DESCRIPTION AND ANALYSIS OF 

CERTAIN FEDERAL TAX PROVISIONS 

EXPIRING IN 2005 AND 2006 

Scheduled for a Public Hearing 

Before the 

SENATE COMMITTEE ON FINANCE 

on March 16, 2005 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

March 11, 2005 

JCX-12-05 
ii

CONTENTS 

Page

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

SUMMARY LISTING OF CERTAIN FEDERAL TAX PROVISIONS EXPIRING 

IN 2005 AND 2006..................................................................................................................... 2 

I. PROVISIONS RELATING TO INDIVIDUAL TAXPAYERS ........................................ 4 

A. Election to Treat Combat Pay as Earned Income for Purposes of the Earned 

Income Credit............................................................................................................. 4 

B. Above-the-Line Deduction for Certain Expenses of Elementary and Secondary 

School Teachers......................................................................................................... 6 

C. Deduction of State and Local General Sales Taxes................................................... 9 

D. Archer Medical Savings Accounts........................................................................... 11 

E. Above-the-Line Deduction for Certain Higher Education Expenses ...................... 16 

II. PROVISIONS RELATING TO BUSINESS TAXPAYERS ........................................... 20 

A. Investment and Employment ................................................................................... 20 

1. Research and experimentation (R&E) tax credit ............................................... 20 

2. Work opportunity tax credit............................................................................... 34 

3. Welfare-to-Work tax credit................................................................................ 40 

4. Indian employment tax credit ............................................................................ 42 

5. Accelerated depreciation for business property on an Indian Reservation........ 44 

6. 15-year straight-line cost recovery for qualified leasehold improvements 

and qualified restaurant improvements.............................................................. 46 

B. Energy and Environment ......................................................................................... 51 

1. Credit for electricity produced from certain renewable resources..................... 51 

2. Expensing of brownfields remediation costs ..................................................... 60 

3. Suspension of 100 percent-of-net-income limitation on percentage depletion 

for oil and gas from marginal wells ................................................................... 63 

C. Miscellaneous .......................................................................................................... 67 

1. Deduction for corporate donations of computer technology ............................. 67 

2. Parity in the application of certain limits to mental health benefits .................. 70 

III. PROVISIONS RELATING TO STATE AND LOCAL GOVERNMENTS................... 73 

A. District of Columbia ................................................................................................ 73 

1. Tax Incentives for investment in the District of Columbia................................ 73 

2. District of Columbia Homebuyer Tax Credit .................................................... 77 

B. New York Liberty Zone........................................................................................... 80 

1. New York Liberty Zone advance refundings..................................................... 80 

2. Tax incentives for investment in the New York Liberty Zone .......................... 82 

C. Qualified Zone Academy Bonds.............................................................................. 89
Page

iii

IV. PROVISIONS RELATING TO TAX ADMINISTRATION........................................... 94 

A. Disclosure of Tax Information to Facilitate Combined Employment Tax 

Reporting.................................................................................................................. 94 

B. Disclosure of Return Information Regarding Terrorist Activities........................... 96 

C. Disclosure of Return Information to Carry Out Income Contingent Repayment 

of Student Loans .................................................................................................... 101 

D. Authority for Undercover Operations.................................................................... 106 

E. Joint Review of IRS Strategic Plans and Budget................................................... 108 
1

INTRODUCTION 

The Senate Committee on Finance has scheduled a public hearing on March 16, 2005, on 

certain Federal tax provisions expiring in 2005 and 2006. This document,1

 prepared by the staff 

of the Joint Committee on Taxation, includes a description and analysis of these provisions. 

In general, this document discusses tax provisions expiring in 2005, except those relating 

to the following areas: (1) individual income tax provisions under the Economic Growth and 

Tax Relief Reconciliation Act of 2001 (“EGTRRA”) and the Jobs and Growth Tax Relief 

Reconciliation Act of 2003 (“JGTRRA”), except those expiring in 2005; (2) provisions relating 

to retirement plans and retirement savings; (3) provisions relating to transportation; and 

(4) provisions relating to Puerto Rico. In addition, this document discusses tax provisions 

expiring in 2006 that relate to tax incentives for investment in the New York Liberty Zone. 

This document begins with a summary listing of the provisions discussed in this 

document. Following the summary listing, Parts I through IV of this document describe in detail 

the relevant Federal tax provisions relating to individual taxpayers, business taxpayers, State and 

local governments, and tax administration, respectively. 

 1

 This document may be cited as follows: Joint Committee on Taxation, Description and 

Analysis of Certain Federal Tax Provisions Expiring in 2005 and 2006 (JCX-12-05), March 11, 2005. 
2

SUMMARY LISTING OF CERTAIN FEDERAL TAX PROVISIONS 

EXPIRING IN 2005 AND 2006 

The following is a summary listing of the tax provisions expiring in 2005 and 2006 that 

are the subject of this document (with the applicable expiration date and section of the Internal 

Revenue Code). 

Provisions relating to individual taxpayers

• Election to include combat pay as earned income for purposes of the earned income 

credit (December 31, 2005; sec. 32(c)(2)(B)(vi)) 

• Above-the-line deduction for certain expenses of elementary and secondary school 

teachers (December 31, 2005; sec. 62(a)(2)(D)) 

• Deduction of State and local general sales taxes (December 31, 2005; sec. 164(b)(5)) 

• Archer medical savings accounts (“MSAs”) (December 31, 2005; sec. 220(i)) 

• Above-the-line deduction for certain higher education expenses (December 31, 2005; 

sec. 222(e)) 

Provisions relating to business taxpayers

Investment and employment

• Research and experimentation (R&E) tax credit (December 31, 2005; sec. 41(h)) 

• Work opportunity tax credit (December 31, 2005; sec. 51(c)(4)) 

• Welfare-to-work tax credit (December 31, 2005; sec. 51A(f)) 

• Indian employment tax credit (December 31, 2005; sec. 45A(f)) 

• Accelerated depreciation for business property on an Indian reservation 

(December 31, 2005; sec. 168(j)(8)) 

• 15-year straight-line cost recovery for qualified leasehold improvements and qualified 

restaurant improvements (December 31, 2005; sec. 168(e)(3)(E)(iv) and (v)) 

Energy and environment

• Credit for electricity produced from certain renewable resources (December 31, 2005; 

sec. 45(d)(1)-(7)) 

• Expensing of “brownfields” remediation costs (December 31, 2005; sec. 198(h)) 

• Suspension of 100 percent-of-net-income limitation on percentage depletion for oil 

and gas from marginal wells (December 31, 2005; sec. 613A(c)(6)(H)) 

Miscellaneous

• Deduction for corporate donations of computer technology (December 31, 2005; 

sec. 170(e)(6)(G)) 

• Parity in the application of certain limits to mental health benefits 

(December 31, 2005; sec. 9812(f)) 
3

Provisions relating to State or local governments

District of Columbia

• Incentives for investment in the District of Columbia: designation of enterprise zone, 

employment tax credit, additional expensing, empowerment zone bonds, and zeropercent capital gains rate (December 31, 2005; secs. 1400(f)(1), 1400A(b), and 

1400B(b)(2), (3)(A), (4)(A)(i), and (4)(B)(i)(I)) 

• Tax credit for first-time D.C. homebuyers (December 31, 2005; sec. 1400C(i)) 

New York Liberty Zone

• Advance refunding of certain tax-exempt bonds (December 31, 2005; 

sec. 1400L(e)(1)) 

• Incentives for investment in the New York Liberty Zone: special depreciation 

allowance, five-year recovery period for certain leasehold improvements, increase in 

expensing under section 179, and extension of replacement period for nonrecognition 

of gain (December 31, 2006; secs. 1400L(b)(2)(A)(v), (c)(2)(B), (f)(2), and (g)) 

Qualified zone academy bonds

• Bond authority (December 31, 2005; sec. 1397E(e)(1)) 

Provisions relating to tax administration

• Disclosure of tax information to facilitate combined employment tax reporting 

(December 31, 2005; sec. 6103(d)(5)) 

• Disclosure of return information regarding terrorist activities (December 31, 2005; 

sec. 6103(i)(3)(C)(iv) and (i)(7)(E)) 

• Disclosure of return information to carry out income contingent repayment of student 

loans (December 31, 2005; sec. 6103(l)(13)(D)) 

• Authority for undercover operations (December 31, 2005; sec. 7608(c)(6)) 

• Joint Committee on Taxation report and joint review of IRS strategic plans 

(June 1, 2005, and December 31, 2005; secs. 8021(f)(2) and 8022(3)(C)) 
4 

I. PROVISIONS RELATING TO INDIVIDUAL TAXPAYERS 

A. Election to Treat Combat Pay as Earned Income 

for Purposes of the Earned Income Credit 

Present Law

Child credit 

Combat pay that is otherwise excluded from gross income under section 112 is treated as 

earned income which is taken into account in computing taxable income for purposes of 

calculating the refundable portion of the child credit. 

Earned income credit

Any taxpayer may elect to treat combat pay that is otherwise excluded from gross income 

under section 112 as earned income for purposes of the earned income credit. This election is 

available with respect to any taxable year ending after the date of enactment and before January 

1, 2006. 

Legislative History

The taxpayer election to treat combat pay as earned income for purposes of the earned 

income credit was enacted in the Working Families Tax Relief Act of 2004. 

President’s Budget Proposal

The proposal extends the provision relating to the earned income credit for one year 

(through December 31, 2006). 

Analysis

The exclusion of combat pay from gross income is intended to benefit military personnel 

serving in combat. However, to the extent that certain tax benefits, such as the child credit and 

the earned income credit, may vary based on taxable or earned income, the exclusion has the 

potential to increase tax liability. Including combat pay in gross income for purposes of the 

refundable child credit is always advantageous to the taxpayer. However, including combat pay 

for purposes of calculating the earned income credit may either help or hurt the taxpayer, 

because the credit both phases in and phases out based on earned income.2

 

If the objective of the present-law rules it to ensure that the exclusion of combat pay from 

gross income does not result in an increase in tax liability, an election to include combat pay in 

income for all Code purposes would be sufficient to achieve that objective. Present law, 

 2

 A similar issue would arise with respect to the child credit, because that credit also is phased 

out based on adjusted gross income. However, present law addresses this potential adverse effect by 

including combat pay only for purposes of calculating the refundable portion of the credit. 
5 

however, takes a more taxpayer favorable approach by allowing the tax treatment of combat pay 

to vary across Code provisions when such variation is favorable, and thus present law (1) always 

treats combat pay as earned income for purposes of the refundable portion of the child credit, as 

that is always the most favorable result because the refundable child credit can only rise as 

income rises, and (2) allows the taxpayer to elect to include combat pay as earned income for 

purposes of the EIC (advantageous to the taxpayer depending on the amount of earned income 

that would result). 

The election to include or exclude combat pay for purposes of the earned income credit 

creates complexity. In general, elections always add complexity, because taxpayers need to 

calculate their tax liability in more than one way in order to determine which result is best for 

them. 

The present-law rules with respect to combat pay treat such pay differently than other 

nontaxable compensation for purposes of the definition of earned income in the refundable child 

credit and the earned income credit. For example, under present law, other nontaxable employee 

compensation (e.g., elective deferrals such as salary reduction contributions to 401(k) plans) is 

not includible in earned income for these purposes. Allowing combat pay to be included in 

earned income creates an inconsistent treatment between it and other nontaxable employee 

compensation and arguably creates inequities between taxpayers who receive combat pay 

compared to other types of nontaxable compensation. 
6

B. Above-the-Line Deduction for Certain Expenses of Elementary 

and Secondary School Teachers 

Present Law

In general, ordinary and necessary business expenses are deductible (sec. 162). However, 

in general, unreimbursed employee business expenses are deductible only as an itemized 

deduction and only to the extent that the individual’s total miscellaneous deductions (including 

employee business expenses) exceed two percent of adjusted gross income. An individual’s 

otherwise allowable itemized deductions may be further limited by the overall limitation on 

itemized deductions, which reduces itemized deductions for taxpayers with adjusted gross 

income in excess of $145,950 (for 2005). In addition, miscellaneous itemized deductions are not 

allowable under the alternative minimum tax. 

Certain expenses of eligible educators are allowed an above-the-line deduction. 

Specifically, for taxable years beginning prior to January 1, 2006, an above-the-line deduction is 

allowed for up to $250 annually of expenses paid or incurred by an eligible educator for books, 

supplies (other than nonathletic supplies for courses of instruction in health or physical 

education), computer equipment (including related software and services) and other equipment, 

and supplementary materials used by the eligible educator in the classroom. To be eligible for 

this deduction, the expenses must be otherwise deductible under 162 as a trade or business 

expense. A deduction is allowed only to the extent the amount of expenses exceeds the amount 

excludable from income under section 135 (relating to education savings bonds), 529(c)(1) 

(relating to qualified tuition programs), and section 530(d)(2) (relating to Coverdell education 

savings accounts). 

An eligible educator is a kindergarten through grade 12 teacher, instructor, counselor, 

principal, or aide in a school for at least 900 hours during a school year. A school means any 

school which provides elementary education or secondary education, as determined under State 

law. 

The above-the-line deduction for eligible educators is not allowed for taxable years 

beginning after December 31, 2005. 

Legislative History

The deduction for certain expenses of elementary and secondary teachers was established 

in the Job Creation and Worker Assistance Act of 2002.3

 The deduction was allowed only for 

taxable years beginning during 2002 and 2003. The deduction was extended in the Working 

Families Tax Relief Act of 20044

 to include taxable years beginning in 2004 and 2005. 

 3

 Pub. Law. No 107-147. sec. 406. 

4

 Pub. Law. No 108-311. sec. 307. 
7

President’s Budget Proposal

The current-law provision would be made permanent and the maximum deduction 

increased to $400. As under current law, the provision would apply to teachers and other school 

personnel employed by public entities, charter schools or private schools (as determined under 

state law). The current-law 900-hour rule would be clarified to refer to a school year ending 

during the taxable year. Eligible, unreimbursed expenses would be expanded to include teacher 

training expenses related to current teaching positions. Neither travel nor lodging expenses nor 

expenditures related to religious instruction or activities would be eligible. Expenses claimed as 

an above-the-line deduction could not be claimed as an itemized deduction or taken into account 

in determining any other tax benefit such as Hope or lifetime learning credits. Taxpayers would 

be required to retain receipts for eligible expenditures along with a certification from a principal 

or other school official that the expenditures qualified. The proposal would be effective for 

expenses incurred in taxable years beginning after December 31, 2005. 

Analysis

Policy issues

The section 62 above-the-line deduction attempts to make fully deductible many of the 

legitimate business expenses of eligible schoolteachers. As described below, and absent an 

above-the-line deduction, the expenses might otherwise be deductible except for the two-percent 

floor that applies to miscellaneous itemized deductions. Some have observed that the twopercent floor increases pressure to enact above-the-line deductions on an expense-by-expense 

basis. In addition to increasing complexity, the expense-by-expense approach is not fair to other 

taxpayers with legitimate business expenses that remain subject to the two-percent floor. For 

example, emergency response professionals incur similar unreimbursed expenses related to their 

employment, a deduction for which also has been separately proposed.5

 

The President’s budget proposal expands the present-law above-the-line deduction for 

eligible educators by increasing the maximum deduction from $250 to $400, thereby making 

additional legitimate business expenses deductible. As is the case with the present-law abovethe-line deduction, the proposal presents compliance issues. One reason the two-percent floor 

was introduced was to reduce the administrative burden on the IRS to monitor compliance with 

small deductions. Some argue that any proposal that circumvents the two-percent floor will 

encourage tax evasion. Others argue that although tax evasion is a risk, the risk is the same for 

similarly situated taxpayers (e.g., independent contractors or taxpayers with trade or business 

income) who are not subject to the two-percent floor on similar expenses. 

Complexity issues

Three provisions of present law restrict the ability of teachers to deduct as itemized 

deductions those expenses covered by the President’s budget proposal: (1) the two-percent floor 

 5

 See the conference report to H.R. 1836, the “Economic Growth and Tax Relief Reconciliation 

Act of 2001,” H. Rep. No. 107-84, at 169-70 (2001). 
8

on itemized deductions; (2) the overall limitation on itemized deductions; and (3) the alternative 

minimum tax. The staff of the Joint Committee on Taxation has previously identified these 

provisions as sources of complexity and has recommended that such provisions be repealed.6

 

These provisions do not apply to eligible expenses under the proposal. While repealing these 

provisions for all taxpayers reduces the complexity of the Federal tax laws, effectively repealing 

these provisions only for certain taxpayers (such as teachers and other eligible educators) likely 

increases complexity. 

Some may view the above-the-line deduction as increasing simplification by providing 

for deductibility of certain expenses without regard to the present-law restrictions applicable to 

itemized deductions and the alternative minimum tax. However, several elements of the abovethe-line deduction increase complexity. The above-the-line deduction may increase 

recordkeeping requirements for certain taxpayers. Taxpayers wishing to take advantage of the 

above-the-line deduction are required to keep records, even if they were not otherwise required 

to do so because their expenses were not deductible as a result of the 2-percent floor for itemized 

deductions. In general, enactment of additional above-the-line deductions for specific expenses 

undermines the concept of the standard deduction, which exists in part to simplify the tax code 

by eliminating the need for many taxpayers to keep track of specific expenses. 

The above-the-line deduction does not completely eliminate the need to apply the 

present-law rules regarding itemized deductions. For example, a teacher with expenses in excess 

of the $250 cap or with other miscellaneous itemized deductions may need to compute tax 

liability under the itemized deduction rules as well as under the above-the-line deduction rules. 

In addition, the above-the-line deduction does not cover all classroom expenses, but only those 

that meet particular requirements. Expenses that do not meet those requirements remain subject 

to the itemized deduction rules. Similarly, under the President’s budget proposal, some expenses 

may either be deductible or used for tax benefits under other provisions. For example, certain 

teacher education expenses may be deductible under the proposal or used for a Hope or Lifetime 

Learning credit. Taxpayers with such expenses need to determine tax liability in more than one 

way in order to determine which provisions result in the lowest tax liability. In addition, 

overlapping provisions increase the likelihood that some taxpayers inadvertently claim more than 

one tax benefit with respect to the same expense. 

 6

 See Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and 

Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 

1986, Volume II, 15, 88, 118 (JCS-3-01), April 2001. 
9

C. Deduction of State and Local General Sales Taxes 

Present Law

For purposes of determining regular tax liability, an itemized deduction is permitted for 

certain State and local taxes paid, including individual income taxes, real property taxes, and 

personal property taxes. The itemized deduction is not permitted for purposes of determining a 

taxpayer’s alternative minimum taxable income. For taxable years beginning in 2004 and 2005, 

at the election of the taxpayer, an itemized deduction may be taken for State and local general 

sales taxes in lieu of the itemized deduction provided under present law for State and local 

income taxes. As is the case for State and local income taxes, the itemized deduction for State 

and local general sales taxes is not permitted for purposes of determining a taxpayer’s alternative 

minimum taxable income.7

 Taxpayers have two options with respect to the determination of the 

sales tax deduction amount. Taxpayers may deduct the total amount of general State and local 

sales taxes paid by accumulating receipts showing general sales taxes paid. Alternatively, 

taxpayers may use tables created by the Secretary of the Treasury that show the allowable 

deduction. The tables are based on average consumption by taxpayers on a State-by-State basis 

taking into account filing status, number of dependents, adjusted gross income and rates of State 

and local general sales taxation. Taxpayers who use the tables created by the Secretary may, in 

addition to the table amounts, deduct eligible general sales taxes paid with respect to the 

purchase of motor vehicles, boats and other items specified by the Secretary. Sales taxes for 

items that may be added to the tables are not reflected in the tables themselves. 

The term “general sales tax” means a tax imposed at one rate with respect to the sale at 

retail of a broad range of classes of items. However, in the case of items of food, clothing, 

medical supplies, and motor vehicles, the fact that the tax does not apply with respect to some or 

all of such items is not taken into account in determining whether the tax applies with respect to 

a broad range of classes of items, and the fact that the rate of tax applicable with respect to some 

or all of such items is lower than the general rate of tax is not taken into account in determining 

whether the tax is imposed at one rate. Except in the case of a lower rate of tax applicable with 

respect to food, clothing, medical supplies, or motor vehicles, no deduction is allowed for any 

general sales tax imposed with respect to an item at a rate other than the general rate of tax. 

However, in the case of motor vehicles, if the rate of tax exceeds the general rate, such excess 

shall be disregarded and the general rate is treated as the rate of tax. 

A compensating use tax with respect to an item is treated as a general sales tax, provided 

such tax is complimentary to a general sales tax and a deduction for sales taxes is allowable with 

respect to items sold at retail in the taxing jurisdiction that are similar to such item. 

 7

 A technical correction may be needed so that the statute reflects this intent. See section 2(a)(8) 

of H.R. 5395 and S. 3019 in the 108th Congress. 
10

Legislative History

Prior to the Tax Reform Act of 1986, taxpayers were permitted a deduction for State and 

local general sales taxes. The Tax Reform Act of 1986 eliminated that deduction. The American 

Jobs Creation Act of 2004 added the present-law provision.8

President’s Budget Proposal

No proposal. 

Analysis

State and local governments rely on a variety of taxes to finance expenditures. The 

primary sources of revenue for such governments are income taxes, sales taxes, and real property 

taxes. The present-law deduction reflects concerns that, because not all States rely on income 

taxes as a primary source of revenue, allowing a deduction for State and local income taxes, but 

not sales taxes, may create inequities across States and may also create biases in the types of 

taxes that States and localities chose to impose. 

Extending the option to deduct State and local general sales taxes in lieu of income taxes 

would cause the Federal tax laws to have a more neutral effect on the types of taxes that State 

and local governments utilize. Additionally, some argue that the deduction for the State and 

local income taxes is proper on the ground that such expense is directly related to the production 

of income, and, in general, expenses related to producing income are deductible. Liability for 

State and local sales taxes, on the other hand, is not directly related to the production of income, 

but rather stems from consumption expenditures. Thus, a deduction for State and local sales 

taxes is arguably a subsidy for consumption. It should be noted, however, that a deduction is 

permitted for State and local personal and real property taxes, which are unrelated to the 

production of income. 

 The election to deduct state and local sales taxes in lieu of income taxes does not 

eliminate inequities across states, as many States rely on both income and sales taxes, to varying 

degrees. Taxpayers of States that rely heavily on either the income or the sales tax would thus in 

general be permitted greater deductions than taxpayers of a State that relied equally on the sales 

and income tax. If the purpose of the deduction for State and local taxes is to reflect ability to 

pay, it would be better to permit the deduction for State and local sales taxes in addition to, rather 

than in lieu of, the deduction for State and local income taxes. Alternatively, if State and local 

taxes are viewed as the cost of the consumption of public goods and services, and the magnitude 

of such taxes reflects local preferences for consumption of public rather than private goods and 

services, many argue that no deduction is justified for State and local taxes, as the deduction 

creates a bias in favor of public over private provision of goods and services.

 8

 Pub. Law 108-357 Sec. 501. 
11

D. Archer Medical Savings Accounts 

Present Law

Archer medical savings accounts

In general

Within limits, contributions to an Archer medical savings account (“Archer MSA”) are 

deductible in determining adjusted gross income if made by an eligible individual and are 

excludable from gross income and wages for employment tax purposes if made by the employer 

of an eligible individual. Earnings on amounts in an Archer MSA are not currently taxable. 

Distributions from an Archer MSA for medical expenses are not includible in gross income. 

Distributions not used for medical expenses are includible in gross income. In addition, 

distributions not used for medical expenses are subject to an additional 15-percent tax unless the 

distribution is made after age 65, death, or disability. 

Eligible individuals

Archer MSAs are available to employees covered under an employer-sponsored high 

deductible plan of a small employer and self-employed individuals covered under a high 

deductible health plan.9 An employer is a small employer if it employed, on average, no more 

than 50 employees on business days during either the preceding or the second preceding year. 

An individual is not eligible for an Archer MSA if he or she is covered under any other health 

plan in addition to the high deductible plan. 

Tax treatment of and limits on contributions

Individual contributions to an Archer MSA are deductible (within limits) in determining 

adjusted gross income (i.e., “above-the-line”). In addition, employer contributions are 

excludable from gross income and wages for employment tax purposes (within the same limits), 

except that this exclusion does not apply to contributions made through a cafeteria plan. In the 

case of an employee, contributions can be made to an Archer MSA either by the individual or by 

the individual’s employer. 

The maximum annual contribution that can be made to an Archer MSA for a year is 65 

percent of the deductible under the high deductible plan in the case of individual coverage and 75 

percent of the deductible in the case of family coverage. 

Definition of high deductible plan

A high deductible plan is a health plan with an annual deductible of at least $1,750 and 

no more than $2,650 in the case of individual coverage and at least $3,500 and no more than 

 9

 Self-employed individuals include more than two-percent shareholders of S corporations who 

are treated as partners for purposes of fringe benefit rules pursuant to section 1372. 
12

$5,250 in the case of family coverage. In addition, the maximum out-of-pocket expenses with 

respect to allowed costs (including the deductible) must be no more than $3,500 in the case of 

individual coverage and no more than $6,450 in the case of family coverage.10 A plan does not 

fail to qualify as a high deductible plan merely because it does not have a deductible for 

preventive care as required by State law. A plan does not qualify as a high deductible health 

plan if substantially all of the coverage under the plan is for certain permitted coverage. In the 

case of a self-insured plan, the plan must in fact be insurance (e.g., there must be appropriate risk 

shifting) and not merely a reimbursement arrangement. 

Cap on taxpayers utilizing Archer MSAs and expiration of pilot program

The number of taxpayers benefiting annually from an Archer MSA contribution is limited 

to a threshold level (generally 750,000 taxpayers). The number of Archer MSAs established has 

not exceeded the threshold level. 

After 2005, no new contributions may be made to Archer MSAs except by or on behalf 

of individuals who previously made (or had made on their behalf) Archer MSA contributions and 

employees who are employed by a participating employer. 

Trustees of Archer MSAs are generally required to make reports to the Treasury by 

August 1 regarding Archer MSAs established by July 1 of that year. If any year is a cut-off year, 

the Secretary is required to make and publish such determination by October 1 of such year.11 

Based on the number of returns filed for 2003 and the projected number filed for 2004, the IRS 

determined that February 1, 2005, is not a cut-off date for the MSA pilot project.12 

Health savings accounts

Health savings accounts (“HSAs”) were enacted by the Medicare Prescription Drug, 

Improvement, and Modernization Act of 2003.13 As discussed in more detail below, like Archer 

MSAs, an HSA is a tax-exempt trust or custodial account to which tax-deductible contributions 

may be made by individuals with a high deductible health plan. HSAs provide tax benefits 

similar to, but more favorable than, those provide by Archer MSA. HSAs were established on a 

permanent basis. 

 10 These dollar amounts are for 2005. These amounts are indexed for inflation, rounded to the 

nearest $50. 

11 The reports required by MSA trustees for 2004 were treated as timely if made within 90 days 

after October 4, 2004. In addition, the determination of whether 2004 is a cut-off year and the publication 

of such determination was to be made within 120 days of October 4, 2004. If 2004 was a cut-off year, the 

cut-off date would be the last day of the 120-day period. 

12 Announcement 2005-12. 

13 Pub. L. No. 108-173. 
13

Legislative History

MSAs were added to the Code effective for taxable years beginning after December 31, 

1996, by Public Law 104-191, the Health Insurance Portability and Accountability Act of 1996 

(“HIPAA”). MSAs were established on a temporary basis, as a four-year pilot program. As 

originally enacted, no new contributions could be made to an MSA after December 31, 2000. 

During the original pilot period of 1997 through 2000, the Department of the Treasury was to 

evaluate MSA participation and the reduction in Federal revenues due to such participation and 

report to the Congress as appropriate.14 The General Accounting Office (now named the 

Government Accountability Office ) was also directed to contract with an organization 

experienced in health economics, health insurance markets and actuarial science to conduct a 

study on the effectiveness of MSAs in the small group market and report to Congress by January 

1, 1999. The study was to measure the impact of MSAs on the broader health care market and 

to evaluate the impact of MSAs on individuals and families experiencing high health care costs. 

The first phase of the study was included in a report submitted to Congress on December 

19, 1997.15 The study found that the insurance industry responded rapidly by offering qualifying 

products, but that consumer demand was lower than anticipated. The final report of the MSA 

study was submitted to Congress on December 31, 1998.16 The information in the final report 

was only from insurers, as the report noted that the low enrollment in MSAs made it impossible 

to conduct useful surveys of enrollees, employers, or financial institutions at a reasonable cost. 

The final report echoed the first report that consumer demand had been lower than expected. 

The total count against the June 30, 1998, enrollment cap of 750,000 MSAs was less than 

40,000. 

MSAs were extended through December 31, 2002, by Public Law 106-554, the 

Consolidated Appropriations Act of 2002, which enacted H.R. 5662 by reference. Public Law 

106-554 also changed the name of MSAs to Archer MSAs. Archer MSAs were extended 

through December 31, 2003, by Public Law 107-147, the Job Creation and Worker Assistance 

Act of 2002. Archer MSAs were extended through December 31, 2005, by Public Law 108-311, 

the Working Families Tax Relief Act of 2004. 

Notwithstanding the extensions of Archer MSAs, no new contributions would be allowed 

to an Archer MSA if it was determined that the threshold level was exceeded. 

President’s Budget Proposal

No proposal. 

 14 H.R. Conf. Rep. No. 104-736. 

15 Medical Savings Accounts: Findings from Insurer Survey (GAO/HEHS-98-57, Dec. 19, 1997). 

16 Medical Savings Accounts: Results from Surveys of Insurers (GAO/HEHS-99-34, Dec. 31, 

1998). 
14

Analysis

MSAs were enacted to provide additional health options and to give individuals more 

control over their health care dollars by providing incentives for individuals to be more cost 

conscious of health care.17 The Congress believed that individuals should be encouraged to save 

for future medical care expenses and that individuals should be allowed to save for such 

expenses on a tax-favored basis. The Congress believed that consumers who spend their own 

savings on health care will make cost-conscious decisions, thus reducing the rising cost of health 

care. 

