be treated as State 

and
local funds for purposes of any Federal program.

 


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

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½ The proposal
reflects a preference for 

subsidizing
transportation infrastructure rather than buildings and other 

private
property.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½Prior Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

A
similar proposal was included in the President's fiscal year 2006 budget

proposals.

 

 

III.
SIMPLY THE TAX LAWS FOR FAMILIES

 

A.
Clarify Uniform Definition of Child

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½Present Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ 

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.ï¿½
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.ï¿½ 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 themselvesï¿½ 

 

A child
who provides over one half of his or her own support generally is

not
considered a qualifying child of another taxpayer.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ A legally adopted
child who does not satisfy the 

residency
or citizenship requirement may nevertheless qualify as a 

qualifying
child (provided other applicable requirements are met) if

(1) the
child's principal place of abode is the taxpayer's home and (2)

the
taxpayer is a citizen or national of the United States Children of 

divorced
or legally separated parents Generally, a custodial parent may 

release
the claim to a dependency exemption (and,therefore, the child 

credit)
to a noncustodial parent. If a waiver is made, the waiver applies

for
purposes of determining whether a child meets the definition of a 

qualifying
child or a qualifying relative under section 152(c) or 152(d)

as
amended by the provision.ï¿½ 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.ï¿½
Thus, a waiver that applies

for the
dependency exemption will also apply for the child credit, and the

waiver
will not apply for purposes of the other provisions.

 

Other
provisions

 

A
taxpayer identification number for a child must be provided on the 

taxpayer's
return.ï¿½ 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.ï¿½ 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.ï¿½
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.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½Description of Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

Limit
definition of qualifying child

 

The
proposal adds a new requirement to the uniform definition. Specifically,

it
provides that an individual who otherwise satisfies the definition of a 

qualifying
child for purposes of the uniform definition is not treated a 

qualifying
child unless he or she is either: (1) younger than the 

individual
claiming him or her as a qualifying child or (2) permanently and

totally
disabled.ï¿½ In addition, the proposal
provides that an individual

who is
married and files a joint return (unless the return is filed only 

as a
claim for a refund) will not be considered a qualifying child for 

child-related
tax benefits, including the child tax credit.

 

Restrict
qualifying child tax benefits to child's parent

 

The
proposal provides that if a parent resides with a qualifying child for

more
than half the taxable year then only the parent can claim the child

as a
qualifying child.ï¿½ 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.ï¿½ The proposal
further provides that dependent 

filers
are not eligible for child-related tax benefits.

 

Effective
date.-The proposal is effective for taxable years beginning 

after
December 31, 2006.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½ Beneficiaries of
the earned income credit are

more
likely to be less sophisticated than other taxpayers.ï¿½ 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.ï¿½
This is 

particularly
important in an area that has a history of high taxpayer 

error
rates 

 

Limit
definition of qualifying child

 

The
first part of the proposal is intended to restore eligibility for the 

earned
income credit to certain individuals.ï¿½
It applies to certain 

working
lower-income siblings with respect to their siblings where no 

other
taxpayers reside in the household.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ 

Such a
situation may arise, for example, where a younger sibling is 

working
but the older sibling is a full-time student. The proposal could 

have
addressed this circumstance and restored eligibility for the earned 

income
credit to this group by denying status as a qualifying child to 

siblings
with lower incomes rather than to siblings that are younger.

Some
child-related tax benefits, such as the dependency exemption, are 

already
restricted where an individual is married and files a joint return.

The proposal
extends this limitation by excluding all joint filers (with a

narrow
exception for taxpayers who file jointly only as a claim 

for
refund) from the uniform definition.ï¿½
This change would affect only a

small
percentage of filers (such as married teenagers filing joint returns)

but
would reduce complexity by eliminating the need to file a special form

in
cases were a qualifying child under the uniform definition is not 

a
dependent.

 

Restrict
qualifying child tax benefits to child's parent

 

Under
certain fact patterns (e.g., certain multi-generational families), 

where
more than one taxpayer within a family can claim a qualifying child 

for
certain tax benefits, the members of the family may arrange to maximize

their
tax benefits. This planning opportunity was available in the case of 

the
earned income credit before the enactment of the uniform definition 

in
2004.ï¿½ The enactment of the uniform
definition potentially expanded this

planning
opportunity to other child-related tax benefits. ï¿½For 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.ï¿½ 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.ï¿½ In

certain
fact patterns, the uniform definition extends tax benefits to 

certain
families who otherwise would not qualify (e.g. when the parents'

income
exceeds otherwise applicable income levels) or increases 

benefits
to certain qualifying families. For example, it may be possible 

in
certain circumstances and financially advantageous for the family as a 

whole,
for parents to forgo claiming a child as a qualifying child so that

an
older child living at home may claim such child as a qualifying child.

This
would be most advantageous in circumstances in which the parents have

income
above the phaseout limits for the child credit or where the older 

sibling
becomes eligible for the earned income credit by claiming the 

younger
sibling as a qualifying child.

 

Under
the circumstances described above, the uniform definition provides a

tax
planning opportunity for families that are more affluent and arguably 

less in
need of a tax benefit. The proposal addresses these situations by 

limiting
the ability of a non-parent to claim a child as a qualifying

child
when the child lives with his or her parents for over half the year.

The
proposal also restricts dependent filers from being eligible for

child-related
tax benefits. The result of this would be to extend the 

limitation
already imposed with respect to the dependency exemption to 

other
child-related tax benefits.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior
Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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

That
proposal, however, did not include the proposal to exclude from the 

definition
of qualifying child married individuals filing a joint return.

In
addition, that proposal did not exclude dependent filers from 

child-related
tax benefits.

 

 

B.
Simplify EIC Eligibility Requirements Regarding Filing Status, Presence 

of
Children, and Work and Immigrant Status

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

Overview

 

Low and
moderate-income workers may be eligible for the refundable earned

income
credit (EIC). Eligibility for the EIC is based on earned income, 

adjusted
gross income investment income, filing status, and immigration and

work
status in the United States. The amount of the EIC is based on the 

presence
and number of qualifying children in the worker's 

family,
as well as on adjusted gross income and earned income.

 

The
earned income credit generally equals a specified percentage of wages

up to a
maximum dollar amount. The maximum amount applies over a certain 

income
range and then diminishes to zero over a specified phaseout range. 

For
taxpayers with earned income (or adjusted gross income (AGI)), if 

greater)
in excess of the beginning of the phaseout range, the maximum 

EIC
amount is reduced by the phaseout rate multiplied by the amount of 

earned
income (or AGI, if greater) in excess of the beginning of the 

phaseout
range.ï¿½ For taxpayers with earned income
(or AGI, if greater)

in
excess of the end of the phaseout range, no credit is allowed.

 

An
individual is not eligible for the EIC if the aggregate amount of 

disqualified
income of the taxpayer for the taxable year exceeds $2,800 

(for
2006). This threshold is indexed. Disqualified income is the sum of:

(1)
interest (taxable and tax exempt); (2) dividends;(3) net rent and 

royalty
income (if greater than zero);(4) capital gains net income; and 

(5) net
passive income (if greater than zero) that is not self-employment

income.

 

The EIC
is a refundable credit, meaning that if the amount of the

credit exceeds
the taxpayer's Federal income tax liability, the excess is 

payable
to the taxpayer as a direct transfer payment. Under an advance 

payment
system, eligible taxpayers may elect to receive the credit 

in
their paychecks, rather than waiting to claim a refund on their tax 

return
filed by April 15 of the following year.

 

Filing
status

 

An
unmarried individual may claim the EIC if he or she files as a single 

filer
or as a head of household.ï¿½ Married
individuals generally may not 

claim
the EIC unless they file jointly. An exception to the joint return 

filing
requirement applies to certain spouses who are separated. Under 

this
exception, a married taxpayer who is separated from his or her spouse

for the
last six months of the taxable year shall not be considered as 

married
(and, accordingly, may file a return as head of household and claim

the
EIC), provided that the taxpayer maintains a household that 

constitutes
the principal place of abode for a dependent child (including

a son,
stepson, daughter, stepdaughter, adopted child, or a foster child) 

for
over half the taxable year, and pays over half the cost of maintaining 

the
household in which he or she resides with the child during the year.

 

Presence
of qualifying children and amount of the earned income credit

 

The EIC
is available to low and moderate-income working taxpayers. Three

separate
schedules apply: one schedule for taxpayers with no qualifying 

children,
one schedule for taxpayers with one qualifying child, and one 

schedule
for taxpayers with more than one qualifying child. 

 

Taxpayers
with one qualifying child may claim a credit in 2006 of 34 

percent
of their earnings up to $8,080, resulting in a maximum credit of

$2,747.
The maximum credit is available for those with earnings between

$8,080
and $14,810 ($16,810 if married filing jointly).ï¿½ 

The
credit begins to phase down at a rate of 15.98 percent of earnings

above
$14,810 ($16,810 if married filing jointly).ï¿½
The credit is phased

down to
0 at $32,001 of earnings ($34,001 if married filing jointly).

 

Taxpayers
with more than one qualifying child may claim a credit in 2006

of 40
percent of earnings up to $11,340, resulting in a maximum credit of

$4,536.
The maximum credit is available for those with earnings between

$11,340
and $14,810 ($16,810 if married filing jointly).ï¿½ The credit

begins
to phase down at a rate of 21.06 percent of earnings above $14,810 

($16,810
if married filing jointly).ï¿½ The credit
is phased down to $0 at

$36,348
of earnings ($38,458 if married filing jointly).

 

Taxpayers
with no qualifying children may claim a credit if they are over

age 24
and below age 65.ï¿½ The credit is 7.65
percent of earnings up to

$5,380,
resulting in a maximum credit of $412, for 2006.ï¿½ The maximum is

available
for those with incomes between $5,380 and $6,740 ($8,740 if 

married
filing jointly).ï¿½ The credit begins to
phase down at a rate of

7.65
percent of earnings above $6,740 ($8,740 if married filing jointly)

resulting
in a $0 credit at $12,120 of earnings ($14,120 if married filing

jointly).

 

If more
than one taxpayer lives with a qualifying child, only one of these

taxpayers
may claim the child for purposes of the EIC.ï¿½
If multiple

eligible
taxpayers actually claim the same qualifying child, then a

tiebreaker
rule determines which taxpayer is entitled to the EIC with 

respect
to the qualifying child.ï¿½ The eligible
taxpayer who does not claim

the EIC
with respect to the qualifying child may not claim the EIC for 

taxpayers
without qualifying children.

 

Definition
of qualifying child

 

Present
law provides a uniform definition of qualifying child (the "uniform

definition")
for purposes of the dependency exemption, the child credit,

the
earned income credit, the dependent care credit, and head of household

filing
status.ï¿½ 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.ï¿½ A 

tie-breaking
rule applies if more than one taxpayer claims a child as a

qualifying
child.

 

Taxpayer
identification number requirements

 

Individuals
are ineligible for the credit if they do not include their 

taxpayer
identification number (TIN) and their qualifying child's TIN 

(and,
if married, their spouse's TIN) on their tax return.ï¿½ Solely for 

these
purposes and for purposes of the present-law identification test

for a
qualifying child, a TIN is defined as a Social Security number issued

to an
individual by the Social Security Administration other than a number

issued
under section 205(c)(2)(B)(i)(II) (or that portion of sec. 205(c)

(2)(B)(i)(III)
relating to it) of the Social Security Act regarding the 

issuance
of a number to an individual applying for or receiving federally

funded
benefits.ï¿½ If an individual fails to
provide a correct taxpayer 

identification
number, such omission will be treated as a mathematical or 

clerical
error by the IRS.

 

A
taxpayer who resides with a qualifying child may not claim the EIC with 

respect
to the qualifying child if such child does not have a valid TIN.

The
taxpayer also is ineligible for the EIC for workers without children 

because
he or she resides with a qualifying child.ï¿½
However, if a taxpayer

has two
or more qualifying children, some of whom do not have a valid TIN,


the
taxpayer may claim the EIC based on the number of qualifying children

for
whom there are valid TINs.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of
Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

Overview

The
proposal modifies present law EIC rules by (1) altering the rules with

respect
to EIC claims made by separated spouses; (2) simplifying the rules

regarding
claiming the EIC for workers without children; and (3) changing 

the
taxpayer identification number requirements for taxpayers and their 

qualifying
children with respect to the EIC.

 

Claims
by separated spouses

 

The
proposal modifies present law regarding EIC claims made by separated

spouses.
Under the proposal, a married taxpayer who files a separate return

(as
married filing separately) is allowed to claim the EIC if he or she

lives
with a qualifying child for over half the year,provided the taxpayer

lives
apart from his or her spouse for the last six months of the taxable 

year
and otherwise satisfies the generally applicable EIC provisions. 

Under
the proposal, a married taxpayer who satisfies these requirements, 

and
files as married filing separately,is not required to provide over 

half
the cost of maintaining the household in which the qualifying child 

resides.


 

Claims
for EIC for workers without children 

 

The
proposal modifies the rules for EIC claims made by multiple taxpayers

residing
in the same principal place of abode in which a qualifying child

resides.ï¿½ Under the proposal, if multiple taxpayers
residing in the same 

principal
place of abode are eligible to claim the same qualifying child,

an
otherwise eligible taxpayer may claim the EIC for workers without 

children
(maximum credit of $412 for 2006) even if another taxpayer within

the
same principal place of abode claims the EIC with respect to the 

qualifying
child.ï¿½ However, if unmarried parents
reside together with 

their
child or children (sons, daughters, stepchildren, adopted children,

or
foster children), then one parent may claim the EIC for taxpayers with

qualifying
children, but neither parent may claim the EIC for workers 

without
children

 

TIN
requirements

 

The
proposal provides that a taxpayer (including his or her spouse, if 

married)
must have a Social Security number that is valid for employment 

in the
United States (that is, the taxpayer must be a United States 

citizen,
permanent resident, or have a certain type of temporary visa that

allows
him to work in the United States). Under the proposal, taxpayers 

who
receive Social Security numbers for non-work reasons, such as for 

purposes
of receiving Federal benefits or for any other reason, are not

eligible
for the EIC. The proposal also provides that if a qualifying 

child
does not have a valid TIN, a taxpayer is eligible to claim the EIC

for
workers without children (maximum credit of $412 for 2006).

 

Effective
date.ï¿½The proposal generally is effective for taxable years 

beginning
after December 31, 2006.

 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½

Claims
by separated spouses

 

The
proposal eliminates the household maintenance test for a separated

spouse
who claims the EIC. Married taxpayers filing separate returns who 

reside
with qualifying children may claim the EIC if they live apart from

their
spouse for the last half of the year.ï¿½
As under present law, such a

taxpayer
could not file as a head of household unless he or she also 

satisfies
a household maintenance test and resides with a dependent child.

This
proposal simplifies the determination of whether a separated spouse

is
eligible to claim the earned income credit, and increases the number of

separated
spouses living with a qualifying child who could claim the 

EIC for
taxpayers with qualifying children.

 

Claims
for EIC for workers without children

 

Some
may argue that the proposal to permit a taxpayer to claim the EIC for

taxpayers
without qualifying children (maximum of $412 for 2006) in cases 

where
the taxpayer has a qualifying child, but another taxpayer claims the 

qualifying
child for EIC purposes, has the potential to add administrative 

complexity
for both taxpayers and the IRS. Under the proposal, each 

eligible
taxpayer has an incentive to calculate his or her taxes under

two
alternatives to determine the maximum aggregate EIC available to the 

multiple
taxpayers who could claim the qualifying child: one alternative in

which
the taxpayer claims the qualifying child for the EIC (and the other

taxpayer
claims the EIC for taxpayers without qualifying children), and

one in
which the taxpayer claims the EIC without the qualifying child (and

the
other taxpayer claims the EIC for taxpayers with a qualifying child). 

Presumably
the taxpayers would wish to select that filing combination that

yields
the lowest tax cost, or the highest tax benefit, to the parties.ï¿½ 

The
proposal provides flexibility to taxpayers so that they are able to 

allocate
the qualifying child to a taxpayer in a manner that maximizes the

aggregate
earned income credit, and may increase the aggregate credit paid

when
compared to present law, but might do so at the cost of increasing 

the
complexity of the tax system. Others may argue that the proposal does

not
increase selectivity or materially increase complexity, because 

multiple
taxpayers who are eligible to claim the same qualifying child for

the EIC
currently have an incentive to calculate their taxes under two 

alternatives
(each computes the EIC for qualifying children, but not the 

EIC for
taxpayers without qualifying children) to yield the lowest tax cost

or the
highest tax benefit for the parties.

 

The
proposal's adoption of different rules for unmarried parents than for

other
taxpayers who reside with a qualifying child in the same residence 

creates
complexity, and places unmarried parents at a disadvantage when 

compared
with other types of extended family situations (e.g., a mother 

and
grandmother sharing the same principal place of abode with a qualifying

child).

 

TIN
requirements

 

The
proposal permits a taxpayer to claim the EIC for taxpayers without a

qualifying
child (maximum credit of $412 for 2006) if the taxpayer has a 

qualifying
child who does not have a valid TIN.ï¿½
The proposal has the

effect
of reducing the amount of the lost tax benefit associated 

with
failing to satisfy the TIN requirement for a qualifying child. Some

may
argue that this is equitable because it treats a taxpayer with a

qualifying
child who lacks a valid TIN in the same manner as a taxpayer 

who
does not have a qualifying child.ï¿½
Others may argue that in some cases 

the
proposal reduces the incentive for a taxpayer to obtain a valid TIN

for a
qualifying child. 

 

The
proposal also requires that taxpayers (including spouses) claiming the

EIC
have Social Security numbers that are valid for employment in the 

United
States.ï¿½ï¿½ This has the effect of denying
the EIC to some taxpayers 

who
have valid TINs and are currently eligible to claim the credit but who

are not
authorized to work in the United States.ï¿½
Proponents of the 

proposal
may argue that individuals who are not authorized to work in the

United
States should not be eligible to claim the EIC.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior
Action

 

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

That
proposal, however, required that taxpayers and any qualifying children

have
Social Security numbers that were valid for employment in the United

States.

 

 

 

C.
Reduce Computational Complexity of Refundable Child Tax Credit

 

ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½Present Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

An
individual may claim a tax credit for each qualifying child under the

age of
17.ï¿½ The amount of the credit per child
is $1,000 through 2010.ï¿½ A

child
who is not a citizen, national, or resident of the United States may

not be
a qualifying child.

 

The
credit is phased out for individuals with income over certain threshold

amounts.
Specifically, the otherwise allowable child tax credit is reduced 

by $50
for each $1,000 (or fraction thereof) of adjusted gross income over

$75,000
for single individuals or heads of households, $110,000 for married

individuals
filing joint returns, and $55,000 for married individuals filing

separate
returns.

 

The
credit is allowable against the regular tax and the alternative minimum

tax.ï¿½ To the extent the child credit exceeds the
taxpayer's tax liability,

the
taxpayer is eligible for a refundable credit (the additional child tax 

credit)
equal to 15 percent of earned income in excess of $11,300 (the 

"earned
income" formula).ï¿½ The threshold
dollar amount is indexed for 

inflation.

 

Families
with three or more children may determine the additional child 

tax
credit using the "alternative formula," if this results in a larger 

credit
than determined under the earned income formula.ï¿½ Under the 

alternative
formula, the additional child tax credit can equal the amount

by
which the taxpayer's social security taxes exceed the taxpayer's earned

income
credit ("EIC"). 

 

Earned
income is defined as the sum of wages, salaries, tips, and other 

taxable
employee compensation plus net self-employment earnings. Unlike the

EIC,
which also includes the preceding items in its definition of earned

income,
the additional child tax credit is based only on earned income to

the
extent it is included in computing taxable income.ï¿½ For example, some 

ministers'
parsonage allowances are considered self-employment income, and

thus
are considered earned income for purposes of computing the EIC, but

the allowances
are excluded from gross income for individual income tax 

purposes,
and thus are not considered earned income for purposes of the

additional
child tax credit since the income is not included in taxable 

income.

 

Residents
of U.S. possessions (e.g., Puerto Rico) are generally not 

eligible
for the refundable child credit, because the earned income formula

is
based on earned income to the extent the earned income is included in 

taxable
income.ï¿½ Because residents of
possessions are not subject to the 

U.S.
income tax on income earned outside the U.S., they are not generally 

eligible
for the refundable child credit.ï¿½
However, the alternative child 

credit
formula for taxpayers with three or more children is based on social

security
taxes, and thus residents of possessions with three or more 

children
are eligible for the refundable child credit if they pay social

security
taxes, as do Puerto Ricans on Puerto Rican or U.S. sourced earnings.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of Proposal

 

The
proposal repeals the alternative formula based on the excess of the 

social
security taxes paid over the amount of the EIC.ï¿½ Thus, the 

additional
child tax credit will be based solely on the earned income 

formula,
regardless of the number of children in a taxpayer's family.

 

Also,
the proposal eliminates the requirement that earned income be 

included
in taxable income for purposes of computing the additional child

tax
credit. This conforms the definition of earned income for purposes of

the
refundable child credit and the EIC (i.e., earned income for both 

credits
equals the sum of wages, salaries, tips, and other taxable 

employee
compensation plus net self-employment earnings). Thus, net 

self-employment
earnings that are not included in taxable income will be 

included
in earned income for purposes the additional child credit.

 

Finally,
the proposal requires taxpayers to reside with a child in the

United
States to claim the additional child tax credit. For these purposes,

the
principal place of abode for members of the U.S. Armed Forces is 

treated
as in the United States for any period the member is stationed 

outside
the United States while serving on extended active duty. Extended

active
duty includes a call or order to such duty for a period in excess

of 90
days.

 

Effective
date.ï¿½The proposal is effective for taxable years beginning 

after
December 31,2006.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

A
single rule for calculating the refundable child credit will provide

simplification
for taxpayers with three or more children who otherwise must

make
two separate calculations: the earned income formula and the 

alternative
formula. The vast majority of such taxpayers find that 

the
alternative formula calculation does not yield a higher credit amount

so its
repeal would make the credit calculation simpler without changing 

total
benefits. While the vast majority of taxpayers benefit from the 

simplification
of this change, taxpayers for whom the alternative 

formula
produces the greater benefit would receive a smaller refundable

child
credit than that provided by current law.ï¿½
In general, taxpayers who

find
the alternative formula more valuable are: (1) residents of Puerto 

Rico,
who do not pay U.S. income taxes and are not eligible to claim 

the
EIC, but who may nonetheless may file a U.S. income tax return to 

claim a
refundable child credit, and (2) taxpayers in the United States 

who are
eligible for the child credit but not eligible to claim the EIC.

 

Use of
the same measure of earned income for both the refundable child

credit
and the EIC will provide simplification for all taxpayers claiming

both
credits.ï¿½ While for virtually all
taxpayers the two measures of income

yield
the same result under present law, the fact that this is not true of

all
taxpayers requires additional instructions for all. Taxpayers for whom

the two
measures of earned income differ are those who have certain

self-employment
earnings, such as a parsonage allowance, that is excluded

from
gross income for individual income tax purposes.The President's 

proposal
to adopt the EIC definition of earned income for purposes of the 

refundable
child credit (that is, to eliminate the requirement that the 

earned
income be included in computing taxable income) will expand the 

availability
of the refundable child credit to income not subject to the 

individual
income tax, which some might view as an undesirable policy

result.ï¿½ The modified definition would allow Puerto
Ricans with fewer than

three
children to claim the refundable child credit but for the 

President's
proposal that eligibility for the refundable credit be 

conditioned
on United States residency (discussed below). 

 

An
alternative proposal that modifies the definition of earned income for

both
EIC and refundable child credit purposes to incorporate only such

income
that is also includable in gross income would appear to achieve 

similar
simplification without affecting the child credit for 

residents
of Puerto Rico with children.ï¿½ The
proposal would also treat

employees
and the self-employed equivalently in determining both the EIC

and
refundable child credit, although it may result in the denial of the

EIC for
some EIC eligible parsons with parsonage allowances.

 

The
President's proposal requires taxpayers to reside in the United States

in
order to claim the refundable child credit. The principal effect of this

proposal
is to prevent the expansion of the refundable child credit to 

residents
of Puerto Rico with fewer than three children that would occur

under
the President's proposal to conform the earned income 

definition
for purposes of the EIC and the refundable child credit.ï¿½ There

does
not appear to be any particular simplification that results from the

proposal
other than to prevent Puerto Ricans,who are not required to file

a U.S.
income tax return, from filing such a return for the sole 

purpose
of claiming a refundable credit.

 

The
President's proposal to require U.S. residency in order to claim a 

refundable
child credit would deny the refundable child tax credit to 

certain
taxpayers living abroad who may currently claim it. In some cases

this
may not be considered desirable, such as in the case of a 

low-income
U.S. citizen who works in the U.S. but who happens to live in

Canada
or Mexico.ï¿½ In other cases the result
may be viewed as desirable.

For
example, a married U.S. taxpayer with two children who lives and works

in a
foreign country with $100,000 foreign earned income would have a

gross
income of only $20,000 as a result of the $80,000 foreign earned 

income
(section 911) exclusion. As a result of other provisions of U.S.

law
such as the personal exemptions and child credits, such a taxpayer

would
have no U.S. income tax liabilityHowever, because the refundable

child
credit is based on only earned income included in taxable 

income,
the taxpayer is eligible for a refundable credit of 15 percent

of the
amount by which such income (in this case $20,000) exceeds $11,300

, or
$8,700, for a refundable credit of $1,305.Under present law, and

under
the proposal, the taxpayer is not eligible for the EIC. The policy

for
paying a refundable child credit in such a case is questionable, 

especially
considering the refundable credit is only payable once the

taxpayer's
earned income reaches $91,300 ($80,000 section 911 exclusion 

plus
refundable child credit earned income threshold of $11,300).

 

Another
situation where present law leads to a potentially undesirable 

result
occurs where a U.S. taxpayer with children living abroad has foreign

tax
liability and claims a foreign tax credit.ï¿½
In some such cases, the 

taxpayer
could pay the foreign tax, use the foreign tax credit to eliminate

any
U.S. tax liability, and then claim a refundable child credit. 

Under
the proposal, the child credit would not be available to such a 

taxpayer.ï¿½ 

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Prior Action

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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

 

IV.
PROVISIONS RELATED TO THE EMPLOYER-BASED PENSION SYSTEM

 

A.ï¿½ Provisions Relating to Cash Balance Plans

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Present
Law

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½

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.ï¿½ 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.ï¿½ 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.ï¿½ 

An
employer is generally subject to an excise tax for a failure to make

required
contributions.ï¿½ Benefits under a defined
benefit pension plan are

generally
guaranteed (within limits) by the Pension Benefit Guaranty 

Corporation
("PBGC").

 

Benefits
under defined contribution plans are based solely on the 

contributions
(and earnings thereon) allocated to separate accounts 

maintained
for each plan participant.ï¿½ Profit
sharing plans and qualified 

cash or
deferred arrangements (commonly called "401(k) plans" after the 

section
of the Internal Revenue Code regulating such plans) are examples of

defined
contribution plans.

 

Cash
balance plans

 

A cash
balance plan is a defined benefit pension plan with benefits 

resembling
the benefits associated with defined contribution plans. Cash 

balance
plans are sometimes referred to as "hybrid" plans because they 

combine
features of a defined benefit pension plan and a defined 

contribution
plan. Other types of hybrid plans exist as well, such as

pension
equity plans.

 

Under a
cash balance plan, benefits are defined by reference to a 

hypothetical
account balance.ï¿½ An employee's
hypothetical account balance

is
determined by reference to hypothetical annual allocations to the 

account
("pay credits"), for example, a certain percentage of the 

employee's
compensation for the year, and hypothetical earnings on the 

account
("interest credits").The method of determining interest credits 

under a
cash balance plan is specified in the plan.ï¿½
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.ï¿½ Alternatively, interest credits are
sometimes based on 

hypothetical
assets held in the account, similar to earnings on an 

individual
account under a defined contribution plan, which are based on

the
assets held in the individual account. 

 

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).ï¿½ That is, the participant's hypothetical
account continues to be

credited
with interest after the participant stops working for the 

employer.ï¿½ 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.ï¿½
Some early cash balance

plans
provided interest credits only while participants' remained employed

(referred
to as "back-loaded" interest credits).ï¿½ 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.ï¿½
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.ï¿½
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.ï¿½ 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;ï¿½ (2) the proper method

for
determining lump-sum distributions;ï¿½ and
(3) the application of the age

discrimination
rules.ï¿½ï¿½ These rules are discussed
below.ï¿½ 

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.ï¿½ 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.ï¿½ 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 ageï¿½ 

 

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.ï¿½ 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.ï¿½ 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.ï¿½ This has the
effect of front-loading benefit

accruals.

 

Under a
plan providing back-loaded interest credits, benefits attributable

to
interest credits do not accrue until the interest credits are credited 

to the
employee's account.ï¿½ 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").ï¿½ For this purpose, an amendment is treated as
reducing accrued 

benefits
if it has the effect of eliminating or reducing an early 

retirement
benefit or a retirement-type subsidy or of eliminating an 

optional
form of benefit provided with respect to benefits that have 

already
accrued.

 

The
anticutback rule applies in the context of cash balance plan 

conversions.
ï¿½Because of this rule, after conversion
to a cash balance

formula,
a plan must provide employees at least with the normal retirement 

benefit
that he or she had accrued before the conversion, as well as with 

any
early retirement benefits or other optional forms of benefit provided

with
respect to the accrued benefit before the conversion.ï¿½ However, the

plan
may determine benefits for years following the conversion in a variety

of
ways, while still satisfying the anticutback rule.ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ As another 

example,
an employer may convert the preconversion accrued 

benefit
into a lump-sum amount and establish this amount as the opening

account
balance. Depending on the interest and mortality assumptions used,

this
lump-sum amount may or may not equal the actuarial present value of

the
participant's accrued benefit as of the date of conversion, determined

using
the statutory interest and mortality assumptions required in 

determining
minimum lump-sum distributions (as discussed below).

 

Under
the wearaway approach, the participant's protected benefit (i.e., the

preconversion
accrued benefit) is compared to the normal retirement benefit

that is
provided by the account balance (plus pay and interest credits),

and the
participant does not earn any new benefits until the new benefit 

exceeds
the protected accrued benefit. That is, the participant's benefit

is the
greater of the preconversion accrued benefit and the benefit 

provided
by the cash balance account.ï¿½ 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.ï¿½ Plan design
can greatly affect the

length
of any wearaway period. 

 

No
wearaway (or "sum of " approach)

Under a
plan without a wearaway, a participant's benefit under the cash 

balance
plan consists of the sum of (1) the benefit accrued before 

conversion,
plus (2) benefits under the cash balance formula for years of 

service
after the conversion. This approach is more favorable to plan 

participants
than the wearaway approach because they earn additional 

benefits
under the new plan formula immediately. This approach is also 

sometimes
referred to as the "A + B" method, where A is the protected 

benefit
and B is the benefit under the cash balance formula.

 

Grandfathering

 

For
older and longer-service participants, benefits under a cash balance

formula
may be lower than the benefits a participant may have expected to

receive
under the traditional defined benefit formula (the "old" formula).

The
employer might therefore provide some type of "grandfather" to 

participants
already covered by the plan or to older or longer-service 

employees.ï¿½ For example, the old formula might continue
to apply to 

participants
who were already covered by the plan before the conversion;

such
participants might be given a choice between the old 

formula
and the cash balance formula for future benefit accruals; or,

in the
case of a final average pay plan, the plan may stop crediting 

service
under the old formula, but continue to apply post-conversion pay

increases,
so the employee's preconversion benefit increases with 

post-conversion
pay increases. These approaches go beyond merely preserving

the
benefit protected by the anticutback rule.

 

Age
discrimination

 

In
general

 

The
Code and ERISA prohibit any reduction in the rate of a participant's 

benefit
accrual (or the cessation of accruals) under a defined benefit 

pension
plan because of the attainment of any age.ï¿½
A parallel requirement 

applies
under the Age Discrimination in Employment Act ("ADEA").ï¿½ 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.ï¿½ 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.ï¿½ 

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 to determine the rate of 

benefit
accrual under a defined benefit pension plan or rate of allocation 

under a
defined contribution plan.

 

The
proposed regulations provided that an employee's rate of benefit 

accrual
for a year under a defined benefit pension plan is generally the

increase
in the employee's accrued normal retirement benefit (i.e., the 

benefit
payable at normal retirement age) for the plan year.ï¿½ However, 

the
proposed regulations provided a special rule under which an employee's

rate of
benefit accrual under a cash balance plan meeting certain 

requirements
(an "eligible" cash balance plan) was based on the rate of 

pay
credit provided under the plan. Thus, under the proposed regulations, 

an
eligible cash balance plan would not violate the prohibition on age 

discrimination
solely because pay credits for younger employees earn 

interest
credits for a longer period. In order for a plan converted to a

cash
balance plan to be an eligible cash balance plan, the regulations 

generally
required the conversion to be accomplished in one of two ways.

 

In
general,the converted plan had to either: (1) determine each 

participant's
benefit as not less than the sum of the participant's 

benefits
accrued under the traditional defined benefit pension plan formula 

and the
cash balance formula; or (2) establish each participant's opening

account
balance as an amount not less than the actuarial present value of

the
participant's prior accrued benefit, using reasonable actuarial 

assumptions.
The proposed regulations also allowed a converted plan to 

continue
to apply the traditional defined benefit formula to some 

participants.

 

Section
205 of the Consolidated Appropriations Act, 2004

(the
"2004 Appropriations Act"), enacted January 24, 2004, provides that

none of
the funds made available in the 2004 Appropriations Act may be used

by the
Secretary of the Treasury, or his designee, to issue any 

rule or
regulation implementing the proposed Treasury regulations or any

regulation
reaching similar results.ï¿½ 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.ï¿½ 

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."ï¿½ï¿½ Treasury and the IRS announced that they do
not intend to 

issue
guidance on compliance with the age discrimination rules for 

cash
balance plans, cash balance conversions, or other hybrid plans or 

hybrid
plan conversions while the issues are under consideration by 

Congress.ï¿½ As previously discussed, Treasury and the
IRS also announced 


that
they do not intend to process the technical advice cases pending with 

the
National Office while cash balance issues are under consideration by 

Congress.

 

Case
law

 

In
response to employers' decisions to implement or convert to cash 

balance
plans, several class action lawsuits have been brought by employees 

claiming
that age discrimination requirements have been violated. Four 

Federal
district court cases have addressed whether cash balance plans 

violate
the age discrimination rules.

 


In
Eaton v. Onan,ï¿½ 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.ï¿½ Under the
plan,participants received pay 

credits
for each year of service as well as front-loaded interest credits.ï¿½ 

The
court considered how the rate of an employee's benefit accrual is 

determined
for purpose of the age discrimination rules and concluded that

the
statute does not require the rate of benefit accrual to be measured 

solely
by the value of a participant's annuity payable at normal retirement 

age.ï¿½ The court found that, in the case of a cash
balance plan, the rate of

benefit
accrual should be defined as the change in the employee's cash 

balance
account from one year to the next. The court held that a cash 

balance
plan does not violate the prohibition on reducing the rate of 

benefit
accrual because of age.

 

After
the proposed Treasury regulations were issued, a Federal district 

court
in Cooper v IBM Personal Pension Planï¿½
held that cash balance 

formulas
are inherently age discriminatory because identical interest 

credits
necessarily buy a smaller age annuity at normal retirement age 

for
older workers than for younger workers due to the time value of money.

The
court interpreted "rate of benefit accrual" as referring to an 

employee's
age 65 annual benefit (i.e.,the annuity payable at normal 

retirement
age) and the rate at which the age 65 annual benefit 

accrues.
The court held that the interest credits must be valued as an age

65
annuity, so that interest credits would always be more valuable to a 

younger
employee as opposed to an older employee, thus violating the 

prohibition
on reducing the rate of benefit accrual because of age. 

 

More
recently, the analysis in Eaton v. Onan Corporation has also been 

applied
in two other cases, Tootle v. ARINC Inc., and Register v. PNC 

Financial
Services Group, Inc.

 

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.ï¿½ If 

the
plan permits benefits to be paid in certain other forms, such as a 

lump
sum, the alternative form of benefit cannot be less than the present

value
of the annuity payable at normal retirement age, determined using 

certain
statutorily prescribed interest and mortality assumptions.ï¿½ 

 

Although
a participant's benefit under a cash balance plan is described in

terms
of a hypothetical account balance, a cash balance plan (like other

defined
benefit pension plans) is required to provide benefits in the form

of an
annuity payable at normal retirement age.ï¿½
Most cash balance plans

are
designed to permit lump-sum distributions of the participant's 

hypothetical
account balance upon termination of employment.ï¿½ 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 minimum lump-sum value (i.e.,

present
value) of the accrued benefit will generally cause a discrepancy 

between
the value of the minimum lump-sum and the employee's hypothetical 

account
balance.ï¿½ In particular, if the plan's
interest crediting rate is

higher
than the statutory interest rate, then the resulting lump-sum amount

will
generally be greater than the hypothetical account balance.ï¿½ This 

result
is sometimes referred to as "whipsaw."ï¿½ Several Federal appellate 

courts
that have addressed the calculation of lump-sum distributions under

cash
balance plans have followed an approach similar to the approach 

described
in IRS Notice 96-8.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Description of
Proposal

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

In
general

 

The
proposal provides rules for conversions of defined benefit pension 

plans
to cash balance plans, applying the age discrimination requirements 

to cash
balance plans, and determining minimum lump-sum distributions from 

cash
balance plans.ï¿½ The proposal makes
conforming amendments to ERISA and

ADEA. 

 

Conversions
to cash balance plans

 

Under
the proposal, for the first five years following the conversion of a

traditional
defined benefit pension plan to a cash balance plan, the 

benefits
earned by any participant in the cash balance plan who was a 

participant
in the traditional plan must be at least as valuable as the 

benefits
the participant would have earned under the traditional plan had

the
conversion not occurred.ï¿½ 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.ï¿½ 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.ï¿½ 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. ï¿½The 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).ï¿½
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.ï¿½ 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.ï¿½ The
Secretary of the Treasury is 

authorized
to provide safe harbors for market rates of return and to 

prescribe
appropriate conditions regarding the calculation of plan 

distributions

 

Effective
date.-The proposal is effective prospectively. No inference is

intended
as to the status of cash balance plans or cash balance conversions

under
present law.

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ Analysis

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

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.ï¿½ The proposal addresses certain
issues relating to cash 

balance
plans, with three stated objectives:ï¿½
(1) to ensure fairness 

for
older workers in cash balance conversions, (2) to protect the defined benefit
pension plan 

system
by clarifying the status of cash balance plans, and (3) to remove the effective
ceiling on 

interest
credits in cash balance plans due to the manner in which lump-sum benefits are 

calculated.ï¿½ Specific issues arise with respect to each
part of the proposal.ï¿½ 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.ï¿½ The system
is a voluntary system, relying heavily on tax 

incentives
in order to encourage employers to establish qualified retirement plans for
their 

employees.ï¿½ 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.ï¿½ 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.ï¿½
Issues of retirement income security with 

respect
to both types of plans have been the subject of recent Congressional action.

Traditional
defined benefit pension plans are viewed by many as providing greater 

retirement
income security than defined contribution plans.ï¿½ This is primarily because such plans 

provide
a specific promised benefit.ï¿½ 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.ï¿½ Within
certain limits, most defined benefit pension 

plan
benefits are guaranteed by the PBGC.ï¿½
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.ï¿½ In addition,
defined benefit pension plans are subject to 

certain
spousal benefit requirements that do not apply to most defined contribution
plans.ï¿½ 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.ï¿½ The
plan participant bears the risk of investment loss.ï¿½ 

Benefits
provided by defined contribution plans are not guaranteed by the PBGC.ï¿½ The extent to 

which
ERISA's fiduciary rules apply to a defined contribution plan depends on the
particular 

plan
structure; in many cases defined contribution plans allow plan participants to
direct the 

investment
of their accounts, in which case more limited fiduciary protections may apply
than in 

the
case of defined benefit pension plans.ï¿½
ERISA's limitations on the amount of plan assets that 

may be
invested in employer stock generally do not apply to defined contribution
plans.ï¿½ In 

addition,
under most defined contribution plans, the spouse has only the right to be
named the 

beneficiary
of the amount (if any) remaining upon the death of the employee.

Cash
balance plans have become an increasing prevalent plan design and, as well, an 

increasing
element in discussions regarding retirement income security and the future of
the 

defined
benefit pension plan system.

During
the 1990s, conversions of traditional defined benefit pension plans to cash 

balance
formulas were common among mid- to large-size employers.ï¿½ 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.ï¿½ While perhaps complying 

with
the law, such plan designs were viewed by many as unfair to certain participants.ï¿½ There 

was
concern that some employers were adversely affecting participants in order to
reduce costs.ï¿½ 

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.ï¿½ While certain legal issues 

have
remained, employers have continued to adopt cash balance plans.ï¿½ In many cases, 

employers
have structured conversions to avoid or minimize potential adverse effects on
older 

and
longer-service employees.ï¿½ 

Attention
again focused on cash balance plans following the IBM decision, which found 

the
basic cash balance formula to violate the age discrimination rules.ï¿½ This case applies not only 

to
conversions, but to all cash balance plans.ï¿½
This decision called into question whether cash 

balance
plans are a permitted form of pension benefit.ï¿½
Although a previous case and two 

subsequent
cases have upheld the cash balance plan design, continued litigation of this
issue has 

resulted
in uncertainty for employers that currently offer cash balance plans and
employees who 

are
participants in such plans.ï¿½ It has also
focused attention on the future of defined benefit 

pension
plans and the role that cash balance plans play within the overall pension
system.

Some
believe that traditional defined benefit pension plans, and final average pay 

formulas
under such plans, generally provide greater benefits than cash balance plans, 

particularly
because traditional plans often provide subsidized early retirement
benefits.ï¿½ Some 

argue
that cash balance plans are primarily adopted by employers who wish to cut
costs and 

reduce
future benefits.ï¿½ 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.ï¿½ 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.ï¿½
It is also argued that cash balance plans 

inherently
discriminate against longer-service older workers, and thus should not be
encouraged 

as a
plan design.

On the
other hand, others point out that employers sponsor qualified retirement plans 

voluntarily.ï¿½ While tax incentives encourage employers to
establish and maintain such plans, 

they
are not required to do so.ï¿½ Thus, if
employers wish to reduce future benefits, or eliminate 

future
benefits altogether, they may do so and many have.ï¿½ Some view preserving cash balance 

plans
as a means of preserving the defined benefit pension plan system and as an
important step 

in
helping to ensure retirement income security.ï¿½ï¿½
Cash balance plans may be attractive to 

employers
for various reasons.ï¿½ The adoption of a
cash balance plan may enable employers to 

better
manage pension liabilities.ï¿½ 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.ï¿½
They argue that a cash balance plan design does 

not
result in such unpredictable funding obligations.

Some
say that, rather than whether workers are better off with a traditional defined


benefit
pension plan than with a cash balance plan, a more appropriate question is
whether 

workers
are better off with a cash balance plan or no defined benefit pension
plan.ï¿½ They note 

that defined
benefit pension plan coverage is falling and that the traditional defined
benefit 

pension
plan continues to be a less and less viable and attractive option for many
employers.ï¿½ 

They
argue that the flexibility offered by cash balance plans enables employers to
continue a 

defined
benefit pension plan, as well as in many cases also provide a defined
contribution plan, 

thus
enhancing retirement income security.

Some
also argue that cash balance plans are more beneficial to many employees than a



traditional
defined benefit pension plan and should be a permitted plan design option.ï¿½ 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.ï¿½ Cash balance plans may also
provide more portable benefits than traditional 

defined
benefit pension plans.ï¿½ 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.ï¿½ Some participants also find cash balance
plans easier to understand than a traditional 

defined
benefit pension plan because their benefit is described in terms of an account
balance. 

