DESCRIPTION OF THE

“SMALL BUSINESS AND FARM ECONOMIC RECOVERY ACT”

Scheduled for a Markup

By the

SENATE COMMITTEE ON FINANCE

on

September 19, 2002

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

September 17, 2002

JCX-88-02
i

CONTENTS

Page

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

A. Provisions to Promote Small Business Investment............................................................. 2

1. Increase in section 179 expensing....................................................................................... 2

2. Recovery period for depreciation of certain leasehold improvements ............................... 3

3. Exclusion of certain indebtedness of small business investment companies from

 acquisition indebtedness ..................................................................................................... 4

B. Provisions to Simplify Small Business Taxation................................................................ 6

1. Disclosure of tax information to facilitate combined employment tax reporting

 (STAWRS).......................................................................................................................... 6

2. Increased deduction for business meals while operating under Department of

 Transportation hours of service limitations ......................................................................... 7

C. Provisions Relating to Tax Relief for Farmers, Ranchers and Fishermen.......................... 9

1. Farm, Fish and Ranch Risk Management accounts ............................................................ 9

2. Exclusion of rental income from self-employment tax..................................................... 10

3. Exclusion of conservation reserve program payments from self-employment tax........... 11

4. Exemption of agricultural bonds from private activity bond volume limits..................... 12

5. Coordinate farmers and fisherman income averaging and the alternative minimum

 tax...................................................................................................................................... 13

6. Modify cooperative marketing rules to include value added processing involving

 animals.............................................................................................................................. 13

7. Extend declaratory judgment procedures to farmers’ cooperative organizations............. 14

8. Payment of dividends on stock of cooperatives without reducing patronage dividends .. 15

9. Special rules for livestock sold on account of weather-related conditions ....................... 15

10. Farmer optional method for computing net earnings from self-employment ................. 17

11. Capital gains treatment to apply to outright sales of timber by landowner .................... 19

12. Expensing of certain reforestation expenditures............................................................. 20

D. Provisions Relating to S Corporation Reform and Simplification.................................... 21

1. Maximum number of shareholders of an S corporation ................................................... 21

2. Termination of election and additions to tax due to passive investment income ............. 21

3. Treatment of S corporation shareholders.......................................................................... 22

4. Provisions relating to banks .............................................................................................. 23

5. Qualified subchapter S subsidiaries.................................................................................. 25

E. Provisions to Promote Economic Development and Rural Investment............................ 26

1. Accelerated depreciation for investment in high out-migration counties......................... 26

2. Treatment of expenses of rural letter carriers’ vehicles.................................................... 29

3. Broadband internet access tax credit................................................................................. 30
ii

4. Broadband provisions relating to housing: modification to the low-income

 housing credit allocation criteria....................................................................................... 31

5. Modify qualified zone academy bond provisions to provide similar bonds for the

 construction of schools for the Bureau of Indian Affairs of the Department of

 the Interior......................................................................................................................... 32

6. Qualified small business stock.......................................................................................... 37

7. Modification to the work opportunity tax credit............................................................... 38

8. Treatment of new markets venture capital companies for the new markets tax credit..... 39

F. Provisions to Simplify Excise Taxes ................................................................................ 41

1. Simplification of excise tax imposed on bows and arrows............................................... 41

2. Custom gunsmiths............................................................................................................. 41

3. Repeal special occupational taxes on producers and marketers of alcoholic beverages .. 42

4. Treat tribal governments the same as State governments for purposes of the Federal

 wagering excise and occupational taxes ........................................................................... 43

G. Rate Reduction For Asbestos-Related Settlement Funds ................................................. 45

H. Provisions to Discourage Corporate Expatriation............................................................. 47

1. Tax treatment of inversion transactions ............................................................................ 47

2. Reinsurance agreements.................................................................................................... 52

3. Excise tax on stock compensation of insiders of inverted corporations ........................... 53

I. Provisions to Curtail Tax Shelters .................................................................................... 58

1. Clarification of the economic substance doctrine ............................................................. 58

2. Penalty for failure to disclose reportable transactions ...................................................... 64

3. Modifications to the accuracy-related penalties for listed transactions and reportable

 transactions having a significant tax avoidance purpose .................................................. 68

4. Penalty for understatements from transactions lacking economic substance ................... 72

5. Modifications to the substantial understatement penalty.................................................. 75

6. Tax shelter exception to confidentiality privileges relating to taxpayer

 communications ................................................................................................................ 76

7. Disclosure of reportable transactions by material advisors.............................................. 76

8. Investor lists and modification of penalty for failure to maintain investor lists ............... 80

9. Actions to enjoin conduct with respect to tax shelters and reportable transactions.......... 81

10. Understatement of taxpayer’s liability by income tax return preparer........................... 82

11. Penalty for failure to report interests in foreign financial accounts................................ 82

12. Frivolous tax returns and submissions ............................................................................ 84

13. Regulation of individuals practicing before the Department of the Treasury................. 84

14. Penalties on promoters of tax shelters............................................................................. 85

15. Extend statute of limitations for certain undisclosed transactions.................................. 86

16. Deny deduction for interest paid to IRS on underpayments involving certain

 tax-motivated transactions .............................................................................................. 87

17. Modify section 162(f) for certain fines and penalties..................................................... 88

18. Authorize additional $300 million per year to the IRS to combat abusive tax

 avoidance transactions .................................................................................................... 89
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J. Other Provisions................................................................................................................ 90

1. Affirmation of consolidated return regulation authority................................................... 90

K. Provisions Relating to Fair Taxation of Executive Compensation................................... 95

1. Taxation of deferred compensation provided through offshore trusts.............................. 95

2. Repeal of limitation on issuance of Treasury guidance regarding nonqualified deferred

 compensation .................................................................................................................... 97

3. Required wage withholding at top marginal rate for supplemental wage payments in

 excess of $1 million ........................................................................................................ 100
1

INTRODUCTION

The Senate Committee on Finance has scheduled a markup on September 17, 2002, of the 

“Small Business and Farm Economic Recovery Act.” This document, 1 prepared by the staff of 

the Joint Committee on Taxation, provides a description of the “Small Business and Farm 

Economic Recovery Act.”

 

1

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

the “Small Business and Farm Economic Recovery Act” (JCX-88-02), September 17, 2002.
2

A. Provisions to Promote Small Business Investment

1. Increase in section 179 expensing

Present Law

Present law provides that, in lieu of depreciation, a taxpayer with a sufficiently small 

amount of annual investment may elect to deduct up to $24,000 ($25,000 for taxable years 

beginning in 2003 and thereafter) of the cost of qualifying property placed in service for the 

taxable year (sec. 179). In general, qualifying property is defined as depreciable tangible 

personal property that is purchased for use in the active conduct of a trade or business. The 

$24,000 ($25,000 for taxable years beginning in 2003 and thereafter) amount is reduced (but not 

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

taxable year exceeds $200,000. 

Additional section 179 incentives are provided with respect to a qualified property used 

by a business in the New York Liberty Zone (sec. 1400(f)) or an empowerment zone (sec. 

1397A). Such a business may elect to deduct an additional $35,000 of the cost of qualified 

property placed in service. In addition, the phase-out range is applied by taking into account 

only 50 percent of the cost of qualified zone property that is section 179 property.

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

for a taxable year that is derived from the active conduct of a trade or business (determined 

without regard to this provision). Any amount that is not allowed as a deduction because of the 

taxable income limitation may be carried forward to succeeding taxable years (subject to similar 

limitations). No general business credit under section 38 is allowed with respect to any amount 

for which a deduction is allowed under section 179.

Description of Proposal

The proposal provides that the maximum dollar amount that may be deducted under 

section 179 is increased to $30,000 for property placed in service in taxable years beginning after 

December 31, 2002.2 In addition, for taxable years beginning after December 31, 2006, the 

maximum dollar amount that may be deducted under section 179 and the present-law $200,000 

limit will be indexed for inflation on an annual basis.3

 As under present law, no general business 

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

under section 179. 

 

2

 Increases to this amount correspondingly increase the annual amount of qualified 

property that may be deducted by a business located in the New York Liberty Zone or an 

empowerment zone.

3

 The maximum amount of qualified property that a taxpayer may deduct is indexed for 

inflation in $1,000 increments while the present-law $200,000 limit is indexed for inflation in 

$10,000 increments. 
3

Effective Date

The proposal applies to taxable years beginning after December 31, 2002.

2. Recovery period for depreciation of certain leasehold improvements

Present Law

Depreciation of leasehold improvements

Depreciation allowances for property used in a trade or business generally are determined 

under the modified Accelerated Cost Recovery System (“MACRS”) of section 168. 

Depreciation allowances for improvements made on leased property are determined under 

MACRS, even if the MACRS recovery period assigned to the property is longer than the term of 

the lease (sec. 168(i)(8)).4 This rule applies regardless of whether the lessor or the lessee places 

the leasehold improvements in service.5

 If a leasehold improvement constitutes an addition or 

improvement to nonresidential real property already placed in service, the improvement is 

depreciated using the straight-line method over a 39-year recovery period, beginning in the 

month the addition or improvement was placed in service (secs. 168(b)(3), (c)(1), (d)(2), and 

(i)(6)).6

Qualified leasehold improvement property

The Job Creation and Worker Assistance Act of 20027 generally provides an additional 

first-year depreciation deduction equal to 30 percent of the adjusted basis of qualified property 

 

4

 The Tax Reform Act of 1986 modified the Accelerated Cost Recovery System 

("ACRS") to institute MACRS. Prior to the adoption of ACRS by the Economic Recovery Act 

of 1981, taxpayers were allowed to depreciate the various components of a building as separate 

assets with separate useful lives. The use of component depreciation was repealed upon the 

adoption of ACRS. The Tax Reform Act of 1986 also denied the use of component depreciation 

under MACRS.

5

 Former sections 168(f)(6) and 178 provided that, in certain circumstances, a lessee 

could recover the cost of leasehold improvements made over the remaining term of the lease. 

The Tax Reform Act of 1986 repealed these provisions.

6

 If the improvement is characterized as tangible personal property, ACRS or MACRS 

depreciation is calculated using the shorter recovery periods and accelerated methods applicable 

to such property. The determination of whether improvements are characterized as tangible 

personal property or as nonresidential real property often depends on whether or not the 

improvements constitute a “structural component” of a building (as defined by Treas. Reg. sec. 

1.48-1(e)(1)). See, for example, Metro National Corp., 52 TCM (CCH) 1440 (1987); King Radio 

Corp., 486 F.2d 1091 (10th Cir. 1973); Mallinckrodt, Inc., 778 F.2d 402 (8th Cir. 1985) (with 

respect to various leasehold improvements).

7

 Pub. Law No. 107-147.
4

placed in service before 2005. Qualified property includes qualified leasehold improvement 

property. For this purpose, qualified leasehold improvement property is any improvement to an 

interior portion of a building that is nonresidential real property, provided certain requirements 

are met. The improvement must be made under or pursuant to a lease either by the lessee (or 

sublessee), or by the lessor, of that portion of the building to be occupied exclusively by the

lessee (or sublessee). The improvement must be placed in service more than three years after the 

date the building was first placed in service. Qualified leasehold improvement property does not 

include any improvement for which the expenditure is attributable to the enlargement of the 

building, any elevator or escalator, any structural component benefiting a common area, or the 

internal structural framework of the building.

Treatment of dispositions of leasehold improvements 

A lessor of leased property that disposes of a leasehold improvement which was made by 

the lessor for the lessee of the property may take the adjusted basis of the improvement into 

account for purposes of determining gain or loss if the improvement is irrevocably disposed of or 

abandoned by the lessor at the termination of the lease. This rule conforms the treatment of 

lessors and lessees with respect to leasehold improvements disposed of at the end of a term of 

lease. 

Description of Proposal

The proposal provides that 25-year property for purposes of the depreciation rules of 

section 168 includes qualified leasehold improvement property. The straight-line method is 

required to be used with respect to qualified leasehold improvement property. 

Qualified leasehold improvement property is defined as under present law for purposes of 

the additional first-year depreciation deduction (sec. 168(k)) with the following modification. If 

a lessor makes an improvement that qualifies as qualified leasehold improvement property such 

improvement shall not qualify as qualified leasehold improvement property to any subsequent 

owner of such improvement. An exception to the rule applies in the case of death and certain 

transfers of property that qualify for non-recognition treatment. 

Effective Date

The proposal applies to qualified leasehold improvement property placed in service after 

September 11, 2004 except if such qualified leasehold improvement qualifies for the additional 

depreciation provided by section 168(k).

3. Exclusion of certain indebtedness of small business investment companies

from acquisition indebtedness

Present Law

In general, an organization that is otherwise exempt from Federal income tax is taxed on 

income from a trade or business that is unrelated to the organization’s exempt purposes. Certain 

types of income, such as rents, royalties, dividends, and interest, generally are excluded from 

unrelated business taxable income except when such income is derived from “debt-financed 
5

property.” Debt-financed property generally means any property that is held to produce income 

and with respect to which there is acquisition indebtedness at any time during the taxable year. 

In general, income of a tax-exempt organization that is produced by debt-financed 

property is treated as unrelated business income in proportion to the acquisition indebtedness on 

the income-producing property. Acquisition indebtedness generally means the amount of unpaid 

indebtedness incurred by an organization to acquire or improve the property and indebtedness 

that would not have been incurred but for the acquisition or improvement of the property. 8 

Acquisition indebtedness does not include, however, (1) certain indebtedness incurred in the 

performance or exercise of a purpose or function constituting the basis of the organization’s 

exemption, (2) obligations to pay certain types of annuities, (3) an obligation, to the extent it is 

insured by the Federal Housing Administration, to finance the purchase, rehabilitation, or 

construction of housing for low and moderate income persons, or (4) indebtedness incurred by 

certain qualified organizations to acquire or improve real property. An extension, renewal, or 

refinancing of an obligation evidencing a pre-existing indebtedness is not treated as the creation 

of a new indebtedness. 

Description of Proposal

The proposal modifies the debt-financed property provisions by excluding from the 

definition of acquisition indebtedness any indebtedness incurred by a small business investment 

company licensed under the Small Business Investment Act of 1958 that is evidenced by a 

debenture (1) issued by such company under section 303(a) of said Act or (2) held or guaranteed 

by the Small Business Administration.

Effective Date

The proposal applies to debt incurred by a small business investment company after 

December 31, 2002, with respect to property it acquires after such date.

 

8

 Special rules apply in the case of an exempt organization that owns a partnership 

interest in a partnership that holds debt-financed income-producing property. An exempt 

organization’s share of partnership income that is derived from such debt-financed property 

generally is taxed as debt-financed income unless an exception provides otherwise.
6

B. Provisions to Simplify Small Business Taxation

1. Disclosure of tax information to facilitate combined employment tax reporting 

(STAWRS)

Present Law

Present law prohibits disclosure of tax returns and return information, except to the extent 

specifically authorized by the Code (sec. 6103). Unauthorized disclosure is a felony punishable 

by a fine not exceeding $5,000 or imprisonment of not more than five years, or both (sec. 7213). 

An action for civil damages also may be brought for unauthorized disclosure (sec. 7431). No tax 

information may be furnished by the IRS to another agency unless the other agency establishes 

procedures satisfactory to the IRS for safeguarding the tax information it receives (sec. 6103(p)).

The Taxpayer Relief Act of 1997 authorized a demonstration project to assess the 

feasibility and desirability of expanding combined reporting. The demonstration project was: (1) 

limited to the State of Montana, (2) limited to employment taxes, (3) limited to taxpayer identity 

(name, address, taxpayer identifying number) and the signature of the taxpayer, and (4) limited 

to a period of five years. Authority for the demonstration project expired on August 5, 2002. 

To implement that demonstration project, the Taxpayer Relief Act of 1997 amended the 

Code to authorize the IRS to disclose the name, address, taxpayer identifying number, and 

signature of the taxpayer, which is common to both the State and Federal portions of the 

combined form (sec. 6103(d)(5)). The IRS is permitted to disclose these common data items to 

the State and not have them subject to the redisclosure restrictions, safeguards, or criminal 

penalty provisions.9 Essentially, the State is allowed to use this information as if the State 

directly received this information from the taxpayer.

Description of Proposal

The provision expands the disclosure authority of the IRS to permit disclosures to any 

State agency, body, or commission for purposes of carrying out a combined Federal and State 

employment tax reporting program. The items authorized for disclosure continue to be limited to 

the name, address, taxpayer identification number, and signature of the taxpayer. The statutory 

redisclosure restrictions, safeguards, and criminal penalty provisions do not apply to disclosures 

or inspections made pursuant to this authority. 

Effective Date

The proposal is effective after December 31, 2002.

 

9

 Section 6103(d)(5). The following restrictions and requirements do not apply: (1) the 

prohibition on disclosure of returns or return information by State officers and employees (sec. 

6103(a)(2)); (2) the Federal penalties for unauthorized disclosure and inspection of returns and 

return information (secs. 7213 and 7213A); and (3) the requirement that the State establish 

safeguards regarding the information obtained from the IRS (sec. 6103(p)(4)).
7

2. Increased deduction for business meals while operating under Department of 

Transportation hours of service limitations

Present Law

Ordinary and necessary business expenses, as well as expenses incurred for the 

production of income, are generally deductible, subject to a number of restrictions and 

limitations. Generally, the amount allowable as a deduction for food and beverages is limited to 

50 percent of the otherwise deductible amount. Exceptions to this 50 percent rule are provided 

for food and beverages provided to crew members of certain vessels and offshore oil or gas 

platforms or drilling rigs. 

The deductible percentage of the cost of food and beverages consumed while away from 

home by an individual during, or incident to, a period of duty subject to the hours of service 

limitations of the Department of Transportation is scheduled to gradually increase to 80 percent.

Individuals subject to the hours of service limitations of the Department of Transportation 

include:

(1) certain air transportation employees such as pilots, crew, dispatchers, mechanics,

and control tower operators pursuant to Federal Aviation Administration 

regulations,

(2) interstate truck operators and interstate bus drivers pursuant to Department of 

Transportation regulations,

(3) certain railroad employees such as engineers, conductors, train crews, dispatchers 

and control operations personnel pursuant to Federal Railroad Administration 

regulations, and

(4) certain merchant mariners pursuant to Coast Guard regulations.

The increase in the deductible percentage is phased in according to the following 

schedule:

Taxable years beginning in: Deductible percentage:

1998 - 1999 ....................................... 55 percent

2000 - 2001 ....................................... 60 percent

2002 - 2003 ....................................... 65 percent

2004 - 2005 ....................................... 70 percent

2006 - 2007 ....................................... 75 percent

2008 and thereafter............................ 80 percent
8

Description of Proposal

The proposal would accelerate the increase in the deduction for business meals while 

operating under Department of Transportation hours of service limitations so that it becomes 80 

percent in 2003 and thereafter.

Effective Date

The proposal would be effective for taxable years beginning after December 31, 2002.
9

C. Provisions Relating to Tax Relief for Farmers, Ranchers and Fishermen

1. Farm, Fish and Ranch Risk Management accounts 

Present Law

There is no provision in present law allowing the elective deferral of farm or fishing 

income.

Description of Proposal

The proposal allows taxpayers engaged in an eligible business to establish Farm, Fish and 

Ranch Risk Management (FFARRM) accounts. An eligible business is any trade or business of 

farming in which the taxpayer actively participates, including the operation of a nursery or sod 

farm or the raising or harvesting of crop-bearing or ornamental trees.10 An eligible business also 

includes the trade or business of commercial fishing in which the taxpayer actively participates. 

The term “commercial fishing” has the meaning given such term by section (3) of the 

Magnuson-Stevens Fishery Conservation and Management Act (16 U.S.C. 1802) and includes 

the trade or business of catching, taking or harvesting fish that are intended to enter commerce 

through sale, barter or trade. 

Contributions to a FFARRM account are deductible and are limited to 20 percent of the 

taxable income that is attributable to the eligible business. For purposes of this 20-percent 

limitation, taxable income is determined without regard to the FFARRM rules. The deduction is 

taken into account in determining adjusted gross income and reduces income attributable to the 

eligible business for all income tax purposes other than the determination of the 20 percent of 

eligible income limitation on contributions to a FFARRM account. Under the proposal, 

contributions made on or before the due date (without regard to extensions) of the taxpayer’s 

return for a taxable year are deemed made on the last day of such year. 

A FFARRM account is taxed as a grantor trust and earnings are required to be distributed 

currently. Thus, any income earned in the FFARRM account is taxed currently to the farmer or 

fisherman who established the account (but is not taken into account for purposes of the 20-

percent limit on contributions).

