Summary 

of the 

Administration's Revenue Proposals 

Department of the Treasury 

February 1993 

Summary of the Administration's Revenue Proposals 

The Department of the Treasury released its "Summary of the 

Administration's Revenue Proposals" on February 28, 1993. The 

Summary describes the revenue proposals included in the 

Administration's comprehensive economic plan. The proposals are 

part of a program designed to achieve three goals: providing a 

short-term economic stimulus for job creation; building an 

environment for long-term investment and growth; and reducing the 

structural budget deficit. The descriptions are not intended to 

be final or comprehensive - many will be revised in the process 

of finalizing the Administration's fiscal year 1994 Budget and 

numerous details will be provided in connection with the 

presentation of the Budget and upon submission of legislation to 

implement the Administration's plan. 

ADMINISTRATIO N REVENU E PROPOSAL S 

This report summarizes the revenue proposals included in the Administration's 

comprehensive economic plan. The proposals are part of a program designed to achieve 

three goals: providing a short-term economic stimulus for job creation; building an 

environment for long-term investment and growth; and reducing the structural budget 

deficit. The investment and stimulus revenue proposals are targeted to achieve the 

maximu m impact for the minimum revenue cost. The revenue raising proposals restore 

progressivity to the income tax system, ensure that both domestic and international 

businesses bear their fair share of the tax burden, and encourage energy conservation 

and independence. 

The descriptions included in this report are not intended to be final. Many of the 

proposals will be revised in the process of finalizing the Administration's fiscal year 1994 

Budget. The descriptions are also not intended to be comprehensive. Numerous details, 

such as rules relating to the prevention of abusive transactions and the limitation of tax 

benefits inconsistent with the principles of the proposals, will be provided in connection 

with the presentation of the Budget and upon submission of legislation to implement the 

Administration's plan. 

In addition to the proposals summarized in this report, the Administration also 

supports initiatives designed to promote sensible and equitable administration of the 

internal revenue laws. These include simplification, good governance and technical 

correction proposals. r r*-~* . -M__> . 

MAR 301995 

TABLE OF CONTENTS 

Page 

STIMULUS/INVESTMENT PROVISIONS 

Training and Education 

Extend exclusion for employer-provided educational assistance 2 

Extend and expand targeted jobs tax credit to include 

youth apprenticeship credit 3 

Capital Investment and Economic Growth 

Investment tax credit 5 

Extend research & experimentation credit 9 

Provide targeted capital gains exclusion 11 

Modify AM T depreciation schedule 13 

Incentives for high-speed rail 15 

Extend small-issue manufacturing and agricultural bonds 16 

Enterprise Zones 17 

Expand Earned Income Tax Credit 18 

Investment in Real Estate 

Extend mortgage revenue bonds 19 

Extend low-income housing credit 20 

Provide passive loss relief for certain real estate activities 21 

Increase recovery period for depreciation of nonresidential 

real property 23 

Facilitate real estate investments by pension funds and others 24 

Other 

Repeal AM T preference for gifts of appreciated property 

to charities 28 

Extend general fund transfer to railroad retirement trust fund 29 

Extend health insurance deduction for self-employed 30 
-11-

REVENUE RAISING PROVISIONS 

Provisions That Improve Fairness of the Tax System 

Increase tax rates paid by high-income individuals 32 

Repeal health insurance wage base cap 36 

Reinstate top estate and gift tax rates at 53 percent and 55 percent 37 

Reduce deductible portion of business meals and 

entertainment expenses from 80 percent to 50 percent 38 

Deny deduction for club dues 39 

Deny deduction for executive pay over one million dollars 40 

Reduce compensation taken into account 

for qualified retirement plan purposes 41 

Disallow moving deductions for meals and real estate expenses 43 

Provisions Affecting Business 

Increase corporate tax rate for taxable income over 

ten million dollars 44 

Deny deduction for lobbying expenses 45 

Require securities dealers to mark to market 46 

Prohibit double-dip related to FSLIC assistance 48 

Extend corporate estimated tax rules 50 

Limit possession tax credit to 65 percent of compensation paid 51 

Provisions Affecting International Businesses 

Eliminate working capital exception for foreign oil and gas 

and shipping income 53 

Transfer pricing initiative 55 

Allocate research and experimentation (R&E ) expenses to place of 

performance and treat royalties as passive income 

for purposes of foreign tax credit limitation 57 

Enhance earnings stripping and other anti-avoidance rules 60 

Require current taxation of certain earnings 

of controlled foreign corporations 62 

Energy Provisions 

Provide a modified BT U tax 64 

Extend motor fuels excise tax 66 

Compliance Initiatives 

Service industry non-compliance initiative 67 

Raise standard for accuracy-related and preparer penalties 68 

Modify tax shelter rules for purposes of the substantial 

understatement penalty 69 

Miscellaneous 71 
STIMULUS/INVESTMENT PROVISIONS 

1 
TRAININ G AN D EDUCATIO N 

EXTEN D EXCLUSIO N FO R EMPLOYER-PROVIDE D EDUCATIONA L 

ASSISTANC E 

Current Law 

Under current law, the value of employer-provided educational assistance is 

included in an employee's income and employment tax wages unless the cost of the 

assistance would qualify as a deductible, job-related expense of the employee if the 

employee had incurred the expense directly. Under prior law, amounts paid by an 

employer with respect to an employee under an educational assistance program were 

excluded from the employee's gross income and employment tax wages to the extent that 

the value of the assistance did not exceed $5,250 per year, regardless of whether the 

expense would otherwise be deductible. Such programs were subject to 

nondiscrimination rules to ensure that the assistance was not provided primarily to 

higher-paid employees. The educational assistance exclusion is not applicable to taxable 

years beginning after June 30, 1992. 

Reasons for Change 

The exclusion encourages employers to provide educational assistance and thereby 

increases the country's productivity. In addition, absence of the exclusion imposes 

significant administrative burdens on employers, workers, and the IRS in distinguishing 

between job-related expenses (which are excludable from gross income under current law 

when paid by the employer) and other employer-provided educational expenses. Absent 

the exclusion, the value of employer-provided educational assistance is excludable from 

gross income only if the education directly relates to the employee's current job and does 

not qualify the employee for a different trade or business. Higher-income, higher-skilled 

individuals may more easily satisfy these requirements because of the breadth of their 

prior training and current job responsibilities. 

Proposal 

The proposal would permanently extend the general exclusion for employerprovided educational assistance. The provision is effective for taxable years ending after 

June 30, 1992. 

2 
EXTEN D AN D EXPAN D TARGETE D JOB S TA X CREDI T 

T O INCLUD E YOUT H APPRENTICE S 

Current Law 

The targeted jobs tax credit is available to employers on an elective basis for 

hiring individuals from nine targeted groups. The targeted groups are: (1) vocational 

rehabilitation referrals; (2) economically disadvantaged youths aged 18 through 22; (3) 

economically disadvantaged Vietnam-era veterans; (4) Supplemental Security Income 

(SSI) recipients; (5) general assistance recipients; (6) economically disadvantaged 

cooperative education students aged 16 through 19; (7) economically disadvantaged exconvicts; (8) eligible work incentive employees; and (9) economically disadvantaged 

summer youth employees aged 16 or 17. Certification of targeted group membership is 

required as a condition of claiming the credit. 

The credit generally is equal to 40 percent of the first $6,000 of qualified first-year 

wages paid to a member of a targeted group. Thus, the maximum credit generally is 

$2,400 per individual. With respect to economically disadvantaged summer youth 

employees, however, the credit is equal to 40 percent of up to $3,000 of wages, for a 

maximum credit of $1,200. 

The credit is not available for wages paid to a targeted group member unless the 

individual either (1) is employed by the employer for at least 90 days (14 days in the 

case of economically disadvantaged summer youth employees), or (2) has completed at 

least 120 hours of work performed for the employer (20 hours in the case of 

economically disadvantaged summer youth employees). The employer's deduction for 

wages must be reduced by the amount of the credit claimed. The credit expired June 30, 

1992. 

Reasons for Change 

The targeted jobs tax credit is intended to encourage employers to hire workers 

w ho otherwise may be unable to find employment and to subsidize training costs. Job 

creation incentives are required in the current economic climate. In addition, a 

significant number of youth in the United States lack the necessary skills to meet 

requirements for entry level positions and, therefore, are unprepared to make the 

transition from school to the workforce. 

Proposal 

The proposal would permanently extend the targeted jobs tax credit. The 

provision is effective for individuals who begin work for the employer after June 30, 

1992. In addition, the targeted jobs tax credit would be expanded to include youth 

3 
apprentices beginning work after December 31, 1993. 

A youth apprentice would be any individual aged 16 through 20 who was enrolled 

in a qualified youth apprenticeship program beginning in the eleventh or twelfth grade 

and certified by the local education agency or other authorized institution participating in 

the program to be making satisfactory progress in completing the program. A program 

would be considered to be a qualified youth apprenticeship program only if it is a 

planned program of structured job training designed to integrate academic instruction 

and work-based learning, is administered by a committee composed of the Secretaries of 

Labor and Education (in addition to other participants), and is established on or after 

the date of enactment of the expanded credit. 

Because the youth apprenticeship program is a work-study program, the credit 

would equal 40 percent of up to $3,000 of first-year wages, for a maximu m credit of 

$1,200. 

4 
CAPITAL INVESTMENT AN D ECONOMI C GROWT H 

INVESTMENT TAX CREDIT 

Current Law 

The "regular" investment tax credit was repealed by the Tax Reform Act of 1986. 

Therefore, there is no such credit under current law. 

Prior to the 1986 Act, the regular investment credit was a credit against tax 

liability for up to 10 percent of a taxpayer's investment in new "section 38 property." 

Section 38 property generally included any tangible personal property and other tangible 

property (not including a building or its structural components) used as an integral part 

of manufacturing, production, or extraction, or for furnishing transportation, 

communications, electrical energy, gas, water, or sewage disposal services. The credit 

also was available for up to $125,000 of the taxpayer's cost of used property placed in 

service during a taxable year. 

The amount of the credit was based on the ACRS recovery period to which the 

property was assigned. The 10 percent credit was allowed for 5-year property, 10-year 

property, and 15-year public utility property. For 3-year property the credit was limited 

to 6 percent. 

Prior law also required that the basis of property taken into account in computi

the credit be reduced by all or a portion of the credit. Recapture rules required a 

taxpayer to increase its tax due if recovery property taken into account in computing the 

credit was disposed of or otherwise ceased to be section 38 property before the close of 

a specified period. This period was 3 years for 3-year property and 5 years for other 

property. 

The regular investment tax credit was subject to the limitations on the use of t

general business credit. Unused credits could be carried back 3 years and forward 15 

years from the year in which the credit arose. C corporations also were permitted to 

offset up to 25 percent of their tentative minimum tax by the regular investment tax 

credit. 

Reasons for Change 

Increasing investment in new plant and equipment is necessary to stimulate the 

economy in the short-run and create new jobs. Additional investment would also 

augment the capacity of the economy to produce goods and services more efficiently, and 

thereby improve the standard of living in the long-run. At the same time, in view of 

current budgetary constraints, any investment stimulus must be designed to provide the 

5 
maximu m incentive to increase productive investments at the least possible cost in terms 

of foregone revenues. Finally, investment incentives should, to the extent practicable, be 

administrable for all taxpayers, with particular attention given to limiting compliance 

burdens on small business. 

Proposal 

Two separate investment tax credit systems would be provided, one for small 

businesses and one for large businesses. Property eligible for the credits generally would 

be defined in the same manner as under the regular investment tax credit prior to its 

repeal, except that used property and certain other categories of property would not be 

eligible. Certain modifications of the eligibility requirements, such as placed-in-service 

rules, would be mad e to simplify administration of the rules and reduce controversies. 

Leased property would be subject to limitations to prevent shifting of the credit to firms 

more able to claim the credit. Related party and aggregation rules would be provided 

for use in determining eligibility and application of the investment tax credit rules 

described below. 

The credits would be part of the section 38 general business credit and, therefore, 

would be subject to current law limitations on use of that credit. The portion of the 

general business credit attributable to the credits could be used by any taxpayer to offset 

up to 25 percent of the tentative minimum tax. A s under current law, any unused 

general business credit could be carried back 3 years and forward 15 years, although no 

carryback of the investment credits would be permitted to years prior to the effective 

date of the proposal. Other limitations applicable to the use of general business credits, 

such as the passive loss limitations and at risk rules, would apply to the credits. 

Small Business Investment Tax Credit 

The small business investment tax credit would be a permanent credit. The rate 

would be 7 percent for property placed in service after December 3, 1992 and on or 

before December 31, 1994, and 5 percent for property placed in service on or after 

January 1, 1995. For 3-year property, the credit would be one-third of the regular rate; 

5-year property would receive a credit of two-thirds of the regular rate; and 7-year 

property would receive a credit of four-fifths of the regular rate. Property with a 

recovery period in excess of 7 years would receive a credit at the full regular rate. 

A small business would generally be defined as a business with average annual 

gross receipts of less than $5 million in the three years immediately preceding the 

taxable year, using principles similar to those provided for determining whether 

corporations ma y use the cash method of accounting under section 448. The small 

business investment tax credit would generally be similar to the regular investment credit 

prior to the 1986 Act. Recapture rules would apply to early dispositions of property. 

T he taxpayer's depreciable basis would be reduced by the amount of the credit. 

6 
T he small business credit would be subject to an annual cap intended to prevent 

abuses of the $5 million gross receipts rule. An y investment in excess of the cap would 

not be eligible for the small business investment credit. However, prior to 1995, an 

eligible small business could elect to use the incremental investment tax credit in lieu of 

the small business credit with respect to all of its investment in a taxable year. 

Incremental Investment Tax Credit 

The incremental investment tax credit would be a temporary credit. Taxpayers 

not qualifying as small businesses would use the incremental credit. Taxpayers would be 

eligible to claim the credit for the excess of their investment in qualified property over a 

fixed base. The rate would be 7 percent for property placed in service after December 

3, 1992 and on or before December 31, 1994. For a calendar year taxpayer, credits with 

respect to assets placed in service after December 3, 1992 and on or before December 

31, 1992 could be claimed on a taxpayer's return for 1992 or, at the taxpayer's option, for 

1993. 

