The President’s 

Tax Proposals 

to the Congress for 

May 1985 
TO THE CONGRESS OF THE UNITED STATES: 

We face an historic challenge: to change our present tax 

system into a model of fairness, simplicity, efficiency, and 

compassion, to remove the obstacles to growth and unlock the 

door to a future of unparalleled innovation and achievement. 

For too long our tax code has been a source of ridicule 

and resentment, violating our Nation's most fundamental 

principles of justice and fair play. While most Americans 

labor under excessively high tax rates that discourage work 

and cut drastically into savings, many are able to exploit the 

tangled mass of loopholes that has grown up around our tax 

code to avoid paying their fair share -- sometimes to avoid 

paying any taxes at all. 

The American people want change and for very good reason. 

Our present tax code is not only unfair, it slows economic 

growth and job creation, and hinders technological advancement 

by interfering with free markets and diverting productive 

investment into tax shelters and tax avoidance schemes. In 

1981, we made the first necessary, historic step by cutting 

tax rates and opening the way to vibrant economic growth and 

expanding opportunity for all Americans. Now is the time to 

build on our success, to redesign the basic structure of our 

tax system in order to discourage non-productive economic 

activity, to encourage greater compliance and to liberete 

incentives still further. 
Accordingly, I hereby submit my proposal to overhaul our 

tax code based on the principles of simplicity and fairness, 

opening the way to a generation of growth. This is a tax 

proposal we can be proud of, a proposal that will help fulfill 

America's commitment to fairness, hope, and opportunity for 

a11 its citizens. 

I urge your prompt enactment of this historic program for 

redesigning the tax code, and I look forward to working with 

you toward that end. 

THE WHITE HOUSE, 

May 29, 1985. 
May 1985 Summary 
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THE PRESIDENT'S PROPOSALS 

FOR FAIRNESS, GROWTH, AND SZFLICITY 

SUMMARY 

The President's proposals would reduce tax rates, reduce 

complexity, increase fairness, and increase growth. The 

following is a summary of the proposals and their rationale. 

I. THE PROBLEM WITH 

THE CURRENT TAX SYSTEM 

(A) The overwhelming majority of Americans are dissatisfied with 

the current tax system. They are concerned because: 

(1) The system is unfair. 

People are troubled by stories of wealthy

individuals and healthy corporations paying little 

or no taxes. 

They can't understand the logic or equity of people

in seemingly similar situations paying dramatically

different amounts of tax. 

They read or hear of one tax break after another -- from credits for investments in windmills to 

deductions for "educational" cruises on ocean 

liners -- and know that they are not getting the 

benefit of such breaks. 

-_ They are skeptical of the economic justification of 

many tax shelter schemes -- and see them as tax 

dodges. 

(2) The system is too complicated. 

For some, it seems a difficult -- and sometimes even 

ridiculous -- administrative burden. About half of 

all Americans seek professional tax advice; no 

doubt, more feel they may need it. 

_- And while others may not find the system so 

burdensome, they often resent complexity

nonetheless: They sense it is unfair -- that 

complexity is the means by which some benefit while 

others do not. 
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(3) The current system needlessly impedes growth. 

By encouraging investment for purposes of tax 

reduction rather than for independently worthy

economic purposes, it prevents the market from 

allocating resources as efficiently and productively 

as it might. 

By taxing workers' earnings at excessive rates -- or 

by being perceived as taxing unfairly -- it 

discourages work, saving, productivity, innovation,

and growth. 

Thus, it prevents workers and the economy from 

reaching their full potential. 

(B) As dissatisfaction increases, the continued viability of the 

tax system is threatened -- and as it is threatened, so too

Is the basis of support for essential governmental services 

and functions. 

(1) The "underground economy" and the "tax " (taxes owed 

but not paid) are large and thought----P­ to e growing. The 

American-tradition of voluntary tax compliance is being

eroded. 

