P94 

1992 

General Explanations 

of the 

President's Budget Proposals 

Affecting Receipts 

Department of the Treasury 

Library 

NOV 0 4 2005 

Department of the Treasury 

January 1992 

SUMMARY OF PROPOSALS 

The President's Budget contains tax proposals designed to create jobs, promote economic growth, assi

families, and promote health, education, savings and home ownership. The tax proposals are divided 

into four categories: (1) Jobs and Investments; (2) Families, Health, Education and Savings; (3) 

Homebuyers; and (4) Other Proposals Affecting Receipts. These proposals are summarized below: 

Jobs and Investments 

Enhance long-term investment by providing for the exclusion from income of up to 45 percent 

of long-term capital gains. 

Provide passive loss relief for real estate developers who materially participate in real estate 

development activity. 

Allow additional first-year depreciation of 15 percent of the cost of equipment acquired on or 

after February 15, 1992 and before January 1, 1993, and placed in service before July 1, 1993. 

Eliminate the depreciation component of the adjusted current earnings (ACE) adjustment for 

property placed in service on or after February 1, 1992. 

Make permanent the 20 percent credit for certain incremental research and experimentation 

(R&E ) expenditures. 

Extend for an additional 18 months the rules for allocating research and experimental (R&E) 

expenditures between domestic and foreign source income. 

Extend the low-income housing tax credit for an additional 18 months. 

Extend the targeted jobs tax credit for an additional 18 months. 

Extend the business energy tax credits for an additional 18 months. 

Extend for an additional 18 months the authority of State and local governments to issue firsttime farmer bonds. 

Establish enterprise zones. 

Modify the debt-financed income rules to facilitate investment in real estate by pension funds 

and qualified educational institutions. 

Repeal the luxury tax. on aircraft and boats and, to offset the revenue loss, repeal the exemption 

from the existing excise tax on diesel fuel sold for use in motor boats. 

- I -
Families, Health, Education and Savings 

• Allow the deduction of interest on student loans for higher education or post-secondary 

vocational education. 

• Establish flexible Individual Retirement Accounts (FIRAs) to which middle income taxpayers 

m a y make nondeductible contributions of up to $2,500 per year, and from which contributions 

and earnings ma y be withdrawn without tax after 7 years. 

• Promote retirement saving through a series of measures designed to encourage employers to 

sponsor retirement plans and simplify the taxation of pension distributions. 

• Waive the 10 percent penalty on early withdrawals from IRAs if the money is used for medical 

or educational expenses of the owner or the owner's spouse or children. 

• Extend for 18 months the deduction provided to self-employed individuals for 25 percent of the 

cost of health insurance coverage. 

• Extend Medicare hospital insurance coverage to State and local governmental employees hired 

prior to April 1, 1986 wh o are not presently assured of Medicare coverage. 

• Restore and double to $3,000 the special needs adoption deduction. 

• Increase to $60, from its present $21 level, the amount of employer-provided public transit pass 

expense that ma y be excluded from an employee's income. 

• Increase the personal exemption for dependent children age 18 and under by $500, effective 

October 1, 1992. 

Homebuyers 

• Provide first-time homebuyers a tax credit of up to $5,000 (to be divided over 2 years) for 

purchases of first homes on or after February 1, 1992 and before January 1, 1993. 

• Allow homeowners who sell their principal residences at a loss to claim a casualty loss deduction 

and, to the extent the casualty loss deduction is not allowed, roll the loss basis over into the 

basis of a new principal residence. 

• Waive the 10 percent penalty on early withdrawals from IRAs for first-time home purchases. 

• Extend for 18 months the authority for State and local governments to issue mortgage revenue 

bonds and mortgage credit certificates. 

- ii -
Other Proposals Affecting Receipts 

• Continue support for revenue neutral tax Code simplification, including simplification of tax 

rules applying to individual taxpayers, relating to amortization of intangible assets, and 

governing payroll tax deposits for small- and medium-sized businesses. 

• Revise the rules for charitable contributions by (1) making permanent the temporary alternative 

minimu m tax exclusion for gifts of appreciated property and expanding it to all types of 

property; (2) treating all deductible charitable contributions as sourced to domestic income for 

foreign tax credit purposes; and (3) to offset the revenue loss from these changes, requiring 

charities to file annual information returns reporting contributions in excess of $500. 

• Conform book and tax accounting for securities dealers by requiring marketable securities to be 

included in inventory at their market value. 

• Extend to all tax returns (including amended returns) the current provision that permits IRS not 

to pay interest on refunds claimed on original income tax returns if payment is mad e within 45 

days. 

• Disallow interest deductions of corporations for interest paid on loans secured by the cash value 

of life insurance policies covering their employees. 

• Prohibit double dipping by thrift institutions by disallowing loss deductions that are reimbursed 

by excludable Federal financial assistance. 

• Equalize the tax treatment of large credit unions and thrifts by repealing the tax exemption for 

credit unions with assets of $50 million in any taxable year. 

• Conform the treatment of annuities without substantial life contingencies to that of comparable 

investments by taxing income on the annuity investment as it is earned. 

• Expand the communications excise tax to include communications via digital transmissions and 

coin-operated telephones. 

• Make the orphan drug tax credit permanent. 

• Adopt other receipts proposals. 

- iii -

TABLE OF CONTENTS

 PAG E 

JOBS AND INVESTMENTS 1 

Enhance Long-Term Investment: Capital Gains 3 

Provide Passive Loss Relief for Real Estate 13 

Adopt Investment Tax Allowance (ITA) 17 

Simplify and Enhance Alternative Minimum Tax Depreciation . 21 

Extend Research and Experimentation (R&E) Tax Credit 23 

Extend Research and Experimental (R&E) Allocation Rules 25 

Extend Low-Income Housing Tax Credit 27 

Extend Targeted Jobs Tax Credit 29 

Extend Business Energy Tax Credit . . . 31 

Extend First-Time Farmer Bonds 33 

Establish Enterprise Zones 35 

Facilitate Real Estate Investments by Pension Funds and Others 37 

Repeal Luxury Tax on Aircraft and Boats and 

Repeal Diesel Fuel Exemption for Pleasure Boats 41 

FAMILIES, HEALTH, EDUCATION AND SAVINGS 43 

Permit Deduction of Interest on Student Loans 45 

Establish Flexible Individual Retirement Accounts (FIRAs) 47 

Promote Retirement Saving and Simplify Taxation of Pension Distributions 51 

Waive Penalty for Withdrawals from IRAs for Medical and Educational Expenses 59 

Extend Health Insurance Deduction for Self-Employed 61 

Extend Medicare Hospital Insurance Coverage to All State and Local Employees 63 

Double and Restore Adoption Deduction 65 

Expand Public Transit Exclusion to $60 Per Month 67 

Family Tax Allowance 69 

HOMEBUYERS 71 

Provide First-Time Homebuyers a $5,000 Tax Credit 73 

Allow Deduction for Loss on Sale of Principal Residence 75 

Waive Penalty for Withdrawals from IRAs for First-Time Homebuyers 77 

Extend Mortgage Revenue Bonds 79 

OTHER PROPOSALS AFFECTING RECEIPTS 81 

Support Revenue Neutral Tax Simplification 83 

Revise Rules for Charitable Contributions 85 

Conform Book and Tax Accounting for Securities Inventories 89 

Extend 45-Day Interest-Free Period to Refunds of All Taxes 91 

Disallow Interest Deductions on Corporate-Owned Life Insurance (COLI) Loans 93 

Prohibit Double Dipping by Thrifts Receiving Federal Financial Assistance 95 

Equalize Tax Treatment of Large Credit Unions and Thrifts 97 

Modify Taxation of Annuities without Life Contingencies 99 

Expand Communications Excise Tax 101 

Extend Orphan Drug Tax Credit 103 

Miscellaneous Proposals Affecting Receipts 105 

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JOBS AND INVESTMENTS 

-1 -

ENHANCE LONG-TERM INVESTMENT: CAPITAL GAINS 

The Budget again includes a reduction of the capital gains tax rate for individuals on long-term 

investments. The Budget provides for a 15, 30, or 45 percent exclusion for long-term capital gains on 

assets held by individual taxpayers for 1, 2, or 3 years, respectively. The 3-year holding period 

requirement will be phased in over 3 years. 

A reduction in capital gains taxes will benefit all Americans by providing incentives for saving 

and investment that result in higher national output and more jobs. 

Current Law 

Under current law, the full amount of capital gains income is generally taxable but the rate on 

such gains is capped at 28 percent. Capital gains are generally subject to 15 percent or 28 percent 

statutory tax rates. However, the actual tax cost of an asset sale can be significantly higher when 

capital gains taxes interact with other tax provisions (for example, the floors on itemized deductions for 

medical and miscellaneous expenses and on itemized deductions generally, and the phase-outs for IR A 

deductions, passive activity loss limitations, and personal exemptions). 

While the Tax Reform Act of 1986 eliminated the capital gains exclusion of prior law, it did not 

eliminate the legal distinction between capital gains and ordinary income, or between short-term and 

long-term capital gains. These distinctions currently serve to identify those transactions eligible for the 

28 percent maximu m rate and subject to the limitations on deduction of capital losses. Depreciation 

recapture rules recharacterize a portion of capital gains on depreciable property as ordinary income. 

These rules vary for different types of depreciable property. 

Reasons for Change 

Current high capital gains rates discourage savings, entrepreneurial activity, and high-risk 

investment in new products, processes, and industries. In the absence of a rate differential for longterm gains, investors are encouraged to focus on short-term earnings rather than on investments with 

longer-term growth potential. Our future competitiveness requires a sustained flow of capital to 

innovative, technologically-advanced activities that may generate minimal short-term earnings but 

promise strong future profitability. A preferential tax rate for longer-term commitments of capital 

encourages business investment patterns that favor innovation and growth over short-term profitability. 

T he resulting increase in national output benefits all Americans by providing jobs and raising living 

standards. In addition to improving productivity and economic growth, lower rates on long-term capital 

gains improve the fairness of the individual income tax by providing a rough adjustment for taxing of 

inflationary gains that do not represent any increase in real income. 

Incentives for Longer-Range Investment. A capital gains preference has long been recognized 

as an important incentive for capital investment. The first tax rate differential for capital gains was 

introduced by the Revenue Act of 1921. For the next 65 years, the tax laws provided a tax rate 

differential for long-term capital gains. This preferential treatment for capital gains has taken various 

forms, including an exclusion of a fixed portion of nominal gains, an exclusion that depended on the 

length of time a taxpayer held an asset, and a special maximu m tax rate for capital gains. But at no 

time between 1921 and 1987 were long-term capital gains taxed at the same rates as ordinary income. 

- 3 -
In 1990, Congress set the maximu m statutory rate on capital sains at 2X „, TM . , 

below the maximu m statutory rate on ordinary income. Nevertheles asS

 : V ^ T P° I 

A&~~4.' *. ± i- j • , . . A^cvcimciess, as shown in Fieure 1 the average 

effective tax rate on realized capital gains is currently substantially higher than it has been int o past. 

The 1986 Act increased the incentives for short-term trading of capital assets This occurred 

because the Act increased the tax rate on long-term capital gains while reducing the tax rate on shortterm capital gains. Th e Budget proposal would increase the incentive for longer term investment, by 

providing a sliding scale exclusion that, when fully phased in, provides full benefits only for investments 

held at least 3 years. 

The Cost of Capital and International Competitiveness. The capital gains tax is an important 

component of the cost of capital, which measures the pre-tax rate of return required to induce business 

to undertake ne w investment. Evidence suggests that the cost of capital in the United States is higher 

than in man y other industrial nations. While not solely responsible for the higher cost of capital, high 

capital gains tax rates hurt the ability of U.S. firms to obtain the capital needed to remain competitive. 

B y reducing the cost of capital, a reduction in the capital gains tax rate would stimulate productive 

investment and create new jobs and growth. 

Our major trading partners already recognize the economic importance of low tax rates on capital 

gains. Virtually all other major industrial nations provide much lower tax rates on capital gains or do 

not tax capital gains at all. Canada, France, Germany, Japan, the Netherlands, and the United 

Kingdom, amon g others, all treat capital gains preferentially. 

The Lock-In Effect. Under our tax system, capital gains are not taxed until realized by the 

taxpayer. Thus, a substantial tax on capital gains tends to "lock" taxpayers into their existing 

investments. Man y taxpayers wh o would prefer to sell their assets to acquire new and better 

investments ma y continue to hold the assets rather than pay the current high capital gains tax on their 

accrued gains. 

This lock-in effect of capital gains taxation has three adverse effects. First, it produces a 

misallocation of the nation's capital stock and entrepreneurial talent because it distorts the investment 

decisions that would be mad e in the absence of the capital gains tax. For example, the lock-in effect 

reduces the ability of entrepreneurs and investors to withdraw funds from an existing enterprise and use 

them to start ne w ventures. Productivity in the economy suffers because entrepreneurs are less likely 

to mov e capital to where it can be most productive, and because capital ma y be used less productively 

than if it were transferred to other, more efficient enterprises. These effects can be especially critical 

for smaller firms that are owner-operated and do not have good access to capital markets. Second, the 

lock-in effect produces distortions in the investment portfolios of individual taxpayers. For example, 

some individual investors ma y be induced to hold a different mix of assets than they desire because they 

are reluctant to sell appreciated investments to diversify their portfolios. Third, the lock-in effect 

reduces government receipts. T o the extent that taxpayers defer sales of existing investments, or hold 

investments until death, taxes that might otherwise have been paid are deferred or avoided altogether. 

-4-
Lh 

26 

24 

22 

20 

« 18 

^ 16 

14 

12-

10 

Figure 1 

Average Effective Tax Rate on Capital Gains, 1964-1989 

i r ~i r i r 

1964 1969 1974 1979 1984 1989 

Year 

Department of the Treasury 

Office of Tax Policy 

January 1992 
Individual investors, the government, and other taxpayers lose from the lock-in effect. The 

investor is discouraged from pursuing more attractive investments and the government loses revenue, 

to the detriment of all taxpayers. 

Substantial evidence from many respected studies demonstrates that high capital gains tax rates 

in previous years have produced significant lock-in effects. The importance of the lock-in effect ma y 

also be demonstrated by the fact that realized capital gains were 16 percent lower under the high tax 

rates in 1987 than under the lower rates in 1985, even though stock prices rose by approximately 50 

percent over this period. The high tax rates on capital gains under current law imply that the lock-in 

effect is greater than at any prior time in our history. 

Penalty on High-Risk Investments. Full taxation of capital gains, in combination with limited 

deductibility of capital losses, discourages risk taking. It therefore impedes investment in emerging 

high-technology and other high-risk firms. While many investors are willing to take risks in anticipation 

of an adequate return, fewer are willing to contribute "venture capital" if a significant fraction of the 

increased reward will be used merely to satisfy higher tax liabilities. A tax system that imposes high 

tax rates on gains from investments reduces the attractiveness of high-risk investments, and may result 

in man y worthwhile projects not being undertaken. 

In particular, it is inherently more risky to start new firms and invest in new products and 

processes than to mak e incremental investments in existing firms and products. It is therefore the most 

dynamic and innovative firms and entrepreneurs that are the most disadvantaged by high capital gain 

tax rates that penalize risk taking. Such firms have traditionally been contributors to America's edge 

in international competition and have provided an important source of new jobs. 

There is evidence of a sharp decline between 1986 and the present in the amount of capital 

available to independent private venture capital funds, which have been one of the most valuable sources 

of capital for innovative but risky new firms. This decline correlates with the high capital gain tax rates 

introduced in 1986. 

Double Tax on Corporate Stock Investment. Under the U.S. income tax system, income earned 

on investments in corporate stock is generally subjected to two layers of tax. Income on corporate 

investments is taxed first at the corporate level at a rate of 34 percent. Corporate income is taxed a 

second time at the individual level in the form of taxes on capital gains and dividends, at rates ranging 

from 15 to 31 percent. The combination of corporate and individual income taxes can thus produce 

effective tax rates that are substantially higher than individual income tax rates alone. T o the extent an 

investor's return is obtained through appreciation in the value of stock (rather than through dividend 

income), a reduction in capital gains tax rates provides a form of relief from this double taxation of 

corporate income. While a lower capital gains tax rate reduces the cost of capital for both corporate 

and noncorporate business, the greater liquidity of shares in publicly-traded companies suggests that the 

overall effect would be to reduce the bias towards noncorporate business that results from our dual-level 

tax system. 

-6-
Proposal 

General Rule. The capital gains tax rate would be reduced by means of a sliding-scale 

exclusion. Individuals would be allowed to exclude a percentage of the capital gain realized upon the 

disposition of qualified capital assets, and would apply their current statutory rate on capital gains 

(either 15 or 28 percent) to the reduced amount of taxable gain. The amount of the exclusion would 

depend on the holding period of the assets. Assets held more than 3 years would qualify for an 

exclusion of 45 percent. Assets held more than 2 years but not more than 3 years would qualify for 

a 30 percent exclusion. Assets held more than 1 year but not more than 2 years would qualify for a 

15 percent exclusion. For example, individuals subject to a 28 percent tax on capital gains would pay 

rates of 23.8, 19.6, and 15.4 percent for assets held 1, 2, or 3 years, respectively. The corresponding 

figures for individuals subject to a 15 percent rate would be 12.8, 10.5, and 8.3 percent. 

Qualified assets would generally be defined as any assets qualifying as capital assets under 

current law and satisfying the holding period requirements, except for collectibles. Collectibles are 

assets such as works of art, antiques, precious metals, gems, alcoholic beverages, and stamps and coins. 

Assets eligible for the exclusion would include, for example, corporate stock, manufacturing and farm 

equipment, and real estate, such as homes, apartment buildings, timber, and family farms. 

Phase-in Rules and Effective Dates. The proposal would be effective generally for dispositions 

of qualified assets after the date of enactment. For the balance of 1992, the full 45 percent exclusion 

would apply to assets held more than 1 year. For dispositions of assets in 1993, assets would be 

required to have been held for more than 2 years to be eligible for the 45 percent exclusion, and more 

than 1 year to be eligible for the 30 percent exclusion. For dispositions of assets in 1994 and thereafter, 

assets would be required to have been held more than 3 years to be eligible for the 45 percent exclusion, 

more than 2 years to be eligible for the 30 percent exclusion, and more than 1 year for the 15 percent 

exclusion. 

Additional Provisions. In order to prevent taxpayers from benefitting from the exclusion 

provision for depreciation deductions that have already been claimed in prior years, the existing 

depreciation recapture rules would be expanded to recapture all prior depreciation deductions. All 

taxpayers would be able to benefit from the proposed exclusion only to the extent that a depreciable 

asset has increased in value above its unadjusted basis. Absent such a provision, a taxpayer could claim 

depreciation deductions against income taxable at, for example, a 31 percent marginal rate, yet pay tax 

on the restoration of those deductions when the asset is sold at 15.4 percent even though there was no 

increase in the value of the asset over its initial purchase price. The excluded portion of capital gains 

would be added back when calculating income under the alternative minimum tax. Installment sale 

payments received after the effective date will be eligible for the exclusion without regard to the date 

the sale actually took place. For purposes of the investment interest limitation, only the net capital gain 

after subtracting the excluded amount would be included in investment income. The 28 percent 

limitation on capital gains not eligible for the exclusion would be retained. 

-7-
Effects of Proposal 

Example A. Taxpayer A is a single individual earning $16,000 whose mutual fund investments 

have a reported long-term capital gain of $500 in late 1992. 

Under current law, her tax on the $500 capital gain would be 15 percent of the full $500 gain, 

or $75. 

