a 

e si 

Volume 2 General Explanation of the 

Treasury Department Proposals 

Office of the Secretary 

Repartment of the Treasury November 1904 
PREFACE 

This volume contains general explanations of the Treasury 

Department proposals for fundamental tax reform. The general 

explanations are intended to provide additional information 

concerning the scope and operative effect of the Treasury 

Department proposals. Much of the information is detailed, 

but an attempt has been made to avoid overly technical 

description. Where possible, the general explantions include 

an analysis of the effects of the proposals on particular 

taxpayers and industries and on the economy as a whole. 

The general explanations are not intended to and do not 

describe the full range of statutory changes that would be 

necessary to implement the Treasury Department proposals. Due 

to the breadth of the proposals, conforming changes would be 

necessary throughout the Internal Revenue Code. No attempt 

has been made to identify all such chasges. In addition, 

subjecting the proposals to the scrutiny of the legislative 

process inevitably would unearth unexpected interactions that 

would, in turn, require modifications in particular proposals. 

That process is welcomed. The Treasury Department proposals 

can be implemented only through fair and orderly transition 

rules. While a general description of the proposed transition 

provisions is contained in this volume, the general explanations do not attempt to address all issues that would arise 

in the transition from current law to the tax system described 

in the Treasury Department proposals. Specifically, the 

movement toward a largely inflation-proof tax system would 

have a significant effect on existing and planned investments; 

effects that must be dealt with if the move is to be accomplished. Although the problems of transition are significant, 

they are technical in nature and capable of solution within 

the framework of the Treasury Department proposals. 

iii 
TABLE OF CONTENTS 

Volume TWO 

I. INDIVIDUAL INCOME TAXES 

Chapter 1. HARGINAL TAX RATES 

1.01 Reduce Marginal Tax Rates 

Chapter 2. FAIRNESS FOR FAMILIES 

2.01 Increase ZBA And Personal Exemptions 

2.02 Combine Tax Benefits For Elderly, Blind, 

2.03 Repeal Two-Earner Deduction 

2.04 Index Earned Income Tax Credit 

2.05 Replace Child And Dependent Care 

Credit With Deduction 

And Disabled Into Expanded Credit 

Chapter 3. FAIR AND NEUTRAL TAXATION 

Part A. Excluded Sources Of Income--Fringe Benefits 

3.01 Limit Employer-Provided Health Insurance 

3.02 Repeal Exclusion For Employer3.03 Repeal $5,000 Exclusion For Employer3.04 Repeal Exclusion FOr Employer-Provided 

3.05 Repeal Exclusion For Employer-Provided 

3.06 Repeal Exclusion For Employer-Provided 

3.07 Repeal Exclusion For Employer-Provided 

3.08 Repeal Exclusion For Employer-Provided 

3.09 Repeal Special Treatment Of Incentive 

3.10 Repeal Tax-Exemption For VEBAS, SUB 

3.11 Repeal Exclusion For Employee Awards 

Provided Group Term Life Insurance 

Provided Death Benefits 

Legal Services 

Dependent Care Services 

Commuting Services 

Educational Assistance 

Cafeteria Plans 

Stock Options 

Trusts, And Black Lung Trusts 

1 

1 

4 

5 

9 

1. 3 

15 

17 

20 

20 

23 

29 

3 t 

33 

34 

36 

37 

39 

41 

43 

45 

V 
3.12 Repeal Exclusion For Military 

3.13 Repeal Exclusion For Parsonage 

Allowances 

Allowances 

Part 8. Excluded Sources Of Income--Waqe Replacement 

Payments 

3.14 Repeal Exclusion For Unemployment And 

Disability Payments 

Part C. Excluded Sources Of Income--Others 

3.15 Limit Scholarship And Fellowship 

3.16 Repeal Exclusion For Prizes And Awards 

Exclusion 

Part D. Preferred Uses Of Income 

3.17 Repeal Deduction Of State And Local 

3.18 Impose Floor On Charitable Deductions 

3.19 Limit Charitable Deduction For 

Appreciated Property 

3.20 Revise Percentage Limitations On 

Charitable Deductions 

3.21 Repeal Charitable Deduction For 

Nonitemizers 

Taxes 

Part E. Tax Abuses--Mixed Business/Personal Use 

3.22 Limit Deduction For Entertainment And 

3.23 Limit Deduction For Travel Expenses 

Business Meal Expenses 

Paxt F. Tax Abuses--Income Shiftinq 

3.24 Adjust Tax Rate Of Unearned Income Of 

3.25 Revise Grantor And Non-Grantor Trust 

3.26 Revise Income Taxation Of Estates 

Minor Children 

Taxation 

Chapter 4, SIMPLIFECATION 

4.01 Study Return-Free System 

4.02 Repeal Alternative Minimum Tax 

4.03 Impose lo or On Employee Business 

Expense And Miscellaneous Deductions 

4.04 Repeal Political Contribution Credit 

47 

49 

51 

51 

58 

58 

60 

61 

62 

69 

72 

,7 5 

'7 8 

80 

81 

86 

91 

92 

96 

107 

110 

111 

112 

115 

117 

vi 
4.05 Repeal Presidential Campaign Check-Off 119 

4.06 Repeal Adoption Expense Deduction 120 

Chapter 5. OTHER MISCELLANEOUS REFORMS 121 

5.01 Increase Limits On Moving Expenses 122 

5.02 Restrict Income Averaging For 

Full-Time Students 125 

11, BUSINESS AND CAPITAL INCOME TAXES 

Chapter 6. CORPORATE TAX RATES 127 

6.01 Reduce Corporate Income Tax Rates 128 

6.02 Repeal Corporate Minimum Tax 130 

Chapter I. TAXATION OF BUSINESS ORGANIZATIONS 133 

7.01 Reduce Double Taxation Of Corporate 

7.02 Repeal $100/$200 Dividend Income 

7.03 Tax Large Limited Partnerships As 

Earnings Distributed To Shareholders 134 

Exclusion 145 

Corporations 146 

Chapter 8. CAPITAL CONSUMPTION ALLOWANCES 151 

8.01 Index And Adjust Depreciation Schedules 152 

8.02 Repeal Investment Tax Credit 173 

Chapter 9. ADJUSTMENTS FOR EFFECTS OF INFLATION 

9.01 lndex Capital Assets 

9.02 Index Inventories 

9.03 Index Indebtedness 

Chapter 10. INCOME MEASUREMENT 

177 

178 

189 

193 

201 

10.01 Revise Accounting Rules For 

Multiperiod Production 202 

10.02 Treat Pledges Of Installment 

Obligations As Payments 212 

10.03 Limit Use Of Cash Method Of Accounting 215 

10.04 Repeal Reserve Method For Bad 

Debt Deductions 2 1.8 

vii 
Chapter 1%. TAXATION OF ENERGY AND NATURAL RESOURCES 

11.01 Repeal Energy Tax Credits 

11.02 Repeal Percentage Depletion 

11.03 Repeal Expensing Of Intangible 

11.04 Repeal Expensing Of Hard Mineral 

11.05 Repeal Deduction For Qualified 

11.06 Revise Royalty Taxation 

11.07 Repeal Nininq And Solid Waste 

11.0% Repeal Windfall Profit Tax 

Drilling Costs 

Exploration and Development Costs 

Tertiary Injectant Expenses 

Xeclamation And Closing Cost Deduction 

Chapter 12. FINANCIAL INSTITUTIONS 

Part. A. Commercial Banks And Thrift Institutions 

12.01 Repeal Special Rules For Bank Bad Debt 

Deductions 

12.02 Deny Deduction For: Interest To Carry 

Tax-Exempt Bonds 

12.03 Repeal Tax Exemption For Credit Unions 

12.04 Repeal Reorganization Rules For 

~ 

223 

224 

229 

232 

234 

236 

238 

240 

243 

245 

245 

246 

249 

253 

Financially Troubled Thrift Institutions 255 

Psrt B. Life Insurance Companies And Products 

12.05 Impose Current Taxation On Life 

Insurance Inside Interest Build-Up 

12.06 Revise Taxation Of Policyholder 

Loans And Partial Withdrawals 

12.07 Impose Current Taxation On Deferred 

Annuity Investment Income 

12.08 Limit Life Insurance Company 

Reserve Deduction 

12.09 Repeal Special Life Insurance 

Company Deductions 

Part C. Property And Casualty Insurance Companies 

12.10 Limit Property And Casualty Insurance 

Company Reserve Deduction 

12.11 Repeal Mutual Property And Casualty 

Insurance Company Protection Against 

Loss Account 

2 57 

258 

263 

266 

268 

270 

272 

273 

280 

viii 
12.12 

12.13 

Part D. Tax Ex 

12.14 

Repeal Special Tax Exemptions, 

Rate Reductions, And Deductions Of 

Small Mutual Property And Casualty 

Insurance Companies 

Limit Mutual Property And Casualty 

Insurance Company Deduction For 

Policyholder Dividends 

mption For Insurance Companies 

Repeal Tax Exemption For Certain 

Insurance Companies 

Chapter 13. STATE AND LOCAL GOVERNMENT DEET AND INVESTMENTS 

13.01 Repeal Tax Exemption For 

Nongovernmental Bonds 

13.02 Limit Tax Arbitrage And Advance 

Refunding For Tax-Exempt Bonds 

13.03 Repeal General Stock Ownership 

Corporation Provisions 

Chapter 14. SPECIAL EXPENSING AND AMORTIZATION RULES 

14.01 Retain $5,000 Limit On Expensing 

14.02 Repeal Rapid Amortization Rules 

Depreciable Business Property 

Chapter 15. OTHER SPECIFIC SUBSIDIES 

15.01 Repeal Tax Credit For 

15.02 Repeal Special Rules For Book, 

15.03 Extend And Modify Research And 

15.04 Repeal Merchant Marine Capital 

15.05 Repeal Possessions Tax Credit 

Qualified Rehabilitation 

Magazine, And Discount Coupon Income 

Experimentation Credit 

Construction Fund Exclusion 

Chapter 16. OTHER CURTAILMENT OF TAX SHELTERS 

16.01 Limit Interest Deductions 

16.02 Extend At-Risk Limitation To 

All Activities 

282 

284 

286 

286 

288 

289 

293 

298 

299 

300 

302 

314 

315 

318 

321 

324 

321 

330 

331 

334 

ix 
Chapter 17. RETIREMENT SAVINGS 336 

17.01 Increase Individual Retirement Account 

17.02 Unify Rules For Qualified Retirement 

17.03 Simplify Deduction Rules For 

17.04 Modify Annual Limits On Qualified 

17.05 Impose Ten Percent Tax On Qualified 

(IRA) Limits 337 

Plan Distributions 339 

Qualified Retirement Plans 345 

Retirement Plan Contributions 

And Benefits 349 

Retirement Plan Assets Reverting 

TO Employer 354 

17.07 Modify Rules For Benefit Forfeitures 358 

17.06 Repeal Cash Or Deferred Arrangement 

(CODA) provisions 356 

Chapter 18. INTERNATIONAL ISSUES 3 59 

18.01 Reform Foreign Tax Credit 360 

18.02 Modify Sourcing Rules For Income 

And Deductions 364 

18.03 Replace Second Dividend Tax With 

Branch Profits Tax 369 

18.04 Impose Interest Treatment On Foreign 

Exchange Gains And Losses 371 

111, OTHER TAX ISSUES 

Chapter 19. TRANSFER TAXATION 

19.01 Unify Estate And Gift Tax Systems 

19.02 Revise Power Of Appointment Rules 

19.03 Revise Federal Gift Tax Property 

Value Determination 

19.04 Simplify Generation-Skipping 

Transfer Tax 

19.05 Expand Credit For Tax On 

Prior Transfers 

19.06 Revise Rules For Installment Payment 

Of Estate Tax 

19.07 Repeal Estate Tax Deduction For 

Interest Expense 

19.08 Revise Income In Respect Of A 

Decedent Rules 

373 

374 

384 

386 

389 

393 

395 

398 

400 

X 
19.09 Limit State Death Tax Credit 402 

19.10 Repeal Capital Gain Treatment For 

Redemptions Of Stock To Pay Death Taxes 404 

Chapter 20. PENALTIES 

20.01 Simplify Penalty Provisions 

406 

406 

xi 
CHAPTER 1 

MARGINAL TAX RATES 

REDUCE MARGINAL TAX RATES 

General Explanation 

Chapter 1.01 

Current Law 

bracket amount of individuals varies from a minimum rate of 11 percent 

to a maximum rate of 50 percent. There are different rate schedules 

for four classes of taxpayers: (1) married individuals filing jointly 

and certain surviving spouses (14 tax rates); (2) heads of households 

(14 tax rates); (3) single individuals (15 tax rates); and (4) married 

individuals filing separately (14 tax rates). Beginning next year 

(1985), the progression of the rates for each cl.ass of taxpayers will 

be adjusted annually for inflation as measured by the Consumer price 

Index. 

Reasons for Change 

has substantially eroded the tax base, forcing higher rates of tax on 

nonexcluded income. High marginal tax rates create disincentives for 

saving, investing, and working. These in turn constrict economic 

growth and productivity. 

The Treasury Department proposals would expand the base of income 

by eliminating many current deductions and exclusions unrelated to the 

proper measurement of taxable income. This expanded base permits a 

significant reduction in marginal tax rates without impairing Federal 

income tax revenues. 

Proposal 

replaced by three rates -- 15, 25, and 35 percent as shown on Table 1. 

The amount of tax imposed on taxable income in excess of the zero 

The accumulation of tax exclusions and deductions over the years 

The current 14 tax rates (15 for single taxpayers) would be 

Effective Date 

The proposal would be effective on July 1, 1986. 

Analysis 

The proposal would reduce individual tax liabilities an average of 

8.5 percent; marginal tax rates on economic income would be 20 percent 

lower than under current law. The percentage reduction in taxes is 

greater at the bottom of the income scale, due to the increase in the 

-1- 
tax threshold. Tax liabilities of families with incomes below $10,000 

would fall by an average of 32.5 percent and the reduction in taxes 

for families with incomes of $10,000 to $15,000 would be 16.6 percent. 

-2- 
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CHAPTER 2 

FAIRNESS TO FAHILIES 

Fair and simple taxation of the family unit is a vital component 

of the Treasury Department proposals. The proposals would accomplish 

these goals by redefining the tax threshold and by simplifying and 

rationalizing the provisions affected by the composition of the family 

unit. 

Families with income at or below the poverty level should not be 

subject to income tax. Thus, the level of income at which tax is 

first paid would be raised so that for most taxpayers it approximates 

the poverty level. This would be accomplished by raising the zero 

bracket amounts, relatively more in the case of heads of households, 

and doubling the personal exemption compared with its 1984 level. 

These proposed changes are designed to reflect differences in ability 

to pay taxes that result from differences in family size and 

composition. The working poor would also be protected by indexing the 

earned income credit for inflation. 

Special relief for the blind, elderly, and disabled would be 

consolidated in a single tax credit, and the existing child care 

credit would be replaced with a more appropriate deduction. In light 

of the flatter rate schedule, which increases work incentives for 

taxpayers generally, the two-earner deduction would be repealed. 

-4- 
INCREASE ZBA AND PERSONAL EXEMPTIONS 

General Explanation 

Chapter 2.01 

Current Law 

Individual income tax rates begin at 11 percent and progress to a 

top marginal rate of 50 percent. For nonitemizing taxpayers, no tax 

is imposed on taxable income up to the ”zero bracket amount” (ZBA), 

which is $2,300 for unmarried individuals and heads of households, 

$3,400 for married couples filing joint returns and certain surviving 

spouses, and $1,700 for married individuals filing separately. 

Generally, a taxpayer may elect to itemize deductions only if the 

total amount of deductions exceeds the applicable ZBA. 

In computing taxable income, each taxpayer is entitled to a personal exemption of $1,000 and to a dependency exemption of $1,000 for 

each of the taxpayer’s dependents. If the taxpayer is blind or 65 

years of age or older, an additional personal exemption of $1,000 is 

provided. On a joint return, each spouse is entitled to claim the 

applicable number of personal exemptions. 

Beginning in 1985, the ZBA and the amount deducted from income for 

each personal and dependency exemption will be adjusted for inflation. 

The percentage increase in each amount will equal the percentage 

increase in prices during the previous fiscal year, as measured by the 

consumer price index for all urban consumers. For 1985, the ZBA will 

be $2,390 for unmarried individuals and heads of households, $3,540 

for married couples filing joint returns and certain surviving 

spouses, and $1, 770 for married individuals filing separately. Each 

personal and dependency exemption will be $1,040. 

Reasons for Change 

The sum of personal and dependency exemptions plus the ZBA establishes a tax threshold below which a taxpayer‘s income is exempt from 

taxati3n. The current levels of the ZBA and the personal and 

dependency exemptions do not exempt from tax an amount necessary to 

maintziin a minimum standard of living. Moreover, as family size 

increases, the cost of maintaining a minimum living standard increases 

more rapidly than the amount of income exempt from tax. For example, 

in 1986 a family of four generally would start paying tax when its 

income exceeds $9,613, which is approximately $2,000 below the poverty 

threshold for such families. 

The additional personal exemptions provided to the blind and the 

elderly serve to exempt the cost of a minimum standard of living for 

two select classes of taxpayers. For all classes of taxpayers, 

however, there is a need to adjust the existing levels of the ZBA and 

personal and dependency exemptions. 

-5- 
Because the current tax thresholds have not kept. up with increases 

in incomes, the number of persons required to file returns has grown, 

along with the percentage of taxpayers forced to itemize deductions. 

The increase in returns and itemizers places additional recordkeeping 

burdens on taxpayers and also drains the resources of the Internal 

Revenue Service. These increased costs are frequently out of 

proportion to the amounts of tax involved. 

Proposal 

The ZBA would be increased to $2,800 for single returns, $3,800 

for joint and certain surviving spouse returns, $1,900 for returns for 

married persons filing separately, and $3,500 for head of household 

returns. The amount deductible for each personal and dependency 

exemption would be increased to $2,000. The additional exemptions for 

the blind and the elderly would be repealed, but special tax treatment 

for the elderly, blind, and disabled would be combined into a single 

tax credit. See Ch. 2.02. 

Effective Date 

The proposal would apply for taxable years beginning on or after 

January 1, 1986. 

Analysis 

and ZBA to current law for 1986. The personal exemption for taxpayers, spouses, and dependents for 1986 would be increased to $2,000, 

compared to $1,090 (after indexing for inflation expected to occur in 

1985). The zero bracket amounts for single returns, head of household 

returns, and joint returns also would increase, as shown on Table 1. 

Although the additional exemptions for the blind and the elderly 

would be repealed, low-income elderly and blind persons would be 

eligible for the expanded credit for the elderly, blind, and disabled. 

When the proposed increase in the personal exemptions is combined with 

the expanded credit, the tax-free income level for elderly and blind 

persons would increase. The expanded tax credit would ensure that the 

income of low-income elderly and blind individuals would be exempt 

from tax. 

Table 1 compares the proposed changes in the personal exemptions 

-6- 
Table 1 

Comparison of Fersonal Exemption and ZBA 

Under Current Law and Treasury Department Proposal 

1986 Levels 

: Current Law 1/: Treasury 

Personal Exemption 

For taxpayers, spouses, and 

For the blind and the 

and dependents (each) $1, 090 $2,000 

elderly (each) 1,090 - 2/ 

Zero-Bracket Amount 

Single persons 

Heads of households 

Married couples 

2,510 

2,510 

3,710 

2,800 

3,500 

3,800 

Office of the Secretary of the Treasury November 30, 1984 

- 1/ Includes indexation for expected inflation in 1985. 

- 2/ Replaced with expanded credit. 

Office of Tax Analysis 

Table 2 compares tax-free income levels for 1986 under current law 

and the proposal with poverty thresholds for households of different 

sizes and compositions. Under the Treasury Department proposal, the 

tax-free income levels would be increased for single persons and 

families of all sizes. For example, the tax-free income level for a 

one-earner married couple with no dependents would increase from 

$5,890 to $7,800. A one-earner married couple with two children would 

pay no income tax unless its income exceeded $11,800. Under current 

law, the same family would pay tax on income above $9,613, assuming 

full. use of the earned income credit. 

Table 2 also shows that the proposed increases in the ZBA and 

personal exemption would exempt families in poverty from income tax. 

Although the gap between the tax-free income level and poverty 

threshold would be narrowed for single persons without dependents, the 

tax-free income level. for such taxpayers would still be $1,000 less 

than the poverty level. If the tax-free income level for single 

persons were raised further to close the gap, however, single persons 

who decided to marry would experience a tax increase or "marriage 

penalty." Irloreover, since single persons frequently live with 

relatives or unrelated persons, comparison of the tax-free income 

levels with the poverty threshold is often misleading for many of 

-7- 
these individuals. When the tax-free income level for single persons 

is combined with the tax-free income levels of parents or other 

household members, the combined tax-free income level may exceed the 

poverty level. 

Table 2 

Comparison of the Poverty Threshold and the Tax-Free Income 

(1986 Levels) 

Level Under Current Law and the Treasury Proposal 

:Tax-free Income Levels 

: Poverty : Current : Treasury 

Status : Threshold : Law 1/ : Proposal 

Single persons without 

dependents 

one dependent 2/ 

Heads of households with 

$ 5,800 $3,600 $ 4,800 

7,900 7,979 9,303 

Married couples A/ 7,400 5,890 7,800 

Married couples with two 

Office of the Secretary of the Treasury November 30, 1984 

dependents 2/ A/ 11,600 9,613 11,800 

Office of Tax Analysis 

- 1/ Includes expected indexation for inflation in 1985. 

- 2/ Assumes full use of the earned income tax credit where 

- 3/ Assumes one earner. 

applicable. 

-8- 
COMBINE TAX BENEFITS FOR ELDERLY, BLIND 

AND DISABLED INTO EXPANDED CREDIT 

General Explanation 

Chapter 2.02 

Current Law 

Individuals aged 5 or over and certain disable persons are 

eligible for a nonrefundable credit equal to 15 percent of a defined 

"base amount." The base amount for the credit is computed by 

reference to the individual's "initial base amount." For those aged 

65 or over, the initial base amount is $5,000 for a single person (or 

for a married couple filing jointly if only one spouse is aged 65 or 

over). If both spouses are 65 or older, the initial base amount is 

$7,500 if they file a joint return and $3,750 if they file a separate 

return and live apart at all times during the year. 

The actual base amount for the credit is equal to an individual's 

initial base amount reduced by (i) the amount of nontaxable pension 

and annuity income (principally social security benefits) and most 

nontaxable disability payments, or (ii) one-half of the taxpayer's 

adjusted gross income in excess of $7,500 (for single taxpayers), 

$lO,OOO (for married couples filing joint returns), or $5,000 (for 

married individuals filing separate returns). When applied to the 

elderly, the credit provides a compensating tax benefit to those 

individuals who receive little or no social security benefits and 

hence derive little or no advantage from the exemption of such 

benefits from tax. 

Individuals under age 65 also may qualify for the credit if (i) 

they receive employer-provided disability income or other taxable 

disability income and (ii) they are (or are expected to be) totally 

disabled for at least one full year. For these individuals, the 

initial base amount is the lesser of such disability income or the 

initial base amount that would apply if they were elderly. In these 

cases, the credit provides individuals receiving taxable disability 

payments with treatment comparable to that provided for recipients of 

tax-free workmen's compensation and veterans' disability payments. 

treatment in other sections of the Code. A taxpayer is allowed an 

additional personal exemption upon attaining age 65, and an additional 

exemption if he or she is blind. Each exemption reduces taxable 

income by $1,090 for 1986. In addition, most disability income is 

untaxed, including workers' compensation, black lung payments, 

veterans' disability payments, and personal injury awards. Finally, 

social security benefits (including social security disability income) 

are excluded from income unless the taxpayer's adjusted gross income 

Elderly, blind, and disabled taxpayers also receive preferential 

-9- 
(with certain modifications) exceeds $25,000 ($32,000 in the case of a 

joint return); in no event are more than one-half of such benefits 

included in income. 

Reasons for Change 

The preferential treatment applicable to elderly, blind, and 

disabled taxpayers recognizes the special hardships and costs such 

individuals encounter. 

Certain of the tax benefits available to such taxpayers under 

current law, however, provide the greatest benefit to those least in 

need. Thus, the additional personal exemptions for the elderly and 

blind provide the greatest benefit to those of the elderly and blind 

with the highest incomes. A $1,090 exemption is worth $545 to an 

individual in the 50 percent tax bracket, but only $218 to an 

individual in the 20 percent tax bracket. There is no justification 

for this disparity. 

In contrast, the current credit for the elderly targets its 

assistance to those with the greatest need. Because of the 

dollar-for-dollat offset for social security benefits, the credit 

provides no benefit to those who receive the average level of social 

security benefits. Moreover, because the credit is phased out as 

income increases, it provides the greatest benefit to low-income 

taxpayers. The credit for taxable disability payments operates in the 

same manner, and thus similarly targets its benefits to low-income 

taxpayers, 

Finally, current law requires that an individual expect to be 

fully disabled for a period of one year in order to receive the 

credit. Limiting eligibility to the long-term disabled is of 

questionable fairness and introduces significant interpretive and 

enforcement problems. 

Proposal 

The current special tax benefits for the elderly, blind, and 

disabled would be combined in a single credit, similar to the current 

credit for the elderly and disabled. All taxable disability income 

would be made eligible for the credit, regardless of the length of 

disability. 

under current law. The initial base amount for the blind and those 

over 65 would be $6,000 (in the case of single taxpayers or taxpayers 

filing joint returns that include only one blind or elderly taxpayer), 

$9,000 (in the case of joint returns where both spouses are blind or 

over 65), $7,500 (in the case of heads of households who are either 

blind or over 65), or $4,500 (in the case of a married individual 

filing a separate return who is either blind or over 65 and has lived 

apart from his or her spouse for the entire year). 

The amount of the credit would be calculated in the same manner as 

- 10 - 
Effective Date 

The proposal would apply to taxable years beginning on or after 

January 1, 1986. Only taxable disability income would be eligible for 

the credit. The Treasury Department proposals would require taxation 

of most workers' compensation, black lung, and veterans' disability 

payments received after January 1, 1987. Thus, with respect to such 

payments, the proposal generally would be effective on or after 

January 1, 1987. 

Analysis 

Table 1 summarizes the proposed increase in the maximum amount 

eligible for the 15 percent credit. When combired with the proposed 

increase in the personal and dependent exemptions (to $2,000), the 

expansion of the credit for the elderly, blind, and disabled would 

increase the tax-exempt threshold for elderly taxpayers, despite the 

elimination of their additional exemptions. The tax-exempt level of 

income would increase from $14,508 to $14,533 for an elderly couple 

with no social security income and from $9,414 to $9,700 for a single 

elderly individual with no social security income. For those 

receiving average amounts of social security, the tax-exempt threshold 

would rise from $16,740 to $16,800 for a couple and from $10,404 to 

$10,800 for single individuals. These tax-exempt levels are far in 

excess of those for taxpayers generally ($7,800 for couples; $4,800 if 

single). 

Similarly, the tax-exempt level of income for the non-elderly 

blind receiving no tax-free income would increase substantially -- 

from $4,580 to $9,700 for blind single taxpayers, and from $7,800 to 

$14,533 for a couple if both are blind. 

The proposal would provide more consistent and more equitable 

treatment for these groups and for the disabled. It also would 

eliminate artificial distinctions between sources of disability 

income. The effect of extending the credit to all forms of disability 

income is discussed more fully in Chapter 3.14, relating to proposed 

changes in the taxation of workers' compensation, black lung benefits, 

and veterans' disability payments. 

- I1 "" 
Table 1 

Naximum Amount Eligible for 15 Percent Credit 

Current Law Proposal 

Age 65 or over 

Single $5,000 $6,000 

Joint Return 7,500 9,000 

Blind (and under age 65) 

Single 

Joint Return 

0 

0 

Under age 65 with taxable 

disability income 

Single 5,000 

Joint Return 7,500 

6,000 

9,000 

6,000 

9,000 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

November 30, 1984 

- 12 - 
REPEAL TWO-EARNER DEDUCTION 

General Explanation 

Chapter 2.03 

Current Law 

The progressive tax rate structure often results in higher 

marginal tax rates for couples whose incomes are combined as a result 

of marriage. This contributes to the so-called "marriage penalty" of 

current law, i.e., the increase in a couple's aggregate tax liability 

that may occur as a consequence of marriage. The marriage penalty is 

ameliorated in part by the joint return rate schedule, under which 

married couples are taxed at lower rates than a single person with the 

same amount of taxable income. Because of the joint return rate 

schedule, marriage can result in a reduction of tax liability for some 

couples. Whether marriage actually results in a tax penalty or 

"bonus" depends principally on the total amount of a couple's taxable 

income and the percentage of such income allocable to each spouse. 

In response to the marriage penalty, current law provides a 

special deduction for married couples in which both spouses earn 

personal service income. Thus, two-earner married couples who file 

joint returns may deduct from gross income the lesser of $3,000 or ten 

percent of the qualified earned income of the spouse with the lower 

qualified earned income for the taxable year. 

ReaEons for Change 

The current deduction for two-earner married couples is poorly 

designed to offset the increased tax liabilities that some couples 

face as a result of marriage. The deduction does not eliminate the 

marriage penalty for many couples, and for some it provides a benefit 

that exceeds any increase in tax liability caused by marriage. For 

still others, the deduction merely increases the marriage bonus. 

Moreover, because the deduction applies only to earned income, it has 

no effect when the marriage penalty arises from investment income. 

The marriage penalty under current law is attributable primarily 

to the progressive rate structure and to the joint return concept, 

under which a married couple's income is aggregated for tax purposes. 

Abandonment of the joint return system would eliminate the marriage 

penalty, but would reintroduce a host of questions concerning how a 

couple's income and deductions may be allocated between spouses. 

Moreover, taxing a married couple on the same basis as two single 

persons with equivalent combined income ignores that married couples 

frequently pool their incomes and may benefit from shared living 

expenses. An equally direct but better conceived response to the 

marriage penalty is to reduce marginal tax rates, which at current 

high levels may discourage labor force participation or reduce the 

number of hours worked by second earners (typically married women). 

- 13 - 
Proposal 

The deduction for two-earner married couples would be repealed. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

The Treasury Department proposals include flatter tax rate 

schedules and lower marginal tax rates. In general, these changes 

would reduce the significance of tax consequences in individual 

decisions and improve incentives for taxpayers to work and invest. 

Since the tax structure would retain a degree of progressivity, as 

well as joint return treatment for married couples, the Treasury 

Department proposals would not eliminate the possibility of a marriage 

penalty, nor, for that matter, of a marriage bonus. They represent, 

however, a more direct and consistent attempt to minimize the impact 

of marriage on tax liabilities than the current two-earner deduction. 

Repeal of the two-earner deduction would eliminate Schedule W and 

one line from Form 1040 and seven lines from Form 1040A. It may also 

increase the number of taxpayers eligible to file Form 1040EZ. 

- 14 - 
INDEX EARNED INCOME TAX CREDIT 

General Explanation 

Chapter 2.04 

Current Law 

An eligible individual is allowed a refundable credit against 

income tax equal to ten percent of the first $5,000 of earned income. 

The maximum credit of $500 is reduced by an amount equal to 12.5 

percent of the excess of adjusted gross income (AGI) or earned income 

(whichever is greater) over $6,000. Thus, the credit is eliminated 

when AGI or earned income reaches $10,000. Earned income eligible for 

the credit includes wages, salaries, tips, and other employee compensation, plus the amount of the taxpayer’s net earnings from selfemployment. 

An individual is eligible for the earned income credit only if the 

individual lives in the United States and (1) is married, files a 

joint return, and is entitled to a dependency exemption for a child 

living with the taxpayer, (2) is a surviving spouse, or (3) is the 

head of a household and entitled to a dependency exemption for a child 

living with the individual for more than one-half of the taxable year. 

Beginning in 1985, the earned income credit will be increased to 

11 percent of the first $5,000 of earned income. The maximum credit 

of $550 will be reduced by 12 2/9 percent of the excess of AGI or 

earned income over $6,500. Thus, the credit will be eliminated when 

AGI or earned income reaches $11,000. 

The maximum credit amount and the AGI or earned income limits are 

not indexed for inflation. 

Reasons for Change 

and income taxes and provides work incentives for many low-income 

families with dependents. However, increases in income attributable 

to inflation have reduced the number of families eligible for the 

credit and the amount of the credit for those who remain eligible for 

it. 

The earned income credit serves as an offset to social security 

The Tax Reform Act of 1984 countered this trend by increasing the 

credit percentage, maximum credit, and income limit for the credit. 

The new amounts, however, are not indexed and will remain fixed until 

changed by legislation. 

To eliminate the need for periodic legislative adjustments in the 

credit, the maximum earned income credit amount and the AGI or earned 

income limit should be indexed to the rate of inflation. 

- 15 - 
Proposal 

The maximum earned income credit and the AGI or earned income 

limit would be adjusted for inflation. The amount of the adjustment 

in a given calendar year would depend on the percentage increase in 

consumer prices for the previous fiscal year, as measured by the 

consumer price index for all urban consumers (CPI). 

Effective Date 

The proposal would apply for taxable years beginning on or after 

January 1, 1986. Adjustments in inflation for 1986 would be based on 

changes in the CPI for the 1985 fiscal year. 

Analysis 

returns) claimed earned income tax credits totalling $1.6 billion. 

Indexation of the earned income credit would ensure that inflationinduced increases in incomes would not reduce the credit for some 

low-income families and exclude other low-income families from 

eligibility. For example, assume that an eligible taxpayer earning 

$6,500 in 1984 receives a five percent increase in income in 1985 and 

that inflation also increases by five percent during the same period. 

Although the taxpayer's nominal income has increased, his or her 

"real" income (i.e., income adjusted for inflation) has stayed the 

same. Under current law, however, the taxpayer's earned income credit 

would fall from $550 to $510, because nominal income has increased. 

Under the proposal, the earned income limit and maximim credit would 

be increased by five percent for 1986. Thus, the taxpayer would be 

eligible for a credit of $578, the inflation-adjusted value of the 

maximum credit. 

In 1982, approximately 6.4 million returns (6.7 percent of total 

- 16 - 
REPLACE CHILD AND DEPENDENT CARE CREDIT WITH DEDUCTION 

General Explanation 

Chapter 2.05 

Current Law 

A nonrefundable credit is allowed to an individual who pays 

employment-related child and dependent care expenses provided the 

individual maintains a household for one or more "qualifying 

individuals." In general, a qualifying individual is (1) a dependent 

of the taxpayer who is under the aye of 15 and for whom the taxpayer 

can claim a dependency exemption, (2) a dependent of the taxpayer who 

is physically or mentally incapable of taking care of himself or 

herself, or (3) a spouse of the taxpayer if the spouse is physically 

or mentally incapable of taking care of himself or herself. 

related only if they are incurred to enable the taxpayer to work and 

are paid for household services and the care of one or more qualifying 

individuals. Expenses for household services include the performance 

of ordinary and usual maintenance in the household, provided the 

expenses are attributable in part to the care of a qualifying 

individual. Thus, amounts paid for the services of a maid or cook 

qualify for the credit if part of the services performed are provided 

for a qualifying individual. 

the credit is subject to both a dollar limit and an earned income 

limit. Employment-related expenses are limited to $2,400 for one 

qualifying individual and $4,800 for two or more qualifying 

individuals. Further, employment-related expenses generally cannot 

exceed the earned income of the taxpayer, if single, or, for married 

couples, the earned income of the spouse with the lower earnings. 

Married couples must file a joint return to claim the credit. 

Taxpayers with adjusted gross incomes of $10,000 or less are 

allowed a credit equal to 30 percent of eligible employment-related 

expenses. For taxpayers with adjusted gross incomes of $10,000 to 

$28,000, the credit is reduced by one percentage point for each $2,000 

or fraction thereof above $10,000. The credit is limited to 20 

percent of employment-related child and dependent care expenses for 

taxpayers with adjusted gross incomes above $28,000. 

Dependent care expenses are considered to be employmentThe amount of employment-related expenses that are eligible for 

Reasons for Change 

Child and dependent care expenses incurred in order to obtain or 

maintain employment affect a taxpayer's ability to pay tax in much the 

same manner as other ordinary business expenses. A family with 

- 17 - 
$30,000 of income and $2,000 of employment-related child care expenses 

does not have greater ability to pay tax than one with $28,000 of 

income and no such expenses. 

There is, of course, a personal element in dependent care expenses 

incurred for household services and the care of one or more qualifying 

individuals. No objective standards exist, however, for allocating 

child and dependent care expenses based upon the personal and business 

benefits derived. Moreover, the cost of dependent care is frequently 

substantially higher than other mixed business/personal expenses for 

which no deduction is allowed, such as the costs of commuting and most 

business clothing. Disallowance of all dependent care costs in the 

computation of taxable income thus could generate a significant work 

disincentive. 

Allowance of a deduction is the appropriate treatment of costs 

incurred in producing income. The current credit for dependent care 

expenses is targeted for the benefit of low-income taxpayers, although 

these expenses reduce the ability to pay tax at all income levels. 

Tax relief for low-income taxpayers is provided best through 

adjustments in tax rates or in the threshold level of income for 

imposition of tax. Such changes benefit all similarly situated 

taxpayers. 

to the complexity of the tax law. 

Computation of the limits on the dependent care credit also adds 

Proposal 

A deduction from gross income would be provided for qualifying 

child and dependent care expenses up to a maximum of $2,400 per year 

for taxpayers with one dependent, and $4,800 per year for taxpayers 

with two or more dependents. Qualifying expenses would continue to be 

limited by the taxpayer's earned income, if single, or, in the case of 

married couples, by the earned income of the spouse with the lower 

earnings. 

Effective Date 

The proposal would apply to taxable years beginning on or after 

January 1, 1986. 

Analysis 

The proposal recognizes that child and dependent care expenses 

constitute legitimate costs of earning income. The extent to which 

such expenses also provide a personal benefit, however, varies in each 

situation. As with certain other expenditures that provide mixed 

business and personal benefits to taxpayers, such as business meal and 

entertainment expenses, the proposal sets an objective limitation on 

the amount allowed as a deduction. This limit to some extent serves 

to deny a deduction for the portion of dependent care expenses 

constituting personal rather than business benefit. An objective 

limit also simplifies the tax law. 

- 18 - 
Under the proposal, approximately five million families (65.5 

percent of all families) would claim deductions for dependent care 

expenses totalling approximately $1 billion. Approximately 61 percent 

of these deductions would be claimed by families with incomes under 

$50,000. The deduction, however, is relatively less favorable to 

low-income families than is the current credit. The choice of the 

deduction reflects the view that progressivity should be provided 

directly through the rate structure. 

- 19 - 
CHAPTER 3 

FAIR AND NEUTRAL TAXATION 

Part A. Excluded Sources of Income--Fringe Benefits 

Current Law 

An employee is generally required to include in gross income all 

compensation received during the year from his or her employer, 

regardless of whether the compensation is paid in cash or in property 

or other in-kind benefits. Current law, however, exempts from 

taxation certain employer-provided in-kind benefits, such as the cost 

of group-term life insurance (up to $50,000), educational assistance, 

accident and health insurance, group legal services, and dependent 

care assistance. These and certain other fringe benefits are 

expressly excluded from an employee's taxable income if provided under 

qualified employer-sponsored plans. 

Reasons for Change 

Compensation paid in the form of in-kind benefits is not different 

in principle from compensation paid directly in cash. The employee 

who receives fringe benefits is not in a different pre-tax economic 

position than the employee who receives cash compensation and uses it 

to purchase the same benefits. The exclusion of certain fringe 

benefits from income under current law is thus unrelated to the proper 

measurement of income. It is intended instead to reduce the after-tax 

cost of certain goods or services and thereby to subsidize consumption 

of such items by eligible taxpayers. 

Assume, for example, that an employee in a 40 percent marginal tax 

bracket is given the choice of receiving $500 in cash compensation or 

$500 in personal legal services that qualify as a nontaxable fringe 

benefit. If the employee were required to purchase the same services 

directly, their $500 cost might well outweigh their value to the 

employee. Since the after-tax value of the $500 cash compensation is 

$300, however, the effective cost to the employee of the legal 

services, as a nontaxable benefit, is also $300. As a consequence, 

the employee may well decide to take the legal services, even though 

their value to the employee may be less than their market cost and the 

employee would not purchase them directly. 

A government subsidy for a good or service may be appropriate 

where consumer demand for the item does not reflect its social value 

or the social cost of failing to provide it. Thus, existing policies 

to ensure retirement security and essential health care b,ay justify 

certain tax or direct incentives to encourage employers and employees 

to provide for these items. Increasingly, however, tax-favored fringe 

benefit treatment has been extended to nonessential employer-provided 

benefits for which no external incentive is necessary or appropriate. 

- 20 - 
The use of the tax system to subsidize employee consumption of these 

nonessential benefits is unfair to taxpayers generally, reduces 

economic efficiency and forces higher than necessary marginal tax 

rates. 

The tax-free character of fringe benefits causes employees to 

overconsume these benefits relative to their actual desire or, in many 

cases, need for them. Such overconsumption distorts the allocation of 

resources and raises prices for the services available in nontaxable 

form. The spiraling costs of health care in recent years may be 

attributable in significant part to overconsumption of health care by 

employees for whom such care is not only tax free but, in many cases, 

available without limit. The costs of such price distortions are 

distributed throughout the economy and affect all taxpayers. They 

fall most cruelly upon those who do not receive employer-provided 

health care and other fringe benefits but must pay for such services 

out of their own pockets. 

The exclusion of fringe benefits from income is also inconsistent 

with the tax system's principles of horizontal and vertical equity. 

Taxpayers not working for employers with qualified benefit plans must 

purchase goods or services such as term life insurance or legal 

services with after-tax dollars. In contrast, taxpayers receiving the 

same goods as fringe benefits in effect purchase them with pre-tax 

dollars. As a result, two taxpayers with identical economic incomes 

may pay significantly different amounts in taxes depending on the 

proportion of income that each receives in the form of fringe 

benefits. 

The unequal distribution of fringe benefits has caused some to 

conclude that they should be made even more broadly available. This 

approach would only exacerbate the distortions and revenue costs of 

existing law, and it would remain seriously unfair to lower income 

taxpayers. Under the progressive rate structure, an exclusion from 

income yields a greater tax benefit to a high-bracket taxpayer than to 

a low-bracket taxpayer. Thus, even if all taxpayers received the same 

amounts of non-taxable fringe benefits, the exclusion of such benefits 

from income would still provide a disproportionate benefit to higher 

income taxpayers. 

A final and most serious consequence of the current exclusion of 

fringe benefits from income is the resulting erosion of the tax base. 

As the base of taxable income narrows, the rates of tax on nonexcluded 

income must increase in order to maintain the same level of revenue. 

The percentage of total compensation paid as fringe benefits has grown 

significantly in recent years, as employees and employers have 

understandably responded to the tax system's incentives. This 

shrinkage of the tax base must be reversed before meaningful 

reductions in tax rates can be achieved. 

- 21 - 

459813 0 - 84 - 2 
Proposal 

The exclusion of most statutory fringe benefits from income would 

be repealed. The current excl.usion of employer-provided health care 

would be retained subject to limits on the maximum amount of such 

insurance that could be provided tax free. These proposals are 

described in greater detail in the following sections. See also Ch. 

17 regarding the tax treatment of individual and employer retirement 

savings plans. 

- 22 - 
LIMIT EMPLOYER-PROVIDED HEALTH INSURANCE 

General Explanation 

Chapter 3.01 

Current Law 

All employer contributions to health insurance plans on behalf of 

an employee are excluded from the employee's gross income, regardless 

of the cost or extent of the coverage. The same rule generally 

applies to amounts paid by an employer to or on behalf of an employee 

under a self-insured medical plan. 

Although medical expense reimbursements under a self-insured 

plan must be provided on a nondiscriminatory basis to be excludable, 

similar benefits provided through an outside insurer are not subject 

to nondiscrimination rules. 

Reasons for Change 

employer-provided health insurance from income subsidizes the cost of 

such insurance for eligible taxpayers. Within limits, this tax-based 

incentive for employee health insurance is an appropriate part of the 

national policy to encourage essential health care services. In its 

present unlimited form, however, the exclusion provides 

disproportionate benefits to certain taxpayers, encourages the 

overconsumption of health care services, and contributes to higher 

than necessary marginal tax rates. 

unfair to individuals who are not covered by employer plans and who 

must therefore pay for their health care with after-tax dollars. 

Table 1 illustrates the impact of the exclusion on two employees 

each of whose compensation costs his respective employer $35,000. 

Individual A receives $2,400 of his compensation in the form of 

employer-provided health insurance; Individual B receives all of his 

compensation in cash. As a result, both employees receive the same 

level of compensation, but A'S after-tax income is $809 higher than 

B's, simply because some of his compensation is in the form of health 

insurance. B must pay for any medical expenses or privately purchased 

insurance out of his lower after-tax earnings. 

Because many employer-provided plans are so generous that the 

employees pay very little, if anything, out-of-pocket for health 

services, the employees are more likely to overuse doctor and hospital 

services and medical tests. The tax system subsidizes this overuse by 

reducing the effective cost of employer-provided insurance. As Table 

1 demonstrates, A receives $2,400 in health insurance at a cost of 

only $1,591, since his taxes fall by $809. The rapid increase in 

As with other tax-free fringe benefits, the exclusion of 

The exclusion from income of employer-provided health insurance is 

- 23 - 
the cost of health care services in recent years can be attributed at 

least in part to overconsumption of such services by employees for 

whom they are tax free and, in many cases, available without Limit. 

The unlimited exclusion for employer-provided health care has also 

contributed to the erosion of the tax base and to consequent high 

marginal tax rates. Compensation paid in this nontaxable form has 

grown significantly in recent years. Imposing reasonable limits on 

the amount of health care available tax-free is an important part of 

the effort to broaden the base of taxable income and reduce marginal 

tax rates. 

In addition, the tax benefits provided for employee health care 

should not be available on a basis that permits discrimination between 

high- and low-paid employees. Thus, nondiscrimination rules should 

apply to employer-provided health benefits regardless of whether such 

benefits are self-insured or provided through third-party coverage. 

Table 1 

Tax Benefits Arising from the Exclusion of Employer-Provided 

Health Insurance - 1/ 

Individual Individual 

A B 

Total Employer Cost $35,000 $35,000 

Non-Taxable Employer-Provided Health Insurance $ 2,400 $ _-I 

Employer Social Security Tax $ 2,147 $ 2,305 

Cash Wages $30,453 $32,695 

Employee Income Tax $ 2,996 $ 3,489 

Employee Social Security Tax $ 2,147 $ 2,305 

After-Tax Income Plus Value of 

Health Insurance $27,710 $26,901 

Cost of $2,400 of Health 

111 sur anc e $ 1,591 $ 2,400 

Average Cost Per $1 of Health 

Insurance $ 0.66 $ 1.00 

Office of the Secretary of the Treasury November 30, 1984- 

- 1/ 1985 tax rates for a family of four with no other income and with 

itemized deductions equal to 23 percent of adjusted gross income. 

- 24 - 

Office of Tax Analysis 
Proposal 

Employer contributions to a health plan would be included in the 

employee's gross income to the extent they exceed $70 per month ($840 

per year) for individual coverage of an employee, or $175 per month 

($2,100 per year) for family coverage (i.e., coverage that includes 

the spouse or a dependent of the employee). These monthly dollar 

limits would be adjusted annually to reflect changes in the Consumer 

Price Index. 

With respect to any employee, an employer's contribution to a 

health plan would be the annual cost of coverage of the employee under 

the plan reduced by the amount of the employee's contributions for 

such coverage. The annual cost of coverage with respect to an employee 

would be calculated by determining the aggregate annual cost of 

providing coverage for all employees with the same type of coverage 

(individual or family) as that of the employee, and dividing such 

amount by the number of such employees. 

The annual cost of providing coverage under an insured plan (or 

any insured part of a plan) would be based on the net premium charged 

by the insurer for such coverage. The annual cost of providing 

coverage under a noninsured plan (or any noninsured part of a plan) 

would be based on the costs incurred with respect to the plan, 

including administrative costs. In lieu of using actual administrative 

costs, an employer could treat seven percent of the plan's incurred 

liability for benefit payments as the administrative costs of the 

plan. A plan would be a noninsured plan to the extent the risk under 

the plan is not shifted from the employer to an unrelated third party. 

The cost of coverage would be determined separately for each 

separate plan of the employer. Coverage of a group of employees would 

be considered a separate plan if such coverage differs from the 

coverage of another group of employees. 

The proposal would require that the cost of coverage under the 

plan be determined in advance of the payroll period. The cost would 

be redetermined at least once every 12 months, and whenever there are 

significant changes in the plan's coverage or in the composition of 

the group of covered employees. 

reasonable estimates of the cost of coverage would be used. If an 

estimated cost were determined not to be reasonable, the employer 

would be liable for the income taxes (at the maximum rate applicable 

to individuals) and the employment taxes (both the employer's and the 

employee's share) that would have been paid if the actual cost of 

coverage had been used. Where an employer makes contributions to a 

multiemployer plan, the multiemployer plan would be treated as the 

employer for purposes of determining the cost of coverage and the 

liability for ecrors in estimates. 

If the actual cost of coverage cannot be determined in advance, 

- 25 - 
If the cost of coverage fluctuates each year depending on bhe 

experience of the employer under the plan, an average annual cost of 

coverage would be used, based on the average cost for the past three 

years (adjusted to reflect increases in health insurance costs). 

Appropriate nondiscrimination rules would be applied to 

employer-provided health benefits, regardless of whether employer 

health plans are self-insured or provided through third parties. 

EEfective Date 

The proposal would generally apply to employer contributions made 

wj th respect to payroll periods beginning on or after January I, 1987. 

However, an exception would be made for contributions made under a 

binding contract entered into before the proposal is introduced as 

legislation, until the earlier of January 1, 1989 or the date such 

contract expires or is renegotiated. 

(based on the Consumer Price Index) starting in 1989. 

The proposed dollar limits would apply in 1987, with indexing 

For 1987, the proposed cap on tax-free employee health care would 

increase the taxable income of only 30 percent of all civilian workers 

(or approximately one-half of civilian employees who receive some 

employer-provided insurance). Even for affected taxpayers, only the 

excess over the $175 family,/$70 individual monthly ceilings would be 

included in gross income. 

Most low-income employees would be unaffected by the proposed 

change because they generally receive employer-provided insurance (if 

at all) in amounts below the cap. Only about ten percent of those 

with incomes below the average for all taxpayers would have increased 

taxable income as a result of the proposal. In contrast, approximately 

40 percent of the wealthiest one-fifth of all taxpayers would have 

additional taxable income as a result of the proposal, with 60 percent 

of the additional tax liability borne by that group. A small number 

of low-income workers now receive an extremely large proportion of 

their compensation in the form of health insurance; the impact on 

those workers, however, would be mitigated by the proposed increases 

in the personal exemptions and zero bracket amounts. 

Table 2 shows how the proposal would affect a taxpayer whose 

compensation costs his employer $35,000, including $2,400 of employer 

contributions for health insurance (Taxpayer A in Table l), assuming 

no other changes in current law. This employee would only pay tax on 

the $25 per month by which the employer's contributions exceed the 

ceiling. Thus, even with the proposed cap, this employee would still 

pay far less tax than an employee whose compensation costs his 

employer the same $35,000 but who received all his compensation in the 

form of cash. However, the subsidy would be reduced from $809 to 

- 26 - 
$707. Each dollar of the employer-provided insurance would now cost 

the employee an average of $0.71, just slightly more than the $0.66 

under current law. 

More importantly, however, each additional dollar of insurance 

above the $2,100 ceiling would cost a full dollar. At the margin, the 

employee with employer contributions above the ceiling would pay the 

full cost of the insurance and would therefore be more cost-conscious. 

As a result, the proposal would help contain escalating medical costs 

by spurring interest in health maintenance organizations, private cost 

review programs, copayments and other market-oriented cost containment 

approaches. Moreover, these strong incentives €or cost control would 

be obtained without undermining the incentives for employer-provided 

insurance that guarantees essential health care and protects agajnst 

the risk of serious injury or illness. 

Table 2 illustrates the impact of implementing the health cap with 

no other changes in current law. Other provisions of the Treasury 

Department proposals would lower individual tax rates and thereby 

reduce the effective subsidy for employer-provided health insurance. 

Under these other proposals, the taxpayer discussed above would be in 

the 15 percent income tax bracket, and the average cost of $2,400 of 

employer-provided health insurance would rise to $0.71 per dollar 

without the health cap and $0.74 with the cap. 

- 27 - 
Table 2 

Impact of a Cap on Excludable Employer Contributions 

for Health Insurance I-/ 

Taxpayer with $2,400 of EmployerProvided Health Insurance 

Current Law Proposed Law 

Total Employer Cost $35,000 $35,000 

Non-Taxable Employer-Provided 

Health Insurance $ 2,400 $ 2,100 

Employer Social Security Tax $ 2,147 $ 2,167 

Cash Wages Plus Taxable Health 

Insurance $30,453 $30,733 

Employee Income Tax $ 2,996 $ 3,058 

Employee Social Security Tax $ 2,147 $ 2,167 

After-Tax Income Plus Value of 

Cost of $2,400 of Health 

Average Cost per $1 of Health 

Cost of each $1 of Health 

Health Insurance $27,710 

Insurance $ 1,591 

Insurance $ 0.66 

Insurance above $2,100 $ 0.64 

$2'7,610 

$ 1,692 

$ 0.71 

$ 1.00 

Office of the Secretary of the Treasury November 36, 1984 

- 1/ Assumes no other change in current law. 

Office of Tax Analysis 

- 28 - 
REPEAL EXCLUSION FOR EMPLOYER-PROVIDED 

GROUP TERM LIFE INSURANCE 

General Explanation 

chapter 3.02 

Current Law 

The cost of employer-provided group-term life insurance is 

excluded from an employee's income to the extent it is not in excess 

of the sum of (1) the cost of $50,000 of such insurance, and (2) the 

amount paid by the employee for such insurance. For purposes of the 

exclusion, the cost of group-term life insurance is determined on the 

basis of uniform premiums established in Treasury regulations. The 

cost of certain kinds of group-term life insurance is excluded without 

limit, including, for example, insurance on a former employee who is 

disabled and insurance under which the employer is directly or 

indirectly the beneficiary. The exclusion is not available to 

self-employed individuals. 

Reasons for Change 

significant inequities among taxpayers. Taxpayers receiving 

group-term life insurance through an employer-sponsored plan 

effectively purchase such insurance with pre-tax dollars, whereas 

taxpayers not covered by an employer plan must use after-tax dollars 

to acquire the same insurance. Thus, two taxpayers with identical 

real incomes may pay different amounts in income taxes. Moreover, 

even among taxpayers covered by employer plans, the exclusion of 

group-term life insurance favors high-bracket over low-bracket 

taxpayers. For a taxpayer in a 50 percent marginal tax bracket, the 

exclusion provides a 50 percent savings in the cost of insurance; on 

the other hand, for a 20 percent bracket taxpayer, the exclusion 

produces only a 20 percent savings. 

of term life insurance and thus encourages employees to request and 

employers to provide more insurance than the employees would be 

willing to pay for on their own. Because this subsidy for term life 

insurance is provided through the tax system, its actual cost to 

society is difficult to control or monitor. As with other fringe 

benefit exclusions, the group-term life insurance exclusion also 

narrows the tax base and thus causes higher than necessary marginal 

tax rates. 

The exclusion of group-term life insurance from income causes 

The group-term life insurance exclusion lowers the after-tax cost 

- 29 - 
Proposal 

The exclusion of group-term life insurance from income would be 

repealed. Group-term life insurance provided by an employer would be 

taxable under the same general principles that apply to other 

employer-provided fringe benefits. 

Effective Date 

The repeal generally would be effective for group-term life 

insurance provided on or after January 1, 1987. However, the 

exclusion would continue for such insurance if provided under a 

binding contract entered into prior to the date this proposal is 

introduced as legislation, unci1 the earlier of January 1, 1989 or the 

date such contract expires or is renegotiated. 

Analysis 

Almost one-half of all families receive some employer-provided 

group-term life insurance. Such insurance accounts for approximately 

40 percent of the value of all life insurance in force. Given the 

lower rates available through group-term insurance, most employers are 

expected to continue to make such insurance available. 

- 30 - 
REPEAL $5,000 EXCLUSION FOR 

EMPLOYER-PROVIDED DEATH BENEFITS 

General Explanation 

Chapter 3.03 

II_ Current Law 

Death benefits paid by an employer to the estate or beneficiaries 

of a deceased employee are excluded from the recipient's income. The 

maximum amount that may be excluded from income with respect to any 

employee is $5,000. Accordingly, an allocation of this exclusion is 

required if multiple beneficiaries receive, in the aggregate, more 

than $5,000. Except with respect to certain distributions from or 

under qualified plans, the exclusion does not apply to self-employed 

individuals. 

In addition to the statutory exclusion, some courts have permitted 

taxpayers to exclude from income payments from a decedent's employer 

in excess of $5,000. The rationale of these cases is that the 

employer's payment to the decedent's estate or beneficiary constitutes 

a gift rather than compensation. Such "gifts" are not subject to the 

$5,000 limitation. 

Reasons for Change 

The exclusion of certain death benefits from income creates an 

artificial preference for compensation to be paid in this form. The 

exclusion of such benefits from the tax base causes the tax rates on 

other compensation to increase. Moreover, the exclusion is unfair 

because it is not available to all taxpayers (such as self-employed 

individuals). 

Finally, confusion exists under present law as to whether a 

payment by an employer to a deceased employee's family constitutes a 

death benefit subject to the $5,000 limitation or a fully excludable 

gift. Treatment of such a payment as a gift is contrary to economic 

reality and leads to different tax treatment on similar facts. 

Proposal 

The proposal would repeal the $5,000 exclusion for employerfurnished death benefits. Any amount paid by or on behalf of an 

employer by reason of the death of an employee to the estate or a 

family member or other beneficiary of the decedent would be 

characterized as a taxable death benefit rather than as an excludable 

gift. 

- 31 - 
Effective Date 

The repeal would be effective for benefits paid due to deaths 

occurring on or after January 1, 1986. The exclusion would continue, 

however, for amounts paid under a binding, written employment contract 

entered into prior to the date this proposal is introduced as 

legislation, until the earlier of January 1, 1989 or the date such 

contract expires or is renegotiated. 

Analysis 

Approximately $400 million of employer-provided death benefits are 

excluded from income under current law. As with a21 exclusions, the 

tax benefit per dollar of the death benefit exclusion increases with 

the recipient's tax bracket. Thus, the exclusion provizes the 

greatest assistance to high-income taxpayers, who are also more likely 

to receive such benefits than low-income taxpayers. 

current exclusion from income of employer-provided group-term life 

insurance. Absent repeal of the death benefit exclusion, the taxation 

of employer-provided group-term life insurance would encourage 

employers to recharacterize life insurance as an excludable death 

benefit . 

Moreover, the Treasury Department proposals would repeal the 

Finally, a specific provision that payments from an employer to a 

deceased employee's estate or family do not constitute gifts would 

simplify current law and also reduce the unfairness created by current 

law where similar facts may lead to different tax results. 

- 32 - 
REPEAL EXCLUSION FOR EMPLOYER-PROVIDED LEGAL SERVICES 

General Explanation 

Chapter 3.04 

Current Law 

Gross income of an employee does not include personal legal 

services provided by an employer under a qualified group legal 

services plan nor does it include amounts contributed by an employer 

on behalf of an employee under such a plan. A qualified group legal 

services plan must satisfy certain statutory rules, including 

provisions regarding nondiscrimination in eligibility, contributions, 

and benefits. 

The group legal services exclusion is currently scheduled to 

expire for taxable years ending after December 31, 1985. 

Reasons for Change 

The exclusion from income of employer-provided group legal 

services encourages overconsumption of legal services by permiting 

employees to purchase them with pre-tax dollars. The exclusion is 

also unfair because it is not available to all taxpayers and, where 

available, is of greater benefit to high-income taxpayers. Finally, 

by encouraging employees to take more of their compensation in this 

untaxed form, the exclusion narrows the tax base and thus places 

upward pressure on marginal tax rates. 

Proposal 

The group legal exclusion would be allowed to expire. 

Effective Date 

Taxpayers have had notice that the group legal services exclusion 

would expire. It would be allowed to expire by its own terms. 

Analysis 

a market for such services to develop without tax-induced distortions. 

Expiration of the exclusion for group legal services will allow 

- 33 - 
REPEAL EXCLUSION FOR EMPLOYER-PROVIDED 

DEPENDENT-CBRE SEVICES 

General Explanation 

Chapter 3.05 

Current Law 

Dependent care assistance paid for or provided by an employer is 

excluded from the income of an employee if the assistance is provided 

under a plan meeting certain nondiscrimination and other requirements. 

Dependent cate assistance is defined to mean the payment for, or 

provision of, household services for, or care of, an eligible 

dependent where such assistar.ce enables the employee to be gainfully 

employed. Eligible dependents include (1) a dependent of the employee 

under the age of 15 with respect to whom the employee is entitled to a 

personal exemption, and (2) a dependent or spouse of the employee who 

is physically or mentally incapable of caring for himself. If the 

employee is not married, the amount excluded may not exceed the 

employee's earned income. If the employee is married, the amount 

excluded may not exceed the lesser of the earned income of the 

employee or of his spouse. 

household are eligible for a tax credit. The credit equals the 

applicable percentage of amounts paid (up to the limits described 

below) for dependent care assistance. The applicable percentage is 30 

percent reduced by one percentage point (but not below 20 percent) for 

each $2,000 by which the taxpayer's adjusted gross income exceeds 

$10,000. The amount subject to the credit in any year may not exceed 

$2,400 for one eligible dependent, or $4,800 for two or more eligible 

dependents. The amounts subject to the credit also may not exceed the 

employee's earned income or, in the case of a married couple, the 

lesser of the earned income of the employee or of the employee's 

spouse. 

and excluded from income is not eligible for the dependent care 

credit. 

Dependent care expenses incurred by an individual maintaining a 

Dependent care assistance that is paid or provided by an employer 

Dependent care expenses that enable a taxpayer to be gainfully 

employed constitute, at least in part, a business expense properly 

deductible from income. Although current law gives some recognition 

to the business component of dependent care expenses, the treatment of 

such expenses depends on whether they are financed by an employer or 

by the individual taxpayer. Dependent care services provided by an 

employer are excluded from income. Taxpayers who pay for such 

services themselves are eligible for a tax credit, which may be worth 

more or less to the taxpayer than a comparable exclusion. 

- 34 - 
There is no basis for the different tax treatment of employerprovided and individual-financed dependent care. In order to 

rationalize tax treatment of dependent care expenses, a deduction for 

certain dependent care expenditures should be available to all 

taxpayers. A proposal to that effect is presented in Chapter 2.05. 

Allowance of a deduction for dependent care expenses makes an 

exclusion of employer-provided dependent care inappropriate and 

unnecessary. 

under the current credit (or the proposed dependent care deduction). 

Without repeal, expenses far above the caps (for very expensive child 

care) could be unfairly excluded in some cases. 

Proposal 

repealed. 

Effective Date 

Finally, the exclusion makes it difficult to enforce the caps 

The exclusion for employer-provided dependent care would be 

The repeal would be effective for taxable years beginning on or 

after January 1, 1986. There would be an exception, however, for 

assistance provided tinder a binding contract entered into prior to the 

date this proposal is introduced as legislation, until the earlier of 

January 1, 1989 or the date such contract expires or is renegotiated. 

anal ys i 6 

Approximately 400 private employers, about three-quarters of 

which are hospitals, provide on-site dependent care centers. A few 

others provide care through vouchers, and a 1984 survey found 60 major 

employers offering dependent care as part of a cafeteria plan. In 

addition, the military provides subsidized care to at least 47,000 

children. 

Further growth in employer-provided dependent care assistance is 

expected, under current law, through cafeteria plans. Except in 

certain special cases (such as hospitals), these programs provide 

benefits to only a small fraction of employees, and therefore do not 

receive broad-based employee support outside of cafeteria plans. The 

Treasury Department proposals would repeal the exclusion of cafeteria 

plans. See Chapter 3.08. 

Repeal of the dependent care exclusion should not adversely 

affect the income tax liabilities of most employees receiving such 

assistance since an offsetting deduction for dependent care 

expenditures would be available. See Chapter 2.05. Employers would 

still have an incentive to provide on-site dependent care services, or 

to contract for their provision, where they promote employee 

convenience or result in cost savings. 

- 35 - 
REPEAL EXCLUSION FOR EMPLOYER-PROVIDED 

COMMUTING SERVICES 

General Explanation 

Chapter 3.06 

Current Law 

The value of employer-provided commuting transportation is 

excluded from the income of employees if the transportation services 

are prcvided under a nondiscriminatory plan using vehicles that meet 

size and usage requirements. The exclusion is not available to 

self-employed individuals and is scheduled to expire for taxable years 

beginning after December 31, 1985. 

Reason6 for Change 

As with most other fringe benefit exclusion?, the exclusion of 

qualified transportation services from employee income is economically 

inefficient, inconsistent with horizontal equity principles, and a 

contributing fsctor in the high marginal rates of tax on taxable 

income. The qualified transportation exclusion is an inefficient 

mechanism to promote energy conservation since it targets only one 

form of group transportation, employer-provided van pools. This may 

cause taxpayers to reject possibly more effective but non-subsidized 

transportation alternatives. The exclusion ia unfair because it is 

not available to all individuals and because, where available, it 

provides a greater benefit to high-bracket taxpayers. 

Pr oposal 

The exclusion from gross income of the value of employer-provided 

commuting transportation would be allowed to expire. 

Effective Date 

Taxpayers have had notice of the scheduled expiration of the 

van-pooling exclusion for taxable years beginning after December 31, 

1985. It would be allowed to expire according to its terms. 

Analysis 

Expiration of the van-pooling exclusion will eliminate this 

unnecessary distort ion. 

- 36 - 
REPEAL EXCLUSION FOR EMPLOYER-PROVIDED 

EDUCATIONAL ASSISTANCE - 

General Explanation 

Chapter 3.07 

Current Law 

Up to $S,OOO of employer-provided educati,onal assistance is 

excluded from an employee's inccine if provided under a 

nondiscriminatory plan. Employers may either provide educational 

assistance directly or reimburse the employee for expenses. The 

education may not involve sports, games, or hobbies, and the 

assistance may not include payment for meals, lodging, transportation, 

or certain supplies. 

The exchsion is currently scheduled to expire for taxable years 

beginning after December 31, 1985. 

Educational expenses geEerally qualify as deductible business 

expenses iE they are "job-related.'' Educational expenses which are 

not job-relat,ed and are not otherwise deductible are treated as 

non-deductible personal expenditures. Under current regulations, to 

be job-related, education must either': (1) maintain or improve skills 

required by the individual in his employment or other trade or 

business, or (2) meet the express requirements of the individual's 

employer, or the requirements of applicable law or regulations, 

imposed as a condition to the retention by the individual of an 

established employment relationship, status, or rate of compensation. 

An employee may not deduct education expenses that are reimbursed 

by the employer if the reimbursement is excluded from incow as 

employer-provided educational assistance. 

Reasons for Change 

Education is a national priority deserving broad public and 

private support. The exclusion from income of employer-provided 

educational assistance, however, is not an appropriate means of 

extending that su.pport. The benefits of the exclusion are not fairly 

distributed since i.t is available only to employees in qualified 

plans. Even within the group of eligib1.e employees, the exclusion is 

of greater value to high-income taxpayers. Finally, as an incentive 

provided through the Code, the educational assistance exclusion avoids 

the regular oversight and administrative controls that apply to direct 

budget expenditures. 

- 37 - 
Proposal 

The exclusion of employer-provided educational assistance would be 

allowed to expire. 

Effective Date 

Taxpayers have had notice of the exclusion's expiration for 

taxable years beginning on or after January 1, 1986. It would be 

allowed to expire pursuant to its terms. 

Analysis 

Job-related educational expenditures are already deductible as 

ordinary and necessary business expenses, whether employer-provided or 

not. In general, repeal of the exclusion for employer-provided 

educational assistance would only affect those for whom the expense 

would not be deductible as a job-related expense; other employees 

would be able to offset the income with a corresponding business 

expense deduction. 

There is no reason to believe that the education assistance 

exclusion of current law benefits primarily the groups for which it 

was intended -- minorities and the unskilled. The tax benefit is 

greatest for high-bracket taxpayers, and participation in adult 

education by those groups is relatively low. 

- 38 - 
REPEAL EXCLUSION FOR EMPLOYER-PROVIDED 

CAFETERIA PLANS 

General Explanation 

Chapter 3.08 

__ Current Law 

No amount may be iricluded in the income of a participant in a 

"cafeteria plan" solely because the participant may choose among the 

benefits available through the plan. A cafeteria plan is a plan 

established by an employer for some or all of its employees under 

which employees may choose between two or more benefits consisting of 

cash and "statut.ory nontaxable benefits. 'I The phrase statutory 

nontaxable benefits includes certain welfare benefits such as accident 

or health insurance and dependent care assistance. Cafeteria plan 

benefits may also include certain taxable benefits, including taxable 

group-term life insurance in excess of $50,000, and vacation days, if 

participants cannot cash out or use in a subsequent plan year any 

vacation days remaining unused at the end of the year. 

does not apply to "highly compensated participants" if the plan 

discriminates in favor of "highly compensated individuals" as to 

eligibility or in favor of highly compensated participants as to 

contributions and benefits. In addition, the exception is not 

available to a "key employee" if the statutory nontaxable benefits 

(without regard to taxable grcup-,term life insurance) provided to key 

employees exceed 25 percent of the aggregate of such benefits provided 

to all employees. 

- Reason6 for Change 

principles, add complexity to the tax law, undermine the coverage 

rules generally applicable to nontaxable fringe benefits, and 

facilitate the provision of increased amounts of compensation as 

nontaxabl,e fringe benefits. In the absence of the cafeteria plan 

rules, the "constructive receipt" doctrine would require that an 

employee with the right to choose between cash compensation and some 

nontaxable benefit be treated for tax purposes as having received the 

cash even though he chooses to receive the nontaxable benefit. In 

overriding the constructive receipt doctrine, the cafeteria plan rules 

disregard the fact that an employee who is entitled to receive cash 

but instead elects an in-kind benefit is in the same pre-tax economic 

position as a taxpayer who receives cash and purchases the benefit 

directly. The cafeteria plan rules result in different tax treatment 

of these similarly situated individuals. 

banefits, the cafeteria plan rules eliminate employee disagreement 

The cafeteria plan exception to general constructive receipt rules 

The cafeteria plan rules depart from general tax accounting 

By allowing employees to pick and choose among nontaxable fringe 

- 39 - 
over the desirability of particular benefits as a limiting factor on 

the availability of such benefits. The rules thus effectively 

increase the percentage of compensation that employees receive in 

nontaxable forms. 

The cafeteria plan rules also undermine the coverage and 

nondiscrimination requirements for statutory fringe benefits by 

permitting individual employees to decide whether they wish to receive 

a particular benefit. Generally, the rationale for excluding an 

employer-provided benefit from employees' income is to encourage the 

broadest extension of the particular benefit to employees on a 

nondiscriminatory basis. The cafeteria plan rules undercut this 

rationale, since they permit individual employees to elect cash over 

the benefit without affecting the tax treatment of other employees. 

In effect, the tax benefits are made available without regard to 

whether all employees receive the particular benefit on a broad, 

nondiscriminatory basis. 

Proposal 

The cafeteria plan exclusion would be repealed. 

Effective Date 

The repeal would generally be effective on and after January 1, 

1986. There would be an exception, however, for cafeteria plans in 

existence after such date under a binding contract entered into prior 

to the date this proposal is introduced as legislation, until the 

earlier of January 1, 1989 or the date such contract expires or is 

renegotiated. 

Analysis 

If current law regarding fringe benefits remains unchanged, rapid 

growth in cafeteria plans is expected, further eroding the tax base. 

It is estimated that the number of employees covered under such plans 

(less than 1,000,000 in 1983) would rise to 25,000,000 by 1989. This 

would mean a rapid increase in the consumption of employer-provided 

nontaxable fringe benefits. The Treasury Department proposals, 

however, would repeal the exclusion of most statutory fringe benefits 

from income. With fewer nontaxable fringe benefits available for 

inclusion in cafeteria plans, the significance of cafeteria plan 

selectivity would be proportionately diminished. 

- 40 - 
P 

REPEAL SPECIAL TREATMENT OF INCENTIVE STOCK OPTIONS 

General Explanation 

Chapter 3.09 

Current Law 

employee is subject to tax under statutorily prescribed rules applying 

to transfers of property in connection with the performance of 

services. Under these rules, if an employee receives an option with a 

readily ascertainable fair market value, such value (less the price 

paid for the option, if any) constitutes ordinary income to the 

employee when the employee becomes substantially vested in the option 

(i.e., the option either becomes transferable or ceases to be subject 

to a substantial risk of forfeiture). If an employee receives an 

option that does not have a readily ascertainable value, the option is 

not taxable to the employee; instead the employee is taxable on the 

stock received upon exercise of the option when the employee becomes 

substantially vested in such stock. Ordinary compensation income is 

recognized at that time equal to the difference between the option 

price and the value of the stock. 

certain "incentive stock options" granted to employees. If a stock 

option qualifies as an incentive stock option, the employee will 

realize no income upon receipt or exercise of the option. Moreover, 

gain upon sale of the stock acquired by exercise of the option will be 

taxed at capital gain rates, provided that (i) the employee does not 

transfer the stock within two years after the option is granted, and 

(ii) the employee holds the stock itself for one year. An employer 

may not claim a deduction with respect to an incentive stock option or 

stock transferred pursuant to such an option. 

To qualify as an incentive stock option, the option must be 

granted pursuant to a plan approved by the corporation's shereholders. 

The plan must provide that an employee cannot be granted, in any one 

year, options to purchase more than $100,000 of stock plus any 

available carryover amount. An incentive stock option must carry an 

option price equal to the fair market value of the stock at the time 

the option is granted. An incentive stock option cannot be 

exercisable more than ten years from the date of its grant, and cannot 

be transferable (other than at death). In addition, an incentive 

stock option cannot be exercised while there is outstanding any other 

incentive stock option granted to the employee at an earlier date 

entitling the employee to purchase stock in the employer corporation, 

its parent, its subsidiaries, or a predecessor of any such 

corporation. Finally, unless certain special requirements are met, 

incentive stock options generally cannot be granted to employees who 

own, at the time of grant, stock possessing more than ten percent of 

the total combined voting power of the employer corporation or its 

parent or subsidiaries. 

In general, a stock option granted by a corporate employer to an 

Current law provides an exception to the above general rules for 

- 41 - 
Reasons for Change 

The special rules applicable to incentive stock options permit 

corporate employers to provide tax-preferred compensation to 

management personnel and other key employees. Thus, compensation 

attributable to incentive stock options not only is eligible for 

preferential capital gain treatment, but its inclusion in income is 

deferred from receipt or exercise of the option to the time the stock 

acquired pursuant to the option is sold. Although employers receive 

no deduction with respect to incentive stock options, differences in 

the marginal tax rates of corporations and their key employees would 

ordinarily produce a net tax savings. 

corporations to attract and retain key management employees. There is 

no substantial evidence, however, that stock options in themselves are 

more attractive to key employees than cash or other forms of 

compensation of equivalent value. Instead, the incentive feature of 

stock options under current law is their highly favorable tax 

treatment. 

The purpose of the incentive stock option provisions is to enable 

Because of the tax treatment of incentive stock options, 

recipients of such options are permitted to understate their income 

for tax purposes and thus to pay less tax than others in the same 

economic position. This Federal subsidy for typically affluent 

taxpayers would never survive as a direct budget expenditure, but 

depends upon concealment in the tax law. It is unfair not only to 

employees who do not receive such tax-preferred compensation, but also 

to the noncorporate employers that cannot issue stock options. 

Proposal 

The incentive stock option provisions would be repealed. All 

employer-provided stock options would thus be taxed under the general 

rules applicable to transfers of property in connection with the 

performance of services. 

Effective Date 

The proposal would apply to options granted on or after January 1, 

1986, except options granted prior to the date the proposal is 

introduced as legislation. 

Analysis 

The impact of repeal would fall largely on the small class of key 

management employees who ordinarily participate in stock option plans. 

Since the Treasury Department proposals would eliminate the current 

preferential tax rate for long-term capital gain, see Ch. 9.01, repeal 

of the incentive stock option rules would only affect the time at 

which compensation income was reported. 

- 42 - 
REPEAL TAX EXEMPTION FOR VEBAS, SUB TRUSTS 

AND BLACK LUNG TRUSTS 

General Explanation 

Chapter 3.10 

Current Law 

In general, the year in which an employer may deduct compensation 

provided to its employees, either in the form of cash or welfare 

benefits, corresponds to the year in which the employees include (or, 

but for an exclusion, would include) the compensation in income. In 

addition, if an employer prefunds its obligations to pay future 

employee compensation, income earned on the amounts set aside for that 

purpose is taxable to the employer. 

In certain circumstances, the tax law has permitted an employer 

more favorable treatment for amounts set aside to prefund future 

compensation obligations. In such cases, the employer has been 

allowed a current deduction for contributions to a reserve for future 

compensation, and the reserve has been permitted to grow on a 

tax-exempt basis. With respect to compensation paid in cash, this 

favorable treatment generally has been available only with respect to 

profit-sharing and pension plans that comply with various 

qualification rules, such as nondiscrimination rules, minimum 

standards relating to participation, vesting, benefit accrual, and 

funding, and annual limits on contributions and benefits. With 

respect to compensation provided in the form of welfare benefits, the 

favorable tax treatment has been available for contributions to 

welfare benefit funds, such as voluntary employees' beneficiary 

associations (VEBAs), supplemental unemployment compensation benefit 

(SUB) trusts, and black lung trusts. Thus, subject to certain 

limitations, employers are able to deduct currently contributions to 

VEBAs, SUB trusts, and black lung trusts which fund future employee 

benefits such as health care and unemployment or disability 

compensation. In general, investment income earned by these 

associations and trusts is exempt from tax. Unlike qualified pension 

plans, VEBAs, SUB trusts and black lung trusts are not subject to 

mimimum standards for funding, participation and benefit accrual, or 

to annual limits on benefits. 

Beginning in 1986, new rules adopted in the Tax Reform Act of 1984 

will govern an employer's deduction for contributions to VEBAs, SUB 

trusts, and other welfare benefit funds and will limit the extent to 

which the income of such associations, trusts, and funds will be 

tax-exempt. (Black lung trusts are not affected by the new rules.) 

Under the new rules, amounts set aside to provide post-retirement life 

insurance up to $50,000 to retired employees and to make disability 

payments to disabled employees will be permitted to continue to grow 

on a tax-exempt basis. In addition, amounts set aside in one year to 

cover claims incurred during that year will be permitted to grow on a 

- 43 - 
tax-exempt basis. Finally, subject to various limits, amounts still 

may be set aside on a tax-exempt basis to provide for future 

unemployment compensation. 

Reasons for Change 

The tax benefit of tax-exempt growth for amounts set aside to fund 

deferred compensation should generally not be available outside of the 

qualified retirement plan area. Although the rules adopted in the Tax 

Reform Act of 1984 will limit the type and levels of benefits for 

which an employer may prefund on a tax-favored basis, the advantage of 

tax-exempt growth remains for certain benefits within the specified 

limits. This exemption of investment income from tax effectively 

shifts a portion of the cost of employee compensation to the general 

public. 

In addition, continuation of the exemption would be inconsistent 

with the tax treatment of reserves for welfare benefits under a policy 

with an insurance company. The Treasury Department proposals include 

taxation of the income on reserves held by casualty insurance 

companies. See Ch. 12.05. In order not to provide more favorable tax 

treatment to self-insured benefit arrangements than to insured 

arrangements, the income earned by VEBAs, SUB trusts, and black lung 

trusts should similarly be subject to tax. 

Proposal 

The tax exemption for VEBAs, SUB trusts, and black lung trusts 

would be repealed. 

Effective Date 

The repeal would apply for taxable years of the VEBAs, SUB trusts, 

and black lung trusts beginning on or after January 1, 1986. 