However,
some note that cash balance plans, while legally defined benefit pension plans,


operate
in a way that does not deliver the full protections of a traditional defined
benefit pension 

plan.ï¿½ For example, many traditional defined
benefit pension plans do not offer lump-sum 

distributions.ï¿½ In contrast, cash balance plans typically
do.ï¿½ 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.ï¿½
In the case of a traditional defined benefit plan, 

the
plan formula promises a specific benefit payable at normal retirement age.ï¿½ Although the 

employer
may benefit from favorable investment returns by making lower contributions,
the 

employer
also bears the risk that plan assets will not be sufficient to provide the
promised 

benefits
and generally must make up investment losses.ï¿½
Rather than providing a specified 

benefit,
a cash balance plan specifies interest credits.ï¿½ This design may reduce the employer's 

risk
that plan assets will underperform compared to the interest credits provided
under the plan, 

while
still giving the employer the benefit of greater than expected investment
performance.ï¿½ï¿½ 

Some
argue that, under certain cash balance plan designs, plan participants face 

investment
risk similar to the risk under defined contribution plans.ï¿½ 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.ï¿½
While many cash balance plans are designed to 

protect
against loss in value, some argue that it is permissible to tie interest
credits to 

hypothetical
investments that may incur losses.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 

Some
argue that, to the extent proposals relating to cash balance plans are
motivated by 

concerns
about retirement income security, other proposals to address such concerns
should also 

be
considered, including ways to make defined benefit pension plans more
attractive to 

employers
on an ongoing basis.ï¿½ 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.ï¿½
It provides rules relating to the benefits 

accrued
by participants in defined benefit pension plans that are converted to cash
balance plans.ï¿½ 

The
proposal provides greater protection for longer-service participants than is currently
required 

under
the present-law rules prohibiting cutbacks in accrued benefits.ï¿½ 

By
requiring that the benefits earned by a participant for the first five years
following a 

conversion
must be at least as valuable as the benefits the participant would have earned
under 

the
traditional plan had the conversion not occurred, the proposal protects
participants in the plan 

who are
close to retirement age against possible disadvantages of conversion to a cash
balance 

plan.ï¿½ Further, prohibiting wearaway in a
conversion to a cash balance plan with respect to the 

benefits
of such participants will reduce possible adverse effects on older and
longer-service 

participants.


Some
argue that the proposal does not go far enough in ensuring that older and
longer 

service
employees will not be disadvantaged.ï¿½
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.ï¿½ 

Others
argue that any such additional requirement would cause employers' qualified
retirement 

plan
costs to increase and could cause employers to reduce benefits further or
terminate existing 

plans.ï¿½ 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.ï¿½ On the other hand, some
consider the present-law anticutback rules to provide 

adequate
protection for participants and view the proposal as protecting employees'
expectations 

of
future benefits in a manner that is likely to increase employers' costs and
discourage 

employers
from continuing to offer defined benefit pension plans.

Some
argue that the 100-percent excise tax on any difference between required
benefits 

and the
benefits actually provided under a plan which has been converted to a cash
balance 

formula
is sufficient to encourage compliance with the proposal.ï¿½ 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.ï¿½ They argue that
absent the potential for plan disqualification, the 

efficacy
of the proposal is diminished, or even eliminated.ï¿½ 

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.ï¿½ 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.ï¿½
These concerns may be addressed, at 

least
to some extent, by requiring that participants receive sufficient information
to make an 

informed
decision.ï¿½ As mentioned above, others
would go further, and require that at least some 

employees
be automatically given the greater of the two formulas.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½
Some argue that, by reducing uncertainty as to 

how
cash balance plans can meet the age discrimination requirements, the proposal
will make 

employers
more likely to sponsor (or continue to sponsor) defined benefit pension plans, 

including
cash balance plans.

The age
discrimination issue results from the effect of front-loaded interest credits,
under 

which a
participant receiving a pay credit also receives the right to future interest
on the pay 

credit,
regardless of whether the participant continues employment.ï¿½ 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.ï¿½ 

However,
some argue that front-loaded pay credits inherently favor younger participants
and are 

thus
inherently age discriminatory.ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 

This
aspect of the proposal raises issues as to how to determine a market rate of
return.ï¿½ 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.ï¿½ The effect of the proposal 

on plan
benefits, and the ease with which the proposal can be implemented by employers,


understood
by employees, and administered by the IRS will depend in large part on the
ability to 

determine
measures of market rates of return.ï¿½
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 ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ 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.ï¿½ However, the 

proposals
do not address all issues with respect to such plans.ï¿½ In addition, certain aspects of the 

proposals
need further clarification, or may add some additional complexities.ï¿½ 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 and 2006
budget 

proposals.

H.R.
2830 (the "Pension Protection Act of 2005"), as passed by the House,
and S. 1783, 

(the
"Pension Security and Transparency Act of 2005"), as passed by the
Senate, both include 

provisions
relating to the application of the Code and ERISA to hybrid plans, including
cash 

balance
plans.

 

 

B.ï¿½ï¿½ï¿½ï¿½ï¿½ Strengthen Funding for Single-Employer
Pension Plans 

1.ï¿½ï¿½ï¿½ï¿½ï¿½ Background and summary

Helping
to assure that individuals have retirement income security is the major
objective 

of the
U.S. private pension system.ï¿½ Federal
law attempts to further this goal in various ways.ï¿½ 

The
Code provides tax-favored treatment for employer-sponsored qualified retirement
plans.ï¿½ 

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.ï¿½
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.ï¿½ 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.ï¿½ If plans are not adequately funded 

by the
employer, then the benefits promised under the plan may not be paid in
full.ï¿½ 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.ï¿½ 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.ï¿½ Some view this combination as a temporary
situation that has artificially increased the 

extent
of pension plan underfunding.ï¿½ 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.ï¿½ Some therefore believe 

the
present-law funding rules are inadequate.ï¿½
Many believe that resolution of funding issues is 

essential
to the long-term viability of the defined benefit pension system. 

As of
September 30, 2005, the PBGC reported a total deficit of $22.8 billion, a
slight 

improvement
from the 2004 fiscal year end deficit of $23.5 billion, but almost double the
2003 

fiscal
year end deficit of $11.5 billion.ï¿½ The
PBGC's deficit is the amount by which its liabilities 

exceed
its assets.ï¿½ï¿½ The PBGC has noted that
its financial state is a cause for concern.ï¿½
The 

Government
Accountability Office ("GAO") has placed the PBGC on its high risk
list.ï¿½ Although 

the
PBGC is a Federal agency, it does not receive financing from general
revenues.ï¿½ï¿½ Instead, the 

PBGC is
funded by assets in terminated plans, amounts recovered from employers who
terminate 

undefended
plans, premiums paid with respect to plans covered by the PBGC insurance
program, 

and
investment earnings.ï¿½ Underfunding of
defined benefit pension plans presents a risk to 

PBGC
premium payors, who may have to pay for the unfunded liabilities of terminating
plans, 

and
plan participants, who may lose benefits if a plan terminates (even with the
PBGC 

guarantee).ï¿½ 

The
President's budget contains a series of proposals designed to strengthen
funding 

levels
in defined benefit pension plans and the ability of the PBGC to provide
guaranteed 

benefits.ï¿½ These proposals consist of:ï¿½ (1) changes to the funding rules to measure
a plan's 

funding
status more accurately and to require faster funding of shortfalls, along with
increased 

deduction
limits to encourage additional contributions; (2) more accurate and timely
reporting of 

funding
status; (3) elimination of a grandfather rule that allows certain plans to
exceed the limits 

on
investments in employer securities and real property; (4) restrictions on
benefit increases and 

accelerated
distributions that result in increases in unfunded liabilities; (5) a prohibition
on 

providing
shutdown benefits; and (6) redesign of the PBGC variable-rate premium
structure, 

limits
on the PBGC guarantee when an employer enters bankruptcy, and enabling the PBGC
to 

perfect
a lien for required contributions against the assets of an employer in
bankruptcy.

2.ï¿½ï¿½ï¿½ï¿½ï¿½ Funding and deduction rules

Present
Law

In
general

Defined
benefit pension plans are subject to minimum funding requirements.ï¿½ï¿½ The 

minimum
funding requirements are designed to ensure that plan assets are sufficient to
pay plan 

benefits
when due.ï¿½ 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.ï¿½
The amount of required annual contributions is 

determined
under one of a number of acceptable actuarial cost methods.ï¿½ Additional 

contributions
are required under the deficit reduction contribution rules in the case of
certain 

underfunded
plans.ï¿½ 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.ï¿½ In addition, contributions in
excess of the amount needed to satisfy the minimum 

funding
requirements may be deductible, subject to certain limits.

General
minimum funding rules

Funding
standard account

As an
administrative aid in the application of the funding requirements, a defined
benefit 

pension
plan is required to maintain a special account called a "funding standard
account" to 

which
specified charges and credits are made for each plan year, including a charge
for normal 

cost
and credits for contributions to the plan.ï¿½ï¿½
Other charges or credits may apply as a result of 

decreases
or increases in past service liability as a result of plan amendments,
experience gains 

or
losses, gains or losses resulting from a change in actuarial assumptions, or a
waiver of 

minimum
required contributions.

In
determining plan funding under an actuarial cost method, a plan's actuary
generally 

makes
certain assumptions regarding the future experience of a plan.ï¿½ These assumptions 

typically
involve rates of interest, mortality, disability, salary increases, and other
factors 

affecting
the value of assets and liabilities.ï¿½ 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.ï¿½ If the actual unfunded
liabilities are greater than those anticipated, then the 

difference
is an experience loss.ï¿½ 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.ï¿½ If the new 

assumptions
result in an increase in the accrued liability, the plan has a loss from
changes in 

actuarial
assumptions.ï¿½ The accrued liability of a
plan is the actuarial present value of projected 

pension
benefits under the plan that will not be funded by future contributions to meet
normal 


cost or
future employee contributions.ï¿½ The gain
or loss for a year from changes in actuarial 

assumptions
is amortized as credits or charges to the funding standard account over ten
years.

If
minimum required contributions are waived (as discussed below), the waived
amount 

(referred
to as a "waived funding deficiency") is credited to the funding
standard account.ï¿½ The 

waived
funding deficiency is then amortized over a period of five years, beginning
with the year 

following
the year in which the waiver is granted.ï¿½
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 a plan year, the funding standard account reflects credits at
least 

equal
to charges, the plan is generally treated as meeting the minimum funding
standard for the 

year.ï¿½ 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."ï¿½ Thus, as a 

general
rule, the minimum contribution for a plan year is determined as the amount by
which the 

charges
to the funding standard account would exceed credits to the account if no
contribution 

were
made to the plan.ï¿½ For example, if the
balance of charges to the funding standard account of 

a plan
for a year would be $200,000 without any contributions, then a minimum
contribution 

equal
to that amount would be required to meet the minimum funding standard for the
year to 

prevent
an accumulated funding deficiency.

Credit
balances

If
credits to the funding standard account exceed charges, a "credit
balance" results.ï¿½ A 

credit
balance results, for example, if contributions in excess of minimum required
contributions 

are
made.ï¿½ Similarly, a credit balance may
result from large net experience gains.ï¿½
The amount of 

the
credit balance, increased with interest at the rate used under the plan to
determine costs, can 

be used
to reduce future required contributions.

Funding
methods and general concepts

A
defined benefit pension plan is required to use an acceptable actuarial cost
method to 

determine
the elements included in its funding standard account for a year.ï¿½ 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.ï¿½ These
elements are referred to as:ï¿½ (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.ï¿½
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.ï¿½
The normal cost will be funded by future 

contributions
to the plan:ï¿½ (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.ï¿½ The most common 

supplemental
cost is that attributable to past service liability, which represents the cost
of future 

benefits
under the plan:ï¿½ (1) on the date the
plan is first effective; or (2) on the date a plan 

amendment
increasing plan benefits is first effective.ï¿½
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.ï¿½ Supplemental costs must be 

amortized
(i.e., recognized for funding purposes) over a specified number of years,
depending on 

the
source.ï¿½ 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.ï¿½ 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.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 

The use
of an actuarial valuation method allows appreciation or depreciation in the
market value 

of plan
assets to be recognized gradually over several plan years.

In
applying the funding rules, all costs, liabilities, interest rates, and other
factors are 

required
to be determined on the basis of actuarial assumptions and methods, each of
which is 

reasonable
(taking into account the experience of the plan and reasonable expectations),
or 

which,
in the aggregate, result in a total plan contribution equivalent to a
contribution that would 

be
obtained if each assumption and method were reasonable.ï¿½ In addition, the assumptions are 

required
to offer the actuary's best estimate of anticipated experience under the plan.

Additional
contributions for underfunded plans

Under
special funding rules (referred to as the "deficit reduction
contribution" rules),ï¿½ 

in the
case of a single-employer plan, an additional contribution to a plan is
generally required if 

the
plan's funded current liability percentage is less than 90 percent.ï¿½ï¿½ A plan's "funded current 

liability
percentage" is the actuarial value of plan assets as a percentage of the
plan's current 

liability.ï¿½ï¿½ In general, a plan's current liability
means all liabilities to employees and their 

beneficiaries
under the plan, determined on a present-value basis.

The
amount of the additional contribution required under the deficit reduction 

contribution
rules is the sum of two amounts:ï¿½ (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.ï¿½ The amount of the additional contribution
cannot exceed the amount needed to increase 

the
plan's funded current liability percentage to 100 percent.ï¿½ 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.ï¿½ï¿½ The
"unfunded old liability amount" is the amount 

needed
to amortize certain unfunded liabilities under 1987 and 1994 transition
rules.ï¿½ The 

"unfunded
new liability amount" is the applicable percentage of the plan's unfunded
new 

liability.ï¿½ 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).ï¿½ 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.ï¿½
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.ï¿½ The value
of any unpredictable contingent event benefit 

is not
considered in determining additional contributions until the event has
occurred.ï¿½ 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.ï¿½ For plans years beginning before 

January
1, 2004, and after December 31, 2005, the interest rate used to determine a
plan's current 

liability
must be within a permissible range of the weighted averageï¿½ of the interest rates on 30-

year
Treasury securities for the four-year period ending on the last day before the
plan year 

begins.ï¿½ The permissible range is generally from 90
percent to 105 percent (120 percent for plan 

years
beginning in 2002 or 2003).ï¿½ï¿½ The
interest rate used under the plan generally must be 

consistent
with the assumptions which reflect the purchase rates which would be used by 

insurance
companies to satisfy the liabilities under the plan. 

Under
the Pension Funding Equity Act of 2004 ("PFEA 2004"),ï¿½ a special interest rate 

applies
in determining current liability for plan years beginning in 2004 or 2005.ï¿½ï¿½ 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.ï¿½ The 

permissible
range for these years is from 90 percent to 100 percent.ï¿½ 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.ï¿½ï¿½ The Secretary of the Treasury has 

required
the use of the 1983 Group Annuity Mortality Table. 

Other
rules

Full
funding limitation

No contributions
are required under the minimum funding rules in excess of the full 

funding
limitation.ï¿½ 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.ï¿½ï¿½
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.ï¿½
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.ï¿½
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.ï¿½ï¿½
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.ï¿½ï¿½
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.ï¿½ 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.ï¿½ï¿½
The excise tax is 10 percent of the 

amount
of the funding deficiency.ï¿½ 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.ï¿½ 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.ï¿½ In addition, the plan must 

provide
for the reversion.ï¿½ A reversion prior to
plan termination may result in disqualification of 

the
plan and may constitute a prohibited transaction.ï¿½ Certain limitations and procedural 

requirements
apply to a reversion upon plan termination.ï¿½
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.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ï¿½ Excess assets generally
means the excess, if any, of the value of the plan's 

assetsï¿½ over the greater of (1) the accrued
liability under the plan (including normal cost) or 

(2) 125
percent of the plan's current liability.ï¿½
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.ï¿½ In the case of a defined benefit pension
plan, the employer generally may deduct the 

greater
of: (1) the amount necessary to satisfy the minimum funding requirement of the
plan for 

the
year; or (2) the amount of the plan's normal cost for the year plus the amount
necessary to 

amortize
certain unfunded liabilities over 10 years, but limited to the full funding
limitation for 

the
year. 

The
maximum amount of deductible contributions is generally not less than the
plan's 

unfunded
current liability.ï¿½ï¿½ For this purpose,
current liability is generally determined using the 

statutory
assumptions used in determining current liability for funding purposes.ï¿½ However, for 

purposes
of determining the maximum amount of deductible contributions for 2004 and
2005, an 

employer
may elect to disregard the temporary interest rate change under PFEA 2004.ï¿½ 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

Under
the proposal, the interest rate used in determining current liability for plan
years 

beginning
in 2004 and 2005 is extended to 2006.ï¿½
Thus, in determining current liability for plan 

years
beginning in 2006, the interest rate used must be within the permissible range
(90 to 100 

percent)
of the weighted average of the rates of interest on amounts invested
conservatively in 

long-term
investment-grade corporate bonds during the four-year period ending on the last
day 

before
the plan year begins.

In the
case of single-employer plans, for plan years beginning after December 31,
2006, 

the
proposal repeals the present-law funding rules and provides a new set of rules
for 

determining
minimum required contributions.ï¿½ï¿½ Under
the proposal, the minimum required 

contribution
to a defined benefit pension plan for a plan year is generally the sum of two 

amounts:ï¿½ (1) the paymentsï¿½ required to amortize over seven years the amount by which the 

plan's
funding target exceeds the market value of the plan assets; and (2) the plan's
normal cost 

for the
plan year.

The
plan's funding target is generally the present value of benefits earned as of
the 

beginning
of the plan year.ï¿½ The plan's normal
cost is generally the present value of benefits 

expected
to be earned during the plan year.ï¿½
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.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 

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.ï¿½ Future expected
benefit payments under the plan are determined 

using a
mortality table prescribed by the Secretary of Treasury.ï¿½ The proposal generally does not 

require
other specified assumptions to be used in determining ongoing liability.ï¿½ 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).ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ However, certain specified
additional assumptions must be used in 

determining
at-risk liability.ï¿½ 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).ï¿½ï¿½ In addition, at-risk liability
includes an additional amount, referred to as a 

loading
factor.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ Such a
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.ï¿½ Ifï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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").ï¿½ 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.ï¿½ï¿½
The corporate bond yield curve is to be 

issued
monthly by the Secretary of Treasury, based on the interest rates (averaged
over 90 

business
days) for high-quality corporate bonds (i.e., bonds rated AA) with varying
maturities.

A
special method of calculating a plan's funding target applies for plan years
beginning 

in 2007
and 2008.ï¿½ For those years, the plan's
funding target is the weighted average of:ï¿½
(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.ï¿½ The transition interest rate is
the interest rate that would apply if the statutory 

interest
rate applicable under the proposal in determining current liability for plan
years 

beginning
in 2006 continued to apply for plan years beginning in 2007 and 2008.ï¿½ That is, the 

interest
rate used must be within a permissible range (from 90 to 100 percent) of the
weighted 

average
of the rates of interest on amounts invested conservatively in long term
investment-grade 

corporate
bonds during the four-year period ending on the last day before the plan year
begins.ï¿½ 

For plan
years beginning in 2007, 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.ï¿½ For plan years beginning in 2008, 

the
respective weighting factors are 1/3 and 2/3.

A
similar method applies in determining a plan's normal cost (i.e., ongoing or
at-risk 

normal
cost, as applicable) for plan years beginning in 2007 and 2008.

Valuation
date

Under
the proposal, a plan's funding target (i.e., ongoing or at-risk liability, as 

applicable),
the plan's normal cost (i.e., ongoing or at-risk normal cost, as applicable),
the market 

value
of the plan's assets, and the minimum required contribution for a plan year are
determined 

as of
the valuation date for the plan year.ï¿½
If a plan has more than 100 participants, the plan's 

valuation
date must be the first day of the plan year.ï¿½
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.ï¿½ï¿½ 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.ï¿½
For plan years beginning in 2008 or later, 

the
present value of the contribution receivable is included in plan assets, and
present value is 

determined
using the average effective interest rate that applied in determining the
plan's 

funding
target for the prior plan year.

Minimum
required contributions

Under
the proposal, the minimum contribution required to be made to a plan for a plan


year is
generally the sum of:ï¿½ (1) the plan's
normal cost for the plan year (i.e., ongoing or at-risk 

normal
cost, as applicable); and (2) the payments required (as described below) to
amortize the 

amount
by which the plan's funding target for the plan year (i.e., ongoing or at-risk
liability, as 

applicable)
exceeds the market value of plan assets. 

Under
the proposal, if the plan's funding target for the plan year beginning in 2007 

exceeds
the market value of the plan's assets for that year, an initial amortization
base is 

established
in the amount of the shortfall.ï¿½
Payments are then required in the amount needed to 

amortize
the initial amortization base over seven years, starting with the plan year
beginning in 

2007.ï¿½ The required amortization 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).ï¿½ 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.ï¿½ 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.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½
However, quarterly contributions are required 

to be
made during a plan year if, for the preceding plan year, the plan's funding
target exceeded 

the
market value of the plan's assets, determined as of the valuation date for the
preceding plan 

year.

A
contribution made after the valuation date for a plan year is credited against
the 

minimum
required contribution for the plan year based on its present value as of the
valuation 

date
for the plan year.ï¿½ 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.ï¿½ The plan's cushion amount is the 

sum
of:ï¿½ (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).ï¿½
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.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ This suggestion tends to arise 

during
a period of economic downturn, either generally or in a particular
industry.ï¿½ 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.ï¿½ They also serve
to limit the tax expenditure associated with 

defined
benefit pension plans.ï¿½ Some argue that
if the maximum limits on plan funding are too 

low,
then benefit security will be jeopardized.ï¿½
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.ï¿½ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ That 

Act
also added the current liability full funding limit.ï¿½ï¿½ Legislation enacted in 1990 allowed 

employers
access to excess assets in defined benefit pension plans in order to pay
retiree health 

liabilities.ï¿½ The Retirement Protection Act of 1994 again
made comprehensive changes to the 

funding
rules.ï¿½ 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.ï¿½ 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.ï¿½
For example, the valuation methods and 

amortization
periods applicable under present law may have the effect of disguising a plan's
true 

funding
status.ï¿½ In some cases, these factors
result in artificial credit balances that can be used to 

reduce
required contributions.ï¿½ Thus, employers
may fully comply with the present-law funding 

rules,
yet still have plans that are substantially underfunded.ï¿½ 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.ï¿½ This 

approach
is intended to provide a more accurate and up-to-date picture of the plan's
financial 

condition.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ In some cases, financially weak status is
determined in accordance with standards 

to be
established under regulations.ï¿½ Some
argue that credit ratings are simply not a reliable 

indicator
of whether a plan will terminate on an underfunded basis.ï¿½ They note that many 

businesses
with below investment grade ratings continue to operate and to maintain a
defined 

benefit
pension plan.ï¿½ Some also suggest that
the possibility of greater required contributions 

could
itself drive down an employer's credit rating.ï¿½
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.ï¿½ 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.ï¿½ 

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.ï¿½
This approach has the effect of increasing such 

liabilities
and required contributions.ï¿½ Some view
this approach as appropriate in order to reduce 

the
financial risk posed by underfunded plans maintained by financially weak
employers.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ Some suggest that credit 

balances
should be adjusted to reflect changes in plan asset values, but not
eliminated.ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½ï¿½
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.ï¿½ Alternatively, the use of a 

higher
interest rate results in a lower present value of future liabilities and
therefore lower 

required
contributions.ï¿½ 

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.ï¿½ 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.ï¿½ As a result, the interest rate 

used to
value pension benefits is intended to approximate the rate used in pricing annuity


contracts.ï¿½ï¿½ Some have described this standard as a rate
comparable to the rate earned on a 

conservatively
invested portfolio of assets.

Under
present law (except for 2004 and 2005), the interest rate used to determine
current 

liability
(and minimum lump-sum benefits) is based on the interest rate on 30-year
Treasury 

obligations.ï¿½ The interest rate issue has received
attention recently, in part because the Treasury 

Department
stopped issuing 30-year obligations in 2001, which meant that a change to the 

statutory
interest rate was needed.ï¿½ Because the
Treasury Department recently resumed the 

issuance
of 30-year obligations, some view a statutory change as no longer
necessary.ï¿½ï¿½ However, 

apart
from the availability of 30-year Treasury obligations, some have argued that
the 30-year 

Treasury
rate has been too low compared to annuity rates, resulting in inappropriately
high levels 

of
minimum funding requirements on employers that are not necessary to maintain
appropriate 

retirement
income security. 

Analysis
of interest rate proposal

Under
the proposal, the rate of interest on 30-year Treasury securities is replaced
with the 

rate of
interest on high quality corporate bonds in calculating the present value of
plan benefits 

for
purposes of determining minimum required contributions.ï¿½ Initially, the interest rate used is 

based
on a weighted average of the yields on high-quality long-term corporate
bonds.ï¿½ After a 

transition
period, the proposal provides for the use of a series of interest rates drawn
from a yield 

curve
of high-quality zero-coupon bonds with various maturities, selected to match
the timing of 

benefit
payments expected to be made from the plan.

Some
believe that, compared with the rate of interest on 30-year Treasury
securities, an 

interest
rate based on long-term corporate bonds better approximates the rate that would
be used 

in
determining the cost of settling pension liabilities, i.e., by purchasing
annuity contracts to 

provide
the benefits due under the plan.ï¿½ï¿½
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.ï¿½ The rationale 

for
this approach is that interest rates differ depending, in part, on the term of
an obligation.ï¿½ 

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.ï¿½
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.ï¿½ Some also question
whether using a yield curve would result in 

such
increased accuracy as to justify the complexity.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ In addition, it has been 

suggested
that simplified methods (such as the use of a single composite rate) can be
provided 

for
smaller plans.

Some
have questioned whether it is possible to construct a yield curve of corporate
bond 

rates
that is appropriate for measuring pension liabilities.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ Thus, investments in bonds may reduce
volatility in the value of plan assets and in 

required
contributions.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 

However,
some argue that the proposal fails to address such volatility.

Prior
Action

A
similar proposal was included in the President's fiscal year 2006 budget
proposal.ï¿½ The 

President's
fiscal year 2005 budget proposal included a proposal to use a yield curve of
interest 

rates
on corporate bonds in determining current liability.

H.R.
2830 (the "Pension Protection Act of 2005"), as passed by the House,
and S. 1783, 

(the
"Pension Security and Transparency Act of 2005"), as passed by the
Senate, both include 

provisions
relating to the funding and deduction rules for single-employer defined benefit


pension
plans.

3.ï¿½ï¿½ï¿½ Form 5500, Schedule B actuarial statement
and summary annual report

Present
Law

Form
5500 and Schedule B actuarial statement

The
plan administrator of a qualified retirement plan generally must file an annual
return 

with
the Secretary of the Treasury, an annual report with the Secretary of Labor,
and certain 

information
with the Pension Benefit Guaranty Corporation ("PBGC").ï¿½ï¿½ Form 5500, 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 with the Department of Labor.

In the
case of a defined benefit pension plan, the annual report must include an
actuarial 

report
(filed on Schedule B of the Form 5500).ï¿½ï¿½
The actuarial report must include, for 

example,
information as to the value of plan assets, the plan's accrued and current
liabilities, 

expected
disbursements from the plan for the year, plan contributions, the plan's
actuarial cost 

method
and actuarial assumptions, and amortization bases established in the year.ï¿½ The report 

must be
signed by an actuary enrolled to practice before the IRS, Department of Labor
and the 

PBGC.

The
Form 5500 is due by the last day of the seventh month following the close of
the plan 

year.ï¿½ The due date may be extended up to two and
one-half months.ï¿½ Copies of filed Form
5500s 

are
available for public examination at the Department of Labor.

Summary
annual report

ERISA
requires that plans furnish a summary annual report of the Form 5500 to plan 

participants
and beneficiaries.ï¿½ï¿½ The summary annual
report must include a statement whether 

contributions
were made to keep the plan funded in accordance with minimum funding 

requirements,
or whether contributions were not made and the amount of the deficit.ï¿½ The current 

value
of plan assets is also required to be disclosed.ï¿½ The summary annual report must be 

furnished
within nine months after the close of the plan year.ï¿½ If an extension applies for the 

Form
5500, the summary annual report must be provided within two months after the
extended 

due
date.ï¿½ 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.ï¿½ï¿½ 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 

In
certain circumstances, the contributing sponsor of a single-employer plan
covered by 

the
PBGC (and members of the contributing sponsor's controlled group) must provide
certain 

information
to the PBGC.ï¿½ This information (referred
to as "section 4010 information") includes 

financial
information with respect to the contributing sponsor (and controlled group
members) 

and
actuarial information with respect to single-employer plans maintained by the
sponsor (and 

controlled
group members).ï¿½ï¿½ï¿½ This reporting is
required if:ï¿½ (1) the aggregate unfunded
vested 

benefits
(determined using the interest rate used in determining variable-rate premiums)
as of the 

end of
the preceding plan year under all plans maintained by members of the controlled
group 

exceed
$50 million (disregarding plans with no unfunded vested benefits); (2) the
conditions for 

imposition
of a lien (i.e., required contributions totaling more than $1 million have not
been 

made)
have occurred with respect to an underfunded plan maintained by a member of the


controlled
group; or (3) minimum funding waivers in excess of $1 million have been granted


with
respect to a plan maintained by any member of the controlled group and any
portion of the 

waived
amount is still outstanding.ï¿½ The PBGC
may assess a penalty for a failure to provide the 

required
information in the amount of up to $1,000 a day for each day the failure
continues. 

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.ï¿½ Section 4010 information 

is
exempt from disclosure under the Freedom of Information Act ("FOIA")
and no such 

information
or documentary materials may be made public, except as may be relevant to an 

administrative
or judicial action or proceeding.ï¿½ 

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),ï¿½ 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.ï¿½ The 

proposal
applies to all PBGC-covered, single-employer defined benefit pension
plans.ï¿½ 

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.ï¿½ 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).ï¿½ 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.ï¿½ The 

funding
status is required to be shown as a percentage based on the ratio of the plan's
assets to its 

funding
target.ï¿½ Information on the employer's
financial status and on the PBGC benefit 

guarantee
must also be provided.ï¿½ The proposal
replaces the requirement of notice to participants 

of
underfundingï¿½ with the summary annual
report disclosure.ï¿½ 

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.ï¿½
A plan administrator that fails to provide a 

summary
annual report on a timely basis is subject to a penalty. 

Public
disclosure of certain PBGC filings

The
proposal eliminates the nondisclosure rules of section 4010(c) of ERISA, which 

exempt
section 4010 information from disclosure under FOIA.ï¿½ Under the proposal, section 4010 

information
can be made available to the public, except for confidential trade secrets and 

commercial
or financial information protected under FOIA. 

Effective
date.-The proposal is effective for plan years beginning in 2006.ï¿½ 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.ï¿½ Participants should be 

adequately
and timely informed about the security of their retirement benefits.ï¿½ Many believe 

that
the asset and liability measures under current law do not provide participants
with an 

accurate
and meaningful measure of a plan's funding status.ï¿½ 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.ï¿½
Thus, in some cases, participants have learned 

of the
extent of a plan's underfunding only when the plan terminated on an underfunded
basis.ï¿½ 

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.ï¿½ 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.ï¿½ Some argue that if a plan 

sponsor
is not financially weak, the Form 5500 should only be required to include the
liability 

applicable
to the plan (i.e., ongoing liability), rather than both ongoing and at-risk
liability. 

In the
case of plans that cover more than 100 participants and are subject to the
quarterly 

contributions
requirement, the proposal accelerates the filing deadline for the Schedule B 

actuarial
report to the 15th day of the second month following the close of the plan
year.ï¿½ Thus, 

in the
case of a calendar year plan, the due date is February 15.ï¿½ Proponents argue that this will 

provide
timely information on the financial situation of defined benefit pension
plans.ï¿½ Others 

may
argue that the accelerated deadline does not provide enough time for completion
of the 

actuarial
statement.ï¿½ 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.ï¿½ In 

such
case, the valuation date will be more than one year before the actuarial
statement is due. 

Summary
annual report

The
proposal requires the summary annual report to include the funding status of
the plan 

for
each of the last three years.ï¿½ The
funding status must be shown as a percentage based on the 

ratio
of the plan's assets to its funding target.ï¿½
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.ï¿½ 

The
proposal also requires the summary annual report to include information on the
company's 

financial
health and on the PBGC guarantee.ï¿½ The
proposal is unclear as to what information 

would
be required to show the company's financial health.ï¿½ 

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.ï¿½ A penalty is imposed for failure 

to
furnish a summary annual report in a timely manner.ï¿½ Specific information regarding the 

penalty
is unclear.ï¿½ The proposal eliminates the
participant notice requirement under section 

4011,
as the proposal assumes that the summary annual report disclosure will provide
more 

accurate
and timely information.ï¿½ 

Public
disclosure of certain PBGC filings

Eliminating
the nondisclosure rules of ERISA section 4010(c) allows section 4010 

information
to be available to the public, with the exception of confidential trade secrets
and 

commercial
or financial information protected under FOIA.ï¿½
By eliminating the nondisclosure 

rule,
the proposal is intended to provide more public information on the financial
status of 

pension
plans and plan sponsors.ï¿½ 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.ï¿½ 

Under
the proposal, information disclosed to the PBGC generally is subject to the 

present-law
FOIA provisions.ï¿½ 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.ï¿½ï¿½ Some argue that FOIA's commercial and
financial information exception 

provides
adequate protection for confidential business information.ï¿½ Others believe that certain 

financial
information outside of the scope of the exception should remain confidential.

Public
availability of financial information will allow participants and the public
more 

transparency
as to the true financial picture of pension plans.ï¿½ The proposal is similar to certain 

securities
laws that require public disclosure of material financial information.ï¿½ Proponents argue 

that
public disclosure of financial information results in greater scrutiny and
accountability 

without
requiring the draining of government resources.ï¿½ Some consider public disclosure to be a 

securities
law issue, rather than a pension law issue.ï¿½
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.ï¿½ They also argue 

that
because the pension system is voluntary, additional requirements on plans and
plan 

sponsors,
particularly small employers, may result in some sponsors discontinuing plan 

sponsorship.

Prior
Action

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

H.R.
2830 (the "Pension Protection Act of 2005"), as passed by the House,
and S. 1783, 

(the
"Pension Security and Transparency Act of 2005"), as passed by the
Senate, both include 

provisions
relating to reporting and disclosure requirements with respect to
single-employer 

defined
benefit pension plans.

4.ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 

ESOPs
are not subject to the 10-percent limit on the acquisition of employer
securities, unless 

the
ESOP is part of a floor-offset arrangement.

Description
of Proposal

The
exception to the 10-percent limit on holding employer securities and employer
real 

property
for floor-offset plans established on or before December 17, 1987, is
eliminated.ï¿½ Floor-

offset
arrangements affected by the proposal are required to reduce their holdings of
employer 

real
property and employer securities to no more than 10 percent of the combined
assets of both 

plans
over a period of seven years.ï¿½ 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.ï¿½ The 

potential
problems with such arrangements are illustrated by the recent experience with
Enron 

Corporation,
which maintained a grandfathered floor-offset arrangement.ï¿½ï¿½ The proposal 

addresses
this concern by eliminating the grandfather for such arrangements.ï¿½ Thus, all floor-

offset
plans will be subject to the same rules under the proposal.ï¿½ The proposal recognizes that it 

may
take some time for a plan to dispose of affected property by allowing a
seven-year period 

for
plans to comply.

Prior
Action

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

5.ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ï¿½
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.ï¿½ Generally, no more than 

three
waivers may be granted within any period of 15 consecutive plan years.

If a
funding waiver is in effect for a plan, subject to certain exceptions, no plan 

amendment
may be adopted that increases the liabilities of the plan by reason of any
increase in 

benefits,
any change in the accrual of benefits, or any change in the rate at which
benefits vest 

under
the plan. 

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.ï¿½ The amount of security 

required
is the excess of:ï¿½ (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.ï¿½ï¿½ 

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.ï¿½
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").ï¿½ï¿½ 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.ï¿½ï¿½ During that period, the plan may not make:ï¿½ (a) any payment in excess of the 

monthly
amount paid under a single life annuity (plus any social security supplement
provided 

under
the plan) in the case of a participant or beneficiary whose annuity starting
date occurs 

during
the period; (b) any payment for the purchase of an irrevocable commitment from
an 

insurer
to pay benefits (e.g., an annuity contract); or (c) any other payment specified
by the 

Secretary
of the Treasury by regulations.

Nonqualified
deferred compensation

Qualified
retirement plans, including defined benefit pension plans, receive tax-favored 

treatment
under the Code.ï¿½ A deferred compensation
arrangement that is not eligible for tax-

favored
treatment is generally referred to as a nonqualified deferred compensation 

arrangement.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ Such
an arrangement is referred to as a "rabbi" trust, 

based
on an IRS ruling issued with respect to such an arrangement covering a rabbi.

Amounts
deferred under a nonqualified deferred compensation plan for all taxable years 

are
currently includible in gross income to the extent not subject to a substantial
risk of forfeiture 

and not
previously included in gross income, unless certain requirements are
satisfied.ï¿½ï¿½ In 

addition,
certain arrangements involving assets transferred or set aside to provide
benefits under 

a
nonqualified deferred compensation plan are treated as a transfer of property
in connection 

with
the performance of services, resulting in income inclusion.ï¿½ If the requirements applicable to 

nonqualified
deferred compensation plan are not satisfied, in addition to current income 

inclusion,
interest applies at the underpayment rate plus 1 percentage point and the
amount 

required
to be included in income is subject to a 20-percent additional tax.

Description
of Proposal

Restrictions
on benefit increases

Under
the proposal, the present-law rule prohibiting amendments that increase benefits


while
the employer is in bankruptcy continues to apply.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ If the plan's funding percentage 

is at
least 100 percent, amendments increasing benefits are not restricted.ï¿½ In addition, the 

restrictions
do not apply for the first five years after a plan is established.

Restrictions
on distributions and accruals

Under
the proposal, the restrictions on distributions during a period of a liquidity
shortfall 

continue
to apply (i.e., only annuity payments are permitted).ï¿½ In addition, such restrictions apply 

if: (1)
the plan's percentage does not exceed 60 percent; (2) in the case of a
financially weak 

employer,
the plan's funding percentage does not exceed 80 percent; or (3) the employer
is in 

bankruptcy
and the plan's funding percentage is less than 100 percent.ï¿½ 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).ï¿½ 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.ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½ The proposal permits the
plan to recover the funded amount plus attorney's fees.ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½
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.ï¿½ 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).ï¿½ 

Notice
must also be provided within a reasonable period of time after the date the
restriction 

ceases
to apply.ï¿½ A plan administrator that
fails to provide the required notice is subject to a 

penalty.ï¿½ 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.ï¿½ 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.ï¿½ In addition,
benefits provided under the amendment are 

subject
to the phase-in of the PBGC guarantee of benefit increases.

Effective
date.-The proposals are generally effective for plan years beginning after 

December
31, 2007.ï¿½ In the case of a plan
maintained pursuant to a collective bargaining 

agreement
in effect on the date of enactment, the proposals are not effective before the
first plan 

year
beginning after the earlier of: (1) the date the collective bargaining
agreement terminates 

(determined
without regard to any extension thereof); or (2) December 31, 2009.ï¿½ 

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).ï¿½ 

In some
cases, because of the limit on the PBGC benefit guarantee, employees bear the
cost of 

underfunding
through the loss of benefits.ï¿½ In
addition, the PBGC bears the cost of the shortfall 

to the
extent plan assets are insufficient to provide guaranteed benefits.ï¿½ 

Providing
benefit increases under an unfunded plan increases these costs.ï¿½ In addition, the 

payment
of lump sums and similar forms of benefit to some participants drains assets
from the 

plan,
thus increasing the cost to the PBGC and other participants.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ Some may also consider it 

inappropriate
to allow a plan to bring action against the executive rather than against the 

employer.ï¿½ On the other hand, the proposal applies only
in the case of a "top" executive.ï¿½


Although
the concept of top executive is not defined, it suggests that the proposal is
aimed at 

company
officials who have the authority to decide whether to adequately fund the
employer's 

defined
benefit pension plan or instead to fund nonqualified deferred compensation
benefits.

Prior
Action

Similar
proposals were included in the President's fiscal year 2005 and 2006 budget 

proposals.

H.R.
2830 (the "Pension Protection Act of 2005"), as passed by the House,
and S. 1783, 

(the
"Pension Security and Transparency Act of 2005"), as passed by the
Senate, both include 

provisions
relating to benefit limitations applicable to underfunded single-employer
defined 

benefit
pension plans.

6.ï¿½ï¿½ï¿½ï¿½ï¿½ Eliminate plant shutdown benefits

Present
Law

Unpredictable
contingent event benefits

A plan
may provide for unpredictable contingent event benefits, which are benefits
that 

depend
on contingencies other than age, service, compensation, death or disability or
that are not 

reliably
and reasonably predictable as determined by the Secretary.ï¿½ Some of these benefits are 

commonly
referred to as "plant shutdown" benefits.ï¿½ 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).ï¿½ï¿½ 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.ï¿½ This restriction is
sometimes referred to as the "anticutback" rule and applies to 

benefits
that have already accrued.ï¿½ï¿½ 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.ï¿½ This protection applies to participants who
satisfy, either before or after the plan 

amendment,
the pre-amendment conditions for the benefit, and even if the condition on
which 

eligibility
for the benefit depends is an unpredictable event such as a plan shutdown. 

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.ï¿½ï¿½ Generally only that part of the retirement
benefit that is payable in monthly 

installments
(rather than, for example, lump sum benefits payable) 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).ï¿½
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.ï¿½ 

In the
case of a plan or a plan amendment that has been in effect for less than five
years 

before
a plan termination, the amount guaranteed is phased in by 20 percent a year.

Description
of Proposal

Prohibition
on providing unpredictable contingent event benefits

Under
the proposal, plans are not permitted to provide benefits that are payable upon
a 

plant
shutdown or any similar unpredictable contingent event as determined under
regulations.ï¿½ 

A plan
that contains such a benefit is required to eliminate the benefit, but only
with respect to an 

event
that occurs after the effective date.ï¿½
Such a plan amendment is deemed not to violate the 

anticutback
rule. 

Effective
date.ï¿½The prohibition on providing unpredictable contingent event benefits 

generally
is effective for plan years beginning in 2008.ï¿½
In the case of a collective bargaining 

agreement
that provides for an unpredictable contingent event benefit on February 1,
2006, the 

prohibition
on unpredictable contingent event benefits is not effective before the end of
the term 

of that
agreement (without regard any to extension of the agreement) or, if earlier,
the first plan 

year
beginning in 2009.

Elimination
of PBGC guarantee

The
proposal amends the guarantee provisions of Title IV of ERISA to provide that
the 

PBGC
guarantee does not apply to benefits that are payable upon a plant shutdown or
any similar 

contingent
event. 

Effective
date.ï¿½The elimination of the PBGC guarantee is effective for benefits that 

become
payable as a result of a plant shutdown or similar contingent event that occurs
after 

February
1, 2006. 