Under the proposal, her tax would be reduced to $41.25, which is 15 percent of $275 ($500 less 

the 45 percent exclusion). 

Example B. Couple B is a two-earner couple with combined taxable income other than capital 

gains of $50,000. In 1994, they sell corporate stock realizing a $1,500 capital gain on stock held 15 

months and a $2,500 capital gain on stock held 5 years. 

Under current law both gains would be taxed at a rate of 28 percent. Tax on the $1,500 gain 

would be $420, and tax on the $2,500 gain would be $700, for a combined tax of $1,120. 

Under the proposal, the gain on the stock held 15 months would be eligible for a 15 percent 

exclusion and the gain on the stock held 5 years would be eligible for a 45 percent exclusion. The tax 

on the stock held 15 months would be $357 and the tax on the stock held 5 years would be $385, for 

a combined tax of $742, which would be 34 percent lower than Couple B's liability under current law. 

Example C. Taxpayer C is the founder of a 5-year old computer software company and would 

like to sell the company in order to start a new company making a new product. Taxpayer C has a 

salary of $380,000 and $20,000 in dividend and interest income. Taxpayer C sells the stock in the 

computer software company for $2 million, resulting in a capital gain of $1.8 million after deduction 

of his $200,000 cost basis. 

Under current law, taxpayer C would pay a capital gains tax of about $520,740 (depending on 

the level and composition of his itemized deductions), leaving him with net proceeds of $1,479,260 

from the sale of the company. 

Under the proposal, the capital gains tax, including the alternative minimum tax, would be about 

$436,455 (again, depending on the level and composition of his itemized deductions). The net proceeds 

from selling the company would be about $1,563,545. Thus, Taxpayer C would have about $84,285 

of additional funds that could be invested in the new business. 

Distributional Effects of Proposal. A capital gains tax reduction is likely to benefit taxpayers 

at all income levels. High-income taxpayers will be better off because of the lower capital gains tax 

rates, even though some of them will actually pay more in taxes because of additional realizations 

induced by the exclusion. Lower and middle-income taxpayers will also be better off because of lower 

taxes on the capital gains they realize. All taxpayers will benefit from the enhanced economic 

productivity and growth which results from a reduction in capital gains tax rates. The benefit to the 

U.S. economy is the most important issue with respect to a capital gains tax reduction, and this benefit 

is shared by all. 

-8-
Revenue Estimate 

Capital gains realizations are highly responsive to changes in stock prices and general economic 

conditions as well as to capital gains tax rates. Furthermore, taxpayers ma y adjust their purchases and 

sales of capital assets and their income sources and deductions in response to ne w tax rules. Since 

1978, Treasury revenue estimates of capital gains have taken into account expected changes in taxpayer 

behavior. 

These behavioral effects are the subject of continued empirical research. Treasury's Office of 

T ax Analysis (OTA ) incorporates unlocking effects and all other behavioral effects believed to be 

important and presents its best estimate of the expected effects. In accordance with revenue estimating 

convention, the estimates do not take into account additional revenues anticipated by reason of increases 

in the gross domestic product. The proposal is expected to increase Treasury receipts as compared to 

current law receipts due to increased realizations. The revenue estimates noted below assume a 

February 1, 1992 effective date. The increase in revenues is expected to be greatest in fiscal year 1993, 

due to the unlocking of existing capital gains, and smaller thereafter. The expected changes in revenues 

are modest in comparison to the magnitude of the expected total amount of revenues from the capital 

gains tax (in excess of $30 billion per year). 

Details of Revenue Estimate. The details of the revenue estimate are shown in Table I. Line 

1 of Table 1 shows the revenue loss that results from a flat 45 percent exclusion of the amount of 

capital gains that would be realized at current law tax rates; LJL , "baseline" realizations that would have 

occurred without a change in tax rates. This loss is what a "static" revenue estimate for a 45 percent 

exclusion would show. This "static" revenue loss is estimated to be $16.3 billion in fiscal year 1993, 

gradually increasing to about $22 billion by 1997. 

Line II of Table 1 shows the estimated revenue from additional realizations that would be 

induced by a flat 45 percent exclusion. These induced gains arise from several sources. They represent 

realizations accelerated from future years, realizations due to portfolio shifting, or realizations that 

would otherwise have been tax-exempt because they would have been held until death, donated to 

charity, or not reported. A s indicated by a comparison of line I and II, revenues from induced 

realizations are estimated to be sufficient to offset the static revenue loss on current gains for several 

years, but not in the long run. This conclusion is based on Treasury's analysis of the findings of 

numerous statistical studies of the responsiveness of capital gains to lower tax rates, and is consistent 

with the revenue experience of previous capital gains tax rate changes. 

Line III shows the revenue effects of limiting the exclusion to 30 percent for assets held 2 years 

and 15 percent for assets held 1 year, and the phase-in of these holding period limitations. Th e 

estimates reflect the net effect of the reduction in static revenue losses, and the deferral of realizations 

of assets not yet qualifying for the full 45 percent exclusion. These provisions, which are aimed at 

promoting a longer-term investment horizon, produce a net revenue gain over the budget period. 

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Table 1 

Revenue Effects of the President's Capital Gains Proposal 

Item 

I. Static effect of 45 percent exclusion 

II. Effect of 45 percent exclusion on 

taxpayer behavior 

III. Effect of reducing exclusion to 15 percent and 

30 percent for assets held one and two years1 

IV. Effect of treating excluded gains as a 

preference item for AM T purposes 

V. Effect of depreciation recapture 

VI. Total revenue effect of proposal 

Department of the Treasury 

Office of Tax Policy 

0.0 

0.1 

0.0 

0.6 

Fiscal Years ($ Billions) 

1992 1993 1994 1995 i55o~^ 7 1992-97 

•2.4 

2.9 

-16.3 

19.2 

-17.9 

18.3 

-19.5 

17.0 

-21.0 

16.6 

-22.5 

17.2 

-99.5 

91.1 

-0.1 

0.7 

0.3 

3.8 

-0.7 -0.5 

1.4 

1.0 

2.1 

2.0 

1.2 

0.3 

1.1 

2.2 

1.3 

0.3 

1.2 

2.5 

1.4 

-0.2 

1.0 

8.9 

5.4 

6.9 

January 1992 

Note: Details may not add to total due to rounding. 

'Assets held 1 to 2 years receive an exclusion of 30 percent in 1993 Beginning in M>TM^ ^ 

15 percent is accorded assets held 1 to 2 years and 30 percent for assets held 2 to 3 years. Note that m e 

along with those in lines IV and V, reflect both static and behavioral effects. 
Lines IV and V show the revenue effects of treating excluded capital gains as a preference item 

for purposes of the alternative minimum tax and expanded depreciation recaptured Over the budget 

period, these two provisions raise $14.3 billion in revenue. The full depreciation recapture proposal 

means that if a depreciable asset is sold, the exclusion will apply only to the amount by which the 

current selling price is higher than the original cost. Treating excluded gains as a preference item for 

purposes of the alternative minimum tax primarily affects high-income individuals and raises $8.9 billion 

over the budget period. The total revenue effect of the proposal is shown in line VI. The proposal is 

expected to raise revenue in every year except 1997, and $6.9 billion over the budget period. 

These estimates do not include the effects of potential increases in long-run economic growth 

expected to result from a lower capital gains tax rate. This conforms to the standard budget and 

revenue estimating practice of assuming that the macroeconomic effects of revenue and spending 

proposals are already included in the economic forecast. 

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PROVIDE PASSIVE LOSS RELIEF FOR REAL ESTATE 

Current Law 

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

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

and carried forward to the next taxable year. The purpose of the passive loss rules is to discourage taxmotivated investments in tax shelters that, prior to the 1986 Act, permitted taxpayers to offset their 

active business and other income by incurring tax losses on investments in which they took no active 

part. 

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

taxpayer's operations must be organized into activities that are either trade or business activities or 

rental activities. If a taxpayer conducts more than one trade or business operation in the same line of 

business, those operations ma y be treated as one activity. Income and losses from all operations 

included in a single activity are taken into account in determining the income or loss from the activity 

for any taxable year. In general, rental operations may not be treated as part of a trade or business 

activity.1 Thus, an individual engaged in a real estate development business that derives 60 percent 

of his gross income from the construction of property and 40 percent of his gross income from the 

rental of property would be engaged in two activities (one trade or business and one rental) rather than 

one, notwithstanding the fact that the operations may be conducted as part of an integrated business. 

Income or loss from a trade or business activity is passive unless the taxpayer materially 

participates in the activity. Regulations provide that, in general, the material participation standard is 

satisfied if a taxpayer participates for more than 500 hours in the activity for the taxable year. A 

taxpayer's participation in an activity is determined by taking the sum of the number of hours the 

taxpayer participates in each of the operations that are included with the activity. 

In the case of rental activities, income and losses are passive, regardless of the level of the 

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

or other passive income. Under a limited exception to the rental rule, a taxpayer with modified adjusted 

gross income not greater than $100,000 may treat up to $25,000 of real estate rental losses as 

nonpassive if the taxpayer actively participates in the rental activities for the taxable year. Active 

participation is a lesser standard of involvement than material participation and generally requires that 

the taxpayer participate in making management decisions or arrange for others to provide services such 

as repairs in a significant and bona fide sense. A taxpayer is generally deemed not to satisfy the active 

participation standard with respect to property he holds through a limited partnership interest. The 

$25,000 amount begins to phase out for taxpayers with modified adjusted gross income over $100,000 

and is completely phased out when a taxpayer's modified adjusted gross income reaches $150,000. This 

exception applies only to the losses from the rental of real property in which the taxpayer holds at least 

a 10 percent interest. 

*An exception to this rule is made when one of the operations (either rental or trade or business) 

generates more than 80 percent of the total gross income of the combined operations. 

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T h e passive loss limitation rules apply to individuals, estates, trusts and personal service 

corporations. Closely-held corporations ma y offset passive losses against active incoihe but ma y not 

offset passive losses against portfolio income, such as interest and dividends. 

Reasons for Change 

A taxpayer whose principal business consists of real estate development may materially 

participate in a variety of endeavors, including the management, renovation, construction, ownership 

and rental of real estate. Nevertheless, losses arising from the rental of real property the taxpayer has 

developed ma y not be used to offset income from the taxpayer's nonrental real estate operations that 

are part of the same real estate development business except to the extent of the limited exception 

described above. A s a result, taxpayers wh o develop real property for rental are required to treat what 

is a single integrated business as two separate activities, one active and one passive. The separation 

of these activities ma y result in income distortions. 

Proposal 

The passive loss rules would be amended to permit taxpayers to treat their real estate 

development operations as a single trade or business activity. Real estate development activity would 

include real estate development operations (as defined below) in which the taxpayer actively participates. 

Income and loss from this activity would be nonpassive if the taxpayer materially participates in the 

activity. Real estate development operations would be defined as (1) the construction, substantial 

renovation and management of real property, regardless of whether the taxpayer holds an interest in the 

property; (2) the lease-up and sale of real property in which the taxpayer has at least a 10-percent 

ownership interest; and (3) the rental of property that was developed by the taxpayer. Property would 

be treated as having been developed by the taxpayer only if the taxpayer materially participated in the 

construction or substantial renovation of the property. N o operations would be included in the real 

estate development activity unless the taxpayer meets the active participation standard with respect to 

the operations. The proposed amendment would be effective for taxable years ending on or after 

December 31, 1992. 

Effects of Proposal 

The proposal would permit taxpayers who actively participate in the rental of the properties they 

develop to offset their rental losses against income from other real estate development operations in 

which they actively participate, as well as income not related to real estate development operations. 

This relaxation of the passive loss rules will ease the income distortions affecting taxpayers wh o develop 

real property for rental. At the same time, this modification will not undermine the important purpose 

of the passive loss rules, Le^, to curb tax shelters. The provision is limited to rental losses from 

properties the taxpayer has developed and is therefore targeted to those taxpayers in the best position 

to mak e investments based on economic rather than tax considerations. 

- 14 -
Revenue Estimate 

Provide passive loss relief for real estate: 

- 15-

Fiscal Years' 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

-0.1 -0.4 -0.4 -0.4 -0.5 -0.6 -2.5 

ADOPT INVESTMENT TAX ALLOWANCE (TTA) 

Current Law 

Current law generally permits purchasers of tangible property that is used in a trade or business 

or held for the production of income to recover the cost of the property by taking annual tax deductions 

during the property's useful life. Certain types of property (for example, inventories) are not 

depreciable. 

In the case of property placed in service after 1986, the Modified Accelerated Cost Recovery 

System (MACRS ) applies in determining the amount of depreciation allowable in any particular taxable 

year. MACR S specifies the period over which the cost of property can be recovered, the method to 

be used to determine the amount of depreciation allowable, and the conventions (or placed-in-servicedate assumptions) to be used in determining depreciation. 

Equipment that is depreciable under MACRS generally has a recovery period of 3, 5, 7, or 10 

years. The cost of property in these classes is generally recovered using the 200 percent decliningbalance method over the established MACR S recovery periods. Owners of property in these classes 

may, however, elect to recover costs using a 150 percent declining-balance method over class lives that 

are somewhat longer than the regular recovery periods. Alternatively, owners of property in these 

classes ma y elect to use straight-line depreciation over either the regular recovery periods or the longer 

class lives. Current law provides tables for calculating depreciation deductions under each of these 

methods. 

In addition, averaging conventions are used to determine placed-in-service dates for depreciation 

calculations. For example, under the half-year convention, which generally applies to property placed 

in service in any particular taxable year, the property is treated as placed in service in the middle of 

the purchaser's taxable year. Accordingly, only half of a year's depreciation is allowable in that year, 

and half of a year's depreciation is allowable in the taxable year in which the recovery period ends. 

There are certain alternative minimum tax adjustments with respect to depreciation. In 

determining alternative minimum taxable income, taxpayers must generally calculate depreciation using 

the 150 percent declining-balance method over the property's class life. During the earlier years of a 

property's recovery period, this results in a deduction for alternative minimum tax purposes smaller than 

that allowed for regular tax purposes using the 200 percent declining-balance method over the property's 

regular recovery period. In addition, corporate taxpayers must compute adjusted current earnings for 

alternative minimu m tax purposes using the straight-line method over the property's class life. 

Corporate taxpayers generally must increase alternative minimum taxable income to reflect an 

adjustment based on adjusted current earnings. 

Current law also provides for recognition of ordinary gain on disposition of certain depreciable 

property. This provision is contained in section 1245 of the Internal Revenue Code, and the property 

to which the provision applies is defined as "section 1245 property." Section 1245 property generally 

includes depreciable or amortizable tangible personal property used in a trade or business or held for 

investment, and other depreciable or amortizable tangible property used in manufacturing or production 

operations, in research facilities, or in producing energy or furnishing services such as communications 

- 17 -
or transportation services. Section 1245 property generally does not include real property, such as 

buildings or their structural components. 

Reasons for Change 

A temporary acceleration of depreciation deductions would accelerate purchases of new 

equipment, thus promoting capital investment, modernization, and a more rapid economic recovery. 

Proposal 

Under the proposal, an investment tax allowance (ITA) would be available for new equipment 

acquired on or after February 1, 1992, and before January 1, 1993, if the equipment is placed in service 

before July 1, 1993. The ITA would equal 15 percent of the purchase price of the equipment. The ITA 

would be taken in the taxable year the equipment is placed in service, and would reduce the tax basis 

of the equipment for purposes of calculating depreciation in the year the equipment is placed in service 

and in subsequent years and for purposes of determining gain or loss on disposition. 

For example, assume that on March 15, 1992, a calendar-year corporate taxpayer purchased 

$1,000,000 of equipment with a 5-year recovery period and a 6-year class life, and the equipment was 

eligible for the 15 percent ITA under the proposal. The taxpayer would be allowed an ITA of $150,000 

for 1992, would adjust its basis in the equipment to $850,000, and would calculate the otherwise 

allowable deduction for 1992 using the $850,000 adjusted basis (and the half-year convention). If the 

taxpayer used the 200 percent declining-balance method over the 5-year MACR S recovery period, the 

1992 depreciation deductions would total $320,000 ($150,000 plus $170,000); if the taxpayer used the 

150 percent declining-balance method over the 6-year class life, the 1992 depreciation deductions would 

total $256,250 ($150,000 plus $106,250); and if the taxpayer elected the straight-line method over the 

regular recovery period, the 1992 depreciation deductions would total $235,000 ($150,000 plus 

$85,000). 

The alternative minimum tax adjustments for depreciation would not apply to the 15 percent ITA 

provided under the proposal. Thus, in the above example, the taxpayer would be allowed a $320,000 

deduction for regular tax purposes and a $256,250 deduction for alternative minimum tax purposes. 

The 15-percent ITA would also be permitted in calculating adjusted current earnings. Under the 

Administration's proposal to eliminate the adjustment for depreciation in computing adjusted current 

earnings with respect to property placed in service on or after February 1, 1992, the depreciation 

deduction allowable in computing adjusted current earnings would equal the $256,250 deduction 

allowable for alternative minimum tax purposes. 

All section 1245 property would benefit from the ITA. Thus, equipment would include any 

depreciable or amortizable tangible personal property used in a trade or business or held for investment, 

such as machinery, a computer, a lathe, or a printing press. Equipment would also include depreciable 

or amortizable tangible property that is not personal property but is section 1245 property, such as a 

broadcast tower, a livestock fence, or a wind tunnel in a research facility. Equipment would not include 

intangibles such as patents or computer software, and generally would not include buildings or structural 

components of buildings. 

- 18 -
In general, equipment would be considered acquired on the date the taxpayer obtains, or enters 

into a binding contract to obtain, the equipment. Equipment constructed or manufactured by the 

taxpayer for the taxpayer's ow n use would be eligible for the ITA if the construction or manufacture 

began on or after February 1, 1992, and before January 1, 1993, and if the equipment was placed in 

service before July 1, 1993. The date on which equipment is placed in service would be determined 

under the generally applicable depreciation rules. 

The proposal is intended to accelerate investment in new equipment. Thus, if a binding contract 

to acquire equipment was in effect before February 1, 1992, the equipment would not be eligible for 

the ITA. 

The gain recognition rules of section 1245 would apply on disposition of equipment on which 

the ITA has been allowed. 

Effects of Proposal 

The proposal would reduce the cost of capital and increase business cash flow, thus providing 

a temporary incentive to increase investment. Because the additional depreciation would be available 

only for equipment acquired during the remainder of 1992, the stimulus to investment during 1992 

would be maximized. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Adopt investment tax allowance: -6.1 -1.6 3.5 0.9 0.8 0.6 -1.7 

- 19-

SIMPLIFY AND ENHANCE ALTERNATIVE MINIMUM TAX DEPRECIATION 

ourrent T a w 

Under current law, a corporation is subject to an alternative minimum tax (AMT) which is 

payable to the extent that the corporation's tentative minimum tax exceeds its regular income tax 

iability. The tentative minimum tax generally equals 20 percent of the corporation's alternative 

ninimum taxable income. Alternative minimum taxable income is the corporation's taxable income 

ncreased by its tax preferences and adjusted by redetermining its tax treatment of certain items in a 

nanner that negates the deferral of income resulting from the regular tax treatment of those items. 

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

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

personal property to which the Modified Accelerated Cost Recovery System (MACRS ) applies is 

generally calculated using the 150 percent declining-balance method over the class life of the property. 

By comparison, a 200 percent declining-balance method over recovery periods shorter than class lives 

is permitted under MACR S in arriving at taxable income. If a corporation elects, or is required, to 

depreciate personal property pursuant to a straight-line depreciation method in computing taxable 

income, this method (and the recovery periods used in computing taxable income) must also be used 

to compute alternative minimum taxable income. 