The fixed base would equal a percentage of a taxpayer's average historic 

investment in new and used property in 1989 through 1991, or, if the taxpayer elects, 

with respect to investments in 1987 through 1991. The amount of historic investment 

would be indexed for growth in the gross domestic product, and multiplied by 70 percent 

to determine the fixed base through December 31, 1993, and multiplied by 80 percent to 

determine the fixed base for 1994. Taxpayers would not be permitted to claim the credit 

on more than 50 percent of qualified investment in a taxable year. Thus, a firm with a 

fixed base of $1 million and qualifying investment of $6 million would only be permitted 

to claim the credit with respect to $3 million of investment. 

Mandatory qualified progress expenditure rules would allow a credit for the 

appropriate portion of an asset with a lengthy construction period. Under these rules, a 

credit would be allowed for certain progress expenditures attributable to periods after 

December 3, 1992 and before January 1, 1995, even though the asset is not placed in 

service until after December 31, 1994. In addition, certain progress expenditures 

attributable to periods prior to December 4, 1992 would not be eligible for the credit, 

even though the asset is placed in service after December 3, 1992 and on or before 

December 31, 1994. 

In determining a taxpayer's qualified investment for a taxable year, there would 

be taken into account one-third of the basis of 3-year property, two-thirds of the basis of 

5-year property, four-fifths of the basis of 7-year property, and all of the basis of property 

with a recovery period of more than seven years. In lieu of basis reduction, taxpayers 

would be required to include in income the amount of the credit ratably over the 

recapture period. Special rules would be provided for applying the incremental 

investment tax credit to start-up firms. 

7 
Recapture rules would be provided to limit any advantage from bunching of 

investments in 1993 and 1994. These rules would require repayment of all or a portion 

of the credits if the taxpayer's investment drops below the fixed base. These rules would 

apply through 1997. For 1995 through 1997, the fixed base, relevant solely for recapture 

purposes, would be determined by multiplying the historic base by 80 percent. 

Effects of Proposal 

The proposal would reduce the cost of capital and increase funds available for 

investment. These additional expenditures on plant and equipment would create more 

jobs in capital goods industries and other manufacturing industries. 

The temporary incremental investment tax credit would promote purchases of new 

equipment, and thereby promote capital investment, modernization, and a more rapid 

economic recovery in the short run. The incremental investment tax credit would 

provide a cost-effective investment incentive by reducing the windfall to investors on 

investments they would have undertaken even without the credit. Because the credit 

would be available only for eligible plant and equipment placed in service on or before 

December 31, 1994, the revenue cost of the credit is reduced and the investment 

stimulus is maximized during 1993 and 1994. 

The permanent credit for small businesses would promote increased investments 

by small businesses. The credit should reduce the marginal cost of capital of small firms. 

In addition, the credit for small businesses would be administratively less burdensome for 

small firms than an incremental credit. 

8 
EXTEN D RESEARC H & EXPERIMENTATIO N CREDI T 

Current Law 

Taxpayers are entitled to a tax credit for incremental "qualified research 

expenditures" paid or incurred on or before June 30, 1992. The credit equals 20 percent 

of the amount by which the taxpayer's qualified research expenditures for the taxable 

year exceed a base amount. The base amount is the product of the taxpayer's "fixed base 

percentage" and the average of the taxpayer's gross receipts for the four preceding years. 

T he fixed base percentage is the ratio of the taxpayer's qualified research expenditures to 

its gross receipts during the 1984-1988 period. The base amount, however, cannot be 

less than 50 percent of the taxpayer's current-year qualified research expenditures. 

Qualified research expenditures consist of (1) "in house" expenses of the taxpayer 

for research wages and supplies used in research, (2) certain time-sharing costs for 

computer use in research, and (3) 65 percent of amounts paid by the taxpayer for 

contract research conducted on the taxpayer's behalf. Certain types of research are 

specifically excluded from qualified research, such as research conducted outside the 

United States, research in the social sciences, arts, or humanities, and research funded by 

another person or governmental entity. 

A special rule determines the fixed base percentage of start-up companies. This 

rule assigns a fixed base percentage of 3 percent to any taxpayer that did not have both 

gross receipts and qualified research in at least three years during the 1984-1988 period. 

The 20 percent tax credit also applies to amounts paid or incurred by a 

corporation on or before June 30, 1992, for basic research by universities or other 

qualified organizations, to the extent that those amounts exceed the greater of two 

prescribed floor amounts plus an amount reflecting decreases in the corporation's nonresearch donations to universities. 

Reasons for Change 

Increasing investment in research activities is important to foster economic growth 

and technological development and improve international competitiveness. Many of the 

benefits of research, however, cannot be captured by the business making the investment. 

Instead, these benefits redound to competitors and to the public. Therefore, in the 

absence of an incentive for research, businesses might not invest in research at the levels 

that are appropriate for the economy as a whole. To foster economic growth and 

technological development and improve international competitiveness, the research credit 

should be permanently extended. 

9 
Proposal 

The proposal would permanently extend the research tax credit. The provision 

would apply to expenditures paid or incurred after June 30, 1992. 

The proposal would add a new rule regarding the determination of the fixed base 

percentage of start-up companies. Under the proposal, a taxpayer that did not have 

gross receipts in at least 3 years during the 1984-1988 period would be assigned a fixed 

base percentage of 3 percent for each of its first five taxable years after 1993 in which it 

incurs qualified research expenditures. Th e taxpayer's fixed base percentage for its sixth 

through tenth taxable years after 1993 in which it incurred qualified research 

expenditures would be as follows: (1) for the taxpayer's sixth year, its fixed base 

percentage would be one-sixth of its ratio of qualified research expenditures to gross 

receipts for its fourth and fifth years; (2) for its seventh year, its fixed based percentage 

would be one-third of its ratio for its fifth and sixth years; (3) for its eighth year, its fixed 

base percentage would be one-half of its ratio for its fifth through seventh years; (4) for 

its ninth year, its fixed base percentage would be two-thirds of its ratio for its fifth 

through eighth years; and (5) for its tenth year, its fixed base percentage would be fivesixths of its ratio for its fifth through ninth years. For subsequent taxable years, the 

taxpayer's fixed base percentage would be its actual ratio of qualified research 

expenditures to gross receipts for five years selected by the taxpayer from its fifth 

through tenth taxable years. 

10 
PROVID E TARGETE D CAPITA L GAIN S EXCLUSIO N 

Current Law 

Under current law, long-term capital gains are generally taxable at an individual 

investor's marginal income tax rate, subject to a maximu m statutory rate of 28 percent. 

While the Tax Reform Act of 1986 eliminated the capital gains exclusion of prior law, it 

did not eliminate the legal distinction between capital gains and ordinary income, or 

between short-term and long-term capital gains. These distinctions currently serve to 

identify those transactions that are eligible for the 28 percent maximu m rate and that are 

subject to the limitations on deducting capital losses. Long-term capital gains on shares 

of stock generally qualify for the 28 percent maximu m rate. 

Reasons for Change 

Small businesses are important to economic growth and job creation in this 

country, and contribute to America's edge in international competition. A sustained flow 

of capital to new businesses that may generate minimal short-term earnings, but promise 

strong future profitability, would improve our future competitiveness. A preferential tax 

rate for long-term commitments of capital to small businesses would encourage 

investments in innovation and growth. The resulting increase in national output would 

benefit all Americans by providing jobs and raising living standards. 

Proposal 

Investors who hold qualified small business stock for at least 5 years would be 

permitted to exclude 50 percent of gains realized on the disposition of their stock. A 

qualified small business is a subchapter C corporation with less than $25 million of 

aggregate capitalization from January 1, 1993, through the date the taxpayer acquires 

stock in the corporation, that uses substantially all of its assets in the active conduct of a 

trade or business during substantially all of the taxpayer's holding period. Certain 

activities, including personal service, banking, leasing, real estate, farming, mineral 

extraction, and hospitality businesses, cannot be qualified small businesses. Qualified 

small business stock must be acquired directly by an individual taxpayer (or indirectly by 

an individual taxpayer through an investment partnership or other pass-through entity) 

after December 31, 1992, and at its original issue (either directly from the corporation or 

through an underwriter). Subchapter C corporations that hold stock in a qualified small 

business would not qualify for the exclusion. 

Individuals would be allowed to exclude 50 percent of capital gains realized upon 

the disposition of qualified small business stock held over 5 years, and would apply their 

current statutory rate on capital gains (either 15 or 28 percent) to the reduced amount of 

taxable gain. Gain eligible for the exclusion would be limited to the greater of ten times 

11 
m e investor's basis in the stock or $1 million for each qualified small business. On e half 

of any exclusion claimed would be treated as a tax preference item under the individual 

alternative minimu m tax. 

The proposal includes safeguards to prevent large corporations from securing the 

exclusion for their shareholders by spinning off new subsidiaries, to prevent existing small 

corporations from redeeming outstanding shares in hopes of reissuing qualified small 

business stock, and to prevent investors from securing the exclusion for certain transfers, 

including the transfer of unrealized gains on appreciated assets to a qualified small 

business. 

12 
MODIF Y AM T DEPRECIATIO N SCHEDUL E 

Current Law 

Under current law, taxpayers are subject to an alternative minimum tax (AMT) 

which is payable to the extent that the taxpayer's tentative minimum tax exceeds its 

regular income tax liability. The tentative minimum tax generally equals 20 percent of a 

corporation's alternative minimum taxable income (24 percent in the case of an 

individual). Alternative minimum taxable income is the taxpayer's taxable income 

increased by its tax preferences and adjusted by redetermining its tax treatment of 

certain items. 

One of the adjustments made to taxable income to arrive at alternative minimum 

taxable income is a depreciation adjustment. In computing alternative minimum taxable 

income, depreciation on personal property to which the Modified Accelerated Cost 

Recovery System (MACRS ) applies is generally calculated using the 150 percent 

declining-balance method over the class life of the property. By comparison, a 200 

percent declining-balance method over recovery periods shorter than class lives is 

generally permitted under MACR S in arriving at taxable income. If a taxpayer elects, or 

is required, to depreciate personal property pursuant to a straight-line depreciation 

method in computing taxable income, this method (and the recovery periods used in 

computing taxable income) must also be used to compute alternative minimum taxable 

income. 

Another adjustment in arriving at a corporation's alternative minimum taxable 

income is based on adjusted current earnings (ACE). In general, the AC E adjustment 

increases taxable income by an amount equal to 75 percent of the excess of AC E over 

alternative minimum taxable income (determined without regard to the AC E 

adjustment). In computing ACE , depreciation is generally computed using the straightline method over the class life of the property. 

To the extent that a taxpayer's regular income tax liability exceeds its tentative 

minimum tax in a particular taxable year, the taxpayer is entitled to reduce its regular 

income tax liability by a credit (the minimum tax credit) which is based on AM T paid in 

preceding years. The minimum tax credit is generally intended to permit the reversal of 

the effects of the AM T when the treatment of items in arriving at taxable income 

becomes less favorable than the treatment permitted in arriving at alternative minimum 

taxable income. 

Reasons for Change 

There is general concern that the AMT treatment of depreciation causes a 

disincentive to capital investment. As a result of depreciation adjustments, many capital13 
mtensive businesses are subject to the AMT . The effects of the adjustments are 

magnified for capital-intensive businesses that are growing or showing depressed 

earnings. Because many businesses may find themselves continually subject to the AMT , 

the minimum tax credit is of reduced value in mitigating the long-term effects of the 

A M T depreciation adjustments. 

The AMT treatment of depreciation is also the source of substantial complexity. 

Corporations must make three separate depreciation computations to determine taxable 

income and alternative minimum taxable income. All taxpayers must compute 

depreciation over one period for regular tax and another for AMT . 

Proposal 

Effective for property placed in service after December 31, 1993, the depreciation 

component of the adjustment used in computing AC E would be eliminated, and AM T 

depreciation would be computed using the 120 percent declining-balance depreciation 

method over the recovery periods applicable for regular tax purposes. This amendment 

would not apply to property eligible only for the straight-line method for regular tax 

purposes (e.g.. residential and nonresidential real property). 

Effects of Proposal 

The proposal would (1) provide relief from the AMT for capital intensive 

businesses, (2) simplify the AM T for corporations by requiring only one computation of 

depreciation for AM T purposes, and (3) generally allow taxpayers to use a single 

recovery period for computing tax depreciation. 

14 
INCENTIVE S FO R HIGH-SPEE D RAI L 

Current Law 

States and local governments are permitted to issue tax-exempt private activity 

bonds to finance certain exempt facilities, including airports, docks and wharves, mass 

commuting facilities, sewage facilities, and high speed rail facilities. With the exception 

of bonds for airports, docks and wharves, and governmentally owned solid waste disposal 

facilities, tax-exempt private activity bonds are generally subject to State private activity 

bond volume limitations. In the case of private activity bonds for high-speed rail 

facilities, only 25 percent of the bonds are subject to the State private activity bond 

volume limitations. 

Reasons for Change 

As a result of the capital intensive nature of high-speed rail facilities, the cost of 

these facilities is very large, resulting in the need to issue a significant amount of bonds 

to finance such facilities. The State private activity bond volume limitations are a 

significant barrier to the issuance of tax-exempt bonds to finance these facilities. 

Proposal 

The proposal would exempt private activity bonds to provide high-speed rail 

facilities from the State private activity bond volume limitations. The provision is 

effective for bonds issued after December 31, 1993. 

15 
EXTEN D SMALL-ISSU E MANUFACTURIN G AN D AGRICULTURA L BOND S 

Current Law 

Interest on small issues of private activity bonds issued by States and political 

subdivisions thereof ("qualified small issue bonds") is excluded from gross income if 

certain conditions are met. First, at least 95 percent of the bond proceeds must be used 

to finance manufacturing facilities or certain agricultural land or equipment. Second, the 

bond issue must be issued in an aggregate amount of $1 million or less, or the aggregate 

amount of the issue, together with the aggregate amount of certain related capital 

expenditures, may not exceed $10 million. A number of other restrictions apply to these 

bonds. 