Analysis

Benefits
for plant shutdowns and similar unpredictable contingent events and the PBGC 

guarantee
of such benefits present many issues, including the lack of funding of the
benefits and 

their
nature as retirement or severance-type benefits.ï¿½ These issues are relevant with respect to 

the
proposals to eliminate such benefits and the PBGC guarantee.ï¿½ 

Unlike
most benefits under a defined benefit pension plan, plant shutdown benefits may


be
predictable only a short while before the shutdown occurs, to the extent that
they can be 

predicted
at all.ï¿½ On the other hand, some
shutdowns may be the result of business decisions.ï¿½ 

Notwithstanding,
under the funding rules, a plan's liabilities for plant shutdown benefits 

generally
remain unfunded until the triggering contingency occurs.ï¿½ After the contingency 

occurs,
the liabilities may be funded over a period of years.ï¿½ In some cases, contingencies may be 

followed
by the employer's insolvency, making it difficult for employers to fully fund
the 

triggered
benefits.ï¿½ Additionally, the departure
of employees from the company may follow a 

shutdown
or other contingency.ï¿½ Many such
employees may take distributions from the plan, 

thereby
draining assets from the plan.ï¿½ If the
plan later terminates, assets might not be sufficient 

to
provide the benefits due other plan participants.ï¿½ In addition, the PBGC may be left with 

increased
unfunded liabilities as a consequence of the shutdown and the related
benefits.ï¿½ Thus, 

plant
shutdown benefits may significantly increase the underfunding taken on by the
PBGC.ï¿½ 

Some
argue that liabilities for such benefits make up a significant percentage of
PBGC losses.

Some
view plant shutdown benefits as severance-type benefits which should not be 

provided
under a retirement plan.ï¿½ Plant shutdown
benefits may, however, be considered a 

variety
of subsidized early retirement benefits, similar to early retirement window
benefits which 

are
provided as an incentive for employees to voluntarily terminate
employment.ï¿½ Some believe 

that it
is appropriate for a defined benefit pension plan to provide such benefits to
employees 

whose
employment is involuntarily terminated.ï¿½
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.ï¿½ 

Others
argue that plant shutdown benefits that are promised to participants under the 

terms
of a plan should be guaranteed by the PBGC like any other benefits under the
plan.ï¿½ Plant 

shutdown
benefits may represent a significant portion of a participant's benefits under
a plan.ï¿½ 

Moreover,
unlike some other types of benefits subject to contingent events, plant
shutdown 

benefits
may be intertwined with the employer's financial well-being.ï¿½ Some feel that eliminating 

the
PBGC guarantee applicable to plant shutdown benefits might further disadvantage
plan 

participants
who are experiencing the effects of their employer's troubled financial
status.ï¿½ As an 

alternative,
some suggest that, rather than eliminating the PBGC guarantee, the occurrence
of an 

event
giving rise to unpredictable contingent event benefits could be treated as a
plan 

amendment,
so that the PBGC guarantee of such benefits is phased in over five years.

Prior
Action

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

H.R.
2830 (the "Pension Protection Act of 2005"), as passed by the House,
and S. 1783, 

(the
"Pension Security and Transparency Act of 2005"), as passed by the
Senate, both include 

provisions
relating to plant shutdown and similar benefits provided under single-employer 

defined
benefit pension plans.

7.ï¿½ï¿½ï¿½ï¿½ï¿½ Proposals relating to the Pension Benefit
Guaranty Corporation ("PBGC")

(a)ï¿½ Single-employer plan premiums that reflect
risk

Present
Law

In
general

The
minimum funding requirements permit an employer to fund defined benefit pension


plan
benefits over a period of time.ï¿½ 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.ï¿½ 

In
order to protect plan participants from losing retirement benefits in such
circumstances, the 

PBGC, a
corporation within the Department of Labor, was created in 1974 under ERISA to 

provide
an insurance program for benefits under most defined benefit pension plans
maintained 

by
private employers. 

Premiums
paid to the PBGC 

The
PBGC is funded by assets in terminated plans, amounts recovered from employers 

who
terminate underfunded plans, premiums paid with respect to covered plans, and
investment 

earnings.ï¿½ Single-employer plans covered by the PBGC
insurance program are required to pay a 

flat-rate
per participant premium.ï¿½ Underfunded
plans are subject to an additional variable-rate 

premium
based on the level of underfunding.ï¿½ In
addition, as discussed below, additional 

termination
premiums apply in certain circumstances if a plan terminates on an underfunded 


basis.

Beginning
in 1991, the flat-rate premium was $19 per participant.ï¿½ï¿½ Under the Deficit 

Reduction
Act of 2005,ï¿½ for plan years beginning
after 2005, the flat-rate premium is increased 

to $30,
with indexing after 2006 based on increases in average wages.

In the
case of an underfunded plan, variable-rate premiums are required in the amount
of 

$9 per
$1,000 of unfunded vested benefits (the amount which would be the unfunded
current 

liability
if only vested benefits were taken into account and if benefits were valued at
the variable 

premium
interest rate).ï¿½ï¿½ No variable-rate
premium is imposed for a year if contributions to the 

plan
for the prior year were at least equal to the full funding limit for that year.

Under
the Deficit Reduction Act of 2005, a new premium generally applies in the case
of 

certain
plan terminations occurring after 2005 and before 2011.ï¿½ A premium of $1,250 per 

participant
is imposed generally for the year of the termination and each of the following
2 years.ï¿½ 

The
premium applies in the case of a plan termination by the PBGC or a distress
termination due 

to
reorganization in bankruptcy, the inability of the employer to pay its debts
when due, or a 

determination
that a termination is necessary to avoid unreasonably burdensome pension costs 

caused
solely by a decline in the workforce.ï¿½
In the case of a termination due to reorganization, 

the
liability for the premium does not arise until the employer is discharged from
the 

reorganization
proceeding.ï¿½ The premium does not apply
with respect to a plan terminated during 

bankruptcy
reorganization proceedings pursuant to a bankruptcy filing before October 18,
2005.

Interest
on premium payments

If any
premium required to be paid to the PBGC is not paid by the last date prescribed
for 

a
payment, interest on the amount of such premium is charged at the rate imposed
on 

underpayment,
nonpayment, or extensions of time for payment of taxï¿½ for the period from such 

date to
the date paid.ï¿½ï¿½ The PBGC is not
authorized to pay interest on premium overpayments.

Description
of Proposal

Under
the proposal, variable rate premiums are replaced by risk-based premiums, which


are
charged to all plans with assets less than their funding target (i.e., ongoing
liability or at-risk 

liability,
depending on the financial status of the plan sponsor).ï¿½ï¿½ The risk-based premium is set 

by the
PBGC, and adjusted by the PBGC, based on forecasts of the PBGC's expected
claims and 

future
financial condition.ï¿½ The premium rate
per dollar of underfunding is uniform for all plans.ï¿½ 

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.ï¿½ The
full-funding exception is eliminated so that all underfunded 

plans
are required to pay risk-based premiums.ï¿½
The proposal also authorizes the PBGC to pay 

interest
on premium overpayments.

Effective
date.ï¿½The proposal is effective for plan years beginning on or after January 1,


2006.

Analysis

Risk-based
premiums

ERISA
requires the pension insurance system to be self-financed, i.e., it is not
funded by 

general
revenues.ï¿½ 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.ï¿½


The
present-law variable rate premium is intended to reflect the greater potential
risk of 

exposure
from underfunded plans.ï¿½ The variable
rate premium is also believed to provide an 

incentive
to plan sponsors to better fund their plans.ï¿½
However, the current premium structure is 

described
by the Administration as resulting in the shifting of costs from
financially-troubled 

companies
to healthy companies with adequately-funded plans, owing to the overdependence
on 

flat-rate
premiums and lack of appropriate risk-based premiums.

The
proposed risk-based premiums are intended to better correlate with the risk a
plan 

poses
to the pension insurance system because they are based on a more accurate
measure of 

underfunding
and reflect the financial condition of the plan sponsor's controlled
group.ï¿½ 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.ï¿½ 

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.ï¿½ An
increase in premiums may be a source of volatility and 

burden
for companies struggling to recover from financial hardships.ï¿½ 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.ï¿½ It may 

be
viewed as more appropriate for the amount of, and increases, in premiums to be
determined 

by
Congressional action.ï¿½ 

The
proposal repeals the present-law exception to variable-rate premiums for plans
at the 

full
funding limit.ï¿½ 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.ï¿½ï¿½ Imposing the risk-based 

premium
on all plans, without a full funding limit exception, will subject more plans
to the 

premium
compared to the present-law variable rate premium.ï¿½ The present-law exception for 

plans
at the full funding limit reflects concerns that it may be unfair to impose the
premium on 

employers
making contributions as required under the funding rules, even if the plan
remains 

underfunded.ï¿½ 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.ï¿½ In some cases, however,
the amount of contributions required to 

eliminate
underfunding could be substantial.

Some
raise the concern that variable-rate premium increases, in addition to the
recent 

increase
in flat-rate premiums, may cause more employers to freeze their plans.ï¿½ 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.ï¿½ Further, companies 

considering
whether to establish a defined benefit pension plan may be discouraged from
doing 

so by
increased premium costs.

The
PBGC premium proposal is one part of the President's overall proposal to
increase 

defined
benefit pension plan security.ï¿½ Some
feel that improved funding rules will adequately 

address
underfunding issues and that better funding rules should be enacted and the
effects of 

those
rules should be determined before additional premium increases are adopted.

Interest
on premium overpayments

Some
believe that premium payers should receive interest on premium overpayment 

amounts
that are owed to them.ï¿½ 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.ï¿½ 

Some
argue that interest may not be appropriate in some cases, depending on how the 

overpayment
arose.ï¿½ 

Prior
Action

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

H.R.
2830 (the "Pension Protection Act of 2005"), as passed by the House,
and S. 1783, 

(the
"Pension Security and Transparency Act of 2005"), as passed by the
Senate, both include 

provisions
relating to PBGC premiums.

(b)ï¿½ 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.ï¿½ï¿½ The
participants and the PBGC must be provided notice 

of the
intent to terminate.ï¿½ 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.ï¿½ï¿½ 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.ï¿½ï¿½ Benefit 

liabilities
may also include certain contingent benefits (for example, early retirement
subsidies).ï¿½ 

If
assets are sufficient to cover benefit liabilities (and other termination
requirements, such as 

notice
to employees, are met), the plan distributes benefits to participants.ï¿½ 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.ï¿½ Reversions are generally subject to an
excise tax, described above.

Distress
terminations and involuntary terminations by the PBGC

Distress
terminations

If
assets in a defined benefit pension plan are not sufficient to cover benefit
liabilities, the 

employer
may not terminate the plan unless the employer meets one of four criteria
necessary for 

a
''distress'' termination:

?ï¿½ï¿½ï¿½ï¿½ 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;

?ï¿½ï¿½ï¿½ï¿½ The contributing sponsor and every member
of the sponsor's controlled group is 

being
reorganized in bankruptcy or similar State proceeding;

?ï¿½ï¿½ï¿½ï¿½ The PBGC determines that termination is
necessary to allow the employer to pay its 

debts
when due; or 

?ï¿½ï¿½ï¿½ï¿½ The PBGC determines that termination is
necessary to avoid unreasonably 

burdensome
pension costs caused solely by a decline in the employer's work force.ï¿½ 

These
requirements are designed to ensure that the liabilities of an underfunded plan


remain
the responsibility of the employer, rather than of the PBGC, unless the
employer meets 

strict
standards of financial need indicating genuine inability to continue funding
the plan.

Involuntary
terminations by the PBGC

The
PBGC may institute proceedings to terminate a plan if it determines that the
plan in 

question
has not met the minimum funding standards, will be unable to pay benefits when
due, 

has a
substantial owner who has received a distribution greater than $10,000 (other
than by 

reason
of death) while the plan has unfunded nonforfeitable benefits, or may
reasonably be 

expected
to increase PBGC's long-run loss unreasonably.ï¿½
The PBGC must institute proceedings 

to
terminate a plan if the plan is unable to pay benefits that are currently due. 

Asset
allocation

ERISA
contains rules for allocating the assets of a single-employer plan when the
plan 

terminates.ï¿½ï¿½ 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.ï¿½ On termination, the plan 

administrator
must allocate plan assets available to pay for benefits under the plan in the
manner 

prescribed
by ERISA.ï¿½ In general, plan assets available
to pay for benefits under the plan are 

allocated
to six priority categories.ï¿½ï¿½ 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.ï¿½ 

This
process is repeated until all benefits in the priority category are provided or
until all 

available
plan assets have been allocated.ï¿½ï¿½ 

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.ï¿½ 

The
PBGC guarantee applies to "basic benefits."ï¿½ 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.ï¿½ Generally only that part of 

the
retirement benefit that is payable in monthly installments is guaranteed
(rather than, for 

example,
lump-sum benefits).ï¿½ 

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).ï¿½
Contingent benefits (for example, subsidized early 

retirement
benefits) are guaranteed only if the triggering event occurs before plan
termination.

For
plans terminating in 2006, the maximum guaranteed benefit for an individual
retiring 

at age
65 is $3,971.59 per month or $47,659.08 per year.ï¿½ ï¿½The dollar limit is
indexed annually 

for
inflation.ï¿½ The guaranteed amount is
reduced for benefits starting before age 65.ï¿½
In the case 

of a
plan or a plan amendment that has been in effect for less than five years
before a plan 

termination,
the amount guaranteed is phased in by 20 percent a year. 

Description
of Proposal

Under
the proposal, certain aspects of the PBGC benefit guarantee are frozen when a 

contributing
sponsor enters bankruptcy or a similar proceeding.ï¿½ The freeze continues for two 

years
after the sponsor emerges from bankruptcy.ï¿½
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.ï¿½ The priority for 

allocating
plan assets and employer recoveries to non-guaranteed benefits in the event of
plan 

termination
is determined as of the date the sponsor enters bankruptcy or a similar
proceeding.

The
administrator of a plan for which guarantees are frozen is required to notify
plan 

participants
about the limitations on benefit guarantees, and potential receipt of non-guaranteed


benefits
in a termination on account of the bankruptcy.

Effective
date.ï¿½The 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
funded status of a defined benefit pension plan may deteriorate during the
pendency 

of the
employer's bankruptcy for various reasons.ï¿½
For example, ongoing benefit accruals 

increase
plan liabilities.ï¿½ The ability of the
employer to make contributions may be impaired, 

reducing
the amount of assets that would be available to pay benefits if contributions
continued.ï¿½ 

In
addition, distributions to participants, especially lump-sum distributions,
decrease plan assets.ï¿½ 

Nonetheless,
under present law, the amount of PBGC-guaranteed benefit is not determined
until 

a plan
terminates.ï¿½ Thus, the PBGC's losses
attributable to paying unfunded guaranteed benefits 

may
worsen during bankruptcy.ï¿½ In addition,
the rights of some participants under the priority in 

which
assets are allocated may be adversely affected by changes that occur during the
period that 

bankruptcy
proceedings are pending.

Using
the date a plan sponsor enters bankruptcy as the determinative date for
freezing the 

amount
of guaranteed benefits may decrease the PBGC's losses for unfunded guaranteed 

benefits.ï¿½ This will also provide certainty as to
priorities in asset allocations.ï¿½ 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.ï¿½ Using this date, it is argued, would 

more
effectively and appropriately limit the PBGC's exposure for unfunded
liabilities.ï¿½ Drains on 

plan
assets and increases in unfunded liabilities that may occur during the period
after the 

bankruptcy
petition is filed and before termination of the plan may no longer result in 

disproportionate
losses for the PBGC. ï¿½For 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.ï¿½ Plan sponsors may be in 

bankruptcy
for years; an additional two years may exacerbate the negative impact on plan 

participants.ï¿½ The guaranteed benefits paid by the PBGC to
participants whose plans are 

terminated
may already be considerably lower than the benefits they were promised under
the 

plan
terms.ï¿½ Freezing the level of benefits
provided by the PBGC as of the date of the bankruptcy 

petition
may further harm participants.

Prior
Action

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

S. 1783
(the "Pension Security and Transparency Act of 2005"), as passed by
the Senate, 

includes
a provision under which certain aspects of the PBGC guarantee are determined as
of the 

date a
plan sponsor enters bankruptcy.

(c)ï¿½ Allow PBGC to perfect liens in bankruptcy
for missed required pension 

contributions

Present
Law

Funding
rules

The
Code and the ERISA impose minimum funding requirements with respect to defined 

benefit
pension plans.ï¿½ï¿½ Under the minimum
funding rules, the contribution required for a plan 

year
("minimum required contribution") is generally the plan's normal cost
for the year (i.e., the 

cost of
benefits allocated to the year under the plan's funding method) plus that
year's portion of 

other
liabilities that are amortized over a period of years, such as benefits
resulting from a grant 

of past
service credit.ï¿½ In addition, for
single-employer plans covering more than 100 participants 

and, in
general, having a funded current liability percentage of less than 90%, an
additional 

deficit
reduction contribution may be required, based on the sum of:ï¿½ (1) the expected increase in 

current
liability for benefits accruing in the current year; and (2) a percentage of
unfunded 

current
liability.ï¿½ Minimum required
contributions generally must be made within 8-1/2 months 

after
the end of the plan year.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ï¿½ 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.ï¿½ï¿½ The amount of the lien is equal 


to the
aggregate unpaid balance of required contributions (including interest) for
plan years 

beginning
after 1987 and for which payment has not been made before the due date for the 

installment
payment or required minimum contribution.ï¿½


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.ï¿½ 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.ï¿½


Bankruptcy
rules affecting liens for missed contributions

Automatic
stays

Federal
bankruptcy law provides for an automatic stay against certain actions by
creditors 

once a
bankruptcy petition is filed.ï¿½ï¿½ 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.ï¿½ 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").ï¿½ï¿½ 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 trusteeï¿½
to avoid statutory liens that are not 

perfected
or enforceable against a hypothetical bona fide purchaser as of the date the
bankruptcy 

petition
is filed.ï¿½ï¿½ 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.ï¿½ 

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.ï¿½ The proposal 

also
provides an exemption for PBGC liens for missed contributions from the lien
avoidance 

provisions
of Federal bankruptcy law.

Effective
date.ï¿½The 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.ï¿½
In many cases, bankruptcy law allows a debtor the 

chance
to cure its financial ills and continue in business.ï¿½ 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.ï¿½ 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.ï¿½ Like other creditors, the PBGC is subject to
these provisions as they apply to a plan 

sponsor
which has petitioned for bankruptcy.

It may
be argued that the automatic stay and lien avoidance provisions of Federal 

bankruptcy
law unfairly allow employers to escape liability for required contributions to
defined 

benefit
pension plans.ï¿½ The PBGC and plan
participants may be adversely affected as a result.ï¿½ 

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.ï¿½ If
a plan terminates while the employer is in 

bankruptcy,
the PBGC may experience losses on account of its inability to perfect liens for


missed
contributions and the lien avoidance rules which may allow the trustee to avoid
the 

PBGC
lien.ï¿½ In addition, plan participants
may receive lower benefits in that the employer's 

failure
to make contributions results in less plan assets.ï¿½ Some feel that the PBGC lien for missed 

contributions
should not be made ineffective by a plan sponsor's entering bankruptcy 

notwithstanding
whether it has been perfected.ï¿½ In many
cases, an employer's liability for unpaid 

contributions
ultimately leads to unfunded liabilities that are taken on by the PBGC once the
plan 

is
terminated.

On the
other hand, the automatic stay and lien avoidance provisions assist in
preserving 

Federal
bankruptcy law's distributional scheme for distributing the debtors'
assets.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½


Some
feel that a more appropriate solution to obstacles the PBGC encounters when a
plan 

sponsor
enters bankruptcy is to modify the non-bankruptcy laws which affect PBGC's
financial 

position,
including the funding rules.

Prior
Action

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

 

 

 

C.ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ï¿½
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.ï¿½ The statutory 

assumptions
consist of an applicable mortality table (the 1994 Group Annuity Reserving
Table 

projected
through 2002) and an applicable interest rate.

The
applicable interest rate is the annual interest rate on 30-year Treasury
securities, 

determined
as of the time that is permitted under regulations.ï¿½ The regulations provide various 

options
for determining the interest rate to be used under the plan, such as the period
for which 

the
interest rate will remain constant ("stability period") and the use
of averaging.

Annual
benefits payable under a defined benefit pension plan generally may not exceed 

the
lesser of (1) 100 percent of average compensation, or (2) $175,000 (for
2006).ï¿½ï¿½ The dollar 

limit
generally applies to a benefit payable in the form of a straight life
annuity.ï¿½ 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.ï¿½ 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.ï¿½ï¿½ 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.

Description
of Proposal

The
proposal changes the interest rate used to calculate lump sums payable from a 

defined
benefit pension plan for plan years beginning in 2008.ï¿½ For plan years beginning in 2006 

and
2007, the present-law interest rate applies in determining minimum lump sums
from defined 

benefit
pension plans, i.e., minimum lump-sum values are determined using the rate of
interest 

on
30-year Treasury securities.

For
plan years beginning after December 31, 2007, the proposal provides that
minimum 

lump-sum
values are calculated using rates drawn from a zero-coupon corporate bond yield


curve.ï¿½ 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.ï¿½ Thus, the interest
rate that applies depends upon how many years in the 

future
a participant's annuity payment will be made.ï¿½
Typically, a higher interest applies for 

payments
made further out in the future.

For
distributions in 2008 and 2009, lump-sum values are determined as the weighted 

average
of two values: (1) the value of the lump sum determined under the methodology
under 

present
law (the "old" methodology); and (2) the value of the lump sum
determined using the 

methodology
applicable for 2010 and thereafter (the "new" methodology).ï¿½ For distributions in 

2008,
the weighting factor is 2/3 for the lump-sum value determined under the old
methodology 

and 1/3
for the lump-sum value determined under the new methodology.ï¿½ For distributions in 

2009,
the weighting factors are reversed. 

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

2007.

Analysis

As
previously discussed, recent attention has focused on the issue of the rate of
interest 

used to
determine the present value of benefits under defined benefit pension plans for
purposes 

of the
plan's current liability and the amount of lump-sum benefits under the
plan.ï¿½ï¿½ 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.ï¿½ï¿½ 

Specifically,
the use of a lower interest rate results in larger lump-sum benefits; the use
of a 

higher
interest rate results in lower lump-sum benefits.

Under
present law, the interest rate used for valuing lump-sum benefits is based on
the 

interest
rate on 30-year Treasury obligations.ï¿½
The interest rate issue has received attention 

recently
in part because the Treasury Department stopped issuing 30-year obligations in
2001, 

which
meant that a change to the statutory interest rate was needed.ï¿½ Because the Treasury 

Department
recently resumed the issuance of 30-year obligations, some view a statutory
change 

as no
longer necessary.ï¿½ï¿½ However, apart from
the availability of 30-year Treasury obligations, 

some
have argued that the 30-year Treasury rate has been inappropriately low,
causing lump-sum 

benefits
to be disproportionately large in comparison with annuity benefit payable under
the 

plan.ï¿½ This raises the concern that use of a low
interest rate provides an incentive for employees 

to take
benefits in a lump sum rather than in the form of a life annuity.ï¿½ Annuity distributions are 

generally
considered to provide greater retirement income security in that they assure an


individual
(and generally the individual's spouse) of an income stream for life.ï¿½ On the other 

hand,
even if a lump-sum distribution is rolled over to an IRA or other retirement
plan, it does 

not
assure a lifetime stream of income.ï¿½
Some also argue that lump sums should not be favored 

as a
form of benefit because they can cause a cash drain on the plan.

Under
the proposal, the rate of interest on 30-year Treasury securities is replaced
with the 

rate of
interest on high quality corporate bonds for purposes of determining a plan's
minimum 

lump-sum
values.ï¿½ 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.ï¿½ Others argue 

that,
once the stream of expected future benefit payments is determined, the
difference in 

difficulty
between discounting using one rate for all payments, or discounting with
varying rates 

(i.e.,
the yield curve), is minor.

Some
believe that the same interest rate should be used in valuing a plan's
liabilities for 

funding
purposes and in determining minimum lump-sum benefits under the plan because to
do 

otherwise
would undermine the accuracy of funding computations.ï¿½ However, the assumptions 

used to
determine other optional forms of benefit under a plan, such as early
retirement benefits, 

often
differ from the assumptions used to value the liabilities attributable to those
benefits for 

funding
purposes.ï¿½ The difference in assumptions
does not undermine the accuracy of funding 

computations,
provided that the benefits expected to be paid from the plan, which form the
basis 

for
valuing plan liabilities, are determined using the assumptions that apply under
the plan.ï¿½ï¿½ 

Moreover,
even though, under present law, an interest rate based on 30-year Treasury
securities 

is used
both in valuing plan liabilities for funding purposes and in determining
minimum lump 

sums,
the interest rates actually used can be very different, for example, because
different 

averaging
periods apply.ï¿½ 

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.ï¿½ While 

most
agree that a transition period is necessary, views may differ on the
appropriate length of the 

transition
period.

The
proposal does not directly change the interest rate used in applying the
limitations on 

benefits
to lump-sum distributions.ï¿½ 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,ï¿½
or (2) the interest rate used in the plan.ï¿½ 

Because
this rule uses the rate applicable in determining minimum lump sums, the
proposal to 

change
the rate used for minimum lump-sum purposes would automatically apply for
purposes 

of
applying this rule.ï¿½ In addition, many
plans use the statutory minimum lump-sum rate to 

determine
lump-sum benefits under the plan.ï¿½ 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.ï¿½
Thus, the proposal indirectly affects the computation 

of the
limitations on benefits. 

Prior Action

A
similar proposal was included in the President's fiscal year 2005 and 2006
budget 

proposals.

Pension
Protection Act of 2005, as passed by the House, and Pension Security and 

Transparency
Act of 2005, as passed by the Senate, both include provisions relating to the 

determination
of minimum lump sums.

 

 

 

V.ï¿½ï¿½ï¿½ TAX SHELTERS, ABUSIVE TRANSACTIONS, AND TAX
COMPLIANCE

A.ï¿½ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 

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."ï¿½ï¿½ 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.ï¿½ 

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.ï¿½
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.ï¿½ This is one example of how a taxpayer 

might
attempt to separate foreign taxes from the related foreign income, and thereby
attempt to 

claim a
foreign tax credit under circumstances in which there is no threat of double
taxation.

The
Treasury Department currently has substantial authority to promulgate
regulations 

under
section 901 and other provisions of the Code to address transactions and
structures that 

produce
inappropriate foreign tax credit results.

Description
of Proposal

The
proposal enhances the regulatory authority of the Treasury Department to
address 

transactions
that involve the inappropriate separation of foreign taxes from the related
foreign 

income
in cases in which taxes are imposed on any person in respect of income of an
entity.ï¿½ 

Regulations
issued pursuant to this authority could, for example, provide for the
disallowance of 

a
credit for all or a portion of the foreign taxes, or for the allocation of the
foreign taxes among 

the
participants in the transaction in a manner more consistent with the economics
of the 

transaction.

Effective
date.ï¿½The proposal generally is effective after the date of enactment.

Analysis

The
proposal clarifies and centralizes existing regulatory authority to facilitate
efforts on 

the
part of the Treasury Department and the IRS to address abusive transactions
involving 

foreign
tax credits.ï¿½ï¿½ This grant of regulatory
authority would supplement existing authority and 

thereby
provide greater flexibility in addressing a wide range of transactions and
structures.ï¿½ 

However,
the proposal does not identify in great detail the scope of transactions that
would be 

covered.ï¿½ Consequently, the effectiveness of these
rules would depend on the degree to which the 

Treasury
Department provides greater detail with respect to the scope of transactions
covered 

and the
means by which these transactions would be curtailed.

Prior
Action

An
identical proposal was included in the President's fiscal year 2005 and 2006
budget 

proposals.

The
proposal is also included in H.R. 4297, as amended by the Senate (the "Tax
Relief 

Act of
2005").

 

 

B.ï¿½ï¿½ï¿½ 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.ï¿½ï¿½ 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.ï¿½ï¿½ 

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.ï¿½ 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").ï¿½ï¿½ 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. 

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.ï¿½


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.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 

Analysis

The
purpose of section 355 is to permit existing shareholders to separate existing 

businesses
for valid business purposes without immediate tax consequences.ï¿½ 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.ï¿½ï¿½ 

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.ï¿½
Recent press reports have referred to these 

transactions
as "cash-rich" tax-free corporate divisions.ï¿½ï¿½ For example, the addition of a 

relatively
small business to an otherwise cash stock redemption transaction can convert an


essentially
cash stock buyback, which would have been taxed to the recipient shareholder,
into a 

tax-free
transaction for the recipient shareholder.ï¿½
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.ï¿½ï¿½ Consideration
could be given to increasing the threshold above 

50
percent.ï¿½ 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. 

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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ Specific clarification of the intended 

scope
of the phrase could be desirable, both from the viewpoint of the government and
of 

taxpayers.ï¿½ 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.ï¿½ 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.ï¿½ï¿½


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.ï¿½ However,
in such situations, the value of such cash or 

investment
assets may be very accessible to the shareholder even without a further
distribution.ï¿½ 

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.ï¿½ 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).ï¿½ 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.ï¿½ï¿½ 

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.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ï¿½ï¿½ 

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.ï¿½ 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.ï¿½ Arguably, however,
applying the new rule to all tax-free corporate 

divisions
could provide greater consistency.ï¿½
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. 

Prior
Action

An
identical provision was contained in the President's fiscal year 2006 budget
proposal.

The Tax
Relief Act of 2005ï¿½ would deny tax-free
treatment under section 355 if, 

immediately
after the distribution of a controlled corporation, 50 percent of either the
vote or 

value
of either the distributing or controlled corporation is owned by a person that
did not 

previously
own such a 50 percent interest and that corporation is a "disqualified
investment 

company."ï¿½ The definition of a "disqualified
investment company" requires 75 percent or more 

of the
value of the company to be in cash or certain other investment assets (as
defined) before 

the
provision applies.ï¿½ Certain corporate
stock and partnership interests are "looked through" for 

this
purpose to their underlying assets, and certain securities of such entities are
disregarded, as 

are
certain assets held for use in the active and regular conduct ofï¿½ a lending or finance, banking, 

or
insurance businesses, and securities held by a dealer that are marked to
market.ï¿½ 

 

 

C.ï¿½ï¿½ï¿½ Impose Penalties on Charities that Fail to
Enforce Conservation Easements

Present
Law

Section
170(h) provides special rules that apply to qualified conservation
contributions, 

which
include charitable contributions of conservation easements and faï¿½ade
easements.ï¿½ 

Qualified
conservation contributions are not subject to the "partial interest"
rule, which generally 

denies
deductions for charitable contributions of partial interests in property.ï¿½ Accordingly, 

qualified
conservation contributions are contributions of partial interests that are
eligible for a 

fair
market value deduction.ï¿½ 

A
qualified conservation contribution is a contribution of a qualified real
property interest 

to a
qualified organization exclusively for conservation purposes.ï¿½ 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.ï¿½ï¿½ Qualified organizations
include certain governmental units, public 

charities
that meet certain public support tests, and certain supporting
organizations.ï¿½ 

Conservation
purposes include:ï¿½ (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.ï¿½ï¿½
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.ï¿½ The
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.ï¿½ 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.ï¿½The proposal is effective for taxable years beginning after December 31, 

2005.

Analysis

The
proposal addresses the concern that charitable contributions of conservation 

restrictions,
which are required to be in perpetuity, are being removed, or are being
transferred 

without
securing the conservation purpose.ï¿½ 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.ï¿½
The proposal applies to "removals," 

which
some might argue includes significant modifications to conservation
restrictions.ï¿½ 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.ï¿½ 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.ï¿½ Some might argue, however, that if
modifications to conservation restrictions are 

penalized,
certain non significant modifications, such as for mistake or clarity, or de
minimis 

modifications,
should not be penalized, and that determining whether a modification is 

significant
introduces administrative complexity.ï¿½
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.ï¿½ 

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."ï¿½ The amount 

of the
penalty is not clear.ï¿½ Under this
standard, the penalty could be any percentage of such 

value.ï¿½ 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.ï¿½ Others 

might
argue that the penalty should equal such amount, plus an additional amount to
penalize the 

charity
for removing or transferring the easement.ï¿½
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.ï¿½ 

In
addition, arguably the penalty also should take into account the present value
of the 

restriction.ï¿½ 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.ï¿½ 

If the
proposal applies to modifications of restrictions, however, a penalty based on 

recapture
of the tax benefit presents additional complexity, in that a before and after
appraisal 

would
be required to determine the effect of the modification on the value of the
property.ï¿½ 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).ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ It is not clear what will constitute a 

failure
for this purpose.ï¿½ 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.ï¿½ In addition, in the case of a failure to 

enforce,
the amount of the penalty is not clear.ï¿½
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.ï¿½ 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.ï¿½ Some 

would
argue that a penalty also should be imposed on such entities, irrespective of
their 

governmental
status.

Prior
Action

The
President's fiscal year 2006 budget proposal included a similar proposal.

 

 

D.ï¿½ï¿½ï¿½ï¿½ï¿½ Eliminate the Special Exclusion from
Unrelated Business Taxableï¿½ 

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.ï¿½ 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.ï¿½ Gains or losses are treated as unrelated
business taxable income, however, if derived 

from
"debt-financed property."ï¿½
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.ï¿½ 

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.ï¿½ 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.ï¿½ 

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.ï¿½ 

Special
rules apply in the case of an exempt organization that owns a partnership
interest 

in a
partnership that holds debt-financed property.ï¿½
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.ï¿½ The exclusion from
unrelated business taxable income generally is 

available
to an exempt organization that acquires, remediates, and disposes of the
qualifying 

brownfield
property.ï¿½ In addition, there is an
exception from the debt-financed property rules for 

such
properties.ï¿½ 

In
order to qualify for the exclusions from unrelated business income and the
debt-

financed
property rules, the eligible taxpayer is required to:ï¿½ (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.ï¿½ 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).ï¿½ 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.ï¿½ 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.ï¿½ 

An
eligible taxpayer does not include an organization that is: (1) potentially
liable under 

section
107 of CERCLA with respect to the property; (2) affiliated with any other
person that is 

potentially
liable thereunder through any direct or indirect familial relationship or any 

contractual,
corporate, or financial relationship (other than a contractual, corporate, or
financial 

relationship
that is created by the instruments by which title to a qualifying brownfield
property 

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.ï¿½ 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;ï¿½ (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,ï¿½ sufficient monitoring,
funding, institutional controls, and 

financial
assurances have been put in place to ensure the complete remediation of the
site in 

accordance
with the remediation plan as soon as is reasonably practicable after the
disposition of 

the
property by the taxpayer; and (5) public notice and the opportunity for comment
on the 

request
for certification (in the same form and manner as required for public
participation 

required
under section 117(a) of CERCLA (as in effect on the date of enactment of the 

provision))
was completed before the date of such request.ï¿½
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 expendituresï¿½ 

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,ï¿½ or to obtain financial guarantees 

required
to manage the remediation and monitoring of the property.ï¿½ 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.ï¿½
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;ï¿½
(3) any amount paid or incurred to the extent 

such
amount is reimbursed, funded or otherwise subsidized by: (a) grants provided by
the United 

States,
a State, or a political subdivision of a State for use in connection with the
property; 

(b)
proceeds of an issue of State or local government obligations used to provide
financing for 

the
property, the interest of which is exempt from tax under section 103; or (c)
subsidized 

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.ï¿½ Income, gain, or loss from other transfers
is not excluded.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ A tax-exempt partner is bound 

by an
election made by the qualifying partnership of which it is a partner.ï¿½ï¿½ï¿½ï¿½ 

Special
rules for multiple properties

The
eligible remediation expenditure determinations generally are made on a
property-

by-property
basis.ï¿½ 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.ï¿½ In the
case of such an election, the taxpayer 

satisfies
the eligible remediation expenditures test with respect to all qualifying
brownfield 

properties
acquired during the election period if the average of the eligible remediation 

expenditures
for all such properties exceeds the greater of: (a) $550,000; or (b) 12 percent
of the 

average
of the fair market value of the properties, determined as of the dates they
were acquired 

by the
taxpayer and as if they were not contaminated.ï¿½
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.ï¿½ 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.ï¿½ 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).ï¿½ 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.ï¿½ 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.ï¿½
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.ï¿½ Property acquired during the
five-year acquisition period need not be 

disposed
of by the termination date in order to qualify for the exclusion.ï¿½ 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.ï¿½The proposal is effective for taxable years beginning after December 31, 

2006.

Analysis

The
proposal repeals the recently enacted exclusion for gains from the disposition
of 

remediated
brownfield property from unrelated business income tax rules, citing
administrative 

and
policy concerns.ï¿½ 

Administrative
concerns

The
proposal states that the exclusion adds significant new complexity to the Code
and 

would
be difficult to administer.ï¿½ By any
measure, the exclusion is complicated; and the 

exclusion's
complexity presents several administrative challenges.ï¿½ 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.ï¿½ 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.ï¿½ 

Although
the proposal does not cite specific administrative concerns, there are several 

aspects
of the exclusion that might be at issue.ï¿½
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.ï¿½ 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.ï¿½ Also, the remediation expense 

test
may be applied on a property-by-property basis or, by an election, on a
multiple property 

basis.ï¿½ 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.ï¿½ 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.ï¿½ 

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.ï¿½ This 

may
require the IRS to make determinations under environmental laws, which may prove


difficult.ï¿½ 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.ï¿½ 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.ï¿½ 

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.ï¿½ The definition of an eligible expense is
detailed and descriptive, but not precise.ï¿½


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.ï¿½ 

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.ï¿½ 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.ï¿½ 

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.ï¿½ The exclusion also contains a related-party
rule and a recapture provision, which 

contribute
to the administrative complexity of the exclusion.ï¿½ 

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.ï¿½ Some might 

argue
that the exclusion should be given time to see whether it proves as complicated
to 

administer
as it appears.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ Nevertheless, the multiple 

property
election of the proposal may permit taxpayers to acquire a brownfield site
where little 

remediation
is required, significantly develop the property, and sell the property without
paying 

tax on
the gain so long as the average expenses over all the properties meet the
requirements of 

the
multiple property election.

Prior
Action

The
President's fiscal year 2006 budget proposal included a similar proposal.

 

 

E.ï¿½ï¿½ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ 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). ï¿½Disqualified 

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").ï¿½ Interest amounts disallowed under these 

rules
can be carried forward indefinitely.ï¿½ 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.ï¿½
This report was due no later than June 30, 2005.

Description
of Proposal

The
proposal eliminates the safe harbor and the excess limitation carryforward of
present 

law.ï¿½ 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.ï¿½ With respect to interest on 

guaranteed
debt, the present-law threshold of 50 percent of adjusted taxable income is
retained.ï¿½ 

The
carryforward of disallowed interest is limited to 10 years.

Effective
date.ï¿½The 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.ï¿½ï¿½ 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.ï¿½ï¿½ 

By
eliminating the debt-equity safe harbor, reducing the adjusted taxable income
threshold from 

50
percent to 25 percent for interest on related-party debt, limiting the
carryforward of 

disallowed
interest to 10 years, and eliminating the carryforward of excess limitation,
the 

proposal
would significantly strengthen rules that have proven ineffective in preventing
certain 

recent
earnings stripping arrangements.

On the
other hand, some view the proposal as unnecessary and overbroad, arguing that 

there
is no empirical evidence of a significant earnings stripping problem outside
the context of 

inversion
transactions.ï¿½ 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.ï¿½ Proponents of the
proposal respond that, although recent legislative and 

treaty
developments have removed some significant opportunities for earnings
stripping, other 

opportunities
may remain, and thus erosion of the U.S. tax base will continue until the
statutory 

earnings
stripping rules themselves are strengthened.

Some
take the view that the proposal does not go far enough in curtailing earnings 

stripping.ï¿½ While the proposal would have the effect of
further limiting the ability of taxpayers to 

erode
the U.S. tax base through earnings stripping transactions involving interest,
the proposal 

does
not address earnings stripping transactions involving the payment of deductible
amounts 

other
than interest (e.g., rents, royalties, and service fees), or the payment of
deductible amounts 

by
taxpayers other than corporations.ï¿½
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.ï¿½ 

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.ï¿½ Proponents of the proposal 

respond
that earnings stripping is much more readily achieved through the use of debt than


through
other means, and that there is insufficient evidence to suggest that these
other forms of 

stripping
warrant a new legislative response.

Finally,
some argue that further action in this area should be deferred until the
Treasury 

Department
completes its earnings stripping study and submits its report of the study to
the 

Congress.ï¿½ The Treasury Department has indicated that
the study is underway and that the report 

may
include further recommendations in this area, but has not announced when the
report will be 

released.ï¿½ It is hoped that this report will provide
new data and analysis that will further inform 

the
discussion in this area.

Prior
Action

The
identical proposal was included in the President's fiscal year 2005 and 2006
budget 

proposals.ï¿½ The President's fiscal year 2004 budget
proposal contained a different earnings 

stripping
proposal that changed present law by modifying the safe harbor provision,
reducing the 

adjusted
taxable income threshold, adding a new disallowance provision based on a
comparison 

of
domestic to worldwide indebtedness, and limiting carryovers.

 

 

 

 

F.ï¿½ï¿½ï¿½ 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.ï¿½ï¿½ 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").ï¿½ï¿½ 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").ï¿½ï¿½ 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.ï¿½ 

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.ï¿½ï¿½ 

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.ï¿½ Qualified tuition accounts or 

contracts
generally require the designation of a person (generally referred to as an
"account 

owner")
whom the program administrator (oftentimes a third party administrator retained
by the 

State
or by the educational institution that established the program) may look to for
decisions, 

recordkeeping,
and reporting with respect to the account established for a designated
beneficiary.ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ Accordingly, a beneficiary of any age may be
named as a designated beneficiary.ï¿½ 

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.ï¿½ï¿½ï¿½ 

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.ï¿½ï¿½ 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.ï¿½ï¿½ 

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),ï¿½ and must provide separate accounting for
each designated beneficiary.ï¿½ï¿½ A
qualified 

tuition
program may not allow any interest in an account or contract (or any portion
thereof) to 

be used
as security for a loan. 

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.ï¿½ï¿½ 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.ï¿½ Earnings
accumulate tax-free until a distribution is 

made.ï¿½ If a distribution is made to pay qualified
higher education expenses, no portion of the 

distribution
is subject to income tax.ï¿½ï¿½ If a
distribution is not used to pay qualified higher 

education
expenses, the earnings portion of the distribution is subject to Federal income
tax,ï¿½ 

and a
10-percent additional tax (subject to exceptions for death, disability, or the
receipt of a 

scholarship).ï¿½ï¿½ A change in the designated beneficiary of
an account or prepaid contract is not 

treated
as a distribution for income tax purposes if the new designated beneficiary is
a member of 

the
family of the old beneficiary. 

Gift
and 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.ï¿½ï¿½ Such contributions qualify for the
per-donee annual gift tax exclusion ($12,000 

for
2006), and, to the extent of such exclusions, also are exempt from the
generation-skipping 

transfer
(GST) tax.ï¿½ 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.ï¿½ï¿½ 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.ï¿½ï¿½
Amounts distributed on account of the death 

of the
designated beneficiary, however, are includible in the designated beneficiary's
gross 

estate.ï¿½ï¿½ 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.ï¿½ In general, a power of 

appointment
includes all powers which are in substance and effect powers of appointment 

regardless
of the nomenclature used in creating the power and regardless of local property
law 

connotations,
and may include, for example, the power to consume or appropriate the property,


or to
affect the beneficial enjoyment of principal or income through a power to
revoke, alter or 

amend
the terms of the instrument (such as changing the designated beneficiary of
property).ï¿½ï¿½ 

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.ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ The designated beneficiary's 

gross
estate would include only amounts (if any) paid to the estate or pursuant to
the designated 

beneficiary's
general power of appointment.

Rules
applicable to contributors; account administrators

Under
the proposal, each section 529 account may have only one contributor.ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½
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").ï¿½ The
account administrator would have no beneficial interest in the 

account.ï¿½ The account administrator would be permitted
to change the designated beneficiary 

"from
time to time".ï¿½ 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.ï¿½ Such 

distributions
are not subject to income tax, regardless of the distributee's identity.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ The excise tax is payable from
the account and is required to be withheld by the 

program
administrator.ï¿½ï¿½ï¿½ï¿½ 

Changes
in reporting requirements

The
proposal modifies the reporting requirements applicable to qualified tuition
accounts.ï¿½ 

For
example, new reporting requirements would be established to facilitate the
administration of 

excise
tax withholding by administrators.ï¿½ 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.ï¿½ï¿½ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ For example, present
law treats a contribution to a qualified tuition 

account
as a completed gift of a present interest to the designated beneficiary,ï¿½ 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.ï¿½ Absent section
529, such contributions generally would not be 

treated
as completed gifts to the designated beneficiary under otherwise applicable
transfer tax 

principles.ï¿½ ï¿½Further, 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.ï¿½ 

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.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ 

The
proposal eliminates these disparities and provides that a change of beneficiary
will 

not be
treated as a distribution or transfer.

