59–010 

110TH CONGRESS REPORT " ! SENATE 1st Session 110–1 

SMALL BUSINESS AND WORK OPPORTUNITY ACT OF 2007 

JANUARY 22, 2007.—Ordered to be printed 

Mr. BAUCUS, from the Committee on Finance, 

submitted the following 

R E P O R T 

together with 

ADDITIONAL VIEWS 

[To accompany S. 349] 

The Committee on Finance, having considered an original bill, S. 

349, to amend the Internal Revenue Code of 1986 to provide additional tax incentives to employers and employees of small businesses, and for other purposes, reports favorably thereon and recommends that the bill do pass. 

CONTENTS 

Page 

I. LEGISLATIVE BACKGROUND ..................................................................... 2 

TITLE I—SMALL BUSINESS TAX RELIEF PROVISIONS ....................... 3 

A. Extension of Increased Expensing for Small Business (sec. 101 

of the bill and sec. 179 of the Code) ................................................. 3 

B. Fifteen-Year Straight-Line Cost Recovery for Qualified Leasehold 

Improvements, Qualified Restaurant Improvements and New 

Restaurant Buildings (Sec. 102 of the bill and sec. 168 of the 

Code) ................................................................................................... 5 

C. Fifteen-Year Straight-Line Cost Recovery for Qualified Retail Improvement Property (sec. 102 of the bill and sec. 168 of the 

Code) ................................................................................................... 7 

D. Expand Eligibility for Cash Method of Accounting (sec. 103 of 

the bill and secs. 446 and 448 of the Code) ..................................... 8 

E. Work Opportunity Tax Credit (sec. 104 of the bill and sec. 51 

of the Code) ......................................................................................... 10 

F. Treatment of Professional Employer Organizations as Employers 

for Employment Tax Purposes (sec. 105 of the bill and new 

secs. 3511 and 7705 of the Code) ...................................................... 15 

G. Subchapter S Provisions (secs. 111–116 of the bill and secs. 1361 

and 1362 of the Code) ........................................................................ 24 

1. Capital gain not treated as passive investment income ................ 24 

2. Treatment of bank director shares .................................................. 25 


hmoore on PROD1PC68 with HMRPT
2 

3. Treatment of banks changing from reserve method of accounting .................................................................................................... 26 

4. Treatment of sale of an interest in a qualified subchapter S 

subsidiary ........................................................................................ 27 

5. Elimination of earnings and profits attributable to pre–1983 

years ................................................................................................ 28 

6. Expansion of qualifying beneficiaries of an electing small business trust ......................................................................................... 28 

TITLE II—REVENUE PROVISIONS ............................................................. 29 

A. Modification of Effective Date of Leasing Provisions of the American Jobs Creation Act of 2004 (sec. 201 of the bill and sec. 

470 of the Code) .................................................................................. 29 

B. Tax Treatment of Certain Inverted Corporate Entities (sec. 202 

of the bill and sec. 7874 of the Code) ............................................... 30 

C. Denial of Deduction for Punitive Damages (sec. 203 of the bill 

and sec. 162(g) of the Code) .............................................................. 35 

D. Denial of Deduction for Certain Fines, Penalties, and Other 

Amounts (sec. 204 of the bill and sec. 162 of the Code) .................. 36 

E. Revision of Tax Rules on Expatriation of Individuals (sec. 205 

of the bill and secs. 102, 877, 2107, 2501, 7701 and 6039G 

of the Code) ......................................................................................... 39 

F. Limit Amounts of Annual Deferrals Under Nonqualified Deferred 

Compensation Plans (sec. 206 of the bill and sec. 409A of the 

Code) ................................................................................................... 51 

G. Increase in Criminal Monetary Penalty Limitation for the Underpayment or Overpayment of Tax Due to Fraud (sec. 207 of the 

bill and secs. 7201, 7203, and 7206 of the Code) ............................. 54 

H. Doubling of Certain Penalties, Fines, and Interest on Underpayments Related to Certain Offshore Financial Arrangements (sec. 

208 of the bill) .................................................................................... 56 

I. Increase in Penalty for Bad Checks and Money Orders (sec. 209 

of the bill and sec. 6657 of the Code) ............................................... 60 

J. Treatment of Contingent Payment Convertible Debt Instruments 

(sec. 210 of the bill and sec. 1275 of the Code) ................................ 61 

K. Extension of IRS User Fees (sec. 211 of the bill and sec. 7528 

of the Code) ......................................................................................... 64 

L. Modification of Collection Due Process Procedures for Employment Tax Liabilities (sec. 212 of the bill and sec. 6330 of the 

Code) ................................................................................................... 64 

M. Whistleblower Reforms (sec. 213 of the bill and sec. 7623 of 

the Code) ............................................................................................. 66 

N. Expand Denial of Deduction for Certain Excessive Employee Remuneration (sec. 214 of the bill and sec. 162(m) of the Code) ........ 68 

II. BUDGET EFFECTS OF THE BILL ............................................................... 69 

III. VOTES OF THE COMMITTEE ...................................................................... 73 

IV. REGULATORY IMPACT AND OTHER MATTERS ..................................... 73 

V. ADDITIONAL VIEWS ..................................................................................... 75 

VI. CHANGES IN EXISTING LAW MADE BY THE BILL, AS REPORTED 76 

I. LEGISLATIVE BACKGROUND 

Since the Fair Labor Standards Act of 1938, Congress has required employers to pay a minimum wage to workers, with some 

exceptions. Congress enacted the current general minimum wage of 

$5.15 an hour in 1996. The decade that has passed since then 

marks the longest period in history without an adjustment to the 

minimum wage. A majority of states have enacted minimum wages 

in excess of the current Federal level. 

A full-time minimum wage worker earns about $10,712 a year. 

Roughly two million workers are paid at or below the federal minimum wage. Millions more would be affected by any increase, because many workers earn slightly more than the minimum wage 

and may also see an increase. According to some research, smaller 

businesses employ a disproportionate share of workers earning the 

minimum wage. Small business owners have therefore argued that 


hmoore on PROD1PC68 with HMRPT
3 

1The Committee heard testimony that while increasing the minimum wage would benefit 

workers through increased wages, a minimum wage increase may also have consequences of employers hiring fewer workers or reducing workers’ hours. Others testified that research has 

shown moderate increases to the minimum wage have little or no adverse employment impact 

with significant benefits to affected workers. 2 Additional section 179 incentives are provided with respect to qualified property meeting applicable requirements that is used by a business in an empowerment zone (sec. 1397A), a renewal community (sec. 1400J), or the Gulf Opportunity Zone (sec. 1400N(e)). 3 Rev. Proc. 2006–53, sec. 2.19, 2006–48 I.R.B. 996 (Nov. 27, 2006). 

any increase in the minimum wage should be accompanied by tax 

incentives targeted for small businesses in order to lower their 

costs. 

The Finance Committee has exclusive jurisdiction over tax matters and held a hearing on January 10, 2007, entitled, ‘‘Tax Incentives for Businesses in Response to a Minimum Wage Increase.’’ The Committee heard from a variety of witnesses, including labor 

economists, small business owners, and tax experts.1 Following this 

hearing, the Committee held a mark-up on January 17, 2007, to 

consider an original bill, S. 349 (the ‘‘Small Business and Work Opportunity Act of 2007’’), a revenue-neutral bill containing a number 

of tax incentives for small businesses and businesses that hire minimum wage workers. With a majority and quorum present, the 

Committee favorably reported the bill by unanimous voice vote on 

that date and this report describes the provisions of the bill. The 

Committee anticipates that the Senate may consider adding the 

substance of this bill to H.R. 2, the ‘‘Fair Minimum Wage Act of 

2007,’’ or similar legislation. 

TITLE I—SMALL BUSINESS TAX RELIEF PROVISIONS 

A. EXTENSION OF INCREASED EXPENSING FOR SMALL BUSINESS

(Sec. 101 of the bill and sec. 179 of the Code) 

PRESENT LAW

In lieu of depreciation, a taxpayer with a sufficiently small 

amount of annual investment may elect to deduct (or ‘‘expense’’) 

such costs under section 179. Present law provides that the maximum amount a taxpayer may expense, for taxable years beginning 

in 2003 through 2009, is $100,000 of the cost of qualifying property 

placed in service for the taxable year.2 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. Offthe-shelf computer software placed in service in taxable years beginning before 2010 is treated as qualifying property. The $100,000 

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

cost of qualifying property placed in service during the taxable year 

exceeds $400,000. The $100,000 and $400,000 amounts are indexed 

for inflation for taxable years beginning after 2003 and before 

2010. For taxable years beginning in 2007, the inflation-adjusted 

amounts are $112,000 and $450,000, respectively.3

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

exceed the taxable income for a taxable year that is derived from 

the active conduct of a trade or business (determined without regard to this provision). Any amount that is not allowed as a deduction because of the taxable income limitation may be carried forward to succeeding taxable years (subject to similar limitations). 


hmoore on PROD1PC68 with HMRPT
4 

4Sec. 179(c)(1). Under Treas. Reg. sec. 1.179–5, applicable to property placed in service in taxable years beginning after 2002 and before 2008, a taxpayer is permitted to make or revoke an 

election under section 179 without the consent of the Commissioner on an amended Federal tax 

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

law for filing an amended return for the taxable year. T.D. 9209, July 12, 2005. 5Sec. 179(c)(2). 

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.4

For taxable years beginning in 2010 and thereafter (or before 

2003), the following rules apply. A taxpayer with a sufficiently 

small amount of annual investment may elect to deduct up to 

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

taxable year. The $25,000 amount is reduced (but not below zero) 

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

service during the taxable year exceeds $200,000. The $25,000 and 

$200,000 amounts are not indexed. 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 (not including off-the-shelf computer software). An expensing election may 

be revoked only with consent of the Commissioner.5

REASONS FOR CHANGE

The Committee believes that section 179 expensing provides two 

important benefits for small businesses. First, it lowers the cost of 

capital for property used in a trade or business. With a lower cost 

of capital, the Committee believes small businesses will invest in 

more equipment and employ more workers. Second, it eliminates 

depreciation recordkeeping requirements with respect to expensed 

property. In 2006, Congress acted to extend the increased value of 

these benefits and the increased number of taxpayers eligible for 

these benefits for taxable years through 2009. The Committee believes that the changes to section 179 expensing will continue to 

provide important benefits if extended, and the bill therefore extends these changes for an additional year. 

EXPLANATION OF PROVISION

The provision extends for one year the increased amount that a 

taxpayer may deduct and the other section 179 rules applicable in 

taxable years beginning before 2010. Thus, under the provision, 

these present-law rules continue in effect for taxable years beginning after 2009 and before 2011. 

EFFECTIVE DATE

The provision is effective for taxable years beginning after December 31, 2009. 


hmoore on PROD1PC68 with HMRPT
5 

6Sec. 168. 

B. FIFTEEN-YEAR STRAIGHT-LINE COST RECOVERY FOR QUALIFIED

LEASEHOLD IMPROVEMENTS, QUALIFIED RESTAURANT IMPROVE- MENTS AND NEW RESTAURANT BUILDINGS

(Sec. 102 of the bill and sec. 168 of the Code) 

PRESENT LAW

In general 

A taxpayer generally must capitalize the cost of property used in 

a trade or business and recover such cost over time through annual 

deductions for depreciation or amortization. Tangible property generally is depreciated under the modified accelerated cost recovery 

system (‘‘MACRS’’), which determines depreciation by applying specific recovery periods, placed-in-service conventions, and depreciation methods to the cost of various types of depreciable property.6

The cost of nonresidential real property is recovered using the 

straight-line method of depreciation and a recovery period of 39 

years. Nonresidential real property is subject to the mid-month 

placed-in-service convention. Under the mid-month convention, the 

depreciation allowance for the first year property is placed in service is based on the number of months the property was in service, 

and property placed in service at any time during a month is treated as having been placed in service in the middle of the month. 

Depreciation of 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. 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 was placed in service. However, exceptions exist for certain qualified leasehold improvements and certain qualified restaurant property. 

Qualified leasehold improvement property 

Section 168(e)(3)(E)(iv) provides a statutory 15-year recovery period for qualified leasehold improvement property placed in service 

before January 1, 2008. Qualified leasehold improvement property 

is recovered using the straight-line method. Leasehold improvements placed in service in 2008 and later will be subject to the general rules described above. 

Qualified leasehold improvement property is any improvement to 

an interior portion of a building that is nonresidential real property, provided certain requirements are met. The improvement 

must be made under or pursuant to a lease either by the lessee (or 

sublessee), or by the lessor, of that portion of the building to be occupied exclusively by the lessee (or sublessee). The improvement 

must be placed in service more than three years after the date the 

building was first placed in service. Qualified leasehold improveVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00005 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
6 

ment property does not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, any structural component benefiting a common 

area, or the internal structural framework of the building. However, if a lessor makes an improvement that qualifies as qualified 

leasehold improvement property, such improvement does not qualify as qualified leasehold improvement property to any subsequent 

owner of such improvement. An exception to the rule applies in the 

case of death and certain transfers of property that qualify for nonrecognition treatment. 

Qualified restaurant property 

Section 168(e)(3)(E)(v) provides a statutory 15-year recovery period for qualified restaurant property placed in service before January 1, 2008. For purposes of the provision, qualified restaurant 

property means any improvement to a building if such improvement is placed in service more than three years after the date such 

building was first placed in service and more than 50 percent of the 

building’s square footage is devoted to the preparation of, and seating for on-premises consumption of, prepared meals. Qualified restaurant property is recovered using the straight-line method. 

REASONS FOR CHANGE

The Committee believes that taxpayers should not be required to 

recover the costs of certain leasehold improvements beyond the 

useful life of the investment. The 39-year recovery period for leasehold improvements for property placed in service after December 

31, 2007 extends beyond the useful life of many such investments. 

Although lease terms differ, the Committee believes that lease 

terms for commercial real estate are also typically shorter than the 

39-year recovery period. In the interests of simplicity and administrability, a uniform period for recovery of leasehold improvements 

is desirable. Therefore, the provision extends the 15-year recovery 

period for leasehold improvements. 

The Committee also believes that unlike other commercial buildings, restaurant buildings generally are more specialized structures. Restaurants also experience considerably more traffic, and 

remain open longer than most commercial properties. This daily 

use causes rapid deterioration of restaurant properties and forces 

restaurateurs to constantly repair and upgrade their facilities. As 

such, restaurant facilities generally have a shorter life span than 

other commercial establishments. The Committee bill extends the 

15-year recovery period for improvements made to restaurant 

buildings, and applies the 15-year recovery period to new restaurants, to more accurately reflect the true economic life of such 

properties. 

EXPLANATION OF PROVISION

The present-law provisions for qualified leasehold improvement 

property and restaurant improvements are extended for three 

months (through March 31, 2008). In addition, the three-year rule 

for restaurant property is repealed. Thus, newly constructed restaurant buildings and restaurant improvements within the first 

three years also qualify for the 15-year recovery period. 


hmoore on PROD1PC68 with HMRPT
7 

7Sec. 168. 

8Sec. 168(e)(3)(E)(iv). 

EFFECTIVE DATE

The provision generally applies to property placed in service after 

December 31, 2007. Repeal of the three-year rule for restaurant 

property is effective for property placed in service after the date of 

enactment, the original use of which begins with the taxpayer after 

the date of enactment. 

C. FIFTEEN-YEAR STRAIGHT-LINE COST RECOVERY FOR QUALIFIED

RETAIL IMPROVEMENT PROPERTY

(Sec. 102 of the bill and sec. 168 of the Code) 

PRESENT LAW

A taxpayer generally must capitalize the cost of property used in 

a trade or business and recover such cost over time through annual 

deductions for depreciation or amortization. Tangible property generally is depreciated under the modified accelerated cost recovery 

system (‘‘MACRS’’), which determines depreciation by applying specific recovery periods, placed-in-service conventions, and depreciation methods to the cost of various types of depreciable property.7

The cost of nonresidential real property is recovered using the 

straight-line method of depreciation and a recovery period of 39 

years. Nonresidential real property is subject to the mid-month 

placed-in-service convention. Under the mid-month convention, the 

depreciation allowance for the first year property is placed in service is based on the number of months the property was in service, 

and property placed in service at any time during a month is treated as having been placed in service in the middle of the month. 

Generally, depreciation allowances for improvements made on retail property are determined under MACRS. If a retail property 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 was placed in service. A special provision provides a 15-year 

recovery period for qualified leasehold improvement property.8

REASONS FOR CHANGE

The Committee believes that taxpayers should not be required to 

recover the costs of certain improvements beyond the useful life of 

the investment. The present law 39-year recovery period for improvements to owner occupied (i.e., not leased) retail property extends beyond the useful life of many such investments. Therefore, 

the provision includes a 15-year recovery period for qualified retail 

improvements. 

Additionally, the Committee believes that retailers should not be 

treated differently based on whether the building in which they operate is owned or leased. The shorter 15-year recovery period for 

leasehold improvements under present law provides an unfair competitive advantage for those retailers who lease space. As many 

small business retailers own the building in which they operate 


hmoore on PROD1PC68 with HMRPT
8 

9 Improvements to portions of a building not open to the general public (e.g., stock room in 

back of retail space) do not qualify under the provision. 10For this purpose, a tax-exempt trust with unrelated business income is treated as a C corporation with respect to the portion of its activities that constitute an unrelated trade or business. Treas. Reg. sec. 1.448–1T(a)(3). 

their business, the Committee believes this provision will provide 

relief to small businesses. 

EXPLANATION OF PROVISION

The provision provides a statutory 15-year recovery period for 

qualified retail improvement property placed in service before 

March 31, 2008. For purposes of the provision, qualified retail improvement property means any improvement to an interior portion 

of a building which is nonresidential real property if such portion 

is open to the general public 9 and is used in the retail trade or 

business of selling tangible personal property to the general public, 

and such improvement is placed in service more than three years 

after the date the building was first placed in service. Qualified retail improvement property does not include any improvement for 

which the expenditure is attributable to the enlargement of the 

building, any elevator or escalator, or the internal structural 

framework of the building. 

For the purposes of this provision, retail establishments that 

qualify for the 15-year recovery period include those primarily engaged in the sale of goods. Examples of these retail establishments 

include, but are not limited to, grocery stores, clothing stores, hardware stores and convenience stores. However, establishments primarily engaged in providing services, such as professional services, 

financial services, personal services, health services, and entertainment, do not qualify. It is generally intended that businesses defined as a store retailer under the current North American Industry Classification System (industry sub-sectors 441 through 453) 

qualify for the provision, while those in other industry classes do 

not qualify under the provision. 

EFFECTIVE DATE

The provision applies to property placed in service after the date 

of enactment. 

D. EXPAND ELIGIBILITY FOR CASH METHOD OF ACCOUNTING

(Sec. 103 of the bill and secs. 446 and 448 of the Code) 

PRESENT LAW

Section 446(c) of the Code generally allows a taxpayer to select 

the method of accounting it will use to compute its taxable income 

provided that such method clearly reflects the income of the taxpayer. A taxpayer is entitled to adopt any one of the permissible 

methods for each separate trade or business, subject to certain restrictions. Permissible methods include the cash receipts and disbursements method (‘‘cash method’’), an accrual method, or any 

other method (including a hybrid method) permitted under regulations prescribed by the Secretary of the Treasury. 

Section 448 generally provides that the cash method of accounting may not be used by any C corporation,10 by any partnership 


hmoore on PROD1PC68 with HMRPT
9 

11Treas. Reg. sec. 1.471–1. 12 Rev. Proc. 2001–10, 2001–02 I.R.B. 272 (January 8, 2001). 13 Under Treas. Reg. sec. 1.162–3, a deduction is permitted for the cost of materials and supplies only in the amount that they are actually consumed and used in operations during the 

tax year. 14Sec. 481. 15 Rev. Proc. 2002–19, 2002–1 C.B. 696. 16 Ibid. 17The threshold is $1 million with respect to inventory accounting. 

that has a C corporation as a partner, or by any tax shelter. Exceptions are made for farming businesses and qualified personal service corporations. Additionally, an exception is provided for C corporations and partnerships that have a C corporation as a partner 

if the average annual gross receipts of the taxpayer is $5 million 

or less for all prior taxable years (including the prior taxable years 

of any predecessor of the entity). For this purpose, average annual 

gross receipts is calculated for each tax year by averaging the annual gross receipts for the three-year period ending in such year. 

The test must be met for all prior tax years beginning after December 31, 1985 in order for a taxpayer to be eligible for the exception. 

Section 471 provides that, regardless of a taxpayer’s overall 

method of accounting, the Secretary may require taxpayers to 

maintain inventories on the accrual method if necessary to clearly 

reflect income. This requirement is generally applied to taxpayers 

for whom the production, purchase, or sale of merchandise is an income-producing factor.11 However, an exception is provided for taxpayers whose average annual gross receipts does not exceed $1 million.12 Such taxpayers account for inventory as materials and supplies that are not incidental pursuant to Regulations section 1.162–

3.13

When a taxpayer changes its method of accounting, there is 

taken into account for the taxable year of the change adjustments 

to taxable income necessary to prevent amounts from being duplicated or omitted by reason of the change.14 Positive adjustments 

(i.e., additions to taxable income), if initiated by the taxpayer and 

made with the consent of the Secretary, are generally spread over 

four taxable years beginning in the year of change.15 Negative adjustments (i.e., reductions to taxable income) are generally taken 

into account entirely in the year of change.16

REASONS FOR CHANGE

The Committee is sensitive to the trade-off between competing 

priorities of simplification and accurate income measurement in the 

tax system. Many taxpayers find the cash method of accounting to 

be simpler to use than the accrual method, which generally is considered to provide a more accurate measurement of income for each 

taxable year. The effect of the differences in income measurement 

is not permanent, as the different methods produce the same total 

amount of taxable income over time. 

The present-law exception for small businesses with gross receipts under $5 million 17 reflects the view that, in the case of small 

businesses, the benefits of simplification under the cash method 

outweigh any impact on accuracy. The Committee believes that the 

threshold has become outdated over time and understates the maximum size of business which should be eligible for use of the cash 

method. Accordingly, the Committee provision increases the threshVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00009 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
10 

old and indexes it for inflation to prevent it from becoming outdated in the future. 

EXPLANATION OF PROVISION

Under the provision, eligibility to use the cash method under the 

annual gross receipts exception is expanded to all non-farm taxpayers other than tax shelters regardless of the presence of inventories, and the threshold for the exception is increased from $5 million to $10 million. 

The provision also resets the December 31, 1985 testing start 

date. Under the provision, the gross receipts test must be met for 

all tax years ending on or after the date of enactment. Thus, a taxpayer who did not meet the $5 million gross receipts test in one 

or more years ending prior to the date of enactment but meets the 

new $10 million test for all tax years ending on or after the date 

of enactment is eligible to use the cash method under the provision. The $10 million threshold is indexed for tax years beginning in 

calendar years after 2008. The indexed amount applies in each 

year for the purposes of testing the average annual gross receipts, 

calculated based on the prior three tax years. Once a taxpayer has 

either met or not met the gross receipts test with respect to a particular tax year, that result cannot subsequently be changed by the 

effect of the indexing. Thus, a tax year that ends on or after the 

date of enactment for which the gross receipts test is not met 

causes the taxpayer to be ineligible to use the cash method under 

the gross receipts test exception in all tax years subsequent to the 

year in which the test is not met, regardless of whether the threshold is subsequently increased by indexing above the amount of average annual gross receipts for the year in which the test was not 

met. 