The volume of qualified small issue bonds that may be issued is limited by the 

annual State private activity bond volume limit. 

Authority to issue qualified small issue bonds expired after June 30, 1992. 

Reasons for Change 

Qualified small issue bonds provide assistance for small businesses and certain 

farmers. It is appropriate to permit State and local governments to continue to issue 

qualified small issue bonds, subject to the State private activity bond volume limit. 

Proposal 

The proposal permanently extends the authority to issue qualified small issue 

bonds. The provision is effective for bonds issued after June 30, 1992. 

16 
^i^TERPRISE ZONE S 

ESTABLIS H ENTERPRIS E ZONE S 

Current Law 

Existing federal tax incentives generally are not targeted to benefit specific 

geographic areas. Although the federal tax law contains incentives that ma y encourage 

development in economically distressed areas, the availability of the incentives is not 

conditioned on activity in or development of the areas. 

Reasons for Change 

A combination of government and private efforts is needed to assist distressed 

cities and rural areas in sharing the benefits of economic growth. 

Proposal 

The Administration proposes to designate 50 federal enterprise zones which 

would benefit from targeted employment and investment incentives. The incentives 

would stimulate government and private sector revitalization of these distressed areas. 

T he enterprise zones would be designated only from areas nominated by State and local 

governments and would have to meet certain objective criteria. A detailed proposal will 

be included in the presentation of the Administration's Budget. 

17 
^XPAND EARNED INCOM E TAX CREDIT 

EXPANSION AN D SIMPLIFICATION OF 

EARNED INCOME TAX CREDIT 

Current Law 

The earned income tax credit (EITC) is a refundable credit consisting of (i) a 

basic credit (adjusted for family size), (ii) a supplemental credit for workers with a child 

under the age of one, and (in) a supplemental credit for certain health insurance 

premium expenses. In 1993, the basic EIT C rate is 18.5 percent of the first $7,750 of 

earned income for a worker with one child (providing a maximu m credit of $1,434) and 

19.5 percent for a worker with two or more children (a maximu m credit of $1,511). The 

young child credit and health insurance credit increase the basic EIT C rate by 5 and 6 

percentage points, respectively (thereby increasing the maximu m credit amount by $388 

and $465, respectively). 

The basic EITC is reduced by an amount equal to 13.21 percent of the excess of 

adjusted gross income (or, if greater, earned income) over $12,200. The phaseout rate 

for a family with two or more children is 13.93 percent. Beginning at the same income 

threshold, the young child credit and health insurance credit increase the phaseout rate 

by 3.57 and 4.285 percentage points, respectively. The credits are not available to 

taxpayers with incomes of $23,050 or more. Each year, the income thresholds for both 

the phasein and phaseout ranges are adjusted for changes in the cost-of-living. 

In 1994 and thereafter, the basic EITC rate will increase to 23 percent for a 

worker with one child and 25 percent for a worker with two or more children. The 

corresponding phaseout rates will be 16.43 percent and 17.86 percent, respectively. 

Reasons for Change 

The federal government assists low-income workers in a number of ways, such as 

through the enforcement of a minimum wage and the food stamp program. Yet, the 

income (including the EIT C and food stamps) of a family of four with only one full-time, 

minimum-wage worker falls below the official poverty threshold. 

Proposal 

The Administration is committed to lifting more working families above the 

poverty threshold and to providing a greater work incentive to low-income workers. In 

order to achieve these goals, the Administration proposes to increase the earned income 

tax credit. A detailed proposal will be included in the presentation of the 

Administration's Budget. 

18 
«_, VESTMENT IN REAL ESTATE 

EXTEND MORTGAG E REVENUE BONDS 

Current Law 

Qualified mortgage bonds (QMBs) are bonds the proceeds of which are used to 

finance the purchase, or qualifying rehabilitation or improvement, of single-family, 

owner-occupied residences. Persons receiving QMB-financed loans generally must satisfy 

principal residence, purchase price, income, first-time homebuyer, and other 

requirements. 

The volume of QMBs that may be issued is limited by the annual State private 

activity bond volume limit. 

Governmental units may exchange annual private activity bond volume limit for 

the authority to issue mortgage credit certificates (MCCs). MCC s entitle homebuyers to 

nonrefundable income tax credits for a specified percentage of the interest paid on 

mortgage loans on their principal residences. MCC s are subject to the same eligibility 

and other requirements as QMBs . Once issued, an MC C remains in effect as long as the 

mortgage loan remains outstanding and the residence financed continues to be used as 

the MCC-recipient's principal residence. 

Authority to issue QMBs and to elect to trade in private activity bond volume 

limit for authority to issue MCC s expired after June 30, 1992. 

Reasons for Change 

The QMB and MCC programs enable lower and middle-income individuals and 

families wh o otherwise would be unable to afford homes to do so. 

Proposal 

The proposal permanently extends the authority to issue QMBs and to elect to 

trade in private activity bond volume limit for authority to issue MCCs . The extension of 

the QM B and MC C programs is effective after June 30, 1992. 

19 
EXTEN D LOW-INCOM E HOUSIN G CREDI T 

Current Law 

A tax credit is allowed in annual installments over 10 years for newly constructed 

or substantially rehabilitated low-income rental housing. For most newly constructed and 

substantially rehabilitated housing, the credit percentages provide a credit stream with a 

present value equal to 70 percent of the total qualified expenditures. In the case of 

housing receiving other federal subsidies, and in the case of the acquisition of an existing 

building that is substantially rehabilitated, the credit percentages provide a credit stream 

with a present value equal to 30 percent of the total qualified expenditures. Generally, 

that part of the building for which the credit is claimed must be rented to qualified lowincome tenants at restricted rents for 15 years after the building is placed in service. 

Generally, in order for a credit to be claimed with respect to a building, the 

building owner must receive a credit allocation from the appropriate credit authority. 

T he low-income housing credit is allocated by State or local government authorities 

subject to an annual limitation for each State. The population component of the annual 

State credit limitation was $1.25 per resident for 1992, but this portion of the State credit 

limitation could not be allocated after June 30, 1992. 

The low-income housing tax credit expired after June 30, 1992. 

Reasons for Change 

The low-income housing credit encourages the private sector to construct and 

rehabilitate the nation's rental housing stock and to make it available to the working 

poor and other low-income families. In addition to tenant-based housing vouchers and 

certificates, the credit is an important mechanism for providing federal assistance to 

families that rent housing. 

Proposal 

The proposal would make permanent the low-income housing tax credit. The 

provision is effective after June 30, 1992. 

20 
PROVID E PASSIV E LOS S RELIE F FO R CERTAI N REA L ESTAT E ACTIVITIE S 

Current Law 

The passive loss limitation rules provide generally that if a taxpayer's losses from 

passive activities exceed his income from passive activities for a taxable year, the excess 

losses are disallowed and carried forward to the next taxable year. Th e purpose of the 

passive loss rules is to discourage tax-motivated investments in tax shelters that, prior to 

the Tax Reform Act of 1986, permitted taxpayers to offset their active business and other 

income by incurring tax losses on investments in which they took no active part. 

To determine whether a taxpayer has passive losses for a taxable year under 

current law, the taxpayer's operations must be organized into activities that are either 

trade or business activities or rental activities. In general, rental operations ma y not be 

treated as part of a trade or business activity. Thus, for example, an integrated real 

estate business that involves the development, management, and rental of real property 

would ordinarily be treated as two activities (one trade or business and one rental) 

rather than one. 

A trade or business activity is passive unless the taxpayer materially participates in 

the activity. Treasury regulations provide that, in general, the material participation 

standard is satisfied if a taxpayer participates for more than 500 hours in the activity for 

the taxable year. Rental activities, however, are passive, regardless of the level of the 

taxpayer's participation. Thus, in general, losses from rental activities ma y offset only 

rental income or other passive income. A limited exception to this treatment of rental 

activities permits a taxpayer to treat up to $25,000 of real estate rental losses as 

nonpassive. This exception applies only to losses from activities in which the taxpayer 

actively participates (a lesser standard of involvement than material participation) and is 

phased out for upper-income taxpayers. 

The passive loss limitation rules apply to individuals, estates, trusts, and personal 

service corporations. Closely-held corporations ma y offset passive losses against active 

income, but ma y not offset passive losses against portfolio income, such as interest and 

dividends. 

Reasons for Change 

A taxpayer whose principal business involves real estate (including rental real 

estate) is disadvantaged under current law. Even if the taxpayer materially participates 

in all aspects of the business (including rentals), losses arising from the rental of real 

property ma y not be used to offset income from other aspects of the taxpayer's real 

estate business, except to the extent of the $25,000 allowance described above. Thus, 

real estate professionals are treated less favorably than other business professionals wh o 

21 
are allowed to deduct losses from activities in which they materially participate. 

Proposal 

The proposal would provide a special rule for real estate professionals. This rule 

would allow an eligible taxpayer to deduct the net loss for the taxable year from rental 

real estate activities in which he materially participates (or, if less, the passive activity 

loss for the year). The deductible loss would be limited, however, to the lesser of (1) the 

taxpayer's net income from nonpassive real property trade or business activities, or (2) 

the taxpayer's taxable income (determined without regard to the special rule for real 

estate professionals). Losses allowed by reason of the current-law $25,000 allowance 

would be determined before the application of the special rule for real estate 

professionals. Similar relief would be provided with respect to credits. 

A taxpayer would meet the eligibility requirements for the special rule if more 

than half of the personal services the taxpayer performs in a trade or business during the 

taxable year are in real property trades or businesses in which he materially participates. 

For purposes of the eligibility requirements, personal services performed as an employee 

would not be treated as performed in a real property trade or business unless the person 

performing the services has more than a 5-percent ownership interest in the employer. 

In addition, the special rule would not apply to closely held C corporations. 

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

1993. 

Effects of Proposal 

The proposal would ameliorate the disadvantageous treatment of real estate 

professionals under current law. This ma y encourage owners to hold troubled properties 

and mak e needed renovations, and make it easier for lenders, including the Resolution 

Trust Corporation, to dispose of troubled properties. The limited relief provided by the 

proposal will not undermine the important purpose of the passive loss rules, (i.e.. curbing 

tax shelters). 

22 
INCREAS E RECOVER Y PERIO D FO R DEPRECIATIO N O F 

NONRESIDENTIA L REA L PROPERT Y 

Current La w 

A taxpayer is allowed to recover, through annual depreciation allowances, the cost 

or other basis of nonresidential real property (other than land) that is used in a trade or 

business or that is held for the production of rental income. For regular tax purposes, 

the amount of the depreciation deduction allowed with respect to nonresidential real 

property for any taxable year generally is determined using the straight-line method and 

a recovery period of 31.5 years. For alternative minimum tax purposes, the amount of 

the depreciation deduction allowed with respect to nonresidential real property for any 

taxable year is determined using the straight-line method and a recovery period of 40 

years. 

Reasons for Change 

The recovery period for nonresidential real property under current law results in 

depreciation allowances that are larger than the actual decline in value of the property. 

In order to measure more accurately the economic income derived from the use of 

nonresidential real property in a trade or business or an investment activity, the recovery 

period for the depreciation of such property should be increased. 

Proposal 

For regular tax purposes, nonresidential real property would be depreciated using 

the straight-line method and a recovery period of 36 years. The proposal generally 

would apply to property placed in service on or after February 25, 1993. The proposal 

would not apply to property that a taxpayer places in service before January 1, 1994, if 

(1) the taxpayer or a qualified person entered into a binding written contract to purchase 

or construct the property before February 25, 1993, or (2) construction of the property 

was commenced by or for the taxpayer or a qualified person before February 25, 1993. 

A qualified person for this purpose is any person who transfers rights in such a contract 

or such property to the taxpayer without first placing the property in service. 

23 
FACILITATE REA L ESTAT E INVESTMENT S B Y PENSIO N FUND S AN D OTHER S 

1. Relax Restrictions on Debt-financed Real Estate Investments by Pension 

Funds and Others. 

Current Law 

Tax-exempt organizations are generally subject to the unrelated business income 

tax (UBIT) on income earned from debt-financed investments. Certain investments in 

real property by "qualified organizations" are excepted. 

To qualify for the exception to the debt-financed income rules: (1) the purchase 

price must be fixed in amount; (2) the indebtedness must not be revenue dependent; (3) 

the real property must not be leased to the seller; (4) in the case of a qualified trust, the 

real property must not be acquired from, or leased to, a person related to any plan with 

respect to which the trust was formed; and (5) no seller financing may be provided. 

Additional requirements apply if the investment vehicle is a partnership. 

4 

Reasons for Change 

The current rules impede legitimate leveraged acquisitions of real estate. One 

major aspect of the problem is that many qualified organizations consider it 

inappropriate to make any investment that generates unrelated business taxable income 

(UBTI), even if the amount of potential UBI T is economically insignificant. 

Proposal 

Relax Sale-leaseback Prohibition. The sale-leaseback prohibition would be 

modified to permit a leaseback of up to 25 percent of a debt-financed property to the 

seller (or a party related to the seller), provided the lease is on commercially reasonable 

terms, independent of the sale and other transactions. 

Allow Seller Financing. Seller financing would be permitted on terms that are 

commercially reasonable, independent of the sale and other transactions. The existing 

fixed price and participating loan restrictions would apply to seller financing. 

Relax Fixed Sales Price and Participating Loan Restrictions for Real Property 

Acquired from Financial Institutions. The fixed price and participating loan restrictions 

would not apply if: (1) a qualified organization acquires the real property from a 

financial institution (which would include some subsidiaries, and conservators or 

receivers); (2) the selling financial institution acquired the real property by foreclosure or 

24 
default, or held the real property at the time it entered conservatorship or receivership; 

(3) gain recognized by the seller of the real property is ordinary income; (4) the seller 

financing does not exceed the amount of the outstanding indebtedness (including accrued 

interest) on the real property at the time of the foreclosure or default; and (5) the 

maximu m amount that ma y be paid.pursuant to any participation features does not 

exceed 30 percent of the total purchase price (i.e.. the fixed component and the 

contingent component) for the real property. 