Because
the proposal expands the class of permissible successor designated
beneficiaries 

without
the imposition of any income or transfer taxes, individuals interested in
establishing a 

qualified
tuition account as a means to fund qualified higher education expenses for
their 

children,
relatives, or others, might view these changes as being a liberalization and 

simplification
of existing law.ï¿½ï¿½ï¿½ 

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.ï¿½ The proposed excise tax is imposed 

only if
an actual distribution occurs and the distributed amounts are not used for
qualified higher 

education
expenses.ï¿½ 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.ï¿½ 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.ï¿½ Such excise taxes are 

intended
to serve as deterrents to using the funds other than for qualified higher
education 

expenses.ï¿½ 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.ï¿½ 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.ï¿½ Enforcing 

such
caps, however, would impose significant administrative burdens on
administrators, 

taxpayers,
and the IRS.ï¿½ 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.ï¿½ Others may counter that 

program-imposed
limits are applied only on a per-State basis, and further, that the ability of
an 

individual
to establish accounts for an unlimited number of designated beneficiaries means
there 

are no
effective limits under present law.

Prior
Action

A
similar proposal was contained in the President's fiscal year 2005 and 2006
budget 

proposals.

 

 

 

 

VI.ï¿½ï¿½ TAX ADMINISTRATION PROVISIONS AND
UNEMPLOYMENT INSURANCE

A.ï¿½ï¿½ï¿½ IRS Restructuring and Reform Act of 1998

1.ï¿½ï¿½ï¿½ 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.ï¿½ The proposal also 

adds
unauthorized inspection of returns and return information to the list of
violations requiring 

termination.ï¿½ 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.ï¿½ 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.ï¿½ 

Effective
date.ï¿½The 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.ï¿½ Late filing generally is not 

grounds
for termination by most employers.ï¿½ In
addition, late filing of refund returns is generally 

not
subject to penalty under the Code.ï¿½ï¿½ Proponents
of the proposal relating to late filings may 

argue
that the late filing of a refund return is not the type of serious conduct for
which the severe 

penalties
imposed by the IRS Restructuring and Reform Act should apply.ï¿½ 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.ï¿½ Other means, such as the Whistleblower Protection
Act, negotiated grievance 

processes,
and civil rights laws, exist to address employee complaints and appeals.ï¿½ 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.ï¿½ 

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.ï¿½
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.ï¿½ They may argue
that including employee versus employee conduct 

in the
section 1203 violation list benefits tax administration.ï¿½ Another issue to consider is the 

extent
to which the inclusion of employee versus employee conduct on the list of
section 1203 

violations
deters inappropriate behavior (by reducing the likelihood of real employee
versus 

employee
actions) or increases inappropriate behavior (by increasing the number of
allegations 

of
inappropriate behavior against other employees for purposes of intimidation,
harassment, or 

retribution).

Unauthorized
inspection of returns 

Advocates
of the proposal argue that unauthorized inspection of tax returns and return 

information
is a serious act of misconduct that should be included in the list of
violations subject 

to
termination, as unauthorized inspection is as serious as the other taxpayer
rights protections 

covered
by section 1203.ï¿½ Code section 7213A
already makes the unauthorized inspection of 

returns
and return information illegal, with violations punishable by fine,
imprisonment, and 

discharge
from employment.ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½ Arguably, more
damage can be done by disclosing sensitive tax 

information
to a third party than by looking at a return out of curiosity.ï¿½ 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.ï¿½ 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.ï¿½
They believe that the certainty provided by 

specific
guidelines would improve IRS employee morale and enhance the fundamental
fairness 

of the
statute.ï¿½ 

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.ï¿½ 

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.ï¿½ The IRS 

must
review and investigate every allegation of a section 1203 violation.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 

Additional
guidelines may increase complexity by creating more rules for the IRS to
establish 

and
follow.ï¿½ The guidelines would also have
to be periodically updated to ensure that 

punishments
for specific violations continue to be appropriate.ï¿½ On the other hand, additional 

penalty
guidelines may decrease complexity by providing clarity as to specific
punishments for 

specific
employee violations, which may enhance the IRS' effectiveness in administering
section 

1203.

Prior
Action

An
identical proposal was included in the President's fiscal year 2003, 2004,
2005, and 

2006
budget proposals.

2.ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ï¿½
The Code also permits the Tax Courtï¿½
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. 

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.ï¿½ First, the proposal permits the IRS to 

dismiss
such requests. ï¿½Second, 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.ï¿½ï¿½ 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.ï¿½The proposal is effective for submissions made on or after the date of 

enactment.

Analysis

In
general

Genuinely
frivolous returns and submissions are those that raise arguments that have 

been
repeatedly rejected by the courts.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 

Complexity
issues

Increasing
the amount of an existing penalty arguably would have no impact on tax law 

complexity.ï¿½ It could be argued that the procedural
changes made by the proposal, taken as a 

whole,
would simplify tax administration by speeding the disposition of frivolous
submissions, 

despite
the fact that some elements of the proposals (such as the requirement to
publish a list of 

frivolous
positions) may entail increased administrative burdens.

Prior
Action

A
substantially similar proposal was included in the President's fiscal year
2003, 2004, 

2005,
and 2006 budget proposals.ï¿½ï¿½ 

3.ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ï¿½ 

An
installment agreement does not reduce the amount of taxes, interest, or
penalties owed.ï¿½ 

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:ï¿½ 

(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.ï¿½ï¿½ 

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 depositï¿½ or fails to timely file a tax return 

(including
extensions).ï¿½ The termination could
occur even if the taxpayer remained current with 

payments
under the installment agreement. 

Effective
date.ï¿½The 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.ï¿½ For example, taxpayers might not understand
why their installment agreement is 

being
terminated, leading to additional phone calls to the IRS.ï¿½ In addition, the proposal would 

require
that additional explanatory information be provided to taxpayers, which will
increase 

complexity.ï¿½ It might be possible to reduce this increase
in complexity by implementing these 

termination
procedures in a manner as parallel as possible to the similar termination
procedures 

for
offers in compromise.ï¿½ 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.ï¿½
Some might be concerned that this does not take into 

account
the benefits of making continued installment payments.ï¿½ A key benefit to the Federal 

Government
of continued installment payments is that the Federal Government continues to 

receive
payments, whereas if the installment agreement is terminated payments under
that 

agreement
stop.ï¿½ Some might note that termination
of the installment agreement permits the IRS 

to
begin immediate collection actions, such as reinstating liens and levies, which
could increase 

Federal
Government receipts.ï¿½ In the past
several years, however, there has been a significant 

decline
in IRS' enforced collection activities, so that others might respond that
terminating 

installment
agreements might not lead to increased receipts to the Federal Government, in
that 

the
cessation of receipts due to termination of installment agreements may outweigh
increases in 

receipts
through additional enforcement activities.

The
proposal is effective for failures occurring on or after the date of
enactment.ï¿½ Some 

may
question whether it is fair to taxpayers who are currently in an installment
agreement to 

terminate
those agreements.ï¿½ 

Prior
Action

An
identical proposal was included in the President's fiscal year 2003, 2004,
2005, and 

2006
budget proposals.ï¿½ 

4.ï¿½ï¿½ï¿½ï¿½ï¿½ Consolidate review of collection due
process cases in the United States Tax Court

Present
Law

In
general, the IRS is required to notify taxpayers that they have a right to a
fair and 

impartial
hearing before levy may be made on any property or right to property.ï¿½ï¿½ Similar rules 

apply
with respect to liens.ï¿½ï¿½ 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.ï¿½ The taxpayer is
entitled to appeal that determination to a court.ï¿½ That 

appeal
must be brought to the United States Tax Court, unless the Tax Court does not
have 

jurisdiction
over the underlying tax liability.ï¿½ If
that is the case, then the appeal must be brought 

in the
district court of the United States.ï¿½ï¿½
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 

Constitutionï¿½ and is a court of limited jurisdiction. 

Description
of Proposal

The
proposal consolidates all judicial review of these collection due process 

determinations
in the United States Tax Court.

Effective
date.ï¿½The 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.ï¿½ 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.ï¿½ 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.ï¿½ï¿½ 

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.ï¿½ï¿½ 

Some
believe that present law "entitles a taxpayer patently seeking delay to
achieve his 

goal by
refiling in the District Court."ï¿½ï¿½
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.ï¿½ï¿½ï¿½ An identical
proposal was included in the President's fiscal year 2005 

and
2006 budget proposals.ï¿½ 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.ï¿½ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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. 

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.ï¿½ The Secretary must 

establish
standards for determining when a written opinion is required with respect to a 

compromise.

Effective
date.ï¿½The 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.ï¿½ Repealing this
requirement also would increase the 

level
of discretionary authority that the IRS may exercise, which may lead to
increasingly 

inconsistent
results among similarly situated taxpayers. Some may believe that Chief Counsel


review
is appropriate for all offers-in-compromise above specified dollar thresholds,
similar to 

the
review of large refund cases by the Joint Committee on Taxation. 

Prior
Action

An
identical proposal was included in the President's fiscal year 2003, 2004,
2005, and 

2006
budget proposals.ï¿½ The $50,000 threshold
was raised from $500 in 1996. 

 

 

B.ï¿½ï¿½ï¿½ï¿½ï¿½ Initiate Internal Revenue Service
("IRS") Cost Saving Measures

1.ï¿½ï¿½ï¿½ 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.ï¿½ï¿½ 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.ï¿½ï¿½
Continuous levies imposed by the IRS on specified Federal 

payments
are administered by the Financial Management Service (FMS) of the Department of


the
Treasury.ï¿½ FMS is generally responsible
for making most non-defense related Federal 

payments.ï¿½ FMS is required to charge the IRS for the
costs of developing and operating this 

continuous
levy program.ï¿½ 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.ï¿½ The amount credited to the taxpayer's
account would not, however, be reduced by this fee.

Effective
date.ï¿½The provision is effective on the date of enactment.

Analysis

Proponents
believe that altering the bookkeeping structure of these costs will provide for


cost
savings to the Federal Government.

Prior
Action

An
identical proposal was included in the President's fiscal year 2005 and 2006
budget 

proposals.ï¿½ 

2.ï¿½ï¿½ï¿½ Expand the authority to require electronic
filing by large businesses and exempt 

organizations

Present
Law

The
Code authorizes the IRS to issue regulations specifying which returns must be
filed 

electronically.ï¿½ï¿½ There are several limitations on this
authority.ï¿½ First, it can only apply to 

persons
required to file at least 250 returns during the year.ï¿½ï¿½ 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

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.ï¿½ 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."ï¿½ï¿½
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.ï¿½The proposal is effective for taxable years beginning after December 31, 

2006;
these returns will be filed in 2008.

Analysis

In
general, the goal of the proposal is to reduce the administrative burdens on
the IRS by 

providing
IRS authority to require more taxpayers to file electronically.ï¿½ The Congress set a goal 

for the
IRS to have 80 percent of tax returns filed electronically by 2007.ï¿½ The overwhelming 

majority
of tax returns are already prepared electronically.ï¿½ Thus, expanding the scope of returns 

that
are required to be filed electronically may be viewed as both helping the IRS
to meet the 80 

percent
goal set by the Congress and improving tax administration.

Prior
Action

A
similar proposal was included in the President's fiscal year 2006 budget
proposal.ï¿½ 

 

 

C.ï¿½ï¿½ï¿½ Other Provisions

1.ï¿½ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 

Under
various State laws, the IRS may negotiate for access to employment and 

unemployment
data directly from State agencies that maintain these data.ï¿½ Generally, the IRS 

obtains
such employment and unemployment data less frequently than quarterly, and there
are 

significant
internal costs of preparing these data for use.

Description
of Proposal

The
proposal amends the Social Security Act to allow the IRS access to NDNH data
for 

general
tax administration purposes, including data matching, verification of taxpayer
claims 

during
return processing, preparation of substitute returns for non-compliant
taxpayers, and 

identification
of levy sources.ï¿½ Data obtained by the
IRS under the proposal is subject to the 

confidentiality
and disclosure rules applicable to taxpayer information.

Effective
date.ï¿½The 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.ï¿½
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.ï¿½ 

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.ï¿½ On the
other hand, data obtained by the IRS from the NDNH is 

protected
by existing disclosure law.ï¿½ Thus, the
proposal does not reduce the current levels of 

taxpayer
privacy.

Prior
Action

An
identical proposal was included in the President's fiscal year 2006 budget
proposal.

 

 

2.ï¿½ï¿½ï¿½ï¿½ï¿½ Extension of IRS authority to fund undercover
operations

Present
Law

IRS
undercover operations are statutorilyï¿½
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).ï¿½ In general, the Code permits
the IRS to use proceeds from an undercover 

operation
to pay additional expenses incurred in the undercover operation, through
2006.ï¿½ 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.ï¿½ 

Description
of Proposal

The
proposal extends this authority through December 31, 2011.

Analysis

Some
believe the extension of this authority is appropriate because they believe
that it 

assists
the fight against terrorism.ï¿½ Some also
believe that it is appropriate for IRS to have this 

authority
because other law enforcement agencies have churning authority.ï¿½ 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.ï¿½
However, it is difficult to show what 

investigative
opportunities were lost due to the lack of churning authority during that
period.ï¿½ 

Some
believe that extension is inappropriate because the provision may provide
incentives to 

continue
undercover operations for extended periods of time.ï¿½ 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.ï¿½ï¿½ The 

exemption
originally expired on December 31, 1989, and was extended by the Comprehensive 

Crime
Control Act of 1990ï¿½ to December 31,
1991.ï¿½ï¿½ There followed a gap of approximately


four
and a half years during which the provision had lapsed.ï¿½ In the Taxpayer Bill of Rights II,ï¿½ 

the
authority to churn funds from undercover operations was extended for five
years, through 

2000.ï¿½ï¿½ The Community Renewal Tax Relief Act of
2000ï¿½ extended the authority of the IRS 

to
"churn" the income earned from undercover operations for an
additional five years, through 

2005.ï¿½ The Gulf Opportunity Zone Act of 2005
extended this authority through 2006. 

 

 

 

D.ï¿½ï¿½ï¿½ Reduce the Tax Gap

1.ï¿½ï¿½ï¿½ï¿½ï¿½ Implement standards clarifying when
employee leasing companies can be held liable for 

their
clients' Federal employment taxes

Present
Law

In
general

Employment
taxes generally consist of the taxes under the Federal Insurance 

Contributions
Act ("FICA"), the tax under the Federal Unemployment Tax Act
("FUTA"), and 

the
requirement that employers withhold income taxes from wages paid to employees
("income 

tax
withholding").ï¿½ï¿½ï¿½ 

FICA
tax consists of two parts: (1) old age, survivor, and disability insurance
("OASDI"), 

which
correlates to the Social Security program that provides monthly benefits after
retirement, 

disability,
or death; and (2) Medicare hospital insurance ("HI").ï¿½ The OASDI tax rate is 6.2 

percent
on both the employee and employer (for a total rate of 12.4 percent).ï¿½ The OASDI tax 

rate
applies to wages up to the OASDI wage base ($94,200 for 2006).ï¿½ The HI tax rate is 1.45 

percent
on both the employee and the employer (for a total rate of 2.9 percent).ï¿½ Unlike the 

OASDI
tax, the HI tax is not limited to a specific amount of wages, but applies to
all wages.

Under
FUTA, employers must pay a tax of 6.2 percent of wages up to the FUTA wage 

base of
$7,000.ï¿½ An employer may take a credit
against its FUTA tax liability for contributions to 

a State
unemployment fund and certain other amounts.

Employers
are required to withhold income taxes from wages paid to employees.ï¿½ 

Withholding
rates vary depending on the amount of wages paid, the length of the payroll
period, 

and the
number of withholding allowances claimed by the employee.

Wages
paid to employees, and FICA and income taxes withheld from the wages, are 

required
to be reported on employment tax returns and on Forms W-2. 

Responsibility
for employment tax compliance

Employment
tax responsibility generally rests with the person who is the employer of an 

employee
under a common-law test that has been incorporated into Treasury
regulations.ï¿½ï¿½ 

Under
the regulations, an employer-employee relationship generally exists if the person
for 

whom
services are performed has the right to control and direct the individual who
performs the 

services,
not only as to the result to be accomplished by the work, but also as to the
details and 

means
by which that result is accomplished.ï¿½ That
is, an employee is subject to the will and 

control
of the employer, not only as to what is to be done, but also as to how it is to
be done.ï¿½ It is 

not
necessary that the employer actually control the manner in which the services
are performed, 

rather
it is sufficient that the employer have a right to control.ï¿½ Whether the requisite control 

exists
is determined on the basis of all the relevant facts and circumstances.ï¿½ The test of whether 

an
employer-employee relationship exists often arises in determining whether a
worker is an 

employee
or an independent contractor.ï¿½ However,
the same test applies in determining whether 

a
worker is an employee of one person or another. 

In some
cases, a person other than the common-law employer (a "third party")
may be 

liable
for employment taxes.ï¿½ For example, if
wages are paid to an employee by a third party and 

the
third party, rather than the employer, has control of the payment of the wages,
the third party 

is the
statutory employer responsible for complying with applicable employment tax 

requirements.ï¿½ï¿½ In addition, an employer may designate a
reporting agent to be responsible for 

FICA
tax and income tax withholding compliance,ï¿½
including filing employment tax returns 

and
issuing Forms W-2 to employees.ï¿½ï¿½ In
that case, the reporting agent and the employer are 

jointly
and severally liable for compliance. 

Employee
leasing arrangements

Under
an employee leasing arrangement, a leasing company provides workers
("leased 

employees")
to perform services in the businesses of the leasing company's clients.ï¿½ï¿½ In many 

cases,
before the leasing arrangement is entered into, the leased employees already
work for the 

client's
business as employees of the client.ï¿½
Under the terms of a typical leasing arrangement, 

the
leasing company is assumed to be the employer of the leased employees and is
responsible 

for
paying the leased employees and the related employment tax compliance.ï¿½ The client 

typically
pays the leasing company a fee based on payroll costs plus an additional
amount.ï¿½ï¿½ 

In many
cases, leased employees are legally the employees of the client and the client
is 

legally
responsible for employment tax compliance.ï¿½
Nonetheless, clients generally rely on the 

leasing
company for employment tax compliance (without designating the leasing company
as a 

payroll
agent) and often take the position that the leased employees are employees of
the leasing 

company.

Description
of Proposal

The
proposal contemplates the establishment of standards for holding employee
leasing 

companies
jointly and severally liable with their clients for Federal employment taxes
and for 

holding
employee leasing companies solely liable for such taxes if they meet specified 

requirements.ï¿½ Details of the proposal have not yet been
provided.

Effective
date.-The proposal is effective for employment tax returns filed with respect
to 

wages
paid on or after January 1, 2007.

Analysis

In the
absence of a detailed proposal, the following analysis discusses general issues


relating
to employee leasing companies and employment taxes.

The IRS
estimates that the portion of the 2001 tax gap attributable to FICA and FUTA 

taxes
is $15 billion.ï¿½ï¿½ An additional portion
of the tax gap is attributable to income taxes due on 

unreported
wages.ï¿½ The proposal is aimed at
narrowing the tax gap attributable to employment 

taxes.

In an
employee leasing arrangement, clients typically rely on the leasing company to 

comply
with the applicable employment tax requirements, regardless of whether legal 

responsibility
for employment taxes rests with the leasing company or with the client.ï¿½ In 

addition,
if a leasing company files employment tax returns and pays employment taxes,
absent 

an
audit, the IRS generally has no way of knowing whether the leasing company or
the client is 

the
employer, or even that a leasing arrangement exists.ï¿½ Moreover, in situations in which neither 

the
leasing company nor the client complies with the applicable employment tax
requirements, it 

may be
difficult to determine which party is liable for employment taxes.ï¿½ Uncertainty as to who 

is
liable for employment taxes in an employee leasing arrangement may mean that,
as a practical 

matter,
no one is held liable.ï¿½ Providing clear
rules for determining who is liable for employment 

taxes
in employee leasing arrangements would address those issues and could improve 

compliance.

Some
believe that leasing companies offer a greater likelihood of employment tax 

compliance
than can be expected from clients (particularly clients that are small
businesses) on 

an
individual basis.ï¿½ On the other hand,
the payroll of a leasing company typically includes the 

payroll
for employees leased to many client businesses, as well as payroll for
employees working 

directly
for the leasing company.ï¿½ Accordingly,
failure of a leasing company to comply may 

result
in noncompliance on a larger scale than the level of noncompliance that would
otherwise 

occur
among client businesses.ï¿½ Rules for
holding leasing companies solely liable for 

employment
taxes should therefore include adequate standards and procedural safeguards to 

assure
that the leasing company will in fact comply.

Some
argue that existing rules, such as the designated payroll agent rules, are sufficient
to 

permit
leasing companies to assume employment tax responsibility and that the need for
rules 

under
which only the leasing company is liable is really a marketing issue for
leasing companies, 

rather
than a true compliance issue.ï¿½ On the other
hand, leasing companies argue that, in addition 

to
improving employment tax compliance with respect to clients, they also often
provide leased 

employees
with employee benefits that cannot be provided by their smaller clients.

To the
extent that the proposal provides clear standards for determining whether a
leasing 

company,
its clients, or both, are liable for employment taxes, without the need to
determine 

which
is the employer of the leased employees or which has control of the payment of
wages, it 

may
reduce the complexity related to employment tax compliance.ï¿½ On the other hand, allowing 

a
leasing company to be solely liable for employment taxes may require
complicated rules and 

procedures.ï¿½ In addition, employer status is relevant for
employment tax purposes other than 

compliance.ï¿½ For example, employment tax exceptions for
certain services or compensation may 

depend
on the type of employer, such as agricultural employers.ï¿½ In addition, certain aspects of 

the
FUTA rules are based on an employer's liability for contributions to a State
unemployment 

system.ï¿½ï¿½ Similarly, certain income tax credits are
available to employers, such as the credit for 

a
portion of employer social security taxes paid with respect to cash tips.ï¿½ Application of these 

provisions
may therefore be more difficult if a leasing company is the person handling 

employment
tax compliance rather than the client businesses.

Prior
Action

No
prior action.

2.ï¿½ï¿½ï¿½ï¿½ï¿½ Increased information reporting on payment
card transactions

Present
Law

Present
law imposes a variety of information reporting requirements that enable the IRS


to
verify the correctness of taxpayers' returns.ï¿½
For example, every person engaged in a trade or 

business
generally is required to file information returns for each calendar year for
payments of 

$600 or
more made in the course of the payor's trade or business.ï¿½ï¿½ By regulation, payments to 

corporations
generally are excepted from this requirement.ï¿½
Certain payments subject to 

information
reporting also are subject to backup withholding if the payee has not provided
a 

valid
taxpayer identification number ("TIN"), or if the IRS determines that
there has been payee 

underreporting
and notice has been provided to the taxpayer with respect to that
underreporting.ï¿½ 

Description
of Proposal

The
proposal provides the Secretary with authority to promulgate regulations
requiring 

issuers
of credit cards and debit cards to report to the IRS annually the aggregate
reimbursement 

payments
made to merchants in a calendar year.ï¿½
The proposal also requires backup withholding 

on
reimbursement payments made to merchants in the event that a merchant payee
fails to 

provide
a TIN, if the IRS notifies the payor that the TIN furnished by the payee is incorrect,
or in 

the
event of payee underreporting.ï¿½ Under
the proposal, the Secretary is expected to exclude 

certain
categories of merchant payees, such as corporations, and certain categories of
payments 

from
the reporting and backup withholding requirements.

Effective
date.-The proposal is effective for payments made by payment card issuers on 

or
after January 1, 2007.

Analysis

Requiring
issuers of payment cards (credit cards and debit cards) to annually report to
the 

IRS the
aggregate reimbursement payments made to merchants, and to impose backup 

withholding
in certain cases on such payments, could be expected to generate additional
positive 

effects
on compliance and IRS collection efforts.ï¿½
In general, income that is subject to 

information
reporting and withholding is less likely to be underreported.ï¿½ In contrast, the absence 

of
information reporting or withholding on many types of payments results in
underreporting and 

contributes
to the tax gap.ï¿½ï¿½ In general, the more
payments to which information reporting 

and/or
withholding applies, the greater improvement in compliance.ï¿½ While some consider it 

inappropriate
to single out payment card reimbursements made to merchants for additional 

information
reporting, others respond that reporting is appropriate in this instance
because of the 

large
amount of income derived by businesses from payment card transactions and
because the 

unreported
income of businesses represents a significant part of the tax gap.ï¿½ Information 

reporting
for payment card reimbursements would also help the IRS focus its audit
resources on 

taxpayers
who are more likely to have unreported income.

Although
the proposal can be expected to increase tax compliance, the extent of the 

increase
will depend on the details of the reporting requirements and any exceptions,
which have 

not yet
been specified.ï¿½ For example, the
proposal is not expected to apply to reimbursement 

payments
to corporations, which suggests that it is more likely to apply to payments to
small 

businesses
rather than to larger businesses.ï¿½ Thus,
the proposal could have the effect of 

discouraging
small businesses from accepting payment cards, which could reduce the 

compliance
benefit of the proposal.ï¿½ Moreover, the
proposal does not provide a definition for 

"merchant,"
so issues arise as to the scope of the proposal, for example, whether it
applies to 

service
providers that accept payment cards, as well as to retail businesses.ï¿½ Clarification of these 

issues
is necessary to implement the proposal.ï¿½


Finally,
imposing additional information reporting and withholding requirements will 

increase
the paperwork burden on financial institutions subject to the provision.ï¿½ The extent of 

the
increase in burden and any associated costs will depend on the details of the
proposal.ï¿½ Any 

additional
burden will be lessened to the extent that the proposal relies on existing
information 

gathering
systems.

Prior
Action

No
prior action.

3.ï¿½ï¿½ï¿½ï¿½ï¿½ Increased information reporting for
certain government payments for goods and 

services

Present
Law

Present
law imposes numerous information reporting requirements that enable the 

Internal
Revenue Service ("IRS") to verify the correctness of taxpayers'
returns.ï¿½ For example, 

every
person engaged in a trade or business generally is required to file information
returns for 

each
calendar year for payments of $600 or more made in the course of the payor's
trade or 

business.ï¿½ï¿½ By regulation, payments to corporations
generally are excepted from this 


requirement.ï¿½ Certain payments subject to information
reporting also are subject to backup 

withholding
if the payee has not provided a valid taxpayer identification number
("TIN"), or if 

the IRS
determines that there has been payee underreporting and notice has been
provided to the 

taxpayer
with respect to that underreporting.ï¿½
Special information reporting requirements exist 

for
employers required to deduct and withhold tax from employees' income.ï¿½ï¿½ In addition, any 

service
recipient engaged in a trade or business and paying for services is required to
make a 

return
according to regulations when the aggregate of payments is $600 or more. 

Government
entities also are required to make an information return, reporting payments 

for
services to corporations as well as individuals.ï¿½ï¿½ Moreover, the head of every Federal 

executive
agency that enters into certain contracts must file an information return
reporting the 

contractor's
name, address, TIN, date of contract action, amount to be paid to the
contractor, and 

any
other information required by Forms 8596 (Information Return for Federal
Contracts) and 

8596A
(Quarterly Transmittal of Information Returns for Federal Contracts).ï¿½ï¿½ 

Description
of Proposal

The
proposal provides the Secretary with authority to promulgate regulations
requiring 

information
reporting on all non-wage payments by Federal, State and local governments to 

procure
property and services.ï¿½ The proposal
also requires backup withholding on such payments 

in the
event that the payee fails to provide a TIN, or if the IRS notifies the payor
that the TIN 

furnished
by the payee is incorrect, or in the event of payee underreporting.ï¿½ Under the proposal, 

the
Secretary is expected to exclude certain categories of payments from the
information 

reporting
and backup withholding requirements, including payments of interest, payments
for 

real
property, payments to tax-exempt entities or foreign governments,
intergovernmental 

payments,
and payments made pursuant to a classified or confidential contract. 

Effective
date.-The proposal is effective for payments made by Federal, State and local 

governments
to procure property and services on or after January 1, 2007.

Analysis

The
proposal could have a positive impact on compliance with the tax laws by
requiring 

additional
information reporting and backup withholding on certain non-wage payments.ï¿½ In 

general,
the more payments to which information reporting and withholding applies, the
greater 

improvement
in compliance.ï¿½ However, the extent to
which the proposal improves compliance 

depends
on details which have not been specified, such as the scope of payments subject
to the 

proposal
and any exceptions.ï¿½ For example, under
present law, government entities are required 

to
report payments to a service provider when the aggregate of payments to such
service provider 

is $600
or more.ï¿½ The proposal does not specify
whether a similar dollar threshold would apply 

to
payments subject to the reporting requirements.ï¿½ Because the extent to which the proposal 

expands
upon present-law requirements is unclear, it is difficult to fully assess the
relative 

benefits
and detriments of the proposal.ï¿½ 

Imposing
additional information reporting requirements also will impose new costs on 

payors.ï¿½ The extent of any new burden and associated
costs will depend on the details of the 

proposal.ï¿½ In general, new burdens will be lessened to
the extent the proposal relies on 

procedures
already in place.ï¿½ For example, present
law imposes information reporting 

requirements
on governmental entities.ï¿½ Arguably, the
proposal only will require the expansion 

of
existing procedures to satisfy the broader requirements under the proposal, not
the creation of 

wholly
new procedures.ï¿½ Similarly, certain
Federal payments to vendors of goods or services are 

subject
to continuous levy authority under present law.ï¿½ï¿½ Thus, government entities are likely to 

have
existing procedures for deducting and remitting taxes from payments to
businesses and 

individuals
that may be tailored to the specific requirements of the proposal. 

Some
might consider it inappropriate to single out payments by Federal, State and
local 

governments
for additional information reporting, rather than expanding the reporting 

requirements
for all payors.ï¿½ Proponents respond that
additional information reporting is 

appropriate
in this instance because unreported income received by government contractors 

represents
an important part of the tax gap. 

Prior
Action

No prior
action.

4.ï¿½ï¿½ï¿½ Amend collection due process procedures for
employment tax liabilities

Present
Law

Levy is
the IRS's administrative authority to seize a taxpayer's property to pay the 

taxpayer's
tax liability.ï¿½ The IRS is entitled to
seize a taxpayer's property by levy if the Federal 

tax
lien has attached to such property.ï¿½ A
Federal tax lien arises automatically where (1) a tax 

assessment
has been made, (2) the taxpayer has been given notice of the assessment stating
the 

amount
and demanding payment, and (3) the taxpayer has failed to pay the amount
assessed 

within
10 days after the notice and demand.

In
general, the IRS is required to notify taxpayers that they have a right to a
fair and 

impartial
collection due process ("CDP") hearing before levy may be made on any
property or 

right
to property.ï¿½ï¿½ Similar rules apply with
respect to notices of tax liens, although the right to 

a
hearing arises only on the filing of a notice.ï¿½ï¿½ The CDP hearing is held by an impartial officer 

from
the IRS Office of Appeals, who is required to issue a determination with
respect to the 

issues
raised by the taxpayer at the hearing.ï¿½
The taxpayer is entitled to appeal that determination 

to a
court.ï¿½ Under present law, taxpayers are
not entitled to a pre-levy CDP hearing if a levy is 

issued
to collect a Federal tax liability from a State tax refund or if collection of
the Federal tax 

is in
jeopardy.ï¿½ However, levies related to
State tax refunds or jeopardy determinations are 

subject
to post-levy review through the CDP hearing process.

Employment
taxes generally consist of the taxes under the Federal Insurance 

Contributions
Act ("FICA"), the tax under the Federal Unemployment Tax Act
("FUTA"), and 

the
requirement that employers withhold income taxes from wages paid to employees
("income 

tax
withholding").ï¿½ï¿½ï¿½ Income tax
withholding rates vary depending on the amount of wages 

paid,
the length of the payroll period, and the number of withholding allowances
claimed by the 

employee.

Description
of Proposal

Under
the proposal, levies issued to collect Federal employment taxes are excepted
from 

the
pre-levy CDP hearing requirement.ï¿½ Thus,
taxpayers would not have a right to a CDP hearing 

before
a levy is issued to collect employment taxes.ï¿½
As with the current procedures applicable to 

levies
issued to collect a Federal tax liability from State tax refunds, the taxpayer
would be 

provided
an opportunity for a hearing within a reasonable period of time after the
levy.ï¿½ 

Collection
by levy would be allowed to continue during the CDP proceedings.

Effective
date.-The proposal is effective for levies issued on or after January 1, 2007.

Analysis

Congress
enacted the CDP hearing procedures to afford taxpayers adequate notice of 

collection
activity and a meaningful hearing before the IRS deprives them of their
property.ï¿½ By 

permitting
the IRS to seize property prior to the CDP hearing, the proposal may increase
the 

burden
on taxpayers with employment tax liabilities who are legitimately seeking
alternatives to 

IRS
forced collection through levy.ï¿½
Opponents of the proposal argue that if such a taxpayer is 

making
a legitimate effort to resolve a tax liability, and the interests of the United
States are 

adequately
protected, it would be appropriate to preclude enforced collection of the
liability.

On the
other hand, proponents argue that taxpayers frequently abuse the CDP procedures


by
raising frivolous arguments simply for the purpose of delaying or evading
collection of tax.ï¿½ 

Moreover,
proponents argue that the opportunity to delay collection of employment tax
liabilities 

presents
a greater risk to the government than delay may present in other contexts
because 

employment
tax liabilities continue to increase as ongoing wage payments are made to 

employees.ï¿½ In addition, much of an employer's
employment tax liability consists of FICA tax 

and
income tax withheld from employees' wages and held in trust for the government
by the 

employer.ï¿½ Others respond that the opportunity to use the
present-law rules in unintended ways to 

delay
or defeat the collection process is not unique to taxpayers with employment tax
liabilities.ï¿½ 

In
addition, opponents argue that it is unnecessary to provide special rules for
employment tax 

liabilities
because present law permits the IRS to levy property prior to providing the CDP


hearing
if collection of the tax is in jeopardy.ï¿½


Prior
Action

No
prior action.

5.ï¿½ï¿½ï¿½ Expand the signature requirement and penalty
provisions applicable to paid preparers


Present
Law

An
income tax return preparer is defined as any person who prepares for
compensation, 

or who
employs other people to prepare for compensation, all or a substantial portion
of an 

income
tax return or claim for refund.ï¿½ï¿½ Under
present law, the definition of an income tax 

return
preparer does not include a person preparing non-income tax returns, such as
estate and 

gift,
excise, or employment tax returns.

Income
tax return preparers are required to sign and include their taxpayer identification


numbers
on income tax returns and income return-related documents prepared for
compensation.ï¿½ 

Penalties
are imposed on any income tax return preparer who, in connection with the
preparation 

of an
income tax return, fails to (1) furnish a copy of a return or claim for refund
to the taxpayer, 

(2)
sign the return or claim for refund, (3) furnish his or her identifying number,
(4) retain a copy 

of the
completed return or a list of the taxpayers for whom a return was prepared, (5)
file a 

correct
information return, and (6) comply with certain due diligence requirements in 

determining
a taxpayer's eligibility for the earned income credit.ï¿½ï¿½ The penalty is $50 for each 

failure
and the total penalties imposed for any single type of failure for any calendar
year are 

limited
to $25,000.

Under
present law, income tax return preparers also are subject to a penalty of $250
with 

respect
to any return if a portion of an understatement of tax liability is due to a
position for 

which
there was not a realistic possibility of success on the merits, the preparer
knew or 

reasonably
should have known of the position, and the position was not disclosed or was 

frivolous.ï¿½ï¿½ In addition, present law imposes a penalty
on income tax return preparers of $1,000 

with
respect to a tax return if a portion of an understatement of tax liability is
due to a willful 

attempt
to understate liability or to reckless or intentional disregard of rules or
regulations. 

Description
of Proposal

The
proposal expands preparer identification and penalty provisions to non-income
tax 

returns
(such as estate and gift, employment tax, and excise tax returns) and
non-income tax 

return-related
documents prepared for compensation.ï¿½
The proposal also subjects paid preparers 

to
penalties for preparing non-income tax return-related documents that contain
false, 

incomplete,
or misleading information or contain frivolous positions that delay collection.

Effective
date.-The proposal is effective for returns filed on or after January 1, 2007.

Analysis

Penalties
for the failure to comply with tax laws are a necessary component of any tax 

system
if broad compliance is to be expected.ï¿½
The present-law penalties that apply to income tax 

return
preparers serve to establish and validate the standards of behavior set forth
by the tax laws 

themselves,
as well as to prevent specific departures from and enforce such laws.ï¿½ The proposal 

to
expand present-law penalties for income tax return preparers to paid preparers
of all types of 

tax
returns and documents may enhance compliance by imposing on non-income tax
return 

preparers
the same or similar requirements that apply to income tax return
preparers.ï¿½ In addition, 

the
proposal may achieve a measure of uniformity and promote fairness in the tax
system by 

treating
similarly situated individuals in the same manner.ï¿½ However, the extent to which the 

proposal
improves the overall functioning of the tax system depends on details which
have not 

been
specified, such as the definition of a "non-income tax return
preparer" and whether such 

preparers
will be subject to the same standards as income tax return preparers for
purposes of 

imposing
penalties for submitting false, incomplete, misleading, or frivolous returns.

Prior
Action

No
prior action.

 

 

E.ï¿½ï¿½ï¿½ï¿½ï¿½ Strengthen the Financial Integrity of
Unemployment Insurance

1.ï¿½ï¿½ï¿½ Reduce improper benefit payments and tax
avoidance

Present
Law

The
Federal Unemployment Tax Act ("FUTA") imposes a 6.2-percent gross tax
rate on 

the
first $7,000 paid annually by covered employers to each employee.ï¿½ 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.ï¿½ Because all States have
approved programs, 0.8 percent is the Federal tax rate 

that
generally applies.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ Generally,
the more unemployment benefits paid to former 

employees,
the higher the State unemployment tax rates.

The
Office of Child Support Enforcement of the Department of Health and Human 

Services
("HHS") maintains the National Directory of New Hires
("NDNH"), which is a 

database
that contains newly-hired employee data from Form W-4, quarterly wage data from


State
and Federal employment security agencies, and unemployment benefit data from
state 

unemployment
insurance agencies.ï¿½ The NDNH was
created to help state child support 

enforcement
agencies enforce obligations of parents across state lines.

Description
of Proposal

The
proposal provides States with an incentive to recover unemployment benefit 

overpayments,
and delinquent employer taxes.ï¿½ The
proposal allows States to redirect up to five 

percent
of overpayment recoveries to additional enforcement activity.ï¿½ The proposal requires 

States
to impose a 15 percent penalty on recipients of fraudulent overpayments; the
penalty 

would
be used exclusively for additional enforcement activity.

Under
the proposal, States are prohibited from relieving an employer of benefit
charges 

due to
a benefit overpayment if the employer had caused the overpayment.ï¿½ In certain 

circumstances
relating to fraudulent overpayments or delinquent employer taxes, States are 

permitted
to employ private collection agencies to retain a portion (up to 25 percent) of
such 

overpayments
or delinquent taxes collected.ï¿½ In
addition, the proposal provides that the Secretary 

of the
Treasury, upon request of a State, will reduce any income tax refund owed to a
benefit 

recipient
when that recipient owes a benefit overpayment to the requesting State.

The
proposal requires employers to report the starting date of employment for all
new 

hires
to the NDNH.ï¿½ Finally, the proposal
authorizes the Secretary of Labor to waive certain 

requirements
to allow states to conduct Demonstration Projects geared to reemployment of 

individuals
eligible for unemployment benefits.

Effective
date.ï¿½The proposal is effective on the date of enactment.

Analysis

States'
abilities to reduce unemployment benefit overpayments and increase overpayment 

recoveries
are limited by funding.ï¿½ In addition,
the present-law requirement that States redeposit 

recoveries
of overpayments to the Federal Unemployment Insurance Trust Fund creates a 

relative
disincentive for States to increase enforcement activity.ï¿½ Permitting States to redirect five 

percent
of overpayment recoveries to additional enforcement activity provides States
with 

additional
resources to detect and recover overpayments.ï¿½
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.ï¿½ However, the proposal does not provide a
definition of what will be considered 

fraudulent.ï¿½ The lack of a uniform definition of a
fraudulent overpayment may result in disparate 

treatment
of individuals in different States.ï¿½ In
addition, there is a question as to whether the 

Federal
Government can ensure that amounts redirected from the Federal Unemployment 

Insurance
Trust Fund are used exclusively for State enforcement purposes.

The
proposal also prohibits States from relieving employers of benefit charges due
to a 

benefit
overpayment if the employer caused the overpayment.ï¿½ Proponents may argue this will 

decrease
overpayments resulting from employer error.ï¿½
In addition, the proposal ensures that 

employers
with high error rates bear the burden of additional costs associated with such
errors.ï¿½ 

On the
other hand, the proposal does not provide a definition of what will be
considered 

employer
fault.ï¿½ 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.ï¿½ 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.ï¿½ Present
law provides States a limited right of offset 

with
respect to legally enforceable State income tax obligations.ï¿½ Present law also establishes the 

priority
of State income tax obligations relative to other liabilities.ï¿½ 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.ï¿½ Clarification of these issues is necessary to 

implement
this element of the proposal.ï¿½ Finally,
some may question whether it is appropriate to 

provide
States an offset right in non-income tax cases, thus, expanding the
circumstances in 

which
the Federal Government acts a collection agent for the States.

Proponents
may argue that the proposal requiring employers to report the starting date of 

employment
for all new hires to the NDNH will reduce unemployment benefit
overpayments.ï¿½ 

Obtaining
taxpayer data from a centralized source such as the NDNH, rather than from
separate 

State
agencies, should increase the efficiency of enforcement efforts.ï¿½ Some may argue, however, 

that
allowing States to access the NDNH for administering unemployment benefits
extends the 

use of
the database beyond that which was originally intended; to enable state child
support 

enforcement
agencies to be more effective in locating noncustodial parents.ï¿½ 

Prior
Action

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

2.ï¿½ï¿½ï¿½ï¿½ï¿½ Extension of Federal Unemployment Surtax

Present
Law

The
Federal Unemployment Tax Act (FUTA) imposes a 6.2 percent gross tax rate on the


first
$7,000 paid annually by covered employers to each employee.ï¿½ Employers in States with 

programs
approved by the Federal Government and with no delinquent Federal loans may
credit 

5.4
percentage points against the 6.2 percent tax rate, making the minimum, net
Federal 

unemployment
tax rate 0.8 percent.ï¿½ Since all States
have approved programs, 0.8 percent is the 

Federal
tax rate that generally applies.ï¿½ This
Federal revenue finances administration of the 

unemployment
system, half of the Federal-State extended benefits program, and a Federal 

account
for State loans.ï¿½ The States use the
revenue turned back to them by the 5.4 percent credit 

to
finance their regular State programs and half of the Federal-State extended
benefits program.

In
1976, Congress passed a temporary surtax of 0.2 percent of taxable wages to be
added 

to the
permanent FUTA tax rate.ï¿½ Thus, the
current 0.8 percent FUTA tax rate has two 

components:
a permanent tax rate of 0.6 percent, and a temporary surtax rate of 0.2
percent.ï¿½ The 

temporary
surtax subsequently has been extended through 2007.

Description
of Proposal

The
proposal extends the temporary surtax rate through December 31, 2012.

Effective
date.-The proposal is effective for labor performed on or after January 1,
2008.