Accounting method changes under the provision are deemed to 

be initiated by the taxpayer and made with the consent of the Secretary. Thus, the adjustments under section 481 are spread over 

four years (in the case of a positive change) or taken into account 

entirely in one year (in the case of a negative change). 

Taxpayers who are eligible to use the cash method under the provision also are exempt from maintaining inventories on the accrual 

method. Thus, the $1 million gross receipts threshold of Rev. Proc. 

2001–10 is effectively increased to $10 million for taxpayers qualifying for the provision. 

EFFECTIVE DATE

The provision is applicable to taxable years beginning after the 

date of enactment. 

E. WORK OPPORTUNITY TAX CREDIT

(Sec. 104 of the bill and sec. 51 of the Code) 

PRESENT LAW

In general 

The work opportunity tax credit is available on an elective basis 

for employers hiring individuals from one or more of nine targeted 

groups. The amount of the credit available to an employer is determined by the amount of qualified wages paid by the employer. GenVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00010 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
11 

erally, qualified wages consist of wages attributable to service rendered by a member of a targeted group during the one-year period 

beginning with the day the individual begins work for the employer 

(two years in the case of an individual in the long-term family assistance recipient category). 

Targeted groups eligible for the credit 

Generally an employer is eligible for the credit only for qualified 

wages paid to members of a targeted group. 

(1) Families receiving TANF 

An eligible recipient is an individual certified by a designated 

local employment agency (e.g., a State employment agency) as 

being a member of a family eligible to receive benefits under the 

Temporary Assistance for Needy Families Program (‘‘TANF’’) for a 

period of at least nine months part of which is during the 18-month 

period ending on the hiring date. For these purposes, members of 

the family are defined to include only those individuals taken into 

account for purposes of determining eligibility for the TANF. 

(2) Qualified veteran 

A qualified veteran is a veteran who is certified by the designated local agency as a member of a family certified as receiving 

assistance under a food stamp program under the Food Stamp Act 

of 1977 for a period of at least three months part of which is during 

the 12-month period ending on the hiring date. For these purposes, 

members of a family are defined to include only those individuals 

taken into account for purposes of determining eligibility for a food 

stamp program under the Food Stamp Act of 1977. 

For these purposes, a veteran is an individual who has served on 

active duty (other than for training) in the Armed Forces for more 

than 180 days or who has been discharged or released from active 

duty in the Armed Forces for a service-connected disability. However, any individual who has served for a period of more than 90 

days during which the individual was on active duty (other than 

for training) is not a qualified veteran if any of this active duty occurred during the 60-day period ending on the date the individual 

was hired by the employer. This latter rule is intended to prevent 

employers who hire current members of the armed services (or 

those departed from service within the last 60 days) from receiving 

the credit. 

(3) Qualified ex-felon 

A qualified ex-felon is an individual certified as: (1) having been 

convicted of a felony under any State or Federal law, and (2) having a hiring date within one year of release from prison or date of 

conviction. 

(4) High risk youth 

A high-risk youth is an individual certified as being at least age 

18 but not yet age 25 on the hiring date and as having a principal 

place of abode within an empowerment zone, enterprise community, or renewal community (as defined under Subchapter U of 

Subtitle A, Chapter 1 of the Internal Revenue Code). Qualified 

wages do not include wages paid or incurred for services performed 


hmoore on PROD1PC68 with HMRPT
12 

after the individual moves outside an empowerment zone, enterprise community, or renewal community. 

(5) Vocational rehabilitation referral 

A vocational rehabilitation referral is an individual who is certified by a designated local agency as an individual who has a 

physical or mental disability that constitutes a substantial handicap to employment and who has been referred to the employer 

while receiving, or after completing: (a) vocational rehabilitation 

services under an individualized, written plan for employment 

under a State plan approved under the Rehabilitation Act of 1973; 

or (b) under a rehabilitation plan for veterans carried out under 

Chapter 31 of Title 38, U.S. Code. Certification will be provided by 

the designated local employment agency upon assurances from the 

vocational rehabilitation agency that the employee has met the 

above conditions. 

(6) Qualified summer youth employee 

A qualified summer youth employee is an individual: (1) who performs services during any 90-day period between May 1 and September 15, (2) who is certified by the designated local agency as 

being 16 or 17 years of age on the hiring date, (3) who has not been 

an employee of that employer before, and (4) who is certified by the 

designated local agency as having a principal place of abode within 

an empowerment zone, enterprise community, or renewal community (as defined under Subchapter U of Subtitle A, Chapter 1 of the 

Internal Revenue Code). As with high risk youths, no credit is 

available on wages paid or incurred for service performed after the 

qualified summer youth moves outside of an empowerment zone, 

enterprise community, or renewal community. If, after the end of 

the 90-day period, the employer continues to employ a youth who 

was certified during the 90-day period as a member of another targeted group, the limit on qualified first year wages will take into 

account wages paid to the youth while a qualified summer youth 

employee. 

(7) Qualified food stamp recipient 

A qualified food stamp recipient is an individual aged 18 but not 

yet 40 certified by a designated local employment agency as being 

a member of a family receiving assistance under a food stamp program under the Food Stamp Act of 1977 for a period of at least six 

months ending on the hiring date. In the case of families that cease 

to be eligible for food stamps under section 6(o) of the Food Stamp 

Act of 1977, the six-month requirement is replaced with a requirement that the family has been receiving food stamps for at least 

three of the five months ending on the date of hire. For these purposes, members of the family are defined to include only those individuals taken into account for purposes of determining eligibility 

for a food stamp program under the Food Stamp Act of 1977. 

(8) Qualified SSI recipient 

A qualified SSI recipient is an individual designated by a local 

agency as receiving supplemental security income (‘‘SSI’’) benefits 

under Title XVI of the Social Security Act for any month ending 

within the 60-day period ending on the hiring date. 


hmoore on PROD1PC68 with HMRPT
13 

18The welfare-to-work tax credit was consolidated into the work opportunity tax credit in the 

Tax Relief and Health Care Act of 2006. 

(9) Long-term family assistance recipients 

A qualified long-term family assistance recipient is an individual 

certified by a designated local agency as being: (1) a member of a 

family that have received family assistance for at least 18 consecutive months ending on the hiring date; (2) a member of a family 

that have 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) 18 if the individual 

is hired within two years after the date that the 18-month total is 

reached; or (3) a member of a family who are no longer eligible for 

family assistance because of either Federal or State time limits, if 

the individual is hired within two years after the Federal or State 

time limits made the family ineligible for family assistance. 

Qualified wages 

Generally, qualified wages are defined as cash wages paid by the 

employer to a member of a targeted group. The employer’s deduction for wages is reduced by the amount of the credit. 

For purposes of the credit, generally wages are defined by reference to the FUTA definition of wages contained in sec. 3306(b) 

(without regard to the dollar limitation therein contained). Special 

rules apply in the case of certain agricultural labor and certain 

railroad labor. 

Calculation of the credit 

The credit available to an employer for qualified wages paid to 

members of all targeted groups except for long-term family assistance recipients equals 40 percent (25 percent for employment of 

400 hours or less) of qualified first-year wages. Generally, qualified 

first-year wages are qualified wages (not in excess of $6,000) attributable to service rendered by a member of a targeted group during 

the one-year period beginning with the day the individual began 

work for the employer. Therefore, the maximum credit per employee is $2,400 (40 percent of the first $6,000 of qualified firstyear wages). With respect to qualified summer youth employees, 

the maximum credit is $1,200 (40 percent of the first $3,000 of 

qualified first-year wages). Except for long-term family assistance 

recipients, no credit is allowed for second-year wages. 

In the case of long-term family assistance recipients, the credit 

equals 40 percent (25 percent for employment of 400 hours or less) 

of $10,000 for qualified first-year wages and 50 percent of the first 

$10,000 of qualified second-year wages. Generally, qualified secondyear wages are qualified wages (not in excess of $10,000) attributable to service rendered by a member of the long-term family assistance category during the one-year period beginning on the day 

after the one-year period beginning with the day the individual 

began work for the employer. Therefore, the maximum credit per 

employee is $9,000 (40 percent of the first $10,000 of qualified firstyear wages plus 50 percent of the first $10,000 of qualified secondyear wages). 


hmoore on PROD1PC68 with HMRPT
14 

Certification rules 

An individual is not treated as a member of a targeted group unless: (1) on or before the day on which an individual begins work 

for an employer, the employer has received a certification from a 

designated local agency that such individual is a member of a targeted group; or (2) on or before the day an individual is offered employment with the employer, a pre-screening notice is completed by 

the employer with respect to such individual, and not later than 

the 28th day after the individual begins work for the employer, the 

employer submits such notice, signed by the employer and the individual under penalties of perjury, to the designated local agency as 

part of a written request for certification. For these purposes, a 

pre-screening notice is a document (in such form as the Secretary 

may prescribe) which contains information provided by the individual on the basis of which the employer believes that the individual is a member of a targeted group. 

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. 

Other rules 

The work opportunity tax credit is not allowed for wages paid to 

a relative or dependent of the taxpayer. No credit is allowed for 

wages paid to an individual who is a more than fifty-percent owner 

of the entity. Similarly, wages paid to replacement workers during 

a strike or lockout are not eligible for the work opportunity tax 

credit. Wages paid to any employee during any period for which the 

employer received on-the-job training program payments with respect to that employee are not eligible for the work opportunity tax 

credit. The work opportunity tax credit generally is not allowed for 

wages paid to individuals who had previously been employed by the 

employer. In addition, many other technical rules apply. 

Expiration 

The work opportunity tax credit is not available for individuals 

who begin work for an employer after December 31, 2007. 

REASONS FOR CHANGE

The Committee believes that the experience with the credit has 

been positive and wishes to extend and expand the credit. In particular, the Committee believes that the credit can be used to improve employment opportunities for broader classes of qualified veterans and designated community residents. Also, the Committee 

believes that the expansion of the vocational rehabilitation referral 

group appropriately conforms availability of the credit to a previous 

expansion of the vocational rehabilitation referral program. Finally, 

the Committee believes that a longer-term expansion will encourage greater employer participation in the credit. 


hmoore on PROD1PC68 with HMRPT
15 

EXPLANATION OF PROVISION

Extension 

The provision extends the work opportunity tax credit for five 

years (for qualified individuals who begin work for an employer 

after December 31, 2007 and before January 1, 2013). 

Qualified veterans targeted group 

The provision expands the qualified veterans’ targeted group to 

include an individual who is certified as entitled to compensation 

for a service-connected disability incurred after September 10, 

2001. Being entitled to such compensation means having a disability rating of 10-percent or higher for service connected injuries. 

Qualified first-year wages 

The provision expands the definition of qualified first-year wages from $6,000 to $12,000 in the case of individuals certified as being 

entitled to compensation for a service-connected disability incurred 

after September 10, 2001 (i.e., having a disability rating of 10-percent or higher). 

High risk youth targeted group 

The provision expands the definition of high risk youths to include otherwise qualifying individuals age 18 but not yet age 40 on 

the hiring date. The provision also changes the name of the category to the ‘‘designated community residents’’ targeted group. 

Vocational rehabilitation referral targeted group 

The provision expands the definition of vocational rehabilitation 

referral to include any individual who is certified by a designated 

local agency as an individual who has a physical or mental disability that constitutes a substantial handicap to employment and 

who has been referred to the employer while receiving, or after 

completing, an individual work plan developed and implemented by 

an employment network pursuant to subsection (g) of section 1148 

of the Social Security Act. 

EFFECTIVE DATE

Generally, the extension of the credit is effective for wages paid 

or incurred to a qualified individual who begins work for an employer after December 31, 2007. The other provisions are effective 

for individuals who begin work for an employer after the date of 

enactment in taxable years ending after such date. 

F. TREATMENT OF PROFESSIONAL EMPLOYER ORGANIZATIONS AS

EMPLOYERS FOR EMPLOYMENT TAX PURPOSES

(Sec. 105 of the bill and new secs. 3511 and 7705 of the Code) 

PRESENT LAW

In general 

Employment taxes generally consist of the taxes under the Federal Insurance Contributions Act (‘‘FICA’’), the taxes under the 

Railroad Retirement Tax Act (‘‘RRTA’’), the tax under the Federal 

Unemployment Tax Act (‘‘FUTA’’), and income taxes required to be 


hmoore on PROD1PC68 with HMRPT
16 

19Secs. 3101–3128 (FICA), 3201–3241 (RRTA), 3301–3311 (FUTA), and 3401–3404 (income 

tax withholding). Sections 3501–3510 provide additional rules. 20The ‘‘SUTA Dumping Prevention Act of 2004’’ (Pub. L. No. 108–295), set standards for State 

law to prevent the practice of ‘‘SUTA dumping,’’ a tax evasion scheme where shell companies 

are formed to obtain low State unemployment insurance tax rates. 21Secs. 6011 and 6051. 22See, e.g., secs. 3121(a) and (b), 3231(e), 3306(b) and (c), and 3401(a). 23Secs. 3121(a)(16) and 3306(c)(8). 24See, e.g., secs. 3121, 3122, 3125, 3126, 3127, 3231, 3306, 3308, 3309, 3401(a), 3404, 3506, 

and 3510. 

withheld by employers from wages paid to employees (‘‘income tax 

withholding’’).19

FICA tax consists of two parts: (1) old age, survivor, and disability insurance (‘‘OASDI’’), which correlates to the Social Security 

program that provides monthly benefits after retirement, disability, 

or death; and (2) Medicare hospital insurance (‘‘HI’’). The OASDI 

tax rate is 6.2 percent on both the employee and employer (for a 

total rate of 12.4 percent). The OASDI tax rate applies to wages 

up to the OASDI wage base for the calendar year ($97,500 for 

2007). The HI tax rate is 1.45 percent on both the employee and 

the employer (for a total rate of 2.9 percent). Unlike the OASDI 

tax, the HI tax is not limited to a specific amount of wages, but 

applies to all wages. 

RRTA taxes consist of tier 1 taxes and tier 2 taxes. Tier 1 taxes 

parallel the OASDI and HI taxes applicable to employers and employees. Tier 2 taxes consist of employer and employee taxes on 

railroad compensation up to the tier 2 wage base for the calendar 

year. For 2007, the tier 2 employer rate is 12.1 percent, the employee rate is 3.9 percent, and the tier 2 wage base is $72,600. 

Under FUTA, employers must pay a tax of 6.2 percent of wages 

up to the FUTA wage base of $7,000. An employer may take a 

credit against its FUTA tax liability for its contributions to a State 

unemployment fund and, in certain cases, an additional credit for 

contributions that would have been required if the employer had 

been subject to a higher contribution rate under State law. For purposes of the credit, contributions means payments required by 

State law to be made by an employer into an unemployment fund, 

to the extent the payments are made by the employer without 

being deducted or deductible from employees’ remuneration.20

Employers are required to withhold income taxes from wages 

paid to employees. Withholding rates vary depending on the 

amount of wages paid, the length of the payroll period, and the 

number of withholding allowances claimed by the employee. 

Wages paid to employees, and FICA, RRTA, and income taxes 

withheld from the wages, are required to be reported on employment tax returns and on Forms W–2.21

Employment taxes generally apply to all remuneration paid by 

an employer to an employee. However, various exclusions apply to 

certain types of remuneration or certain types of services, which 

may depend on the type of employer for whom an employee performs services.22 For example, remuneration (subject to a dollar 

limit) paid to an employee by a tax-exempt organization is excluded 

from wages for FICA purposes, and services performed in the employ of certain tax-exempt organizations are excluded from employment for FUTA purposes.23 In addition, various definitions and 

special rules apply to certain types of employers.24


hmoore on PROD1PC68 with HMRPT
17 

25Treas. Reg. secs. 31.3121(d)–1(c)(1), 31.3306(i)–1(a), and 31.3401(c)–1. 26 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. 27Sec. 3401(d)(1) (for purposes of income tax withholding, if the employer does not have control of the payment of wages, the person having control of the payment of such wages is treated 

as the employer); Otte v. United States, 419 U.S. 43 (1974) (the person who has the control of 

the payment of wages is treated as the employer for purposes of withholding the employee’s share of FICA from wages); In re Armadillo Corporation, 561 F.2d 1382 (10th Cir. 1977), and 

In re The Laub Baking Company v. United States, 642 F.2d 196 (6th Cir. 1981) (the person who 

has control of the payment of wages is the employer for purposes of the employer’s share of 

FICA and FUTA). The mere fact that wages are paid by a person other than the employer does 

not necessarily mean that the payor has control of the payment of the wages. Rather, control 

depends on the facts and circumstances. See, e.g., Consolidated Flooring Services v. United 

States, 38 Fed. Cl. 450 (1997), and Winstead v. United States, 109 F. 2d 989 (4th Cir. 1997). 

As discussed above, certain employment taxes apply only on 

amounts up to a specified wage base. If an employee works for multiple employers during a year, separate wage bases generally apply 

to each employer. However, a single OASDI, RRTA tier 1 or tier 

2, or FUTA wage base applies in certain cases in which an employer (a ‘‘successor’’ employer) takes over the business of another 

employer (the ‘‘predecessor’’ employer) and employs the employees 

of the predecessor employer. 

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.25 Under the regulations, an employer-employee relationship generally exists if the 

person for whom services are performed has the right to control 

and direct the individual who performs the services, not only as to 

the result to be accomplished by the work, but also as to the details 

and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer, not only 

as to what is to be done, but also as to how it is to be done. It is 

not necessary that the employer actually control the manner in 

which the services are performed, rather it is sufficient that the 

employer have a right to control. Whether the requisite control exists is determined on the basis of all the relevant facts and circumstances. The test of whether an employer-employee relationship exists often arises in determining whether a worker is an employee or an independent contractor. However, the same test applies in determining whether a worker is an employee of one person or another.26

In some cases, a person other than the common-law employer (a 

‘‘third party’’) may be liable for employment taxes. For example, if 

wages are paid to an employee by a third party and the third 

party, rather than the employer, has control of the payment of the 

wages, the third party is the statutory employer responsible for 

complying with applicable employment tax requirements.27 In addition, certain designated agents are jointly and severally liable with 

the employer for employment taxes with respect to wages paid to 

the employer’s employees. These designated agents prepare and file 

employment tax returns using their own name and employer identification number. In contrast, reporting agents (often referred to as 

payroll service providers) are generally not liable for the employment taxes reported on their clients’ returns. Reporting agents preVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00017 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
18 

28 As discussed in the text above, the issue of whether a worker is an employee of a particular 

entity for employment tax purposes is generally determined by reference to section 3121(d), 

which incorporates the common law definition of employee. This common law definition also 

generally applies for purposes of who is an employee for retirement plan purposes. In some 

cases, a professional employer organization may provide benefits to workers who are legally the 

employees of the customer. The IRS has issued guidance with respect to how the retirement 

plan rules apply in such cases. For example, Revenue Procedure 2002–11, 2002–1 C.B. 911, provides that employees of a customer may be covered under a multiple employer defined contribution plan of the professional employer organization if the customer adopts the plan and certain 

other requirements are satisfied. See also Rev. Proc. 2003–86, 2003–2 C.B. 1211. 29See, e.g., secs. 41 (credit for research expenses), 45A (Indian employment credit), 45B (credit 

for employer FICA tax paid on tips), 45C (credit for clinical drug testing expenses), 51 (work 

opportunity credit), 51A (welfare-to-work credit), 1396 (empowerment zone employment credit), 

1400(d) (DC Zone employment credit), and 1400H (renewal community employment credit). 30Sec. 51(c)(1). 31Sec. 45B(b)(1). 32Sec. 6053(c). 

pare and file employment tax returns for their clients using the client’s name and employer identification number. 

Professional employer organizations 

A professional employer organization (sometimes called an employee leasing company) provides employees to perform services in 

the businesses of the professional employer organization’s customers, generally small and medium-sized businesses. In many 

cases, before the professional employer organization arrangement 

is entered into, the employees already work in the customer’s business as employees of the customer. The terms of a typical professional employer organization agreement provide that the professional employer organization is responsible for paying the employees and for the related employment tax compliance. Legally, the 

employees may be the employees of the customer, rather than the 

professional employer organization; nonetheless, customers typically rely on the professional employer organization to satisfy employment tax obligations.28

Income tax credits based on wages for employment tax purposes 

The Code provides various income tax credits to employers under 

which the amount of the credit is determined by reference to the 

amount of wages for employment tax purposes.29 For example, the 

amount of an employer’s work opportunity credit is based on a portion of FUTA wages paid by the employer to employees who are 

members of certain targeted groups.30 In addition, the credit for 

employer FICA tax paid on tips is based on the employer share of 

FICA tax paid by the employer with respect to certain tips treated 

as wages for FICA purposes.31

Reporting by large food and beverage establishments 

Certain reporting requirements relating to tips apply to large 

food or beverage establishments.32 In the case of such an establishment, an employer is generally required to report the following information to the IRS each calendar year: (1) the gross receipts of 

the establishment from the provision of food and beverages (other 

than certain receipts); (2) the aggregate amount of charge receipts 

(other than certain receipts); (3) the aggregate amount of charged 

tips on the charge receipts; (4) the sum of the aggregate amount 

of tips reported to the employer by employees and certain amounts 

required to be reported by the employer on employees’ Form W–2s; 

and (5) with respect to each employee, the amount of tips allocated 


hmoore on PROD1PC68 with HMRPT
19 

33Sec. 7528. 34 Internal Revenue Service, IRS Updates Tax Gap Estimates, IR–2006–28, and attachment 

(Feb. 14, 2006). 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. 

to the employee based on the receipts of the establishment. The 

employer must also provide employees with written statements 

showing certain information each calendar year, including the 

amount of tips allocated to the employee for the year. 

User fees 

User fees apply to requests to the IRS for ruling letters, opinion 

letters, determination letters, and similar requests.33 The user fees 

that apply are determined by the IRS and are generally required 

to be determined after taking into account the average time and 

difficulty involved in a request. 

REASONS FOR CHANGE

The IRS estimates that the portion of tax gap attributable to 

FICA and FUTA taxes is $15 billion.34 An additional portion of the 

tax gap is attributable to income taxes due on unreported wages. 

Professional employer organizations specialize in providing employees and employment-related services, including employment 

tax compliance, to their customers, which are generally small and 

medium-sized businesses. In addition, a professional employer organization can obtain economies of scale not available to its individual customers. As a result, professional employer organizations 

may improve employment tax compliance. 

