General Explanations

of the

Administration’s Revenue Proposals

Department of the Treasury

February 1999
- I -

Making Health Care More Affordable

ASSISTING TAXPAYERS WITH LONG-TERM CARE NEEDS ......................... 1

DISABLED WORKERS TAX CREDIT ......................................... 4

PROVIDE TAX RELIEF TO ENCOURAGE SMALL BUSINESS HEALTH PLANS ............. 6

Expand Education Initiatives

PROVIDE TAX CREDITS FOR HOLDERS OF QUALIFIED SCHOOL

MODERNIZATION BONDS AND QUALIFIED ZONE ACADEMY BONDS .......... 10

EXCLUSION FOR EMPLOYER-PROVIDED EDUCATIONAL ASSISTANCE ............... 14

TAX CREDIT FOR EMPLOYER-PROVIDED WORKPLACE LITERACY AND BASIC

EDUCATION PROGRAMS .......................................... 15

CORPORATE SPONSORSHIP OF QUALIFIED ZONE

ACADEMIES IN EMPOWERMENT ZONES AND ENTERPRISE COMMUNITIES ...... 17

ELIMINATE 60-MONTH LIMIT ON STUDENT LOAN INTEREST DEDUCTION ............ 19

ELIMINATING TAX ON FORGIVENESS OF DIRECT STUDENT LOANS

SUBJECT TO INCOME CONTINGENT REPAYMENT ........................ 20

TAX TREATMENT OF EDUCATION AWARDS UNDER CERTAIN FEDERAL PROGRAMS .... 21

Making Child Care More Affordable

INCREASE, EXPAND AND SIMPLIFY THE CHILD AND DEPENDENT CARE TAX CREDIT ... 23

PROVIDE TAX INCENTIVES FOR EMPLOYER-PROVIDED CHILD-CARE FACILITIES ....... 26

Provide Incentives to Revitalize Communities

INCREASE LOW-INCOME HOUSING TAX CREDIT PER CAPITA CAP ................. 28

PROVIDE TAX CREDITS FOR HOLDERS OF BETTER AMERICA BONDS ............... 29

PROVIDE NEW MARKETS TAX CREDIT ..................................... 33

SPECIALIZED SMALL BUSINESS INVESTMENT COMPANY TAX INCENTIVES ........... 37

EXTEND WAGE CREDIT FOR TWO NEW EMPOWERMENT ZONES ................... 39

Promote Energy Efficiency and Improve the Environment

PROVIDE TAX CREDIT FOR ENERGY-EFFICIENT BUILDING EQUIPMENT .............. 40

TAX CREDIT FOR PURCHASE OF ENERGY EFFICIENT NEW HOMES ................. 42

EXTEND TAX CREDIT FOR ELECTRIC VEHICLES AND 

PROVIDE TAX CREDIT FOR CERTAIN FUEL-EFFICIENT HYBRID VEHICLES ...... 43

INVESTMENT TAX CREDIT FOR COMBINED HEAT AND POWER (CHP) SYSTEMS ....... 45

PROVIDE TAX CREDIT FOR ROOFTOP SOLAR EQUIPMENT ....................... 47

EXTEND WIND AND BIOMASS TAX CREDIT AND EXPAND ELIGIBLE BIOMASS SOURCES . 48
- II -

Promote Expanded Retirement Savings, Security, and Portability

PROMOTE INDIVIDUAL RETIREMENT ACCOUNT CONTRIBUTIONS 

THROUGH PAYROLL DEDUCTIONS ................................... 49

PROVIDE SMALL BUSINESS TAX CREDIT 

FOR EXPENSES OF STARTING NEW RETIREMENT PLANS ................... 50

THE SMART PLAN --

A SIMPLIFIED PENSION PLAN FOR SMALL BUSINESS ...................... 51

PROVIDE FASTER VESTING OF EMPLOYER MATCHING CONTRIBUTIONS ............. 56

COUNT FMLA LEAVE FOR RETIREMENT ELIGIBILITY AND 

VESTING PURPOSES .............................................. 57

REQUIRE JOINT AND SEVENTY-FIVE PERCENT 

SURVIVOR ANNUITY OPTION FOR PENSION PLANS ....................... 58

IMPROVE PENSION DISCLOSURE .......................................... 59

IMPROVE BENEFITS OF NONHIGHLY COMPENSATED EMPLOYEES UNDER

401(K) SAFE HARBOR PLANS ...................................... 62

SIMPLIFY DEFINITION OF HIGHLY COMPENSATED EMPLOYEE .................... 64

SIMPLIFY BENEFIT LIMITS FOR MULTIEMPLOYER PLANS

UNDER SECTION 415 ............................................. 65

SIMPLIFY FULL FUNDING LIMITATION FOR MULTIEMPLOYER PLANS ............... 66

ELIMINATE PARTIAL TERMINATION RULES

 FOR MULTIEMPLOYER PLANS ...................................... 67

ALLOW ROLLOVERS BETWEEN QUALIFIED RETIREMENT PLANS

AND SECTION 403(B) TAX-SHELTERED ANNUITIES ....................... 68

ALLOW ROLLOVERS FROM REGULAR IRAS TO QUALIFIED

RETIREMENT PLANS OR SECTION 403(B) TAX-SHELTERED ANNUITIES

............................................................ 70

ALLOW ROLLOVERS OF AFTER-TAX CONTRIBUTIONS ........................... 71

ALLOW ROLLOVERS OF CONTRIBUTIONS FROM NONQUALIFIED

DEFERRED COMPENSATION PLANS OF STATE AND LOCAL GOVERNMENTS

TO IRAS ...................................................... 72

FACILITATE THE PURCHASE OF SERVICE CREDITS IN

GOVERNMENTAL DEFINED BENEFIT PLANS ............................ 73

Extend Expiring Provisions

EXTEND AMT RELIEF FOR INDIVIDUALS .................................... 74

EXTEND THE WORK OPPORTUNITY TAX CREDIT .............................. 75

EXTEND THE WELFARE-TO-WORK TAX CREDIT ............................... 76

EXTEND THE R&E TAX CREDIT .......................................... 77

MAKE PERMANENT THE EXPENSING OF BROWNFIELDS REMEDIATION COSTS ......... 78

EXTEND TAX CREDIT FOR FIRST-TIME D.C. HOMEBUYERS ...................... 79
- III -

Simplify the Tax Laws

PROVIDE OPTIONAL SELF-EMPLOYMENT CONTRIBUTIONS ACT (SECA) COMPUTATIONS 80

PROVIDE STATUTORY HEDGING AND OTHER RULES TO ENSURE

BUSINESS PROPERTY IS TREATED AS ORDINARY PROPERTY ................ 82

CLARIFY RULES RELATING TO CERTAIN DISCLAIMERS ......................... 83

SIMPLIFY THE FOREIGN TAX CREDIT LIMITATION

FOR DIVIDENDS FROM 10/50 COMPANIES ............................. 84

INTEREST TREATMENT FOR DIVIDENDS PAID BY CERTAIN REGULATED

INVESTMENT COMPANIES TO FOREIGN PERSONS ........................ 85

EXPAND DECLARATORY JUDGMENT REMEDY FOR NONCHARITABLE

ORGANIZATIONS SEEKING DETERMINATIONS OF TAX-EXEMPT STATUS ....... 86

SIMPLIFY THE ACTIVE TRADE OR BUSINESS REQUIREMENT FOR TAX-FREE SPIN-OFFS . . 87

Miscellaneous Provisions

EXTEND AND MODIFY PUERTO RICO ECONOMIC-ACTIVITY TAX CREDIT (SECTION 30A) 88

MAKE FIRST $2,000 OF SEVERANCE PAY EXEMPT FROM INCOME TAX ............. 90

EXTEND CARRYBACK PERIOD FOR NOLS OF STEEL COMPANIES .................. 91

Electricity Restructuring

TAX-EXEMPT BONDS FOR ELECTRIC FACILITIES .............................. 92

MODIFY TREATMENT OF CONTRIBUTIONS TO NUCLEAR DECOMMISSIONING FUNDS .... 94

Corporate Tax Shelters

MODIFY SUBSTANTIAL UNDERSTATEMENT PENALTY FOR CORPORATE TAX SHELTERS . . 95

DENY CERTAIN TAX BENEFITS TO PERSONS AVOIDING INCOME TAX AS A

RESULT OF TAX AVOIDANCE TRANSACTIONS .......................... 97

DENY DEDUCTIONS FOR CERTAIN TAX ADVICE AND

IMPOSE AN EXCISE TAX ON CERTAIN FEES RECEIVED .................... 99

IMPOSE EXCISE TAX ON CERTAIN RESCISSION PROVISIONS

AND PROVISIONS GUARANTEEING TAX BENEFITS ...................... 100

PRECLUDE TAXPAYERS FROM TAKING TAX POSITIONS INCONSISTENT WITH

THE FORM OF THEIR TRANSACTIONS ................................ 102

TAX INCOME FROM CORPORATE TAX SHELTERS INVOLVING

TAX-INDIFFERENT PARTIES ...................................... 104

REQUIRE ACCRUAL OF TIME VALUE ELEMENT ON 

FORWARD SALE OF CORPORATE STOCK .............................. 106

MODIFY TREATMENT OF BUILT-IN LOSSES

AND OTHER ATTRIBUTE TRAFFICKING ............................... 107

MODIFY TREATMENT OF ESOP AS S CORPORATION SHAREHOLDER .............. 110
- IV -

LIMIT TAX-FREE LIQUIDATIONS OF U.S. SUBSIDIARIES

OF FOREIGN CORPORATIONS IN ORDER TO PRESERVE THE IMPOSITION OF

U.S. TAX ON THE DISTRIBUTED EARNINGS ........................... 111

PREVENT CAPITAL GAINS AVOIDANCE THROUGH BASIS SHIFT

TRANSACTIONS INVOLVING FOREIGN SHAREHOLDERS ................... 112

LIMIT INAPPROPRIATE TAX BENEFITS FOR LESSORS

OF TAX-EXEMPT USE PROPERTY ................................... 113

PREVENT MISMATCHING OF DEDUCTIONS AND INCOME INCLUSIONS IN

TRANSACTIONS WITH RELATED FOREIGN PERSONS ..................... 114

RESTRICT BASIS CREATION THROUGH SECTION 357(C) ........................ 115

MODIFY ANTI-ABUSE RULES RELATED TO ASSUMPTION OF LIABILITIES ............ 117

MODIFY CORPORATE-OWNED LIFE INSURANCE (COLI) RULES .................. 118

Financial Products

REQUIRE BANKS TO ACCRUE INTEREST ON SHORT-TERM OBLIGATIONS ............ 120

REQUIRE CURRENT ACCRUAL OF MARKET DISCOUNT

BY ACCRUAL METHOD TAXPAYERS ................................. 121

LIMIT CONVERSION OF CHARACTER OF INCOME FROM CONSTRUCTIVE

OWNERSHIP TRANSACTIONS WITH RESPECT TO PARTNERSHIP INTERESTS ..... 122

MODIFY RULES FOR DEBT-FINANCED PORTFOLIO STOCK ....................... 124

MODIFY AND CLARIFY CERTAIN RULES RELATING TO DEBT-FOR-DEBT EXCHANGES . . 125

MODIFY AND CLARIFY STRADDLE RULES .................................. 126

DEFER INTEREST DEDUCTION AND ORIGINAL ISSUE DISCOUNT (OID)

ON CERTAIN CONVERTIBLE DEBT .................................. 127

Corporate Provisions

CONFORM CONTROL TEST FOR TAX-FREE INCORPORATIONS, DISTRIBUTIONS, AND

REORGANIZATIONS ............................................. 128

TAX ISSUANCE OF TRACKING STOCK ........................................ 129

REQUIRE CONSISTENT TREATMENT AND PROVIDE BASIS ALLOCATION RULES FOR

TRANSFERS OF INTANGIBLES IN CERTAIN NONRECOGNITION TRANSACTIONS . . 130

MODIFY TAX TREATMENT OF DOWNSTREAM MERGERS ....................... 131

DENY DIVIDENDS-RECEIVED DEDUCTION FOR CERTAIN PREFERRED STOCK ........ 132

Provisions Affecting Pass-through Entities

MODIFY BASIS ADJUSTMENT RULES FOR PARTNERSHIP DISTRIBUTIONS ............ 134

MODIFY STRUCTURE OF BUSINESSES INDIRECTLY CONDUCTED BY REITS .......... 140

MODIFY TREATMENT OF CLOSELY HELD REITS ............................. 142

REPEAL TAX-FREE CONVERSIONS OF LARGE C CORPORATIONS TO S CORPORATIONS . 143
- V -

Tax Accounting

DENY CHANGE IN METHOD TREATMENT TO TAX-FREE TRANSACTIONS ............ 145

REPEAL INSTALLMENT METHOD FOR ACCRUAL BASIS TAXPAYERS ............... 146

DENY DEDUCTION FOR PUNITIVE DAMAGES ................................ 147

APPLY UNIFORM CAPITALIZATION RULES TO TOLLERS ........................ 148

REPEAL LOWER-OF-COST-OR-MARKET INVENTORY ACCOUNTING METHOD ......... 149

ELIMINATE THE INCOME RECOGNITION EXCEPTION FOR ACCRUAL METHOD SERVICE

PROVIDERS ................................................... 150

DISALLOW INTEREST ON DEBT ALLOCABLE TO TAX-EXEMPT OBLIGATIONS ......... 151

Cost Recovery

PROVIDE CONSISTENT AMORTIZATION PERIODS FOR INTANGIBLES ............... 152

CLARIFY CLASS LIFE OF UTILITY GRADING COSTS ........................... 153

Insurance Provisions

REQUIRE RECAPTURE OF POLICYHOLDER SURPLUS ACCOUNTS .................. 154

MODIFY RULES FOR CAPITALIZING POLICY ACQUISITION COSTS

OF LIFE INSURANCE COMPANIES ................................... 156

INCREASE THE PRORATION PERCENTAGE FOR PROPERTY CASUALTY (P&C) INSURANCE

COMPANIES .................................................. 159

Exempt Organizations

SUBJECT INVESTMENT INCOME OF TRADE ASSOCIATIONS TO TAX ................ 160

Estate and Gift Taxation

RESTORE PHASE-OUT OF UNIFIED CREDIT FOR LARGE ESTATES .................. 162

REQUIRE CONSISTENT VALUATION FOR ESTATE AND INCOME TAX PURPOSES ....... 163

REQUIRE BASIS ALLOCATION FOR PART SALE/PART GIFT TRANSACTIONS .......... 164

CONFORM TREATMENT OF SURVIVING SPOUSES IN COMMUNITY PROPERTY STATES . . 165

INCLUDE QUALIFIED TERMINABLE INTEREST PROPERTY (QTIP) TRUST

ASSETS IN SURVIVING SPOUSE'S ESTATE ............................. 166

ELIMINATE NON-BUSINESS VALUATION DISCOUNTS .......................... 167

ELIMINATE GIFT TAX EXEMPTION FOR PERSONAL RESIDENCE TRUSTS ............ 168

International

EXPAND SECTION 864(C)(4)(B) TO INTEREST AND DIVIDEND EQUIVALENTS ........ 169
- VI -

RECAPTURE OVERALL FOREIGN LOSSES WHEN CFC STOCK IS DISPOSED .......... 171

AMEND 80/20 COMPANY RULES ......................................... 172

MODIFY FOREIGN OFFICE MATERIAL PARTICIPATION EXCEPTION

APPLICABLE TO INVENTORY SALES ATTRIBUTABLE TO

NONRESIDENT'S U.S. OFFICE ..................................... 173

STOP ABUSE OF CONTROLLED FOREIGN CORPORATION (CFC) EXCEPTION

TO OWNERSHIP REQUIREMENTS OF SECTION 883 ....................... 174

REPLACE SALES-SOURCE RULES WITH ACTIVITY-BASED RULES .................. 176

MODIFY RULES RELATING TO FOREIGN OIL AND GAS EXTRACTION INCOME ........ 177

Pensions

INCREASE ELECTIVE WITHHOLDING RATE FOR NONPERIODIC DISTRIBUTIONS FROM

DEFERRED COMPENSATION PLANS ................................. 179

INCREASE SECTION 4973 EXCISE TAX FOR EXCESS IRA CONTRIBUTIONS .......... 180

PLACE LIMITATION ON PRE-FUNDING OF WELFARE BENEFITS ................... 181

SUBJECT SIGNING BONUSES TO EMPLOYMENT TAXES ......................... 183

Compliance

EXPAND REPORTING OF CANCELLATION OF INDEBTEDNESS INCOME .............. 184

TIGHTEN THE SUBSTANTIAL UNDERSTATEMENT PENALTY

FOR LARGE CORPORATIONS ...................................... 185

REQUIRE WITHHOLDING ON CERTAIN GAMBLING WINNINGS .................... 186

INCREASE PENALTIES FOR FAILURE TO FILE

CORRECT INFORMATION RETURNS ................................. 187

Miscellaneous

MODIFY DEPOSIT REQUIREMENT FOR FEDERAL UNEMPLOYMENT ACT (FUTA) ...... 188

REINSTATE OIL SPILL LIABILITY TRUST FUND TAX ........................... 189

SIMPLIFY FOSTER CHILD DEFINITION UNDER EITC ........................... 190

REPEAL PERCENTAGE DEPLETION FOR NON-FUEL MINERALS

MINED ON FEDERAL AND FORMERLY FEDERAL LANDS .................. 191

IMPOSE EXCISE TAX ON PURCHASE OF STRUCTURED SETTLEMENTS .............. 192

REQUIRE TAXPAYERS TO INCLUDE RENTAL INCOME OF RESIDENCE IN

INCOME WITHOUT REGARD TO PERIOD OF RENTAL ..................... 193
- VII -

Other Provisions That Affect Receipts

REINSTATE ENVIRONMENTAL TAX IMPOSED ON CORPORATE TAXABLE

INCOME AND DEPOSITED IN THE

HAZARDOUS SUBSTANCE SUPERFUND TRUST FUND .................... 194

REINSTATE EXCISE TAXES DEPOSITED IN THE

HAZARDOUS SUBSTANCE SUPERFUND TRUST FUND .................... 195

CONVERT A PORTION OF THE EXCISE TAXES DEPOSITED IN THE

AIRPORT AND AIRWAY TRUST FUND TO COST-BASED USER FEES ASSESSED

FOR FEDERAL AVIATION ADMINISTRATION (FAA) SERVICES .............. 196

RECEIPTS FROM TOBACCO LEGISLATION ................................... 197
 To qualify as a dependent, an individual must (1) be a specified relative or member of 1

the taxpayer’s household; (2) be a citizen or resident of the U.S. or resident of Canada or Mexico;

(3) not be required to file a joint tax return with his or her spouse; (4) have gross income below

the dependent exemption amount ($2,750 in 1999) if not the taxpayer’s child; and (5) receive over

half of his or her support from the taxpayer. The taxpayer may be deemed as providing over half

the cost of supporting the individual if (a) no one person contributes over half the support of such

individual; (b) over half the support is received from persons each of whom, but for the fact that

he or she did not provide over half such support, could claim the individual as a dependent; (c) the

taxpayer contributes over 10 percent of such support; and (d) the other caregivers, who provide

over 10 percent of the support, file written declarations stating that they will not claim the

individual as a dependent. 

Making Health Care More Affordable

ASSISTING TAXPAYERS WITH LONG-TERM CARE NEEDS

Current Law

Several provisions in the tax code provide assistance to taxpayers with a disabled family

member or with long-term care expenses. A taxpayer can receive a child and dependent care tax

credit for expenses incurred to care for a disabled spouse or dependent so the taxpayer can work.

A low-income working taxpayer can qualify for the earned income tax credit if he or she resides with

a disabled child (of any age). A taxpayer who itemizes can deduct expenses for qualified long-term

care services if he or she is chronically ill or such expenses were incurred on behalf of a chronically

ill spouse or dependent. 

Reasons for Change

A long illness or a disability can impose significant burdens on individuals and their caregivers.

Taxpayers who have long-term care needs or who care for others with such needs do not have the

same ability to pay taxes as other taxpayers. Providing a tax credit is an equitable and efficient way

of recognizing the formal and informal costs of providing long-term care.

Proposal

A taxpayer would be allowed to claim a $1,000 credit if he or she has long-term care needs.

A taxpayer also would be allowed to claim the credit with respect to a spouse or each qualifying

dependent who has long-term care needs. The credit (aggregated with the child credit and the

1

proposed disabled worker credit) would be phased-out for certain high-income taxpayers--that is, the

aggregate credit amount would be phased out by $50 for each $1,000 (or fraction thereof) by which

the taxpayer’s modified AGI exceeds $110,000 (in the case of a joint return), $75,000 (in the case

of a taxpayer who is not married), or $55,000 (in the case of a married individual filing a separate

return).
 A portion of the period certified by the physician must occur within the taxable year for 2

which the credit is claimed. After the initial certification, individuals must be re-certified by their

physician within three years or such other period as the Secretary prescribes.

- 2 -

For purposes of the proposed tax credit only, the dependency tests of section 151 would be

modified in two ways. First, the gross income threshold would increase to the sum of the personal

exemption amount, the standard deduction, and the additional deduction for the elderly and blind (if

applicable). In 1999, the gross income threshold would generally be $7,050 for a non-elderly single

dependent and $8,100 for an elderly single dependent. 

Second, the current-law support tests would be deemed to be met if the taxpayer and an

individual with long-term care needs reside together for a specified period. The length of the

specified period would depend on the relationship between the taxpayer and the individual with longterm care needs. The specified period would be over half the year if the individual is the parent

(including stepparents and in-laws), or ancestor of the parent, or child, or descendant of the child, of

the taxpayer. Otherwise, the individual must reside with the taxpayer the full year. If more than one

taxpayer resides with the person with long-term care needs and would be eligible to claim the credit

for that person, then those taxpayers generally must designate the taxpayer who will claim the credit.

If the taxpayers fail to do so or if they are married to each other and filing separate returns, then only

the taxpayer with the highest adjusted gross income would be eligible to claim the credit.

An individual age six or older would be considered to have long-term care needs if he or she

were certified by a licensed physician (prior to the filing of a return claiming the credit) as being

unable for at least six months to perform at least three activities of daily living (ADLs) without

substantial assistance from another individual, due to a loss of functional capacity (including

individuals born with a condition that is comparable to a loss of functional capacity). As under

2

section 7702B(c)(2)(B), ADLs would be eating, toileting, transferring, bathing, dressing, and

continence. Substantial assistance would include both hands-on assistance (that is, the physical

assistance of another person without which the individual would be unable to perform the ADL) and

stand-by assistance (that is, the presence of another person within arm’s reach of the individual that

is necessary to prevent, by physical intervention, injury to the individual when performing the ADL).

As an alternative to the three-ADL test described above, an individual would be considered

to have long-term care needs if he or she were certified by a licensed physician as (a) requiring

substantial supervision for at least six months to be protected from threats to health and safety due

to severe cognitive impairment and (b) being unable for at least six months to perform at least one

or more ADL or engage in age appropriate activities as determined under regulations prescribed by

the Secretary of the Treasury in consultation with the Secretary of Health and Human Services.

A child between the ages of two and six would be considered to have long-term care needs

if he or she were certified by a licensed physician as requiring substantial assistance for at least six
 More than one credit amount could be attributable to a single individual. For example, a 3

disabled worker with long-term care needs would have two credit amounts–a disabled workers

credit and a long-term care credit. Similarly, a taxpayer with a child under age 17 with long-term

care needs would have two credit amounts–a child credit and a long-term care credit--for that

child.

- 3 -

months with two of the following activities: eating, transferring, and mobility. A child under the age

of two would qualify if he or she were certified by a licensed doctor as requiring for at least six

months specific durable medical equipment (for example, a respirator) by reason of a severe health

condition or requiring a skilled practitioner trained to address the child’s condition when the parents

are absent. Within five years of enactment, the Department of the Treasury and the Department of

Health and Human Services would report to Congress on the effectiveness of the definition of

disability for children and recommend, if necessary, modifications to the definition. 

The taxpayer would be required to provide a correct taxpayer identification number for the

individual with long-term care needs, as well as a correct physician identification number (e.g., the

Unique Physician Identification Number that is currently required for Medicare billing) for the

certifying physician. Failure to provide correct taxpayer and physician identification numbers would

be subject to mathematical error procedures. Further, the taxpayer could be required to provide other

proof of the existence of long-term care needs in such form and manner, and at such times, as the

Secretary requires.

The credit would be coordinated with the current law child credit and the proposed disabled

workers credit to allow these credits to be refundable for a taxpayer claiming three or more credit

amounts. As under the current-law child credit, the amount of refundable credit would be the

3

amount that the nonrefundable personal credits would increase if the tax liability limitation of section

26(a) were increased by the excess of the taxpayer’s social security taxes over the taxpayer’s earned

income credit (if any). 

The proposal would effective for taxable years beginning after December 31, 1999.
- 4 -

DISABLED WORKERS TAX CREDIT

Current Law 

Taxpayers who are handicapped may claim an itemized deduction for impairment-related work

expenses. The deduction is treated as a miscellaneous deduction subject to the two-percent of

adjusted gross income (AGI) floor. 

A handicapped individual is defined as any individual who has a physical or mental disability

(including, but not limited, to blindness or deafness), which for such individual constitutes or results

in a functional limitation to employment, or who has any physical or mental impairment (including,

but not limited to, a sight or hearing impairment), which substantially limits one or more major life

activities.

Impairment-related work expenses are defined as expenses for attendant care services at the

individual’s place of employment and other expenses in connection with such place of employment

which are necessary for the individual to be able to work. Impairment-related work expenses must

be ordinary and necessary. 

Depreciable capital items are not included under the definition of impairment-related work

expenses. Depreciation attributable to these items, however, may be deductible, subject to certain

limitations (such as, for example, the two-percent AGI floor).

Reasons for Change

Disabled individuals may incur additional costs in order to work and earn taxable income, and

thus do not have the same ability to pay as taxpayers who do not incur such expenses. However,

many moderate-income disabled individuals do not benefit from the current-law tax deduction for

impairment-related work expenses because they do not have sufficient work-related expenses and

other deductions to benefit from itemizing deductions. In addition, many disabled individuals do not

benefit from the current-law deduction because they incur significant work-related expenses outside

the workplace (which do not qualify for the deduction) or rely on unpaid relatives or friends for

assistance. For example, they may require personal assistance to get dressed and driven to work.

Proposal

A taxpayer would qualify for a $1,000 tax credit if he or she had earned income and was

disabled. The credit could not exceed the disabled individual’s earned income during the tax year.

The credit (aggregated with the child credit and the proposed long-term care credit) would be

phased-out for certain high-income taxpayers--that is, the aggregate credit amount would be phased

out by $50 for each $1,000 (or fraction thereof) by which the taxpayer’s modified AGI exceeds

$110,000 (in the case of a joint return), $75,000 (in the case of a taxpayer who is not married), or

$55,000 (in the case of a married individual filing a separate return).
 A portion of the period certified by the physician must occur within the taxable year for 4

which the credit is claimed. After the initial certification, individuals must be re-certified by their

physician within three years or such other period as the Secretary prescribes.

 More than one credit amount could be attributable to a single individual. For example, a 5

disabled worker with long-term care needs would have two credit amounts–a disabled workers

credit and a long-term care credit. Similarly, a taxpayer with a child under age 17 with long-term

care needs would have two credit amounts–a child credit and a long-term care credit--for that

child.

- 5 -

A taxpayer with earned income would be considered to be a disabled worker if he or she were

certified by a licensed physician (prior to the filing of a return claiming the credit) as being unable for

at least 12 months to perform at least one activity of daily living without substantial assistance from

another individual, due to loss of functional capacity. As under section 7702B(c)(2)(B), activities 4

of daily living would be eating, toileting, transferring, bathing, dressing, and continence. A taxpayer

could potentially qualify for both the proposed long-term care credit and the disabled workers tax

credit. 

The taxpayer would be required to provide a correct physician identification number (e.g.,

the Unique Physician Identification Number that is currently required for Medicare billing) for the

certifying doctor. Failure to provide the correct physician identification number would be subject to

mathematical error procedures. Further, the taxpayer could be required to provide other proof of the

existence of disability in such form and manner, and at such times, as the Secretary requires. 

The credit would be coordinated with the current law child credit and the proposed long-term

care credit to allow these credits to be refundable for a taxpayer claiming three or more credit

amounts. As under the current-law child credit, the amount of refundable credit would be the

5

amount that the nonrefundable personal credits would increase if the tax liability limitation of section

26(a) were increased by the excess of the taxpayer’s social security taxes over the taxpayer’s earned

income credit (if any). 

The proposal would be effective for tax years beginning after December 31, 1999.
- 6 -

PROVIDE TAX RELIEF TO ENCOURAGE SMALL BUSINESS HEALTH PLANS

Current Law

Employer contributions toward employee accident or health insurance are generally deductible

by employers and excluded from gross income by employees. An employee’s share of his or her

health insurance premiums is an itemized deduction, but is deductible only to the extent that medical

or long-term care expenses (including health insurance costs) exceed 7.5 percent of the employee’s

adjusted gross income.

A self-employed individual may deduct as a trade or business expense a percentage

(60 percent in 1999, increasing to 70 percent in 2002 and 100 percent in 2003) of insurance premiums

covering the individual and his or her family, but only if the individual is not eligible to participate in

a subsidized health plan maintained by any employer of the individual or of the individual’s spouse.

The deduction is limited by the self-employed individual’s earned income derived from the relevant

trade or business.

A multiple employer welfare arrangement, or MEWA, is an employee benefit plan or other

arrangement that provides medical or certain other benefits to employees of two or more employers.

MEWAs are generally subject to applicable State insurance laws, including provisions of State

insurance law that generally comply with requirements imposed on insurance issuers under the Health

Insurance Portability and Accountability Act of 1996 (HIPAA) and subsequent federal laws.

MEWAs (whether or not funded through insurance) are also regulated under the Employee

Retirement Income Security Act (ERISA) with respect to reporting, disclosure, fiduciary, and claims

procedures.

Private foundation grants must be used for charitable purposes. To ensure that foundation

grants are used for the intended charitable purpose, so-called “expenditure responsibility”

requirements apply whenever such grants are made to non-charitable organizations for exclusively

charitable purposes. These requirements involve certain recordkeeping and reporting requirements.

Among other things, there must be a written agreement between the foundation and the grantee that

specifies clearly how the grant funds will be expended, the grantee’s books and records must account

separately for the grant funds, and the grantee must report annually to the foundation on the use of

the grant funds and the progress made in accomplishing the purposes of the grant.

Reasons for Change

Over a quarter of private-sector workers in firms with 50 or fewer employees lack health

insurance -- significantly more than the national average (about 17 percent of workers). This

deficiency in insurance coverage occurs, in part, because the costs of setting up and operating health

plans in the current small business insurance market are higher than those for larger employers.

Consequently, small employers tend to pay more for similar employee health insurance benefits than

do larger employers. In addition, insurance companies may need a minimum number of covered
- 7 -

employees in order to be able to provide insurance to a group. This makes it difficult for small

employers to offer multiple health plans to their employees. Only a tiny fraction of the small

businesses that offer health insurance benefits provide their workers with a choice of health plans.

Health benefit purchasing coalitions pool employer workforces, negotiate with insurers over

health plan benefits and premiums, provide comparative information about available health plans to

participating employees, and may administer premium payments made by employers and their

participating employees. Such coalitions provide an opportunity for small employers to purchase

health insurance for their workers at reduced cost and to offer a greater choice of health plans than

is currently available to employees of small businesses.

The formation of health benefit purchasing coalitions has been hindered by their limited access

to capital, but some private foundations have indicated a willingness to fund coalition start-up

expenses. However, private foundations are prohibited under the Internal Revenue Code from

making grants for other than charitable purposes. Current law provides no assurance that the funding

of start-up expenses of health benefit purchasing coalitions would qualify as a “charitable purpose.”

Consequently, private foundations are reluctant to make grants to fund coalition start-up expenses.

Proposal

The proposal has two parts. First, it would establish a special rule that will facilitate private

foundation grants to qualified health benefit purchasing coalitions. Second, it would create a new

income tax credit designed to encourage use of these purchasing coalitions by small businesses that

currently do not provide health insurance to their workforces. Both provisions would be temporary

and are proposed to expire after a set period of time.

Foundation Grants to Qualified Health Benefit Purchasing Coalitions

Any grant or loan made by a private foundation to a qualified health benefit purchasing

coalition (“qualified coalition”) to support the coalition’s initial operating expenses would be treated

as a grant or loan made for charitable purposes. As with any other grant or loan to a non-charitable

organization for exclusively charitable purposes, private foundations would be required to comply

with the “expenditure responsibility” record-keeping and reporting requirements under current law.

Initial operating expenses of a qualified coalition would include all ordinary and necessary

expenses incurred in connection with the establishment of the qualified coalition and its initial

operations, including the payment of reasonable compensation for services provided to the qualified

coalition and rental payments. In addition, initial operating expenses would include the cost of

tangible personal property purchased by the qualified coalition for its own use. Initial operating

expenses would not include (1) the purchase of real property, (2) any payment made to, or for the

benefit of, members (or employees or affiliates of members) of the qualified coalition, such as any

payment of insurance premiums on policies insuring members (or their employees or affiliates), or (3)

any expense incurred more than 24 months after the date of formation of the coalition.
- 8 -

Requirements Imposed on Qualified Health Benefit Purchasing Coalitions

A qualified health benefit purchasing coalition would be required to operate on a non-profit

basis and to be formed as a separate legal entity whose objective is to negotiate with health insurers

for the purpose of providing health insurance benefits to the employees of its small business members.

A qualified coalition would be authorized to collect and distribute health insurance premiums and

provide related administrative services. It would need to be certified annually by an appropriate State

or federal agency as being in compliance with the following requirements. Its board would be

required to have both employer and employee representatives of its small business members, but

could not include service providers, health insurers, insurance agents or brokers, and others who

might have a conflict of interest with the coalition’s objectives. The qualified coalition could not bear

insurance or financial risk, or perform any activity relating to the licensing of health plan issuers.

Where feasible, the coalition would have to enter into agreements with three or more unaffiliated,

licensed health plans, and would be required to offer at least one open enrollment period per calendar

year. The qualified coalition would have to service a significant geographic area, but would not be

required to cross State boundaries. It would be required to accept as members all eligible employers

on a first-come, first-served basis, and would need to market its services to all eligible employers

within its designated area. An eligible employer would be defined as any small employer, as defined

under HIPAA (generally, businesses that employ an average of at least two, but not more than 50,

employees)..

Qualified coalitions would be subject to HIPAA and subsequent federal health laws, including

participant nondiscrimination rules and provisions applicable to MEWAs under ERISA and the Code.

Thus, coalition health plans could not discriminate against any individual participant as regards

enrollment eligibility or premiums on the basis of his or her health status or claims experience. In

addition, employers would have guaranteed renewability of health plan access. Health plans sold

through qualified coalitions would also be required to meet State laws concerning health insurance

premiums and minimum benefits. State “fictitious group” laws would be preempted, and States

would be required to permit an insurer to reduce premiums negotiated with a qualified coalition in

order to reflect administrative and other cost savings or lower profit margins. Health plans sold

through qualified coalitions would not be considered to be 10-or-more employer plans for purposes

of the welfare benefit fund rules. Accordingly, participating employers would be subject to the

welfare benefit fund contribution limits.

Small Business Health Plan Tax Credit

The second part of the proposal would create a temporary tax credit for small businesses to

encourage the purchase of employee health insurance through qualified health benefit purchasing

coalitions. The credit would be available to employers with at least two, but not more than 50,

employees, counting only employees with annual compensation (including 401(k) and SIMPLE

employer contributions) of at least $10,000 in the prior calendar year. Eligible employers could not

have had an employee health plan during any part of 1997 or 1998, and they would be required to

purchase insurance through a qualified coalition. The credit would equal ten percent of employer
- 9 -

contributions to employee health plans. The maximum credit amount per policy would be $200 per

year for individual coverage and $500 per year for family coverage (to be ratably reduced if coverage

is provided for less than 12 months during the employer’s taxable year). The credit would be allowed

to a qualifying small employer only with respect to contributions made during the first 24 months that

the employer purchases health insurance through a qualified coalition. For employers that begin to

purchase health insurance in 1999, this 24-month limit would not include months beginning before

January 1, 2000. As a condition of qualifying for the credit, employers would need to cover 70

percent of those workers who have compensation (including 401(k) and SIMPLE employer

contributions) of at least $10,000 and who are not covered elsewhere by a health plan. A selfemployed individual who is eligible to take a business deduction for his or her family’s health

insurance premiums would not be allowed to include any of those insurance premiums in the

calculation of the credit amount. The small business health plan credit would be treated as a

component of the general business credit, and would be subject to the limitations of that credit.

Effective Dates

The proposal would be effective for taxable years beginning after December 31, 1999. The

special foundation rule would apply to grants and loans made prior to January 1, 2004 for initial

operating expenses incurred prior to January 1, 2006. The credit would be available only for health

plans established before January 1, 2004. No carrybacks of the credit would be allowed to taxable

years beginning before January 1, 2000.
- 10 -

Expand Education Initiatives

PROVIDE TAX CREDITS FOR HOLDERS OF QUALIFIED SCHOOL

MODERNIZATION BONDS AND QUALIFIED ZONE ACADEMY BONDS

Current Law

Under current law, State and local governments fund public school construction by issuing

bonds the interest on which generally is exempt from Federal income tax. In addition, State and local

governments can issue “qualified zone academy bonds” to fund the improvement of certain eligible

public schools. An eligible holder of a qualified zone academy bond receives annual Federal income

tax credits. These annual credits compensate the holder for lending money and, therefore, are treated

like taxable interest payments for Federal tax purposes. Eligible holders are banks, insurance

companies, and corporations actively engaged in the business of lending money. The “credit rate”

on a qualified zone academy bond is used to determine the amount of the annual tax credit and

currently is set by regulations at 110 percent of the applicable federal rate (AFR) for the month in

which the bond is issued. The maximum term of a qualified zone academy bond issued during any

month is determined by reference to the “adjusted” AFR for the month in which the bond is issued.

A total of $400 million of qualified zone academy bonds may be issued in each of 1998 and

1999. The annual cap is allocated among the States in proportion to their respective populations of

individuals with incomes below the poverty line. Unused authority to issue qualified zone academy

bonds may be carried forward to subsequent years.

 

There are a number of requirements that must be met for a bond to be treated as a qualified

zone academy bond. First, the bond must be issued pursuant to an allocation of bond authority from

the issuer’s State educational agency. Second, at least 95 percent of the bond proceeds must be used

for an eligible purpose at a qualified zone academy. Eligible purposes include renovating school

facilities, acquiring equipment, developing course materials, or training teachers. A qualified zone

academy is a public school (or an academic program within a public school) that is designed in

cooperation with business and is either (1) located in an empowerment zone or enterprise community,

or (2) attended by students at least 35 percent of whom are estimated to be eligible for free or

reduced-cost lunches under the National School Lunch Act. Third, private business entities must

have promised to contribute to the qualified zone academy certain property or services with a present

value equal to at least 10 percent of the bond proceeds.

Reasons for Change

Aging school buildings, new educational technologies, growing enrollments, the need for

smaller class sizes, and changing demographics have created a need to renovate older school buildings

and to build new ones. Many school systems have insufficient fiscal capacity to finance needed

renovation and new construction. The proposal would leverage Federal support to spur new State
- 11 -

and local investment in public schools. Minor changes in the structure of qualified zone academy

bonds will allow them to be marketed more easily.

Proposal

The proposal would authorize the issuance of two types of bonds; qualified school

modernization bonds and qualified zone academy bonds. These bonds would be issued as “tax credit

bonds,” that is, they would provide the holder a Federal income tax credit in lieu of an interest

payment. As described elsewhere, “Better America Bonds” are also proposed using the same tax

credit bond format. The common features of tax credit bonds will speed the development of efficient

primary and secondary markets for all three types of bonds.

Qualified school modernization bonds

State and local governments would be able to issue “qualified school modernization bonds”

in the form of tax credit bonds to fund the construction, rehabilitation or repair of public schools. $11

billion of qualified school modernization bonds would be allocated among States and certain school

districts in each of 2000 and 2001. Half of this annual cap would be allocated among the 100 school

districts with the largest number of children living in poverty and up to 25 additional school districts

that the Secretary of Education determines are in particular need of assistance. The other half of the

cap would be allocated among States and Puerto Rico. A small portion of the total cap would be set

aside for each U.S. possession (other than Puerto Rico) based on its share of the total U.S. poverty

population. In addition, $200 million in each year would be allocated by the Secretary of the Interior

for the construction, rehabilitation, and repair of the Bureau of Indian Affairs-funded elementary and

secondary schools. The allocation among qualifying school districts and among States would be

based on the amounts of federal assistance received under the Basic Grant Formula for Title I of the

Elementary and Secondary Education Act of 1965. This assistance is based primarily upon the

number of low-income children residing in the district, with an adjustment for differences in per-pupil

expenditures. States could use any appropriate mechanism for distributing their allocation among

school districts, not necessarily the Title I formula. Allocated amounts unissued in the year of

allocation could be issued up until the end of the third following year. A qualifying school district

could transfer any unused portion of its allocation to the State in which it is located at any time prior

to that date.

Under the proposal, a bond would be treated as a qualified school modernization bond if three

requirements are met. First, the Department of Education must approve the school modernization

plan of the State or eligible school district. The plan must (1) demonstrate that a comprehensive

survey has been undertaken of the construction and renovation needs in the jurisdiction, and (2)

describe how the jurisdiction will ensure that bond proceeds are used for the purposes of this

proposal. Second, the issuing government must receive a bond allocation for a school modernization

bond. Third, 95 percent or more of the bond proceeds must be used to construct, rehabilitate, or

repair elementary and secondary public school facilities. Modernization plans for Bureau of Indian

Affairs-funded schools would be approved by the Department of the Interior. The term construction
- 12 -

includes land upon which a constructed school facility is located. Unlike qualified zone academy

bonds, qualified school modernization bonds would not be conditioned on contributions from private

businesses. 

Qualified zone academy bonds.

The proposal would provide authority for $1 billion in 2000 and $1.4 billion in 2001 of

qualified zone academy bonds. The list of permissible uses of proceeds of qualified zone academy

bonds would be expanded to include school construction. In addition, the proposal would make

several changes to the existing qualified zone academy bond statute applicable to bonds issued after

the effective date to conform to the structure of tax credit bonds described below.

Rules applicable to tax credit bonds generally.

 The holder of a tax credit bond would receive annual Federal income tax credits equal to the

applicable credit rate multiplied by the amount held on its anniversary date. Because the annual

credits compensate the holder for lending money, they would be treated as payments of interest for

Federal income tax purposes and, accordingly, would be included in the holder’s gross income. The

credit rate would be set equal to a measure of the yield on outstanding corporate bonds, specified in

Treasury regulations, for the business day prior to the date of issue. The maximum term of the bonds

would be 15 years. Any taxpayer would be able to hold a tax credit bond and thereby claim the tax

credit. Treasury would provide regulations regarding the treatment of credits that flow through from

a mutual fund to the holder of mutual fund shares. Unused credits would not be carried backward

but would be carried forward for 5 years. The proposal would grant regulatory authority to the

Secretary to require information returns to be provided with respect to holders (including

corporations) that are entitled to credits.

Under the proposal, at least 95 percent of the tax credit bond proceeds must be used for

qualifying purposes. Any investment earnings (and earnings on those earnings) associated with

unexpended proceeds during the three-year period following the date of issuance are treated as

proceeds, i.e., they must also be used for qualifying purposes. As of the date of issue, issuers must

reasonably expect that 95 percent of the proceeds will be expended for qualifying purposes within

three years and that any property financed with bond proceeds will be used for a qualified purpose

for at least a 15-year period after the date of issuance. During the three-year period, unexpended

proceeds may only be invested in bank accounts or U.S. Treasury securities maturing in three years

or less. Issuers must incur a binding obligation with a third party to expend at least 10 percent of the

proceeds of the issue within 6 months of the issue date and allocate the bond sale proceeds to

expenditures with due diligence. To the extent 95 percent of proceeds are not expended by the end

of the 3-year period for qualifying purposes, unexpended proceeds must be used to retire bonds

within 90 days. If the issuer establishes a sinking fund to repay principal, sinking fund assets must

be held in State and Local Government Securities (SLGS) issued by the Treasury. Property financed

with the sale proceeds of qualified zone academy bonds or school modernization bonds must be

owned by a State or local governmental unit or an agency thereof. 
- 13 -

Bonds would cease to be qualified bonds and would accrue no further tax credits in the event

that any of the tax-related requirements fail to be met. The issuer would be obligated to reimburse

the Federal government (with interest) for any credits accruing three years prior to the date of noncompliance. If this obligation is not timely paid by the issuer, the Federal government has the right

to recover the credit amount from the current holder of the bonds.