Another adjustment in arriving at alternative minimum taxable income is based on adjusted 

current earnings (ACE). In general, the AC E adjustment increases taxable income by an amount equal 

to 75 percent of the excess of AC E over alternative minimum taxable income (determined without 

regard to the AC E adjustment). In computing ACE , depreciation is generally computed using the 

straight-line method over the class life of the property. 

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

in a particular taxable year, the corporation is entitled to reduce its regular income tax liability by a 

credit (the minimum tax credit) which is based on AM T paid in preceding years. The minimum tax 

credit is generally intended to permit the reversal of the effects of the AM T when the treatment of items 

in arriving at taxable income becomes less favorable than the treatment permitted in arriving at 

Edternative minimum taxable income. For AM T paid in a taxable year beginning on or after January 1, 

1990, a corporation is entitled to a minimum tax credit equaling its entire AM T liability. 

Reasons for Change 

There is general concern that the depreciation component of the ACE adjustment causes a 

disincentive to capital investment for U.S. corporations. A s a result of the depreciation adjustment 

required in computing ACE , many capital-intensive corporations are subject to the AMT . The effects 

of the adjustment are magnified for capital-intensive corporations that are growing or showing depressed 

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

minimum tax credit is of little value in mitigating the long-term effects of the AC E depreciation 

adjustment. 

- 21 -
T he AC E depreciation adjustment is also the source of substantial complexity. As a result of 

the adjustment, corporations must make three separate depreciation computations to determine taxable 

income and alternative minimum taxable income. 

Proposal 

Effective for property placed in service on or after February 1, 1992, the depreciation component 

of the AC E adjustment would not apply. The general requirement that a corporation use the 150 

percent declining-balance depreciation method over the class life of the property would continue to 

apply, however, for purposes of computing alternative minimum taxable income. In computing ACE , 

the corporation would compute depreciation for this property using the same methods and recovery 

periods that it uses in computing alternative minimum taxable income. 

Effects of Proposal 

The proposal would (1) target the reduction in the AMT on new investments in depreciable 

property, without providing a windfall for prior investments, (2) simplify the AM T by requiring only 

one computation of depreciation for AM T purposes, and (3) generally provide a more appropriate AC E 

depreciation method than straight-line. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Simplify and enhance AM T depreciation: -0.2 -0.4 -0.4 -0.3 -0.2 -0.1 -1.5 

-22 -
EXTEND RESEARCH AND EXPERIMENTATION (R&E) TAX CREDIT 

Current T,aw 

Current law allows a 20 percent tax credit for a certain portion of a taxpayer's "qualified 

research expenses." The portion of qualified research expenses that is eligible for the credit is the 

increase in the current year's qualified research expenses over its base amount for that year. The base 

amount for the current year is computed by multiplying the taxpayer's "fixed-base percentage" by the 

average amount of the taxpayer's gross receipts for the 4 preceding years. A taxpayer's fixed-base 

percentage generally is the ratio of its total qualified research expenses for the 1984-88 period to its total 

gross receipts for this period. Special rules for start-up companies provide a fixed-base percentage of 

3 percent. In no event will a taxpayer's fixed-base percentage exceed 16 percent. A taxpayer's base 

amount ma y not be less than 50 percent of its qualified research expenditures for the current year. 

In general, qualified expenditures consist of (1) "in-house" expenditures for wages and supplies 

used in research; (2) 65 percent of amounts paid by the taxpayer for contract research conducted on the 

taxpayer's behalf; and (3) certain time-sharing costs for computers used in research. Restrictions further 

limit the credit to expenditures for research that is technological in nature and that will be useful in 

developing a ne w or improved business component. In addition, certain research is specifically 

excluded from the credit, including research performed outside the United States, research relating to 

style, taste, cosmetic, or seasonal design factors, research conducted after the beginning of commercial 

production, research in the social sciences, arts, or humanities, and research funded by persons other 

than the taxpayer. 

The credit is available only for research expenditures paid or incurred in carrying on a trade or 

business of the taxpayer. A taxpayer is treated as meeting the trade or business requirement with 

respect to in-house research expenses if, at the time such in-house research expenses are incurred, the 

principal purpose of the taxpayer in making such expenditures is to use the results of the research in 

the active conduct of a future trade or business of the taxpayer or certain related taxpayers. 

Current law also provides a separate 20 percent tax credit ("the university basic research credit") 

for corporate funding of basic research through grants to universities and other qualified organizations 

performing basic research. The university basic research credit is measured by the increase in spending 

from certain prior years. This basic research credit applies to the excess of (1) 100 percent of corporate 

cash expenditures (including grants or contributions) paid for university basic research over (2) the sum 

of a fixed research floor plus an amount reflecting any decrease in nonresearch giving to universities 

by the corporation as compared to such giving during a fixed based period (adjusted for inflation). A 

grant is tested first to see if it constitutes a basic research payment; if not, it ma y be tested as a 

qualified research expenditure under the general R& E credit. 

The R&E credit is aggregated with certain other business credits and made subject to a limitation 

based on tax liability. The sum of these credits ma y reduce the first $25,000 of regular tax liability 

without limitation, but ma y offset only 75 percent of any additional tax liability. Taxpayers ma y carry 

credits not usable in the current year back 3 years and forward 15 years. 

The amount of any deduction for research expenses is reduced by the amount of the tax credit 

taken for that year. 

-23 -
T he R& E credit in the form described above is in effect for taxable years beginning after 

December 31, 1989. However, the credit will not apply to amounts paid or incurred after June 30, 

1992. 

Reasons for Change 

The current law tax credit for research provides an incentive for technological innovation. 

Although the benefit to the country from such innovation is unquestioned, the market rewards to those 

w h o take the risk of research and experimentation may not be sufficient to support the level of research 

activity that is socially desirable. The credit is intended to reward those engaged in research and 

experimentation of unproven technologies. 

The credit cannot induce additional R&E expenditures unless its future availability is known at 

the time businesses are planning R& E projects and projecting costs. R& E activity, by its nature, is 

long-term, and taxpayers should be able to plan their research activity knowing that the credit will be 

available when the research is actually undertaken. Thus, if the R& E credit is to have the intended 

incentive effect, it should be made permanent. 

Proposal 

The R&E credit would be made permanent. 

Effects of Proposal 

Stable tax laws that encourage research allow taxpayers to undertake research with greater 

assurance of the future tax consequences. A permanent R& E credit (including the university basic 

research credit) permits taxpayers to establish and expand research activities without fear that the tax 

incentive would not be available when the research is carried out. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Extend R& E credit: -0.2 -0.8 -1.4 -1.6 -1.8 -2.1 -7.8 

-24 -
EXTEND RESEARCH AND EXPERIMENTAL (R&E) ALLOCATION RULES 

Current T *TM 

The tax credit allowed for payments of foreign tax is limited to the amount of U.S. tax otherwise 

payable on the taxpayer's income from foreign sources. The purpose of this limitation is to prevent the 

foreign tax credit from offsetting U.S. tax imposed on income from U.S. sources. Accordingly, a 

taxpayer claiming a foreign tax credit is required to determine whether income arises from U.S. or 

foreign sources and to allocate expenses between such U.S. and foreign source income. 

Under the above limitation rules, an increase in the portion of a taxpayer's income determined 

to be from foreign sources will increase the allowable foreign tax credit. Therefore, taxpayers generally 

receive greater foreign tax credit benefits to the extent that their expenses are applied against U.S. 

source income rather than foreign source income. 

Treasury regulations issued in 1977 described methods for allocating expenses between U.S. and 

foreign source income. Those regulations contained specific rules for the allocation of research and 

experimental (R&E ) expenditures, which generally required a certain portion of R& E expense to be 

allocated to foreign source income. Absent such rules, a full allocation of R& E expense to U.S. source 

income would overstate foreign source income, thus allowing the foreign tax credit to apply against 

U.S. tax imposed on U.S. source income and thwarting the limitation on the foreign tax credit. 

Since 1981 these R&E allocation regulations have been subject to seven different suspensions 

and temporary modifications by Congress. The Technical and Miscellaneous Revenue Act of 1988 

(TAMRA ) adopted allocation rules which were in effect for only 4 months. For 20 months following 

the period when the TAMR A rules were in effect, R& E allocation was controlled by the 1977 Treasury 

regulations. The Budget Reconciliation Act of 1989 subsequently reintroduced the TAMR A rules, once 

again on a temporary basis. These rules were extended to taxable years beginning on or before 

August 1, 1991 by the Omnibus Budget Reconciliation Act of 1990, and were further extended to the 

first 6 months of the first taxable year beginning on or after August 1, 1991 by the Tax Extension Act 

of 1991. 

Under the R&E allocation rules enacted by TAMRA (and temporarily extended in 1989, 1990 

and 1991), a taxpayer must allocate 64 percent of R& E expenses for research conducted in the United 

States to U.S. source income and 64 percent of foreign-performed R& E expenses to foreign source 

income. The remaining portion can be allocated on the basis of the taxpayer's gross sales or gross 

income. However, the amount allocated to foreign source income on the basis of gross income must 

be at least 30 percent of the amount allocated to foreign source income on the basis of gross sales. 

Reasons for Change 

The Administration believes providing tax incentives to increase the performance of U.S.-based 

research activities. The allocation rules in this proposal provide such an incentive. Although the 

orooosal benefits only multinational corporations that are subject to the foreign tax credit limitation, it 

will provide an incentive with respect to such entities. By enhancing the return on R& E expenditures, 

the proposal encourages the growth of overall R& E activity as well as the location of such research 

within the United States. 

-25 -
Proposal 

T he proposal would provide an 18-month extension of the R& E allocation rules. 

Effects of Proposal 

The automatic allocation of 64 percent of U.S.-performed R&E to U.S. source income under 

the proposal generally permits a greater amount of income to be classified as foreign source than under 

the 1977 regulations. A s discussed above, this will increase the benefits of the foreign tax credit for 

certain taxpayers. 

The operation of these rules is best illustrated through an example. Assume that an unaffiliated 

U.S. taxpayer has $100 of expense from research performed in the United States, that 50 percent of 

relevant gross sales produces foreign source income, and that 30 percent of the taxpayer's gross income 

is from foreign sources. Subject to certain limitations not applicable to these facts, the 1977 regulations 

would have required the taxpayer to allocate at least $30 of R& E expense to foreign source income 

($100 x 30 % gross income from foreign sources). 

Under the proposal $64 is automatically allocated to U.S. source income based on the place of 

performance ($100 x 64%) . The remaining $36 may be allocated either on the basis of gross sales or 

on the basis of gross income (subject to the limitation described below). A gross sales apportionment 

of the remainder would result in $18 ($36 x 50% ) being allocated to foreign source income, while a 

gross income apportionment would result in $10.80 ($36 x 30% ) being allocated to foreign source 

income. 

The amount allocated to foreign source income using the gross income method must be at least 

30 percent of the amount so allocated using the gross sales method. That limitation will not affect the 

result here since the $10.80 apportioned to foreign source income under the gross income method is 

greater than $5.40 ($18 apportioned under gross sales x 30 % limitation). 

As a result of the allocation rules in the proposal, the taxpayer in this example would allocate 

$10.80 of U.S.-performed R& E expense to foreign source income, compared to the $30 required to be 

so allocated under the 1977 regulations. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Extend R& E allocations rules: -0.2 -0.5 -0.3 0.0 0.0 0.0 -0.9 

-26 -
EXTEND LOW-INCOME HOUSING TAX CREDIT 

Current T ^w 

A tax credit is allowed for certain expenditures with respect to low-income residential rental 

housing. Generally, owners of qualified low-income buildings ma y claim the low-income housing tax 

credit in equal annual installments over a 10-year credit period as long as the buildings continue to 

provide low-income housing over a 15-year compliance period. 

The discounted present value of the installments of the credit is generally 70 percent of the 

depreciable costs of new construction and substantial rehabilitations, and 30 percent of the cost of 

acquiring existing buildings which have been substantially rehabilitated (so long as they have not been 

placed in service within the previous 10 years and are not already subject to a 15-year compliance 

period). The basis of property is not reduced by the amount of the credit for purposes of calculating 

depreciation and capital gain. 

The annual credit available for a building cannot exceed the amount allocated to the building by 

the designated State or local housing agency. A State credit allocation is not required, however, for 

certain projects financed with tax-exempt bonds subject to the State's private activity bond volume 

limitation. 

The low-income housing tax credit was enacted as part of the Tax Reform Act of 1986. 

Originally, it provided States with the authority to allocate credits for 1987 to 1989 in annual amounts 

equal to $1.25 per State resident. The Omnibus Budget Reconciliation Act of 1989 extended each 

State's allocation authority through 1990, but at a reduced annual level of $0.9375 per State resident. 

The Omnibus Budget Reconciliation Act of 1990, however, increased the allocation authority for 1990 

to $1.25 per State resident and extended allocation authority through 1991 at the same annual level. 

The Tax'Extension Act of 1991 extended each State's allocation authority until June 30, 1992, at the 

level of $1.25 per State resident. 

Reasons for Change 

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

nation's rental housing stock and to make it available to the working poor and other low-income 

families. In addition to tenant-based housing vouchers and certificates, the credit is an important 

mechanism for providing Federal assistance to rental households. A study for the Department of 

Housing and Urban Development that was completed in February 1991 concluded that roughly 128,000 

tax credit units were completed during 1987 and 1988, the first 2 years of the program, and that the 

families occupying these units typically had an income well below the allowable program maximu m (60 

percent of area median family income). 

Proposal 

The proposal would extend the authority of States to allocate the credit through December 31, 

1993, at the level of $1.25 per State resident. 

Effcrls_pf Pr°Posal 

-27 -
Extending the low-income housing tax credit would encourage the private sector to continue to 

construct and rehabilitate housing and to make it available to low-income families. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Extend low-income housing tax credit: -* -0.2 -0.3 -0.4 -0.4 -0.4 -1.7 

* Less than $50 million. 

-28 -
EXTEND TARGETED JOBS TAX CREDIT 

Current La w 

The targeted jobs tax credit is available on an elective basis for hiring individuals from nine 

targeted groups. The targeted groups are: (1) vocational rehabilitation referrals; (2) economically 

disadvantaged youths aged 18 through 22; (3) economically disadvantaged Vietnam-era veterans; (4) 

Supplemental Security Income (SSI) recipients; (5) general assistance recipients; (6) economically 

disadvantaged cooperative education students aged 16 through 19; (7) economically disadvantaged 

former convicts; (8) eligible work incentive employees; and (9) economically disadvantaged summer 

youth employees aged 16 or 17. Certification of targeted group membership is required as a condition 

of claiming the credit. 

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

to a member of a targeted group. Thus, the maximum credit generally is $2,400 per individual. With 

respect to economically disadvantaged summer youth employees, however, the credit is equal to 40 

percent of up to $3,000 of wages, for a maximum credit of $1,200. 

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

(1) is employed by the employer for at least 90 days (14 days in the case of economically disadvantaged 

summer youth employees), or (2) has completed at least 120 hours of work performed for the employer 

(20 hours in the case of economically disadvantaged summer youth employees). The employer's 

deduction for wages must be reduced by the amount of the credit claimed. The credit was scheduled 

to expire December 31, 1991, but was extended by the Tax Extension Act of 1991 through June 30, 

1992. Accordingly, the credit is available with respect to targeted-group individuals wh o begin work 

for the employer on or before June 30, 1992. 

Reasons for Change 

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

m ay be unable to find employment. Job creation incentives are required in the current economic 

climate. 

Proposal 

The targeted jobs tax credit would be extended for 18 months. The credit would be available 

with respect to targeted-group individuals who begin work for the employer on or before December 31, 

1993. 

-29 -
Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Extend targeted jobs tax credit: -0.1 -0.2 -0.2 -0.1 -* -* -0.5 

* Less than $50 million. 

-30 -
EXTEN D BUSINES S ENERG Y TA X CREDI T 

Current T p W 

A tax credit is allowed for investment in solar or geothermal energy property. The amount of 

the credit is 10 percent of the investment. Solar property is equipment that uses solar energy to 

generate electricity or steam or to provide heating, cooling, or hot water in a structure. Geothermal 

property consists of equipment, such as a turbine or generator, that converts the internal heat of the 

earth into electrical energy or another form of useful energy. The credits for solar and geothermal 

property have been scheduled for expiration a number of times in recent years, but have been extended 

each time, most recently by the Tax Extension Act of 1991, which extended the credits through June 

30, 1992. 

Reasons for Change 

The geothermal and solar credits are intended to encourage investment in renewable energy 

technologies. Increased use of solar and geothermal energy would reduce our nation's reliance on 

imported oil and other fossil fuels and would improve our long-term energy security. Use of 

geothermal and solar energy resources also reduces air pollution. 

Proposal 

The solar and geothermal credits would be extended for 18 months to December 31, 1993. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Extend business energy tax credits: -* -* _* _* * * -0.1 

* Less than $50 million. 

-31 -

EXTEND FIRST-TIME FARMER BONDS 

Current La w 

State and local governments may use the proceeds of tax-exempt bonds to make loans to private 

individuals or entities for the purpose of acquiring or constructing manufacturing facilities or to make 

loans to certain first-time farmers for the purpose of acquiring farmland and equipment. Tax-exempt 

bonds used for these purposes are authorized under the Internal Revenue Code as qualified small issue 

bonds. 

Only individuals or entities with relatively small capital investments (i.e.. less than $1 million 

in some cases and less than $10 million in other cases) in the jurisdiction of the issuer of the bonds are 

eligible to use qualified small issue bonds for manufacturing facilities. Proceeds of qualified small issue 

bonds loaned to first-time farmers may not exceed $250,000 per farmer and may be used only to acquire 

qualifying farmland and certain farm-related depreciable property. 

Qualified small issue bonds are subject to the tax-exempt bond volume cap and must compete 

with other private activity bonds for a share of a State's volume cap. The authority to issue qualified 

small issue bonds was scheduled to expire December 31, 1991. This authority was extended through 

June 30, 1992 by the Tax Extension Act of 1991: 

Reasons for Change 

The provision of a modest amount of low-interest rate financing to first-time farmers through 

qualified small issue bonds is intended to encourage new individuals to become farmers. There has 

been a steady reduction in the number of smaller "family farms" in operation and fewer new individuals 

are entering into the smaller-scale farming business. 

Proposal 

Those portions of section 144 of the Code which provide the authority to issue qualified small 

issue bonds for first-time farmers would be extended 18 months, to December 31, 1993. 

Effects of Proposal 

The availability of low-interest rate financing should encourage new individuals to engage in the 

business of small-scale farming. Lower costs of borrowing to these individuals should help make them 

become more competitive and improve profitability of small farming operations. 

-33 -
Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-

(Billions of Dollars) 

Extend first-time farmer bonds: -* -* -* -* -* -* -* 

* Less than $50 million. 

-34 -
ESTABLISH ENTERPRISE ZONES 

Current La w 

Existing Federal tax incentives generally are not targeted to benefit specific geographic areas. 

Although the Federal tax law contains incentives that ma y encourage economic development in 

economically distressed areas, the availability of the incentives is not conditioned on activity in or 

development of such areas. 

Among the existing general Federal tax incentives that aid economically distressed areas is the 

targeted jobs tax credit. This credit provides an incentive for employers to hire economically 

disadvantaged workers and often is available to firms located in economically distressed areas. A 

Federal tax credit also is allowed for certain investment in low-income housing or the rehabilitation of 

certain structures that ma y be located in economically distressed areas. Another Federal tax incentive 

permits the deferral of capital gains taxation upon certain transfers of low-income housing. In addition, 

tax-exempt State and local government bonds may be used to finance certain activities conducted in 

economically distressed areas. 

