II ~***************************** 

Tax Treatment of Individuals 
IIA-1 

INDIVIDUAL TAX RATES AND THE PERSONAL CREDIT 

Present Law 

Three elements of the tax law that affect all individual 

taxpayers are the personal exemption, the general tax credit, 

and the schedule of tax rates. An individual is allowed an 

exemption of $750 for himself and for each dependent. On a 

joint return, both husband and wife are allowed exemptions. 

Additional $750 exemptions are allowed for individuals who 

are aged or blind. 

The general tax credit is equal to (a) $35 for each 

personal exemption, or (b) two percent of the first $9,000 of 

taxable income, whichever is greater. 

There are four rate schedules -- joint, single, married 

filing separately, and head of household. 1/ Onder, the 

joint table, the first bracket, or zero bracket, includes 

$3,200 of taxable income. No tax is paid on income in the 

zero bracket. The other tax rates range from 14 percent (for 

the first $1,000 of taxable income in excess of this zero 

bracket amount) to 70 percent in the highest bracket (more 

than $200,000 over the zero bracket amount). For single 

taxpayers, the zero bracket includes the first $2,200 of 

taxable income. Rates range from 14 percent for the first 

$500 in excess of the zero bracket amount to 70 percent in 

the highest bracket (more than $100,000 over the zero 

bracket amount). The schedule for the separate returns of 

married persons is obtained from the joint schedule by 

dividing all dollar amounts by two. Finally, a single 

taxpayer with a dependent may qualify to use the head of 

household schedule. Under this schedule, tax liability is 

the average of the amounts that would be owed on a joint 

return and a single return with the same taxable income above 

the zero bracket amount. 

Reasons for Change 

The economy requires a substantial tax cut to ensure 

that the current recovery is sustained. In particular, 

individual income tax reductions are needed to offset both 

increases in social security taxes in 1978 and 1979 and to 

counteract the tendency of inflation to increase the share of 

personal income that taxpayers pay in Federal income tax. 

Although major income tax cuts are needed to offset the 

restraining effects, or fiscal drag, of rising tax 

collections on the economy, the opportunity is afforded at 

the same time for restructuring the tax system to achieve 

other important goals. In particular, rates and credits can 

- 25 -
be designed to make the tax system more equitable and more 

progressive and to simplify the tax laws. 

First, a personal credit is more equitable than an 

exemption in that it grants equal tax relief at all levels of 

income. A personal exemption reduces the amount of income 

subject to tax. The value of the exemption is dependent upon 

the marginal rate of tax which would otherwise apply to the 

income that is excluded and, therefore, rises with income. 

For instance, for a taxpayer in the 14 percent bracket, a 

$750 exemption is worth $105 in tax savings, while, for a 

taxpayer in a 50 percent bracket, a similar exemption is 

worth $375. A personal credit, on the other hand, reduces 

the amount of tax liability by the amount of the credit. 

Thus, the value of the credit does not depend upon the 

taxpayer's marginal tax rate or his income. 

To the extent that the tax system relieves taxpayers of 

the burden of dependents, this relief should not be greater 

for high income taxpayers than it is for low and middle 

income taxpayers. Also, a credit is more appropriate than an 

exemption for providing assistance to taxpayers who are blind 

or aged. The expenses of blindness or age affect all blind 

and aged taxpayers without regard to their income, and 

accordingly, there is little justification for designing a 

tax assistance program which provides greater benefits as 

income rises. 

Second, rates and credits can be changed to increase the 

level of income at which the taxpayer first begins to pay income tax. The income tax should avoid taxing those 

families with income near or below poverty levels. 

Third, structural changes can be made to simplify the 

tax law. The combination of the personal exemption plus the 

general tax credit creates needless confusion for the average 

taxpayer trying to understand how his liability is 

determined. Also, the elimination of $5.8 billion in 

itemized deductions (see ITEMIZED DEDUCTIONS) will lead to 

substantial simplification of the tax law. However, to 

ensure that the average taxpayer enjoys the full benefits of 

simplification, the money saved by eliminating these itemized 

deductions will be used to further reduce tax rates. 

Finally, the tax system should be designed in such a 

manner that changes in the law can be easily accomodated. 

Future changes may make use of the income tax system to 

rebate energy taxes or to meet the needs of those on welfare. 

In both cases -- energy rebates and welfare assistance -- it 

may be desirable to provide the same per capita tax benefits 

at every level of income. This can be most easily 

accomplished through modification of a personal credit. 

- 26 -
General Explanation 

Under the proposal beginning with 1978 a personal credit 

of $249 will replace the personal exemption and the general 

tax credit. For each exemption that a taxpayer is allowed 

under present law, he will be allowed a personal credit. 

Thus, for example, if a husband and wife file a joint return, 

they will both be allowed a personal credit. 

Marginal tax rates will be reduced for all taxpayers. 

For 1979 and later years, the lowest rate will be decreased 

from 14 percent to 12 percent. The highest rate will be 

decreased from 79 percent to 68 percent. In many tax 

brackets, the reduction in rates will be even greater. For 

1978, there will be a transitional rate schedule which will 

allow changes to begin in the last quarter of the year and 

which will result in a net tax reduction approximately 

one-fourth the size of the reduction for all of 1979. Tables 

IIA-1 and IIA-2 show the proposed reduction in rates for 

married couples filing joint returns and for single individuals. 

- 27 -
Table IIA-1 

Individual Taz Rate Schedule• For 

JoiDt hturna 

Present Law Taz Propoaal 1978 

Taxable Incoae : Taz Pro2oaal 

Bracket Taz At : Taz llate Taz At : Taz llate-: Taz At : Taz late 

Low End : on Incoae Low End : on Incoae I Low End : on Incoae 

:of Bracket :In Bracket :of Bracket :ID Bracket :of Bracket :In Bracket 

0 - 3,200 0 0% 0 0% 0 0% 

3,200 - 3,700 0 14 0 12 0 14 

3,700 - 4,200 70 14 60 12 70 14 

4,200 - 5,200 140 15 120 14 140 15 

5,200 - 6,200 290 16 260 16 290 16 

6,200 - 7,200 450 17 420 17 450 17 

7,200 - 11,200 620 19 590 18 620 19 

11,200 - 15,200 1,380 22 1,310 19 1,380 21 

15,200 - 19,200 2,260 25 2,070 20 2,220 23 

19,200 - 23,200 3,260 28 2,870 23 3,140 26 

23,200 - 27,200 4,380 32 3,790 27 4,180 30 

27,200- 31,200 5,660 36 4,870 32 4,380 33 

31,200 - 35,200 7,100 39 6,150 36 6,700 36 

35,200 - 39,200 8,660 42 7,590 39 8,140 40 

39,200 - 43,200 10,340 45 9,150 42 9,740 43 

43,200 - 47,200 12,140 48 10,830 44 11,460 45 

47,200- 51,200 14,060 50 12,590 48 13,260 48 

51,200 - 55,200 16,060 50 14,510 48 15,180 48 

55,200 - 57,200 18,060 53 16,430 51 17,100 52 

57,200- 65,200 19,120 53 17,450 51 18,140 52 

65,200 - 67,200 23,360 53 21,530 51 22,300 52 

67,200- 79,200 24,420 55 22,550 54 23,340 55 

79,200 - 91,200 31,020 58 29,030 57 29,940 56 

91,200 - 93,200 37,980 60 35,870 57 36,660 60 

93,200 - 103,200 39,180 60 37,010 60 37,860 60 

103,200 - 113,200 45,180 62 43,010 60 43,860 61 

113,200 - 123,200 51,380 62 49,010 62 49,960 62 

123,200 - 133,200 57,580 64 55,210 62 56,160 63 

133,200 - 143,200 63,980 64 61,410 64 62,460 64 

143,200 - 153,200 70,380 66 67,810 64 68,860 66 

153,200 - 163,200 76,980 66 74,210 65 75,460 66 

163,200 - 178,200 83,580 68 80,710 65 82,060 67 

178,200 - 183,200 93,780 68 90,460 66 92,110 67 

183,200 - 203,200 97,180 69 93,760 66 95,460 69 

203,200 aDd over 110,980 70 106,960 68 109,260 70 

Office of the Secretary of the Treaaury January 26, 1978 

Office of Taz Ana1yaia 
Table IIA-2 

Individual Tax Rate Schedul .. For 

S1q1e Jleturna 

Preaent Lav Tax Propou1 1978 

Taxable Income Tax Proeoaa1 

Bracket Tax At : Tax Rate I Tax At 1 Tax Rate Tu At Tax Rate 

Low End : on Incoae Low End 1 on Incoae I Lov End on Incoae 

:of Bracket :In Br.acket :of Bracket zln Bracket rof Bracket In Bracket 

0 - 2,200 0 0% 0 0% 0 0% 

2,200 - 2,700 0 14 0 12 0 14 

2,700 - 3,200 70 15 60 13 70 15 

3,200 - 3, 700 145 16 125 15 145 16 

3,700 - 4,200. 225 17 200 15 225 17 

4,200 - 5,200 310 19 275 18 310 18 

5,200 - 6,200 500 19 455 19 490 19 

6,200 - 8,200 690 21 645 20 680 20 

8,200 - 10,200 1,110 24 1,045 20 1,080 20 

10,200 - 12,200 1,590 25 1,445 22 1,480 24 

12,200 - 14,200 2,090 27 1,885 23 1,960 25 

14,200 - 16,200 2,630 29 2,345 25 2,460 28 

16,200 - 18,200 3,210 31 2,845 25 3,020 31 

18,200 - 20,200 3,830 34 3,345 29 3,640 33 

20,200 - 22,200 4,510 36 3,925 29 4,300 35 

22,200 - 24,200 5,230 38 4,505 33 5,000 37 

24,200 - 26,200 5,990 40 5,165 33 5,740 39 

26,200 - 28,200 6,790 40 5,825 38 6,520 40 

28,200 - 30,200 7,590 45 6,585 38 7,320 44 

30,200 - 34,200 8,490 45 7,345 41 8,200 45 

34,200 - 38,200 10,290 50 8,985 46 10,000 50 

38,200 - 40,200 12,290 50 10,825 50 12,000 55 

40,200 - 42,200 13,290 55 11,825 50 13,100 55 

42,200 - 46,200 14,390 55 12,825 51 14,200 55 

46,200 - 50,200 16,590 60 14,865 57 16,400 60 

50,200 - 52,200 18,990 60 17,145 58 18,800 60 

52,200 - 54,200 20,190 62 18,305 58 20,000 60 

54,200 - 56,200 21,430 62 19,465 60 21,200 62 

56,200 - 62,200 22,670 62 20,665 60 24440 62 

62,200 - 64,200 26,390 64 24,265 60 26,160 64 

64,200 - 66,200 27,670 64 25,465 63 27,440 64 

66,200 - 72,200 28,950 64 26,725 63 28,720 64 

72,200 - 78,200 32,790 66 30,505 63 32,560 65 

78,200 - 82,200 36,750 66 34,285 66 36,460 65 

82,200 - 90,200 39,390 68 36,925 66 39,060 68 

90,200 - 92,200 44,830 68 42,205 66 44,.500 68 

92,200 - 102,200 46,190 69 43,.525 67 45,860 69 

102,200 and over 53,090 70 50,225 68 .52,760 70 

Office of the Secretary of the Treasury January 26, 1978 

Office of Tax Ana1yaia 
Analysis of Impact 

The proposals for the personal credit and the change in 

marginal tax rates will reduce individual income tax 

liabilities by $23.5 billion in 1979. As shown at 1976 

levels of income in Table IIA-3, the proposed credit and rate 

structure will increase the progressivity of the Federal 

income tax. The largest percentage reduction in tax will 

occur at the lowest income levels, the next greatest at 

middle income levels, and the least at upper income levels. 

The new credit and rate schedule will provide tax reduction 

at every level of income, and, on average, will more than 

offset income tax increases proposed elsewhere in the program 

except for taxpayers at the highest levels of income. 

Futhermore, for most taxpayers, the income tax 

reductions provided by the rate changes and the personal 

credit (despite the tax increases resulting from a loss of 

itemized deductions) will yield a net reduction in combined 

income and payroll tax liability through 1979 even after the 

scheduled social security tax increases are considered. 

Tables IIA-4 and IIA-5 compare the combined income and FICA 

taxes under 1977 law and proposed law for 1978 and 1979. 

Included in the calculations are the FICA tax increases 

resulting from legislation enacted prior to 1977 as well as 

the increases contained in the Social Security Financing Act 

Amendments of 1977. The tables assume a four person, 

one-earner family with wage income at various levels. With 

the exception of those who have virtually no income tax 

liability, the proposed income tax cuts will offset the 

increase in social security taxes for families with wage 

income up to $25,000 in 1978 and $20,000 in 1979. 

Furthermore, as shown in Table IIA-6, the personal 

credit and, to a slight degr e e, the reductions in tax will 

raise tax-free levels of income substantially. For a married 

couple with two dependents, the tax-free levels will rise 

from $7,200 to $9,256. These changes will also result in 5.9 

million returns becoming non-taxable. 

The proposed rate cuts and the personal credit have been 

designed as a single package. Nonetheless, the separate 

effect of the credit by itself is of interest. Under the 

present tax rate schedule, a "break-even" level of income 

may be defined as that level at which the substitution of a 

$240 credit for the current $750 exemption and the general 

tax credit leaves a family with the same tax liability. As 

the example below demonstrates, for a family of four which 

does not itemize, the break-even level of income is $20,200. 

If tax rates were not changed, all families of four below 

this income level would have a tax decrease, and all other 

four person families would have a tax increase. 

- 30 -
Example: 

"Break-Even• Income Level for a Family of Four ~/ 

Adjusted gross income 

Less personal exemptions 

Taxable income 

Tax before credits 

General tax credit 

Per capita credit 

Tax after credits 

$ 

$ 

Present 

Law 

20,200 

3,000 

17,200 

2,760 

180 

2,580 

- 31 -

Proposed Law 

(assuming present law 

rate schedule) 

$ 20,200 

20,200 

3,540 

960 

$ 2,580 
Table IIA-3 

Change in Tax Liability 

$240 Personal Credit and Rate Changes vs Current Law 

EXpanded Income Class 

($000) 

Less than 5 

5-10 

10-15 

15-20 

2D-30 

3D-50 

50-100 

100-200 

200 or more 

TOTAL 

(1976 Levels of Income) 

Tax Liability 

Under Present Law 

( $ millions) 

141 

8,227 

18,071 

23,009 

32,778 

22,017 

16,492 

8,084 

6,476 

$135,293 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Change in Tax Liability 

($ millions) (Percentage) 

-423 -300.0 

-2,008 -24.4 

-3,149 -17.4 

-3,587 -15 . 6 

-4,687 -14.3 

-2,215 -10.1 

-879 -5.3 

-216 -2.7 

-143 -2.2 

-$17,305 -12.8 

January 27, 1978 
Table IIA-4 

1978 

Combined Income Tax and FleA Tax Burden& 

Four Person, One-earner Familiea 

Waae • 

Present Law Tax 1978 Pro2osed Tax Cb!Ye in Tax 

Incoae : FICA : Total Income : FICA/ Total lncoae : FICA Total income; tax};,/ : tax Y : tax . . tax 1/ : tax l tax tax tax tu 

( • • • • • • • • • • • · • • • • • • • • • • • · • . . . . . . . . . . . . dollar• .....................•..•........•....• ) 

5,000 -300 292 -8 -300 303 3 0 11 

10,000 446 585 1,031 192 605 797 -254 20 

15,000 1,330 877 2,207 1,166 908 2,074 -164 31 

20,000 2,180 965 3,145 2,042 1,071 3,113 -138 106 

25,000 3,150 965 4,115 3,025 1,071 4,096 -125 106 

30,000 4,232 965 5,197 4,150 1,071 5,221 -82 106 

40,000 6,848 965 7,813 6,748 1,071 7,819 -100 106 

50,000 9,950 965 10,915 9,855 1,071 10,926 -95 106 

100,000 28,880 965 29,845 28,640 1,071 29,711 -240 106 

Office of the Secretary of the Treasury January 

Office of Tax Analysis 

11 Assumes deductible expenses equal to 23 percent of incoae. 

11 Calculated under prior law rate for 1977 (5.85 percent) and prior law 

base for 1977 ($16,500), employees' share only. 

11 

-234 

-133 

-32 

-19 

24 

6 

11 

-134 

20, 1978 

11 Calculated under present law rate and base for 1978 (6.05 percent and $17,700), 

employees' share only. 
Table IIA-5 

1979 

Collbinecl Incoae Tax and FICA Tax lu.rdena 

Four Peraon1 One-earner Familiea 

Present Lav Tax 1979 Proposed Tax Chanae in Tax Vase - - incoae lncoae : FICA : Total Income : FICA : Total : Income : FICA : Total 

tax 1/ : tax 2/ : tax : tax 11 : tax 4/: tax : tax : tax : tax 

( • . . . . . . . . . . . . . • . . . . . . . . . . . . . . . . . . . . . . . dollars , ............. . ................. , ... , , , ) 

5.ooo -300 

1o.ooo 446 

30.000 4.232 

40.000 6.848 

50.000 9.950 

100.000 28.880 

292 

585 

877 

965 

965 

965 

965 

965 

965 

-8 

3.145 

4.115 

-300 306 6 

134 613 747 

919 1.991 

2.830 1.404 4.234 

3.910 11 404 5.314 

6.630 1.404 8.034 

0 

-312 

-258 

-270 

-320 

-322 

-218 

-80 

590 

14 

28 

42 

261 

439 

439 

439 

439 

439 

14 

-284 

-216 

-9 

119 

117 

221 

359 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

January 20, 1978 

!/ Assumes deduc~ible expenses equal to 23 percent of income under present lav. 

11 Calculated under prior lav rate for 1977 {5.85 percent) and prior lav 

base for 1977 {$161 500), e.ployees' share only. 

21 Assumes deductible expenses equal to 20 percent of income under proposal. 

!/ Calculated under present lav rate and base for 1979 {6.13 percent and $22 1 900) 1 

employees' share only. 

. . 

... · ... 

. . 

. . . 
Table IIA-6 

Tax-Exempt and Poverty Levels 

Family 

Size 1/ 

1 

2 

3 

4 

5 

6 

Tax-lxempt Levels 

of Income Under 

Current Law J:/ 

3,200 

5,200 

6,200 

7,200 

8,183 

9,167 

Of Income 

Tax-Exempt 

Levels of Income 

Under Proposal !/ 

3,967 

6,553 

7,922 

9,256 

10,589 

11,884 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

1979 

Poverty Levels 11 

3,449 

4,438 

5,429 

6,954 

8,223 

9,280 

Jan. 26, 1978 

11 Family size assumed to equal number of exemptions. For family sizes greater 

than two, families are assumed to file joint returns and be two parent famdlies. 

2/ Excludes Earned Income Credit. 

]f Non-farm families. 
Table IIA-7 shows this "break-even" income level for 

various family sizes again assuming the present tax rate 

schedules apply. 

In the absence of changes in the rate structure, a personal credit would be a highly progressive tax change, and by 

itself would increase taxes in the upper range of the income 

distribution. However, these tax increases have been avoided 

or limited under the Administration's proposal by changing the whole structure of marginal tax rates. 

The net effects of substituting the $240 personal credit 

for the exemption and general tax credit under present law, 

and of restructuring the schedule of marginal tax rates may be summarized as follows: 

(1) The tax system will be made more progressive but 

not to the degree that would be accomplished by instituting 

the $240 credit by itself. 

(2) A substantial increase will occur in tax-free 

levels of income so that those at or near poverty levels will 

have no income tax liability. 

(3) The tax structure will be made more equitable. An 

additional dependent will result in the same tax savings 

regardless of an individual's income level. 

(4) The tax structure will be simplified by combining several provisions of the law into one. 

(5) The tax system will also be made more adaptable to 

future changes in policy. Re bates of energy taxes, for 

example, could easily be made through modifications of the 

personal credit. 

- 36 -
Table IIA-7 

"Break-Even" Levels of Income 

$240 Credit in Lieu of Exemptions, Credits 

and Rate Schedule of 1977 Law 

Number of Exemptions 

1 

2 

3 

4 

5 

6 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

nBreak-Even" Level 

(millions of dollars) 

7,075 

12,500 

16,700 

20,200 

21,950 

22,700 

January 27, 1978 

Note: The case of one exemption is for a single return; cases of moLe than one 

exemption are for joint returns. Assumes taxpayers h.qve no itemized 

deductions in excess of the zero bracket amount. 
Revenue Estimate 

1978 

-6,067 

Change In Tax Liability 

($ millions) 

Calendar Years 

1979 1980 1981 1982 1983 

-23,538 -26,583 -30,272 -34,732 -40,110 

Footnotes 

ll There is also a separate schedule for estate and trusts. 

2/ The example assumes the taxpayer has no itemized 

deductions in excess of the zero bracket amount. 

- 38 -
IIA-2 

ORDERING TAX CREDITS 

Present Law 

There are eight nonrefundable tax credits: the general 

tax credit, the credit for the elderly, the foreign tax 

credit, the investment credit, the political contributions 

credit, the WIN credit, the child care credit, and the jobs 

credit. In additi on, certain tax credits are refundable, 

including the earned income credit and other credits which 

involve a repayment of taxes previously paid. 

Several sections of the Code must be examined to 

determine the order in which these credits may be claimed. 

Moreover, some credits which may be carried over and applied 

against tax liabilities in other tax years must be taken in 

the current tax year prior to credits which expire that year 

if unused. Finally, the tax base against which the credits 

may be claimed varies. Some credits can be taken against 

certain special taxes (such as the minimum tax) while others 

cannot. 

Reasons for Change 

As a structural matter, the prov1s1ons which govern the 

order in which credits are allowed and the taxes against 

which they can be applied are unduly complex. Moreover, no 

consistent theory underlies the present variations in the tax 

base against which certain credits may be claimed. 

Significant simplification and consistency can be achieved by 

providing in a single section a uniform tax base against 

which credits are applied in a prescribed order. 

The order in which credits must presently be taken may 

result in the unjustified loss of credits that expire if 

unused. This occurs because some of the credits that may be 

carried to different tax years are applied before other 

credits that expire if unused. For example, a taxpayer must 

take the foreign tax credit, which can be carried over to 

later taxable years, before the child care credit, which 

cannot be carried over. Thus, instead of using the child 

care credit in the current year and the foreign tax credit 

next year, a taxpayer is required to use the foreign tax 

credit currently, even though the child care credit expires 

unused. A taxpayer should not be required to use a credit 

that may be carried over before a credit that cannot. 

- 39 -
General Explanation 

The order in which tax credits must be taken as well as 

the tax base against which all nonrefundable credits must be 

applied will be prescribed in a single section of the 

Internal Revenue Code. All credits that expire if unused in 

the year they arise will be taken prior to credits that may 

be carried over. Refundable credits will be taken last. 

The base against which nonrefundable credits may be 

applied will be limited to the amount of tax imposed by the 

section pursuant to which the primary income tax liability of 

the particular taxpayer is determined. Thus, the tax base 

will not include special taxes such as the m1n1mum tax and 

the tax on accumulation distributions from trusts. 

Effective Date 

The proposal will apply to taxable years beginning after 

December 31, 1978. 

Revenue Estimate 

The proposal will have a negligible effect on tax 

liability. 

Technical Explanation 

Under the proposal, a taxpayer will be required to take 

credits in the following order: 

{1) All credits which are nonrefundable and for which 

no carryover is allowed, including (a) the personal credit 

(which under the Administration's proposal replaces the 

present personal exemption and general tax credit), (b) the 

credit for the elderly, (c) the political contributions 

credit, and (d) the child care credit. Since all these 

credits are limited to tax liability and cannot be carried 

over, no order need be prescribed. 

(2) The foreign tax credit. 

(3) The investment credit and the WIN credit. 1/ Since 

under the Administration's proposal the base and carryback 

and carryover periods of these credits will be identical (see 

INVESTMENT CREDIT), no order need be prescribed. 

(4) The refundable credits (the withholding credits: 

the credit for certain uses of gasoline, special fuels, and 

lubricating oil; and the earned income credit). l/ 

- 40 -
Individuals will be allowed to take nonrefundable tax 

credits only against the tax imposed by section 1 of the 

Internal Revenue Code or taxes imposed in lieu thereof. 

Corporations will be allowed to take nonrefundable credits 

only against the applicable normal tax and surtax (imposed by 

sections 11, 511, 892, 821, 831, 852, or 857 of the Internal 

Revenue Code) or taxes imposed in lieu thereof. Both 

individuals and corporations will be allowed to take 

refundable credits against all taxes imposed by the Internal 

Revenue Code. 

Footnotes 

1/ The jobs credit will not be affected by this proposal 

because it is not allowable for taxable yers beginning after 

December 31, 1978. 

~/ The Energy bill, which is now in conference, provides for 

residential and business energy credits. Upon enactment, an 

adjustment in the ordering of credits will be required. 

- 41 -
IIB-1 

ITEMIZED DEDUCTIONS 

INTRODUCTION 

One of the major principles underlying our system of 

taxation is that individuals with equal income should pay the 

same amount of tax regardless of how they spend their income. 

This is implemented by not allowing deductions for personal, 

living, or family expenses. Over the years, many exceptions 

to this principle have been introduced into the tax laws. 

The exceptions generally are justified on one of two grounds. First, some deductions are allowed in order to further a 

public policy. For example, by allowing a deduction for 

charitable contributions, charitable organizations are able 

to attract more contributions than would otherwise be 

possible. Second, certain deductions are allowed on equity 

grounds in recognition of the fact that substantial 

expenditures which are unanticipated and unavoidable reduce 

an individual's ability to pay tax. Deductions for medical 

expenses are justified on this basis. 

All deductions for personal, living, or family expenses 

are in conflict with the goal of simplicity. For the average 

taxpayer, these deductions are one of the greatest sources of 

complexity in the tax laws. A taxpayer has to maintain 

burdensome records to substantiate the deductions, and has to 

cope with extremely complicated statutory rules to calculate 

the deductions. Furthermore, a taxpayer faces the task of 

having to support the correctness of the deduction if the tax 

return is audited. 

Several of the prov1s1ons which allow deductions for 

personal, living, or family expenses can be greatly 

simplified without sacrificing either policy goals or equity. 

In general, the deductions for which changes are proposed are 

claimed in approximately the same amounts by taxpayers within 

the same income group. The President's tax proposals limit 

the availability of the deductions and at the same time lower 

individual tax rates so that the tax burden on most taxpayers 

who itemize will not increase. This is illustrated by Table 

IIB-1. 

- 42 -
Table IIB-1 

Distribution and Average Amount of Tax Change under the President's Proposals 

for Tax Returns under Present Law Using Itemized Deductions, 

by Income Class 

Number of Returns . Returns with Tax Decrease . . 

. Returns with Tax Increase 

Expanded . . : Returns with : : : : Average Average Income Class : All Returns : Tax Change :11: Percentage : . Percentage : Decrease . Increase (millions) . . (millions) 

Under $5,000 0.53 0.14 94.9% $ -62 5.1% $ 27 

$ 5,000 - 10,000 1. 76 1.34 79.2 -94 20.8 60 

$ 10,000 - 15,000 3.48 3.36 78.9 -155 21.1 74 

$ 15,000 - 20,000 4.59 4.56 89.4 -207 10.6 106 

$ 20,000 - 30,000 6.29 6.26 93.6 -306 6.4 119 

$ 30,000 - 50,000 2.74 2.73 88.4 -391 11.6 266 

$ 50,000 - 100,000 0.89 0.88 80.1 -519 19.9 725 

$100,000 - 200,000 0.19 0.19 58.8 -614 41.2 1,641 

$200,000 and over 0.05 0.05 31.0 -2,196 69.0 6,979 

TOTAL 20.52 19.52 87.3% $-268 12.7% $295 

Office of the Seeretary of the Treasury January 28, 1978 

Office of Tax Analysis 

~/ Most tax returns with no tax change are nontaxable under present law. 
As described below, changes are proposed with respect to 

deductions for the following items: medical care expenses, 

casualty and theft losses, taxes, and political 

contributions. The proposed changes will result in 

approximately six million taxpayers switching to the standard 

deduction. In addition, the administrative burden on 

taxpayers who continue to itemize will be significantly 

reduced. 

- 44 -
DEDUCTIONS FOR MEDICAL CARE EXPENSES AND 

CASUALTY AND THEFT LOSSES 

Present Law 

IIB-2 

An individual is allowed a deduction for medical care 

expenses and casualty and theft losses only if he elects to 

itemize deductions on his tax return. 

Calculating the deduction for medical care expenses is a 

formidable task. The deduction consists of two components: 

(a) the lesser of $158 or one-half of the amounts paid for 

medical insurance, plus (b) the amount by which medical care ~xpe nses exceed 3 percent of the taxpayer's adjusted gross 

1ncome . For purposes of the 3 percent computation, amounts 

paid for medical insurance are included as medical care 

expenses to the extent they are not deductible under (a), and 

amounts paid for medicine and drugs are so included to the 

extent they exceed 1 percent of adjusted gross income. Of 

course, in order to make the calculation a taxpayer must 

first determine whether and to what extent expenditures 

qualify as medical care expenses. Furthermore, to support 

the deduction the taxpayer must keep records dividing medical 

expenses into three categories: medical care insurance, 

medicine and drugs, and all other medical care. An Internal 

Revenue Service study of 1973 tax returns 1/ indicates that 

of those taxpayers deducting medical expenses, more than 75 

percent claimed the wrong amount. 

Deductions for casualty and theft losses are calculated 

independently of the deduction for medical care expenses. 

Regardless of the amount of an individual's income, each such 

loss is deductible to the extent it exceeds $100. The same 

Internal Revenue Service study indicates that of those 

taxpayers deducting casualty and theft losses, more than 64 

percent claimed the wrong amount. 

Reasons for Change 

A common rationale underlies the deduction for medical 

care expenses and the deduction for casualty and theft 

losses. Substantial expenditures which are unanticipated and 

unavoidable reduce an individual 's ability to pay tax. To 

prevent an unwarranted hardship, a deduction should be 

allowed for these expenditures. 

To determine whether unanticipated and unavoidable 

expenditures are substantial and so have impaired an 

individual's ability to pay tax, it obviously is necessary 

to aggregate all such expenditures. Current law, however , 

- 45 -
fails to do this. The deduction for medical care expenses 

and the deduction for casualty and theft losses are computed independently of one another. 

Furthermore, the separate floors provided in the 

respective provisions allow deductions even though expenditures could have been anticipated or are not 

substantial. In 1978 the average taxpayer will spend 

approximately 8 percent of income on medical care. This 

means that today for the average taxpayer medical care 

expenditures can be characterized as unanticipated only if 

they exceed 8 percent of income. Nevertheless, an individual 

with medical care expenses in excess of 3 percent of income 

is allowed a deduction. In the case of casualty and theft 

losses, the statute allows a deduction even though the 

expenditures are not substantial. The $100 floor is merely a 

de minimis rule. The homeowner who loses a $200 tree in a 

windstorm has not had his ability to pay tax reduced. 

The allowance of deductions even where expenditures and 

losses could have been anticipated or are not substantial 

results in millions of taxpayers itemizing deductions even 

though they have not experienced extraordinary expenses or 

losses. Also, the tax laws, in effect, provide insurance 

against loss for individuals in high-tax brackets. For 

example, through reduction of tax liability, a taxpayer in 

the 68 percent marginal bracket can recover from the Federal 

Government 68 cents for each dollar of casualty loss in 

excess of $100. There is no reason for the Federal 

Government to provide this benefit. 

The deductions for medical care expenses and casualty 

and theft losses should be combined and the floor on these 

deductions should be set at 10 percent of income. Consistent 

with the rationale for their allowance, medical care expenses 

and casualty and theft losses would be deductible only under 

extraordinary circumstances. Furthermore, wealthy 

individuals could no longer rely on the Government to provide 

insurance against loss since the "insurance coverage" would 

apply only when the loss was extraordinary in comparison to 

income. 

In addition, several elements of the medical care 

deduction provision are theoretically inconsistent or 

unnecessarily complex and can be simplified. 

Medical insurance premiums should be treated 

the same as any other medical care expense. 

Present law allows $150 of medical insuLance 

premiums to be deducted without regard to the 

3 percent floor on the ground that people 

with insurance do not incur large unreimbursed medical expenses and so would otherwise be unable to utitize the deduction. This 

- 46 -
rationale is inconsistent with the theory 

underlying the deduction since payment of the 

premiums is not unanticipated or unavoidable. 

It is also inconsistent with the fact that 

individuals who claim the standard deduction are 

not allowed to deduct medical insurance premiums. 

The separate 1 percent floor on amounts paid 

for medicine and drugs should be eliminated. 

Present law imposes the 1 percent floor in 

order to deny a deduction where amounts expended 

on medicine and drugs are not extraordinary. A 

combined floor for medical expenses and casualty 

and theft losses would achieve the same purpose 

and the complexity of a separate floor could 

be eliminated. 

The definition of medical care expenses should 

be tightened. Frequent disputes arise over 

the deductibility of expenditures which produce 

substantial nonmedical benefits. For example, 

the Tax Court recently sustained a medical expense deduction for a substantial portion of 

the cost of a $194,000 indoor swimming pool. 

Disputes such as this can be prevented by 

restricting deductions to expenses incurred primarily 

for medical purposes. 

General Explanation 

Medical care expenses and casualty and theft losses wi l l 

be deductible only to the extent that, in the aggregate, the y 

exceed 10 percent of adjusted gross income. A casualty or 

theft loss will be taken into account only to the extent it 

exceeds $100. 

Medical insurance premiums and expenses for medicine a nd 

drugs will be treated just like any other medical care 

expenditures. The special deduction for insurance premiums 

and the special 1 percent floor for medicine and drug 

expenditures will be repealed. The definition of medical 

care expenses which qualify for deduction will be amended so 

that the cost of facilities, services, and devices will be 

deductible only if they are of a type customarily used 

primarily for medical purposes, and are in fact intended 

primarily for medical use of the taxpayer or a dependent. 

Analysis of Impact 

Adoption of the new hardship deduction will reduce by 

11.1 million, or 83 percent, the number of taxpayers who 

itemize their medical expenses and nonbusiness casualty and 

theft losses under current law (see Table IIB-2). Consistent 

- 47 -
Expanded 

Income Class 

$ 5,000 or less 

$ 5,000 - 10,000 

$ 10,000 - 15,000 

$ 15,000 - 20,000 

$ 20,000 - 30,000 

$ 30,000 - 50,000 

$ 50,000 - 100,000 

$100,000 - 200,000 

$200,000 and over 

TOTAL 

Table IIB-2 

Numbers of Taxpayers Using Present Medical and Casualty Deduction and 

Proposed Hardship Deduction 

(Compared to 1976 Law at 1976 Levels of Income) 

(millions of taxpayers) 

Proposal Excluding Hardship Proposal : Proposal Including Hardship Deduction 

Medical : Medical Deduction : : Usin : Not Using : Switching 

and/or : Insurance : Other : Casualty : Hards~i : Hardship : to 

Casualty : Premiums : Medical : Deduction : D d ti p : Deduction : Standard 

e uc on Deduction : Only : Expenses : : :but Itemizing: Deduction 

0.4 * 0.4 * 0.3 0.1 * 

1.3 0.2 1.1 0.2 0.6 0.4 0.3 

2.2 0.4 1.7 0.3 0.5 1.0 0.6 

2.8 0.9 1.9 0.3 0.4 1.8. 0.6 

3.9 1.7 2.2 0.4 0.3 3.1 0.6 

1.9 1.1 0.7 0.2 0.1 1.7 0.1 

0.6 0.4 0.1 0.1 * 0.6 * 

0.1 0.1 * * * 0.1 * 

* * * * * * * 

13.3 4.9 8.2 1.5 2.2 8.9 2. 3 

Office -of -the Secretary of the Treasury January 28, 1978 

Office of Tax Analysis 

* Less than .05 million. 
with the rationale for allowing these deductions the hardship 

deduction will be utilized only by individuals whose ability 

to pay tax has truly been reduced as a result of substantial 

expenditures which were unanticipated and unavoidable. Over 

35 percent of amounts currently deductible on account of 

medical expenses and casualty and theft losses will continue 

to be deductible by these individuals. All other taxpayers 

will be spared the administrative burden involved in claiming 

and substantiating the medical, and casualty and theft loss, 

deductions. 

Most significantly, these changes will cause 2.3 million 

taxpayers to switch to the standard deduction. For these 

taxpayers the burden of compliance will be vastly reduced 

since they will be relieved of the numerous difficulties 

encountered in itemizing deductions. In addition, the 

proposed revision of the medical expense portion of the 

deduction will simplify the burden of compliance for those 

taxpayers claiming the hardship deduction. 

Table IIB-3 shows the distribution of tax increases by 

income class for this proposal at 1976 levels of income. 

Effective Date 

The proposal will be effective for taxable years 

beginning after December 31, 1978. 

Revenue Estimates 

1978 1979 

1,989 

Change In Tax Liability 

($ millions) 

Calendar Year 

198~ 1981 : 1982 

2,119 2,352 2,611 

Footnote 

1983 

2,898 

!/ Study prepared under the Taxpayer Compliance Measurement 

Program of the Internal Revenue Service, Cycle 5 of the 

individual income tax returns filed phase. 

- 49 -
Table IIB-3 

Revenue Effect of Hardship Deduction 

with 10 Percent Floor 

Expanded Revenue Increase 

Income Class ($ in millions) 

$ 5,000 or less 1 

$ 5,000 - 10,000 41 

$ 10, 000 - 15,000 143 

$ 15,000 - 20,000 237 

$ 20,000 - 30,000 401 

$ 30,000 - 50,000 308 

$ 50,000 - 100,000 173 

$100,000 - 200,000 53 

$200, 000 and over 39 

TOTAL 1,396 

Office of the Secretary of the Treasury 

Office of Tax Ana1ysis 

Percent of 

Total 

0.1% 

2. 9 

10.2 

17 .o 

28.7 

22.1 

12.4 

3.8 

2.8 

100.0% 

January 28 , 1978 
IIB-3 

DEDUCTION FOR TAXES 

Present Law 

An individual who elects to itemize deductions on his 

income tax return is allowed a deduction for the following 

State and local taxes 1/ even if they are not related to any 

business activity: -

1. income taxes 

2. real property taxes 

3. sales taxes 

4. gasoline taxes 

5. personal property taxes 

In addition , with certain limited exceptions, all State and 

local, and foreign, taxes related to business activity are 

deductible in the year paid or incurred. A taxpayer other 

than a regular corporation must capitalize and amortize real 

estate taxes paid during the period real property is under 

construction. 

Reason for Change 

The deduction for State and local income taxes is 

necessary to assure that the aggregate marginal rate of 

income tax is not confiscatory. The deduction for real 

property taxes reflects long-standing public policy to 

encourage home ownership. In addition, the deductibility of 

these taxes imposes only a small recordkeeping burden on 

taxpayers. This is not true for other taxes which are 

currently deductible. 

Nonbusiness sales, gasoline, and personal property 

taxes. In the case of sales taxes, gasoline taxes, and 

personal property taxes, there are no significant policy 

reasons to justify an exception from the general principle 

that people with equal income should pay the same amount of 

tax regardless of how they spend their income. These taxes 

are relatively small in amount. For example , a marr ied 

taxpayer with $30,000 of adjusted gross income who drives 

12,000 miles a year for personal purposes reduces his tax 

liability only by about $30 on account of the gasoline tax 

deduction and by about $65 on account of the sales tax 

deduction. Because of their relatively small size, and 

because a large portion of these taxes is paid by taxpayers 

who do not itemize deductions , deductibility is not a major 

factor to a State or local government in determining the rate 

of tax to impose. The deduction for personal property taxes 

- 51 -
does encourage State and local governments to impose personal 

property taxes on automobiles in lieu of license and similar 

fees which are nondeductible. There is no policy reason to 

encourage this shift. 

Aside from policy considerations, deductibility of sales 

and gasoline taxes raises substantial administrative 

problems. The average taxpayer incurs small amounts of these 

taxes in hundreds of separate transactions over the course of 

a year. Maintaining adequate records to calculate and 

substantiate the deduction would place an enormous burden on 

taxpayers. Moreover, auditing these records would place an 

unwarranted burden on the Internal Revenue Service in view of 

the extremely small amount of revenue generally involved in 

the deduction claimed on any one return. An Internal Revenue 

Service study 2/ of 1973 tax returns indicates that of those 

taxpayers deducting State and local taxes (other than real 

estate and income taxes) more than 53 percent claimed the 

wrong amount. 

In recognition of these administrative problems, the 

Service permits taxpayers to use standard tax tables to 

determine the amount of their sales and gasoline tax 

deduction. For taxpayers using these tables, there is no 

direct relationship between the amount of the deduction and 

the amount of taxes actually paid. The absence of a direct 

relationship further weakens any policy argument in favor of 

the deductibility of these taxes. In effect, taxpayers who 

itemize are being allowed a mini-standard deduction in lieu 

of deducting the actual amount of taxes paid. This is 

especially true in the case of the sales tax since the table 

is based primarily on adjusted gross income. It is also true 

in the case of the gasoline tax. Although the table is based 

on miles driven, there is generally no way to check the 

accuracy of the amount claimed, and many taxpayers claim an 

average amount regardless of the number of miles they actually drive. In addition, allowing a deduction for the 

gasoline tax is inconsistent with our national energy policy 

which seeks to encourage gasoline conservation. 