The proposal would be effective for bonds issued on or after January 1, 2000.
- 14 -

EXCLUSION FOR EMPLOYER-PROVIDED EDUCATIONAL ASSISTANCE

Current Law

Section 127 provides that an employee’s gross income and wages do not include amounts paid

or incurred by the employer for educational assistance provided to the employee if such amounts are

paid or incurred pursuant to a qualified educational assistance program. This exclusion is limited to

$5,250 of educational assistance with respect to an individual during a calendar year. The exclusion

applies whether or not the education is job-related. In the absence of this exclusion, educational

assistance is excludable from income only if it is related to the employee’s current job. 

The exclusion applies with respect to undergraduate courses beginning before June 1, 2000.

The exclusion does not apply to graduate level courses beginning after June 30, 1996.

Reasons for Change

Well-educated workers are essential to an economy experiencing technological change and

facing global competition. Extension of section 127, including reinstatement of its application to

graduate courses, will expand educational opportunity and increase productivity. In addition, these

provisions will encourage the retraining of current and former employees to reflect the changing

needs of the workplace. The extension of section 127 also will simplify the rules for employers and

workers by eliminating the need to distinguish between job-related expenses and other employerprovided educational assistance. 

Proposal

The current-law exclusion would be extended by 18 months to apply to undergraduate

courses beginning before January 1, 2002. In addition, the exclusion would be reinstated for graduate

education, effective for courses beginning after June 30, 1999 and before January 1, 2002.
- 15 -

TAX CREDIT FOR EMPLOYER-PROVIDED WORKPLACE LITERACY AND BASIC

EDUCATION PROGRAMS

Current Law

Workplace literacy and basic education expenses are deductible to employers, either as

ordinary and necessary business expenses to the extent they are job-related or as employee

compensation. If they are deemed to be compensation, the expenses are includable in the worker’s

gross income unless provided under a section 127 educational assistance plan or treated as a working

condition fringe benefit. Under a section 127 plan, educational expenses other than for graduate

education are excluded from an employee’s gross income for income and employment tax purposes,

up to $5,250 per year. (Section 127 expires with respect to courses beginning after May 31, 2000.)

Educational expenses paid by an employer outside of a section 127 plan that are related to the

employee’s current job may be excludable from the employee’s gross income as a working condition

fringe benefit, but not if the education relates to certain minimum educational requirements or enables

the employee to begin working in a new trade or business.

No credits are allowed to employers for workplace literacy or other types of employee

education expenses. Lifetime Learning tax credits may be available to employees for high school

equivalency courses taken at postsecondary institutions such as community colleges. 

Reasons for Change

With the increasing technological level of the workplace of the 21 century, workers with low st

levels of education will fall farther behind their more educated coworkers and run greater risk of

unemployment. However, low-skilled workers may not undertake needed education because they

lack the time for the courses or the resources to overcome barriers such as cost, child care, and

transportation. Their employers may hesitate to provide general education because the benefits of

basic skills and literacy education are more difficult for employers to capture through increased

productivity than the benefits of job-specific education. Providing a credit will encourage employers

to provide workplace literacy and basic education programs to their employees.

Proposal

Employers who provide certain workplace literacy, English literacy, and basic education

programs for their eligible employees would be allowed to claim a credit against the employer’s

Federal income taxes. The amount of the credit would equal 10 percent of the employer’s eligible

expenses incurred with respect to qualified education programs, with a maximum credit of $525 per

participating employee. The credit would be treated as a component of the general business credit,

and would be subject to the limitations of that credit.

Qualified education would be limited to (1) basic skills instruction at or below the level of a

high school degree; and (2) English literacy instruction. Eligible employees -- employees with respect
- 16 -

to whom the employer could claim a credit -- would generally not have received a high school degree

or its equivalent, or, for English literacy programs, would have limited English proficiency. The

employer could claim a credit with respect to employees with high school degrees but who lack

sufficient mastery of basic educational skills to function effectively in the workplace only if an eligible

provider both assesses the educational level of the employees and provides the instructional program

for the employer. Eligible employees must be citizens or resident aliens aged 18 or older who are

employed by the taxpayer in the United States for at least six months.

To be eligible for the credit, the provision of literacy or basic education by an employer must

meet the nondiscrimination requirements for educational assistance programs under current-law

section 127. If expenses for a literacy or basic education program are eligible for the credit, then the

educational benefits provided to employees under that program would be treated as tax-free working

condition fringe benefits under section 132(d).

Expenses eligible for the credit would include payments to third parties and payments made

directly to cover instructional costs, including but not limited to salaries of instructors, curriculum

development, textbooks, and instructional technology used exclusively to support basic skills

instruction. Wages paid to workers while they participate as students in the literacy or basic

education program would not be eligible for the credit. The amount of the credit claimed reduces,

dollar for dollar, the amount of education expenses that the employer may otherwise deduct in

computing its taxable income. 

Unless the employer provides basic skills instruction through an eligible provider, the

curriculum must be approved by a State adult education authority, defined as an “eligible agency” in

section 203(4) of the Adult Education and Family Literacy Act. An "eligible provider" would be an

entity that is receiving Federal funding for adult education and literacy services or English literacy

programs under the Adult Education and Family Literacy Act, Title II of the Workforce Investment

Act of 1998. Eligible providers include local education agencies, certain community-based or

volunteer literacy organizations, institutions of higher education, and other public or private nonprofit

agencies. 

The proposal would be effective for taxable years beginning after December 31, 1999.
- 17 -

ENCOURAGE CORPORATE SPONSORSHIP OF QUALIFIED ZONE

ACADEMIES IN EMPOWERMENT ZONES AND ENTERPRISE COMMUNITIES 

Current Law

Pursuant to the Omnibus Budget Reconciliation Act of 1993 and the Taxpayer Relief Act of

1997, 31 empowerment zones and 95 enterprise communities have been designated under section

1391 of the Internal Revenue Code. Designated empowerment zones and enterprise communities are

required to satisfy certain eligibility criteria, including specified poverty rates and population and

geographic size limitations. Special tax incentives are available for certain businesses located in an

empowerment zone or enterprise community.

Under current-law section 1397E, State and local governments can issue qualified zone

academy bonds to fund improvements in certain Aqualified zone academies@ which provide elementary

or secondary education. A total of $400 million of qualified zone academy bonds may be issued in

each of 1998 and 1999 (and unused authority to issue such bonds may be carried forward to

subsequent years). The annual cap is allocated among the States in proportion to their populations

of individuals with incomes below the poverty level. An eligible holder of a qualified zone academy

bond receives annual Federal income tax credits, which compensate the holder for lending the money

and, therefore, are treated like taxable interest payments for Federal income tax purposes. Qualified

zone academies must be located in either a designated empowerment zone or enterprise community

or, if not, there must be a reasonable expectation that at least 35 percent of the students attending the

academy will be eligible for free or reduced-cost lunches under the National School Lunch Act. 

Reasons for Change

To encourage private-sector support of, and participation in, educational programs conducted

at qualified zone academies located in empowerment zones and enterprise communities, a tax credit

should be provided for certain corporate sponsorship payments made to qualified zone academies.

Proposal

A credit against Federal income taxes would be allowed for certain corporate sponsorship

payments made to a qualified zone academy located in a designated empowerment zone or enterprise

community. The credit would equal 50 percent of cash contributions, plus 50 percent of the fair

market value of certain in-kind contributions made to a qualified zone academy. For purposes of the

credit, a qualified zone academy would be treated as located in a designated empowerment zone or

enterprise community if a significant percentage of its students reside in the zone or community.

The credit would be available only if a credit allocation has been made with respect to the

corporate sponsorship payment by the local governmental agency with responsibility for implementing

the strategic plan of the empowerment zone or enterprise community under section 1391(f)(2), in
- 18 -

consultation with the local educational agency with jurisdiction over public schools in the zone or

community. The local governmental agency for each of the 31 designated empowerment zones would

be allowed to designate up to $8 million of sponsorship payments to qualified zone academies as

eligible for the 50-percent credit (that is, up to $4 million of credits). The local governmental agency

for each of the 95 designated enterprise communities would be allowed to designate up to $2 million

of contributions to qualified zone academies as eligible for the 50-percent credit (that is, up to $1

million of credits). The deduction otherwise allowed for a corporate sponsorship payment would be

reduced by the amount of the credit claimed with respect to such payment by the corporate sponsor.

The proposed credit would be subject to the general business credit rules under present-law section

38, and would be effective for corporate sponsorship payments made after December 31, 1999.
- 19 -

ELIMINATE 60-MONTH LIMIT ON STUDENT LOAN INTEREST DEDUCTION

Current Law

Section 221, which was enacted in 1997, provides a deduction for certain interest paid on a

qualified education loan during the first 60-months that interest payments are required on the loan,

effective for interest due and paid after December 31, 1997. The maximum allowable deduction is

$1,000 in 1998, $1,500 in 1999, $2,000 in 2000 and $2,500 in 2001 and subsequent years. The

maximum deduction is not indexed for inflation. In addition, the deduction is phased out ratably for

single taxpayers with adjusted gross income (AGI) between $40,000 and $55,000 and for married

taxpayers filing a joint return with AGI between $60,000 and $75,000. The phase-out ranges are

indexed for inflation beginning after 2002.

Reasons for Change

The 60-month limitation under section 221 adds significant complexity and administrative

burdens for taxpayers, lenders, loan servicing agencies and the IRS. For example, a taxpayer may

have several student loans, which may have entered repayment status on different dates. In addition,

special rules are required to apply the 60-month limitation in common situations, such as periods of

loan deferment or forbearance, loan refinancings, and loan consolidations. The 60-month limitation

could also lead to the inconsistent treatment of taxpayers based on how a lender structures the

interest payments on a qualified education loan and when a taxpayer chooses to make interest

payments. For example, a taxpayer who elects to capitalize interest that accrues on a qualified

education loan while the taxpayer is enrolled in college (and the loan is in deferment) may be able to

deduct more total interest payments than a taxpayer (with the same size qualified education loan) who

elects to pay the interest currently during college. This is true because, in the former case, the 60-

month period is suspended while the loan is in deferment; in the latter case, the 60-month period

continues to elapse. Eliminating the 60-month limitation would simplify the calculation of deductible

interest payments, avoid inconsistent treatment of taxpayers and also provide longer-term relief to

taxpayers with large educational debt.

Proposal

The proposal would eliminate the limit on the number of months during which interest paid

on a qualified education loan is tax-deductible. The proposal generally would be effective for interest

paid on qualified education loans after December 31, 1999.
- 20 -

ELIMINATING TAX ON FORGIVENESS OF DIRECT STUDENT LOANS

SUBJECT TO INCOME CONTINGENT REPAYMENT

Current Law

Generally, when a lender forgives a borrower’s loan, the borrower has income equal to the

loan balance that is forgiven. In the case of student loans, an exception is provided when the lender

is a governmental agency or tax-exempt charitable or educational organization, and the lender

forgives all or part of the loan in return for the borrower’s providing professional services for a

certain period of time to certain employers for the benefit of the community. 

Individuals who borrow money to pay for postsecondary education through the Federal

government’s Direct Loan program may elect income contingent repayment of their loans. If they

elect income contingent repayment, the size of their repayment installments is adjusted in accordance

with their income. If an individual who has elected income contingent repayment still has an

outstanding loan balance after having been in income contingent repayment status for twenty-five

years, the loan balance is forgiven. 

Reasons for Change

When taxpayers who have elected income contingent repayment qualify for loan forgiveness

after having been in income contingent repayment status for twenty-five years, the taxpayers should

be able to take advantage of the loan forgiveness without undertaking a substantial new obligation

for income tax to the Federal government.

Proposal

The proposal would allow a taxpayer to exclude from income any amount the taxpayer would

otherwise include as a result of the forgiveness of a student loan made under the Direct Loan

program. 

The proposal would be effective for loan cancellations after December 31, 1999.
- 21 -

TAX TREATMENT OF EDUCATION AWARDS

UNDER CERTAIN FEDERAL PROGRAMS

1. Eliminate Tax on Awards under National Health Corps Scholarship Program and F.

Edward Hebert Armed Forces Health Professions Scholarship and Financial Assistance

Program

Current Law

Section 117 provides tax-free treatment for certain scholarship and fellowship grants used to

pay qualified tuition and related expenses, but not to the extent that any grant represents

compensation for services. The National Health Service Corps (NHSC) Scholarship Program and

the F. Edward Hebert Armed Forces Health Professions Scholarship and Financial Assistance

Program provide certain education awards to participants on condition that the participants provide

certain services. These education awards generally involve the payment of higher education expenses

(under the NHSC program, the awards may be also used for the repayment or cancellation of existing

or future student loans). Because the recipients are required to perform services in exchange for the

education awards, the awards used to pay higher education expenses are taxable income to the

recipient.

Reasons for Change

Imposing a tax liability on education awards under these Federal programs undercuts the

objective of providing an incentive for health professionals to serve in medically underserved

geographic areas, in the case of the NHSC Scholarship Program, or the Armed Forces, in the case

of the Armed Forces Health Professions Program.

Proposal

The proposal would provide that amounts received by an individual under the National Health

Service Corps Scholarship Program or the Armed Forces Health Professions Scholarship and

Financial Assistance Program are “qualified scholarships” excludable from income, without regard

to any service obligation by the recipient. 

The proposal would be effective for education awards received after December 31, 1999.
For this purpose, qualified expenses were not taken into account to the extent that the 6

otherwise allowable credit was reduced due to the taxpayer’s AGI.

- 22 -

2. Eliminate Tax on Repayment or Cancellation of Student Loans under NHSC

Scholarship Program, Americorps Education Award Program, and Armed Forces

Health Professions Loan Repayment Program

Current Law

Section 108(f) provides tax-free treatment for certain discharges of student loans which result

from the debtor’s agreeing to work for a certain period of time in certain professions for any of a

broad class of employers. The NHSC Scholarship Program, the Americorps Education Award

Program, and the Armed Forces Health Professions Loan Repayment Program provide education

awards to participants that may be used for the repayment or cancellation of existing or future student

loans. However, the repayment or cancellation of student loans under these programs appears not

to meet the requirements for exclusion under current-law section 108(f).

Reasons for Change

The tax liability on student loan repayments or cancellations under these Federal programs

reduces the incentive for individuals to participate in these programs, which provide important health,

education, and other services to underserved areas, in the case of the NHSC and Americorps

programs, and maintain quality health services for the Armed Forces, in the case of the Armed Forces

Health Professions Program.

Proposal

The proposal would provide that any repayment or cancellation of a student loan under the

NHSC Scholarship Program, the Americorps Education Award Program, or the Armed Forces Health

Professions Loan Repayment Program is excludable from income. The tax-free treatment would

apply only to the extent that the student incurred qualified tuition and related expenses in excess of

those which were taken into account in determining the amount of any education credit claimed

during academic periods when the student loans were incurred.6

The proposal would be effective for repayments or cancellations of student loans received

after December 31, 1999.
- 23 -

Making Child Care More Affordable

INCREASE, EXPAND AND SIMPLIFY THE CHILD AND 

DEPENDENT CARE TAX CREDIT

Current Law 

A taxpayer may be eligible for a nonrefundable tax credit if he or she pays for the care of a

qualifying individual in order to work. Qualifying individuals include dependents under the age of

13 and disabled dependents or spouses. The credit is equal to a percentage of the taxpayer’s

employment-related expenditures for child or dependent care. A taxpayer must provide over half the

costs of maintaining the household in which the taxpayer and the qualifying dependent reside.

Taxpayers who do not incur out-of-pocket child care expenses are not eligible for the credit.

The credit rate depends on the taxpayer’s adjusted gross income. The credit rate is phaseddown from 30 percent (for taxpayers with adjusted gross incomes of $10,000 or less) to 20 percent

(for taxpayers with adjusted gross incomes above $28,000). The maximum amounts of qualifying

employment-related expenses for which credits can be claimed are limited to $2,400 for one

qualifying individual and $4,800 for two or more qualifying individuals. Thus, the maximum credit

ranges from $480 to $720 for a taxpayer with one qualifying individual and $960 to $1,440 for a

taxpayer with two or more qualifying individuals.

Employees may exclude from their taxable income (and their earnings for social security tax

purposes) amounts their employers provide as child and dependent care benefits, including those

provided through a cafeteria plan. The exclusion is limited to $5,000 of child care expenses per year

and does not vary with the number of qualifying dependents. The amount of a taxpayer's expenses

eligible for the child and dependent care credit is reduced dollar for dollar by the amount of

excludable benefits provided by the employer.

Reasons for Change

Many working parents cannot find affordable and safe child care. In the FY 2000 budget, the

Administration is proposing a comprehensive initiative to address the child care needs of both lowand moderate-income working families. Low-income families will receive additional assistance

through an expansion of the Child Care and Development Block Grant. The needs of moderateincome families can be best served through an expansion of the child and dependent care tax credit,

which was last increased in 1982. 

Infants require special care and attention. Infants especially benefit from bonding with their

parents during their first year, although many parents cannot afford to stay at home to care for their

children. To enable parents to make the best choices for caring for their youngest children, the child

and dependent care tax credit should be expanded to provide additional assistance to taxpayers with

infants.
- 24 -

Proposal

Expand basic child and dependent care credit

The maximum child and dependent care tax credit rate would be increased from 30 percent

to 50 percent. Taxpayers would be eligible for the 50-percent credit rate if their adjusted gross

income is $30,000 or less. For taxpayers with adjusted gross incomes between $30,000 and $59,000,

the credit rate would be reduced by one percentage point for each additional $1,000, or fraction

thereof, of adjusted gross income in excess of $30,000. Taxpayers with adjusted gross incomes over

$59,000 would be eligible for a 20-percent credit rate. The current-law maximum amounts of

employment-related expenses for which the credit can be claimed ($2,400 for one qualifying

individual and $4,800 for two or more qualifying individuals) would be retained. Thus, the maximum

credit would range from $480 to $1,200 for a taxpayer with one qualifying individual and $960 to

$2,400 for a taxpayer with two or more qualifying individuals.

Taxpayers generally would no longer be required to provide over half the costs of 

maintaining the home in which the taxpayer and the qualifying individual reside to claim the child and

dependent care tax credit, but would still be required to demonstrate that they resided in the same

household as the qualifying individual. A married taxpayer who files a separate return, however,

would still have to meet the current law household maintenance test in order to qualify for the credit.

The provision would be effective for tax years beginning after December 31, 1999. Beginning

2001, the $30,000 starting point for the phase-down range would be indexed for inflation. The

maximum amounts of qualifying child and dependent care expenses that could be claimed for the

credit also would be indexed, beginning in 2001.

Additional credit for taxpayers with infants

The child and dependent care tax credit would be expanded to provide an additional credit

for all taxpayers with qualifying dependents under the age of one (“infants”), whether or not they

incur out-of-pocket child care expenses. The additional credit amount would be equal to the

applicable credit rate multiplied by $500 for an infant ($1,000 for two or more infants). 

For taxpayers with infants who incur out-of-pocket child care expenses in order to work, the

proposed expanded basic child and dependent care tax credit would be augmented by allowing these

taxpayers to add $500 (or $1,000 if two or more infants) to these expenses. For example, a twoearner couple with an infant could qualify for a maximum child and dependent care tax credit of up

to $1,450 if they incurred $2,400 or more of out-of-pocket child care expenses (50 percent x

($2,400+$500)). 

Taxpayers with infants who do not incur any out-of-pocket child care expenses would also

be eligible for the additional credit for infants. For example, a taxpayer with a stay-at-home spouse

who cares for their infant would qualify for a maximum credit of up to $250 (50 percent x $500)
- 25 -

($500 if they have two or more infants). Similarly, a two-earner couple with an infant could qualify

for a credit of up to $250 even if they rely on unpaid relatives and friends to help care for their infant

while they are at work. 

The provision would be effective for taxable years beginning after December 31, 1999. The

additional credit for taxpayers with infants would be appropriately indexed for inflation beginning in

2000.
- 26 -

PROVIDE TAX INCENTIVES FOR

EMPLOYER-PROVIDED CHILD-CARE FACILITIES

Current Law

If an employer incurs expenses to assist employees in obtaining child care, either by acquiring

or constructing a child care facility for their use or arranging for third parties to provide child care

services, those expenses generally are either immediately deductible under section 162 as ordinary

and necessary business expenses or capitalized and then recovered over time through depreciation

deductions. Employers may also treat up to $5,000 per year in dependent care assistance provided

to an employee who is a long-term family assistance recipient as wages for purposes of the Welfareto-Work Tax Credit provided under section 51A. Otherwise, an employer is not eligible to take a

credit against Federal income tax for expenses incurred that relate to child care for its employees.

Reasons for Change

As part of the Administration's comprehensive initiative to address the child care needs of both

low- and moderate-income working families, the Administration intends to provide private sector

employers with an incentive to make quality child care services available to their employees.

Proposal

Taxpayers would receive a credit against their Federal income tax equal to 25 percent of

qualified expenses for employee child care. These expenses would include costs incurred:

(1) to acquire, construct, rehabilitate or expand property that is to be used

as part of a taxpayer's qualified child care facility;

(2) for the operation of a taxpayer's qualified child care facility, including

the costs of training and continuing education for employees of the child

care facility; or

(3) under a contract with a qualified child care facility to provide child

care services to employees of the taxpayer.

To be a qualified child care facility, the principal use of the facility must be for child care, and the

facility must be duly licensed by the State agency with jurisdiction over its operations. Also, if the

facility is owned or operated by the taxpayer, at least 30 percent of the children enrolled in the center

(based on an annual average of the enrollment measured at the beginning of each month) must be

children of the taxpayer’s employees. If a taxpayer opens a new facility, it must meet the 30 percent

employee enrollment requirement within two years of commencing operations. If a new facility failed

to meet this requirement, the credit would be subject to recapture.
- 27 -

To qualify for the credit, the taxpayer must offer child care services, either at its own facility

or through third parties, on a basis that does not discriminate in favor of highly compensated

employees. 

A taxpayer would also be entitled to a credit for ten percent of expenses incurred to provide

employees with child care resource and referral services.

A taxpayer’s total credit under this proposal would be limited to $150,000 per year. Any

deduction the taxpayer would otherwise be entitled to take for the qualified expenses would be

reduced by the amount of the credit. Similarly, if the credit is taken for expenses of acquiring,

constructing, rehabilitating, or expanding a facility, the taxpayer’s basis in the facility would be

reduced by the amount of the credit. The credit would be subject to the general business credit rules

of section 38.

The credit would be effective for taxable years beginning after December 31, 1999.
- 28 -

Provide Incentives To Revitalize Communities

INCREASE LOW-INCOME HOUSING TAX CREDIT PER CAPITA CAP

Current Law

A tax credit is allowed in annual installments over 10 years for qualifying low-income rental

housing, which may be newly constructed or substantially rehabilitated residential units. In order for

a credit to be claimed with respect to a building, the building owner must receive a credit allocation

from a State or local housing authority. The low-income housing credit is allocated by State or local

government authorities subject to an annual limitation for each State. The annual State housing credit

limitation, expressed in terms of first-year credits, is currently equal to the sum of $1.25 per capita,

the amount of unused housing credit (if any) for the preceding calendar year, the amount of housing

credits (if any) returned to the State or local authority in the calendar year, and the housing credit

amounts (if any) allocated to such State by the Secretary of the Treasury out of a pool of returned

credits. The $1.25 per capita amount, used in determining a State’s total amount of available firstyear credits, was set in 1986. 

Reasons for Change

 The need for decent low-income housing exceeds the amount markets provide at affordable

rents. Most State agencies receive qualified proposals for far more low-income rental housing than

they can support with available credits. Without the tax credits, these projects will not be undertaken.

A modest increase in the per capita amount will allow additional low-income housing to be provided

but still will require that State agencies choose projects that meet specific housing needs.

Proposal 

The annual State low-income housing credit limitation would be increased to $1.75 per capita,

effective for calender years beginning after 1999.
- 29 -

PROVIDE TAX CREDITS FOR HOLDERS OF BETTER AMERICA BONDS

Current Law

State and local governments may issue tax-exempt bonds without limit for environmental

purposes so long as no more than 10 percent of the bond proceeds are: 1) used by private entities in

a trade or business and payments or security associated with that use are available to pay interest and

principal on the bonds, and 2) no more than 5 percent of the bond proceeds are lent to private

businesses or individuals. If these private activity tests are met, tax-exempt private activity bonds

may nonetheless be issued, subject to State-by-State volume caps, for the following environmental

purposes: water, sewage, solid waste disposal facilities, hazardous waste facilities, environmental

enhancements of hydro-electric generating facilities and redevelopment infrastructure in blighted areas

if the bonds are supported by incremental property taxes. The federal subsidy indirectly provided by

tax-exempt bonds is limited by market forces to the differential in interest rates between tax-exempt

bonds and taxable bonds of similar risk and maturity. Deeper subsidies are provided to Qualified

Zone Academy Bonds, the entire interest on which is paid in the form of tax credits.

Taxpayers are allowed to expense, rather than capitalize or amortize, certain environmental

remediation costs with respect to certain areas referred to as brownfields.

Reasons for Change

Significant public benefits are provided by protecting open spaces; creating forest preserves

near urban areas; rehabilitating land that has been degraded by toxic or other wastes or destruction

of its ground cover; improving parks and reestablishing wet lands. These benefits include creating

more livable urban, suburban, and rural environments, protecting public health, repairing

environmental damage and, in the case of reforestation, absorbing greenhouse gases. Local

governments are typically unwilling to assume the major financial burdens required to take the actions

necessary to secure these benefits because the benefits are so widely diffused. Tax-exempt bond

financing may not provide a deep enough subsidy to induce State and local governments to undertake

beneficial environmental infrastructure projects. Moreover, the expensing provision does not provide

an incentive for environmental remediation of property owned by governments and intended for

future public use or for use by a tax-exempt entity.

Proposal

State and local governments (including Native American tribal governments and U.S.

Possessions) would be able to issue Better America Bonds (BABs) to the extent of authority to do

so allocated by the Administrator of the Environmental Protection Agency (EPA). The volume of

authority to issue BABs that may be allocated by the EPA Administrator in each of the five years,

beginning in 2000, would be $1.9 billion. Amounts unallocated for any year may be allocated in the
- 30 -

following year. Allocated amounts unissued in the year of allocation may be issued up until the end

of the third following year.

As part of an annual competition, States (including Native American Tribal governments and

U.S. possessions), and local governments could apply to the EPA for authority to issue BABs.

Applications would be submitted following guidelines which EPA would publish prior to January 1,

2000. Those guidelines would indicate the criteria to be used for approving applications. EPA, in

consultation with other federal agencies, would review applications and award bond allocations in

conjunction with the Community Empowerment Board. A government could issue BABs under an

agreement with the sponsor of an approved application. Issuers would be responsible for repayment

of principal to the holders of BABs upon their maturity. 

The structure of BABs as tax credit bonds would be identical to that proposed for Qualified

School Modernization Bonds and Qualified Zone Academy Bonds. The holder of a tax credit bond

would receive annual federal income tax credits equal to the applicable credit rate multiplied by the

amount held on its anniversary date. Because the annual credits compensate the holder for lending

money, they would be treated as payments of interest for federal income tax purposes, and

accordingly would be included in the holder’s gross income. The credit rate would be set equal to

a measure of the yield on outstanding corporate bonds, specified in Treasury regulations, for the

business day prior to the date of issue. The maximum term of the bonds would be 15 years. Any

taxpayer would be able to hold a tax credit bond and thereby claim the tax credit. Treasury would

provide regulations regarding the treatment of credits that flow through from a mutual fund to the

holder of mutual fund shares. Unused credits could be carried forward for 5 years. The proposal

would require information returns to be provided with respect to holders (including corporations) that

are entitled to credits.

Issuers must reasonably expect, as of the date of issue, that 95 percent of the proceeds will

be expended for qualifying purposes within three years and that any property financed with bond

proceeds will be used for a qualified purpose for at least a 15-year period after the date of issuance.

For purposes of the requirement that 95 percent of tax credit bond proceeds be used for qualifying

purposes, any investment earnings (and earnings on those earnings) associated with unexpended

proceeds during the three-year period following the date of issuance are treated as proceeds, i.e., they

must also be used for qualifying purposes. During the three-year period, unexpended proceeds may

only be invested in bank accounts or U.S. Treasury securities maturing in three years or less. If the

issuer establishes a sinking fund to repay principal, sinking fund assets must be held in State and Local

Government Securities (SLGS) issued by the Treasury. Issuers must incur a binding obligation with

a third party to expend at least 10 percent of the proceeds of the issue within 6 months of the issue

date and allocate the sale proceeds to expenditures with due diligence. If 95 percent of proceeds are

not expended by the end of the three-year period for qualifying purposes, unexpended proceeds must

be used to retire a portion of the bonds within 90 days. No depreciation deductions would be allowed

with respect to property financed with tax credit bonds.
- 31 -

Acquisition of land and facilities is only a qualifying purpose if the property is intended to be

available, and is in fact reasonably available, for use by members of the general public. Any

agreement, other than a management contract that would be a qualified management contract if the

land or facilities had been financed with tax-exempt bonds, conveying priority rights or other

preferential benefits to a private person violates the general public use provision and would not

constitute a qualified purpose. Furthermore, repayment of principal may not be secured or paid with

monies derived from private persons in any capacity other than that of the general public. 

Bonds would cease to be qualified bonds and would accrue no further tax credits after the

date the use of any bond-financed facilities changes to a non-qualifying use. The issuer would be

obligated to reimburse the federal government (with interest) for any credits accruing prior to that

date. If this obligation is not timely paid by the issuer, the federal government has the right to recover

the credit amount from the current holder of the bonds. In the event the issuer fails to satisfy one of

the other tax-related requirements, no further tax credits would accrue and the issuer would be

obligated to reimburse the federal government (with interest) for all past credits claimed with respect

to the bonds. In the event this obligation is not timely paid by the issuer, the federal government has

the right to recover the credit amount from current bond holders.

The qualifying purposes for BABs are:

a. Acquisition of land for open space, wetlands, public parks or greenways to be owned by

an eligible issuer or by a 501(c)(3) entity whose exempt purpose includes environmental

preservation.

b. Construction of visitor facilities, such as campgrounds and hiking or biking trails, in

connection with such acquired land or other open space, wetlands, or parks that are owned

by an eligible issuer or by a 501(c)(3) entity whose exempt purpose includes environmental

preservation.

c. Remediation of land acquired under (a) above or of publicly owned open space, wetlands

or parks (for example, for enhancing water quality) by planting trees or other vegetation,

creating settling ponds to control runoff, undertaking reasonable measures to control erosion

or protect endangered species, and remediating conditions caused by the prior disposal of

toxic or other waste. 

d. Acquisition of easements on privately owned open land that prevent commercial

development and any substantial change in the use or character of the land. Such easements

must be in a form which, if contributed by the owner of the open land, would qualify under

section 170(h).

e. Environmental assessment and remediation of contaminated property -- brownfields –

owned by State or local governments because it was abandoned by the prior owner, e.g., for

non-payment of taxes. The property would have to be an area at or on which there has been
- 32 -

a release (or threat of release) or disposal of any hazardous substance within the meaning of

section 198. For this use, and this use only, private use (by an entity which is not a 501(c)(3)

entity) of proceeds as well as private payment of bond principal is permitted. For example,

the cost of environmental remediation of such property could be financed with BABs and the

land subsequently sold to a private entity with the proceeds of the sale used to repay principal

through the use of a sinking fund. The federal government would not be a qualifying private

entity. No expenditures financed with BAB proceeds would be eligible for expensing under

section 198.

To encourage continuing use of property financed with BABs, such property could not be

converted to a non-qualifying use after the expiration of the 15-year compliance period without a

reasonable amount of time being allowed for any 501(c)(3) entity whose exempt purpose includes

environmental protection to exercise an option, granted upon issuance of the bonds and recorded in

property records, to purchase the property at the price originally paid in conjunction with the

expenditure of bond proceeds so long as the purchasing entity covenanted to retain the property in

a qualifying use in perpetuity.

Issuance of BABs would be subject to the public approval rules of section 147(f). BABs

could be issued in a pool bond format so long as the 3-year spend-out rule was observed.

The proposal would be effective for bonds issued on or after January 1, 2000.
- 33 -

PROVIDE NEW MARKETS TAX CREDIT

Current Law

In general, there are limited tax incentives for investing and making loans to businesses in lowincome communities. For example, current law provides for targeted tax incentives that are intended

to encourage investment in specialized small business investment companies that are licensed by the

Small Business Administration to make loans to, or equity investments in, small businesses owned

by persons who are socially or economically disadvantaged.

Reasons for Change

Businesses in our nation’s inner cities and isolated rural communities often lack access to

equity capital to grow and succeed. To help attract new capital to these businesses, a new tax credit

for equity investments in these businesses is proposed. 

Proposal

In general.--Taxpayers would be allowed a credit against Federal income taxes for qualified

investments made to acquire stock or other equity interests in a selected community development

entity. The credits would be allocated to selected community development entities by the Department

of Treasury, pursuant to regulations to be issued by that Department. For each year during the period

2000-2004, the Treasury Department would be permitted to authorize selected community

development entities to issue an aggregate of $1.2 billion of equity interests with respect to which

credits could be claimed under the proposal (a total of $6 billion of new equity investment). If the

selected community development entity fails to sell equity interests to investors up to the amount

authorized within five years of the authorization, then the remaining authorization would be canceled,

and the Treasury Department would have up to two years to authorize another community

development entity to issue equity interests for the unused portion.

The credit allowed to the investor (either the original purchaser or a subsequent holder) would

be a six-percent credit for each year during the five-year period after the equity interest is purchased

from the selected community development entity. A taxpayer holding a qualified investment would

be entitled to a credit on each credit allowance date (meaning each one-year anniversary, during a

five-year period, of the date the investment was originally purchased from the community

development entity). The taxpayer’s basis in the investment would be reduced by the amount of the

credit. The credit would be subject to the general business credit rules. 

Qualified investments.--“Qualified investments” which entitle the investor to a credit must be

common stock or other similar equity interest acquired from a selected community development entity
 To ensure that credits are available only for new equity investments in selected 7

community development entities, the term “qualified investment” would not include any stock or

other equity interest acquired from a community development entity which made a substantial

stock redemption or distribution (without a bona fide business purpose therefor) in an attempt to

avoid the purposes of the proposal.

 If at least 85 percent of the aggregate gross assets of the community development entity 8

are invested (directly or indirectly) in equity interests in, or loans to, qualified active businesses

located in low-income communities, then there would be no need to trace the use of the proceeds

from the particular stock (or other equity ownership) issuance with respect to which the credit is

claimed.

 A community development entity would be treated as indirectly making “qualified low- 9

income community investment” when it purchases loans previously made by another community

development entity which, in turn, uses the proceeds from the transaction to provide additional

capital to qualified active businesses located in low-income communities.

 Expenditures made by a community development entity to provide financial counseling 10

and certain other services to businesses located in, and residents of, low-income communities

would also be treated as “qualified low-income community investment.”

- 34 -

in exchange for cash. The stock or other equity interest must not be redeemed (or otherwise cashed 7

out) by the selected community development entity for at least five years. Substantially all of the

proceeds of the investment must be used by the community development entity to make “qualified

low-income community investments,” meaning equity investments in, or loans to, qualified active

businesses located in low-income communities. Qualified low-income community investments could 8

be made directly by a selected community development entity, or could be made indirectly through

another community development entity.9

Community development entities.--“Community development entities” that could apply for

credit allocations would include (but would not be limited to) Community Development Financial

Institutions, Community Development Corporations, Small Business Investment Corporations-LMIs,

New Market Venture Capital Firms, America’s Private Investment Corporations, or other investment

funds (including for-profit subsidiaries of nonprofit organizations). To be selected for a credit

allocation, the community development entity’s primary mission must be serving or providing

investment capital for low-income communities or low-income persons, the entity must maintain

accountability to residents of low-income communities (through representation on governing or

advisory boards, or otherwise), and at least 60 percent of the aggregate gross assets of the entity must

be invested in “qualified low-income community investments” or residential property located in lowincome communities.10

As part of the credit allocation process, the Treasury Department would certify entities as

eligible “community development entities.” Certified entities would be required to file annual reports
 As under current-law section 1394(b)(3)(D), the term “qualified active business” would 11

include any trade or business which would qualify as such a business if the trade or business were

separately incorporated.

- 35 -

demonstrating that they continue to meet all the requirements for initial certification, and would be

required to identify the amount (and purchasers) of equity interests with respect to which allocated

credits may be claimed by the purchaser and to demonstrate that the entity monitors its investments

to ensure that capital is used in low-income communities. 

If an entity fails to be a community development entity during the five-year period following

the taxpayer’s purchase of an equity interest in the entity, or if the equity interest is redeemed by the

issuing entity during that five-year period, then any credits claimed with respect to the equity interest

would be recaptured and no further credits would be allowed.

Low-income communities.--For purpose of the credit, “low-income communities” would be

defined as census tracts with either (1) poverty rates of at least 20 percent (based on the most recent

census data), or (2) median family income which does not exceed 80 percent of metropolitan area

income (or for a non-metropolitan census tract, 80 percent of non-metropolitan statewide median

family income).

Qualified active businesses.--“Qualified active businesses” generally would be defined as

businesses which meet the following requirements: (1) at least 50 percent of the total gross income 11

of the business is derived from the active conduct of trade or business activities in low-income

communities; (2) a substantial portion of the use of the tangible property of such business is used

within low-income communities; (3) a substantial portion of the services performed for such business

by its employees are performed in low-income communities; and (4) less than 5 percent of the average

of the aggregate unadjusted bases of the property of such business is attributable to certain financial

property (e.g., debt, stock, partnership interests, options, futures contracts) or to collectibles (other

than collectibles held primarily for sale to customers).

For purposes of the credit, there would be no requirement that employees of a “qualified

active business” be residents of the low-income community. Rental of improved commercial real

estate located in a low-income community (e.g., an office building or shopping mall) would be a

qualified active business, regardless of the characteristics of the commercial tenants of the property.

In addition, a qualified active business that receives a loan from a community development entity

could include an organization that is organized and operated on a non-profit basis. The purchase and

holding of unimproved real estate would not be a qualified active business. In addition, a qualified

active business would not include (a) any business consisting predominantly of the development or

holding of intangibles for sale or license; (b) operation of any facility described in sec. 144(c)(6)(B)

(e.g., commercial golf course, country club, massage parlor, hot tub facility, suntan facility, liquor

store); or (c) any business if a significant equity interest in such business is held by a person who also

holds a significant equity interest in the community development entity.
- 36 -

Regulatory authority.--The Treasury Department would be granted authority to prescribe such

regulations as may be necessary or appropriate to carry out the purposes of the proposal, including

regulations limiting the benefit of the proposed tax credit in circumstances where investments are

directly or indirectly being subsidized by other Federal programs (e.g., low-income housing credit and

tax-exempt bonds), and regulations preventing abuse of the credit through the use of related parties.

The Treasury Department would issue regulations describing the certification process for community

development entities, annual reporting requirements for such entities, and application of the lowincome community investment requirements to start-up entities.

Effective date.--The proposal would be effective for qualified investments made after

December 31, 1999.
- 37 -

SPECIALIZED SMALL BUSINESS INVESTMENT COMPANY TAX INCENTIVES

Current Law

Certain existing tax incentives are intended to encourage investment in specialized small

business investment companies (“SSBICs”). SSBICs are partnerships or corporations that are

licensed by the Small Business Administration to make long-term loans to, or equity investments in,

small businesses owned by persons who are socially or economically disadvantaged.

One such incentive allows any C corporation or individual to elect to roll over without

payment of tax any capital gains realized upon the sale of publicly-traded securities where the

corporation or individual uses the proceeds from the sale to purchase common stock or a partnership

interest in a SSBIC within 60 days of the sale of the securities. The amount of gain that an individual

may elect to roll over under this provision for a taxable year is limited to the lesser of (1) $50,000 or

(2) $500,000 reduced by the gain previously excluded under this provision. For corporations, these

limits are $250,000 annually and $1,000,000 cumulatively.

Another incentive provides favorable qualification requirements, relative to other small

businesses, for purposes of section 1202. Under section 1202, 50 percent of the gain realized by an

individual upon the sale of qualifying small business stock is excluded from income. In order to be

qualified, the small business must be engaged in an active business. The incentive provides that a

SSBIC automatically is deemed to satisfy the active business requirement.

Certain regulated investment companies are entitled to deduct dividends paid to shareholders.

To qualify for this favorable tax treatment, which effectively eliminates some or all of the tax on

corporate earnings that would otherwise be imposed at the corporate level, the regulated investment

company must meet certain requirements. These include a requirement that 90 percent of the

company’s gross income be derived from dividends, interest, and other specified categories of passive

income, a requirement that the company currently distribute 90 percent of its income in certain

categories, and a requirement that at least 50 percent of the value of the company’s assets be

adequately diversified in accordance with rules specifying the amount of investment in the securities

of specific issuers.

Reasons for Change

Additional tax incentives would further encourage investment in SSBICs, thereby increasing

the amount of equity capital available to small businesses owned by persons who are socially or

economically disadvantaged.
- 38 -

Proposal

The proposal expands the tax-free rollover incentive in several ways. First, the 60-day

rollover period is extended to 180 days. Second, a taxpayer who uses the proceeds of the sale of

publicly-traded securities to purchase preferred stock in the SSBIC is also eligible for the exclusion.

Third, the proposal increases the lifetime cap on the SSBIC rollover gain exclusion from $500,000

to $750,000 in the case of an individual, and from $1,000,000 to $2,000,000 in the case of a

corporation. The annual caps on gain exclusion of $50,000 per individual and $250,000 per

corporation are eliminated.

The proposal also provides that a SSBIC that is organized as a corporation may convert to

a partnership within 180 days of enactment, without giving rise to tax at either the corporate or

shareholder levels (although the shareholders would be taxed on gain to the extent of boot received

in addition to partnership interests). To qualify for this treatment, the corporation must first distribute

all of its accumulated earnings and profits (as taxable dividends), then contribute its assets to a

partnership (in which it holds an interest of at least 80-percent immediately after the contribution),

distribute the partnership interests to its shareholders, and immediately liquidate. The shareholders’

basis in the partnership interests generally would carry over from their basis in the SSBIC stock. The

partnership would remain subject to an entity-level tax immediately upon ceasing activity as a SSBIC

or at any time that it disposes of assets that were held at the time of conversion on the amount of

“built-in” gains inherent in such assets at the time of conversion.

The proposal relaxes several of the requirements for a SSBIC’s qualification as a regulated

investment company. First, income derived by a SSBIC from its limited partner interest in a

partnership whose normal business operations the SSBIC does not actively manage will be treated

as passive income which counts toward satisfaction of the 90 percent qualifying income test. Second,

a SSBIC will be deemed to satisfy the 90 percent distribution requirement if it distributes all of the

income that it is permitted to distribute under the Small Business Investment Act of 1958 (as in effect

on May 13, 1993). Third, the SSBIC will be deemed to satisfy the diversification of assets

requirement to the extent that its investments are permitted to a SSBIC under the Small Business

Investment Act of 1958 (as in effect on May 13, 1993).

In the case of a direct or indirect sale of SSBIC stock that qualifies for treatment under

section 1202, the proposal raises the exclusion of gain from 50-percent to 60-percent.

A SSBIC would be defined as any partnership or corporation which is licensed by the Small

Business Administration under section 301(d) of the Small Business Investment Act of 1958 (as in

effect on May 13, 1993).