MSAs were established for a four-year pilot period (1997-2000), but have been extended 

three times. There has been debate whether Archer MSAs have been successful as the number of 

Archer MSAs is considerably less than the maximum threshold level of 750,000. The IRS 

determined that the number of Archer MSA returns filed for 2003 was 79,235.18 Of this total, 

18,403 were for taxpayers reported as previously uninsured.19 The IRS also determined that 

4,062 taxpayers who did not have Archer MSA contributions for 2003 established Archer MSAs 

for 2004 prior to July 1, 2004. Of this total, 3,362 were reported as previously uninsured. 

Archer MSAs provide tax benefits similar to, but generally not as favorable as, those 

provided by HSAs for certain individuals covered by high deductible health plans. HSAs 

promote the same policy objectives as Archer MSAs on a more tax-favored basis. The rules 

relating to Archer MSAs and HSAs are similar. Like Archer MSAs, HSAs are tax-exempt trusts 

or custodial accounts which can be used to accumulate funds on a tax-free basis. Distributions 

used for qualified medical expenses are excluded from gross income. However, there are 

important differences that favor HSAs. 

Contributions to an HSA made by or on behalf of any individual covered by a high 

deductible health plan are deductible. In addition, contributions made by an employer (including 

though salary reduction) are excludible from income and wages. In the case of Archer MSAs, 

only self-employed individuals and employees of small employers are eligible to have Archer 

MSAs, contributions cannot be made through salary reduction, and contributions cannot be made 

by both the employee and employer. 

The definition of high deductible health plan for HSA purposes includes a lower annual 

deductible than that required for Archer MSAs.20 For HSA purposes, a high deductible health 

plan is a plan that has a deductible that is at least $1,000 for self-only coverage or $2,000 for 

 17 H.R. Rep. No. 107-251. 

18 Announcement 2005-12. 

19 Returns of individuals who were reported as previously being uninsured do not count toward 

the applicable statutory limitation. 

20 There is no maximum annual deductible for an HSA high deductible health plan. The limit on 

out-of-pocket expenses is higher for HSAs than for Archer MSAs. 
15

family coverage and that has an out-of-pocket expense limit that is no more than $5,100 for selfonly coverage and $10,200 for family coverage (for 2005). The minimum annual deductible 

required for Archer MSAs is at least $1,750 in the case of individual coverage and at least 

$3,500 in the case of family coverage (for 2005). Unlike HSAs, the rules for Archer MSAs also 

include requirements for the maximum annual deductible. 

The provisions for HSAs allow larger tax-favored contributions than that allowed for 

Archer MSAs. For 2005, the maximum deductible contribution that can be made to an Archer 

MSA is $1,723 in the case of self-only coverage and $3,938 in the case of family coverage, while 

the maximum deductible contribution that can be made to an HSA is $2,650 in the case of selfonly coverage and $5,250 in the case of family coverage. In addition, additional contributions 

are allowed to HSAs of individuals who are age 55 or older. 

The additional tax on distributions not used for medical expenses is lower in the case of 

HSAs; the additional tax is 10 percent in the case of HSAs rather than 15 percent in the case of 

Archer MSAs. 

Unlike Archer MSAs, there is no limit on the number of HSAs that may be established, 

and HSAs were enacted on a permanent basis. 

Some argue that those with existing Archer MSAs should be allowed to continue using 

MSAs during a limited transition period. This may not be necessary, however, as amounts can 

be rolled over into an HSA from an Archer MSA on a tax-free basis. The more tax-favored rules 

of HSAs are available to all individuals who currently have Archer MSAs. Some providers of 

Archer MSAs are currently facilitating roll-overs into HSAs. In rare cases in which Archer MSA 

providers are not offering HSAs, it is more tax advantageous for Archer MSA account holders to 

move their accounts to providers that do offer HSAs. 

Some believe that Archer MSAs should be extended for a limited transition period as 

more companies begin to offer HSAs. They believe that until the HSA market is more 

developed, individuals should be allowed to establish Archer MSAs. Others counter that such 

transition is unnecessary, as most companies who offer Archer MSAs also offer HSAs. 

Retaining Archer MSAs adds complexity to the tax system because of the existence of 

similar HSA provisions. In addition, retaining Archer MSAs creates a trap for the unwary, as 

HSAs provide more favorable tax benefits even in the case when no new contributions are made 

to the account.
16

E. Above-the-Line Deduction for Certain Higher Education Expenses 

Present Law

An individual is allowed an above-the-line deduction for qualified tuition and related 

expenses for higher education paid by the individual during the taxable year.21 Qualified tuition 

and related expenses are defined in the same manner as for the Hope and Lifetime Learning 

credits, and includes tuition and fees required for the enrollment or attendance of the taxpayer, 

the taxpayer’s spouse, or any dependent of the taxpayer with respect to whom the taxpayer may 

claim a personal exemption, at an eligible institution of higher education for courses of 

instruction of such individual at such institution.22 The expenses must be in connection with 

enrollment at an institution of higher education during the taxable year, or with an academic term 

beginning during the taxable year or during the first three months of the next taxable year. The 

deduction is not available for tuition and related expenses paid for elementary or secondary 

education. 

For taxable years beginning in 2004 or 2005, the maximum deduction is $4,000 for an 

individual whose adjusted gross income for the taxable year does not exceed $65,000 ($130,000 

in the case of a joint return), or $2,000 for other individuals whose adjusted gross income does 

not exceed $80,000 ($160,000 in the case of a joint return). No deduction is allowed for an 

individual whose adjusted gross income exceeds the relevant adjusted gross income limitations, 

for a married individual who does not file a joint return, or for an individual with respect to 

whom a personal exemption deduction may be claimed by another taxpayer for the taxable year. 

The deduction is not available for taxable years beginning after December 31, 2005. 

The amount of qualified tuition and related expenses must be reduced by certain 

scholarships, educational assistance allowances, and other amounts paid for the benefit of such 

individual,23 and by the amount of such expenses taken into account for purposes of determining 

any exclusion from gross income of: (1) income from certain United States Savings Bonds used 

to pay higher education tuition and fees; and (2) income from a Coverdell education savings 

account.24 Additionally, such expenses must be reduced by the earnings portion (but not the 

return of principal) of distributions from a qualified tuition program if an exclusion under section 

529 is claimed with respect to expenses eligible for exclusion under section 222. No deduction 

is allowed for any expense for which a deduction is otherwise allowed or with respect to an 

individual for whom a Hope credit or Lifetime Learning credit is elected for such taxable year. 

 21 Sec. 222. 

22 The deduction generally is not available for expenses with respect to a course or education 

involving sports, games, or hobbies, and is not available for student activity fees, athletic fees, insurance 

expenses, or other expenses unrelated to an individual’s academic course of instruction. 

23 Sec. 222(d)(1) and sec. 25A(g)(2). 

24 Sec. 222(c). These reductions are the same as those that apply to the Hope and Lifetime 

Learning credits. 
17

Legislative History

The above-the-line deduction for qualified tuition and related expenses for higher 

education was enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 

2001.25

President’s Budget Proposal

No proposal. 

Analysis

In general

All levels of government make substantial direct expenditures to subsidize postsecondary education. In addition, private educational organizations channel gifts from private 

persons into subsidies for the education of other persons. By exempting such organizations from 

income tax and permitting the gifts to such organizations to be deductible, additional implicit 

subsidies under the Code are created for education. Other subsidies for education provided by the 

Code permit students to receive tax-free qualified scholarships, tax-free employer-provided 

educational assistance, tax-free cancellation of certain governmental student loans, and a 

deduction for student loan interest. Students and parents also are provided the benefits of the 

Hope and Lifetime Learning credits, the exclusion from income of earnings on education savings 

accounts and qualified tuition programs, and the exclusion from income of the interest on United 

States savings bonds used to pay for post-secondary education.26 

The deduction for qualified tuition and related expenses was enacted due to a concern 

that certain taxpayers were unable to utilize the full benefits of the Hope or Lifetime learning 

credits due to income limitations and to guard against the possibility that Congress might not 

extend the provisions that allow the education credits be claimed against the alternative 

minimum tax. 

Analysts attempt to evaluate subsidies in terms of their efficiency, equity, and 

administrability. In this regard, subsidies to post-secondary education have been argued to 

improve both economic efficiency and to promote economic equity. As discussed further below, 

subsidies to education, such as the deduction, can improve economic efficiency when the social 

returns to education exceed the private returns to education. It is less likely that the deduction 

has a significant affect on the equity issue of affordable access to college, given that the 

deduction is designed to assist taxpayers with incomes beyond the eligibility levels for the 

education credits, a population that has had a high rate of college attendance even prior to the 

deduction. With regard to administrability and complexity, it has been suggested by numerous 

 25 Note that the tuition deduction, though enacted in the Economic Growth and Tax Relief 

Reconciliation Act of 2001, sunsets prior to the general sunset in the Act. 

26 Certain income limits restrict some benefits. 
18

observers that the education credits and the deduction could be combined for simplicity without 

sacrificing any policy goals because they have substantially similar objectives.27 The following 

is a general discussion of the efficiency and equity issues regarding subsidies to education. 

Efficiency as a goal of subsidies to education

Economists generally have a predilection for favoring the outcomes of the free market 

and have reasoned that taxes or subsidies in the market generally lead to inefficient outcomes. 

That is, taxes or subsidies distort choices and divert resources from their highest and best use. 

However, economists also recognize that sometimes markets do not work efficiently. Economists 

observe that the consumption or acquisition of certain goods may create spillover, or external, 

effects that benefit society at large as well as the individual consumer who purchases the good. 

An example of such a good is a vaccination. The individual who is vaccinated benefits by not 

contracting an infectious disease, but the rest of society benefits as well, because by not 

contracting the disease the vaccinated individual also slows the spread of the disease to those 

who are not vaccinated. Economists call such a spillover effect a “positive externality.” On his 

or her own, the individual would weigh only his or her own reduced probability of contracting 

the disease against the cost of the vaccination. The individual would not account for the 

additional benefit the vaccination produces for society. As a result, the individual might choose 

not to be vaccinated, even though from society's perspective, total reduction in the rate of 

infection throughout the population would be more than worth the cost of the vaccination. In this 

sense, the private market might produce too few of the vaccinations. The private market 

outcome is inefficiently small. Economists have suggested that the existence of positive 

externalities provides a rationale for the government to subsidize the acquisition of the good that 

produces the positive externalities. The subsidy will increase the acquisition of the good to its 

more efficient level. 

While much evidence suggests that job skill acquisition and education benefit the private 

individual in terms of higher market wages, many people have long believed that education also 

produces positive externalities. Commentators argue that society functions better with an 

educated populace and that markets function better with educated consumers. They observe that 

education promotes innovation and that, because ideas and innovations are easily copied in the 

market place, the market return (wage or profit) from ideas and innovations may not reflect the 

full value to society from the idea or innovation. Just as a single individual does not appreciate 

the full benefit of a vaccination, a single individual may not be able to reap the full benefit of an 

idea or innovation. Thus, it is argued, subsidies for education are needed to improve the 

efficiency of society. 

On the other hand, recognizing that a subsidy might be justified does not identify the 

magnitude of the subsidy necessary to promote efficiency nor the best method for delivery of the 

subsidy. It is possible to create inefficient outcomes by over-subsidizing a good that produces 

 27 See, for example, Joint Committee on Taxation, Options to Improve Tax Compliance and 

Reform tax Expenditures (JCS-02-05), January 27, 2005; and National Taxpayer Advocate, 2004 Annual 

Report to Congress, Publication 2104 (Rev. 12-2004). 
19

positive externalities. Given that the United States already provides substantial subsidies to postsecondary education, it is not possible to say whether new subsidies would increase or decrease 

economic efficiency without some empirical analysis of the social benefits that would arise from 

creating new subsidies. 

Some observers note that, aside from potential spillover effects that education might 

create, the market for financing education may be inefficient. They observe that, while investors 

in housing or other tangible assets have property that can be pledged to secure financing to 

procure the asset, an individual cannot generally pledge his or her future earnings as security for 

a loan to obtain education or training designed to increase the individual's future earning 

potential. This inability to provide security for education loans may constrain borrowing as an 

alternative to finance education for some taxpayers. Taxpayers who cannot borrow to finance 

education or training may forgo the education or training even though it would produce a high 

return for the investor. This inefficiency in the market for education finance may offer a 

justification for public subsidies. The inefficiency in the market for financing is likely most acute 

among lower-income taxpayers who generally do not have other assets that could be pledged as 

security for an education loan. This suggests that this potential source of market inefficiency also 

relates to the considerations of equity as a rationale for subsidies of education (discussed below). 

Equity as a goal of subsidies to education

As noted above, there is evidence indicating that education and training are rewarded in 

the market place. Recognizing this market outcome, some argue that it is appropriate to subsidize 

education to ensure that educational opportunities are widely available, including to lowerincome individuals. Commentators argue that education can play an important role in reducing 

poverty and income inequality. They observe that even if there were no positive externalities 

from education, promoting economic equity within a market economy provides a basis for 

subsidizing education. If equity is the goal of expanded subsidies to education, the cost of the 

subsidies should be weighed in terms of the private benefits received by the target groups, rather 

than the social benefits that might be generated by any possible spillovers. 
20 

II. PROVISIONS RELATING TO BUSINESS TAXPAYERS 

A. Investment and Employment 

1. Research and experimentation (R&E) tax credit 

Present Law

General rule

Section 41 provides for a research tax credit equal to 20 percent of the amount by which a 

taxpayer’s qualified research expenses for a taxable year exceed its base amount for that year. 

The research tax credit is scheduled to expire and generally will not apply to amounts paid or 

incurred after December 31, 2005. 

A 20-percent research tax credit also applies to the excess of (1) 100 percent of corporate 

cash expenses (including grants or contributions) paid for basic research conducted by 

universities (and certain nonprofit scientific research organizations) over (2) the sum of (a) the 

greater of two minimum basic research floors plus (b) an amount reflecting any decrease in 

nonresearch giving to universities by the corporation as compared to such giving during a fixedbase period, as adjusted for inflation. This separate credit computation is commonly referred to 

as the university basic research credit (see sec. 41(e)). 

Computation of allowable credit

Except for certain university basic research payments made by corporations, the research 

tax credit applies only to the extent that the taxpayer’s qualified research expenses for the current 

taxable year exceed its base amount. The base amount for the current year generally is computed 

by multiplying the taxpayer’s fixed-base percentage by the average amount of the taxpayer’s 

gross receipts for the four preceding years. If a taxpayer both incurred qualified research 

expenses and had gross receipts during each of at least three years from 1984 through 1988, then 

its fixed-base percentage is the ratio that its total qualified research expenses for the 1984-1988 

period bears to its total gross receipts for that period (subject to a maximum fixed-base 

percentage of 16 percent). All other taxpayers (so-called start-up firms) are assigned a fixedbase percentage of three percent.28 

 28 The Small Business Job Protection Act of 1996 expanded the definition of start-up firms under 

section 41(c)(3)(B)(i) to include any firm if the first taxable year in which such firm had both gross 

receipts and qualified research expenses began after 1983. 

A special rule (enacted in 1993) is designed to gradually recompute a start-up firm’s fixed-base 

percentage based on its actual research experience. Under this special rule, a start-up firm will be 

assigned a fixed-base percentage of three percent for each of its first five taxable years after 1993 in 

which it incurs qualified research expenses. In the event that the research credit is extended beyond the 

scheduled expiration date, a start-up firm’s fixed-base percentage for its sixth through tenth taxable years 

after 1993 in which it incurs qualified research expenses will be a phased-in ratio based on its actual 
21 

In computing the credit, a taxpayer’s base amount may not be less than 50 percent of its 

current-year qualified research expenses. 

To prevent artificial increases in research expenditures by shifting expenditures among 

commonly controlled or otherwise related entities, a special aggregation rule provides that all 

members of the same controlled group of corporations are treated as a single taxpayer 

(sec. 41(f)(1)). Under regulations prescribed by the Secretary, special rules apply for computing 

the credit when a major portion of a trade or business (or unit thereof) changes hands, under 

which qualified research expenses and gross receipts for periods prior to the change of ownership 

of a trade or business are treated as transferred with the trade or business that gave rise to those 

expenses and receipts for purposes of recomputing a taxpayer’s fixed-base percentage 

(sec. 41(f)(3)). 

Alternative incremental research credit regime

Taxpayers are allowed to elect an alternative incremental research credit regime.29 If a 

taxpayer elects to be subject to this alternative regime, the taxpayer is assigned a three-tiered 

fixed-base percentage (that is lower than the fixed-base percentage otherwise applicable under 

present law) and the credit rate likewise is reduced. Under the alternative incremental credit 

regime, a credit rate of 2.65 percent applies to the extent that a taxpayer’s current-year research 

expenses exceed a base amount computed by using a fixed-base percentage of one percent (i.e., 

the base amount equals one percent of the taxpayer’s average gross receipts for the four 

preceding years) but do not exceed a base amount computed by using a fixed-base percentage of 

1.5 percent. A credit rate of 3.2 percent applies to the extent that a taxpayer’s current-year 

research expenses exceed a base amount computed by using a fixed-base percentage of 1.5 

percent but do not exceed a base amount computed by using a fixed-base percentage of two 

percent. A credit rate of 3.75 percent applies to the extent that a taxpayer’s current-year research 

expenses exceed a base amount computed by using a fixed-base percentage of two percent. An 

election to be subject to this alternative incremental credit regime may be made for any taxable 

year beginning after June 30, 1996, and such an election applies to that taxable year and all 

subsequent years unless revoked with the consent of the Secretary of the Treasury. 

Eligible expenses

Qualified research expenses eligible for the research tax credit consist of: (1) in-house 

expenses of the taxpayer for wages and supplies attributable to qualified research; (2) certain 

time-sharing costs for computer use in qualified research; and (3) 65 percent of amounts paid or 

 

research experience. For all subsequent taxable years, the taxpayer’s fixed-base percentage will be its 

actual ratio of qualified research expenses to gross receipts for any five years selected by the taxpayer 

from its fifth through tenth taxable years after 1993 (sec. 41(c)(3)(B)). 

29 Sec. 41(c)(4). 
22 

incurred by the taxpayer to certain other persons for qualified research conducted on the 

taxpayer’s behalf (so-called contract research expenses).30 

To be eligible for the credit, the research must not only satisfy the requirements of 

present-law section 174 (described below) but must be undertaken for the purpose of discovering 

information that is technological in nature, the application of which is intended to be useful in 

the development of a new or improved business component of the taxpayer, and substantially all 

of the activities of which must constitute elements of a process of experimentation for functional 

aspects, performance, reliability, or quality of a business component. Research does not qualify 

for the credit if substantially all of the activities relate to style, taste, cosmetic, or seasonal design 

factors (sec. 41(d)(3)). In addition, research does not qualify for the credit: (1) if conducted 

after the beginning of commercial production of the business component; (2) if related to the 

adaptation of an existing business component to a particular customer’s requirements; (3) if 

related to the duplication of an existing business component from a physical examination of the 

component itself or certain other information; or (4) if related to certain efficiency surveys, 

management function or technique, market research, market testing, or market development, 

routine data collection or routine quality control (sec. 41(d)(4)). Research does not qualify for 

the credit if it is conducted outside the United States, Puerto Rico, or any U.S. possession. 

Relation to deduction

Under section 174, taxpayers may elect to deduct currently the amount of certain research 

or experimental expenditures paid or incurred in connection with a trade or business, 

notwithstanding the general rule that business expenses to develop or create an asset that has a 

useful life extending beyond the current year must be capitalized.31 However, deductions 

allowed to a taxpayer under section 174 (or any other section) are reduced by an amount equal to 

100 percent of the taxpayer’s research tax credit determined for the taxable year (Sec. 280C(c)). 

Taxpayers may alternatively elect to claim a reduced research tax credit amount (13 percent) 

under section 41 in lieu of reducing deductions otherwise allowed (sec. 280C(c)(3)). 

Legislative History

The research tax credit initially was enacted in the Economic Recovery Tax Act of 1981 

as a credit equal to 25 percent of the excess of qualified research expenses incurred in the current 

 30 Under a special rule enacted as part of the Small Business Job Protection Act of 1996, 75 

percent of amounts paid to a research consortium for qualified research is treated as qualified research 

expenses eligible for the research credit (rather than 65 percent under the general rule under section 

41(b)(3) governing contract research expenses) if (1) such research consortium is a tax-exempt 

organization that is described in section 501(c)(3) (other than a private foundation) or section 501(c)(6) 

and is organized and operated primarily to conduct scientific research, and (2) such qualified research is 

conducted by the consortium on behalf of the taxpayer and one or more persons not related to the 

taxpayer. Sec. 41(b)(3)(C). 

31 Taxpayers may elect 10-year amortization of certain research expenditures allowable as a 

deduction under section 174(a). Secs. 174(f)(2) and 59(e). 
23 

taxable year over the average of qualified research expenses incurred in the prior three taxable 

years. The credit was scheduled to expire December 31, 1985. The research tax credit was 

modified in the Tax Reform Act of 1986, which: (1) extended the credit through December 31, 

1988; (2) reduced the credit rate to 20 percent; (3) tightened the definition of qualified research 

expenses eligible for the credit; and (4) enacted the separate university basic research credit. 

The Technical and Miscellaneous Revenue Act of 1988 (“1988 Act”) extended the 

research tax credit for one additional year, through December 31, 1989. The 1988 Act also 

reduced the deduction allowed under section 174 (or any other section) for qualified research 

expenses by an amount equal to 50 percent of the research tax credit determined for the year. 

The Omnibus Budget Reconciliation Act of 1989 (“1989 Act”) effectively extended the 

research credit for nine months (by prorating qualified expenses incurred before January 1, 

1991). The 1989 Act also modified the method for calculating a taxpayer’s base amount (i.e., by 

substituting the present-law method which uses a fixed-base percentage for the prior-law moving 

base which was calculated by reference to the taxpayer’s average research expenses incurred in 

the preceding three taxable years). The 1989 Act further reduced the deduction allowed under 

section 174 (or any other section) for qualified research expenses by an amount equal to 100 

percent of the research tax credit determined for the year. 

The Omnibus Budget Reconciliation Act of 1990 extended the research tax credit through 

December 31, 1991 (and repealed the special rule to prorate qualified expenses incurred before 

January 1, 1991). 

The Tax Extension Act of 1991 extended the research tax credit for six months (i.e., for 

qualified expenses incurred through June 30, 1992). 

The Omnibus Budget Reconciliation Act of 1993 (“1993 Act”) extended the research tax 

credit for three years--i.e., retroactively from July 1, 1992 through June 30, 1995. The 1993 Act 

also provided a special rule for start-up firms, so that the fixed-base ratio of such firms 

eventually will be computed by reference to their actual research experience. 

Although the research tax credit expired during the period July 1, 1995, through June 30, 

1996, the Small Business Job Protection Act of 1996 (“1996 Act”) extended the credit for the 

period July 1, 1996, through May 31, 1997 (with a special 11-month extension for taxpayers that 

elect to be subject to the alternative incremental research credit regime). In addition, the 1996 

Act expanded the definition of start-up firms under section 41(c)(3)(B)(i), enacted a special rule 

for certain research consortia payments under section 41(b)(3)(C), and provided that taxpayers 

may elect an alternative research credit regime (under which the taxpayer is assigned a threetiered fixed-base percentage that is lower than the fixed-base percentage otherwise applicable 

and the credit rate likewise is reduced) for the taxpayer’s first taxable year beginning after 

June 30, 1996, and before July 1, 1997. 

The Taxpayer Relief Act of 1997 (“1997 Act”) extended the research credit for 13 

months--i.e., generally for the period June 1, 1997, through June 30, 1998. The 1997 Act also 

provided that taxpayers are permitted to elect the alternative incremental research credit regime 

for any taxable year beginning after June 30, 1996 (and such election will apply to that taxable 
24 

year and all subsequent taxable years unless revoked with the consent of the Secretary of the 

Treasury). The Tax and Trade Relief Extension Act of 1998 extended the research credit for 12 

months, i.e., through June 30, 1999. 

The Ticket To Work and Work Incentive Improvement Act of 1999 extended the 

research credit for five years, through June 30, 2004, increased the rates of credit under the 

alternative incremental research credit regime, and expanded the definition of research to include 

research undertaken in Puerto Rico and possessions of the United States. 

The Working Families Tax Relief Act of 2004 extended the research credit through 

December 31, 2005. 

President’s Budget Proposal

The President’s budget proposal makes the research tax credit permanent. 

Analysis

Overview

Technological development is an important component of economic growth. However, 

while an individual business may find it profitable to undertake some research, it may not find it 

profitable to invest in research as much as it otherwise might because it is difficult to capture the 

full benefits from the research and prevent such benefits from being used by competitors. In 

general, businesses acting in their own self-interest will not necessarily invest in research to the 

extent that would be consistent with the best interests of the overall economy. This is because 

costly scientific and technological advances made by one firm are cheaply copied by its 

competitors. Research is one of the areas where there is a consensus among economists that 

government intervention in the marketplace can improve overall economic efficiency.32 

However, this does not mean that increased tax benefits or more government spending for 

research always will improve economic efficiency. It is possible to decrease economic 

efficiency by spending too much on research. However, there is evidence that the current level 

of research undertaken in the United States, and worldwide, is too little to maximize society’s 

well-being.33 Nevertheless, even if there were agreement that additional subsidies for research 

 32 This conclusion does not depend upon whether the basic tax regime is an income tax or a 

consumption tax. 

33 See Zvi Griliches, “The Search for R&D Spillovers,” Scandinavian Journal of Economics, vol. 

XCIV, (1992), M. Ishaq Nadiri, “Innovations and Technological Spillovers,” National Bureau of 

Economic Research, Working Paper No. 4423, 1993, and Bronwyn Hall, “The Private and Social Returns 

to Research and Development,” in Bruce Smith and Claude Barfield, editors, Technology, R&D and the 

Economy, (Washington, D.C.: Brookings Institution Press), 1996, pp. 1-14. These papers suggest that 

the rate of return to privately funded research expenditures is high compared to that in physical capital 

and the social rate of return exceeds the private rate of return. Griliches concludes, “in spite of [many] 

difficulties, there has been a significant number of reasonably well-done studies all pointing in the same 

direction: R&D spillovers are present, their magnitude may be quite large, and social rates of return 

remain significantly above private rates.” Griliches, p. S43. 
25 

are warranted as a general matter, misallocation of research dollars across competing sectors of 

the economy could diminish economic efficiency. It is difficult to determine whether, at the 

present levels and allocation of government subsidies for research, further government spending 

on research or additional tax benefits for research would increase or decrease overall economic 

efficiency. 

If it is believed that too little research is being undertaken, a tax subsidy is one method of 

offsetting the private-market bias against research, so that research projects undertaken approach 

the optimal level. Among the other policies employed by the Federal Government to increase 

the aggregate level of research activities are direct spending and grants, favorable anti-trust rules, 

and patent protection. The effect of tax policy on research activity is largely uncertain because 

there is relatively little consensus regarding magnitude of the responsiveness of research to 

changes in taxes and other factors affecting its price. To the extent that research activities are 

responsive to the price of research activities, the research and experimentation tax credit should 

increase research activities beyond what they otherwise would be. However, the present-law 

treatment of research expenditures does create certain complexities and compliance costs. 

Scope of research activities in the United States and abroad

In the United States, private for-profit enterprises and individuals, non-profit 

organizations, and the public sector undertake research activities. Total expenditures on research 

and development in the United States are large, representing 2.8 percent of gross domestic 

product in 2002.34 This rate of expenditure on research and development exceeds that of the 

European Union and the average of all countries that are members of the Organisation for 

Economic Co-operation and Development (“OECD”), but is less than that of Japan. See 

Figure 1, below. In 2001, expenditures on research and development in the United States 

represented 43.7 percent of all expenditures on research and development undertaken by OECD 

countries, were 55 percent greater than the total expenditures on research and development 

undertaken in the European Union, and were more than two and one half times such expenditures 

in Japan.35 Expenditures on research and development in the United States have grown at an 

average real rate of 5.4 percent over the period 1995-2001. This rate of growth has exceeded 

that of Japan (2.8 percent), Germany (3.3 percent), France (2.4 percent for the period 1997-

1999), Italy (2.7 percent for the period 1997-2000), and the United Kingdom, (2.3 percent), but 

is less than that of Canada (5.6 percent), Ireland (7.5 percent), and Spain (6.5 percent).36 

 34 Organisation for Economic Co-operation and Development, OECD Science, Technology and 

Industry Scoreboard, 2003, (Paris: Organisation of Economid Co-operation and Development), 2003. 

The OECD, measuring in real 1995 dollars, calculates that the United States spent approximately $253 

billion on research and development in 2001. 

35 Ibid.

36 Ibid. The OECD calculates the annual real rate of growth of expenditures on research and 

development for the period 1995-2001 in the European Union and in all OECD countries at 3.7 percent 

and 4.7 percent, respectively. 
26 

Source: OECD Science, Technology and Industry Scoreboard, 2003.

The scope of present-law tax expenditures on research activities

The tax expenditure related to the research and experimentation tax credit is estimated to 

be $4.8 billion for 2005. The related tax expenditure for expensing of research and development 

expenditures was estimated to be $4.0 billion for 2005 growing to $6.3 billion for 2009.37 As 

noted above, the Federal Government also directly subsidizes research activities. For example, 

in fiscal 2004, the National Science Foundation made $4.0 billion in grants, subsidies, and 

contributions to research activities, the Department of Defense financed $11.5 billion in basic 

research, applied research, and advanced technology development, and the Department of 

Energy financed $0.7 billion in research in high energy physics, $1.0 billion in basic research in 

the sciences, $0.6 billion in biological and environmental research, and $197 million for research 

in advance scientific computing.38 

 37 Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2005-

2009 (JCS-1-05), January 12, 2005, p. 30. 

38 Office of Management and Budget, Budget of the United States Government, Fiscal Year 

2006, Appendix, pp. 1081-1085, 295-300 and 395-397. 