2. Repeal Rule Regarding Publicly Traded Partnerships. 

Current Law 

All tax-exempt organizations are subject to UBIT on their distributive share of 

income from publicly traded partnerships, regardless of whether the investment is debtfinanced or whether the income is derived from an unrelated trade or business. 

Reasons for Change 

There is no compelling reason to subject all investments in a publicly traded 

partnership to UBI T since a direct investment (or an investment through a non-publicly 

traded partnership) in the same activity would in many instances not be subject to UBIT . 

Proposal 

The rule subjecting income from publicly traded partnerships to UBIT would be 

repealed. The income would be subject to UBI T only if the activity conducted by the 

partnership is unrelated to the exempt purpose of the tax-exempt organization or is 

taxable under the debt-financed income rules. 

3. Permit title-holding companies to receive some UBTI. 

Current law 

Tax-exempt status is granted to certain corporations organized to hold title to real 

property and remit income to certain tax-exempt persons. These corporations may lose 

their exempt status if they generate any amount of certain UBTI . 

Reasons for Change 

The tax-exempt status of title-holding companies is unnecessarily precarious 

because they often receive small amounts of UBT I (such as parking or vending machine 

revenues) that relate to real property to which they hold title. 

25 
Proposal 

The tax-exempt status of a title-holding company would not be jeopardized if ten 

percent or less of its gross income is UBT I incidentally derived from holding real 

property. However, the incidental income would be subject to UBIT. 

4. Exclude From UBTI Gains and Losses from the Disposition of Certain 

Real Property Acquired from Financial Institutions in Conservatorship or 

Receivership. 

Current Law 

Gain or loss from the sale, exchange or other disposition of property generally is 

excluded from UBTI. However, gain or loss from property held primarily for sale in the 

ordinary course of a trade or business is not excluded from UBTI. 

Reasons for Change 

Financial institutions in conservatorship or receivership routinely package parcels 

of real property to facilitate the sale of their real estate inventory. Purchasers typically 

"cull" unwanted properties, and retain only properties consistent with their long-term 

strategic needs. Exempt organizations often do not purchase packaged properties 

because they fear culled properties might be treated as sold to customers in the ordinary 

course of a trade or business and thereby subject the organization to UBIT. 

Proposal 

There would be excluded from UBTI gains from the sale, exchange, or other 

disposition of certain real property acquired from financial institutions that are in 

conservatorship or receivership or from the conservator or receiver of such an institution. 

5. Exclude from UBTI Loan Commitment Fees and Certain Option 

Premiums. 

Current Law 

Gains on the lapse of options on securities are exempted from UBTI. Loan 

commitment fees and premiums from unexercised options on real estate may be subject 

to UBTI . 

Reasons for Change 

Subjecting loan commitment fees and option premiums on real estate to UBIT is 

inconsistent with the taxation of the underlying transactions, and impedes legitimate 

26 
transactions. 

Proposal 

Loan commitment fees and premiums from unexercised options on real estate 

would be excluded from UBTI. 

6. Effective Date 

The proposals generally would be effective January 1, 1994. 

27 
OTHER 

REPEAL AMT PREFERENCE FOR GIFTS 

OF APPRECIATED PROPERTY TO CHARITIES 

Current Law 

In calculating taxable income for regular income tax purposes, a taxpayer is 

generally allowed to deduct the fair market value of property contributed to charitable 

organizations. For purposes of the alternative minimum tax (AMT) , however, a taxpayer 

m a y not deduct the full value of long-term capital gain property contributed after June 

30, 1992. Instead, the taxpayer must treat as a tax preference, and thus add back to 

alternative minimum taxable income (AMTI), the amount by which the fair market value 

of the property exceeds the taxpayer's basis in the property. Therefore, for AM T 

purposes, the taxpayer's deduction is effectively limited to the basis of the contributed 

property. 

Reasons for Change 

Eliminating the tax preference for contributions of appreciated property would 

encourage contributions of such property to universities, museums, and other charitable 

institutions. 

Proposal 

The proposal would eliminate the tax preference for contributions of appreciated 

property. The deduction allowable for a contribution of appreciated property would be 

the same for both regular tax and AM T purposes (and also for adjusted current earnings 

purposes, in the case of a C corporation), and generally would equal the full fair market 

value of the contributed property. The provision would apply to contributions of tangible 

personal property made after June 30, 1992, and contributions of other property mad e 

after 1992. 

28 
EXTEN D GENERA L FUN D TRANSFE R T O 

RAILROA D RETIREMEN T TIER II TRUS T FUN D 

Current Law 

The Railroad Retirement Solvency Act of 1983 changed the tax treatment of Tier 

II benefits under the Railroad Retirement system to parallel that of private pensions. It 

also provided for the transfer of income taxes resulting from the change (not to exceed 

$877 million) on benefits received before October 1, 1988, from the General Fund of the 

Treasury to the Railroad Retirement Account. The $877 million limit was repealed and 

the 1988 deadline was delayed to 1992 by the Omnibus Budget Reconciliation Act 

(OBRA ) of 1987, OBR A 1989, and OBR A 1990. 

Reasons for Change 

The condition of the Railroad Retirement Account has deteriorated in recent 

years due to declining employment in the railroad industry. Currently, there are three 

retirees for every active employee in the railroad industry. Assuming that the current 

employment trends persist, the trust fund is estimated to be insolvent by 2016. 

Proposal 

The proposal would permanently extend, retroactive to taxes on benefits received 

after September 30, 1992, General Fund transfers to the railroad retirement trust fund. 

29 
EXTEN D HEALT H INSURANC E DEDUCTIO N FO R SELF-EMPLOYE D 

Current Law 

Under current law, an incorporated business can generally deduct, as an employee 

compensation expense, the full cost of any health insurance coverage provided for its 

employees (including owners serving as employees) and its employees' spouses and 

dependents. By contrast, a self-employed individual operating through an 

unincorporated business can only deduct the cost of health insurance coverage for 

himself and his dependents to the extent that it, together with their other allowable 

medical expenses, exceeds 7.5 percent of adjusted gross income. Self-employed 

individuals can deduct the cost of health insurance for employees as employee 

compensation. 

For coverage prior to July 1, 1992, a self-employed individual was allowed to 

deduct as a business expense up to 25 percent of the amount paid for health insurance 

coverage for himself, his spouse, and his dependents. Only amounts paid prior to July 1, 

1992 are eligible for deduction. The deduction was not allowed if the self-employed 

individual or his or her spouse was eligible for employer-paid health benefits. Originally, 

this deduction was only available if the insurance was provided under a plan that 

satisfied the non-discrimination requirements of section 89. Section 89 was repealed 

before it became effective, however, after which no non-discrimination requirements 

applied to such insurance. The amount paid for health insurance coverage for selfemployed individuals and their families was not deductible for self-employment tax 

purposes. 

Reasons for Change 

Current law creates a disparity between the tax treatment of owners of 

incorporated and unincorporated businesses (e.g.. partnerships and sole proprietorships). 

A n extension of the 25 percent deduction through the end of 1993 would retain current 

tax treatment for affected individuals until the Administration's comprehensive health 

care proposals have been formulated. 

Proposal 

Extend the 25 percent deduction through December 31, 1993. The provision is 

effective for taxable years ending after June 30, 1992. 

30 
REVENUE RAISING PROVISIONS 

31 
PROVISION S THA T IMPROV E FAIRNES S O F TH E TA X SYSTE M 

INCREASE TAX RATES PAID BY HIGH-INCOME INDIVIDUALS 

Current Law 

Regular Tax Rates. The highest marginal tax rate imposed on the income of 

individuals, estates and trusts is 31 percent. For 1993, this rate applies to taxable income 

in excess of the following thresholds: 

Filing Status Applicable Threshold 

Married individuals filing 

joint returns $89,150 

Heads of households $76,400 

Unmarried individuals $53,500 

Married individuals filing 

separate returns $44,575 

Estates and trusts $11,250 

Rates of 15 and 28 percent apply to income ranges below these thresholds. For 

example, for estates and trusts, the 15 percent rate applies to income up to $3,750, and 

the 28 percent rate applies to income between $3,750 and $11,250. 

For years after 1993, the threshold amounts will be indexed for inflation. 

The 31 percent marginal tax rate does not apply to capital gains, which are taxed 

at a maximu m rate of 28 percent. 

Alternative Minimum Tax Rate. Taxpayers are required to pay an alternative 

minimum tax (AMT ) to the extent that tax exceeds their regular tax liability. For 

taxpayers other than corporations, AM T liability generally equals 24 percent of the 

amount by which the taxpayer's alternative minimum taxable income (AMTI) exceeds a 

prescribed exemption amount. The exemption amount is $40,000 for married individuals 

filing joint returns, $30,000 for unmarried individuals, and $20,000 for married individuals 

filing separate returns, estates, and trusts. The exemption is reduced by 25 percent of 

the excess of AMT I over threshold amounts that vary by filing status: $150,000 for 

married taxpayers filing joint returns; $112,500 for heads of household or unmarried 

individuals; and $75,000 for married taxpayers filing separate returns, estates and trusts. 

32 
A taxpayer's AMT I is computed by adding certain tax preference items, and making 

other specified adjustments, to the taxpayer's taxable income. The AM T thus limits the 

extent to which taxpayers can use various tax preferences to reduce their tax liability, and 

insures that taxpayers with substantial economic income pay at least a minimu m amount 

of tax. 

Itemized Deduction Limitation. Individuals who do not elect the standard 

deduction ma y claim itemized deductions (subject to certain limitations) for certain 

expenses. Amon g these deductible expenses are unreimbursed medical expenses, 

casualty and theft losses, charitable contributions, qualified residence interest, investment 

interest and other investment expenses, State and local income and property taxes, 

unreimbursed employee business expenses, certain moving expenses, and gambling losses 

(to the extent that they do not exceed winnings). 

Taxpayers with AGI in excess of a prescribed threshold are required to reduce 

their otherwise allowable itemized deductions. The required reduction equals 3 percent 

of the amount by which the taxpayer's AG I exceeds the prescribed threshold. For 1993, 

the prescribed threshold is $108,450. The threshold for subsequent years will be indexed 

for inflation. Otherwise allowable deductions, however, cannot be reduced by more than 

80 percent. Further, the reduction does not apply to medical expenses, casualty and theft 

losses, investment interest, and gambling losses. 

The reduction of otherwise allowable itemized deductions does not apply to 

taxable years beginning after December 31, 1995. 

Phaseout of Personal Exemptions. In determining taxable income, an individual 

taxpayer is entitled to a deduction for each allowable personal exemption. A separate 

exemption is allowed for the taxpayer, the taxpayer's spouse, and each dependent of the 

taxpayer. For 1993, the deduction allowable for each exemption is $2,350. For 

subsequent years, this amount will be indexed for inflation. 

Taxpayers whose AGI exceeds a prescribed threshold must reduce or eliminate 

the deduction for personal exemptions to which they would otherwise be entitled. For 

1993, the thresholds are $162,700 for married individuals filing joint returns, $135,600 for 

heads of households, $108,450 for unmarried individuals, and $81,350 for married 

individuals filing separate returns. For subsequent years, these threshold amounts will be 

indexed for inflation. 

A taxpayer generally must reduce the deduction for exemptions by 2 percent of 

the otherwise allowable amount for each $2,500 increment (or portion thereof) by which 

the taxpayer's AG I exceeds the applicable threshold. For married taxpayers filing 

separate returns, however, the applicable increment is $1,250 instead of $2,500. 

The phaseout of personal exemption deductions does not apply to taxable years 

33 
beginning after December 31, 1996. 

Reasons for Change 

The proposal would increase the fairness of the tax system by ensuring that upper 

income taxpayers pay their fair share of federal income taxes. The proposal would 

provide a higher marginal tax rate for upper income taxpayers, wh o have the greatest 

ability to pay taxes. 

Proposal 

New Marginal Tax Rates. The proposal would provide a new 36 percent marginal 

tax rate that would apply to taxable income in excess of the following thresholds: 

Filing Status Applicable Threshold 

Married individuals filing 

joint returns $140,000 

Heads of households $127,500 

Unmarried individuals $115,000 

Married individuals filing 

separate returns $ 70,000 

Estates and trusts $ 5,500 

For estates and trusts, the 15 percent rate would apply to income up to $1,500, 

the 28 percent rate would apply to income between $1,501 and $3,500, and the 31 

percent rate would apply to income between $3,501 and $5,500. Under this modified tax 

rate schedule for estates and trusts, the benefits of the rates below the 39.6 percent 

surtax rate (described below) for 1993 would approximate the benefits of the 15 and 28 

percent rates for 1993 under current law. 

As under current law, the tax rate bracket thresholds (including the thresholds for 

the new 36 percent rate) would be indexed for inflation. 

Alternative Minimum Tax Rate and Exemption Amounts. The proposal would 

provide a two-tiered progressive rate schedule for the AMT . This rate schedule would 

apply to taxpayers other than corporations. A 26 percent rate would apply to the first 

$175,000 of a taxpayer's AMTI , and a 28 percent rate would apply to AMT I in excess of 

34 
$175,000. For married individuals filing separate returns, the 28 percent rate would 

apply to AMT I in excess of $87,500. The proposal would increase the exemption 

amounts to $45,000 for married individuals filing joint returns, $33,750 for unmarried 

individuals, and $22,500 for married individuals filing separate returns, estates and trusts. 

Surtax on High Income Taxpayers. The proposal would provide a 10 percent 

surtax on individuals with taxable income in excess of $250,000 and on estates and trusts 

with taxable income in excess of $7,500. The surtax would be computed by applying a 

39.6 percent rate to taxable income in excess of the applicable threshold. Under this 

method of computation, unlike a simple 10 percent increase in tax liability, capital gains 

would not be subject to tax at a rate in excess of the current 28 percent maximu m rate. 

For married taxpayers filing separate returns, the threshold amount for the surtax would 

be $125,000. 

Itemized Deduction Limitation and Phaseout of Personal Exemptions. The 

proposal would make permanent the provisions that limit itemized deductions and phase 

out personal exemptions. 