The tax-free rollover and section 1202 provisions are effective for sales occurring after the

date of enactment. The regulated investment company provisions are effective for taxable years

beginning on or after the date of enactment.
- 39 -

EXTEND WAGE CREDIT FOR TWO NEW EMPOWERMENT ZONES

Current Law

The Omnibus Budget Reconciliation Act of 1993 (OBRA ‘93) authorized a Federal

demonstration project in which nine empowerment zones and 95 enterprise communities would be

designated in a competitive application process. Of the nine empowerment zones, six were to be

located in urban areas and three were to be located in rural areas. State and local governments would

nominate distressed areas and propose strategic plans to stimulate economic and social revitalization.

Among other benefits, businesses located in the nine original empowerment zones are eligible

for three Federal tax incentives: a wage credit; an additional $20,000 per year of section 179

expensing; and a new category of tax-exempt private activity bonds. Businesses located in enterprise

communities are eligible for the new category of tax-exempt bonds. OBRA ‘93 also provided that

Federal grants would be made to designated areas.

The Taxpayer Relief Act of 1997 authorized the designation of two additional empowerment

zones located in urban areas (the “additional empowerment zones”) which generally are eligible for

the same tax incentives as are available within the empowerment zones authorized by OBRA ‘93.

The two additional empowerment zones, which have now been designated, are located in Cleveland,

Ohio and Los Angeles, California. The tax incentives provided for these new zones take effect on

January 1, 2000 and generally remain in effect for 10 years. The wage credit, however, is phased

down beginning in 2005 and expires after 2007.

Reasons for Change

The Administration believes that the availability of the tax incentives for the two additional

empowerment zones should be expanded in order to help combat the pervasive poverty, and to

stimulate the revitalization, of these areas. 

Proposal

The proposal would provide that the wage credit would remain in effect for a 10-year period

from that date and would be phased down using the same percentages that apply to the original

empowerment zones designated under OBRA '93.

The proposal would be effective as of January 1, 2000. 
- 40 -

Promote Energy Efficiency and Improve the Environment

PROVIDE TAX CREDIT FOR ENERGY-EFFICIENT BUILDING EQUIPMENT

Current Law

No income tax credit is provided currently for investment in energy-efficient building

equipment.

Reasons for Change

A credit for types of building equipment that are substantially more energy efficient than

conventional equipment will help to accelerate the development and distribution of energy-efficient

technologies. A credit would reduce costs to consumers, increasing demand for the equipment and

reducing manufacturing costs, while also spurring technological innovation and reducing energy

consumption.

Proposal

A credit of 10 percent of the purchase price (up to a maximum of $250 per unit) would be

allowed for the purchase after December 31, 1999 and before January 1, 2002 of the following

building equipment:

Electric heat pumps (equipment using electrically powered vapor compression cycles to

extract heat from air in one space and deliver it to air in another space) with a heating

efficiency of at least 9 HSPF (Heating Seasonal Performance Factor) and a cooling efficiency

of at least 13.5 SEER (Seasonal Energy Efficiency Rating).

Central air conditioners with an efficiency of at least 13.5 SEER.

Advanced natural gas water heaters (equipment using a variety of mechanisms to increase

steady-state efficiency and reduce standby and vent losses) with an Energy Factor of at least

0.65 in the standard Department of Energy (DOE) test procedure.

A credit of 20 percent of the purchase price would be allowed for the purchase after

December 31, 1999 and before January 1, 2004 of the following building equipment:

Fuel cells (equipment using an electrochemical process to generate electricity and heat) with

an electricity-only generation efficiency of at least 35 percent and a minimum generating

capacity of 5 kilowatts. The maximum credit would be $500 per kilowatt of capacity.

Electric heat pump hot water heaters (equipment using electrically powered vapor

compression cycles to extract heat from air and deliver it to a hot water storage tank) with
- 41 -

an Energy Factor of at least 1.7 in the standard DOE test procedure. The maximum credit

would be $500 per unit.

Electric heat pumps with a heating efficiency of at least 9 HSPF and a cooling efficiency of

at least 15 SEER. The maximum credit would be $500 per unit.

Central air conditioners with an efficiency of at least 15 SEER. The maximum credit would

be $500 per unit.

Advanced natural gas water heaters with an Energy Factor of at least 0.80 in the standard

DOE test procedure. The maximum credit would be $500 per unit.

Natural gas heat pumps (equipment using either a gas-absorption cycle or a gas-driven engine

to power the vapor compression cycle to extract heat from one source and deliver it to

another) with a coefficient of performance for heating of at least 1.25 and for cooling of at

least 0.70. The maximum credit would be $1,000 per unit. 

A credit would be allowed only for final purchases from unrelated third parties. The credit

would be nonrefundable. Credits for equipment used for business purposes would be subject to the

limitations on the general business credit and would reduce the basis of the equipment.
- 42 -

TAX CREDIT FOR PURCHASE OF ENERGY EFFICIENT NEW HOMES

Current law

No deductions or credits are provided currently for the purchase of energy-efficient new

homes.

Reasons for change

Residences, which account for about one-sixth of all U.S. greenhouse gases, offer one of the

largest single sources of carbon saving potential. Some States and certain Federal programs require

new houses to meet Model Energy Code standards for insulation and related construction standards,

and for heating, cooling and hot water equipment. By the use of cost-effective means, many new

homes could reduce energy consumption by 30 to 50 percent or more compared to the standards in

the Model Energy Code or the more recent 1998 International Energy Conservation Code (IECC).

A targeted credit for such highly energy-efficient new housing could increase the use of energyefficient building practices and efficient heating and cooling equipment. In addition, it may help spur

innovation in the ways that houses are designed and built, thereby providing significant energy-saving

and environmental benefits over the long term.

Proposal

A tax credit of up to $2,000 would be available to purchasers of highly energy-efficient new

homes that meet energy-efficiency standards for heating, cooling and hot water that significantly

exceed those of the IECC. A taxpayer may claim the credit only if the new home is the taxpayer’s

principal residence and reduces energy use by prescribed amounts as compared to the IECC for single

family residences. The tax credit would be $1,000 for new homes that are at least 30 percent more

energy efficient than the IECC standard, and that are purchased in the two-year period beginning

January 1, 2000 and ending December 31, 2001. The tax credit would be $1,500 for new homes that

are at least 40 percent more energy efficient than the IECC standard, and purchased in the three-year

period beginning January 1, 2000 and ending December 31, 2002. The tax credit would be $2,000

for new homes that are at least 50 percent more energy efficient than the IECC standard, and

purchased in the five-year period beginning January 1, 2000 and ending December 31, 2004. 
- 43 -

EXTEND TAX CREDIT FOR ELECTRIC VEHICLES AND 

PROVIDE TAX CREDIT FOR CERTAIN FUEL-EFFICIENT HYBRID VEHICLES

Current Law

No generally available income tax credit for purchases of fuel-efficient vehicles is provided

currently. A 10-percent tax credit is provided for the cost of a qualified electric vehicle, up to a

maximum credit of $4,000. A qualified electric vehicle is a motor vehicle that is powered primarily

by an electric motor drawing current from rechargeable batteries, fuel cells, or other portable sources

of electric current, the original use of which commences with the taxpayer, and that is acquired for

use by the taxpayer and not for resale. The full amount of the credit is available for purchases prior

to 2002. The credit begins to phase down in 2002 and does not apply to vehicles placed in service

after 2004.

Certain costs of qualified clean-fuel vehicle property may be deducted when such property

is placed in service. Qualified electric vehicles do not qualify for the clean-fuel vehicle deduction.

The deduction begins to phase down in 2002 and does not apply to property placed in service after

2004.

Reasons for Change

The transportation sector now accounts for one-third of greenhouse gas emissions in the

United States. Cars, sport utility vehicles, light trucks and minivans alone account for 20 percent of

our greenhouse gas emissions.

The proposed credits will encourage the early introduction and purchase of vehicles that

incorporate new fuel-efficient technologies and will help to move ultra fuel-efficient vehicles with two

or three times the fuel efficiency of today’s vehicles from the laboratory to the highway. These

vehicles can significantly reduce emissions of carbon dioxide, the most prevalent greenhouse gas.

Proposal

The proposal would extend the present credit for qualified electric vehicles and provide

temporary tax credits for fuel-efficient hybrid vehicles:

(1) Credit for electric vehicles. The phase down of the credit for electric vehicles would be

eliminated and the credit would be extended through 2006. Thus, the maximum $4,000 credit

would be available for purchases before 2007. 

(2) Credit for fuel-efficient hybrid vehicles. The credit would be: (a) $1,000 for each vehicle

that is one-third more fuel efficient than a comparable vehicle in its class, effective for

purchases of qualifying vehicles after December 31, 2002 and before January 1, 2005; (b)

$2,000 for each vehicle that is two-thirds more fuel efficient than a comparable vehicle in its
- 44 -

class, effective for purchases of qualifying vehicles after December 31, 2002 and before

January 1, 2007; (c) $3,000 for each vehicle that is twice as fuel efficient as a comparable

vehicle in its class, effective for purchases of qualifying vehicles after December 31, 2003 and

before January 1, 2007; and (d) $4,000 for each vehicle that is three times as fuel efficient as

a comparable vehicle in its class, effective for purchases of qualifying vehicles after December

31, 2003 and before January 1, 2007.

 A qualifying hybrid vehicle would be a vehicle powered by onboard fuel which uses

regenerative braking and an energy storage system that will recover at least 60 percent of the

energy in a typical 70-0 braking event. A qualifying vehicle would have to meet all emission

requirements applicable to gasoline-powered automobiles.

These credits would be available for all qualifying light vehicles including cars, minivans, sport

utility vehicles, and light trucks. Taxpayers who claim one of these credits would not be able

to claim the qualified electric vehicle credit or the deduction for clean-fuel vehicle property

for the same vehicle.
- 45 -

INVESTMENT TAX CREDIT FOR COMBINED HEAT AND POWER (CHP) SYSTEMS

Current law

Combined heat and power (CHP) systems are used to produce electricity (and/or mechanical

power) and usable thermal energy from a single primary energy source. Depreciation allowances for

CHP property vary by asset use and capacity. Assets employed in the production of electricity used

by the taxpayer in an industrial manufacturing process or plant activity (and not ordinarily available

for sale to others) have a general cost recovery period of 15 years if rated with total capacity in

excess of 500 kilowatts. Electricity production assets of lesser rated capacity generally are classified

with other manufacturing assets and have cost recovery periods of five to ten years. Assets used in

the production of electricity for sale have either a 15-year or 20-year recovery period. For assets that

are structural components of buildings, however, the recovery period is either 39 years (if

nonresidential) or 27.5 years (if residential), and the straight-line method for computing depreciation

allowances must be used. For assets with recovery periods of 10 years or less, the 200 percent

declining balance method may be used to compute depreciation allowances. The 150 percent

declining balance method may be used for assets with recovery periods of 15 or 20 years.

Reasons for change

Combined heat and power systems utilize thermal energy that is otherwise wasted in

producing electricity by more conventional methods. CHP systems achieve a greater level of overall

energy efficiency, and thereby lessen the consumption of primary fossil fuels, lower total energy costs,

and reduce carbon emissions. An investment tax credit for CHP assets is expected to encourage

increased energy efficiency by accelerating planned investments and inducing additional investments

in such systems. The increased demand for CHP equipment should, in turn, reduce CHP production

costs and spur additional technological innovation in improved CHP systems.

Proposal

The proposal would establish an 8-percent investment credit for qualified CHP systems with

an electrical capacity in excess of 50 kilowatts or with a capacity to produce mechanical power in

excess of 67 horsepower (or an equivalent combination of electrical and mechanical energy

capacities). CHP property would be defined as property comprising a system that uses the same

energy source for the simultaneous or sequential generation of (1) electricity or mechanical shaft

power (or both) and (2) steam or other forms of useful thermal energy (including heating and cooling

applications). A qualified CHP system would be required to produce at least 20 percent of its total

useful energy in the form of thermal energy and at least 20 percent of its total useful energy in the

form of electrical or mechanical power (or a combination thereof) and would also be required to

satisfy an energy-efficiency standard. For CHP systems with an electrical capacity in excess of

50 megawatts (or a mechanical energy capacity in excess of 67,000 horsepower), the total energy

efficiency of the system would have to exceed 70 percent. For smaller systems, the total energy
- 46 -

efficiency would have to exceed 60 percent. For this purpose, total energy efficiency would be

calculated as the sum of the useful electrical, thermal, and mechanical power produced by the system

at normal operating rates, measured on a Btu basis, divided by the lower heating value of the primary

fuel source for the system supplied. The credit would be allowed with respect to qualified CHP

property only if its eligibility is verified under regulations prescribed by the Secretary of the Treasury.

The regulations would require taxpayers claiming the credit to obtain proper certification by qualified

engineers that the system meets the energy-efficiency and percentage-of-energy tests.

Investments in qualified CHP assets that are otherwise assigned cost recovery periods of less

than 15 years would be eligible for the credit, provided that the taxpayer elected to treat such

property as having a 22-year class life. Thus, regular tax depreciation allowances would be calculated

using a 15-year recovery period and the 150 percent declining balance method.

The credit would be treated as energy property under the investment credit component of the

section 38 general business credit, and would be subject to the rules and limitations governing such

property. Thus, only property placed in service in the United States would be eligible for the credit,

and the basis of qualified property would be reduced by the amount of the credit. Regulated public

utilities claiming the credit would be required to use a normalization method of accounting with

respect to the credit. Taxpayers using the credit for CHP equipment would not be entitled to any

other tax credit for the same equipment. 

The credit would apply to investments in CHP equipment placed in service after December

31, 1999, but before January 1, 2003.
- 47 -

PROVIDE TAX CREDIT FOR ROOFTOP SOLAR EQUIPMENT 

Current Law

 A 10-percent investment tax credit is provided to businesses for qualifying equipment that

uses solar energy to generate electricity, to heat or cool or to provide hot water for use in a structure,

or to provide solar process heat.

Reasons for Change

A tax credit for rooftop solar photovoltaic systems and solar water heating systems will

reduce the cost of these investments and encourage individuals and businesses to adopt these systems.

Heat and electricity from these sources produce no greenhouse gasses.

Proposal

Under this proposal, a tax credit would be available for purchasers of rooftop photovoltaic

systems and solar water heating systems that are located on or adjacent to a building and are used

exclusively for purposes other than heating swimming pools. The credit would be equal to 15 percent

of qualified investment up to a maximum of $1,000 for solar water heating systems and $2,000 for

rooftop photovoltaic systems. This credit would be nonrefundable. For businesses, this credit would

be subject to the limitations of the general business credit. The depreciable basis of the qualified

property would be reduced by the amount of the credit claimed. The credit would apply only to

equipment placed in service in the five-year period after December 31, 1999 and before January 1,

2005 for solar water heating systems and for the seven-year period after December 31, 1999 and

before January 1, 2007 for rooftop photovoltaic systems. Taxpayers would have to choose between

the proposed credit and the present tax credit for each investment. 
- 48 -

EXTEND WIND AND BIOMASS TAX CREDIT

AND EXPAND ELIGIBLE BIOMASS SOURCES

Current Law

Current law provides taxpayers a 1.5-cent-per-kilowatt-hour tax credit for electricity

produced from wind or “closed-loop” biomass (organic material from a plant which is planted

exclusively for purposes of being used at a qualified facility to produce electricity). The electricity

must be sold to an unrelated third party and the credit is limited to the first 10 years of production.

The credit applies only to facilities placed in service before July 1, 1999. The credit amount is

indexed for inflation after 1992.

Reasons for Change

The tax credit helps make electricity produced from wind and biomass competitive with other

forms of electricity. Expanding eligible biomass sources will increase the use of this renewable energy

source. Electricity from these sources produces no greenhouse gases. 

Proposal

The proposal would extend the current credit for five years, to facilities placed in service

before July 1, 2004, and would expand eligible biomass sources for facilities placed in service before

July 1, 2004. In addition, biomass that is co-fired in coal plants to produce electricity would be

eligible for the credit at a reduced rate (1.0 cent per kilowatt hour adjusted for inflation after 1999)

through June 30, 2004. Biomass qualifying for the credit would include (in addition to closed-loop

biomass) any solid, nonhazardous, cellulosic waste material, that is segregated from other waste

materials, and that is derived from the following forest-related resources: mill residues, precommercial thinnings, slash and brush, but not including old growth timber, waste pallets, crates, and

dunnage, and landscape or right-of-way tree trimmings, and biomass derived from agriculture

sources, including orchard tree crops, vineyard grain, legumes, sugar, and other crop-by-products or

residues. Unsegregated municipal solid waste (garbage) would not qualify for the credit.
- 49 -

Promote Expanded Retirement Savings, Security, and Portability

PROMOTE INDIVIDUAL RETIREMENT ACCOUNT CONTRIBUTIONS 

THROUGH PAYROLL DEDUCTIONS

Current Law

Individuals who contribute to an individual retirement account or annuity (“IRA”) typically

do so by depositing funds into IRAs. However, an employee whose employer permits such an

arrangement may contribute to an IRA by electing to have the employer withhold requested amounts

from the employee’s paycheck and forward them to the employee’s IRA. These payroll deduction

contributions to an IRA appear as wages on the employee’s Form W-2, but the employee is allowed

to deduct the contributions on the employee’s tax return, subject to the normal rules governing IRA

contributions. 

Reasons for Change

Payroll deduction contributions to IRAs could be an important means of increasing retirement

savings among employees. The advantages of saving through payroll deduction -- the convenience

of contributions continuing after the employee’s initial election, reinforcement of the value of savings

by peer groups in the workplace, and the incentive of tax-favored treatment of contributions --

encourage employees to save more for retirement. One way to encourage employers to offer, and

employees to make, payroll deduction contributions to IRAs would be to provide employees with a

convenient way to receive an immediate tax benefit for these contributions that eliminates the need

for most employees to report the contributions on their tax returns and enables some employees to

use simpler tax forms. 

Proposal

Contributions of up to $2,000 made to an IRA through payroll deduction generally would be

excluded from an employee’s income and, accordingly, would not be reported as income on the

employee’s Form W-2. However, the amounts would be subject to FICA and FUTA taxes and would

be reported as a contribution to an IRA on the employee’s Form W-2. In the event the amounts

would not have been deductible had the employee contributed directly to an IRA, the employee

would be required to include the amounts in income on the employee’s tax return. 

The proposal would be effective for taxable years beginning after December 31, 1999.
- 50 -

PROVIDE SMALL BUSINESS TAX CREDIT 

FOR EXPENSES OF STARTING NEW RETIREMENT PLANS

Current Law

An employer’s costs related to the establishment of a retirement plan (e.g., payroll system

changes, investment vehicle set-up fees, consulting fees, etc.) generally are deductible as business

expenses.

Reasons for Change

Plan start-up, plan administration, and retirement education costs may pose a barrier to the

establishment of new retirement plans, especially for smaller employers. Providing a tax credit for

creating new plans could promote their adoption, not only by defraying some of these costs, but also

by providing a marketing tool for financial institutions or advisors to use in promoting new plan

adoption and by increasing awareness of retirement saving options.

Proposal

The proposal would provide a three-year tax credit, in lieu of a deduction, for 50 percent of

the administrative and retirement-education expenses for any small business that adopts a new

qualified defined benefit or defined contribution plan (including a section 401(k) plan), SIMPLE,

SEP, or payroll deduction IRA arrangement. The credit would cover 50 percent of the first $2,000

in administrative and retirement-education expenses for the plan or arrangement for the first year of

the plan or arrangement and 50 percent of the first $1,000 of administrative and retirement-education

expenses for each of the second and third years.

The credit would be available to employers that did not employ, in the preceding year, more

than 100 employees with compensation in excess of $5,000, but only if the employer did not have a

plan or payroll deduction IRA arrangement during any part of 1997. In order for an employer to get

the credit, the plan would have to cover at least two individuals. In addition, if the credit is for the

cost of a payroll deduction IRA arrangement, the arrangement would have to be made available to

all employees of the employer who have worked with the employer for at least three months.

The credit would be effective beginning in the year of enactment and would be available only

for plans established after 1997 and on or before December 31, 2001. For example, if an eligible

employer adopted a plan in the year 2001, the credit would be available for the years 2001, 2002 and

2003. 
- 51 -

THE SMART PLAN --

A SIMPLIFIED PENSION PLAN FOR SMALL BUSINESS

Current Law

Under current law, small business employers that wish to sponsor a tax-favored retirement

savings plan, yet seek to avoid the administrative cost and complexity associated with traditional

qualified retirement plans, may instead establish a SIMPLE plan. SIMPLE IRA and SIMPLE 401(k)

plans are defined contribution plans that are not subject to many of the rules applicable to qualified

retirement plans, and are subject to only minimal reporting and disclosure requirements. SIMPLE

plans allow employees to make salary reduction contributions up to a lower limit ($6,000 a year) than

401(k) plans. SIMPLE plans must provide for certain specified employer contributions.

Alternatively, small business employers may offer their employees a simplified employee

pension (SEP). SEPs are employer-sponsored plans under which employer contributions are made

to IRAs established by employees. Contributions under a SEP generally must bear a uniform

relationship to the compensation of each employee covered under the SEP (e.g., each employee

receives a contribution to the employee’s IRA equal to 5 percent of the employee’s compensation for

the year).

Reasons for Change

There is no alternative, similar to SIMPLE plans or SEPs, that is available for small business

employers seeking to provide their employees with a simplified, tax-favored defined benefit pension

plan. The need for complex actuarial calculations, administrative costs, and the unpredictability of

funding requirements may inhibit these employers from adopting such plans.

Proposal

The proposal would allow small employers to adopt a new simplified, tax-favored pension

plan that combines attractive features of both defined benefit and defined contribution plans. The new

plan would be known as the SMART (Secure Money Annuity or Retirement Trust) Plan. As in the

case of other qualified plans, contributions to the SMART Plan would be excludable from income,

earnings would accumulate tax-free, and distributions would be subject to income tax (unless rolled

over).

SMART Plans would provide participants with a minimum guaranteed benefit at retirement

that provides payments over the course of an employee’s retirement years, and Pension Benefit

Guaranty Corporation insurance, together with the potential for additional investment return and the

portability of individual accounts.
- 52 -

Employer Eligibility

An employer generally would be eligible to maintain a SMART Plan if the employer did not

employ more than 100 employees who received at least $5,000 in compensation in the prior year and

the employer has not maintained a defined benefit pension plan or a money purchase pension plan

within the preceding five years.

Employee Eligibility and Vesting

If an employer establishes a SMART Plan, all employees who have completed two years of

service with at least $5,000 in compensation and who are reasonably expected to receive $5,000 in

compensation in the current year would participate in the Plan. An employee’s benefit would be 100

percent vested at all times.

Benefits and Funding

Minimum Defined Benefit

SMART Plans would provide a fully funded minimum defined benefit, with a possible higher

benefit if cumulative investment returns exceed 5 percent.

Each year the employee participates, the employee would earn a minimum annual benefit at

retirement equal to 1 percent or 2 percent of compensation for that year. For example, if an employee

participated for 25 years in a SMART Plan of an employer that elected a 2 percent benefit, and the

employee’s average salary over the entire period was $50,000, the employee would accrue a

minimum benefit of $25,000 per year at age 65. Moreover, an employer could elect, for each of the

first 5 years the SMART Plan is in existence, to provide all employees with a benefit equal to 3

percent of compensation (in lieu of 1 percent or 2 percent of compensation). The maximum

compensation that could be taken into account in determining an employee’s benefit for a year would

be $100,000 (indexed for inflation).

Funding and Investment Returns

Funding would be provided either through a SMART Plan individual retirement annuity

(“SMART Annuity”) issued by an insurance company, or through a trust (“SMART Trust”) that

invests only in readily tradable securities and insurance products regulated by State law. Each year,

an employer would be required to contribute an amount sufficient to provide the annual benefit

accrued for that year payable at age 65, using actuarial assumptions specified in the statute (including

a 5 percent annual interest rate). 

In the case of a SMART Trust, each employee would have an account to which actual

investment returns would be credited. If a participant’s account balance were less than the total of

past employer contributions credited with 5 percent interest per year, the employer would be required
- 53 -

to contribute an additional amount for the year to make up for any shortfall. Moreover, the employer

would be required to contribute an additional amount for the year to make up for any shortfall

between the balance in the employee’s account and the purchase price of an annuity paying the

minimum guaranteed benefit when an employee retires and takes a life annuity. On the other hand,

if the investment returns exceeded the 5 percent assumption, the employee would be entitled to the

larger account balance. If the employee elected to receive an annuity, the larger account balance

would translate to a larger annuity.

In the case of a SMART Annuity, each year an employer would be required to contribute the

amount necessary to purchase an annuity that provides the benefit accrual for that year on a

guaranteed basis.

The required contributions would be deductible under the rules applicable to qualified defined

benefit pension plans. An excise tax would apply if the employer failed to make the required

contributions for a year.

Distributions

Timing

No distributions would be allowed from a SMART Plan prior to an employee’s attainment

of age 65, except in the event of death or disability, or where the account balance of a terminated

employee was not more than $5,000. However, an employer could allow a terminated employee who

has not yet attained age 65 to directly transfer the individual’s account balance from a SMART Trust

to either a SMART Annuity or a special individual retirement account (“SMART Account”) that is

subject to the same distribution restrictions as the SMART Trust.

If a terminated employee’s account balance did not exceed $5,000, the SMART Plan would

be allowed to make a cashout of the account balance. The employee would be allowed to transfer

any such distribution tax-free to a SMART Annuity, a SMART Account, or a regular IRA.

Form 

SMART Plans would be subject to the qualified joint and survivor annuity rules that apply to

qualified defined benefit pension plans. Lump sum payments also could be made available. In

addition, an employer could allow the transfer of a terminated employee’s account balance from a

SMART Trust to either a SMART Annuity or a SMART Account.

Taxation

Distributions from SMART Plans would be subject to tax under current rules applicable to

the taxation of annuities under section 72.
- 54 -

A 20 percent additional tax would be imposed for violating the pre-age 65 distribution

restrictions under a SMART Annuity or SMART Account.

PBGC Guarantee and Premiums 

The minimum guaranteed benefit under the SMART Trust would be guaranteed by the PBGC.

Reduced PBGC premiums would apply to the SMART Trust. Neither the PBGC guarantee, nor

PBGC premiums, would apply to the SMART Annuity or SMART Account.

Reporting and Disclosure

Because SMART Plans do not have complex actuarial calculations, they would be subject to

simplified reporting requirements.

Nondiscrimination Requirements and Benefit Limitations

SMART Plans would not be subject to the nondiscrimination or top-heavy rules applicable

to qualified retirement plans. SMART Plans also would not be subject to the limitations on benefits

under section 415. However, if an employer maintained a SMART Plan, and then terminated it and

established a qualified defined benefit plan, the SMART Plan accruals would be taken into account

for purposes of the section 415 limitations applicable to the defined benefit plan.

Miscellaneous

Other plans maintained by the employer. An employer that maintained a SMART Plan could

not maintain additional tax-qualified plans, other than a SIMPLE plan, or a 401(k) plan or 403(b) taxsheltered annuity plan under which the only contributions that are permitted are elective contributions

and matching contributions that are not greater than those provided for under the design-based safe

harbor for 401(k) plans described in section 401(k)(12)(B)(I).

Employee contributions. No employee contributions would be permitted to a SMART Plan.

IRS model. The IRS would be directed to issue model SMART Plan provisions or a model

SMART Plan document. Vendors and employers would have the option of using their own

documents instead of the models.

Coordination with IRA deduction rules. SMART Plans would be treated as qualified plans

for purposes of the IRA deduction phase-out rules. Thus, employees who participated in a SMART

Plan and had modified AGI in excess of the applicable thresholds would be phased out of making

deductible IRA contributions. This is the same rule that currently applies to SEPs and SIMPLE plans.
- 55 -

Calendar plan year. The plan year for all SMART Plans would be the calendar year, which

would be used in applying SMART Plan contribution limits, eligibility, and other requirements.

These provisions would be effective for calendar years beginning after 1999.
- 56 -

PROVIDE FASTER VESTING OF EMPLOYER MATCHING CONTRIBUTIONS

Current Law

Generally, employer matching contributions on behalf of an employee under a section 401(k)

plan (or other type of plan) either must be fully vested after the employee has completed five years

of service, or must become vested in increments of 20 percent for each year beginning after the

employee has completed three years of service, with full vesting after the employee has completed

seven years of service. If a plan is a “top-heavy plan” within the meaning of section 416, employer

matching contributions either must be fully vested after an employee has completed three years of

service, or must become vested in increments of 20 percent for each year beginning after the

employee has completed two years of service, with full vesting after the employee has completed six

years of service. Employer matching contributions that are treated as elective contributions for

purposes of the actual deferral percentage test under section 401(k) (“qualified matching

contributions”) must be fully vested immediately. 

Reasons for Change

The popularity and importance of 401(k) plans has grown substantially over the years.

Employers often choose to contribute to 401(k) plans by matching the salary reduction contributions

made by employees. Given the mobile nature of today’s workforce, there is a significant risk that

many participants will leave employment before fully vesting in employer matching contributions

under 401(k) plans. One way to increase the portability of benefits for 401(k) plan participants is to

require faster vesting for employer matching contributions. 

Proposal

Employer matching contributions under 401(k) plans (or other qualified plans) would be

required either to be fully vested after an employee has completed three years of service, or to

become vested in increments of 20 percent for each year beginning after the employee has completed

two years of service, with full vesting after the employee has completed six years of service.

Qualified matching contributions would continue to be fully vested immediately, as under current law.

These provisions would be effective for plan years beginning after December 31, 1999, with

an extended effective date for plans maintained pursuant to a collective bargaining agreement.
- 57 -

COUNT FMLA LEAVE FOR RETIREMENT ELIGIBILITY AND 

VESTING PURPOSES

Current Law

Under the Family and Medical Leave Act (FMLA), eligible workers are entitled to up to 12

weeks of unpaid leave to care for a new child, to care for a family member who has a serious health

condition, or because the worker has a serious health condition. The employer must provide

continued medical coverage during the unpaid leave. Upon return from leave, the employee must be

restored to the position or an equivalent position (i.e., same benefits, pay, and terms and conditions

of employment).

Although the person must generally be restored to the same position, the employer is not

required to count the period of unpaid leave for purposes of eligibility to participate in a qualified

retirement plan or plan vesting.

Reason for Change

Many workers, especially women, may need to leave the workforce to care for a seriously ill

family member or to raise a child. This can cause them to lose service credit for determining plan

eligibility or vesting. Counting FMLA leave for these purposes would increase the opportunity for

workers taking time off under the FMLA to become eligible for or vest in retirement benefits.

Proposal

Leave taken under the FMLA would be taken into account in determining retirement plan

eligibility and vesting. 

The proposal would be effective for plan years beginning after December 31, 1999.
A single life annuity pays benefits only for the lifetime of the plan participant. 12

- 58 -

REQUIRE JOINT AND SEVENTY-FIVE PERCENT 

SURVIVOR ANNUITY OPTION FOR PENSION PLANS

Current Law

Traditional pension plans are currently required to offer to pay pension benefits in the form

of a “joint and survivor annuity” option. This protects a surviving spouse of a plan participant by

providing the spouse with regular annuity payments for life. Under these rules, an annuity payment

is made as long as either spouse is alive. This amount is usually less than the amounts that would

have been payable if the participant had elected a single life annuity . However, if the participant dies 12

first, the surviving spouse continues to receive benefit payments for life (although usually in an

amount less than the amounts that were paid while both spouses were alive). Plans can meet the joint

and survivor annuity requirement by offering only a joint and 50 percent survivor annuity. Under this

option, the monthly pension payments to the surviving spouse are reduced to 50 percent of the level

of monthly payments that were made while both spouses were alive. 

Reason for Change

Many couples may prefer an option that pays a somewhat smaller benefit to the couple while

both are alive but a benefit larger than the 50 percent survivor benefit to the surviving spouse.

Typically, a surviving spouse has retirement needs that exceed half the retirement needs of a couple.

For example, the poverty threshold for an aged individual is almost 80 percent of the threshold for

an aged couple. This option would be especially helpful to women, because they tend to live longer

than men, and many aged widows have income below the poverty level. 

Proposal

Plans that are required to provide a joint and survivor annuity option would be required to

offer an option that pays a lifetime benefit to the participant’s surviving spouse equal to at least 75

percent of the benefit the couple received while both were alive. Participants would not be required

to choose this joint and 75 percent survivor annuity option. For example, a participant could still

choose a joint and 50 percent survivor annuity (if offered under the plan) or single life annuity (with

the spouse’s consent). However, a plan could limit choices for a joint and survivor annuity to a joint

and 75 percent survivor annuity and satisfy this rule.

The proposal would be effective for plan years beginning after December 31, 1999 with an

extended effective date for plans maintained pursuant to a collective bargaining agreement.
- 59 -

IMPROVE PENSION DISCLOSURE

A. Spouse’s Right to Know Distribution Information

Current Law

In general, when a tax-qualified pension plan commences a distribution of retirement benefits

to a participant in the plan, the benefits must be distributed as an annuity over the life of the

participant. If the participant is married on the annuity starting date, the annuity must continue to pay

at least one half of these monthly amounts to the surviving spouse following the participant’s death

(a form of benefit known as a “qualified joint and survivor annuity”). If the participant dies before

the annuity starting date, the surviving spouse generally must be paid an annuity (known as a

“qualified preretirement survivor annuity”) that is not less than what the spouse would have been paid

under the survivor portion of the qualified joint and survivor annuity. Most defined contribution plans

(such as 401(k) plans) are not required to provide these annuities if certain conditions are satisfied,

including the condition that, upon the participant’s death, the participant’s vested account balance

is payable in full to the surviving spouse.

A plan may allow a participant to waive the right to receive these survivor annuities if certain

conditions are satisfied. In particular, the spouse generally must provide a written consent to the

waiver, witnessed by a plan representative or a notary public, which acknowledges the effect of the

waiver. Further, the participant must have been provided with a written explanation of the terms and

conditions of the survivor annuity, the participant’s right to make, and the effect of, a waiver of the

survivor annuity, the rights of the spouse to waive the survivor annuity, and the right of a participant

to revoke the waiver. (Similar waiver and explanation rules apply concerning the death benefit

payable to the spouse under a defined contribution plan.) 

Reasons for Change

Although the survivor rules provide important rights to spouses, these rules do not require

plans to furnish spouses a copy of the written explanation of survivor benefits that is required to be

furnished to participants. In order to help spouses understand their rights and the implications of

waiving these survivor benefits, spouses should be able to receive a copy of the explanation of

survivor benefits.

Proposal

When an explanation of a plan’s survivor benefits is provided to participants, a copy of the

explanation would be required to be provided to the participant’s spouse. If the last known mailing

address of the participant and spouse is the same, then the explanation and a copy of the explanation

can be provided in a single mailing addressed to the participant and the spouse.

The proposal would be effective for plan years beginning after December 31, 1999.
- 60 -

B. Election Periods and Right to Know Employer Contribution Formula

Current Law

The actual deferral percentage (ADP) test generally applies to the elective contributions

(typically made by salary reduction) of all employees eligible to participate in a 401(k) plan. The

ADP test is satisfied if the average percentage of elective contributions for highly compensated

employees does not exceed the average percentage of elective contributions for nonhighly

compensated employees by a specified percentage. Because the ADP test looks to the actual pattern

of deferrals by the highly compensated and nonhighly compensated employees, the employer has an

incentive to increase participation by the nonhighly compensated employees and will take steps (such

as publicizing the ease of saving through the plan and providing matching contributions) in order to

encourage employees to contribute.

As an alternative to annual testing under the ADP test (and the similar ACP test that applies

to matching contributions and after-tax employee contributions), the Small Business Job Protection

Act of 1996 provided two alternative “design-based” 401(k) safe harbors, effective beginning in 1999.

If the employees are provided a specified matching contribution (or a specified nonelective

contribution), the employer can avoid all ADP and ACP testing of employee elective contributions

and employer matching contributions. Unlike the similar safe-harbor designs under the SIMPLE plan

and the SIMPLE 401(k) plan that require annual 60-day election periods and notification tied to those

election periods, for 401(k) plans using a safe harbor, there are no specific requirements that prescribe

the length and frequency of the election period or that tie the timing of the notice describing employee

rights and obligations under the plan to the election period.

Reasons for Change

Employers that use the safe harbor plan design have no built-in incentive to make it easy for

employees to elect to make contributions and to notify employees of the employer matching

contribution in connection with that election period. In order for the safe harbor plan design to be

an adequate substitute for nondiscrimination tests, employees need to have reasonable opportunities

to start making elective deferrals and need to receive information about the employer contribution

formula in connection with these opportunities.

Proposal

Employers that use either one of the safe harbor plan designs to avoid ADP and ACP testing

would be required to provide notice and contribution opportunities comparable to those provided

under SIMPLE plans. Thus, employees would have to be offered an opportunity to elect to make

contributions (or modify a prior election) during a 60-day period before the beginning of each year

and a 60-day period when they first become eligible. In addition, the current law requirement that

employers provide employees with notice of their rights to make contributions and notice of the safe

harbor contribution formula the employer is currently using (in order to notify employees of their
- 61 -

rights and obligations) would be modified to require the notice within a reasonable period of time

before the 60-day periods begin rather than before the beginning of the year.

The proposal would be effective for plan years beginning after December 31, 1999.
- 62 -

IMPROVE BENEFITS OF NONHIGHLY COMPENSATED EMPLOYEES UNDER

401(k) SAFE HARBOR PLANS

Current Law

The actual deferral percentage (ADP) test generally applies to the elective contributions

(typically made by salary reduction) of all employees eligible to participate in a 401(k) plan. The test

requires the calculation of each eligible employee's elective contributions as a percentage of the

employee's pay. The ADP test is satisfied if the average percentage of elective contributions for

highly compensated employees does not exceed the average percentage of elective contributions for

nonhighly compensated employees by a specified percentage. Thus, the ADP tests looks to the actual

pattern of deferrals by the highly compensated and nonhighly compensated employees who are

eligible to make elective contributions. Accordingly, the employer has a built-in incentive to

encourage nonhighly compensated employees to contribute. The actual contribution percentage

(ACP) test is almost identical to the ADP test, but generally applies to employer matching

contributions and after-tax employee contributions under any qualified employer retirement plan.

As an alternative to annual testing under the ADP and ACP tests, the Small Business Job

Protection Act of 1996 provided two alternative “design-based” safe harbors, effective beginning in

1999. If a plan were designed to use one of these safe harbors, the employer could avoid all ADP

and ACP testing of employee elective contributions and employer matching contributions. Under

the first safe harbor, the employer would have to make nonelective contributions of at least three

percent of compensation for each nonhighly compensated employee eligible to participate in the plan.

Alternatively, under the second safe harbor, the employer would have to make a 100 percent

matching contribution on an employee’s elective contributions up to the first 3 percent of

compensation and a matching contribution of at least 50 percent on the employee’s elective

contributions up to the next 2 percent of compensation.

Reasons for Change

Under the section 401(k) safe harbor plan design, employers need not perform

nondiscrimination tests and may not have adequate incentives to encourage nonhighly compensated

employees to contribute or to educate them about the value of tax-deferred savings for retirement.

Providing a one percent nonelective contribution to all eligible nonhighly compensated employees,

in addition to the matching contribution, would help demonstrate the value of tax-deferred

compounding to those employees who initially might not make deferrals. This one percent

contribution would also help ensure that more low- and moderate-wage workers begin accumulating

savings for retirement and acquire the savings habit.
- 63 -

Proposal

The proposal would modify the section 401(k) matching formula safe harbor by requiring that,

in addition to the matching contribution, employers make a contribution of one percent of

compensation for each eligible nonhighly compensated employee, regardless of whether the employee

makes elective contributions.

The proposal would be effective for plan years beginning after December 31, 1999.
- 64 -

SIMPLIFY DEFINITION OF HIGHLY COMPENSATED EMPLOYEE

Current Law

A qualified retirement plan must satisfy various nondiscrimination tests to ensure that it does

not discriminate in favor of "highly compensated employees." In order to apply these tests, the

employer must identify its "highly compensated employees." Under current law, effective for plan

years beginning after December 31, 1996, an employee is treated as a highly compensated employee

if the employee (1) was a five-percent owner of the employer at any time during the year or the

preceding year, or (2) for the preceding year, had compensation in excess of $80,000 (indexed for

inflation), and, if the employer elects, was in the top-paid group of employees for the preceding year.

For this purpose, an employee is in the top-paid group if the employee was among the top 20 percent

of employees of the employer when ranked on the basis of compensation paid to the employees

during the preceding year.

Reasons for Change

The definition of highly compensated employee, while simpler than the seven-part test that

applied under prior law, could be further simplified by elimination of the top-paid group election.

Permitting elections that may vary from year to year increases complexity. In addition, under the

current definition, it is possible for employees earning very high compensation (of several hundred

thousand dollars or more) to be treated as nonhighly compensated for testing purposes if the

employer has a sufficient percentage of high-paid employees in its workforce. This would allow some

employers to effectively eliminate benefits for low- and moderate-wage workers without violating the

nondiscrimination rules. The simplified definition of highly compensated employee should better

reflect the purpose of promoting meaningful benefits for low- and moderate-wage workers, not only

the high-paid.

Proposal

The top-paid group election would be eliminated from the definition of highly compensated

employee. Under the simplified definition, an employee would be treated as a highly compensated

employee if the employee (1) was a five-percent owner of the employer at any time during the year

or the preceding year, or (2) for the preceding year, had compensation in excess of $80,000 (indexed

for inflation).

The proposal would be effective for plan years beginning after December 31, 1999.
- 65 -

SIMPLIFY BENEFIT LIMITS FOR MULTIEMPLOYER PLANS

UNDER SECTION 415

Current Law

Annual benefits payable under a defined benefit plan are limited to the lesser of $130,000 (for

1999) or 100 percent of “three-year-high average compensation.” (Reductions in the dollar or

percentage limit for defined benefit plans may be required if the employee has fewer than ten years

of plan participation or service.) If benefits under a defined benefit plan begin before the social

security retirement age, the dollar limit must be actuarially reduced to compensate for the earlier

commencement. Certain special rules apply to governmental plans.

Reasons for Change

The qualified plan limitations present significant administrative problems for many

multiemployer plans. These plans typically base benefits on years of credited service, not on a

participant's compensation. In addition, the 100 percent-of-compensation limit is based on an

employee's average compensation for the three highest consecutive years. This rule often produces

an artificially low limit for employees in certain industries, such as building and construction, where

wages vary significantly from year to year.

Proposal

The section 415 limits applicable to multiemployer plans would be modified to eliminate the

100 percent-of-compensation limit (but not the $130,000 limit) for such plans, and to exempt certain

survivor and disability benefits from the adjustments for early commencement and for participation

and service of less than 10 years. This would be comparable to the changes made to the section 415

limits for governmental plans in the Small Business Job Protection Act of 1996.

The proposals would be effective for limitation years beginning after December 31, 1999.
- 66 -

SIMPLIFY FULL FUNDING LIMITATION FOR MULTIEMPLOYER PLANS

Current Law

An employer's annual deduction for contributions to a defined benefit plan may not exceed

the plan’s full funding limitation. The full funding limitation is generally defined as the excess of the

plan's accrued liability (or, if less, a specified percentage of the plan’s current liability) over the value

of the plan's assets. The specified percentage is 150 percent for plan years beginning before January

1, 1999 and it increases by 5 percent every other year beginning in 1999, until it reaches 170 percent

for plan years beginning on or after January 1, 2005. Whenever the specified percentage of current

liability is less than the plan’s accrued liability, the full funding limitation restricts the extent to which

an employer can deduct contributions for benefits that have not yet accrued.

Defined benefit plans are required to have an actuarial valuation no less frequently than

annually. 

Reasons for Change

An employer has little, if any, incentive to make "excess" contributions to a multiemployer

plan, yet, under current law, the employer must perform the calculations to apply this limit. The

amount an employer contributes to a multiemployer plan is determined by the collective bargaining

agreement, and a particular employer's contributions are not set aside to pay benefits solely to the

employees of that employer. 

Proposal

The limit on deductible contributions based on a specified percentage of current liability would

be eliminated for multiemployer plans. Therefore, the annual deduction for contributions to such a

plan would be limited to the amount by which the plan's accrued liability exceeds the value of the

plan's assets. In addition, actuarial valuations would be required under the Code no less frequently

than every three years for multiemployer plans. Parallel changes would be made to the Employee

Retirement Income Security Act of 1974, as amended. 