Figure 1.--Gross Domestic Expenditure on R&D as a Percentage of GDP,

United States, Japan, the European Union, and the OECD,

1995-2001

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

1995 1996 1997 1998 1999 2000 2001

European Union

Total OECD United States

Japan

Percentage 

Year 
27 

Table 1 and Table 2 present data for 2002 on those industries that utilized the research tax 

credit and the distribution of the credit claimants by firm size. In 2002, more than 15,000 

taxpayers claimed more than $5.8 billion in research tax credits.39 Taxpayers whose primary 

activity is manufacturing claimed two thirds of the research tax credits claimed. Firms with 

assets of $50 million or more claimed nearly 85 percent of the credits claimed. Nevertheless, as 

Table 2 documents, a large number of small firms are engaged in research and were able to claim 

the research tax credit. 

 39 The $5.8 billion figure reported for 2002 is not directly comparable to the $4.8 billion tax 

expenditure estimate for 2005 reported in the preceding paragraph. The tax expenditure estimate 

accounts for the present-law requirement that deductions for research expenditures be reduced by research 

credits claimed. Also, the $5.8 billion figure does not reflect the actual tax reduction achieved by 

taxpayers claiming research credits in 2002 as the actual tax reduction will depend upon whether the 

taxpayer had operating losses, was subject to the alternative minimum tax, or other aspects specific to 

each taxpayer’s situation. 
28 

Table 1.–Percentage Distribution of Firms Claiming Research Tax Credit 

and Percentage of Credit Claimed by Sector, 2002 

Industry 

Percent of 

Corporations 

Claiming Credit 

Percent of 

Total 

R&E Credit 

Manufacturing 47.76 66.68 

Information 9.05 13.96 

Professional, Scientific, and Technical 

Services 28.23 10.55 

Wholesale Trade 4.08 2.83 

Holding Companies 0.77 1.74 

Finance and Insurance 1.36 1.63 

Retail Trade 1.32 0.63 

Health Care and Social Services 0.84 0.48 

Administrative and Support and Waste 

Management and Remediation Services 0.33 0.47 

Construction 0.27 0.19 

Mining 0.48 0.16 

Utilities 2.98 0.12 

Agriculture, Forestry, Fishing and Hunting 0.38 0.06 

Real Estate and Rental and Leasing 0.24 0.05 

Other Services 1.46 0.04 

Transportation and Warehousing (1) (1) 

Arts, Entertainment, and Recreation (1) (1) 

Accommodation and Food Services (1) (1) 

Educational Services (1) (1) 

Not Allocable (1) (1) 

Wholesale and Retail Trade not Allocable (1) (1) 

1

 Data undisclosed to protect taxpayer confidentiality. 

Source: Joint Committee on Taxation calculations from Internal Revenue Service, Statistics of Income data. 
29 

Table 2.–Percentage Distribution of Firms Claiming Research Tax Credit 

and of Amount of Credit Claimed by Firm Size, 2002 

Asset Size ($) Percent of Firms 

Claiming Credit 

Percent of 

Credit Claimed 

0 2.84 0.59 

1 to 99,999 12.47 0.26 

100,000 to 249,999 2.3 0.18 

250,000 to 499,999 7.04 0.35 

500,000 to 999,999 8.25 0.63 

1,000,000 to 9,999,999 34.85 5.38 

10,000,000 to 49,999,999 17.21 7.68 

50,000,000 + 14.95 84.94 

Note: Totals may not add to 100 percent due to rounding

Source: Joint Committee on Taxation calculations from Internal Revenue Service, Statistics of Income data. 

Flat or incremental tax credits?

For a tax credit to be effective in increasing a taxpayer’s research expenditures it is not 

necessary to provide that credit for all the taxpayer’s research expenditures (i.e., a flat credit). 

By limiting the credit to expenditures above a base amount, incremental tax credits attempt to 

target the tax incentives where they will have the most effect on taxpayer behavior. 

Suppose, for example, a taxpayer is considering two potential research projects: Project A 

will generate cash flow with a present value of $105 and Project B will generate cash flow with a 

present value of $95. Suppose that the research cost of investing in each of these projects is 

$100. Without any tax incentives, the taxpayer will find it profitable to invest in Project A and 

will not invest in Project B. 

Consider now the situation where a 10-percent flat credit applies to all research 

expenditures incurred. In the case of Project A, the credit effectively reduces the cost to $90. 

This increases profitability, but does not change behavior with respect to that project, since it 

would have been undertaken in any event. However, because the cost of Project B also is 

reduced to $90, this previously neglected project (with a present value of $95) would now be 

profitable. Thus, the tax credit would affect behavior only with respect to this marginal project. 

Incremental credits attempt not to reward projects that would have been undertaken in 

any event but to target incentives to marginal projects. To the extent this is possible, incremental 

credits have the potential to be far more effective per dollar of revenue cost than flat credits in 

inducing taxpayers to increase qualified expenditures. In the example above, if an incremental 

credit were properly targeted, the Government could spend the same $20 in credit dollars and 

induce the taxpayer to undertake a marginal project so long as its expected cash flow exceeded 
30 

$80. Unfortunately, it is nearly impossible as a practical matter to determine which particular 

projects would be undertaken without a credit and to provide credits only to other projects. In 

practice, almost all incremental credit proposals rely on some measure of the taxpayer’s previous 

experience as a proxy for a taxpayer’s total qualified expenditures in the absence of a credit. 

This is referred to as the credit’s base amount. Tax credits are provided only for amounts above 

this base amount. 

Since a taxpayer’s calculated base amount is only an approximation of what would have 

been spent in the absence of a credit, in practice, the credit may be less effective per dollar of 

revenue cost than it otherwise might be in increasing expenditures. If the calculated base amount 

is too low, the credit is awarded to projects that would have been undertaken even in the absence 

of a credit. If, on the other hand, the calculated base amount is too high, then there is no 

incentive for projects that actually are on the margin. 

Nevertheless, the incentive effects of incremental credits per dollar of revenue loss can be 

many times larger than those of a flat credit. However, in comparing a flat credit to an 

incremental credit, there are other factors that also deserve consideration. A flat credit generally 

has lower administrative and compliance costs than does an incremental credit. Probably more 

important, however, is the potential misallocation of resources and unfair competition that could 

result as firms with qualified expenditures determined to be above their base amount receive 

credit dollars, while other firms with qualified expenditures considered below their base amount 

receive no credit. 

The responsiveness of research expenditures to tax incentives

Like any other commodity, the amount of research expenditures that a firm wishes to 

incur generally is expected to respond positively to a reduction in the price paid by the firm. 

Economists often refer to this responsiveness in terms of price elasticity, which is measured as 

the ratio of the percentage change in quantity to a percentage change in price. For example, if 

demand for a product increases by five percent as a result of a 10-percent decline in price paid by 

the purchaser, that commodity is said to have a price elasticity of demand of 0.5.40 One way of 

reducing the price paid by a buyer for a commodity is to grant a tax credit upon purchase. A tax 

credit of 10 percent (if it is refundable or immediately usable by the taxpayer against current tax 

liability) is equivalent to a 10-percent price reduction. If the commodity granted a 10-percent tax 

credit has an elasticity of 0.5, the amount consumed will increase by five percent. Thus, if a flat 

research tax credit were provided at a 10-percent rate, and research expenditures had a price 

elasticity of 0.5, the credit would increase aggregate research spending by five percent.41 

 40 For simplicity, this analysis assumes that the product in question can be supplied at the same 

cost despite any increase in demand (i.e., the supply is perfectly elastic). This assumption may not be 

valid, particularly over short periods of time, and particularly when the commodity--such as research 

scientists and engineers--is in short supply. 

41 It is important to note that not all research expenditures need be subject to a price reduction to 

have this effect. Only the expenditures that would not have been undertaken otherwise--so called 

marginal research expenditures--need be subject to the credit to have a positive incentive effect. 
31 

Despite the central role of the measurement of the price elasticity of research activities, 

the empirical evidence on this subject has yielded quantitative measures of the response of 

research spending to tax incentives. While all published studies report that the research credit 

induced increases in research spending, early evidence generally indicated that the price 

elasticity for research is substantially less than one. For example, one early survey of the 

literature reached the following conclusion: 

In summary, most of the models have estimated long-run price elasticities of 

demand for R&D on the order of -0.2 and -0.5. . . . However, all of the 

measurements are prone to aggregation problems and measurement errors in 

explanatory variables.42 

If it took time for taxpayers to learn about the credit and what sort of expenditures qualified, 

taxpayers may have only gradually adjusted their behavior. Such a learning curve might explain 

a modest measured behavioral effect. 

A more recent survey of the literature on the effect of the tax credit suggests a stronger 

behavioral response, although most analysts agree that there is substantial uncertainty in these 

estimates. 

[W]ork using US firm-level data all reaches the same conclusion: the tax price 

elasticity of total R&D spending during the 1980s is on the order of unity, maybe 

higher. ... Thus there is little doubt about the story that the firm-level publicly 

 42 Charles River Associates, An Assessment of Options for Restructuring the R&D Tax Credit to 

Reduce Dilution of its Marginal Incentive (final report prepared for the National Science Foundation), 

February, 1985, p. G-14. The negative coefficient in the text reflects that a decrease in price results in an 

increase in research expenditures. Often, such elasticities are reported without the negative coefficient, it 

being understood that there is an inverse relationship between changes in the “price” of research and 

changes in research expenditures. 

In a 1983 study, the Treasury Department used an elasticity of 0.92 as its upper range estimate of 

the price elasticity of R&D, but noted that the author of the unpublished study from which this estimate 

was taken conceded that the estimate might be biased upward. See, Department of the Treasury, “The 

Impact of Section 861-8 Regulation on Research and Development,” p. 23. As stated in the text, although 

there is uncertainty, most analysts believe the elasticity is considerable smaller. For example, the General 

Accounting Office (now called the Government Accountability Office) summarizes: “These studies, the 

best available evidence, indicate that spending on R&E is not very responsive to price reductions. Most 

of the elasticity estimates fall in the range of 0.2 and 0.5. . . . Since it is commonly recognized that all of 

the estimates are subject to error, we used a range of elasticity estimates to compute a range of estimates 

of the credit’s impact.” See, The Research Tax Credit Has Stimulated Some Additional Research 

Spending (GAO/GGD-89-114), September 1989, p. 23. Similarly, Edwin Mansfield concludes: “While 

our knowledge of the price elasticity of demand for R&D is far from adequate, the best available 

estimates suggest that it is rather low, perhaps about 0.3.” See, “The R&D Tax Credit and Other 

Technology Policy Issues,” American Economic Review, Vol. 76, no. 2, May 1986, p. 191. 
32 

reported R&D data tell: the R&D tax credit produces roughly a dollar-for-dollar 

increase in reported R&D spending on the margin.43 

However this survey notes that most of this evidence is not drawn directly from tax data. For 

example, effective marginal tax credit rates are inferred from publicly reported financial data and 

may not reflect limitations imposed by operating losses or the alternative minimum tax. The 

study notes that because most studies rely on “reported research expenditures” that a “relabelling 

problem” may exist whereby a preferential tax treatment for an activity gives firms an incentive 

to classify expenditures as qualifying expenditures. If this occurs, reported expenditures increase 

in response to the tax incentive by more than the underlying real economic activity. Thus, 

reported estimates may overestimate the true response of research spending to the tax credit.44 

Apparently there have been no specific studies of the effectiveness of the university basic 

research tax credit. 

 43 Bronwyn Hall and John Van Reenen, “How effective are fiscal incentives for R&D? A review 

of the evidence,” Research Policy, vol.29, 2000, p. 462. This survey reports that more recent empirical 

analyses have estimated higher elasticity estimates. One recent empirical analysis of the research credit 

has estimated a short-run price elasticity of 0.8 and a long-run price elasticity of 2.0. The author of this 

study notes that the long-run estimate should be viewed with caution for several technical reasons. In 

addition, the data utilized for the study cover the period 1980 through 1991, containing only two years 

under the revised credit structure. This makes it empirically difficult to distinguish short-run and long-run 

effects, particularly as it may take firms some time to fully appreciate the incentive structure of the 

revised credit. See, Bronwyn H. Hall, “R&D Tax Policy During the 1980s: Success or Failure?” in James 

M. Poterba (ed.), Tax Policy and the Economy, vol. 7, (Cambridge: The MIT Press, 1993), pp. 1-35. 

Another recent study examined the post-1986 growth of research expenditures by 40 U.S.-based 

multinationals and found price elasticities between 1.2 and 1.8. However, including an additional 76 

firms, that had initially been excluded because they had been involved in merger activity, the estimated 

elasticities fell by half. See, James R. Hines, Jr., “On the Sensitivity of R&D to Delicate Tax Changes: 

The Behavior of U.S. Multinationals in the 1980s” in Alberto Giovannini, R. Glenn Hubbard, and Joel 

Slemrod (eds.), Studies in International Taxation, (Chicago: University of Chicago Press 1993). Also see 

M. Ishaq Nadiri and Theofanis P. Mamuneas, “R&D Tax Incentives and Manufacturing-Sector R&D 

Expenditures,” in James M. Poterba, editor, Borderline Case: International Tax Policy, Corporate 

Research and Development, and Investment, (Washington, D.C.: National Academy Press), 1997. While 

their study concludes that one dollar of research tax credit produces 95 cents of research, they note that 

time series empirical work is clouded by poor measures of the price deflators used to convert nominal 

research expenditures to real expenditures. 

Other research suggests that many of the elasticity studies may overstate the efficiency of 

subsidies to research. Most R&D spending is for wages and the supply of qualified scientists is small, 

particularly in the short run. Subsidies may raise the wages of scientists, and hence research spending, 

without increasing actual research. See Austan Goolsbee, “Does Government R&D Policy Mainly 

Benefit Scientists and Engineers?” American Economic Review, vol. 88, May, 1998, pp. 298-302. 

44 Hall and Van Reenen, “How effective are fiscal incentives for R&D? A review of the 

evidence,” p. 463. 
33 

Other policy issues related to the research and experimentation credit

Perhaps the greatest criticism of the research and experimentation tax credit among 

taxpayers regards its temporary nature. Research projects frequently span years. If a taxpayer 

considers an incremental research project, the lack of certainty regarding the availability of 

future credits increases the financial risk of the expenditure. A credit of longer duration may 

more successfully induce additional research than would a temporary credit, even if the 

temporary credit is periodically renewed. 

An incremental credit does not provide an incentive for all firms undertaking qualified 

research expenditures. Many firms have current-year qualified expenditures below the base 

amount. These firms receive no tax credit and have an effective rate of credit of zero. Although 

there is no revenue cost associated with firms with qualified expenditures below base, there may 

be a distortion in the allocation of resources as a result of these uneven incentives. 

If a firm has no current tax liability, or if the firm is subject to the alternative minimum 

tax (“AMT”) or the general business credit limitation, the research credit must be carried forward 

for use against future-year tax liabilities. The inability to use a tax credit immediately reduces its 

present value according to the length of time between when it actually is earned and the time it 

actually is used to reduce tax liability.45 

Under present law, firms with research expenditures substantially in excess of their base 

amount may be subject to the 50-percent base amount limitation. In general, although these 

firms receive the largest amount of credit when measured as a percentage of their total qualified 

research expenses, their marginal effective rate of credit is exactly one half of the statutory credit 

rate of 20 percent (i.e., firms subject to the base limitation effectively are governed by a 10-

percent credit rate). 

Although the statutory rate of the research credit is currently 20 percent, it is likely that 

the average marginal effective rate may be substantially below 20 percent. Reasonable 

assumptions about the frequency that firms are subject to various limitations discussed above 

yield estimates of an average effective rate of credit between 25 and 40 percent below the 

statutory rate, i.e., between 12 and 15 percent.46 

Since sales growth over a long time frame will rarely track research growth, it can be 

expected that over time each firm’s base will drift from the firm’s actual current qualified 

research expenditures. Therefore, increasingly over time there will be a larger number of firms 

either substantially above or below their calculated base. This could gradually create an 

undesirable situation where many firms receive no credit and have no reasonable prospect of 

 45 As with any tax credit that is carried forward, its full incentive effect could be restored, absent 

other limitations, by allowing the credit to accumulate interest that is paid by the Treasury to the taxpayer 

when the credit ultimately is utilized. 

46 For a more complete discussion of this point see Joint Committee on Taxation, Description 

and Analysis of Tax Provisions Expiring in 1992 (JCS-2-92), January 27, 1992, pp. 65-66. 
34 

ever receiving a credit, while other firms receive large credits (despite the 50-percent base 

amount limitation). Thus, over time, it can be expected that, for those firms eligible for the 

credit, the average marginal effective rate of credit will decline while the revenue cost to the 

Federal Government increases. 

Complexity and the research tax credit

Administrative and compliance burdens also result from the present-law research tax 

credit. The General Accounting Office (“GAO”) has testified that the research tax credit is 

difficult for the IRS to administer. The GAO reported that the IRS states that it is required to 

make difficult technical judgments in audits concerning whether research was directed to 

produce truly innovative products or processes. While the IRS employs engineers in such audits, 

the companies engaged in the research typically employ personnel with greater technical 

expertise and, as would be expected, personnel with greater expertise regarding the intended 

application of the specific research conducted by the company under audit. Such audits create a 

burden for both the IRS and taxpayers. The credit generally requires taxpayers to maintain 

records more detailed than those necessary to support the deduction of research expenses under 

section 174.47 An executive in a large technology company has identified the research credit as 

one of the most significant areas of complexity for his firm. He summarizes the problem as 

follows. 

Tax incentives such as the R&D tax credit ... typically pose compliance 

challenges, because they incorporate tax-only concepts that may be only 

tenuously linked to financial accounting principles or to the classifications used 

by the company’s operational units. ... [I]s what the company calls “research and 

development” the same as the “qualified research” eligible for the R&D tax credit 

under I.R.C. Section 41? The extent of any deviation in those terms is in large 

part the measure of the compliance costs associated with the tax credit.48

2. Work opportunity tax credit 

Present Law

Targeted groups eligible for the credit

The work opportunity tax credit is available on an elective basis for employers hiring 

individuals from one or more of eight targeted groups. The eight targeted groups are: (1) certain 

families eligible to receive benefits under the Temporary Assistance for Needy Families 

 47 Natwar M. Gandhi, Associate Director Tax Policy and Administration Issues, General 

Government Division, U.S. General Accounting Office, “Testimony before the Subcommittee on 

Taxation and Internal Revenue Service Oversight,” Committee on Finance, United States Senate, April 3, 

1995. 

48 David R. Seltzer, “Federal Income Tax Compliance Costs: A Case Study of Hewlett-Packard 

Company,” National Tax Journal, vol. 50, September 1997, pp. 487-493. 
35 

Program; (2) high-risk youth; (3) qualified ex-felons; (4) vocational rehabilitation referrals; 

(5) qualified summer youth employees; (6) qualified veterans; (7) families receiving food 

stamps; and (8) persons receiving certain Supplemental Security Income (“SSI”) benefits. 

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

under State or Federal law; (2) being a member of an economically disadvantaged family; and 

(3) having a hiring date within one year of release from prison or conviction. 

Qualified wages

Generally, qualified wages are defined as cash wages paid by the employer to a member 

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

Calculation of the credit

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

qualified first-year wages. Generally, qualified first-year wages are qualified wages (not in 

excess of $6,000) attributable to service rendered by a member of a targeted group during the 

one-year period beginning with the day the individual began work for the employer. Therefore, 

the maximum credit per employee is $2,400 (40 percent of the first $6,000 of qualified first-year 

wages). With respect to qualified summer youth employees, the maximum credit is $1,200 (40 

percent of the first $3,000 of qualified first-year wages). 

Minimum employment period

No credit is allowed for qualified wages paid to employees who work less than 120 hours 

in the first year of employment. 

Coordination of the work opportunity tax credit and the welfare-to-work tax credit

An employer cannot claim the work opportunity tax credit with respect to wages of any 

employee for which the employer claims the welfare-to-work tax credit. 

Other rules

The work opportunity tax credit is not allowed for wages paid to a relative or dependent 

of the taxpayer. Similarly, wages paid to replacement workers during a strike or lockout are not 

eligible for the work opportunity tax credit. Wages paid to any employee during any period for 

which the employer received on-the-job training program payments with respect to that 

employee are not eligible for the work opportunity tax credit. The work opportunity tax credit 

generally is not allowed for wages paid to individuals who had previously been employed by the 

employer. In addition, many other technical rules apply. 

Expiration date

The work opportunity tax credit is effective for wages paid or incurred to a qualified 

individual who begins work for an employer before January 1, 2006. 
36 

Legislative History

The work opportunity tax credit was enacted in the Small Business Job Protection Act of 

1996, to replace the targeted jobs tax credit.49 Initially, the work opportunity tax credit was 

available only for wages paid or incurred to qualified individuals who began work for an 

employer after September 30, 1996, and before October 1, 1997. The Taxpayer Relief Act of 

1997 (“TRA 1997”) extended the credit for nine months, through June 30, 1998. TRA 1997 also 

expanded the Aid to Families with Dependent Children (“AFDC”) category,50 extended the 

credit to certain Supplemental Security Income beneficiaries, and modified the minimum 

employment period and credit percentages. The Tax and Trade Relief Extension Act of 1998 

extended the credit for one year (through June 30, 1999). The Tax Relief Extension Act of 1999 

clarified the definition of first year of employment for credit purposes and extended the credit for 

30 months (through December 31, 2001). The Job Creation and Worker Assistance Act of 2002 

extended the credit for two years (through December 31, 2003). The Working Families Tax 

Relief Act of 2004 extended the credit for two years (through December 31, 2005). 

President’s Budget Proposal

In general

The President’s budget proposal combines the work opportunity and welfare-to-work tax 

credits and extends the combined credit for one year. The welfare-to-work tax credit is discussed 

in II.A.4., below. 

Targeted groups eligible for the combined credit

The combined credit is available on an elective basis for employers hiring individuals 

from one or more of all nine targeted groups. The nine targeted groups are the present-law eight 

groups with the addition of the welfare-to-work credit/long-term family assistance recipient as 

the ninth targeted group. 

The proposal repeals the requirement that a qualified ex-felon be an individual certified 

as a member of an economically disadvantaged family. 

Qualified wages

Qualified first-year wages for the eight work opportunity tax credit categories remain 

capped at $6,000 ($3,000 for qualified summer youth employees). No credit is allowed for 

second-year wages. In the case of long-term family assistance recipients, the cap is $10,000 for 

 49 The targeted jobs tax credit was initially enacted in 1978 as a substitute for the new jobs credit 

which was available in 1977 and 1978. 

50 The AFDC program was the predecessor to the Temporary Assistance to Needy Families 

program 
37 

both qualified first-year wages and qualified second-year wages. For all targeted groups, the 

employer’s deduction for wages is reduced by the amount of the credit. 

Calculation of the credit

First-year wages.–For the eight work opportunity tax credit categories, the credit equals 

40 percent (25 percent for employment of 400 hours or less) of qualified first-year wages. 

Generally, qualified first-year wages are qualified wages (not in excess of $6,000) attributable to 

service rendered by a member of a targeted group during the one-year period beginning with the 

day the individual began work for the employer. Therefore, the maximum credit per employee 

for members of any of the eight work opportunity tax credit targeted groups generally is $2,400 

(40 percent of the first $6,000 of qualified first-year wages). With respect to qualified summer 

youth employees, the maximum credit remains $1,200 (40 percent of the first $3,000 of qualified 

first-year wages). For the welfare-to-work/long-term family assistance recipients, the maximum 

credit equals $4,000 per employee (40 percent of $10,000 of wages). 

Second-year wages.–In the case of long-term family assistance recipients the maximum 

credit is $5,000 (50 percent of the first $10,000 of qualified second-year wages). 

Minimum employment period

No credit is allowed for qualified wages paid to employees who work less than 120 hours 

in the first year of employment. 

Coordination of the work opportunity tax credit and the welfare-to-work tax credit

Coordination is no longer necessary once the two credits are combined. 

Effective date

The proposal is effective for wages paid or incurred to a qualified individual who begins 

work for an employer after December 31, 2005, and before January 1, 2007. 

Analysis

Overview of policy issues

The WOTC is intended to increase the employment and earnings of targeted group 

members. The credit is made available to employers as an incentive to hire members of the 

targeted groups. To the extent the value of the credit is passed on from employers to employees, 

the wages of targeted group employees will be higher than they would be in the absence of the 

credit.51 

 51 For individuals with productivity to employers lower than the minimum wage, the credit may 

result in these individuals being hired and paid the minimum wage. For these cases, it would be clear that 
38 

The rationale for the WOTC is that employers will not hire certain individuals without a 

subsidy, either because the individuals are stigmatized (e.g., convicted felons) or the current 

productivity of the individuals is below the prevailing wage rate. Where particular groups of 

individuals suffer reduced evaluations of work potential due to membership in one of the 

targeted groups, the credit may provide employers with a monetary offset for the lower perceived 

work potential. In these cases, employers may be encouraged to hire individuals from the 

targeted groups, and then make an evaluation of the individual’s work potential in the context of 

the work environment, rather than from the job application. Where the current productivity of 

individuals is below the prevailing wage rate, on-the-job-training may provide individuals with 

skills that will enhance their productivity. In these situations, the WOTC provides employers 

with a monetary incentive to bear the costs of training members of targeted groups and providing 

them with job-related skills which may increase the chances of these individuals being hired in 

unsubsidized jobs. Both situations encourage employment of members of the targeted groups, 

and may act to increase wages for those hired as a result of the credit. 

As discussed below, the evidence is mixed on whether the rationales for the credit are 

supported by economic data. The information presented is intended to provide a structured way 

to determine if employers and employees respond to the existence of the credit in the desired 

manner. 

Efficiency of the credit

The credit provides employers with a subsidy for hiring members of targeted groups. For 

example, assume that a worker eligible for the credit is paid an hourly wage of w and works 

2,000 hours during the year. The worker is eligible for the full credit (40 percent of the first 

$6,000 of wages), and the firm will receive a $2,400 credit against its income taxes and reduce 

its deduction for wages by $2,400. Assuming the firm faces the full 35-percent corporate income 

tax rate, the cost of hiring the credit-eligible worker is lower than the cost of hiring a creditineligible worker for 2,000 hours at the same hourly wage w by $2,400 (1-.35) = $1,560.52 This 

$1,560 amount would be constant for all workers unless the wage (w) changed in response to 

whether or not the individual was a member of a targeted group. If the wage rate does not 

change in response to credit eligibility, the WOTC subsidy is larger in percentage terms for 

lower wage workers. If w rises in response to the credit, it is uncertain how much of the subsidy 

remains with the employer, and therefore the size of the WOTC subsidy to employers is 

uncertain. 

To the extent the WOTC subsidy flows through to the workers eligible for the credit in 

the form of higher wages, the incentive for eligible individuals to enter the paid labor market 

may increase. Since many members of the targeted groups receive governmental assistance 

 

the credit resulted in the worker receiving a higher wage than would have been received in the absence of 

the credit (i.e., zero). 

52 The after-tax cost of hiring this credit eligible worker would be ((2,000)(w)-2,400)(1-.35) 

dollars. This example does not include the costs to the employer for payroll taxes (e.g., Social Security, 

Medicare and unemployment taxes) and any applicable fringe benefits. 
39 

(e.g., Temporary Assistance for Needy Families or food stamps), and these benefits are phased 

out as income increases, these individuals potentially face a very high marginal tax rate on 

additional earnings. Increased wages resulting from the WOTC may be viewed as a partial offset 

to these high marginal tax rates. In addition, it may be the case that even if the credit has little 

effect on observed wages, credit-eligible individuals may have increased earnings due to 

increased employment. 

The structure of the WOTC (the 40-percent credit rate for the first $6,000 of qualified 

wages) appears to lend itself to the potential of employers churning employees who are eligible 

for the credit. This could be accomplished by firing employees after they earn $6,000 in wages 

and replacing them with other WOTC-eligible employees. If training costs are high relative to 

the size of the credit, it may not be in the interest of an employer to churn such employees in 

order to maximize the amount of credit claimed. Empirical research in this area has not found an 

explicit connection between employee turnover and utilization of WOTC’s predecessor, the 

Targeted Jobs Tax Credit (“TJTC”).53 

Job creation

The number of jobs created by the WOTC is certainly less than the number of 

certifications of eligible workers. To the extent employers substitute WOTC-eligible individuals 

for other potential workers, there is no net increase in jobs created. This could be viewed as 

merely a shift in employment opportunities from one group to another. However, this 

substitution of credit-eligible workers for others may not be socially undesirable. For example, it 

might be considered an acceptable trade-off for a targeted group member to displace a secondary 

earner (e.g., a spouse or student working part-time) from a well-to-do family. 

In addition, windfall gains to employers or employees may accrue when the WOTC is 

received for workers that the firm would have hired even in the absence of the credit. When 

windfall gains are received, no additional employment has been generated by the credit. 

Empirical research on the employment gains from the TJTC has indicated that only a small 

portion of the TJTC-eligible population found employment because of the program. One study 

indicates that net new job creation was between five and 30 percent of the total certifications. 

This finding is consistent with some additional employment as a result of the TJTC program, but 

with considerable uncertainty as to the exact magnitude.54 

A necessary condition for the credit to be an effective employment incentive is that firms 

incorporate WOTC eligibility into their hiring decisions. This could be done by determining 

credit eligibility for each potential employee or by making a concerted effort to hire individuals 

from segments of the population likely to include members of targeted groups. Studies 

examining this issue through the TJTC found that some employers made such efforts, while 

 53 See, for example, Macro Systems, Inc., Final Report of the Effect of the Targeted Jobs Tax 

Credit Program on Employers, U.S. Department of Labor, 1986. 

54 Macro Systems, Inc., Impact Study of the Implementation and Use of the Targeted Jobs Tax 

Credit: Overview and Summary, U.S. Department of Labor, 1986. 
40 

other employers did little to determine eligibility for the TJTC prior to the decision to hire an 

individual.55 In these latter cases, the TJTC provided a cash benefit to the firm, without affecting 

the decision to hire a particular worker. 

