99–010 

Calendar No. 496

107TH CONGRESS REPORT " SENATE ! 2d Session 107–211 

CARE ACT OF 2002

JULY 16, 2002.—Ordered to be printed 

Mr. BAUCUS, from the Committee on Finance, 

submitted the following 

R E P O R T 

[To accompany H.R. 7] 

The Committee on Finance, to which was referred the bill (H.R. 

7) to provide incentives for charitable contributions by individuals 

and businesses, to improve the effectiveness and efficiency of government program delivery to individuals and families in need, and 

to enhance the ability of low-income Americans to gain financial security by building assets, having considered the same, report favorably thereon with an amendment in the nature of a substitute and 

recommend that the bill as amended do pass.

CONTENTS 

Page 

I. LEGISLATIVE BACKGROUND ..................................................................... 3

II. EXPLANATION OF THE BILL ...................................................................... 4

TITLE I. CHARITABLE GIVING INCENTIVES ................................................. 4

A. Charitable Deduction for Nonitemizers (sec. 101 of the bill and secs. 

63 and 170 of the Code) ................................................................................ 4

B. Tax-Free Distributions From Individual Retirement Arrangements for 

Charitable Purposes (sec. 102 of the bill and secs. 408 and 6034 of 

the Code) ........................................................................................................ 6

C. Charitable Deduction for Contributions of Food Inventory (sec. 103 

of the bill and sec. 170 of the Code) ............................................................ 13

D. Charitable Deduction for Contributions of Book Inventory (sec. 104 

of the bill and sec. 170 of the Code) ............................................................ 15

E. Expand Charitable Contribution Allowed for Scientific Property Used 

for Research and for Computer Technology and Equipment (sec. 105 

of the bill and sec. 170 of the Code) ............................................................ 17

F. Encourage Contributions of Capital Gain Real Property Made for Conservation Purposes (sec. 106 of the bill and sec. 170 of the Code) ............ 18 

G. Exclusion of 25 Percent of Capital Gain for Certain Sales Made for 

Qualifying Conservation Purposes (sec. 107 of the bill and new sec. 

121A of the Code) .......................................................................................... 21 

H. Cost Sharing Payments under the Partners for Fish and Wildlife 

Program (sec. 108 of the bill and sec. 126 of the Code) ............................. 27 

2

I. Basis Adjustment to Stock of S Corporation Contributing Property 

(sec. 109 of the bill and sec. 1367 of the Code) ........................................... 28 

J. Enhanced Deduction for Charitable Contribution of Literary, Musical, 

Artistic, and Scholarly Compositions (sec. 110 of the bill and sec. 170 

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

TITLE II. DISCLOSURE OF INFORMATION RELATING TO TAX-EXEMPT 

ORGANIZATIONS ............................................................................................... 31

A. Disclosure of Written Determinations (sec. 201 of the bill and sec. 

6110 of the Code) .......................................................................................... 31

B. Disclosure of Internet Web Site and Name Under Which Organization 

Does Business (sec. 202 of the bill and sec. 6033 of the Code) ................. 35

C. Modification to Reporting of Capital Transactions (sec. 203 of the 

bill and secs. 6033 and 6104 of the Code) ................................................... 36

D. Disclosure that Form 990 is Publicly Available (sec. 204 of the bill) ...... 37

E. Disclosure to State Officials of Proposed Actions Related to Section 

501(c) Organizations (sec. 205 of the bill and sec. 6104 of the Code) ....... 37 

TITLE III. OTHER CHARITABLE AND EXEMPT ORGANIZATION PROVISIONS ................................................................................................................... 40

A. Modify Tax on Unrelated Business Taxable Income of Charitable Remainder Trusts (sec. 301 of the bill and sec. 664 of the Code) ................. 40

B. Modify Tax Treatment of Certain Payments to Controlling Exempt 

Organizations (sec. 302 of the bill and sec. 512 of the Code) .................... 42

C. Simplification of Lobbying Expenditure Limitation (sec. 303 of the 

bill and secs. 501 and 4911 of the Code) ..................................................... 43

D. Expedited Review Process for Certain Tax-Exemption Applications 

(sec. 304 of the bill) ....................................................................................... 47

E. Clarification of Definition of Church Tax Inquiry (sec. 305 of the 

bill and sec. 7611 of the Code) ..................................................................... 49

F. Extension of Declaratory Judgment Procedures to Non-501(c)(3) TaxExempt Organizations (sec. 306 of the bill and sec. 7428 of the Code) .... 50

G. Definition of Convention or Association of Churches (sec. 307 of the 

bill and sec. 7701 of the Code) ..................................................................... 51

H. Charitable Contribution Deduction for Certain Expenses in Support 

of Native Alaskan Subsistence Whaling (sec. 308 of the bill and sec. 

170 of the Code) ............................................................................................ 52

I. Payments by Charitable Organizations to Victims of War on Terrorism 

(sec. 309 of the bill) ....................................................................................... 54

J. Modify Rules Governing Tax-Exempt Bonds for Section 501(c)(3) Organizations as Applied to Organizations Engaged in Timber Conservation 

Activities (sec. 310 of the bill and sec. 145 of the Code) ............................ 55

K. Provide Tax Exemption for Organizations Created by a State to Provide Property and Casualty Insurance Coverage for Property for Which 

Such Coverage is Otherwise Unavailable (sec. 311 of the bill and sec. 

501(c)(28) of the Code) .................................................................................. 57

L. Conform Provisions Relating to Arbitrage Treatment of Certain University Fund to State Constitutional Amendments (sec. 312 of the 

bill) ................................................................................................................. 60

M. Matching Grants to Low-Income Taxpayer Clinics for Return Preparation (sec. 313 of the bill) ............................................................................... 61

N. Increase Percentage Limits for Certain Employer-Related Scholarship 

Programs (sec. 314 of the bill) ..................................................................... 62

TITLE IV. SOCIAL SERVICES BLOCK GRANT (secs. 401–403 of the bill) ..... 64

TITLE V. INDIVIDUAL DEVELOPMENT ACCOUNTS (secs. 501–511 of the 

bill) ........................................................................................................................ 65

TITLE VI. REVENUE PROVISIONS .................................................................... 69

A. Tax Shelter Transparency Requirements .................................................. 69

1. Penalty for failure to disclose reportable transactions (sec. 601 

of the bill and new sec. 6707A of the Code) ......................................... 69

2. Modifications to the accuracy-related penalties for listed transactions and reportable transactions having a significant tax avoidance purpose (sec. 602 of the bill and new sec. 6662A and secs. 

6662 and 6664 of the Code) .................................................................. 74

3. Modifications to the substantial understatement penalty (sec. 603 

of the bill and sec. 6662 of the Code) ................................................... 78

4. Tax shelter exception to confidentiality privileges relating to taxpayer communications (sec. 604 of the bill and sec. 7525 of the 

Code) ....................................................................................................... 79

3

5. Disclosure of reportable transactions by material advisors (secs. 

611 and 612 of the bill and secs. 6111 and 6707 of the Code) ........... 93 

6. Investor lists and applicable penalties (secs. 611 and 613 of the 

bill and secs. 6112 and 6708 of the Code) ............................................ 96 

7. Actions to enjoin conduct with respect to tax shelters (sec. 614 

of the bill and sec. 7408 of the Code) ................................................... 98 

8. Understatement of taxpayer’s liability by income tax return preparer (sec. 621 of the bill and sec. 6694 of the Code) ......................... 99 

9. Penalty on failure to report interests in foreign financial accounts 

(sec. 622 of the bill and sec. 5321 of Title 31, United States Code) .. 100 

10. Frivolous tax returns and submissions (sec. 623 of the bill and 

sec. 6702 of the Code) ............................................................................ 101 

11. Regulation of individuals practicing before the Department of 

the Treasury (sec. 624 of the bill and sec. 330 of Title 31, United 

States Code) ........................................................................................... 102 

12. Penalties on promoters of tax shelters (sec. 625 of the bill and 

sec. 6700 of the Code) ............................................................................ 103 

13. Affirmation of consolidated return regulation authority (sec. 631 

of the bill and sec. 1502 of the Code) ................................................... 105 

B. Tax Treatment of Inversion Transactions (sec. 641 of the bill and 

new sec. 7874 of the Code) ........................................................................... 111 

C. Reinsurance Agreements (sec. 651 of the bill and sec. 845 of 

the Code) ................................................................................................ 117 

D. Extension of IRS User Fees (sec. 661 of the bill and new sec. 

7527 of the Code) ................................................................................... 119 

E. Extension of Customs Service User Fees (sec. 671 of the bill) ......... 120 

III. BUDGET EFFECTS OF THE BILL ............................................................... 121 

A. Committee Estimates .................................................................................. 121 

B. Budget Authority and Tax Expenditures ................................................... 122 

C. Consultation with Congressional Budget Office ........................................ 122 

IV. VOTES OF THE COMMITTEE ...................................................................... 123 

V. REGULATORY IMPACT AND OTHER MATTERS ..................................... 124 

A. Regulatory Impact ....................................................................................... 124 

B. Unfunded Mandates Statement .................................................................. 124 

C. Tax Complexity Analysis ............................................................................. 125 

VI. CHANGES IN EXISTING LAW MADE BY THE BILL AS REPORTED 127

I. LEGISLATIVE BACKGROUND 

Overview 

H.R. 7 (the ‘‘Community Solutions Act of 2001’’) was passed by 

the House of Representatives on July 19, 2001. H.R. 7 was referred 

to the Senate Committee on Finance on July 19, 2001. The Senate 

Committee on Finance marked up the bill on June 13, 2002, and 

June 18, 2002. The bill, as amended by an amendment in the nature of a substitute, was ordered reported on June 18, 2002 by 

voice vote. 

Committee hearings 

The Committee held a hearing regarding encouraging charitable 

giving on March 14, 2001. 

The Committee held a hearing on March 21, 2002, regarding the 

proliferation of tax shelters. At such hearing, notice was given that 

the Committee intended to take action to curtail the benefits of inversion transactions 

4

1 All section references are to the Internal Revenue Code of 1986, unless otherwise indicated. 

2Secs. 170(b) and (e). 

3Sec. 170(a). The Economic Recovery Tax Act of 1981 adopted a temporary provision that permitted individual taxpayers who did not itemize income tax deductions to claim a deduction 

from gross income for a specified percentage of their charitable contributions. The maximum deduction was $25 for 1982 and 1983, $75 for 1984, 50 percent of the amount of the contribution 

for 1985, and 100 percent of the amount of the contribution for 1986. The nonitemizer deduction 

terminated after 1986. 4See. 170(f)(8). 

5Sec. 6115. 

II. EXPLANATION OF THE BILL 

Title I. Charitable Giving Incentives 

A. CHARITABLE DEDUCTION FOR NONITEMIZERS

(Sec. 101 of the bill and secs. 63 and 170 of the Code) 

PRESENT LAW

In computing taxable income, an individual taxpayer who 

itemizes deductions generally is allowed to deduct the amount of 

cash and up to the fair market value of property contributed to a 

charity described in section 501(c)(3) 1 or a Federal, State, or local 

governmental entity. The deduction also is allowed for purposes of 

calculating alternative minimum taxable income. 

The amount of the deduction allowable for a taxable year with 

respect to a charitable contribution of property may be reduced depending on the type of property contributed, the type of charitable 

organization to which the property is contributed, and the income 

of the taxpayer.2

A taxpayer who takes the standard deduction (i.e., who does not 

itemize deductions) may not take a separate deduction for charitable contributions.3

A payment to a charity (regardless of whether it is termed a 

‘‘contribution’’) in exchange for which the donor receives an economic benefit is not deductible, except to the extent that the donor 

can demonstrate that the payment exceeds the fair market value 

of the benefit received from the charity. To facilitate distinguishing 

charitable contributions from purchases of goods or services from 

charities, present law provides that no charitable contribution deduction is allowed for a separate contribution of $250 or more unless the donor obtains a contemporaneous written acknowledgement of the contribution from the charity indicating whether the 

charity provided any good or service (and an estimate of the value 

of any such good or service) to the taxpayer in consideration for the 

contribution.4 In addition, present law requires that any charity 

that receives a contribution exceeding $75 made partly as a gift 

and partly as consideration for goods or services furnished by the 

charity (a ‘‘quid pro quo’’ contribution) is required to inform the 

contributor in writing of an estimate of the value of the goods or 

services furnished by the charity and that only the portion exceeding the value of the goods or services is deductible as a charitable 

contribution.5

Under present law, total deductible contributions of an individual 

taxpayer to public charities, private operating foundations, and certain types of private nonoperating foundations may not exceed 50 

percent of the taxpayer’s contribution base, which is the taxpayer’s 

5

adjusted gross income for a taxable year (disregarding any net operating loss carryback). To the extent a taxpayer has not exceeded 

the 50-percent limitation, (1) contributions of capital gain property 

to public charities generally may be deducted up to 30 percent of 

the taxpayer’s contribution base, (2) contributions of cash to private 

foundations and certain other charitable organizations generally 

may be deducted up to 30 percent of the taxpayer’s contribution 

base, and (3) contributions of capital gain property to private foundations and certain other charitable organizations generally may 

be deducted up to 20 percent of the taxpayer’s contribution base. 

Contributions by individuals in excess of the 50-percent, 30-percent, and 20-percent limit may be carried over and deducted over 

the next five taxable years, subject to the relevant percentage limitations on the deduction in each of those years. 

In addition to the percentage limitations imposed specifically on 

charitable contributions, present law imposes a reduction on most 

itemized deductions, including charitable contribution deductions, 

for taxpayers with adjusted gross income in excess of a threshold 

amount, which is indexed annually for inflation. The threshold 

amount for 2002 is $137,300 ($68,650 for married individuals filing 

separate returns). For those deductions that are subject to the 

limit, the total amount of itemized deductions is reduced by three 

percent of adjusted gross income over the threshold amount, but 

not by more than 80 percent of itemized deductions subject to the 

limit. Beginning in 2006, the overall limitation on itemized deductions phases-out for all taxpayers. The overall limitation on 

itemized deductions is reduced by one-third in taxable years beginning in 2006 and 2007, and by two-thirds in taxable years beginning in 2008 and 2009. The overall limitation on itemized deductions is eliminated for taxable years beginning after December 31, 

2009; however, this elimination of the limitation sunsets on December 31, 2010. 

REASONS FOR CHANGE

The Committee recognizes that the Administration believes that 

providing a charitable deduction for taxpayers who do not itemize 

deductions will result in an increase in charitable giving. In addition, the Committee appreciates that the charitable deduction is an 

important part of the President’s faith-based initiative. The proposal is for a two-year period. To provide Congress adequate information in considering extending the proposal, the Committee requires the Secretary of the Treasury to submit a report on the effectiveness of the provision. The report should consider the extent 

to which charitable giving has increased, the burdens of complexity 

to taxpayers and the impact on tax compliance.

EXPLANATION OF PROVISION

In the case of an individual taxpayer who does not itemize deductions, the provision allows a ‘‘direct charitable deduction’’ from adjusted gross income for charitable contributions paid in cash during 

the taxable year. This deduction is allowed in addition to the 

standard deduction. The deduction is available only for that portion 

of contributions actually made during the year that in the aggregate exceed $250 ($500 in the case of a joint return). The maximum 

deduction is $250 ($500 in the case of a joint return). Contributions 

6

that are below the minimum amount or that exceed the maximum 

deduction may not be carried over for purposes of a subsequent 

taxable year’s calculation of the direct charitable deduction. Under 

the provision, an individual is not entitled to a charitable deduction 

for the first $250 of cash contributions made during the tax year, 

is entitled to a deduction on a dollar-for-dollar basis for contributions of $251 to $500 (e.g., a $1 contribution deduction in the case 

of $251 of contributions, and a $250 deduction in the case of $500 

of contributions), and is not entitled to a deduction for contributions exceeding $500. 

The provision does not alter present-law rules regarding the carryover of contributions to or from a taxable year, including a taxable year in which the taxpayer elects the standard deduction. The 

direct charitable deduction generally is subject to the tax rules normally governing charitable contribution deductions, such as the 

substantiation requirements. The deduction is allowed in computing alternative minimum taxable income. 

The provision requires the Secretary of the Treasury to complete 

a study by December 31, 2003, of the effect of the provision on increased charitable giving, and of taxpayer compliance, for example, 

by comparing compliance by taxpayers who itemize their charitable 

contributions with compliance by those who claim the direct charitable deduction. The Secretary shall report on the study to the 

Committee on Finance of the Senate and the Committee on Ways 

and Means of the House of Representatives. 

EFFECTIVE DATE

The direct charitable deduction is effective for taxable years beginning after December 31, 2001, and before January 1, 2004. The 

Treasury study is required by December 31, 2003. 

B. TAX-FREE DISTRIBUTIONS FROM INDIVIDUAL RETIREMENT

ARRANGEMENTS FOR CHARITABLE PURPOSES

(Sec. 102 of the bill and secs. 408 and 6034 of the Code) 

PRESENT LAW

In general 

If an amount withdrawn from a traditional individual retirement 

arrangement (‘‘IRA’’) or a Roth IRA is donated to a charitable organization, the rules relating to the tax treatment of withdrawals 

from IRAs apply to the amount withdrawn and the charitable contribution is subject to the normally applicable limitations on deductibility of such contributions. 

Charitable contributions 

In computing taxable income, an individual taxpayer who 

itemizes deductions generally is allowed to deduct the amount of 

cash and up to the fair market value of property contributed to a 

charity described in section 501(c)(3) or a Federal, State, or local 

governmental entity. The deduction also is allowed for purposes of 

calculating alternative minimum taxable income. 

The amount of the deduction allowable for a taxable year with 

respect to a charitable contribution of property may be reduced depending on the type of property contributed, the type of charitable 

7

6Secs. 170(b) and (e). 

7Sec, 170(a). The Economic Recovery Tax Act of 1981 adopted a temporary provision that permitted individual taxpayers who did not itemize income tax deductions to claims a deduction 

from gross income for a specified percentage of their charitable contributions. The maximum deduction was $25 for 1982 and 1983, $75 for 1984, 50 percent of the amount of the contribution 

for 1985, and 100 percent of the amount of the contribution for 1986. The nonitemizer deduction 

terminated after 1986. 8Sec. 170(f)(8). 

9Sec. 6115. 

organization to which the property is contributed, and the income 

of the taxpayer.6

A taxpayer who takes the standard deduction (i.e., who does not 

itemize deductions) may not take a separate deduction for charitable contributions.7

A payment to a charity (regardless of whether it is termed a ‘‘contribution’’) in exchange for which the donor receives an economic benefit is not deductible, except to the extent that the donor 

can demonstrate that the payment exceeds the fair market value 

of the benefit received from the charity. To facilitate distinguishing 

charitable contributions from purchases of goods or services from 

charities, present law provides that no charitable contribution deduction is allowed for a separate contribution of $250 or more unless the donor obtains a contemporaneous written acknowledgement of the contribution from the charity indicating whether the 

charity provided any good or service (and an estimate of the value 

of any such good or service) to the taxpayer in consideration for the 

contribution.8 In addition, present law requires that any charity that receives a contribution exceeding $75 made partly as a gift 

and partly as consideration for goods or services furnished by the 

charity (a ‘‘quid pro quo’’ contribution) is required to inform the 

contributor in writing of an estimate of the value of the goods or 

services furnished by the charity and that only the portion exceeding the value of the goods or services is deductible as a charitable 

contribution.9

Under present law, total deductible contributions of an individual 

taxpayer to public charities, private operating foundations, and certain types of private nonoperating foundations may not exceed 50 

percent of the taxpayer’s contribution base, which is the taxpayer’s 

adjusted gross income for a taxable year (disregarding any net operating loss carryback). To the extent a taxpayer has not exceeded 

the 50-percent limitation, (1) contributions of capital gain property 

to public charities generally may be deducted up to 30 percent of 

the taxpayer’s contribution base, (2) contributions of cash to private 

foundations and certain other charitable organizations generally 

may be deducted up to 30 percent of the taxpayer’s contribution 

base, and (3) contributions of capital gain property to private foundations and certain other charitable organizations generally may 

be deducted up to 20 percent of the taxpayer’s contribution base. 

Contributions by individuals in excess of the 50-percent, 30-percent, and 20-percent limit may be carried over and deducted over 

the next five taxable years, subject to the relevant percentage limitations on the deduction in each of those years. 

In addition to the percentage limitations imposed specifically on 

charitable contributions, present law imposes a reduction on most 

itemized deductions, including charitable contribution deductions, 

for taxpayers with adjusted gross income in excess of a threshold 

amount, which is indexed annually for inflation. The threshold 

8

10Secs. 170(f), 2055(e)(2), and 2522(c)(2). 11Sec. 170(f)(2). 

amount for 2002 is $137,300 ($68,650 for married individuals filing 

separate returns). For those deductions that are subject to the 

limit, the total amount of itemized deductions is reduced by three 

percent of adjusted gross income over the threshold amount, but 

not by more than 80 percent of itemized deductions subject to the 

limit. Beginning in 2006, the overall limitation on itemized deductions phases-out for all taxpayers. The overall limitation on 

itemized deductions is reduced by one-third in taxable years beginning in 2006 and 2007, and by two-thirds in taxable years beginning in 2008 and 2009. The overall limitation on itemized deductions is eliminated for taxable years beginning after December 31, 

2009; however, this elimination of the limitation sunsets on December 31, 2010. 

In general, a charitable deduction is not allowed for income, estate, or gift tax purposes if the donor transfers an interest in property to a charity (e.g., a remainder) while also either retaining an 

interest in that property (e.g., an income interest) or transferring 

an interest in that property to a noncharity for less than full and 

adequate consideration.10 Exceptions to this general rule are provided for, among other interests, remainder interests in charitable 

remainder annuity trusts, charitable remainder unitrusts, and 

pooled income funds, and present interests in the form of a guaranteed annuity or a fixed percentage of the annual value of the property.11 For such interests, a charitable deduction is allowed to the 

extent of the present value of the interest designated for a charitable organization. 

IRA rules 

Within limits, individuals may make deductible and nondeductible contributions to a traditional IRA. Amounts in a traditional 

IRA are includible in income when withdrawn (except to the extent 

the withdrawal represents a return of nondeductible contributions). 

Individuals also may make nondeductible contributions to a Roth 

IRA. Qualified withdrawals from a Roth IRA are excludable from 

gross income. Withdrawals from a Roth IRA that are not qualified 

withdrawals are includible in gross income to the extent attributable to earnings. Includible amounts withdrawn from a traditional IRA or a Roth IRA before attainment of age 591⁄2 are subject 

to an additional 10-percent early withdrawal tax, unless an exception applies. 

If an individual has made nondeductible contributions to a traditional IRA, a portion of each distribution from an IRA is nontaxable, until the total amount of nondeductible contributions has 

been received. In general, the amount of a distribution that is nontaxable is determined by multiplying the amount of the distribution by the ratio of the remaining nondeductible contributions to 

the account balance. In making the calculation, all traditional IRAs 

of an individual are treated as a single IRA, all distributions during any taxable year are treated as a single distribution, and the 

value of the contract, income on the contract, and investment in 

the contract are computed as of the close of the calendar year. 

9

12 Conversion contributions refer to conversions of amounts in a traditional IRA to a Roth IRA. 13Sec. 6034. This requirement applies to all split-interest trusts described in section 

4947(a)(2). 14Sec. 642(c). 

15 Sec. 6104(b). 

16 Sec. 6011; Treas. Reg. sec. 53.6011–1(d). 

In the case of a distribution from a Roth IRA that is not a qualified distribution, in determining the portion of the distribution attributable to earnings, contributions and distributions are deemed 

to be distributed in the following order: (1) regular Roth IRA contributions; (2) taxable conversion contributions;12 (3) nontaxable 

conversion contributions; and (4) earnings. In determining the 

amount of taxable distributions from a Roth IRA, all Roth IRA distributions in the same taxable year are treated as a single distribution, all regular Roth IRA contributions for a year are treated as 

a single contribution, and all conversion contributions during the 

year are treated as a single contribution. 

Split-interest trust filing requirements 

Split-interest trusts, including charitable remainder annuity 

trusts, charitable remainder unitrusts, and pooled income funds, 

are required to file an annual information return 13 (Form 1041A). 

Trusts that are not split-interest trusts but that claim a charitable 

deduction for amounts permanently set aside for a charitable purpose 14 also are required to file Form 1041A. The returns are required to be made publicly available.15 A trust that is required to 

distribute all trust net income currently to trust beneficiaries in a 

taxable year is exempt from this return requirement for such taxable year. A failure to file the required return may result in a penalty on the trust of $10 a day for as long as the failure continues, 

up to a maximum of $5,000 per return. 

In addition, split-interest trusts are required to file annually 

Form 5227.16 Form 5227 requires disclosure of information regarding a trust’s noncharitable beneficiaries. The penalty for failure to 

file this return is calculated based on the amount of tax owed. A 

split-interest trust generally is not subject to tax and therefore, in 

general, a penalty may not be imposed for the failure to file Form 

5227. Form 5227 is not required to be made publicly available. 

REASONS FOR CHANGE

Under present law, an individual who wants to use IRA proceeds 

to make charitable contributions must treat the IRA distribution as 

a withdrawal subject to IRA income recognition rules and is subject 

to deduction limitation provisions on the contributions made to the 

charity. 

In some cases, this can result in taxable income even though the 

individual used the entire IRA distribution to make the charitable 

contribution. The Committee believes that taxpayers who want to 

make charitable contributions from IRAs generally should be permitted to do so without recognizing income because of the distribution from the IRA, whether such contribution is made directly to 

the charitable organization or indirectly through the use of a splitinterest entity. The Committee believes that facilitating charitable 

contributions from IRAs will help increase giving to charitable organizations. 

10

EXPLANATION OF PROVISION

Qualified charitable distributions from IRAs 

The provision provides an exclusion from gross income for otherwise taxable IRA distributions from a traditional or a Roth IRA in 

the case of qualified charitable distributions. Special rules apply in 

determining the amount of an IRA distribution that is otherwise 

taxable. The present-law rules regarding taxation of IRA distributions and the deduction of charitable contributions continue to 

apply to distributions from an IRA that are not qualified charitable 

distributions. 

A qualified charitable distribution is defined as any distribution 

from an IRA that is made directly by the IRA trustee either to (1) 

an organization to which deductible contributions can be made (a 

‘‘direct distribution’’) or (2) a ‘‘split-interest entity.’’ A split-interest 

entity means a charitable remainder annuity trust or charitable remainder unitrust (together referred to as a ‘‘charitable remainder 

trust’’), a pooled income fund, or a charitable gift annuity. Direct 

distributions are eligible for the exclusion only if made on or after 

the date the IRA owner attains age 701⁄2. Distributions to a split 

interest entity are eligible for the exclusion only if made on or after 

the date the IRA owner attains age 591⁄2. In the case of split-interest distributions, no person may hold an income interest in the 

amounts in the split-interest entity attributable to the charitable 

distribution other than the IRA owner, his or her spouse, or a charitable organization. 

The exclusion applies to direct distributions only if a charitable 

contribution deduction for the entire distribution would otherwise 

be allowable, determined without regard to the generally applicable 

percentage limitations. Thus, for example, if the deductible amount 

is reduced because of a benefit received in exchange, or if a deduction is not allowable because the donor did not obtain sufficient 

substantiation, the exclusion is not available with respect to any 

part of the IRA distribution. Similarly, the exclusion applies in the 

case of a distribution directly to a split-interest entity only if a 

charitable contribution deduction for the entire present value of the 

charitable interest (for example, a remainder interest) is allowable, 

determined without regard to the generally applicable percentage 

limitations. 

If the IRA owner has any IRA that includes nondeductible contributions, a special rule applies in determining the portion of a 

distribution that is includible in gross income (but for the provision) and thus is eligible for qualified charitable distribution treatment. In such case, the IRA owner aggregates all IRAs to determine eligibility for the exclusion. Under the special rule, the distribution is treated as consisting of income first, up to the aggregate amount that is includible in gross income (but for the provision) if all amounts were distributed from all IRAs otherwise taken 

into account in determining the amount of IRA distributions during 

the year that is includible in income. In determining the amount 

of subsequent IRA distributions includible in income, proper adjustments are made to reflect the amount treated as a qualified charitable distribution under the special rule. 

Special rules apply for distributions to split-interest entities. For 

distributions to charitable remainder trusts, the provision provides 

11

that subsequent distributions from the charitable remainder trust 

are treated as ordinary income in the hands of the beneficiary, notwithstanding how such amounts normally are treated under section 664(b). In addition, for a charitable remainder trust to be eligible to receive qualified charitable distributions, the charitable remainder trust has to be funded exclusively by such distributions. 

For example, an IRA owner may not make qualified charitable distributions to an existing charitable remainder trust any part of 

which was funded with assets that were not qualified charitable 

distributions. 

Under the provision, a pooled income fund is eligible to receive 

qualified charitable distributions only if the fund accounts separately for amounts attributable to such distributions. In addition, 

all distributions from the pooled income fund that are attributable 

to qualified charitable distributions are treated as ordinary income 

to the beneficiary. Qualified charitable distributions to a pooled income fund are not includible in the fund’s gross income. 

In determining the amount includible in gross income by reason 

of a payment from a charitable gift annuity purchased with a qualified charitable distribution from an IRA, the portion of the distribution from the IRA used to purchase the annuity is not an investment in the annuity contract. 

Any amount excluded from gross income by reason of the provision is not taken into account in determining the deduction for 

charitable contributions under section 170.

Qualified charitable distribution examples 

The following examples illustrate the determination of the portion of an IRA distribution that is a qualified charitable distribution and the application of the special rules for a qualified charitable distribution to a split-interest entity. In each example, it is 

assumed that the requirements for qualified charitable distribution 

treatment are otherwise met (e.g., the applicable age requirement 

and the requirement that contributions are otherwise deductible) 

and that no other IRA distributions occur during the year. 

Example 1. Individual A has a traditional IRA with a balance of 

$100,000, consisting solely of deductible contributions and earnings. Individual A has no other IRA. The entire IRA balance is distributed in a direct distribution to a charitable organization. Under 

present law, the entire distribution of $100,000 would be includible 

in Individual A’s income. Accordingly, under the provision, the entire distribution of $100,000 is a qualified charitable distribution. 

As a result, no amount is included in Individual A’s income as a 

result of the distribution and the distribution is not taken into account in determining the amount of Individual A’s charitable deduction for the year. 

Example 2. The facts are the same as in Example 1, except that 

the entire IRA balance of $100,000 is distributed to a charitable remainder unitrust, which contains no other assets. Under the terms 

of the trust, Individual A is entitled to receive five percent of the 

value of the trust each year. As explained in Example l, the entire 

$100,000 distribution is a qualified charitable distribution, no 

amount is included in Individual A’s income as a result of the distribution, and the distribution is not taken into account in determining the amount of Individual A’s charitable deduction for the 

12

17Sec. 6652(c)(4)(C). 

year. In addition, under a special rule in the provision for charitable remainder trusts, any distribution from the charitable remainder unitrust to Individual A is includible in gross income as 

ordinary income, regardless of the character of the distribution 

under the usual rules for the taxation of distributions from such a 

trust. 

Example 3. Individual B has a traditional IRA with a balance of $100,000, consisting of $20,000 of nondeductible contributions and 

$80,000 of deductible contributions and earnings. Individual B has 

no other IRA. In a direct distribution to a charitable organization, 

$80,000 is distributed from the IRA. Under present law, a portion 

of the distribution from the IRA would be treated as a nontaxable 

return of nondeductible contributions. The nontaxable portion of 

the distribution would be $16,000, determined by multiplying the 

amount of the distribution ($80,000) by the ratio of the nondeductible contributions to the account balance ($20,000/$100,000). Accordingly, under present law, $64,000 of the distribution ($80,000 

minus $16,000) would be includible in Individual B’s income. 

Under the provision, notwithstanding the present-law tax treatment of IRA distributions, the distribution is treated as consisting 

of income first, up to the total amount that would be includible in 

gross income (but for the provision) if all amounts were distributed 

from all IRAs otherwise taken into account in determining the 

amount of IRA distributions. The total amount that would be includible in income if all amounts were distributed from the IRA is 

$80,000. Accordingly, under the provision, the entire $80,000 distributed to the charitable organization is treated as includible in 

income (before application of the provision) and is a qualified charitable distribution. As a result, no amount is included in Individual 

B’s income as a result of the distribution and the distribution is not 

taken into account in determining the amount of Individual B’s 

charitable deduction for the year. In addition, for purposes of determining the tax treatment of other distributions from the IRA, 

$20,000 of the amount remaining in the IRA is treated as Individual B’s nondeductible contributions. 

Split-interest trust filing requirements 

The provision increases the penalty on split-interest trusts for 

failure to file a return and for failure to include any of the information required to be shown on such return and to show the correct 

information. The penalty is $20 for each day the failure continues 

up to $10,000 for any one return. In the case of a split-interest 

trust with gross income in excess of $250,000, the penalty is $100 

for each day the failure continues up to a maximum of $50,000. In 

addition, if a person (meaning any officer, director, trustee, employee, or other individual who is under a duty to file the return 

or include required information) 17 knowingly failed to file the return or include required information, then that person is personally 

liable for such a penalty, which would be imposed in addition to the 

penalty that is paid by the organization. Information regarding 

beneficiaries that are not charitable organizations as described in 

section 170(c) is exempt from the requirement to make information 

publicly available. In addition, the provision repeals the presentVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00012 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
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18Sec. 170(e)(3). In general, a C corporation’s charitable contribution deductions for a year 

may not exceed 10 percent of the corporation’s taxable income. Sec. 170(b)(2). 19Lucky Stores Inc. v. Commissioner, 105 T.C. 420 (1995). 

law exception to the filing requirement for split-interest trusts that 

are required in a taxable year to distribute all net income currently 

to beneficiaries. Such exception remains available to trusts other 

than split-interest trusts that are otherwise subject to the filing requirement. 