(2) Efforts to increase compliance within the framework of 

the current system seem not only to have reached the 

point of diminishing returns. They often seem to be 

counter-productive: They increase resentment and 

disrespect for a system that cannot long function 

without a firm foundation of public confidence. 

Americans want change. 

America was born in a revolutionary context that grew out of 

popular resentment of an unfair tax system. Two centuries 

later, another revolution is quietly growing. It is a 

peaceful revolution -- but again it is born of popular 

resentment of a tax system that has gone awry. 

Americans want a new system. This is not a conventional 

artisan matter. The tax reform movement has strong {dvocates within both political parties. With bipartisan

effort and cooperation, Americans can have the new system

they want and deserve: a system that interferes less with 

economic choices; that promotes growth; that is simpler; and,

perhaps most importantly, that people perceive to be fair. 
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11. THE PRESIDENT’S 

PROPOSALS FOR REFORM 

To increase growth, reduce complexity, and make the system more 

fair, the President has proposed a comprehensive set of reforms. 

The following are key features: 

(A) PERSONAL RATE REDUCTION: 

personal income tax rates must be lowered substantially as 

the tax base is broadened. 

(1) The President‘s proposals would eliminate the present

svstem of 14 brackets of tax rates ranaina from 11 to .. 50__ percent. In its place would be a simpie <.-bracket 

system -- with tax rates of 15, 25, and 35 percent. 

(For joint returns, the rates would be: 0% UD to $4.000 ’ 

in taxable income; 15% on the amount from $4,500 to 

$29,000 ; 25% on the amount from $29,000 to $70,000; and 

35% on the amount over $70,000.) 

marginal tax rates would be reduced by an average of 

19 percent. 

Average tax rates would be reduced for all income 

classes. 

_- Total taxes paid by individuals would be reduced by

7 percent. 

(2) The complex system of itemized deductions, exclusions,

and special credits would be substantially simplified ’ 

and reformed. More than 65 categories of preferential

tax treatment would be eliminated or curtailed. For 

example: 

Deductions for entertainment and business meal 

expenses would be limited. 

The deductibility of state and local taxes -- which 

contributes to the problem of high federal. tax 

rates, and which can be conceived as a special.

subsidy to high-income taxpayers in high-tax 

states -- would be repealed. 

Unemployment and disability payments (with the 

exception of veterans’ disability payments) would be 

treated as income. 
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Relatively narrow tax benefits available only to a 

few like "business" deductions for educational 

seminars on cruise ships or for the use of sky-boxes 

at sporting events -- would be eliminated. 

Similarly, such tax abuses as those associated with 

income shifting to minor children or to certain 

trusts would be limited. 

(3) Only a limited number of special deductions and 

exclusions would be retained -- principally those that 

are widely used, and generally judged to be central to 

American values. For example: 

In view of America's unequivocal commitment to 

private home-ownership, the home mort- interest 

deduction would be retained for a taxpayer's

principal residence. 

In view of America's special obligations to Social 

Security beneficiaries and disabled veteranscurrent ureferential treatment of Social Security

and vete;ans' disability payments would be retained. 

_- And in view of America's longstanding commitment to 

charity and voluntarism, the itemized deductions 

would be retained for charitable contributions. 

(B) SUPPORT FOR FAMILIES: 

Insofar as the tax system affects the American familyi if 

should contribute to strengthening it rather than wea eninq -it. Accordingly: 

The President's proposals would increase the personal

exemption to $2,000 as of January 1, 1986 for each 

taxpayer and dependent -- and would index this amount to 

protect against-inflation. 

The "earned income tax credit" for the working poor

wouldTe increased and indexed to protect against

inflation. 

The incentive for private saving through Individual 

Retirement Accounts (IRAS) -- now available to all 

wage-earners -- would be expanded to afford the same 

benefit to spouses working in the home. 
-5-

(C) FAIRNESS FOR THE POOR: 

The tax system should not be an additional burden to those 

who are struggling to escape from poverty; insofar as 

possible, those below the poverty line should be freed from 

taxation altogether. 