Definition of "taxes". Recently, uncertainty has 

developed as to whether employees may deduct State 

unemployment disability fund taxes withheld from their wages. 

The revenue collected from these taxes is used to provide 

insurance against loss of wages resulting from injuries or 

illnesses which are not job related. In several states, the 

tax is levied only if the employer does not provide private 

coverage. The Internal Revenue Service takes the position in 

published Revenue Rulings that these taxes in reality are a 

nondeductible personal expenditure for insurance coverage. 

However, the United States Tax Court has disagreed with the 

Service's position in two cases and has held that these taxes 

are an " income tax" and so are deductible by employees. 

- 52 -
The payor of the unemployment disability fund taxes 

receives an economic benefit in the form of insurance 

coverage which is directly related to the amount of the 

taxes. Amounts received under these insurance policies as 

compensation on account of injuries or illness are not 

includible in income. Because of this exclusion, it is 

inappropriate to allow a deduction for the taxes paid to 

acquire the insurance coverage. A combined deductionexclusion creates tax-exempt income, and, therefore, is 

inconsistent with basic principles of taxation. In addition, 

regardless of whether these taxes technically constitut ~ an 

"income tax", it is inequitable to allow a deduction to 

individuals in one State who acquire the insurance coverage 

through a State program, while denying a deduction to 

individuals in another State who acquire their insurance 

coverage privately. 

Business taxes. Taxes related to a business activity 

generally are deductible in the year paid or incurred even if 

they constitute part of the cost of a capital asset. In this 

respect, a deduction is inconsistent with the general principle that the cost of a busine ss asset should be 

recovered through depreciation over the life of the asset. 

For example, a person constructing a building for business 

use can deduct sales taxes imposed on his purchase of 

building materials even though the other expenses relating to 

the construction of the building generally have to be 

capitalized and recovered through depreciation. There is no 

reason why these taxes should receive special treatment. 

General Explanation 

State and loca l sales taxes, gasoline taxes, and 

personal property taxes not r elated to a business activity 

will no longer be deductible. Payments for unemploymen t 

disability fund taxes will not be deductible by employees. 

Taxe s relating to a business activity wi ll be deductible 

under normal tax accounting principles. If t he taxes r elate 

to the acquisition of a capital asset they will have to be 

capitalized. However, as under present law State and local 

income taxes and real property taxes generally will be 

deductible in the year paid or incurred. 

Analysis of Impact 

Limiting the deduction for taxes will result in an 

increase of approximately 3.8 million in the number of 

individual taxpayers using the standard deduction. 

Among income groups the greatest increase in tax burden 

as a result of the proposal will be only 3 percent (a 0.5 

percentage point increase in effective tax rates). 

- 53 -
Effective Date 

The proposal will be effective for taxable years 

beginning after December 31, 1978. 

Revenue Estimates 

1978 1979 

3,998 

Change In Tax Liability 

($ millions) 

Calendar Years 

1989 1981 1982 

4,456 5,979 5,799 

Technical Explanation 

1983 

6,601 

I 

Section 164(a) will be amended to eliminate the 

deduction for State and local (and foreign) sales, gasoline, 

and personal property taxes which are not business related. 

Section 164(a) will be amended to provide for the future that 

State unemployment disability fund taxes are not deductible 

by employees. The amendment will overrule prospectively the 

decisions in two Tax Court cases: James R. McGowan, 67 

T.C. 599 (1976) and Anthony Trujillo, 68 T.C. 679 (1977). 

The last sentence in section 164(a) will be eliminated. 

As a result of this change, business related taxes other than 

those specifically listed in section 164(a) will be 

deductible in the same manner as other business expenditures 

generally. In other words, these taxes will be deductible 

currently under section 162 or 212 unless they relate to the 

acquisition of a capital asset in which case they will be 

capitalized. Taxes specifically listed in section 164(a) 

(i.e., State and local, and foreign, income taxes and real 

property taxes) will continue to be deductible when paid or 

incurred, unless section 189 applies. 

Footnotes 

1/ Foreign real property taxes and, if the taxpayer elects 

not to claim a credit, foreign income taxes are also 

deductible. 

~/ Study prepared under the Taxpayer Compliance Measurement 

Program of the Internal Revenue Service, Cycle 5 of the 

individual income tax returns filed phase. 

- 54 -
IIB-4 

DEDUCTION FOR POLITICAL CONTRIBUTIONS 

Present Law 

Under present law, an individual who elects to itemize 

deductions on a tax return is allowed a deduction for 

specified political contributions. The deduction is allowed 

for the first $100 ($200 on a joint return) of contributions. 

In lieu of the deduction, an individual, whether or not 

itemizing deductions, can claim a credit equal to one-half of 

the first $50 ($100 on a joint return) of contributions. 

Corporations, estates, and trusts cannot claim the credit or 

deduction. 

Reasons for Change 

The tax subsidy for political contributions was intended 

by Congress to be an incentive for political contributions. 

In practice, the deduction and credit generally benefit only 

those few taxpayers who would contribute anyway, and they are 

used disproportionately by high-income contributors. 

The effect of the optional deduction is to provide a 

greater tax benefit to those taxpayers who itemize, a 

relatively small group (24 percent of all taxpayers currently 

and estimated to be less than 17 percent under the other 

proposals in this package) who generally have higher incomes 

than nonitemizers. This is illustrated by Table IIB-4 which 

shows the distribution of the tax credit and the deduction 

for political contributions by income class for 1975. 

With a deduction, high-bracket taxpayers can make the 

same dollar contribution more cheaply than low-bracket 

taxpayers. Put another way, the greater the income of the 

itemizer (the higher the marginal tax rate), the greater the 

benefit to the taxpayer of the deduction. There is no policy 

reason for attempting to provide a greater tax incentive to 

taxpayers with high incomes. 

For example, two married couples that both contribute 

$200 receive different tax treatment if one itemizes. The 

couple that itemizes and is in the highest marginal tax 

bracket will receive 2.7 times the benefit of the couple that 

does not itemize. In a 68 percent marginal bracket (the 

highest proposed), the couple that itemizes and contributes 

$200 would receive a tax benefit of $136. The couple that 

contributes the same amount and uses the standard deduction 

would claim the tax credit and receive a tax benefit of only $50. 

- 55 -
Adjusted 

Gross Income 

Table llB-4 

Deduction and Tax Credit for Political Contributions 

by Income Class -- 1975 

Credit and Deduction Tax Credit Deductions 

Percent of Returns Number of Amount of Number of : Amount of Class in Income Class Returns Credit ($000) Returns :Deductions 

(%) 

0 - 10 1.1% 

10 - 20 3.3 

20 - 30 5.7 

30 - 50 10.6 

50 - 100 18.4 

100 and over 29.4 

TOTAL 2.7% 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

(000) 

424 

610 

302 

180. 

48 

5 

1,569 

Source: Preliminary 1975 Statistics of Income. 

($000) (000) ($000) 

7,022 41 2,684 

15,428 213 14,740 

8,531 177 15,990 

4,917 110 11,020 

1,463 96 10,501 

183 50 6,443 

37,546 688 61,378 

November 2, 1977 
Moreover, a recent study concludes that tax incentives 

have had an insignificant impact on the level of 

contributions to political campaigns, 1/ and merely provide a 

windfall to high income taxpayers who would contribute 

anyway. In the past, taxpayers with income of over $20,000 

have claimed tax benefits for political contributions more 

than 25 times as often as taxpayers with income under $5,000. 

Moreover, within the lower income group, individuals 

frequently contribute and do not claim the tax benefits to 

which they are entitled. Among contributors, higher income 

taxpayers claimed these tax benefits almost three times more 

often than lower income taxpayers. 

In addition, the present option of a credit or deduction 

unnecessarily complicates both the tax return and the 

instructions. 

General Explanation 

The deduction for political contributions will be 

repealed. The credit for political contributions will, 

however, remain. 

Analysis of Impact 

The elimination of the deduction for political 

contributions will result in all taxpayers receiving equal 

tax benefits from their political contributions. 

Contributions to political campaigns will not be greatly 

reduced. Significant simplification will be achieved. Tax 

forms and instructions will be shortened. Individuals will 

no longer need to make alternative computations to determine 

whether the credit or deduction is more advantageous to them. 

Effective Date 

The political contributions deduction will be eliminated 

for taxable years beginning after December 31, 1978. 

Revenue Estimate 

Change In Tax Liabilit~ 

($ millions) 

Calendar Years 

1978 . 1979 1989 1981 1982 . . . 1983 

2 4 2 3 3 

- 57 -
Footnote 

1/ D.W. Adamany and G.E. Agree, Political Money, 125-128 

(1975). This study is based in part upon data compiled in 

the Twentieth Century Fund Survey, along with data provided by the IRS and the States of California and Oregon, two 

states which provide tax incentives for political campaign contributions. This is the only published study which 

considers the impact of tax incentives on political contributions. 

- 5 8 -
IIC 

CAPITAL GAINS -- REPEAL OF ALTERNATIVE TAX 

Present Law 

The tax rate applicable to the net capital gain realized 

by an individual taxpayer is generally equal to one -half of 

the taxpayer's regular tax rate. However, an individual 

taxpayer may elect to pay a 25 percent alternative rate on 

the first $50,000 of net capital gain. An individual will 

choose this alternative rate only if his marginal tax rate 

exceeds 50 percent. 

More specifical ly, if an individual taxpayer has a net 

capital gain for the taxable year (i.e., net long-term 

capital gain exceeds net short-term capital loss), the 

taxpayer can deduct an amount equal to 50 percent of the net 

capital gain. The 50 percent e xclusion in effect makes the 

tax rate applicable to the gain equal to one-half of the 

taxpayer's regular ra te. 

The "alternative tax on capital gains" involves a 

special computation under which the total tax is the sum of: 

(1) the tax otherwise payable on all income other than net 

capital gain for the year: (2) a tax of 25 percent on the 

first $50,000 of long-term capital gain ($25,000 in the case 

of a married individual filing a separate return): and (3) a 

separate tax on the amount of net capital gain, if any, in 

excess of $50,000, computed at the taxpayer's highest rate 

brackets after taking into account the deduction for capital 

gains. In effect, the taxpayer will benefit from a maximum 

tax of 25 percent on the first $50,000 of long-term capital 

gain plus the 50 percent deduction for the balance of net 

capital gain. By choosing the alternative tax, however, a 

taxpayer must forego regular income averaging. 

Prior to 1969, the 25 percent alternative tax was not 

limited to $50,000. In retaining the alternative tax for 

that amount of long-term capital gains, the Congress 

indicated that it thought that taxpayers with relatively 

small amounts of capital gains should continue to be eligible 

for the alternative tax. However, the present alternative 

tax applies whether a taxpayer's capital gains are large or 

small and, as is indicated below, is useful only for high 

income taxpayers. 

Reasons for Change 

The deduction for capital gains provides a significant 

tax benefit for individual taxpayers, reducing the tax on net 

- 59 -
capital gain by 50 percent. The alternative tax, on the 

other hand, benefits only those taxpayers with the highest 

incomes. A taxpayer in the 70 percent bracket with $50,090 

of capital gain can use the alternative tax to reduce the tax 

on that income by nearly 65 percent. For example, if a 

taxpayer has ordinary income of $50,008 which is taxable at 

70 percent, the tax on that income will be $35,000. However, 

if that income is in the form of a net capital gain, the 

taxpayer will, under the alternative method, be required to 

pay a tax of only $12,500 on the net capital gain. 

The alternative tax is only $5,008 less than the maximum 

tax on $50,000 of capital gain (70 percent of $25,000, or 

$17,500, as compared to $12,500). Yet it introduces 

significant additional complexity into the tax calculation. 

The alternative tax computations are themselves complex. 

But, in addition, because taxpayers electing the alternative 

tax cannot use regular income averaging, they must compute 

their tax under the two special methods (income averaging and 

alternative tax) in order to determine which will produce the 

greater tax savings. 

The existence of the alternative tax can also affect the 

structuring or timing of transactions to maximize the benefit 

of this special provision. For example, a high-income 

taxpayer may enter into an installment sale solely to spread 

any gain over a number of years and thereby multiply the 

impact of the alternative tax on the transaction. Similarly, 

a taxpayer who has already recognized long-term capital gains 

of $50,000 for a year may postpone an additional capital gain 

transaction until the following year in order to subject the 

gain to the alternative tax. 

General Explanation 

In order to make tax benefits for capital gains more 

uniformly applicable, the alternative tax for noncorporate 

taxpayers will be eliminated. The deduction for capital 

gains will remain unchanged. 

Analysis of Impact 

The proposal will affect only noncorporate taxpayers in 

marginal tax brackets above 50 percent. For example, it is 

estimated that for 1976, 88 million tax returns were filed, 

and 7.4 million reported gains from sales of capital assets. 

Of those returns, 186 thousand, or 2.5 percent of all returns 

with net capital gains, used the alternative tax to compute 

at least some part of the tax liability. Using 1976 levels 

of income and taking into account the Administration's other 

proposals, over 78 percent of the net taxable gain taxed 

under the alternative tax would be reported on returns with 

expanded incomes of over $100,000. (See Table IIC-1.) 

- 60 -
Table II C-1 

Capital Gains i n Adjusted Gross Income and Capital Gains 

Taxed at Alternative Rate 

(Proposed Law at 1976 Levels of Income) 

All Taxpayers with Taxpayers Electing 

Ca ital Gain or Loss Alternative Tax 

Expanded Num er . Amount Percent: Num er . Amount . . . . Percent 

Income of of Net of . . of :Taxed At: of 

Class Returns: Gain Total Returns:Alterna-: Total 

tive 

Rate 

(thousands~ : (thous. ~: ($ bil.) : : (thous.): ($ bil.): 

Less than 

$ 5 910 $ 1.2 6 % 

$ 5 - $ 10 1,068 0.9 4 

$ 10 - $ 15 1,239 1.2 6 

$ 15 - $ 20 1,138 1.6 7 

$ 20 - $ 30 1,428 2.6 12 

$ 30 - $ SI!J 980 3.6 17 1 * * 

$ 50 - $100 457 3.6 17 101 $."6 23 % 

$100 - $200 116 2.5 12 64 1.4 49 

$201!J and 

over 36 3.9 19 19 0.8 28 

TOTAL 7,372 $21.0 li!J0 % 186 $2.8 100 % 

Office of the Secretar y of the Treasury Janua r y 6, 1978 

Office of Tax Analysis 

* Less than $ I!J.S billion or less than I!J.S percent 
Upon repeal of the alternative tax, all long-term capital 

gains will be treated similarly. All such gains will be taxed at 

one-half of the ordinary rates. However, high-income taxpayers 

will no longer receive even more preferential treatment on the 

first $58,008 of such gains. 

It should be recognized that only high tax bracket taxpayers 

who currently use the alternative tax will be affected. Many 

taxpayers who would otherwise be eligible to use the alternative 

tax forego its benefits because they receive even greater benefits 

from income averaging. Such taxpayers would not be affected by 

repeal of the alternative tax. Taxpayers who sell small 

businesses at a large gain generally should fall into this 

category. l/ 

Effective Date 

The proposed change will be effective for taxable years 

beginning after December 31, 1978. 

Revenue Estimate 

1978 1979 

148 

Technical Explanation 

Change in Tax Liability ($ millions) 

Calendar Years 

1980 1981 1982 

151 162 174 

1983 

187 

The proposal will apply to all gains recognized in taxable 

years beginning after December 31, 1978. Thus the alternative tax 

will not apply to the ratable portion of gain recognized by a 

calendar year taxpayer for 1979 as the result of an installment 

sale which occurred in 1977. Similarly, the alternative tax will 

not apply to gain recognized in a transaction occurring within a 

taxable year to which the proposal applies, even though the 

transaction is completed pursuant to a binding obligation entered 

into before the effective date of the proposal. 

- 62 -
Footnote 

1/ For example, assume that a married individual owns a small 

business which was sold at the end of 1977 at a gain of $200,000. 

The business has resulted in taxable income of $60,000 each year 

for the last five years, including 1977. The taxpayer has no 

dependent children, had no other income for 1977, and filed a 

joint return for 1977. In this case, the taxpayer would be in the 

53 percent bracket for 1977 if the sale were not made. If the 

sale at a gain of $200,000 is made, the tax computed at the 

regular rates (taking into account the deduction for capital 

gains) is $81,288. The alternative tax computation results in a 

lesser tax of $80,008, but income averaging produces an even lower 

tax of $76,840--a saving of $4,448 compared to the tax at the 

regular rates and a saving of $3,168 compared to the tax computed 

under the alternative tax. 

- 63 -
IID-1 

TAX SHELTERS 

INTRODUCTION 

The Tax Reform Act of 1976 took some steps toward 

curbing the continued proliferation of tax shelters. Direct 

limitations were imposed on certain activities, particularly 

farm operations, motion pictures, and sports franchises~ the 

partnership rules were tightened to reduce abuse~ a rule was 

introduced to limit deductions in certain activities to the 

amount the taxpayer has "at risk"~ minor changes were made in 

the tax treatment of real estate, oil and gas and equipment leasing~ and the minimum and maximum taxes were changed to 

have additional impact on tax shelters. 

Despite these changes, tax shelter activity has not 

diminished. Tax shelter promoters have reacted to the 1976 

Act by developing a wide range of investments specifically 

designed to avoid the limitations of the 1976 Act. In 1977, 

widely advertised tax shelters involved such diverse 

activities as master phonograph records, lithographic plates, books, Christmas trees and research and development. 

Securities agencies, brokerage houses, and news media all 

report tax shelter activity during 1977 far in excess of 1976 

levels. The Securities and Exchange Commission (SEC) reports registrations offering a total tax shelter investment of $1.2 

billion during the first ten months of 1977, as compared to 

$690 million during the same period in 1976. The National 

Association of Securities Dealers (NASD) reports that during 

1977, its members made 182 public offerings of tax shelters 

with total investments of $1.8 billion~ during 1976, 196 

offerings for a total of $1.2 billion were made. These 

statistics do not include officially unreported shelter deals 

(so-called "private placements"), which by some estimates are 

at least ten times the volume of public offerings. For 

example, in Ohio the number of registrations of limited 

partnerships (the majority of which are tax shelters) was 570 

in 1975, 779 in 1976, and 931 in 1977. 

Under the Internal Revenue Code, taxable income can 

deviate substantially from economic income. These deviations 

are frequently a result of deductions being taken into 

account earlier than the income to which they relate. Such 

- 64 -
timing differences create so-called "paper losses", that is, 

situations in which taxable income during the initial years 

of an activity is significantly less than true income. 

Taxpayers engaged in the activities giving rise to these 

tax preferences can reduce their tax liabilities directly, or 

when they cannot, they may realize a portion of the economic 

benefit of the preferences by selling the tax benefits to 

others. The investment vehicle used to transfer the tax 

preferences is often referred to as a tax shelter. Although 

shelters take a wide variety of forms and include a great 

diversity of activities, the common characteristic of tax 

shelters is the generation of "tax losses" which are 

available as deductions not only against the taxpayer's share 

of taxable income from the tax shelter investment, but also 

against his taxable income from other sources, such as his 

business or profession. Through such investments taxpayers 

who take no active part in the subsidized activity are able 

to "shelter" their regular income from tax. The result is 

that taxpayers with substantial economic income are able to 

reduce tax liabilities simply by purchasing tax preferences. 

Tax shelters may possess as many as three major 

tax-saving features. The first, as described above, is 

deferral. A tax shelter generates substantial tax losses in 

the early years of the investment which are used to reduce 

the investor's tax liability on his unrelated income. The 

investment generates taxable income, if any, only in later 

years. Thus, tax liability on the investor's regular source 

of income is deferred until income resulting from the tax 

shelter investment is realized. The economic effect of 

deferral is equivalent to an interest-free loan from the 

Federal Government. For the same amount of deductions, the 

size of the "loan" increases as the investor's marginal tax 

rate increases. 

The tax benefit of deferral may be continued by 

investing in additional tax shelter investments at the time 

that the initial shelters begin generating taxable income. 

The tax losses generated by the newly purchased tax shelters 

are used to offset the tax liability on the older tax 

shelters, thereby so extending the period of deferral as to 

approximate a complete exemption. 

The second important element of many tax shelters is 

leverage. Leverage is the use of someone else's money to 

finance an investment activity. Frequently, a tax shelter is 

structured so that an investor, or the investor's 

partnership, borrows 80 percent or more of the purchase price 

of the investment. Since an investor is allowed deductions 

not only with respect to his equity, but also with respect to 

the borrowed funds, he can greatly increase the benefits of 

deferral by incurring deductions which substantially exceed 

his equity investment. 

- 65 -
In the most abusive tax shelters, a nonrecourse loan 

(i.e. a loan for which the investor has no personal 

liability, directly or indirectly). is provided by the seller 

of the property in order to finance a highly inflated 

purchase price. This nonrecourse debt allows the investors 

to claim inflated deductions without risking their own 

capital. In many cases the tax savings resulting from the 

inflated deductions are so great that the investors 

completely ignore the economics of the underlying business 

transactions. 

A further problem of leveraged tax shelters of this type 

is that investors frequently fail to report the taxable 

income which arises when the nonrecourse debt which financed 

the investment is cancelled. To the extent the Service is 

unable to discover this failure to report income, the 

deferral of tax produced by shelters is made permanent. 

Investors neglect to report this income for several reasons. 

Promoters of shelters often fail to mention that cancellation 

of the nonrecourse debt produces income. Also, this taxable 

income is not accompanied by any cash flow from the 

investment with which the investor can pay the tax. Finally, it is extremely difficult for the Service to discover on 

audit that the events which produce this income have 

occurred. 

The third tax savings feature of many tax shelter 

investments is the conversion of ordinary income into capital 

gains at the time of the sale or other disposition of the 

asset used in the tax shelter or of the taxpayer's interest 

in the shelter. Conversion occurs when the portion of the 

gain which reflects the accelerated deductions (taken against 

ordinary income) is taxed as capital gains. (If the taxpayer 

is in a lower tax bracket in the year of disposition, he 

effectively "converts" the tax rate as well.) Various 

"recapture" provisions have been enacted in recent years, the 

effect of which has been that conversion benefits are not 

available for many investments. 

In order to facilitate the sale of these tax benefits to 

those not directly engaged in the activity, a limited 

partnership is most commonly chosen as the investment vehicle 

for tax shelters. The partnership form is chosen because it 

allows the immediate flow-through to the investors of the tax 

preferences and also provides i nvestors with limited 

liability. Flow-through is available since partners -- unlike shareholders of corporations -- obtain an immediate 

deduction on their return for their share of partnership tax 

losses. Moreover, by making the tax shelter investors 

limited partners, their financial risk -- like that of 

shareholders -- is limited to their equity in the 

partnership. 

- 66 -
In many cases interests in tax shelter limited 

partnerships are publicly offered for sale to potential 

investors throughout the country. As a prerequisite to such 

public sale the partnerships must comply with applicable 

Federal or State securities laws, which require protections 

for the investor-limited partners (e.g., transferability of 

shares) not commonly enjoyed by limited partners. In fact, 

in the usual publicly syndicated tax shelter venture the 

limited partners enjoy the same protections and benefits as 

corporate shareholders, while receiving the additional 

benefit (which makes the transaction marketable) of the 

immediate enjoyment of losses generated by the tax shelter 

activity. 

The marketing of interests in these tax shelter ventures 

are directed at taxpayers whose marginal tax rates are 50 

percent or above. Promotional literature on tax shelter 

offerings clearly advise potential investors that the primary 

benefit of the investment is the tax deductions generated in 

the early years of the investment: the prospect of any future 

economic gain is clearly of secondary importance. In a 

recent article on tax shelters published in a leading 

financial periodical, a tax shelter promoter admitted that: 

We don't even want people to buy our programs based 

on (the program's) econom1cs ..•. If we find that 

anybody's going to purchase a program from us based on 

the expectation or necessity of receiving money, we 

recommend he not try it .•• 

Also, careful examination of the promotional literature 

demonstrates that typically a substantial part of the 

investors' initial cash contribution is used to pay 

promotional expenses, rather than to purchase assets to be 

used in the tax shelter activity . 

The continuing spectacle of high income taxpayers paying little or no tax through the use of tax shelters seriously 

undermines taxpayer morale. Low and middle income persons 

who cannot benefit significantly from tax shelters strongly 

resent the fact that they must bear the greatest burden of 

taxation, while certain high income taxpayers can obtain 

extensive tax relief. 

Although some tax preferences, such as the investment 

tax credit (as well as most other tax credits), and the 

special allowance for percentage depletion of minerals, were 

enacted or continued in order to encourage investment in 

certain industries or activities, other preferences are the 

unintentional by-products of legislative or administrative 

actions. These include the expensing of periodical 

circulation costs and research and development expenditures 

(enacted to resolve disputes concerning the proper tax 

- 67 -
treatment of such expenditures), and cash-basis accounting 

for farms (allowed by the Internal Revenue Service to assist 

unsophisticated taxpayers in determining their tax 

liabilities). The cost to the Treasury in foregone revenues 

is multiplied considerably when these accounting distortions 

are packaged for "sale" to those not active in the business. 

Thus, one cannot argue that tax shelter arrangements simply facilitate more complete implementation of the tax benefits 

intended by Congress. Changes are needed to eliminate tax 

preferences which neither encourage desired economic activity 

nor facilitate the proper measurement of income for those 

engaged in business. 

Further, even where investment in intentionally favored 

activities is concerned, a very serious problem is presented 

by the illegal or highly questionable enhancement of tax 

shelters through inflated purchase prices financed with 

nonrecourse debt. Too often, tax shelter promoters and 

investors take extremely questionable positions knowing that 

the substantive and administrative provisions of the Code 

greatly inhibit the Service's ability to police illegal or 

questionable tax shelter activities. 

Summary of Proposals 

(a) The Administration proposes to reduce certain tax 

preferences directly so that the deduction is more nearly 

based on the actual economic income or loss of the taxpayer. 

Real Estate. Depreciation of real estate will be 

limited to either (1) straight line depreciation based on a 

zero salvage value and useful lives nP.termined by the 

Treasury to be the average useful lives used by taxpayers or 

(2) depreciation based on the taxpayer's particular facts and 

circumstances. Taxpayers who use the facts and circumstances 

alternative would not be permitted to depreciate real estate 

in any tax year below its current salvage value. However, in 

order to maintain investment in low income and multi-family 

housing, this real estate will be depreciated on a more 

favorable basis. 

Accounting by Agricultural Corporations. All farming 

syndicates which under the Tax Reform Act of 1976 were lim~ted in their ability to deduct the cost of poultry, farm 

supplies such as feed, and the development costs of fruit and 

nut trees will be required like corporate farms to use the 

accrual method of accounting in the same manner as other 

business corporations. (This proposal which also applies to 

all corporate farms with gross receipts of more than $1 

million is more fully described in the section on corporate 

preferences.) 

Deferred Annuities. Deferral of tax may be achieved by deferr~ng the recognition of income as well as by 

- 68 -
accelerating deductions. One type of income deferral shelter 

involves the purchase of tax deferred annuities by high-income taxpayers as a way (to quote from a promoter's 

sales literature) to "pile up interest indefinitely, and not 

pay a penny of taxes until you take your money out -- usually 

at retirement when your tax bracket is likely to be lower. 

By not paying taxes on the interest every year, you actually 

earn extra income with Uncle Sam's money." Such contracts 

usually permit a purchaser to withdraw earnings, not in 

excess of amounts previously paid for the contract, at any 

time on a tax-free basis. Under a recent court decision, it 

also appears that high-income taxpayers may be able to avoid 

paying tax currently on the income earned through the annuity 

even when they are able to direct the investments to be made 

by the company. 

Under the Administration's proposal, insurance companies 

will be required to report each year to the purchaser of a 

deferred annuity the actual amount earned on his investment 

and the purchaser will be required to include this amount in 

income. This treatment will not apply to one annuity 

contract per taxpayer, the annual contributions to which do 

not exceed $1,000. 

(b) Direct limitations on tax preferences cannot be 

accomplished in some instances because the continued Federal 

subsidy of certain industries is regarded as essential or 

because a totally accurate matching of deductions against 

income will produce unduly complex accounting rules. In 

these cases, proposals are made to curtail abuse. In 

particular, it is desired to prevent uneconomic, gimmicky 

investments that waste the supply of venture capital without 

producing needed goods or services. 

Extension of At Risk Rules. The effectiveness of the at 

risk limitation added by the Tax Reform Act of 1976 (relating 

to the use of nonrecourse financing) will be enhanced by 

extending its application to certain closely held 

corporations and to all activities other than real estate. 

Limited Partnerships Treated as Corporations. Those 

newly formed limited partnerships that have more than 15 

limited partners will be classified as corporations for tax 

purposes. 

Partnership Audit. The Internal Revenue Service will be 

provided with a more effective tool to police partnerships, 

including tax shelter limited partnerships, by authorizing 

the Service to audit and make binding tax determinations at 

the partnership level. 

(c) Finally, in order to curtail excessive utilization 

of tax preferences the Administration proposes 

- 69 -
Minimum Tax. The deduction for half of the regular tax 

paid in the case of individuals will be eliminated; the 

deduction against preference income will thus be limited to 

$10,000. 

Investment Tax Credit. Currently, the investment tax 

credit and work incentive (WIN) credit may offset completely 

the first $25,000 and $50,000, respectively, of tax 

liability. This offset will be allowed instead only to the 

extent of 90 percent of tax liability. 

- 70 -
IID-2 

EXAMPLES OF TAX SHELTER ABUSE 

A. The Continuing Tax Shelter Problem 

Thousands of high-income taxpayers continue to avoid 

payment of their fair share of income tax. The most popular 

techniques by which they do so are generally referred to as 

tax shelters. Tax shelters -- thought by many to have been 

eliminated by the 1976 Reform Act -- have continued to thrive 

during the past year Low and moderate income taxpayers are 

particularly annoyed when they read of high-income taxpayers 

utilizing tax shelters or see newspaper advertisements and 

articles in magazines extolling new tax shelter techniques 

and their promoters. This publicity undermines compliance 

generally. Frustrated and angered taxpayers who cannot 

afford to invest in these tax shelters may resort to their 

own "tax shelter" devices, such as "forgetting" to report 

income from a second job. 

Sales of tax shelters have become a regular part of 

business commerce For example, the following advertisements 

appeared in the Wall Street Journal of December 23, 1977, in 

the midst of prime tax shelter retail season: 

, • •·· :-o J~r-•r Maoll~ ... ell II rr.. ....... "'"'"'- ••chlo .. ·rr. na- .. 

____ .,, .. , ... truclla, etc, IUo.•oo. Fn4 

,.rle M.•ll•'&"• te 11•-'"•• A••• .'l'i;IIITIEII . •.-•-•• "" 08111d. t1W11t ll:o8-:u:4. 

80AT I'F.'\TAL.~--AI&I!'fA 

.......... .:. ............ ~ ..... ~·-·· ~ ........... ....... , , .. 

~·· .... ..... , ........... • ... ••~r .. ,. 

I · 

-

- 71 -

[f 

o ... , ... nra. 

11M •••• fw ,., ... , ....... floaco •••lr· ,.,.,., . n•t 1...,..1 

eiiTt:O 

AVAJl.AtU 

.. INTE~~ATIONAL 

·BANK -. 

,..h,clpal• oal, ....... ,., ..... 

, 

-
Sales of tax shelters have become so profitable that 

major brokerage houses can no longer afford to overlook this 

source of revenue. An article in the July 25, 1977 issue of 

Forbes Magazine, page 27, entitled nGimme Sheltern explains 

Tu sheJten are bonmm1 

apin. Ia aood part becaute IDIatioo, pessfve prosperity tu laws bep -~ 

more and more IDto 

brackets whele paylac really 

burtL Civeo Merrill Lynch's he 

reputatkla. a appealed tD customers who wciuldD't 1ru1t a 

ordinary tu-sbelter deal .... 197S .. attracted t53 adllloa Ia [tu ahelw] 

equity laveatmenta. • Loulblla •ya. 

leanln1 b.ck Ia his chair. -u.t year, 

t77 mDiioo; this year we expect to do 

over flOO adl1iao. • 

Merrill L)'DCh .. by DO lneUII aloae. 

Today Deady fNfq ntad brobrap 

house ia the COUDby Jw c1iscownd 

the potential Gl tu ahelten u a DeW 

IOUI'CI ol buslaea 

Sales commfuloaa nm &om 81 tD 

I.SI ol the mooey lavested. the ldDcl 

ol retum that fJDerllzed all daose .... 

lual lund l8lesmeD beck .. lhe •· 

tlelaodFiftiea. 

Lut year tu ahelten attracted 8t 

leut flU billion. About fl.l bdllon 

ol that wu Ia public placements rea· 

B. Illustrations of the Problem 

llterecl wltb the Securities • Euhanp 

ComrnlllioD or with ltate ....-. fte other WI (or 11101'8) IIID pdv8te 

placemeota. whkh are llmlted tD IS 

or few. IDveston and which do DOt 

.. ve tD ,.sst• with the SEC. Pdwte placemeots are the proviDce Gl 

DOt oaly dae brolen. INt • whole 

army Gl lawyers. eccountaDtl IDd 

promoters-some ahup, - Gl them 

justdwb. . 

'l1lls ~· take .. tu daeltert- publie and prlvate-cou1cl be ...... 

ttdL n.e Industry's rule Gl 

thumb II that anyooe who Us 

part Gl his Income Ia the feel. 

eraJ 501 lncltet .. • prospect. 

PubllsheciiDtemal Reveaue SerYice data f« 1973 (the latest 

Iawes > abowed sea,&e9 tupayen at the 501 level or 'hiP. 

• that year. That's a lot ol ~ 

tential busfnesL SiDce 6aa. 

maay more thousands Gl rack 

lincen. 1V penonalitiet, docton. airline pdots, lawyen and 

assorted aecutives have joined 

the top bradceta. 

Would you invest $65,000 of your own money to buy the 

rights to a book about the life story of a virtually unknown 

bodybuilder written by an unknown author? Probably not, 

unless you determined that the chances of making a profit 

justified this enormous risk. Tax shelter promoters, 

however, devise schemes to entice wealthy investors to do 

exactly this. Bow? By making Uncle Sam a silent partner in 

the investment. 

In one such tax shelter, the investor invests $65,000 of 

his own cash. The purchase price for the book, however, is 

not $65,000 but rather is inflated to $300,000. Does the 

investor personally owe $235,000? No. The difference is 

payable only out of a small percentage of the receipts, if 

any, and only after the investor has been repaid his entire 

$65,000 cash payment. 

Under the terms of the deal, over 1,000,000 copies of 

the book must be sold before the $300,000 npurchase pricen is 

repaid. The prospectus promoting the deal contains 

- 72 -
appraisals from "experts" who, even in their optimistic 

opinion, place the upward sales limit for the book at 600,000 

copies. Thus, even assuming that the appraisals cited by the 

promoter prove accurate, the projected book sales would repay 

only two-thirds of the so-called "loan". It is obvious that 

the "loan" will never be repaid. What then is going on? The 

answer lies in the purported tax benefits. The investor is 

encouraged to write-off as rapidly as possible the full 

$300,000 "cost", thereby giving him tax benefits far in 

excess of his cash investment . As a result, through tax 

revenue losses, Uncle Sam has become the major investor in 

the book. 

The key to the shelter is the inflated valuation given 

to the asset. An asset, such as a book, is difficult to 

value. Hence, an irresistable temptation is presented to 

aggressive tax shelter promoters to overstate this value. 

Nevertheless, despite difficult questions on valuation, 

and the near certainty that, if audited, the Internal Revenue 

Service will contest these aggressive valuations, book 

shelters have thrived so much so that a major literary (not 

business) journal felt bound to describe the phenomenon. 

- 73 -
Book RevieW 

BOOKENDS 

By Richard R Li..,geman 

The _Sheltering Book 

W EALTHY people _;:;.~~~;:--

about taWD facina & 

!alp tu bite this 

:JUC are lnvestlDa money m 

boola as t:u:: ~ters. The 

tradltloaal "tU shelters. · of 

course. are oil wells. c:attle 

fanns, :::otfoo pic:tu.""es and the 

lin, but refor::u lD t!le Intemal 

Revenue Cot.e last year have 

made books (also master 

records aod ·IODI copyriJhb) 

ruddenly attractive. 

The reason is Qat the Tu: 

Refonn Act ot 1976 still per.n.its 

individually owned tax-shelterasseu to be pcn:!lased with no- risk. noa-recoane loans. after ellmina.tioa sudl practices 

by partnenhips.. ~ all Jets very tedmical. but the way 

It works is that the shelter--seeker buys ao assiJDZDeut of 

copyrlJhl fro:o the alllhoc-(or publishloJ house if it owns 

the copyriJht), u.saally for a limited time-say, 1~ yeanalter whlcb c:opyrizbt reverts to the author. lbe autbor 

ls serunc his ~Pta to i.ocome from the book duriDc t!l.at 

time: lD other words, for some c::asb in baud. he pves up 

the chance of mUi:ct evea·.mme mocey ID the event thle 

book takes ott. 'Ibe tu-sbelter. seeker acquires aa assetbe can de9red:ate epiDst current income. 

The amount the mvestor pays ls supposec! to represent 

'the boolc's val~ Ia terms of pr:ojected incame; such evaluations nnr. from. Cia IDtlated to the falrty rU!ist1c. The 

LR..S. C3n be expected to casf a cold eye on book-shelter 

evaluations; C:e prac::ice js so new that 1t baa made oo rulIDp 011 them as yet. :\forton J&Dldow, !l New York l&wy~: 

aaeot who sees a lot of. book-shelter proposals. says thtt. 

Wee any bx ~Zeiter, they can be. bo.aa fide but .. the key 

element is wber.'!er the atT&Q&eme.at was en~ into for a 

leJitimate business purpose." 

Book shelters caa inyolve the investor puhlishin& the 

book himself, az:d Jetti:lc a ~utor, but mon C'OIDJ:10ft 

are the tu·she!t!r promoters ·who buy up a namber or 

c:opyrl&hts and oHer tbera around to ·high-braclcet rollers. 

A-typical promOler r:U:ht offer 30 or .CO books with· a total 

Y&Jue of over S2 mUlioa, of ·which he will bke bett:r thaD 

a fourth u his cocmlssioa with the· remainder &Oin& about 

equally to autl:.on aocl for ~ ~ces· of individual 

booics we·ve he&:d about rznge from $50,000 oa up to 

Sl millior. "for one ~Jrt.ly published, sensar:iocal commerci31 coveL 
In many of these deals, the tax benefits are so great that the quality of the asset, such as a book or recording, 

is irrelevant. All that is needed is the appearance of a bona 

fide transaction, to avoid disqualification as an outright 

sham. This fact is well described in an article entitled 

"Ah, Tax Shelters! What Horrors Are Committed in Thy Name" 

which appeared in the January 23, 1978 issue of Forbes 

Magazine. 

Cal-Am dutifully warns )'OU in fts sales 

ltterature that there may be one big 

problem: the 1125,000 purchase price. 

'Jbe IRS has announced that ft will ICI'\Itinlr.r lax return• In which the "ti.ir mar· 

bt ..Jue • ol proper1y is less tb.n tbe 

nonrecourw debt used to ~ for fl But 

tl1125,000 IOUnds ltke IDo much to~ 

for a master reawding by • unJcncw..n 

artist. sit tight: Cal-Am provides )'OU 

with two appraisals by experts in the 

music remrdlog business who wiD attest 

to Its wlue. . · . 1be IRS,·ol course. may oootest. the 

8ppraisals;wticularly in light ol what 

one record-industry source told FOftiU: 

"I visited Cal-Am ~eraJ months 110 

because I thought they were interested 

fn purchasing good master recordinjp. 

They looked It me like I was crazy. '(A 

Cal-Am o&lciaJ] said: "Can you &et me 

records ~r $1 ,000 or $1,SOO apiecer 

And J wd to him, 'No, I can't.' He wd. ~t's the price se2k I'm loolcing b .' 

ADd I said to him, "That's impossible. You're going lo have two oeUists banging 

their cellos togf'ther for $l,(XX). · He said, 

"I don't care what we have.' " !Our 

source .dds that a typicaJ cost .for pro- durin~( a good master recording, is between $45,000 and $100,000.) 

Obviously, reasonable men may disagree over the fair 

market value of an asset. For tax shelter promoters, 

however, the possibility of reasonable differences of opinion 

is the excuse justifying the most favorable, and in many 

cases outrageous, valuation. One way to deal with this 

problem is for the Service to hire an army of appraisers. 