Complexity issues

Extension of the WOTC for one year provides some continuity and simplifies tax 

planning during that period for taxpayers and practitioners. Some argue that a permanent 

extension will have a greater stabilizing effect on the tax law. They point out that temporary 

expirations, like the current one, not only complicate tax planning but also deter some taxpayers 

from participating in the program. Each time the expiration date for the provision approaches, 

taxpayers may be less likely to begin participation in the program. Any such effect would likely 

grow stronger as a result of program expirations, even when the program is retroactively 

extended.56 Others argue that allowing the credit to expire could eliminate a windfall benefit to 

certain taxpayers and reduce complexity in the Code. 

3. Welfare-to-Work tax credit 

Present Law

Targeted group eligible for the credit

The welfare-to-work tax credit is available on an elective basis to employers of qualified 

long-term family assistance recipients. Qualified long-term family assistance recipients are: 

(1) members of a family that has received family assistance for at least 18 consecutive months 

ending on the hiring date; (2) members of a family that has received such family assistance for a 

total of at least 18 months (whether or not consecutive) after August 5, 1997 (the date of 

enactment of the welfare-to-work tax credit) if they are hired within two years after the date that 

the 18-month total is reached; and (3) members of a family that is no longer eligible for family 

assistance because of either Federal or State time limits, if they are hired within two years after 

the Federal or State time limits made the family ineligible for family assistance. For these 

purposes, family assistance is assistance provided under the IV-A program of the Social Security 

Act (“Temporary Assistance for Needy Families”). 

Qualified wages

Qualified wages for purposes of the welfare-to-work tax credit are defined more broadly 

than for the work opportunity tax credit. Unlike the definition of wages for the work opportunity 

tax credit, which includes simply cash wages, the definition of wages for the welfare-to-work tax 

 55 For example, see U.S. General Accounting Office, Targeted Jobs Tax Credit: Employer 

Actions to Recruit, Hire, and Retain Eligible Workers Vary (GAO-HRD 91-33), February 1991. 

56 For example, the work opportunity tax credit, which had expired on January 1, 2004, was 

retroactively extended on October 4, 2004, by the Working Families Tax Relief Act of 2004 (Pub. L. No. 

108-311). 
41 

credit includes cash wages paid to an employee plus amounts paid by the employer for: 

(1) educational assistance excludable under a section 127 program; (2) health plan coverage for 

the employee, but not more than the applicable premium defined for purposes of the health care 

continuation rules under section 4980B(f)(4); and (3) dependent care assistance excludable under 

section 129. The employer’s deduction for wages is reduced by the amount of the credit. 

Calculation of the credit

The welfare-to-work tax credit is available on an elective basis to employers of qualified 

long-term family assistance recipients during the first two years of employment. The maximum 

credit is 35 percent of the first $10,000 of qualified first-year wages and 50 percent of the first 

$10,000 of qualified second-year wages. Qualified first-year wages are defined as qualified 

wages (not in excess of $10,000) attributable to service rendered by a member of the targeted 

group during the one-year period beginning with the day the individual began work for the 

employer. Qualified second-year wages are defined as qualified wages (not in excess of 

$10,000) attributable to service rendered by a member of the targeted group during the one-year 

period beginning immediately after the first year of that individual’s employment for the 

employer. The maximum credit is $8,500 per qualified employee. 

Minimum employment period

No credit is allowed for qualified wages paid to a member of the targeted group unless 

they work at least 400 hours or 180 days in the first year of employment. 

Coordination of the work opportunity tax credit and the welfare-to-work tax credit

An employer cannot claim the work opportunity tax credit with respect to wages of any 

employee for which the employer claims the welfare-to-work tax credit. 

Other rules

The welfare-to-work tax credit incorporates directly or by reference many of the rules 

applicable to the work opportunity tax credit (see item II.A.2., above). 

Expiration date

The welfare-to-work tax credit is effective for wages paid or incurred to a qualified 

individual who begins work for an employer before January 1, 2006. 

Legislative History

The welfare-to-work tax credit was enacted in the Taxpayer Relief Act of 1997. Initially 

the credit was available only for wages paid or incurred to qualified individuals who began work 

for an employer on or after January 1, 1998, and before May 1, 1999. The Tax and Trade Relief 

Extension Act of 1998 extended the credit for two months (through June 30, 1999). The Tax 

Relief Extension Act of 1999 extended the credit for 30 months (through December 31, 2001). 

The Job Creation and Worker Assistance Act of 2002, extended the credit for two years (through 
42 

December 31, 2003). The Working Families Tax Relief Act of 2004 extended the credit for two 

years (through December 31, 2005). 

President’s Budget Proposal

A discussion of the President’s budget proposal to combine the work opportunity tax 

credit and welfare-to-work tax credit and extend the combined credit for one year is included in 

II.A.2., above. 

Analysis

Policy issues

Proponents of the credit argue that extension of the welfare-to-work tax credit encourages 

employers to hire, train, and provide certain benefits and more permanent employment to longerterm welfare recipients. Opponents argue that tax credits to employers for hiring certain classes 

of individuals do not increase overall employment and may disadvantage other deserving job 

applicants. There are also concerns about the efficiency of tax credits as an incentive to potential 

employees to enter the job market, as well as an incentive for employers to retain such 

employees after they no longer qualify for the tax credit. It is argued that basing of the credit on 

only the first two years of a person's employment motivates employers to replace an employee 

whose wages no longer qualify for the tax credit with another employee whose wages do qualify. 

For a more detailed discussion of these issues, refer to the analysis section of the extension of the 

work opportunity tax credit, immediately above (see item II.A.2., above). 

Complexity issues

The expiration of the credit has complicated tax planning for affected taxpayers by 

creating uncertainty. The temporary extension may reduce or eliminate that uncertainty for 

some time. Some argue, however, either the permanent expiration of the credit or the permanent 

extension of the credit would provide reduced uncertainty permanently. Preference between 

these latter two alternatives would correlate to perceived efficacy of the welfare-to-work credit 

generally. 

If both the welfare-to-work credit and work opportunity credit were extended, then 

simplification could be achieved by combining the two credits. Such a combination would 

eliminate dual certification and filing requirements. It would also reduce tax law complexity by 

eliminating the need for two separate but similar sets of rules for the two credits. 

4. Indian employment tax credit 

Present Law

In general, a credit against income tax liability is allowed to employers for the first 

$20,000 of qualified wages and qualified employee health insurance costs paid or incurred by the 
43 

employer with respect to certain employees.57 The credit is equal to 20 percent of the excess of 

eligible employee qualified wages and health insurance costs during the current year over the 

amount of such wages and costs incurred by the employer during 1993. The credit is an 

incremental credit, such that an employer’s current-year qualified wages and qualified employee 

health insurance costs (up to $20,000 per employee) are eligible for the credit only to the extent 

that the sum of such costs exceeds the sum of comparable costs paid during 1993. No deduction 

is allowed for the portion of the wages equal to the amount of the credit. 

Qualified wages means wages paid or incurred by an employer for services performed by 

a qualified employee. A qualified employee means any employee who is an enrolled member of 

an Indian tribe or the spouse of an enrolled member of an Indian tribe, who performs 

substantially all of the services within an Indian reservation, and whose principal place of abode 

while performing such services is on or near the reservation in which the services are performed. 

An employee is not treated as a qualified employee for any taxable year of the employer 

if the total amount of wages paid or incurred by the employer with respect to such employee 

during the taxable year exceeds an amount determined at an annual rate of $30,000 (which after 

adjusted for inflation after 1993 is currently $35,000). In addition, an employee will not be 

treated as a qualified employee under certain specific circumstances, such as where the employee 

is related to the employer (in the case of an individual employer) or to one of the employer’s 

shareholders, partners, or grantors. Similarly, an employee will not be treated as a qualified 

employee where the employee has more than a 5 percent ownership interest in the employer. 

Finally, an employee will not be considered a qualified employee to the extent the employee’s 

services relate to gaming activities or are performed in a building housing such activities.58 

The wage credit is available for wages paid or incurred on or after January 1, 1994, in 

taxable years that begin before January 1, 2006. 

Legislative History

The provision was added to the Code by the Omnibus Budget Reconciliation Act of 1993 

(Pub. L. No. 103-66). The credit was to expire on December 31, 2003. It has been extended 

twice. First, the Job Creation and Workers Assistance Act of 2002 (Pub. L. No. 107-147), 

extended the credit an additional year, through December 31, 2004. Subsequently, the Working 

Families Tax Relief Act of 2004 (Pub. L. No. 108-311), extended the credit through December 

31, 2005. 

President’s Budget Proposal

No proposal. 

 57 Sec. 45A. 

58 Sec. 45A(c)(5). 
44 

Analysis

The Indian employment credit was created to encourage businesses to employ members 

of Indian tribes by establishing or expanding nongaming operations on Indian reservations. 

Labor-intensive businesses employing a significant number of qualified employees could find 

the credit valuable. However, some may argue that the incremental nature of the credit (based on 

amounts from 1993) adds to its complexity. In 2001, the most recent year for which data is 

available, taxpayers claimed approximately $54 million in credits under this provision. 

Like the Work Opportunity Tax Credit (“WOTC”) and Welfare to Work (“WTW”) 

credits, the Indian employment credit serves a similar purpose in encouraging the employment of 

a targeted group, however, there are significant differences in the credits. The Indian 

employment credit is an incremental credit (based on the excess of eligible costs over amounts 

incurred in 1993), while WOTC and WTW are not. The Indian employment credit is location 

dependent (e.g., substantially all of the services must be performed on an Indian reservation), 

while WOTC and WTW do not require a specific location for the performance of services. In 

addition, the WOTC and WTW credits are temporary credits for employers to take with regard to 

an individual. For example, the WTW incentive is worth up to $8,500 per qualified employee 

over a period of two years. The WOTC incentive is worth up to $2,400 per qualified employee 

for the employee’s first year of wages only. The Indian employment credit incentive may be 

taken annually, up to $4,000 per qualified employee, until the authority for the credit expires. 

5. Accelerated depreciation for business property on an Indian Reservation 

Present Law

With respect to certain property used in connection with the conduct of a trade or 

business within an Indian reservation, depreciation deductions under section 168(j) are 

determined using the following recovery periods: 

3-year property................................... 2 years 

5-year property................................... 3 years 

7-year property................................... 4 years 

10-year property................................. 6 years 

15-year property................................. 9 years 

20-year property................................. 12 years 

Nonresidential real property .............. 22 years 

“Qualified Indian reservation property” eligible for accelerated depreciation includes 

property which is (1) used by the taxpayer predominantly in the active conduct of a trade or 

business within an Indian reservation, (2) not used or located outside the reservation on a regular 

basis, (3) not acquired (directly or indirectly) by the taxpayer from a person who is related to the 

taxpayer (within the meaning of section 465(b)(3)(C)), and (4) described in the recovery-period 

table above. In addition, property is not “qualified Indian reservation property” if it is placed in 

service for purposes of conducting gaming activities. Certain “qualified infrastructure property” 

may be eligible for the accelerated depreciation even if located outside an Indian reservation, 

provided that the purpose of such property is to connect with qualified infrastructure property 
45 

located within the reservation (e.g., roads, power lines, water systems, railroad spurs, and 

communications facilities). 

An “Indian reservation” means a reservation as defined in section 3(d) of the Indian 

Financing Act of 1974 or section 4(1) of the Indian Child Welfare Act of 1978. For purposes of 

the preceding sentence, section 3(d) is applied by treating “former Indian reservations in 

Oklahoma” as including only lands that are (1) within the jurisdictional area of an Oklahoma 

Indian tribe as determined by the Secretary of the Interior, and (2) recognized by such Secretary 

as an area eligible for trust land status under 25 C.F.R. Part 151 (as in effect on August 5, 1997). 

The accelerated depreciation deduction for Indian reservations allowed for regular tax 

purposes is also allowed for purposes of the alternative minimum tax. The accelerated 

depreciation deduction is available with respect to property placed in service on or after 

January 1, 1994, and before January 1, 2006. 

Legislative History

Accelerated depreciation for Indian reservations was added to the Code by the Omnibus 

Budget Reconciliation Act of 1993 (Pub. L. No. 103-66). The provision was to expire on 

December 31, 2003. It has been extended twice. First, the Job Creation and Workers Assistance 

Act of 2002 (Pub. L. No. 107-47), extended the provision for property placed in service through 

December 31, 2004. Subsequently, the Working Families Tax Relief Act of 2004 (Pub. L. No. 

108-311), extended the provision for property placed in service through December 31, 2005. 

The Taxpayer Relief Act of 1997 (Pub. L. No. 105-34) clarified the definition of Indian 

reservation. Section 3(d) of the Indian Financing Act of 1974 includes not only officially 

designated Indian reservations and public domain Indian allotments, but also all “former Indian 

reservations in Oklahoma,” which covers most of the State of Oklahoma even though parts of 

such “former Indian reservations” may no longer have a significant nexus to an Indian tribe. The 

Taxpayer Relief Act of 1997 added the present law requirements for interpreting section 3(d) of 

the Indian Financing Act of 1997 as it relates to former Indian reservations in Oklahoma. 

President’s Budget Proposal

No proposal. 

Analysis

The provision was intended to encourage businesses to establish or expand nongaming 

operations on Indian reservations. By permitting accelerated depreciation for qualified property, 

the provision creates a tax incentive for such operations. The accelerated deprecation for 

qualified property creates a tax incentive for such operations by reducing the present-value aftertax cost of investing in qualifying property, which in turn increases the return on investments in 

qualified property. The shorter recovery periods can have the effect of substantially decreasing 

the tax liability of a business. However, the degree of benefit for each business varies based on 

the particular nature and situation of the business. For businesses engaged in activities that rely 

heavily on large depreciable assets, such as those involved in power generation, the shorter 

recovery periods could be very attractive. 
46 

Some might argue that the location of business property on a reservation does not ensure 

that significant benefits will flow through to the tribal members living on such reservation. 

Indian ownership of the business property is not required. In addition, over two-thirds of the 

land in Oklahoma meets the definition of Indian reservation and qualifies for accelerated 

depreciation. Oklahoma currently has no current “Indian reservations” but it does have a very 

high Native American population.59

No data are currently available to measure the effectiveness of this provision in spurring 

economic development on Indian reservations. 

6. 15-year straight-line cost recovery for qualified leasehold improvements and qualified 

restaurant improvements 

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-inservice conventions, and depreciation methods to the cost of various types of depreciable 

property (sec. 168). 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.60 This rule applies regardless of whether the lessor or the 

 59 Senate Staff, Indian Land Tax Credit Issues: Federal Property and Employment Tax Benefits 

for Indian Lands (October 1997) www.lsb.state.ok.us/senate/publications/issue_papers/IPIndianTax.html. 

60 Sec. 168(i)(8). The Tax Reform Act of 1986 modified the Accelerated Cost Recovery System 

(“ACRS”) to institute MACRS. Prior to the adoption of ACRS by the Economic Recovery Tax Act of 

1981, taxpayers were allowed to depreciate the various components of a building as separate assets with 

separate useful lives. The use of component depreciation was repealed upon the adoption of ACRS. The 

Tax Reform Act of 1986 also denied the use of component depreciation under MACRS. 
47 

lessee places the leasehold improvements in service.61 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.62 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, 2006. Qualified leasehold 

improvement property is recovered using the straight-line method. Leasehold improvements 

placed in service in 2006 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 improvement 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, 2006. For purposes of the provision, 

qualified restaurant property means any improvement to a building if such improvement is 

 61 Former sections 168(f)(6) and 178 provided that, in certain circumstances, a lessee could 

recover the cost of leasehold improvements made over the remaining term of the lease. The Tax Reform 

Act of 1986 repealed these provisions. 

62 Secs. 168(b)(3), (c), (d)(2), and (i)(6). If the improvement is characterized as tangible personal 

property, ACRS or MACRS depreciation is calculated using the shorter recovery periods, accelerated 

methods, and conventions applicable to such property. The determination of whether improvements are 

characterized as tangible personal property or as nonresidential real property often depends on whether or 

not the improvements constitute a “structural component” of a building (as defined by Treas. Reg. sec. 

1.48-1(e)(1)). See, e.g., Metro National Corp v. Commissioner, 52 TCM (CCH) 1440 (1987); King Radio 

Corp Inc. v. U.S., 486 F.2d 1091 (10th Cir. 1973); Mallinckrodt, Inc. v. Commissioner, 778 F.2d 402 (8th 

Cir. 1985) (with respect to various leasehold improvements). 
48 

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. 

Legislative History

The 15-year straight-line cost recovery for qualified leasehold improvements and 

qualified restaurant property was enacted as part of the American Jobs Creation Act of 2004. 

Prior to that Act, such improvements and property were generally subject to a 39-year cost 

recovery period. 

Analysis

The reduction of the cost recovery period for qualified leasehold improvements and 

qualified restaurant property from 39 years to 15 years was intended to more accurately reflect 

the true economic useful life of such property.63 Conforming the recovery period of a property 

class as closely as possible to the economic life of the property results in a more accurate 

measure of economic income derived from such property. Additionally, to the extent that the 

depreciation schedules of other property are designed to accurately measure economic 

depreciation, a depreciation schedule for an asset class that deviates from economic depreciation 

may distort investment decisions. If the depreciation schedule provides for faster cost recovery 

than economic depreciation, an incentive is created to invest in such assets relative to other 

assets. Similarly, if the depreciation schedule provides for slower cost recovery than economic 

depreciation, a disincentive to invest in such assets is created. If the depreciation schedules 

uniformly match economic depreciation, the depreciation system will be generally neutral as to 

the choice of investment across asset classes. Such neutrality promotes economically efficient 

investment choices by helping to insure that investments with the highest post-tax return (the 

return that the investor cares about) are also those with the highest pre-tax return (the measure of 

the value of the investment to society). When MACRS was enacted in 1986, neutrality was cited 

as one of the reasons for extending the recovery period for real property (and, by extension, 

leasehold improvements). At that time, the Congress noted that a neutral tax system allows the 

economy to most quickly adapt to changing economic needs.64

There is some economic evidence that the present-law 39-year recovery period leads to 

higher effective tax rates on investments in commercial real estate than in other investments.65 

This study does not estimate the “correct” economic life, but suggests that 39 years may be too 

long. However, even admitting that a 39-year recovery period is too long, it would not 

necessarily follow that a reduction in the recovery period for certain investments in commercial 

 63 H.R. Rep. No. 108-548, at 122 (2004). 

64 S. Rep. No. 99-313, at 96 (1986). 

65 Jane G. Gravelle, “Whither Tax Depreciation?” National Tax Journal, vol. 54, September 

2001. 
49 

real estate creates an overall economic improvement. This is because neutrality has not been 

attained as distortions between different types of investment in commercial real estate as well as 

distortions between investments in commercial real estate and other investments remain. 

In addition to neutrality, depreciation policy objectives include reducing complexity and 

stimulating investment. While permitting depreciation of individual assets over their actual 

economic lives would be consistent with the goal of neutrality, determination of each asset’s 

individual economic life would be complex and potentially contentious between taxpayers and 

the IRS. For this reason, the MACRS system generally provides a small number of depreciation 

classes and relatively short recovery periods.66 Depreciation schedules may also be accelerated 

relative to economic depreciation for the purpose of stimulating investment. However, if the 

acceleration is not provided uniformly across asset classes, the depreciation system would not be 

neutral in the choice of investment. 

When weighing the various policy objectives in determining the appropriate recovery 

period for a specific asset class, it could be argued that it is preferable to err on the side of a 

recovery period which is shorter than the estimated economic life of property within the class. 

Grouping assets together into classes for purposes of simplicity necessitates that not all assets 

will have recovery periods equal to their estimated economic lives. If accelerated depreciation 

methods are an appropriate policy to stimulate investment, then a recovery period longer than 

economic life would tend to counteract the policy justification for accelerated methods. Thus, it 

may be preferable for cost recovery periods to trend toward the shorter end of the range of 

economic lives within a property class. A recovery period which is too short results in improper 

measure of economic income, but a recovery period longer than economic life results in both an 

improper measure of economic income and a disincentive to investment. In addition, a shorter 

recovery period may compensate for the fact that depreciation deductions are based on nominal 

values and therefore become less valuable over time in an inflationary environment. 

With respect to leasehold improvements made by lessees, it could be argued that 

permitting depreciation over the remaining lease term (including any expected renewal periods) 

would be a more appropriate policy than a 15-year cost recovery period because the cost of the 

investment would be recovered over the life of the investment. However, a uniform recovery 

period for all similar property (regardless of lease term) may be desirable for purposes of 

simplicity and administrability, especially in light of the difficulties in anticipating whether a 

lease is likely to be renewed. Although lease terms differ, it is possible that lease terms for 

commercial real estate typically are shorter than the 39-year recovery period which applies under 

present law to leasehold improvements placed in service after December 31, 2005. Thus, the 15-

year recovery period may be more reflective of average lease terms. 

While average remaining lease term may be an appropriate factor in determining the 

recovery period for leasehold improvements placed in service by lessees, it may not be relevant 

with respect to leasehold improvements by lessors, who will continue to own the improvements 

 66 Id. at 95. 
50 

after the current lease has expired. Thus, it is unclear why leasehold improvements placed in 

service by the lessor should be subject to the special 15-year recovery period. 

With respect to restaurant property, it could be argued that restaurant improvements 

should be treated similarly to improvements to all other retail establishments. Proponents of the 

shorter life for restaurant property argue that restaurants are more specialized structures than 

other commercial buildings, and therefore they require more frequent updates, shortening the 

economic useful life of prior improvements. Proponents also argue that restaurants experience 

more traffic and remain open for longer hours than most retail properties, resulting in more rapid 

deterioration of restaurant property than other commercial property. However, some restaurants 

are open only at common meal times, and others experience periods of reduced usage (and foot 

traffic) in between common meal times. Thus, it is unclear whether restaurants experience 

greater foot traffic than other retail establishments. Moreover, it is also unclear whether a 

significant relationship exists between foot traffic and the rate of deterioration or obsolescence of 

commercial property. 

Assigning a shorter recovery period to specific types of improvements which meet certain 

criteria is a source of complexity in the tax code which some may view as unjustified. 

Moreover, it is not clear why certain improvements, but not others, qualify for the special 

recovery period. Current-law distinctions regarding the type of improvements that qualify for 

the 15-year recovery period potentially raise difficult compliance and enforcement issues for the 

taxpayer and the IRS. 

Overall, the provision may promote neutrality between investment in qualifying property 

and other property classes by more closely approximating the economic life of qualifying 

property, but the provision may also disturb the existing neutrality between investment in 

qualifying property and similar nonqualifying property (e.g., non-leasehold retail property 

improvements) to the extent that the that the similar nonqualifying property has a similar 

economic life. In addition, the provision encourages investment in qualifying property, but it 

adds complexity by creating an additional property class. In considering whether an extension 

of the 15-year cost recovery period for leasehold improvements and restaurant property is 

appropriate, the unique characteristics of such property should be considered within the context 

of the overall policy goals of the depreciation system, including neutrality, simplicity, and 

investment incentives. 
51 

B. Energy and Environment 

1. Credit for electricity produced from certain renewable resources 

Present Law 

In general

An income tax credit is allowed for the production of electricity from qualified facilities 

(sec. 45). Qualified facilities comprise wind energy facilities, “closed-loop” biomass facilities, 

open-loop biomass (including agricultural livestock waste nutrients) facilities, geothermal energy 

facilities, solar energy facilities, small irrigation power facilities, landfill gas facilities, and trash 

combustion facilities. In addition, an income tax credit is allowed for the production of refined 

coal. 

Credit amounts and credit period

In general

The base amount of the credit is 1.5 cents per kilowatt hour (indexed for inflation) of 

electricity produced. The amount of the credit was 1.8 cents per kilowatt hour for 2004. A 

taxpayer may claim credit for the 10-year period commencing with the date the qualified facility 

is placed in service. The credit is reduced for grants, tax-exempt bonds, subsidized energy 

financing, and other credits. The amount of credit a taxpayer may claim is phased out as the 

market price of electricity (refined coal in the case of refined coal) exceeds certain threshold 

levels. 

Reduced credit amounts and credit periods

In the case of open-loop biomass facilities (including agricultural livestock waste nutrient 

facilities), geothermal energy facilities, solar energy facilities, small irrigation power facilities, 

landfill gas facilities, and trash combustion facilities, the 10-year credit period is reduced to five 

years commencing on the date the facility is placed in service. In general, for eligible preexisting facilities and other facilities placed in service prior to January 1, 2005, the credit period 

commences on January 1, 2005. In the case of a closed-loop biomass facility modified to co-fire 

with coal, to co-fire with other biomass, or to co-fire with coal and other biomass, the credit 

period begins no earlier than October 22, 2004. 

In the case of open-loop biomass facilities (including agricultural livestock waste nutrient 

facilities), small irrigation power facilities, landfill gas facilities, and trash combustion facilities, 

the otherwise allowable credit amount is 0.75 cent per kilowatt hour, indexed for inflation 

measured after 1992. 

Credit applicable to refined coal

The amount of the credit for refined coal is $4.375 per ton (also indexed for inflation 

after 1992 and would have equaled $5.350 per ton for 2004). 
52 

Other limitations on credit claimants and credit amounts

In general, in order to claim the credit, a taxpayer must own the qualified facility and sell 

the electricity produced by the facility (or refined coal in the case of refined coal) to an unrelated 

party. A lessee or operator may claim the credit in lieu of the owner of the qualifying facility in 

the case of qualifying open-loop biomass facilities originally placed in service on or before the 

date of enactment and in the case of a closed-loop biomass facilities modified to co-fire with 

coal, to co-fire with other biomass, or to co-fire with coal and other biomass. In the case of a 

poultry waste facility, the taxpayer may claim the credit as a lessee or operator of a facility 

owned by a governmental unit. 

For all qualifying facilities, other than closed-loop biomass facilities modified to co-fire 

with coal, to co-fire with other biomass, or to co-fire with coal and other biomass, the amount of 

credit a taxpayer may claim is reduced by reason of grants, tax-exempt bonds, subsidized energy 

financing, and other credits, but the reduction cannot exceed 50 percent of the otherwise 

allowable credit. In the case of closed-loop biomass facilities modified to co-fire with coal, to 

co-fire with other biomass, or to co-fire with coal and other biomass, there is no reduction in 

credit by reason of grants, tax-exempt bonds, subsidized energy financing, and other credits. 

The credit for electricity produced from renewable sources is a component of the general 

business credit (sec. 38(b)(8)). 

A taxpayer’s tentative minimum tax is treated as being zero for purposes of determining 

the tax liability limitation with respect to the section 45 credit for electricity produced from a 

facility (placed in service after October 22, 2004) during the first four years of production 

beginning on the date the facility is placed in service. 

Qualified facilities

Wind energy facility

A wind energy facility is a facility that uses wind to produce electricity. To be a qualified 

facility, a wind energy facility must be placed in service after December 31, 1993, and before 

January 1, 2006. 

Closed-loop biomass facility

A closed-loop biomass facility is a facility that uses any organic material from a plant 

which is planted exclusively for the purpose of being used at a qualifying facility to produce 

electricity. In addition, a facility can be a closed-loop biomass facility if it is a facility that is 

modified to use closed-loop biomass to co-fire with coal, with other biomass, or with both coal 

and other biomass, but only if the modification is approved under the Biomass Power for Rural 

Development Programs or is part of a pilot project of the Commodity Credit Corporation. 

To be a qualified facility, a closed-loop biomass facility must be placed in service after 

December 31, 1992, and before January 1, 2006. In the case of a facility using closed-loop 

biomass but also co-firing the closed-loop biomass with coal, other biomass, or coal and other 
53 

biomass, a qualified facility must be originally placed in service and modified to co-fire the 

closed-loop biomass at any time before January 1, 2006. 

Open-loop biomass (including agricultural livestock waste nutrients) facility

An open-loop biomass facility is a facility using open-loop biomass (including 

agricultural livestock waste nutrients) to produce electricity. Open-loop biomass is defined as 

any solid, nonhazardous, cellulosic waste material which is segregated from other waste 

materials and which is derived from any of forest-related resources, solid wood waste materials, 

or agricultural sources. Eligible forest-related resources are mill residues, other than spent 

chemicals from pulp manufacturing, precommercial thinnings, slash, and brush. Solid wood 

waste materials include waste pallets, crates, dunnage, manufacturing and construction wood 

wastes (other than pressure-treated, chemically-treated, or painted wood wastes), and landscape 

or right-of-way tree trimmings. Agricultural sources include orchard tree crops, vineyard, grain, 

legumes, sugar, and other crop by-products or residues. However, qualifying open-loop biomass 

does not include municipal solid waste (garbage), gas derived from biodegradation of solid 

waste, or paper that is commonly recycled. In addition, open-loop biomass does not include 

closed-loop biomass or any biomass burned in conjunction with fossil fuel (cofiring) beyond 

such fossil fuel required for start up and flame stabilization. 

Agricultural livestock waste nutrients are defined as agricultural livestock manure and 

litter, including bedding material for the disposition of manure. 

To be a qualified facility, an open-loop biomass facility must be placed in service after 

October 22, 2004 and before January 1, 2006, in the case of facility using agricultural livestock 

waste nutrients and must be placed in service at any time prior to January 1, 2006 in the case of a 

facility using other open-loop biomass. 

Geothermal facility

A geothermal facility is a facility that uses geothermal energy to produce electricity. 

Geothermal energy is energy derived from a geothermal deposit which is a geothermal reservoir 

consisting of natural heat which is stored in rocks or in an aqueous liquid or vapor (whether or 

not under pressure). To be a qualified facility, a geothermal facility must be placed in service 

after the date of enactment and before January 1, 2006. 

Solar facility

A solar facility is a facility that uses solar energy to produce electricity. To be a qualified 

facility, a solar facility must be placed in service after the date of enactment and before January 

1, 2006. 

Small irrigation facility

A small irrigation power facility is a facility that generates electric power through an 

irrigation system canal or ditch without any dam or impoundment of water. The installed 

capacity of a qualified facility is not less than 150 kilowatts and less than five megawatts. To be 
54 

a qualified facility, a small irrigation facility must be originally placed in service after the date of 

enactment and before January 1, 2006. 

Landfill gas facility

A landfill gas facility is a facility that uses landfill gas to produce electricity. Landfill gas 

is defined as methane gas derived from the biodegradation of municipal solid waste. To be a 

qualified facility, a landfill gas facility must be placed in service after October 22, 2004 and 

before January 1, 2006. 