EFFECTIVE DATE

The provision generally is effective for taxable years beginning 

after December 31, 2002. The provision relating to information returns of split-interest trusts is effective for returns for taxable 

years beginning after December 31, 2002.

C. CHARITABLE DEDUCTION FOR CONTRIBUTIONS OF FOOD

INVENTORY

(Sec. 103 of the bill and sec. 170 of the Code) 

PRESENT LAW

Under present law, a taxpayer’s deduction for charitable contributions of inventory generally is limited to the taxpayer’s basis 

(typically, cost) in the inventory. 

However, for certain contributions of inventory, C corporations 

may claim an enhanced deduction equal to the lesser of (1) basis 

plus one-half of the item’s appreciated value (i.e., basis plus one 

half of fair market value in excess of basis) or (2) two times basis.18

To be eligible for the enhanced deduction, the contributed property 

generally must be inventory of the taxpayer, contributed to a charitable organization described in section 501(c)(3) (except for private 

nonoperating foundations), and the donee must (1) use the property 

consistent with the donee’s exempt purpose solely for the care of 

the ill, the needy, or infants, (2) not transfer the property in exchange for money, other property, or services, and (3) provide the 

taxpayer a written statement that the donee’s use of the property 

will be consistent with such requirements. In the case of contributed property subject to the Federal Food, Drug, and Cosmetic Act, 

the property must satisfy the applicable requirements of such Act 

on the date of transfer and for 180 days prior to the transfer. 

To use the enhanced deduction, the taxpayer must establish that 

the fair market value of the donated item exceeds basis. The valuation of food inventory has been the subject of ongoing disputes between taxpayers and the IRS. In one case, the Tax Court held that 

the value of surplus bread inventory donated to charity was the full 

retail price of the bread rather than half the retail price, as the 

IRS asserted.19

REASONS FOR CHANGE

The Committee believes that expanding the present-law enhanced deduction for contributions of food inventory to non-C corporations will increase charitable contributions of food to those in 

need. By clarifying the definition of fair market value, the Committee believes that taxpayers will be better able to avoid disputes 

with the IRS about the valuation of food and receive an appropriate 

14

20This includes, for example, taxpayers who are eligible for administrative relief under Revenue Procedures 2002–28 and 2001–10. 

deduction for their contribution. In addition, the Committee believes that providing certain low-basis taxpayers with a deemed 

basis equal to one quarter of the fair market value of the food will 

increase food donations, thus further providing needed nourishment to the nation’s hungry. 

EXPLANATION OF PROVISION

Under the provision, any taxpayer, whether or not a C corporation, engaged in a trade or business is eligible to claim the enhanced deduction for donations of food inventory. For taxpayers 

other than C corporations, the total deduction for donations of food 

inventory in a taxable year generally may not exceed 10 percent of 

the taxpayer’s net income for such year from its trade or business 

(or interest therein) from which contributions are made. For example, if a taxpayer is a sole proprietor, a shareholder in an S corporation, and a partner in a partnership, and each business makes 

charitable contributions of food inventory, the taxpayer’s deduction 

for donations of food inventory is limited to 10 percent of the taxpayer’s net income from the sole proprietorship, and the taxpayer’s 

interests in the S corporation and partnership. However, if only the 

sole proprietorship and the S corporation made charitable contributions of food inventory, the taxpayer’s deduction would be limited 

to 10 percent of the net income from the trade or business of the 

sole proprietorship and the S corporation, but not the partnership. 

The 10 percent limitation does not affect the application of the 

generally applicable percentage limitations. For example, if 10 percent of a sole proprietor’s net income from the proprietor’s trade or 

business was greater than 50 percent of the proprietor’s contribution base, the available deduction for the taxable year (with respect 

to contributions to public charities) would be 50 percent of the proprietor’s contribution base. Consistent with present law, such contributions may be carried forward because they exceed the 50 percent limitation. Contributions of food inventory by a taxpayer that 

is not a C corporation that exceed the 10 percent limitation but not 

the 50 percent limitation could not be carried forward. 

For purposes of calculating the enhanced deduction, taxpayers 

who do not account for inventories under section 471 and who are 

not required to capitalize indirect costs under section 263A are able 

to elect to treat the basis of the contributed food as being equal to 

25 percent of the food’s fair market value.20

Under the provision, the enhanced deduction is available only for 

food that qualifies as ‘‘apparently wholesome food.’’ ‘‘Apparently 

wholesome food’’ is defined as food intended for human consumption that meets all quality and labeling standards imposed by Federal, State, and local laws and regulations even though the food 

may not be readily marketable due to appearance, age, freshness, 

grade, size, surplus, or other conditions. 

In addition, the provision provides that the fair market value of 

donated apparently wholesome food that cannot or will not be sold 

solely due to internal standards of the taxpayer or lack of market 

is determined without regard to such internal standards or lack of 

market and by taking into account the price at which the same or 

15

21Sec. 170(e)(3). 

substantially the same food items are sold by the taxpayer at the 

time of the contribution or, if not so sold at such time, in the recent 

past. 

EFFECTIVE DATE

The provision is effective for taxable years beginning after December 31, 2002.

D. CHARITABLE DEDUCTION FOR CONTRIBUTIONS OF BOOK

INVENTORY

(Sec. 104 of the bill and sec. 170 of the Code) 

PRESENT LAW

Under present law, a taxpayer’s deduction for charitable contributions of inventory generally is limited to the taxpayer’s basis 

(typically, cost) in the inventory. 

However, for certain contributions of inventory, C corporations 

may claim an enhanced deduction equal to the lesser of (1) basis 

plus one-half of the item’s appreciated value (i.e., basis plus one 

half of fair market value in excess of basis) or (2) two times basis.21

To be eligible for the enhanced deduction, the contributed property 

generally must be inventory of the taxpayer, contributed to a charitable organization described in section 501(c)(3) (except for private 

nonoperating foundations), and the donee must: (1) use the property consistent with the donee’s exempt purpose solely for the care 

of the ill, the needy, or infants, (2) not transfer the property in exchange for money, other property, or services, and (3) provide the 

taxpayer a written statement that the donee’s use of the property 

will be consistent with such requirements. 

REASONS FOR CHANGE

Under present law, taxpayers sometimes are prohibited from receiving an enhanced deduction for charitable contributions of their 

book inventory, in part because of the requirement that the inventory be used for care of the ill, the needy, or infants. For example, 

such requirement generally prohibits donations to public libraries 

and adult literacy programs. The Committee believes that suitable 

book inventory should be eligible for an enhanced deduction in 

cases where a contribution is made to an appropriate educational 

organization. To minimize disputes between taxpayers and the IRS 

about the value of books and to encourage contributions of books 

that are suitable in terms of currency, content, and quantity, the 

Committee provides a special rule for determining the amount of 

the contribution of such books. A clear rule is needed so that taxpayers know that if they donate books to schools, libraries, and literacy programs, they will receive an enhanced deduction that more 

adequately reflects the costs of the donation. 

EXPLANATION OF PROVISION

The provision modifies the present-law enhanced deduction for C 

corporations so that it is equal to the lesser of fair market value 

or twice the taxpayer’s basis in the case of qualified book contribuVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00015 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
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tions. The provision provides that the fair market value for this 

purpose is determined by reference to a bona fide published market 

price for the book (using the same printing and same edition), published within seven years preceding the contribution. The Committee intends that a bona fide published market price of a book 

would be a price that was reached as a result of an arm’s length 

transaction within the seven years preceding the contribution, and 

for which the book was customarily sold. A publisher’s listed retail 

price for a book would not meet the standard unless the publisher 

could demonstrate to the satisfaction of the Secretary that the price 

was one at which the book was customarily sold. For example, if 

a publisher entered into a contract with a local school district to 

sell textbooks six years prior to making a qualified book contribution of such textbooks, the publisher could use as a ‘‘bona fide published market price,’’ the price at which such books were regularly 

sold to the school district under the contract. By contrast, if a publisher listed in a catalogue or elsewhere a ‘‘suggested retail price,’’

but books were not in fact frequently sold at such price, the publisher could not use the ‘‘suggested retail price’’ to determine the 

fair market value of the book for purposes of the enhanced deduction. Thus, in general, the Committee intends that a bona fide published market price must be independently verifiable by reference 

to actual sales within the seven year period preceding the contribution, and not to a publisher’s own price list. 

As an illustration of the mechanics of calculating the enhanced 

deduction under the provision, a C corporation that made a qualified book contribution with a bona fide published market price of 

$10 and a basis of $4 could take a deduction of $8 (twice basis). 

If the taxpayer’s basis is $6 instead of $4, then the deduction is 

$10. Also, in such latter case, if the book’s bona fide market published market price was $5 at the time of the contribution but was 

$10 five years before the contribution, then the deduction is $10. 

A qualified book contribution means a charitable contribution of 

books to: (1) an educational organization that normally maintains 

a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where 

its educational activities are regularly carried on; (2) a public library; or (3) an organization described in section 501(c)(3) (except 

for private nonoperating foundations), that is organized primarily 

to make books available to the general public at no cost or to operate a literacy program. The donee must: (1) use the property consistent with the donee’s exempt purpose; (2) not transfer the property in exchange for money, other property, or services; (3) provide 

the taxpayer a written statement that the donee’s use of the property will be consistent with such requirements and also that the 

books are suitable, in terms of currency, content, and quantity, for 

use in the donee’s educational programs and that the donee will 

use the books in such educational programs. 

EFFECTIVE DATE

The provision is effective for taxable years beginning after December 31, 2002. 

17

22Sec. 170(e)(1). 23Secs. 170(e)(4) and 170(e)(6). 

E. EXPAND CHARITABLE CONTRIBUTION ALLOWED FOR SCIENTIFIC

PROPERTY USED FOR RESEARCH AND FOR COMPUTER TECHNOLOGY

AND EQUIPMENT

(Sec. 105 of the bill and sec. 170 of the Code) 

PRESENT LAW

In the case of a charitable contribution of inventory or other ordinary-income or short- term capital gain property, the amount of the 

charitable deduction generally is limited to the taxpayer’s basis in 

the property. In the case of a charitable contribution of tangible 

personal property, the deduction is limited to the taxpayer’s basis 

in such property if the use by the recipient charitable organization 

is unrelated to the organization’s tax-exempt purpose. In cases involving contributions to a private foundation (other than certain 

private operating foundations), the amount of the deduction is limited to the taxpayer’s basis in the property.22

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.’’ 23 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. 

A qualified research contribution means a charitable contribution 

of inventory that is tangible personal property. The contribution 

must be to a qualified educational or scientific organization and be 

made not later than two years after construction of the property is 

substantially completed. The original use of the property must be 

by the donee, and be used substantially for research or experimentation, or for research training, in the U.S. in the physical or biological sciences. The property must be scientific equipment or apparatus, constructed by the taxpayer, and may not be transferred by 

the donee in exchange for money, other property, or services. The 

donee must provide the taxpayer with a written statement representing that it will use the property in accordance with the conditions for the deduction. For purposes of the enhanced deduction, 

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) do not exceed 50 percent of the taxpayer’s basis in the property. 

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 

18

24 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). 25This requirement does not apply if the property was reacquired by the manufacturer and 

contributed. Sec. 170(e)(6)(D)(ii). 26Sec. 170(e)(6)(C). 27Secs. 170, 2055, and 2522, respectively. 

property is substantially completed.24 The original use of the property must be by the donor or the donee,25 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. Contributions may be 

made to private foundations under certain conditions.26

REASONS FOR CHANGE

The Committee believes that extension of the enhanced deduction to include property assembled by the taxpayer will lead to increased charitable contributions of scientific property used for research and computer technology and equipment and will help to 

eliminate confusion in determining whether property is ‘‘constructed’’ or ‘‘assembled’’ for purposes of claiming the enhanced deduction. 

EXPLANATION OF PROVISION

Under the provision, property assembled by the taxpayer, in addition to property constructed by the taxpayer, is eligible for either 

enhanced deduction. The Committee does not intend that old or 

used components assembled by the taxpayer into scientific property 

or computer technology or equipment are eligible for the enhanced 

deduction. 

EFFECTIVE DATE

The provision is effective for taxable years beginning after December 31, 2001.

F. ENCOURAGE CONTRIBUTIONS OF CAPITAL GAIN REAL PROPERTY

MADE FOR CONSERVATION PURPOSES

(Sec. 106 of the bill and sec. 170 of the Code) 

PRESENT LAW

Charitable contributions generally 

In general, a deduction is permitted for charitable contributions, 

subject to certain limitations that depend on the type of taxpayer, 

the property contributed, and the donee organization. The amount 

of deduction generally equals the fair market value of the contributed property on the date of the contribution. Charitable deductions are provided for income, estate, and gift tax purposes.27

In general, in any taxable year, charitable contributions by a corporation are not deductible to the extent the aggregate contributions exceed 10 percent of the corporation’s taxable income comVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00018 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
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puted without regard to net operating or capital loss carrybacks. 

For individuals, the amount deductible is a percentage of the taxpayer’s contribution base, which is the taxpayer’s adjusted gross income computed without regard to any net operating loss carryback. 

The applicable percentage of the contribution base varies depending on the type of donee organization and property contributed. 

Cash contributions of an individual taxpayer to public charities, 

private operating foundations, and certain types of private nonoperating foundations may not exceed 50 percent of the taxpayer’s 

contribution base. Cash contributions to private foundations and 

certain other charitable organizations generally may be deducted 

up to 30 percent of the taxpayer’s contribution base. 

In general, a charitable deduction is not allowed for income, estate, or gift tax purposes if the donor transfers an interest in property to a charity while also either retaining an interest in that 

property or transferring an interest in that property to a noncharity for less than full and adequate consideration. Exceptions to 

this general rule are provided for, among other interests, remainder interests in charitable remainder annuity trusts, charitable remainder unitrusts, and pooled income funds, present interests in 

the form of a guaranteed annuity or a fixed percentage of the annual value of the property, and qualified conservation contributions. 

Capital gain property 

Capital gain property means any capital asset or property used 

in the taxpayer’s trade or business the sale of which at its fair market value, at the time of contribution, would have resulted in gain 

that would have been long-term capital gain. Contributions of capital gain property to a qualified charity are deductible at fair market value within certain limitations. Contributions of capital gain 

property to charitable organizations described in section 

170(b)(1)(A) (e.g., public charities, private foundations other than 

private non-operating foundations, and certain governmental units) 

generally are deductible up to 30 percent of the taxpayer’s contribution base. An individual may elect, however, to bring all these 

contributions of capital gain property for a taxable year within the 

50-percent limitation category by reducing the amount of the contribution deduction by the amount of the appreciation in the capital 

gain property. Contributions of capital gain property to charitable 

organizations described in section 170(b)(1)(B) (e.g., private non-operating foundations) are deductible up to 20 percent of the taxpayer’s contribution base. 

For purposes of determining whether a taxpayer’s aggregate 

charitable contributions in a taxable year exceed the applicable 

percentage limitation, contributions of capital gain property are 

taken into account after other charitable contributions. Contributions of capital gain property that exceed the percentage limitation 

may be carried forward for five years. 

Qualified conservation contributions 

Qualified conservation contributions are not subject to the ‘‘partial interest’’ rule, which generally bars deductions for charitable 

contributions of partial interests in property. A qualified conservation contribution is a contribution of a qualified real property interVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00019 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
20

est to a qualified organization exclusively for conservation purposes. A qualified real property interest is defined as: (1) the entire 

interest of the donor other than a qualified mineral interest; (2) a 

remainder interest; or (3) a restriction (granted in perpetuity) on 

the use that may be made of the real property. Qualified organizations include certain governmental units, public charities that meet 

certain public support tests, and certain supporting organizations. 

Conservation purposes include: (1) the preservation of land areas 

for outdoor recreation by, or for the education of, the general public; (2) the protection of a relatively natural habitat of fish, wildlife, 

or plants, or similar ecosystem; (3) the preservation of open space 

(including farmland and forest land) where such preservation will 

yield a significant public benefit and is either for the scenic enjoyment of the general public or pursuant to a clearly delineated Federal, State, or local governmental conservation policy; and (4) the 

preservation of an historically important land area or a certified 

historic structure. 

Qualified conservation contributions of capital gain property are 

subject to the same limitations and carryover rules of other charitable contributions of capital gain property. 

REASONS FOR CHANGE

The Committee desires to provide additional incentives for charitable donations of real property made for qualified conservation 

purposes. The Committee believes that increasing the percentage 

limitations applicable to qualified conservation contributions of real 

property, and increasing the carryover period applicable to such 

contributions from five to fifteen years, will increase donations 

made for qualified conservation purposes. The Committee also believes that special incentives are required to encourage qualified 

conservation contributions of farm and ranch properties. 

EXPLANATION OF PROVISION

In general 

Under the provision, the 30-percent contribution base limitation 

on contributions of capital gain property by individuals does not 

apply to qualified conservation contributions (as defined under 

present law). Thus, individuals may include the fair market value 

of any qualified conservation contribution of capital gain property 

in determining the amount of the charitable contributions subject 

to the 50-percent contribution base limitation. 

Individuals are allowed to carryover any qualified conservation 

contributions that exceed the 50-percent limitation for up to 15 

years. The 50-percent contribution base limitation applies first to 

contributions other than qualified conservation contributions and 

then to qualified conservation contributions. For example, assume 

an individual with a contribution base of $100 makes a qualified 

conservation contribution of property with a fair market value of 

$80 and makes other charitable contributions of $60. The individual is allowed a deduction of $50 in the current taxable year for 

the other contributions (50 percent of the $100 contribution base) 

and is allowed to carryover the excess $10 for up to 5 years. No 

current deduction is allowed for the qualified conservation conVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00020 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
21

tribution but the entire $80 qualified conservation contribution 

may be carried forward for up to 15 years. 

Farmers and ranchers 

In the case of an eligible farmer or rancher, a qualified conservation contribution is allowable up to 100 percent of the taxpayer’s 

contribution base (after taking into account other charitable contributions). This rule applies both to individuals and corporations. 

In addition, corporate (as well as non-corporate) eligible farmers 

and ranchers are allowed to carryover any excess qualified conservation contributions for up to 15 years. The 100-percent contribution base limitation applies first to contributions other than 

qualified conservation contributions (to the extent allowable under 

other percentage limitations) and then to qualified conservation 

contributions. For example, assume an individual farmer or rancher with a contribution base of $100 makes a qualified conservation 

contribution of property with a fair market value of $80 and makes 

other charitable contributions of $60. The individual is allowed a 

deduction of $50 in the current taxable year for the other contributions (50 percent of the $100 contribution base) and is allowed to 

carryover the excess $10 for up to 5 years. The individual is also 

allowed a deduction of $50 in the current taxable year for the 

qualified charitable contribution (the amount of the remaining contribution base). The remaining $30 qualified conservation contribution may be carried forward for up to 15 years. 

For this purpose, an eligible farmer or rancher means a taxpayer 

(other than a publicly traded C corporation) whose gross income 

from the trade of business of farming is at least 51 percent of the 

taxpayer’s gross income for the taxable year. 

EFFECTIVE DATE

The provision is effective for contributions made in taxable years 

beginning after December 31, 2002.

G. EXCLUSION OF 25 PERCENT OF CAPITAL GAIN FOR CERTAIN SALES

MADE FOR QUALIFYING CONSERVATION PURPOSES

(Sec. 107 of the bill and new sec. 121A of the Code) 

PRESENT LAW

Sales of capital gain property 

Gain from the sale or exchange of land held more than one year 

generally is treated as long-term capital gain. Generally, the net 

capital gain of an individual (i.e., long-term capital gain less shortterm capital loss) is subject to a maximum tax rate of 20 percent. 

Charitable contributions of capital gain property for conservation 

purposes 

Special rules apply to charitable contributions of qualified conservation contributions. Qualified conservation contributions are 

not subject to the ‘‘partial interest’’ rule, which generally bars deductions for charitable contributions of partial interests in property. A qualified conservation contribution is a contribution of a 

qualified real property interest to a qualified organization exclusively for conservation purposes. A qualified real property interest 

22

28Ltr. Rul. 8626029. 29Treas. Reg. sec. 1.170A–14(c)(2). 30 Id. 

is defined as: (1) the entire interest of the donor other than a qualified mineral interest; (2) a remainder interest; or (3) a restriction 

(granted in perpetuity) on the use that may be made of the real 

property. Charitable contributions of interests that constitute the 

taxpayer’s entire interest in the property are not regarded as qualified real property interests within the meaning of section 170(h),28

but instead are subject to the general rules applicable to charitable 

contributions of entire interests of the taxpayer. Qualified organizations include certain governmental units, public charities that meet 

certain public support tests, and certain supporting organizations. 

Conservation purposes include: (1) the preservation of land areas 

for outdoor recreation by, or for the education of, the general public; (2) the protection of a relatively natural habitat of fish, wildlife, 

or plants, or similar ecosystem; (3) the preservation of open space 

(including farmland and forest land) where such preservation will 

yield a significant public benefit and is either for the scenic enjoyment of the general public or pursuant to a clearly delineated Federal, State, or local governmental conservation policy; and (4) the 

preservation of an historically important land area or a certified 

historic structure. 

Treasury regulations provide that a deduction for a qualified conservation contribution is allowed only if the donor prohibits in the 

instrument of conveyance the donee from subsequently transferring 

the qualified real property interest, whether or not for consideration, unless the donee organization, as a condition of the subsequent transfer, requires that the conservation purpose which the 

contribution was originally intended to advance continues to be carried out.29 Moreover, subsequent transfers of such interests are restricted to organizations that are qualified conservation organizations.30

REASONS FOR CHANGE

Some landowners may want their land to be protected for conservation purposes but cannot afford simply to donate either the 

land or an easement on the land, especially if the land is the landowner’s primary asset. The Committee desires to encourage the 

sale of appreciated, environmentally sensitive land and real property interests in land or water, as well as controlling stock interests in certain land corporations, to qualified conservation organizations and governments, thus achieving conservation goals 

through voluntary sales of property. The Committee believes that 

providing taxpayers a partial exclusion of capital gain derived from 

the voluntary sale of properties for conservation purposes will increase the number of properties dedicated to conservation purposes. 

The Committee desires to facilitate the transfers of properties to 

conservation organizations in a manner that will, to the extent 

practicable, preserve the value of the properties once they are acquired by the conservation organizations, while providing safeguards designed to ensure the protection of the conservation purposes for which the properties are intended to be used. 

23

31The exclusion is mandatory if all of the requirements of the provision are satisfied, and a 

taxpayer need not file an election to take advantage of the exclusion. A taxpayer who transfers 

qualifying property to a qualified organization may opt out of the 25-percent exclusion by choosing not to satisfy one or more of the provision’s requirements without having to file a formal 

election with the Secretary, such as by failing to obtain the requisite letter of intent from the 

qualified organization. 

EXPLANATION OF PROVISION

In general 

The bill provides a 25–percent exclusion from gross income of 

long-term capital gain from the qualifying sale or exchange of land, 

or an interest in land or water rights, provided that the land or interest in land or water rights constitutes an interest in real property that has been held by the taxpayer or the taxpayer’s family 

at all times during the five years preceding the date of sale. The 

qualifying sale must be made to a qualified organization that intends that the acquired property be used for qualified conservation 

purposes in perpetuity.31

Qualifying interests 

The exclusion applies only to sales or exchanges of real property 

interests in land or water rights that constitute the entire interest 

of the taxpayer in such land or water rights, or that constitute 

qualified real property interests as defined in section 170(h), specifically: (1) the entire interest of the taxpayer other than a qualified mineral interest; (2) a remainder interest; or (3) a restriction 

(granted in perpetuity) on the use which may be made of the real 

property. Partial interests in property that are not the entire interest of the taxpayer or a qualified real property interest do not qualify for the exclusion. For example, a taxpayer who owns land and 

related mineral rights but who sells only the mineral rights is not 

eligible for the exclusion. However, a taxpayer who owns only mineral rights is eligible for the 25–percent exclusion if the taxpayer

sells his or her entire interest in the mineral rights and satisfies 

the other requirements of the provision. 

Generally, an undivided interest that constitutes the taxpayer’s 

entire interest in the property is eligible for the exclusion. A partial 

interest (for example, an undivided interest) that constitutes the 

taxpayer’s entire interest in the property, however, does not qualify 

for the exclusion if the property in which such partial interest exists was divided in an attempt to avoid the partial interest rules. 

The Committee intends that the partial interest rules contained in 

Treasury Regulations section 1.170A–7(a)(2)(i) and generally applicable to contributions of partial interests be applied similarly for 

purposes of this provision. For example, if a taxpayer transfers an 

undivided interest in property to a spouse and immediately thereafter sells the remaining undivided interest to a qualified organization, the exclusion will not apply to the taxpayer’s sale to the qualified organization. 

Under the provision, the exclusion is available for long-term capital gain from certain sales or exchanges of stock in a C corporation 

if the qualified organization ultimately obtains a controlling stock 

interest (generally a stock interest that provides the qualified organization at least 90 percent of the total voting power and total 

value of the corporation’s stock) and if at least 90 percent of the 

fair market value of the C corporation’s assets at the time of the 

24

32The Committee intends that soil and water conservation expenditures in the nature of those 

described in section 175, determined without regard to whether the taxpayer is engaged in a 

farming business and that the land be used for farming, generally be treated as furthering a 

qualified conservation purpose. 33The Committee intends that the taxpayer be required to use this gain allocation rule unless 

the taxpayer has adequate records to substantiate the adjusted basis and fair market value to 

support a separate calculation. 

sale or exchange consists of land or water rights, or interests in 

land or water rights, that were held by the corporation at all times 

during the five years preceding the sale. Stock in a corporation will 

not qualify if at the time of the sale or exchange the fair market 

value of water rights and infrastructure relating to the delivery of 

water constitutes more than 50 percent of the fair market value of 

all of the corporation’s assets. Only a stock interest held by the taxpayer or the taxpayer’s family at all times during the five years 

preceding the sale qualifies for the 25–percent exclusion. The Committee intends that in appropriate circumstances a controlling 

stock interest may be acquired by the qualified organization from 

multiple persons in multiple transactions, and authorizes the Secretary to issue guidance regarding the availability of the exclusion 

in such cases. 

Qualifying gain 

The exclusion applies only to long-term capital gain. Gain treated 

as ordinary income, such as under depreciation recapture provisions, is not eligible for the exclusion. Gain attributable to certain 

improvements, such as buildings or structures that do not further 

a qualified conservation purpose (‘‘disqualified improvements’’), also 

does not qualify for the exclusion.32 The bill provides that the maximum amount of gain that may be excluded by a shareholder in the 

case of a sale or exchange of a controlling stock interest is 25 percent of the shareholder’s proportionate share of the C corporation’s 

underlying gain attributable to qualifying land, water rights, or interests therein held by the C corporation. 

Consistent with present law, the determination of gain or loss is 

to be calculated on an asset-by-asset basis whenever that is required for other purposes of the Code (such as for purposes of section 1245 or section 1250). To minimize administrative complexity 

and assist taxpayers in the preparation of their returns, the Committee intends that in those cases where the Code does not otherwise require a separate determination of gain or loss for the disqualified improvement, the gain allocable to the disqualified improvement shall be determined by reference to the fair market 

value of the disqualified improvement relative to the fair market 

value of all assets for which a gain or loss determination is not otherwise required by the Code.33

For example, if a taxpayer sells a qualifying land interest with 

a fair market value of $100 and a basis of $30, that includes a 

building or structure that does not further a conservation purpose 

(a disqualified improvement) and that has a fair market value of 

$40, the taxpayer must determine the portion of the gain that is 

attributable to the eligible land and to the disqualified improvement. If determination of gain or loss on the sale of the improvement is required for other purposes of the Code, then the gain or 

loss determined for those purposes governs, and the taxpayer must 

determine his or her basis of the disqualified improvement (in this 

25

34 A sale or exchange made prior to the issuance of an order, but that is the result of the 

threat of condemnation or eminent domain, may qualify for the exclusion. 

case, assumed to be zero), with the result that the $40 gain on the 

disqualified improvement is not eligible for the 25–percent exclusion and the gain of $30 on the land is eligible for the 25–percent 

exclusion. On the other hand, if the determination of gain or loss 

on the sale of the improvement is not required for other purposes 

of the Code, then the Committee intends that the taxpayer allocate 

the aggregate gain of $70 attributable to the land and the disqualified improvement between the land and the improvement on the 

basis of their respective fair market values (i.e., 40 percent to the 

improvement and 60 percent to the land). Under this gain allocation rule, the $28 of gain allocable to the improvement is not eligible for the 25–percent exclusion, and the $42 of gain allocable to 

the land qualifies for the 25-percent exclusion. 

Eligible sales 

An eligible sale is a sale or exchange (excluding a transfer made 

by order of condemnation or eminent domain) 34 that may be made 

only to a qualified organization, defined as a Federal, State, or 

local government, or an agency or department thereof or a section 

501(c)(3) organization that is organized and operated primarily to 

meet a qualified conservation purpose. In addition, to be an eligible 

sale, the organization acquiring the property interest must provide 

the taxpayer with a letter stating that the intent of such organization in acquiring the property is to further a qualified conservation 

purpose and that any subsequent transfer of the acquired interest 

will be to a qualified organization and made to protect the conservation purpose in perpetuity. A qualified conservation purpose 

is: (1) the preservation of land areas for outdoor recreation by, or 

the education of, the general public; (2) the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem; or (3) the preservation of open space (including farmland 

and forest land) where the preservation is for the scenic enjoyment 

of the general public or pursuant to a clearly delineated Federal, 

State, or local governmental conservation policy and will yield a 

significant public benefit. 

Protection of conservation purposes 

The bill provides for the imposition of penalty excise taxes in appropriate cases where a qualified organization fails to take steps 

consistent with the protection of conservation purposes. Because 

the penalty taxes are imposed on an organization that fails to protect the conservation purpose, and do not serve to encumber the 

property in the same manner as a restriction contained in an instrument of conveyance, the Committee believes that the penalty 

taxes will adequately protect conservation purposes without decreasing the value of the property in the hands of the conservation 

organizations. 

If ownership or possession of the property is transferred by a 

qualified organization other than to another qualified organization, 

or a legal restriction contained in an instrument of conveyance that 

protects the qualified conservation purpose is removed, then: (1) a 

20-percent excise tax applies to the proceeds or fair market value 

26

of the property, (2) any realized gain or income is subject to an additional excise tax imposed at the highest income tax rate applicable to C corporations, and (3) any otherwise applicable non-recognition provisions of the Code shall not apply to the transferor. The 

Committee intends that the excise taxes apply to all cases involving the transfer of ownership or possession of the property to a 

transferee that is not a qualified organization unless the transferring qualified organization demonstrates to the satisfaction of the 

Secretary that qualified conservation purposes will be protected in 

perpetuity. In the case of a removal of a legal restriction contained 

in an instrument of conveyance, the qualified organization must 

demonstrate to the satisfaction of the Secretary that a later unexpected change in the conditions surrounding the property makes 

retaining the conservation restriction impossible or impractical and 

that any proceeds derived from the removal of the restriction will 

be used to further qualified conservation purposes. The Committee 

authorizes the Secretary to provide guidance to identify appropriate cases where transfers to persons other than qualified organizations are regarded as protecting a conservation purpose in perpetuity. The Committee intends, for example, that a qualified organization may acquire a fee simple interest in real property operated 

as a farm and then transfer, without imposition of the penalty 

taxes, the real property subject to a conservation easement that 

constitutes a qualified real property interest if, in a recorded instrument of conveyance, the transferor prohibits the transferee 

from subsequently transferring the real property unless the transferee, as a condition of the subsequent transfer, requires that the 

qualified conservation purpose of preserving the property as open 

space farmland will continue to be carried out. 

In the case of a transfer by a qualified organization to another 

qualified organization, the transferee must provide the transferor 

at the time of the transfer a letter stating that the intent of the 

transferee is to further a qualified conservation purpose and that 

any subsequent transfer of the acquired interest will be made to 

protect the conservation purpose in perpetuity, and the transferee 

becomes subject to the excise tax provisions for subsequent transfers. The Committee intends that in the case of a sale or exchange 

of stock of a C corporation in which a qualified organization acquires a controlling stock interest, all of the stock of such corporation acquired by the qualified organization (including any stock 

which did not qualify for the exclusion), as well as the property 

held by such C corporation, becomes subject to the penalty tax provisions. 

The bill provides that the Secretary may require such reporting 

as may be necessary or appropriate to further the purpose that any 

conservation use be in perpetuity. 

Relationship with other provisions 

In the case of an individual, the exclusion applies both for purposes of the regular tax and the alternative minimum tax. In the 

case of a corporation, the present-law alternative minimum tax provisions apply without modification. 

If a taxpayer sells a real property interest to a qualified organization for less than the property’s fair market value, the amount 

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35Sec. 1011(b) and Treas. Reg. sec. 1.1011–2. 

ance with the bargain sale rules,35 and the taxpayer shall not fail 

to qualify for a contribution deduction under those rules solely because the taxpayer derives a tax benefit from the partial exclusion 

of long-term capital gain from the sale. For example, if a taxpayer 

sells qualifying land with a fair market value of $100 and an adjusted basis of $10 to a qualified organization for a sales price of 

$95 (or alternatively, for a sale price of $50), the taxpayer’s basis 

of $10 shall be allocated between the sale and the contribution 

components of the transfer under the bargain sale rules, and the 

tax savings resulting from the 25-percent exclusion of long-term 

capital gain on the sale will not reduce the portion of the transfer 

treated as a charitable contribution under the bargain sale rules. 

The present-law requirements applicable to the charitable contribution component of the transfer, including, for example, the recordkeeping, substantiation, and appraisal provisions of Treasury Regulations section 1.170A–13, must be satisfied. 

EFFECTIVE DATE

The provision is effective for sales or exchanges occurring after 

December 31, 2003, in taxable years ending after such date.