Reasons for Change 

To help economically distressed areas share in the benefits of economic growth, the 

Administration proposes to designate Federal enterprise zones which will benefit from targeted tax 

incentives and regulatory relief. The tax incentives and regulatory relief provided by this proposal will 

stimulate government and private sector revitalization of the areas. 

Proposal 

The proposed enterprise zone initiative would include selected Federal income tax employment 

and investment incentives. These incentives would be offered beginning in 1993 in conjunction with 

Federal, State, and local regulatory relief. U p to 50 zones would be selected over a 4-year period. 

The incentives are: (1) a 5 percent refundable tax credit for qualified employees with respect to 

their first $10,500 of wages earned in an enterprise zone (up to $525 per worker, with the credit 

phasing out when the worker earns between $20,000 and $25,000 of total annual wages); (2) elimination 

of capital gains taxes for tangible property located within an enterprise zone and used in an enterprise 

zone business for at least 2 years; and (3) expensing by individuals of contributions to the capital of 

corporations engaged in the conduct of enterprise zone businesses (provided the corporation does not 

have more than $5 million of total assets and uses the contributions to acquire tangible assets located 

within an enterprise zone, and with the expensing limited to $50,000 annually per investor with a 

$250,000 lifetime limit per investor). 

The willingness of States and localities to "match" Federal incentives would be considered in 

selecting the enterprise zones to receive these additional Federal incentives. 

-35 -
Effects of Proposal 

Enterprise zones would encourage private sector investment and job creation in economically 

distressed areas by removing regulatory and other barriers inhibiting growth. They would also promote 

growth through selected tax incentives to reduce the risks and costs of operating or expanding businesses 

in severely depressed areas. A new era of public/private partnerships is needed to help distressed cities 

and rural areas help themselves. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Establish enterprise zones: - -* -0.2 -0.3 -0.5 -0.8 -1.8 

*Less than $50 million. 

-36 -
FACILITATE REAL ESTATE INVESTMENTS BY PENSION FUNDS AND OTHERS 

Current I^w 

Tax-exempt organizations are generally subject to the unrelated business income tax (UBIT) on 

income earned from debt-financed investments. The debt-financed income rules do not apply, however, 

to certain investments in real estate by qualified pension or profit sharing trusts ("qualified trusts") and 

certain educational organizations that provide instruction to enrolled students ("educational institutions"). 

The following requirements must be satisfied in order for a direct investment in real property 

by a qualified trust or educational institution to be excepted from the debt-financed income rules: (1) 

the price of the real property must be a fixed amount determined as of the date the investment is 

acquired; (2) the amount of (or any amount payable with respect to) any indebtedness, or the time for 

making payment of any such amount, must not be dependent, in whole or in part, upon any revenue, 

income, or profits derived from the real property; (3) the real property must not, at any time after the 

acquisition, be leased to the person wh o sold the property to the qualified trust or educational institution, 

or to a person related to such person; (4) in the case of a qualified trust, the real property must not be 

acquired from a person related to any plan with respect to which the trust was formed; and (5) the seller 

of the real property (or a person related to the plan with respect to which a qualified trust was formed) 

must not provide the qualified trust or educational institution with financing in connection with the 

acquisition of the property. (These are collectively referred to as the sale-leaseback rules.) 

The requirements described above were intended to prevent abusive transactions in which a 

business was sold to a tax-exempt entity on the installment basis (i.e.. with seller financing) and then 

leased back to the seller, often with both the purchase price and the rents contingent on profits from the 

business. The seller deducted the profits from the business as they were paid to the exempt organization 

in the form of rent and then reported them as capital gain when the exempt organization paid them back 

in the form of installment payments on the purchase of the business. 

Under a separate statute, all tax-exempt organizations are subject to UBIT on income they earn 

(whether or not debt-financed or unrelated) through publicly traded partnerships that are not otherwise 

treated as corporations for tax purposes. These types of publicly traded partnerships include those 

engaged in real estate investment activities. 

Reasons for Change 

If any of the elements described above are present, a debt-financed investment in real estate will 

not qualify for exception from taxation as debt-financed income under the sale-leaseback rules even 

where the transaction is not abusive. Modifications to the debt-financed income rules are necessary to 

permit qualified trusts and educational institutions to make debt-financed investments in real property 

on commercially reasonable terms in circumstances where there is no potential for abuse. In addition, 

there is no compelling reason to subject a non-leveraged investment in a publicly traded partnership to 

UBI T where a direct investment (or an investment in a non-publicly traded partnership) engaged in the 

same activity could be conducted free of tax. 

Proposal 

-37 -
1. General exceptions. 

D e minimis exception to sale-leaseback prohibition. The sale-leaseback prohibition would be 

modified to permit a de minimis leaseback to the seller (or a party related to the seller) of debt-financed 

real property. Th e de minimis exception would apply only if (1) no more than 10 percent of the 

leasable floor space in a building is leased back to the seller (or related party) and (2) the lease is on 

commercially reasonable terms. 

Seller financing exception. The prohibition on seller-financing would be modified to permit 

seller-financing on terms that are commercially reasonable. Standards would be provided for 

determining a commercially reasonable interest rate for this purpose. Because of the separate 

prohibition on debt-financed income measured by revenue, income, or profits, a participating loan 

(including an equity kicker) would not under this proposal be considered a commercially reasonable 

term. Th e seller-financing exception would not be available if the seller is related to the qualified trust 

(or to any plan with respect to which the trust was formed) or to the educational institution (including 

as a substantial contributor). 

2. Special Rules for Investments in Partnerships. 

The sale-leaseback rules would not apply to an investment made by a qualified trust or 

educational institution in a large partnership (that is, a partnership having at least 250 partners) if (1) 

investment units in the partnership are marketed primarily to taxable individuals; (2) a significant 

percentage (at least 50 percent) of each class of interests is owned by taxable individuals; (3) the 

partners that are qualified trusts or educational institutions participate on substantially the same terms 

as taxable individuals owning interests of the same class; and (4) a principal purpose of the partnership 

allocations is not tax avoidance. In the case of any partnership other than a large partnership in which 

taxable partners ow n a significant (at least 25 percent) interest, the sale-leaseback rules would not apply 

to an investment mad e by a qualified trust or educational institution if the partnership satisfies the 

allocation rules presently applicable to debt-financed investments in real estate through partnerships. 

In addition, the rule that automatically subjects investments in publicly traded partnerships to UBI T 

would be repealed for all tax-exempt investors. Thus, such investments would be subject to UBI T only 

if the activity conducted by the partnership is unrelated to the exempt purpose of the partner or is 

taxable under the debt-financed rules (as modified by this proposal). 

3. Special Exception for Property Foreclosed on by Financial Institutions. In the case of certain 

sales of property foreclosed on by financial institutions, the prohibition on participating loans would be 

relaxed as part of a further modification to the proposal described above relating to seller-financing. 

This special rule would apply only in a case where (1) the qualified trust or educational institution 

acquires the property from a financial institution (including an institution in receivership) that acquired 

the property by foreclosure; (2) the financial institution treats the property as an ordinary income asset 

and the amount of the seller financing does not exceed the amount of the financial institution's 

outstanding indebtedness (determined without regard to accrued but unpaid interest) with respect to the 

property at the time of foreclosure; (3) the terms and interest rate are commercially reasonable; and (4) 

the value of any equity participation feature (including an equity kicker) does not exceed 25 percent of 

the principal amount of the seller-provided loan and must be paid no later than the earlier of satisfaction 

of the loan or disposition of the property. Standards would be provided for determining a commercially 

reasonable interest rate for this purpose. 

-38 -
4. Effective Date. The proposal would generally be effective for debt-financed acquisitions of 

real estate on or after February 1, 1992, and for partnership interests acquired on or after February 1, 

Effects of Proposal 

Pension funds and educational institutions are a major source of investment capital for real estate. 

T he debt-financing rules, which were designed to prevent abuses in transactions between taxable and 

tax-exempt persons, are overbroad, and impose needless transaction costs which impede the efficient 

flow of capital. The proposal would eliminate these problems while continuing rules that prevent 

abusive transactions. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Facilitate real estate investments by pension 

funds and others: -* -* -* -* -* -* -* 

* Less than $50 million. 

-39 -

REPEAL LUXURY TAX ON AIRCRAFT AND BOATS AND 

REPEAL DIESEL FUEL EXEMPTION FOR PLEASURE BOATS 

Current Law 

An excise tax is imposed on the first retail sale of boats and aircraft. The tax is equal to 10 

percent of the excess of the sales price over $100,000 for boats and $250,000 for aircraft. The tax is 

also imposed on parts and accessories that are installed on new boats or aircraft within 6 months of 

purchase, and on the use of boats and aircraft before there has been a retail sale. The tax is not 

imposed on boats or aircraft that will be used in the active conduct of a trade or business. Most dieselpowered pleasure boats are subject to the tax. In addition, aircraft sold for more than $250,000 are 

subject to the tax unless the purchaser keeps records for 2 years showing that the business-use 

requirement has been satisfied. The tax applies to sales or uses between January 1, 1991 and 

December 31, 1999. 

An excise tax of 20.1 cents per gallon is generally imposed on the sale of diesel fuel that is sold 

for use (or used) in a diesel-powered highway vehicle. The tax does not apply to diesel fuel sold for 

use in a boat. The revenues from the tax are split between three funds: 2.5 cents per gallon is retained 

in the general fund, 17.5 cents per gallon goes to the Highway Trust Fund, and . 1 cent per gallon goes 

to the Leaking Underground Storage Tank Trust Fund. 

Reasons for Change 

The excise tax on boats and aircraft raises very little revenue and causes inappropriate economic 

dislocations. 

Proposal 

The Administration proposes to repeal the excise tax imposed on boats and aircraft. The repeal 

would be effective for sales on or after February 1, 1992. 

The revenue loss resulting from the repeal would be offset by extending the excise tax on diesel 

fuel to diesel fuel sold for use (or used) in pleasure boats.2 The change in the tax on diesel fuel would 

generally not affect business users. The change would be effective July 1, 1992 and revenues 

attributable to the change would be retained in the general fund. 

2 T he Administration has not proposed an offset for the repeal of the airplane luxury tax because 

collection experience indicates that the revenue to be raised by the tax over the next 5 years is less 

than $5 million. However, the cost of repeal could be offset by increasing the tax rate on 

noncommercial jet fuel by $0,001 per gallon. 

- 41 -
Effects of Proposal 

The extension of the diesel fuel tax would provide the revenue needed to offset the repeal of the 

luxury tax on boats and aircraft without significant dislocational effects. The burden of the new diesel 

fuel tax would be borne primarily by persons wh o own motor boats costing more than $100,000. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Repeal luxury tax on aircraft and boats and 

repeal diesel fuel exemption for pleasure boats: -* * * * * * * 

* Less than $50 million. 

-42 -
FAMILIES, HEALTH, EDUCATION AND SAVINGS 

-43-

PERMIT DEDUCTION OF INTEREST ON STUDENT LOANS 

Current Law 

Under current law, interest on educational loans is considered personal interest and is not 

deductible. Nondeductible personal interest also includes interest on consumer loans, such as car loans 

or credit card debt incurred to buy consumer goods. 

Current law allows a deduction for qualified mortgage interest, which can include interest on a 

hom e equity loan. A taxpayer can deduct interest on a hom e equity loan that is secured by a qualified 

residence, except that interest on a hom e equity loan generally cannot be deducted to the extent the loan 

exceeds the lesser of $100,000 or the amount of the taxpayer's equity in the residence. Ho w the 

taxpayer uses the proceeds of a hom e equity loan does not affect the deductibility of the interest. Thus, 

a taxpayer can deduct interest on a hom e equity loan that is used to pay for educational expenses. 

Reasons for Change 

To remain competitive in the international economy, the nation must have a well-educated, welltrained workforce. A deduction for interest costs incurred in financing higher education and training 

would encourage individuals to pursue and complete courses of study requiring higher education and 

vocational training. 

Proposal 

In general, the proposal would allow a deduction for certain interest expenses incurred to pay 

for education above the high school level, including vocational education and job-related courses. The 

deduction would be allowed for interest paid on or after July 1, 1992, and would be taken as an 

itemized deduction. The deduction would be available for interest on existing loans as well as loans 

incurred after enactment. 

Under the proposal, a taxpayer could deduct interest paid during the year on qualifying 

educational loans. For a loan to qualify, a number of conditions would have to be met. The loan 

would have to be made pursuant to a Federal or State guarantee or insurance program, by a tax-exempt 

nonprofit organization, by a financial institution under a type of program requiring payment to an 

educational institution, or by an accredited educational or vocational institution. In addition, the loan 

would have to be a conventional student loan, with conventional repayment terms, and would have to 

be incurred to pay for certain types of educational expenses. These expenses would have to be paid or 

incurred at a time that is reasonably contemporaneous with the time the loan proceeds are received. 

Eligible educational expenses would include tuition and related expenses of the taxpayer, or the 

taxpayer's spouse or child, for attendance as a student at an educational institution. The student would 

have to be either a high school graduate or over age 18, and would have to be pursuing a course of 

study that either led to a degree or certificate or was related to present or future full-time employment. 

Eligible educational expenses related to tuition would include fees, the cost of books, supplies, and 

equipment, and reasonable living expenses of the student if the student lived away from hom e while 

attending the educational institution. Tuition or related expenses would not be eligible if a third party 

reimbursed the taxpayer or the taxpayer's spouse or child for the expenses. 

-45 -
T he proposal would coordinate the deduction for qualified educational interest with the deduction 

for interest on hom e equity indebtedness. If a taxpayer with qualified educational indebtedness also had 

hom e equity indebtedness, the amount the taxpayer could treat as hom e equity indebtedness for any 

period would be reduced by any amount treated by the taxpayer as qualified educational indebtedness 

for that period. For example, if a taxpayer had an existing hom e equity loan of $150,000 in 1993 and 

incurred qualified educational indebtedness of $20,000 in that year, the taxpayer could only treat 

$80,000 of the hom e equity loan as hom e equity indebtedness in 1993 (applying first the $100,000 

limitation and then the reduction for qualified educational indebtedness). If in 1994 the taxpayer 

incurred an additional $15,000 of qualified educational indebtedness, the taxpayer could only treat 

$65,000 of the hom e equity loan as hom e equity indebtedness in 1994. T o avoid reduction of the 

interest deduction on the hom e equity loan as a result of a lower interest rate (or no current payments) 

on the educational indebtedness, a taxpayer would be permitted to elect, for any taxable year, to forego 

the educational indebtedness interest deduction and deduct the interest on up to $100,000 of hom e equity 

indebtedness. 

Under the proposal, lenders receiving interest on qualified educational indebtedness would be 

required to file annual information returns with the IRS. 

Effects of Proposal 

By encouraging individuals to pursue and complete courses of study requiring higher education 

or vocational training, the proposal would increase the nation's pool of well-educated workers. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Permit deduction of interest on student loans: -0.1 -0.4 -0.7 -0.7 -0.8 -0.9 -3.6 

-46 -
ESTABLISH FLEXIBLE INDIVIDUAL RETIREMENT ACCOUNTS (FIRAS) 

Current Law 

Taxation of Investment Income and Saving. Investment income earned by an individual taxpayer 

is generally subject to tax. The funds saved out of each year's income, which are used to make 

additional deposits to savings or other investment accounts, additional purchases of stocks or bonds, or 

to acquire other investments, are generally not deductible in calculating taxable income, and the income 

from such investments is generally subject to tax. The major exception is the tax treatment of 

retirement savings under certain tax-favored retirement savings arrangements, contributions to which 

are generally deductible and investment earnings of which are generally excludable from gross income. 

These investments are generally taxed when the amounts contributed and earned are later distributed, 

but the income earned from these investments is in effect never taxed. 

Individual Retirement Accounts. The current law for Individual Retirement Accounts (IRAs) 

generally grants married taxpayers wh o do not participate in a qualified retirement plan or wh o have 

adjusted gross incomes (AGIs) below $50,000 the right to make deductible contributions to an IRA. 

There is a lower income threshold of $35,000 if the taxpayer is unmarried. The deductibility of 

contributions for taxpayers participating in a qualified retirement plan is phased out as their AG I 

increases from $10,000 below the income threshold up to the threshold. Taxpayers wh o do participate 

in a qualified retirement plan and wh o have AGIs above these thresholds may make only nondeductible 

contributions to an IRA. Both deductible and nondeductible IRA contributions are limited to the lesser 

of $2,000 or the individual's compensation for the year. 

Married individuals who both work and otherwise qualify may each contribute to an IRA, so that 

each ma y contribute up to $2,000 if each spouse has compensation of $2,000 or more. Each $2,000 

limit on deductible contributions is then proportionately reduced for AGIs in the applicable phase-out 

ranges. If only one spouse works, qualifying married individuals also have the opportunity to contribute 

an additional $250 to an IR A for the nonworking spouse. The combined $2,250 limit on deductible 

contributions is also then proportionately reduced for AGIs in the applicable phase-out ranges. 

Withdrawals from an IRA prior to age 59lA are generally subject to a 10 percent additional tax 

unless arrangements are made to withdraw substantially equal amounts over the taxpayer's expected 

remaining life. Except for distributions of amounts that were not deductible when contributed, IR A 

withdrawals are subject in full to the regular income tax. Withdrawals must begin by age 70V2, and 

are subject to minimum withdrawal requirements thereafter. 

In economic terms, deductible IRAs effectively exempt investment income from taxation. (The 

income tax imposed on withdrawals merely recaptures the tax saved from deducting the contribution, 

plus interest on that tax savings; the investment income itself is effectively exempt from tax.) This 

favorable tax treatment provides an incentive to save: IRAs are designed to provide this incentive 

specifically for retirement savings. The tax exemption of investment income is also a feature of section 

401(k) and other tax-qualified retirement arrangements. Nondeductible IRAs allow only a deferral of 

taxes on investment income, not an exemption. 

Tysons for Change 

-47 -
There is general concern that the rate of national saving and investment is too low relative to 

that needed to sustain future growth and to maintain our economic position relative to that of other 

industrial nations. Addressing this problem requires that both public dissaving (the budget deficit) be 

reduced, and that private saving be increased in such a way as to increase net national savings. 

Incentives provided by the proposed FIRAs will provide an important incentive to encourage private 

saving. 

The availability of savings accounts in the form of IRAs was sharply curtailed by the Tax 

Reform Act of 1986, which resulted in a large decline in IRA participation. Prior to the Act, any 

individual under the age of 70^2 could make deductible contributions, up to the current dollar limits, 

to an IRA. On e of the goals of the current proposal is to expand the availability and attractiveness of 

tax-exempt saving to a large segment of the population. 

An additional goal of the current proposal is to expand savings incentives to income that is saved 

for other than retirement purposes, while not eroding incentives for retirement savings. The proposal 

recognizes that individuals save for many reasons: for down payments on homes, for educational 

expenses, for large medical expenses, and as a hedge against uncertain income in the future. 

Proposal 

The FIRA differs from a deductible current-law IRA in two respects: the contributions are not 

deductible, but, if the contributions are retained in the account for at least 7 years, neither the 

contributions nor the investment earnings are taxed when withdrawn. A s in the case of IRAs, the 

economic effect of a FIR A is to exempt investment income from taxation. The proposal would allow 

individuals (other than dependents) to make nondeductible contributions to a FIR A up to the lesser of 

$2,500 ($500 more than the $2,000 maximu m currently allowed for IRAs) or the individual's 

compensation for the year. For purposes of determining the contribution limits, married taxpayers filing 

a joint return would each be treated as earning half the compensation reported on the return. 