Trash combustion facility

Trash combustion facilities are facilities that burn municipal solid waste (garbage) to 

produce steam to drive a turbine for the production of electricity. To be a qualified facility, a 

trash combustion facility must be placed in service after October 22, 2004 and before January 1, 

2006. 

Refined coal facility

A qualifying refined coal facility is a facility producing refined coal that is placed in 

service after the date of enactment and before January 1, 2009. Refined coal is a qualifying 

liquid, gaseous, or solid synthetic fuel produced from coal (including lignite) or high-carbon fly 

ash, including such fuel used as a feedstock. A qualifying fuel is a fuel that when burned emits 

20 percent less nitrogen oxides and either SO2 or mercury than the burning of feedstock coal or 

comparable coal predominantly available in the marketplace as of January 1, 2003, and if the 

fuel sells at prices at least 50 percent greater than the prices of the feedstock coal or comparable 

coal. In addition, to be qualified refined coal the fuel must be sold by the taxpayer with the 

reasonable expectation that it will be used for the primary purpose of producing steam. 

Legislative History

The Energy Policy Act of 1992 created section 45 as a production credit for electricity 

produced from wind and closed-loop biomass for production from certain facilities placed in 

service before July 1, 1999. The Ticket to Work and Work Incentives Improvement Act of 1999 

added poultry waste as a qualifying energy source, extended the placed in service date through 

December 31, 2001, and made certain modifications to the requirements of qualifying wind 

facilities. The Job Creation and Worker Assistance Act of 2002 extended the placed in service 

date through December 31, 2003. The Working Families Tax Relief Act of 2004 extended the 

generally applicable placed in service date for wind facilities, closed-loop biomass facilities, and 

poultry waste facilities through December 31, 2005. The American Jobs Creation Act modified 

the provision to add as qualified facilities open-loop biomass (including agricultural livestock 

waste nutrients67), geothermal energy, solar energy, small irrigation power, and municipal solid 

waste (both landfill gas and trash combustion facilities). The American Jobs Creation Act of 

 67 The definition of agricultural livestock waste nutrients subsumes poultry waste, so the Act 

repealed, prospectively, poultry waste facilities as a separate category of qualified facility. 
55 

2004 defined refined coal as a qualifying resource eligible for credit. The American Jobs 

Creation Act of 2004 also made other modifications. 

At the time of passage of the credit, the House Committee on Ways and Means stated that 

“the credit is intended to enhance the development of technology to utilize the specified 

renewable energy sources and to promote competition between renewable energy sources and 

conventional energy sources.”68 The House Committee on Ways and Means further stated that 

the purpose of the original expiration date (June 30, 1999) was “to provide the committee with 

the opportunity to assess the effectiveness of the credit in encouraging the utilization of 

renewable energy sources.”69 

President’s Budget Proposal

The proposal extends the placed in service date for facilities that produce electricity from 

wind, closed-loop biomass, open-loop biomass (other than agricultural waste nutrients), and 

landfill gas to include electricity from those facilities placed in service before January 1, 2008.70 

The proposal does not extend the placed in service date for facilities that produce electricity from 

agricultural waste nutrient facilities, geothermal facilities, solar power facilities, small irrigation 

facilities, or trash combustion facilities. 

In addition, the proposal permits taxpayers to claim a credit at 60 percent of the otherwise 

allowable credit for electricity produced from open-loop biomass (0.45 cents per kilowatt-hour 

before adjustment for inflation indexing) for electricity produced from open-loop biomass (other 

than agricultural waste nutrients) co-fired in coal plants during the three-year period January 1, 

2006 through December 31, 2008. 

Effective date.–The proposal is effective on the date of enactment. 

Analysis

For a taxpayer with a positive tax liability, the electricity production credit is equivalent 

to a subsidy that pays the taxpayer for each kilowatt-hour of electricity produced in addition to 

the price at which the producer sells the electricity. That is, a tax credit that reduced a taxpayer’s 

tax liability and therefore increases the taxpayer’s bottom line can be thought of as equivalent to 

a direct subsidy that is paid to the taxpayer to improve the taxpayer’s top line. Measured at a rate 

per kilowatt-hour, the direct subsidy equivalent of the electricity production tax credit is c/(1-t), 

 68 House of Representatives, Rept.102-474, Part 6, “Comprehensive National Energy Policy 

Act,” H.R. 776, p. 42. 

69 Ibid.

70 The extended placed in service date also will apply to the date of modification of facilities 

modified to co-fire closed-loop biomass with coal, other biomass, or both coal and other biomass. 
56 

where c is the credit rate per kilowatt-hour and t is the taxpayer’s marginal tax rate.71 If the 

taxpayer is a corporate taxpayer with a marginal tax rate of 35 percent, the subsidy equivalent of 

the 1.5 cents-per-kilowatt-hour base credit amount is approximately 2.3 cents per kilowatt-hour 

of electricity produced. The subsidy equivalent amount of the 2004 level of the credit (1.8 cents 

per kilowatt hour) is approximately 2.8 cents per kilowatt-hour. For producers of electricity 

from qualifying renewable sources this “subsidy” would be in addition to the wholesale price 

they receive from the sale of power. Data on wholesale prices are not readily available. 

However, the Department of Energy reports data on retail prices. The Department of Energy 

reports that the national average retail price of electricity for the first 11 months of 2004 was 

7.59 cents per kilowatt-hour, with the average for residential customers of 8.97 cents per 

kilowatt-hour and the average for industrial customers of 5.12 cents per kilowatt-hour.72 Thus, 

the tax credit for production of electricity is equivalent to a subsidy equal to nearly 37 percent of 

the average retail price of electricity. As electricity prices vary by region, the rate of subsidy is 

higher in some parts of the country and lower in other parts of the country. 

The electricity production tax credit economically is equivalent to an open-ended 

subsidy, available to any taxpayer without having to make an application to a government 

 71 To see that c/(1-t) is the direct subsidy equivalent of the electricity production tax credit, the 

analysis will focus on marginal after-tax profit. As such, the analysis can disregard all fixed costs of 

production at a qualifying facility. Let R denote the revenue per kilowatt-hour from the sale of electricity 

and let X be the variable cost expense of generating one kilowatt-hour of electricity. Let h be the number 

of kilowatt-hours of electricity produced and let c be the credit rate per kilowatt-hour of electricity 

produced. Finally let t be the taxpayer’s marginal tax rate. 

If the taxpayer qualifies to claim the electricity production tax credit, the taxpayer’s after-tax 

profit per kilowatt-hour of electricity production is given by equation (1). 

(1) (R-X) • h • (1-t) + c • h = marginal after-tax profit. 

Now assume that instead of a tax credit the taxpayer is paid a subsidy, S, per kilowatt-hour of electricity 

produced. The taxpayer’s marginal after-tax profit per kilowatt-hour of electricity production under this 

scenario is given by equation (2). 

(2) (S+R-X) • h • (1-t) = marginal after-tax profit. 

If one asks what value of S yields the same marginal after-tax profit as the electricity production 

tax credit, c, by equating equations (1) and (2), one finds that the subsidy equivalent to the production tax 

credit is: 

S = c/(1-t) 

72 Energy Information Administration, Monthly Energy Review, February 2005. The reported 

average retail prices include any State and local sales or excise taxes applicable to electricity within 

various jurisdictions. 
57 

agency for the subsidy.73 If a taxpayer believes that sum of electricity prices plus the credit 

creates a profitable rate of return, the taxpayer will invest in a qualifying facility. In theory, 

investors should invest in qualifying facilities up to the point where the return from additional 

investment in qualifying facilities is no greater than alternative investments. With the tax credit 

equal for all taxpayers and because qualifying renewable energy sources are not uniformly 

available at equal cost, the credit is more valuable to investors in certain facilities in certain 

geographic locations, compared to similar facilities in other geographic locations. For example, 

sustained winds are stronger in some parts of the country than in other parts of the country, but 

assume that in neither of two locations would a wind facility be profitable in the absence of a 

subsidy. If cost of construction and operation and access to the electricity grid are equivalent in 

the two locations, an investment in a qualifying wind facility should be more profitable in the 

windy location than in the less windy location. One would expect investment to occur in the 

most profitable locations first. In this sense, the tax credit mechanism is efficient in that 

potential investors will attempt to exploit the most profitable opportunities to produce electricity 

from qualifying renewable resources first. As a result, the investors will provide the most 

amount of qualifying renewable electricity with the least amount of investment. 

However, a tax credit is not likely to be a fully efficient subsidy mechanism from the 

perspective of the government’s fisc. The credit amount is invariant for any specific category of 

qualified facility. While two investments may both be estimated to be profitable enough to merit 

investment by prospective investors, because of one’s access to relatively inexpensive qualified 

renewable energy resources compared to the other, the one proposed investment is likely to be 

more profitable than the other proposed investment. By providing the same uniform credit, the 

government pays more subsidy than is necessary to bring the one investment in a qualified 

facility on line. For example, there may be some potential qualifying facilities that would be 

profitable investments in the absence of any subsidy, but they may claim the credit. As several 

States have enacted “renewables mandates,” requiring that electricity providers include a 

minimum amount of electricity from renewable sources as a condition of sale to consumers, this 

source of inefficiency (paying for production that will happen regardless of the credit) will grow. 

A subsidy, such as the credit, can promote economic efficiency when there is a 

divergence between the private costs of an activity and the social costs of the activity. Such a 

divergence is called an “externality.” Analysts commonly identify pollution as an externality 

because pollution imposes costs on society in terms of environmental degradation and health 

costs that are not reflected in the cost of producing the good or service that creates the pollution. 

By subsidizing non-polluting, or less polluting activities, the tax credit for production of 

electricity from renewable sources can produce a more economically efficient outcome. To be 

fully efficient, however, the subsidy should be equated to the incremental social benefit created 

by the displacement of a polluting source with a less polluting source. The incremental social 

benefit from the displacement of current sources of electricity production with electricity 

produced from renewable sources derives from the net change in all types of pollution from the 

 73 Of course, building codes and other regulations may require government approval for a 

proposed investment in a qualifying facility, but a taxpayer does not require approval before claiming the 

implicit subsidy offered by the credit. 
58 

current source of production to the renewable source of production. With a credit at a uniform 

rate applicable to multiple technologies, ranging from wind power to burning paper mill 

residues, it is unlikely that the subsidy provided by the credit will equal the incremental social 

benefit produced by each separate technology. 

Some analysts have argued that there is social benefit meriting subsidy in the potential for 

domestic renewable resources to displace foreign energy sources, principally oil. Oil-fired 

electricity generation accounted for approximately 3.1 percent of net electricity generation in the 

United States in 2003 and the amount of petroleum consumed in electricity production was 

approximately 3.1 percent of refined petroleum products produced in the United States in 2003.74 

If a credit-eligible facility displaces electricity produced at an unsubsidized facility, market 

economics dictate that it generally would be the highest cost producer that is displaced. It need 

not be the case that a petroleum-fired electricity generating facility is the highest-cost producer. 

In addition, if a petroleum-fired electricity generating facility ceases production, thereby 

reducing the demand for petroleum, it need not be the case that the reduction in demand for 

petroleum leads to a reduction in imported oil. As the demand for petroleum falls, market 

economics dictate that it generally would be the highest-cost suppliers that are displaced. The 

highest-cost suppliers of petroleum may be domestic producers. 

The production credit for electricity from qualified facilities has been available to 

taxpayers since 1993, but until the passage of the AJCA the credit was available only with 

respect to wind facilities, closed-loop biomass facilities, and poultry waste facilities. In practice, 

investors have only found it profitable to invest in wind facilities. Since 1993, the year before 

which qualified wind facilities became eligible for the credit, the annual production of electricity 

from wind has quadrupled.75 See Figure 2 below. Figure 2 reveals that the most rapid growth 

did not occur in the first five years after the credit was created, but over the past six years.76 

Over the past decade technological gains have been made in the design and efficiency of wind 

turbines. Figure 2 suggests that the credit was not solely responsible for the growth in 

production of electricity from wind, but it is not possible from available data to identify the 

extent to which the credit, technological improvements, the price of alternative production 

sources (e.g., fossil fuel facilities), State regulation, or other factors contributed to growth of 

wind power. Nevertheless, even with this significant growth, wind power accounted for less 

than three-tenths of one percent of total net generation of electricity in the United States in 

2003.77 

 74 Energy Information Administration, Monthly Energy Review, February 2005 

75 Ibid.

76 As noted above, the tax credit for production from wind facilities was enacted in 1992, 

effective for facilities placed in service after 1993. The Energy Information Administration reports that in 

1998, six years after the credit was enacted effective for new facilities in 1994 and thereafter, the 

production of electricity from wind was 3,026 million kilowatt-hours compared to a production of 3,006 

million kilowatt-hours in 1993. Ibid.

77 Ibid.
59 

Source: Energy Information Administration. 

Note: 2004 total includes output only through November. 

Since the inception of the credit, other sources of renewable energy, many of which are 

now eligible under present law, have been more significant sources of renewable energy than 

wind power. Figure 3, below, reports the annual production of electricity from wood (including 

wood, black liquor, and other wood waste), waste (including municipal solid waste, landfill gas, 

sludge waste, tires, agricultural byproducts, and other biomass), and geothermal. These three 

categories accounted for 1.9 percent of total net generation of electricity in the United States in 

2003.78 Electricity generation from solar power, both solar thermal and photovoltaic sources, has 

been substantially less, but growing. Electricity generation from solar sources totaled 251 

million kilowatt-hours in 1990 and 534 million kilowatt-hours in 2003.79 

 78 Ibid.

79 Ibid.

Figure 2.–Electricity Generation from Wind, 1989-2004 

(millions of kilowatts-hours)

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

First year for credit 

eligible facilities 

Year

Millions of kilowatt-hours 
60 

Source: Energy Information Administration. 

Note: 2004 total includes output only through November. 

2. Expensing of brownfields remediation costs 

Present Law

Code section 162 allows a deduction for ordinary and necessary expenses paid or 

incurred in carrying on any trade or business. Treasury regulations provide that the cost of 

incidental repairs that neither materially add to the value of property nor appreciably prolong its 

life, but keep it in an ordinarily efficient operating condition, may be deducted currently as a 

business expense. Section 263(a)(1) limits the scope of section 162 by prohibiting a current 

deduction for certain capital expenditures. Treasury regulations define “capital expenditures” as 

amounts paid or incurred to materially add to the value, or substantially prolong the useful life, 

of property owned by the taxpayer, or to adapt property to a new or different use. Amounts paid 

for repairs and maintenance do not constitute capital expenditures. The determination of whether 

an expense is deductible or capitalizable is based on the facts and circumstances of each case. 

Under Code section 198, taxpayers can elect to treat certain environmental remediation 

expenditures that would otherwise be chargeable to capital account as deductible in the year paid 

or incurred. The deduction applies for both regular and alternative minimum tax purposes. The 

Figure 3.–Electricity Generation from Other Renewable Sources, 1989-2004

(millions of kilowatt-hours)

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Wood

Waste

Geotheomal

Year 

Millions of kilowatt -hours 

Millions of kilowatt-hours 
61 

expenditure must be incurred in connection with the abatement or control of hazardous 

substances at a qualified contaminated site. In general, any expenditure for the acquisition of 

depreciable property used in connection with the abatement or control of hazardous substances at 

a qualified contaminated site does not constitute a qualified environmental remediation 

expenditure. However, depreciation deductions allowable for such property, which would 

otherwise be allocated to the site under the principles set forth in Commissioner v. Idaho Power 

Co.80 and section 263A, are treated as qualified environmental remediation expenditures. 

A “qualified contaminated site” (a so-called “brownfield”) generally is any property that 

is held for use in a trade or business, for the production of income, or as inventory and is 

certified by the appropriate State environmental agency to be an area at or on which there has 

been a release (or threat of release) or disposal of a hazardous substance. Both urban and rural 

property may qualify. However, sites that are identified on the national priorities list under the 

Comprehensive Environmental Response, Compensation, and Liability Act of 1980 

(“CERCLA”) cannot qualify as targeted areas. Hazardous substances generally are defined by 

reference to sections 101(14) and 102 of CERCLA, subject to additional limitations applicable to 

asbestos and similar substances within buildings, certain naturally occurring substances such as 

radon, and certain other substances released into drinking water supplies due to deterioration 

through ordinary use. 

In the case of property for which a qualified environmental remediation expenditure 

otherwise would have been capitalized, any deduction allowed under section 198 is treated as a 

depreciation deduction and the property is treated as section 1245 property. Thus, deductions for 

qualified environmental remediation expenditures are subject to recapture as ordinary income 

upon a sale or other disposition of the property. In addition, sections 280B (demolition of 

structures) and 468 (special rules for mining and solid waste reclamation and closing costs) do 

not apply to amounts that are treated as expenses under this provision. 

Eligible expenditures are those paid or incurred before January 1, 2006. 

Legislative History

The Taxpayer Relief Act of 1997 created section 198 to permit taxpayers to expense 

certain qualified environmental remediation expenditures paid or incurred after August 5, 1997, 

in tax years ending after that date. The provision included a termination date, which excluded 

from the provision expenditures paid or incurred after December 31, 2000. The Ticket to Work 

and Work Incentives Improvement Act of 1999 extended the termination date to December 31, 

2001. The Consolidated Appropriations Act, 2001, further extended the termination date to 

December 31, 2003. The Consolidated Appropriations Act, 2001, also modified the definition of 

“qualified contaminated site” under section 198(c). The Working Families Tax Relief Act of 

2004 extended the termination date to December 31, 2005. 

 80 Commissioner v. Idaho Power Co., 418 U.S. 1 (1974) (holding that equipment depreciation 

allocable to the taxpayer’s construction of capital facilities must be capitalized under section 263(a)(1)). 
62 

At the time of passage of the provision, the Senate Committee on Finance stated that the 

provision was intended to “encourage the cleanup of contaminated sites, as well as to eliminate 

uncertainty regarding the appropriate treatment of environmental remediation expenditures for 

Federal tax law purposes.”81 

President’s Budget Proposal

The President’s budget proposal eliminates the requirement that expenditures must be 

paid or incurred before January 1, 2006, to be deductible as qualified environmental remediation 

expenditures. Thus, the provision becomes permanent. 

Effective date.–The proposal is effective on the date of enactment. 

Analysis

The provision is intended to encourage environmental remediation, and general business 

investment, at contaminated sites. With respect to environmental remediation tax benefits as an 

incentive for general business investment, it is possible that the incentive may have the effect of 

distorting the location of new investment, rather than increasing investment overall.82 If the new 

investments are offset by less investment in neighboring, but not qualifying, areas, the 

neighboring communities could suffer. On the other hand, the increased investment in the 

qualifying areas could have spillover effects that are beneficial to the neighboring communities. 

The proposal to make permanent the expensing of brownfields remediation costs would 

promote the goal of environmental remediation and remove doubt as to the future deductibility of 

remediation expenses. Removing the doubt about deductibility may be desirable if the presentlaw expiration date is currently affecting investment planning. For example, the temporary 

nature of relief under present law may discourage projects that require a significant ongoing 

investment, such as groundwater clean-up projects. On the other hand, extension of the 

provision for a limited period of time would allow additional time to assess the efficacy of the 

law, adopted only recently as part of the Taxpayer Relief Act of 1997, prior to any decision as to 

its permanency. 

The present-law provision also may simplify tax planning and investment planning by 

providing more clarity regarding expenses that must be capitalized and those that can be 

expensed. However, in general, the provision treats expenditures at certain geographic locations 

differently from otherwise identical expenditures at other geographic locations. Such 

distinctions generally require additional record keeping on the part of taxpayers and more 

complex tax return filings. Concomitantly, such distinctions increase the difficulty of IRS audits. 

 81 S. Rpt. No. 105-33 at 110. 

82 For a discussion of the economic effects of targeting economic activity to specific geographic 

areas, see Leslie E. Papke, “What Do We Know About Enterprise Zones,” in James M. Poterba, ed., Tax 

Policy and the Economy, vol. 7 (Cambridge, MA: The MIT Press), 1993. 
63 

By making the present law provision permanent, the President’s proposal may simplify tax 

planning and investment planning by taxpayers by providing more certainty. 

3. Suspension of 100 percent-of-net-income limitation on percentage depletion for oil and 

gas from marginal wells 

Present Law

The Code permits taxpayers to recover their investments in oil and gas wells through 

depletion deductions. Two methods of depletion are currently allowable under the Code: (1) the 

cost depletion method, and (2) the percentage depletion method.83 Under the cost depletion 

method, the taxpayer deducts that portion of the adjusted basis of the depletable property which 

is equal to the ratio of units sold from that property during the taxable year to the number of units 

remaining as of the end of taxable year plus the number of units sold during the taxable year. 

Thus, the amount recovered under cost depletion may never exceed the taxpayer's basis in the 

property. 

The Code generally limits the percentage depletion method for oil and gas properties to 

independent producers and royalty owners.84 Generally, under the percentage depletion method, 

15 percent of the taxpayer’s gross income from an oil- or gas-producing property is allowed as a 

deduction in each taxable year.85 The amount deducted generally may not exceed 100 percent of 

the net income from that property in any year (the “net-income limitation”).86 The 100-percent 

net-income limitation for marginal production has been suspended for taxable years beginning 

after December 31, 1997, and before January 1, 2006. 

Marginal production is defined as domestic crude oil and natural gas production from 

stripper well property or from property substantially all of the production from which during the 

calendar year is heavy oil. Stripper well property is property from which the average daily 

production is 15 barrel equivalents or less, determined by dividing the average daily production 

of domestic crude oil and domestic natural gas from producing wells on the property for the 

calendar year by the number of wells. Heavy oil is domestic crude oil with a weighted average 

gravity of 20 degrees API or less (corrected to 60 degrees Fahrenheit). 

Legislative History

The 100-percent net income limitation as it applies to marginal wells has been suspended 

since 1998. The Taxpayer Relief Act of 1997 (Pub. L. No. 105-34) first suspended the limitation 

 83 Secs. 611-613. 

84 Sec. 613A. 

85 Sec. 613A(c). 

86 Sec. 613(a). 
64 

for taxable years beginning after December 31, 1997 and before January 1, 2000.87 In 1999, the 

Ticket to Work and Work Incentives Improvement Act of 1999 (Pub. L. No. 106-170), further 

suspended the limitation for taxable years beginning before January 1, 2002. Although the 

extension was added at conference, both the House Committee on Ways and Means, and the 

Senate Committee on Finance had reported similar bills from their committees. The reasons for 

change were substantially similar: 

The Committee notes that oil is, and will continue to be, vital to the American 

economy. The Committee observes that low oil prices have created substantial 

economic hardship in the oil industry and particularly in those communities where 

the majority of jobs are related to the oil and gas industry. The current economic 

hardship in the industry could lead to business failures and job losses. The 

Committee finds it appropriate to extend the present-law rule suspending the 100-

percent-of-net-income limitation with respect to oil and gas production from 

marginal wells. The Committee believes that by reducing current taxable income, 

less cash will have to be devoted to income tax payments, and the current cash 

position of many such businesses will improve, helping them weather this current 

economic storm.88

 87 The Senate provision would have suspended the 100-percent-of-net-income property limitation 

for any taxable year beginning in a calendar year in which the annual average wellhead price per barrel 

for crude oil (within the meaning of section 29(d)(2)(C)) is below $14 per barrel. The Senate Committee 

on Finance report stated, “The Committee believes that a suspension of the net income property limitation 

for marginal oil and gas production is appropriate if the price of oil falls to unexpectedly low levels, to 

prevent such wells from being plugged and potentially losing their production in the long run.” S. Rpt. 

No. 105-33. 

88 S. Rpt. 106-201, at 12. The Senate bill, S. 1792, would have extended the suspension of the 

limitation to include taxable years beginning after December 31, 1999 and before January 1, 2001. The 

House bill, H.R. 2923, would have extended the suspension of the limitation somewhat longer to include 

taxable years beginning after December 31, 1999 and before January 1, 2005. The House Report noted: 

The Committee notes that oil is, and will continue to be, vital to the American economy. 

The Committee observes that low oil prices have created substantial economic hardship 

in the oil industry and particularly in those communities where the majority of jobs are 

related to providing this vital commodity to the nation. Skilled workers and industry 

know-how will be critical to the exploration for and production of oil and gas in the 

future. The Committee, therefore, is concerned that the current economic hardship in the 

industry could lead to business failures and job losses. The Committee understands that 

many of these businesses are cash starved. The Committee finds it appropriate to extend 

the present-law rule suspending the 100-percent-of-net-income limitation with respect to 

oil and gas production from marginal wells. The Committee believes that by reducing 

current taxable income, less cash will have to be devoted to income tax payments and the 

current cash position of many such businesses will improve, helping them weather this 

current economic storm. 
65 

In 2002, the limitation was suspended for taxable years beginning before January 1, 2004, 

by the Jobs Creation and Worker Assistance Act of 2002 (Pub. L. No. 107-147). Finally, the 

Working Families Tax Relief Act of 2004 (Pub. L. No. 108-311) suspended the limitation a 

fourth time for taxable years beginning before January 1, 2006.89

President’s Budget Proposal

No proposal. 

Analysis

The provision potentially allows taxpayers to take greater depletion deductions. In the 

absence of a suspension, percentage depletion for marginal wells would be limited to 100 percent 

of net income from the property. There may be some taxpayers that find they can take greater 

deductions in the absence of a limitation, thereby further reducing their tax liability and 

offsetting taxable income from other properties, as well as other activities. This may enable 

them to potentially reinvest more revenue into drilling for oil and gas and invest in new 

technologies to extend the life of existing fields. Such actions would be consistent with a 

national energy policy of trying to decrease dependence on foreign oil. 

It should be noted, however, that unlike other cost recovery systems, percentage 

depletion deductions over the life of the subject property are not limited to the taxpayer’s cost 

basis in such property. To the extent of any excess, the taxpayer is afforded deductions which 

exceed actual cash expenditures. Thus, it could be argued that the benefits of percentage 

depletion, even with the net income limitation, represent sufficient incentive for taxpayers to 

engage in domestic oil and gas exploration and drilling. 

In addition, if the present-law provision was intended as a temporary measure to assist 

taxpayers in times of depressed oil prices, further suspension of the limitation may not be 

warranted. Domestic crude oil prices are currently above $50.00 per barrel.90 When the 

suspension was first put into place, domestic crude oil averaged $10.87 per barrel.91 Figure 1, 

 

See, H.R. Rept. 106-344 at 16. The Senate bill, S. 1792, would have extended the suspension of the 

limitation to include taxable years beginning after December 31, 1999 and before January 1, 2001. 

89 The 2002 and 2004 extensions were added during the conference of the respective bills. 

90 The Wall Street Journal, March 2, 2005, p. B7, reported the spot price of West Texas 

Intermediate at $51.69 per barrel in trading on March 1, 2005. 

91 The average price is the average domestic first purchase price for crude oil reported by the 

Energy Information Administration. Energy Information Administration, Monthly Energy Review

(February 2005). 
66 

below, reports the average annual first purchase price of domestic crude oil for the period 1995 

through 2004.92 

Note: 2004 is average through November. 

Source: Energy Information Administration. 

In light of current oil prices, it could be argued that it is profitable to operate marginal 

wells and there is not a current economic hardship to be addressed. 

 92 The data from the Energy Information Administration are available only through November 

2004. The average price figure for 2004 reflects only the first eleven months of the year. 

$0.00

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

$35.00

$40.00

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Figure 4.–Average Annual First Purchase Price of Domestic Crude Oil, 

1995-2004 

(Dollars per Barrel)

Dollars per Barrel 

Year
67 

C. Miscellaneous 

1. Deduction for corporate donations of computer technology 

Present Law

In the case of a charitable contribution of inventory or other ordinary-income or shortterm capital gain property, the amount of the charitable deduction generally is limited to the 

taxpayer’s basis in the property. In the case of a charitable contribution of tangible personal 

property, the deduction is limited to the taxpayer’s basis in such property if the use by the 

recipient charitable organization is unrelated to the organization’s tax-exempt purpose. In cases 

involving contributions to a private foundation (other than certain private operating foundations), 

the amount of the deduction is limited to the taxpayer’s basis in the property.93

Under present law, a taxpayer’s deduction for charitable contributions of scientific 

property used for research and for contributions of computer technology and equipment 

generally is limited to the taxpayer’s basis (typically, cost) in the property. However, certain 

corporations may claim a deduction in excess of basis for a “qualified research contribution” or a 

“qualified computer contribution.”94 This enhanced deduction is equal to the lesser of (1) basis 

plus one-half of the item’s appreciated value (i.e., basis plus one half of fair market value minus 

basis) or (2) two times basis. The enhanced deduction for qualified computer contributions 

expires for any contribution made during any taxable year beginning after December 31, 2005. 

A qualified computer contribution means a charitable contribution of any computer 

technology or equipment, which meets standards of functionality and suitability as established by 

the Secretary of the Treasury. The contribution must be to certain educational organizations or 

public libraries and made not later than three years after the taxpayer acquired the property or, if 

the taxpayer constructed the property, not later than the date construction of the property is 

substantially completed.95 The original use of the property must be by the donor or the donee,96

and in the case of the donee, must be used substantially for educational purposes related to the 

function or purpose of the donee. The property must fit productively into the donee’s education 

plan. The donee may not transfer the property in exchange for money, other property, or 

services, except for shipping, installation, and transfer costs. To determine whether property is 

constructed by the taxpayer, the rules applicable to qualified research contributions apply. That 

is, property is considered constructed by the taxpayer only if the cost of the parts used in the 

construction of the property (other than parts manufactured by the taxpayer or a related person) 

 93 Sec. 170(e)(1). 

94 Secs. 170(e)(4) and 170(e)(6). 

95 If the taxpayer constructed the property and reacquired such property, the contribution must be 

within three years of the date the original construction was substantially completed. Sec. 170(e)(6)(D)(i). 