Under present law, responsibility for employment tax compliance 

generally rests with the employer. Uncertainty may exist as to 

whether a professional employer organization or its customer is the 

employer of the employees provided to the customer, making it unclear which party bears employment tax responsibility. In the case 

of noncompliance, the IRS may have difficulty establishing either 

party’s liability for unpaid employment taxes. The Committee believes that improved employment tax compliance can be achieved 

by providing rules under which a professional employer organization that meets certain standards and follows certain procedures is 

treated for employment tax purposes as the employer of employees 

provided to customers, and thus is responsible for employment tax 

compliance, rather than the customers. 

EXPLANATION OF PROVISION

Treatment of certified professional employer organization as employer for employment tax purposes 

Under the provision, if certain requirements are met, solely for 

purposes of employment taxes and other obligations under the employment tax rules, a certified professional employer organization 

is treated as the employer of any work site employee performing 

services for any customer of the certified professional employer organization, but only with respect to remuneration remitted to the 

work site employee by the certified professional employer organization. In addition, no other person is treated as the employer for employment tax purposes with respect to remuneration remitted by 


hmoore on PROD1PC68 with HMRPT
20 

35See sec. 3121(a)(8). 36See sec. 3121(b)(20). 37Whether a customer and a certified professional employer organization are related is determined under the rules of section 267(b) (relating to transactions between related taxpayers) or 

707(b) (relating to transactions between a partner and partnership). However, rules based on 

more than 50 percent ownership are applied by substituting 10 percent for 50 percent. 

the certified professional employer organization to a work site employee. 

Under the provision, if an individual (other than a self-employed 

individual) who is not a work site employee, but who performs 

services under a contract that meets the contract requirements applicable to work site employees, then, solely for purposes of a certified professional employer organization’s liability for employment 

taxes and other obligations under the employment tax rules, a certified professional employer organization is treated as the employer 

of the individual, but only with respect to remuneration remitted 

to the individual by the certified professional employer organization. 

Under the provision, exclusions, definitions, and special rules 

that are based on the type of employer and that would apply if the 

certified professional employer organization were not treated as the 

employer under the provision continue to apply. Thus, for example, 

if services performed in the employ of a customer that is a tax-exempt organization would be excluded from employment for FUTA 

purposes, the fact that a certified professional employer organization is treated as the employer for employment tax purposes does 

not affect the application of the exclusion. Similarly, if remuneration for agricultural labor 35 or for catching fish 36 would not be 

subject to FICA taxes, the application of the exclusion is not affected by the fact that a certified professional employer organization is treated as the employer for employment tax purposes under 

the provision. 

The provision provides rules under which, on entering into a 

service contract with a customer with respect to a work site employee, a certified professional employer organization is treated as 

a successor employer and the customer is treated as the predecessor employer. Similarly, on termination of a service contract 

with respect to a work site employee, the customer is treated as a 

successor employer and the certified professional employer organization is treated as a predecessor employer. Thus, wages paid by 

the customer and the certified professional employer organization 

to a work site employee during a calendar year are subject to a single OASDI, RRTA tier 1 or tier 2, or FUTA wage base. 

The provision does not apply in the case of a customer who is related to the certified professional employer organization.37 In addition, an individual with net earnings from self-employment derived 

from a customer’s trade or business (i.e., a self-employed individual), including a customer who is a sole proprietor or a partner 

of a customer that is a partnership, is not a work site employee for 

employment tax purposes with respect to remuneration paid by a 

certified professional employer organization. 

A certified professional employer organization is eligible for the 

FUTA credit with respect to contributions made to a State unemployment fund with respect to a work site employee by the certified 

professional employer organization or a customer. An additional 

FUTA credit may be claimed by a certified professional employer 


hmoore on PROD1PC68 with HMRPT
21 

organization if, under State law, a certified professional employer 

organization is permitted to collect and remit contributions with respect to a work site employee to the State unemployment fund. 

Certified professional employer organization 

A certified professional employer organization is a person who 

has been certified by the Secretary, for purposes of being treated 

as the employer for employment tax purposes under the provision, 

as meeting certain requirements. These requirements are met if 

the person— • demonstrates that the person (and any owner, officer, and 

such other persons as may be specified in regulations) meets 

requirements established by the Secretary with respect to tax 

status, background, experience, business location, and annual 

financial audits; • computes its taxable income using an accrual method of 

accounting unless the Secretary approves another method; • agrees to satisfy the bond and independent financial review requirements (described below) on an ongoing basis; • agrees to satisfy any reporting obligations imposed by the 

Secretary; • agrees to verify on such periodic basis as prescribed by the 

Secretary that it continues to meet the requirements for certification; and • agrees to notify the Secretary in writing within such time 

as prescribed by the Secretary of any change that materially 

affects whether it continues to meet the requirements for certification. 

Under the bond requirement, a certified professional employer 

organization must post a bond for the payment of employment 

taxes in a minimum amount and in a form acceptable to the Secretary. The minimum amount is determined for the period April 1 

of any calendar year through March 31 of the following calendar 

year and is the greater of (1) five percent of the employment taxes 

for which the certified professional employer organization is liable 

under the provision during the preceding calendar year (but not to 

exceed $1,000,000), or (2) $50,000. 

Under the independent financial review requirements, a certified 

professional employer organization must: (1) have, as of the most 

recent review date (i.e., six months after the completion of the certified professional employer organization’s fiscal year), caused to be 

prepared and provided to the Secretary an opinion of an independent certified public accountant that the certified professional 

employer organization’s financial statements are presented fairly in 

accordance with generally accepted accounting principles; and (2) 

provide to the Secretary, not later than the last day of the second 

month beginning after the end of each calendar quarter, from an 

independent certified public accountant an assertion regarding 

Federal employment tax payments and an examination level attestation on the assertion. The assertion must state that the certified 

professional employer organization has withheld and made deposits 

of all required FICA, RRTA, and withheld income taxes for the calendar quarter, and the attestation must state that the assertion is 

fairly stated in all material respects. If a certified professional employer organization fails to file the required assertion and attestaVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00021 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
22 

38Whether entities are members of a controlled group of corporations or under common control is determined under the rules of section 414(b) and (c). 39 As discussed above, a self-employed individual is not a work site employee. 40For this purpose, excluded employees under section 414(q)(5), such as employees who are 

under age 21 or have not completed six months of service, are not taken into account. 

tion with respect to any calendar quarter, the independent financial review requirements are treated as not satisfied for the period 

beginning on the due date for the attestation. 

For purposes of the bond and independent financial review requirements, all professional employer organizations that are members of a controlled group of corporations or under common control 

are treated as a single organization.38 The Secretary may suspend 

or revoke the certification of a person’s certified professional employer organization status if the Secretary determines that the person does not satisfy the representations or other requirements for 

certification or fails to satisfy the applicable accounting, reporting, 

payment, or deposit requirements. 

Work site employee 

A work site employee is an individual who: (1) performs services 

for a customer of a certified professional employer organization 

pursuant to a contract between the customer and the certified professional employer organization that meets certain requirements 

(described below); and (2) performs services at a work site meeting 

certain requirements (described below).39 Thus, if the contract or 

work site fails to meet applicable requirements, the individual is 

not a work site employee. 

The contract between the customer and the certified professional 

employer organization must be in writing and, with respect to an 

individual performing services for the customer, must provide that 

the certified professional employer organization will—

• assume responsibility for payment of wages to the individual, without regard to the receipt or adequacy of payment 

from the customer; 

• assume responsibility for reporting, withholding, and paying any employment taxes with respect to the individual’s 

wages, without regard to the receipt or adequacy of payment 

from the customer; 

• assume responsibility for any employee benefits that the 

contract may require the certified professional employer organization to provide, without regard to the receipt or adequacy 

of payment from the customer; 

• assume responsibility for hiring, firing, and recruiting 

workers in addition to the customer’s responsibility for hiring, 

firing and recruiting workers; 

• maintain employee records relating to the individual; and 

• agree to be treated as a certified professional employer organization for employment tax purposes with respect to such 

individual. 

For purposes of whether an individual is a work site employee, 

the work site where the individual performs services meets the applicable requirements if at least 85 percent of the individuals performing services for the customer at the work site are subject to 

one or more contracts with the certified professional employer organization that meet the above requirements.40


hmoore on PROD1PC68 with HMRPT
23 

41Secs. 41 (credit for research expenses), 45A (Indian employment credit), 45B (credit for employer FICA tax paid on tips), 45C (credit for clinical drug testing expenses), 51 (work opportunity credit), 51A (welfare-to-work credit), 1396 (empowerment zone employment credit), 

1400(d) (DC Zone employment credit), 1400H (renewal community employment credit), and any 

other provision as provided by the Secretary. 42Present law provides a deduction from taxable income (or, in the case of an individual, adjusted gross income) that is equal to a portion of the taxpayer’s qualified production activities 

income (sec. 199). The deduction for a taxable year is limited to 50 percent of the wages deducted in arriving at qualified production activities income. To be taken into account, wages 

must be paid by the taxpayer to its employees and reported on Form W–2. For this purpose, 

wages means wages subject to income tax withholding, as well as elective deferrals and certain 

other amounts. Under regulations dealing with wages paid by an entity other than the commonlaw employer, a taxpayer may take into account wages paid by another entity and reported by 

the other entity on Form W–2 (with the other entity listed as the employer on the Form W–

2), provided that the wages were paid to employees of the taxpayer for employment by the taxpayer. Treas. Reg. sec. 1.199–2(a)(2). The provision does not affect the application of these rules. 

Regulations 

The Secretary of Treasury (‘‘Secretary’’) is directed to prescribe 

such regulations as may be necessary or appropriate to carry out 

the purposes of the provision. The Secretary is also directed to develop reporting and recordkeeping rules, regulations, and procedures to ensure compliance with the provision with respect to entities applying for and receiving certification as certified professional 

employer organizations. These are to be designed in a manner to 

streamline, to the extent possible, the application of the requirements of the provision, the exchange of information between a certified professional employer organization and its customers, and 

the reporting and recordkeeping obligations of a certified professional employer organization. 

No inference with respect to other provisions 

Nothing contained in the provision or the amendments made by 

the provision is to be construed to create any inference with respect 

to the determination of who is an employee or employer (1) for Federal tax purposes (other than the purposes set forth in the provision), or (2) for purposes of any other provision of law. 

Other rules 

Income tax credits based on wages for employment tax purposes 

Under the provision, for purposes of various income tax credits 41

under which the amount of the credit is determined by reference 

to the amount of employment tax wages or employment taxes: (1) 

the credit with respect to a work site employee performing services 

for a customer applies to the customer (not to the certified professional employer organization); (2) the customer (and not the certified professional employer organization) is to take into account 

wages and employment taxes paid by the certified professional employer organization with respect to the work site employee and for 

which the certified professional employer organization receives payment from the customer; and (3) the certified professional employer 

organization is required to furnish the customer with any information necessary for the customer to claim the credit.42

Reporting by large food and beverage establishments 

Under the provision, if a certified professional employer organization is treated for employment tax purposes as the employer of 

a work site employee, the customer for whom the work site emVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00023 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
24 

ployee performs services is the employer for purposes of the reporting required with respect to a large food or beverage establishment. 

The certified professional employer organization is required to furnish the customer with any information necessary to complete the 

required reporting. 

User fees 

Under the provision, the user fee charged under the program for 

certifying a professional employer organization may not exceed 

$500. 

EFFECTIVE DATE

The provision is effective with respect to wages paid for services 

performed on or after January 1 of the first calendar year beginning more than 12 months after the date of enactment of the provision. The Secretary is directed to establish the certification program for professional employer organizations not later than six 

months before the provision becomes effective. 

G. SUBCHAPTER S PROVISIONS

(Secs. 111–116 of the bill and secs. 1361 and 1362 of the Code) 

OVERVIEW

In general, an S corporation is not subject to corporate-level income tax on its items of income and loss. Instead, an S corporation 

passes through its items of income and loss to its shareholders. The 

shareholders take into account separately their shares of these 

items on their individual income tax returns. To prevent double 

taxation of these items when the stock is later disposed of, each 

shareholder’s basis in the stock of the S corporation is increased by 

the amount included in income (including tax-exempt income) and 

is decreased by the amount of any losses (including nondeductible 

losses) taken into account. A shareholder’s loss may be deducted 

only to the extent of his or her basis in the stock or debt of the 

S corporation. To the extent a loss is not allowed due to this limitation, the loss generally is carried forward with respect to the shareholder. 

REASONS FOR CHANGE

Many small businesses are organized as S corporations. The bill 

contains a number of provisions relating to these corporations. 

These provisions modernize the S corporation rules and eliminate 

undue restrictions on S corporations. The Committee believes that 

these changes will improve the operation of Subchapter S and 

therefore will benefit small businesses. 

1. Capital gain not treated as passive investment income 

PRESENT LAW

Passive investment income 

An S corporation is subject to corporate-level tax, at the highest 

corporate tax rate, on its excess net passive income if the corporation has (1) accumulated earnings and profits at the close of the 


hmoore on PROD1PC68 with HMRPT
25 

43Sec. 1361(c)(4). Treasury regulations provide that buy-sell and redemption agreements are 

disregarded in determining whether a corporation’s outstanding shares confer identical distribution and liquidation rights unless (1) a principal purpose of the agreement is to circumvent the 

one class of stock requirement and (2) the agreement establishes a purchase price that, at the 

time the agreement is entered into, is significantly in excess of, or below, the fair market value 

of the stock. Treas. Reg. sec. 1.1361–1(l). 44 12 U.S.C. secs. 71–72. 

taxable year and (2) gross receipts more than 25 percent of which 

are passive investment income. 

Excess net passive income is the net passive income for a taxable 

year multiplied by a fraction, the numerator of which is the 

amount of passive investment income in excess of 25 percent of 

gross receipts and the denominator of which is the passive investment income for the year. Net passive income is defined as passive 

investment income reduced by the allowable deductions that are directly connected with the production of that income. Passive investment income generally means gross receipts derived from royalties, 

rents, dividends, interest, annuities, and sales or exchanges of 

stock or securities (to the extent of gains). Passive investment income generally does not include interest on accounts receivable, 

gross receipts that are derived directly from the active and regular 

conduct of a lending or finance business, gross receipts from certain 

liquidations, gain or loss from any section 1256 contract (or related 

property) of an options or commodities dealer, or certain interest 

and dividend income of banks and depository institution of holding 

companies. 

In addition, an S corporation election is terminated whenever the 

S corporation has accumulated earnings and profits at the close of 

each of three consecutive taxable years and has gross receipts for 

each of those years more than 25 percent of which are passive investment income. 

EXPLANATION OF PROVISION

The provision eliminates gains from sales or exchanges of stock 

or securities as an item of passive investment income. 

EFFECTIVE DATE

The provision applies to taxable years beginning after the date 

of enactment. 

2. Treatment of bank director shares 

PRESENT LAW

An S corporation may have no more than 100 shareholders and 

may have only one outstanding class of stock. 

An S corporation has one class of stock if all outstanding shares 

of stock confer identical rights to distribution and liquidation proceeds. Differences in voting rights are disregarded.43

National banking law requires that a director of a national bank 

own stock in the bank and that a bank have at least five directors.44 A number of States have similar requirements for Statechartered banks. In some cases, a bank director enters into an 

agreement under which the bank (or a holding company) will reacVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00025 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
26 

45See Private Letter Ruling 200217048 (January 24, 2002) describing such an agreement and 

holding that it creates a second class of stock. Nonetheless, the ruling concluded that the election to be an S corporation was inadvertently invalid and that an amended agreement did not 

create a second class of stock so that the corporation’s election was validated. 46 No inference is intended as to the proper income tax treatment of restricted bank director 

stock or other similar stock under present law. 47Sec. 1361(b)(2)(A). 48Sec. 481. 

quire the stock upon the director’s ceasing to hold the office of director, at the price paid by the director for the stock.45

EXPLANATION OF PROVISION

Under the provision, restricted bank director stock is not taken 

into account as outstanding stock in applying the provisions of subchapter S.46 Thus, the stock is not treated as a second class of 

stock; a director is not treated as a shareholder of the S corporation 

by reason of the stock; the stock is disregarded in allocating items 

of income, loss, etc. among the shareholders; and the stock is not 

treated as outstanding for purposes of determining whether an S 

corporation holds 100 percent of the stock of a qualified subchapter 

S subsidiary. 

Restricted bank director stock is stock in a bank (as defined in 

sec. 581), or a depository institution holding company (within the 

meaning of sec. 3(w)(1) of the Federal Deposit Insurance Act), if the 

stock is required to be held by an individual under applicable Federal or State law in order to permit the individual to serve as a 

director of the bank or holding company and which is subject to an 

agreement with the bank or holding company (or corporation in 

control of the bank or company) pursuant to which the holder is required to sell the stock back upon ceasing to be a director at the 

same price the individual acquired the stock. 

A distribution (other than a payment in exchange for the stock) 

with respect to the restricted stock is includible in the gross income 

of the director and is deductible by the S corporation for the taxable year that includes the last day of the director’s taxable year 

in which the distribution is included in income. 

EFFECTIVE DATE

The provision applies to taxable years beginning after December 

31, 2006. 

The provision also provides that restricted bank director stock is 

not treated as a second class of stock for taxable years beginning 

after December 31, 1996. 

3. Treatment of banks changing from reserve method of accounting 

PRESENT LAW

A financial institution which uses the reserve method of accounting for bad debts may not elect to be an S corporation.47 If a financial institution changes from the reserve method of accounting, 

there is taken into account for the taxable year of the change adjustments to taxable income necessary to prevent amounts from 

being duplicated or omitted by reason of the change.48

Positive adjustments (i.e., additions to taxable income) are generally spread over four taxable years beginning in the year of 


hmoore on PROD1PC68 with HMRPT
27 

49 Rev. Proc. 2002–19, 2002–1 C.B. 696. 50 Id. 51Treas. Reg. sec. 1.1361–5(b). 52 Example 1 of Treas. Reg. sec. 1.1361–5(b)(3). 

change.49 Negative adjustments (i.e., reductions to taxable income) 

are generally taken into account entirely in the year of change.50

In the case of a financial institution that changes from the reserve method and elects to be an S corporation for the year of 

change, the adjustments are both included in the income of the 

shareholders and are taken into account in computing the tax on 

built-in gain under section 1374. If the change in accounting method is made for the last taxable year prior to becoming an S corporation, any adjustments for that year are taken into account in computing the corporation’s taxable income, but not taken into account 

by the shareholders. 

EXPLANATION OF PROVISION

The provision allows a bank which changes from the reserve 

method of accounting for bad debts for its first taxable year for 

which it is an S corporation to elect to take into account all adjustments under section 481 by reason of the change in the last taxable 

year it was a C corporation. 

EFFECTIVE DATE

The provision applies to taxable years beginning after December 

31, 2006. 

4. Treatment of sale of an interest in a qualified subchapter S subsidiary 

PRESENT LAW

Under present law, an S corporation that owns all the stock of 

a corporation may elect to treat the subsidiary corporation as a 

qualified subchapter S subsidiary (‘‘QSub’’). A qualified subchapter 

S subsidiary is disregarded as a separate entity for Federal tax 

purposes and its items of income, deduction, loss, and credit are 

treated as items of the S corporation. 

If the subsidiary corporation ceases to be a QSub (e.g., fails to 

meet the wholly-owned requirement) the subsidiary is treated as a 

new corporation acquiring all its assets (and assuming all of its liabilities) immediately before such cessation from the parent S corporation in exchange for its stock. Under Treasury regulations,51

the tax treatment of the termination of the QSub election is determined under general principals of tax law, including the step transaction doctrine. The regulations set forth an example 52 in which an 

S corporation sells 21 percent of the stock of a QSub to an unrelated party. In the example, the deemed transfer of all the assets 

to the QSub is treated as a taxable sale because the S corporation 

was not in control of the QSub immediately after the transfer by 

reason of the sale, and thus the transfer did not qualify for nonrecognition treatment under section 351. 

EXPLANATION OF PROVISION

The provision provides that where the sale of stock of a QSub results in the termination of the QSub election, the sale is treated 


hmoore on PROD1PC68 with HMRPT
28 

as a sale of an undivided interest in the assets of the QSub (based 

on the percentage of the stock sold) followed by a deemed transfer 

to the QSub in a transaction to which section 351 applies. 

Thus, in the above example, the S corporation will be treated as 

selling a 21 percent-interest in all the assets of the QSub to the unrelated party, followed by a transfer of all the assets to a new corporation in a transaction to which section 351 applies. Thus, the 

S corporation will recognize 21 percent of the gain or loss in the 

assets of the QSub. 

EFFECTIVE DATE

The provision applies to taxable years beginning after December 

31. 2006. 

5. Elimination of earnings and profits attributable to pre-1983 

years 

PRESENT LAW

The Small Business Jobs Protection Act of 1996 provided that if 

a corporation was an S corporation for its first taxable year beginning after December 31, 1996, the accumulated earnings and profits of the corporation as of the beginning of that year were reduced 

by the accumulated earnings and profits (if any) accumulated in a 

taxable year beginning before January 1, 1983, for which the corporation was an electing small business corporation under subchapter S. 

EXPLANATION OF PROVISION

The provision provides in the case of any corporation which was 

not an S corporation for its first taxable year beginning after December 31, 1996, the accumulated earnings and profits of the corporation as of the beginning of the first taxable year beginning 

after the date of the enactment of this provision is reduced by the 

accumulated earnings and profits (if any) accumulated in a taxable 

year beginning before January 1, 1983, for which the corporation 

was an electing small business corporation under subchapter S. 

EFFECTIVE DATE

The provision applies to taxable years beginning after the date 

of enactment. 

6. Expansion of qualifying beneficiaries of an electing small business trust 

PRESENT LAW

Under present law, an electing small business trust (‘‘ESBT’’) 

may be a shareholder of an S corporation. Generally, the eligible 

beneficiaries of an ESBT include individuals, estates, and certain 

charitable organizations eligible to hold S corporation stock directly. A nonresident alien individual may not be a potential current beneficiary of an ESBT. 

The portion of an ESBT which consists of the stock of an S corporation is treated as a separate trust and is generally taxed on 

its share of the S corporation’s income at the highest rate of tax 

imposed on individual taxpayers (currently 35 percent). This inVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00028 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
29 

come (whether or not distributed by the ESBT) is not taxed to the 

beneficiaries of the ESBT. 

EXPLANATION OF PROVISION

The provision allows a nonresident alien individual to be a potential current beneficiary of an ESBT. 

EFFECTIVE DATE

The provision is effective on the date of enactment. 

TITLE II—REVENUE PROVISIONS 

A. MODIFICATION OF EFFECTIVE DATE OF LEASING PROVISIONS OF

THE AMERICAN JOBS CREATION ACT OF 2004 

(Sec. 201 of the bill and sec. 470 of the Code) 

PRESENT LAW

Present law provides for the deferral of losses attributable to certain tax exempt use property, generally effective for leases entered 

into after March 12, 2004. The deferral provision does not apply to 

property located in the United States that is subject to a lease with 

respect to which a formal application: (1) was submitted for approval to the Federal Transit Administration (an agency of the Department of Transportation) after June 30, 2003, and before March 

13, 2004; (2) is approved by the Federal Transit Administration before January 1, 2006; and (3) includes a description and the fair 

market value of such property (the ‘‘qualified transportation property exception’’). 