H. COST SHARING PAYMENTS UNDER THE PARTNERS FOR FISH AND

WILDLIFE PROGRAM

(Sec. 108 of the bill and sec. 126 of the Code) 

PRESENT LAW

Under present law, gross income does not include the excludable 

portion of payments made to taxpayers by federal and state governments for a share of the cost of improvements to property under 

certain conservation programs. These programs include payments 

received under (1) the rural clean water program authorized by section 208(j) of the Federal Water Pollution Control Act, (2) the rural 

abandoned mine program authorized by section 406 of the Surface 

Mining Control and Reclamation Act of 1977, (3) the water bank 

program authorized by the Water Bank Act, (4) the emergency conservation measures program authorized by title IV of the Agricultural Credit Act of 1978, (5) the agriculture conservation program 

authorized by the Soil Conservation and Domestic Allotment Act, 

(6) the great plains conservation program authorized by section 16 

of the Soil Conservation and Domestic Policy Act, (7) the resource 

conservation and development program authorized by the 

Bankhead-Jones Farm Tenant Act and by the Soil Conservation 

and Domestic Allotment Act, (8) the forestry incentives program 

authorized by section 4 of the Cooperative Forestry Assistance Act 

of 1978, (9) any small watershed program administered by the Secretary of Agriculture which is determined by the Secretary of the 

Treasury or his delegate to be substantially similar to the type of 

programs described in items (1) through (8), and (10) any program 

of a State, possession of the United States, a political subdivision 

of any of the foregoing, or the District of Columbia under which 

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36Sec. 1366(a)(1)(A). 37Sec. 1367(a)(2)(B). 

serving soil, protecting or restoring the environment, improving forests, or providing a habitat for wildlife. 

REASONS FOR CHANGE

The Committee believes that payments received by taxpayers 

under the Partners for Fish and Wildlife Program are similar to 

payments made under other government programs that are excludable from gross income under present law. Accordingly, the Committee believes it is appropriate to extend the present-law exclusion to payments under this program. 

EXPLANATION OF PROVISION

The provision expands the types of qualified cost-sharing payments to include payments under the Partners for Fish and Wildlife Program. 

EFFECTIVE DATE

The provision applies to taxable years beginning after December 

31, 2002. 

I. BASIS ADJUSTMENT TO STOCK OF S CORPORATION CONTRIBUTING

PROPERTY

(Sec. 109 of the bill and sec. 1367 of the Code) 

PRESENT LAW

Under present law, if an S corporation contributes money or 

other property to a charity, each shareholder takes into account the 

shareholder’s pro rata share of the contribution in determining its 

own income tax liability.36 A shareholder of an S corporation reduces the basis in the stock of the S corporation by the amount of 

the charitable contribution that flows through to the shareholder.37

REASONS FOR CHANGE

Under present law, if an S corporation makes a charitable contribution of appreciated property, the shareholder may be taxed on 

an amount equal to the appreciation in the contributed property 

when the S corporation stock is sold. Thus, under present law, a 

charitable contribution of appreciated property made by an S corporation receives less favorable tax treatment than other contributions of appreciated property. 

The Committee wishes to preserve the benefit of providing a 

charitable contribution deduction for contributions of property by 

an S corporation with a fair market value in excess of its adjusted 

basis. Thus, the bill provides that the basis adjustment to the stock 

of an S corporation for charitable contributions made by the corporation will be in an amount equal to the shareholder’s pro rata 

share of the adjusted basis of the property contributed. This adjustment will prevent the later recognition of gain attributable to the 

appreciation in the contributed property on the disposition of the 

S corporation stock. 

29

38See Rev. Rul. 96–11 (1996–1 C.B. 140) for a rule reaching a similar result in the case of 

charitable contributions madee by a partnership. 39Sec. 170(e)(1). 40Sec. 170(e)(1)(B)(ii). 41Sec. 170(f)(3). 

EXPLANATION OF PROVISION

The provision provides that the amount of a shareholder’s basis 

reduction in the stock of an S corporation by reason of a charitable 

contribution made by the corporation will be equal to the shareholder’s pro rata share of the adjusted basis of the contributed 

property.38

Thus, for example, assume an S corporation with one individual 

shareholder makes a charitable contribution of stock with a basis 

of $200 and a fair market value of $500. The shareholder will be 

treated as having made a $500 charitable contribution (or a lesser 

amount if the special rules of section 170(e) apply), and will reduce 

the basis of the S corporation stock by $200. 

EFFECTIVE DATE

The provision applies to contributions made in taxable years beginning after December 31, 2002.

J. ENHANCED DEDUCTION FOR CHARITABLE CONTRIBUTION OF

LITERARY, MUSICAL, ARTISTIC, AND SCHOLARLY COMPOSITIONS

(Sec. 110 of the bill and sec. 170 of the Code) 

PRESENT LAW

In the case of a charitable contribution of inventory or other ordinary-income or short- term capital gain property, the amount of the 

deduction generally is limited to the taxpayer’s basis in the property.39 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 of tangible personal property to a private foundation 

(other than certain private foundations),40 the amount of the deduction is limited to the taxpayer’s basis in the property. 

Under present law, charitable contributions of literary, musical, 

and artistic compositions are considered ordinary income property 

and a taxpayer’s deduction of such property is limited to the taxpayer’s basis (typically, cost) in the property. To be eligible for the 

deduction, the contribution must be of an undivided portion of the 

donor’s entire interest in the property.41 For purposes of the charitable income tax deduction, the copyright and the work in which 

the copyright is embodied are not treated as separate property interests. Accordingly, if a donor owns a work of art and the copyright to the work of art, a gift of the artwork without the copyright 

or the copyright without the artwork will constitute a gift of a ‘‘partial interest’’ and will not qualify for the income tax charitable deduction. 

REASONS FOR CHANGE

The Committee believes that it is appropriate to provide an enhanced deduction for charitable contributions of certain literary, 

30

musical, artistic, and scholarly compositions created by the personal efforts of the donor. In many cases, such works have a low 

basis, and because present law generally limits the deduction for 

such contributions to basis, the creators of literary, musical, artistic, and scholarly compositions do not have an appropriate incentive to contribute their works to charity. In addition, the Committee believes that the present-law rule that a charitable contribution deduction generally is not available for contributions of 

less than the taxpayer’s entire property interest is an inappropriate 

disincentive for contributions of such works. 

EXPLANATION OF PROVISION

The bill provides that a deduction for ‘‘qualified artistic charitable contributions’’ generally is increased from the value under 

present law (generally, basis) to the fair market value of the property contributed, measured at the time of the contribution. However, the amount of the increase of the deduction provided by the 

provision may not exceed the amount of the donor’s adjusted gross 

income for the taxable year attributable to: (1) income from the 

sale or use of property created by the personal efforts of the donor 

that is of the same type as the donated property; and (2) income 

from teaching, lecturing, performing, or similar activities with respect to such property. In addition, the increase to the present-law 

deduction provided by the provision may not be carried over and 

deducted in other taxable years. 

The provision defines a qualified artistic charitable contribution 

to mean a charitable contribution of any literary, musical, artistic, 

or scholarly composition, or similar property, or the copyright 

thereon (or both) that meets certain requirements. First, the contributed property must have been created by the personal efforts 

of the donor at least 18 months prior to the date of contribution. 

The Committee intends that ‘‘personal efforts’’ shall be defined by 

reference to Treasury regulations section 1.1221–1(c). Second, the 

donor must obtain a qualified appraisal of the contributed property, 

a copy of which is required to be attached to the donor’s income tax 

return for the taxable year in which such contribution is made. The 

appraisal must include evidence of the extent (if any) to which 

property created by the personal efforts of the taxpayer and of the 

same type as the donated property is or has been owned, maintained, and displayed by certain charitable organizations and sold 

to or exchanged by persons other than the taxpayer, donee, or any 

related person. Third, the contribution must be made to a public 

charity or to certain limited types of private foundations. Finally, 

the use of donated property by the recipient organization must be 

related to the organization’s charitable purpose or function, and the 

donor must receive a written statement from the organization 

verifying such use. 

Under the provision, the tangible property and the copyright on 

such property are treated as separate properties for purposes of the 

‘‘partial interest’’ rule; thus, a gift of artwork without the copyright 

or a copyright without the artwork does not constitute a gift of a 

partial interest and is deductible. Contributions of letters, memoranda, or similar property that are written, prepared, or produced 

by or for an individual while the individual is an officer or employee of any person (including a government agency or instrumenVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00030 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
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42Sec. 6103(a). A ‘‘return’’ includes any tax or information return, declaration of estimated 

tax, or claim for refund required by, or provided for, or permitted under the provisions of the 

Code, which is filed with the IRS. Sec. 6103(b)(1). ‘‘Return’’ also includes any amendment or supplement to the filed return. Sec. 6103(b)(1). ‘‘Return information’’ is defined broadly to include 

any data received by, recorded by, prepared by, furnished to, or collected by the Secretary with 

respect to a return or with respect to the determination of the existence, or possible existence, 

of liability (or the amount thereof) of any person for any tax, penalty, interest, fine, forfeiture, 

or other imposition, or offense under the Code. The term ‘‘return information’’ does not include 

data in a form that cannot be associated with, or otherwise identify, directly or indirectly, a particular taxpayer. Sec. 6103(b)(2). 43Sec. 6110(l)(1). 44Section 6104(a)(1)(A) provides that ‘‘any papers submitted in support of’’ an application for 

tax-exempt status must be available for inspection. Treasury regulations limit the definition of 

Continued

tality) do not qualify for a fair market value deduction unless the 

contributed property is entirely personal. 

EFFECTIVE DATE

The deduction for qualified artistic charitable contributions applies to contributions made after December 31, 2002, in taxable 

years ending after such date.

Title II. Disclosure of Information Relating to Tax-Exempt 

Organizations 

A. DISCLOSURE OF WRITTEN DETERMINATIONS

(Sec. 201 of the bill and sec. 6110 of the Code) 

PRESENT LAW

In general 

Three provisions of present law govern the disclosure of information relating to tax-exempt organizations. First, section 6103 provides a general rule that tax returns and return information generally are not subject to public disclosure.42 Second, in order to 

allow the public to scrutinize the activities of tax-exempt organizations, section 6104 grants an exception to the confidentiality rule 

of section 6103 for certain categories of tax-exempt organization 

documents and information. Section 6104 permits the release in 

unredacted form of approved applications for tax-exempt status, 

certain related documents, and annual information returns filed by 

tax-exempt organizations. As a general rule, to the extent section 

6104 specifically provides for the disclosure of tax-exempt organization information, other disclosure provisions do not apply. If tax-exempt organization information does not come within the scope of 

section 6104, other disclosure provisions will govern whether the 

information may be disclosed. Third, section 6110 provides that 

written determinations by the IRS and related background file documents generally are open to public inspection in redacted form. 

Section 6110 does not apply to any matter to which section 6104 

applies.43

Disclosure of applications for recognition of tax exemption and annual information returns 

Under present law, tax-exempt organizations are required to 

make a copy of their application for recognition of tax-exempt status (and certain related documents) 44 and their annual information 

32

supporting documents to papers submitted by the organization. Treas. Reg. sec. 301.6104(a)– 1(e). 45Treas. Reg. sec. 301.6104(d)–1(b)(3)(iii)(A). 46Sec. 6104(a)(1)(D). In the case of a pension plan, information may be withheld if it would 

identify any particular individual covered under the plan. Id. 47Treas. Reg. sec. 301.6104(a)–5(a)(1). 48Sec. 6110(a). 49 A ruling is a written statement issued by the National Office to a taxpayer or his or her 

authorized representative. Treas. Reg. sec. 301.6110–2(d). It generally recites the relevant facts, 

sets forth the applicable provisions of law, and shows the application of the law to the facts. 

Treas. Reg. sec. 301.6110–2(d). 50 A district director issues a ‘‘determination letter’’ in response to a written inquiry from an 

individual or organization that applies principles and precedents previously announced by the 

IRS National Office to the particular facts involved. Treas. Reg. sec. 301.6110–2(e). 51 A ‘‘technical advice memorandum’’ is a written statement issued by the IRS National Office 

to a district director in connection with the examination of a taxpayer’s return or consideration 

of a taxpayer’s claim for refund or credit. Treas. Reg. sec. 301.6110–2(f). Generally, a technical 

advice memorandum states the relevant facts, sets forth the applicable law, and states a legal 

conclusion. Treas. Reg. sec. 301.6110–2(f). 52Sec. 6110(b)(1). Any IRS National Office component of the Office of Chief Counsel can issue 

Chief Counsel advice. The IRS National Office component issues the advice to IRS field or service center employees, or to regional or district employees of Chief Counsel. Sec. 6110(i)(A)(i). The 

definition of Chief Counsel advice does not encompass advice issued from one IRS National Office component of the Office of Chief Counsel to another. The advice by definition conveys: (1) 

a legal interpretation of a revenue provision; (2) the IRS or Chief Counsel position or policy concerning a revenue provision; or (3) a legal interpretation of any law (Federal, State, or foreign) 

relating to the assessment or collection of liability under a revenue provision. Sec. 6110(i)(A)(ii). 53Sec. 6103(b)(2)(D); sec. 6110(b)(1)(B). 54Sec. 6110(b)(2). Communications between the IRS and the Department of Justice relating 

to a pending civil or criminal case are not considered background file documents. 

return (Form 990 or Form 990–PF) available for public inspection. 

Organizations are not required to disclose an application for tax exemption filed by the organization unless the IRS responded favorably to the application.45 Charitable organizations that are not 

classified as private foundations are not required to disclose the 

names of donors to the organization. 

The Secretary may withhold disclosure of certain information described in an organization’s application for tax-exempt status if disclosure would: (1) divulge a trade secret, patent, process, style of 

work, or apparatus of the organization, and the Secretary determines that such disclosure would harm the organization; or (2) that 

the Secretary determines would harm the national defense.46 The 

organization must apply to the Commissioner for a determination 

that the disclosure would violate one of these criteria. The organization will be given 15 days to contest an adverse determination 

before the information is made available for public inspection.47

Disclosure of written determinations 

Section 6110 provides that the text of any written determination 

by the IRS and related background file document is open to public 

inspection.48 The term ‘‘written determination’’ means a ruling,49

determination letter,50 technical advice memorandum,51 or Chief 

Counsel advice.52 Closing agreements, which are final and conclusive written agreements entered into by the IRS and a taxpayer in 

order to settle the taxpayer’s tax liability with respect to a taxable 

year, do not constitute written determinations.53 A background file 

document includes the request for a written determination, any 

written material submitted by the taxpayer in support of the request, and any communications between the IRS and other persons 

in connection with the written determination received before 

issuance of the written determination.54

A background file document is available upon written request to 

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55Sec. 6110(e). 56Sec. 6110(c) provides the following exemptions from disclosure: (1) the names, addresses, 

and other identifying details of the person to whom the written determination pertains and of 

any other person, other than a person with respect to whom a notation is made under subsection 

(d)(1) (relating to third party contacts), identified in the written determination or any background file document; (2) information specifically authorized under criteria established by an 

Executive order to be kept secret in the interest of national defense or foreign policy, and which 

is in fact properly classified pursuant to such Executive order; (3) information specifically exempted from disclosure by any statute (other than this title) which is applicable to the Internal 

Revenue Service; (4) trade secrets and commercial or financial information obtained from a person and privileged or confidential; (5) information the disclosure of which would constitute a 

clearly unwarranted invasion of personal privacy; (6) information contained in or related to examination, operating, or condition reports prepared by, or on behalf of, or for use of an agency 

responsible for the regulation or supervision of financial institutions; and (7) geological and geophysical information and data, including maps, concerning wells. 57Sec. 6110(l)(1); Treas. Reg. sec. 301.6110–1(a). 

58Treas. Reg. sec. 301.6110–1(a). 58Treas. Reg. sec. 301.6104(a)–1(i). 

tion.55 Before releasing any written determination or background 

file document, the IRS must delete identifying details of the person 

about whom the written determination pertains and certain other 

information.56 With respect to tax-exempt organizations, disclosure 

under section 6110 is limited to letters and rulings unrelated to an 

organization’s tax-exempt status.57

The application of section 6110 to guidance relating to tax-exempt organizations is limited. Section 6110(l)(1) provides, ‘‘this section shall not apply to any matter to which section 6104 applies.’’

The regulations under section 6110 clarify which matters are within the ambit of section 6104 and, therefore, are not subject to disclosure under section 6110:

[a]ny application filed with the Internal Revenue Service 

with respect to the qualification or exempt status of an organization * * *; any document issued by the Internal Revenue Service in which the qualification or exempt status of 

an organization is * * * granted, denied or revoked or the 

portion of any document in which technical advice with respect thereto is given to a district director; * * * the portion of any document issued by the Internal Revenue Service in which is discussed the effect on the qualification or 

exempt status of an organization * * * of proposed transactions by such organization * * * ; and any document 

issued by the Internal Revenue Service in which is discussed the qualification or status of a [private foundation 

or private operating foundation].58

In addition, the regulations under section 6104 provide that some 

determination letters and other documents relating to tax exemption that are not open to public inspection under section 

6104(a)(1)(A) are nevertheless ‘‘within the ambit’’ of section 6104 

for purposes of the disclosure provisions of section 6110.59 The regulation explains that the following documents are, therefore, not 

available for public inspection under either section 6104 or 6110: 

(1) Unfavorable rulings or determination letters issued in response to applications for tax exemption; 

(2) Rulings or determination letters revoking or modifying a 

favorable determination letter; 

(3) Technical advice memoranda relating to a disapproved 

application for tax exemption or the revocation or modification 

of a favorable determination letter; 

34

60 Id. 

(4) Any letter or document filed with or issued by the IRS 

relating to whether a proposed or accomplished transaction is 

a prohibited transaction under section 503; 

(5) Any letter or document filed with or issued by the IRS 

relating to an organization’s status as a private foundation or 

private operating foundation, unless the letter or document relates to the organization’s application for tax exemption; and 

(6) Any other letter or document filed with or issued by the 

IRS which, although it relates to an organization’s tax exempt 

status as an organization described in section 501(c), does not 

relate to that organization’s application for tax exemption.60

The effect of these limitations is that written determinations relating to exempt status issues are not released, even in redacted 

form. The IRS does, however, release written determinations issued 

to tax-exempt organizations that include issues that clearly are not 

within the ambit of section 6104, such as the application of the unrelated business income tax to a particular proposed transaction. 

REASONS FOR CHANGE

The Committee believes that present law inappropriately protects from disclosure certain written determinations and background file documents that relate to the tax-exempt status of organizations described in section 501(c) and (d). The Committee believes that written determinations and background file documents 

that ordinarily would be disclosed under section 6110 but for the 

nondisclosure provided by section 6104 should be disclosed in redacted form, and that such disclosure will provide additional guidance to taxpayers as to the views of the IRS on certain issues. 

EXPLANATION OF PROVISION

The provision requires disclosure in redacted form of written determinations and related background file documents, as defined in 

section 6110, relating to the tax-exempt status of an organization 

described in section 501(c) or (d) that are not required to be disclosed by section 6104(a)(1)(A) but that are within the scope of section 6104 and thus are not presently disclosed. The provision provides that such written determinations and related background file 

documents shall be disclosed under the provisions of section 6110. 

Documents that are within the scope of section 6104 and that are 

not presently disclosed include: (1) unfavorable rulings or determination letters issued in response to applications for tax exemption; (2) rulings or determination letters revoking or modifying a 

favorable determination letter; (3) technical advice memoranda relating to a disapproved application for tax exemption or the revocation or modification of a favorable determination letter; (4) any letter or document filed with or issued by the IRS relating to whether 

a proposed or accomplished transaction is a prohibited transaction 

under section 503; (5) any letter or document filed with or issued 

by the IRS relating to an organization’s status as a private foundation or private operating foundation, unless the letter or document 

relates to the organization’s application for tax exemption; and (6) 

any other letter or document filed with or issued by the IRS which, 

although it relates to an organization’s tax exempt status as an orVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00034 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
35

61Sec. 6033(a). See, e.g., Form 990—Return of Organization Exempt From Income Tax. An or- ganization that is required to file Form 990, but that has gross receipts of less than $100,000 

during its taxable year, and total assets of less than $250,000 at the end of its taxable year, 

may file Form 990–EZ instead of Form 990. Private foundations are required to file Form 990– PF rather than Form 990. 62The IRS requires disclosure of an organization’s Internet web site address on Forms 990 

and 990–EZ. 63The staff of the Joint Committee on Taxation recommended the adoption of this provision. 

Joint Committee on Taxation, Study of Present-Law Taxpayer Confidentiality and Disclosure 

Provisions as Required by Section 3802 of the Internal Revenue Service Restructuring and Reform Act of 1998, Volume II: Study of Disclosure Provisions Relating to Tax-Exempt Organizations (JCS–1–00), January 28, 2000 at 96–97. 

ganization described in section 501(c) or (d), does not relate to that 

organization’s application for tax exemption. To the extent section 

6110 applies to such documents, they would be disclosed under the 

provision. 

EFFECTIVE DATE

The provision is effective for written determinations issued after 

December 31, 2002.

B. DISCLOSURE OF INTERNET WEB SITE AND NAME UNDER WHICH

ORGANIZATION DOES BUSINESS

(Sec. 202 of the bill and sec. 6033 of the Code) 

PRESENT LAW

Most types of tax-exempt organizations are required to file annually an information return.61 The Internal Revenue Code does not 

require an exempt organization to furnish on the applicable information return any name under which the organization operates or 

does business, if such name differs from the legal name of the organization, or the organization’s Internet web site address, if any.62

REASONS FOR CHANGE

Some tax-exempt organizations do business and solicit contributions under a name that is different from the organization’s legal 

name. This can cause confusion to individuals and others seeking 

information about the organization. Further, although much information regarding the operations and activities of tax-exempt organizations is available on the Internet web sites of such organizations, some members of the public might experience difficulties obtaining access to an organization’s web site if they do not know the 

organization’s web site address. The Committee believes that reducing confusion and increasing public access to relevant information regarding a tax-exempt organization would be achieved by requiring a tax-exempt organization to report on its annual return 

any name under which such organization operates or does business, and the Internet web site address (if any) of such organization.63

EXPLANATION OF PROVISION

The provision requires a tax-exempt organization subject to reporting requirements under section 6033(a) to include on its annual 

return any name under which such organization operates or does 

business, and the Internet web site address (if any) of such organization. 

36

64Sec. 6033(a). 65The staff of the Joint Committee on Taxation recommended the adoption of this provision. 

Joint Committee on Taxation, Study of Present-Law Taxpayer Confidentiality and Disclosure 

Provisions as Required by Section 3802 of the Internal Revenue Service Restructuring and Reform Act of 1998, Volume II: Study of Disclosure Provisions Relating to Tax-Exempt Organizations (JCS–1–00), January 28, 2000 at 99. 

EFFECTIVE DATE

The provision applies to returns filed after December 31, 2002.

C. MODIFICATION TO REPORTING OF CAPITAL TRANSACTIONS

(Sec. 203 of the bill and secs. 6033 and 6104 of the Code) 

PRESENT LAW

Private foundations are required to file an annual information return (Form 990–PF).64 Part IV of the Form 990–PF requires that 

private foundations report detailed information regarding the gain 

or loss from the sale or other disposition of property, including a 

description of the property sold, how it was acquired (purchase or 

donation), the date acquired, the date sold, the gross sales price, 

the amount of depreciation allowed or allowable, and the cost or 

other basis plus expenses of the sale. Such information generally 

is required for the IRS to calculate the tax on the private foundation’s net investment income. The Form 990–PF is required to be 

made available to the public. 

REASONS FOR CHANGE

Under present law, private foundations that engage in capital 

transactions must report detailed information about each transaction on Form 990–PF, which is filed with the IRS and available 

to the public. For some foundations, listing these transactions involves hundreds of pages. The Committee believes that automatic 

disclosure of such voluminous information does not necessarily benefit the public, and may in fact reduce the level of meaningful disclosure by obscuring other important information. The Committee 

believes that meaningful disclosure to the public will be increased 

if the version of the Form 990–PF that is automatically available 

to the public summarizes rather than lists the capital transactions 

that affect the calculation of the organization’s net investment income. In order to preserve the public’s access to more specific information regarding such capital transactions, the Committee believes 

that the more detailed information provided to the IRS on the 

Form 990–PF should be made available to those members of the 

public that explicitly request such information.65

EXPLANATION OF PROVISION

The provision requires that any information regarding capital 

gains and losses that is required to be furnished by private foundations in order to calculate the tax on net investment income be furnished also in summary form. 

In addition, information regarding capital gains and losses required to be filed with the IRS but that is not in summary form 

is not required to be made available to the public by the IRS or 

by the private foundation except by the explicit request of a member of the public to the IRS or to the foundation. A member of the 

37

66The staff of the Joint Committee on Taxation recommended the adoption of this provision. 

Joint Committee on Taxation, Study of Present-Law Taxpayer Confidentiality and Disclosure 

Provisions as Required by Section 3802 of the Internal Revenue Service Restructuring and Reform Act of 1998, Volume II: Study of Disclosure Provisions Relating to Tax-Exempt Organizations (JCS–1–00), January 28, 2000 at 96–97. 

public may request disclosure of such information from the Secretary, who shall prescribe the manner of making such request and 

the manner of disclosure. A member of the public also may request 

disclosure of the private foundation, which must be made in person 

or in writing. If the request is made in person, the foundation shall 

provide a copy of the information immediately and, if the request 

is made in writing, the foundation shall provide the information 

within 30 days. 

The bill also provides that private foundations are required to 

state on the furnished summary that the more detailed description 

is available upon request. 

EFFECTIVE DATE

The provision applies to returns filed after December 31, 2002.

D. DISCLOSURE THAT FORM 990 IS PUBLICLY AVAILABLE

(Sec. 204 of the bill) 

PRESENT LAW

Under present law, there is no requirement that the IRS notify 

the public that the Form 990 is publicly available. 

REASONS FOR CHANGE

The information provided on Forms 990 is useful to the public 

only to the extent that the public is aware that the form are publicly available. The Committee believes that the availability of 

Forms 990 that have been filed by exempt organizations will be increased by requiring the IRS to inform the public regarding the 

availability of such forms. 

EXPLANATION OF PROVISION

The provision requires the IRS to notify the public in appropriate 

publications and other materials of the extent to which an exempt 

organization’s Form 990, Form 990–EZ, and Form 990–PF are publicly available.66

EFFECTIVE DATE

The provision applies to publications or materials issued or revised after the date of enactment. 

E. DISCLOSURE TO STATE OFFICIALS OF PROPOSED ACTIONS

RELATED TO SECTION 501(C) ORGANIZATIONS

(Sec. 205 of the bill and sec. 6104 of the Code) 

PRESENT LAW

In the case of organizations that are described in section 

501(c)(3) and exempt from tax under section 501(a) or that have 

applied for exemption as an organization so described, present law 

38

67The applicable taxes include the termination tax on private foundations; taxes on public 

charities for certain excess lobbying expenses; taxes on a private foundation’s net investment 

income, self-dealing activities, undistributed income, excess business holdings, investments that 

jeopardize charitable purposes, and taxable expenditures (some of these taxes also apply to certain non-exempt trusts); taxes on the political expenditures and excess benefit transactions of 

section 501(c)(3) organizations; and certain taxes on black lung benefit trusts and foreign organizations. 68Sec. 6103(a). 69Sec. 6103(p)(3). 70Sec. 6103(p)(4). 71Secs. 7213 and 7213A. 72Sec. 7431.

(sec. 6104(c)) requires that Secretary to notify the appropriate 

State officer of (1) a refusal to recognize such organization as an 

organization described in section 501(c)(3, (2) a revocation of a section 501(c)(3) organization’s tax-exempt status, and (3) the mailing 

of a notice of deficiency for an tax imposed under section 507, chapter 41, or chapter 42.67 In addition, at the request of such appropriate State officer, the Secretary is required to make available for 

inspection and copying, such returns, filed statements, records, reports, and other information relating to the above-described disclosures, as are relevant to any State law determination. An appropriate State officer is the State attorney general, State tax officer, 

or any State official charged with overseeing organizations of the 

type described in section 501(c)(3). 

In general, return and return information (as such terms are defined in sec. 6103(b)) is confidential and may not be disclosed or inspected unless expressly provided by law.68 Present law requires 

the Secretary to keep records of disclosures and requests for inspection 69 and requires that persons authorized to receive return and 

return information maintain various safeguards to protect such information against unauthorized disclosure.70 Willful unauthorized 

disclosure or inspection of return or return information is subject 

to a fine and/or imprisonment.71 The knowing or negligent unauthorized inspection or disclosure of returns or return information 

gives the taxpayer a right to bring a civil suit.72 Such present-law 

protections against unauthorized disclosure or inspection of return 

and return information do not apply to the disclosures or inspections, described above, that are authorized by section 6104(c). 

REASONS FOR CHANGE

The Committee believes that State officials that are charged with 

oversight of certain organizations described in section 501(c) have 

an important and legitimate interest in receiving certain information about such organizations’ tax-exempt status and tax filings, in 

some cases before the IRS has made a final determination with respect to an organization’s tax-exempt status or liability for tax. By 

providing appropriate State officials with earlier access to information about the activities of certain section 501(c) organizations, 

State officials will be able to monitor such organizations more effectively and better protect the public’s interest in assuring that organizations that have been given the benefit of tax-exemption operate 

consistently with their exempt purposes. In addition, the Committee believes that permitting the IRS to share return and return 

information about certain section 501(c) organizations with appropriate State officials, when doing so will facilitate the resolution of 

39

73Such information also may be open to inspection by an appropriate State officer. 

Federal or State issues relating to the organization’s tax-exempt 

status, will significantly improve oversight of such organizations. 

The Committee stresses the importance of maintaining the confidentiality of taxpayer return and return information and believes 

it is important to extend existing protections against unauthorized 

disclosure or inspection of return and return information to disclosures made or inspections allowed by the Secretary of return and 

return information regarding such section 501(c) organizations. 

EXPLANATION OF PROVISION

The bill provides that upon written request by an appropriate 

State officer, the Secretary may disclose: (1) a notice of proposed 

refusal to recognize an organization as a section 501(c)(3) organization; (2) a notice of proposed revocation of tax-exemption of a section 501(c)(3) organization; (3) the issuance of a proposed deficiency 

of tax imposed under section 507, chapter 41, or chapter 42; (4) the 

names and taxpayer identification numbers of organizations that 

have applied for recognition as section 501(c)(3) organizations; and 

(5) return and return information of organizations 73 with respect 

to which information has been disclosed under (1) through (4) 

above. Disclosure or inspection is permitted for the purpose of, and 

only to the extent necessary in, the administration of State laws 

regulating section 501(c)(3) organizations, such as laws regulating 

tax-exempt status, charitable trusts, charitable solicitation, and 

fraud. Disclosure or inspection may be made only to or by designated representatives of the appropriate State officer, which does 

not include independent contractors. The Secretary also is permitted to disclose or open to inspection the return and return information of an organization that is recognized as tax- exempt under 

section 501(c)(3), or that has applied for such recognition, to an appropriate State officer if the Secretary determines that disclosure 

or inspection may facilitate the resolution of Federal or State 

issues relating to the tax-exempt status of the organization. For 

this purpose, appropriate State officer means the State attorney 

general or any other State official charged with overseeing organizations of the type described in section 501(c)(3). 

In addition, the bill provides that upon the written request by an 

appropriate State officer, the Secretary may make available for inspection or disclosure returns and return information of an organization described in section 501(c)(2) (certain title holding companies), 501(c)(4) (certain social welfare organizations), 501(c)(6) (certain business leagues and similar organizations), 501(c)(7) (certain 

recreational clubs), 501(c)(8) (certain fraternal organizations), 

501(c)(10) (certain domestic fraternal organizations operating under 

the lodge system), and 501(c)(13) (certain cemetery companies). 

Such return and return information is available for inspection or 

disclosure only for the purpose of, and to the extent necessary in, 

the administration of State laws regulating the tax-exempt status 

of such organizations. Disclosure or inspection may be made only 

to or by designated representatives of the appropriate State officer, 

which does not include independent contractors. For this purpose, 

appropriate State officer means the State attorney general and the 

head of an agency designated by the State attorney general as havVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00039 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
40

74Treas. Reg. sec. 1.664–1(d)(2). 

ing primary responsibility for overseeing the tax-exempt status of 

such organizations. 

In addition, the bill provides that any return and return information disclosed under section 6104(c) may be disclosed in civil administrative and judicial proceedings pertaining to the enforcement 

of State laws regulating the applicable tax-exempt organization in 

a manner prescribed by the Secretary. Returns and return information are not to be disclosed under section 6104(c), or in such an administrative or judicial proceeding, to the extent that the Secretary 

determines that such disclosure would seriously impair Federal tax 

administration. The provision makes disclosures of returns and return information under section 6104(c) subject to many of the provisions of section 6103, including the requirements that such information remain confidential (sec. 6103(a)(2)), that the Secretary 

maintain a permanent system of records of requests for disclosure 

(sec. 6103(p)(3)), and that the appropriate State officer maintain 

various safeguards that protect against unauthorized disclosure 

(sec. 6103(p)(4)). The bill provides that the willful unauthorized disclosure of return or return information described in section 6104(c) 

is a felony subject to a fine of up to $5,000 and/or imprisonment 

of up to five years (sec. 7213(a)(2)), the willful unauthorized inspection of return or return information described in section 6104(c) is 

subject to a fine of up to $1,000 and/or imprisonment of up to one 

year (sec. 7213A), and provides the taxpayer the right to bring a 

civil action for damages in the case of knowing or negligent unauthorized disclosure or inspection of such information (sec. 

7431(a)(2)). 

EFFECTIVE DATE

The provision is effective on the date of enactment but does not 

apply to requests made before such date.

Title III. Other Charitable and Exempt Organization Provisions 

A. MODIFY TAX ON UNRELATED BUSINESS TAXABLE INCOME OF

CHARITABLE REMAINDER TRUSTS

(Sec. 301 of the bill and sec. 664 of the Code) 

PRESENT LAW

Charitable remainder annuity trusts and charitable remainder 

unitrusts are exempt from Federal income tax for a tax year unless 

the trust has any unrelated business taxable income for the year. 