Effective Date. The proposal would be effective for taxable years beginning on or 

after January 1, 1993. The withholding tables for 1993 would not be revised to reflect 

the changes in tax rates. Penalties for the underpayment of estimated taxes, however, 

would be waived for underpayments of 1993 taxes attributable to the changes in tax 

rates. 

35 
REPEA L HEALT H INSURANC E WAG E BAS E CA P 

urrent Law 

As part of the Federal Insurance Contributions Act (FICA), a tax is imposed on 

mployees and employers up to a maximum amount of employee wages. The tax is 

amposed of old-age, survivor, and disability insurance (OASDI) and Medicare hospital 

lsurance (HI). For wages paid in 1993 to covered employees, the H I tax rate is 1.45 

ercent on both the employer and the employee on the first $135,000 of wages, and the 

)ASDI tax rate is 6.2 percent on both the employer and the employee on the first 

57,600 of wages. 

Under the Self-Employment Contributions Act of 1954 (SECA), a tax is imposed 

n an individual's self-employment income. The self-employment tax bases are the same 

s for employees (Le,, $135,000 for HI and $57,600 for OASDI), and the self-employment 

ax rates are the same as the total rates for employers and employees (i.e.. 2.9 percent 

or H I and 12.40 percent for OASDI) . The tax is generally reduced to the extent that 

tie individual had wages for which employment taxes were withheld during the year. 

The cap on wages and self-employment income subject to FICA and SECA taxes 

> indexed to reflect changes in the average wages in the economy. 

Reasons for Change 

HI taxes fund Medicare. Unlike OASDI benefits, Medicare benefits are not 

united by a taxpayer's lifetime earnings that have been subject to FICA taxes. 

elimination of all restrictions on earnings subject to HI taxes would therefore make the 

alculation of Medicare contributions consistent with the calculation of Medicare 

enefits. 

Proposal 

The proposal would eliminate the dollar limit on wages and self-employment 

icome subject to H I taxes for wages and income received after December 31, 1993. 

Iffect of Proposal 

The proposal would enhance the solvency of the HI trust fund. Approximately 1.2 

lillion high-wage workers would be affected by the increase. 

36 
REINSTAT E TO P ESTAT E AN D GIF T TA X RATE S 

A T 53 PERCEN T AN D 55 PERCEN T 

Current La w 

The federal estate and gift taxes are unified so that a single progressive rate 

schedule is applied to an individual's cumulative gifts and bequests. The generationskipping transfer tax is computed by reference to the maximu m federal estate and gift tax 

rate. 

In 1992, the federal estate and gift tax rates began at 18 percent on the first 

$10,000 of taxable transfers and reached 55 percent on taxable transfers in excess of $3 

million. For transfers occurring after 1992, the maximu m federal estate and gift tax rates 

was reduced to 50 percent on taxable transfers over $2.5 million. The benefit of the 

graduated rates and the unified credit is phased out at a 5 percent rate for taxable 

transfers that exceed $10,000,000 and do not exceed $18,340,000. 

Reasons for Change 

Due to the need for all taxpayers to contribute to the current deficit situation, the 

Administration believes that a permanent extension of the top rates in effect in 1992 

should be implemented, effective January 1, 1993. 

Proposal 

The top estate and gift tax rate would be reinstated, effective January 1, 1993. 

For taxable transfers over $2.5 million but not over $3.0 million, the rate would be 53 

percent. For taxable transfers over $3.0 million, the rate would be 55 percent. The 

phase out of the graduated rates and unified credit would be between $10,000,000 and 

$21,040,000. Also, the rate of tax on generation-skipping transfers would be 55 percent. 

37 
REDUC E DEDUCTIBL E PORTIO N O F BUSINES S MEAL S AN D 

ENTERTAINMEN T EXPENSE S FRO M 80 PERCEN T T O 50 PERCEN T 

Current Law 

In general, deductions are allowable for ordinary and necessary expenditures paid 

or incurred in carrying on a trade or business or for the production or collection of 

income. Deductions are not allowed with respect to personal, living, or family expenses. 

Meals and entertainment expenses are deductible only if they are "directly related to" or 

"associated with" the active conduct of a taxpayer's trade or business. Meals and 

entertainment expenses are not deductible to the extent they are lavish or extravagant. 

Meals and entertainment expenses include, for example, food, beverages, entertainment 

at night clubs, cocktail lounges, theaters, sporting events and similar activities. 

Allowable meal and entertainment expenses are deductible to the extent of 80 

percent of cost. This reduction rule was added by Congress in 1986 to reflect the fact 

that all meals and entertainment inherently involve an element of personal living 

expense. Certain exceptions from the reduction rule apply (e.g.. exceptions for expenses 

treated as compensation and reimbursed expenses). 

Reasons for Change 

The Administration believes that it is inappropriate to permit a deduction for the 

portion of these expenditures that is inherently personal in nature. Reducing the 

deductible percentage of otherwise allowable meal and entertainment expenses would 

reduce the amount of personal and living expense inherent in these expenditures that is 

deducted for federal income tax purposes. 

Proposal 

The proposal would reduce the deductible portion of otherwise allowable business 

meals and entertainment expenses from 80 percent to 50 percent for taxable years 

beginning after December 31, 1993. 

38 
DEN Y DEDUCTIO N FO R CLU B DUE S 

Current Law 

In general, deductions are allowable for ordinary and necessary expenditures paid 

or incurred in carrying on a trade or business or for the production or collection of 

income. Deductions are not allowed with respect to personal, living, or family expenses. 

No deduction is permitted for club dues unless the taxpayer establishes that his use of 

the club was primarily for the furtherance of the taxpayer's trade or business. After this 

test is met, the taxpayer may then deduct only that portion of the dues which qualify as 

"directly related" to the active conduct of the taxpayer's trade or business. No deduction 

is permitted for an initiation or similar fee that is payable only upon joining a club if the 

useful life of the fee extends over more than one year. Such initiation fees are 

nondeductible capital expenditures. 

Reasons For Change 

Under present law, taxpayers can obtain a tax deduction for dues for a club (such 

as a country club) with respect to which a significant element of personal pleasure, 

enjoyment and social benefit is present. The Administration believes that it is 

inappropriate to permit a deduction for such expenditures because of the personal nature 

of these expenditures. 

Proposal 

Under the proposal, no deduction would be permitted for club dues for taxable 

years beginning after December 31, 1993. This rule would apply to all types of clubs, 

including business, social, athletic, luncheon, and sporting clubs. Specific business 

expenses (e.g.. meals) incurred at a club would be deductible only to the extent they 

otherwise satisfy the standards for deductibility. 

39 
DEN Y DEDUCTIO N FO R EXECUTIV E PA Y OVE R ON E MILLIO N DOLLAR S 

Current La w 

The gross income of an employee includes any compensation received for services 

rendered. A n employer is allowed a corresponding deduction for reasonable salaries and 

other compensation. Whether compensation is reasonable is determined on a case-bycase basis. However, the reasonableness standard has been used primarily to limit 

payments by closely-held companies where dividends may be disguised as deductible 

compensation. 

Reasons for Change 

Given that current law does not provide any significant restrictions on deductions 

for compensation payments, there is no limitation on the amount of tax benefit provided 

for executive compensation. This unlimited tax benefit is particularly troubling in light of 

concerns that, in some cases, the compensation paid to corporate executives has 

increased despite a decline in business performance. In addition, there is concern that 

current law does not provide significant incentives for corporations to link compensation 

to business performance. 

Proposal 

The proposal would preclude a corporation from taking a deduction for 

compensation paid to an executive in excess of $1 million per year. However, the $1 

million limitation would not apply to compensation payments that are linked to 

productivity. The Treasury is reviewing appropriate standards regarding this exception. 

Certain other payments also would be excluded from the deduction limit, such as 

payments mad e to a tax-qualified retirement plan and certain fringe benefits that are 

excludable from gross income by the executive. The proposal would be effective for 

taxable years beginning after December 31, 1993. 

Effects of Proposal 

The proposal would limit the tax benefit for salaries paid to executives and would 

provide a strong incentive for corporations to explicitly link compensation to productivity. 

40 
REDUC E COMPENSATIO N TAKE N INT O ACCOUN T FO R QUALIFIE D 

RETIREMEN T PLA N PURPOSE S 

Current Law 

Section 401(a)(17) precludes a tax-qualified retirement or savings plan from 

providing benefits or making allocations on account of compensation in excess of 

$235,840 (as indexed for 1993). Thus, if an employee has compensation in excess of the 

$235,840 limit, the excess compensation cannot be used to determine the amount of the 

employee's benefit or allocation under a plan. 

Reasons for Change 

The tax benefit for tax-qualified retirement and savings plans is designed to give 

employers an incentive to provide reasonable levels of retirement income for their 

employees. A reexamination of the section 401(a)(17) limit is appropriate to ensure that 

the tax benefit is used primarily for the benefit of employees who, otherwise, might not 

save at adequate levels for retirement. In addition, it is appropriate to ensure that 

highly-compensated employees are not earning excessive retirement benefits through a 

tax-qualified plan. 

Proposal 

Under the proposal, the section 401(a)(17) limit would be reduced to $150,000, 

for plan years beginning after December 31, 1993. As under current law, the section 

401(a)(17) limit would be indexed for cost-of-living adjustments on an annual basis. 

Benefits accrued prior to the effective date for compensation in excess of the reduced 

limit would be grandfathered. Corresponding changes also would be made to other 

provisions that take into account the section 401(a)(17) limit. 

Effects of Proposal 

Although the reduction in the section 401(a)(17) limit would reduce the amount 

of benefits and contributions that could be provided through a tax-qualified plan for 

some employees, the affected individuals would be employees at higher compensation 

levels who are most able to save for retirement outside of the tax benefited qualified 

plan system. The proposal would not result in any cut-back of benefits already accrued 

because the reduced limit would be imposed only on compensation that is taken into 

account for determining benefits accrued in 1994 and thereafter. 

The proposal's impact on employers' incentives to maintain a tax-qualified plan 

should not be significant. Even as limited under the proposal, tax-qualified plans would 

continue to provide an opportunity for meaningful retirement benefits on a tax-preferred 

41 
basis. In addition, it is possible that an employer could offset the effect of the reduction 

in the section 401(a)(17) limit by increasing other variables in a plan's formula. Such 

changes in the formula would increase benefits and contributions for lower-paid 

employees as well. 

42 
DISALLO W MOVIN G DEDUCTION S FO R MEAL S AN D REA L ESTAT E EXPENSE S 

Current Law 

Any amount paid to or on behalf of an individual to move to a new residence is 

included in the individual's gross income as compensation for services. If the taxpayer's 

n ew job is at least 35 miles further from his former residence than was his former job, 

the taxpayer is permitted an itemized deduction for certain moving expenses that are 

incurred in connection with starting work at the new location. Deductible moving 

expenses include the costs of: 

(1) moving household goods; 

(2) travel, meals and lodging to transport the taxpayer and his family; 

(3) travel, meals and lodging for househunting trips; 

(4) meals and temporary lodging for up to 30 days' stay near the new job location; 

and 

(5) selling (or settling an existing lease on) the old residence and buying (or acquiring 

a lease on) the new residence. 

The moving expense deduction is subject to a number of limitations. Generally, 

the deduction for househunting and temporary quarters may not exceed $1,500. The 

deduction for selling, buying and settling leases may not exceed the net of $3,000 less the 

amount claimed for househunting and temporary quarters. The moving expense 

deduction is not subject to the 2 percent floor on miscellaneous itemized deductions, but 

is subject to the overall limitation on itemized deductions. 

Reasons for Change 

The Administration believes that the cost of meals consumed during the course of 

a move should not be deductible. Moving does not generally increase the cost of meals 

significantly because the taxpayer would have eaten meals at either location. The costs 

of selling and buying homes are properly treated as reductions of the selling price (i.e.. 

amount realized) and additions to the purchase price (i.e.. basis). The costs of settling 

old leases and acquiring new leases are nondeductible personal expenses for most 

taxpayers. 

Proposal 

The proposal would exclude from the definition of moving expenses: (1) the costs 

of meals consumed while traveling and while living in temporary quarters near the new 

workplace, and (2) the costs of selling (or settling an unexpired lease on) the old 

residence and buying (or acquiring a lease on) the new residence. 

43 
PROVISIONS AFFECTING BUSINESS 

INCREASE CORPORATE TAX RATE FOR TAXABLE INCOME 

OVER TEN MILLION DOLLARS 

Current Law 

The highest marginal tax rate imposed on the income of corporations is 34 

percent. This rate applies to income in excess of $75,000. Rates of 15 and 25 percent 

apply to income ranges below $75,000. A corporation with taxable income in excess of 

$100,000 is required to increase its tax liability by the lesser of 5 percent of the excess or 

$11,750. This increase in tax recaptures the benefits of the 15 and 25 percent rates. 

Reasons for Change 

The corporate income tax rates and the amount of taxes paid by corporations, as 

a percentage of both total federal revenues and gross domestic product (GDP) , are 

relatively low by historical standards. The top marginal tax rate for corporations is 34 

percent. By contrast, between 1979 and 1987, the top marginal rate for corporations was 

46 percent. Prior to 1979, the rate was even higher. Similarly, the amount of income 

taxes paid by corporations is currently about 9 percent of total federal revenues and 1.5 

percent of GDP . By contrast, in 1955, corporate income taxes were 27.3 percent of total 

federal revenues and 4.7 percent of GDP . Therefore, raising the top marginal tax rate 

for profitable corporations is an appropriate means to help reduce the budget deficits 

projected for the federal government. 

Proposal 

The proposal would provide a new 36 percent marginal tax rate on corporate 

taxable income in excess of $10,000,000. A corporation with taxable income in excess of 

$15 million would be required to increase its tax liability by the lesser of 3 percent of the 

excess or $200,000. This increase in tax would recapture the benefits of the 34 percent 

rate in a manner analogous to the recapture of the benefits of the 15 and 25 percent 

rates. Because the 36 percent rate would apply only to income in excess of $10,000,000, 

the vast majority of corporations would not be subject to the new rate. The 36 percent 

marginal rate would be effective for taxable years beginning on or after January 1, 1993. 