By raising the personal exemption, the "zero bracket 

amounts," and earned income tax credit, and by expanding the 

credit for the blind, elderly, and disabled, the President's 

proposals would: 

(1) assure that virtually all families at or below the 

poverty line would be freea from taxation; and 

(2) assure that virtually all older, blind, or disabled 

Americans at or below the poverty line would be freed 

from taxation. 

(D) RETURN-FREE FILING: 

The administrative burden on individuals should be reduced, 

not increased. 

If the President's proposals are adopted, the number of 

taxpayers likely to itemize will be reduced to only 33 

percent. And it will be possible to administer a 

'return-free" filing system that would permit more than half 

of all taxpayers to receive an appropriate tax bill or refund 

without ever having to file a return. This system woulr 

entirely voluntary. At the taxpayer's discretion, the 

administrative buiden would be borne by the IRS based on 

information already scheduled to be available to it. 

(E) INCENTIVES FOR GROWTH: 

The tax system should, insofar as possible, foster economic 

growth by encouraging work, savinrisk-taking from which there is general benefit; and allowing 

resources to be allocated efficiently on the basis of 

economic rather than tax considerations. With this in view: 

(1) Changes in the tax system for individuals -- reducing 

rates and increasing the perception of fairness -- should increase incentives for work, saving, investment,

risk-taking, and innovation. In addition, a more 

efficient and productive economy and faster growth would 

be fostered through the following, which relate 

primarily to business taxation. 
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(2) Special subsidies or preferences for specific industries 

or sectors should be curtailed except where there is a 

clear national security interest that argues to the 

contrary. Accordingly, the President's detailed 

-

proposals - include limitations on preferences that are

now available to: 

banking ; 

insurance; 

mining; 

timber; 

oil and gas; and 

non-government beneficiaries of tax-exempt bonds. 

(3) Distortions of investment patterns resulting from

unjustifiable tax shelter schemes should be reduced --

as, for example, through the extension of "at risk" 

rules to the real estate sector. 

(4) Incentives for investment in research and 

experimentation should be preserved through a more 

accurately targeted credit for such investment. 

(5) Incentives for higher-risk venturing -- from which there 

is often greater social gain should be provided by

excluding from taxable income 50 percent of long-term

capital gains. (This would reduce the present maximum 

capital gains tax from 20% to 17.5%.) 

(6) Tax-induced distortions among differing categories of 

investment should be reduced, while avoiding an overall 

increase in the cost-of-capital. To this end: 

The investment tax credit should be repealed and the 

accelerated depreciation system should be revised 

and indexed for inflation to bring effective tax 

rates closer together for different categories of 

investment. 

Firms using the "FIFO" (first-in-first-out)

inventory accounting system should also be allowed 

to index the value of inventories for inflation (or

to use "LIFO" without the conformity obligation). 
-- 

-7-

To alleviate the double taxation of dividends, the 

principle of corporate dividend deductibility should 

be established with an initial deductible amount of 

10 percent. 

_I The maximum corporate tax rate should be reduced to 

33 percent -- keeping it roughly in line with the 

maximum individual rate. 

(7) Small business formation and development -- from which 

much of America's extraordinary job-creation comes -- should be facilitated through a graduated corporate rate 

structure that benefits small business and is phased out 

for laraer ones. 

NOTE RE GROWTH AND "REVENUE NEUTRALITY": 

Taken 

neutral" 

together, 

(plus-or-minus 

the President's 

1.5% of 

proposals 

total revenues) 

are "revenue --- using

conventional estimating procedures, without changing

macro-economic assumptions. That is, under these 

assumptions, the proposals would, when fully effective, raise 

virtually the same amount of revenue as current law. 

For reasons suggested above, it is reasonable to expect

improved economic performance as a result of the President's 

tax proposals. The Treasury Department estimates that the 

effect of the proposals would be to cause real GNP to be at 

least 1.5 percent higher by 1995 than it would be under 

current law. Because of the inherent uncertainty in such 

forecasts, however, this additional growth has not been added 

to Administration forecasts and is not reflectenn higher 

revenue estimates. 