Clearly, this is not desirable. The Administation proposes 

instead to replace the army of appraisers with a simple rule: 

an investor can deduct tax losses only to the extent of his 

economic investment in the activity. In the foregoing 

example this rule will limit the investor's deductions to 

$65,000. The value of the tax deductions can then never 

exceed his personal investment. The investor, therefore, 

will lose some part of his investment unless the deal 

produces a profit. Under this rule, it is hard to conceive 

of a prudent person who would invest $65,000, let alone 

$300,000 of his own money in this venture. An investor could 

no longer ignore the strong probability that the book will be 

a flop. The need for this rule is not limited to book deals. 

Ingenious promoters have packaged tax shelters involving 

master recordings as well as lithographic plates of original 

works of art. Obviously, the only limit is the imagination 

of the promoters. Thus, the rule extends to virtually all 

activities. 

In many tax shelters an investor makes profits while 

losing his entire cash investment. This interesting 

phenomenon can be demonstrated by the projected tax savings 

supplied by the promoter of a tax shelter involving a 

lithographic plate of an original work of art. As the 

attached projection shows, for a cash investment of $25,000, 

- 75 -
the promoter projects that the cash value of the tax savings 

during the first four years of the investment to a taxpayer 

in the 60 percent bracket would exceed $65,000. Thus, 

assuming that the projections of the promoter can sustain a 

challenge by the Service, the investor has received almost a 

300 percent return simply by losing his entire investment. 

Even the medieval alchemists could not so skillfully turn 

lead into gold. 

- 76 -
u.oYD PRMB1!:R • ASSOCIATBS 

KTATt:Jit:JIT' Rf riiOJt:CTI'JI fll't:JIATIIliiS 

(llnaiHIILodl 

t'lach u-.d ror thle pra.Jtlotlnn 

rlod 

Tnl•l cnnt to tnvoalor (Not~ 3) sru,ono 

1nVIlAI.ant L•a credit avall&ble !.J!&IOO 

TAx hr111:kc l or JIOlentiat· lnvut.or 

fur CftCh yeAr or pi'Cijucllon lOll 

-= 

Hnt c prlnc:ipnl atod lnl ernt •nr lheol 

( Ne>lo :1 1 llono 

-

un 

A. In•·•- t.u ..rrcct (MuLe tel 

lnc••tte: 

Gt'OIII pa-orlt on ulea (llotu t6 •nd 4) • - t'or .,cloaure or ncote (Nnlu to •nd 3) - Tut.a I I nr.neo - DNuc t:t """: 

fnvut:.l:nt tu credit (Not.e td) 20,1U 

Uq>r<:cl•llon (llfrte lei 13,111 

fntcrcat (Nnle I r) II MIG 

Tohl doclnotlone :111221 

U71 U71 IIIII 

• - • - • - • - - - - - -

- - - 24,111 11,204 14,137 

l ,ooo l•ooo 1,000 

311,111 211204 1011:17 

lilt 111:1 1113 ..... 111!1 "" t!l7 Tnlnl 

- ' - • - • - ' - • - s - • - - - - - - 141,272 ~t.!!~ 

- - - - - - 1411.272 1411.:!72 

- - - - - - - :n.•ll 

ll ,lt7 1,031 7,021 1 , 411 4, 211 1, 153 - 111,77:! 

••ooo 1,0011 l,ono 1,000 I ,IJIIO l•ono •• UfiO ~1100 

17,117 aa1

oll 13.021 11,411 rn1211 '•In 1101111 I !1·1 1Uib 

Taxabl e lncoee (loee) S(31, 22Z) 1(30, 111 ) $(11,204) S(ZO,I37) 1(17 , 1171 Slli,Olll S(tl,0'-11 Jl11 , 411l 1(10,2111 J( 7,153) $142,2?2 S(4U,A:lll =====.s 

... • :t,T33 I 11,411 I 11,122 I U,liiJ I• 10 ,110 I' I,OZ:Z • 7,111 • 1 , 110 • 1 ,151 • 4,111 J(IS,314) S ~7 $~ 

- - - - - - - - - - - - r.:m li,4t S til, Ill u,su I io,~7o 1,022 7,117 i,IIO 1 , 1111 4;61:! ies,ll4t ~~ 

CAPJTAJ, CtiiiTMIIIVTt:ll (Note :1) u 1100 u,5Cl0 - - - - - - - - ~11,11110 

lll't euh l>et.eflt (coetl • 112:13 ct- ••••• ~.. . ... 122 t'i'2jllll • 10.570 I t 1oz:z s 71111 I ., .. o • a1ut • 411tz S(l!l,ll41 ! l!lllllll 

C•••latlvc caah he...:r lt fr.Gte 1 1 • 1 1 2ll I t ll,l 41 • :10,270 S 42 , U:.! I !13,40:1 s 12,424 ! 70.241 S 77 , 121 s u .uz S A7 ,1U • 3,f'()l) ' ~ 

Ttoc •a;,_,,..,LJ,,n• and note• c:CifttAined In lhla rupArl. "" • n lnto•arat 

ro~ ·l. nl' lhill prujC!ctcd Al•lc .. ent. 

- lief' l!!ll!'l' .. r t.rAn ... lllnl ..... nncorlclenll•l -•ran,_ ., Lloyd Probber 1: Aaaooiatftl 
Returning to the book shelter deal described above, 

let's assume for the sake of this discussion that the 

valuation is reasonable. At a later time, the book is a 

flop, and the $235,000 note becomes worthless. What happens? 

The investor has no personal liability for the note so the 

only thing the investor loses is the copyright asset. 

However, under the tax laws, the investor must then report as 

income the amount of the forgiven loan. As noted in the 

following excerpt from the recent Forbes article, many 

investors and promoters suffer from convenient memory lapses 

at this time. 

. Even if )'OU manage to 

escape challenge. on your 

deductions and credits ~ 

the IRS, you stiU may have 

problems. Remember how 

)'OU paid tor~ master~ 

cording: •20.000 down, 

Sl05,000 in a ieven•year. 

nonrecourse note. Let's JS· 

sume the record has failed 

to bring in more than a lew 

dollan of income for you at 

I~ end of seven years. So )'OU decide tO 

«kfju1t On the note. II )'OU did. )'OU'd 

flnd yourself stuck with a huge tu bill. 

After .0. )'OU signed a DOte b 

SIOS,OOO, deducted that amount &om 

.your tues, and have now said that )'OU 

n~er, intend to pay il OS: So the 

. Sl05,000, and possibly more, is suddenly Mrecaptured" into income the ~ 

ment your debt is wiped out. ' 

In other words, you'd bener ~ a 

very big wad o( cash ready to hand c-Ner 

to Internal Revenue. But there k a ony 

out. 1be DOnrec.'OUrse note is renewable 

at your option. So you can rpO it over for 

another seven yean, and postpone. the 

day ol reckoning. 

Okay. but at the end of 14 years, 

you've got ~ same problem. That point 

was raised during a meeting with a c.J. 

Am of'ICial, Don Ferrari, who was talking to a poop of prospective c.J.Am 

salesmen. •5ome people: Ferrari uid 

with an ~pression ol mod sadness, Mwill 

have lapses fA memory at the end.oC 14 

)'ai"'•M 

Although the proposed substantive changes will be of 

enormous assistance in limiting shelter activity, the Service 

must be able to audit shelters adequately. Many shelter 

schemes are of such enormous complexity and geographic scope 

that even the best efforts of the Service are unable to cope 

fully with the logistical problems presented. 

A common practice in tax shelter deals is to "layer" one 

partnership on top of another in arrangements that involve 

investors from coast to coast. For example, consider the 

arrangement illustrated on the following page. This tax 

shelter which the Service is presently examining contains 

four tiers of partnerships. The 69 taxpayer partners are 

scattered throughout the various tiers. There are six 

partnerships which are mere conduits, although in 

investigating this tax shelter the Internal Revenue Service 

must examine the returns of these conduits to identify the 

actual taxpayers. 

Even where the tax shelter partnership is not structured 

in a multi-tiered arrangement, the mere number or geographic 

diversity of limited partner-investors makes the Service's 

audit task extremely difficult. One group of tax shelter 

cases presently under examination by the Service involves 

over 20 partnerships, with an aggregate number of limited 

partner-investors in excess of 1,600. Certain of these 

- 78 -
partnerships each have in excess of 400 limited partners who 

are located from New York to California. 

There is no reason to permit highly questionable and 

sometimes illegal tax positions to go unchallenged by the 

Service as a result of complexity and subterfuge attributable 

to taxpayers. As a result, the Administration has proposed 

streamlining the partnership audit rules so that these 

complex schemes can at least be adequately scrutinized by the 

Service. 

- 79 -
FIRST TIER 

SECOND TIER 

THIRD TIER 

FOURTH TIER 

.... 

TOTAL RETURNS 

Individual 62 

Corporate 5 

Trust 2 

Partnership 6 

75 

10 

INDIVIDUALS I 

PARTNERSHIP 

15 PARTNERS 

2 

TRUSTS 

2 

PARTNERSHIPS 

21PARTNERS 2 BENEFICIARIES 

1 

CORPORATION 

20 

INDIVIDUALS I 

10 

INDIVIDUALS 

1 

PARTNERSHIP 

12 PARTNERS 

20 

INDIVIDUALS 

2 

PARTNERSHIPS 

24 PARTNERS 

2 

INDIVIDUALS 

4 

CORPORATIONS 
IID-3 

REAL ESTATE DEPRECIATION 

Present Law 

Present law allows a depreciation deduction for the 

exhaustion, wear and tear of buildings used in a trade or 

business or held for the production of income. 

A building will experience a gradual loss in value over 

its life equal to the difference between the cost of the 

building and its salvage value. This loss in value is a cost 

of producing the rents or other income from the building. 

The purpose of the depreciation deduction is to provide an 

accurate measure of the annual taxable income derived from 

the building by allocating this cost of produ~ing income over 

the period during which the income is produced. To 

accomplish this purpose, the total loss in the value of the 

building must be allocated year-by-year over the life of the 

building. 

If the entire cost of a building were deducted in the 

year it was placed in service, there would be large tax 

savings at the beginning of the property's life that would be 

offset by taxation of the entire gross income from the 

property (net of operating expenses) during the remainder of 

its life. The deduction of all of the anticipated 

depreciation at the beginning of a building's life would be 

inappropriate because it would not reflect a current loss in 

its value. 

The opposite policy would be equally inappropriate. If 

a deduction for the loss in value of a building were 

permitted only when its amount could be determined with certainty(~, when the building was sold), the taxpayer would be required to pay tax on the entire gross income from 

the property (net of operating expenses) and would receive a 

refund of the overpaid tax only when a loss was sustained on 

the building's sale. Taxpayers would properly object that 

the loss of value occurred during the period of the 

building's use and should be netted against the income earned 

during that period, rather than accumulated and deducted in a 

single year. 

The allowance for depreciation is intended to avoid the 

distortion of income that would result from either of these 

extremes by permitting annual deductions that reasonably 

allocate the cost of producing income from the building over 

the period during which income is produced. Thus, the rate 

at which a taxpayer recovers his investment in a building 

- 81 -
through depreciation deductions is, in general, intended to 

correspond with the gradual loss of that investment as the 

property deteriorates physically or becomes obsolete. Under 

present law the amount of the annual depreciation deduction 

is a function of three factors: 

(1) the estimated useful life of the asset: the length 

of time it will be used in the taxpayer's trade or 

business or held for the production of income: 

(2) the salvage value of the asset: the amount which 

the taxpayer estimates will be realized upon sale 

or other disposition of an asset when it is no 

longer used by that taxpayerJ and 

(3) the method of depreciation: the method of 

apportioning the property's decrease in value from 

its original cost to its salvage value over its 

useful life. !/ 

Methods of depreciation. 

Until 1954 the most common method of depreciating 

buildings was the straight-line method. Under the 

straight-line method, which is now required only for used 

nonresidential real property, the annual deduction for 

depreciation is a pro rata portion of the difference between 

a building's cost and its estimated salvage value. 

Accelerated methods of depreciation (~, the declining 

balance method) allow more depreciation in the early years of 

an asset's life and less in later years.2/ These accelerated 

methods, first permitted on a limited basis by administrative 

practice in 1946, were specifically authorized by the 

Congress in 1954, when its primary focus was the depreciation 

pattern of industrial machinery and equipment. However, 

these faster methods of depreciation are now generally 

permitted to be used for all assets, including buildings. 

New residential rental buildings may be depreciated at a 

rate of up to 200 percent of the straight-line rate (or the 

sum of the years-digits method, which gives approximately the 

same results). Other new buildings may be depreciated under 

the declining balance method at 150 percent of the 

straight-line rate. Used residential properties can be 

depreciated at a rate of up to 125 percent of the 

straight-line rateJ only used nonresidential properties are 

limited to the straight-line method. 

Useful life and salvage value. 

While depreciation methods for buildings are specified 

by statute, estimates of useful life and salvage value are 

made by the taxpayer subject only to the requirement that 

- 82 -
they reflect all the "facts and circumstances" bearing on the 

taxpayer's anticipated use of the property. 

The taxpayer must make subjective judgments to estimate 

both the useful life and the salvage value of a building when 

it is first placed in service. To the extent that a taxpayer 

makes a judgment underestimating a building's useful life and 

salvage value, the taxpayer overstates depreciation during 

the shorter life claimed, producing premature deductions. 

In 1971 Congress requested a Treasury study of the 

useful lives over which taxpayers were in fact depreciating 

buildings, intending to establish useful lives for buildings 

under the class life system of depreciation (Asset 

Depreciation Range, or "ADR"). The Treasury study, completed 

in 1974, showed that taxpayers almost always assume salvage 

values of buildings to be zero and claim useful lives that 

are significantly shorter than the relevant lives for 

buildings published previously by the Internal Revenue 

Service (Rev. Proc. 62-21, 1962-1 C.B. 418). (See Table 

IID-1.) 

Instead of estimating the overall useful life and salvage 

value of a building, taxpayers may allocate the cost of a new 

building among its various components (~, the building shell, 

wiring, plumbing, roof, ceiling, flooring) and then may estimate 

separate useful lives and salvage values for each of these 

components. It is not uncommon for a single building to be 

divided into more than 100 separate components. 

Reasons for Change 

Present law authorizes a reasonable deduction for 

depreciation to ensure that the annual income derived from a 

building is clearly reflected. The current procedures for 

determining depreciation deductions for buildings do not produce 

depreciation deductions which are reasonable. The use of useful 

lives and salvage values that are far less than are economically 

justifiable are combined with the accelerated methods permitted by 

statute to produce excessive depreciation deductions that distort 

income and enable taxpayers, especially high-income taxpayers, to 

avoid taxes. 

Straight-line method more appropriate. 

Prohibiting use of the accelerated methods of depreciation 

for real estate is supported by (1) prior Congressional action, 

(2) studies of actual economic declines in the value of buildings, 

and (3) the realities of the marketplace. 

1. Prior Congressional action. 

Accelerated methods of depreciation for real estate were 

- 83 -
Building 

Type 

Retail 

(including 

shopping 

centers) 

Warehouse 

Factory 

Apartment 

Office 

Bank 

Table IID-1 

Comparison of 1962 Guidelins and 

Lives Claimed (In Years) 

Guideline Lives 

: Under Revenue 

Procedure 

62-21 

50 

60 

45 

40 

45 

50 

. . 

: Average Lives 

Claimed by 

Taxpayers 

:(New Buildings 

Only) 

36 

37 

37 

32 

41 

43 

: 

Percentage of 

Taxpayers 

Claiming Lives 

Shorter Than 

Guideline Lives 

93 

99 

77 

78 

91 

79 

Office of the Secretary of the Treasury January 27, 1978 

Office of Industrial Economics 

Source: Office of Industrial Economics, Department of the 

Treasury, Business Building Statistics (GPO, Washington, 1975). 
permitted virtually as an afterthought. When the Congress 

originally authorized the accelerated methods in 1954, it was 

primarily concerned with the depreciation pattern of machinery and 

equipment; the purpose of the accelerated methods was to afford a 

more realistic timing of depreciation deductions by properly 

recognizing the early obsolescence of these assets. ll 

Obsolescence may affect the length of building lives as it does 

those of machinery and equipment. However, experience 

demonstrates that the technological obsolescence of buildings is 

not nearly as rapid as that of machinery and equipment. 

The potential physical lifetimes of most buildings are 

extremely long. That is, with reasonable maintenance, there is no 

physical reason that most buildings cannot remain in service for 

hundreds of years, as many buildings currently in use attest. In 

spite of the physical durability of buildings, they are frequently 

removed, abandoned, or converted to another use, most often for 

reasons that are social, cultural, and political, rather than 

physical. These changes occur gradually. The rapid technological 

changes in the fields of computer technology, electronics and 

production machinery, for example, do not equally affect real 

estate. 

- 85 -
The legislative history indicates that in authorizing 

accelerated methods of depreciation the Congress did not consider 

the different pattern of the loss in value of buildings compared 

to that of machinery and equipment. The allowance of the 

accelerated depreciation methods for buildings simply happened, 

and was not intended as a device to stimulate real estate 

construction. 

In 1969 the Congress recognized the distinction between the 

depreciation pattern of buildings and that of machinery and 

equipment. The Tax Reform Act of 1969 restricted the use of the 

accelerated methods of depreciation for buildings. Further 

recognition that the Congress has viewed the straight-line method 

as a more appropriate one or buildings is provided both by the 

recapture rules and by the definition of tax preference items. 

The recapture rules, enacted in 1964, generally require that 

the portion of gain realized on the disposition of a building 

equal to the excess of accelerated over straight-line depreciation 

be recognized and taxed as ordinary income rather than as capital 

gains. The excess of accelerated over straight-line depreciation 

is also considered an item of tax preference for purposes of the 

minimum and maximum taxes, introduced in 1969. 

2. Studies of actual declines in value. 

Recent studies of the actual economic depreciation pattern of 

real estate unequivocally conclude that any method of tax 

depreciation for buildings that yiel~s deductions more accelerated 

than those produced by the straight-line method over the lives 

presently in use is unjustifiable. 

A study conducted for the Treasury in 1970 investigated the 

actual economic depreciation (in constant dollars) of real estate. 

This study concluded that allowabl~ tax depreciation--even on the 

straight-line method over useful lives of 40 to 60 years--greatly 

exceeds the actual economic depreciation of both office and 

apartment buildings: 

"For both office and apartment buildings we find that 

the tax depreciat1on rules--even after the 1969 

revision--confer substantial subsidies. For example, the 

true depreciation of office buildings in the first year is 

less than one-tenth of that allowed under straight line 

depreciation. Indeed, true depreciation for office buildings 

falls short of that allowed by the straight line method for 

each of the first 45 years of the office building's useful 

life. We calculate that on a before tax basis, the straight 

line depreciation allowed by the law yields a subsidy of 18 

percent of the purchase price while double declining balance 

adds approximately 10 percent more. 

- 86 -
•The results are similar for apartment buildings. In 

the first year, true depreciation is less than one-fourth of 

that allowed under the straight line method and true 

depreciation does not exceed the tax allowance until after 

the passage of 40 years. The straight line tax depreciation 

methed confers a subsidy of 14 percent while accelerated 

methods can double this. In both industries a reverse sum of 

the years digits method would approximate true 

depreciation." !/ 

Another Treasury study compared tax and economic depreciation 

(in constant dollars) on the basis of the extensive data collected 

in connection with the Treasury's 1974 ADR survey of lives 

actually being used to depreciate buildings. 5/ This study also 

concluded that even straight-line depreciation: given current 

lives in use, greatly exceeds economic depreciation. 

3. Realities of the marketplace. 

The inappropr i ateness of accelerated methods of 

depreciation for buildings is clearly demonstrated by the 

disparity between the implied rates of decline in building 

values and the lending practices of major financial 

institutions. These institutions lend hundreds of millions 

of dollars each year, accepting buildings (and their sites) 

as security. These lenders must be concerned wi th the true 

rates of depreciation of the properties the y take as 

collateral. If a property depreciated more rapidly than the 

loan was repaid, the lender would find the value of the 

collateral to be insufficient to recover the unpaid balance 

of the loan in the event of default. 

The behavior of equity invest ors in buildings also 

clearly demonstrates that accelerated depreciatipn is 

unrealistic. These investments, if the investors' tax 

depreciation schedules are to be bel i eved, have rates of 

return that are not only we ll below prevailing market rates, 

but that are sometimes even negative. These points ar e 

illustrated by the following example. 

Example 

Assume an investor purchases a newly constructed office 

building and its site for $1 million. The site has a value 

of $120,000. The i nvestor finances the purchase with 

$250,000 of his own funds and a loan of $750,000 from an 

insurance company. The loan has an interest rate of 9 

percent per annum, will be amortized over 22 years and i s 

secured by the property. The building is fully rented and 

generates $104,051 annual revenues, net of operating 

expenses. ~/ 

The financi a l results for the first five years are shown 

in the following table. Depreciation is shown under both the 

- 87 -
150 percent declining balance and straight-line methods based 

on a 30-year useful life. 

1. Operating income before 

interest and depreciation 

2. Mortgage amortization 

3. Depreciation 

4. Interest 

5. Cash flow (item 1 less 

items 2 and 4) 

150\ 

Declining Balance 

$ 520,255 

71,390 

199,072 

325,753 

123,112 

Straightline 

$ 520,255 

71,390 

146,665 

325,753 

123,112 

The depreciation deducted under the 150 percent 

declining balance method in the first five years is almost 

three times as great as the mortgage amortization required by 

the lender. If the depreciation deductions accurately 

reflected true depreciation, the lender's margin of safety 

(i.e., the excess of the property's value over the loan 

balance) would be reduced from 33 percent to 18 percent. To 

maintain the 33 percent margin of safety, the lender would 

anticipate no more than approximately $95,000 of economic 

depreciation over the five-year period. In contrast, tax 

depreciation computed on the basis of the 150 percent 

declining balance method is $199,072. 

To calculate the investor's before tax rate of return, 

assume that the property will be sold after ten years. The 

annual cash flow from the property is $24,623. If the 150 

percent declining balance method with the 30-year useful life 

accurately reflected true depreciation, the property would 

sell for $646,890 after ten years. From the proceeds of the 

sale, the investor would have to repay the remaining balance 

on the mortgage of $568,767. The net cash from the sale 

would be $78,123. Given that the investor committed $250,000 

when the property was purchased, the rate of return on the 

investment is 4.17 percent. This is an unrealistically low 

figure for rates of return to equity investors in an 

environment where mortgage rates are 9\ and higher. If 

investors truly anticipated rates of return of this size, no 

investment in buildings would occur. Clearly, in order to 

earn a reasonable return on equity, the sales value, and 

hence the undepreciated basis at the end of ten years, should 

be substantially higher than that implied by presently 

allowable deductions. Even straight-line depreciation over a 

30-year useful life provides a rate of return of only 6.53 

percent. A similar example for apartment buildings for which 

the investor uses 200 percent declining balance depreciation 

produces a negative rate of return. 

- 88 -
Need for guideline lives. 

The Treasury has consistently attempted to make the 

calculation of depreciation for all kinds of property simple, 

uniform and administrable by providing guideline systems for 

the determination of useful lives. Guideline lives which 

taxpayers may elect and not have challenged by the Internal 

Revenue Service have generally been established for most 

depreciable property, but are not currently used for 

buildings. 

The present facts and circumstances test for determining 

building depreciation is a cumbersome and inexact process 

that produces widely varying depreciation allowances. There 

is no evidence that these variances reflect actual 

differences in declines in value. In addition to being 

inequitable, the present system is also costly for both 

taxpayers and the government. 

Uniform guideline lives for real estate would (1) 

provide simplicity, certainty, and relieve the administrative 

burdens imposed by the facts and circumstances test, and 

(2) ensure that similarly situated taxpayers are treated 

consistently. 

1. Facts and circumstances foster disputes. 

Under the facts and circumstances test, taxpayers must 

estimate useful lives and salvage values of buildings in the 

year they are first used in a trade or business or held for 

the production of income. The facts and circumstances test 

thus requires both taxpayers and the Internal Revenue Service 

to predict technological, social, cultural, and political 

events to determine a reasonable allowance for depreciation. 

It is not surprising that under this subjective 

standard, requiring numerous judgments on which reasonable 

persons could differ, disputes frequently arise over the 

appropriate useful lives of buildings. A 1977 report 

prepared by the General Accounting Office (GAO) on ways in 

which the tax laws could be simplified identifies disputes 

over useful lives of depreciable property as one of the tax 

issues most frequently in controversy. 7/ These disputes, 

involving basically factual issues, require taxpayers and the 

government to devote substantial time, effort and expense to 

the determination of a mutually acceptable useful life. 

It is unreasonable, and as demonstrated by the empirical 

testing of the depreciation rules that have been used for 

buildings to date, virtually impossible, to base economically 

justifiable rates of tax depreciation on these 

taxpayer-by-taxpayer predictions. 

- 89 -
2. Facts and circumstances inequitable. 

Prohibiting use of accelerated methods of depreciation 

for real estate is insufficient by itself to prevent 

unrealistic depreciation deductions that distort income and 

produce artificial losses. In fact, depreciation on real 

estate tax shelters currently being sold to high-income 

taxpayers is frequently computed under the straight-line 

method to avoid the unfavorable impact of the excess of 

accelerated over straight-line depreciation under the minimum 

and maximum taxes and the recapture rules. These taxpayers 

are able to obtain the benefits of unrealistically large depreciation deductions without resorting to the accelerated 

methods by playing the "audit lottery" and by using the 

component method of depreciation. 

The audit lottery: Internal Revenue Service audits 

indicate that, in the absence of objective guidelines, many 

high-income taxpayers are taking aggressive "tax return 

positions" in claiming useful lives far shorter, and salvage 

values much lower, than are justified by the facts and 

circumstances. 

These taxpayers have little to lose by claiming short 

useful lives and low salvage values. In the event the 

taxpayer's return is not selected for audit, the excessive 

depreciation deductions produce artificial losses that reduce 

the taxpayer's tax liability. The odds are that the 

taxpayer's return will not be audited. 

On the other hand, if the taxpayer's return is audited 

and his estimated life challenged, the taxpayer merely 

regards the estimated useful life on the return as a "first 

offer" to the Internal Revenue Service. (The Internal 

Revenue Serivce rarely asserts penalties in these cases, 

since the taxpayer will be able to argue that the tax return 

position is justifiable under the facts and circumstances.) 

In the absence of objective guidelines, these disputes become 

negotiations between the taxpayer and the Service to arrive 

at a useful life that will be mutually acceptable. Because 

the government cannot afford to allocate significant 

resources to litigate these basically factual issues, which 

would have little or no value as precedents, disputes over 

the useful lives of buildings are almost always settled 

administratively. 

Thus, instead of similarly situated taxpayers being 

treated equally, the facts and circumstances test ensures 

that aggressive taxpayers--not necessarily those who 

experience the most rapid depreciation of their 

buildings--will take the largest depreciation deductions. 

Component depreciation: The use of the component method 

to depreciate buildings has become increasingly popular in 

- 90 -
recent years--particularly in tax shelter real estate deals. 

This recent popularity may be explained in part by the fact 

that, in actual practice, component depreciation results in 

the acceleration of deductions into the early years of a 

building's life that are far greater than are justified by 

the facts and circumstances. One of the principal ·reasons 

for this unwarranted acceleration of deductions is that the 

abuses of the facts and circumstances test are compounded 

under the component method. 

Taxpayers divide a building into its component parts and 

then assign useful lives to those parts that are unreasonably 

short. For example, the longest lived component of a 

building is its structure or "shell." Taxpayers using the 

component method frequently assign a life to a building shell 

equa l to the life the Treasury previously sugge sted for that 

type of building in Revenue Procedure 62-21 (~, 45 years 

for office buildings). However, the previously suggested 

lives were composite lives; that is, they were averages of 

all building components of which the shell was only one. The 

shell life was 67 years. It is clearly inappropriate to use 

the shorter composite building lives for shells. Since the 

shell of a building ordinarily accounts for approximately 

one-half of a building's cost, an underestimation of its 

useful life greatly accelerates depreciation deductions for a 

building. 

In addition to assigning the lowest possible lives to a 

building's components, to further accelerate depreciation 

deductions taxpayers allocate disproportionately large 

portions of a building's cost to the shorter-lived 

components. For example, it is common practice for an owner 

of a new building to assign the entire cost of the plumbing 

contract to a separate component called "plumbing", and then 

to assign a short life to that account on the ground that the 

fixtures will be replaced after a few years. However, a 

large part of the cost of installing plumbing in a building 

is associated with the permanent piping within the building. 

This piping ordinarily will have a useful life equal to that 

of the structure itself. 

A sample of a few of the many cases which have come to 

the attention of the Internal Revenue Service shows that 

taxpayers are using component depreciation to claim 

unrealistically large deductions on the basis of 

unjustifiably short building lives. (See Table II o-2.) 

- 91 -
TABLE II D-2 

Examples of Abuse of the Component Method 

(In Years) 

Type of Approximate Normal Life 

Building . . Cost Estimated by 

IRS Engineer 

. . 

Apartment $1,200,000 40 

Apartment 1,000,000 40 

Apartment 1,000,000 40 

Apartment 981,000 40 

Apartment 1,300,000 40 

Apartment 800,000 40 

Apartment 1,000,000 40 

Office 635,000 45 

Office 375,000 45 

Industrial 130,000 45 

Industrial 65,000 45 

Industrial 31,000 45 

Industrial 31,000 45 

20 Motels 35,000,000 35 - 40 

Shopping 

Center 1,850,000 40 

Shopping 

Center 

1st Phase 1,900,000 35 - 40 

2nd Phase 6,000,000 35 - 40 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Composite Life 

Claimed by 

Taxpayer under 

Component Method 

10 

15 

15 

15 

15 

20 

18 

17 

17 

16 

13 

16 

20 

24 - 27 

20 

19 

16 

January 24, 1978 
These abuses of the component method cannot be handled 

effectively by audit enforcement procedures. In an audit 

involving the depreciation claimed for a large building, the 

sheer complexity of examining a very large number of 

components, frequently in excess of 100, makes it virtually 

impossible for the agent to thoroughly examine the accounts 

in the limited time available. A related problem is that 

many large buildings are owned by partnerships. A single 

taxpayer may be a member of several partnerships; 

consequently, examination of one return necessitates 

consideration of complex depreciation schedules for many 

large buildings. 

Real estate shelters. 

The excess of tax depreciation over true economic 

depreciation in the early years of a building's life produces 

deductions that both offset income earned from the property 

during these years and shelter other income of the taxpayer. 

Real estate tax shelters have been labelled and are sold 

as a lucrative means for high-income taxpayers to shelter 

their income from other sources. The Tax Reform Act of 1976, 

which cut back somewhat on real estate tax shelters, also 

encouraged their growth by leaving them relatively untouched 

in comparison with other tax shelters. 

The increased popularity of real estate shelters was 

noted in a recent article entitled "Outwitting Uncle Sam: 

Despite 'Reform', Tax Shelters Continue to Thrive": 

•owing to restrictions imposed by the 1976 act on 

other programs, real estate has become more popular than 

ever as a haven. It is the only major shelter using 

non-liability financing for tax deductions which has 

been allowed to continue the practice and to utilize 

partnerships to receive the benefits. Accordingly, 

money has been pouring into real estate shelters, 

especially in the Sunbelt where industrial growth is 

strong." ~/ 

General Explanation 

Under the proposal, taxpayers will be able to elect one 

of two ways to depreciate buildings. Under the first option, 

taxpayers will depreciate their buildings based on zero 

salvage value and the average useful lives now claimed by 

taxpayers as determined by the Treasury study requested by 

Congress in 1971. These lives are listed in Appendix A. 

Taxpayers who make this election will be required to use the 

straight-line method of depreciation. It is anticipated that 

most taxpayers will elect this option. 

- 93 -
The second option is one which maintains the integrity 

of the guideline system while affording a meaningful 

alternative for taxpayers whose buildings rapidly decline in 

value. Under this option, a taxpayer will be permitted in 

any year to depreciate a building to its current salvage 

value, based on a facts and circumstances test. The 

determination of current salvage value, below which a 

taxpayer may not depreciate a building, will be made annually 

and will be the building's fair market value. The taxpayer 

will have the burden of establishing the fair market value of 

the building. 

More advantageous methods of depreciation will be 

provided for low-income and new multi-family housing. After 

1982, the advantage for new multi-family housing and used 

low-income housing will be eliminated and that for new 

low-income housing reduced. 

The proposal will provide simplicity and certainty to 

taxpayers and will substantially relieve the aclministrative 

burden imposed upon both taxpayers and the government under 

the facts and circumstances test. Under the guideline life 

option, taxpayers will receive uniform deductions and will 

know in advance of investing in real estate the depreciation 

allowances that will be permitted. Under the facts and 

circumstances option, the relevant facts, namely the 

property's current fair market value, will be ascertainable 

without resort to su.bjective judgments as to uncertain future 

events. 

Analysis of Impact 

The proposed changes in tax depreciation rules for 

buildings will help correct abuses of the tax system with 

little impact on the underlying process of capital formation 

in real estate. The proposal particularly impacts on 

high-income passive investors in real estate syndications. A 

reduction in the volume of this kind of financing will have 

little effect on real estate capital formation because real 

estate syndicate promotions are largely predicated on the 

marketing of tax losses. They often attract investors 

unqualified to judge the long-term economics of real estate 

projects and consequently finance projects which, even 

including the tax benefits, fail to yield a normal rate of 

return. These investments are socially wasteful and 

adversely affect the long-run health of real estate markets. 

Because the real estate industry is highly competitive, 

in the long-run the proposal may be expected to result in 

higher market rentals. However, the increase in market 

rentals required to maintain after-tax returns on real estate 

investments will be quite small. On the basis of recent data 

on operating costs, mortgage financing terms, site-building 

cost ratios, and taking into account the proposed change s in 

- 94 -
both the tax rates and the real estate depreciation rules, it 

is estimated that increases in market rentals will be only 

1.2 percent for shopping centers and 0.7 percent for office 

buildings. For housing (other than low-income housing), the 

increase in required rentals will be 1.4 percent during the 

period through 1982 when declining balance depreciation at 

150 percent of the straight-line rate is permitted, and an 

additional 1 percent thereafter. 

Moreover, recent studies have concluded that current 

depreciation practices for real estate may even induce a 

shortening of the economic lives of buildings. Based on the 

1970 study conducted for the Treasury, Taubman and Rasche 

found that a shift from the accelerated to the straight-line 

method would lower the supply of office space by only a very 

small amount, in part because the economic lives of buildings 

would be lengthened by a few years. They estimated that the 

use of accelerated rather than straight-line depreciation 

diverted more resources to the office building market, but 

less than one-sixth of these resources were made available to 

renters in additional space. "Even if it were true that 

subsidies were justified, it is impossible to justify a type 

of subsidy that causes so much pure waste," they concluded. 

9/ The same general effect occurs with respect to apartment 

buildings. 

Revenues lost through real estate shelters (from 

accelerated rather than straight-line depreciation, expensing 

rather than capital izing construction period interest and 

taxes and failure to recapture excess depreciation) are 

remarkably ineffic i ent tax expenditures. The recent study of 

real estate tax shelters by the Congressional Budget Office 

finds that only about 40 to 60 percent of the revenue lost by the government--estimated at $1.3 billion annually--goes to 

the builder/developer and thus to help reduce rental costs. 

The balance of the revenue loss does not produce compensatory 

increases in the flow of financial capital. Part of this 

inefficiency is attributable to the fact that investors 

frequently are in higher tax brackets than the pricing of the 

shelter reflects. Consequently, the highest bracket 

taxpayers receive windfalls. The remainder of the tax 

expenditure is absorbed by the costs of organizing syndicates 

and marketing the shares. 

In addition to being inefficient, almost all of the 

current tax expenditure supports investm~nt in buildings 

other than low- and moderate-income housing, such as office 

buildings, shopping centers and luxury apartments. The CBO 

Shelter Study estimated that only 11 percent of the 

government's $1.3 billion annual expenditure on real estate 

tax shelters assists low- and moderate-income rental housing 

construction. Approximately 35 percent subsidizes office 

buildings, shopping cente rs and other commercial buildings 

and the remainder (54 percent) subsidizes middle- and 

upper-income rental housing. 

- 9 5 -
It is essential that, given the inefficiency of tax 

shelters, tax and nontax subsidies for housing be reviewed 

and coordinated. It is equally important, however, that 

there be no major changes in this segment of the industry 

while the review is completed. Consequently, accelerated 

depreciation deductions will be continued generally through 

1982 for specific housing areas. 

Effective Date 

The proposal is generally effective for buildings 

acquired after December 31, 1978. 

In the case of used low-income and new multi-family 

housing, the limitation to the straight-line method of 

depreciation will be effective for buildings acquired after 

December 31, 1982. The limitation to the 150 percent 

declining balance method of depreciation for new low-income 

housing will also be effective for buildings acquired after 

December 31, 1982. 

In the case of construction begun prior to the relevant 

date (January 1, 1979 or January 1, 1983), the new rules will 

not apply if original use of the building begins with the 

taxpayer. 

Revenue Estimate 

1978 1979 

101 

Change In Tax Liability 

($ millions) 

Calendar Years 

1980 1981 

299 490 

Technical Explanation 

1982 1983 

672 849 

Taxpayers will be permitted to depreciate buildings on 

the basis of zero salvage values and the average lives now in 

use as determined by the Treasury study requested by Congress 

in 1971. Appendix A lists these lives by classes of 

buildings and also lists the lives of building components. 

Taxpayers who make this election will be required to use 

the straight-line method of depreciation for their buildings, 

including buildings depreciated under the ADR system of 

depreciation. Although taxpayers will be able to use lives 

- 96 -
longer than the guideline lives, except under the facts and 

ci(cumstances option described below, there will be no 

allowance of lives shorter than the guideline lives. For the 

few buildings for which ADR classes are established, the ADR 

life will be used. 

As an a lternative to using the average useful lives and 

straight-line method, a taxpayer will be able to elect on his 

tax return to use a facts and circumstances test that will 

permit a depreciation deduction in any year sufficient to 

decrease the basis of the building to its fair market value 

as of the end of the year. 

By limiting depreciation to the current fair market 

value of the property, taxpayers and the Internal Revenue 

Service will not have to speculate as to the effects of 

future events on the value of the property. The 

determination instead will be made under the facts and 

circumstances which exist at the time the deduction is 

claimed. 

Once the facts and circumstances test is elected for a 

structure a taxpayer has constructed or acquired, the 

t axpayer will not be permitted to change to the guideline 

system. 

The facts and circumstances option may be illustrated by 

the following example. Assume a calendar year taxpayer 

purchases a building for $500,000 on January 1, 1981; the 

taxpayer will be allowed a depreciation deduction for 1981 of 

$25,000 as long as the taxpayer can establish that the fair 

market value of the building on December 31, 1981, is not 

greater than $475,000. If the fair market value of the 

building remains at $500,000 during 1981 no depreciation 

deduction will be allowed. The fair market value will be 

determined by reference to objective standards, including the 

current sales price of comparable structures and the amount 

of rental income the building produces. 

The component method of depreciation will not be 

permitted for new or used buildings. Prescribed guideline 

lives will be required for components placed in service after 

the original construction or acquisition of a building by a 

taxpayer. The useful lives in Appendix A are based on 

average s of lives used by taxpayers using the component 

method as well as by taxpayers using composite building 

lives. Consequently, the shorter building lives that are 

produced by the component method already have been taken into 

account. 

Used buildings. 

The guidelines shown in Appendix A are based on taxpayer 

estimates of useful lives for new buildings. Detailed 

- 97 -
examination of the Treasury Department data shows that 

taxpayers who purchase buildings that are less than 6 years 

old assign them useful lives which are roughly the same as 

those assigned to new buildings. The useful lives assigned 

by taxpayers decline gradually for older buildings, but 

stabilize at approximately 75 percent of the period assigned 

to new buildings. 

Therefore, based on the Treasury survey, the depreciation period for used buildings not older than 5 years will 

be the same as that for new buildings of the same class. The 

depreciation period for buildings older than 5 years but 

younger than 22 years will be the guideline life for new 

buildings of the same class less 1.5 percent of that 

guideline life for each year of the building's age in excess 

of 5 years. For buildings 22 years or older at the time of 

acquisition, the depreciation period will be 75 percent of 

the life for new buildings in that class. Useful lives 

computed under these rules will be rounded to the nearest 

half year. For example, if a taxpayer acquires a 20 year old 

building that had an original guideline life of 35 years, 

under the guideline life option the building will have a 

useful life of 27 years. 

Subsidized housing 

Low-income and new multi-family rental housing will not 

be limited to straight-line depreciation for buildings 

acquired before January 1, 1983. Until 1983, new low-income 

housing will be allowed a depreciation deduction based on the 

200 percent declining balance or sum of the years-digits 

method and new multi-family rental housing will be allowed a 

depreciation deduction based on the 150 percent declining 

balance method. Used low-income housing will continue to be 

depreciated on the 125 percent declining balance method. 

After 1982, multi-family and used low-income housing 

will be limited to the straight-line method, and new 

low-income housing will be allowed a depreciation deduction 

based on the 150 percent declining balance method. 

For purposes of these rules, low-income housing will be 

defined as it was most recently by the Congress in applying 

the special recapture rules (section 1250 of the Code). 