Contributions to a FFARRM account do not reduce earnings from self-employment. 

Generally, distributions are not included in self-employment income. 

Amounts may remain on deposit in a FFARRM account for up to five years. Any 

amount that has not been distributed by the close of the fourth year following the year of deposit 

is deemed distributed and includible in the gross income of the account owner. Distributions for 

the year are considered first made from the earnings that are required to be distributed. 

Additional amounts distributed for the year are considered to be made from the oldest deposits.

 

10 An evergreen tree that is more than 6 years old when severed from the roots (and thus 

eligible for capital gains treatment on cutting) is not considered an ornamental tree for this 

purpose.
10

Distributions from a FFARRM account may not be used to purchase, lease, or finance 

any new fishing vessel, add capacity to any fishery, or otherwise contribute to the 

overcapitalization of any fishery. The Secretary of Commerce shall implement regulations 

enforcing this restriction.

A taxpayer who has ceased to engage in an eligible business may not maintain a 

FFARRM account. If the taxpayer does not engage in an eligible business during two 

consecutive taxable years, the balance in the FFARRM account is deemed distributed to the 

taxpayer on the last day of such two-year period.

If the taxpayer who established the FFARRM account dies, and the taxpayer’s surviving 

spouse acquires the taxpayer’s interest in the FFARRM account by reason of being designated as 

the beneficiary of the account at the death of the taxpayer, the surviving spouse would “step into 

the shoes” of the deceased taxpayer with respect to the FFARRM account. In other cases, the 

account would cease to be a FFARRM account on the date of the taxpayer’s death and the 

balance in the account would generally be deemed distributed to the taxpayer on the date of 

death. 

A FFARRM account is a trust that is created or organized in the United States for the 

exclusive benefit of the taxpayer who establishes it. The trustee must be a bank or other person 

who demonstrates to the satisfaction of the Secretary that it will administer the trust in a manner 

consistent with the requirements of the section. At all times, the assets of the trust must consist 

entirely of cash and obligations which have adequate stated interest (as defined in section 

1274(c)(2)) and which pay such adequate interest not less often than annually. The trust must 

distribute all income currently, and its assets may not be commingled except in a common trust 

fund or common investment fund. Additional protections, including rules preventing the trust 

from engaging in prohibited transactions or from being pledged as security for a loan, are 

provided.

Penalties would apply in the case of excess contributions and failures to make required 

distributions.

Effective Date

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

2. Exclusion of rental income from self-employment tax 

Present Law

Generally, tax under the Self-Employment Contributions Act (SECA) is imposed on the 

self-employment income of an individual.

11 SECA tax has two components. Under the old-age, 

survivors, and disability insurance component, the rate of tax is 12.40 percent on 

self-employment income up to the social security wage base ($84,900 for 2002). Under the 

 

11 Section 1401.
11

hospital insurance component, the rate is 2.90 percent of all self-employment income (without 

regard to the social security wage base).

Self-employment income subject to the SECA tax is determined as the net earnings from 

self-employment. This means the gross income (including the individual’s net distributive share 

of partnership income) derived by an individual from any trade or business carried on by the 

individual, less the deductions attributable to the trade or business that are allowed under the 

SECA tax rules. An exclusion from net earnings from self-employment is allowed for certain 

real estate rentals. Under this present-law rule, net earnings from self-employment for an owner 

or tenant of land do not include income from the rental of real estate and from personal property 

leased with the real estate unless: (A) the rental income is received under an arrangement 

between the owner or tenant of the land and another individual that provides: (1) such other 

individual produces agricultural or horticultural commodities on such land; and (2) there is 

material participation by the owner or tenant with respect to any such agricultural or horticultural 

commodities; and (B) there is material participation by the owner or tenant with respect to any 

such agricultural or horticultural commodities. Other rules apply to rental payments received by 

an individual in the course of the individual’s trade or business as a real estate dealer.

Description of Proposal

The proposal provides that net earnings from self-employment for an owner or tenant of 

land do not include income from the rental of real estate except under certain lease agreements 

(rather than arrangements) between the owner or tenant of land and another individual. Under 

this proposal, an owner or tenant of land has self-employment income only where (A) the rental 

income is received under a written lease agreement between the owner or tenant of land and 

another individual which provides: (1) such other individual shall produce agricultural or 

horticultural commodities on such land; and (2) there shall be material participation by the owner 

or tenant in the production or management of the production of such agricultural or horticultural 

commodities; and (B) there is material participation by the owner or tenant with respect to any 

such agricultural or horticultural commodities.

Effective Date

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

3. Exclusion of conservation reserve program payments from self-employment tax

Present Law

Generally, tax under the Self-Employment Contributions Act (SECA) is imposed on the 

self-employment income of an individual.12 SECA tax has two components. Under the old-age, 

survivors, and disability insurance component, the rate of tax is 12.40 percent on 

self-employment income up to the social security wage base ($84,900 for 2002). Under the 

hospital insurance component, the rate is 2.90 percent of all self-employment income (without 

regard to the social security wage base).

 

12 Section 1401.
12

Self-employment income subject to the SECA tax is determined as the net earnings from 

self-employment. This means the gross income derived by an individual from any trade or 

business carried on by the individual, less the deductions attributable to the trade or business that 

are allowed under the SECA tax rules. A recent court decision found that payments made under 

the Department of Agriculture’s conservation reserve program are includible in an individual’s 

self-employment income for purposes of SECA tax. 13

Description of Proposal 

The proposal provides for purposes of the SECA tax that net earnings from selfemployment do not include conservation reserve program payments. 

Effective Date

The proposal is effective for payments made after December 31, 2002.

4. Exemption of agricultural bonds from private activity bond volume limits

Present Law

Interest on bonds issued by States and local governments is excluded from income if the 

proceeds of the bonds are used to finance activities conducted and paid for by the governmental 

units (sec. 103). Interest on bonds issued by these governmental units to finance activities 

carried out and paid for by private persons (“private activity bonds”) is taxable unless the 

activities are specified in the Internal Revenue Code. Private activity bonds on which interest 

may be tax-exempt include bonds issued to finance loans to first-time farmers for the acquisition 

of land and certain equipment (so-called “aggie bonds”).

The volume of tax-exempt private activity bonds that States and local governments may 

issue in each calendar year (including aggie bonds) is limited by State-wide volume limits. For 

2002, the volume limits will be the greater of: (1) $75 per resident of the State; or (2) $225 

million. The volume limits do not apply to private activity bonds to finance airports, docks and 

wharves, certain governmentally owned, and privately operated solid waste disposal facilities, 

certain high speed rail facilities, and to certain types of private activity tax-exempt bonds that are 

subject to other limits on their volume (qualified veterans’ mortgage bonds and certain 

empowerment zone and enterprise community bonds).

Description of Proposal

The proposal exempts aggie bonds from the private activity bond volume limits. 

Effective Date

The proposal is effective for bonds issued after December 31, 2002.

 

13 Wuebker v. Commissioner, 205 F.3d 897 (6th Cir. 2000), rev'g 110 T.C. 431 (1998).
13

5. Coordinate farmers and fisherman income averaging and the alternative minimum tax

Present Law

An individual taxpayer engaged in a farming business as defined by section 263A(e)(4) 

may elect to compute his or her current year tax liability by averaging, over the prior three-year 

period, all or portion of his or her taxable income from the trade or business of farming. The 

averaging election is not coordinated with the alternative minimum tax. Thus, some farmers may 

become subject to the alternative minimum tax solely as a result of the averaging election.

Description of Proposal

The proposal extends to individuals engaged in the trade or business of fishing the 

election that is available to individual farmers to use income averaging.

The proposal also coordinates farmers and fishermen income averaging with the 

alternative minimum tax. Under the proposal, a farmer would owe alternative minimum tax only 

to the extent he or she would owe alternative minimum tax had averaging not been elected. This 

result is achieved by excluding the impact of the election to average farm income from the 

calculation of both regular tax and tentative minimum tax, solely for the purpose of determining 

alternative minimum tax.

Effective Date

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

6. Modify cooperative marketing rules to include value added processing involving animals

Present Law

Under present law, cooperatives generally are treated similarly to pass-through entities in 

that the cooperative is not subject to corporate income tax to the extent the cooperative timely 

pays patronage dividends. Farmers' cooperatives are tax-exempt and include cooperatives of 

farmers, fruit growers, and like organizations that are organized and operated on a cooperative 

basis for the purpose of marketing the products of members or other producers and remitting the 

proceeds of sales, less necessary marketing expenses, on the basis of either the quantity or the 

value of products furnished by them (sec. 521). Farmers' cooperatives may claim a limited 

amount of additional deductions for dividends on capital stock and patronage-based distributions 

of nonpatronage income.

In determining whether a cooperative qualifies as a tax-exempt farmers' cooperative, the 

IRS has apparently taken the position that a cooperative is not marketing certain products of 

members or other producers if the cooperative adds value through the use of animals (e.g., 

farmers sell corn to a cooperative which is fed to chickens that produce eggs sold by the 

cooperative).
14

Description of Proposal

The proposal provides that marketing products of members or other producers includes 

feeding products of members or other producers to cattle, hogs, fish, chickens, or other animals 

and selling the resulting animals or animal products.

Effective Date

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

7. Extend declaratory judgment procedures to farmers’ cooperative organizations 

Present Law

In limited circumstances, the Code provide declaratory judgment procedures, which 

generally permit a taxpayer to seek judicial review of an IRS determination prior to the issuance 

of a notice of deficiency and prior to payment of tax. Examples of declaratory judgment 

procedures that are available include disputes involving the initial or continuing classification of 

a tax-exempt organization described in section 501(c)(3), a private foundation described in 

section 509(a), or a private operating foundation described in section 4942(j)(3), the qualification 

of retirement plans, the value of gifts, the status of certain governmental obligations, or 

eligibility of an estate to pay tax in installments under section 6166.14 In such cases, taxpayers 

may challenge adverse determinations by commencing a declaratory judgment action. For 

example, where the IRS denies an organization’s application for recognition of exemption under 

section 501(c)(3) or fails to act on such application, or where 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 exempt status.

Declaratory judgment procedures are not available under present law to a cooperative 

with respect to an IRS determination regarding its status as a farmers’ cooperative under section 

521.

Description of Proposal

The proposal extends the declaratory judgment procedures to cooperatives. Such a case 

may be commenced in the U.S. Tax Court, a U.S. district court, or the U.S. Court of Federal 

Claims, and such court would have jurisdiction to determine a cooperative’s initial or continuing 

qualification as a farmers’ cooperative described in section 521.

 

14 For disputes involving the initial or continuing qualification of an organization 

described in sections 501(c)(3), 509(a), or 4942(j)(3), declaratory judgment actions may be 

brought in the U.S. Tax Court, a U.S. district court, or the U.S. Court of Federal Claims. For all 

other Federal tax declaratory judgment actions, proceedings may be brought only in the U.S. Tax 

Court.
15

Effective Date

The proposal is effective for pleadings filed after the date of enactment with respect to 

determinations (or requests for determinations) made after January 1, 2002.

8. Payment of dividends on stock of cooperatives without reducing patronage dividends

Present Law

Under present law, cooperatives generally are treated similarly to pass-through entities in 

that the cooperative is not subject to corporate income tax to the extent the cooperative timely 

pays patronage dividends. In general, patronage dividends are comprised of amounts that are 

paid to patrons (1) on the basis of the quantity or value of business done with or for patrons, (2) 

under a valid enforceable written obligation to the patron that was in existence before the 

cooperative received such amounts, and (3) which are determined by reference to the net 

earnings of the cooperative from business done with or for patrons.

Treasury Regulations provide that net earnings are reduced by dividends paid on capital 

stock or other proprietary capital interests. The effect of this rule is to reduce the amount of 

earnings that a cooperative can treat as patronage income and, thus, the amount that the 

cooperative can deduct as patronage dividends.

Description of Proposal

The proposal provides a special rule for dividends on capital stock of a cooperative. To 

the extent provided in organizational documents of the cooperative, dividends on capital stock do 

not reduce patronage income.

Effective Date

The proposal is effective for distributions in taxable years beginning after December 31, 

2002.

9. Special rules for livestock sold on account of weather-related conditions

Present Law

Generally, a taxpayer recognizes gain to the extent the sales price (and any other 

consideration received) exceeds the seller’s basis in the property. The recognized gain is subject 

to current income tax unless the gain is deferred or not recognized under a special tax provision. 

Under section 1033, gain realized by a taxpayer from an involuntary conversion of 

property is deferred to the extent the taxpayer purchases property similar or related in service or 

use to the converted property within the applicable period. The taxpayer’s basis in the 

replacement property generally is the same as the taxpayer’s basis in the converted property, 

decreased by the amount of any money or loss recognized on the conversion, and increased by 

the amount of any gain recognized on the conversion.
16

The applicable period for the taxpayer to replace the converted property begins with the 

date of the disposition of the converted property (or if earlier, the earliest date of the threat or 

imminence of requisition or condemnation of the converted property) and ends two years after 

the close of the first taxable year in which any part of the gain upon conversion is realized (the 

“replacement period”). Special rules extend the replacement period for certain real property and 

principle residences damaged by a Presidentially declared disaster to three years and four years, 

respectively, after the close of the first taxable year in which gain is realized. 

Section 1033(e) provides that the sale of livestock (other than poultry) that is held for 

draft, breeding, or dairy purposes in excess of the number of livestock that would have been sold 

but for drought, flood, or other weather-related conditions is treated as an involuntary 

conversion. Consequently, gain from the sale of such livestock could be deferred by reinvesting 

the proceeds of the sale in similar property within a two-year period.

In general, cash-method taxpayers report income in the year it is actually or 

constructively received. However, section 451(e) provides that a cash-method taxpayer whose 

principal trade or business is farming who is forced to sell livestock due to drought, flood, or 

other weather-related conditions may elect to include income from the sale of the livestock in the 

taxable year following the taxable year of the sale. This elective deferral of income is available 

only if the taxpayer establishes that, under the taxpayer's usual business practices, the sale would 

not have occurred but for drought, flood, or weather-related conditions that resulted in the area 

being designated as eligible for Federal assistance. This exception is generally intended to put 

taxpayers who receive an unusually high amount of income in one year in the position they 

would have been in absent the weather-related condition.

Description of Proposal

The proposal extends the applicable period for a taxpayer to replace livestock sold on 

account of drought, flood, or other weather-related conditions from two years to four years after 

the close of the first taxable year in which any part of the gain on conversion is realized. The 

extension is only available if the taxpayer establishes that, under the taxpayer's usual business 

practices, the sale would not have occurred but for drought, flood, or weather-related conditions 

that resulted in the area being designated as eligible for Federal assistance. In addition, the 

Secretary of the Treasury is granted authority to further extend the replacement period on a 

regional basis should the weather-related conditions continue longer than 3 years. Also, for 

property eligible for the proposal’s extended replacement period, the proposal provides that the 

taxpayer can make an election under section 451(e) until the period for reinvestment of such 

property under section 1033 expires. 

Effective Date

The proposal is effective for taxable years ending after date of enactment.
17

10. Farmer optional method for computing net earnings from self-employment

Present Law

In general

Generally, tax under the Self-Employment Contributions Act (SECA) is imposed on the 

self-employment income of an individual.15 SECA tax has two components. Under the old-age, 

survivors, and disability insurance component, the rate of tax is 12.40 percent on 

self-employment income up to the social security wage base ($84,900 for 2002). Under the 

hospital insurance component, the rate is 2.90 percent of all self-employment income (without 

regard to the social security wage base).

Self-employment income subject to the SECA tax is determined as the net earnings from 

self-employment. An individual may use one of three methods to calculate net earnings from 

self-employment. Under the generally applicable rule, net earnings from self-employment 

means gross income (including the individual’s net distributive share of partnership income) 

derived by an individual from any trade or business carried on by the individual, less the 

deductions attributable to the trade or business that are allowed under the SECA tax rules. 

Alternatively, an individual may elect to use one of two optional methods for calculating net 

earnings from self-employment. 16 These methods17 are the: (1) the farmer optional method; and 

(2) the nonfarm optional method. The farmer optional method allows individuals to pay SECA 

taxes (and secure Social Security benefit coverage) when they have low net profits or a loss from 

farming. The nonfarm optional method is similar to the farmer optional method.

Farmer optional method

If an individual is engaged in a farming business, either as a sole proprietor or as a 

partner, the individual may elect to use the farmer optional method in one of two instances. The 

first instance is an individual engaged in a farming business who has gross farm income of 

$2,400 or less for the taxable year. In this instance, the individual may elect to report two-thirds 

of gross farm income as their net earnings from self-employment. In the second instance, an 

individual engaged in a farming business may elect the farmer optional method even though 

gross farm income exceeds $2,400 for the taxable year but only if the net farm profits is less than 

$1,733 for the taxable year. In this second instance the individual may elect to report $1,600 as 

their net earnings farm self-employment for the taxable year. In all other instances (i.e., more 

than $2,400 of gross farm income and net farm profits of at least $1,733) a person engaged in a 

 

15 Section 1401.

16 An individual must use actual self-employment income for purposes of computing 

income tax liability regardless of the method used in calculating SECA tax liability.

17 An individual may elect to use both optional methods but net earnings from farming 

and nonfarming activities must be separately calculated. Also, such an individual cannot report 

more than $1,600 of combined net earnings from self-employment each taxable year.
18

farming business must compute net earnings from self-employment under the generally 

applicable rule.

Nonfarm optional method

The nonfarm optional method is available only to individuals that have been selfemployed for at least two of the three years before the year in which they seek to elect the 

nonfarm optional method and who meet certain other requirements. Specifically, an individual 

may elect the nonfarm optional method, if the individual’s:(1) net nonfarm profits for the taxable 

year are less than $1,733; and (2) net nonfarm profits for the taxable year are less than 72.189% 

of their gross nonfarm income. An individual may elect to use the nonfarm optional method for 

no more than five years in the course of the individual’s lifetime. If a qualified individual 

engaged in a nonfarming business who elects the nonfarm optional method has gross nonfarm 

income of $2,400 or less for the taxable year, then the individual may elect to report two-thirds 

of gross nonfarm income as their net earnings from self-employment. If the electing individual 

engaged in a nonfarming business has gross nonfarm income of at least $2,400 for the taxable 

year, then the individual may elect to report $1,600 as their net earnings farm self-employment 

for the taxable year. In all other instances a person engaged in a nonfarming business must 

compute net earnings from self-employment under the generally applicable rule.

Description of Proposal

The proposal simplifies the calculation of the optional method of self-employment 

income for both farmers and nonfarmers. This simplification is achieved by combining the 

farmer optional method and the nonfarm optional method. Also, the new combined optional 

method allows an electing individual to be eligible for up to four quarters of Social Security 

coverage in each taxable year. This is achieved by coordinating the optional method election 

amounts to the minimum amounts of income necessary for four quarters of Social Security 

coverage. Unlike present law, the amounts under the combined optional method will be adjusted 

automatically when the minimum amounts necessary for four quarters of Social Security 

coverage is changed.

Under the proposal, if an individual has: (1) gross income for the taxable year from a 

trade or business that does not exceed one and one-half times the amount of net income required 

to qualify for four quarters of Social Security coverage in the taxable year; and (2) net earnings 

for the taxable year from such trade or business which are less then two-thirds of the individual’s 

gross income for the taxable year, such individual may elect to report two-thirds of gross income 

as net earnings from self-employment for the taxable year. Similar treatment is provided for a 

member of a partnership carrying on a trade or business.

Also under the proposal, if an individual has: (1) gross income for the taxable year from a 

trade or business in excess of one and one-half times the amount of net income required to 

qualify for four quarters of Social Security coverage in the taxable year, and (2) net earnings for 

the taxable year from such trade or business are less than the amount of net income required to 

qualify for four quarters of Social Security coverage in the taxable year; such individual may 

elect to report the amount of net income required to qualify for four quarters of coverage in the 
19

taxable year as net earnings from self-employment for the taxable year. Similar treatment is 

provided for a member of a partnership carrying on a trade or business.

In the case of a cash method trade or business, gross income is defined as the gross 

receipts from such trade or business less the cost or other basis of property sold in carrying out 

such trade or business with certain adjustments. In the case of an accrual method trade or 

business, gross income is defined as the gross income from the trade or business with certain

adjustments. In each case, these adjustments are similar to those made under present-law. If an 

individual (including a member of a partnership) derives gross income from more than one trade 

or business then such gross income (including the individual’s distributive share of the gross 

income of any partnership) is treated as derived from a single trade or business. Under the 

proposal, the election is allowed for a taxable year only if elected on the first tax return filed for 

such taxable year. There is no limit on the number of years that an individual may elect this 

method during such individual’s lifetime.