Penalties for the underpayment of estimated taxes, however, would be waived for 

underpayments of 1993 taxes attributable to the changes in tax rates. 

44 
DEN Y DEDUCTIO N FO R LOBBYIN G EXPENSE S 

Current Law 

Under current law, businesses may deduct certain lobbying expenses. Deductible 

lobbying expenses include: amounts paid or incurred for direct communications with 

Congress or another legislative body concerning legislation of direct interest to the 

taxpayer in conducting a trade or business; the cost of communicating with a trade 

organization of which the taxpayer is a membe r in regard to relevant legislation; and a 

part of the dues for membership in an organization that engages in lobbying. N o 

deduction is permitted for amounts paid or incurred for participation in political 

campaigns or grassroots lobbying. 

Organizations that are exempt from taxation under section 501(c)(3) are subject 

to certain limitations on lobbying activities. Such organizations may mak e an election 

whereby they will not lose exempt status if their lobbying expenditures normally do not 

exceed a safe-harbor amount. Electing organizations are subject to an excise tax for 

lobbying expenditures in excess of the safe-harbor amount. Private foundations are 

subject to an excise tax on all lobbying expenditures. N o tax is imposed on lobbying 

expenditures of trade associations and similar organizations. Corporations may deduct 

the part of their dues paid to such organizations that are for ordinary and necessary 

business expenses and for direct lobbying, but not for the part of their dues used for 

grassroots lobbying. 

Reasons for Change 

The deduction for lobbying expenses inappropriately benefits corporations and 

special interest groups for intervening in the legislative process. 

Proposal 

Businesses would no longer be allowed to deduct lobbying expenses. Lobbying 

expenses for this purpose would be defined similarly to the definition of expenditures to 

influence legislation in section 4911(d) and would include attempts to influence 

legislation through communications with the executive branch as well as the legislative 

branch of government. The current restrictions on deductions for expenses of grassroots 

lobbying and participation in political campaigns would remain. These rules would 

prevent charities from engaging in more than an insubstantial amount of lobbying. N o 

deduction would be allowed for the part of membership dues that are used for lobbying, 

but as under current law, trade associations and similar organizations would not lose 

their exempt status for lobbying. Trade associations and similar organizations would be 

required to report to their members the portion of their dues used for lobbying activities. 

45 
REQUIR E SECURITIE S DEALER S T O MAR K T O MARKE T 

Current Law 

Under Treasury regulations, dealers' inventories of marketable securities may be 

valued at market, at cost, or at the lower of cost or market for purposes of computing 

taxable income. 

The market method of inventory valuation (often referred to as the "mark-tomarket" method) requires the taxpayer to determine the market value of its inventory at 

the end of each taxable year and include all unrealized inventory gains and losses in its 

income for the year. The market method tends to give the most accurate measure of a 

taxpayer's annual income, but it works best if the taxpayer's inventory is composed of 

property that can be readily valued at the end of each taxable year. 

Because inventories of most businesses are difficult to value, however, many 

taxpayers use the cost method of inventory valuation (often referred to as the "historical 

cost" method). Under this method, a taxpayer values its inventory at cost, and does not 

recognize any increases or decreases in the inventory's value until the inventory is sold. 

For most businesses, the cost of the taxpayer's inventory will ordinarily be less than its 

market value and inventory levels will ordinarily increase over time. Thus, the taxpayer's 

annual income computed under the cost method will tend to be less than when 

computed under the market method. 

Under the lower-of-cost-or-market method of inventory valuation (LCM), a 

taxpayer values each item of inventory at its market value or at its cost, whichever is 

lower at the end of each taxable year. Thus, the LC M method permits the taxpayer to 

deduct unrealized losses without requiring any unrealized gains to be included in income. 

When Treasury regulations regarding securities dealers' inventories were issued, 

the lower-of-cost-or-market method conformed to the best financial accounting practice 

in the industry, and securities dealers generally valued their securities inventories on that 

basis in their financial statements. Because the LC M method provides a lower annual 

income, compared to either the market method or the cost method, it was considered a 

very conservative method of financial accounting. Since 1973, however, generally 

accepted accounting principles (GAAP ) have required securities dealers to mark their 

inventories to market to more accurately measure financial income and net worth. 

Reasons for Change 

Inventories of marketable securities are easily valued at year end, and in fact are 

currently valued by securities dealers in computing their income for financial statement 

purposes and in adjusting their inventory to an LC M basis for federal income tax 

46 
purposes. The cost method and the LC M method tend to provide a lower taxable 

income compared to the market method that securities dealers use to report their 

income to shareholders, creditors and regulators. The market method represents the 

required GAA P method in the trade or business of dealing in securities and is the 

method that provides the most accurate measure of the income of a securities dealer. 

Proposal 

The proposal would require securities dealers to compute their taxable income by 

marking their inventories of securities to market, as they already do when preparing 

financial statements in accordance with GAAP . Any gain or loss recognized under the 

mark-to-market method would generally be treated as ordinary gain or loss. 

Each dealer that currently uses the cost or LCM method of accounting for its 

inventory of securities would be required to change to the mark-to-market method. The 

dealer would be required to value its inventory of securities at market for all taxable 

years ending on or after December 31, 1993. Under a transitional rule, the resulting 

change in inventory value would be included in taxable income ratably over a 5-year 

period. For example, a dealer that uses a calendar year and that is required to change 

from the LC M method to the mark-to-market method for the year ending December 31, 

1993, would increase its taxable income for 1993 and each of the next 4 years by 20 

percent of the difference between the values of its inventory at market and at LC M as of 

the beginning of 1993. 

47 
PROHIBI T DOUBLE-DI P RELATE D T O FSLIC ASSISTANC E 

Current Law 

A taxpayer generally may claim a deduction for a loss on the sale or other 

disposition of property only to the extent that the taxpayer's adjusted basis for the 

property exceeds the amount realized on the disposition and the loss is not compensated 

for by insurance or otherwise. In the case of a taxpayer on the specific charge-off 

method of accounting for bad debts, a deduction is allowable for the debt only to the 

extent that the debt becomes worthless and the taxpayer does not have a reasonable 

prospect of being mad e whole for the loss. If the taxpayer accounts for bad debts on the 

reserve method, the worthless portion of a debt is charged against the taxpayer's reserve 

for bad debts, potentially increasing the taxpayer's deduction for an addition to this 

reserve. 

Before it was amended by the Financial Institutions Reform, Recovery, and 

Enforcement Act of 1989 (FIRREA), a special tax rule exempted financial assistance 

received by a thrift institution from the Federal Savings and Loan Insurance Corporation 

(FSLIC) from the thrift's income and prohibited a reduction in the tax basis of the 

thrift's assets on account of the receipt of the assistance. The FSLIC entered into a 

number of assistance agreements in which it agreed to provide loss protection to 

acquirers of troubled thrift institutions by compensating them for the difference between 

the book value and sales proceeds of the "covered assets." "Covered assets" typically are 

assets that were classified as nonperforming or troubled at the time of the assisted 

transaction. Man y of these covered assets are also subject to yield maintenance 

guarantees, under which the FSLIC guarantees the acquirer a minimum return or yield 

on the value of the assets. The assistance agreements also generally grant the FSLIC the 

right to purchase covered assets at market or book value. 

In addition, many of the assistance agreements permit the FSLIC to order assisted 

institutions to write down the value of covered assets on their books to fair market value 

in exchange for a payment in the amount of the write-down. It was not clear under prior 

law whether FSLIC assistance should be taken into account in determining the amount 

of an institution's tax loss on the sale or other disposition of an asset or deduction in 

connection with the write-down of a loan. 

In September 1990, the Resolution Trust Corporation (RTC), in accordance with 

the requirements of FIRREA , issued a report to Congress and the Oversight Board of 

the RT C on certain FSLIC-assisted transactions (the "1988/89 FSLIC transactions"). The 

report recommended further study of the covered loss and other tax issues relating to 

these transactions. A March 4, 1991 Treasury Department report on tax issues relating 

to the 1988/89 FSLIC transactions concluded that deductions should not be allowed for 

losses that are reimbursed with exempt FSLIC assistance and recommended that 

48 
Congress enact clarifying legislation disallowing these deductions. 

Reasons for Change 

Allowing tax deductions for losses on covered assets that are compensated for by 

FSLIC assistance gives thrift institutions an inappropriate incentive to hold these assets 

and to minimize their value when sold. The FSLIC, and not the institution, bears the 

economic burden corresponding to any reduction in value because it is required to 

reimburse the thrift for the loss. However, the tax benefit to the thrift and its affiliates 

increases as tax losses increase. The institution, therefore, has an incentive to minimize 

the value of covered assets in order to maximize its tax loss and the attendant tax 

savings. 

Proposal 

The proposal would treat FSLIC assistance with respect to any loss as 

compensation for that loss for purposes of section 165 of the Code. FSLIC assistance 

with respect to any debt would be taken into account in determining the worthlessness of 

that debt for purposes of sections 166, 585 and 593 of the Code. FSLIC assistance would 

be defined as assistance provided with respect to domestic building and loan associations 

pursuant to section 406(f) of the National Housing Act or section 21 A of the Federal 

Hom e Loan Bank Act. 

The proposal would apply to FSLIC assistance credited on or after March 4, 1991, 

with respect to (1) assets disposed of and charge-offs mad e in taxable years ending on or 

after March 4, 1991, and (2) assets disposed of and charge-offs mad e in taxable years 

ending before March 4, 1991, but only for the purpose of determining the amount of any 

net operating loss carryover to a taxable year ending on or after March 4, 1991. For this 

purpose, assistance generally would be considered to be credited when the taxpayer 

mad e an approved debit entry to a Special Reserve Account required to be maintained 

under the assistance agreement to reflect the asset disposition or charge-off. 

49 
EXTEN D CORPORAT E ESTIMATE D TA X RULE S 

Current Law 

Under current law, a corporation is subject to an addition to tax for any 

underpayment of estimated tax. For taxable years beginning after June 30, 1992, and 

before January 1, 1997, a corporation generally does not have an underpayment of 

estimated tax if it makes four timely estimated tax payments based on 97 percent of (1) 

its current year tax liability, or (2) its tax liability computed by annualizing income as of 

the month or quarter ending immediately prior to its estimated tax payment due dates. 

A corporation that is not a "large corporation" generally may avoid the addition to 

tax if it makes four timely estimated tax payments each equal to at least 25 percent of its 

tax liability for the preceding taxable year. Additionally, a large corporation may use this 

rule with respect to its estimated tax payment for the first quarter of its current taxable 

year. A large corporation is one that had taxable income of $1 million or more for any 

of the three preceding taxable years. 

Upon expiration, in 1997, of the 97 percent requirement applicable for estimated 

payments based on a corporation's current year tax liability or its liability based on 

annualized income, a 91 percent requirement will apply. 

Reasons for Change 

The Administration believes that the corporate estimated tax requirements 

generally applicable to 1993, 1994, 1995, and 1996 taxable years should be made 

permanent. Under the proposal, corporate estimated tax payments will more accurately 

reflect ultimate tax liabilities for a particular taxable year. 

Proposal 

The proposal would permanently extend the 97 percent requirement applicable 

for estimated tax payments based on a corporation's current year tax liability or its 

liability based on annualized income. The proposal would not alter rules permitting the 

payment of estimated taxes based on a corporation's tax liability for its preceding taxable 

year. 

50 
LIMIT POSSESSION TAX CREDIT 

TO 65 PERCENT OF COMPENSATION PAID 

Current Law 

Domestic corporations with business operations in United States possessions may 

elect under section 936 to eliminate the United States tax on certain income related to 

their possession-based operations. The credit spares the electing corporation United 

States tax whether or not it pays income tax to the possession. 

In order to qualify for the section 936 credit, a domestic corporation must derive 

at least 75 percent of its gross income from the active conduct of a trade or business 

within a possession over a three-year period, and at least 80 percent of the corporation's 

gross income must be derived from sources within a possession during that period. 

Reasons for Change 

Section 936 was enacted to foster economic development in the possessions, 

principally Puerto Rico. Man y studies conducted over the past 15 years, however, have 

indicated that a disproportionate share of the tax benefits attributable to section 936 is 

realized by intangible-intensive industries that create relatively few jobs in the 

possessions. For instance, Treasury data indicate that in 1989 the tax expenditure for 

each job that pharmaceutical corporations created in Puerto Rico was $66,081, and that 

the pharmaceutical industry enjoyed 50 percent of the section 936 tax benefits in that 

year. Overall, the average tax benefit per employee in that year was $22,375, or 109 

percent of average compensation paid to those employees. Data of this nature suggests 

that while section 936 has created employment in Puerto Rico, the number of jobs 

created is too small in relation to the tax expenditure. 

Linking the credit more directly to wages paid in the possession would both 

reduce the revenue cost of the provision and more effectively encourage employment in 

the possessions. 

Proposal 

The section 936 credit would be limited to 65 percent of the wages the 

possessions corporation pays to its employees in the possession. For this purpose, wages 

are defined by reference to the Federal Unemployment Tax Act (FUTA ) definition of 

wages. The amount of wages taken into account for each employee would be limited to 

the amount of wages subject to federal social security withholding (currently $57,600). 

Related possessions corporations would be permitted to consolidate for purposes of 

determining their section 936 credit. This proposal would be effective for taxable years 

beginning after December 31, 1993, except that, for 1994 and 1995, possessions 

51 
corporations ma y elect to claim a reduced credit not linked to compensation. Under this 

alternative, the credit will be limited to 80 percent of the current law credit in 1994 and 

60 percent in 1995. 

Effects of Proposal 

Possessions corporations that have created a relatively large number of jobs will 

continue to enjoy the tax credit that they now receive. Possessions corporations for 

which tax credits exceed 65 percent of payrolls will lose some of their tax benefits unless 

they expand their Puerto Rican employment. The result should be a much more costeffective possessions credit. 