(F) OVERALL FAIRNESS OF CHANGES: 

In addition to the increased perception of fairness that 

derives from rate reduction, base-broadening, and the 

elimination of special preferences, it is important that the 

overall effect of the proposals be deemed fair when judged by

such measures as the followinq: 

(1) The number of taxpayers who "win" and who "lose": The 

President's proposals would produce benefits or no 

change in individual tax liabilities for 79 percent of 

families and losses for only 21 percent of families. 

This pattern holds across all income groups -- and is 

strongest in the lowest income categories. (Even those 

whose taxes would not change would benefit from 

simplification and increased fairness.) 
-0-

(2) The pattern of tax reductions by income class: The 

President's proposals would reduce total individual 

income taxes by 7 percent overall. The amount of taxes 

paid bv those in the lowest three income cateoories 

would be reduced by the largest percentages, an average

of 18.3 percent. 

(3) The distribution of the overall tax burden by income 

class: The President's -. DroDosals would result in

m l y the same percentage of total revenues being

contributed by each income class as is contributed under 

current law -- except for the poor, who would pay a much 

smaller percentage. 

(4) The effects on those at or below the poverty line: The 

President's proposals would remove from income taxation 

altogether virtbally all families, married couples,

single heads of households, and older Americans at or 

below the poverty line. 

(5) T I 

individuals and corporations who may escape taxation 

alto ether: The President's proposals to reform +in ivi ua and corporate taxes will substantially reduce 

incentives and opportunities to escape all income 

taxation ("zero out"). As additional assurance that 

some contribution is made by all economically healthy,

income-earning individuals and corporations, the 

proposals also include minimum tax requirements for both 

individuals and corporations. 

(6) The distribution of the tax changes between corporations ~~~and individuals: This is not a particularly relevant 

economic measure; but it is often judged to-be important 

as a matter of perception. When fully effective, the 

President's proposals would raise total corporate tax 

payments by an estimated 9 percent, and would lower 

total individual tax payments by 7 percent. 

Charts that amplify these points are attached. Also attached,

for summary reference purposes, is a chart that compares current 

law, the November 1984 Treasury Department proposals, and the 

President's May 1985 proposals. Detailed discussion of the 

President's proposals is provided in the associated volume. 

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Tax Proposals 

to the Co gress for 

Fairness, Growt 

icity 

May 1985 General Explanation 
TABLE OF CONTENTS 

I. INDIVIDUAL INCOME TAXES 

Chapter 1. REDUCE MARGINAL TAX RATES 

1.01 Reduce Marginal Tax Rates .................... 

Chapter 2. INCREASE FAIRNESS FOR FAMILIES 

2.01 

2.02 

2.03 

2.04 

2.05 

Increase ZBA and Personal Exemptions ......... Combine Tax Benefits for Elderly, Blind, and 

Disabled into Expanded Credit ................ Repeal Two-Earner Deduction .................. Increase and Index Earned Income Tax Credit .. Replace Child and Dependent Care 

Credit with Deduction ........................ 

Chapter 3. HAKE TEE SYSTEM MORE NEUTRAL AND FAIR 

Part A. Excluded Sources of Income--Fringe Benefits 

3.01 Include in Income a Limited Amount of 

Employer-Provided Health Insurance ........... 3.02 Repeal $5,000 Exclusion for EmployerProvided Death Benefits ...................... 3.03 Repeal Exclusion for Employer-Provided

Commuting Services ........................... 3.04 Establish a Uniform Nondiscrimination Rule ... 3.05 Repeal Exc1,usion for Employee Awards ....,.... 

Part B. Excluded Sources of Income--Wage

Replacement Payments 

3.06 Repeal Exclusion for Unemployment and 

Disability Payments .......................... 