Analysis 

Although the proposal would subject the income of VEBAs, SUB 

trusts, and black lung trusts to tax, the existing rules governing 

employer deductions for contributions to these associations and trusts 

would not be altered. Thus, to the extent permitted under current 

law, an employer would be able to continue to deduct contributions to 

these organizations. 

- 44 - 
REPEAL EXCLUSION FOR EMPLOYEE AWARDS 

General Explanation 

Chapter 3.11 

Current Law 

Gifts are excluded from the gross income of the donee. Whether an 

employer's award to an employee constitutes taxable compensation or a 

gift excludable from gross income depends upon the facts and circumstances surrounding the award. 

If an employee award is excludable from income as a gift, the 

amount that can be deducted by the employer is limited by statute. In 

general, the cost of a gift of an item of tangible personal property 

awarded to an employee by reason of length of service, productivity or 

safety achievement may not be deducted by the employer to the extent 

that it exceeds $400. In the case of an awar6 made under a permanent, 

written plan which does not discriminate in favor of officers, shareholders OK highly compensated employees, gifts of items with a cost up 

to $1600 may be deducted, provided that the average cost of all items 

awarded under all such plans of the employer does not exceed $400. 

The fact that an award does not exceed the dollar limitations on 

deductions has no bearing on whether the award constitutes taxable 

compensation to the employee; in all cases that issue depends on the 

facts and circumstances surrounding the award. Nevertheless, many 

taxpayers take the position that if the dollar limitations are not 

exceeded, the award automatically constitutes a gift and is excludable 

from the employee's income. 

___ Reasons for Change 

A gift for tax purposes is a transfer of property or money 

attributable to detached and disinterested generosity, motivated by 

affection, respect, admiration, or charity. The on-going business 

relationship between an employer and employee is generally inconsistent with the disinterest necessary to establish a gift for tax 

purposes. Moreover, in the unusual circumstances where an employee 

award truly has no business motivation, it cannot consistently be 

deducted as an ordinary and necessary expense of the employer's 

business. 

Current law not only allows employee awards to be characterized as 

gifts but provides a tax incentive for such characterization. The 

amount of an employee award treated as a gift is excluded from the 

income of the employee, and the employer may nevertheless deduct the 

award to the extent it does not exceed certain dollar limits. Even to 

the extent an award exceeds those limits, gift characterization 

produces a net tax advantage if the employee's marginal tax rate 

exceeds that of the employer. 

- 45 - 
Current law also generates substantial administrative costs and 

complexity by requiring the characterization of employee awards to 

turn on the facts and circumstances of each particular case. The 

dedication of Internal Revenue Service and taxpayer resources to this 

issue is inappropriate, since relatively few employee awards represent 

true gifts and since the amounts involved are frequently not 

substantial. 

Proposal 

Gift treatment would generally be denied for all employee awards 

of tangible personal property. Such awards would ordinarily be 

treated as taxable compensation, but in appropriate circumstances 

would also be subject to dividend or other non-gift characterization. 

It is anticipated that a de minimis award of tangible personal 

property would be excludable by the employee under rules of current 

law concerning de minimis fringe benefits. 

Effective Date 

The proposal would be effective for awards made on or after 

January 1, 1986. 

Analysis 

Available data concerning employee awards of tangible personal 

property is incomplete. Surveys indicate that businesses made gifts 

to employees totalling approximately $400 million in 1983. It is 

unclear what portion of these gifts were in the form of tangible 

personal property; however, the majority of these gifts were less than 

$25 in value. Less than ten percent of all employees are covered by 

an employer plan for such benefits. Thus, the proposal would affect 

few employees and would promote horizontal equity. 

- 46 - 
REPEAL EXCLUSIONS FOR MILITARY ALLOHANCES 

General. Explanation 

Chapter 3.12 

Current Law 

Most military personnel and members of other uniformed services 

receive tax-free cash allowances for quarters and subsistence in 

addition to their taxable basic pay. The exclusion from income of 

military housing and subsistence allowances stems from an early 

decision of the courts and is now codified in Treasury regulations and 

Federal statutes governing military compensation. 

Compensation received by members of the armed forces while serving 

in a combat zone 01 while hospitalized for combat-related injuries is 

excluded from income. In the case of a commissioned officer, the 

amount of this exclvsion is limited to $500 per month. Current law 

also provides for complete forgiveness of income tax for servicemen 

dying while in active service in a combat zone or as a result of 

wounds, disease, or injury incurred while so serving. The forgiveness 

applies to the year of death and prior years ending on OK after the 

serviceman's first day of service in a combat zone. A similar 

forgiveness of income tax is available to military and civilian 

employpes of the United States who die as a result of wounds or injury 

incurred outside the United States in a terroristic or military action. 

Amounts received by a member of the uniformed services as a 

pension, annuity or similar allowance for combat-related injuries or a 

veteran's disability also are excluded from income. A further 

exclusion is provided for mustering-out payments to members of the 

armed services. 

- Reasons for Change 

Military personnel should be compensated fairly for their work and 

sacrifices. It is especially appropriate that the nation provide for 

those who have been injured or killed in the service of their country, 

as well as for their survivors. The provision of a portion of military 

compensation in the form of tax benefits, however, interferes with the 

budget process. Decisions concerning the form and amount of direct 

military compensation cannot be made intelligently unless the full 

revenue costs are understood. Current tax exemptions disguise these 

costs. 

The provision of a portion of compensation in the form of tax 

benefits is not a fair substitute for additional taxable compensation. 

The tax benefit of an exclusion from income or a forgiveness of tax is 

disproportionately greater for those with higher incomes and higher 

marginal tax rates. The current forms of tax relief for the military 

thus discriminate in favor of high-income over low-income members of 

the military. Tax revenue lost as a result of tax relief for the 

- 41 - 
military reduces the level of direct compensation that the nation can 

afford to pay. Thus, the cost of tax relief is borne by all members of 

the military, even though it disproportionately benefits those with 

higher incomes. Increasing basic pay and other direct compensation is 

the fairest method of compensating military personnel. 

Proposal 

Compensation received by members of the uniformed services 

generally would be subject to Federal income tax under the same 

principles applicable to civilian employees. Thus, cash allowances for 

quarters and subsistence would be includible in gross income. In-kind 

allowances also would be subject to taxation, but meals and lodging 

provided on military premises would be excluded from income if the 

convenience of the employer standard of current law is satisfied, 

The exclusion from income of combat-related compensation would be 

repealed. The exclusion from income of allowances for combat-related 

injuries and disablility compensation also would be repealed. However, 

such allowances, as with disability income of civilian workers 

generally, would be eligible for the credit for the elderly, blind and 

disabled. See Ch. 2.02. Finally, the current forgiveness of income 

tax for servicemen and other employees of the United States dying as a 

result of terroristic or military action outside the United States 

would be repealed, along with the exclusion for mustering-out pay. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1987. 

Analysis 

It is expected that, through the regular budget process, military 

pay and allowance schedules would be adjusted to reflect the taxation 

of previously tax-free allowances. Thus, on average, servicemen and 

women would not suffer a reduction in after-tax compensation. 

The proposed changes generally would make the taxation of military 

compensation equivalent to the taxation of compensation in other areas 

in the economy. Thus, regular cash and in-kind compensation of members 

of the military would be taxable under the same general principles that 

apply to civilian employees. In addition, similar treatment of injury 

and disability wage-based compensation would be provided for military 

and civilian employees. Thus, the current exclusion for military 

disability compensation would be repealed, consistent with the Treasury 

Department proposal to include civilian worker's compensation in 

income. See Chapter 3.14. 

The delayed effective date should provide ample time for 

adjustments in military compensation. 

- 48 - 
REPEAL EXCLUSION FOR PARSONAGE ALLOWANCES 

General Explanation 

Chapter 3.13 

Current Law 

Employer-provided housing is generally taxable compensation to an 

employee unless the housing is on the business premises of the 

employer, must be accepted as a condition of employment, and is 

provided for the convenience of the employer. Under current law, 

however, a minister does not include in his gross income the rental 

value of a home furnished as part of his compensation. Cash rental 

allowances, to the extent used to rent or obtain a home, also are 

excluded from a minister's income. 

Reasons for Change 

The exclusion from income of parsonage allowances departs from 

generally applicable income measurement principles, with the result 

that ministers pay less tax than other taxpayers with the same or even 

smaller economic incomes. Thus, a minister with a salary of $18,000 

and a $6,000 cash housing allowance is in the same economic position 

and has the same ability to pay tax as a taxpayer (such as a teacher) 

earning $24,000 in taxable income and spending $6,000 on housing. The 

tax liability of the minister is considerably less, however, due to 

the current exclusion from taxable income of the parsonage allowance. 

Further, as with other deviations from income measurement principles, 

the exclusion of parsonage allowances narrows the tax base and places 

upward pressure on marginal tax rates. 

There is no evidence that the financial circumstances of ministers 

justify special tax treatment. The average minister's compensation is 

low compared to other professions, but not compared to taxpayers in 

general. Moreover, the tax benefit of the exclusion provides a 

disproportionately greater benefit to relatively affluent ministers, 

due to the higher marginal tax rates applicable to their incomes. 

Proposal 

The income exclusion for parsonage allowances would be repealed. 

Ministers would include in their gross income any cash housing 

allowance. The fair market rental value of employer-provided housing 

would also be taxable unless it met the convenience of the employer 

standard of current law. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January I, 1987. 

- 49 - 
Analysis 

Repeal of the exclusion for parsonage allowances would reduce the 

after-tax income of the more than 140,000 ministers who receive 

housing or housing allowances if no compensatory adjustment in salary 

is made. Current salary levels for ministers often reflect the 

favorable treatment of parsonage allowances. It may be expected that, 

in many cases, salaries would be adjusted to take account of repeal of 

the exclusion for parsonage allowances, so that ministers' after-tax 

incomes would not be significantly affected. 

In some cases, however, particularly where the work of a minister 

is identical to that of a non-minister (such as teaching in religious 

schools), no compensating increase in salary is likely. These cases, 

however, provide the clearest examples of how current law provides 

different treatment for taxpayers with the same economic income. 

employer-provided housing, however, will require determination of 

whether the housing may be excluded from income under the current law 

convenience of the employer standard, and, if not, an estimation of 

the fair market rental value of such housing. These determinations 

involve some administrative costs and taxpayer burdens, but they are 

no different than those required in other cases where employees 

receive housing or other taxable in-kind compensation from their 

employers. 

readjustments of compensation arrangements in which ministers 

currently receive tax-free housing either in kind or through rental 

allowances. 

Taxing cash housing allowances is administratively easy. Taxing 

The delayed effective date should provide sufficient time for 

- 50 - 
Part 8. Excluded Sources cf Income--Wage Replacement Payments 

REPEAL EXCLUSON FOR UNEMPLOYMENT AND DISABILITY PAYMENTS 

General Explanation 

Chapter 3.14 

Current Law 

In general, any cash wage or salary compensation received by an 

employee is fully includible in the employee's income. Under current 

law, however, payments under a variety of programs designed to replace 

wages lost due to unemployment or disability are fully or partially 

exempt from tax. 

Unemployment Compensation. If the sum of a taxpayer's adjusted 

gross income (determined without regard to certain Social Security and 

railroad retirement benefits and the deduction for two-earner married 

couples) and his unemployment compensation is less than a "base 

amount" ($12,000 for single returns and $18,000 for joint returns), 

unemployment compensation will be totally excluded from gross income. 

If such sum exceeds the base amount, then the taxpayer's gross income 

will include the lesser of (i) one-half of such excess, or (ii) all of 

the taxpayer's unemployment compensation. 

Thus, for example, if a married couple filing a joint return 

receives $8,000 in unemployment compensation and has no other income, 

the unemployment compensation will be totally excluded from gross 

income. On the other hand, if the couple has $18,000 of other income, 

one-half of the unemployment compensation will be included in their 

gross income. As income other than unemployment compensation 

increases, a greater percentage of unemployment compensation will be 

included (up to 100 percent if their other income equals or exceeds 

$26,000). 

Disability Compensation. Workers' compensation payments as well 

as black lung benefits to disabled coal miners are fully excluded from 

income. In addition, under statutory provisions outside the tax code, 

all benefits provided under laws administered by the Veterans' 

Administration are exempt from tax. 

Net Replacement Rates. most wage replacement programs pay 

benefits equal to a flat percentage of gross earninqs, subiect to 

minimum and maximum dolla; limits; 

generally stated as a gross replacement rate, the effect of a wage 

replacement program can be determined only by analyzing its "net 

replacement rates" -- the fraction of a worker's lost after-tax wages 

that the program replaces. Exclusion of wage replacement payments 

from income causes a program's net replacement rate to exceed its 

gross replacement rate. Assume, for example, that Individual A would 

Although this percentage is 

- 51 - 
have earned $25,000 last year and would have paid taxes of $5,000, 

leaving after-tax income of $20,000. If A is disabled and receives 

one-half of his gross earnings ($12,500) in tax-free wage replacement 

payments, the 50 percent gross replacement rate results in a 62.5 

percent net replacement rate, since $12,500 is 62.5 percent of 

$20,000. 

Reasons for Change 

Fairness. The fairness of a wage replacement system must be 

examined in terms of net rather than gross wage replacement rates, 

since it is the net replacement rate that indicates what percentage of 

the individual's true loss in wage income has been restored. The 

current exclusion of wage replacement benefits from income typically 

causes net replacement rates to exceed gross replacement rates. 

Moreover, this excess increases with the tax rate of the recipient's 

family. 

and that each earns $160 per week. Due to disability or unemployment, 

both suffer a loss of all wages, and each receives a payment of $80 

per week. Although each has a gross replacement rate of 50 percent, 

their net replacement rates may differ greatly. If A has several 

dependents and no other source of income, he would have paid no income 

tax on his $160 per week; thus his net replacement rate equals his 

gross replacement rate of 50 percent. On the other hand, if B's 

spouse has substantial earnings so that the family is in the 30 

percent tax bracket, B's net replacement rate will exceed 70 percent 

because his $80 tax-free payment has replaced after-tax income of 

$112. 

As illustrated by a comparison of net replacement rates, the 

exclusion of wage replacement payments from income under current law 

provides the greatest benefit to single taxpayers with no dependents 

and to taxpayers with other sources of income. Correspondingly, 

current law provides the least benefit to taxpayers with several 

dependents and no other source of income. Moreover, the exclusion 

generally results in higher net replacement rates for those unemployed 

or disabled for short periods than for those suffering from long-term 

unemployment or disability. 

The current disparity in net replacement rates could be redressed 

by redesigning wage replacement programs to take total family income 

into account. This solution, however, would add greatly to 

administrative complexity. A more efficient approach would be to tax 

wage replacement payments, recognizing that payment schedules could 

also be adjusted to maintain average net replacement rates. This 

would ensure comparable net replacement rates for individuals 

receiving benefits under the same programs. 

incentives by reducing the net gain from returning to work. This 

effect is greatest when such payments are nontaxable, since net wage 

Assume, for example, that individuals A and B have identical jobs 

Work Incentives. Any wage replacement program will reduce work 

- 52 - 
replacement rates then increase with family income. For example, if a 

66 percent net replacement rate is desired for low-income families, it 

will be necessary to provide a 66 percent gross replacement rate for 

low-wage workers. Unless benefit payments are based on need, however, 

a 66 percent gross replacement rate may result in net replacement 

rates in excess of 100 percent for low-wage workers from high-income 

families. 

Such high replacement rates are clearly undesirable. However, as 

long as payments are nontaxable and are not based on need, any 

increase in the net replacement rates for low-income families will 

create extremely high net replacement rates for low-wage workers from 

wealthier families. With respect to unemployment compensation, taxing 

an increasing percentage of unemploymant compensation as the 

recipient's income increases above his "base amount" creates peculiar 

work disincentives. For example, if a married individual receives 

$5,000 in unemployment compensation, each additional dollar that the 

individual or his or her spouse earns between $13,000 and $23,000 will 

require inclusion in their gross income of another $0.50 of the 

unemployment compensation. In effect, each additional dollar of 

earned income within that range increases their taxable income by 

$1.50, and thereby multiplies their marginal tax rate by 1.5 for each 

dollar of earned income within that range. Such perverse results are 

inevitable if such a threshold is used. 

The conflict between minimum replacement rates and work incentives 

is greatly reduced if benefits are taxed, even if the average net 

replacement rate is maintained through higher payments. 

recognition that they are nontaxable, thereby reducing the cost of 

funding such programs. If the programs are paid for by employers 

(either through insurance or taxes), exclusion provides an indirect 

subsidy to industries with high injury or layoff rates, and indirectly 

raises tax rates on other income. Since the costs of job-related 

injuries and anticipated layoffs is a real cost of production, this 

subsidy distorts market prices and resource allocation. Although 

neutrality could also be achieved by treating wage replacement 

programs as insurance and taxing employees on the "premiums" paid by 

employers, this would be administratively difficult and would do 

nothing to reduce the problems of fairness or work disincentives 

discussed above. 

Neutrality. Wage replacement payments are presumably reduced in 

The exclusion from taxation may also hide the true cost of 

government-mandated programs from the policymakers who determine their 

scope and size. Taxing wage replacement payments would enable 

policymakers to make more informed decisions. 

- 53 - 

459813 0 - 84 - 3 
Proposal 

All unemployment compensation would be included in income. 

In addition, all cash payments for disability from workers' 

compensation, black lung, and veterans' programs would be included in 

income, except for payments for medical services (unless previously 

deducted), payments for physical and vocational rehabilitation, burial 

fees, and non-service related veterans' disability payments. 

the elderly, blind, and disabled. See Chapter 2.02. In order to 

protect low- and moderate-income disabled taxpayers, the proposal 

would make all taxable disability payments (up to $6,000 for 

individual returns and $9,000 for joint returns) eligible for a 15 

percent tax credit. The amount eligible for the credit would be 

reduced by any Title I1 social security benefits and by one-half of 

the excess of adjusted gross income over $7,500 ($10,000 for joint 

returns). 

The Treasury Department proposals include an expanded credit for 

Effective Dates 

The proposal would apply to all unemployment compensation received 

on or after January 1, 1987. 

With respect to workers' compensation payments, the proposal 

would apply to all payments received by employees or their survivors 

for disabilities occurring on or after January 1, 1987. Payments 

received for a disability occurring before such date would remain 

nontaxable. 

The proposal would apply to all black lung and veterans' 

service-related disability payments received on or after 

January 1, 1987, regardless of the date on which the disability 

occurred. 

Analysis 

In General. Taxing wage replacement payments would eliminate the 

disparities in net replacement rates under current law. It would thus 

be possible to replace 50 percent of lost wages for workers in 

low-income families without providing net replacement rates far above 

that rate for workers from families with substantial income from other 

sources. This would enable wage replacement programs to target the 

benefits to those who need them most. 

Unemployment Compensation. Most unemployment compensation is now 

excluded from gross income. In 1982, only one-third of such payments 

was taxed. Of $20.6 billion in payments, only $7 billion were included 

in gross income. Over $3.8 billion was received by taxpayers with 

adjusted gross incomes between $18,000 and $30,000, more than 30 

percent of which was excluded from gross income. 

- 54 - 
Most unemployment compensation is received by families with other 

sources of income. In addition, most unemployed individuals remain 

unemployed for less than 15 weeks, so their unemployment compensation 

supplements income from employment during the rest of the year. Under 

such circumstances, the exclusion of unemployment compensation from 

income provides an unnecessary and unfair tax advantage. For example, 

a married person earning $15,000 during the year and receiving $3,000 

in unemployment compensation now pays substantially less tax than 

someone working all year and earning $18,000. 

some work disincentives. The proposal, however, would eliminate the 

peculiar disincentives created by the threshold for taxing such 

benefits under the current system. 

Any unemployment compensation program will necessarily create 

States may wish to adjust their unemployment compensation 

programs if all such compensation is included in gross income. A State 

that pays benefits equal to 50 percent of gross wages will provide net 

replacement rates of less than 50 percent to most unemployed workers. 

The Treasury Department proposals include increased personal 

exemptions and zero bracket amounts, along with lower tax rates. As a 

consequence, most workers who are unemployed for a long time and have 

little access to other sources of income would pay little or no tax on 

their benefits. The proposed effective date would provide time, 

however, for States to adjust benefits to protect even more workers. 

Disability Payments. By combining all special treatment for the 

disabled in a single tax credit, the proposal would ensure that 

preferential treatment for the disabled is provided in a fair and 

consistent manner. Persons receiving workers' compensation, black 

lung, and service-related veterans' disability payments would be 

treated similarly to persons who are disabled and receive disability 

pay from an employer. In both cases, the tax-exempt level of income 

for a single person who is disabled for the entire year and depends 

mostly on such disability payments would be $9,700. For a family of 

four, the tax-exempt level would be $17,200. These tax-exempt levels 

are substantially in excess of the tax-exempt levels applicable to 

other taxpayers ($4,800 for single returns; $11,800 for families of 

four). In approximately 80 percent of the States, a family of four 

solely dependent on workers' compensation would pay no Federal income 

tax even if it received the maximum payment under that State's 

program. 

- 55 - 
Table 1 

Distribution of Workers' Compensation Payouts 

Percentage of 

Percentage of Cash Payments From 

Family Economic Income All Families Workers' Compensation 

$ 0 - 10,000 

10,000 - 15,000 

15,000 - 20,000 

20,000 - 30,000 

30,000 - 50,000 

50,000 - 100,000 

100,000 - 200,000 

200,000 and above 

15.0 

12.7 

11.7 

19.3 

23.3 

15.4 

2.1 

0.5 

100.0 

4.1 

1.4 

8.3 

22.2 

33.7 

22.4 

1.3 

0.4 

100.0 

Office of the Secretary of The Treasury November 30, 1984 

Office of Tax Analysis 

As illustrated in Table 1, workers' compensation benefits are 

received primarily by middle- and upper-income taxpayers. This is 

largely attributable to the fact that most of those receiving workers' 

compensation are off work for less than three weeks (with less than 

one percent permanently and totally disabled), and benefits are 

related to wage levels. Since each dollar of excluded income is worth 

more to those in higher tax brackets, the tax benefits from current 

law are concentrated among higher income families. The higher 

tax-free threshold would ensure that no families below the poverty 

line are taxed on income from any soutce. 

Despite the extensive protection the proposal provides for the 

low- and moderate-income disabled, the taxation of these forms of 

disability income generates substantial revenue which can be used to 

reduce tax rates on other income. 

The repeal of the exclusion is delayed until 1987 to allow the 

State and the Federal governments to make any desired compensatory 

changes in their benefit schedules. Moreover, in the case of workers' 

compensation, the repeal would apply only to those receiving workers' 

compensation for disabilities occurring on or after January 1, 1987. 

Since most workers' compensation payments are made by private 

insurance companies, payments for past injuries are funded from 

premiums paid in the past. As a result, there is no easy way to adjust 

such payments for the change in tax status. No such grandfathering is 

proposed for the two Federal programs (black lung and veterans' 

service-related disability) because those payments can be adjusted, if 

desired, for all beneficiaries. 

- 56 - 
The exception for non-service-related disability payments is 

justified by the nature of that program, which is most accurately 

categorized as a welfare program. Benefits are small and strictly based 

any other source. Such means-tested payments are generally excluded 

from gross income. Moreover, the criteria for such payments would 

ensure that no recipient of these veterans' benefits would pay income 

tax even if such benefits were made fully taxable. 
Part C. Excluded Sources of Income--Others 

LIMIT SCHOLARSHIP AND FELLOWSHIP EXCLUSION 

General Explanation 

Chapter 3.15 

Current Law 

Current law provides an exclusion from income for the amount of 

certain scholarships or fellowship grants. In the case of candidates 

for a degree at an educational organization with a regular faculty, 

curriculum and enrolled body of students, any scholarship or 

fellowship grant is excludable unless it represents compensation for 

services. If teaching, research, or other services are required of 

all such degree candidates, a scholarship or fellowship grant is not 

regarded as compensation for such services. 

Nondegree candidates may exclude scholarships or fellowship grants 

only if the grantor is a charitable organization, a foreign government 

or an international organization, or an agency of the United States or 

a State. The amount that may be excluded is limited to $300 per 

month, with a lifetime maximum of 36 months. This limit does not 

apply, however, to amounts received to cover expenses for travel, 

research, clerical help, or equipment, which are incident to the 

scholarship or the fellowship grant ("incidental expenses"). 

Compensation for past, present, or future services is generally 

not treated as a scholarship or as a fellowship grant. However, in 

addition to the special rule for degree candidates, there is an 

exception for certain amounts received under a Federal program. These 

amounts are treated as scholarships even though the recipient must 

agree to perform future services as a Federal employee as a condition 

of obtaining the scholarship. 

Reasons €or Change 

Scholarships and fellowship grants confer a benefit on the 

recipient that should be taxed as income. The full exclusion of these 

benefits from income under current law is unfair to the ordinary 

taxpayer who must pay for education with earnings that are subject to 

tax. 

any scholarship in income. In practice, this would create real 

hardships for many scholarship recipients. Scholarship awards are 

often made on the basis of need. If students were taxed on such 

amounts, they would often not have the resources to pay the tax. 

Moreover, unlike most cases in which in-kind benefits are subject to 

tax, the recipient of a scholarship is not receiving an in-kind 

benefit in lieu of a cash amount and does not otherwise have the 

In theory, it might be appropriate to include the full amount of 

- 58 - 
ability to convert the in-kind benefit to cash. The definition of 

income for tax purposes is appropriately limited by considerations of 

ability to pay. Accordingly, income from a scholarship for tax 

purposes should, in general, be limited to amounts that represent 

out-of-pocket savings for regular living expenses. 

An exception for incidental expenses of nondegree candidates is 

also appropriate. Such expenses would typically be deductible as 

ordinary and necessary business expenses, and thus in most cases an 

exclusion simply provides an equivalent tax result. 

P r opo sa 1 

Scholarships and fellowship grants generally would be includible 

in gross income. In the case of degree candidates, scholarships would 

be excludable to the extent that they were required to be, and in fact 

were, spent on tuition and equipment required for courses of 

instruction. In the case of nondegree candidates, reimbursements for 

incidental expenses (as defined in current law) would be excludable. 

The special rules concerning performance of future services as a 

Federal employee and compensation for services required of all degree 

candidates would be repealed. 

Effective Date 

The proposal generally would be effective with respect to 

scholarships and fellowships received on or after January 1, 1986. 

However, if a binding commitment to grant a scholarship in the case of 

a degree candidate was made before January 1, 1986, amounts received 

pursuant to such commitment would be excludable under the current-law 

rules through the end of 1990. 

Analysis 

The proposal generally would tax scholarships and fellowship 

grants in the same manner as other income. For degree candidates, 

amounts granted to cover room and board or other living expenses would 

be taxable. Students receiving scholarships that were used for 

tuition and fees would not be liable for tax by reason of the award. 

Moreover, even students receiving scholarship amounts for expenses 

other than tuition and fees would not pay tax as a result of the award 

where the student's total income is less than the sum of the zero 

bracket amount and the personal exemption ($4,800 if single, and 

$7,800 for a married couple filing jointly). 

- 59 - 
REPEAL EXCLUSION FOR PRIZES AND AWARDS 

General Explanation 

Chapter 3.16 

Current Law 

0x1 the same basis as other receipts of cash or valuable property. 

Current law provides an exception to this general rule, however, for 

prizes and awards made primarily in recognition of religious, 

charitable, scientific, educational, artistic, literary, or civic 

achievement. To quali€y for this exclusion, the recipient of the 

prize or award must be selected without any action on his or her part 

to enter the contest or proceeding, and must not be required to render 

substantial future services as a condition of receiving the prize or 

award. 

Reasons for Change 

Prizes or awards increase an individual's ability to pay tax the 

same as any other receipt that increases an individual's economic 

wealth. In effect, the failure to tax all prizes and awards creates a 

program of matching grants under which certain prizes or awards also 

bestow the government-funded benefit of tax relief. Basing this 

program in the tax code permits it to escape public and legislative 

scrutiny and causes benefits to be distributed not according to merit 

but to the amount of the tax the individual would otherwise owe. 

Proposal 

fully includible in income, regardless of whether for religious, 

charitable, scientific, educational, artistic, literary, or civic 

achievement. The rule of current law would continue to apply, 

however, to the extent that the individual recipient of a prize or 

award designated that such prize or award go to a tax-exempt 

cha r i tab1 e or gani z a t i on. 

In general, the amount of a prize or award is includible in income 

The amount of any prize or award received by a taxpayer would be 

Effective Date 

The proposal would be effective for prizes and awards received on 

or after January 1, 1986. 

Analysis 

the tax liability of only a few taxpayers, but it will reduce the 

complexity of the tax laws and preclude attempts to characterize 

income as a tax-exempt award. 

Repeal of the exclusion for certain prizes and awards will affect 

- 60 - 
Part D. Preferred Uses of Income 

The Treasury Department proposals would curtail itemized 

deductions for certain personal. exenditures, in order to broaden the 

tax base, simplify compliance and administration, and allow rates to 

be reduced. The deduction for State and local taxes would be phased 

out, and the charitable contribution deduction would be eliminated for 

nonitemizers and limited for itemizers. The deductions for medical 

expenses, casualty losses, and principal-residence mortgage interest 

would be left unchanged. Changes to the itemized deduction for 

intrest expense deduction are described in Chapter 9.03 (indexing) and 

Chapter 16.01 (limit on interest deduction). The deduction for 

miscellaneous expenses would be replaced with an adjustment to income. 

(See Chapter 4.03). 

- 61 - 
REPEAL DEDUCTION OF STATE AND LOCAL TAXES 

General Explanation 

Chapter 3.17 

Current Law 

Individuals who itemize deductions are permitted to deduct certain 

State and local taxes without regard to whether they were incurred in 

carrying on a trade or business or income-producing activity. The 

following such taxes are deductible: 

o State and local real property taxes. 

o State and local personal property taxes. (In some States, 

payments for registration and licensing of an automobile are 

wholly or partially deductible as a personal property tax.) 

o State and local income taxes. 

o State and local general sales taxes. 

Other State and local taxes are deductible by individuals only if 

they are incurred in carrying on a trade or business or 

income-producing activity. This category includes taxes on gasoline, 

cigarettes, tobacco, alcoholic beverages, admission taxes, occupancy 

taxes and other miscellaneous taxes. Taxes incurred in carrying on a 

trade or business or which are attributable to property held for the 

production of rents or royalties (but not other income-producing 

property) are deductible in determining adjusted gross income. Thus, 

these taxes are deductible by both itemizing and nonitemizing 

taxpayers. Taxes incurred in carrying on other income-producing 

activities are deductible only by individuals who itemize deductions. 

Examples of these taxes include real property taxes on vacant land 

held for investment and intangible personal property taxes on stocks 

and bonds. State and local income taxes are not treated as incurred 

in carrying on a trade or business or as attributable to property held 

for the production of rents or royalties, and therefore are deductible 

only by individuals who itemize deductions. 

Reasons for Change 

The current deduction for State and local taxes in effect provides 

a Federal subsidy for the public services provided by State and local 

governments, such as public education, road construction and repair, 

and sanitary services. When taxpayers acquire similar services by 

private purchase (for example, when taxpayers pay for water or sewer 

services), no deduction is allowed for the expenditure. Allowing a 

deduction for State and local taxes simply permits taxpayers to 

finance personal consumption expenditures with pre-tax dollars. 

- 62 - 
Many of the benefits provided by State and local governments, such 

as police and fire protection, judicial and administrative services, 

and public welfare or relief, are not directly analagous to privately 

purchased goods or services. They nevertheless provide substantial 

personal benefits to State and local taxpayers, whether directly or by 

enhancing the general quality of life in State and local communities. 

Arguably, some individuals receive greater benefit from these services 

than others, but they are generally available on the same basis to 

all. Moreover, they are analagous to the services provided by the 

Federal government, and yet no deduction is allowed for the payment of 

Federal income taxes. 

It is argued by some that State and local taxes should be 

deductible because they are not voluntarily paid. The argument is 

deficient in a number of respects. First, State and local taxes are 

voluntary in the sense that State and local taxpayers control their 

rates of taxation through the electoral process. Recent State and 

local tax reduction initiatives underline the importance of this 

process. Just as importantly, taxpayers are free to locate in the 

jurisdiction which provides the most amenable combination of public 

services and tax rates. Taxpayers have increasingly "voted with their 

feet" in recent years by moving to new localities to avoid high rates 

of taxation. Indeed, taxpayers have far greater control over the 

amount of State and local taxes they pay than over the level of 

Federal income taxes. Nevertheless, Federal income taxes are 

nondeductible. 

The subsidy provided through the current deduction for State and 

local taxes is distributed in an uneven and unfair manner. Taxpayers 

in high-tax States receive disproportionate benefits, while those in 

low-tax States effectively subsidize the public service benefits 

received by taxpayers in neighboring States. Even within a single 

State or locality, the deduction of State and local taxes provides 

unequal benefits. Most State and local taxes are deductible only by 

taxpayers who itemize, and among itemizers, those with high incomes 

and high marginal tax rates receive a disproportionate benefit. 

most serious omissions from the Federal income tax base. Repeal of 

the deduction is projected to generate $33.8 billion in revenues for 

1988. IJnless those revenues are recovered, the rates of tax on 

nonexcluded income will remain at their current unnecessarily high 

levels. 

Finally, the deduction for State and local taxes is one of the 

Proposal 

The itemized deduction for State and local income taxes and other 

taxes that are not incurred in carrying on a trade or business or 

income-producing activity would be phased out over a two-year period. 

For taxable years beginning on or after January 1, 1986, only 50 

percent of such taxes would be deductible. For taxable years 

beginning on or after January 1, 1987, no portion of such taxes would 

be deductible. State and local taxes (other than income taxes) which 

- 63 - 
currently are deductible only by itemizers, but which are incurred in 

carrying on an income-producing activity, would be aggregated with 

employee business expenses and other miscellaneous deductions and 

would be deductible subject to a threshold. See Ch. 4.03. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986, subject to the transitional rules described 

above. 

Analysis 

State and local taxes are the cost paid by citizens for public 

services provided by State and local governments, such as public 

schools, roads, and police and fire protection. For the one-third of 

all families that itemize deductions, these public services are 

purchased with pre-tax dollars. 

for State and local taxes. While one-third of all families itemized 

deductions in 1983, most high-income families itemized (95 percent of 

families with incomes over $100,000) while there were relatively few 

itemizers among lower-income families. Two-thirds of the total 

deductions for State and local tax payments were claimed by families 

with economic incomes of $50,000 or more. The benefits of the 

deduction are even further skewed toward high-income families because 

deductions are worth more to families with higher marginal tax rates. 

various States make differing use of itemized deductions and pay 

different marginal tax rates. That is, residents of high-income, 

high-tax States make more use of itemized deductions than do residents 

of low-income, low-tax States. Under current law, the Federal 

government underwrites a greater share of State and local government 

expenditures in high-income and high-tax States than in low-income and 

low-tax States. Table 2 shows the States ranked on the basis of per 

capita incomes and the percent of returns with itemized deductions. 

the United States are the general sales tax, the personal income tax, 

and the property tax. There may be a tendency to believe that 

itemized deductions should be eliminated for some of these taxes, but 

retained for others. The degree of reliance on these three tax bases, 

however, varies widely from State to State, as shown in Table 3. For 

example, 97 percent of the revenue that New Hampshire derives from 

these three tax bases came from property taxes, while Louisiana relies 

primarily 011 sales taxes (69 percent) and Delaware on income taxes (73 

percent). Allowing itemized deductions for some of these revenue 

Table 1 shows the distribution of families that itemize deductions 

Because income levels vary across the country, taxpayers in 

The three most important sources of State and local tax revenue in 

- 64 - 
sources but not others would unfairly benefit the residents of the State 

policy decisions at the State and local level away from the 

nondeductible revenue source, just as current law discourages 

localities from using nondeductible fees and user charges. 

- 65 - 
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- 66 - 
lable 2 

States mnked by Deductible Taxes Per Capita - 1982 

: wductible : Taxes as : : eern?nt of : 

: Taxes : Percent of : : 1nccme : : Returns 

state : Percapita : Incm : Rank : Per capita : Rank : Itemizing : Rank 

District of Co: 

New York 

Wyming 

Hawaii 

Massachusetts 

California 

Michigan 

varyland 

Wisconsin 

New Jersey 

%ode Island 

Minnesota 

Alaska 

Connectimt 

Colorado 

Illinois 

1- 

Orego" 

Washington 

Ran*a5 

Arizona 

Nebraska 

Utah 

Maine 

Vermont 

M0"taM 

Pennsylvania 

Idiana 

West Virginia 

Virginia 

Ohio 

Georgia 

south Dakota 

Delaware 

Nevada 

Missouri 

Oklahm 

Texas 

North Carolina 

Idho 

South Carolina 

rauisiba 

New Mexico 

Florida 

North Dakota 

New Hampshire 

Kentucky 

Mississippi 

Tennessee 

Arbas 

Alabama 

Lunbia $ 1,583 

1.422 

1;375 

1,122 

1,018 

1,000 

992 

987 

948 

940 

925 

925 

917 

917 

899 

868 

845 

827 

823 

812 

799 

1,066 

797 

785 

759 .. 

750 

745 

734 

71R . .. 

718 

718 

697 

679 

676 

610 

609 

598 

581 

576 

571 _. . s70 

496 

443 

10.7 3 

11.7 1 

11.3 2 

9.7 4 

8.7 9 

8.1 16 

9.3 5 

8.1 14 

9.2 7 

7.2 26 

8.6 10 

9.0 8 

5.5 45 

6.6 35 

7.5 20 

7.5 21 

8.2 13 

8.3 12 

7.1 27 

6.9 28 

8.1 15 

7.3 22 

9.2 6 

8.5 11 

8.0 18 

7.8 19 

6.8 30 

7.3 23 

8.0 17 

6.3 36 

6.7 33 

7.2 25 

7.3 24 

5.7 44 

5.4 47 

6.1 38 

5.7 42 

5.4 46 

6.7 34 

6.8 32 

6.9 29 

5.8 41 

6.2 37 

5.2 49 

5.2 48 

5.1 50 

6.1 39 

6.8 31 

5.7 43 

5.9 40 

5.1 51 

$ 14,743 

12,204 

12,222 

11,590 

12,287 

12,617 

10,751 

12,280 

10,774 

13,164 

10,930 

10,290 

16.854 

13;939 

12,239 

12,027 

10,635 

10,148 

11,694 

11.850 

10,053 

10,886 

8,693 

9,264 

9.518 

9;617 

10,928 

10.019 

8.966 

11;353 

10,659 

9,637 

9,332 

11,912 

10,403 

11,071 

11,919 

11;380 

9,147 

9,012 

8,613 

10,065 

9,285 

10,929 

10,866 

11,131 

9,122 

7.733 

9;029 

8.444 

8,684 

10 

9 

16 

6 

5 

27 

7 

26 

4 

21 

31 

2 

3 

8 

11 

29 

32 

15 

14 

34 

24 

47 

41 

38 

37 

23 

35 

46 

18 

28 

36 

39 

13 

12 

30 

20 

17 

42 

45 

49 

33 

40 

22 

25 

19 

43 

51 

44 

50 

48 

34.2% 

43.9 

31.4 

34.4 

34.1 

37.2 

40.9 

44.7 

36.8 

35.1 

31.8 

41.6 

30.2 

33.8 

44.7 

33.8 

33.1 

39.7 

36.1 

34.2 

39.8 

35.4 

45.0 

17.9 

34.2 

21.6 

28.0 

28.5 

17.7 

34.1 

28.5 

29.8 

17.9 

41.2 

35.1 

32.7 

35.9 

26.1 

27.7 

32.1 

31.0 

24.7 

29.7 

26.8 

23.5 

21.4 

33.8 

23.8 

21.6 

28.9 

31.8 

20 

4 

31 

17 

22 

10 

7 

3 

11 

15 

29 

5 

33 

24 

2 

25 

26 

9 

12 

18 

8 

14 

50 

19 

47 

39 

37 

51 

21 

38 

34 

49 

6 

16 

27 

13 

42 

40 

28 

32 

43 

35 

41 

45 

48 

23 

44 

46 

36 

30 

33.4% - Total $ 835 7.5% - $ 11,113 - 

Office of the Secretary of the Treasury November 30, 198i 

Oifioe of may Rnalysis 

l~ mese represent 94% of the deductions for Wes paid in 1982. 

source: ~reasury estimates and Mvisory C-ission on lntergovermntal Relations. 

- 67 - 
Table 3 

Use of Different oeductible Taxes by States in 1982 

Percent of Taxes that can be Itemized L/ 

: Property : General Sales : Individual 

State : Taxes : Taxes : Income Taxes 

Alabama 

Alaska 

Arizona 

Arkansas 

California 

Colorado 

Connecticut 

0°C. 

Delaware 

Florida 

Georgia 

Hawaii 

Idaho 

Illinois 

Indiana 

Iowa 

Kansas 

Kentucky 

Louisiana 

Maine 

Maryland 

Massachusetts 

Michigan 

Minnesota 

Mississippi 

Missouri 

Montana 

Nebraska 

Nevada 

New Hampshire 

New Jersey 

New Mexico 

New York 

North Carolina 

North Dakota 

Ohio 

Oklahoma 

Oregon 

Pennsylvania 

Rhode Island 

South Carolina 

South Dakota 

Tennessee 

Texas 

Utah 

Vermont 

Virginia 

Washington 

West Virginia 

Wisconsin 

Wyoming 

U.S. Average 

19.8% 

89.1 

38.7 

31.6 

33.1 

43.0 

60.6 

34.0 

26.8 

53.1 

35.3 

22.8 

37.9 

47.2 

42.7 

50.5 

51.0 

27.0 

22.4 

48.6 

33.9 

47.4 

53.1 

36.5 

30.5 

35.7 

76.1 

55.6 

33.0 

97.3 

61.8 

25.4 

40.2 

33.0 

52.2 

45.7 

26.2 

56.8 

39.0 

54.0 

32.6 

56.8 

37.2 

55.7 

33.5 

59.0 

40.6 

40.8 

22.2 

43.9 

60.4 

42.5% 

50.7% 29.5% 

10.9 0 

42.4 18.9 

37.4 31.0 

37.3 29.6 

37.3 19.7 

34.7 4.7 

24.8 41.2 

0 73.2 

46.9 0 

34.6 30.1 

51.8 25.5 

24.7 37.4 

31.1 21.7 

37.9 19.5 

20.8 28.7 

25.7 23.2 

33.5 39.5 

68.9 8.7 

27.9 23.5 

18.9 47.2 

14.8 37.8 

20.2 26.7 

23.0 40.5 

57.1 12.4 

36.2 28.1 

0 23.9 

26.5 17.8 

67.0 0 

0 2.7 

19.7 18.6 

72.8 1.7 

23.3 36.5 

27.4 39.6 

38.5 9.3 

26.0 28.3 

42.0 31.8 

0 43.2 

25.1 35.9 

22.1 23.9 

33.8 33.6 

32.2 0 

60.8 1.9 

44.3 0 

39.2 27.3 

12.2 28.7 

22.7 36.7 

59.2 0 

55.8 22.0 

20.4 35.7 

39.6 0 

31.4% 26.28 

Office of the Secretary of Treasury November 29, 1984 

Office of Tax Analysis 

- 1/ Certain other taxes can also be itemized deductions. These 

three major taxes accounted for 94 percent of total taxes 

itemized in 1982. 

Source: Advisory Commission on Intergovernmental Relations, 

Significant Features of Fiscal Federalism, 1982-83 

Edition, Table 28. 

- 68 - 
IMPOSE FLOOR ON CHARITABLE DEDUCTIONS 

General Explanation 

Chapter 3.18 

Current Law 

Individuals and corporations are allowed a deduction for 

contributions to or for the benefit of religious, charitable, 

educational, and similar nonprofit organizations. Current law limits 

the allowable deduction to a specified percentage of the donor's 

income but does not set a threshold below which contributions may not 

be deducted. 

Reasons for Change 

It is extremely difficult for the Internal Revenue Service to 

monitor deductions claimed for countless small donations to eligible 

charities. The expense of verification is out of proportion to the 

amounts involved. Dishonest taxpayers are thus encouraged to believe 

that they can misrepresent their charitable contributions without 

risk. 

Most individuals would contribute small amounts to charitable 

organizations without the incentive of an income tax deduction. Thus, 

the efficiency of the Federal subsidy to charitable organizations is 

very low with respect to small donations. 

B r opos al 

Individuals and corporations would be allowed charitable 

contribution deductions only to the extent such contributions exceed 

two percent of the taxpayer's adjusted gross income (AGI). 

Effective Date 

The proposal would be effective for contr 

years beginning on or after January 1, 1986. 

in taxable years beginning after December 31, 

January 1, 1987, however, a one percent floor 

the two percent fioor. 

Analysis 

butions made in taxable 

For contributions made 

1985, and before 

would apply in place of 

Two percent of AGI is approximately the median charitable 

contribution deduction claimed by taxpayers who itemize deductions. 

In other words, one-half of all itemizers claim less than one percent 

of their AGI, while one-half claim more than that, as charitable 

contribution deductions. Thus, the proposal would disallow all of the 

charitable deductions of about one-half of all taxpayers who itemize. 

- 69 - 
Table 1 shows the distributioc of charitable contributions by 

families. The first two columns (labeled Total Donors) refer to all 

contributions, whether itemized as deductions on tax returns or not. 

Of the 68 million families making donations, about 40 percent claim an 

itemized deduction for charitable contributions under current law, as 

shown in the next two columns, ranging from three percent in the 

lowest income class to 90 percent in the highest. Although itemizers 

account for only 40 percent of a11 donating families, they give almost 

70 percent of total contributions. 

By removing tax deductions for small charitable gifts, the 

proposal would simplify recordkeeping requirements for taxpayers and 

would eliminate the need for the Internal Revenue Service to spend 

resources verifying these small contributions. 

The proposal would have some effect on charitable giving, but the 

impact is not expected to be significant. It is doubtful that the 

first dollars of giving, or the giving of those who give only modest 

amounts, are affected significantly by tax considerations. Rather, 

contributions also depend on factors such as financial ability to 

give, membership in charitable or philanthropic organizations and 

general donative desire. As potential giving becomes large relative 

to income, however, taxes are more likely to affect the actual level 

of donations. Under the proposal, the current incentive would be 

maintained for the most tax sensitive group -- taxpayers who give 

above-average amounts. 

- 70 - 
Table 1 

Distribution of Total and Deductible 

Charitable Contributions by Economic Income -- 1983 - 1/ 

Total Donors : Itemized Deductions 

: (Includes non-filers) : -- Present Law 2/ 

Family Economic : : All Contri- : : DeducIncome : Families : butions : Families : tions 

(thousands) (millions) (thousands) (millions) 

$ a - 9,999 

10,000 - 14,999 

15,000 - 19,999 

20,000 - 29,999 

30,000 - 49,999 

50,000 - 99,999 

100,000 - 199,999 

200,000 or more 

Total 

5,349 

7,891 

8,159 

12,814 

17,892 

12,992 

1,819 

424 

67,340 

$ 1,398 

2,054 

2,394 

5,230 

10,108 

13,164 

4,715 

6,628 

$ 45,691 

164 

380 

'1 4 3 

3,075 

9,603 

10,633 

1,729 

411 

26,738 

$ 190 

264 

415 

1,902 

6,757 

11,116 

4,484 

6,593 

$31,721 

Office of the Secretary of the Treasury November 29, 1984 

Office of Tax Analysis 

- 1/ Source: Treasury estimates. - 2/ Includes itemized returns only. 

- 71 - 
LIMIT CHARITABLE DEDUCTION FOR APPRECIATED PROPERTY 

General Explanation 

Chapter 3.19 

Current Law 

A taxpayer who makes a gift of appreciated property to charity 

generally does not realize income with respect to any appreciation in 

the property's value. (In the case of a sale of appreciated property 

to charity for less than its fair market value, the transaction is 

treated as in part a gift and in part a sale, and the taxpayer 

realizes income with respect to an allocable portion of the property's 

appreciation.) A taxpayer also does not realize a loss for tax 

purposes on a charitable donation of depreciated property. Any 

deductible loss with respect to such property will be realized, 

however, if the taxpayer sells the property and donates the proceeds 

to charity. 

for the fair market value of appreciated (or depreciated) property 

donated to charity. This general rule is subject to exceptions 

depending on the identity of the donee, the donee's use of the 

property and the character and holding period of the property in the 

hands of the donor. In the case of long-term capital gain property, 

if the donee's use of the property is unrelated to its exempt purpose 

or if the donation is to certain types of private foundations, the 

amount of the deduction is reduced by 40 percent (about 57 percent for 

a corporate donor) of the donor's unrealized long-term capital gain. 

Thus, a deduction is allowed for the entire adjusted basis of the 

property plus 60 percent of the appreciation (about 43 percent for a 

corporate donor). In the case of other appreciated property, the 

allowable deduction is reduced by the amount of ordinary income or 

short-term capital gain that the donor would have realized if the 

property had been sold for its fair market value. 

Donors of most property with a value of more than $5,000 must 

obtain an appraisal of the property from a qualified appraiser and 

must attach a summary of the appraisal to the tax return on which the 

deduction is claimed in order to obtain a deduction. Contributions of 

other property must be substantiated under regulations. 

In general, current law allows a charitable contribution deduction 

Reasons for Change 

The current treatment of certain charitable gifts of appreciated 

property is unduly generous and in conflict with basic principles 

governing the measurement of income for tax purposes. In other 

circumstances where appreciated property is used to pay a deductible 

- 12 - 
expense, or where such property is the subject of a deductible loss, 

the deduction allowed may not exceed the taxpayer's adjusted basis 

plus any gain recognized. Thus, a taxpayer generally may not receive 

a tax deduction with respect to untaxed appreciation in property. The 

current tax treatment of certain charitable gifts departs from this 

principle by permitting the donor a deduction for the full value of 

the property, including the element of appreciation with respect to 

which the donor does not realize gain. 

The generous tax treatment for certain gifts of appreciated 

property also creates an incentive for taxpayers to make gifts of such 

property rather than gifts of cash, even though in many instances 

charities would prefer to receive cash rather than propercy of 

equivalent value. A taxpayer in the 40 percent bracket making a gift 

of $200 in cash receives a $200 deduction. This translates to an $80 

savings in tax, which reduces the after-tax cost of the $200 gift to 

$120. The same taxpayer donating $200 worth of property that is a 

capital asset held for the long-term capital gain holding period 

receives the same $200 deduction and $80 in tax savings. If, however, 

the donated property is appreciated property, the donor receives an 

additional tax savings by avoiding tax on the property's appreciation. 

Although the value of this tax savings depends on the amount of the 

property's appreciation and on when and how the donor otherwise would 

have disposed of the asset, its availability has proved to have a 

significant influence on the form of charitable donations. 

gifts of appreciated property, but these rules are only a partial 

response to the problem and require complicated inquiries concerning 

the donee's use of the property and the character of the property in 

the donor's hands. In addition, under current law it is necessary in 

almost all instances to value the donated property. This is a 

significant burden for taxpayers and for the Internal Revenue Service 

and leaves the system open to serious abuse through fraudulent 

overvaluations of contributed property. 

Current law does limit the amount of the deduction for certain 

Proposal 

A deduction for charitable donations of property would be allowed 

for the lesser of the fair market value or the inflation-adjusted 

basis of the property. See Chapter 9.01 for a discussion of the 

indexation of capital assets. (In the case of a part sale/part gift, 

the amount of the charitable contribution deduction would be the 

portion of the inflation-adjusted basis of the property attributable 

to the gift portion of the transaction). As under current law, gain 

or loss would not be realized on charitable gifts. 

- 73 - 
Effective Date 

The proposal would be effective for contributions made in taxable 

years beginning on or after January 1, 1986. 

Analysis 

For most income groups, charitable contributions are usually made 

in the form of cash, rather than property. For returns with adjusted 

gross incomes under $100,000, less than ten percent of contributions 

constitute property. Only for incomes over $200,000 does property 

account for as much as 40 percent of all contributions. Thus, the 

benefits of present law accrue to taxpayers with the highest marginal 

tax rates. 

The proposal would eliminate the unwarranted tax advantages for 

donations of appreciated long-term capital gain property, as well as 

the complex rules limiting deductions for the various types of 

property that may be given to charity. In addition, the proposal 

would substantially eliminate the most serious opportunities for abuse 

through overvaluations of donated property. 

The proposal also would eliminate the need for detailed valuations 

of contributed property in those cases in which the fair market value 

of the property clearly exceeds its adjusted basis. A determination 

of fair market value would still be needed for a part sale/part gift 

of appreciated property. Although valuations also would continue to 

be necessary for many gifts of depreciated property, taxpayers could 

ordinarily be expected, as under current law, to sell certain types of 

depreciated property and donate the proceeds of the sale in order to 

receive the benefit of any deductible loss. By significantly reducing 

the instances in which property valuations would be necessary, the 

proposal would ease the burden on taxpayers and the Internal Revenue 

Service caused by appraisal requirements. 

of appreciated long-term capital gain property may have some adverse 

impact on the level of charitable giving. Some taxpayers, who are 

able to make gifts to charity at little or no after-tax cost under 

current law, may reduce their level of giving if current tax benefits 

are no longer available. The charitable contribution deduction, 

however, would still provide a significant incentive for charitable 

giving. 

The elimination of the current overly generous treatment of gifts 

- I4 - 
REVISE PERCENTAGE LIMITATION 

ON CHARITABLE CONTRIBUTION DEDUCTIONS 

General Explanation 

Chapter 3.20 

Current Law 

The deduction for charitable contributions is subject to a variety 

of limitations based on the amount of the donor's income, the identity 

of the charitable donee and the character of the donation. For 

individual donors the charitable contribution dr Juction in any taxable 

year generally is limited to (a) 50 percent of the taxpayer's 

contribution base (defined as adjusted gross income before net 

operating loss carrybacks) for contributions to -- but not those for 

the use of -- certain organizations (generally public charities and 

private operating foundations), often referred to as "50 percent 

charities," or (b) the lesser of (i) the amount described in (a) that 

is unused and (ii) 20 percent of the taxpayer's contribution base for 

other charitable contributions (those for the use of 50 percent 

charities and those to or for the benefit of charities other than 50 

percent charities). If, however, an individual contributes an 

appreciated capital asset that has been held for the long-term capital 

gain holding period, the deduction with respect to that property 

generally is limited (subject to the additional 50 percent and 20 

percent limits) to 30 percent of the taxpayer's contribution base. 

This 30 percent limitation does not apply if the taxpayer elects to 

deduct only the adjusted basis, rather than the fair market value, of 

such property. 

If an individual's contributions exceed the 50 percent limit or 

the 30 percent limit in any year, the excess ordinarily may be carried 

forward for five years. Excess contributions for the use of (but not 

to) 50 percent charities may not be carried forward. Excess 

contributions to 20 percent charities also may not be carried forward. 

For corporations, the charitable contribution deduction is limited 

to ten percent of the corporation's taxable income, computed without 

regard to net operating or capital loss carrybacks. Amounts in excess 

of the ten percent limit may be carried forward for five years. 

Corporate contributions are deductible only if the gift is to be used 

within the United States. 

Reasons for Change 

The percentage limitations on charitable contribution deductions 

were imposed by the Tax Reform Act of 1969. At that time the 

after-tax cost of a charitable contribution could be extremely small 

for high income donors because of high marginal. tax rates and because 

a deduction was allowed for the element of untaxed appreciation in 

certain types of donated property. The limitations on charitable 

- 75 - 
contributions were adopted in order to prevent wealthy donors €rom 

taking advantage of the favorable tax treatment of charitable 

donations substantially to eliminate their tax liabilities. 

Since 1969, the top marginal tax rate has been reduced from 70 

percent to 50 percent and would be further reduced to 35 percent under 

the Treasury Department proposals. In addition, the Treasury 

Department proposals would deny a charitable contribution deduction 

for the element of untaxed appreciation in donated property. Since 

those changes would increase the after-tax cost of charitable 

contributions, there would be no continuing need to limit the amounts 

of contributions for which donors receive deductions. Although a 

generous donor might still be able substantially to eliminate a 

particular year's tax liability through a large donation, the 

contribution would involve a proportionately large out-of-pocket cost 

to the donor. 

Repeal of the percentage limitations for individual donors would 

also greatly simplify the tax treatment of charitable gifts. In 

addition, repeal would substantially eliminate the difficult questions 

arising under current law when an individual dedicates all or a 

substantial portion of his or her earnings to a charitable 

organization. Since income is generally taxed to the person who earns 

it, even if it is given away before it is earned, the percentage 

limitations may result in a tax liability for the individual on 

earnings dedicated to charity. This is a harsh result in a number of 

cases, such as where a member of a religious order donates his or her 

entire income to charity under a vow of poverty. 

Proposal 

The percentage limitations on gifts to or for the use of 50 

percent charities would be repealed, together with the related 

carryover rules. (Carryovers from years prior to the effective date 

of the proposal would be allowed, subject to the percentage 

limitations under current law.) The current 20 percent limit on gifts 

by individuals to or for the use of charities other than 50 percent 

charities would be retained. In addition, contributions by 

corporations to or for the use of charitable organizations other than 

50 percent charities would be limited to five percent of the 

corporation's taxable income, computed without regard to net operating 

or capital loss carrybacks. This five percent limit on gifts by 

corporations also would apply to contributions to any charitable 

organization that owns, directly or indirectly, more than one percent 

of the value or voting power of the donor corporation, or that is 

owned or controlled by persons who own or control the donor 

corporation. This limit is necessary to maintain the integrity of the 

feeder organization rules, which generally provide that a corporation 

shall not be exempt from tax merely because it pays all of its profits 

to a tax-exempt organization. (Section 502.) No carryovers of 

contributions in excess of these limits would be allowed. A provision 

- 76 - 
that in effect provides relief from the percentage limitation in the 

case of certain corporate contributions to the American Red Cross 

would be repealed as superfluous. (Section 114.) 

Effective Date 

The proposal would be effective for charitable contributions made 

in taxable years beginning on or after January 1, 1986. 

Analysis 

Although difficult to estimate precisely, it appears that fewer 

than 50,000 taxpayers (out of 100 million) would be affected by the 

proposal. Over one-half of the estimated revenue loss that would 

result from the proposal would be attributable to returns with AGI in 

excess of $200,000. 

- 71 - 
REPEAL CHARITABLE CONTRIBUTION DEDUCTION FOR NONITEMIZERS 

General Explanation 

Chapter 3.21 

Current Law 

Contributions and gifts to or for the use of certain charitable 

and similar organizations are deductible, subject to certain 

limitations. Prior to 1981, a charitable contribution could be 

deducted only by individuals who itemized their deductions. The 

Economic Recovery Tax Act of 1981 (ERTA) extended the charitable 

contribution deduction to nonitemizing taxpayers, phased in over a 

five-year period. For contributions made in the 1984 tax year, 

individuals who do not itemize deductions are permitted to deduct 25 

percent of the first $300 of contributions made. For 1985 and 1986, 

the $300 limitation is removed and the percentage of contributions 

deductible by nonitemizers is increased to 50 percent and 100 percent, 

respectively. Thus, under current law, the charitable contribution 

deduction will be allowed in full to nonitemizers in 1986. This 

provision, however, is scheduled to expire after 1986. After that 

time the charitable contribution deduction again will be limited to 

individuals who itemize their deductions. 

Reasons for Change 

Taxpayers are not subject to tax on their income up to the zero 

bracket amount (ZBA). This exemption is generally regarded as an 

allowance for certain personal expenses which ought not to be included 

in income and which all taxpayers are deemed to incur. In lieu of the 

ZBA, a taxpayer may itemize deductible personal expenses, such as 

certain medical expenses, interest expenses, and, prior to the ERTA 

changes, charitable contributions. Allowing a deduction for 

charitable contributions by nonitemizers in effect creates a double 

deduction for such contributions -- first through the ZBA, which is 

available only to nonitemizers, and second through the charitable 

deduction. 

The allowance of a charitable contribution deduction for 

nonitemizers adds complexity to the tax law. These taxpayers must 

retain records of their gifts and go through additional computational 

steps in calculating their tax liability. 

enforcement problems. Nonitemizers generally make smaller charitable 

gifts than itemizers. A deduction may be claimed for numerous small 

gifts, made to a number of different organizations. It is extremely 

difficult and expensive for the Internal Revenue Service to monitor 

these deductions. Further, the cost of administration is 

The charitable contribution deduction also creates serious 

- 78 - 
disproportionate to the amounts involved. These factors may prompt 

dishonest taxpayers to conclude that they can misrepresent their 

charitable gifts with impunity. 

The charitable contribution deduction was extended to 

nonitemizers in order to stimulate charitable giving by such 

individuals. There is little data, however, indicating that the 

provision has had any significant effect on charitable giving by such 

individuals. 

Proposal 

The charitable contribution deduction for nonitemizers would be 

repealed. 

Effective Date 

The proposal would be effective for contributions made in taxable 

years beginning on or after January 1, 1986. 

Analysis 

In 1982, 19 million returns, representing 31 percent of all 

nonitemizers, claimed $431 million in charitable deductions. For 

1983, preliminary statistics indicate that 23 million returns, 40 

percent of all nonitemizers, claimed $500 million in charitable 

deductions. 

Although repeal of the charitable contribution deduction for 

nonitemizers may have some effect on charitable giving, any adverse 

impact is not expected to be significant. Nonitemizers generally have 

lower incomes and, thus, have lower marginal tax rates than itemizers. 

For this reason, tax incentives have less influence on nonitemizers. 

Moreover, since the deduction under current law is scheduled to expire 

in 1987, the proposal would have no impact on tax liabilities in years 

subsequent to 1987. 

the short-form (1040A). The current deduction requires that a 

"worksheet" be included in the tax form instructions, on which the 

taxpayer makes calculations, the results of which are subsequently 

transferred onto Form 1040 or 1040A. 

The proposal would simplify both the regular tax form (1040) and 

- I9 - 
Part E. Tax Abuses-Mixed Business/Personal Use 

Many expenses that involve significant personal consumption are 

currently being deducted as business expenses. This is unfair to 

taxpayers who do not have access to business perquisites and also 

distorts consumption choices. The proposals would limit deductions 

for entertainment, business meals, and travel expenses. In addition, 

rules are proposed to specify the circumstances under which taxpayers 

who have no regular place of work can deduct commuting expenses. 

- 80 - 
LIMIT DEDUCTION FOR 

ENTERTAINMENT AND BUSINESS MEAL EXPENSES 

General Explanation 

Chapter 3.22 

Current Law 

Ordinary and necessary expenses paid or incurred during a taxable 

year generally are deductible if the expenses bear a reasonable and 

proximate relation to the taxpayer's trade or business or to 

activities engaged in for profit. Although ordinary and necessary 

business expenses may include entertainment expenses, the 

deductibility of business entertainment expenses is subject to a 

number of separate and additional requirements. 

that are "conducive to a business discussion." There is no 

requirement that business actually be discussed, either before, 

during, or after the meal. Expenses for other entertainment 

activities are deductible only if they are "directly related to" or 

"associated with" the taxpayer's trade or business. Entertainment 

activities are considered "directly related" if the taxpayer has more 

than a general expectation of deriving income or a specific trade or 

business benefit (other than goodwill) from the activity. The 

taxpayer need not show that income actually resulted from the 

entertainment. In general, entertainment expenses satisfy the 

"associated with" standard if they are directly preceded or followed 

by a substantial and bona fide business discussion. A business 

discussion may be considered substantial and bona fide even if it 

consumes less time than the associated entertainment and does not 

occur on the same day as the entertainment activity. 

country clubs, used to entertain clients or customers are also subject 

to separate rules. A deduction is allowed for the portion of the cost 

of club memberships that are "directly related" to the taxpayer's 

business if the facilities are used primarily for business purposes. 

No deduction is allowed for other types of entertainment facilities. 

Tickets to sporting and theatrical events, and the costs of skyboxes, 

lounges, boxes or other similar arrangements that provide the taxpayer 

a specific viewing area to a sporting or theatrical event are not, 

however, considered to be expenses related to an entertainment 

facility. Thus, such expenses are fully deductible if they meet the 

"directly related to" or "associated with" tests for entertainment 

activities. 

Business meals are deductible if they occur under circumstances 

Entertainment facilities, such as yachts, hunting lodges, or 

Entertainment expenses also are subject to separate substantiation 

requirements. Deductions for entertainment expenses must be supported 

by records showing the amount of the expense, time and place of 

- 81 - 
entertainment, business purpose of the expense, and business 

relationship to the taxpayer of any persons entertained. 

Reasons for Change 

In General. The special requirements for deductibility of 

business entertainment expenses have been the subject of repeated 

Congressional concern since their enactment in 1962. The existing 

requirements are an attempt to provide taxpayers and the Internal 

Revenue Service with standards for deductibility. Current standards, 

however, are predominantly subjective, leaving application of the law 

uncertain and creating significant opportunities for abuse. Under 

present law, the costs of country club memberships, football and 

theater tickets, parties, and lunches and dinners at expensive 

restaurants are all deductible, if a plausible business connection can 

be demonstrated. The existing tests for whether a business connection 

exists are premised upon the taxpayer's expectations and intentions, 

and thus may result in a deduction being allowed in cases where less 

time was devoted to business than to entertainment, no business was 

discussed, or the taxpayer was not even present at the entertainment 

activity . 

treatment of other kinds of expenses that provide both business and 

personal benefits. In some cases, such as work-related clothing, the 

presence of any personal benefit is deemed sufficient reason to 

disallow any deduction. In other cases, taxpayers are allowed to 

deduct only the proportion of expenses allocated to business. In 

contrast, present law often allows full deductibility of certain 

entertainment expenses even though the connection between the 

entertainment expense and business activity is extremely tenuous. 

Efficiency. The treatment of "business related" entertainment 

under current law encourages excessive spending on entertainment. The 

business person in a 40 percent marginal tax bracket considering 

whether to order a $20 or a $30 "business meal" knows that the more 

expensive dinner, though its price is $10 higher, will only cost $6 

more because of the available deduction. The taxpayer's choice of 

meals is much more likely to be based on personal rather than business 

considerations, but the deductibility of the expense makes selection 

of the expensive meal more likely than in a nonbusiness context. 

Similarly, a business person in the 50 percent marginal tax bracket 

may conclude that it costs nothing extra to take a business associate 

to the theater even if it serves little or no business purpose. The 

attendance of the business associate permits a claim that the cost of 

both tickets are deductible, and thus an extra ticket costs nothing on 

an after-tax basis. 

The liberality of the law in this area is in sharp contrast to the 

Present law has no effective response to these practices because 

it attempts to separate personal from business entertainment expenses 

on the basis of the taxpayer's intentions and purposes. It is 

frequently possible to demonstrate an actual business purpose or 

connection for an entertainment expense that nevertheless has a 

- 02 - 
strong, if not predominant, element of personal consumption. The 

problem is exacerbated by the fact that no objective standards exist 

for determining whether an expense is based upon the personal or 

business benefits derived. The use of the subjective terms "directly 

related" and "associated with" leads to liberal interpretations by 

taxpayers, who cannot reasonably be expected to deny themselves the 

benefit of any doubt. Moreover, as an administrative matter, 

entertainment expense deductions are often difficult to audit. The 

cost of giving a party for friends who are also business associates is 

often allowed even if the primary motive for the party was personal 

enjoyment, not business benefit. 

Fairness. The current treatment of business entertainment 

expenses encourages taxpayers to indulge personal entertainment 

desires while at work or in the company of business associates. The 

majority of taxpayers, however, do not benefit from this incentive. 

Most hold jobs that do not permit business entertainment, and many 

others are scrupulous in claiming business deductions for personal 

entertainment. 

Current law thus creates a preference for the limited class of 

taxpayers willing and able to satisfy personal entertainment desires 

in a setting with at least some business trappings. Lunches are 

deductible for a business person who eats with clients at an elegant 

restaurant, but not for a plumber who eats with other workers at the 

construction site. A party for friends of a business person is 

deductible if they are business associates, but a party for friends of 

a secretary, sales clerk, or nurse is not deductible. 

Extreme abuses of these deductions are frequently cited by those 

who assail the tax system as unfair. Abuses, even if rare, seriously 

undermine the integrity of the tax system and undercut the public 

trurt that is essential to it. Some limitation on the deductibility 

of entertainment expenses is necessary if such perceptions of 

unfairness are to be eliminated. 

Proposal 

No deduction would be allowed for entertainment expenses, except 

for certain business meals. A deduction would be allowed for ordinary 

and necessary business meals furnished in a clear business setting (as 

defined in Treasury regulations). For each person participating in 

each business meal, this deduction would be limited to $10 for 

breakfast, $15 for lunch, and $25 for dinner. The meal cost 

limitations would include gratuities and tax with respect to the meal. 

Effective Date 

The proposal would apply to taxable years beginning on or after 

January 1, 1986, except that a deduction would be allowed for 50 

percent of ordinary and necessary business meals expense (in excess of 

meal limit) incurred in taxable years beginning on or before 

January 1, 1987. 

- 83 - 
Analysis 

Business Meal Limitations. Business meals provide a mixture of 

business and personal benefits. The extent to which a meal provides a 

personal benefit will vary, and it is not possible to develop rules 

that would specify the precise percentage of personal benefit in 

specific cases. The proposal, therefore, provides objective 

limitations that are intentionally quite generous, yet are intended to 

deny deductions for that portion of meal costs which is most likely to 

constitute personal rather than business benefit. Expenses in excess 

of the limitation are deemed to be incurred for personal rather than 

business reasons. The deduction will be disallowed only for the 

amount above the stated limit. 

Representatives of the restaurant industry in testimony before 

Congress have provided several estimates of the average cost of 

restaurant meals. If adjusted for inflation, those estimates would 

range between $6.50 and $10.00 for 1983. In addition, Census data 

shows that only about 2.5 percent of all restaurant meals in 1977 were 

in restaurants where the average bill exceeded $10.00. Adjusted for 

inflation, this suggests that only about 2.5 percent of all meals were 

in restaurants with average bills over $17.00 in 1983. 

While the proposal will reduce the number of expensive business 

meals, it is expected that the limitations will not have a 

significant impact on more than five percent of restaurants. 

Moreover, since some high-cost meals will be replaced by moderate-cost 

meals, the effect on total employment in the restaurant industry is 

expected to be modest. 

deductible meals. Therefore, the additional recordkeeping costs 

should be minimal. 

Businesses are currently required to keep detailed records for all 

Placing ceilings on the deductibility of business meals would 

eliminate the extreme cases of abuse -- those that affect the average 

taxpayer the most. Despite its small revenue effect, the proposal 

would be of significant assistance in restoring trust in the tax 

system. 

The Elimination of Other Entertainment Deductions. The proposal 

would completely eliminate deductions for entertainment expenses such 

as tickets to professional sporting events, tickets to the theater, 

the costs of fishing trips, and country club dues. Because all such 

entertainment has a large personal component, the proper tax 

treatment, on both efficiency and equity grounds, is to disallow a 

deduction. 

Approximately one-third of all baseball tickets and over one-half 

of all hockey tickets are purchased by businesses. The net effect is 

often to raise the cost of tickets for those who are not subsidized 

through the tax system for their purchases. Some performing arts 

- a4 - 
organizations also sell large proportions of their tickets to 

businesses. Some tickets bought by businesses would remain deductible 

as gifts to their employees, but only if individual gifts are valued 

at less than $25. 

If a public subsidy of such entertainment is desirable, a direct 

expenditure program could better target the aid. Further, current law 

raises serious equity questions by increasing the demand for tickets 

thereby causing the price of tickets to rise for the general public. 

- 85 - 

459-813 0 - 84 - 4 
LIMIT DEDUCTION FOR TRAVEL EXPENSES 

Genecal Explanation 

Chapter 3.23 

___ Current Law 

Travel expenses incurred by a taxpayer while "away from home" are 

deductible if such expenses are reasonable and necessary in the 

taxpayer's business and are directly attributable to the taxpayer's 

business. Travel expenses may include the cost of travel to and from 

the destination and the cost of meals, lodging, and other incidental 

travel costs (e.g., laundry, taxi fares) incurred while at the 

business destination. A taxpayer's "home" for purposes of the 

deduction is generally his or her business headquarters. A taxpayer 

is considered to be "away" from his or her business headquarters only 

if the travel involves a 'temporary" rather than an "indefinite" 

assignment at another location. If a taxpayer accepts a job at a 

distant location for an indefinite period, the new job location 

becomes the taxpayer's tax home. Temporary employment generally is 

expected to last for a short or foreseeable period of time, but 

whether employment is temporary or indefinite is essentially a factual 

quest ion. 

The cost of commuting to and from a taxpayer's business 

headquarters is not considered business travel. Commuting costs 

generally are considered to relate to an individual's personal choice 

of his or her place of residence rather than to business necessity and 

are not deductible. An exception to the commuting rule has sometimes 

been made for taxpayers, such as construction workers, who are 

employed on a temporary basis at one or more job sites beyond the 

metropolitan area where they reside. 

the costs of meals and lodging) in the North American area are 

deductible if the taxpayer is able to show that attendance at the 

convention is directly related to his or her trade or business and 

that such attendance is advancing the interests of the taxpayer's 

trade or business. The North American area includes the United 

States, the U.S. possessions, the Trust Territory of the Pacific 

Islands, Canada, Mexico, and certain Caribbean countries that have 

entered into exchange of tax information agreements with the United 

States. A stricter rule applies for conventions held outside the 

North American area. In order to claim a deduction for the costs of 

attending such a convention, a taxpayer must also show that it was "as 

reasonable" for the meeting to be held outside the North American area 

as within it. 

Deductions for conventions, seminars, or other meetings held on 

The costs of attending a convention or other meeting (including 

cruise ships are subject to additional limitations. No deduction is 

allowed unless the cruise ship is registered in the United States and 

- 86 - 
only at ports of call in the United States or in possessions of the 

United States. In any event, a taxpayer may deduct no more than 

$2,000 for such meetings per year. 

education, are deductible if the education maintains or improves 

existing employment skills or is required by an employer, or 

applicable law or regulation. To be deductible, the travel must be 

directly related to the duties of the taxpayer in his or her 

employment or other trade or business. The deductible educational 

travel may occur while the taxpayer is on sabbatical leave. 

Reasons for Change 

The present limitations on deductions for business travel fail to 

establish reasonable distinctions between costs incurred for business 

purposes and costs reflecting personal consumption. The deduction for 

expenses for meals and lodging incurred "away from home" is premised 

on the assumption that the business traveler incurs additional costs 

while away from home. Restaurant meals are likely to be more 

expensive than the cost to the taxpayer of eating at home, and hotel 

accomodations are a duplicative expense for the taxpayer who maintains 

regular living quarters elsewhere. These excess costs incurred by a 

taxpayer away from home are, at least in part, legitimate business 

expenses. 

Current law, however, does not limit the deduction for away from 

home meals and lodging to the portion of the cost that represents an 

extra or duplicate expense. The full deductiblility of such travel 

expenses permits a taxpayer who is away from home to deduct some costs 

that would be incurred even if he had stayed at home. For example, a 

taxpayer may deduct the full cost of meals even though some costs for 

meals would have been incurred if the taxpayer were not away from 

home. Moreover, the full deductibility of business travel expenses 

encourages excessive spending. For example, an additional $30 for 

more expensive accomodations will cost a business traveler only $18 if 

he or she is in the 40 percent marginal tax bracket and, as is likely 

under current standards, can establish that such accomodations are an 

ordinary and necessary expense. 

away from home in a single city for an extended period of time. 

Extended travel status permits the taxpayer to take advantage of 

certain economies not available on shorter trips. For example, a 

professor visiting another university for a year probably will spend 

the same amount for lunch or dinner as he or she would have spent at 

home. Similarly, a taxpayer on extended travel at a single location 

ordinarily will be able to reduce the incidental costs of travel, such 

as laundry or transportation to the office. 

Tn addition, the current tax treatment of trips that combine 

business travel with a vacation create opportunities for abuse. Many 

travel and business publications feature articles and promotional 

Professional education expenses, including travel as a form of 

The liberality of current law is greatest for taxpayers who remain 

- 07 - 
material that explain how taxpayers can pay for vacations with tax 

deductible dollars. These abuses distort business decisions and 

reduce the efficiency of the economy. For example, a taxpayer may 

alter the place and timing of business meetings for no reason other 

than to coincide with vacation plans. The current rules are also 

unfair. Some individuals are able to take deductions for personal 

expenses simply because they are better informed about the law. The 

presence of such obvious abuses undercut taxpayer trust in the 

integrity of the tax system. 

The current deduction for travel as a form of education creates an 

even greater opportunity for abuse. Availability of the deduction is 

premised solely on the taxpayer's intent and expectation in making the 

trip. Accurate administrative review of such expenses is impossible 

due to the lack of objective standards. 

Proposals 

incurred by a taxpayer while located in one city away from home for 30 

days or less would be limited to 200 percent of the maximum Federal 

reimbursement rate per day for that city, as published in the Federal 

Property Management Regulations, 101-7, G.S.A. Bulletin F.P.M.R. A-40. 

For example, the current applicable limit for a taxpayer located in 

Baltimore, Maryland for 30 days or less would be $150 per day. 

Deductions for expenses for meals and lodging incurred by a taxpayer 

while located in one city away from home for more than 30 days would 

be limited to 150 percent of the Federal per diem rate for that city. 

No deduction would be allowed for incidental travel expenses (e.g., 

lanudry, taxi fares) incurred by a taxpayer while located in one city 

away from home for more than 30 days. For purposes of determining 

whether a taxpayer is away from home, travel assignments which extend 

for more than one year in one city would be considered indefinite, and 

travel deductions be allowed. 

2. A deduction for the daily transportation expenses of taxpayers 

1. Deductions for meals, lodging, and incidental travel expenses 

(such as construction workers) who have no regular place of work and 

must travel at least 35 miles (one way) to job assignments that last 

less than one year would be allowed €or the commuting expenses 

incurred for mileage in excess of 35 miles (one way). 

3. For purposes of determining whether a taxpayer is away from 

home, travel assignments which extend for more than one year in one 

city would be considered indefinite, and no travel deductions would be 

allowed. 

4. Employee business travel expenses that are not reimbursed by a 

taxpayer's employer under a reimbursement or other expense allowance 

arrangement would be deductible to the extent such expenses, together 

with miscellaneous itemized deductions, exceed one percent of the 

employee's adjusted gross income. For a discussion of the one percent 

floor on the deductibility of the such expenses, see Chapter 4.03. 

- 88 - 
5. No deduction would be allowed for business travel by ocean 

liner, cruise ship, or other form of luxury water transportation in 

excess of the cost of otherwise available business transportation 

unless the taxpayer provides proof of existing medical reasons for 

utilizing such transportation. 

6. No deduction would be allowed for conventions, seminars, or 

other meetings held aboard cruise ships. 

education. 

Effective Date 

7. No deduction would be allowed for travel as a form of 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

The proposed limitations on travel expense deductions are designed 

to provide reasonable boundaries and eliminate the most extreme cases 

of abuse without unduly restricting deductions for legitimate business 

expenses. The dollar limitations are intentionally quite generous and 

are intended to deny deductions for that portion of travel expenses 

that is most likely to constitute personal satisfaction rather than 

business convenience. Expenditures in excess of the applicable 

limitation are deemed to represent luxury accomodations and meal costs 

incurred for personal rather than business reasons. The lower limits 

for trips lasting longer than 30 days reflect the economies that are 

available during extended periods of travel; the disallowance of 

incidental expenses after 30 days in one city recognizes the 

significant personal component of such expenses. 

The proposed treatment for taxpayers, such as construction 

workers, who have no regular place of work addresses an area of the 

law that is a continuing source of litigation and confusion. Although 

commuting expenses to and from a regular place of work are 

nondeductible without regard to the length of the commute, it is 

reasonable to permit a deduction for transportation expenses to a 

nonregular place of work, such as a construction site, where the 

taxpayer is employed for a temporary period. Commuting expenses 

generally are disallowed on the theory that where a taxpayer chooses 

to reside -- whether near or far from the workplace -- is a matter of 

personal choice. That rationale is inappropriate when a taxpayer’s 

workplace is constantly shifting, the jobs are temporary in nature, 

and the taxpayer must travel long distances to reach the job site. 