96 This requirement does not apply if the property was reacquired by the manufacturer and 

contributed. Sec. 170(e)(6)(D)(ii).
68 

does not exceed 50 percent of the taxpayer’s basis in the property. Contributions may be made 

to private foundations under certain conditions.97 

Legislative History

The enhanced deduction for computer contributions was enacted as part of the Taxpayer 

Relief Act of 1997. The temporary nature of the deduction was added as part of the conference 

agreement to the 1997 Act. The conference agreement intended that the provision expire after 

three years, but a drafting error established a two-year provision, which required a 1998 technical 

correction to extend the deduction to contributions made in taxable years beginning before 

January 1, 2001. The Community Renewal Tax Relief Act of 2000 extended the enhanced 

deduction for an additional three years, to contributions made in taxable years beginning before 

January 1, 2004. The Working Families Tax Relief Act of 2004 extended the deduction an 

additional two years, to contributions made in taxable years beginning before January 1, 2006. 

President’s Budget Proposal

The President’s budget proposal extends the enhanced deduction to donations made in 

taxable years beginning before January 1, 2007. 

Analysis

The enhanced deduction for computer equipment and software is intended to give 

businesses greater incentive to contribute computer equipment and software to educational 

organizations and public libraries. In the absence of the enhanced deduction of present law, if a 

taxpayer were to dispose of excess inventory by dumping unneeded computer equipment in a 

garbage dumpster, the taxpayer generally could claim the purchase price of the inventory (the 

taxpayer’s basis in the property) as an expense against the taxpayer’s gross income. In the 

absence of the enhanced deduction, if the taxpayer were to donate the unneeded computer 

equipment to a school or library, the taxpayer generally would be able to claim a charitable 

deduction equal to the taxpayer’s basis in the computer equipment (subject to certain limits on 

charitable contributions). From the perspective of the taxpayer’s profit motive, the taxpayer 

would be indifferent between donating the computer equipment and dumping the computer 

equipment in a garbage dumpster. If the taxpayer must incur costs to deliver the computer 

equipment to the school or library, the taxpayer may not find it in the taxpayer’s financial 

interest to donate the computer equipment to the school or library. On the other hand, a taxpayer 

may make a contribution regardless of any tax benefit because of goodwill generated by the gift. 

For example, a company may determine that a contribution of computers to public libraries will 

expose potential new buyers to their products and that such goodwill alone is worth any 

incremental costs incurred to deliver the equipment. 

Proponents argue that present law helps accelerate the nationwide adoption of computer 

technology in education and helps avail more individuals internet access through their local 

public library. Proponents argue that more time is needed to achieve higher levels of computer 

 97 Sec. 170(e)(6)(C). 
69 

access and that it is appropriate to extend the present-law enhanced deduction to help attain this 

outcome. However, some argue that if the intended policy is to promote adoption of computer 

technology in education and internet access via public libraries, it would be more direct and 

efficient to provide a direct government subsidy instead of making a tax expenditure through the 

tax system, which cannot be monitored under the annual budgetary process. 

The enhanced deduction, and thus its extension, creates complexities for the taxpayer and 

the IRS. The enhanced deduction is allowed to the donor only for equipment that the donee does 

not trade or sell. Generally, once the equipment is in the hands of the donee it is difficult for the 

donor to monitor the use of the equipment. Likewise, it is difficult for the IRS to ascertain 

whether a claim for an enhanced deduction is valid. Also, the enhanced deduction is predicated 

on an ascertainable fair market value of the computer technology.98 With the rapid advances in 

the field, such determinations are difficult at times. Computers lose value quickly.99 However, 

third-party tracking of prices for used computer equipment do exist. In this regard, the limitation 

to equipment less than three years old may aid taxpayer compliance and IRS administration. 

Nonetheless, because value is uncertain, the IRS is at a disadvantage in enforcing the provision. 

To ease administration and provide greater certainty for taxpayers and the IRS, the enhanced 

deduction generally could be based not on the value of the computer equipment but on the 

taxpayer’s basis in the equipment and the equipment’s age. For example, equipment one year 

old or less could receive a deduction of up to twice the taxpayer’s basis; equipment between one 

and two years old could receive a deduction of a lesser multiple of the taxpayer’s basis; and 

equipment two years old or greater could receive a deduction of an even lesser multiple of the 

taxpayer’s basis.100 The reduction in the deduction over time could be justified by the generally 

rapid decrease in value of computer equipment over time. The deduction still would be an 

enhanced deduction because the taxpayer would receive more than its basis in the property. 

Under such an alternative, the basis multiple would have to be determined based on information 

about the markup of new items and the rate of loss of value over time. However, assuming that 

the relationship between value and basis varies over time, the basis multiple should be adjusted 

regularly. 

Taxpayers who contribute computer equipment from inventory must consider multiple 

factors to ensure that they deduct the permitted amount (and no more than the permitted amount) 

 98 The enhanced deduction is equal to the lesser of basis plus one-half of the item’s appreciated 

value (that is, one-half basis plus one-half fair market value) or two times basis. The two times basis 

limitation is binding only if the fair market value of the item exceeds three times the item’s basis. Thus, a 

measure of fair market value always is necessary. 

99 A recent study concludes that “[n]ot surprisingly, our empirical results indicate that PCs lose 

value at a rapid pace. ... [T]he value of a PC declines roughly 50 percent, on average, with each year of 

use, implying that a newly installed PC can be expected to be nearly worthless after five or six years of 

service. Mark E. Doms, Wendy E. Dunn, Stephen D. Oliner, and Daniel E. Sichel, “How Fast Do 

Personal Computers Depreciate? Concepts and New Estimates,” in James M. Poterba (ed.), Tax Policy 

and the Economy, vol. 18, (Cambridge, MA: The MIT Press), 2004 

100 As under present law, the deduction could not exceed fair market value. 
70 

with respect to contributed equipment. Taxpayers who are required to maintain inventories for 

such items must consider the fair market value of the contributed equipment, the basis of the 

equipment (and twice the basis of the equipment), and the resulting income that would be 

realized if the equipment were sold, and coordinate the resulting contribution deduction with the 

determination of cost of goods sold.101 

2. Parity in the application of certain limits to mental health benefits 

Present Law

The Internal Revenue Code (the “Code”), the Employee Retirement Income Security Act 

of 1974 (“ERISA”) and the Public Health Service Act (“PHSA”) contain provisions under which 

group health plans that provide both medical and surgical benefits and mental health benefits 

cannot impose aggregate lifetime or annual dollar limits on mental health benefits that are not 

imposed on substantially all medical and surgical benefits (“mental health parity requirements”). 

In the case of a group health plan which provides benefits for mental health, the mental health 

parity requirements do not affect the terms and conditions (including cost sharing, limits on 

numbers of visits or days of coverage, and requirements relating to medical necessity) relating to 

the amount, duration, or scope of mental health benefits under the plan, except as specifically 

provided in regard to parity in the imposition of aggregate lifetime limits and annual limits. 

The Code imposes an excise tax on group health plans which fail to meet the mental 

health parity requirements.102 The excise tax is equal to $100 per day during the period of 

noncompliance and is generally imposed on the employer sponsoring the plan if the plan fails to 

meet the requirements.103 The maximum tax that can be imposed during a taxable year cannot 

exceed the lesser of 10 percent of the employer’s group health plan expenses for the prior year or 

$500,000. No tax is imposed if the Secretary determines that the employer did not know, and 

exercising reasonable diligence would not have known, that the failure existed. 

The mental health parity requirements do not apply to group health plans of small 

employers104 nor do they apply if their application results in an increase in the cost under a group 

health plan of at least one percent. Further, the mental health parity requirements do not require 

group health plans to provide mental health benefits. 

 101 Such taxpayers must remove the amount of the contribution deduction for the contributed 

equipment inventory from opening inventory, and do not treat the removal as a part of cost of goods sold. 

IRS Publication 526, Charitable Contributions, pp. 7-8. 

102 Sec. 9812. 

103 Sec. 4980D. 

104 In general, a small employer is, with respect to a calendar year and a plan year, an employer 

who employed an average of at least two but not more than 50 employees on business days during the 

preceding calendar year and who employs at least two employees on the first day of the plan year. Sec. 

4980D(d)(2). 
71 

Legislative History

The Mental Health Parity Act of 1996 (“MHPA”) amended ERISA and the PHSA to 

include the mental health parity requirements. Initially, the provisions of the MHPA were 

effective only with respect to plan years beginning on or after January 1, 1998, and applied to 

benefits for services furnished before September 30, 2001. The Taxpayer Relief Act of 1997 

added to the Code the mental health parity requirements imposed under the MHPA, and imposed 

an excise tax on group health plans which fail to meet the requirements. The Code requirements 

had same the effective date as the ERISA and PHSA provisions. The mental health parity 

requirements in all three statutes were extended to apply to benefits for services furnished on or 

after December 31, 2002, by the Departments of Labor, Health and Human Services, and 

Education, and Related Agencies Appropriations Act, 2002. 

The Job Creation and Worker Assistance Act of 2002 amended the effective date of the 

mental health parity requirements in the Code to provide that it is inapplicable to benefits for 

services furnished on or after September 30, 2001, and before January 10, 2002, and extended 

them to apply to benefits for services furnished on or before December 31, 2003. The ERISA 

and PHSA provisions were extended for one year to apply to benefits for services furnished 

before December 31, 2003, by the Mental Health Parity Reauthorization Act of 2002. The 

Mental Health Parity Reauthorization Act of 2003, extended these provisions for an additional 

year to apply to benefits for services furnished before December 31, 2004. 

The Working Families Tax Relief Act of 2004 extended the ERISA and PHSA provisions 

relating to mental health parity to benefits for services furnished before January 1, 2006. It also 

extended the Code provisions relating to mental health parity to benefits for services furnished 

on or after the date of enactment and before January 1, 2006. 

President’s Budget Proposal

No proposal. 

Analysis

The mental health parity requirements are enforced through an integrated statutory 

system found in ERISA, PHSA, and the Code. The mental health parity requirements in ERISA 

generally apply to all group health plans other than governmental plans, church plans, and certain 

other plans. These provisions also apply to health insurance issuers that offer health insurance 

coverage in connection with such group health plans. The requirements in the PHSA generally 

apply to health insurance issuers that offer health insurance coverage in connection with group 

health plans and to certain State and local governmental plans. The Code’s mental health parity 

requirements generally apply to all group health plans other than governmental plans, but they do 

not apply to health insurance issuers. Even in the absence of the mental health parity 

requirements in the Code, covered plans would still have to comply with the mental health parity 

requirements under ERISA and the PHSA. 

The issues raised with respect to the mental health parity provisions are primarily health 

issues, rather than tax policy issues. The primary focus of the mental health parity requirements 

is to require that annual or lifetime limits for mental health benefits are not lower than those 
72 

applicable to medical and surgical benefits. Employer-provided mental health coverage is not 

mandated by the requirements, nor are employers prevented from imposing terms and conditions 

on mental health benefits offered, provided the terms and conditions are not less favorable than 

those applicable to other types of care.. 

From an employer’s perspective, balancing the level of the health benefits with cost 

containment is an important aspect of providing health coverage. Employers seeking to attract 

and retain employees may find that it is in their best interest to offer the most comprehensive 

health benefits possible while incurring manageable costs. Employee benefits, including health 

benefits, may factor into individuals’ decisions about whether to accept a job with or remain with 

a particular employer. 

Cost containment may be a reason that employers limit mental health benefits under 

group health plans. Additionally, limiting benefits for mental healthcare under a plan may 

facilitate providing health care to a greater number of people. Alternatively, it may be argued 

that untreated mental health problems ultimately result in other medical issues, thus, mental 

health care is an important part of total health care. Some believe that overall health care costs 

generally are lower as a result of providing mental health coverage. 

Some feel that the limited nature of the mental health parity requirements ensures that 

employers will not eliminate mental health benefits in response to the requirements. The 

requirements permit employers whose plans offer mental health benefits through group health 

plans to choose from several options for maintaining cost controls on mental health benefits. 

Flexibility to define the scope of benefits, establish cost-sharing requirements, and impose limits 

on hospital stays and out-patient visits is maintained under the requirements. 

On the other hand, although lifetime and annual caps applicable only to mental health 

benefits are eliminated under the mental health parity requirements, employers may still change 

their group health plans to include other generally-applicable caps, such as limits on inpatient 

and outpatient days or higher coinsurance rates. As a result, individuals who receive mental 

health benefits may have to pay higher copayments and deductibles for their benefits. This may 

actually raise the overall expenditures of those who use mental health services. Another possible 

response by employers to the mental health parity requirements is to lower the dollar caps 

applicable to general medical care to offset the increase in mental health coverage or to drop 

mental health coverage altogether. Some argue that because small employers are exempted form 

the mental health parity requirements, the provisions do not reach many employees who need 

mental health care services. However, some point out that small employers were exempted from 

the requirements due to cost concerns; health insurance coverage tends to be more expensive on 

a per-employee basis for small employers than for large employers. 
73 

III. PROVISIONS RELATING TO STATE AND LOCAL GOVERNMENTS 

A. District of Columbia 

1. Tax incentives for investment in the District of Columbia 

Present Law

In general

The Taxpayer Relief Act of 1997 designated certain economically depressed census tracts 

within the District of Columbia as the District of Columbia Enterprise Zone (the “D.C. Zone”), 

within which businesses and individual residents are eligible for special tax incentives. The 

census tracts that compose the D.C. Zone are (1) all census tracts that presently are part of the 

D.C. enterprise community designated under section 1391 (i.e., portions of Anacostia, Mt. 

Pleasant, Chinatown, and the easternmost part of the District), and (2) all additional census tracts 

within the District of Columbia where the poverty rate is not less than 20 percent. The D.C. 

Zone designation remains in effect for the period from January 1, 1998, through December 31, 

2005. In general, the tax incentives available in connection with the D.C. Zone are a 20-percent 

wage credit, an additional $35,000 of section 179 expensing for qualified zone property, 

expanded tax-exempt financing for certain zone facilities, and a zero-percent capital gains rate 

from the sale of certain qualified D.C. zone assets. 

Wage credit

A 20-percent wage credit is available to employers for the first $15,000 of qualified 

wages paid to each employee (i.e., a maximum credit of $3,000 with respect to each qualified 

employee) who (1) is a resident of the D.C. Zone, and (2) performs substantially all employment 

services within the D.C. Zone in a trade or business of the employer. 

Wages paid to a qualified employee who earns more than $15,000 are eligible for the 

wage credit (although only the first $15,000 of wages is eligible for the credit). The wage credit 

is available with respect to a qualified full-time or part-time employee (employed for at least 90 

days), regardless of the number of other employees who work for the employer. In general, any 

taxable business carrying out activities in the D.C. Zone may claim the wage credit, regardless of 

whether the employer meets the definition of a “D.C. Zone business.”105

An employer’s deduction otherwise allowed for wages paid is reduced by the amount of 

wage credit claimed for that taxable year.106 Wages are not to be taken into account for purposes 

 105 However, the wage credit is not available for wages paid in connection with certain business 

activities described in section 144(c)(6)(B) or certain farming activities. In addition, wages are not 

eligible for the wage credit if paid to (1) a person who owns more than five percent of the stock (or capital 

or profits interests) of the employer, (2) certain relatives of the employer, or (3) if the employer is a 

corporation or partnership, certain relatives of a person who owns more than 50 percent of the business. 

106 Sec. 280C(a). 
74 

of the wage credit if taken into account in determining the employer’s work opportunity tax 

credit under section 51 or the welfare-to-work credit under section 51A.107 In addition, the 

$15,000 cap is reduced by any wages taken into account in computing the work opportunity tax 

credit or the welfare-to-work credit.108 The wage credit may be used to offset up to 25 percent of 

alternative minimum tax liability.109

Section 179 expensing

In general, a D.C. Zone business is allowed an additional $35,000 of section 179 

expensing for qualifying property placed in service by a D.C. Zone business.110 The section 179 

expensing allowed to a taxpayer is phased out by the amount by which 50 percent of the cost of 

qualified zone property placed in service during the year by the taxpayer exceeds $200,000 

($400,000 for taxable years beginning after 2002 and before 2008). The term “qualified zone 

property” is defined as depreciable tangible property (including buildings), provided that (1) the 

property is acquired by the taxpayer (from an unrelated party) after the designation took effect, 

(2) the original use of the property in the D.C. Zone commences with the taxpayer, and (3) 

substantially all of the use of the property is in the D.C. Zone in the active conduct of a trade or 

business by the taxpayer.111 Special rules are provided in the case of property that is 

substantially renovated by the taxpayer. 

Tax-exempt financing

A qualified D.C. Zone business is permitted to borrow proceeds from tax-exempt 

qualified enterprise zone facility bonds (as defined in section 1394) issued by the District of 

Columbia.112 Such bonds are subject to the District of Columbia’s annual private activity bond 

volume limitation. Generally, qualified enterprise zone facility bonds for the District of 

Columbia are bonds 95 percent or more of the net proceeds of which are used to finance certain 

facilities within the D.C. Zone. The aggregate face amount of all outstanding qualified 

enterprise zone facility bonds per qualified D.C. Zone business may not exceed $15 million and 

may be issued only while the D.C. Zone designation is in effect. 

 107 Secs. 1400H(a), 1396(c)(3)(A, and 51A(d)(2). 

108 Secs. 1400H(a), 1396(c)(3)(B), and 51A(d)(2). 

109 Sec. 38(c)(2). 

110 Sec. 1397A. 

111 Sec. 1397D. 

112 Sec. 1400A. 
75 

Zero-percent capital gains

A zero-percent capital gains rate applies to capital gains from the sale of certain qualified 

D.C. Zone assets held for more than five years. 113 In general, a qualified “D.C. Zone asset” 

means stock or partnership interests held in, or tangible property held by, a D.C. Zone business. 

For purposes of the zero-percent capital gains rate, the D.C. Enterprise Zone is defined to include 

all census tracts within the District of Columbia where the poverty rate is not less than 10 

percent. 

In general, gain eligible for the zero-percent tax rate means gain from the sale or 

exchange of a qualified D.C. Zone asset that is (1) a capital asset or property used in the trade or 

business as defined in section 1231(b), and (2) acquired before January 1, 2006. Gain that is 

attributable to real property, or to intangible assets, qualifies for the zero-percent rate, provided 

that such real property or intangible asset is an integral part of a qualified D.C. Zone business.114 

However, no gain attributable to periods before January 1, 1998, and after December 31, 2010, is 

qualified capital gain. 

Legislative History

The Omnibus Budget Reconciliation Act of 1993 authorized the designation of nine 

empowerment zones and 95 enterprise communities to provide tax incentives for businesses to 

locate within certain geographic areas designated by the Secretaries of Housing and Urban 

Development and Agriculture. Portions of the District of Columbia were designated an 

enterprise community in 1994 and thus became eligible to issue tax-exempt enterprise zone 

facility bonds. 

The Taxpayer Relief Act of 1997 created the D.C. Zone designation and related tax 

incentives effective for the period from January 1, 1998, through December 31, 2002. The 

Community Renewal Tax Relief Act of 2000 extended the designation and related tax incentives 

of the D.C. Zone for one additional year, through December 31, 2003. The Working Families 

Tax Relief Act of 2004 generally extended the designation and related tax incentives of the D.C. 

Zone for two additional years, through December 31, 2005. 

President’s Budget Proposal

No proposal. Although there is no current proposal of the President to extend the D.C. 

Zone designation, the President’s budget proposals contain a separate proposal that would 

establish “opportunity zones.” Under this proposal, the D.C. Zone automatically is eligible to 

apply for designation as an opportunity zone. If opportunity zone status were granted, the D.C. 

Zone would qualify for a different mix of tax incentives through December 31, 2009. 

 113 Sec. 1400B. 

114 However, sole proprietorships and other taxpayers selling assets directly cannot claim the 

zero-percent rate on capital gain from the sale of any intangible property (i.e., the integrally related test 

does not apply). 
76 

Analysis

The D.C. Zone designation and related tax incentives were enacted to reduce the District 

of Columbia’s high levels of poverty, unemployment, and economic distress. Extending the 

D.C. Zone incentives through 2005 was intended to encourage the continued economic 

redevelopment of distressed areas. 

Some argue that the designation of the D.C. Zone as an area in need of special tax 

incentives always was intended to be a temporary provision. Either the tax incentives would 

help contribute to a successful revitalization of the designated area, rendering their continued 

provision unnecessary, or the incentives would not have the desired economic effect, in which 

case they were not working as intended and should be discontinued or modified. The extensions 

of the designation and incentives in 2000 and 2004 could be viewed as necessary to permit the 

incentives to have the intended effect, for a full evaluation of such effect, and to be comparable 

with the lifespans of other empowerment zones. 

Whether the D.C. Zone should expire depends in part on a determination of whether the 

tax incentives have been effective in reducing poverty and unemployment levels in the D.C. 

Zone. In general, studies of the effectiveness of enterprise community, empowerment zone, and 

renewal community tax incentives are few and lacking in analytical detail, making such a 

determination difficult. The most comprehensive such study, the Housing and Urban 

Development Interim Assessment,115 found that employment of zone residents nationwide 

increased from 1995 to 2000 and that larger businesses were more likely to utilize zone tax 

benefits than smaller businesses. Although this information may be helpful to analyzing trends 

with respect to the D.C. Zone, it is not specific to the D.C. Zone and does not address benefits 

such as the capital gain exclusion. 

Some argue that if the designation is allowed to expire, the D.C. Zone area should 

continue to be monitored to determine whether economic activity in the area declines 

substantially as a result, and thus whether at some future time the designation and tax benefits 

should be reinstated. Others argue that although there has been economic revitalization of parts 

of the District of Columbia, there are areas within the District that still exhibit signs of high 

levels of poverty and unemployment. Under this view, the tax incentives should not be allowed 

to expire completely, but should be modified, perhaps to target a different set of census tracts or 

by providing a different mix of incentives. 

If the designation is not allowed to expire, some argue that a long-term extension, such as 

for five or more years may be preferable to a short-term extension of one or two years. Such 

short-term extensions create uncertainty for businesses and employers within the designated area, 

 115 Herbert, Scott, et al., “Interim Assessment of the Empowerment Zones and Enterprise 

Communities (EZ/EC) Program: A Progress Report, prepared for the U.S. Department of Housing and 

Urban development,” November 2001; see also U.S. General Accounting Office, Community 

Development: Business Use of Empowerment Zone Tax Incentives, (GAO/RCED-99-253, September 

1999) (noting that few businesses used the available tax-exempt bond financing; predominantly because 

businesses did not know of their existence). 
77 

which may affect economic decisions with respect to future expansion or investment 

opportunities. 

2. District of Columbia Homebuyer Tax Credit 

Present Law

First-time homebuyers of a principal residence in the District of Columbia are eligible for 

a nonrefundable tax credit of up to $5,000 of the amount of the purchase price. The $5,000 

maximum credit applies both to individuals and married couples. Married individuals filing 

separately can claim a maximum credit of $2,500 each. The credit phases out for individual 

taxpayers with adjusted gross income between $70,000 and $90,000 ($110,000-$130,000 for 

joint filers). For purposes of eligibility, “first-time homebuyer” means any individual if such 

individual did not have a present ownership interest in a principal residence in the District of 

Columbia in the one-year period ending on the date of the purchase of the residence to which the 

credit applies. The credit is scheduled to expire for residences purchased after December 31, 

2005.116

Legislative History

The District of Columbia first-time homebuyer credit was enacted as part of the Taxpayer 

Relief Act of 1997, and was scheduled to expire on December 31, 2000. The Tax Relief 

Extension Act of 1999 extended the first-time homebuyer credit for one year, through 

December 31, 2000. The Community Renewal Tax Relief Act of 2000 extended the first-time 

homebuyer credit for two additional years, through December 31, 2003. The Working Families 

Tax Relief Act of 2004 extended the first-time homebuyer credit for two additional years, 

through December 31, 2005. 

President’s Budget Proposal

The President’s budget proposal extends the first-time homebuyer credit for one year, 

through December 31, 2006. 

Analysis

The D.C. first-time homebuyer credit is intended to encourage home ownership in the 

District of Columbia in order to stabilize or increase its population and thus to improve its tax 

base. Recently, home sales in D.C. have reached record levels, and sales prices have increased. 

However, this has been equally true in surrounding communities. It is difficult to know the 

extent to which the D.C. homebuyer credit may have been a factor in the surge in home sales. 

According to the Treasury Department, the homeownership rate in the District of Columbia is 

significantly below the rate for the neighboring States and the nation as a whole. Arguably, 

extending the credit would enhance the District of Columbia’s ability to attract new homeowners 

and establish a stable residential base. 

 116 Sec. 1400C(i). 
78 

A number of policy issues are raised with respect to whether the D.C. homebuyer credit 

should be extended. One issue is whether it is the proper role of the Federal government to 

distort local housing markets by favoring the choice of home ownership in one jurisdiction over 

another. Favoring home ownership in one area comes at the expense of home ownership in 

adjacent areas. Thus, if the credit stimulates demand in the District of Columbia, this comes at 

the expense of demand in other portions of the relevant housing market, principally the nearby 

suburbs of Virginia and Maryland. 

To the extent that local jurisdictions vary in their tax rates and services, individuals 

purchasing a home may choose to buy in the jurisdiction that offers them the combination of tax 

rates and services and other amenities that they desire.117 If a jurisdiction has a low tax rate, 

some might choose it on that basis. If a jurisdiction has a high tax rate but offers a high level of 

services, some will decide that the high tax rate is worth the services and will choose to buy in 

that jurisdiction. If tax rates are high but services are not correspondingly high, individuals may 

avoid such jurisdictions. It is in part this individual freedom to choose where to live that can 

promote competition in the provision of local public services, helping to assure that such services 

are provided at reasonable tax rates. If a jurisdiction fails at providing reasonable services at 

reasonable tax rates, individuals might choose to move to other jurisdictions. This may cause 

property values in the jurisdiction to fall and, together with taxpayer departures, may put 

pressure on the local government to change its behavior and improve its services. If the Federal 

government were to intervene in this market by encouraging the purchase of a home in one local 

market over another, competition among local jurisdictions in the provision of public services 

may be undermined. 

In the above scenario, however, a dwindling tax base may make it financially difficult to 

improve government services. Some argue that the District of Columbia is in this position and 

that it needs Federal assistance to improve the District’s revenue base. An alternative view is 

that the tax credit could take some of the pressure off the local government to make necessary 

improvements. By improving the local government’s tax base without a commensurate 

improvement in government services, the Federal expenditure could encourage a slower 

transition to better governance. 

Some argue that the credit is appropriate because a number of factors distinguish the 

District of Columbia from other cities or jurisdictions and that competition among the District 

and neighboring jurisdictions is constrained by outside factors. For example, some argue that the 

credit is a means of compensating the District for an artificially restricted tax base. While many 

residents of the suburbs work in the District and benefit from certain of its services, the Federal 

government precludes the imposition of a “commuter tax,” which is used by some other 

jurisdictions to tax income earned within the jurisdiction by workers who reside elsewhere. In 

addition, some argue that the District has artificially reduced property, sales, and income tax 

revenues because the Federal government is headquartered in the District. The Federal 

government makes a payment to the District to compensate for the forgone revenues, but some 

 117 Other factors may also affect the choice of where to live, such as closeness to work or family 

members. 
79 

argue that the payment is insufficient. Some also argue that to the extent migration from the 

District is a result of poor services, it is not entirely within the control of the District to fix such 

problems, because the District government is not autonomous, but is subject to the control of 

Congress. 

Another issue regarding the D.C. homebuyer credit is how effectively it achieves its 

objective. Several factors might diminish its effectiveness. First, the $5,000 will not reduce the 

net cost of homes by $5,000. Some of the $5,000 is likely to be captured by sellers, as eligible 

buyers entering the market with effectively an additional $5,000 to spend will push prices to 

levels higher than would otherwise attain. If the supply of homes for sale is relatively fixed, and 

potential buyers relatively plentiful, then the credit will largely evaporate into sellers’ hands 

through higher prices for homes. 

A second reason the credit might not be very effective at boosting the residential base of 

the District is that it applies to existing homes as well as any new homes that are built. Thus, the 

family that sells its D.C. home to a credit-eligible buyer must move elsewhere. To the extent that 

they sell in order to move outside of the District of Columbia, there is no gain in D.C. residences. 

And, to the extent that the credit caused home prices to rise, the credit can be seen as an 

encouragement to sell a home in the District as much as an encouragement to buy. 
80 

B. New York Liberty Zone 

1. New York Liberty Zone advance refundings 

Present Law

In general

Interest on debt incurred by States or local governments is excluded from income if the 

proceeds of the borrowing are used to carry out governmental functions of those entities or the 

debt is repaid with governmental funds (sec. 103). Interest on bonds that nominally are issued by 

States or local governments, but the proceeds of which are used (directly or indirectly) by a 

private person and payment of which is derived from funds of such a private person is taxable 

unless the purpose of the borrowing is approved specifically in the Code or in a non-Code 

provision of a revenue Act. These bonds are called “private activity bonds.” The term “private 

person” includes the Federal Government and all other individuals and entities other than States 

or local governments. 

In most cases, the aggregate volume of tax-exempt private activity bonds that may be 

issued in a State is restricted by annual volume limits. For calendar year 2005, these annual 

volume limits are equal to the greater of $80 per resident of the State or $239 million. 

The Code also contains different rules for “current” as opposed to “advance” refunding 

bonds. A refunding bond is defined as any bond used to pay principal, interest, or redemption 

price on a prior bond issue (the refunded bond). A current refunding occurs when the refunded 

bond is redeemed within 90 days of issuance of the refunding bonds. Conversely, a bond is 

classified as an advance refunding if it is issued more than 90 days before the redemption of the 

refunded bond.118

Although there is no statutory limitation on the number of times that tax-exempt bonds 

may be currently refunded, the Code limits advance refundings. Generally, governmental bonds 

and qualified 501(c)(3) bonds may be advance refunded one time.119 Private activity bonds, 

other than qualified 501(c)(3) bonds, may not be advance refunded at all.120

New York Liberty Zone bonds

Tax-exempt financing is allowed for qualified New York Liberty Bonds issued during 

calendar years before January 1, 2010. An aggregate limit of $8 billion of tax-exempt private 

 118 Sec. 149(d)(5). 

119 Sec. 149(d)(3). Bonds issued before 1986 and pursuant to certain transition rules contained in 

the Tax Reform Act of 1986 may be advance refunded more than one time in certain cases. 