REASONS FOR CHANGE

The Committee is aware that certain leasing transactions entered into with foreign lessees prior to March 12, 2004 are continuing to provide a benefit to the taxpayers who participated in 

such transactions. The Committee finds these transactions and 

their continuing benefit to be inappropriate. Thus, the provision denies any future tax benefit with respect to the transactions. 

EXPLANATION OF PROVISION

The provision changes the effective date of the loss deferral rules 

with respect to certain leases. Under the provision, the loss deferral rules also apply to leases entered into on or before March 12, 

2004, if the lessee is a foreign person or entity. With respect to 

such leases, losses are deferred starting in taxable years beginning 

after December 31, 2006. 

No inference is intended with respect to the tax treatment of 

leases entered into on or before March 12, 2004, if the lessee is not 

a foreign person or entity. 

EFFECTIVE DATE

The provision is effective as if included in the provisions of the 

American Jobs Creation Act of 2004 to which it relates. 


hmoore on PROD1PC68 with HMRPT
30 

B. TAX TREATMENT OF CERTAIN INVERTED CORPORATE ENTITIES

(Sec. 202 of the bill and sec. 7874 of the Code) 

PRESENT LAW

Determination of corporate residence 

The U.S. tax treatment of a multinational corporate group depends significantly on whether the parent corporation of the group 

is domestic or foreign. For purposes of U.S. tax law, a corporation 

is treated as domestic if it is incorporated under the law of the 

United States or of any State. Other corporations (i.e., those incorporated under the laws of foreign countries or U.S. possessions) 

generally are treated as foreign. 

U.S. taxation of domestic corporations 

The United States employs a ‘‘worldwide’’ tax system, under 

which domestic corporations generally are taxed on all income, 

whether derived in the United States or abroad. In order to mitigate the double taxation that may arise from taxing the foreignsource income of a domestic corporation, a foreign tax credit for income taxes paid to foreign countries is provided to reduce or eliminate the U.S. tax owed on such income, subject to certain limitations. 

Income earned by a domestic parent corporation from foreign operations conducted by foreign corporate subsidiaries generally is 

subject to U.S. tax when the income is distributed as a dividend 

to the domestic corporation. Until such repatriation, the U.S. tax 

on such income generally is deferred, and U.S. tax is imposed on 

such income when repatriated. However, certain anti-deferral regimes may cause the domestic parent corporation to be taxed on a 

current basis in the United States with respect to certain categories of passive or highly mobile income earned by its foreign 

subsidiaries, regardless of whether the income has been distributed 

as a dividend to the domestic parent corporation. The main antideferral regimes in this context are the controlled foreign corporation rules of subpart F (secs. 951–964) and the passive foreign investment company rules (secs. 1291–1298). A foreign tax credit is 

generally available to offset, in whole or in part, the U.S. tax owed 

on this foreign-source income, whether such income is repatriated 

as an actual dividend or included under one of the anti-deferral regimes. 

U.S. taxation of foreign corporations 

The United States taxes foreign corporations only on income that 

has a sufficient nexus to the United States. Thus, a foreign corporation is generally subject to U.S. tax only on income that is ‘‘effectively connected’’ with the conduct of a trade or business in the 

United States. Such ‘‘effectively connected income’’ generally is 

taxed in the same manner and at the same rates as the income of 

a U.S. corporation. An applicable tax treaty may limit the imposition of U.S. tax on business operations of a foreign corporation to 

cases in which the business is conducted through a ‘‘permanent establishment’’ in the United States. 

In addition, foreign corporations generally are subject to a grossbasis U.S. tax at a flat 30-percent rate on the receipt of interest, 


hmoore on PROD1PC68 with HMRPT
31 

dividends, rents, royalties, and certain similar types of income derived from U.S. sources, subject to certain exceptions. The tax generally is collected by means of withholding by the person making 

the payment. This tax may be reduced or eliminated under an applicable tax treaty. 

U.S. tax treatment of inversion transactions prior to the American 

Jobs Creation Act of 2004 

Prior to the American Jobs Creation Act of 2004 (‘‘AJCA’’), a U.S. 

corporation could reincorporate in a foreign jurisdiction and thereby replace the U.S. parent corporation of a multinational corporate 

group with a foreign parent corporation. These transactions were 

commonly referred to as inversion transactions. Inversion transactions could take many different forms, including stock inversions, 

asset inversions, and various combinations of and variations on the 

two. Most of the known transactions were stock inversions. In one 

example of a stock inversion, a U.S. corporation forms a foreign 

corporation, which in turn forms a domestic merger subsidiary. The 

domestic merger subsidiary then merges into the U.S. corporation, 

with the U.S. corporation surviving, now as a subsidiary of the new 

foreign corporation. The U.S. corporation’s shareholders receive 

shares of the foreign corporation and are treated as having exchanged their U.S. corporation shares for the foreign corporation 

shares. An asset inversion could be used to reach a similar result, 

but through a direct merger of the top-tier U.S. corporation into a 

new foreign corporation, among other possible forms. An inversion 

transaction could be accompanied or followed by further restructuring of the corporate group. For example, in the case of a stock 

inversion, in order to remove income from foreign operations from 

the U.S. taxing jurisdiction, the U.S. corporation could transfer 

some or all of its foreign subsidiaries directly to the new foreign 

parent corporation or other related foreign corporations. 

In addition to removing foreign operations from U.S. taxing jurisdiction, the corporate group could seek to derive further advantage 

from the inverted structure by reducing U.S. tax on U.S.-source income through various earnings stripping or other transactions. 

This could include earnings stripping through payment by a U.S. 

corporation of deductible amounts such as interest, royalties, rents, 

or management service fees to the new foreign parent or other foreign affiliates. In this respect, the post-inversion structure could 

enable the group to employ the same tax-reduction strategies that 

are available to other multinational corporate groups with foreign 

parents and U.S. subsidiaries, subject to the same limitations (e.g., 

secs. 163(j) and 482). 

Inversion transactions could give rise to immediate U.S. tax consequences at the shareholder and/or the corporate level, depending 

on the type of inversion. In stock inversions, the U.S. shareholders 

generally recognized gain (but not loss) under section 367(a), based 

on the difference between the fair market value of the foreign corporation shares received and the adjusted basis of the domestic corporation stock exchanged. To the extent that a corporation’s share 

value had declined, and/or it had many foreign or tax-exempt 

shareholders, the impact of this section 367(a) ‘‘toll charge’’ was reduced. The transfer of foreign subsidiaries or other assets to the 

foreign parent corporation also could give rise to U.S. tax conVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00031 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
32 

53 Acquisitions with respect to a domestic corporation or partnership are deemed to be ‘‘pursuant to a plan’’ if they occur within the four-year period beginning on the date which is two years 

before the ownership threshold under the provision is met with respect to such corporation or 

partnership. 54Since the top-tier foreign corporation is treated for all purposes of the Code as domestic, 

the shareholder-level ‘‘toll charge’’ of sec. 367(a) does not apply to these inversion transactions. 

sequences at the corporate level (e.g., gain recognition and earnings 

and profits inclusions under secs. 1001, 311(b), 304, 367, 1248 or 

other provisions). The tax on any income recognized as a result of 

these restructurings could be reduced or eliminated through the 

use of net operating losses, foreign tax credits, and other tax attributes. 

In asset inversions, the U.S. corporation generally recognized 

gain (but not loss) under section 367(a) as though it had sold all 

of its assets, but the shareholders generally did not recognize gain 

or loss, assuming the transaction met the requirements of a reorganization under section 368. 

U.S. tax treatment of inversion transactions under AJCA 

In general 

AJCA added new section 7874 to the Code, which defines two different types of corporate inversion transactions and establishes a 

different set of consequences for each type. Certain partnership 

transactions also are covered. 

Transactions involving at least 80 percent identity of stock 

ownership 

The first type of inversion is a transaction in which, pursuant to 

a plan 53 or a series of related transactions: (1) a U.S. corporation 

becomes a subsidiary of a foreign-incorporated entity or otherwise 

transfers substantially all of its properties to such an entity in a 

transaction completed after March 4, 2003; (2) the former shareholders of the U.S. corporation hold (by reason of holding stock in 

the U.S. corporation) 80 percent or more (by vote or value) of the 

stock of the foreign-incorporated entity after the transaction; and 

(3) the foreign-incorporated entity, considered together with all 

companies connected to it by a chain of greater than 50 percent 

ownership (i.e., the ‘‘expanded affiliated group’’), does not have substantial business activities in the entity’s country of incorporation, 

compared to the total worldwide business activities of the expanded 

affiliated group. The provision denies the intended tax benefits of 

this type of inversion (‘‘80-percent inversion’’) by deeming the toptier foreign corporation to be a domestic corporation for all purposes of the Code.54

In determining whether a transaction meets the definition of an 

inversion under the provision, stock held by members of the expanded affiliated group that includes the foreign incorporated entity is disregarded. For example, if the former top-tier U.S. corporation receives stock of the foreign incorporated entity (e.g., so-called 

‘‘hook’’ stock), the stock would not be considered in determining 

whether the transaction meets the definition. Similarly, if a U.S. 

parent corporation converts an existing wholly owned U.S. subsidiary into a new wholly owned controlled foreign corporation, the 

stock of the new foreign corporation would be disregarded, with the 

result that the transaction would not meet the definition of an inVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00032 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
33 

version under the provision. Stock sold in a public offering related 

to the transaction also is disregarded for these purposes. 

Transfers of properties or liabilities as part of a plan a principal 

purpose of which is to avoid the purposes of the provision are disregarded. In addition, the Treasury Secretary is to provide regulations to carry out the provision, including regulations to prevent 

the avoidance of the purposes of the provision, including avoidance 

through the use of related persons, pass-through or other noncorporate entities, or other intermediaries, and through transactions 

designed to qualify or disqualify a person as a related person or a 

member of an expanded affiliated group. Similarly, the Treasury 

Secretary has the authority to treat certain non-stock instruments 

as stock, and certain stock as not stock, where necessary to carry 

out the purposes of the provision. 

Transactions involving at least 60 percent but less than 80 

percent identity of stock ownership 

The second type of inversion is a transaction that would meet the 

definition of an inversion transaction described above, except that 

the 80–percent ownership threshold is not met. In such a case, if 

at least a 60–percent ownership threshold is met, then a second set 

of rules applies to the inversion. Under these rules, the inversion 

transaction is respected (i.e., the foreign corporation is treated as 

foreign), but any applicable corporate-level ‘‘toll charges’’ for establishing the inverted structure are not offset by tax attributes such 

as net operating losses or foreign tax credits. Specifically, any applicable corporate-level income or gain required to be recognized 

under sections 304, 311(b), 367, 1001, 1248, or any other provision 

with respect to the transfer of controlled foreign corporation stock 

or the transfer or license of other assets by a U.S. corporation as 

part of the inversion transaction or after such transaction to a related foreign person is taxable, without offset by any tax attributes 

(e.g., net operating losses or foreign tax credits). This rule does not 

apply to certain transfers of inventory and similar property. These 

measures generally apply for a 10-year period following the inversion transaction. 

Other rules 

Under section 7874, inversion transactions include certain partnership transactions. Specifically, the provision applies to transactions in which a foreign-incorporated entity acquires substantially all of the properties constituting a trade or business of a domestic partnership, if after the acquisition at least 60 percent (or 

80 percent, as the case may be) of the stock of the entity is held 

by former partners of the partnership (by reason of holding their 

partnership interests), provided that the other terms of the basic 

definition are met. For purposes of applying this test, all partnerships that are under common control within the meaning of section 

482 are treated as one partnership, except as provided otherwise 

in regulations. In addition, the modified ‘‘toll charge’’ rules apply 

at the partner level. 

A transaction otherwise meeting the definition of an inversion 

transaction is not treated as an inversion transaction if, on or before March 4, 2003, the foreign-incorporated entity had acquired directly or indirectly more than half of the properties held directly 


hmoore on PROD1PC68 with HMRPT
34 

or indirectly by the domestic corporation, or more than half of the 

properties constituting the partnership trade or business, as the 

case may be. 

REASONS FOR CHANGE

The Committee believes that the inversions regime should generally apply to companies that completed 80-percent inversion 

transactions after public notice was given that eventual legislation 

on this issue could be effective after March 20, 2002. 

EXPLANATION OF PROVISION

The provision generally extends the 80-percent inversion regime 

of section 7874 to 80-percent inversions completed after March 20, 

2002 but on or before March 4, 2003, with certain modifications as 

described below. A transaction otherwise meeting the definition of 

an 80-percent inversion under the provision (i.e., one completed 

after March 20, 2002 but on or before March 4, 2003) is not treated 

as an 80-percent inversion if, on or before March 20, 2002, the foreign-incorporated entity had acquired directly or indirectly more 

than half the properties held directly or indirectly by the domestic 

corporation, or more than half the properties constituting the partnership trade or business, as the case may be. 

Under the provision, an 80-percent inversion that is completed 

after March 20, 2002 but on or before March 4, 2003 is respected 

until the end of the last day of the foreign-incorporated entity’s taxable year that began in 2006. At the end of that day, the inverted 

foreign-incorporated entity that completed the 80-percent inversion 

(or if relevant, any successor entity) is deemed to have transferred 

all of its assets and liabilities to a domestic corporation in a transaction that is generally treated as a nontaxable inbound reorganization (‘‘repatriation’’). The basis of the assets of the foreign-incorporated entity generally remains the same in the hands of the 

domestic corporation, subject to any special adjustments for importing built-in losses (e.g., sec. 362(e)). Shareholders of the domestic 

corporation inherit the respective bases of their shares of the foreign-incorporated entity. 

On the day of the repatriation, the earnings and profits of the 

inverted foreign-incorporated entity transfer over to the domestic 

corporation. The transfer of such earnings and profits is not a 

deemed dividend and does not result in a tax upon the domestic 

corporation or its shareholders. In addition, any foreign taxes attributable to such earnings and profits are not creditable. However, 

shareholders may be subject to tax on distributions of such earnings and profits. 

Beginning on the day after the repatriation, the inverted foreignincorporated entity is treated for all tax purposes as a domestic corporation. Thus, any income earned by the inverted foreign-incorporated entity after the date of repatriation is deemed to be earned 

by a domestic corporation, and therefore, is fully taxable at U.S. 

corporate income tax rates. As a further consequence of the repatriation of the inverted foreign-incorporated entity, foreign subsidiaries become controlled foreign corporations, subject to the rules of 

subpart F. 

It is intended that the Secretary will prescribe regulations that 

are necessary or appropriate to carry out the provision, including, 


hmoore on PROD1PC68 with HMRPT
35 

55Sec. 162(a). 56Sec. 162(c). 57Sec. 162(f). 58Sec. 162(g). 59Sec. 104(a). 60Sec. 104(a)(2). 

but not limited to, regulations to prevent the avoidance of the purposes of the provision. 

EFFECTIVE DATE

The provision is effective for taxable years beginning after December 31, 2006. 

C. DENIAL OF DEDUCTION FOR PUNITIVE DAMAGES

(Sec. 203 of the bill and sec. 162(g) of the Code) 

PRESENT LAW

In general, a deduction is allowed for all ordinary and necessary 

expenses that are paid or incurred by the taxpayer during the taxable year in carrying on any trade or business.55 However, no deduction is allowed for any payment that is made to an official of 

any governmental agency if the payment constitutes an illegal 

bribe or kickback or if the payment is to an official or employee of 

a foreign government and is illegal under Federal law.56 In addition, no deduction is allowed under present law for any fine or 

similar payment made to a government for violation of any law.57

Furthermore, no deduction is permitted for two-thirds of any damage payments made by a taxpayer who is convicted of a violation 

of the Clayton antitrust law or any related antitrust law.58

In general, gross income does not include amounts received on 

account of personal physical injuries and physical sickness.59 However, this exclusion does not apply to punitive damages.60

REASONS FOR CHANGE

The Committee believes that allowing a tax deduction for punitive damages undermines the societal role of punitive damages in 

discouraging and penalizing the activities or actions for which punitive damages are imposed. If a taxpayer deducts a payment for 

punitive damages, the amount of the payment does not reflect the 

true after-tax punitive effect on the taxpayer. The Committee is 

concerned that allowing a deduction for such payments in effect 

shifts a portion of the penalty to the Federal Government and to 

the public. Furthermore, the Committee believes that determining 

the amount of punitive damages to be disallowed as a tax deduction is not administratively burdensome because taxpayers generally can make such a determination readily by reference to pleadings filed with a court, and plaintiffs already make such a determination in determining the taxable portion of any payment. The 

Committee also believes that reporting the amount of any insurance payment for punitive damages to the IRS and the taxpayer 

will promote effective tax administration and foster compliance 

with the tax laws. 


hmoore on PROD1PC68 with HMRPT
36 

61S. Rep. No. 91–552, 91st Cong, 1 Sess., 273–74 (1969), referring to Tank Truck Rentals, Inc. 

v. Commissioner, 356 U.S. 30 (1958). 

EXPLANATION OF PROVISION

The provision denies any deduction for punitive damages that 

are paid or incurred by the taxpayer as a result of a judgment or 

in settlement of a claim. If the liability for punitive damages is covered by insurance, any such punitive damages paid by the insurer 

are included in gross income of the insured person and the insurer 

is required to report such amounts to both the insured person and 

the IRS. 

EFFECTIVE DATE

The provision is effective for punitive damages that are paid or 

incurred on or after the date of enactment. 

D. DENIAL OF DEDUCTION FOR CERTAIN FINES, PENALTIES, AND

OTHER AMOUNTS

(Sec. 204 of the bill and sec. 162 of the Code) 

PRESENT LAW

Under present law, no deduction is allowed as a trade or business expense under section 162(a) for the payment of a fine or similar penalty to a government for the violation of any law (sec. 

162(f)). The enactment of section 162(f) in 1969 codified existing 

case law that denied the deductibility of fines as ordinary and necessary business expenses on the grounds that ‘‘allowance of the deduction would frustrate sharply defined national or State policies 

proscribing the particular types of conduct evidenced by some governmental declaration thereof.’’ 61

Treasury regulation section 1.162–21(b)(1) provides that a fine or 

similar penalty includes an amount: (1) paid pursuant to conviction 

or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding; (2) paid as a civil penalty imposed by Federal, State, or local law, including additions to tax and 

additional amounts and assessable penalties imposed by chapter 68 

of the Code; (3) paid in settlement of the taxpayer’s actual or potential liability for a fine or penalty (civil or criminal); or (4) forfeited 

as collateral posted in connection with a proceeding which could result in imposition of such a fine or penalty. Treasury regulation 

section 1.162–21(b)(2) provides, among other things, that compensatory damages (including damages under section 4A of the Clayton Act (15 U.S.C. 15a), as amended) paid to a government do not 

constitute a fine or penalty. 

REASONS FOR CHANGE

The Committee is concerned that there is a lack of clarity and 

consistency under present law regarding when taxpayers may deduct payments made in settlement of government investigations of 

potential wrongdoing, as well as in situations where there has been 

a final determination of wrongdoing. If a taxpayer deducts payments made in settlement of an investigation of potential wrongdoing or as a result of a finding of wrongdoing, the publicly announced amount of the settlement payment does not reflect the 


hmoore on PROD1PC68 with HMRPT
37 

62The Government Acountability Office (‘‘GAO’’) reported that the majority of companies responding to a GAO survey deducted civil settlement payments when their settlement agreements did not label the payments as penalties. See, Government Accountability Office, TAX ADMINISTRATION: Systematic Information Sharing Would Help IRS Determine the Deductibility 

of Civil Settlement Payments (GAO–05–747). 63The provision does not affect amounts paid or incurred in performing routine audits or reviews such as annual audits that are required of all organizations or individuals in a similar 

business sector, or profession, as a requirement for being allowed to conduct business. However, 

if the government or regulator raised an issue of compliance and a payment is required in settlement of such issue, the provision would affect that payment. 64The provision provides that such amounts are nondeductible under chapter 1 of the Internal 

Revenue Code. 65The provision does not affect the treatment of antitrust payments made under section 4 of 

the Clayton Act, which continue to be governed by the provisions of section 162(g). 66 If a settlement agreement does not specify a specific amount to be paid for the purpose of 

coming into compliance but instead simply requires the taxpayer to come into compliance, it is 

sufficient identification to so state. Amounts expended by the taxpayer for that purpose would 

then be considered identified. However, if an agreement specifies a specific dollar amount that 

must be paid or incurred, the amount would not be eligible to be deducted without a specification that it is for restitution (including remediation of property), or coming into compliance. 67Thus, amounts paid or incurred as taxes due are not affected by the provision (e.g., State 

taxes that are otherwise deductible). The reference to taxes due is also intended to include interest with respect to such taxes (but not interest, if any, with respect to any penalties imposed 

with respect to such taxes). 68Thus, for example, the provision would not apply to payments made by one private party 

to another in a lawsuit between private parties, merely because a judge or jury acting in the 

capacity as a court directs the payment to be made. The mere fact that a court enters a judgment or directs a result in a private dispute does not cause a payment to be made ‘‘at the direction of government′′ for purposes of the provision. 

true after-tax penalty on the taxpayer.62 The Committee also is 

concerned that allowing a deduction for such payments in effect 

shifts a portion of the penalty to the Federal government and to 

the public. The Committee believes that reporting the payments to 

the IRS and the taxpayer promotes effective tax administration 

and fosters compliance with the tax law. 

EXPLANATION OF PROVISION

The provision modifies the rules regarding the determination 

whether payments are nondeductible payments of fines or penalties 

under section 162(f). In particular, the provision generally provides 

that amounts paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government in relation to the 

violation of any law or the investigation or inquiry into the potential violation of any law 63 are nondeductible under any provision 

of the income tax provisions.64 The provision applies to deny a deduction for any such payments, including those where there is no 

admission of guilt or liability and those made for the purpose of 

avoiding further investigation or litigation. An exception applies to 

payments that the taxpayer establishes are either restitution (including remediation of property), or amounts required to come into 

compliance with any law that was violated or involved in the investigation or inquiry, and that are identified in the court order or settlement as restitution, remediation, or required to come into compliance.65 The IRS remains free to challenge the characterization 

of an amount so identified; however, no deduction is allowed unless 

the identification is made.66

An exception also applies to any amount paid or incurred as 

taxes due.67

The provision is intended to apply only where a government (or 

other entity treated in a manner similar to a government under the 

provision) is a complainant or investigator with respect to the violation or potential violation of any law.68


hmoore on PROD1PC68 with HMRPT
38 

69Similarly, a payment to a charitable organization benefiting a broader class than the persons or property actually harmed, or to be paid out without a substantial quantitative relationship to the harm caused, would not qualify as restitution. Under the provision, such a payment 

not deductible under section 162 would also not be deductible under section 170. 