Contributions would be allowed for single filers with AGIs of no more than $60,000, for heads of 

households with AGIs of no more than $100,000, and for married taxpayers filing joint returns with 

AGIs of no more than $120,000. Contributions to FIRAs would be allowed in addition to contributions 

to current-law qualified pension plans, IRAs, section 401(k) plans, and other tax-favored forms of 

saving. 

Earnings on contributions retained in the FIRA for at least 7 years would be eligible for full tax 

exemption upon withdrawal. However, withdrawals of earnings allocable to contributions retained in 

the FIR A for less than 3 years would be subject to both a 10 percent additional tax and the regular 

income tax. Withdrawals of earnings allocable to contributions retained in the FIR A for 3 to 7 years 

would be subject only to the regular income tax. The proposal would be effective for years ending on 

or after December 31, 1992. 

An individual otherwise eligible to contribute to a FIRA would be allowed to transfer amounts 

from existing IRAs (other than an IRA formed from amounts rolled over from a qualified plan) to a 

FIR A (without regard to the $2,500 limitation) from February 1 through December 31, 1992. Such 

amounts (including initial contributions and accumulated interest) would be subject to the regular income 

tax, but would not be subject to the additional 10 percent tax for premature withdrawals. In addition, 

the regular income tax due on such transfers would not be due immediately, but would be spread over 

-48 -
a period of 4 years. The 3- and 7-year holding periods would begin to run on the date of the rollover 

contribution. 

Effects Of Prnpn^l 

The proposal would increase the total amount of individual saving that can earn tax-free 

investment income. Generally, individuals would be able to contribute to FIRAs, IRAs, section 401(k) 

plans, and similar tax-favored plans, and would receive tax exemption on the investment income from 

each source. 

The ability to contribute to a FIRA would significantly raise the total amount of allowable 

contributions to tax-favored savings accounts. The contribution limit is generally $5,000 for a married 

couple filing a joint return, even if only one spouse has compensation income. In contrast, the $4,000 

I R A limit for a married couple is available only if each spouse has compensation income of at least 

$2,000. These higher total contribution limits for FIRAs will provide additional marginal incentives 

for personal saving. The higher eligibility limits on FIRAs also extend the incentives to more 

taxpayers. 

Despite the difference in structure, the value of the tax benefits (in present value terms) of a 

FIR A per dollar of contribution is equivalent to the value of the tax benefits of a current-law deductible 

IRA, assuming that tax rates are constant over time. Both FIRAs and deductible IRAs effectively 

exempt all investment income from tax. The contributions to FIRAs are not deductible, but the income 

tax imposed on withdrawals from an IRA effectively offsets the tax savings from the deduction of the 

contribution (plus interest on the tax savings). Individuals wh o expect, at the time the funds are 

withdrawn, to be subject to tax at rates as high or higher than their current rates would generally prefer 

the tax treatment offered in a FIR A to that in an IRA. Conversely, individuals wh o expect to be taxed 

at lower rates at the time the funds are withdrawn would generally prefer an IR A as a vehicle for 

retirement savings. 

However, the FIRA offers more flexibility, because full tax benefits are available 7 years after 

contribution, and the account need not be held until retirement. This gives individuals an added degree 

of liquidity. In addition, because individuals are allowed to roll amounts over from an existing IR A 

to a FIRA, this additional liquidity is also available to individuals whose savings are currently placed 

in an IRA. 

-49 -
Revenue Estimate 

Establish flexible IRA accounts: 

-50 -

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992^7 

(Billions of Dollars) 

0.1 0.5 0.1 -0.4 -1.0 -2.1 -2.8 
PROMOTE RETIREMENT SAVING AND SIMPLIFY TAXATION 

OF PENSION DISTRIBUTIONS 

*• Small Business Model Retirement Plan 

Current T aw 

Simplified Employee Pension Under a Simplified Employee Pension (SEP) contributions are 

made to an Individual Retirement Account (IRA) established on behalf of each participant. Because a 

S E P is an alternative form of an employer-sponsored pension plan, the contribution limits that apply 

to each employee in the SE P are the limits that apply to employer-sponsored pension .plans in general, 

as opposed to the $2,000 maximum on contributions that normally applies to IRA contributions. In 

general, the employer is required to make a contribution for each employee wh o has attained age 21, 

has performed service for the employer during at least 3 out of the last 5 years and receives at least 

$374 (indexed) in compensation in the year. A n employer contribution to a SE P is not taxable income 

to the employee at the time the contribution is made. 

Salary Reduction Arrangement Within a Simplified Employee Pension. If an employer has less 

than 25 employees wh o meet the eligibility requirements for receiving a contribution under a SEP, the 

employer may include a salary reduction arrangement in the SEP. Under the salary reduction 

arrangement, an employee may elect to have the employer contribute a portion of his or her 

compensation to the SEP, in lieu of the employer paying the same amount directly to the employee as 

cash. These contributions are known as elective deferrals. There are nondiscrimination rules, similar 

to the nondiscrimination rules applicable to section 401(k) plans, that govern the amount that each 

individual highly compensated employee can defer under such a salary reduction arrangement. 

Reasons for Change 

Pension plan coverage for employees of small business is low. Small businesses need an 

affordable, easy to administer pension program for their employees. According to the Department of 

Labor, while 66 percent of employees in firms with 100 or more employees are covered by pension 

plans, only 23 percent of employees in firms with less than 100 employees have pension coverage. 

Under the proposal, the Small Business Model Retirement Plan would be available to nearly 95 percent 

of America's businesses. The proposal would also encourage expansion of coverage by providing 

employers with a simplified salary reduction plan that does not require nondiscrimination testing 

provided the required base contributions are made on behalf of all eligible employees and the employer 

agrees to make matching contributions at a specified level. 

Proposal 

A small business (defined as a business that normally employs less than 100 employees 

throughout the year) that has no other pension plan can provide a Small Business Model Retirement Plan 

for its employees. A n employer that sponsors a Small Business Model Retirement Plan will be required 

to contribute 1 percent of pay into an account for the benefit of each employee wh o meets the eligibility 

requirements to receive a contribution under a SEP. Employees will be eligible to make elective 

deferrals into their accounts up to a maximum contribution of $3,000, subject to the section 415 

limitation on contributions. T o encourage employees to elect deferrals, the employer must make 

- 51 -
matching contributions equal to the first 3 percent of compensation that an employee elects to defer plus 

50 percent of the employee's elective deferrals that represent between 3 percent and 5 percent of the 

employee's compensation. The Small Business Model Retirement Plan would generally replace the 

Salary Reduction SE P under existing law. 

2. Cash or Deferred Arrangements and Matching Plans 

Current Law 

An employer may sponsor a section 401(k) plan that provides employees the ability to defer 

some of the compensation that they would otherwise receive in cash into a qualified retirement plan. 

T he amount that highly compensated employees may defer into the plan is limited by the degree that 

nonhighly compensated employees make deferrals under the special average deferral percentage (ADP) 

test under section 401(k)(3). Plans ma y also provide for employer matching contributions and employee 

after-tax contributions. 

Actual Deferral Percentage Test. To satisfy the ADP test, the average of the deferral rates 

(expressed as a percentage of compensation) for each highly compensated employee eligible to 

participate in the plan generally cannot exceed the greater of (1) 125 percent of the average of the 

deferral rates for the current year of all nonhighly compensated employees eligible to participate in the 

plan or (2) the lesser of (a) 200 percent of such average, and (b) such average plus 2 percentage points. 

Amon g the permitted remedies for failure of the AD P test is the recharacterization of the deferrals as 

after-tax employee contributions. 

Contribution Percentage Test. If a plan permits after-tax employee contributions, or provides 

for employer contributions that are contingent on a participant's elective deferrals or after-tax employee 

contributions ("matching contributions"), the amount of such contributions generally must satisfy a 

special average contribution percentage (ACP) test under section 401(m)(2). The AC P test generally 

is the same as the AD P test described above, except that it applies to matching and after-tax employee 

contributions rather than to elective deferrals. 

Where contributions to a plan are subject to both the ADP test and the ACP test described above, 

special rules apply to preclude the full amount of the alternative limit (i.e.. the 200/2 percentage points 

limit) to be used in both tests. 

Reasons for Change 

Because the present law ADP test is based on current year deferrals and because the test is based 

on averaging of the deferral rates for eligible employees, the maximu m deferral permitted for the highly 

compensated employees is not known until year end. A s a result, excess deferrals can occur, and the 

correction methods are cumbersome. If employers could base the AD P test on prior year deferrals by 

the nonhighly compensated group, one of the variables that determines the extent that an individual 

highly compensated employee is permitted to defer is known at the beginning of the year. For 

employers wh o wish to remove all the uncertainty as to whether the deferrals of highly compensated 

employees will satisfy the AD P test, an option could be provided to apply the AD P on the basis of each 

individual highly compensated employee's deferral rate (rather than the average of such rates). This 

-52 -
would minimize, if not eliminate, excess deferrals and the necessity for correction. Similar 

considerations apply with respect to the present law AC P test. 

The multiple use test adds unnecessary complexity to the ADP and ACP tests. The ability to 

recharacterize excess deferrals as after-tax contributions also adds unnecessary complexity where 

modifications to the AD P and AC P tests will minimize, if not eliminate, excess deferrals. 

Proposal 

The ADP test would be modified such that the determination of the amount that highly 

compensated employees can defer is based on the average of the deferral rates for the eligible nonhighly 

compensated employees for the preceding plan year. In the case of an employer that has not previously 

maintained a 401(k) plan, the AD P test for the first plan year would be calculated as if the nonhighly 

compensated employee deferral rate was 3 percent. 

The ADP test would be further modified by providing employers with an election to apply the 

current law AD P test (as modified as described in the preceding paragraph) or to apply a simplified 

A D P test. Corresponding modifications would be made to the AC P test. 

Under the simplified ADP test, each eligible highly compensated employee individually would 

not be permitted to defer more than a prescribed amount based on the average of the deferral rates for 

the eligible nonhighly compensated employees. If the nonhighly compensated employee deferral rate 

was between zero and 3 percent, each highly compensated employee could defer an amount up to 2 

times that rate. If the nonhighly compensated employee deferral rate was greater than 3 percent, each 

highly compensated employee could defer an amount up to that rate plus 3 percentage points. Under 

this simplified AD P test, the multiple use test would not apply and the employer would not be permitted 

to recharacterize excess deferrals as after-tax employee contributions. 

3. Definition of Highly Compensated Employees and Family Aggregation Rules 

Current Law 

Various qualified pension plan requirements (principally those relating to nondiscrimination 

requirements) require a determination of the employer's highly compensated employees. The term 

"highly compensated employee" is defined to include any employee wh o during the current or preceding 

year (1) was a 5-percent owner, (2) earned over $75,000 (indexed), (3) earned over $50,000 (indexed) 

and was in the top 20-percent of the employer's workforce by compensation, or (4) was an officer 

earning compensation over $45,000 (indexed) or was the highest paid officer, if no officer earned more 

than the stated amount. Certain family aggregation rules apply in the case of 5-percent owners and 

other highly compensated employees wh o are among the top 10 employees by compensation. These 

family aggregation rules apply for purposes of identifying highly compensated employees and for 

purposes of applying the compensation limit under qualified plans. 

Rftasnns for Change 

Eliminating the rules regarding officers and the top 20 percent of employees by compensation 

would simplify the current rules. In addition, by generally basing the determination of highly 

-53 -
compensated employees on the prior year compensation, an employer would be able to determine its 

highly compensated employees at the beginning of a year. Amon g other things, this will facilitate 

determining compliance with the various qualified plan nondiscrimination rules (including those 

applicable to 401(k) plans). 

The family aggregation rules are a source of great complexity and create inequities for two wage 

earner families where both spouses work for the same employer. 

Proposal 

The term "highly compensated employee" would be redefined to include only 5-percent owners 

and employees wh o earn over $50,000 (indexed). If an employer had no highly compensated employees 

under this definition, then the one employee with the highest compensation would be treated as highly 

compensated. In addition, compensation generally would be determined based on the prior year's 

compensation. Finally, the family aggregation rules would be repealed. 

4. Cash or Deferred Arrangements for Employees of Tax-Exempt Employers 

Current Law 

Tax-exempt employers cannot adopt qualified cash or deferred arrangements (section 401(k) 

plans) for their employees. Certain existing plans adopted before July 2, 1986 were grandfathered. 

Similar rules apply to State and local governmental employers. 

Reasons for Change 

Certain tax-exempt employers (e.g.. section 501(c)(6) trade associations or section 501(c)(18) 

credit unions) are not permitted currently to offer any type of broad-based salary reduction program to 

their employees. In addition, section 401 (k) plans offer certain advantages over alternative vehicles 

available to other tax-exempt employers. For example, amounts deferred under a section 401(k) plan 

must generally be held in trust, while amounts deferred under section 457 plans (unfunded deferred 

compensation plans of tax-exempt employers) must remain subject to the general creditors of the 

employer. A s a matter of equity, employees of tax-exempt employers should have the same retirement 

vehicles available to them as private employers. 

Proposal 

Tax-exempt employers would be permitted to adopt section 401(k) plans for their employees. 

Current law would continue to apply to State and local governmental employers. 

-54 -
5- Promote Retirement Saving and Simplify Taxation of Pension Distributions 

Current T aw 

Distributions from qualified plans and other tax-preferred retirement programs are generally 

subject to income tax upon receipt. Premature distributions, generally those mad e before age 59 V2, ma y 

also be subject to a 10-percent additional tax under section 72(t). In addition, excess distributions 

(generally those in excess of $150,000) are subject to a 15-percent excise tax. A number of special 

rules ma y alter the general rule, if applicable. 

Lump Sum Distributions. Certain lump sum distributions from qualified plans are eligible to 

be taxed under special rules with respect to both the income tax and excise tax provisions. A participant 

m a y be able to elect to use the 5-year forward averaging rules in determining the income tax on a lump 

s um distribution if the distribution is received after attainment of age 59J/2 and other requirements are 

met. 

Participants who attained age 50 before January 1, 1986, have several additional options which 

m a y reduce the rate of tax on a lump sum distribution. First, they may elect to use the 5-year forward 

averaging rules even if they are younger than the currently prescribed age requirements if all other the 

requirements for using those rules are met. In addition, they ma y elect to use the 10-year forward 

averaging rules that were available before the Tax Reform Act of 1986. Finally, they ma y elect to have 

the entire portion of a lump sum distribution attributable to pre-1974 participation taxed at a 20 percent 

rate. 

If a lump sum distribution includes securities of the employer corporation, the "net unrealized 

appreciation" (NUA ) generally is not subject to tax until the securities are sold, unless the recipient 

elects to have the normal distribution rules apply. Whe n the securities are sold, the NU A is treated as 

long-term capital gain. If a distribution is not a lump sum distribution, only the NU A attributable to 

the employee's ow n contributions ma y be excluded from income under these special rules. 

Rollovers. Current income tax and, if applicable, the additional tax on a premature distribution 

can be avoided if the taxable portion of an eligible distribution is "rolled over" within 60 days to an 

individual retirement account (IRA) or to another qualified plan. Only "qualified total distributions" 

or "partial distributions" are eligible for rollover treatment. Neither after-tax employee contributions 

nor minimu m required distributions ma y be rolled over. 

Reasons for Change 

The tax treatment of qualified plan distributions is unnecessarily complex. The burden of this 

complexity falls primarily on plan participants and beneficiaries, wh o ma y not kno w the rules governing 

rollovers or the tax consequences of failing to take timely action. Given the 1986 changes in the basic 

structure of the individual tax rates and brackets, the highly complex rules for forward averaging, NUA , 

and capital gains treatment are no longer needed. The liberalized rollover proposal facilitates the 

retention of pension benefits in retirement savings vehicles, such as IRAs which give the participant 

control over the timing of distributions. 

-55 -
T he single largest source of lost pension benefits is preretirement cashouts of pension savings 

in lump sum distributions. The proposal would facilitate the preservation of such benefit's for retirement 

purposes by permitting employees to direct the transfer of their benefits to an IRA. 

Proposal 

Lump Sum Distributions. The 5-year forward averaging for lump sum distributions and the 

special tax treatment for NU A would be repealed. The special rules making 10-year forward averaging 

and capital gains treatment available to individuals wh o attained age 50 before January 1, 1986 would 

be phased out over a number of years. A s under current law, one lump sum distribution of up to 

$750,000 would be exempt from the excise tax on excess distributions. 

Rollovers. In general, most of the restrictions on the types of distributions eligible for rollover 

treatment would be eliminated. The only distributions not eligible for rollover treatment would be 

periodic distributions made in the form of an annuity payable for the life of the participant (or the joint 

lives of the participant and his or her designated beneficiary) or distributions payable in installments 

over, a period of 10 years or longer. The current law restrictions on the rollover of after-tax employee 

contributions and of minimum required distributions would be retained. 

In addition, a qualified plan making a distribution that is eligible for rollover treatment would 

be required to give the employee the option of having the distribution transferred directly to an IRA or 

another qualified plan. 

6. Taxable Portion of Pension Payments 

Current Law 

Distributions from a qualified retirement plan are generally subject to income tax when paid, 

except to the extent that the distribution constitutes a return of the employee's investment (primarily 

composed of after-tax contributions made by the employee). The portion of the payment that is 

excludable from tax is equal to the employee's investment divided by the "expected return". The 

expected return is the total annual annuity payment multiplied by the distributee's remaining life 

expectancy at retirement. In addition, up to $5,000 in death benefits paid by an employer ma y be 

excluded from gross income. If the death benefit is paid in the form of an annuity, the benefit is 

included in the employee's investment amount. Payors of pensions are required to report total pensions 

distributions and annuity payments and other partial payments from pension plans. 

Reasons for Change 

The rules for determining the tax consequences of a pension distribution are complicated and 

burdensome. The proposal would simplify current law by adopting a single, simpler method for 

determining the amount of tax. 

-56 -
Proposal 

T he death benefit exclusion would be repealed. The general rule for calculating the taxable 

portion of a distribution would be replaced with the alternative method currently provided in IRS Notice 

88-118. 

7- IRS Master and Prototype Program 

Current Law 

The IRS currently administers a master and prototype program under which trade and 

professional associations, banks, insurance companies, brokerage houses, and other financial institutions 

can obtain IRS approval of model retirement plans and make the pre-approved plans available for 

adoption by their customers, investors or association members. Under similar administrative programs, 

law firms and other organizations are able to get advance approval of model plans. 

Reasons for Change 

As the laws relating to retirement plans have become increasingly complex, employers have 

experienced an increase in the frequency and cost of amending plans and in the burdens of administering 

the plans. Master and prototype plans, and other model plans, reduce these costs and burdens, 

particularly for small to medium sized employers. They also improve IRS administration of the 

retirement plan rules. Today, the majority of employer-maintained tax-qualified retirement plans, 

including 401(k) plans and SEPs, are approved master and prototype plans. While the IRS believes that 

the further expansion of the master and prototype and other model plan programs is desirable, it is 

appropriate to provide the IRS with the statutory authority to specifically define the duties of model plan 

sponsors as the program becomes more widely utilized. 

In addition, ERISA and the Code generally prohibit plan amendments which have the effect of 

eliminating certain subsidies or optional forms of benefit under tax-qualified plans. Under the proposal, 

the Secretary of the Treasury would be authorized to issue regulations which would permit the 

relaxation of these "anti-cut back" rules when an employer replaces an individually designed plan with 

an IRS approved model plan, provided that the rights of participants under the individually designed 

plan were not significantly impaired. This would facilitate the shift by employers from individually 

designed plans to IRS model plans. 