Rental housing will be defined by reference to section 

167(j) (2) (B) of the Code; multi-family dwellings will be 

multiple dwelling housing with more that four apartments. 

Taxpayers who own subsidized housing and elect to use 

the facts and circumstances test will not be permitted a 

depreciation deduction in any year which will decrease the 

basis of the property below its current fair market value. 

- 98 -
Footnotes 

1/ For example, if upon purchase of a building for $10 

million a taxpayer estimates that he will use the building 

for 30 years, estimates salvage value at the end of that 

period to be $4 million and uses the straight-line method of 

depreciation, the taxpayer will take depreciation deductions 

of $200,000 each year ($6 million divided by 30). Salvage 

value limits the depreciation deduction either by reducing 

the amount subject to depreciation, under the straight-line 

method, or by setting a floor below which no depreciation 

deductions may be taken, under a declining balance method. 

~/ Under the 200 percent declining balance method, for 

example, a taxpayer is permitted a depreciation deduction up 

to twice the straight-line rate applied to the unrecovered 

cost (i.e., cost less accumulated depreciation for prior 

taxable years) • 

ll Congressional Research Service, "Study of Legislative 

History of the Rapid Depreciation Provision," in 

Congressional Record, March 1, 1974, at 4948; Congressional 

Budget Office, Real Estate Tax Shelter Subsidies and Direct 

Subsidy Alternat1ves (GPO, Washington, May 1977), at 22-23 

(hereafter "CBO Shelter Study"). 

!/ This study was conducted for the Treasury by Paul Taubman 

and Robert Rasche. See, ~, Taubman and Rasche, 

"Subsidies, Tax Law, and Real Estate Investment," 5 

Economics of the Federal Subsidy Programs 343 (1972), Joint 

Economic Committee. 

~/ This study was conducted for the Treasury in 1974-1976 by 

Charles R. Hulten and Frank C. Wykoff. 

~/ The assumptions concerning the terms of the financing and 

the income from the building are derived from the American 

Council of Life Insurance, Investment Bulletin, No. 766, 

August 26, 1977. 

7/ Letter Report to the Joint Committee on Taxation from the 

Comptroller General, U.S. General A.ccounting Off ice, "Tax 

Issues Generating a Significant Level of Controversy" (Report 

No. GG7-78; June 15, 1977). 

~/ Barron's, September 19, 1977, p. 20. 

~/ Taubman and Rasche, supra, at 360. 

- 99 -
APPENDIX A 

PROPOSED BUILDING GUIDELINE CLASSES 

AND DEPRECIATION PERIODS 

Buildings 

Two groups of classes are provided for buildings. The 

first group includes complete buildings. The appropriate 

class for a given building is determined by the predominant 

use of the building. However, certain types of buildings 

which are explicitly covered by other asset guideline classes 

(such as farm buildings, service stations, railroad station 

and office buildings, and telephone central office buildings) 

are not included in these classes. For these buildings, 

their ADR class lives will be used. 

The second group of classes includes replacement 

building components. The appropriate class for a given 

component is determined by the type of component, without 

regard to the type of building of which it is a part. 

Buildings--Complete 

These classes include structural shells of buildings and 

all original components thereof, such as machinery and 

equipment that serves heating, plumbing, air conditioning, 

illumination, fire prevention and power requirements; 

machinery and equipment for the movement of passengers and 

freight within buildings; interior partitions, both fixed and 

movable; floor and wall coverings, doors, windows, ceilings and other items of interior finish; and associated land 

improvements. (Land improvements which constitute the 

principal asset of a taxpayer in a given location, to which 

buildings are incidental, such as golf courses and race 

tracks, are not included.) These classes also include 

structural shells and all original components of building 

additions which expand the floor space of the existing 

buildings to which they pertain. 

Office buildings (including bank buildings) 

Office buildings--three or fewer 

floors above ground . . . . • • . • . • • 30 

Office buildings--more than three 

floors above ground •••..• 

- 100 -

. . . . . . . 40 
Industrial buildings 

Factories 

Includes all buildings directly related to 

manufacturing processes on contiguous parcels 

of land . . . . . . . . . . . . . . . . . . 35 

Repair garages and shops 

Includes all buildings housing equipment 

for repair of industrial machinery or 

vehicles (except those directly related to 

manufacturing processes, which are included 

in the factory building classification) • 

Includes new car dealership buildings •••••• 30 

Storage buildings 

Warehouses 

Includes all buildings used for storage 

of consumer goods, machinery, raw materials, 

foodstuffs (except grain elevators), or 

finished manufactured goods • • • • • • • • 35 

Grain elevators . . . . 40 

Retail buildings 

Includes buildings in which goods, 

including prepared food, are sold to the public. 

Retail buildings--less than 50,000 square 

feet of indoor floor space on contiguous 

parcels of land • • • • . • • • • • • • • • • 30 

Retail buildings--50,000 or more square 

feet of indoor floor space on contiguous 

parcels of land . • • • • . • • . • • • • 35 

Service buildings 

Theater buildings. . . . . . . . 

Recreational services buildings 

(except stadia and arenas) ••. 

Medical services buildings 

Includes nursing homes, hospitals, 

clinics, and physicians' and dentists' 

35 

30 

office buildings •••••...••.•••• 35 

- 101 -
Common carrier passenger terminals 

(except railroad stations) . • • 

Other service buildings 

Includes buildings in which other services 

are provided for the public, such as barber 

shop buildings, appliance repair buildings, 

laundry and dry cleaning buildings (except 

central laundry and dry cleaning plants, which 

are included in the factory classification), 

25 

and photographic studios • • • • • • • • • • 30 

Residential buildings 

Single-family and two-family dwellings. • • 30 

Apartment buildings--three or fewer floors 

above ground • • • • • • • • • • • • • • . • 30 

Apartment buildings--more than three 

floors above ground • • • • • • • • • • • 35 

Hotels and motels--three or fewer floors 

above ground . . . . . . . . . . . . 

Hotels and motels--more than three floors 

above ground . . . . . . . . . . . . . . . 

Buildings--replacement components 

Includes all capitalized expenditures for 

building components for existing buildings 

30 

. 35 

(except roof coverings) . . • . • • . • • . 20 

Roof covering 

Includes felt and asphalt, corrugated 

metal, plastic, shingle, or other types of 

weather-proofing membranes • • • • • • • • 15 

- 102 -
IID-4 

MINIMUM TAX FOR INDIVIDUALS 

Present Law 

To ensure that individuals 1/ with large amounts of 

economic income do not take excessive advantage of special 

deductions or exclusions under the Code, a min i mum tax of 15 

percent is imposed on the amount of items of tax preference 

in excess of the greater of $10,000 or one-half of a 

taxpayer's regular tax liability. The items of tax 

preference subject to the minimum tax include: 

1. Spec i al provisions which accelerate deductions for 

depreciation including the excess of accelerated over 

straight l i ne depreciation on real property. 

2. The amount by which the deduction for percentage 

depletion exceeds the basis of the property. 

3. Itemized deductions (other than medical and casualty 

deductions) i n excess of 60 percent of adjusted gross income. 

4. The excluded one-half of capital gains. 

Reasons for Change 

The minimum tax, which was introduced into the Code by 

the Tax Reform Act of 1969, initially reduced the number of 

nontaxable high income persons (returns with $200,000 or more 

of adjusted gross income (AGI)) from 300 or 1.62 percent of 

all returns in their income class in 1969, to 111 or 0.73 

percent of all returns in their income class in 1970. 

However, in later years, the trend was reversed. The number 

of nontaxable returns increased from a low in 1971 of 82 or 

0.45 percent of all returns in the income class to highs of 

244 and 230 (0.78 and 0.67 percent) in 1974 and 1975 (see 

Table IID-3}. Congress reacted to this development by 

strengthening the minimum tax provisions in the Tax Reform 

Act of 1976. The number of nontaxable high income returns is 

expected to be substantially reduced as a result of the 1976 

Act. (Data for 1976, the first year the 1976 Act applies, 

will be available April 1978.) 

- 103 -
Table IID-3 

Number and Percentage of Nontaxable Income Tax Returns 

with Adjusted Gross Incomes of $200,000 or over 

Year 

1966 

1967 

1968 

1969 

1970 

1971 

1972 

1973 

1974 

1975 

Number of 

Returns 

154 

167 

222 

300 

111 

82 

108 

164 

244 

230 

Off1ce of the Secretary of the Treasury 

Office of Tax Analysis 

Source: Statistics of Income 

Percent of All 

:Returns with AGI of 

$200,000 or over 

1. 26% 

1. 07 

1.15 

1. 62 

0.73 

0.45 

0.47 

0.64 

0.78 

0.67 

January 11, 1978 
However, the problem of untaxed preference income is not 

limited to nontaxable returns. For example, in 1974 for each 

nontaxable return with AGI of $200,000 or more, there were 

more than four returns with equally high incomes and 

effective tax rates of less than 10 percent. 2/ The minimum 

tax under current law does not affect those taxpayers who 

make excessive use of preferences but who have a large 

regular tax liability. The current offset against 

preferences equal to one-half of regular tax paid allows 

persons who pay a regular income tax to avoid any tax on 

preferences. It thus undermines an important purpose of the 

minimum tax--the imposition of a fair share of the tax burden 

on taxpayers receiving large benefits from certain tax 

preferences. Clearly, two individual taxpayers with 

preferences of $100,000 each will have very different minimum 

tax liabilities under present law if one has a regular tax 

liability of $200,000 and the other has none. To impose the 

same burden on both of these taxpayers, the offset to the 

minimum tax base for one-half of the regular tax liability 

must be repealed. 

The offset for regular tax liability also distorts the 

impact of the minimum tax on those taxpayers using this 

offset instead of the $10,000 exclusion. In effect, 

preferential deductions, such as excess itemized deductions, 

are subjected to a higher rate of tax than preferential 

exclusions, such as the exempt portion of capital gains. II 

There is no indication that this result was intended by 

Congress. 

Thus, the proposal deletes the offset for one-half of an 

individual taxpayer's regular tax liability. No changes will 

be made in the basic description of preference items, 

although some (accelerated depreciation on real estate) would 

be affected by reason of other proposals. 

In one respect, however, the minimum tax would be 

liberalized for individual taxpayers. Application of the 

minimum tax to the sale of a principal residence could create 

an undue hardship inconsistent with the purposes of the 

minimum tax. At present, the Code allows a taxpayer to avoid 

completely any current tax on gain from the sale of a 

principal residence when be buys another principal residence 

of at least equal value within a prescribed period of time. 

If a taxpayer is unable to take advantage of that provision, 

the regular tax on the gain should not be augmented by the 

minimum tax. Thus, capital gains from the sale of a 

principal residence will be excluded from the minimum tax 

base. 

General Explanation 

The basic structure of the minimum tax will be retained, 

- 105 -
but the offset for one-half of regular tax liability would be 

repealed in the case of individuals. 

In the case of the sale of a principal residence, all 

recognized capital gain will be excluded as an item of tax 

preference. However, a taxpayer will not be able to use this 

exception to avoid the minimum tax on the sale of a 

substantial amount of land surrounding a principal residence. 

Thus, for example, upon the sale of a ranch, including the 

seller's principal residence, only a reasonable portion of 

the land adjacent to the residence will be covered by the 

principal residence exclusion. 

Analysis of Impact 

Eliminating the half-tax offset for individual taxpayers 

will raise taxes by $228 million on a total of 91 thousand 

taxpayers, virtually all of whom will have expanded incomes 

(adjusted gross income plus tax preferences and less 

investment interest to the extent of investment income) of 

over $50,000 (see Table IID-4). 

- 106 -
Table IID-4 

Effect of Eliminating the Half-Tax Offset for Individuals 

Expanded Income 

Class 

$ 50,000 to $100,000 

$100,000 to $200,000 

$200,000 and over 

Number of Returns 

With Increased 

Minimum Tax 

(Thousands) 

15 

47 

29 

91 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Effective Date 

Amount of 

Increased 

: Minimum Tax 

: ($ in Millions) 

$ 4 

47 

177 

$ 228 

December 22, 1977 

The changes in the rn1n1mum tax would be effective for 

taxable years beginning after December 31, 1978. 

Revenue Estimate 

1978 1979 

284 

Change In Tax Liability ($ millions) 

Calendar Years 

1980 1981 

306 329 

Footnotes 

1982 1983 

353 380 

.!/ The m1.n1murn tax with some modifications also applies to 

corporations; the tax as it applies to corporations will not 

be changed under this proposal. 

- 107 -
2/ Office of Tax Analysis, Department of the Treasury, High Tncome Tax Returns: 1974 and 1975, March 1977. 

ll If an individual taxpayer already subject to the minimum 

tax on itemized deductions incurs additional expenses which 

are itemized deductions, the amount of the taxpayer's 

preference items will increase by the amount of the expenses. 

At the same time, the taxpayer's tax liability will decrease. 

Therefore, the amount to which the minimum tax rate is 

applied will increase by more than the amount of the 

additional deduction, since, for taxpayers not using the 

$10,000 exclusion, the minimum tax is imposed on the 

difference between total preferences and one-half of total 

regular tax liability. On the other hand, a larger capital 

gain will increase the taxpayer's regular tax liability, and 

thus the amount subject to the preference tax will increase 

by less than the additional preference from the capital gain 

transaction. 

- 108 -
IID-5 

AT RISK 

Present Law 

A significant attack on tax shelters was made by the Tax 

Reform Act of 1976 through enactment of the "at risk" rules. 

Generally, the at risk rules have been effective. However, 

there are some weaknesses in the rules, and promoters have 

designed tax shelters to exploit these weaknesses. 

A taxpayer is allowed to deduct the purchase price of an 

asset over the life of the asset . The higher the purchase 

price, the larger the deductions. Ordinarily, arm's length 

negotiations between a buyer and a seller assure that 

purchase price equals fair market value. A buyer does not 

want to pay more than the property is worth; a dollar of tax 

deduction does not offset a dollar of economic loss. Abusive 

tax shelters, however, are able to create highly inflated 

purchase prices, and thus highly inflated tax deductions, 

through the use of nonrecourse debt, i . e., debt that entails 

no personal liability on the part of the borrower. 

Nonrecourse debt allows investors to claim inflated 

deductions without risking their own ca?ital . The seller is 

not risking any funds in making the loan since the loan is 

part of the purchase price that is paid to him. Also, the 

seller does not incur additional tax liability on account of 

the inflated purchase price because under acceptable methods 

of tax accounting the seller can report his gain pro rata as 

cash is received. 

For example, in a typical shelter of this type, an 

individual taxpayer would purchase the distribution rights to 

a book for $100,000. The rights might be worth considerably 

less. The individual would pay $20,000 out of his own 

capital and borrow the remaining $80,000 from the seller on a 

nonrecourse basis. The seller would report his gain only as 

cash was rece ived. The nonrecourse loan would be pay?ble to 

the seller solely out of the receipts from the distribution 

of the book. The investor would deduct the full $100,000 

purchase price even though he had invested only $20,000. For 

a taxpayer in the 60 percent bracket, these deductions would 

have an after-tax value of $60,000, or three times his actual 

cash investment. The taxpayer could thus obtain a 

substantial return on his investment without regard to any 

expected economic profit from the activity . 

Even if income were neve r realized from distribution of 

the book, the taxpayer would not suffer the full economic 

- 109 -
loss represented by his tax deductions. The loan would be 

"repaid" by reconveying the book rights to the seller-lender. 

Assuming that the rights were fully depreciated, this 

"repayment" of the loan would produce taxable income for the 

investor equal to the outstanding balance of the loan. In 

such circumstances, many investors fail to report what they 

call "phantom" income. On audit, it may be difficult for the 

Internal Revenue Service to detect this income because the 

taxpayer does not receive any cash in the year the income 

arises. Even if the investor pays the taxes he owes, he 

still obtains the benefits of deferral from the time he 

claims the deduction to the time he reports the income. 

Furthermore, he can attempt to increase the period of 

deferral by extending the term of the loan. Frequently, a 

delayed repayment date has no business purpose and is 

designed solely to provide the investor with the benefits of 

deferral, or the opportunity to evade reporting the income 

entirely. 

The new at risk rules effectively identify tax shelters 

that are based on inflated purchase prices, and prevent 

investors in those shelters from deducting tax losses that 

they can never bear economically.!/ The at risk rules limit 

deduction of tax losses to the amount of a taxpayer's 

economic investment in an activity. Any tax losses in excess 

of the amount of such investment cannot be deducted until the 

taxpayer's economic investment in the activity increases. 

For example, in the tax shelter described above the investor 

would be able to deduct only $20,000, which is the amount of 

his own capital at risk. 

Under present law, the at risk rules apply to 

investments in all activities except real estate. However, 

the at risk rules generally do not apply if a taxpayer 

invests in an activity directly (and not though a 

partnership). The at risk rules apply to direct investments 

only if they are made in movies, farming, leasing of property 

other than real estate, or oil and gas. 

For the most part, the at risk rules do not apply to 

corporations. However, they do apply to personal holding 

companies and to Subchapter S corporations. In addition, 

they apply to a corporation which invests in an activity 

{other than movies, farming, leasing of property other than 

real estate, or oil and gas) through a partnership. 

There are several theories on which the Internal Revenue 

Service can attack tax shelter transactions that are not 

subject to the at risk rules. The success of the attack, 

however, depends on establishing elusive facts, such as the 

fair market value of unique property. Because of this, 

attacking these shelters under present law through an 

expanded audit program is difficult, expensive, and 

relatively unproductive. 11 

- 110 -
Reasons for Change 

The at risk rules can be an effective means for dealing 

with certain tax shelter abuses that cannot be adequately 

dealt with on a case by case basis. They do not interfere 

with legitimate business transactions because they do not 

prevent a taxpayer from deducting losses that could possibly 

reduce his real wealth. There are , however, three weaknesses 

in the present at risk rules. 

First, although they apply to all activities except real 

estate, the at risk rules do not apply to direct investments 

in most activities. Tax shelter promoters have exploited 

this weakness extensively and developed a wide range of 

investments suitable for d i r ect ownership. For e xample, the 

following investments were widely advertised for direct sale 

to individual owners at the end of 1977: master phonograph 

records, lithographic plates, books, 3/ Christmas tree s, 

coal mi ning, gold mi ning , and research and deve lopment . 

These investments were generally pr iced within the reach of 

upper middl e class taxpayers . For ex~mpl , a gold mine was 

sold by the square foot. 

Second, the at risk rules generally do not apply to 

corporations. One leading member of the tax bar has 

commented on this a s follows: 

"It is d i fficult to find any logical reason for 

this favored treatment of corporations. It probably 

arises from the percept ion (clearly erroneous) that it 

is individuals who reap the maximum benefit from tax 

shelters, and from the view (equally erroneous) that tax 

shelter syndicates do not generally include corporate 

limited partners .•.. If the Act is successful in 

closing the tax shelter syndication market to many 

individuals, the purveyors of tax shelters eventually 

will saturate the corporate market. 

Tax shelter investments are as available to 

corporations a s ever. To the extent individuals have 

been effectively legislated out of this market, the 

corporate investors should have less competition and 

ther e for e better terms. Of course, many corporations 

seeking tax shelter investments may be (and are) 

privately and very closely held. Indeed, tax shelter 

holds much attraction for those with section 531 

problems; accumulated earnings are available to buy 

shelter. Publicly owned corporations, with the 

exception of financial institutions and insurance 

companies which represent the principal market for 

equipment leasing tax shelters, generally have not 

indulged in pure tax shelter transactions." !/ 

- 111 -
Under present law, the at risk rules do apply to 

personal holding companies. Personal holding companies are 

more likely than most other corporations to invest in tax 

shelters because they are closely held. Five or fewer 

shareholders must own more than 50 percent of the stock of a 

personal holding company. A closely held corportion may be 

able to pass the benefits of a tax shelter through to its 

shareholders, if the shareholders are also employees. 5/ 

Thus, an investment made by a closely held corporation Tn a 

tax shelter may be equivalent to an investment made directly 

by the shareholders. Even if the controlling shareholders 

are not all employees, tax shelters may be used to defeat 

the accumulated earnings tax. ~/ 

On the other hand, these opportunities are generally not 

available to widely held corporations. Few employees of a 

widely held corporation are able to control the timing and 

amount of their compensation, and no shareholder is likely to 

be able to control the corporation's investment policy. In 

addition, few widely held corporations are subject to the 

accumulated earnings tax. Further, a widely held corporation 

is unlikely to enter into a transaction that has no economic 

substance because such a transaction may be challenged either 

by shareholders or the Internal Revenue Service. A widely 

held corporation generally is subject to frequent audits by 

the Internal Revenue Service and to the public disclosure 

requirements of the Securities and Exchange Commission. 

It has been common for widely held corporations to 

invest in only one kind of tax shelter--equipment leasing. 

However, equipment leasing by corporations has the desirable 

effect of making the tax incentives to new investment more 

efficient. Typically, the lessee does not have enough income 

to make full use of these tax incentives (chiefly the 

investment credit and accelerated depreciation). On the 

other hand, the lessor (typicaly a bank) does have enough 

income. The equipment lease allows the lessor to realize the 

benefit of the tax incentives, and to pass at least part of 

the benefit along in a form that the lessee can use--lower 

rents. Because the same corporate tax rate applies to both 

the lessee and the lessor, the tax benefit is no greater than 

Congress intended it to be. However, if the lessor is a 

closely held corporation, there can be an abuse. As , previously explained, an investment made by a closely held 

corporation in a tax shelter may be equivalent to an 

investment made directly by the shareholders. Where this is 

so, and where the shareholders are in tax brackets above the 

maximum corporate rate, the tax benefits will exceed those 

which Congress intended to provide. Thus, equipment leasing 

by a closely held corporation may lead to tax abuse, even 

though equipment leasing by a widely held corporation is 

generally a desirable activity. 

- 112 -
Although widely he ld corporations have made limited use 

of other tax shelters thus far, they may enter the market 

after other taxpayers have been excluded by these proposa ls. 

The Administration will continue to monitor tax shelter 

activity and will propose further expansion of the rules in 

this area if new abuses develop. 

The th i rd we akness in the at risk rules is that, if read 

literally, they require the taxpayer to be at risk only for 

the brief moment that the deductions are allowed. Ther e for e , 

it may be possible to defeat the at risk rules by careful 

timing. For example, in 1979 an investor puts $100,0~ 0 at 

risk and deducts $60,000. In 1981, the investor withdraws 

$90,000 of his original investment. Although the rema ining 

$10,000 could not support a deduction of $60,000, the 

investor may have succeeded in circumventing the at risk 

rules. 

General Explanation 

Under the proposal, the at risk rules will extend to all 

activities except real estate. They will apply whether an 

investment is made directly or through a partnership. In 

addition, the at risk rules will extend to all closely held 

corporations (i.e., to all corporations that have five or 

fewer controlling shareholders). Further, a special 

provision will be added to prevent taxpayers from using 

careful timing to circumvent the at risk rules. 

Nonrecourse loans have traditionally been used to 

finance the purchase of real estate. They are used for 

legitimate financial reasons and not to avoid taxes. 

Therefore, the at risk rules will not be extended to real 

estate. The Administration is, however, making other 

proposals to deal with certain real estate tax shelters. 

Effective Date 

The proposed changes will apply to transactions entered 

into after December 31, 1978. 

Revenue Estimates 

1978 : 1979 

14 

Change In Tax Liability 

($ millions) 

Calendar Years 

1980 1981 1982 

10 8 5 

Technical Explanation 

- 113 -

1983 

6 
The Internal Revenue Code now contains two different 

sets of at risk rules. The first set (section 465 of the 

Code) applies to four activities--movies, farming, leasing of 

property other than real estate, and oil and gas. It applies 

whether an investment in one of these four activities is made 

directly or through a partnership . The second set of at risk 

rules (section 704(d) of the Code) applies to all other 

activities, except real estate. However, it applies only to 

investments that are made through a partnership (and not to 

those that are made directly). The Administration proposal 

will extend the first set of rules (section 465) to all 

activities except real estate. Therefore, the second set of 

rules (section 704(d)) will become unnecessary and will be 

repealed. 

The at risk rules will also be extended to apply to all 

closely held corporations (i.e., all corporations in wh i ch 

five or fewer shareholders own more tha n 50 percent of the 

stock). Thus, the at risk rules will apply to any 

corporation that meets the stock ownership test for a 

personal holding company, regardless of the source of the 

corporation's income. On the other hand, the at risk rules 

will be restricted to Subchapter S and closely held 

corporations, and will not apply to other corporations in any circumstances. 

In addition, a new prov1s1on will be added to ensure 

that taxpayers cannot use careful timing to circumvent the at 

risk rules. This provision will require a taxpayer to 

recognize income if three conditions are met. First, the 

taxpayer has deducted losses from an activity. Second, the 

taxpayer reduces the amount that he has at risk in the 

activity during a subsequent taxable year. Third, the losses 

taken as deductions exceed the amount remaining at risk. 

(For this purpose, the amount at risk is not reduced by 

losses. ) If these three conditions are met, the taxpayer 

must recognize income to the extent that the losses taken as 

deductions exceed the amount remaining at risk. For example, 

a taxpayer buys a movie for $100,000 in cash and deducts 

losses of $60,000 in 1979. In 1981, he borrows $90,000 on a 

nonrecourse loan secured by the movie. At the end of 1981, 

the taxpayer has only $10,000 remaining at risk in the movie 

(disregarding the losses sustained in 1979) . Therefore, he 

must recognize $50,000 7/ (i.e., $60,000- $10,000) of income 

8/ in 1981. -

Footnotes 

1/ The at risk rules are also effective against tax 

shelters that transfer deductions from a low bracket taxpayer 

to a high bracket taxpayer. For instance, in the example in 

the text, the at risk rules would limit the buyer's 

- 114 -
deductions even if the purchase price of the book equalled 

fair market value. This limitation is necessary to prevent 

tax abuse if, for example, the seller is a corporation in the 

44 percent tax bracket and the buyer is an individual in the 

68 percent tax bracket. 

2/ In Rev. Rul. 77-110, 1977-1 Cum. Bull. 58, the Internal 

Revenue Service stated that the basis of a movie does not 

include the portion of the purchase price paid with a 

nonrecourse loan made by the seller and secured by the movie, 

if the fair market value of the movie does not approximate 

the amount of the loan. Aggressive tax shelter promoters 

have either disregarded the ruling or else relied upon highly 

questionable appraisals, and continued to sell this type of 

investment. 

3/ In Rev. Rul. 77-397, I.R.S. 1977-44, the Internal 

Revenue Service stated that the at risk rules do apply to the 

direct acquisition and leasing of master phonograph records. 

In News Release IR-1921 dated December 23, 1977, the Service 

announced that the principles of Rev. Rul. 77-397 apply to 

similar arrangements involving books, lithographic plates, 

musical tapes and similar property. Aggressive tax shelter 

promoters, however, have taken the position that the ruling 

is incorrect and have continued to sell these investments. 

In this area, the proposed legislation will be a helpful 

confirmation of existing law. 

4/ Martin J. Rab i nowitz, Some Reflections on the Social and 

Economic Impact of the Tax Reform Act of 1976, 31 The Tax 

Lawyer 163, 171-172 (1977). 

~I A simple example illustrates the possible advantages. 

Assume Mr. A, a taxpayer in the 60 percent marginal 

bracket, is-the sole shareholder of corporation X and 

that in year one X has $20,000 of taxable income-before 

payment of a bonus to A. 

Case 1. At the end of year one, X distributes the 

$20,000 to A as a bonus. X is allowed a $20,000 deduction 

and has no taxable income for the year. A pays $10,000 of 

tax (the maximum tax on earned income) and invests the 

remaining $10,000 in a bond that yields 10 percent before 

tax. In year two, A will earn $1,000 in interest on the bond 

and pay $600 of tax~ leaving him with $10,400 after tax. 

Case 2. ! invests in a tax shelter that produces 

$20,000 of deductions in year one and a matching $2~,000 

of income in year two. The deductions allow X to reduce its 

taxable income to zero in year one, so that it has $20,00 ~ of 

cash and no tax liability. X invests the $20,000 in a bond 

that yields 10 percent before tax. At the end of year two, X 

has $2,000 of income from the bond plus $20,000 of income - from the tax shelter. X pays the $22,000 to A at the end of 

- 115 -
year two as salary and owes no corporate tax. A will pay 

$11,999 of tax (the maximum tax on earned income) and be left 

with $11,999. 

In Case 2, A's investment yield on his $19,999 of after 

tax salary is $1~999 rather than $499 as a result of the use 

of a tax shelter at the corporate level. 

6/ If a corporation has an unreasonably large accumulation 

of earnings, it may be subject to an accumulated earnings 

tax. The tax is up to 38-1/2 percent of the corporation's 

taxable income (after certain adjustments). However, if a 

corporation invests· in tax shelters and reduces its taxable 

income, it can escape the accumulated earnings tax. Further, 

by using its earnings to invest in tax shelters the 

corporation can make it difficult for an IRS agent to detect 

accumulated earnings. The agent might find it hard to 

distinguish between investments in tax shelters and the 

corporation's regular business assets merely by examining the 

books of the corporation. 

21 The $59,999 recognized in 1981 recaptures the losses 

taken as deductions in 1979. Thus, in effect, the taxpayer 

is denied a deduction for these losses. However, the 

taxpayer will be permitted to deduct these losses if he 

increases his amount at risk in the movie in 1982 or any 

later year. 

8/ The $59,999 recognized in 1981 will have the same 

character as the losses deducted in 1979. For example, if 

the losses were capital losses, the $59,099 recognized in 

1981 will be a capital gain. 

- 116 -
IID-6 

CLASSIFICATION OF LIMITED PARTNERSHIPS 

Present Law 

The Internal Revenue Code currently provides definitions 

of the terms "partnership" and "corporation." The term 

"partnership" is defined to include most syndicates, groups, 

pools, joint ventures, and other unincorporated 

organizations. The term "corporation" is defined to include 

associations, joint-stock companies, and insurance companies. 

These definitions are, however, very general. As a result, 

in determining whether an organization is properly classified 

as a partnership or corporation for tax purposes, the 

principal source of law is the decision of the Supreme Court 

in Morrissey v. Comissioner, 296 u.s. 344 (1935). The 

existing regulations draw upon the rationale of this decision 

in describing corporate and noncorporate characteristics. 

In addition, the existing regulations provide that an 

organization formed as a partnership under local law will not 

be classified as a corporation for tax purposes unless it has 

more corporate characteristics than noncorporate ones. This 

"preponderance" test was adopted in response to the decision 

in United States v. Kintner, 216 F. 2d 418 (9th Cir. 1954), 

in an effort to keep unincorporated organizations from 

obtaining the benefits of corporate pension plans. As a 

result of this long- standing bias in the regulations, 

organizations formed as partnerships under the Uniform 

Limited Partnership Act are nearly always classified as 

partnerships for tax purposes. This bias was recently 

criticized by the Tax Court in its decision in Philip G. 

Larson, 66 T.C. 159 (1976). In that case the Court found 

that the tax shelter partnership before it more closely 

resembled a corporation on the basis of the criteria set 

forth in the Supreme Court's decision in Morrissey. The 

Court concluded, however, that the existing regulations 

compelled classification of the organization as a 

partnership. 

Under present law, partnerships are not treated as 

taxable entities. Each partner is taxed on hi s share of the 

partnership income , and each partner is allowed to deduct his 

share of any partnership losses. Consequently, partnerships 

are an effective means for jo i nt participation in tax 

shelters. On the other hand, corporations (except for 

certain electing corporati ons with a limited number of 

shareholders) are taxed as separate entities. Losses 

sustained by a corporation do not reduce the shareholders' 

i ncome. Thus, corporations are generally no t as effective a 

- 117 -
means for joint participation in tax shelters. 

Reasons for Change 

Syndicated partne rships are being used as the vehicle 

for many thousands of tax shelters. These tax shelters are 

advertised in daily newspapers throughout the country. For 

example, advertisements of a 200% "year end" real estate 

shelter, a "400% coal shelter," and a "5 to 1 cattle breeding 

shelter" all appeared in the Wall Street Journal on Thursday, 

December 22, 1977. Such flagrant exploitation of tax 

shelters has done much to destroy public confidence in the 

tax law. Moreover, many publicly marketed shelters owe their 

success to a widespread misunderstanding of the tax law . Often, participants in tax shelters do not understand that 

for each artificial deduction they take today, they must 

include an equal amount in income at some future time. Many 

participants claim the deductions but fail to report the 

income. 

In addition, a syndicated partnership is, to all intents 

and purposes, the equivalent of a corporation. The limited 

partners are not responsible for the debts of the partnership 

and have no voice in its day-to-day management. As a 

practical matter, moreover, the syndicated partnership has 

the same ability to maintain its existence as a corporation, 

and a limited partner has the same ability to transfer his 

partnership interest as he would stock in a comparably sized 

corporation. Were it not for the long-standing bias in the 

existing regulations, these partnerships would be classified 

as corporations under the criteria enunciated by the Supreme 

Court in the Morrissey decision. Because substantive 

differences between a syndicated partnership and a 

corporation are minimal, the same tax rules should apply to 

both. 

Further, the Internal Revenue Code treats a partnership 

largely as an aggregate of individuals. Many limitations, 

deductions, and credits must be calculated separately by each 

partner. The tax effect of distributions depends on each 

partner's adjusted basis in his partnership interest. 

Special allocations of partnership income and losses and of 

particular items of income, gain, loss, and deduction can be 

made, as can special elections affecting the depreciable 

basis of assets with respect to a particular partner. These 

features of partnership taxation were intended to offer 

flexibility, and to preserve some degree of individuality, 

for the members of small partnerships. In the case of large 

syndicated partnerships with many passive investors, however, 

they complicate the law and are both unnecessary and 

inappropriate. 

General Explanation 

- 118 -
The proposal will treat a partnership formed after the 

effective date as a corporation for tax purposes if the 

partnership has more than 15 limited partners. However, the 

proposal will not apply to a partnership if substantially all 

(i.e., more than 90 percent) of the partnership's assets 

consist of new low-income housing. The Administration plans 

to study present methods of subsidizing low-income housing. 

So long as a special benefit is provided to new low-income 

housing through accelerated depreciation, it would be 

inappropriate to apply the proposal to such a partnership. 

Under the Administrati on's proposals, the maximum number 

of limited partners in a partnership--15--will be the same as 

the maximum number of shareholders in a Subchapter S 

corporation. Thus, a business organization, whether it is 

formed under local law as a corporation or a limited 

partnerhsip, wi ll be allowed conduit tax treatment if it is 

owned by 15 or fewer passive investors. 

Effective Date 

Generally, the effective date will be December 31, 1978. 

However, if substantially all of a partnership's assets 

consist of housing, the effective date will be December 31, 

1982. (As stated above the proposal does not apply to a 

partnership if substantially all of its assets consist of new 

low-income housing.) 

The proposal will apply to any partnership formed after 

the effective date. In addition, the proposal will apply to 

a partnership formed on or before the effective date in two 

circumstances. First, it will apply if the number of limited 

partners increases after the effective date. Second, it will 

apply if a limited partner contributes money or property to 

the partnership after the effective date (unless the 

contribution is made pursuant to a binding agreement entered 

into on or before the effective date). For this purpose, a 

partner will not be treated as making a contribution merely 

because the partnership retains some or all of its earnings. 

Revenue Estimate 

The proposal has a negligible effect on tax liabilities. 

Technical Explanation 

If a partnership has more than 15 limited partners, it 

will be treated as a corporation for tax purposes. Once a partne~ship is classified as a corporation, it will always be 

treated as a corporation (regardless of any subsequent 

decrease in the number of limited partners). In applying 

these rules, the term "partnership" will include any 

unincorporated organization availed of for investment 

purposes or for the joint production, extraction, or use of 

- 119 -
property. It will be immaterial whether the organization is 

a joint venture for joint profit, and it will be immaterial 

whether the organization seeks to elect under section 76l(a) 

not to be treated as a partnership. 

Generally, the term "limited partner" will mean a 

partner whose liability is limited under local law to the 

amount of his investment (including amounts he is 

contractually obligated to invest). Five additional classes 

of investors will also be treated as limited partners. 

First, if a Subchapter S corporation is a partner in a 

partnership, then each shareholder will be treated as a 

limited partner. Second, if a grantor trust is a partner in 

a partnership, then each person who is treated as an owner of 

the trust will also be treated as a limited partner. Third, 

if a partnership is a general partner in a second 

partnership, then each limited partner in the first 

partnership will be treated as a limited partner in the 

second partnership. Fourth, if a partnership is a limited 

partner in a second partnership, then each partner (whether 

limited or general) in the first partnership will be treated 

as a limited partner in the second partnership. Fifth, if a 

partner assigns his interest in a partnership, and if the 

assignee includes a share of the partnership income or losses 

in his own income, then the assignee will be treated as a 

limited partner. However, a person who is both a general 

partner and a limited partner will be treated as a general 

partner for tax purposes, and will not be counted toward the 

ceiling of 15 limited partners. In addition, a partner who 

performs full-time personal services for the partnership (or 

who has performed such services for 36 months or longer) will 

not be counted toward the ceiling of 15. Further, a husband 

and wife will not be counted as more than one partner. 

In certain circumstances, a partnership could be 

recognized as such for a period of time, and then be 

reclassified as a corporation. For example, a partnership 

with 15 limited partners will be reclassified as a 

corporation when a 16th limited partner is added. Whenever a 

partnership is reclassified as a corporation, the partners 

will recognize gain under section 357(c) of the Code to the 

extent that the partnership's liabilities exceed its assets. 

- 120 -
IID-7 

AUDIT OF PARTNERSHIPS 

Present Law 

Partnerships are not subject to Federal income taxation. 

Although the items of income, gain, loss, deduction and 

credit are computed at the partnership level, they are taken 

into account separately by each of the member partners. The 

partners are liable for any Federal income tax in their 

individual capacities. Partnerships are required only to 

file an annual information return, which sets forth the items 

of income, deduction, and credit and includes the names, 

addresses, and distributive shares of the partners as well as 

any other information required by regulation. 

Since the partnership is not a taxable entity, there is 

no administrative mechanism for making tax adjustments at the 

partnership level. Nor is the partnership subject to civil 

penalties for failure to file, or late filing of, a 

partnership return. Although the Service may examine 

partnership books and records in consultation with one or 

more general partners, the Service must audit each partner 

separately with respect to partnership matters, even though 

each such audit may involve the same substantive partnership 

determinations. 1/ For example, whether a partnership has 

correctly computed its depreciation allowance for the taxable 

year, and whether partnership allocations have been properly 

made, must be separately determined for each member of the 

partnership. A settlement arrived at by one partner with an 

agent is not binding on any other partner or on the agent who 

deals with such partner. Similarly, a judicial determination 

of a partnership tax dispute may be conclusive only as to 

those partners who are parties to the proceeding. Thus, each 

separate deficiency or overpayment attributable to the 

partnership may be the subject of a separate administrative 

proceeding, and, at the option of each partner, the subject 

of a separate judicial proceeding. 

Reasons for Change 

Present law does not permit the Service to make 

adjustments to partnership tax items at the partnership level 

that are binding on the partners. The result is a 

multiplication of administrative effort and, in some cases, a 

proliferation of lawsuits to decide the same issue. 

The fact that partnership issues are ultimately 

- 121 -
determined at the taxpayer level may impose a substantial 

administrative burden on the Service since it is required to 

control each taxpayer's return individually while the 

partnership matter is being determined. Once a partnership 

issue is raised, the Service must locate and review the 

partnership return while placing the partner's return in 

"suspense" pending completion of the partnership audit. 

Often, the partner return and the partnership return will be 

filed in different districts. Occasionally, there may be 

different locations for the partner return, partnership 

return, principal office or place of business of the 

partnership, partnership books and records, principal 

partnership asset and principal general partner. In 

addition, items relating to a partnership may be reported on 

an individual return even though the partnership return has 

not as yet been filed. 

Once a partnership return has been selected for review, 

a decision must be made as to whether an examination of the 

partnership books and records is warranted. In many cases, 

where it appears that little or no benefit would accrue from 

an examination, the audit process ends with review of the 

partnership return. If an examination is required, the 

partner who signed the return will be contacted, and 

arrangements made to conduct the examination. At the same 

time, the Service must identify, locate, notify and obtain 

waivers of the individual statute of limitations from each 

partner. This may be an extremely difficult process. The 

Service must frequently proceed on the basis of incomplete, 

inaccurate, or out of date information supplied on the 

partnership return. Taxpayer-partners may reside in many 

different Internal Revenue districts. The partnership under 

examination may itself be a partner in another partnership, and may include as partners other partnerships, as well as 

corporations, trusts and estates. 

If the Service cannot locate the ultimate partners and 

obtain waivers, the partnership review may be futile since 

the limitations periods may close for many of the partners. 

Even if the Service is successful in locating a partner, the 

partner may refuse to provide a waiver, thereby forcing the 

Service to issue a deficiency notice for some partners but 

not for others. As a result, with respect to the same 

partnership matter, there may be partners who have waived the 

statute of limitations period, partners who have refused to 

provide waivers and, therefore, received deficiency notices, 

and partners who could not be located and whose limitations 

period closed. 