Analysis

The
proposal reflects the belief that a surtax extension is needed in order to
increase 

funds
for the Federal Unemployment Trust Fund to provide a cushion against future
Trust Fund 

expenditures.ï¿½ The monies retained in the Federal
Unemployment Account of the Federal 

Unemployment
Trust Fund can then be used to make loans to the 53 State Unemployment 

Compensation
benefit accounts as needed.

An
argument against the proposal is that an extension is not necessary at this
time 

because
Federal Unemployment Trust Fund projected revenues are sufficient to cover
projected 

expenditures
for the next several years.ï¿½ Some argue
that the proposal is simply an attempt to 

improve
the unified Federal budget by collecting the surtax for five additional
years.ï¿½ 

Prior
Action

No
prior action.

 

 

 

VII.ï¿½  MODIFY ENERGY POLICY ACT OF 2005

A.ï¿½ï¿½ï¿½ Repeal Temporary 15-Year Recovery Period for
Natural Gas Distribution Lines

Present
Law

The
applicable recovery period for assets placed in service under the Modified 

Accelerated
Cost Recovery System is based on the "class life of the
property."ï¿½ Except where 

provided
specifically by statute, the class lives of assets placed in service after 1986
are generally 

set
forth in Revenue Procedure 87-56.ï¿½ï¿½ In
the Revenue Procedure, natural gas distribution 

pipelines
are assigned a 20-year recovery period and a class life of 35 years.ï¿½ However, natural 

gas distribution
pipelines the original use of which commences with the taxpayer after April 11,


2005,
and which are placed in service before January 1, 2011 are assigned a statutory
15-year 

recovery
period. 

Description
of Proposal

Under
the proposal, the temporary 15-year recovery period for natural gas
distribution 

lines
is repealed for property placed in service after December 31, 2006.ï¿½ Thus, under the 

proposal,
all natural gas distribution lines placed in service after December 31, 2006
are assigned 

a
recovery period of 20 years and a class life of 35 years. 

Analysis

The
temporary reduced recovery period for natural gas distribution lines under
present 

law
encourages investment in such property by reducing the present-value after-tax
cost of 

investment.ï¿½ In considering the shorter recovery period,
the Senate Committee on Finance and 

the
House Ways and Means Committee each cited an aging energy infrastructure and a
desire to 

encourage
investment in energy property:

"The
Committee recognizes the importance of modernizing our aging energy 

infrastructure
to meet the demands of the twenty-first century, and the Committee also 

recognizes
that both short-term and long-term solutions are required to meet this 

challenge.ï¿½ The Committee understands that investment in
our energy infrastructure has 

not
kept pace with the nation's needs.ï¿½ In
light of this, the Committee believes it is 

appropriate
to reduce the recovery period for investment in certain energy infrastructure 

property
to encourage investment in such property." 

However,
supporters of the proposal to repeal the reduced recovery period argue that the


nation's
energy policy should be focused not just on modernization but on increased
energy 

supply,
and that incentives for investment should therefore be offered to suppliers
rather than 

distributors.ï¿½ï¿½ This argument suggests that the reduced
recovery period should be repealed in 

favor
of incentives for energy production and energy efficiency.

Proponents
also argue that the shorter recovery period unfairly benefits gas utilities
over 

competitors
such as electric utilities.ï¿½ï¿½ This
argument raises two primary questions.ï¿½
The first 

question
is whether it is accurate that the 15-year and 20-year recovery periods for gas
utilities 

and
electric utilities, respectively, favor investment in gas distribution lines
over electric 

distribution
lines.ï¿½ The second question is, if so,
whether there is a policy justification for doing 

so.

The
first question is one of neutrality, and requires analysis of the economic
lives of the 

properties
whose recovery periods are being compared.ï¿½
Conforming the recovery period of a 

property
as closely as possible to the economic life of the property results in a more
accurate 

measure
of economic income derived from such property.ï¿½
Additionally, to the extent that the 

depreciation
schedules of other property are designed to accurately measure economic 

depreciation,
a depreciation schedule for an asset class that deviates from economic
depreciation 

may
distort investment decisions.ï¿½ If the
depreciation schedule provides for faster cost recovery 

than
economic depreciation, an incentive is created to invest in such assets
relative to other 

assets.ï¿½ Similarly, if the depreciation schedule
provides for slower cost recovery than economic 

depreciation,
a disincentive to invest in such assets is created.ï¿½ If the depreciation schedules 

uniformly
match economic depreciation, the depreciation system will be generally neutral
as to 

the choice
of investment across asset classes.ï¿½
Such neutrality promotes economically efficient 

investment
choices by helping to insure that investments with the highest post-tax return
(the 

return
that the investor cares about) are also those with the highest pre-tax return
(the measure of 

the
value of the investment to society).ï¿½
Thus, the 15-year recovery period for gas distribution 

lines
creates an advantage for gas distributors over electric utilities only if it is
shorter than the 

economic
life of the gas distribution lines to a greater degree than the 20-year
recovery period for 

electric
utility lines is shorter than their economic life.ï¿½ 

The
relationship between the economic lives of gas distribution lines and electric
utility 

lines
is unclear and would require an empirical study to determine.ï¿½ As part of the Tax and Trade 

Relief
Extension Act of 1998,ï¿½ Congress
directed the Secretary of the Treasury to conduct a 

study
of recovery periods and depreciation methods, in part due to concerns that
present-law 

depreciation
rules may create competitive disadvantages such as the one which could be
asserted 

with
respect to gas and electric utilities.ï¿½ï¿½
In the resulting report, Treasury cited time, cost, and 

difficulty
as reasons not to address the recovery periods of specific assets as part of a
study of the 

overall
depreciation system:

"Resolution
of the issue of how well the current recovery periods and methods 

reflect
useful lives and economic depreciation rates would involve detailed empirical 

studies
and years of analysis.ï¿½ In addition, the
data required for this analysis would be 

costly
and difficult to obtain." 

While
the time, cost, and difficulty of empirically studying the economic lives of
all 

assets
makes doing so impractical, addressing individual assets such as those used in
the electric 

and gas
utility industries would be feasible.ï¿½ï¿½ 

The
question of whether a policy justification exists for providing an incentive to
invest 

in gas
distribution lines rather than electric utility lines is primarily one of
efficiency.ï¿½ On one 

hand,
it could be argued that such an incentive is inappropriate policy because it
reduces the 

efficiency
of the market, making it less likely to steer consumption decisions toward the
least 

expensive
energy sources.ï¿½ However, it could also
be argued that an incentive to invest in gas 

distribution
lines overcomes an existing market inefficiency.ï¿½ While certain household appliances 

and
systems can be operated using gas or electric energy, many others require only
electricity 

(e.g.,
a microwave oven).ï¿½ Thus, electric
utilities are likely to be offered to every residential 

consumer
while not all of those consumers are also offered the option of natural
gas.ï¿½ An 

incentive
to invest in gas distribution lines may result in more customers having the
option to 

choose
between gas and electric energy, allowing them to efficiently choose household 

appliances
according to cost and performance.ï¿½ This
would also promote increased competition 

among
energy sources, forcing producers and distributors to become more efficient.

Prior
Action

No
prior action.

 

 

B.ï¿½ï¿½ï¿½ Modify Amortization for Certain Geological
and Geophysical Expenditures

Present
Law

Geological
and geophysical expenditures ("G&G costs") are costs incurred by
a taxpayer 

for the
purpose of obtaining and accumulating data that will serve as the basis for the
acquisition 

and
retention of mineral properties by taxpayers exploring for minerals.ï¿½ G&G costs incurred in 

connection
with oil and gas exploration in the United States may be amortized over two
years 

(sec.
167(h)).ï¿½ In the case of property
abandoned during the two year period, no abandonment 

loss
deduction for G&G costs is allowed.ï¿½
G&G costs associated with abandoned property 

continue
to be recovered over the two-year amortization period.

Description
of Proposal

The
proposal establishes a five-year amortization period for G&G costs incurred
in 

connection
with oil and gas exploration in the United States.ï¿½ The five-year amortization period 

applies
even if the property to which the G&G costs relate is abandoned, and any
remaining 

unamortized
G&G costs associated with the abandoned property are recovered over the 

remainder
of the five-year period. 

Effective
date.ï¿½The proposal is effective for G&G costs paid or incurred in taxable
years 

beginning
after December 31, 2006.

Analysis

Prior
to the enactment of the two-year amortization period for G&G costs such
costs were 

treated
as capital expenditures deductible over the useful life of the property to
which they 

related.ï¿½ In the event the G&G costs associated
with a particular area of interest did not result in 

the
acquisition or retention of property, the entire amount of the G&G costs
allocable to the area 

of
interest was deductible as a loss under section 165 for the taxable year in
which such area of 

interest
was abandoned as a potential source of mineral production.

As part
of the Energy Policy Act of 2005, the amortization period for G&G costs was


fixed
at two years, regardless of whether such costs resulted in the acquisition or
abandonment of 

any
property.ï¿½ While this simplified the
process for recovering G&G costs, it also had the result 

of
extending the recovery period for G&G costs associated with abandoned
property.ï¿½ On 

average,
however, the two-year amortization period accelerated the recovery of G&G
costs.ï¿½ 

Having
a more rapid recovery period was intended to foster increased exploration for
sources of 

oil and
natural gas within the United States. 

Extending
the recovery period for domestic G&G costs from two to five years increases


the
after-tax costs associated with oil and gas exploration in the United States
and thus reduces 

the
incentive to engage in such activities. ï¿½Proponents of the proposal believe that high energy 

prices
are already providing sufficient incentives for companies to invest in oil and
gas 

exploration.ï¿½ While a five year amortization period may
more closely match the useful life of 

property
acquired for mineral production as a result of the geological and geophysical 

expenditures,
the longer amortization period also increases the difference between the
assumed 

life of
the asset for tax purposes versus its actual economic life, in cases where property
is 

abandoned.ï¿½ï¿½ï¿½ 

Prior
Action

The Tax
Relief Act of 2005 contains a provision that would require certain large 

integrated
oil companies to amortize their G&G costs over the useful life of the
property to 

which
those costs relate.

 

 

VIII.ï¿½ï¿½ï¿½ï¿½ï¿½ EXPIRING PROVISIONS

A.ï¿½ï¿½ï¿½ Extend Alternative Minimum Tax Relief for
Individuals

Present
Law

The
alternative minimum tax is the amount by which the tentative minimum tax
exceeds 

the
regular income tax.ï¿½ An individual's
tentative minimum tax is the sum of (1) 26 percent of so 

much of
the taxable excess as does not exceed $175,000 ($87,500 in the case of a
married 

individual
filing a separate return) and (2) 28 percent of the remaining taxable
excess.ï¿½ The 

taxable
excess is so much of the alternative minimum taxable income ("AMTI")
as exceeds the 

exemption
amount.ï¿½ The maximum tax rates on net
capital gain and dividends used in computing 

the
regular tax are used in computing the tentative minimum tax.ï¿½ AMTI is the individual's 

taxable
income adjusted to take account of specified preferences and adjustments.

The
exemption amount is: (1) $45,000 ($58,000 for taxable years beginning after
2002 

and
before 2006) in the case of married individuals filing a joint return and
surviving spouses; 

(2) $33,750
($40,250 for taxable years beginning before 2006) in the case of other
unmarried 

individuals;
(3) $22,500 ($29,000 for taxable years beginning after 2002 and before 2006) in
the 

case of
married individuals filing a separate return; and (4) $22,500 in the case of an
estate or 

trust.ï¿½ The exemption amount is phased out by an
amount equal to 25 percent of the amount by 

which
the individual's AMTI exceeds (1) $150,000 in the case of married individuals
filing a 

joint
return and surviving spouses, (2) $112,500 in the case of other unmarried
individuals, and 

(3)
$75,000 in the case of married individuals filing separate returns, an estate,
or a trust.ï¿½ These 

amounts
are not indexed for inflation.

Present
law provides for certain nonrefundable personal tax credits (i.e., the
dependent 

care
credit, the credit for the elderly and disabled, the adoption credit, the child
tax credit, the 

credit
for interest on certain home mortgages, the HOPE Scholarship and Lifetime
Learning 

credits,
the credit for savers, the credit for certain nonbusiness energy property, the
credit for 

residential
energy efficient property, and the D.C. first-time homebuyer credit).ï¿½ï¿½ In addition, the 

Energy
Tax Incentives Act of 2005 enacted, effective for 2006, nonrefundable tax
credits for 

alternative
motor vehicles, and alternative motor vehicle refueling property. 

For
taxable years beginning in 2005, the nonrefundable personal credits are allowed
to 

the
extent of the full amount of the individual's regular tax and alternative
minimum tax.

For
taxable years beginning after 2005, the nonrefundable personal credits (other
than the 

adoption
credit, child credit and saver's credit) are allowed only to the extent that
the individual's 

regular
income tax liability exceeds the individual's tentative minimum tax, determined
without 

regard
to the minimum tax foreign tax credit.ï¿½
The adoption credit, child credit, and saver's credit 

are
allowed to the full extent of the individual's regular tax and alternative minimum
tax.ï¿½ï¿½ 

Description
of Proposal 

The
proposal extends the higher individual AMT exemption amounts ($58,000, $40,250,


and
$29,000) through 2006.

For
2006, the proposal allows an individual to offset the entire regular tax
liability and 

alternative
minimum tax liability by the nonrefundable personal credits.

Effective
date.ï¿½The proposal is effective for taxable years beginning in 2006.

Analysis

Allowing
the nonrefundable personal credits to offset the regular tax and alternative 

minimum
tax, and increasing the exemption amounts results in significant
simplification.ï¿½ 

Substantially
fewer taxpayers need to complete the alternative minimum tax form (Form 6251), 

and the
forms and worksheets relating to the various credits can be simplified. 

Congress,
in legislation relating to expiring provisions in recent years, has determined 

that
allowing these credits to fully offset the regular tax and alternative minimum
tax does not 

undermine
the policy of the individual alternative minimum tax and promotes the important


social
policies underlying each of the credits.

Congress
also has temporarily increased the exemption amount in recent years to limit 

the
impact of the AMT.

The
following example compares the effect of not extending minimum tax relief with
the 

effect
of the proposal extending minimum tax relief:

Example.ï¿½Assume
in 2006, a married couple has an adjusted gross income of $80,000, 

they do
not itemize deductions, and they have four dependent children, two of whom are
eligible 

for the
child tax credit and two of whom are eligible for a combined $3,000 HOPE
Scholarship 

credit.ï¿½ The couple's net tax liability (without and
with an extension) is shown in Table 1.

 

Table
1.ï¿½Comparison of Individual Tax Liability, Without 

and
With Extension of Rules, 2006

 

 

Present
Law 

(Without


Extension)

Proposal


(With 

Extension)


Adjusted
gross income

$80,000

$80,000

Less
standard deduction1

10,300

10,300

Less
personal exemptions (6 @ $3,300)

19,800

19,800

Taxable
income

49,900

49,900

Regular
tax

6,730

6,730

Tentative
minimum tax

9,100

5,720

HOPE
Scholarship credit before tax limitation

3,000

3,000

HOPE
credit after tax limitation

0

3,000

Child
tax credit

2,000

2,000

Net tax
(greater of tentative minimum tax or 

regular
tax, less allowable credits)

ï¿½ï¿½ï¿½ï¿½ï¿½ 7,100

ï¿½ï¿½ï¿½ï¿½ï¿½ 1,730

Net tax
reduction due to extension of provisions

 

5,370

ï¿½

1ï¿½ This example assumes the taxpayers claim the
standard deduction and have no itemized 

ï¿½ï¿½ï¿½ï¿½ï¿½ deductions (other than taxes and miscellaneous
itemized deductions).

Prior
Action

A
similar proposal was included in the President's fiscal year 2004 and 2005
budget 

proposals.

H.R.
4297, as passed by the House (the "Tax Relief Extension Reconciliation Act
of 

2005")
and H.R. 4297, as amended by the Senate (the "Tax Relief Act of
2005"), both extend the 

use of
the nonrefundable personal credits against the AMT for 2006.

H.R.
4096, as passed by the House (the "Stealth Tax Act of 2005"), extends
the 2005 

AMT
exemption amounts for 2006 and indexes the amounts for inflation.ï¿½ H.R. 4297, as 

amended
by the Senate (the "Tax Relief Act of 2005"), increases the AMT
exemption amounts 

for
2006 to $62,550 for joint returns, to $42,500 for unmarried taxpayers, and to
$31,275 for 

separate
returns.

 

 

 

 

B.ï¿½ï¿½ï¿½ï¿½ï¿½ Permanently Extend the Research and
Experimentation 

("R&E")
Tax Credit

Present
Law

General
rule

Prior
to January 1, 2006, a taxpayer could claim a research credit equal to 20
percent of 

the
amount by which the taxpayer's qualified research expenses for a taxable year
exceeded its 

base
amount for that year.ï¿½ï¿½ Thus, the
research credit was generally available with respect to 

incremental
increases in qualified research.

A
20-percent research tax credit was also available with respect to the excess of
(1) 100 

percent
of corporate cash expenses (including grants or contributions) paid for basic
research 

conducted
by universities (and certain nonprofit scientific research organizations) over
(2) the 

sum of
(a) the greater of two minimum basic research floors plus (b) an amount
reflecting any 

decrease
in nonresearch giving to universities by the corporation as compared to such
giving 

during
a fixed-base period, as adjusted for inflation.ï¿½ This separate credit computation was 


commonly
referred to as the university basic research credit (see sec. 41(e)).

Finally,
a research credit was available for a taxpayer's expenditures on research 

undertaken
by an energy research consortium.ï¿½ This
separate credit computation was commonly 

referred
to as the energy research credit.ï¿½
Unlike the other research credits, the energy research 

credit
applied to all qualified expenditures, not just those in excess of a base
amount.

The
research credit, including the university basic research credit and the energy
research 

credit,
expired on December 31, 2005. 

Computation
of allowable credit

Except
for energy research payments and certain university basic research payments 

made by
corporations, the research tax credit applied only to the extent that the
taxpayer's 

qualified
research expenses for the current taxable year exceeded its base amount.ï¿½ The base 

amount
for the current year generally was computed by multiplying the taxpayer's
fixed-base 

percentage
by the average amount of the taxpayer's gross receipts for the four preceding
years.ï¿½ 

If a
taxpayer both incurred qualified research expenses and had gross receipts
during each of at 

least
three years from 1984 through 1988, then its fixed-base percentage was the
ratio that its 

total
qualified research expenses for the 1984-1988 period bore to its total gross
receipts for that 

period
(subject to a maximum fixed-base percentage of 16 percent).ï¿½ All other taxpayers (so-

called
start-up firms) were assigned a fixed-base percentage of three percent.ï¿½ï¿½ 

In
computing the credit, a taxpayer's base amount could not be less than 50
percent of its 

current-year
qualified research expenses.

To
prevent artificial increases in research expenditures by shifting expenditures
among 

commonly
controlled or otherwise related entities, a special aggregation rule provided
that all 

members
of the same controlled group of corporations were treated as a single taxpayer
(sec. 

41(f)(1)).ï¿½ Under regulations prescribed by the
Secretary, special rules applied for computing the 

credit
when a major portion of a trade or business (or unit thereof) changed hands,
under which 

qualified
research expenses and gross receipts for periods prior to the change of
ownership of a 

trade
or business were treated as transferred with the trade or business that gave
rise to those 

expenses
and receipts for purposes of recomputing a taxpayer's fixed-base percentage
(sec. 

41(f)(3)).

Alternative
incremental research credit regime

Taxpayers
were allowed to elect an alternative incremental research credit regime.ï¿½ï¿½ If a 

taxpayer
elected to be subject to this alternative regime, the taxpayer was assigned a
three-tiered 

fixed-base
percentage (that is lower than the fixed-base percentage otherwise applicable under


present
law) and the credit rate likewise was reduced.ï¿½
Under the alternative incremental credit 

regime,
a credit rate of 2.65 percent applied to the extent that a taxpayer's
current-year research 

expenses
exceeded a base amount computed by using a fixed-base percentage of one percent


(i.e.,
the base amount equaled one percent of the taxpayer's average gross receipts
for the four 

preceding
years) but did not exceed a base amount computed by using a fixed-base
percentage of 

1.5
percent.ï¿½ A credit rate of 3.2 percent
applied to the extent that a taxpayer's current-year 

research
expenses exceeded a base amount computed by using a fixed-base percentage of
1.5 

percent
but did not exceed a base amount computed by using a fixed-base percentage of
two 

percent.ï¿½ A credit rate of 3.75 percent applied to the
extent that a taxpayer's current-year research 

expenses
exceeded a base amount computed by using a fixed-base percentage of two
percent.ï¿½ 

An
election to be subject to this alternative incremental credit regime could be
made for any 

taxable
year beginning after June 30, 1996, and such an election applied to that
taxable year and 

all
subsequent years unless revoked with the consent of the Secretary of the
Treasury.

Eligible
expenses

Qualified
research expenses eligible for the research tax credit consisted of:ï¿½ (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).ï¿½ï¿½ Notwithstanding the limitation for 

contract
research expenses, qualified research expenses included 100 percent of amounts
paid or 

incurred
by the taxpayer to an eligible small business, university, or Federal
laboratory for 

qualified
energy research.

To be
eligible for the credit, the research did not only have to satisfy the
requirements of 

present-law
section 174 (described below) but also had to be undertaken for the purpose of 

discovering
information that is technological in nature, the application of which was
intended to 

be
useful in the development of a new or improved business component of the
taxpayer, and 

substantially
all of the activities of which had to constitute elements of a process of 

experimentation
for functional aspects, performance, reliability, or quality of a business 

component.ï¿½ Research did not qualify for the credit if
substantially all of the activities related to 

style,
taste, cosmetic, or seasonal design factors (sec. 41(d)(3)).ï¿½ In addition, research did not 

qualify
for the credit:ï¿½ (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)).ï¿½ Research did not qualify for the credit if
it was conducted outside the United States, 

Puerto
Rico, or any U.S. possession.

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.ï¿½ï¿½ While the research credit 

was in
effect, however, deductions allowed to a taxpayer under section 174 (or any
other section) 

were
reduced by an amount equal to 100 percent of the taxpayer's research tax credit
determined 

for the
taxable year (Sec. 280C(c)).ï¿½ Taxpayers
could alternatively elect to claim a reduced 

research
tax credit amount (13 percent) under section 41 in lieu of reducing deductions
otherwise 

allowed
(sec. 280C(c)(3)).

Description
of Proposal

The
research tax credit, excluding the energy research credit, is made permanent.

Effective
date.ï¿½The proposal is effective for amounts paid or incurred after December 31,


2005. 

Analysis

Overview

Technological
development is an important component of economic growth.ï¿½ 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.ï¿½ 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.ï¿½ This is because 

costly
scientific and technological advances made by one firm are cheaply copied by
its 

competitors.ï¿½ Research is one of the areas where there is
a consensus among economists that 

government
intervention in the marketplace can improve overall economic efficiency.ï¿½ï¿½ 

However,
this does not mean that increased tax benefits or more government spending for 

research
always will improve economic efficiency.ï¿½
It is possible to decrease economic 

efficiency
by spending too much on research.ï¿½
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.ï¿½ï¿½ Nevertheless, even if there were agreement
that additional subsidies for research 

are
warranted as a general matter, misallocation of research dollars across
competing sectors of 

the
economy could diminish economic efficiency. It is difficult to determine
whether, at the 

present
levels and allocation of government subsidies for research, further government
spending 

on research
or additional tax benefits for research would increase or decrease overall
economic 

efficiency.ï¿½ï¿½ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ However, the pre-2006 

research
credit did create certain complexities and compliance costs.

Scope
of research activities in the United States and abroad

In the
United States, private for-profit enterprises and individuals, non-profit 

organizations,
and the public sector undertake research activities.ï¿½ Total expenditures on research 

and
development in the United States are large, representing 2.6 percent of gross
domestic 

product
in 2003.ï¿½ï¿½ 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.ï¿½ See Figure 

1,
below.ï¿½ In 2003, expenditures on
research and development in the United States represented 

42.1
percent of all expenditures on research and development undertaken by OECD
countries, 

were 37
percent greater than the total expenditures on research and development
undertaken in 

the
European Union, and were more than two and one half times such expenditures in
Japan.ï¿½ï¿½ 

Expenditures
on research and development in the United States have grown at an average real 

rate of
2.7 percent over the period 1995-2003.ï¿½
This rate of growth has exceeded that of France 

(1.5
percent) and the United Kingdom (2.4 percent), and equaled that of Japan (2.7
percent), but 

is less
than that of Germany (2.9 percent), Italy (3.8 percent for the period
1995-2002), Canada 

(5.0
percent), Ireland (6.7 percent for the period 1995-2002), and Spain (7.4
percent).ï¿½ï¿½ 

 

ï¿½

Source:
OECD, OECD Science, Technology and Industry Scoreboard, 2005.

Direct
expenditures are not the only means by which governments subsidize research 

activities.ï¿½ A number of countries, in addition to the
United States, provide tax benefits to 

taxpayers
who undertake research activities.ï¿½ The
OECD has attempted to quantify the relative 

value
of such tax benefits in different countries by creating an index that measures
the total value 

of tax
benefits accorded research activities relative to simply permitting the
expensing of all 

qualifying
research expenditures.ï¿½ Table 2 below,
reports the value of this index for selected 

countries.ï¿½ A value of zero would result if the only tax
benefit a country offered to research 

activities
was the expensing of all qualifying research expenditures.ï¿½ Negative values reflect tax 

benefits
less generous than expensing.ï¿½ Positive
values reflect tax benefits more generous than 

expensing.ï¿½ For example, in 2004 in the United States
qualifying taxpayers could expense 

research
expenditures and, in certain circumstances claim the research and
experimentation tax 

credit.ï¿½ The resulting index number for the United
States is 0.066. 

Table
2.-Index Number of Tax Benefits for Research Activities 

in
Selected Countries, 2005

Country

Index
Number1

Italy

ï¿½ï¿½ï¿½ï¿½ï¿½ -0.027

Germany

ï¿½ï¿½ï¿½ï¿½ï¿½ -0.024

Ireland

ï¿½ï¿½ï¿½ï¿½ï¿½ 0.049

United
States

ï¿½ï¿½ï¿½ï¿½ï¿½ 0.066

United
Kingdom

ï¿½ï¿½ï¿½ï¿½ï¿½ 0.096

France

ï¿½ï¿½ï¿½ï¿½ï¿½ 0.134

Japan

ï¿½ï¿½ï¿½ï¿½ï¿½ 0.135

Canada

ï¿½ï¿½ï¿½ï¿½ï¿½ 0.173

Spain

ï¿½ï¿½ï¿½ï¿½ï¿½ 0.441

1ï¿½ Index number reported is only that for
"large firms."ï¿½ Some countries
have additional tax 

benefits
for research activities of "small" firms.

Source:
OECD, OECD Science, Technology and Industry Scoreboard, 2005.

The
scope of tax expenditures on research activities before the expiration of the
research 

credit

The tax
expenditure related to the research and experimentation tax credit is estimated
to 

be $4.8
billion for 2005.ï¿½ 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.ï¿½ï¿½ As 

noted
above, the Federal Government also directly subsidizes research
activities.ï¿½ Direct 

government
outlays for research have substantially exceeded the annual estimated value of
the 

tax
expenditure provided by either the research and experimentation tax credit or
the expensing 

of
research and development expenditures.ï¿½
For example, in fiscal 2005, the National Science 

Foundation
made $3.9 billion in grants, subsidies, and contributions to research
activities, the 

Department
of Defense financed $11.8 billionï¿½ in
basic research, applied research, and 

advanced
technology development, and the Department of Energy financed $0.7 billion in 

research
in high energy physics, $1.0 billion in basic research in the sciences, $0.6
billion in 

biological
and environmental research, and $226 million for research in advance scientific


computing.ï¿½ï¿½ However, such direct government outlays
generally are for directed research on 

projects
selected by the government.ï¿½ The
research credit provides a subsidy to any qualified 

project
of an eligible taxpayer with no application to a grant-making agency
required.ï¿½ Projects 

are
chosen based on the taxpayer's assessment of future profit potential.

Table 3
and Table 4 present data for 2003 on those industries that utilized the
research tax 

credit
and the distribution of the credit claimants by firm size.ï¿½ In 2003, more than 15,500 

taxpayers
claimed more than $5.7 billion in research tax credits.ï¿½ï¿½ Taxpayers whose primary 

activity
is manufacturing claimed just over two-thirds of the research tax credits
claimed.ï¿½ Firms 

with
assets of $50 million or more claimed nearly 85 percent of the credits
claimed.ï¿½ 

Nevertheless,
as Table 3 documents, a large number of small firms are engaged in research and


were
able to claim the research tax credit.

 

 

Table
3.ï¿½Percentage Distribution of Firms Claiming Research Tax Credit 

and
Percentage of Credit Claimed by Sector, 2003

Industry

Percent
of 

Corporations


Claiming
Credit

Percent
of 

Total 

R &
E Credit

Manufacturing

47.65

68.92

Information

7.79

11.56

Professional,
Scientific, and Technical 

Services

30.61

10.21

Wholesale
Trade

4.18

3.03

Finance
and Insurance

2.05

1.73

Holding
Companies

0.91

1.71

Retail
Trade


1.26

0.66

Administrative
and Support and Waste 

Management
and Remediation Services

0.57

0.55

Health
Care and Social Services

0.43

0.52

Mining

0.15

0.32

Construction

0.20

0.20

Utilities

3.08

0.11

Agriculture,
Forestry, Fishing and Hunting

0.43

0.09

Other
Services

0.29

0.02

Arts,
Entertainment, and Recreation

(1)

(1)

Accommodation
and Food Services

(1)

(1)

Educational
Services

(1)

(1)

Real
Estate and Rental and Leasing

(1)

(1)

Transportation
and Warehousing

(1)

(1)

Wholesale
and Retail Trade not Allocable

(1)

(1)

Not
Allocable

(1)

(1)

1ï¿½ Data undisclosed to protect taxpayer
confidentiality. 

ï¿½

Source:ï¿½ Joint Committee on Taxation calculations
from Internal Revenue Service, Statistics of Income data.

Table
4.ï¿½Percentage Distribution of Firms Claiming Research Tax Credit 

and of
Amount of Credit Claimed by Firm Size, 2002

Asset
Size ($)

Percent
of Firms 

Claiming
Credit

Percent
of 

Credit
Claimed

0

1.27

0.29

1 to
99,999

17.58

0.36

100,000
to 249,999

4.85

0.22

250,000
to 499,999

2.70

0.22

500,000
to 999,999

7.61

0.48

1,000,000
to 9,999,999

34.86

5.48

10,000,000
to 49,999,999

16.51

6.86

50,000,000
+

14.62

85.49

Note:ï¿½ Totals may not add to 100 percent due to
rounding. 

Source:ï¿½ Joint Committee on Taxation calculations
from Internal Revenue Service, Statistics of Income data.

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).ï¿½ 

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.ï¿½ Suppose that the research
cost of investing in each of these projects is 

$100.ï¿½ 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.ï¿½ In the case of Project A, the
credit effectively reduces the cost to $90.ï¿½


This
increases profitability, but does not change behavior with respect to that
project, since it 

would
have been undertaken in any event.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ 

This is
referred to as the credit's base amount.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½
However, in comparing a flat credit to an 

incremental
credit, there are other factors that also deserve consideration.ï¿½ A flat credit generally 

has
lower administrative and compliance costs than does an incremental credit.ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½ï¿½ One way of 

reducing
the price paid by a buyer for a commodity is to grant a tax credit upon
purchase.ï¿½ 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.ï¿½
If the commodity granted a 10-percent tax 

credit
has an elasticity of 0.5, the amount consumed will increase by five
percent.ï¿½ 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.ï¿½ï¿½ 

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.ï¿½ 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.ï¿½
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.ï¿½ï¿½ 

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.ï¿½ Such a learning curve 

might
explain a modest measured behavioral effect.

A more
recent survey of the literature on the effect of the tax credit suggests a
stronger 

behavioral
response, although most analysts agree that there is substantial uncertainty in
these 

estimates.

[W]ork
using US firm-level data all reaches the same conclusion:ï¿½ the tax price 

elasticity
of total R&D spending during the 1980s is on the order of unity, maybe 

higher.
ï¿½ï¿½ Thus there is little doubt about the
story that the firm-level publicly 

reported
R&D data tell:ï¿½ the R&D tax
credit produces roughly a dollar-for-dollar 

increase
in reported R&D spending on the margin.ï¿½ï¿½


However
this survey notes that most of this evidence is not drawn directly from tax
data.ï¿½ 

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.ï¿½ The 

study
notes that because most studies rely on "reported research
expenditures" that a "relabelling 

problem"
may exist whereby a preferential tax treatment for an activity gives firms an
incentive 

to
classify expenditures as qualifying expenditures.ï¿½ If this occurs, reported expenditures increase 

in
response to the tax incentive by more than the underlying real economic
activity.ï¿½ 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.ï¿½ Research
projects frequently span years.ï¿½ 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.ï¿½ 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.ï¿½ Many firms have
current-year qualified expenditures below the base 

amount.ï¿½ These firms receive no tax credit and have
an effective rate of credit of zero.ï¿½
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.ï¿½
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
pre-2006 law, firms with research expenditures substantially in excess of their


base
amount could be subject to the 50-percent base amount limitation.ï¿½ In general, although 

these
firms received the largest amount of credit when measured as a percentage of
their total 

qualified
research expenses, their marginal effective rate of credit was exactly one half
of the 

statutory
credit rate of 20 percent (i.e., firms subject to the base limitation
effectively are 

governed
by a 10-percent credit rate).

Although
the statutory rate of the research credit was 20 percent, it is likely that the


average
marginal effective rate may be substantially below 20 percent.ï¿½ Reasonable assumptions 

about
the frequency that firms were subject to various limitations discussed above
yield 

estimates
of an average effective rate of credit between 25 and 40 percent below the statutory


rate,
i.e., between 12 and 15 percent. 

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. ï¿½Therefore, if the
research credit were made permanent, increasingly over 

time
there would be a larger number of firms either substantially above or below
their calculated 

base.ï¿½ This could gradually create an undesirable
situation where many firms would receive no 

credit
and have no reasonable prospect of ever receiving a credit, while other firms
would 

receive
large credits (despite the 50-percent base amount limitation).ï¿½ Thus, over time, it can be 

expected
that, for those firms eligible for the credit, the average marginal effective
rate of credit 

would
decline while the revenue cost to the Federal Government increased.

As
explained above, because costly scientific and technological advances made by
one 

firm
may often be cheaply copied by its competitors, research is one of the areas
where there is a 

consensus
among economists that government intervention in the marketplace, such as the 

subsidy
of the research tax credit, can improve overall economic efficiency.ï¿½ This rationale 

suggests
that the problem of a socially inadequate amount of research is not more likely
in some 

industries
than in other industries, but rather it is an economy-wide problem.ï¿½ The basic 

economic
rationale argues that a subsidy to reduce the cost of research should be
equally applied 

across
all sectors.ï¿½ As described above, prior
to the expiration of the research credit, the Energy 

Tax
Incentives Act of 2005 had provided that energy related research undertaken by
certain 

energy
research consortia receive a greater tax subsidy than other research.ï¿½ Some argue that it 

makes
the tax subsidy to research inefficient by biasing the choice of research
projects.ï¿½ They 

argue
that an energy related research project could be funded by the taxpayer in lieu
of some 

other
project that would offer a higher rate of return absent the more favorable tax
credit for the 

energy
related project.ï¿½ In addition, taxpayers
may have an incentive to enter into such research 

consortia
without the additional tax benefit because a research consortia potentially
reduces the 

cost of
all participants by eliminating duplication of effort.ï¿½ Proponents of the differential 

treatment
for energy related research argue that broader policy concerns such as
promoting 

energy
independence justify creating a bias in favor of energy related research.ï¿½ The President's 

budget
proposal would not extend the special energy credit.ï¿½ It would provide that energy related 

research
be treated equivalently to any other proposed research under the tax credit.

Complexity
and the research tax credit

Administrative
and compliance burdens also resulted from the research tax credit.ï¿½ The 

General
Accounting Office ("GAO") has testified that the research tax credit
had been difficult 

for the
IRS to administer.ï¿½ 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.ï¿½ 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.ï¿½ Such audits create a burden for 

both
the IRS and taxpayers.ï¿½ The credit
generally requires taxpayers to maintain records more 

detailed
than those necessary to support the deduction of research expenses under
section 174.ï¿½ï¿½ 

An
executive in a large technology company has identified the research credit as
one of the most 

significant
areas of complexity for his firm.ï¿½ 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. ï¿½ [I]s what the company calls "research and 

development"
the same as the "qualified research" eligible for the R&D tax
credit 

under
I.R.C. Section 41?ï¿½ 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 budget proposals for fiscal years 2003 through 2006 contained an 

identical
provision.

H.R.
4297, as passed by the House (the "Tax Relief Extension Reconciliation Act
of 

2005"),
contains a one year extension of a modified research credit, effective
retroactively to the 

expiration
of the research credit under present law.ï¿½
H.R. 4297, as passed by the Senate ("the Tax 

Relief
Act of 2005"), also contains a two year extension of a modified research
credit.

 

 

C.ï¿½ï¿½ï¿½ 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.ï¿½
The eight targeted groups are: (1) certain 

families
eligible to receive benefits under the Temporary Assistance for Needy Families 

Program;
(2) high-risk youth; (3) qualified ex-felons; (4) vocational rehabilitation
referrals; 

(5)
qualified summer youth employees; (6) qualified veterans; (7) families
receiving food 

stamps;
and (8) persons receiving certain Supplemental Security Income (SSI) benefits.

A
qualified ex-felon is an individual certified as: (1) having been convicted of
a felony 

under
State or Federal law; (2) being a member of an economically disadvantaged
family; and 

(3)
having a hiring date within one year of release from prison or conviction.

The
Katrina Emergency Tax Relief Act of 2005 created a new category of Hurricane 

Katrina
employees and provided special rules for their eligibility.

Qualified
wages

Generally,
qualified wages are defined as cash wages paid by the employer to a member 

of a
targeted group.ï¿½ 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.ï¿½ Therefore, 

the
maximum credit per employee is $2,400 (40 percent of the first $6,000 of
qualified first-year 

wages).ï¿½ 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.ï¿½ Similarly wages paid to
replacement workers during a strike or lockout are not 

eligible
for the work opportunity tax credit.ï¿½
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.ï¿½ The work opportunity tax credit 

generally
is not allowed for wages paid to individuals who had previously been employed
by the 

employer.ï¿½ 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.ï¿½ 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.ï¿½
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.ï¿½ 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.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ The maximum credit is $8,500 per qualified
employee.

Minimum
employment period

No
credit is allowed for qualified wages paid to a member of the targeted group
unless 

they
work at least 400 hours or 180 days in the first year of employment.

Coordination
of the work opportunity tax credit and the welfare-to-work tax credit

An
employer cannot claim the work opportunity tax credit with respect to wages of
any 

employee
on which the employer claims the welfare-to-work tax credit.

Other
rules

The
welfare-to-work tax credit incorporates directly or by reference many of these
other 

rules
contained on the work opportunity tax credit.

Expiration
date

The
welfare-to-work tax credit is effective for wages paid or incurred to a
qualified 

individual
who begins work for an employer before January 1, 2006.

Description
of Proposal

Combined
credit

The
proposal combines the work opportunity and welfare-to-work tax credits and
extends 

the
combined credit for one year.

Targeted
groups eligible for the combined credit

The
combined credit is available for employers hiring individuals from one or more
of all 

nine
targeted groups.ï¿½ The welfare-to-work
credit/long-term family assistance recipient is the 

ninth
targeted group.ï¿½ The special rules for
Hurricane Katrina employees are unchanged by the 

proposal.

The
proposal repeals the requirement that a qualified ex-felon be an individual
certified 

as a
member of an economically disadvantaged family.

Qualified
wages

Qualified
first-year wages for the eight WOTC categories remain capped at $6,000 

($3,000
for qualified summer youth employees).ï¿½
No credit is allowed for second-year wages.ï¿½ 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.ï¿½ For
purposes of the combined credit, qualified wages 

are
defined as cash wages paid by the employer to a member of a targeted group (not
the broader 

WWTC
definition of wages).ï¿½ Also, for all
targeted groups, the employer's deduction for wages 

is
reduced by the amount of the credit.

Calculation
of the credit

First-year
wages.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.ï¿½ 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.ï¿½ 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).ï¿½ 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).ï¿½ 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 necessary once the two credits are combined

Effective
date.ï¿½The proposal is effective for wages paid or incurred to a qualified 

individual
who begins work for an employer after December 31, 2005 and before January 1, 

2007.

Analysis

Overview
of policy issues

The
WOTC and WWTC are intended to increase the employment and earnings of their 

targeted
group members, respectively.ï¿½ The
credits are made available to employers as an 

incentive
to hire members of the targeted groups.ï¿½
To the extent the value of the credits is passed 

on from
employers to employees, the wages of target group employees will be higher than
they 

would
be in the absence of the credit. 

The
rationale for the WOTC and WWTC is that employers will not hire certain 

individuals
without a subsidy, because either the individuals are stigmatized (e.g.,
convicted 

felons)
or the current productivity of the individuals is below the prevailing wage
rate.ï¿½ Where 

particular
groups of individuals suffer reduced evaluations of work potential due to
membership 

in one
of the targeted groups, the credits may provide employers with a monetary
offset for the 

lower
perceived work potential.ï¿½ 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.ï¿½ 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.ï¿½ In these situations, the 

WOTC
and WWTC provides employers with a monetary incentive to bear the costs of
training 

members
of targeted groups and providing them with job-related skills which may
increase the 

chances
of these individuals being hired in unsubsidized jobs.ï¿½ Both situations encourage 

employment
of members of the targeted groups, and may act to increase wages for those
hired as 

a
result of the credit.

As
discussed below, the evidence is mixed on whether the rationales for the WOTC
are 

supported
by economic data.ï¿½ The information
presented is intended to provide a structured way 

to
determine if employers and employees respond to the existence of the WOTC in
the desired 

manner.ï¿½ A similar analysis may be appropriate for
the WWTC.

Efficiency
of the WOTC

The
WOTC provides employers with a subsidy for hiring members of targeted
groups.ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ï¿½ 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.ï¿½ If the wage rate does not 

change
in response to credit eligibility, the WOTC subsidy is larger in percentage
terms for 

lower
wage workers.ï¿½ 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.ï¿½ 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.ï¿½ Increased wages resulting
from the WOTC may be viewed as a partial offset 

to
these high marginal tax rates.ï¿½ 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.ï¿½ This could be accomplished by
firing employees after they earn $6,000 in wages 

and
replacing them with other WOTC-eligible employees.ï¿½ 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.ï¿½
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.ï¿½ To the extent employers substitute
WOTC-eligible individuals for other potential 

workers,
there is no net increase in jobs created.ï¿½
This could be viewed as merely a shift in 

employment
opportunities from one group to another.ï¿½
However, this substitution of credit-

eligible
workers for others may not be socially undesirable.ï¿½ 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.ï¿½ When 

windfall
gains are received, no additional employment has been generated by the
credit.ï¿½ 

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.ï¿½ One study 

indicates
that net new job creation was between five and 30 percent of the total
certifications.ï¿½ 

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.ï¿½
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.ï¿½ Studies 

examining
this issue through the TJTC found that some employers made such efforts, while 

other
employers did little to determine eligibility for the TJTC prior to the
decision to hire an 

individual.ï¿½ï¿½ In these latter cases, the TJTC provided a
cash benefit to the firm, without 

affecting
the decision to hire a particular worker.