120 Sec. 149(d)(2). 
81 

activity bonds to finance the construction and rehabilitation of nonresidential real property121 and 

residential rental real property122 in a designated “Liberty Zone” (the “Zone”) of New York City 

is allowed. Property eligible for financing with these bonds includes buildings and their 

structural components,fixed tenant improvements,123 and public utility property (e.g., gas, water, 

electric and telecommunication lines). All business addresses located on or south of Canal Street, 

East Broadway (east of its intersection with Canal Street), or Grand Street (east of its intersection 

with East Broadway) in the Borough of Manhattan are considered to be located within the Zone. 

Issuance of these bonds authorized is limited to projects approved by the Mayor of New York 

City or the Governor of New York State, each of whom may designate up to $4 billion of the 

bonds authorized under the bill. 

If the Mayor or the Governor determines that it is not feasible to use all of the authorized 

bonds that he is authorized to designate for property located in the Zone, up to $2 billion of 

bonds may designated by each to be used for the acquisition, construction, and rehabilitation of 

nonresidential real property (including fixed tenant improvements) located outside the Zone and 

within New York City.124 Bond-financed property located outside the Zone must meet the 

additional requirement that the project have at least 100,000 square feet of usable office or other 

commercial space in a single building or multiple adjacent buildings. 

Certain bonds outstanding on September 11, 2001, used to fund facilities located in New 

York City are permitted one additional advance refunding through December 31, 2005. In 

addition to satisfying other requirements, the bond refunded must be (1) a State or local bond 

that is a general obligation of New York City, (2) a State or local bond issued by the New York 

Municipal Water Finance Authority, the Metropolitan Transportation Authority of the City of 

New York, or the Municipal Assistance Corporation or (3) a qualified 501(c)(3) bond which is a 

qualified hospital bond issued by or on behalf of the State of New York or the City of New York. 

The maximum amount of advance refunding bonds is $9 billion. 

 121 No more than $800 million of the authorized bond amount may be used to finance property 

used for retail sales of tangible property (e.g., department stores, restaurants, etc.) and functionally related 

and subordinate property. The term nonresidential real property includes structural components of such 

property if the taxpayer treats such components as part of the real property structure for all Federal 

income tax purposes (e.g., cost recovery). The $800 million limit is divided equally between the Mayor 

and the Governor.

122 No more than $1.6 billion of the authorized bond amount may be used to finance residential 

rental property. The $1.6 billion limit is divided equally between the Mayor and the Governor. 

123 Fixtures and equipment that could be removed from the designated zone for use elsewhere are 

not eligible for financing with these bonds.

124 Public utility property and residential property located outside the Zone cannot be financed 

with the bonds. 
82 

Legislative History

The Job Creation and Worker Assistance Act of 2002 authorized the issuance of Liberty 

Zone bonds and an additional advance refunding with respect to bonds financing certain facilities 

located in New York City before January 1, 2005.125 The Working Families Tax Relief Act of 

2004 extended the authority to issue Liberty Zone bonds through December 31, 2009 and the 

additional advance refunding authority through December 31, 2005.126

President’s Budget Proposal

No proposal. 

Analysis

The New York Liberty Zone provisions, including authority to issue an additional 

advance refunding of certain bonds, were enacted to aid the City of New York’s economic 

recovery from the terrorist attacks of September 11, 2001. Proponents of extending the authority 

to issue additional advance refunding bonds argue that additional time is necessary to fully 

utilize the bond authority and complete the recovery of New York City. Opponents argue that 

the New York Liberty Zone provisions were intended as a one-time measure to address the 

extraordinary circumstances of September 11, 2001. Some also may argue that the additional 

advance refunding authority does not provide an effective mechanism for assisting the City of 

New York’s recovery efforts because the permitted additional advance refundings, unlike New 

York Liberty Bonds generally, are not limited to bonds financing facilities within the Zone. 

More generally, advance refundings are inefficient because they result in multiple issues of 

bonds outstanding simultaneously for a single activity. On the other hand, the additional 

advance refunding authority allows certain New York issuers to reduce their debt service 

payments, thus, improving revenue flows that may be used to assist with New York City’s 

recovery efforts. 

2. Tax incentives for investment in the New York Liberty Zone 

Present Law

In general

Present law provides several incentives for taxpayers to invest in the area of New York 

City most heavily impacted by the terrorist attacks on September 11, 2001, and to assist 

taxpayers whose property was destroyed by those attacks. These incentives include a special 

depreciation allowance, an increase in expensing under section 179, a reduced depreciable life 

for certain leasehold improvements, and an extended replacement period for certain property that 

 125 Pub. L. No. 107-147, sec. 301(a) (2002). 

126 Pub. L. No. 108-311, sec. 309(b) and (c) (2004). 
83 

was involuntarily converted as a result of the terrorist attacks. These incentives are generally 

available with respect to property located within the New York Liberty Zone (“NYLZ”). 127

New York Liberty Zone special depreciation allowance

Section 1400L(b) allows an additional first-year depreciation deduction equal to 30 

percent of the adjusted basis of qualified NYLZ property. In order to qualify, property generally 

must be placed in service on or before December 31, 2006 (December 31, 2009 in the case of 

nonresidential real property and residential rental property).

The additional first-year depreciation deduction is allowed for both regular tax and 

alternative minimum tax purposes for the taxable year in which the property is placed in 

service.128 The basis of the property and the depreciation allowances in the year of purchase and 

later years are appropriately adjusted to reflect the additional first-year depreciation deduction. 

In addition, the provision provides that there is no adjustment to the allowable amount of 

depreciation for purposes of computing a taxpayer’s alternative minimum taxable income with 

respect to property to which the provision applies. A taxpayer is allowed to elect out of the 

additional first-year depreciation for any class of property for any taxable year. 

In order for property to qualify for the additional first-year depreciation deduction it must 

meet all of the following requirements. First, the property must be property to which the general 

rules of the Modified Accelerated Cost Recovery System (“MACRS”)129 apply with (1) an 

applicable recovery period of 20 years or less, (2) water utility property (as defined in section 

168(e)(5)), (3) certain nonresidential real property and residential rental property, or (4) 

computer software other than computer software covered by section 197. A special rule 

precludes the additional first-year depreciation under this provision for (1) qualified NYLZ 

leasehold improvement property130 and, (2) property eligible for the additional first-year 

depreciation deduction under section 168(k) (i.e., property is eligible for only one 30% additional 

first-year depreciation). Second, substantially all of the use of such property must be in the 

 127 The “New York Liberty Zone” means the area located on or south of Canal Street, East 

Broadway (east of its intersection with Canal Street), or Grand Street (east of its intersection with East 

Broadway) in the Borough of Manhattan in the City of New York, New York. 

128 The additional first-year depreciation deduction is subject to the general rules regarding 

whether an item is deductible under section 162 or subject to capitalization under section 263 or section 

263A. 

129 A special rule precludes the additional first-year depreciation deduction for property that is 

required to be depreciated under the alternative depreciation system of MACRS. 

130 Qualified NYLZ leasehold improvement property is defined in another provision. Leasehold 

improvements that do not satisfy the requirements to be treated as “qualified NYLZ leasehold 

improvement property” may be eligible for the 30 percent additional first-year depreciation deduction 

(assuming all other conditions are met). 
84 

NYLZ. Third, the original use131 of the property in the NYLZ must commence with the taxpayer 

on or after September 11, 2001.132 Finally, the property must be acquired by purchase133 by the 

taxpayer after September 10, 2001 and placed in service on or before December 31, 2006. For 

qualifying nonresidential real property and residential rental property the property must be 

placed in service on or before December 31, 2009 in lieu of December 31, 2006. Property will 

not qualify if a binding written contract for the acquisition of such property was in effect before 

September 11, 2001. 134

Nonresidential real property and residential rental property is eligible for the additional 

first-year depreciation only to the extent such property rehabilitates real property damaged, or 

replaces real property destroyed or condemned as a result of the terrorist attacks of September 

11, 2001. Property shall be treated as replacing destroyed property, if as part of an integrated 

plan, such property replaces real property which is included in a continuous area which includes 

real property destroyed or condemned. For purposes of this provision, it is intended that real 

property destroyed (or condemned) only include circumstances in which an entire building or 

structure was destroyed (or condemned) as a result of the terrorist attacks. Otherwise, such 

property is considered damaged real property. For example, if certain structural components 

(e.g., walls, floors, or plumbing fixtures) of a building are damaged or destroyed as a result of the 

terrorist attacks but the building is not destroyed (or condemned), then only costs related to 

replacing the damaged or destroyed components qualifies for the provision. 

Property that is manufactured, constructed, or produced by the taxpayer for use by the 

taxpayer qualifies if the taxpayer begins the manufacture, construction, or production of the 

property after September 10, 2001, and the property is placed in service on or before December 

 131 Thus, used property may constitute qualified property so long as it has not previously been 

used within the NYLZ. In addition, it is intended that additional capital expenditures incurred to 

recondition or rebuild property the original use of which in the Liberty Zone began with the taxpayer 

would satisfy the “original use” requirement. See Treasury Regulation 1.48-2 Example 5. 

132 A special rule applies in the case of certain leased property. In the case of any property that is 

originally placed in service by a person and that is sold to the taxpayer and leased back to such person by 

the taxpayer within three months after the date that the property was placed in service, the property will 

be treated as originally placed in service by the taxpayer not earlier than the date that the property is used 

under the leaseback. 

If property is originally placed in service by a lessor (including by operation of section 

168(k)(2)(D)(i)), such property is sold within three months after the date that the property was placed in 

service, and the user of such property does not change, then the property is treated as originally placed in 

service by the taxpayer not earlier than the date of such sale. 

133 For purposes of this provision, purchase is defined under section 179(d). 

134 Property is not precluded from qualifying for the additional first-year depreciation merely 

because a binding written contract to acquire a component of the property is in effect prior to September 

11, 2001. 
85 

31, 2006135 (and all other requirements are met). Property that is manufactured, constructed, or 

produced for the taxpayer by another person under a contract that is entered into prior to the 

manufacture, construction, or production of the property is considered to be manufactured, 

constructed, or produced by the taxpayer. 

New York Liberty Zone five-year recovery period for depreciation of certain leasehold 

improvements 

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.136 This rule applies regardless of whether the lessor or the 

lessee places the leasehold improvements in service.137 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.138 

Depreciation of New York Liberty Zone leasehold improvements

A special rule exists for qualified NYLZ leasehold improvement property, which is 

recovered over five years using the straight-line method. The term qualified NYLZ leasehold 

improvement property means property defined in section 168(e)(6) that is acquired and placed in 

service after September 10, 2001 and before January 1, 2007 (and not subject to a binding 

 135 In the case of qualified nonresidential real property and residential rental property, the 

property must be placed in service on or before December 31, 2009. 

136 Sec. 168(i)(8). The Tax Reform Act of 1986 modified the Accelerated Cost Recovery System 

(“ACRS”) to institute MACRS. Prior to the adoption of ACRS by the Economic Recovery Tax Act of 

1981, taxpayers were allowed to depreciate the various components of a building as separate assets with 

separate useful lives. The use of component depreciation was repealed upon the adoption of ACRS. The 

Tax Reform Act of 1986 also denied the use of component depreciation under MACRS. 

137 Former sections 168(f)(6) and 178 provided that, in certain circumstances, a lessee could 

recover the cost of leasehold improvements made over the remaining term of the lease. The Tax Reform 

Act of 1986 repealed these provisions. 

138 Secs. 168(b)(3), (c), (d)(2), and (i)(6). If the improvement is characterized as tangible 

personal property, ACRS or MACRS depreciation is calculated using the shorter recovery periods, 

accelerated methods, and conventions applicable to such property. The determination of whether 

improvements are characterized as tangible personal property or as nonresidential real property often 

depends on whether or not the improvements constitute a “structural component” of a building (as defined 

by Treas. Reg. sec. 1.48-1(e)(1)). See, e.g., Metro National Corp v. Commissioner, 52 TCM (CCH) 1440 

(1987); King Radio Corp Inc. v. U.S., 486 F.2d 1091 (10th Cir. 1973); Mallinckrodt, Inc. v. 

Commissioner, 778 F.2d 402 (8th Cir. 1985) (with respect to various leasehold improvements). 
86 

contract on September 10, 2001) in the NYLZ. For purposes of the alternative depreciation 

system, the property is assigned a 9-year recovery period. 

New York Liberty Zone increase in expensing under section 179

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

may elect to deduct such costs. For taxable years beginning in 2003 through 2007, a taxpayer 

may deduct up to $100,000 of the cost of qualifying property placed in service for the taxable 

year. In general, qualifying property for this purpose is defined as depreciable tangible personal 

property (and certain computer software) that is purchased for use in the active conduct of a trade 

or business. The $100,000 amount is reduced (but not below zero) by the amount by which the 

cost of qualifying property placed in service during the taxable year exceeds $400,000. The 

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

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

amount of annual investment may elect to deduct up to $25,000 of the cost of qualifying property 

placed in service for the taxable year. The $25,000 amount is reduced (but not below zero) by 

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

exceeds $200,000. In general, qualifying property for this purpose is defined as depreciable 

tangible personal property that is purchased for use in the active conduct of a trade or business. 

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

for a taxable year that is derived from the active conduct of a trade or business (determined 

without regard to this provision). Any amount that is not allowed as a deduction because of the 

taxable income limitation may be carried forward to succeeding taxable years (subject to similar 

limitations). No general business credit under section 38 is allowed with respect to any amount 

for which a deduction is allowed under section 179. 

The amount a taxpayer can deduct under section 179 is increased for qualifying property 

used in the NYLZ. Specifically, the maximum dollar amount that may be deducted under 

section 179 is increased by the lesser of (1) $35,000 or (2) the cost of qualifying property placed 

in service during the taxable year. This amount is in addition to the amount otherwise deductible 

under section 179. 

Qualifying property for purposes of the NYLZ provision means section 179 property139

purchased and placed in service by the taxpayer after September 10, 2001 and before January 1, 

2007, where (1) substantially all of its use is in the NYLZ in the active conduct of a trade or 

business by the taxpayer in the zone, and (2) the original use of which in the NYLZ commences 

with the taxpayer after September 10, 2001.140

 139 As defined in section 179(d)(1). 

140 See Rev. Proc. 2002-33, 2002-20 I.R.B. 963 (May 20, 2002), for procedures on claiming the 

increased sec. 179 expensing deduction by taxpayers who filed their tax returns before June 1, 2002. 
87 

The phase-out range for the section 179 deduction attributable to NYLZ property is 

applied by taking into account only 50 percent of the cost of NYLZ property that is section 179 

property. Also, no general business credit under section 38 is allowed with respect to any 

amount for which a deduction is allowed under section 179. 

The provision is effective for property placed in service after September 10, 2001 and 

before January 1, 2007. 

New York Liberty Zone extension of replacement period for nonrecognition of gain 

A taxpayer may elect not to recognize gain with respect to property that is involuntarily 

converted if the taxpayer acquires within an applicable period (the “replacement period”) 

property similar or related in service or use (section 1033). If the taxpayer does not replace the 

converted property with property similar or related in service or use, then gain generally is 

recognized. If the taxpayer elects to apply the rules of section 1033, gain on the converted 

property is recognized only to the extent that the amount realized on the conversion exceeds the 

cost of the replacement property. In general, the replacement period begins with the date of the 

disposition of the converted property and ends two years after the close of the first taxable year 

in which any part of the gain upon conversion is realized.141 The replacement period is extended 

to three years if the converted property is real property held for the productive use in a trade or 

business or for investment.142 

The replacement period is extended to five years with respect to property that was 

involuntarily converted within the NYLZ as a result of the terrorist attacks that occurred on 

September 11, 2001. However, the five-year period is available only if substantially all of the 

use of the replacement property is in New York City. In all other cases, the present-law 

replacement period rules continue to apply. 

Legislative History

The incentives for investment in NYLZ property and the extended replacement period for 

NYLZ property involuntarily converted as a result of the September 11, 2001 terrorist attacks 

were enacted as part of The Jobs Creation and Worker Assistance Act of 2002 (“JCWAA”).143

In 2003, the Senate amendment to H.R. 2, the Jobs and Growth Tax Relief Reconciliation 

Act of 2003, would have permitted property purchased by another member of the taxpayer’s 

 141 Section 1033(a)(2)(B). 

142 Section 1033(g)(4). 

143 Pub. Law No. 107-147, sec. 301 (2002). 
88 

affiliated group (in lieu of the taxpayer) to be treated as replacement property for purposes of the 

provision.144 The provision was not included in the conference agreement.145

President’s Budget Proposal

The Administration has indicated that some of the tax benefits of the NYLZ legislation 

likely will not be usable in the form in which they were originally provided. Accordingly, the 

Administration has proposed to repeal the provisions as part of an overall proposal to restructure 

the New York City assistance program. The repeal would be effective on the date of enactment, 

such that the extended replacement period for involuntarily converted NYLZ property would end 

on the earlier of (1) the date of enactment or (2) the last day of the five-year period specified in 

JCWAA. 

Analysis

The NYLZ incentive provisions were intended as a one-time measure to encourage 

investment in the area of New York City most heavily impacted by the terrorist attacks on 

September 11, 2001, and to assist taxpayers whose property was destroyed by those attacks. 

Generally, the accelerated depreciation and expensing provisions for NYLZ property 

create an incentive for taxpayers to invest in NYLZ property by reducing the present value aftertax cost of investment, which in turn increases the return on that investment. Likewise, the 

extended replacement period provision provides an opportunity for gain deferral if the taxpayer 

invests in property in New York City during the extended replacement period, indirectly 

reducing the cost of the New York City investment relative to a similar investment outside of 

New York City. However, the effectiveness of the NYLZ incentives may not yet be 

determinable because insufficient time has passed since they were enacted. 

 144 The affiliated group rule would have applied only with respect to the replacement of NYLZ 

property. 

145 H.R. Conf. Rep. No. 108-126, at 220-221 (2003). 
89 

C. Qualified Zone Academy Bonds 

Present Law

Tax-exempt bonds

Interest on State and local governmental bonds generally is excluded from gross income 

for Federal income tax purposes if the proceeds of the bonds are used to finance direct activities 

of these governmental units or if the bonds are repaid with revenues of the governmental units. 

Activities that can be financed with these tax-exempt bonds include the financing of public 

schools (sec. 103). 

Qualified zone academy bonds

As an alternative to traditional tax-exempt bonds, States and local governments are given 

the authority to issue “qualified zone academy bonds” (sec. 1397E). A total of $400 million of 

qualified zone academy bonds may be issued annually in calendar years 1998 through 2005. The 

$400 million aggregate bond cap is allocated each year to the States according to their respective 

populations of individuals below the poverty line. Each State, in turn, allocates the credit 

authority to qualified zone academies within such State. 

Unlike traditional State and local bonds which pay interest, a taxpayer holding a qualified 

zone academy bond on the credit allowance date is entitled to a credit. Financial institutions that 

hold qualified zone academy bonds are entitled to a nonrefundable tax credit in an amount equal 

to a credit rate multiplied by the face amount of the bond. The credit is includable in gross 

income (as if it were a taxable interest payment on the bond), and may be claimed against regular 

income tax and AMT liability. 

The Treasury Department sets the credit rate at a rate estimated to allow issuance of 

qualified zone academy bonds without discount and without interest cost to the issuer. The 

maximum term of the bond is determined by the Treasury Department, so that the present value 

of the obligation to repay the bond is 50 percent of the face value of the bond. 

“Qualified zone academy bonds” are defined as any bond issued by a State or local 

government, provided that: (1) at least 95 percent of the proceeds are used for the purpose of 

renovating, providing equipment to, developing course materials for use at, or training teachers 

and other school personnel in a “qualified zone academy”, and (2) private entities have promised 

to contribute to the qualified zone academy certain equipment, technical assistance or training, 

employee services, or other property or services with a value equal to at least 10 percent of the 

bond proceeds. 

A school is a “qualified zone academy” if: (1) the school is a public school that provides 

education and training below the college level, (2) the school operates a special academic 

program in cooperation with businesses to enhance the academic curriculum and increase 

graduation and employment rates, and (3) either (a) the school is located in an empowerment 

zone or enterprise community designated under the Code, or (b) it is reasonably expected that at 

least 35 percent of the students at the school will be eligible for free or reduced-cost lunches 

under the school lunch program established under the National School Lunch Act. 
90 

Legislative History

The authority to issue qualified zone academy bonds was enacted by the Taxpayer Relief 

Act of 1997.146 Initially, qualified zone academy bonds were authorized to be issued in 1998 and 

1999. The Tax Relief Extension Act of 1999 extended authority through 2001.147 The Job 

Creation and Worker Assistance Act of 2002 extended issuance authority through 2003.148 The 

Working Families Tax Relief Act of 2004 generally extended the authority to issue qualified 

zone academy bonds through 2005.149

President’s Budget Proposal

The proposal authorizes issuance of up to $400 million of qualified zone academy bonds 

annually in calendar years 2006 and 2007. For qualified zone academy bonds issued after the 

date of enactment, the proposal requires issuers to report issuance to the IRS in a manner similar 

to the information returns required for tax-exempt bonds. 

Effective date.–The provision is effective generally for obligations issued after the date of 

enactment. 

Analysis

Policy issues

Extending authority to issue qualified zone academy bonds subsidizes a portion of the 

costs of new investment in public school infrastructure and, in certain qualified areas, equipment 

and teacher training. By subsidizing such costs, it is possible that additional investment will take 

place relative to investment that would take place in the absence of the subsidy. If no additional 

investment takes place than would otherwise, the subsidy merely represents a transfer of funds 

from the Federal Government to States and local governments. This would enable States and 

local governments to spend the savings on other government functions or to reduce taxes.150 In 

this event, the stated objective of the provision would not be achieved. 

 146 Pub. L. No. 105-34 (1997). 

147 Pub. L. No. 106-170, sec. 509(a) (1999). 

148 Pub. L. No. 107-147, sec. 608(a) (2002). 

149 Pub. L. No. 108-311, sec. 304(a) (2004). 

150 Most economic studies have found that when additional funding is made available to localities 

from outside sources, there is indeed an increase in public spending (this is known as the “fly-paper” 

effect, as the funding tends to “stick” where it is applied). The additional spending is not dollar for dollar, 

however, implying that there is some reduction of local taxes to offset the outside funding. See Harvey 

Rosen, Public Finance, sixth ed., 2002, p. 502-503 for a discussion of this issue. 
91 

Though called a tax credit, the Federal subsidy for tax credit bonds is equivalent to the 

Federal Government directly paying the interest on a taxable bond issue on behalf of the State or 

local government that benefits from the bond proceeds.151 To see this, consider any taxable bond 

that bears an interest rate of 10 percent. A thousand dollar bond would thus produce an interest 

payment of $100 annually. The owner of the bond that receives this payment would receive a 

net payment of $100 less the taxes owed on that interest. If the taxpayer were in the 28-percent 

Federal tax bracket, such taxpayer would receive $72 after Federal taxes. Regardless of whether 

the State government or the Federal Government pays the interest, the taxpayer receives the 

same net of tax return of $72. In the case of tax credit bonds, no formal interest is paid by the 

Federal Government. Rather, a tax credit of $100 is allowed to be taken by the holder of the 

bond. In general, a $100 tax credit would be worth $100 to a taxpayer, provided that the 

taxpayer had at least $100 in tax liability. However, for tax credit bonds, the $100 credit also has 

to be claimed as income. Claiming an additional $100 in income costs a taxpayer in the 28-

percent tax bracket an additional $28 in income taxes, payable to the Federal Government. With 

the $100 tax credit that is ultimately claimed, the taxpayer nets $72 on the bond. The Federal 

Government loses $100 on the credit, but recoups $28 of that by the requirement that it be 

included in income, for a net cost of $72, which is exactly the net return to the taxpayer. If the 

Federal Government had simply agreed to pay the interest on behalf of the State or local 

government, both the Federal Government and the bondholder/taxpayer would be in the same 

situation. The Federal Government would make outlays of $100 in interest payments, but would 

recoup $28 of that in tax receipts, for a net budgetary cost of $72, as before. Similarly, the 

bondholder/taxpayer would receive a taxable $100 in interest, and would owe $28 in taxes, for a 

net gain of $72, as before. The State or local government also would be in the same situation in 

both cases. 

Use of qualified zone academy bonds to subsidize public school investment raises some 

questions of administrative efficiencies and tax complexity (see below). Because potential 

purchasers of the zone academy bonds must educate themselves as to whether the bonds qualify 

for the credit, certain “information costs” are imposed on the buyer. Additionally, since the 

determination as to whether the bond is qualified for the credit ultimately rests with the Federal 

Government, further risk is imposed on the investor. These information costs and other risks 

serve to increase the credit rate and hence the costs to the Federal Government for a given level 

of support to the zone academies. For these reasons, and the fact that tax credit bonds will be 

less liquid than Treasury Securities, the bonds would bear a credit rate that is equal to a measure 

of the yield on outstanding corporate bonds. 

Inefficiency in the program and, thus, arguments against extension or for modification to 

the program, also can be attributed to the fact that qualified zone academy bonds, unlike interestbearing State and local bonds, are not subject to the arbitrage or rebate requirements of the Code. 

The ability to earn and retain arbitrage profits provides an incentive for issuers to issue more 

 151 This is true provided that the taxpayer faces tax liability of at least the amount of the credit. 

Without sufficient tax liability, the proposed tax credit arrangement would not be as advantageous. 

Presumably, only taxpayers who anticipate having sufficient tax liability to be offset by the proposed 

credit would hold these bonds. 
92 

bonds and to issue them earlier than necessary,152 which increases the cost of the subsidy. On 

the other hand, the lack of arbitrage or rebate requirements for qualified zone academy bonds 

subsidizes the repayment of principal on such bonds, as well as other qualified expenditures, by 

allowing issuers to invest proceeds at unrestricted yields and retain the earnings from such 

investments. Opponents to the imposition of arbitrage or rebate requirements may argue that 

such restrictions will decrease the amount of subsidy available to assist schools with significant 

needs, but limited means through which to satisfy those needs. Moreover, arbitrage or rebate 

requirements would add complexity by imposing a requirement not previously applied to 

qualified zone academy bonds. 

The direct payment of interest by the Federal Government on behalf of States or 

localities, which was discussed above as being economically the equivalent of the credit 

proposal, would involve less complexity in administering the income tax, as the interest could 

simply be reported as any other taxable interest. Additionally, the tax credit approach implies 

that non-taxable entities would only be able to invest in the bonds to assist school investment 

through repurchase agreements or by acquiring rights to repayment of principal if a tax credit 

bond is stripped. In the case of a direct payment of interest, by contrast, tax-exempt 

organizations would be able to enjoy such benefits. 

Complexity issues

A temporary extension provides some stability in the qualified zone academy bond 

program. Certainty that the program would continue at least temporarily, without further 

interruption or modification, arguably would facilitate financial planning by taxpayers during 

that period. The uncertainty that results from expiring provisions may adversely affect the 

administration of and perhaps the level of participation in such provisions. For example, a 

taxpayer may not be willing to devote the time and effort necessary to satisfy the complex 

requirements of a provision that expires shortly. Similarly, the Internal Revenue Service must 

make difficult decisions about the allocation of its limited resources between permanent and 

expiring tax provisions. 

Some argue that a permanent or long-term extension is necessary to encourage optimal 

participation among potential qualified zone academy bond issuers. Others respond that the 

permanent repeal of expiring provisions such as the qualified zone academy bond rules that are 

inherently complex would provide the same level of certainty for tax planning purposes as a 

long-term or permanent extension, and would further reduce the overall level of complexity in 

the Code. A related argument is that programs such as qualified zone academy bonds would be 

more efficient if administered as direct expenditure programs rather than as a part of the tax law. 

The proposal in the President’s budget to impose reporting requirements may assist in the 

monitoring of the use of these bonds. On the other hand, it will add to complexity in that it 

 152 The Treasury Department issued proposed regulations on March 26, 2004 that would require 

issuers of qualified zone academy bonds to spend proceeds with due diligence. 69 CFR 15747 (March 

26, 2004). 
93 

imposes a requirement not previously applied to qualified zone academy bonds. In addition, the 

proposal increases the paperwork burden on issuers in that forms must be completed and filed 

with the IRS. 
94 

IV. PROVISIONS RELATING TO TAX ADMINISTRATION 

A. Disclosure of Tax Information to Facilitate Combined 

Employment Tax Reporting 

Present law

Traditionally, Federal tax forms are filed with the Federal government and State tax 

forms are filed with individual States. This necessitates duplication of items common to both 

returns. The Code permits the IRS to disclose taxpayer identity information and signatures to 

any agency, body, or commission of any State for the purpose of carrying out with such agency, 

body or commission a combined Federal and State employment tax reporting program approved 

by the Secretary. The Federal disclosure restrictions, safeguard requirements, and criminal 

penalties for unauthorized disclosure and unauthorized inspection do not apply with respect to 

disclosures or inspections made pursuant to this authority. 

The authority for this program expires December 31, 2005. 

Under section 6103(c), the IRS may disclose a taxpayer’s return or return information to 

such person or persons as the taxpayer may designate in a request for or consent to such 

disclosure. Pursuant to Treasury regulations, a taxpayer’s participation in a combined return 

filing program between the IRS and a State agency, body or commission constitutes a consent to 

the disclosure by the IRS to the State agency of taxpayer identity information, signature and 

items of common data contained on the return.153 No disclosures may be made under this 

authority unless there are provisions of State law protecting the confidentiality of such items of 

common data. 

Legislative History

The Taxpayer Relief Act of 1997 permitted implementation of a limited demonstration 

project to assess the feasibility and desirability of expanding combined Federal and State 

reporting. As enacted, it was limited to the sharing of information between the State of Montana 

and the IRS. The project was limited to employment tax reporting. In addition, it was limited to 

disclosure of the name, address, TIN, and signature of the taxpayer. The authority for the 

demonstration project expired on the date five years after the date of enactment (August 5, 

2002). 

The Working Families Tax Relief Act of 2004 reinstated and expanded to all States the 

authority to participate in a combined Federal and State employment tax reporting program. 

President’s Budget Proposal

No proposal. 