The proposal would be effective for taxable years beginning after December 31, 1999.
- 67 -

ELIMINATE PARTIAL TERMINATION RULES

 FOR MULTIEMPLOYER PLANS

Current Law

When a qualified retirement plan is terminated, all plan participants are required to become

100 percent vested in their accrued benefits to the extent those benefits are funded. In the case of

certain "partial terminations" that are not actual plan terminations (e.g., a large reduction in the work

force), all affected employees must become 100 percent vested in their benefits accrued to the date

of the termination, to the extent the benefits are funded.

Whether a partial termination has occurred in a particular situation is generally based on

specific facts and circumstances, including the exclusion from the plan of a group of employees who

have previously been covered by the plan by reason of a plan amendment or severance by the

employer. In addition, if a defined benefit plan stops or reduces future benefit accruals under the

plan, a partial termination is deemed to occur under certain circumstances.

Reasons for Change

Over the years, court decisions have left unanswered many key questions as to how to apply

the partial termination rules. Accordingly, applying the rules can often be difficult and uncertain,

especially for multiemployer plans. For example, multiemployer plans experience frequent

fluctuations in participation levels caused by the commencement and completion of projects that

involve significant numbers of union members. Many of these terminated participants are soon

rehired for another project that resumes their active coverage under the plan. In addition, it is

common for participants leaving one multiemployer plan's coverage to maintain service credit under

a reciprocal agreement if they move to the coverage of another plan sponsored by the same union.

As a result, these participants do not suffer the interruption of their progress along the plan's vesting

schedule that ordinarily occurs when an employee stops being covered by a plan. Given these factors,

the difficulties associated with applying the partial termination rules to multiemployer plans outweigh

the benefits.

Proposal

The requirement that affected participants become 100 percent vested in their accrued benefits

(to the extent funded) upon the partial termination of a qualified employer retirement plan would be

repealed with respect to multiemployer plans.

The proposal would be effective for partial terminations that begin after December 31, 1999.
- 68 -

ALLOW ROLLOVERS BETWEEN QUALIFIED RETIREMENT PLANS

AND SECTION 403(B) TAX-SHELTERED ANNUITIES

Current Law

An eligible rollover distribution from a qualified retirement plan (i.e., a plan qualified under

section 401(a) or 403(a)) may be either (1) rolled over by the distributee to an eligible retirement plan

if the rollover occurs within 60 days of the distribution, or (2) directly rolled over by the distributing

plan to an eligible retirement plan. Generally, an "eligible rollover distribution" is a distribution other

than (1) a distribution which is required under section 401(a)(9) or (2) a distribution which is part of

a series of substantially equal periodic payments made for life, life expectancy or over a period of ten

years or more. An "eligible retirement plan" is a section 401 plan, a section 403(a) plan or an IRA.

In the case of section 403(b) tax-sheltered annuities, distributions which would be eligible rollover

distributions except for the fact that they are distributed from a section 403(b) tax-sheltered annuity

may be rolled over to another section 403(b) tax-sheltered annuity or a traditional IRA. Under these

rules, for example, an eligible rollover distribution from a section 401(k) plan may not be rolled over

to a section 403(b) tax-sheltered annuity, and an eligible rollover distribution from a section 403(b)

tax-sheltered annuity may not be rolled over to a section 401(k) plan. 

An amount may be rolled over from a qualified retirement plan to a traditional IRA and

subsequently rolled over to another qualified retirement plan if amounts in the IRA are attributable

only to rollovers from qualified retirement plans. Also, under these “conduit IRA” rules, an amount

may be rolled over from a section 403(b) tax-sheltered annuity to a traditional IRA and subsequently

rolled over to a section 403(b) tax-sheltered annuity if amounts in the IRA are attributable only to

rollovers from section 403(b) tax-sheltered annuities.

Reasons for Change

 Given the increasing mobility of the American workforce, some individuals could accumulate

a number of small retirement savings accounts and small amounts in many different qualified

retirement plans and section 403(b) tax-sheltered annuities. Expansion of the current law rules

permitting rollovers between qualified retirement plans and section 403(b) tax-sheltered annuities

would allow participants in these plans to combine their retirement plan savings in one vehicle if they

change jobs.

Proposal

An eligible rollover distribution from a qualified retirement plan could be rolled over to a

qualified retirement plan, a section 403(b) tax-sheltered annuity, or a traditional IRA. Likewise, an

eligible rollover distribution from a section 403(b) tax-sheltered annuity could be rolled over to

another section 403(b) tax-sheltered annuity, a qualified retirement plan, or a traditional IRA. The

conduit IRA rules would be modified in the same manner. A special rule would prevent participants
- 69 -

from receiving special capital gains and income averaging treatment available to distributions from

qualified retirement plans if their accounts include any amounts previously held under a section 403(b)

tax-sheltered annuity. 

 The proposal would be effective for distributions after December 31, 1999.
- 70 -

ALLOW ROLLOVERS FROM REGULAR IRAS TO QUALIFIED

RETIREMENT PLANS OR SECTION 403(B) TAX-SHELTERED ANNUITIES

Current Law

Regular contributions to a traditional IRA (i.e., contributions subject to the deduction

limitations of section 219, as opposed to rollover contributions from a qualified retirement plan or

a section 403(b) tax-sheltered annuity) cannot be directly or indirectly rolled over to a qualified

retirement plan or a section 403(b) tax-sheltered annuity. 

Reasons for Change

Expansion of the current law rules permitting rollovers will allow participants in qualified

retirement plans or section 403(b) tax-sheltered annuities, who also have made regular contributions

to traditional IRAs, more opportunities to consolidate their retirement savings in one vehicle.

Proposal

 Under this proposal, individuals who have a traditional IRA and whose IRA contributions

have all been tax deductible would be offered the opportunity to transfer funds from their traditional

IRA into their qualified defined contribution retirement plan or section 403(b) tax-sheltered annuity --

provided that the retirement plan trustee meets the same standards as an IRA trustee. 

The proposal would be effective for distributions after December 31, 1999.
- 71 -

ALLOW ROLLOVERS OF AFTER-TAX CONTRIBUTIONS

Current Law

Employees are allowed to make after-tax contributions to qualified retirement plans.

However, they are not permitted to roll over distributions of those after-tax contributions to a

traditional IRA or another qualified retirement plan.

Reasons for Change

After-tax savings in qualified retirement plans enhance retirement security. Allowing such

distributions to be rolled over to a traditional IRA or another qualified retirement plan would increase

the chances that those amounts would be retained until needed for retirement.

Proposal

After-tax employee contributions to a qualified retirement plan could be included in a rollover

contribution to a traditional IRA or another qualified retirement plan, provided that the plan or IRA

provider agrees to track and report the after-tax portion of the rollover for the individual.

Distributions of after-tax contributions would continue to be nontaxable.

The proposal would be effective for distributions after December 31, 1999. 
- 72 -

ALLOW ROLLOVERS OF CONTRIBUTIONS FROM NONQUALIFIED

DEFERRED COMPENSATION PLANS OF STATE AND LOCAL GOVERNMENTS

TO IRAS

Current Law

Unlike participants in qualified retirement plans and section 403(b) tax-sheltered annuities,

participants in eligible nonqualified deferred compensation plans of State and local governments under

section 457(b) (also known as “governmental section 457 plans”) may not roll over distributions from

these plans to IRAs. Accordingly, amounts distributed from these plans are includable in gross

income on distribution.

Reasons for Change

Like participants in qualified retirement plans and section 403(b) tax-sheltered annuities,

participants in governmental section 457 plans should be able to transfer distributed amounts to IRAs,

thereby further deferring tax on retirement savings.

Proposal

The proposal would allow individuals to roll over distributions from a governmental section

457 plan to a traditional IRA.

The proposal would be effective for distributions after December 31, 1999.
- 73 -

FACILITATE THE PURCHASE OF SERVICE CREDITS IN

GOVERNMENTAL DEFINED BENEFIT PLANS

Current Law

Employees of State and local governments, particularly teachers, often move between States

and school districts in the course of their careers. Under State law, these employees often have the

option of purchasing service credits in their State defined benefit pension plans in order to make up

for time spent in another State or district. With purchase of these service credits, workers can earn

a pension reflecting a full career of employment in the State in which they conclude their career.

Under current law, these employees cannot make a tax-free transfer of the money they have saved

in their section 403(b) tax-sheltered annuities or governmental section 457 plans to purchase these

service credits.

Reason for Change

The inability to make tax-free transfers from section 403(b) tax-sheltered annuities and

governmental section 457 plans to purchase permissive service credits poses a barrier to portability

for employees of State and local governments, particularly for those employees who lack other

resources to use for this purpose. 

Proposal

Under the proposal, State and local government employees would be able to use funds from

their section 403(b) tax-sheltered annuities or governmental section 457 plans to purchase service

credits through a direct transfer without first having to take a taxable distribution of these amounts.

The proposal would be effective for transfers made after December 31, 1999.
- 74 -

Extend Expiring Provisions

EXTEND AMT RELIEF FOR INDIVIDUALS

Current Law

An individual is subject to an alternative minimum tax (AMT) to the extent the individual’s

tentative minimum tax is greater than his or her regular tax liability. In addition, an individual

generally is allowed to offset his or her tax liability with the nonrefundable personal credits (e.g., the

child and dependent care credit, adoption credit, child credit, and the Hope and Lifetime Learning

credits) only to the extent the individual’s regular tax (determined before such credits) exceeds his

or her tentative minimum tax. A special rule, applicable only to the 1998 tax year, allows an

individual to offset his or her regular tax liability by nonrefundable tax credits regardless of the

amount of the individual’s tentative minimum tax. 

Reasons for Change

The original individual AMT was enacted in the 1960's as a separate tax system within the

income tax because of a belief that many upper-income individuals were avoiding regular tax through

the use of certain tax preferences. Over time, the individual AMT has becomes less focused, as some

of these tax preferences have been removed from the regular tax base, while others have been deleted

from the AMT base. 

The Administration is concerned that the individual AMT may impose financial and

compliance burdens upon taxpayers that have few tax preference items and were not the originally

intended targets of the AMT. In particular, the Administration is concerned that the individual AMT

may act to erode the benefits of nonrefundable tax credits that are intended to provide tax relief for

middle income taxpayers. In response, the Administration proposes to extend, as a temporary relief

measure, the provision enacted in 1998 that facilitates the use of personal credits. The Administration

looks forward to working with Congress to address the long-term issues raised by the individual

AMT.

Proposal 

The proposal would allow an individual, for taxable years 1999 and 2000, to offset his or her

regular tax liability by nonrefundable tax credits regardless of the amount of the individual’s tentative

minimum tax.
- 75 -

EXTEND THE WORK OPPORTUNITY TAX CREDIT

Current Law

A work opportunity tax credit (WOTC) currently is provided for hiring individuals from

certain targeted groups. The credit equals a percentage of qualified wages paid during the first year

of the individual's employment with the employer. The credit percentage is 25 percent for

employment of at least 120 hours but less than 400 hours and 40 percent for employment of 400 or

more hours. The maximum amount of qualified wages paid to an individual is $6,000. The credit

expires with respect to employees who begin work after June 30, 1999.

Reasons for Change

The goal of the Work Opportunity Tax Credit is to provide employers with a tax incentive

to hire individuals who have traditionally had difficulty entering and remaining in the work force. An

extended wage credit would continue to serve as an inducement for employers to hire these

individuals and to invest in their training.

Proposal

The Work Opportunity Tax Credit would be extended so that the credit would apply with

respect to employees who begin work before July 1, 2000.

The proposal would also clarify the coordination of the Work Opportunity Tax Credit and the

Welfare-to-Work Tax Credit with respect to an individual whose first year of employment does not

coincide with the employer’s taxable year. The proposed clarification would be effective for taxable

years beginning on or after the date of first committee action.
- 76 -

EXTEND THE WELFARE-TO-WORK TAX CREDIT

Current Law

 The welfare-to-work tax credit enables employers to claim a tax credit for eligible wages paid

to certain long-term family assistance recipients. The credit is 35 percent of the first $10,000 of

eligible wages in the first year of employment and 50 percent of the first $10,000 of eligible wages

in the second year of employment. Thus, the maximum credit is $8,500 per qualified employee. The

credit expires with respect to individuals who begin work after June 30, 1999. 

Reasons for Change

Extending the welfare-to-work tax credit would continue to encourage employers to hire,

invest in training, and provide certain benefits and more permanent employment, to long-term welfare

recipients.

Proposal

The welfare-to-work tax credit would be extended for one year, so that the credit would be

effective for individuals who begin work before July 1, 2000.
- 77 -

EXTEND THE R&E TAX CREDIT

Current Law

The research tax credit generally applies on an incremental basis to a taxpayer’s “qualified

research” expenses for a taxable year. The credit generally is equal to 20 percent of the amount by

which the taxpayer’s qualified research expenses for the taxable year exceed a base amount. The base

amount is the product of the taxpayer’s “fixed base percentage” and the average of the taxpayer’s

gross receipts for the four preceding years. The base amount cannot be less than 50 percent of the

taxpayer’s qualified research expenses for the taxable year.

Taxpayers are allowed to elect an alternative incremental credit for any taxable year beginning

after June 30, 1996. If a taxpayer elects to be subject to this alternative regime, the taxpayer is

assigned a three-tiered fixed-base percentage (that is lower than the fixed-base percentage otherwise

applicable under current law) and the credit rate likewise is reduced.

The research credit is not available for activities conducted outside the United States. Puerto

Rico is not a part of the United States for purposes of this provision.

The credit expires for qualified research expenses paid or incurred after June 30, 1999.

Reasons for Change

The Administration supports the extension of the research tax credit. The Administration

recognizes the importance of technology to our national ability to compete in the global marketplace,

and the research credit is useful in supporting and fostering technology. The credit provides

incentives for private-sector investment in research and innovation that can help increase America’s

economic competitiveness and enhance U.S. productivity. The Administration also believes that the

credit should be extended to research activities by U.S. corporations in Puerto Rico.

Proposal

The research tax credit would be extended for twelve months, from July 1, 1999 to June 30,

2000. Under the proposal, the credit would be available with respect to qualified activities conducted

in Puerto Rico for taxable years beginning on or after the date of enactment.
- 78 -

MAKE PERMANENT THE EXPENSING OF BROWNFIELDS REMEDIATION COSTS

Current Law

Generally, costs incurred to clean up land and groundwater increase the value of any property

and are not currently deductible, but must be capitalized. In a ruling issued in 1994 (Revenue Ruling

94-38), the IRS concluded that certain environmental cleanup costs incurred are currently deductible

as business expenses. That ruling only addressed cleanup costs incurred by the same taxpayer that

contaminated the land, rather than someone who acquired previously contaminated property. 

As part of the Taxpayer Relief Act of 1997, certain remediation costs are currently deductible

if incurred with respect to a qualified contaminated site, Aso-called brownfields@. Generally, these

expenses are limited to those paid or incurred in connection with the abatement or control of

environmental contaminants. For example, expenses incurred with respect to the demolition of

existing buildings and their structural components do not qualify for this treatment except in the

unusual circumstance where the demolition is required as part of ongoing remediation. This

deduction applies for both alternative minimum tax and regular tax purposes.

A Aqualified contaminated site@ generally is any property that (1) is held for use in a trade or

business, for the production of income, or as inventory; (2) is certified by the appropriate State

environmental agency to be located within a targeted area; and (3) contains (or potentially contains)

a hazardous substance. Targeted areas are defined as: (1) empowerment zones and enterprise

communities; (2) sites that were announced before February 1997 as being subject to one of the

Environmental Protection Agency (AEPA@) Brownfields Pilots; (3) any population census tract with

a poverty rate of 20 percent or more; and (4) certain industrial and commercial areas that are adjacent

to tracts described in (3) above.

This special treatment does not apply to expenditures paid or incurred after December 31,

2000.

Reasons for Change

The Administration believes that encouraging environmental remediation is an important

national goal. Extending special treatment on a permanent basis would remove doubt among

taxpayers as to the future deductibility of remediation expenditures and would promote the goal of

encouraging environmental remediation.

Proposal

The proposal would make permanent the deduction under section 198 for brownfields

remediation costs. The restriction requiring that expenditures must be paid or incurred on or before

December 31, 2000 in order to be deductible as environmental remediation expenditures would be

eliminated.
- 79 -

EXTEND TAX CREDIT FOR FIRST-TIME D.C. HOMEBUYERS

Current Law

First-time homebuyers of a principal residence in the District of Columbia are eligible for a

nonrefundable tax credit of up to $5,000 of the amount of the purchase price. The $5,000 maximum

credit applies both to individuals and married couples. Married individuals filing separately can claim

a maximum credit of $2,500 each. The credit phases out for individual taxpayers with adjusted gross

income between $70,000 and $90,000 ($110,000-$130,000 for joint filers).

The credit expires for residences purchased after December 31, 2000.

Reasons for Change

The Administration recognizes the importance of a stable residential base for the District of

Columbia and the need to attract new homeowners to the District of Columbia.

Proposal

The D.C. first-time homebuyer tax credit would be extended for twelve months, from January

1, 2001 to December 31, 2001.
- 80 -

Simplify the Tax Laws

PROVIDE OPTIONAL SELF-EMPLOYMENT CONTRIBUTIONS ACT (SECA)

COMPUTATIONS

Current Law

The Self-Employment Contributions Act (SECA) imposes taxes on net earnings from selfemployment to provide social security coverage to self-employed workers. The maximum amount

of earnings subject to the self-employment (or SECA) tax is coordinated with, and is set at the same

level as, the maximum level of wages and salaries subject to FICA taxes ($72,600 for OASDI taxes

in 1999 and indexed annually, and without limit for the Hospital Insurance tax).

Special rules allow certain self-employed individuals to continue to maintain social security

coverage during a period of low income. The method applicable to farmers is slightly more favorable

than the method applicable to other self-employed persons. A farmer may increase his or her selfemployment income, for purposes of obtaining social security coverage, by reporting two thirds of

the first $2,400 of gross income as net earnings from self-employment, i.e., the optional amount of

net earnings from self-employment would not exceed $1,600. There is no limit to the number of

times a farmer may use this method. The optional method for non-farm income is similar, also

permitting two thirds of the first $2,400 of gross income to be treated as self-employment income.

However, the optional non-farm method may not be used more than five times by any individual, and

may only be used if the taxpayer had net earnings from self-employment of $400 or more in at least

two of the three years immediately preceding the year in which the optional method is elected.

Reasons for Change

Combining the two different optional methods of computing self-employment income for selfemployment tax purposes into a single combined optional method will simplify the self-employment

tax for the approximately 45,000 taxpayers (in 1994) who use one of these methods. Forms and

instructions will also be simplified for the millions of self-employed workers who do not use the

optional methods. 

There is no policy reason for providing different methods for farm and non-farm selfemployed workers. By permitting non-farm self-employed workers to use the more liberal

requirements that currently apply to the farm optional method, more non-farm self-employed persons

would be expected to use the combined optional method and, thereby, to obtain additional social

security and Medicare coverage and, eventually, to receive higher social security benefits. 
- 81 -

Proposal

The two current optional methods would be combined into a single combined optional method

under which self-employment income for SECA tax purposes would be two-thirds of the first $2,400

of gross income. A self-employed worker could elect the proposed combined optional method an

unlimited number of times. If it is used, it would have to be applied to all self-employment earnings

for the year, both farm and non-farm. 

The proposal would be effective for taxable years beginning after December 31, 1999.
- 82 -

PROVIDE STATUTORY HEDGING AND OTHER RULES TO ENSURE

BUSINESS PROPERTY IS TREATED AS ORDINARY PROPERTY

Current law

Under current law, there is a significant issue of whether income from hedging transactions is capital or

ordinary. The Supreme Court in Arkansas Best Corp. v. Commissioner, 350 U.S. 46 (1955), established a

restrictive definition of ordinary asset. As a result, the IRS sought to treat certain business hedges as capital

assets. That effort resulted in additional litigation and considerable taxpayer efforts to change the rules

legislatively.

In 1994, the IRS and Department of the Treasury finalized regulations to provide ordinary character for

most business hedges and to provide rules to ensure that the timing of income or loss from hedging transactions

matches the timing of economically offsetting income or loss from the related hedged items.

Reasons for Change

The hedging regulations issued by the Department of the Treasury do not eliminate the possibility that

a business hedge can be improperly characterized for tax purposes. The rules governing hedging transactions

need to be modernized. 

Proposal

The proposal would codify the approach taken in the regulations and make some modifications to clarify

the rules. In particular, the proposal would add three categories of ordinary assets to section 1221: (1) Adealer

derivatives contracts,@ (2) supplies of a type regularly used by the taxpayer in the provision of services or the

production of ordinary property, and (3) Ahedging transactions.@ A new provision would define Adealer derivative

contract@ as a derivative contract that is purchased or written by a taxpayer that makes a market in derivatives

contracts in the course of the taxpayer’s trade or business. A new provision would define Ahedging transactions@

as transactions entered into primarily to manage the risk of ordinary property held or to be held, or certain

liabilities incurred or to be incurred. Importantly, a transaction would qualify as a hedging transaction only if it

were identified as a hedging transaction on the books and records of the taxpayer. If a transaction was improperly

identified as a hedging transaction, losses would retain their usual character (i.e., usually capital), but gains would

be ordinary. If a hedging transaction was not identified, gains would be ordinary but losses would retain their

non-hedging character. Other rationales for ordinary treatment (such as surrogacy for a non-capital asset or

insurance against a business risk) would not be allowed.

The proposal would provide that the timing of income, gain, deduction, or loss from a hedging

transaction must reasonably match the timing of the income, gain, deduction, or loss from the hedged item. 

The proposal generally would be effective after the date of enactment, and would give the Treasury

Department authority to issue regulations similar to the hedging provisions governing hedging transactions

entered into prior to the effective date.
- 83 -

CLARIFY RULES RELATING TO CERTAIN DISCLAIMERS

Current Law 

State laws permit donees of gifts and bequests to refuse to accept (i.e., disclaim) such

transfers prior to acceptance. In that event, State laws typically provide that the disclaimed property

passes as if the intended recipient died before the transfer was made. Under section 2518, a State law

type disclaimer is effective for Federal transfer tax purposes if it is an irrevocable and unqualified

refusal to accept an interest in property, the disclaimer is made in writing not later than nine months

after the transfer creating the interest occurs, and certain other requirements are satisfied. Disclaimers

are permitted for an “undivided portion” of the disclaimant’s interest. Also, a spouse is permitted to

disclaim even when the result of the disclaimer is that the disclaimed property will pass to a trust of

which the spouse is a beneficiary. When a qualified disclaimer is made, the property passes in

accordance with State law and the transfer tax provisions apply as if no transfer had been made to

the disclaiming person. The effect of a qualified disclaimer for Federal income tax purposes is

unclear.

Certain transfers of property also can be treated as qualified disclaimers under section

2518(c)(3). In order to qualify, these transfer-type disclaimers must be a written transfer of the

disclaimant’s “entire interest in the property” to the person who would have received the property

had there been a valid disclaimer under State law. Like other disclaimers, the transfer-type disclaimer

generally must be made within nine months of the transfer creating the interest.

Reasons for Change

The Administration wishes to clarify that transfer-type disclaimers should be treated the same

as non-transfer-type disclaimers. In addition, qualified disclaimers should be effective for income tax

purposes as well as for transfer tax purposes, so that if a person disclaims property that is income in

respect of a decedent (IRD), the income tax liability for the IRD goes with the disclaimed property.

Proposal 

The proposal would amend the disclaimer rules to state that, in the case of a transfer-type

disclaimer, partial disclaimers are permitted and a spouse can make a disclaimer that is effective for

gift tax purposes even where the disclaimed property passes to a trust in which the surviving spouse

has an income interest. The proposal also would clarify that disclaimers are effective for income tax

purposes. This proposal would apply to disclaimers made after the date of enactment.
- 84 -

SIMPLIFY THE FOREIGN TAX CREDIT LIMITATION

FOR DIVIDENDS FROM 10/50 COMPANIES

Current Law

U.S. persons may credit foreign taxes against U.S. tax on foreign source income. The amount

of foreign tax credits that can be claimed in a year is subject to a limitation that prevents taxpayers

from using foreign tax credits to offset U.S. tax on U.S. source income. Separate limitations are

applied to specific categories of income.

Special foreign tax credit limitation rules apply in the case of dividends received from a

foreign corporation in which the taxpayer owns at least 10 percent of the stock by vote and which

is neither a controlled foreign corporation nor a passive foreign investment company (a so-called

"10/50 company"). Dividends paid by a 10/50 company in taxable years beginning before January

1, 2003, are subject to a separate foreign tax credit limitation for each 10/50 company. Dividends

paid by a 10/50 company in taxable years beginning after December 31, 2002, from earnings and

profits accumulated in taxable years beginning before January 1, 2003, are subject to a single foreign

tax credit limitation for all 10/50 companies. Dividends paid by a 10/50 company in taxable years

beginning after December 31, 2002, from earnings and profits accumulated in taxable years beginning

after December 31, 2002, are treated as income in a foreign tax credit limitation category in

proportion to the ratio of the earnings and profits attributable to income in such foreign tax credit

limitation category to the total earnings and profits (a so-called "look-through" approach).

Regulatory authority is granted to provide rules regarding the treatment of distributions out of

earnings and profits for periods prior to the taxpayer’s acquisition of such stock.

Reasons for Change

With respect to dividends paid by a 10/50 company in taxable years beginning after December

31, 2002, the concurrent application of both the single basket approach (for pre-2003 earnings and

profits) and the look-through approach (for post-2002 earnings and profits) will result in significant

complexity to taxpayers. A reduction in complexity and compliance burdens will reduce the bias

against U.S. participation in foreign joint ventures and foreign investment by U.S. companies through

affiliates that are not majority owned.

Proposal

The proposal would simplify the application of the foreign tax credit limitation by applying

the look-through approach immediately to dividends paid by a 10/50 company, regardless of the year

in which the earnings and profits out of which the dividend is paid were accumulated. The proposal

would grant regulatory authority to provide rules regarding the treatment of distributions out of

earnings and profits for periods prior to the taxpayer’s acquisition of the stock, including rules to

disregard preacquisition earnings and profits, and foreign taxes, in appropriate circumstances. The

proposal would be effective for taxable years beginning after December 31, 1998.
- 85 -

INTEREST TREATMENT FOR DIVIDENDS PAID BY CERTAIN REGULATED

INVESTMENT COMPANIES TO FOREIGN PERSONS

Current Law

Interest income and short-term capital gains received by a U.S. money market or bond mutual

fund are recharacterized as dividend income that is subject to U.S. withholding tax when distributed

to foreign investors. However, in general, no U.S. withholding tax is imposed on interest income and

short-term capital gains received by foreign investors from direct investments or investments through

foreign funds in U.S. bonds and money market instruments. 

Reasons for Change

Imposition of U.S. withholding tax on investments through U.S. money market or bond

mutual funds, when tax is not imposed on comparable investments through foreign funds, puts U.S.

mutual funds at a significant competitive disadvantage in attracting foreign investors. The proposal

would eliminate this disadvantage, as well as needless complications now associated with structuring

vehicles for foreign investment in U.S. debt securities.

Proposal

The proposal generally would treat all income received by a U.S. mutual fund that invests

substantially all of its assets in U.S. debt securities or cash as interest that is exempt from U.S.

withholding tax. In determining whether a fund invests substantially all of its assets in U.S. debt

securities or cash, a fund generally will not fail to meet this test if it also invests some of its assets in

foreign debt instruments that are free from foreign tax pursuant to the domestic laws of the relevant

foreign countries.

The proposal would be effective for mutual fund taxable years beginning after the date of

enactment.
- 86 -

EXPAND DECLARATORY JUDGMENT REMEDY FOR NONCHARITABLE

ORGANIZATIONS SEEKING DETERMINATIONS OF TAX-EXEMPT STATUS

Current Law

In contrast to the rules governing charities, non-charities (i.e., organizations not described in

section 501(c)(3)) generally are not required to file an application with the IRS to obtain a

determination of their tax-exempt status. In practice, however, some organizations voluntarily do

so by filing a Form 1024. If an organization that voluntarily files Form 1024 later receives a favorable

determination from the IRS, the determination of tax-exempt status is usually effective as of the date

of formation of the organization if its purposes and activities during the period prior to the date of

the determination letter were consistent with the requirements for exemption. However, if the

organization later receives an adverse determination from the IRS, the IRS may assert that the

organization is subject to tax on some or all of its income for open taxable years. The IRS position

could be challenged in court only in the context of a deficiency or refund proceeding.

Under current law, any organization seeking tax-exempt status as a charity under section

501(c)(3) is allowed to seek a declaratory judgment as to its tax status if its application for

recognition of exemption is denied or delayed by the IRS.

Reasons for Change

One reason that non-charities voluntarily file Form 1024 is to achieve greater certainty about

their tax status. However, this goal is undermined if the IRS determination is delayed for a significant

period of time. If such an organization ultimately receives an adverse determination from the IRS

with respect to its tax-exempt status, the organization faces potential tax liability for the period during

which its application was pending at the IRS.

Proposal

The proposal would extend declaratory judgment procedures similar to those currently

available only to charities under section 7428 to other section 501(c) determinations. Thus, if the

application of any organization seeking tax-exempt status under section 501(c) is pending with the

IRS for more than 270 days, and the organization has exhausted all administrative remedies available

within the IRS, then the organization may seek a declaratory judgment as to its tax status from the

United States Tax Court. 

The proposal would be effective for applications for recognition of exemption filed after

December 31, 1999.
- 87 -

SIMPLIFY THE ACTIVE TRADE OR BUSINESS REQUIREMENT

FOR TAX-FREE SPIN-OFFS

Current Law

In order for a spin-off, split-off, or split-up to qualify for tax-free treatment, among other

requirements, either the distributing and controlled corporations both must be engaged in the active

conduct of a trade or business immediately after the distribution or, immediately before the

distribution, the distributing corporation must have no assets other than stock or securities in the

controlled corporations and each of the controlled corporations must be engaged in the active

conduct of a trade or business immediately after the distribution. If a corporation is not itself active,

it may satisfy the active trade or business test indirectly, but only if substantially all of its assets

consist of stock and securities of a controlled corporation that is engaged in the active conduct of a

trade or business. 

Reasons for Change

Because the substantially all standard is much higher than that required if the corporation is

directly engaged in the active conduct of a trade or business, a taxpayer often must engage in

pre-distribution restructurings that it otherwise would not have undertaken. There is no clear policy

reason that justifies imposing a different standard for meeting the active trade or business requirement

depending upon whether a corporation is considered to be active on a direct or indirect basis. 

Proposal

The Administration proposes to simplify the active trade or business requirement by removing

the substantially all test and generally allowing an affiliated group to satisfy this requirement as long

as the relevant affiliated group, taken as a whole, is considered active. The relevant affiliated group

would be determined immediately after the distribution. With respect to the distributing corporation,

the relevant affiliated group would consist of the distributing corporation as the common parent and

all corporations (regardless of whether such corporations are includable corporations under section

1504(b)) connected with the distributing corporation through stock ownership described in section

1504(a)(1)(B). The relevant affiliated group for the controlled corporation would be determined in

the same manner, treating the controlled corporation as the common parent of such group.

This proposal would be effective for transactions after the date of enactment. 
- 88 -

Miscellaneous Provisions

EXTEND AND MODIFY PUERTO RICO

ECONOMIC-ACTIVITY TAX CREDIT (SECTION 30A)

Current Law 

Domestic corporations with business operations that were established by October 13, 1995

in U.S. possessions may continue to benefit from the credit provided under section 936 or 30A to

reduce or eliminate the U.S. tax on certain income that is related to their possession-based operations.

The credit may offset the U.S. tax on income arising from the active conduct of a trade or business

within a U.S. possession or from the sale or exchange of substantially all of the assets used by the

taxpayer in the active conduct of such trade or business. The credit offsets the beneficiary

corporation’s U.S. tax whether or not it pays income tax to the possession.

Limitations on the credit were enacted in 1993, and the credit was repealed in 1996, subject

to a phase-out for companies benefitting at that time from the credit. 

Currently, under the phase-out, beneficiary companies operating in Puerto Rico calculate the

allowable credit either (1) taking 40 percent of the credit as allowed under prior law, subject to a cap

based on pre-1996 possessions income (claimants with the percentage limitation in place for their

1997 fiscal year), or (2) based on the company’s economic activity in Puerto Rico (measured by

wages and other compensation, depreciation, and certain taxes paid), subject beginning in 2002 to

a cap based on pre-1996 possessions income. (The credit under the economic-activity regime is

provided in section 30A.) 

No credit is available in taxable years beginning after December 31, 2005. No credit is

available with respect to business operations established after October 13, 1995.

Reasons for Change

The Administration proposed to reformulate the credit in 1993 and again in 1996 to make it

a more efficient incentive for job creation and economic activity in Puerto Rico; the amendments

enacted in 1993 moved part way toward the Administration’s proposals, but the phase-out enacted

in 1996 eliminated all incentives for new investment in Puerto Rico. The Administration continues

to believe that there should be a tax credit to provide an incentive for increased economic activity in

Puerto Rico.

Proposal

To provide a more efficient and effective tax incentive for the economic development of

Puerto Rico and to continue the shift from an income-based credit to an economic-activity-based

credit that was begun in the 1993 Act, the proposal would modify the economic-activity-based credit

under section 30A by (1) opening it to newly established business operations, effective for taxable
- 89 -

years beginning after December 31, 1998, and (2) extending the phase-out to cover taxable years

beginning before January 1, 2009.
- 90 -

MAKE FIRST $2,000 OF SEVERANCE PAY EXEMPT FROM INCOME TAX

Current Law

Severance payments are includable in the gross income of the recipient.

Reasons for Change

The tax on severance payments places an additional burden on displaced workers, especially

if the worker is separated from service because of a reduction in work force by the employer, in which

case it may be difficult for the worker to find new, comparable employment.

Proposal

Under the proposal, up to $2,000 of certain severance payments would be excludable from

the income of the recipient. This exclusion would apply to payments received by an individual who

was separated from service in connection with a reduction in the employer’s work force. The

exclusion is not available if the individual attains employment within six months of the separation from

service at a compensation level that is at least 95 percent of the compensation the individual received

before the separation from service. The exclusion also does not apply if the total severance payments

received by the individual exceed $75,000.

The proposal would be effective for severance pay received in taxable years beginning after

December 31, 1999 and before January 1, 2003.
- 91 -

EXTEND CARRYBACK PERIOD FOR NOLS OF STEEL COMPANIES

Current Law

Under current law, a net operating loss (NOL) of a taxpayer generally may be carried back

2 years and forward 20 years. Special carryback rules apply to specified liability losses (10 years),

farm losses (5 years), casualty or theft losses (3 years), losses of small businesses and farmers

attributable to activities in a Presidentially declared disaster area (3 years), and losses of real estate

investment trusts (no carryback).

Reasons for Change

Some steel companies are experiencing financial troubles. The benefit proposed by the

Administration will feed directly into a financially troubled steel company's cash flow, providing

immediate needed relief.

Proposal

The proposal would extend the carryback period for the NOL of a steel company to 5 years.

The proposal would not change the 20-year carryforward period. An eligible taxpayer could elect

to forgo the 5-year carryback and apply the current-law carryback rules. Only losses related to

activities incurred in the manufacture or production of steel and steel products would be eligible for

the 5-year carryback.

The proposal would be effective for taxable years ending after the date of enactment,

regardless of when the NOL arose. The provision would not apply to taxable years ending five years

after the date of enactment.
- 92 -

Electricity Restructuring

TAX-EXEMPT BONDS FOR ELECTRIC FACILITIES

Current Law

Interest on State and local government bonds generally is excluded from gross income if the

bonds are issued to finance governmental activities. Bonds issued by State and local governments are

governmental bonds unless the bonds are private activity bonds. Bonds are private activity bonds if

the issue meets both the private use test and private payment or security test. Bonds are also private

activity bonds if the issue satisfies the private loan test.

Facilities for electric generation, transmission, and distribution are eligible for financing with

governmental tax-exempt bonds when the financed facilities are used by or paid for by a State or local

governmental entity. Generally, bond-financed facilities are used for a governmental purpose even

when the electricity they generate or transmit is sold to private persons provided those persons are

treated as members of the general public. Private use arises, however, when electricity is sold under

terms, such as under take-or-pay contracts, which transfer the benefits and burdens of ownership of

the facility to private persons. Such private use may render the interest on outstanding bonds taxable.

Treasury and IRS have written temporary and proposed regulations that will enable State and

local government issuers of tax-exempt bonds that finance output facilities to comply with current

provisions of the Internal Revenue Code relating to private activity bonds and still participate, to a

limited extent, in a deregulated environment. These regulations were published in the Federal Register

on January 22, 1998. They became effective on February 23, 1998. Because the regulations are

temporary, they expire under law three years after they are published.

Reasons for Change

Restructuring the electric industry to deregulate transmission service and encourage retail

competition promises significant economic benefits to both business and household consumers of

electricity. On March 24, 1998, the Department of Energy announced the Administration’s

Comprehensive Electricity Competition Plan (the Plan) which is estimated to save consumers $20

billion per year. Full implementation of the Plan requires revision of the rules governing private use

of tax-exempt bond-financed electric facilities. 

In order to develop efficient nondiscriminatory transmission services, publicly-owned electric

utility companies will be required to turn the operation of their transmission facilities over to

independent systems operators or use those facilities in a manner that may violate the private use rules.

As traditional service areas of both investor-owned and publicly-owned systems are opened to retail

competition, the latter may find it necessary to enter into contracts with private users of electricity in

order to prevent their generation facilities from becoming stranded costs. Without relief from the
- 93 -

private use rules, publicly-owned electric systems may not choose to open their service areas to

competition or to allow their transmission facilities to be operated by a private party.

Proposal

No new facilities for electric generation or transmission may be financed with tax-exempt

bonds after enactment of legislation implementing the Plan. Because electric distribution facilities are

inherently local and in a restructured industry will continue to serve customers as members of the

general public, distribution facilities may continue to be financed with tax-exempt bonds subject to

existing private use rules. Distribution facilities are facilities operating at 69 kilovolts or less (including

functionally related and subordinate property).

Bonds issued to finance transmission facilities before enactment of legislation implementing

the Plan would continue their tax-exempt status if private use resulted from action pursuant to a FERC

order requiring non-discriminatory open access to those facilities. Under the Plan, FERC would be

given the power to require publicly-owned electric utilities to provide such open access. Bonds issued

to finance generation or distribution facilities issued before enactment of legislation implementing the

Plan would continue their tax-exempt status if private use results from retail competition, or if private

use results from the issuer entering into a contract for the sale of electricity or use of its distribution

property that will become effective after implementation of retail competition. Sale of facilities

financed with tax-exempt bonds to private entities would continue to constitute a change in use.

Bonds issued to refund, but not advance refund, bonds issued before enactment of legislation

implementing the Plan would be permitted.

The proposal would be effective on the date of enactment. 
- 94 -

MODIFY TREATMENT OF CONTRIBUTIONS TO

NUCLEAR DECOMMISSIONING FUNDS

Current law

Current law allows a deduction for contributions to a qualified nuclear decommissioning fund.

The amount that may be contributed for a taxable year is limited to the lesser of the cost of service

amount or the ruling amount. The cost of service amount is the amount of nuclear decommissioning

costs included in the taxpayer’s cost of service for ratemaking purposes for the taxable year. The

ruling amount is the amount that the IRS determines to be necessary to provide for level funding of

an amount equal to the taxpayer's nuclear decommissioning costs. The IRS specifies a schedule of

these amounts in a ruling issued to the taxpayer. If circumstances change, a taxpayer may request a

revised schedule of ruling amounts. In addition, the schedule is reviewed at intervals of no more than

10 years.

Reasons for Change

The favorable tax treatment of contributions to nuclear decommissioning funds recognizes the

national importance of the establishment of segregated reserve funds for paying nuclear

decommissioning costs. Although the favorable tax treatment was adopted at a time when nuclear

power plants were operated by regulated public utilities, deregulation will not reduce the need for such

funds. Deregulation will, however, generally eliminate traditional cost of service determinations for

ratemaking purposes. In many cases, a line charge or other fee will be imposed by a State or local

government or a public utility commission to ensure that adequate funds will be available for

decommissioning, but there is no assurance that this will be the case under all State deregulation plans.

Proposal

The cost of service requirement for deductible contributions to nuclear decommissioning funds

would be repealed. Thus, taxpayers, including unregulated taxpayers, would be allowed a deduction

for amounts contributed to a qualified nuclear decommissioning fund. As under current law, however,

the maximum contribution and deduction for a taxable year could not exceed the ruling amount for

that year. 

The proposal would be effective for taxable years beginning after December 31, 1999.
- 95 -

Corporate Tax Shelters

MODIFY SUBSTANTIAL UNDERSTATEMENT PENALTY FOR 

CORPORATE TAX SHELTERS

Current Law

The substantial understatement penalty imposes a 20 percent penalty on any substantial

understatement of tax. The penalty was modified in 1994 and 1997 to more effectively deter

aggressive corporate tax shelters. The 1994 modification eliminated, with respect to corporate

taxpayers, the exception to the substantial understatement penalty regarding tax shelter items for which

the taxpayer had substantial authority and reasonably believed that its treatment was more likely than

not the proper treatment. Instead, the substantial understatement penalty applied unless the taxpayer

could demonstrate reasonable cause and acted in good faith with respect to the portion of the

underpayment attributable to the tax shelter item (section 6664(c)). The legislative history stated that

a determination by the taxpayer or a professional tax advisor that the substantial authority and more

likely than not standards were satisfied would be an important factor, but not enough by itself, to

establish that the reasonable cause exception applied. It was the intent of the provision that the

standards applicable to corporate shelters be tightened. In 1997, the statutory definition of a tax

shelter was modified to eliminate the requirement that the tax shelter have as “the principal purpose”

the avoidance or evasion of Federal income tax and required that the tax shelter have only as “a

significant purpose” the avoidance or evasion of tax. 

Reason for Change

Despite the heightened substantial understatement penalty for corporate tax shelters, there

continue to be a significant number of abusive tax shelter transactions involving corporate taxpayers.

The more narrow reasonable cause exception for corporate tax shelters does not appear to adequately

deter such transactions. Accordingly, the standards applicable to corporate tax shelters should be

tightened.

Proposal

The proposal would increase the penalty applicable to a substantial understatement by

corporate taxpayers from 20 percent to 40 percent for any item attributable to a corporate tax shelter.

The penalty would be reduced to 20 percent if the corporate taxpayer (1) discloses to the National

Office of the Internal Revenue Service within 30 days of the closing of the tax shelter transaction

appropriate documents describing the transaction, (2) files a statement with its tax return verifying that

such disclosure has been made, and (3) provides adequate disclosure on its tax returns as to the

book/tax differences resulting from the corporate tax shelter item for the taxable years in which the

tax shelter transaction applies. The reasonable cause exception of section 6664(c) would be eliminated

for any item attributable to a corporate tax shelter.
- 96 -

For this purpose, a corporate tax shelter would be any entity, plan, or arrangement (to be

determined based on all facts and circumstances) in which a direct or indirect corporate participant

attempts to obtain a tax benefit in a tax avoidance transaction. A tax benefit would be defined to

include a reduction, exclusion, avoidance, or deferral of tax, or an increase in a refund, but would not

include a tax benefit clearly contemplated by the applicable provision (taking into account the

Congressional purpose for such provision and the interaction of such provision with other provisions

of the Code).

A tax avoidance transaction would be defined as any transaction in which the reasonably

expected pre-tax profit (determined on a present value basis, after taking into account foreign taxes

as expenses and transaction costs) of the transaction is insignificant relative to the reasonably expected

net tax benefits (i.e., tax benefits in excess of the tax liability arising from the transaction, determined

on a present value basis) of such transaction. In addition, a tax avoidance transaction would be

defined to cover certain transactions involving the improper elimination or significant reduction of tax

on economic income.

The Secretary may prescribe regulations necessary to carry out the purposes of this provision.