Effective Date

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

11. Capital gains treatment to apply to outright sales of timber by landowner

Present Law

Under present law, a taxpayer disposing of timber held for more than one year is eligible for 

capital gains treatment in three situations. First, if the taxpayer sells or exchanges timber that is 

a capital asset (sec. 1221) or property used in the trade or business (sec. 1231), the gain generally 

is long-term capital gain; however, if the timber is held for sale to customers in the taxpayer’s 

business, the gain will be ordinary income. Second, if the taxpayer disposes of the timber with a 

retained economic interest, the gain is eligible for capital gain treatment (sec. 631(b)). Third, if 

the taxpayer cuts standing timber, the taxpayer may elect to treat the cutting as a sale or 

exchange eligible for capital gains treatment (sec. 631(a)). 

Description of Proposal

Under the proposal, in the case of a sale of timber by the owner of the land from which the 

timber is cut, the requirement that a taxpayer retain an economic interest in the timber in order to 

treat gains as capital gain under section 631(b) does not apply. Outright sales of timber by the 

landowner will qualify for capital gains treatment in the same manner as sales with a retained 

economic interest qualify under present law, except that the usual tax rules relating to the timing 

of the income from the sale of the timber will apply (rather than the special rule of section 631(b) 

treating the disposal as occurring on the date the timber is cut).

Effective Date

The proposal applies to sales of timber after December 31, 2002.
20

12. Expensing of certain reforestation expenditures

Present Law

Amortization of reforestation costs (sec. 194)

A taxpayer may elect to amortize up to $10,000 ($5,000 in the case of a separate return 

by a married individual) of qualifying reforestation expenditures incurred during the taxable year 

with respect to qualifying timber property. Amortization is taken over 84 months (seven years) 

and is subject to a mandatory half-year convention. In the case of an individual, the 

amortization deduction is allowed in determining adjusted gross income (i.e., an “above-the-line 

deduction”) rather than as an itemized deduction. 

Qualifying reforestation expenditures are the direct costs a taxpayer incurs in connection 

with the forestation or reforestation of a site by planting or seeding, and include costs for the 

preparation of the site, the cost of the seed or seedlings, and the cost of the labor and tools 

(including depreciation of long lived assets such as tractors and other machines) used in the 

reforestation activity. Qualifying reforestation expenditures do not include expenditures that 

would otherwise be deductible and do not include costs for which the taxpayer has been 

reimbursed under a governmental cost sharing program, unless the amount of the reimbursement 

is also included in the taxpayer’s gross income.

The amount amortized is reduced by one half of the amount of reforestation credit 

claimed under section 48(b) (see below). Reforestation amortization is subject to recapture as 

ordinary income on sale of qualifying timber property within 10 years of the year in which the 

qualifying reforestation expenditures were incurred. 

Reforestation tax credit (sec. 48(b))

A tax credit is allowed equal to 10 percent of the reforestation expenditures incurred 

during the year that are properly elected to be amortized. An amount allowed as a credit is 

subject to recapture if the qualifying timber property to which the expenditure relates is disposed 

of within five years.

Description of Proposal

The proposal permits taxpayers to elect to deduct (i.e., expense) up to $15,000 ($7,500 in 

the case of a separate return by a married individual) of qualifying reforestation expenditures 

incurred during the taxable year with respect to qualifying timber property. 

The proposal replaces both the amortization and credit provisions of present law.

Effective Date

The proposal is effective for expenditures paid or incurred in taxable years beginning 

after December 31, 2002. 
21

D. Provisions Relating to S Corporation Reform and Simplification 

1. Maximum number of shareholders of an S corporation

Present Law

The taxable income or loss of an S corporation is taken into account by the corporation's 

shareholders, rather than by the entity, whether or not such income is distributed. A small 

business corporation may elect to be treated as an S corporation. A "small business corporation" 

is defined as a domestic corporation which is not an ineligible corporation and which does not 

have (1) more than 75-shareholders; (2) as a shareholder, a person (other than certain trusts, 

estates, charities, and qualified retirement plans) who is not an individual; (3) a nonresident alien 

as a shareholder; and (4) more than one class of stock. For purposes of the 75-shareholder 

limitation, a husband and wife are treated as one shareholder. An "ineligible corporation" means 

any corporation that is a member of an affiliated group, certain financial institutions that use the 

reserve method of accounting for bad debts, certain insurance companies, a section 936

corporation, or a DISC or former DISC.

Description of Proposal

The proposal provides that all family members owning stock can elect to be treated as 

one shareholder. A family is defined as the lineal descendants of a common ancestor (and their 

spouses). The common ancestor cannot be more than three generations removed from the 

youngest generation of shareholder at the time the S election is made (or the effective date of this 

provision, if later). The election is made available to only one family per corporation, must be 

made with the consent of all shareholders of the corporation and remains in effect until 

terminated.

The proposal increases the maximum number of eligible shareholders from 75 to 100.

Effective Date

The proposal relating to families applies to taxable years beginning after December 31, 

2003. 

The proposal relating to the number of shareholders applies to taxable years beginning 

after December 31, 2002.

2. Termination of election and additions to tax due to passive investment income

Present Law

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

rate, on its net passive income if the corporation has (1) subchapter C earnings and profits at the 

close of the taxable year and (2) gross receipts more than 25 percent of which are passive 

investment income.
22

In addition, an S corporation election is terminated whenever the corporation has 

subchapter C earnings and profits at the close of three consecutive taxable years and has gross 

receipts for each of such years more than 25 percent of which are passive investment income.

For these purposes, "passive investment income" generally means gross receipts derived 

from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities 

(to the extent of gains). "Passive investment income" generally does not include interest on 

accounts receivable, gross receipts that are derived directly from the active and regular conduct 

of a lending or finance business, gross receipts from certain liquidations, or gain or loss from any 

section 1256 contract (or related property) of an options or commodity dealer. "Net passive 

income" is defined as passive investment income reduced by the allowable deductions that are 

directly connected with the production of the income.

Description of Proposal

The proposal increases the 25-percent threshold to 60 percent.

The proposal repeals capital gain as a category of passive income.

Effective Date

The proposal applies to taxable years beginning after December 31, 2002.

3. Treatment of S corporation shareholders

(a) In general

Present Law

In general, each S corporation shareholder takes into account its pro rata share of the S 

corporation income and loss for the taxable year. 

Description of Proposal

The proposal makes the following changes in the treatment of S corporation shareholders:

Under the proposal, if a shareholder’s stock in an S corporation is transferred incident to 

a divorce decree, the pro rata share of any suspended corporate loss is transferred to the 

transferee spouse.

Under the proposal, the beneficiary of a qualified subchapter S trust is allowed the 

suspended losses under the at-risk rules and the passive loss rules when the trust disposes of the 

stock.

Effective Date

The provisions apply to taxable years beginning after December 31, 2002.
23

(b) Electing small business trusts

Present Law

Under present law, an electing small business trust (“ESBT”) may be an S corporation 

shareholder. In general, the beneficiaries of an ESBT must be individuals and others taxpayers 

that may own stock in an S corporation directly. Each potential current beneficiary of the trust is 

counted as a shareholder in determining whether or not the corporation meets the requirement 

that an S corporation have no more than 75 shareholders. 

The portion of the trust consisting of S corporation stock is treated as a separate trust. 

The trust is taxed at the maximum trust tax rate (which is the same as the maximum individual 

tax rate) on the items of income, deduction, gain, or loss passing through from the S corporation. 

The remaining portion of the trust is treated as a separate trust taxed under the normal rules 

relating to the taxation of trusts and beneficiaries. In computing the amount of the distribution 

deduction for the trust, no subchapter S items are taken into account.

Description of Proposal

Under the proposal, unexercised powers of appointment are disregarded in determining 

the beneficiaries of an electing small business trust.

Under the proposal, the treatment of distributions from an electing small business trust is 

clarified by treating distributions from each portion (i.e., the portion attributable to the S 

corporation stock and the remaining portion) of the trust as separate distributions.

Effective Date

The proposals apply to taxable years beginning after December 31, 2002. 

4. Provisions relating to banks

(a) IRAs holding bank stock

Present Law

An individual retirement arrangement (“IRA”) may not hold stock in an S corporation.

Description of Proposal

The proposal allows an IRA holding bank stock to sell the stock to the beneficiary of the 

IRA without the imposition of a prohibited transaction tax, in order to allow the corporation to be 

eligible to elect to be an S corporation.

Effective Date

The proposal applies to stock held by an IRA on the date of enactment.
24

(b) Exclusion of investment securities income from passive income test for bank S 

corporations

Present Law

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

rate, on its net passive income if the corporation has (1) subchapter C earnings and profits at the 

close of the taxable year and (2) gross receipts more than 25 percent of which are passive 

investment income.

In addition, an S corporation election is terminated whenever the corporation has 

subchapter C earnings and profits at the close of three consecutive taxable years and has gross 

receipts for each of such years more than 25 percent of which are passive investment income.

For these purposes, "passive investment income" generally means gross receipts derived 

from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities 

(to the extent of gains). "Passive investment income" generally does not include interest on 

accounts receivable, gross receipts that are derived directly from the active and regular conduct 

of a lending or finance business, gross receipts from certain liquidations, or gain or loss from any 

section 1256 contract (or related property) of an options or commodity dealer. "Net passive 

income" is defined as passive investment income reduced by the allowable deductions that are 

directly connected with the production of the income.

Description of Proposal

The proposal provides that, in the case of a bank or bank holding company, passive 

income does not include interest and does not include dividends on assets required to be held by 

the bank or bank holding company.

Effective Date

The proposal applies to taxable years beginning after December 31, 2002.

(c) Treatment of qualifying director shares

Present Law

A small business corporation may elect to be treated as an S corporation. A "small business 

corporation" is defined as a domestic corporation which is not an ineligible corporation and 

which does not have (1) more than 75 shareholders; (2) as a shareholder, a person (other than 

certain trusts, estates, charities, or qualified retirement plans) who is not an individual; (3) a 

nonresident alien as a shareholder; and (4) more than one class of stock.

Description of Proposal

Under the proposal, shares held by reason of being a bank director that are subject to an 

agreement pursuant to which the holder is required to dispose of the shares upon termination of 
25

the holder’s status as a director at the same price the individual acquired the shares are not 

treated as a second class of stock. Distributions are treated like interest payments.

Effective Date

The proposal applies to taxable years beginning after December 31, 2002.

5. Qualified subchapter S subsidiaries

(a) Relief from inadvertently invalid qualified subchapter S subsidiaries and 

elections and terminations

Present Law

Under present law, inadvertent subchapter S elections and terminations may be waived.

Description of Proposal

The proposal allows inadvertent qualified subchapter S subsidiary elections and 

terminations to be waived by the IRS.

Effective Date

The proposal applies to taxable years beginning after December 31, 2002.

(b) Information returns for qualified subchapter S subsidiaries

Present Law

Under present law, a wholly owned subsidiary of an S corporation may elect to be treated 

as not a separate corporation. The assets, liabilities, and items of income, deduction, and credit 

of the subsidiary are treated as assets, liabilities, and items of the parent S corporation.

Description of Proposal

The proposal provides authority to the Secretary of the Treasury to provide guidance 

regarding information returns of subchapter S subsidiaries.

Effective Date

The proposal applies to taxable years beginning after December 31, 2002.
26

E. Provisions to Promote Economic Development and

Rural Investment

1. Accelerated depreciation for investment in high out-migration counties

Present Law

In general

Overview

Present law permits taxpayers to recover the costs of investment through annual 

deductions for depreciation or amortization or, in some circumstances, through expensing of the 

cost of acquisition in the year of acquisition. These rules apply generally regardless of the 

geographic location of the taxpayer or the property. However, in certain circumstances, the 

Code modifies these rules depending upon the geographic location of the property.

Cost recovery through depreciation deductions

Under present law, a taxpayer generally must capitalize the cost of property used in a 

trade or business and recover such cost over time through annual deductions for depreciation or 

amortization. Tangible property generally is depreciated under the Modified Accelerated Cost 

Recovery System (MACRS) of section 168, which determines depreciation by applying specific 

recovery periods, placed-in-service conventions, and depreciation methods to the cost of various 

types of depreciable property.

Present law allows an additional first-year depreciation deduction equal to 30 percent of 

the adjusted basis of qualified property. The additional first-year depreciation deduction is 

allowed for both regular tax and alternative minimum tax purposes for the taxable year in which 

the property is placed in service. The basis of the property and the depreciation allowances in the 

year of purchase and later years are appropriately adjusted to reflect the additional first-year 

depreciation deduction. 

In order for property to qualify for the additional first-year depreciation deduction, it 

must meet the following requirements. First, the property must be property to which the rules of 

MACRS apply with (1) an applicable recovery period of 20 years or less, (2) water utility 

property (as defined in section 168(e)(5)), (3) computer software (other than computer software 

covered by section 197), or (4) certain qualified leasehold improvement property. In addition, 

the original use of the qualifying property must commence with the taxpayer on or after 

September 11, 2001. In general, the taxpayer must purchase the property after September 10, 

2001 and before September 11, 2004. Finally, the property must be placed in service before 

January 1, 2005. 

Cost recovery through expensing

Present law provides that, in lieu of depreciation, a taxpayer with a sufficiently small 

amount of annual investment may elect to deduct up to $24,000 of the cost of qualifying property 
27

placed in service for the taxable year (sec. 179). This amount is increased to $25,000 of the cost 

of qualified property placed in service for taxable years beginning in 2003 and thereafter. In 

general, qualifying property is defined as depreciable tangible personal property that is 

purchased for use in the active conduct of a trade or business. The $24,000 ($25,000 for taxable 

years beginning in 2003 and thereafter) amount is reduced (but not below zero) by the amount by 

which the cost of qualifying property placed in service during the taxable year exceeds $200,000. 

Accelerated depreciation of property on Indian reservations

A special depreciation recovery period is available to qualified Indian reservation 

property. 18 In general, qualified Indian reservation property is property used predominantly in 

the active conduct of a trade or business within an Indian reservation, which is not used outside 

the reservation on a regular basis and was not acquired from a related person. Property used to 

conduct or house certain gaming activities is not qualified Indian reservation property. 

The applicable recovery period for qualified Indian reservation property is as follows:

In the case of: The applicable recovery period is:

3 year property 2 years

5 year property 3 years

7 year property 4 years

10 year property 6 years

15 year property 9 years

20 year property 12 years

Nonresidential real property 22 years

Accelerated depreciation of property on Indian reservations is not available for property 

placed in service after December 31, 2004.

Additional first-year depreciation deduction for New York Liberty Zone property 

Present law allows an additional first-year depreciation deduction equal to 30 percent of 

the adjusted basis of qualified New York Liberty Zone19 (“Liberty Zone”) property. The 

additional first-year depreciation deduction is allowed for both regular tax and alternative 

minimum tax purposes for the taxable year in which the property is placed in service. The basis 

of the property and the depreciation allowances in the year of purchase and later years are 

appropriately adjusted to reflect the additional first-year depreciation deduction. A taxpayer is 

allowed to elect out of the additional first-year depreciation for any class of property for any 

taxable year.

 

18 Section 168(j).

19 The “New York Liberty Zone” means the area located on or south of Canal Street, 

East Broadway (east of its intersection with Canal Street), or Grand Street (east of its intersection 

with East Broadway) in the Borough of Manhattan in the City of New York, New York.
28

In order for property to qualify for the additional first-year depreciation deduction it must 

meet all of the following requirements. First, the property must be property to which the general 

rules of MACRS apply with (1) an applicable recovery period of 20 years or less, (2) water 

utility property (as defined in sec. 168(e)(5)), (3) certain nonresidential real property and 

residential rental property, or (4) computer software other than computer software covered by 

section 197. A special rule precludes the additional first year depreciation under this provision 

for qualified leasehold improvement property and property eligible for the additional first year 

depreciation under section 168(k). Second, substantially all of the use of such property must be 

in the Liberty Zone. Third, the original use of the property in the Liberty Zone must commence 

with the taxpayer on or after September 11, 2001. Finally, the property must be acquired by 

purchase by the taxpayer (1) after September 10, 2001 and placed in service on or before 

December 31, 2006. For qualifying nonresidential real property and residential rental property 

the property must be placed in service on or before December 31, 2009 in lieu of December 31, 

2006. Property will not qualify if a binding written contract for the acquisition of such property 

is in effect before September 11, 2001.

Increased expensing allowances

Additional expensing under section 179 is provided with respect to qualified property 

used by a business in an empowerment zone (sec. 1397A), used in a renewal community (sec. 

1400J), or used in the New York Liberty Zone (sec. 1400L). Such a business may elect to 

deduct an additional $35,000 of the cost of qualified zone property placed in service in years 

beginning in 2002 and thereafter. In addition, the phase-out range is applied by taking into 

account only 50 percent of the cost of qualified zone property that is section 179 property. 

Qualified zone property means property to which section 168 applies (or would apply if no sec. 

179 deduction were allowed) if such property was (1) acquired by the taxpayer through purchase 

after the date on which the empowerment zone designation took effect, (2) the original use of the 

property in an empowerment zone commenced with the taxpayer and (3) substantially all of the 

use of the property is in an empowerment zone and in the active conduct of a qualified business 

by the taxpayer in an empowerment zone. For renewal communities, qualified renewal property 

is qualified zone property if renewal community were substituted for the reference to 

empowerment zone and the property was acquired by the taxpayer by purchase after December 

31, 2001 and before January 1, 2010. In the case of the New York Liberty Zone, qualifying 

property means section 179 property purchased and placed in service by the taxpayer after 

September 10, 2001 and before January 1, 2007.

Description of Proposal

The proposal provides a special depreciation recovery period for qualified rural 

investment property. In general, qualified rural investment property is property used 

predominantly in the active conduct of a trade or business within a high out-migration county, 

which is not used outside such county on a regular basis, and was not acquired from a related 

person. A “high out-migration county” is a county located outside a metropolitan statistical area 

(as defined by the Office of Management and Budget) that experienced net population loss

during the five-year period 1990 through 1994 and also during the five-year period 1995 through 

1999. Property used to conduct or house certain gaming activities is not qualified rural 

investment property. 
29

The applicable recovery period for qualified rural investment property is as follows:

In the case of: The applicable recovery period is:

3 year property 2 years

5 year property 3 years

7 year property 4 years

10 year property 6 years

15 year property 9 years

20 year property 12 years

Nonresidential real property 22 years

Accelerated depreciation of property in high out-migration counties is not available for 

property placed in service after December 31, 2004.

Effective Date

The proposal is effective for property placed in service after December 31, 2002.

2. Treatment of expenses of rural letter carriers’ vehicles 

Present Law

A taxpayer who uses his or her automobile for business purposes may deduct the business 

portion of the actual operation and maintenance expenses of the vehicle, plus depreciation 

(subject to the limitations of sec. 280F). Alternatively, the taxpayer may elect to utilize a 

standard mileage rate in computing the deduction allowable for business use of an automobile 

that has not been fully depreciated. Under this election, the taxpayer's deduction equals the 

applicable rate multiplied by the number of miles driven for business purposes and is taken in 

lieu of deductions for depreciation and actual operation and maintenance expenses.

Rural letter carriers are paid an equipment maintenance allowance (EMA) by the U.S. 

Postal Service to compensate them for the use of their personal automobiles in delivering the 

mail. For tax purposes, the rate of reimbursement provided by the U.S. Postal Service to rural 

letter carriers is considered to be equivalent to their expenses (sec. 162(o)). Accordingly, carriers 

whose actual expenses are less than the amount reimbursed do not recognize the excess as 

income and carriers whose actual expenses are more than the amount reimbursed are not allowed 

to claim an itemized deduction for the costs that exceed their reimbursements. 

Description of Proposal

The proposal provides that if the reimbursements that a rural letter carrier receives from 

the U.S. Postal Service are less than the carrier’s otherwise allowable costs, the costs in excess of 

reimbursements qualify as a miscellaneous itemized deduction subject to the two-percent floor.

Effective Date

The proposal is effective for taxable years beginning after December 31, 2002.
30

3. Broadband internet access tax credit

Present Law

Present law does not provide a credit for investments in telecommunications 

infrastructure.