Proposal 

Under the proposal, the IRS would be required to define the duties of sponsors of master and 

prototype and other model plans, consistent with the objective of protecting adopting employers from 

a sponsor's failure to timely amend the plan and with the objective of insuring adequate administrative 

services are provided with respect to the plan. Model plan sponsors that did not comply with the duties 

imposed by the IRS could be precluded from continuing to sponsor model plans. 

-57 -
8. Multiemployer Plan Vesting Requirements 

Current Law 

Multiemployer plans (i.e.. plans sponsored by more than one employer, maintained pursuant to 

collective bargaining) are permitted to use a 10-year cliff vesting schedule. By contrast, the Tax 

Reform Act of 1986 subjected single-employer plans to shorter minimum vesting standards (e.g.. 5-year 

cliff vesting or 7-year graded vesting). 

Reasons for Change 

Reducing vesting schedules for multiemployer pension plans would have a significant effect in 

enhancing pension benefits and portability for workers covered by these plans. A s a matter of equity, 

the multiemployer plan vesting rules should parallel the single employer plan rules. 

Proposal 

Multiemployer plans would be subject to the same minimum vesting standards as single-employer 

plans. 

9. PBGC Changes. The minimum funding rules for defined benefit plans would be changed. 

Details are provided in a separate document describing this and other PBG C reforms. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Promote retirement saving and simplify taxation 

of pension distributions (Items 1-8): 0.1 * * 0.3 0.4 0.4 1.1 

*Less than $50 million. 

-58 -
WAIVE PENALTY FOR WITHDRAWALS FROM IRAS FOR MEDICAL 

AND EDUCATIONAL EXPENSES 

Current T ^w 

Married taxpayers who do not participate in a qualified retirement plan or who have adjusted 

gross income below $50,000 generally may make deductible contributions to an Individual Retirement 

Account (IRA). There is a lower threshold of $35,000 for unmarried taxpayers. The deductibility of 

contributions for taxpayers participating in a qualified retirement plan is phased out over the last 

$10,000 below the income threshold for each income tax filing status. Taxpayers wh o do participate 

in a qualified retirement plan and wh o have adjusted gross incomes above these thresholds ma y make 

only nondeductible contributions to an IRA. Both deductible and nondeductible IR A contributions are 

limited to the lesser of $2,000 or the individual's compensation for the year. Married individuals 

generally ma y contribute an additional $250 to an IRA for a nonworking spouse. 

Withdrawals for IRAs must begin by age 70V2. IRA withdrawals, except those from 

nondeductible contributions, are subject to income tax. Withdrawals from an IR A prior to age 59lh are 

generally subject to a 10 percent additional tax unless arrangements are made to withdraw substantially 

equal amounts over the taxpayer's expected remaining life. There is an exception from the 10 percent 

additional tax under current law for distributions from qualified plans that do not exceed the amount 

allowable as a deduction for medical care during the year, but this exception does not apply to IRAs. 

Reasons for Change 

The Tax Reform Act of 1986 sharply curtailed the attractiveness and availability of IRAs for 

many taxpayers. This resulted in a large decline in IRA participation. Prior to the 1986 Act, any 

individual under the age of IOV2 could make deductible contributions, up to the current limits, to an 

IRA. The current proposal is designed to enhance the attractiveness of IRAs by making them more 

flexible. It would also provide an incentive for more taxpayers to save for educational and medical 

expenses and would provide additional sources of funds to pay these expenses, which can often be 

significant. 

Proposal 

The proposal would provide an exception from the 10 percent tax on early withdrawals for 

distributions from an IR A that do not exceed the amount of qualifying educational expenses of the 

taxpayer or his or her spouse or child. Qualifying educational expenses are expenses for higher 

education and post-secondary vocational education. The proposal would also extend the current law 

exception for distributions from qualified plans for certain medical expenses to distributions from an 

IRA. The proposal would be effective for withdrawals on or after February 1, 1992. 

-59 -
Effects of Proposal 

This proposal would enhance the attractiveness of IRAs. It would also provide an incentive fc 

more taxpayers to save for educational and medical expenses and would provide additional sources c 

funds to pay these expenses. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-9 

(Billions of Dollars) 

Waive penalty for withdrawals from IRAs 

for medical and educational expenses: -* -0.1 -0.1 -0.1 -0.1 -0.1 -0.6 

* Less than $50 million. 

-60 -
EXTEND HEALTH INSURANCE DEDUCTION FOR SELF-EMPLOYED 

Current T aw 

Current law generally allows a self-employed individual to deduct as a business expense up to 

25 percent of the amount paid during a taxable year for health insurance coverage for himself, his 

spouse, and his dependents. The deduction is not allowed if the self-employed individual or his or her 

spouse is eligible for employer-paid health benefits. Originally, this deduction was only available if the 

insurance was provided under a plan that satisfied the non-discrimination requirements of section 89 of 

the Code. Section 89 has since been repealed retroactively, however, and no non-discrimination 

requirements currently apply to such insurance. The value of any coverage provided for such 

individuals and their families by the business is not deductible for self-employment tax purposes. The 

availability of the deduction was extended by the Tax Extension Act of 1991 and is currently scheduled 

to expire June 30, 1992. 

Reasons for Change 

The 25 percent deduction for health insurance costs of self-employed individuals was added by 

the Tax Reform Act of 1986 because of a disparity between the tax treatment of owners of incorporated 

and unincorporated businesses (e.g.. partnerships and sole proprietorships). Under prior law, 

incorporated businesses could generally deduct, as an employee compensation expense, the full cost of 

any health insurance coverage provided for their employees (including owners serving as employees) 

and their employees' spouses and dependents. By contrast, self-employed individuals operating through 

an unincorporated business could only deduct the cost of health insurance coverage for themselves and 

their spouses and dependents to the extent that it, together with other allowable medical expenses, 

exceeded 5 percent of their adjusted gross income. (Coverage provided to employees of the selfemployed however, was and remains a deductible business expense for the self-employed.) The special 

25 percent deduction was designed to mitigate this disparity in treatment. Further, the Tax Reform Act 

of 1986 raised the floor for deductible medical expenses (including health insurance) to 7.5 percent of 

adjusted gross income. 

Proposal 

The proposal would extend the 25 percent deduction through December 31, 1993. 

Effects of Proposal 

The proposal will continue to reduce the disparity in tax treatment between self-employed 

individuals and owners of incorporated businesses, compared to prior law. 

- 61 -
Revenue Estimate 

Extend health insurance deduction 

for self-employed: 

Fiscal Year 

1992 1993 1994 1995 1996 1997 \992z 

(Billions of dollars) 

-0.1 -0.2 -0.3 - - - -0.6 

-62 -
EXTEND MEDICARE HOSPITAL INSURANCE (HI) COVERAGE TO ALL 

STATE AND LOCAL EMPLOYEES 

Current I a w 

State and local government employees hired on or after April 1, 1986, and employees who are 

not members of their employer's retirement system, are covered by Medicare Hospital Insurance, and 

their wages are subject to the Medicare tax (1.45 percent on both employers and employees). Unless 

a State or local government has a voluntary agreement with the Secretary of Health and Huma n 

Services, employees hired prior to April 1, 1986, who are members of their employer's retirement 

system are not covered by Medicare Hospital Insurance, nor are their wages subject to the tax. 

Reasons for Change 

State and local government employees are the only major group of employees not assured 

Medicare coverage. One out of six State and local government employees are not covered by voluntary 

agreements or by law. However, an estimated 85 percent of these employees receive full Medicare 

benefits through their spouse or because of prior work in covered employment. Over their working 

lives, they contribute on average only half as much tax as is paid by workers in the private sector. 

Extending coverage would assure that the remaining 15 percent have access to Medicare and would 

eliminate the inequity and the drain on the Medicare Trust Fund caused by those who receive Medicare 

without contributing fully. 

Proposal 

As of July 1, 1992, all State and local government employees would be covered by Medicare 

Hospital Insurance. 

Effects of Proposal 

An additional two million State and local government employees would contribute to Medicare. 

Of these, roughly 300,000 employees would become newly eligible to receive Medicare benefits subject 

to satisfying the minimum 40 quarters of covered employment. 

Revenue Estimate3 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Extend HI coverage to State and 

local employees: 0.3 1.6 1.5 1.5 1.5 1.5 8.1 

lNet of income tax offset. 

-63-

DOUBLE AND RESTORE ADOPTION DEDUCTION 

Current Law 

Expenses associated with the adoption of children are not deductible under current lav 

However, expenses associated with the adoption of special needs children are reimbursable under th 

Federal-State Adoption Assistance Program (Title IV-E of the Social Security Act). Special neec 

children are those wh o by virtue of special conditions such as age, physical or mental handicap, c 

combination of circumstances, are difficult to place for adoption. The Adoption Assistance Prograr 

includes several components. One of these components requires States to reimburse families for cos! 

associated with the process of adopting special needs children. The Federal Government shares 5 

percent of these costs up to a maximu m Federal share of $1,000 per child. Reimbursable expense 

include those associated directly with the adoption process such as legal costs, social service review 

and transportation costs. Som e children are also eligible for continuing Federal-State assistance unde 

Title IV-E of the Social Security Act. This assistance includes Medicaid. Other children ma y b 

eligible for continuing assistance under State-only programs. 

Reasons for Change 

The Tax Reform Act of 1986 (1986 Act) repealed the deduction for adoption expenses associate* 

with special needs children. Under prior law, a deduction of up to $1,500 of expenses associated wit 

the adoption of special needs children was allowed. The 1986 Act provided for a new outlay prograr 

under the existing Adoption Assistance Program to reimburse expenses associated with the adoptioi 

process of these children. The group of children covered under the outlay program is somewhat broade 

than the group covered by the prior deduction. The prior law deduction was available only for specia 

needs children assisted under Federal welfare programs, Aid to Families with Dependent Children, Titl 

IV-E Foster Care, or Supplemental Security Income. The current adoption assistance outlay progran 

provides assistance for adoption expenses for these special needs children, as well as special need 

children in private and State-only programs. 

Repeal of the special needs adoption deduction may have appeared to some as a lessening of th 

Federal concern for the adoption of special needs children. 

An important purpose of the Adoption Assistance Program is to enable families in modes 

circumstances to adopt special needs children. In a number of cases the children are in foster care wit 

the prospective adoptive parents. The prospective parents would like to adopt the child formally, bi 

find that to do so would impose a financial hardship on the entire family. 

While the majority of eligible expenses are expected to be reimbursed under the continuin 

expenditure program, the Administration is concerned that in some cases the limits ma y be set beto 

actual cost in high-cost areas or in special circumstances. Moreover, inclusion in the tax code of 

deduction for special needs children may alert families wh o are hoping to adopt a child to the man 

forms of assistance provided to families adopting a child with special needs. 

-65 -
Proposal 

T he proposal would permit the deduction from income of unreimbursed expenses th 

associated with the adoption of special needs children, up to a maximu m of $3,000 per child. E 

expenses would be limited to those directly associated with the adoption process that are digit 

reimbursement under the Adoption Assistance Program. These include court costs, legal exp 

social service review, and transportation costs. Expenses that are deducted and then reimburse 

later tax year would be included in income in the year the reimbursement occurs. Only expens 

adopting children defined as eligible under the rules of the Adoption Assistance Program woi 

allowed. The proposal would be effective for adoptions on or after February 1, 1992. 

Effects of Proposal 

The proposal when combined with the current outlay program would assure that reasc 

expenses associated with the process of adopting a special needs child do not cause financial hai 

for the adoptive parents. The proposed deduction would supplement the current Federal i 

program. In addition, the proposal highlights the Administration's concern that adoption of 

children be specially encouraged and may call to the attention of families interested in adoptic 

various programs that help families adopting children with special needs. 

While the costs of adoption of a special needs child are only a small part of the total 

associated with adoption of these children, the Administration believes that it is important to re 

this small one-time cost barrier that might leave any of these children without a permanent fami 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1< 

(Billions of Dollars) 

Double and restore adoption deduction: -* -* -* -* -* -* -* 

* Less than $50 million. 

-66 -
EXPAND PUBLIC TRANSIT EXCLUSION TO $60 PER MONTH 

Current La w 

Certain employer-provided fringe benefits are excluded from gross income under current law. 

Amon g the fringe benefits excluded from gross income are so-called "de minimis fringes," which are 

generally defined as any employer-provided property or service the value of which is so small as to 

make accounting for it unreasonable or administratively impractical. The 1984 legislation creating the 

exclusion instructed the Treasury to treat as a de minimis fringe up to $15 per month of employerprovided passes, tokens, fare cards and reimbursements to cover the costs of commuting by public 

transit. Regulations were issued in January 1992 to increase this amount to $21 to reflect inflation since 

1984. 

The exclusion for employer-provided commuting benefits applies only if the total value of the 

passes, tokens, fare cards and reimbursements provided to an employee does not exceed $21 per month. 

That is, an employee wh o receives benefits valued at more than $21 per month cannot exclude any 

portion of the value from income, even if the value exceeds $21 by only a small amount. 

Reasons for Change 

The Administration believes that a significant increase in the amount of employer-provided public 

transit commuting benefits that may be excluded from income subject to tax would create a more 

meaningful incentive for commuting by public transit than the exclusion provided under current law. 

The Administration also believes that the requirement under current law that the entire value of public 

transit commuting benefits that exceed the excludable amount be included in income subject to tax may 

discourage the provision of these benefits. 

Proposal 

The proposal would allow taxpayers to exclude from gross income up to $60 per month of 

employer-provided passes, tokens, fare cards and reimbursements to cover the costs of commuting by 

public transit, regardless of whether the total amount exceeds $60. The proposal would apply to 

benefits covering expenses incurred on or after February 1, 1992. 

Effects of Proposal 

The proposal would increase incentives for commuting by public transit. Increasing the 

excludable amount to $60 would allow taxpayers to exclude up to approximately $2.75 per work day 

in commuting expenses from income subject to tax, an amount sufficient to cover the cost of commuting 

by public transit for many taxpayers. The proposal would also create greater parity between the tax 

treatment of commuting by public transit and commuting by private automobile, the latter of which 

benefits from an exclusion from income for employer-provided parking for employees on or near the 

business premises of their employers. 

-67 -
Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 19 

(Billions of Dollars) 

Expand public transit exclusion: -* -* -*

 -* ~* '* "^ 

* Less than $50 million. 

-68 -
FAMILY TAX ALLOWANCE 

Current Law 

In general, a taxpayer is allowed a personal exemption for himself, his spouse, and for each 

dependent. Personal exemptions are allowed as deductions in computing taxable income. The amount 

of each personal exemption is $2,300 for taxable years beginning in 1992. 

In general, a child age 18 or under qualifies as a dependent if the taxpayer furnishes over half 

the child's support. A "child" includes a child by blood, an adopted child, a stepchild, and a child 

placed with the taxpayer by an authorized placement agency for legal adoption. In addition, a child wh o 

is a member of the taxpayer's household and lives with the taxpayer during the entire taxable year ma y 

be considered the taxpayer's "child." The amount of the personal exemption is indexed for inflation. 

Personal exemptions are phased out for high-income taxpayers. 

Reasons for Change 

Taxpayers incur significant costs in rearing children. An increase in the personal exemption for 

dependent children is a simple and effective way to decrease the financial burden on families. 

Proposal 

The proposal increases the personal exemption for dependent children age 18 and under at the 

end of the taxable year by $500 per child. This amount would be indexed for inflation. The proposal 

is effective October 1, 1992. 

Effects of Proposal 

Under the proposal, the personal exemption for dependent children age 18 or under at the end 

of the taxable year will increase by $500 per child. For taxable years beginning in 1992, the increase 

will be prorated. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of dollars) 

Family tax allowance: 0 -4.4 -4.6 -4.7 -5.0 -5.2 -23.8 

-69 -

HOMEBUYERS 

-71 -

PROVIDE FIRST-TIME HOMEBUYERS A $5,000 TAX CREDIT 

£yiTefltLaw 

There is no tax credit for homebuyers under current law. There are a number of other tax 

benefits for homeowners under current law. For example, homeowners are allowed to deduct mortgage 

interest and property taxes if they itemize their deductions. In addition, capital gains on the sale of a 

principal residence ma y be deferred if the seller purchases a ne w principal residence within a specified 

rollover period and the ne w residence costs at least as muc h as the adjusted sales price of the old 

residence. 

Reasons for Change 

A temporary tax credit for first-time homebuyers would accelerate the time at which first-time 

homebuyers purchase a home . B y accelerating and increasing expenditures on hom e purchases, such 

a credit would also assist in the recovery of the homebuilding industry. 

Proposal 

First-time homebuyers would receive a tax credit on the purchase of a principal residence. The 

credit would equal 10 percent of the purchase price of the residence, up to a maximu m of $5,000. Half 

of the credit would be allowed in the year the residence is purchased and half in the succeeding year. 

The credit would be available to any first-time homebuyer, regardless of income, and could be taken 

on the purchase of any residence that is the purchaser's principal residence. 

The tax credit would be available for any purchase of a first home on or after February 1. 1992. 

and before January 1, 1993. For calendar-year taxpayers, half the credit would thus be available to 

offset 1992 income tax liability and half to offset 1993 income tax liability. Although the credit would 

not be refundable if it exceeded income tax liability, any unused portion of the credit could be carried 

forward for up to 5 years if it could not be used in the current year. 

For example, if a first-time homebuyer purchased a principal residence in June 1992 for 

$80,000, the allowable credit would be the maximu m of $5,000. Under the proposal, the taxpayer 

Wild take a credit of $2,500 in 1992 and $2,500 in 1993. Alternatively, * ^ n^cecos t $40 000, 

die allowable credit would be $4,000; the taxpayer could take a credit of $2,000 in 199. and $.,000 

in 1993. 

A first-time homebuyer would include any individual who did not own a present interest in any 

residence at any time during the 3-year period prior to the date of purchasing the principal residence 

on which the credit is to be claimed However, if an individual is deferring tax on ga m from sale ot 

an old principal residence and is permitted an extended rollover period that individual would not be 

considered a first-time homebuyer until after the end of the extended rollover period. 

Only a single credit may be claimed per residence and all purchasers must be first-time 

homebuyers. If the credit is claimed on more than one return (e^ , in the case of a married couple 

filing a separate return), the credit must be apportioned under rules to be provided in regulations. 

-73 -
T he credit would be recaptured if the residence on which the credit is claimed is disposed 

within 3 years of the date the residence was purchased. The recapture rule would not apply, however, 

to dispositions by reason of the taxpayer's death or pursuant to the taxpayer's divorce. If the tf^^f 1 

disposed of the residence within 3 years but purchased a new residence within the rollover period, the 

credit would be recaptured to the extent the taxpayer could not have claimed as much credit on the new 

residence. 

Effects of Proposal 

The tax credit would assist first-time homebuyers in entering the housing market to purchase 

homes. By encouraging such purchases during 1992, the credit would stimulate the housing industry. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Provide tax credit to first-time homebuyers: -0.2 -2.1 -2.5 -0.6 0.2 0.1 -5.2 

-74 -
ALLOW DEDUCTION FOR LOSS ON SALE OF PRINCIPAL RESIDENCE 

Current Law 

Under current law, a deduction for nonbusiness losses is only available if the losses are casualty 

losses, and is limited in a number of ways. Casualty losses include losses arising from fire, storm 

shipwreck, or other casualty, or from theft. A taxpayer can deduct casualty losses only if the taxpayei 

itemizes deductions. T o calculate the amount of the deduction, the taxpayer must reduce each casualty 

loss by $100, and reduce the total amount of casualty losses by 10 percent of the taxpayer's adjuster 

gross income. Net casualty losses are deductible against ordinary income. 