The special commuting deduction would be allowed only for 

transportation expenses in excess of 35 miles (one way), would not 

extend to meal costs, and would be available only for job assignments 

that last less than one year. By using an objective mileage standard 

- 89 - 
rather than requiring that travel be outside the "metropolitan area," 

the proposal would eliminate uncertainty and create uniformity among 

taxpayers located in different parts of the country. 

The one-year rule for defining temporary employment would 

eliminate a significant source of dispute between taxpayers and the 

Internal Revenue Service, and would provide a reasonable division 

between temporary and indefinite assignments. One year is sufficient 

time for regular living patterns to be established at the new location 

and, thus, food and lodging expenses would no longer need to be 

duplicative or more expensive than comparable costs at the original 

job site. 

The disallowance of a deduction for the cost of travel by cruise 

ships, ocean liner, or other form of luxury water transportation in 

excess of the cost of otherwise available business transportation is 

intended to deny a deduction for the portion of the travel cost most 

likely to constitute personal rather than business benefit. 

- 90 - 
Part F. Tax Abuses--Income Shifting 

Although the proposed rate schedule for individuals is flatter 

than under current law, there would remain a substantial difference 

between the top rate and bottom rate. Thus, as under current law, 

taxpayers subject to the top rate would have an incentive to shift 

income to their children or other family members subject to tax at 

lower rates. Current law limits income shifting through various 

rules, including the assignment-of-income doctrine and the 

interest-free loan provisions. This Part discusses proposed rules 

that would butress current limits on income-shifting by preventing 

taxpayers from reducing the tax on unearned income by transferring 

income to minor children or establishing trusts. 

- 91 - 
ADJUST TAX RATE OF UNEARNED INCOME OF MINOR CHILDREN 

General Explanation 

Chapter 3.24 

Current Law 

Minor children generally are subject to the same income tax rules 

as adults. If a child is claimed as a dependent on another taxpayer's 

return, however, the zeLo bracket amount is limited to the amount of 

the child's earned income. Accordingly, the child must pay tax on any 

unearned income in excess of the personal exemption ($1,040 in 1985). 

Under current law, when parents or other persons transfer 

investment assets to a child, the income from such assets generally is 

taxed thereafter to the child, even if the transferor retains 

significant control over the assets. For example, under the Uniform 

Gifts to Minors Act (UGMA), a person may give stock, a security (such 

as a bond), a life insurance policy, an annuity contract, or money to 

a custodian for the child (who generally may be the donor). As a 

result of the gift, legal title to the property is vested indefeasibly 

in the child. During the child's minority, however, the custodian has 

the power to sell and reinvest the property; to pay over amounts for 

the support, maintenance, and benefit of the minor; or to accumulate 

income in the custodian's discretion. 

Results similar to that achieved by a transfer under UGMA may be 

obtained by transferring property to a trust or to a court-appointed 

guardian. Parents also may shift income-producing assets to their 

children, without relinquishing control over the assets, by 

contributing such assets to a partnership or S corporation and giving 

the children partnership interests or shares of stock. 

Reasons for Change 

Under current law, a family may reduce its aggregate tax liability 

by splitting assets among family members. So-called income splitting 

is a common tax-planning technique. Parents frequently tranfser 

assets to their children so that a portion of the family income will 

be taxed at the child's lower marginal tax rate. 

Income splitting undermines the progressive rate structure and is 

a source of unfairness in the tax system. It increases the relative 

tax burden of taxpayers who are unable to use this device, either 

because they do not have significant investment assets or do not have 

children. 

The ability to shift investment income to children under current 

law is primarily of benefit to wealthy taxpayers. A family whose 

income consists largely of wages earned by one or both parents pays 

- 92 - 
tax on that income at the marginal rate of the parents. Even though 

the income is used in part for the living expenses of the children, 

parents may not allocate a portion of their salary to their children 

and have it taxed at the children's lower tax rates. Moreover, 

parents with modest savings may not be able to afford to transfer such 

savings to their children; thus, such families must pay tax on the 

income from their savings at the parents' marginal tax rate. Farcilies 

with larger amounts of capital, however, can afford to transfer some 

of it to the children, thereby shifting the income to lower tax 

brackets. Use of a trust or a gift under UGMA allows the parents to 

achieve this result without relinquishing control over the property 

until the children come of age. 

Proposal 

Unearned income of children under 14 years of age that is 

attributable to property received from their parents would be taxed at 

the marginal tax rate of their parents. This rule would apply only to 

the extent that the child's unearned income exceeded the personal 

exemption ($2,000 under the Treasury Department proposals). The 

child's tax liability on such unearned income would be equal to the 

additional tax that his or her parents would owe if such income were 

added to the parents' taxable income and reported on their return. If 

the parents reported a net loss on their return, the child's tax 

liability would be computed as if his or her parents' taxable income 

was zero. If more than one child has unearned income which is taxable 

at the parents' rate, such income would be aggregated and added to the 

parents' taxable income. Each child would then be liable for a 

proportionate part of the incremental tax. 

property received from a parent, unless the income was derived from a 

qualified segregated account. A child who receives money or property 

from someone other than a parent, such as another relative, or who 

earns income, could place such property or earnings into a qualified 

segregated account. No amount received directly or indirectly from a 

parent could be placed into such an account. 

be the adoptive parent or parents. In the case of a foster child, the 

parents would be either the natural parents or the foster parents, at 

the child's election. If the parents are married and file a joint 

return, the child's tax would be computed with reference to the 

parents' joint income. If the parents live together as of the close 

of the taxable year, but do not file a joint return (i.e., file 

separate returns if married or file as single individuals), then the 

child's tax would be computed with reference to the income of the 

parent with the higher taxable income. If the parents do not file a 

joint return and are not living together as of the close of the 

taxable year, the child's tax would be computed with reference to the 

income of the parent having custody of the child for the greater 

portion of the taxable year. 

All unearned income of a child would be treated as attributable to 

For purposes of this provision, an adopted child's parents would 

- 93 - 
Expenses that are properly attributable to the child's unearned 

income would be allowed as deductions against such income. Itemized 

deductions generally would be allocated between earned and unearned 

income in any manner chosen by the taxpayer. Interest expense, 

however, would be deductible against unearned income that is taxable 

at the parents' tax rate only if it was attributable to debt that was 

assumed by the child in connection with a transfer of property from 

the parents, or to debt that encumbered such property at the time of 

the transfer. 

The personal exemption would be used first against income from a 

qualified segregated account and then against other unearned income. 

Thus, such income would not be taxable unless the child's total 

unearned income was greater than the personal exemption. Earned 

income and income from a qualified segregated account in excess of the 

personal exemption would be taxable (after subtracting the zero 

bracket amount or itemized deductions) under the rate schedule 

applicable to single individuals, starting at the lowest rate. 

(Unlike current law, the zero bracket amount could be used against 

both the child's earned income and unearned income from a segregated 

account. ) 

The proposed taxation of income of children under 14 years of age 

may be illustrated by the following example. Assume that a child had 

$3,000 of income from a qualified segregated account, other unearned 

income of $2,000, and earned income of $500. The personal exemption 

($2,000) would be used against the qualified segregated account 

income, leaving $1,000 of such income plus $500 of earned income 

subject to tax at the child's rate. No tax on this $1,500 would be 

due, since it would be less than the zero bracket amount. The $2,000 

unearned income would be subject to tax at the parents' rate. If the 

child had itemized deductions, they could be used against either this 

$2,000 or against the $1,500 taxable at the child's rate. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

The proposal would help to ensure the integrity of the progressive 

tax rate structure, which is designed to impose tax burdens in 

accordance with each taxpayer's ability to pay. Families would be 

taxed at the rate applicable to the total earned and unearned income 

of the parents, including income from property that the parents 

transferred to the children's names. The current tax incentive for 

transferring investment property to minor children would be 

eliminated. 

Under the proposal, the unearned income of a minor child under 14 

years of age would be taxed at his or her parent's rate. This is the 

age at which children may work in certain employment under the Fair 

- 94 - 
Labor Standards Act. In addition, in most cases the income tax return 

of a child under 14 years of age is prepared by or on behalf of the 

parent and signed by the parent as guardian of the child. Thus, in 

most cases, the requirement that a child's income be aggregated with 

that of his or her parents would not create a problem of 

confidentiality with respect to the parents' return information, since 

there would be no need to divulge this information to the child. 

Only children required to file a return under current law would be 

required to do so under the proposal. In 1981, only 612,000 persons 

who filed returns reporting unearned income were claimed as dependents 

on another taxpayer's return. This represents less than one percent 

of the number of children claimed as dependents in that year. 

Although the return would generally be filed by a parent on behalf of 

a child, liability for the tax would rest, as under current law, on 

the child. 

- 95 - 
REVISE GRANTOR AND NON-GRANTOR TRUST TAXATION 

Genetal Explanation 

Chaptet 3.25 

Current Law 

In General 

The manner in which the income from property held in trust is 

taxed depends upon the extent to which the grantor has retained an 

interest in the trust. A so-called "grantor trust," a trust in which 

the grantor has retained a proscribed interest, is treated as owned by 

the grantor and the trust's income is taxable directly to the grantor. 

Non-grantor trusts, including "Clifford trusts," on the other hand, 

are treated as separate taxpayers for Federal income tax purposes, 

with trust income subject to a separate graduated rate structure. 

The rules for determining whether a trust will be treated as a 

grantor trust are highly complex. In general, however, the test is 

whether the grantor has retained an interest in the trust's assets or 

income or is able to exercise certain administrative powers. For 

example, to the extent that the grantor (or a party whose interests 

are not adverse to the grantor) has the right to vest the trust's 

income or assets in the grantor, the trust will be treated as a 

grantor trust. Similarly, to the extent that the trust's assets or 

income may reasonably be expected to revert to the grantor within ten 

years of the trust's creation, the trust will generally be treated as 

a grantor trust. 

In general, the income of a non-grantor trust is subject to one 

level of tax; it is taxable either to the trust itself or to the 

beneficiaries of the trust. Under this general model, trust income is 

included as gross income of the trust, but distributions of such 

income to trust beneficiaries are deductible by the trust and 

includible in the income of the beneficiaries. 

The maximum distribution deduction permitted to a trust, and the 

maximum amount includible in the income of trust beneficiaries, is the 

trust's "distributable net income" (DNI). A trust's DNI consists of 

its taxable income computed with certain modifications, the most 

significant of which are the subtraction of most capital gain and the 

addition of any tax-exempt income earned by the trust. 

To the extent that a trust distribution carries out DNI to a 

beneficiary, the trust essentially serves as a conduit, with the 

beneficiary taking into account separately his or her share of 

each trust item included in DNI. Under a complex set of rules, the 

computation of each beneficiary's share of an item of trust income 

generally depends upon the amount distributed to the beneficiary and 

the "tier" to which the beneficiary belongs. A distribution that does 

- 96 - 
not carry out DNI -- such as one in satisfaction of a gift or bequest 

of specific property or a specific sum of money, or one in excess of 

DNI -- is not deductible by the trust and is not includible in the 

recipient's income. Similarly, because capital gains generally are 

excluded from the computation of DNI, a trust ordinarily is subject to 

taxation on the entire amount of its capital gain income even when it 

distributes an amount in excess of its DNI. 

Adoption of Taxable Year 

The trustee of a non-grantor trust may select a year ending on the 

last day of any month as the trust's taxable year. Although a trust 

distribution that carries out DNI is generally deductibLe by the trust 

in the taxable year during which it is made, the distribution is not 

t;:,.:able to the beneficiary until his or her taxable year with which or 

in which the trust's taxable year ends. Thus, for example, if an 

individual is a calendar-year taxpayer and is the beneficiary of a 

trust with a taxable year ending January 31, distributions made by the 

trust with respect to its year ending January 31, 1984, will not be 

subject to tax until the beneficiary's year ending December 31, 1984, 

even if they were made as early as February 1983. 

Throwback Rules 

The so-called "throwback rules" are applicable only to trusts that 

accumulate income rather than distribute it currently to the 

beneficiaries. These rules limit the use of a trust as a device to 

accumulate income at a marginal tax rate lower than that of the 

beneficiaries. DNI that is accumulated rather than distributed 

currently becomes undistributed net income (UNI) and may be subject to 

additional tax when distributed to the beneficiaries. 

The rules for determining the amount, if any, of such additional 

tax are complex. In general, however, if a trust's current 

distributions exceed its DNI and the trust has UNI from prior taxable 

years, the excess distributions (to the extent of UNI) will be taxed 

at the beneficiary's average marginal tax rate over a specified period 

preceding the distribution as reduced by a credit for the tax paid by 

the trust on such UNI. 

Reasons for Change 

Taxpayer Fairness 

The treatment of trusts as separate taxpayers with a separate 

graduated rate structure is inconsistent with a basic principle of the 

ta.x system that all income of an individual taxpayer should be subject 

to tax under the same progressive rate structure. The primary 

purposes of a trust are to manage investment assets and to allocate 

the income from those assets to beneficiaries. If trust income is to 

be taxed at a rate that is consistent with the purpose of the 

progressive rate structure, it should be taxed currently to those who 

have control over or receive the benefit of the trust's income. Where 

- 91 - 
the grantor may reasonably be considered to have retained control or 

enjoyment of the trust, the trust's income is included appropriately 

in the grantor's income or taxed at the grantor's marginal tax rate; 

where the grantor has effectively divested himself of control and 

enjoyment, the income should be taxed to the beneficial owners of the 

trust. There is no persuasive justification for taxing a trust under 

its own graduated rate structure. The lowest marginal tax rate is 

designed to protect low-income individuals from paying an undue 

percentage of their income as tax. Although this rationale applies to 

individual trust beneficiaries, it does not apply to trusts as 

separate entities. 

splitting between trusts and beneficiaries in order to take advantage 

of trusts' separate rate structure, these rules often do not recapture 

the tax savings from the accumulation of income inside the trust. The 

throwback formula, for example, often does not properly reflect 

whether the beneficiary's tax rate declined between the time of 

accumulation and distribution. In addition, the throwback rules do 

not take into account the benefit of the deferral of tax during the 

period between the income accumulation and the taxation of an 

accumulation distribution. Finally, the throwback rules are wholly 

inapplicable to income accumulated while the beneficiary is under 

21 years of age as well as to retained capital gain income. 

Present law also permits a grantor to shift income to family 

members through creation of a trust, even when the grantor retains 

significant control over or a beneficial interest in the trust's 

assets. For example, trust income will not be taxed to the grantor 

even though the trust's assets will revert to the grantor as soon as 

ten years after the trust's creation. Similarly, trust income will 

not be taxed to the grantor even though the grantor appoints himself 

or herself as trustee with certain discretionary powers to accumulate 

income or distribute trust assets. Significantly broader discretion 

over trust income and distributions may be vested in an independent 

trustee, who, though not formally subject to the grantor's control, 

may be expected to exercise his or her discretion in a manner that 

minimizes the aggregate tax burden of the trust's grantor and 

beneficiaries. 

Although the throwback rules are designed to prevent income 

Efficiency and Simplification 

The significant income-splitting advantages that may be gained by 

placing income-producing assets in trust have resulted in greater 

utilization of the trust device than would be justified by non-tax 

economic considerations. Moreover, even where there are non-tax 

reasons for a trust's creation, tax considerations heavily influence 

the trustee's determination of whether to accumulate or distribute 

trust income. No discernable social policy is served by this tax 

incentive for the creation of trusts and the accumulation of income 

within them. Thus, current tax policy has not only sacrificed tax 

- 98 - 
revenue with respect to trust income, it also has encouraged 

artificial and inefficient arrangements for the ownership and 

management of property. 

The tax advantages that current law provides to trusts also have 

spawned a complex array of anti-abuse provisions. The grantor trust 

rules and the throwback rules are highly complex and often arbitrary 

in their application. Rules that attribute capital gain of certain 

non-grantor trusts to the grantor are also complex in operation and 

can have unforeseen consequences to trust grantors. In addition, the 

fact that the tax benefits of the trust form can be increased through 

the creation of multiple trusts has resulted in the creation of 

numerous trusts with essentially similar dispositive provisions. This 

"multiple trust" problem has necessitated a statutory response that 

would be unnecessary if the tax benefits of creating trusts could be 

minimized. 

Proposal 

Taxation of Trusts During Lifetime of Grantor 

1. Overview 

During the lifetime of the grantor, all trusts created by the 

grantor would be divided into two categories: trusts that are treated 

as owned by the grantor for Federal income tax purposes, because the 

grantor has retained a present interest in or control over the trust 

property; and trusts that are not treated as owned by the grantor, 

because the grantor does not have any present interest in or control 

over the property. As under current law, the income of a trust 

classified as a grantor-owned trust generally would be taxed directly 

to the grantor to the extent that the grantor is treated as the owner. 

A non-grantor-owned trust generally would be respected as a separate 

taxable entity. During the grantor's lifetime, however, income would 

be taxed to the trust at the grantor's marginal tax rate, unless the 

trust instrument requires the distribution of income to specified 

beneficiaries. 

2. Grantor-owned trusts 

The grantor would be treated as the owner of a trust to the extent 

that (i) payments of property or income are required to be made 

currently to the grantor or the grantor's spouse; (ii) payments of 

property or income may be made currently to the grantor or the 

grantor's spouse under a discretionary power held in whole or in part 

by either one of then; (iii) the grantor or the grantor's spouse has 

any power to amend or to revoke the trust and cause distributions of 

property to be made to either one of them; (iv) the grantor or the 

grantor's spouse has any power to cause the trustee to lend trust 

income or corpus to eith2r of them; or (v) the grantor or the 

grantor's spouse has borrowed trust income or corpus and has not 

completely repaid the loan or any interest thereon before the 

beginning of the taxable year. For purposes of these rules, the fact 

- 99 - 
that a power held by the grantor or the grantor's spouse could be 

exercised only with the consent of another person or persons would be 

irrelevant, regardless of whether such person or persons would be 

characterized as "adverse parties" under present law. 

may be treated as owner of a trust would be retained and made 

consistent with these rules. A grantor or other person who is treated 

as the owner of any portion of a trust under these rules would be 

subject to tax on the income of such portion. Transactions between 

the trust and its owner would be disregarded for Federal income tax 

purposes where appropriate. 

The present law rules under which a person other than the grantor 

3, Non-grantor-owned trusts 

(a) _zr?. general. A trust that is not treated as owned by the 

grancor or by any other person under the rules described above would 

be subject to tax as a separate entity. Unlike present law, however, 

non-grantor-owned trusts would be required to adopt the same taxable 

year as the grantor, thereby limiting the use of fiscal years by 

trusts to defer the taxation of trust income. 

The trust would compute its taxable income in the same manner as 

an individual, but would not be entitled to a zero bracket amount or a 

personal exemption (or deduction in lieu of a personal exemption). 

The trust would be entitled to a deduction for charitable 

contributions, but only to the extent that the grantor would have 

received a deduction if the grantor were the owner of the entire 

trust. Thus, if the grantor's charitable contributions were less than 

two percent of his or her adjusted gross income, the trust would 

receive a charitable contribution deduction only to the extent that 

its contributions exceed the sum of the (i) grantor's unused 

charitable deduction floor and (ii) two percent of the trust's 

adjusted gross income. See Ch. 3.18. In order to be deductible, a 

charitable contribution would have to be made within 65 days of the 

close of the trust's taxable year. 

deductibility of distributions made by a trust to non-charitable 

beneficiaries would be substantially changed. First, during the 

lifetime of the grantor, only mandatory distributions would be 

deductible by a trust. A distribution would qualify for this 

deduction only if a fixed or ascertainable amount of trust income or 

property is required to be distributed to a specific beneficiary or 

beneficiaries. As under present law, distributions required to be 

made would be deductible regardless of whether actually made by the 

trustee. 

(b) Distribution deduction. The present rules regarding the 

The amount of a mandatory distribution would be considered fixed 

or ascertainable if expressed in the governing instrument as a portion 

or percentage of trust income. The requirement that each 

beneficiary's share be fixed or ascertainable also would be satisfied 

by a requirement that distributions be made on a per capita or per 

- 100 - 
stirpital basis that does not give any person the right to vary the 

beneficiaries' proportionate interests. Thus, distributions would not 

qualify as mandatory if the governing instrument requires the 

distribution of all income among a class of beneficiaries, but gives 

any person the right to vary the proportionate interests of the 

members of the class in trust income. 

A distri.bution would be considered mandatory if required upon the 

happening of an event not within the control of the grantor, the 

grantor's spouse, or the trustee, such as the marriage of a 

beneficiary or the exercise by an adult beneficiary of an unrestricted 

power of withdrawal. The requirement that the governing instrument 

specify the beneficiary or beneficiaries of a mandatory distribution 

would be satisfied if a class of beneficiaiies were specified and 

particular beneficiaries could be added or removed only upon the 

happening of certain events not within the control of the grantor, 

grantor's spouse, or trustee, such as the birth or adoption of a 

child, marriage, divorce, or attainment of a certain age. 

set aside for a beneficiary would be treated as a mandatory 

distribution, provided the amount set aside is required to be 

distributed ultimately to the beneficiary or the benefi,ciary's estate, 

or is subject to a power exercisable by the beneficiary the possession 

of which will cause the property to be included in the benefici,ary's 

estate for Federal estate tax purposes. Thus, the trustee could 

designate property as irrevocably set aside for a beneficiary and 

obtain a distribution deduction (proviled that a distribution or 

set-aside is mandatory under the governing instrument) without making 

an actual distribution to the beneficiary. 

If the tax imposed on a beneficiary by reason of a set-aside 

exceeds the amount actually distributed to the beneficiary in any 

year, the beneficiary could be permitted under the governing 

instrument to obtain a contribution from the trustee equal to the tax 

liability imposed by reason of the set-aside (less any amounts 

previously distributed to the beneficiary during the taxable year). 

Such contribution would be paid out of the amount set aside, and 

therefore would not carry out additional DNI. This structure, unlike 

present law, would permit a fiduciary to obtain the benefit of a 

beneficiary's lower tax bracket through an irrevocable set-aside. 

Accordingly, tax motivations would not override non-tax factors which 

might indicate that an actual distribution is undesirable. 

Second, unli,ke present law, property required to be irrevocably 

Third, whether mandatory or not, distributions to non-charitable 

beneficiaries would not be deductible during the lifetime of the 

grantor under the following circumstances indicating incomplete 

relinquishment of interest i,n or dominion and control over the trust: 

(i) If any person has the discretionary power to make 

distri,butions of corpus or income to the grantor or the 

grantor's spouse; 

- 101 - 
If any portion of the trust may revert to the grantor or 

the grantor's spouse, unless the reversion cannot occur 

prior to the death of the income beneficiary of such 

portion and such beneficiary is younger than the grantor, 

or prior to the expiration of a term of years that is 

greater than the life expectancy of the grantor at the 

creation or the funding of the trust; 

If any person has the power exercisable in a non-fiduciary 

capacity to control trust investments, to deal with the 

trust for less than full and adequate consideration, or to 

exercise any general administrative powers in a 

non-fiduciary capacity without the consent of a fiduciary; 

If and to the extent that an otherwise deductible mandatory 

distribution satisfies a legal obligation of the grantor or 

grantor's spouse, including a legal obligation of support 

or maintenance; or 

If trust income or corpus can be used to carry premiums on 

life insurance policies on the life of the grantor or the 

grantor's spouse with respect to which the grantor or the 

grantor's spouse possesses any incident of ownership. 

(c) Computation of tax liability. Once the taxable income of an 

inter vivos trust has been computed under the rules described above, 

the trust's tax liability would be determined. This liability would 

be the excess of (i) the tax liability that would have been imposed on 

the grantor had the trust's taxable income been added to the greater 

of zero or the grantor's taxable income and reported on the grantor's 

return, over (ii) the tax liability that is actually imposed on the 

grantor. Thus, the trust's tax liability generally would equal the 

incremental amount of tax that the grantor would have paid had the 

trust been classified as a grantor trust, with two exceptions. First, 

to avoid the difficulty associated with any recomputation of a 

grantor's net operating loss carryover and other complexities, if the 

grantor has incurred a loss in the taxable year or in a prior taxable 

year, such loss would be disregarded and the grantor would be deemed 

to have a taxable income of zero for purposes of computing the trust's 

tax liability. Second, the addition of the trust's taxable income to 

the taxable income of the grantor would not affect the computation of 

the grantor's taxable income. For example, trust income would not be 

attributed to the grantor for purposes of determining the grantor's 

floor on various deductions. See Ch. 3.18 and Ch. 4.03. 

If the grantor has created more than one non-grantor trust, then 

each such trust would be liable for a proportionate share of the tax 

that would result from adding their aggregate taxable income to the 

greater of zero or the grantor's taxable income. If one or more 

trusts do not cooperate with the grantor and other trusts in 

determining their tax liability under these rules, the trusts failing 

to cooperate would be subject to the highest marginal rate applicable 

to individuals and would be ineligible for the charitable contribution 

- 102 - 
deduction. Similarly, if the grantor does not provide a trustee with 

information sufficient to enable the trustee to compute the trust's 

tax liability under these rules, the trustee would be required to 

assume (for purposes of computing the trust's tax) that the grantor 

had taxable income placing him or her in the highest marginal rate and 

had an unused charitable deduction floor that exceeds the trust's 

charitable contributions. 

(d) Taxation of beneficiaries. As under current law, 

distributions to beneficiaries that are deductible bv a trust would be 

taxable to the beneficiaries, with the trust's DNI representing the 

maximum amount deductible by the trust and includible in the income of 

the beneficiaries. Capital gain deemed to be distributed would be 

included in the computation of the trust's DNI. Capital gain income 

would be deemed to be distributed if the trust instrument requires 

that it be distributed or if and to the extent that mandatory 

distributions and set-asides exceed DNI (as computed without regard to 

such gain). Each recipient of a required distribution or set-aside 

would take into account his or her proportionate share of DNI. Thus, 

the tier rules of present law would be eliminated. Each item entering 

the computation of DNI, including capital gains that are deemed to be 

distributed and hence are included in DNI, would be allocated among 

the beneficiaries and the trust, based on the proportionate amounts 

distributed to or set aside for each beneficiary. 

(e) Multiple grantors. For purposes of determining whether the 

grantor is the owner of any portion of a trust, and for purposes of 

determining whether a mandatory distribution is deductible, if there 

is more than one grantor, a trust would be treated as consisting of 

separate trusts with respect to each grantor. If a husband and wife 

are both grantors with respect to a trust, however, they would be 

entitled to elect one of them to be treated as the grantor with 

respect to the entire trust. Once made, such an election would be 

irrevocable and would apply to all subsequent transfers made during 

the course of the marriage by either spouse. 

Taxation of Trusts After Death of Grantor 

For all taxable years beginning after the death of an individual, 

all inter vivos and testamentary trusts established by such individual 

would compute their taxable income as in the case of an individual, 

but with no zero bracket amount, no personal exemption (or deduction 

in lieu of a personal exemption), and with a distribution deduction 

for all distributions or set-asides required to be made and for all 

distributions and set-asides, whether mandatory or discretionary, 

actually made to or for non-charitable beneficiaries. As under 

present law, distributions made within 65 days of the close of the 

taxable year would be treated as made on the last day of the taxable 

year. A similar rule would apply to set-asides. Charitable 

contributions would be fully deductible to the extent that they exceed 

two percent of the trust's adjusted gross income. All trusts would 

- 103 - 
compute DNI in the same manner as non-grantor trusts. Any taxable 

income of the trust would be subject to tax at the highest individual 

marginal rate. 

For the taxable year in which the grantor's death occurs, a 

grantor-owned trust would close a short taxable year ending with the 

date of the grantor's death, and its income for such period would be 

taxed to the grantor as under present law. For the remainder of the 

taxable year, the trust would compute its taxable income with a 

distribution deduction computed under the post-death rules. Rather 

than being subject to tax at the highest marginal rate, however, the 

trust would compute its tax liability for this short taxable period by 

adding its taxable income to the taxable income of the grantor for the 

grantor's final taxable year. 

non-grantor-owned inter vivos trust would compute taxable income in 

the same manner as before the death of the grantor. Accordingly, such 

a trust would be entitled to a deduction for qualifying distributions 

to charity and for all mandatory distributions or set-asides with 

respect to non-charitable beneficiaries. The trust's taxable year 

would not terminate with the death of the grantor, but the trust would 

be entitled to a distribution deduction under the post-death rules for 

all distributions or set-asides made after the grantor's death. As 

with taxable years ending before the grantor's death, the trust would 

compute its tax liability for the grantor's final year by reference to 

the taxable income of the grantor. 

Testamentary trusts would compute their income using the same 

taxable year as the decedent and the decedent's estate. A 

testamentary trust created before the end of the taxable year of the 

decedent's death would compute its tax liability for its first (short) 

taxable year along with all other trusts created by the decedent, by 

reference to the decedent's taxable income for that year. 

For the period ending with the death of the grantor, a 

Effective Date 

The proposal would apply generally to irrevocable trusts created 

after the date that legislation containing the proposal is introduced 

and to trusts that are revocable on the date that the legislation is 

introduced, for taxable years beginning on or after January 1, 1986. 

A trust that is irrevocable on the date that the legislation is 

introduced would nevertheless be treated as created after the date 

that the legislation is introduced if any amount is transferred to 

such trust after such date. Similarly, a trust that is revocable on 

the date that the legislation is introduced and that becomes 

irrevocable after such date would be treated as a new 

trust for purposes of these rules. A trust that is created after the 

date that legislation is introduced, but prior to January 1, 1986, 

would be required to adopt the taxable year of the grantor. 

- 104 - 
For trusts that are irrevocable on the date that the legislation 

is introduced, the proposal would apply according to the following 

rules. Trusts that are grantor trusts under present law would be 

subject to the new rules beginning with the first taxable year of the 

grantor that begins on or after January 1, 1986. If a trust that is 

classified as a grantor trust under present law is classified as a 

non-grantor trust uqder the new rules, however, it would be entitled 

to elect to be treated as if the grantor were the owner for Federal 

income tax purposes (such election to be made jointly by the grantor 

and the trustee). 

legislation is introduced and are not classified as grantor trusts 

under present law, the proposal would apply to taxable years beginning 

on or after January 1, 1986, with the following exceptions. First, if 

such a trust has already validly elected a fiscal year other than the 

grantor's taxable year on the date the legislation is introduced, the 

trust would be entitled to retain that year as its taxable year. In a 

case where the grantor and the trust have different taxable years, the 

trust would compute its tax liability by reference to the grantor's 

income for the grantor's taxable year ending within the taxable year 

of the trust. Second, such trusts would be entitled to a distribution 

deduction for all distributions and set-asides, whether discretionary 

or mandatory, made during the grantor's lifetime. Finally, such 

trusts would be entitled to elect to continue the tier system of 

present law for allocating DNI among trust beneficiaries. 

the throwback rules generally would be repealed. However, 

distributions out of previously accumulated income would be subject to 

tax in the hands of the beneficiary when distributed. Because the 

beneficiary's rate of tax may be significantly lower than under 

current law, the beneficiary would not be entitled to any credit for 

the taxes previously paid by the trust. The trust would be able to 

avoid application of this transitional throwback rule by a 

distribution or set-aside on the last day of the taxable year 

beginning prior to January 1, 1986, or by paying a tax at th? trust 

level on UNI subject to the throwback rules based on the highest 

individual rate applicable under present law (with a credit for taxes 

previously paid by the trust). 

With respect to trusts that are irrevocable on the date that the 

With respect to income accumulated prior to the January 1, 1986, 

Analysi 6 

Because all trust income would be taxed to the grantor, taxed to 

trust beneficiaries, taxed to the trust at the grantoz's marginal rate 

(during the grantor's lifetime), or taxed to the trust at the highest 

individual rate (after the grantor's death), the proposal would 

eliminate the use of trusts as an income-splitting device. In this 

respect, the proposal would reinforce the integrity of the progressive 

rate structure and thus enhance the fairness of the tax system. 

- 105 - 
The proposal would, in general, permit the use of non-grantor 

trusts to shift income among family members only if distributions or 

set-asides are mandatory and only if the grantor has effectively 

relinquished all rights in the trust property (other than the exercise 

of certain powers as trustee). In addition, present law would be 

liberalized in that amounts irrevocably set aside for a beneficiary 

would be treated as actually distributed. At the same time, wholly 

discretionary distributions would be ineffective to shift income to 

trust beneficiaries regardless of the identity of the trustee. 

The proposal also would result in substantial simplification of 

the rules for taxation of trust income. The throwback rules, the tier 

system, and the special rule taxing some trust capital gain to the 

grantor would be repealed. In addition, the present grantor trust 

rules would be replaced by rules causing trusts to be taxed as grantor 

trusts or denying a distribution deduction in fairly limited 

circumstances. Requiring virtually all new trusts to use a calendar 

year would eliminate the artificial tax advantage often created by the 

selection of fiscal years. The simplicity created by these rules 

would more than offset whatever complexity is created by taxing inter 

vivos trusts at the grantor's marginal rate in certain circumstances. 

The removal of the artificial tax advantages of trusts would cause 

decisions regarding the creation of trusts to be based on non-tax 

considerations. For example, because the income of a ten-year 

"Clifford" trust would be taxed at the grantor's marginal rate with no 

distribution deduction, such trusts would be created only where 

warranted by non-tax considerations. At the same time, however, the 

proposal would not impose a tax penalty on the use of a trust to hold 

and to manage a family's assets. At the worst, during the grantor's 

lifetime, trust income would be taxed as if the grantor had not 

established the trust. Although accumulated income would be taxed at 

the highest individual rate following the grantor's death, the 

deduction for set-asides as well as actual distributions would give 

the trustee ample flexibility to minimize the aggregate tax burden on 

trust income without making distributions. 

- 106 - 
REVISE INCOME TAXATION OF ESTATES 

General Explanation 

Chapter 3.26 

Current Law 

flnder present law, a decedent's estate is recognized as a separate 

taxable entity for Federal income tax purposes. The separate 

existence of the estate begins with the death of the decedent, and the 

estate computes its income without regard to the decedent's taxable 

income for the period prior to the decedent's death. Because the 

estate's separate existence begins with the decedent's death, the 

estate is entitled to adopt its own taxable year without regard to the 

taxable year of the decedent or the taxable year of any beneficiary of 

the estate. Furthermore, any trust created by the decedent's will is 

entitled to select its own taxable year without regard to the year 

selected by the estate. 

An estate generally computes its income in the same manner as an 

individual, with a $600 deduction allowed in lieu of the personal 

exemption. The amount of tax on an estate's income generally is 

determined in the same manner as a trust -- with a deduction allowed 

for distributions not in excess of distributable net income (DNI) -- 

except that the throwback rules applicable to trusts do not apply to 

estates. Thus, an estate can accumulate taxable income using its 

separate graduated rate structure and distribute the income in a later 

year free of any additional tax liability. 

Under present law, the decedent's final return includes all items 

properly includible by the decedent in income for the period ending 

with the date of his death. All income received or accrued after the 

date of death is taxed to the estate rather than the decedent. The 

decedent's surviving spouse may elect, however, to file a joint 

Federal income tax return for the taxable year in which the decedent's 

death occurs. 

Reasons for Change 

to continue the period of administration for as long as possible in 

order to take advantage of the estate's separate graduated rate 

structure. Although current regulations provide for termination of an 

estate as a separate entity if the period of administration is 

unreasonably prolonged, the regulations are generally ineffective and 

seldom applied. Even where the period of administration is not 

unnecessarily extended, the inapplicability of the throwback rules to 

estates creates the likelihood that estate income will be subject to 

tax at a lower rate than the marginal tax bracket of the ultimate 

recipient. 

Present law provides an incentive for the fiduciary of an estate 

- 107 - 
The availability to an estate of a taxable year other than the 

calendar year creates tax avoidance opportunities. By appropriately 

timing distributions to beneficiaries of the estate, tax on income 

generated in the estate may be deferred for a full year. This 

deferral potential is exacerbated through the use of different fiscal 

years by testamentary trusts. 

income among the maximum number of t.axpayers acd thereby minimize the 

aggregate tax burden imposed on estate income. The current rules for 

taxation of income during the tazable year in which the decedent dies 

create additional distortions. There is no necessary correlation 

between the timing of items of income and deduction and the date of 

death. Thus, for example, deductible expenses incurred prior to the 

date of death are not matched against income received after the date 

of death. This can result in the wasting of deductions on the 

decedent's final return or the stacking of income in the decedent's 

estate. 

Estates can also use "trapping distributions" to allocate estate 

- 108 - 

Proposal 

The rules governing the taxation of estates would be changed so 

that the decedent's final taxable year would continue through the end 

of the taxable year in which his death occurs. Distributions by the 

decedent's personal representative to beneficiaries of the decedent's 

estate would not give rise to a distribution deduction against the 

decedent's income. 

The first taxable year of the estate as a separate entity would be 

the first taxable year beginning after the decedent's death. The 

estate would be subject to tax at a separate rate schedule, with no 

zero bracket amount, no personal exemption (or deduction in lieu of a 

personal exemption), and no deduction for distributions to 

beneficiaries. 

At its election, however, an estate could compute its taxable 

income in the same manner as any trust following the death of the 

grantor. The election, once made, would apply to all subsequent 

years. Thus, the estate would be entitled to a deduction for 

distributions or set-asides that carry out DNI, and such distributions 

or set-asides would be taxable to the beneficiaries. Any amount of an 

estate's taxable income not distributed or irrevocably set aside 

currently would be subject to tax at the highest individual marginal 

rate. For this purpose, set-asides and distributions made within 65 

days of the close of the taxable year would be treated as made on the 

last day of the taxable year. As under present law, distributions 

or set-asides that are made in satisfaction of a bequest or gift of 

specific property or a specific sum of money would not carry out DNI, 

although an estate (or trust) would be entitled to elect to have 

specific gifts 01 bequests carry out DNI (with the consent of the 
distributee). Appropriate rules would be provided to limit the 

ability of estates to obtain unintended tax benefits by prolonging 

their administration. 

Effective Date 

The proposal would apply to estates of decedents dying on or after 

January 1, 1986. 

Analysis 

By placing estates on the same taxable year as the decedent, the 

proposal would eliminate the selection of a taxable year for an estate 

that defers the taxation of the estate's income. Moreover, the denial 

of a distribution deduction would prevent the splitting of income 

between the estate and its beneficiaries, while permitting estate 

income to be taxed under a separate rate schedule. In cases in which 

the absence of a distribution deduction was undesirable, however, the 

executor could elect to have the estate taxed ifs if it were a 

post-death trust. 

- 109 - 
CHAPTER 4 

SIMPLIFICATION 

Simplification is advanced by a number of the Treasury Department 

p oposals discussed in other chapters, This chapter is devoted to 

proposals particularly aimed at simplifying the tax system for 

individuals. The greatest simplification for individuals could come 

from a fundamental change in the procedures for collecting tax 

liabilities -- the elimination of the income tax return for many 

taxpayers. The Internal Revenue Service will consider implementing a 

return-free system for taxpayers who today file uncomplicated returns 

The proposals also would repeal the minimum tax for individuals, 

the political contribution credit and the presidential campaign 

check-off, and the adoption expense deduction. A floor would be 

imposed on employee business expenses and miscellaneous itemized 

deductions. 

- 110 - 
STUDY RETURN-FREE SYSTEM 

General Explanation 

Chapter 4.01 

Current Law 

file income tax returns each year. 

Individuals whose income exceeds specified levels are required to 

Reasons for Change 

The requirement to file income tax returns imposes a paperwork 

burden on taxpayers. This burden should be reduced to the extent 

consistent with sound tax administration. 

Proposal 

The Internal Revenue Service is considering the implementation of 

a return-free tax system. Individual taxpayers who meet requirements 

to be specified by the Internal Revenue Service would not be required 

to file income tax returns. Under a return-free system, the Internal 

Revenue Service would, at the election of each eligible taxpayer, 

compute the taxpayer's liability, based on withholding and information 

reports provided to the Internal Revenue Service currently. The 

taxpayer would be sent a report, which would set forth the taxpayer's 

tax liability, and the taxpayer would be free to challenge the 

Internal Revenue Service's calculation of tax. 

Analysis 

Institution of the return-free system, together with the increases 

in zero bracket amounts and the personal exemptions, would 

substantially reduce the number of returns that taxpayers need to file 

with the Internal Revenue Service each year. This, in turn, would 

eliminate burdensome recordkeeping required of taxpayers and costs 

incurred by them in preparing returns. The return-free system would 

initially be limited to single wage earners with uncomplicated 

financial transactions, roughly the 15 million taxpayers now filing 

the simplified Form 1040EZ. After a pilot program, the system could 

be extended to other individual taxpayers, and by 1990, roughly 66 

percent of all taxpayers could be covered by the return-free system. 

It is estimated that at this level of participation the return-free 

system would save taxpayers annually approximately 97 million hours 

and $1.9 billion in fees paid to professional tax preparers. 

- 111 - 
REPEAL ALTERNATIVE MINIMUM TAX 

General Explanation 

Chapter 4.02 

Current Law 

Taxpayers whose taxable incomes are substantially reduced by 

specified "items of tax preference" are subject to "minimum taxes" 

which may increase their overall tax liabilities. Noncorporate 

taxpayers with substantial tax preferences are subject to the 

"alternative r,lnimun; -ax." 

Noncorporate taxpayers whose regular tax liabilities are 

substantially reduced by tax preferences are, in effect, subject to 

the alternative minimum tax (AMT) in lieu of the regular income tax. 

The AMT is equal to 20 percent of the excess of the taxpayer's 

"alternative minimum taxable income" (AMTI) over an exemption 

amount.h/ A taxpayer's AMTI is computed by (a) adding tax preferences 

back to adjusted gross income, (b) subtracting the "alternative tax 

itemized deductions," and fc) making adjustments for net operating 

loss carryovers and certain trust distributions included in income 

under the so-called "throwback rules." The alternative tax itemized 

deductions include (a) casualty losses, (b) charitable contributions, 

(c) a portion of deductible medical expenses, (d) certain interest 

expenses (including interest on debt incurred to acquire the 

taxpayer's principal residence), and (e) estate taxes attributable to 

income in respect of a decedent. The exemption amount for the AMT is 

(a) $40,000 for a joint return or a surviving spouse, (b) $30,000 for 

a single taxpayer, and (c) $20,000 for other noncorporate taxpayers. 

Items of tax preference generally include: 

(a) interest and dividends excluded from gross income; 

(b) the excess of accelerated over straight-line depreciation for 

real property and leased personal property (other than recovery 

property); 

(c) in the case of recovery property other than leased 18-year real 

property, the excess of ACRS deductions over depreciation 

- */ The statutory term "alternative minimum tax" actually refers to 

the excess of (1) 20% of AMTI less the exemption amount over (2) 

the regular income tax. This excess is imposed in addition to 

the regular tax. For convenience, however, the terms 

"alternative minimum tax" and "AMT," as used herein, will refer 

to the sum of the true alternative minimum tax and the regular 

income tax. 

- 112 - 
deductions that would have been allowed had the property been 

depreciated using under the straight-line method over prescribed 

(extended) recovery periods; 

(d) the tax preference for capital gains; 

(e) the excess of amortization deductions for pollution control 

facilities over depreciation deductions that would otherwise have 

been allowable in the absence of special amortization; 

(f) in the case of mining exploration and development costs and 

circulation expenditures, the excess of the amount allowable as a 

deduction over the amount that would have been allowable had such 

costs or expenditures been amortized over a ten-year period; 

(9) in the case of intangible drilling and development costs of oil, 

gas, and geothermal properties, the amount by which (i) the 

excess of the amount allowable as a deduction over the amount 

that would have been allowable had such costs been amortized over 

a ten-year period, exceeds (ii) the taxpayer's net income from 

oil, gas, and geothermal properties; 

depletable property; and 

incentive stock option, the excess of the fair market value over 

the option price. 

(h) the excess of depletion deductions over the basis of the 

(i) in the case of stock transferred pursuant to the exercise of an 

Reasons For Change 

The alternative and corporate minimum taxes were originally 

enacted as part of the Tax Reform Act of 1969 to ensure that "all 

taxpayers are required to pay significant amounts of tax on their 

economic income." The measures (originally a single minimum tax for 

all taxpayers) were considered necessary because, as concluded by 

Congress, "many individuals and corporations did not pay tax on a 

substantial part of their economic income as a result of the receipt 

of various kinds of tax-favored income or special deductions." 

ambivalence about the desirability and effectiveness of the tax 

preferences subject to the tax. For example, percentage depletion and 

accelerated methods of depreciation have traditionally been allowed in 

part to subsidize the cost of productive depreciable assets and 

mineral production activities. However, Congress disapproved the 

necessary consequence that taxpayers receiving the bulk of their 

income from nonpreferred activities were taxed at relatively higher 

rates than taxpayers engaged in activities, such as real estate or 

natural resource production, that benefitted from tax preferences. 

The judgment that a minimum tax is necessary reflects an 

- 113 - 
The ambivalence in current law toward tax preferences reflects 

significant doubt about their fairness, efficiency, costs in lost 

revenue and consequent effect on marginal tax rates. In general, the 

Treasury Department proposals accept these doubts as well founded and 

seek to redesign the income tax base to approximate more closely 

economic income. If the proposals were fully implemented, the 

alternative minimum tax would be unnecessary. 

To the extent that (1) existing tax preferences (which generally 

cause a taxpayer's taxable income to be less than economic income) are 

phased out over an extended period, or (2) taxpayers currently holding 

tax-favored assets are permitted to retain benefits not available for 

after-acquired assets, immediate repeal of the alternative minimum tax 

would be inappropriate. 

Proposal 

The alternative minimum tax would be repealed 

Effective Date 

The repeal would be effective for taxable years beginning on or 

after January 1, 1990. 

Analysis 

Currently, between 100,000 and 200,000 individuals, generally 

with large incomes, are subject to the alternative minimum tax. 

Because of the ANT'S complexity and its interactions with numerous 

deductions and tax computations, many more taxpayers -- perhaps 

several million -- must actually compute the AMT to determine if they 

are subject to it. In addition to its computational complexity and 

burdens, the presence or potential presence of the AMT obscures the 

tax consequences of certain activities. Because the impact of the AMT 

may not be determinable until after the close of the taxable year, 

taxpayers are likely to act in ways that are not economically 

efficient, and, hence, do not allocate resources efficiently and do 

not maximize economic output. 

- 11.4 - 
IMPOSE FLOOR ON EMPLOYEE BUSINESS EXPENSE AND OTHER 

MISCELLANEOUS DEDUCTIONS 

General Explanation 

Chapter 4.03 

Current Law 

Four categories of employee business expenses may be deducted by 

taxpayers regardless of whether they itemize deductions. These are: 

o expenses paid by the employee and reimbursed by the employer; 

o employee expenses of travel, meals, and lodging while away from 

home ; 

o employee transportation expenses; and 

o business expenses of employees who are outside salesmen. 

Various miscellaneous itemized deductions are allowed for 

taxpayers who itemize deductions. These miscellaneous itemized 

deductions comprise all itemized deductions other than medical 

expenses, charitable contributions, interest, taxes, and theft and 

casualty losses. They include: 

o employee business expenses other than those described above, 

including educational expenses, union and professional dues, 

safety equipment, small tools, supplies, uniforms, protective 

clothing, professional subscriptions, and employment agency 

fees; 

o gambling losses not in excess of gambling winnings; 

o expenses of producing certain income, including fees for 

investment services, safe deposit box rentals, trustee fees, 

and tax return preparation and tax advice fess. 

Reasons for Change 

Allowance of the various employee business expense deductions and 

the miscellaneous itemized deductions complicates recordkeeping for 

many taxpayers. Moreover, the small amounts that are typically 

involved present significant administrative and enforcement problems 

for the Internal Revenue Service. These deductions are also a source 

of numerous taxpayer errors concerning what amounts and what items are 

properly deductible. 

- 115 - 
Proposal 

employer) and the miscellaneous itemized deductions would be 

consolidated into a single category, together with the deduction for 

State and local taxes (other than income taxes) which are currently 

required to be itemized but which are incurred in carrying on an 

income-producing activity. To the extent that these items, in the 

aggregate, exceed one percent of a taxpayer's adjuste6 gross income 

(AGI), they would be deductible by the taxpayer, whether or not he 

itemizes deductions. In lieu of a deduction, employer reimbursements 

would be excluded from the employee's income to the extent that the 

employee would have been entitled to a deduction without regard to the 

one percent floor. 

Employee business expenses (other than those reimbursed by the 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

analysis 

Disallowance of a deduction for a normal level of employee 

business expenses and miscellaneous itemized deductions would simplify 

recordkeeping, reduce taxpayer errors and ease administrative burdens 

for the Internal Revenue Service while still providing fair treatment 

for taxpayers who incur an unusually high level of such expenses. 

In 1982, one-half of all itemizers claimed miscellaneous 

deductions of less than one-half of one percent of their AGI. 

Fifty-eight percent claimed deductions of less than one percent of 

their AGI, and 93 percent claimed deductions of less than five percent 

of their AGI. Thus, introduction of a "floor" or "threshold" of one 

percent of AGI would substantially reduce the number of returns 

claiming this deduction. The proposed extension of the miscellaneous 

deduction to nonitemizers would partially offset the revenue gain from 

introduction of the floor. 

the reduction in marginal tax rates. Any increase in tax liability 

resulting from this proposal should be more than offset by the reduced 

marginal rates and the increase in the zero bracket amount and the 

personal exemption. 

The proposal would broaden the tax base and, thus, contribute to 

- 116 - 
REPEAL POLITICAL CONTRIBUTION CREDIT 

General Explanation 

Chapter 4.04 

Current Law 

Individuals are allowed a nonrefundable tax credit for 

contributions to political candidates and political action committees. 

The credit equals one-half of the first $100 ($200 for joint returns) 

of an individual's contributions during the year. 

Reasons For Change 

The tax credit for political campaign contributions is not 

related to the proper measurement of income, but rather is intended to 

encourage individuals to contribute to the cost of the political 

process. The actual effect of the political contribution credit in 

producing additional political contributions is open to question. The 

credit produces no marginal incentive for taxpayers who without regard 

to the credit would make contributions of $100 or more. The credit 

also creates no incentive for low-income individuals who have no 

income tax liability. 

The political contribution credit presents administrative and 

compliance problems for the Internal Revenue Service. The subject 

matter of the credit may involve the Internal Revenue Service in 

sensitive inquiries about political affiliation. Moreover, the small 

dollar amounts involved on each tax return make verification difficult 

and expensive relative to the amounts involved. There are some 

indications that increasing numbers of taxpayers may be claiming 

credits for which no contributions have been made. 

Finally, the political contribution credit creates complexity for 

taxpayers. It adds a line to income tax forms, and, for honest 

taxpayers, entails an additional recordkeeping burden. 

Proposal 

The credit for political contributions would be repealed. 

Effective Date 

The repeal would be effective for taxable years beginning on or 

after January 1, 1986. 

~nalysis 

5.2 million returns, or about 6.6 percent of all individual returns 

with some tax liability before deducting tax credits. 

In 1982, the political contribution credit was claimed on about 

- 117 - 

459-813 0 - 84 - 5 
As shown in Table 1, the number of users of the credit is skewed 

heavily toward higher-income taxpayers. Only 2.8 percent of all 

returns with income of $10,000 or less (and with some tax liability) 

used the credit whereas 38.4 percent of all returns with income of 

$100,000 or more claimed the credit. However, because the credit is 

limited to $50 ($100 on joint returns), tax benefits slighly favor 

those in lower-income brackets. In 1982, the Federal revenue loss 

from the credit was $270 million. The percentage distribution of 

those benefits is shown in the Table 1. 

Table 1 

Use'of the Political Contributions Tax Credit - 1982 

Percentage Distribution Distribution 

of Returns of Tax Benefit of Tax 

C 1 a i mi ng from Credit Liability 

AGI Class Credit 1/ (p ercentaqes) (p ercentaqes) 

I 

$ 0 to 9,999 

10,000 to 19,999 

20,000 to 29,999 

30,000 to 49,999 

50,000 to 99,999 

100,000 and over 

2.8 8.2 

4.5 17.1 

6.5 20.9 

10.0 29.4 

20.8 16.6 

38.4 7.8 

2.5 

12.5 

18.8 

30.8 

18.2 

17.2 

All Returns 6.6 100.0 100.0 

Office of the Secretary of the Treasury November 30, 1984 

- 1/ Percentage of all returns with some tax liability before tax 

Office of Tax Analysis 

credits. 

Even if a large portion of the tax reduction attributable to the 

credit is not simply a windfall benefit to taxpayers who would have 

made a contribution anyway, the total subsidy from the credit 

represents only a relatively small portion of total political campaign 

expenditures in the United States. 

tax liability for any group of taxpayers. 

Repeal of the credit would not cause a significant increase in 

- 118 - 
REPEAL PRESIDENTIAL CAMPAIGN CHECK-OFF 

General Explanation 

Chapter 4.05 

Current Law 

The Presidential election campaign check-off permits each 

individual who has income tax liability to elect to have one dollar of 

that liability used to finance Presidential election campaigns. By 

statute, the check-off information must be either on the first page of 

the income tax return or on the page that bears the taxpayer's 

signature. 

Reasons For Change 

purposes of the income tax and is a source of complexity for 

taxpayers. The check-off does not directly affect individual tax 

liabilities, but simply allows taxpayers to direct that a small 

portion of their taxes be spent in a particular way. The use of the 

tax return system for this purpose is unique to the campaign 

check-off. For the many taxpayers who do not understand its purpose 

or effect, the check-off is a source of confusion. In addition, the 

check-off complicates tax forms, significantly in the case of the 

shorter forms, such as the 1040EZ. 

Proposal 

The Presidential election campaign check-off is unrelated to the 

The Presidential election campaign check-off would be repealed. 

Effective Date 

The repeal would be effective for tax liability in taxable years 

beginning on or after January 1, 1986. 

Analysis 

Approximately one-fourth of all taxpayers (one-third of those 

taxpayers with some income tax liability) use this provision to 

earmark funds for Presidential campaigns. The percentage of taxpayers 

using the provision varies somewhat between election and none1,ection 

years. 

Since use of the campaign check-off does not increase any 

individual's income tax liability, taxpayers would not be adversely 

affected by repeal of this provision. Repeal of the check-off would 

eliminate public funds for Presidential campaigns unless direct 

appropriations were provided. 

- 119 - 
REPEAL ADOPTION EXPENSE DEDUCTION 

General Explanation 

Chapter 4.06 

Current Law 

Current law permits a deduction for "qualified adoption expenses" 

paid or incurred during the taxable year. In general, qualified 

adoption expenses include the reasonable and necessary adoption fees, 

court costs, attorney's fees, and other expenses directly related to 

the legal adoption of a "child with special needs" as defined in the 

Social Security Act. 

The maximum amount of qualified adoption expenses that may be 

deducted with respect to a child is $1,500. Moreover, no expense may 

be deducted as a qualified adoption expense if a credit or deduction 

is otherwise allowable for such expense or if such expense is paid for 

by a grant from a Federal, State or local program. 

Reasons for Change 

The allowance of a deduction for certain adoption expenses is an 

inappropriate way of providing Federal support for those who adopt 

children with special needs. Federal programs supporting such 

children or the families who adopt them should be under the 

supervision and control of agencies familiar with their needs. Such 

agencies should also have budgetary responsibility for costs of 

programs serving these purposes. Providing Federal support through 

the tax system is inconsistent with each of these objectives. 

Proposal 

The deduction for qualified adoption expenses would be repealed 

and replaced by a direct expenditure program. 

Effective Date 

The proposal would generally be effective for taxable years 

beginning on or after January 1, 1987 and would generally apply to 

expenses paid or incured after such date. Taxpayers having incurred 

qualified adoption expenses with respect to a child prior to the date 

the proposal is introduced in legislation would be entitled to deduct 

qualified adoption expenses incurred after the effective date with 

respect to such child. 

Analysis 

It is anticipated that a direct expenditure program would be 

enacted to continue Federal support for families adopting children 

with special needs. The effective date of such program should be 

coordinated with the proposed repeal of the curreiit deduction. 

- 120 - 
CKRPTER 5 

OTHER MISCELLANEOUS REFORMS 

This Chapter discusses proposals to reform the moving expense and 

income averaging provisions. The limits on moving expenses would be 

increased to reflect current costs. Income averaging would be 

modified in line with its original. purposes, by denying it to persons 

who were full-time students during the base period. 

- 121 - 
INCREASE LIMITS ON MOVING EXPENSES 

General Explanation 

Chapter 5.01 

Current Law 

An employee or self-employed individual is allowed a deduction in 

computing adjusted gross income for certain moving expenses incurred 

in connection with the commencement of work at a new principal place 

of work. Direct costs of moving (costs of moving household goods and 

personal effects and traveling from the former residence to the new 

residence, including the cost of meals and lodging en route) are 

deductible regardless of amount, provided that they are reasonable. 

In addition, certain indirect costs of moving are deductible, subject 

to a dollar limitation. Deductible indirect costs include: 

(1) temporary living expenses (for up to 30 days) at a new job 

(2) expenses of round trip travel (including meals and lodging), 

after obtaining employment, from the former residence to the 

general location of the new principal place of work for the 

purpose of searching for a new residence; and 

residence, such as real estate commissions and State transfer 

taxes. 

location; 

(3) certain expenses incident to a sale, purchase, or lease of a 

The deduction for indirect costs is limited to $3,000, with the 

deduction for items (1) and (2) combined not to exceed $1,500 of the 

$3,000. A husband and wife who begin work at a new principal place of 

employment in the same general location are subject to a single $3,000 

(and $1,500) limitation. 

In order for moving expenses to be deductible, the taxpayer's new 

principal place of work must be at least 35 miles farther from his 

former residence than was his former principal place of work. For a 

taxpayer with no former principal place of work, the new principal 

place of work must be at least 35 miles from his former residence. In 

addition, the taxpayer must generally either (a) be a full-time 

employee for at least 39 weeks during the 12-month period immediately 

following arrival at the general location of the new principal place 

of work, or (b) perform services as an employee or self-employed 

individual (or both) on a full-time basis in such general location for 

at least 78 weeks during the 24-month period immediately following 

arrival at the general location (of which at least 39 weeks must be 

during the 12-month period immediately following arrival). 

- 122 - 
Similar rules apply to moving expenses incurred in connection 

with the commencement of work at a new principal place of work outside 

the United States. In these cases, the dollar limitation on indirect 

costs is $6,000, with a limit of $4,500 on items (1) and (2). 

Reasons for Change 

Moving expenses that are related to a change or relocation in 

employment are properly deductible as an expense of producing income. 

Available data indicates, however, that the fixed limits on indirect 

moving expenses are inadequate in relation to the actual costs of 

moving. A review of moving expense deductions in 1979 revealed that a 

typical taxpayer's indirect moving expenses were approaching $10,000. 

Inflation has since increased the level of such expenses. 

costs of business-related moves for either the employer or the 

employee. Costs for employers increase where moving expense 

reimbursements are increased to account for taxation of the 

reimbursement to the employee. The after-tax cost of moving also 

increases for employees who are not reimbursed and who cannot deduct 

all of their legitimate moving expenses. These extra costs adversely 

affect the mobility of the labor force and thus reduce the efficiency 

of the economy generally. 

Inadequate deduction limits for moving expenses increase the 

Proposal 

The overall dollar limitation on the deduction for indirect 

moving expenses would be increased from $3,000 to $10,000. The dollar 

limitation applicable to temporary living expenses and round trip 

travel expenses (items (1) and (2) above) would be increased from 

$1,500 to $3,000. 

For moves from the United States to a foreign country, the 

overall dollar limitation would be increased from $6,000 to $10,000, 

and the limitation applicable to items (1) and (2) would be increased 

from $4,500 to $6,000. Moves from one foreign country to another 

foreign country would be subject to the same limitations that apply to 

moves within the United States. 

All dollar limitations would be subject to indexing for future 

inflation. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

- 123 - 
Analysis 

Although costs incurred for all indirect moving expenses have 

increased, the costs associated with the sale, purchase and rental of 

housing (item 3 above) have shown the most significant increases. 

These expenses generally are a stable percentage of the cost of 

housing, which has increased greatly. For this reason, the proposed 

increase in the dollar limitation that is applicable to such expenses 

is proportionately greater than the proposed increase for other 

indirect moving expenses. 

moving expenses incurred by employees of the Internal Revenue Service. 

The proposed dollar limitations generally would cover the indirect 

moving expenses (including real estate commissions, transfer taxes, 

and other transaction costs) incurred by taxpayers in connection with 

the transfer of an average-priced house in the United States. 

However, because the cost of housing varies throughout the country, 

the proposed limits may not cover all legitimate indirect moving 

expenses in some areas. In particular, the costs associated with 

transferring even an average-priced house is expected to exceed the 

limits in some high-cost areas. Larger increases in the dollar 

limitations, however, would cause a significant increase in the 

revenue loss and, more importantly, would permit taxpayers who do no 

not live in high-cost areas to deduct costs associated with an 

extremely high standard of living. Such costs are in the nature of 

personal expenses and should not be deductible. 

need for periodic review of the statute. 

The proposed dollar limitations are based on data on the average 

The proposal to index the dollar limitations would minimize the 

- 124 - 
RESTRICT INCOME AVERAGING 

FOR FULL-TIME STUDENTS 

General Explanation 

Chapter 5.02 

Current Law 

Because of the progressive tax rate structure, an individual whose 

income varies widely from year to year pays more tax over a period of 

years than an individual who earns comparable income evenly over the 

same period. The income averaging provisions mitigate this effect. 

Under these provisions, if an eligible individual's income for the 

taxable year exceeds 140 percent of his average income for the three 

preceding years ("base years"), the effective tax rate applicable to 

such excess income ("averageble income") generally will be the rate 

that would apply to one-fourth of the averageble income. The 

individual's tax liability will be an amount equal to the sum of (i) 

the tax on 140 percent of the three-year base period income, plus (ii) 

four times the extra tax from stacking one-fourth of the averageble 

income on top of 140 percent of base period income. 

Two basic eligibility requirements restrict the availability of 

income averaging. First, the individual must have been a citizen or 

resident of the United States during the current year and each of the 

base years. Second, the individual (and the individual's spouse) 

generally must have provided at least 50 percent of his or her support 

during each of the three base years. This support test need not be 

satisfied if: 

(1) the individual has attained the age of 25 and was not a 

full-time student during at least four years after attaining 

the age of 21; 

current year is attributable to work performed during two or 

more of the base years; or 

(3) the individual files a joint return for the current year and 

not more than 25 percent of the aggregate adjusted gross income 

on the joint return is attributable to such individual. 

(2) more than one-half of the individual's taxable income for the 

In the case of an individual filing a joint return, the above 

requirements must be met by both the individual and the individual's 

spouse. 

of the base years is permitted to use income averaging, provided that 

he or she is otherwise eligible. 

An individual who has been a full-time student during any or all 

- 125 - 
Reasons for Change 

Income averaging is intended primarily to benefit taxpayers with 

widely fluctuating incomes. Under current law, however, taxpayers 

with sharp but sustained increases in income, typically young persons 

entering the job market for the first time, may qualify for income 

averaging and benefit substantially from it. The availability of 

income averaging to such persons is inconsistent with the principles 

of the progressive tax structure. 

The availability of income averaging to individuals who were 

full-time students during the base period is also a source of 

complexity. Application of the support test to full-time students is 

difficult and a frequent source of contention between taxpayers and 

the Internal Revenue Service. The case-by-case determinations that 

are required represent an administrative burden and prevent any fair 

and consistent application of the eligibility rules. 

Proposal 

A taxpayer who was a full-time student in any base year would not 

be eligible for income averaging. This rule, however, would not apply 

where an individual files a joint return and 25 percent or less of the 

adjusted gross income reportable on the joint return is attributable 

to the individual. Thus, the benefits of income averaging would be 

available in situations where one spouse was a full-time student 

during one or more of the base years but had a relatively 

insubstantial amount of income in the current year. 

rule for taxpayers who are 25 years of age or older and were not 

full-time students during at least four of the years after they 

reached 21 years of age would be eliminated. 

In conformity with these changes, the exception to the support 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

The proposal would help restrict income averaging to its intended 

beneficiaries -- taxpayers whose incomes fluctuate widely from year to 

year. By reducing the number of taxpayers using the complex income 

averaging provisions, the proposal would simplify the tax system. The 

proposed flattening of the tax rate schedule also should reduce the 

number of taxpayers who use income averaging. 

- 126 - 
CHAPTER 6 

CORPORATE TAX RATES 

The Treasury Department proposals would define the corporate tax 

base more accurately and comprehensively. The corporate income tax 

rate could thus be reduced to 33 percent. Moreover, the corporate 

minimum tax and the personal holding company tax could be repealed. 

- 127 - 
REDUCE CORPORATE INCOME TAX RATES 

General Explanation 

Chapter 6.01 

Current Law 

In general, a tax is imposed on the taxable income of corporations 

at a maximum rate of 46 percent for all such income in excess of 

$100,000. For corporate income under $100,000, tax generally is 

imposed under the following schedule: 

(1) 15 percent of so much of the taxable income as does not 

(2) 18 percent of so much of the taxable income as exceeds 

(3) 30 percent of so much of the taxable income as exceeds 

(4) 40 percent of so much of the taxable income as exceeds 

The graduated rates are phased out for corporations with taxable 

income over $1,000,000, so that corporations with taxable income of 

$1,405,000 or more pay, in effect, a flat tax at the 46 percent rate 

exceed $25,000; 

$25,000 but does not exceed $50,000; 

$50,000 but does not exceed $75,000; and 

$75,000 but does not exceed $100,000. 

Reasons for Change 

The current corporate income tax structure overtaxes some 

corporations and undertaxes others. Although corporations generally 

are subject to a uniform rate structure, the base of income subject to 

tax differs depending on the extent to which corporations are able to 

generate preferred sources of income or deductions. For corporations 

with overstated deductions or losses, or deferred or exempt income, 

the effective rate of tax may be far below the prescribed statutory 

rate. By broadening the base of corporate income, corporate tax rates 

can be reduced and made applicable on a more nearly uniform basis. 

income serves no affirmative purpose and encourages the use of 

corporations to gain the advantage of low marginal tax rates. The 

progressive rate structure for individuals is premised on the 

ability-to-pay concept, which in turn reflects an assumption that 

additional amounts of income are increasingly available for 

discretionary, nonessential consumption. These concepts have no 

relevance to corporate income, all of which is either distributed or 

used to produce additional income. Moreover, under current law a 

small corporation can escape high marginal tax rates on corporate 

income by electing pass-through treatment as an S corporation. 

In addition, the current progressive rate structure for corporate 

- 128 - 
Finally, the Treasury Department proposals include partial dividend 

relief, which would mitigate the impact of corporate tax rates on a11 

corporations. See Chapter 7.01. 

The current low rates of tax for certain amounts of corporate 

income permit the use of corporations as tax shelters for individuals. 

Thus, an individual may attempt to accumulate investment income within 

a corporation in order to defer tax on the income at the individual's 

rate. Where the corporate rate is significantly below the 

individual's marginal rate, the deferral advantage can more than 

offset the extra burden of the corporate tax. Current law attempts to 

limit this use of the corporate form through a surtax on the 

undistributed income of "personal holding companies." The personal 

holding company rules are complex and not uniformly effective. 

multiple corporations in order to maximize income taxed at the lowest 

rates. The current rules limiting this use of the corporate form are 

again complex and not consistently effective. 

The progressive tax structure for corporate income also encourages 

Proposal 

The present corporate rate structure would be replaced by a flat 

tax rate for corporations of 33 percent. 

Effective Date 

The reduction in the maximum corporate tax rate to 33 percent 

would be effective for taxable years beginning on or after July 1, 

1986. 

For corporations formed after the date legislation is introduced, 

the repeal of the graduated corporate rate structure would be 

effective for taxable years beginning on or after July 1, 1986. For 

corporations formed on or before such date, the repeal of the 

graduated rate structure would be phased in. For these corporations, 

the one-half of the rate increase necessary to raise the lower bracket 

rates to 33 percent would be implemented for taxable years beginning 

on or after July 1, 1986, but before January 1, 1987. For taxable 

years beginning on or after January 1, 1987, all corporations would be 

subject to the flat rate. 

Analysis 

Elimination of the graduated corporate rate structure would 

generally make unnecessary the current provisions concerning domestic 

personal holding companies and mul.tiple surtax exemptions. 

Accordingly, those provisions would be repealed to the extent 

appropriate for taxable years beginning on or after January 1, 1987, 

when repeal of the graduated corporate rate structure is complete. 

- 129 - 
REPEAL CORPORATE MINIMUM TAX 

General Explanation 

Chapter 6.02 

Current Law 

Taxpayers whose taxable incomes are substantially reduced by 

specified "items of tax preference" are subject to "minimum 

taxes" which may increase their overall tax liabilities. 

Corporations with substantial tax preferences ate subject to the 

add-on corporate minimum tax. 

In general, the corporate minimum tax (CMT) is equal to 15 

percent of the amount by which the taxpayer's items of tax 

preference exceed the greater of (a) $10,000 or (b) the regular 

corporate income tax for the taxable year (without regard to the 

accumulated earnings tax or personal holding company tax, if any, 

and reduced by most allowable tax credits). 

Items of tax preference, in general (some are applicable 

(a) the excess of accelerated over straight-line depreciation for 

real property and leased personal property (other than recovery 

(b) in the case of recovery property other than leased 18-year 

real property, the excess of ACRS deductions over depreciation 

deductions that would have been allowed had the property been 

depreciated using under the straight-line method over prescribed 

(extended) recovery periods; 

(c) the tax preference for long-term capital gains; 

(d) the excess of amortization deductions for pollution control 

facilities over the depreciation deductions which would otherwise 

have been allowable in the absence of special amortization; 

(e) in the case of mining exploration and development costs and 

circulation expenditures, the excess of the amount allowable as a 

deduction over the amount which would have been allowable had 

such costs or expenditures been amortized over a ten-year period; 

(f) in the case of intangible drilling and development costs of 

oil, gas, and geothermal properties, the amount by which (i) the 

excess of the amount allowable as a deduction over the amount 

which would have been allowable had such costs been amortized 

over a ten-year period, exceeds (ii) the taxpayer's net income 

from oil, gas, and geothermal properties; 

only to personal holding companies), include: 

property); 

- 130 - 
(9) the excess of a financial institution's deduction for bad 

debt reserves over the deduction that would have been allowable 

had the institution maintained its reserves on the basis of 

actual experience; and 

(h) the excess of depletion deductions over the basis of the 

depletable property. 

Reasons For Change 

The minimum taxes for both individuals and corporations were 

originally enacted as part of the Tax Reform Act of 1969 to ensure 

that "all taxpayers are required to pay significant amounts of tax on 

their economic income." The measures (originally a single minimum tax 

for all taxpayers) were considered necessary because, as concluded by 

Congress, "many individuals and corporations did not pay tax on a 

substantial part of their economic income as a result of the receipt 

of various kinds of tax-favored income or special deductions." 

ambivalence about the desirability and effectiveness of the tax 

preferences subject to the tax. For example, percentage depletion and 

accelerated methods of depreciation have traditionally been allowed in 

part to subsidize the cost of productive depreciable assets and 

mineral production activities. However, Congress disapproved the 

consequence that taxpayers receiving the bulk of their income from 

nonpreferred activities were taxed at relatively higher rates than 

taxpayers engaged in activities, such as real estate or natural 

resource production, that benefitted from tax preferences. 

The judgment that a minimum tax is necessary reflects an 

The ambivalence in current law toward tax preferences reflects 

significant doubt about their fairness, efficiency, costs in lost 

revenue, and consequent effect on marginal tax rates. In general, the 

Treasury Department proposals accept these doubts as well founded and 

seek to redesign the income tax base to more closely approximate 

economic income. If the proposals were fully implemented, the 

corporate minimum tax would be unnecessary. 

To the extent that (1) existing tax preferences (which generally 

cause a taxpayer's taxable income to be less than economic income) are 

phased out over an extended period, or (2) taxpayers currently holding 

tax-favored assets are permitted to retain benefits not available for 

after-acquired assets, immediate repeal of the corporate minimum taxes 

would be inappropriate. 

Proposal 

The corporate minimum tax would be repealed. 

Effective Date 

The repeal would be effective for taxable years beginning on or 

after January 1, 1990. 

- 13.1 - 
Anal ys i 6 

Once the corporate tax base is redefined under the proposals to 

approximate economic income, the need for the corporate minimum tax is 

eliminated. A by-product of repeal is a slight reduction in the 

tax-filing burden for the approximately ten thousand corporations who 

currently pay some minimum tax as well as the computations for most 

other large corporations which are necessary to determine that they do 

not, in fact, have any minimum tax liability. 

- 132 - 
CHAPTER 7 

TAXATION OF BUSINESS ORGANIZATIONS 

Equity investment in the corporate sector is discouraged by the 

relatively high effective rate of taxation imposed on the return from 

such investment. The only relief provided by current law from the 

relatively high rate, caused by the double taxation of corporate 

dividends, is the exclusion available to individual shareholders for 

the first $100 of dividend income received. The Treasury Department 

proposes to repeal this exclusion and to institute a corporate-level 

deduction for 50 percent of previously taxed corporate earnings paid 

out as dividends. 

Investors are able to form limited partnerships that closely 

resemble corporations, but are not so treated for tax purposes. The 

Treasury Department proposal would classify certain large limited 

partnerships as corporations subject to the corporate income tax. 

- 133 - 
REDUCE DOUBLE TAXATION OF CORPORATE EARNINGS 

DISTRIBUTED TO SHAREHOLDERS 

General Explanation 

Chapter 7.01 

Current Law 

In general, corporations are treated as taxpaying entities 

separate from their shareholders for Federal income tax purposes. 

Thus, a corporation separately reports and is directly taxable on its 

income. Correspondingly, the income of a corporation is not taxable 

to its shareholders until actually distributed to them. An exception 

to these rules is provided on an elective basis under Subchapter S of 

the Code. Taxable income of an S corporation is allocated among and 

taxed directly to its shareholders. This pass-through tax regime is 

limited to corporations meeting certain requirements, including that 

the corporation have only one class of stock and 35 or fewer 

shareholders. 

Dividends paid by corporations other than S corporations are taxed 

to individual shareholders as ordinary income (except for a $100 per 

year exclusion). Corporate shareholders generally are taxed on only 

15 percent of dividends received from other corporations, and are not 

subject to tax on dividends received from certain affiliated domestic 

corporations, such as controlled subsidiaries. Corporations are not 

entitled to a deduction for dividends paid to shareholders. Consequently, corporate taxable income paid as dividends to individual 

shareholders generally bears two taxes, the corporate income tax and 

the individual income tax. Corporations are permitted, however, to 

deduct interest paid on corporate indebtedness, even if paid to creditors who also are shareholders. 

Corporate distributions to shareholders generally are taxable 

"dividends" to the extent of (i) the corporation's earnings and profits in the year of distribution plus (ii) earnings and profits accumulated in prior years. In concept, a corporation's earnings and 

profits represent its ability to make distributions to shareholders 

without impairing invested capital, Thus, earnings and profits, in 

general, measure economic income of the corporation available for 

distribution to shareholders. Distributions to shareholders in excess 

of current and accumulated earnings and profits first reduce the 

shareholders' basis in their stock, and, to the extent of the excess, 

are taxed as amounts received in exchange for the stock. 

If a corporation redeems its stock from a shareholder, the distribution from the corporation generally is treated as a payment in 

exchange for the stock and any resulting gain to the shareholder is 

taxed as a capital gain. Similarly, amounts received by a shareholder 

in a distribution in complete liquidation of the corporation are 

- 134 - 
treated as payments in exchange for the stock. Such sale or exchange 

treatment also applies to distributions in partial liquidation to 

noncorporate shareholders. 

Reasons for Change 

Distortions in Economic Behavior. The disparate tax treatment of 

debt and equitv in the corporate sector distorts a variety of 

decisions concerning a corporation's capita1,ization as weil as its 

policies with regard to investment or distribution of earnings. 

Because interest payments are deductible by a corporation and dividend 

distributions are not, corporate earnings distributed to shareholders 

are subject to both corporate and shareholder income taxes, whereas 

corporate earnings distributed as interest are taxable only to the 

creditor. The effective double taxation of dividends encourages 

corporations to finance their operations with debt rather than equity. 

This reliance on debt capital increases the vulnerability of 

corporations both to the risks of bankruptcy and to cyclical changes 

in the economy. 

The different treatment of interest and dividends under current 

law also places great significance on rules for distinguishing debt 

from equity. Historically, the distinction for tax purposes has 

rested on a series of general factors which have been given different 

weight depending on the circumstances of the taxpayer and on the 

particular court making the determination. This approach has 

increasingly generated uncertainty, especially as more sophisticated 

financial instruments have merged the traditional characteristics of 

debt and equity. Although attempts have been made to formulate and 

codify more or less mechanical tests for distinguishing debt from 

equity, no consensus exists concerning the proper criteria for such 

tests, Considerable uncertainty thus remains under current law as to 

whether instruments will be treated as debt or equity for tax 

purposes. 

The doub1.e taxation of earnings distributed as dividends to 

shareholders also affects corporate distribution policy in ways that 

detract from the efficiency of the economy. Corporations with 

shareholders in relatively high tax brackets are encouraged to retain 

earnings, in order to defer shareholder level income tax. 

Corporations with shareholders who are tax exempt or in relatively low 

tax brackets are encouraged to distribute earnings, so that the 

shareholders may invest those earnings without bearing future 

cerporate-level income tax. These incentives for or against 

distribution of earnings interfere with ordinary market incentives to 

place funds in the hands of the most efficient users. 

The double taxation of corporate earnings distributed to shareholders also increases the cost of capital for corporations and 

discourages capital-intensive means of production in the corporate 

sector. Similarly, double taxation discriminates against goods and 

services that are more readily produced or provided by the corporate 

sector as well as activities customarily engaged in by corporations. 

Investors are thus discouraged from using the corporate form, even 

- 135 - 
in circumstances where nontax considerations make it desirable. The 

elective provisions of Subchapter S provide only limited relief from 

these effects. 

Proposal 

Deduction for Dividends Paid. The double taxation of corporate 

earnings distributed as dividends would be partially relieved under 

the proposal by allowing domestic corporations, other than those 

subject to special tax regimes (e.g., regulated investment companies), 

a deduction equal to 50 percent of dividends paid to their 

shareholders ("dividends paid deduction"). The amount of dividends 

subject to the dividends paid deduction would be limited, however, to 

ensure that the deduction is allowed only with respect to dividends 

attributable to corporate earnings that have borne the regular corporate income tax. Thus, relief from double taxation of dividends would 

be provided only when the income with respect to which the dividends 

are paid is actually taxed at the corporate level. The dividends paid 

deduction, therefore, would not be available with respect to corporate 

distributions from so-called tax preference income. 

The limitation on the source of deductible dividends would be provided by requiring every corporation to maintain a Qualified Dividend 

Account. The amount of dividends with respect to which a deduction 

could be claimed in any taxable year would be limited to the Qualified 

Dividend ACCOUnt balance as of the end of the year during which the 

dividends were paid. Dividends paid during a taxable year in excess 

of the Qualified Dividend Account balance as of the end of the year 

would not be eligible for the dividends paid deduction. Moreover, 

these excess dividends could not be carried forward and deducted with 

respect to amounts added to the Qualified Dividend Account in subsequent years. 

have borne the regular corporate tax, less any deductible dividends 

paid by the corporation. Thus, the Qualified Dividend Account would 

be increased each year by the amount of the corporation's taxable 

income (computed without regard to the dividends paid deduction). The 

amount of taxable income added to the Qualified Dividend Account each 

year, however, would be reduced by the amount of any taxable income 

that, because of any allowable credit, did not actually bear the 

corporate tax. For this purpose, foreign tax credits would be treated 

the same as any other credit. The Qualified Dividend Account would 

thus include none of the corporation's tax preference income. 

The Qualified Dividend Account would be decreased each year by the 

amount of any dividends paid by the corporation with respect to which 

a dividends paid deduction was allowable. Dividends paid during a 

year in excess of the Qualified Dividend Account balance as of the end 

of the year, however, would have no effect. Thus, the Qualified 

Dividend Account balance would never be reduced below zero. As 

The Qualified Dividend Account would consist of all earnings that 

- 136 - 
described below, the Qualified Dividend Account also would be eeduced 

to reflect distributions in redemption or in partial or complete 

liquidation. 

for inflation. Rules would be provided to govern the transferability 

of the Qualified Dividend Account in mergers and acquisitions. 