Complexity
issues

Extension
of the provisions for one year even in a modified form provides some 

continuity
(especially in the case of the eight WOTC categories) and simplifies tax
planning 

during
that period for taxpayers and practitioners.ï¿½
Some argue that a permanent extension will 

have a
greater stabilizing effect on the tax law.ï¿½
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.ï¿½ Others who are
skeptical of the efficacy of the WOTC and WWTC 

programs
argue that not extending the credits could eliminate a windfall benefit to
certain 

taxpayers
and permanently reduce complexity in the Code.ï¿½ï¿½ 

The
partial combining of the WOTC and the WWTC will provide some simplification 

benefits,
particularly with respect to limiting the WWTC to the WOTC cash-only definition
of 

wages.ï¿½ Allowing the WWTC to use the WOTC minimum
employment periods is likely to 

provide
limited simplification since it expands the eligibility for the WWTC.ï¿½ The failure to fully 

combine
the two credits (e.g., by maintaining the larger cap on eligible first year
wages for the 

WWTC,
and maintaining the second-year benefit under the WWTC) essentially means that
two 

separate
credits remain in effect which limits the simplification benefits under the
proposal.

Prior
Action

Separate
proposals to extend the two credits without combining them were included in 

the
President's fiscal year 2002 and 2003 budget proposals.ï¿½ï¿½ A similar proposal was included 

in the
President's fiscal year 2004, 2005, and 2006 budget proposals.

Similar
provisions are contained in H.R. 4297, "the Tax Relief Extension
Reconciliation 

Act of
2005" as passed by the House and H.R. 4297, the "Tax Relief Act of
2005," as amended 

by the
Senate.

The Tax
Relief Extension Reconciliation Act of 2005 as passed by the House separately 

extends
the work opportunity credit and the welfare-to-work tax credits for one year
(through 

December
31, 2006).ï¿½ Also, the House bill raises
the maximum age limit for the WOTC food 

stamp
recipient category to include individuals who are at least age 18 but under age
35 on the 

hiring
date.

The
"Tax Relief Act of 2005," as amended by the Senate combines the work
opportunity 

and
welfare-to-work tax credits and extends the combined credit for one year.ï¿½ The welfare-to-

work
credit is repealed.ï¿½ The combined credit
is available on an elective basis for employers 

hiring
individuals from one or more of all nine targeted groups.ï¿½ The nine targeted groups are the 

present-law
eight groups with the addition of the welfare-to-work credit/long-term family 

assistance
recipient as the ninth targeted group.ï¿½
Also, the "Tax Relief Act of 2005," as amended 

by the
Senate on February 2, 2006: (1) raises the age limit for the high-risk youth
category to 

include
individuals aged 18 but not aged 40 on the hiring date; (2) renames the
high-risk youth 

category
to be the designated community resident category; (3) repeals the requirement
that a 


qualified
ex-felon be an individual certified as a member of an economically
disadvantaged 

family;
and (4) raises the age limit for the food stamp recipient category to include
individuals 

aged 18
but not aged 40 on the hiring date.

 

 

 

D.ï¿½ï¿½ï¿½ 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.ï¿½ The $5,000 

maximum
credit applies both to individuals and married couples.ï¿½ Married individuals filing 

separately
can claim a maximum credit of $2,500 each.ï¿½
The credit phases out for individual 

taxpayers
with adjusted gross income between $70,000 and $90,000 ($110,000-$130,000 for 

joint
filers).ï¿½ 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.ï¿½ The credit expired 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.ï¿½ 

Effective
date.ï¿½The 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.ï¿½ Recently, home sales in D.C. have reached
record levels, and sales prices have increased.ï¿½ 

However,
this has been equally true in surrounding communities.ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ Favoring home ownership in one area comes at
the expense of home ownership in 

adjacent
areas.ï¿½ 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.ï¿½ï¿½ 

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.ï¿½ï¿½ If a jurisdiction has a low tax rate, 

some
might choose it on that basis.ï¿½ 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.ï¿½ If tax rates are high but
services are not correspondingly high, individuals may 

avoid
such jurisdictions.ï¿½ 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.ï¿½ If a
jurisdiction fails at providing reasonable services at 

reasonable
tax rates, individuals might choose to move to other jurisdictions.ï¿½ 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.ï¿½ 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.ï¿½ Some argue that
the District of Columbia is in this position and 

that it
needs Federal assistance to improve the District's revenue base.ï¿½ An alternative view is 

that
the tax credit could take some of the pressure off the local government to make
necessary 

improvements.ï¿½ 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.ï¿½ For example, some argue that the 

credit
is a means of compensating the District for an artificially restricted tax
base.ï¿½ 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.ï¿½ 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.ï¿½ The Federal 

Government
makes a payment to the District to compensate for the forgone revenues, but
some 

argue
that the payment is insufficient.ï¿½ Some
also argue that to the extent migration from the 

District
is a result of poor services, it is not entirely within the control of the
District to fix such 

problems,
because the District government is not autonomous, but is subject to the
control of 

Congress.

Another
issue regarding the D.C. homebuyer credit is how effectively it achieves its 

objective.ï¿½ Several factors might diminish its
effectiveness.ï¿½ First, the $5,000 will
not reduce the 

net
cost of homes by $5,000.ï¿½ 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.ï¿½ 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.ï¿½ 

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.ï¿½ To the extent that 

they
sell in order to move outside of the District of Columbia, there is no gain in
D.C. residences.ï¿½ 

And, to
the extent that the credit caused home prices to rise, the credit can be seen
as an 

encouragement
to sell a home in the District as much as an encouragement to buy.

Prior
Action

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

budget
proposals. 

H.R.
4297, as passed by the House (the "Tax Relief Extension Reconciliation Act
of 

2005")
and as amended by the Senate (the "Tax Relief Act of 2005"), contains
a similar 

proposal.

 

 

 

 

E.ï¿½ï¿½ï¿½ 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.ï¿½ 

Activities
that can be financed with these tax-exempt bonds include the financing of
public 

schools.ï¿½ï¿½ Issuers must file with the IRS certain
information about the bonds issued by them in 

order
for interest on those bonds issues to be tax-exempt.ï¿½ï¿½ 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.ï¿½ï¿½ 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.ï¿½ï¿½ï¿½ 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").ï¿½
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".ï¿½ï¿½ A total of $400 million of 

qualified
zone academy bonds was authorized to be issued annually in calendar years 1998 

through
2005.ï¿½ The $400 million aggregate bond
cap was allocated each year to the States 

according
to their respective populations of individuals below the poverty line.ï¿½ Each State, in 

turn,
allocated the credit authority to qualified zone academies within such
State.ï¿½ 

Only
certain financial institutions are eligible to hold qualified zone academy
bonds. 

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.ï¿½ A taxpayer 

holding
a qualified zone academy bond on the credit allowance date is entitled to a
credit.ï¿½ The 

credit
is includable in gross income (as if it were a taxable interest payment on the
bond), and 

may be
claimed against regular income tax and alternative minimum tax liability.

The
Treasury Department set the credit rate at a rate estimated to allow issuance
of 

qualified
zone academy bonds without discount and without interest cost to the
issuer.ï¿½ The 

maximum
term of the bond was determined by the Treasury Department, so that the present


value
of the obligation to repay the bond was 50 percent of the face value of the
bond.

"Qualified
zone academy bonds" are defined as any bond issued by a State or local 

government,
provided that (1) at least 95 percent of the proceeds are used for the purpose
of 

renovating,
providing equipment to, developing course materials for use at, or training
teachers 

and
other school personnel in a "qualified zone academy" and (2) private
entities have promised 

to
contribute to the qualified zone academy certain equipment, technical
assistance or training, 

employee
services, or other property or services with a value equal to at least 10
percent of the 

bond
proceeds.

A
school is a "qualified zone academy" if (1) the school is a public
school that provides 

education
and training below the college level, (2) the school operates a special
academic 

program
in cooperation with businesses to enhance the academic curriculum and increase 

graduation
and employment rates, and (3) either (a) the school is located in an
empowerment 

zone or
enterprise community designated under the Code, or (b) it is reasonably
expected that at 

least
35 percent of the students at the school will be eligible for free or
reduced-cost lunches 

under
the school lunch program established under the National School Lunch Act.

Description
of Proposal

The
proposal authorizes issuance of up to $400 million of qualified zone academy
bonds 

in
calendar year 2006.ï¿½ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ This would enable States 

and
local governments to spend the savings on other government functions or to
reduce taxes.ï¿½ï¿½ 

In this
event, the stated objective of the proposal would not be achieved.

Though
called a tax credit, the Federal subsidy for tax credit bonds is equivalent to
the 

Federal
Government directly paying the interest on a taxable bond issue on behalf of
the State or 

local
government that benefits from the bond proceeds.ï¿½ï¿½ To see this, consider any taxable bond 

that
bears an interest rate of 10 percent.ï¿½ A
thousand dollar bond would thus produce an interest 

payment
of $100 annually.ï¿½ The owner of the bond
that receives this payment would receive a 

net
payment of $100 less the taxes owed on that interest.ï¿½ If the taxpayer were in the 28-percent 

Federal
tax bracket, such taxpayer would receive $72 after Federal taxes.ï¿½ Regardless of whether 

the
State government or the Federal Government pays the interest, the taxpayer
receives the 

same
net of tax return of $72.ï¿½ In the case
of tax credit bonds, no formal interest is paid by the 

issuer
or the Federal Government.ï¿½ Rather, a
tax credit of $100 is allowed to be taken by the 

holder
of the bond on its Federal income tax return.ï¿½
In general, a $100 tax credit would be worth 

$100 to
a taxpayer, provided that the taxpayer had at least $100 in tax liability.ï¿½ However, for tax 

credit
bonds, the $100 credit also has to be claimed as income.ï¿½ 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.ï¿½ With the $100 tax credit
that is ultimately claimed, the taxpayer nets 

$72 on
the bond, after taxes.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ The State or local 

government
also would be in the same situation in both cases.

Use of
qualified zone academy bonds to subsidize public school investment raises some 

questions
of administrative efficiencies and tax complexity (see below).ï¿½ Because potential 

purchasers
of the qualified zone academy bonds must educate themselves as to whether the 

bonds
qualify for the credit, certain "information costs" are imposed on
the buyer.ï¿½ 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.ï¿½ 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.ï¿½ For
these reasons, and the fact that tax credit bonds will 

be less
liquid than Treasury securities, the bonds would bear a credit rate that is
equal to a 

measure
of the yield on outstanding corporate bonds.

Qualified
zone academy bonds, unlike interest-bearing State and local bonds, are not 

subject
to the arbitrage or rebate requirements of the Code.ï¿½ The ability to earn and retain 

arbitrage
profits provides an incentive for issuers to issue more bonds and to issue them
earlier 

than
necessary.ï¿½ As a result, there may be
increased delays in the expenditure of bond proceeds 

for
approved purposes in order to earn greater arbitrage profits.ï¿½ï¿½ï¿½ Further, there are transaction 

costs,
such as brokers and investment advisor fees, associated with investing to earn
arbitrage, 

which
diverts funds away from the rehabilitation or repair of a school facility.ï¿½ï¿½ 

On the
other hand, the ability of issuers to invest proceeds at unrestricted yields
and 

retain
the earnings from such investments, increases the subsidy available for
qualified 

expenditures,
as well as the repayment of principal on such bonds, beyond the savings
achieved 

through
having the issuer's interest costs paid by Federal tax credit.ï¿½ Opponents of imposition of 

arbitrage
or rebate requirements argue that such restrictions will decrease the amount of
subsidy 

available
to assist schools with significant needs, but limited means through which to
satisfy 

those
needs.ï¿½ Increasing the subsidy through
permitted arbitrage, however, results in costs to the 

Federal
Government beyond the revenue loss associated with providing Federal tax
credits.ï¿½ The 

lack of
arbitrage restrictions and rebate also results in foregone tax revenues on the
arbitrage 

profits
because the issuing entity is tax-exempt.

The
direct payment of interest by the Federal Government on behalf of States or 

localities,
which was discussed above as being economically the equivalent of the credit 

proposal,
would involve less complexity in administering the income tax, as the interest
could 

simply
be reported as any other taxable interest.ï¿½
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.ï¿½ 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.ï¿½ Certainty that the program would continue at
least temporarily, without further 

interruption
or modification, arguably would facilitate financial planning by taxpayers
during 

that
period.ï¿½ The uncertainty that results
from expiring provisions may adversely affect the 

administration
of and perhaps the level of participation in such provisions.ï¿½ 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.ï¿½
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 qualified zone academy bond issuers.ï¿½ Others respond that the 

permanent
repeal of expiring provisions such as the qualified zone academy bond rules
that are 

inherently
complex would provide the same level of certainty for tax planning purposes as
a 

long-term
or permanent extension, and would further reduce the overall level of
complexity in 

the
Code. ï¿½A 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.ï¿½ On the other hand, it will add to complexity
in that it imposes a requirement not 

previously
applied to qualified zone academy bonds.ï¿½
In addition, the proposal increases the 

paperwork
burden on issuers in that forms must be completed and filed with the IRS.

Prior
Action

Similar
proposals were included in the President's fiscal year 2003, 2004, 2005, and
2006 

budget
proposals.

H.R.
4297, as passed by the House (the "Tax Relief Extension Reconciliation Act
of 

2005"),
authorizes up to $400 million of qualified zone academy bonds for calendar year
2006.ï¿½ï¿½ 

H.R.
4297, as amended by the Senate (the "Tax Relief Act of 2005"),
authorizes up to 

$400
million of qualified zone academy bonds for each of calendar years 2006 and 2007.ï¿½ The 

Tax
Relief Act of 2005 also imposes information reporting requirements for
qualified zone 

academy
bonds, limits acceptable private business contributions to cash or cash
equivalents, 

requires
ratable principal amortization, imposes a five-year expenditure period in which
to spend 

bond
proceeds, and applies the arbitrage rules of section 148 to these bonds.

 

 

 

 

F.ï¿½ï¿½ï¿½ Extend Provisions Permitting Disclosure of
Tax Return 

Information
Relating to Terrorist Activity

Present
Law

In
general

Section
6103 provides that returns and return information are confidential may not be 

disclosed
by the IRS, other Federal employees, State employees, and certain others having
access 

to the
information except as provided in the Internal Revenue Code.ï¿½ï¿½ A "return" is any tax or 

information
return, declaration of estimated tax, or claim for refund required by, or
permitted 

under,
the Internal Revenue Code, that is filed with the Secretary by, on behalf of,
or with 

respect
to any person.ï¿½ï¿½ Return also includes
any amendment or supplement thereto, including 

supporting
schedules, attachments, or lists which are supplemental to, or part of, the
return so 

filed. 

The
definition of "return information" is very broad and includes any
information 

gathered
by the IRS with respect to a person's liability or possible liability under the
Internal 

Revenue
Code.ï¿½ï¿½ "Taxpayer return
information" is a subset of return information. Taxpayer 

return
information is return information filed with or furnished to the IRS by, or on
behalf of, the 

taxpayer
to whom the information relates.ï¿½ For
example, information submitted to the IRS by a 

taxpayer's
accountant on behalf of the taxpayer is "taxpayer return
information."ï¿½ 

Section
6103 contains a number of exceptions to the general rule of confidentiality, 

which
permit disclosure in specifically identified circumstancesï¿½ when certain conditions are 

satisfied.ï¿½ï¿½ One of those exceptions is for the
disclosure of return and return information 

regarding
terrorist activity.

The
Code permits the disclosure of returns and return information for purposes of 

investigating
terrorist incidents, threats, or activities, and for analyzing intelligence
concerning 

terrorist
incidents, threats, or activities.ï¿½ The
term "terrorist incident, threat, or activity" is 

statutorily
defined to mean an incident, threat, or activity involving an act of domestic
terrorism 

or
international terrorism, as both of those terms are defined in the USA PATRIOT
Act. 

Return
information generally is available Federal law enforcement and Federal 

intelligence
agencies upon a written request meeting specific requirements. However, a
return or 

information
submitted to the IRS by the taxpayer or on his behalf may only be obtained
pursuant 

to an
ex parte court order.ï¿½ No disclosures
may be made under this provision after December 31, 

2006.

Disclosure
of return information other than taxpayer return information

Disclosure
by the IRS without a request

The
Code permits the IRS to disclose return information, other than taxpayer return


information,
related to a terrorist incident, threat, or activity to the extent necessary to
apprise the 

head of
the appropriate Federal law enforcement agency responsible for investigating or


responding
to such terrorist incident, threat, or activity.ï¿½ï¿½ï¿½ The IRS on its own initiative and 

without
a written request may make this disclosure.ï¿½
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.ï¿½ 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.ï¿½ï¿½ A taxpayer's
identity is not treated as taxpayer return 

information
for this purpose and may be disclosed under this authority.ï¿½ï¿½ The request must:ï¿½ (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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ï¿½ Use of 

the
information is limited to use by such officers and employees in such
investigation, collection, 

or
analysis.ï¿½ 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.ï¿½ The request is to be made by an individual 

who
is:ï¿½ (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.ï¿½ The
Director of the United States Secret Service also is 

an
authorized requester. 

Disclosure
of returns and return information by ex parte court order 

Ex
parte court orders sought by Federal law enforcement and Federal intelligence 

agencies

In
order to obtain a return or information submitted to the IRS by the taxpayer or
his 

representative,
court approval must be obtained.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ These officers and employees 

are
permitted to use this information solely for their use in the investigation,
response, or 

analysis,
and in any judicial, administrative, or grand jury proceeding, pertaining to
any such 

terrorist
incident, threat, or activity.

The
Attorney General, Deputy Attorney General, Associate Attorney General, an 

Assistant
Attorney General, or a United States attorney, may authorize the application
for the ex 

parte
court order to be submitted to a Federal district court judge or
magistrate.ï¿½ The Federal 

district
court judge or magistrate would grant the order if based on the facts submitted
he or she 

determines
that:ï¿½ (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.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ Further, use of the 

information
is limited to use in a Federal investigation, analysis, or proceeding
concerning a 

terrorist
incident, threat, or activity.ï¿½ 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.

Description
of Proposal

The
proposal extends for one year the disclosure authority relating to terrorist
activities 

(through
December 31, 2007).

Effective
date.ï¿½The 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.ï¿½ï¿½
There has been no study of the effectiveness 

of the
provisions.ï¿½ 

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.ï¿½ï¿½ However, the IRS used its authority to make
disclosures in emergency 

circumstances
to make an additional 12,236 disclosures to the FBI.ï¿½ 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.ï¿½ Pursuant to the ex parte court order
authority, 2,215 disclosures were made to U.S. 

Attorneys
in calendar year 2002.ï¿½ 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.

ï¿½For calendar year 2003, 1,626 disclosures
were made under the terrorist activity 

provisions
governing IRS disclosures to Federal law enforcement.ï¿½ Under the ex parte court 

order
authority, 1,724 disclosures were made to U.S. Attorneys in calendar year
2003.ï¿½ 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.ï¿½ï¿½ 

For
calendar year 2004, the IRS made 883 disclosures to under the provisions
permitting 

disclosure
to Federal law enforcement.ï¿½ Under the
ex parte court order authority, 3,992 

disclosures
were made to U.S. Attorneys in calendar year 2004. Again, for calendar year
2004, 

the IRS
did not report any disclosures to Federal intelligence agencies or in response
to request 

from
Federal law enforcement agencies.ï¿½ï¿½ 

The
fact that the IRS has not reported any responses in connection with requests by


Federal
intelligence agencies and Federal law enforcement, may be an indication that
further 

extension
of those provision is not warranted.ï¿½
However, the data does indicate that the IRS is 

using
its self-initiated disclosure authority and that U.S. Attorneys are taking
advantage of the ex 

parte
court order provision to obtain returns and return information.ï¿½ï¿½ 

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. ï¿½As noted 

above,
the IRS used its emergency disclosure authorization to make disclosures to the
Federal 

Bureau
of Investigation concerning terrorist activity.ï¿½ï¿½ However, the emergency disclosure 

authorization
is to be used under circumstances involving an imminent danger of death or 

physical
injury.ï¿½ 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.ï¿½
Thus, the existence of a specific disclosure 

provision
for terrorist activity information provides clear authority and direction for
making 

disclosures
to combat terrorism.

The
requirements for disclosure of terrorist activity information are not as
stringent as 

those
required for criminal investigations.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ Some argue 

that
the less stringent requirements facilitate a proactive approach to combating
terrorism.

Prior
Action

A
similar proposal was included in the President's fiscal years 2004, 2005, and
2006 

budget
proposals.

 

 

G.ï¿½ï¿½ï¿½ï¿½ï¿½ 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.ï¿½ï¿½ 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.ï¿½ï¿½ The Department 

of
Education disclosure authority is scheduled to expire after December 31,
2006.ï¿½ï¿½ 

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.ï¿½ï¿½ 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.ï¿½ï¿½ The
Department of Treasury has reported that the Internal 

Revenue
Service processes approximately 100,000 consents per year for this
purpose.ï¿½ï¿½ 

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.ï¿½ï¿½ The Higher Education 

Act,
however, did not amend the Code to permit disclosure for this purpose.ï¿½ Therefore, the 

disclosure
provided by the Higher Education Act may not be made unless the taxpayer
consents 

to the
disclosure pursuant to section 6103(c).

The
financial aid application is submitted to the Department of Education and is
then 

given
to a contractor for processing.ï¿½ Based
on the information given, the contractor calculates an 

expected
family contribution that determines the amount of aid a student will
receive.ï¿½ 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.ï¿½ The
applicants must furnish a copy of their tax returns.ï¿½ The 

applicants
are not required to obtain copies of tax returns from the IRS or to produce
certified 

copies.ï¿½ 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.ï¿½


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.ï¿½ 

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.ï¿½
ï¿½To 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.ï¿½ï¿½ Maintaining such records is a prerequisite
to obtaining and continuing to obtain 

returns
and return information.ï¿½ Such agencies
must also establish procedures satisfactory to the 

IRS for
safeguarding the information it receives.ï¿½
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. 

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).ï¿½ 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.ï¿½ 

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.ï¿½ 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.ï¿½ 

Effective
date.ï¿½The 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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ï¿½ï¿½ 

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.ï¿½ 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.ï¿½ 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.ï¿½ 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.ï¿½ 

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.ï¿½
The IRS processes over 100,000 consents 

for
this program.ï¿½ Some might argue that
since the specific statutory authority is not being used, 

it
should not be extended.ï¿½ 

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.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ï¿½ 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
millionsï¿½ 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.ï¿½ On the other
hand, some might argue that since this financial 

information
is already required to be submitted as part of the financial aid form, the
infringement 

on
taxpayer privacy is minimal.

Prior
Action 

Similar
proposals were contained in the President's fiscal year 2003, 2004, 2005, and 

2006
budget proposals.

 

 

H.ï¿½ï¿½ï¿½ 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.ï¿½ The rate is 55
cents per ton on coal sold by the producer from 

surface
mining operations.ï¿½ In either case, the
tax cannot exceed 4.4 percent of the coal 

producer's
selling price.ï¿½ 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.ï¿½ 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.ï¿½ 

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.ï¿½ After repayment of the Trust
Fund's debt, the reduced rates of $.50 per ton for 

coal
from underground mines and $.25 per ton for coal from surface mines would apply
and the 

tax per
ton of coal would be capped at two percent of the amount for which it is sold
by the 

producer.

Effective
date.ï¿½The proposal is effective for coal sales after December 31, 2005.

Analysis

Trust
fund financing of benefits was established in 1977 to reduce reliance on the 

Treasury
and to recover costs from the mining industry.ï¿½
Claims were much more numerous than 

expected
and it was difficult to find responsible operators, litigate their challenges
and collect 

from
them.ï¿½ Therefore, deficits were financed
with interest-bearing advances from the General 

Fund.ï¿½ 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.ï¿½ï¿½ Direct costs (benefits 

and
administration), however, have been less than revenues.ï¿½ According to the Congressional 

Research
Service, if it were not for the interest on the accumulated deficit, the trust
fund would 

be
self-supporting:ï¿½ "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.ï¿½ 

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.ï¿½ 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.ï¿½ï¿½ 

Based
on historical trends, it appears that the trust fund will not be able to pay
off its debt 

by
December 31, 2013.ï¿½ 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.ï¿½ On the other hand, since 

the tax
is not scheduled to be reduced until December 31, 2013, it could be argued that
this 

proposal
to further extend the rates is premature.

Prior
Action

Identical
proposals (except for effective date) were included in the President's fiscal
year 

2005
and 2006 budget proposals.

 

 

I.ï¿½ï¿½ï¿½ï¿½ï¿½ Election to Treat Combat Pay as Earned
Income 

for
Purposes of the Earned Income Credit

Present
Law

In
General

Subject
to certain limitations, military compensation earned by members of the Armed 

Forces
while serving in a combat zone may be excluded from gross income.ï¿½ In addition, for up 

to two
years following service in a combat zone, military personnel may also exclude 

compensation
earned while hospitalized from wounds, disease, or injuries incurred while
serving 

in the
zone.

Child
Credit 

Combat
pay that is otherwise excluded from gross income under section 112 is treated
as 

earned
income which is taken into account in computing taxable income for purposes of 

calculating
the refundable portion of the child credit.

Earned
Income Credit

Any
taxpayer may elect to treat combat pay that is otherwise excluded from gross
income 

under
section 112 as earned income for purposes of the earned income credit.ï¿½ This election is 

available
with respect to any taxable year ending after the date of enactment and before 

January
1, 2007.

Description
of Proposal

The
proposal extends the elections to treat combat pay as earned income for
purposes of 

the
earned income credit for one year (through December 31, 2007).

Effective
date.ï¿½Generally, the proposal would be effective after December 31, 2006.

Analysis

The
exclusion of combat pay from gross income is intended to benefit military
personnel 

serving
in combat. However, to the extent that certain tax benefits, such as the child
credit and 

the
earned income credit, may vary based on taxable or earned income, the exclusion
has the 

potential
to limit the availability of certain refundable tax credits (i.e. the child
credit and the 

earned
income credit).ï¿½ Including combat pay in
gross income for purposes of the refundable 

child
credit is always advantageous to the taxpayer.ï¿½
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 is to ensure that the exclusion of combat
pay from 

gross
income does not result in a net economic detriment through the elimination of
otherwise 

available
refundable credits, an election to include combat pay in income for all Code
purposes 

would
be sufficient to achieve that objective.ï¿½
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.ï¿½ 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.ï¿½ 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.ï¿½ Allowing combat pay to be included in 

earned
income creates an inconsistent treatment between it and other nontaxable
employee 

compensation
and arguably creates inequities between taxpayers who receive combat pay 

compared
to other types of nontaxable compensation.

Prior
Action

A
similar proposal was included in the President's 2006 budget.ï¿½ That proposal extended 

the
earned income credit combat pay election through December 31, 2006, and was
enacted as 

part of
the Gulf Opportunity Zone Act of 2005 (Pub. Law 109-135).

 

 

IX.ï¿½ï¿½ OTHER PROVISIONS MODIFYING THE INTERNAL
REVENUE CODE

A.ï¿½ï¿½ï¿½ï¿½ï¿½ Extension of the Rate of Rum Excise Tax
Cover Over 


to
Puerto Rico and Virgin Islands

Present
Law

A
$13.50 per proof gallonï¿½ excise tax is
imposed on distilled spirits produced in or 

imported
(or brought) into the United States.ï¿½ï¿½
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.ï¿½ï¿½ 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.ï¿½ Tax
amounts attributable to shipments to the United 

States
of rum produced in the Virgin Islands are covered over to the Virgin
Islands.ï¿½ 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.ï¿½ï¿½ 

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.ï¿½ï¿½ All of the amounts covered over 

are
subject to the limitation.

Description
of Proposal

The
proposal extends the $13.25-per-proof-gallon cover over rate for two additional


years,
through December 31, 2007.

Effective
date.ï¿½The 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.ï¿½ Rather than rely on rum 

consumption
in the United States, increased revenue could be achieved by intergovernmental 

support
through a direct appropriation.ï¿½ The
advantage of a direct appropriation is that it provides 

for
annual oversight.ï¿½ Some argue that a
cover over is akin to an entitlement in terms of the 

annual
budget process and making it permanent ensures a steady flow of revenue.ï¿½ Although the 

cover
over may provide a more stable revenue stream, it may be more difficult to
administer than 

a
direct appropriation.ï¿½ 

Prior
Action

The
$13.25 per-proof-gallon cover over rate had been scheduled to expire after 

December
31, 2003.ï¿½ 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.ï¿½ The Working Families
Tax Relief Act of 2004 enacted that 

proposal
into law.ï¿½ï¿½ The President's fiscal year
2006 budget proposal included a proposal that 

extended
the $13.25 per-proof-gallon cover over rate for one additional year, through
December 

31,
2006.ï¿½ H.R. 4388, as passed by the House
(the "Tax Revision Act of 2005"), would extend 

the
$13.25 cover over rate through December 31, 2006.

 

 

B.ï¿½ï¿½ï¿½ï¿½ï¿½ Establish Program of User Fees for Certain
Services Provided to the 

Alcohol
Industry by the Alcohol and Tobacco Tax and Trade Bureau

Present
Law

The
Alcohol and Tobacco Tax and Trade Bureau ("TTB"), under the Secretary
of the 

Treasury,
is responsible for the collection of alcohol, tobacco, firearms, and ammunition
excise 

taxes,
for ensuring that such products are labeled, advertised, and marketed in
accordance with 

the
law, and for administering certain laws and regulations concerning these
products.ï¿½ 

TTB
issues permits to members of the alcohol industry engaged in the business of 

producing
distilled spirits or wine, or importing or wholesaling distilled spirits, wine,
or malt 

beverages.ï¿½ï¿½ In addition, bottlers and importers of
these alcoholic beverages must obtain a 

certificate
of label approval from TTB prior to bottling or selling its product in
interstate 

commerce
or removing the bottled product from customs custody.ï¿½ï¿½ TTB also reviews formulas 

and
statements of process, and performs laboratory tests pursuant to the Federal
Alcohol 

Administration
Act.ï¿½ï¿½ For example, formulas are
required for distilled spirits operations that 

change
the character, composition, class, or type of the spirits.ï¿½ These formulas must be approved 

by
TTB.ï¿½ï¿½ TTB does not currently charge
fees for these services.

Under
the Code, manufacturers may claim a drawback of most of the tax for the use of 

tax-paid
distilled spirits in nonbeverage products.ï¿½
Currently TTB imposes a fee of one dollar per 

proof
gallon to process such claims. 

The
Code authorizes the Secretary to establish a user fee program for requests to
the 

Internal
Revenue Service for ruling letters, opinion letters, determination letters, and
other 

similar
requests.ï¿½ï¿½ The user fees charged under
the IRS program must (1) vary according to 

categories
(or subcategories) established by the Secretary, (2) be determined after taking
into 

account
the average time for (and difficulty of) complying with requests in each
category (and 

subcategory),
and (3) be payable in advance. 

Description
of Proposal

The
proposal directs the Secretary to establish a program requiring the payment of
certain 

user
fees to TTB.ï¿½ User fees would be
required for the following categories of services, in no less 

than
the following minimum amounts:

Category

Minimum


Fee

Applications
for basic permits

$500

Applications
for certificates of label approval -- electronic filing

ï¿½$50

Applications
for certificates of label approval -- paper filing

$100

Petitions
for the establishment of new American viticultural areas or adjustment 

of
established viticultural areas

ï¿½ï¿½ï¿½ï¿½ $3,000

Formula
review -- with no laboratory analysis

$200

Formula
review -- with laboratory analysis

$600

Laboratory
analysis -- other than for formula review

$150

Other
similar filings or requests

ï¿½

The
proposal provides that the amount of fees charged may vary according to
categories 

(or
subcategories) established by the Secretary, after taking into account the
average time for, 

and
difficulty of, processing such requests in each category (and
subcategory).ï¿½ The fees are 

required
to be payable in advance.ï¿½ However, the
foregoing rules do not limit the Secretary's 

authority
to use any other measures or standards in setting fees as the Secretary deems 

appropriate
and necessary.ï¿½ The proposal also
provides that, except for the minimum fees stated 

in the
fee schedule, the Secretary may provide for reduced or increased program fees
as the 

Secretary
determines to be appropriate.

In
exercising the authority under this proposal, the normal regulatory process of
notice, 

comment,
and hearing would not be required.ï¿½
Instead, the Secretary is required only to publish a 

notice
of the new fees or adjustment to such fees not less than 60 days prior to the
effective date 

of such
new fees or adjustment.

In
addition to the regulatory fees described above, the proposal increases the fee
for 

processing
tax drawback claims of manufacturers of nonbeverage products from one dollar to


two
dollars per proof gallon.

The
fees in excess of one dollar per proof gallon for processing the drawback
claims and 

all of
the other fees imposed under the proposal are to be deposited in an Alcohol and
Tobacco 

Regulatory
Fund within the Treasury Department.ï¿½
Amounts in such Fund are authorized to be 

appropriated
for activities of TTB, and remain available until expended.ï¿½ However, such amounts 

must be
appropriated to be spent.


Effective
date.ï¿½The proposal is effective on date of enactment.ï¿½ The increased fee for 

processing
drawback claims is effective on date of enactment.ï¿½ The other fees become effective 

no
sooner than 60 days after publication of a notice of such fees in the Federal
Register. 

Analysis

Some
argue that TTB's regulatory services provide value to the industry by providing


information
and assurance to the public that enhances the applicant's value, and,
therefore, the 

applicant
should pay for these benefits, in the same manner as users of IRS ruling
services.ï¿½ 

Others
argue that the primary beneficiary of TTB's regulatory services is the public,
and that 

Congress
should take these expenses into account when appropriating general funds for
the TTB 

budget.ï¿½ Proponents of these arguments stress that it
is unfair to require taxpayers to pay to apply 

for
government-mandated approvals, and that it is burdensome on small business
taxpayers.

TTB
employs a high percentage of highly educated and technically trained staff;
more 

than
half are analysts, chemists, investigators, and auditors.ï¿½ Accordingly, some argue that the 

cost to
TTB of regulatory approval may be greater than that of some other government
agencies.ï¿½ 

On the
other hand, it is not clear that the current TTB budget is inadequate for TTB
to provide 

these
services.

The
proposal gives the Secretary wide latitude to set the fees without providing
the public 

an
opportunity for notice and comment on whether the fee is justified in light of
the related 

expense
or its effect on the industry.ï¿½ While
the IRS has changed the amounts of user fees 

without
formal notice, comment, and hearing procedures,ï¿½ the IRS user fees are constrained by 

the
statutory requirements that they shall vary by category and shall be determined
after taking 

into
account the average time and difficulty of complying with the requests.ï¿½ The proposal states 

these
same requirements with respect to TTB program fees, but only as nonbinding
permissive 

guidelines.ï¿½ Some argue that the lack of binding
statutory standards for these TTB fees 

(particularly
when compared with the statutory requirements applicable to the IRS), combined 

with
lack of notice, comment, and hearing rulemaking procedures vests too much
discretion in 

the
Secretary.

The
drawback fee under section 5134(a) has not been increased in over 50 years, and


some
argue that the fee should keep up with the agency's increase in costs over that
time span.ï¿½ 

On the
other hand, some argue that two dollars per proof gallon is an unreasonably
large 

proportion
of the entire tax on distilled spirits, i.e., $13.50 per proof gallon.

Prior
Action

An
identical proposal was included in the President's fiscal year 2006 budget
proposal.

 

ï¿½ï¿½ This document may be cited as follows:ï¿½ Joint Committee on Taxation, Description of
Revenue 

Provisions
Contained in the President's Fiscal Year 2007 Budget Proposal (JCS-1-06), March
2006.

ï¿½ï¿½ See Office of Management and Budget, Budget
of the United States Government, Fiscal Year 

2007:
Analytical Perspectives (H. Doc. 109-79, Vol. III), at 285-328.

ï¿½ï¿½ See Department of the Treasury, General
Explanations of the Administration's Fiscal Year 

2007Revenue
Proposals, February 2006.

ï¿½ï¿½ However, certain provisions expire separately
under the Act before the end of 2010.ï¿½
For 

example,
the increased AMT exemption amounts expire after 2005, and thus is unaffected
by the 

proposal.

ï¿½ï¿½ The President's fiscal 2007 budget proposal
includes a separate proposal to increase the 

$100,000
and $400,000 amounts under section 179 to $200,000 and $800,000,
respectively.ï¿½ That 

proposal
is described in section II. B. of this document.

ï¿½ï¿½ Sec. 408.

ï¿½ï¿½ Sec. 219.

ï¿½ï¿½ Sec. 408A.

ï¿½ï¿½ Under the Economic Growth and Tax Relief
Reconciliation Act of 2001 ("EGTRRA"), the 

dollar
limit on IRA contributions increases to $5,000 in 2008, with indexing for
inflation thereafter, and 

the
catch-up limit is indexed for inflation for years after 2006. The provisions of
EGTRRA generally do 

not
apply for years beginning after December 31, 2010.ï¿½ As a result, the dollar limit on annual IRA 

contributions
is $2,000 for years after 2010, and catch-ups contributions are not
permitted.ï¿½ A proposal to 

make
the EGTRRA provisions that expire on December 31, 2010, permanent is discussed
in Part I of this 

document.

ï¿½ï¿½ Sec. 72(t).

ï¿½ï¿½ Sec. 25B.ï¿½
The Saver's credit does not apply to taxable year beginning after
December 31, 

2006.

ï¿½ï¿½ Sec. 530.

ï¿½ï¿½ The present-law contribution limit and the
adjusted gross income levels are subject to the 

general
sunset provision of EGTRRA.ï¿½ Thus, for
example, the limit on annual contributions to a 

Coverdell
education savings account is $500 after 2010.

ï¿½ï¿½ A proposal relating to qualified tuition
programs is discussed in Part V.F. of this document.

ï¿½ï¿½ Sec. 529.ï¿½
The general sunset provision of EGTRRA applies to certain aspects of the
rules for 

qualified
tuition programs, including tuition programs maintained by one or more eligible
educational 

institutions
(which may be private institutions).ï¿½
Thus, for example, after 2010 a qualified tuition program 

may be
established and maintained only by a State or agency or instrumentality
thereof.

ï¿½ï¿½ Sec. 223.

ï¿½ï¿½ Sec. 220.

ï¿½ï¿½ The contribution limit is indexed for
inflation.

ï¿½ï¿½ The proposal relating to ERSAs is discussed
in Part II.A.2. of this document.

ï¿½ï¿½ Total contributions to an LSA for a year
may not exceed $5,000, regardless of whether any 

distributions
are taken from the LSA during the year.ï¿½
The contribution limit is indexed for inflation.

ï¿½ï¿½ State tax law and qualified tuition program
investment options may provide incentives for 

savings
used for educational purposes.

ï¿½ï¿½ The Treasury Department expects that,
beginning with the 2007 filing season for individual 

income
tax returns, taxpayers will be able to direct that a portion of their refunds
be deposited into an 

LSA or
RSA.

ï¿½ï¿½ Unlike present-law IRAs, an LSA does not
require that contributions be no greater than 

compensation.ï¿½ Under the proposal, regardless of income, an
individual may make nondeductible annual 

contributions
to an LSA of up to $5,000.ï¿½ To the
extent an individual makes contributions to his or her 

own LSA
that exceed his or her income, then the amounts transferred in excess of income
must represent 

a
transfer of assets from existing savings and not new savings from forgoing
current consumption.ï¿½ 

Additionally,
individuals other than the LSA owner may make contributions to an LSA.

ï¿½ï¿½ Some argue that contributions to deductible
IRAs declined substantially after 1986 for 

taxpayers
whose eligibility to contribute to deductible IRAs was not affected by the
income-related limits 

introduced
in 1986 because financial institutions cut back on promoting contributions as a
result of the 

general
limits on deductibility.ï¿½ Thus, they
would argue, universally available tax-preferred accounts such 

as LSAs
and RSAs will increase saving at all income levels.

ï¿½ï¿½ Whether an RSA and a traditional IRA to
which deductible contributions are made are in fact 

economically
equivalent depends on the difference between the taxpayer's marginal tax rate
in the year 

contributions
are made and the marginal tax rate in the year IRA funds are withdrawn.ï¿½ When marginal 

rates
decrease over time (because tax rates change generally or taxpayers fall into
lower tax brackets), a 

traditional
IRA to which deductible contributions are made is more advantageous than an RSA
because 

the
traditional IRA permits taxpayer to defer payment of tax until rates are
lower.ï¿½ When marginal tax 

rates
increase over time, an RSA is more advantageous.

ï¿½ï¿½ Sec. 403(b).

ï¿½ï¿½ Sec. 457.

ï¿½ï¿½ Sec. 408(p).

ï¿½ï¿½ Sec. 408(k).

ï¿½ï¿½ Elective deferrals are treated as employer
contributions for this purpose.

ï¿½ï¿½ For purposes of the nondiscrimination
requirements, an employee is treated as highly 

compensated
if the employee (1) was a five-percent owner of the employer at any time during
the year or 

the
preceding year, or (2) either (a) had compensation for the preceding year in
excess of $100,000 (for 

2006)
or (b) at the election of the employer had compensation for the preceding year
in excess of 

$100,000
(for 2006) and was in the top 20 percent of employees by compensation for such
year 

(sec.
414(q)).ï¿½ï¿½ A nonhighly compensated
employee is an employee other than a highly compensated 

employee.

ï¿½ï¿½ Sec. 401(a)(4).ï¿½ A qualified retirement plan of a State or local governmental
employer is not 

subject
to the nondiscrimination requirements.

ï¿½ï¿½ See Treas. Reg. sec. 1.401(a)(4)-1.

ï¿½ï¿½ See Treas. Reg. sec. 1.401(a)(4)-2(b) and
(c) and sec. 1.401(a)(4)-8(b).

ï¿½ï¿½ Except for certain grandfathered plans, a
State or local governmental employer may not 

maintain
a section 401(k) plan.

ï¿½ï¿½ The Economic Growth and Tax Relief
Reconciliation Act of 2001 ("EGTRRA") increased 

many of
the limits applicable to employer-sponsored retirement plans and provided for
catch-up 

contributions,
generally effective for years beginning after December 31, 2001.ï¿½ The provisions of 

EGTRRA
generally do not apply for years beginning after December 31, 2010.

ï¿½ï¿½ Sec. 401(k)(3).

ï¿½ï¿½ Sec. 401(k)(12).

ï¿½ï¿½ Sec. 401(m).

ï¿½ï¿½ For proposals to provide greater conformity
between section 403(b) and section 401(k) plans, 

see
Joint Committee on Taxation, Options to Improve Tax Compliance and Reform Tax
Expenditures 

(JCS-02-05),
January 27, 2005, Part IV.E, at 122-129.

ï¿½ï¿½ The EGTRRA sunset applies to the
contribution limits applicable to section 403(b) plans.

ï¿½ï¿½ As in the case of a qualified retirement
plan, a section 403(b) plan of a State or local 

governmental
employer is not subject to the nondiscrimination rules.

ï¿½ï¿½ Section 457 applies also to deferred
compensation plans of tax-exempt entities.ï¿½
Those plans 

are not
affected by the proposal; only the rules for governmental section 457 plans are
relevant for 

purposes
of this discussion.

ï¿½ï¿½ The EGTRRA sunset applies to the
contribution limits applicable to section 457 plans.

ï¿½ï¿½ The EGTRRA sunset applies to the
contribution limits applicable to SIMPLE plans.

ï¿½ï¿½ The EGTRRA sunset applies to the
contribution limits applicable to SARSEPs.

ï¿½ï¿½ The EGTRRA sunset applies to the ability to
make designated Roth contributions to a section 

401(k)
or 403(b) plan.

ï¿½ï¿½ Special transition rules are to be provided
for plans maintained pursuant to collective 

bargaining
agreements and for plans sponsored by State and local governments.

ï¿½ï¿½ For a detailed discussion of complexity
issues related to retirement savings, see, Joint 

Committee
on Taxation, Study of the Overall State of the Federal Tax System and
Recommendations for 

Simplification,
Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986 (JCS-3-01),


April
2001.