The proposal would be effective for transactions occurring on or after the date of first

committee action. 
- 97 -

DENY CERTAIN TAX BENEFITS TO PERSONS AVOIDING INCOME TAX AS A

RESULT OF TAX AVOIDANCE TRANSACTIONS

Current Law

Under section 269, if a person acquires (directly or indirectly) control of a corporation, or a

corporation acquires (directly or indirectly) carryover basis property of a corporation not controlled

(directly or indirectly) by the acquiring corporation or its shareholders, and the principal purpose for

such acquisition is evasion or avoidance of Federal income tax by securing the benefit of a deduction,

credit, or other allowance, the Secretary may disallow such tax benefit either in whole or in part to the

extent necessary to eliminate such evasion or avoidance of income tax. For purposes of this rule,

control means the ownership of 50 percent of the corporation’s stock (by vote or value). The rule

applies also in the case of a qualified stock purchase by one corporation of another corporation, in the

event that the acquiring corporation does not elect to treat the stock purchase as an asset acquisition,

and where the acquired corporation is liquidated pursuant to a plan of liquidation adopted not more

than two years after the acquisition date, the principal purpose of which is to secure the benefit of a

deduction, credit, or other allowance.

Tax benefits also can be disallowed when those benefits are generated in transactions that lack

economic substance and undermine the purposes of the Code. Sheldon v. Comm’r, 94 T.C. 738

(1990). Treasury has exercised its general regulatory authority to promulgate anti-avoidance rules in

specific contexts, including rules incorporating business purpose and economic substance standards.

See, e.g., Treas. Reg. section 1.701-2; Notice 98-5, 1998-3 I.R.B. 3. 

Reasons for Change

The Administration is concerned about the proliferation of corporate tax shelter activity that

allows a direct or indirect corporate participant to obtain a tax benefit that the participant otherwise

did not possess in a tax avoidance transaction. The current law anti-avoidance provision may not be

sufficient to address many current corporate tax shelter schemes. First, the provision only applies to

the acquisition of control of a corporation or the acquisition of carryover basis property. In addition,

although tax evasion or avoidance might be the most significant factor motivating an acquisition or

liquidation, it is difficult from an administrative standpoint to contest a taxpayer’s assertion that the

transaction had another more significant purpose.

Furthermore, some taxpayers take aggressive positions that they are entitled to a tax benefit

even in circumstances in which there is little or no expected pre-tax economic profit from a structure.

The proposal would clarify that tax benefits arising from tax avoidance transactions would be

disallowed. The Administration proposes to expand the anti-avoidance provision to better address the

types of transactions that the Administration believes are abusive.
- 98 -

Proposal

The proposal would expand the scope of the anti-avoidance rule by adding a provision

authorizing the Secretary to disallow a deduction, credit, exclusion or other allowance obtained in a

tax avoidance transaction. For purposes of this proposal, Atax avoidance transaction@ would be

defined in the same manner as that provided in the Administration’s proposed new substantial

understatement penalty. No inference is intended regarding the treatment of such transactions under

current law. 

 The proposal would apply to transactions entered into on or after the date of first committee

action.
- 99 -

DENY DEDUCTIONS FOR CERTAIN TAX ADVICE AND

IMPOSE AN EXCISE TAX ON CERTAIN FEES RECEIVED

Current Law

Buyers of corporate tax shelter advice generally may deduct the fees paid for such advice as

an ordinary and necessary business expense.

Reasons for Change

The Administration has become increasingly concerned with the prevalence of corporate tax

shelters and thus wants to impose impediments to the purchase, promotion and sale of corporate tax

shelters. Further, the Administration does not believe that payments made for the purchase and

implementation of corporate tax shelter schemes should be treated as ordinary and necessary business

expenses.

Proposal

The proposal would deny a deduction to the corporate participant in a tax avoidance

transaction for fees paid or incurred in connection with the purchase and implementation of corporate

tax shelters and the rendering of tax advice related to corporate tax shelters. The proposal also would

impose a 25 percent excise tax on fees received in connection with the purchase and implementation

of corporate tax shelters (including fees related to the underwriting or other fees) and the rendering

of tax advice related to corporate tax shelters. This proposal would not apply to expenses incurred

with respect to representing the taxpayer before the IRS or a court. If a taxpayer claims a deduction

that otherwise would be denied under this proposal, the amount of deduction could be subject to the

Administration’s proposed new substantial understatement penalty. For purposes of this proposal,

“corporate tax shelter” would be defined in the same manner as that provided in the Administration’s

proposed new substantial understatement penalty.

The proposal would be effective for fees paid or incurred, and fees received, on or after the

date of first committee action.
- 100 -

IMPOSE EXCISE TAX ON CERTAIN RESCISSION PROVISIONS

AND PROVISIONS GUARANTEEING TAX BENEFITS

Current Law

Because taxpayers entering into corporate tax shelter transactions know that such transactions

are risky, particularly because the expected tax benefits are not justified economically, purchasers of

corporate tax shelters often -- 

(1) require a rescission clause that requires the seller of the shelter or a counterparty to

unwind the transaction and make the taxpayer whole financially if there is a change in or

clarification of law that interferes with the successful completion of the transaction,

(2) require a guarantee of tax benefits necessitated not by a change or misstatement of the

facts but by a change in or clarification of the law (to distinguish this from a normal

representation and warranty clause), or 

(3) enter into insurance arrangements with third parties to guarantee the tax benefits.

The tax treatment of payments under these arrangements depends upon the nature of the

payments.

Reasons for Change

The Administration has become increasingly concerned with the prevalence of corporate tax

shelters and is concerned that provisions that insulate the purchaser from risk encourage participation

in tax shelter activity. The Administration wants to impose impediments to the purchase, promotion

and sale of corporate tax shelters by taking away the benefit of provisions that insulate the purchaser

from risk.

Proposal

The proposal would impose on the corporate purchaser of a corporate tax shelter an excise

tax of 25 percent on the maximum payment under a tax benefit protection arrangement at the time the

arrangement is entered into. For this purpose, a tax benefit protection arrangement would include a

rescission clause, guarantee of tax benefits arrangement or any other arrangement that has the same

economic effect (e.g., insurance purchased with respect to the transaction). The maximum payment

under the arrangement would be the aggregate amount the taxpayer would receive if the tax benefits

were denied. For example, if a taxpayer purchases for $100 protection against the risk that the tax

benefits derived from a transaction will not be realized and the agreement values the tax benefits at

$10,000, the taxpayer would be subject to an excise tax of $2,500, even if it is later determined that

only $5,000 of the tax benefits from the transaction were denied. For purposes of this proposal,

“corporate tax shelter” would be defined in the same manner as that provided in the Administration’s

proposed new substantial understatement penalty.
- 101 -

The Secretary would have regulatory authority to provide that arrangements entered into in

connection with specified transactions are not subject to the proposal.

The proposal would apply to arrangements entered into on or after the date of first committee

action.
- 102 -

PRECLUDE TAXPAYERS FROM TAKING TAX POSITIONS INCONSISTENT WITH

THE FORM OF THEIR TRANSACTIONS

Current Law

In general, if a taxpayer enters into a transaction in which the economic substance and legal

form of the transaction are different (and, thus, provide for different Federal income tax

consequences), the taxpayer may take the position that, notwithstanding the form of the transaction,

the substance is controlling for determining the Federal income tax consequences of the transaction.

To successfully assert that the substance, and not the form, of the transaction controls the Federal

income tax consequences, taxpayers must meet a relatively high standard of proof. Depending on the

jurisdiction in which the taxpayer resides, the taxpayer will be required to show that the substance of

the transaction is indeed different from its form through either proof that would alter the construction

of the agreement or render it unenforceable (the so-called "Danielson rule") or strong proof

(something more than a preponderance of the evidence and something less than the Danielson rule).

See, e.g., Ullman v. Commissioner, 264 F.2d 305 (2d Cir. 1959); Danielson v. Commissioner, 378

F.2d 771 (3d Cir. 1967), cert. denied, 389 U.S. 858 (1967); Illinois Power Co. v. Commissioner, 87

T.C. 1417 (1986). 

Under section 385(c), an issuer’s characterization of an interest in a corporation as debt or

equity is binding on the issuer and all holders of such interests, unless the holder discloses that it is

treating the interest in a manner inconsistent with the issuer’s characterization. Under section 1060(a),

if, in connection with an applicable asset acquisition, the transferor and transferee agree in writing as

to the allocation of any consideration, or as to the fair market value of any of the assets, such

agreement shall be binding on both the transferee and transferor unless the Secretary determines that

the allocation (or fair market value) is not appropriate.

Reasons for Change

Because a taxpayer has control over the form of its transactions, it is appropriate to impose

restrictions on the taxpayer’s ability to argue against the form it has chosen. In addition, many

taxpayers enter into transactions in which the substance is different from the form in order to arbitrage

U.S. and foreign tax and regulatory laws. In transactions involving a taxable and tax indifferent party,

the taxable party may believe it has even greater freedom to disavow the form of the transaction

because such recharacterization would have no effect upon the tax indifferent party.

Proposal

The proposal would generally provide that a corporate taxpayer would be precluded from

taking any position (on any return or refund claim) that the Federal income tax treatment of a

transaction is different from that dictated by its form if a tax indifferent party has a direct or indirect

interest in such transaction. This rule would not apply (i) if the taxpayer discloses the inconsistent

position on a timely filed original Federal income tax return for the taxable year that includes the date

the transaction is entered into; (ii) to the extent provided in regulations, if reporting the substance of
- 103 -

the transaction more clearly reflects the income of the taxpayer; or (iii) to certain transactions (such

as publicly available securities lending and sale-repurchase transactions) identified in regulations. For

this purpose, the form of a transaction is to be determined based on all facts and circumstances,

including the treatment given the transaction for regulatory or foreign law purposes. A tax indifferent

party would be defined as a foreign person, a Native American tribal organization, a tax-exempt

organization, and domestic corporations with expiring loss or credit carryforwards. (For this purpose,

loss and credit carryforwards would generally be treated as expiring if the carryforward is more than

3 years old.) The Secretary would have the authority to prescribe regulations to carry out the

purposes of the rule, including regulations that would define the “form” of a transaction. Nothing in

the proposal would prevent the Secretary from asserting the substance-over-form doctrine or imposing

any applicable penalties. No inference is intended as to what extent a corporate taxpayer may disavow

the form of its transactions under current law.

The proposal would be effective for transactions entered into on or after the date of first

committee action.
- 104 -

TAX INCOME FROM CORPORATE TAX SHELTERS INVOLVING

 TAX-INDIFFERENT PARTIES

Current Law

The Federal income tax system has many participants who are indifferent to tax consequences,

e.g., foreign persons, tax-exempt organizations, and Native American tribal organizations. Foreign

persons are subject to U.S. Federal income tax on a net basis on income that is effectively connected

to a U.S. trade or business (ECI) and on a gross basis on income that is fixed or determinable annual

or periodic (FDAP). Tax-exempt organizations (including pension plans and charitable organizations)

are subject to Federal income tax only on income that is unrelated (UBTI) to the organization’s

exempt purpose.

Reasons for Change

Many corporate tax shelters involve a timing mismatch or separation of income or gains from

losses or deductions that is exploited through the use of tax indifferent parties. In these transactions,

the tax indifferent party absorbs the income or gain generated in the transaction, leaving the

corresponding loss or deductions to the taxable corporate participants. Tax indifferent parties often

agree to engage in such transaction in exchange for an enhanced return on investment or for an

accommodation fee. Corporate taxpayers should not be entitled to buy the special tax status of tax

indifferent parties. Imposing a tax on the income allocated to tax indifferent parties should limit the

sale of their special tax status and, thus, their participation in corporate tax shelters.

Proposal

The proposal would provide that any income allocable to a tax indifferent party with respect

to a corporate tax shelter is taxable to such party. The tax on the income allocable to the tax

indifferent party would be determined without regard to any statutory, regulatory, or treaty exclusion

or exception. All other participants of the corporate tax shelter (i.e., any participant other than the tax

indifferent party in question) would be jointly and severally liable for the tax. For this purpose, a

corporate tax shelter would be defined in the same manner as that provided in the Administration’s

proposed new substantial understatement penalty. A tax indifferent party would be defined as a

foreign person, a Native American tribal organization, a tax-exempt organization, and domestic

corporations with expiring loss or credit carryforwards. (For this purpose, loss and credit

carryforwards would generally be treated as expiring if the carryforward is more than 3 years old.)

In the case of a tax-exempt organization, the income would be characterized as UBTI. In the

case of a domestic corporation with expiring loss or credit carryovers, tax would be computed without

regard to such losses or credits. In the case of a foreign person, tax on the income or gain allocable

to such person would first be determined without regard to any exclusion or exception (provided in

a treaty or otherwise) and any such income or gain that is not U.S. source FDAP would be treated as

ECI, regardless of its source. If the foreign person properly claimed the benefit of a treaty, however,

the tax otherwise owing by such person would be collected from the other participants who are not
- 105 -

exempt from U.S. tax. Similarly, in the case of a Native American tribal organization, the tax on the

income allocable to such person would be determined without regard to any exclusion or exception;

however, the tax would be collected only from the participants who are not exempt from U.S. tax,

rather than the tribal organization.

The proposal would be effective for transactions entered into on or after the date of first

committee action.
- 106 -

REQUIRE ACCRUAL OF TIME VALUE ELEMENT ON 

FORWARD SALE OF CORPORATE STOCK

Current law

A corporation generally does not recognize gain or loss on the issuance or repurchase of its

own stock. Thus, a corporation does not recognize gain or loss on the forward sale of its own stock.

A corporation sells its stock forward by agreeing to issue its stock in the future in exchange for

consideration to be paid in the future.

Although a corporation does not recognize gain or loss on the issuance of its own stock, a

corporation does recognize interest income upon the current sale of stock for deferred payment. 

Reason for Change

There is little substantive difference between a corporate issuer’s current sale of its stock for

deferred payment and an issuer’s forward sale of the same stock. The only difference between the two

transactions is the timing of the stock issuance. In a current sale, the stock is issued at the inception

of the transaction, while, in a forward sale, the stock is issued at the time the deferred payment is

received. In both cases, a portion of the deferred payment economically compensates the corporation

for the time-value of the deferred payment. It is inappropriate to treat these two transactions

differently.

Proposal

The proposal would require a corporation that enters into a forward contract to issue its stock

to treat a portion of the payment on the forward issuance as a payment of interest.

The proposal would be effective for forward contracts entered into on or after the date of first

committee action. 
- 107 -

MODIFY TREATMENT OF BUILT-IN LOSSES

AND OTHER ATTRIBUTE TRAFFICKING

Current Law

Under current law, a taxpayer that becomes subject to U.S. taxation may take the position that

it determines its beginning bases in its assets under U.S. tax principles as if the taxpayer had historically

been subject to U.S. taxation. Other tax attributes are computed similarly. Because the Code does

not explicitly prevent the importation of beneficial tax attributes when non-U.S. taxpayers (such as taxexempt organizations or foreign taxpayers) or their assets become subject to U.S. taxing jurisdiction,

a taxpayer may “import” built-in losses or other favorable tax attributes incurred outside U.S. taxing

jurisdiction to offset income or gain that would otherwise be subject to U.S. tax. For example,

taxpayers can shelter income from U.S. tax by acquiring built-in losses or other built-in items such as

built-in deductions, foreign tax credits and deficits in earnings and profits that were generated outside

the U.S. taxing jurisdiction. Conversely, taxpayers may “import” built-in gains to their detriment by

acquiring low basis high value assets or other unfavorable tax attributes in transactions in which there

is a carryover of attributes (e.g., transactions described in sections 332, 351 and 368, contributions

to a U.S. trade or business, or the change to U.S. residency by a nonresident alien). Many taxpayers,

however, trigger built-in gains on assets for U.S. tax purposes immediately prior to importing an asset,

thereby obtaining a step-up in basis without a resulting U.S. tax, or make a section 338 election if such

election is beneficial and available.

The Code provides a number of rules to discourage U.S. taxpayers from obtaining beneficial

tax attributes accrued by another. See, e.g., sections 269 and 381 through 384. For various reasons,

however, those provisions are not effective at preventing the types of trafficking described above. 

In addition, in certain circumstances under current law, tax histories of non-U.S. taxpayers that

accrued before they enter the U.S. taxing jurisdiction must be recreated. For example, a taxpayer is

required to recreate, under U.S. tax principles, bases and other tax histories (such as earnings and

profits histories) that occurred while outside of the U.S. taxing jurisdiction, even if adequate records

have not been kept and the histories date back many years. 

Reasons for Change

Current law does not properly reflect the U.S. taxing interest when attributes are imported into

the United States. This can lead to purposeful tax avoidance by taxpayers. For example, by acquiring

tax attributes, U.S. taxpayers may manipulate foreign tax credit positions or avoid income tax, capital

gains tax or subpart F inclusions. Non-U.S. taxpayers investing in the United States may avoid U.S.

tax on U.S. operations that would otherwise be subject to tax (e.g., operations through U.S.

subsidiaries or as income effectively connected with a U.S. trade or business (ECI)). Similar issues

can arise in transactions involving organizations exempt from tax under section 501 or other taxexempt entities. In addition, as described above, the carryover of tax attributes can lead to unfair

results to taxpayers in other contexts. Such results should be minimized. A taxpayer should not obtain

the benefit of favorable tax attributes for U.S. purposes in circumstances where such taxpayer has not
- 108 -

previously been subject to U.S. taxing jurisdiction. The same may be said of unfavorable tax

attributes. 

Current law also creates unnecessary administrative complexity for both taxpayers and the

government when attributes are carried over. Tax histories frequently span long periods of times,

including periods in which the recreation of attributes under U.S. principles may be difficult or

impossible, and may require costly bases and earnings and profits studies of questionable accuracy.

The proposal represents a simplification from the current administrative difficulty of recreating tax

histories for entities and assets when they had little or no U.S. nexus. 

The proposal would address these concerns and provide a rule that is fair to both taxpayers

and the government by limiting the importation of tax attributes while reducing the administrative and

compliance burdens of current law. 

Proposal

The proposal would provide taxpayers with a “fresh start” by eliminating tax attributes

(including built-in items) and marking-to-market bases, as applicable, when an entity or an asset

becomes “relevant” for U.S. tax purposes. An entity would become relevant for U.S. tax purposes

when (i) a “tax-exempt entity” becomes a “taxable U.S. entity,” or (ii) a foreign corporation that is not

a controlled foreign corporation (CFC) but is a “taxable U.S. entity” becomes a CFC or a U.S. person.

For these purposes, a tax-exempt entity would include an entity that is exempt from tax under

section 501, a Native American tribal organization, a nonresident alien, and a foreign corporation that

is not a member of a “qualified group” under section 902(b)(2). A taxable U.S. entity would be a U.S.

person (as defined in section 7701(a)(30) other than an organization that is exempt from tax under

section 501), a foreign corporation that is part of a qualified group, or a CFC. Thus, for example, the

proposal would apply to a section 501 organization that loses its tax-exempt status, a tax-exempt

foreign corporation that domesticates in an F reorganization, a nonresident alien that becomes a U.S.

resident, a tax-exempt foreign corporation that becomes a taxable U.S. entity because of stock

acquisitions by a U.S. person, or a noncontrolled section 902 corporation as defined in section

904(d)(2)(E) (a “10/50 company”) that becomes a CFC or U.S. corporation. The proposal would

provide the Secretary with authority to prescribe regulations in which certain tax-exempt entities

would not be subject to this rule, such as in the case of a section 501(c)(12) corporation that changes

from taxable to tax-exempt status from year-to-year based on income earned. 

The proposal would provide analogous rules to those described above for the transfer of assets

and liabilities. Thus, for example, assets that are transferred from a tax-exempt entity to a taxable U.S.

entity (such as in a section 351 transaction) or to a business unit that generates unrelated business

taxable income (UBTI) or ECI, or from a 10/50 company to a CFC, U.S. resident, or a business unit

that generates UBTI or ECI would be marked-to-market at the time of the transfer. Special valuation

rules would be provided with respect to the transfer of intangible assets. The proposal would provide
- 109 -

the Secretary with authority to identify the circumstances under which transfers to partnerships and

transfers of partnership interests would be subject to the rule. 

A special rule would be provided to exclude items that are related to UBTI or ECI prior to the

time an asset or its owner becomes relevant, as well as for personal assets in the case of a nonresident

alien who becomes a U.S. resident. Special rules would also be provided for U.S. shareholders of a

foreign corporation whose assets were marked to market and attributes eliminated, where such U.S.

shareholders were shareholders of the foreign corporation both before and after the mark. These rules

would preserve tax attributes to pre-existing U.S. shareholders through shareholder level accounts that

would not affect the attributes of other shareholders. 

The proposal would provide the Secretary with authority to prescribe regulations to carry out

the purposes of the proposal, including regulations governing the proper treatment of deficits that

existed in an entity prior the elimination of attributes and related foreign tax credits, and the proposal’s

interaction with section 367(b) (and the regulations thereunder) and the passive foreign investment

company regime. The proposal would also provide the Secretary with authority to prescribe

regulations necessary to prevent trafficking in favorable tax attributes involving foreign corporations

to the extent not specifically addressed by the statute. This would include, for example, trafficking

in favorable attributes among CFCs. 

The proposal would be effective for transactions entered into on or after the date of enactment.

No inference would be intended as to the treatment under present law of transactions that purport to

result in the use for U.S. tax purposes of tax attributes arising outside the U.S. taxing jurisdiction. 
- 110 -

MODIFY TREATMENT OF ESOP AS S CORPORATION SHAREHOLDER

Current Law

Pursuant to a provision of the Small Business Job Protection Act of 1996, an employee stock

ownership plan (ESOP) may be a shareholder in an S corporation. Under that provision, any income

of the S corporation that flowed through to the ESOP (or gain on the sale of S corporation shares by

the ESOP) was treated as unrelated business income and subject to tax at the ESOP level. A provision

of the Taxpayer Relief Act of 1997 repealed this unrelated business income rule; thus, S corporation

income allocable to an ESOP is not subject to current taxation, but is deferred until distributions are

made to the ESOP beneficiaries. 

Reasons for Change

The 1997 Act provision repealed the UBIT rule because it was thought that the 1996 Act

provision unfairly taxed S corporation earnings twice --once when earned and again when distributed.

However, this rule violates the general principle that business income, including S corporation income,

should be subject to tax when the income is earned. This allows significant deferral, and possible

avoidance, of tax on S corporation income to the extent the S corporation is owned by an ESOP. 

Proposal

The proposal would repeal the 1997 Act provision and would restore the rule that treats any

income of an S corporation that flowed through to the ESOP (or gain on the sale of S corporation

shares by the ESOP) as unrelated business income subject to current tax at the ESOP level. An ESOP

would be allowed a deduction for distributions made to its participants and beneficiaries. This

deduction would only apply to the extent that distributions exceed undistributed amounts that were

previously not subject to unrelated business income tax (i.e., earnings in taxable years after 1997 and

before the effective date of the proposal, reduced by distributions made in taxable years after 1997).

Net operating loss rules would be modified to the extent necessary in order for ESOP distribution

deductions that exceed net unrelated business taxable income to be carried back two years or forward

20 years to offset S corporation income recognized pursuant to this rule.

The proposal would be effective for taxable years beginning on or after the date of first

committee action. In addition, the proposal would be effective for acquisitions of S corporation stock

by an ESOP on or after that date and for S corporation elections made on or after that date.
- 111 -

LIMIT TAX-FREE LIQUIDATIONS OF U.S. SUBSIDIARIES

OF FOREIGN CORPORATIONS IN ORDER TO PRESERVE THE IMPOSITION OF

U.S. TAX ON THE DISTRIBUTED EARNINGS 

Current Law

The income of a U.S. corporation is taxed at the corporate level when earned and again at the

shareholder level when distributed as a dividend. U.S. tax rules impose withholding tax on dividend

distributions of U.S. subsidiaries to foreign corporations consistent with the taxation of income at the

shareholder level. However, U.S. withholding tax generally is not imposed on a distribution of U.S.

subsidiary earnings in a complete liquidation under section 332 because that provision treats any such

distribution as a non-taxable payment in exchange for the stock. 

Reasons for Change

In order to avoid the withholding tax that would otherwise apply to a dividend distribution,

some foreign corporations carry out serial liquidations by establishing U.S. holding companies to

receive tax-free dividends from operating subsidiaries, liquidating the holding companies and then reestablishing the holding companies. Through this means, subsidiary earnings repeatedly are distributed

in tax-free liquidating distributions to foreign corporations and the operating subsidiaries producing

the earnings continue in operation. Foreign corporations similarly may be able to avoid the branch

profits tax through terminations of U.S. businesses conducted in branch form. 

Proposal

The proposal generally would treat as a dividend distribution any distribution of earnings by

a U.S. holding company to a foreign corporation in a complete liquidation if the U.S. holding company

subsidiary of the foreign corporation was in existence for less than 5 years. A coordination rule would

ensure that a similar result obtains on the termination of a U.S. branch of a foreign corporation.

The proposal would be effective for liquidations and terminations occurring on or after the date

of enactment.
- 112 -

PREVENT CAPITAL GAINS AVOIDANCE THROUGH BASIS SHIFT

TRANSACTIONS INVOLVING FOREIGN SHAREHOLDERS

Current Law

A distribution in redemption of stock is treated as a dividend, rather than as a sale of stock,

if it is essentially equivalent to a dividend. A redemption of the stock of a shareholder generally is

essentially equivalent to a dividend if it does not result in a meaningful reduction in the shareholder’s

proportionate interest in the distributing corporation. The rules for determining whether a

shareholder’s proportionate interest in the distributing corporation has been meaningfully reduced

include reference to the option attribution rules of section 318(a)(4).

Under Treasury regulations, if an amount received in redemption of stock is treated as a

distribution of a dividend, the basis of the remaining stock generally is increased to reflect the basis

of the stock redeemed. The basis of the remaining stock is not increased, however, to the extent that

the basis of the redeemed stock was reduced or eliminated pursuant to section 1059.

Section 1059 requires a corporate shareholder that receives an Aextraordinary dividend@ to

reduce the basis of the stock by the nontaxed portion of the dividend. The nontaxed portion of the

dividend effectively equals the amount of the dividend that is offset by the dividends received

deduction. A dividend resulting from a non pro rata redemption or a liquidation is an extraordinary

dividend, as is a dividend resulting from a redemption that is treated as a dividend due to options being

counted as stock ownership.

Reasons for Change

Taxpayers have attempted to offset capital gains by generating artificial capital losses through

basis shift transactions involving foreign shareholders. Similar transactions involving dividends to

domestic shareholders were addressed by amendments to section 1059 in the Taxpayer Relief Act of

1997.

Proposal

For purposes of section 1059, the nontaxed portion of the dividend would include the amount

of the dividend that is not subject to current U.S. tax. In the event that a treaty between the United

States and a foreign country reduces the rate of U.S. tax imposed on the dividend (and the dividend

is not otherwise subject to U.S. tax), the nontaxed portion would be the amount of the dividend

multiplied by a fraction the numerator of which is the tax rate applicable without reference to the treaty

less the tax rate applicable under the treaty and the denominator of which is the tax rate applicable

without reference to the treaty. Similar rules would apply in the event that the foreign shareholder is

not a corporation. No inference is intended as to the treatment of such transactions under current law.

The proposal would be effective for distributions on or after the date of first committee action.
- 113 -

LIMIT INAPPROPRIATE TAX BENEFITS FOR LESSORS

OF TAX-EXEMPT USE PROPERTY

Current Law

Under current law, certain property leased to governments, tax-exempt organizations, or

foreign persons is considered to be Atax-exempt use property.@ There are a number of restrictions

on the ability of lessors of tax-exempt use property to claim tax benefits from transactions related to

the tax-exempt use property. For example, a lessor of tax-exempt use property cannot depreciate the

property using an accelerated method of depreciation. Instead, the lessor must depreciate the property

using a straight-line method over a term that is the longer of class life or 125 percent of the lease term.

Under Section 469, an individual generally may not deduct net losses from activities (including leases)

in which the taxpayer does not materially participate. Any losses disallowed may be carried forward

to offset taxable income generated from such activities. 

Reasons for Change

The Administration is concerned that certain leasing transactions involving tax-exempt use

property are being used to generate inappropriate tax benefits. These transactions are structured to

take advantage of mismatches between reported income and expense and the tax-exempt status of an

accommodating party in order to generate significant tax benefits for a U.S. lessor which can shelter

other income. 

Proposal

The proposal would apply principles similar to those that apply under Section 469 to leases

involving tax-exempt use property. Thus, a lessor of tax-exempt use property would not be able to

recognize a net loss from a leasing transaction involving tax-exempt use property during the lease

term. A lessor would be able to carry forward a net loss from a leasing transaction and use it to offset

net gains from the transaction in subsequent years. In the year the leasing transaction terminates, the

lessor would be able to recognize any previously unrecognized net loss.

A special rule would define a leasing transaction to include the lease itself and all related

agreements (i.e., sales, loans, and option agreements) entered into by the lessor with respect to the

lease of the tax-exempt use property. Thus, for example, if a taxpayer purchased property from a

foreign government, leased the property to the foreign government, financed the purchase with a

nonrecourse loan from a bank, and entered into an option to sell the property to a third party, each of

these individual transactions would be considered part of the overall leasing transaction.

The proposal would be effective for leasing transactions entered into on or after the date of

enactment.
- 114 -

PREVENT MISMATCHING OF DEDUCTIONS AND INCOME INCLUSIONS IN

TRANSACTIONS WITH RELATED FOREIGN PERSONS

Current Law

Section 163(e)(3) provides that if any debt instrument having original issue discount (OID) is

held by a related foreign person, any portion of such original issue discount shall not be allowable as

a deduction to the issuer until paid. This general rule does not apply, however, to the extent that the

OID is effectively connected with the conduct by such foreign related person of a trade or business

within the United States (unless such OID is exempt from taxation or is subject to a reduced rate of

taxation under a treaty obligation). The general rule also is modified so that a deduction is allowed

when the OID is includable in the income of a foreign personal holding company (FPHC), controlled

foreign corporation (CFC) or passive foreign investment company (PFIC). Section 267 and the

regulations thereunder apply similar rules to other expenses and interest owed to related foreign

persons. The regulations under section 267(a)(3) contain a general rule similar to that of section

163(e)(3), but those regulations generally do not apply to OID deductions. Moreover, those

regulations contain a special rule similar to the rule under section 163(e)(3) applicable to amounts

deductible when the corresponding amounts are includable in the income of a FPHC, CFC or PFIC.

Reasons for Change

The Treasury has learned of certain structured transactions (involving both U.S. payors and

U.S.-owned foreign payors) designed to allow taxpayers inappropriately to take advantage of the

current rules by accruing deductions to related FPHCs, CFCs or PFICs, without the U.S. owners of

such related entities taking into account for U.S. tax purposes an amount of income appropriate to the

accrual. This results in an improper mismatch of deductions and income.

Proposal

The proposal would amend sections 163(e)(3) and 267(a)(3). It would provide that the

deductions for amounts accrued but unpaid (whether by U.S. or foreign persons) to related foreign

CFCs, PFICs or FPHCs would be allowable only to the extent the amounts accrued by the payor are,

for U.S. tax purposes, reflected in the income of the direct or indirect U.S. owners of the related

foreign person. An exception would be provided for amounts accrued under circumstances where

payment of the amount accrued occurs within a short period after accrual and the transaction giving

rise to the payment is entered into by the payor in the ordinary course of a business in which the payor

is predominantly engaged. In addition, the Secretary would be granted regulatory authority to

provide exceptions to these rules.

The proposal would be effective for payments accrued on or after the date of first committee

action. No inference is intended as to the treatment of such payments under current law.
- 115 -

RESTRICT BASIS CREATION THROUGH SECTION 357(c)

Current Law

Section 351 provides that no gain or loss shall be recognized if property is exchanged solely

for stock of a controlled corporation. If the sum of the amount of liabilities assumed by the transferor,

plus the amount of the liabilities to which the transferred property is subject, exceeds the total adjusted

basis of the property transferred pursuant to a section 351 exchange, the transferor must recognize

gain from the sale or exchange of the property (with certain exceptions) pursuant to section 357(c).

The basis of property transferred equals the transferor’s basis in such property increased by

the amount of gain recognized by the transferor, including section 357(c) gain. 

Reasons for Change

Where a recourse liability is secured by multiple assets, the tax treatment is unclear under

current law whether a transfer of one asset where the transferor remains liable is a transfer Asubject

to@ the liability. As a result, many taxpayers lack the certainty necessary to engage in legitimate

transactions while others have structured transactions to take advantage of different interpretations.

For example, if a foreign transferor transfers an asset that partially secures a line of credit, taxpayers

have taken the position that gain would be computed under section 357(c) by treating the entire

liability as an amount realized and the transferee’s basis in the asset would be increased accordingly.

Alternatively, under this interpretation, if a transferor transfers the assets securing a single liability to

several different subsidiaries, taxpayers have taken the position that each asset has a basis increased

by the entire liability. Similar issues arise with respect to nonrecourse liabilities.

Proposal

The distinction between the assumption of a liability and the acquisition of an asset subject to

a liability generally would be eliminated. Except as provided in regulations, recourse liability or any

portion thereof would be treated as having been assumed if, as determined on the basis of all facts and

circumstances, the transferee has agreed and is expected to satisfy the liability or portion thereof

(whether or not the transferor has been relieved of the liability). Thus, where more than one person

agrees to satisfy a liability or portion thereof, only one would be treated as expected to satisfy such

liability or portion thereof. Except as provided in regulations, a nonrecourse liability would be treated

as having been assumed by the transferee of any asset subject to the liability with a limitation. The

amount treated as assumed would be reduced by the amount of the liability which an owner of other

assets not transferred to the transferee and also subject to such liability has agreed with the transferee,

and is expected to satisfy, up to the fair market of such other assets (determined without regard to

section 7701(g)).

In determining whether any person has agreed and is expected to satisfy a liability, all facts and

circumstances would be considered. In any case where the transferee does agree to satisfy a liability,
- 116 -

the transferee would be treated as expected to satisfy the liability in the absence of facts indicating the

contrary.

In determining any increase to the basis of property transferred to the transferee as a result of

gain recognized because of the assumption of liabilities under section 357, the increase would not

cause the basis to exceed the fair market value of the property (determined without regard to section

7701(g)). In addition, if gain is recognized to the transferor as the result of an assumption by a

corporation of a nonrecourse liability that is also secured by property not transferred to the

corporation, and if no person is subject to U.S. tax on such gain, then for purposes of determining the

basis of assets transferred, the amount of gain so treated as recognized would be determined as if the

liability assumed by the transferee equaled such transferee’s ratable portion of the liability, based on

the relative fair market values (determined without regard to section 7701(g)) of all assets subject to

such nonrecourse liability.

The Treasury Department would have authority to prescribe any regulations which may be

necessary to carry out the purposes of the provision. Where appropriate, the Treasury Department

would also be authorized to prescribe regulations which provide that the manner in which a liability

is treated as assumed under this proposal is applied elsewhere in the Code.

No inference regarding the tax treatment under current law is intended by this proposal.

The proposal would be effective for transfers on or after October 19, 1998.
- 117 -

MODIFY ANTI-ABUSE RULES RELATED TO ASSUMPTION OF LIABILITIES

Current Law

No gain or loss is recognized if property is exchanged for stock of a controlled corporation.

The transferor may recognize gain to the extent other property (“boot”) is received by the transferor.

The assumption of liabilities by the transferee generally is not treated as boot received by the

transferor. The assumption of a liability is treated as boot to the transferor, however, “[i]f, taking into

consideration the nature of the liability and the circumstances in the light of which the arrangement for

the assumption or acquisition was made, it appears that the principal purpose of the taxpayer...was a

purpose to avoid Federal income tax on the exchange, or...if not such purpose, was not a bona fide

business purpose.” Thus, this exception requires that the principal purpose of having the transferee

assume the liability was the avoidance of tax on the exchange. The transferor’s basis in the stock of

the transferee received in the exchange is reduced by the amount of any liability assumed, but generally

increased in the amount of any gain recognized by the transferor on the exchange. Similar rules apply

in connection with certain tax-free reorganizations.

Reasons for Change

The anti-abuse rule related to the assumption of liabilities is inadequate to address the

avoidance concerns that underlie the provision, especially given the high standard before it is

applicable. The provision rarely applies because the tax avoidance is made possible by the exchange,

but the exchange itself is not the tax avoidance transaction. 

In one inappropriate transaction, taxpayers transfer assets with a fair market value basis in

exchange for preferred stock and the transferee’s assumption of a contingent liability that is deductible

in the future but easily valued currently. The transferor claims an artificially high basis in the stock of

the transferee corporation because the payment of a liability that would give rise to a deduction

generally is not taken into account in determining the amount of liabilities assumed and thus does not

reduce the taxpayer’s basis. Thus, the transferor can accelerate the deduction by selling or exchanging

the stock at a loss, and the transferee might take the position that it is entitled to deduct payments on

the liability, effectively duplicating the deduction attributable to the same liability. 

Proposal

The Administration proposes to delete the limitation that the assumption of liabilities anti-abuse

rule only applies to tax avoidance on the exchange itself, and to change “the principal purpose”

standard to “a principal purpose”. A taxpayer may have “a principal purpose” of tax avoidance even

though it is outweighed by other purposes (taken together or separately). In addition, a modification

to the basis rule would be made to require a decrease in the transferor’s basis in the transferee’s stock

when a liability, the payment of which would give rise to a deduction, is treated as boot under the antiabuse rule. 

This proposal is effective for assumptions of liabilities on or after the date of first committee

action.
- 118 -

MODIFY CORPORATE-OWNED LIFE INSURANCE (COLI) RULES

Current Law

In general, no Federal income tax generally is imposed on a policyholder with respect to the

earnings under a life insurance contract or endowment contract, and Federal income tax generally is

deferred with respect to the earnings under an annuity contract. In addition, amounts received under

a life insurance contract paid by reason of death of the insured are excluded from gross income.

Interest on policy loans or other indebtedness with respect to life insurance, endowment or

annuity contracts generally is not deductible, unless the insurance contract insures the lives of a key

person of a business. A key person includes a 20 percent owner of the business, as well as a limited

number of the business’ officers or employees. However, this interest disallowance rule applies to

businesses only to the extent that the indebtedness can be traced to a life insurance, endowment or

annuity contract.

In addition, the interest deductions of a business other than an insurance company are reduced

under a proration rule if the business owns or is a direct or indirect beneficiary with respect to certain

life insurance, endowment or annuity contracts. This proration rule generally does not apply if the

contract covers an individual who is a 20 percent owner of the business or an officer, director or

employee of such business. This proration rule also does not apply if the contract is a joint life policy

covering a 20 percent owner of the business and his or her spouse. 

Special proration rules apply to life insurance companies and property casualty insurance

companies if such insurance companies own or are direct or indirect beneficiaries under the same types

of life insurance, endowment and annuity contracts. Under the special life insurance company

proration rules, the life insurance company’s reserve and policyholder dividend deductions are reduced

to the extent that such reserves or dividends are funded by the inside buildup on certain life insurance,

endowment and annuity contracts. Under the special property casualty insurance company rules, the

losses incurred deductions of the property casualty insurance company are reduced by 15 percent of

the inside buildup on certain life insurance, endowment and annuity contracts.

Reasons for Change

Leveraged businesses can still fund deductible interest expenses with tax-exempt or taxdeferred inside buildup on life insurance, endowment or annuity contracts insuring certain types of

individuals. For example, banks, commercial credit companies and other leveraged businesses

frequently invest in single premium or other investment-oriented insurance policies covering the lives

of their employees, officers, directors or owners. These entities do not take out policy loans or other

indebtedness that is secured or otherwise traceable to the insurance contracts. Instead, they borrow

from depositors or other lenders, or issue bonds.

Similar tax arbitrage benefits result when insurance companies invest in certain insurance

contracts that cover the lives of their employees, officers, directors or 20 percent shareholders. Life
- 119 -

insurance companies can still fund deductible reserves or policyholder dividends with tax-exempt or

tax-deferred investment income on insurance contracts with respect to their employees, officers,

directors or 20 percent owners. Similarly, property casualty insurance companies can still fund

deductible loss reserves with tax-exempt or tax-deferred investment income on insurance contracts

with respect to their employees, officers, directors or 20 percent owners.

Proposal

The proposal would repeal the exception under the COLI proration rules for contracts

covering employees, officers or directors, other than 20 percent owners of the business that is the

owner or beneficiary of an annuity, endowment or life insurance contract. The proposal would be

effective for taxable years beginning after the date of enactment.
- 120 -

Financial Products

REQUIRE BANKS TO ACCRUE INTEREST ON SHORT-TERM OBLIGATIONS

Current Law

In 1984, Congress enacted section 1281, which required certain taxpayers including banks to

accrue discount on short-term obligations. In the case of a governmental obligation, a taxpayer must

accrue acquisition discount, which is the excess of the obligation’s stated redemption price at maturity

over the taxpayer’s basis in the obligation. In the case of a non-governmental obligation, a taxpayer

generally must accrue original issue discount, which is the excess of the obligation’s stated redemption

price at maturity over the issue price of the obligation. A short-term obligation is a debt instrument

that has a term of one year or less.

In 1986, Congress clarified that taxpayers who were subject to accrual under section 1281,

including banks, must accrue all interest on short-term obligations irrespective of whether the interest

is stated as interest, is in the form of acquisition discount, or is original issue discount. Thus, under

current law, a bank (regardless of its accounting method) must accrue stated interest, acquisition

discount, original issue discount, or any combination thereof on short-term obligations that it holds.

Reason for Change

Recent court cases have held that banks that use the cash receipts and disbursements method

of accounting do not have to accrue stated interest and original issue discount on short-term loans

made in the ordinary course of the bank’s business. The courts reasoned that because these loan were

originated (not acquired), the Aacquisition discount@ rules of section 1281 did not apply. The

Administration believes it is inappropriate to treat short-term obligations originated by a bank

differently than short-term obligations purchased by the bank. In both cases, compensation for the use

of money, whether in the form of stated interest, acquisition discount, or original issue discount,

should be accrued.

Proposal

The proposal would clarify that banks must accrue all interest, original issue discount, and

acquisition discount on short-term obligations, including loans made in the ordinary course of the

bank’s business, regardless of the bank’s overall accounting method.

The proposal would be effective for obligations acquired (including those originated) on or

after the date of enactment. No inference is intended regarding the tax treatment of obligations

acquired (including those originated) prior to the effective date of the proposal.
- 121 -

REQUIRE CURRENT ACCRUAL OF MARKET DISCOUNT

BY ACCRUAL METHOD TAXPAYERS

Current Law

Market discount is the excess, if any, of the principal amount of a debt instrument (or the

adjusted issue price in the case of a debt instrument originally issued at a discount) over the holder’s

basis in the instrument immediately after acquisition. In general, if a holder acquires a debt instrument

with market discount, the holder must treat any gain on the disposition of the debt instrument as

ordinary income to the extent of accrued market discount. The holder generally determines the

amount of accrued market discount by spreading the market discount ratably over the term of the

instrument or electing to use constant yield principles. A special rule requires a holder to treat partial

principal payments as ordinary income to the extent of economically accrued market discount. A

holder may elect to include market discount in income as it accrues. Absent this election, a holder that

uses an accrual method of accounting need not currently include market discount in income. 

Reasons for Change

In general, market discount arises when the market yield on a debt instrument exceeds its

original yield. To a holder, market discount is economically equivalent to original issue discount,

which the holder of a debt instrument must include in income on a current basis. The failure of current

law to require holders to currently include market discount creates asymmetries between similarly

situated holders. For example, a taxpayer that purchases a debt instrument with market discount is

taxed more favorably than a similarly situated holder that purchases a debt instrument with original

issue discount. 

An accrual method taxpayer generally is required to include amounts in income as they are

earned. Because market discount is earned over time, it is appropriate to require an accrual method

taxpayer to accrue market discount over time.

In cases where the credit of the issuer is severely impaired, it may be inappropriate to treat the

entire difference between the holder’s basis and the principal amount as market discount. A significant

portion of this difference, if realized, is more in the nature of a gain on an equity investment in the

issuer than income from a lending transaction. 

Proposal

The proposal would require holders that use an accrual method of accounting to include

market discount in income as it accrues. The holder’s yield for purposes of determining and accruing

market discount would be limited to the greater of (1) the original yield-to-maturity of the debt

instrument plus 5 percentage points, or (2) the applicable Federal rate at the time the holder acquired

the debt instrument plus 5 percentage points. The proposal would be effective for debt instruments

acquired on or after the date of enactment.
- 122 -

LIMIT CONVERSION OF CHARACTER OF INCOME FROM CONSTRUCTIVE

OWNERSHIP TRANSACTIONS WITH RESPECT TO PARTNERSHIP INTERESTS

Current Law

Gain or loss from the sale of a capital asset generally is treated as capital gain or loss.