Any partner may separately litigate a partnership issue 

at any time. A partner need only refuse to extend the 

statute of limitations, forcing the Service to issue a 

statutory notice of deficiency. The partner then has the 

option of proceeding in Tax Court, or paying the deficiency 

- 122 -
and contesting the Service's position by means of a claim for 

refund. 

In the case of a contested audit of a large partnership, 

waivers of the individual statute of limitations will be 

obtained for as many partners as possible while a limited 

number of "test" cases proceed through litigation. This 

"suspensing" of partner returns keeps the returns open for 

all issues, until the partnership issues are settled. Each 

separate return represents a separate case requiring 

individual control and separate pleadings. Joinder is 

possible with the agreement of the partners, but has not 

proven particularly effective. 

An administrative or judicial determination arrived at 

with respect to one partner generally does not preclude 

another partner from challenging the same issue. Partners 

are free to challenge partnership level determinations and, 

in effect, reopen the partnership audit in their local 

districts. Thus, it is impossible to obtain one final 

binding administrative determination of a tax issue arising 

from a partnership. This may result in lack of uniformity 

and consistency. 

Current partnership audit rules, therefore, produce two 

generally undesirable consequences. First, in order to audit 

a partnership, the Service must separately control each tax 

return which includes an item attributable to that 

partnership. Second, even if the Service successfully 

initiates and manages a partnership audit, each partner may 

separately determine where and when his partnership matter 

will be determined. 

The problems of effectively auditing partners of 

partnerships have been present for a long time. However, 

these problems have been vastly compounded by the widespread 

use of partnerships in the tax shelter area. The large number of partners involved in syndicated, and often 

interrelated, tax shelter partnerships makes Service efforts 

to ensure compliance with the tax laws extremely difficult 

under existing administrative and judicial procedures. 

The size of partnerships, measured by number of 

partners, has grown dramatically in recent years. Although 

the total number of partnerships increased by only 16.3 

percent in the 1~-year period from 1966 through 1975, the 

average number of partners per partnership increased by 52.6 

percent during the same period. 

This expansion in size of partnerships is attributable 

to a rapid increase in the number of very large 

partnerships. Table IID-5 indicates where this growth has 

occurred. 

- 123 -
Table IID-5 

Growth in Size of Partnerships!/ 

I 

Total Number 

Number of Partners 501 I of 

Per Partnershi~ 2-4 5-10 11-50 51-100 101-500 or more Partnerships 

Number of Partnerships: 

Year 

1975 909,71)4 103,434 54,941 2,860 1,610 545 1,073,094 

1974 911,951 96,672 49,137 2,328 1,803 377 l r 062,268 

1973 899,238 90,384 45,505 2,056 1,559 350 11,039,092 

1972 867,604 80,~00 40,620 2,01 3 1,266 309 992,012 

Percentage change, 

1972-1975 4.9 30.0 35.5 42.1 27.2 76.4 I 8.2 

~ All figures are estimates based on samples 

from 1972. 

Data by number of partners available only 
Effect on 

Table II E-6 

Administration's Pension Integration Proposal 

Employees: Benefits as Replacement of Earnings at Retirement, 

Selected Private Pension PlansUnder Present Law and 

Under the I!ltegr~_tion Proposal 

Integrated Repracement of Earn-ings at Retirement 

(Percent of Pinal Average Pay)l/ for 

Defined Benefit Plan E-- Employees with _Final Average Pav~/ in 

Offset Plan ,uuu : ~l.:>,uuu : ~.,u,uuu : ~:>u,voo : $75,000:-$1-00,000 

Present Plan: 50% of final average 

pay, offset by 83 1/3% 

of primary insurance 

amount. 

Private pension benefits only 5% 

Private pension and social 

security benefits 59t 

Plan under Proposal: 50% of final average 

pay, offset by 50% 

of primary insurance 

amount 

Private pension benefits only 23% 

Private pen.sion and social 

security benefits 77% 

20% 34% 40% 44% 

56% 53% 52% 52% 

32% 40% 44% 46% 

68% 59% 55% 54% 

Office of the Secretary of the Treasury January 25, 1978 

Office of Tax Analysis 

y 

y 

Assumes employees retire at age 65 in 1992 with 35 years of service with employer. 

Final average pay is assumec to be average over the last 5 years; earnings are assumed 

to increase at 6t per ·year. 

45% 

51% 

47% 

53% 

y The Social Security amounts shown do not reflect the special transition minimum benefits 

ava!lable for retirees in the early 1980's. Thus, the numbers reflect patters of replacement which will be in effect under the Social Security Amendments of 1977 after the transition period. 
Table II E-5 

~nistration•s Pension Integration Proposal 

Effect on Employees; Selected 

Benefits ~s Replacement of ·Earnings at· Retirement, 

Private Pension Plans Under Present Law and 

Under the Iptegration Proposal 

a Replacement of Earnings at Retirement 

Integrated Defined Benefit Plan Q--

Excess.. Plan 

(Percent of Pinal Average Pay)l/ for l/ 

; ·- .~ploy~;s.~!th P!~el.~yera~;xPe~:at ~e-1!~~ o!;:x xxx 

Present Plana 52 1/2% up to $11,004 

of compensation; 90 over $11,004 

Privata pension benefits only 

Private pension and social 

aecurity benefits 

; 

Plan under Proposal: 50% np to $11,004 

of compensation; 

90% over $1~,004 

Private pension benefits only 

Private pension an4 social 

aecurity benefits 

53~ 

107% 

50% 

104% 

62% 76' 82% 84% 

98% 9st 93% 92% 

61% 75% 81% 84% 

97% 971% 92% 92' 

Office of the Secretary of th8 Treaaury January 25, 1178 

Office of Tax Analysis 

y 

y 

Assumes employees retire at age 65 in 19 with 35 years of service with employer. 

Pinal average pay ia a•sumed to be average over the last 5 years, earnings are assumed 

to increase at 6\ per ye&J:. 

86% 

92% 

86% 

92% 

y The Social Security amounts shown do not reflect the special transition minimum benefits 

available for retirees in the early 1980's. Thus, the numbers reflect patterns of replacement 

which will be in effect under the Social Secfrrity Amendments of 1977 after the transition 

period. 
Table II E-4 

Administration's Pension Integration Proposal 

Effect on 

Integrated 

Defined Benefit Plan C -- Excess Plan 

-- Present Plan: 16 1/2% up t 9 $11,004 

of compensation; 54% over $~1,004 

Private pension benefits only 

Private pension and social 

security benefits 

Plan. under Pro2osal: 30% up to $11,004 

of compensation: 

54% over $11,004 

Private pension benefits only 

Private pension and social 

security benefits 

Office of the Secretary of the Treasury 

Office of Tax Analysis· 

17% 26% 40% 

71% 62% 59% 

30% 36% 45% 

84% 72% 64% 

Retirement, 

and 

46' 

57\ 

49\ 

60, 

48' 

56' 

SO% 

58% 

January 251 1978 

!/ 

y 

Assumes employees retire at age 65 in 1982 with 35 years of service with employer. 

Final average pay is assumed to be average over the last 5 years; earnings are assumed 

to increase at 6% per year. 

50% 

56% 

51% 

57% 

ll The Social Security amounts shown do not reflect the special transition minimum benefits 

available for retirees in the early 1980's. Thus, the numbers reflect patterns of replacement which will be in effect under the Social Security Amendments of 1977 after the 

transition period. 
Table II E-3 

~nistration•s Pension Integration Proposal 

Effect on Employees& Benefits ~s Replacement of ·Earnings at· aetirement, 

Selected Private Pension Plans Under Present Law and 

Under the Ip~egration Proposal 

Integrated 1 Replacement of Earnings at Retirement 

Defined Benefit Plan B-- 1 (Percent of Pinal Average Pay)l/ for 3/ 

Excess Plan· : Nr R~plo~~:sx~~th F~~~lx~!eray:xP~r:at ~e.l!!!-o!;; 

Present Plana 0% up to Sil,004 

compensation; 36% 

over S11, 0 0 4 ·. 

Private pension benefits only 

Private pension and social 

security benefits 

Plan under Proposal& 20% up to $1~,004 

of compensatl.on; 

36% over $11,004 

Private pension benefits only 

Private pension and social 

security benefits 

0% 

54' 

20% 

74l 

10% 23% 28\ 31% 

46% 42~ 39% 39% 

24% 30% 32% 34% 

60~ 49t 43% 42l 

Office-oTtlle Secretary of ~Treasury January .2-5, lt78 

Office of Tax Analysis 

y 

y 

Assumes employees retire at age 65 in 1982 with 35 years of service with employer. 

Pinal average pay is assumed to be average over the last 5 years' earnings are assumed 

to increase at 6' per ye~. 

32% 

38% 

34% 

40% 

3/ The .Social Security amounts shown do not reflect the special transition minimum benefits 

available for retirees in the early 1980's. Thus, the numbers reflect patterns of replacement which will be in effect under the Social Security Amendments of 1977 after the 

transition period. 
Effect on 

Table II E-2 

Administration's Pension Integration Proposal 

Employees: Benefits as Replacement of Earnings at Retirement, 

Selected Private Pension Plans Under Present Law and 

Under the Inteqration Prooosal 

Replacement of Earnings at Retirement 

(Percent of Final Average Pay)l/ for 31 

: Employees with Final Average Pay-2/ in 1982=-of-- Integrated De£ined Benefit Plan A--

Excess Plan : $5,000 : $15,000 : $30,000 : $50,000 : $75,000: $100,000 

Present Plan: 0% up to $Lt., 004 

of compensation; 

18% over $11,004 

Private pension benefits only 0% 5% 11% 14% 15% 

Private pension and social 

security benefits 54% 41\ 30% 25% 23% 

Plan under Pro12osal: 10% up to $11,004 

of compensation; 

18% over $11,004 

Private pension benefits only 10% 12% 15% 16% 17% 

Private pension and social 

security benefits 64% 48% 34% 27% 25% 

Office of the Secretary of the Treasury January 25, 1978 

Office of Tax Analysis 

!f Assumes employees retire at age 65 in 1982 with 35 years of service with employer. 

2/ Final average pay is assumed to be average over the last 5 years; earnings are assumed - to increase at 6% per year. 

16% 

22% 

17% 

23% 

l/ The Social Security amounts shown do not reflect the special transition minimum benefits 

available for retirees in the early 1980's. Thus, the numbers reflect patterns of replacement which will be in effect under the Social Security Amendments of 1977 after the 

transition period. 
A similar rule will apoly to the type of plan that 

"offsets" the Social Security benefit ag~inst the plan 

benefit. The offset (or negative part of the formula) will 

be governed by the positive part of the formula. 

Specifically, a plan could offset the same percenc of Social 

Security benefits as the percent of finol average pay used to 

compute the plan's gross benefit. That is, 2 plan could 

offset by 50 percent of the Social Security benefit if it 

provided for a benefit of 50 percent of final average pay. 

Analysis of Impact 

The integration rules proposed he re will substantially 

affect only plans which tend to be highly discriminatory in 

favor of higher-paid persons by excluding or virtually 

excluding the rank-and-file. For e xample, a plan under which 

an employee received nothing on pa y up to the taxable wage 

base ($17,700 in 1978) and 7 percent of pay in excess of the 

taxable wage base will no longer qualify. On the other han d , plans designed to provide for the retir ement of employees at 

all leve ls rather than as a t a x shelter for a few highly paid 

individuals will generally continue to meet the integration 

tests. For these plans, any requir ed changes will gener a lly be relatively minor. 

Tables IIE-2 through 7 show some common formulas under 

current law and under the proposal and how these formulas 

will affect employees at different wage levels. 

- 153 -
amount an employer contributes for that employee. The Social 

Security benefits of a current employee are not directly funded by his or her employer . Rather, such benefits are 

largely funded by employer and employee contributions paid 

after the worker has retired: that is, the Social Security 

system is essentially on a pay-as-you-go basis. 

The basic integration rules, in addition to Pncouraging 

inequity, are exceedingly complex: integrated plans, 

therefore, a re less easily understood by participants than 

are other plans. As the Social Security wage base and 

benefits have changed over the ye a rs, so, too, have the 

numerous rules which coordinate the Social Security wage base 

and basic benefit with the way in which a plan can be 

integrated. Complications also result because plans almost 

always provide more than retirement benefits (for example, 

there may be disability and death provisions) and because 

benefits may be paid at different ages and in different forms 

(for example, a lump sum distribution or lif e annuity). The 

integration rules have elaborate actuarial ad justments for 

these ancillary benefits and variations as they relate to 

each type of plan. 

General Explanation 

The principal abuse of integration is tha t it uses t ax 

subsidies to permit, and even encourage, benefits to be pa ia 

to very highly paid persons while paying none at all to 

lower-paid persons. The Administration proposes to end this 

abuse, while still permitting employers to use integration to 

limit retirement benefits so that benefits from Social 

Security and private pensions do not exceed a certain percent 

of pay. This could be accomplished by allowing plans to 

integrate only if they provided a specified minimum benefit 

aesi9ned to provide full replacement of pre-retirement earn1ngs. This approach, which would add ?nother layer of 

complexity to the existing integ r ation rules, would entir el y de ny the benefits of integration to those plans which did not 

set full replacement as a goal. The proposal, however, does 

not go this far but rather provides a formula for integration 

which would approximate the ideal res ult while, at the same 

time, virtually eliminating the complexity of integr a tion. 

The basic integration rules will be replaced with a 

formula establishing a maximum ratio of contributions or 

benefits above and below the integration level. More 

specifically, so long as a plan provides X percent below the 

integration level, i t could provide up to 1.6 times X percent 

above that level. I n a defined contribution plan, for 

example, an employer could contribute 9 percent of pay on 

wages above the plan's integr a tion level if it contributed 5 

percent of pay on wag e s below the integration level. 

- 152 -
lower-paid persons. In fact, however, the percentage of 

pre-retirement earnings that are ess~nt ial to fulfill basic 

needs after retirement decreases as earnings increase. 

Second, and the logical extension of the first assum9tion, 

the current tax system implies that Social Security is 

adequate for lower-paid persons (but not for higher-paid 

persons), so th3t only a higher-paid person 's retirement 

income need be tax subsidized through a private plan. In 

fact, however, if Social Security were adequate for 

rank-and-file employees, there would be no need for a tax 

subsidized private pension system at all . If Social Security 

is not adequate , one must question the extent to which tax 

benefits must flow d isproportionate ly to highe r-paid oersons, 

often to the total exclusion of the rank-?nd-file, in order 

to encourage cdequate retir ement pay at all levels of the 

workforce. 

The inequity in the current system of Social Security 

integration has been recognized by Congress . Congress has 

imposed severe limitations on the usc of Social Security 

integration in plans that benefit owners, such as Keogh plans 

for the self-employed, and it has prohibited integration in 

plans designed especially for rank- and-file employees-- employee stock ownership plans. Further , durin3 the 

consideration of ERIS~, Congr ess, through the Conference 

Committee, voted a freeze on further integration as a 

temporary measure prior to full consideration of the 

integration question after a two-year Congressional study. Because of last minute opposition, the freeze was deleted by 

a concurrent resolution of the Congress . 

Integration has been defended by employers on the 

grounds tha t, without it, they would have to provide more 

than 100 percent of pre-retirement pay to lowe r-paid persons 

in order to provide an adequate percent of fi nal average pay 

to higher-paid persons. Employers also contend that the cost 

of an apparently excessive deferred benefit (i.e., one in 

e xcess of 80 percent or 100 percent of final ~ve rage pay) 

results in lower current wages for lower-paio pe rsons, and 

that it unnec essa rily lowers their pre-retirement standard of 

living. One couJd see some justification for these arguments 

if, in fact, the employer and Social Security together 

provided a r e asonable percentage (such as 80 pe rcent) of 

final average pay for the $10,000 employee. But, und e r the 

current integration system, there is no requirem~nt that 

employers provide any specified percentage of final average 

pay to lower-paid persons. 

Social Security integration also has b~en iustified, not 

on the grounds of encouraging ration a l public policy, but on 

the grounds that employers s hould be able to "count" their 

contributions to Social Security as p~ rt of their overall 

retirement programs. But there is only a small correlation 

between an employee 's benefits under Soc ial Secu rity anu the 

- LSl -
Table IIE-1 

Effect of Integration on Constant Employer 

Contribution 

Salary of Employee 

$ 10,000 

15 , 000 

20 , 000 

100,000 

Total Employer 

Con tribution 

Defined 

Contribution Plan 

in 1S78 

Total Contribution of $5 , 922 

Not 

Integrated 

(4 . 08 %) 

$ 408 

613 

817 

4 , 004 

s 5,922 

Integrated 

(7% a bove $17,700) 

s 0 

0 

161 

5 , 761 

$ 5, 922 

The first Social Security law antedated the first nondiscrimin~tion requirement for qualified plans . Oy the 

time the Treasury Department proQosed a nondiscrimination 

requirement which was enacted as part of the Revenue Act of 

1942, several large plans already existed which integrated 

benefits with Social Security. Consequently, integration was 

first developed at a time when there was undoubtedly concern 

about disturbing l a rge , existing pension plans which had been 

established before there were nondiscrimination requirements. 

Today , however, the integration of pension plans with 

Social Security is a wide ly us ed tax device which can result 

in lower- paid pe rsons rece iving inadequate retirement 

benefits. Integrated plans often are sold, particularly to 

smaller employers, on the assumption that such plans either 

exclude or proviae relatively small benefits for lower-pa id 

employees earning below t he Sociel Security wage ba se . Employers are encouraged -- before they provide any private 

retirement income for lowe r-paid pe rsons -- to provide 

retirement income at higher levels of pay equivalent, on a 

percent-of-pay basis, to the benefit provided by Social 

Security for those with lesser earnings . 

The above approach therefore suggests two assumptions. 

First, it assumes that it is more importent to provide after 

retirement the same percent of pre-retirement pay at all 

income levels than it is to provide minimum benefits for 

- 150 -
Integration is widely used. The Congressional Research 

Service concluded in 1974 that 60 percent of tax-qualified 

pension plans in existence at that time, covering 

approximately 25 to 30 percen t of participants in the private pension system, were integrated with Social Security. 2/ 

Integration may be even more popular today given the - substantial increases in Social Security taxes and the 

mandated wider covera~e for lower income workers under the 

Employee Retirement Income Security Act of 1974 (ERISA). 

Reasons for Change 

Notwithstanding the anti-discrimination requirements and 

the major reforms under ERIS~, retirement plans still afford 

substantial tax advantages which a re more beneficial to a 

person in a higher tax bracket, because the higher-paid 

person, for whom more dol lars are contributed, defers paying 

tax on more dollars, and also because deferral ~rovides a 

greater tax subsidy per dollar for persons in higher tax 

brackets. Although the degree of difference varies from case 

to case, under one set of reasonable assumptions, the tax 

subsidy increases the pension benefit by 140 percent for an 

executive with a starting salary of $100,000, while the 

subsidy increases the benefit by only 60 percent for the 

employee with a starting salary of $10,000. 3/ 

The disparity is even greater in an integrated plan. 

An employer making the same dollar contribution (e.g. $5,922) 

to a private plan would distribute much more to the highly 

paid person, and much less to lower-paid persons, if the plan 

were integrated. 4/ Table IIE-1 illustrates how an 

integration provision affects the distribution of employer 

contributions to a plan, to the detriment of lower-paid 

employees. 

- 149 -
for officers, shareholders, or the highly 9aid. For exemple, 

if an employer contributes lu percent of pay, or $10,000, to 

a oefined contribution plan for an employee eerning $lOO,OOu, 

the employer must z lso contribute 10 percent of pay on behalf 

of a lower-paid employee -- for example , $1,200 if the 

employee earns $12,00~ -- in oroer for contributions not to 

be discriminatory. However, the law ?ermits an ex ep ~ion to 

the percent-of-pay rule in the ccse of plans which take 

Social Security into account. Tnis process is called 

"integration". 

Specifics of Integration -- An employer is oermitted to 

"count" its employer contributions to the Social Security 

system in determining whether its plan discriminates in favor 

of officers, shareholders, or highly p~id persons. Thus, 

employer contributions to a qualified pl an may be he~vily 

weighted in favor of higher-paid employees. For example, 

under a defined contribution plan an employer can contribute 

7 percent of pay in excess of the Social Security wage base 

($17,700 for 19/b), which for an employee earning $100,000 

amounts to $5 ,761. The plan would not be considered 

discriminatory even though the employer does not contribute 

anything to the qualified plan for ~n employee earning less 

than the wage base, because the employer will be deemed to 

have contributed 7 percent of pay up to $17,700 to Social 

Security for all employees. ·rhe deemed contribution rate of 

7 percent does not depend upon the r a te of tax under Social 

Security, which is currently below that level. 

This type of plan is an "e xcess " plan, because the 

employer contributes only an amount de termined by ref e r ence 

to the employee's pay in excess of the integration level . ~s 

the integration level increases, the opportunity to r educe 

coverage unde r an excess plan also increases. It is 

estimated that, beginning in 1981, 94 percent of ell 

employees will ea rn less than the Social Security wage base, 

which for tha t year will be $29,7u~ (with automatic 

adjustments thereafter). 

The more common type of integ rated defined contribution 

plan is the step-rate plan, which provides some percentage of 

pay up to the integration leve l and a higher perce ntage of 

pay (but not more than 7 percent higher) above that level. 

For example, for 1978 an employer can contribute 5 percent of 

pay up to the Social Se curity wage base and 12 percent of pay 

in excess of the wage base for the SlOO,OuO employee, 

amounting to $10,761, while under this formula a contribution 

of not more than $600 would be required for the Sl2,UOO 

employee (5 percent of $12,000). 

Defined benefit plans may be integrated in a similar 

fashion, although they are integrated on the basis of 

benefits rather than contributions. The rules for 

integration of these plans are even more complicated than the 

rules for defined contribution plans. 

- 148 -
IIE-2 

QU~LIFIED RETIREMENT PLANS AND SOCIAL SECURifY 

Present Law 

In General--Retirement plans can be classified as two 

principal types -- "defined benefit" plans and "defined 

contribution" plans. ~ defined benefit plan provide s t~at an 

individual will receive a specified amount upon retirement; a 

defined contribution plan provides that specified a~ounts 

will be set aside each year, and the employee will eventually 

receive those amounts plus the earnings on them. 

Tnese plans aualify for advantageous tax treatment only 

if they do not discriminate in favor of officers, 

shareholders, or highly paid persons. The income tax 

benefits -- which include current deductions for employers, 

exclusion of the contributions from employee income, and tax 

exemption for income earned by the retirement fund -- a re 

designed to induce employers to provide pensions. The 

objective of the anti-discrimination rule is to insure that 

employers in fact provide pensions for persons at all levels 

of their workforce, rather than primarily for officers, 

shareholders, or highly paid persons. When it first 

established the anti- discrimination rule in 1942, the House 

Ways and Means Committee reported: 

"The present law endeavors to encourage the setting 

up of retirement benefits by employers for their 

employees and in pursuance of this policy permits 

employers to take as a deduction amounts irrevocably set 

aside in a pension trust or other fund to ?rovide 

annuities or retirement benefits for superannuated 

employees. This provision ha s been considerably bused 

by the use of discriminatory plans which either cover 

only a small percentage of the employees or else f a vor 

the higher paid or stock- holding employees as against 

the lower-paid or non-stock-holding employees. Under 

the present law, it is contenced the officers of a 

corporation ~ay set up pension plans for themselves ana 

make no provision for the other employees. Such actions 

are not in keeping with the purpose of this ~rovision. 

"The coverage and nondiscrimination requirements 

would operate to safeguard the public against the use of 

the pension plan as a tax-avoidance device by management 

groups seeking to compensate themselves without paying 

their appropriate taxes." l/ 

Specifically, under current law, a plan must provide 

rank-and-file employees with at least the contri~utions or 

benefits expressed as a percentage of pay that are provided 

- 147 -
requirin3 as a condition for obt?ining favorable tax 

treatment that group-term life insurance and alt~ 

and disability plans not discrimin a te in favor of 

officers, shareholders, or the highly paid. 

repealing the $5,000 exclusion for death benefits 

paid by the employer . 

texing unemployment benefits for those with total 

income in excess of $20 ,000 per year ($25,000 in the 

case of 2 joint return). 

- 146 -
IIE-1 

EMPLOYEE BENEFirS 

INTRODUCTION 

The Internal Revenue Code provides favorable tax 

treatment for certain forms of compensation. If salary is 

paid in cash, it will be deductible by the employer and 

taxable immediately to the employee. However, compensation 

in other forms, w~ile continuing to be deductible by the 

employer, may be either excluded entirely from tax by the 

employee or taxed only at a later date. This tax treatment 

can be justified only as a means of encouraging compensation 

to be paid in certain forms so that individuals, particularly 

lower income employees, will be assured of protection against 

certain contingencies -- sickness, disability, retirement -- which are particularly difficult to plan for at low income 

levels. 

The tax law falls short of this goal. For life 

insurance and health plans, there is no requirement that 

employees at all levels be benefitted. Retirement plans 

ostensibly must not discriminate in favor of officers, 

shareholders, or other highly paid individuals to qualify for 

favorable tax treatment. Nevertheless, under current law too 

much of the tax subsidy of thes~ arrangements (termed 

"qualified" plans) can inure to the benefit of the highly 

paid, and too little to the benefit of the low paid. 

Moreover, exclusion and deferral of income are obviously 

of greater benefit to those taxpayers with high m~rginal 

rates. As the tax benefits expand, they seriously interfere 

with the goal of a progressive tax system an~ are 

increasingly unfair to those persons not employed by employers who provide compensation in the favored form. 

The Administration proposes to reduce the disparate tax 

treatment which is based solely upon the form in which 

compensation is provided. Where such disparity remains, the 

Administration ~roposes to assure that it serves a public 

purpose by requ1ring that a greater proportion of the tax 

benefits inure to rank-and-file employees, compared with 

present law. Thus, the Administration proposes 

assuring that a gr~ater portion of the benefits from 

tax-favored qualified retir~ment plans will inure to 

the benefit of the lower-paio by mocification of the 

rules by which such plans interrelate with Social 

Security. 

- 145 -
Assuming surrender charges of 7 percent (or $8,921), the 

investor would receive a lump sum of $118,515. Taxes on the 

gain of $88,515 ($118,515 - $30,000) at 35 percent would 

amount to $30,980, leaving after tax proceeds of $87,535 

($118,515- $30,980). If the taxable gain of $88,515 in one 

year pushed the taxpayer into a bracket higher than 35% he 

could elect to receive the $118,515 in periodic payments over 

several years. 

5/ The 1977 annual averag~ interest rate on tax-exempt 

general obligation bonds with a maturity of 20 years and 

rated AAA by Moodys was 5.21 percent. The 1977 annual 

average interest rate on such bonds with a rating of AA was 

5.36 percent. 

~/ Forbes Magazine, May 1, 1976, p. 86. 

Zl U. S. News and World Report, October 10, 1977, page 91. 

~/ Ibid. 

- 144 -
c. Existing Contracts 

The proposed elimination of tax deferral during the 

accumulation period of non-qualified deferred annuities will 

apply to contracts issued before February 1, 1978 only to the 

extent that the holder makes additional contributions to the 

contract after that date. Where additional contributions are 

made after January 31, 1978, subsequent earnings credited to 

the holder's account will be apportioned between those 

allocable to prior contributions (the earnings on which will 

not be taxed currently) and to subsequent contributions (the 

earn1ngs on which will be taxed currently). 

However, dividends, cash withdrawals and loans made by 

the issuing company to the contract holder after December 31, 

1978 will be treated as taxable distributions to the extent 

of the accumulated and untaxed income as of the end of the 

year of the distribution, even if such income was earned and 

credited to the contract before February 1, 1978. 

Footnotes 

!/ The annuity payments may be made by the company for the 

life of an individual (a "single life annuity"), for the 

lives of more than one individual (a "joint and survivor 

annuity"), or for a specified period of time (an "annuity 

certain"). The individual during whose lifetime the annuity 

is payable is called the annuitant and is usually the 

purchaser of the contract. 

~/ Wall Street Journal, May 2, 1977, page 32, Col. 1. 

3/ These contracts are offered at interest rates as hig~ as 

7 to 8 percent despite the fact that state law reserve 

requirements applicable to life insurers prevent them from 

guaranteeing rates in excess of 3-1/2 to 4 percent for the 

duration of the contract. These limits have been 

circumvented by the combination of a guarantee of an 

underlying rate of 3-1/2 to 4 percent for the life of the 

contract, with an additional 3 to 4 percent guaranteed for 

shorter periods of time. Even though the full interest rate 

is not guaranteed for the life of the contract, the sales 

literature often represents that the purchaser can expect the 

combined interest paid each year to compare "very favorably 

to rates then being paid by other fixed money plans." 

4/ At 7-1/2 percent compounded annually, $30,000 invested 

In a deferred annuity would grow in 20 years to $127,436. 

- 14 3 -
distribution and, to the extent thereof, as taxable during 

that year. Loans after December 31, 1978, by the issuing 

life insurance company to the holder of a designated contract 

or a deferred annuity contract issued before February 1, 

1978, will be treated as taxable distributions to the extent 

of the previously untaxed income under the contract as of the 

end of the year in which the loan was made. 

B. Designated Contracts 

An individual will be permitted to designate a single 

deferred annuity contract, the earnings on which will remain 

eligible for tax deferral during the accumulation period. 

The individual will be required to designate the contract as 

one qualifying for deferral by informing the issuer at the 

time the contract is purchased. The designated contract must 

be separate from any other annuity contract held by the same 

purchaser. The maximum annual premium under a designated 

contract will be limited to $1,000 per year. 

The only contracts that may qualify as designated 

contracts will be those in which the issuing life insurance 

company guarantees the purchaser both a return of the 

aggregate premiums paid in (less any applicable loading or 

surrender charges) plus the lower of (i) the maximum rate of 

interest that may be guaranteed under state law for the 

duration of the contract, or (ii) the rate actually offered 

for the duration of the contract. Any contract whose value 

depends, in whole or part, on the value of an underlying 

investment fund or segregated asset account will not be 

eligible for designation. 

While unwithdrawn interest on a designated contract will 

be excludable from income, any dividends or other withdrawals 

from, or loans from the issuer of, a designated contract will 

be treated as coming first from accumulated and untaxed 

income and, to the extent thereof, as taxable during the year 

received. 

As in the case of all deferred annuities, the issuing 

company will be required to report to both the government and 

the holder of a designated contract the earnings credited to 

the contract each year. The reporting form will identify the 

interest earned on a designated contract as being excludable 

from gross income during the accumulation period. This 

reporting requirement will ensure that each holder has 

purchased only a single designated contract and that the 

contributions thereunder do not exceed the $1,000 annual 

limitation. 

The interest earned during the accumulation period of a 

designated contract will not be added to the policyholder•s 

investment in the contract, and therefore will be taxed when 

received by the policyholder as annuity payments or in a lump sum. 

- 142 -
Revenue Estimate 

1978 1979 

12 

Change in Tax Liability ($ millions) 

Calendar Years 

1980 1981 1982 

26 40 57 

Technical Explanation 

A. In General 

1983 

80 

Income earned during the accumulation period of a 

deferred annuity contract will be taxed to the policyholder 

in the year credited to his account or otherwise earned. A 

deferred annuity contract will be defined to include any 

annuity contract u~der which the annuity payments commence 

more than one year after payment of the initial premium. 

However, it will not include an annuity purchased or provided 

under a tax-favored retirement plan, such as a qualifed 

pension or profit sharing plan or an individual retirement 

annuity, or an annuity purchased with amounts excludable from 

income under section 403(b) of the Internal Revenue Code. 

The issuer of a deferred annuity will be required to 

report to both the contract holder and the government the 

amount of interest or other earnings paid or credited in 

connection with the contract each year. These reporting 

requirements should not pose significant problems for the 

life insurance companies that issue annuities. 

Owners of the annuity contracts will be required to 

include in their taxable incomes each year the amount of 

income reported to them by the company. Amounts taxed to the 

owner during the accumulation period will be added to the 

investment in the contract and will not be taxed again when 

the contract is surrendered or annuity payments are received. 

In the case of variable annuities the holder will be 

taxed only on current investment income, whether or not 

distributed. No change is proposed in the treatment of 

realized gains or losses from the sale or other disposition 

of assets held by the issuer of a variable annuity. 

For all deferred annu i ty contracts, including designated 

contracts (described below) and contracts issued before 

February 1, 1978, any dividends distributed or other 

withdrawals will be treated as having been made first out of 

accumulated and untaxed income as of the close of the year of 

- 141 -
treatment of these contracts into line with that applicable 

to similiar investments such as certificates of deposit and 

or.iginal issue discount bonds. The change will not, however, 

apply to deferred annuities purchased or provided under a 

tax-favored retirement plan, such as a qualified retirement 

plan or an i ndividual retirement annuity. 

In recognition of the fact that the traditional deferred 

annuity can play a legitimate role in planning for 

retirement, the proposal will permit an individual to 

designate a single deferred annuity contract, the annual 

contributions to which may not exceed $1,000, as one for 

which the tax deferral of present law would continue. The 

$1,000 annual limitation on contributions should preclude the 

use of designated contracts by high-income taxpayers as tax 

shelters, and by self-employed persons as a means to avoid 

providing retirement benefits for their employees. 

The present law treatment of cash withdrawals and 

dividends from annuity contracts as tax-free returns of 

principal will be changed. Under the proposal, withdiawals 

and dividends distributed during any year will be treated as 

taxable to the extent of untaxed accumulations of income as 

of the end of the year of distribution; only after these 

distributions have exhausted the previously untaxed income 

will they be considered tax-free returns of principal. Loans 

from the issuing company to the holder of the annuity 

contract will be treated as distributions for this purpose. 

Effective Dates 

Income earned after December 31, 1978, and during the 

accumulation period (i) of non-qualified deferred annuity 

contracts issued after January 31, 1978, or (ii) on 

contributions made after January 31, 1978, to non-qualified 

deferred annuity contracts issued before February 1, 1978, 

will be taxed currently to the purchaser. 

Dividends, cash withdrawals and loans made by the 

issuing company to the contract holder after December 31, 

1978, and during the accumulation period of any non-qualified 

deferred annuity contract, will be treated as taxable 

distributions to the extent of the accumulated untaxed income 

as of the end of the year of the distribution, regardless of 

when the contract was issued or the income was earned. 

- 140 -
Security Act of 1974. These rules prevent employers from 

discriminating against lower paid or non-owner employees. 

However, by purchasing a deferred annuity a selfemployed person can obtain tax deferral similiar to that 

available through a qualified retirement plan (~, a Keogh 

Plan), thereby providing generously for his own retirement 

without providing retirement benefits for his employees. 

This may be a particularly attractive option in conjunction 

with an Individual Retirement Account ("IRA"). An IRA may be 

established by any individual not covered by a qualified 

plan. Like a deferred annuity, earnings in an IRA are not 

taxed currently to the owner. In addition, contributions to 

an IRA, like those to a qualified plan, are deductible. 

However, to avoid the use of IRAs by self-employed persons to 

circumvent the non-discrimination rules applicable to 

qualified plans, Congress bas generally limited annual 

contributions to an IRA to a maximum of $1,500. 

This use of a deferred annuity was publicized in a 

recent article: 

"Virtually everyone is eligible for the tax 

break [available through a deferred annuity]. You do 

not have to work for a company that lacks a pension 

plan, as you do in order to set up an IRA--an Individual 

Retirement Account. And if you are self-employed, you 

do not have to provide pensions for your employees as 

you do when you establish a so-called Keogh Plan. 

"Those features have brought a surge of popularity 

to the 'nonqualified deferred annuity,' so labeled 

because it does not qualify as an IRA under the pensionreform law." .!!_/ 

Thus, a further reason for rev1s1ng the current tax 

treatment of deferred annuities is to forestall their use by 

self-employed persons as a way to provide for their own 

retirement with tax-deferred income, while avoiding the 

expense of providing retirement benefits for their employees. 

General Explanation 

The proposal will correct the current abuse of using 

deferred annuities as tax shelters without interfering with 

their traditional role as investments that ensure retired 

persons against the risk of outliving their income. 

The tax deferral afforded income earned during the 

accumulation period of a deferred annuity will be eliminated. 

Income earned during the accumulation period will be taxed 

currently to the policyholder. This change will apply to all 

deferred annuities, including variable annuities and the 

so-called "wraparound" or "investment" annuities. Taxation 

of earnings annually to each policyholder will bring the tax 

- 139 -
financial planning ($10,000 minimum). 

"The annuity policy permits the owner to direct 

the choice of permitted investments and to change 

investments, both before and during retirement." 

The recent growth in sales of deferred annuities has 

been dramatic, reflecting the appeal the foregoing abuses 

have for the investing public. It is at least partly because 

the rules governing taxation of deferred annuities have not 

been revised, while the rules governing taxation of other 

investment vehicles (such as long-term certificates of 

deposit and original issue discount bonds) have, that the 

deferred annuity has acquired such substantial recent 

popularity. Deferred annuities are now virtually the only 

remaining, widely-available investment vehicle that enables 

investors to defer taxes on regularly recurring investment 

income. 

Moreover, the current abuses have had undesirable side 

effects. For example, there has been a substantial diversion 

of savings into deferred annuities and away from commercial 

banks, savings and loan associations and other forms of 

saving. The magnitude of the shift was noted in a recent 

journal: 

"So far in 1977 , Americans are shifting funds into 

these tax-delaying devices at an annual rate of 

between 800 million and 1 billion dollars, one 

expert estimates. That's about seven times more 

than just three years ago. 

"The total is expected to soar even higher. People 

are looking for places to reinvest billions of 

dollars they socked into savings certificates 

carrying unusally high rates of interest that were 

issued in 1973 by banks and other lending institutions 

and started maturing around the middle of this year. 

"Most funds for deferred annuities in the past two 

years have been coming from cashed-in stocks, bonds, 

mutual funds and savings accounts. But some families 

have even mortgaged their houses and put the proceeds 

into the annuities." l/ 

This shift in the flow of savings, induced solely by 

unwarranted differences in tax treatment, is undesirable. 

The current abuses of the deferred annuity also pose a 

serious threat to the elaborate rules designed by Congress 

over the past 40 years to safeguard qualified retirement 

plans, most recently in the Employee Retirement Income 

- 138 -
'this is something to be seriously looked at.'"~/ 

Although the Internal Revenue Service has ruled that 

these so-called "investment annuities" do not qualify for tax 

deferral as annuity contracts {Revenue Ruling 77-85, 1977-1 

Cum. Bull. 12), under a recent court decision, if sustained, 

it is possible that these devices can be used by high-income 

taxpayers to defer tax on their investment income while 

retaining the same, active control over their investment 

portfolios as though the annuity never had been purchased. 

See Investment Annuit~, Inc. v. Blumenthal, No. 77-810 

{D. D.C. November 9, 1 77), notice of appeal filed (D.C. Cir. 

January 3, 1978). 

The ability to defer tax on otherwise taxable 

investments (such as long-term certi ficates of deposit) by 

simply "wrapping" them in what looks like an annuity could 

turn the deferred annuity into the exclusive method for 

high-income taxpayers to purchase investment assets. This 

possibility has not been overlooked by promoters, as 

evidenced by the following excerpts from sales literature for 

wraparound annuities: 

•now DO YOU WANT YOUR INTEREST, WITH OR WITHOUT CURRENT 

TAXES?" 

* * * * 

•you NO LONGER NEED TO PAY CURRENT TAXES ON INTEREST 

AND DIVIDEND INCOME WHEN YOU UTILIZE THE BENEFITS 

OF A TAX-DEFERRED INVESTMENT ANNUITY. 

"Unlike other annuities, the investment annuity 

allows the owner to direct the investment of the 

funds within his personal custodian account. You 

may choose from a broad list of accepted assets. 

This permits you to use our high interest yielding 

certificate accounts as well as stocks, bonds and 

mutual funds." 

* * * * 

"NOW YOU ~AN DEFER INCOME TAXES ON CURRENT INTEREST 

AND DIVIDEND INCOME ON YOUR SAVINGS ACCOUNTS AND 

OTHER ASSETS. C$10,000 MINIMUM) 

"The key is a tax-deferred Investment Annuity. Under 

Section 72 of the IRS Code, certain tax advantages 

are available to holders of an Investment Annuity 

contract. 

"The Investment Annuity is a policy for long range 

- 137 -
In addition to being more attractive than taxable 

investments, the high interest rates at which tax-shelter 

annuities are being offered may actually make them more 

attractive to some high-income taxpayers than investments in 

tax-exempt municipal bonds. 3/ For example, if a taxpayer who anticipates being in a 3~ percent or lower bracket during 

retirement invests $30,000 in a deferred annuity bearing 

interest at a rate of 7 1/2 percent and elects to receive a 

lump sum cash payment after 20 years, he will realize a 

return of $87,535 after taxes and expenses. 4/ Municipal 

bonds of comparable security and matur i ty would bear interest 

at approximately 5 1/4 percent per annum. 5/ Thus, an 

investor who purchased $30,000 of such bonds, and invested 

the resulting tax-exempt income in additional tax-exempt 

bonds, would accumulate only $83,476 on his investment after 

20 years. 