The dividends paid deduction allowed to corporations would be 

treated similarly to other business deductions. For example, the 

deduction would enter into the determination of a corporation's net 

operating loss and thus could be carried back and forward. Similarly, 

the dividends paid deduction would be taken into account for purposes 

of computing a corporation's estimated tax liability. 

Distributions in Redemption, Partial Liquidation, and Complete 

Liquidation, and Other Corporate Distributions. A corporation would 

be entitled to the dividends paid deduction with respect to 

distributions in redemption of stock, including distributions in 

partial or complete liquidation. Consequently, the Qualified Dividend 

Account would be reduced by the amount of the redemption or liquidation proceeds with respect to which the corporation was entitled 

to a deduction. 

The Qualified Dividend Account balance would be indexed to account 

In the case of a distribution in complete liquidation, the liquidating corporation would be entitled to a dividends paid deduction 

though it had distributed dividends in an amount equal to the 

Qualified Dividend Account balance at the time of the liquidation 

not in excess of the amount of the liquidation proceeds). 

In the case of a distribution in redemption or partial liquida 

tion, the corporation would be entitled to-the divihends paiddeduction as though it had distributed dividends equal to a specif 

portion of the corporation's Qualified Dividend Account. The port 

of the Qualified Dividend Account treated as distributed would be computed using a method similar to the one used under current law to compute the portion of a distribution in redemption that is properly 

chargeable to earnings and profits. Accordingly, the portion of the 

Qualified Dividend Account treated as distributed in redemption or 

partial liquidation generally would be proportionate to the amount of 

the corporation's outstanding stock that is redeemed (but not in 

excess of the amount of proceeds distributed to shareholders). 

as dividends by distributing corporations are treated as dividends for 

tax purposes. These transactions include certain redemptions (section 

302(d)), certain stock purchases by corporations related to the issuer 

(sections 302(d) and 304), certain stock dividends (sections 305(b) 

and (c)), certain sales and other distributions of preferred stock 

(section 306), and certain "boot" received in otherwise tax-free 

reorganizations or divisions (sections 356(a)(2), 356(b), and 356(e)). 

Corporations making distributions to shareholders in such transactions 

would be permitted to treat the distributions as dividends subject to 

under current law, certain transactions not formally denominated 

- 137 - 

as 

but 

ed 

on 
the dividends paid deduction, provided that the corporations tr;eated 

the distributions as dividends for information reporting purposes. In 

the event a distributing corporation did not treat such a distribution 

as a dividend for information reporting purposes and therefore did not 

claim a dividends paid deduction, the Internal Revenue Service would 

have the authority to allow the deduction if the transaction were 

subsequently characterized as a dividend and the corporation and 

shareholder treated the transaction consistently. 

dividends paid to corporate shareholders would ensure that the relief 

from double taxation of corporate earnings would not be available 

until the earnings were distributed outside the corporate sector. In 

addition, current law applicable to the receipt of dividends by 

corporate shareholders would be changed to eliminate the small portion 

of certain dividends (generally 15 percent) that is subject to more 

than two levels of tax. 

Under the proposal, a corporation paying dividends would compute 

its dividends paid deduction without regard to whether the recipient 

shareholders were corporations. A payor corporation, however, would 

be required to report to its corporate shareholders the portion of 

dividends paid to such shareholders that was allowable as a deduction 

to the payor corporation. 

Corporate shareholders would be required to include in their taxable income the portion of dividends for which the payor corporation 

received the dividends paid deduction. Accordingly, the dividends 

received deduction allowable under current law would be reduced to 50 

percent of deductible dividends received. A 100 percent dividends 

received deduction would be allowed, however, with respect to 

dividends that were not deductible by the payor corporation. Thus, a 

corporate shareholder would be entitled to a 100 percent dividends 

received deduction with respect to dividends paid in excess of the 

payor corporation's Qualified Dividend Account balance. 

one-half of the dividends it receives, the full amount of such dividends would increase the corporate shareholder's own Qualified 

Dividend Account balance. This full increase would ensure that the 

relief from double taxation is not diminished simply because of the 

existence of multiple layers of corporate shareholders. 

A foreign corporation would not be eligible for the dividends paid 

deduction. However, the dividends received deduction allowable under 

current law with respect to dividends received by a domestic corporate 

shareholder from a foreign corporation's earnings subject to United 

States corporate tax would be increased to 100 percent of such dividends received. 

Intercorporate Investment. The treatment under the proposal of 

Although a corporate shareholder generally would be taxed on only 

The current law rules that fully tax certain dividends received by 

corporate shareholders would not be changed by the proposal. If, 

therefore, a corporate shareholder would not be entitled to a dedution 

- 138 - 
under current law with respect to the receipt of a particular 

dividend, the dividend would not be subject to the special 

intercorporate rules of the proposal. Accordingly, the payor 

corporation would be eligible for a deduction with respect to the 

dividend paid, the full amount of the dividend would be taken into 

account in computing the corporate shareholder's taxable income, no 

dividends received deduction would be allowed to the shareholder, and 

no special rules would be used to compute the shareholder's Qualified 

Dividend Account. 

The application of these intercorporate rules may be illustrated 

by assuming that a wholly owned subsidiary corporation with a Qualified Dividend Account balance of $1,500 paid a $500 dividend to its 

parent corporation. The entire $500 dividend would be eligible for 

deduction by the subsidiary, which would thus be entitled to a 

dividends paid deduction of $250 and would be required to reduce its 

Qualified Dividend Account by the amount of the dividend to $1,000. 

The subsidiary also would be required to inform its parent that it was 

allowed a $250 dividends paid deduction with respect to the $500 dividend. The parent would thus include $500 in its gross income and 

would be entitled to a $250 dividends received deduction. The parent 

would thus be taxed on one-half of the dividends received from its 

subsidiary. The parent's Qualified Dividend Account, however, would 

be increased by $500 with respect to the dividend received, 

In summary, the subsidiary corporation would be subject to tax on 

$250 with respect to the earnings from which the dividend is treated 

as having been paid. In addition, if the parent corporation made no 

distributions to its shareholders, it would be subject to tax on $250 

of income with respect to the intercorporate dividend. Under current 

law, an equivalent $500 of income would be taxed to the two corporations, although the entire amount would be taxed to the subsidiary. 

The proposal thus imposes the full measure of the corporate tax, but 

no more than that, in the case of intercorporate dividends that are 

not distributed outside the corporate sector. 

shareholders, all of whom were individuals, it would be entitled to a 

$250 dividends paid deduction. Accordingly, the parent would not be 

subject to any tax with respect to the earnings attributable to the 

intercorporate dividend and, while the individual shareholders have 

been taxed on the distribution, one-half of the double taxation would 

thus be relieved. The parent's Qualified Dividend Account would be 

reduced by $500 with respect to the dividends paid to its 

shareholders. 

Treatment of foreign shareholders. A compensatory withholding tax 

would be imposed on dividends paid to foreign shareholders who are not 

entitled to the benefits of a bilateral tax treaty. The compensatory 

withholding tax rate would equal the corporate income tax rate times 

the percentage of dividends that is eligible for the dividends paid 

deduction. Thus, the compensatory withholding tax rate would be 16.5 

percent (50 percent of the corporate income tax rate). Dividends that 

If, however, the parent paid $500 in dividends to its 

- 139 - 
were not eligible for the dividends paid deduction, because they 

exceeded the balance in the corporation's Qualified Dividend Account, 

would not bear the compensatory withholding tax. The compensatory 

withholding tax would be imposed in addition to the basic 30 percent 

withholding tax on dividends paid to foreign shareholders who are not 

entitled to treaty benefits. In addition, subject to the reservations 

expressed in the Analysis section of this chapter, the compensatory 

withholding tax would not be imposed on dividends paid to foreign 

shareholders entitiled to treaty benefits. 

Earnings and Profits. The measurement of the extent to which 

corporate distributions to shareholders constitute dividends would 

continue to be based on the payor corporation's current and 

accumulated earnings and profits. Earnings and profits would continue 

to be a measure of the economic income of the corporation. The 

precise definition of earnings and profits, however, would be modified 

as necessary to reflect other proposed changes. In addition, earnings 

and profits accumulated after the effective date would be indexed to 

account for inflation. 

Effective Date 

The proposal generally would be effective on January 1, 1987. The 

relief from double taxation would be phased in over six years, with a 

25 percent deduction allowed with respect to dividends paid in 1987 

and a five percentage point increase in the deduction for each of the 

next five calendar years. Accordingly, the 50 percent dividends paid 

deduction would apply in 1992 and later years. 

Similarly, the reduction in the current law dividends received 

deduction for corporate shareholders would be phased in over six 

years, with a 75 percent deduction allowed with respect to deductible 

dividends paid in 1987 and a five percentage point decrease in the 

deduction for each of the next five calendar years. A 50 percent 

dividends received deduction with respect to deductible dividends 

would thus begin to apply in 1992. The compensatory withholding tax 

imposed on foreign shareholders not entitled to treaty benefits also 

would be phased in from 8.25 percent (25 percent of the corporate tax 

rate) in 1987 to 16.5 percent (50 percent of the corporate tax rate) 

in 1992 and later years. 

The Qualified Dividend Account would include taxable income only 

for taxable years beginning after December 31, 1986. In addition, 

dividends paid after December 31, 1986, in taxable years beginning 

before January 1, 1987, would be treated for purposes of the dividends 

paid deduction as having been paid during the first taxable year 

beginning after December 31, 1986. Finally, current law would continue to apply to dividends paid with respect to preferred stock 

issued prior to January 1, 1987. 

- 140 - 
Analysis 

corporations to raise capital by issuing debt and would make equity 

securities more competitive with debt. Because dividend relief also 

would reduce the incentive to retain earnings, corporations would be 

likely to pay greater dividends and to seek new capital, both equity 

and debt, in the financial markets. Corporations would thus be 

subject to greater discipline in deciding whether to retain or how to 

invest their earnings. The increased level of corporate distributions 

would expand the pool of capital available to new firms. This should, 

in turn, enhance productivity and efficiency across the economy. 

earnings paid out as dividends to an individual shareholder in the 

highest tax bracket may be subject to an overall tax rate of 73 

percent (46 percent on the earnings at the corporate level and 50 

percent on the after-tax amount of the dividend at the individual 

shareholder level). Because interest payments are deductible by the 

corporation, earnings paid out as interest to an individual creditor 

are taxed at a maximum rate of only 50 percent. Consequently, 

earnings distributed as dividends are relatively overtaxed by 23 

percentage points. Without other changes, lowering the maximum 

corporate rate to 33 percent and the maximum individual rate to 35 

percent would reduce the relative overtaxation only by a small amount, 

from 23 points to approximately 21 points. Therefore, the reduction 

in tax rates proposed by the Treasury Department would not reduce the 

need for relief from the double taxation of dividends. Under the 

proposal for partial dividend relief, the maximum overall tax rate on 

corporate earnings distributed as dividends to individual shareholders 

would be approximately 45 percent. This rate exceeds the maximum rate 

on corporate earnings paid out as interest by approximately ten 

percentage points. 

In General. The proposal would reduce the existing incentive for 

Effect of Reduction in Tax Rates. Under curyent law, corporate 

Effects on Specific Industries. Industries and firms that 

distribute a larqe fraction of their earninqs as dividends are more 

seriously affected by the current double taxation of dividends. The 

proposal, therefore, may increase the flow of resources to these 

industries. Prime examples of industries that may derive relatively 

greater benefit from the dividends paid deduction are the 

communication industry and public utilities, such as electric, natural 

gas, and sanitary utilities. These industries each distributed 

approximately 100 percent of their after-tax profits as dividends 

during the period from 1980 through 1983. 

Foreign Experience. The United Kingdom, France, West Germany, 

Japan, Canada, and other countries have adopted tax regimes that 

partially relieve the double taxation of dividends. Many of these 

countries enacted relief for policy reasons that do not apply equally 

to the United States, and have chosen different systems than the one 

proposed by the Treasury Department. As shown in Appendix C of Volume 

I of this Report, the extent of dividend relief provided by these 

countries ranges from 38 percent to 100 percent. The Treasury 

- 141 - 
Department proposal, for a 50 percent dividends paid deduction, would 

provide more relief than Japan (at 38 percent) or Canada (at 40 

percent), the same as France, and less than Germany (at 100 percent) 

or the United Kingdom (at 80 percent after 1986). In sum, the 

proposal would bring the taxation of corporate dividends in the United 

States more in line with that imposed by some of its major trading 

partners. 

Treatment of Foreign Shareholders. Most of the countries that 

have adopted some form of relief from the classical system of double 

taxation of corporate earnings distributed to shareholders have denied 

part or all of the benefits of that relief to foreign shareholders, 

although some countries have granted dividend relief to foreign 

shareholders through bilateral tax treaties. The United States has 

been only partially successful in obtaining the benefits of other 

countries’ dividend relief provisions for its citizens and residents. 

these countries is the so-called “imputation“ system. Under such a 

system, shareholders include in income and are entitled to claim a 

credit for a portion of corporate taxes paid on distributed earnings. 

The benefits of such a system usually are denied to foreign shareholders simply by allowing only domestic shareholders to obtain the 

credit for taxes paid by the corporation. 

In contrast to the imputation system adopted in many countries, 

the proposal would allow domestic corporations a deduction equal to 

one-half of certain dividends paid to their shareholders. The benefits of this dividend deduction system could be denied to foreign 

shareholders by imposing a compensatory withholding tax on deductible 

dividends paid to foreign shareholders. The amount of the compensatory withholding tax would exactly offset the deduction allowable to 

the payor corporation. 

Virtually all United States bilateral tax treaties, however, establish a maximum rate at which withholding taxes may be assessed on 

dividends. Those treaty provisions would be directly violated if the 

benefits of the dividends paid deduction were denied to foreign shareholders by imposing a compensatory withholding tax on dividends paid 

to residents of treaty countries. 

difficulty, while denying the benefits of dividend relief to foreign 

shareholders, because, as a purely formalistic matter, no increased 

withholding tax is imposed when the ability to obtain the credit is 

limited to domestic shareholders. Accordingly, the denial of the benefit to foreign shareholders technically does not result in a direct 

treaty violation. 

denying foreign shareholders a credit for corporate taxes paid under 

an imputation system of dividend relief and imposing a compensatory 

withholding tax on distributions to foreign shareholders under a 

The most common method of dividend relief that has been adopted by 

Countries using the imputation system have avoided this treaty 

As a matter of economic substance, there is no difference between 

- 142 - 
dividends paid deduction system. Because the two schemes are 

economically equivalent, it would be unwarranted to adopt an imputation system, rather than a dividend deduction system, merely to avoid 

technical treaty violations. Moreover, in the context of the United 

States economy and tax system, an imputation approach to dividend relief would be extremely cumbersome. A dividend deduction system, 

therefore, has been proposed. 

Because the United States benefits significantly from its biLateral income tax treaties and takes seriously its obligations under 

those treaties, it is reluctant unilaterally to violate the treaties. 

Accordingly, subject to the concerns expressed below, the proposed 

compensatory withholding tax initially would not be imposed with respect to dividends paid to shareholders resident in treaty countries 

and the benefits of dividend relief thus would be extended unilaterally to such shareholders. 

This unilateral extension of dividend relief to certain foreign 

shareholders is troubling in two respects. The first concern involves 

"treaty shopping," which is the use, through conduit corporations, of 

tax treaties by residents of non-treaty countries. Only a limited 

number of treaties presently lend themselves to abuse in this way and 

negotiations aimed at resolving this problem with these countries are 

continuing. The incentives to engage in treaty shopping, however, may 

be increased under the proposal. Therefore, efforts to eliminate 

treaty shopping would be intensified. If it is not possible to resolve this problem in the very near future, then the United states 

should, at a minimum, refuse to allow the benefits of the dividends 

paid deduction to persons claiming benefits under treaties that lend 

themselves to treaty shopping. 

Second, as already noted, countries with imputation systems generally have not unilaterally extended the benefits of dividend relief 

to rJnited States residents, although several have extended some or all 

of the benefits through treaty negotiations. The United States would 

expect that countries that have not previously done so would extend 

the benefits of their dividend relief rules to United States residents. Treaty negotiations would thus be undertaken with that view. 

Unwillingness of treaty partners to negotiate meaningfully on this 

issue would cause a reevaluation of the decision unilaterally to 

extend benefits to foreign shareholders in treaty countries. The 

Treasury Department expects to work closely with United States treaty 

partners and Congress in assessing concerns and progress in these 

areas. 

Transition Issue: Effect on Share Prices. The double taxation of 

coruorate earninss distributed as dividends probably has resulted in 

corborate shares-trading at lower prices than would-have occured if 

all corporate income were taxed only once. Reducing or eliminating 

the second level of tax might initially cause share prices to rise. 

Most current owners of corporate shares acquired their shares at 

prices that reflected a discount for most or all of the expected double tax on corporate income. Consequently, reducing the double tax 

- 143 - 
would reward many who did not bear the effect of current law on share 

prices, producing windfall profits for those shareholders. For this 

reason, any relief from the double taxation of corporate earnings 

distributed to shareholders should be phased in over time. 

from the double taxation of dividends, the Treasury Department 

proposals do not address the general principles of current law 

governing taxation of corporations and shareholders. Thus, in 

general, no proposals have been made regarding the taxation of 

corporate liquidations, reorganizations, or the carryover of corporate 

tax attributes, including net operating losses. The rules in these 

areas are frequently cited as in need of reform, and important work 

has been undertaken in a number of sectors to rationalize and simplify 

current law. The Treasury Department is interested in and supportive 

of efforts to reform current rules for the taxation of corporations 

and shareholders. No inference to the contrary should be drawn from 

the fact that these issues have not been addressed in the Treasury 

Department proposals. 

Scope of Proposal. Other than the proposal for partial relief 

- 144 - 
REPEAL $100/$200 DIVIDEND INCONE EXCLUSION 

General Explanation 

Chapter 7.02 

Current Law 

Dividend income received by an individual generally is subject to 

Federal income taxation. There is, however, an exclusion from gross 

income for the first $100 of dividend income received by an individual 

from domestic corporations. In the case of a husband and wife filing 

a joint return, the first $200 of dividend income is excluded 

regardless of whether the dividend income is received by one or both 

spouses. 

Reasons for Change 

The $100 dividend exclusion narrows the base of income subject to 

tax without creating a proportionate incentive for investment in 

domestic corporations. The exclusion provides no marginal investment 

incentive for individuals with dividend income in excess of $100, and 

only a minor incentive for other individual taxpayers. In addition, 

the partial dividends-received exclusion contributes to complexity in 

the tax system by adding an extra line (and two entries) on the 

individual tax Form 1040 and two lines on the Form 1040A. 

Proposal 

be repealed. 

The partial exclusion for dividends received by individuals would 

Effective Date 

The provision would apply to taxable years beginning on or after 

January I, 1986. 

Analysis 

significant effect on aggregate economic behavior. The great majority 

(76 percent) of taxpayers who receive dividends claim the full amount 

of the dividend exclusion. For these taxpayers, repeal of the 

exclusion would have no effect on marginal tax rates and thus should 

not affect investment decisions. Even for those taxpayers who do not 

receive sufficient dividends to claim the full amount of the 

exclusion, repeal should not have a significant impact. Although the 

current marginal rate of tax for such persons on additional dividends 

(up to the amount of the exclusion) is zero, the relatively small tax 

savings available from the exclusion (up to $50 for individuals and 

$100 for joint returns, assuming a maximum tax rate of 50 percent) is 

not a substantial investment incentive. 

Repeal of the dividend exclusion is not likely to have a 

- 145 - 
TAX LARGE LIMITED 

PARTNERSHIPS AS CORPORATIONS 

General Explanation 

Chapter 7.03 

Current Law 

In general, business organizations treated as corporations are 

separate taxable entities for Federal income tax purposes. Thus, a 

corporation separately determines and reports its income and is 

directly taxable on such income. A corporation's income is not 

taxable to its shareholders until actually distributed to them, and 

corporate losses do not pass through to shareholders, but must be 

absorbed, if at all, against corporate income. 

In contrast to the tax treatment of corporations, business 

organizations treated as partnerships are not separate entities for 

tax purposes. Although a partnership determines and reports its 

income as though a separate entity, it has no direct liability for 

tax. Instead, each item of partnership income, gain, loss, deduction 

or credit flows through to its partners, who must report such items on 

their respective separate tax returns. 

Under Treasury regulations, business organizations are treated as 

corporations or partnerships for tax purposes depending on the extent 

to which they possess the following characteristics found in a "pure" 

corporation: continuity of life; centralization of management; 

limited liability; and free transferability of interests. 

Business organizations not possessing a "preponderance" of corporate 

c ha r a c t e r i s t i c s a re treated as part ne r s ti i ps . 

Current law also permits corporations which meet certain 

requirements to elect to be treated as S corporations for tax 

purposes. An S corporation is not subject to the corporate income 

tax. Instead, its income and losses flow through to its shareholders 

and are reported by them on their respective separate tax returns. 

Among the requirements for S corporation status is that the 

corporation have no more than 35 shareholders. 

Reasons for Change 

The existing rules for distinguishing partnerships and 

corporations are inadequate. They permit many organizations, not 

formally incorporated but having most of the practical attributes of 

corporations, to be treated as partnerships for tax purposes. These 

rules in turn have permitted investors in such a partnership to 

receive pass-through tax treatment with respect to the partnership's 

-146- 
income and loss even though their economic relationship to the 

partnership and with other partners is in important respects 

indistinguishable from that of shareholders of a comparably sized 

corporation. 

form have been exploited by investment tax shelters organized as 

limited partnerships. These tax shelter partnerships draw capital 

from a diverse and widely situated group of investors. Moreover, 

because of the legal characteristics of a limited partnership, the 

investor limited partners are not active in the day-to-day management 

of the enterprise, are protected from loss in excess of their 

investment, and frequently face minimal restrictions on transfer or 

assignment of their interests. In short, the limited partnership 

vehicle offers many of the investment and legal characteristics of a 

corporation, yet under current law is treated for tax purposes as a 

partnership. 

The availability of pass-through tax treatment for limited 

partnerships, regardless of size, has encouraged a significant shift 

in investment capital from the corporate sector to the partnership 

sector. It is also inconsistent with the tax law's general 

limitations on losses from wholly passive investments. These 

limitations properly extend to investments in active businesses where 

the number of investors involved or the legal relations between 

investors and the business indicate the absence of direct investor 

management, control, or responsibility. 

presents serious audit and administrative problems for the Internal 

Revenue Service. An adjustment in income or loss of the partnership 

generates a corresponding adjustment for each of the partners. This 

requires a large number of returns to be held open and may necessitate 

multiple collection actions. Where the adjustment occurs years after 

the fact, transfers of partnership interests or changes in the 

circumstances of individual partners may have occurred so as to make 

collection impossible. 

Proposal 

A limited partnership would be treated as a corporation for tax 

purposes if at any time during the taxable year the partnership has 

more than 35 limited partners. If an S corporation were a limited 

partner in a partnership, each shareholder in the S corporation would 

be treated as a separate limited partner for purposes of the 35 

limited partner rule. If a grantor trust were a limited partner, each 

owner of the trust would be counted as a limited partner. If a 

partnership were a limited partner in a second partnership, each 

partner in the first partnership would be treated as a limited partner 

in the second partnership. In addition, as under the current law S 

corporation rules, a husband and wife would be counted as one limited 

partner. 

In large part, the pass-through characteristics of the partnership 

A limited partnership with a large number of limited partners also 

-147- 
In general, the addition of the 36th limited partner to an 

existing limited partnership would be treated as a termination of the 

limited partnership and contribution of the partnership assets to a 

newly formed corporation. 

Effective Date 

In general, the proposal would be effective January I, 1986. For 

limited partnerships organized before the proposal is introduced as 

legislation, the proposal would be effective January I, 1990. 

Analysis 

The proposal would bring the treatment of corporations and limited 

partnerships closer to economic reality while at the same time 

preserving the reasonable certainty necessary for effective tax 

planning. The limitation proposed on the number of limited partners 

corresponds to the current limitation on the number of shareholders 

permitted in an S corporation. 

Tables 1 and 2 contain estimates of the number of limited 

partnerships and partners that would be affected by the proposal. Ln 

1982, approximately 15,000 limited partnerships -- less than one 

percent of all partnerships -- would have been taxed as corporations 

under the proposal. Of these limited partnerships, roughly two-thirds 

were engaged in two activities, oil and gas drilling and real estate, 

each of which has generated significant tax shelter activity. The 

number of partners affected would have been approximately 2.8 million. 

Of these, over two-thirds would have been partners with interests in 

oil and gas drilling and real estate. 

Limited partnerships reclassified as corporations under the 

proposal would no longer pass through income or loss to the individual 

partners. In the case of a profitable limited partnership, the 

effects of this change on taxes paid would depend on relative 

corporate and personal income tax rates, the partnership's policy with 

regard to distribution of income, and the extent to which dividends 

were subject to double taxation. The Treasury Department proposals 

include partial relief from the double taxation of corporate earnings 

distributed as dividends, which could offset the effect on a 

profitable limited partnership of corporate classification. 

In the case of an unprofitable limited partnership, corporate 

classification would increase tax liabilities. Partnership losses 

previously available to offset unrelated income of the partners would 

instead be deductible only against past or future income of the 

partnership. Under current law, losses could be carried back for 

three years or carried forward for 15 years against past or future 

partnership income. 

-148- 
Table 1 

Number of Limited Partnerships Affected by Reclassification -- 1982 - 1/ 

Limited Partnerships 

Total Number of With More than 35 

Industry All Partnerships Partners - 2/ 

All industries 1,514,212 14,896 

Agriculture 132,394 171 

Mining and Drilling 55,766 3,664 

Construction 64,632 13 

Manufacturing 23,156 216 

Finance and Insurance 155,236 3,212 

Real Estate 562,515 6,257 

Transportation and 

Communications 18,185 146 

Wholesale and Retail 

Trade 202,531 93 

Services 287,529 1,064 

Office of the Secretary of the Treasury November 30, 1984 

Office of Tax Analysis 

- 1/ Sources: Statistics of Income Bulletin (September 1984); 

Treasury Department estimates. 

- 2/ Table includes all limited partnerships with more than 35 

partners, regardless of whether the partnership has 35 

limited partners. To the extent that some limited 

parnterships have more than 35 partners, but 35 or fewer 

limited partners, the table overstates the number of 

partnerships and partners that would be affected by the 

proposal. 

-149- 

459-813 0 - 84 - 6 
Table 2 

Number of Limited Partners Affected by Reclassification -- 1982 I./ 

Total Number of 

Partners in 

Limited Partnerships 

Total Number of Partners With More than 

Industry Partners 35 Partners 2/ 

All industries 

Agriculture 

Mining and 

~r i 11 ing 

Construct ion 

Manufacturing 

Finance and 

~n su r an c e 

Real Estate 

Transportation and 

Communications 

Wholesale and 

Retail Trade 

Services 

9,764,667 

448,623 

1,574,375 

149,600 

76,649 

2,006,381 

3,720,805 

92,611 

485,413 

1,171,642 

2,720,920 

39,938 

995,893 

1,068 

14,395 

483,932 

965,611 

32,061 

4,358 

183,664 

Office of the Secretary of the Treasury November 30, 1984 

Office of Tax Analysis 

- 1/ Sources: Statistics of Income Bulletin (Summer 1984); 

- 2/ See note 2, Table 1. 

Treasury Department estimates. 

-150- 
CHAPTER 8 

CAPITAL CONSUMPTION ALLOWANCES 

This Chapter discusses one of the most important of the Treasury 

Department proposals -- replacement of the Accelerated Cost Recovery 

System and the investment tax credit with a capital cost recovery 

system that provides annual capital consumption allowances that 

approximate real economic depreciation. The proposed Real Cost 

Recovery System wou1.d increase productivity, give proper allowance for 

inflation, eliminate the "front loading" of deductions that encourages 

tax shelters, and make lower tax rates possible through a broader tax 

base. 

- 151 - 
INDEX AND ADJUST DEPRECIATION SCHEDULES 

General Explanation 

Chapter 8.01 

Current Law 

The Accelerated Cost Recovery System (ACRS) was established by the 

Economic Recovery Tax Act of 1981 and generally governs depreciation 

allowances for tangible property placed in service after 1980. ACRS 

assigns all "recovery property" to a class with a specified recovery 

period and depreciation schedule. In general, recovery property is 

defined to include all depreciable property placed in service after 

1980, except intangible property, property subject to amortization, 

and property for which the taxpayer properly elects a method of 

depreciation, such as the units of production method, that is not 

expressed in terms of years. 

The pre-ACRS depreciation rules remain in effect for property 

placed in service by a taxpayer prior to 1981. In general, these 

rules require taxpayers to recover an asset's original cost less 

salvage value over its estimated useful life. Taxpayers can elect 

among several rates of recovery ranging from straight line to methods 

that are substantially accelerated. Certain taxpayers can elect to 

depreciate assets under a system employing prescribed industry-wide 

class lives, with additional rules for salvage values, retirement, 

repair deductions, and other matters (the ADR system). 

ACRS differs from prior depreciation rules in many important 

respects. ACRS recovery periods are not based on the economic useful 

life of assets, and for most assets are significantly shorter than 

under prior law. ACRS employs accelerated depreciation schedules and 

also allows recovery of full original cost without reduction €or 

salvage value. Thus, for most assets, ACRS allows much faster cost 

recovery and greater present value depreciation deductions than were 

obtainable under prior law. 

ACRS classifies all personal property (other than public utility 

property) as three-year or five-year property. Automobiles, light 

trucks and research and experimentation property are the principal 

three-year property items, while most other personal property, 

including machinery and equipment, is recovered over five years. Most 

real property is classified as 18-year property, although some real 

property, including real property placed in service prior to March 16, 

1984, qualifies as 10-year or 15-year property. Low-income housing is 

classified as 15-year property. Public utility property may be 

five-year, 10-year or 15-year property depending upon the class life 

of such property under prior law. 

- 152 - 
under ACRS, foreign property (property used predominantly outside 

the United States during the taxable year) is subject to longer 

recovery periods than comparable domestic property. Generally, 

foreign personal property is recovered over 12 years and foreign real 

property is recovered over 35 years. 

The ACRS depreciation schedules for three-year, five-year and 

ten-year property are based on the 150 percent declining-balance 

method switching to the straight-line method. The schedules reflect a 

half-year convention which halves the first year's depreciation rate 

regardless of when during the year the property is placed in service. 

No depreciation deduction is allowed in the year of disposition of 

personal property. 

special transition rules, is based on the 175 percent decliningbalance method switching to the straight-line method. The 

depreciation schedule for 15-year low-income housing is based on the 

200 percent declining balance method switching to the straight-line 

method. First-year depreciation rates for 15-year and 18-year real 

property are reduced to reflect the number of months during the first 

year in which property is held in service. Depreciation deductions 

for real property are allowed for the year of disposition, based on 

the number of months during which the property was in service for that 

year. 

conditioning and electrical systems, is not recoverable over periods 

shorter than the building's recovery period. The recovery period for 

a component generally begins at the later of the time the component or 

the building is placed in service. The cost recovery for the 

component is accounted for separately from the building. Substantial 

improvements to a building are treated as a separate property item 

entitled to a separate recovery period and depreciation rate. 

A lessee who makes capital improvements to leased ACRS property 

may recover the cost of such improvements over the remaining lease 

term, if such term is less than the ACRS recovery period. If the 

lessor and lessee are related parties, however, leasehold improvements 

must be recovered over the ACRS recovery period, even if the remaining 

lease term is shorter. 

The depreciation schedule for 18-year real property, except for 

Under ACRS, the cost of building components, such as airA taxpayer may elect longer recovery periods than the prescribed 

ACRS recovery period, but in doing so must use the straight-line 

method for determining the depreciation allowance. A taxpayer may 

also elect to use the straight-line method over the ACRS recovery 

period. 

Taxpayers may elect to establish mass asset accounts for assets 

where separate identification is impractical. Only assets of the same 

recovery class which are placed in service in the same year may be 

included in a single mass asset account. Gain or loss is not computed 

upon dispositions of items from a mass asset account, and instead all 

- 153 - 
proceeds from sales of items from a mass asset account are treated as 

ordinary income. Correspondingly, dispositions do not reduce the 

unadjusted basis of the mass asset account, so that original cost 

basis can be fully recovered over the class recovery period. 

A special exception to ACRS allows taxpayers to expense a small 

amount of property used in a trade or business. For taxable years 

beginning before 1988, a taxpayer may elect to expense a maximum of 

$5,000 per year. The limit on expensing increases to $7,500 for 

taxable years beginning in 1988 and 1989 and to $10,000 thereafter. 

No investment tax credit may be taken on expensed property. 

Generally, ACRS depreciation schedules apply to the unadjusted 

cost basis of an asset. However, if an investment tax credit is 

taken, the cost basis of an asset must be reduced by 50 percent of the 

amount of the credit before applying the depreciation rate. Gain or 

loss is generally recognized on the disposition (including retirement) 

of ACRS property. Gain or loss is computed with respect to the 

adjusted basis of property which reflects previously taken 

depreciation. 

disposition. For all personal and most real property, all previously 

allowed depreciation constitutes ordinary income, up to the amount of 

gain realized. There is no depreciation recapture on property for 

which a straight-line method has been elected. Only the excess of 

ACRS deductions over the straight-line method is recaptured on 

residential rental property, low-income housing and property used 

predominantly outside the United States. 

are available under current law for intangible assets of limited 

useful life that are used in a business or held for the production of 

income. Generally, amortization allowances are computed using a 

straight-line method. Certain income-producing properties, such as 

motion picture and television films, may be amortized under the income 

forecast method which allocates costs proportionately to income 

expected to be produced. 

ACRS deductions are subject to recapture upon an asset's 

ACRS does not apply to intangible assets. Amortization allowances 

Reasons for Change 

Mismeasurement of Inflation-Adjusted Zncome. Tax liabilities 

should be imposed on the basis of real economic income. In the case 

of investment in depreciable property, measurement of real economic 

income requires an allowance for the property's economic depreciation. 

If that allowance is understated, income from the investment is 

overtaxed and a tax disincentive is created which impairs capital 

formation and retards the economy's productive capacity. By the same 

token, overstating depreciation and thus understating income creates 

an artificial incentive for one form of investment over another, 

discriminates among companies within an industry, and encourages 

nonproductive, tax-motivated investment activity. 

- 154 - 
The proper measure of economic depreciation in any year is the 

amount of decline in the real value of an asset over the year, which 

is equal to the cost of replacing the lost productive value. Due to 

inflationary increases in replacement costs, pre-ACRS depreciation 

deductions for many assets understated actual economic depreciation 

and thus resulted in overtaxation of the income from such assets. 

The cost recovery system introduced with ACRS eliminated the prior 

overtaxation of capital investment by providing for more rapid 

acceleration of depreciation deductions. ACRS, however, continued to 

base depreciation allowances on historic costs rather than current 

replacement costs, and thus left the present value of depreciation 

deductions tied to the rate of inflation. Moreover, at recently 

experienced levels of inflation, ACRS, in combination with investment 

tax credits, reduced effective tax rates on investment in depreciable 

assets substantially below statutory tax rates. Where effective tax 

rates are reduced substantially below statutory tax rates, the tax 

system is undertaxing real economic income. 

stated assumptions, of average effective tax rates for income from 

assets in the various ACRS classes. Table 1 demonstrates (1) the 

substantial extent to which ACRS and investment tax credits reduce 

effective tax rates, (2) the variance among ACRS classes in the extent 

to which ACRS and investment tax credits reduce effective tax rates, 

and (3) the volatility of effective tax rates in response to different 

inflation rates. 

Table 1 displays Treasury Department estimates, based on certain 

- 155 - 
Table 1 

Effective Tax Rates on Equity Financed Investments 

with Various Rates of Inflation 

for 46 Percent Taxpayer Under Current Law IJ 

Asset class : Inflation rate (percent) 

(years) 0 5 10 

3 

5 

-90 -8 22 

-51 -3 19 

10 -5 20 32 

15 9 35 45 

18 28 40 45 

Office of the Secretary of the Treasury November 23, 1984 

Office of Tax Analysis 

- 1/ Assumptions: Real return after tax is four percent. The 

investment tax credit selected is the maximum allowable (six percent 

on three-year equipment and ten percent on five-, ten-, and 15-year 

equipment). Effective tax rates are the difference between the real 

before-tax rate of return and the real after-tax rate of return 

divided by the real before-tax rate of return. 

Investment Distortions. The low or negative effective tax rates 

on ACRS property and the tax deferral resulting from accelerated 

depreciation allowances distort investment decisions in a variety of 

ways. First, ACRS disproportionately benefits capital-intensive 

industries and methods of production. Income from sectors of the 

economy without significant investment in depreciable property 

typically face higher effective tax rates. Second, ACRS favors 

existing businesses over new, start-up businesses, and tax paying 

businesses over those with tax losses. Accelerated cost recovery 

allowances are more likely to be used fully by established, profitable 

businesses than by new companies with substantial start-up costs OK by 

loss companies without net income. The potential unavailability of 

ACRS benefits may in turn lead to tax-motivated acquisitions or 

combinations that permit the benefits to be used fully in the year 

incur red. 

negative effective tax rates on ACRS property, especially in the early 

years of acquisition, make possible the sheltering of an investor's 

unrelated income and the accompanying deferral of tax liability. This 

Finally, ACRS has fueled the growth of tax shelters. The low or 

- 156 - 
encourages taxpayers to make otherwise uneconomic investments in order 

to obtain tax benefits. Also, the prospect of substantial up-front 

deductions encourages excessive churning of assets. 

other capital cost recovery provisions hamper economic efficiency. 

The tax code effectively guides the allocation of capital, overriding 

private market factors and the individually expressed consumer 

preferences they represent. This undeclared government industrial 

policy has grown dramatically in scale and yet it largely escapes 

public scrutiny or systematic review. 

Complexity. As with other provisions that distort accurate 

measurement of income, the cost recovery rules of current law generate 

complexity and add to the administrative and enforcement burdens of 

the Internal Revenue Service. As tax shelter activity has increased 

due to ACRS and other provisions that mismeasure income, anti-abuse 

rules have proliferated and the Internal Revenue Service has been 

required to devote additional resources to policing tax shelter 

investments. Moreover, whether or not abusive, tax shelters invite 

disrespect for the tax laws from those who perceive, correctly or not, 

that the laws are unfair and, hence, not worthy of compliance. 

ACRS also contributes to complexity which extends beyond tax 

shelter investments, affecting potentially every taxpayer. For 

example, ACRS deductions and investment tax credits must be recaptured 

upon disposition of depreciable property to prevent ordinary income 

from being taxed at preferential capital gain rates. The recapture 

provisions are necessarily complex. While ACRS is not the sole reason 

for recapture rules, a taxpayer cannot obtain ACRS deductions without 

being exposed to such complexity. 

Uncertainty. ACRS fails to take account of fluctuating inflation 

rates. As a consequence, taxpayers continue to face uncertainties 

about the likely effect of inflation on the real after-tax value of a 

depreciable asset. This, in turn, acts as a depressant on economic 

activity. Table 1 illustrates the variance of real effective tax 

rates at different rates of inflation. The certainty of obtaining 

inflation-proof cost recovery should be an effective stimulus to risk 

taking and investment. 

Investment distortions created by ACRS, investment tax credits and 

Proposal 

New capital cost recovery rules would be established that 

explicitly account for inflation and the real economic loss inherent 

in the use of assets over time. The new Real Cost Recovery System 

(RCRS) would modify ACRS in several important respects. First, RCRS 

would allow cost recovery of the real or inflation-adjusted cost of 

business assets, rather than only the original nominal cost. Second, 

RCRS would revise the assignment of property among recovery classes. 

Third, RCRS would assign an invariant percentage rate of depreciation 

to each recovery class, rather than having rates vary each year as 

under ACRS. Fourth, the percentage rate of depreciation for each 

- 151 - 
recovery class would be a measure of the estimated decline in economic 

value. The resulting RCRS depreciation allowances would measure more 

closely than does ACRS the real economic loss for all assets within a 

single class. 

one of seven classes, which would replace the present five ACRS 

recovery classes. Each RCRS class would be assigned an invariant 

depreciation rate, ranging from 32 percent to three percent. The 

depreciation rate would be applied to the indexed basis of an asset, 

as described below. The depreciation rates assigned to each class of 

assets and the assignment of types of assets to each class would be 

designed to minimize the variance in the effective tax rates for all 

assets, in light of real economic depreciation. Under RCRS, as under 

ACRS, taxpayers would not estimate useful lives and salvage values for 

each asset. Intangible assets would not be subject to RCRS and would 

be amortized generally under current law rules. In addition, assets 

such as motion pictures, that are depreciable under the income 

forecast method or other method not measured in terms of years would 

continue to be depreciable under rules similar to current law. 

RCRS would adjust depreciation allowances for inflation by means 

of a basis adjustment. Under ACRS, only the unadjusted original cost 

basis of an asset is recovered over the class recovery period. Under 

RCRS, the remaining unrecovered basis of an asset would be increased 

each year by the inflation rate and the fixed depreciation rate 

applicable to the asset's class would be applied against the resulting 

adjusted basis. The basis of depreciable property not subject to RCRS 

would be indexed for inflation in a similar manner. 

Under RCRS, all depreciable tangible assets would be assigned to 

If an asset's basis were adjusted each year for inflation, 

applying a fixed depreciation rate of less than 100 percent to the 

adjusted basis would never fully recover such basis. To simplify 

accounting, RCRS would allow a taxpayer to close out its depreciation 

account for any asset in a particular class after a specified period 

of years. The close-out year is not an estimate of the economic 

useful life of assets in a particular class. The year in which 

depreciation allowances would be closed out would be the year for each 

class of assets in which 15 percent of the inflation-adjusted original 

basis remains to be depreciated. For example, an asset eligible for a 

32 percent depreciation rate would be entitled to a 100 percent 

depreciation rate in the fifth year in which the asset is retained in 

service. An asset eligible for a 12 percent depreciation rate would 

be allowed a 100 percent depreciation rate in the 17th year in which 

the asset is retained in service. 

In current dollar terms, the depreciation deduction in the 

close-out year would exceed substantially the annual deductions 

allowed in prior years. To mitigate this bunching effect, rules would 

be provided to spread the amount of the close-out deduction over a 

period of years. In addition, retirement of an asset prior to the 

- 150 - 
close-out year would be treated as a disposition, upon which a 

taxpayer would obtain full recovery of an asset's remaining basis and 

recognize gain or loss. 

Under RCRS, taxpayers would pro rate first-year depreciation 

allowances based upon the number of months assets are placed in 

service. There would be a mid-month convention for prorating 

depreciation allowances in the month in which an asset is placed in 

service. There would be no half-year convention as is applied to 

personal property under ACRS. A similar pro rating would be required 

in the year of disposition. There would be no inflation adjustment to 

basis for purposes of determining depreciation in the year in which an 

asset is placed in service. There would be a pro-rata inflation 

adjustment to basis in the year of disposition. 

the aggregate cost of personal property not in excess of $5,000 would 

be retained. See Chapter 14.01. Vintaged mass asset accounts would 

also be retained for property qualifying for such treatment under 

current law. RCRS would retain the current law distinction between 

deductible repairs and expenditures that appreciably prolong an 

asset's useful life or materially add to its value, and thus, must be 

capitalized. Capitalized costs would generally be added to the 

adjusted basis of the underlying asset, subject to the appropriate 

partial-year convention or, in some cases, depreciated separately. 

Each RCRS class would be assigned a safe-harbor repair allowance 

factor. The safe-harbor would permit expenses incurred after the 

asset is placed in service to be deducted without challenge, if such 

expenses are allocable to the asset and do not exceed the product of 

the asset's remaining inflation-adjusted basis and the repair 

allowance factor. 

The current law provision permitting taxpayers to elect to expense 

Under RCRS, the cost of leasehold improvements that may be 

deducted by a lessee would be recovered under the general rules 

applicable to such property, regardless of the term of the lease. 

However, in the event leasehold improvements are reasonably expected 

to have no residual value upon termination of the lease term, special 

rules would be provided to permit different depreciation rates to be 

applied to such improvements, taking into account the term of the 

lease (including any renewal options and reasonably expected renewal 

periods). In the case of leasehold improvements depreciated by a 

lessee under the general rules, a lessee would treat the termination 

of a lease as a disposition of the leasehold improvements and would 

compute gain or loss upon the adjusted basis in such improvements. 

The RCRS inflation-adjusted basis of an asset would be used to 

compute gain or loss on the disposition or retirement of the asset. 

Since the Treasury Department is also proposing to tax all real 

gains on sales or dispositions of property as ordinary income, there 

would be no provision for the recapture of previously taken 

depreciation. Since no investment tax credits would be available for 

- 159 - 
depreciable assets, there would be no provisions for the adjustment of 

basis due to such credits or for the recapture of the credits upon 

early disposition. 

to each class. Table 2 specifies the depreciation rate for each RCRS 

class and the year in which a close-out deduction of all remaining 

basis may be taken. 

The Treasury Department proposes to define the scope of each RCRS 

class by reference to existing ACRS classes in the following manner. 

All three-year ACRS property would be classified in RCRS Class 1. All 

18-year ACRS property would be classified in RCRS Class 7. In 

addition, low-income housing, which is 15-year ACRS property, would be 

classified in RCRS Class 7. All ten-year ACRS property and 15-year 

public utility property would be classified in RCRS Class 6. 

through 5. Class 2 would encompass trucks (other than light purpose 

trucks which are three-year ACRS property), buses, and office, 

computing and accounting equipment. Class 3 would cover construction 

machinery, tractors, aircraft, mining and oil field machinery, service 

industry machinery and equipment and instruments. Class 5 would 

include railroad equipment, ships and boats, and engines and turbines. 

All other five-year ACRS property is grouped in Class 4. If an item 

of machinery, equipment or other property is not described by the 

asset types listed in classes 2, 3 and 5, and is not reclassified 

specifically under the procedure described below, such item would be 

assigned to Class 4. 

The constant depreciation rates for each RCRS class reflect 

Treasury Department empirical studies showing that a geometric pattern 

of constant-dollar economic depreciation is generally an appropriate 

method to apply to all classes of business assets, even though the 

geometric pattern may not accurately characterize all items within a 

class. Each of the seven RCRS classes that resulted from the Treasury 

Department studies is comprised of a group of asset types that, on 

average, have approximately the same observed geometric rate of 

economic depreciation. The RCRS classes are organized so as to 

minimize the variance in observed economic depreciation rates for 

assets within a class. (Treasury Department studies relied upon "The 

Measurement of Economic DeDreCiatiOn.' bv Charles R. Hulten and Frank 

Table 2 lists the seven RCRS classes and assigns types of assets 

ACRS five-year property would be classified in RCRS Classes 2 

C. Wykoff in Depreciation,'Inflation; an; the Taxation of Income from 

Capital (ed. C. Hulten, 1981.) 

The Treasury Department intends to continue conducting empirical 

studies of economic depreciation. The proposed RCRS system 

contemplates that the Treasury Department would establish permanent 

facilities to conduct these studies. Such studies would gather 

evidence of changing economic depreciation rates due to such factors 

as changing technological obsolescence or market conditions. In 

addition, the Treasury Department would develop data that would enable 

economic depreciation rates to be measured more precisely for specific 

- 160 - 
Table 2 

RCRS Asset Classes L/ 

: Close-Out: 

RCRS : Depreciation : : Classification : : Period 

Class : Rate : of ACRS Property: : (Years) 2/ 

Class 1 32% 3-year property 5 

Class 2 24% Trucks, Buses and 8 

Trailers, Office, 

Computing and 

Accounting Equipment 

Machinery, Tractors, 

Aircraft, Mining 

and Oil Field 

Machinery, Service 

Industry Machinery, 

Instrument s 

Class 3 18% Construction, 12 

Class 4 12% 5-year property not 17 

assigned to Class 2,3 or 5 

including Metal Working 

Machinery, Furniture and 

Fixtures, General Industrial 

Machinery, Other Electrical 

Equipment, Electrical 

Transmission/Distribution 

Equipment, Communications 

Equipment, Fabricated Metal 

Product s 

Class 5 8% Railroad Equipment, ships 25 

and Boats, Engines and 

Turbines 

Class 6 5% 10-year property; 15-year 38 

public utility property 

low-income housing 

Class 7 3% 18-year property; 15-year 63 

- 1/ 

- 2/ The close-out year is the year in which 15 percent of the 

Items of property are assigned to RCRS classes under rules described 

in the text of the General Explanation. 

inflation-adjusted original basis remains to be depreciated. 

- 161 - 
asset types. The Treasury Department would review data on economic 

depreciation and would promulgate regulations to reclassify asset 

types upon evidence that economic depreciation for an asset type 

deviates significantly from its class norm. The Treasury Department 

would also consider whether the depreciation rates for each class 

should be revised periodically. Pending development of an 

institutionalized process for reviewing economic depreciation rates, 

the Treasury Department proposes that ACRS property be classified 

among RCRS classes in the manner described above. 

Effective Date 

RCRS would be effective for property purchased on OK after 

January 1, 1986 (other than property purchased pursuant to a binding 

contract entered into prior to January 1, 1986). Anti-churning rules, 

similar to those enacted as part of ACRS, would be provided to prevent 

a taxpayer from treating property owned prior to January 1, 1986, as 

being subject to RCRS on or after such date. In addition, 

anti-retention rules would be applied to prevent taxpayers who obtain 

ownership of assets on or after January 1, 1986, from continuing to 

account for such assets under ACRS or other prior law. However, 

assets acquired in tax-free liquidations and reorganizations would not 

be subject to RCRS if the basis of such assets carries over in the 

hands of a transferee. 

Analysis 

Neutral Capital Cost Recovery System. The Treasury Department 

proposals for the taxation of capital and business income include, 

principally, RCRS; inflation adjustment of inventories, interest 

income and expense and gain from the sale of most property; repeal of 

investment tax credits; and dividend relief. On the whole, these 

proposals would facilitate a lowering of statutory tax rates to 33 

percent for corporations and 35 percent for the highest individual tax 

bracket. Moreover, RCRS, in concert with other inflation adjustment 

proposals, would ensure that effective tax rates throughout the 

economy would not vary significantly from the proposed statutory tax 

rates. In addition, effective tax rates would remain invariant if 

inflation were to fluctuate. Thus, RCRS would correct the three 

principal defects of the capital cost recovery system of current law 

(see Table 1) -- the substantial reduction in effective tax rates from 

statutory tax rates; the variance in effective tax rates among 

different assets and industries; and the volatility of effective tax 

rates in response to fluctuating inflation. 

The economic neutrality among new investments in equipment and 

structures in different industries that would occur under RCRS is 

illustrated in Table 3. Under RCRS, the variance of effective tax 

rates from statutory tax rates across different industries is minor 

compared to the unsystematic distortions created under current law. 

There may be some significant variance in effective tax rates of 

several industries under RCRS, such as farming, mining, and 

- 362 - 
communications. The Treasury Department proposal contains a procedure 

for periodic adjustment of classifications, if actual effective tax 

rates under RCRS vary too widely from class norms. 

Under RCRS, cost recovery allowances would no longer be 

front-loaded, as occurs under current law, due to the operation of 

accelerated depreciation rates and the investment tax credit. 

However, this does not mean that RCRS would be less valuable to 

taxpayers than ACRS would be after repeal of the investment tax 

credit. Tables 4 through 10 list present values of depreciation 

deductions available over the entire life of an asset under RCRS, 

ACRS, and straight-line methods. In many cases, RCRS produces a 

greater inflation-adjusted present value deduction than even ACRS. In 

all cases, RCRS produces the same present value deduction regardless 

of inflation rates, while ACRS and straight line methods, which 

recover original cost only, yield real present value deductions which 

decrease as inflation increases. 

Comparisons of RCRS with current 1,aw should also consider the 

continued tax burden at the corporate and individual levels resulting 

from the integration of all of the Treasury Department proposals for 

taxing capital and business income. Table 11 presents the combined 

effective tax rates at the corporate and individual levels for various 

cost recovery systems and for the integrated Treasury Department 

proposal for cost recovery. Table 12 presents the same comparisons of 

effective tax rates at only the corporate level. In sum, Tables 11 

and 12 show that the Treasury Department proposed capital cost 

recovery system, of which RCRS is a centerpiece, produces 

approximately the same effective tax rate on income from all forms of 

investment, while the alternative approaches produce widely varying 

effective tax rates that depend on the rate of inflation. With 

respect to many types of property, the Treasury Department proposal is 

more generous than the alternative approaches, including current law. 

Simplicity and Fairness of RCRS. RCRS is designed to correct the 

previously mentioned defects in ACRS, while at the same time 

preserving the simplicity of a depreciation system based on relatively 

few classes of property, each of which would have a single constant 

depreciation rate to be applied to inflation adjusted basis. The 

hallmark of RCRS is the more realistic reflection of economic 

depreciation and thus a fair and more accurate measurement of real 

economic income. 

For purposes of measuring real income, RCRS emphasizes the 

importance of taking into account not only inflation, but also dynamic 

factors, such as technological change and changing market conditions, 

which determine economic depreciation. In modifying the ACRS classbased system, RCRS does not revert to prior flawed methods of 

depreciation which depended upon determining each asset's useful life, 

without regard to the pattern of economic depreciation over such life. 

categorizations of the myriad of depreciable assets. These asset 

The asset types classified in Table 2 are obviously broad 

- 163 - 
types are much broader than the categorization of assets under the ADR 

depreciation system which preceded ACRS. The seven RCRS classes 

however, are more differentiated and hence, fairer depreciation rates 

than are obtained under ACRS. ACRS has a single depreciation rate for 

assets as diverse as computers, service industry machinery and 

equipment, electrical equipment, and ships. The single ACRS 

depreciation rate applicable to these diverse assets may be simple in 

application, but it is neither fair nor conducive of efficient 

resource allocation. 

The classification of assets under RCRS is not more complex than 

under ACRS. RCRS would be a relatively simple system for taxpayers to 

comply with and for the Internal Revenue Service to administer. 

Recordkeeping would be no more involved than under ACRS. Although 

there would undoubtedly be a need for regulations to refine technical 

classification of certain items of property, such regulations would 

not be more complex than existing regulations under ACRS. Class 4 

would initially serve as a residual class for five-year ACRS propety 

not specifically classified in Classes 2, 3, or 5. The Treasury 

Department expects that further refinement of property classification 

would be possible as the Treasury Department conducts ongoing studies 

of economic depreciation for different assets and industries. Thus, 

the Treasury Department expects that additional items of five-year 

ACRS property which are classified in RCRS Class 4 could be 

reclassified among RCRS Classes 2, 3, or 5. Future studies might also 

justify reclassifying assets in RCRS Classes 1, 6, and 7. Similarly, 

the Treasury Department would evaluate periodically the 

appropriateness of depreciation rates and close-out periods assigned 

to each RCRS Class. 

reforms of the capital cost recovery system of current law would 

permit a substantial simplification of the tax system. Even where 

some existing rules are retained, their significance and complexity to 

taxpayers and the Internal Revenue Service would be lessened with a 

more accurate measure of real income. 

Simplification of Other Tax Provisions. RCRS and other proposed 

RCRS and repeal of the preferential capital gain tax rate would 

permit repeal of recapture rules. Such repeal would greatly simplify 

the tax treatment of dispositions of assets. RCRS would also permit 

repeal of various provisions governing the allocation of depreciation 

allowances, such as the special tax-exempt leasing rules and special 

recovery rules for lessees of property, although lessees would be 

permitted to take RCRS deductions. RCRS in combination with a 

uniform tax rate on capital and non-capital income would permit repeal 

of much of the corporate minimum tax. See Chapter 6.02. 

RCRS should dramatically reduce the proliferation of tax shelters 

based on the accelerated capital cost recovery rules of current law. 

As a consequence, the significance of many anti-tax shelter rules, 

such as the at-risk rules, would be lessened. Fewer transactions 

would involve these provisions, enabling Internal Revenue Service 

enforcement resources to be committed elsewhere. 

- 164 - 
Table 3 

Effective Tax Rates on Equity Financed Investments 

in Equipment and Structures by Industry 

Current law lJ : RCRS 

(percent) Earnings 2/ 

: Inflation rate : 

Industry :5 10 : Paid : Aeld 

Ag r i cul ture 29 37 16 21 

Mining 13 31 24 39 

Logging 21 34 19 33 

Wood products and furniture 28 38 20 34 

Glass, cement and clay 20 31 20 34 

Primary metals 16 28 19 33 

Fabricated metals 28 38 19 33 

Machinery and instruments 26 36 19 33 

Electrical equipment 26 38 19 32 

Motor vehicles 8 26 19 31 

Transportation equipment 25 36 20 34 

Food 25 35 19 33 

Tobacco 18 30 19 33 

Textiles 19 32 19 33 

Appa re 1 28 38 21 34 

Pulp and paper 12 26 20 34 

Printing and publishing 22 34 19 33 

Chemicals 19 32 20 33 

Petroleum refining 12 2 19 32 

Rubber 18 30 20 34 

Leather 30 40 20 33 

Transport services 9 26 21 34 

Utilities 28 38 22 36 

Communications 19 33 24 39 

Services and trade 31 40 19 31 

Office of the Secretary of the Treasury November 29, 1984 

- 1/ 

- 2/ 

Office of Tax Analysis 

Current law assumes a 46 percent corporate tax rate. 

RCRS assumes a 33 percent corporate tax rate. 

One-half of paid earnings are deductible. 

- 165 - 
Table 4 

Amount of Depreciation Allowances Under 

Alternative Depreciation Schemes for Class 1 Asset A/ 

(per $1,000 investment) 

:RCRS Depreciation Rate 32 Percent :: ACAS : Straight-1 

Year :at 0% :at 5% :at 10% :: 3 Years: 3 Years 

Inflation: 

1 

2 

3 

$160 $160 $160 

269 282 296 

ie3 202 221 

4 124 144 165 

5 2/ 264 321 387 

Nominal 

Total 3/ $1,000 $1,109 $1,229 

Inflation 

Ad j u s t ed 

Present 

Value S/ 

Total A/ $1,000 $1,000 $1,000 

0% inflation $924 N/A N/A 

5% inflation N/A 924 N/A 

10% inflation N/A N/A 924 

$250 

380 

$167 

333 

370 333 

0 167 

0 0 

$1,000 

$948 

$957 

908 

865 

$1,000 

$930 

$944 

879 

824 

Office of the Secretary of the Treasury November 30, 1984 

Office of Tax Analysis 

- 1/ Depreciation is computed on an asset placed in service on July 1 of 

- 2/ The close-out year deduction would be spread over a period of years, a 

- 3/ Current dollars. 

_. 4/ ASSUmeS 5 percent inflation rate. 

- 5/ Assumes a 4 percent real rate of return. 

year 1 by a calendar year taxpayer. 

described in the General Explanation. 

- 166 - 
Table 5 

Amount of Depreciation Allowances Under 

Alternative Depreciation Schemes for Class 2 Asset - 1/ 

(per $1,000 investment) 

_. 

: RCRS Depreciation Rate 24 Percent :: ACRS : Straiqht-line 

Year : at 5% inflation : at 10% inflation ::5 Years: 5 Years 

1 

2 

3 

4 

5 

6 

7 

8 _z/ 

$120 

222 

177 

141 

113 

090 

072 

239 

Nominal 

Total - 3/ $1,173 

Inflation 

Adjusted 

Present 

Value 5/ 

Total _. 4/ $1,000 

5% inflation $888 

10% inflation N/A 

$120 $150 $100 

232 220 200 

194 210 200 

162 210 200 

136 210 200 

113 0 100 

095 0 0 

330 0 0 

$1,383 $1,000 $1,000 

$1,000 $904 $888 

N/A $837 $810 

888 766 729 

Office of the Secretary of the Treasury November 30, 1984 

Office of Tax Analysis 

See footnotes for Class 1 asset 

- 167 - 
Table 6 

Amount of Depreciation Allowances Under 

Alternative Depreciation Schemes for Class 3 Asset &/ 

(per $1,000 investment) 

- : RCRSDepreciation Rate 18 Percent :: ACRS : Straight-line - Year : at 5% inflation : at 10% inflation :: 5 Years : 5 Years 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

12 - 2/ 

Nominal 

Total 3/ 

Inflation 

Ad jus ted 

Total i/ 

Present 

Value 5/ 

$90 

172 

148 

128 

110 

95 

81 

70 

60 

52 

45 

214 

$1,264 

$1,000 

5% iii'flation $847 

10% inflation N/A 

$90 $150 $100 

180 220 200 

163 210 200 

147 210 200 

132 210 200 

119 0 100 

108 0 0 

97 0 0 

88 0 0 

79 0 0 

71 0 0 

357 0 0 

$1,630 $1,000 $1,000 

$1,000 $904 $888 

N/A $837 $810 

847 766 729 

Office of the Secretary of the Treasury November 30, 1984 

Office of Tax Analysis 

See footnotes for Class 1. asset 

- 168 - 
Table 7 

Amount of Depreciation Allowances Under 

Alternative Depreciation Schemes for Class 4 Asset - 1/ 

(per $1,000 investment) 

: RCRS Depreciation Rate 12 Percent :: ACRS : Straight-line 

Year : at 5% inflation : at 10% inflation :: 5 Years: 5 Years 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

12 

13 

14 

15 

16 

17 A/ 

$60 

118 

109 

101 

93 

86 

80 

74 

68 

63 

58 

54 

50 

46 

42 

39 

302 

Nominal 

Total J/ $1,444 

Inflation 

Adjusted 

Present 

Value 5/ 

5% inF1ation $781 

10% inflation N/A 

Total A/ $1,000 

$60 

124 

120 

116 

113 

109 

105 

102 

99 

96 

93 

90 

87 

84 

81 

79 

635 

$2,192 

$150 

220 

210 

210 

210 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

100 

200 

200 

200 

200 

100 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

$1,000 $1,000 

$1,000 $904 $888 

N/A $837 $810 

781 766 729 

Office of the Secretary of the Treasury November 30, 1984 

Office of Tax Analysis 

See footnotes for Class 1 asset. 

- 169 - 
Table 8 

Amount of Depreciation Allowances Under 

Alternative Depreciation Schemes for Class 5 Asset &/ 

(per $1,000 investment) 

____ : RCRS Depreciation Rate 8 Percent :: ACRS : Straight-line 

Year : at 5% inflation : at 10% inflation ::lo-Year: 10-Year 

8 

9 

10 

11 

12 

13 

14 

15 

16 

17 

18 

19 

20 

21 

22 

23 

24 

25 2/ 

$40 

81 ._ 

78 

75 

73 

70 

68 

66 

63 

61 

59 

57 

55 

53 

51 

50 

48 

46 

45 

43 

42 

40 

39 

38 

455 

Nominal 

Total 3/ $1,796 

Inflation 

Ad j us t ed 

Present 

Total - 4/ $1,000 

Value 5j/ 

5% inflation $697 

10% inflation N/A 

$40 

84 

85 

87 

88 

89 

90 

91 

92 

93 

94 

95 

96 

97 

99 

100 

101 

102 

103 

105 

106 

107 

109 

110 

1,389 

$3,652 

$1,000 

N/A 

697 

$80 

140 

120 

100 

100 

100 

90 

90 

90 

90 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

$50 

100 

100 

100 

100 

100 

100 

100 

100 

100 

50 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

$1,000 $1,000 

$819 $'791 

$707 $665 

603 551 

Office of the Secretary of the Treasury November 30, 1.984 

Office of Tax Analysis 

See footnotes for Class 1 asset. 

- 170 - 
Table 9 

Amount of Depreciation Allowances Under 

Alternative Depreciation Schemes for Class 6 Asset lJ 

(per $1,000 investment) 

: RCRS Depreciation Rate 5 Percent :: ACRS : Straiqht-line 

Year : at 5% inflation : at 10% inflation ::15-Year: 15-year - 

1 $25 

2 51 

3 51 

4 51 

5 51 

6 51 

7 51 

8 50 

9 50 

10 50 

11 50 

12 50 

13 50 

14 50 

15 50 

16 49 

17 49 

18 49 

19 49 

20 49 

21 49 

22 49 

23 49 

24 

25 

26 

48 

48 

48 

27 48 

28 48 

29 ~~ . 48 

30 

31 

32 

48 

48 .~ 41 ~. 

33 47 

34 47 

35 41 

36 47 

37 47 

38 2J 936 

Nominal 

Total 3/ $2,725 

Inflation 

Adjusted 

Present Value SJ 

Total 4/ $1,000 

5% inflation $582 

10% inflation N/A 

$25 

54 

56 

59 

61 

64 

67 

70 

73 

76 

80 

83 

87 

91 

95 

99 

104 

108 

113 

118 

124 

129 

135 

141 

148 

154 

161 

168 

176 

184 

192 

201 

210 

219 

229 

240 

258 

5,231 

$9,877 

$1,000 

N/A 

582 

$50 

100 

90 

80 

70 

70 

60 

60 

60 

60 

60 

60 

60 

60 

60 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

$1,000 

$143 

$603 

485 

$33 

67 

67 

67 

67 

67 

67 

67 

67 

67 

61 

67 

67 

67 

67 

33 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

0 

$1,000 

$709 

$556 

430 

Office of t,he Secretary of the Treasury November 30, 1984 

See footnotes for Class 1 asset. 

Office of Tax Analysis 

- 171 - 
Table 10 

Current Amount of Depreciation Allowances Under 

Alternative Depreciation Schemes for Class 7 Asset &/ 

(per $L,OOO investment) 

: RCRS Depreciation Rate 3 Percent :: ACRS : Straight-line 

Year : at 5% inflation : at 10% inflation ::lE-Year: 18-Year 

1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

12 

13 

14 

15 

16 

17 

18 

19 

20 

30 

40 

50 

63 - 2/ 

Nominal 

Total 2/ 

$15 

31 

32 

32 

33 

33 

34 

35 

35 

36 

37 

37 

38 

39 

39 

40 

41 

42 

42 

43 

53 

63 

76 

3,164 

$6 , 6 3 3 

$15 

33 

35 

37 

39 

42 

45 

48 

51 

55 

58 

62 

66 

71 

I6 ._ 

81 

86 

92 

98 

104 

200 

382 

'7 3 1 

56,605 

$81,480 

$50 

90 

80 

80 

70 

60 

60 

50 

50 

50 

50 

50 

40 

40 

40 

40 

40 

40 

20 

0 

0 

0 

0 

0 

$1,000 

$28 

56 

56 

56 

56 

56 

56 

56 

56 

56 

56 

56 

56 

56 

56 

56 

56 

56 

28 

0 

0 

0 

0 

0 

$1,000 

Irif lation 

Ad jus ted 

Total $/ $1,000 $1,000 $715 $666 

Present 

Value 5/ 

5% iiiflatiori $445 

10% inflation N/A 

N/A 

445 

$570 $502 

454 377 

Office of the Secretary of the Treasury November 30, 1984 

Office of Tax Analysis 

See footnotes for Class 1 asset. 

- 172 - 
REPEAL INVESTMENT TAX CREDIT 

General Explanation 

Chapter 8.02 

Current Law 

A credit against income tax liability is provided for a taxpayer's 

investment in certain depreciable property. Subject to a long list of 

exceptions, the following classes of property qualify for the 

investment credit: (1) tangible personal property (other than air 

conditioning or heating units); (2) certain other tangible property 

(not including buildings and their structural components); (3) 

elevators and escalators; (4) single purpose agricultural or 

horticultural structures; (5) rehabilitated buildings; (6) certain 

timber property; and (7) storage facilities (not including buildings 

and their structural components) used in connection with the 

distribution of petroleum or certain petroleum products. 

In general, the credit is equal to ten percent of qualified 

investment in property that is placed in service during the taxable 

year. In the case of three-year property, the applicable credit rate 

is generally six percent. All qualifying costs for new property are 

eligible for the credit; in the case of used property, the qualifying 

costs that may be taken into account are generally limited to $125,000 

for each taxable year. 

credits in any year may not exceed $25,000 plus 85 percent of the tax 

liability in excess of $25,000. Credits in excess of this limitation 

may be carried back three years and forward 15 years. 

Reasons for Change 

The investment tax credit creates an investment incentive that 

favors some forms of economic activity over others, discriminates 

among taxpayers within a single industry, and encourages 

tax-motivated, noneconomic behavior. Because the investment credit is 

generally limited to investments in tangible personal property, it 

favors capital-intensive industries over labor-intensive industries. 

In addition, the ability of taxpayers to benefit from the credit 

depends on their having taxable income. Thus, start-up, fast-growing, 

and loss corporations typically derive less benefit from the credit 

than existing, profitable corporations in the same industries. 

The investment tax credit also distorts investor behavior by 

skewing the relationship between pre-tax and after-tax returns on 

investment. 

for the credit or other preferences rather than activities which, in 

the absence of tax considerations, might produce a greater economic 

return. 

The amount of tax liabflity that may be offset by investment 

Taxpayers are encouraged to invest in activities eligible 

The intrusion of tax into economic life is shown most plainly 

- 173 - 
in the numerous tax shelter offerings which depend upon the investment 

tax credit and certain other deductions and credits for their 

viability. To the extent taxpayer energy and resources are consumed 

in pursuing tax rather than economic advantage, the growth and 

productivity of the economy as a whole are weakened. 

straightforward, the applicable statutory provisions are exceedingly 

complex. Repeal of the credit would substantially simplify the tax 

system by eliminating these complicated rules. 

Although the concept of the investment tax credit is 

Proposal 

The investment tax credit would be repealed. See Ch. 15.01 for a 

discussion of repeal of the investment credit for rehabilitated 

buildings. 

Effective Date 

The proposal generally would be effective for property purchased 

on or after January 1, 1986 (other than for property purchased 

pursuant to a binding contract entered into prior to January 1, 1986). 

Analysis 

Repeal of the investment tax credit would result in more equitable 

and neutral tax treatment of business taxpayers by eliminating the 

preferential tax treatment for investments in certain types of assets. 

Repeal also would eliminate the variations in tax rates among firms 

that is caused by differences in their capacity to utilize credits. 

Table 1 shows the industry variations, which are often substantial, in 

the value of the investment credit. Industries with a low ratio of 

credit used to credit earned receive less benefit from the investment 

credit than industries that ordinarily can use the credit immediately. 

When combined with the impact of accelerated cost recovery, the 

variation shown in the table probably would be even larger. 

Since repeal of the investment tax credit would eliminate the bias 

in favor of property that is eligible for the credit, investment in 

such property is expected to diminish. Aggregate business investment, 

however, should not be diminished. As a result of the benefits 

accruing to taxpayers from lower overall tax rates and the Treasury 

Department proposal for an indexed depreciation system, the tax rates 

on capital in the aggregate would be reduced. See Chapter 8.01. 

Repeal of the investment tax credit also would eliminate 

complexity associated with existing rules (1) to distinguish qualified 

from non-qualified property, (2) to determine the amount of the 

credit, (3) to adjust basis as a result of the credit, (4) to 

determine the amount of previously allowed credits subject to 

- 174 - 
recapture in the event of early disposition of an asset, and (5) to 

carryback and carryforward unused credits. Other rules also would be 

repealed: the at-risk rules for the credit, the rules which deny the 

credit to certain noncorporate lessors, the rules governing 

pass-through of the credit, the definition of qualified United States 

production costs and other special rules for films and sound 

recordings, the rules governing property used by certain tax-exempt 

entities, the rules pertaining to the treatment of qualified progress 

expenditures, the rules denying the credit for foreign use property 

(other than property that meets one of eleven exceptions) and for 

certain property used in connection with the furnishing of lodging, 

the rul.es governing the credit for livestock, the rules governing the 

credit for certain boilers, and the rules distinguishing used and new 

property. 

- 175 - 
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- 176 - 
CHAPTER 9 

ADJUSTMENTS FOR EFFECTS OF INFLATION 

Current law is woefully inadequate in making allowances for 

the effects of inflation. Provisions designed to compensate for 

inflation create further distortions and rarely achieve their 

goal with any degree of accuracy. In other cases, such as the 

taxation of interest income and expense, current law makes no 

adjustment for inflation. 

Even at moderate inflation levels, the failure to reflect 

inflation in the measurement of capital income significantly 

distorts decisions regarding capital investment. This Chapter 

discusses Treasury Department proposals that, together with the 

rules for indexing depreciation allowances discussed in Chapter 

8, would adjust the tax system for inflation on a relatively 

comprehensive basis. 

'- 177 '- 
INDEX CAPITAL ASSETS 

General Explanation 

Chapter 9.01 

Current Law 

held for more than six months (one year for assets acquired 

before June 23, 1984) are treated as long-term capital gains or 

losses. Long-term capital gains receive preferential tax 

treatment. For individuals and other noncorporate taxpayers, 60 

percent of net capital gain is excluded from income, with the 

balance of 40 percent taxable at ordinary rates. Thus, a 

taxpayer in the maximum 50 percent tax bracket has a marginal tax 

rate on net capital gain of 20 percent. For corporations, the 

regular maximum tax rate of 46 percent is reduced to 28 percent 

on net capital gain if the tax computed using that rate is lower 

than the corporation's regular tax. 

A taxpayer determines net capital gain by first netting 

long-term capital gain against long-term capital loss and 

short-term capital gain against short-term capital loss. The 

excess o€ any net long-term capital gain over any net short-term 

capital loss equals net capital gain entitled to the preferential 

tax rate. 

Capital losses are deductible under different rules for 

corporate and noncorporate taxpayers. For corporations, any net 

short-term or long-term capital loss is offset against any net 

long-term or short-term gain. Excess capital losses are not 

deductible but may generally be carried back for three taxable 

years and forward for five taxable years as a short-term capital 

loss in the carryover year. 

Individuals and other noncorporate taxpayers also deduct any 

net short-term or long-term capital loss first against any net 

long-term or short-term gain. In addition, a noncorporate 

taxpayer with an excess net capital loss may generally take up to 

$3,000 of such loss as a deduction against other income. For 

this purpose, only one-half of net long-term capital loss is 

usable. Net capital loss in excess of the deduction limitations 

may be carried forward indefinitely, retaining its character in 

the carryover year as either a short- or long-term loss. 

A capital asset is defined generally as property held by a 

taxpayer other than (1) inventory, stock in trade, or property 

held primarily for sale to customers in the ordinary course of 

the taxpayer's trade or business, (2) depreciable or real 

property used in the taxpayer's trade or business, (3) rights to 

Literary or artistic works held by the creator of such works, or 

Gains or losses from the sale or exchange of capital assets 

- 118 - 
acquired from the creator in certain tax-free transactions, (4) 

accounts and notes receivable, and (5) certain publications of 

the government. 

Special rules apply to gains and losses with respect to 

"section 1231 property" and "section 1256 contracts." Section 

1231 property is defined as (1) depreciable or real property held 

for more than six months and used in a taxpayer's trade or 

business, but not includible in inventory or held primarily for 

sale in the ordinary course of a trade or business, (2) property 

subject to compulsory or involuntary conversion, and (3) special 

industry property, including timber, coal, domestic iron ore, 

certain livestock and certain unharvested crops. Gains and 

losses from all transactions involving section 1231 property are 

netted for each taxable year. If there is a net gain from 

section 1231 property, all gains and losses from section 1231 

property are treated as long-term capital gains and losses and 

are combined with the taxpayer's other capital gains and losses. 

If there is a net loss from section 1231 property, all 

transactions in section 1231 property produce ordinary income and 

ordinary loss. 

regulated futures contract, (2) any foreign currency contract, 

(3) any nonequity option, and (4) any dealer option. Gain or 

loss with respect to a section 1256 contract generally is treated 

as 60 percent long-term capital gain or loss and 40 percent 

short-term capital gain or loss. 

Subject to certain exceptions, capital gains and losses are 

taken into account when "realized," generally by sale, exchange 

or other disposition of the property. Section 1256 contracts 

generally are treated as if sold on the last business day of the 

taxable year in which held and accrued gains or losses are 

realized upon such deemed sales. Certain disposi,tions of capital. 

assets, such as transfers by gift, are not realization events for 

tax purposes. Thus, in the case of gifts, no gain or loss is 

realized by the donor, and, in general, the donor's basis in the 

property carries over into the hands of the donee. Gain or loss 

also is not realized on transfer at death, even though the 

transferee's basis in the property is stepped-up to fair market 

value at the time of death. 

The amount of a seller's gain or loss is equal to the 

difference between the amount realized by the seller and the 

seller's adjusted basis (i.e., the cost or other original basis 

adjusted for items chargeable against basis). Under various 

nonrecognition provisions, however, realized gains and losses in 

certain transactions are deferred for tax purposes. Examples of 

such nonrecognition transactions include certain like-kind 

exchanges of property, involuntary conversions followed by an 

acquisition of replacement property, corporate reorganizations, 

and the sale of a principal residence within two years of the 

Section 1256 contracts are defined to i,nclude (I) any 

- 179 - 
acquisition of a new principal residence. Generally, 

nonrecognition treatment defers gain or loss for tax purposes by 

providing for a substitution of basis from the old property to 

the new or for a carryover basis from the old holder to the new 

holder. 

Reasons for Change 

Measurement of Income. Tax liabilities should be imposed on 

the basis of real economic income. During periods of inflation, 

nominal gains or losses on sales of capital assets will reflect 

inflationary increases in the value of property which do not 

represent real changes in economic value. Current law, however, 

computes capital gains and losses by reference to historic 

investment cost, unadjusted for inflation, and thus overstates 

capital gains or understates capital losses to the extent of 

inflation during the period property is held before sale. 

The current preferential tax rate for capital gains has 

often been justified as an allowance for the overstatement of 

capital gains caused by inflation. The preferential rate 

actually serves this purpose only sporadically. The effects of 

inflation accumulate over time, yet the preferential tax rate 

does not vary with the holding period of an asset (beyond the 

minimum 6 months or one year) or with the actual rates of 

inflation during such period. As a result, the preferential rate 

undertaxes real income at low rates of inflation and overtaxes 

capital gains at higher rates of inflation; for any inflation 

rate, the longer an asset is held the greater is the 

undertaxation of real income. Moreover, the preferential rate 

does not prevent taxation of inflation-caused nominal gains in 

circumstances where the taxpayer has in fact suffered an economic 

loss. 

Because the preferential tax rate does not account 

accurately for the effects of inflation, investors currently face 

substantial uncertainty regarding the eventual effective rate of 

tax on their investments. Such uncertainty poses unnecessary and 

incalculable risks for investors and thus impairs the capital 

formation needed for economic growth. 

Neutrality. The preferential tax rate for capital gains 

also distorts investment decisions by providing a potentially 

lower effective rate of tax on assets that offer a return in the 

form of asset appreciation rather than current income such as 

dividends or interest. Along with other provisions that 

establish special tax treatment for particular sources and uses 

of income, the preferential tax rate for capital gains is one of 

an elaborate series of tax incentives for particular businesses 

and investments. These incentives impede the efficiency of an 

economy based on free market principles. This undeclared 

- 180 - 
government industrial policy largely escapes public scrutiny, yet 

it increasingly controls the form and content of business and 

investment activity. 

Simplification. The sharp distinction in tax rates under 

current law between capital gains and ordinary income has been 

the source of substantial complexity. Application of different 

tax rates to different sources of income inevitably creates 

disputes over which assets are entitled to the preferential rate 

and encourages taxpayers to mischaracterize their income as 

derived from the preferred source. A significant body of law, 

based both in the tax code and in judicial rules, has developed 

to deal with these matters. Its principles are complicated in 

concept and application, typically requiring carerul scrutiny of 

the facts in each case. The taxpayer and Internal Revenue 

Service resources consumed in this process are substantial, yet 

there is little basis for confidence that the results derived in 

particular cases are even roughly consistent. 

Proposal 

The preferential tax rate for long-term capital gains would 

be repealed. Gains and losses from sales of property would no 

longer be classified as either capital gains and losses (i.e., 

gains and losses from sales of capital assets) or ordinary gains 

and losses. Thus, net capital gain as defined under current law 

would be fully includible in taxable income and subject to tax at 

regular rates. Moreover, the holding period of property would no 

longer affect the tax treatment of gains or losses from sales. 