It is intended that a payment will be treated as restitution (including remediation of property) only if substantially all of the payment is required to be paid to the specific persons, or in relation 

to the specific property, actually harmed by the conduct of the taxpayer that resulted in the payment. Thus, a payment to or with respect to a class substantially broader than the specific persons or 

property that were actually harmed (e.g., to a class including similarly situated persons or property) does not qualify as restitution 

or included remediation of property.69 Restitution and included remediation of property is limited to the amount that bears a substantial quantitative relationship to the harm caused by the past 

conduct or actions of the taxpayer that resulted in the payment in 

question. If the party harmed is a government or other entity, then 

restitution and included remediation of property includes payment 

to such harmed government or entity, provided the payment bears 

a substantial quantitative relationship to the harm. However, restitution or included remediation of property does not include reimbursement of government investigative or litigation costs, or payments to whistleblowers. 

It is intended that a payment will be treated as an amount required to come into compliance only if it directly corrects a violation with respect to a particular requirement of law that was under 

investigation. For example, if the law requires a particular emission standard to be met or particular machinery to be used, 

amounts required to be paid under a settlement agreement to meet 

the required standard or install the machinery are deductible to 

the extent otherwise allowed. Similarly, if the law requires certain 

practices and procedures to be followed and a settlement agreement requires the taxpayer to pay to establish such practices or 

procedures, such amounts would be deductible. However, amounts 

paid for other purposes not directly correcting a violation of law are 

not deductible. For example, amounts paid to bring other machinery that is already in compliance up to a standard higher than required by the law, or to create other benefits (such as a park or 

other action not previously required by law), are not deductible if 

required under a settlement agreement. Similarly, amounts paid to 

educate consumers or customers about the risks of doing business 

with the taxpayer or about the field in which the taxpayer does 

business generally, which education efforts are not specifically required under the law, are not deductible if required under a settlement agreement. 

The provision requires government agencies to report to the IRS 

and to the taxpayer the amount of each settlement agreement or 

order entered where the aggregate amount required to be paid or 

incurred to or at the direction of the government under such settlement agreements and orders with respect to the violation, investigation, or inquiry is least $600 (or such other amount as may be 

specified by the Secretary of the Treasury as necessary to ensure 

the efficient administration of the Internal Revenue laws). The reports must be made within 30 days of the date the court order is 

issued or the settlement agreement is entered into, or such other 


hmoore on PROD1PC68 with HMRPT
39 

70 As in the case of the identification requirement, if the agreement does not specify a specific 

amount to be expended to come into compliance but simply requires that to occur, it is expected 

that the report may state simply that the taxpayer is required to come into compliance but no 

specific dollar amount has been specified for that purpose in the settlement agreement. 71For example, the IRS might require such separate reporting as part of, or in addition to, 

reporting of amounts that are not deducted and that thus create a book tax difference on the 

schedule M–3. 

time as may be required by Secretary. The report must separately 

identify any amounts that are restitution or remediation of property, or correction of noncompliance.70

The IRS is encouraged to require taxpayers to identify separately 

on their tax returns the amounts of any such settlements with respect to which reporting is required under the provision, including 

separate identification of the nondeductible amount and of any 

amount deductible as restitution, remediation, or required to correct noncompliance.71

Amounts paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, any self-regulatory entity that regulates a financial market or other market that is a qualified board 

or exchange under section 1256(g)(7), and that is authorized to impose sanctions (e.g., the National Association of Securities Dealers) 

are likewise subject to the provision if paid in relation to a violation, or investigation or inquiry into a potential violation, of any 

law (or any rule or other requirement of such entity). To the extent 

provided in regulations, amounts paid or incurred to, or at the direction of, any other nongovernmental entity that exercises selfregulatory powers as part of performing an essential governmental 

function are similarly subject to the provision. The exception for 

payments that the taxpayer establishes are paid or incurred for 

restitution, remediation of property, or coming into compliance and 

that are identified as such in the order or settlement agreement 

likewise applies in these cases. The requirement of reporting to the 

IRS and the taxpayer also applies in these cases. 

No inference is intended as to the treatment of payments as nondeductible fines or penalties under present law. In particular, the 

provision is not intended to limit the scope of present-law section 

162(f) or the regulations thereunder. 

EFFECTIVE DATE

The provision is effective for amounts paid or incurred on or after 

the date of enactment; however the provision does not apply to 

amounts paid or incurred under any binding order or agreement 

entered into before such date. Any order or agreement requiring 

court approval is not a binding order or agreement for this purpose 

unless such approval was obtained before the date of enactment. 

E. REVISION OF TAX RULES ON EXPATRIATION OF INDIVIDUALS

(Sec. 205 of the bill and secs. 102, 877, 2107, 2501, 7701 and 6039G 

of the Code) 

PRESENT LAW

In general 

U.S. citizens and residents generally are subject to U.S income 

taxation on their worldwide income. The U.S. tax may be reduced 

or offset by a credit allowed for foreign income taxes paid with reVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00039 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
40 

72For this purpose, however, U.S.-source income has a broader scope than it does typically 

in the Code. 

spect to foreign source income. Nonresident aliens are taxed at a 

flat rate of 30 percent (or a lower treaty rate) on certain types of 

passive income derived from U.S. sources, and at regular graduated 

rates on net profits derived from a U.S. trade or business. The estates of nonresident aliens generally are subject to estate tax on 

U.S.-situated property (e.g., real estate and tangible property located within the United States and stock in a U.S. corporation). 

Nonresident aliens generally are subject to gift tax on transfers by 

gift of U.S.-situated property (e.g., real estate and tangible property 

located within the United States), but excluding intangibles, such 

as stock, regardless of where they are located. 

Income tax rules with respect to expatriates 

For the 10 taxable years after an individual relinquishes his or 

her U.S. citizenship or terminates his or her U.S. long-term residency, unless certain conditions are met, the individual is subject 

to an alternative method of income taxation than that generally applicable to nonresident aliens (the ‘‘alternative tax regime’’). Generally, the individual is subject to income tax for the 10-year period 

at the rates applicable to U.S. citizens, but only on U.S.-source income.72

A ‘‘long-term resident’’ is a noncitizen who is a lawful permanent 

resident of the United States for at least eight taxable years during 

the period of 15 taxable years ending with the taxable year during 

which the individual either ceases to be a lawful permanent resident of the United States or commences to be treated as a resident 

of a foreign country under a tax treaty between such foreign country and the United States (and does not waive such benefits). 

A former citizen or former long-term resident is subject to the alternative tax regime for a 10-year period following citizenship relinquishment or residency termination, unless the former citizen or 

former long-term resident: (1) establishes that his or her average 

annual net income tax liability for the five preceding years does not 

exceed $124,000 (adjusted for inflation after 2004) and his or her 

net worth is less than $2 million, or alternatively satisfies limited, 

objective exceptions for certain dual citizens and minors who have 

had no substantial contacts with the United States; and (2) certifies under penalties of perjury that he or she has complied with 

all U.S. Federal tax obligations for the preceding five years and 

provides such evidence of compliance as the Secretary of the Treasury may require. 

Anti-abuse rules are provided to prevent the circumvention of the 

alternative tax regime. 

Estate tax rules with respect to expatriates 

Special estate tax rules apply to individuals who die during a 

taxable year in which he or she is subject to the alternative tax regime. Under these special rules, certain closely-held foreign stock 

owned by the former citizen or former long-term resident is includible in his or her gross estate to the extent that the foreign corporation owns U.S.-situated assets. The special rules apply if, at the 

time of death: (1) the former citizen or former long-term resident 


hmoore on PROD1PC68 with HMRPT
41 

directly or indirectly owns 10 percent or more of the total combined 

voting power of all classes of stock entitled to vote of the foreign 

corporation; and (2) directly or indirectly, is considered to own 

more than 50 percent of (a) the total combined voting power of all 

classes of stock entitled to vote in the foreign corporation, or (b) the 

total value of the stock of such corporation. If this stock ownership 

test is met, then the gross estate of the former citizen or former 

long-term resident includes that proportion of the fair market value 

of the foreign stock owned by the individual at the time of death, 

which the fair market value of any assets owned by such foreign 

corporation and situated in the United States (at the time of death) 

bears to the total fair market value of all assets owned by such foreign corporation (at the time of death). 

Gift tax rules with respect to expatriates 

Special gift tax rules apply to individuals who make gifts during 

a taxable year in which he or she is subject to the alternative tax 

regime. The individual is subject to gift tax on gifts of U.S.-situated 

intangibles made during the 10 years following citizenship relinquishment or residency termination. In addition, gifts of stock of 

certain closely-held foreign corporations by a former citizen or 

former long-term resident are subject to gift tax, if the gift is made 

during the time that such person is subject to the alternative tax 

regime. The operative rules with respect to these gifts of closelyheld foreign stock are the same as described above relating to the 

estate tax, except that the relevant testing and valuation date is 

the date of gift rather than the date of death. 

Termination of U.S. citizenship or long-term resident status for U.S. 

Federal income tax purposes 

An individual continues to be treated as a U.S. citizen or longterm resident for U.S. Federal tax purposes, including for purposes 

of section 7701(b)(10), until the individual: (1) gives notice of an expatriating act or termination of residency (with the requisite intent 

to relinquish citizenship or terminate residency) to the Secretary of 

State or the Secretary of Homeland Security, respectively; and (2) 

provides a statement to the Secretary of the Treasury in accordance with section 6039G. 

Sanction for individuals subject to the individual tax regime who 

return to the United States for extended periods 

The alternative tax regime does not apply to any individual for 

any taxable year during the 10-year period following citizenship relinquishment or residency termination if such individual is present 

in the United States for more than 30 days in the calendar year 

ending in such taxable year. Such individual is treated as a U.S. 

citizen or resident for such taxable year and, therefore, is taxed on 

his or her worldwide income. 

Similarly, if an individual subject to the alternative tax regime 

is present in the United States for more than 30 days in any calendar year ending during the 10-year period following citizenship 

relinquishment or residency termination, and the individual dies 

during that year, he or she is treated as a U.S. resident, and the 

individual’s worldwide estate is subject to U.S. estate tax. Likewise, if an individual subject to the alternative tax regime is 


hmoore on PROD1PC68 with HMRPT
42 

73Secs. 7701(b)(3)(D), 7701(b)(5) and 7701(b)(7)(B)–(D). 74 An individual has such a relationship to a foreign country if (1) the individual becomes a 

citizen or resident of the country in which the individual was born, such individual’s spouse was 

born, or either of the individual’s parents was born, and (2) the individual becomes fully liable 

for income tax in such country. 75 An individual has a minimal prior physical presence in the United States if the individual 

was physically present for no more than 30 days during each year in the ten-year period ending 

on the date of loss of United States citizenship or termination of residency. However, for purposes of this test, an individual is not treated as being present in the United States on a day 

if the individual remained in the United States because of a medical condition that arose while 

the individual was in the United States. Sec. 7701(b)(3)(D)(ii). 

present in the United States for more than 30 days in any year 

during the 10-year period following citizenship relinquishment or 

residency termination, the individual is subject to U.S. gift tax on 

any transfer of his or her worldwide assets by gift during that taxable year. 

For purposes of these rules, an individual is treated as present 

in the United States on any day if such individual is physically 

present in the United States at any time during that day. The 

present-law exceptions from being treated as present in the United 

States for residency purposes 73 generally do not apply for this purpose. However, for individuals with certain ties to countries other 

than the United States 74 and individuals with minimal prior physical presence in the United States,75 a day of physical presence in 

the United States is disregarded if the individual is performing 

services in the United States on such day for an unrelated employer (within the meaning of sections 267 and 707(b)), who meets 

the requirements the Secretary of the Treasury may prescribe in 

regulations. No more than 30 days may be disregarded during any 

calendar year under this rule. 

Annual return 

Former citizens and former long-term residents are required to 

file an annual return for each year following citizenship relinquishment or residency termination in which they are subject to the alternative tax regime. The annual return is required even if no U.S. 

Federal income tax is due. The annual return requires certain information, including information on the permanent home of the individual, the individual’s country of residence, the number of days 

the individual was present in the United States for the year, and 

detailed information about the individual’s income and assets that 

are subject to the alternative tax regime. This requirement includes information relating to foreign stock potentially subject to 

the special estate and gift tax rules. 

If the individual fails to file the statement in a timely manner 

or fails correctly to include all the required information, the individual is required to pay a penalty of $10,000. The $10,000 penalty 

does not apply if it is shown that the failure is due to reasonable 

cause and not to willful neglect. 

Immigration rules with respect to expatriates 

Under U.S. immigration laws, any former U.S. citizen who officially renounces his or her U.S. citizenship and who is determined 

by the Attorney General to have renounced for the purpose of U.S. 

tax avoidance is ineligible to receive a U.S. visa and will be denied 

entry into the United States. This provision was included as an 


hmoore on PROD1PC68 with HMRPT
43 

amendment (the ‘‘Reed amendment’’) to immigration legislation 

that was enacted in 1996. 

REASONS FOR CHANGE

The Committee is aware that some individuals each year relinquish their U.S. citizenship or terminate their U.S. residency for 

the purpose of avoiding U.S. income, estate, and gift taxes. By so 

doing, such individuals reduce their annual U.S. income tax liability and reduce or eliminate their U.S. estate and gift tax liability. 

The Committee recognizes that citizens and residents of the 

United States have a right not only physically to leave the United 

States to live elsewhere, but also to relinquish their citizenship or 

terminate their residency. The Committee does not believe that the 

Internal Revenue Code should be used to stop U.S. citizens and 

residents from relinquishing citizenship or terminating residency; 

however, the Committee also does not believe that the Code should 

provide a tax incentive for doing so. In other words, to the extent 

possible, an individual’s decision to relinquish citizenship or terminate residency should be tax-neutral. 

The Committee recognizes that the American Jobs Creation Act 

of 2004 altered prior law regarding expatriation in a number of respects, including the replacement of the subjective ‘‘principal purpose of tax avoidance test’’ with objective rules. Notwithstanding 

these changes, the Committee remains concerned that the presentlaw expatriation tax rules (as modified in 2004) are difficult to administer and could be made more effective. In addition, the Committee is concerned that the alternative method of taxation under 

section 877 can be avoided by postponing the realization of U.S.- 

source income for 10 years. 

Consequently, the Committee believes that the present-law expatriation tax rules should be replaced with a new tax regime applicable to former citizens and residents. Because U.S. citizens and 

residents who retain their citizenship or residency generally are 

subject to income tax on accrued appreciation when they dispose of 

their assets, as well as estate tax on the full value of assets that 

are held until death, the Committee believes it fair to tax individuals on the appreciation in their assets when they relinquish their 

citizenship or terminate their residency. The Committee believes 

that an exception from such a tax should be provided for individuals with a relatively modest amount of appreciated assets. The 

Committee also believes that, where U.S. estate or gift taxes are 

avoided with respect to a transfer of property to a U.S. person by 

reason of the expatriation of the donor, it is appropriate for the recipient to be subject to an income tax based on the value of the 

property. 

The Committee also believes that the present-law immigration 

rules applicable to former citizens are ineffective. The Committee 

believes that the rules should be modified to eliminate the requirement of proof of a tax avoidance purpose, and to coordinate the application of those rules with the tax rules provided under the new 

regime. 


hmoore on PROD1PC68 with HMRPT
44 

EXPLANATION OF PROVISION

In general 

The provision generally subjects certain U.S. citizens who relinquish their U.S. citizenship and certain long-term U.S. residents 

who terminate their U.S. residence to tax on the net unrealized 

gain in their property as if such property were sold for fair market 

value on the day before the expatriation or residency termination 

(‘‘mark-to-market tax’’). Gain from the deemed sale is taken into 

account at that time without regard to other Code provisions. Any 

loss from the deemed sale generally is taken into account to the extent otherwise provided in the Code, except that the wash sale 

rules of section 1091 do not apply. Any net gain on the deemed sale 

is recognized to the extent it exceeds $600,000 per covered expatriate. The $600,000 amount is increased by a cost of living adjustment factor for calendar years after 2007. 

Individuals covered 

The mark-to-market tax applies to U.S. citizens who relinquish 

citizenship and long-term residents who terminate U.S. residency 

(collectively, ‘‘covered expatriates’’). The definition of ‘‘long-term 

resident’’ under the provision is the same as that under present 

law. As under present law, an individual is considered to terminate 

long-term residency when the individual either ceases to be a lawful permanent resident (i.e., loses his or her green card status), or 

is treated as a resident of another country under a tax treaty and 

does not waive the benefits of the treaty. 

Exceptions to an individual’s classification as a covered expatriate are provided in two situations. The first exception applies to 

an individual who was born with citizenship both in the United 

States and in another country; provided that (1) as of the expatriation date the individual continues to be a citizen of, and is taxed 

as a resident of, such other country, and (2) the individual was not 

a resident of the United States for the five taxable years ending 

with the year of expatriation. The second exception applies to a 

U.S. citizen who relinquishes U.S. citizenship before reaching age 

181⁄2, provided that the individual was a resident of the United 

States for no more than five taxable years before such relinquishment. 

For purposes of the mark-to-market tax, an individual is treated 

as having relinquished U.S. citizenship on the earliest of four possible dates: (1) the date that the individual renounces U.S. nationality before a diplomatic or consular officer of the United States 

(provided that the voluntary relinquishment is later confirmed by 

the issuance of a certificate of loss of nationality); (2) the date that 

the individual furnishes to the State Department a signed statement of voluntary relinquishment of U.S. nationality confirming 

the performance of an expatriating act (again, provided that the 

voluntary relinquishment is later confirmed by the issuance of a 

certificate of loss of nationality); (3) the date that the State Department issues a certificate of loss of nationality; or (4) the date that 

a U.S. court cancels a naturalized citizen’s certificate of naturalization. 

In addition, the provision provides that, for all tax purposes (i.e., 

not limited to the mark-to-market tax), a U.S. citizen continues to 


hmoore on PROD1PC68 with HMRPT
45 

be treated as a U.S. citizen for tax purposes until that individual’s 

citizenship is treated as relinquished under the rules of the immediately preceding paragraph. However, under Treasury regulations, 

relinquishment may occur earlier with respect to an individual who 

became at birth a citizen of the United Sates and of another country. 

Election to be treated as a U.S. citizen 

Under the provision, a covered expatriate is permitted to make 

an irrevocable election to continue to be taxed as a U.S. citizen 

with respect to all property that otherwise is covered by the expatriation tax. This election is an ‘‘all or nothing’’ election; an individual is not permitted to elect this treatment for some property 

but not for other property. The election, if made, applies to all 

property that would be subject to the expatriation tax and to any 

property the basis of which is determined by reference to such 

property. Under this election, following expatriation the individual 

continues to pay U.S. income taxes at the rates applicable to U.S. 

citizens on any income generated by the property and on any gain 

realized on the disposition of the property. In addition, the property 

continues to be subject to U.S. gift, estate, and generation-skipping 

transfer taxes. In order to make this election, the taxpayer is required to waive any treaty rights that would preclude the collection 

of the tax. 

The individual is also required to provide security to ensure payment of the tax under this election in such form, manner, and 

amount as the Secretary of the Treasury requires. The amount of 

mark-to-market tax that would have been owed but for this election (including any interest, penalties, and certain other items) becomes a lien in favor of the United States on all U.S.-situated property owned by the individual. This lien arises on the expatriation 

date and continues until the tax liability is satisfied, the tax liability has become unenforceable by reason of lapse of time, or the Secretary of the Treasury is satisfied that no further tax liability may 

arise by reason of this provision. The rules of section 6324A(d)(1), 

(3), and (4) (relating to liens arising in connection with the deferral 

of estate tax under section 6166) apply to liens arising under this 

provision. 

Deemed sale of property upon expatriation or residency termination 

and tentative tax 

The deemed sale rule of the provision generally applies to all 

property interests held by the individual on the date of relinquishment of citizenship or termination of residency. Special rules apply 

in the case of trust interests, as described below. U.S. real property 

interests (which remain subject to U.S. tax in the hands of nonresident noncitizens), with the exception of stock of certain former 

U.S. real property holding corporations, are exempted from the provision. Regulatory authority is granted to the Treasury to exempt 

other types of property from the provision. 

Under the provision, an individual who is subject to the markto-market tax is required to pay a tentative tax equal to the 

amount of tax that would be due for a hypothetical short tax year 

ending on the date the individual relinquishes citizenship or terminates residency. Thus, the tentative tax is based on all income, 


hmoore on PROD1PC68 with HMRPT
46 

gains, deductions, losses, and credits of the individual for the year 

through such date, including amounts realized from the deemed 

sale of property. Moreover, notwithstanding any other provision of 

the Code, any period during which recognition of income or gain 

had been deferred terminates on the day before relinquishment of 

citizenship or termination of residency (and, therefore, such income 

or gain recognition becomes part of the tax base of the tentative 

tax). The tentative tax is due on the 90th day after the date of relinquishment of citizenship or termination of residency, subject to 

the election, described below, to defer payments of the mark-tomarket tax. In addition, notwithstanding any other provision of the 

Code, any extension of time for payment of tax ceases to apply on 

the day before relinquishment of citizenship or termination of residency, and the unpaid portion of such tax becomes due and payable 

at the time and in the manner prescribed by the Secretary of the 

Treasury. 

Deferral of payment of mark-to-market tax 

Under the provision, an individual is permitted to elect to defer 

payment of the mark-to-market tax imposed on the deemed sale of 

property. Interest is charged for the period the tax is deferred at 

a rate two percentage points higher than the rate normally applicable to individual underpayments. The election is irrevocable and is 

made on a property-by-property basis. Under the election, the deferred tax attributable to a particular property is due when the 

property is disposed of (or, if the property is disposed of in a transaction in which gain is not recognized in whole or in part, at such 

other time as the Secretary of the Treasury may prescribe). The deferred tax attributable to a particular property is an amount that 

bears the same ratio to the total mark-to-market tax as the gain 

taken into account with respect to such property bears to the total 

gain taken into account under these rules. The deferral of the 

mark-to-market tax may not be extended beyond the due date of 

the return for the taxable year which includes the individual’s 

death. 

In order to elect deferral of the mark-to-market tax, the individual is required to provide a bond in the amount of the deferred 

tax to the Secretary of the Treasury. Other security mechanisms 

are permitted provided that the individual establishes to the satisfaction of the Secretary of the Treasury that the security is adequate. In the event that the security provided with respect to a 

particular property subsequently becomes inadequate and the individual fails to correct the situation, the deferred tax and the interest with respect to such property will become due. As a further condition to making the election, the individual is required to consent 

to the waiver of any treaty rights that would preclude the collection 

of the tax. 

The deferred tax amount (including any interest, penalties, and 

certain other items) becomes a lien in favor of the United States 

on all U.S.-situated property owned by the individual. This lien 

arises on the expatriation date and continues until the tax liability 

is satisfied, the tax liability has become unenforceable by reason of 

lapse of time, or the Secretary is satisfied that no further tax liability may arise by reason of this provision. The rules of section 


hmoore on PROD1PC68 with HMRPT
47 

76 Application of the provision is not limited to an interest that meets the definition of property under section 83 (relating to property transferred in connection with the performance of 

services). 

6324A(d)(1), (3), and (4) (relating to liens arising in connection with 

the deferral of estate tax under section 6166) apply to such liens. 