What is perhaps an even more serious abuse of the tax 

treatment traditionally afforded retirement annuities is 

presented by a variation of the deferred annuity known as a 

"wraparound" or "investment" annuity. This device permits a 

taxpayer to defer paying tax on income from existing 

investments, such as bank accounts or common stocks, by the 

simple expedient of "wrapping" an annuity around these 

investments. The nature of the wraparound or investment 

annuity·, and the dangers inherent in the existing situation, 

were recently summarized in a financial journal: 

"Keystone Custodian Funds manages over $1.7 billion 

in mutual funds, but the product that has the company 

most excited at the moment comes from the company's 

insurance subsidiary, Keystone Provident Life. The 

product is called the investment annuity or 'wraparound' annuity. Keystone is joining a growing number of companies offering this instrument . 

"The investment annuity resembles other annuities 

save for this crucial difference: You determine 

what securities make up the annuity. ~n effect, the 

wraparound allows you to take an existing investment, 

use it to 'buy' an annuity and thus defer taxes on 

all interest and dividends. 

"Say you have $100,000 of 8.7% American 

Telephone & Telegraph bonds due in 2002. By 

wrapping it around an annuity, your account can 

collect $8,700 a year, and you pay no income taxes 

until you actually beg i n collecting on your plan, 

which can be, i f you wish, decades hence. 

"'For anyone in the 30% income bracket or higher,' 

says w. Thomas Kelly, chairman of the First Investment 

Annuity Co. of America, which invented the product, 

- 136 -
30 

40 

50 

60 

65 

other investments that do not provide you taxfavored interest benefits. 

"Tax deferred annuities have become enormously 

popular with successful people because the 

Internal Revenue Code permits you to pile up 

interest indefinitely, and not pay a penny of 

taxes until you take your money out--usually 

at retirement when your tax bracket is likely to 

be lower. By not paying taxes on the interest 

every year, you actually earn extra income with 

Uncle Sam's money! 

"To demonstrate how beneficial this tax 

postponement can be to you, just see what 

happens when the same amount of money is put 

into a tax-deferred annuity and a savings 

account, both at the same rate of interest and 

for the same length of time -- assuming a 

continuing interest of 7 l/2 % per year 

for the entire period illustrated. ($30,000 

is used here only as an example. You can put 

in as little as $5,000, or as much more as you 

wish.) 

BANK SAVINGS ACCOUNT TAX-DEFERRED 

ANNUITY 

35% Tax 

Bracket 

$ 30,000 

$ 48,288 

$ 77,725 

$125,106 

$158,722 

50% Tax 

Bracket 

$ 30,000 

$ 43,351 

$ 62,644 

$ 90,524 

$108,819 

$ 30,000 

$ 61,830 

$127,435 

$262,648 

$377,066 

"Your money is safe because it is guaranteed by a 

legal reserve life insurance company. Your cash value 

(never less than your total payments) may be withdrawn 

in whole or part at any time. However, as with bank 

certificates of deposit, withdrawals may be subject to 

surrender charges. 

"And you can 

put in and pay no 

principal and all 

grow tax-free • • 

take out any part of the money you taxes~ while the balance of your 

accumulated interest continues to 

" 

- 135 -
oldest and dowdiest 'investments' around. 

"Insurance. That right. Specifically, insurance 

that yields a return as high as 7% or 8% with income 

taxes deferred for as long as you tie up your money. 

"This insurance is known technically as a singlepremium deferred annuity contract. The name is a little 

misleading. You may buy a contract and add to your 

investment by paying more than one premium, and you may 

buy a contract without ever committing yourself to a 

lifetime annuity. 

* * * 

"A tax lawyer with no particular ax to grind says, 

'If you need to balance your investments with a fixedincome vehicle, and if you can get 8% that accumulates 

tax-deferred, then you're in real good shape with this 

kind of annuity.' 

"'Annuiti es have been in existence a long time,' 

Shearson Hayden Stone observes. 'Traditionally they 

carried very low yields of 2.5% - 3% and high sales 

charges, perhaps as much as 70% of the initial amount 

invested, and were therefore a poor investment.' That 

is not, Shearson hastens to add, the kind of annuity now 

being offered -- 'a modern new deferred annuity which 

features high guaranteed interest rates.'" ~/ 

Instead of being sold by insurance salesmen, tax-shelter 

annuities are being promoted aggressively by stock brokers as 

a means to accumulate tax-free income. The annuity feature 

and the provision for income during retirement play a 

distinctly subsidiary role in the marketing of these 

annuities. The following promotional literature illustrates 

their predominantly tax-shelter nature: 

"BOW TO POSTPONE TAXES LEGALLY AND EARN INTEREST ON 

UNCLE SAM'S MONEY ... With An Investment That Never 

Goes Down, Always Goes Up, And Is Guaranteed Against 

Loss. 

"If you're successful enough to be in a 

tax bracket that forces you to share at least 

35% of your top dollars with the I.R.S., you 

deserve something better than congratulations. 

You need an investment that not only is safe, 

with good earning rates, but which also allows 

you to keep more of the interest you earn than 

you can with regular savings accounts, CO's, or 

- 134 -
The rules for taxing dividends and cash withdrawals from 

annuity contracts during the accumulation period are also 

favorable. Cash withdrawals and dividends are deemed to come 

first from principal and are thus tax-free. Only after the 

purchaser has made withdrawals and/or received dividends in 

an amount greater than the aggregate premiums paid will such 

distributions be taxable. In effect, a policyholder may 

withdraw amounts equal to all or a substantial portion of the 

interest earned tax-free. 

Reasons for Change 

Traditionally, most annuity contracts purchased by 

individuals were immediate annuities. The annuity was viewed 

as a safe, conservative but low-yielding investment purchased 

by individuals who wished both to provide for income during 

their retirement and to ensure against the possibility of 

outliving their assets. 

Where deferred annuities were sold, it was typical for 

the issuer to guarantee both the rate of interest, usually 

limited by state law and quite low, at which the principal 

would grow during the accumulation period and the rates at 

which an annuity could be purchased at the end of that 

period. Although taxes were not imposed during the 

accumulation period, the relatively low yields and high 

expenses (or "loading" costs) rendered deferred annuities 

unattractive to high-income taxpayers by comparison with 

other investment alternatives (~, municipal bonds). 

In recent years the traditional role of the deferred 

annuity as a retirement income vehicle has changed 

dramatically. Emphasizing the combined benefits of tax 

deferral during the accumulation period, cash options 

providing for lump sum settlements and the tax-favored 

treatment of contract withdrawals, brokers and other 

promoters have been actively marketing deferred annuities to 

high-income taxpayers as tax shelters. The transformation of 

retirement annuities into tax shelters was summarized in a 

recent article in the financial press: 

"HIGH TAX-DEFERRED YIELDS ON ANNUITY POLICIES GIVE 

THEM FRESH APPEAL TO SOME INVESTORS 

* * * 

"As everybody knows by now, you can't outperform 

the stock market. Bond prices may fall. Commodities 

are risky. Tax shelters are leaky. Gold pays no 

interest. Savings-account earnings are taxable. So 

where's the smart money going these days? 

"Well, some of it is going into one of the 

- 133 -
IID-8 

TAX-SHELTER ANNUITIES 

Present Law 

A typical annuity contract provides for the issuing life 

insurance company, in return for a purchase price paid either 

in a lump sum or in installments, to make periodic payments 

to the purchaser, usually from the time of retirement until 

death. 1/ Annuities may be classified broadly into two main 

groups:- immediate annuities and deferred annuities. 

The purchaser of an immediate annuity begins to receive 

annuity payments on, or shortly after, the date the annuity 

is purchased. 

Under a deferred annuity, the purchaser begins to 

receive annuity payments at a time significantly after the 

date on which the contract was purchased. Payments under a 

deferred annuity generally commence when the annuitant 

attains a given age (~, 65). Between the time the 

premiums are paid and the commencement of annuity payments 

(the "accumulation period"), the premiums (after deduction of 

expenses) are invested by the company and earn interest. 

These earnings may be reinvested by the company, distributed 

to the purchaser as dividends or, in some instances, may be 

withdrawn at the purchaser's election. 

At the end of the accumulation period the premiums and 

accumulated interest (less expenses, withdrawals and 

dividends) constitute a fund that may be used to purchase an 

annuity at rates originally guaranteed by the insurance 

company. In lieu of using the fund to acquire an annuity, 

the purchaser almost always has the option of receiving the 

amount in the fund as a lump sum cash payment (the "cash 

option"). The purchaser of a deferred annuity generally does 

not lose access to the invested funds; in most cases the 

contract grants the purchaser the right to withdraw his 

premiums and accumulated interest, in whole or part, at any 

time before the commencement of annuity payments. 

Under present law the interest earned on the premiums 

deposited in a deferred annuity is not taxed to the purchaser 

during the accumulation period. Instead, a ratable share of 

this interest is taxed to the recipient as each annuity 

payment is received (or is taxed in full on receipt of a lump 

sum cash payment). The purchaser is thus permitted unlimited 

deferral of income taxes on the accruing interest until the 

end of the accumulation period (unless the contract is 

surrendered before that date). 

- 132 -
Current law and procedures will generally continue to 

apply to the review of nonpartnership matters. Such matters 

may be resolved separately from partnership matters. 

It is anticipated that the audit of the partnership will 

be conducted in the district in which the principal place of 

business or principal office of the partnership is located. 

While this may cause inconvenience to some partners under 

certain circumstances, this provision is essential in order 

to consolidate the partnership level audit effectively. 

Since a meaningful audit at the partnership level places 

great emphasis on the partnership return, the timely and 

proper filing of such return should be encouraged. The 

complete absence of civil penalties under current law for 

late filing and failure to file is inconsistent with this 

objective. Thus, under the proposal, the partnership return 

will be treated as a tax return rather than as an information 

return. Late filing and failure to file partnership returns 

will be subject to penalties. As under current law, the 

return must be filed in accordance with the location of the 

partnership's principal office or principal place of 

business. 

Effective Date 

Existing partnerships. Partnerships existing as of 

January 1, 1979 will be subject to the rules of this proposal 

starting with the second taxable year of the partnership 

beginning after December 31, 1978. 

New partnerships. All partnerships formed after 

December 31, 1978 will be subject to the rules of this 

proposal. 

Revenue Estimate 

The proposal will have a negligible effect on t a x 

liabilities. 

Footnote 

!/ Present law does not require a separate administrative 

or judicial proceeding for each partner. Any set of partners 

may voluntarily join together at any stage from district 

conference through judicial appeal, and consent to a mutually 

binding determination. However, the Service cannot require 

any group of partners to join together in a single proceeding 

and subject themselves to a mutually binding determination. 

- 131 -
In order to facilitate the audit at the partnership 

level, each general partner will be presumed authorized to 

act for the partnership. However, all partners will be 

accorded the status of interested parties and allowed to 

participate in all aspects of administrative proceedings. 

In order to ensure that all partners have a fair 

opportunity to participate in the administrative and judicial 

determination of partnership tax matters, the Service will be 

required initially to notify each partne~ that the 

partnership's books and records are being examined. At the 

conclusion of the administrative proceeding, either by 

settlement or ultimate disagreement, the Service will be 

required to issue a notice of final administrative 

determination to the partnership, and to notify each member 

of the partnership accordingly. 

The partnership level determination will be subject to 

the statute of limitations at the partnership level based 

upon the limitations rules now in effect generally. Any 

waiver of the period may be consented to by any general 

partner. Once the statute of limitations has run at the 

partnership level, the partnership's return becomes final, 

and there can be no adjustment of items on a partner's return 

attributable to the partnership. Discrepancies between the 

partner's return and the partnership's return will then be 

treated as mathematical errors. Assessments of tax or claims 

for refund at the partner level based on a final 

determination at the partnership level may be made at any 

time within one year after the partnership level 

determination has become final. Thus, the partnership 

statute of limitati ons automatically keeps the partner 

statute of limitati ons open for changes attributable to the 

partnership. 

The entity approach extends to initiating changes in 

partnership items. A partnership will be permitted to 

initiate a redetermination of partnership items by simply 

filing an amended partnership return within the partnership's 

limitations period. However, individual partners will not be 

permitted to initiate a partnership level redetermination, or 

to file individual claims for refund based upon partnership 

matters if the claims are inconsistent with the partnership 

return. 

The partnership may seek judicial review of a final 

partnership determination, or bring an action for 

redetermination upon denial of, or inaction with respect to, 

a partnership-initiated proceeding. This judicial proceeding 

must be brought in the name of the partnership. The action 

may be brought in the Tax Court, Federal District Court, or 

Court of Claims. All partners will be provided an 

opportunity to participate in the judicial proceeding. 

- 130 -
For example, the Service recently conducted a limited 

coordinated tax shelter program designed to examine a total 

of less than 100 partnerships in four primary tax shelter 

areas: motion pictures, farm operations, real estate, and 

oil and gas. This limited program resulted in the 

administrative nightmare of examining the tax returns of 

approximately 450 partnerships and 23,100 investing partners. 

In addition, over 50,000 other returns with similar issues 

were examined. These results highlight the fact that through the partnership rules, a virtually limitless number of 

taxpayers may be involved with a single partnership. The 

initial audit sample of less than 100 partnerships required 

almost 450 partnerships to be audited because of partnership 

tiering. Such multi-tiered arrangements substantially 

increase the Service's burden of locating individual partners 

and auditing their returns within the requisite statute of 

limitations period. 

, 

It has become increasingly clear that tax shelters have 

proliferated in significant part because promoters and 

investors believe that there is little risk that the Service 

can muster an effective audit against the investors in the 

shelter. Thus, highly creative and ingenious tax positions 

which are often taken by a tax shelter limited partnership 

and which are questionable under the law can go unchallenged 

because of the necessity to audit separately each and every 

member of the partnership within the requisite limitations 

periods. If, however, partnerships were audited at the 

partnership level, potential investors in tax shelters would 

have to take into account the very high probability that 

their investments will be subject to close scrutiny by the 

Service. Given the fact that under current law, most shelter 

investors do not take the possibility of extensive IRS audit 

seriously, it may be expected that the full implementation of 

this proposal will have a significant impact on shelter 

activity. 

General Explanation 

Under the proposal, the partnership will be treated as 

an entity for purposes of the audit of partnership-related 

issues, including administrative settlement and judicial 

review. The Service will make determinations at the 

partnership level of the correct amount of partnership ~axable income or loss, and the partners' distributive shares ~f partnership items. This determination will be conclusive, 

and the individual partners, as well as the Service, will be 

precluded from seeking any further substantive review. As 

under current law, the member partners will remain subject to 

any changes in tax liabilities resulting from a determination 

of these issues, but a subsequent audit of a partner's return 

will be limited to the correct mathematical application of 

the partnership level determination. 

- 129 -
FIRST TIER 

SECOND TIER 

THIRD TIER 

FOURTH TIER 

TOTAL RETURNS 

Individual at least 80 

& Corpol'ltll 

Partnership 9 

at least89 

1 

PARTNERSHIP 

36 PARTNERS 

30 

INDIVIDUALS 

& CORPORATIONS 

UNDETERMINED 

NUMBER OF 

INDIVIDUALS AND 

CORPORATIONS 

1 

PARTNERSHIP 

2 PARTNERS 

1 

CORPORATION 

6 

PARTNERSHIPS 

?PARTNERS 

1 

PARTNERSHIP 

1 PARTNERS 

UNDETERMINED 

NUMBER OF 

INDIVIDUALS 
FIRST TIER 

SECOND TIER 

THIRD TIER 

TOTAL RETURNS 

Individuals 

Trusts 

Partnerships 

at least 16 

at least 7 

at least 4 

at least 27 

1 

INDIVIDUAL 

UNDETERMINED 

NUMBER OF 

BENEFICIARIES 

1 

PARTNERSHIP 

5 PARTNERS 

3 

TRUSTS 

15 

INDIVIDUALS 

1 

PARTNERSHIP 

21PARTNERS 

4 

TRUSTS 

UNDETERMINED 

NUMBER OF 

BENEFICIARIES 

2 

PARTNERSHIPS 

UNDETERMINED 

NUMBER OF 

PARTNERS 
FIRST TIER 

SECOND TIER 

THIRD TIER 

TOTAL RETURNS 

Partnership 1 

Others 69 

76 

1 

PARTNERSHIP 

2 PARTNERS 

1 

EXEMPT 

ORGANIZATION 

1 

ORPORA 

TION 

1 

PARTNERSHIP 

4 PARTNERS 

1 

PARTNERSHIP 

19 PARTNERS 

19 

INDIVIDUALS 

1 

PARTNERSHIP 

1 PARTNERS 

4 

CORPORA 

liONS 

1 

CORPORA· 

TION 

1 

PARTNERSHIP 

4 PARTNERS 

1 

PARTNERSHIP 

27 PARTNERS 

27 

INDIVIDUALS 

1 

PARTNERSHIP 

11 PARTNERS 

14 

INDI· 

VI DUALS 
During the period 1972 through 1975, the total number of 

partnerships grew by only 8.2 percent. The larger 

partnerships, however, proliferated much more rapidly. The 

largest growth occurred in partnerships with 501 or more 

partners, which increased by 76.4 percent during the 

four-year period. 

These large partnerships are most often involved in 

coast-to-coast tax shelter activities. For example: 

o One promoter has put together over 35 partnerships 

involving over 55,000 partners, for an average of 

over 1,500 partners per partnership. One of these 

partnerships has more than 7,500 partners. 

o A group of promoters established over 350 

partnerships with more than 3,000 separate limited 

partner interests. The investors are located in 

all seven Internal Revenue regions, and in 52 out 

of the 58 Internal Revenue districts. 

o Another promoter created over 20 partnerships 

involving over 5,000 separate investments and more 

than 1,600 limited partner investors located all 

across the country. Some of the partnerships have 

more than 400 partners. 

Size alone is not the only troublesome factor. 

Partnerships may be "pyramided 11 in multi-tiered arrangements 

of enormous complexity. Examples of such arrangements appear 

on the following pages. Tiering is possible since 

partnerships may include as partners not only individuals, 

but other partnerships, as well as corporations, trusts, and 

other entities. 

If a trust is a partner, an additional layer of 

complexity is added as beneficiary returns must be 

identified, located, and controlled. Worse still, is the 

partner that turns out to be a partnership. In such 

arrangements, usually part of tax shelter schemes, tracing 

may be extremely difficult. Once it is discovered that an 

entity being audited is a partner, or that a partnership 

includes as a partner another partnership, it may take many 

months to identify completely the next partnership tier. New 

partnership identification numbers are frequently only 

"applied for" and partnerships frequently file in districts 

other than the one in which their address is located. 

Moreover, in a multi-tier situation, the audit will not 

always begin with the top tier. If the audit begins 

elsewhere, as it frequently will, the Service must cope with 

expanding and controlling the audit as upper- and lower-tier 

entities are identified. 

- 125 -
Table II E-7 

Administration's Pension Integration Proposal 

Effect on 

Select-ed 

Present Plan: 100% of final average 

pay, offset by 83 1/3% 

of primary insurance 

amount. 

Private pension benefits only 55% 70% 84% 

Private pension and social 

90% 94% 95% 

security benefits 109% 106% 103% 101% 101% 101% 

Plan under Proposal: 100% of final average 

pay, offset by 100% 

of primary insurance 

amount. 

Private pension benefits only 46% 64% 81% 89% 92% 94% 

Private pension and social 

security benefits 100% 100% 100% 100% 100% 100% 

Office of the Secretary of the Treasury January 2 541 1978 

Office of Tax Analysis 

y 

y 

Assumes emplovees retire at age 65 in 1982 with 35 years of service with employer. 

Pinal average pay is assumed to be average over the last 5 years1 earnings are assumed 

to increase at 6' per year. 

3/ The , Social Security amounts shown do not reflect the special transition minimum benefits 

available for retirees in the early 1980's. Thus, the numbers reflect patterns of replacement which will be in effect under the Social Security Amendments of 1977 after the 

transition period. 
The new rules will apply only to benefits accruing after 

the effective date, so that even if an employer chose to · increase benefits for some employees, the employer would not 

be required to fund any increased benefits for periods prior 

to the effective date. 

Also, because elaborate rules will no longer be 

necessary, administrative costs will decrease for all 

integrated plans. For ~nstance, the current rules provide 

different types of adjustments for different types of plans, 

different benefits, and persons retiring in various years. 

The proposal will require only minor adjustments in such 

cases. 

Effective Dcte 

The new formulas will apply to benefits accrued for plan 

years beginning after December 31, 1979. 

Revenue Estimate 

It is not possible to project the revenue impact of this 

proposal: the proposal may have a negligible impact on 

revenues. Some employers would change their plans by 

providing higher benefits for rank-~nd-file employees: others 

might shift their costs by providing somewhat lesser benefits 

for higher-paid persons to meet the need for more benefits 

for the lower-paid. It is also possible that the simplified 

rules and the provision of minimum benefits would encourage 

some employers to integrate previously nonintegrated plans. 

Technical Explanation and Transition Rules 

In general -- The current rules relatiog to Social 

Security integration will be replaced with a rule under which 

a plan will not be viewed as discriminatory in favor of 

officers, shareholders, or highly compensated employees 

merely because it provides benefits or contributions in the 

form of: 

X percent of total compensation not in excess of a 

specified integration level, plus no more than 

1.8 times X percent of total compensation in excess of 

that level. 

G 

The rule will apply to both defined contribution and defined 

benefit plans and to plans providing unit or flat benefits. 

The X factor will be specified by the employer. 

Adjustments for any pre-retirem~nt ancillary benefits, 

post-retirement annuity forms, early retirement benefits, or 

employee contributions will be required only to the extent 

these features are internally inconsistent. For example, an 

- 160 -
X percent/l.BX percent plan will not have to adjust if 

employee contributi ons are Y percent up to the integration 

level and 1.8Y percent in excess of that level (e.o., 3.0 

percent and 5.4 percent). If, however, employee 

contributions are a constant percentage of all compensation, 

an adjustment will be required. Also, a plan will not have 

to adjust if the annuity is payable in the form of a 10-year 

certain and continuous benefit, so long as the annuity both 

above and below the integration level is paid as a lG-year 

certain and continuous benefit. And no adjustment will be 

required even though some plans might use different types of 

compensation (c areer average pay, final average pay, etc .), 

so long as the same type is used to compute benefits both 

above and below the integration level. 

Each separate plan of an employer will be required to 

satisfy the new rules, or all plans maintained by ?n employer 

can be agg r egated to satisfy these rules. Thus, for example, 

if an employer maintains an integrated plan and a 

nonintegrated plan, contributions or benefits under both 

plans can be aggregated to determine whether the new 

integration requirements are satisfied. (However, 

aggregation will ' be limited to plans which provide similar 

degrees of retirement security. For example , a profit 

sharing plan allowing discretionary withdrawals of employer 

contributions prior to death , disability, or other separation 

from service could not be aggregated with a pension plan, 

since the two plans do not provide similar degrees of 

retirement security.) Further, as under present law, a plan which does not satisfy the integration rules might 

nonetheless be nondiscr iminatory under the particular facts 

and circumstances. 

Excess plans -- The integration level for c definec 

contribution or a defined benefit excess plan \~ill be 

computed in much the same manner as is provided under the 

current rules. For plans which use the Social Security wage base to measure the integration level (such ~s a profit 

sharing plan), the maximum permissible integration level for 

a particular year will continue to be the Social Security 

wage base for that year as dete rmined under the Social 

Security Act. These are fixed amounts ranging from $17,700 

to $29,700 for 1978 through 1981, with automatic acjust~ents 

after 1981. A plan will not be permitted to us e a higher 

integration level with a smaller spread between the 

percentage of contributions above and below the higher level. 

That option would introduce significant complexity and would 

reintroduce the problem existing under the current rules of 

disproportionately large benefits for a very highly compensated participant. 

For plans using an integration level based upon covereo 

compensation, the Internal Revenue Service will provide new 

tables of covered compensation. These tables will not take 

- 161 -
into acco unt the newly enacted indexing provisions of the 

Social Security Act, since the future level of indexing 

cannot be precisely for eczst during any current year. The 

table amounts will be maximums: a plan will not be able to 

use a higher level of covered compensation by adopting a 

smaller benefit spread. 

Offset plans -- Offset plans maintain a diff€rent 

benefit structure and , therefore, will use a different rule . 

An offset plDn will be permitted to reduce the gross benefit 

provided under the plzn (the plan benefit befor e reduction 

for Social Security, usually expressed as X percent times 

fin a l average pay) with tha t portion of the Social Security 

primary insurance amount (PIA) equal to the sume percent of 

the gross benefit percentage . That is, a plan will be 

permitted to offset up to 50 percen t of Social Security if it 

applies the offset against a gross benefit of 50 percent of 

compensation, or a plan can offset 100 percent of Soci a l 

Security if it applies the offset against a gross benefit of 

100 percent. 

The rule for offse t plQns will apply to both unit 

benefit and flat benefit plans. No adj ustments will be 

required for pre-retirement ancillary benefits, 

post-retirement annuity forms, or ea rly retirement ben e fits. 

However, the plan benefit de rived from em9loyee contributions 

will have to be subtracted from the gross benefit befor e 

determining the size of the a llowable offset. ~djustments 

for form of pay will have to be made only if compensation 

other than final average ~ay is used. In that c~se, the 

employee's gross benefit will be determined and d ivided by 

final average pay to ascertain the equivalent X. 

Transition tules -- The new formulas will apply only to 

benefits accrued after the effective da te. Benefits accrued 

up to that date can be frozen at their leve ls under current 

law. In the case of a final average pay excess or step- rrte 

plan, the benefits can be prorated, based on years of 

participation, to determine benefits accruing before and 

after the effective date . Alternutively, the benefit accrued 

up to the effective date, as if the employee terminated on 

that date fully vested, can be used to determine 

pre-effective date accruals. Similar proration rules will 

apply to offset plans. However, in lieu of these pror a tion 

rules, a plan can provide a minimum total benefit for e?ch 

employee (other than a 10 percent s~areholder) equal to the 

employee's benefit computed under the plan as in effect 

immed1ately prior to the effective date , determined as 

though the employee's compensation continued until r e tirem?n t 

or severance at the same rate as immediately prior to the 

effective date. 

These transition rules ~re the same as thos e currently 

in use for transitions from the rules in effect 9rior to 

- 162 -
July 5, 1968. The grandfather rules permit a gradual 

phase-in of the new integration requirements. 

Footnotes 

1/ The Revenue Bill of 1942 , H. Rep. No. 2333, 77th Cong ., 2d 

Sess., 50-51 (1942). 

~/ Raymond Schmitt, "Integration of Private Pension Plans 

with Social Security," Issues in Financin Retirement Income, 

Studies in Public Welfare Paper No. , prepare or t e use 

of the Subcommittee on Fiscal Policy of the Joint Economic 

Committee, U.S. Congress (Washington, 1974}, pp. 173-200. 

ll The executive receives an after-tax pension of $85,145, 

compared with $14,713 for the lower-paid worker. The 

executive's pension includes $53,625 in tax subsidy, compared with only $5,655 for the lower-paid worker. Assumptions: 

Nonintegrated, 15% defined contribution plan: participation 

ages 35 to 65; 6% annual interest; 4% annual salary increases; joint returns; both employees have outside income 

equal to deductions and exemptions . The percent of tax 

subsidy is the ratio of the after-tax pension with tax 

benefits compared to the after-tax pension without tax 

benefits. "With tax benefits," 15% goes into a qualified 

plan; "without tax benefits," the same amount, reduced by 

taxes paid, goes into a savings account at 6% annual 

interest. 

!/ Note that even in a nonintegrated plan, most of the dollQr 

amount of the contribution, and therefore the tax benefits, 

goes to the highly paid person, because nondiscrimination is 

based on a percent of pay. 

- 163 -
IIE-3 

MEDICAL, DIS~BILI Y, ~ND LJPE INSURANCE 

PROVIDED BY EMPLOYER 

(1) PLANS WITH PIXED BENEFITS 

Present Law 

An employee can exclude from gross income the medical, 

disability, and group term life insurance benefits provided 

under plans mainta ined by his or her employer, even thoug h 

the employer c an deduct plan contributions l/ and even though 

such a plan (referred to hereafter as a welfare plan) 

discriminates in fa vor of the highly paid. Retirement plans, 

on the other hand, do not receive favorable tax tr ea tment if 

they so discriminate. Similar nondiscrimination requirements 

apply to qualified group legal services plans and 

supplemental un employment compens~tion pl ans. 

Reasons for Change 

Un de r current law, an individual cannot deduct the 

premiums paid for life ana disability insurance, and pr emiums 

for medical insur~nce are usually only ?articlly tcx 

deductible . Thus, the exclusion for benefits provided under 

an employer-sponsored plan affords more favorable tax 

treatment for those covered thQn is avai l abl e for those who 

must purchase individua l coverage. 

Non-taxation of c e rtain forms of income is obviously of gre ter be nefit to those in higher marginal tax brackets and 

interferes with the policy of a progressive income tax. This 

departure from normal tax policy can be justified only as a 

means of s ecuring protection for a wide group of employees. 

There is no r eason to f avor plans which cover only a highly 

paid group--persons who c~n mor e readily provide for 

themselve s than can r ank- and-file employees. 

Current law has led to two p~rticu arly abusive 

situations. Pirst, unfunoed medical r e imbursement plans ccn 

be established to cover primarily the stockholders or 

office rs of a corporution . Although such a plan mcy cover 

one or a small number of r?nk- and-file employees for the 

purpose of countering an argument by the Internal Revenue 

Service that distributions constitute dividends, it results 

in clear discrimination against r ank -and-fil e employee s. 

Second, a corpor a tion having a single dominant employee (who 

- 164 -
is also the sole or majority shareholder) can adopt a funded 

or unfunded plan solely to make that employee's health 

insurance premiums or medical expenses fully deductible. 

In the course of auditing returns, Internal Revenue 

Service agents have found numerous cases of medical plans 

providing coverage primarily, or only, for 

employee-shareholders and officers of the employer. The 

following are some specific instances of this problem 

reported by IRS auditors:' 

(1) Corporztion A established a medical plan for its 

three officer-shareholders. No other employees were covered. 

Over a three year period, $54,000 in medical bills for 

officers and their families were paid by the corporation. 

Over $46,000 of this amount was for the majority shareholder 

and the shareholder's family. 

(2) Corporation B established a medical plan covering 

both officer-shareholders and some other employees, but with 

small amounts of coverage for the other employees. Over an 

eight year period during which the corporation expended $21,794 in connection with the plan, $18,604 was for the 

officer-shareholders. 

(3) Corporation C adopted a medical reimbursement plan 

for all corporate officers, including the person who owns 100 

percent of the corporation's stock. The corporation employs 

a number of other employees, none of whom are covered by the 

plan. The child of the 100 percent shareholder will require 

institutional care for life. The expenses of the child ~verage $8,000 ~nnually. The 100 percent shareholder is in 

the 50 percent income tax bracket and would not be able to 

deduct ~ significant part of the medical expenses because of 

the 3 percent floor applicable to individuals. The pl~n 

discriminates seriously against rank-and-file employees, and 

the sole shareholder, through control of the corporation, is 

able to circumvent the limitations on medical expense deductions for individuals. 

(4) In a similar situation, corporation D adopted an 

accioent and heath plan for the benefit of the individual who 

is both the sole shareholder and the sole employee of the 

corporation. Since there are no other employees, the plan is 

not cctually ~iscrimin~tory. However, the sole shareholder 

is in a position in which the limitations on the medical 

expense deduction for individuals would result in no 

allowable deduction. The adoption of the plan by the 

corporation causes a deduction to be available where it would 

not be available for the ordinary taxpayer who is not able to 

use a business entity to deduct medical expenses. 

The cases cited here are not isolated. Furthermore, 

these schemes are being actively promoted, as witness an 

- 165 -
advertisement in the January 17 , 1978, Wall Street Journ a l 

entitle6 nrntroducing ••• The Ultimate Tex Shelter" by Ted 

Nicholas. Mr. Nicholas , who promot~s his book on the 

advantages ot incorporated businesses, writes: 

"rher e are still other adv?nt?ges . Your own 

corporation ena bles you to mo r e easily maintain 

continuity and f ac ilita t 0 t r a ns fer of ownership. Ta xfree fringe benefits can be arr~ ng ed . You c an set un 

your health and life insurance ?nd o t he r programs for 

you and your family wherein they ~ trx ~e0uctib . 

~nether very important option availa ble to you through 

incorpor ation is a medica l reimbursement pl n (MRP ). 

Unde r an RP, a ll medical , den t a l, ph? rmaceutical 

e xpenses for you and your family can become tax 

deduc tible to the corporation . ~n unincorpor2te6 p~ son 

must e xclude the fi r sc three percen t of family's me ic ! expenses from a pe rsone l tax r e turn. For an 

in6ividual ea rning $2U , U00 t he f i rst $600 ? r e not 

ded uctibl e ." 

General Explanat ion 

Unde r t he ~roposal, special tax benefits will continue 

to be fully available with respect to an empl oye r' s me~ical , 

d isability, or group t erm life insurance plan only if thP 

pl an s a tisfi es c e rtain minimum pa rtic ipation standards 

oesigned to pr e vent disc rimin ation, and if the olan does not 

d iscrimina te with regard to the benefits it provides. ~,us , 

tne pla n could not 6iscriminate in favor of officers, 

shareholders, or highly paid employees -- i.e. the so-ca lled 

prohibited group, consisting of the same employees who are 

members of the prohibited group unde r the qualified 

retirement plan provisions. If benefits e re provided un6e r a 

discriminatory plan, employer contributions to the plan 

a lloca bl e to members o f the prohibite o group will be 

includible in t he gross incomes of a ll cove r ed members of the 

prohibited group. Exclusions for rank-and-file employees 

will continue to apply. 

In addition, in order to deny speci a l tax benefitsf for 

what is essentially an inoividual purcha se of insur ance, a 

limit will be established on the portion of the benefits 

provided for employee-owners. Similar conditions were 

applied to group legal service s pl ans under the Tax Re form 

Act of 1976. 

Effective Date 

The new rules for welfare plans will apply for taxable 

years of employers beginning afte r December 31, 1978. 

- 166 -
Revenue Est1rnate 

Change In Tax L1ab1!1ty 

(Including proposal on Cafeteria Plans described below) 

($ millions) 

1978 1979 : 

32 

Technical Explanation 

Calendar Years 

1980 

33 

. . 1981 

34 

1982 19 83 

35 36 

Plans Covered -- The proposal will apply to group t e rm 

life 1nsurance plans and accident and health pl ans which now 

receive favorable tax treatment under sections 79, 105 , and 

106 of the Internal Revenue Code. Benefits under these oluns 

include term life insurance: payments during permanent or 

temporary disability: hospitalization, ~edical, and surgical 

benefits: and dental care. However, if any of these benefits 

are provided under a qualified retirement plan, the 

retirement plan rules will continue to apply. 

Prohibited Group -- Discrimination in favor of e 

prohibited group of employees, consisting of officers and 

shareholders of the employer and those who a r e highly 

compensated, will not be permitted. This same definition of 

the prohibited group now is used for qualified r etirement 

plans. 

In the qualified plan area, there were previously 

attempts to circu~vent the nondiscrimination r equir emen ts by artificially dividing a single business into two corporztions 

under common control, with the members of the prohibited 

group employed by one corporation an d the rank-~n -fil c 

employees employed by the other corporation. The corporation 

employing the prohibited group would then establish a 

retirement plan, contending that the rank-and-file employees did not have to be covered by the plan because they were not 

employed by that corporation. ERISA attacked this problem by 

treating a ll employees as employees of a single employer when 

their employers are under common control. This will occur 

whether the employers are corporations, partnerships, or a 

mixture of those or other types of entities. The ERISA 

common control rules will apply to welfar e plans. 

Participation Standards -- (a ) Waiting Per1oo. ~ plan 

will not be able to provide more stringent concitions on 

- 167 -
participation for rank-and-file employees than for members of 

the ~rohibited group. For ex ample, a member of the 

prohtbited group could not be come a participant imm diat~ly 

upon employment if a member of the rank- and-file could 

participate only a fter on e yea r of employment. 

A plan shoulc not be requir ed to provide immediate 

coverage, since adverse s e l e ction agains t the plan could 

result. On the othe r han d , too long a wa iting period could 

unduly favor the prohibited group, the membe rs of which ofte n 

will ha ve mor e years of service a t the inception of the plan. 

Ther e fore, a plan will not be dis crimin a tory me r e ly beca use 

it requires up to three ye a rs of actu? l employment before 

commencement of pa rticipa tion. Moreover, the plan could 

defer pa rticipa tion until the firs t day of t he pl a n yea r 

beginning after the date on which an employee comple t ed t hr ee 

ye a rs of employment. 

~ wel far e pl an c an a lso mee t t he pa rticipation 

requirements by s a tisfying the ERISA participation rules for 

qualified plan s (se ction 410( a ) of the Code ). 

(b) Permanenc e . If a we lfa r e plan provides cove r age for 

members of the prohibited group, it will be nond iscriminatory 

only if i t constitutes a pe rmanent progr am. The test for 

permanence will be applied in the same fashion a s the simila r 

test is applied to qua lified pl ans unc e r s e ction 40l( a ) of 

the Code. That is, a we lfare pl an will be presumec to be 

permanent at the time it is established . If the pl an is 

terminated within a few years and in the absence of a 

business necessity, it may be he l d to be discrimin a tory from 

its inception. This rul e is de s i gned to preclude the 

establishment of a plan prima rily for the purpose of 

benefitting a membe r of the prohibited group, with 

termin a tion occurring a fter that member or a bene ficiary ha s 

rece ived a significant portion of the tota l benefits provided 

under the plan. 

(c) Eligible Group. Qualified retirement plans 

historically have been subject to alterna tive tests for 

nondiscrimination in cover age. Under the rul e s in effect 

since 1942, a qualified plan will not be dis crimina tory if 

the plan provides benefits for: (n) 70 percent or more of 

all employees, or 80 percent or more of all employees who are 

eligible to benefit under the plan if 70 percent or more of 

all the employees a re eligible to bene f it un der the plan, 

excluding employees who ha ve not s a tisfied the plan's 

qualifying minimum age and service requir ements, or (b) a 

group which the S~rvice finds to be nondiscrimin a tory. The se 

coverage tests will apply to welfare plans. As under ERISA, 

nonresident aliens and employees covered by colle ctive 

bargaining agreements (if there is evidence that we lfare 

benefits were the subject of good faith bargaining) can be 

excluded from consideration in determining whether the 

- 168 -
coverage requirements are satisfied. ~lso, if a welfare plan 

is maintained pursuant to a collective bargaining agreement, 

the plan will automatically be viewed as nondiscriminatory 

with respect to eligibility (and benefits). The latter is 

not the rule under ERIS~. 

Benefit Standards -- A plan cannot discriminate on the 

basis of benefits. With regard to benefits (such as· disability or life insurance) which are generally designee to 

replace wages, discrimination generally will not occur where 

benefits are proportionate to compensation. Thus, for 

example, a plan will be able to provide twice as much life 

insurance coverage for an employee in the prohibited group 

whose compensation is double that of a member of the r~nk-and-file. 

In the case of health benefits (such as hospitalization, 

surgical, and medical benefits), the pl cn will have to 

provide the same benefits, dollar for dollar, for all 

employees and, where applicable, for members of employees' 

families. Howe ver, some pl ans provide options under which 

the level of benefits will vary with the level of 

contributions made by participating employees. 

Discrimination generally will not occur where the same 

employee contribution buys the s~me level of benefits and all 

employees have the same opportunity to make every level of 

employee contributions allowed under the plan. 

Discrimination will exist where there is employer coercion or 

if not more than an insignificant portion of the 

rank-and-file employees can reasonably afford the higher 

contributions. Discrimination will not exist merely because 

a significant number of rank-and-file employees choose to 

make smaller contributions and therefore receive smaller 

benefits or merely where, because of family status, a 

significant number of rank-and-file employees elect cheaper 

single-only coverage, whereas prohibited group employees make 

larger contributions and receive family coverage. 

Limits on Benefits for Owner-Employees 

Not more than 25 percent of the employer contributions 

can be used to purchase benefits for a class of individuals 

each of whom owns (directly or indirectly) an ownership interest of more than 10 percent. For example, assume that 

two individuals each own 50 percent of the stock of a 

corporation which employs both of them and one other 

individual. If contributions used to provide benefits for 

the shareholaers exceed 25 percent of the total employer 

contributions under the plan, allocable employer 

contributions will be includible in the gross incomes of the 

shareholders even though all three employees are coverPd by 

the plan. (In the case of benefits which are generally 

designed to replace wages, this test can be applied on the I 

- 169 -
basis of benefits rather than contributions.) A similar g~neral rule applies to qualified group legal s ervices plans, 

but at a level of 5-percent ownership. Implementation of 

this rule at the level of 10-percent ownership matches the 

level at which the stricter rules for Keogh plans covering owner-employees become applicable . 