Unrelated business taxable income includes certain debt financed 

income. A charitable remainder trust that loses exemption from income tax for a taxable year is taxed as a regular complex trust. As 

such, the trust is allowed a deduction in computing taxable income 

for amounts required to be distributed in a taxable year, not to exceed the amount of the trust’s distributable net income for the 

year. Taxes imposed on the trust are required to be allocated to 

corpus.74

Distributions from a charitable remainder annuity trust or charitable remainder unitrust are treated in the following order as: (1) 

ordinary income to the extent of the trust’s current and previously 

41

75Sec. 664(b). 76Treas. Reg. sec. 1.664–1(d)(4). 77Sec. 664(d). 

undistributed ordinary income for the trust’s year in which the distribution occurred, (2) capital gains to the extent of the trust’s current capital gain and previously undistributed capital gain for the 

trust’s year in which the distribution occurred, (3) other income 

(e.g., tax-exempt income) to the extent of the trust’s current and 

previously undistributed other income for the trust’s year in which 

the distribution occurred, and (4) corpus.75

In general, distributions to the extent they are characterized as 

income are includible in the income of the beneficiary for the year 

that the annuity or unitrust amount is required to be distributed 

even though the annuity or unitrust amount is not distributed 

until after the close of the trust’s taxable year.76

A charitable remainder annuity trust is a trust that is required 

to pay, at least annually, a fixed dollar amount of at least five percent of the initial value of the trust to a noncharity for the life of 

an individual or for a period of 20 years or less, with the remainder 

passing to charity. A charitable remainder unitrust is a trust that 

generally is required to pay, at least annually, a fixed percentage 

of at least five percent of the fair market value of the trust’s assets 

determined at least annually to a noncharity for the life of an individual or for a period 20 years or less, with the remainder passing 

to charity.77

A trust does not qualify as a charitable remainder annuity trust 

if the annuity for a year is greater than 50 percent of the initial 

fair market value of the trust’s assets. A trust does not qualify as 

a charitable remainder unitrust if the percentage of assets that are 

required to be distributed at least annually is greater than 50 percent. A trust does not qualify as a charitable remainder annuity 

trust or a charitable remainder unitrust unless the value of the remainder interest in the trust is at least 10 percent of the value of 

the assets contributed to the trust.

REASONS FOR CHANGE

The Committee believes that in years that a charitable remainder trust has unrelated business income, an excise tax of 100 percent on such income is a more appropriate remedy than loss of tax 

exemption for the year. 

EXPLANATION OF PROVISION

The provision imposes a 100–percent excise tax on the unrelated 

business taxable income of a charitable remainder trust. This replaces the present-law rule that takes away the income tax exemption of a charitable remainder trust for any year in which the trust 

has any unrelated business taxable income. Consistent with 

present law, the tax is treated as paid from corpus. The unrelated 

business taxable income is considered income of the trust for purposes of determining the character of the distribution made to the 

beneficiary. 

42

EFFECTIVE DATE

The provision is effective for taxable years beginning after December 31, 2001.

B. MODIFY TAX TREATMENT OF CERTAIN PAYMENTS TO

CONTROLLING EXEMPT ORGANIZATIONS

(Sec. 302 of the bill and sec. 512 of the Code) 

PRESENT LAW

In general, interest, rents, royalties, and annuities are excluded 

from the unrelated business income of tax-exempt organizations. 

However, section 512(b)(13) generally treats otherwise excluded 

rent, royalty, annuity, and interest income as unrelated business 

income if such income is received from a taxable or tax-exempt subsidiary that is 50 percent controlled by the parent tax-exempt organization. In the case of a stock subsidiary, ‘‘control’’ means ownership by vote or value of more than 50 percent of the stock. In the 

case of a partnership or other entity, control means ownership of 

more than 50 percent of the profits, capital or beneficial interests. 

In addition, present law applies the constructive ownership rules of 

section 318 for purposes of section 512(b)(13). Thus, a parent exempt organization is deemed to control any subsidiary in which it 

holds more than 50 percent of the voting power or value, directly 

(as in the case of a first-tier subsidiary) or indirectly (as in the case 

of a second-tier subsidiary). 

Under present law, interest, rent, annuity, or royalty payments 

made by a controlled entity to a tax-exempt organization are includable in the latter organization’s unrelated business income and 

are subject to the unrelated business income tax to the extent the 

payment reduces the net unrelated income (or increases any net 

unrelated loss) of the controlled entity. 

The Taxpayer Relief Act of 1997 (the ‘‘1997 Act’’) made several 

modifications to the control requirement of section 512(b)(13). In 

order to provide transitional relief, the changes made by the 1997 

Act do not apply to any payment received or accrued during the 

first two taxable years beginning on or after the date of enactment 

of the 1997 Act (August 5, 1997) if such payment is received or accrued pursuant to a binding written contract in effect on June 8, 

1997, and at all times thereafter before such payment (but not pursuant to any contract provision that permits optional accelerated 

payments). 

REASONS FOR CHANGE

The present-law rule that requires a controlling entity to include 

as unrelated business income certain payments made by a controlled entity applies without regard to whether the amount of the 

payment is fair and reasonable under the circumstances or would 

otherwise constitute unrelated business income if paid by an organization not controlled by the exempt organization. The Committee 

believes that the controlling organization should not be subject to 

the unrelated business income tax if the amount of the payment 

from the controlled entity is determined in accordance with established arm’s-length principles. The Committee intends that the controlling organization be subject to the present-law rule only to the 

43

78Sec. 501(c)(3). 

extent that a payment made by a controlled entity exceeds the 

amount that would have been paid if the payment had been determined under established arm’s-length principles. In order to discourage controlled entities from claiming deductions in excess of 

the arm’s-length amount, the Committee believes that it is appropriate to subject the controlling organization to a penalty tax for 

making excess payments. 

EXPLANATION OF PROVISION

The bill provides that the general rule of section 512(b)(13), 

which includes interest, rent, annuity, or royalty payments made 

by a controlled entity to a tax-exempt organization in the latter organization’s unrelated business income to the extent the payment 

reduces the net unrelated income (or increases any net unrelated 

loss) of the controlled entity, applies only to the portion of payments received or accrued in a taxable year that exceed the amount 

of the specified payment that would have been paid or accrued if 

such payment had been determined under the principles of section 

482. Thus, if a payment of rent by a controlled subsidiary to its 

tax-exempt parent organization exceeds fair market value, the excess amount of such payment over fair market value (as determined in accordance with section 482) is included in the parent organization’s unrelated business income, to the extent that such excess reduced the net unrelated income (or increased any net unrelated loss) of the controlled entity. In addition, the provision imposes a 20–percent penalty on the larger of such excess determined 

without regard to any amendment or supplement to a return of tax, 

or such excess determined with regard to all such amendments and 

supplements. 

The bill provides that if modifications to section 512(b)(13) made 

by the 1997 Act did not apply to a contract because of the transitional relief provided by the 1997 Act, then such modifications also 

do not apply to amounts received or accrued under such contract 

before January 1, 2001. 

EFFECTIVE DATE

The provision applies to payments received or accrued after December 31, 2000.

C. SIMPLIFICATION OF LOBBYING EXPENDITURE LIMITATION

(Sec. 303 of the bill and secs. 501 and 4911 of the Code) 

PRESENT LAW

In general 

An organization does not qualify for tax-exempt status under section 501(c)(3) unless ‘‘no substantial part’’ of the activities of the organization is ‘‘carrying on propaganda, or otherwise attempting, to 

influence legislation,’’ except as provided by section 501(h).78 Carrying on propaganda and attempting to influence legislation commonly are referred to as ‘‘lobbying’’ activities. Thus, section 

44

79Organizations that do not make a section 501(h) election are subject to the ‘‘no substantial 

part’’ test. 80Secs. 501(h)(2)(A), 4911(c)(1), 4911(d). 81 Exempt purpose expenditures generaally are expenses incurred for exempt purposes, such 

as amounts paid to accomplish exempt purposes, administrative expenses such as overhead, lobbying expenses, and certain fundraising expenses. Exempt purpose expenditures do not include, 

for example, expenses not for exempt purposes, payments of unrelated business income tax, or 

capital expenses in connection with an unrelated business. See Treas. Reg. sec. 56.4911–4. 82Sec. 501(h)(1). 83Treas. Reg. sec. 1.501(h)–3. 84Secs. 501(h)(2)(C) & 4911(d)(1)(A). 

501(c)(3) permits a limited amount of lobbying activity without loss 

of tax-exempt status. 

For purposes of determining whether lobbying activities are a 

substantial part of an organization’s overall functions, an organization may choose between two standards, the ‘‘no substantial part’’ test of section 501(c)(3) or the ‘‘expenditure’’ test of section 501(h). 

Whether an organization meets the ‘‘no substantial part’’ test is 

based on all the facts and circumstances. There is no statutory or 

regulatory guidance, and it is not clear whether the determination 

is based on the organization’s activities, its expenditures, or both. 

Alternatively, under section 501(h), certain organizations described 

in section 501(c)(3) can elect to be subject to the expenditure test,79

which consists of bright-line rules that specify the dollar amount 

of permitted expenses on lobbying activities. 

Consequences of excess lobbying under section 501(h) 

Organizations that make a section 501(h) election (‘‘electing charities’’) are subject to tax if the electing charity makes either ‘‘lobbying expenditures’’ or ‘‘grass roots expenditures’’ in excess of a certain amount established for each type of expenditure for each taxable year. Lobbying expenditures are the sum of grass-roots expenditures and ‘‘direct lobbying’’ expenditures.80

The expenditure limits are based on a ‘‘lobbying nontaxable 

amount’’ for the taxable year and a ‘‘grass roots nontaxable 

amount’’ for the taxable year. The lobbying nontaxable amount is the lesser of $1 million or an amount determined as a percentage 

of an organization’s exempt purpose expenditures.81 The grassroots nontaxable amount is 25 percent of the organization’s lobbying nontaxable amount. An electing charity that exceeds either 

of the spending limitations is subject to a 25 percent tax on the excess. An electing charity that exceeds both of the spending limitations is subject to a 25 percent tax on the greater of the excess of 

the lobbying expenditures or the grass-roots expenditures. 

An electing charity that normally exceeds either of two ‘‘ceiling 

amounts,’’ which are based on the expenditure limits, will lose its 

tax exemption.82 The ‘‘lobbying ceiling amount’’ is 150 percent of 

the electing charity’s lobbying nontaxable amount for the taxable 

year and the ‘‘grass roots ceiling amount’’ is 150 percent of the 

grass-roots nontaxable amount for the taxable year. For this purpose, ‘‘normal’’ expenditures are calculated based on a four-year 

averaging mechanism.83

Definitions 

Grass-roots expenditures are defined as ‘‘any attempt to influence any legislation through an attempt to affect the opinions of 

the general public or any segment thereof.’’ 84 For a communication 

45

85Treas. Reg. sec. 56.4911–2(b)(2)(i). 86Treas. Reg. sec. 56.4911–2(b)(2)(iii). The regulations provide that the first three elements 

constitute ‘‘direct’’ encouragement, whereas the fourth element is ‘‘indirect’’ encouragement. This 

distinction becomes relevant in determining whether a communication meets one of the prescribed exceptions to lobbying, i.e., an indirect call to action in a grass-roots communication may 

qualify as ‘‘nonpartisan analysis, study or research’’ (Treas. Reg. sec. 56.4911–2(b)(2)(iv)), and 

in determining the proper allocation of expenses between grass-roots and direct lobbying. Treas. 

Reg. sec. 56.4911–5(e). 87Treas. Reg. sec. 56.4911–2(b)(5)(ii). 88 Id. 89Secs. 501(h)(2)(A) and 4911(d)(1)(B) and Treas. Reg. sec. 56.4911–2(b)(1). 

to constitute grass-roots lobbying, it must refer to ‘‘specific legislation,’’ reflect a view on such legislation, and encourage the recipient 

of the communication to take action with respect to such legislation 

(a ‘‘call to action’’).85 A communication includes a call to action if 

it incorporates one of four elements: (1) it urges the recipient to 

contact a legislator, employee of a government body, or any other 

government official or employee who may participate in the formulation of legislation with the principal purpose of influencing legislation; (2) it states the address, telephone number, or similar information of a legislator or an employee of a legislative body; (3) it 

provides a petition, tear-off postcard, or similar device for the recipient to communicate with government officials or employees who 

participate in the formulation of legislation with the principal purpose of influencing legislation; or (4) it states the position of one 

or more legislators on the legislation, except that a communication 

may name the main sponsors of legislation for purposes of identifying the legislation without constituting a call to action.86 In addition, a communication is presumed to be grass-roots lobbying if the 

communication is a paid advertisement that: (1) appears in the 

mass media within two weeks before a vote by a legislative body 

or committee (but not a subcommittee) on a highly publicized piece 

of legislation; (2) reflects a view on the general subject of the legislation; and (3) either refers to the legislation or encourages the 

public to communicate with legislators on the general subject of 

such legislation.87 The presumption is rebuttable if the electing 

charity demonstrates that the timing of the communication was not 

related to the legislation or that the advertisement was of a type 

regularly made by the electing charity without regard to the timing 

of the legislation (a customary course of business exception).88

Direct lobbying expenditures are ‘‘any attempt to influence any 

legislation through communication with any member or employee 

of a legislative body, or with any government official or employee 

who may participate in the formulation of the legislation’’ if the 

principal purpose of the communication is to influence legislation.89

A communication would constitute direct lobbying only if the communication ‘‘refers to specific legislation’’ and reflects a view on 

such legislation. 

Certain specified activities do not constitute attempts to influence legislation and therefore expenditures for such activities are 

not subject to the expenditure limits for lobbying expenditures or 

grass-roots expenditures. In general, such activities include: (1) 

making available the results of nonpartisan analysis, study, or research; (2) providing technical advice or assistance to a governmental body or to a committee in response to a written request; (3) 

appearances before, or communications to, any legislative body 

with respect to a possible decision of such body that might affect 

reasons for change 46

90Sec. 4911(d)(2). 91Treas. Reg. sec. 56.4911–59(e). 92See Treas. Reg. sec. 56.4911–6. 

the existence of the organization, its powers and duties, tax-exempt 

status, or the deduction of contributions to the organization (socalled ‘‘self-defense’’ expenditures); (4) certain communications to 

members of the electing charity; and (5) communications with governmental officials or employees that are not intended to influence 

legislation.90

Special rules for mixed lobbying expenditures 

Expenses that serve both direct and grass-roots lobbying purposes, e.g., communications that are sent to members and nonmembers, or ‘‘mixed lobbying’’ expenditures, are subject to special rules. 

The regulations specify how an electing charity is to allocate mixed 

lobbying expenditures between direct and grass-roots lobbying purposes.91 For example, for a mixed lobbying communication that is 

designed primarily for members (i.e., more than half the recipients 

are members) and that directly encourages grass-roots lobbying 

(even if it also encourages direct lobbying), the grass-roots expenditure amount includes all the costs of preparing the material used 

for purposes of grass-roots lobbying plus the mechanical and distributional costs associated with the communication. If a mixed lobbying communication encourages direct lobbying, but only indirectly encourages grass-roots lobbying, then the entire costs of the 

communication are allocated based on the proportion of members 

and nonmembers receiving the communication. 

Disclosure of lobbying expenditures 

An electing charity must disclose lobbying expenditures annually 

on Schedule A of Form 990. In order to meet disclosure requirements, electing charities are required to keep detailed records of direct and grass-roots lobbying expenditures. Required records of 

grass-roots expenditures include: (1) all amounts directly paid or 

incurred for grass-roots lobbying; (2) payments to other organizations earmarked for grass-roots lobbying; (3) fees and expenses paid 

for grass-roots lobbying; (4) the printing, mailing, and other costs 

of reproducing and distributing materials used in grass-roots lobbying; (5) the portion of amounts paid or incurred as current or deferred compensation for an employee’s grass-roots lobbying services; (6) any amount paid for out-of-pocket expenditures incurred 

on behalf of the electing charity for grass-roots lobbying; (7) the allocable portion of administrative, overhead and other general expenditures attributable to grass-roots lobbying; and (8) expenditures for grass-roots lobbying of a controlled organization.92

REASONS FOR CHANGE

The Committee believes that the separate limitation on grassroots lobbying expenditures is an unnecessary complication for 

electing charities. The Committee believes that the overall limit on 

lobbying expenditures is a sufficient ceiling on the lobbying activities of electing charities, irrespective of the proportion of lobbying 

activities that are grass-roots lobbying or direct lobbying. 

47

93Sec. 508(a). 

EXPLANATION OF PROVISION

The provision eliminates the separate limitation for grass-roots 

lobbying expenditures applicable to electing charities. Electing 

charities remain subject to the overall limitation on lobbying expenditures, which does not change in amount, but electing charities 

are not required to limit grass roots expenditures as a percentage 

of overall lobbying. Thus, an electing charity is able to make taxfree any combination of grass-roots and direct lobbying expenditures up to the lobbying non-taxable amount and does not risk loss 

of tax-exemption as a result of such expenditures until total lobbying expenditures normally exceed the lobbying ceiling amount. 

For purposes of the section 501(h) election, electing charities are 

not required to distinguish between grass-roots lobbying and direct 

lobbying, whether for mixed lobbying expenditures or otherwise. 

EFFECTIVE DATE

The provision is effective for taxable years beginning after December 31, 2001.

D. EXPEDITED REVIEW PROCESS FOR CERTAIN TAX-EXEMPTION

APPLICATIONS

(Sec. 304 of the bill) 

PRESENT LAW

Most organizations that seek tax-exempt status as a charitable 

organization are required to file an Application for Recognition of 

Exemption (Form 1023) with the IRS.93 Organizations that are not 

required to file Form 1023 include churches, their integrated auxiliaries, and conventions or associations of churches, and any organization (other than a private foundation) that normally has gross receipts of $5,000 or less in a taxable year. Organizations that file 

Form 1023 within 15 months of the end of the month of the organization’s formation will, if the application is approved, be recognized 

as tax-exempt from the date of formation. The IRS will automatically grant an organization’s request for an additional 12–month 

extension of the 15-month period. Otherwise, exemption normally 

will be recognized as of the date the application was received by 

the IRS. In appropriate circumstances, upon written request, the 

IRS will expedite consideration of applications for tax-exemption. 

For example, organizations formed to provide relief to victims of 

disasters or other emergencies often receive expedited consideration. 

REASONS FOR CHANGE

Many social service organizations that want to apply for government funding through grants or contracts are required as a condition of application to have been recognized as an exempt charitable 

organization. The Committee wishes to facilitate the formation of 

charitable organizations that intend to work with Federal, State 

and local governments to provide vital social services to many of 

the neediest members of society by implementing an expedited review procedure for exempt status applications, and by waiving IRS 

reasons for change 48

user fees pertaining to such applications filed by smaller social 

service organizations. 

EXPLANATION OF PROVISION

The bill provides that the Secretary or its delegate shall adopt 

procedures to expedite consideration of applications for exempt status by organizations that are organized and operated for the primary purpose of providing social services. To be eligible, the organization must: (1) be seeking a contract or grant under a Federal, 

State, or local program that provides funding for social service programs; (2) establish that tax-exempt status is a condition of applying for such contract or grant; (3) include a completed copy of the 

contract or grant application with the application for exemption; 

and (4) meet such other criteria as the Secretary may provide. Organizations that meet the eligibility requirements described above 

(except for the requirement that tax-exempt status is a condition 

of the contract or grant application), and that certify that the organization’s average annual gross receipts over the four year period 

preceding the application was not more than $50,000 (or, in the 

case of an organization in existence less than four years, is not expected to be more than $50,000 during the organization’s first four 

years) are entitled to a waiver of any fee for application of tax-exempt status. 

For this purpose, social services is defined as services directed at 

helping people in need, reducing poverty, improving outcomes of 

low-income children, revitalizing low-income communities, and empowering low-income families and low-income individuals to become self-sufficient, including: (1) child care services, protective 

services for children and adults, services for children and adults in 

foster care, adoption services, services related to the management 

and maintenance of the home, day care services for adults, and 

services to meet the special needs of children, older individuals, 

and individuals with disabilities (including physical, mental, or 

emotional disabilities); (2) transportation services; (3) job training 

and related services, and employment services; (4) information, referral, and counseling services; (5) the preparation and delivery of 

meals, and services related to soup kitchens or food banks; (6) 

health support services; (7) literacy and mentoring programs; (8) 

services for the prevention and treatment of juvenile delinquency 

and substance abuse, services for the prevention of crime and the 

provision of assistance to the victims and the families of criminal 

offenders, and services related to the intervention in, and prevention of, domestic violence; and (9) services related to the provision 

of assistance for housing under Federal law. Social services does 

not include a program having the purpose of delivering educational 

assistance under the Elementary and Secondary Education Act of 

1965 or under the Higher Education Act of 1965. 

EFFECTIVE DATE

The provision applies to applications for tax-exempt status filed 

after December 31, 2002.

49

94Sec. 7611. Prior to the year 2000 IRS restructuring, the lowest level official who could initiate a church tax inquiry was an IRS Regional Commissioner. 

E. CLARIFICATION OF DEFINITION OF CHURCH TAX INQUIRY

(Sec. 305 of the bill and sec. 7611 of the Code) 

PRESENT LAW

Under present law, the IRS may begin a church tax inquiry only 

if an appropriate high-level Treasury official reasonably believes, 

on the basis of the facts and circumstances recorded in writing, 

that an organization (1) may not qualify for tax exemption as a 

church, (2) may be carrying on an unrelated trade or business, or 

(3) otherwise may be engaged in taxable activities.94 A church tax 

inquiry is defined as any inquiry to a church (other than an examination) that serves as a basis for determining whether the organization qualified for tax exemption as a church or whether it is carrying on an unrelated trade or business or otherwise is engaged in 

taxable activities. An inquiry is considered to commence when the 

IRS requests information or materials from a church of a type contained in church records, other than routine requests for information or inquiries regarding matters that do not primarily concern 

the tax status or liability of the church itself. 

REASONS FOR CHANGE

The Committee believes that the present-law church tax inquiry 

procedures provide important safeguards against the IRS engaging 

in unnecessary and intrusive examinations of churches. However, 

the church tax inquiry procedures also have the effect of hampering 

IRS efforts to educate churches with respect to actions that are not 

permissible under section 501(c)(3). The Committee believes that a 

clarification of the scope of the church tax inquiry procedures to 

make it clear that the IRS may undertake educational outreach efforts with respect to specific churches (e.g., initiating meetings with 

representatives of a particular church to discuss the rules that 

apply to such church) will improve compliance with the law by 

churches. 

EXPLANATION OF PROVISION

The provision clarifies that the church tax inquiry procedures do 

not apply to contacts made by the IRS for the purpose of educating 

churches with respect to the federal income tax law governing taxexempt organizations. For example, the IRS does not violate the 

church tax inquiry procedures when written materials are provided 

to a church or churches for the purpose of educating such church 

or churches with respect to the types of activities that are not permissible under section 501(c)(3). 

EFFECTIVE DATE

The provision is effective on the date of enactment. 

reasons for change 50

F. EXTENSION OF DECLARATORY JUDGMENT PROCEDURES TO NON- 501(C)(3) TAX-EXEMPT ORGANIZATIONS (SEC. 306 OF THE BILL AND

SEC. 7428 OF THE CODE) 

PRESENT LAW

In order for an organization to be granted tax exemption as a 

charitable entity described in section 501(c)(3), it generally must 

file an application for recognition of exemption with the IRS and 

receive a favorable determination of its status. Similarly, for most 

organizations, a charitable organization’s eligibility to receive taxdeductible contributions is dependent upon its receipt of a favorable determination from the IRS. In general, a section 501(c)(3) organization can rely on a determination letter or ruling from the 

IRS regarding its tax-exempt status, unless there is a material 

change in its character, purposes, or methods of operation. In cases 

in which an organization violates one or more of the requirements 

for tax exemption under section 501(c)(3), the IRS is authorized to 

revoke an organization’s tax exemption, notwithstanding an earlier 

favorable determination. 

In situations in which the IRS denies an organization’s application for recognition of exemption under section 501(c)(3) or fails to 

act on such application, or in which the IRS informs a section 

501(c)(3) organization that it is considering revoking or adversely 

modifying its tax-exempt status, present law authorizes the organization to seek a declaratory judgment regarding its tax status (sec. 

7428). Section 7428 provides a remedy in the case of a dispute involving a determination by the IRS with respect to: (1) the initial 

qualification or continuing qualification of an organization as a 

charitable organization for tax exemption purposes or for charitable 

contribution deduction purposes; (2) the initial classification or continuing classification of an organization as a private foundation; (3) 

the initial classification or continuing classification of an organization as a private operating foundation; or (4) the failure of the IRS 

to make a determination with respect to (1), (2), or (3). A ‘‘determination’’ in this context generally means a final decision by the 

IRS affecting the tax qualification of a charitable organization, although it also can include a proposed revocation of an organization’s tax-exempt status or public charity classification. Section 

7428 vests jurisdiction over controversies involving such a determination in the U.S. District Court for the District of Columbia, 

the U.S. Court of Federal Claims, and the U.S. Tax Court. 

Prior to utilizing the declaratory judgment procedure, an organization must have exhausted all administrative remedies available 

to it within the IRS. An organization is deemed to have exhausted 

its administrative remedies at the expiration of 270 days after the 

date on which the request for a determination was made if the organization has taken, in a timely manner, all reasonable steps to 

secure such determination. 

If an organization (other than a section 501(c)(3) organization) 

files an application for recognition of exemption and receives a favorable determination from the IRS, the determination of tax-exempt status is usually effective as of the date of formation of the 

organization if its purposes and activities during the period prior 

to the date of the determination letter were consistent with the requirements for exemption. However, if the organization files an apVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00050 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
51

95This limitation currently applies to declaratory judgments relating to tax qualification for 

certain employee retirement plans (sec. 7476). 96Sec. 6033(a)(2)(A)(i). 97Sec. 7611(h)(1)(B). 98See, e.g., Sec. 402(g)(8)(B) (limitation on elective deferrals); sec. 403(b)(9)(B) (definition of 

retirement income account); sec. 410(d) (election to have participation, vesting, funding, and certain other provisions apply to church plans); sec. 414(e) (definition of church plan); sec. 415(c)(7) 

(certain contributions by church plans); sec. 501(h)(5) (disqualification of certain organizations 

from making the sec. 501(h) election regarding lobbying expenditure limits); sec. 501(m)(3) (definition of commercial-type insurance); sec. 508(c)(1)(A) (exception from requirement to file appliContinued

plication for recognition of exemption and later receives an adverse 

determination from the IRS, the IRS may assert that the organization is subject to tax on some or all of its income for open taxable

years. In addition, as with charitable organizations, the IRS may 

revoke or modify an earlier favorable determination regarding an 

organization’s tax-exempt status. 

Under present law, a non-charity (i.e., an organization not described in section 501(c)(3)) may not seek a declaratory judgment 

with respect to an IRS determination regarding its tax-exempt status. The only remedies available to such an organization are to petition the U.S. Tax Court for relief following the issuance of a notice of deficiency or to pay any tax owed and sue for refund in federal district court or the U.S. Court of Federal Claims. 

REASONS FOR CHANGE

The Committee believes that it is important to provide certainty 

for organizations that have sought a determination of their tax-exempt status. Thus, the Committee finds it appropriate to extend 

the present-law declaratory judgment procedures to all organizations that apply for tax-exempt status as organizations described in 

section 501(c). 

EXPLANATION OF PROVISION

The provision extends declaratory judgment procedures similar 

to those currently available only to charities under section 7428 to 

other section 501(c) determinations. The provision limits jurisdiction over controversies involving such determinations to the United 

States Tax Court.95

EFFECTIVE DATE

The extension of the declaratory judgment procedures to organizations other than section 501(c)(3) organizations is effective for 

pleadings filed with respect to determinations made after December 31, 2001. 

G. DEFINITION OF CONVENTION OR ASSOCIATION OF CHURCHES

(Sec. 307 of the bill and sec. 7701 of the Code) 

PRESENT LAW

Under present law, an organization that qualifies as a ‘‘convention or association of churches’’ (within the meaning of sec. 

170(b)(1)(A)(i)) is not required to file an annual return,96 is subject 

to the church tax inquiry and church tax examination provisions 

applicable to organizations claiming to be a church,97 and is subject 

to certain other provisions generally applicable to churches.98 The 

reasons for change 52

cation seeking recognition of exempt status); sec. 512(b)(12) (allowance of up to $1,000 deduction 

for purposes of determining unrelated business taxable income); sec. 514(b)(3)(E) (definition of 

debt-financed property); sec. 3121(w)(3)(A) (election regarding exemption from social security 

taxes); sec. 3309(b)(1) (application of federal unemployment tax provisions to services performed 

in the employ of certain organizations); sec. 6043(b)(1) (requirement to file a return upon liquidation or dissolution of the organization); and sec. 7702(j)(3)(A) (treatment of certain death 

benefit plans as life insurance). 

Internal Revenue Code does not define the term ‘‘convention or association of churches.’’

REASONS FOR CHANGE

The term ‘‘convention or association of churches’’ was added to 

the Code to ensure that hierarchical churches and congregational 

churches would not be treated dissimilarly for Federal income tax 

purposes merely because of their organizational and governance 

structures. The Committee understands that some congregational 

church organizations have only churches as members, and that others have both churches and individuals as members. The Committee is concerned that an organization with the characteristics of 

a convention or association of churches, including having a substantial number of churches as members, might fail to be regarded 

as a convention or association of churches merely because it includes individuals in its membership. The Committee intends that 

a congregational church organization that otherwise constitutes a 

convention or association of churches not be denied recognition as 

such merely because its membership includes individuals as well as 

churches. 

EXPLANATION OF PROVISION

The bill provides that an organization that otherwise is a convention or association of churches does not fail to so qualify merely because the membership of the organization includes individuals as 

well as churches, or because individuals have voting rights in the 

organization. 

EFFECTIVE DATE

The provision is effective on the date of enactment.

H. CHARITABLE CONTRIBUTION DEDUCTION FOR CERTAIN EXPENSES

IN SUPPORT OF NATIVE ALASKAN SUBSISTENCE WHALING

(Sec. 308 of the bill and sec. 170 of the Code) 

PRESENT LAW

In computing taxable income, individuals who do not elect the 

standard deduction may claim itemized deductions, including a deduction (subject to certain limitations) for charitable contributions 

or gifts made during the taxable year to a qualified charitable organization or governmental entity (sec. 170). Individuals who elect 

the standard deduction may not claim a deduction for charitable 

contributions made during the taxable year. 

No charitable contribution deduction is allowed for a contribution 

of services. However, unreimbursed expenditures made incident to 

the rendition of services to an organization, contributions to which 

are deductible, may constitute a deductible contribution (Treas. 

Reg. sec. 1.170A–1(g)). Specifically, section 170(j) provides that no 

53

charitable contribution deduction is allowed for traveling expenses 

(including amounts expended for meals and lodging) while away 

from home, whether paid directly or by reimbursement, unless 

there is no significant element of personal pleasure, recreation, or 

vacation in such travel. 

REASONS FOR CHANGE

The Committee believes that subsistence bowhead whale hunting 

activities are important to certain native peoples of Alaska and further charitable purposes. The Committee believes that certain expenses paid by individuals recognized as whaling captains by the 

Alaska Eskimo Whaling Commission in the conduct of sanctioned 

whaling activities conducted pursuant to the management plan of 

that Commission should be deductible as charitable contributions 

even though they are paid other than directly to a charitable organization. 

EXPLANATION OF PROVISION

The provision allows certain individuals to claim a deduction under section 170 not exceeding $7,500 per taxable year for certain 

expenses incurred in carrying out sanctioned whaling activities. 

The deduction is available only to an individual who is recognized 

by the Alaska Eskimo Whaling Commission as a whaling captain 

charged with the responsibility of maintaining and carrying out 

sanctioned whaling activities. The deduction is available for reasonable and necessary expenses paid by the taxpayer during the taxable year for: (1) the acquisition and maintenance of whaling boats, 

weapons, and gear used in sanctioned whaling activities, (2) the 

supplying of food for the crew and other provisions for carrying out 

such activities, and (3) storage and distribution of the catch from 

such activities. The Committee intends that the Secretary shall require that the taxpayer substantiate deductible expenses by maintaining appropriate written records that show, for example, the 

time, place, date, amount, and nature of the expense, as well as the 

taxpayer’s eligibility for the deduction. In addition, the Committee 

believes that it is appropriate for the taxpayer to provide such substantiation as part of the taxpayer’s income tax return, to the extent provided by the Secretary. 

For purposes of the provision, the term ‘‘sanctioned whaling activities’’ means subsistence bowhead whale hunting activities conducted pursuant to the management plan of the Alaska Eskimo 

Whaling Commission. 

EFFECTIVE DATE

The provision applies to expenses paid after December 31, 2002, 

in taxable years ending after such date.

I. PAYMENTS BY CHARITABLE ORGANIZATIONS TO VICTIMS OF WAR

ON TERRORISM

(Sec. 309 of the bill) 

PRESENT LAW

In general, organizations described in section 501(c)(3) of the 

Code are exempt from taxation. Contributions to such organizaVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00053 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
reasons for change 54

99Sec. 170. 100Sec. 4941. 

tions generally are tax deductible.99 Section 501(c)(3) organizations 

must be organized and operated exclusively for exempt purposes 

and no part of the net earnings of such organizations may inure 

to the benefit of any private shareholder or individual. An organization is not organized or operated exclusively for one or more exempt purposes unless the organization serves a public rather than 

a private interest. Thus, an organization described in section 

501(c)(3) generally must serve a charitable class of persons that is 

indefinite or of sufficient size. 