Repeal of the preferential tax rate for capital gains would 

be coupled with inflation adjustment for realized gains from 

sales or other dispositions of property. For property other than 

inventory assets or debt instruments, a taxpayer's original cost 

basis would be indexed for inflation during the period a taxpayer 

holds the property. Computation of the basis adjustment for 

inflation is explained below. Assets required to be inventoried 

would not ba indexed under the rules proposed here, but would be 

subject to inflation adjustment under the method of inventory 

accounting elected by the taxpayer. See Chapter 9.02. Inflation 

adjustment for bonds, notes and other debt instruments would be 

accomplished by indexing interest payments rather than the basis 

in the indebtedness. See Chapter 9.03. The above rules for 

indexing of basis would in general be available not only for U.S. 

taxpayers but also for property held by nonresident aliens and 

foreign corporations. In addition, conforming changes would be 

made in the current rules governing taxation of nonresident 

aliens and foreign corporations to take account of the 

elimination of the current law capital asset concept. 

would permit indexing of basis with respect to nondeductible 

employee contributions for purposes of determining the taxable 

As applied to tax-favored retirement plans, the proposal 

- 181 - 

459-013 0 - 84 - 7 
portion of distributions from such plans. No indexing would be 

permitted with respect to tax deductible contributions by an 

employee or employer not included in income. 

Losses from sales of investment property would remain 

subject to limitations. Excluding personal use property, losses 

from sales of property other than investment property could be 

deducted without limitation. In general, investment property 

would be defined as all nonpersonal use property other than (1) 

property used in a trade or business, (2) inventory property and 

property held primarily for sale to customers in the ordinary 

course of business, (3) a general partnership interest, or (4) an 

interest in an S corporation in which the holder actively 

participates in management of the entity. For purposes of these 

loss limitation rules, investment property would generally 

include notes, bonds and other debt instruments. For 

noncorporate taxpayers, losses from sales of investment property 

would offset gains from such property, with any excess loss 

deductible up to a maximum of $3,000 in each taxable year. 

Investment property losses in excess of this limitation could be 

carried forward indefinitely. For corporate taxpayers, 

investment property losses would offset gains from such property, 

but would not be otherwise deductible. Excess losses from sales 

of investment property by a corporation also could be carried 

forward indefinitely. 

The proposal would not alter the basic realization and 

nonrecognition rules of current law. Thus, a taxpayer would take 

inflation-adjusted gains and losses into account only when 

realized upon a sale, exchange or other disposition of property. 

Current law rules regarding taxable realization events would be 

retained. Thus, a taxpayer would generally recognize gains or 

losses at year-end on section 1256 contracts, but would not 

recognize gain or loss upon gratuitous transfers of property, 

whether inter vivos or upon death. As under current law, the 

donor's basis and holding period for purposes of inflation 

adjustment would carry over in the case of inter vivos gifts. In 

the case of transfers of property at death, the donor's basis 

would be stepped-up to fair market value and the transferee would 

start anew the holding period for indexing such basis. 

Nonrecognition provisions of current law, which require 

realized gains or losses to be deferred, would also generally be 

retained. In particular, homeowners would be permitted, subject 

to existing rules, to roll over gain on the sale of a principal 

residence, if a new principal residence is acquired within 2 

years of the sale of the prior principal residence. Moreover, 

subject to existing rules, homeowners who are age 55 or older 

would exclude permanently the first $125,000 of inflation 

adjusted gain upon the sale of a principal residence. 

relating to determination of the amount realized upon a sale, 

The proposal generally would retain current law rules 

- 182 - 
exchange, or disposition of property. In particular, current law 

rules concerning the amount realized in respect of liabilities 

(recourse or conrecourse) assumed or taken subject to upon 

disposition of property would be retained. 

The Internal Revenue Service would implement the indexing 

proposal by publishing inflation tables using the Bureau of Labor 

Statistics' Consumer Price Index for Urban Households. These 

tables would contain inflation adjustment factors which would be 

applied to the original cost basis to determine the inflation 

adjusted basis. The tables would specify inflation adjustment 

factors by calendar quarters that an asset was held. Thus, a 

taxpayer who bought an asset in the third quarter of 1984 and 

sold the asset in the second quarter of 1990 would locate in the 

tables a single inflation adjustment factor to be applied to the 

original cost basis. The tables would contain inflation 

adjustment factors back to January 1, 1965. Assets obtained 

prior to that date would be indexed as if acquired on that date. 

The inflation adjustment factors would be computed using a 

half-quarter convention, which would allow only half the 

applicable quarterly inflation rate regardless of when during a 

quarter an asset was acquired or sold. An asset would be 

required to be held for one full calendar quarter in order to 

qualify for indexing. Assets held only for one full quarter 

would obtain an inflation adjustment factor only for that full 

quarter, and not for the partial quarters in which acquired and 

disposed of. 

functional currency other than the U.S. dollar, the measure of 

inflation generally would be based on the inflation rate in the 

functional currency (as determined by the Internal Revenue 

Service). 

If assets are used in a trade or business that employs a 

Effective Date 

The proposal would be effective on January I, 1986 for all 

assets purchased on or after that date (other than assets 

purchased pursuant to a binding contract entered into before 

January 1, 1986). Thus, assets purchased on or after January 1, 

1986 would be subject to indexing from the date of purchase; in 

addition, gains or losses from such assets, whenever recognized, 

would be taxed under the new rules of the proposal. 

nondepreciable assets purchased before January 1, 1986 ("old 

depreciable assets" and "old nondepreciable assets, 'I 

respectively). For old nondepreciable assets, there would be a 

three year transition period, beginning on January 1, 1986, 

during which gain or loss would be computed without indexing of 

basis. In general, gains or losses during this period from old 

nondepreciable assets would be taxed under the principles and 

Different transition rules would apply to depreciable and 

- 183 - 
effective tax rates of current law. Thus, net capital gain from 

such assets would be subject to partial exclusion, with the 

amount of exclusion calculated to produce approximately the same 

maximum rate under current law of 20 percent. Thus, if the 

maximum individual marginal tax rate during this period is 35 

percent, the fractional exclusion for all taxpayers would be 43 

percent. Similarly, corporations would be eligible for an 

alternative rate that, in relative terms, would approximate the 

available current law rate of 28 percent. 

During the three year transition period, taxpayers holding 

certain old nondepreciable assets would be allowed an election to 

realize gain or loss without a sale or other disposition. This 

mark-to-market election could be exercised only with respect to 

assets which are regularly traded on an established market, such 

as a stock or commodity exchange. If the mark-to-market election 

is not exercised and the taxpayer holds old nondepreciable assets 

on January 1, 1989, the basis of those assets is indexed as of 

that date (for post-1964 inflation). 

to determine at any time during the transition period whether 

they are better off realizing gain by applying the preferential 

tax rate to unindexed basis or by indexing historic basis 

(post-1964) and applying the uniform marginal tax rate. Thus, 

the transition period affords a taxpayer electability of tax 

treatment for readily marketable assets which would be retained 

after the transition period closes. Assets that were marked-tomarket during the transition period would be indexed only from 

the date of the mark-to-market election. 

The one-time mark-to-market election would permit taxpayers 

Old nondepreciable assets sold on or after January 1, 1989, 

would be fully subject to the proposals. Thus, gain or loss from 

such assets would be determined by reference to an inflation 

adjusted basis (indexed for inflation back to the date of 

purchase, but not earlier than January 1, 1965). No 

mark-to-market election would be available on or after January 1, 

1989. 

Sales and other dispositions of old depreciable assets 

during the three year transition period would be taxed under 

current law principles. Thus, gains from the sale of old 

depreciable assets would be subject to recapture as ordinary 

income under current law recapture rules. Net capital gain from 

old depreciable assets sold during the transition period would be 

taxed in the same manner as net capital gain from old 

nondepreciable assets during the transition period. That is, net 

capital gain would be subject to partial exclusion at a rate 

calculated to maintain the same maximum tax rate of 20 percent 

for individuals. In general, net losses from sales of old 

depreciable assets during the transition period would be 

deductible in full, as under current law. 

- 184 - 
For sales of old depreciable assets after the transition 

period ends on January 1, 1989, gains would be taxed in two 

parts. First, all depreciation not in excess of realized gain 

(computed with respect to the asset's basis without adjustment 

for inflation) would be recaptured and subject to tax at regular 

tax rates. Second, the excess, if any, of such realized gain 

over the recapture amount would be adjusted for inflation by 

indexing the original cost basis of assets using the published 

inflation adjustment factors. Thus, the excess of the amount 

realized on the sale over the inflation adjusted original cost 

basis would be taxed at the regular tax rate. After the 

transition period, losses from the sale of old depreciable assets 

(computed with respect to the basis of assets unadjusted for 

inflation) would be deductible in full. 

analysis 

the proposal would either hold roughly constant or reduce 

effective tax rates on realized capital gains; the proposal 

should thus either have no or a somewhat stimulative effect on 

saving and investment. At current rates of inflation (four 

percent in 1983 and 1984), most high-bracket taxpayers would be 

subject to roughly the same effective tax rate on long-term 

capital gains as under current law (i.e., a maximum rate of 20 

percent on nominal gains). At rates of inflation experienced in 

recent years (an average annual rate of 7.9 percent between 1972 

and 1982), the proposal would reduce significantly the effective 

tax rate on most real capital gains. This is shown by Table 1, 

which provides maximum effective tax rates on real capital gains 

under current law for various combinations of inflation rates, 

rates of real appreciation, and holding periods. 

effective tax rates that accompanies inflation; the associated 

reduction in uncertainty should stimulate saving and investment. 

The "insurance" benefits of a tax system which guarantees an 

explicit inflation adjustment should not be minimized. For 

example, inflation averaged seven percent annually between 1971 

and 1975. Over the same period, nominal capital gains on sales 

of corporate stock totaled $24.6 billion. Once adjusted for 

inflation, however, these sales actually represented a loss of 

$0.4 billion. 

Effect on Saving and Investment. Under most circumstances, 

Also, indexing would eliminate the current volatility in 

Finally, indexing capital gains for inflation would produce 

more accurate measurement of real losses; the associated increase 

in government risk-sharing should also stimulate saving and 

investment. 

Effect on risk-takinq. The effect of capital gains taxation 

on private risk-taking in the economy is of critical importance. 

The venture capital and associated high-technology industries 

seem particularly sensitive to changes in effective tax rates. 

- 185 - 
Shareholders in some ventures--those which are highly successful 

over short periods of time--would face higher effective tax rates 

under the proposal. Nevertheless, more accurate measurement of 

economic losses and the reduction of inflation caused variations 

in effective tax rates would stimulate investment generally. 

Moreover, a maximum marginal tax rate of 35 percent on indexed 

gains would produce effective rates that are not substantially 

above those experienced during the last two venture capital 

booms. (Tax rates of 25 percent during the 1960s and 28 percent 

from 1978-81 on nominal gains were actually higher effective 

rates due to inflation.) In addition, all investors would 

continue to benefit from the deferral of tax on accrued but 

unrealized gains. 

Also, the increase in saving stimulated by reductions in 

individual marginal rates and expansion of IRAs, as well as the 

elimination of many industry-specific tax preferences and the 

enactment of measures to reduce the advantages of investment in 

unproductive tax shelters, should increase the supply of capital 

available to high technology industries. 

Housing. The indexing proposal should not, on balance, 

significantly affect the housing industry or the desire of 

individuals to invest in their own homes. Most capital gains in 

the housing industry have been inflationary gains that would not 

be subject to tax under the indexing proposal. Moreover, the 

proposal retains the provisions of current law permitting 

taxpayers to roll over realized gains on the sale of a principal 

residence and granting a one-time exclusion of $125,000 on the 

sale of a principal residence by taxpayers over the age of 55. 

Indeed, the one-time exclusion would be more generous under the 

proposal since it would apply to inflation-adjusted rather than 

nominal gains. 

Retention of Realization Requirement. The proposal would 

retain the realization requirement of current law, under which 

gains and losses generally are not taxed until realized by sale, 

exchange or other disposition. One of the consequences of the 

realization requirement is that tax on accrued but unrealized 

gains is deferred, except in the case of section 1256 contracts. 

The tax advantage of deferring gains creates an incentive for 

taxpayers to continue to hold appreciated assets in order to 

avoid realizing gain. This so-called "lock-in" effect impairs 

capital resource allocation to the extent taxpayers are deterred 

from reallocating investments by the tax costs of realizing 

accrued appreciation. 

Indexing mitigates the lock-in effect of the realization 

requirement by ensuring that only real gains are taxed. Under 

current law, unrealized inflationary gains cause a lock-in effect 

as much as unrealized real gains. Moreover, although the 

proposal eliminates the preferential tax rate for capital gains, 

the Treasury Department proposals include a reduction in marginal 

- 186 - 
tax rates that reduces the current law distinction between 

capital gain and ordinary income. On balance, the relative 

significance of the lock-in effect under the indexing proposal 

versus current law depends on prospective rates of inflation. 

Since the lock-in effect cannot be eliminated fully in any system 

that retains the realization concept, the gains in certainty and 

measurement of income attributable to indexing and the 

distortions caused by a rate differential override concerns over 

the lock-in effect. 

The proposal retains the mark-to-market accounting concept 

currently applicable to section 1256 contracts. The primary 

advantage of the mark-to-market concept in this limited context 

is that it negates the need to identify offsetting positions for 

purposes of the loss deferral rules applicable to straddles. 

Straddle transactions utilizing section 1256 contracts would 

provide numerous opportunities for abuse for taxpayers with large 

volumes of trades in such contracts absent retention of 

mark-to-market accounting for these assets. 

would retain the capital loss limitation rules of current law for 

assets held for investment and not for use in a trade or 

business. Such limitations are appropriately applied to 

investors who may selectively realize gains and losses on 

investment assets. 

Scope of Loss Limitation Rules. In general, the proposal 

Simplification. Repealing the preferential tax rate on 

capital gains and taxing all inflation-adjusted income at uniform 

tax rates would eliminate a source of substantial complexity in 

current law. Schemes to convert ordinary income to capital gain 

would be deprived of their principal tax motivation. For 

example, use of a so-called "collapsible corporation" as a device 

to convert ordinary income into capital gain from a sale or 

exchange of stock would no longer be abusive. Thus, current 

law's collapsible corporation provisions and related provisions 

concerning collapsible partnerships could be repealed. 

prior depreciation rules to prevent excessive depreciation 

deductions from being converted into capital gain. Indexing 

depreciation allowances and gains and losses from dispositions of 

property obviates the need for depreciation recapture provisions. 

Excessive depreciation would be "recaptured" as ordinary income, 

which (assuming no intervening change in the taxpayer's marginal 

tax rate) would substantially restore the tax benefit derived 

from the original deduction. Although the taxpayer would 

continue to receive a timing advantage where RCRS allowances 

exceed economic depreciation, taxing all recapture income as 

ordinary income would permit repeal of the recapture provisions 

for depreciable property acquired after the proposals become 

fully effective. 

Depreciation recapture has been necessary under ACRS and 

- 18'7 - 
Beyond the benefits of repealing provisions rendered 

superfluous, repeal of the preferential tax rate would reduce the 

scope of disputes between taxpayers and the government and would 

inevitably curb or reverse the growth of rules -- legislative, 

judicial and administrative -- intended to confine the 

preferential treatment of capital gains within certain bounds. 

Although legal uncertainties would not be eliminated, the tax 

stakes in subsequent disputes would be substantially reduced, 

easing the pressures that have spawned complexity under current 

law. 

- 188 - 
INDEX INVENTORIES 

General Explanation 

Chapter 9.02 

Current Law 

In general, current law requires the use of inventory accounting 

methods where necessary to determine clearly a taxpayer's income. 

Treasury regulations implementing this rule generally require 

inventories to be maintained where the production, purchase or sale of 

merchandise is an income-producing factor. A taxpayer that keeps 

inventories for tax purposes must use the accrual method of accounting 

with respect to purchases and sales of inventory items. 

the sale of goods; this measurement, in turn, depends on the value for 

tax accounting purposes of the goods on hand at the close of the 

taxable year. The cost of goods sold during the year is generally 

equal to the dollar value of beginning inventory, plus purchases and 

other inventoriable costs incurred during the year, minus the dollar 

value of ending inventory. Thus, a taxpayer with beginning inventory 

of $100, purchases and other inventoriable costs of $500, and ending 

inventory of $150, has a cost of goods sold for the year of $450 ($100 

plus $500 minus $150 = $450). The measurement of income from the sale 

of goods changes with any change in the valuation of ending inventory. 

Thus, if ending inventory, in the preceding example, had a higher 

value, the cost of goods sold would have been lower, and gross income 

from sales would have been correspondingly higher. Conversely, a 

lower figure for ending inventory would have increased the cost of 

goods sold and reduced gross income. 

cost, although in certain cases the lower of cost or market value is 

permitted. In order to determine the cost of ending inventory the 

goods on hand at year-end must be identified. In making this 

determination, a taxpayer may identify each specific item of inventory 

and ascertain its actual cost or value. In most cases, however, this 

"specific identification" method is impractical because of the number 

and fungible nature of the goods on hand. The Code and regulations 

therefore permit alternative methods which employ simplifying 

assumptions regarding the flow of goods from inventory. 

purchased or produced are the first goods sold. Under FIFO the most 

recently produced goods are deemed on hand at year-end, and ending 

inventories are thus valued at the most recent purchase or production 

costs. The last in, first-out (LIFO) method assumes that the last 

goods purchased or produced are the first goods sold. Since LIFO 

accounting values ending inventory at the oldest purchase or 

Inventory accounting assists in accurately measuring income from 

Under Treasury regulations, inventories generally are valued at 

The first-in, first-out (FIFO) method assumes that the first goods 

- 189 - 
production costs, in periods of increasing purchase or production 

costs its use results in higher cost of goods sold and lower taxable 

income than FIFO. 

Since 1939, taxpayers who use the LIFO method for tax purposes 

have been required to use LIFO in preparing annual financial 

statements for credit purposes and for reports to stockholders, 

partners, proprietors or beneficiaries (the "LIFO conformity 

requirement"). 

Reasons for Change 

Taxes should be imposed on real economic income, not on increases 

that are attributable to inflation. Current inventory accounting 

methods depart from this principle by failing to reflect inflation in 

a consistent manner. 

Because the LIFO method treats the most recently acquired goods as 

the first goods sold, LIFO accounting reflects income from inventory 

sales more accurately during periods of inflation than FIFO. 

Notwithstanding the advantages of the LIFO method in an inflationary 

economy, many businesses nevertheless use the FIFO method. Some 

businesses find that the use of LIFO for financial accounting purposes 

-- as required by the LIFO conformity requirement -- is unacceptable. 

Whatever the original reasons for the LIFO conformity requirement, it 

is not appropriate in a tax system designed to neutralize the effects 

of inflation. Many small firms are reluctant to use the LIFO method 

because they view LIFO as significantly more complex than FIFO. 

Although LIFO better accounts for the effects of inflation than 

FIFO, it does not fully account for these effects. LIFO takes account 

only of price changes in the inventoried goods, which may or may not 

correspond to the effects of inflation on prices generally. Moreover, 

since LIFO represents only a flow of goods assumption rather than an 

adjustment of inventory costs in line with inflation, it results in 

only the deferral rather than the elimination of inflationary gains. 

When a firm that uses the LIFO method either liquidates OK reduces 

inventories, it is taxed on previously deferred inflationary gains. 

This factor distorts business decisions and creates a tax bias in 

favor of transactions such as mergers and reorganizations which permit 

continued deferral of the inflationary gain. 

Proposal 

Taxpayers would be permitted to use an Indexed FIFO method in 

addition to the current LIFO and FIFO methods of accounting. Under 

the Indexed FIFO method, inventories would be indexed using inflation 

adjustment factors based on the Consumer Price Index. Indexing would 

be based on relatively simple computational methods, such as applying 

the percentage increase in the Consumer Price Index to the FIFO cost 

of the number of units in beginning inventory which does not exceed 

the number of units in ending inventory. Indexing would be permitted 

only with respect to inflation occurring after the effective date of 

- 190 - 
the proposal. The requirement under current law that the Internal 

Revenue Service consent to changes in accounting methods would be 

waived for taxpayers changing to LIFO or to Indexed FIFO accounting 

methods during an appropriate transition period. In addition, the 

LIFO conformity requirement would be repealed. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

About two-thirds of inventories in the United States are owned by 

firms which continue to use FIFO accounting, despite the resulting 

overstatement of income tax liability during inflationary times. 

Table 1 provides data on the use of FIFO by industry group. Repeal of 

the LIFO conformity requirement would permit such firms to switch to 

either Indexed FIFO or LIFO inventory tax accounting, while continuing 

to use the FIFO method for financial accounting purposes. It is 

expected that taxpayers that currently use the FIFO method would 

switch to the Indexed FIFO method or the LIFO method. An immediate 

switch by all firms that currently use FIFO to either Indexed FIFO or 

LIFO would result in a maximum aggregate annual tax saving to those 

firms of approximately $6 billion. 

Firms that currently use LIFO, however, would be unlikely to 

change to Indexed FIFO, unless the economic advantages were sufficient 

to offset the associated administrative costs as well as the tax costs 

resulting from recapture of LIFO reserves. LIFO inventories would not 

be eligible for an inflation adjustment under the capital asset 

indexing proposal described at Chapter 9.01. Such an adjustment would 

generally be inappropriate because the LIFO inventory valuation merely 

reflects a flow of goods assumption; it does not purport to reflect 

the taxpayer's historic cost of the physical goods on hand. Moreover, 

those using LIFO have benefitted in the past relative to taxpayers 

using FIFO as a result of this flow of goods assumption. It would 

provide a further relative tax advantage to those using LIFO to permit 

their inventories to be indexed. For LIFO firms that do switch to 

Indexed FIFO, inventory stocks would thereafter be valued more 

accurately. Moreover, distortion of decision-making with respect to 

liquidations of firms and reductions in inventories would be reduced. 

measurement of income for tax purposes since inflationary gains would 

be permanently removed from the tax base. The Indexed FIFO method 

also would be more consistent with the proposed system for indexing 

depreciation than other methods of inventory accounting. In 

particular, for firms that elected the Indexed FIFO option, economic 

gains and losses on inventory would be included in the tax base. This 

treatment would be analogous to the proposed treatment for depreciable 

assets, where depreciation allowances would be indexed for general 

inflation. 

The proposal to index the FIFO method would improve the 

- 191 - 
Finally, the current disincentive to entry into industries that 

have historically used the FIFO accounting system and thus borne an 

artificially high tax burden would be removed. 

Table 1 

Percentage of Ending Inventory Valued 

by the FIFO Method by Industry IJ 

Industry 

Value of Ending Percentage 

Inventory ($Billions) FIFO (%) 

Agriculture 

Mining 

Construction 

Food 

Tobacco 

Textiles 

Appa r e 1 

Lumber 

Furniture 

Pulp and Paper 

Printing and Publishing 

Chemicals 

Petroleum 

Rubber 

Leather 

Stone, Clay and Glass Products 

Primary Metals 

Fabricated Metals 

Machinery 

Electrical Equipment 

Motor Vehicles 

I xis t rument s 

Transportation Equipment 

Transportation Public Utilities 

Communications 

Wholesale Trade 

Retail Trade 

Finance, Insurance, 

Services 

and Real Estate 

4.6 

8.2 

23.1 

24.0 

6.7 

5.8 

8.3 

6.0 

6.0 

6.5 

5.4 

26.4 

23.9 

5.1 

2.1 

5.9 

20.7 

20.7 

38.9 

30.1 

16.1 

8.2 

18.3 

31.9 

6.5 

108.8 

102.2 

12.8 

11.0 

97 

81 

97 

66 

15 

50 

82 

77 

77 

60 

70 

50 

41 

63 

74 

58 

39 

39 

67 

68 

47 

57 

78 

92 

99 

80 

69 

89 

95 

Total All Industries 594.2 70 

Office of the Secretary of the Treasury November 28, 1984 

Office of Tax Analysis 

- 1/ Source: 1981 Corporation Income Tax Returns, computed by the 

Bureau of Economic Analysis 

- 192 - 
INDEX INDEBTEDNESS 

General Explanation 

Chapter 9.03 

Current Law 

As a general rule, a borrower can deduct all interest paid or 

accrued on indebtedness. Interest is ordinarily deductible by the 

borrower whether the indebtedness is incurred in the conduct of a 

trade or business, in connection with an income-producing investment, 

or in financing personal consumption. Interest incurred to carry or 

acquire tax-exempt bonds is not deductible, however, and limitations 

apply to the deductibility of interest incurred to produce investment 

income. 

Corresponding to the general deductibility of interest incurred, 

interest received by or credited to a holder of indebtedness is fully 

includible in income and taxable at ordinary income rates. Interest 

received on certain obligations of State and local governments, 

however, is exempt from Federal income tax. 

In general, the making of a loan and the satisfaction of 

indebtedness are not taxable events for Federal income tax purposes. 

Thus, a debtor does not have income upon the receipt of the principal 

amount of a loan or a deduction when such principal amount is repaid. 

Similarly, the principal amount of a loan is neither a deductible 

amount to the lender when the loan is made nor an item of income when 

it is repaid. If indebtedness is discharged at less than its face 

amount, the debtor may recognize discharge of indebtedness income and 

the lender ordinarily recognizes a loss. 

Reasons for Change 

aver time inflation erodes the value of a creditor's claim for 

repayment of an indebtedness with a fixed principal amount, and the 

debtor's liability to repay principal is correspondingly reduced. 

Debtors and creditors routinely take account of the anticipated 

effects of inflation on a lending transaction by adjusting the rate of 

interest charged. Thus, nominal interest rates typically include an 

inflation component which compensates the lender for the anticipated 

reduction in the real value of an obligation of a fixed dollar amount; 

as to the borrower, this payment is an offsetting charge for the 

inflationary reduction in the value of the principal amount of the 

borrowing. 

in effect, a repayment of principal, the current treatment of nominal 

interest payments as fully deductible by the debtor and fully taxable 

to the creditor mismeasures the income of each. These inaccuracies in 

the measurement of income distort a variety of investment decisions, 

Because the inflation component of nominal interest payments is, 

- 193 - 
greatly increasing the significance of tax considerations in such 

matters as the allocation of investment funds between debt and equity 

and between long-term and short-term financing. Moreover, in a 

progressive tax system, overstatement of interest expense and income 

accentuates the existing incentive for lower tax-bracket taxpayers 

(including tax-exempt institutions) to be net creditors and higher 

tax-bracket taxpayers to be net borrowers. This so-called "clientele 

effect" occurs because the tax savings from interest deductions is 

greater for high-bracket borrowers than is the increased tax liability 

from interest income to low-bracket lenders. This clientele effect is 

aggravated during times of high inflation and corresponding high 

nominal interest rates. 

inflation component of nominal interest payments also accentuates the 

economic effects of variable inflation on debtors and creditors. If 

the rate of inflation increases unexpectedly, a creditor with 

fixed-interest indebtedness suffers an economic loss, and the debtor 

has a corresponding economic gain. These changes in economic position 

are compounded by the treatment of interest under current law, since 

the entire amount of nominal interest payments remains deductible or 

includible in income regardless of changes in the inflation rate. The 

resulting mismeasurement of income in an economy with variable 

inflation spawns economic uncertainty. Such uncertainty likely 

contributes to reduced levels of savings, investment and risk-taking. 

Finally, the overstatement of interest under current law 

encourages borrowing for investments in which income is tax exempt or 

tax deferred. For example, the investment of borrowed funds in 

capital assets produces a current deduction for interest expense but 

no realization of the increase in value of the capital asset until its 

sale or disposition. This mismatching of income and expense from 

related transactions understates current income and thus permits the 

deferral of tax. Overstatement of interest expense thus increases the 

extent to which debt--financed tax shelter investments can be used to 

offset taxable income from other sources. 

The failure of the current tax system to recognize and measure the 

Proposal 

Interest would be indexed for tax purposes by excluding a 

fractional amount of interest receipts from income and denying a 

deduction for a corresponding fraction of interest payments. For 

example, with a fractional exclusion rate of 25 percent, taxpayers 

would include in income only 75 percent of otherwise taxable interest 

receipts and deduct only 75 percent of otherwise deductible interest 

payments. The fractional exclusion rate would be based on the annual 

inflation rate, as explained below. 

to a taxpayer's net interest income or net interest expense, subject 

to the following exceptions. First, an individual would deduct any 

mortgage interest on indebtedness secured by or allocable to his or 

In general, the proposal would apply the fractional exclusion rate 

.- 194 - 
her principal residence. Qualifying mortgage indebtedness for this 

purpose could not exceed the fair market value of the principal 

residence. Next, an individual would net aggregate gross interest 

expenses (excluding home mortgage interest) against aggregate gross 

interest income (excluding tax-exempt interest). An individual with 

net interest expense would apply the fractional exclusion rate to the 

amount of interest expense in excess of $5,000 ($2,500 in the case of 

a married person filing a separate return). Interest expense, after 

any reduction by the fractional exclusion rate, would be deductible. 

See Chapter 16.01, however, relating to limitations on the deduction 

of investment interest. An individual with net interest income would 

apply the fractional exclusion rate to such net interest income. 

Interest income, after reduction by the fractional rate would be 

includible in income. 

All of a corporation's interest income and expense would be 

subject to the fractional exclusion. Interest incurred by a 

partnership or other pass-through entity would be treated as incurred 

by the partner or other person to whom the payments are allocable. 

Interest received by a partnership or other pass-through entity 

would be treated as received by the partner or other person reporting 

such payments. 

Tax-favored retirement plans, such as an individual retirement 

account or qualified pension plan, which earn interest income would 

not be able to pass on the benefit of the fractional exclusion to the 

plan beneficiaries. Thus, the fractional exclusion rate could not be 

claimed with respect to distributions from tax-favored retirement 

plans. See Chapter 9.01 for application of the basis indexing rules 

to retirement plans. 

The fractional exclusion rate would be modified annually to 

reflect changes in the rate of inflation, as measured by the Bureau of 

Labor Statistics' Consumer Price Index. The proposed relationship 

between fractional exclusion rates and inflation rates is set forth in 

Table 1. The proposed relationship set forth in Table 1 is based on 

an assumption of a constant six percent real, before-tax interest 

rate. Assumption of lower real interest rates would result in higher 

exclusion rates for any given inflation rate. The fractional 

exclusion rate for a taxpayer that uses a functional currency other 

than the U.S. dollar should be based on the inflation rate in the 

foreign currency. 

- 195 - 
Table 1 

Fractional Exclusion Rate 

Inflation Fractional 

Rate Exclusion 

(Percent) Rates (Percent) L/ 

9 

10 

11 

12 

0 

14 

25 

33 

40 

45 

50 

54 

51 

60 

62 

65 

61 

Office of the Secretary of the Treasury November 30, 1984 

Office of Tax Analysis 

- 1/ Fractional exclusion rate is determined by assuming a constant, 

six percent real interest rate (rate of return). 

- 196 - 
The proposal would not alter the current law definition of 

interest. The current law rules which impute interest income in 

certain transactions would also be retained. 

Effective Date 

The proposal to index interest payments and receipts would become 

effective January 1, 1988 and would apply to all indebtedness 

regardless of when incurred. The delay in effective date would 

mitigate the effects of the change in the tax treatment of interest 

paid and received on existing loans. 

Analysis 

Indexing Interest Rather than Principal. An ideal measure of real 

economic income for tax purposes would recognize the inflationary 

reduction in principal on a loan as creating loss for the creditor and 

income for the debtor on an annual basis. That ideal system departs 

from the realization doctrine of current law, however, under which 

mere changes in the value of an asset, including a debt instrument, do 

not trigger income or loss. Abandonment of the realization doctrine 

in this context would introduce substantial costs in complexity and 

recordkeeping. 

Inflation's impact on indebtedness may be indirectly accounted 

for, however, without departing from the realization doctrine. 

Instead of computing inflationary gain or loss on principal, the 

effects of inflation can be approximated by indexing interest payments 

and receipts through application of the proposed fractional exclusion 

rate. 

For example, A borrows $100 from B on January 1, agreeing to pay 

back the principal plus ten percent interest on December 31. Over the 

course of the year, there is four percent inflation and the real, 

pre-tax rate of return is six percent. On December 31, A satisfies 

its indebtedness by repaying the $100 principal and $10 in interest. 

B's receipt of the $100 in principal actually represents a loss of $4 

in real purchasing power. B's receipt of $10 in nominal interest, 

however, actually represents a $6 real return on the loan, plus a $4 

inflationary component which offsets the reduction in the value of the 

$100 principal. Thus, in this example, a fractional exclusion rate of 

40 percent would be appropriate. 

The example demonstrates that, in theory, the effects of inflation 

on indebtedness may be reflected for tax purposes either by indexing 

principal or indexing interest. Indexing interest retains the 

realization rules of current law, and is a much more administrable 

system. 

Determining the Fractional Exclusion Rate. In a world with but 

one nominal interest rate, real interest income and expense would be 

accurately measured by a fractional exclusion rate equal to the ratio 

of the inflation rate to the nominal interest rate. With such an 

- 197 - 
exclusion rate, the excluded interest payments and receipts would 

correspond to the inflationary component of nominal interest. 

rate obviously oversimplifies the relationships between inflation and 

nominal interest rates in a diverse economy. The real rate of return 

earned on indebtedness will differ from lender to lender. The 

proposal's economy-wide fractional exclusion rate, however, allows a 

more accurate measurement of real economic income than does current 

law, which implicitly provides a zero fractional exclusion rate for 

all interest. 

The proposal's single fractional exclusion rate for each inflation 

Effects on Nominal Interest Rates. The proposal would likely 

result in lower nominal interest rates than would prevail under 

current law for any given set of economic conditions. For any 

expected inflation rate, lenders would not demand as high an inflation 

premium since the inflation component of nominal interest receipts 

would not be taxed. Similarly, borrowers would be less willing to pay 

a high inflation premium, since the inflation component of nominal 

interest payments would not be tax deductible. Accordingly, nominal 

interest rates would likely fall, relative to levels that would 

prevail under current law for any given economic conditions. Whether 

interest rates would actually fall after enactment of the proposal 

would, of course, depend upon factors beyond the tax laws, such as 

monetary policy and international capital flows. 

The proposal also likely would result in reduced volatility of 

interest rates with respect to changes in inflation. Under the 

proposal, a change in inflation should induce a smaller change in 

nominal rates than would occur under current law. 

Effects of the Exceptions to Fractional Exclusion Rate. The 

proposal would not apply the fractional exclusion rate to all 

deductible interest payments, resulting in some asymmetric treatment 

of borrowers and lenders. Homeowners would be permitted full 

deduction of mortgage interest on a principal residence, while 

mortgagees would be entitled to apply the fractional exclusion rate to 

interest received on home mortgages. All individuals would be allowed 

full deduction (without indexing) of the first $5,000 of other net 

interest expense. Although these exceptions depart from theoretical 

symmetry for all interest payments and receipts, their retention 

facilitates the transition from an unindexed to an indexed tax system. 

The exception for home mortgages, however, would create an incentive 

for taxpayers both to mortgage the existing equity in their homes, and 

to disguise consumer, investment or business indebtedness as increases 

in home mortgages. These opportunities for tax arbitrage present 

serious revenue concerns, and it may be necessary to develop strict 

rules to prevent such schemes from circumventing the intent of the 

exception. 

interest receipts and excluding a portion of such receipts from income 

may lead taxpayers to try to characterize certain periodic payments as 

Characterization of Non-Interest Payments as Interest. Indexing 

- 198 - 
partially excludable interest rather than fully taxable income such as 

rents or royalties. Some disincentive for mischaracterization exists, 

since treatment of payments as interest would limit the interest 

deduction available to the payor. Nevertheless, payors and payees in 

different tax brackets could produce a net tax savings by 

mischaracterizing payments as interest. 

mischaracterize payments as interest, principally with regard to the 

characterization of corporate distributions as interest or dividends. 

No single, mechanical approach to such questions is likely to prove 

satisfactory, and it is contemplated that. the response to abusive 

cases would evolve under current doctrines distinguishing between 

substance and form. 

Current law has substantial experience with attempts to 

The interest exclusion could also encourage overstatement of 

interest rates in deferred payment transactions in order to 

characterize profit on the sale as excludable interest. Although 

similar incentives can exist under current law, for example, in 

deferred payment transactions involving nondepreciable property, much 

greater attention has been focused on transactions in which interest 

is understated in order to take advantage both of front-loaded ACRS 

deductions and of the current favorable treatment of capital gains. 

interest rates would be measured against comparable transactions and 

disregarded where unrealistic. Although not part of the proposal, it 

could eventually be appropriate to establish mechanical limits on 

maximum interest rates analogous to the imputed interest rules of 

current law. 

In order to limit overstatement of interest, stated valuations and 

Interaction with Other Proposals. Indexing interest receipts and 

payments is consistent with the Treasury Department proposals relating 

to inflation indexing for capital gains, RCRS property and 

inventories. Since both interest receipts and stock in a corporation 

holding interest-bearing assets would be adjusted for inflation, there 

might be some question of a potential for over-indexing or of double 

counting for inflation. In general, however, no such double counting 

would occur, since it is appropriate that the corporation's income and 

the shareholder's return on stock be separately adjusted for 

inflation. 

Because the fractional exclusion rate is not a precise measure of 

inflationary effects, interest generally would not be excluded in the 

same proportion as a shareholder or partner would be allowed to index 

basis in stock or a partnership interest. Even though not precisely 

accurate, the fractional exclusion rate comes closer to achieving the 

appropriate correspondence between a shareholder's basis in a 

corporation's stock and the corporation's income from indebtedness 

than would a system that failed either to index the shareholder's 

stock basis or to apply the fractional exclusion to the corporation's 

interest income. 

- 199 - 
The variation between basis indexing and application of the 

fractional exclusion rate could in some cases be exploited by 

taxpayers if future variations could be known with sufficient 

certainty. Such exploitation seems to present the greatest likelihood 

of taxpayer manipulation in the case of pass-through entities holding 

a substantial proportion of interest bearing assets. In such cases, 

partners would be precluded from increasing basis in their partnership 

interests faster than at the rate implied by the fractional exclusion 

rate applied to the partnership's interest receipts. In other cases, 

similar limitations on indexing stock may be required to ensure that 

the relationship between indexing capital assets and indebtedness is 

not abused. 

- 200 - 












































CHAPTER 12 

FINANCIAL INSTITUTIONS 

Part A. Commercial Banks and Thrift Institutions 

This Part discusses proposals to conform special rules relating t 

the taxation of banks and thrift institutions to the general rules for 

the taxation of corporate income. The special bad debt reserve 

deduction for banks and thrift institutions would be repealed. 

Interest allocable to tax-exempt obligations held by banks, savings 

and loans, and certain other thrift institutions would be deductible. 

The tax exemption of credit unions and special reorganization rules 

for failing thrift institutions would be repealed. 

- 2.15 - 

459-813 'I - 84 - 9 
REPEAL SPECIAL RULES FOR SANK SAD DEET DEDUCTIONS 

General Explanation 

Chaptet 12.01 

Current Law 

Commercial banks and thrift institutions are generally subject to 

the corporate income tax, but receive preferred tax treatment that 

permits them to deduct additions to reserves for bad debts using a 

method unrelated to their actual loan loss experience. 

Commercial banks may utilize either the percentage method or a 

modified version of the experience method for determining their bad 

debt deductions. The percentage method allows a current deduction for 

additions to reserves sufficient to maintain a reserve of up to 0.6 

percent of eligible loans outstanding. The experience method for 

banks generally is based on average loan losses over the most recent 

six-year period. Banks need not be consistent in their choice of 

method from one taxable year to another. The provision permitting use 

of the percentage method is scheduled to expire at the end of 1987, at 

which time all commercial banks must use the experience method. 

Thrift institutions may use modified versions of the percentage 

method or experience method available to banks. Alternatively, thrift 

institutions, if they hold sufficient amounts of their assets in 

certain eligible investments (primarily residential mortgages), may 

elect the percentage of taxable income method for purposes of 

establishing their bad debt reserves for qualifying real property 

loans. Savings and loan associations and stock savings banks must 

hold at least 82 percent of their total assets in eligible investments 

to receive the maximum deduction, which is equal to 40 percent of 

taxable income (computed with certain modifications). A lower 

percentage of taxable income is deductible if less than 82 percent of 

total assets constitute eligible investments. Mutual savings banks 

must hold at least 72 percent of their total assets in eligible 

investments to receive the maximum deduction, which is also subject to 

reduction if the percentage of eligible investments is less than 72 

percent. 

method are limited in the amounts of certain other tax benefits they 

may claim. For example, they may claim only one-half of the 

otherwise-allowable investment tax credit and their dividends-received 

deduction is reduced from that available to other corporations. 

The corporate preference item reduction provisions reduce the 

amount of bad debt reserve deductions that a depository institution 

not on the experience method may claim. No deduction is allowed for 

an amount equal to 20 percent of the excess of a depository 

Thrift institutions that utilize the percentage of taxable income 
ins;itution's addition to its bad debt reserves over the additions 

that would have been deductible had the institution used the 

experience method. In addition, an amount equal to 59-5/6 percent of 

such excess constitutes a tax preference item for purposes of the 

corporate minimum tax. 

Reasons for Change 

Current 1,aw provides more favorable tax treatment of bad debt 

losses to depository institutions than to lenders in other industries 

This tax preference distorts the investment decisions of some 

depository institutions. A thrift institution may utilize the 

favorable percentage of taxable income method only if it specializes 

in residential mortgage lending. The maximum deduction is available 

only if 82 percent of the thrift's assets (72 percent for mutual 

savings banks) are invested in loans on residential real estate, 

liquid assets, or certain other assets. The linkage between a lower 

effective tax rate and residential mortage lending provides a 

disincentive to diversification by thrift institutions and thereby 

subjects thrifts to increased portfolio risk. 

Finally, the special percentage of taxable income deduction 

benefits only profitable thrift institutions. Thrifts with no taxable 

income must elect the percentage of eligible loan method to maximize 

their net operating losses. Thus, the special bad debt deduction tied 

to residential mortgage lending benefits only a fraction of all 

mortgage lenders. 

P r opo 6 a1 

The special rules for commercial banks and thrift institutions for 

computing additions to a bad debt reserve would be repealed. 

Depository institutions would be subject to the general rule 

applicable to all taxpayers. The Treasury Department proposals would 

require generally that bad debt losses be deducted only a5 they occur. 

See Chapter 10.04. This requirement would apply equally to commercial 

banks and thrift institutions. 

Effective Date 

The proposal would be effective for all taxable years beginning on 

or after January 1, 1986. Depository institutions would be required 

to include existing reserves in income over ten years, starting with 

the first taxable year beginning on or after January 1, 1986. 

Analysis 

Deductions for additions to reserves for bad debts are overstated 

for depository institutions compared to deductions for bad debts for 

other businesses. Because a bad debt reserve for tax purposes 

involves only bookkeeping entries with no set-aside of assets, the 

only practical effect of present law is to increase the after-tax 

income of depository institutions. The lower effective tax rate 

- 247 - 
resulting from excess bad debt deductions subsidizes loans from 

depository institutions and enables them to offer loans at 

artificially low rates. The proposal would eliminate this subsidy. 

The proposal would reduce the amount of bad debt deductions 

reported by depository institutions. Present law permits depository 

institutions to select from a variety of methods the one providing the 

largest deductions. For example, the percentage of eligible loan 

reserve method permits a bank to maintain a reserve equal to 0.6 

percent of its outstanding loans without regard to actual loss 

experience. Thus, it only benefits banks with bad debt experience 

rates below that level; banks with higher bad debt rates will utilize 

the experience reserve method. In 1983, an estimated 73 percent of 

commercial banks found the percentage method to be more beneficial 

(actually, more used it because of special transition rules), while 

only 27 percent found the experience method to be more advantageous. 

Excess deductions for additions to bad debt reserves by thrift 

institutions under the percentage of taxable income method reduce 

their effective marginal tax rates. Most thrift institutions were 

unable to take advantage of the percentage of taxable income method in 

1981 and 1982 because they did not have taxable income. Only 

profitable thrift institutions derive any benefit from the percentage 

of taxable income method permitted under current law. For example, 

the total bad debt deductions claimed by savings and loan associations 

fell from $1.41 billion in 1979 to $0.14 billion in 1981, because the 

preferential tax treatment is tied to profits, not actual loan losses. 

In 1983, an estimated 60 percent of savings and loans found the 

percentage of taxable income method to be beneficial (actually, fewer 

did because of net operating loss carry forwards), while the remaining 

40 percent found the percentage of outstanding loans method to be more 

beneficial. 

Additional analysis of the proposed repeal of the reserve method 

for all bad debt deductions is provided in Chapter 10.04. 

Ninety-seven percent of all savings and loan associations and 64 

percent of all commercial banks had loss-to-loan ratios below the 

percentage method's allowable 0.6 percent. Also in 1983, 99 percent 

of all savings and loan associations and 58 percent of all commercial 

banks wrote off for financial reporting purposes less than 0.6 percent 

of their outstanding loans. The special bad debt reserve rules are 

clearly a large subsidy for most savings and loan associations and 

commercial banks and a significant distortion from the measurement of 

economic income. 

- 248 - 
DENY DEDUCTION FOR INTEREST TO 

CARRY TAX-EXEMPT BONDS 

General. Explanation 

Chapter 12.02 

Current Law 

Current law generally denies a deduction to any taxpayer for 

interest on indebtedness incurred or continued to purchase or carry 

tax-exempt obligations. Whether indebtedness is incurred or continued 

to purchase or carry tax-exempt obligations is based on the taxpayer's 

purpose in incurring indebtedness while holding tax-exempt 

obligations, as indicated by the facts and circumstances of the 

particular case. 

Until 1982, banks, thrifts, and certain other financial 

institutions could invest their depository funds in tax-exempt 

obligations without losing the deduction for interest paid on their 

deposits or short-term obligations. Under current law, however, such 

financial institutions are denied 20 percent of their interest 

deduction allocable to indebtedness (including deposits and other 

short-term obligations), incurred or continued in order to purchase or 

to carry tax-exempt obligations acquired after 1982. A statutory 

presumption treats a portion of a bank's or other financial 

institution's indebtedness as allocable to tax-exempt obligations in 

an amount equal to the ratio of (i) the average adjusted basis over 

the year of all tax-exempt obligations (acquired after 1982) held by 

the bank or financial institution to (ii) the average adjusted basis 

over the year of all assets held by the bank or financial institution. 

The corporate mimimum tax generally does not apply to interest 

received by banks and financial institutions from the holding of 

tax-exempt obligations. 

Reasons for Change 

Basic measurement of income principles require that income be 

matched with the costs of its production. In line with these 

principles, the costs of producing tax-exempt income, including 

interest expense incurred to carry tax-exempt bonds, are properly 

nondeductible. Since the income to which such costs are attributable 

is exempt from tax, disallowance of a deduction is necessary to 

prevent the taxpayer from offsetting other nonexempt income. 

incurred by commercial banks and thrifts has enabled these 

institutions to hold a substantial portion of their investment 

portfolios in tax-exempt obligations, substantially reducing their 

Federal tax liability. The full allowance of interest deductions to 

banks holding tax-exempt obligations contributes to the relatively low 

effective tax rates of banks. In 1981, prior to the changes reflected 

The exception from the above principles for interest paid or 

- 249 - 
in current law, commercial banks paid only $926 million of Federal 

income tax on approximately $15 billion of net income. 

In addition, the special rule for commercial banks and thrifts 

provides them with a competitive advantage over other financial 

institutions that are disallowed interest deductions for carrying 

tax-exempt obligations. Brokers and dealers currently are not allowed 

to deduct any portion of the interest paid to purchase or to carry 

tax-exempt securities. Similarly, life insurance companies must 

prorate their tax-exempt investment income between policyholders and 

the company, which is comparable to denying a deduction for interest 

incurred to carry tax-exempt obligations. 

Proposal 

Banks, thrifts and the other financial institutions favored under 

current law would be denied a deduction for 100 percent of their 

interest payments allocable to the purchase or carrying of tax-exempt 

obligations. The portion of a financial institution's interest 

payments that would be deemed allocable to the purchase or carrying of 

tax-exempt obligations would be the same as under current law. Thus, 

such portion would be equal to the ratio of (i) the average adjusted 

basis over the year of all tax-exempt obligations (acquired on or 

after January 1, 1986) held by the financial institution to (ii) the 

average adjusted basis over the year of all assets held by the 

financial institution. For example, if a bank holds $1,000,000 of 

tax-exempt bonds acquired after January 1, 1986, (measured by their 

average adjusted basis over the year) and $3,000,000 of other assets 

(similarly measured), its otherwise allowable interest deduction would 

be reduced by 25 percent without regard to whether paid to depositors, 

short-term obligors, or long-term obligors. The prorata presumption 

would be irrebuttable. 

Effective Date 

The proposal would be effective for interest allocable to 

tax-exempt obligations acquired on or after January 1, 1986. The 

current disallowance rule of 20 percent would continue to apply after 

December 31, 1985 to tax-exempt obligations acquired between January 

1, 1983 and December 31, 1985. 

Analysis 

The deductibility of interest paid to purchase or to carry 

tax-exempt bonds increases the attractiveness of tax-exempt 

obligations because of the attendant opportunity to shelter other 

taxable income. Moreover, present law encourages banks to make 

investments that are not economically attractive except for the tax 

benefits. For example, a bank may borrow at a nine percent interest 

rate and invest in tax-exempt obligations yielding only seven percent 

interest. Economically, the bank would lose two percent on such a 

transaction; however, because the bank can deduct 80 percent of the 

interest paid, it pays an after-tax interest rate of only 5.7 percent 

- 250 - 
(9 x [1 - (.46 x .i3)]) and makes an after-tax profit of 1.3 pelcent. 

Denying banks a deduction for interest allocable to the purchase or 

carrying of tax-exempt obligations would eliminate a tax incentive to 

make an otherwise unattractive economic investment. 

Commercial banks hold one-third of outstanding tax-exempt 

securities and loans, as shown in Table 1. Commercial banks are the 

largest institutional investors, and are second only to households in 

total holdings of tax-exempt obligations. Commercial banks are the 

major institutional investors because of their ability to borrow funds 

and deduct interest to carry investments that earn tax-exempt income. 

The transitional rule would continue to allow banks to deduct interest 

attri,butable to bonds acquired prior to the effective date, so that 

there would be no incentive to sell existing holdings. Banks would 

continue to buy some tax-exempt bonds after the effective date as 

evidenced by the current holdings of life insurance companies and 

brokers and dealers, who are already subject to the proposed rule. 

Viewed in isolation, this proposal would tend to reduce bank 

demand for tax-exempt bonds and exert upward pressure on tax-exempt 

interest rates, particularly short-term yields. Several of the 

Treasury Department proposals, however, would affect the interest 

rates of tax-exempt obligations. The aggregate impact on tax-exempt 

interest rates is uncertain because the elimination of 

non-governmental tax-exempt bonds, bonds issued for arbitrage 

purposes, and other tax shelters would tend to increase demand for the 

remaining governmental bonds and exert downward pressure on the 

interest costs paid by state and local governments. 

- 251 - 
Table 1 

Distribution of Tax-Exempt Securities and Loans -- 1983 

Outstanding Tax-Exempt Bonds 

Amount 

(In Billions) Percent - 

Households 

Nonfinancial Corporate Businesses 

State and Local Government General 

Funds 

Commercial Banks 

Savings and Loan Associations 

Mutual Savings Banks 

Mutual Funds 

Life Insurance Companies 

State and Local Retirement Funds 

Other Insurance Companies 

Brokers and Dealers 

$173.8 35.9 

4.2 0.9 

9.1 2.0 

162.4 33.5 

0.9 0.2 

2.2 0.4 

31.5 6.4 

10.0 2.1 

1.8 0.4 

86.1 11.9 

1.4 0.3 

Total $484.6 100.0 

Office of the Secretary of the Treasury November 30, 1984 

Source: Board of Governors of the Federal Reserve System, 

Office of Tax Analysis 

Flow of Funds Accounts, Assets and Liabilities outstanding, 

1960-83 

- 252 - 
REPEAL TAX EXEMPTION FOR CREDIT UNIONS 

General Explanation 

Chapter 12.03 

Current Law 

income is retained or distributed to depositors. 

Reasons for Change 

advantage over other financial institutions such as commercial banks 

and savings and loan associations. Their tax-exempt status has 

enabled credit unions to grow rapidly since 1951, when savings and 

loan associations and mutual savings banks became subject to the 

corporate income tax. Credit unions accounted for 5.1 percent of small 

time and savings deposits and 13.8 percent of consumer installment 

credit outstanding in 1983. 

In an economy based on free market principles, the tax system 

should not provide a competitive advantage for particular commercial 

enterprises. Credit unions should thus be subject to tax on the same 

basis as other financial institutions. 

Proposal 

unions would be subject to tax under the same rules that apply to 

other thrift institutions. 

Effective Date 

after January 1, 1986. 

Analysis 

Tax exemption at the company level allows credit union 

customer/owners to defer tax liability on earnings retained by the 

credit union. By retaining their earnings tax-free, credit unions can 

offer their customer/owners higher rates of return than other 

financial institutions. Repealing the tax exemption of credit unions 

would eliminate the incentive for credit unions to retain, rather than 

distribute, current earnings. 

The proposal will subject credit unions to tax on their retained 

earnings. To the extent that retained earnings are necessary for 

growth, credit unions will have to increase the spread between their 

"dividend" rates and loan rates to cover the Federal tax liability in 

Credit unions are exempt from tax on their income, whether such 

Because of their tax exemption, credit unions enjoy a competitive 

The tax exemption for credit unions would be repealed. Credit 

The proposal would be effective for taxable years beginning on or 

- 253 - 
the same manner as stock companies. As with other mutual depository 

institutions, however, credit unions could reduce the amount of 

Federal income tax paid at the corporate level by distributing more 

"dividends" to depositors or by providing lower loan rates to 

borrowers. Distributions of earnings would be included in taxable 

income currently at the individual level. 

In 1983, Federal credit unions earned $4.0 billion in net income 

and distributed $3.6 billion in dividends or interest refunds to 

customer/owners. Retained earnings, which are tax-exempt and accrue 

tax-free interest income, were 10.6 percent of current net earnings. 

Some of the retained earnings would be distributed currently and taxed 

at the individual level; the remaining amounts would be subject to tax 

at the company level. 

- 254 - 
REPEAL REORGANIZATION RULES FOR FINANCIALLY 

TROUBLED THRIFT INSTITUTIONS 

General Explanation 

Chapter 12.04 

Current Law 

Certain acquisitions of the stock or assets of one corporation by 

another qualify as tax-free reorganizations under current law. In 

general, the shareholders of a corporation that is acquired in a 

reorganization may exchange their stock for stock of the acquiring 

corporation on a tax-free basis. In addition, a corporation acquired 

in a reorganization may exchange its assets on a tax-free basis for 

stock of the acquiring corporation. 

Corporate acquisitions generally do not qualify as tax-free 

reorganizations unless they satisfy the "continuity of interest" 

requirement. Stated generally, an acquisition will satisfy the 

continuity of interest requirement only if the shareholders of the 

acquired corporation receive a significant, continuing equity interest 

in the acquiring corporation. 

Special rules enacted in 1981 permit the acquisition of a 

"financially troubled" thrift institution to qualify as a tax-free 

reorganization without regard to the contincity of interest 

requirement. The continuity of interest requirement would generally 

pose an obstacle in such an acquisition because depositors are the 

only persons holding interests in the financially troubled thrift who 

would receive an interest in the acquiring corporation. Because of 

their insured position, however, the depositors in the failing thrift 

generally will not accept an equity interest in the acquiring 

corporation with its attendant risk of loss. For this reason, the 

acquiring corporation ordinarily will assume the failing thrift's 

liabilities to its depositors. In the absence of the special waivei-, 

an interest as a depositor would not satisfy the continuity of 

interest requirement. 

For the special rule to apply, the Federal Savings and Loan 

Insurance Corporation (FSLIC), Federal Home Loan Bank Board (FHLBB), 

or, where neither has supervisory authority, an equivalent State 

authority, must certify that the transferor thrift is insolvent, that 

it cannot meet its obligations currently, or that it will be unable to 

meet its obligations in the immediate future. In addition, the 

transferee must acquire substantially all of the transferor's assets 

and must assume substantially all of its liabilities. If an 

acquisition of a failing thrift institution satisfies these rules, the 

- 255 - 
tax attributes of the failing thrift survive the acquisition and the 

acquiring corporation can use the net operating losses of the acquired 

thrift to lower its own taxable income. 

In addition to the special reorganization rule, present law 

provides an exclusion from income for payments by the FSLIC to a 

thrift institution in connection with a reorganization. Such payments 

are not included in the thrift's gross income and do not reduce the 

thrift's basis in any of its assets. 

Reasons for Change 

The special rules governing reorganizations of financially 

troubled thrift institutions were enacted in 1981 to facilitate 

mergers and reorganizations of the then-ailing thrift industry. In 

such acquisitions, a profitable financial institution typically agrees 

to assume a failing thrift's obligations in consideration for payments 

from a regulatory body, such as the FSLIC, and the right to utilize 

the failing thrift's tax losses. 

Thrift institutions and their shareholders should be subject to 

tax on the same basis as other business enterprises. The special 

rules for reorganizations of financially troubled thrift institutions 

depart from that objective, and effectively shift some of the burden 

of thrift losses to the Federal government. If such subsidization of 

reorganized financial institutions is necessary, it should be effected 

through direct appropriations. This would permit the appropriate 

regulatory agency to determine the need for and amount of a subsidy on 

a case-by-case basis. 

Proposal 

The special reorganization rules for acquisitions of financially 

troubled thrifts and the exclusion from income of FSLIC payments to 

thrift institutions in connection with a reorganization would be 

repealed. 

Effective Date 

The repeal of the special reorganization rules would be effective 

for acquisitions occurring on or after January 1, 1986. The repeal of 

the exclusion for certain FSLIC payments would apply to taxable years 

beginning on or after January 1, 1986. 

Anal y s i s 

The Federal assistance provided through special tax rules hides 

the total subsidy cost and is likely to exceed the amount of 

assistance that would otherwise be provided through direct 

appropriations. 

- 256 - 
Part B. Life Insurance Companies and Products 

The current Federal income tax treatment of life insurance 

companies and their products al.lows investors in such products to 

obtain a substantially higher after-tax return than is available on 

investments whose income is fully taxed on a current basis. The 

Treasury Department proposals would do away with this special 

treatment. Deferral on the income earned on the investment of life 

insurance premiums (other than term insurance) wuld be ended by taxing 

to the policyholder the annual increase in the cash surrender value of 

the policy. The same treatment would apply to annuity contracts. 

Policyholder loans and partial withdrawals would also be taxed to the 

policyholder, to the extent of any income credited to the policy but 

not previously taxed to the policyholder. 

companies would also be modified. The life insurance reserve for any 

contract would be limited to the contract's net surrender value. The 

special 20-percent life insurance deduction and 60-percent small life 

insurance company deduction would be repealed. 

Special rules that reduce the income tax paid by life insurance 

- 251 - 
IMPOSE CURRENT TAXATION ON LIPE 

INSURANCE INSIDE INTEREST BUILD-UP 

General Explanation 

Chapter 12.05 

Current Law 

The premium paid on any life insurance policy (other than a term 

insurance policy) can be divided into three components: a pure 

insurance component, a loading component, and an investment or savings 

component. During any period, the pure insurance component of a 

policy serves to redistribute funds from policyholders who pay charges 

for insurance protection to beneficiaries of policyholders who die 

during the period. The loading component serves to cover the 

insurance company's expenses and to provide it with a measure of 

profit. The investment component of a policy arises from the fact 

that the company can invest funds paid by policyholders between the 

time the funds are received by the company and the time they are paid 

out to beneficiaries. The company in turn credits fixed or variable 

amounts in the nature of interest to the policy, thereby increasing 

the cash value of the policy and providing a return to the 

policyholder on his investment in the policy. 

insurance and loading charges for the year in which the premium is 

paid is, in effect, making a deposit into a savings account that earns 

interest for the benefit of the policyholder. 

Current law permits life insurance policyholders to earn this 

income on amounts invested in the policy free of current tax. This 

untaxed investment income is commonly referred to as "inside interest 

build-up.'' The company issuing the policy is allowed a deduction for 

increases in its insurance reserves. Because the level of reserves 

relating to a policy increases as interest is credited to the policy, 

the reserve deduction effectively shields the investment income from 

tax at the company level. 

If a policy fails at any time to satisfy a Federal tax statutory 

definition of life insurance, which requires that the contract have a 

significant insurance component, the policy is treated as a 

combination of term life insurance and an investment fund, with the 

income generated by the fund being currently taxable to the 

policyholder. 

death of the insured is excluded from the gross income of the 

beneficiary. Thus, if a policyholder holds a life insurance policy 

until his death, the investment income on the policy, which was not 

taxed when credited to the policy, escapes tax permanently. If a 

Thus, a policyholder who pays a premium in excess of the cost of 

Any amount paid under a life insurance policy by reason of the 

- 258 - 
policyholder surrenders his life insurance policy before death in 

exchange for the policy's cash surrender value or receives 

distributions in the form of policyholder dividends, the policyholder 

recognizes ordinary income equal to the excess of the cash received 

over his net investment in the policy. The policyholder's investment 

in the policy includes the portion of his premiums that has been used 

to pay the cost of life insurance. Consequently, any investment 

income taxed to the policyholder is reduced by the cost of his life 

insurance, even though this cost is a personal expense of the 

policyholder and would not be deductible if paid directly. 

Reasons for Change 

The deregulation of financial institutions and various economic 

factors have resulted in an increase in the rate of interest paid on 

traditional investment products (e.g., bank accounts and whole life 

insurance policies) and a proliferation of competing investment 

vehicles offered by different types of financial institutions. The 

effect of these changes has been to increase the already substantial 

investment orientation of cash value life insurance products. 

Although the definition of life insurance places some broad limits on 

the use of life insurance as a tax-favored investment vehicle, it is 

still possible to design an insurance policy meeting this definition 

under which the cumulative investment earnings at currently prevailing 

interest rates are projected to be as much as eight times as large as 

the cumulative insurance costs. Thus, the favorable tax treatment of 

inside interest build-up on life insurance policies can be obtained 

through a contract that provides a relatively small amount of pure 

insurance coverage. 

Interest income on comparable investment vehicles generally is not 

tax free or tax deferred. Instead, interest income credited on such 

investments generally is subject to tax whether or not the interest is 

currently received by the taxpayer. For example, taxpayers generally 

are subject to current tax on interest credited on certificates of 

deposit although the interest is not received until the certificate of 

deposit matures. 

Moreover, life insurance is not subject to the significant 

limitations on the timing and amount of contributions, withdrawals, 

and loans that apply to other tax-favored investments, such as 

qualified pension plans and individual retirement accounts (IRAs). 

build-up on life insurance policies goes only to individuals with 

excess disposable income that enables them to save, and particularly 

to individuals in high tax brackets. This benefit is not available to 

lower income taxpayers and other individuals buying term insurance 

since it derives solely from the investment component of a policy 

(which is not present in a term insurance policy). 

individuals to save through life insurance companies rather than other 

The benefit of deferring or avoiding tax on the inside interest 

The tax-favored treatment of inside interest build-up encourages 

- 259 - 
financial institutions and perhaps to purchase life insurance that 

they would not buy except to gain access to the favorable tax 

treatment of the investment income. This distorts the flow of savings 

and investment in the economy. 

Proposal 

Owners of life insurance policies would be treated as being in 

constructive receipt of the cash surrender value (taking into account 

any surrender charge or penalty) of their policies. Thus, a 

policyholder would include in interest income for a taxable year any 

increase during the taxable year in the amount by which the policy‘s 

cash surrender value exceeds the policyholder‘s investment in the 

contract. A policyholder‘s investment in the contract would be equal 

to the aggregate of his gross premiums, reduced by the aggregate 

policyholder dividends and other distributions under the policy and by 

the aggregate cost of renewable term insurance under the policy. 

The investment component of a long-term life insurance contract 

would be”eligib1e for any general savings incentive available to 

comparable investments. For example, the otherwise-taxable interest 

income produced by an increase in the cash surrender value of a life 

insurance contract during a taxable year could be designated as a 

contribution to an IRA. 

Effective Date 

The proposal would be effective for all inside interest build-up 

credited to policies sold on or after January 1, 1986. In the case of 

policies outstanding on December 31, 1985, inside interest build-up 

would continue to be free from tax until December 31, 1990. Beginning 

in 1991, this proposal would be phased in over a five-year period, so 

that future inside interest build-up on policies sold before 

January 1, 1986 would be fully subject to tax starting in 1995. 

Deferral of untaxed inside interest build-up would continue until 

withdrawal of funds from the policy. See Chapter 12.06. The 

policyholder’s investment in the contract would not be reduced by the 

cost of term insurance for any period prior to January 1, 1986. 

Analysis 

Taxing the inside interest build-up on life insurance policies 

would eliminate the largest tax distortion in the financial services 

area and would place competing financial products and institutions on 

more equal footing. This would promote the efficient flow of 

long-term savings. 

Current taxation of inside interest build-up also would eliminate 

the need for complex rules and restrictions in several areas, 

including the determination of tax liability when a policy matures or 

is surrendered and the definition of contracts that qualify as life 

insurance. For a discussion of how this proposal would affect the 

treatment of policyholder loans, see Chapter 12.06. 

- 260 - 
Table 1 shows the distribution of cash value life insurance 

policies by family economic income. High-income families are more 

likely to have cash value policies as well as larger policies. The 

average annual tax-deferred interest income earned on life insurance 

and annuity policies in 1983 is estimated at $3,050 for families with 

income greater than $200,000 and less than $200 for families with 

income less than $30,000. Because the purchase of life insurance 

policies for predominantly investment purposes is a recent 

development, the difference between the amount of inside interest 

build-up earned by wealthier individuals and that earned by less 

wealthy individuals is expected to grow in the future. 

- 261 - 
Table 1 

Distribution of Ownership of Cash-Value Life Insurance Policies and 

By Economic Income - 1983 

the Annual Inside Interest Build-up - 1/ 

: Families with 

Family : Cash-Value Life : Average Annual 

Economic Income : Insurance Policies : Inside Build-up 2/ 

$ 0 - 9,999 13 $ 85 

10,000 - 14,999 25 110 

15,000 - 19,999 33 135 

20,000 - 29,999 41 190 

30,000 - 49,999 53 310 

50,000 - 99,999 68 520 

100,000 - 199,999 78 1,240 

200,000 or more 70 3,050 

All Families 42 $ 355 

Percentage 

Office of the Secretary of the Treasury November 29, 1984 

Office of Tax Analysis 

- 1/ Includes annuities. - 2/ For those with policies. 

Source: Treasury estimates. 

It is anticipated that many low- and middle-income individuals who 

currently own relatively small amounts of cash value life insurance 

and who would not otherwise maintain IRns will designate their 

existing policies as IRAs. If the annual premium (net of policyholder 

dividends) plus the inside interest build-up on the policy does not 

exceed the applicable IRA limit, the inside interest build-up would 

continue, in effect, to be free from current tax. However, the rules 

respecting the timing of distributions from IRAs would apply and any 

cash value held in a life insurance IRA at the policyholder's death 

would be taxed to the beneficiary like any other IRA distribution. 

(The excess of the death proceeds over the cash value would be exempt 

from tax, as under current law.) 

- 262 - 
REVISE TAXATION OF POLICYHOLDER 

LOANS ___ 

AND PARTIAL WITHDRAWALS 

General Explanation 

Chapter 12.06 

Current Law 

funds from the life insurance company in an amount up to the cash 

value of the policy. Until repaid, the amount of a policyholder loan 

reduces the proceeds payable to the policyholder in the event of a 

surrender of the policy or to the beneficiaries in the event of the 

death of the policyholder. 

withdrawals from the policy, even if the loans are not repaid prior to 

the death of the insured. Moreover, subject to certain restrictions, 

interest paid on policyholder loans is deductible by the policyholder 

even though the policy‘s inside interest build-up is not subject to 

current tax. 

Life insurance policies normally permit the policyholder to borrow 

Policyholder loans are respected as loans and are not treated as 

Generally, if a policyholder withdraws cash from his policy, he is 

treated as recovering first his investment in the policy. Only after 

the entire investment has been recovered is the excess amount 

withdrawn subject to tax. However, a special rule in the definition 

of life insurance provides that if cash is withdrawn from a policy as 

a result of a reduction of future death benefits under the policy, the 

cash will be treated as “boot” in an exchange transaction and subject 

to tax. 

Reasons for Change 

Because the inside interest build-up on life insurance policies is 

not taxed until withdrawal, and is not taxed at all if the policy is 

held until death, interest deductions from policyholder loans can be 

used to shelter other taxable income. Currently, life insurance 

companies are able to market policies with fixed borrowing schedules 

that provide substantial tax advantages to the policyholder. Under 

some of these plans, the tax advantages are so large that they have 

been marketed primarily as tax shelters and oniy incidentally as life 

insurance. 

Through a partial withdrawal of the cash surrender value from a 

life insurance policy, a policyholder may receive back an amount that 

does not exceed his investment in the policy free from tax. A 

policyholder should not be allowed to cash in his investment while 

continuing to defer the payment of tax on income from that investment. 

- 263 - 
Borrowing against the cash value of a life insurance policy 

reduces the total amount invested by the individual in the policy and 

has the effect of a partial withdrawal of the policy's cash surrender 

value, These economically equivalent transactions should be accorded 

equivalent tax treatment. 

Although current taxation of inside interest build-up is proposed 

in Chapter 12.05, the transitional rule under that proposal would 

permit the continued deferral of tax on certain inside interest 

build-up for policies outstanding on December 31, 1985. Accordingly, 

even if the proposal in Chapter 12.05 is adopted, a revision of the 

policyholder loan and partial withdrawal rules is needed as a 

temporary measure. 

Ftoposal 

Policyholder loans and partial withdrawals under a policy (not 

including policyholder dividends and similar distributions), to the 

extent of any income credited to the policy but not yet included in 

the taxable income of the policyholder, would be treated as a 

distribution of such income to the policyholder. The amount of income 

treated as distributed to the policyholder would be limited to the 

excess of the cash surrender value of the policy (taking into account 

any surrender charge or penalty) over the policyholder's investment in 

the contract. The policyholder's investment in the contract would 

equal the aggregate amount of premiums paid for the contract reduced 

by the sum of the aggregate amount of policyholder dividends and 

similar distributions and the aggregate cost of insurance, taking into 

account only the cost of insurance after December 31, 1985. 

Effective Date 

The proposal would apply to policyholder loans and partial 

withdrawals made on or after January 1, 1986. In addition, all 

policyholder loans outstanding on December 31, 1985, to the extent not 

repaid before January 1, 1991, would be treated as new loans to which 

the proposal applies. 

Analysis 

The treatment of policyholder loans and partial withdrawals as 

distributions coming first out of any untaxed investment income under 

the policy ensures that the tax deferral of inside interest build-up 

occurring prior to the effective date of these proposals will continue 

only as Long as savings arid investment income are retained in the 

policy. The treatment of outstanding loans not repaid before January 

1, 1991 as new loans subject to the proposal would reduce an otherwise 

strong incentive for policyholders to withdraw funds through 

policyholder loans shortly before the effective date of the proposal. 

- 264 - 
The need for this rule (and for the provisions of current law 

prescribing special treatment of policyholder loans) will disappear 

after all policies containing untaxed inside interest build-up mature 

or are surrendered. However, if the proposal in Chapter 12.05 to tax 

currently the inside interest build-up on life insurance policies is 

not adopted, thi,s proposal would be needed as a permanent rule. 

- 265 - 
IMPOSE CURRENT TAXATION ON DEFERRED 

ANNUITY INVESTMENT IMCOMEGeneral Explanation 

Chapter 12.07 

Current Law 

Income credited to a deferred annuity contract is not taxed 

currently to the owner of the contract or to the insurance company 

issuing the contract. In general, amounts received by the owner of an 

annuity contract before the annuity starting date (including loans 

under the contract) are taxed as ordinary income to the extent that 

the cash value of the contract exceeds the owner's investment in the 

contract. A portion of each distribution received after the annuity 

starting date is taxed as ordinary income based on the ratio of the 

investment in the contract to the total distributions expected to be 

received. Penalties are imposed on certain premature distributions 

under an annuity contract. 

Reasons for Change 

Investment income earned on deferred annuities is similar to 

investment income earned on other savings instruments with other 

financial institutions. Interest on savings accounts and certificates 

of deposits is taxed currently, howsver, while investment income 

earned on annuities is not taxed until withdrawal. Moreover, deferred 

annuities are not subject to the significant limitations on the timing 

and amount of investments that apply to other tax-favored investments, 

such as pension plans and individual retirement accounts (IRns). Yet 

deferred annuity savings are more likely than other tax-favored 

investments to be withdrawn before retirement because of the smaller 

withdrawal penalty. 

Since tax-favored annuities can be purchased only from life 

insurance companies, this tax deferral directs the flow of savings 

toward life insurance companies and away from other financial 

institutions. There is no reason to favor savings through insurance 

companies over savings through competing financial institutions. 

The deferral of tax on investment income credited to deferred 

annuities is available only to persons with disposable income 

available for savings and is of greatest benefit to persons in the 

highest tax brackets. The tax deferral thus favors wealthier 

individuals. 

Proposal 

Owners of deferred annuity contracts would be treated as being in 

constructive receipt of the cash value (taking into account any 

- 266 - 
surrender charge or penalty) of their contracts. Thus, the owner 

would include in interest income for a taxable year any increase 

during the taxable year in the amount by which the contract's cash 

value exceeds the owner's investment in the contract. 

A deferred annuity contract would be eligible for any general 

savings incentive available to comparable investments. For example, 

the otherwise-taxable interest income produced by an increase in the 

cash surrender value of a deferred annuity contract during a taxable 

year could be designated as a contribution to an IRA. 

Effective Date 

The proposal would be effective for all investment income credited 

to contracts sold on or after Jauary 1, 1986. In the case of 

contracts outstanding on December 31, 1985, investment income credited 

to the contracts would continue to be untaxed until December 31, 1990. 

Beginning in 1991, this proposal would be phased in over a five-year 

period, so that future income credited to contracts outstanding on 

December 31, 1985 would be fully subject to tax starting in 1995. 

Deferral of untaxed investment income credited to a contract would 

continue until withdrawal or distribution of funds from the policy. 

The penalty imposed on premature distributions under a deferred 

annuity contract would be repealed for distributions on or after 

January 1, 1986. All of the other provisions prescribing special 

treatment of distributions under annuity contracts before the annuity 

starting date would become obsolete as annuities containing untaxed 

investment income are surrendered or mature. 

Analysis 

Taxing the investment income credited to deferred annuity 

contracts would eliminate a major distortion in the financial services 

area and would place competing financial products and institutions on 

more equal footing. This would permit the efficient flow of long-term 

savings. 

Since life insurance companies selling deferred annuities are 

accustomed to designing investment vehicles to provide for 

policyholders' retirement, it can be anticipated that companies 

currently selling deferred annuities will be able to compete 

effectively for IRA investments. For example, life annuities sold by 

life insurance companies are the only financial instrument to insure 

against living beyond one's wealth after retirement. An IRA 

maintained with a life insurance company may be attractive to 

investors since a life annuity is available as a direct settlement 

option, avoiding the need for a rollover from an IRA maintained with 

another financial institution into a separate annuity IRA upon 

retirement. 

- 261 - 
LIMIT LIFE INSURANCE COMPANY RESERVE DEDUCTION 

General Explanation 

Chapter 12.08 

Current Law 

The gross amount of premiums received by a life insurance company 

is included in the taxable income of the company. As described in 

Chapter 12.05, the premium paid on any life insurance policy (other 

than a term insurance policy) can be divided into a loading component, 

a term insurance component, and a savings component. The savings 

component of a premium is held, in effect, for the benefit of the 

policyholder in an interest-bearing account. The savings component is 

needed to help fund the higher cost of insurance protection in later 

years and is currently available to the policyholder in the form of 

the policy's cash surrender value. 

Life insurance companies are allowed a deduction from taxable 

income for any net increase in life insurance and other reserves and 

must include in income any net decrease in reserves. The life 

insurance reserve for any contract is the greater of the net cash 

value of the contract (taking into account any surrender penalty or 

charge) or the reserve for policy claims determined under a prescribed 

set of rules (based on prevailing State regulatory requirements) 

relating to the reserve method, assumed interest rate, and assumed 

mortality or morbidity rate. These latter rules attempt to measure 

the amount needed to fund the anticipated excess of the present value 

of future claims and benefits to be paid under the policy over the 

present value of future premiums (if any) to be received under the 

policy. The reserve deduction thus serves to adjust the company's 

income to account for its liability to pay, in the event of a 

surrender of the policy, the cash value or, in the event of a claim 

under the policy, the face amount of the policy. 

Reasons for Change 

Like the receipt of savings deposits by a bank, the receipt of the 

savings component of life insurance premiums should not be taxed to 

the company. However, the remaining portions of the gross premiums -- 

the loading component and the term insurance component -- should be 

taxed to the company, with corresponding deductions for sales and 

administrative costs and the payment of claims. Thus, if gross 

premiums are included in the gross income of the company, an 

offsetting deduction for the savings component of the premiums is 

appropriate. 

taxable year in the greater of the policy's cash surrender value or 

the reserve for policy claims often will overstate the company's 

The allowance of a reserve deduction for the increase during the 

- 268 - 
reserve deduction, especially in the initial years of the polioy. 

This is because the reserve for policy claims, i.e., the estimate of 

the excess of the present value of future claims and benefits over the 

present value of future premiums, is calculated using conservative 

assumptions required for State regulatory purposes. 

A reserve deduction equal to the increase in the cash surrender 

value of a policy generally would be sufficient to exclude the savings 

component of gross premiums from the company's taxable income and 

allow a deduction for the exact amount of interest credited to the 

policyholder's savings account. Moreover, the policy's cash surrender 

value is an objective measure of the reserve for policy claims needed 

by the company. This is because the cash surrender value is, in 

effect, the amount the company is willing to giv to the policyholder 

if he gives up his right to claims and benefits under the policy. 

results in tax deferral and a reduced effective tax rate for life 

insurance companies. This enables life insurance companies to offer 

policyholders higher rates of return on savings or lower costs of 

insurance, thereby attracting investment dollars from other financial 

institutions. 

The initial overstatement of reserves allowed under current law 

Proposal 

For tax purposes, the life insurance reserves for any contract 

would be limited to the net cash surrender value of the 

contract (taking into account any surrender penalty or charge). The 

reserve deduction would be adjusted to reflect the indexing of 

interest. See Chapter 9.03. 

Effective Date 

The proposal would be effective for policies sold on or after 

January 1, 1986. 

Analysis 

reserves to the increase in the cash surrender value of policies 

issued by the company would be consistent with the separation of 

income and liabilities of other financial institutions. The actual 

amount of the savings deposits included in life insurance premiums 

effectively would be excluded from taxable income. Similarly, the 

actual amount of interest credited to policyholders would be deducted 

by the company and, as proposed in Chapter 12.05, included in the 

income of the policyholders. This would eliminate the different tax 

treatment of savings at the company level between life insurance 

companies and depository institutions. 

Restricting life insurance companies' deductions for additions to 

Life insurance companies would increase their premiums (or earn 

lower profits) as a result of any increased tax liability resulting 

from the more accurate measurement of their taxable income. 

- 269 - 
REPEAL SPECIAL LIFE INSURANCE COMPANY DEDUCTIONS 

General Explanation 

Chapter 12.09 

Current Law 

percent of their otherwise taxable income. In addition, a small life 

insurance company is allowed a deduction equal to 60 percent of the 

first $3 million of its otherwise taxable income. This deduction 

phases out as otherwise taxable income increases from $3 million to 

$15 million. The small company deduction is allowed only to companies 

with gross assets of less than $500 million. Consolidated group tests 

generally are used in applying the taxable income and gross asset 

standards. 

Reasons for Change 

to reduce the competitive impact of the Tax Reform Act of 1984, which 

broadened the tax base of life insurance companies without similarly 

broadening the tax base for competing financial institutions. Enactment of comprehensive tax reform that affects all financial 

institutions and reduces the maximum marginal tax rate would eliminate 

the justification for the special deduction for life insurance 

companies. Retention of the special deduction for life insurance 

companies would be unfair to their competitors and would cause 

tax-induced economic distortions. 