Part C. Excluded Sources of Income---Other 

3.07 Limit Scholarship and Fellowship Exclusion ... 3.08 Repeal Exclusion for Prizes and Awards ....... 

iii 

1 

1. 

1 

5 

6 

11 

15 

17 

19 

23 

23 

24 

30 

32 

33 

47 

49 

49 

57 

57 

59 
Part D. Preferred Uses Of Income 61 

3.09 Repeal Deduction of State and Local Taxes .... 621 

3.10 Accelerate Expiration of Charitable 

Contribution Deduction for Nonitemizers ...... 70 

Part E. Tax Abuses.. Mixed Business/Personal Use 73 

3.11 Limit Deduction for Entertainment and 

Business Meal Expenses ....................... 74 

3.12 Limit Deduction for Travel Expenses .......... 79 

Part F. Tax Abuses.. Income Shiftinq 83 

3.13 Adjust Tax Rate on unearned Income of 

Minor Children ............................... 84 

3.14 Revise Grantor and Non-Grantor 

Trust Taxation ............................... 88 

3.15 Revise Income Taxation of Estates ............ 99 

Chapter 4 . REDUCE RECORDKEEPING AND COMPLEXITY 103 

4 .01 Impose Floor on Employee Business Expense

and Other Miscellaneous Deductions ........... 104 

4 .02 Repeal PoliticaI. Contribution Credit ......... 106 

4 .03 Repeal Presidential Campaign Check-Off ....... 108 

4.04 Repeal Adoption Expense Deduction ............ 109 

4.05 Repeal Income Averaging ...................... 110 

4.06 Simplify Penalty Provisions .................. 112 

Chapter 5 . SIMPLIFY THE SYSTEM OF FILING 115 

5.01 Implement Return-Free System ................. 115 

I1. BUSINESS AND CAPITAL INCOME TAXES 117 

Chapter 6 . REVISE TEE TAXATION OF CORPORATE INCOME 117 

6.01 Reduce Corporate Income Tax Rates ............ 118 

6.02 Reduce Double Taxation of Corporate Earnings

Distributed to Shareholders .................. 120 

6.03 Repeal $100/$200 Dividend Income Exclusion ... 130 

iv 
Chapter 1. REVISE TAXATION OF BUSINESS PROPERTY AND 

CAPITAL ASSETS 131 

7.01 Adopt New Capital Cost Recovery System

(CCRS) ....................................... 132 

7.02 Repeal Investment Tax Credit ................. 160 

7.03 Revise Tax Treatment of Capital Gains ........ 164 

7.04 Index Inventories ............................ 174 

7.05 Retain $5,000 Limit on Expensing Depreciable

Business Property ............................ 179 

7.06 Repeal Rapid Amortization Rules .............. 181 

7.07 Deny Rate Reduction Benefit Attributable 

to Excess Depreciation ....................... 192 

Chapter 8. REASURE INCOME PROPERLY 197 

8.01 Revise Accounting Rules for Production Costs . 198 

8.02 Recognize Gain on Pledges of 

Installment Obligations ...................... 208 

8.03 Limit Use of Cash Method of Accounting ....... 212 

8.04 Repeal Reserve Method for 

Bad Debt Deductions .......................... 215 

8.05 Repeal Mining and Solid Waste Reclamation 

and Closing Cost Deduction ................... 220 

Chapter 9. REVISE TAXATION OF ENERGY AND NATURAL RESOURCES 223 

9.01 Repeal Energy Tax Credits .................... 224 

9.02 Repeal Percentage Depletion .................. 228 

9.03 Revise Minimum Tax on 

Intangible Drilling Costs .................... 231 

9.04 Revise Royalty Taxation ...................... 234 

Chapter 10. REFORM TAXATION OF FINANCIAL INSTITUTIONS 231 

Part A. Commercial Banks and Thrift Institutions 231 

10.01 Repeal Special Rules for Depository

Institution Bad Debt Deductions .._...........238 

t0.02 Deny Deduction for Interest to 

Carry Tax-Exempt Bonds ....................... 243 

10.03 Repeal Tax Exemption for Large Credit Unions . 247 

10.04 Repeal Reorganization Rules for Financially