Retirement plans and similar arrangements 

Subject to certain exceptions, the provision applies to all property 

interests held by covered expatriates at the time of relinquishment 

of citizenship or termination of residency. Accordingly, such property includes an interest in an employer-sponsored qualified plan 

or deferred compensation arrangement as well as an interest in an 

individual retirement account or annuity (i.e., an IRA).76 However, 

the provision contains a special rule for an interest in a ‘‘retirement 

plan.’’ For purposes of the provision, a ‘‘retirement plan’’ includes 

an employer-sponsored qualified plan (sec. 401(a)), a qualified annuity (sec. 403(a)), a tax-sheltered annuity (sec. 403(b)), an eligible 

deferred compensation plan of a governmental employer (sec. 

457(b)), an individual retirement account (sec. 408(a)), and an individual retirement annuity (sec. 408(b)). The special retirement plan 

rule also applies, to the extent provided in regulations, to any foreign plan or similar retirement arrangement or program. An interest in a trust that is part of a retirement plan is subject to the special retirement plan rules and not to the rules for interests in 

trusts (discussed below). 

Under the special retirement plan rules, in lieu of the deemed 

sale rule, an amount equal to the present value of the individual’s 

vested, accrued benefit under a retirement plan is treated as having been received by the individual as a distribution under the retirement plan on the day before the individual’s relinquishment of 

citizenship or termination of residency. In the case of any later distribution to the individual from the retirement plan, the amount 

otherwise includible in the individual’s income as a result of the 

distribution is reduced to reflect the amount previously included in 

income under the special retirement plan rule. The amount of the 

reduction applied to a distribution is the excess of: (1) the amount 

included in income under the special retirement plan rule, over (2) 

the total reductions applied to any prior distributions. It is not intended that the retirement plan would be deemed to have made a 

distribution at the time of expatriation for purposes of the tax-favored status of the retirement plan, such as whether a plan may 

permit distributions before a participant has severed employment. 

However, the retirement plan, and any person acting on the plan’s 

behalf, will treat any later distribution in the same manner as the 

distribution would be treated without regard to the special retirement plan rule. 

It is expected that the Treasury Department will provide guidance for determining the present value of an individual’s vested, 

accrued benefit under a retirement plan, such as the individual’s 

account balance in the case of a defined contribution plan or an 

IRA, or present value determined under the qualified joint and survivor annuity rules applicable to a defined benefit plan (sec. 

417(e)). 


hmoore on PROD1PC68 with HMRPT
48 

77 Allocable expatriation gain is subject to the $600,000 exemption (adjusted for cost of living 

increases). 

Interests in trusts 

In general 

Detailed rules apply under the provision to trust interests held 

by an individual at the time of relinquishment of citizenship or termination of residency. The treatment of trust interests depends on 

whether the trust is a ‘‘qualified trust.’’ A trust is a qualified trust 

if a court within the United States is able to exercise primary supervision over the administration of the trust and one or more U.S. 

persons have the authority to control all substantial decisions of 

the trust. 

Constructive ownership rules apply to a trust beneficiary that is 

a corporation, partnership, trust, or estate. In such cases, the 

shareholders, partners, or beneficiaries of the entity are deemed to 

be the direct beneficiaries of the trust. In addition, an individual 

who holds (or who is treated as holding) a trust instrument at the 

time of relinquishment of citizenship or termination of residency is 

required to disclose on his or her tax return the methodology used 

to determine his or her interest in the trust, and whether such individual knows (or has reason to know) that any other beneficiary 

of the trust uses a different method. 

Nonqualified trusts 

If an individual holds an interest in a trust that is not a qualified 

trust, a special rule applies for purposes of determining the amount 

of the mark-to-market tax due with respect to such trust interest. 

The individual’s interest in the trust is treated as a separate trust 

consisting of the trust assets allocable to such interest. Such separate trust is treated as having sold its net assets for their fair market value on the day before the date of relinquishment of citizenship or termination of residency and having distributed the assets 

to the individual, who then is treated as having recontributed the 

assets to the trust. Any income, gain, or loss of the individual arising from the deemed distribution from the trust is taken into account as if it had arisen under the deemed sale rules. 

The election to defer payment is available for the mark-to-market 

tax attributable to a nonqualified trust interest. A beneficiary’s interest in a nonqualified trust is determined under all the facts and 

circumstances, including the trust instrument, letters of wishes, 

historical patterns of trust distributions, and the existence of, and 

function performed by, a trust protector or any similar advisor. 

Qualified trusts 

If an individual has an interest in a qualified trust, the amount 

of mark-to-market tax on unrealized gain allocable to the individual’s trust interest (‘‘allocable expatriation gain’’) is calculated at 

the time of expatriation or residency termination, but is collected 

as the individual receives distributions from the qualified trust. 

The allocable expatriation gain is the amount of gain which would 

be allocable to the individual’s trust interest if the individual directly held all the assets allocable to such interest.77 If any individual’s interest in a trust is vested as of the day before the expatriaVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00048 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
49 

tion date (e.g., if the individual’s interest in the trust is non-contingent and non-discretionary), the gain allocable to the individual’s 

trust interest is determined based on the trust assets allocable to 

his or her trust interest. If the individual’s interest in the trust is 

not vested as of the expatriation date (e.g., if the individual’s trust 

interest is a contingent or discretionary interest), the gain allocable 

to his or her trust interest is determined based on all of the trust 

assets that could be allocable to his or her trust interest, determined by resolving all contingencies and discretionary powers in 

the individual’s favor (i.e., the individual is allocated the maximum 

amount that he or she could receive). 

Taxes are imposed on each distribution from a qualified trust. 

These distributions also may be subject to other U.S. income taxes. 

If a distribution from a qualified trust is made after the individual 

relinquishes citizenship or terminates residency, the mark-to-market tax is imposed in an amount equal to the amount of the distribution multiplied by the highest tax rate generally applicable to 

trusts and estates for the taxable year which includes the date of 

expatriation, but in no event will the tax imposed exceed the balance in the ‘‘deferred tax account’’ with respect to the trust interest. For this purpose, the balance in the deferred tax account is 

equal to (1) the hypothetical tax calculated under the ‘‘regular’’ deemed sale rules with respect to the allocable expatriation gain, 

(2) increased by interest charged on the balance in the deferred tax 

account at a rate two percentage points higher than the rate normally applicable to individual underpayments, for periods beginning after the 90th day after the expatriation date and calculated 

up to 30 days prior to the date of the distribution, (3) reduced by 

any mark-to-market tax imposed on prior trust distributions to the 

individual, and (4) to the extent provided in Treasury regulations, 

in the case of a covered expatriate holding a nonvested interest, reduced by mark-to-market taxes imposed on trust distributions to 

other persons holding nonvested interests. 

The tax that is imposed on distributions from a qualified trust 

generally is to be deducted and withheld by the trustees. If the individual does not agree to waive treaty rights that would preclude 

collection of the tax, the tax with respect to such distributions is 

imposed on the trust, the trustee is personally liable for the tax, 

and any other beneficiary has a right of contribution against such 

individual with respect to the tax. 

Mark-to-market taxes become due immediately if the trust ceases 

to be a qualified trust, the individual disposes of his or her qualified trust interest, or the individual dies. In such cases, the amount 

of mark-to-market tax equals the lesser of (1) the tax calculated 

under the rules for nonqualified trust interests as of the date of the 

triggering event, or (2) the balance in the deferred tax account with 

respect to the trust interest immediately before that date. Such tax 

is imposed on the trust, the trustee is personally liable for the tax, 

and any other beneficiary has a right of contribution against such 

individual (or his or her estate) with respect to such tax. 

Regulatory authority 

The provision authorizes the Secretary of the Treasury to prescribe such regulations as may be necessary or appropriate to carry 

out the purposes of the provision. In addition, the Secretary of the 


hmoore on PROD1PC68 with HMRPT
50 

Treasury may provide for adjustments to the bases of assets in a 

trust or a deferred tax account, and the timing of such adjustments, to ensure that gain is taxed only once. 

Income tax treatment of gifts and inheritances from a former citizen 

or former long-term resident 

Under the provision, the exclusion from income provided in section 102 (relating to exclusions from income for the value of property acquired by gift or inheritance) does not apply to the value of 

any property received by gift or inheritance from a covered expatriate. Accordingly, a U.S. taxpayer who receives a gift or inheritance from such an individual is required to include the value of 

such gift or inheritance in gross income and is subject to U.S. tax 

on such amount. Having included the value of the property in income, the recipient takes a basis in the property equal to that 

value. The tax does not apply to property that is shown on a timely 

filed gift tax return and that is a taxable gift by the former citizen 

or former long-term resident, or property that is shown on a timely 

filed estate tax return and included in the gross U.S. estate of the 

former citizen or former long-term resident (regardless of whether 

the tax liability shown on such a return is reduced by credits, deductions, or exclusions available under the estate and gift tax 

rules). In addition, the tax does not apply to property in cases in 

which no estate or gift tax return was filed, but no such return 

would have been required to be filed if the former citizen or former 

long-term resident had not relinquished citizenship or terminated 

residency, as the case may be. 

Coordination with present-law alternative tax regime 

The provision provides a coordination rule with the present-law 

alternative tax regime. Under the provision, the present-law expatriation income tax rules under section 877, and the special 

present-law expatriation estate and gift tax rules under sections 

2107 and 2501(a)(3) (generally described above), do not apply to a 

covered expatriate whose expatriation or residency termination occurs on or after the date of enactment. 

Information reporting 

Certain information reporting requirements under the law presently applicable to former citizens and former long-term residents 

(sec. 6039G) also apply for purposes of the provision. 

Immigration rules 

The provision amends the immigration rules that deny tax-motivated expatriates reentry into the United States by removing the 

requirement that the expatriation be tax-motivated, and instead 

denies former citizens reentry into the United States if the individual is determined not to be in compliance with his or her tax 

obligations under the provision’s expatriation tax provisions (regardless of the subjective motive for expatriating). For this purpose, the provision permits the IRS to disclose certain items of return information of an individual, upon written request of the Attorney General or his delegate, as is necessary for making a determination under section 212(a)(10)(E) of the Immigration and Nationality Act. Specifically, the provision permits the IRS to disclose 


hmoore on PROD1PC68 with HMRPT
51 

78 Code sec. 409A. 

to the agency administering section 212(a)(10)(E) whether such taxpayer is in compliance with the new tax rules, and to identify the 

items of any noncompliance. Recordkeeping requirements, safeguards, and civil and criminal penalties for unauthorized disclosure 

or inspection apply to return information disclosed under this provision. 

EFFECTIVE DATE

The provision generally is effective for U.S. citizens who relinquish citizenship or long-term residents who terminate their residency on or after the date of enactment. The due date for tentative 

tax, however, may not occur before the 90th day after the date of 

enactment. The portion of the provision relating to income taxes on 

gifts and inheritances is effective for gifts and inheritances received 

from former citizens or former long-term residents (or their estates) 

on or after the date of enactment, whose relinquishment of citizenship or residency termination occurs after such date. The portion 

of the provision relating to immigration and disclosure with respect 

to former citizens is effective with respect to individuals who relinquish citizenship on or after the date of enactment. 

F. LIMIT AMOUNTS OF ANNUAL DEFERRALS UNDER NONQUALIFIED

DEFERRED COMPENSATION PLANS

(Sec. 206 of the bill and sec. 409A of the Code) 

PRESENT LAW

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.78 The requirements include rules relating to distributions, acceleration of benefits and funding. For example, distributions from a nonqualified deferred compensation plan may be allowed only upon certain times and events. Rules also apply for the 

timing of elections. In general, elections to defer compensation for 

a taxable year must be made not later than the close of the preceding taxable year. Section 409A does not include rules limiting 

the amount that may be deferred under a nonqualified deferred 

compensation plan. 

A nonqualified deferred compensation plan generally includes 

any plan that provides for the deferral of compensation other than 

a qualified employer plan or any bona fide vacation leave, sick 

leave, compensatory time, disability pay, or death benefit plan. A 

qualified employer plan means a qualified retirement plan, tax-deferred annuity, simplified employee pension, and SIMPLE. A qualified governmental excess benefit arrangement (sec. 415(m)) and an 

eligible deferred compensation plan (sec. 457(b)) is a qualified employer plan. 

If the requirements of section 409A are not satisfied, in addition 

to current income inclusion, interest at the underpayment rate plus 

one percentage point is imposed on the underpayments that would 

have occurred had the compensation been includible in income 


hmoore on PROD1PC68 with HMRPT
52 

79See, e.g., Ellen E. Schultz and Theo Francis, As Workers’ Pensions Wither, Those for Executives Flourish, Wall St. J., June 23, 2006, at A1, and Deferring Compensation Also Creates A 

Company Debt to Executives, June 23, 2006, at A8. Theo Francis, ‘Phantom’ Accounts for CEOs 

Draw Scrutiny, Wall St. J., June 13, 2005, at B1. 

when first deferred, or if later, when not subject to a substantial 

risk of forfeiture. The amount required to be included in income is 

also subject to a 20-percent additional tax. 

Under present law, Treasury is authorized to prescribe regulations as are necessary or appropriate to carry out the purposes of 

the provision. 

REASONS FOR CHANGE

The Committee is concerned with the large amount of executive 

compensation that is deferred in order to avoid the payment of income taxes. Rank and file employees generally do not have the opportunity to defer taxation on otherwise includible income in excess 

of the qualified plan limits. However, it is common for nonqualified 

deferred compensation arrangements to allow executives to choose 

the amount of income inclusion they wish to defer.79 The Committee is concerned that the ability to defer unlimited amounts of 

compensation gives executives more control over the timing of income inclusion than rank and file employees. The Committee believes that the amount of compensation that can be deferred to 

avoid the payment of tax should be limited. 

EXPLANATION OF PROVISION

The provision adds an additional requirement to the rules governing the income inclusion of amounts deferred under a nonqualified deferred compensation plan. Under the provision, the annual aggregate amounts deferred under a nonqualified deferred 

compensation plan by an individual may not exceed the applicable 

dollar amount for the taxable year. The applicable dollar amount 

is the lesser of (1) $1 million or (2) the average annual compensation payable during the base period to the participant by the employer maintaining the nonqualified deferred compensation plan (or 

a predecessor or related entity) and which was includible in the 

participant’s gross income for taxable years in the base period. 

Earnings (whether actual or notional) attributable to nonqualified 

deferred compensation are treated as additional deferred compensation and are subject to the provision. Thus, such amounts are 

taken into account in determining whether the limit on the amount 

deferred is exceeded. 

If the requirement is not satisfied, the present-law sanctions for 

failure to satisfy section 409A apply. Thus, if the requirement is 

not satisfied, all amounts deferred under the 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. If the requirements of the provision are not satisfied, as under present law, in 

addition to current income inclusion, interest at the underpayment 

rate plus one percentage point is imposed on the underpayments 

that would have occurred had the compensation been includible in 

income when first deferred, or if later, when not subject to a subVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00052 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
53 

80These consequences apply under the provision to amounts deferred after the effective date 

of the provision. 

stantial risk of forfeiture. The amount required to be included in 

income is also subject to a 20-percent additional tax.80

Earnings (whether actual or notional) in a subsequent taxable 

year on amounts included in income under the provision are includible in income in such subsequent taxable year to the extent such 

earnings are not subject to a substantial risk of forfeiture and not 

previously included in gross income. The present-law sanctions 

under 409A (interest at the underpayment rate plus one percentage 

point and a 20-percent additional tax) also apply. 

The base period is the five-taxable-year period ending with the 

taxable year preceding the taxable year for which the limitation is 

being determined (the ‘‘computation year’’). If, before the beginning 

of the computation year, an election is made to defer compensation 

for services performed in the computation year, the base period is 

the five-taxable-year period ending with the taxable year preceding 

the taxable year in which the election is made. For example, suppose an executive elects in 2008 to defer a portion of compensation 

to be earned in 2009. The base period for the 2009 computation 

year would be 2003 to 2007. In the case that the individual does 

not perform services for the employer for the entire five-year period, the base period is the portion of such period during which the 

individual performs services for the employer (or a predecessor employer). It is intended that the Secretary of the Treasury issue 

guidance similar to that under section 280G regarding the base period determination in cases in which the individual does not perform services for the employer for the entire five-year period. 

As under section 409A generally, except as provided by the Secretary, aggregation rules similar to the rules under section 414(b) 

and (c) apply. In addition, all nonqualified deferred compensation 

plans maintained by all employers treated as a single employer 

under these aggregation rules are treated as one plan. 

The provision applies to all amounts deferred under nonqualified 

deferred compensation plans (as defined under section 409A), including plans of both private and publicly-held corporations. 

As under section 409A generally, this limitation is not intended 

to prevent the inclusion of amounts in gross income under any provision or rule of law earlier than the time provided in the provision. The provision does not affect the rules regarding the timing 

of an employer’s deduction for nonqualified deferred compensation. 

The regulatory authority of the Secretary of the Treasury to prescribe regulations as are necessary to carry out the purposes of section 409A generally applies to the provision. Under such existing 

regulatory authority, it is expected that the Secretary of the Treasury will issue guidance relating to defined benefit arrangements, 

including the application of the annual limitation and determination of the amounts deferred. 

EFFECTIVE DATE

The provision applies to taxable years beginning after December 

31, 2006, with respect to amounts deferred after such date (and 

earnings on such amounts). Amounts deferred (and earnings on 

amounts deferred) in taxable years beginning before January 1, 


hmoore on PROD1PC68 with HMRPT
54 

2007, are not subject to the provision. Taxable years beginning on 

or before December 31, 2006, are taken into account in determining 

the average annual compensation of a participant during any base 

period. 

The provision directs the Secretary of the Treasury, within 60 

days after enactment, to issue guidance providing a limited time 

period during which a nonqualified deferred compensation plan 

adopted before December 31, 2006, may, without violating the requirements of section 409A, be amended to provide that a participant may, no later than December 31, 2007, cancel or modify an 

outstanding deferral election with regard to all or a portion of 

amounts deferred after December 31, 2006, to the extent necessary 

to meet the requirements of the provision. Amounts subject to the 

cancellation or modification are currently includible in income to 

the participant to the extent not subject to a substantial risk of forfeiture and not previously included in income. Such guidance must 

also allow nonqualified deferred compensation plans adopted before 

December 31, 2006, to be amended to conform to the requirements 

of the provision with regard to amounts deferred after December 

31, 2006. 

G. INCREASE IN CRIMINAL MONETARY PENALTY LIMITATION FOR THE

UNDERPAYMENT OR OVERPAYMENT OF TAX DUE TO FRAUD

(Sec. 207 of the bill and secs. 7201, 7203, and 7206 of the Code) 

PRESENT LAW

Attempt to evade or defeat tax 

In general, section 7201 imposes a criminal penalty on persons 

who willfully attempt to evade or defeat any tax imposed by the 

Code. Upon conviction, the Code provides that the penalty is up to 

$100,000 or imprisonment of not more than five years (or both). In 

the case of a corporation, the Code increases the monetary penalty 

to a maximum of $500,000. 

Willful failure to file return, supply information, or pay tax 

In general, section 7203 imposes a criminal penalty on persons 

required to make estimated tax payments, pay taxes, keep records, 

or supply information under the Code and who willfully fail to do 

so. Upon conviction, the Code provides that the penalty is up to 

$25,000 or imprisonment of not more than one year (or both). In 

the case of a corporation, the Code increases the monetary penalty 

to a maximum of $100,000. 

Fraud and false statements 

In general, section 7206 imposes a criminal penalty on persons 

who make fraudulent or false statements under the Code. Upon 

conviction, the Code provides that the penalty is up to $100,000 or 

imprisonment of not more than three years (or both). In the case 

of a corporation, the Code increases the monetary penalty to a 

maximum of $500,000. 

Uniform sentencing guidelines 

Under the uniform sentencing guidelines established by 18 

U.S.C. 3571, a defendant found guilty of a criminal offense is subVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00054 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
55 

81Section 7206 states that making fraudulent or false statements under the Code is a felony. 

In addition, this offense is a felony pursuant to the classification guidelines of 18 U.S.C. 

3559(a)(5). 82 In United States v. Booker, 543 U.S. 220 (2005), the Supreme Court held that mandatory 

application of the Federal Sentencing Guidelines is incompatible with the Sixth Amendment 

jury trial requirement. As a result of this decision, the Federal Sentencing Guidelines are effectively advisory, i.e., requiring a sentencing court to consider the sentencing ranges under the 

Guidelines, but permitting it to tailor a sentence in light of other statutory concerns. 

ject to a maximum fine that is the greatest of: (a) the amount specified in the underlying provision; (b) for a felony,81 $250,000 for an 

individual or $500,000 for an organization; or (c) twice the gross 

gain if a person derives pecuniary gain from the offense. This Title 

18 provision applies to all criminal provisions in the United States 

Code, including those in the Internal Revenue Code.82 For example, 

for an individual, the maximum fine under present law upon conviction of violating section 7206 is $250,000 or, if greater, twice the 

amount of gross gain from the offense. 

REASONS FOR CHANGE

The Committee believes that existing criminal tax penalties do 

not adequately deter criminal behavior, which results in increased 

noncompliance and an increase in the tax gap. Increasing monetary 

penalties will raise the economic risk of failing to comply with tax 

laws. In addition, classifying certain willful failure to file cases as 

felonies should discourage criminal tax violations by substantially 

increasing the monetary and sentencing consequences of the offense together with the long term repercussions associated with a 

felony record. 

EXPLANATION OF PROVISION

Attempt to evade or defeat tax 

The provision increases the criminal penalty under section 7201 

of the Code for individuals to $500,000 and for corporations to 

$1,000,000. The provision increases the maximum prison sentence 

to ten years. 

Willful failure to file return, supply information, or pay tax 

The provision increases the criminal penalty under section 7203 

of the Code for individuals from $25,000 to $50,000 and, in the case 

of an ‘‘aggravated failure to file’’ (defined as a failure to file a return for a period of three or more consecutive taxable years if the 

aggregated tax liability for such period is at least $100,000), 

changes the crime from a misdemeanor to a felony and increases 

the maximum prison sentence to ten years. 

Fraud and false statements 

The provision increases the criminal penalty for making fraudulent or false statements to $500,000 for individuals and $1,000,000 

for corporations. The provision increases the maximum prison sentence for making fraudulent or false statements to five years. The 

provision provides that in no event shall the amount of the monetary penalty under the provision be less than the amount of the underpayment or overpayment attributable to fraud. 


hmoore on PROD1PC68 with HMRPT
56 

EFFECTIVE DATE

The provision is effective for actions and failures to act occurring 

after the date of enactment. 

H. DOUBLING OF CERTAIN PENALTIES, FINES, AND INTEREST ON UNDERPAYMENTS RELATED TO CERTAIN OFFSHORE FINANCIAL ARRANGEMENTS

(Sec. 208 of the bill) 

PRESENT LAW

In general 

The Code contains numerous civil penalties, such as the delinquency, accuracy-related, fraud, and assessable penalties. These 

civil penalties are in addition to any interest that may be due as 

a result of an underpayment of tax. If all or any part of a tax is 

not paid when due, the Code imposes interest on the underpayment, which is assessed and collected in the same manner as 

the underlying tax and is subject to the respective statutes of limitations for assessment and collection. 