Capital gain on the sale of a residence is taxable unless a specific deferral or exclusion of the 

gain is available. Capital loss on the sale of a residence, however, is not deductible and cannot offsei 

capital gain. 

The tax on capital gain on the sale of a principal residence may be deferred if the seller 

purchases a new principal residence within a 2-year rollover period and the new residence costs at least 

as much as the adjusted sales price of the old residence. The tax basis of the new residence is reduced 

by the amount of any untaxed gain on the sale of the old residence. The 2-year rollover period is 

extended for certain taxpayers residing abroad and certain military personnel on active duty. 

Capital gain on the sale of a principal residence may be excluded by a taxpayer who is age 55 

or older and meets certain qualifications. This exclusion is limited to $125,000 of capital gain and is 

only available to a taxpayer once. 

Reasons for Change 

In a period of declining home values, the asymmetry of current law treatment of gains and losses 

on sales of homes places an inappropriate burden on homeowners wh o must sell their homes at a loss. 

Proposal 

The proposal would allow homeowners who sell their homes at a loss to treat the capital loss 

as a casualty loss, thus allowing a partial deduction. The limitations on deductibility of casualty losses 

would apply, and the deduction would be available only if the homeowner itemizes deductions. 

In addition, the proposal would allow a homeowner who sells a principal residence at a loss and 

purchases a ne w principal residence within the 2-year rollover period to add the nondeductible portion 

of the loss to the tax basis of the new principal residence. The nondeductible portion of the loss would 

thus reduce gain on eventual sale of the residence. If a homeowner was eligible for a longer rollover 

period than 2 years by reason of foreign residency or military status, the longer rollover period would 

apply. 

For example, if a homeowner with an adjusted gross income of $40,000 sold his or her home 

at a loss of $10,000 and had no other casualty gains or losses for the year, the homeowner would have 

a casualty loss deduction from the sale of the hom e of $5,900 ($10,000 less $100 less 10 percent oi 

adjusted gross income). If the homeowner purchased a new principal residence within 2 years foi 

-75 -
$90,000, the homeowner could add $4,100 (the nondeductible portion of the $10,000 loss) to the basis 

of the new principal residence. Under current law, the homeowner would have a nondeductible capital 

loss of $10,000 and no basis adjustment reflecting that loss. 

The one-time $125,000 exclusion would still be available to homeowners who later sold their 

n ew principal residences at a gain. 

The proposal would be effective for sales of principal residences on or after February 1, 1992. 

In addition, homeowners wh o sustained a loss on the sale of a principal residence on or after January 1, 

1991 would be permitted to add the entire loss basis to the basis of a new principal residence purchased 

within the rollover period. 

Effects of Proposal 

The proposal would benefit homeowners who must sell their homes at a loss, thus easing the tax 

burden on such individuals. Although the full amount of the loss would not be currently deductible, 

the partial deduction combined with the basis adjustment would operate to correct much of the current 

imbalance between treatment of capital gains and capital losses from sales of principal residences. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Allow deduction for loss on sale 

of principal residence: -* -0.4 -0.4 -0.4 -0.4 -0.3 -1.9 

* Less than $50 million. 

-76 -
WAIVE PENALTY FOR WITHDRAWALS FROM IRAS 

FOR FIRST-TIME HOMEBUYERS 

Current Law 

Married taxpayers who do not participate in a qualified retirement plan or who have adjustec 

gross income below $50,000 generally ma y make deductible contributions to an Individual Retiremem 

Account (IRA). There is a lower threshold of $35,000 for unmarried taxpayers. The deductibility oi 

contributions for taxpayers participating in a qualified retirement plan is phased out over the lasl 

$10,000 below the income threshold for each income tax filing status. Taxpayers wh o do participate 

in a qualified retirement plan and wh o have adjusted gross incomes above these thresholds ma y make 

only nondeductible contributions to an IRA. Both deductible and nondeductible IR A contributions are 

limited to the lesser of $2,000 or the individual's compensation for the year. Married individuals 

generally ma y contribute an additional $250 to an IRA for a nonworking spouse. 

Withdrawals for IRAs must begin by age 70V2. IRA withdrawals, except those from 

nondeductible contributions, are subject to income tax. Withdrawals from an IRA prior to age 59lh are 

generally subject to a 10 percent additional tax unless arrangements are made to withdraw substantially 

equal amounts over the taxpayer's expected remaining life. 

Reasons for Change 

The intent of this proposal is to expand savings incentives with respect to income that is saved 

for first-time hom e purchases. Increasing the flexibility of IRAs would help alleviate the difficulties 

that many individuals have in purchasing a new home. 

The Tax Reform Act of 1986 sharply curtailed the attractiveness and availability of IRAs for 

many taxpayers. This resulted in a large decline in IRA participation. Prior to the 1986 Act, any 

individual under the age of IOV2 could make deductible contributions, up to the current limits, to an 

IRA. The current proposal is designed to enhance the attractiveness of IRAs by making them more 

flexible. It would also provide an incentive for taxpayers to save for the purchase of their first home. 

Proposal 

The proposal would allow individuals to withdraw amounts of up to $10,000 from their IRAs 

for their first purchase of a principal residence. The 10 percent additional tax on early withdrawals 

would be waived for eligible individuals. Eligibility for penalty-free withdrawals would be limited to 

individuals wh o did not ow n a present interest in a residence at any time during the 3 years period prior 

to the purchase of the principal residence, or wh o are not within an extended period for rolling over 

gain from the sale of a principal residence. The proposal would be effective for withdrawals on or after 

February 1, 1992. 

-77 -
Effects of Proposal 

This proposal would enhance the attractiveness of IRAs and help encourage individuals to save 

for the purchase of a first home. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Waive penalty for withdrawals from IRAs for 

first-time homebuyers: -* -0.1 -0.1 -0.1 -0.1 -0.1 -0.5 

* Less than $50 million. 

-78 -
EXTEND MORTGAGE REVENUE BONDS 

flurrent La w 

State and local governments may use the proceeds of tax-exempt bonds to make loans to low and 

middle income individuals for the purpose of purchasing a single family residence to be used as their 

principal residence. Tax-exempt bonds used for this purpose are authorized under the Internal Revenue 

Code as mortgage revenue bonds. In lieu of issuing mortgage revenue bonds, State and local 

governments may issue mortgage credit certificates (MCC's) to low and middle income individuals with 

respect to qualifying purchases of principal residences. MCC' s provide qualifying purchasers of 

principal residences a tax credit equal to a portion of the home mortgage interest paid by the purchaser. 

Generally, only individuals with family incomes of less than 115 percent of the median family 

income for the area in which a residence is located are eligible to borrow proceeds of mortgage revenue 

bonds or to receive MCC's . In addition, the purchase price of a residence purchased with proceeds of 

mortgage revenue bonds or subsidized with MCC' s may not exceed 90 percent of the average purchase 

price of residences in that area. 

Mortgage revenue bonds and MCC's are subject to the tax-exempt bond volume cap and must 

compete with other private activity bonds for a share of a State's volume cap. The authority to issue 

mortgage revenue bonds and MCC' s was scheduled to expire on December 31, 1991. This authority 

was extended through June 30, 1992 by the Tax Extension Act of 1991. 

Reasons for Change 

Programs funded with the proceeds of mortgage revenue bonds that provide loans to low and 

middle income homebuyers and programs providing MCC' s to low and middle income homebuyers have 

been popular with many State and local governments. Making mortgage revenue bond proceeds and 

MCC's available to homebuyers results in lower costs of borrowing, thereby making housing more 

affordable for lower and middle income families. Extending this program will help lower and middle 

income families acquire residences. 

Proposal 

The authority to issue mortgage revenue bonds and MCC's would be extended 18 months, to 

December 31, 1993. 

Effects of Proposal 

The availability of low-interest rate or subsidized mortgage financing should make home 

ownership possible for more lower and middle income individuals and families. 

-79 -
Revenue Estimate 

Extend mortgage revenue bonds: 

* Less than $50 million. 

1992 1993 

Fiscal Years 

1994 1995 1996 1991 ]3SQM 

(Billions of Dollars) 

-0.1 -0.1 -0.1 -0.1 -0.3 

-80 -
OTHER PROPOSALS AFFECTING RECEIPTS 

-81 -

SUPPORT REVENUE NEUTRAL TAX SIMPLIFICATION 

To reform the burden of taxpayer compliance with the nation's tax law, the Administration will 

continue to support revenue-neutral simplification of the tax Code, including simplification of tax rules 

applying to individual taxpayers, relating to amortization of purchased intangible assets and governing 

payroll tax deposits for small- and medium-sized businesses. 

The Administration has set forth its position on specific simplification proposals currently 

pending before Congress in Treasury Department testimony delivered on July 23, 1991, before the 

House Committee on Way s and Means; on July 25, 1991, before the Select Revenue Measures 

Subcommittee of the House Committee on Way s and Means; on July 29, 1991, before the Select 

Revenue Measures Subcommittee of the House Committee on Ways and Means; on September 10, 

1991, before the Senate Committee on Finance; and on October 2, 1991, before the House Committee 

on Ways and Means. 

-83 -

REVISE RULES FOR CHARITABLE CONTRIBUTIONS 

r.nrrent Law 

Alternative Minimum Tax. In calculating taxable income for ordinary income tax purposes, 

taxpayer is generally allowed to deduct (subject to certain limits) the fair market value of propei 

contributed to charitable organizations. The amount of the deduction, however, is generally limiti 

to the taxpayer's basis in the property if a sale of the property would have given rise to ordinary incor 

or to a short-term capital gain. The amount of the deduction is also limited to the taxpayer's basis 

the property is tangible personal property and the recipient's use of the property is unrelated to its ta 

exempt purpose. 

A different rule was adopted in 1986 for donations of long-term capital gain property under tl 

alternative minimum tax (AMT) . In computing alternative minimum taxable income (AMTI) , tl 

taxpayer ma y not deduct the full value of the property. Rather, the taxpayer treats as a tax prefereno 

and therefore adds back to AMTI , the amount by which the fair market value of the property excee< 

the taxpayer's basis. However, under a special rule that applies for taxable years beginning in 195 

and for contributions made before July 1, 1992 in taxable years beginning in 1992, charitafr 

contributions of tangible personal property do not result in this tax preference.4 

Source Rule. Under the current statute and regulations, a taxpayer's charitable deductior 

generally are ratably allocated and apportioned between U.S. source and foreign source gross incom< 

In making this computation, an affiliated group of corporations generally is treated as a single taxpaye 

The allocation and apportionment of a charitable deduction to a taxpayer's foreign source income ma 

reduce the allowed foreign tax credit of taxpayers with excess foreign tax credits. 

Reporting by Charitable Donees. Section 6033 of the Internal Revenue Code requires most tai 

exempt organizations eligible to receive tax-deductible charitable contributions to file an annuj 

information return (the For m 990). However, of these entities, churches and their affiliate 

organizations and public charities with gross receipts of $25,000 or less are generally not required 1 

file the Form 990. B y regulation, exempt organizations required to file the For m 990 must generall 

report, among other items, the names and addresses of all persons wh o contributed, bequeathed, c 

devised $5,000 or more (in money or other property) during the taxable year. 

In the Revenue Act of 1987, Congress adopted rules requiring exempt organizations other tha 

charities (that is, other than organizations exempt under section 501(c)(3)) to disclose in their func 

raising solicitations that payments to the organization are not deductible as charitable contribution: 

Charities are not required to disclose, in soliciting donations, the circumstances under which donation: 

membership dues, payments for goods or services, or other items might not be deductible as charitab] 

contributions. 

Reporting by Donors. On Schedule A to the Form 1040, an individual taxpayer must separate] 

state the aggregate amount of charitable contributions made by cash or check and the aggregate amoui 

made other than by cash or check. In addition, on a form attached to the Form 1040, taxpayers m u 

4See Rev. Rul. 90-111, 1990-2 C.B. 30 for the rules that apply to donations made in 1991. 

-85-
separately identify charitable contributions of property valued at more than $500. The donor must 

provide certain specified information about the contributed property, including a description or the 

property and the date it was acquired, and the method used to determine its fair market value. 

Generally, a qualified appraiser must sign the form if the claimed deduction exceeds $5,000 per item 

or group of similar items. In the case of donated art for which a deduction of $20,000 or more is 

claimed, a complete copy of the signed appraisal must be attached. 

A taxpayer is not required to provide information regarding specific contributions made by cash 

or check, regardless of amount. 

Reasons for Change 

Making the temporary AMT exclusion permanent and expanding it to cover intangible personal 

property and real property as well as tangible personal property will encourage charitable contributions 

of property. Items that might otherwise be sold would instead be given to charitable institutions, to the 

benefit of the general public. Charitable organizations have indicated that since the beginning of 1991, 

when the temporary exclusion from the AM T for gifts of tangible personal property took effect, gifts 

of this type of property have increased significantly. 

Pro rata allocation and apportionment of charitable deductions on an affiliated group basis may 

discourage charitable giving by U.S. multinational corporations with excess foreign tax credits. Other 

methods of allocation and apportionment that could be allowed, by regulation, under the current statute 

(such as allocation based on the place of use of the charitable gift) may favor some charities over others. 

On audit of individual taxpayers, the IRS is not readily able to distinguish between charitable 

donations to charities and payments to charities for goods and services, such as the admission to 

entertainment events and the purchase of consumer items. For example, a popular fundraising technique 

is the use of "charity auctions." Where the winning bidder writes a check to the charity for a large sum 

of money, significant tax revenues are lost if the taxpayer treats the payment as a charitable contribution 

rather than as a nondeductible payment for goods or services. Such payments, however, are difficult 

to identify on the face of the taxpayer's return, if they are aggregated on Schedule A with other cash 

contributions. 

Proposal 

Under the proposal, the temporary exclusion from AMTI would be made permanent and would 

be expanded to include the fair market value of all gifts of appreciated property, including real estate 

and stocks and bonds. By making permanent the temporary exclusion currently in effect and by 

expanding that exclusion to all types of property, the proposal restores the exclusion of gifts of 

appreciated property from the AM T that existed before the Tax Reform Act of 1986. The AM T change 

would be effective for contributions made in calendar years ending on or after December 31 1992 

The proposal would also allocate all charitable contribution deductions of a taxpayer to U S 

source gross income to the extent thereof, effective for contributions made in calendar years ending on 

or after December 31, 1992.

 6 

-86 -
In addition organizations eligible to receive tax-deductible contributions would generally be 

required to file information returns with the IRS (and with the donor) reporting charitable contributions 

received from any individual in excess of $500 (in cash or property) during the calendar year. The 

organization would determine whether the amount received is potentially eligible for the charitable 

contribution deduction, based on whether the organization provided goods or services to the donor. 

Organizations with annual gross receipts of less than $25,000 would be exempt from this reporting 

requirement. It is expected that the IRS would revise Schedule A to the For m 1040 to require 

individuals wh o itemize deductions to separately report contributions of more than $500 (whether in cash 

or in kind) made in a calendar year to a single organization. The proposal for additional reporting 

would apply to contributions made on or after July 1, 1992. 

Effects of Proposal 

The proposal should encourage additional charitable contributions of appreciated property by 

individuals and by U.S. multinationals with excess foreign tax credits. The proposal also would avoid 

disadvantaging charities with activities abroad in seeking contributions from such corporations. 

Preliminary data collected by IRS under its TCMP program show that taxpayers have frequently 

overstated charitable contributions. The proposal would reduce the amount of this overstatement by 

providing the IRS with information needed to monitor the claimed tax treatment of large donations made 

to charities. In addition, providing information to taxpayers should increase voluntary compliance and 

should simplify return preparation. 

Revenue Estimate 

Revise rules for charitable contributions: 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

-* 0.1 0.1 0.1 0.1 0.2 0.6 

* Less than $50 million. 

-87 -

CONFORM BOOK AND TAX ACCOUNTING FOR SECURITIES INVENTORIES 

Current Law 

Under Treasury regulations, inventories of marketable securities held by dealers for sale to 

customers ma y be valued at market, at cost, or at the lower of cost or market for purposes of computing 

taxable income. 

The market method of inventory valuation (often referred to as the "mark to market" method) 

requires the taxpayer to determine the market value of its inventory at the end of each taxable year and 

include all unrealized inventory gains and losses in its income for the year. The market method tends 

to give the most accurate measure of a taxpayer's annual income, but it works best if the taxpayer's 

inventory is composed of items that can be readily valued at the end of each taxable year. 

Because inventories of most businesses are difficult to value, however, most taxpayers use the 

cost method of inventory valuation (often referred to as the "historical cost" method). Under the cost 

method, a taxpayer values its inventory at the cost reflected on the taxpayer's books until the inventory 

is sold, and does not recognize any of the unrealized gains and losses that are reflected in the 

inventory's value. For most profitable businesses, the cost of the taxpayer's inventory will ordinarily 

be less than its market value and inventory levels will ordinarily increase over time. Thus, the cost 

method will tend to understate the taxpayer's annual income, compared to the market method. 

Under the lower of cost or market method of inventory valuation (LCM), a taxpayer values each 

item of inventory at its market value or at its cost, whichever is lower at the end of each taxable year. 

Thus, the LC M method permits the taxpayer to deduct unrealized losses without requiring any 

unrealized gains to be included in income. 

When the Treasury regulations regarding securities dealers were issued, the lower of cost or 

market method conformed to the best accounting practice in the trade or business, and securities dealers 

regularly inventoried their unsold securities on that basis in their financial statements. Because the 

L C M method understates a taxpayer's annual income, compared to either the market method or the cost 

method, it was considered a very conservative method of financial accounting. Since 1973, however, 

generally accepted accounting principles (GAAP ) have required securities dealers to mark their 

inventories to market. 

Reasons for Change 

Inventories of marketable securities are easily valued at year end, and in fact are currently valued 

by securities dealers in computing their income for financial statement purposes and in adjusting their 

inventory to an LC M basis for Federal income tax purposes. The cost method and the LC M method 

tend to understate taxable income compared to the market method that securities dealers use to report 

their income to shareholders and creditors. The market method represents the best accounting practice 

in the trade or business of dealing in securities and is the method that most clearly reflects the income 

of a securities dealer. 

Proposal 

-89 -
T he Administration proposes to eliminate the ability of securities dealers to use the cost and 

L C M methods. Securities dealers would be required to compute their taxable income by marking theii 

inventories of securities to market, as they already do when preparing financial statements in accordance 

with GAAP . 

Each dealer that currently uses the cost or LCM method of accounting for its inventory of 

securities would be required to change to the market method for all of its securities held for sale to 

customers. The dealer would be required to value its inventory of securities at market for all taxable 

years ending on or after December 31, 1992. Under a transitional rule, the resulting change in 

inventory value would be included in taxable income ratably over a 10-year period. For example, a 

dealer that uses a calendar year and that is required to change from the LC M method to the market 

method on December 31, 1992, would increase its taxable income for 1992 and each of the next 9 years 

by 10 percent of the difference between the market value of its inventory on December 31, 1992, and 

the value of that inventory on December 31, 1992 under the LC M method. 

Effects of Proposal 

The proposal would more clearly reflect the annual income earned by dealers in securities. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Conform book and tax accounting for 

securities inventories: 0.2 0.6 0.8 0.8 0.8 0.8 4.0 

-90 -
EXTEND 45-DAY INTEREST-FREE PERIOD TO REFUNDS OF ALL TAXES 

Current I^aw 

Current law provides that no interest is to be paid by the Government on a refund arising from 

an original income tax return if the refund is issued by the 45th day after the later of the due date for 

the return (determined without regard to any extensions) or the date the return is filed. 