52 
PROVISIONS AFFECTING INTERNATIONAL BUSINESSES 

ELIMINATE WORKING CAPITAL EXCEPTION FOR 

FOREIGN OIL AND GAS AND SHIPPING INCOME 

Current Law 

United States taxpayers may claim a foreign tax credit for foreign taxes paid. The 

foreign tax credit is limited to the taxpayer's United States tax liability on foreign source 

taxable income. The foreign tax credit limitation is computed separately for specified 

categories of income, to prevent taxpayers from "cross-crediting" high foreign taxes paid 

on certain types of income to reduce United States tax on passive types of income, which 

typically are subject to low foreign tax. 

One of the separate limitation categories is the "passive" category. Although most 

income of a passive nature falls into this category, interest on bank deposits or on other 

temporary investments of working capital in connection with foreign oil and gas 

extraction income (FOGEI), foreign oil related income (FORI), or shipping income is 

excluded from the passive category. N o other industries enjoy a working capital 

exception. 

Current law also imposes a special limitation on the amount of foreign oil and gas 

extraction taxes that ma y be credited against the United States tax on FOGEI . Passive 

income related to foreign oil and gas extraction taxes is included in the computation of 

this limitation. This increases the amount of the foreign tax credit that may be claimed 

against United States tax on such income. 

Taxpayers' ability under current law to cross-credit taxes on certain passive 

income earned in connection with FOGEI , FORI , or shipping income reduces the 

residual tax that the United States may collect on such income. The inclusion of passive 

income in computing the special FOGE I foreign tax credit limitation has the same effect. 

Reasons for Change 

Current law creates incentives for taxpayers in the oil and gas and shipping 

industries to keep their working capital abroad rather than in the United States. The 

Administration believes that these incentives are inappropriate. In addition, current law 

provides more favorable foreign tax credit treatment for income associated with foreign 

oil and gas or shipping activities than for income earned abroad by other United States 

industries. The Administration believes that there is no sound policy reason for this 

difference in treatment and that foreign oil and gas and shipping activities should be put 

on an equal footing with other industries. 

53 
Proposal 

The proposal would prevent the cross-crediting of foreign taxes on FOGEI, FORI, 

and shipping income by placing investment income related to these types of income in 

the passive category for foreign tax credit limitation purposes. In addition, the proposal 

would exclude passive income related to foreign oil and gas extraction from the 

computation of the FOGE I foreign tax credit limitation. The proposal would apply to 

income earned in taxable years beginning after December 31, 1993. 

54 
TRANSFE R PRICIN G INITIATIVE 

Current La w 

Section 6662 imposes a penalty in the amount of 20 percent of any underpayment 

attributable to certain section 482 allocations that constitute substantial valuation 

misstatements. For this purpose, a substantial valuation misstatement arises if (1) the 

transfer price for any property or services (or for the use of property) claimed on a 

return is 200 percent or more (or 50 percent or less) of the amount determined under 

section 482 to be the arm's length price, or (2) the net section 482 adjustment exceeds 

$10 million. In the case of a gross valuation misstatement (as defined in section 6662(h)), 

the penalty is increased to 40 percent. 

Section 482 adjustments are excluded for purposes of section 6662 if there was 

reasonable cause for the taxpayer's determination of the transfer price and the taxpayer 

acted in good faith. The requirements to satisfy this exclusion are not set forth in the 

statute. 

Reasons for Change 

In part, because no definition of the reasonable cause and good faith exclusion 

has been provided by statute, the IRS has not attempted to apply the penalty under 

section 6662(e) since the provision was enacted in 1990. By statutorily defining this 

exclusion, the IRS will have sufficient guidance to apply the penalty. 

In the absence of an effective penalty, many multinational corporations appear to 

establish their transfer prices without reference to the arm's length standard. Moreover, 

taxpayers whose transfer pricing results are under examination often feel little obligation 

to provide the examiner with detailed data demonstrating that their prices led to an 

arm's length result. A s a result, the burden of establishing whether a particular 

intercompany price was arm's length effectively falls on the examiner in man y cases. 

This determination normally includes obtaining data of comparable uncontrolled 

transactions and applying a transfer pricing methodology under the section 482 

regulations to such data. 

Proposal 

Section 6662(e) would be amended to provide that the reasonable cause and good 

faith exclusion will be satisfied if the taxpayer provides contemporaneous documentation 

demonstrating the application of one or more reasonable transfer pricing methodologies 

to the taxpayer's controlled transactions. In order for the application of transfer pricing 

methodologies to be reasonable, any procedural or other requirements imposed by 

section 482 regulations with respect to the application of such method must be observed 

55 
and documented. For example, if adjustments required under a particular method were 

not made, the taxpayer's application of such method would not be reasonable. In 

addition, methods other than those specifically prescribed in the section 482 regulations 

m a y be reasonable if the taxpayer could establish that, at the time of the controlled 

transactions, the prescribed methods would not be likely to lead to an arm's teng* 

result, and that the method actually applied was likely to lead to such a result. The 

proposal would be effective for taxable years beginning after December 31, 1993. 

This legislative proposal would be supplemented by a transfer pricing enforcement 

initiative. 

Effects of Proposal 

The proposal should improve compliance for two reasons. First, compliance 

should improve, given the substantial penalty that otherwise could be imposed, because 

taxpayers will have a strong incentive to apply and document a methodology that leads to 

an arm's length result. Second, such documentation would enhance the effectiveness of 

examinations. Instead of devoting resources to identifying transfer pricing issues, and 

then developing comparable data to support application of a methodology, examiners 

would be able to focus immediately on assessing the validity of the methodology and 

supporting data that the taxpayer employed. 

In addition, the transfer pricing enforcement initiative should yield a substantial 

improvement in tax collections from taxpayers wh o use abusive transfer prices to shift 

profits beyond the United States taxing jurisdiction. 

56 
ALLOCAT E RESEARC H AN D EXPERIMENTATIO N (R&E ) EXPENS E T O PLAC E O F 

PERFORMANC E AN D TREA T ROYALTIE S A S PASSIVE INCOM E FO R PURPOSE S 

O F FOREIG N TA X CREDI T LIMITATIO N 

Current Law 

United States taxpayers may claim a foreign tax credit for foreign income taxes 

paid. The foreign tax credit is limited to the United States tax liability on foreign source 

taxable income. T o compute this limitation, deductions for expenses must be allocated 

to gross income from domestic and foreign sources. Allocation of an expense to foreign 

source gross income reduces foreign source taxable income and thus reduces the amount 

of foreign tax credit that a taxpayer may claim. Allocation of an expense to domestic 

source income does not affect the foreign tax credit limitation. 

A Treasury regulation issued in 1977 provides generally that research and 

experimentation (R&E ) expense may be allocated to domestic and foreign source gross 

income based on either the taxpayer's relative amounts of domestic and foreign source 

gross income in the appropriate product category or the taxpayer's relative gross sales 

receipts from domestic and foreign sources in the product category. If the sales method 

is chosen, the taxpayer may first allocate 30 percent of its R& E expense to gross income 

from the location where most of its R& E activity is conducted (usually the United States, 

in the case of a United States taxpayer). 

Since 1981, the 1977 Treasury regulation has been modified eight times by 

temporary legislation. Each temporary legislative rule permitted direct allocation of a 

substantial percentage (ranging from 50 percent to 100 percent) of the expense 

associated with United States-based R& E to domestic source income, whether or not the 

expense actually related to such income. The most recent statutory rule permitted 

taxpayers to allocate 64 percent of United States-based R& E expense to domestic source 

income and 64 percent of foreign-based R& E expense to foreign source income. This 

statutory rule expired in mid-1992, but an IRS announcement permits taxpayers to 

continue to apply the 64 percent rule for an additional 18-month period. A direct 

allocation of United States-based R& E expense to domestic source income encourages 

taxpayers to conduct R& E in the United States by ensuring that this expense does not 

reduce the foreign tax credit limitation. 

Passive foreign source income is subject to a separate foreign tax credit limitation 

that prevents taxpayers from sheltering passive income (usually subject to low foreign 

taxes) from residual United States tax by "cross-crediting" excess foreign taxes paid on 

other types of foreign source income. The separate limitation for passive income applies 

to foreign source royalties, with two exceptions. First, royalties received from an 

unrelated person in the conduct of an active trade or business are excluded from the 

passive limitation category; these royalties are subject instead to the general foreign tax 

57 
credit limitation or one of several other separate limitations for specified types of 

business income. Second, certain royalties received from foreign affiliates are 

categorized on a "lookthrough" basis that often results in the royalties being treated as 

general limitation income. Since royalties tend to be subject to low rates of foreign tax, 

the treatment of royalties as general limitation income often permits taxpayers to offset 

residual United States tax on foreign source royalties with excess foreign taxes paid on 

other items of general limitation income. 

Reasons for Change 

The 1977 Treasury regulations governing the allocation of R&E expense seek to 

allocate R& E expense based on the "factual relationship" of R& E expense to gross 

income. Current R& E expense generally relates to future gross income, however, rather 

than the current gross income to which it must be allocated. Thus, application of the 

"factual relationship" principle is difficult and requires complex regulatory rules. 

Moreover, the frequent statutory modifications of the 1977 regulatory rules have added 

both complexity and uncertainty to the allocation of R& E expense. Accordingly, there is 

a need both to simplify the R& E allocation rules and to make them permanent. 

Eliminating complex, changing rules would promote compliance. A permanent rule 

permitting a direct allocation of all expense for United States-based R& E to domestic 

source income would encourage United States corporations to perform research in the 

United States. 

The treatment of substantial portions of foreign source royalty income as general 

limitation income for foreign tax credit limitation purposes (under either the "active 

royalty" exception or the "lookthrough" rule) can result in a tax preference for licensing 

of intangible property to a foreign person for use in production activities abroad. This 

occurs because royalties which are treated as general limitation income but incur low 

rates of foreign tax can absorb high foreign taxes paid on other general limitation 

income. A s a result, the royalty income can avoid residual United States tax. In 

contrast, royalties or other income received for the use of intangible property in domestic 

production activities generally cannot be similarly sheltered. 

The treatment of all foreign source royalty income as income within the separate 

limitation category for passive income would remove the preference for foreign licensing 

of intangible property. Placement of royalties in the passive category would generally 

eliminate existing opportunities for cross-crediting of high foreign taxes paid on other 

business income against low-taxed royalty income. 

Proposal 

The proposal would allocate R&E expense to the place of performance of the 

R&E . In addition, it would provide for the treatment of all foreign source royalty 

income as income in the separate foreign tax credit limitation category for passive 

58 
income. The proposal would apply to taxable years beginning after December 31, 1993. 

Effects of Proposal 

The proposal would eliminate the existing tax preference for licensing intangible 

property for use in foreign production activities. In addition, the rules governing the 

allocation of R& E would be simplified and would encourage the conduct of R& E in the 

United States. 

59 
ENHANC E EARNING S STRIPPIN G AN D OTHE R ANTI-AVOIDANC E RULE S 

Current Law 

Under current law, a thinly capitalized corporation may not claim a current 

deduction for excessive interest paid to a related party if the interest income is exempt 

from United States taxation. These "earnings stripping" rules apply, for example, if a 

foreign parent corporation capitalizes a United States subsidiary with excessive amounts 

of debt and the interest payments on the debt are wholly or partially exempt from 30 

percent withholding tax under a United States income tax treaty. 

The earnings stripping rules apply to a corporation only if it has a debt-equity 

ratio in excess of 1.5 to 1. In the case of such a corporation, an interest deduction is 

disallowed to the extent that the corporation's net interest expense exceeds 50 percent of 

its adjusted taxable income for the year. Disallowed interest expense ma y be carried 

forward indefinitely and deducted in a taxable year in which the corporation has "excess 

limitation" (i.e.. net interest expense in an amount less than 50 percent of its adjusted 

taxable income). 

Reasons for Change 

The earnings stripping rules may be easily circumvented if the rules are not 

applied to unrelated party debt guaranteed by a related party. In general, the 

application of the earnings stripping rules in such cases is necessitated by the close 

economic equivalence between the guaranteed debt and a loan from the unrelated 

lender to the related party, followed by a separate loan from the related party to the 

debtor corporation. 

Proposal 

Any loan from an unrelated lender that is guaranteed by a related party would be 

treated as related party debt for purposes of the earnings stripping rules. Except as 

provided in regulations, a guarantee would be defined to include any arrangement under 

which a person directly or indirectly assures (on an unconditional or contingent basis) the 

payment of another's obligation. For purposes of determining whether the interest paid 

on the guaranteed debt is exempt from United States tax, the fact that the unrelated 

lender is subject to net basis United States taxation (as opposed to United States 

withholding tax) on its interest income would not be taken into account. This proposal 

would apply to any interest paid or accrued in taxable years commencing after December 

31, 1993. 

Other provisions would be adopted to prevent the use of back-to-back loans and 

60 
other tax avoidance arrangements. These provisions would apply beyond the earnings 

stripping rules. 

Effects of Proposal 

The proposal would eliminate current law incentives to use guaranteed unrelated 

party debt and other arrangements to avoid the application of the earnings stripping 

rules and other provisions of the Code. 

61 
REQUIRE CURREN T TAXATION OF CERTAIN EARNINGS O F CONTROLLE D 

FOREIGN CORPORATIONS 

Current Law 

Generally, the Code does not tax income earned by a foreign corporation unti 

the earnings are repatriated to United States shareholders. The Code P'0TM

6*,. d 

exceptions to this general deferral rule, including the subpart F rules for ""J TM , 

foreign corporations (CFCs) and the passive foreign investment company (tri w 

Under the subpart F rules, a 10 percent United States shareholder of a CFC fc 

required to include in income currently its pro rata share of the "subpart t mco TM 

the CFC . A CF C generally is defined as a foreign corporation more than MJ perc 

owned by 10 percent United States shareholders. "Subpart F income SP^TMTM?" 

passive income and certain types of active income considered to be particularly mobile, 

however, it does not include most types of active business income. 