Tax-exempt private foundations are a type of organization described in section 501(c)(3) and are subject to special rules. Private 

foundations are subject to excise taxes on acts of self-dealing between the private foundation and a disqualified person with respect 

to the foundation.100 For example, it is self-dealing if assets of a 

private foundation are used for the benefit of a disqualified person, 

such as a substantial contributor to the foundation or a person in 

control of the foundation, and the benefit is not incidental or tenuous. 

REASONS FOR CHANGE

The Committee believes that payments by charities to members 

of the Armed Forces of the United States (and their immediate 

families) made by reason of death, injury, wounding or illness and 

incurred as a result of our nation’s military response to the terrorist attacks of September 11, 2001, should be treated as consistent with the charity’s exempt purpose, to the extent the payments are made in good faith and pursuant to a reasonable and objective formula that is consistently applied. 

EXPLANATION OF PROVISION

The bill provides that organizations described in section 501(c)(3) 

that make certain payments are not required to make a specific assessment of need for the payments to be related to the purpose or 

function constituting the basis for the organization’s exemption, 

provided that the organization makes the payments in good faith 

and uses an objective formula that is consistently applied in making the payments. 

The provision applies to payments to a member of the Armed 

Forces of the United States (as defined in section 7701(a)(15)), or 

to a member of such person’s immediate family (including spouses, 

parents, children, and foster children), by reason of the death, injury, wounding, or illness of a member of the Armed Forces of the 

United States that was incurred as a result of the military response of the United States to the terrorist attacks against the 

United States on September 11, 2001. As under present law, such 

payments must be for public and not private benefit and therefore 

must serve a charitable class. For example, a charitable organization that assists the families of members of the Armed Forces 

killed in the line of duty may make pro-rata distributions to the 

families of those killed, even though the specific financial needs of 

each family are not directly considered. Similarly, if the amount of 

a distribution is based on the number of dependents of a charitable 

55

class of persons killed in the military response to the attacks and 

this standard is applied consistently among distributions, the specific needs of each recipient do not have to be taken into account. 

However, it is not appropriate for a charity to make pro-rata payments based on the recipients’ living expenses before the harm occurred if the result generally provides significantly greater assistance to persons in a better position to provide for themselves than 

to persons with fewer financial resources. Although such a distribution might be based on objective criteria, it is not a reasonable formula for distributing assistance in an equitable manner. Similarly, 

although specific assessments of need are not required, payments 

that do not further public purposes are not permitted. The provision does not change the substantive standards for exemption 

under section 501(c)(3), including the prohibition on private 

inurement. The provision also provides that if a private foundation 

makes payments under the conditions described above, the payment is not treated as made to a disqualified person for purposes 

of section 4941. 

EFFECTIVE DATE

The provision applies to payments made after the date of enactment and before September 11, 2003.

J. MODIFY RULES GOVERNING TAX-EXEMPT BONDS FOR SECTION

501(C)(3) ORGANIZATIONS AS APPLIED TO ORGANIZATIONS ENGAGED IN TIMBER CONSERVATION ACTIVITIES

(Sec. 310 of the bill and sec. 145 of the Code) 

PRESENT LAW

Interest on State or local government bonds is tax-exempt when 

the proceeds of the bonds are used to finance activities carried out 

by or paid for by those governmental units. Interest on bonds 

issued by State or local governments acting as conduit borrowers 

for private businesses is taxable unless a specific exception is included in the Code. One such exception allows tax-exempt bonds to 

be issued to finance activities of non-profit organizations described 

in Code section 501(c)(3) (‘‘qualified 501(c)(3) bonds’’). 

Qualified 501(c)(3) bonds may be issued only to finance the activities that qualify the organization for tax-exemption, as opposed 

to unrelated business activities of these organizations. If the bonds 

are issued to finance property that is intended to be sold to a private business while the bonds are outstanding, bond interest may 

not qualify for tax-exemption. Similarly, if the property is in fact 

sold, bond interest may become retroactively taxable unless remedial actions specified in Treasury Department regulations are 

taken. An example of such a situation would be qualified 501(c)(3) 

bonds issued to finance the purchase of land and standing timber 

when the timber was to be sold. 

As is true of governmental activities receiving tax-exempt financing, section 501(c)(3) organizations are restricted in the arrangements they may have with private businesses relating to control 

and use of bond-financed property. 

reasons for change 56

REASONS FOR CHANGE

The Committee notes that thousands of acres of productive forest 

are being lost to urban uses. The Committee believes it is appropriate to offer greater protection of areas of particular environmental sensitivity and open space, while at the same time maintaining viable forest operations and jobs near growing urban areas. 

This provision will give qualified 501(c)(3) organizations the flexibility to acquire and preserve larger tracts of forest land by lowering the financing costs. Thus, the provision should reduce the 

need to acquire these lands on a smaller, more piecemeal basis. 

Further, by allowing trees to be harvested to cover the bond payments, the provision will provide jobs, while subjecting the land to 

a conservation easement will preserve areas of particular environmental sensitivity and open space. 

EXPLANATION OF PROVISION

The provision modifies the rules governing issuance of qualified 

501(c)(3) bonds to permit the issuance of long-term bonds for the 

acquisition of land and timber associated with such land subject to 

a conservation restriction. Under the provision, the bonds will not 

fail to be qualified 501(c)(3) bonds if the timber is sold or leased 

to, or otherwise used by, an unrelated person to the extent that 

such sale, leasing, or other use does not constitute an unrelated 

trade or business, and so long as the other requirements of the provision are met. In addition, these bonds will not be qualified 

501(c)(3) bonds unless the seller of the land and timber property 

that is to be acquired with the bond proceeds irrevocably elects not 

to exclude from income any portion of the gain on the sale of such 

property made for qualifying conservation purposes under section 

121A of the Code as added by section 107 of the bill. 

Under the provision, section 501(c)(3) organizations may enter 

into certain otherwise prohibited timber management arrangements with private businesses without losing tax-exemption on 

bonds used to finance the property and timber provided that those 

arrangements do not constitute an unrelated trade or business with 

respect to the organization. Similarly, the bonds may be issued on 

a tax-exempt basis notwithstanding plans by the section 501(c)(3) 

organization to harvest and sell standing timber on land being acquired. 

The provision imposes a national limitation of $2 billion on the 

aggregate amount of bonds that may be issued pursuant to this 

provision. This volume limitation, for the period October 1, 2002, 

to December 31, 2005, will be allocated by the Department of 

Treasury to qualified section 501(c)(3) organizations based on criteria established by the Department of Treasury (after consultation 

with appropriate Federal, State, and local officials). The Committee 

anticipates that the criteria will be based on, among other factors, 

the environmental merit and economic viability of a particular 

project, rather than an attempt to achieve geographical balance in 

making the allocations. The Committee further expects that no 

later than 90 days after the date of enactment, the Department of 

Treasury will issue guidance that specifies (1) how section 501(c)(3) 

organizations are to apply for an allocation and (2) the procedure 

57

through which such allocations are to be made to the appropriate 

organizations. 

EFFECTIVE DATE

The provision is effective for bonds issued after September 30, 

2002 and before January 1, 2006.

K. PROVIDE TAX EXEMPTION FOR ORGANIZATIONS CREATED BY A

STATE TO PROVIDE PROPERTY AND CASUALTY INSURANCE COV- ERAGE FOR PROPERTY FOR WHICH SUCH COVERAGE IS OTHERWISE

UNAVAILABLE

(Sec. 311 of the bill and sec. 501(c)(28) of the Code) 

PRESENT LAW

In general 

A life insurance company is subject to tax on its life insurance 

company taxable income, which is its life insurance income reduced 

by life insurance deductions (sec. 801). Similarly, a property and 

casualty insurance company is subject to tax on its taxable income, 

which is determined as the sum of its underwriting income and investment income (as well as gains and other income items) (sec. 

831). Present law provides that the term ‘‘corporation’’ includes an 

insurance company (sec. 7701(a)(3)). 

In general, the Internal Revenue Service (‘‘IRS’’) takes the position that organizations that provide insurance for their members or 

other individuals are not considered to be engaged in a tax-exempt 

activity. The IRS maintains that such insurance activity is either 

(1) a regular business of a kind ordinarily carried on for profit, or 

(2) an economy or convenience in the conduct of members’ businesses because it relieves the members from obtaining insurance 

on an individual basis. 

Certain insurance risk pools have qualified for tax exemption 

under Code section 501(c)(6). In general, these organizations (1) assign any insurance policies and administrative functions to their 

member organizations (although they may reimburse their members for amounts paid and expenses); (2) serve an important common business interest of their members; and (3) must be membership organizations financed, at least in part, by membership dues. 

State insurance risk pools may also qualify for tax-exempt status 

under section 501(c)(4) as a social welfare organization or under 

section 115 as serving an essential governmental function of a 

State. In seeking qualification under section 501(c)(4), insurance 

organizations generally are constrained by the restrictions on the 

provision of ‘‘commercial-type insurance’’ contained in section 

501(m). Section 115 generally provides that gross income does not 

include income derived from the exercise of any essential governmental function and accruing to a State or any political subdivision 

thereof. 

Certain specific provisions provide tax-exempt status to organizations meeting statutory requirements. 

Health coverage for high-risk individuals 

Section 501(c)(26) provides tax-exempt status to any membership 

organization that is established by a State exclusively to provide 

reasons for change 58

coverage for medical care on a nonprofit basis to certain high-risk 

individuals, provided certain criteria are satisfied. The organization 

may provide coverage for medical care either by issuing insurance 

itself or by entering into an arrangement with a health maintenance organization (‘‘HMO’’). 

High-risk individuals eligible to receive medical care coverage 

from the organization must be residents of the State who, due to 

a pre-existing medical condition, are unable to obtain health coverage for such condition through insurance or an HMO, or are able 

to acquire such coverage only at a rate that is substantially higher 

than the rate charged for such coverage by the organization. The 

State must determine the composition of membership in the organization. For example, a State could mandate that all organizations 

that are subject to insurance regulation by the State must be members of the organization. 

The provision further requires the State or members of the organization to fund the liabilities of the organization to the extent that 

premiums charged to eligible individuals are insufficient to cover 

such liabilities. Finally, no part of the net earnings of the organization can inure to the benefit of any private shareholder or individual. 

Workers’ compensation reinsurance organizations 

Section 501(c)(27)(A) provides tax-exempt status to any membership organization that is established by a State before June 1, 

1996, exclusively to reimburse its members for workers’ compensation insurance losses, and that satisfies certain other conditions. A 

State must require that the membership of the organization consist 

of all persons who issue insurance covering workers’ compensation 

losses in such State, and all persons and governmental entities who 

self-insure against such losses. In addition, the organization must 

operate as a nonprofit organization by returning surplus income to 

members or to workers’ compensation policyholders on a periodic 

basis and by reducing initial premiums in anticipation of investment income. 

State workmen’s compensation act companies 

Section 501(c)(27)(B) provides tax-exempt status for any organization that is created by State law, and organized and operated exclusively to provide workmen’s compensation insurance and related 

coverage that is incidental to workmen’s compensation insurance, 

and that meets certain additional requirements. The workmen’s 

compensation insurance must be required by State law, or be insurance with respect to which State law provides significant disincentives if it is not purchased by an employer (such as loss of exclusive remedy or forfeiture of affirmative defenses such as contributory negligence). The organization must provide workmen’s 

compensation to any employer in the State (for employees in the 

State or temporarily assigned out-of-State) seeking such insurance 

and meeting other reasonable requirements. The State must either 

extend its full faith and credit to the initial debt of the organization 

or provide the initial operating capital of such organization. For 

this purpose, the initial operating capital can be provided by providing the proceeds of bonds issued by a State authority; the bonds 

may be repaid through exercise of the State’s taxing authority, for 

59

example. For periods after the date of enactment, either the assets 

of the organization must revert to the State upon dissolution, or 

State law must not permit the dissolution of the organization absent an act of the State legislature. Should dissolution of the organization become permissible under applicable State law, then the 

requirement that the assets of the organization revert to the State 

upon dissolution applies. Finally, the majority of the board of directors (or comparable oversight body) of the organization must be appointed by an official of the executive branch of the State or by the 

State legislature, or by both.

REASONS FOR CHANGE

The Committee understands that certain types of insurance to 

support governmental programs to prepare for or mitigate the effects of natural catastrophic events (such as hurricanes) may be 

limited or unavailable at reasonable rates in the authorized insurance market in some States. The Committee believes it is appropriate to provide tax-exempt status to certain types of associations 

that provide property and casualty insurance for windstorm, hail 

and fire damage to property located within a State if the State has 

determined that coverage in the authorized insurance market is in 

fact not reasonably available to a substantial number of insurable 

real properties. 

EXPLANATION OF PROVISION

The provision provides tax-exempt status for any association created before January 1, 1999, by State law and organized and operated exclusively to provide property and casualty insurance coverage for windstorm, hail and fire damage to property located within the State for which the State has determined that coverage in 

the authorized insurance market is not reasonably available to a 

substantial number of insurable real properties, provided certain 

requirements are met. 

Under the provision, no part of the net earnings of the association may inure to the benefit of any private shareholder or individual. Except as provided in the case of dissolution, no part of the 

assets of the association may be used for, or diverted to, any purpose other than: (1) to satisfy, in whole or in part, the liability of 

the association for, or with respect to, claims made on policies written by the association; (2) to invest in investments authorized by 

applicable law; (3) to pay reasonable and necessary administration 

expenses in connection with the establishment and operation of the 

association and the processing of claims against the association; or 

(4) to make remittances pursuant to State law to be used by the 

State to provide for the payment of claims on policies written by 

the association, purchase reinsurance covering losses under such 

policies, or to support governmental programs to prepare for or 

mitigate the effects of natural catastrophic events. The provision 

requires that the State law governing the association permit the 

association to levy assessments on insurance companies authorized 

to sell property and casualty insurance in the State, or on property 

and casualty insurance policyholders with insurable interests in 

property located in the State to fund deficits of the association, including the creation of reserves. The provision requires that the 

plan of operation of the association be subject to approval by the 

reasons for change 60

chief executive officer or other official of the State, by the State legislature, or both. In addition, the provision requires that the assets 

of the association revert upon dissolution to the State, the State’s 

designee, or an entity designated by the State law governing the 

association, or that State law not permit the dissolution of the association. 

The provision provides a special rule in the case of any entity or 

fund created before January 1, 1999, pursuant to State law and organized and operated exclusively to receive, hold, and invest remittances from an association exempt from tax under the provision, to 

make disbursements to pay claims on insurance contracts issued by 

the association, and to make disbursements to support governmental programs to prepare for or mitigate the effects of natural 

catastrophic events. The special rule provides that the entity or 

fund may elect to be disregarded as a separate entity and be treated as part of the association exempt from tax under the provision, 

from which it receives such remittances. The election is required to 

be made no later than 30 days following the date on which the association is determined to be exempt from tax under the provision, 

and would be effective as of the effective date of that determination. 

An organization described in the provision is treated as having 

unrelated business taxable income (‘‘UBIT’’) in the amount of its 

taxable income (computed as if the organization were not exempt 

from tax under the provision), if at the end of the immediately preceding taxable year, the organization’s net equity exceeds 15 percent of the total coverage in force under insurance contracts issued 

by the organization and outstanding at the end of that preceding 

year. 

Under the provision, no income or gain is recognized solely as a 

result of the change in status to that of an association exempt from 

tax under the provision. 

EFFECTIVE DATE

The provision is effective for taxable years beginning after December 31, 2002. No inference is intended as to the tax status 

under present law of associations described in the provision.

L. CONFORM PROVISIONS RELATING TO ARBITRAGE TREATMENT OF

CERTAIN UNIVERSITY FUND TO STATE CONSTITUTIONAL AMEND- MENTS

(Sec. 312 of the bill) 

PRESENT LAW

In general, present law tax-exempt arbitrage restrictions provide 

that interest on a State or local government bond is not eligible for 

tax-exemption if the proceeds are invested, directly or indirectly, in 

materially higher yielding investments or if the debt service on the 

bond is secured by or paid from (directly or indirectly) such investments. An exception, enacted in 1984, provides that the pledge of 

income from investments in a permanent university fund (‘‘the 

Fund’’) established under a provision of a State constitution adopted in 1876 as security for a limited amount of tax-exempt bonds 

will not cause interest on those bonds to be taxable. The terms of 

61

101Sec. 7526. 

this exception are limited to State constitutional or statutory restrictions in effect as of October 9, 1969. 

The Fund consists of certain State lands that were set aside for 

the benefit of higher education, the income from mineral rights to 

these lands, and certain other earnings on Fund assets. The State 

constitution directs that monies held in the Fund are to be invested 

in interest-bearing obligations and other securities. The constitution does not permit the expenditure or mortgage of the Fund for 

any purpose. Income from the Fund is apportioned between two 

university systems operated by the State. Tax-exempt bonds issued 

by the two university systems are secured by and payable from the 

income of the Fund. These bonds are used to finance buildings and 

other permanent improvements for the universities. 

The State constitutional rules governing the Fund have been 

modified with regard to the manner in which amounts in the Fund 

are paid for the benefit of the two university systems. 

REASONS FOR CHANGE

The Committee understands that the State constitutional amendments have the effect of permitting the Fund to make annual distributions in a manner similar to standard university endowment 

funds, rather than the previous practice which tied distributions to 

annual income performance, which can create a variable pattern of 

distributions. The Committee does not believe that the Fund should 

lose the benefits of the 1984 exception from the tax-exempt bond 

arbitrage restrictions by adopting a sounder, more modern approach to the management of Fund distributions. 

EXPLANATION OF PROVISION

The 1984 exception is conformed to the present State constitutional provisions governing the Fund’s ability to make annual distributions in a manner similar to standard university endowment 

funds. Limitations on the aggregate amount of bonds that may benefit from the exception are not modified. 

EFFECTIVE DATE

The provision is effective on the date of enactment. 

M. MATCHING GRANTS TO LOW-INCOME TAXPAYER CLINICS FOR

RETURN PREPARATION

(S(sec. 313 of the bill) 

PRESENT LAW

The Secretary is authorized to provide up to $6 million per year 

in matching grants to certain low-income taxpayer clinics that represent low-income taxpayers in controversies with the IRS or that 

operate programs to inform individuals for whom English is a second language about their tax-related rights and responsibilities.101

reasons for change 62

102Treas. Reg. sec. 1.117–3(a). 103Treas. Reg. sec. 1.117–4(c). 104Secs. 4945(a) and (b). 105Secs. 4945(d)(3) and (g). 106For the purpose of section 4945(g), the term ‘‘scholarship or fellowship’’ refers to the provisions of section 117(a) as in effect before the Tax Reform Act of 1986. Sec. 4945(g)(1). 107Secs. 4945(g)(1) and 170(b)(1)(A)(ii). 

REASONS FOR CHANGE

The Committee believes that the low-income taxpayer clinic program should be expanded to provide grants to assist low-income 

taxpayers in the preparation of their Federal tax returns. 

EXPLANATION OF PROVISION

The provision authorizes the Secretary to create a separate grant 

program to provide up to $10 million per year in matching grants 

to not for profit organizations that assist low-income taxpayers in 

the preparation of their Federal tax returns. 

EFFECTIVE DATE

The provision is effective on the date of enactment.

N. INCREASE PERCENTAGE LIMITS FOR CERTAIN EMPLOYER-RELATED

SCHOLARSHIP PROGRAMS

(Sec. 314 of the bill) 

PRESENT LAW

Gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree 

at an educational organization (sec. 117(a)). For this purpose, a 

scholarship generally means an amount paid or allowed to, or for 

the benefit of, a student to aid that student in pursuing studies.102

However, an amount paid or allowed to, or on behalf of, an individual to enable the individual to pursue studies is not treated as 

a scholarship if the amount represents compensation for past, 

present, or future services.103 The determination of whether an 

amount is properly treated as a scholarship or compensation for 

services is made in light of all the relevant facts and circumstances. 

Present law imposes excise taxes on the taxable expenditures of 

a private foundation.104 A taxable expenditure includes, among 

other things, any amount paid or incurred by a private foundation 

as a grant to an individual for travel, study, or other similar purposes by such individual, unless such grant is awarded on an objective and nondiscriminatory basis pursuant to a procedure approved 

in advance by the Secretary.105 In the case of individual grants to 

be made as scholarships or fellowships, the private foundation 

must demonstrate to the satisfaction of the Secretary that the 

grant: (1) constitutes a scholarship or fellowship which would be 

subject to the provisions of section 117(a),106 and (2) is to be used 

for study at an educational organization which normally maintains 

a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where 

its educational activities are regularly carried on.107

63

108 Rev. Proc. 76–47, 1976–2 C.B. 670. The revenue procedure defines an employer-related program as a program that treats some or all of the employees, or children of some or all of the 

employees, of an employer as a group from which grantees of some or all of the grants will be 

selected, limits the potential grantees from some or all of the grants to individuals who are employees or children of employees of an employer, or otherwise gives such individuals a preference 

or priority over others in being selected as grantees. 109The seven conditions include: (1) the program must not be used to recruit employees, to 

induce employees to continue their employment, or to compel a course of action sought by the 

employer; (2) the selection of grant recipients must be made by a committee consisting of independent individuals; (3) the program must impose identifiable minimum requirements for grant 

eligibility; (4) the selection of grant recipients must be based solely upon substantial objective 

standards that are completely unrelated to employment and to the employer’s line of business; 

(5) a grant may not be terminated because the recipient or the recipient’s parent terminates 

employment with the employer; (6) the courses of study for which grants are available must not 

be limited to those would be of particular benefit to the employer or the foundation; and (7) 

the terms of the grant and the courses of study for which grants are available must meet all 

other requirements of section 117 and must be consistent with the disinterested purpose of education for personal benefit rather than for the benefit of the employer or the foundation. 

Private foundations may in the course of their activities make 

scholarship or fellowship grants to individuals to be used for educational purposes. However, a private foundation’s grant program 

may not be designed or administered to the end of providing compensation, an employment incentive, or an employee fringe benefit 

to persons employed by the foundation or by another employer (including, for example, employees of a ‘‘related’’ employer organization). Revenue Procedure 76–47 provides advance approval guidelines to determine whether grants made by private foundations 

under employer-related grant programs to an employee or to a 

child of an employee of the employer to which the program relates 

is considered a scholarship or fellowship grant subject to the provisions of section 117(a).108 To the extent that such grants are considered scholarships or fellowships under these guidelines, the Secretary will assume the grants are not taxable expenditures subject 

to section 4945 taxes. Educational grants that are not scholarships 

or fellowships under these guidelines might, depending upon the 

circumstances, lead to a loss of the private foundation’s exempt status. 

Under Revenue Procedure 76–47, a grant made under an employer-related grant program that satisfies seven conditions and a 

percentage test is considered a scholarship or fellowship.109 Grants 

awarded to children of employees and to employees are considered 

as having been awarded under separate programs for purposes of 

the revenue procedure, regardless of whether they are awarded 

under separately administered programs. All such grants must satisfy each of the seven conditions to obtain advance approval of the 

grant program. The percentage test applicable to grants to children 

of employees requires that the number of grants awarded not exceed either 25 percent of the eligible applicants considered by the 

selection committee in selecting grant recipients or 10 percent of 

those eligible for grants (regardless of whether they submitted 

grant applications). The percentage test applicable to grants to employees requires that the number of grants awarded not exceed 10 

percent of eligible applicants considered by the selection committee 

in selecting grant recipients. If the seven conditions are met, but 

the relevant percentage test is not satisfied, then the question of 

whether the grants constitute scholarships or fellowships is based 

upon all of the facts and circumstances. 

Similar requirements and percentage limits apply to determine 

whether educational loans made by a private foundation under an 

reasons for change 64

110 Rev. Proc. 80–39, 1980–2 C.B. 772. 111 Id.

employer-related loan program are taxable expenditures.110 If an 

employer-related program encompasses educational loans and 

scholarship or fellowship grants to the same group of eligible employees or employees’ children, the percentage tests applicable to 

the loan program apply to the total number of individuals receiving 

combined grants of scholarships, fellowships, and educational 

loans.111

REASONS FOR CHANGE

The Committee believes that the quantitative limits set forth in 

Revenue Procedure 76–47 are too low for employer-related grant 

programs that provide scholarships or fellowships to children of 

employees. The Committee believes that higher percentage limits 

will encourage increases in grants made for educational purposes. 

The Committee also believes that the higher percentage limits 

should be available only in cases where the foundation maintains 

a comparable grant program for children who are not affiliated 

with the employer to which the employer-related grant program relates. 

EXPLANATION OF PROVISION

The percentage limits set forth in Revenue Procedure 76–47 for 

grants to children of employees are increased to 35 percent of eligible applicants considered by the selection committee or 20 percent 

of those eligible for the grants. However, the higher percentage limits are available only if the private foundation meets the other requirements of the Revenue Procedure and demonstrates that the 

foundation provides a comparable number and aggregate amount of 

grants during the same grant-program year to children who are not 

children of former or current employees of any employer to which 

an employer-related grant program relates. The provision does not 

amend the percentage limits for grants to employees, or the percentage limits of Revenue Procedure 80–39 relating to loan programs or programs which encompass both loans and grants. 

EFFECTIVE DATE

Revenue Procedure 76–47 is to be amended effective for grants 

awarded after December 31, 2002. 

Title IV. Social Services Block Grant 

(Secs. 401–403 of the bill) 

PRESENT LAW

Social Services Block Grant Funding (‘‘SSBG’’), also known as ‘‘Title XX’’ (because it is Title XX of the Social Security Act), is a 

flexible funding stream, providing states with resources to support 

a variety of social services. SSBG funds can be used to assist the 

elderly and disabled so that they do not need to enter institutions, 

to prevent child and elder abuse, to provide child care, to promote 

and support adoption, and for several other services. There are certain specified limitations so that SSBG cannot fund most medical 

65

care, for example, or cash welfare payments. It is a mandatory 

capped entitlement, distributed by a population-based formula 

among the states. 

States use SSBG in differing ways. Much of the funding supports 

local social service providers, including faith-related organizations, 

through contracts with state and local governments. Overall, in fiscal year 1999, SSBG spending was as follows: 13.4 percent for ‘‘prevention’’ and case management; 13 percent for day care; 12.4 percent for child and adult protective services; 10.9 percent for foster 

care; 7.4 percent for home-based services. There are several other 

categories in the expenditure data as well. Prior to the 1996 welfare reform law, SSBG was funded at $2.8 

billion. That legislation reduced SSBG to $2.38 billion, as part of 

achieving budgetary savings, and permitted states to transfer up to 

10 percent of their new Temporary Assistance for Needy Families 

(TANF) welfare block grant allocations to SSBG. (Any transferred 

funds are required to be spent on behalf of families below 200 percent of poverty.) In 1998, as part of the TEA–21 highway legisla- tion, SSBG funding as further reduced, declining to $1.7 billion for 

fiscal year 2001 and fiscal year 2002. The TANF transfer was further limited to 4.25 percent. 

REASONS FOR CHANGE

The Committee believes that an increase in funding for SSBG 

will allow social service organizations to provide more assistance to 

families in need and disadvantaged individuals. The flexible nature 

of SSBG permits states and localities to choose their own priorities 

for the uses of the increased funding. 

EXPLANATION OF PROVISION

The provision increases SSBG funding to $1.975 billion for fiscal 

year 2003 and $2.8 billion for fiscal year 2004. In addition, the 

TANF transfer limit is restored to 10 percent. These two measures 

provide additional resources to faith-related social service organizations. Finally, the Secretary of HHS is required to submit annual 

reports on SSBG expenditures to the Congress. 

EFFECTIVE DATE

The provision is effective for amounts made available for fiscal 

year 2003 and for amounts made available each fiscal year thereafter. The provision requiring annual reports applies to such reports with respect to fiscal year 2002 and each fiscal year thereafter.

Title V. Individual Development Accounts 

(Secs. 501–511 of the bill) 

PRESENT LAW

Individual development accounts were first authorized by the 

Personal Work and Responsibility Act of 1996. In 1998, the Assets 

for Independence Act established a five-year $125 million demonstration program to permit certain eligible individuals to open 

and make contributions to an individual development account. Contributions by an individual to an individual development account 

reasons for change 66

112 Rev. Rul. 99–44, 1999–2 C.B. 549. 

do not receive a tax preference but are matched by contributions 

from a State program, a participating nonprofit organization, or 

other ‘‘qualified entity.’’ The IRS has ruled that matching contributions by a qualified entity are a gift and not taxable to the account 

owner.112 The qualified entity chooses a matching rate, which must 

be between 50 and 400 percent. Withdrawals from individual development accounts can be made for certain higher education expenses, a first home purchase, or small-business capitalization expenses. Matching contributions (and earnings thereon) typically are 

held separately from the individuals’ contributions (and earnings 

thereon) and must be paid directly to a mortgage provider, university, or business capitalization account at a financial institution. 

The Department of Health and Human Services administers the individual development account program. 

REASONS FOR CHANGE

The Committee recognizes that the rate of private savings in the 

United States is too low. In particular, many low-income individuals either have inadequate savings or no savings at all. The Committee believes that a tax-subsidized match by financial institutions may help encourage more savings by low-income working individuals. The program is intended to encourage a pattern of individual savings and wealth accumulation. Finally, the Committee 

believes that the program will allow individuals to use their savings for three important purposes: (1) to afford better educations; 

(2) to achieve home ownership; and (3) to start their own businesses. 

EXPLANATION OF PROVISION

The bill provides for a nonrefundable tax credit for an eligible entity (i.e., a qualified financial institution) that has an individual development account program in a taxable year. The tax credit equals 

the amount of matching contributions made by the eligible entity 

under the program (up to $500 per taxable year) plus $50 for each 

individual development account maintained during the taxable 

year under the program. Except in the first year that each account 

is open, the $50 credit is available only for accounts with a balance 

of more than $100 at year-end (including matching funds). No deduction or other credit is available with respect to the amount of 

matching funds taken into account in determining the credit. 

The credit applies with respect to the first 300,000 individual development accounts opened before January 1, 2011, and with respect to matching funds for participant contributions that are made 

after December 31, 2003, and before January 1, 2011. An account 

is considered open if at any time the balance in the account exceeds 

$100 (including matching amounts). The individual development 

accounts will be available on the following basis: (1) a maximum 

of 100,000 accounts may be opened after December 31, 2003 and 

before January 1, 2007; (2) a second 100,000 accounts may be 

opened after December 31, 2006 and before January 1, 2009, if the 

entire 100,000 of authorized accounts are opened after December 

31, 2003 and before January 1, 2007 and the Secretary of the 

Treasury determines that these accounts are being reasonably and 

67

113 If less than 100,000 accounts are opened before January 1, 2007, then the number of accounts that can be opened after December 31, 2006 and before January 1, 2009 will be reduced 

to the lesser of 75,000 accounts of three times the number of accounts opened before January 

1, 2007. 114Married taxpayers filing separate returns are not eligible to open an IDA or to receive 

matching funds for an IDA that is already open. 

responsibly administered;113 and (3) a third 100,000 accounts may 

be opened after December 31, 2008 and before January 1, 2011 if 

the previous cohorts of 100,000 accounts have been opened under 

the schedule described above and the Secretary of the Treasury 

makes a four-part determination. Specifically, the Secretary will 

have to determine: (1) that all previously opened accounts have 

been reasonably and responsibly administered to date; (2) that the 

individual development account program has increased net savings 

of participants in the program; (3) whether participants in the individual development account program have increased Federal income tax liability and decreased utilization of Federal assistance 

programs (e.g., Temporary Assistance to Needy Families and Food 

Stamps) relative to similarly situated individuals that did not participate in the individual development account program; and (4) 

that the sum of the increased Federal tax liability and reduction 

of Federal assistance program benefits to participants in the individual development account program is greater than the cost of the 

individual development account program to the Federal government. If the Secretary finds that any of the four determinations 

has not been satisfied, the Congress will have the discretion to authorize the third 100,000 accounts after the Secretary makes his or 

her report to the Congress regarding the four determinations. The 

third 100,000 accounts must be equally divided among the States. 

For all accounts, the Secretary will take steps to encourage use of 

individual development accounts in rural areas. 

Nonstudent U.S. citizens or lawful permanent residents between 

the ages of 18 and 60 (inclusive) who meet certain income requirements are eligible to open and contribute to an individual development account. The income limit for participation is modified adjusted gross income of $18,000 for single filers, $38,000 for joint filers, and $30,000 for head-of-household filers.114 Eligibility in a taxable year generally is based on the previous year’s modified adjusted gross income and circumstances (e.g., status as a student). 

Modified adjusted gross income is adjusted gross income plus certain items that are not includible in gross income. The items added 

are tax-exempt interest and the amounts otherwise excluded from 

gross income under Code sections 86, 893, 911, 931, and 933 (relating to the exclusion of certain social security and Tier 1 railroad 

retirement benefits; the exclusion of compensation of employees of 

foreign governments and international organizations; the exclusion 

of income of U.S. citizens or residents living abroad; the exclusion 

of income for residents of Guam, American Samoa, and the Northern Mariana Islands; and the exclusion of income for residents of 

Puerto Rico). The income limits are adjusted for inflation after 

2003. These amounts are rounded to the nearest multiple of 50 dollars. 

Under the bill, an individual development account must: (1) be 

owned by the eligible individual for whom the account was established; (2) consist only of cash contributions; (3) be held by a person 

authorized to be a trustee of any individual retirement account 

reasons for change 68

under section 408(a)(2); and (4) not commingle account assets with 

other property (except in a common trust fund or common investment fund). These requirements must be reflected in the written 

governing instrument creating the account. The entity establishing 

the program is required to maintain separate accounts for the individual’s contributions (and earnings thereon) and for matching 

funds and earnings thereon (a ‘‘parallel account’’). 

Contributions to individual development accounts by individuals 

are not deductible and earnings thereon are taxable to the account 

holder. Matching contributions and earnings thereon are not taxable to the account holder. 