 153 Treas. Reg. sec. 301.6103(c)-1(d)(2)(i). Common data means information reflected on the 

Federal return required by State law to be attached to or included on the State return. 
95 

Analysis

Traditionally, Federal tax forms are filed with the Federal government and State tax 

forms are filed with individual states. A combined employment tax program reduces the burdens 

on taxpayers by combining employment tax reporting on one form. 

After the section 6103 authority for the demonstration program lapsed, the Department of 

Treasury issued regulations permitting disclosures to State agencies for purposes of combined 

employment tax reporting by treating participation in the program by a taxpayer as deemed 

consent to disclosure. Some argue that in light of the Treasury regulations, extension of the 

temporary statutory authority is unnecessary. On the other hand, implementation of the 

combined Montana-Federal employment tax reporting project was hindered because section 

6103 can be interpreted to apply that provision’s restrictions on disclosure to information 

common to both the State and Federal portions of the combined form, although if that 

information were supplied separately to both the State and the IRS, section 6103’s restrictions 

would not apply to the State’s use of State-requested information. Having the disclosure 

authority contained in the Code prevents any ambiguity as to whether such disclosures are 

authorized and clarifies whether the restrictions of section 6103 apply. 
96 

B. Disclosure of Return Information Regarding Terrorist Activities 

Present Law

In general

Section 6103 provides that returns and return information may not be disclosed by the 

IRS, other Federal employees, State employees, and certain others having access to the 

information except as provided in the Internal Revenue Code. Section 6103 contains a number 

of exceptions to this general rule of nondisclosure that authorize disclosure in specifically 

identified circumstances (including nontax criminal investigations) when certain conditions are 

satisfied. 

Among the disclosures permitted under the Code is disclosure of returns and return 

information for purposes of investigating terrorist incidents, threats, or activities, and for 

analyzing intelligence concerning terrorist incidents, threats, or activities. The term “terrorist 

incident, threat, or activity” is statutorily defined to mean an incident, threat, or activity 

involving an act of domestic terrorism or international terrorism, as both of those terms are 

defined in the USA PATRIOT Act.154 In general, returns and taxpayer return information must 

be obtained pursuant to an ex parte court order. Return information, other than taxpayer return 

information, generally is available upon a written request meeting specific requirements. The 

IRS also is permitted to make limited disclosures of such information on its own initiative to the 

appropriate Federal law enforcement agency. 

No disclosures may be made under these provisions after December 31, 2005. 

Separate from the terrorist activity provisions, the IRS has the authority to make 

disclosures of return information to the extent necessary to apprise appropriate officers and 

employees of any Federal of State law enforcement agency of circumstances involving imminent 

danger of death or physical injury to any individual. 

Disclosure of returns and return information - by ex parte court order

Ex parte court orders sought by Federal law enforcement and Federal intelligence 

agencies

The Code permits, pursuant to an ex parte court order, the disclosure of returns and return 

information (including taxpayer return information155) to certain officers and employees of a 

Federal law enforcement agency or Federal intelligence agency. These officers and employees 

are required to be personally and directly engaged in any investigation of, response to, or 

analysis of intelligence and counterintelligence information concerning any terrorist incident, 

 154 18 U.S.C. 2331. 

155 “Taxpayer return information” is return information that is filed with, or furnished to, the 

Secretary by or on behalf of the taxpayer to whom such return information relates. 
97 

threat, or activity. These officers and employees are permitted to use this information solely for 

their use in the investigation, response, or analysis, and in any judicial, administrative, or grand 

jury proceeding, pertaining to any such terrorist incident, threat, or activity. 

The Attorney General, Deputy Attorney General, Associate Attorney General, an 

Assistant Attorney General, or a United States attorney, may authorize the application for the ex 

parte court order to be submitted to a Federal district court judge or magistrate. The Federal 

district court judge or magistrate would grant the order if based on the facts submitted he or she 

determines that: (1) there is reasonable cause to believe, based upon information believed to be 

reliable, that the return or return information may be relevant to a matter relating to such terrorist 

incident, threat, or activity; and (2) the return or return information is sought exclusively for the 

use in a Federal investigation, analysis, or proceeding concerning any terrorist incident, threat, or 

activity. 

Special rule for ex parte court ordered disclosure initiated by the IRS

If the Secretary of Treasury possesses returns or return information that may be related to 

a terrorist incident, threat, or activity, the Secretary of the Treasury (or his delegate), may on his 

own initiative, authorize an application for an ex parte court order to permit disclosure to Federal 

law enforcement. In order to grant the order, the Federal district court judge or magistrate must 

determine that there is reasonable cause to believe, based upon information believed to be 

reliable, that the return or return information may be relevant to a matter relating to such terrorist 

incident, threat, or activity. The information may be disclosed only to the extent necessary to 

apprise the appropriate Federal law enforcement agency responsible for investigating or 

responding to a terrorist incident, threat, or activity and for officers and employees of that agency 

to investigate or respond to such terrorist incident, threat, or activity. Further, use of the 

information is limited to use in a Federal investigation, analysis, or proceeding concerning a 

terrorist incident, threat, or activity. Because the Department of Justice represents the Secretary 

of the Treasury in Federal district court, the Secretary is permitted to disclose returns and return 

information to the Department of Justice as necessary and solely for the purpose of obtaining the 

special IRS ex parte court order. 

Disclosure of return information other than by ex parte court order

Disclosure by the IRS without a request

The Code permits the IRS to disclose return information, other than taxpayer return 

information, related to a terrorist incident, threat, or activity to the extent necessary to apprise the 

head of the appropriate Federal law enforcement agency responsible for investigating or 

responding to such terrorist incident, threat, or activity. The IRS on its own initiative and 

without a written request may make this disclosure. The head of the Federal law enforcement 

agency may disclose information to officers and employees of such agency to the extent 

necessary to investigate or respond to such terrorist incident, threat, or activity. A taxpayer’s 

identity is not treated as taxpayer return information for this purpose, and may be disclosed under 

this authority. 
98 

Disclosure upon written request of a Federal law enforcement agency

The Code permits the IRS to disclose return information, other than taxpayer return 

information, to officers and employees of Federal law enforcement upon a written request 

satisfying certain requirements. A taxpayer’s identity is not treated as taxpayer return 

information for this purpose and may be disclosed under this authority. The request must: 

(1) be made by the head of the Federal law enforcement agency (or his delegate) involved in the 

response to or investigation of terrorist incidents, threats, or activities, and (2) set forth the 

specific reason or reasons why such disclosure may be relevant to a terrorist incident, threat, or 

activity. The information is to be disclosed to officers and employees of the Federal law 

enforcement agency who would be personally and directly involved in the response to or 

investigation of terrorist incidents, threats, or activities. The information is to be used by such 

officers and employees solely for such response or investigation. 

The Code permits the head of a Federal law enforcement agency to redisclose return 

information received, in response to the written request described above, to officers and 

employees of State and local law enforcement personally and directly engaged in the response to 

or investigation of the terrorist incident, threat, or activity. The State or local law enforcement 

agency must be part of an investigative or response team with the Federal law enforcement 

agency for these disclosures to be made. 

Disclosure upon request from the Departments of Justice or Treasury for intelligence 

analysis of terrorist activity

Upon written request satisfying certain requirements discussed below, the IRS is to 

disclose return information (other than taxpayer return information) to officers and employees of 

the Department of Justice, Department of Treasury, and other Federal intelligence agencies, who 

are personally and directly engaged in the collection or analysis of intelligence and 

counterintelligence or investigation concerning terrorist incidents, threats, or activities. Use of 

the information is limited to use by such officers and employees in such investigation, collection, 

or analysis. A taxpayer’s identity is not treated as taxpayer return information for this purpose 

and may be disclosed under this authority. 

The written request is to set forth the specific reasons why the information to be disclosed 

is relevant to a terrorist incident, threat, or activity. The request is to be made by an individual 

who is: (1) an officer or employee of the Department of Justice or the Department of Treasury, 

(2) appointed by the President with the advice and consent of the Senate, and (3) responsible for 

the collection, and analysis of intelligence and counterintelligence information concerning 

terrorist incidents, threats, or activities. The Director of the United States Secret Service also is 

an authorized requester under the Act. 

Legislative History

The terrorist activity disclosure provisions were added to the Code by the Victims of 

Terrorism Tax Relief Act of 2001 (Pub. L. 107-134). Authority for making disclosures under 

this provision lapsed on January 1, 2004. The Working Families Tax Relief Act of 2004 (Pub. L. 
99 

No. 108-311) restored the authority for disclosures made on or after October 4, 2004, through 

December 31, 2005. 

President’s Budget Proposal

The proposal extends the disclosure authority relating to terrorist activities. Under the 

proposal, no disclosures can be made after December 31, 2006. 

Effective date.–The proposal is effective for disclosures on or after the date of enactment. 

Analysis

The temporary nature of the present-law provision introduces a degree of uncertainty 

regarding the disclosure of return information relating to terrorist activities, i.e., whether the 

provision will be the subject of further extensions. There has been no study of the effectiveness 

of the provisions. 

According to IRS accountings of disclosures made under the authority of the provisions 

in calendar year 2002, the IRS reported 39 disclosures to the Federal Bureau of Investigation 

under the terrorist activity provisions governing IRS-initiated disclosures to Federal law 

enforcement.156 However, the IRS used its authority to make disclosures in emergency 

circumstances to make an additional 12,236 disclosures to the FBI. The IRS made 25 

disclosures to the Department of Justice for purposes of preparing an application for an ex parte

court order to permit the IRS to initiate an affirmative disclosure of returns and return 

information. Pursuant to the ex parte court order authority, 2,215 disclosures were made to U.S. 

Attorneys in calendar year 2002. The IRS did not report any terrorist activity disclosures to 

Federal intelligence agencies, nor did it report any disclosures in response to requests from 

Federal law enforcement agencies for calendar year 2002. 

 For calendar year 2003, 1,626 disclosures were made under the terrorist activity 

provisions governing IRS disclosures to Federal law enforcement. Under the ex parte court 

order authority, 1,724 disclosures were made to U.S. Attorneys in calendar year 2003. The IRS 

did not report any disclosures to Federal intelligence agencies or in response to requests from 

Federal law enforcement agencies for calendar year 2003.157 This limited usage could be an 

indication that further extension of the provision is not warranted. On the other hand, this may 

not be a significant number of disclosures to evaluate the effectiveness of the provision. An 

additional temporary extension provides additional time to evaluate the effectiveness of the 

provision and whether any modifications need to be implemented to enhance the provision. 

 156 Joint Committee on Taxation, Revised Disclosure Report for Public Inspection Pursuant to 

Internal Revenue Code Section 6103(p)(3)(c) for Calendar Year 2002 (JCX-29-04), April 6, 2004. 

157 Joint Committee on Taxation, Disclosure Report for Public Inspection Pursuant to Internal 

Revenue Code Section 6103(p)(3)(C) for Calendar Year 2003 (JCX-30-04), April 6, 2004. 
100 

Some argue that the terrorist activity disclosure provisions are duplicative provisions that 

were already in place for emergency disclosures and for use in criminal investigations. As noted 

above, the IRS used its emergency disclosure authorization to make disclosures to the Federal 

Bureau of Investigation concerning terrorist activity. However, the emergency disclosure 

authorization is to be used under circumstances involving an imminent danger of death or 

physical injury. In the case of terrorist activity, it may not be clear whether the danger is 

“imminent”, which could lead to the misapplication of the emergency authority and uncertainty 

as to whether a particular disclosure is authorized. Thus, the existence of a specific disclosure 

provision for terrorist activity information provides clear authority and direction for making 

disclosures to combat terrorism. 

The requirements for disclosure of terrorist activity information are not as stringent as 

those required for criminal investigations. For example, the granting of an ex parte order 

relating to terrorist activities does not require a finding that there is reasonable cause to believe 

that a specific criminal act has been committed. In cases involving terrorist activity the judge or 

magistrate needs to determine that there is reasonable cause to believe that the return or return 

information may be relevant to a matter relating to such terrorist incident, threat or activity. In 

addition, unlike the requirements for criminal investigations, the judge or magistrate does not 

need to find that the information cannot be reasonably obtained from another source before 

granting the request for an ex parte order for disclosure relating to terrorist activity. Some argue 

that the less stringent requirements facilitate a proactive approach to combating terrorism. 
101 

C. Disclosure of Return Information to Carry Out Income 

Contingent Repayment of Student loans 

Present Law

Income-contingent loan verification program

Present law prohibits the disclosure of returns and return information, except to the extent 

specifically authorized by the Code.158 An exception is provided for disclosure to the 

Department of Education (but not to contractors thereof) of a taxpayer’s filing status, adjusted 

gross income and identity information (i.e., name, mailing address, taxpayer identifying number) 

to establish an appropriate repayment amount for an applicable student loan.159 The Department 

of Education disclosure authority is scheduled to expire after December 31, 2005.160 

An exception to the general rule prohibiting disclosure is also provided for the disclosure 

of returns and return information to a designee of the taxpayer.161 Because the Department of 

Education utilizes contractors for the income-contingent loan verification program, the 

Department of Education obtains taxpayer information by consent under section 6103(c), rather 

than under the specific exception.162 The Department of Treasury has reported that the Internal 

Revenue Service processes approximately 100,000 consents per year for this purpose.163 

Verifying financial aid applications

The Higher Education Act of 1998 (“Higher Education Act”) authorized the Department 

of Education to confirm with the Internal Revenue Service four discrete items of return 

information for the purposes of verifying student aid applications.164 The Higher Education Act, 

however, did not amend the Code to permit disclosure for this purpose. Therefore, the disclosure 

provided by the Higher Education Act may not be made unless the taxpayer consents to the 

disclosure under section 6103(c). 

 158 Sec. 6103. 

159 Sec. 6103(l)(13). 

160 Pub. L. No. 108-311 (2004). 

161 Sec. 6103(c). 

162 Department of Treasury, Report to the Congress on Scope and Use of Taxpayer 

Confidentiality and Disclosure Provisions, Volume I: Study of General Provisions (October 2000) at 91. 

163 Department of Treasury, General Explanations of the Administration’s Fiscal Year 2004 

Revenue Proposals (February 2003), p. 133. 

164 Pub. L. No. 105-244, sec. 483 (1998). 
102 

The financial aid application is submitted to the Department of Education and is then 

given to a contractor for processing. Based on the information given, the contractor calculates an 

expected family contribution that determines the amount of aid a student will receive. All 

Department of Education financial aid is disbursed directly through schools or various lenders. 

The Department of Education requires schools to verify the financial aid information of 

30 percent of the applicants. The applicants must furnish a copy of their tax returns. The 

applicants are not required to obtain copies of tax returns from the IRS or to produce certified 

copies, and the returns supplied by applicants to the Department of Education are not matched 

with the returns filed with the IRS. If the information reflected on the student’s copy of the tax 

return does not match the information on the financial aid application, the school requires 

corrective action to be taken before a student receives the appropriate aid. 

The Office of Inspector General of the Department of Education has reported that, 

because many applicants are reporting incorrect information on their financial aid applications, 

erroneous overpayments of Federal Pell grants have resulted. 

Overpayments of Pell grants and defaulted student loans

For purposes of locating a taxpayer to collect an overpayment of a Federal Pell grant or to 

collect payments on a defaulted loan, the Internal Revenue Service may disclose the taxpayer’s 

mailing address to the Department of Education.165 To assist in locating the defaulting taxpayer, 

the Department of Education may redisclose the mailing address to the officers, employees and 

agents of certain lenders, States, nonprofit agencies, and educational institutions whose duties 

relate to the collection of student loans.166

Safeguard procedures and recordkeeping

Federal and State agencies that receive returns and return information are required to 

maintain a standardized system of permanent records on the use and disclosure of that 

information.167 Maintaining such records is a prerequisite to obtaining and continuing to obtain 

returns and return information. Such agencies must also establish procedures satisfactory to the 

IRS for safeguarding the information it receives. The IRS must also file annual reports with the 

House Committee on Ways and Means, the Senate Committee on Finance, and the Joint 

Committee on Taxation regarding procedures and safeguards followed by recipients of return 

and return information.168

 165 Sec. 6103(m)(4). 

166 Id. 

167 Sec. 6103(p)(4). 

168 Sec. 6103(p)(5). 
103 

Legislative History

The disclosure of return information to carry out the income contingent repayment of 

student loans was first enacted on a temporary basis in the “Omnibus Budget Reconciliation Act 

of 1993”169 and was scheduled to expire on September 30, 1998. The provision was enacted on a 

temporary basis because the Committee was concerned about the increasing number of requests 

for disclosure of confidential tax information for nontax purposes and the effect of such 

disclosure on voluntary taxpayer compliance.170 The “Tax and Trade Relief Extension Act of 

1998”171 extended the disclosure authority again on a temporary basis for an additional five years 

through September 30, 2003. The “Temporary Assistance for Needy Families Act of 2003”172

extended the disclosure authority through December 31, 2004. The “Working Families Tax 

Relief Act of 2004”173 extended the disclosure authority an additional year through December 

31, 2005. 

President’s Budget Proposal

The President’s budget proposal allows the disclosure to the Department of Education 

and its contractors of the adjusted gross income, filing status, total earnings from employment, 

Federal income tax liability, type of return filed and taxpayer identity information for the 

financial aid applicant or of the applicant’s parents (if the applicant is a dependent) or spouse (if 

married). Pursuant to the President’s budget proposal, the Department of Education could use 

the information not only for establishing a loan repayment amount but also for verifying items 

reported by student financial aid applicants and their parents. 

The President’s budget proposal allows the Department of Education to use contractors to 

process the information disclosed to the Department of Education, eliminating the need for 

consents. It is understood that the proposal imposes the present-law safeguards applicable to 

disclosures to Federal and State agencies on disclosures to the Department of Education and its 

contractors. Similar proposals were contained in the President’s fiscal year 2003, 2004 and 2005 

budget proposals. 

Effective date.–The proposal is effective with respect to disclosures made after the date 

of enactment. 

 169 Pub. L. No. 103-66 (1993). 

170 H.R. Rept. 103-111 (1993). 

171 Pub. L. No. 105-277 (1998). 

172 Pub. L. No. 108-89 (2003). 

173 Pub. L. No. 108-311 (2004). 
104 

Analysis

Income contingent loan verification program

Currently the Department of Education uses consents to obtain tax information for 

purposes of its income contingent loan verification program, and does not rely on the statutory 

authority to receive that information without consent. The IRS processes over 100,000 consents 

for this program. Some might argue that since the specific statutory authority is not being used, 

it should not be extended. 

Verifying financial aid applications

Congress has expressed a concern about the increasing number of requests for the 

disclosure of confidential tax information for nontax purposes and the effect of such disclosures 

on voluntary taxpayer compliance.174 Some might argue that consensual disclosure of return 

information, in which the taxpayer knowingly consents to the disclosure of his or her return 

information (“consents”), is less likely to adversely impact taxpayer compliance than adding a 

nonconsensual provision for the disclosure of taxpayer information. Since the IRS is already 

processing consents for the Department of Education, some would argue that the current practice 

simply could be extended to financial aid applications.175 On the other hand, some might argue 

that because present law does not impose restrictions on redisclosure of return information 

obtained by consent, the proposal, which imposes such restrictions, would be preferable. 

Critics might argue that the disclosure of sensitive return information of millions176 of 

taxpayers to identify the abuse of a few does not strike the appropriate balance between the need 

to know and the right to privacy. On the other hand, some might argue that since this financial 

information is already required to be submitted as part of the financial aid form, the infringement 

on taxpayer privacy is minimal. 

 174 S. Prt. No. 103-37 at 54 (1993). 

175 In its study on the disclosure of return information, the Department of Treasury noted: “The 

burden of processing this number of consents obviously would be reduced if the consents were executed 

and transmitted electronically. Accordingly, the Department of Education has asked to be included in the 

TDS program.” Department of Treasury, Report to the Congress on Scope and Use of Taxpayer 

Confidentiality and Disclosure Provisions, Volume I: Study of General Provisions (2000) at 92. 

176 The Department of Education seeks access to the return information of approximately 15 

million taxpayers each year. The Department of Education receives approximately 10 million 

applications for student financial assistance each year. Because roughly half of the applicants are 

dependents, income information is needed for both the student and his or her parents. Thus, verification 

under this provision could apply to over 15 million taxpayers each year. It is not clear what percentage 

of applicants submit fraudulent financial aid applications. Id. 
105 

Contractors

The Administration’s proposal permits the disclosure of a taxpayer’s return information 

to contractors and agents of the Department of Education, not just to Department of Education 

employees. Some might argue that the use of contractors significantly expands the risk of 

unauthorized disclosure, particularly when return information is used by a contractor outside of 

the recipient agency. The volume of taxpayer information involved under this proposal and the 

disclosure of millions of taxpayer records, significantly contributes to the risk of unauthorized 

disclosure. On the other hand, some might argue that it is appropriate to permit the disclosure of 

otherwise confidential tax information to contractors to ensure the correctness of Federal student 

aid. 

Opponents of the proposal may argue that it is not clear that the IRS has the resources 

and computer specialists to implement and enforce the safeguards that the proposal imposes. 

However, proponents of the proposal argue that the proposal alleviates some of the burden on the 

IRS by requiring the Department of Education to monitor its contractors as a supplement to the 

safeguard reviews conducted by the IRS. 

Burdens on IRS

In general, the Administration’s proposal eases the burden on the financial aid applicant 

because the applicant will not be required to produce copies of their tax returns for verification of 

their financial aid applications. The proposal arguably provides simplification for the schools as 

well, because the schools will no longer be required to match the information of 30 percent of its 

applicants. On the other hand, the proposal tends to increase complexity for the IRS by requiring 

it to resolve discrepancies between tax information and income data on the financial aid 

application if the applicant is unable to resolve the discrepancy with the school. 
106 

D. Authority for Undercover Operations 

Present Law

IRS undercover operations are exempt from the otherwise applicable statutory restrictions 

controlling the use of Government funds (which generally provide that all receipts must be 

deposited in the general fund of the Treasury and all expenses be paid out of appropriated funds). 

In general, the exemption permits the IRS to “churn” the income earned by an undercover 

operation to pay additional expenses incurred in the undercover operation. The IRS is required 

to conduct a detailed financial audit of large undercover operations in which the IRS is churning 

funds and to provide an annual audit report to the Congress on all such large undercover 

operations. 

Legislative Background

The provision was originally enacted in The Anti-Drug Abuse Act of 1988.177 The 

exemption originally expired on December 31, 1989, and was extended by the Comprehensive 

Crime Control Act of 1990178 to December 31, 1991.179 There followed a gap of approximately 

four and a half years during which the provision had lapsed. In the Taxpayer Bill of Rights II,180

the authority to churn funds from undercover operations was extended for five years, through 

2000.181 The Community Renewal Tax Relief Act of 2000182 extended the authority of the IRS to 

“churn” the income earned from undercover operations for an additional five years, through 

2005. 

President’s Budget Proposal

The President’s Budget proposes to extend this authority through December 31, 2010. 

 177 Sec. 7601(c) of Pub. L. 100-690 (Nov. 18, 1988). 

178 Sec. 3301 of Pub. L. 101-647 (Nov. 29, 1990). 

179 The Ways and Means Committee Report stated: “The committee believes that it is appropriate 

to extend this provision for two additional years, to provide additional time to evaluate its effectiveness.” 

Rept. 101-681, Part 2, p. 5 (September 10, 1990). 

180 Sec. 1205 of Pub. L. 104-168 (July 30, 1996). 

181 The Ways and Means Committee Report stated: “Many other law enforcement agencies have 

churning authority. It is appropriate for IRS to have this authority as well.” Rept. 104-506, p. 47 (March 

28, 1996). The Senate passed the House bill without alteration. 

182 Pub. L. 106-554. 
107 

Analysis

 Some believe the extension of this authority is appropriate because they believe that it 

assists the fight against terrorism. Some also believe that it is appropriate for IRS to have this 

authority because other law enforcement agencies have churning authority. Others, however, 

point to the four and a half year gap during which the provision had lapsed as evidence that this 

authority is not essential to the operation of the IRS. However, it is difficult to show what 

investigative opportunities were lost due to the lack of churning authority during that period. 

Some believe that extension is inappropriate because the provision may provide incentives to 

continue undercover operations for extended periods of time. IRS data for fiscal years 2002, 

2003, and 2004 reveal that a total of approximately $748,000 was churned while only $6,700 

was deposited in the general fund of the Treasury due to the cessation of undercover operations. 
108 

E. Joint Review of IRS Strategic Plans and Budget 

Present Law

Under present law, the Joint Committee on Taxation (“Joint Committee”) is required to 

conduct a joint review of the strategic plans and budget of the IRS by June 1 of each year after 

1998 and before 2004. In addition, the Joint Committee is required to hold a joint review before 

June 1, 2005.183 The joint review is to be held at the call of the Chair of the Joint Committee, 

and is to include two members of the majority and one member of the minority from each of the 

Committees on Finance, Appropriations, and Homeland Security and Governmental Affairs184 of 

the Senate and the Committees on Ways and Means, Appropriations, and Government Reform185

of the House. 

For years 1999 through 2003, the Joint Committee is required to provide a report to the 

committees included in the joint review with respect to the: 

• strategic and business plans for the IRS; 

• progress of the IRS in meeting its objectives; 

• budget for the IRS and whether it supports its objectives; 

• progress of the IRS in improving taxpayer service and compliance; 

• progress of the IRS on technology modernization; and 

• annual filing season.186

 183 Sec. 8021(f). Joint reviews were held on May 25, 1999, May 3, 2000, May 8, 2001, May 14, 

2002, and May 20, 2003. Transcripts of the joint reviews for 1999-2002 were published by the Joint 

Committee on Taxation as follows: Joint Review of Strategic Plans and Budget of the Internal Revenue 

Service, 1999 (JCS-4-99); Joint Review of Strategic Plans and Budget of the Internal Revenue Service, 

2000 (JCS-4-00); Joint Review of Strategic Plans and Budget of the Internal Revenue Service, 2001 (JCS2-02); Joint Review of Strategic Plans and Budget of the Internal Revenue Service, 2002 (JCS-4-02). 

184 This committee was previously named the Committee on Governmental Affairs. 

185 This committee was previously named the Committee on Government Reform and Oversight. 

186 The reports for 1999-2003 are as follows: Joint Committee on Taxation, Report of the Joint 

Committee on Taxation Relating to the Internal Revenue Service as Required by the IRS Reform and 

Restructuring Act of 1998 (JCX-24-99), May 20, 1999; Joint Committee on Taxation, Report of the Joint 

Committee on Taxation Relating to the Internal Revenue Service as Required by the IRS Reform and 

Restructuring Act of 1998 (JCX-46-00), April 28, 2000; Joint Committee on Taxation, Report of the Joint 

Committee on Taxation Relating to the Internal Revenue Service as Required by the IRS Reform and 

Restructuring Act of 1998 (JCX-33-01), May 4, 2001; Joint Committee on Taxation, Report of the Joint 

Committee on Taxation Relating to the Internal Revenue Service as Required by the IRS Reform and 

Restructuring Act of 1998 (JCX-38-02), May 20, 2002; Joint Committee on Taxation, Report of the Joint 
109 

With respect to the joint review that is required to occur before June 1, 2005, the Joint 

Committee is to report on the matters that are the subject of the joint review. 

Legislative History

The requirements for a joint review and the Joint Committee report were enacted on a 

temporary basis as part of the Internal Revenue Service Restructuring and Reform Act of 

1998.187 Under that Act, joint reviews (and reports) were required for 1999-2003. The 

requirement for a joint review by June 1, 2005, and the changes to the required contents of the 

Joint Committee report were enacted as part of the Working Families Tax Relief Act of 2004.188

President’s Budget Proposal

No proposal. 

Analysis

There are six committees of the Congress that exercise primary oversight authority over 

the IRS: the Committees on Ways and Means, Appropriations, and Government Reform of the 

House, and the Committees on Finance, Appropriations, and Homeland Security and 

Governmental Affairs of the Senate. While these Committees have a shared interest in IRS 

matters, they typically act independently and have separate hearings and make separate 

investigations into IRS matters. Each committee also has jurisdiction over certain issues. 

The requirement for a joint review including all committees with IRS oversight 

jurisdiction was enacted as a result of findings by the National Commission on Restructuring the 

Internal Revenue Service189 that the Congressional committees responsible for IRS oversight 

“focus on different issues that change from year to year. While the issues they address are 

important, there is a lack of coordinated focus on high level and strategic matters. Because the 

IRS tries to satisfy requests from Congress, this nonintegrated approach to oversight further blurs 

the ability to set strategic direction and focus on priorities.” The Congress believed that 

Congressional oversight of the IRS should be more coordinated and should include long-term 

objectives.”190 

 

Committee on Taxation Relating to the Internal Revenue Service as Required by the IRS Reform and 

Restructuring Act of 1998 (JCX-53-03), May 19, 2003. 

187 Pub. L. No. 105-206. 

188 Pub. L. No. 108-311. 

189 See Report of the National Commission on Restructuring of the Internal Revenue Service “A 

Vision of a New IRS,” June 25, 1997. 

190 Id. at 2; H.R. Rept. No. 105-364, Part I at 84. 
110 

The joint review provides the opportunity for members of the committees with 

jurisdiction over various IRS issues come together to discuss areas of concern. To the extent 

utilized, this opportunity may assist in determining the issues of common concern (as well as 

those where there are differences) and assist both the IRS and the Congress in setting priorities 

with respect to IRS matters. 

In practice, the extent to which the joint review has produced such results is unclear. 

Each committee continues to have its own hearings with respect to the issues within the 

jurisdiction of the committee. Thus, the joint review may add additional burdens on IRS 

personnel, which may detract from carrying out its responsibilities. In considering whether to 

extend the requirement for a joint review, it may be appropriate to balance potential benefits, 

which may be difficult to measure, against the additional burdens placed on the IRS. 

The changes made to the Joint Committee report by the Working Families Tax Relief Act 

are intended to better tailor the report to the particular topics to be addressed by the joint review. 

Compared to the previously-required more generalized report, a more tailored report may 

provide a more useful tool for the Congress in addressing the issues of most concern.