Description of Proposal

The proposal provides a credit of 10 percent of the qualified expenditures incurred by the 

taxpayer with respect to qualified equipment with which the taxpayer offers “current generation” 

broadband services to subscribers in rural and underserved areas. In addition, the proposal 

provides a credit of 20 percent of the qualified expenditures incurred by the taxpayer with 

respect to qualified equipment with which the taxpayer offers “next generation” broadband 

services to subscribers in rural areas, underserved areas, and to residential subscribers. Current 

generation broadband services are defined as the transmission of signals at a rate of at least 1.0 

million bits per second to the subscriber and at a rate of at least 128,000 bits per second from the 

subscriber. Next generation broadband services are defined as the transmission of signals at a 

rate of at least 22 million bits per second to the subscriber and at a rate of at least 5.0 million bits 

per second from the subscriber.

Qualified expenditures are those amounts otherwise chargeable to the capital account 

with respect to the purchase and installation of qualified equipment for which depreciation is 

allowable under section 168. Qualified expenditures are those that are incurred by the taxpayer 

after December 31, 2002, and before January 1, 2005. The expenditures are taken into account 

for purposes of claiming the credit in the first taxable year in which the taxpayer provides 

broadband service to potential subscribers. In the case of a taxpayer who incurs expenditures for 

equipment capable of serving both subscribers in qualifying areas and other areas, qualifying 

expenditures are determined by multiplying otherwise qualifying expenditures by the ratio of the 

number of potential qualifying subscribers to all potential subscribers the qualifying equipment is 

capable of serving. For purposes of the current generation broadband credit, residential 

subscribers residing in a rural or underserved area that is a “saturated market” are not qualified 

subscribers in determination of the allocation of expenses eligible for the credit. A “saturated 

market” is any census tract in which a single provider provides current generation broadband 

service to 85 percent or more of potential residential subscribers.

Qualifying equipment must be capable of providing broadband services at least a 

majority of the time during periods of maximum demand to each subscriber who is utilizing such 

services. In the case of a telecommunications carrier, qualifying equipment is only that 

equipment that extends from the last point of switching to the outside of the building in which 

the subscriber is located. In the case of a commercial mobile service carrier, qualifying 

equipment is only that equipment that extends from the customer side of a mobile telephone 

switching office to a transmission/reception antenna (including the antenna) of the subscriber. In 

the case of a cable operator or open video system operator, qualifying equipment is only that 

equipment that extends from the customer side of the headend to the outside of the building in 

which the subscriber is located. In the case of a satellite carrier or other wireless carrier (other 

than a telecommunications carrier), qualifying equipment is only that equipment that extends 
31

from a transmission/reception antenna (including the antenna) to a transmission/reception 

antenna on the outside of the building used by the subscriber. In addition, any packet switching 

equipment deployed in connection with other qualifying equipment is qualifying equipment, 

regardless of location, provided that it is the last such equipment in a series as part of 

transmission of a signal to a subscriber or the first in a series in the transmission of a signal from 

a subscriber. Multiplexing and demultiplexing equipment is qualifying equipment if located 

between qualifying packet switching equipment and the subscriber's premises.

A rural area is any census tract that is not within 10 miles of any incorporated or census 

designated place with a population of more than 25,000 and that is not within a county with a 

population density of more than 500 people per square mile. An underserved area is any census 

tract which is located in an empowerment zone, enterprise community, the District of Columbia 

enterprise zone, renewal community, or any census tract in which the poverty level is greater 

than or equal to 20 percent or in which the median family income is less than 80 percent of the 

greater of metropolitan area median family income (if applicable) or statewide median family 

income. A residential subscriber is any individual who purchases broadband service to be 

delivered to his or her dwelling.

Effective Date

The proposal is effective for expenditures incurred after December 31, 2002.

4. Broadband provisions relating to housing: modification to the low-income housing 

credit allocation criteria

Present Law

The low-income housing tax credit (the “LIHC”) may be claimed over a 10-year period 

for the cost of rental housing occupied by tenants having incomes below specified levels. The 

credit percentage for newly constructed or substantially rehabilitated housing that is not 

Federally subsidized is adjusted monthly by the Internal Revenue Service so that the 10 annual 

installments have a present value of 70 percent of the total qualified expenditures. The credit 

percentage for new substantially rehabilitated housing that is Federally subsidized and for 

existing housing that is substantially rehabilitated is calculated to have a present value of 30 

percent qualified expenditures. The aggregate credit authority provided annually to each State is 

$1.75 per resident, except in the case of projects that also receive financing with proceeds of taxexempt bonds issued subject to the private activity bond volume limit and certain carry-over 

amounts. The $1.75 per resident cap is indexed for inflation.

Each State must develop a plan for allocating credits and such plan must include certain 

allocation criteria including: (1) project location; (2) housing needs characteristics; (3) project 

characteristics; (4) sponsor characteristics; (5) tenant populations with special needs; (6) public 

housing waiting lists; (7) tenant populations of individuals with children; and (8) projects 

intended for eventual tenant ownership. Project characteristics include whether the project 

includes the use of existing housing as part of a community revitalization plan. 

The State allocation plan must give preference to housing projects: (1) that serve the 

lowest income tenants; (2) that are obligated to serve qualified tenants for the longest periods; 
32

and (3) that are located in certain qualified census tracts, the development of which contributes to 

a concerted redevelopment plan.

Description of Proposal

The proposal adds another project characteristic under the third criterion for allocation of 

the low-income housing credit. Specifically, the proposal includes among the project 

characteristics that the project has infrastructure permitting each residential unit the use of highspeed Internet technology.

Effective Date

The proposal generally is effective for calendar years beginning after December 31, 2002, 

and buildings placed-in-service after such date in the case of projects that also receive financing 

with proceeds of tax-exempt bonds subject to the private-activity bond volume limit which are 

issued after such date.

5. Modify qualified zone academy bond provisions to provide similar bonds for the 

construction of schools for the Bureau of Indian Affairs of the Department of the Interior

Present Law

Tax-exempt bonds

In general

Interest on State or local bonds is excluded from income if the proceeds of the borrowing 

are used to carry out governmental functions of those entities or the debt is repaid with 

governmental funds (sec. 103).20 Similar to other activities carried out or paid for by States and 

local governments, the construction, renovation, and operation of public schools is an activity 

eligible for financing with the proceeds of tax-exempt bonds.

Interest on bonds that nominally are issued by States or local governments, but the 

proceeds of which are used (directly or indirectly) by a private person and payment of which is 

derived from funds of such a private person is taxable unless the purpose of the borrowing is 

approved specifically in the Code or in a non-Code provision of a revenue Act. These bonds are 

called “private activity bonds.”21 The term "private person" includes the Federal Government 

and all other individuals and entities other than States or local governments.

 

20 Interest on this debt is included in calculating the “adjusted current earnings” 

preference of the corporate alternative minimum tax.

21 Interest on private activity bonds (other than qualified 501(c)(3) bonds) is a preference 

item in calculating the alternative minimum tax.
33

Private activities eligible for financing with tax-exempt private activity bonds

Present law includes several exceptions permitting States or local governments to act as 

conduits providing tax-exempt financing for private activities. Both capital expenditures and 

limited working capital expenditures of charitable organizations described in section 501(c)(3) of 

the Code -- including elementary, secondary, and post-secondary schools -- may be financed 

with tax-exempt private activity bonds ("qualified 501(c)(3) bonds"). Bonds for section 

501(c)(3) organizations are not subject to generally applicable State volume limi ts on most other 

private activity bonds.

States or local governments also may issue tax-exempt “exempt-facility bonds” to 

finance elementary and secondary public school facilities which are owned by private, for-profit 

corporations pursuant to public-private partnership agreements with a State or local educational 

agency. The term “school facility” includes school buildings and functionally related and 

subordinate facilities and land, including stadiums or other athletic facilities primarily used for 

school events, and depreciable personal property used in the school facility. The school facilities 

for which these bonds are issued must be operated by a public educational agency as part of a 

system of public schools. A “public private partnership agreement” is an arrangement under 

which the for-profit corporate party agrees to construct, rehabilitate, refurbish, or equip a school 

facility. The agreement also must provide that, at the end of the contract term, ownership of the 

bond-financed property is transferred to the public school agency for no additional consideration. 

These exempt facility bonds are subject to annual limits separate and apart from the 

general volume cap for private activity bonds. The volume limit applicable to each State equals 

the greater of $10 per State resident or $5 million. Individual States decide how to allocate the 

bond authority to State and local government agencies. Unused bond authority may be carried 

forward, but can only be used for public school projects. This provision sunsets after December 

31, 2010.

Arbitrage restrictions on tax-exempt bonds

The Federal income tax does not apply to the income of States and local governments 

that is derived from the exercise of an essential governmental function. To prevent these taxexempt entities from issuing more Federally subsidized tax-exempt bonds than is necessary for 

the activity being financed or from issuing such bonds earlier than needed for the purpose of the 

borrowing, the Code includes arbitrage restrictions limiting the ability to profit from investment 

of tax-exempt bond proceeds. In general, arbitrage profits may be earned only during specified 

periods (e.g., defined “temporary periods” before funds are needed for the purpose of the 

borrowing) or on specified types of investments (e.g., “reasonably required reserve or 

replacement funds”). Subject to limited exceptions, profits that are earned during these periods 

or on such investments must be rebated to the Federal Government.

Present law includes three exceptions to the arbitrage rebate requirements applicable to 

education-related bonds. First, issuers of all types of tax-exempt bonds are not required to rebate 

arbitrage profits if all of the proceeds of the bonds are spent for the purpose of the borrowing 
34

within six months after issuance.22 Second, in the case of bonds to finance certain construction 

activities, including school construction and renovation, the six-month period is extended to 24 

months. Arbitrage profits earned on construction proceeds are not required to be rebated if all 

such proceeds (other than certain retainage amounts) are spent by the end of the 24-month period 

and prescribed intermediate spending percentages are satisfied.23 Issuers qualifying for this 

“construction bond” exception may elect to be subject to a fixed penalty payment regime in lieu 

of rebate if they fail to satisfy the spending requirements.

Third, governmental bonds issued by “small” governments are not subject to the rebate 

requirement. Small governments are defined as general-purpose governmental units that issue 

no more than $5 million of tax-exempt governmental bonds in a calendar year. The $5 million 

limit is increased to $15 million if at least $10 million of the bonds are used to finance public 

schools.24

Qualified zone academy bonds

As an alternative to traditional tax-exempt bonds, States and local governments are given 

the authority to issue “qualified zone academy bonds.” Under present law, a total of $400 

million of qualified zone academy bonds may be issued in each of 1998 through 2003. The $400 

million aggregate bond authority is allocated each year to the States according to their respective 

populations of individuals below the poverty line. Each State, in turn, allocates the credit to 

qualified zone academies within such State. A State may carry over any unused allocation for up 

to two years (three years for authority arising before 2000).

Certain financial institutions (i.e., banks, insurance companies, and corporations actively 

engaged in the business of lending money) that hold qualified zone academy bonds are entitled 

to a nonrefundable tax credit in an amount equal to a credit rate multiplied by the face amount of 

the bond. An eligible financial institution holding a qualified zone academy bond on the credit 

allowance date (i.e., each one-year anniversary of the issuance of the bond) is entitled to a credit. 

The credit amount is includible in gross income (as if it were a taxable interest payment on the 

bond), and the credit may be claimed against regular income tax and alternative minimum tax 

liability.

 

22 In the case of governmental bonds (including bonds to finance public schools), the sixmonth expenditure exception is treated as satisfied if at least 95 percent of the proceeds is spend 

within six months and the remaining five percent is spent within 12 months after the bonds are 

issued.

23 Retainage amounts are limited to no more than five percent of the bond proceeds, and 

these amounts must be spent for the purpose of the borrowing no later than 36 months after the 

bonds are issued.

24 The Small Business Job Protection Act of 1996 permitted issuance of the additional $5 

million in public school bonds by small governments. Previously, small governments were 

defined as governments that issued no more than $5 million of governmental bonds without 

regard to the purpose of the financing.
35

The Treasury Department sets the credit rate daily at a rate estimated to allow issuance of 

qualified zone academy bonds without discount and without interest cost to the issuer. The 

maximum term of the bonds also is determined by the Treasury Department, so that the present 

value of the obligation to repay the bond is 50 percent of the face value of the bond. Present 

value is determined using as a discount rate the average annual interest rate of tax-exempt 

obligations with a term of 10 years or more issued during the month.

“Qualified zone academy bonds” are defined as bonds issued by a State or local 

government, provided that: (1) at least 95 percent of the proceeds is used for the purpose of 

renovating, providing equipment to, developing course materials for use at, or training teachers 

and other school personnel in a “qualified zone academy” and (2) private entities have promised 

to contribute to the qualified zone academy certain equipment, technical assistance or training, 

employee services, or other property or services with a value equal to at least 10 percent of the 

bond proceeds.

A school is a “qualified zone academy” if (1) the school is a public school that provides 

education and training below the college level, (2) the school operates a special academic 

program in cooperation with businesses to enhance the academic curriculum and increase 

graduation and employment rates, and (3) either (a) the school is located in a designated 

empowerment zone or a designated enterprise community, or (b) it is reasonably expected that at 

least 35 percent of the students at the school will be eligible for free or reduced-cost lunches 

under the school lunch program established under the National School Lunch Act. 

Description of Proposal

The proposal modifies the qualified zone academy bond program to allow eligible Indian 

tribes the authority to issue tribal school modernization bonds. The proceeds from tribal school 

modernization bonds are to be used for funding the construction, rehabilitation, or repair of tribal 

schools. The proceeds also may be used for (1) advance planning, design and engineering of the 

school, (2) payments to financial advisors, underwriters, attorneys, trustees and other 

professionals who provide assistance to the tribe in issuing the bonds and (3) certain other 

activities. The qualified tribal school modernization bond limitation for the calendar year 2003 

is $200 million and zero for calendar years thereafter. The qualified tribal school modernization 

bond limitation is to be allocated by the Treasury Department after consultation with the 

Secretary of Interior. Unused authority may be carried forward for up to two years. 

As with qualified zone academy bonds, certain financial institutions (i.e., banks, 

insurance companies, and corporations actively engaged in the business of lending money) that 

hold qualified tribal school modernization bonds are entitled to a nonrefundable tax credit in an 

amount equal to a credit rate multiplied by the face amount of the bond. In lieu of interest, an 

eligible financial institution holding a qualified tribal school modernization bond on the credit 

allowance date (i.e., each one-year anniversary of the issuance of the bond) is entitled to a credit. 

The credit amount is includible in gross income (as if it were a taxable interest payment on the 

bond), and the credit may be claimed against regular income tax and alternative minimum tax 

liability.
36

As with qualified zone academy bonds, the Treasury Department sets the credit rate daily 

at a rate estimated to allow issuance of qualified zone academy bonds without discount and 

without interest cost to the issuer. The maximum term of the bonds also is determined by the 

Treasury Department, so that the present value of the obligation to repay the bond is 50 percent 

of the face value of the bond. Present value is determined using as a discount rate the average 

annual interest rate of tax-exempt obligations with a term of 10 years or more issued during the 

month.

 No principal payments on any qualified tribal school modernization bond will be 

required until the stated maturity of such bond. At that time, the entire outstanding principal 

shall become due and payable. Payment of principal is guaranteed solely by amounts deposited 

with the respective bond trustee. Any land or facilities purchased or improved with bond 

proceeds can not be mortgaged or used as collateral for such bonds.

Under the proposal, a bond is treated as a qualified tribal school modernization bond if: 

(1) 95 percent or more of the bond proceeds are to be used for the construction, rehabilitation or 

repair of school facility funded by the Bureau of Indian Affairs or for the acquisition of land on 

which such a facility is to be constructed with part of the proceeds of such issue, (2) the bond is 

issued by a tribal government; (3) the issuer designates such bond for purposes of this section; 

and (4) the term of the bonds does not exceed the maximum term allowable for such bonds.

To be eligible to issue qualified tribal school modernization bonds, a tribe must (1) 

prepare and submit to the Treasury Department and the Secretary of Interior a plan of 

construction that meets certain requirements;25 (2) provide for quarterly and final inspection of 

the project by the Bureau of Indian Affairs; and (3) pledge that the facilities financed by such 

bond will be used primarily for elementary and secondary educational purposes for not less than 

the period such bond remains outstanding. Priority is given to projects described in the 

Education Facilities Replacement Construction Priorities List as of FY 2000 of the Bureau of 

Indian Affairs or any subsequent priorities list published in the Federal Register, or which meet 

the criteria for ranking schools as described in Instructions and Application for Replacement 

School Construction, Revision 6, dated February 6, 1999. 

The proposal makes any tribal school modernization bond subject to a trust agreement 

between a tribe and a trustee. Under the trust agreement, the trustee is to act as a repository for 

the proceeds of the bonds, make payments to bond holders, and invest the funds received. In 

lieu of a private business contribution requirement, the proposal authorizes the Secretary of 

Interior to deposit not more than $30 million into a tribal school modernization escrow account 

in FY 2003. It requires the Secretary of Interior to use any amounts deposited to make payments 

 

25 The plan of construction must contain a description of the construction to be 

undertaken with the funding, demonstrate that a comprehensive survey has be undertaken 

concerning the construction needs of the tribal school involved, contain assurances that the 

funding under the bond will be used only for the activities described in the plan, contain a 

response to the valuation criteria contained in Instructions and Application for Replacement 

School Construction, Revision 6, dated February 6, 1999; and contain any other reasonable and

related information determined appropriate by the Secretary.
37

to trustees, or for advance planning and design. Trustees are to invest money received from the 

escrow account in obligations of or fully guaranteed by the United States. Trust agreement 

earnings are not subject to Federal income tax.

Effective Date

The proposal is effective on date of enactment with respect to bonds issued after 

December 31, 2002.

6. Qualified small business stock

Present Law

Under present law, individuals may exclude 50 percent (60 percent for certain 

empowerment zone businesses) of the gain from the sale of certain small business stock acquired 

at original issue and held for at least five years. The taxable portion of the gain is taxed at a 

maximum rate of 28 percent. Forty-two percent of the excluded gain is a minimum tax 

preference. The amount of gain eligible for the exclusion by an individual with respect to any 

corporation is the greater of (1) ten times the taxpayer's basis in the stock or (2) $10 million. In 

order to qualify as a small business, when the stock is issued, the gross assets of the corporation 

may not exceed $50 million. The corporation also must meet certain active trade or business 

requirements.

A qualifying trade or business is any trade or business other than (1) a trade or business 

involving the performance of services in the fields of health, law, engineering, architecture, 

accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage 

services, or other trades or businesses based upon the reputation or skill of one or more of its 

employees; (2) banking, insurance, financing, leasing, investing, or similar business; (3) farming 

businesses, including raising or harvesting timber; (4) mining businesses; and (5) any business of 

operating a hotel, motel, or restaurant. 

Description of Proposal

Under the proposal, any business engaged in the development or provision of a “critical 

technology” as (as defined in section 2500(6) of title 10, United States Code), including 

transportation security technologies, antiterrorism technologies, technologies enhancing security 

by improving methods of personal identification (including biometrics), or environmental 

technologies for pollution minimization, remediation, or waste management, is a qualifying 

business.

Also under the proposal, if an eligible critical technology business is located in a high 

out-migration county, the 50-percent exclusion of gain is increased to a 60-percent exclusion. A 

“high out-migration county” is a county located outside a metropolitan statistical area (as defined 

by the Office of Management and Budget) that experienced net population loss during the fiveyear period 1990 through 1994 and also during the five-year period 1995 through 1999. 
38

Effective Date

The proposals apply to stock acquired after December 31, 2002.

7. Modification to the work opportunity tax credit

Present Law

Targeted groups eligible for the credit

The work opportunity tax credit is available on an elective basis for employers hiring 

individuals from one or more of eight targeted groups. The eight targeted groups are: (1) certain 

families eligible to receive benefits under the Temporary Assistance for Needy Families 

Program; (2) high-risk youth; (3) qualified ex-felons; (4) vocational rehabilitation referrals; (5) 

qualified summer youth employees; (6) qualified veterans; (7) certain members of families 

receiving food stamps; and (8) persons receiving certain Supplemental Security Income (SSI) 

benefits.

Vocational rehabilitation referrals are individuals who have a physical or mental 

disability that constitutes a substantial handicap to employment and who have been referred to 

the employer while receiving, or after completing, vocational rehabilitation services under an 

individualized, written rehabilitation plan under a State plan approved under the Rehabilitation 

Act of 1973 or under a rehabilitation plan for veterans carried out under Chapter 31 of Title 38, 

U.S. Code. Certification is provided by the designated local employment agency upon 

assurances from the vocation rehabilitation agency that the employee has met the above 

conditions.