Delinquency penalties 

Failure to file 

Under present law, a taxpayer who fails to file a tax return on 

a timely basis is generally subject to a penalty equal to 5 percent 

of the net amount of tax due for each month that the return is not 

filed, up to a maximum of five months or 25 percent. An exception 

from the penalty applies if the failure is due to reasonable cause. 

In the case of fraudulent failure to file, the penalty is increased to 

15 percent of the net amount of tax due for each month that the 

return is not filed, up to a maximum of five months or 75 percent. 

The net amount of tax due is the excess of the amount of the tax 

required to be shown on the return over the amount of any tax 

paid on or before the due date prescribed for the payment of tax. 

Failure to pay 

Taxpayers who fail to pay their taxes are subject to a penalty of 

0.5 percent per month on the unpaid amount, up to a maximum 

of 25 percent. If a penalty for failure to file and a penalty for failure to pay tax shown on a return both apply for the same month, 

the amount of the penalty for failure to file for such month is reduced by the amount of the penalty for failure to pay tax shown 

on a return. If an income tax return is filed more than 60 days 

after its due date, then the penalty for failure to pay tax shown on 

a return may not reduce the penalty for failure to file below the 

lesser of $100 or 100 percent of the amount required to be shown 

on the return. For any month in which an installment payment 

agreement with the IRS is in effect, the rate of the penalty is half 

the usual rate (0.25 percent instead of 0.5 percent), provided that 

the taxpayer filed the tax return in a timely manner (including extensions). 


hmoore on PROD1PC68 with HMRPT
57 

Failure to make timely deposits of tax 

The penalty for the failure to make timely deposits of tax consists of a four-tiered structure in which the amount of the penalty 

varies with the length of time within which the taxpayer corrects 

the failure. A depositor is subject to a penalty equal to 2 percent 

of the amount of the underpayment if the failure is corrected on or 

before the date that is five days after the prescribed due date. A 

depositor is subject to a penalty equal to 5 percent of the amount 

of the underpayment if the failure is corrected after the date that 

is five days after the prescribed due date but on or before the date 

that is 15 days after the prescribed due date. A depositor is subject 

to a penalty equal to 10 percent of the amount of the underpayment if the failure is corrected after the date that is 15 days 

after the due date but on or before the date that is 10 days after 

the date of the first delinquency notice to the taxpayer (under sec. 

6303). Finally, a depositor is subject to a penalty equal to 15 percent of the amount of the underpayment if the failure is not corrected on or before earlier of 10 days after the date of the first delinquency notice to the taxpayer and 10 days after the date on 

which notice and demand for immediate payment of tax is given in 

cases of jeopardy. 

An exception from the penalty applies if the failure is due to reasonable cause. In addition, the Secretary may waive the penalty for 

an inadvertent failure to deposit any tax by specified first-time depositors. 

Accuracy-related penalties 

In general 

The accuracy-related penalties are imposed at a rate of 20 percent of the portion of any underpayment that is attributable, in relevant part, to (1) negligence, (2) any substantial understatement of 

income tax, (3) any substantial valuation misstatement, and (4) 

any reportable transaction understatement. The penalty for a substantial valuation misstatement is doubled for certain gross valuation misstatements. In the case of a reportable transaction understatement for which the transaction is not disclosed, the penalty 

rate is 30 percent. These penalties are coordinated with the fraud 

penalty. This statutory structure operates to eliminate any stacking of the penalties. 

No penalty is to be imposed if it is shown that there was reasonable cause for an underpayment and the taxpayer acted in good 

faith, and in the case of a reportable transaction understatement, 

the relevant facts of the transaction have been disclosed, there is 

or was substantial authority for the taxpayer’s treatment of such 

transaction, and the taxpayer reasonably believed that such treatment was more likely than not the proper treatment. 

Negligence or disregard for the rules or regulations 

If an underpayment of tax is attributable to negligence, the negligence penalty applies only to the portion of the underpayment 

that is attributable to negligence. Negligence means any failure to 

make a reasonable attempt to comply with the provisions of the 

Code. Disregard includes any careless, reckless, or intentional disregard of the rules or regulations. 


hmoore on PROD1PC68 with HMRPT
58 

Substantial understatement of income tax 

Generally, an understatement is substantial if the understatement exceeds the greater of (1) 10 percent of the tax required to 

be shown on the return for the tax year, or (2) $5,000. In determining whether a substantial understatement exists, the amount of 

the understatement is reduced by any portion attributable to an 

item if (1) the treatment of the item on the return is or was supported by substantial authority, or (2) facts relevant to the tax 

treatment of the item were adequately disclosed on the return or 

on a statement attached to the return. 

Substantial valuation misstatement 

A penalty applies to the portion of an underpayment that is attributable to a substantial valuation misstatement. Generally, a 

substantial valuation misstatement exists if the value or adjusted 

basis of any property claimed on a return is 200 percent or more 

of the correct value or adjusted basis. The amount of the penalty 

for a substantial valuation misstatement is 20 percent of the 

amount of the underpayment if the value or adjusted basis claimed 

is 200 percent or more but less than 400 percent of the correct 

value or adjusted basis. If the value or adjusted basis claimed is 

400 percent or more of the correct value or adjusted basis, then the 

overvaluation is a gross valuation misstatement. 

Reportable transaction understatement 

A penalty applies to any item that is attributable to any listed 

transaction, or to any reportable transaction (other than a listed 

transaction) if a significant purpose of such reportable transaction 

is tax avoidance or evasion. 

Fraud penalty 

The fraud penalty is imposed at a rate of 75 percent of the portion of any underpayment that is attributable to fraud. The accuracy-related penalty does not apply to any portion of an underpayment on which the fraud penalty is imposed. 

Assessable penalties 

In addition to the penalties described above, the Code imposes a 

number of additional penalties, including, for example, penalties 

for failure to file (or untimely filing of) information returns with respect to foreign trusts, and penalties for failure to disclose any required information with respect to a reportable transaction. 

Interest provisions 

Taxpayers are required to pay interest to the IRS whenever 

there is an underpayment of tax. An underpayment of tax exists 

whenever the correct amount of tax is not paid by the last date prescribed for the payment of the tax. The last date prescribed for the 

payment of the income tax is the original due date of the return. 

Different interest rates are provided for the payment of interest 

depending upon the type of taxpayer, whether the interest relates 

to an underpayment or overpayment, and the size of the underpayment or overpayment. Interest on underpayments is compounded daily. 


hmoore on PROD1PC68 with HMRPT
59 

83 Rev. Proc. 2003–11, 2003–4 C.B. 311. 84 Internal Revenue News Release 2002–135, IR–2002–135 (December 11, 2002). 85 Rev. Proc. 2003–11, 2003–4 C.B. 311. 86 Internal Revenue News Release 2004–19, IR–2002–19 (February 10, 2004). 

Offshore Voluntary Compliance Initiative 

In January 2003, Treasury announced the Offshore Voluntary 

Compliance Initiative (‘‘OVCI’’) to encourage the voluntary disclosure of previously unreported income placed by taxpayers in offshore accounts and accessed through credit card or other financial 

arrangements. A taxpayer had to comply with various requirements in order to participate in the OVCI, including sending a 

written request to participate in the program by April 15, 2003. 

This request had to include information about the taxpayer, the 

taxpayer’s introduction to the credit card or other financial arrangements and the names of parties that promoted the transaction. A taxpayer entering into a closing agreement under the 

OVCI is not liable for the civil fraud penalty, the fraudulent failure 

to file penalty, or the civil information return penalties. Such a taxpayer is responsible for back taxes, interest, and certain accuracyrelated and delinquency penalties.83

Voluntary disclosure policy 

A taxpayer’s timely, voluntary disclosure of a substantial unreported tax liability has long been an important factor in deciding 

whether the taxpayer’s case should ultimately be referred for criminal prosecution. The voluntary disclosure must be truthful, timely, 

and complete. The taxpayer must show a willingness to cooperate 

(as well as actual cooperation) with the IRS in determining the correct tax liability. The taxpayer must make good-faith arrangements 

with the IRS to pay in full the tax, interest, and any penalties determined by the IRS to be applicable. A voluntary disclosure does 

not guarantee immunity from prosecution. It creates no substantive 

or procedural rights for taxpayers.84 The IRS treats participation 

in the OVCI as a voluntary disclosure.85

REASONS FOR CHANGE

The Committee is aware that individuals and corporations, 

through sophisticated transactions, are placing unreported income 

in offshore financial accounts accessed through credit or debit cards 

or other financial arrangements in order to avoid or evade Federal 

income tax. Such a phenomenon poses a serious threat to the efficacy of the tax system because of both the potential loss of revenue 

and the potential threat to the integrity of the self-assessment system. The IRS estimates there may be several hundred thousand 

taxpayers using offshore financial arrangements to conceal taxable 

income from the IRS, potentially costing the government billions of 

dollars in lost revenue. On February 10, 2004, the IRS announced 

that over 1,300 applications to participate in the OVCI initiative 

were received, and that it had received over $175 million in taxes, 

interest, and penalties from these cases.86 At the start of the program, the clear message to taxpayers was that those who failed to 

come forward would be pursued by the IRS and would be subject 

to more significant penalties and possible criminal sanctions. The 

Committee believes that doubling the civil penalties, fines, and inVerDate Aug 31 2005 04:21 Jan 26, 2007 Jkt 059010 PO 00000 Frm 00059 Fmt 6659 Sfmt 6602 E:\HR\OC\SR001.XXX SR001

hmoore on PROD1PC68 with HMRPT
60 

87These arrangements were described and classified as listed transactions in Notice 2003–22, 

2003–1 C.B. 851. 88Sec. 6657. 

terest applicable to taxpayers who participate in these types of arrangements and who do not voluntarily disclose such arrangements 

(through the OVCI or otherwise) will provide the IRS with the significant sanctions needed to stem the promotion of, and participation in, these abusive schemes. 

EXPLANATION OF PROVISION

The provision doubles the amounts of civil penalties, interest, 

and fines related to taxpayers’ underpayments of U.S. income tax 

liability through the direct or indirect use of certain offshore financial arrangements. The provision applies to taxpayers who did not 

(or do not) voluntarily disclose such arrangements through the 

OVCI or otherwise. Under the provision, the determination of 

whether any civil penalty is to be applied to such underpayment 

is made without regard to whether a return has been filed, whether 

there was reasonable cause for such underpayment, and whether 

the taxpayer acted in good faith. 

The proscribed financial arrangements include, but are not limited to, the use of certain foreign leasing corporations for providing 

domestic employee services,87 certain arrangements whereby the 

taxpayer may hold securities trading accounts through offshore 

banks or other financial intermediaries, certain arrangements 

whereby the taxpayer may access funds through the use of offshore 

credit, debit, or charge cards, and offshore annuities or trusts. 

The Secretary of the Treasury is granted the authority to waive 

the application of the provision if the use of the offshore financial 

arrangements is incidental to the transaction and, in the case of a 

trade or business, such use is conducted in the ordinary course of 

the type of trade or business in which the taxpayer is engaged. 

EFFECTIVE DATE

The provision generally is effective with respect to a taxpayer’s 

open tax years on or after the date of enactment. 

I. INCREASE IN PENALTY FOR BAD CHECKS AND MONEY ORDERS

(Sec. 209 of the bill and sec. 6657 of the Code) 

PRESENT LAW

The Code 88 imposes a penalty on a person who tenders a bad 

check or money orders. The penalty is two percent of the amount 

of the bad check or money order. For checks or money orders that 

are less than $750, the minimum penalty is $15 (or, if less, the 

amount of the check or money order). 

REASONS FOR CHANGE

The Committee believes that it is appropriate to increase the 

minimum amount of this penalty so that it is more consistent with 

amounts charged by the private sector for bad checks. 


hmoore on PROD1PC68 with HMRPT
61 

89Treas. Reg. sec. 1.1275–4. 90Treas. Reg. sec. 1.1275–4(a)(4). 

EXPLANATION OF PROVISION

The provision increases the minimum penalty to $25 (or, if less, 

the amount of the check or money order), applicable to checks or 

money orders that are less than $1,250. 

EFFECTIVE DATE

The provision is effective with respect to checks or money orders 

received after the date of enactment. 

J. TREATMENT OF CONTINGENT PAYMENT CONVERTIBLE DEBT

INSTRUMENTS

(Sec. 210 of the bill and sec. 1275 of the Code) 

PRESENT LAW

Under present law, a taxpayer generally deducts the amount of 

interest paid or accrued within the taxable year on indebtedness 

issued by the taxpayer. In the case of original issue discount 

(‘‘OID’’), the issuer of a debt instrument generally accrues and deducts, as interest, the OID over the life of the obligation, even 

though the amount of the OID may not be paid until the maturity 

of the instrument. The holder of the instrument includes the OID 

in income over the term of the instrument. 

The amount of OID with respect to a debt instrument is equal 

to the excess of the stated redemption price at maturity over the 

issue price of the debt instrument. The stated redemption price at 

maturity includes all amounts that are payable on the debt instrument by maturity. The amount of OID with respect to a debt instrument is allocated over the life of the instrument through a series of adjustments to the issue price for each accrual period. The 

adjustment to the issue price is determined by multiplying the adjusted issue price (i.e., the issue price increased or decreased by adjustments prior to the accrual period) by the instrument’s yield to 

maturity, and then subtracting any payments on the debt instrument (other than non-OID stated interest) during the accrual period. Thus, in order to compute the amount of OID and the portion 

of OID allocable to a particular period, the stated redemption price 

at maturity and the time of maturity must be known. Issuers of 

debt instruments with OID accrue and deduct the amount of OID 

as interest expense in the same manner as the holders of such instruments accrue and include in gross income the amount of OID 

as interest income. 

Treasury regulations provide special rules for determining the 

amount of OID allocated to a period with respect to certain debt 

instruments that provide for one or more contingent payments of 

principal or interest.89 The regulations provide that a debt instrument does not provide for contingent payments merely because it 

provides for an option to convert the debt instrument into the stock 

of the issuer, into the stock or debt of a related party, or into cash 

or other property in an amount equal to the approximate value of 

such stock or debt.90 The regulations also provide that a payment 

is not a contingent payment merely because of a contingency that, 


hmoore on PROD1PC68 with HMRPT
62 

91Treas. Reg. sec. 1.1275–4(a)(5). 92Treas. Reg. sec. 1.1275–4(b). 93Treas. Reg. sec. 1.1275–4(b)(4)(i)(A). 94 Rev. Rul. 2002–31, 2002–1 C.B. 1023. 

as of the issue date of the debt instrument, is either remote or incidental.91

In the case of contingent payment debt instruments that are 

issued for money or publicly traded property,92 the regulations provide that interest on a debt instrument must be taken into account 

(as OID) whether or not the amount of any payment is fixed or determinable in the taxable year. The amount of OID that is taken 

into account for each accrual period is determined by constructing 

a comparable yield and a projected payment schedule for the debt 

instrument, and then accruing the OID on the basis of the comparable yield and projected payment schedule by applying rules 

similar to those for accruing OID on a noncontingent debt instrument (the ‘‘noncontingent bond method’’). If the actual amount of 

a contingent payment is not equal to the projected amount, appropriate adjustments are made to reflect the difference. The comparable yield for a debt instrument is the yield at which the issuer 

would be able to issue a fixed-rate noncontingent debt instrument 

with terms and conditions similar to those of the contingent payment debt instrument (i.e., the comparable fixed-rate debt instrument), including the level of subordination, term, timing of payments, and general market conditions.93

With respect to certain debt instruments that are convertible into 

the common stock of the issuer and that also provide for contingent 

payments (other than the conversion feature)—often referred to as ‘‘contingent convertible’’ debt instruments—the IRS has stated that 

the noncontingent bond method applies in computing the accrual of 

OID on the debt instrument.94 In applying the noncontingent bond 

method, the IRS has stated that the comparable yield for a contingent convertible debt instrument is determined by reference to a 

comparable fixed-rate nonconvertible debt instrument, and the projected payment schedule is determined by treating the issuer stock 

received upon a conversion of the debt instrument as a contingent 

payment. 

REASONS FOR CHANGE

The Committee is aware that, in recent years, several corporate 

taxpayers have issued convertible debt instruments that also include a separate contingent feature, usually consisting of an interest rate reset provision. The Committee understands that the primary intent of these corporations is simply to issue straight convertible debt instruments, and that the contingency is unlikely to 

have any meaningful impact on either the stated interest rate or 

overall economic yield of the debt instrument. Rather, the contingency is incorporated into the financing for the purpose of subjecting the debt instrument to the contingent payment OID regulations, which would not otherwise apply solely on the basis of the 

conversion feature. As with straight convertible debt instruments, 

the stated interest rate on contingent payment convertible debt instruments typically is substantially less than the stated interest 

rate would be on a nonconvertible debt instrument, usually less 

than 400 basis points. 


hmoore on PROD1PC68 with HMRPT
63 

The Committee is aware that, in determining the comparable 

yield on contingent payment convertible debt instruments under 

the contingent payment OID regulations, borrowers and their advisors take the position that the regulations call for using a comparable noncontingent debt instrument that is also nonconvertible. 

The net effect of applying the contingent payment OID regulations 

in this manner (i.e., determining the comparable yield on the basis 

of a noncontingent, nonconvertible—rather than noncontingent, 

convertible—debt instrument), is to significantly and artificially enhance the interest deductions generated by what is essentially a 

straight convertible debt instrument. Because the corresponding interest income inclusions to holders of these debt instruments likewise is significantly and artificially enhanced, the Committee understands that the debt instruments almost exclusively are sold to 

and purchased by tax indifferent holders. 

Notwithstanding the endorsement of the taxpayer position by the 

IRS in Rev. Rul. 2002–31, the Committee believes that applying 

the contingent payment OID regulations in this manner is inappropriate, from an economic standpoint and based upon a reasonable 

interpretation of the plain meaning of the regulations. Furthermore, applying the regulations in this manner creates disparate tax 

treatment between contingent payment convertible debt instruments and straight convertible debt instruments that differ only on 

the basis of an economically meaningless contingency. 

The Committee believes that the methodology mandated by this 

provision would require the comparable yield on a contingent payment convertible debt instrument to be based upon a truly comparable noncontingent debt instrument (i.e., one that is convertible, 

like the actual debt instrument issued by the taxpayer). This methodology would provide parity between straight convertible debt instruments and contingent payment convertible debt instruments, 

and eliminate the unwarranted tax benefits that are currently attained merely by incorporating an essentially meaningless contingency into an otherwise ordinary convertible debt instrument. 

In its ruling, the IRS indicated that determining the comparable 

yield on contingent payment convertible debt instruments based 

upon a contingent nonconvertible debt instrument is more consistent with the overall economic rationale of the contingent payment OID regulations. However, the Committee believes that this 

view incorrectly assumes that the economic rationale of these regulations deviates from the rest of the OID rules—and, for that matter, general tax principles—in giving tax significance to a conversion feature in a debt instrument. The Committee recognizes that 

contingent payment convertible debt instruments highlight a potential flaw in the current tax system whereby both the Code and general tax principles typically disregard the economic yield provided 

by convertibility features in debt instruments. However, the Committee believes that this issue should be addressed legislatively 

through comprehensive reform of the tax treatment of financial 

products, rather than through administrative acquiescence in taxpayer self-help that is achieved using a particular financial product 

designed specifically to obtain a favorable tax result, particularly if 

that result is in conflict with the current operation of the Code and 

general tax principles. 


hmoore on PROD1PC68 with HMRPT
64 

95 Under the provision, a contingent convertible debt instrument is defined as a debt instrument that: (1) is convertible into stock of the issuing corporation, or a corporation in control 

of, or controlled by, the issuing corporation; and (2) provides for contingent payments. 96Sec. 7528. 

EXPLANATION OF PROVISION

The provision provides that, in the case of a contingent convertible debt instrument,95 any Treasury regulations which require 

OID to be determined by reference to the comparable yield of a 

noncontingent fixed-rate debt instrument shall be applied as requiring that such comparable yield be determined by reference to 

a noncontingent fixed-rate debt instrument which is convertible 

into stock. For purposes of applying the provision, the comparable 

yield shall be determined without taking into account the yield resulting from the conversion of a debt instrument into stock. Thus, 

the noncontingent bond method in the Treasury regulations shall 

be applied in a manner such that the comparable yield for contingent convertible debt instruments shall be determined by reference 

to comparable noncontingent fixed-rate convertible (rather than 

nonconvertible) debt instruments. 

EFFECTIVE DATE

The provision is effective for debt instruments issued on or after 

date of enactment. 

K. EXTENSION OF IRS USER FEES

(Sec. 211 of the bill and sec. 7528 of the Code) 

PRESENT LAW

The IRS generally charges a fee for requests for a letter ruling, 

determination letter, opinion letter, or other similar ruling or determination.96 These user fees are authorized by statute through 

September 30, 2014. 

REASONS FOR CHANGE

The Committee believes that it is appropriate to provide an extension of these user fees. 

EXPLANATION OF PROVISION

The provision extends the statutory authorization for IRS user 

fees for two years, through September 30, 2016. 

EFFECTIVE DATE

The provision is effective for requests made after the date of enactment. 

L. MODIFICATION OF COLLECTION DUE PROCESS PROCEDURES FOR

EMPLOYMENT TAX LIABILITIES

(Sec. 212 of the bill and sec. 6330 of the Code) 

PRESENT LAW

Levy is the IRS’s administrative authority to seize a taxpayer’s 

property to pay the taxpayer’s tax liability. The IRS is entitled to 


hmoore on PROD1PC68 with HMRPT
65 

97Sec. 6330(a). 98Sec. 6320. 99Secs. 3101–3128 (FICA), 3301–3311 (FUTA), and 3401–3404 (income tax withholding). FICA 

taxes consist of an employer share and an employee share, which the employer withholds from 

employees’ wages. 100Government Accountability Office, Tax Administration: Little Evidence of Procedural Errors in Collection Due Process Appeals Cases, but Opportunities Exist to Improve the Program, 

GAO–07–112, October 2006. 

seize a taxpayer’s property by levy if a Federal tax lien has attached to such property. A Federal tax lien arises automatically 

when (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.97

Similar rules apply with respect to notices of tax liens, although 

the right to a hearing arises only on the filing of a notice.98 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. The taxpayer is 

entitled to appeal that determination to a court. Under present 

law, taxpayers are not entitled to a pre-levy CDP hearing if a levy 

is issued to collect a Federal tax liability from a State tax refund 

or if collection of the Federal tax is in jeopardy. However, levies related to State tax refunds or jeopardy determinations are subject 

to post-levy review through the CDP hearing process. 

Employment taxes generally consist of the taxes under the Federal Insurance Contributions Act (‘‘FICA’’), the tax under the Federal Unemployment Tax Act (‘‘FUTA’’), and the requirement that 

employers withhold income taxes from wages paid to employees 

(‘‘income tax withholding’’).99 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. 