Generally, net capital gain (i.e., net long-term capital gain less net short-term capital loss) of an

individual is subject to tax at preferential rates, and net capital losses in excess of $3,000 are not

deductible against ordinary income.

A partnership is not subject to Federal income tax. Instead, the partners include in their taxable

income their distributive share of the partnership’s income. Each partner includes its distributive share

of the partnership’s income on the last day of the partnership’s taxable year, regardless of whether a

distribution to the partner was made in that taxable year. Generally, the character of the partnership’s

income is determined at the partnership level and flows through as such to the partners. A sale of a

partnership interest generally is treated as a sale of a capital asset.

Reasons for Change

Because of their trading strategies, certain partnerships generate significant amounts of

ordinary income and short-term capital gain. A partner in this type of partnership is required, under

current law, to currently include significant amounts of ordinary income and short-term capital gain,

even though the partner may not be entitled to actual distributions from the partnership for a number

of years.

To avoid the current recognition of partnership income and to convert ordinary income and

short-term capital gain into long-term capital gain, certain taxpayers have entered into derivatives

transactions that are designed to give the taxpayer the Aeconomics@ of an equity interest in the

partnership without giving the taxpayer an actual ownership interest in the partnership. These

so-called Aconstructive ownership@ transactions, although economically equivalent to current

ownership, purportedly allow taxpayers to defer income and to convert ordinary income and

short-term capital gain into long-term capital gain. 

Proposal

The proposal would limit the amount of long-term capital gain a taxpayer could recognize from

a Aconstructive ownership@ transaction with respect to a partnership interest. Under the proposal, gain

from a constructive ownership transaction would be treated as ordinary income to the extent that the

gain exceeds the Anet underlying long-term capital gain@ with respect to the transaction. 

Under the proposal, a taxpayer would be treated as having entered into a Aconstructive

ownership@ transaction if the taxpayer (1) holds a long position under a notional principal contract with

respect to the partnership interest, (2) enters into a forward contract to acquire the partnership
- 123 -

interest, (3) is the holder of a call option and the grantor of a put option with respect to the partnership

interest, or (4) enters into one or more transactions that have substantially the same effect.

The Anet underlying long-term capital gain@ with respect to the transaction is the aggregate

amount of capital gain the taxpayer would have had had the taxpayer held a partnership interest

directly during the term of the constructive ownership transaction.

To the extent gain is recharacterized as ordinary income under the proposal, an interest charge

applies. For purposes of computing the interest charge, the taxpayer must assume that the ordinary

gain was earned ratably over the term of the transaction. The taxpayer then computes the interest that

would have been owed under section 6601 had these ratable amounts been taxable income in prior

years.

The proposal allows taxpayers to elect mark-to-market treatment for constructive ownership

transactions in lieu of applying the gain recharacterization and interest rule.

The proposal would be effective for gains recognized on or after the date of first committee

action.
- 124 -

MODIFY RULES FOR DEBT-FINANCED PORTFOLIO STOCK

Current Law

A corporate taxpayer that receives a dividend from another corporation generally is allowed

a dividends received deduction equal to a percentage of the dividend received. A special rule disallows

a percentage of the corporate taxpayer’s dividends received deduction on Adebt-financed portfolio

stock.@ This percentage is equal to the ratio of the average amount of portfolio indebtedness over the

average amount of the adjusted bases of the portfolio stock during the period. In general, stock is

Aportfolio stock@ if (1) it is held by a corporate taxpayer and (2) the corporate taxpayer holds less than

50 percent of the vote or value of the stock. Portfolio stock is considered to be debt-financed if the

corporate taxpayer has incurred indebtedness that is directly attributable to its investment in the

portfolio stock.

Reason for Change

In general, a taxpayer should not be allowed to arbitrage the tax system by having tax-exempt

income on one hand and related deductible expenses on the other. The current-law rules relating to

debt-financed portfolio stock reflect this principle. However, the Adirectly attributable@ standard of

current law is too easily avoided. Under current law, a corporation can structure indebtedness that

is designed to purchase or carry the portfolio stock but that does not meet the Adirectly attributable@

standard. 

Proposal

The proposal would modify the standard for determining whether portfolio stock is

debt-financed. Under the proposal, the percentage of portfolio stock considered to be debt-financed

would be equal to the sum of (1) the percentage of stock that is directly financed by indebtedness, and

(2) the percentage of remaining stock that is indirectly financed by indebtedness. The percentage that

is indirectly financed by indebtedness would be determined by using a pro-rata concept similar to the

one used in section 264(f) (pro-rata allocation of interest expense to life insurance policy cash values).

The proposal would be effective for portfolio stock acquired on or after the date of enactment.
- 125 -

MODIFY AND CLARIFY CERTAIN RULES RELATING

TO DEBT-FOR-DEBT EXCHANGES

Current Law

Under current law, if a taxpayer issues a debt instrument in a debt-for-debt exchange, the taxpayer

generally treats the difference between the issue price of the new debt instrument and the adjusted issue price of

the old debt instrument as an adjustment to income in the year of the exchange. If the difference is positive (the

issue price of the new instrument is greater than the adjusted issue price of the old instrument), the issuer has

additional interest expense, commonly called Abond repurchase premium.@ If the difference is negative (the issue

price of the new instrument is less than the adjusted issue price of the old instrument), the issuer has income from

the discharge of indebtedness.

Treasury regulations under section 163 provide a special rule in cases where neither the old nor the new

debt instrument is publicly traded and there is bond repurchase premium. Under this rule, the bond repurchase

premium is not deducted currently; rather, it is amortized over the term of the newly issued debt instrument in the

same manner as if it were original issue discount.

Reason for Change

In cases where either the old or the new debt instrument is publicly traded and the issuer’s cost of

borrowing has declined, the issuer can inappropriately accelerate its future interest deductions by refinancing its

outstanding debt through a debt-for-debt exchange. For financial accounting purposes, an issuer generally spreads

the repurchase premium over the term of the new debt instrument.

Proposal

The proposal would spread the issuer’s net deduction for bond repurchase premium in a debt-for-debt

exchange over the term of the new debt instrument using constant yield principles. The proposal would apply only

to issuers that use an accrual method of accounting.

The proposal would also clarify the measurement of the net income or deduction in cases where the new

debt instrument is contingent and neither the new debt instrument nor the old debt instrument is publicly traded.

In these cases, the net income or deduction from the exchange would be determined by comparing (1) the sum of

the issue price of the new debt instrument and the fair market value of any contingent payments payable under the

instrument, with (2) the adjusted issue price of the old debt instrument. 

The proposal would also modify a holder’s tax consequences in a debt-for-debt exchange that is part of

a corporate reorganization. Under the proposal, if a holder exchanges an old debt security for a new debt security

as part of a reorganization, the holder would treat as taxable boot the excess, if any, of the issue price of the new

security over the adjusted issue price of the old security. If either the old security or the new security is publicly

traded, the amount of taxable boot would be capped at an amount equal to the excess of the issue price of the new

security over the fair market value of the old security. The proposal would not otherwise affect holders of debt

instruments.

The proposal would apply to debt-for-debt exchanges occurring on or after the date of enactment.
- 126 -

MODIFY AND CLARIFY STRADDLE RULES

Current Law

A Astraddle@ is a collection of two or more offsetting positions with respect to actively traded

personal property. Positions are offsetting if there is a substantial diminution of the risk of loss from

holding one position by reason of holding one or more other positions. A taxpayer that realizes a loss

on one leg of a straddle during a taxable year may recognize the loss only to the extent the loss

exceeds the unrecognized gain (if any) on the other legs of the straddle. If a loss is deferred under the

straddle rules, the taxpayer must carry the loss forward to the succeeding taxable year. A taxpayer

may not deduct net interest and carrying charges properly allocable to personal property which is part

of a straddle. Instead, the taxpayer must capitalize these costs.

A direct ownership interest in an actively traded stock and a short sale of the same actively

traded stock, although offsetting positions, do not constitute a straddle.

Reasons for Change

If a taxpayer holds an appreciated position in personal property and enters into a structured

financial transaction that substantially reduces the taxpayer’s risk of loss in the appreciated position,

the two items are legs of a straddle. If the structured financial transaction includes a debt component,

some taxpayers have taken the position that interest on this component is currently deductible because

this interest expense was not incurred to purchase or carry the straddle. Some taxpayers have taken

similar positions with respect to periodic payments made under the terms of structured financial

transactions. It is inappropriate for a taxpayer to deduct expenses associated with the one leg of a

straddle to the extent there is unrecognized gain in the other leg of the straddle.

Proposal

The proposal would clarify that a taxpayer that holds an appreciated position in personal

property cannot currently recognize loss or deduct expenses (including interest expenses) that are

attributable to structured financial transactions that include a leg of the straddle. Thus, for example,

if a taxpayer holds an appreciated position in actively traded stock and the taxpayer enters into a

prepaid (or collateralized) forward contract to sell the stock, the taxpayer must capitalize all expenses

associated with that forward contract. 

In addition, the proposal would repeal the exception for stock in the definition of personal

property. Thus, under the proposal, offsetting positions with respect to actively traded stock would

generally constitute a straddle.

The proposal would be effective for straddles entered into on or after the date of enactment.

No inference is intended with respect to the tax treatment of transactions entered into before such

date.
- 127 -

DEFER INTEREST DEDUCTION AND ORIGINAL ISSUE DISCOUNT (OID)

ON CERTAIN CONVERTIBLE DEBT

Current Law

If a financial instrument qualifies as a debt instrument, the issuer of the instrument may deduct

stated interest as it economically accrues. In addition, if the instrument is issued at a discount, the

issuer may deduct original issue discount (AOID@) as it economically accrues, even though the OID

may not be paid until the instrument matures. The holder of a debt instrument includes stated interest

under its regular method of accounting and OID as it economically accrues.

In the case of a debt instrument that is convertible into stock of the issuer or a related party,

an issuer may deduct accrued interest and OID up until the time of the conversion, even if the accrued

interest and OID is never paid because the instrument is converted.

Reasons for Change

In many cases, the issuance of convertible debt instrument is viewed by market participants as

a de facto issuance of equity. Allowing issuers to deduct accrued interest and OID is inconsistent with

this market view.

Proposal

The proposal would defer the deduction for accrued stated interest and OID on convertible

debt until actual payment. Conversion into the stock of the issuer or a related party (within the

meaning of sections 267(b) and 707(b)) would not be treated as a payment of accrued OID or interest.

Payments in equity of the issuer or a related party, and payments in cash, the amount of which is

determined by reference to the value of such equity, would also be disregarded for this purpose. For

purposes of this proposal, convertible debt would include (I) debt exchangeable for the stock of the

issuer or a related party, (ii) debt that provides for cash-settlement conversion features, or (iii) debt

issued with warrants (or similar instruments) as part of an investment unit in which the debt component

may be used to satisfy the exercise price for the warrant. This proposal would not apply to any debt

that would be convertible solely because a fixed payment of principal or interest is payable, at the

election of the holder, in an amount of the issuer’s or related party’s equity that has a value equal to

the amount of the fixed payment. The proposal would not affect the treatment of holders. 

The proposal would be effective generally for convertible debt issued on or after the date of

first committee action.
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Corporate Provisions

CONFORM CONTROL TEST

FOR TAX-FREE INCORPORATIONS, DISTRIBUTIONS, AND REORGANIZATIONS

Current Law

For tax-free incorporations, distributions, and reorganizations, “control” is defined as the

ownership of 80 percent of the voting stock and 80 percent of the number of shares of all other classes

of stock of the corporation. In contrast, the necessary “ownership” for affiliation to insure that two

corporations are permitted to file consolidated returns, tax-free liquidations, and qualified stock

purchases is at least 80 percent of the total voting power of the corporation’s stock and at least 80

percent of the total value of the corporation’s stock. Prior to 1984, the test for affiliation was based

on 80 percent of the voting stock and 80 percent of the number of shares of all other classes of stock

of the corporation. In response to concerns that corporations were filing consolidated returns under

circumstances in which a parent corporation’s interest in the issuing corporation accounted for less

than 80 percent of the real equity value of such corporation, Congress amended the test. In 1986, the

control test for tax-free liquidations and qualified stock purchases was harmonized with the test for

affiliation.

Reasons for Change

The control test for tax-free incorporations, distributions, and reorganizations is easily

manipulated by allocating voting power among the shares of a corporation. The absence of a value

component allows corporations to retain control of a corporation but to “sell” a significant amount

of the value of the corporation. While the ability to manipulate control has been present since the

provision was enacted, there has been a proliferation of transactions that qualify under tax-free

provisions but resemble sales because the value of the company has been stripped away from the

voting power. Congress amended the test for affiliation to address similar concerns about

manipulating the equity value of controlled corporations. 

Proposal

The Administration proposes to conform the control test for tax-free incorporations,

distributions, and reorganizations with the test for determining whether corporations satisfy the

ownership test for affiliation. Thus, “control” would be defined as the ownership of at least 80 percent

of the total voting power and at least 80 percent of the total value of the corporation’s stock. For this

purpose, stock would not include certain preferred stock that meets the requirements of section

1504(a)(4).

This proposal is effective for transactions on or after the date of enactment.
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TAX ISSUANCE OF TRACKING STOCK

Current Law

“Tracking stock” is an economic interest that is intended to relate to, and track the economic performance

of, one or more separate assets of the issuer, and gives its holder a right to share in the earnings or value of less

than all of the corporate issuer’s earnings or assets (a vertical slice of the issuer). Subsidiary tracking stock is in

form stock of a parent corporation that is intended to relate to and track the economic performance of a subsidiary

of the parent. The Internal Revenue Service has not issued any guidance regarding whether tracking stock is

treated as stock of the issuer. Such determination is dependent upon the correlation to the underlying tracked

assets.

Reasons for Change

The use of tracking stock is clearly outside the contemplation of subchapter C and other sections of the

Internal Revenue Code. As a result, a principal consequence of treating such a stock interest as stock of the issuer

is the potential avoidance of these provisions. The use of tracking stock permits the circumvention of General

Utilities repeal by allowing a corporation to “sell” an economic interest in a subsidiary without recognizing any

gain. By treating tracking stock as stock of the issuer/parent, there is no gain or loss on the issuance of the

tracking stock, the subsidiary may remain a member of the parent’s consolidated group, a distribution of the shares

is tax-free to the shareholders and to the issuer, and the issuer can achieve separation from the tracked assets or

subsidiary without satisfying the strict requirements for tax-free distributions. 

Proposal

The Administration proposes to provide that, upon issuance of “tracking stock” or a recapitalization of

stock or securities into tracking stock, gain will be recognized in an amount equal to the excess of the fair market

value of the tracked asset over its adjusted basis. General principles of tax law would continue to apply to

determine whether tracking stock is stock of the issuer or not stock of the issuer. In addition, the Secretary would

have authority to treat tracking stock as nonstock (e.g., debt, a notional principal contract, etc.) or as stock of

another entity as appropriate to prevent tax avoidance, and to provide for increased basis in the tracked assets as

a result of gain recognized.

For this purpose, “tracking stock” would be defined as stock that relates to, and tracks the economic

performance of, less than all of the assets of the issuing corporation (including the stock of a subsidiary), and either

(1) the dividends are directly or indirectly determined by reference to the value or performance of the tracked

entity or assets, or (2) the stock has liquidation rights directly or indirectly determined by reference to the tracked

entity or assets. The issuance of tracking stock will not result in another class of the stock of the corporation

becoming tracking stock if the dividend and liquidation rights of such other class are determined by reference to

the corporation’s general assets, even though limited by the rights attributable to the tracking stock.

No inference regarding the tax treatment of the above-described stock under current law is intended by

this proposal.

This proposal is effective for tracking stock issued on or after the date of enactment.
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REQUIRE CONSISTENT TREATMENT AND

PROVIDE BASIS ALLOCATION RULES FOR TRANSFERS OF INTANGIBLES

IN CERTAIN NONRECOGNITION TRANSACTIONS

Current Law

No gain or loss is recognized if one or more persons transfer property to a corporation solely in exchange

for stock in the corporation and immediately after the exchange such person or persons are in control of the

corporation. Similarly, no gain or loss is recognized in the case of a contribution of property in exchange for a

partnership interest. Neither the Internal Revenue Code nor the regulations provide the meaning of the requirement

that a person transfer property in exchange for stock (or a partnership interest). The Internal Revenue Service

interprets the requirement consistent with the “sale or other disposition of property” language in the context of

a taxable disposition of property. See, e.g., Rev. Rul. 69-156, 1969-1 C.B. 101. Thus, a transfer of less than “all

substantial rights” to use property will not qualify as a tax-free exchange and stock received will be treated as

payments for the use of the property rather than for the property itself. These amounts are characterized as

ordinary income. However, the Claims Court has rejected the Service’s position and held that the transfer of a

nonexclusive license to use a patent (or any transfer of “something of value”) could be a “transfer” of “property”

for purposes of the nonrecognition provision. See E.I. DuPont de Nemours & Co. v. U.S., 471 F.2d 1211 (Ct. Cl.

1973).

Reasons for Change

The inconsistency between the Service’s and the Claims Court’s positions has effectively resulted in

taxpayers’ ability to choose taxable or tax-free treatment. In some cases, in order to achieve tax-free treatment,

transferors take the position under Dupont that a transfer of less than all substantial rights is a transfer of property

entitled to tax-free treatment. To the extent the intangible has basis, taxpayers generally do not allocate any basis

to the partial interest in the intangible that is transferred, thereby allowing for the retention of basis by the

transferor even though the value of the transferor’s interest in the intangible has been diminished. In other

situations, taxpayers follow the Service’s position to create taxable income on the transfer to utilize expiring net

operating losses or to increase basis in the transferred intangible.

Proposal

The transfer of an interest in intangible property constituting less than all of the substantial rights of the

transferor in the property would be treated as a transfer of property for purposes of the nonrecognition provisions

regarding transfers of property to controlled corporations and partnerships. Consistent reporting by the transferor

and the transferee would be required. Further, the Administration proposes that, in the case of a transfer of less

than all of the substantial rights, the transferor must allocate the basis of the intangible between the retained rights

and the transferred rights based upon respective fair market values.

The proposal would not apply to transactions that are properly structured as licenses of intangibles. No

inference is intended as to the treatment of these or similar transactions prior to the effective date.

This proposal is effective for transfers on or after the date of enactment.
- 131 -

MODIFY TAX TREATMENT OF DOWNSTREAM MERGERS

Current Law

In a downstream transaction, one corporation (a “target corporation”) that holds stock of

another corporation (an “acquiring corporation”) transfers its assets (including acquiring corporation

stock) to the acquiring corporation, and the shareholders of the target corporation receive stock of

the acquiring corporation in exchange for their target corporation stock. Downstream transactions

have been held to qualify as tax-free reorganizations. 

Reasons for Change

In substance, where the target corporation holds acquiring corporation stock, a downstream

transaction has the same effect as a distribution by the target corporation of its acquiring corporation

stock to its shareholders. This distribution generally would result in the recognition of gain by the

target corporation. Also, where property is acquired in a reorganization, the acquiring corporation

takes a carryover basis in the acquired property so that an appropriate amount of gain will be

recognized when the property is eventually sold. However, where the property acquired is stock of

the acquiring corporation, this treatment does not follow because the acquiring corporation does not

recognize gain on any subsequent issuance of its own shares. 

Proposal

Under the proposal, where a target corporation does not satisfy the stock ownership

requirements of section 1504(a)(2) (generally, 80 percent or more of vote and value) with respect to

the acquiring corporation, and the target corporation combines with the acquiring corporation in a

reorganization in which the acquiring corporation is the survivor, the target corporation must

recognize gain, but not loss, as if it distributed the acquiring corporation stock that it held immediately

prior to the reorganization. As long as the other requirements for a reorganization are satisfied,

nonrecognition treatment will continue to apply to other assets transferred by the target corporation

and to the target corporation shareholders. The proposal also would apply to the acquisition of target

corporation stock by the acquiring corporation in a transaction qualifying for nonrecognition treatment

where the target corporation is liquidated pursuant to a plan of liquidation adopted not more than two

years after the acquisition date. 

The proposal applies to transactions that occur on or after the date of enactment.
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DENY DIVIDENDS-RECEIVED DEDUCTION FOR CERTAIN PREFERRED STOCK

Current Law

A corporate taxpayer is entitled to a deduction of 70 percent of the dividends it receives from

a domestic corporation. The percentage deduction generally is increased to 80 percent if the taxpayer

owns at least 20 percent (by vote and value) of the stock of the dividend-paying corporation, and to

100 percent for Aqualifying dividends,@ which generally are from members of the same affiliated group

as the taxpayer. 

The dividends-received deduction is disallowed if the taxpayer has held the stock for 45 days

or less during the 90-day period beginning on the date which is 45 days before the date on which such

share becomes ex-dividend with respect to such dividend. In the case of certain preferred stock, the

dividends-received deduction is disallowed if the taxpayer has held the stock for 90 days or less during

the 180-day period beginning on the date which is 90 days before the date on which such share

becomes ex-dividend with respect to such dividend. The holding period generally does not include

any period during which the taxpayer has a right or obligation to sell the stock, or is otherwise

protected from the risk of loss otherwise inherent in the ownership of an equity interest. When an

instrument is treated as stock for tax purposes, but provides for payment of a fixed amount on a

specified maturity date and affords holders the rights of creditors to enforce such payment, no

dividends-received deduction is allowed for distributions on the instrument. See Rev. Rul. 94-28.

The Taxpayer Relief Act of 1997 amended sections 351, 354, 355, 356, and 1036 to treat

Anonqualified preferred stock@ as boot in corporate transactions, subject to certain exceptions.

Nonqualified preferred stock is defined in section 351(g) as preferred stock that does not participate

(through a conversion privilege or otherwise) in corporate growth to any significant extent, if (I) the

holder has the right to require the issuer or a related person to redeem or purchase the stock, (ii) the

issuer or a related person is required to redeem or purchase the stock, (iii) the issuer or a related

person has the right to redeem or purchase the stock and, as of the issue date, it is more likely than

not that such right will be exercised, or (iv) the dividend rate on the stock varies in whole or in part

(directly or indirectly) with reference to interest rates, commodity prices, or similar indices, regardless

of whether such varying rate is provided as an express term of the stock (as in the case of an adjustable

rate stock) or as a practical result of other aspects of the stock (as in the case of auction rate stock).

For this purpose, clauses (I), (ii), and (iii) apply if the right or obligation may be exercised within 20

years of the issue date and is not subject to a contingency which, as of the issue date, makes remote

the likelihood of the redemption or purchase.

Reasons for Change

Taxpayers have taken advantage of the benefit of the dividends received deduction for

payments on instruments that, while treated as stock for tax purposes, economically perform as debt

instruments and have debt-like characteristics (e.g., enhanced likelihood of recovery of principal or

of maintaining a dividend over the term of the instrument, or both). Current law denies the dividends
- 133 -

received deduction on similar instruments that are treated as stock for tax purposes where the taxpayer

is protected from the risk of loss otherwise inherent in the ownership of an equity interest.

Proposal

Except in the case of Aqualifying dividends@, the dividends-received deduction would be

eliminated for dividends on nonqualified preferred stock (as defined in section 351(g)). 

The proposal would apply to stock issued on or after the date of enactment.
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Provisions Affecting Pass-through Entities

MODIFY BASIS ADJUSTMENT RULES FOR PARTNERSHIP DISTRIBUTIONS

The following coordinated proposals relate to gain recognition and basis adjustments upon the

distribution of cash or property by a partnership.

1. Provide mandatory basis adjustments with respect to partnership distributions

Current Law

The basis of retained partnership property is not adjusted upon a distribution of other property

to a partner unless an election under section 754 is in effect. Under section 734(b), if such an election

is in effect, a partnership must increase the basis of retained partnership property by (1) the amount

of gain recognized by a distributee partner and (2) the excess of the basis of the distributed property

to the partnership over the basis of the property to the distributee partner. Conversely, where such

an election is in effect, a partnership must decrease the basis of retained partnership property by (1)

the amount of loss recognized by the distributee partner and (2) the excess of the basis of the

distributed property to the distributee over the adjusted basis of the distributed property to the

partnership.

Reasons for Change

The electivity of adjustments under section 734(b) provides substantial opportunities for

taxpayer abuse. The primary abuse relates to the duplication of losses. Where a partner contributes

loss property to a partnership and subsequently recognizes a loss upon receipt of cash in liquidation

of that partner’s interest in the partnership, the loss is attributable to the adjusted basis of the property

that was contributed to the partnership. However, if a section 754 election has not been made so that

the basis of the contributed property, which remains in the partnership, is not adjusted, the partnership

will recognize the loss again when the property is sold. By avoiding a section 734(b) basis adjustment,

the parties to the transaction essentially are able to create two losses where, without the use of the

partnership, there would have been only one.

Apart from the opportunities for abuse, there are additional problems with the current

operation of section 734(b). The objective of the section 734(b) basis adjustment is to conform the

basis of the partnership’s undistributed properties to the tax investment of the continuing partners; that

is, the continuing partners’ inside basis in partnership property prior to the distribution. Present law

does not meet this objective because it adjusts basis by reference to the distributee partner’s outside

basis in its partnership interest. 

Proposal

The Administration proposes that basis adjustments under section 734(b) be made mandatory.

In addition, under the proposal, section 734(b) adjustments no longer would be measured by reference
- 135 -

to gain or loss recognized by the distributee partner or the difference between the basis of the

distributed property and the distributee partner’s basis in its partnership interest. Instead, the basis

adjustment would be measured by reference to the difference between the basis of the distributed

property and the amount by which the distributee partner’s proportionate share of the adjusted basis

of partnership property is reduced by the distribution. Special rules would apply with respect to tiered

partnerships.

This proposal would apply to partnership distributions made on or after the date of enactment.

2. Modify rules for allocation of basis adjustments for partnership distributions

Current Law

The adjusted basis of property distributed to a partner other than in liquidation of the partner’s

interest is equal to the adjusted basis of the property to the partnership immediately before the

distribution, except that the adjusted basis to the distributee partner may not exceed the adjusted basis

of the partner’s interest in the partnership reduced by the money distributed in the transaction. The

adjusted basis of property distributed to a partner in liquidation of its partnership interest is equal to

the basis of such partner’s interest in the partnership reduced by the money distributed in the

transaction. The adjusted basis of distributed property is allocated first to unrealized receivables and

inventory items in an amount equal to the adjusted basis of each such property to the partnership, with

any remaining basis being allocated among the other distributed property.

With respect to partnership basis adjustments under section 734(b), the partnership basis

adjustment is divided between (1) capital assets and section 1231(b) property and (2) other assets.

The portion of the increase or decrease in basis is allocated to the properties in a class in a manner

which reduces the difference between the fair market value and the adjusted basis of partnership

properties. With respect to basis adjustments relating to gain or loss recognized by a distributee

partner, the basis adjustment is allocated only to capital assets or section 1231(b) property. Other

adjustments relating to property distributions must be allocated to remaining partnership property of

a character similar to that with respect to which the adjustment arose.

Reasons for Change

These basis allocation rules are intended to prevent partners from improperly shifting basis

from capital assets or section 1231(b) property to ordinary income assets. While generally

accomplishing this goal, the allocation rules still allow for a shifting of basis from non-depreciable

assets to depreciable assets. Depreciation expenses are deducted against ordinary income, so such a

shift in basis provides taxpayers with an opportunity to use the partnership rules to reduce ordinary

income. 
- 136 -

Proposal

The proposal would modify the basis allocation rules for partnership liquidating distributions

to include three asset classes. In a liquidating distribution, a partner would allocate basis to unrealized

receivables, inventory items, and other ordinary income assets only to the extent of the adjusted basis

of such assets to the partnership. The partner then would allocate basis to property of a character

which is subject to the allowance for depreciation or amortization, again, only to the extent of the

adjusted basis of such assets to the partnership. Residual allocations then would go to the remaining

assets distributed from the partnership. A partner would recognize a long-term capital loss if it did

not have assets to absorb the full basis in its partnership interest. Allocations of a basis increase (which

only could occur in the third category) would be made first so as to reduce the difference between the

fair market value and adjusted basis of each asset in the third category based upon the amount of such

difference for each asset. Additional positive adjustments would be made in proportion to the fair

market value of each asset in the third category. Negative adjustments (which could occur in any

category) would be made first to third category assets so as to reduce the difference between the fair

market value and adjusted basis of each such asset. Any remaining negative basis adjustment then

would be allocated among third category assets in proportion to the adjusted basis of such assets. If

a negative basis adjustment still remains after eliminating all asset basis in third category assets, basis

adjustments then would be allocated among second category assets and finally first category assets

using the same methodology. 

The inside asset basis adjustments made pursuant to section 734(b) would be determined in

the same manner. Accordingly, positive basis adjustments could be made only to third category assets.

To the extent that a positive basis adjustment could not be made because the partnership did not

possess any third category assets, the partnership would be treated as recognizing a long-term capital

loss in the amount of the prevented adjustment. If a negative adjustment could not be made because

the partnership holds no third category assets or has insufficient basis in such assets, the partnership

would make a downward adjustment to the basis of the assets in the second and then first category

assets. 

Basis adjustments under section 743(b) would not be affected by this proposal. 

This proposal would apply to partnership distributions made on or after the date of enactment.

3. Modify rules for partial liquidations of a partnership interest

Current Law

A partner does not recognize gain upon a distribution from a partnership except to the extent

that any money distributed exceeds the adjusted basis of the partner’s interest in the partnership

immediately before the distribution. A partner will not recognize a loss, except that upon a distribution

in liquidation of a partner’s interest where only cash, unrealized receivables, and inventory are

distributed to the partner, loss is recognized to the extent of the excess of the adjusted basis of such

partner’s interest in the partnership over the amount of cash and the basis of such other property
- 137 -

received. The basis of property (other than money) distributed to a partner other than in liquidation

of the partner’s interest is its adjusted basis to the partnership, unless such basis exceeds the partner’s

basis in its partnership interest. The basis of property distributed to a partner in liquidation of the

partner’s interest is equal to the adjusted basis of such partner’s interest in the partnership reduced by

any money distributed in the same transaction. 

Reasons for Change

The rules relating to partnership distributions provide for an inappropriate deferral of gain with

respect to partnership distributions where all of a partner’s basis in its partnership interest offsets cash

that is used to redeem only a portion of the partner’s interest. The rules also may allow a partner to

obtain an inflated basis in partnership property distributed in partial liquidation of a partner’s interest.

In addition, the section 734(b) basis allocation rules described in the first proposal in this part do not

operate properly in a system where a partner’s entire basis in its partnership interest can be allocated

to property distributed in partial redemption of the partner’s interest.

Proposal

The Administration proposes to treat a partial liquidation of a partner’s interest in a partnership

as a complete liquidation of that portion of the partner’s interest. A partial liquidation would be a

reduction in a partner’s percentage share of capital, and the percentage that is reduced would be

treated as a separate interest that is completely liquidated in the distribution. In the event of a partial

liquidation, a distributee partner’s basis in its partnership interest would be allocated between the

redeemed interest and the partner’s remaining interest, determined by reference to the percentage

reduction in the partner’s share of capital. Because the rules applicable to a complete liquidation

would apply to the separate interest that is treated as being liquidated, it would be possible for a

partner to recognize gain upon the receipt of cash in excess of the partner’s basis in the separate

interest, even if that partner’s basis in its overall interest is greater than the amount of the cash

distribution. In addition, section 734(b) and the basis allocation rules of section 732(c) would apply

to the complete liquidation of the separate interest. 

This proposal would apply to partnership distributions made on or after the date of enactment.

4. Rules relating to distributions treated as sales or exchanges with respect to unrealized

receivables and inventory items

Current Law

Under section 751(b), to the extent that a partner receives (1) unrealized receivables or

substantially appreciated inventory in exchange for all or part of its interest in other partnership

property, or (2) partnership property other than unrealized receivables or substantially appreciated

inventory in exchange for all or part of its interest in partnership property that is unrealized receivables

or substantially appreciated inventory, such transactions are, under regulations, treated as a sale or

exchange of such property between the distributee and the partnership. 
- 138 -

Reasons for Change

Section 751(b) has been criticized for being overly complex. This provision was designed to

prevent taxpayers from converting ordinary income to capital gains through partnership distributions

where the distributee partner essentially transferred his share of ordinary income assets to the

partnership in exchange for capital gain assets or vice versa. The proposals discussed above would

prevent positive basis adjustments from being made to ordinary income assets, which would greatly

reduce the ability to carry out the abuses that section 751(b) was intended to prevent. 

Proposal

The Administration proposes to repeal section 751(b). 

This proposal would apply to partnership distributions made on or after the date of enactment.

5. Require basis adjustments when a partnership distributes certain stock to a corporate partner

Current Law

The basis of property distributed to a partner in liquidation of the partner’s interest is equal to

the adjusted basis of such partner’s interest in the partnership reduced by any money distributed in the

same transaction. No gain or loss is recognized on the receipt by a corporation of property distributed

in complete liquidation of a subsidiary corporation where the stock ownership requirements of section

1504(a)(2) (generally, 80 percent or more of vote and value) are satisfied and certain other

requirements are met. The basis of property received by the distributee in such a corporate liquidation

is the same as it was in the hands of the liquidated corporation. 

Reasons for Change

The rules regarding corporate liquidations provide taxpayers with the ability to negate the

effect of a downward basis adjustment in a distribution by a partnership where the inside basis of

partnership assets is higher than the basis of the partner’s interest in the partnership. This can be

accomplished by having the partnership contribute property to a corporation prior to a distribution to

a corporate partner. Although the basis of the stock may be reduced as a result of the distribution, the

stock basis is irrelevant if the corporation subsequently is liquidated by a corporate parent that owns

80 percent or more of the subsidiary.

Proposal

The proposal would require that if stock of a corporation is distributed to a corporate partner

that, after the distribution (and considering related transactions), owns stock satisfying the

requirements of section 1504(a)(2), then the distributed corporation must adjust the basis of its assets

by an amount equal to the amount by which the stock basis is adjusted as a result of the distribution.
- 139 -

The basis must be reduced using the same methodology as is used in section 732(c), determined as if

the corporation’s assets were being distributed.

This proposal would apply to partnership distributions made on or after the date of enactment.
- 140 -

MODIFY STRUCTURE OF BUSINESSES INDIRECTLY CONDUCTED BY REITS

Current Law

Real estate investment trusts (REITs) generally are restricted to making passive investments

in real estate and certain securities. In furtherance of this purpose, REITs generally are limited under

a 95 percent gross income test to receiving income that qualifies as rents from real property and, to

a more limited degree, portfolio income.

The REIT provisions also contain a number of rules that limit a REIT’s ownership of other

corporations in order to prevent REITs from becoming active in the management and operations of

companies that engage in activities that currently are prohibited activities for a REIT. One of these

rules provides that a REIT may not own more than 10 percent of the outstanding voting securities of

any issuer. Another rule provides that no single corporation can account for more than five percent

of the total value of a REIT’s assets.

Reasons for Change

The Administration understands that REITs are conducting businesses through subsidiary

corporations that, if operated directly, would generate nonqualifying income under the 95-percent

gross income test. Through the use of multiple subsidiaries, up to 25 percent of the value of a REIT’s

assets can consist of subsidiaries that conduct these currently prohibited activities. Through the

retention of non-voting preferred stock and debt, the REIT is able to retain most, if not all, of the

income generated by the impermissible businesses and, due to the transmuting of operating income into

interest paid to the REIT and other non-arm’s length pricing arrangements, that income often is not

subject to any corporate level tax. 

Many of the businesses performed by the REIT subsidiaries are natural outgrowths of a REIT’s

traditional operations, such as third-party management and development businesses. While it is

inappropriate for the earnings from these non-REIT businesses to be sheltered through a REIT, it also

is counter-intuitive to prevent these entities from taking advantage of their evolving experiences and

expanding into areas where their expertise may be of significant value.

Currently, a REIT cannot derive more than a de minimis amount of income from the provision

of services to REIT tenants unless such income would be excluded from unrelated business taxable

income if received by certain tax-exempt entities. These services generally must be rendered by an

independent contractor from whom the REIT does not derive or receive any income. The

determination of what are permissible services for a REIT consumes substantial time and resources

for both REITs and the Internal Revenue Service. In addition, the prohibition of a REIT performing,

either directly or indirectly, non-customary services can put REITs at a competitive disadvantage in

relation to others in the same market. 
- 141 -

Proposal

Under the proposal, the 10-percent vote test in section 856(c)(4)(B) would be changed to a

“vote or value” test. This would prevent REITs from undertaking prohibited activities through

preferred stock subsidiaries, as is the current practice. 

The proposal also would provide an exception to the five-percent and 10-percent asset tests

so that REITs could have “taxable REIT subsidiaries.” Under the proposal, there would be two types

of taxable REIT subsidiaries, a “qualified independent contractor subsidiary” and a “qualified business

subsidiary.” A qualified business subsidiary would be allowed to undertake non-tenant related

activities that currently generate non-qualifying income for a REIT, such as third-party management

and development. A qualified independent contractor subsidiary would be allowed to perform noncustomary and other currently prohibited services with respect to REIT tenants as well as activities

that could be performed by a qualified business subsidiary.

A number of constraints would be imposed on a taxable REIT subsidiary to ensure that the

REIT could not, through a taxable REIT subsidiary, engage in substantial non-real estate activities,

and also to ensure that the taxable REIT subsidiary pays a corporate level tax on its earnings. First,

the value of all taxable REIT subsidiaries owned by a REIT could not represent more than 15 percent

of the value of the REIT’s total assets, and within that 15-percent limitation, no more than five percent

of the total value of a REIT’s assets could consist of qualified independent contractor subsidiaries.

Second, a taxable REIT subsidiary would not be entitled to deduct any interest incurred on debt

funded directly or indirectly by the REIT. Third, a 100-percent excise tax would be imposed on excess

payments to ensure arm’s length (1) pricing for services provided to REIT tenants (i.e., REIT tenants

could not pay for services provided by the taxable REIT subsidiary through increased rental payments

to the REIT) and (2) allocation of shared expenses between the REIT and the taxable REIT subsidiary.

Fourth, there would be significant limits placed upon intercompany rentals between the REIT and a

taxable REIT subsidiary. Finally, certain additional limitations may apply.

This proposal would be effective after the date of enactment. REITs would be allowed to

combine and convert preferred stock subsidiaries into taxable REIT subsidiaries tax-free prior to a

certain date. There would be a transition period to allow for conversion of preferred stock subsidiaries

before the 10-percent vote or value test would become effective. Persons other than the REIT who

hold stock in a preferred stock subsidiary would recognize gain to the extent that they received

consideration other than REIT stock for their interest in the subsidiary. 
- 142 -

MODIFY TREATMENT OF CLOSELY HELD REITS

Current Law

When originally enacted, the real estate investment trust (“REIT”) legislation was intended to

provide a tax-favored vehicle through which small investors could invest in a professionally managed

real estate portfolio. H.R. Rep. No. 2020, 86 Cong., 2d Sess., 2 (1960). REITs are intended to be th

widely held entities, and certain requirements of the REIT rules are designed to ensure this result.

Among other requirements, in order for an entity to qualify for REIT status, the beneficial ownership

of the entity must be held by 100 or more persons. In addition, a REIT cannot be closely held, which

is determined by reference to the stock ownership requirement in the personal holding company rules.

Under these rules, generally no more than 50 percent of the value of the REIT’s stock can be owned

by five or fewer individuals during the last half of the taxable year. Certain attribution rules apply in

making this determination. 

Reasons for Change

A number of tax avoidance transactions involve the use of closely held REITs. In these

transactions, in order to meet the 100 or more shareholder requirement, the REIT generally issues

common stock and a separate class of non-voting preferred stock. The common stock, which reflects

virtually all of the REIT’s economic value, is acquired by a single shareholder, and the preferred stock

is acquired by 99 other “friendly” shareholders (generally, employees of the majority shareholder).

The current-law closely held limitation does not disqualify the REITs that are utilizing this ownership

structure because the majority shareholder of these REITs is not an individual. 

The Administration believes that certain closely held structures may facilitate the use and

development of corporate tax shelters in ways unintended by Congress. The Administration proposes

modifying the closely held REIT requirements to address these potential abuses without frustrating

the intended viability of REITs.

Proposal

The proposal would impose as an additional requirement for REIT qualification that no person

can own stock of a REIT possessing 50 percent or more of the total combined voting power of all

classes of voting stock or 50 percent or more of the total value of all shares of all classes of stock.

For purposes of determining a person’s stock ownership, rules similar to the attribution rules contained

in section 856(d)(5) would apply. This proposal would not apply to ownership by a REIT of 50

percent or more of the stock (vote or value) of another REIT.

The proposal would be effective for entities electing REIT status for taxable years beginning

on or after the date of first committee action. An entity that elects REIT status for a taxable year

beginning prior to the date of first committee action will be subject to this proposal if it does not have

significant business assets or activities as of such date.
- 143 -

REPEAL TAX-FREE CONVERSIONS OF LARGE C CORPORATIONS

TO S CORPORATIONS

Current Law

C corporations generally are subject to a two-tier tax. A corporation can avoid this two-tier

tax by electing to be treated as an S corporation or by converting to a partnership. Converting to a

partnership is a taxable event that generally requires the corporation to recognize any built-in gain on

its assets and requires the shareholders of the corporation to recognize any built-in gain in their

corporate stock. In contrast, the conversion of a C corporation to an S corporation generally is

tax-free for both the corporation and its shareholders. Under section 1374, however, the S

corporation must recognize the built-in gain on assets held at the time of conversion if the assets are

sold within ten years.

A corporation generally also can avoid the two-tier tax if it can qualify as a regulated

investment company (RIC) or a real estate investment trust (REIT) (by deducting dividends paid to

its shareholders). The conversion of a C corporation to a RIC or REIT, however, is treated as if the

corporation had sold all of its assets at their fair market value and immediately liquidated, thereby

requiring the corporation to recognize any built-in gain in its assets at the time of the conversion.

Notice 88-19, 1988-1 C.B. 486. The IRS, however, permits the corporation to avoid the immediate

recognition of its built-in gain if the corporation elects to be subject to rules similar to section 1374.

Reasons for Change

The tax treatment of the conversion of a C corporation to an S corporation generally should

be consistent with the tax treatment of the conversion of a C corporation to a partnership. Any

appreciation in corporate assets that occurred during the time the corporation is a C corporation

should be subject to the corporate-level tax.

Proposal

The proposal would repeal section 1374 for large corporations. A C-to-S corporation

conversion by a large corporation to S corporation status (whether by a C corporation electing S

corporation status or by a C corporation merging into an S corporation) would be treated as a

liquidation of the C corporation followed by a contribution of the assets to an S corporation by the

recipient shareholders. Thus, the proposal would require immediate gain recognition by both the

corporation (with respect to its appreciated assets) and its shareholders (with respect to their stock)

upon the conversion to S corporation status.

For this purpose, a large corporation is one with a value of more than $5 million at the time

of conversion. The value of the corporation would be the fair market value of all the stock of the

corporation on the date of conversion.
- 144 -

The proposal would be effective for subchapter S elections that are first effective for a taxable

year beginning after January 1, 2000. The proposal also would apply to acquisitions (e.g., the merger

of a C corporation into an S corporation) after December 31, 1999. Thus, C corporations would

continue to be permitted to elect S corporation status effective for taxable years beginning in 1999 or

on January 1, 2000 without incurring the tax on conversion.

In addition, the Internal Revenue Service would revise Notice 88-19 to conform to the

proposed amendment to section 1374, with an effective date similar to the statutory proposal. As a

result, the conversion of a large C corporation to a RIC or a REIT after the revisions would result in

immediate recognition by the C corporation of the net built-in gain in its assets.
 Treasury regulations under section 1.1502-17 provide a general anti-abuse rule to 13

prohibit a taxpayer from transferring an activity to another member with the principal purpose to

avail the group of an accounting method that would be unavailable.

- 145 -

Tax Accounting

DENY CHANGE IN METHOD TREATMENT TO TAX-FREE TRANSACTIONS

Current Law

In general, a taxpayer that desires to change its method of accounting must obtain the consent

of the Commissioner. In addition, in a nonrecognition transaction to which section 381 applies, an

acquiring corporation must use the method of accounting used by the distributor or transferor

corporation unless different methods of accounting were used by the parties to the transaction. If

different methods of accounting were used, Treasury regulations generally provide that the acquiring

corporation must adopt the principal method of accounting of the parties to the transaction. An

acquiring corporation may use a method of accounting other than that required by section 381 and the

regulations thereunder only if consent of the Commissioner is obtained. 