A qualified food stamp recipient is an individual aged 18 but not aged 25 certified as 

being a member of a family either currently or recently receiving assistance under an eligible 

food stamp program.

Qualified wages

Generally, qualified wages are defined as cash wages paid by the employer to a member 

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

Calculation of the credit

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

qualified first-year wages. Generally, qualified first-year wages are qualified wages (not in 

excess of $6,000) attributable to service rendered by a member of a targeted group during the 

one-year period beginning with the day the individual began work for the employer. Therefore, 

the maximum credit per employee is $2,400 (40 percent of the first $6,000 of qualified first-year 

wages). With respect to qualified summer youth employees, the maximum credit is $1,200 (40 

percent of the first $3,000 of qualified first-year wages).
39

Minimum employment period

No credit is allowed for qualified wages paid to employees who work less than 120 hours 

in the first year of employment.

Other rules

The work opportunity tax credit is not allowed for wages paid to a relative or dependent 

of the taxpayer. Also, wages paid to replacement workers during a strike or lockout are not 

eligible for the work opportunity tax credit. Wages paid to any employee during any period for 

which the employer received on-the-job training program payments with respect to that 

employee are not eligible for the work opportunity tax credit. The work opportunity tax credit 

generally is not allowed for wages paid to individuals who had previously been employed by the 

employer. In addition, many other technical rules apply.

Description of Proposal

The proposal adds an additional type of individual eligible for the credit under the 

category of vocational rehabilitation referrals. Under the proposal, certain individuals who have 

a physical or mental disability that constitutes a substantial handicap to employment and who are 

receiving vocational services or have completed an individual work plan developed by a private 

employment network as defined under section 1148(f) of the Social Security Act qualify as 

members of the vocational rehabilitation referral targeted group.

The proposal increases the age limit for qualified food stamp recipients. Therefore a food 

stamp recipient is an individual aged 18 but not aged 30 certified as being a member of a family 

either currently or recently receiving assistance under an eligible food stamp program.

Effective Date

The provision is effective for wages paid or incurred to a qualified individual who begins 

work for an employer after December 31, 2002.

8. Treatment of new markets venture capital companies for the new markets tax credit

Present Law

The Community Renewal Tax Relief Act of 2000 created a new tax credit for qualified 

equity investments made to acquire stock or a partnership interest in a selected community 

development entity ("CDE"). The Treasury Department is responsible for allocating the credit 

among eligible CDEs, and the maximum annual amount of qualifying equity investments that is 

eligible for the credit is capped as follows:
40

Calendar Year Maximum Qualifying Equity Investment

2002-2003 $1.5 billion per year

2004-2005 $2.0 billion per year

2006-2007 $3.5 billion per year

The amount of the tax credit to the investor (either the original purchaser or a subsequent 

holder) is (1) a five-percent credit for the year in which the equity interest is purchased from the 

CDE and the first two anniversary dates after the interest is purchased from the CDE, and (2) a 

six percent credit on each anniversary date thereafter for the following four years. 

A CDE is any domestic corporation or partnership (1) whose primary mission is serving 

or providing investment capital for low-income communities or low-income persons, (2) that 

maintains accountability to residents of low-income communities by their representation on any 

governing board or on any advisory board of the CDE, and (3) is certified by the Treasury 

Department as an eligible CDE. A specialized small business investment company and a 

community development financial institution are treated as satisfying the requirements for a 

CDE. 

Description of Proposal

The proposal treats any conditionally approved new markets venture capital company (as 

defined in section 101 of the Community Renewal and New Markets Initiatives Act of 2001) as 

satisfying the requirements for a CDE.

Effective Date

The proposal is effective beginning on January 1, 2003.
41

F. Provisions to Simplify Excise Taxes

1. Simplification of excise tax imposed on bows and arrows

Present Law

The Code imposes an excise tax of 11 percent on the sale by a manufacturer, producer or 

importer of any bow with a draw rate of 10 pounds or more (sec. 4161(b)(1)(A)). An excise tax 

of 12.4 percent is imposed on the sale by a manufacturer or importer of any shaft, point, nock, or 

vane designed for use as part of an arrow which after its assembly (1) is over 18 inches long, or 

(2) is designed for use with a taxable bow (if shorter than 18 inches) (sec. 4161(b)(2)). No tax is 

imposed on finished arrows. An 11-percent excise tax also is imposed on any part of an 

accessory for taxable bows and on quivers for use with arrows (1) over 18 inches long or (2) 

designed for use with a taxable bow (if shorter than 18 inches) (sec. 4161(b)(1)(B)). 

Description of Proposal

The proposal increases the minimum draw weight for a taxable bow from 10 pounds to

30 pounds. The proposal also imposes an excise tax of 12 percent on arrows generally. An 

arrow for this purpose would be defined as an arrow shaft to which additional components are 

attached. The present law 12.4-percent excise tax on certain arrow components is unchanged by 

the proposal. The proposal provides that the 12-percent excise tax on arrows would not apply if 

the arrow contains an arrow shaft that was subject to the tax on arrow components. Finally, the 

proposal subjects certain broadheads (a type of arrow point) to an excise tax equal to 11 percent 

of the sales price instead of 12.4 percent.

Effective Date

The proposal is effective for articles sold by the manufacturer, producer, or importer after 

December 31, 2002.

2. Custom gunsmiths

Present Law

The Code imposes an excise tax upon the sale by the manufacturer, producer or importer 

of certain firearms and ammunition (sec. 4181). Pistols and revolvers are taxable at 10 percent. 

Firearms (other than pistols and revolvers), shells, and cartridges are taxable at 11 percent. The 

excise tax for firearms imposed on manufacturers, producers, and importers does not apply to 

machine guns and short barreled firearms. Sales to the Defense Department of firearms, pistols, 

revolvers, shells and cartridges also are exempt from the tax (sec. 4182). 

Description of Proposal

The proposal exempts from the firearms excise tax articles manufactured, produced, or 

imported by a person who manufactures, produces, and imports less than 50 of such articles 

during the calendar year. Controlled groups are treated as a single person for determining the 

50-article limit.
42

Effective Date

The proposal is effective for articles sold by the manufacturer, producer, or importer after 

December 31, 2002. No inference is intended from the prospective effective date of this 

proposal as to the proper treatment of pre-effective date sales. 

3. Repeal special occupational taxes on producers and marketers of alcoholic beverages

Present Law

Under present law, special occupational taxes are imposed on producers and others 

engaged in the marketing of distilled spirits, wine, and beer. These excise taxes are imposed as 

part of a broader Federal tax and regulatory engine governing the production and marketing of 

alcoholic beverages. The special occupational taxes are payable annually, on July 1 of each year. 

The present tax rates are as follows:

Producers: 

Distilled spirits and wines (sec. 5081) $1,000 per year, per premise

Brewers (sec. 5091) $1,000 per year, per premise

Wholesale dealers (sec. 5111):

Liquors, wines, or beer $500 per year

Retail dealers (sec. 5121):

Liquors, wines, or beer $250 per year

Nonbeverage use of distilled spirits (sec. 5131): $500 per year

Industrial use of distilled spirits (sec. 5276): $250 per year

Description of Proposal

The special occupational taxes on producers and marketers of alcoholic beverages are 

repealed. For purposes of the recordkeeping requirements for wholesale and retail liquor dealers, 

the proposal provides a rebuttable presumption that a person who sells, or offers for sale distilled 

spirits, wine, or beer, in quantities of 20 wine gallons or more to the same person at the same 

time, is engaged in the business of a wholesale dealer in liquors or a wholesale dealer in beer. In 

addition, the proposal makes it unlawful for any liquor dealer to purchase distilled spirits from 

any person other than a wholesale liquor dealer subject to the recordkeeping requirements.

Effective Date

The proposal is effective on July 1, 2003. The proposal does not affect liability for taxes 

imposed with respect to periods before July 1, 2003.
43

4. Treat tribal governments the same as State governments for purposes of the Federal 

wagering excise and occupational taxes

Present Law

Two excise taxes generally apply to wagering activities: a wager tax and an occupational 

tax. Section 4401 imposes a tax of 0.25 percent on any wager authorized under the law of the 

State in which the wager is accepted (the rate increases to 2.0 percent of any wager that is not so 

authorized). Certain wagering activities licensed or conducted by States are exempt from these 

excise taxes.26

 The Code also imposes a tax of $50 per year (the rate increases to $500 per year where 

unauthorized wagers are accepted) for each person liable for the tax imposed under section 4401 

and for each person who is engaged in receiving wagers for or on behalf of a person liable to pay 

the tax under section 4401 (sec. 4411). 

The United States Supreme Court recently resolved a split of authority27 regarding 

whether pull-tab games conducted by Indian tribes are exempt from these wagering and 

occupational excise taxes. The Court held that the Indian Gaming Regulatory Act does not 

exempt tribes from these taxes. 28

Section 7871 expressly provides that Indian tribal governments are treated as States for 

certain tax purposes. First, tribal governments may be recipients of deductible charitable 

donations for income, estate and gift tax purposes. Second, tribal governments are extended the 

treatment provided to States under the following excise taxes: tax on special fuels, manufacturers 

excise taxes, communications excise tax, and tax on use of certain highway vehicles. Special 

treatment relating to excise taxes is available to tribal governments only with regard to 

transactions involving the exercise of an essential governmental function by the Indian tribal 

government. Third, taxes paid to Indian tribal governments are deductible for income tax 

 

26 Wagers placed with a paramutuel wagering enterprise licensed under State law, 

wagers placed in certain coin-operated devices, and wagers placed with certain State-conducted 

lotteries are exempt under sec. 4402.

27 The Court of Appeals for the Federal Circuit in Little Six, Inc. & Shakopee 

Mdewakanton Sioux (Dakota) Community v. United States, 210 F. 3d 1361 (Fed. Cir. 2000) held 

that Indian Gaming Regulatory Act, at 25 U.S.C. sec. 2719(d)(1), provided tribes with the same 

exemption from Federal excise taxes enjoyed by the States for lotteries. The Court of Appeals 

for the Tenth Circuit held that the Indian Gaming Regulatory Act did not provide tribes with an 

exception in The Chickasaw Nation v. United States, 208 F. 3d 871 (10th Cir. 2000), cert. 

granted, January 22, 2001. 

28 Chickasaw Nation v. United States, 534 U.S. 84 (2001). Affirming the Tenth Circuit, 

the Supreme Court rejected the argument that the Indian Gaming Regulatory Act exemp ted the 

Chickasaw and Choctow nations from the excise taxes in chapter 35 of the Code, finding no such 

exemption. 
44

purposes to the same extent as States taxes. Fourth, Indian tribal governments may issue taxexempt bonds and private activity bonds under certain conditions.

Description of Proposal

The proposal treats Indian tribes as States for purposes of chapter 35 of the Code (relating 

to wagering). As a result, the wagering and occupational excise taxes would not apply to Indian 

tribes.

Effective Date

The proposal is effective July 1, 2003, but does not apply to taxes imposed for periods 

before such date.
45

G. Rate Reduction For Asbestos-Related Settlement Funds

Present Law

In general, section 461(h) provides that liabilities are not treated as incurred prior to the 

time when economic performance occurs. In the case of the taxpayer's liability to another 

person, arising under any workers compensation act or any tort, economic performance occurs as 

payments to such person are made, except to the extent provided in regulations. 

Section 468(B) provides that under certain limited circumstances, a qualified payment to 

a designated settlement fund that extinguishes tort liability of the taxpayer constitutes economic 

performance with respect to such liability. In addition, the regulations under section 468(B) 

provide that a payment to a qualified settlement fund to resolve or satisfy certain liabilities 

constitutes economic performance with respect to such liability. 

A designated settlement fund means a fund (1) which is established pursuant to a court 

order, (2) which extinguishes completely the taxpayer's tort liability with respect to a class of 

claimants, as determined by the court, (3) which is managed and controlled by persons unrelated 

to the taxpayer, (4) in which the taxpayer does not have a beneficial interest in the income or 

corpus, and (5) to which no amount may be transferred other than qualified payments.

The regulations define a qualified settlement fund as a fund, account, or trust (1) which 

is established pursuant to an order of, or approved by, a governmental authority and must be 

subject to the continuing jurisdiction of that governmental authority, (2) which is established to 

resolve or satisfy one or more claims that result from an event, or series of events, that has 

occurred and that gives rise to liabilities under the Comprehensive Environmental Response, 

Compensation and Liability Act, out of a tort, breach of contract (which is not defined in the 

same manner as in Treasury Regulation section 1.461-4(g)(2)(i)), or violation of law; or 

designated by the Commissioner in a revenue ruling or revenue procedure, and (3) which must 

be a trust under state law or its assets must be segregated from other assets of the transferor (and 

related persons). 

In general, a qualified payment means cash or property, other than indebtedness of the 

taxpayer (or a related party), which is contributed to a designated settlement fund or a qualified 

settlement fund. If indebtedness of the taxpayer (or related party) is contributed to a qualified 

settlement fund, economic performance occurs as the transferor (or related party) makes 

principal payments on the debt. Stock of the taxpayer (or related party) is not a qualified 

payment if contributed to a designated settlement fund.

A designated or qualified settlement fund is taxed as a separate entity at the maximum 

trust rate. The fund is subject to tax on modified gross income, which is defined as gross income 

computed with certain modifications. One modification excludes amounts transferred to the 

qualified settlement fund by, or on behalf of, the transferor. The other modifications are 

deductions for administrative costs and other incidental expenses incurred in connection with the 

operation of the fund; losses sustained by the fund in connection with the sale, exchange, or 

worthlessness of property; and specially defined net operating losses. Thus, distributions to 

claimants are not deductible.
46

A contribution of property to a designated or qualified settlement fund is treated as if the 

taxpayer sold the property for fair market value and donated the proceeds to the fund. Thus, the 

taxpayer's deduction is limited to fair market value. The taxpayer recognizes gain or loss at the 

time property is contributed, and the fund takes a fair market value basis in the property.

No deduction is allowed under this provision for payment to a fund of an amount 

received from the settlement of an insurance claim, if the amount received is excluded from the 

taxpayer's gross income.

Description of Proposal

The proposal provides a Federal income tax rate of 15 percent on the gross income (less 

permitted expenses) of a designated settlement fund (or a qualified settlement fund as defined 

under the regulations of section 468B) established for the principle purpose of resolving and 

satisfying present and future claims relating to asbestos. 

Effective Date

The proposal is effective shall apply to taxable years ending after December 31, 2002.
47

H. Provisions to Discourage Corporate Expatriation

1. Tax treatment of inversion transactions

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 

corporation’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 foreign-source 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 foreignsource income, whether repatriated as an actual dividend or included under one of the antideferral 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 
48

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 gross-basis 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” 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 taxreduction 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 
49

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 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.

Description of Proposal

In general

The proposal 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 corporation to be a domestic corporation for all purposes of the Code.29 

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 

 

29 Since the top-tier foreign corporation is treated for all purposes of the Code as 

domestic, the shareholder-level “toll charge” of sec. 367(a) does not apply to these inversion 

transactions. However, regulated investment companies and certain similar entities are allowed 

to elect to recognize gain as if sec. 367(a) did apply. This election is available for the calendar 

year of enactment and, if enactment occurs after October 31, the succeeding calendar year.
50

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 wholly owned 

controlled foreign corporation, the stock of such foreign corporation would be disregarded, and 

the definition would not be met. Stock sold in a public offering related to the transaction also is 

disregarded for these purposes. Acquisitions with respect to a domestic corporation or 

partnership are deemed to be “pursuant to a plan” if they occur within the four-year period 

beginning on the date which is two years before the ownership threshold under the provision is 

met with respect to such corporation or partnership.

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 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 
51

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 acquiring 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 proposal, both types of inversion transactions include certain partnership 

transactions. Specifically, both parts of the provision apply to transactions in which a foreignincorporated 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 
52

than 80 percent, as the case ma y 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. 

2. Reinsurance agreements

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. 30 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. 31 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 of another party to the agreement, or a 

conduit between related persons. 

Description of Proposal

The proposal 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 proposal 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 

 

30 Sec. 845(a).

31 See 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).
53

authority32 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 crossborder 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.

No regulations have been issued under section 845(a). It is expected that the Treasury 

Department will 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.

3. Excise tax on stock compensation of insiders of inverted corporations

Present Law

The income taxation of a nonstatutory33 compensatory stock option is determined under 

the rules that apply to property transferred in connection with the performance of services (sec. 

83). If a nonstatutory stock option does not have a readily ascertainable fair market value at the 

time of grant, which is generally the case unless the option is actively traded on an established 

market, no amount is included in the gross income of the recipient with respect to the option until 

the recipient exercises the option. 34 Upon exercise of such an option, the excess of the fair 

market value of the stock purchased over the option price is included in the recipient’s gross 

income as ordinary income in such taxable year. 

The tax treatment of other forms of stock-based compensation (e.g., restricted stock and 

stock appreciation rights) is also determined under section 83. The excess of the fair market 

value over the amount paid (if any) for such property is generally includable in gross income in 

the first taxable year in which the rights to the property are transferable or are not subject to 

substantial risk of forfeiture. 

 

32 The authority to allocate, recharacterize or make other adjustments was granted in 

connection with the repeal of provisions relating to modified coinsurance transactions.

33 Nonstatutory stock options refer to stock options other than incentive stock options 

and employee stock purchase plans, the taxation of which is determined under sections 421-424. 

34 If an individual receives a grant of a nonstatutory option that has a readily 

ascertainable fair market value at the time the option is granted, the excess of the fair market 

value of the option over the amount paid for the option is included in the recipient’s gross 

income as ordinary income in the first taxable year in which the option is either transferable or 

not subject to a substantial risk of forfeiture.
54

Shareholders are generally required to recognize gain upon stock inversion transactions. 

An inversion transaction is generally not a taxable event for holders of stock options and other 

stock-based compensation.

Description of Proposal

Under the proposal, specified holders of stock options and other stock-based 

compensation are subject to an excise tax upon certain inversion transactions. The proposal 

imposes a 20 percent excise tax on the value of specified stock compensation held (directly or 

indirectly) by or for the benefit of a disqualified individual, or a member of such individual’s 

family, at any time during the 12-month period beginning six months before the corporation’s 

inversion date. Specified stock compensation is treated as held for the benefit of a disqualified 

individual if such compensation is held by an entity, e.g., a partnership or trust, in which the 

individual, or a member of the individual’s family, has an ownership interest.

A disqualified individual is any individual who, with respect to a corporation, is, at any 

time during the 12-month period beginning on the date which is six months before the inversion 

date, subject to the requirements of section 16(a) of the Securities and Exchange Act of 1934 

with respect to the corporation, or any member of the corporation’s expanded affiliated group,35

or would be subject to such requirements if the corporation (or member) were an issuer of equity 

securities referred to in section 16(a). Disqualified individuals generally include officers (as 

defined by section 16(a)),36 directors, and 10-percent owners of private and publicly-held 

corporations.

The excise tax is imposed on a disqualified individual of an inverted corporation only if 

gain (if any) is recognized in whole or part by any shareholder by reason of either the 80 percent 

or 50 percent identity of stock ownership corporate inversion transactions previously described 

in the proposal.

Specified stock compensation subject to the excise tax includes any payment37 (or right to 

payment) granted by the inverted corporation (or any member of the corporation’s expanded 

affiliated group) to any person in connection with the performance of services by a disqualified 

individual for such corporation (or member of the corporation’s expanded affiliated group) if the 

value of the payment or right is based on, or determined by reference to, the value or change in 

 

35 An expanded affiliated group is an affiliated group (under section 1504) except that 

such group is determined without regard to the exceptions for certain corporations and is 

determined applying a greater than 50 percent threshold, in lieu of the 80 percent test.

36 An officer is defined as the president, principal financial officer, principal accounting 

officer (or, if there is no such accounting officer, the controller), any vice-president in charge of 

a principal business unit, division or function (such as sales, administration or finance), any other 

officer who performs a policy-making function, or any other person who performs similar 

policy-making functions.

37 Under the proposal, any transfer of property is treated as a payment and any right to a 

transfer of property is treated as a right to a payment. 
55

value of stock of such corporation (or any member of the corporation’s expanded affiliated 

group). In determining whether such compensation exists and valuing such compensation, all 

restrictions, other than non-lapse restrictions, are ignored. Thus, the excise tax applies, and the 

value subject to the tax is determined, without regard to whether such specified stock 

compensation is subject to a substantial risk of forfeiture or is exercisable at the time of the 

inversion transaction. Specified stock compensation includes compensatory stock and restricted 

stock grants, compensatory stock options, and other forms of stock-based compensation, 

including stock appreciation rights, phantom stock, and phantom stock options. Specified stock 

compensation also includes nonqualified deferred compensation that is treated as though it were 

invested in stock or stock options of the inverting corporation (or member). For example, the 

proposal applies to a disqualified individual’s deferred compensation if company stock is one of 

the actual or deemed investment options under the nonqualified deferred compensation plan. 