Reasons for Change 

There is no interest-free period for refunds of taxes other than income taxes (i.e.. employment, 

excise and estate and gift taxes), or for refunds arising from amended returns. This treatment results 

in taxpayers receiving interest on some overpayments of tax that are refunded within a 45-day period, 

but not on others, although in all cases taxpayers control the time of filing and the IRS needs a 

minimum time period to process the return. 

Proposal 

The Administration proposes to provide a 45-day interest-free period in which the IRS may 

process refunds of any type of tax overpayment, regardless of whether the refund arises pursuant to an 

original return or an amended return. 

Effects of Proposal 

The proposal would eliminate the disparity in the payment of interest on overpayments of income 

tax and overpayments of other taxes, as well as the disparity in the payment of interest on refunds 

arising from original tax returns and refunds arising from amended tax returns. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Extend 45-day interest-free period: * 0.3 0.3 0.4 0.4 0.4 1.8 

* Less than $50 million. 

- 91 -

DISALLOW INTEREST DEDUCTIONS ON CORPORATE-OWNED 

LIFE INSURANCE (COLD LOANS 

Current Law 

A corporation is allowed to own life insurance policies insuring the lives of its employees and 

retirees. The investment income on the cash value of these COL I policies is exempt from current 

taxation, in accordance with the tax treatment provided life insurance policies generally. Interest on 

indebtedness secured by the cash value of these policies is deductible to the extent the amount of the 

indebtedness does not exceed $50,000 per insured life. 

Reasons for Change 

Corporations that borrow against the cash value of a life insurance policy are able to generate 

tax savings because the interest paid on the indebtedness is deductible while the build up of investment 

income on the cash value is not currently subject to tax. The corporation's actual net interest expense 

is minimal because the interest paid on the loan is approximately equal to the investment income the 

insurance company credits to the cash value. The Tax Reform Act of 1986 attempted to curtail this tax 

arbitrage by imposing a $50,000 per-insured-employee limitation on the amount of indebtedness on 

which interest ma y be deducted. 

Since 1986, new types of COLI policies have evolved. Under these policies, a corporation 

insures a large number of employees, and the cash value with respect to each employee's insurance 

coverage is less than $50,000. This technique has allowed corporations to avoid the $50,000 perinsured-employee limitation and shelter large amounts of investment income from current taxation. 

Furthermore, COL I policies are being structured to pay for health and retirement benefits and could be 

used to avoid restrictions on benefit plans applicable under other provisions of the Code. 

Proposal 

The Administration proposes to disallow the deduction for interest paid by corporations on loans 

secured by the cash value of life insurance policies. The proposal would be effective for interest 

incurred on or after February 1, 1992. 

Effects of Proposal 

The proposal would eliminate tax arbitrage on COLI policies by disallowing the deduction for 

interest expense. Furthermore, it would remove an avenue by which corporations can avoid the 

nondiscrimination and other restrictions that are generally applicable to deductions for fringe benefit 

payments. Although the proposal would discourage borrowing against COL I policies insuring the lives 

of key employees, it would not prevent corporations from purchasing such policies. 

-93 -
Revenue Estimate. 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Disallow interest deductions on corporate-owned 

life insurance loans: 0.1 0.3 0.4 0.5 0.6 0.6 2.5 

-94 -
PROHIBIT DOUBLE DIPPING BY THRIFTS 

RECEIVING FEDERAL FINANCIAL ASSISTANCE 

Current Law 

A taxpayer may claim a deduction for a loss on the sale or other disposition of property only 

to the extent that the taxpayer's adjusted basis for the property exceeds the amount realized on the 

disposition and the loss is not compensated for by insurance or otherwise. In the case of a taxpayer on 

the specific charge-off method of accounting for bad debts, a deduction is allowable for the debt only 

to the extent that the debt becomes worthless and the taxpayer does not have a reasonable prospect of 

being reimbursed for the loss. If the taxpayer accounts for bad debts on the reserve method, the 

worthless portion of a debt is charged against the taxpayer's reserve for bad debts, potentially increasing 

the taxpayer's deduction for an addition to this reserve. 

Before it was amended by the Financial Institutions Reform, Recovery, and Enforcement Act 

of 1989 (FIRREA), a special tax rule exempted financial assistance received by a thrift institution from 

the Federal Savings and Loan Insurance Corporation (FSLIC) from the thrift's income and prohibited 

a reduction in the tax basis of the thrift's assets on account of the receipt of the assistance. The FSLIC 

entered into a number of assistance agreements in which it agreed to provide loss protection to acquirers 

of troubled thrift institutions by compensating them for the difference between the book value and sales 

proceeds of the "covered assets." "Covered assets" typically are assets that were classified as 

nonperforming or troubled at the time of the assisted transaction. Man y of these covered assets are also 

subject to yield maintenance guarantees, under which the FSLIC guarantees the acquirer a minimum 

return or yield on the value of the assets. The assistance agreements also generally grant the FSLIC 

the right to purchase covered assets at market or book value. 

In addition, many of the assistance agreements permit the FSLIC to order assisted institutions 

to write dow n the value of covered assets on their books to fair market value in exchange for a payment 

in the amount of the write-down. It was not clear under prior law whether FSLIC assistance should 

be taken into account in determining the amount of an institution's tax loss on the sale or other 

disposition of an asset or deduction in connection with the write-down of a loan. 

In September 1990, the Resolution Trust Corporation (RTC), in accordance with the 

requirements of FIRREA , issued a report to Congress and the Oversight Board of the RT C on certain 

FSLIC-assisted transactions (the" 1988/89 FSLIC transactions"). The report recommended further study 

of the covered loss and other tax issues relating to these transactions. A March 4, 1991 Treasury 

Department report on tax issues relating to the 1988/89 FSLIC transactions concluded that deductions 

should not be allowed for losses that are reimbursed with exempt FSLIC assistance and recommended 

that Congress enact clarifying legislation disallowing these deductions. 

Reasons for Change 

Allowing tax deductions for losses on covered assets that are compensated for by FSLIC 

assistance gives thrift institutions a perverse incentive to hold these assets and to minimize their value 

when sold. The FSLIC, and not the institution, bears the economic burden corresponding to any 

reduction in value because it is required to reimburse the thrift for the loss. However, the tax benefit 

to the thrift and its affiliates increases as tax losses are enhanced. The institution, therefore, has an 

-95 -
incentive to minimize the value of covered assets in order to maximize its tax loss and the attendant tax 

savings. 

Proposal 

Under the Administration proposal, FSLIC assistance with respect to (1) any loss would be taken 

into account as compensation for that loss for purposes of section 165, and (2) any debt would be taken 

into account in determining the worthlessness of that debt for purposes of sections 166, 585 and 593 

of the Code. FSLIC assistance would be defined as assistance provided with respect to a domestic 

building and loan association pursuant to section 406(f) of the National Housing Act or section 21 A of 

the Federal Hom e Loan Bank Act. 

The proposal would apply to FSLIC assistance credited on or after March 4, 1991 with respect 

to (1) assets disposed of and charge-offs made in taxable years ending on or after March 4, 1991; and 

(2) assets disposed of and charge-offs made in taxable years ending before March 4, 1991, but only for 

the purpose of determining the amount of any net operating loss carryover to a taxable year ending on 

or after March 4, 1991. 

Effects of Proposal 

Assisted thrift institutions will no longer have an incentive to minimize the value of covered 

assets in order to maximize their tax loss on the sale or write-down of these assets and the attendant tax 

savings. In addition, clarification of the tax treatment of FSLIC assistance will facilitate measures to 

renegotiate and reduce the cost of the 1988/89 FSLIC transactions. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Prohibit double dipping by thrifts receiving 

Federal financial assistance: 0.4 0.4 0.1 * -* 0.1 0.9 

* Less than $50 million. 

-96 -
EQUALIZE TAX TREATMENT OF LARGE CREDIT UNIONS AND THRIFTS 

Current Law 

Credit unions are exempt from tax on their income, whether such income is retained or 

distributed to depositors. 

Reasons for Change 

Because of their tax exemption, credit unions enjoy a competitive advantage over other financial 

institutions such as commercial banks and savings and loan associations. Credit unions have grown 

rapidly since 1951, when savings and loan associations and mutual savings banks became subject to the 

corporate income tax. Federally insured credit unions accounted for approximately 10 percent of 

consumer installment credit (not including mortgages) in 1991 and their asset size approximated $200 

billion. 

In an economy based on free market principles, the tax system should not provide a tax subsidy 

to particular commercial enterprises or a competitive advantage to those enterprises over others that 

perform substantially the same functions. Although credit unions were founded to extend short-term 

personal loans to narrowly defined groups, today large credit unions frequently function more as fullservice consumer banks. 

Most credit unions, however, are relatively small. Approximately 94 percent of all Federally 

insured credit unions have $50 million or less in assets and approximately 39 percent of all Federally 

insured credit union assets are held by these smaller institutions. 

Proposal 

The proposal would repeal the tax exemption for a credit union that has assets of more than $50 

million in any taxable year ending on or after December 31, 1992. Such credit unions would be subject 

to tax under the same rules that apply to thrift institutions. Credit unions with $50 million or less in 

assets would continue to be exempt from tax. 

Effects of Proposal 

Repealing the tax exemption for large credit unions would place credit unions that perform the 

same functions as other financial institutions on the same competitive footing as those institutions and 

would contribute to a more efficient allocation of financial resources. The repeal also would eliminate 

a distinction under the tax law that is based on historical differences that, in the case of large credit 

unions, no longer exist. 

In addition, the repeal would eliminate the incentive that large credit unions currently have to 

retain earnings free of tax, rather than distribute them to customer/owners. T o the extent that retained 

earnings are necessary for growth, large credit unions would have to increase the spread between their 

"dividend" rates and loan rates to cover the Federal tax liability. As with other mutual depository 

institutions, however, large credit unions could reduce the amount of Federal income tax paid at the 

corporate level by distributing more "dividends" to depositors or by providing lower loan rates to 

-97 -
borrowers. Distributions of earnings would be included in taxable income currently at the individual 

level. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Equalize tax treatment of large credit 

unions and thrifts: 0.1 0.2 0.2 0.2 0.2 0.2 1.1 

-98 -
MODIFY TAXATION OF ANNUITIES WITHOUT LIFE CONTINGENCIES 

Current La w 

The tax law does not distinguish between annuities from which periodic payments are made for 

the duration of the taxpayer's life and annuities from which periodic payments are not based on the 

taxpayer's life. Individuals owning either type of annuity receive the tax advantage of deferral of 

investment income during the accumulation period and favorable basis recovery rules as annuity 

payments are made. 

Reasons for Change 

Most deferred annuities allow the owner of the annuity to select a settlement option prior to the 

time payments begin. The settlement options are generally (1) a pure life or joint lives contingency, 

(2) a life-contingent annuity containing a term or amount certain feature where annuity payments are 

guaranteed for a certain term or amount without regard to the time of the annuitant's death, (3) a lump 

s um payment, and (4) a term certain payment schedule without a life contingency. Deferred annuities 

that do not have substantial life contingency risks are similar to alternative investments offered by other 

financial institutions in which the investment earnings are currently taxed. Eliminating the tax 

advantages of these types of annuities would prevent tax avoidance through the purchase of annuities 

and reduce incentives to misallocate savings between investment vehicles. 

Proposal 

The Administration proposes to retain the current-law treatment of annuities, Le^., the deferral 

of tax on inside buildup during the accumulation phase and the pro rata exclusion of basis, only for 

annuities with substantial life contingencies. For other annuities, investment income would be taxed 

as earned. The distinction between annuities would be based on whether the annuity contains a 

substantial risk of loss of investment if the taxpayer dies prematurely. The policy would generally be 

considered an annuity for tax purposes only if payments were guaranteed (1) for a period of time equal 

to less than one-third of the annuitant's remaining life expectancy on the annuity starting date, or (2) 

for less than one-third of the annuity's cash value on the annuity starting date (or date of death, if 

earlier). Pension annuities and annuities that are part of structured settlements would not be included 

in this proposal. The proposal would be effective for all annuity contracts entered into on or after 

February 1, 1992. 

Effects of Proposal 

By conforming the tax treatment of annuities without substantial life contingencies to the tax 

treatment of similar investments, the proposal will require investors to decide whether they need the life 

expectancy protection an annuity offers, and the corresponding risk of loss of their investment due to 

premature death. For those investors wh o are primarily interested in tax deferred investment earnings, 

the proposal ma y have the effect of reallocating savings to different investment vehicles. 

-99 -
Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Modify taxation of annuities without 

life contingencies: * 0.2 0.2 0.3 0.4 0.5 1.7 

* Less than $50 million. 

- 100-
EXPAND COMMUNICATIONS EXCISE TAX 

flnrrent La w 

The communications excise tax is imposed on amounts paid for local telephone service, toll 

telephone (i.e.. long distance) service, and teletypewriter exchange service. The tax does not apply to 

amounts paid for access to a local digital data network that cannot be used for telephonic (voice) quality 

communication. It also does not apply to amounts paid for long distance transmission of digital data. 

Although the communications excise tax is imposed on amounts paid for local telephone service 

and toll telephone service, the tax is not imposed on local telephone service paid for by inserting coins 

in a coin-operated telephone available to the public. A similar exemption applies to long distance 

telephone service, but only if the total charge is less than 25 cents. 

Reasons for Change 

Digital data transmission over a local digital data network or over a long distance line is similar 

to telephonic communication both in purpose and in method of transmission. The communications 

excise tax should be updated to reflect this technological advance. 

The exemptions for coin-operated telephone service are not justified by any fundamental 

difference in the nature of the services provided. Their anomalous nature is particularly evident when 

the treatment of local calls from the same public telephone is compared. Calls that are paid for by coin 

are not subject to the tax, but tax is imposed on calls that are paid for by credit card. 

Proposal 

The proposal would impose the communications excise tax on amounts paid for access to a local 

digital data network or for long distance transmission of digital data. The proposal would also repeal 

the exemptions for coin-operated telephone service. Both changes would be effective July 1, 1992. 

Effects of Proposal 

The proposed expansion of the communications excise tax would equalize the tax treatment of 

voice and digital data transmissions over long distance lines and would also equalize the tax treatment 

of local telephone systems and local digital data networks. 

Repealing the exemptions for coin-operated telephone service would eliminate disparities in the 

tax treatment of amounts paid for essentially equivalent services. 

- 101 -
Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of dollars) 

Expand communications excise tax: * 0.1 0.1 0.1 0.1 0.1 0.5 

* Less than $50 million. 

- 102-
EXTEND ORPHAN DRUG TAX CREDIT 

Turrent La w 

Drugs for the treatment of rare diseases or physical conditions are often called "orphan drugs" 

because the narrow demand for them discourages taxpayers from undertaking the costly investment in 

clinical testing that must be completed before manufacture and distribution of the drugs can be approved 

by the Food and Drug Administration. T o encourage development of the drugs, current law allows an 

elective, non-refundable tax credit for the clinical testing costs incurred by the taxpayer. Although 

expenses qualifying for the orphan drug credit cannot also qualify for the research and experimentation 

(R&E) credit, clinical testing expenses do qualify as R& E expenditures for purposes of determining 

whether the taxpayer's other research expenditures qualify for the R& E credit. If the taxpayer elects 

to claim the orphan drug credit, no deduction is allowed for an amount of the taxpayer's clinical testing 

expenses equal to the credit allowable for the taxable year. 

The orphan drug credit expires with respect to amounts paid or incurred after June 30, 1992. 

Reasons for Change 

Although the country benefits from the development of drugs for rare diseases and conditions, 

taxpayers are not adequately rewarded financially for their clinical testing activities. Clinical testing 

is long-term in nature, and taxpayers should be able to plan their activities knowing that the credit will 

be available when the clinical testing is actually undertaken. Thus, if the orphan drug credit is to have 

its intended incentive effect, it should be made permanent. 

Proposal 

The Administration proposes to make the orphan drug credit permanent. 

Effects of Proposal 

Stable incentives allow taxpayers to undertake the development of drugs with greater assurance 

of future tax consequences. A permanent orphan drug credit permits taxpayers to undertake 

developmental activities without fear that the tax incentive will not be available when the clinical testing 

is carried out. 

Revenue Estimate 

Fiscal Years 

1992 1993 1994 1995 1996 1997 1992-97 

(Billions of Dollars) 

Extend orphan drug tax credit: -* -* -*. -* -* -* -0.1 

* Less than $50 million. 

- 103-

MISCELLANEOUS PROPOSALS AFFECTING RECEIPTS 

Proposals 

Establish Federal Communications Commission (FCC) non-application processing fees. The 

Administration proposes to establish fees to cover non-application processing costs of the Commission. 

A portion of the amounts collected from these fees would be dedicated to the expansion of FC C 

services. 

Extend abandoned mine reclamation fees. The abandoned mine reclamation fees, which are 

scheduled to expire on September 30, 1995, would be extended. Collections from the existing fees of 

35-cents per ton for surface mined coal, 15-cents per ton for underground mined coal, and 10-cents per 

ton for lignite coal are allocated to States for reclamation grants. Abandoned mine land problems are 

expected to exist in certain States after all the money from the collection of fees under current law is 

expended. 

Increase employee contributions to the Civil Service Retirement System (CSRS). Currently, 

most CSR S employees and their employing agencies are each contributing 7 percent of base pay to the 

retirement system. This is less than one-half the accruing cost of CSR S retirement benefits. T o prevent 

further increases in the existing CSR S unfunded liability of $560 billion, the Administration proposes 

to increase CSR S employee contributions by 1 percentage point effective January 1, 1993 and by an 

additional 1 percentage point effective January 1, 1994. 

Conform definition of compensation under Railroad Retirement Tax Act to that of social security. 

The Administration proposes to conform the definition of employee compensation under the Railroad 

Retirement Tax Act to the definition of employee compensation under social security. Discrepant tax 

treatment of employee compensation under the two systems results in unnecessary revenue losses to the 

ailing rail pension trust funds. 

Implement Uruguay Round of Multilateral Trade Negotiations. The Uruguay Round of 

Multilateral Trade negotiations, due to be completed in early 1992, is a wide-ranging and complex 

negotiation to open global markets and energize world trade. Som e aspects of the agreement, 

particularly the tariff negotiations, will affect customs duties and other tax receipts. Most of these tariff 

reductions are provided for in the Omnibus Trade and Competitiveness Act of 1988. However some 

tariff changes likely to be agreed to in the negotiations as well as some non-tariff agreements in the 

Uruguay Round will require new legislation. This implementing legislation will be transmitted to 

Congress under the "fast-track" procedures specified in the 1988 Act when the Uruguay Round 

negotiations are complete. 

- 105-
Revenue Estimate 

Establish FC C nonapplication processing fees: 

Extend abandoned mine reclamation fees: 

Increase employee contributions to CSRS: 

Conform definition of compensation under 

Railroad Retirement Tax Act: 

Implement Uruguay Round: 

Fiscal Years 

1992 1993 1994 1995 1996 

(Billions of Dollars) 

0 

0 

0 

0 

0 

0.1 

0 

0.4 

* 

.* 

0.1 

0 

1.1 

* 

* 

0.1 

0 

1.2 

* 

* 

0.1 

0.2 

1.2 

* 

_* 

- 106-

Department of the Treasury 

Washington, D.C. 20220 

Official Business 

Penalty for Private Use, $300