The bill permits individuals to withdraw amounts from an individual development account for qualified expenses of the account 

owner, owner’s spouse, or dependents as well as for nonqualified 

expenses, subject to certain restrictions. Qualified expenses include 

qualified: (1) higher education expenses (as generally defined in 

section 529(e)(3)); (2) first-time homebuyer costs (as generally provided in section 72 (t)(8)); (3) business capitalization or expansion 

costs (expenditures made pursuant to a business plan that has 

been approved by the financial institution); (4) rollovers of the balance of the account (including the parallel account) to another individual development account for the benefit of the same owner; and 

(5) final distributions in the case of a deceased account owner. 

Withdrawals for qualified expenses must be made from funds that 

have been in the account for at least one year and must be paid 

directly to the unrelated third party to whom the amount is due, 

except in the case of expenses under a qualified business plan, rollover, or final distribution. Such withdrawals generally are not permitted until the account owner completes a financial education 

course offered by a qualified financial institution. The Secretary of 

the Treasury (the ‘‘Secretary’’) is required to establish minimum 

standards for such courses. Withdrawals for nonqualified expenses 

may result in the account owner’s forfeiture of matching funds. The 

amount of the forfeiture is the lesser of: (1) an amount equal to the 

nonqualified withdrawal; or (2) the excess of the amount in the 

parallel account (excluding earnings on matching funds) over the 

amount remaining in the individual development account after the 

nonqualified withdrawal. If the individual development account (or 

a portion thereof) is pledged as security for a loan, then the portion 

so used will be treated as a nonqualified withdrawal and will result 

in the loss of an equal amount of matching funds from the parallel 

account. 

The qualified entity administering the individual development 

account program generally is required to make quarterly payments 

of matching funds to a parallel account on a dollar-for-dollar basis 

for the first $500 contributed by the account owner in a taxable 

year. Matching funds also may be provided by State, local, or private sources. Balances of the individual development account and 

parallel account must be reported annually to the account owner. 

If an account owner ceases to meet eligibility requirements, matching funds generally may not be contributed during the period of ineligibility. Any amount withdrawn from a parallel account is not 

includible in an eligible individual’s gross income or the account 

sponsor’s gross income. 

69

115Temp. Treas. Reg. sec. 1.6011–4T; Prop. Treas. Reg. sec. 1.6011–4. Effective June 14, 2002, 

the regulations were modified to require non-corporate taxpayers (i.e., individuals, trusts, partnerships, and S corporations) to disclose their participation in reportable transactions that have 

been specified by the Treasury Department as ‘‘listed’’ transactions. See T.D. 9000, 67 Fed. Reg. 

41,324 (June 18, 2002). Disclosure of other reportable transactions under the regulations continues to be limited to corporate taxpayers. 116The recently-modified regulations clarify that the term ‘‘substantially similar’’ includes any 

transaction that is expected to obtain the same or similar types of tax benefits and that is either 

factually similar or based on the same or similar tax strategy. Also, the term must be broadly 

construed in favor of disclosure. See T.D. 9000, 67 Fed. Reg. 41,324 (June 18, 2002). 

Qualified entities administering a qualified program are required 

to report to the Secretary that the program is administered in accordance with legal requirements. If the Secretary determines that 

the program was not so operated, the Secretary would have the 

power to terminate the program. Qualified entities also are required to report annually to the Secretary information about: (1) 

the number of individuals making contributions to individual development accounts; (2) the amounts contributed by such individuals; 

(3) the amount of matching funds contributed; (4) the amount of 

funds withdrawn and for what purpose; (5) balance information; 

and (6) any other information that the Secretary deems necessary. 

The fiduciary requirements of Title 12 of the United States Code 

with respect to insured depository institutions and insured credit 

unions (as defined therein) continue to apply to those financial institutions participating in the individual development account program. 

The Secretary is authorized to prescribe necessary regulations, 

including rules to permit individual development account program 

sponsors to verify eligibility of individuals seeking to open accounts 

and rules to allow a financial institution (e.g., a tax-exempt credit 

union) to transfer those credits to another taxpayer. The Secretary 

also is authorized to provide rules to recapture credits claimed with 

respect to individuals who forfeit matching funds. 

The Secretary must submit annual reports to Congress on the 

status of the qualified individual account program. 

EFFECTIVE DATE

The provision is effective for taxable years ending after December 

31, 2003, and beginning before January 1, 2011.

Title VI. Revenue Provisions 

A. TAX SHELTER TRANSPARENCY REQUIREMENTS

1. Penalty for failure to disclose reportable transactions (sec. 601 

of the bill and new sec. 6707A of the Code) 

PRESENT LAW

Regulations under section 6011 require a taxpayer to disclose 

with its tax return certain information with respect to each ‘‘reportable transaction’’ in which the taxpayer participates.115

There are two categories of reportable transactions. The first category includes any transaction that is the same as (or substantially 

similar to) 116 a transaction that is specified by the Treasury Department as a tax avoidance transaction whose tax benefits are 

subject to disallowance under present law (referred to as a ‘‘listed 

transaction’’). A taxpayer must disclose any listed transaction that 

reasons for change 70

117Temp. Treas. Reg. sec. 1.6011–4T(b)(2) and (b)(4)(i). 118Temp. Treas. Reg. sec. 1.6011–4T(b)(3)(i)(A)–(E). In certain circumstances, a taxpayer can 

avoid disclosure with respect to the second category of reportable transactions. See Temp. Treas. 

Reg. sec. 1.6011–4T(b)(3)(ii)(A)–(E). 119Section 6664(c) provides that a taxpayer can avoid the imposition of a section 6662 accuracy-related penalty in cases where the taxpayer can demonstrate that there was reasonable 

cause for the underpayment and that the taxpayer acted in good faith. 120 In this regard, the Committee has concerns with the outcomes and rationales used by 

courts in some recent decisions involving tax-motivated transactions. For a more detailed discussion of recent court decisions and other developments regarding tax shelters, see Joint Committee on Taxation Background and Present Law Relating to Tax Shelters (JCX 19–02) March 

19, 2002. 

is expected to reduce the taxpayer’s Federal income tax liability by 

more than $1 million in any single taxable year or more than $2 

million in any combination of years.117

The second category of reportable transactions includes transactions that are expected to reduce a taxpayer’s Federal income tax 

liability by more than $5 million in any single year or $10 million 

in any combination of years and that have at least two of the following characteristics: (1) the taxpayer has participated in the 

transaction under conditions of confidentiality; (2) the taxpayer has 

obtained or been provided with contractual protection against the 

possibility that part or all of the intended tax benefits from the 

transaction will not be sustained; (3) the promoters of the transaction have received or are expected to receive fees or other consideration with an aggregate value in excess of $100,000, and such 

fees are contingent on the taxpayer’s participation; (4) the transaction results in a reported book/tax difference in excess of $5 million in any taxable year; or (5) the transaction involves a person 

that the taxpayer knows or has reason to know is in a Federal income tax position that differs from that of the taxpayer (such as 

a tax-exempt entity or foreign person), and the taxpayer knows or 

has reason to know that such difference has permitted the transaction to be structured to provide the taxpayer with a more favorable Federal income tax treatment.118

Under present law, there is no specific penalty for failing to disclose a reportable transaction; however, such a failure may jeopardize the taxpayer’s ability to claim that any income tax understatement attributable to such undisclosed transaction is due to 

reasonable cause, and that the taxpayer acted in good faith.119

The Committee is aware that individuals and corporations are 

increasingly using sophisticated transactions to avoid or evade Federal income tax.120 Such a phenomenon could pose a serious threat 

to the efficacy of the tax system because of both the potential loss 

of revenue and the potential threat to the integrity of the self-assessment system. 

The Committee over two years ago began working on legislation 

to address this significant compliance problem. In addition, the 

Treasury Department, using the tools available, issued regulations 

requiring disclosure of certain transactions and requiring organizers and promoters of tax-engineered transactions to maintain 

customer lists and make these lists available to the IRS. Nevertheless, the Committee believed that additional legislation was needed 

to provide the Treasury Department with additional tools to assist 

its efforts to curtail abusive transactions. In that regard, the Committee issued for public comment three separate staff discussion 

drafts designed to address the tax shelter problem. The most recent 

71

121See generally, ‘‘The Treasury Department’s Enforcement Proposals for Abusive Tax Avoidance Transactions,’’ released on March 20, 2002, reprinted electronically at 2002 TNT 55–28 

(March 21, 2002). 

draft (released in August 2001) focused on a regime that emphasized disclosure of tax shelter transactions. 

On March 21, 2002, the Committee heard testimony from Treasury Department and IRS officials that only 272 transactions by 99 

different taxpayers were disclosed under the present law for the 

2001 tax-filing season. In connection with the hearing, the Treasury Department announced a new initiative (the ‘‘Treasury shelter 

initiative’’) that is designed to provide the Treasury Department 

and the Internal Revenue Service (‘‘IRS’’) with the tools necessary 

to respond to abusive tax avoidance transactions.121 The Treasury 

shelter initiative emphasizes combating abusive transactions by requiring increased disclosure of such transactions by all parties involved. To facilitate such disclosure, the Treasury shelter initiative 

proposes clearer definitions to identify transactions that must be 

disclosed, and stiffer penalties for failure to disclose such transactions. The Treasury shelter initiative provides for

[A] series of clear, mutually reinforcing rules for disclosure, registration, and list maintenance. These rules will 

be easier for taxpayers and their advisors to apply, and 

harder for those who seek to avoid disclosure to manipulate. * * * The Treasury Department’s proposals, for example, will broaden and align the rules and regulations for 

disclosure, registration, and list keeping under Sections 

6011, 6111, and 6112 of the Code. * * * The Treasury Department’s enforcement initiative will create a single, clear 

definition of a transaction that must be disclosed and registered, and for which lists must be maintained.

The Committee believes that the course of action outlined in the 

Treasury shelter initiative will bolster ongoing efforts to combat 

abusive tax avoidance transactions, and that encouraging greater 

disclosure of transactions with a potential for tax avoidance is beneficial to the tax system. Moreover, the Committee believes that a 

penalty for failing to make the required disclosures, when the imposition of such penalty is not dependent on the tax treatment of 

the underlying transaction ultimately being sustained, will provide 

an additional incentive for taxpayers to satisfy their reporting obligations under the new disclosure provisions. 

EXPLANATION OF PROVISION

In general 

The provision creates a new penalty for any person who fails to 

include with any return or statement any required information 

with respect to a reportable transaction. The new penalty applies 

without regard to whether the transaction ultimately results in an 

understatement of tax, and applies in addition to any accuracy-related penalty that may be imposed. 

reasons for change 72

122The provision states that, except as provided in regulations, a listed transaction means a 

reportable transaction, which is the same as, or similar to, a transaction specifically identified 

by the Secretary as a tax avoidance transaction for purposes of section 6011. The Committee 

anticipates that regulations under section 6011 will provide that a transaction is similar to a 

listed transaction if such transaction is expected to obtain the same or similar types of tax benefits and that is either factually similar or based on the same or similar tax strategy. The Secretary will have discretion to modify this definition as appropriate (as well as the definitions 

of reportable and listed transactions). 123The Treasury shelter initiative stated that a reportable transaction would be defined as 

any transaction with any of the following characteristics: (1) any transaction specifically identified by the IRS in published guidance as a tax avoidance transaction without regard to the size 

of the tax savings (i.e., a ‘‘ listed transaction’’), (2) certain loss transactions under section 165 

in excess of $10 million for corporations, partnerships, and S corporations ($2 million for trusts 

and individuals), (3) any transaction resulting in a tax credit in excess of $250,000 if the taxpayer held the underlying asset for less than 45 days, (4) any book-tax difference of at least 

$10 million, subject to certain exceptions, and (5) any transaction marketed under conditions 

of confidentiality, if the transaction is expected to result in a reduction in taxable income of at 

least $250,000 ($500,000 in the case of a corporation). 

Transactions to be disclosed 

The provision does not define the terms ‘‘listed transaction’’ 122 or ‘‘reportable transaction,’’ nor does the provision explain the type of 

information that must be disclosed in order to avoid the imposition 

of a penalty. Rather, the provision authorizes the Treasury Department to define a ‘‘listed transaction’’ and a ‘‘reportable transaction’’ under section 6011. As part of the Treasury shelter initiative, the 

Committee expects the Treasury Department to issue new regulations under section 6011 that will provide taxpayers with a set of 

objective standards to be applied in determining whether a taxpayer must disclose information regarding a particular transaction. 

The Committee anticipates that the new regulations will define a 

reportable transaction to include (but not be limited to) transactions with any of the following characteristics: (1) a significant 

loss, (2) a brief holding period, (3) a transaction that is marketed 

under conditions of confidentiality, (4) a transaction that is subject 

to indemnification agreements, or (5) a certain amount of book-tax 

difference.123

Disclosure requirements 

The Committee further expects that the new regulations will 

specify the manner in which a taxpayer must disclose reportable 

transactions. The Committee anticipates that the information required to be disclosed with respect to reportable transactions will 

be sufficiently detailed so as to provide the Treasury Department 

and IRS the ability to analyze all aspects of the transaction and determine an appropriate course of action (if any). To accomplish this 

objective, a taxpayer may be required to disclose the following information with respect to a reportable transaction: (1) a detailed 

description of all facts relevant to the expected tax treatment of the 

reportable transaction (such as the structure of the transaction and 

the principal elements of the transaction), (2) a description and 

schedule of the expected tax benefits for all tax years resulting 

from the reportable transaction (including any anticipated transactions as part of the overall strategy), (3) if applicable, the names 

and addresses of any party who promoted, solicited, or recommended the taxpayer’s participation in the transaction and who 

had a financial interest (including the receipt of fees) in the taxpayer’s decision to participate, and (4) other information that the 

Secretary may prescribe (e.g., the involvement of any accommodation party or any tax-indifferent party, the receipt of a tax opinion 

73

124The Committee recognizes that the Secretary’s present-law authority to postpone certain 

tax-related deadlines because of Presidentially-declared disasters (sec. 7508A) will also encompass the authority to postpone the reporting deadlines established by the provision. 125This category of transactions is described in greater detail below in connection with the 

provision modifying the accuracy-related penalty to tax shelters. 

with respect to the transaction, the amount of any fees paid to any 

promoter or advisor in connection with the transaction, any anticipated subsequent transactions or exit strategies).

The Committee intends that, in accordance with section 6065 (relating to verification of returns), the form the Secretary prescribes 

for taxpayer disclosure of reportable transactions will include a 

written declaration that the information is being provided under 

penalties of perjury. Moreover, the Committee intends that the 

verification under penalties of perjury also will apply to any large 

entity that discloses that it did not enter into any reportable transactions during the tax year covered by such declaration. 

Penalty rate 

The penalty for failing to disclose a reportable transaction is 

$50,000. The amount is increased to $100,000 if the failure is with 

respect to a listed transaction. For large entities and high net 

worth individuals, the penalty amount is doubled (i.e., $100,000 for 

a reportable transaction and $200,000 for a listed transaction). The 

penalty cannot be waived with respect to a listed transaction. As 

to reportable transactions, the penalty can be rescinded or abated 

only in exceptional circumstances.124 All or part of the penalty may 

be rescinded only if: (1) the taxpayer on whom the penalty is imposed has a history of complying with the Federal tax laws, (2) it 

is shown that the violation is due to an unintentional mistake of 

fact, (3) imposing the penalty would be against equity and good 

conscience, and (4) rescinding the penalty would promote compliance with the tax laws and effective tax administration. The authority to rescind the penalty can only be exercised by the Commissioner personally or the head of the Office of Tax Shelter Analysis; 

this authority to rescind cannot otherwise be delegated by the 

Commissioner. Thus, the penalty cannot be rescinded by a revenue 

agent, an appeals officer, or other IRS personnel. The decision to 

rescind a penalty must be accompanied by a record describing the 

facts and reasons for the action and the amount rescinded. There 

will be no taxpayer right to appeal a refusal to rescind a penalty. 

The IRS also is required to submit an annual report to Congress 

summarizing the application of the disclosure penalties and providing a description of each penalty rescinded under this provision 

and the reasons for the rescission. 

A ‘‘large entity’’ is defined as any entity with gross receipts in excess of $10 million in the year of the transaction or in the preceding year. A ‘‘high net worth individual’’ is defined as any individual whose net worth exceeds $2 million, based on the fair market value of the individual’s assets and liabilities immediately before entering into the transaction. 

A public entity that is required to pay a penalty for failing to disclose a listed transaction (or is subject to an accuracy-related penalty for a nondisclosed listed transaction or a nondisclosed reportable transaction with a significant tax avoidance purpose 125) must 

disclose the imposition of the penalty in reports to the Securities 

reasons for change 74

126Sec. 6662. 127Sec. 6662(d)(2)(B). 128Sec. 6662(d)(2)(C). 129Sec. 6664(c). 

and Exchange Commission (‘‘SEC’’) for such period as the Secretary 

shall specify. The provision applies without regard to whether the 

taxpayer determines the amount of the penalty to be material to 

the reports in which the penalty must appear, and treats any failure to disclose a transaction in such reports as a failure to disclose 

a listed transaction. A taxpayer must disclose a penalty in reports 

to the SEC once the taxpayer has exhausted its administrative and 

judicial remedies with respect to the penalty (or if earlier, when 

paid). 

As described above in connection with present law, current regulations under section 6011 require the disclosure of certain reportable transactions. Until such regulations are modified to reflect the 

new categories of reportable transactions, the penalty will apply to 

taxpayers who fail to timely disclose any reportable transaction 

under the definitions contained in the current regulations. 

EFFECTIVE DATE

The provision is effective for returns and statements the due date 

for which is after the date of enactment. 

2. Modifications to the accuracy-related penalties for listed transactions and reportable transactions having a significant tax avoidance purpose (sec. 602 of the bill and new sec. 6662A and secs. 

6662 and 6664 Of the Code) 

PRESENT LAW

The accuracy-related penalty applies to the portion of any underpayment that is attributable to (1) negligence, (2) any substantial 

understatement of income tax, (3) any substantial valuation 

misstatement, (4) any substantial overstatement of pension liabilities, or (5) any substantial estate or gift tax valuation understatement. If the correct income tax liability exceeds that reported by 

the taxpayer by the greater of 10 percent of the correct tax or 

$5,000 ($10,000 in the case of corporations), then a substantial understatement exists and a penalty may be imposed equal to 20 percent of the underpayment of tax attributable to the understatement.126 The amount of any understatement generally is reduced 

by any portion attributable to an item if (1) the treatment of the 

item is supported by substantial authority, or (2) facts relevant to 

the tax treatment of the item were adequately disclosed and there 

was a reasonable basis for its tax treatment.127

Special rules apply with respect to tax shelters.128 For understatements by non-corporate taxpayers attributable to tax shelters, 

the penalty may be avoided only if the taxpayer establishes that, 

in addition to having substantial authority for the position, the taxpayer reasonably believed that the treatment claimed was more 

likely than not the proper treatment of the item. This reduction in 

the penalty is unavailable to corporate tax shelters. 

The understatement penalty generally is abated (even with respect to tax shelters) in cases in which the taxpayer can demonstrate that there was ‘‘reasonable cause’’ for the underpayment 

and that the taxpayer acted in good faith.129 The relevant regulaVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00074 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
75

130Treas. Reg. sec. 1.6662–4(g)(4)(i)(B); Treas. Reg. sec. 1.6664–4(c). 131See ‘‘The Treasury Department’s Enforcement Proposals for Abusive Tax Avoidance Transactions,’’ at 12 (released on March 20, 2002), reprinted electronically at 2002 TNT 55–28 (March 

21, 2002). 132The terms ‘‘reportable transaction’’ and ‘‘listed transaction’’ have the same meanings as 

previously described in connection with the penalty for failing to disclose a reportable transaction. 

tions provide that reasonable cause exists where the taxpayer ‘‘reasonably relies in good faith on an opinion based on a professional 

tax advisor’s analysis of the pertinent facts and authorities [that] 

* * * unambiguously concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld 

if challenged’’ by the IRS.130

REASONS FOR CHANGE

The Committee understands that taxpayers are being advised 

not to disclose tax avoidance transactions on the grounds that any 

accuracy-related penalty that could result from an underpayment 

of tax on such a transaction can be avoided.131 Because the Treasury shelter initiative emphasizes combating abusive tax avoidance 

transactions by requiring increased disclosure of such transactions 

by all parties involved, the Committee believes that taxpayers 

should be subject to a strict liability penalty on an understatement 

of tax that is attributable to non-disclosed listed transactions or 

non-disclosed reportable transactions that have a significant purpose of tax avoidance. Furthermore, in order to deter taxpayers 

from entering into tax avoidance transactions, the Committee believes that a more meaningful (but less stringent) accuracy-related 

penalty should apply to such transactions even when disclosed. 

EXPLANATION OF PROVISION

In general 

The provision modifies the present-law accuracy related penalty 

by replacing the rules applicable to tax shelters with a new accuracy-related penalty that applies to listed transactions and reportable transactions with a significant tax avoidance purpose (hereinafter referred to as a ‘‘reportable avoidance transaction’’).132 The 

penalty rate and the taxpayer defenses available to avoid the penalty vary depending on the category of the transaction (i.e., listed 

or reportable avoidance transaction) and whether the transaction 

was adequately disclosed. 

In general, a 20-percent accuracy-related penalty is imposed on 

any understatement attributable to a listed transaction or a reportable avoidance transaction. The only exception to the penalty is if 

the taxpayer satisfies a more stringent reasonable cause and good 

faith exception (hereinafter referred to as the ‘‘strengthened reasonable cause exception’’), which is described below. The strengthened reasonable cause exception is available only if the relevant 

facts affecting the tax treatment are adequately disclosed, there is 

or was substantial authority for the claimed tax treatment, and the 

taxpayer reasonably believed that the claimed tax treatment was 

more likely than not the proper treatment. 

If the taxpayer does not adequately disclose the transaction, the 

strengthened reasonable cause exception is not available (i.e., a nofault penalty applies), and the taxpayer is subject to an increased 

reasons for change 76

133For this purpose, any reduction in the excess of deductions allowed for the taxable year 

over gross income for such year, and any reduction in the amount of capital losses which would 

(without regard to section 1211) be allowed for such year, shall be treated as an increase in 

taxable income. 134See the previous discussion regarding the penalty for failing to disclose a reportable transaction. 

penalty rate. If the understatement is attributable to an undisclosed listed transaction, the penalty rate is increased to 30 percent 

of the understatement. For understatements attributable to an undisclosed reportable avoidance transaction, the penalty rate is 25 

percent of the understatement. 

Determination of the understatement amount 

The penalty is applied to the amount of any understatement attributable to the listed or reportable avoidance transaction without 

regard to other items on the tax return. For purposes of this provision, the amount of the understatement is determined as the sum 

of (1) the product of the highest corporate or individual tax rate (as 

appropriate) and the increase in taxable income resulting from the 

difference between the taxpayer’s treatment of the item and the 

proper treatment of the item (without regard to other items on the 

tax return),133 and (2) the amount of any decrease in the aggregate 

amount of credits which results from a difference between the taxpayer’s treatment of an item and the proper tax treatment of such 

item. 

Except as provided in regulations, the taxpayer’s treatment of an 

item shall not take into account any amendment or supplement to 

a return if the amendment or supplement is filed after the earlier 

of when the taxpayer is first contacted regarding an examination 

of the return or such other date as specified by the Secretary. 

Strengthened reasonable cause exception 

A penalty is not imposed under the provision with respect to any 

portion of an understatement if it is shown that there was reasonable cause for such portion and the taxpayer acted in good faith. 

Such a showing requires (1) adequate disclosure of the facts affecting the transaction in accordance with the regulations under section 6011,134 (2) there is or was substantial authority for such 

treatment, and (3) the taxpayer reasonably believed that such 

treatment was more likely than not the proper treatment. For this 

purpose, a taxpayer will be treated as having a reasonable belief 

with respect to the tax treatment of an item only if such belief (1) 

is based on the facts and law that exist at the time the tax return 

(that includes the item) is filed, and (2) relates solely to the taxpayer’s chances of success on the merits and does not take into account the possibility that (a) a return will not be audited, (b) the 

treatment will not be raised on audit, or (c) the treatment will be 

resolved through settlement if raised. 

A taxpayer may (but is not required to) rely on an opinion of a 

tax advisor in establishing its reasonable belief with respect to the 

tax treatment of the item. However, a taxpayer may not rely on an 

opinion of a tax advisor for this purpose if the opinion (1) is provided by a ‘‘disqualified tax advisor,’’ or (2) is a ‘‘disqualified opinion.’’

77

135The term ‘‘material advisor’’ (defined below in connection with the new information filing 

requirements for material advisors) means any person who provides any material aid, assistance, or advice with respect to organizing, promoting, selling, implementing, or carrying out any 

reportable transaction, and who derives gross income in excess of $50,000 in the case of a reportable transaction substantially all of the tax benefits from which are provided to natural persons ($250,000 in any other case). 136This situation could arise, for example, when an advisor has an arrangement or understanding (oral or written) with an organizer, manager, or promoter of a reportable transaction 

that such party will recommend or refer potential participants to the advisor for an opinion regarding the tax treatment of the transaction. 137 An advisor should not be treated as participating in the organization of a transaction if 

the advisor’s only involvement with respect to the organization of the transaction is the rendering of an opinion regarding the tax consequences of such transaction. However, such an advisor may be a ‘‘disqualified tax advisor’’ with respect to the transaction if the advisor participates 

in the management, promotion or sale of the transaction (or if the material advisor is compensated by another material advisor, has a fee arrangement that is contingent on the tax benefits of the transaction, or as determined by the Secretary, has a continuing financial interest 

with respect to the transaction). 

Disqualified tax advisor 

A disqualified tax advisor is any material advisor 135 who (1) participates in the organization, management, promotion or sale of the 

transaction or is related (within the meaning of section 267 or 707) 

to any person who so participates, (2) is compensated by another 

material advisor with respect to the transaction, (3) has a fee arrangement with respect to the transaction that is contingent on all 

or part of the intended tax benefits from the transaction being sustained, or (4) as determined under regulations prescribed by the 

Secretary, has a continuing financial interest with respect to the 

transaction.136

Organization, management, promotion or sale of a transaction 

The Committee intends that a material advisor be considered as 

participating in the ‘‘organization’’ of a transaction if the advisor 

performs acts relating to the development of the transaction. This 

may include, for example, preparing documents (1) establishing a 

structure used in connection with the transaction (such as a partnership agreement), (2) describing the transaction (such as an offering memorandum or other statement describing the transaction), 

or (3) relating to the registration of the transaction with any federal, state or local government body.137 Participation in the ‘‘management’’ of a transaction means involvement in the decision-making process regarding any business activity with respect to the 

transaction. Participation in the ‘‘promotion or sale’’ of a transaction means involvement in the marketing or solicitation of the 

transaction to others. Thus, an advisor who provides information 

about the transaction to a potential participant is involved in the 

promotion or sale of a transaction, as is any advisor who recommends the transaction to a potential participant. 

Disqualified opinion 

An opinion may not be relied upon if the opinion (1) is based on 

unreasonable factual or legal assumptions (including assumptions 

as to future events), (2) unreasonably relies upon representations, 

statements, finding or agreements of the taxpayer or any other person, (3) does not identify and consider all relevant facts, or (4) fails 

to meet any other requirement prescribed by the Secretary. 

reasons for change 78

138Sec. 6662(a) and (d)(1)(A). 139Sec. 6662(d)(2)(B). 40Sec. 6662(d)(2)(D) 

Coordination with other penalties 

Any understatement to which a penalty is imposed under this 

provision is not subject to the accuracy-related penalty under section 6662. However, such understatement is included for purposes 

of determining whether any understatement (as defined in sec. 

6662(d)(2)) is a substantial understatement as defined under section 6662(d)(1). 

The penalty imposed under this provision shall not apply to any 

portion of an understatement to which a fraud penalty is applied 

under section 6663. 

EFFECTIVE DATE

The provision is effective for taxable years ending after the date 

of enactment. 

3. Modifications to the substantial understatement penalty (sec. 

603 of the bill and sec. 6662 of the Code) 

PRESENT LAW

Definition of substantial understatement 

An accuracy-related penalty equal to 20 percent applies to any 

substantial understatement of tax. A ‘‘substantial understatement’’ exists if the correct income tax liability for a taxable year exceeds 

that reported by the taxpayer by the greater of 10 percent of the 

correct tax or $5,000 ($10,000 in the case of most corporations).138

Reduction of understatement for certain positions 

For purposes of determining whether a substantial understatement penalty applies, the amount of any understatement generally 

is reduced by any portion attributable to an item if (1) the treatment of the item is supported by substantial authority, or (2) facts 

relevant to the tax treatment of the item were adequately disclosed 

and there was a reasonable basis for its tax treatment.139

The Secretary is required to publish annually in the Federal Register a list of positions for which the Secretary believes there is not 

substantial authority and which affect a significant number of taxpayers.140

REASONS FOR CHANGE

The Committee believes that the present-law definition of substantial understatement allows large corporate taxpayers to avoid 

the accuracy-related penalty on questionable transactions of a significant size. The Committee believes that an understatement of 

more than $10 million is substantial in and of itself, regardless of 

the proportion it represents of the taxpayer’s total tax liability. 

The Committee believes that a higher compliance standard 

should be imposed on any taxpayer in order to reduce the amount 

of an understatement resulting from a transaction that the taxpayer did not adequately disclose. The Committee further believes 

that a taxpayer should not take a position on a tax return that 

could give rise to a substantial understatement penalty that the 

79

taxpayer does not believe is more likely than not the correct tax 

treatment unless this information is disclosed to the IRS. 

EXPLANATION OF PROVISION

Definition of substantial understatement 

The provision modifies the definition of ‘‘substantial’’ for corporate taxpayers. Under the provision, a corporate taxpayer has a 

subs 

tantial understatement if the amount of the understatement for 

the taxable year exceeds the lesser of (1) 10 percent of the tax required to be shown on the return for the taxable year (or, if greater, $10,000), or (2) $10 million. 

Reduction of understatement for certain positions 

The provision elevates the standard that a taxpayer must satisfy 

in order to reduce the amount of an understatement for undisclosed 

items. With respect to the treatment of an item whose facts are not 

adequately disclosed, a resulting understatement is reduced only if 

the taxpayer had a reasonable belief that the tax treatment was 

more likely than not the proper treatment. The provision also authorizes (but does not require) the Secretary to publish a list of positions for which it believes there is not substantial authority or 

there is no reasonable belief that the tax treatment is more likely 

than not the proper treatment (without regard to whether such positions affect a significant number of taxpayers). The list shall be 

published in the Federal Register or the Internal Revenue Bulletin. 

EFFECTIVE DATE

The provision is effective for taxable years beginning after date 

of enactment. 

4. Tax shelter exception to confidentiality privileges relating to taxpayer communications (sec. 604 of the bill and sec. 7525 of the 

Code) 

PRESENT LAW

In general, a common law privilege of confidentiality exists for 

communications between an attorney and client with respect to the 

legal advice the attorney gives the client. The Code provides that, 

with respect to tax advice, the same common law protections of 

confidentiality that apply to a communication between a taxpayer 

and an attorney also apply to a communication between a taxpayer 

and a federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it 

were between a taxpayer and an attorney. This rule is inapplicable 

to communications regarding corporate tax shelters. 

REASONS FOR CHANGE

The Committee believes that the rule currently applicable to corporate tax shelters should be applied to all tax shelters, regardless 

of whether or not the participant is a corporation. 

reasons for change 80

141Sec. 6111(A) 142The tax shelter ratio is, with respect to any year, the ratio that the aggregate amount of 

the deductions and 350 percent of the credits, which are represented to be potentially allowable 

to any investor, bears to the investment base (money plus basis of assets contributed) as of the 

close of the tax year. 143Sec. 6111(c). 144Sec. 6111(d). 145Temp. Treas. Reg. sec. 301.6111–2T(b)(2). 146Temp. Treas. Reg. sec. 301.6111–2T(b)(3). 147Temp. Treas. Reg. sec. 301.6111–2T(b)(4). 

EXPLANATION OF PROVISION

The bill modifies the rule relating to corporate tax shelters by 

making it applicable to all tax shelters, whether entered into by 

corporations, individuals, partnerships, tax-exempt entities, or any 

other entity. Accordingly, communications with respect to tax shelters are not subject to the confidentiality provision of the Code that 

otherwise applies to a communication between a taxpayer and a 

federally authorized tax practitioner. 

EFFECTIVE DATE

The provision is effective with respect to communications made 

on or after the date of enactment.

5. Disclosure of reportable transactions by material advisors (secs. 

611 and 612 of the bill and secs. 6111 and 6707 of the Code) 

PRESENT LAW

Registration of tax shelter arrangements 

An organizer of a tax shelter is required to register the shelter 

with the Secretary not later than the day on which the shelter is 

first offered for sale.141 A ‘‘tax shelter’’ means any investment with 

respect to which the tax shelter ratio 142 for any investor as of the 

close of any of the first five years ending after the investment is 

offered for sale may be greater than two to one and which is: (1) 

required to be registered under Federal or State securities laws, (2) 

sold pursuant to an exemption from registration requiring the filing of a notice with a Federal or State securities agency, or (3) a 

substantial investment (greater than $250,000 and at least five investors).143

Other promoted arrangements are treated as tax shelters for 

purposes of the registration requirement if: (1) a significant purpose of the arrangement is the avoidance or evasion of Federal income tax by a corporate participant; (2) the arrangement is offered 

under conditions of confidentiality; and (3) the promoter may receive fees in excess of $100,000 in the aggregate.144

A transaction has a ‘‘significant purpose of avoiding or evading 

Federal income tax’’ if the transaction: (1) is the same as or substantially similar to a ‘‘listed transaction,’’ 145 or (2) is structured 

to produce tax benefits that constitute an important part of the intended results of the arrangement and the promoter reasonably expects to present the arrangement to more than one taxpayer.146

Certain exceptions are provided with respect to the second category 

of transactions.147

An arrangement is offered under conditions of confidentiality if: 

(1) an offeree has an understanding or agreement to limit the disclosure of the transaction or any significant tax features of the 

81

148The regulations provide that the determination of whether an arrangement is offered 

under conditions of confidentiality is based on all the facts and circumstances surrounding the 

offer. If an offeree’s disclosure of the structure or tax aspects of the transaction are limited in 

any way by an express or implied understanding or agreement with or for the benefit of a tax 

shelter promoter, an offer is considered made under conditions of confidentiality, whether or not 

such understanding or agreement is legally binding. Treas. Reg. sec. 301.6111–2T(c)(1). 149Sec. 6707. 150The Treasury Department’s enforcement proposals for abusive tax avoidance transactions 

are described in greater detail above in connection with the penalty for failing to disclose reportable transactions (new sec. 6707A). 151The terms ‘‘reportable transaction’’ and ‘‘listed transaction’’ have the same meaning as previously described in connection with the taxpayer-related provisions. 

transaction; or (2) the promoter claims, knows, or has reason to 

know that a party other than the potential participant claims that 

the transaction (or any aspect of it) is proprietary to the promoter 

or any party other than the offeree, or is otherwise protected from 

disclosure or use.148

Failure to register tax shelter 

The penalty for failing to timely register a tax shelter (or for filing false or incomplete information with respect to the tax shelter 

registration) generally is the greater of one percent of the aggregate amount invested in the shelter or $500.149 However, if the tax 

shelter involves an arrangement offered to a corporation under conditions of confidentiality, the penalty is the greater of $10,000 or 

50 percent of the fees payable to any promoter with respect to offerings prior to the date of late registration. Intentional disregard 

of the requirement to register increases the penalty to 75 percent 

of the applicable fees. 