All life insurance companies are allowed a deduction equal to 20 

The special deduction for all life insurance companies was enacted 

Similarly, the special deduction for small life insurance 

companies was a deviation from the proper measurement of economic 

income to prevent a dramatic increase in the tax burden of small life 

insurance companies as a result of the 1984 Act. After comprehensive 

tax reform, special rules for small life insurance companies would no 

longer be appropriate. 

P r oposa 1 

The special life insvrance company deduction and small life 

insurance company deduction would be repealed. 

Effective Date 

after January 1, 1986. 

Analysis __ 

in 1984 essentially broadened their tax bases and reduced their 

The proposal would be effective for taxable years beginning on or 

The revision of the tax rules governing life insurance companies 

- 270 - 
effective marginal tax rates. Repeal of the special 20 percent 

deduction provision would be more than offset by the reduction in the 

maximum corporate tax rate. The 20 percent deduction of otherwise 

taxable income lowers life insurance companies' effective marginal tax 

rate to 36.8 percent. The Treasury Department proposals would lower 

the corporate rate to 33 percent. 

Small 1,ife insurance companies would be placed on a par with all 

other life insurance companies and other small corporations. 

Elimination of preferential tax rates based on the size of the firm 

would end tax-induced distortions that favor sales of life insurance 

through small firms. 

- 271 - 
Part C. Property and Casualty Insurance Companies 

This Part discusses proposals to curtail favorable tax rules for 

property and casualty (P&C) insurance companies. The deduction for 

estimated unpaid losses, which is currently allowed on an undiscounted 

basis, would be allowed only to the extent of the discounted present 

value of the losses. Special provisions that reduce the effective tax 

rate on P&C insurance companies would be eliminated. Thus, the 

deduction for contributions to a protection against loss account would 

be repealed. The deduction for policyholder dividends by mutual P&C 

companies would be repealed. The deduction for policyholder dividends 

by mutual P&C companies would be limited in conformity with the 

deduction allowed mutual life insurance companies. 

- 272 - 
LIMIT PROPERTY AND CASUALTY 

INSURANCE COMPANY RESERVE DEDUCTION 

General Explanation 

Chapter 12.10 

Current Law 

Property and casualty ("P&C") insurance companies are allowed a 

deduction for "losses incurred" during a taxable year. The deduction 

includes the company's estimate of "unpaid losses," whether or not 

unpaid losses have accrued under traditional tax accounting rules. 

Unpaid losses include amounts that will be paid in connection with 

claims filed with the company during the taxable year as well as 

amounts that relate to claims expected to arise from events occurring 

during the taxable year that have not been reported to the company. 

The deduction for these claims generally is not discounted to reflect 

the fact that they will not be paid until some time in the future. 

Reasons for Change 

The deduction of additions to reserves, unadjusted for the 

investment income that will be earned on those reserves, results in 

deferral of P&C companies' tax liability and reduces their effective 

tax rates. In other cases where tax deductions for additions to 

reserves are allowed, such as for life insurance companies, the 

allowable reserves are discounted for the expected future investment 

earnings on the reserve funds. The reserve deduction available to P&C 

companies should also be discounted. 

choice between self-insurance and third-party insurance. P&C 

companies deduct currently the full amount of the future liability for 

many casualty losses that would not be deductible currently by the 

self-insurer. Because a current tax deduction is more valuable than a 

future deduction, individuals and businesses are encouraged to insure 

against risks with a P&C company in order to take advantage of this 

favorable tax treatment. 

The current tax treatment of P&C insurance reserves distorts the 

Proposal 

The deduction by P&C companies for unpaid losses during a taxable 

year would be computed under the "qualified reserve account" method. 

Under this method, the company would establish reserve accounts for 

claims to be paid in an amount estimated by the company to be 

sufficient to fund payment of the claims, taking into account the 

company's estimates of the amount of the claims, the time of payment 

of the cl.aims, and the company's after-tax rate of return on its 

investment assets. Separate reserve accounts would be established by 

- 273 - 
line of business and year of policy issuance. In other words, one 

account would be established for all claims under all policies in a 

particular line of business issued in a particular taxable year. 

The initial reserve with respect to a policy could not exceed the 

premiums received under the policy reduced by the share of the 

company's deductible sales and administrative expenses allocated to 

the policy. Beyond this, the company would not be subject to 

federally prescribed rules for discounting future losses in 

establishing the reserve account. Instead, the company would be free 

to use any reasonable disccunting method (e.g., the same estimates it 

used in pricing its insurance policies). 

Each reserve established by the company would be increased 

annually by a percentage equal to the after-tax rate of return 

actually earned by the company on its investments during that year. 

To prevent the company's investment income from being sheltered from 

tax, no additional reserve deduction would be allowed for the annual 

increase in the reserve accounts attributable to the allocation of 

investment income. 

The company would be allowed a deduction each year for the full 

amount paid to satisfy claims, but would be required to include in 

taxable income an offsetting amount released from the appropriate 

reserve account. This would ensure that, if the company's estimates 

of the amount. and timing of claims and after-tax rate of return on 

investment assets were accurate, the reserve would be exhausted and 

the last claim would be paid simultaneously. If the reserve was 

insufficient to cover all claims, the excess claims would be 

deductible when paid. Conversely, if any amount remained in a reserve 

account after payment of the last claim in that account, that amount 

would he included in taxable income. 

A company would he permitted to strengthen a reserve it felt was 

insufficient to cover future claims and a deduction would be given for 

additional amounts placed into a reserve. However, the company would 

be required to establish the need for reserve strengthening by a 

showing of objective factors affecting the amount needed to fund the 

payment of claims. Such factors would include a strengthening of the 

company's reserves on its annual statement or a decline in prevailing 

interest rates. Companies also would be free to release into income 

additional amounts from reserves it felt to be excessive. This would 

allow companies to avoid or reduce a large income item in a single 

year from the release of an excessive reserve. 

A company would not be able to maintain a reserve indefinitely. 

Rules would be established limiting the maximum life of a reserve, 

depending on the line of business. Any reserve balance at the end of 

the maximum life would be released into income. Any subsequent claims 

under policies covered by that reserve would be deductible when paid. 

- 214 - 
Effective Date 

The proposal would be effective for all unpaid losses with respect 

to all policies issued on or after January 1, 1986. 

Analysis 

Under the proposal, P&C companies would still be permitted to use 

the reserve method to match income and losses occurring in different 

taxable years. The discounting of losses, however, would prevent the 

reserve deduction from yielding greater tax benefits than a deduction 

claimed at the time the losses are paid or accrued. Discounting the 

amount of allowable reserves for tax purposes would take into account 

the time value of money. A current deduction of $1,000 is worth 

considerably more than a future deduction of $1,000 because investment 

income will be earned on the tax saving. For the same reasons, less 

than $1,000 needs to be held in reserve to fund a future liability of 

$1,000. For example, if interest income accumulates at an after-tax 

rate of six percent, a reserve of only $792.09 is needed to provide 

sufficient funds to satisfy a liability four years in the future of 

$1,000. 

A substantial portion of the claims paid by P&C companies are paid 

in years subsequent to the year in which premium income is received 

and a deduction for losses paid or incurred is claimed. Table 1 shows 

the average period of loss payment for all insurance written by P&C 

companies and for several major lines of business. As shown on the 

table, over 60 percent of all losses of P&C companies are paid after 

the year of deduction. The actual discounted value of these losses at 

the time the premium income is received, assuming a six percent 

discount rate, is approximately 91 percent of their undiscounted 

value. In the case of medical malpractice insurance, a line of 

business where long delays in the payment of claims are common, more 

than one-half of all losses are paid beyond the fourth year after the 

year of deduction and the discounted value of the losses at the time 

the premium is received is only approximately 76 percent of their 

undiscounted value. 

It has been argued by some that the present system of undiscounted 

claims reserves results in "rough justice" since it allows a deduction 

to some taxpayer in the full amount of an economic loss (of either the 

policyholder or a third party to whom the policyholder is liable) when 

the loss is incurred. Arguably, it is proper to match the time of the 

P&C companyls deduction to the time the underlying economic loss is 

sustained. However, except in the case of business losses, a large 

portion of property and casualty liabilities would not be deductible 

losses to the party suffering the underlying economic loss. For 

instance, individual taxpayers can claim a casualty loss deduction on 

personal property only for the amount of loss in excess of ten percent 

of the individual's adjusted gross income. Deductions for medical 

expenses are limited to those in excess of five percent of adjusted 

gross income. In the case of medical malpractice and workers' 

- 275 - 
Table 1 

Timing oE Uss Payments to Total Losses Incurred 

by Major Lines of Business of Property and Casualty 

Insurance Companies - 1975 to 1983 Exprience 

Payments as Percent of Tosses Incurred 

Line of Business 

Time Between Loss : All : Auto : Other : Medical : Workers' :Multiple 

Incurred and Pa~nent:Business:Liability:Liability:Malpractice:Compensation: Peril 

Same year 

1 year 

2 years 

3 years 

4 years 

5 years 

6 years 

7 years 

8 years or later 

Present value 

loss of $100 

36.7% 36.0% 12 * 1% 

26.1 29.7 15.6 

10.5 14.4 11.4 

8.3 9.0 13.1 

4.6 4.5 9.9 

3.2 2.6 8.3 

2.4 1.2 7.0 

1.4 0.9 6.5 

6.7 1.8 16.2 

5.8% 

8.6 

9.0 

12.1 

10.3 

10.6 

8.1 

3.3 

32.1 

27.4% 

24.8 

12.7 

8.8 

4.9 

3.6 

2.9 

1.4 

13.7 

56.2% 

26.2 

5.1 

4.5 

2.3 

1.4 

1.3 

0.7 

1.6 

incurred. - 1/ $90.56 $92.40 $81.34 $76.28 $87.48 $95.13 

Off ice of the Secretary of tile Treasury 

- 1/ Discounted by the payment stream at six percent. 

the middle of the year and discounted to the middle of the Eirst year. 

present value is overstated because many of the payments eight years or later are 

not fully discounted, which would particularly affect medical malpractice, 

otiier ltabilities, and workers' compensation. 

November 29, 1984 

Office of Tax Analysis 

i%ssurnes payments are made in 

"he 

- 276 - 
compensation liabilities, payments on contested or uncertain 

liabilities generally are not deductible by the policyholder until 

payment is actually made nor is the "economic" loss to the injured 

party generally a deductible expense to such party. 

It has also been argued that it is inappropriate to mandate the 

discounting of reserves for Federal tax purposes because P&C companies 

are generally underreserved (as a result of underestimating future 

claims). Under current law, however, even a company that has 

established an initial reserve equal to (or even less than) the 

present value of a future claim derives a significant benefit. For 

example, if a P&C company establishes a reserve of $792.09 for a 

future claim that it estimates will be $792.09, and if the claim turns 

out to be $1,000, the company will receive an additional deduction of 

$207.91 when the claim is paid, even though it received a full 

deduction (in present value terms) when the reserve was established. 

The discounting of reserves for tax purposes would not affect 

State law requirements for reserves to protect policyholders against 

company insolvency. State law would continue to require adequate 

funding of statutory reserves. The tax reserve account would be 

smaller tnan the statutory reserve and would be only a bookkeeping 

entry. The lower tax reserve would increase the current tax liability 

of P&C companies and affiliated companies, but as described above the 

proposal would simply eliminate the deferral of tax liability allowed 

under current law. P&C companies could be expected to increase their 

premiums to cover any increased tax liability resulting from the more 

accurate measurement of their taxable income. 

The property and casualty industry may argue that this proposal is 

not appropriate for an industry with large underwriting losses (-$11.0 

billion in 1983). However, as shown in Table 2, P&C companies earned 

total net income of $6.6 billion in 1983, this being the excess of 

their $17.9 billion of investment income over their underwriting 

losses. The large underwriting losses occur because P&C companies 

lower premiums (discount) for the expected future investment income, 

but they currently do not discount statutory reserves which are used 

in calculating underwriting income. Total net income is the 

appropriate measure of company profitability, not underwriting income. 

- 277 - 

459-813 0 - 84 - 10 
Table 2 

Investment Gain and Underwriting Loss of Property 

and Casualty Insurance Companies - 1979 to 1983 

(In millions of dollars) 

- 

Net Net Other : Total 

: Underwriting : Investment : Miscellaneous : Net 

Year : Gain or Loss : Gain or Loss : Income : Income l/ 

1979 $ - 21 $ 9,607 $ - 161 $ 9,424 

1980 -1,819 11,628 - 208 9,601 

1981 -4,563 13,520 - 265 8 , 692 

1982 -8,302 15,479 - 406 6,771 

1983 -11,033 17,923 - 306 6,584 

Office of the Secretary of the Treasury November 29, 1984 

Office of Tax Analysis 

I 1/ Before policyholder dividends. 

Source: Best'5 Aggregates and Averages. 

- 278 - 
The principal advantage of the qualified reserve account method of 

discounting reserves is that it assures that the ultimate after-tax 

return that a company realizes on a group of policies does not depend 

on the amount the company places into the reserve for those policies, 

assuming that the company's tax rate is constant over time. In fact, 

the qualified reserve account method would yield the same ultimate 

after-tax return as the cash method of accounting, although it would 

achieve a better matching of income and deductions on a year-by-year 

basis. This means that it would be unnecessary to prescribe a Federal 

standard for discounting reserves -- companies are free to discount 

using any reasonable set of assumptions (e.g., the assumptions used in 

pricing the policies). A company would not have a tax incentive to 

overreserve since any excess tax deduction would be recaptured when 

the claims are ultimately paid with an interest factor equal to the 

company's actual after-tax rate of return. Conversely, companies that 

underreserve would receive additional deductions at the time they pay 

their claims to ensure that they will not be penalized for 

underreserving. 

- 219 - 
REPEAL MUTUAL PROPERTY AND CASUALTY INSURANCE - COMPANY 

PROTECTION AGAINST LOSS ACCOUNT 

General Explanation 

Chapter 12.11 

Current Law 

Most mutual property and casualty (P&C) insurance companies are 

allowed deductions for net contributions to a protection against loss 

(PAL) account. A deduction is generally allowed for contributions to 

the account in an amount equal to one percent of the losses (both 

known and estimated) incurred during the taxable year plus 25 percent 

of the underwriting gain for the taxable year. Companies that have a 

high percentage of risks relating to windstorms, hail, flood, 

earthquakes, or similar hazards may defer a larger percentage of their 

unde rwr i t ing income. 

The portion of the deferred income representing one percent of 

losses incurred and one-half of the deduction for 25 percent of 

underwriting income is brought back into income after, at most, a 

five-year deferral period. The remaining amount, 12.5 percent of 

underwriting income, continues to be deferred indefinitely, until the 

company has underwriting losses. 

Reasons for Change 

The special PAL deduction is unrelated to the measurement of 

economic income. The PAL deduction is allowed in addition to the full 

deduction that mutual P&C companies receive for estimates of future 

losses. Furthermore, the PAL account is simply a bookkeeping entry 

made for tax purposes; a corresponding reserve account is not required 

by State regulatory authorities to provide for the financial solvency 

of the companies. 

to a PAL account reduces the effective tax rate on mutual P&C 

companies with underwriting income. The lower effective tax rate 

provides a competitive advantage to mutual P&C companies vis-a-vis 

stock P&C companies and life insurance companies that offer similar 

insurance products. 

distinction between underwriting and investment income. This 

distinction increases the complexity of the tax code and increases the 

possibility that companies will undertake uneconomic transactions 

solely to minimize tax liability. 

The tax deferral resulting from the deductibility of contributions 

The calculation of the PAL account requires an arbitrary 

- 280 - 
Proposal 

The deduction for contributions to a PAL account would be 

repealed. Amounts currently held in the account would be included in 

income no later than ratably over a five-year period. 

Effective Date 

The proposal would apply to taxable years beginning on or after 

January 1, 1986. 

Ana ly s i s 

The benefits of the special PAL deduction accrue largely to 

profitable companies that do not have underwriting losses and 

therefore obtain the maximum tax deferral. The special deduction 

provides little benefit to companies with periodic underwriting 

losses. Repeal of the special PAL deduction should have minimal 

impact on premium rates. 

- 281 - 
REPEAL SPECIAL TAX EXEMPTIONS, RATE REDUCTIONS, 

AND DEDUCTIONS OF SPLtLL MUTUAL PROPERTY 

AND CASUALTY INSURANCE COMPANIES 

General Explanation 

Chapter 12.12 

Current Law 

certain small mutual property and casualty (P&C) insurance companies. 

Mutual P&C companies with taxable investment and underwriting income 

of not more than $6,000 are exempt from tax; a limitation on the rate 

of tax on income in excess of $6,000 phases out between $6,000 and 

$12,000. Mutual P&C companies that during the taxable year receive a 

gross amount of not more than $150,000 from premiums and certain 

investment income are also exempt from tax, regardless of the amount 

of their taxable income. Unless they elect to the contrary, companies 

that receive a gross amount from premiums and certain investment 

income of more than $150,000 but not more than $500,000 are taxed only 

on their investment income (and are not taxed at all if their 

investment income is not more than $3,000); their underwriting income 

is exempt from tax. A limitation on the rate of tax on the investment 

income of such companies in excess of $3,000 phases out between $3,000 

and $6,000. A further reduction of the rate of tax on the investment 

income of such companies phases out as the gross amount from premiums 

and certain investment income increases from $150,000 to $250,000. 

Finally, mutual P&C companies that receive a gross amount from 

premiums and certain investment income of less than $1,100,000 are 

allowed a special deduction against their underwriting income (if it 

is subject to tax). The maximum amount of the deduction is $6,000, 

and the deduction phases out as the gross amount increases from 

$500,000 to $1,100,000. 

Numerous special rules reduce or eliminate the tax liability of 

Reasons for Change 

The special tax rules that reduce or eliminate the tax liability 

of certain small mutual P&C companies provide competitive advantages 

to those companies vis-a-vis stock companies and larger mutual 

companies. The application of these rules requires arbitrary 

distinctions between underwriting and investment income, thereby 

increasing the complexity of the tax code. 

Proposal 

The special tax exemptions, rate reductions, and deductions of 

small mutual P&C companies would be repealed. 

- 282 - 
Effective Date 

The proposal would be phased in over a five-year period, starting 

with the first taxable year beginning on or after January 1, 1986. 

Analysis 

Small mutual P&C companies would be placed on a par with all other 

P&C companies and other small corporations. Elimination of 

preferential rates based on the size of the firm would end tax-induced 

distortions that favor the sale of insurance through small firms. 

- 283 - 
LIMIT MUTUAL PROPERTY AND CASUALTY INSURANCE 

COMPANY DEDUCTION FOR POLICYHOLDER DIVIDENDS 

General Explanation 

Chapter 12.13 

Current Law 

In general, 

companies are a 

stock and mutual property and casualty (P&C) 

lowed to deduct dividends and similar distri 

pais or declared to policvholders in their capacitv as such. 

insurance 

utions 

These 

;list ributions are treated- by policyholders as- price rebates rather 

than as taxable distributions. Because policyholder dividends 

distributed by mutual companies are substantially larger than similar 

distributions by stock companies, this deduction primarily benefits 

mutual P&C companies. 

In the case of life insurance companies, the amount of the 

deduction allowed mutual companies for policyholder dividends is 

subject to certain limitations. The deductibility constraint stems 

from a recognition that policyholder dividends paid by mutual 

companies are, to some extent, distributions of the companies' 

earnings to policyholders in their capacity as owners of the company. 

Consequently, the deduction for policyholder dividends is reduced by 

an amount determined to be the owner/policyholder's share of the 

distributed earnings of the company. 

Reasons for Change 

The allowance of a deduction for income distributed in the form of 

policyholder dividends by mutual P&C companies provides a competitive 

advantage to such companies vis-a-vis stock P&C companies and other 

corporations. This competitive advantage of mutual companies was 

recognized in the 1984 overhaul of the life insurance company tax 

rules, which imposed a limitation on the deductibility of policyholder 

dividends by mutual life insurance companies. A similar limitation on 

the deductibility of mutual P&C company policyholder dividends would 

ensure that corporate profits are taxed at least once, thereby 

reducing the distortion caused by the deduction. 

Proposal 

The deduction for policyholder dividends allowed mutual P&C 

companies would be reduced in a manner similar to the way in which the 

deduction for policyholder dividends allowed mutual life insurance 

companies is reduced under current law. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

- 284 - 
Analysis 

The proposal would subject all income of mutual P&C companies, 

including profits distributed to policyholders, to tax at the company 

level. Mutual companies may distribute a lesser amount of 

policyholder dividends and charge slightly higher premiums as a result 

of the tax on equity income, similar to the effect of corporate taxes 

on other companies. The advantage of mutual companies over stock 

companies would be reduced, as would the advantage of mutual P&C 

companies selling insurance products in competition with life 

insurance companies. 

- 285 - 
Part D. Tax Exemption for Insurance Companies 

REPEAL TAX EXEMPTION FOR CERTAIN INSURANCE COMPANIES 

General Explanation 

Chapter 12.14 

Current Law 

Current law exempts from Federal income tax a large and diverse 

group of nonprofit organizations. These organizations are, however, 

taxable on income received from the conduct of business that is 

unrelated to the organization's exempt purpose. Although the sale of 

insurance by tax-exempt organizations generally is an unrelated trade 

or business, there are numerous organizations that engage in the 

insurance business without tax liability. Current law expressly 

provides a tax exemption for the insurance activities of some 

organizations, including: certain fraternal beneficiary societies that 

provide for the payment of insurance benefits to their members; 

voluntary employee beneficiary associations that provide insurance 

benefits to their members; local benevolent life insurance 

associations; mutual insurance companies or associations (other than 

life or marine) if the gross amount received from certain sources does 

not exceed $150,000; trusts for the payment of supplemental 

unemployment benefits; Black Lung trusts; veterans' organizations; and 

shipowners' protection and indemnity associations. In addition, some 

organizations that sell insurance have been held to be tax exempt 

under provisions of law exempting from tax religious, charitable, or 

educational organizations and social welfare organizations.l/ - 

Reasons for Change 

The statutory tax exemptions for the organizations listed above 

generally were enacted at a time when large parts of the United States 

were rural and agricultural, and when many individuals and businesses 

were unable to obtain insurance from commercial companies. Similarly, 

tax-exempt status was recognized by the courts and the Internal 

Revenue Service for certain organizations because they met a need that 

was not met by the commercial sector. These organizations generally 

were small and had little income. 

- 1/ Where an insurance organization's exempt status is not expressly 

mandated by statute but rather has been recognized under a more 

general provision for exempt status, the Internal Revenue Service has 

authority to revoke the organization's exemption if it is no longer 

justified . 

- 206 - 
Today, tax-exempt insurance companies are generally 

indistinguishable from their taxable counterparts. They sell the same 

products as taxable insurance companies and compete with taxable 

companies for business. Several insurance companies that are exempt 

from tax rank among the largest insurance companies in the United 

States. 

All businesses that sell insurance should be treated equally. 

Retention of tax-exempt status for some insurance companies would give 

those companies an unfair competitive advantage. The absence of a tax 

burden on these companies may be reflected in lower premiums charged 

to policyholders, thereby giving individuals who are able to purchase 

insurance from one of these companies an advantage over other 

individuals. 

Proposal 

Existing tax exemptions for insurance businesses would be 

repealed. In general, these insurance businesses would be taxed under 

the rules applying to taxable corporations. Any organization 

qualifying as a life insurance company or property and casualty 

insurance company would be taxed under the rules applying to that type 

of company. Special rules would be provide6 for certain organizations 

that are not subject to the same system of regulation for State law 

purposes as other insurance companies or that have relatively small 

insurance activities. 

The providing of insurance at less than cost to a class of 

charitable recipients would continue to be recognized as a charitable 

activity entitled to exemption from Federal income tax. 

Effective Date 

The proposal would be phased in over a five-year period, starting 

with the first taxable year beginning on or after January 1, 1986. 

Analysis 

Nonprofit organizations providing insurance in competition with 

taxable stock and mutual insurance companies would be placed on a par 

with their competitors. Elimination of the tax exemption would end 

tax-induced distortions that favor the provision of insurance through 

tax-exempt organizations and that favor individuals who have access to 

insurance sold by these organizations. 

- 287 - 
CHAPTER 13 

STATE AND LOCAL GOVERNMENT DEBT AND INVESTMENTS 

This Chapter discusses proposals to limit the tax exemption of 

interest on State and local obligations to its proper scope -- the 

financing of governmental activities, such as schools and roads for 

State and local governments. Future issues of nongovernmental bonds 

would not be exempt from Federal income tax. Restrictions on 

arbitrage with respect to tax-exempt obligations would be tightened, 

and advance refundings would be prohibited. Finally, the general 

stock ownership corporation provisions would be repealed as 

superfluous. 

-288- 
REPEAL TAX EXEMPTION FOR NONGOVERNMENTAL BONDS 

General Explanation 

Chapter 13.01 

Current Law 

Interest on State and local obligations generally is exempt from 

Federal income tax. In many cases, proceeds from the issuance of 

tax-exempt bonds are made available for use by private businesses, 

certain tax-exempt organizations, homeowners and students, as well as 

for use by State and local governments. 

Industrial development bonds. State and local government 

obliqations are classified as industrial development bonds (IDBs) if 

the bond proceeds are to be used in any trade 02 business carried on 

by a nonexempt person and the payment of principal or interest on the 

bonds is derived from or secured by money or property used in a trade 

or business. Interest on IDBs as a general rule is taxable, but 

interest on two categories of LDBs is tax exempt: (I) IDBs that 

qualify as exempt small issues, and (2) IDBs issued to finance certain 

exempt activities. 

Exempt small issue IDBs can be issued in amounts of $1 million or 

less to assist any principal user in the acquisition, construction or 

improvement of land or depreciable property located in any one city or 

county. The $1 million limitation may be increased to $10 million if 

the aggregate amount of capital expenditures of the principal users in 

the particular jurisdiction do not exceed $10 million over a six-year 

period. Current law also provides an exemption for interest on IDBs 

used to finance certain specific exempt activities. Any land, 

buildings or other property that is functionally related and 

subordinate to the exempt facility also may be financed through 

tax-exempt bonds. 

mortgage subsidy bonds to finance mortgages on owner-occupied 

residences. There are two categories of mortgage subsidy bonds that 

are tax-exempt: (1) qualified mortgage bonds, and (2) qualified 

veterans' mortgage bonds. Qualified mortgage bonds provide mortgage 

financing for qualified homebuyers. Qualified veterans' mortgage 

bonds provide mortgage financing for certain veterans, but may be 

issued only by States with programs in place before June 22, 1984. 

Mortgage subsidy bonds. State and local governments may issue 

Other nongovernmental bonds. Tax-exempt obligations may be 

issued for certain tax-exempt organizations such as nonprofit 

hospitals and educational institutions. Tax-exempt student loan bonds 

-289- 
may be issued to finance educational and related expenses by nonprofit 

corporations or public agencies or inscrumentalities of a State. 

Finally, other tax-exempt bonds that are not IDBs may be used to 

provide financing to nongovernmental entities and individuals. 

Reasons for Change 

local government obligations exists as a matter of comity between the 

Federal government and State and local governments. This tax 

exemption lowers the cost to State and local governments of financing 

public facilities, such as schools, roads and sewers. Increasingly, 

however, State and local governments have used their tax-exempt 

financing privilege to obtain funds for use by nongovernmental 

persons. Thus, State and local tax-exempt obligations are now 

commonly used to provide financing for private businesses, residential 

mortgages, nonprofit corporations and student loans. A total of $58 

billion of such nongovernmental bonds was issued in 1983, accounting 

for 61 percent of all long-term tax-exempt bonds issued that year. 

Tax-exempt nongovernmental bonds have caused serious erosion in 

the Federal income tax base, lowering tax receipts and forcing 

increases in the tax rates on nonexempt income. The ~evenues lost as 

a result of tax-exempt nongovernmental bonds represent an indirect 

Federal subsidy program, based in the tax code, and thus significantly 

free of the scrutiny that attaches to direct Federal expenditures. In 

many cases, the issuer of nongovernmental bonds would not spend its 

own revenues to support the activities that are Federally subsidized 

through tax-exempt nongovernmental bonds. 

Tax-exempt nongovernmental bonds also have anti-competitive and 

distortive effects on the economy. Activities receiving tax-exempt 

financing have a significant advantage over their competitors, which 

must raise capital with higher-cost taxable obligations. Yet, the 

availability of tax-exempt financing for nongovernmental persons 

depends upon which jurisdiction has the necessary programs in place 

and upon the ability of perscins to negotiate through obstacles of 

State and local law and procedure. These factors have little relation 

to the value or efficiency of particular activities, and ought not to 

influence the allocation of capital among sectors of the economy. 

Finally, the volume of tax-exempt nongovernmental bonds has 

worked to the deteriment of bonds issued to provide financing for 

State and local governments. As a result of the issuance of these 

additional securities, tax-exempt interest rates must rise in order to 

attract additional capital. This increases costs for State and local 

governments, with no corresponding increase in the level of government 

services provided. Moreover, these increased costs are borne by all 

State and local governments, not simply those issuing nongovernmental 

bonds. 

The exemption from Federal income tax of interest on State and 

-290- 
Proposal 

would be taxable if more than one percent of the proceeds were used 

directly or indirectly by any person other than a State or local 

government. Generally, use of a facility financed with proceeds of 

tax-exempt obligations would be considered to be use of those 

proceeds. There would be an exception from this general rule for use 

by nongovernmental persons of tax-exempt financed facilities if the 

facilities were used by the general public and if such use were on the 

same basis as for all members of the general public. In addition, a __ de minimis exception would allow use of tax-exempt financed facilities 

by a nongovernmental person pursuant to a short-term management 

contract. Allocation rules would permit tax-exempt financing for a 

proportionate share of the cost of a facility used in part for public 

and in part for private purposes. Finally, an exception to the 

nongovernmental use rule would permit bond proceeds to be (a) used to 

fund a reasonably required reserve fund, (b) invested for the initial 

temporary period before use for the governmental purpose of the 

borrowing, or (c) deposited in a bona fide debt service fund. 

The proposal would preserve the tax exemption for obligations 

issued to finance ordinary government operations, such as tax 

anticipation notes, as well as those issued to finance the acquisition 

or construction of government buildings. If the government leased a 

portion of a building to a nongovernmental person for more than a 

brief interim period, however, the portion so leased could not be 

financed with tax-exempt obligations. 

Obligations issued to acquire or construct facilities to be used 

by the general public would also continue to be tax-exempt so long as 

no nongovernmental person uses the facility (or has access to the 

facility) on a basis other than that applicable to the general public. 

(For example, extension of a road, sewer or other system serving the 

general public to a newly constructed house or business could be 

financed on a tax-exempt basis. On the other hand, construction of an 

airstrip adjacent to a business that would be its sole user could not 

be financed through the issuance of tax-exempt bonds.) Thus, a solid 

waste disposal facility serving the general public could be financed 

with tax-exempt obligations if it were owned by a city and operated by 

the city or by a private manager under a short-term management 

contract. If the proceeds of the financing were made available to a 

nongovernmental person to construct a privately-owned solid waste 

disposal facility, however, the bonds would not be tax exempt. 

The proposal would extend certain of the requirements under 

current law, such as the IDB reporting requirements, to all tax-exempt 

bonds and would retain certain other existing restrictions, such as 

the prohibition against Federal guarantees. Most other provisions of 

code section 103 would be repealed. The proposal would assure 

governmental control over tax-exempt bond issues and the facilities 

they finance by the requirement that issuers be a State or a local 

Interest on obligations issued by a State or local government 

-291- 
government rather than an "on behalf of" issuer or a nonprofit 

corporation. Since State and local governments would no longer be 

entitled to issue mortgage subsidy bonds under the proposal, the 

mortgage credit certificate program would no longer operate. 

Effective Date 

The proposal would be effective for obligations issued on or 

after January 1, 1986. A transition rule would be provided for 

current refundings of outstanding obligations if the refunding does 

not extend the weighted average maturity date of the obligations 

outstanding at the time of the refunding or exceed the outstanding 

amount of the refunded obligation. 

Analysi 6 

The proposal would replace the standard for tax-exemption in 

current law, which grants tax-exempt status to obligations on the 

basis of their qualifying as student loan bonds, mortgage subsidy 

bonds, veterans' mortgage bonds, small issue IDBs, exempt activity 

IDBs or other tax-exempt non-IDBs, with a new standard for determining 

the tax-exempt status of obligations. The proposal would virtually 

eliminate (rather than 1imi.t through a volume ceiling) the Federal 

subsidy currently made available to nongovernmental persons through 

tax-exempt financing. State and local governments would, however, 

retain the ability to finance projects with tax-exempt obligations if 

the proceeds are not used by nongovernmental persons. 

Elimination of nongovernmental tax-exempt bonds would cause the 

spread between tax-exempt and taxable interest rates to increase, due 

to a lower volume of tax-exempt obligations. Thus, the value of the 

Federal subsidy provided to governmental activities financed with 

tax-exempt bonds would increase. The proposal would, of course, 

increase financing costs for nongovernmental persons currently 

receiving tax-exempt financing. Such increase, however, would simply 

restore parity among all nongovernmental persons in the competition 

for capital. 

-292- 
LIMIT TAX ARBITRAGE AND ADVANCE 

REFUNDING FOR TAX-EXEMPT BONDS 

General Explanation 

Chapter 13.02 

Current Law 

Interest on State and local obligations generally is exempt from 

Federal income tax. An issuer of tax-exempt bonds may borrow at 

tax-exempt rates and earn "arbitrage" by investing the borrowed 

amounts in obligations that pay higher returns. Current law denies 

tax-exempt status to interest on bonds issued with the expectation 

that the proceeds will be used to earn arbitrage in excess of 

specified amounts. 

arbitrage restrictions to different types of obligations acquired with 

bond proceeds. "Acquired purpose obligations" are obligations 

acquired to carry out the purpose of the bond issue. Permissible 

arbitrage on acquired purpose obligations generally is limited to a 

spread between the yield on the bonds and the yield on the acquired 

purpose obligations of 0.125 percent plus reasonable administrative 

costs. Administrative costs basically are the costs of issuing, 

carrying and repaying the bonds, the underwriter's discount, and the 

costs of acquiring, carrying, redeeming or selling the obligation of 

the bond user. All obligations other than acquired purpose 

obligations acquired with bond proceeds are "acquired nonpurpose 

obligations." The arbitrage spread for investments of bond proceeds 

in acquired nonpurpose obligations is restricted to 0.125 percent plus 

certain costs. There are two principal exceptions to these rules. 

First, unlimited arbitrage is permitted on bond proceeds invested for 

a temporary period prior to use, without regard to whether such 

proceeds are held by the user or the issuer. The temporary period is 

generally three years for new money financings and up to two years for 

a refunding transaction. An issuer may waive the temporary period and 

receive an arbitrage spread of 0.5 percent plus allowable costs with 

respect to obligations subject to yield restrictions. Second, 

unlimited arbitrage is permitted on investments held in a reasonably 

required reserve or replacement fund ("4R fund"). Additional 

arbitrage restrictions apply to other types of tax-exempt obligations, 

as discussed below. 

Restrictions on Arbitrage. Treasury regulations apply different 

Calculation of Yield. The limitations on permissible arbitrage 

earnings under current law require a comparison of the yield on the 

bonds and the yield on the acquired obligations. In computing yield, 

current law permits various costs to be taken into account that either 

increase bond yield or decrease acquired obligation yield. The result 

is to increase the amount of permissible arbitrage that issuers may 

earn. One court has held that bond yield is the discount rate at 

which the present value of all payments of principal and interest on 

- 293 - 
the bonds equals the net proceeds of the issue after deducting the 

costs of issuing the bonds. Permitting issuance costs to reduce net 

proceeds results in a corresponding increase in the bond yield. The 

effect of calculating bond yield in this fashion is that the bond 

issuer is permitted to earn an amount equal to issuance costs out of 

arbitrage. This method of calculating bond yield does not apply for 

mortgage subsidy bond rebate purposes, where bond yield is based on 

the initial offering price to the public (excluding bond houses and 

brokers). In addition, premiums paid to insure a bond issue are 

treated as additional interest on the issue (to the extent that the 

present value of the premiums does not exceed the present value of the 

interest savings) with a resulting increase in the yield on the bond 

issue. Similarly, the yield on acquired purpose obligations is 

calculated by excluding from the payments to be received with respect 

to such obligations a portion of the payments having a present value 

equal to the costs of issuing, carrying or repaying the bonds, the 

underwriter's spread and the costs of purchasing, carrying, redeeming 

or selling acquired purpose obligations. The bond issuer cannot use 

the same cost to both increase bond yield and decrease yield on 

acquired obligations. 

certain tax-exempt bonds. For this purpose, an advance refunding 

generally is defined as the issuance of bonds to retire another bond 

issue on a date after the issuance date of the refunding bonds. 

Advance refundings of industrial development bonds and mortgage 

subsidy bonds are generally prohibited. For industrial development 

bonds and mortgage subsidy bonds, however, an advance refunding is 

defined as the issuance of bonds to retire another bond issue more 

than 180 days after the issuance date of the refunding bonds. 

Permissible arbitrage on advance refunding issues, in addition to that 

earned during any applicable temporary period, basically is limited to 

interest on $25,000 at the bond rate, plus an amount sufficient to 

recover reasonable administrative costs. 

Advance Refundings. Current law permits the advance refunding of 

Special Arbitrage Rules for Certain Bonds. Current law applies 

special arbitrage rules to certain types of tax-exempt bonds. 

Mortgage subsidy bonds are permitted to earn an arbitrage spread of 

1.125 percent on acquired purpose obligations (the mortgages). 

Arbitrage earned on nonpurpose obligations must be paid to the 

mortgagors or to the United States. The amount of bond proceeds that 

can be invested in nonpurpose obligations at a yield above the bond 

yield is limited to 150 percent of annual debt service for the bond 

year. Certain industrial development bonds issued after December 31, 

1984, are subject to an arbitrage rebate requirement and a limitation 

on investment in nonpurpose obligations similar to those imposed on 

mortgage subsidy bonds. Student loan bonds and other obligations 

issued in connection with certain governmental programs are generally 

permitted an arbitrage spread of 1.5 percent plus reasonable 

administrative costs on the acquired purpose obligations. Interest 

subsidies paid by the Department of Education can be excluded in 

determining yield on the acquired purpose obligations (student loans) 

for student loan bond issues. 

- 294 - 
Reasons for Change 

interest on State and local government obligations provides two 

separate benefits to State and local issuers. The basic benefit is 

the reduction in interest cost for the financing. The additional 

benefit, however, is the ability of the issuer to invest bond proceeds 

to earn arbitrage. Arbitrage consists of the amounts directly 

permitted as arbitrage spread and amounts earned when yield 

restrictions do not apply. By virtue of the definition of yield, the 

spread includes issuance costs and bond insurance premiums. 

Current law is overly generous in that it allows issuers or bond 

users to retain the economic benefit of all permissible arbitrage, 

even though many of the rules permitting arbitrage (those for 

temporary periods and 4R funds, for example) are intended only to 

reduce the complexity of the arbitrage restrictions. Moreover, 

because the current rules generally prevent only the issuance of bonds 

that are expected to earn arbitrage and do not prohibit the retention 

of arbitrage ultimately earned, issuers and bond users often are 

rewarded with substantial amounts of "unexpected" arbitrage. 

activities ineligible for tax-exempt bond financing, since arbitrage 

is not subject to the use limitations applicable to proceeds of 

tax-exempt bonds. Second, arbitrage also increases the volume of 

tax-exempt bonds. This increase in volume occurs for several reasons. 

First, the availability of arbitrage makes feasible bond issues that 

otherwise would be uneconomical. For example, since issuance costs 

for advance refundings can be recovered out of arbitrage, such bonds 

may be issued even though issuance costs dwarf the economic benefit to 

the issuer or the bond user. Bond counsel and underwriters benefit 

from the resulting lack of motivation on the part of the issuer to 

restrain costs. Second, the arbitrage encourages issuers to sell more 

bonds than are necessary in order to invest the excess proceeds in 

higher yielding investments. Finally, the arbitrage encourages 

issuers to sell bonds earlier or keep them outstanding longer than is 

necessary in order to invest the proceeds to earn the arbitrage. f or 

example, it was recently reported that New York City will earn $3 

million in legal arbitrage simply by extending the maturity of its tax 

anticipation notes five months beyond the date on which the taxes will 

be collected. 

Under current law, the exclusion from Federal income tax of 

Arbitrage has two undesirable results. First, it may be used for 

Advance refundings of tax-exempt bonds also have the undesirable 

effect of increasing the volume of tax-exempt bonds. Advance 

refundings result in twice as many bonds being outstanding as are 

required for a given project. 

Increased bond volume brought about by arbitrage and advance 

refundings increases the Federal revenue loss associated with 

tax-exempt bonds, thereby causing taxpayers all over the country to 

pay additional taxes to support this subsidy of selected governmental 

issuers. Furthermore, additional volume in the tax-exempt bond market 

- 295 - 
raises the interest rates that must be paid to finance State and local 

government projects. This expansion also results in pressure for 

additional Federal aid for those projects from more jurisdictions 

because of the increased cost of providing the governmental services. 

Issuers of tax-exempt bonds would be required to rebate to the 

United States all arbitrage on acquired nonpurpose obligations 

(adjusted for gains and losses on the obligations and earnings on the 

gains and on the arbitrage). Investments in acquired nonpurpose 

obligations would be limited to 150 percent of annual debt service 

with exceptions for the initial temporary period and for bona fide 

debt service funds. 

Yield on the bond issue would be determined without regard to 

the underwriter's discount, costs of issuance, credit enhancement fees 

or other costs. Calculation of yield on acquired obligations also 

would be changed to prevent any reduction for costs. 

explicitly that it only protects inadvertent errors and not 

intentional acts to create arbitrage. For example, any fund that will 

be used to pay debt service on an issue will be subject to the rebate 

requirement regardless of whether its creation or its arbitrage was 

anticipated at the time of the tax-exempt bond issuance. 

proceeds are used would be made more strict than the current rules. 

There would be no temporary period for bond issues to finance 

acquisitions. The temporary period for construction projects would 

terminate when the project is substantially completed or when an 

amount equal to bond proceeds has been expended on the project and 

would in all cases be limited to three years. The right to waive the 

temporary period and earn a yield exceeding the bond yield by 0.5 

percent would be repealed. 

issuer would be required to spend a significant part of the bond 

proceeds within one month and spend all bond proceeds (excluding 

proceeds in a 4R fund) within three years of issuance. 

Refundings would be permitted only if the proceeds of the refunding 

bonds are used immediately to retire the prior bond issue. 

The reasonable expectations test would be clarified to provide 

Temporary period rules permitting unlimited arbitrage until bond 

Early issuance of bonds for a project would be prohibited. The 

Advance refundings would be prohibited for all tax-exempt bonds. 

Effective Date 

The proposal would be effective for obligations issued on or 

after January 1, 1986. 

- 296 - 
The proposal's rebate requirement would eliminate most of the 

economic motivation to issue tax-exempt bonds to earn arbitrage. In 

addition, arbitrage earned on obligations that are issued for 

governmental functions would not result in a windfall profit for the 

issuer. Proposed changes in the method of calculating yield and in 

the reasonable expectations test are necessary to implement the rebate 

requirement properly. 

The prohibition of advance refundings would result in a reduction 

in the aggregate volume of tax-exempt obligations being issued. 

Individual bond issues would be limited in size by the proposal's 

restriction on the amount of investments in acquired nonpurpose 

obligations. In addition, the period during which bonds may be 

outstanding would be limited by the proposal's restrictions on 

temporary periods and early issuance. The reductions in both the 

overall volume and individual size of bond issues would reduce the 

Federal revenue cost of tax-exempt bonds and would also reduce the 

interest costs to issuers of obtaining financing for governmental 

functions. 

State and local governments would continue to fulfill. necessary 

governmental functions. Governmental facilities and services could 

still be financed on a tax-exempt basis. Issuers, however, would not 

obtain the unnecessary "double dipping" provided by arbitrage in 

addition to the basic benefit of reduced interest cost. 

The proposal would eliminate many complex provisions in the Code 

and in the Treasury regulations interpreting the Code. The rules on 

advance refundings would be unnecessary and those dealing with yield 

computation would be simplified. The special arbitrage rules for 

certain bonds under current law also would be unnecessary because 

these bonds would not be exempt under the proposal for repeal of tax 

exemption for nongovernmental bonds. 

- 297 - 
REPEAL GENERAL STOCK OWNERSHIP CORPORATION PROVISIONS 

General Explanat ion 

Chapter 13.03 

Current Law 

Current law authorizes a State to establish a General Stock 

Ownership Corporation ("GSOC") for the benefit of its citizens. A 

GSOC meeting certain statutory requirements and making an appropriate 

election is exempt from Federal income tax. Instead, the shareholders 

of the GSOC are taxable on their daily pro rata share of the GSOC's 

taxable income. The GSOC computes its taxable income in the same 

manner as a regular corporation, but is not eligible for the 

dividends-received deduction. Losses of a GSOC do not flow through to 

its shareholders, but the GSOC is allowed as a 10-year net operating 

loss carryforward. 

December 31, 1978, and before January 1, 1984. 

Reasons for Change 

which they may be formed has expired. 

Proposal 

Current law permits such corporations to be chartered after 

No GSOC has been organizad under this law and the period during 

The proposal would repeal the law permitting creation of GSOCs. 

Effective Date 

The proposal would be effective as of January 1, 1984, the sunset 

date for creation of GSOCs. 

Analysis 

The complex provisions governing organization and operation of 

GSOCs have never been utilized. Repeal of these provisions would 

simplify the Code and have no economic effect. There would be no 

impact on revenues or expenditures as a result of implementing this 

proposal. 

- 298- 
CHAPTER 14 

SPECIAL EXPENSING AND AMORTIZATION RULES 

This Chapter discusses Treasury Department proposals that, in 

conjunction with the proposed Real Cost Recovery System, provide the 

recovery of capital investment on a basis that reflect economic 

depreciation. Thus, the special rules allowing rapid amortization for 

various types of capital investment would be repealed. As a 

simplification measure, the provision allowing $5,000 of certain 

capital investments to be expensed annually would be retained. The 

scheduled increases in the limit would be eliminated. 

-299- 
.----_I RETAIN $5 000 LIMIT ON EXPENSING 

DEPRECIABLE BUSINESS PROPERTY 

General Explanation 

Chapter 14.01 

Current Law 

Under current law, taxpayers may elect to expense the cost of 

a limited amount of qualifying property rather than to recover such 

cost over time through deductions for depreciation. In general, 

property qualifying for this expensing election must be purchased for 

use in a trade or business and must otherwise be eligible for the 

investment tax credit. No investment credit is allowable with respect 

to amounts expensed under this rule. 

the amount that may be expensed is $5,000 per year. This limitation 

is scheduled to increase to $7,500 for taxable years beginning in 1988 

and 1989, and to $10,000 for taxable years beginning after 1989. In 

each case, the limitation that applies to a married individual who 

files a separate return is one-half of the dollar limitation described 

above. 

Reasons for Change 

one year overstates the taxpayer's cost of producing income for the 

year. The overstatement of current deductions shelters other income 

from tax and thus results in a deferral of tax liability. This 

deferral advantage creates some incentive for investment in assets 

eligible for expensing, but only for taxpayers who would not otherwise 

have acquired qualifying property up to the amount eligible for 

expensing. For other taxpayers, the limited expensing election 

creates no marginal investment incentive. 

In addition, permitting taxpayers to expense the cost of an asset 

creates compliance problems. After the year in which the asset is 

expensed, the asset is removed from the tax form. As a result, it is 

relatively easy to convert the asset to personal use or to sell the 

asset without complying with the rules requiring recapture of the 

deduction. 

For taxable years beginning before 1988, the dollar limitation on 

Expensing the cost of an asset that produces income for more than 

A limited expensing election does, however, have certain 

simplification advantages. For smaller businesses, expensing 

eliminates or reduces the recordkeeping and computational burdens of 

recovering an asset's cost over a number of years. 

-300- 
Proposal 

depreciable business property would be eliminated, leaving the dollar 

limitation at $5,000. 

Analysis 

taxpayer. Elimination of the increase in the limitation should have 

little effect on investment in depreciable assets. The proposal would 

The scheduled increase of the dollar limitation on expensing of 

The proposal would not change the current treatment of any 

simply retain a de minimis alternative to the more complicated 

depreciation ru1.E. 

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REPEAL RAPID AMORTIZATION RULES 

General Explanation 

Chapter 14.02 

Introduction 

Current law contains a number of special amortization and 

expensing rules that allow taxpayers to elect premature deductions for 

capital expenditures. The deferral of income tax that these 

provisions permit is intended to create incentives or subsidies for 

investment in certain assets or activities. 

Some of these provisions originally were intended to be effective 

only for brief periods, but were later extended. Others have expired 

in whole or in part since they do not apply to expenditures made in 

the current year or in future years. Although these provisions target 

various industries and various assets, they have similar effects on 

the efficiency and fairness of the tax system and present related 

questions of tax and economic policy. 

Current Law 

1. Five-year amortization of trademark and trade name 

exvenditures. Current law uermits taxuavers to amortize over a ueriod 

of at least 60 months any expenditure bald or incurred in the takable 

year for the acquisition, protection, expansion, registration, or 

defense of a trademark or trade name, other than an expenditure which 

is part of the consideration for an existing trademark or trade name. 

(Section 177.) A separate election may be made by the taxpayer with 

respect to each separate trademark or trade name expenditure. 

2. Five-year amortization of pollution control facilities. 

Current law permits taxpayers to amortize the cost of a certified 

pollution control facility over a 60-month period. (Section 169.) To 

the extent, however, that a pollution control facility has a useful 

life in excess of 15 years, or, in the case of recovery property, has 

a recovery period in excess of 15 years, a portion of the facility's 

cost is not eligible for 60-month amortization, but must be recovered 

through depreciation or through the Accelerated Cost Recovery System 

( ACRS ) . 

A certified pollution control facility is a treatment facility 

used in connection with a plant or other property to abate or control 

water or air pollution, if (1) the plant or other property was in 

operation before January 1, 1976, (2) the facility is certified by the 

appropriate State and Federal authorities as meeting certain pollution 

control standards, and (3) the facility does not significantly 

increase the output, extend the life, or reduce the operating costs of 

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the plant or other property. In general, a profitable or "break even" 

facility is not eligible for certification. 

If an election is not made with respect to a certified pollution 

control facility, its cost may be recovered through depreciation or, 

in the case of recovery property, through ACRS. 

3. Five-year amortization of certain expenditures for qualified 

child care facilities. Current law permitted employers to amortize 

over a 60-month ueriod cauital costs incurred before Januarv _I,- 1. 1982. 

to acquire, construct, or'rehabilitate child care facilities for their 

employees. (Section 188.) 

low-income housing. current law permits taxpayers to amortize over a 

60-month period expenditures to rehabilitate low-income rental housing 

(other than hotels or other similar facilities primarily serving 

transients). (Section 167(lc).) Expenditures qualify for 60-month 

amortization only if they are incurred for additions or improvements 

to property with a useful life of at least five years. Expenditures 

for a taxable year with respect to a dwelling unit are eligible for 

60-month amortization only if the aggregate of such expenditures over 

two consecutive taxable years including the taxable year exceeds 

$3,000. In general, a taxpayer's rehabilitation expenditures with 

respect to a dwelling unit are not eligible for five-year amortization 

to the extent that the aggregate of such expenditures exceeds $20,000. 

In certain cases, this limitation is increased to $40,000. 

housing will not be available for expenditures incurred afer December 

31, 1986 (except in cases where rehabilitation began, or a binding 

contract for such expenditures was entered into, before January 1, 

1987). 

4. Five-year amortization of expenditures to rehabilitate 

The election to amortize expenditures to rehabilitate low-income 

5. Five-year amortization of certain railroad rolling stock. At 

the election of the taxpayer, current law permitted taxpayers to 

amortize over a 60-month period the adjusted basis of railroad rolling 

stock placed in service after 1968 and before 1976. (Section 184.) 

6. Fifty-year amortization of qualified railroad grading and 

tunnel bores. Current law permits domestic railroad common carriers 

to amortize the cost of qualified railroad qradinq and tunnel bores 

over a 50-year period. (Section 185.) "Qualified railroad grading 

and tunnel bores" include all land improvements (including tunneling) 

necessary to provide, construct, reconstruct, alter, protect, improve, 

replace, or restore a roadbed or right-of-way for railroad track. 

railroad grading or tunnel bores, but no additional deduction is 

allowed on account of such retirement. 

Amortizable basis is not reduced upon the retirement of qualified 

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I. Expensing of soil and water conservation expenditures, 

fertilizer and soil conditioning expenditures, and field clearing 

expenditures. Current law permits taxpayers engaged in the business 

of farminq ("farmers') to deduct a variety of costs that would 

otherwise-be capitalized or inventoried. 

expenditures that do not increase the basis of depreciable assets. 

(Section 175.) The deduction is limited annually to 25 percent of the 

taxpayer's gross income from farming. Deductible expenditures include 

costs of the following: leveling, grading, and terracing; contour 

furrowing; the construction, control, and protection of diversion 

channels, drainage ditches, earthen dams, watercourses, outlets, and 

ponds; the eradication of brush; and the planting of windbreaks. 

Expenditures with respect to land held by the taxpayer for less than 

ten years are subject to recapture as ordinary income. 

other material used to enrich, neutralize, or condition farmland. 

(Section 180.) 

c. Farmers may deduct currently expenditures incurred to clear 

land and make the land suitable for farming. (Section 182.) The 

deduction is limited in any taxable year to the lesser of $5,000 or 25 

percent of the farmer's taxable income from farming. Expenditures 

with respect to land held by the taxpayer for less than ten years are 

subject to recapture as ordinary income. 

8. Seven-year amortization of reforestation expenditures. 

Current law permits taxpayers to amortize over an 84-month period up 

to $10,000 of reforestation expenditures incurred in each taxable 

year. (Section 194.) Reforestation expenditures include amounts 

spent on site preparation, seed or seedlings, labor, and tools. 

Amortized expenditures are subject to recapture if the underlying 

property is disposed of within ten years from the year of the 

expenditure. 

a. Farmers may deduct currently soil and water conservation 

b. Farmers may deduct currently expenditures for fertilizer or 

Reasons For Change 

Summary 

Government subsidies for particular industries and assets 

distort market-based resource allocations and the consumer preferences 

on which they are based. In circumstances where private markets fail 

to reflect the social value of particular goods or services, 

government intervention in the form of a subsidy may be appropriate. 

However, many recently enacted tax incentives for business do not 

address problems of market failure, but instead subsidize specific 

business activities at some cost in economic efficiency. 

Even where government support of a particular activity is 

warranted, providing such support through the allowance of premature 

cost recovery deductions results in a subsidy that is difficult to 

- 304 - 
measure or control, discriminatory in its effects, and poorly targeted 

to encourage the particular form of investment. 

The value to a taxpayer of premature cost recovery deductions 

depends on a variety of factors unrelated to the purpose of the 

subsidy. For example, the benefit from premature deductions will 

depend upon the difference in the taxpayer's marginal tax rate for the 

years in which the premature deductions are taken and the marginal 

rates for the years in which deductions would have been allowed under 

general tax accounting principles. Similarly, interest rates and the 

level of inflation over the same period will affect the actual value 

of the premature deductions. 

In addition, since the benefit from premature cost recovery 

deductions is greater for taxpayers with high current marginal tax 

rates, incentives in that form discriminate against new businesses 

which have not started to generate taxable income, as well as growing 

businesses which reinvest their profits in ways that reduce current 

taxable income. Thus, such businesses are encouraged to diversify 

through expansion or merger solely to increase their taxable income. 

A subsidy in the form of premature cost deductions is also 

difficult to target. Ideally, the incentive should benefit the most 

efficient owners of the asset to which the subsidy is directed. Since 

the subsidy's value is dependent on marginal tax rates, however, there 

is a strong incentive for subsidized assets to be owned by taxpayers 

in the highest brackets, who may or may not be efficient owners. 

Finally, a subsidy in the form of premature cost recovery 

deductions is difficult to monitor or control. The contingencies in 

the val.ue of the subsidy make prediction of its revenue cost extremely 

difficult. Problems in targeting the subsidy make it difficult to 

measure the subsidy's effect, which may in turn result in the subsidy 

being retained beyond the point at which it provides an efficient 

incentive. 

1. Trademark and trade name expenditures. A trademark or trade 

name distinguishesa firm and/or its products from other firms and/or 

their products. 

for an intangible asset, similar to expenditures to organize a 

business. Investors are willing to make such expenditures because in 

doing so they acquire an asset that will, over the course of time, 

yield a rate of return at least as high as could be earned by other 

investments. Although a trademark or trade name may prove to be 

unprofitable, or even worthless, there can be no presumption that it 

will decline in value. To the contrary, the ordinary investor 

acquiring a trademark or trade name expects the value of the asset to 

apprecLate along with the development of the products that it 

represents. There is consequently no basis for imputing deductions 

for "capital cost recovery" for such investments. 

yields a greater benefit to society than is reflected in the expected 

The costs of acquiring trademarks are capital outlays 

There is no evidence that investment in a trademark or trade name 

- 305 - 
market return to the investor. Allocation of resources to such 

investment should thus be determined by general market principles 

There is correspondingly no basis for a tax incentive through 

premature recovery of the costs of such investment. 

2. Certified pollution control facilities. The special 

amortization rules for Dollution control facilities were enacted in 

1969, shortly after the-enactment of Federal legislation which imposed 

phased-in restrictions on industrial plant emissions. The thrust of 

the environmental protection laws was to require producers and their 

customers to pay the costs of avoiding environmental damage in excess 

of the standards imposed. At the same time, concern was expressed 

that existing plants would be subject to burdensome retrofitting 

costs, which would place them at a competitive disadvantage compared 

to newer plants that were designed after pollution control 

requirements were imposed. The special amortization rules were 

adopted to mitigate the cost of retrofitting older facilities. 

Consistent with the transitional objective, the special rules were 

scheduled to expire after seven years (December 31, 1975), a period 

presumably long enough to bring pre-1969 plants into compliance with 

emission standards. 

The special amortization rules for pollution control facilities 

are poorly designed to offset the burden, if any, that revised 

environmental standards imposed on operators of existing plants. 

Ordinarily, plants in industries where emissions are a major concern 

are continuously "replaced" and their capacity altered in an orderly 

process of maintenance, repair, and modernization stages. Thus, at the 

margin, revised emission standards raised investment and operating 

costs for "old" and "new" plants alike. The only cost disadvantage to 

"old" plants was the difference between (a) the total additional cost 

of incorporating emission control features into "modernization" 

programs, and (b) the total additional cost of incorporating emission 

control features into the construction of new plants. This 

difference, which reflected differences in operating costs as well as 

capital costs, presumably varied from industry to industry, and from 

plant to plant. Thus, the extra burden imposed on taxpayers operating 

old plants, if any, was not related in some simple way to the cost of 

a depreciable retrofit facility, nor was it approximately equal to the 

interest savings on deferred taxes provided by five-year amortization. 

The five-year amortization rules are also poorly targeted to 

encourage pollution control activities. The subsidy is available only 

with respect to depreciable assets, and thus provides no incentive for 

numerous other ways of reducing pollution from existing plants, such 

as using cleaner but more expensive grades of fuel and other taw 

material inputs. Favoring capital intensive pollution control 

measures wastes scarce resources to accomplish the program objective. 

Finally, although the special amortization rule for pollution 

control facilities was originally a temporary measure, it was extended 

indefinitely in 1976. Even if some justification existed for 

- 306 - 
transitional relief to operators of old plants, there is no basis for 

an ongoing subsidy of pollution control costs. 

3. Qualified child care facilities. The special rule permitting 

five-year amortization of expenditures to construct or rehabilitate 

child care facilities applies only to expenditures made before January 

1, 1982, and, therefore, has effectively expired. 

low-income housing has benefited from a variety of direct and indirect 

government subsidies, including rental subsidies, grants, loans, and 

credit supports and guarantees. A number of Federal programs, 

including the housing voucher program initiated in 1983, have provided 

direct or indirect assistance to low-income families unable to afford 

market rents. Also initiated in 1983 were two programs providing 

grants to assist private sector rehabilitation and new construction of 

low-income housing. Direct low-interest loans are made available to 

assist low-income individuals in rural areas to obtain adequate 

housing. Finally, a number of mortgage insurance and guarantee 

programs make credit available to many families who could not afford 

to purchase homes in the absence of such measures. 

In addition to these targeted direct subsidies, the current 

income tax laws contain numerous provisions which encourage investment 

in real estate, including housing. These provisions include (1) 

accelerated depreciation of real property, (2) full deductibility of 

interest, including the portion of interest intended to compensate the 

lender for the effects of inflation, (3) reduced tax rates for capital 

gains realized on disposition of real property, (4) relaxed recapture 

rules for dispositions of real property, (5) exemption of real estate 

investments from the limitation of losses to amounts at risk, and (6) 

tax-exempt status for bonds issued to finance low-income rental 

property. In addition, several special provisions apply only to 

low-income housing, including (1) immediate deductibility of 

construction-period interest and taxes, (2) the 15-year ACRS recovery 

period, and (3) five-year amortization of rehabilitation expenditures. 

The tax benefits associated with real estate investment attract 

capital from high-income taxpayers who are willing to trade negative 

cash flows or below-market returns for substantial tax savings, and 

therefore appear to cause increased investment in real estate, 

including low-income housing. However, in a 1977 report entitled 

"Real Estate Tax Shelter Subsidies and Direct Subsidy Alternatives," 

the Congressional Budget Office estimated that, because of the costs 

of packaging tax shelters and the high after-tax returns enjoyed by 

tax shelter investors, less than one-half of government revenue losses 

attributable to real estate tax shelters ever reach builders and 

developers. Thus, to the extent that the current tax laws encourage 

investment in low-income housing, the incentive is unnecessarily 

costly to the government. 

4. Rehabilitation of low-income housing. Historically, 

- 307 - 
Moreover, the provision permitting five-year amortization of 

expenditures to rehabilitate low-income housing, by itself, is 

probably insufficient to cause taxpayers to invest in low-income 

properties. The tax consequences of such investments are beneficial 

only in conjunction with accelerated depreciation of other capitalized 

costs (such as the purchase price of the unrehabilitated property), 

full deductibility of interest, and high marginal tax rates. In a tax 

system with economic depreciation, indexation of capital gains and 

interest, and reduced marginal rates, five-year amortization of 

rehabilitation expenditures would be of dubious value, and would 

merely complicate the tax laws. 

If additional measures are needed to stimulate investment in 

low-income housing, existing targeted spending programs should be 

expanded. 

5. Railroad rolling stock, The special rule permitting 

five-vear amortization of the adjusted basis of railroad rolling stock 

applies only to rolling stock placed in service before 1976, ana, 

therefore, has effectively expired. 

6. Qualified railroad grading and tunnel bores. For much of its 

history, the U.S. railroad industry was subject to rate and service 

regulation designed to favor shipments of bulk raw materials over 

shipments of finished and semi-finished products. As a consequence, 

the industry's capacity to haul bulk commodities, demand for which is 

highly seasonal in volume, depended heavily on cross-subsidization 

from rates that were charged for "high value" manufactured goods. 

railroad industry held a virtual monopoly on long distance overland 

haulage. Competition from trucking progressively eroded this 

monopoly, however, shifting the railroad's mix of transported goods to 

the low-value markets. Railroad rate schedules failed to keep pace 

with the shift in markets, depressing industry earnings and causing 

investment in right of way and rolling stock to decline. 

In 1969, Congress responded to the railroad industry's financial 

plight by allowing 50-year amortization for the cost of railroad 

grading (the basic roadway, but not the track, ties, and ballast) and 

tunnel bores, which, as assets in the nature of land improvements, had 

previously been considered nondepreciable. This special amortization 

rule, after its expansion in 1976, applied regardless of when the 

assets were placed in service, effectively granting railroad companies 

a 50-year stream of tax deferrals. 

The special amortization rule for railroad grading and tunnel 

bores is a poorly conceived subsidy. The value of the subsidy depends 

on a railroad's historical investment in grading and tunnel bores. In 

many cases, these costs were incurred prior to imposition of the 

income tax, and, in any event, are not correlated with regulatory 

mispricing. 

In general, such cross-subsidization was possible so long as the 

- 308 - 
In addition, the subsidy targets its benefits to railroads least 

in need of or entitled to relief. Those railroads most affected by 

regulatory mispricing may not have significant taxable income, and 

thus may realize no benefit from the subsidy. Only profitable 

railroads can take full advantage of the special amortization rules, 

yet they may have escaped the burdens that the subsidy is intended to 

offset. 

conditioning expenditures, and land clearing expenditures. ~n 

recognition of various economic conditions which disfavor small unit 

farming, often called family farming, Federal programs to mitigate 

farm price and income instability have been in place since 1926. In 

addition to price support programs, farmers have access to Federal 

credit on a subsidized basis. The Department of Agriculture also 

administers programs for agricultural conservation and rural water 

supply, as well as providing farmers broad scale technical and 

management assistance. 

7. Soil and water conservation expenditures, fertilizer and soil 

The extensive Federal involvement in agricultural input and 

output markets makes additional tax-based subsidies unnecessary and 

inefficient. Qutlays to drain marshy soil, create ponds, install 

irrigation ditches, and condition soil, all have the objective of 

yielding greater farm output in the future; under ordinary accounting 

principles they should be capitalized or inventoried -- treated as the 

purchase of an asset -- rather than treated as a cost of the current 

year's output. If the land-improving investments are rationally made, 

the farmer has merely exchanged cash for an asset of equal value -- improved land -- the expected market value of which will accrue to him 

as output occurs. 

Finally, as with many other tax-based subsidies, the special 

expensing rules for farmers are of full value only to those with 

significant income. This effectively denies the benefits of the 

subsidy to the new or unprofitable farmer, who is thus given a 

relative disincentive for farm improvements. 

8. Reforestation expenditures. It has been argued that the 

market price of timber understates the social value of forested land 

because some important benefits are not expressed in the market price. 

National security, flood control, arresting land erosion that degrades 

the quality of streams, and opportunities for outdoor recreation are 

claimed to be among the additional benefits derived from forested 

land. 

In view of these "externalities," government invervention to 

increase the volume of forest output may be justified. Thus, $1.8 

billion was spent in fiscal year 1984 for management of more than 100 

million acres of national forests and for cooperative forestry and 

forestry research. 

- 309 - 

459-813 0 - 84 - 11 
In addition to these direct budget expenditures, present law 

contains tax subsidies intended to encourage forestry by small-scale 

landowners. All taxpayers investing in timberland are entitled to an 

investment tax credit equal to ten percent of up to $10,000 of 

forestation expenditures each year. In addition, the total amount 

eligible for the credit may be amortized over seven years, 

notwithstanding the fact that the taxpayer has expended only 90 

percent of that amount and the trees planted are likely to appreciate 

in value. 

Even if one agrees that there are "externalities" in forestry in 

excess of the direct expenditures presently provided in the Federal 

budget, the tax subsidy is so poorly designed that its continuation is 

difficult to justify. Any forestation expenditure qualifies for the 

investment credit and amortizaton, whether or not it yields 

recreational, flood control, or erosion control benefits, or relates 

to a tree species with national security significance. Moreover, the 

subsidy is so structured that it cannot appreciably affect marginal 

industry investment. Due to economies of scale, most commercial 

forestry (i.e., that type which is likely to produce external benefits 

of the kind that justify a subsidy) occurs on a scale far in excess of 

$10,000 per year. For most commercial forestry, therefore, the 

subsidy is the equivalent of a fixed grant, plus assured tax deferral 

per year, and is independent of the taxpayer's decision to increase 

marginal qualified expenditures. Consequently, repealing these tax 

subsidy provisions would reduce the budget deficit without measurably 

increasing soil erosion and flood damage, or reducing recreational 

opportunities and national security. 

Proposal and Effective Dates 

1. Trademark and trade name expenditures. The current election 

to amortize trademark and trade name expenditures would be repealed. 

Repeal would be effective for expenditures paid or incurred on or 

after January 1, 1986, other than expenditures paid or incurred 

pursuant to binding contracts entered into prior to the date that the 

proposal is introduced in legislation. 

2. Certified pollution control facilities. The election to 

amortize the cost of certified pollution control facilities would be 

repealed. Repeal would be effective for expenditures paid or incurred 

on or after January 1, 1986, other than expenditures paid or incurred 

pursuant to binding contracts entered into prior to the date that the 

proposal is introduced in legislation. 

3. Qualified child care facilities. This provision would be 

deleted from the Code as deadwood, since it applies only to costs 

incurred prior to January 1, 1982. 

amortize expenditures to rehabilitate low-income housing would be 

4. Rehabilitation of low-income housing. The election to 

- 310 - 
repealed. Repeal would be effective for expenditures paid or incurred 

on or after January I, 1986, other than expenditures paid or incurred 

pursuant to binding contracts entered into prior to the date that 

the proposed is introduced in legislation. 

5. Railroad rolling stock. This provision would be deleted from 

the Code as deadwood, since it applies only to rolling stock placed in 

service prior to 1976. 

6. Qualified railroad grading and tunnel bores. The election to 

amortize the cost of qualified railroad grading and tunnel bores would 

be repealed. Repeal would be effective for expenditures paid or 

incurred on or after January 1, 1986, other than expenditures paid or 

incurred pursuant to binding contracts entered into prior to the date 

that the proposal is introduced in legislation. 

7. Soil and water conservation expenditures, fertilizer and soil 

conditionhg expenditures, and land clearing expenditures. The 

elections to deduct currentlv exuenditures for soil and water 

conservation, fertilizer and-soii conditioning, and land clearing, 

would be repealed. Repeal would be effective for expenditures paid or 

incurred on or after January 1, 1986, other than expenditures paid or 

incurred pursuant to binding contracts entered into prior to the date 

that the proposal is introduced in legislation. 

8. Seven-year amortization of reforestation expenditures. The 

election to amortize reforestation expenditures would be repealed. 

Repeal would be effective for expenditures paid or incurred-on or 

after January 1, 1986, other than expenditures paid or incurred 

pursuant to binding contracts entered inta prior to the date that the 

proposal is introduced in legislation. 

Analysis 

In general, costs that currently qualify for the special 

expensing and amortization rules discussed in this section create 

wasting or non-wasting long-lived assets. Thus, repeal of the special 

rules would cause those costs to be capitalized or inventoried, and 

recovered under the normal cost recovery rules or at the time of 

disposition. The effect on taxpayer behavior of such repeal would 

generally depend on (.I) the extent to which marginal investment 

choices are influenced by the special rules provided by current law 

and (2) the degree of neutrality achieved by the cost recovery rules 

replacing the special provisions. 

1. Trademark and trade name expenditures. An investment in a 

trademark or trade name creates an intangible asset for which there is 

no reason to impute deductions for a decline in value over time. 

Accordingly, if such an investment were capitalized it would be 

recovered only upon disposition of the asset. Thus, the interest-free 

tax deferral which currently results from the tax treatment of 

trademark and trade name expenditures would be eliminated. 

- 311 - 
Nevertheless, the effect of repeal on business would be minimal. 

Unlike investments in plants and equipment, investments in trademarks 

and trade names do not vary with firm output. Rather, they are fixed 

capital costs which are relatively small compared to the initial 

investment in an enterprise, and constitute a declining proportion of 

total investment as firm output increases. Thus, the importance of 

trademark and trade name income tax deferral is initially small and is 

thereafter of diminishing significance to firms with average rates of 

growth. 

2. Certified pollution control facilities. Pollution control 

facilities that are currently elisible for five-vear amortization are 

for the most part comprised of eqcipment which, hder a system of 

economic depreciation, would be depreciated over periods longer than 

five years. Since, under such a system, the relative tax benefit from 

investing in such equipment, compared to the tax consequences of 

investing in other means of controlling pollution, would be reduced or 

eliminated, choices of pollution control methods would be based on 

economic, rather than tax, considerations. Since compliance with 

emission control standards is mandatory in most cases, the functional 

value of investments in pollution control facilities would not 

decline. However, under a neutral cost recovery system, only the most 

cost-efficient pollution control methods would be used. 

3. Rehabilitation of low-income housinq. In the absence of 

five-year amortization of expenditures to rehabilitate low-income 

housing, such expenditures would be recovered in accordance with the 

normal rules for depreciating real property. Accordingly, repeal of 

this amortization provision would reduce to some extent the currently 

inflated after-tax return earned by investments in low-income housing 

rehabilitation. Nevertheless, the proposal is not expected to 

diminish the volume of low-income housing. 

A tax preference for “rehabilitated‘ low-income housing directs 

private investment toward rehabilitation rather than new construction. 

New construction, however, even of housing for moderate- and 

high-income families, increases the stock of housing for low-income 

occupancy as tenants relocate. ~hus, increased rehabilitation induced 

by tax subsidies largely displaces new construction. Accordingly, 

repeal of the subsidy would have little effect on the availability of 

low-income housing. 

4. Qualified railroad grading and tunnel bores. In the absence 

of 50-vear amortization of expenditures for railroad sradins and 

tunnel-bores, such expenditures should generally be capitalized as 

costs of land improvements, and recovered upon disposition of the 

improvements or the underlying land. This treatment would be 

consistent with the nature of the asset created by such expenditures, 

the value of which generally does not decline over time. In view of 

the fact that future improvements of and additions to railroad grading 

and tunnel bores are likely to be insubstantial in relation to 

improvements and additions of track and rolling stock, repeal of 

- 312 - 
50-year amortization should not have an appreciable effect on the 

volume of railroad investment or on after-tax rates of return on such 

investment. 

5. Soil and water conservation expenditures, fertilizer and soil 

conditioning expenditures, and land clearing expenditures. In the 

absence of special expensing rules for farmers' expenditures for 

clearing, conditioning, and-conserving farmland, some of these 

expenditures would be capitalized as a cost of improving the land to 

make it suitable for farming and, as such, would be recovered under 

normal cost recovery rules. TO the extent that farmers who make such 

investments have significant marginal tax rates (generally large-scale 

operators and corporations), the loss of tax deferral would make 

investments in larid i.mprovement less attractive than alternative 

investments, such as investments in farm machinery or in other 

industries. In addition to the resulting social gain from a better 

allocation of scarce private capital, eliminating this subsidy could 

result in a reduced level of Federal expenditures for price-support 

programs, since expansion of farm acreage would no longer be 

encouraged by the tax laws. 

6. Reforestation expenditures. Repeal of seven-year 

amortization of qualified reforestation expenditures and the 

associated ten percent investment credit would have no measureable 

effect on the rate of investment: in private forest lands. These 

incentives are structured so that they do not affect forest investment 

decisions; they apply only to the first $10,000 of forestation 

investment, a rate far below the annual size of a viable commercial 

forestry operation. The existing tax subsidies, however, also benefit 

farmers and other landowners who use tree planting to control 

wind-related soil damage or otherwise to improve the value of their 

land. Absent the current subsidy, this type of tree planting probably 

would decline and investors would select other investment projects 

with higher market yields. 

- 313 - 
CHAPTER 15 

OTHER SPECIFIC SUBSIDIES 

The Treasury Department proposals would repeal various business 

subsidies contained in the Code, including the rehabilitation tax 

credit, the merchant marine capital construction fund provisions, the 

possession tax credit, and special rules for book, magazine, and 

discount coupon income. The research and experimentation credit would 

be retained, but modified to improve its efficiency. 

-. 3 14 "' 
REPEAL TAX CREDIT FOR QUALIFIED 

REHABILITATION 

General Explanation 

Chapter 15.01 

Current Law 

A special investment tax credit (the "rehabilitation credit") is 

provided for qualified expenditures incurred in connection with the 

rehabilitation (but not enlargement) of certain old or historic 

buildings. The credit rate is equal to (a) 15 percent for qualified 

expenditures incurred in connection with buildings at least 30 years 

old but less than 40 years old, (b) 20 percent for qualified 

expenditures incurred in connection with buildings at least 40 years 

old, and (c) 25 percent for qualified expenditures incurred in 

connection with certified historic structures of any age. The regular 

investment tax credit and the energy investment tax credit do not 

apply to any portion of an expenditure which qualifies for the 

rehabilitation credit. 

The rehabilitation credit is limited to expenditures incurred in 

connection with buildings that will not be used for lodging (except 

in the case of certified historic structures), and is available only 

if the taxpayer elects to use the straight-line recovery method with 

respect to the expenditures. A rehabilitation must be substantial to 

qualify for the credit. In general, this requirement is met if 

rehabilitation expenditures incurred over a 24-month period exceed the 

adjusted basis of the property at the beginning of that period. In 

addition, at least 75 percent of the building's external walls must be 

retained in place. 

The 25 percent credit for fehabilitations of certified historic 

structures is subject to certain additional requirements. In general, 

the 25 percent credit is not available unless the rehabilitation is 

certified by the Secretary of the Interior as being consistent with 

the historic character of the building or the district in which the 

building is located. Certified historic structures include only (a) 

buildings listed in the National Register and (b) buildings located in 

a registered historic district and certified by the Secretary of the 

Interior as being of historic significance to the district. 

In the case of a qualified rehabilitation of a certified historic 

structure, the basis of the rehabilitated building is reduced by 50 

percent of the amount of the credit. The reduction is 100 percent of 

the credit in the case of other qualified rehabilitations. If a 

rehabilitation credit is subsequently recaptured, corrective basis 

adjustments are made (and treated as occurring immediately before the 

recapture event). 

- 315 - 
Reasons For Change 

As enacted in 1962, the investment tax credit was unavailable for 

buildings and their structural components. In limiting the credit to 

tangible personal property, Congress was primarily concerned about the 

greater average age and lower efficiency of domestic machinery and 

equipment in comparison with the facilities of major foreign 

producers. 

In 1978, Congress noted a decline in the usefulness of existing, 

older buildings, primarily in central cities and older neighborhoods, 

and extended the regular investment tax credit to older buildings for 

the purpose of promoting stability and economic vitality in 

deteriorating areas. No special credit was provided for certified 

historic structures, although the credit was made available for 

rehabilitation of such structures only if the Secretary of the 

Interior certified the rehabilitation as appropriate. 

In 1981, Congress enacted the Accelerated Cost Recovery System 

(ACRS), and noted that ACRS had the unintended effect of reducing the 

relative attractiveness of the original (ten percent) credit for 

rehabilitating older buildings. Accordingly, Congress replaced the 

original rehabilitation credit with the three-tier credit contained in 

current law. The three-tier system had the effect of (1) increasing 

the amount of the credit available for all qualified buildings, (2) 

further increasing the credit for buildings more than 30 years old, 

and (3) providing a special increased credit for certified historic 

structures. 

The current rehabilitation tax credit is flawed in several 

respects. First, the credits are embedded in a complicated natrix of 

tax rules which, taken as a whole, result in widely varying after-tax 

returns for investments in different types of assets. There is no 

evidence that the combined tax benefits granted to rehabilitators of 

older buildings, when compared to the tax benefits available to 

constructors or rehabilitators of newer buildings, are an appropriate 

incentive for investment in older buildings. Moreover, since the 

amount of the credit for any qualified rehabilitation is generally a 

function only of (1) the age of the existing structure, and (2) the 

cost of the rehabilitation, the incentive effects of the credit are 

not limited to investment in deteriorating areas, as opposed to 

modernization of older structures in stable areas. 

In addition, the 25 percent credit for certified historic 

structures is effectively administered by an agency without budgetary 

responsibility for the revenue cost, The Secretary of the Interior is 

given sole authority to determine whether a structure meets the 

requirements for the credit, but the subsidy is not included in the 

Interior Department's budget. Thus, in 

determining the availability of the credit, the sole reviewing agency 

has no direct incentive to compare probable costs and benefits. 

- 316 - 
Proposal 

The rehabilitation credit Would be repealed. 

Effective Date 

Repeal would be effective for expenditures incurred on or after 

January I, 1986. An exception would be provided for expenditures 

incurred pursuant to binding commitments entered into prior to the 

introduction of this proposal in legislation. Expenditures incurred, 

other than pursuant to binding commitments, after the effective date 

would be aggregated with expenditures incurred prior to the effective 

date for purposes of determining whether the earlier expenditures were 

incurred in connection with a "substantial" rehabilitation. 