REASONS FOR CHANGE

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. However, the 

Committee understands that some taxpayers abuse the CDP procedures by raising frivolous arguments simply for the purpose of delaying or evading collection of tax. 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. A Governmental Accountability Office 

study found that businesses with employment tax liabilities were 

delinquent on more than twice as many periods than individuals. 

On average, businesses requesting a CDP appeal for delinquent 

employment taxes had not paid for nearly 11⁄2 years and had a median employment tax liability of $30,000.100 Thus, the Committee 

believes it is appropriate to revise the CDP procedures in cases 

where taxpayers are liable for unpaid employment taxes. 


hmoore on PROD1PC68 with HMRPT
66 

101Sec. 7623. 102Pub. L. No. 109–432. 

EXPLANATION OF PROVISION

Under the provision, levies issued to collect Federal employment 

taxes are excepted from the pre-levy CDP hearing requirement. 

Thus, under the provision, taxpayers have no right to a CDP hearing before a levy is issued to collect employment taxes. However, 

the taxpayer is provided an opportunity for a hearing within a reasonable period of time after the levy. Collection by levy is permitted 

to continue during the CDP proceedings. 

EFFECTIVE DATE

The provision is effective for levies issued on or after the date 

that is 120 days after the date of enactment. 

M. WHISTLEBLOWER REFORMS

(Sec. 213 of the bill and sec. 7623 of the Code) 

PRESENT LAW

The Code authorizes the IRS to pay such sums as deemed necessary for: ‘‘(1) detecting underpayments of tax; and (2) detecting 

and bringing to trial and punishment persons guilty of violating 

the internal revenue laws or conniving at the same.’’ 101 Generally, 

amounts are paid based on a percentage of tax, fines, and penalties 

(but not interest) actually collected based on the information provided. 

The Tax Relief and Health Care Act of 2006 (the ‘‘Act’’) 102 established an enhanced reward program for actions in which the tax, 

penalties, interest, additions to tax, and additional amounts in dispute exceed $2,000,000 and, if the taxpayer is an individual, the individual’s gross income exceeds $200,000 for any taxable year. The 

reward floor in such cases is 15 percent of the collected proceeds 

(including penalties, interest, additions to tax and additional 

amounts) if the IRS moves forward with an administrative or judicial action based on information brought to the IRS’s attention by 

an individual. The available reward in such cases is limited to 30 

percent of the collected proceeds. 

Under present law, the Secretary is required to issue guidance 

within one year of the date of enactment of the Act for the establishment of the Whistleblower Office within the IRS to administer 

the reward program. The Whistleblower Office may seek assistance 

from the individual providing information or from his or her legal 

representative, and may reimburse the costs incurred by any legal 

representative out of the amount of the reward. To the extent the 

disclosure of returns or return information is required to render 

such assistance, the disclosure must be pursuant to an IRS tax administration contract. 

The Act permits an individual to appeal the amount or a denial 

of an award determination to the United States Tax Court (the 

‘‘Tax Court’’) within 30 days of such determination. Tax Court review of an award determination may be assigned to a special trial 

judge. 


hmoore on PROD1PC68 with HMRPT
67 

103Treasury Inspector General for Tax Administration, The Informants’ Rewards Program 

Needs More Centralized Management Oversight, 2006–30–092 (June 2006). 104Treasury Inspector General for Tax Administration, The Informants’ Rewards Program 

Needs More Centralized Management Oversight, 2006–30–092 (June 2006). 

The Act also required the Secretary to conduct a study and report to Congress on the effectiveness of the whistleblower reward 

program and any legislative or administrative recommendations regarding the administration of the program. 

REASONS FOR CHANGE

A recent report by the Treasury Inspector General for Tax Administration concluded that the IRS’s informant reward program 

has been an effective method of identifying and collecting unpaid 

taxes.103 The report made several recommendations for enhancing 

the effectiveness of the program, including centralizing management of the reward program and reducing the processing time for 

claims. The Act enhanced the reward program by establishing a 

minimum reward for certain cases and requiring the Secretary to 

establish a centralized office. The Committee believes that further 

enhancements to the reward program would make the program 

more attractive to future informants wishing to report violations of 

the tax laws. The Committee also believes that enhancements to 

the program will provide assurance that informants’ claims are not 

lost, overlooked or forgotten, and that award amounts are determined in a consistent and equitable manner. 

EXPLANATION OF PROVISION

The provision modifies the reward program established under the 

Act. Under the provision, this reward program applies to any actions in which the tax, penalties, interest, additions to tax, and additional amounts in dispute exceed $20,000 and, if the taxpayer is 

an individual, the individual’s gross income exceeds $200,000 for 

any taxable year. 

The provision also establishes the Whistleblower Office under the 

Code, rather than pursuant to regulation as provided in the Act. 

Although recognizing that many functions of the IRS may be involved in evaluating or otherwise addressing an informant’s claim, 

the Congress intends that one office within the IRS ultimately is 

responsible and accountable for monitoring informant claims for reward and determining the amounts to be rewarded. This will ensure that all claims are considered and that awards are issued in 

a consistent, timely and equitable manner. 

In addition, the provision requires the Secretary to report to Congress within six months of the date of enactment on the implementation of this provision, including the operation of the Whistleblower Office and the implementation of the recommendations of 

the Treasury Inspector General for Tax Administration.104

Finally, the provision authorizes the Tax Court to adopt rules to 

preserve the anonymity, privacy, or confidentiality of any person 

that may be identified during the appeal of an award determination appeal. 


hmoore on PROD1PC68 with HMRPT
68 

105Sec. 162(m). 106 In addition, the following types of compensation are not subject to the deduction limitation and are not taken into account in determining whether other compensation exceeds $1 million: 

(1) compensation payable on a commission basis; (2) payments to a tax-qualified retirement plan 

(including salary reduction contributions); and (3) amounts that are excludable from the individual’s gross income (such as employer-provided health benefits). Sec. 162(m)(4). 

EFFECTIVE DATE

The provision generally is effective for information provided on or 

after the date of enactment. The provision authorizing the Tax 

Court to adopt rules to preserve the anonymity, privacy, or confidentiality of any person that may be identified in the appeal of 

an award determination is effective as if included in section 406 of 

the Act. 

N. EXPAND DENIAL OF DEDUCTION FOR CERTAIN EXCESSIVE

EMPLOYEE REMUNERATION

(Sec. 214 of the bill and sec. 162(m) of the Code) 

PRESENT LAW

Under present law, compensation in excess of $1 million paid by 

a publicly-held corporation to the corporation’s ‘‘covered employees’’

generally is not deductible.105 Covered employees are the chief executive officer as of the close of the taxable year and the four other 

most highly compensated officers of the company as reported in the 

company’s proxy statement. 

Subject to certain exceptions, the deduction limitation applies to 

all otherwise deductible compensation of a covered employee for a 

taxable year, regardless of the form in which the compensation is 

paid, whether the compensation is for services as a covered employee, and regardless of when the compensation was earned. The 

deduction limitation applies when the deduction would otherwise 

be taken. 

Performance-based compensation is not subject to the deduction 

limitation and is not taken into account in determining whether 

other compensation exceeds $1 million. In general, performancebased compensation is compensation payable solely on account of 

the attainment of one or more performance goals and with respect 

to which certain requirements are satisfied, including a shareholder approval requirement.106

REASONS FOR CHANGE

The Securities and Exchange Commission recently modified the 

group of executives for whom compensation is required to be disclosed under the Securities Exchange Act of 1934. Given these 

modifications, the Committee believes that it is appropriate to 

delink the definition of covered employee from the Securities laws. 

The Committee also believes that the denial of the deduction for 

certain excess employee remuneration should apply to any individual who serves as the Chief Executive Officer during the year, 

regardless of whether that position is retained on the last day of 

the taxable year. Under present law, the deduction limitations for 

certain excess employee remuneration can be avoided by delaying 

payment of compensation to a year in the future in which the individual is no longer a covered employee. The Committee believes 


hmoore on PROD1PC68 with HMRPT
69 

that it is appropriate to continue to treat individuals as covered 

employees if they had been covered employees in a preceding taxable year. 

EXPLANATION OF PROVISION

The provision modifies the definition of covered employee. Under 

the provision, covered employees include any individual who was 

the Chief Executive Officer of the company (or individual acting in 

such a capacity) at any time during the taxable year. In addition, 

covered employees include the four officers with the highest compensation for the year (other than the Chief Executive Officer). 

Under the provision, covered employees also include individuals 

who previously were covered employees for any preceding taxable 

year beginning after December 31, 2006, with respect to the corporation or any predecessor. In the case of an individual who is a 

covered employee after December 31, 2006, covered employees also 

include beneficiaries of such employees with respect to any remuneration for services performed by such employee as a covered employee (whether or not such services are performed during the taxable year in which the remuneration is paid). For example, under 

the provision, if the Chief Executive Officer retires in November, 

compensation received in the year of retirement, or paid under a 

deferral agreement in a succeeding year, is subject to the deduction 

limitations for a covered employee. 

EFFECTIVE DATE

The provision is effective for taxable years beginning after December 31, 2006. 

II. BUDGET EFFECTS OF THE BILL 

A. COMMITTEE ESTIMATES

In compliance with paragraph 11(a) of rule XXVI of the Standing 

Rules of the Senate, the following statement is made concerning 

the estimated budget effects of the revenue provisions of the ‘‘Small 

Business and Work Opportunity Act of 2007’’ as reported. 


hmoore on PROD1PC68 with HMRPT
ESTIMATED REVENUE EFFECTS OF S. 349, THE ‘‘SMALL BUSINESS AND WORK OPPORTUNITY ACT OF 2007,’’ AS REPORTED BY THE COMMITTEE ON FINANCE—

YEARS 2007–2016 

[Millions of Dollars] 

Provision Effective 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2007–11 

I. Small Business Provisions 

A. General Provisions 

1. Extension of increased expensing for small 

business—increase section 179 expensing from $25,000 to $100,000 and increase the phaseout threshold amount from $200,000 to $400,000; include software in section 179 property; and extend indexing of both the deduction limit and the phaseout threshold (sunset 12/31/10).

tyba 12/31/09 — — — ¥2,964 ¥1,897 1,732 1,092 792 613 375 ¥4,861 

2. Extension of the 15-year straight-line cost 

recovery period for qualified leasehold and restaurant improvements (sunset 3/31/08).

ppisa 12/31/ 

07.

— ¥30 ¥88 ¥114 ¥112 ¥109 ¥100 ¥95 ¥100 ¥98 ¥345 

3. 15-year recovery period for new restaurant 

buildings (sunset 3/31/08).

ppisa DOE .... ¥22 ¥66 ¥94 ¥99 ¥99 ¥98 ¥97 ¥95 ¥93 ¥86 ¥379 

4. 15-year recovery period for retail improvements (sunset 3/31/08). ppisa DOE .... ¥22 ¥76 ¥119 ¥127 ¥123 ¥114 ¥106 ¥108 ¥109 ¥108 ¥467 

5. Increase gross receipts threshold for cash 

accounting to $10M regardless of inventories, index for inflation, and reset testing period.

tyba DOE ...... ¥9 ¥278 ¥151 ¥52 ¥57 ¥63 ¥69 ¥76 ¥84 ¥92 ¥547 

6. Extension and modification of combined 

Work Opportunity Tax Credit and Welfareto-work credit-expansions on post 9/11 disabled veterans, high-risk youth, and vocational rehabilitation referrals (sunset 12/ 31/12).

wpoifibwa 12/ 

31/07.

— ¥150 ¥411 ¥569 ¥657 ¥726 ¥591 ¥302 ¥143 ¥75 ¥1,788 

7. Treatment of certified professional employer organizations as employers.

(1) ................. — — ¥2 ¥3 ¥4 ¥4 ¥4 ¥5 ¥5 ¥6 ¥8 

B. Subchapter S Provisions 

1. Exclude capital gains from passive investment income. tyba DOE ...... — ¥15 ¥30 ¥32 ¥34 ¥35 ¥37 ¥40 ¥43 ¥46 ¥111 

2. Treatment of qualifying director shares ...... tyba 12/31/06 ¥4 ¥10 ¥14 ¥18 ¥20 ¥21 ¥22 ¥23 ¥23 ¥23 ¥66 


hmoore on PROD1PC68 with HMRPT
3. Recapture of bad debt reserves .................. tyba 12/31/06 11 27 ¥22 ¥40 ¥36 ¥23 ¥21 ¥22 ¥23 ¥24 ¥60 

4. Treatment of sale of interest in a qualified 

subchapter S subsidiary.

tyba 12/31/06 ¥1 ¥3 ¥3 ¥4 ¥4 ¥4 ¥5 ¥5 ¥5 ¥6 ¥15 

5. Elimination of all earnings and profits attributable to pre-1983 years. tyba DOE ...... ¥3 ¥2 ¥2 ¥2 ¥2 ¥2 ¥2 ¥2 ¥2 ¥2 ¥11 

6. Expansion of qualifying beneficiaries of an 

electing small business trust.

DOE ...............

— ¥1 ¥2 ¥3 ¥4 ¥4 ¥4 ¥5 ¥5 ¥5 ¥10 

Total of Small Business Provisions ........ ....................... ¥50 ¥604 ¥938 ¥4,027 ¥3,049 529 34 14 ¥22 ¥196 ¥8,668 

II. Provisions That Raise Revenue 

1. Modify the effective date for the application of 

the AJCA 2004 leasing (SILO) provision

—apply 

loss limitation to leases with foreign entities regardless of when the lease was entered into.

tyba 12/31/06 1,018 1,662 896 407 290 288 260 135 ¥239 ¥629 4,273 

2. Tax treatment of inversion transactions .............. tyba 2006 ..... 42 86 99 107 115 123 123 143 153 162 449 3. Deny deduction for punitive damages ................. dpoio/a DOE 3 37 29 30 31 32 33 34 35 36 130 4. Denial of deduction for certain fines, penalties, 

and other amounts.

generally 

apoio/a DOE.

25 87 31 15 15 15 15 15 15 15 172 

5. Impose mark-to-market on individuals who expatriate.

(2) ................. 13 57 54 50 46 43 41 39 38 36 220 

6. Limitation on annual amounts which may be deferred under nonqualified deferred compensation 

arrangements.

tyba 12/31/06 43 59 60 63 83 94 97 100 103 106 307 

7. Increase in certain criminal penalties ................. aaftaoa DOE (3) (3) (3) (3) (3) (3) (3) (3) (3) (3) 1 

8. Double certain penalties, fines, and interest on 

underpayments related to certain offshore financial arrangements.

oyo/a DOE ..... 1 1 1 1 1 1 1 1 1 1 5 

9. Increase in penalty for bad checks and money 

orders.

comora DOE .. 2 2 2 2 2 2 2 2 2 2 10 

10. Change the tax treatment of contingent convertible debt instruments. diio/a DOE .... 8 37 52 62 63 58 49 45 39 35 222 11. Extension of IRS user fees (sunset 9/30/16) (4) ra 9/30/14 ....

—

—

—

—

—

—

—

— 30 30 

— 

12. Modification of collection due process procedures for employment tax liabilities. lio/a 120da DOE.

— 58 50 28 20 17 20 23 26 29 156 

13. Modifications to Whistleblower reforms (5) ........ ipo/a DOE ..... 1 6 15 23 32 42 51 63 79 90 77 

14. Modify definition of covered employee for denial 

of deduction for excessive employee remuneration.

tyba 12/31/06 1 3 4 5 7 10 14 18 20 23 20 

Total of Provisions That Raise Revenue ....................... 1,157 2,095 1,293 793 705 725 706 618 302 ¥64 6,042 


hmoore on PROD1PC68 with HMRPT
ESTIMATED REVENUE EFFECTS OF S. 349, THE ‘‘SMALL BUSINESS AND WORK OPPORTUNITY ACT OF 2007,’’ AS REPORTED BY THE COMMITTEE ON FINANCE

—

YEARS 2007–2016

—Continued 

[Millions of Dollars] 

Provision Effective 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2007–11 

NET TOTAL ........................................... ....................... 1,107 1,491 355 ¥3,234 ¥2,344 1,254 740 632 280 ¥260 ¥2,626 

1 Effective with respect to wages paid for services performed on or after January 1 of the first calendar year beginning more than 12 months after the date of enactment. 2 Generally effective for U.S. citizens who expatriate or long-term residents who terminate their residency on or after the date of enactment. 3 Gain of less than $500,000. 4 Estimate provided by the Congressional Budget Office. 5 Net of outlays. 

Note.

—Details may not add to totals due to rounding. Date of enactment is assumed to be April 1, 2007. 

Legend for ‘‘Effective’’ column: aaftaoa = actions and failure to act occurring after, apoio/a = amounts paid or incurred on or after, comora=checks for money orders received after, diio/a = debt intrument issued on or after, 

enactment, dpoio/a = damages paid or incurred on or after, oyo/a = open years on or after, ppisa = property placed in service after, ipo/a = information provided on or after, lio/a = levies issued on or after, tyba = taxable yeaafter, ra = requests after, wpoifibwa = wages paid or incurred for individuals beginning work after, 120da = 120 days after. 

Source: Joint Committee on Taxation. 


hmoore on PROD1PC68 with HMRPT
73 

B. BUDGET AUTHORITY AND TAX EXPENDITURES

Budget authority 

In compliance with section 308(a)(1) of the Budget Act, the Committee states that no provisions of the bill as reported involve new 

or increased budget authority. 

Tax expenditures 

In compliance with section 308(a)(2) of the Budget Act, the Committee states that the revenue-reducing provisions of the bill involve increased tax expenditures (see revenue table in Part A, 

above). The revenue-increasing provisions of the bill involve reduced tax expenditures (see revenue table in part A, above). 

C. CONSULTATION WITH CONGRESSIONAL BUDGET OFFICE

In accordance with section 403 of the Budget Act, the Committee 

advises that the Congressional Budget Office has not submitted a 

statement on the bill. The letter from the Congressional Budget Office has not been received, and therefore will be provided separately. 

III. VOTES OF THE COMMITTEE 

In compliance with paragraph 7(b) of rule XXVI of the standing 

rules of the Senate, the Committee states that, with a majority and 

quorum present, the ‘‘Small Business and Work Opportunity Act of 

2007,’’ as amended, was ordered favorably reported by a voice vote 

on January 17, 2007. 

The Committee accepted the following resolution: It is the sense 

of the Committee on Finance that the small business provisions 

should be extended beyond the dates contained in the Mark. 

IV. REGULATORY IMPACT AND OTHER MATTERS 

A. REGULATORY IMPACT

Pursuant to paragraph 11(b) of rule XXVI of the Standing Rules 

of the Senate, the Committee makes the following statement concerning the regulatory impact that might be incurred in carrying 

out the provisions of the bill as amended. 

Impact on individuals and businesses, personal privacy and paperwork 

The bill includes provisions to extend present-law tax benefits, 

expand eligibility for other benefits, and update Subchapter S of 

the Code. The bill also includes provisions increasing certain penalties and extending IRS user fees. The bill modifies the treatment 

of corporate inversion transactions and individuals who expatriate, 

and imposes limitations on the amount of compensation which may 

be deducted by employers or deferred by employees under the 

Code. The bill includes a provision to improve employment tax compliance by providing rules under which certain professional employer organizations is treated as the employer of employees provided to customers. 


hmoore on PROD1PC68 with HMRPT
74 

The bill includes various other provisions that are not expected 

to impose additional administrative requirements or regulatory 

burdens on individuals or businesses. 

The provisions of the bill do not impact personal privacy. 

B. UNFUNDED MANDATES STATEMENT

This information is provided in accordance with section 423 of 

the Unfunded Mandates Reform Act of 1995 (Pub. L. 104–4). 

The Committee has determined that the following two tax provisions of the reported bill contain Federal private sector mandates 

within the meaning of Public Law 104–4, the Unfunded Mandates 

Reform Act of 1995: (1) modifying the effective date for the application of the AJCA 2004 leasing (‘‘SILO’’) provision—apply loss limitation to leases with foreign entities regardless of when the lease 

was entered into; and (2) tax treatment of inversion transactions. 

The tax provisions of the reported bill do not impose a Federal 

intergovernmental mandate on State, local, or tribal governments 

within the meaning of Public Law 104–4, the Unfunded Mandates 

Reform Act of 1995. 

The costs required to comply with each Federal private sector 

mandate generally are no greater than the aggregate estimated 

budget effects of the provision. Benefits from the provisions include 

improved administration of the tax laws and a more accurate measurement of income for Federal income tax purposes. 

C. TAX COMPLEXITY ANALYSIS

Section 4022(b) of the Internal Revenue Service Restructuring 

and Reform Act of 1998 (the ‘‘IRS Reform Act’’) requires the Joint 

Committee on Taxation (in consultation with the Internal Revenue 

Service and the Department of the Treasury) to provide a tax complexity analysis. The complexity analysis is required for all legislation reported by the Senate Committee on Finance, the House 

Committee on Ways and Means, or any committee of conference if 

the legislation includes a provision that directly or indirectly 

amends the Internal Revenue Code (the ‘‘Code’’) and has widespread applicability to individuals or small businesses. 

The staff of the Joint Committee on Taxation has determined 

that a complexity analysis is not required under section 4022(b) of 

the IRS Reform Act because the bill contains no provisions that 

have ‘‘widespread applicability’’ to individuals or small businesses. 


hmoore on PROD1PC68 with HMRPT
(75) 

V. ADDITIONAL VIEWS OF SENATOR JOHN F. KERRY 

I support the majority of the provisions in the Small Business 

and Work Opportunity Act of 2007. I would have preferred that 

this package move separately rather than in tandem with a minimum wage bill. However, the reality is that we need a tax package 

in order to advance minimum wage legislation. 

Most of the provisions are targeted and will help small businesses. For example, the provision to provide fifteen-year straight 

line cost recovery for qualified retail improvement will help small 

businesses that own their stores. However, there is one provision 

that I find troubling. This provision would treat professional employer organizations as employers for employment tax purposes. 

The reason for including this provision is to improve compliance. 

I am concerned that the provision which that makes certified professional employer organizations liable for payroll taxes may not 

actually result in improved compliance. The Joint Committee on 

Taxation has estimated that this provision has a ten-year cost of 

$33 million. If this provision truly improved compliance, I would 

expect it to raise revenue. 

This proposal lets the workers’ real employer off the hook for 

payroll taxes, and creates confusion about who is an employer 

under labor laws. I know the language says it will not affect other 

laws, but as a practical matter it will. It confuses workers, who will 

not be able to tell who their real employer is, and it sets a bad 

precedent that could make it harder for workers to protect their 

rights under important labor laws. 

I realize the Committee has reported out this provision in the 

past, but I believe this provision will result in unintended consequences. The Committee should review this proposal in order to 

address concerns that have been raised. 


hmoore on PROD1PC68 with HMRPT
76 

VI. CHANGES IN EXISTING LAW MADE BY THE BILL, AS 

REPORTED 

In the opinion of the Committee, it is necessary in order to expedite the business of the Senate, to dispense with the requirements 

of paragraph 12 of rule XXVI of the Standing Rules of the Senate 

(relating to the showing of changes in existing law made by the bill 

as reported by the Committee). 

Æ 


hmoore on PROD1PC68 with HMRPT