Specified stock compensation includes a compensation arrangement that gives the 

disqualified individual an economic stake substantially similar to that of a corporate shareholder. 

Thus, the excise tax does not apply where a payment is simply triggered by a target value of the 

corporation’s stock or where a payment depends on a performance measure other than the value 

of the corporation’s stock. Similarly, the tax does not apply if the amount of the payment is not 

directly measured by the value of the stock or an increase in the value of the stock. For example, 

an arrangement under which a disqualified individual is paid a cash bonus of $500,000 if the 

corporation’s stock increased in value by 25 percent over two years or $1,000,000 if the stock 

increased by 33 percent over two years is not specified stock compensation, even though the 

amount of the bonus generally is keyed to an increase in the value of the stock. By contrast, an 

arrangement under which a disqualified individual is paid a cash bonus equal to $10,000 for 

every $1 increase in the share price of the corporation’s stock is subject to the proposal because 

the direct connection between the compensation amount and the value of the corporation’s stock 

gives the disqualified individual an economic stake substantially similar to that of a shareholder.

The excise tax applies to any such specified stock compensation previously granted to a 

disqualified individual but cancelled or cashed-out within the six-month period ending with the 

inversion transaction, and to any specified stock compensation awarded in the six-month period 

beginning with the inversion transaction. As a result, for example, if a corporation were to 

cancel outstanding options three months before the transaction and then reissue comparable 

options three months after the transaction, the tax applies both to the cancelled options and the 

newly granted options. It is intended that the Secretary issue guidance to avoid double counting 

with respect to specified stock compensation that is cancelled and then regranted during the 

applicable twelve-month period.

Specified stock compensation subject to the tax does not include a statutory stock option 

or any payment or right from a qualified retirement plan or annuity, a tax-sheltered annuity, a 

simplified employee pension, or a simple retirement account. In addition, under the proposal, the 

excise tax does not apply to any stock option that is exercised during the six-month period before 

the inversion or to any stock acquired pursuant to such exercise. The excise tax also does not 

apply to any specified stock compensation which is sold, exchanged, distributed or cashed-out 

during such period in a transaction in which gain or loss is recognized in full.
56

For specified stock compensation held on the inversion date, the amount of the tax is 

determined based on the value of the compensation on such date. The tax imposed on specified 

stock compensation cancelled during the six-month period before the inversion date is 

determined based on the value of the compensation on the day before such cancellation, while 

specified stock compensation granted after the inversion date is valued on the date granted. 

Under the proposal, the cancellation of a non-lapse restriction is treated as a grant. 

The value of the specified stock compensation on which the excise tax is imposed is the 

fair value in the case of stock options (including warrants and other similar rights to acquire 

stock) and stock appreciation rights and the fair market value for all other forms of 

compensation. For purposes of the tax, the fair value of an option (or a warrant or other similar 

right to acquire stock) or a stock appreciation right is determined using an appropriate optionpricing model, as specified or permitted by the Secretary, that takes into account the stock price 

at the valuation date; the exercise price under the option; the remaining term of the option; the 

volatility of the underlying stock and the expected dividends on it; and the risk-free interest rate 

over the remaining term of the option. Options that have no intrinsic value (or “spread”) because 

the exercise price under the option equals or exceeds the fair market value of the stock at 

valuation nevertheless have a fair value and are subject to tax under the proposal. The value of 

other forms of compensation, such as phantom stock or restricted stock, are the fair market value 

of the stock as of the date of the inversion transaction. The value of any deferred compensation 

that could be valued by reference to stock is the amount that the disqualified individual would 

receive if the plan were to distribute all such deferred compensation in a single sum on the date 

of the inversion transaction (or the date of cancellation or grant, if applicable). It is expected that 

the Secretary issue guidance on valuation of specified stock compensation, including guidance 

similar to the revenue procedures issued under section 280G, except that the guidance would not 

permit the use of a term other than the full remaining term. Pending the issuance of guidance, it 

is intended that taxpayers could rely on the revenue procedures issued under section 280G 

(except that the full remaining term must be used). 

The excise tax also applies to any payment by the inverted corporation or any member of 

the expanded affiliated group made to an individual, directly or indirectly, in respect of the tax. 

Whether a payment is made in respect of the tax is determined under all of the facts and 

circumstances. Any payment made to keep the individual in the same after-tax position that the 

individual would have been in had the tax not applied is a payment made in respect of the tax. 

This includes direct payments of the tax and payments to reimburse the individual for payment 

of the tax. It is expected that the Secretary issue guidance on determining when a payment is 

made in respect of the tax and that such guidance would include certain factors that give rise to a 

rebuttable presumption that a payment is made in respect of the tax, including a rebuttable 

presumption that if the payment is contingent on the inversion transaction, it is made in respect 

to the tax. Any payment made in respect of the tax is includible in the income of the individual, 

but is not deductible by the corporation.

To the extent that a disqualified individual is also a covered employee under section 

162(m), the $1,000,000 limit on the deduction allowed for employee remuneration for such 

employee is reduced by the amount of any payment (including reimbursements) made in respect 

of the tax under the proposal. As discussed above, this includes direct payments of the tax and 

payments to reimburse the individual for payment of the tax. 
57

The payment of the excise tax has no effect on the subsequent tax treatment of any 

specified stock compensation. Thus, the payment of the tax has no effect on the individual’s 

basis in any specified stock compensation and no effect on the tax treatment for the individual at 

the time of exercise of an option or payment of any specified stock compensation, or at the time 

of any lapse or forfeiture of such specified stock compensation. The payment of the tax is not 

deductible and has no effect on any deduction that might be allowed at the time of any future 

exercise or payment.

Under the proposal, the Secretary is authorized to issue regulations as may be necessary 

or appropriate to carry out the purposes of the section.

Effective Date

The proposal is effective as of July 11, 2002, except that periods before July 11, 2002, are 

not taken into account in applying the tax to specified stock compensation held or cancelled 

during the six-month period before the inversion date.
58

I. Provisions to Curtail Tax Shelters

1. Clarification of the economic substance doctrine

Present Law

In general

The Code provides specific rules regarding the computation of taxable income, including 

the amount, timing, source, and character of items of income, gain, loss and deduction. These 

rules are designed to provide for the computation of taxable income in a manner that provides for 

a degree of specificity to both taxpayers and the government. Taxpayers generally may plan 

their transactions in reliance on these rules to determine the federal income tax consequences 

arising from the transactions. 

In addition to the statutory provisions, courts have developed several doctrines that can 

be applied to deny the tax benefits of tax motivated transactions, notwithstanding that the 

transaction may satisfy the literal requirements of a specific tax provision. The common-law 

doctrines are not entirely distinguishable, and their application to a given set of facts is often 

blurred by the courts and the IRS. Although these doctrines serve an important role in the 

administration of the tax system, invocation of these doctrines can be seen as at odds with an 

objective, “rule-based” system of taxation. Nonetheless, courts have applied the doctrines to 

deny tax benefits arising from certain transactions.38 

A common-law doctrine applied with increasing frequency is the “economic substance” 

doctrine. In general, this doctrine denies tax benefits in transactions that do not result in a 

meaningful change to the taxpayer’s economic position other than a purported reduction in 

federal income tax. 39

Economic substance doctrine

Courts generally deny claimed tax benefits if the transaction that gives rise to those 

benefits lacks economic substance independent of tax considerations -- notwithstanding that the 

purported activity actually occurred. The Tax Court has described the doctrine as follows:

The tax law . . . requires that the intended transactions have economic substance 

separate and distinct from economic benefit achieved solely by tax reduction. 

The doctrine of economic substance becomes applicable, and a judicial remedy is 

 

38

 See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), aff’g 73 

T.C.M. (CCH) 2189 (1997), cert. denied 526 U.S. 1017 (1999).

39 Closely related doctrines also applied by the courts (sometimes interchangeable with 

the economic substance doctrine) include the “sham transaction doctrine” and the “business 

purpose doctrine”. See, e.g., Knetsch v. U.S., 364 U.S. 361 (1960) (denying interest deductions 

on a “sham transaction” whose only purpose was to create the deductions).
59

warranted, where a taxpayer seeks to claim tax benefits, unintended by Congress, 

by means of transactions that serve no economic purpose other than tax savings.40

A court decision often credited for laying the foundation of the economic substance 

doctrine is the Second Circuit decision in Gregory v. Helvering.

41 In Gregory, a transitory 

subsidiary was established to effectuate, utilizing the corporate reorganization provisions of the 

Code, a tax advantaged distribution from a corporation to its shareholder of appreciated 

corporate securities that the corporation (and its shareholder) intended to sell. Although the tax 

court found that the transaction satisfied the literal definition of a tax-free reorganization, the 

Second Circuit held (and the Supreme Court affirmed) that satisfying the literal definition was 

not enough:

The purpose of the [reorganization] section is plain enough; men engaged in 

enterprises--industrial, commercial, financial, or any other--might wish to 

consolidate, or divide, to add to, or subtract from, their holdings . . .But the 

underlying presupposition is plain that the readjustment shall be undertaken for 

reasons germane to the conduct of the venture in hand, not as an ephemeral 

incident, egregious to its prosecution. To dodge the shareholder’s taxes is not one 

of the transactions contemplated as corporate “reorganizations.”42

Business purpose doctrine

Another common law doctrine that overlays and is often considered together with (if not 

part and parcel of) the economic substance doctrine is the business purpose doctrine. The 

business purpose test is a subjective inquiry into the motives of the taxpayer -- that is, whether 

the taxpayer intended the transaction to serve some useful non-tax purpose. In making this 

determination, some courts have bifurcated a transaction in which independent activities with 

non-tax objectives have been combined with an unrelated item having only tax-avoidance 

objectives in order to disallow the tax benefits of the overall transaction. 43

Application by the courts

Elements of the doctrine

There is a lack of uniformity regarding the proper application of the economic substance 

doctrine. Some courts apply a conjunctive test that requires a taxpayer to establish the presence 

 

40

 ACM, 73 T.C.M. at 2215.

41 69 F.2d 809 (2nd Cir. 1934), aff’d 293 U.S. 465 (1935). The Gregory decision also is 

cited as the seminal case for the substance over form and business purpose doctrines. See, e.g.,

Department of Treasury, The Problem of Corporate Tax Shelters: Discussion, Analysis and 

Legislative Proposals, at 47, 55 (July 1999).

42

 Gregory, 69 F.2d at 811.

43

 ACM, 157 F.3d at 256 n.48.
60

of both economic substance (i.e., the objective component) and business purpose (i.e., the 

subjective component) in order for the transaction to sustain court scrutiny. 44 A narrower 

approach used by some courts is to invoke the economic substance doctrine only after a

determination that the transaction lacks both a business purpose and economic substance (i.e., the 

existence of either a business purpose or economic substance would be sufficient to respect the 

transaction).45 A third approach regards economic substance and business purpose as “simply 

more precise factors to consider” in determining whether a transaction has any practical 

economic effects other than the creation of tax benefits.46 

Profit potential

There also is a lack of uniformity regarding the necessity and level of profit potential 

necessary to establish economic substance. Since the time of Gregory, several courts have 

denied tax benefits on the grounds that the subject transactions lacked profit potential.47 In 

 

44

 See, e.g., Pasternak v. Commissioner, 990 F.2d 893, 898 (6th Cir. 1993) (“The 

threshold question is whether the transaction has economic substance. If the answer is yes, the 

question becomes whether the taxpayer was motivated by profit to participate in the 

transaction.”)

45

 See, e.g., Rice’s Toyota World v. Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985)

(“To treat a transaction as a sham, the court must find that the taxpayer was motivated by no 

business purposes other than obtaining tax benefits in entering the transaction, and, second, that 

the transaction has no economic substance because no reasonable possibility of a profit exists.”); 

IES Industries v. U.S., 253 F.3d 350, 358 (8th Cir. 2001) (“In determining whether a transaction 

is a sham for tax purposes [under the Eighth Circuit test], a transaction will be characterized as a 

sham if it is not motivated by any economic purpose out of tax considerations (the business 

purpose test), and if it is without economic substance because no real potential for profit exists” 

(the economic substance test).”) As noted earlier, the economic substance doctrine and the sham 

transaction doctrine are similar and sometimes are applied interchangeably. For a more detailed 

discussion of the sham transaction doctrine, see, e.g., Joint Committee on Taxation, Study of 

Present-Law Penalty and Interest Provisions as Required by Section 3801 of the Internal 

Revenue Service Restructuring and Reform Act of 1998 (including Provisions Relating to 

Corporate Tax Shelters) (JCS-3-99) at 182.

46

 See, e.g., ACM, 157 F.3d at 247; James v. Commissioner, 899 F.2d 905, 908 (10th Cir. 

1995); Sacks v. Commissioner, 69 F.3d 982, 985 (9th Cir. 1995) (“Instead, the consideration of 

business purpose and economic substance are simply more precise factors to consider . . ..We 

have repeatedly and carefully noted that this formulation cannot be used as a ‘rigid two-step 

analysis’.”).

47

 See, e.g., Knetsch, 364 U.S. at 361; Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 

1966) (holding that an unprofitable, leveraged acquisition of Treasury bills, and accompanying 

prepaid interest deduction, lacked economic substance); Ginsburg v. Commissioner, 35 T.C.M. 

(CCH) 860 (1976) (holding that a leveraged cattle-breeding program lacked economic 

substance).
61

addition, some courts have applied the economic substance doctrine to disallow tax benefits in 

transactions in which a taxpayer was exposed to risk and the transaction had a profit potential, 

but the court concluded that the economic risks and profit potential were insignificant when 

compared to the tax benefits.48 Under this analysis, the taxpayer’s profit potential must be more 

than nominal. Conversely, other courts view the application of the economic substance doctrine 

as requiring an objective determination of whether a “reasonable possibility of profit” from the 

transaction existed apart from the tax benefits.49 In these cases, in assessing whether a 

reasonable possibility of profit exists, it is sufficient if there is a nominal amount of pre-tax profit 

as measured against expected net tax benefits.

Description of Proposal

In general

The proposal clarifies and enhances the application of the economic substance doctrine. 

The proposal provides that a transaction has economic substance (and thus satisfies the economic 

substance doctrine) only if the taxpayer establishes that (1) the transaction changes in a 

meaningful way (apart from Federal income tax consequences) the taxpayer’s economic position, 

and (2) the taxpayer has a substantial non-tax purpose for entering into such transaction and the 

transaction is a reasonable means of accomplishing such purpose. 

Conjunctive analysis

The proposal clarifies that the economic substance doctrine involves a conjunctive 

analysis -- there must be an objective inquiry regarding the effects of the transaction on the 

taxpayer’s economic position, as well as a subjective inquiry regarding the taxpayer’s motives 

for engaging in the transaction. Under the proposal, a transaction must satisfy both tests -- i.e., it 

must change in a meaningful way (apart from Federal income tax consequences) the taxpayer’s 

economic position, and the taxpayer must have a substantial non-tax purpose for entering into 

such transaction (and the transaction is a reasonable means of accomplishing such purpose) -- in 

order to satisfy the economic substance doctrine. This clarification eliminates the disparity that 

exists among the circuits regarding the application of the doctrine, and modifies its application in 

 

48

 See, e.g., Goldstein, 364 F.2d at 739-40 (disallowing deduction even though taxpayer 

had a possibility of small gain or loss by owning Treasury bills); Sheldon v. Commissioner, 94 

T.C. 738, 768 (1990) (stating, “potential for gain . . . is infinitesimally nominal and vastly 

insignificant when considered in comparison with the claimed deductions”).

49

 See, e.g., Rice’s Toyota World, 752 F.2d at 94 (the economic substance inquiry 

requires an objective determination of whether a reasonable possibility of profit from the 

transaction existed apart from tax benefits); Compaq Computer Corp., 277 F.3d at 781 (applied 

the same test, citing Rice’s Toyota World); IES Industries, 253 F.3d at 354 (the application of the 

objective economic substance test involves determining whether there was a “reasonable 

possibility of profit . . . apart from tax benefits.”). 
62

those circuits in which either a change in economic position or a non-tax business purpose 

(without having both) is sufficient to satisfy the economic substance doctrine.50 

Non-tax business purpose

The proposal provides that a taxpayer’s non-tax purpose for entering into a transaction 

(the second prong in the analysis) must be “substantial,” and that the transaction must be “a 

reasonable means” of accomplishing such purpose. Under this formulation, the non-tax purpose 

for the transaction must bear a reasonable relationship to the taxpayer’s normal business 

operations or investment activities.51 

In determining whether a taxpayer has a substantial non-tax business purpose, it is 

intended that an objective of achieving a favorable accounting treatment for financial reporting 

purposes will not be treated as having a substantial non-tax purpose.52 Furthermore, a 

transaction that is expected to increase financial accounting income as a result of generating tax 

deductions or losses without a corresponding financial accounting charge (i.e., a permanent 

book-tax difference)53 should not be considered to have a substantial non-tax purpose unless a 

substantial non-tax purpose exists apart from the financial accounting benefits.54 

 

50

 Cf., e.g., Boca Investerings Partnership v. U.S., 167 F. Supp. 2d 298, 376-77 (D.D.C. 

2001) (in determining whether the transaction in question should be respected under the 

economic substance doctrine, the test in the D.C. Circuit requires a transaction to be respected 

under the doctrine unless it lacks both a valid non-tax business purpose and a reasonable 

possibility of profit).

51

 See, Martin McMahon Jr., Economic Substance, Purposive Activity, and Corporate 

Tax Shelters, 94 Tax Notes 1017, 1023 (Feb. 25, 2002) (advocates “confining the most rigorous 

application of business purpose, economic substance, and purposive activity tests to transactions 

outside the ordinary course of the taxpayer’s business -- those transactions that do not appear to 

contribute to any business activity or objective that the taxpayer may have had apart from tax 

planning but are merely loss generators.”); Mark P. Gergen, The Common Knowledge of Tax 

Abuse, 54 SMU L. Rev. 131, 140 (Winter 2001) (“The message is that you can pick up tax gold 

if you find it in the street while going about your business, but you cannot go hunting for it.”).

52 However, if the tax benefits are clearly contemplated and expected by the language 

and purpose of the relevant authority, such tax benefits should not be disallowed solely because 

the transaction results in a favorable accounting treatment. An example is the repealed foreign 

sales corporation rules.

53 This includes tax deductions or losses that are anticipated to be recognized in a period 

subsequent to the period the financial accounting benefit is recognized. For example, FAS 109 

in some cases permits the recognition of financial accounting benefits prior to the period in 

which the tax benefits are recognized for income tax purposes.

54 Claiming that a financial accounting benefit constitutes a substantial non-tax purpose 

fails to consider the origin of the accounting benefit (i.e., reduction of taxes) and significantly 

diminishes the purpose for having a substantial non-tax purpose requirement. See, e.g., 
63

By requiring that a transaction be a “reasonable means” of accomplishing its non-tax 

purpose, the proposal broadens the ability of the courts to bifurcate a transaction in which 

independent activities with non-tax objectives are combined with an unrelated item having only 

tax-avoidance objectives in order to disallow the tax benefits of the overall transaction.

Profit potential

Under the proposal, a taxpayer may rely on factors other than profit potential to 

demonstrate that a transaction results in a meaningful change in the taxpayer’s economic 

position; the proposal merely sets forth a minimum threshold of profit potential if that test is 

relied on to demonstrate a meaningful change in economic position. Specifically, if a taxpayer 

relies on a profit potential, the present value of the reasonably expected pre-tax profit must be 

substantial in relation to the present value of the expected net tax benefits that would be allowed 

if the transaction were respected.55 Moreover, the profit potential must exceed a risk-free rate of 

return. In addition, in determining pre-tax profit, fees and other transaction expenses and foreign 

taxes are treated as expenses.

In applying the profit test to the lessor of tangible property, depreciation and other 

applicable tax credits (such as the rehabilitation tax credit and the low income housing tax credit) 

are not taken into account in measuring tax benefits. Thus, a traditional leveraged lease is not 

affected by the bill to the extent it meets the present law standards.

Transactions with tax-indifferent parties

The proposal also provides special rules for transactions with tax-indifferent parties. For 

this purpose, a tax-indifferent party means any person or entity not subject to Federal income tax, 

or any person to whom an item would have no substantial impact on its income tax liability. 