Analysis 

In the absence of investment tax credits for rehabilitation 

expenditures, the full amount of such expenditures would be recovered 

through normal cost recovery rules. Under a system of economic 

depreciation, effective tax rates on investment in rehabilitation of 

older and historic structures would be comparable to effective tax 

rates on other investments. 

- 317 - 
REPEAL SPECIAL RULES FOR BOOK, PPBGAZINE, AND 

DISCOUNT COUPON INCOME 

General Explanation 

Chapter 15.02 

Current Law 

Magazine, Paperback, and Record Returns. An accrual basis 

taxpayer that distributes magazines, paperbacks, or sound recordings 

for resale may elect (irrevocably) to exclude from gross income for 

the taxable year certain amounts attributable to the sale of such 

items if the purchaser fails to resell the items and returns them 

within a specified period after the end of the taxable year (2-1/2 

months in the case of magazines, and 4-1/2 months in the case of 

paperbacks and recordings). The exclusion applies only if, at the 

time of sale, the taxpayer has a legal obligation to adjust the sales 

price if the items are not resold, and the exclusion is limited to the 

amount of price reductions for returns that are actually made within 

the prescribed periods. 

application of special transitional adjustment rules designed to 

prevent the "bunching" of deductions in the first year of the 

election. In the case of an election relating to magazines, the 

decrease in income resulting from the bunching of deductions in the 

first year is spread over a five-year period. In the case of an 

election relating to paperbacks or records, however, the decrease is 

placed in a suspense account. Adjustments to this suspense account 

permit additional exclusions from income in subsequent taxable years 

only to the extent the taxpayer's adjustments from post-year returns 

decline over time. In general, the effect of the suspense account is 

to defer deduction of the transitional adjustment until the taxpayer 

ceases to be engaged in the trade or business of publishing or 

distributing paperbacks or records. 

An election to take advantage of this exclusion triggers the 

Redemptions of Qualified Discount Coupons. AI: accrual basis 

taxpayer that issues discount coupons with respect to merchandise 

marketed by unrelated retailers may irrevocably elect to deduct in the 

taxable year the cost of redeeming qualified coupons that are returned 

within six months after the end of the taxable year. A shorter period 

may be used at the taxpayer's election. 

income resulting from the "bunching" of deductions in the first year 

is not allowed but is placed in a suspense account. Adjustments to 

this suspense account permit additional deductions in subsequent 

taxable years only to the extent the taxpayer's qualified discount 

coupon redemptions decline over time. If such redemptions do not 

decline, the suspended amounts may be deducted only when the taxpayer 

ceases to be engaged in the business. 

~n the case of an election under this provision, the decrease in 

- 318 - 
Reasons for Change 

The primary purpose of the special provisions for magazine, 

paperback, and record returns, and redemptions of qualified discount 

coupons, was to enable taxpayers to conform their tax accounting to 

their financial accounting. In both cases, the exclusion or deduction 

is designed to approximate decreases in adjusted gross income that 

would have accrued at the end of the taxable year if the amount of the 

taxpayer's price-adjustment or redemption obligation were known at 

that time. 

On the other hand, there is a general standard for accrual of 

liabilities in the taxable year -- occurrence of all events sufficient 

to establish the existence and amount of the liability. The cases 

covered by the current rules do not satisfy this standard, since the 

events establishing the taxpayer's liability for the adjustment -- 

return of magazines, paperbacks, or records, or presentment of 

coupons -- have not occurred a5 of the end of the year. 

Both provisions lead to a mismatching of income and deductions 

and an understatement of total income in the economy. Redemptions of 

discount coupons in year two are deducted by the issuer in year one 

even though the retailer may not include the redemptions in income 

until year two. Similarly, refunds for returns of magazines, 

paperbacks, and records are deducted in year one by the publisher even 

though the retailer may not include the refunds in income until year 

two. The mismatching results in a one-year deferral of taxation of 

the income, a deferral that increases annually in the case of new and 

growing firms. 

Repeal of these rules would also simplify the tax code and would 

make it unnecessary to determine the correctness of taxpayers' claims 

that post-year price adjustments and redemptions are made pursuant to 

obligations or coupons that were outstanding prior to the end of the 

taxable year. 

Proposal 

The elections (a) to exclude from income certain adjustments 

relating to magazines, paperbacks, and record returns, and (b) to 

deduct costs of redeerning qualified discount coupons, would be 

repealed. 

Effective Date 

The repeal would be effective for taxable years ending on or 

after January 1, 19813. Affected taxpayers would be permitted to 

deduct the balances of their suspense accounts or suspended amounts in 

the first taxable year in which the proposal is effective. 

- 319 - 
Anal ys i s 

Taxpayers adversely affected by repeal of these special 

accounting rules would gain a compensating benefit from the proposed 

general reductions in tax rates. 

- 320 - 
EXTEND AND MODIFY RESEARCH AND EXPERIMENTATION CREDIT 

General Explanation 

Chapter 15.03 

Current Law 

A 25 percent nonrefundable tax credit is allowed for the portion 

of a taxpayer's qualified research expenses which is equal to the 

lesser of (1) the excess of such expenses in the current year over the 

average amount of such expenses for the prior three years or (2) 50 

percent of qualified research expenses in the current year. Special 

rules apply to aggregate qualified research expenses of certain 

related persons to ensure that the credit is available onLy for real 

increases in qualified research expenditures. 

"Qualified research expenses" geqerally include only research and 

development costs in the experimental or laboratory sense. Qualified 

research expenses that are eligible for the credit include (1) 

expenses paid or incurred for qualified research conducted directly by 

the taxpayer, (2) 65 percent of any amounts paid or incurred to 

another person €or qualified research (i.e., "contract research" 

expenses), and (3) in the case of corporate taxpayers, 65 percent of 

any amounts contributed to universities and other qualifying 

organizations for the conduct of basic research. 

The credit is available only for research expenses paid or 

incurred in connection with an ongoing trade or business of the 

taxpayer. Employee wages are treated as qualified research expenses 

to the extent paid to an employee for engaging in (1) the actual 

conduct of qualified research, (2) the immediate supervision of 

qualified research activities, or (3) the direct support of such 

activities. Payments for supplies used in the conduct of qualified 

research and amounts paid for the right to use personal property in 

the conduct of qualified research also constitute qualified research 

expenses. 

Expenses of (1) research conducted outside the United States, (2) 

research in the social sciences and humanities, and (3) funded 

research are speciEically excluded from qualified research expenses 

eligible for the credit. 

Credits that are not used in a taxable year may be carried back 

three years and forward 15 years. The credit will not be available 

for expenses paid or incurred after December 31, 1985. 

Reasons For Change 

The existing credit for research and experimentation activities is 

intended to create an incentive for technological innovation. The 

benefit to the country from such innovation is unquestioned, and there 

- 321 - 
are reasonable grounds for believing that market rewards to those who 

take the risks of research and experimentation are not sufficient to 

support an optimal level of such activity. The credit is intended to 

reward those engaged in research and experimentation of unproven 

technologies. 

Although the credit for research and experimentation is justified 

in concept, the existirig definition of eligible activities is overly 

broad. Some taxpayers take the view that the costs of any trial and 

error procedure are eligible for the credit even though there may be 

little doubt about the outcome of the procedure. 

The definition of qualifying expenses for purposes of the credit 

should identify clearly those innovative research activities which 

merit government support. This definition also should incorporate 

standards that are sufficiently objective to permit taxpayers, in 

planning their activities, to determine with reasonable certainty 

whether the credit will be available. A definition that satisfies 

these two criteria would be more effective in encouraging taxpayers to 

undertake innovative research and experimental activities. 

Proposal 

The credit for increases in research and experimentation 

expenditures would be extended for an additional three years (until 

December 31, 1988), and the definition of qualified research would be 

revised to target those research activities likely to result in 

technological innovations. 

Effective Date 

The revised definition of qualified research would be effective 

for expenses paid or incurred after December 31, 1985. 

Analys i s_ 

The definition of expenses qualifying for the research credit 

should target private research activities designed to lead to 

technological innovations in products and production processes. At 

the same time, the definition must be phrased in terms that permit 

taxpayers to know with reasonable certainty what research activities 

qualify for the credit. 

Senate amendmPnt to H.R. 4170 (enacted as the "Tax Reform Act of 

1984"). Although the conference committee agreed to defer 

consideration of the research credit, the Senate definition targets 

technological innovation and provides taxpayers with relatively 

objective rules. 

A useful definition incorporating both principles is found in the 

The Sen6te definition focuses on new or technologically improved 

products and processes and provides that research qualifies for the 

credit only if it relates to a process of experimentation encompassing 

- 322 - 
the evaluation of alternatives that involve a serious degree of: 

uncertainty as to whether the desired result can be achieved. This 

requirement is designed to ensure that the credit is available only 

for research activities intended to lead to technological innovation. 

In addition, the Senate definition excludes a number of activities, 

such as reverse engineering and debugging, that, by their nature, will 

not result in technological innovation. 

additional exclusions from the scope of qualifying research, may be 

appropriate to ensure that the credit does not subsidize 

private research activities that are not innovative. In addition, the 

revenue loss resulting from the extension of the credit must be 

considered in redefining the scope of qualifying expenses. 

Finally, the proposal to extend the research credit does not 

include support for other proposals traditionally associated with the 

credit, such as a separate credit for contributions to fund basic 

university research or an enhanced charitable deduction for 

contributions of scientific equipment to universities. 

Further refinements in the Senate definition, such as identifying 

- 323 - 
REPEAL MERCHANT MARINE CAPITAL 

CONSTRUCTION FUND EXCLUSION 

General Explanation 

Chapter 15.04 

Current Law 

The Merchant Marine Act provides special tax treatment for U.S. 

citizens and domestic corporations owning or leasing certain eligible 

vessels operated in the foreign or domestic commerce of the United 

States or in U.S. fisheries. A vessel qualifies as an eligible vessel 

only if it was constructed or reconstructed in the United States and 

is documented under the laws of the united States. 

In general, a taxpayer that qualifies for this treatment receives 

a deduction for amounts deposited in a capital construction fund 

pursuant to an agreement with the Secretary of Transportation or, in 

the case of U.S. fisheries, the Secretary of Commerce. The deductible 

amount is limited to the portion of the taxable income of the owner or 

lessee that is attributable to the qualified operation of the vessel 

covered by the agreement. In addition, nondeductible deposits may be 

made up to the amount of depreciation on such vessel for the year. 

Earnings on all amounts in the fund are exempt from federal income tax 

liability. 

The tax consequences of a withdrawal from such a fund are 

determined by reference to three accounts. The capital account 

represents deposits that were not deductible as well as the fund's 

tax-exempt income (that is, income exempt from tax without regard to 

the fund's special exemption). The capital gain account represents 

accumulated net long-term capital gain income of the fund. The 

ordinary income account represents deductible deposits and accumulated 

taxable income of the fund (that is, income that would have been 

taxable if the fund were not exempt). 

The tax treatment of a withdrawal depends 011 whether it is 

"qualified." A withdrawal is qualified if used to acquire, construct, 

or reconstruct eligible vessels (or barges and containers which are 

part of the complement of such vessels) in accordance with the terms 

of the applicable agreement, or to repay principal on debt incurred 

with respect to such acquisition, construction, or reconstruction. 

come first out of the capital account, then out of the capital gain 

account, and finally out of the ordinary income account (after the 

other accounts have been exhausted). Amounts withdrawn from the 

ordinary income or capital gain accounts reduce the taxpayer's basis 

in its investment in the vessels (only in part in the case of capital 

gain account withdrawals). A taxpayer may, however, compute its 

A qualified withdrawal is not currently taxable, and is deemed to 

- 324 - 
investment tax credit by including at least one-half of its qualified 

withdrawals in basis. Accordingly, the taxpayer is entitled to at 

least a partial investment tax credit on investments made with fund 

withdrawals, even though its basis attributable to withdrawals is zero 

for purposes of computing depreciation. A qualified withdrawal out of 

the ordinary income or capital gain account made to retire debt 

requires a reduction in the basis of vessels, barges, and containers 

owned by the person maintaining the fund. 

Nonqualified withdrawals are deemed to come first out of the 

ordinary income account, then out of the capital gain account, and 

finally out of the capital account. A nonqualified withdrawal treated 

as made out of the ordinary income account must be included in taxable 

income. To the extent the withdrawal comes out of the capital gain 

account it is taxed as long-term capital gain; a withdrawal out of the 

capital account is not taxable. Interest on the tax liability 

attributable to the withdrawal is payable from the time for payment of 

tax for the year in which the item was deposited into the fund. 

Reasons for Change 

The current rules for taxation of merchant marine capital 

construction funds are a gross departure from generally applicable 

principles of taxation. The special rules generally exempt from tax 

earnings on deposits in such funds. Moreover, they permit bn eligible 

taxpayer to expense capital investments made with fund withdrawals as 

well as claim an investment tax credit on an asset in which it has a 

zero basis. 

The special tax treatment of capital construction funds 

originated, along with a direct appropriations program, to assure an 

adequate supply of shipping in the event of war. It was thus feared 

that because of comparative shipbuilding and operating cost 

disadvantages, peacetime demand for U.S.-flag vessels would not 

reflect possible wartime needs. 

construction is today very much in doubt. U.S. citizens own or 

control large numbers of ships registered in Danama, Liberia, and 

Honduras that would be available to the United States in an emergency, 

and most U.S. allies possess substantial fleets of oceangoing cargo 

ships that would be available in any common emergency. Largely for 

this reason, direct appropriations for maritime construction (the 

construction differential and operating differential subsidies) are 

being phased out. A similar fate is appropriate for the special tax 

rules applicable to capital construction funds. 

A national security justification for subsidies of U.S. maritime 

Proposal 

The rules providing special tax treatment for capital 

construction funds would be repealed. 

- 325 - 
Effective Date 

Earnings on assets in capital construction funds attributable to 

the period after January 1, 1986, would be subject to tax. No further 

tax-free contributions could be made after the date legislation is 

introduced. Any withdrawals from a fund after January 1, 1986, would 

be treated as nonqualified withdrawals, but would be treated as coming 

first out of the capital account, then the capital gain account, and 

finally the ordinary income account. Any amounts remaining in a 

capital construction fund on January 1, 1996, would be treated as 

withdrawn at that time. 

Analys i 8 

Repeal of the special tax treatment for capital construction 

funds would promote neutrality by ensuring that capital investments 

are made only when justified by economic rather than tax 

considerations. 

- 326 - 
REPEAL POSSESSIONS TAX CREDIT 

General Explanation 

Chapter 15.05 

Current Law 

Section 936 provides a special credit for certain income of 

qualifying corporations operating in Puerto Rico and possessions of 

the United States other than the Virgin Islands. A section 936 

corporation is generally subject to tax on its worldwide income in a 

manner similar to any other U.S. corporation, but a ful.1 credit is 

given for the U.S. tax on the business and qualified investment income 

from the possessions regardless of whether any tax is paid to the 

government of the possessions. The effect of this treatment is to 

exempt from tax the income from business activities and qualified investments in the possessions and the income from disposition of a 

possessions business. (Rules having similar effect, but through a 

different mechanism, for the Virgin Islands are contained in section 

934(b)). All other income of section 936 corporations is taxed currently with the usual credit for foreign taxes paid on foreign source 

income. To avoid a double credit against U.S. taxes, no ::,,edit is 

allowed under section 901 for taxes paid on income subject to the 

section 936 credit, and no deduction is allowed for such tax. 

Any domestic corporation which elects to be a section 936 

corporation can receive the section 936 credit if it sati,sfies two 

conditions. Pirst, 80 percent or more of its gross income for the 

three year period immediately preceding the close of the taxable year 

must be from sources within a possession (or possessions). Second, 

for tax years beginning after 1984 at-least 65 percent of its income 

for that period must be from the active conduct of a trade or business 

within a possession (or possessions). 

Puerto Rico has complemented the section 936 credit with incentives of its own. Puerto Rico grants tax exemptions of up to 90 

percent for income of certain approved enterprises for specified 

periods of time (generally 10 to 25 years). In addition, Puerto Rico 

exempts from tax certain passive income. The combination of.the 

section 936 credit and the Puerto Rican incentives means that qualifying corporations are essentially exempt from tax on their Puerto 

Rico source income. 

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) made 

two changes designed to reduce the revenue cost due to (a) the 

attempted allocation of intangible income to possessions in order to 

claim exemption for such income, and (b) the exemption of passive 

income. The problem of intangible income was addressed by adding a 

very complex set of allocation rules to section 936 for tax years 

- 327 - 
beginning after 1982. The revenue cost of exempting passive income 

was addressed by increasing the active trade or business percentage 

from 50 percent in 1982 to 65 percent in 1985. 

mirror the Internal Revenue Code but with special exceptions and 

provisions that vary from one territory to another. 

Reasons for Change 

Independently of the section 936 credit, a corporation can 

generally achieve indefinite deferral of U.S. tax on possessions 

business source income, under the rules applicable to the income of 

foreign corporations, simply by incorporating in a possession. The 

section 936 credit produces an additional benefit in the form of a 

negative effective tax rate on possessions source income. This is 

accomplished by providing income allocation rules which, in many 

cases, permit shifting income from the U.S. parent to a section 936 

corporation. This distorts investment decisions without necessarily 

transferring real economic activity to the possessions. 

The stated purpose of section 936 is to "assist the U.S. 

possessions in obtaining employment-producing investments by U.S. 

corporations". Despite the fact that the inflation-corrected taxexempt income of possessions corporations has more than doubled since 

1972, employment levels (both overall and in the manufacturing sector) 

have been flat. The average tax benefit per employee for all section 

936 corporations was mDre than $22,000 in 1982. In that year the 

average wage of possessions corporations' employees was $14,210. 

Fourteen corporations received tax benefits in excess of $100,000 per 

employee. 

The TEFRA changes were designed to reduce the revenue cost of this 

program. There remains, however, 110 direct incentive under current 

law to increase employment in the possessions. As a result, we have a 

system which is one of the most complex in the tax law, expensive, 

difficult to administer and yet has not been effective in creating 

jobs in the possessions. 

ambiguities which have made it difficult to coordinate the Federal and 

territorial income taxes, and make them susceptible to abuse. They 

also result in unequal tax burdens on comparable incomes in the 

different territories. 

The income tax systems in effect in the U.S. territories basically 

The territorial tax systems are replete with inconsistencies and 

P r opo sa 1 

The Treasury Department does not believe that there should be a 

permanent tax subsidy for operations in the possessions. As noted 

above, the general rules for taxation of foreign corporations provide 

for deferral of U.S. tax on the income of such corporations until the 

income is repatriated. However, it is important to minimize the 

disruption cause2 by changes in the tax law. Therefore, the current 

- 328 - 
system will be replaced with a more cost-effective approach which 

would then be phased out after several years. 

The current section 936 credit will be replaced by a wage credit. 

The amount of the credit will be a fixed dollar amount per hour 

worked. The credit will be available for all persons employed in the 

possessions by an establishment engaged in manufacturing. The credit 

will not be refundable but may be carried to any other taxable year in 

the period 1987-2000. The deduction for wages will be reduced by the 

amount of the credit. A similar change will be made for corporations 

receiving the benefits of section 934(b). 

The wage credit will replace the existing credit for taxable years 

beginning on or after January 1, 1987. It will be 60 percent of the 

minimum wage for a six year period, 1987 through 1992 and then will be 

phased out in equal installments over the next six years: 

Year 

1987-1992 

1993 

1994 

1995 

1996 

Credit as percent 

of minimum wage 

60 

50 

40 

30 

20 

1997 10 

1998 and subsequent 0 

The territorial income tax systems will be rationalized to make 

them simpler and fairer and to reduce the potential for abuse. 

Anal ysi s 

The current system is complex, expensive and ineffective. The 

rules for determining possessions source income are among the most 

complex in the tax law. The average revenue cost per job was more 

than 150 percent of the average total compensation of employees of 

section 936 corporations. Despite this, total employment has been 

flat. The proposal will simplify the law considerably and will provide a more direct and more cost-effective incentive to create jobs in 

the possessions. 

Since the tax benefits received by some current section 936 corporations will be substantially reduced under a wage credit, these 

corporations, primarily in the pharmaceutical and electronics industries, may decide to restructure or even close their operations in the 

possessions. However, the proposal should attract more labor 

i n tens ive industries . 

- 329 - 
CHAPTER 16 

OTHER CURTAILMENT OF TAX SHELTERS 

Current rules limiting the deduction of investment interest are 

inadequate to curtail tax shelter abuses. This Chapter proposes a 

comprehensive limitation on the deduction of nonbusiness interest. In 

addition, the special exceptions to the at-risk limitations for 

certain leasing and real estate activities would be repealed, so that 

the at-risk rules would apply uniformly to all activities. 

- 330 - 
LIMIT INTEREST DEDUCTIONS 

General Explanation 

Chapter 16.01 

Current Law 

In general, interest paid or incurred on indebtedness is fully 

deductible from income. This general rule is subject to exceptions 

for- interest on indebtedness incurred to generate certain taxpreferred income. Thus, for taxpayers other than certain financial 

institutions, no deduction is allowed for interest on indebtedness 

incurred to purchase or carry obligations which generate tax-exempt 

income, In addition, for noncorporate taxpayers, interest on debt 

incurred to acquire or carry investment property ("investment 

interest") is deductible only to the extent of the sum of (i) $l0,000 

($5,000 for married persons filing separately), (ii) "net investment 

income," and (iii) certain deductions attributable to net-leased 

property. Amounts disallowed under this limitation for a taxable year 

are carried forward and treated as investment interest in the 

succeeding taxable year. 

property or business property is ordinarily deductible currently, even 

if that property does not produce taxable income or is likely to 

appreciate substantially (resulting in deferred capital gains). (See 

Ch. 10.01 for a discussion of circumstances in which interest costs 

must be capitalized when incurred in connection with certain 

production or manufacturing activities.) 

Reasons for Change 

Clear reflection of income for tax purposes requires that the 

costs of generating income be matched with the income actually earned. 

If a current deduction is allowed for the cost of producing income 

that is exempt from tax or includible in income on a deferred basis, 

the current deduction will offset other taxable income and thus 

eliminate or defer tax. Such "tax arbitrage" occurs, for example, 

when an investor deducts interest on indebtedness incurred to acquire 

or carry assets that yield tax-exempt income such as personal-use 

property or assets held in an Individual Retirement Account. It also 

occurs, though with less predictability, where indebtedness is 

incurred to acquire or carry interests in busi.ness property that 

experiences real appreciation over time. 

Interest on debt incurred to acquire or carry personal-use 

Cu.rrent law permits taxpayers to deduct the interest costs of 

generating certain tax-exempt or tax-deferred income. Although 

interest incurred to acquire or carry tax-exempt bonds is 

nondeductible, interest incurred to produce analogous forms of 

- 331 - 
tax-preferred income is deductible without limitation. Thus, 

“consumer interest,” i.e., interest incurred to acquire personal 

assets, such as a car or vacation home, is fully deductible, even 

though such assets do not generate taxable income. Similarly, current 

law limits the deductibility of “investment interest,” but interest 

incurred in a trade or business is fully deductible, even if the 

investor is not actively engaged in the management of the business and 

much of the return from the business is expected to be in the form of 

deferred capital gains. This current deductibility of interest is an 

important feature of real estate tax shelter investments structured as 

limited partnerships. 

The unlimited deduction for consumer and “passive“ business 

interest also undermines existing limitations on investment interest 

and interest incurred to acquire tax--exempt bonds. Since money is 

fungible, the identification required under current law of the purpose 

for which indebtedness is incurred is difficult at best. The general 

deductibility of all consumer and business interest complicates the 

task of determining whether debt was incurred for a nondeductible 

purpose. 

Proposal 

Interest subject to the current investment interest limitation 

would be expanded to include: (a) all interest not incurred in 

connection with a trade or business (other than interest on debt 

secured by the taxpayer‘s principal residence, to the extent such debt 

does not exceed the fair market value of the residence), (b) the 

taxpayer’s share of all interest expense of S corporations (other than 

S corporations in which the taxpayer actively participates in 

management), and (c) the taxpayer’s distributive share of all interest 

expense of limited partnerships in which the taxpayer is a limited 

partner. Interest on indebtedness incurred to carry or acquire 

business rental property used by the taxpayer for personal purposes 

for part of a taxable year would generally be treated as business 

interest (and thus not subject to limitation) in the same proportion 

that the number of days the property is rented at a fair rental bears 

to the number of days in the taxable year. 

extent of the sum of (a) $5,000 ($2,500 in the case of a married 

person filing a separate return), and (b) the taxpayer‘s net 

investment income. In general, net investment income for this purpose 

would have the same meaning as under current law, except that it would 

include the taxpayer’s share of all income of S corporations not 

managed by the taxpayer, and the taxpayer’s distributive share of all 

income of limited partnerships in which the taxpayer is a limited 

partner. Any interest deduction disallowed for the taxable year under 

this limitation would be treated as investment interest expense for 

the succeeding taxable year. 

In general, interest income and expense would be adjusted by 

application of the fractional exclusion rate (see Ch. 9.03) prior to 

Interest subject to the limitation would be deductible only to the 

- 332 - 
application of the investment interest limitation. Suspended interest 

deductible in a succeeding taxable year would not be subject to 

further adjustment by the fractional exclusion rate. If interest 

subject to the limitation includes both itemized and nonitemized 

interest expense deductions, suspended interest would first reduce the 

current deduction for nonitemized interest expense to the extent 

thereof, and the current deduction for itemized interest expense to 

the extent of any excess. Suspended interest deductions subsequently 

allowed would first be treated as itemized interest expense, to the 

extent of suspended itemized interest deductions, and nonitemized 

interest expense to the extent of the excess. 

Effective Date 

The proposal would be effective for interest expense paid or 

incurred in taxable years beginning on or after January 1, 1986. The 

expanded limitation would be phased in so that for taxable years 

beginning before January 1, 1980, interest subject to limitation would 

be deductible to the extent of $10,000 plus net investment income. 

Analysis 

Because the expanded limitation on interest deductions would not 

apply to mortgage interest deductions on the taxpayer's principal 

residence nor to the first $5,000 of any additional interest expense, 

the vast majority of taxpayers would not be affected by the proposal. 

Interest expenses attributable to a trade or business in which the 

taxpayer actively participates also would not be subject to the 

limitation. Thus, sole proprietors, owner-operators of farms, general 

partners, and shareholder-managers of S corporations would continue to 

treat their business expenses in the same manner as under current law. 

However, taxpayers with substantial tax shelter interest expense would 

be prevented, in many cases, from using that interest expense to 

offset business and employment income. 

- 333 - 

459-813 0 - 84 - 12 
EXTEND AT-RISK LIMITATION TO ALL ACTIVITIES 

General Explanation 

Chapter 16.02 

Current Law 

In general, current law limits the loss a taxpayer may deduct 

from an investment to the amount the taxpayer has at-risk with 

respect to such investment. This "at-risk" limitation on 

deductible losses applies to individuals and to certain closely 

held corporations, and is applied on an "activity-by-activity" 

basis. 

For purposes of the at-risk rules, a taxpayer is generally 

at-risk in an activity to the extent that the taxpayer has 

contributed money or property (to the extent of its basis) to the 

activity, or is personally liable to repay borrowed funds used in 

the activity. A taxpayer is not considered to be at-risk with 

respect to amounts protected against loss through nonrecourse 

financing, guarantees and stop loss or similar arrangements. 

Losses which are disallowed for a taxable year under the at-risk 

rules are carried forward indefinitely and are allowed in a 

succeeding taxable year to the extent that the taxpayer increases 

the amount at-risk in the activity giving rise to the losses. 

The at-risk rules apply to all activities other than (1) real 

estate activities and (2) certain equipment leasing activities 

conducted by closely held corporations. Accordingly, an investor 

in real estate (or a closely held corporation engaging in certain 

equipment leasing activities) may deduct losses from the 

investment for tax purposes that exceed the investor's maximum 

possible economic loss from the investment. 

Reasons for Change 

The at-risk rules of current law reflect the fact that, as an 

economic matter, an investor cannot lose more than the amount 

that he or she has directly invested plus any additional amount 

for which the investor is liable. This principle is no less true 

for investments in real estate or equipment leasing than it is 

for the activities to which the current at-risk rules apply. 

The exclusion of real estate and equipment leasing from the 

at-risk rules allows taxpayers investing in such activities to 

offset taxable income with tax losses that will never be matched 

by economic losses. The allowance of such noneconomic losses for 

tax purposes is a necessary basis for many tax shelter 

investments. Front-loaded tax losses that have no economic basis 

permit the investor to shelter other income from tax. The 

resulting deferral of tax liability guarantees a return to the 

- 334 - 
investor that may make an otherwise noneconomic investment 

plausible. Tax-driven noneconomic investment activity diverts 

capital from more productive uses, causes overinvestment in the 

tax-preferred activities and thus distorts prices and capital 

costs throughout the economy. 

Whether legally justified or not, the use of tax shelters by 

high-income, well advised taxpayers is viewed with confusion and 

skepticism by taxpayers. These perceptions undermine the 

voluntary compliance that is crucial to the income tax system. 

Tax shelter activity also invites disrespect for the tax law. 

Proposal 

The at-risk rules would be extended to all investment and 

business activities, including real estate and equipment leasing 

activities. The at-risk rules would continue to be applicable 

only to individuals and certain closely held corporations. 

Effective Date 

The proposal would be effective for losses attributable to 

property acquired after the date on which the proposal is 

introduced as legislation, unless acquired pursuant to a binding 

contract entered into prior to that date. 

Analysis 

Extending the at-risk rules to all activities would not 

inhibit the leveraged acquisition of properties expected to yield 

a market rate of return. The proposal, however, would require 

that investors in real estate and leasing activities evaluate the 

economic risk of loss associated with investments in those 

activities as well as their tax benefits and income potential. 

The proposal thus would leave real estate and equipment leasing 

investments subject to the same market discipline as currently 

applies to investments generally. The enhanced neutrality among 

investment alternatives would improve resource allocation and 

reduce overinvestment in these activities that are currently tax 

preferred. This, in turn, should lead to overall productivity 

gains. 

It is possible that the laws of some States that preclude 

the use of recourse debt in connection with the acquisition of 

certain real estate could prevent certain investors in those 

States from receiving full tax benefits from leveraged real 

estate investments. It is anticipated that any such States would 

act quickly to permit business investments in real estate to 

employ recourse indebtedness. 

- 335 - 
CHAPTER 11 

RETIRERENT SAVINGS 

The Treasury Department proposals would maintain the current 

tax-favored treatment of retirement saving, and would expand the 

tax-deductible amounts that may be placed into individual retirement 

accounts (IRAs). Cash or deferred arrangements, which effectively 

allow employees to avoid limits on IRAs, would be repealed. Other 

revisions would provide more consistent treatment of various types of 

retirement plans. Uniform rules, including an excise tax on premature 

distributions, would govern distributions from various types of plans, 

and more uniform contribution limits would be established. The 

overall limit on non-top-heavy defined benefit and defined 

contribution plans would be eliminated and an excise tax would be 

imposed on annual distributions in excess of specified limits. To 

preclude employers from receiving unintended tax benefits by 

overfunding plans, a ten percent additional tax would be imposed on 

plan funds reverting to an employer upon plan termination. Finally, 

qualified pension plans would be permitted to use benefits forfeited 

by a separated employee to increase the benefits of other employees. 

- 336 - 
INCREASE INDIVIDUAL RETIREMENT ACCOUNT (IRA) LIMITS 

General Explanation 

Chapter 17.01 

Current Law 

An individual generally is permitted to deduct annual 

contributions to an individual retirement account or annuity (IRA) up 

to the lesser of $2,000 or 100 percent of the individual‘s annual 

compensation. Thus, if a married individual and his or her spouse 

each receive compensation during a year, each may make separate 

deductible contributions to his or her own IRA up to the lesser of 

$2,000 or 100 percent of compensation. 

If an individual receives no compensation during a year, the 

individual generally is not allowed to make a deductible IRA 

contribution for such year. Special “spousal IRA” limits, however, 

provide that if a married individual’s spouse earns no compensation 

during a year and if the married couple files a joint return for the 

year, the individual may deduct annual IRA contributions up to the 

lesser of $2,250 or 100 percent of the individual’s annual 

compensation. The contributions may be allocated in any fashion 

between the individual‘s IRA and the nonearning spouse‘s IRA, except 

that no more than $2,000 may be contributed to either IRA. 

The special spousal IRA maximum limit of $2,250 is not available 

if the married individual’s spouse has compensation income during the 

year. Thus, if a husband and wife each have compensation income, each 

is subject separately to the $2,000 and 100 percent of compensation 

limits on deductible contributions. As a consequence of this rule, a 

married couple with a nonearning spouse is permitted to make larger 

total deductible IRA contributions than a married couple with a spouse 

who has compensation income of less than $250. 

Reasons for Change 

The tax benefits applicable to IRAs are intended to encourage 

individuals to make adequate provision for their retirement security. 

Savings for this purpose also contribute to the formation of 

investment capital needed for economic growth. For many individuals, 

including individuals who are covered by employer-maintained 

retirement plans, IRAs are an important element in an overall strategy 

to provide for retirement security. The use of IRAs for retirement 

saving should thus not only be encouraged, but made available on a 

broad and consistent basis. 

The existing limitations on IRA contributions are illogical and 

inequitable as applied to married couples. The relatively minor 

allowances for a spousal IRA fail to recognize the important economic 

contributions made by nonearning spouses. Moreover, they are 

- 331 - 
inconsistent with other tules of current law under which married 

couples are treated as an economic and taxpaying unit. Thus, a 

husband and wife that each earn $10,000 can make aggregate IRA 

contributions of $4,000 under current law. A couple with the same 

joint income of $20,000, all of it earned by one spouse, can make 

aggregate IRA contributions of only $2,250. A third couple, also with 

$20,000 of joint income, but with one spouse earning only $200, is 

limited even further to a $2,200 aggregate IRA contribution. These 

disparate results are inconsistent with both the retirement savings 

policy reflected in XRAs and with general tax principles requiring 

similar treatment of similarly situated taxpayers. 

Proposals 

The dollar limit on the deductible IRA contributions that may be 

made by an individual would be increased from $2,000 to $2,500. 

A married individual filing a joint return, including an 

individual with no annual compensation, would be permitted to take 

into account his or her spouse's compensation (less the deductible IRA 

contribution made by such spouse) in determining the deduction limit 

for such individual. Thus, married couples with aggregate 

compensation of $5,000 or more would be entitled to the same $5,000 

aggregate IRA contribution ($2,500 apiece) regardless of how much of 

the aggregate compensation was generated by either spouse. 

Effective Date 

The increased dollar limit on IRA contributions and the spousal 

compensation rule for married individuals would apply to taxable years 

beginning on or after January 1, 1986. 

Analysis 

Increasing the IRA deduction limits would encourage taxpayers to 

set aside additional amounts in long-term savings. This would not 

only enhance individual retirement security, but should also 

contribute to increased capital formation and productivity. 

- 338 - 
UNIFY RULES FOR QUALIFIED 

RETIREMENT PLAN DISTRIBUTIONS 

General Explanation 

Chapter 17.02 

Current Law 

set aside under any of several employer-sponsored or individual plans 

providing for deferred compensation or retirement savings. Such 

tax-favored plans include qualified profit-sharing, stock bonus, and 

pension plans (section 401(a)), qualified annuity plans (section 

403(a)), tax-sheltered annuities and custodial accounts (section 

403(b)), individual retirement accounts and annuities (section 

408(a)&(b)), and simplified employee pensions (section 408(k)). 

Although these tax-favored retirement plans are related in concept and 

purpose, distributions from the plans are subject to differing 

requirements and may result in significantly different tax 

consequences to individual recipients. 

are subject to certain minimum requirements concerning the timing and 

amount of distributions. Qualified profit-sharing, stock bonus, 

pension, and annuity plans must generally commence distributions no 

later than the April 15 following the year in which the employee 

attains aye 70-1/2, or, if later, the year in which the employee 

retires. Benefits thereafter must be distributed under a minimum 

distribution schedule. Additional rules require minimum annual 

distributions where the employee dies before benefit distributions 

have commenced or have been completed. A qualified plan failing to 

satisfy the minimum distribution rules with respect to a participant 

may lose its tax-favored status. 

Individual retirement accounts (IRAs) and simplified employee 

pensions (SEPs) must commence distributions no later than the year in 

which the IRA or SEP owner attains age 70-1/2, without regard to 

whether such owner has retired. Thereafter, benefits must be 

distributed under lifetime and after-death distribution schedules 

similar to those for qualified plans. An IRA or SEP that fails to 

satisfy the minimum distribution rules does not lose its tax-favored 

status. Instead, the payee is subject to an excise tax of 50 percent 

of the amount by which the required distribution exceeds the amount 

actually distributed. 

Benefits provided through tax-sheltered annuities and custodial 

Current law provides tax-favored treatment with respect to funds 

Minimum Distribution Requirements. Tax-favored retirement plans 

accounts are not subject to minimum distribution rules for the period 

during which the original holder of the annuity or custodial account 

remains alive. If, however, the holder dies before the entire 

- 339 - 
interest in the annuity or account is distributed, distribution rules 

based on the after-death rules for qualified plans must be satisfied. 

tax-favored retirement plans are fully taxable to the recipient at the 

time of distribution. There are a variety of exceptions to this 

general rule, however, under which certain distributions incur 

additional taxes and certain others receive more favorable tax 

treatment than ordinary distributions. 

Early Distributions. In general, amounts distributed from 

Distributions from an IRA or SEP before the IRA or SEP owner dies, 

becomes disabled, or attains age 59-1/2 generally are subject to a ten 

percent additional tax. Similar distributions from a qualified 

profit-sharing, stock bonus, pension, or annuity plan are subject to 

an additional tax only in the case of employees owning more than five 

percent of the employer. Early distributions from tax-sheltered 

3nnuities are not subject to any additional tax. Early distributions 

from tax-sheltered custodial accounts are generally prohibited absent 

financial hardship or disability. 

Lump Sum Distributions. Preferential tax treatment is currently 

available for certain lump sum distributions from a qualified 

profit-sharing, stock bonus, pension or annuity plan. Under a special 

averaging rule, the tax liability on a lump sum distribution is 

determined as though the individual received the distribution ratably 

over ten years. In addition, the portion of a lump sum distribution 

attributable to plan participation before 1974 may be taxed at capital 

gain rather than ordinary income rates. Whether a lump sum 

distribution qualifies for favorable treatment is determined under an 

extensive set of rules, based in part on the employee's age, 

employment status and years of participation in the plan. Favorable 

lump sum treatment is not available for distributions from IRAs, SEPs, 

or tax-sheltered annuities or custodial accounts. 

Employer Securities. Current law also provides preferential tax 

treatment for net unrealized appreciation on employer securities 

included in a lump sum distribution from a qualified profit-sharing, 

stock bonus, or pension plan. Such appreciation is not included in 

income at the time of distribution, but instead is taxable upon 

subsequent disposition of the securities, ordinarily at capital gain 

rates. If the distribution is not a lump sum distribution, only the 

unrealized appreciation on employer securities purchased with employee 

contributions qualifies for the special treatment. unrealized 

appreciation on plan distributions of securities other than employer 

securities is fully taxable upon distribution. 

Basis Recovery. Tax-favored retirement plans are also subject to 

special rules for the recovery of contributions by the employee that 

were previously subject to tax. Outside the area of tax-favored 

retirement plans, amounts not received as annuities before the annuity 

starting date are generally treated first as a taxable distribution 

and second as a tax-free recovery of the employee's contributions. 

This basis recovery rule is reversed, however, for non-annuity 

- 340 - 
distributions from qualified profit-sharing, stock bonus, pension, and 

annuity plans and tax-sheltered annuities and custodial accounts, so 

that distributions are treated first as a tax-free recovery of 

employee contributions. 

for amounts received as annuities after the annuity starting date. 

Under general basis recovery rules, employee contributions are 

recovered tax-free on a pro rata basis, in accordance with an 

exclusion ratio based on the employee's life expectancy at the time 

distributions commence. An employee's after-tax investment in a 

tax-favored plan, however, is recovered prior to any taxable 

distributions, provided that the aggregate amount to be distributed 

during the first three years exceeds such after-tax investment. 

Tax-favored retirement plans are also granted special treatment 

Rollovers. Distributions from a tax-favored retirement plan are 

not subject to taxation to the extent rolled over to another 

retirement plan. A complex series of rules governs the extent to 

which distributions from particular plans may be rolled over as well 

as the type of plans to which rollovers may be made. In general, 

these rules are designed to p~event individuals from avoiding 

restrictions applicable to certain plans by shifting benefits to a 

plan that is free of the restrictions. 

Constructive Receipt. In general, benefits under tax-favored 

plans are taxable when received. For most plans, receipt occurs for 

tax purposes only when benefits are actually distributed. The 

doctrine of constructive receipt is applied, however, to benefits 

under tax-sheltered annuities and custodial accounts, which may be 

treated as received either when actually distributed or when made 

available to the individual. As a consequence, benefits in such plans 

may be taxable prior to their actual distribution. 

Reasons for Change 

The current rules for distributions from tax-favored retirement 

plans are burdensomely complex for taxpayers and inconsistent in their 

treatment of similarly situated individuals. The current rules also 

undercut the basic rationale for tax-favored plans, which is the 

encouragement of savings for retirement. 

Uniform Treatment of Distributions. The various tax-favored 

retirement plans are important components of a general policy to 

enhance individual retirement security. The current absence of 

uniformity in the treatment of such plans creates significant 

disparities among individuals based on the type of plans to which the 

individuals happen to have access. Uniform rules would eliminate such 

disparities and also reduce the complexity of the existing rules 

governing plan distributions. Existing differences in the tax 

treatment of plan distributions give tax considerations undue 

influence over an individual's choice of retirement plans. Moreover, 

they require individuals either to master a complex set of rules or to 

seek professional advice. In too many cases they may result in a loss 

- 341. - 
of possible benefits. Uniform rules would have the additional 

advantage of making unnecessary the current restrictions on the 

shifting of benefits from one plan to another. 

The tax-favored status of retirement plans is intended to enable 

individuals to replace compensation that terminates with retirement. 

Minimum distribution rules support this rationale by limiting the 

extent to which tax-deferral on retirement savings can be extended 

beyond the individual's retirement. Given the purpose of minimum 

distribution rules, they should apply to all retirement plans 

receiving tax-favored treatment. 

distribution rules. The sanction of disqualification, however, is too 

onerous for a plan's failure to satisfy the highly technical 

requirements. Disqualification may result in adverse tax consequences 

to all plan participants, even though plan administration generally is 

outside the control of the participants and the failure may have 

occurred with respect to only a single participant. Plan 

disqualification procedures also impose a significant administrative 

burden on the Internal Revenue Service. 

Uniform sanctions should also apply to violations of minimum 

Encourage Retirement Savings. The current favorable treatment of 

certain plan distributions undercuts retirement saving by encouraging 

lump sum or early withdrawals. The special basis recovery rules for 

certain distributions permit accelerated tax-free recovery of employee 

contributions. This reduces the tax cost of early withdrawals, and 

permits employees to use tax-favored plans as short-term savings 

accounts rather than as retirement savings vehicles. The rules 

permitting deferral of tax on unrealized gain iri distributions of 

employer securities also reduce the tax cost of such withdrawals. 

certain lump sum distributions encourage such distributions and thus 

are inconsistent with the policy to provide individuals with income 

throughout the entire period of retirement. The original purpose of 

the capital gain and ten-year averaging provisions was to mitigate the 

effect of the progressive tax structure on individuals receiving all 

of their benefits in a single year. The same purpose is now served, 

however, by permitting individuals to roll over lump sum distributions 

into an IRA. This results in the individual being taxed only as 

amounts are subsequently withdrawn from the IRA. 

The special ten-year averaging and capital gain provisions for 

Proposals 

All tax-favored retirement plans, including tax-sheltered 

annuities and custodial accounts, would be subject to uniform minimum 

distribution rules governing both lifetime and after-death 

distributions. Thus, distributions from all tax-favored retirement 

plans would be required to commence no later than the year in which 

the individual attains age 70-1/2. Thereafter, both lifetime and 

after-death distributions would have to conform with minimum payout 

schedules. 

- 342 - 
The uniform sanction for failure to satisfy the minimum 

distribution rules would be a 50 percent excise tax, based on the 

amount by which the minimum amount required to be distributed exceeds 

the amount actually distributed. The recipient of the distribution 

would be primarily liable for payment of the tax, with a right, where 

applicable, to recover the tax from the plan. The current sanction of 

disqualification for certain plans would be eliminated. 

form of an annuity contract issued by an insurance company or a 

custodial account holding regulated investment company stock, would be 

subject to the same distribution restrictions currently applicable 

only to such custodial accounts. 

IJniform rules would also govern the tax consequences of plan 

distributions to individual recipients. Thus, distributions would be 

subject to tax only upon actual receipt. Current application of the 

constructive receipt doctrine to tax-sheltered annuities and custodial 

accounts would be eliminated. In addition, the taxable portion of any 

distribution from a tax-favored plan would be taxed fully as ordinary 

income. Thus, the special capital gain and ten-year averaging 

treatment for lump sum distributions and the deferred inclusion of 

unrealized appreciation on distributions of employer securities would 

be eliminated. 

In calculating the taxable portion of a plan distribution, the 

generally applicable basis recovery rules, with certain modifications, 

would apply. Thus, an amount received before the annuity starting 

date would be treated, first, as a taxable distribution and, second, 

as a nontaxable return of basis. Annuity distributions after the 

annuity starting date would be taxed in accordance with the exclusion 

ratio established when such distributions commenced. In establishing 

the exclusion ratio for an individual, standardized recovery periods 

of five, ten, fifteen, and twenty years would be used in lieu of the 

individual's actual life expectancy; the recovery period for a 

particular individual would be the period closest to the individual's 

life expectancy at the time distributions commence. If distributions 

cease before the individual recovered his entire basis tax-free, the 

individual, his estate, or his heirs would be entitled to a deduction 

for the unrecovered basis. If the individual receives benefits for 

longer than his recovery period, all additional distributions would be 

fully taxable. 

Early distributions would also be subject to uniform treatment. 

Thus, the taxable portion of a distribution from any tax-favored 

retirement plan before the individual's death, disability, or 

attainment of age 59-1/2 would be subject to an additional tax of 20 

percent of such taxable portion. However, if the early distribution 

is used to pay for college expenses incurred by a dependent or for the 

purchase of the individual's first principal residence, the rate of 

the additional tax would be reduced to ten percent. In either case, 

the additional tax would be nondeductible and could not be offset by 

any deductions or credits otherwise available to the individual. 

Tax-sheltered annuity contracts, whether they actually are in the 

- 343 - 
Individuals generally would be permitted to make a tax-free 

rollover of funds, within 60 days, from one tax-favored retirement 

plan to another. Rollovers and transfers would be limited, however, 

to prevent individuals from avoiding the minimum distribution rules. 

70-1/2 as proxies for retirement may subject some distributions being 

used for retirement purposes to the additional tax and may trigger 

minimum distributions to individuals who have not retired. 

Modifications to these conditions would be considered if they could be 

uniformly applied without serious administrative difficulty. 

The Treasury Department recognizes that the use of ages 59-1/2 and 

Effective Date 

The new tax rules generally would apply to all distributions from 

tax-favored retirement plans on or after January 1, 1986. The 

additional tax on early distributions would apply to all such 

distributions made after the date this proposal is introduced as 

legislation. 

Analysis 

The purpose of the additional tax on early distributions and of 

the minimum distribution rules is to assure that tax-favored 

retirement plans are used for retirement purposes. The tax would 

reduce or eliminate the tax advantages that can be obtained by using 

tax-favored plans to save for nonretirement purposes, including 

colleges expenses and the purchase of a residence. 

The elimination of capital gain and ten-year averaging treatment 

for lump sum distributions would not subject individuals using their 

tax-favored benefits for retirement purposes to significant adverse 

tax effects. Except to the extent precluded under the minimum 

distribution rules, an individual receiving a large distribution from 

a tax-favored plan could still avoid a large tax liability by rolling 

over some or all of such benefits to an IRA or other qualified plan. 

This would be consistent with the basic objective of promoting 

tax-favored distributions over an individual's entire retirement 

period. In addition, the generally available income averaging 

provisions (section 1301) would continue to apply to such individuals. 

The proposed modifications to the calculation of the exlcusion 

ratio applicable to distributions after the annuity starting date 

would assure that an individual (or his estate or heirs) would receive 

the individual's after-tax investment in the plan without additional 

tax. Also, the modifications would assure that an individual who 

outlives his life expectancy would not receive significant amounts in 

excess of his after-tax investment without tax. Finally, the use of 

standardized recovery periods would simplify the calculation and 

application of the exclusion ratio by taxpayers and would ease the 

administration and enforcement of such rules by the Internal Revenue 

Service. 

- 344 - 
SIMPLIFY DEDUCTION RULES 

FOR QUALIFIED RETIREMENT PLANS 

General. Explanation 

Chapter 17.03 

Current Law 

In general, amounts paid as deferred compensation are deductible 

by an employer only as they are included in the income of employees. 

Moreover, income on amounts set aside by an employer to fund deferred 

compensation is generally taxable to the employer as earned. 

Exceptions to these general rules are provided for deferred 

compensation provided under qualified Stock bonus, pension, 

profit-sharing, and annuity plans. Thus, within certain limits, 

employer contributions to such qualified plans are currently 

deductible by the employer even though employees will not be taxable 

until they receive distributions from the plans. In addition, the 

income earned on assets held in a qualified plan is not subject to tax 

while it remains within the plan. 

An employer's deduction for contributions to a qualified plan is 

subject to two separate limitations. The first applies on an 

individual-by-individual basis and covers contributions to defined 

contribution plans (i.e., profit-sharing, stock bonus, and money 

purchase pension plans), defined benefit plans, and combinations of 

the two. The second limitation applies plan by plan and is based on 

the total contributions for the group of employees covered by the 

particular plan. This group-based limitation applies to pension plans 

(i.e., money purchase pension plans and defined benefit pension 

plans), profit-sharing and stock bonus plans, and combinations of the 

two. 

The individual-by-individual limitation is as follows: (i) the 

contributions and other additions on behalf of an individual under a 

defined contribution plan for a year may not exceed the lesser of 

$30,000 (indexed beginning in 1988) or 25 percent of the individual's 

compensation for the year; (ii) the contribution to a defined benefit 

plan to fund an individual's annual retirement benefit may not exceed 

the contribution necessary, under reasonable actuarial methods, to 

fund an annual retirement benefit of $90,000 (indexed beginning in 

1988); and (iii) the total contributions with respect to an individual 

covered by both a defined contribution plan and a defined benefit plan 

may not exceed a percentage, between 62.5 and 70 (depending on the 

individual's compensation), of the sum of the two preceding limits. 

In addition to being nondeductible, contributions in excess of these 

limits may also trigger disqualification of the plan. 

plans and to profit-sharing and stock bonus plans. An employer's 

deduction for contributions to a pension plan is subject to 

The group-based limitation applies different limits to pension 

- 345 - 
limitations based on the minimum funding standards applicable to 

pension plans and on certain other actuarial determinations. An 

employer's deduction for contributions to a profit-sharing or stock 

bonus plan is limited to 15 percent of the aggregate compensation paid 

during the taxable year to all employees in the plan. A carryforward 

of the unused portion of the 15 percent limit to a succeeding year is 

permitted, subject to an overall 25 percent of aggregate compensation 

limit for the succeeding year. Excess contributions may be carried 

forward and deducted in a succeeding year, subject to the 15 percent 

of compensation limit for such year. 

profit-sharing or stock bonus plan, the total deduction for a year is 

limited to the greater of (i) 25 percent of the aggregate compensation 

paid during the year to the employees covered by the plans, or (ii) 

the amount necessary to contribute to the pension plan to satisfy the 

minimum funding standards for such year. An employer may carry 

forward excess contributions to a succeeding year, but the deduction 

of current and carryforward contributions for any year is limited to 

25 percent of compensation paid for such year. 

The group-based deduction limitation also provides special rules 

with respect to the deductibility of contributions to employee stock 

ownership plans (ESOPs), which in general are profit-sharing, stock 

bonus, and money purchase pension plans that invest primarily in 

employer securities. Contributions to an ESOP to repay principal and 

interest on a loan incurred by the ESOP for the purpose of buying 

employer securities may be deductible even though they ate in excess 

of the generally applicable limits. In addition, an employer may be 

allowed a tax credit in lieu of a deduction for contributions to an 

ESOP for up to 0.5 percent of the aggregate compensation paid during 

the year to employees under the ESOP. (Certain other tax preferences 

also are available with respect to ESOPS: deduction for dividends 

paid on ESOP stock, partial exclusion of interest on ESOP loans, 

nonrecognition of gain on certain sales of stock to an ESOP, and 

assumption of estate tax liability by an ESOP.) 

If an employer contributes to both a pension plan and a 

Reasons for ehange 

The limitations on an employer's deduction for qualified plan 

contributions are intended to restrict the tax-favored treatment 

associated with qualified plans for individual employees to amounts 

reasonably necessary to provide retirement security. Amounts in 

excess of these limitations are presumptively in excess of the amounts 

necessary to provide reasonable retirement benefits and should not be 

eligible for tax advantages. 

The current group-based limitation on deductible plan 

contributions is intended to be more restrictive for contributions to 

plans that may be used to finance current consumption or otherwise 

serve nonretirement purposes. Thus, employer deductions for 

contributions to profit-sharing and stock bonus plans have been 

subject to greater restrictions, since, unlike pension plans, 

- 346 - 
profit-sharing and stock bonus plans are not subject to minimum 

funding requirements, are more liberal in permitting pre-retirement 

distributions, and permit employees to defer or receive employer 

contributions currently. 

Although profit-sharing and stock bonus plans are appropriately 

subject to greater limitations than pension plans, the current 15 

percent of aggregate compensation limit on the deductibility of 

contributions to profit-sharing and stock bonus plans is not fully 

effective in restricting the use of these plans. The effectiveness of 

the 15 percent limit is undermined by the carry forward rules and, in 

certain situations, the ability of employers to contribute more than 

15 percent of compensation for highly paid individuals and less than 

15 percent for lower-paid individuals. 

In addition, the 25 percent of aggregate compensation deduction 

limit applies only to combinations of profit-sharing or stock bonus 

plans and pension plans, rather than to combinations of defined 

contribution plans and defined benefit pension plans. As a result, an 

employer may make contributions to a money purchase pension plan and a 

defined benefit pension plan without regard to the 25 percent of 

aggregate compensation limit, even though money purchase pension plans 

are essentially equivalent to profit-sharing and stock bonus plans in 

that the retirement benefit provided under each is based entirely on 

the individual's account balance at the time of retirement. 

The special tax treatment of ESOPs is also inconsistent with basic 

retirement policy. ESOPs are not primarily retirement plans, but 

rather are aimed at promoting employee ownership of employer stock and 

at facilitating employers in raising capital. By providing increased 

deduction limits and a tax credit in lieu of a deduction for certain 

contributions to ESOPs (and by making certain other preferential 

treatment available with respect to ESOPs), current law permits 

tax-favored treatment for plans serving nonretirement purposes. 

Proposals 

The 15 percent of aggregate compensation limit on deductions for 

contributions to profit-sharing and stock bonus plans would be 

eliminated. The current annual limit on the contributions and other 

additions for any individual in a defined contribution plan would be 

modified so that the contri,butions to a profit-sharing or stock bonus 

plan for any individual could not exceed 15 percent of such 

individual's compensation for the year. Contributions in excess of 

this limit would be deductible in a succeeding year subject to the 15 

percent of compenstion limit for that year. There would be no 

carryforward of an unused limit to a succeeding year. 

total contributions to combinations of pension plans and of 

profit-sharing or stock bonus plans would be modified by applying the 

limit to combinations of defined contribution plans and defined 

benefit plans. Thus, if an employer maintained a money purchase 

The 25 percent of aggregate compensation limit on deductions for 

- 347 - 
pension plan and a defined benefit pension plan, the employer's 

deduction for total contributions to both plans would be limited to 

the lesser of (i) 25 percent of the aggregate compensation paid to the 

employees covered by the plans, or (ii) the amount necessary to 

satisfy minimum funding standards for the defined benefit plan. 

An excess contribution to a qualified plan would generally not 

trigger plan disqualification, but rather would be subject to an 

annual tax of six percent for as long as the excess contribution both 

remained in the plan and was nondeductible. 

The special rules for ESOPs--the tax credit and the special limits 

for repayments of principal and interest--would be eliminated. Thus, 

the deductibility of contributions to an ESOP would be governed by the 

generally applicable deduction limits. (In addition, the deduction 

for dividends paid on ESOP stock, the partial exclusion of interest on 

ESOP loans, the nonrecognition of gain on certain sales of stock to an 

ESOP, and the assumption of estate tax liability by an ESOP would be 

eliminated.) 

Effective Date 

The proposals would be effective January 1, 1986. 

Analysis 

The annual six percent tax on accumulated excess contributions is 

intended to offset the advantage of tax-free accumulation to which 

excess contributions are currently entitled. The tax would parallel 

the tax currently applicable to excess contributions to a 

tax-sheltered annuity contract or custodial account, individual 

retirement account or simplified employee pension. 

- 348 - 
MODIFY ANNUAL LIMITS ON 

QUALIFIED RETIREMENT PLAN 

CONTRIBUTIONS AND BENEFITS 

General Explanation 

CHAPTER 17.04 

Current Law 

Current law provides favorable tax treatment to funds set aside in 

qualified employer plans for deferred compensation or retirement 

savings. Among the qualification requirements applicable to such 

plans are restrictions on the annual contributions and benefits that 

may be provided with respect to any individual under the defined 

contribution plans and defined benefit plans of an employer. For this 

purpose, defined contribution plans generally include qualifisd 

profit-sharing, stock bonus, money purchase pension and annuity plans, 

tax-sheltered annuities and custodial accounts, and simplified 

employee pensions. Defined benefit plans for this purpose are limited 

to defined benefit pension plans. Separate annual limits apply to 

each individual in a defined contribution plan and to each individual. 

in a defined benefit plan ("separate plan limits"). An "overall 

limit" also applies to each individual covered by both a defined 

contribution plan and a defined benefit plan. 

generally that the annual contributions, forfeitures, and other 

additions for any individual may not exceed the lesser of $30,000 

(indexed for inflation beginning in 1988) or 25 percent of the 

individual's compensation for such year. In determining whether the 

applicable limit is satisfied with respect to an individual for a 

year, the lesser of (i) one-half of the employee contributions for the 

year or (ii) the excess of the employee contributions for the year 

over 6 percent of the individual's compensation for the year are 

treated as annual additions. 

Special rules permit the employees of certain tax-exempt 

organizations, such as educational institutions, hospitals, and 

churches, to benefit from contributions and other additions to 

tax-sheltered annuity contracts and custodial accounts in excess of 

the general defined contribution plan limits. Similarly, special 

limits applicable to employee stock ownership plans (ESOPs) permit 

contributions to exceed the general limits for defined contribution 

plans. 

The separate plan limit for a defined benefit plan provides that 

the benefit payable with respect to an individual for a year, when 

expressed as an annual retirement benefit, may not exceed the lesser 

of $90,000 (indexed for inflation beginning in 1988) or 100 percent of 

the average of the individual's highest three years of compensation. 

The defined benefit limit is not violated if the annual benefit 

The separate plan limit for a defined contribution plan provides 

- 349 - 

459-813 0 - 84 - 13 
payable to an ind vidual who has never participated in a defined 

contribution plan is not in excess of $10,000. If an individual has 

less than ten years of service with an employer, the $90,000, the 100 

percent of compensation, and the $10,000 annual benefit limits are 

reduced on a pro rata basis. 

may be provided to an individual covered by both a defined 

contribution plan and a defined benefit plan. Calculation of the 

overall limit is complex, requiring that the sum of the defined 

contribution fraction and the defined benefit fraction for any 

individual subject to the separate plan dollar limits for any year not 

exceed 1.25. For an individual who is subject to the separate plan 

percentage-of-compensation limits, rather than the dollar limits, the 

sum of the fractions may not exceed 1.4. The numerator of an 

individual's defined contribution fraction is the aggregate additions 

made on behalf of the individual under the plan during all years of 

the individual's participation, and the denominator is the sum of each 

of the separate defined contribution plan limits that applied, or 

would have applied, for each of the individual's years of service with 

the employer. The defined benefit fraction is the individual's 

accrued annual retirement benefit over the applicable separate defined 

benefit plan limit for the year. 

In the case of a "top-heavy" plan, i.e., a plan in which more than 

60 percent of the total accrued benefits are for key employees (5 

percent owners, 1 percent owners with $150,000 in compensation, the 

ten employees with the largest ownership interests, and officers), the 

1.25 limit on the sum of the defined contribution and defined benefit 

fractions for key employees subject to the separate plan dollar limits 

is reduced to 1.0. If accrued benefits for the key employees are not 

greater than 90 percent of the total accrued benefits under the plan 

and if the non-key employees are provided with the required additional 

minimum contributions or benefits (section 416(h)(2)), the overall 

limit for key employees subject to the dollar limits is increased from 

1.0 to 1.25. 

The overall limit coordinates the contributions and benefits that 

Reasons for Change 

The separate plan and overall limits on annual contributions and 

benefits reflect a policy that favorable tax treatment should be 

available only up to levels needed for reasonable retirement savings. 

The limits under current law, however, are unnecessarily complex 

and fail to limit the use of qualified plans in a consistent or 

equitable manner. 

employers and plans, and indeed may be the primary source of 

complexity in the retirement plan area. It requires an employer to 

maintain significant records for many employees and to coordinate the 

contributions and benefits under all of its tax-favored retirement 

plans. 

Calculation of the overall limit imposes a significant burden on 

- 350 - 
The overall limit also creates a disincentive for employers to 

establish both defined contribution and defined benefit plans, since 

aggregate contributions and benefits to an individual subject to the 

separate plan dollar limits may not exceed 62.5 percent of the sum of 

the separate plan limits. In most situations, the maintenance of both 

a defined contribution plan and a defined benefit plan would better 

serve the interests of employees generally; younger, more mobile 

employees tend to be favored by defined contribution plans, while 

older employees, particularly those close to retirement, generally are 

favored by defined benefit plans. 

The effectiveness of the current limits is undermined by the 

inconsistency in their application. The separate and overall limits 

fail to take into account benefits under such tax-favored plans as 

individual retirement accounts (IRAs). In addition, certain 

individuals (e.g., participants in tax-sheltered annuity contracts and 

custodial accounts, and ESOP participants) are permitted to receive 

annual contributions and benefits in excess of the generally 

applicable limits. Moreover, the limits consider only the 

contributions and benefits provided to an individual by a single 

employer; individuals who have accrued tax-favored benefits with more 

than one employer may receive total contributions and benefits far in 

excess of the existing limits. Finally, the limits do not effectively 

restrict the tax-favored benefits (as compared to the tax-favored 

contributions) that may be provided to an individual under a defined 

contribution plan. 

In addition, the current limits fail to count all employee 

contributions and thus disregard the tax advantages such contributions 

receive. Although not deductible, employee contributions to a 

qualified plan accumulate income on a tax-deferred basis. Also, 

highly-paid individuals generally are in a financial position to take 

disproportionate advantage of the tax benefits for employee 

contributions to qualified plans. 

individual's first ten years of service with an employer fails to 

preclude the key employee of an employer, typically a small employer, 

from delaying the establishment of a defined benefit plan until such 

employee is close to retirement. Because such a key employee 

generally will have in excess of ten years of service with the 

employer, the employee may be provided with a fully funded benefit 

under the defined benefit plan up to the full, unreduced annual limit. 

By delaying the establishment of the plan, however, the employer is 

able to avoid providing benefits to non-key employees who may have 

worked for the employer in earlier years. 

Finally, the phase-in of the annual defined benefit limits over an 

Proposal 

The overall limit on the annual contributions and benefits that 

may be provided to an individual under the defined contribution and 

- 351 - 
defined benefit plans of an employer would be eliminated. For 

top-heavy plans, however, the existing overall limits would continue 

to apply. 

distributed to or with respect to a participant from all tax-favored 

retirement plans, including IRAs and tax-sheltered annuity contracts 

and custodial accounts. The additional tax would be ten percent of 

the amount by which such annual benefits exceed 1.25 times the defined 

benefit dollar limit in effect for the year. The additional tax would 

be nondeductible for income tax purposes, and losses, deductions, and 

credits would not be applicable against the tax. 

In determining whether the separate plan limit for an employee in 

a defined contribution plan is satisfied, all employee contributions 

would be treated as annual additions on behalf of the employee. In 

addition, the special limits for employees of certain tax-exempt 

organizations participating in tax-sheltered annuity contracts and 

custodial accounts and for employees participating in ESOPs would be 

eliminated. 

Finally, the phase-in of the separate defined benefit plan limit 

An additional tax would be applied to taxable, annual benefits 

over ten years of service with the employer would be modified by 

providing for a phase-in of the $90,000 annual defined benefit dollar 

limit over the first ten years of plan participation. A minimum 

annual benefit would be permitted, however, for low-paid employees 

near retirement with significant years of service at the time plan 

participation commences. 

Effective Date 

The modifications to the annual limits on contributions and 

benefits would apply for years beginning on or after January 1, 1986. 

The ten percent additional tax would apply to tax-favored retirement 

plan distributions made on or after January 1, 1986. 

Analysis 

Eliminating the overall limit for non-top-heavy plans would 

eliminate a significant source of complexity and thus should promote 

adoption of qualified plans. It should also provide employers with a 

significant incentive to maintain both defined contribution plans and 

defined benefit plans. 

in excess of 1.25 times the applicable defined benefit dollar limit 

for the year is an appropriate limit on an individual's annual 

tax-favored retirement benefits. For example, if in 1986 an 

individual receives tax-favored retirement benefits of $200,000, the 

excess of the $200,000 over $112,500, or $87,500, would be subject to 

the ten percent tax. This tax would recapture a portion of the tax 

benefits provided to the excess distributions. By applying at the 

individual level, rather than on an employer-by-employer basis, the 

The ten percent additional tax on annual tax-favored distributions 

- 352 - 
additional tax also would apply to individuals who accrue excess 

benefits from multiple employers, without requiring significant 

employer involvement or administrative burden. 

the minimum distribution rules, an individual may avoid the ten 

percent additional tax on an excess distribution by rolling over some 

or all of such distribution to an IRA or qualified plan. 

Of course, unless required to take a distribution into income by 

- 353 - 
IMPOSE TEN PERCENT TAX ON QUALIFIED RETIREMENT PLAN 

ASSETS REVERTING TO EMPLOYER 

General Explanation 

Chapter 17.05 

Current Law 

As a general rule, amounts paid as deferred compensation are 

deductible by an employer only as they are included in the income of 

the employee. Moreover, income from amounts set aside to fund 

deferred compensation is fully taxable to the employer as it is 

earned. Current law provides exceptions to these general rules for 

employer contributions to qualified defined benefit plans. Thus, 

within certain limits, employer contributions to defined benefit plans 

are currently deductible, even though employees are not taxable until 

they receive distributions from the plan. In addition, income 

generated from plan assets is exempt from tax until distributed by the 

plan. These tax advantages are intended to encourage the creation of 

qualified plans and thus to improve retirement security for employees. 

plans on a "going concern," rather than a "termination," basis; i.e., 

employers must fund not merely benefits already accrued, but also some 

portion of the plan's projected benefits. Current minimum funding 

standards also provide that experience gains (e.g., better-thanexpected claims or earnings experience), may not be taken into account 

in a single year for purposes of determining required contributions, 

but rather must be amortized over a fifteen-year period. As a result 

of these funding standards, and because employers may also receive a 

deduction for certain plan contributions in excess of minimum funding 

requirements, the funds in a defined benefit plan at any particular 

time may exceed the amount necessary to fund benefits accrued as of 

such time. 

Current law requires employers to fund qualified defined benefit 

Although current law generally prohibits the use of plan assets by 

the employer, upon termination of a plan the employer may receive plan 

assets in excess of those necessary to fund fixed and contingent 

benefits as of the date of termination. Plan assets that revert to 

the employer upon termination generally are included in the employer's 

gross income. 

Reasons for Change 

Current law permits employers to gain unintended tax advantages by 

overfunding defined benefit plans and receiving assets back on plan 

termination. Although plan assets reverting to the employer are 

includible in its income, the employer retains the benefit of an 

initial deduction and of tax-deferral on the plan's income. Such 

tax-favored treatment is inappropriate where plan assets are not used 

to provide employee retirement benefits. 

- 354 - 
The use of qualified plans for nonretirement purposes is evidenced 

in a number of recent cases in which employers have undertaken 

transactions that effectively permit the employer to receive assets 

from a defined benefit plan while continuing to maintain a defined 

benefit plan for its employees. These transactions are inconsistent 

with the minimum funding standards for qualified defined benefit plans 

and undermine the security of the promised benefits in the continuing 

plans. Although the Treasury Department, along with the Labor 

Department and the Pension Benefit Guaranty Corporation, have recently 

issued current law guidelines regarding these transactions, the 

possibility for significant abuse remains. 

Proposal 

An additional tax of ten percent of the plan funds reverting to 

the employer upon plan termination would be imposed on such employer. 

This tax would be nondeductible for income tax purposes, and could not 

be offset by losses or other deductions or credits. 

Effective Date 

The ten percent additional tax would be applicable to qualified 

plan assets reverting to an employer pursuant to a plan termination on 

or after the date this proposal as introduced as legislation. 

Analysis 

The additional tax on plan assets reverting to an employer would 

parallel the additional tax on early distributions to individuals from 

tax-favored retirement plans. The additional tax also would be an 

effective and administratively simple deterrent to transactions 

designed merely to draw assets from an ongoing defined benefit plan 

without encouraging employers to substitute defined contribution plans 

for their terminating defined benefit plans. 

- 355 - 
REPEAL CASH OR DEFERRED ARRANGEMENT (CODA) PROVISIONS 

General Explanation 

Chapter 17.06 

Current Law 

In general, employees are subject to tax not only on compensation 

actually received but also on amounts the receipt of which is, at the 

employee's election, deferred until a later year. An exception to 

this rule of constructive receipt is provided for so-called cash or 

deferred arrangements (CODAs), under which an employee may elect to 

defer the receipt of cash compensation and have the deferred amount 

contributed as an employer contribution to a qualified profit-sharing 

or stock bonus plan. If the CODA meets certain qualification 

requirements, the employee is not currently taxable on the deferred 

amount. Contributions to CODAs are subject to the limits that apply 

generally to defined contribution plans. Thus, if allowed under the 

special nondiscrimination test for CODAs, the maximum amount that may 

be contributed to a CODA on behalf of any individual is the lesser of 

$30,000 (indexed beginning in 1988) or 25 percent of the individual's 

compensation. 

nonforfeitable, (2) may not be distributed to the employee before the 

earlier of age 59-1/2, separation from service, disability, or death, 

and (3) satisfy the "actual deferral percentage test" (the ADP test). 

In general, the ADP test is satisfied if the average percentage of 

compensation deferred for "highly compensated employees" does not 

exceed 150 percent of the average percentage deferred for other 

employees. 

are currently limited to the lesser of $2,000 ($2,250 for a spousal 

IRA) or 100 percent of compensation. Individual contributions to an 

IRA receive the same tax-deferral advantages as deferred compensation 

under a CODA. Thus, subject to certain limits, an individual receives 

a deduction for contributions to an IRA, and is taxable on such 

amounts only as they are withdrawn from the IRA. 

A CODA is qualified only if the deferred amounts (1) are wholly 

Deductible contributions to an individual retirement account (IRA) 

Reasons for Change 

The tax-favored treatment applicable to individual and employersponsored retirement plans is intended to enhance individual 

retirement security. Consistent with that policy, the ability to make 

deductible contributions to tax-favored retirement plans should be 

made available on a broad and consistent basis. 

- 356 - 
An employer's contribution of a deferred amount to a retirement 

plan under a CODA has the same economic and tax effect for the 

employee as a deductible contribution by the employee to an IRA. 

Despite this equivalence, the limitations on deferred compensation 

under a CQDA are far more liberal than the IRA contribution limits. 

Current law thus provides tax benefits for employees of employers 

maintaining a CODA that substantially exceed those available to other 

individuals. 

Unlike CODAS or other employer-sponsored plans, IRAs are available 

to all individual taxpayers, without regard to form of employment or 

occupation. IRAs, thus, are the appropriate vehicle for receipt of 

deductible retirement plan contributions by individuals. 

Proposals 

The provisions of the tax law authorizing CODAS would be repealed. 

Effective Date 

January 1, 1986. 

Analysis 

receipt rules of current law would apply with respect to employee cash 

or deferred elections. Thus, if an employee has the right to defer 

the receipt of some or all of his or her cash compensation and to have 

the deferred amount contributed to a tax-favored retirement plan, the 

employee would be treated as having received the deferred amounts. 

This would be the case without regard to whether the employee's 

election was before or after the period in which the employee earned 

the compensation subject to the election. Thus, the defesred amount 

would be included in the employee's gross income and the contributions 

would be treated as after-tax contributions to the plan. Qf course, 

such after-tax contributions may be deductible subject to the 

generally applicable IRA deduction limits. See Ch. 17.01, proposing 

an increase in current IRA deduction limits. 

Repeal would be effective for contributions to a CQDA on or after 

After repeal of the CODA provisions, the general constructive 

- 357 - 
MODIFY RULES FOR BENEFIT FORFEITURES 

General Explanation 

Chapter 17.07 

Current Law 

Tax-favored treatment is provided with respect to funds set aside 

to provide deferred compensation under profit-sharing, pension, and 

stock bonus plans that satisfy certain qualification requirements. 

Among these requirements is a rule providing that a pension plan is 

not qualified unless the plan provides that benefits forfeited upon 

the separation of an employee's service for the employer maintaining 

the plan will not be used to increase the benefits any other employee 

would otherwise receive under the plan. The forfeited amounts must 

be used to reduce future employer contributions to the plan or to 

offset plan administrative expenses. The effect of this is to deny 

benefit increases to employees. Forfeited benefits under a 

profit-sharing or stock bonus plan may be reallocated to the remaining 

participants and thus may be used to increase the benefits that the 

participants would otherwise receive. 

Reasons for Change 

Uniform rules governing the treatment of forfeitures should be 

applied to all qualified plans. Also, because forfeitures are treated 

as contributions and other additions for purposes of the annual limits 

on contributions, permitting pension plans to reallocate forfeitures 

among plan participants generally will benefit rank-and-file 

employees, and not merely highly compensated employees. 

Proposal 

Qualified pension plans would be permitted to use benefits 

forfeited by a separated employee to increase the benefits that other 

employees would otherwise receive under the plan. 

Analysis 

Under the proposal, a qualified pension plan could provide that 

forfeited benefits will be used to reduce future employer 

contributions or to offset administrative expenses, or that 

forfeitures will be reallocated among the remaining participants. 

- 358 - 
CHAPTER 18 

INTERNATIONAL ISSUES 

The Treasury Department proposals would retain the basic scheme 

for taxing foreign-source income, but would address certain anomalies. 

A per-country limitation on the foreign tax credit would be instituted 

to remove the current incentive for corporations with excess foreign 

tax credits to invest in low-tax foreign jurisdictions. Sourcing 

rules used in computing the credit and in taxing non-resident aliens 

and foreign corporations would also be improved. The taxation of 

income earned by foreign corporations through U.S. branches would be 

rationalized to bring it more into line with the taxation of income 

earned through U.S. subsidiaries. Finally, the uncertainty relating 

to the proper treatment of foreign exchange gain and loss under 

current law would be resolved with respect to hedged transactions by 

treating such gain or loss as adjustments to interest. 

- 359 - 
REFORM FOREIGN TAX CREDIT 

General Explanation 

Chapter 18.01 

Current Law 

To avoid international double taxation of income, the United 

States allows U.S. taxpayers to credit foreign income taxes paid. The 

amount of credit which may be claimed is limited to the U.S. tax on 

foreign source income; this limit is measured as the portion of total 

U.S. tax, before credit, corresponding to the portion that foreign 

taxable income is of worldwide taxable income. The limitation is 

calculated on an "overall" basis; that is, the amount of potential 

credit is the aggregate of income taxes paid to all foreign countries, 

and foreign source taxable income is the aggregate of taxable income 

from all foreign countries. In effect, each taxpayer is allowed to 

average foreign effective tax rates above and below the U.S. rate; 

only if the average exceeds the U.S. rate are any potential credits 

denied. 

pay directly. In addition, U.S. multinational corporations are allowed to credit a share of taxes paid by their foreign subsidiary 

corporations; this feature is called the "deemed paid" or "indirect" 

foreign tax credit. The share of taxes eligible for credit is related 

to the share of income repatriated to the U.S. parents. These taxes 

are subject to the limitation described above. 

Reasons for Change 

The objective of the foreign tax credit is to avoid double taxation of foreign income. The limitation is intended to prevent abuse 

by preserving the U.S. tax on domestic income. Assume, for example, 

that a U.S. taxpayer has $100 of U.S. income and $100 worth of income 

from country x, and that tax rates are 46 percent in the United States 

and 60 percent in X. Worldwide taxable income is thus $200 and U.S. 

tax before credit is $92. An unlimited foreign tax credit would yield 

only $32 of U.S. tax ($92-$60=$32). Even though a full $100 was 

earned in the United States, less than $46 in U.S. tax would be paid. 

In effect, the United States would be refunding the excess $14 of 

foreign tax paid on foreign income. With a properly designed 

limitation, the foreign tax credit claimed may not exceed $46, the 

U.S. tax on the foreign income. The limitation would prevent the 

credit from reducing U.S. tax on domestic income. 

country, rather than on an overall basis, would be more consistent 

with this goal and would lead to more rational incentives for investment. Computing the limitation on an overall basis gives many 

taxpayers a tax-motivated incentive to invest abroad rather than in 

All taxpayers are allowed to credit foreign income taxes that they 

Limiting the credit to the U.S. tax on foreign income country by 

- 360 - 
the United States. To continue the example from the preceding paragraph, note that the U.S. taxpayer investing in X and facing an 

overall limitation can lower his tax by shifting his investment from 

the United States to a foreign country with a low tax rate. For 

example, if he could earn $100 in a country Y, which has no income 

tax, he would be able to credit the full $60 paid to X, and his net 

U.S. tax would be only $32. Therefore, the U.S. tax system gives this 

taxpayer a $14 subsidy to earn $100 in Y rather than at home. The 

taxpayer is able to reduce his U.S. tax because the overall limitation 

allows the high tax in X to be averaged with the low tax in Y. Just 

as excess credits in X should not be allowed to offset U.S. tax on 

domestic income, the excess credits should not be made available 

merely because the taxpayer shifts domestic income to Y, a low tax 

foreign country. 

In sum, the overall limitation leads U.S. multinational companies 

to distort their worldwide investment decisions for purely tax motivated reasons. The overall limitation is also inequitable. Two U.S. 

taxpayers investing in the same country may face different incentives 

and pay different net U.S. tax on their investments there, depending 

on unrelated activities. 

Present methods for calculating deemed paid credits also have 

certain effects which should be corrected. Specifically, measurement 

of earnings and profits is not done consistently in all instances, the 

timing of distributions causes opportunities for tax avoidance and 

unintended tax penalties, and the rules concerning transactions in 

foreign currencies bias investment incentives in certain cases. 

Proposal 

The amount of income tax paid to a foreign country which may be 

claimed as a foreign tax credit in any year would be limited to the 

U.S. tax on income from that country. The limitation with respect to 

each country would be a fraction of the total pre-credit U.S. tax, 

equal to the ratio of taxable income from that country to worldwide 

taxable income. 

The separate "baskets" of income (certain interest, DISC/FSC, and 

other) defined under current law would be retained and a limitation 

calculated for each basket within each foreign country. The separate 

limitation provisions of current law relating to oil and gas extraction income would also be retained and would operate on a country by 

country basis. 

For purposes of these limitations, foreign taxes would be matched 

as closely as possib1.e with the income to which they relate. Foreign 

subsidiaries that earn income in countries other than the one in which 

they are incorporated require special consideration. To prevent 

taxpayers in such situations from circumventing the per country 

limitation by mixing highly and lightly taxed foreign income, the 

proposal will require taxpayers to identify the countries of origin of 

the income repatriated by the subsidiaries, as well as the countries 

to which the taxes are paid. 