Under the PFIC rules, a United States shareholder of a PFIC is subject to 

provisions designed to eliminate the benefit of deferral of United States tax onflie 

shareholder's pro rata share of the PFIC's total undistributed earnings These^provisions 

apply regardless of the United States shareholder's percentage ownership. A PFIC is any 

foreign corporation (whether or not a CFC ) if (1) 75 percent or more of its gross income 

for the taxable year is passive income, or (2) 50 percent of its assets produce, or are held 

for the production of, passive income. For this purpose, passive income generally does 

not include active banking or insurance income. A United States shareholder of a PFIC 

m a y elect to include currently in income its pro rata share of the PFIC's total earnings. 

If this election is not made in a timely manner, the United States shareholder is subject 

to an interest charge when it receives certain distributions of PFIC earnings or disposes 

of PFIC stock. 

Reasons for Change 

Under current law, United States shareholders of CFCs may defer United States 

tax on the CFC s earnings that are not subpart F income, unless the earnings are 

repatriated or a PFIC inclusion is triggered. Man y CFC s are able to defer tax 

indefinitely by managing their passive income and assets so as to avoid the PFIC 

thresholds. The Administration believes that the unlimited deferral of tax on earnings 

not reinvested in an active business contributes to the transfer of business activities to 

non-United States jurisdictions and is difficult to justify on competitiveness or other 

policy grounds. 

62 
Proposal 

The proposal would require 10 percent United States shareholders of certain 

CFC s to include in income currently their pro rata shares of a specified portion of the 

CFC s current and accumulated earnings. The proposal would apply to a CF C (including 

a CF C that is a PFIC) holding passive assets representing 25 percent or more of the 

value of the CFC s total assets. The portion of current and accumulated earnings subject 

to inclusion ("includible earnings") would be the lesser of (1) total current and 

accumulated earnings and profits, or (2) the amount by which the value of the CFC s 

passive assets exceeds 25 percent of the value of its total assets. Includible earnings 

would be adjusted to account for amounts previously taxed. For this purpose, passive 

assets would be defined as under the PFIC rules (including the definition of passive 

income thereunder). 

The proposal generally would be effective for taxable years beginning after 

December 31, 1993. Under a phase-in rule, the amount subject to current inclusion 

would be limited to the 10 percent United States shareholder's pro rata share of the 

applicable percentage of includible earnings (20 percent in 1994, 25 percent in 1995, 35 

percent in 1996, 50 percent in 1997, and 100 percent in 1998 and thereafter). 

Effects of Proposal 

The proposal would eliminate deferral of United States tax on a portion of CFC 

earnings invested in passive assets, and thus would encourage the repatriation of active 

earnings that are not reinvested in an active business. 

63 
ENERG Y PROVISION S 

PROVID E A MODIFIE D BT U TA X 

Current Law 

The United States currently does not impose a broad-based energy tax. The 

United States does impose an excise tax on motor fuels (gasoline, special motor fuels, 

and diesel fuel) used for highway transportation; special motor fuels used in motorboats; 

and diesel fuel used in trains. The United States also imposes an excise tax on coal from 

domestic mines and an excise tax on crude oil received at domestic refineries and 

petroleum products entered into the United States. With the exception of the motor fuels 

tax, all energy taxes are minor. For the most part, these are dedicated revenues that are 

deposited in various trust funds. The motor fuels tax also has a deficit reduction portion 

that is not dedicated, but is retained in the General Fund. 

Reasons for Change 

A broad-based energy tax would help reduce the deficit and put the government 

on a pay-as-you-go basis for needed public programs. In addition, the tax would advance 

three goals: reduction of environmental damages, energy conservation, and reduced 

dependence on foreign sources of energy. The tax would encourage energy efficiency 

and fuel mix choices better reflecting the true environmental and security costs of energy 

use. Moreover, an energy tax would help move the United States economy from incomebased to consumption-based taxation, with attendant benefits to saving, investment, and 

returns to work effort. 

Proposal 

The proposal would impose an excise tax on fossil fuels (coal, oil, natural gas) at 

a basic rate of $0.257-per-million-Btus plus a $0.342-per-million-Btus supplemental tax on 

oil. The tax would also be imposed on alcohol fuels (ethanol and methanol produced, 

other than from fossil fuels, for use as a fuel). The tax would be imposed on hydro-and 

nuclear-generated electricity, and on imported electricity at a rate equal to the national 

average of tax embedded in electricity generated from fossil fuel. Additionally, the tax 

would be imposed on imported taxable products at a rate equal to the average tax 

imposed on equivalent domestic products. All tax amounts would be indexed for general 

inflation after 1997. A single national average of Btu content would be used for oil, gas, 

and alcohol fuels, while actual Btu content would be used for coal. Nonconventional 

fuels (including solar, geothermal, biomass, and wind), exported taxable products, and 

non-fuel uses of fossil and alcohol fuels (including coke and feedstocks) would be 

exempt. 

64 
T he collection point for the tax would be the refinery for oil, the pipeline for 

natural gas, the minemouth for coal, the production facility for alcohol fuels, the utility 

for hydro- and nuclear-generated electricity, and the importation point for imported 

electricity and imported taxable products. Exemptions or downstream credits would be 

provided for nonfuel use and exports. 

The tax at one-third of the rates specified above would be imposed beginning July 

1, 1994; two-thirds beginning July 1, 1995; and the full rates beginning July 1, 1996. A n 

appropriate delay in the phase-in of the supplemental tax on oil would be provided in 

the case of hom e heating oil. 

Effects of Proposal 

The proposal would raise substantial revenues for deficit reduction while 

advancing environmental, energy conservation and security objectives. In particular, the 

proposal would reduce carbon emissions and vehicle use, and reductions in consumption 

of oil would come disproportionately from imports. With the indexation feature, 

revenues from the proposal (in constant dollars) would be relatively stable. 

65 
EXTEND MOTOR FUELS EXCISE TAX 

Current Law 

The federal motor fuels excise tax generally is imposed on motor fuels (gasoline, 

special motor fuels, and diesel fuel) used for highway transportation, special motor fuels 

used in motorboats, and diesel fuels used in trains. Off-highway business uses are 

generally exempt from motor fuels taxes as are sales for export, for the exclusive use of 

State and local governments and nonprofit educational organizations, and for certain 

other uses. 

The rate of tax on motor fuels is 14.1 cents per gallon on gasoline and special 

motor fuels and 20.1 cents per gallon on diesel fuel and includes a deficit reduction rate 

of 2.5 cents per gallon. The deficit reduction rate is also imposed on diesel fuel used in 

trains. The deficit reduction rate does not apply after September 30, 1995. 

Reasons for Change 

An extension of the expiring 2.5-cents-per-gallon tax on motor fuels would raise 

substantial revenue and advance three goals: reduction of environmental damages, 

energy conservation, and reduced dependence on foreign sources of energy. 

Proposal 

The proposal would extend the 2.5-cents-per-gallon deficit reduction rate 

permanently. The proposal would retain current-law exemptions. 

66 
COMPLIANC E INITIATIVES 

SERVICE INDUSTRY NON-COMPLIANCE INITIATIVE 

Current Law 

Under current law, payors are required to file information returns with the IRS 

indicating the names and tax identification numbers of persons to who m they have mad e 

annual payments of $600 or more in the course of the payor's trade or business, as well 

as the amounts paid. Payors are also required to furnish this information to the payees. 

Treasury regulations generally provide, however, that payments to a corporation need not 

be reported. 

Reasons for Change 

Payors cannot easily determine whether a business is actually conducted in 

corporate form because payees can simply claim to be incorporated, and payors are not 

required to verify such claims. Moreover, the level of voluntary tax compliance among 

corporations that provide services appears to be lower than that of most other corporate 

businesses due to nonfilers and underreporters. Therefore, the regulatory exception for 

corporations has significantly reduced the benefits possible under an information 

reporting program. 

Proposal 

The proposal would require that annual payments by a payor of $600 or more for 

services purchased in the course of the payor's trade or business be reported to the IRS 

by a payor for all service providers, including corporations. The proposal would apply to 

payments for services made by a payor after December 31, 1993. 

Effects of Proposal 

The IRS's ability to identify nonfilers and require backup withholding would be 

substantially improved. Moreover, experience with information reporting has shown that 

when taxpayers know that the IRS has received information on payments made to them, 

they are more likely to file tax returns and to accurately report their income. 

Accordingly, the proposal should reduce the number of nonfilers and the amount of 

underreporting by service providers. Although payors would be required to furnish 

information for more service providers, payors generally must have reporting systems in 

place under current law. Indeed, some payors have suggested that it would be less 

burdensome to report all payments, rather than to except payments made to corporate 

service providers. 

67 
RAIS E STANDAR D FO R ACCURACY-RELATE D AN D 

PREPARE R PENALTIE S 

Current La w 

A taxpayer generally may avoid a substantial understatement or negligence 

penalty for an underpayment of tax attributable to a position taken on a tax return if the 

position is not frivolous and is adequately disclosed. A n income tax return preparer 

generally ma y avoid a preparer penalty for an understatement of tax due to a position on 

an income tax return if the position is not frivolous and is adequately disclosed. A 

"frivolous" position for these purposes is one that is patently improper. 

Reasons for Change 

Permitting taxpayers and preparers to avoid penalties by disclosure of return 

positions as long as they are not "patently improper" ma y not sufficiently discourage the 

reporting of unreasonable return positions. Taxpayers and preparers should try to 

comply with the tax laws in a reasonable manner. 

Proposal 

Under the proposal, the "reasonable basis" standard would replace the "not 

frivolous" standard for purposes of the accuracy-related and income tax return preparer 

penalties. "Reasonable basis" would be defined as a standard that is significantly higher 

than "not patently improper." The reasonable basis standard intended by the proposal, 

therefore, would be a relatively high standard of tax reporting. This standard would not 

be satisfied by a return position that is merely arguable or that is merely a colorable 

claim. 

As a result of the proposal, a taxpayer could avoid a substantial understatement 

penalty by adequately disclosing a return position only if the position had at least a 

reasonable basis. Similarly, a taxpayer could avoid the penalty that applies to 

disregarding rules or regulations by adequately disclosing a return position only if the 

position had at least a reasonable basis. A disclosure exception would no longer be 

necessary to avoid a penalty for negligence, because a taxpayer generally would not be 

considered to have been negligent with respect to a return position, regardless of 

whether it was disclosed, if the position had a reasonable basis. Also, as a result of the 

proposal, a preparer could avoid a penalty by adequately disclosing a return position only 

if the position had at least a reasonable basis 

The proposal would apply to tax returns due (without regard to extensions) on or 

after December 31, 1993. 

68 
MODIF Y TA X SHELTE R RULE S FO R PURPOSE S O F TH E 

SUBSTANTIA L UNDERSTATEMEN T PENALT Y 

Current Law 

Under current law, the substantial understatement penalty applies to any portion 

of an underpayment of income tax required to be shown on a return that is attributable 

to a substantial understatement of income tax. 

Generally, the amount of an "understatement" of income tax is the excess of the 

tax required to be shown on the return, over the tax shown on the return (reduced by 

any rebates of tax). A n understatement is considered "substantial" if it exceeds the 

greater of (1) 10 percent of the tax required to be shown on the return, and (2) $5,000 

($10,000 in the case of a corporation other than an S corporation or a personal holding 

company). 

In determining whether an understatement is substantial, the understatement 

generally is reduced by the portion of the understatement that is attributable to an item 

for which there was substantial authority or adequate disclosure. However, in the case of 

tax shelter items, the understatement is reduced only by the portion of the 

understatement that is attributable to an item for which there both was substantial 

authority and with respect to which the taxpayer reasonably believed that the claimed 

treatment of the item was more likely than not the proper treatment. Disclosure made 

with respect to a tax shelter item does not affect the amount of an understatement. 

A tax shelter is any partnership or other entity, any investment plan or 

arrangement, or any other plan or arrangement if the principal purpose of such 

partnership, entity, plan or arrangement is to avoid or evade federal income tax. A n 

item of income, gain, loss, deduction or credit is a "tax shelter item" if the item is directly 

or indirectly attributable to the principal purpose of a tax shelter. 

Reasons for Change 

The substantial understatement penalty may not effectively deter certain abusive 

tax shelter transactions that are structured with little anticipated profit apart from the 

expected tax benefits. Taxpayers could assert that these types of tax shelter transactions 

have "economic substance" because of the existence of nominal profit potential coupled 

with some form of economic risk. As long as they are able to make this assertion, 

taxpayers may be able to avoid the penalty by arguing that they reasonably believed the 

tax treatment of the tax shelter items was more likely than not the proper treatment. 

The Administration believes that to the extent a substantial understatement of 

income tax is determined to be attributable to tax shelter items, taxpayers should not be 

69 
able to avoid the penalty in situations where the expected tax benefits of the shelter are 

significantly greater that the anticipated pre-tax economic profit. 

Proposal 

The proposal would strengthen the requirements for reducing the amount of an 

understatement in the case of tax shelter items. Under the proposal, an understatement 

would be reduced by the portion of the understatement attributable to a tax shelter item 

only if, in addition to satisfying existing requirements, the taxpayer could demonstrate 

that the reasonably anticipated tax benefits from the shelter did not significantly exceed 

the reasonably anticipated pre-tax economic profit from the shelter (over the reasonably 

anticipated life of the shelter). 

Thus, an understatement would be reduced by the portion of the understatement 

attributable to a tax shelter item only if (1) there was substantial authority for the 

treatment of the item claimed on the return; (2) the taxpayer reasonably believed that 

the claimed treatment was more likely than not the proper treatment; and (3) the 

reasonably anticipated tax benefits from the shelter did not significantly exceed the 

reasonably anticipated pre-tax economic profit from the shelter. 

This proposal would apply to tax returns due (without regard to extensions) on or 

after December 31, 1993. 

70 
MISPFT I ANEOUS 

T he Administration's proposals incorporate certain items from H.R. 11 (the 

Revenue Act of 1992), including provisions that would require substantiation and 

disclosure relating to charitable contributions, expand the 45-day interest free period for 

certain refunds, deny the travel deduction for spouses, and increase the applicable 

withholding rate on bonuses to 28 percent. 

71 


Department of the Treasury 

Washington, D.C. 20220 

Official Business 

Penalty for Private Use, $300