Under these rules, the form of a financing transaction will not be respected if the present value of 

the tax deductions to be claimed is substantially in excess of the present value of the anticipated 

economic returns to the lender. Also, the form of a transaction with a tax-indifferent party will 

not be respected if it results in an allocation of income or gain to the tax-indifferent party in 

excess of the tax-indifferent party’s economic gain or income or if the transaction results in the 

shifting of basis on account of overstating the income or gain of the tax-indifferent party.

 

American Electric Power, Inc. v. U.S., 136 F. Supp. 2d 762, 791-92 (S.D. Ohio, 2001) (“AEP’s 

intended use of the cash flows generated by the [corporate-owned life insurance] plan is 

irrelevant to the subjective prong of the economic substance analysis. If a legitimate business 

purpose for the use of the tax savings ‘were sufficient to breathe substance into a transaction 

whose only purpose was to reduce taxes, [then] every sham tax-shelter device might succeed,’” 

citing Winn-Dixie v. Commissioner, 113 T.C. 254, 287 (1999)). 

55 Thus, a “reasonable possibility of profit” will not be sufficient to establish that a 

transaction has economic substance.
64

Other rules

The Secretary may prescribe regulations which provide (1) exemptions from the 

application of this proposal, and (2) other rules as may be necessary or appropriate to carry out 

the purposes of the proposal. 

No inference is intended as to the proper application of the economic substance doctrine 

under present law. In addition, except with respect to the economic substance doctrine, the 

proposal shall not be construed as altering or supplanting any other common law doctrine 

(including the sham transaction doctrine), and this proposal shall be construed as being additive 

to any such other doctrine.

Effective Date

The proposal applies to transactions entered into after the date of enactment.

2. Penalty for failure to disclose reportable transactions

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.56 

There are two categories of reportable transactions. The first category includes any 

transaction that is the same as (or substantially similar to)57 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”). 

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 

 

56 Temp. 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.

57 The 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).
65

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. 58 

Under present law, there is no specific penalty for failing to disclose a reportable 

transaction; however, such a failure may jeopardize a 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. 59 

Description of Proposal

In general

The proposal 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.

Transactions to be disclosed

The proposal does not define the terms “listed transaction” 60 or “reportable transaction,” 

nor does the proposal explain the type of information that must be disclosed in order to avoid the 

imposition of a penalty. Rather, the proposal authorizes the Treasury Department to define a 

“listed transaction” and a “reportable transaction” under section 6011. It is expected that the 

Treasury Department will 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 new regulations are expected to define a 

reportable transaction to include (but not be limited to) transactions with any of the following 

 

58 Temp. 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).

59 Section 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.

60 The proposal states that, except as provided in regulations, a listed transaction means a 

reportable transaction, which is the same as, or substantially similar to, a transaction specifically 

identified by the Secretary as a tax avoidance transaction for purposes of section 6011. For this 

purpose, it is expected that the definition of “substantially similar” will be the same as the one 

used in Temp. Treas. Reg. 1.6011-4T(b)(i). However, the Secretary may modify this definition 

(as well as the definitions of “listed transaction” and “reportable transactions”) as appropriate. 
66

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.61 

Disclosure requirements

It is expected that the new regulations will specify the manner in which a taxpayer must 

disclose reportable transactions. The information required to be disclosed with respect to 

reportable transactions should 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 informa tion that the Secretary may prescribe (e.g., the 

involvement of any accommodation party or any tax-indifferent party, the receipt of a tax 

opinion 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). 

It is intended 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 verification under penalties of perjury also should apply to any large entity that discloses that 

it did not enter into any reportable transactions during the tax year covered by such declaration.

 

61

 See 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) (the “Treasury shelter initiative”). The 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).
67

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.62 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 IRS 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 

any 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 proposal 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 understatement penalty attributable to a non-disclosed listed transaction, a 

non-disclosed reportable avoidance transaction, or a transaction that lacks economic substance63) 

must disclose the imposition of the penalty in reports to the Securities and Exchange 

Commission (“SEC”) for such period as the Secretary shall specify. The proposal 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).

 

62 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 proposal.

63 These categories of transactions are described in greater detail below in connection 

with the proposals modifying the accuracy-related penalty for listed and certain reportable 

transactions and a penalty for understatements attributable to transactions that lack economic 

substance.
68

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 proposal is effective for returns and statements the due date for which is after the 

date of enactment.

3. Modifications to the accuracy-related penalties for listed transactions and

reportable transactions having a significant tax avoidance purpose

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. 64 

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. 65 

Special rules apply with respect to tax shelters.66 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. 67 The relevant regulations 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 

 

64 Sec. 6662.

65 Sec. 6662(d)(2)(B).

66 Sec. 6662(d)(2)(C).

67 Sec. 6664(c).
69

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.68

Description of Proposal

In general

The proposal 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”).69 The penalty rate and 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.

Disclosed transactions

In general, a 20-percent accuracy-related penalty is imposed on any understatement 

attributable to an adequately disclosed listed transaction or 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.

Undisclosed transactions

If the taxpayer does not adequately disclose the transaction, the strengthened reasonable 

cause exception is not available (i.e., a strict-liability penalty applies), and the taxpayer is subject 

to an increased penalty rate equal to 30 percent of the understatement. 

In addition, a public entity that is required to pay the 30 percent penalty must disclose the 

imposition of the penalty in reports to the SEC for such periods as the Secretary shall specify. 

The disclosure to the SEC 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 any failure to 

disclose such penalty in the reports is treated 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).

Once the 30 percent penalty has been included in the Revenue Agent Report, the penalty 

cannot be compromised for purposes of a settlement without approval of the Commissioner 

 

68 Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 1.6664-4(c).

69 The terms “reportable transaction” and “listed transaction” have the same meanings as 

previously described in connection with the penalty for failing to disclose reportable 

transactions.
70

personally or the head of the Office of Tax Shelter Analysis. Furthermore, the IRS is required to 

submit an annual report to Congress summarizing the application of this penalty and providing a 

description of each penalty compromised under this proposal and the reasons for the 

compromise. 

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 proposal, 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) 70, 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, a 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 proposal with respect to any portion of an 

understatement if it 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 6011,71 (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.”

 

70 For 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.

71

 See the previous discussion regarding the penalty for failing to disclose a reportable 

transaction.
71

Disqualified tax advisor

A disqualified tax advisor is any advisor who (1) is a material advisor72 and who 

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 

directly or indirectly73 by a 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. 

Organization, management, promotion or sale of a transaction

A material advisor is 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. 74 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.

 

72 The 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). 

73 This 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. 

74 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 advisor is compensated by a 

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). 
72

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.

Coordination with other penalties

Any understatement to which a penalty is imposed under this proposal 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 proposal shall not apply to any portion of an 

understatement to which a fraud penalty is applied under section 6663.

Effective Date

The proposal is effective for taxable years ending after the date of enactment.

4. Penalty for understatements from transactions lacking economic substance 

Present Law

An 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. 75 

The amount of any understatement 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. 

Special rules apply with respect to tax shelters.76 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. 

 

75 Sec. 6662.

76 Sec. 6662(d)(2)(C).
73

The 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. 77 The relevant regulations 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.78

Description of Proposal

The proposal imposes a penalty for an understatement attributable to any transaction that 

lacks economic substance (referred to in the statute as a “non-economic substance transaction 

understatement”).79 The penalty rate is 40 percent (reduced to 20 percent if the taxpayer 

adequately discloses the relevant facts in accordance with regulations prescribed under section 

6011). No exceptions (including the reasonable cause or rescission rules) to the penalty would 

be available under the proposal (i.e., the penalty is a strict-liability penalty).

A “non-economic substance transaction” means any transaction if (1) the transaction 

lacks economic substance (as defined in the earlier proposal regarding the economic substance 

doctrine),80 (2) the transaction was not respected under the rules relating to transactions with taxindifferent parties (as described in the earlier proposal regarding the economic substance 

doctrine),81 or (3) any similar rule of law. For this purpose, a similar rule of law would include, 

for example, an understatement attributable to a transaction that is determined to be a sham 

transaction.

For purposes of this proposal, the calculation of an “understatement” is made in the same 

manner as in the separate proposal relating to accuracy-related penalties for listed and reportable 

avoidance transactions (new sec. 6662A). Thus, the amount of the understatement under this 

proposal would be 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 

 

77 Sec. 6664(c).

78 Treas. Reg. sec. 1.6662-4(g)(4)(i)(B); Treas. Reg. sec. 1.6664-4(c).

79 Thus, unlike the new accuracy-related penalty under section 6662A (which applies 

only to listed and reportable avoidance transactions), the new penalty under this proposal applies 

to any transaction that lacks economic substance.

80 The proposal provides that a transaction has economic substance only if (1) the 

transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s 

economic position, and (2) the transaction has a substantial non-tax purpose for entering into 

such transaction and is a reasonable means of accomplishing such purpose.

81 The proposal provides that the form of a transaction that involves a tax-indifferent 

party will not be respected in certain circumstances.
74

items on the tax return), 82 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. In essence, the penalty will apply to the amount of any understatement 

attributable solely to a non-economic substance transaction.

 Except as provided in regulations, the taxpayer’s treatment of an item will not take into 

account any amendment or supplement to a return if the amendment or supplement is filed after 

the earlier of the date the taxpayer is first contacted regarding an examination of the return or 

such other date as specified by the Secretary. 

A public entity that is required to pay a penalty under this proposal (regardless of whether 

the transaction was disclosed) must disclose the imposition of the penalty in reports to the SEC 

for such periods as the Secretary shall specify. The disclosure to the SEC 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 any failure to disclose such penalty in the reports is treated 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). 

Once a penalty (regardless of whether the transaction was disclosed) has been included in 

the Revenue Agent Report, the penalty cannot be compromised for purposes of a settlement 

without approval of the Commissioner personally or the head of the Office of Tax Shelter 

Analysis. Furthermore, the IRS is required to submit an annual report to Congress summarizing 

the application of this penalty and providing a description of each penalty compromised under 

this proposal and the reasons for the compromise.

Any understatement to which a penalty is imposed under this proposal will not be subject 

to the accuracy-related penalty under section 6662 or under new 6662A (accuracy-related 

penalties for listed and reportable avoidance transactions). However, an understatement under 

this proposal would be taken into account 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 proposal will not apply to any portion of an 

understatement to which a fraud penalty is applied under section 6663.

Effective Date

The proposal applies to transactions after the date of enactment.

 

82 For 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 that 

would (without regard to section 1211) be allowed for such year, would be treated as an increase 

in taxable income.
75

5. Modifications to the substantial understatement penalty 

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).83 

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. 84 

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.85

Description of Proposal

Definition of substantial understatement

The proposal modifies the definition of “substantial” for corporate taxpayers. Under the 

proposal, a corporate taxpayer has a substantial 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 proposal 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 proposal 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 

 

83 Sec. 6662(a) and (d)(1)(A).

84 Sec. 6662(d)(2)(B).

85 Sec. 6662(d)(2)(D).
76

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 proposal is effective for taxable years beginning after date of enactment.

6. Tax shelter exception to confidentiality privileges relating to taxpayer communications

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.

Description of Proposal

The proposal 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 proposal of the Code that otherwise applies to a communication 

between a taxpayer and a federally authorized tax practitioner.

Effective Date

The proposal is effective with respect to communications made on or after the date of 

enactment.

7. Disclosure of reportable transactions by material advisors

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.86 A “tax shelter” means any investment 

with respect to which the tax shelter ratio87 for any investor as of the close of any of the first five 

 

86 Sec. 6111(a).

87 The 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.
77

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).88

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.89 

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,”90 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.91 Certain exceptions are provided with respect to the second category of transactions.92

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 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.93 

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 $500.94 However, if the tax shelter involves an 

 

88 Sec. 6111(c).

89 Sec. 6111(d).

90 Temp. Treas. Reg. sec. 301.6111-2T(b)(2).

91 Temp. Treas. Reg. sec. 301.6111-2T(b)(3).

92 Temp. Treas. Reg. sec. 301.6111-2T(b)(4).

93 The 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).

94 Sec. 6707.
78

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.

Description of Proposal

Disclosure of reportable transactions by material advisors

The proposal repeals the present law rules with respect to registration of tax shelters. 

Instead, the proposal requires each material advisor with respect to any reportable transaction 

(including listed transaction) 95 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. 

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. 96

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 (including, for example, rules regarding the 

aggregation of fees in appropriate circumstances).

 

95 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related proposals.

96

 See the previous discussion regarding the disclosure requirements under new section 

6707A.
79

Penalty for failing to furnish information regarding reportable transactions

The proposal repeals the present law penalty for failure to register tax shelters. Instead, 

the proposal imposes a penalty on any material advisor who fails to file an information return, or 

who files a false or incomplete information return, with respect to a reportable transaction 

(including a listed transaction).97 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 the 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.98 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 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 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 proposal 

and the reasons for the rescission.

Effective Date

The proposal 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 proposal imposing a penalty for failing to disclose reportable transactions applies to 

returns the due date for which is after the date of enactment.

 

97 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related proposals.

98 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 proposal.
80

8. Investor lists and modification of penalty for failure to maintain investor lists

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).99 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).100 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.101 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. 102

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). 

Description of Proposal

Investor lists

Each material advisor103 that is required to file an information return with respect to a 

reportable transaction (including a listed transaction)104 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 proposal authorizes (but does not require) the Secretary to prescribe 

 

99 Sec. 6112.

100

 See Temp. Treas. Reg. sec. 301.6112-1T Q&A 17.

101

 See Temp. Treas. Reg. sec. 301-6112-1T Q&A 8.

102 Sec. 6112(c)(2).

103 The term “material advisor” has the same meaning as when used in connection with 

the requirement to file an information return under section 6111.

104 The terms “reportable transaction” and “listed transaction” have the same meaning as 

previously described in connection with the taxpayer-related proposals.
81

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 proposal 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.105

Effective Date

The proposal 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 proposal imposing a penalty for failing to maintain investor lists applies to requests 

made after the date of enactment. 

9. Actions to enjoin conduct with respect to tax shelters and reportable transactions

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.106

Description of Proposal

The proposal expands this rule so that injunctions may also be sought with respect to the 

requirements relating to the reporting of reportable transactions 107 and the keeping of lists of 

investors by material advisors.108 Thus, under the proposal, an injunction may be sought against 

a material advisor to enjoin the advisor from (1) failing to file an information return with respect 

 

105 In no event will failure to maintain a list be considered reasonable cause for failing to 

make a list available to the Secretary.

106 Sec. 7408.

107 Sec. 6707, as amended by other proposals of this bill.

108 Sec. 6708, as amended by other proposals of this bill.
82

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 proposal is effective on the day after the date of enactment.

10. Understatement of taxpayer’s liability by income tax return preparer

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.

Description of Proposal

The proposal alters the standards of conduct that must be met to avoid imposition of the 

first penalty. The proposal 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 proposal 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 proposal 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 proposal is effective for documents prepared after the date of enactment.

11. Penalty for failure to report interests in foreign financial accounts

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. 109 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 

 

109 31 U.S.C. 5314.
83

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 

$25,000.110 In addition, any person who willfully violates this reporting requireme nt is subject to 

a criminal penalty. The 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.111

On April 26, 2002, the Secretary of the Treasury submitted to the Congress a report on 

these reporting requirements.112 This report, which was statutorily required,113 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.

Description of Proposal

The proposal 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 proposal is effective with respect to failures to report occurring on or after the date of 

enactment.

 

110 31 U.S.C. 5321(a)(5).

111 31 U.S.C. 5322.

112

 A Report to Congress in Accordance with Sec. 361(b) of the Uniting and 

Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct 

Terrorism Act of 2001, April 26, 2002.

113 Sec. 361(b) of the USA PATRIOT Act of 2001 (Pub. L. 107-56).
84

12. Frivolous tax returns and submissions 

Present Law

The Code provides that an individual who files a frivolous income tax return is subject to 

a penalty of $500 imposed by the IRS (sec. 6702). The Code also permits the Tax Court114 to 

impose a penalty of up to $25,000 if a taxpayer has instituted or maintained proceedings 

primarily for delay or if the taxpayer’s position in the proceeding is frivolous or groundless (sec. 

6673(a)).

Description of Proposal

The proposal modifies 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 proposal also modifies present law with respect to certain submissions that raise 

frivolous arguments or that are intended to delay or impede tax administration. The submissions 

to which this proposal applies are requests for a collection due process hearing, installment 

agreements, offers-in-compromise, and taxpayer assistance orders. First, the proposal permits 

the IRS to dismiss such requests. Second, the proposal 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 proposal requires the IRS to publish a list of positions, arguments, requests, and 

proposals determined to be frivolous for purposes of these proposals.

Effective Date

The proposal is effective for submissions made and issues raised after the date on which 

the Secretary first prescribes the required list.

13. Regulation of individuals practicing before the Department of the Treasury

Present Law

The Secretary of the Treasury is authorized to regulate the practice of representatives of 

persons before the Department of the Treasury. 115 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 practice before the Department, or who (with 

intent to defraud) willfully and knowingly misleads or threatens the person being represented (or 

 

114 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.

115 31 U.S.C. 330.
85

a person who may be represented). The rules promulgated by the Secretary pursuant to this 

proposal are contained in Circular 230.

Description of Proposal

The proposal makes two modifications to expand the sanctions that the Secretary may 

impose pursuant to these statutory proposals. First, the proposal expressly permits censure as a 

sanction. Second, the proposal 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 proposal 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.

14. Penalties on promoters of tax shelters

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. 116 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 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.

 

116 Sec. 6700.
86

Description of Proposal

The proposal 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 proposal is effective for activities after the date of enactment.

15. Extend statute of limitations for certain undisclosed transactions

Present Law

In general, the Code requires that taxes be assessed within three years117 after the date a 

return is filed.118 If there has been a substantial omission of items of gross income that total 

more than 25 percent of the amount of gross income shown on the return, the period during 

which an assessment must be made is extended to six years.119 If an assessment is not made 

within the required time periods, the tax generally cannot be assessed or collected at any future 

time. Tax may be assessed at any time if the taxpayer files a false or fraudulent return with the 

intent to evade tax or if the taxpayer does not file a tax return at all.120

Description of Proposal

The proposal extends the statute of limitations to six years with respect to the entire tax 

return121 if a taxpayer required to disclose a listed transaction122 fails to do so in the manner 

required. For example, if a taxpayer entered into a transaction in 2001 that becomes a listed 

 

117 Sec. 6501(a).

118 For this purpose, a return that is filed before the date on which it is due is considered 

to be filed on the required due date (sec. 6501(b)(1)).

119 Sec. 6501(e).

120 Sec. 6501(c).

121 The tax year extended is the tax year the transaction is entered into.

122 The term “listed transaction” has the same meaning as described in a previous 

proposal regarding the penalty for failure to disclose reportable transactions.
87

transaction in 2002 and the taxpayer fails to disclose such transaction in the manner required by 

Treasury regulations, the 2001 tax return will be subject to a six-year statute of limitations.123

Effective Date

The proposal is effective for transactions entered into in taxable years beginning after the 

date of enactment.

16. Deny deduction for interest paid to IRS on underpayments involving certain 

tax-motivated transactions

Present Law

In general, corporations may deduct interest paid or accrued within a taxable year on 

indebtedness.124 Interest on indebtedness to the Federal government attributable to an 

underpayment of tax generally may be deducted pursuant to this provision. 

Description of Proposal

The proposal disallows any deduction for interest paid or accrued within a taxable year 

on any portion of an underpayment of tax that is attributable to an understatement arising from 

(1) an undisclosed reportable avoidance transaction, (2) an undisclosed listed transaction, or (3) a 

transaction that lacks economic substance.125

Effective Date

The proposal is effective for underpayments attributable to transactions entered into in 

taxable years beginning after the date of enactment.

 

123 However, if the Treasury Department lists a transaction in a year subsequent to the 

year a taxpayer entered into such transaction, and the taxpayer’s tax return for the year the 

transaction was entered into is closed by the statute of limitations prior to the transaction 

becoming a listed transaction, this proposal does not re-open the statute of limitations for such 

year. 

124 Sec. 163(a). 

125 The definitions of these transactions are the same as those previously described in 

connection with the proposal to modify the accuracy-related penalty for listed and certain 

reportable transactions and the proposal to impose a penalty on understatements attributable to 

transactions that lack economic substance.
88

17. Modify section 162(f) for certain fines and penalties

Present Law

Under present law, no deduction is allowed as a trade or business expense under section 

162(a) for the payment of a fine or penalty to a government for the violation of any law (sec. 