Section 6707 also imposes (1) a $100 penalty on the promoter for 

each failure to furnish the investor with the required tax shelter 

identification number, and (2) a $250 penalty on the investor for 

each failure to include the tax shelter identification number on a 

return. 

REASONS FOR CHANGE

The Committee has been advised that the current promoter registration rules have not proven particularly helpful, because the 

rules are not appropriate for the kinds of abusive transactions now 

prevalent, and because the limitations regarding confidential corporate arrangements have proven easy to circumvent. 

The Committee believes that providing a single, clear definition 

regarding the types of transactions that must be disclosed by taxpayers and material advisors (as outlined in the Treasury shelter 

initiative), coupled with more meaningful penalties for failing to 

disclose such transactions, are necessary tools if the effort to curb 

the use of abusive tax avoidance transactions is to be effective.150

EXPLANATION OF PROVISION

Disclosure of reportable transactions by material advisors 

The provision repeals the present law rules with respect to registration of tax shelters. Instead, the provision requires each material advisor with respect to any reportable transaction 151 to timely 

file an information return with the Secretary (in such form and 

manner as the Secretary may prescribe). The return must be filed 

on such date as specified by the Secretary. 

reasons for change 82

152See the previous discussion regarding the disclosure requirements under new section 

6707A. 153The terms ‘‘reportable transaction’’ and ‘‘listed transaction’’ have the same meaning as previously described in connection with the taxpayer-related provisions. 154The Committee recognizes that the Secretary’s present-law authority to postpone certain 

tax-related deadlines because of Presidentially-declared disasters (sec. 7508A) will also encompass the authority to postpone the reporting deadlines established by the provision. 

The information return will include (1) information identifying 

and describing the transaction, (2) information describing any potential tax benefits expected to result from the transaction, and (3) 

such other information as the Secretary may prescribe. It is expected that the Secretary may seek from the material advisor the 

same type of information that the Secretary may request from a 

taxpayer in connection with a reportable transaction.152

A ‘‘material advisor’’ means any person (1) who provides material 

aid, assistance, or advice with respect to organizing, promoting, 

selling, implementing, or carrying out any reportable transaction, 

and (2) who directly or indirectly derives gross income in excess of 

$250,000 ($50,000 in the case of a reportable transaction substantially all of the tax benefits from which are provided to natural persons) for such advice or assistance. 

The Secretary may prescribe regulations which provide (1) that 

only one material advisor has to file an information return in cases 

in which two or more material advisors would otherwise be required to file information returns with respect to a particular reportable transaction, (2) exemptions from the requirements of this 

section, and (3) other rules as may be necessary or appropriate to 

carry out the purposes of this section. 

Penalty for failing to furnish information regarding reportable 

transactions 

The provision repeals the present law penalty for failure to register tax shelters. Instead, the provision imposes a penalty on any 

material advisor who fails to file an information return with respect to any reportable transaction, or who files a false or incomplete information return with the Secretary with respect to a reportable transaction.153 The amount of the penalty is $50,000. If 

the penalty is with respect to a listed transaction, the amount of 

the penalty is increased to the greater of (1) $200,000, or (2) 50 

percent of the gross income of such person with respect to aid, assistance, or advice which is provided with respect to the reportable 

transaction before the date the information return that includes 

the transaction is filed. Intentional disregard by a material advisor 

of the requirement to disclose a reportable transaction increases 

the penalty to 75 percent of such gross income. 

The penalty cannot be waived with respect to a listed transaction. As to reportable transactions, the penalty can be rescinded 

or abated only in exceptional circumstances.154 All or part of the 

penalty may be rescinded only if: (1) the material advisor on whom 

the penalty is imposed has a history of complying with the Federal 

tax laws, (2) it is shown that the violation is due to an unintentional mistake of fact, (3) imposing the penalty would be against 

equity and good conscience, and (4) rescinding the penalty would 

promote compliance with the tax laws and effective tax administration. The authority to rescind the penalty can only be exercised by 

the Commissioner personally or the head of the Office of Tax ShelVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00082 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
83

155Sec. 6112. 156See Temp. Treas. Reg. sec. 301.6112–1T Q&A 17. 157See Temp. Treas. Reg. sec. 301–6112–1T Q&A 8. 158Sec. 6112(c)(2). 

ter Analysis; this authority to rescind cannot otherwise be delegated by the Commissioner. Thus, the penalty cannot be rescinded 

by a revenue agent, an appeals officer, or other IRS personnel. The 

decision to rescind a penalty must be accompanied by a record describing the facts and reasons for the action and the amount rescinded. There will be no right to appeal a refusal to rescind a penalty. The IRS also is required to submit an annual report to Congress summarizing the application of the disclosure penalties and 

providing a description of each penalty rescinded under this provision and the reasons for the rescission. 

EFFECTIVE DATE

The provision requiring disclosure of reportable transactions by 

material advisors applies to transactions with respect to which material aid, assistance or advice is provided after the date of enactment. 

The provision imposing a penalty for failing to disclose reportable 

transactions applies to returns the due date for which is after the 

date of enactment. 

6. Investor lists and applicable penalties (secs. 611 and 613 of the 

bill and secs. 6112 and 6708 of the Code) 

PRESENT LAW

Investor lists 

A promoter must maintain (for a period of seven years) a list 

identifying each person who was sold an interest in any tax shelter 

with respect to which registration was required under section 6111 

(even though the particular party may not have been subject to 

confidentiality restrictions).155 Regulations under section 6112 provide that, in addition to the name, tax shelter identification number and other identifying information the promoter must include 

detailed information about the tax shelter (including details of the 

shelter and the expected tax benefits, as well as copies of any additional written material given to any participant or advisor).156 A 

limited exception is provided for certain shelters if the total fees 

are less than $25,000 or if the expected reduction in tax liabilities 

for any single year is less than $1 million for corporations or 

$250,000 for non-corporate taxpayers.157 The Secretary is required 

to prescribe regulations which provide that, in cases in which 2 or 

more persons are required to maintain the same list, only one person would be required to maintain the list.158

Penalties for failing to maintain investor lists 

Under section 6708, the penalty for failing to maintain the list 

required under section 6112 is $50 for each name omitted from the 

list (with a maximum penalty of $100,000 per year). 

reasons for change 84

159The Treasury Department’s enforcement proposals for abusive tax avoidance transactions 

are described in greater detail above in connection with the penalty for failing to disclose reportable transactions (new sec. 6707A). 160The term ‘‘material advisor’’ has the same meaning as when used in connection with the 

requirement to file an information return under section 6111. 161The term ‘‘reportable transaction’’ has the same meaning as previously described in connection with the taxpayer-related provisions. 162 In no event will failure to maintain a list be considered reasonable cause for failing to 

make a list available to the Secretary. 

REASONS FOR CHANGE

The Committee has been advised that the present-law penalties 

for failure to maintain customer lists are not meaningful and that 

promoters often have refused to provide requested information to 

the IRS. The Committee believes that requiring material advisors 

to maintain a list of advisees with respect to each reportable transaction, coupled with more meaningful penalties for failing to maintain an investor list, are important tools in the ongoing efforts to 

curb the use of abusive tax avoidance transactions. Furthermore, 

these provisions are consistent with the course of action outlined 

in the Treasury shelter initiative.159

EXPLANATION OF PROVISION

Investor lists 

Each material advisor 160 that is required to file an information 

return with respect to a reportable transaction 161 is required to 

maintain a list that (1) identifies each person with respect to whom 

the advisor acted as a material advisor with respect to the reportable transaction, and (2) contains other information as may be required by the Secretary. In addition, the provision authorizes (but 

does not require) the Secretary to prescribe regulations which provide that, in cases in which 2 or more persons are required to 

maintain the same list, only one person would be required to maintain the list. 

Penalty for failing to maintain investor lists 

The provision modifies the penalty for failing to maintain the required list by making it a time-sensitive penalty. Thus, a material 

advisor who is required to maintain an investor list and who fails 

to make the list available upon request by the Secretary within 20 

business days after the request will be subject to a $10,000 per day 

penalty. The penalty applies to a person who fails to maintain a 

list, maintains an incomplete list, or has in fact maintained a list 

but does not make the list available to the Secretary. The penalty 

can be waived if the failure to make the list available is due to reasonable cause.162

EFFECTIVE DATE

The provision requiring a material advisor to maintain an investor list applies to transactions with respect to which material aid, 

assistance or advice is provided after the date of enactment. 

The provision imposing a penalty for failing to maintain investor 

lists applies to requests made after the date of enactment. 

85

163Sec. 7408. 164Sec. 6707, as amended by other provisions of this bill. 165Sec. 6708, as amended by other provisions of this bill. 

7. Actions to enjoin conduct with respect to tax shelters (sec. 614 

of the bill and sec. 7408 of the Code) 

PRESENT LAW

The Code authorizes civil action to enjoin any person from promoting abusive tax shelters or aiding or abetting the understatement of tax liability.163

REASONS FOR CHANGE

The Committee understands that some promoters are blatantly 

ignoring the rules regarding registration and list maintenance regardless of the penalties. An injunction would place these promoters in a public proceeding under court order. Thus, the Committee believes that the types of tax shelter activities with respect 

to which an injunction may be sought should be expanded. 

EXPLANATION OF PROVISION

The bill expands this rule so that injunctions may also be sought 

with respect to the requirements relating to the reporting of tax 

shelters 164 and the keeping of lists of investors by material advisors.165 Thus, under the provision, an injunction may be sought 

against a material advisor to enjoin the advisor from (1) failing to 

file an information return with respect to a reportable transaction, 

or (2) failing to maintain, or to timely furnish upon written request 

by the Secretary, a list of investors with respect to each reportable 

transaction. 

EFFECTIVE DATE

The provision is effective on the day after the date of enactment. 

8. Understatement of taxpayer’s liability by income tax return preparer (sec. 621 of the bill and sec. 6694 of the Code) 

PRESENT LAW

An income tax return preparer who prepares a return with respect to which there is an understatement of tax that is due to a 

position for which there was not a realistic possibility of being sustained on its merits and the position was not disclosed (or was frivolous) is liable for a penalty of $250, provided that the preparer 

knew or reasonably should have known of the position. An income 

tax return preparer who prepares a return and engages in specified 

willful or reckless conduct with respect to preparing such a return 

is liable for a penalty of $1,000. 

REASONS FOR CHANGE

The Committee believes that the standards of conduct applicable 

to income tax return preparers should be the same as the standards applicable to taxpayers. Accordingly, the minimum standard 

for each undisclosed position on a tax return would be that the preparer must reasonably believe that the tax treatment is more likely 

than not the proper tax treatment. The Committee believes that 

reasons for change 86

166 31 U.S.C. 5314. 167 31 U.S.C. 5321(a)(5). 

this standard is appropriate because the tax return is signed under 

penalties of perjury, which implies a high standard of diligence in 

determining the facts and substantial accuracy in determining and 

applying the rules that govern those facts. The Committee believes 

that it is both appropriate and vital to the tax system that both 

taxpayers and their return preparers file tax returns that they reasonably believe are more likely than not correct. In addition, conforming the standards of conduct applicable to income tax return 

preparers to the standards applicable to taxpayers will simplify the 

law by reducing confusion inherent in different standards applying 

to the same behavior. 

EXPLANATION OF PROVISION

The bill alters the standards of conduct that must be met to 

avoid imposition of the first penalty. The bill replaces the realistic 

possibility standard with a requirement that there be a reasonable 

belief that the tax treatment of the position was more likely than 

not the proper treatment. The bill also replaces the not frivolous 

standard with the requirement that there be a reasonable basis for 

the tax treatment of the position. 

In addition, the bill increases the amount of these penalties. The 

penalty relating to not having a reasonable belief that the tax 

treatment was more likely than not the proper tax treatment is increased from $250 to $1,000. The penalty relating to willful or reckless conduct is increased from $1,000 to $5,000. 

EFFECTIVE DATE

The provision is effective for documents prepared after the date 

of enactment. 

9. Penalty on failure to report interests in foreign financial accounts (sec. 622 of the bill and sec. 5321 of Title 31, United 

States Code) 

PRESENT LAW

The Secretary of the Treasury must require citizens, residents, or 

persons doing business in the United States to keep records and 

file reports when that person makes a transaction or maintains an 

account with a foreign financial entity.166 In general, individuals 

must fulfill this requirement by answering questions regarding foreign accounts or foreign trusts that are contained in Part III of 

Schedule B of the IRS Form 1040. Taxpayers who answer ‘‘yes’’ in 

response to the question regarding foreign accounts must then file 

Treasury Department Form TD F 90–22.1. This form must be filed 

with the Department of the Treasury, and not as part of the tax 

return that is filed with the IRS. 

The Secretary of the Treasury may impose a civil penalty on any 

person who willfully violates this reporting requirement. The civil 

penalty is the amount of the transaction or the value of the account, up to a maximum of $100,000; the minimum amount of the 

penalty is $25,000.167 In addition, any person who willfully violates 

this reporting requirement is subject to a criminal penalty. The 

87

168 31 U.S.C. 5322. 169 A Report to Congress in Accordance with Sec. 361(b) of the Uniting and Strengthening 

America by Providing Appropriate Tools Required to itercept and Obstruct Terrorism Act of 

2001, April 26, 2002. 170Sec. 361(b) of the USA PATRIOT Act of 2001 (Pub. L. 107–56). 171 Because in general the Tax Court is the only pre-payment forum available to taxpayers, 

it deals with most of the frivolous, groundless, or dilatory arguments raised in tax cases. 

criminal penalty is a fine of not more than $250,000 or imprisonment for not more than five years (or both); if the violation is part 

of a pattern of illegal activity, the maximum amount of the fine is 

increased to $500,000 and the maximum length of imprisonment is 

increased to 10 years.168

On April 26, 2002, the Secretary of the Treasury submitted to 

the Congress a report on these reporting requirements.169 This report, which was statutorily required,170 studies methods for improving compliance with these reporting requirements. It makes 

several administrative recommendations, but no legislative recommendations. A further report is required to be submitted by the 

Secretary of the Treasury to the Congress by October 26, 2002. 

REASONS FOR CHANGE

The Committee understands that the number of individuals involved in using offshore bank accounts to engage in abusive tax 

scams has grown significantly in recent years. For one scheme 

alone, the IRS estimates that there may be one to two million taxpayers with offshore bank accounts attempting to conceal income 

from the IRS. The Committee is concerned about this activity and 

believes that improving compliance with this reporting requirement 

is vitally important to sound tax administration, to combating terrorism, and to preventing the use of abusive tax schemes and 

scams. Adding a new civil penalty that applies without regard to 

willfulness will improve compliance with this reporting requirement. 

EXPLANATION OF PROVISION

The bill adds an additional civil penalty that may be imposed on 

any person who violates this reporting requirement (without regard 

to willfulness). This new civil penalty is up to $5,000. The penalty 

may be waived if any income from the account was properly reported on the income tax return and there was reasonable cause 

for the failure to report. 

EFFECTIVE DATE

The provision is effective with respect to failures to report occurring on or after the date of enactment. 

10. Frivolous tax returns and submissions (sec. 623 of the bill and 

sec. 6702 of the Code) 

PRESENT LAW

The Code provides that an individual who files a frivolous income 

tax return is subject to a penalty of $500 imposed by the IRS (sec. 

6702). The Code also permits the Tax Court 171 to impose a penalty 

of up to $25,000 if a taxpayer has instituted or maintained proVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00087 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
reasons for change 88

172 31 U.S.C. 330. 

ceedings primarily for delay or if the taxpayer’s position in the proceeding is frivolous or groundless (sec. 6673(a)). 

REASONS FOR CHANGE

The IRS has been faced with a significant number of tax filers 

who are filing returns based on frivolous arguments or who are 

seeking to hinder tax administration by filing returns that are patently incorrect. In addition, taxpayers are using existing procedures for collection due process hearings, offers-in-compromise, installment agreements, and taxpayer assistance orders to impede or 

delay tax administration by raising frivolous arguments. These procedures were intended to provide assistance to taxpayers genuinely 

seeking to resolve legitimate disputes with the IRS, and the use of 

these procedures for impeding or delaying tax administration diverts scarce IRS resources away from resolving genuine disputes. 

Allowing the IRS to assert more substantial penalties for frivolous 

submissions and to dismiss frivolous requests without the need to 

follow otherwise mandated procedures will deter frivolous taxpayer 

behavior and enable the IRS to use its resources to better assist 

taxpayers in resolving genuine disputes. 

EXPLANATION OF PROVISION

The bill modifies the IRS-imposed penalty by increasing the amount of the penalty to up to $5,000 and by applying it to all taxpayers and to all types of Federal taxes. 

The provision also modifies present law with respect to certain 

submissions that raise frivolous arguments or that are intended to 

delay or impede tax administration. The submissions to which this 

provision applies are requests for a collection due process hearing, 

installment agreements, offers-in-compromise, and taxpayer assistance orders. First, the provision permits the IRS to dismiss such 

requests. Second, the provision permits the IRS to impose a penalty 

of up to $5,000 for such requests, unless the taxpayer withdraws 

the request after being given an opportunity to do so. 

The provision requires the IRS to publish a list of positions, arguments, requests, and proposals determined to be frivolous for 

purposes of these provisions. 

EFFECTIVE DATE

The provision is effective for submissions made and issues raised 

after the date on which the Secretary first prescribes the required 

list. 

11. Regulation of individuals practicing before the Department of 

the Treasury (sec. 624 of the bill and sec. 330 of Title 31, United 

States Code) 

PRESENT LAW

The Secretary of the Treasury is authorized to regulate the practice of representatives of persons before the Department of the 

Treasury.172 The Secretary is also authorized to suspend or disbar 

from practice before the Department a representative who is incompetent, who is disreputable, who violates the rules regulating pracVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00088 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
89

173Sec. 6700. 

tice before the Department, or who (with intent to defraud) willfully and knowingly misleads or threatens the person being represented (or a person who may be represented). The rules promulgated by the Secretary pursuant to this provision are contained in 

Circular 230. 

REASONS FOR CHANGE

The Committee believes that it is critical that the Secretary have 

the authority to censure tax advisors as well as to impose monetary 

sanctions against tax advisors because of the important role of tax 

advisors in our tax system. Use of these sanctions is expected to 

curb the participation of tax advisors in both tax shelter activity 

and any other activity that is contrary to Circular 230 standards. 

EXPLANATION OF PROVISION

The bill makes two modifications to expand the sanctions that 

the Secretary may impose pursuant to these statutory provisions. 

First, the bill expressly permits censure as a sanction. 

Second, the bill permits the imposition of a monetary penalty as 

a sanction. If the representative is acting on behalf of an employer 

or other entity, the Secretary may impose a monetary penalty on 

the employer or other entity if it knew, or reasonably should have 

known, of the conduct. This monetary penalty on the employer or 

other entity may be imposed in addition to any monetary penalty 

imposed directly on the representative. These monetary penalties 

are not to exceed the gross income derived (or to be derived) from 

the conduct giving rise to the penalty. These monetary penalties 

may be in addition to, or in lieu of, any suspension, disbarment, or 

censure. 

The bill also confirms the present-law authority of the Secretary 

to impose standards applicable to written advice with respect to an 

entity, plan, or arrangement that is of a type that the Secretary determines as having a potential for tax avoidance or evasion. 

EFFECTIVE DATE

The modifications to expand the sanctions that the Secretary 

may impose are effective for actions taken after the date of enactment. 

12. Penalties on promoters of tax shelters (sec. 625 of the bill and 

sec. 6700 of the Code) 

PRESENT LAW

A penalty is imposed on any person who organizes, assists in the 

organization of, or participates in the sale of any interest in, a 

partnership or other entity, any investment plan or arrangement, 

or any other plan or arrangement, if in connection with such activity the person makes or furnishes a qualifying false or fraudulent 

statement or a gross valuation overstatement.173 A qualified false 

or fraudulent statement is any statement with respect to the allowability of any deduction or credit, the excludability of any income, 

or the securing of any other tax benefit by reason of holding an interest in the entity or participating in the plan or arrangement 

reasons for change 90

174Sec. 1501. 

which the person knows or has reason to know is false or fraudulent as to any material matter. A ‘‘gross valuation overstatement’’

means any statement as to the value of any property or services 

if the stated value exceeds 200 percent of the correct valuation, and 

the value is directly related to the amount of any allowable income 

tax deduction or credit. 

The amount of the penalty is $1,000 (or, if the person establishes 

that it is less, 100 percent of the gross income derived or to be derived by the person from such activity). A penalty attributable to 

a gross valuation misstatement can be waived on a showing that 

there was a reasonable basis for the valuation and it was made in 

good faith. 

REASONS FOR CHANGE

The Committee believes that the present-law penalty rate is insufficient to deter the type of conduct that gives rise to the penalty. 

EXPLANATION OF PROVISION

The provision modifies the penalty amount to equal 50 percent 

of the gross income derived by the person from the activity for 

which the penalty is imposed. The new penalty rate applies to any 

activity that involves a statement regarding the tax benefits of participating in a plan or arrangement if the person knows or has reason to know that such statement is false or fraudulent as to any 

material matter. The enhanced penalty does not apply to a gross 

valuation overstatement. 

EFFECTIVE DATE

The provision is effective for activities after the date of enactment. 

13. Affirmation of consolidated return regulation authority (sec. 

631 of the bill and sec. 1502 of the Code) 

PRESENT LAW

An affiliated group of corporations may elect to file a consolidated return in lieu of separate returns. A condition of electing to 

file a consolidated return is that all corporations that are members 

of the consolidated group must consent to all the consolidated return regulations prescribed under section 1502 prior to the last day 

prescribed by law for filing such return.174

Section 1502 states:

The Secretary shall prescribe such regulations as he 

may deem necessary in order that the tax liability of any 

affiliated group of corporations making a consolidated return and of each corporation in the group, both during and 

after the period of affiliation, may be returned, determined, computed, assessed, collected, and adjusted, in such 

manner as clearly to reflect the income-tax liability and 

the various factors necessary for the determination of such 

91

175Sec. 1502. 176 Regulations issued under the authority of section 1502 are considered to be ‘‘legislative’’ regulations rather than ‘‘interpretative’’ regulations, and as such are usually given greater deference by courts in case of a taxpayer challenge to such a regulation. See, S. Rep. No. 960, 70th 

Cong., 1st Sess. at 15, describing the consolidated return regulations as ‘‘legislative in character’’. The Supreme Court has stated that ‘‘. . . legislative regulations are given controlling 

weight unless they are arbitrary, capricious, or manifestly contrary to the statute.’’ Chevron, 

U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 844 (1984) (involving an 

environmental protection regulation). For examples involving consolidated return regulations, 

see, e.g., Wolter Construction Company v. Commissioner, 634 F.2d 1029 (6th Cir. 1980); Garvey, 

Inc. v. United States, 1 Ct. Cl. 108 (1983), aff’d 726 F.2d 1569 (Fed. Cir. 1984), cert. denied 

469 U.S. 823 (1984). Compare, e.g., Audrey J. Walton v. Commissioner, 115 T.C. 589 (2000), 

describing different standards of review. The case did not involve a consolidated return regulation. 177 255 F.3d 1357 (Fed. Cir. 2001), reh’g denied, 2001 U.S. App. LEXIS 23207 (Fed. Cir. Oct. 

3, 2001). 178Prior to this decision, there had been a few instances involving prior laws in which certain 

consolidated return regulations were held to be invalid. See, e.g., American Standard, Inc. v. 

United States, 602 F.2d 256 (Ct. Cl. 1979), discussed in the text infra. see also Union Carbide 

Corp. v. United States, 612 F.2d 558 (Ct. Cl. 1979), and Allied Corporation v. United States, 

685 F. 2d 396 (Ct. Cl. 1982), all three cases involving the allocation of income and loss within 

a consolidated group for purposes of computation of a deduction allowed under prior law by the 

Code for Western Hemisphere Trading Corporations. . See also Joseph Weidenhoff v. Commissioner, 32 T.C. 1222, 1242–1244 (1959), involving the application of certain regulations to the 

excess profits tax credit allowed under prior law, and concluding that the Commissioner had 

applied a particular regulation in an arbitrary manner inconsistent with the wording of the regulation and inconsistent with even a consolidated group computation. Cf. Kanawha Gas & Utilities Co. v. Commissioner, 214 F.2d 685 (1954), concluding that the substance of a transaction 

was an acquisition of assets rather than stock. Thus, a regulation governing basis of the assets 

of consolidated subsidiaries did not apply to the case. See also General Machinery Corporation 

v. Commissioner, 33 B.T.A. 1215 (1936); Lefcourt Realty Corporation, 31 B.T.A. 978 (1935); 

Helvering v. Morgans, Inc., 293 U.S. 121 (1934), interpreting the term ‘‘taxable year.’’ 179Treas. Reg. Sec. 1.1502–20(c)(1)(iii). 180Treasury Regulation section 1.1502–20, generally imposing certain ‘‘loss disallowance’’

rules on the disposition of subsidiary stock, contained other limitations besides the ‘‘duplicated 

loss’’ rule that could limit the loss available to the group on a disposition of a subsidiary’s stock. 

Treasury Regulation section 1.1502–20 as a whole was promulgated in connection with regulations issued under section 337(d), principally in connection with the so-called General Utilities 

repeal of 1986 (referring to the case of General Utilities & Operating Company v. Helvering, 

296 U.S. 200 (1935)). Such repeal generally required a liquidating corporation, or a corporation 

acquired in a stock acquisition treated as a sale of assets, to pay corporate level tax on the excess of the value of its assets over the basis. Treasury regulation section 1.1502–20 principally 

reflected an attempt to prevent corporations filing consolidated returns from offsetting income 

with a loss on the sale of subsidiary stock. Such a loss could result from the unique upward 

adjustment of a subsidiary’s stock basis required under the consolidated return regulations for 

subsidiary income earned in consolidation, an adjustment intended to prevent taxation of both 

the subsidiary and the parent on the same income or gain. As one example, absent a denial 

of certain losses on a sale of subsidiary stock, a consolidated group could obtain a loss deduction 

with respect to subsidiary stock, the basis of which originally reflected the subsidiary’s value 

at the time of the purchase of the stock, and that had then been adjusted upward on recognition 

of any built-in income or gain of the subsidiary reflected in that value. The regulations also contained the duplicated loss factor addressed by the court in Rite Aid. The preamble to the regulations stated: ‘‘it is not administratively feasible to differentiate between loss attributable to 

built-in gain and duplicated loss.’’ T.D. 8364, 1991–2 C.B. 43, 46 (Sept. 13, 1991). The government also argued in the Rite Aid case that duplicated loss was a separate concern of the regulations. 255 F.3d at 1360. 

liability, and in order to prevent the avoidance of such tax 

liability.175

Under this authority, the Treasury Department has issued extensive consolidated return regulations.176

In the recent case of Rite Aid Corp. v. United States,177 the Federal Circuit Court of Appeals addressed the application of a particular provision of certain consolidated return loss disallowance 

regulations, and concluded that the provision was invalid.178 The 

particular provision, known as the ‘‘duplicated loss’’ provision,179

would have denied a loss on the sale of stock of a subsidiary by a 

parent corporation that had filed a consolidated return with the 

subsidiary, to the extent the subsidiary corporation had assets that 

had a built-in loss, or had a net operating loss, that could be recognized or used later.180

reasons for change 92

181For example, the court stated: ‘‘The duplicated loss factor . . . addresses a situation that 

arises from the sale of stock regardless of whether corporations file separate or consolidated returns. With I.R.C. secs. 382 and 383, Congress has addressed this situation by limiting the subsidiary’s potential future deduction, not the parent’s loss on the sale of stock under I.R.C. sec. 

165.’’ 255 F.3d 1357, 1360 (Fed. Cir. 2001). 182S. Rep. No. 960, 70th Cong., 1st Sess. 15 (1928). Though not quoted by the court in Rite 

Aid, the same Senate report also indicated that one purpose of the consolidated return authority 

was to permit treatment of the separate corporations as if they were a single unit, stating ‘‘The 

mere fact that by legal fiction several corporations owned by the same shareholders are separate 

entities should not obscure the fact that they are in reality one and the same business owned 

by the same individuals and operated as a unit.’’ S. Rep. No. 960, 70th Cong., 1st Sess. 29 

(1928). 183 American Standard, Inc. v. United States, 602 F.2d 256, 261 (Ct. Cl. 1979). That case did 

not involve the question of separate returns as compared to a single return approach. It involved 

the computation of a Western Hemisphere Trade Corporation (‘‘WHTC’’) deduction under prior 

law (which deduction would have been computed as a percentage of each WHTC’s taxable income if the corporations had filed separate returns), in a case where a consolidated group included several WHTCs as well as other corporations. The question was how to apportion income 

and losses of the admittedly consolidated WHTCs and how to combine that computation with 

the rest of the group’s consolidated income or losses. The court noted that the new, changed 

regulations approach varied from the approach taken to a similar problem involving public utilities within a group and previously allowed for WHTCs. The court objected that the allocation 

method adopted by the regulation allowed non-WHTC losses to reduce WHTC income. However, 

the court did not disallow a method that would net WHTC income of one WHTC with losses 

of another WHTC, a result that would not have occurred under separate returns. Nor did the 

court expressly disallow a different fractional method that would net both income and losses of 

the WHTCs with those of other corporations in the consolidated group. The court also found that 

the regulation had been adopted without proper notice. 

The Federal Circuit Court opinion contained language discussing 

the fact that the regulation produced a result different than the result that would have obtained if the corporations had filed separate 

returns rather than consolidated returns.181

The Federal Circuit Court opinion cited a 1928 Senate Finance 

Committee Report to legislation that authorized consolidated return regulations, which stated that ‘‘many difficult and complicated 

problems, * * * have arisen in the administration of the provisions 

permitting the filing of consolidated returns’’ and that the committee ‘‘found it necessary to delegate power to the commissioner 

to prescribe regulations legislative in character covering them.’’ 182

The Court’s opinion also cited a previous decision of the Court of 

Claims for the proposition, interpreting this legislative history, that 

section 1502 grants the Secretary ‘‘the power to conform the applicable income tax law of the Code to the special, myriad problems 

resulting from the filing of consolidated income tax returns;’’ but 

that section 1502 ‘‘does not authorize the Secretary to choose a 

method that imposes a tax on income that would not otherwise be 

taxed.’’ 183

The Federal Circuit Court construed these authorities and applied them to invalidate Treas. Reg. Sec. 1.1502–20(c)(1)(iii), stating that:

The loss realized on the sale of a former subsidiary’s assets after the consolidated group sells the subsidiary’s 

stock is not a problem resulting from the filing of consolidated income tax returns. The scenario also arises where 

a corporate shareholder sells the stock of a non-consolidated subsidiary. The corporate shareholder could realize 

a loss under I.R.C. sec. 1001, and deduct the loss under 

I.R.C. sec. 165. The subsidiary could then deduct any 

losses from a later sale of assets. The duplicated loss factor, therefore, addresses a situation that arises from the 

sale of stock regardless of whether corporations file separate or consolidated returns. With I.R.C. secs. 382 and 383, 

93

184 Rite Aid, 255 F.3d at 1360. 185See Temp. Reg. 1.1502–20T(i)(2). The Treasury Department has also indicated its intention 

to continue to study all the issues that the original loss disallowance regulations addressed (including issues of furthering single entity principles) and possibly issue different regulations (not 

including the particular approach of Treas. Reg. Sec. 1.1502–20(c)(1)(iii)) on the issues in the 

future. See Notice 2002–11, 2002–7 I.R.B. 526 (Feb. 19, 2002); T.D. 8984, 67 F.R. 11034 (March 

12, 2002); REG–102740–02, 67 F.R. 11070 (March 12, 2002); see also Notice 2002–18, 2002–12 

I.R.B. 644 (March 25, 2002). 

Congress has addressed this situation by limiting the subsidiary’s potential future deduction, not the parent’s loss 

on the sale of stock under I.R.C. sec. 165.184

The Treasury Department has announced that it will not continue to litigate the validity of the duplicated loss provision of the 

regulations, and has issued interim regulations that permit taxpayers for all years to elect a different treatment, though they may 

apply the provision for the past if they wish.185

REASONS FOR CHANGE

The Committee is concerned that the language and analysis in 

the Rite Aid decision might lead taxpayers to attempt to challenge 

other Treasury consolidated return regulations that prescribe a tax 

result different from the result that would occur if separate returns 

were filed. 

The Committee is concerned that any such challenges may lead 

to protracted litigation and commitment of Internal Revenue Service resources to defending the consolidated return provisions. 