Under current law, section 381 does not apply to the tax-free contribution to a corporation

described in section 351 or the tax-free contribution to a partnership described in section 721.

Consequently, taxpayers who transfer assets to a subsidiary or a partnership may avail themselves of

a new method of accounting without obtaining the consent of the Commissioner.13

Reasons for Change

The Administration believes that it is inappropriate to allow taxpayers to circumvent the

requirement to obtain consent of the Commissioner to change a method of accounting by merely

contributing a business to a corporation or partnership.

Proposal

The proposal would expand the transactions to which the carryover of method of accounting

rules in section 381 and the regulations thereunder apply to include section 351 and section 721

transactions.

The proposal would be effective for transfers after the date of enactment.
- 146 -

REPEAL INSTALLMENT METHOD FOR ACCRUAL BASIS TAXPAYERS

Current Law

Generally, an accrual method requires a taxpayer to recognize income when all events have

occurred that fix the right to its receipt and its amount can be determined with reasonable accuracy.

The installment method of accounting provides an exception to this general recognition principle by

allowing a taxpayer to defer the recognition of income from the disposition of certain property until

payment is received. To the extent that an installment obligation is pledged as security for any

indebtedness, the net proceeds of the secured indebtedness are treated as a payment on such

obligation, thereby triggering the recognition of income. 

A taxpayer generally is not allowed to use the installment method with respect to sales of its

inventory. Exceptions to this rule are provided to farmers and dealers of timeshares and residential

lots.

Reasons for Change

The installment method is inconsistent with an accrual method of accounting and effectively

allows an accrual method taxpayer to recognize income from certain property using the cash receipts

and disbursements method. Consequently, the method fails to reflect the economic results of a

taxpayer's business during the taxable year.

In addition, the pledging rules, which are designed to require the recognition of income when

the taxpayer receives cash related to an installment obligation, are inadequate. For example, while a

taxpayer who borrows money and pledges its installment obligation as security triggers the recognition

of such installment obligation as if payment was received, a taxpayer who borrows money and gives

a put right against its installment obligation may not trigger recognition of such installment obligation.

Further, a taxpayer who, for example, pledges half of its installment obligation is able to obtain

proceeds (from the loan and from actual subsequent payments on the obligation) equal to the full

amount of the obligation while only recognizing half of the related income. Such a result occurs

because actual payments received on the installment obligation subsequent to the receipt of the loan

proceeds are not taken into account until such subsequent payments exceed the loan proceeds that

were treated as payments.

Proposal

The proposal would repeal the installment method of accounting for accrual method taxpayers

(other than those taxpayers that benefit from dealer disposition exceptions under current law). The

proposal also would eliminate the inadequacies in the pledging rules by clarifying that put rights or

other similar arrangements will receive the same treatment as pledges and modifying the subsequent

payment rule to take into account both loan proceeds and subsequent payments to the extent of the

full amount of the installment obligation. The proposal generally would be effective for installment

sales entered into on or after the date of enactment.
- 147 -

DENY DEDUCTION FOR PUNITIVE DAMAGES

Current Law

No deduction is allowed for a fine or similar penalty paid to a government for the violation of

any law. If a taxpayer is convicted of a violation of the antitrust laws, or the taxpayer’s plea of guilty

or nolo contendere to such a violation is entered or accepted in a criminal proceeding, no deduction

is allowed for two-thirds of any amount paid or incurred on a judgment or in settlement of a civil suit

brought under section 4 of the Clayton Antitrust Act on account of such or any related antitrust

violation.

Where neither of these two provisions is applicable, a deduction is allowed for damages paid

or incurred as ordinary and necessary expenses in carrying on any trade or business, regardless of

whether such damages are compensatory or punitive. 

Reasons for Change

The deductibility of punitive damage payments undermines the role of such damages in

discouraging and penalizing certain undesirable actions or activities.

Proposal

No deduction would be allowed for punitive damages paid or incurred by the taxpayer,

whether upon a judgment or in settlement of a claim. Where the liability for punitive damages is

covered by insurance, such damages paid or incurred by the insurer would be included in the gross

income of the insured person. The insurer would be required to report such payments to the insured

person and to the Internal Revenue Service. The proposal would apply to damages paid or incurred

on or after the date of enactment.
- 148 -

APPLY UNIFORM CAPITALIZATION RULES TO TOLLERS

Current Law

Section 263A provides uniform rules for capitalization of certain expenses. Section 263A requires the

capitalization of the direct costs and an allocable portion of the indirect costs of real or tangible personal property

produced by a taxpayer or real or personal property described in section 1221(1) that is acquired by a taxpayer

for resale. Costs attributable to producing or acquiring property generally must be capitalized by charging such

costs to basis or, in the case of property which is inventory in the hands of the taxpayer, by including such costs

in inventory.

In general, a toller performs certain manufacturing or processing operations on property owned by its

customers either for a fee (known as a toll) or for a share of the production. Where the toller does not take title

to the property, it may contend that it does not produce property or acquire property for resale. As a result, a toller

may not capitalize certain direct and indirect costs attributable to some of its tolling activities. 

Reasons for Change

The uniform capitalization rules are intended to make the tax system more neutral by eliminating the

differences in capitalization rules that created distortions between similarly situated taxpayers in the allocation of

economic resources and in the manner in which certain economic activity was organized. The manufacturing and

processing operations performed by a toller are identical to the manufacturing and processing operations

performed by a producer subject to section 263A. However, a toller generally currently deducts the direct and

indirect costs attributable to its tolling activities, while a producer must capitalize the direct and indirect costs

attributable to its production activities. The disparate treatment between tollers and producers based on ownership

of the property leads to the very distortions that the uniform capitalization rules were intended to eliminate.

Proposal

The proposal would modify section 263A to require a toller to capitalize direct, and an allocable portion

of indirect, costs allocable to property manufactured or processed under a contract manufacturing arrangement

to the extent the toller would have been a producer subject to section 263A if it owned the property. For this

purpose, a contract manufacturing arrangement is one in which the toller performs manufacturing or processing

operations (including manufacturing, processing, finishing, assembling, or packaging) on property owned by its

customers for a fee without the passage of title. Tollers would be required to capitalize direct and indirect costs

(such as labor and overhead) allocable to property tolled. An exception would be provided for tollers that have

average annual gross receipts for the prior three taxable years of less than $1 million.

The proposal would be effective for taxable years beginning after the date of enactment. If a taxpayer

is required to change its method of accounting to comply with the proposal, such change would be treated as

initiated by the taxpayer with the consent of the Secretary of Treasury and any section 481 adjustment generally

would be included in income ratably over a four-year period.

REPEAL LOWER-OF-COST-OR-MARKET INVENTORY ACCOUNTING METHOD
- 149 -

Current Law

Taxpayers required to maintain inventories are permitted to use a variety of methods to

determine the cost of their ending inventories, including the last-in, first-out (ALIFO@) method, the

first-in, first-out (AFIFO@) method, and the retail method. Taxpayers not using a LIFO method may

determine the carrying values of their inventories by applying the lower-of-cost or market (ALCM@)

method or by writing down the cost of goods that are unsalable at normal prices or unusable in the

normal way because of damage, imperfection or other similar causes (the Asubnormal goods@ method).

Reasons for Change

The allowance of write-downs under the LCM and subnormal goods methods is an

inappropriate exception from the realization principle and is essentially a one-way mark-to-market

method that understates taxable income.

Proposal

The proposal would repeal the LCM and subnormal goods methods. Appropriate wash-sale

rules also would be included. The proposal would be treated as a change in the method of accounting

for inventories, and any resulting section 481(a) adjustment generally would be included in income

ratably over a four-year period beginning with the year of change. These changes would not apply to

taxpayers with average annual gross receipts over a three-year period of $5 million or less, with

appropriate aggregation rules.

The proposal would be effective for taxable years beginning after the date of enactment. 
- 150 -

ELIMINATE THE INCOME RECOGNITION EXCEPTION

FOR ACCRUAL METHOD SERVICE PROVIDERS

Current Law

An accrual method taxpayer generally must recognize income when all events have occurred

that fix the right to its receipt and its amount can be determined with reasonable accuracy. In the event

that a receivable arising in the ordinary course of the taxpayer's trade or business later becomes

uncollectible, the accrual method taxpayer may deduct the account receivable as a business bad debt

in the year in which it becomes wholly or partially worthless. 

Accrual method service providers are provided a special exception to these general rules.

Under this exception, a taxpayer using an accrual method with respect to amounts to be received for

the performance of services is not required to accrue any portion of such amounts which (on the basis

of experience) will not be collected (the "non-accrual experience method"). This exception applies

as long as the taxpayer does not charge interest or penalties for failure to timely pay on such amounts.

Reasons for Change

The Administration believes that the non-accrual experience method is an inappropriate method

of accounting for tax purposes. The non-accrual experience method allows an accrual method service

provider to reduce current taxable income by an estimate of its future bad debt losses. Thus, this

method is the equivalent of establishing a bad debt reserve. The reserve method of accounting for bad

debts repeatedly has been determined an unacceptable method of accounting for tax purposes because

it results in a mismeasurement of economic income. Accordingly, it is inappropriate to continue to

provide this tax benefit to service providers. In addition, because the tax benefit only applies to

amounts to be received for the performance of services, it discriminates in favor of service providers

and promotes controversy over whether a taxpayer’s receivables represent amounts to be received for

the performance of services or for the provision of goods.

Proposal

The proposal would repeal the non-accrual experience method exception effective for taxable

years beginning after the date of enactment. If a taxpayer is required to change its method of

accounting to comply with the proposal, such change would be treated as initiated by the taxpayer

with the consent of the Secretary of Treasury and any section 481 adjustment generally would be

included in income ratably over a four-year period.
- 151 -

DISALLOW INTEREST ON DEBT ALLOCABLE TO TAX-EXEMPT OBLIGATIONS

Current Law

No income tax deduction is allowed for interest on debt used directly or indirectly to acquire

or hold investments that produce tax-exempt income. The determination of whether debt is used to

acquire or hold tax-exempt investments differs depending on the holder of the instrument. For banks

and a limited class of other financial institutions, debt generally is treated as financing all of the

taxpayer's assets proportionately. For other corporations, and for individuals, however, a tracing rule

is employed. Under this approach, deductions are disallowed only when indebtedness is incurred or

continued for the purpose of purchasing or carrying tax-exempt investments. Securities dealers are

not included in the definition of “financial institution,” and although they are subject to a caselaw-based, pro-rata rule similar to the one that applies to other financial institutions, they benefit from

a special exception to which financial institutions are not entitled. Securities dealers are allowed to

trace borrowings to non-exempt purposes and to exclude the interest on those borrowings from the

interest that is subject to the pro-rata disallowance rule. Thus, in general, the portion of a securities

dealer’s interest subject to possible disallowance under the pro-rata rule is generally much smaller than,

for example, a bank’s portion. Other financial intermediaries, such as finance companies, are also

excluded from the definition of “financial institution,” and therefore are subject only to the direct

tracing rule, even though they operate similarly to banks.

Reasons for Change

The current rules applicable to securities dealers and financial intermediaries other than banks

permit them to reduce their tax liabilities inappropriately through double Federal tax benefits of interest

expense deductions and tax-exempt interest income, notwithstanding that they operate similarly to

banks. The treatment of banks should be applicable to other taxpayers engaged in the business of

financial intermediation, such as securities dealers. There is no reason to distinguish between banks

and other financial intermediaries in this context. In both cases, it is difficult to trace funds within the

institution and nearly impossible to assess the taxpayer’s purpose in accepting deposits or making

other borrowings.

Proposal

Under the proposal, the definition of “financial institution” under section 265(b) would be

amended to include any person engaged in the active conduct of a banking, financing, or similar

business, such as securities dealers and other financial intermediaries. Thus, a financial intermediary

investing in tax-exempt obligations would be disallowed deductions for a portion of its interest

expense equal to the portion of its total assets that is comprised of tax-exempt investments. The

proposal would be effective for taxable years beginning after the date of enactment with respect to

obligations acquired on or after the date of first committee action.
- 152 -

Cost Recovery

PROVIDE CONSISTENT AMORTIZATION PERIODS FOR INTANGIBLES

Current Law

Under current law, start-up and organizational expenditures are amortized at the election of

the taxpayer over a period of not less than 60 months beginning with the month in which the trade or

business begins pursuant to section 195 and section 248, respectively. Section 197 requires certain

acquired intangible assets (goodwill, trademarks, franchises, patents, etc.) held in connection with the

conduct of a trade or business or an activity for the production of income to be amortized over 15

years beginning with the month in which the intangible was acquired. 

Reasons for Change

The Administration believes that to encourage the formation of new businesses, a fixed amount

of start-up and organizational expenditures should be deductible in the year in which the trade or

business begins. Further, the amortization period for the start-up and organizational expenditures that

are not deductible in the year in which the trade or business begins should be consistent with the

15-year amortization period for section 197 intangibles. 

Proposal

The proposal would allow a taxpayer to elect to deduct up to $5,000 each of start-up or

organizational expenditures in the taxable year in which the trade or business begins. However, each

$5,000 amount is reduced (but not below zero) by the amount by which the cumulative cost of start-up

or organizational expenditures exceeds $50,000, respectively. Start-up and organizational

expenditures that are not deductible in the year in which the trade or business begins would be

amortized over a 15-year period consistent with the amortization period for section 197 intangibles.

The proposal generally is effective for start-up and organizational expenditures incurred after

the date of enactment.
 Rev. Proc. 87-56, 1987-2 C.B. 674 14

 Rev. Rul. 72-403, 1972-2 C.B. 102 15

- 153 -

CLARIFY CLASS LIFE OF UTILITY GRADING COSTS

Current Law

A taxpayer is allowed as a depreciation deduction a reasonable allowance for the exhaustion,

wear and tear, and obsolescence of property that is used in a trade or business or held for the

production of income. For most tangible property placed in service after 1986, the amount of the

depreciation deduction is determined under the modified accelerated recovery system (MACRS) using

a statutorily prescribed depreciation method, recovery period, and placed in service convention. For

some assets, the recovery period for the asset is provided in section 168. In other cases, the recovery

period of an asset is determined by reference to its class life. The class life of an asset may be provided

in section 168, or may be determined with regard to the list of class lives provided by the Treasury

Department that was in effect on January 1, 1986.14

Electric and gas utility clearing and grading costs incurred to extend distribution lines and

pipelines have not been assigned a class life. Consequently, electric and gas utility clearing and grading

costs are classified as section 1245 real property with no class life. Such assets have a 7- year

recovery period under MACRS.

Reason for Change

The recovery period used for electric and gas utility clearing and grading costs does not reflect

the economic useful life of such costs. Under pre-accelerated cost recovery system (ACRS) law, the

IRS ruled that an average useful life of 84 years and 46 years would be accepted for the initial clearing

and grading relating to electric transmission lines and electric distribution lines, respectively. In

15

addition, the electric utility transmission and distribution lines and the gas utility trunk pipelines

benefitted by the clearing and grading costs have MACRS recovery periods of 20 years and 15 years,

respectively. 

Proposal

The proposal would assign a class life to depreciable electric and gas utility clearing and

grading costs incurred to locate transmission and distribution lines and pipelines. The proposal would

classify these assets into the asset classes of the property to which the clearing and grading costs relate

(generally, asset class 49.14 for electric utilities and asset class 49.24 for gas utilities, giving these

assets a recovery period of 20 years and 15 years, respectively).

The proposal would be effective for electric and gas utility clearing and grading costs incurred

after the date of enactment.
- 154 -

Insurance Provisions

REQUIRE RECAPTURE OF POLICYHOLDER SURPLUS ACCOUNTS

Current Law

Between 1959 and 1983, stock life insurance companies deferred tax on a portion of their

profits. These untaxed profits were added to a policyholders surplus account (APSA@). In 1984,

Congress precluded life insurance companies from continuing to defer tax on any future profits

through PSAs. However, companies were permitted to continue their existing PSA accounts, and to

pay tax on the previously untaxed profits only in certain circumstances. 

Previously untaxed profits are taxed when and to the extent they are distributed or treated as

being distributed to shareholders. Amounts are treated as being distributed from a PSA if a company

ceases being an insurance company for a single taxable year, or if the company is not a life insurance

company for two consecutive taxable years. 

PSAs also are deemed to be distributed to the extent that the PSA exceeds the greatest of 15

percent of the company’s life insurance reserves, 25 percent of the amount by which the company’s

current life insurance reserves exceed its life insurance reserves at the end of 1958, or 50 percent of

the net amount of premiums and other consideration paid to the company. 

Reasons for Change

Congress permitted stock life insurance companies to defer tax on a portion of their profits

between 1959 and 1983 in part because of the perceived difficulty in Adetermining on an annual basis

the true income of a life insurance company.@ These rules were intended to allow insurance companies

to deduct contingency reserves in case they needed funds in excess of their regular reserves to fulfill

their legal obligations under their insurance policies. Previously untaxed profits were supposed to

become subject to taxation when Athey were no longer used to comply with the insurance company’s

obligations to policyholders.@ See Bankers Life and Casualty Co. v. United States, 142 F.3d 973 (7th

Cir. 1998); Green v. United States, 42 Fed. Cl. 18 (1998).

There is no remaining justification for allowing stock life insurance companies to continue to

defer tax on profits they earned between 1959 and 1983. Most pre-1984 policies have terminated,

because pre-1984 policyholders have surrendered their pre-1984 contracts for cash, ceased paying

premiums on those contracts, or died. Life insurance companies rarely, if ever, paid cash surrender

values, death benefits or other benefits that exceeded the reserves they established for those pre-1984

contracts. To the extent pre-1984 contracts have not terminated, some companies that issued those

contracts have reinsured them with other insurance companies, while either retaining their PSAs or

distributing their PSAs to parent life insurance companies. Thus, PSAs typically have been separated

from any remaining pre-1984 contracts. Companies generally take the position that these transactions

do not trigger inclusion of PSAs into their gross income under current law.
- 155 -

Proposal

Companies would be required to include in their gross income over ten years their PSA

balances as of the beginning of the first taxable year starting after the date of enactment. In general,

companies would be required to include one-tenth of this amount each year. To the extent that a

company was required to include a portion of this PSA balance in income during this ten-year period

due to a direct or indirect distribution, the company would include a prorata portion of its remaining

PSA balance in income over the remainder of the 10-year period.
- 156 -

MODIFY RULES FOR CAPITALIZING POLICY ACQUISITION COSTS

OF LIFE INSURANCE COMPANIES

Current Law

Since 1990, insurance companies issuing life insurance, annuity or noncancellable (including

guaranteed renewable) health insurance policies have been required to capitalize a portion of their total

policy acquisition costs. The amounts capitalized generally are equal to 2.05 percent of the net

premiums on group life insurance contracts, 1.75 percent of the net premiums on annuity contracts,

and 7.7 percent of the net premiums on individual life insurance, group and individual health insurance

and certain other types of specified insurance contracts. No amounts are capitalized for pension plan,

flight insurance, certain foreign branch contracts, and medical savings accounts. These percentages

are applied to net premiums paid not only in the first contract year, when most policy acquisition costs

are incurred for a policy, but also in subsequent contract years. In general, these capitalized amounts

are amortized over 10 years (5 years for small companies). This special regime applies in lieu of

normal tax accounting rules.

Under section 848(h), Treasury has the authority to modify these percentages and categories

if the deferral of acquisition expenses for a type of contract under these provisions is substantially

greater than the deferral of acquisition expenses that would have resulted if actual acquisition expenses

(including indirect expenses) and the actual useful life for such type of contract had been used. If

Treasury exercises this authority with respect to contracts in one of these statutory categories, the

percentage of net premiums that is capitalized for the remaining contracts in that category must be

adjusted so that Treasury’s exercise of its authority does not decrease the amount of tax revenue

received for any fiscal year.

Corporations generally are required to capitalize all of their costs of acquiring assets with

useful lives that extend substantially beyond the taxable year, and to amortize those capitalized costs

over the life of the asset. The purpose of these rules is to match income and deductions, thereby

resulting in a more accurate calculation of income. See INDOPCO, Inc. v. Commissioner, 503 U.S.

79 (1992). These capitalization rules apply to financial intermediaries that compete against insurance

companies. 

Reasons for Change

Current tax law fails to accurately reflect the economic income of life insurance companies for

several reasons. First, life insurance companies generally capitalize only a fraction of their actual

policy acquisition costs. In contrast, when preparing their financial statements using generally

accepted accounting principles (GAAP), life companies generally capitalize their actual policy

acquisition costs.

The life insurance industry currently capitalizes less than half of its actual policy acquisition

costs, based on data reported annually by the life insurance companies to State insurance

commissioners. Policy acquisition costs include commissions and other amounts that would be
- 157 -

required to be capitalized if normal capitalization rules applied, such as expense reimbursements to

agents and amounts paid to agents’ supervisors. Even if one assumed that policy acquisition expenses

were limited to commissions, current tax law required capitalization of only a small portion of total

commissions over the past five years (1993 through 1997):

Type of Insurance Contract Percentage of Net Premiums Ratio of Commissions to

Capitalized Under Current Law Net Premiums, 1993-1997

Individual life insurance 7.70% 13.6%

Individual annuities 1.75% 6.1%

Group annuities generally 0% 1.4%

Group health, including 7.70% 7.6%

disability and long-term care 

Individual health, including 7.70% 18.9%

disability and long-term care

Group life insurance 2.05% 4.3%

Credit life insurance generally 2.05% 49.0%

Credit health insurance 7.70% 53.3%

Current law also fails to accurately reflect the economic income of many life insurance

companies, by imposing a 10-year straight-line amortization schedule for all lines of business, even

though some types of policies (such as cash value life insurance) have substantially longer lives than

other types of policies (such as certain types of guaranteed renewable health insurance or term life

insurance). 

Finally, current law fails to accurately reflect the economic income of companies that have

lower than average or higher than average policy acquisition costs. Companies with low policy

acquisition expenses are required to capitalize the same percentage of their net premiums as companies

with high policy acquisition expenses. Companies that sell few new policies, and therefore incur low

acquisition costs compared to their net premiums (which includes premiums paid on old policies) are

required to capitalize the same percentage of their net premiums as companies with high total policy

acquisition costs that are generated because their net premiums are generated disproportionately from

newly issued policies.

Proposal

Insurance companies generally would be required to capitalize modified percentages of net

premiums for five categories of insurance contracts. These modified percentages more closely reflect

both the historic ratio of commissions to net premiums from 1993 through 1997 shown above and the

typical useful lives for the policies included in each of these categories. As under current law,
- 158 -

capitalized amounts would be required to be amortized on a straight-line basis over a 10-year period

(5 years for small companies). 

As under current law, companies that issued pension contracts, flight insurance, qualified

foreign branch contracts and medical savings accounts would not be required to capitalize any of their

policy acquisition costs for these contracts. Companies that issued group or individual noncancellable

health insurance also would continue to capitalize 7.7 percent of the net premiums for such contracts.

The proposal would modify current law in several respects. First, companies would be

required to capitalize 2.05 percent of the net premiums on group or individual term life insurance.

Second, companies would be required to capitalize 4.25 percent of the net premiums on non-pension

annuity contracts for the first through fifth taxable year beginning after the date of enactment, and 5.15

percent of the net premiums on such contracts for the sixth and subsequent taxable years beginning

after the date of enactment. Third, companies would be required to capitalize 10.50 percent of net

premiums on cash value life insurance, credit life insurance, credit health insurance and any other

specified insurance contracts (as defined under current law) for the first through fifth taxable years

beginning after the date of enactment. This percentage of net premiums would increase from 10.50

percent to 12.85 percent for the sixth and subsequent taxable years beginning after the date of

enactment.

Although these percentages are higher than the current capitalization percentages for certain

lines of business, they are lower than the reported industry-wide ratio of commissions to net premiums

for the lines of business in each category of contracts. To ensure that insurance companies are not

required to capitalize more than would be appropriate under general tax principles, a special rule

would apply. Under this rule, insurance companies that would capitalize a smaller amount of policy

acquisition expenses for all their life insurance, annuity and noncancellable health insurance policies

under general capitalization rules than by applying the statutory capitalization percentages to their net

premiums on the types of contracts described above could elect to capitalize their actual policy

acquisition expenses as a method of accounting. For this purpose, controlled insurance companies

would be aggregated using the same rules that apply in determining whether a company qualifies for

the small company 5-year amortization period.
- 159 -

INCREASE THE PRORATION PERCENTAGE

FOR PROPERTY CASUALTY (P&C) INSURANCE COMPANIES

Current Law

Property casualty insurance companies generally are taxable on the sum of their underwriting

income, investment income and other income. In computing their underwriting income, property

casualty companies deduct reserves for losses and loss expenses incurred from their premiums earned.

These loss reserves are funded in part with the property casualty company’s investment income. The

taxable investment income of property casualty companies generally does not include interest on taxexempt bonds, the deductible portion of certain dividends received, or inside buildup on most

insurance policies.

In 1986, Congress concluded that it was inappropriate for property casualty companies to fund

fully deductible loss reserves with investment income that might be exempt from tax, such as interest

on tax-exempt bonds or the deductible portion of certain dividends received. Thus, Congress reduced

the reserve deductions of property casualty companies by 15 percent of the tax-exempt interest or the

deductible portion of certain dividends received, for stock or obligations acquired after August 7,

1986. 

In 1997, Congress concluded that it also was inappropriate for property casualty companies

to fund fully deductible loss reserves with investment income that might be tax-exempt or tax-deferred

under certain types of insurance contracts. Given this conclusion, Congress expanded the 15 percent

proration rule to apply to the inside buildup on certain annuity, endowment, or life insurance contracts.

Reasons for Change

The existing 15 percent proration rule still enables property casualty insurance companies to

fund a substantial portion of their deductible reserves with tax-exempt or tax-deferred income. Other

financial intermediaries, such as life insurance companies and banks, are subject to more stringent

proration rules that substantially reduce or eliminate their ability to use tax-exempt or tax-deferred

investments to fund currently deductible reserves or interest on loans.

Proposal

The proration percentage would be increased from 15 percent to 25 percent, for taxable years

beginning after the date of enactment with respect to investments acquired on or after the date of first

committee action.
- 160 -

Exempt Organizations

SUBJECT INVESTMENT INCOME OF TRADE ASSOCIATIONS TO TAX

Current Law

Nonprofit business leagues, chambers of commerce, trade associations, and professional sports

leagues described in section 501(c)(6) generally are exempt from Federal income taxes. Such

organizations generally are not subject to tax on membership dues and contributions they receive, and

generally are not subject to tax on their investment income. However, section 501(c)(6) organizations

are subject to tax on their unrelated business taxable income, which includes investment (and other)

income derived from debt-financed property. In addition, the investment income of a section 501(c)(6)

organization is subject to tax under section 527(f) to the extent that the organization makes

expenditures during the taxable year in an attempt to influence the selection of an individual to any

Federal, State, or local public office (which generally are referred to as Aelectioneering@ expenditures).

In the case of tax-exempt social clubs, voluntary employees’ beneficiary associations (VEBAs),

and certain other mutual benefit organizations, the unrelated business income tax (UBIT) generally

applies under current law to all gross income --including investment income --other than certain

Aexempt function income,@ such as membership receipts, income set aside to be used for charitable

purposes specified in section 170(c)(4), and Arollover@ gain on certain dispositions of property directly

used by the organization in carrying out its exempt functions (sec. 512(a)(3)). 

Reasons for Change

The current-law exclusion from the UBIT for certain investment income of a trade association

allows the organization’s members to obtain an immediate deduction for dues or similar payments to

the organization in excess of the amounts needed for current operations, while avoiding tax on a

proportionate share of the earnings from investing such surplus amounts. If the trade association

member instead had retained its proportionate share of the surplus and itself had invested that amount,

the earnings thereon would have been taxed in the year received by the member. Although in some

instances investment income earned tax-free by a trade association may be used to reduce member

payments in later years, and hence reduce deductions claimed by members in such years, the member

still has gained a benefit under current law through tax deferral. Thus, under current-law rules, trade

association members may be able to claim current deductions for future expenses. Even assuming that

dues and similar payments would be deductible by the member if made in a later year, to the extent that

investment income is earned by the trade association in one year and spent in a later year, the

current-law exclusion effectively provides the benefit of a deduction before the expenditure actually

is made.
- 161 -

Proposal

Trade associations and other organizations described in section 501(c)(6) would generally be

subject to tax (at applicable corporate income tax rates) on their net investment income in excess of

$10,000. For this purpose, Anet investment income@ would be computed by adding all items of income

described in paragraphs 1, 2, and 3 of section 512(b) (e.g., dividends, interest, royalties, and rents) and

certain gains and losses from dispositions of property described in section 512(b)(5), and deducting

all expenses directly connected with such items of income. 

As under current-law section 512(a)(3), tax would not be imposed under the proposal to the

extent that income is set aside to be used exclusively for a charitable purpose specified in section

170(c)(4). In addition, if an organization described in section 510(c)(6) sells property that is used

directly in the performance of its exempt function, any gain from such sale is subject to tax under the

proposal only to the extent that the association’s sales price of the old property exceeds the

association’s cost of purchasing certain replacement property (see sec. 512(a)(3)(D)).

Under current-law section 6033(e)(1)(C), any lobbying and electioneering expenditures made

by an organization described in section 501(c)(6) would be deemed to be made first out of the dues

payments made by the members, which could result in a portion of dues payments being nondeductible

under section 162(e) (or, as an alternative, the organization could elect to pay a proxy tax under sec.

6033(e)(2) on its lobbying and electioneering expenditures.)

The proposal would be effective for taxable years beginning on or after the date of enactment.
- 162 -

Estate and gift taxation

RESTORE PHASE-OUT OF UNIFIED CREDIT FOR LARGE ESTATES

Current Law

Prior to the Taxpayer Relief Act of 1997, the five-percent surtax added to the estate tax

gradually phased out two benefits for estates with a value above $10 million: the benefit of the estate

tax brackets below 55 percent and the benefit of the unified credit. The Taxpayer Relief Act of 1997

amended the unified credit, increasing it gradually over the years 1998 through 2006 and effectively

increasing the amount exempt from the estate and gift tax from $600,000 (in 1997) to $1,000,000 (in

2006). In attempting to amend the surtax provision to accommodate the scheduled increases to the

unified credit, the Taxpayer Relief Act of 1997 inadvertently altered the operation of the surtax such

that it currently phases out only the graduated estate tax brackets and does not phase out the benefit

of the unified credit. 

Reasons for Change

As evidenced by the legislative history of the Taxpayer Relief Act of 1997, there was no

intention to change the application of the five percent surtax. The inadvertent reduction in the surtax

gives an estate tax reduction to estates in excess of $17,184,000.

Proposal

The proposal would increase the range of the five-percent surtax in order to restore its purpose

of phasing out the benefit of the unified credit as well as the benefit of the graduated estate tax

brackets. The phase-out range would increase as the unified credit continues to rise until 2006. 

This proposal would be effective for decedents dying after the date of enactment.
- 163 -

REQUIRE CONSISTENT VALUATION FOR ESTATE AND INCOME TAX PURPOSES

Current Law

Under current law, the basis of property acquired from a decedent is the fair market value of

the property on the date of death. In addition, property included in the gross estate of a decedent

generally is valued at its fair market value on the date of death. However, there is no requirement that

the determination of fair market value for estate tax purposes and the determination of fair market

value for income tax purposes be consistent. The only current duty of consistency for estates concerns

the duty of the beneficiary of a trust or estate to report for income tax purposes consistent with the

Form K-1 information received from the trust or estate (section 6034A). The K-1, however, does not

include basis information.

When a lifetime gift of property is made, the donee generally takes a carryover basis in the

property. (Adjustments are made if gift tax is paid on the transfer, and the dual basis rules apply if the

property is later sold at a loss.) However, there is no duty on the donor to notify the donee of the

basis. 

Reasons for Change

Taxpayers should be required to take consistent positions when dealing with the Internal

Revenue Service. The rationale for the step-up in basis at death is linked to the inclusion of the

property in the estate of the decedent. Therefore, the reported estate tax value and the new basis

should be the same. In the case of a gift in which the donee takes a carryover basis, the donor is in

the best position to notify the donee of the basis. If such information is not passed on to the donee

at the time of the gift, such information may be lost or unavailable by the time the property is sold by

the donee. 

Proposal

The proposal would impose both a duty of consistency and a reporting requirement. First, a

person taking a basis under section 1014 (property acquired from a decedent) would be required to

use fair market value as reported on the estate tax return (if one is filed) as the basis for the property

for income tax purposes. Second, a reporting requirement would be imposed on the estate (the

executor) and the donor of a lifetime gift. The estate, by its executor, would be required to notify

each heir of the fair market value on the date of death as reported on the estate tax return for any

property distributed to such heir. This requirement would include property not passing under the will

if such property is included in the gross estate. Donors of gifts (other than annual exclusion gifts)

would be required to notify donees of the donor’s basis in the property at the time of the transfer, as

well as any payment of gift tax that would increase basis. A copy of these notices must be furnished

to the IRS. 

The proposal would be effective for transfers after the date of enactment in the case of lifetime

gifts, and decedents dying after the date of enactment in the case of transfers at death. 
 All of the examples assume that no gift tax is paid on the gift. 16

- 164 -

REQUIRE BASIS ALLOCATION FOR PART SALE/PART GIFT TRANSACTIONS

Current Law

Under current law, where there is a transaction that is part gift, part sale, the treatment of the

donor and the donee are as follows: The donee takes a basis equal to the greater of the amount paid

by the donee or the donor’s adjusted basis at the time of the transfer. (As in any gift transaction,

however, there is a "dual basis," that is, if the property is later sold at a loss, the basis is limited to the

fair market value at the time of the gift.) The treatment of the donor is not specified under current

law. Thus donors presumably take the position that their basis is adjusted cost basis. This treatment

by the donor and donee is not necessarily consistent. 

Reasons for Change

The donor and the donee in a part gift, part sale transaction should be required to take

consistent positions so that no basis is lost or created by the transaction. Simple and rational rules are

needed to allocate basis between the gift portion and the sale portion of the transaction. 

Proposal

This proposal would rationalize basis allocation in a part gift, part sale transaction by adopting

the rule applied to bargain sales to charity under Code section 1011: the basis of part gift, part sale

property would be allocated ratably between the gift portion and the sale portion based on the fair

market value on the date of transfer and the consideration paid. For example, if the donor transferred

property with a basis of $40,000 and a fair market value of $100,000 to child, and child paid

consideration of $50,000, child would take a basis of $70,000 ($50,000 for the consideration plus

$20,000 allocated portion of the donor’s basis) and the donor would take a basis of $20,000 (allocated

portion of donor’s basis on the date of transfer) for the purpose of reporting the gain on the sale part

of the transaction. The donor would realize gain in the amount of $30,000 ($50,000 less $20,000).16

The dual basis rule would continue to apply if there is a loss transaction and the fair market value on

the date of the gift was less than basis. For example, take the facts from above except the donor’s

basis just prior to the transfer was $140,000. The donor would have a loss of $20,000 ($50,000 of

consideration less allocated basis of $70,000). Child’s unadjusted basis would be $120,000, but if

child sold the property at a loss, basis would be limited to $100,000. As under present law, if the

amount realized from the sale by child is between the basis for loss and the basis for gain, no gain or

loss is realized. 

This proposal would be effective for transactions entered into after the date of enactment. 
- 165 -

CONFORM TREATMENT OF SURVIVING SPOUSES IN

COMMUNITY PROPERTY STATES

Current Law

Subject to limited exceptions, property acquired from a decedent at death is assigned a new

basis equal to the fair market value of the property at the date of the decedent’s death (a "stepped-up

basis"). In a common law (non-community property) State, property jointly owned by husband and

wife at the time one of them dies is treated as owned one-half by the deceased spouse and one-half by

the surviving spouse. The surviving spouse receives a stepped-up basis in the deceased spouse’s half.

The half already owned by the surviving spouse, however, is not eligible for a step up in basis.

Similarly, in a community property State, each spouse is treated as owning one-half of the community

property. Under section 1014(b)(6), however, the surviving spouse is entitled to a stepped-up basis

in the portion of the community property owned by the surviving spouse, as well as the portion owned

by the decedent. 

At present, there are 9 community property States and at least one other State with an elective

community property regime.

Reasons for Change

When enacted in 1948, the stepped-up basis for community property was premised on the fact

that "the usual case was that practically all the wealth of the married couple was the property of the

husband." S. Rep. 1013, 80th Cong., 2d Sess. (1948), 1948-1 C.B. 285, 304. Societal changes and

changes to the estate tax treatment of jointly held property in 1981 have undermined the premises on

which section 1014(b)(6) was based. Consequently, surviving spouses in community property States

now enjoy an unwarranted tax advantage over those in common law States. 

Proposal

The proposal would eliminate the stepped-up basis in the part of the community property

owned by the surviving spouse prior to the deceased spouse’s death. The half of the community

property owned by the deceased spouse would continue to be entitled to a stepped-up basis.

This proposal would be effective for decedents dying after the date of enactment. 
- 166 -

INCLUDE QUALIFIED TERMINABLE INTEREST PROPERTY (QTIP) TRUST

ASSETS IN SURVIVING SPOUSE'S ESTATE

Current Law

A marital deduction is allowed for qualified terminable interest property (QTIP) passing to a

qualifying trust for a spouse either by gift or by bequest. Under section 2044, the value of the

recipient spouse’s estate includes the value of any such property in which the decedent had a qualifying

income interest for life and a deduction was allowed under the gift or estate tax. 

Reasons for Change

The marital deduction is intended to defer the estate tax until the death of the surviving spouse,

not to excuse payment of the tax permanently. In some cases, taxpayers have attempted to whipsaw

the government by claiming the marital deduction for QTIP property in the first estate and then, after

the statute of limitations for assessing tax on the first estate has elapsed, arguing against inclusion

under section 2044 in the second estate due to some technical flaw in the QTIP eligibility or election

in the first estate. Since the surviving spouse has benefitted from the deferral of estate tax due to the

marital deduction taken in the first estate, the property should be includable in the surviving spouse’s

estate even if the surviving spouse later discovers that the marital trust did not in fact qualify for the

QTIP election in the first estate. 

Proposal

The proposal would amend section 2044 to provide that, if a marital deduction is allowed with

respect to QTIP property under section 2523(f) or 2056(b)(7), inclusion is required in the beneficiary

spouse’s estate under section 2044.

The proposal would be effective for decedents (i.e., surviving spouses) dying after the date of

enactment. 
- 167 -

ELIMINATE NON-BUSINESS VALUATION DISCOUNTS

Current Law

Under current law, taxpayers making gratuitous transfers of fractional interests in entities

routinely claim discounts on the valuation of such interests. The concept of valuation discounts

originated in the context of active businesses, where it has long been accepted that a willing buyer

would not pay a willing seller a proportionate share of the value of the entire business when purchasing

a minority interest in a non-publicly traded business. 

Without legislation in this area, tax planners have carried this concept over into the family

estate planning area, where a now common planning technique is to contribute marketable assets to

a family limited partnership or limited liability company and make gifts of minority interests in the

entity to other family members. Taxpayers then claim large discounts on the valuation of these gifts.

Reasons for Change

The use of family limited partnerships and similar devices is eroding the transfer tax base.

Taxpayers take the position that they can make value disappear by making contributions of marketable

assets to an entity, and then making gifts of interests in such entity to family members. This

disappearing value is illusory, because family members are not minority interest holders in any

meaningful sense. Moreover, it is implausible that the donor would intentionally take an action

(contribution of the property to an entity) if the donor really believed that such action would cause the

family’s wealth to decline substantially.

Proposal

The proposal would eliminate valuation discounts except as they apply to active businesses.

Interests in entities would be required to be valued for transfer tax purposes at a proportional share

of the net asset value of the entity to the extent that the entity holds non-business assets (such as cash,

cash equivalents, foreign currency, publicly traded securities, real property, annuities, royaltyproducing assets, non-income producing property such as art or collectibles, commodities, options and

swaps) at the time of the gift or death. To the extent the entity conducts an active business, the

reasonable working capital needs of the business would be treated as part of the active business (i.e.,

not subject to the limits on valuation discounts). No inference is intended as to whether these

discounts are allowable under current law.

This proposal would be effective for transfers made after the date of enactment.
- 168 -

ELIMINATE GIFT TAX EXEMPTION FOR PERSONAL RESIDENCE TRUSTS

Current Law

Under section 2702, if an interest is retained by a grantor in a trust when other interests are

transferred to family members, the retained interest is valued at zero for gift tax purposes unless it

takes the form of an annuity (a GRAT), a unitrust (a GRUT), or a remainder interest after a GRAT

or a GRUT. However, section 2702(a)(3)(A)(ii) provides an exception for a trust Aall the property

in which consists of a residence to be used as a personal residence by persons holding term interests

in such trust.@ As written, this exemption completely removes personal residence trusts from the

purview of section 2702. 

Reasons for Change

Because the exemption under section 2702 completely removes personal residence trusts from

section 2702, such trusts receive more favorable gift tax treatment than that given to the statutorily

authorized GRATs and GRUTs. Specifically, when valuing the gift made to the remainderman in a

personal residence trust, the value of any reversionary interest in the grantor can be taken into account,

and such value reduces the amount of the taxable gift. In contrast, even if the grantor has a

reversionary interest in a GRAT or a GRUT, section 2702 prohibits the actuarial value of that interest

from being taken into account in valuing the gift. 

Furthermore, by requiring a grantor’s retained interest in a trust to take the form of an annuity

or a unitrust, section 2702 was attempting to make sure that the grantor would actually receive the

interest valued by the actuarial tables. This requirement was designed to prohibit the pre-2702 grantor

retained income trusts (GRITs), in which the actuarial tables were used to value the grantor’s retained

income interest even when the projected income was zero or minimal. 

Experience has shown that the use value of the residence retained by the grantor is a poor

substitute for an annuity or unitrust interest. In the personal residence trust, the grantor ordinarily

remains responsible for the insurance, maintenance and property taxes on the residence. Therefore,

the true rental value of the house should be less than fair market rent. In these circumstances, the

actuarial tables overstate the value of the grantor’s retained interest in the house.

Proposal

The proposal would repeal the personal residence exception of section 2702(a)(3)(A)(ii). If

a residence is used to fund a GRAT or a GRUT, the trust would be required to pay out the required

annuity or unitrust amount; otherwise the grantor’s retained interest would be valued at zero for gift

tax purposes. 

The proposal would be effective for transfers in trust after the date of enactment.
- 169 -

International

EXPAND SECTION 864(c)(4)(B) TO INTEREST AND DIVIDEND EQUIVALENTS

Current Law

Under sections 871(b) and 882, a foreign person is subject to taxation in the United States on

a net income basis with respect to income that is effectively connected with a U.S. trade or business

(ECI). A foreign person may also be subject to a 30 percent gross basis tax with respect to U.S.-

source fixed or determinable annual or periodical gains, profits or income (FDAP) and certain capital

gains that do not constitute ECI. A foreign person generally is not subject to U.S. tax on foreignsource income that does not constitute ECI.

Section 864(c) provides rules for determining whether income is ECI. The test for determining

whether income is effectively connected with a U.S. trade or business differs depending on whether

the income at issue is U.S.-source or foreign source. U.S.-source FDAP is ECI if it is derived from

assets used in or held for use in the active conduct of a trade or business in the United States or from

business activities conducted in the United States. All U.S.-source income other than FDAP

automatically constitutes ECI. 

Foreign-source income may constitute ECI only if it consists of certain enumerated types of

income -- rents, royalties, dividends, interest, gains from the sale of inventory property, and insurance

income -- and certain other conditions are met. In the case of dividends and interest, the income must

be attributable to an office of the foreign person in the United States and the foreign person must

derive the income in the active conduct of a banking, financing or similar business within the United

States or be a foreign corporation engaged in business in the United States whose principal business

is trading in stocks or securities for its own account. 

Court decisions have held that the source of certain types of payments -- such as acceptance

and confirmation letter of credit and loan guarantee fees -- should be determined by analogy to the

rules for determining the source of interest income because the recipient is being compensated for

substituting its credit for the credit of the person whose obligations are being guaranteed. As a result,

the payment is foreign source if the person being guaranteed is a foreign person. 