- 361 - 
This approach could have harsh results in the case where a foreign 

subsidiary incorporated in a country that taxes worldwide income has 

to pay tax (net of foreign tax credit) to this country on income 

earned elsewhere. The tax would be attributed to the country of incorporation but the income would not. In principle, this situation 

should be remedied by reassigning the tax to the countries from which 

the income arises. In practice, such tracing can present 

difficulties. Therefore, the Treasury Department expects that this 

issue will be addressed, as necessary, on a bilateral basis through 

U.S. income tax treaties. 

The proposal would allow losses to offset income earned in other 

countries, with provisions for "recapture" and "regeneration" when 

income is subsequently earned in the loss country or countries. In 

the year a loss occurs, it would be prorated against the income earned 

in all other countries, in proportion to each country's share in taxable income. The loss can have two effects in the year it is 

prorated. It can reduce U.S. tax liability, by reducing U.S. income 

and/or lightly taxed foreign income, and it can increase the amount of 

excess foreign tax credits, by reducing the limitations in high tax 

countries. When income is subsequently earned in the loss country, 

each of these effects will be counteracted; the reduction in U.S. 

liability will be recaptured and the lost credits will be regenerated. 

The purpose of these rules is to make the total (undiscounted) U.S. 

tax liability over a period of several years depend only on total 

income and taxes in each country over the period, and not on the 

geographic pattern of income and losses in particular years. 

consistent measurement of earnings and profits, to prevent manipulation and penalties resulting from the timing of distributions, and 

to deal with foreign currency translation issues. 

Consideration will also be given to indexing certain accumulations 

and items of foreign source taxable income for inflation. The methods 

would be as consistent as possible with the methods developed for 

indexing domestic source concepts. However, alterations may be necessary due to the administrative complexities and other concerns added 

by the international context in which these rules must operate. 

Effective Date 

beginning on or after January 1, 1986. A five year carryforward of 

current excess foreign tax credits into the new system would be 

allowed; taxpayers may choose the country or countries to which they 

will apply. This rule helps ease the transition to the per country 

limitation in a natural way. Due to the substantial reduction in U.S. 

tax rates, however, excess credits generated under the reformed system 

will not be comparable to pre-reform quantities; therefore, carryback 

from post to pre-reform years will not be allowed. With these 

exceptions, the proposal would allow three years of carrybacks and 

five years of carryforwards on a per country basis. 

Certain changes in the deemed paid credit would be made to ensure 

The proposal would be effective, in general, for taxable years 

- 362 - 
Pre-reform overall foreign losses that have not been recapkured 

will require another set of transition rules. Each year, until these 

pre-reform losses are exhausted, taxpayers will determine the amount 

that they would have been required to recapture under current rules. 

This amount of foreign income will then be recharacterized as U.S. 

source; the taxpayers will be allowed to specify the countries from 

which this income is to be taken. 

Analysi 6 

A per country limitation to the foreign tax credit would eliminate 

double taxation of foreign income in a way that is in accord with U.S. 

tax treaties, without distorting the choice between domestic and 

foreign investment. A U.S. taxpayer deciding between investing in the 

United States or a foreign country would be less motivated by tax considerations to undertake the less profitable project. In contrast, 

with the overall limitation, a taxpayer with activities in a high tax 

foreign country pays less U.S. tax by making an investment in a low 

tax foreign country than by making an investment in the United States. 

The averaging of high and low foreign taxes allowed by the overall 

limitation results in investments being made which would not be profitable but for the tax savings. The proposed reduction in the U.S. 

corporate tax rate would increase excess foreign tax credits and, 

accordingly, would increase the incentive to divert investment and 

income to low-tax countries if the overall limitation were left in 

place. Adopting a per country limitation, together with the proposed 

changes in certain source rules, would preserve the U.S. tax on 

domestic income while avoiding double taxation of foreign income. 

Adoption of a per country limitation is consistent with 

international practice. Most countries which avoid international 

double taxation by allowing a foreign tax credit use a per country 

limitation; and a per country limitation was used in the United States 

for many years (1932-1976), either alone or in combination with the 

overall limitation. 

The proposed changes in the deemed paid credit would also remove 

biases in investment decisions and treat similar taxpayers more 

eqtia 11 y . 

might be changed by the proposal, but the direction would be toward 

greater efficiency and equity. 

It is difficult to measure the extent to which investment patterns 

- 363 - 
PIODIFY SOURCING RULES FOR INCOME AND DEDUCTIONS 

r items of in 

Current Law 

Rules for defining the source of particul 

General Explanation 

Chapter 18.02 

ome serve 

two principal purposes. First, those-rules define the scope of U.S. 

taxation of non-resident aliens and foreign corporations, particularly 

those that do not engage in a U.S. trade or business. Second, through 

the operation of the foreign tax credit mechanism, the source of 

income rules define the circumstances under which the United States is 

willing to concede primary jurisdiction to a foreign country to tax 

U.S. citizens and residents on income earned by them in that foreign 

country. In the respects relevant to the proposals set forth below, 

existing rules for determining the source of income and the allocation 

and apportionment of related expenses are as follows: 

(a) Income Derived from Purchase and Resale of Property. Income 

derived from the purchase and resale of personal property, both 

tangible and intangible, is sourced at the location where the sale 

occurs. The place of sale is generally deemed to be the place where 

title to the property passes to the purchaser. 

(b) Income Derived from Manufacture and Sale of Property. Income 

derived from the manufacture of products in one country and their sale 

in a second country is treated as having a divided source. Generally, 

such income is allocated one-half on the basis of the place of 

manufacture and half on the basis of the place of sale (determined 

under the title passage test), although resort to an independent 

factory price for purposes of this allocation is permitted if such a 

price exists. 

(c) Income Derived from License of Intangible Property. Royalty 

income derived from the license of intanqible property is sourced by 

reference to the place where the licensea intangible property is used. 

(d) Dividend Income. Dividend income is generally sourced at the 

place of incorporation of the payor. However, if a U.S. corporation 

earns more than 80 percent of its income from foreign sources, 

dividends paid by that corporation are treated as foreign source 

income. 

(e) Interest Income. Interest income is generally sourced on the 

basis of the residence of the payor. Under one exception to this 

rule, interest income received from a U.S. corporation which earns 

more than 80 percent of its income from foreign sources is treated as 

- 364 - 
foreign source income. Other exceptions to the interest source rules 

are designed to be tax exemptions for limited classes of income. 

(f) Interest Expense. Interest expense incurred by a related 

group of corporations is required to be allocated between domestic and 

foreign source income in computing foreign source taxable income and 

the foreign tax credit limitation. Under existing law, this 

allocation is made on a separate company basis, rather than on a 

combined group basis. Thus, a company within the related group that 

incurs interest expense takes only its own operations into account in 

allocating the expense, rather than the operations of the entire 

related group. 

Reasons for Change 

The following basic principles should be applied in formulating 

rules for determining the source of income. First, appropriate source 

of income rules should allocate income to the place where the economic 

activity generating that income occurs. Income derived from the use 

of property or capital should be sourced where the property or capital 

is used. Second, the rules should be neutral in the sense that the 

United States would have no ground for objection if its source of 

income rules were applied by other countries. Unless there are 

sufficient reasons to the contrary, international norms for source of 

income determinations should be followed to the extent such norms 

exist. Third, the rules should not allow erosion of the legitimate 

U.S. tax base through taxpayer manipulation of the source rules or of 

the foreign tax credit limitation. Fourth, the rules should be cl.ear 

and readily applied. Adoption of a per country foreign tax credit 

limitation would increase the need for such clarity by requiring 

sourcing of income to specific foreign countries rather than simply 

requiring allocation between domestic and all foreign sources. 

Existing rules for determining source of income fail to meet these 

standards in the following respects: 

(a) Sales Income. Under the existing title passage test, the 

source of income derived from the sale of goods bears no necessary 

relationship to the economic activity generating that income. Because 

the place of title passage may be arbitrarily determined by affected 

taxpayers, the existing rule permits artificial manipulation of the 

foreign tax credit limitation and the U.S. tax base. The possibility 

of such manipulation is particularly troublesome in connection with 

transactions between related taxpayers. 

(b) Sales of Intangible Property. Income derived from the sale 

of intanqible property is determined under a title passaqe test while 

income derived-frbm the license of such property is'deteimined by 

reference to the place where the property is used. Often the economic 

distinction between a sale and a license of intangible property is 

elusive. Clarity and uniformity of treatment would be served by 

- 365 - 
applying the same source of income rules to all transactions involving 

intangible property. 

(c) Dividend Income. The existing source rule applicable to 

dividend income focuses on the domicile of the corporation 

distributing the dividend income. This rule, or a close variant of it 

focusing on the corporation's place of management, is followed in the 

tax systems of most countries. The rule is clear and easily applied 

and otherwise satisfies the characteristics of appropriate source 

rules. 

The exception to this general rule for so-called 80-20 companies 

is much more questionable. It alters a sound, well accepted rule 

under circumstances where most foreign countries do not assert a 

competing source based claim to tax the income. This can result in 

total tax exemption of the dividend both in the United States and the 

relevant foreign country, and can facilitate tax haven opportunities 

for taxpayers. 

to the general source rule applicable to interest income alters an 

accepted rule in the absence of competing source based claims of 

foreign countries. Accordingly, the 80-20 company rule gives rise to 

tax haven type opportunities for some taxpayers and to opportunities 

for manipulation of the foreign tax credit limitation. 

(e) Interest Expense. The separate company method of allocation 

enables taxpayers to limit artificially the interest expense allocated 

to foreign source income by manipulating the corporate structure of 

the related group. This may result in an unwarranted increase in the 

amount of foreign tax credit available to a related group of 

corporations. 

Proposal 

derived from the purchase and resale of inventory-type goods would be 

sourced in the country of the taxpayer's residence. An exception to 

this general rule would be provided if the predominant portion of the 

selling activity generating the income is carried on through a fixed 

place of business located outside the taxpayer's country of residence. 

In such a case, the income would be sourced in the country where the 

fixed place of business is located. The place where title to the 

goods passes to the buyer, the place where purchasing activity is 

carried out and the place of ultimate destination of the goods all 

would be irrelevant for purposes of determining the source of sales 

income. It is believed that this rule would correlate the source of 

sales income more closely with the location of the underlying selling 

activity without necessitating in every case an administratively 

complex determination of where the relevant sales activity occurs. 

(d) Interest Income. Just as with dividends, the 80-20 exception 

(a) Source Rules Relating to Sales Income, In general, income 

- 366 - 
Similar changes would also be made in the rules for determining 

the source of income derived from the manufacture and sale of 

products. The existing practice of sourcing one-half of such income 

on the basis of the place of manufacture would continue. The 

remaining one-half of the income would be attributed to sales activity 

and would be sourced on the basis of the rules described in the 

preceding paragraph. The title passage test would be abandoned. 

Accordingly, no portion of the income derived from the manufacture of 

products in the United States and the sale of such products abroad 

would be sourced in a foreign country unless the predominant selling 

activity giving rise to the sales is carried out through a fixed place 

of business in that foreign country. The option of applying an 

independent factory price in allocating divided source income would be 

retained, provided that the predominant portion of the relevant sales 

activity is conducted through a fixed place of business outside the 

country of manufacture. 

Income derived from sales of personal property used by the 

taxpayer in its business would be sourced in the place where the 

property is used. Income derived from the sale of personal property 

not described above, including in particular passive investment 

property, would be sourced at the place of the taxpayer's residence. 

(b) Income Derived from Sales of Intangible Property. The rules 

relating to royalty income derived from licenses of intangible 

property would-be retained in their present form. Source rules 

relating to sales of intangible property would be modified to 

correspond generally to the rules relating to licenses. Accordingly, 

intangible property related sales income generally would be sourced on 

the basis of where the underlying property is to be used. 

Consideration will be given to whether exceptions should be made to 

this rule for sales of certain types of intangible property. 

IC) 80-20 Corporation Rules Relating to Interest and Dividends. 

The 80-20 corporation exceptions to the general source rules 

applicable to dividend and interest income would be repealed. Thus, 

dividend income would be sourced on the basis of the place of 

incorporation of the corporation paying the dividend. Interest income 

received from all U.S. residents and domestic corporations would be 

sourced on the basis of the residence of the payor without looking to 

the underlying source of the payor's income. Provisions of the 

existing source rules relating to interest income that are designed to 

provide tax exemptions for particular activities would not be repealed 

but would be restructured as overt exemption provisions in the 

interest of establishing neutral source rules. 

required to be allocated to income from various sources on a combined 

group basis, rather than on a separate company basis. 

(d) Allocation of Interest Expense. Interest expense would be 

- 367 - 
Effective Date 

The proposals would generally be effective for taxable years 

beginning on or after January 1, 1986. The modification of the source 

rule for interest income received from 80-20 corporations would be 

effective only with respect to interest paid on debt obligations 

incurred after the date of introduction of the legislation. 

Transitional rules would be provided for sales made under certain 

contracts executed prior to the date of introduction of the proposal 

as legislation. 

Analysis 

The proposals would create a set of rules for determining the 

source of income that is less subject to manipulation and more 

reflective of real underlying economic activity than the existing 

rules. The new rules would also be more suitable to the computation 

of the foreign tax credit limitation on a per country basis. It can 

be anticipated that under these proposals somewhat greater amounts of 

the income of U.S. taxpayers derived from sales of products to 

destinations located outside the United States would be treated in the 

future as domestic source income. As a result some foreign tax 

credits on income from U.S. economic activity may not be available. 

However, the United States should retain the primary taxing right over 

this income. 

- 368 - 
REPLACE SECOND DIVIDEND TAX WITH BRANCH PROFITS TAX 

General Explanation 

Chapter 18.03 

Current Law 

The effectively connected income of a U.S. branch of a 

foreign corporation is subject to u.S. income tax, but there is 

no additional tax, comparable to the withholding tax imposed on 

dividends paid by a U.S. subsidiary of a foreign corporation, on 

the branch's remittances to the home office. Instead, the tax 

code provides for the imposition of a U.S. withholding tax, known 

as the "second dividend tax", on a proportionate part of the 

dividends paid by the foreign corporation, if more than 50 

percent of the corporation's gross income is effectively 

connected with a U.S. trade or business. 

Reasons for Change 

tax on its profits, and, in addition, its foreign shareholders 

are subject to a tax on the dividends which they receive (30 

percent by statute, reduced to as little as five percent by 

treaty). No comparable tax, beyond the corporate tax, is imposed 

on the distributed profits of a U.S. branch of a foreign corporation. The "second dividend tax" is intended as the analogue 

to the dividend withholding tax, but it fails to equalize the tax 

treatment of branches and subsidiaries in many cases. The 

"second dividend tax" applies only when a majority of the income 

of the foreign corporation is derived from its U.S. branches, 

while the dividend withholding tax applies to all distributions 

of subsidiary profits. Moreover, the enforcement of this tax is 

very difficult. It is difficult to know when the tax is due and 

difficult to enforce its collection by a foreign corporation. 

Proposal 

The "second dividend tax" would be repealed and replaced by 

an additional tax on the profits of U.S. branches of foreign 

corporations which would place the branch of a foreign 

corporation on a more comparable footing with a U.S. subsidiary 

of a foreign corporation. 

All foreign corporations with a branch in the United States 

(a trade or business under the tax code or a permanent 

establishment under tax treaties) would be subject to the branch 

profits tax, unless it is prohibited by an existing U.S. tax 

treaty. The branch profits tax would not override existing 

treaties, but the Treasury Department would seek to amend those 

treaties which now prohibit the tax to permit its imposition. 

(Many treaties do not prohibit the imposition of such a tax.) 

A U.S. corporation owned by nonresidents is subject to income 

- 369 - 
The tax base would be defined so as to approximate the 

distributed profits of a U.S. subsidiary. The taxable income of 

the branch as shown on its U.S. corporate tax return would be 

reduced by the U.S. corporate tax before foreign tax credits and 

by further adjustment to reflect reinvestment of profits in the 

branch. To adjust for such reinvestment, increases in net 

investment in the branch, for both fixed and working capital, 

would be deducted from the after corporate tax branch profits. 

The rate of the branch tax would be the same as the dividend 

withholding tax rate, currently 30 percent. Where the foreign 

corporation is resident in a treaty country, the treaty rate 

applicable to direct investment dividends would apply. 

The second withholding tax on interest raises further 

questions which need to be addressed. If it is decided to repeal 

that tax, adjustments to the branch profits tax must be 

considered. 

Effective Date 

The proposal would take effect for taxable years beginning on 

or after January 1, 1986. 

Analysis 

Under the proposal, U.S. tax would apply more evenly to 

foreign corporations doing business in the United States than 

under present law. Thus the tax rules would no longer influence 

a foreign investor's decision whether to operate in the United 

States through a branch or a subsidiary. (Under current law a 

branch operation is generally subject to lower U.S. taxes than a 

subsidiary, if the subsidiary pays dividends.) The branch 

profits tax is also more easily administrable and enforceable 

than the "second dividend tax." It can be handled on the regular 

income tax form of the branch. 

There may be situations under bilateral income tax treaties 

with other countries where the availability of a dividends-paid 

deduction to a U.S. subsidiary of a company resident in the 

treaty country will result in heavier U.S. taxation of income 

earned through a U.S. branch of such company than through a 

subsidiary. In that event, consideration might be given to 

granting comparable corporate tax relief to branches of companies 

resident in the other country in the context of bilateral treaty 

negotiations. 

The proposed change is not likely to have a significant 

effect on flows of capital into the United States. The latest 

available data indicate that most foreign corporations operating 

in the United States through branches are in the finance, 

insurance and real estate industries, with most of the income 

attributable to branch banks. 

- 370 - 
IMPOSE INTEREST TREATMENT ON 

FOREIGN EXCHANGE GAINS AND LOSSES 

General Explanation 

Chapter 18.04 

Current Law 

The Federal income tax consequences with respect to the treatment 

of foreign exchange rate fluctuations have been uncertain because 

there is little guidance with respect to such matters in the tax code 

and regulations, and precedents such as cases, revenue rulings and 

technical advice memoranda have taken different positions on the same 

issues. 

Reasons for Change 

The uncertainty of current law leads to abuse by taxpayers, and 

whipsawing of the Internal Revenue Service. Over the long run, actual 

foreign exchange gains and losses adjust for differences in interest 

rates across currencies. In the case of hedging transactions, the 

adjustment is almost perfect even in the short run. Making the tax 

treatment correspond to business and economic reality reduces 

opportunities for tax abuse and whipsawing. 

Proposal 

Foreign exchange gain or loss on a business-related foreigncurrency-denominated asset that is hedged would be treated as an 

increase or decrease in the interest income from the asset. 

Similarly, foreign exchange gain or loss on a business-related 

foreign-currency-denominated liability would be treated as a decrease 

or increase in the interest expense on the liability. Gain or loss on 

the item, e.g., a forward contract, hedging the business-related 

foreign-currency-denominated asset or liability would also be treated 

as an adjustment in interest. As a result, foreign exchange gain 

would be sourced, and foreign exchange loss allocated and apportioned, 

in the same manner as interest. Although, as proposed, the change 

only would apply to hedged positions, further consideration will be 

given to extending these rules to all foreign currency-denominated 

assets and liabilities. 

Effective Date 

The modifications in the treatment of exchange gains and losses on 

business-related hedging transactions would be effective for 

transactions entered into after enactment. There would be no 

provisions for phase-in but there would be the opportunity for a 

taxpayer to elect grandfathering on hedging transactions that are open 

as of the date of enactment. 

- 311 - 
Analysis 

Treating exchange gains and losses as adjustments in interest 

would eliminate the uncertainty of current law and correspond to 

business and economic reality. Gains and losses are treated as 

adjustments in interest in other areas of the tax code. Treating 

gains and losses on hedging transactions as an addition to or 

subtraction from interest may be easily integrated with the tax 

straddle provisions in the tax code. Moreover, the proposed changes 

would eliminate the potential for abuse by taxpayers. Since the 

potential for tax abuse is largely a function of the currency in which 

the transaction is denominated rather than the substance of the 

transaction, transactions would continue to correspond to business and 

economic reality. Thus, eliminating the potential would not have an 

appreciable direct effect on economic behavior. 

- 312 - 
CHAPTER 19 

Transfer Taxation 

The Treasury Department proposals rel.ating to the estate, gift, 

and generation-skipping transfer taxes are designed to continue the 

process begun in 1976 of integrating these taxes into a unified 

system. To this end, the proposals would impose the gift tax on a 

tax-inclusive basis, would revise the rules governing when a transfer 

is complete for gift tax purposes, would revamp the 

generation-skipping transfer tax, and would revise the credit for tax 

on prior transfers consistently with the theory of the 

generation-skipping transfer tax. 

transfer taxes and curtail abuses and inequities. New valuation rules 

would apply to transfers of fractional interests in property; the 

rules for payment of estate tax in installments would be simplified 

and liberalized; the state death tax credit would be replaced with a 

flat-rate credit; the estate tax deduction for interest as an 

administration expense would be denied; and the powers-of-appointment 

rules would be revised. Finally, coordination with the income tax 

would be advanced by revising the rules relating to income and 

deductions in respect of a decedent, and repealing the special rules 

for redemption of stock to pay death taxes. 

The proposals also include a number of reforms to simplify the 

- 313 - 
UNIFY ESTATE WD GIFT TAX SYSTEMS 

General Explanation 

Chapter 19.01 

Current Law 

(referred to collectively as transfer taxes) are imposed using the 

same graduated rate structure. Under this unified rate structure, the 

marginal transfer tax rate applicable to any taxable transfer is 

determined by taking into account all prior transfers, whether made 

during lifetime or at death. Current law also provides a unified 

transfer tax credit, which is used to offset the transfer tax payable 

by a donor or a decedent's estate. The unified credit is being phased 

in gradually and will reach $192,800 in 1987; at that time, the credit 

will effectively exempt from transfer tax liability the first $600,000 

in otherwise taxable transfers made by an individual. 

The purpose of the single rate and unified credit structure is to 

ensure that the gift tax fulfills its function as a backstop to the 

estate tax; that is, gifts are subject to tax at the same rate and are 

treated like transfers at death for purposes of the unified credit. 

Unification of the gift and estate taxes is designed to ensure that 

taxes are a relatively neutral factor in an individual's decision 

whether to make a lifetime gift. In addition, since wealthier 

individuals are more likely to be financially able to make substantial 

lifetime gifts, taxing lifetime transfers and transfers made at death 

in the same manner helps to ensure fairness and progressivity in the 

overall transfer tax system. 

Although imposed at the same nominal rate as the estate tax, the 

gift tax is not imposed on the same tax base as the estate tax. The 

estate tax is imposed on the entire amount of the taxable estate, with 

no deduction or exclusion from the base for the portion of the estate 

that goes to pay the tax. Because the estate tax base includes the 

amount used to pay the tax, the estate tax is said to be imposed on a 

"tax-inclusive" basis. In contrast, the gift tax is imposed on a 

"tax-exclusive' basis (i.e., only the amount of property that actually 

passes to the donee is subject to tax). In addition, the first 

$10,000 transferred to each donee during a taxable year is excluded 

from the gift tax base. 

governing when a transfer is complete for purposes of applying the 

gift tax. In general, these rules provide that a gift will not be 

complete unless the donor has so parted with dominion and control over 

the property that he or she no longer possesses any power to change 

its disposition, whether for the donor or another. 

In General. Under current law, the estate tax and the gift tax 

Completion of Gift. Present law contains a complex set of rules 

- 374 - 
Transfers within three years of death. Any gift tax paid with 

respect to a gift made within three years of a decedent's death will 

be included in the decedent's gross estate for Federal estate tax 

purposes. In the case of a transfer by the decedent of the incidents 

of ownership of a life insurance policy on the life of the decedent 

within three years of death, the amount includible in the decedent's 

estate will be the proceeds of the policy rather than its value at the 

time of the gift. In effect, these rules cause any taxable gifts made 

within three years of the donor's death to be subject to tax on a 

tax-inclusive basis, as if the property had been retained by the donor 

until his death (although post-gift appreciation is not brought back 

into the donor's gross estate). 

The Retained Interest Rules. Because of the preferential tax 

treatment afforded to transfers by -- qift, the role of the sift tax as a 

backstop to the estate tax can be fully realized only if kles exist 

that prevent the structuring of a testamentary transfer in a form that 

qualifies such transfer for gift tax treatment. When applicable, the 

retained interest rules require the full date-of-death value of the 

transferred property (offset by any consideration received by the 

decedent on the initial transfer) to be included in the donor's 

estate. Such value will thus be subject to tax on a tax-inclusive 

basis, although a credit is given for any gift tax paid at the time of 

the original conveyance of the property. The most important of these 

rules are described briefly in the following paragraphs. 

Transfers with retained beneficial enjoyment. There must be 

included in a decedent's gross estate the date-of-death value of 

any property transferred during his lifetime by gift if the 

decedent retained for his lifetime possession or enjoyment of the 

property or the right to the income from the property. This 

estate tax rule applies even though the decedent reported the 

underlying transfer as a taxable gift and paid a gift tax on all 

or a portion of the value of the property. 

Transfers with retained control. A decedent's gross estate 

includes the fair market value of property previously transferred 

by gift where the decedent has retained for his lifetime "the 

right . . . to designate the persons who shall possess or enjoy 

the property or the income therefrom," or "a power . . . to alter, 

amend, revoke, or terminate" the transfer. As a practical matter, 

these two inclusion rules often provide overlapping coverage. 

The premise of these two provisions is that the power to 

determine the ultimate recipient of the property, or to control 

the time or manner of enjoyment of the property by the recipient, 

is a sufficient ownership interest in the property to cause it to 

be treated as if owned by the transferor. Thus, these provisions 

can apply even though the retained power did not give the decedent 

the power to revoke the transfer or otherwise to revest title in 

himself. 

- 375 - 
- Re 

Reversionary interests. Also included in the decedenti's 

gross estate is the value of any interest in property with respect 

to which the decedent has previously made a transfer and has 

retained a proscribed reversionary interest. This rule applies 

only if the value of the decedent's reversionary interest 

immediately before the death of the decedent exceeds five percent 

of the value of the property. 

sons for Ctiange 

Notwithstanding the policies supporting full unification of the 

estate and gift taxes, significant tax incentives remain for 

individuals to make lifetime gifts. Arguably, some of these tax 

advantages are justifiable because of practical considerations. For 

example, the $10,000 annual exclusion from gift tax is often justified 

as a threshold for application of the tax because of the compliance 

and administrative problems that otherwise would be created. The 

application of the same progressive rate schedule to all transfers, 

without adjustment for post-transfer appreciation in the value of the 

property, may also be justified because of simplicity and because a 

lifetime transfer deprives the donor of the use of the property and 

the use of any money used to pay gift tax on the transfer. 

be justified either on grounds of tax policy or administrative 

convenience. Specifically, neither tax policy concerns nor 

administrative convenience support application of the gift tax on a 

tax-exclusive basis while the estate tax is computed on a 

tax-inclusive basis. Such a rule hampers the overall fairness of the 

transfer tax system because the individuals it benefits are those who 

can afford to give away a significant portion of their property during 

life. Those individuals who are unable or unwilling to make lifetime 

gifts, and who therefore retain their property until death, are 

subject to tax at a higher effective rate. 

In addition, the preferential treatment accorded lifetime gifts 

encourages individuals to make lifetime transfers solely to reduce 

their overall transfer tax burden. The transfer tax system should not 

treat an individual wishing to retain his or her property until death 

either more or less favorably than it treats an individual wishing to 

make lifetime gifts. 

Finally, the preference given lifetime gifts has resulted in a 

complex and often arbitrary set of rules that attempt, with uneven 

results, to prevent taxpayers from taking unintended advantage of the 

preference. In some cases, these rules do not fully remove the 

preference given to lifetime gifts; in others, the rules are punitive 

and cause transfer tax consequences that are more severe than if the 

individual had not made a lifetime gift. 

On the other hand, some of the advantages of lifetime gifts cannot 

- 376 - 
Proposal 

unification of gift and estate taxes 

The gift tax would be computed on a tax-inclusive basis. Under 

this system, the gift tax payable on a transfer of a fixed net amount 

to a donee would be determined by calculating the gross amount that, 

when subject to the transfer tax rate schedule, would be sufficient to 

pay the gift tax on the transfer and leave the net amount for the 

donee. Stated differently, the amount of the gift would be "grossed 

up" by the amount of the gift tax payable with respect to the 

transfer. The tax imposed on a decedent's estate would be computed by 

adding the amount of the decedent's taxable estate to the sum of the 

decedent's adjusted taxable gifts and the gift tax paid by the 

decedent. 

In order to prevent taxpayers from having to make somewhat 

complicated gross-up calculations, the gross-up factor would be built 

into the rate table contained in the statute. Under this method, the 

stated rate applicable to gifts would be higher than the stated rate 

applicable to estates, but the effective rate imposed on a net 

transfer would be the same regardless of whether subject to the gift 

tax or the estate tax. Assuming that the rates of present law remain 

in effect, and that the 50 percent maximum effective transfer tax rate 

and the $600,000 credit-equivalent are fully phased in, the gift tax 

rates would be as set forth in Table 1. 

- 311 - 
Table I 

Gift Tax Rates Imposed on Tax-Inclusive Basis 

Net Amount Transferred Tax Payable After Credit 

0 - $600,000 0 

over $600,000 but not 

over $694,500 

over $694,500 but not 

over $847,000 

over $847,000 but not 

over $994,500 

over $994,500 but not 

over $1,137,000 

over $1,137,000 but not 

over $1,412,000 

over $1,412,000 but not 

over $1,667,000 

over $1,66'7,000 

58.73 percent of amount over 

$600,000 

$55,500 plus 63.93 percent of 

amount over $694,500 

$153,000 plus 69.49 percent of 

amount over $847,000 

$255,500 plus 75.44 percent of 

amount over $994,500 

$363,000 plus 81.82 percent of 

amount over $1,137,000 

$588,000 plus 96.08 percent of 

amount over $1,412,000 

$833,000 plus 100 percent of 

amount over $1,667,000 

Simplification of Rules Pertaining to Completed Gifts and 

Testamentary Strings 

Application of the gift tax on a tax-inclusive basis would 

eliminate the major disparity between the transfer tax treatment of 

lifetime gifts and transfers at death. Therefore, it would be 

possible to eliminate the rule requiring inclusion in the gross estate 

of gift taxes paid on transfers made within three years of death. The 

complex retained interest rules would be replaced with a simpler set 

of rules determining when a transfer of less than an entire interest 

constitutes a completed gift for Federal transfer tax purposes. These 

new rules would ensure that a transfer is subject to gift or estate 

tax, but not to both taxes. In addition, the rules would assure a 

more accurate valuation and provide greater consistency between the 

transfer tax rules and the rules governing when trust income is taxed 

at the grantor's rate. 

Retained beneficial enjoyment. The proposal would simplify 

present law bv providins that a transfer tax would be imposed onlv 

;once, when the beneficial enjoyment retained by the dono; terminaces. 

Thus, if a donor makes a gift of a remainder interest in property, but 

retains the intervening income interest, no gift would occur until the 

- 378 - 
termination of the donor's income interest. At that time, the 

property would be subject to gift or estate tax at its full fair 

market value. Because the transferor would be treated as the owner of 

the property during the interim, any distributions made to 

beneficiaries other than the transferor would be treated as transfers 

when made. 

The transferor would continue to be treated as owner of the 

property for all transfer tax purposes. Such treatment would 

foreclose any opportunity for tax avoidance through the transferor's 

repurchase of the remainder interest free of gift tax. 

The proposal would also apply to the creation of inter vivos 

charitable lead trusts. The creator of such a trust would be treated 

as owning the property for transfer tax purposes until the vesting of 

the non-charitable interest or his or her death, if sooner. 

(Testamentary charitable lead trusts would be taxed as under present 

law. ) 

Revocable transfers. The rules of present law would continue with 

respect to any transfer where the transferor retains the right to 

regain possession or enjoyment of the property. Such a transfer would 

be treated as incomplete for gift and estate tax purposes, and would 

be treated as complete only when the transferor's retained right or 

power to revoke terminates. Distributions from the property to 

beneficiaries other than the donor would be treated as gifts when 

made, thereby providing consistency with the rules governing the 

income taxation of trusts as well as the rules governing the income 

and gift tax treatment of demand loans. 

Retained powers. In determining whether a gift is complete for 

transfer tax purposes, the proposal would treat a retained power to 

control the beneficial enjoyment of the transferred property as 

irrelevant where the power could not be used to distribute income or 

principal to the donor. Thus, the fact that the transferor as trustee 

or custodian can exercise control over the identity of the distributee 

of the property or over the amount or timing of a distribution would 

be irrelevant in determining whether a gift is complete (although such 

factors may be relevant in determining whether the transfer qualifies 

for the annual gift tax exclusion). Under this rule, a transfer would 

be complete for gift tax purposes where the grantor creates an 

irrevocable trust but retains the absolute right to determine who 

(other than himself) will receive the trust income or principal. 

Reversionary interests. Current rules regarding retained 

reversionary interests would be replaced by a rule that disregards 

reversionary interests retained by the grantor in valuing transferred 

property for Federal gift tax purposes. The existence of the 

reversionary interest would be relevant only for purposes of 

determining the timing of the transfer for estate and gift tax 

purposes. 

- 379 - 
If the donor makes a gift of property for a term of years or for 

the life of one or more beneficiaries, and if the donor retains a 

reversionary interest that is more likely than not to return the 

property to the donor or his or her estate, the transfer would be 

treated as incomplete. Interim distributions of income or principal 

(or the value of the use of the property) would be treated as gifts by 

the donor on an annual basis. On the other hand, if it is more likely 

than not that the reversionary interest will not return the property 

to the donor or his or her estate, the transfer will be treated as 

complete and the full fair market value of the property will be 

subject to gift tax, without reduction for the actuarial value of the 

reversionary interest. If the donor dies with the reversion 

outstanding, the value of the reversionary interest will be excluded 

from the donor's estate, whether or not the reversion terminates at 

that time. If the property reverts to the donor prior to his or her 

death, the donor would have the right to retransfer the property at 

any time free from additional gift tax liability. If not 

retransferred during the donor's lifetime, the property would be 

excluded from the donor's estate. In order to prevent disputes 

arising from the reversion and subsequent retransfer of fungible 

assets, however, the proposal would require the donor to place the 

reverted property in a segregated account in order to benefit from the 

exclusion. 

The determination of whether a reversionary interest is more 

likely than not to return property to the donor during his lifetime 

generally would depend on the life expectancy of the donor and the 

anticipated duration of the intervening interest. For example, a 

reversion following a term of years less than the donor's life 

expectancy or following the life of a beneficiary older than the donor 

would be more likely than not to return the property to the donor. 

Similar actuarial determinations would be made for multiple 

intervening income beneficiaries. These rules are the same as those 

that would apply in determining whether a trust that may revert to the 

grantor is entitled to an income tax deduction for distributions (or 

whether trust income is taxed at the grantor's rate). See Chapter 

3.25. 

Effective Dates 

The proposal would apply generally to lifetime transfers made on 

or after January 1, 1986. For this purpose, any transfer that is 

revocable on the effective date would be treated as occurring when it 

becomes irrevocable. In addition, the gift tax paid with respect to 

post-1976 gifts made prior to the effective date would be included in 

the decedent's adjusted taxable gifts solely for the purpose of 

determining the transfer tax rate applicable to the decedent's estate. 

gifts made before 1986 with respect to the same property would be 

subject to the following transition rules: 

With respect to transfers occurring on or after January 1, 1986, 

- 380 - 
Retained Beneficial Enjoyment. If prior to the effective date a 

donor has made an irrevocable transfer and has retained current 

beneficial enjoyment over the property, the proposal would apply and 

on termination of the donor's interest the full value of the property 

would be treated as a taxable transfer. Similarly, any interim 

distributions would be treated as taxable gifts when made. If the 

donor paid gift tax on the original transfer, he or she would have 

until the end of 1986 to claim a refund (with interest) of the tax 

paid. If the donor was required to file a gift tax return, but did 

not pay any gift tax on the original transfer because of the 

availability of the unified credit, the portion of the credit so 

utilized would be made available to offset tax liability on future 

transfers . 

Reversionary Interests. The transition rule applicable to a 

pre-1986 irrevocable transfer with a retained reversionary interest 

would depend on whether the transfer would have been treated as a 

completed gift if made after the effective date. If the transfer 

would have been treated as incomplete because, at the time of the 

gift, the property was more likely than not to revert to the donor, 

and the property has not reverted to the donor at the time of his or 

her death, then the property would be included in the donor's estate 

at its fair market value on the date of his death. To avoid double 

taxation in such cases, the earlier transfer would not be included in 

computing adjusted taxable gifts and a credit would be available for 

any gift tax paid at the time of the original gift. 

If the proposal would have treated the transfer as complete when 

made because the property was not likely to revert to the donor, the 

amount includible in the donor's estate would depend on whether the 

reversion was reflected in the value of the initial gift. If the full 

value of the property had been taxed at the time of the initial gift, 

with no reduction for the reversion, then no amount would be 

includible in the donor's estate by reason of the reversionary 

interest. On the other hand, if the donor discounted the value of the 

original gift to reflect the actuarial value of the reversionary 

interest, then the amount includible in the donor's estate would be 

the fair market value of the property at the time of his or her death 

multiplied by the percentage of the value excluded from the original 

gift by reason of the reversion. 

Retained Controls. If the donor has made a pre-1986 transfer 

treated as an incomplete gift under present law, then the proposal 

would be fully applicable to such transfer as of the effective date. 

Thus, the relinquishment of the retained control, whether during 

lifetime or at death, would be treated as a taxable transfer. In 

addition, the donor would have until the end of 1986 to elect to treat 

the fair market value of the property on January 1, 1986 as a taxable 

gift (on a tax-inclusive basis) without relinquishing the retained 

control (assuming the donor has retained no other interest in the 

property); the making of such election would exclude any subsequent 

appreciation from the donor's transfer tax base. 

- 381 - 

459-813 0 - 84 - 14 
If the pre-1986 transfer was treated as a partially completed gift 

when made, then the full value of the property would be subject to 

transfer tax when the retained control is relinquished, but a credit 

would be given for the gift tax previously paid and the prior transfer 

would be disregarded in computing the transferor's adjusted taxable 

gifts. As in the first case, the donor would have until the end of 

1986 to elect to treat the fair market value of the property on 

January 1, 1986 as a taxable gift without relinquishing the retained 

control. 

Finally, if the donor has previously made a transfer constituting 

a completed gift, so that the full value of the property subject to 

the power was subject to transfer tax, then the property would not be 

includible in the donor's estate (assuming the donor's death occurs on 

or after January 1, 1986). 

Analysis 

Application of the gift tax on a tax-inclusive basis would remove 

the primary tax incentive for lifetime gifts and therefore would make 

tax considerations a relatively neutral factor in the decision whether 

to dispose of property during one's lifetime or to retain it until 

death. Moreover, the proposal would provide greater fairness in the 

application of the transfer tax system because all persons paying the 

transfer tax would do so on the same tax-inclusive basis. Finally, by 

removing the major incentive for disguising testamentary transfers as 

lifetime gifts, the proposal would permit the simplification of the 

rules governing when a transfer is complete for estate and gift tax 

purposes. 

The proposed rules for determining when a transfer is complete 

would ensure that each transfer is subject to estate or gift tax, but 

not to both taxes. By delaying the imposition of transfer tax 

liability until the donor's interest terminates, the proposed rules 

would reduce the number of instances in which it is necessary to 

consult an actuarial table to value the transfer of a partial interest 

in property and would provide greater accuracy in the valuation of the 

transferred interest. 

Finally, the proposal would provide greater consistency between 

the gift tax rules governing when a transfer is complete and the rules 

governing when trust income is taxed at the grantor's rate. 

It is anticipated that the proposal would result in a revenue 

increase in the year prior to the effective date because of an 

increase in the number of tax-motivated gifts designed to take 

advantage of present law. Because many donors are likely to 

accelerate gifts prior to the effective date, and because 

tax-motivated gifts would be greatly reduced by the proposal, gift tax 

collections should be lower in years after the effective date. On the 

other hand, since all transfers would be subject to tax on a 

tax-inclusive basis, the increase in estate tax revenues would 

eventually outweigh the decline in gift tax revenues; hence, the 

- 382 - 
present value of total transfer tax collections would increase. Over 

time, this may permit some reductions in transfer tax rates; however, 

because the increase in estate tax revenues probably would not exceed 

the decline in gift tax revenues for a number of years, it is not 

possible to propose rate reductions at this time. 

- 383 - 
REVISE POWER OF APPOINTMENT RULES 

General Explanation 

Chapter 19.02 

Current Law 

A decedent's gross estate includes all property with respect to 

which the decedent possessed a "general power of appointment" at the 

time of his or her death. For purposes of this rule, the term 

"general power of appointment" is defined as a power given the holder 

by another (rather than a power created by the holder) enabling the 

holder to appoint the property to the holder or the holder's estate, 

or to creditors of either. The purpose of this rule is to include in 

a decedent's estate property with respect to which the decedent 

possessed virtually the same control as if the property were owned 

outright. Thus, a power will not be classified as a general power of 

appointment if it can be exercised only in conjunction with the 

creator of the power or in conjunction with a person having a 

"substantial interest" in the property that would be adversely 

affected by the exercise of the power of appointment. Moreover, a 

power will not be classified as a general power of appointment if the 

ability to exercise the power is limited by an "ascertainable 

standard" relating to the support, health, education, or maintenance 

of the holder. 

Reasons for Change 

The present rules governing general powers of appointment are 

largely ineffective. They can be circumvented easily by creation of a 

power that is purportedly limited by an ascertainable standard but 

that, in reality, gives the holder substantial discretion and control 

over the trust property. 

In addition, present law can often trap the unwary taxpayer. For 

example, the general power of appointment rule may be invoked where 

neither the creator of the power nor the donee of the power is aware 

that a particular power is likely to be construed as a general power 

of appointment. To a great extent, this uncertainty exists because 

State law determines whether a limitation placed on the exercise of 

the power constitutes an "ascertainable standard." Thus, unless a 

standard is used that is identical with the language of the statute or 

the regulations, construction of the standard for Federal transfer tax 

purposes must generally await a construction of the language under 

State law. 

be unnecessary if application of the generation-skipping tax would 

ensure that a transfer tax is collected at the decedent's generation. 

See Chapter 19.04, relating to modifications of the 

generation-skipping tax. 

Finally, the general power of appointment rule would in many cases 

- 384 - 
Proposal 

The current power of appointment rules would be replaced by a rule 

treating an individual as the owner of property for transfer tax 

purposes where the individual possesses a nonlapsing right or power to 

vest the property or trust corpus in himself or herself. For purposes 

of this rule, a power or right would be treated as nonlapsing if it 

did not, by its terms, expire prior to the death of the powerholder. 

The release of such a power (or the extinguishment of such a power 

at death) would be treated in the same manner as a transfer by the 

outright owner of the underlying property. Thus, for example, if the 

holder of a power releases the power and retains an income interest in 

the property which would cause a gift of the property to be treated as 

incomplete, he or she would continue to be treated as the owner of the 

property for Federal transfer tax purposes. 

Effective Date 

The proposal would apply generally to powers held by individuals 

dying after January 1, 1986, without regard to when the power was 

created. The proposal would also apply to powers that are exercised 

or relinquished by individuals on or after January 1, 1986, again 

without regard to when the power was created. Special rules would 

provide that property previously qualifying for the estate or gift tax 

marital deduction would be subject to transfer tax on the exercise or 

release of the power by, or on the death of, the transferee spouse. 

Analysi 6 

In general, the proposal would treat an individual as possessing a 

general power of appointment over property under circumstances similar 

to those in which the individual would be treated as the owner of 

trust property for Federal income tax purposes. Although a power of 

appointment might not result in the inclusion of property in the gross 

estate of the person holding the power, the property would potentially 

be subject to tax under the generation-skipping transfer tax rules. 

The proposal would simplify the treatment of powers of appointment 

for Federal transfer tax purposes, and would make the transfer tax 

rules and the income tax rules more consistent. By eliminating the 

importance of determining whether an "ascertainable standard" exists 

or whether another person whose consent is required possesses an 

"adverse interest," the proposal would also remove some of the 

unexpected consequences that can arise from the creation of such a 

power . 

- 385 - 
REVISE FEDERAL GIFT TAX PROPERTY VALUE DETERMINATION 

General Explanation 

Chapter 19.03 

Current Law 

purposes at its fair market value, in general the price it would bring 

in a transaction between a willing buyer and a willing seller, neither 

being under any compulsion to buy or to sell and both having 

reasonable knowledge of all relevant facts. Thus, property 

transferred by gift is not valued by reference to the amount by which 

it increases the value of the donee's estate, nor is it valued by 

reference to the amount by which it decreases the value of the donor's 

estate. 

Reasons For Change 

be the same regardless of whether such value is determined by 

reference to the separate value of the property, the diminution in 

value of the transferor's estate, or the enhancement in value of the 

transferee's estate. In other instances, however, these measures of 

value can vary greatly. This is particularly true in the case of 

transfers of minority interests in closely held businesses and 

undivided interests in assets such as real estate. These interests 

are often valued, for transfer tax purposes, at significant discounts 

from their pro rata share of the value of the underlying business or 

asset. 

Property transferred by gift is valued for Federal gift tax 

In most instances, the value of property transferred by gift will 

For example, assume that A owns 100 percent of the outstanding 

stock of X, and that the value of A'S stock in X is $1,500,000. If A 

transfers ten percent of the X stock to B, A may claim that for 

Federal gift tax purposes the value of the ten percent block of stock 

is as little as $90,000, reflecting a discount of as much as 40 

percent from the proportionate share of the total value of the 

corporation. If A makes such gifts annually for six years, A may 

claim that the aggregate gift tax value of the 60 percent interest is 

only $540,000. Moreover, if A dies holding the remaining 40 percent 

block, A'S estate may claim a minority discount on that stock. Tf 

those values are sustained, A has transferred stock worth $1,500,000, 

but for Federal estate and gift tax purposes has made transfers 

aggregating only $900,000. 

Minority or fractional-share discounts enable taxpayers to 

structure transfers so as to reduce the aggregate value of property 

brought within the transfer tax base. This is inconsistent with the 

underlying purpose of the gift tax, which is to serve as a backstop 

- 386 - 
for the estate tax. Moreover, the overall reduced value of the 

property as it is reported for transfer tax purposes is inconsistent 

with economic reality. 

Proposal 

The value for transfer tax purposes of a fractional interest in 

any asset owned, in whole or in part, by a donor or decedent would be 

a pro rata share of the fair market value of that portion of the asset 

owned by the donor or decedent. Prior gifts of fractional interests 

in the asset, as well as any fractional interests in the asset held by 

the transferor's spouse, would be attributed to the donor or decedent 

for purposes of determining the value of the fractional interest 

transferred. A fractional interest in an asset would include shares 

of stock in a corporation, partnership units, or similar interests in 

a single entity or asset. Rules would be provided to aggregate (or 

segregate) two different interests in property based upon the 

criterion of whether the ownership by the transferor of one such 

interest affects the valuation of the other such interest. For 

example, two publicly held classes of stock in a corporation generally 

would be valued independently. 

This special valuation rule would apply to transfers of fractional 

interests, however, only if the donor retains a fractional interest 

after the gift or has previously made a gift of a fractional interest 

in the asset. This special valuation rule would also apply for 

purposes of determining whether a sale by the donor to a related party 

constitutes a transfer for less than an adequate and full 

consideration. 

The proposal can be illustrated by the following examples. 

Example. A owns 60 percent of the outstanding stock of a 

corporation worth $100~. A, whose controlling interest is worth $70x, 

transfers one-half of his interest to B. The value of the gift for 

gift tax purposes is $35~ (i.e., 50 percent of the value of A'S 60 

percent block of stock). If A retains his remaining 30 percent block 

until his death, the estate tax value of such block will be 50 percent 

of the value of a 60 percent block of stock at the date of A'S death. 

corporation worth $l00x. B's minority interest is worth $30x, and B 

transfers one-half of her interest to A. The value of the gift to A 

would be $15x, i.e., 50 percent of the value of the 40 percent block 

possessed by B immediately prior to the gift. However, if B's spouse 

S owned stock representing 20 percent of the corporation, so that the 

combined interest of S and B was worth $75x, the value of the gift to 

A would be $25x, (i.e., 33-1/3 percent of the value of the 60 percent 

block held jointly by B and S). 

Example. B owns 40 percent of the outstanding stock of a 

- 387 - 
The proposal would contain rules to prevent unfairness or abuse 

that could result from an individual's acquisition and subsequent 

transfer of a fractional interest in an asset after having made a gift 

of a fractional interest in the same asset. 

Effective Date 

The proposal would apply to transfers occurring and estates of 

decedents dying on or after January 1, 1986. In the case of donors 

who have transferred fractional interests in property prior to January 

1, 1986 at a discount, the proposal would apply to any subsequent 

transfers of fractional interests in the same property without regard 

to the discounts obtained on the prior transfers. In those cases 

where a prior transfer of a fractional interest was valued at a 

premium, subsequent transfers of minority interests in the same 

property would be discounted by an appropriate factor to reflect the 

premium on the prior transfer. For example, if a donor owning all 100 

shares of a corporation worth $100~ transferred 60 of those shares 

prior to the effective date in a gift valued for Federal gift tax 

purposes at $75x, transfers of all or any of the remaining 40 shares 

after the effective date would be discounted by 37.5 percent. This 

ensures that if the total value of the corporation remains at $10Ox, 

the aggregate value of the remaining shares for transfer tax purposes 

would be $25~. 

Analysis 

By valuing fractional interests in property on the same basis 

regardless of whether such interests are transferred during lifetime 

or at death, the proposal would prevent the erosion of the transfer 

tax base through lifetime transfers aimed at artificially reducing the 

value of property. The proposal would support the full unification of 

the estate and gift taxes and would ensure that lifetime transfers are 

treated no more favorably than transfers at death. 

- 388 - 
SIMPLIFY GENERATION-SKIPPING TRANSFER TAX 

General Explanation 

Chapter 19.04 

Current Law 

As part of the Tax Reform Act of 1976, Congress enacted a new tax 

on certain yeneration-skippiny transfers. This tax, designed to be 

separate from but complementary to the estate and gift taxes, applies 

to yeneration-skippiny transfers effected through "yeneration-skippiny 

trusts" and "trust equivalents." A yeneration-skippiny trust is one 

that has two or more generations of beneficiaries who belong to 

generations that are younger than the generation of the grantor of the 

trust. The tax is imposed when the generation-skippiny transfer 

actually occurs and is substantially equivalent to the tax that would 

have been imposed if the property had actually been transferred 

outright to each successive generation. 

An exception is provided for transfers under irrevocable trusts in 

existence on June 11, 1976, other than transfers attributable to 

corpus added to such trusts after that date. Additionally, in the 

case of any decedent dying before January 1, 1983, the tax does not 

apply to transfers pursuant to the decedent's will (or a revocable 

trust that becomes irrevocable by reason of the decedent's death) if 

the will (or revocable trust) was in existence on June 11, l976, and 

was not amended (except in ways that did not create, or increase the 

amount of, a yeneration-skippiny transfer) at any time after that 

date. 

The tax generally applies to transfers made after June 11, 1976. 

Reasons for Change 

The principal problems with the present generation-skippiny 

transfer tax (GST tax) may be summarized as follows: 

o Scope - Every trust, no matter how small, that has 

beneficiaries in two or more generations below the grantor is a 

generation-skipping trust subject to the provisions of the GST 

tax. Yet such trusts are found in even the simplest of wills, 

often drafted by general practitioners whose knowledge of the 

intricacies of the GST tax is necessarily limited. 

because the amount of tax depends on the identification of a 

"deemed transferor" and a calculation based on that 

individual's transfer tax profile. This makes the GST tax 

difficult to understand, even for tax practiti,oners who 

specialize in estate planning, and can be a major complicating 

factor in advising clients. The complexity of the current GST 

tax also makes it unduly difficult to administer. 

o Complexity - The GST tax is extremely complex, primarily 

- 389 - 
o Effectiveness - Because of its numerous exceptions, the GST tax 

is ineffective against many generation-skipping arrangements. 

The wealthiest transferors can avoid the tax at the generation 

level of their children (and grandchildren) by layering, i.e., 

passing large portions of their wealth directly to their 

grandchildren (and great-grandchildren). Moreover, the present 

GST tax exempts distributions of income from 

generation-skipping trusts, thereby permitting a substantial 

amount of property to avoid the tax. Thus, in many cases the 

GST tax encourages taxpayers to adopt more complex estate plans 

that deviate further from their natural dispositive 

preferences. 

o Fairness - The scope and ineffectiveness of the present GST tax 

are also sources of unfairness. Both factors discriminate in 

favor of the "super wealthy" as compared to families of more 

modest wealth. The wealthiest families are in a much better 

position to incur the cost of the highly sophisticated tax 

advice and administrative fees necessary to understand and 

exploit the present statute. Moreover, the wealthiest 

individuals can better afford to layer their estates in a 

manner that avoids the GST tax. 

P r oposal 

Simplify and Improve the Generation-Skipping Transfer Tax. A draft of 

statutory language to implement this proposal was released on November 

9, 1983, with subsequent drafts released on January 6, 1984 and 

February 2, 1984. The proposal also formed the basis for H.R. 6260, a 

bill introduced in the 98th Congress on September 18, 1984. Treasury 

incorporates into its proposals for fundamental tax reform the April 

29, 1983 GST tax proposal, with only one significant modification 

(discussed below). 

GST tax system. 

On April 29, 1983, the Treasury Department released A Proposal to 

The proposal would make three fundamental changes in the present 

Exemption of $1,000,000 Per Grantor 

First, every individual would be permitted to make transfers 

aggregating as much as $1,000,000, during lifetime and at death, which 

would be wholly exempt from the GST tax. This exemption would be 

freely transferable between spouses, so that a married couple would 

have an exemption of $2,000,000 without regard to which spouse makes 

the transfer. 

Flat Rate Tax on Non-Exempt Transfers 

Second, generation-skipping transfers not covered by the 

$1,000,000 exemption would be taxed at a flat rate equal to 80 percent 

of the highest estate tax rate in effect at the time of the transfer. 

This means that for taxable generation-skipping transfers after 1987, 

- 390 - 
the tax rate would be 40 percent. The substitution of a flat cate for 

a tax computation based on the tax profile of a deemed transferor 

would be a major simplification over present law. 

April 29, 1983 (alluded to above) is that under the current proposal 

the tax would be imposed uniformly on a "tax-inclusive" basis. This 

further simplification is made possible by the proposed change under 

which the gift tax would also be imposed on a tax-inclusive basis. 

See Chapter 19.01. 

The difference between the current proposal and that of 

Taxation of All Generation-Skipping Transfers Not Covered by the 

$1,0~0,000 Exemption 

Third, subject to the $1,000,000 exemption given each transferor 

and the other exclusions noted above, the proposal would apply a GST 

tax to property when all interests in the property are transferred to 

or held for the benefit of recipients at least two generations below 

that of the transferor without the payment of estate or gift tax in an 

intervening generation. Thus, the GST tax would apply immediately to 

outright transfers to any person two or more generations below the 

transferor and to any transfer in trust for the exclusive benefit of 

one or more such beneficiaries. However, transfers to trusts where a 

member of the grantor's generation or the generation of the grantor's 

children has an interest would not be subject to immediate tax. AS 

under present law, the tax in that case would be postponed until 

actual distributions are made to lower generation beneficiaries or 

until all interests of the higher generation beneficiaries terminate, 

at which time the tax would be imposed on the value of the distributed 

property or the property remaining in the trust. Unlike the present 

GST tax, however, the proposed GST tax would not provide an exclusion 

for income distributions. Instead, an income tax deduction would be 

provided for the GST tax imposed on such income distributions. 

Further details of this proposal may be found by consulting the 

April 29, 1983 proposal. Of course, the examples set forth at the end 

of that proposal must be modified to take into account the imposition 

of the tax on a tax-inclusive basis. See also Chapter 19.05, relating 

to the credit for tax on prior transfers. 

Effective Date 

all transfers from irrevocable trusts created on or after the date of 

enactment of the proposal, and to all direct generation-skipping 

transfers made on or after that date. The proposal would not apply, 

however, to generation-skipping transfers (either outright or in 

trust) under wills or revocable trusts of decedents dying before the 

date which is one year from the date of enactment. The effective date 

would be extended for testators who are incompetent on the date of 

enactment. This one-year transition rule would give estate planners 

time to understand the new rules and to adjust their planning 

accordingly. 

In general, the GST tax imposed under this proposal would apply to 

- 391 - 
The existing tax 011 generation-skipping transfers would be 

repealed retroactively, so that no trust would ever be subject to the 

provisions of that tax. 

Analysi s 

A transfer tax system without a GST tax is unfair. Without a GST 

tax the wealthiest families will pay a transfer tax on their 

accumulated wealth only once in every two or three generations. 

Families of more modest wealth may be reluctant or unable to enter 

into generation-skipping arrangements. This disparity greatly 

undermines the progressivity and equity of the Federal transfer tax 

system and, ironically, results in a system that taxes wealth that an 

individual has accumulated during his own lifetime more harshly than 

wealth that has been inherited. 

Once the proposed GST tax becomes fully effective, transfer taxes 

should play a significantly reduced role in taxpayers' estate 

planning. Those taxpayers who wish to leave their property outright 

to their children would be free to do so, knowing that they are not 

missing a significant tax avoidance opportunity through the creation 

of a multi-generational trust or through direct transfers to 

grandchildren. On the other hand, those who wish to use flexible 

trusts or to make direct transfers to grandchildren would not be 

penalized. No matter how the assets are transferred, a transfer tax 

of roughly comparable magnitude would be collected once in each 

gene rat ion. 

Of course, the proposed $1,000,000 exemption and the flat rate of 

tax mean that the system would not be perfectly neutral. Moreover, to 

avoid unfairness, the system has been designed so that in virtually 

every case the GST tax that would be imposed on a generation-skipping 

arrangement is less than the estate or gift tax that would be avoided. 

This means that some benefit from making generation-skipping transfers 

would remain in the system. It is impossible, however, to eliminate 

the residual benefit for generation-skipping transfers without 

reintroducing the scope and complexity problems that are present in 

current Law. The proposal represents a reasonable compromise between 

the concerns of neutrality and effectiveness, on the one hand, and 

simplicity on the other. Most importantly, the proposal would 

introduce a degree of overall fairness that has heretofore been absent 

in the transfer tax system. 

- 392 - 
EXPAND CREDIT FOR TAX ON PRIOR TRANSFERS 

General Explanation 

Chapter 19.05 

Current Law 

If a decedent's estate includes property that was transferred to 

the decedent in the ten years preceding (or the two years following) 

the decedent's death and was the subject of an estate tax in the 

estate of the transferor, the decedent's estate is given a credit for 

the prior estate tax paid with respect to that property. The credit 

phases out over time, in two-year brackets. Thus, a full credit is 

given if the decedent dies within two years of the prior death, an 80 

percent credit is given if the decedent dies more than two years but 

not more than four years after the prior death, and so on. 

Reasons for Change 

In certain situations, the current credit for tax on prior 

transfers is inconsistent with the rationale underlying the proposed 

tax on generation-skipping transfers, i.e., that the transfer tax 

ought to be imposed once per generation. For example, if A leaves 

property to his brother B, and if B dies more than two years after A, 

the property will be subject to more than one full estate tax in the 

generation of A and B. If B dies more than ten years after A, the 

property will be subject to two full estate taxes in that generation. 

payable at B's death by leaving the property in trust for B's benefit 

during his lifetime or by giving B a life estate in the property. 

Both these alternatives, however, require advance planning and entail 

administrative costs. More significantly, they place restrictions on 

B's use of the property that A may not wish to impose. 

In many cases, A can avoid the necessity of a second estate tax 

Proposal 

In a case where a decedent's estate includes property inherited 

from a member of the same generation or a lower generation, a full 

estate tax credit would be given to the estate for any estate tax paid 

by the original transferor of the property. The credit would not 

phase out over time. 

Effective Date 

The proposal would apply to estates of decedents dying one year 

after enactment of the proposal. 

- 393 - 
Analysis 

As with the proposal regarding the GST tax (Chapter 19.04), this 

proposal would make the transfer tax system fairer and a more neutral 

consideration for taxpayers in planning their estates. The system 

would be fairer because those taxpayers who wish to transfer property 

to a parent or sibling before the property passes to members of lower 

genesations would not be penalized vis-a-vis the taxpayers who do not 

make such transfers and taxpayers who use trusts or life estates. The 

system would be more neutral because nontax considerations would 

generally determine the form of ownership for transfers of property. 

- 394 - 
REVISE RULES FOR INSTALLMENT 

PAYMENT OF ESTATE TAX 

General Explanation 

Chapter 19.06 

Current Law 

Payment of the estate tax can be deferred under two provisions of 

current law. Section 6161 gives the Internal Revenue Service the 

discretion to grant a one-year extension or a longer extension (up to 

ten years) upon a showing of reasonable cause. If the time for 

payment of estate tax is extended under this provision, interest on 

the tax liability must be paid at the generally applicable rate. 

Section 6166 allows the estate tax to be paid in ten annual 

installments beginning with the fifth year after the due date of the 

return in certain cases where a farm or closely held business 

comprises a substantial portion of the estate. Where section 6166 

applies, the portion of the estate tax that can be deferred is limited 

to the portion attributable to the inclusion of the closely held 

business interest in the decedent's estate. 

No showing of reasonable cause for the deferral is required under 

section 6166. In addition, the interest rate payable under that 

provision on the first $345,800 of tax (reduced by the unified credit) 

is four percent. Once the unified credit is fully phased in (in 

1986), the amount of deferred tax eligible for four-percent interest 

will be $153,000. Interest on estate tax in excess of that amount is 

payable at the generally applicable rate. 

Reasons for Change 

The estate tax deferral provisions of current law need to be 

harmonized and modified to ensure that deferral is available only when 

appropriate. Clear standards should make it easy for taxpayers to 

determine when deferral is available and adequate interest on the 

deferred tax liability should always be charged. 

In many cases, the provisions of section 6166 allow deferral of 

estate tax for a period longer than is warranted. Tax may be deferred 

even though sufficient liquid assets to pay the tax are on hand. 

These assets together with income of the estate may in fact be 

distributed to beneficiaries without accelerating the estate tax 

payment schedule. 

Conversely, estates that do not meet the mechanical rules of 

section 6166 may be unable to obtain deferral under section 6161 for 

more than one year even though a longer deferral period may be 

justified. This uncertainty under section 6161 stems from the absence 

of any fixed rules for determining when the reasonable cause standard 

is satisfied. 

- 395 - 
Finally, the four-percent interest rate available under section 

6166 for qualifying estates effectively reduces the estate tax burden 

on those estates with no tax policy justification. On the other hand, 

as long as the interest charge is adequate, it seems appropriate to 

allow deferred payment of estate tax under a fairly liberal standard. 

Proposal 

Section 6166 would be replaced with a provision that, when 

applicable, would allow all or a portion of the estate tax to be paid 

over a period of up to 15 years, with interest only for up to five 

years, and payment in ten annual installments thereafter. Eligibility 

would be based on the lack of cash or readily marketable assets that 

the estate has on hand, not on whether the estate holds assets of a 

closely held business. Interest on amounts deferred would be payable 

at the rate generally applicable to overpayments and underpayments of 

tax. 

An initial one-year extension of time to pay the tax would be 

automatically available. Upon expiration of this period the amount of 

cash and readily marketable assets held by the estate would be 

determined. The amount of tax payable in installments would be the 

excess of the total estate tax liability over 75 percent of the 

estate's available cash and marketable assets. Administration 

expenses and debts of the estate paid prior to the determination date 

would therefore reduce the amount of available cash and make 

eligibility for deferral more likely. In addition, available cash 

would be reduced by any unpaid State or foreign death taxes. Cash and 

marketable property distributed to beneficiaries or converted into 

nonmarketable property would, however, be added back to cash on hand. 

available cash and readily marketable assets would be recomputed. 

Shortly after each such date, the estate would have to apply toward 

its tax and interest liability an amount equal to 75 percent of any 

excess of such amount over the highest amount of cash and marketable 

property previously remaining after payment of estate tax and 

interest. For example, if the estate previously had $100~ in cash and 

had to pay estate tax of $75x, the amount of cash that would have to 

be used to pay tax on the next determination date would be 75 percent 

of cash in excess of the $25~ that the estate had on hand. In order 

to ensure that the tax is eventually paid, however, at a minimum the 

estate would have to pay in each of the first five years the interest 

accrued on the outstanding estate tax balance, and, starting five 

years after the due date of the return, would have to pay principal in 

ten annual installments. This payment schedule is the same as that 

available to an estate that is currently eligible to defer all its tax 

under section 6166. Any payment in excess of this minimum would be 

credited against the minimum payment for the following year. 

Cash and marketable property would include cash, deposits with 

financial institutions OK mutual funds that are convertible into cash 

without substantial penalty, and any other personal property that is 

On each anniversary of the first determination date, the amount of 

- 396 - 
readily tradable (less any commission that would be due upon sale). 

Such property would not, however, include stock in a closely held 

business in which the decedent owned a ten percent or greater 

interest, even if such stock were readily tradable. Nor would 

property used in the conduct of a sole proprietorship (such as working 

capital) be included. Property held by an entity that the estate 

could cause to distribute such property and that was not reasonably 

necessary for the conduct of the business of such entity would be 

included in available property, but only if the value of such excess 

property exceeded five percent of the value of the assets of the 

entity in question. 

beneficiaries and were sold, the sales proceeds would be included in 

available property. 

Section 6161 would be retained so that the Internal Revenue 

Service would continue to have the ability to grant extended deferral 

of tax in unusual circumstances. The one-year extension provided for 

in section 6161 would be made automatic. 

If property other than marketable property were distributed to 

Effective Date 

The proposal would be effective for estates of decedents dying on 

or after January 1, 1986. 

Analysis 

The schedule for paying estate taxes should be more generous than 

that for paying income taxes because the estate tax is a one-time levy 

on property, not just on current income. Moreover, the risk that the 

tax will not be collected is relatively small, since there is a lien 

on assets of the estate until the Federal estate tax is satisfied. 

Under the proposal, distributions would be indicative of the fact 

that the estate holds sufficient liquid funds to meet its obligations, 

including its Federal tax liability. This rule should not impose an 

undue burden on the estate beneficiaries. Indeed, a prudent executor 

may refuse to make any substantial distributions until the estate tax 

liability has been satisfied, even in the absence of the proposal. 

Although some estates may seek long deferral periods, there would be 

pressure on the part of the beneficiaries to close out the estate, 

particularly because distributions to beneficiaries would reduce the 

amount of tax that could be deferred. The charging of adequate 

interest would also give estates an incentive to satisfy the estate 

tax liability in a reasonable time. 

should have no long-term effect on the present value of Federal estate 

tax receipts. 

Because a market rate of interest would be charged, this proposal 

- 391 - 
REPEAL ESTATE TAX DEDUCTION 

FOR INTEREST EXPENSE 

General Explanation 

Chapter 19.07 

Current Law 

necessary estate administration expenses that are allowable as 

administration expenses under the laws of the jurisdiction in which 

the estate is administered. Whether interest expense incurred by an 

estate can be deducted for estate tax purposes as a necessary 

administration expense is unclear in some cases. 

The gross estate subject to the estate tax is reduced for 

Interest expense paid by an estate is generally deductible on the 

estate's income tax return for the year when paid. No income tax 

deduction may be taken, however, if the interest is deducted as an 

administration expense for Federal estate tax purposes. 

Reasons for Change 

Estate administration expenses are deductible for estate tax 

purposes because they are necessary costs incurred in passing property 

to the beneficiaries, and thus reduce the value of the estate to the 

beneficiaries. Interest expense accrued after the decedent's death 

differs from most major expenses of administering the estate in that 

it is a cost of carrying the estate's assets, which typically produce 

income for the estate or its beneficiaries. Such income is subject to 

the income tax, but is not included in the decedent's estate for 

estate tax purposes. Thus, interest is properly offset against income 

of the estate. Permitting the deduction for interest incurred by the 

estate, while not including the income produced by the estate, permits 

the estate tax to be artificially reduced. 

Pt oposal 

administration expense. 

Interest would not be deductible for estate tax purposes as an 

Effective Date 

The proposal would be effective for interest accruing on or after 

January 1, 1986. 

Analysis 

Denying an estate tax deduction for interest incurred after the 

decedent's death would make the estate tax more equitable and would 

simplify the determination of estate tax liability. Permitting the 

deduction reduces the effective estate tax rate for those estates that 

- 398 - 
happen to be highly leveraged, even though the interest cost does not 

necessarily reduce the value of the assets passing to the estate 

beneficiaries. Allowance of an interest deduction on the estate tax 

return complicates the resolution of estate tax liability, because 

such liability may be successively adjusted downward as the estate 

pays additional interest. The resulting computation of tax liability 

can become quite complex. 

the context of the Treasury Department proposal to lower the marginal 

income tax rates. See Chapter 1.01. If the deduction were not 

denied, an estate could earn income taxed at a relatively low rate and 

deduct interest expenses against the higher estate tax rate. This 

type of tax arbitrage should not be permitted. 

Denying the estate tax deduction for interest cost is important in 

- 399 - 
REVISE INCONE IN RESPECT 

OF A DECEDENT RULES 

General Explanation 

Chapter 19.08 

Current Law 

Section 691(a) of the Code governs the Federal income tax 

treatment of items of income in respect of a decedent (IRD). In 

general, IRD items include items of income that, as an economic 

matter, were earned or accrued by a decedent during lifetime but, 

under the decedent's method of accounting, were not properly 

includible by the decedent in computing taxable income prior to death. 

~n IRD item is includible as income when recognized by the decedent's 

estate or by the beneficiary acquiring the right to the IRD item from 

the decedent. 

The taxation of an item of IRD is intended to parallel the Federal 

income and estate tax consequences that would have resulted had the 

decedent received payment immediately prior to death. For estate tax 

purposes an item of IRD is includible in the decedent's gross estate 

at its fair market value without diminution for the income tax 

liability inherent in the right to the IRD. Section 691(c), however, 

provides a person recognizing IRD with an income tax deduction equal 

to the estate tax attributable to the inclusion in the decedent's 

estate of the "net value" of the item of IRD. 

Deductions in respect of a decedent (DRD) consist of certain 

expenses that accrued during the lifetime of the decedent but were not 

properly deductible by the decedent under the decendent's method of 

accounting. Items of DRD are fully deductible when paid by the estate 

or, if the estate is not obligated to pay the item, by the person who, 

by reason of succeeding to the property of the decedent, succeeds to 

the obligation to make payment. 

An item of DRD is fully deductible for estate tax purposes and 

generally is fully deductible for income tax purposes as well. No 

adjustment similar to the section 691(c) adjustment limits this double 

benefit for DRD items. Payment of a DRD gives rise to a double 

deduction except in cases where the DRD must be netted against IRD. 

Reasons for Change 

The double deduction generated by DRD items grants an undue 

benefit to estates that can take advantage of it and should be 

eliminated. The section 691(c) deduction is available only to 

taxpayers who itemize their deductions. 

- 400 - 
Proposal 

The deduction allowed by section 691(c) would be replaced by a 

rule providing for a basis increase in each item of IRD equal to the 

estate tax liability attributable to such item. 

IJpon payment of an item of DRD, the income tax deduction otherwise 

allowable would be reduced by an amount equal to the estate tax 

savings attributable to the deduction of the liability for Federal 

estate tax purposes. The amount of estate tax savings would be 

computed in a manner similar to that utilized to compute the estate 

tax attributable to an item of IRD. Thus, the estate tax liability 

(including liability for State death taxes) would be computed with and 

without the deductions attributable to the items of DRD, with the 

difference allocated among each DRD item according to their relative 

amounts. 

Effective Date 

The proposal would be effective generally for items of IRD and DRD 

attributable to decedents dying on or after January 1, 1986. With 

respect to decedents dying prior to that date, the proposal would 

apply to items of IRD recognized and items of DRD paid on or after 

January 1, 1987. 

Analysis 

By providing for a basis increase rather than a deduction for 

estate tax attributable to an item of IRD, the proposal would simplify 

present law and treat all taxpayers (both itemizers and nonitemizers) 

equally. More important, by reducing the deduction allowable for 

items of DRD, the proposal would ensure that the payment of deductible 

expenses after the obligor's death would be treated no more favorably 

than payment prior to death. 

- 401 - 
LIMIT STATE DEATH TAX CREDIT 

General Explanation 

Chapter 19.09 

Current Law 

Present law allows a credit against Federal estate ax liability 

for the amount of any estate, inheritance, legacy, or succession taxes 

(i) actually paid by an estate to any State or the District of 

Columbia, and (ii) attributable to property included in the decedent's 

Federal gross estate. The maximum amount of this credit, which is 

generally referred to as the state death tax credit, is computed by 

reference to the decedent's taxable estate and a graduated rate table 

providing twenty separate brackets ranging from 0.8 percent to 16 

percent. 

Reasons for Change 

The original purpose of the State death tax credit was to prevent 

States from competing with each other for high-income residents by 

having low (or no) State death taxes. Today, however, almost all 

States have enacted estate or inheritance taxes that provide 

significant revenue; arguably, therefore, the State death tax credit 

is no longer needed to prevent competition among the States for 

wealthy residents. 

as a device for sharing Federal estate tax revenues with the States. 

This purpose can be served without the use of a highly detailed, 

graduated credit schedule. 

In its present form, the State death tax credit functions largely 

Proposal 

The present schedule setting forth the maximum state death tax 

credit would be replaced by a flat rate maximum credit equal to five 

percent of the decedent's Federal taxable estate. 

Effective Date 

The proposal would apply to estates of decedents dying one year 

after enactment of the proposal. 

Analysis 

The proposed change in the State death tax credit would not 

significantly alter the current level of Federal estate tax revenue 

sharing being provided by the credit. Use of a flat rate credit as 

the maximum instead of the twenty-bracket graduated schedule of 

present law would greatly simplify computation of the credit. 

- 402 - 
Moreover, setting the maximum credit at a flat rate would be more 

consistent with the limited progressivity of the present Federal 

estate tax rate structure. 

- 403 - 
REPEAL CAPITAL GAIN TREATMENT FOR 

REDEMPTIONS OF STOCK TO PAY DEATH TAXES 

General Explanation 

Chapter 19.10 

Current Law 

A corporate distribution in redemption of stock included in the 

gross estate of a deceased shareholder may result in capital gain 

treatment to the redeeming shareholder even if the distribution does 

not meet the capital gain requirements otherwise applicable in a 

redemption of corporate shares. The favorable treatment is limited to 

that amount of the distribution that does not exceed the sum of the 

estate, inheritance, legacy, and succession taxes paid by the estate 

and the funeral and administration expenses allowable in computing the 

taxable estate. 

A redemption qualifies for the favorable income tax treatment only 

if the value of the decedent's entire stock interest in the 

corporation exceeds 35 percent of the decedent's adjusted gross 

estate. The decedent's estate may satisfy the 35 percent requirement 

by aggregating the stock of two or more corporations if the decedent 

has more than a 20 percent interest in each such corporation. 

Reasons for Change 

The adjusted basis for Federal income tax purposes of stock 

included in a decedent's estate will generally equal its fair market 

value on the date of death. Thus, a sale of those shares would not 

result in the recognition of gain or loss. The special redemption 

rules for qualifying stock held by estates permit estate taxes and 

administration expenses to be paid out of tax-free distributions of 

accumulated corporate earnings. 

Proposal 

to pay death taxes would be repealed. 

Effective Date 

in the gross estate of decedents dying on or after January 1, 1986. A 

one-year delay in the effective date would be provided, however, for 

redemptions carried out pursuant to redemption agreements or 

shareholders' agreements that were binding on January 1, 1986. 

The favorable treatment under current law for redemptions of stock 

The proposal would be effective for redemptions of stock included 

- 404 - 
Analysis 

The special rules for redemptions to pay estate taxes may be 

defended as a method to prevent adverse income tax consequences where 

a decedent’s estate has insufficient liquid assets to pay its Federal 

estate tax and expenses of administration, but does not qualify for 

the payment of estate tax in installments under section 6166. The 

proposal to liberalize the rules governing the payment of estate tax 

in installments described at Chapter 19.06 should eliminate those 

concerns. In addition, the proposal for dividend relief described at 

Chapter 7.01 would reduce the tax cost of corporate distributions. 

The proposal would result in similar distributions being taxed equally 

whether made before or after the death of the decedent. 

- 405 - 
CHAPTER 20 

SIMPLIFY PENALTIES 

General Explanation 

Chapter 20.01 

Current Law 

The Internal Revenue Code contains a wide array of civil penalties 

for violation of its reporting and payment provisions. These 

penalties, set forth in over 75 different provisions, are intended to 

impress upon taxpayers the significance of their Federal tax 

obligations, to provide meaningful incentives for compliance and to 

compensate the United States for the expense of investigation and 

collection. 

Penalties are imposed in addition to interest on deficiencies. 

The penalty under current law for failure to pay taxes when due is 

.5 percent of the amount of the overdue tax per month, up to a maximum 

of 25 percent. 

Reasons for Change 

The penalty provisions under existing law are overly complex and 

often result in inconsistent treatment of similar violations. 

Penalties have been added piecemeal to the Code as new filing and 

reporting requirements have been legislated. The inconsistencies in 

the present penalty structure undermine horizontal equity among 

taxpayers and make the penalty provisions difficult to understand and 

administer. 

The existing penalty for failure to pay taxes when due is overly 

burdensome, and generally falls on taxpayers whose failure to pay is 

not willful. 

Proposal 

The penalties relating to failure to file information returns, 

failure to furnish information, failure to provide information on a 

return, and filing false information would be consolidated into one 

provision with uniform penalties as follows: 

(a) failure to file information tax return: $1,000 or 10 

percent of gross proceeds required to be reported on the 

return, whichever is less; 

- 406 - 
(b) failure to file information statement: $50 for each 

statement; 

transaction; 

document: $10 for each failure; 

(c) failure to furnish or provide data: $50 for each 

(d) failure to supply information on return, statement, or 

(e) filing incorrect information on a return or statement: 

(f) if any failure described in (a), (b), (c), or (d) above 

$50 for each false statement; 

is due to intentional disregard of the filing 

requirement, then the penalty shall be 10 percent of the 

gross proceeds or other amount required to be reported on 

the return or statement with no maximum limitation, or 

$500, whichever is greater. If the filing of incorrect 

information in (e) above is intentional or due to 

reckless disregard of the truth, then the penalty shall 

be $500 per false statement. 

All statutory maximum amounts on fixed dollar penalties would 

be eliminated. In addition, the present penalty for failure to 

pay taxes would be eliminated and replaced with a cost of 

collection charge. 

Effective Date 

The proposals would apply to taxable years beginning on or 

after January 1, 1986. 

Analysis 

The proposed restructuring of the penalty provisions should 

promote simplification in the administration of the penalty 

provisions and provide greater fairness in their application. 

The proposal would integrate many of the information reporting 

penalties into a single provision and provide uniform penalty 

amounts for similar reporting violations. Simplification of the 

penalty system also should promote compliance with the tax laws 

by enabling taxpayers to understand more easily the consequences 

of noncompliance. 

The proposal imposes fixed dollar penalty levels for each 

category of information return violation. A higher penalty, 

based on the percentage of the unreported transaction, is imposed 

if the violation is willful rather than merely inadvertent or 

careless. Willful violations would involve deliberate, knowing 

or intentional disregard of filing or reporting obligations. If 

the heavier penalty is applicable for a willful violation, the 

notice and deficiency procedures generally applicable to ad 

valorem penalties would not apply. 

- 407 - 
The elimination of maximum penalty amounts would serve the 

interests of fairness and compliance. Maximum penalty amounts do 

not encourage compliance with the tax laws, nor do they promote 

uniformity of treatment among equals. There is no reason, for 

example, why an employer who fails to file 5,000 W-2 reports 

should receive relatively more favorable treatment than the 

employer who fails to file 50 or 500 such reports. Yet that is 

the result under current law, which imposes a statutory maximum 

on the penalty level of the larger employer.