162(f)). The enactment of section 162(f) in 1969 codified existing case law that denied the 

deductibility of fines as ordinary and necessary business expenses on the grounds that 

“allowance of the deduction would frustrate sharply defined national or State policies proscribing 

the particular types of conduct evidenced by some governmental declaration thereof.”

Treasury regulation section 1.162-21(b)(1) provides that a fine or penalty includes an 

amount: (1) paid pursuant to conviction or a plea of guilty or nolo contendere for a crime 

(felony or misdemeanor) in a criminal proceeding; (2) paid as a civil penalty imposed by Federal, 

State, or local law, including additions to tax and additional amounts and assessable penalties 

imposed by chapter 68 of the Code; (3) paid in settlement of the taxpayer’s actual or potential 

liability for a fine or penalty (civil or criminal); or (4) forfeited as collateral posted in connection 

with a proceeding which could result in imposition of such a fine or penalty. Treasury regulation 

section 1.162-21(b)(2) provides, among other things, that compensatory damages (including 

damages under section 4A of the Clayton Act (15 U.S.C. 15a), as amended) paid to a 

government do not constitute a fine or penalty.

Description of Proposal

The proposal modifies the rules regarding the determination whether payments are 

nondeductible payments of fines or penalties under section 162(f). In particular, the proposal 

generally provides that amounts paid or incurred (whether by suit, agreement, or otherwise) to, 

or at the direction of, a government in relation to the violation of any law or the investigation or 

inquiry into the potential violation of any law are nondeductible. The proposal applies to deny a 

deduction for any payments, including those where there is no admission of guilt or liability and 

those made for the purpose of avoiding further investigation or litigation. An exception applies 

to payments that the taxpayer establishes are restitution. 

 It is intended that a payment will be treated as restitution only if the payment is required 

to be paid to the specific persons, or in relation to the specific property, actually harmed by the 

conduct of the taxpayer that resulted in the payment. Thus, a payment to or with respect to a 

class broader than the specific persons or property that were actually harmed (for example, to a 

class including similarly situated persons or property) does not qualify as restitution. Restitution 

is limited to the amount that bears a substantial quantitative relationship to the harm caused by 

the past conduct or actions of the taxpayer that resulted in the payment in question. If the party 

harmed is a government or other entity, then restitution includes payme nt to such harmed 

government or entity, provided the payment bears a substantial quantitative relationship to the 

harm. However, restitution does not include reimbursement of government investigative or 

litigation costs, or payments to whistleblowers.

Any self-regulatory entity that regulates a financial market or other market that is a 

qualified board or exchange under section 1256(g)(7), and that imposes sanctions (as one 
89

example, the National Association of Securities Dealers) is treated as a government for purposes 

of the proposal. To the extent provided in regulations, any other nongovernmental entity that 

exercises self-regulatory powers as part of performing an essential governmental function shall 

be treated as a government. 

No inference is intended as to the treatment of payments as nondeductible fines or 

penalties under present law. In particular, the proposal is not intended to limit the scope of 

present-law section 162(f) or the regulations thereunder. 

Effective Date

The proposal is effective for amounts paid or incurred after the date of enactment; 

however the proposal does not apply to fines or penalties imposed on or before such date or 

amounts paid or incurred under any agreement entered into on or before such date. 

18. Authorize additional $300 million per year to the IRS to combat abusive tax avoidance 

transactions

The proposal includes an authorization of an additional $300 million to the Internal 

Revenue Service to be used to combat abusive tax avoidance transactions.
90

J. Other Provisions

1. Affirmation of consolidated return regulation authority

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. 126 

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 liability, and in order to prevent the avoidance of such tax 

liability.127

Under this authority, the Treasury Department has issued extensive consolidated return 

regulations.128

 In the recent case of Rite Aid Corp. v. United States,129 the Federal Circuit Court of 

Appeals addressed the application of a particular provision of certain consolidated return loss 

 

126 Sec. 1501.

127 Sec. 1502. 

128 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.

129 255 F.3d 1357 (Fed. Cir. 2001), reh’g denied, 2001 U.S. App. LEXIS 23207 (Fed. 

Cir. Oct. 3, 2001).
91

disallowance regulations, and concluded that the provision was invalid.130 The particular 

provision, known as the “duplicated loss” provision,131 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.132 

 

130 Prior 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.” 

131 Treas. Reg. Sec. 1.1502-20(c)(1)(iii).

132 Treasury 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 socalled 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 
92

 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.133 

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.”134 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.” 135

 

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. 

133 For 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).

134 S. 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). 

135

 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 
93

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, 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. 165.136

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. 137

Description of Proposal

The proposal 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 

 

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. 

136

 Rite Aid, 255 F.3d at 1360.

137

 See 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). 
94

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 proposal 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 subsidiary138 to the extent the subsidiary 

had net operating losses or built in losses that could be used later outside the group.139

 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.140

Effective Date

The proposal is effective for all years, whether beginning before, on, or after the date of 

enactment of the proposal.

No inference is intended that the results following from this proposal are not the same as 

the results under present law. 

 

138 Treas. Reg. Sec. 1.1502-20(c)(1)(iii).

139 The proposal is not intended 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). 

140

 See, 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.
95

K. Provisions Relating to Fair Taxation of Executive Compensation

1. Taxation of deferred compensation provided through offshore trusts 

Present Law

The determination of when amounts deferred under a nonqualified deferred compensation 

arrangement are includible in the gross income of the individual earning the compensation 

depends on the facts and circumstances of the arrangement. A variety of tax principles and Code 

provisions may be relevant in making this determination, including the doctrine of constructive 

receipt, the economic benefit doctrine,141 the provisions of section 83 relating generally to 

transfers of property in connection with the performance of services, and provisions relating 

specifically to nonexempt employee trusts (sec. 402(b)) and nonqualified annuities (sec. 403(c)).

In general, the time for inclusion of nonqualified deferred compensation depends on 

whether the arrangement is unfunded or funded. If the arrangement is unfunded, then the 

compensation is generally includible in income when it is actually or constructively received 

(i.e., when it is paid or otherwise made available). If the arrangement is funded, then income is 

includible for the year in which the individual’s rights are transferable or not subject to a 

substantial risk of forfeiture. 

Nonqualified deferred compensation is generally subject to social security and Medicare 

tax when it is earned (i.e., when services are performed), unless the nonqualified deferred 

compensation is subject to a substantial risk of forfeiture. If nonqualified deferred compensation 

is subject to a substantial risk of forfeiture, it is subject to social security and Medicare tax when 

the risk of forfeiture is removed (i.e., when the right to the nonqualified deferred compensation 

vests). This treatment is not affected by whether the arrangement is funded or unfunded, which 

is relevant in determining when amounts are includible in income (and subject to income tax 

withholding).

In general, an arrangement is considered funded if there has been a transfer of property 

under section 83. Under that section, a transfer of property occurs when a person acquires a 

beneficial ownership interest in such property. The term “property” is defined very broadly for 

purposes of section 83.142 Property includes real and personal property other than money or an 

unfunded and unsecured promise to pay money in the future. Property also includes a beneficial 

interest in assets (including money) that are transferred or set aside from claims of the creditors 

of the transferor, for example, in a trust or escrow account. Accordingly, if, in connection with 

the performance of services, vested contributions are made to a trust on an individual’s behalf 

and the trust assets may be used solely to provide future payments to the individual, the payment 

of the contributions to the trust constitutes a transfer of property to the individual that is taxable 

under section 83. On the other hand, deferred amounts are generally not includible in income in 

 

141

 See, e.g., Sproull v. Commissioner, 16 T.C. 244 (1951), aff’d per curiam, 194 F.2d 

541 (6th Cir. 1952); Rev. Rul. 60-31, 1960-1 C.B. 174.

142 Treas. Reg. sec. 1.83-3(e). This definition in part reflects previous IRS rulings on 

nonqualified deferred compensation.
96

situations where nonqualified deferred compensation is payable from general corporate funds 

that are subject to the claims of general creditors, as such amounts are treated as unfunded and 

unsecured promises to pay money or property in the future.

Rabbi trusts 

Arrangements have developed in an effort to provide employees with security for 

nonqualified deferred compensation, while still allowing deferral of income inclusion. A “rabbi 

trust” is a trust or other fund established by the employer to hold assets from which nonqualified 

deferred compensation payments will be made. The trust or fund is generally irrevocable and 

does not permit the employer to use the assets for purposes other than to provide nonqualified 

deferred compensation. However, the terms of the trust or fund provide that the assets are 

subject to the claims of the employer’s creditors in the case of bankruptcy or insolvency.

As discussed above, for purposes of section 83, property includes a beneficial interest in 

assets set aside from the claims of creditors, such as in a trust or fund, but does not include an 

unfunded and unsecured promise to pay money in the future. In the case of a rabbi trust, terms 

providing that the assets are subject to the claims of creditors of the employer in the case of 

bankruptcy or insolvency have been the basis for the conclusion that the creation of a rabbi trust 

does not cause the related nonqualified deferred compensation arrangement to be funded for 

income tax purposes.143 As a result, no amount is included in income by reason of the rabbi 

trust; generally income inclusion occurs as payments are made from the trust.

The IRS has issued guidance setting forth model rabbi trust provisions.144 Revenue 

Procedure 92-64 provides a safe harbor for taxpayers who adopt and maintain grantor trusts in 

connection with unfunded deferred compensation arrangements. The model trust language 

requires that the trust provide that all assets of the trust are subject to the claims of the general 

creditors of the company in the event of the company’s insolvency or bankruptcy.

Since the concept of rabbi trusts was developed, arrangements have developed which 

attempt to protect the assets from creditors despite the terms of the trust. Arrangements also 

have developed which effectively allow deferred amounts to be available to individuals, while 

still meeting the safe harbor requirements set forth by the IRS.

Description of Proposal

The proposal provides that assets that are designated or otherwise available for the use of 

providing nonqualified deferred compensation and are located outside the United States (e.g., in 

a foreign trust, arrangement or account) are not treated as subject to the claims of general 

creditors. Therefore, to the extent of such assets, nonqualified deferred compensation amounts 

 

143 This conclusion was first provided in a 1980 private ruling issued by the IRS with 

respect to an arrangement covering a rabbi; hence the popular name “rabbi trust.” Priv. Ltr. Rul. 

8113107 (Dec. 31, 1980).

144 Rev. Proc. 92-64, 1992-2 C.B. 422, modified in part by Notice 2000-56, 2000-2 C.B. 

393.
97

are not treated as unfunded and unsecured promises to pay, but are treated as property under 

section 83 and includible in income when the right to the compensation is no longer subject to a 

substantial risk of forfeiture, regardless of when the compensation is paid. No inference is 

intended that nonqualified deferred compensation assets located outside of the U.S. would be 

treated as subject to the claims of creditors under present law.

The proposal does not apply to assets located in a foreign jurisdiction if substantially all 

of the services to which the nonqualified deferred compensation relates are performed in such 

foreign jurisdiction.

The proposal is specifically intended to apply to foreign trusts and arrangements that 

effectively shield from the claims of general creditors any assets intended to satisfy nonqualified 

deferred compensation obligations. The proposal provides the Secretary of the Treasury 

authority to prescribe regulations as are necessary to carry out the proposal and to provide 

additional exceptions for specific arrangements which do not result in improper deferral of U.S. 

tax if the assets involved in the arrangement are readily accessible in any insolvency or 

bankruptcy proceeding. 

Effective Date

The proposal is effective for amounts deferred after December 31, 2002.

2. Repeal of limitation on issuance of Treasury guidance regarding nonqualified deferred 

compensation

Present Law

General tax treatment of nonqualified deferred compensation

The determination of when amounts deferred under a nonqualified deferred compensation 

arrangement are includible in the gross income of the individual earning the compensation 

depends on the facts and circumstances of the arrangement. A variety of tax principles and Code 

provisions may be relevant in making this determination, including the doctrine of constructive 

receipt, the economic benefit doctrine, the provisions of section 83 relating generally to transfers 

of property in connection with the performance of services, and provisions relating specifically 

to nonexempt employee trusts (sec. 402(b)) and nonqualified annuities (sec. 403(c)).

In general, the time for inclusion of nonqualified deferred compensation depends on 

whether the arrangement is unfunded or funded. If the arrangement is unfunded, then the 

compensation is generally includible in income when it is actually or constructively received. If 

the arrangement is funded, then income is includible for the year in which the individual’s rights 

are transferable or not subject to a substantial risk of forfeiture. 

In general, an arrangement is considered funded if there has been a transfer of property 

under section 83. Under that section, a transfer of property occurs when a person acquires a 

beneficial ownership interest in such property. The term “property” is defined very broadly for 
98

purposes of section 83.145 Property includes real and personal property other than money or an 

unfunded and unsecured promise to pay money in the future. Property also includes a beneficial 

interest in assets (including money) that are transferred or set aside from claims of the creditors 

of the transferor, for example, in a trust or escrow account. Accordingly, if, in connection with 

the performance of services, vested contributions are made to a trust on an individual’s behalf 

and the trust assets may be used solely to provide future payments to the individual, the payment 

of the contributions to the trust constitutes a transfer of property to the individual that is taxable 

under section 83. On the other hand, deferred amounts are generally not includible in income in 

situations where nonqualified deferred compensation is payable from general corporate funds 

that are subject to the claims of general creditors, as such amounts are treated as unfunded and 

unsecured promises to pay money or property in the future.

As discussed above, if the arrangement is unfunded, then the compensation is generally 

includible in income when it is actually or constructively received under section 451. Income is 

constructively received when it is credited to an individual’s account, set apart, or otherwise 

made available so that it can be drawn on at any time. Income is not constructively received if 

the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. A 

requirement to relinquish a valuable right in order to make withdrawals is generally treated as a 

substantial limitation or restriction.

Special statutory provisions govern the timing of the deduction for nonqualified deferred 

compensation, regardless of whether the arrangement covers employees or nonemployees and 

regardless of whether the arrangement is funded or unfunded.146 Under these provisions, the 

amount of nonqualified deferred compensation that is includible in the income of the individual 

performing services is deductible by the service recipient for the taxable year in which the 

amount is includible in the individual’s income.

Rulings on nonqualified deferred compensation

In the 1960’s and early 1970’s, various IRS revenue rulings considered the tax treatment 

of nonqualified deferred compensation arrangements.147 Under these rulings, a mere promise to 

pay, not represented by notes or secured in any way, was not regarded as the receipt of income 

for tax purposes. However, if an amount was contributed to an escrow account or trust on the 

individual’s behalf, to be paid to the individual in future years with interest, the amo unt was held 

to be includible in income under the economic benefit doctrine. Deferred amounts were not 

currently includible in income in situations in which nonqualified deferred compensation was 

payable from general corporate funds that were subject to the claims of general creditors and the 

plan was not funded by a trust, or any other form of asset segregation to which individuals had 

 

145 Treas. Reg. sec. 1.83-3(e). This definition in part reflects previous IRS rulings on 

nonqualified deferred compensation.

146 Secs. 404(a)(5), (b) and (d) and sec. 83(h).

147 The seminal ruling dealing with nonqualified deferred compensation is Rev. 

Rul. 60-31, 1960-1 C.B. 174.
99

any prior or privileged claim. 148 Similarly, current income inclusion did not result when the 

employer purchased an annuity contract to provide a source of funds for its deferred 

compensation liability if the employer was the applicant, owner and beneficiary of the annuity 

contract, and the annuity contract was subject to the general creditors of the employer.149 In 

these situations, deferred compensation amounts were held to be includible in income when 

actually received or otherwise made available.

Proposed Treasury regulation 1.61-16, published in the Federal Register for February 3, 

1978, provided that if a payment of an amount of a taxpayer’s compensation is, at the taxpayer’s 

option, deferred to a taxable year later than that in which such amount would have been payable 

but for his exercise of such option, the amount shall be treated as received by the taxpayer in 

such earlier taxable year. 150 

Section 132 of the Revenue Act of 1978

Section 132 of the Revenue Act of 1978151 was enacted in response to proposed Treasury 

regulation 1.61-16. Section 132 of the Revenue Act of 1978 provides that the taxable year of 

inclusion in gross income of any amount covered by a private deferred compensation plan is 

determined in accordance with the principles set forth in regulations, rulings, and judicial 

decisions relating to deferred compensation which were in effect on February 1, 1978. The term, 

“private deferred compensation plan” means a plan, agreement, or arrangement under which the 

person for whom service is performed is not a State or a tax-exempt organization and under 

which the payment or otherwise making available of compensation is deferred. However, the 

provision does not apply to certain employer-provided retirement arrangements (e.g., a qualified 

retirement plan), a transfer of property under section 83, or an arrangement that includes a 

nonexempt employees trust under section 402(b). Section 132 was not intended to restrict 

judicial interpretation of the law relating to the proper tax treatment of deferred compensation or 

interfere with judicial determinations of what principles of law apply in determining the timing 

of income inclusion.

Description of Proposal

The proposal repeals section 132 of the Revenue Act of 1978. It is intended that the 

Secretary of the Treasury issue guidance with respect to the tax treatment of nonqualified 

deferred compensation arrangements focusing on arrangements that improperly defer income. 

For example, it is intended that the Secretary address what is considered a substantial limitation 

 

148 Rev. Rul. 69-650, 1969-2 C.B. 106; Rev. Rul. 69-49, 1969-1 C.B. 138.

149 Rev. Rul. 72-25, 1972-1 C.B. 127. See also, Rev. Rul. 68-99, 1968-1 C.B. 193, in 

which the employer’s purchase of an insurance contract on the life of the employee did not result 

in an economic benefit to the employee if all rights to any benefits under the contract were solely 

the property of the employer and the proceeds of the contract were payable only to the employer.

150 Prop. Treas. Reg. 1.61-16, 43 Fed. Reg. 4638 (1978).

151 Pub. L. No. 95-600.
100

under the constructive receipt doctrine and situations in which an individual’s right to receive 

compensation is, at least in form, subject to substantial limitations, but in fact is not so limited. It 

is also intended that the Secretary address arrangements which purport to not be funded, but 

should be treated as funded. In addition, it is intended that the Secretary address arrangements in 

which assets, by the technical terms of the arrangements, appear to be subject to the claims of an 

employer’s general creditors, but practically are unavailable to creditors. Arrangements that the 

Secretary is expected to address include the following: the ability to receive funds on account of 

financial hardship, the use of trusts or other arrangements under which the rights of general 

creditors to gain access to funds is limited, the use of triggers and third-party guarantees to fund 

arrangements, and the ability to receive funds subject to a forfeiture of some portion of the 

participant’s deferred compensation (often referred to as a “haircut”). It is intended that such 

future guidance be consistent with the executive compensation provisions of the bill.

It is not intended that the Secretary take the position (as taken in proposed Treasury 

regulation 1.61-16) that all elective nonqualified deferred compensation is currently includible in 

income.

No inference is intended that the Secretary is prohibited under present law from issuing 

guidance with respect to nonqualified deferred compensation arrangements or that any existing 

nonqualified deferred compensation guidance issued by the Secretary is invalid. In addition, no 

inference is intended that any arrangements covered by future guidance provide permissible 

deferrals of income under present law.

Effective Date

The proposal is effective for taxable years beginning after the date of enactment.

3. Required wage withholding at top marginal rate for supplemental wage payments in 

excess of $1 million

Present Law

An employer must withhold income taxes from wages paid to employees; there are 

several possible methods for determining the amount of income tax to be withheld. The IRS 

publishes tables (Publication 15, “Circular E”) to be used in determining the amount of income 

tax to be withheld. The tables generally reflect the income tax rates under the Code so that 

withholding approximates the ultimate tax liability with respect to the wage payments. In some 

cases, “supplemental” wage payments (e.g., bonuses or commissions) may be subject to 

withholding at a flat rate 152, based on the third lowest income tax rate under the Code (27 percent 

for 2002).153

 

152 See section 13273 of the Revenue Reconciliation Act of 1993.

153 See section 101(c)(11) of the Economic Growth and Tax Relief Reconciliation Act of 

2001.
101

Description of Proposal

Under the proposal, once annual supplemental wage payments to an employee exceed $1 

million, any additional supplemental wage payments to the employee in that year are subject to 

withholding at the highest income tax rate (38.6 percent for 2002), regardless of any other 

withholding rules and regardless of the employee’s FormW-4. 

This rule applies only for purposes of wage withholding; other types of withholding (such 

as pension withholding and backup withholding) are not affected.

Effective Date

The proposal is effective with respect to wage payments made after December 31, 2002.