Reasons for Change

The rules for determining whether income that is sourced by analogy to interest and dividends

is ECI should be the same as the rules for determining whether interest and dividends themselves

would be ECI. The current rules create arbitrary distinctions between economically similar

transactions that are equally related to the U.S. trade or business. Guarantees of foreign risk by a

U.S. trade or business are closely analogous to an extension of credit through the material activities

of the U.S. office or fixed place of business, but currently are treated differently. For example, under

current law, a short-term loan to a foreign customer by the U.S. branch of a foreign corporation would
- 170 -

generate ECI, while the guarantee of a note which the foreign customer could then negotiate in order

to raise cash would not.

Proposal

The proposal would expand the categories of foreign-source income that could constitute ECI

under section 864(c)(4)(B)(ii) to include interest equivalents and dividend equivalents. Such income

would constitute ECI in the same circumstances as dividends or interest. For these purposes, the term

“interest equivalent” would include letter of credit fees, guarantee fees and loan commitment fees

(whether or not the loan is actually made). 

The proposal does not affect the determination of whether such interest or dividend equivalents

would be U.S.-source or foreign-source. 

The proposal would be effective for taxable years beginning after date of enactment.
- 171 -

RECAPTURE OVERALL FOREIGN LOSSES WHEN CFC STOCK IS DISPOSED

Current Law

Section 904(f) establishes a regime for the treatment of overall foreign losses (OFLs). Under

section 904(f)(3), if a taxpayer disposes of trade or business property used predominantly outside the

United States, any gain arising from such disposition may be recharacterized as U.S. source income

up to the lesser of the amount of the gain, or the amount of outstanding OFLs (without being subject

to the 50 percent limitation on recapture in section 904(f)(1)). However, for purposes of section

904(f), stock is not treated as trade or business property for purposes of the recapture rules. If,

therefore, a domestic corporation disposes of stock in a subsidiary, gain on such disposition is not

subject to the section 904(f)(3) disposition rules.

Reasons for Change

A U.S. corporation may choose to conduct its operations through a subsidiary controlled

foreign corporation (CFC), rather than directly through ownership of foreign assets. Under the

interest allocation rules of section 864(e) and §1.861-9T, interest is allocated to foreign sources based

not only on the value of foreign assets, but also on the tax book value of the stock of any CFCs owned

by the U.S. corporation. Ownership of stock in a foreign subsidiary can, therefore, lead to, or

increase, an overall foreign loss by increasing interest deductions allocated against foreign income.

If, however, following the creation of this OFL the CFC is, for example, spun off to unaffiliated

shareholders, OFLs which relate to ownership of the CFC may never be recaptured. The proposal

corrects this asymmetry.

Proposal

For purposes of section 904(f), the property subject to the recapture rules upon disposition

under section 904(f)(3) would include stock in a controlled foreign corporation. The proposal would

be effective from date of enactment.
- 172 -

AMEND 80/20 COMPANY RULES

Current Law

A portion of interest and dividends paid by a domestic corporation is effectively exempt from

U.S. withholding tax provided the corporation qualifies as a so-called 80/20 corporation. In general,

interest or dividends paid by a domestic corporation will be treated as interest or dividends from an

80/20 corporation if at least 80 percent of the gross income of the corporation for the testing period

is foreign source income attributable to the active conduct of a foreign trade or business (or the foreign

business of a subsidiary). The testing period is the three year period preceding the year of the

dividend.

Reasons for Change

The testing period relevant for determining 80/20 company status is subject to manipulation

such that certain foreign persons may utilize the 80/20 company rules in order to improperly avoid

U.S. withholding tax with respect to certain distributions attributable to U.S. source earnings of a

subsidiary.

Proposal

The proposal would prevent taxpayers from manipulating the testing period in order to avoid

U.S. withholding tax on certain distributions attributable to U.S. source earnings by applying the 80/20

test on a group-wide basis. For this purpose, the group would include the U.S. corporation making

the payment, as well as any subsidiary in which that corporation owns, directly or indirectly, at least

50 percent of the stock.

The proposal would apply to interest or dividends paid or accrued more than 30 days after the

date of enactment.
- 173 -

MODIFY FOREIGN OFFICE MATERIAL PARTICIPATION EXCEPTION

APPLICABLE TO INVENTORY SALES ATTRIBUTABLE

TO NONRESIDENT'S U.S. OFFICE

Current Law

Foreign corporations and nonresident alien individuals engaged in a trade or business within

the United States are taxable on a net basis on their taxable income that is effectively connected with

the conduct of a U.S. trade or business. The determination of whether income is effectively connected

depends in part on whether the income is from sources within the United States or without the United

States. In general, if a nonresident maintains an office or other fixed place of business in the United

States, income from any sale of personal property (including inventory property) attributable to such

place of business is sourced in the United States. As a result, such income is treated as effectively

connected with the conduct of the U.S. trade or business and is subject to net basis taxation.

However, this general rule does not apply to any sale of inventory property that is sold for use,

disposition, or consumption outside the United States if an office or other fixed place of business of

the taxpayer in a foreign country materially participates in the sale. Under these circumstances, the

source of the income depends on where title to the inventory property passes. As a result, if title

passes outside the United States, the income is not treated as effectively connected with the conduct

of a U.S. trade or business, and is not subject to tax by the United States.

Reasons for Change

As a result of this material participation exemption, the sale of inventory property for use,

disposition, or consumption outside the United States may not be subject to United States taxation

even though the sale is attributable to an office or other fixed place of business in the United States.

Moreover, the sale may not be subject to taxation in any other jurisdiction. The United States should

not cede its jurisdiction to tax sales of inventory property that are attributable to an office or other

fixed place of business in the United States unless the sale is actually taxed by a foreign country at

some minimal level.

Proposal

The proposal would provide that the source rule exception for sales of inventory property for

use, disposition, or consumption outside the United States in which the nonresident’s foreign office

or other fixed place of business materially participates shall apply only if an income tax equal to at least

10 percent of the income from the sale is actually paid to a foreign country with respect to such

income. The proposal would be effective for transactions occurring on or after the date of enactment.
- 174 -

STOP ABUSE OF CONTROLLED FOREIGN CORPORATION (CFC) EXCEPTION

TO OWNERSHIP REQUIREMENTS OF SECTION 883

Current Law 

Section 887 of the Code imposes a 4 percent tax on the United States source gross

transportation income of nonresident alien individuals and foreign corporations, if the income is not

effectively connected with a United States trade or business. Sections 871 and 882 impose tax on

income that is effectively connected with a United States trade or business at the graduated rates that

apply to U.S. persons. However, sections 872(b)(1) and (2) and section 883 provide that the gross

income of nonresident alien individuals and foreign corporations is not to include income from the

international operation of ships or aircraft derived by such foreign persons resident in a foreign country

that grants an equivalent exemption to U.S. persons, either by agreement or under domestic law. To

prevent abusive use of “exemption-country” corporations by residents of non-exemption countries,

section 883(c) denies the exclusion from gross income to corporations that are 50 percent or more

owned by individuals who are not residents of an exemption country. That exception to the exclusion

does not apply, however, to a foreign corporation that is a controlled foreign corporation (a “CFC”).

Section 883(c)(2). That is, if a foreign corporation is a CFC, there are no (further) restrictions placed

on its ownership with respect to eligibility for the exclusion. Thus, a CFC formed in an exemption

country may exclude its international shipping income from gross income, regardless of the nationality

of its ultimate owners. 

In general, a CFC is a foreign corporation that is more than 50 percent owned by U.S. persons

that each own 10 percent or more of the foreign corporation. A partnership organized in the U.S. or

under U.S. law is a U.S. person for these purposes, regardless of the nationality of its owners. Thus,

a foreign corporation that is wholly owned by non-resident aliens through a U.S. partnership is a CFC.

Such a corporation is thereby eligible for the exemption regardless of whether its ultimate individual

owners are residents of exemption countries.

Reasons for Change

Foreign persons from non-exemption countries are forming U.S. partnerships and then having

the partnerships form corporations resident in exemption countries. The foreign corporations are

CFCs because they are wholly owned by U.S. persons (the U.S. partnerships), and therefore the antiabuse rule of section 883(c) requiring exemption country ownership does not apply. In this manner,

the foreign persons achieve exemption of their foreign corporations’ international ship and aircraft

transportation income from the 4 percent gross tax under section 887 and from the tax on effectively

connected income. Thus, interposing the U.S. partnership eliminates an otherwise applicable U.S. tax

by circumventing an anti-abuse rule. Besides allowing foreign persons to avoid U.S. tax, the

provisions provide a disincentive for countries to enter into reciprocal exemption agreements with the

United States, as the exemption from United States tax is already easily and generally available to their

residents.
- 175 -

Proposal

The Code would be amended to provide that the anti-abuse rule of Code section 883(c)(2)

requiring at least 50 percent ownership by foreign individuals who are residents of an exemption

country shall apply unless more than 50 percent of the stock of the CFC is owned (within the meaning

of Code section 958(b)) by United States shareholders that are individuals or corporations required

to include in gross income the subpart F income of the CFC . That narrows the exception and ensures

the exception is available only when U.S. persons subject to U.S. tax own the CFC. That should

prevent the abuse and, in addition, encourage countries to negotiate reciprocal exemptions with the

United States. It is intended that no inference be drawn from this proposal regarding the authority of

the Secretary to achieve the same result through the issuance of regulations. The provision would be

effective for taxable years beginning after the date of enactment.
- 176 -

REPLACE SALES-SOURCE RULES WITH ACTIVITY-BASED RULES

Current Law

The foreign tax credit generally reduces U.S. tax on foreign source income, but does not

reduce U.S. tax on U.S. source income. Where products are manufactured in the United States and

sold abroad, Treasury regulations provide that 50 percent of such income generally is treated as earned

in production activities, and sourced on the basis of the location of assets held or used to produce

income which is derived from the export sales. The remaining 50 percent of the income is treated as

earned in sales activities and sourced based on where title to the inventory transfers. Thus, if a U.S.

manufacturer sells inventory abroad, half of the income generally is treated as derived from domestic

sources, and half of the income generally is treated as derived from foreign sources. However, the

taxpayer may use a more favorable method if it can establish to the satisfaction of the IRS that more

than half of its economic activity occurred in a foreign country. Different rules apply to the export of

natural resources.

Reasons for Change

The existing 50/50 rule provides a benefit for U.S. exporters that also operate in high-tax

foreign countries. Thus, U.S. multinational exporters have a competitive advantage over U.S.

exporters that conduct all their business activities in the United States. Different categories of

exporters should be treated equally.

In addition, the United States has established an income tax treaty program that encompasses

approximately 50 countries during the 70 years since the 50/50 rule of current law has been in place.

These treaties protect export sales income from local taxation in the country where the goods are sold.

Now that export sales income generally is not subject to foreign tax, it is not appropriate to maintain

the existing allowance of foreign tax credits against that income.

Proposal

Under the proposal, the 50/50 rule would be replaced by a rule requiring that the allocation

between production activities and sales activities be based on actual economic activity.

The proposal would not change the tax rules that apply to the export of natural resources. 

The proposal would be effective for taxable years beginning after the date of enactment. 
- 177 -

MODIFY RULES RELATING TO FOREIGN OIL AND GAS EXTRACTION INCOME

Current Law

The United States taxes U.S. persons on their worldwide income. A credit against U.S. tax

on foreign income is allowed for foreign income taxes paid by the U.S. person. In addition, a credit

is allowed to a U.S. corporation for foreign taxes paid by certain foreign subsidiary corporations upon

payment of an actual or deemed dividend by the subsidiary (the “deemed paid” or “indirect” foreign

tax credit).

To be a creditable income tax, a foreign levy must be the substantial equivalent of an income

tax in the U.S. sense, regardless of the label the foreign government attaches to it. Under regulations,

a foreign levy is a tax if it is a compulsory payment under the authority of a foreign government to levy

taxes and is not compensation for a specific economic benefit provided by the foreign country.

Taxpayers that are subject to a foreign levy and that also receive (directly or indirectly) a specific

economic benefit from the levying country are referred to as “dual capacity” taxpayers and may not

claim a credit for that portion of the foreign levy paid as compensation for the specific economic

benefit received. Under a regulatory safe-harbor test, if a country has a generally imposed income tax,

the dual-capacity taxpayer may treat as a creditable tax the portion of the levy that application of the

generally imposed income tax would yield (to the extent the levy otherwise constitutes an income tax

or an “in lieu of” tax); the balance is treated as compensation for the specific economic benefit. If

there is no generally imposed income tax, the regulation treats as a creditable tax that portion of the

payment that does not exceed the applicable U.S. tax rate applied to net income. A foreign tax is

treated as “generally imposed” even if it applies only to persons who are not residents or nationals of

that country.

There is no separate section 904 foreign tax credit “basket” for oil and gas income. However,

under section 907, the amount of creditable foreign taxes imposed on FOGEI is limited in any year to

the applicable U.S. tax on that income.

Reasons for Change

The purpose of the foreign tax credit is to avoid double taxation of income by both the United

States and a foreign jurisdiction. When a payment to a foreign government is made as compensation

for a specific economic benefit, there is no incidence of double taxation. Current law recognizes the

distinction between creditable taxes and non-creditable payments for a specific economic benefit but

fails to achieve the appropriate split between the two in a case where a foreign country imposes a levy

on, for example, oil and gas income only, but has no generally imposed income tax. 

Proposal

The proposal would treat payments by a dual-capacity taxpayer to a foreign country that would

otherwise qualify as income taxes or “in lieu of” taxes as taxes only if there is a “generally applicable

income tax” in that country. For this purpose, a generally applicable income tax is an income tax (or
- 178 -

a series of income taxes) that applies to trade or business income from sources in that country, so long

as the levy has substantial application both to non-dual-capacity taxpayers and to persons who are

citizens or residents of that country. The proposal thus would replace that part of the regulatory safe

harbor that treats a foreign levy as a tax up to the amount of the U.S. tax where the foreign country

has no generally applicable income tax. The proposal generally would retain the rule of current law

where the foreign country does generally impose an income tax. In that case, credits would be allowed

up to the level of taxation that would be imposed under that general tax, so long as the tax satisfies

the statutory definition of a “generally applicable income tax.” The proposal also would convert the

special foreign tax credit limitation rules of current-law section 907 into a new foreign tax credit

basket within section 904 for foreign oil and gas income. 

The proposal would be effective for taxable years beginning after the date of enactment. The

proposal would yield to U.S. treaty obligations that allow a credit for taxes paid or accrued on certain

oil or gas income.
- 179 -

Pensions

INCREASE ELECTIVE WITHHOLDING RATE FOR NONPERIODIC

DISTRIBUTIONS FROM DEFERRED COMPENSATION PLANS

Current Law

Under current law, section 3405 provides that the payor of any Adesignated distribution@ that

is a nonperiodic distribution must withhold ten percent of the amount of the distribution unless the

individual to whom the distribution is to be made elects not to have any amount withheld from the

distribution. The term Adesignated distribution@ means any distribution from an employer deferred

compensation plan (including a qualified plan), an individual retirement account or annuity, or a

commercial annuity. The term does not include any amount otherwise treated as wages, the portion

of any distribution which it is reasonable to believe is not includable in gross income, any amount

subject to withholding of tax on nonresident aliens and foreign corporations, and certain dividends paid

with respect to employee stock ownership plans. This ten-percent elective withholding under section

3405 does not apply in the case of Aeligible rollover distributions@ from qualified plans (which are

subject to 20-percent mandatory withholding unless the participant elects a Adirect rollover@). 

Reasons for Change

The ten-percent withholding rate for nonperiodic distributions is generally too low for

taxpayers who wish to have the proper amount withheld from such distributions. Because this

withholding is elective, the withholding rate should more closely approximate the amount of tax

liability that the taxpayer will have with respect to the distribution.

Proposal

The proposal would increase the 10 percent elective withholding rate on nonperiodic

distributions (such as lump sum distributions) from pensions, IRAs and annuities to 15 percent. Thus,

a nonperiodic distribution from a deferred compensation plan would be subject to 15-percent federal

income tax withholding unless the recipient of the distribution elected not to have withholding apply.

The proposal would be effective for distributions made after 1999.
- 180 -

INCREASE SECTION 4973 EXCISE TAX

FOR EXCESS IRA CONTRIBUTIONS

Current Law

A taxpayer’s regular contributions to all of his or her IRAs for a year are limited to the lesser

of $2,000 or the taxpayer’s compensation for that year. A special rule for married taxpayers permits

one spouse to treat the other spouse’s compensation as his or her own for purposes of the limit on

regular contributions. Any contribution in excess of the contribution limit is subject to the six-percent

excise tax under section 4973 unless it is distributed to the taxpayer (with allocable net income) under

section 408(d)(4) by the federal income tax return due date (with extensions) for the year of the

contribution.

AQualified distributions@ from a Roth IRA are not includable in gross income. A qualified

distribution is a distribution that is both (1) made after the end of the five-taxable-year period that

begins with the first taxable year for which an individual first makes any regular or conversion

contribution to a Roth IRA and (2) made at any time after the Roth IRA owner has reached age

59-1/2, made to a beneficiary (or to the Roth IRA owner’s estate) after the Roth IRA owner’s death,

attributable to the Roth IRA owner’s being disabled, or made for certain first-time home purchases.

The statute does not preclude amounts attributable to excess contributions (other than excess

contributions and net allocable income distributed under section 408(d)(4)) from constituting qualified

distributions if they satisfy these requirements.

Reasons for Change

The potential to secure qualified-distribution treatment for amounts attributable to excess Roth

IRA contributions may encourage taxpayers to make regular Roth IRA contributions in excess of the

applicable limits. As a policy matter, it is inappropriate for taxpayers intentionally to make excess

contributions. If the Roth IRA has significant investment returns, the annual six-percent excise tax

under section 4973 may not provide adequate disincentive for making such contributions. 

Proposal

The proposal would increase the section 4973 excise tax for excess contributions to IRAs

(including Roth and traditional IRAs). Under the proposal, the excise tax would remain at six percent

for the taxable year for which an excess contribution is made but would be increased to ten percent

for each subsequent taxable year. 

The proposal would be effective for taxable years beginning after December 31, 1999.
- 181 -

PLACE LIMITATION ON PRE-FUNDING OF WELFARE BENEFITS

Current Law

Sections 419 and 419A generally limit the deduction available for contributions to welfare

benefit funds used to fund and pre-fund welfare benefit expenses. Section 419A(f)(6) provides an

exception to these deduction rules for amounts contributed to multiple employer welfare benefit funds

that (i) have at least 10 employers, none of whom normally contributes more than 10 percent of the

total contributions, and (ii) do not maintain experience rating arrangements with respect to individual

employers. In 1995, Notice 95-34, 1995-1 C.B. 309 was issued informing taxpayers that certain

severance pay and death benefit arrangements that did not satisfy the requirements of the section

419A(f)(6) exemption did not provide the deductions claimed by the promoters for a number of

reasons. In 1997, the Tax Court ruled that an employer’s deductions for contributions to certain of

these arrangements were limited because the arrangements did not qualify as 10 or more employer

plans. See Robert D. Booth and Janice Booth v. Commissioner, 108 T.C. No. 25 (1997). Several

other cases are in progress.

Reasons for Change

Sections 419 and 419A were enacted to limit abusive practices associated with the pre-funding

of welfare benefits, and generally limit the prefunding of welfare benefits, including severance benefits

and benefits provided pursuant to life insurance contracts. Congress permitted a limited exception to

the general limitations for certain multiple employer welfare benefit funds with 10 or more

participating employers where the relationship of participating employers would be closer to the

relationship of insureds to an insurer than to the relationship of an employer to a fund.

Promoters have been aggressively marketing multiple employer welfare benefit funds that they

claim qualify for the 10-or-more-employer exception, even though these arrangements lack the

characteristics of insurance. In particular, the requirement of the exception that there not be

experience rating with respect to participating employers has proven to be difficult to enforce with

respect to certain types of benefits, such as severance and certain death benefits, because the

complexities of the arrangements disguise experience rating. As a result, it appears that in many cases

this requirement has effectively been ignored, and there has been extensive activity involving programs

that rely on the expectation of each participating employer that its contributions will be used to fund

or purchase benefits for its own employees. 

 The arrangements being promoted to high-income taxpayers sometimes are sold as alternatives

to qualified retirement plans and are designed to avoid the deduction rules applicable to traditional

welfare benefit and nonqualified deferred compensation arrangements, which would generally require

that the deduction for the employer be deferred until benefits are paid. In many cases, these

arrangements claim to offer employee-owners tax-deductible cash value life insurance, with the cash

value to be transferred to the employee-owner at a later date. Thus, a participating employer (typically

a closely held corporation owned by one or more high-income taxpayers) that contributes to such a
- 182 -

shelter arrangement is promised a current deduction for benefits to be paid to its employee-owners in

the future, a deduction that has been foreclosed in most cases by other provisions of the Code. 

Proposal

The exception contained in section 419A(f)(6) would be limited to medical, disability, and

group term life insurance benefits. These benefits do not present the same potential for abuse as

severance pay and death benefits (other benefits paid through than group term life insurance). Thus,

effective for contributions paid after the date of enactment, the existing deduction limits of the Code

would apply to any plan if the plan provides benefits other than medical, disability and group term life

insurance benefits. Thus, an employer would be prohibited from claiming a current deduction for

severance pay, life insurance (other than group term life insurance), supplemental unemployment

benefits, or other benefits in future years. In addition, rules would be added to prevent amounts

deducted in accordance with the 10-or-more-employer exception of section 419A(f)(6), and earnings

attributable to such amounts, from being used to pay benefits other than medical, disability or group

term life insurance benefits. No inference should be drawn regarding the validity, if any, of these

arrangements under current law. 

The proposal would be effective with respect to contributions paid after the date of enactment.
- 183 -

SUBJECT SIGNING BONUSES TO EMPLOYMENT TAXES

Current Law

Bonuses paid to individuals for signing their first contracts of employment are ordinary income

in the year received. However, IRS Revenue Ruling 58-145 provides that bonuses that do not require

the performance of later services do not represent remuneration for services and thus are not Awages@

for purposes of income tax withholding. Similarly, to the extent that a bonus payment is not

remuneration for services, the bonus would not be Awages@ for purposes of FICA taxes. 

Reason for Change

Withholding on signing bonuses could improve compliance and enforcement and eliminate the

deferral of the tax payment. These bonuses are inextricably tied to the employment of the individual

and are more appropriately treated as remuneration for services.

Proposal

The proposal would impose income tax withholding on signing bonuses and clarify that signing

bonuses are subject to other employment taxes, without regard to whether the bonus is conditioned

on any additional action by the recipient. No inference is intended with respect to the application of

prior law withholding rules to signing bonuses. 

The proposal would be effective for signing bonuses paid after the date of enactment.
- 184 -

Compliance

EXPAND REPORTING OF CANCELLATION OF INDEBTEDNESS INCOME

Current Law

Taxable income includes income from the cancellation of indebtedness. If a bank, thrift

institution, or credit union discharges $600 or more of any indebtedness of a debtor, the institution

must report such discharge to the debtor and the IRS. 

Reasons for Change

A significant amount of indebtedness is originated and held by institutions in the trade or

business of lending that are not banks, thrift institutions, or credit unions. Loans made and held by

these nonregulated institutions resemble loans made by regulated institutions. Thus, it is appropriate

that the reporting requirements imposed upon regulated lending institutions also should be applied to

regulated lending institutions. Such additional reporting will facilitate tax compliance with respect to

discharged loans.

Proposal

The proposal would extend the cancellation of indebtedness reporting requirements to

additional entities involved in the trade or business of lending, effective for cancellations on or after

the date of enactment.
- 185 -

TIGHTEN THE SUBSTANTIAL UNDERSTATEMENT PENALTY

FOR LARGE CORPORATIONS

Current Law

 Currently, taxpayers may be penalized for erroneous, but non-negligent, return positions only

if the taxpayer did not have “substantial authority” for the claimed position, the taxpayer did not

disclose the position in a statement or return, and the amount of the understatement is “substantial.”

(Special rules apply in the case of tax shelters.) “Substantial” is defined for this purpose as the greater

of $5,000 ($10,000 for certain corporations) or 10 percent of the taxpayer's total tax liability.

Reasons for Change

Under the current definition of “substantial,” large corporations are allowed to have a very

sizable understatement that does not exceed 10 percent of their total tax bill. This may encourage

them to take very aggressive tax positions. In effect, they can “play the audit lottery” without any

downside risk of a penalty if they are caught, even if huge amounts of potential tax liability are at

stake.

Proposal

The proposal would treat a corporation's deficiency of more than $10 million as substantial for

purposes of the substantial understatement penalty, whether or not it exceeds 10 percent of the

taxpayer’s total tax liability. This proposal should help to deter aggressive tax planning by large

corporate taxpayers that have tax liabilities of $100 million or more.

The proposal would be effective for taxable years beginning after the date of enactment.
- 186 -

REQUIRE WITHHOLDING ON CERTAIN GAMBLING WINNINGS

Current Law

Proceeds of most wagers with odds of less than 300 to 1 are exempt from withholding, as are

all bingo and keno winnings.

Reasons for Change

Withholding on gambling winnings would improve compliance and enforcement.

Proposal

The proposal would impose withholding on proceeds of bingo or keno in excess of $5,000 at

a rate of 28 percent, regardless of the odds of the wager. The proposal would be effective for

payments made after the beginning of the first month that begins at least 10 days after the date of

enactment.
- 187 -

INCREASE PENALTIES FOR FAILURE TO FILE

CORRECT INFORMATION RETURNS

Current Law 

Any person who fails to file required information returns in a timely manner or incorrectly

reports such information is subject to penalties. The amount of the penalty is generally $50 for each

return with respect to which a penalty is incurred, not to exceed $250,000 during any calendar year.

If any failure or error is corrected within 30 days after the required filing date, the penalty imposed is

$15 per return, not to exceed $75,000. Failures corrected more than 30 days after the required filing

date but before August 1 are subject to a $30 per return penalty, not to exceed $150,000 in any

calendar year.

Reasons for Change 

For taxpayers filing large volumes of information returns or reporting significant payments, the

general penalty provisions may not be sufficient to encourage timely and accurate reporting. By basing

the penalty amount on either the number of returns or amount to be reported, the proposal encourages

taxpayers to assure both the accuracy and timeliness of information on each return and in the

aggregate. 

Proposal 

The proposal would increase the general penalty amount for any failure to the greater of $50

per return or 5 percent of the total amount required to be reported, subject to the overall dollar

limitations. The increased penalty would not apply if the aggregate amount actually reported by the

taxpayer on all returns filed for that calender year was at least 97 percent of the amount required to

be reported. The proposal would be effective for returns the due date for which (without regard to

extensions) is more than 90 days after the date of enactment of the proposal. 
- 188 -

Miscellaneous

MODIFY DEPOSIT REQUIREMENT FOR FEDERAL UNEMPLOYMENT ACT (FUTA)

Current Law

The Federal Unemployment Tax Act (FUTA) currently imposes a federal payroll tax on

employers of 6.2 percent of the first $7,000 paid annually to each employee. The tax funds a portion

of the federal/state unemployment benefits system. States also impose an unemployment tax on

employers. Employers in States that meet certain federal requirements are allowed a credit for State

unemployment taxes of up to 5.4 percent, making the minimum net federal tax rate 0.8 percent.

Generally, federal and State unemployment taxes are collected quarterly and deposited in federal trust

fund accounts.

Reasons for Change

Accelerating collections may reduce losses to the federal unemployment trust funds caused by

employer delinquencies and provide a regular inflow of money into State funds to offset the regular

payment of benefits. Limiting the application of acceleration to larger employers would avoid

imposing additional burdens on small businesses. 

Proposal

The proposal would require an employer to pay federal and State unemployment taxes on a

monthly basis in a given year if the employer’s FUTA tax liability in the prior year was $1,100 or more

(reflecting approximately 20 employees earning at least $7,000). A safe harbor would be provided for

the required deposits for the first two months of each calendar quarter. For the first month in each

quarter, the payment would be required to be the lesser of 30 percent of the actual FUTA liability for

the quarter or 90 percent of the actual FUTA liability for the month. The cumulative deposits paid

in the first two months of each quarter would be required to be the lesser of 60 percent of the actual

FUTA liability for the quarter or 90 percent of the actual FUTA liability for the two months. The

employer would be required to pay the balance of the actual FUTA liability for each quarter by the last

day of the month following the quarter. States would be allowed to provide a similar mechanism for

paying State unemployment taxes.

The collection proposal would be effective for months beginning after December 31, 2004.
- 189 -

REINSTATE OIL SPILL LIABILITY TRUST FUND TAX

Current Law

Before January 1, 1995, a five-cents-per-barrel excise tax was imposed on domestic crude oil

and imported petroleum products. The tax was dedicated to the Oil Spill Liability Trust Fund to

finance the cleanup of oil spills and pay other costs associated with oil pollution. The tax was not

imposed for a calendar quarter if the unobligated balance in the Trust Fund exceeded $1 billion at the

close of the preceding quarter.

Reasons for Change

It is essential that the Oil Spill Liability Trust Fund remain funded because of the continuing

potential for oil spills and the magnitude of damages such spills can cause. Moreover, the full funding

level was last changed by the Omnibus Budget Reconciliation Act of 1989 and is no longer adequate.

After the enactment of the current $1 billion limitation, the Oil Pollution Act of 1990 permitted the

use of amounts in the Trust Fund for additional expenditure purposes and doubled the limits on Trust

Fund expenditures with respect to a single incident (increasing the overall limit from $500 million to

$1 billion and the limit for natural resource damages payments from $250 million to $500 million).

In addition, the Department of the Treasury's authority to advance up to $1 billion to the Trust Fund

expired in 1994.

Proposal

The Oil Spill Liability Trust Fund excise tax would be reinstated for the period after the date

of enactment and before October 1, 2009. In addition, the full funding limitation would be increased

from $1 billion to $5 billion, effective on the date of enactment.
- 190 -

SIMPLIFY FOSTER CHILD DEFINITION UNDER EITC

Current Law

A taxpayer is eligible to claim the earned income tax credit (EITC) if he or she resides with a

son, daughter, or grandchild for over half the year. EITC qualifying children also include foster

children, defined to mean individuals who reside with a taxpayer for a full year and whom the taxpayer

“cares for as the taxpayer’s own child.” All EITC qualifying children (including foster children) must

either be under the age of 19 (24 if a full-time student) or permanently and totally disabled.

When more than one taxpayer can meet the eligibility criteria with respect to the same child,

only the taxpayer with the highest modified adjusted gross income may claim the credit.

Reasons for Change

The foster child rule is difficult to administer. For example, some taxpayers claim unrelated

children for EITC purposes, by arguing that they lived with the child’s parent and “cared for the child

as if the child was their own.” Without more objective standards regarding the definition of a foster

child, the IRS cannot easily determine whether, in fact, these taxpayers are eligible for the EITC.

Clarifying the definition of a foster child would prevent unintentional errors by confused

taxpayers, reduce potential abuse by noncompliant taxpayers, and provide better guidance to the IRS

when investigating questionable claims.

 

Proposal

In addition to the existing requirement that the foster child be a child who is cared for by the

taxpayer as if he or she were the taxpayer’s own child, the proposal requires that a foster child, for

purposes of claiming the EITC, also meet a specified relationship test. Under this test, the foster child

must be the taxpayer’s sibling (or descendant of the taxpayer’s sibling), or be placed in the taxpayer’s

home by an agency of a State or one of its political subdivisions or a tax-exempt child placement

agency licensed by a State. The proposal would be effective for taxable years beginning after

December 31, 1999.
- 191 -

REPEAL PERCENTAGE DEPLETION FOR NON-FUEL MINERALS

MINED ON FEDERAL AND FORMERLY FEDERAL LANDS

Current Law

Taxpayers are allowed to deduct a reasonable allowance for depletion relating to certain hard

mineral deposits. The depletion deduction for any taxable year is calculated under either the cost

depletion method or the percentage depletion method, whichever results in the greater depletion

allowance for the year.

Under the cost depletion method, the taxpayer deducts that portion of the adjusted basis of the

property that is equal to the ratio of the units sold from that property during the taxable year to the

estimated total units remaining at the beginning of that year.

Under the percentage depletion method, a deduction is allowed in each taxable year for a

statutory percentage of the taxpayer's gross income from the property. The percentage depletion

deduction for these minerals may not exceed 50 percent of the net income from the property for the

taxable year (computed without allowance for depletion). Percentage depletion is not limited to the

taxpayer's basis in the property; thus, the aggregate amount of percentage depletion deductions

claimed may exceed the amount expended by the taxpayer to acquire and develop the property.

The 1872 mining act has allowed investors to acquire mining rights on Federal lands at a cost

of $5.00 per acre or less.

Reasons for Change

The percentage depletion provisions under current law generally are viewed as an incentive

for mineral production rather than as a normative rule for recovering the taxpayer's investment in the

property. This incentive is excessive, however, with respect to minerals acquired under the 1872

mining act, in light of the minimal costs of acquiring these mining rights. In addition, the measurement

of income in the affected industries will be improved by the repeal of these percentage depletion

provisions.

Proposal

The proposal would repeal percentage depletion provisions under current law for non-fuel

minerals mined on Federal lands where the mining rights were originally acquired under the 1872 law,

and on private lands acquired under the 1872 law. The proposal would be effective for taxable years

beginning after the date of enactment.
- 192 -

IMPOSE EXCISE TAX ON PURCHASE OF STRUCTURED SETTLEMENTS

Current Law

Current law facilitates the use of structured personal injury settlements by permitting a

defendant to assign to a structured settlement company (ASSC@) the liability to make periodic payments

to an injured person, such that the defendant can deduct the payment immediately, but the SSC does

not include the amount received from the defendant in income. This favorable treatment is conditioned

on a requirement that the periodic payments cannot be accelerated, deferred, increased or decreased

by the injured person. If the SSC purchases a deferred annuity contract to fund the liability, it is

exempted from the section 72(u) inclusion of inside buildup, and is subject to the more favorable rules

of annuity taxation usually applicable only to individual owners. As a result, the income under the

annuity is taxable to the SSC only upon receipt by the SSC, at which time the SSC is entitled to an

offsetting deduction for corresponding payments to the injured person. The exclusion for physical

personal injury damages applies also to amounts received periodically, thus effectively exempting the

interest income in the hands of the injured person from tax as well.

Reasons for Change

Congress enacted favorable tax rules intended to encourage the use of structured settlements

--and conditioned such tax treatment on the injured person’s inability to accelerate, defer, increase or

decrease the periodic payments --because recipients of structured settlements are less likely than

recipients of lump sum awards to consume their awards too quickly and require public assistance.

Consistent with the condition that the injured person not be able to accelerate, defer, increase

or decrease the periodic payments, SSC agreements with injured persons uniformly contain

anti-assignment clauses. Notwithstanding these contractual provisions, however, many injured persons

are willing to accept heavily discounted lump sum payments from certain Afactoring@ companies in

consideration for their payment streams. These Afactoring@ transactions directly undermine the

Congressional objective to create an incentive for injured persons to receive periodic payments as

settlements of personal injury claims.

Proposal

Under the proposal, any person purchasing (or otherwise acquiring for consideration) a

structured settlement payment stream would be subject to a 40 percent excise tax on the difference

between the amount paid by the purchaser to the injured person and the undiscounted value of the

purchased income stream, unless such purchase is pursuant to a court order finding that the

extraordinary and unanticipated needs of the original intended recipient render such a transaction

desirable. The proposal would apply to purchases occurring after the date of enactment. No inference

is intended as to the contractual validity of the factoring transaction or its effect on the tax treatment

of any party other than the purchaser.
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REQUIRE TAXPAYERS TO INCLUDE RENTAL INCOME OF RESIDENCE IN

INCOME WITHOUT REGARD TO PERIOD OF RENTAL

Current Law

Gross income generally includes all income from whatever source derived, including rents.

Section 280A provides rules for determining deductibility of expenses attributable to rental property.

Section 280A(g) provides a de minimis exception to these rules where a dwelling unit is used during

the taxable year by the taxpayer as a residence and such dwelling unit is actually rented for less than

15 days during the taxable year. In this case, the income from such rental is not included in gross

income and no expenses arising from such rental use are allowed as a deduction.

Reasons for Change

The 15-day rule allows certain taxpayers to exclude from income large rental payments for the

short-term rental of the taxpayer’s residence. Similar exclusions are not provided for other types of

passive income such as interest, dividends or capital gains. Such amounts generally should be included

in income of the taxpayers.

Proposal

The proposal would repeal the 15-day rule of section 280A(g). Consequently, a taxpayer

would be required to include in gross income the rental income received with respect to the rental of

the residence without regard to the period of rental. The rules of section 280A would be applied to

determine deductibility of expenses attributable to the rental of such property. The proposal would

apply to taxable years beginning after December 31, 1999.
- 194 -

Other Provisions That Affect Receipts

REINSTATE ENVIRONMENTAL TAX IMPOSED ON CORPORATE TAXABLE

INCOME AND DEPOSITED IN THE

HAZARDOUS SUBSTANCE SUPERFUND TRUST FUND

Current Law

For taxable years beginning before January 1, 1996, a corporate environmental income tax was

imposed at a rate of 0.12 percent on the amount by which the modified alternative minimum taxable

income of a corporation exceeded $2 million. Modified alternative minimum taxable income was

defined as a corporation's alternative minimum taxable income, determined without regard to the

alternative minimum tax net operating loss deduction and the deduction for the corporate

environmental income tax.

The tax was dedicated to the Hazardous Substance Superfund Trust Fund (the Superfund

Trust Fund). Amounts in the Superfund Trust Fund are available for expenditures incurred in

connection with releases or threats of releases of hazardous substances into the environment under

specified provisions of the Comprehensive Environmental Response, Compensation, and Liability Act

of 1980 (as amended). Spending from the Superfund Trust Fund is classified as discretionary domestic

spending for Federal budget purposes.

Reasons for Change

The corporate environmental income tax should be reinstated because of the continuing need

for funds to remedy damages caused by releases of hazardous substances.

Proposal

The corporate environmental income tax would be reinstated for taxable years beginning after

December 31, 1998, and before January 1, 2010.
- 195 -

REINSTATE EXCISE TAXES DEPOSITED IN THE

HAZARDOUS SUBSTANCE SUPERFUND TRUST FUND

Current Law

The following Superfund excise taxes were imposed before January 1, 1996:

(1) An excise tax on domestic crude oil and on imported petroleum products at a rate of 9.7

cents per barrel;

(2) An excise tax on listed hazardous chemicals at a rate that varied from $0.22 to $4.87 per

ton; and

(3) An excise tax on imported substances that use as materials in their manufacture or

production one or more of the hazardous chemicals subject to the excise tax described in (2) above.

Amounts equivalent to the revenues from these taxes were dedicated to the Hazardous

Substance Superfund Trust Fund (the Superfund Trust Fund). Amounts in the Superfund Trust Fund

are available for expenditures incurred in connection with releases or threats of releases of hazardous

substances into the environment under specified provisions of the Comprehensive Environmental

Response, Compensation, and Liability Act of 1980 (as amended). Spending from the Superfund

Trust Fund is classified as discretionary domestic spending for Federal budget purposes.

Reasons for Change

The Superfund excise taxes should be reinstated because of the continuing need for funds to

remedy damages caused by releases of hazardous substances.

Proposal

The three Superfund excise taxes would be reinstated for the period after the date of enactment

and before October 1, 2009.
- 196 -

CONVERT A PORTION OF THE EXCISE TAXES DEPOSITED IN THE

AIRPORT AND AIRWAY TRUST FUND TO COST-BASED USER FEES ASSESSED

FOR FEDERAL AVIATION ADMINISTRATION (FAA) SERVICES

Current Law

The Airport and Airway Trust Fund is supported by taxes on air passenger transportation,

domestic air freight transportation, and aviation fuel. The current tax on domestic air passenger

transportation is 8 percent of the amount paid for the transportation plus $2.00 for each segment of

the transportation, the current tax on international departures and arrivals is $12.20 per person, and

the tax on domestic air freight transportation is 6.25 percent of the amount paid for the transportation.

The rate of tax on amounts paid for domestic air transportation is phased down to 7.5 percent after

September 30, 1999. The domestic segment fee is phased up in four steps to a fully phased-in fee of

$3.00 per segment after December 31, 2001. In addition, the segment fee is indexed for inflation

beginning in calendar year 2003 and the international arrival and departure fees are currently indexed

for inflation. The tax on aviation fuel, to the extent dedicated to the Trust Fund, is 4.3 cents per gallon

in the case of commercial aviation fuel, 19.3 cents per gallon in the case of gasoline used in

noncommercial aviation, and 21.8 cents per gallon in the case of noncommercial aviation fuel other

than gasoline.

Reasons for Change

As part of the Administration's effort to create a more business-like Federal Aviation

Administration, the excise taxes on domestic air passenger transportation, international departures and

arrivals, and domestic air freight transportation should be reduced and cost-based user fees imposed.

Proposal

The Administration will propose legislation to reduce the excise taxes on domestic air

passenger transportation, international departures and arrivals, and domestic air freight transportation

as more efficient cost-based user fees for air traffic services are phased in beginning in fiscal year 2000.

The excise taxes would be reduced as necessary to ensure that the amount collected each year from

the new user fees and from the excise taxes dedicated to the Airport and Airway Trust Fund is, in the

aggregate, equal to the total budget resources requested for the FAA in the succeeding year.
- 197 -

RECEIPTS FROM TOBACCO LEGISLATION

Current Law

The following is a listing of the Federal excise taxes imposed on tobacco products under

current law:

Calendar year Article Tax imposed

1999 Cigars:

Small cigars . . . . . . . . $1.125 per thousand

Large cigars . . . . . . . . 12.75% of manufacturer's price, up to

 $30.00 per thousand

Cigarettes:

Small cigarettes . . . . . $12.00 per thousand (24 cents per pack of

 20 cigarettes)

Large cigarettes . . . . . $25.20 per thousand

Cigarette papers . . . . . . . . . . . $0.0075 per 50 papers

Cigarette tubes . . . . . . . . . . . . $0.015 per 50 tubes

Chewing tobacco . . . . . . . . . . $0.12 per pound

Snuff . . . . . . . . . . . . . . . . . . . . $0.36 per pound

Pipe tobacco . . . . . . . . . . . . . . $0.675 per pound

2000 and 2001 Cigars:

Small cigars . . . . . . . . $1.594 per thousand

Large cigars . . . . . . . . 18.063% of manufacturer's price, up to

 $42.50 per thousand

Cigarettes:

Small cigarettes . . . . . $17.00 per thousand (34 cents per pack of

 20 cigarettes)

Large cigarettes . . . . . $35.70 per thousand

Cigarette papers . . . . . . . . . . . $0.0106 per 50 papers

Cigarette tubes . . . . . . . . . . . . $0.0213 per 50 tubes

Chewing tobacco . . . . . . . . . . $0.17 per pound

Snuff . . . . . . . . . . . . . . . . . . . . $0.51 per pound

Pipe tobacco . . . . . . . . . . . . . . $0.9567 per pound

Roll-your-own tobacco . . . . . . $0.9567 per pound

2002 or later Cigars:

Small cigars . . . . . . . . $1.828 per thousand

Large cigars . . . . . . . . 20.719% of manufacturer's price, up to

 $48.75 per thousand

Cigarettes:

Small cigarettes . . . . . $19.50 per thousand (39 cents per pack of
- 198 -

 20 cigarettes)

Large cigarettes . . . . . $40.95 per thousand

Cigarette papers . . . . . . . . . . . $0.0122 per 50 papers

Cigarette tubes . . . . . . . . . . . . $0.0244 per 50 tubes

Chewing tobacco . . . . . . . . . . $0.195 per pound

Snuff . . . . . . . . . . . . . . . . . . . . $0.585 per pound

Pipe tobacco . . . . . . . . . . . . . . $1.0969 per pound

Roll-your-own tobacco . . . . . . $1.0969 per pound

Reasons for Change

The Federal government incurs substantial amounts of tobacco-related health care costs. The

burden of these costs should be borne by the tobacco industry and tobacco users rather than by

taxpayers generally.

Proposal

The Administration will propose tobacco legislation providing for net revenues of

approximately $34 billion during the period from October 1, 1999, through September 30, 2004.