The Committee wishes to clarify that the fact that a result under 

the consolidated return regulations differs from the result under 

separate returns does not provide a basis to challenge a Treasury 

consolidated return regulation.

The Committee believes that the result of the case with respect 

to the type of factual situation in Rite Aid, involving the ‘‘duplicated loss factor’’ portion of Treasury Regulation section 1.1502–20, 

which Treasury has announced that taxpayers need not follow, 

should not be overturned. Therefore, the committee legislatively allows the specific result of the case to stand for the taxpayer in Rite 

Aid or any similarly situated taxpayers. 

Apart from that specific result, the Committee disagrees with the 

reasoning of the case and believes it should not be applied to support any challenge to other consolidated return regulations. The 

Committee also wishes to reaffirm the broad authority of the 

Treasury Department to issue consolidated return regulations. 

EXPLANATION OF PROVISION

The provision confirms that, in exercising its authority under 

section 1502 to issue consolidated return regulations, the Treasury 

Department may provide rules treating corporations filing consolidated returns differently from corporations filing separate returns. 

Thus, under the statutory authority of section 1502, the Treasury 

Department is authorized to issue consolidated return regulations 

utilizing either a single taxpayer or separate taxpayer approach or 

a combination of the two approaches, as Treasury deems necessary 

in order that the tax liability of any affiliated group of corporations 

making a consolidated return, and of each corporation in the group, 

both during and after the period of affiliation, may be determined 

reasons for change 94

186Treas. Reg. Sec. 1.1502–20(c)(1)(iii). 187The Committee does not intend to overrule the current Treasury Department regulations, 

which allow taxpayers for the past to follow Treasury Regulations Section 1.1502–20(c)(1)(iii), 

if they choose to do so. Temp. Reg. Sec. 1.1502–20T(i)(2). 188See, e.g., Notice 2002–11, 2002–7 I.R.B. 526 (Feb. 19, 2002); T.D. 8984, 67 F.R. 11034 

(Mar.12, 2002); REG–102740–02, 67 F.R. 11070 (Mar.12, 2002); see also Notice 2002–18, 2002– 12 I.R.B. 644 (Mar. 25, 2002). In exercising its authority under section 1502, the Secretary is 

also authorized to prescribe rules that protect the purpose of General Utilities repeal using presumptions and other simplifying conventions. 

and adjusted in such manner as clearly to reflect the income-tax 

liability and the various factors necessary for the determination of 

such liability, and in order to prevent avoidance of such liability. 

Rite Aid is thus overruled to the extent it suggests that there is 

not a problem that can be addressed in consolidated return regulations if application of a particular Code provision on a separate taxpayer basis would produce a result different from single taxpayer 

principles that may be used for consolidation. 

The provision nevertheless allows the result of the Rite Aid case 

to stand with respect to the type of factual situation presented in 

the case. That is, the legislation provides for the override of the 

regulatory provision that took the approach of denying a loss on a 

deconsolidating disposition of stock of a consolidated subsidiary 186

to the extent the subsidiary had net operating losses or built in 

losses that could be used later outside the group.187

Retaining the result in the Rite Aid case with respect to the particular regulation section 1.1502–20(c)(1)(iii) as applied to the factual situation of the case does not in any way prevent or invalidate 

the various approaches Treasury has announced it will apply or 

that it intends to consider in lieu of the approach of that regulation, including, for example, the denial of a loss on a stock sale if 

inside losses of a subsidiary may also be used by the consolidated 

group, and the possible requirement that inside attributes be adjusted when a subsidiary leaves a group.188

EFFECTIVE DATE

The provision is effective for all years, whether beginning before, 

on, or after the date of enactment of the provision. 

No inference is intended that the results following from this provision are not the same as the results under present law.

B. TAX TREATMENT OF INVERSION TRANSACTIONS

(Sec. 641 of the bill and new sec. 7874 of the Code) 

PRESENT LAW

Determination of corporate residence 

The U.S. tax treatment of a multinational corporate group depends significantly on whether the top-tier ‘‘parent’’ corporation of 

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

corporation is treated as domestic if it is incorporated under the 

law of the United States or of any State. All other corporations 

(i.e., those incorporated under the laws of foreign countries) are 

treated as foreign. Thus, place of incorporation determines whether 

a corporation is treated as domestic or foreign for purposes of U.S. 

tax law, irrespective of other factors that might be thought to bear 

on a corporation’s ‘‘nationality,’’ such as the location of the corporaVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00094 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
95

tion’s management activities, employees, business assets, operations, or revenue sources, the exchanges on which the corporation’s stock is traded, or the residence of the corporation’s managers and shareholders. 

U.S. taxation of domestic corporations 

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

which domestic corporations generally are taxed on all income, 

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

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

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

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

on such income is generally deferred. However, certain anti-deferral regimes may cause the domestic parent corporation to be taxed 

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

subsidiaries, regardless of whether the income has been distributed 

as a dividend to the domestic parent corporation. The main antideferral regimes in this context are the controlled foreign corporation rules of subpart F (sections 951–964) and the passive foreign 

investment company rules (sections 1291–1298). A foreign tax credit is generally available to offset, in whole or in part, the U.S. tax 

owed on this foreign-source income, whether repatriated as an actual dividend or included under one of the anti-deferral regimes. 

U.S. taxation of foreign corporations 

The United States taxes foreign corporations only on income that 

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

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

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

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

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

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

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

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

U.S. tax treatment of inversion transactions 

Under present law, U.S. corporations may reincorporate in foreign jurisdictions and thereby replace the U.S. parent corporation 

of a multinational corporate group with a foreign parent corporation. These transactions are commonly referred to as ‘‘inversion’’

reasons for change 96

transactions. Inversion transactions may take many different 

forms, including stock inversions, asset inversions, and various 

combinations of and variations on the two. Most of the known 

transactions to date have been stock inversions. In one example of 

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

which in turn forms a domestic merger subsidiary. The domestic 

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

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

corporation. The U.S. corporation’s shareholders receive shares of 

the foreign corporation and are treated as having exchanged their 

U.S. corporation shares for the foreign corporation shares. An asset 

inversion reaches a similar result, but through a direct merger of 

the top-tier U.S. corporation into a new foreign corporation, among 

other possible forms. An inversion transaction may be accompanied 

or followed by further restructuring of the corporate group. For example, in the case of a stock inversion, in order to remove income 

from foreign operations from the U.S. taxing jurisdiction, the U.S. 

corporation may transfer some or all of its foreign subsidiaries directly to the new foreign parent corporation or other related foreign 

corporations. 

In addition to removing foreign operations from the U.S. taxing 

jurisdiction, the corporate group may derive further advantage 

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

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

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

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

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

available to other multinational corporate groups with foreign parents and U.S. subsidiaries, subject to the same limitations. These 

limitations under present law include section 163(j), which limits 

the deductibility of certain interest paid to related parties, if the 

payor’s debt-equity ratio exceeds 1.5 to 1 and the payor’s net interest expense exceeds 50 percent of its ‘‘adjusted taxable income.’’

More generally, section 482 and the regulations thereunder require 

that all transactions between related parties be conducted on terms 

consistent with an ‘‘arm’s length’’ standard, and permit the Secretary of the Treasury to reallocate income and deductions among 

such parties if that standard is not met. 

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

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

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

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

value has declined, and/or it has many foreign or tax-exempt shareholders, the impact of this section 367(a) ‘‘toll charge’’ is reduced. 

The transfer of foreign subsidiaries or other assets to the foreign 

parent corporation also may give rise to U.S. tax consequences at 

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

inclusions under sections 1001, 311(b), 304, 367, 1248 or other provisions). The tax on any income recognized as a result of these 

97

restructurings may be reduced or eliminated through the use of net 

operating losses, foreign tax credits, and other tax attributes. 

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

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

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

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

REASONS FOR CHANGE

The Committee believes that inversion transactions resulting in 

a minimal presence in a foreign country of incorporation are a 

means of avoiding U.S. tax and should be curtailed. In particular, 

these transactions permit corporations and other entities to continue to conduct business in the same manner as they did prior to 

the inversion, but with the result that the inverted entity avoids 

U.S. tax on foreign operations and may engage in earnings-stripping techniques to avoid U.S. tax on domestic operations. The Committee believes that certain inversion transactions (involving 80 

percent or more identity of stock ownership) have little or no nontax effect or purpose and should be disregarded for U.S. tax purposes. The Committee believes that other inversion transactions 

(involving more than 50 but less than 80 percent identity of stock 

ownership) may have sufficient non-tax effect and purpose to be respected, but warrant heightened scrutiny and other restrictions to 

ensure that the U.S. tax base is not eroded through related-party 

transactions. 

EXPLANATION OF PROVISION

In general 

The provision defines two different types of corporate inversion 

transactions and establishes a different set of consequences for 

each type. Certain partnership transactions also are covered. 

Transactions involving at least 80 percent identity of stock ownership 

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

a plan or a series of related transactions: (1) a U.S. corporation becomes a subsidiary of a foreign-incorporated entity or otherwise 

transfers substantially all of its properties to such an entity; (2) the 

former shareholders of the U.S. corporation hold (by reason of holding stock in the U.S. corporation) 80 percent or more (by vote or 

value) of the stock of the foreign-incorporated entity after the 

transaction; and (3) the foreign-incorporated entity, considered together with all companies connected to it by a chain of greater than 

50 percent ownership (i.e., the ‘‘expanded affiliated group’’), does 

not have substantial business activities in the entity’s country of 

incorporation, compared to the total worldwide business activities 

of the expanded affiliated group. The provision denies the intended 

tax benefits of this type of inversion by deeming the top-tier foreign 

reasons for change 98

189Since the top-tier foreign corporation would be treated for all purposes of the Code as domestic, the shareholder-level ‘‘toll charge’’ of sec. 367(a) would not apply to these inversion 

transactions. 

corporation to be a domestic corporation for all purposes of the 

Code.189

In determining whether a transaction would meet the definition 

of an inversion under the provision, stock held by members of the 

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

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

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

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

stock of the new foreign corporation would be disregarded. Stock 

sold in a public offering related to the transaction also is disregarded for these purposes. 

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

purpose of which is to avoid the purposes of the provision are disregarded. In addition, the Treasury Secretary is granted authority 

to prevent the avoidance of the purposes of the provision, including 

avoidance through the use of related persons, pass-through or other 

noncorporate entities, or other intermediaries, and through transactions designed to qualify or disqualify a person as a related person or a member of an expanded affiliated group. Similarly, the 

Treasury Secretary is granted authority to treat certain non-stock 

instruments as stock, and certain stock as not stock, where necessary to carry out the purposes of the provision. 

Transactions involving greater than 50 percent but less than 80 percent identity of stock ownership 

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

definition of an inversion transaction described above, except that 

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

a greater-than-50-percent ownership threshold is met, then a second set of rules applies to the inversion. Under these rules, the inversion transaction is respected (i.e., the foreign corporation is 

treated as foreign), but: (1) any applicable corporate-level ‘‘toll 

charges’’ for establishing the inverted structure may not be offset 

by tax attributes such as net operating losses or foreign tax credits; 

(2) the IRS is given expanded authority to monitor related-party 

transactions that may be used to reduce U.S. tax on U.S.-source income going forward; and (3) section 163(j), relating to ‘‘earnings 

stripping’’ through related-party debt, is strengthened. These measures generally apply for a 10–year period following the inversion 

transaction. In addition, inverting entities are required to provide 

information to shareholders or partners and the IRS with respect 

to the inversion transaction. 

With respect to ‘‘toll charges,’’ any applicable corporate-level income or gain required to be recognized under sections 304, 311(b), 

367, 1001, 1248, or any other provision with respect to the transfer 

of controlled foreign corporation stock or other assets by a U.S. corporation as part of the inversion transaction or after such transaction to a related foreign person is taxable, without offset by any 

tax attributes (e.g., net operating losses or foreign tax credits). To 

99

the extent provided in regulations, this rule will not apply to certain transfers of inventory and similar transactions conducted in 

the ordinary course of the taxpayer’s business. 

In order to enhance IRS monitoring of related-party transactions, 

the provision establishes a new pre-filing procedure. Under this 

procedure, the taxpayer will be required annually to submit an application to the IRS for an agreement that all return positions to 

be taken by the taxpayer with respect to related-party transactions 

comply with all relevant provisions of the Code, including sections 

163(j), 267(a)(3), 482, and 845. The Treasury Secretary is given the 

authority to specify the form, content, and supporting information 

required for this application, as well as the timing for its submission. 

The IRS will be required to take one of the following three actions within 90 days of receiving a complete application from a taxpayer: (1) conclude an agreement with the taxpayer that the return 

positions to be taken with respect to related-party transactions 

comply with all relevant provisions of the Code; (2) advise the taxpayer that the IRS is satisfied that the application was made in 

good faith and substantially complies with the requirements set 

forth by the Treasury Secretary for such an application, but that 

the IRS reserves substantive judgment as to the tax treatment of 

the relevant transactions pending the normal audit process; or (3) 

advise the taxpayer that the IRS has concluded that the application was not made in good faith or does not substantially comply 

with the requirements set forth by the Treasury Secretary. 

In the case of a compliance failure described in (3) above (and in 

cases in which the taxpayer fails to submit an application), the following sanctions will apply for the taxable year for which the application was required: (1) no deductions or additions to basis or cost 

of goods sold for payments to foreign related parties will be permitted; (2) any transfers or licenses of intangible property to related foreign parties will be disregarded; and (3) any cost-sharing 

arrangements will not be respected. 

If the IRS fails to act on the taxpayer’s application within 90 

days of receipt, then the taxpayer will be treated as having submitted in good faith an application that substantially complies with 

the above-referenced requirements. Thus, the deduction disallowance and other sanctions described above will not apply, but the 

IRS will be able to examine the transactions at issue under the 

normal audit process. The IRS is authorized to request that the 

taxpayer extend this 90-day deadline in cases in which the IRS believes that such an extension might help the parties to reach an 

agreement. 

The ‘‘earnings stripping’’ rules of section 163(j), which deny or 

defer deductions for certain interest paid to foreign related parties, 

are strengthened for inverted corporations. With respect to such 

corporations, the provision eliminates the debt-equity threshold 

generally applicable under section 163(j) and reduces the 50-percent thresholds for ‘‘excess interest expense’’ and ‘‘excess limitation’’ to 25 percent. In cases in which a U.S. corporate group acquires subsidiaries or other assets from an unrelated inverted corporate group, the provisions described above generally do not apply 

to the acquiring U.S. corporate group or its related parties (including the newly acquired subsidiaries or assets) by reason of acquirVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00099 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
reasons for change 100

190Sec. 845(a). 191See S. Rep. No. 97–494, ‘‘Tax Equity and Fiscal Responsibility Act of 1982,’’ July 12, 1982, 

337 (describing provisions relating to the repeal of modified coinsurance provisions). 

ing the subsidiaries or assets that were connected with the inversion transaction. The Treasury Secretary is given authority to issue 

regulations appropriate to carry out the purposes of this provision 

and to prevent its abuse. 

Partnership transactions 

Under the provision, both types of inversion transactions include 

certain partnership transactions. Specifically, both parts of the provision apply to transactions in which a foreign-incorporated entity 

acquires substantially all of the properties constituting a trade or 

business of a domestic partnership, if after the acquisition at least 

80 percent (or more than 50 percent but less than 80 percent, as 

the case may be) of the stock of the entity is held by former partners of the partnership (by reason of holding their partnership interests), and the ‘‘substantial business activities’’ test is not met. 

For purposes of determining whether these tests are met, all partnerships that are under common control within the meaning of section 482 are treated as one partnership, except as provided otherwise in regulations. In addition, the modified ‘‘toll charge’’ provisions apply at the partner level. 

EFFECTIVE DATE

The regime applicable to transactions involving at least 80 percent identity of ownership applies to inversion transactions completed after March 20, 2002. The rules for inversion transactions 

involving greater-than-50-percent identity of ownership apply to inversion transactions completed after 1996 that meet the 50-percent 

test and to inversion transactions completed after 1996 that would 

have met the 80-percent test but for the March 20, 2002 date.

C. REINSURANCE AGREEMENTS

(Sec. 651 of the bill and sec. 845 of the Code) 

PRESENT LAW

In the case of a reinsurance agreement between two or more related persons, present law provides the Treasury Secretary with 

authority to allocate among the parties or recharacterize income 

(whether investment income, premium or otherwise), deductions, 

assets, reserves, credits and any other items related to the reinsurance agreement, or make any other adjustment, in order to reflect 

the proper source and character of the items for each party.190 For 

this purpose, related persons are defined as in section 482. Thus, 

persons are related if they are organizations, trades or businesses 

(whether or not incorporated, whether or not organized in the 

United States, and whether or not affiliated) that are owned or 

controlled directly or indirectly by the same interests. The provision may apply to a contract even if one of the related parties is 

not a domestic company.191 In addition, the provision also permits 

such allocation, recharacterization, or other adjustments in a case 

in which one of the parties to a reinsurance agreement is, with respect to any contract covered by the agreement, in effect an agent 

101

192The authority to allocate, recharacterize or make other adjustments was granted in connection with the repeal of provisions relating to modified coinsurance transactions. 

of another party to the agreement, or a conduit between related 

persons. 

REASONS FOR CHANGE

The Committee is concerned that reinsurance transactions are 

being used to allocate income, deductions, or other items inappropriately among U.S. and foreign related persons. The Committee is 

concerned that foreign related party reinsurance arrangements 

may be a technique for erosion of the U.S. tax base. The Committee 

believes that the provision of present law permitting the Treasury 

Secretary to allocate or recharacterize items related to a reinsurance agreement should be applied to prevent misallocation, improper characterization, or to make any other adjustment in the 

case of such reinsurance transactions between U.S. and foreign related persons (or agents or conduits). The Committee also wishes 

to clarify that, in applying the authority with respect to reinsurance agreements, the amount, source or character of the items may 

be allocated, recharacterized or adjusted. 

EXPLANATION OF PROVISION

The provision clarifies the rules of section 845, relating to authority for the Treasury Secretary to allocate items among the parties to a reinsurance agreement, recharacterize items, or make any 

other adjustment, in order to reflect the proper source and character of the items for each party. The provision authorizes such allocation, recharacterization, or other adjustment, in order to reflect 

the proper source, character or amount of the item. It is intended 

that this authority 192 be exercised in a manner similar to the authority under section 482 for the Treasury Secretary to make adjustments between related parties. It is intended that this authority be applied in situations in which the related persons (or agents 

or conduits) are engaged in cross- border transactions that require 

allocation, recharacterization, or other adjustments in order to reflect the proper source, character or amount of the item or items. 

No inference is intended that present law does not provide this authority with respect to reinsurance agreements. 

The Committee notes that no regulations have been issued under 

section 845(a). The Committee expects that the Treasury Department shall issue regulations under section 845(a) to address effectively the allocation of income (whether investment income, premium or otherwise) and other items, the recharacterization of such 

items, or any other adjustment necessary to reflect the proper 

amount, source or character of the item. 

EFFECTIVE DATE

The provision is effective for any risk reinsured after April 11, 

2002.

reasons for change 102

193 An Act to provide that members of the Armed Forces performing services for the peacekeeping efforts in Bosnia and Herzegovina, Croatia, and Macedonia shall be entitled to tax benefits in the same manner as if such services were performed in a combat zone, and for other purposes (March 20, 1996). 194These user fees were originally enacted in section 10511 of the Revenue Act of 1987 (Public 

Law 100–203, December 22, 1987). 

D. EXTENSION OF IRS USER FEES

(Sec. 661 of the bill and new sec. 7527 of the Code) 

PRESENT LAW

The IRS provides written responses to questions of individuals, 

corporations, and organizations relating to their tax status or the 

effects of particular transactions for tax purposes. The IRS generally charges a fee for requests for a letter ruling, determination 

letter, opinion letter, or other similar ruling or determination. Public Law 104–117 193 extended the statutory authorization for these 

user fees 194 through September 30, 2003. 

REASONS FOR CHANGE

The Committee believes that it is appropriate to extend the statutory authorization for these user fees. 

EXPLANATION OF PROVISION

The bill extends the statutory authorization for these user fees 

through June 30, 2008. The bill also moves the statutory authorization for these fees into the Internal Revenue Code. 

EFFECTIVE DATE

The provision, including moving the statutory authorization for 

these fees into the Code and repealing the off-Code statutory authorization for these fees, is effective for requests made after the 

date of enactment. 

E. EXTENSION OF CUSTOMS SERVICE USER FEES

(Sec. 671 of the bill) 

PRESENT LAW

Section 13031(j)(3) of the Consolidated Omnibus Budget Reconciliation Act of 1985 (19 U.S.C. 58c(j)(3)) authorizes the temporary imposition and collection of custom user fees in connection 

with services provided by the United States Customs Service. The 

authorization is scheduled to expire on September 30, 2003. 

REASONS FOR CHANGE

The Committee believes that it is appropriate to extend the statutory authorization for these user fees. 

EXPLANATION OF PROVISION

The provision extends the authority to impose and collect custom 

user fees through June 30, 2008, provided, however, that any revenue generated from such custom user fees may be used only to 

fund the operations of the United States Customs Service. 

103

EFFECTIVE DATE

The provision is effective on the date of enactment.

III. BUDGET EFFECTS OF THE BILL 

A. COMMITTEE ESTIMATES

In compliance with paragraph 11(a) of rule XXVI of the Standing 

Rules of the Senate, the following statement is made concerning 

the estimated budget effects of the committee amendment to the 

bill as reported.

reasons for change 104


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Insert offset folio 128 here SR211.002
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Insert offset folio 130 here SR211.004
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B. BUDGET AUTHORITY AND TAX EXPENDITURES

Budget authority 

In compliance with section 308(a)(1) of the Budget Act, the Committee states that the revenue provisions of the committee amendment to the bill as reported involve new or increased budget authority. 

Tax expenditures 

In compliance with section 308(a)(2) of the Budget Act, the Committee states that the revenue-reducing provisions of the committee 

amendment to the bill involve increased expenditures (see revenue 

table in Part III.A., above). The revenue increasing provisions of 

the Committee amendment to the bill involve reduced expenditures 

(see revenue table in Part III.A., above). 

C. CONSULTATION WITH CONGRESSIONAL BUDGET OFFICE

In accordance with section 403 of the Budget Act, the Committee 

advises that the Congressional Budget Office has not submitted a 

statement on the committee amendment to the bill. The letter from 

the Congressional Budget Office was not received in a timely manner, and therefore will be provided separately. 

IV. VOTES OF THE COMMITTEE 

In compliance with paragraph 7(b) of rule XXVI of the Standing 

Rules of the Senate, the following statements are made concerning 

the votes taken on the Committee’s consideration of the amendment to the bill. 

Motion to report the committee amendment 

The amendment to the bill was ordered favorably reported by a 

voice vote, a quorum being present, on June 18, 2002. 

Votes on other amendments 

An amendment by Senator Breaux to increase the percentage 

limitations on certain scholarship grant programs of private foundations was agreed to by a voice vote. 

An amendment by Senator Grassley to provide a tax credit for 

qualified financial institutions that have an individual development 

account program was agreed to by a voice vote. 

An amendment by Senator Gramm to strike the provision excluding 25 percent of the capital gain on sales of land or interests in 

land made for conservation purposes was not agreed to by a voice 

vote. 

An amendment by Senator Baucus in a Chairman’s modification 

to the bill adding the provision regarding the affirmation of the 

consolidated return regulation authority was agreed to by voice 

vote.

V. REGULATORY IMPACT AND OTHER MATTERS 

A. REGULATORY IMPACT

Pursuant to paragraph 11(b) of rule XXVI of the Standing Rules 

of the Senate, the Committee makes the following statement conVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00108 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
109

cerning the regulatory impact that might be incurred in carrying 

out the provisions of the bill as amended. 

Impact on individuals and businesses 

With respect to the provisions that do not increase revenue, the 

committee amendment to the bill modifies the rules relating to (1) 

certain charitable giving incentives; (2) disclosure of information 

relating to tax-exempt organizations; (3) tax treatment and procedures relating to exempt organizations; (4) restoration of funds for 

the Social Services Block Grant; and (5) individual development accounts. The Social Services Block Grant provisions provide increased funding to States to support a variety of social services. 

Under the other provisions listed above, taxpayers may elect 

whether to avail themselves of the provisions. Thus, the provisions 

do not impose increased regulatory burdens on individuals or businesses. 

With respect to the revenue-increasing provisions, the committee 

amendment to the bill modifies the rules relating to (1) the disclosure of reportable transactions and tax shelters; (2) the substantial 

understatement penalty; (3) actions to enjoin conduct with respect 

to tax shelters; (4) an understatement of a taxpayer’s liability by 

an income tax return preparer; (5) the imposition of a civil penalty 

(of up to $5,000) on a failure to report interest in foreign financial 

accounts; (6) frivolous tax submissions; and (7) inversion and certain partnership transactions. These provisions relate to taxpayers 

that engage in certain tax avoidance transactions; taxpayers that 

have not undertaken or planned to undertake such transactions 

generally are not affected by the provisions of the bill. Thus, the 

revenue provisions generally do not impose increased regulatory 

burdens on individuals or businesses. 

Impact on personal privacy and paperwork 

The provisions of the committee amendment to the bill do not impact personal privacy. Individuals either elect whether to avail 

themselves of the provisions of the committee amendment to the 

bill or are subject to the committee amendment to the bill for engaging in certain tax avoidance transactions. The bill does not impose increased paperwork burdens on individuals. Individuals who 

elect to take advantage of provisions in the committee amendment 

to the bill may in some cases need to keep records in order to demonstrate that they qualify for the treatment provided. Individuals 

who elect to engage in tax avoidance transactions, and certain advisors who provide material aid, assistance, or advice with respect to 

such transactions, may in some cases need to file certain disclosure 

statements with the IRS. 

B. UNFUNDED MANDATES STATEMENT

The information is provided in accordance with section 423 of the 

Unfunded Mandates Reform Act of 1995 (P.L. 104–4). 

The Committee has determined that the following provisions of 

the bill contain Federal mandates on the private sector: (1) provisions relating to reportable transactions and tax shelters; (2) modifications to the substantial understatement penalty; (3) actions to 

enjoin conduct with respect to tax shelters; (4) understatement of 

taxpayer’s liability by an income tax return preparer; (5) the impoVerDate jun 06 2002 06:05 Jul 20, 2002 Jkt 099010 PO 00000 Frm 00109 Fmt 6659 Sfmt 6602 E:\HR\OC\SR211.XXX pfrm15 PsN: SR211
reasons for change 110

sition of a civil penalty (of up to $5,000) on a failure to report interest in foreign financial accounts; (6) frivolous tax submissions; and 

(7) provisions relating to the tax treatment of inversion transactions and reinsurance agreements. 

The costs required to comply with each Federal private sector 

mandate generally are no greater than the estimated budget effect 

of the provision. Benefits from the provisions include improved administration of the Federal income tax laws and a more accurate 

measurement of income for Federal income tax purposes. 

C. TAX COMPLEXITY ANALYSIS

Section 4022(b) of the Internal Revenue Service Reform and Restructuring Act of 1998 (the ‘‘IRS Reform Act’’) requires the Joint 

Committee on Taxation (in consultation with the Internal Revenue 

Service and the Department of the Treasury) to provide a tax complexity analysis. The complexity analysis is required for all legislation reported by the Senate Committee on Finance, the House 

Committee on Ways and Means, or any committee of conference if 

the legislation includes a provision that directly or indirectly 

amends the Internal Revenue Code (the ‘‘Code’’) and has widespread applicability to individuals or small businesses. For each 

such provision identified by the staff of the Joint Committee on 

Taxation, a summary description of the provision is provided, along 

with an estimate of the number and type of affected taxpayers, and 

a discussion regarding the relevant complexity and administrative 

issues. Following the analysis of the staff of the Joint Committee 

on Taxation are the comments of the IRS regarding each provision 

included in the complexity analysis, including a discussion of the 

likely effect on IRS forms and any expected impact on the IRS. 

Direct charitable deduction for nonitemizers (sec. 101 of the bill) 

Summary description of provision 

In the case of an individual taxpayer who does not itemize deductions, the bill would allow a direct charitable deduction from adjusted gross income for charitable contributions paid in cash. This 

deduction would be allowed in addition to the standard deduction. 

The deduction would be available only for that portion of contributions that in the aggregate exceed $250 ($500 in the case of a joint 

return). The maximum deduction would be $250 ($500 in the case 

of a joint return). The direct charitable deduction generally would 

be subject to the tax rules normally governing charitable contribution deductions, such as the substantiation requirements. The deduction would be allowed in computing alternative minimum taxable income. The direct charitable deduction would be effective for 

taxable years beginning after December 31, 2001, and before January 1, 2004. 

Number of affected taxpayers 

It is estimated that the provision could affect up to 85 million individual income tax returns each year the deduction is in effect. 

Discussion 

Individuals who do not itemize their deductions will need to keep 

additional records (e.g., canceled checks, a receipt from the donee 

111

organization, or other reliable written records) in order to substantiate that a contribution was made to a qualified charitable organization. The information necessary to implement the provision 

should be readily available to taxpayers (in the form of new tax return forms and instructions). The direct charitable deduction is expected to require an additional line on the individual income tax 

return forms. The provision might result in an increase in disputes 

with the IRS for taxpayers who are unable to substantiate a 

claimed deduction. Additional regulatory guidance will not be necessary to implement this provision. Any increase in tax preparation 

costs is expected be negligible.

(113)

DEPARTMENT OF THE TREASURY, 

INTERNAL REVENUE SERVICE, 

Washington, DC, June 24, 2002. 

Ms. LINDY L. PAULL, 

Chief of Staff, Joint Committee on Taxation, 

Washington, DC. 

DEAR MS. PAULL: Enclosed are the combined comments of the Internal Revenue Service and the Treasury Department on the provision for a charitable deduction for non-itemizers from the Senate 

Finance Committee’s markup of H.R. 7 the ‘‘Care Act of 2002,’’ that 

you identified for complexity analysis in your letter of June 19, 

2002. Our comments are based on the description of that provision 

in your letter and in JCX–57–02, Joint Committee on Taxation, Description of the Care Act of 2002, June 11, 2002. 

Due to the short turnaround time, our comments are provisional 

and subject to change upon a more complete and in-depth analysis 

of the provision. 

Sincerely, 

CHARLES O. ROSSOTTI, 

Commissioner. 

Enclosure. 

COMPLEXITY ANALYSIS OF PROVISION FROM H.R. 7, THE CARE ACT

OF 2002

CHARITABLE DEDUCTION FOR NON-ITEMIZERS

Provision: Taxpayers who do not itemize would be allowed to deduct their cash contributions to qualified charitable organizations 

in addition to claiming the standard deduction. This deduction 

would be calculated as the lesser of (a) the excess, if any, of the 

charitable contributions over $250 ($500 in the case of a joint return) or (b) $250 ($500 in the case of a joint return). The tax rules 

that apply to the charitable contribution deduction allowed to 

itemizers would generally apply to this deduction. The non-itemizer 

deduction would not be a preference item for purposes of the alternative minimum tax and would not affect the calculation of adjusted gross income (AGI). The proposal would be effective for tax 

years beginning after December 31, 2001, and before January 1, 

2004. 

IRS and Treasury comments 

Two lines would have to be added to Forms 1040, 1040A, 

1040EZ, 1040NR, and 1040NR–EZ for 2002 and 2003; one for the 

allowable deduction and one to reflect the total of the standard deduction and the charitable contribution deduction. One line would 

be added to the TeleFile Tax Record for 2002 and 2003 (taxpayers 

114

would enter their total contributions on the new line and TeleFile 

would calculate the allowable deduction). No new forms would be 

required. 

The new deduction would also have to be reflected on Form 

1040–ES for 2003 and in the instructions for Forms 1040X and 

1045 for 2002 and 2003. Subsequent to enactment, the IRS may 

have to advise taxpayers who make estimated tax payments for 

2002 how they can adjust their estimated tax payments for 2002 

to reflect the new deduction. 

Information necessary for taxpayers to determine their eligibility 

for the deduction, including the AGI limitation applicable to cash 

contributions, and the substantiation requirements would have to 

be reflected in the 2002 and 2003 instructions for Forms 1040, 

1040A, 1040EZ, 1040NR, and 1040NR–EZ and for TeleFile. 

A worksheet (consisting of four lines) for taxpayers to calculate 

their allowable deduction would have to be reflected in the 2002 

and 2003 instructions for Forms 1040, 1040A, 1040EZ, 1040NR, 

and 1040NR–EZ. 

Changes to the Telefile script for 2002 and 2003 would be required to allow the deduction to taxpayers who use TeleFile. 

All of the above changes would have to be reversed for tax years 

beginning after December 31, 2003, to reflect the termination of the 

charitable deduction for non-itemizers (e.g., the lines would be removed from the Form 1040 series of returns, the worksheet would 

be removed from the instructions for these returns, and programming and script changes would be necessary to eliminate the deduction). 

Ensuring compliance with the new charitable deduction would be 

difficult. The only means of verifying amounts deducted would be 

through examination, which is not practical because of the relatively small amounts involved. 

The direct charitable deduction line on the 2002 and 2003 Form 

1040 series of returns would need to be transcribed and incorporated into our computation of taxable income. The programming 

changes needed to effectuate this for 2003 processing (of 2002 returns) will put a strain on IRS’ ability to complete and test other 

programming needed for the 2003 filing season. Since IRS is well 

into its program development for January 2003, we recommend 

that the effective date be delayed so that the provision would be 

effective for tax years beginning in 2003 and 2004. A delayed effective date would be especially important if the provision were not 

enacted before September 2002. 

VI. CHANGES IN EXISTING LAW MADE BY THE BILL AS 

REPORTED 

In the opinion of the Committee, it is necessary in order to expedite the business of the Senate, to dispense with the requirements 

of paragraph 12 of rule XXVI of the Standing Rules of the Senate 

(relating to the showing of changes in existing law made by the bill 

as reported by the Committee).

Æ