ï¿½ï¿½ This issue is discussed in Joint Committee
on Taxation, Study of the Overall State of the 

Federal
Tax System and Recommendations for Simplification, Pursuant to Section
8022(3)(B) of the 

Internal
Revenue Code of 1986 (JCS-3-01), April 2001, at Vol. II, Part III.A.1 (General
simplification 

issues,
at 149-150) and Part III.C.5 (Sources of Complexity, at 186), and in Joint
Committee on Taxation, 

Options
to Improve Tax Compliance and Reform Tax Expenditures (JCS-02-05), Jan. 2005,
Part IV.E, at 

122-129.

ï¿½ï¿½ The proposals relating to Lifetime Savings
Accounts and Retirement Savings Accounts are 

discussed
in Part II.A.1. of this document.

ï¿½ï¿½ Rev. Rul. 99-44, 1999-2 C.B. 549.

ï¿½ï¿½ If the qualified entity is tax-exempt,
other persons may claim the credit as provided for in 

Treasury
regulations.

ï¿½ï¿½ Married taxpayers filing separate returns
are not eligible to open an IDA or to receive 

matching
funds for an IDA that is already open.

ï¿½ï¿½ See section I.A. of this document for the
description of the President's fiscal 2007 budget 

proposal
permanently to extend those rules of section 179 that are currently in effect
for taxable years 

beginning
before 2008.

ï¿½ï¿½ To see this, consider an investment of $100
that yields the normal return in the following year, 

assumed
to be 10-percent pre-tax return, resulting in $110 (this example assumes no
remaining basis for 

simplicity).ï¿½ If the tax rate is 50 percent, expensing of
the $100 investment yields a $50 reduction in tax 

liability,
meaning the after-tax cost to the taxpayer for the $100 investment is $50.ï¿½ The $110 return in the 

following
year results in a $55 tax, and thus a $55 after-tax return.ï¿½ Thus, the after-tax rate if return on the 

investment
is 10 percent ($55-$50, divided by $50), the same as the pre-tax rate of
return, and the present 

value
of tax liability, discounted at the normal rate of return, is zero.ï¿½ While an investment that realized a 

return
in excess of the normal return would also have the same pre-tax rate of return
as after-tax rate of 

return,
the return in excess of the normal return would bear the statutory rate of tax
and the present value 

of tax
liability would be greater than zero.ï¿½
It should be noted that when a deduction for interest on debt-

financed
investment is taken along with expensing, the effective rate of tax on the
normal return to such 

investment
turns negative.

ï¿½ï¿½ Secs. 106, 3121(a)(2), and 3306(b)(2).

ï¿½ï¿½ Sec. 105.ï¿½
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).ï¿½ Medical care is defined as under section
213(d) and generally includes amounts paid for qualified 

long-term
care insurance and services.

ï¿½ï¿½ Secs. 125, 3121(a)(5)(G), and
3306(b)(5)(G).ï¿½ Long-term care insurance
and services may not 

be
provided through a cafeteria plan.

ï¿½ï¿½ 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).

ï¿½ï¿½ Sec. 125(d)(2).

ï¿½ï¿½ 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.

ï¿½ï¿½ Sec. 162(l).ï¿½ The deduction does not apply for self-employment tax (SECA)
purposes.

ï¿½ï¿½ Sec. 213.ï¿½
The adjusted gross income percentage is 10 percent for purposes of the
alternative 

minimum
tax. Sec. 56(b)(1)(B).

ï¿½ï¿½ Pub. L. No. 107-210, secs. 201(a), 202 and
203 (2002).

ï¿½ï¿½ Pub. L. No. 108-173 (2003).

ï¿½ï¿½ Sec. 223.

ï¿½ï¿½ 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.ï¿½ Permitted coverage is coverage 

(whether
provided through insurance or otherwise) for accidents, disability, dental care,
vision care, or 

long-term
care.

ï¿½ï¿½ The limits are indexed for inflation.

ï¿½ï¿½ Sec. 220.

ï¿½ï¿½ The deductible and out-of-pocket expenses
dollar amounts are for 2006.ï¿½ These
amounts are 

indexed
for inflation in $50 increments.

ï¿½ï¿½ While the proposal provides that the
deduction (and the credit, described below) is not allowed 

for
individuals covered by employer plans, it is unclear what specifically
constitutes an employer plan.ï¿½ 

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.ï¿½
It is unclear whether such plan would qualify for the 

deduction.

ï¿½ï¿½ For Federal fiscal years 2005-2009, the tax
expenditure for the exclusion of employer 

contributions
for health care, health insurance premiums, and long-term care insurance
premiums is 

estimated
to be $493.7 billion.ï¿½ Joint Committee
on Taxation, Estimates of Federal Tax Expenditures for 

Fiscal
Years 2005-2009 (JCS-1-05), January 12, 2005.ï¿½


ï¿½ï¿½ The policy may cover more than one
individual, e.g., the policyholder and his or her family.

ï¿½ï¿½ The refundable HCTC provides a greater tax
benefit than the exclusion.ï¿½ However,
the credit is 

available
to only limited classes of taxpayers.ï¿½
Less than one-half million taxpayers per year are estimated 

to be
eligible for the credit.ï¿½ For a
comparison of the value of health tax benefits for individuals covered 

under a
plan that is not a high deduction plan and for individuals covered under a high
deductible plan, 

see
Joint Committee on Taxation, Present Law and Analysis Relating to the Tax
Treatment of Health 

Care
Expenses (JCX-12-06) March 6, 2006, tables 2 and 3, at p. 13-14.

ï¿½ï¿½ With an HSA, both self-employed individuals
and those with employer-provided coverage 

receive
a tax benefit for the purchase of the health insurance as well as a tax benefit
for out-of-pocket 

expenses
(through the HSA).ï¿½ However, in some
circumstances, an employee could, in addition, have an 

FSA or
HRA that provides coverage for additional expenses on a tax-free basis.ï¿½ Thus, for example, an 

employer
plan could provide that the cost of a high deductible plan is paid by the
employer and could also 

allow
an FSA that provides certain limited coverage, e.g., for dental or vision
benefits.ï¿½ In addition, under 

Treasury
guidance, the individual could also have an FSA or HRA in certain other
situations, such as an 

FSA or
HRA that pays expenses in excess of the deductible under the high deductible
plan.ï¿½ In such cases, 

the
individual could also have an HSA to which deductible contributions could be
made.ï¿½ A self-

employed
individual, in contrast, would not have the opportunity to have an FSA or
HRA.ï¿½ Individuals 

(other
than self-employed individuals) who purchase a high deductible plan may make
deductible 

contributions
to an HSA, but would not receive a subsidy for the purchase of the insurance
unless 

aggregate
medical expenses exceed the adjusted gross income threshold.ï¿½ There is not always a clear 

distinction
between out-of-pocket expenses and expenses covered by insurance, because
insurance 

policies
differ.ï¿½ That is, some insurance
policies will cover expenses that are out-of-pocket expenses other 

policies.

ï¿½ï¿½ Specifically, because of the income tax
exclusion, a dollar of consumption of tax favored 

health
care actually costs the taxpayer only $(1-t), where t is the tax rate of the
individual.ï¿½ In other words, 

the
taxpayer is able to convert $(1-t) dollars of after-tax income into $1 of
health consumption.ï¿½ The last 

column
of Tables 2 and 3 reports the value of the tax subsidy as a percentage of the
total health costs.

ï¿½ï¿½ Discussions relating to inequities of the
present-law rules typically do not include the itemized 

deduction
for medical expenses in excess of 7.5 percent of adjusted gross income.ï¿½ This is because that 

deduction
is generally viewed as having a different policy rationale than the other
present-law provisions.ï¿½ 

While
the other provisions are generally intended to provide subsidies in various
ways of the purchase of 

health
care, the policy behind the itemized deduction is that medical expenses in
excess of a certain 

amount
generally are not discretionary and that high levels of such expenses adversely
impact an 

individual's
ability to pay taxes.

ï¿½ï¿½ The definition of what insurance qualifies
under the proposal is not clear in all cases. For 

example,
it is not clear whether an employee who participates in a high deductible plan
of the employer 

(so
that premiums are calculated on a group basis) and who pays for 100 percent of
the premium is 

eligible
for the tax benefits provided by the proposal.

ï¿½ï¿½ The issue of adverse selection is discussed
in greater detail in Joint Committee on Taxation, 

Present
Law and Analysis Relating to the Tax Treatment of Health Care Expenses
(JCX-12-06) March 6, 

2006,
tables 2 and 3, at p. 16-17 and 20-21.

ï¿½ï¿½ This issue may also arise under the
proposed refundable credits designed to offset FICA taxes.

ï¿½ï¿½ For a discussion of issues relating to
income phase-outs, see Joint Committee on Taxation, 

Study
of the Overall State of the Federal Tax System and Recommendations for
Simplification, Pursuant 

to
Section 8022(3)(B) of the Internal Revenue Code of 1986 (JCS-3-01), April 2001,
Volume II at 79.

ï¿½ï¿½ Pub. L. No. 107-210 (2002).

ï¿½ï¿½ This date is 90 days after the date of
enactment of the Trade Act of 2002, which was August 6, 

2002.

ï¿½ï¿½ Part I of subchapter B, or subchapter D, of
chapter 2 of title II of the Trade Act of 1974.

ï¿½ï¿½ Excepted benefits are:ï¿½ (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.

ï¿½ï¿½ An
amount is considered paid by the employer if it is excludable from income.ï¿½ Thus, for 

example,
amounts paid for health coverage on a salary reduction basis under an employer
plan are 

considered
paid by the employer.

ï¿½ï¿½ Specifically, an individual is not eligible
for the credit if, as of the first day of the month, the 

individual
is (1) entitled to benefits under Medicare Part A, enrolled in Medicare Part B,
or enrolled in 

Medicaid
or SCHIP, (2) enrolled in a health benefits plan under the Federal Employees
Health Benefit 

Plan,
or (3) entitled to receive benefits under chapter 55 of title 10 of the United
States Code (relating to 

military
personnel).ï¿½ An individual is not
considered to be enrolled in Medicaid solely by reason of 

receiving
immunizations.

ï¿½ï¿½ 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.ï¿½ Such term does not include 

Federal-
or State-based health insurance coverage.

ï¿½ï¿½ 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.

ï¿½ï¿½ Creditable coverage is determined under the
Health Insurance Portability and Accountability 

Act
(Code sec. 9801(c)).

ï¿½ï¿½ There is an exception for those on American
Samoa who are U.S. nationals.

ï¿½ï¿½ The refundable child tax credit is
available to residents of the possessions if the individual has 

three
or more qualifying children and pays FICA or SECA taxes.

ï¿½ï¿½ Joint Committee on Taxation, Study of the
Overall State of the Federal Tax System and 

Recommendations
for Simplification, Pursuant to Section 8022(3)(b) of the Internal Revenue Code
of 

1986,
Vol. II (JCS-3-01), April 2001, p. 310.

ï¿½ï¿½ Secs. 170(b) and (e).

ï¿½ï¿½ Sec. 170(a).

ï¿½ï¿½ Sec. 170(f)(8).

ï¿½ï¿½ Sec. 6115.

ï¿½ï¿½ Secs. 170(f), 2055(e)(2), and 2522(c)(2).

ï¿½ï¿½ Sec. 170(f)(2).

ï¿½ï¿½ï¿½ Minimum distribution rules also apply to
the case of distributions after the death of a 

traditional
or Roth ITA owner.

ï¿½ï¿½ Conversion contributions refer to
conversions of amounts in a traditional IRA to a Roth IRA.

ï¿½ï¿½ Lucky Stores Inc. v. Commissioner, 105 T.C.
420 (1995) (holding that the value of surplus 

bread
inventory donated to charity was the full retail price of the bread rather than
half the retail price, as 

the IRS
asserted).

ï¿½ï¿½ The Katrina Emergency Tax Relief Act of
2005 defines "apparently wholesome food" as that 

term is
defined under the Bill Emerson Good Samaritan Food Donation Act.ï¿½ 42 U.S.C.A. sec. 1791.

ï¿½ï¿½ 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).

ï¿½ï¿½ In general, it is never more profitable to
donate food than to sell food unless the taxpayer is 

permitted
to deduct a value greater than the current fair market value of the food.ï¿½ To see this:

?ï¿½ï¿½ï¿½ï¿½ let Y denote the taxpayer's pre-tax income
from all other business activity;

?ï¿½ï¿½ï¿½ï¿½ let B denote the taxpayer's acquisition
cost (basis) of the item to be donated;

?ï¿½ï¿½ï¿½ï¿½ 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;

?ï¿½ï¿½ï¿½ï¿½ let ï¿½ 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 ï¿½B; 

and let
t denote the taxpayer's marginal tax rate. 

Further
assume that ï¿½ < 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 + ï¿½B ï¿½ 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).ï¿½ For the case in which the
permitted deduction would exceed twice the taxpayer's 

basis,
the taxpayer's after-tax income from contribution of the item is 

Y ï¿½ B ï¿½
t(Y ï¿½ 2B). 

It is
more profitable to donate the item than to sell it when the following
inequality is satisfied.

(1)ï¿½ï¿½ï¿½ (Y + ï¿½B ï¿½ B)(1-t) < Y ï¿½ B ï¿½ t(Y ï¿½ aB).

This
inequality reduces to:

(2)ï¿½ï¿½ï¿½ ï¿½/(ï¿½ + (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 (ï¿½) 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.ï¿½ 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.ï¿½ 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, ï¿½ <0.538.

ï¿½ï¿½ See Martin A. Sullivan, "Economic
Analysis: Can Bush Fight Hunger With a Tax Break?," 

Tax
Notes, vol. 94, February 11, 2002, p. 671.

ï¿½ï¿½ 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.ï¿½ IRS 

Publication
526, Charitable Contributions, pp. 7-8.

ï¿½ï¿½ Sec. 4942(g).

ï¿½ï¿½ Sec. 4940(e).

ï¿½ï¿½ Sec. 4942.

ï¿½ï¿½ Sec. 4940(d)(1).ï¿½ Exempt operating foundations generally include organizations such
as 

museums
or libraries that devote their assets to operating charitable programs but have
difficulty meeting 

the
"public support" tests necessary not to be classified as a private
foundation.ï¿½ To be an exempt 

operating
foundation, an organization must: (1) be an operating foundation (as defined in
section 

4942(j)(3));
(2) be publicly supported for at least 10 taxable years; (3) have a governing
body no more 

than 25
percent of whom are disqualified persons and that is broadly representative of
the general public; 

and (4)
have no officers who are disqualified persons.ï¿½
Sec. 4940(d)(2).

ï¿½ï¿½ Sec. 4942(d)(2).

ï¿½ï¿½ Operating foundations are not subject to
the minimum charitable payout rules.ï¿½
Sec. 

4942(a)(1).

ï¿½ï¿½ The proposal does not, however, increase
the total amount required to be paid out for 

charitable
and tax purposes; rather, by reducing the rate of tax, the proposal decreases
the amount of the 

pay out
that may be satisfied through payment of tax.

ï¿½ï¿½ In general, foundations that make only the
minimum amount of charitable distributions and 

seek to
minimize total payouts have no incentive to decrease their rate of excise tax
because such a 

decrease
would result in an increase in the required minimum amount of charitable
distributions, thus 

making
no difference to the total payout of the private foundation.

ï¿½ï¿½ See C. Eugene Steuerle and Martin A.
Sullivan, "Toward More Simple and Effective Giving: 

Reforming
the Tax Rules for Charitable Contributions and Charitable Organizations,"
American Journal 

of Tax
Policy, 12, Fall 1995, at 399-447.

ï¿½ï¿½ For example, if over a 10-year period the
foundation increased its payout rate from the 

minimum
5.00 percent to 5.01 percent, to 5.02 percent, up to 5.10 percent, the
foundation generally would 

qualify
for the one-percent excise tax rate throughout the 10-year period.

ï¿½ï¿½ Whether a reduction in payout rate causes
the foundation to pay the two-percent tax rate 

depends
upon the specific pattern of its payout rate in the preceding five years and
the magnitude of the 

decrease
in the current year.

ï¿½ï¿½ In this example, after having paid out 8.0
percent, the five-year average payout for the first 

year in
which the foundation pays out 5.5 percent would be 5.6 percent.

ï¿½ï¿½ See Figure G in Melissa Ludlum,
"Domestic Private Foundations and Charitable Trusts, 

2001,"
Internal Revenue Service, Statistics of Income Bulletin, 24, Fall 2004 at 150.

ï¿½ï¿½ Steuerle and Sullivan, "Toward More Simple
and Effective Giving: Reforming the Tax Rules 

for
Charitable Contributions and Charitable Organizations," at 438.

ï¿½ï¿½ See Figure I in Paul Arnsberger,
"Private Foundations and Charitable Trusts, 1995," Internal 

Revenue
Service, Statistics of Income Bulletin, 18, Winter 1998-1999 at 73 and Figure I
in Melissa 

Ludlum,
"Domestic Private Foundations and Charitable Trusts, 1999," Internal
Revenue Service, 

Statistics
of Income Bulletin, 22, Fall 2002 at 148. 

ï¿½ï¿½ See Figure J in Melissa Ludlum, "Domestic
Private Foundations and Charitable Trusts, 

2001,"
Internal Revenue Service, Statistics of Income Bulletin, 24, Fall 2004 at 153.

ï¿½ï¿½ See Figure I in Paul Arnsberger,
"Private Foundations and Charitable Trusts, 1995," Internal 

Revenue
Service, Statistics of Income Bulletin, 18, Winter 1998-1999 at 73 and Figure I
in Melissa 

Ludlum,
"Domestic Private Foundations and Charitable Trusts, 1999," Internal
Revenue Service, 

Statistics
of Income Bulletin, 22, Fall 2002 at 148.

ï¿½ï¿½ See Figure J in Melissa Ludlum,
"Domestic Private Foundations and Charitable Trusts, 

2001,"
Internal Revenue Service, Statistics of Income Bulletin, 24, Fall 2004 at 153.

ï¿½ï¿½ Sec. 664(d).

ï¿½ï¿½ Sec. 664(b).

ï¿½ï¿½ Treas. Reg. sec. 1.664-1(d)(4).

ï¿½ï¿½ Sec. 1366(a)(1)(A).

ï¿½ï¿½ Sec. 1367(a)(2)(B).

ï¿½ï¿½ See Rev. Rul. 96-11 (1996-1 C.B. 140) for a
similar rule applicable to contributions made by 

a
partnership.

ï¿½ï¿½ S. Rep. 105-33 (June 20, 1997), at 24-25.

ï¿½ï¿½ H. Rep. 105-220 (July 30, 1997), at
372-373.

ï¿½ï¿½ Section 142(a)(7) describes an exempt
facility bond as any bond issued as part of an issue of 

bonds
if 95 percent or more of the net proceeds of the issue are to be used to
provide qualified residential 

rental
projects.

ï¿½ï¿½ H.R. Rep. No. 100-795 at 585 (1988).ï¿½ The report also noted:ï¿½ "The press has reported 

housing
industry representatives stating publicly that a primary attraction of some
housing financed with 

governmental
and qualified 501(c)(3) bonds is that the low-income tenant requirements and
State volume 

caps
applicable to for-profit developers do not apply."ï¿½ Id.

ï¿½ï¿½ H.R. Conf. Rep. 100-1104, vol. II at 126
(1988).

ï¿½ï¿½ Treas. Reg. sec. 1.162-5.

ï¿½ï¿½ Sec. 222.

ï¿½ï¿½ A separate proposal contained in the
President's fiscal year 2007 budget permanently extends 

the
elimination of the overall limitation on itemized deductions after 2010
(I.A.,above ).

ï¿½ï¿½ 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.

ï¿½ï¿½ 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.

ï¿½ï¿½ 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.

ï¿½ï¿½ 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)).

ï¿½ï¿½ 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.

ï¿½ï¿½ In addition to the NYLZ provisions
described above, other NYLZ incentives are provided:ï¿½ 

(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.

ï¿½ï¿½ The amount of the additional first-year
depreciation deduction is not affected by a short 

taxable
year.

ï¿½ï¿½ 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.

ï¿½ï¿½ Qualified NYLZ leasehold improvement
property is defined in another provision.ï¿½
Leasehold 

improvements
that do not satisfy the requirements to be treated as "qualified NYLZ
leasehold 

improvement
property" maybe eligible for the 30 percent additional first-year depreciation
deduction 

(assuming
all other conditions are met).

ï¿½ï¿½ For purposes of this provision, purchase is
defined as under section 179(d).

ï¿½ï¿½ 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.

ï¿½ï¿½ December 31, 2009 with respect to qualified
nonresidential real property and residential rental 

property.

ï¿½ï¿½ Sec. 168(i)(8).ï¿½ The Tax Reform Act of 1986 modified the Accelerated Cost Recovery
System 

("ACRS")
to institute MACRS.ï¿½ Prior to the
adoption of ACRS by the Economic Recovery Tax Act of 

1981,
taxpayers were allowed to depreciate the various components of a building as
separate assets with 


separate
useful lives.ï¿½ The use of component
depreciation was repealed upon the adoption of ACRS.ï¿½ The 

Tax
Reform Act of 1986 also denied the use of component depreciation under MACRS.

ï¿½ï¿½ 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.ï¿½ The Tax Reform 

Act of
1986 repealed these provisions.

ï¿½ï¿½ Secs. 168(b)(3), (c), (d)(2), and
(i)(6).ï¿½ 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)).ï¿½ 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).

ï¿½ï¿½ As defined in sec. 179(d)(1).

ï¿½ï¿½ 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.

ï¿½ï¿½ Section 1033(a)(2)(B).

ï¿½ï¿½ Section 1033(g)(4).

ï¿½ï¿½ The proposal does not change the
present-law rules relating to certain NYLZ private activity 

bond
financing and additional advance refunding bonds.

ï¿½ï¿½ Pub. Law No. 107-147, sec. 301 (2002).

ï¿½ï¿½ A foster child must reside with the
taxpayer for the entire taxable year.

ï¿½ï¿½ All income thresholds are indexed for
inflation annually.

ï¿½ï¿½ Secs. 32(d) and 7703(b).

ï¿½ï¿½ The proposal adopts the qualifying child
test for this purpose, rather than the "dependent 

child"
test that applies under present law.

ï¿½ï¿½ Both under the proposal and present law,
unmarried parents who reside together with multiple 

qualifying
children who are their sons, daughters, stepchildren, adopted children, or
foster children, may 

allocate
the qualifying children between them for earned income credit purposes.ï¿½ 


ï¿½ï¿½ The proposal does not require that
qualifying children have Social Security numbers 

authorizing
them to work in the United States.

ï¿½ï¿½ Under pension equity plans (often called
"PEPs"), benefits are generally described as a 

percentage
of final average pay, with the percentage determined on the basis of points
received for each 

year of
service, which are often weighted for older or longer service employees.ï¿½ Pension equity plans 

commonly
provide interest credits for the period between a participant's termination of
employment and 

commencement
of benefits.

ï¿½ï¿½ The assets of the cash balance plan may or
may not include the assets or investments on 

which
interest credits are based.ï¿½ 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.

ï¿½ï¿½ 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.ï¿½ 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.

ï¿½ï¿½ Sec. 411(d)(6); ERISA sec. 204(g).

ï¿½ï¿½ Sec. 417(e); ERISA sec. 205(g).

ï¿½ï¿½ 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).

ï¿½ï¿½ Sec. 411(b); ERISA sec. 204(b).

ï¿½ï¿½ Announcement 2003-1, 2003-2 I.R.B. 281.

ï¿½ï¿½ Id.

ï¿½ï¿½ Sec. 411(b); ERISA sec. 204(b).

ï¿½ï¿½ Sec. 411(a)(7).ï¿½ 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.ï¿½ Treas. Reg. sec. 

1.411(a)-7(a)(1)(ii).

ï¿½ï¿½ Notice 96-8, 1996-1 C.B. 359.

ï¿½ï¿½ Sec. 411(d)(6); ERISA sec. 204(g).ï¿½ The provisions do not, however, protect
benefits that 

have
not yet accrued but would accrue in the future if the plan's benefit formula
were not changed.

ï¿½ï¿½ Sec. 411(d)(6)(B); ERISA sec. 204(g)(2).

ï¿½ï¿½ This description applies to normal
retirement benefits.ï¿½ Other issues may
arise with respect to 

early
retirement benefits.ï¿½ For example, a
plan might have provided a subsidized early retirement benefit 

before
the conversion.ï¿½ After the conversion,
the subsidized early retirement benefit must still be provided 

with
respect to the preconversion accrued benefit.ï¿½
However, the plan is not required to provide a 

subsidized
early retirement benefit with respect to benefits that accrue after the
conversion.

ï¿½ï¿½ This is sometimes the reduction in benefits
that is referred to in connection with cash balance 

conversions,
i.e., a reduction in expected benefits, not accrued benefits.

ï¿½ï¿½ Code sec. 411(b)(1)(H); ERISA sec.
204(b)(1)(H).ï¿½ 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.

ï¿½ï¿½ 29 U.S.C. Code sec. 623(i).

ï¿½ï¿½ Sec. 411(b)(1)(H)(ii); ERISA sec.
204(b)(1)(H)(ii).

ï¿½ï¿½ Other age discrimination issues may also
arise in connection with cash balance plan 

conversions,
depending in part on how the conversion is made, such as whether the plan has a


"wearaway."ï¿½ However, the recent focus of age
discrimination has related to the basic cash balance plan 

design.

ï¿½ï¿½ 67 Fed. Reg. 76123 (December 11,
2002).ï¿½ Prop. Treas. Reg. sec.
1.411(b)-2.ï¿½ (The proposed 

regulations
were issued after consideration of comments on regulations proposed in
1988.ï¿½ 53 Fed. Reg. 

11876
(April 11, 1988).)ï¿½ Treasury had
previously discussed the cash balance age discrimination issue in 

the
preamble to regulations issued in 1991 under section 401(a)(4), which provided
a safe harbor for cash 

balance
plans that provide frontloaded interest credits and meet certain other
requirements.ï¿½ The preamble 

to these
regulations stated "[t]he fact that interest adjustments through normal
retirement age are accrued 

in the
year of the related hypothetical allocation will not cause a cash balance plan
to fail to satisfy the 

requirements
of section 411(b)(1)(H), relating to age-based reductions in the rate at which
benefits accrue 

under a
plan."ï¿½ 56 Fed. Reg. 47528 (Sept.
19, 1991).

ï¿½ï¿½ The proposed regulations also addressed a
number of other issues, including 

nondiscrimination
testing for cash balance plans under section 401(a)(4).ï¿½ 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.ï¿½
Announcement 2003-22, 2002-17 I.R.B. 846 (April 28, 

2003).

ï¿½ï¿½ Pub. L. No. 108-199 (2004).

ï¿½ï¿½ The Treasury Department complied with this
requirement by including its cash balance 

proposal
in the President's fiscal year 2005 budget proposal.

ï¿½ï¿½ Announcement 2004-57, 2004-27 I.R.B. 15.

ï¿½ï¿½ Id.

ï¿½ï¿½ 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.ï¿½ In Campbell v. BankBoston, 327 F.3d 1 

(1st
Cir. 2003), the plaintiff argued for the first time only on appeal that the
cash balance plan at issue 

violated
the age discrimination rules.ï¿½ The court
therefore held that the issue had been waived and did not 

resolve
the issue.ï¿½ However, the court briefly
described the various arguments involved and the 

disagreement
as to how rate of benefit accrual should be determined.ï¿½ While the BankBoston decision is 

often
cited for the position that cash balance plans are not age discriminatory, the
appeals court did not 

actually
resolve the age discrimination issue.ï¿½
In Engers v. AT&T, 2000 U.S. Dist. LEXIS 10937 (D.N.J. 

June
29, 2000), the court dismissed an age discrimination claim based on disparate
impact, but ruled that 

a claim
that AT&T's cash balance plan reduced the rate of benefit accrual on
account of age in violation 

of
ERISA and the ADEA could proceed to trial.

ï¿½ï¿½ 117 F. Supp. 2d 812 (S.D. Ind. 2000).

ï¿½ï¿½ 274 F. Supp. 2d 1010 (S.D. Ill. 2003).

ï¿½ ï¿½222
F.R.D. 88 (D. Md. 2004).

ï¿½ï¿½ No. 04-CV-6097, 2005 WL 3120268 (E.D. Pa.
Nov. 21, 2005).

ï¿½ï¿½ Sec. 401(a)(11); ERISA sec. 205(a).

ï¿½ï¿½ Secs. III.B. and C of Notice 96-8.

ï¿½ï¿½ Berger v. Xerox Corp. Retirement Income
Guarantee Plan, 338 F.3d 755 (7th Cir. 2003); 

Esden
v. Bank of Boston, 229 F.3d 154 (2d Cir. 2000), cert. dismissed, 531 U.S. 1061
(2001); and Lyons 

v.
Georgia Pacific Salaried Employees Retirement Plan, 221 F.3d 1235 (11th Cir.
2000), cert. denied, 

532
U.S. 967 (2001).ï¿½ See also, West v. AK
Steel Corp. Retirement Accumulation Plan, 2004 U.S. Dist. 

LEXIS
9224 (S.D. Ohio April 8, 2004).ï¿½
Additionally, under Esden, if participants accrue interest credits 

under a
cash balance plan at an interest rate that is higher than the interest assumptions
prescribed by the 

Code
for determining the present value of the annuity, the interest credits must be
reflected in the 

projection
of the participant's hypothetical account balance to normal retirement age in
order to avoid 

violating
the Code's prohibition against forfeitures.

ï¿½ï¿½ A proposal to change the interest rate used
to determine minimum lump-sum values is 

discussed
in Part IV.C.

ï¿½ï¿½ These concerns led to the enactment of the
present-law notice requirements regarding future 

reductions
in benefit accruals.ï¿½ Sec. 4980F and
ERISA sec. 204(h).

ï¿½ï¿½ Joint Committee on Taxation, Report of
Investigation of Enron Corporation and Related 

Entities
Regarding Federal Tax and Compensation Issues, and Policy Recommendations
(JCS-3-03), 

February
2003, at Vol. I, 487.

ï¿½ï¿½ 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.:p>

ï¿½ï¿½ Many believe that resolution of the
uncertainty surrounding cash balance plans is also 

essential
to the long-term viability of the defined benefit pension system, as discussed
more fully in 

connection
with the Administration's proposal relating to cash balance plans in Part IV.A.

ï¿½ï¿½ A variety of estimates and assumptions are
used by the PBGC in evaluating the present value 

of its
liability for future benefits, including assumptions about future plan
terminations.ï¿½ According 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.

ï¿½ï¿½ Sec. 412; ERISA secs. 301-308.ï¿½ The minimum funding rules do not apply to
governmental 

plans
or to church plans, except church plans with respect to which an election has
been made to have 

various
requirements, including the funding requirements, apply to the plan.ï¿½ In some respects, the 

funding
rules applicable to multiemployer plans differ from the rules applicable to
single-employer plans.ï¿½ 

In
addition, special rules apply to certain plans funded exclusively by the
purchase of individual insurance 

contracts
(referred to as "insurance contract" plans).

ï¿½ï¿½ Present law also provides for the use of an
"alternative" funding standard account, which has 

rarely
been used.

ï¿½ï¿½ The deficit reduction contribution rules
apply to single-employer plans, other than single-

employer
plans with no more than 100 participants on any day in the preceding plan
year.ï¿½ Single-

employer
plans with more than 100 but not more than 150 participants are generally
subject to lower 

contribution
requirements under these rules.

ï¿½ï¿½ 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.

ï¿½ï¿½ In determining a plan's funded current
liability percentage for a plan year, the value of the 

plan's
assets is generally reduced by the amount of any credit balance under the
plan's funding standard 

account.ï¿½ However, this reduction does not apply in
determining the plan's funded current liability 

percentage
for purposes of whether an additional charge is required under the deficit reduction


contribution
rules.

ï¿½ï¿½ 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.

ï¿½ï¿½ In making these computations, the value of
the plan's assets is reduced by the amount of any 

credit
balance under the plan's funding standard account.

ï¿½ï¿½ 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.ï¿½ Notice 88-73, 1988-2 C.B. 383.

ï¿½ï¿½ If the Secretary of the Treasury determines
that the lowest permissible interest rate in this 

range
is unreasonably high, the Secretary may prescribe a lower rate, but not less
than 80 percent of the 

weighted
average of the 30-year Treasury rate.

ï¿½ï¿½ Sec. 412(b)(5)(B)(iii)(II); ERISA sec.
302(b)(5)(B)(iii)(II).ï¿½ Under Notice
90-11, 1990-1 C.B. 

319,
the interest rates in the permissible range are deemed to be consistent with
the assumptions reflecting 

the
purchase rates that would be used by insurance companies to satisfy the
liabilities under the plan.

ï¿½ï¿½ Pub. L. No. 108-218 (2004).

ï¿½ï¿½ In addition, under PFEA 2004, if certain
requirements are met, reduced contributions under 

the
deficit reduction contribution rules apply for plan years beginning after
December 27, 2003, and 

before
December 28, 2005, in the case of plans maintained by commercial passenger
airlines, employers 

primarily
engaged in the production or manufacture of a steel mill product or in the
processing of iron ore 

pellets,
or a certain labor organization.

ï¿½ï¿½ Sec. 412(l)(7)(C)(ii); ERISA sec.
302(d)(7)(C)(ii).

ï¿½ï¿½ Rev. Rul. 95-28, 1995-1 C.B. 74.ï¿½ Under Prop. Treas. Reg. 1.412(l)(7)-1,
beginning in 2007, 


RP-2000
Mortality Tables are used with improvements in mortality (including future
improvements) 

projected
to the current year and with separate tables for annuitants and
nonannuitants.ï¿½ 

ï¿½ï¿½ For plan years beginning before 2004, the
full funding limitation was generally defined as the 

excess,
if any, of (1) the lesser of (a) the accrued liability under the plan
(including normal cost) or (b) a 

percentage
(170 percent for 2003) of the plan's current liability (including the current
liability normal 


cost),
over (2) the lesser of (a) the market value of plan assets or (b) the actuarial
value of plan assets, but 

in no
case less than the excess, if any, of 90 percent of the plan's current
liability over the actuarial value 

of plan
assets.ï¿½ Under the Economic Growth and
Tax Relief Reconciliation Act of 2001 ("EGTRRA"), the 

full
funding limitation based on 170 percent of current liability is repealed for
plan years beginning in 

2004
and thereafter.ï¿½ The provisions of
EGTRRA generally do not apply for years beginning after 

December
31, 2010.

ï¿½ï¿½ Sec. 412(m); ERISA sec. 302(e).

ï¿½ï¿½ Sec. 412(d); ERISA sec. 303.ï¿½ Under similar rules, the amortization period
applicable to an 

unfunded
past service liability or loss may also be extended.

ï¿½ï¿½ Sec. 4971.ï¿½
An excise tax applies also if a quarterly installment is less than the
amount 

required
to cover the plan's liquidity shortfall.

ï¿½ï¿½ Sec. 4980.

ï¿½ï¿½ Sec. 420.

ï¿½ï¿½ The value of plan assets for this purpose
is the lesser of fair market value or actuarial value.

ï¿½ï¿½ Sec. 404(a)(1).

ï¿½ï¿½ Sec. 404(a)(1)(D).ï¿½ 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").

ï¿½ï¿½ Sec. 4972.

ï¿½ï¿½ The proposal does not change the funding
rules applicable to multiemployer plans or 

insurance
contract plans.ï¿½ Governmental plans and
church plans continue to be exempt from the funding 

rules
to the extent provided under present law.

ï¿½ï¿½ As discussed below, different payments may
be required with respect to amortization bases 

established
for different years.

ï¿½ï¿½ A proposal to use interest rates drawn from
a corporate bond yield curve in determining 

benefits
subject to the minimum value rules, such as lump sums, is discussed in Part
IV.C.

ï¿½ï¿½ These additional assumptions are intended
to reflect behavior that may occur when the 

financial
health of the plan sponsor deteriorates.

ï¿½ï¿½ The loading factor is intended to reflect
the cost of purchasing group annuity contracts in the 

case of
termination of the plan.

ï¿½ï¿½ At-risk normal cost does not include a
loading factor of $700 per plan participant.

ï¿½ï¿½ Typically, higher interest rates apply to
bonds of longer durations, and lower interest rates 

apply
to bonds of shorter durations.ï¿½ 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.

ï¿½ï¿½ Such benefits are taken into account in
determining the plan's normal cost for the plan year.

ï¿½ï¿½ The present-law rules permitting the waiver
of the minimum funding requirements continue to 

apply.

ï¿½ï¿½ Under the proposal, the present-law rules
permitting the extension of amortization periods are 

repealed
with respect to single-employer plans.

ï¿½ï¿½ Some employers may also wish to make
additional contributions to improve the funding 

status
of their plans for financial reporting purposes.

ï¿½ï¿½ A proposal to use a corporate bond yield
curve in determining minimum lump-sum benefits is 

discussed
in Part IV.C.

ï¿½ï¿½ In practice, the price of an annuity
contact encompasses not only an interest rate factor but 

also
other factors, such as the costs of servicing the contract and
recordkeeping.ï¿½ Under present law, the 

interest
rate used for determining current liability is intended to embody all of these
factors.ï¿½ See H.R. 

Rpt.
No. 100-495, at 868 (1987).

ï¿½ï¿½ As discussed above, temporary increases in
the permissible interest rate for purposes of 

determining
current liability were enacted in 2002 and 2004.

ï¿½ï¿½ Some also argue that the interest rate used
for funding purposes should be based on the 

expected
return on plan investments, rather than on annuity purchase rates.

ï¿½ï¿½ Code secs. 6058 and 6059; ERISA secs. 103
and 4065.

ï¿½ï¿½ Code sec. 6059; ERISA sec. 103(d).

ï¿½ï¿½ ERISA sec. 104(b).ï¿½ A participant must also be provided with a
copy of the full annual report 

on
written request.

ï¿½ï¿½ ERISA sec. 4011.

ï¿½ï¿½ ERISA sec. 4010.

ï¿½ï¿½ ERISA sec. 4071.

ï¿½ï¿½ ERISA sec. 4010(c).

ï¿½ï¿½ As discussedï¿½ connection with the proposal relating to funding rules for
single-employer 

defined
benefit pension plans in Part IV.B.2, for a plan sponsor that is not
financially weak, the funding 

target
is the plan's ongoing liability.ï¿½ For a
plan sponsor that is financially weak, the funding target 

generally
is the plan's at-risk liability.ï¿½ 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.ï¿½ 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.

ï¿½ï¿½ ERISA sec. 4011.

ï¿½ï¿½ The exception for trade secrets and
commercial or financial information also applies for 

purposes
of the Code rule allowing public inspection of written determinations. Sec.
6110(c)(4).

ï¿½ï¿½ ERISA sec. 407.

ï¿½ï¿½ ERISA uses the term "individual
account plan" to refer to defined contribution plans.ï¿½ Money 

purchase
pension plans (a type of defined contribution plan) are subject to the
10-percent limitation unless 

the
plan was established before ERISA.ï¿½
Special rules apply with respect to certain plans to which elective 

deferrals
are made.

ï¿½ï¿½ 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.

ï¿½ï¿½ Code sec. 412(d); ERISA sec. 303.

ï¿½ï¿½ Code sec. 412(f); ERISA sec. 304(b)(1).

ï¿½ï¿½ Code sec. 401(a)(29); ERISA sec. 307.

ï¿½ï¿½ Code sec. 401(a)(33); ERISA sec. 204(i).

ï¿½ï¿½ Code sec. 401(a)(32); ERISA sec. 206(e).

ï¿½ï¿½ Rules governing nonqualified deferred
compensation arrangements are contained in Code 

section
409A.

ï¿½ï¿½ Sec. 409A.

ï¿½ï¿½ Treas. Reg. sec. 1.401-1(b)(1)(i).

ï¿½ï¿½ Treas. Reg. secs. 1.401(a)(4)-3(f)(4) and
1.411(a)-7(c).

ï¿½ï¿½ Sec. 411(d)(6).ï¿½ Section 204(g) of ERISA provides similar rules for ERISA-covered
plans.

ï¿½ï¿½
Treas. Reg. sec. 1.411(d)-3(b).

ï¿½ï¿½ ERISA sec. 4022(a).

ï¿½ï¿½ ERISA sec. 4022(b) and (c).

ï¿½ï¿½ The PBGC termination insurance program does
not cover plans of professional service 

employers
that have fewer than 25 participants.

ï¿½ï¿½ ERISA sec. 4006(a).

ï¿½ï¿½ Pub. L. No. 109-171, enacted February 8,
2006.ï¿½ The Deficit Reduction Act of 2005
was 

enacted
after the issuance of the President's fiscal year 2007 budget proposal.

ï¿½ï¿½ 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.

ï¿½ï¿½ Sec. 6601.

ï¿½ï¿½ ERISA sec. 4007(b).

ï¿½ï¿½ For a plan sponsor that is not financially
weak, the funding target is the plan's ongoing 

liability.ï¿½ For a plan sponsor that is financially weak,
the funding target generally is the plan's at-risk 

liability.ï¿½ Ongoing liability and at-risk liability are
discussed in the proposal relating to the funding and 

deduction
rules in Part IV.B.2.ï¿½ 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.ï¿½ 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.

ï¿½ï¿½ Testimony of Bradley D. Belt, Executive
Director, Pension Benefit Guarantee Corporation, 

before
the Committee on Finance, United States Senate (March 1, 2005) at 15.

ï¿½ï¿½ ERISA sec. 4041.

ï¿½ï¿½ Id.

ï¿½ï¿½ ERISA sec. 4001(a)(16).

ï¿½ï¿½ ERISA sec. 4041.

ï¿½ï¿½ ERISA sec. 4044(a).

ï¿½ï¿½ Id.

ï¿½ï¿½ The asset allocation rules also apply in
standard terminations.

ï¿½ï¿½ ERISA sec. 4022(b) and (c).

ï¿½ï¿½ The PBGC generally pays the greater of the guaranteed
benefit amount and the amount that 

was
covered by plan assets when it terminated.ï¿½
Thus, depending on the amount of assets in the 

terminating
plan, participants may receive more than the amount guaranteed by PBGC.

ï¿½ï¿½ GAO, High-risk Series: An Update,
GAO-05-207 (Washington, D.C.: January 2005).

ï¿½ï¿½ Code sec. 412; ERISA sec. 302.

ï¿½ï¿½ Code sec. 412(n); ERISA sec. 302(f).

ï¿½ï¿½ The term "controlled group" means
any group treated as a single employer under subsections 

(b),
(c), (m) or (o) of Code section 414.

ï¿½ï¿½ 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.ï¿½ An
unperfected lien is valid between the debtor and the creditor, 

but in
the context of a bankruptcy proceeding, an unperfected lien may be treated as
behind liens created 

later
in time, but perfected earlier.ï¿½ In
addition, an unperfected lien can be avoided in bankruptcy.ï¿½ State 

law
generally applies to perfection of liens.ï¿½
A lien generally may be perfected in various ways, including 

by
filing or recording with various government offices.ï¿½ 

ï¿½ï¿½ 11 U.S.C. sec. 362 (2005).

ï¿½ï¿½ 11 U.S.C. sec. 101(53) (2005).

ï¿½ï¿½ The bankruptcy trustee is the
representative of the debtor's estate.ï¿½
The estate is generally is 

comprised
of the legal or equitable interests of the debtor as of the filing of the
petition for bankruptcy.ï¿½ 

See 11
U.S.C. secs. 323 and 541 (2005).

ï¿½ï¿½ 11 U.S.C. sec. 545(2) (2005).ï¿½ Statutory liens may also be avoided to the
extent that the lien 

first
becomes effective against the debtor: (1) when a bankruptcy case is commenced;
(2) when an 

insolvency
proceeding other than under bankruptcy law is commenced; (3) when a custodian
is appointed 

or
authorized to take or takes possession; (4) when the debtor becomes insolvent;
(5) when the debtor's 

financial
condition fails to meet a specified standard; or (6) at the time of an
execution against property of 

the
debtor levied at the instance of an entity other than the holder of such statutory
lien.ï¿½ 11 U.S.C. sec. 