In the case of an unfunded medical reimbursement plan with 25 or fewer participants, this limitation will be based 

on amounts of reimbursement rather than contributions. If 

such a plan has more than 25 participants, the test for 

discrimination in benefits will be based on benefits promised 

und er the plan. 

Determinations by Internal Revenue Service -- The 

Internal Revenue Se rvice will not make advance determinations 

regarding whe ther a welfare plan is nondiscriminatory. 

Determinations r ega rding discrimination will be made on audit 

and will be applied retroactively only if the Internal 

Revenue Se rvice further determines that the employer did not 

make a reasonable effort to meet the discrimination 

requirements or that the permanence requirement has not been 

satisfied. Alternat ively , the plan will not be viewed as 

discriminatory for a past plan year if, within a reasonable 

time after the Internal Revenue Service determination, the 

plan can be (and is) made nondiscriminatory for the plan 

year. 

(2) CAFETERIA PLANS 

Present Law 

Some plans provide only a single type of benefit, such 

as medical benefits, or various types of benefits in 

proportions fixed by the terms of the particular plan. Those 

plans are subject to the nondiscrimination proposal described 

above. Other plans, known as "cafeteria plans," are 

structured differently. These plans provide that a 

participant may designate how an employer contribution on the 

employee's behalf should be spent. In some cases, the 

participant may have the employer contribution paid, in whole 

or in part, in cash. If the participant's only choice is 

among benefits which, considered individually, would not 

result in the inclusion of any amount in gross income, the 

availability of the choice will not create immediate income. 

However, different rules apply if the participant may choose 

among benefits and at least one of those benefits, if offered 

separately (e.g., cash or group term life insurance in excess 

of the excludable amount), would immediately be includible in 

gross income. 

- 170 -
As a result of ERIS~, an employer contribution to a 

cafeteria plan in existence on June 27, 1974, must be 

included in a participant's gross income only to the extent 

that the participant elects to apply the contribution to a 

taxable benefit. If the pl an was not in existence on 

June 27, 1974, the employer contribution will be includibl e 

in the participant's gross income to the extent that the 

participant could have e lected to apply t he contribution to a 

taxa ble benefit or bene fits. These rul es apply with r espect 

o employer contributions made befor e J anu a ry 1, 1978. ERIS~ 

joes not provide specific guidance for contributions made 

the reafter. 

Reasons for Change 

A cafeteria plan ~ay d iscriminate in favor of highly 

compensated employees of t he employer, This c an occur in 

either of two ways. First, r ank- and-file employees may be 

excluded from coverage under the plan. Second, the plan may 

cove r rank-and-file employees and provide for the al loca tion 

of employer contributions proportionate to compens a tion. In 

such cases, a nk-and-fil ~ employee often may obta in 

adequa t e medical benefit coverage only by designating most or 

all of that a lloca tion to pay for medical benefits, which a r e 

typically the most e xpensive benefits provided under the 

pl an. Since membe rs of the prohibited group receive la rger 

allocations of employer contributions, the y a r e able to 

purchase the same level of med ical coverage plus other 

tax-favored ben e fits which a re not available, as a pr actical 

matter, to the r ank-and-f ile participants. 

The state of the law r ega rding cafeteri a pl ans for the 

future is unsettled. Moreover, even under pre-19/d law, the 

tax treatment of a participant could diffe r significantly 

depending upon whether the plan was in e xistence on June 2/, 

1974. 

General Explanation 

If a cafeteria plan does not discrimin te in the 

distribution of tax-free benefits between the r ank-and-file 

and the prohibited group (officers, shareholders, end highly 

paia), then an employer contribution allocated to the account 

of a participant will be includible in the participant's 

gross income only ~o the extent tha t the participant 

designates all or part of the contribution to be used to 

purchase taxable benefits. 

The nondiscrimination t e st will require that the plan 

give employees an equal opportunity to select tax-free 

benefits (nondiscriminatory coverage). Also, in practice 

rank-and-file employees could not disproportionately elect to 

receive taxable benefits in cash or otherwise 

(nondiscriminatory distribution). 

- 171 -
Nondiscrimination generally could be measured with 

respect to contributions or benefits. However , a cafeteria 

plan providing health benefits will not be viewed as nondiscriminatory merely because each employee is allocated an 

equal percentage of pay . Such a plan will have to 

demonstrate either that overall benefits do not discr i minate 

in favor of the prohibited group or that health benefits are 

provided equally and that contributions for other benefits 

represent an equal percentage of pay. 

If a cafeteria plan discriminates in favor of the 

pr ohibited group , all employer contributions to the plan 

?llocateo to members of the prohibited group wiJl currently 

be includible in the gross income s of all covered members of 

the prohibited group . Rank-and-file participants will 

include only the amounts they designate to be used to 

purchase taxable benefits. 

Effective Date 

The new rules for ca feteria plans will apply for t a xable 

years of employers beginning after December 31 , 1978. 

Technical Expl anation 

Plans Covered -- The proposal will apply to those 

welfare pl~ns which allow a perticipant to designate , to any 

extent, the amount of aJlocable employer contributions which 

may be used to purchase any particular kind of benefit . 

Benefit and Contribution Standards. --For ca f ete ria plans 

which do not provide health benefits, a two-step test will 

apply for determining nondiscrimination. First, the plan 

will have to be nondiscriminatory on the basis of ~ither 

contributions or benefits. ~ pl~n satisfying the coverage 

requirements generally applicable to welfare plans and alloc~ting an equal percentage of pay to each participant 

will meet this test. 

~dditionally, the plan will have to be nondiscrimin a- tory in oper a tion with respect to the allocation of taxable 

contributions or benefits. The plan will be discriminatory 

if the allocation of contributions to taxa ble benefits made 

by rank-and-file employees is significantly higher, as a 

proportion of the total a llocation of contributions made by 

those employees, than the allocation of contributions made by 

members of the prohibited group. Any differences 

attributable to different family situations will be 

disregarded for this purpose. Alternatively, this 

me2sur ement c a n be mcde on th~ ba sis of be nefits by applying 

the nondiscrimination test applicable to plans not of the 

caf~teria type. 

- 172 -
Although measurement of discrimination can be made on 

the basis of either contributions or bene fits, the same ba sis 

for me a surement will have to be used for both parts of the 

two-step test. 

For a cafeteria plan providing hea lth benefits, the t est 

will be somewhat different if t he plan chooses to determine 

nondiscrimination on the basis of contributions. SincP nondiscrimination in health benefits under a welfare pla n must 

be determined without regard to compens a tion, a c~feteria 

plan which allocated to participants an amount equa l to a 

specified percentage of pay to be used for health and othe r 

benefits will be conside red discriminatory . The r efor e , in 

addition to an allocation based on a percentage of pay, there 

will have to be an equa l dollar allocation sufficient to 

enable lowe r-paid employees to pu rchase basic health benefits 

without precluding them from obtaining othe r benefits unde r 

the pl an. Basic health benefits will generally be the amount 

of health coverage selected by the majority of the prohibited 

group in a similar family situation. 

Footnote 

1/ In the ca se of gr oup term life insurance, the exclusion is 

Iimited to contributions for insurance not in excess of 

$50,000 . There is a lso a limit on the 2mount of disab ility 

benefits which may be excluded from income . 

- 173 -
IIE-4 

EMPLOYEE DEl\TU BENEFI'r5 

Present Law 

Up to $5,000 of the death benefits paid by en employer because of the death of any employee can be excluded from the 

gross income of the employee's beneficiaries or estate. This 

exclusion applies to direct payments anc to less direct 

payments, such as lump sum distributions from qualified 

retirement plans. 

Reasons tor Ch~nge 

The value of an exclusion v~ries directly with an 

employee's marginal tax rate. For individuals with income 

below taxable levels, it obviously is of no significance 

whether certain compensation is exempt or not. On the other 

hand, at a 50 percent or higher bracket, nontaxable benefits 

are equivalent to twice the amount of cash or more. It is, 

therefore, directly contrary to the principles of a 

progressive tax system to exempt compensation from tax. 

The death benefit exclusion is largely a benefit for 

wealthy individuals, not only because their marginal income 

tax rates are the highest but also because they are more 

likely to receive death benefits which equal or exceed the 

full amount of the exclusion. Lower-paid individuals receive 

smaller death benefits, if any. 

Further problems have arisen where courts have allowed 

an employer to deduct an amount which is, in essence, a death 

benefit but, at the same time, the recipient has been allowed 

to treat the payment as an excludable gift. 

General Explanation 

In many c~ses, a de~th benefit is clearly designated as 

such by the death benefit plan or other plan under which it 

is provided. In such cases, the exclusion for death benefits 

paid by employers will be eliminated. 

In other cases, the status of a benefit as a death 

benefit or gift is not as clear from the terms of the plan or 

arrangement under which payment is made. l\ payment will be 

treated as a death benefit in any case in which it is 

.occasioned by the death of an employee and deducted by the 

employer. However, if the employee owns more than a 10 

percent . ownership interest in the employer or is an officer, 

- 174 -
any payment occasioned by the employee 's death will be 

tr eated as a death benefit whether or not deductec by the 

employe r. In either c2se , the amount viewed as a death 

benefit will be includible in gross income by the recipient. 

The beneficiaries of employees at all income l evels, 

including lower-paid employees, will continue to receive the 

protection of the exclusion for life insurance proceeds. 

Effective Date 

The elimination of the death benefit exclusion will 

appl y to benefits paid after December 31, 1978. 

Revenue Est1mate 

197H 1979 

32 

Technical Explanation 

Change In Tax Liability 

($ millions) 

Calendar Years 

1980 1981 

32 33 

1982 

33 

1983 

34 

~ payment made by an employer to the surviving spouse or 

other beneficiaries of a deceased employee is often claimed 

by the r ecipient to be excludable as a gift. Sometimes this 

occurs even though the employer claims a deduction not 

allowable in the case of a gift. Under the proposal, if an 

employer claims a deduction for the payment, the payment will 

be includible in the gross income of the r ecipient or 

recipients. The fact that the employer con sidered the 

payment to be an expense deductible for income tax purposes 

would indicate that the payment was not viewed as a 

gratuitous transfer. Also, if the deceased employee own ed 

more than a 10 percent ownership interest in the employer or 

was an officer, the payment will be includible in the gross 

income of the recipient whether or not deducted by the 

employer. 

It is not clear under present law whether benefits 

payable under a self-insured plan (perhaps payable from a 

separate trust) 2re excludable from income as life insurance 

proceeds. Such a plan could be subject to serious abuse. 

For example, an empl oyer might set up a self-insured life 

insurance plan for a non-discriminatory group of employees, 

with the expectation that benefits will be provided primarily 

upon the death of the controlling employee. If the 

- 175 -
controlling employee we re to d i e shortly a ft e r the pl an wa s 

established, the benefits payabl e to his or her bene fici a ries 

might exce ed the total ass e ts of the plan. T~ n, t he 

employer would ma ke an addition a l, ccductible c~ntribution to 

the plan to cover t he ba l ance of the be ne fits . If the 

plan were treated as on e providing dea th be ne fits, up to 

$5,000 would be excluded . If it we r e tr ea t ed s a pla n of 

life insur ance, nothing would be includ ibl e in gross income 

by any individua l. ~ft r payment of bene fits to the 

beneficiaries of the controlling employee , the pl an could be 

discontinued. Under the propos ? ! it will be clea r t ha t 

payments under c. self-insured a rrang ement a re not life 

insurance and, thus, they will be fully subject to t a x. 

- 176 -
II E-5 

UNEMPLOYMENT COMPENS~TION BENEFITS 

Present Law 

Compensation in the nature of wage replacemen t for 

periods of unemployment is paid through a wide variety of 

public and private progr ams and plans, each of which may 

ciiffer as to sources of funding, and eligibility for and 

amounts of benefits. The income tax tr ea tment of 

unemployment benefits also varies, depending primarily upon 

whether the source of the benefit is a government program or 

a private plan. 

In general, unemployment compensation received pursuant 

to government programs is, by administrative decision, 

excludable from gross income. By compzrison, unemployment 

compensation received from employer financed unemployment 

benefit plans or from the general funds of a union 

(accumulated from regular union dues) is includible in full 

in gross income when received . Similarly, unemployment 

benefits received from employee contributory plans are 

generally includible to the extent payments received e xceed 

amounts contributed to the plan by the recipient. 

Reasons for Change 

The present exclusion for un employment benefits ~aid 

pursuant to government programs is incorrect as a matter of 

proper income definition, tends to cr ea t e artificial 

distortions in the labor marke tpl ace, and promotes 

unjustified vertical and horizontcl inequities in the 

incidence of the income tax. 

Compensation paid to individu~ls during ?eriods of 

unemployment is, in subst ance, ~ substitute for taxable 

wag es. As recognized by the present l aw tr ea tment of 

privately funded un employment compe nsation plans, unemployment benefits are properly includ ible in the gross 

income of a recipient to the extent they exceed nondeduct ible 

contributions made by the r ecip ient to acquir e the benefits. 

Unemployment benefits paid pursuant to government programs 

are substantively equivalent to unemployment benefits paid 

pursuant to employer funded plans and, like privately funded 

unemployment benefits, should be includible in gross income. 

The present exclusion t ends to cr~ate a work 

disincentive and, in certain cases, influe nce s decisions both 

as to the timing of entry into th ~ labor mark~t and the 

duration of employment thereafter. It has been e stimated 

that under the present system, government un employment 

- 177 -
benefits on average replace more than 60 percent of lost 

after tax income. For women as a class, the replacement rate 

is close to 80 percent. Empirical studies confirm the fact 

that the existence of unemployment compensation edds to 

unemployment. The tax-free nature of unemployment compensation increases the incentive to remain une~ployed. 

The exclusion therefore contributes, to some extent, to the 

period of unemployment and the consequent cost of maintaining unemployment coverage. 

Finally, the present exclusion benefits taxpayers 

subject to tax at higher marginal tax rates more than those 

subject to tax at lower marginal rates and provides no tax 

benefits at all to those who ~ould be nontaxable even if all 

such benefits were included in gross income. Those who 

derive the greatest benefit from the tax-free treatment 

afforded un employment compensation by existing law are the 

unemployed with other sources of income, those who ha ve 

spouses with su~stantial income, or those who earned large 

amounts of income during some 90rtion of a year and were 

unemployed for the balance. Indeeo, there are t~ose w~o pl~n 

employment patterns to maximize the after- tax benefits ~vailable throug~ the receipt of nontaxable unemployment 

compensation. 

- 178 -
Table IIE-8 

Distribution of Unemployment Compensation and 

of Personal Income Tax Savings from Exclusion 

Number of : Percent of : - Percent of : Tax : Percent of 

Expanded . . :Total Unemployment : Saving : Tax Savings 

Income : 

Returns11 : All Returns 

(000) - : With Unernploy- : Compensation : " ($millions): by Income 

:ment Compensation : : : 

Under $ 5,000 4,700 41.2 27.3 190 

$ 5,000 - $10,000 2,762 24.2 26.8 438 

10,000 - 15,000 1,863 16.3 19.2 369 

15,000 - 20,000 1,234 10.8 13.7 318 

20,000 - 25,000 485 4.2 6.3 167 

25,000 - 30,000 196 1.7 3.0 92 

30,000 - 35,000 69 0.6 0.9 30 

35,000 - 40,000 36 0.3 1.0 38 

40,000 - 50,000 27 0.2 0.6 25 

50,000 - 75,000 25 0.2 0.7 31 

$75,000 and over 16 0.1 0.5 30 

Total 11,413 100.0 100.0 1,728 

Off1ce of the Secretary of the Treasury 

Office of Tax Analysis 

1/ Number of Personal Income Tax Returns which would report Unemployment 

- Compensation were all Unemployment Compensation includible in Adjusted 

Gross Income. 

Nore: Details may not add to totals due to rounding. 

January 26, 

Class 

11.0 

25.3 

21.4 

18.4 

9.7 

5.3 

1.7 

2.2 

1.4 

1.8 

1.7 

100.0 

1978 
As Table IIE-8 demonstrates, tne distri~ution of tax 

savings attributable to the receipt of excluded unemployment 

compensation differs markedly from the distribution of such 

bene fits by income class. Those with income s above $20,000 

received 13 percent of the total unemployment compensation 

paid. Yet 23.8 percent of the savings attributable to the 

unemployment compensation exclusion went to those 

individuals. Those with incomes from other sources of less 

than $10,0u0 received 54.1 percent of the unemployment 

compensation but only 36.3 percent of the savings. 

General Explanation 

In order to e liminate the horizont~l <nd ve rtic a l 

inequity and l a bor ~arket misallocations produced by the 

~resent exclusion for unemployment compensation and yet avo i d 

t axation in hardship situations, benefits in the nat ur e of 

un mploym~nt compensa~ion paid pursuant to government progra~s, incluaing trade r eadj ustment allowances, will be 

includible in the income of t a xpaye rs with cd justed gross 

income from ll sources (including un employmen t compensation) 

in e xcess of $2 0,00 0 if the r ec ipient is s ingle or $25, 000 if 

ma rried. 

Effective Da te 

T~e provision will be e ff ective for tax~ble yecrs 

beginning after De cembe r 31, 1976 . 

Revenue Estimate 

Change In Tc x Li ? bility 

( $ millions) 

Calendar Yea rs 

1978 1979 1980 19d l 

212 207 204 

r e chnicaJ Expl n~tion 

19h 2 

204 214 

Benefits in the nature of un empl oymen t compen se tion ~a c 

pursuant to gov rn~ent programs will be includible in i ncome 

to the ext ent of one-he lf of the e xcess of adjusted gross 

income (including the total amount of un employment bene fits 

and d isa bility pa yments ) over $ 20,000 in the as~ of single 

taxpayers and $2 5 ,000 in the case of married taxpayers. For 

example, if a single taxpaye r received income from other 

sources of $22,000 and unemployment compe nsation of $3 , 000 , 

- 180 -
$2,500 (adjusted gross income of $25,000 less the applicable 

threshold limitation of $20,000, divided by two) of 

unemployment compensation will be included in income. To 

prevent abuse of the foregoing income limitations, married 

taxpayers who desire to exclude unemployment compensation 

will be required to file joint returns for the taxable period 

within which such compensation was received. 

The proposal will apply to the following programs: 

(1) Federal-State Regular Unemployment Insurance 

Program; 

(2) Federal-State Extended Unemployment Insurance 

Program; 

(3) Unemployment Compensation Program for Federal 

Civilian Employees and Ex-servicemen; 

(4) Railroad Unemployment Insurance Program; 

(5) Trade readjustment assistance pursuant to the Trade 

Act of 1974; and 

(6) Payments in the nature of unemployment compensation 

pursuant to the Disaster Relief Act of 1974. 

For purposes of determining the includible amount of 

unemployment compensation, adjusted gross income will include 

all disability payments received by a taxpayer despite the 

fact that all or a portion of such payments might be excluded 

from income under present law. Similarly, for purposes of 

determining the includible amounts of disability payments, 

adjusted gross income will include all unemployment 

compensation received by the taxpayer. For example, if a 

single taxpayer received income from other sources of 

$17,000, disability payments subject to exclusion of $3,000 

and unemployment compensation of $1,000, the taxpayer's 

adjusted gross income for purposes of determining both the 

includible amount of unemployment compensation and the 

excludable amount of disability payments will be $21,000. 

Five hundred dollars of unemployment compensation will be 

includible (adjusted gross income of $21,000 less the 

applicable threshold limitation of $20,000, divi~ed by two). 

The entire disability payment will be includible, be cause the 

disability payment exclusion phases out on a 

dollar-for-dollar basis to the extent adjusted gross income 

exceeds $15,000. 

- 181 -
IIF-1 

ENTERTAINMENT AND TRAVEL 

INTRODUCTION 

"Business related" entertainment which is deductible 

under present law provides personal benefits to the 

recipient. Sometimes the entertainment provides luxuries. 

Often it is merely personal entertainment in disguise. Some 

types of deductible business travel also provide personal 

benefits. These personal benefits generally are not taxed to 

the recipient, thereby encouraging this form of consumption 

over consumption which must be purchased with after-tax 

dollars. 

Allowing entertainment and travel expenses to be 

deducted, without taxing the related personal benefits to the 

recipient, has the effect of providing these benefits 

partially at public expense. In effect, present law requires 

the many taxpayers who cannot or do not obtain these 

subsidized entertainment and travel benefits themselves to 

help pay for the benefits enjoyed by others. These benefits 

tend to be disproportionately distributed to upper-income 

taxpayers. Moreover, some types of entertainment and travel 

deductions are sources of abuse due to the vagueness of the 

standards applied to determine deductibility. 

For these reasons, the President proposes to disallow 

deductions for some entertainment and travel expenses not 

taxed to the recipient. In general, the proposals will 

disallow deductions for: 

expenses of all entertainment activities and 

facilities, except SO percent of expenses of 

entertainment meals: 

first class air fare, to the extent tbat it exceeds 

coach fare: and 

expenses of attending foreign conventions which 

are held outside the United States without gooQ 

reason. 

- 182 -
IlF-2 

EXAMPLES OF PROBLEMS UNDER PRESENT LAW 

The deductibility of expenses related to owning and 

operating a yacht is illustrated in the following excerpt from an article entitled "The Great Tax Write-off", which 

appeared in the February 1976 issue of Motor Boating and 

Sailing Magazine, at p.63: 

"An awful lot of rules for only a limited tax 

deduction? It isn't really all that complex. As an 

illustration of how these rules actually work, consider 

the situation of Robert Gaylor, a young lawyer who 

recently joined an established law firm. His success 

with the firm -- in fact, his continued employment 

depends on his contributing to the growth of the 

company. Robert joined the Lakeside Yacht Club 

expressly to meet the members, many of whom he 

considered potential clients. As a result of his 

participation in the club's activities, he made several 

valuable contacts which led to an increase in his -- and 

the law firm's -- practice. 

The situation of Dr. Roger Lawrence, an orthopedist, 

is not very different. Dr. Lawrence bought a 28-foot 

powerboat on which he entertained other doctors who 

referred patients to him. Since entertainment of this 

nature was generally expected of him, and since a 

substantial number of patients were referred to him as a 

result of his entertainment, the deduction was allowed . 

What specific expenses on your boat are deductible by 

you as the owner, chief stockholder, employee, or 

professional when the yacht is used primarily for 

business entertainment? Certainly all of the following will qualify: 

1) Operating costs: gas, oil, tune-ups, phone calls; 

2) Maintenance and repairs, and even storage fees; 

3) Insurance; 

4) Salaries paid to hired hands or workers; 

5) Yacht depreciation: ~ portion of your 

boat's cost may be written off each year 

for wear and tear. Your deduction would be 

the percentage of that figure that 

represents the entertainment portion of its 

use; - 183 -
6) Sales losses: If you sell your boat at a 

loss after several years of claiming a 

percentage of its expenses for business 

entertainment, a fraction of the loss would 

be deductible. The balance, of course, 

would be a non-deductable personal loss: 

7) Cost of food and beverages during the 

boat's business use. 

* * * * * * * * * * 

Families with children unfortunately find themselves 

faced with a problem when it comes to determining the 

business and personal use of a club's facilities. Use 

of the club by any member of the family constitutes 

personal use and makes it doubly difficult for the club 

to qualify as a business entertainment facility. For 

this reason many members will, as soon as possible under 

club rules, buy their children junior memberships. 

Since the junior memberships are not counted as personal 

use bf the parent/taxpayer, the parent is in a better 

posit1on to establish the more-than-50 percent use for 

tax purposes. The cost of a junior membership is 

usually modest when compared to the amount an individual 

would be permitted to deduct on his own membership for 

business use." 

Advice on how to structure personal consumption 

expenditures in order to support deductions is readily 

available. Prentice-Hall, Inc., has published a pamphlet 

entitled "How to Get Top Trouble-Free Deductions for Travel, 

Entertainment, and Related Business Expenses Under the Latest 

Liberalizations and Crackdowns" containing the following headings: 

Two cases show -- how to use a diary to win every deductible expense. 

Mix your vacation with a business trip -- let the 

company foot most of the bill. 

Bring your wife along and deduct the cost? 

How to nail down deductions for home entertainment . 

"On the town" 

Club dues 

Yachts, hunting lodges, and other facilities 

"Quiet business me als" are "directly rela t ed." 

- 184 -
Another Prentice-Hall, Inc. publication "Executives Tax 

Report" answers que stions on how best to arrange 

entertainment so as to obtain the maximum t ax be ne fits • 

.. fi T6Jr llfJU'I'-"' 

Bow a .. 11~8llten Get Top-DoDar Dedaetlo-

-Y~ r. ••• Y~ar Old 

Oub mcmbetships an mean bi& deductions. It makes oo dilfcrmcr whether 

they're country duhs, athtdic dubs, or mhin& and hunting dubs. They are all &ood 

for bwiness---eithd 10 have a customer 10 diona', to J01I with a group of execs, or 

f01 an outing sponsored by a local businc:ssmm's organization. 

Key tpeadon # lz I( I use my club to entertain other business people-..nd I 

do it for business reasons-do I gd a deductioo? 

A11srun : Chances are you an dedutt 1 &ood·siud chunk of your dub costseven though you and )'OW' family also use the dub for your own enjoyment. 

Key qualloa #2r How much an I deduct? 

The answer here depends on the kind of expense it is. 

• Mellis IINi INw bills: Suppose you talce your top-level exea to dinner at your 

d~r you have a fnt drinks with them at the dub t.r. Detl11rtibh? Yes.. You 

can write off t!Verf sin&Je penny. And you an deduct it w~ or not you and 

your guests discuss business matters. 

• Gruru fus lllltl otbn clllb exp111JII." ufs II)' you have a me«ing with a 

customer in the mominJ aod take him to your golf dub for lunch and a round 

ol golf in the aftaoooo. All your expenses (or the day would be ckductibk. RMI#: f 

Goodwill expenses ol this kind are deductible if they directly preade or follow a 

substa.otial discussion of business a1Jai.rs. 

How soon before or after is "directly?"' Generally it mexas tbe same dayfor example, golf in the afternooo followina a morning mcd.ing. But if the aastomer were (rom out of town, talcing him to the club the day be-lore or the day 

after your meding i.s all right, too. 

• IMPORTANT-+ The eo.t of the lunch ia dedortible nu wllea oUier 

upenaee aru't. It's • "quiet buainua mul"- lhua deductible oa Ita OWL 

J[ey tpatloll #Sr How about my dub dues? They're probably my bigest 

single expenx. 

lf11swn: Dues.-in whole or in put- may be deductible. BUTy DN cm't tlttlllct 0111 ttic!tl of t/1111 11nleu JDII 1111 yo•r cl11b mort tiNDI JO«J'> 

oj lbt time /II' b11JiJUJI " IIJDJU. IfNI II lfl t/n11, JDII t n J"UICI 0111] IJut ,. 

cnr14zt of UIJIW 1 .. tlirect9 rrweJ" ID JD"' ••shms lttllitlfJ. 

Es.ample• lllr. Jloller'a countr7 dab dua run to f2,IOO • )'e&r. Durlnt 

~ -· lie - tie dub &II IWI"ale ot three da7• a week. Oa oae of th- - .. Koller p!Qa pll with other bum.&-, but ~'t dilcu8l UIJtlliD• 

coeaeded with hi. COCDJIIIUI.)' cluriq" the pme. lt'a atrictl)' for ,_twiL 0. two 

dan. he lllllea Ilia cutomen or top aiel people to luDda or dl--t whicll 

tllen ~ or IIIQ' not br actue1 ~ 4ivavi- lJa ..Wltioa to theM ~ 

at the dllll, Jlr. liAr or Ilia faaQ1 - It for plnan u ...,..,.. of two 

..,. ...... Is /lb. Molin nllitlH lo • JrtiNctiotl! Ya! Since be uses the dub for businesa 

thrft days out ol five, he easily ~~lefts the '"over )or.,·· test. So he an 4educt what· 

"er portion ol the dub's use was "dirutly related'" 10 business. lo his case, only 

the days when he's hosting "busioc:ss meals" are coosidered directly related. SiDc:e 

these constitute two-fifths ol the total use ol the dub, Moller can deduct two 6fths 

(St,OOO) ol the total dues. 

• ADDED BONUS-+ A da7 who you're uain• the dub for bui- I'UIOIII c:ouala aa • buaiaaa da)' nu if the famllTa uala• it. for plaaure at 

the UIIH! time. So 7011 cu pt extra peiWDII use out of the club without 

JeopardWq your utertalnDteDt deductiou. 

J[ey a-...ua, -"' MBe a point ol haYing a quid bwioess lunch (or 

braklut for that matter) with your ~non the same day you play golf witb 

them. If Mr. Moller had done that, all three days wouJd have been directly 

- 185 -
rdakd. ~ business meal in the day is mough. AnDIIHr poilll: A few drinks 

with JOUl customeR at the club bar can abo tn.oslorm a cuual golf elate into a 

fall-tedp business ~7· One qua.liliation: 1M b&r 111111t br quiet and haft "ao 

subsuntial distnrtions to discussioo:' 

Bow d- a meal at .. h.icll bullinea mellen_, tU.nu.ed quaUf:r • a 

'"dlredly related .. apeaee r 

It's simply the big exception 10 otherwise strict eotertainmmt rules. Jl JOU aocl 

a cuscomer have a qujet lunch or dinnet at the dub, JOU get ~ 

. TRIPLE BENEFIT+ ( 1) The cost of the mal Ia deductJble In ami of 

lt.elf. It also bel~ nail down and i~~ereuc 70111" clvb dues deduetlon, countlnc 

u (!) a bui11u• da11 that helps brlnr )'0111" bual- ue of tbe dub OftT the 

50,; mart, and u (S) a direetl11 re1Gte4 c that adda t.o tbe amount of 

your dues deduction. 

1Rtl11ttio• UJJn: 1M quiet busiDCSS meal break is particululy important when 

you UK the dub partly for business ~ and partly fot pleasure. As you gtt 

down 10 t~ end of tM year, you may find your personai·UK days running neck 

and n«k with your busineu·relatN days. WMD this happens. hae's-

• lVBAT TO DO+ ~ule aome quiet buaineu meaJa at the dub. 1'11e7 can malre the bir difl"ermce that willa JOU the deduction. 

".,.,U,I: Just OM cxtn family outing at the d._ family dinner, for enmple, 

or a Sunday afternoon ~ cost you your entire dues deduction. 

• mEA IN ACTION+ · 11yoa belonr t.o more than ooe dub--.ancl m&DJ 

c»-rou ID&J want t.o ue one club atrictly for buaineu enterlalnlnr, ami 

the other for IOC!ialWDI • 

.lfrrotlnr _,.;,,_. 1M tu rules specifically state that you must keep accurate 

r«otds. H you don't, JOUfUK ol the dub is presumed to be primarily pmoaaL 

RIJII/1: You won't qualify for .,11 dNuction for •1 dub expenses. 

THE EXECUTiVES TAX REPORT brinp JOU IDEAS for recluelnr tu• 

aDd IIIC!ftUlq -'UL It II ~ tlaal JOU couult roar own profeuional 

MYi8on befon actlq oa these i4leu. 

A,rt1 lt, 1976 IU 

- 186 -
How do you deduct at-home entertainment expenses? Business Week of May 30, 1977, t e lls you: 

Deducting at-home entertainment expenses 

Tax dt'tluctlons for nonreimbursed oosinrliS entertaining nt home can get sticky 

for an)·onc \\ ho glos..'II!S ov~r the n1les on 

ri'<'Ordkrepi ng. "RI'COrds, records-that's the key point," says a nationnlly known 

taJt writer. Ocr nard G rci~ma . 

Fewer court cases or late and less time 

spent on Lhe suhj~t in tax ~lviscrs' 

offiet><~ imlicale t hal lhe I nlornal Reve- nue Scrvire hns n.ocl!ntly taken some of 

the heat ofT ~uc h deduction-taking by 

executh·es. Wining and dining business 

as~oriates at home has become an acN>ptcd routine, note.; Grcisman. "With 

credit catiiB, k.l'cping track of what 

you've spo.•nl in home t'ntertaining is 

ttll!l}', anyway,'' he :ulrls. "So k~p your 

gurst lisb trai~thL" 

There arc h' o b:\bic rules: • For thi'l yMr, i>«'ginning now, ket!p a 

diary of all hu~incss entertaining at 

home. lnt'lude all r1oceipls. plus entries 

,;howing d:~tcs, gtl\'!ilS, lh(lir oosinN;S 

id~ntil)', the businl'ss purpose (noted 

briefly), nnd amounts &pc!nL F.:ven a sm&rt f'PA cannot win points with the IRS 

by "l!lltim:~ting" these east&. • For past. months, if you have railed to 

ket!p complete retOrrls. remember that it 

is possible- and pennissible- to reconstruct needed tax records. This can save you tax dollars. It is not possible, of 

course, to erl'ttle a II\'( diary, but }'OU can reconlr mispln~ed r('('ripls, bills, canceled chrekll, and :~uch, anti gill her some 

that h:l\'e never bt•en collertcd. Often, an ex('Cuti\·c's !lpousc can help solve the 

problem by recalling guest lists, dates, 

items purchnc;ed, nnd such. 

Rt'member, too, thnt if rh:1llcnged by 

I he IRS, a t:~xpayt>r muNt be ablt> to show 

Lh:ll his gui'Sts were, indrNI, business 

assoeiat(IS "ho wPre in his home for 

bu~iness purpost.'S. "A!ISOCiAt(IS" has a 

brooder meaning than you mA)' realiw. It co'-ers etllilorners, clients, supplirrs, 

ad,·isers weh as manng4'ment consultants and lawyers, :~nd pi'Ollpcetive IL.'ISO· 

ciatcs such M a poo;sihle cu~1.omer or supplirr. The term also covi!Ml the wives 

of businHS contacts- or the husbandsanti one's own ~;pouse, ns well. 

The purpose counla. "Goodwill" ~nle

taining oouots, to(), nutwilh~1nndinl( its 

pure informality and lndir!'Ct connection to a particulllr business deal It nero not 

be shown, for instance, ~at after cocktails and dinner, the exet!Uthes at the 

party departed to Lhe dt>n to ta lk busi- ness. The underl)ing bu~inm purpose is 

what counts. Once the validity of taking the deduction is ('Sfnblished, the quPstion of what 

to deduct becomes a bookkeeping chol't!. 

It amounts to more than the cost or food 

and drink for business ns,)Oeiates and 

their spou!I(!S. You also can write olf 

expenses ror a Cll\terer, flowers-including n table or buffet centerpiece-lent or other equipment rental, music, car parkers, and in\•itations. 

It is even possible to prorate some 

expc.>nses-such? music-"hen some or the guests are; business poople and 

others purely llbcial friend! But such 

mixed guest lilts at home p.uties cause 

talC troubles. llere the records for tax 

deductions net!<! to be gi~en special 

altttntion, with the people and business 

purposes clearly sho" n. There also must 

be a 'ery rlMr bre:~kd011 n of t>xpcnses on a pc!r·guest basis.. 

Grei ·man t'autions: "You may ha1·e a hard time supporling the d!'lluclion ir 

the businl'SS conta('ts are in\'it(l(J to a 

weddinR reception or sornr similar ll.ffair lhat is purely sociAl." 

Fo r e ign conventions and study progr ams are also popul a r 

means of writing off vacations at othe r taxpayers' expense. 

Reproduced be low a re excerpts f rom a brochure of the 

Ca l ifornia Tri a l Lawye rs Associ a tion for the year 1977. 

- 187 -
CALIFORNIA TRilL LlWYIU ASSOCIATION 

..... ,__ IIAI.PII DIIAY'TOti,S.....-

liAIIPOilll OAO&, ~ H.U. 

JOHN GAIID&N.U..S.. ,.,.__ 

JAMISIIOllll.a-.. 

·..., 15de _,.,.._ 10 1M•--.-o(IM 1-u ell,...._ ofJ,.,I«" 

GlJAIIA!nU .uJUJINO 

n...l"-

Dear Colleague: 

Here it Is ••• 

An entirely new concept in professional group travel/study programs • 

The idea of combining seminars and trips, of travel as a learning 

experience, has long been emphasized for the more sophisticated traveler. 

But an entire year-long program planned exclusively for one professional 

group is a ~answer to today's problems. 

We have combined the best travel bargains available with superior legal 

seminars, and have arranged a comprehensive schedule that allows you to 

plan early. 

Look over the trips de$crlbed in this booklet .•• to exciting destinations 

~:=:& .. eo., all over the world. Decide where you would like to go this year: Rome. IUCH.UD_,. o.u-~ The Alps. The Holy Land. Paris and London. The Orient. Cruise the 

=:c~;--_ Rhine River or the Mediterranean. Visit the islands in the Caribbean. 

uUCCCOIIN&UII,,.., ,_- DeUgtrt in the art treasures of Florence • 

.1011111 - ·- ,.,._ PAIJI.A lllll.aS..,_ 

-UT POX,SAor- OM> 

J -~""'""'"" GAilY IIWlLUAJI. 0.0...., IAI" IIDZOG.,_A.,.... SAI.IfADOII UCCAIIDO. S..- IWIULL -IIIQY, v..u .. TDCHCa J 0111 T-

~A III1TIIl ,_A ...... IONALD IOUOA,S.. ,.,._ Do\IIIUW.J SAU*ON . ... ,,_ 

WIWAOI llldANO,, Clerw_, 

.IOHN IC 11IOT1P. So- A .. 

lfANCIJ lfAII'I'....U..-• 

UN& WUCIIICII. S.. ,.,.__ 

A-C-C.. 

Dol N-IHM•Wib 

'.-M•R ,._ •~ 

We are proud to offer seminar programs emphasizing current legal issues, 

headed by distinguished legal personalities. Eadl seminar Is sponsored by 

the California Trial Law ers Association. 

An additional benefit ls that these travel/seminar programs have been 

designed to qualify ~r the 1976 Tax Reform Act as deductible foreign 

seminars. 

We feel that all the ingredients of great travel for lawyers are here in a 

truly &rique combination, so please look through this booklet and begin 

your plans. Contact your Travel Asent for further information and/or 

reservations. 

Many of you have participated with your colleagues before in group travel 

programs. This year, let's welcome the newcomers and all share together 

these splendid travel oportunitles. 

- 188 -
ISRAEL AND THE 

HOLY LAND 

15 Days/14 Nights 

Lawyen' Seminar Departure: 

June 20, &om Oakland and Seattle •••• • r-$'199 

Including: 

* Round trip jet air from the West Coast via World Airways 

747. 

* Acxoaunodations for aeven nights at the delwce Hilton or first-dale Buel Hotel in Tel Aviv and seven nights at the 

del~ Hilton or first-class Shalom in Jerusalem. 

* Welcome cocktail party and dinner. * Hall-cl.y lightleeing in Tel Aviv and Jerusalem. * Tour escort throughout, plus hospitality mH on hand to 

aaaist you at all times. * Transfers to and from airport and hotels; all hotel taxes. * Baggage handling, including gratuities. 

* Many more special featurea. 

A variety of optional aighbfting excursions in and around 

Tel Aviv and Jerusalem ia available. 

Wodd A!rw-,. II a u.s. Cllltl&dld aappiuaerltal air canm. 

- 189 -

•Beersheba 
1977 CTLA TRAVEL SEMINAR ~J-20, 1977&.ao.klud _. SattJe 

ISJlAEL AND THE HOLY LAND 

An exating in-depth Rmilw' to enrich your knowledge of the J.w • well 

• the piK'I! and culture you visJt. In 1977. • cnJdA1 )'l'ar for the ton .and 

trial ~tml and ita future, this leD\inar will COI"IC!mtrate on vuious 

•p«tsol the syttem with emphasiS onc111m1t practice by .n outst.and· 

ing ~trial J.wyer and on suggested judkial and legislative 

reforms fntunns outstanding cmlom•• jurists .and Calilomtalegisla· 

tive leaders. Improve your present skills .and participate in thought· 

provoking dl.scuMions ~ng the shape of the J.w In the years to 

come. 

An in-depth study of HANDUNGTiiE PERSONAL INJURY CASE. with 

emphasis on cun"etlt trial practia> and techniques. AdditiOnally, the 

le.d.ing cues in this are• will be rPViewed .nd the J.lesiJudidal.nd 

legisYtive devdopments will be discussed. An expenenced trial •ttomey 

wiD dUcusa c:umnt ~and le-s dilcu!sions of praent .nd future 

developments. Writtrn DYterials will be distribu!N 10 all those in attrn· 

dance. 

AD of the •bove will be included in the registratiOn fee for this exdtmg 

sem.itw-. lt is ut excellent opportunity to obWn that need~ relanhon 

and education in conjunction with other members of the CUifomill BaT 

and their spouses and &iends. 