545(1)
(2005).

ï¿½ï¿½ Code sec. 417(e)(3); ERISA sec. 205(g)(3).

ï¿½ï¿½ Code sec. 415(b).

ï¿½ï¿½ The President's proposal relating to the
interest rate to be used to value a plan's liabilities for 

funding
purposes is discussed in Part IV.B.2.

ï¿½ï¿½ Under the proposal relating to changes in
the funding rules, discussed in Part IV.B.2, lump-

sum
benefits expected to be paid from a plan are required to be reflected in
valuing plan liabilities.

ï¿½ï¿½ For 2004 and 2005, 5.5 percent is used in
lieu of the interest rate used in determining 

minimum
lump sums.ï¿½ However, the proposal is not
effective until after such years.

ï¿½ï¿½ Treas. Reg. sec. 1.901-2(f)(1).

ï¿½ï¿½ See, e.g., Notices 2004-19 and 2004-20,
2004-11 I.R.B. 1.

ï¿½ï¿½ Secs. 311(b) and 336.

ï¿½ï¿½ Secs. 301 and 302.

ï¿½ï¿½ Sec. 355(b).ï¿½ Certain taxable acquisitions that are considered expansions of an
existing active 

trade
or business are not treated as the taxable acquisition of a business for
purposes of the rules.ï¿½ Treas. 

Reg.
sec. 1.355-3(b)(3)(ii) and sec. 1.355-3(c), Examples (7) and (8).

ï¿½ï¿½ 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.ï¿½ 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.

ï¿½ï¿½ The ruling guidelines also provided the
possibility that the IRS might rule the active trade or 

business
test was satisfied if the trades or businesses relied upon were not "de
minimis" compared with 

the
other assets or activities of the corporation and its subsidiaries. Rev. Proc.
2003-3, sec. 4.01(30), 

2003-1
I.R.B. 113.

ï¿½ï¿½ Rev. Proc. 2003-48, 2003-29 I.R.B. 86.

ï¿½ï¿½ In one of the reported recent transactions,
the Clorox Company distributed $2.1 billion cash 

and a
business worth $740 million to a U.S. subsidiary of the German company Henkel
KGaA in 

redemption
of that subsidiary's 29 percent interest in Clorox.ï¿½ Other reported transactions were 

undertaken
by Janus Capital Group and DST Systems, Inc. (with cash representing 89 percent
of the value 

of the
distributed corporation); Houston Exploration Company and KeySpan Corp. (87
percent cash); and 

Liberty
Media Corporation and Comcast Corporation (53 percent cash).ï¿½ See, e.g., Allan Sloan, "Leading 

the Way
in Loophole Efficiency," Washington Post, (October 26, 2004), at E.3;ï¿½ Robert S. Bernstein, 

"Janus
Capital Group's Cash Rich Split-Off," Corporate Taxation,
(November-December 2003) at 39; 

Robert
S. Bernstein, "KeySpan Corp.'s Cash-Rich Split Off," Corporate
Taxation, (September-October 

2004)
at 38.ï¿½ Robert Willens, "Split
Ends," Daily Deal, (August 31, 2004); and Richard Morgan, 

"Comcast
Exits Liberty Media," Daily Deal, (July 22, 2004).ï¿½ See also, The Clorox Company Form 8-K 

SEC
File No. 001-07151), (October 8, 2004); Janus Capital Group, Inc. Form 8-K (SEC
File No. 001-

15253)
(August 26, 2003); The Houston Exploration Company Form 8-K (SEC File No.
001-11899) 

(June
4, 2004); Key Span Corp. Form 8-K (SEC File No. 001-14161 (June 2, 2004); and
Liberty Media 

Corporation
Form 8-K (SEC File No. 001-16615) (July 21, 2004).ï¿½ 

ï¿½ï¿½ The proposal does not explicitly define the
situations in which various types of assets could 

qualify
under the test as "used or held for use" in an active trade or
business.ï¿½ Thus, it is unclear whether, 

or to
what extent, the proposal categorically would preclude investment assets or
cash from being 

considered
such assets. See additional discussion of these issues in the following
text.ï¿½ 

ï¿½ï¿½ Secs. 1202(c)(2), 1202(e)(1)(A), and
1045(b). For purposes of this 80-percent test, the statute 

expressly
provides that assets are treated as used in the active conduct of a trade or
business if they are 

held as
part of the reasonably required working capital needs of a qualified trade or
business or if they are 

held
for investment or are reasonably expected to be used within two years to
finance research and 

experimentation
in a qualified trade or business or increases in working capital needs of a
qualified trade 

or
business. However, for periods after the corporation has been in existence for
at least two years, no 

more
than 50 percent of the assets of the corporation can qualify as used in the
active conduct of a trade 

or
business by reason of these provisions. Sec. 1202(e)(6).

ï¿½ï¿½ 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.ï¿½ Sec. 355(a)(1)(B). The statute does not
contain any 

absolute
percentage threshold of nonbusiness assets that is forbidden under this test.ï¿½ 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
in the pro-rata 

situation.

ï¿½ï¿½ A similar proposal addressing the group to
which the present law active business test is 

applied
was contained in the Joint Tax Committee Staff Simplification recommendations.
Joint 

Committee
on Taxation, Study of the Overall State of the Federal Tax System and Recommendations
for 

Simplification,
Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986 (JCS-3-01),
April 

2001,
Vol. II at 251-252. 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).ï¿½ See H.R. Rep.
108-755, 108th Cong. (2004) at 361-362.

ï¿½ï¿½ Section 467 of H.R. 4297 as passed by the
Senate in 2006.ï¿½ The provision is
identical to 

section
567 of S. 2020, passed by the Senate in 2005. 

ï¿½ï¿½ Both the Senate and House tax
reconciliation bills for Fiscal Year 2006 also modify the active 

trade
or business test to apply on a group basis to each of the affiliated chains of
corporations of which the 

distributing
and controlled corporations are the respective parent corporations, immediately
after the 

distribution.ï¿½ H.R, 4297, the Tax Relief Extension
Reconciliation Act of 2005, as passed by the House of 

Representatives,
sec. 302; H.R. 4297, the Tax Relief Act of 2005, as passed by the Senate, sec.
467(a). 

The
House bill does not contain the restrictions on disqualified investment
companies that the Senate bill 

contains.ï¿½ï¿½ 

ï¿½ï¿½ 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)).ï¿½ Priv. Ltr. Rul.
8626029 (March 25, 1986).

ï¿½ï¿½ Treas. Reg. sec. 1.170A-14(e)(2).

ï¿½ï¿½ Id.

ï¿½ï¿½ 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.ï¿½


ï¿½ï¿½ In general, a person is potentially liable
under section 107 of CERCLA if: (1) it is the owner 

and
operator of a vessel or a facility; (2) at the time of disposal of any
hazardous substance it owned or 

operated
any facility at which such hazardous substances were disposed of; (3) by
contract, agreement, or 

otherwise
it arranged for disposal or treatment, or arranged with a transporter for
transport for disposal or 

treatment,
of hazardous substances owned or possessed by such person, by any other party
or entity, at 

any
facility or incineration vessel owned or operated by another party or entity
and containing such 

hazardous
substances; or (4) it accepts or accepted any hazardous substances for
transport to disposal or 

treatment
facilities, incineration vessels or sites selected by such person, from which
there is a release, or 

a
threatened release which causes the incurrence of response costs, of a
hazardous substance.ï¿½ 42 U.S.C. 

sec.
9607(a) (2004).

ï¿½ï¿½ 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.

ï¿½ï¿½ 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.

ï¿½ï¿½ 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.ï¿½
Re-opener or regulatory action coverage is coverage for costs 

associated
with any future government actions that require further site cleanup, including
costs associated 

with
the loss of use of site improvements.ï¿½ 

ï¿½ï¿½ 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.ï¿½ Owner/operator liability coverage is coverage 

for
those parties that own the site or conduct business or engage in cleanup
operations on the site.ï¿½ 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.

ï¿½ï¿½ The Secretary of the Treasury is authorized
to issue guidance regarding the treatment of 

government-provided
funds for purposes of determining eligible remediation expenditures.

ï¿½ï¿½ For example, rent income from leasing the
property does not qualify under the proposal.ï¿½


ï¿½ï¿½ Depreciation or section 198 amounts that the
taxpayer had not used to determine its unrelated 

business
taxable income are not treated as gain that is ordinary income under sections
1245 or 1250 (secs. 

1.1245-2(a)(8)
and 1.1250-2(d)(6)), and are not recognized as gain or ordinary income upon the
sale, 

exchange,
or disposition of the property.ï¿½ 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.

ï¿½ï¿½ The exclusions do not apply to a tax-exempt
partner's gain or loss from the tax-exempt 

partner's
sale, exchange, or other disposition of its partnership interest.ï¿½ Such transactions continue to be 

governed
by present-law.ï¿½ 

ï¿½ï¿½ 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.

ï¿½ï¿½ If the taxpayer fails to satisfy the
averaging test for the properties subject to the election, then 

the
taxpayer may not apply the exclusion on a separate property basis with respect
to any of such 

properties.

ï¿½ï¿½ A taxpayer is subject to tax on gain
previously excluded (plus interest) in the event a site 

subsequently
becomes ineligible for gain exclusion under the multiple-property election.

ï¿½ï¿½ For example, it appears that the
U.S.-Barbados income tax treaty was often used to facilitate 

earnings
stripping arrangements.ï¿½ That treaty was
amended in 2004 to make it less amenable to such use.ï¿½ 

It is
possible, however, that other treaties in the U.S. network might be used for
similar purposes.ï¿½ For a 

discussion
of this issue, see Joint Committee on Taxation, Explanation of Proposed
Protocol to the 

Income
Tax Treaty Between the United States and Barbados (JCX-55-04), September 16,
2004, 12-20, 

22.

ï¿½ï¿½ See, e.g., Department of the Treasury,
General Explanations of the Administration's Fiscal 

Year
2004 Revenue Proposals, February 2003, 104 ("Under current law,
opportunities are available to 

reduce
inappropriately the U.S. tax on income earned from U.S. operations through the
use of foreign 

related-party
debt.ï¿½ 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").

ï¿½ï¿½ 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.

ï¿½ï¿½ 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.

ï¿½ï¿½ Sec. 529(b)(1)(A).

ï¿½ï¿½ Sec. 529(b)(1)(A).

ï¿½ï¿½ Sec. 529(e)(3)(A).

ï¿½ï¿½ Sec. 529(e)(3)(B).

ï¿½ï¿½ Section 529 refers to contributors and
designated beneficiaries, but does not define or 

otherwise
refer to the term account owner, which is a commonly used term among qualified
tuition 

programs.ï¿½ 

ï¿½ï¿½ Sec. 529(b)(6).

ï¿½ï¿½ 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.ï¿½ In the 

case of
prepaid tuition contracts, the limit might be expressed in terms of a maximum
number of 

semesters.

ï¿½ï¿½ Sec. 529(b)(2).

ï¿½ï¿½ Sec. 529(b)(4).

ï¿½ï¿½ Sec. 529(b)(3).

ï¿½ï¿½ Sec. 529(b)(5).

ï¿½ï¿½ Sec. 529(c)(3)(B)(v) and (vi).

ï¿½ï¿½ Sec. 529(a).ï¿½ An interest in a qualified tuition account is not treated as debt
for purposes of the 

debt-financed
property rules.ï¿½ Sec. 529(e)(4).

ï¿½ï¿½ Sec. 529(c)(3)(B).ï¿½ Any benefit furnished to a designated
beneficiary under a qualified tuition 

account
is treated as a distribution to the beneficiary for these purposes.ï¿½ Sec. 529(c)(3)(B)(iv).

ï¿½ï¿½ Sec. 529(c)(3)(A) and (B)(ii).

ï¿½ï¿½ Sec. 529(c)(6).

ï¿½ï¿½ Sec. 529(c)(3)(C)(ii).ï¿½ For this purpose,ï¿½ "member of family" means, with respect to a 

designated
beneficiary: (1) the spouse of such beneficiary; (2) an individual who bears a
relationship to 

such
beneficiary which is described in paragraphs (1) through (8) of section 152(a)
(i.e., with respect to 

the
beneficiary, a son, daughter, or a descendant of either; a stepson or
stepdaughter; a sibling or 

stepsibling;
a father, mother, or ancestor of either; a stepfather or stepmother; a son or
daughter of a 

brother
or sister; a brother or sister of a father or mother; and a son-in-law,
daughter-in-law, father-in-law, 

mother-in-law,
brother-in-law, or sister-in-law), or the spouse of any such individual; and
(3) the first 

cousin
of such beneficiary.ï¿½ Sec. 529(e)(2).

ï¿½ï¿½ Sec. 529(c)(2)(A).

ï¿½ï¿½ Sec. 529(c)(2)(B).

ï¿½ï¿½ Sec. 529(c)(5)(A).

ï¿½ï¿½ Sec. 529(c)(5)(B).

ï¿½ï¿½ Sec. 529(c)(4)(A).

ï¿½ï¿½ Sec. 529(c)(4)(B).

ï¿½ï¿½ Sec. 529(c)(4)(C).

ï¿½ï¿½ Sec. 20.2041-1(b)(1).ï¿½ See also secs. 674, 2041, and 2514.

ï¿½ï¿½ Powers of appointment are often classified
as "general powers of appointment" or as 

"limited"
or "special" powers of appointment.

ï¿½ï¿½ 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.

ï¿½ï¿½ In cases where an existing account or
contract is subject to the new rules, the entire account or 

contract
is subject to the new rules, not just that portion of the account or contract
that relates to 

contributions
made, or prepaid benefits acquired, after the date of enactment.

ï¿½ï¿½ Sec. 529(c)(2).

ï¿½ï¿½ 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).ï¿½ In cases 

where
the contributor and the account owner are the same person, no gift would take
place under 

generally
applicable transfer tax principles.

ï¿½ï¿½ A change of account owner might be regarded
as a completed gift of a present interest from 

the old
account owner to the new account owner, or as having no tax consequences
because a completed 

gift
had been made to the designated beneficiary.ï¿½


ï¿½ï¿½ The refund claim must be filed prior to the
expiration of the applicable statute of limitations 

for the
taxpayer to receive the refund.

ï¿½ï¿½ Sec. 6702.

ï¿½ï¿½ 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.ï¿½ As a result, it also deals with most 

of the
frivolous, groundless, or dilatory arguments raised in tax cases.

ï¿½ï¿½ Sec. 6673(a).

ï¿½ï¿½ It is unclear how this portion of the
proposal is intended to interact with the statutory 

prohibition
on the designation of taxpayers by the IRS as "illegal tax protesters (or
any similar 

designation)"
(sec. 3707 of the Internal Revenue Service Restructuring and Reform Act of
1998; P.L. 

105-206
(July 22, 1998)).

ï¿½ï¿½ The fiscal year 2004 and 2005 budget
proposals applied to all types of tax returns, not just 

income
tax returns.

ï¿½ï¿½ Sec. 6159.

ï¿½ï¿½ Sec. 6159(b).

ï¿½ï¿½
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).

ï¿½ï¿½ Sec. 6330(a).

ï¿½ï¿½ Sec. 6320.

ï¿½ Sec. 6330(d).

ï¿½ Sec. 7441.

ï¿½ï¿½ Sec. 7442.

ï¿½ï¿½ This reduction is attributable to the
elimination of time periods built into the judicial review 

process
to permit the refiling of appeals that have been filed with the wrong court.

ï¿½ï¿½ Nestor v. Commissioner, 118 T.C. No. 10
(February 19, 2002), concurring opinion by Judge 

Beghe.

ï¿½ï¿½ There was a slight difference in the
effective dates of those proposals.

ï¿½ï¿½ Sec. 3401(b) of P.L. 105-206 (July 22,
1998).

ï¿½ï¿½ Sec. 7122.

ï¿½ï¿½ Sec. 6405.ï¿½
The threshold for Joint Committee review is currently $2 million.

ï¿½ï¿½ Sec. 503 of the Taxpayer Bill of Rights 2
(P.L. 104-168; July 30, 1996).

ï¿½ï¿½ Sec. 6331.

ï¿½ï¿½ Sec. 6331(h).

ï¿½ï¿½ Sec. 6011(e).

ï¿½ï¿½ Partnerships with more than 100 partners
are required to file electronically.

ï¿½ï¿½ Treasury General Explanations, p. 131.

ï¿½ï¿½ Sec. 7608(c).

ï¿½ï¿½ Sec. 7601(c) of Pub. L. 100-690 (Nov. 18,
1988).

ï¿½ï¿½ Sec. 3301 of Pub. L. 101-647 (Nov. 29,
1990).

ï¿½ï¿½ The Ways and Means Committee Report stated:
"The committee believes that it is appropriate 

to
extend this provision for two additional years, to provide additional time to
evaluate its effectiveness." 

Rept.
101-681, Part 2, p. 5 (September 10, 1990).

ï¿½ï¿½ Sec. 1205 of Pub. L. 104-168 (July 30,
1996).

ï¿½ï¿½ The Ways and Means Committee Report stated:
"Many other law enforcement agencies have 

churning
authority.ï¿½ It is appropriate for IRS to
have this authority as well." Rept. 104-506, p. 47 

(March
28, 1996).ï¿½ The Senate passed the House
bill without alteration.

ï¿½ï¿½ Pub. L. 106-554.

ï¿½ï¿½ Pub. L. 109-135.

ï¿½ï¿½ Secs. 3101-3128 (FICA), 3301-3311 (FUTA),
and 3401-3404 (income tax withholding).

ï¿½ï¿½ Secs. 6011 and 6051.

ï¿½ï¿½ Treas. Reg. secs. 31.3121(d)-1(c)(1),
31.3306(i)-1(a), and 31.3401(c)-1.

ï¿½ï¿½ Issues relating to the classification of
workers as employees or independent contractors are 

discussed
in Joint Committee on Taxation, Study of the Overall State of the Federal Tax
System and 

Recommendations
for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code
of 

1986
(JCS-3-01), April 2001, at Vol. II, Part XV.A, at 539-550.

ï¿½ï¿½ Sec. 3401(d)(1) (for purposes of income tax
withholding, if the employer does not have 

control
of the payment of wages, the person having control of the payment of such wages
is treated as the 

employer);
Otte v. United States, 419 U.S. 43 (1974) (the person who has the control of
the payment of 

wages
is treated as the employer for purposes of withholding the employee's share of
FICA from wages); 

In re
Armadillo Corporation, 561 F.2d 1382 (10th Cir. 1977), and In re The Laub
Baking Company v. 

United
States, 642 F.2d 196 (6th Cir. 1981) (the person who has control of the payment
of wages is the 

employer
for purposes of the employer's share of FICA and FUTA).ï¿½ The mere fact that wages are paid 

by a
person other than the employer does not necessarily mean that the payor has
control of the payment 

of the
wages.ï¿½ Rather, control depends on the
facts and circumstances.ï¿½ See, e.g.,
Consolidated Flooring 

Services
v. United States, 38 Fed. Cl. 450 (1997), and Winstead v. United States, 109 F.
2d 989 (4th Cir. 

1997).

ï¿½ï¿½ The designated reporting agent rules do not
apply for purposes of FUTA compliance.

ï¿½ï¿½ Sec. 3504.ï¿½
Form 2678 is used to designate a reporting agent.

ï¿½ï¿½ For administrative convenience, an employer
may also use a payroll service to handle payroll 

and
employment tax filings on its behalf, but the employer, not the payroll
service, continues to be 

responsible
for employment tax compliance.

ï¿½ï¿½ Employee leasing companies are sometimes
referred to as professional employer 

organizations
or "PEOs".

ï¿½ï¿½ The leasing company may also provide the
leased employees with employee benefit coverage, 

such as
under a pension plan or a health plan.ï¿½
In such a case, the fee paid by the client also covers 

employee
benefit costs.

ï¿½ï¿½ IRS news release IR-2006-28 and attachment
(Feb. 14, 2006).ï¿½ The tax gap is the
amount of 

tax
that is imposed by law for a given tax year but is not paid voluntarily and
timely.ï¿½ 

ï¿½ï¿½ As noted above, the designated payroll
agent rules do not apply for FUTA purposes.

ï¿½ï¿½ Sec. 6041(a).

ï¿½ï¿½ The tax gap is the amount of tax that is
imposed by law for a given tax year but is not paid 

voluntarily
and timely.

ï¿½ï¿½ Sec. 6041(a).

ï¿½ï¿½ Sec. 6051(a).

ï¿½ï¿½ Sec. 6041A.

ï¿½ï¿½ Sec. 6041A(d)(3)(A).

ï¿½ï¿½ Sec. 6050M.

ï¿½ï¿½ Sec. 6331(h).

ï¿½ï¿½ The tax gap is the amount of tax that is
imposed by law for a given tax year but is not paid 

voluntarily
and timely.

ï¿½ï¿½ Sec. 6330(a).

ï¿½ï¿½ Sec. 6320.

ï¿½ï¿½ Secs. 3101-3128 (FICA), 3301-3311 (FUTA),
and 3401-3404 (income tax withholding).ï¿½


FICA
taxes consist of an employer share and an employee share, which the employer
withholds from 

employees'
wages.

ï¿½ï¿½ Sec. 7701(a)(36)(A).

ï¿½ï¿½ Sec. 6695.

ï¿½ï¿½ Sec. 6694(a).

ï¿½ï¿½ Sec. 6694(b).

ï¿½ï¿½ 1987-2 C.B. 674 (as clarified and modified
by Rev. Proc. 88-22, 1988-1 C.B. 785). 

ï¿½ï¿½ Sec. 168(e)(3)(E)(viii).

ï¿½ï¿½ See H.R. Rep. No. 108-67, at 51 (2003) and
S. Rep. No. 108-54, at 58 (2003).ï¿½ Sec. 

168(e)(3)(E)(viii)
was enacted as part of the Energy Policy Act of 2005 (Pub. L. No. 109-58).ï¿½ While 

neither
tax committee filed a committee report with respect to the Energy Policy Act of
2005, a 

substantially
identical provision to sec. 168(e)(3)(E)(viii) was passed by both the House and
the Senate in 

2003.ï¿½ The quoted text appears in each of the cited
committee reports under the heading "Reasons for 

Change."ï¿½ 

ï¿½ï¿½ While high voltage electric transmission
lines are also assigned a 15-year recovery period, the 

lower
voltage lines which go into individual homes are recovered over 20 years.ï¿½ No such distinction 

exists
with respect to the depreciable life of gas lines; thus, gas lines which serve
individual homes and 

businesses
are eligible for the 15-year recovery period under present law.

ï¿½ï¿½ Division J of the Omnibus Consolidated and
Emergency Supplemental Appropriations Act, 

H.R.
4328, Pub. L. No. 105-206 (1999).

ï¿½ï¿½ The Congress also cited improper
measurement of income and inefficient allocation of 

investment
capital as concerns.ï¿½ See Joint
Committee on Taxation, General Explanation of Tax 

Legislation
Enacted in 1998 (JCS-6-98), November 24, 1998, at 279.

ï¿½ï¿½ Department of the Treasury, Report to The
Congress on Depreciation Recovery Methods and 

Periods,
July 2000, at 1.

ï¿½ï¿½ During the years 1989 through 1991 the
now-defunct Depreciation Analysis Division of 

Treasury's
Office of Tax Analysis completed a number of property-specific reports which
included the 

results
of such studies.ï¿½ A summary of these
reports can be found in the Treasury report. See id. at 123.

ï¿½ï¿½ The portion of these credits relating to
personal use property is subject to the same tax 

liability
limitation as the nonrefundable personal tax credits (other than the adoption
credit, child credit, 

and
saver's credit).

ï¿½ï¿½ The rule applicable to the adoption credit,
child credit, and savers' credit is subject to the 

EGTRRA
sunset.

ï¿½ï¿½ For a recommendation that the repeal of the
individual alternative minimum tax will result in 

significant
tax simplification, see Study of the Overall State of the Federal Tax System
and 

Recommendations
Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986, Volume II:


Recommendations
of the Staff of the Joint Committee on Taxation to Simplify the Federal Tax
System, p. 

2.

ï¿½ï¿½ Sec. 41.

ï¿½ï¿½ The research tax credit initially was
enacted in the Economic Recovery Tax Act of 1981 as a 

credit
equal to 25 percent of the excess of qualified research expenses incurred in
the current taxable year 

over
the average of qualified research expenses incurred in the prior three taxable
years.ï¿½ The research tax 

credit
was modified in the Tax Reform Act of 1986, which (1) extended the credit
through December 31, 

1988,
(2) reduced the credit rate to 20 percent, (3) tightened the definition of
qualified research expenses 

eligible
for the credit, and (4) enacted the separate university basic research credit.

The
Technical and Miscellaneous Revenue Act of 1988 ("1988 Act") extended
the research tax 

credit
for one additional year, through Decemberï¿½
31, 1989.ï¿½ The 1988 Act also
reduced the deduction 

allowed
under section 174 (or any other section) for qualified research expenses by an
amount equal to 50 

percent
of the research tax credit determined for the year.

The
Omnibus Budget Reconciliation Act of 1989 ("1989 Act") effectively
extended the research 

credit
for nine months (by prorating qualified expenses incurred before January 1,
1991).ï¿½ The 1989 Act 

also
modified the method for calculating a taxpayer's base amount (i.e., by
substituting the present-law 

method
which uses a fixed-base percentage for the prior-law moving base which was
calculated by 

reference
to the taxpayer's average research expenses incurred in the preceding three
taxable years).ï¿½ The 

1989
Act further reduced the deduction allowed under section 174 (or any other
section) for qualified 

research
expenses by an amount equal to 100 percent of the research tax credit
determined for the year.

The
Omnibus Budget Reconciliation Act of 1990 extended the research tax credit
through 

December
31, 1991 (and repealed the special rule to prorate qualified expenses incurred
before January 1, 

1991).

The Tax
Extension Act of 1991 extended the research tax credit for six months (i.e.,
for qualified 

expenses
incurred through June 30, 1992).

The
Omnibus Budget Reconciliation Act of 1993 ("1993 Act") extended the
research tax credit 

for
three years-i.e., retroactively from July 1, 1992 through June 30, 1995.ï¿½ The 1993 Act also provided a 

special
rule for start-up firms, so that the fixed-base ratio of such firms eventually
will be computed by 

reference
to their actual research experience.

Although
the research tax credit expired during the period July 1, 1995, through June
30, 1996, 

the
Small Business Job Protection Act of 1996 ("1996 Act") extended the
credit for the period July 1, 

1996,
through May 31, 1997 (with a special 11-month extension for taxpayers that
elect to be subject to 

the
alternative incremental research credit regime).ï¿½ In addition, the 1996 Act expanded the definition of 

start-up
firms under section 41(c)(3)(B)(i), enacted a special rule for certain research
consortia payments 

under
section 41(b)(3)(C), and provided that taxpayers may elect an alternative
research credit regime 

(under
which the taxpayer is assigned a three-tiered fixed-base percentage that is
lower than the fixed-

base
percentage otherwise applicable and the credit rate likewise is reduced) for
the taxpayer's first 

taxable
year beginning after June 30, 1996, and before July 1, 1997.

The
Taxpayer Relief Act of 1997 ("1997 Act") extended the research credit
for 13 months-i.e., 

generally
for the period June 1, 1997, through June 30, 1998.ï¿½ 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).ï¿½ The Tax and Trade Relief Extension 

Act of
1998 extended the research credit for 12 months, i.e., through June 30,
1999.ï¿½ 

The
Ticket To Work and Work Incentive Improvement Act of 1999 extended the research
credit 

for
five years, through June 30, 2004, increased the rates of credit under the
alternative incremental 

research
credit regime, and expanded the definition of research to include research
undertaken in Puerto 

Rico
and possessions of the United States.

The
Working Families Tax Relief Act of 2004 extended the research credit through
December 31, 

2005.

The
Energy Tax Incentives Act of 2005 added the energy research credit.

ï¿½ï¿½ 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.ï¿½ A special rule (enacted in 1993) was designed 

to
gradually recompute a start-up firm's fixed-base percentage based on its actual
research experience.ï¿½ 

Under
this special rule, a start-up firm would be assigned a fixed-base percentage of
three percent for 

each of
its first five taxable years after 1993 in which it incurs qualified research
expenses.ï¿½ In the event 

that
the research credit is extended beyond its expiration date, a start-up firm's
fixed-base percentage for 

its
sixth through tenth taxable years after 1993 in which it incurs qualified
research expenses will be a 

phased-in
ratio based on its actual research experience.ï¿½
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)).

ï¿½ï¿½ Sec. 41(c)(4).

ï¿½ï¿½ Under a special rule enacted as part of the
Small Business Job Protection Act of 1996, 75 

percent
of amounts paid to a research consortium for qualified research were treated as
qualified research 

expenses
eligible for the research credit (rather than 65 percent under the general rule
under section 

41(b)(3)
governing contract research expenses) if (1) such research consortium was a
tax-exempt 

organization
that is described in section 501(c)(3) (other than a private foundation) or
section 501(c)(6) 

and was
organized and operated primarily to conduct scientific research, and (2) such qualified
research 

was
conducted by the consortium on behalf of the taxpayer and one or more persons
not related to the 

taxpayer.ï¿½ Sec. 41(b)(3)(C).

ï¿½ï¿½ Taxpayers may elect 10-year amortization of
certain research expenditures allowable as a 

deduction
under section 174(a).ï¿½ Secs. 174(f)(2)
and 59(e).

ï¿½ï¿½ This conclusion does not depend upon
whether the basic tax regime is an income tax or a 

consumption
tax.

ï¿½ï¿½ 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 Barfield, editors,
Technology, R&D and the 

Economy,
(Washington, D.C.:ï¿½ Brookings
Institution Press), 1996, pp. 1-14.ï¿½
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.ï¿½ 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."ï¿½
Griliches, p. S43.

ï¿½ï¿½ Organisation for Economic Co-operation and
Development, OECD Science, Technology and 

Industry
Scoreboard, 2005, (Paris:ï¿½ Organisation
for Economic Co-operation and Development), 2005.ï¿½ 

These
data represent outlays by private persons and by governments.ï¿½ The figures reported in this 

paragraph
and Figure 1 do not include the value of tax expenditures, if any.ï¿½ The OECD, measuring in 

real
1995 dollars, calculates that the United States spent approximately $268
billion on research and 

development
in 2003.

ï¿½ï¿½ Ibid.ï¿½
While the OECD attempts to present these data on a standardized basis
the cross-

country
comparisons are not perfect.ï¿½ For
example, the United States reporting for research spending 

generally
does not include capital expenditure outlays devoted to research while the
reporting of some 

other
countries does include capital expenditures.

ï¿½ï¿½ Ibid.ï¿½
The OECD calculates the annual real rate of growth of expenditures on
research and 

development
for the period 1995-2003 in the European Union and in all OECD countries at 3.3
percent 

and 3.7
percent, respectively.

ï¿½ï¿½ Organisation for Economic Co-operation and
development, OECD Science, Technology and 

Industry
Scoreboard, 2005. (Paris: Organisation for Economic Co-operation and
development), 2005.ï¿½ 

The
index is calculated as one minus the so-called "B-index."ï¿½ The B-index is equal to the after-tax cost 

of an
expenditure of one dollar on qualifying research, divided by one minus the
taxpayer marginal tax 

rate.ï¿½ Alternatively, the B-index represents the
present value of pre-tax income that is necessary to earn in 

order
to finance the research activity and earn a positive after-tax profit.ï¿½ In practice, construction of the 

B-index
and the index number reported in Table 2 requires a number of simplifying
assumptions.ï¿½ As a 

consequence,
the relative position of the tax benefits of various countries reported in the
table is only 

suggestive.

ï¿½ï¿½ Joint Committee on Taxation, Estimates of
Federal Tax Expenditures for Fiscal Years 2005-

2009
(JCS-1-05), January 12, 2005, p. 30.ï¿½ 

ï¿½ï¿½ Office of Management and Budget, Budget of
the United States Government, Fiscal Year 

2007,
Appendix, pp. 294-299.ï¿½ (Figures include
military and non-military departments.)

ï¿½ï¿½ Office of Management and Budget, Budget of
the United States Government, Fiscal Year 

2007,
Appendix, pp. 1073-1074, 294-299 and 387-388.

ï¿½ï¿½ The $5.7 billion figure reported for 2003
is not directly comparable to the $4.8 billion tax 

expenditure
estimate for 2005 reported in the preceding paragraph.ï¿½ The tax expenditure estimate 

accounts
for the present-law requirement that deductions for research expenditures be
reduced by research 

credits
claimed.ï¿½ Also, the $5.7 billion figure
does not reflect the actual tax reduction achieved by 

taxpayers
claiming research credits in 2003 as the actual tax reduction will depend upon
whether the 

taxpayer
had operating losses, was subject to the alternative minimum tax, or other
aspects specific to 

each
taxpayer's situation.

ï¿½ï¿½ 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).ï¿½ 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.

ï¿½ï¿½ It is important to note that not all
research expenditures need be subject to a price reduction to 

have
this effect.ï¿½ Only the expenditures that
would not have been undertaken otherwise-so called 

marginal
research expenditures-need be subject to the credit to have a positive incentive
effect.

ï¿½ï¿½ 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.ï¿½ The negative coefficient
in the text reflects that a decrease in price results in an 

increase
in research expenditures.ï¿½ 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.ï¿½ See, Department of the Treasury, "The 

Impact
of Section 861-8 Regulation on Research and Development," p. 23.ï¿½ As stated in the text, although 

there
is uncertainty, most analysts believe the elasticity is considerable
smaller.ï¿½ 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.ï¿½ 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.ï¿½
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.

ï¿½ï¿½ Bronwyn Hall and John Van Reenen, "How
effective are fiscal incentives for R&D?ï¿½
A 

review
of the evidence," Research Policy, vol.29, 2000, p. 462.ï¿½ This survey reports that more recent 

empirical
analyses have estimated higher elasticity estimates.ï¿½ 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.ï¿½ The 

author
of this study notes that the long-run estimate should be viewed with caution
for several technical 

reasons.ï¿½ In addition, the data utilized for the study
cover the period 1980 through 1991, containing only 

two
years under the revised credit structure.ï¿½
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.ï¿½ 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.ï¿½ï¿½ 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.ï¿½ 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.ï¿½ 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).ï¿½ 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.ï¿½ 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.ï¿½ 

Other
research suggests that many of the elasticity studies may overstate the
efficiency of 


subsidies
to research.ï¿½ Most R&D spending is
for wages and the supply of qualified scientists is small, 

particularly
in the short run.ï¿½ Subsidies may raise
the wages of scientists, and hence research spending, 

without
increasing actual research.ï¿½ See Austan
Goolsbee, "Does Government R&D Policy Mainly 

Benefit
Scientists and Engineers?"ï¿½
American Economic Review, vol. 88, May, 1998, pp. 298-302.

ï¿½ï¿½ Hall and Van Reenen, "How effective
are fiscal incentives for R&D?ï¿½ A
review of the 

evidence,"
p. 463.ï¿½ 

ï¿½ï¿½ 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.

ï¿½ï¿½ 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.

ï¿½ï¿½ 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.

ï¿½ï¿½ David R. Seltzer, "Federal Income Tax
Compliance Costs:ï¿½ A Case Study of
Hewlett-Packard 

Company,"
National Tax Journal, vol. 50, September 1997, pp. 487-493.

ï¿½ï¿½ 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).

ï¿½ï¿½ 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.

ï¿½ï¿½ 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.

ï¿½ï¿½ 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.

ï¿½ï¿½ 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.

ï¿½ï¿½ Pub. L. No. 107-147, "The Job Creation
and Worker Assistance Act of 2002," extended the 

credits
for two years.

ï¿½ï¿½ Sec. 1400C(i).ï¿½ The District of Columbia first-time homebuyer credit was enacted
as part of 

the
Taxpayer Relief Act of 1997, and was scheduled to expire on December 31,
2000.ï¿½ The Tax Relief 

Extension
Act of 1999 extended the first-time homebuyer credit for one year, through
December 31, 

2000.ï¿½ The Community Renewal Tax Relief Act of 2000
extended the first-time homebuyer credit for two 

additional
years, through December 31, 2003.ï¿½ The
Working Families Tax Relief Act of 2004 extended 

the
first-time homebuyer credit for two additional years, through December 31,
2005.

ï¿½ï¿½ Other factors may also affect the choice of
where to live, such as closeness to work or family 

members.

ï¿½ï¿½ Sec. 103.

ï¿½ï¿½ Sec. 149(e).

ï¿½ï¿½ Sec. 103(a) and (b)(2).

ï¿½ï¿½ Sec. 148. 

ï¿½ï¿½ Sec. 1397E.

ï¿½ï¿½ 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).ï¿½ The additional spending is not dollar for
dollar, 

however,
implying that there is some reduction of local taxes to offset the outside funding.ï¿½ See Harvey 

Rosen,
Public Finance, sixth ed., 2002, p. 502-503 for a discussion of this issue.

ï¿½ï¿½ This is true provided that the taxpayer
faces tax liability of at least the amount of the credit.ï¿½ 

Without
sufficient tax liability, the proposed tax credit arrangement would not be as
advantageous.ï¿½ 

Presumably,
only taxpayers who anticipate having sufficient tax liability to be offset by
the proposed 

credit
would hold these bonds.

ï¿½ï¿½ 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.ï¿½ REG 121475-03, 69 CFR 

15747
(March 26, 2004).

ï¿½ï¿½ Sec. 6103(a).

ï¿½ï¿½ Sec. 6103(b)(1).

ï¿½ï¿½ Sec. 6103(b)(2).ï¿½ Return information isï¿½ 

?ï¿½ï¿½ï¿½ï¿½ a taxpayer's identity, the nature, source,
or amount of his income, payments, receipts, 

deductions,
exemptions, credits, assets, liabilities, net worth, tax liability, tax
withheld, 

deficiencies,
overassessments, or tax payments, whether the taxpayer's return was, is 

being,
or will be examined or subject to other investigation or processing, or any
other 

data,
received by, recorded by, prepared by, furnished to, or collected by the
Secretary 

with
respect to a return or with respect to the determination of the existence, or
possible 

existence,
of liability (or the amount thereof) of any person under this title for any
tax, 

penalty,
interest, fine, forfeiture, or other imposition, or offense,

?ï¿½ï¿½ï¿½ï¿½ any part of any written determination or
any background file document relating to such 

written
determination (as such terms are defined in section 6110(b)) which is not open
to 

public
inspection under section 6110,

?ï¿½ï¿½ï¿½ï¿½ any advance pricing agreement entered into
by a taxpayer and the Secretary and any 

background
information related to such agreement or any application for an advance 

pricing
agreement, and

?ï¿½ï¿½ï¿½ï¿½ï¿½ closing agreement under section 7121, and
any similar agreement, and any background 

information
related to such an agreement or request for such an agreement,

Return
information does not include data in a form which cannot be associated with, or
otherwise 

identify,
directly or indirectly, a particular taxpayer.ï¿½


ï¿½ï¿½ï¿½ Sec. 6103(c) - (o).

ï¿½ï¿½ 18 U.S.C. 2331.

ï¿½ï¿½ Sec. 6103(i)(3)(C).

ï¿½ï¿½ Sec. 6103(i)(7)(A).

ï¿½ï¿½ Sec. 6103(i)(7)(B).

ï¿½ï¿½ Sec. 6103(i)(7)(C).

ï¿½ï¿½ As noted above, an ex parte court order is
not necessary to obtain information gathered from a 

source
other than the taxpayer.

ï¿½ï¿½ Sec. 6103(i)(7)(D).

ï¿½ï¿½ 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.

ï¿½ï¿½ 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.

ï¿½ï¿½ Joint Committee on Taxation, Disclosure
Report for Public Inspection Pursuant to Internal 

Revenue
Code Section 6103(p)(3)(C) for Calendar Year 2004 (JCX-63-05), August 19, 2005.

ï¿½ï¿½ Sec. 6103.

ï¿½ï¿½ Sec. 6103(l)(13).

ï¿½ï¿½ Sec. 6103(l)(13)(D).

ï¿½ï¿½ Sec. 6103(c).

ï¿½ï¿½ Department of Treasury, Report to the
Congress on Scope and Use of Taxpayer 

Confidentiality
and Disclosure Provisions, Volume I:ï¿½
Study of General Provisions (October 2000) at 91.

ï¿½ï¿½ Department of Treasury, General
Explanations of the Administration's Fiscal Year 2004 

Revenue
Proposals (February 2003), p. 133.

ï¿½ï¿½ Pub. L. No. 105-244, sec. 483 (1998).

ï¿½ï¿½ Sec. 6103(m)(4).

ï¿½ï¿½ Id.

ï¿½ï¿½ Sec. 6103(p)(4).

ï¿½ï¿½ Sec. 6103(p)(5).

ï¿½ï¿½ S. Prt. No. 103-37 at 54 (1993).

ï¿½ï¿½ 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.ï¿½
Accordingly, the Department of Education has asked to be included in the


TDS
program."ï¿½ Department of Treasury,
Report to the Congress on Scope and Use of Taxpayer 

Confidentiality
and Disclosure Provisions, Volume I:ï¿½
Study of General Provisions (2000) at 92.

ï¿½ï¿½ The Department of Education seeks access to
the return information of approximately 15 

million
taxpayers each year.ï¿½ The Department of
Education receives approximately 10 million 

applications
for student financial assistance each year.ï¿½
Because roughly half of the applicants are 

dependents,
income information is needed for both the student and his or her parents.ï¿½ Thus, verification 

under
this provision could apply to over 15 million taxpayers each year.ï¿½ï¿½ It is not clear what percentage 

of
applicants submits fraudulent financial aid applications.ï¿½ Id.

ï¿½ï¿½ Congressional Research Service, RS21239 The
Black Lung Benefits Program (June 12, 2002) 

at 6.

ï¿½ï¿½ Id.

ï¿½ï¿½ A similar issue would arise with respect to
the child credit, because that credit also is phased 

out
based on adjusted gross income.ï¿½
However, present law addresses this potential adverse effect by 

including
combat pay only for purposes of calculating the refundable portion of the
credit.

ï¿½ï¿½ A proof gallon is a liquid gallon
consisting of 50 percent alcohol.ï¿½ See
sec. 5002(a)(10) and 

(11).

ï¿½ï¿½ Sec. 5001(a)(1).

ï¿½ï¿½ Secs. 5062(b), 7653(b) and (c).

ï¿½ï¿½ Secs. 7652(a)(3), (b)(3), and (e)(1).ï¿½ 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).

ï¿½ï¿½ 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.ï¿½
Sec. 7652(f)(2).

ï¿½ï¿½ Sec. 7652(e)(2).

ï¿½ï¿½ Secs. 7652(a)(3), (b)(3), and (e)(1).

ï¿½ï¿½ Pub. L. No. 108-311, sec. 305 (2004).

ï¿½ï¿½ 27 U.S.C. sec. 204.

ï¿½ï¿½ 27 U.S.C. sec. 205(e).

ï¿½ï¿½ 27 CFR secs. 5.25-5.28.

ï¿½ï¿½ Sec. 5134(a).

ï¿½ï¿½ Sec. 7528(a).ï¿½ See Rev. Proc. 2006-8, 2006-1 I.R.B. 245.

ï¿½ï¿½ Sec. 7528(b).

ï¿½ï¿½ Minimum fees would be in accordance with
the minimum fees for the appropriate category of 

services
to which the relevant service is similar.

ï¿½ï¿½ See Rev. Proc. 93-23, 1993-1 CB 538.

ï¿½

ï¿½

 

ï¿½

 

ï¿½

 

ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ï¿½ 

 

 

 

 

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