AcnvrTY SCHEDULE J6 HOURS Of SCHIDUUD AcnviTIES 

DAY 1 [)q>Mt USA 

DAY 2 Amvt" Td AVIV 

DAY J hm·12pm:SEMINAR-LECTURE 

2pm· 4pm: SEMINAR- WORKSHOP 

DAY 4 10-· Upm: SEMINAR- WORJ<SHOP 

2pm· 6pm· SCMlNAR- UCTURE 

DAYS l2pm· 3pm SEMINAR - WORJ<SHOP 

DAY 6 hm· Upm· SEMINAR- WORJ<SHOP 

1 pm-lpm. SEMINAR - WORKSHOP 

DAY 7 AI l..riJw-e 

Dot. y 8 All..riJw-e 

o.t.Y9 T.......m-oo~ 

DAY 10 8am-Upm. SEMINAR -L£CTIJRE 

2pm· 4pm SEMJNAR- WORXSHOP 

Dot.Y U 2pm · 4pm SEMINAR- W0RJ<SH0P 

6:l0pm·1D-.30pm SEMlNAR- LECTURE 

Dot.Y 12 AI '--""' 

DAY lJ All..eaurr 

DAY 14 AII...N.-

OAYlS 9am· Upm SEMINAR-CONCLUSION 

DAY 16 ~ kr.te1 

,.,._USA 

- 190 -
WESTERN 

MEDITERRANEAN 

AIR/SEA CRUISE 

15 Days/14 Nights 

Lawyen' SemiJau Departme: 

JUDe 10, &om ()akland and Loa Anples . . ·'-$1099 

Including: 

* Round trip jet air from the West Coast to Milan via ONA 

orTIA DC-8. 

* Complete 7-day cruise aboard the SS AMERD<ANIS in· 

eluding cabin accommodations with private facilities, 

three gourmet meals daily plus nightly midnight buffet 

and exciting international entertainment. 

* Sailing from Genoa to Cannes, Palma, Tunis, Malta, 

Messina and Naples. 

* One-week holiday at your choice of eight of Europe's 

most popular resort areas: 

PALMA ADVENTURE: 7 nights in Palma. 

ROMEIMrLAN ADVENTURE: 6 nights in Rome, 2 nights 

in Milan. (Including half-day sightseeing in Rome.) 

RNIERA ADVENTURE: 1 night in Milan, 7 nights in Nice. 

SWISS ADVENTIJRE: 1 night in Milan, 3 nights in 

Lucerne, 2 nights in Montreux, 1 night in Lugano. 

BAVARIAN ADVENTURE: 2 n ights in Milan, 4 nights in 

Munich, 1 night in Verona. 

FRENCH/SWISS ADVENTIJRE: 1 night in Milan, 2 nights 

in Lausanne, 2 nights in Grenoble, 3 nights in Nice. 

AUSTRIAN ADVENTURE: 1 night in Milan, 1 night in 

Villach, 1 night in Vienna, 2 nights in SalzbUJ"g, 2 nights 

in lnnsbruck. 

NORTHERN IT AUAN ADVENTURE: 3 nights in Flor· 

ence, 2 nights in Venice, 2 nights in Milan. (Including 

half-day sightseeing in Aorence.) 

* Continental breakfast daily on land portion of tour. 

* Multi-lingual tour escort throughout land portion of tour. 

* All transfers between airportlhotelslpier. 

* All city transfers by private, air-conditioned motorcoaches. 

* Baggage handling and gratuities. 

* Many more special features! 

Forded< plana and adcliti«W c:ru:iw infonMiion . .... write or caD yow 

TnwlApnt. 

~lied brochurn m' avada .. upon request. 

Trans lntenwtional Airtinn .nd Ovetxas NatioMI Ali'Ways aft U.S. certillcah!d 

supplemmu! ••rcanil'rs. Thl' SS AMERIJ(ANIS is registr~ m G~. 

- 191 -
1977 CTLA TRAVEL SEMINAR 

An e'llciting in-depth lmlinar 10 enrich your know.ledge of the In! u well 

• the piKe GKf cultuft you visit. In 1971, • aucial year for the tort .nd 

trW llystrm GKf its future, this llell\inar wiD conomtra~ on vuiou 

aspects of the system with emphais on currr11t practice by IUl outstandin3 California trW J.wyer Uld on suggested judicW Uld legislative 

relonns fe•turing outstanding CalifomUI jurists .nd Ulilornia lrpslative lnden;. Improve your present slciUs md putici~tr in thoughtprovoking discussions reguding the sNipe of the In! in the yeus to 

come. 

An in-depth study of11UAL ADVOCACY, with emp"-is on current 

trW practice .nd techniqun. AdditioJWiy, the leaclin& CllleS in thiswiD be reviewed Uld the J.test judicW IUld ~developments will 

be discussed. An experienced trW attorney wiD discua CUI1ft'lt pn·.'tice 

.nd Jeild discussions on present and future developments. Written materW. will be distributed to .U those in •ttend..-. 

AU of the above wiD be included in the registration 1ft for this exciting 

semiN.r. It is an exceJJent opportunity 10 obtain that needed relumon 

Uld edUCJition in conjunction with other members of the Calilomia &: 

IUld their spouses and friends. 

A.C11VJTY SOiEDULE l6 HOURS Of 

SCHEDUlfD ACTlVJTY 

DAY 1 [)q>art USA 

DAY 2 Atriv~ Milan 

DAY 3-0AY 8 LAND 

DAY9 bn1~.7 pm 10pm SEMINARINTROOUCTION 

DAY 10 Cnriw, 2pm· 6pm· SEMJNARLECn.JRE 

8pm-l0pm: SEMINARWORKSHOP 

DAY 11 ena-. 7am-9am: SEMINAR -

WORJ<SHOP 

3pm-7pm: SEMINAR- U:cruRE 

DAY U Cndae.lam· Upm: SEMINARUcruRE 

2pm-4pm: SEMINAR-WORKSHOP 

DAY 13 Crulw.8am-Upm: SEMINARUcruRE 

2pm-4 pm: S£MINAR- WClRJ<SHOP 

DAY 14 Cruise. 2:30pm-6:30pm: SEMINAR 

-WORKSHOP 

7:30pm-9:30pm: SEMINARWORKSHOP 

DAY 15 CruR. 8am-lhm; SEMINARCONCUJSION 

DAY 16 Cruise. 

Almnoon. lr.lnJe-to Mibn 

Orpart Milan 

ArrivtUSA 

(For your information. IN appliable Y-cbs 

ecciiOII'IY air fan. TOUnd lt1p &om San Francisco 

-to.~ 10 Milan. includina departure 

1D. is nDS.OO.) 

- 192 -
One wonders how the Holy places of Jerusalem will 

stimulate the trial lawyers of California in "Handling the 

Personal Injury Case•: or, how the ambiance of Italy, 

Switzerland, Austria, and France will promote "Trial 

Advocacy.• The answer, of course, is that they won't and 

that the "study" portions of the trip are designed to 

disguise vacations subsidized by the majority of taxpayers. 

Nevertheless, such vacation programs are claimed to be tax 

deductible as ordinary and necessary business expenses. 

Theater tickets and tickets to sports events are also 

popular forms of business entertainment. The following is an 

excerpt from an article in the March 20, 1977, issue of the 

Philadelphia Bulletin: 

"Many of Philadelphia's major companies occupy 

•superboxes• at Veterans Stadium. They include Atlantic 

Richfield, Girard Bank, First Pennsylvania Bank, 

McCloskey and~·· Fidelity Bank, Central Penn National 

Bank, c. Schmidt and Sons, Telesystems Corp., Industrial 

Valley Bank, Philadelphia National Bank and Brooks 

Armored Car Service, Inc. 

The annual rental of a 28-seat superbox is $18,000, 

allowing the occupant privileges both for Phillies and 

Eagles games. One Philadelphia businessman estimated 

that costs of food and maintenance of a superbox run 

upwards of $15,000 a year." 

The Prentice- Hall, Inc., "Executives Tax Report" 

instructs executives on how to record ticket 

entertainment expense: 

- AU I'D QllefJif• lllli.D• 

... ,_ C:.W• All TM ..._ Wllea Y- Tllke a ~-­

te Clle .... JIU'It 

ADOthet budldl JSJOa is jult UOUDCI the comer. Sioa teUOG tickets for ti.ft 

aocl eatatainmeot pUrposes are hi& items with many businesses, the quatioa ol 

deductibility is 'lital. The Tu U. is tou&fl when it comes to thae deductioas--

but it's not impoaible. W"ltb this in mind, let's t:.t out IIXIX quesrions and IIIS'WaS 

oo the do's IDd dont's for deducting the COlt ofseasoo tidceb. 

Qaatloa1 Suppote I buy a season ticket for business purposes. How do I 

baodle it tuwise? 

Atrsw": F'tnt ol all, you must break down the cost of tach individual ticket. 

'I'M ckdud.ibility ol rach ticket depends 0t1 the use you put it to. 

Eumplet A eeuon ticket for four bosseatl at Yankee Stadium eo.ta S1.400 

(S1.300 for admiaaloo pia PIS ach for Stadium Club membenhip). It COftJ'a 

- 81 bome pmea pla7ed on 78 admiaalon data. (The rat- for thoee of 700 

wbo dcm't follow t.be rame-ue double heaclen). Eacll seat coati SS2& for the 

-.on and it breab down to about SU'I per date ('SS26 + 78). 

Qaedl-• What will ~ coosickred a deductible business use ol a sasoo 

ticket? 

Aruw,: Business en.tc:rtairunc:; business gifts; and recreation for ranJc..aoc:l· 

file employc:a. 

- 193 -
1-' 

1.0 

~ 

I rr~· r t fl l!t~ It r~ r.f ~~~~I II t- t" lr"" •Hfi ~ ~ ~~- !II! r r.~ ~r n ,~ rJ ·! l'il :fi ' ''i 1 ~ n.} J r ~I r !' • ~ h fp . ~ l n= ~~~~ ;:·J rr :·l"h .. h =t ;:J.a ! . ~ i~ u~ r I r. ~ t f I ~ ; ;r . El I e. J . i B' .. 1 ~ r

f r .. ~ ' f8 !. 1.1 r • [1· . • 1. ' .s 1· i .. ,. i a· :· r, ~ ! . .g t11.i J .. . ~ J tli ;! 1 i u ! f! ~ ~It e 1• r1 1 f Hi ~ r ;!;f!f B l !H; t !i!Hi t1r=~ ~f fl1 ~~: ~ ;H; f l~it~ ~ e.[h ;; 

I J ..l!t r J 1 i H 1 ·. f ! ~! # 1- : :. ! . ' f r f l -- f I l ~ 1. "" r1 ! ! '~ .~ !i 

i 11' r ll· &' r ~ ,. l! 1. i ~ 1 a [~ 
IIF-3 

ENTERT~INMENT EXPENSES 

Present Law 

Present law imposes relatively few restrictions on the 

deductibility of •business• entertainment. To be deductible, 

entertainment expenses must be "ordinary and necessary• in 

the taxpayer's business. Voluminous litigation attests to 

the difficulty of defining the "ordinary and necessary" 

standard. However, it is clear that "necessary" does not 

mean "essential." Rather, courts generally have construed 

the term "necessary" as imposing only the minimal requirement 

that an expense be appropriate and helpful for the 

development of the taxpayer's business. 

The regulations require that entertainment expenses be 

reasonable in amount. Theoretically, an entertainment 

expense is not deductible to the extent that it is lavish or 

extravagant. However, since one man's "lavish" is another 

man's "moderate," this requirement is difficult to apply 

evenhandedly -- and hence difficult to apply at all. 

Theoretically, entertainment is deductible only to the 

extent that it is allocable to the taxpayer's business. 

However, it is seldom possible to distinguish between 

personal and business motives in entertainment, let alone to 

prove that distinction. Further, even entertainment provided 

for business reasons must produce personal enjoyment in order 

to have its intended effect. Thus, the personal element in 

business related entertainment generally is not disallowed. 

In short, some taxpayers are in a position to deduct 

many of the luxuries of life as business entertainment. 

Costs of country club memberships, cocktail parties, cruises, hunting lodges, lunches, dinners, nightclub shows, yachts, 

hotel suites, swimming pools, tennis courts, and vacation 

trips--all can be deductible under present law. 

In response to President Kennedy's tax reform proposals, 

in 1962 Congress enacted several provisions intended to 

prevent abuse of entertainment deductions. However, most 

entertainment expenses deductible before 1962 still can be 

deducted today. 

One provision enacted in 1962 requires substantiation of 

entertainment expenses that are deducted. The taxpayer must 

substantiate, "by adequate records or by sufficient evidence 

corroborating his own statement," the amount of expense, time 

and place of entertainment, business purpose of expense, and 

business relationship to the taxpayer of any persons 

- 195 -
entertained. To the limited extent the IRS can enforce this 

requirement, it impedes those who previously crea ted 

entertainment expenses out of whole cloth or simply guessed 

at what they had spent. However, the substantiation 

requirement is not a serious obstacle to those who actually incur expenses and keep c a reful records. 

Another provision enacted in 1962 requires that expenses of entertainment activities be •directly related to• or 

"associated with• the taxpayer's business in order to be 

deductible. These tests are easy to meet. 

While the "directly related• rules purport to require 

some ex~ectation that business will be conducted at the 

enterta1nment event, entertainment is considered "directly 

related" without a showing that business benefit resulted 

from the entertainment, or that more time was devoted to 

business than entertainment, or even that business was 

discussed. Even the loose "directly related" standard does 

not apply if meals are furnished under circumstances 

•conducive to a business discussi on.• As described in a 

prominent publication which advises taxpayers how to obtain 

•trouble-free• deductions, this exception operates as 

follows: 

Say you take a customer or a client to dinner at • 

[a) restaurant. Or, perhaps you prefer to t a ke 

him to a hotel bar or cocktail lounge for a few 

drinks. As long as he's a business associate, you 

can deduct the tab whether or not you discuss 

business, make a sales pitch, or even if it's only 

for goodwill. The only limitation is that the 

atmosphere must be conducive to a business 

discussion. 

In short, the "directly related• requirement may have little 

more practical effect than to disallow deductions for 

entertainment which offers little or no opportunity for 

business discussion--such as entertainment at night clubs, 

entertainment at cocktail parties where non-business 

associates are present, or entertainment which the taxpayer does not attend. 

Moreover, even entertainment which offers no opportunity 

for business discussion is deductible if it meets the 

•associated with• test. Thus, expenses of an entertainment 

activity which does not qualify as •directly related• still 

may be deducted if the activity has some proximity to a 

business discussion. Under the "associated with" rule, 

expenses for dinner and a night on the town for the taxpayer, 

a business contact, and their spouses, are deductible merely 

because that afternoon or the following morning some of the 

participants talked or will talk business. 

- 196 -
Like expenses of entertainment activities, expenses of 

entertainment facilities such as yachts and swimming pools 

may be deductible. (Dues or fees paid to a social, athletic, 

or sporting club are also considered entertainment facility 

expenses.) To be deductible, such expenses must meet the 

•directly related" test, and more than half of the use of 

the facility must be for business entertainment. 

Reasons for Change 

Present law on deductibility of entertainment expenses 

is an open invitation to charge personal expenses to the 

Treasury, and many taxpayers accept the invitation. Some who 

have done so in recent years are described below. The 

expenses described in these examples are deductible under 

present law. 

A New York City taxpayer claimed deductible 

expenses of $9,665 for business lunches throughout the 

year. According to the taxpayer's records, he 

entertained a business client or associate each day for 

338 days of the year. The taxpayer skipped his business 

lunch on Thanksgiving Day, but not on the Friday, Saturday, or Sunday of Thanksgiving weekend. He 

entertained at top restaurants on an average of 6-1/2 

days a week all year, at a cost of well over $20 each 

lunch time. 

In a recent year, an electrical fixture salesman 

structured his business calls so that he ate breakfast, 

lunch, and dinner, five days a week, with a customer or 

purchasing agent either before or after a business 

discussion. The deductible amount for the year was 

$8,000, of which $3,000 was spent on the salesman's 

meals. 

A university professor received $30,000 in annual 

salary and, in addition, many of his expenses were 

reimbursed. His department did not reimburse him for 

$1,300 spent to entertain visiting professors, but these 

expenses were deductible on the basis of his department chairman's statement that entertaining visiting 

professors was required as part of the professor's job. 

A surgeon deducted $14,000 a year for expenses of 

entertaining doctors who referred patients to him. He 

entertained the doctors on a yacht, where they discussed 

patients recently referred. The surgeon claimed that he 

took care to begin each medical discussion early in the 

cruise in case a doctor l a ter became seasick. 

The corporation of an incorporated dental surgeon 

had gross income of $500,000, a deduction of $160,000 for the surgeon's salary, and taxable income of only 

- 197 -
$26,000. ~n amount close to $17,000 was deducted for 

the surgeon's expenses of entertaining dentists who 

referred patients to him during the year. The surgeon 

entertained the dentists (and sometimes their wives) at 

home, at a country club, at sporting events, at 

restaurants, and at a rental cottage. He entertained 

the same few dentists the preceding year, and they are 

his personal friends. 

~ small corporate manufacturer with few competitors 

owned a yacht. Before and after business discussions, 

the corporation entertained customers and potential 

customers on cruises and fishing trips. Yacht exPenses 

of $67,000 were deductible for the year. 

A corporation which operated an iron foundry and 

machine shop in Virginia owned several hunting and 

fish1ng lodges on an island off the coast of North 

Carolina. The corporation used these lodges to 

entertain employees of its major customers. Deductible 

costs of lodge operation and depreciation, plus airplane 

expenses, were over $100,000 a year. 

These taxpayers are not isolated examples. As President 

Kennedy said 16 years ago: 

Too many firms and individuals have devised 

means of deducting too many personal living expenses ~s 

business expenses, thereby charging a large part of 

their cost to the Federal Government. Indeed, expense 

account living has become a byword in the American 

scene. This is a matter of national concern, affecting 

not only our public revenues, our sense of fairness, and 

our respect for the tax system, but our moral and 

business practices as well. 

Even when entertainment promotes business and hence can 

be argued to have a business purpose, the entertainment 

provides substantial personal benefits to the recipient. It 

is this personal consumption which distinguishes entertain~ent from other business purchases, such as 

advertising. 

Reading an advertisement is not comparable to dining at 

an elegant restaurant, sailing on a yacht, or attending a 

Sunday football game. Entertain:nent is more closely 

analogous to wages; they both provide personal benefits. 

However, the tax collector withholds a portion of wages 

before they can be spent for personal consumption while 

entertainment benefits are now received tax-free. 

The benefits associated with business related 

entertainment tend to be disproportionately distributed to 

upper-income taxpayers. For example, lunches are deductible 

- 198 -
by a lawyer who eats with clients at a club, but not by a 

carpenter who eats with other workers at a construction site. 

Costs of giving a party for friends are deductible by a 

businessman whose friends are his business associates, but 

not by a secretary or nurse, for whom entertaining cannot be 

said to have a business purpose. In light of the personal 

benefits associated with entertainment, the disproportionate 

availability of entertainment deductions to upper-income 

taxpayers makes the allowance of such deductions particularly 

unfair. 

And entertainment expenses intended primarily to promote 

business are not the whole problem. Frequently "business 

related" entertainment is personal entertainment in disguise. 

A taxpayer in the 50 percent tax bracket can purchase two 

tickets to a football game for the price of one if he deducts 

their cost. Therefore, he has nothing to lose by inviting a 

friend who is also a business associate to join him for the 

game. If the expense account fan happens to pick up a little 

business as a result of this entertainment or to receive a 

return invitation from the friend, this is all gravy paid for 

by Uncle Sam. Since it is extremely difficult to distinguish 

between personal and business intent in entertainment, 

entertainment which is intended to provide ta~-free personal 

benefits often cannot be disallowed. 

In addition to entertainment expenses which are 

deductible under present law, some nondeductible expenses are 

in fact deducted. The subjectivity-of present law encourages 

taxpayers to deduct entertainment expenses which, though not 

clearly deductible, are "arguably" so. 

For example: 

A life insurance salesman recently deducted his 

tennis club dues on the theory that tennis games enabled 

him to judge the physical fitness of prospective 

customers. 

A large casino operation in Nevada deducted as 

promotion expenses the costs of using and maintaining a 

lake property and a hunting lodge. The annual deduction 

was $110,000 for the lake property and $350,000 for the 

hunting lodge. 

A practicing attorney with gross income of $150,000 

entertained clients throughout the year on his yacht. He claimed deductions of $22,000 for operating the 

yacht, $19,000 for depreciation of the yacht, and $6,000 

for operating an airplane to fly clients to the yacht. 

A physician deducted $13,000 a year for expenses of 

entertainin9 other physicians at parties, dinners, and a 

hunting cab1n -- all on the theory that any physician is 

a potential source of referrals. 

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The sole shareholder-officer of a small corporation 

deducted the costs of entertaining employees ~f another 

corporation from w~ich he bought scrap on a "h i ghe st 

bidder" b?sis. 

The owner of an insurance agency ded ucted $31,000 

one yea r and $32, 000 the next on a cla im that every single meal during the two years (e xcept for the meals 

on one day) was motivated by busin ~s s. 

~ med ium-size corpora tion which su~pl es parts to 

au to manufacturers deducted $35,000 in e ach of two 

consecutive years for lunch e xpenses of the 

corporation's three owners and three salesmen. 

According to their or al testimony, supported only by 

invoices, the owners and s a l esmen ente rtained purchasing 

agents and other r epr esen t a tives of customers under 

circumstances conducive to business discussion. 

The controlling shareholder of a small r etail sales 

corporation received a sala ry of $19,000. From this, he 

deducted $26,000 for the expenses of entertain i ng a t a 

cottage on a Caribbean island. 

Taxpayers may claim "arg uably deductible" entert?inment 

e xpenses in the belief that they are prope rly deductible, or 

in the hope or expectation that they will not be audited , or 

in an a ttempt to obtain bargaining power f or use if they are 

aud ited. Wnatever the re ason, many nondeductible 

en tertainment expenses are in fact deducted. IRS data 

suggest that about 20 percen t of all entertainment e xpenses deducted on individual r etu rns should not be deduc ted . 

Overreporting of this magnitude breeds disrespect for the law 

and impairs the integrity of the tax system . 

Stricter enforcement of present law cannot solve the 

overreporting problem. Present law on the deductibility of 

entertainment expenses is so generous, and its application so 

subjective, that it invites taxpayers to test the boundaries. 

Determinations of "necessary," "reasonable," "directly related," and "associated with," as well as the allowance of 

substantiation by means othe r than adequate records, 

necessarily leave much to the judgment of the individua l IRS 

agent. They make administration extremely difficult, and 

uniform administration unattainable. 

General Explanation 

To reduce the unfairness and abuse associated with 

present law, the Administration proposes to disallow 

deductions for expenses of entertainment which is not taxed 

to the recipient as compensation. In general, deductions for 

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expenses of all entertainment activities and facilities will 

be disallowed. However, scr percent of currently deductible 

entertainment expenses for food and beverages will remain 

deductible. 

Regardless of the existence of a business purpose, the 

high level of personal value associated with entertainment 

justifies the proposed disallowance of deductions. 

Disallowance is required to achieve the equivalent of 

including in the tax base the personal value of the benefit 

to the recipient. Since entertainment meals often involve 

business conversations, they may be less likely than other 

forms of entertainment to have personal value to the 

recipient equal to cost. Fifty percent disallowance is 

roughly equivalent to allowing a full deduction to the payor 

and including half of the cost of the meal in the income of 

the recipients. 

This proposal will affect entertainment expenses only. 

Costs of business travel away from home will continue to be 

deductible, subject to the limitations proposed with respect 

to foreign conventions and first class air fare. Travel is 

less likely to have personal value to the businessman than 

entertainment, and travel deductions are less subject to 

abuse. Therefore, it is appropriate to continue to a llow 

them to be deducted. 

However, since entertainment is entertainment, no matter 

where it takes place, entertainment expenses incurred in 

connection with business travel will be subject to the 

Administration proposal. For example, if an employe e 

traveling away from home on business entertains associates by taking them to the theater, the cost of the theater tickets 

will not be deductible. ~lso, if the only purpose of a trip 

is to entertain the traveler, no deduction will be allowed. 

For example, no deductions will be allowed for costs of a 

cross country trip by business a ssociat e s to attend the 

Masters Golf Tournament or the Superbowl. 

Certain employer-provided me als wi ll be e xcepted from 

the proposal. Present law excludes from an employee's i ncome 

the value of meals which are furnished to him by his employer 

on the employer's business premises and for the employer's 

convenience. In applying this exclusion, meals ~re 

considered to be furnished for the employer's convenience 

only upon a clear and strong showing of bus iness ne c e ssity. 

The proposals do not modify the statutory exclusion, and 

costs of providing such meals will continue to be fully 

deductible under the proposals. 

An a lysis of Impact 

The Administration proposal will not hurt Ame rican 

business. If the increased revenue from the proposa l is used 

to lower tax rates, as recommended, the proposal will simply 

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make it relatively more expensive for businesses to provide 

entertainment to employees and business associates, and 

relatively less expensive to lower prices or to increase 

salaries. 

In terms of economic efficiency, the proposed changes 

will be beneficial. The government will no longer be 

subsidizing consumption in such forms as yachts, theater 

tickets, and country club memberships connected with an 

ostensible business purpose. The governmP.nt subsidy for 

entertainment meals will also be reduced. Persons will 

continue to engage in such entertainment, either on their own 

or in the company of business associates, if they feel that 

the benefit derived from the entertainment is worth its cost. 

Because entertainment expenses will have to be purchased with 

after-tax dollars, there will no longer be a bias in favor of 

entertainment over other forms of consumption. 

It is true that many forms of business entertainment 

have become accepted as social custom and are viewed by some 

businessmen as necessary to attract and keep customers. 

However, one reason that business entertainment has become 

accepted as social custom is because the tax system lowers 

its price. In the long run, social customs related to 

business entertainment might change if the tax subsidies that 

encourage it change. Even in the very short run, changes in 

deductibility of entertainment expenses will affect all 

business firms engaging in entertainment alike. 

The Administration proposal will not have a substantial 

effect on those industries benefiting from tax incentives for 

entertainment. Expensive restaurants catering to individuals 

eating tax deductible meals might suffer some decline in the 

demand for their services. However, the Administration pro~osal will cause relatively little, if any, loss of jobs. It 1s estimated that the total employment reduction in the 

restaurant industry will be no more than 2 percent, at most, 

of all such jobs. The rapid employment turnover in that 

industry will absorb much · of any such employment reduction. 

Hotels and other travel related industries generally will not 

lose business as a result of the proposal since most costs of 

business travel and domestic convention attendance will 

continue to be fully deductible. 

It should be emphasized that output and employment in 

the economy as a whole will NOT decline as a result of the ~dministration proposal. Any reduced spending on 

entertainment will be balanced by increased spending on other 

goods and services by individuals ben~fiting from the reduced 

tax rates. 

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Effective Date 

The proposed changes in the deductibility of 

entertainment expenses will take effect for tax years 

beginning after December 31, 1978. 

Revenue Estimate 

1978 1979 

1,195 

Change In Tax Liability 

($ millions) 

Calendar Years 

1980 1981 

1,322 1,434 

Technical Explanation 

1982 

1,564 

1983 

1,706 

For purposes of the proposal, as under present law, 

entertainment activities include any activity of a type 

generally considered to constitute entertainment, amusement, 

or recreation. Thus, expenses of activities such as theater 

parties, attendance at sports events, and fishing trips will 

be fully disallowed. 

For purposes of the proposal, as under present law, 

entertainment facilities include any facility used in 

connection with an entertainment activity. Thus, expenses of 

facilities such as hunting lodges and swimming pools will be 

fully disallowed. ~s under present law, dues or fees paid to 

any social, athletic, or sporting club or organization will 

be considered expenses of entertainment facilities. Such 

dues or fees will not be deductible unless the club or 

organization operates solely to provide lunches under 

circumstances conducive to business discussion. Dues or fees 

paid to such business lunch clubs will be treated the same as 

meal expenses and hence will be disallowed only by half. 

Similarly, expenses of employer facilities used primarily to 

provide meals to employees will be treated the same as the 

expenses of the meals provided. 

Costs of business travel away from home will continue 

to be deductible, subject to the limitations proposed with 

respect to foreign conventions and first class air fare. 

Deductible business travel costs include costs of 

transportation, lodging, and meals. However, they do not 

include expenses of a trip unde rtaken purely to provide 

entertainment to those trave ling. 

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Whether a meal is considered a travel meal or an 

entertainment meal will depend on the travel status of the 

person who eats the meal, not the person who pays for it. 

For example, assume Mr. A lives in New York City, Mr. B is in 

New York City away from home on business, and they eat a 

business meal together. Regardless of whether Mr. A or Mr. a 

picks up the check, Mr. A's meal is SO percent deductible and 

Mr. B's meal is fully deductible. For reasons of 

administrative convenience, all meals consumed at the same 

time will be presumed to have the same cost. In the example, 75 percent of the total check will be deductible. As a 

consequence of this rule, meals purchased for those attending 

a bona fide business convention generally will be deductible. 

Where entertainment is furnished to an employee by his 

employer, the Administration proposal will limit or disallow 

a deduction to either the employer or the employee, but not 

both. Rules for preventing double disallowance are as 

follows: (1) The proposal will not apply to an employer to 

the extent that he treats entertainment expenses as 

compensation to the recipient employee. For this purpose, 

treatment as compensation means treatment as compensation to 

the employee on the employer's income tax return as 

originally filed and treatment as wages to the employee for 

purposes of withholding. Entertainment expenses treated as 

compensation will remain fully deductible by the employer as 

wages or salary: at the same time, such expenses will be 

subject to the proposed disallowance rules for purposes of 

determining deductibility by the employee. Expenses incurred 

by an employee and not reimbursed by or charged to his 

employer also will be subject to the ~roposed disallowance 

rules. Of course, the Administration proposal will not 

operate to allow deductions, but simply to disallow them. 

(2) Entertainment expenses paid or reimbursed, or 

entertainment provided, by an employer to an employee and not 

treated by the employer as compensation will be subject to 

the proposed disallowance rules for purposes of determining deductibility by the employer, but not for determining 

deductibility by the employee. Similar rules to prevent 

double disallowance will apply to independent contractors. 

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IIF-4 

FIRST CLASS AIR FARE 

Present Law 

Transport~tion expenses may be deductible if incurred in 

connection with the tax9ayer's travel away from home on 

business. The deductibility of such expenses depends on the 

primary purpose of the trip. If the trip is related 

primarily to the taxpayer's business, expenses of 

transportation to and from the destination are deductible. 

These expenses are not deductible if the trip is primarily 

personal in nature. The primary purpose of the trip is 

determined on the basis of the facts and circumstances in the 

individual case. 

First class air fare generally is deductible under the 

above rules. However, first class air fare incurred in 

connection with travel to attend a foreign convention, is not 

deductible to the extent that it exceeds coach fare. 

Reasons for Change 

For most people, first class air fare is a luxury. The 

primary difference between a first class seat and a coach 

seat on an airplane is personal indulgence. 

The speed of air travel may be a business necessity, but 

the luxury of first class seating is not. Both ends of the 

plane arrive at the same time. Coach seating adequately 

serves the business purpose. 

Allowing the full amount of first class fare to be 

deducted, without taxing the first class portion to the 

recifient, provides a tax subsidy for first class travel. 

Thus, present law requires the many taxpayers who either 

cannot afford first class fare for themselves, or choose to 

forego it, to subsidize the personal benefits enjoyed by 

others. 

General Explanation 

To remove this tax subsidy, the President proposes to 

disallow deductions for the portion of air fare attributable 

to first class. The portion of first class fare which is 

equal to coach fare will remain deductible. 

Specifically, the President proposes to disallow 

deductions for costs of regularly scheduled, commercial air 

transportation to the extent that they exceed the amount of 

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the lowest priced, generally available fare for regularly 

scheduled flights between the same points at the same time of 

day. A fare will not be considered "generally available" if 

it is available only to those who fly on stand-by status, 

purchase tickets a specified period of time in advance, or 

stay at their destination a specified period of time. The 

deductibility of costs of air transportation which is 

noncommercial or not regularly scheduled will not be 

affected. 

This proposal will apply to all currently deductible 

costs of regularly scheduled, commercial air transportation 

incurred in connection with the taxpayer's own travel on 

business (including, as under present law, travel to attend 

foreign conventions). Under the Administration's separate 

proposal on deductibility of entertainment expenses, the full 

amount of any transportation expenses incurred in connection 

with a trip whose sole purpose is to entertain the traveler 

will be disallowed. 

Where first class air fare is furnished to an employee 

by his employer, a deduction for the portion of the fare 

attributable to first class will be disallow~d to either the 

employer or the employee, but not both. For rules to prevent 

double disallowance, see the Technical Expl anation of the 

Entertainment Expenses proposal. 

Analysis of Impact 

The major effect of this proposal will be to cause a 

shift in demand among business travellers using commercial 

airlines from first class to coach seats. However, some 

business travellers currently using first class travel may 

reduce their use of commercial airlines and shift to 

corporate aircraft. 

Since first class seats sell for a higher price than 

coach seats, these expected shifts will cause some loss of 

revenue to the commercial airlines. At the same time, a 

change in airline seating configurations to increase the 

proportion of space devoted to coach travel would increase 

airline seating capacity. If these additional available 

seats are filled, the net loss of revenue to the airlines 

from the switch will be very small . 

The proposal is expected to have little or no effect on 

overall use of air transportation or on employment in the air 

transportation industry. Employment will not decline because 

the existing air fleet will still be used to service roughly 

the same number of passengers. 

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Effective Date 

The proposed change in the deductibility of first class 

air fare will take effect for tax years beginning after 

December 31, 1978. 

Revenue Estimate 

1978 1979 

281 

Change In Tax Liability 

($ millions) 

Calendar Years 

1980 1981 

311 337 

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1982 1983 

368 401 
IIF-5 

FOREIGN CONVENTIONS 

Present Law 

Expenses of business travel away from home, including 

costs of transportation, meals, and lodging, may be 

deductible. It a trip is related primarily to the taxpayer's 

business, all travel expenses to and from the destination are deductible~ none are deductible if the trip is primarily personal in nature. Even if expenses of traveling to and 

from the destination are not deductible, subsistence expenses 

incurred at the destination are deductible if allocable to 

the t a xpayer's bu~iness. 

Foreign travel is subject to a special allocation rule. 

If a trip outside the United States lasts longer than ~ week 

and 25 percent or more of the t~xpayer's time on the trip is 

devoted to personal pursuits, all travel costs ~ust be 

allocated between personal and business activities, generally 

in proportion to the number of days spent on each. 

Otherwise, the "primary purpose" test applicable to domestic 

travel applies. 

Convention expenses are considered alloceble to the 

taxpayer's business if the relationship between the 

taxpayer's trade or business and his attendance at the 

convention is such that by his attendance he is benefiting or 

advancing the interests of his trade or business. Whether 

such a relationship exists depends on the facts and circum t~nces of each case. 

In 1976 Congress recognized the growing practice among 

professional, business and trade organizations to sponsor cruises, trips and conventions during which only a small 

portion of time was devoted to business activity. Committee 

reports noted that promotional material often highlighted the 

ded uctibility of expenses incurr ed in attending a foreign 

convention and, in some ceses, described the meeting in such 

terms as a "ta x-paid vacation" in a "glorious" location. 

Committee reports also noted th a t some organizations 

advertised that they would find a convention for the t~xpayer 

to attend in any part of the world at any given time of the ye~r. 

In short, many t a xpayers we re cttending for e ign 

conventions primarily to take advantage of opportunities for 

sightseeing and recreation. However, since it was extremely 

difficult to distinguish between personal and b~sines s 

motives in taking such tri9s, often the personal element was 

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not disallowed. As a result, deductions for attending 

foreign conventions had become a source of t ax abuse. 

In an effort to prevent this abuse , the 1976 Tax Reform 

Act imposed special limitations on such deductions. Those 

limitations provide that when a person attends more than two 

foreign conventions in one tax year, no more than the costs 

of two conventions may be deducted. 

With respect to foreign conventions for which a 

deduction is allowable , the 1976 Act limits the deductible 

amount. The amount deductible for transportation outside the 

United States, to and from a convention, generally may not 

exceed the lowest coach or economy rate charged by any commercial airline for such transportation during the month 

of the convention. This amount may be deducted in full only 

if at least half of the days of the trip, excluding transportation days, are devoted to business-related 

activities: otherwise, only a proportionate amount may be 

deducted. 

The 1976 Act also limits the amount deductible for 

subsistence expenses. If at least six hours of business 

activities are scheduled during each day of the convention 

and an individual attends at least two-thirds of these 

activities, his subsistence expenses for each convention day 

may be deducted. If at least three hours of business 

activities are scheduled each day and the individual attends 

at least t wo-thirds, half of his subsistence e xpenses may be 

deducted. However, in no event may the amount of subsistence 

expenses deducted exceed the Federal per diem for the 

convention site . 

Reasons for Change 

The present limitations on deductions for attending 

foreign conventions are inadequate to prevent abuse. These 

rules allow taxpayers to take two foreign vacations a year at 

public expense, and opportunities for such vacations are not 

hard to find. For example, the California Trial Lawyers 

Association sponsored seminars all over the world for its 

members in 1977. The promotion al booklet advertises as 

follows: 

Decide where you would like to go this year: Rome. 

The Alps. The Holy Land. Paris and London. The 

Orient. Cruise the Rhine River or the Mediterranean. 

Visit the islands in the Caribbean. Delight in the art 

treasures of Florence. 

The booklet also notes that these trips have been "designed 

to qualify under the 1976 Tax Reform Act as deductible 

foreign seminars." This type of ~dvertising breeds 

disrespect for the tax system. 

- 209 -
~nother group, the Association of Tri a l Lawyers of 

America, is holding its mid-winter convention in ~onte Carlo 

this year. The word "convention" is the closest that a 

recent 4-page advertisement for the convention comes to 

mentioning business -- except to note th~t expenses of 

attending continuing legal education programs have been held 

deductible for Federal income tax purposes. The 

advertisement is devoted to describing the vacation aspects 

of Monte Carlo, "the jewel of the Riviera" and the "most 

exciting square mile on earth." 

The 1976 tax provisions on foreign conventions not only f~il to prevent abuse, but also increase tax complexity. They require close scrutiny of conference agendas and 

individual attendance records. In claiming deductions, it is 

particularly difficult for employers to be sure th~t the 

required number of hours of business activities were 

scheduled for each day of each convention and that each 

employee for whom expenses ~re deducted actually attended 

two-thirds of the scheduled activities. 

General Explanation 

To prevent abuse and simplify the law, the President 

proposes that expenses of attending a foreign convention be 

deductible only if it is as reasonable to hold the convention 

outside the United States and possessions as within. For 

purposes of this proposal, as under present law, conventions 

include seminars and similar meetings. The factors to be 

considered in determining reasonableness of the convention 

site are the purpose and activities of the convention; the 

purpose and activities of the sponsoring organization; the 

residence of active members of the sponsoring organization; 

the places at which other meetings of the sponsoring organization have been held; and the particular reason(s) why 

the convention is being held abroad rather than in the United 

States or possessions. 

For example, if a significant portion of an 

organization's members resided in Canada, it could be 

considered as reasonable for the organization to hold a 

convention in Canada as in the United States. Similarly, if 

the members of an organization composed of individuals 

engaged in a certain type of business regularly conducted a 

portion of their business in Mexico, it could be considered 

as reasonable for the organization to hold a conv~ntion in 

Mexico as in the United States. 

With respect to foreign conventions for which deductions 

are allowable, the limitations on deductible amount which 

were enacted in 1976 (including the detailed attendance 

rules) will not be continued. However, subsistence expenses 

will be nondeductible to the extent that they exceed 125 

- 210 -
percent of the Federal per diem for the convention site . 

Thus, if it is as reasonable to hold a convention outside the 

United States as within and if the expenses of attending the 

convention a r e ordinary and necessary business expenses , then 

(subject to the allocation rules of pre-1976 law and 3ny disallowance of the first class portion of air fare} the full 

cost of transportation to and from the convention will be 

deductible, and subsistence expenses will be deductible up to 

125 percent of the Federal per diem. 

Where an employee 's expenses of attending a foreign 

convention are paid or reimbursed by his employer, a 

deduction for such expenses may be disallowed to either the 

employer or the employee, but not both. For rules to prevent 

double disallowance, see the Technical Explanation of the 

Entertainment Expenses proposal. 

Analysis of Impact 

The proposal will not decrease the number of conventions 

held outside the United-states and possessions for 

non-vecation reasons. However, as compared to both pre-1 976 

and present law, the proposal can be expected to r erluce the 

number of conventions held outside the United States and 

possessions which a r e essentially vacations at public 

expense . 

Pr es umably most conventions not held outside the United 

States as a result of the proposal, will be held inside the 

United States. Thus, the proposal can be e xpected to 

increase the number of conventions held in this country and 

hence increase employment in some hotels end restaur ants in 

the United States and possessions. 

While the proposal can be e xpecte d to reduce the overall 

number of conventions held outside the United States and 

possessions by American org aniz a tion s , e s compared to present 

law the ~roposal probably will incr eas e the number ,eld in 

neighbor1ng countries such a s Ca ned a bec ause business recsons 

for holding conventions there ar e likely to exist . 

Effective Date 

The proposed change in the deductibility of expenses of 

travel to foreign conventions will take effect for tax years 

beginning after December 31, 1978. 

Revenue Estimate 

The proposal will have a negligible effect on tax 

liability. 

• 

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