Troubled Thrift Institutions ................. 249 

10.05 Repeal Special Rules for Net Operating

Losses of Depository Institutions ............ 252 

V 
Part B. Life Insurance Companies and Products 253 

10.06 Impose Current Taxation on Life Insurance 

Inside Build-Up ............................ . 254 

10.07 Impose Current Taxation on Deferred Annuity

Investment Income .......................... . 259 

10.08 Limit Life Insurance Company

Reserve Deduction .......................... . 261 

10.09 Repeal Special Life Insurance 

Company Deductions ......................... . 263 

Part C. Property And Casualty Insurance Companies 265 

10.10 Revise Treatment of Losses by Property and 

Casualty Insurance Companies and Allow 

Deduction to Certain of Their Policyholders .. 266 

10.11 Repeal Mutual Property and Casualty insurance 

Company Protection Against Loss Account ...... 274 

10.12 Repeal Special Tax Exemptions, Rate Reductions,

and Deductions of Small Mutual Property and 

Casualty Insurance Companies ................. 276 

10.13 Limit Mutual Property and Casualty Insurance 

Company Deduction for Policyholder Dividends . 218 

Chapter 11. REFORM TREATMENT OF STATE AND 

LOCAL GOVERNMENT DEBT AND INVESTMENTS 281 

11.01 Repeal Tax Exemption for 

Nongovernmental Bonds ........................ 282 

11.02 Limit Tax Arbitrage and Advance Refunding

for Tax-Exempt Bonds ......................... 288 

11.03 Repeal General Stock Ownership Corporation

Provisions ................................... 293 

Chapter 12. MODIFY OTHER SPECIFIC SUBSIDIES 295 

12.01 Repeal Tax Credit for Qualified

Rehabilitation ............................... 296 

12.02 Repeal Special Rules for Book, Magazine, and 

Discount Coupon Income ....................... 299 

12.03 Extend and Modify Research and 

Experimentation Credit ....................... 301 

12.04 Repeal Merchant Marine Capital Construction 

Fund Provisions .............................. 304 

12.05 Replace Possessions Tax Credit 

with a Wage Credit ........................... 307 

12.06 Revise Rules for Leveraged ESOPs ............. 314 

vi 
Chapter 13. CURTAIL TAX SHELTERS 321 

13.01 Limit Interest Deductions .................... 322 

13.02 Extend At-Risk Limitation to Real Estate .,... 325 

13.03 Revise Alternative Minimum Tax for 

Noncorporate Taxpayers ....................... 328 

13.04 Revise Corporate Minimum Tax ................. 333 

Chapter 14. REVISE TREATHENT OF RETIREMENT SAVINGS 339 

14.01 Increase Spousal Individual Retirement 

Account Limit ................................ 340 

14.02 Unify Rules for Distributions from 

Tax-Favored Retirement Plans ................. 342 

14.03 Modify Deduction Rules for Tax-Favored 

Retirement Plans ............................. 350 

14.04 Modify Annual Limits on Contributions and 

Benefits under Tax-Favored Plans ............. 355 

14.05 Apply Ten Percent Recapture Tax to 

Qualified Plan Assets Reverting to Employer .. 360 

14.06 Revise Cash or Deferred Arrangement

(Section 401(k)) and Employer Matching

Contribution Rules ........................... 363 

14.07 Modify Rules for Benefit Forfeitures ......... 371 

14.05 Modify Loan Rules for Tax-Favored 

Retirement Plans ............................. 372 

14.09 Modify Nondiscriminatory Coverage Test for 

Tax-Favored Retirement Plans ................. 374 

14.10 Unify Rules for Unfunded Deferred 

Compensation Arrangements of States and 

Tax-Exempt Employers ......................... 319 

Chapter 15. REFORK INTERNATIONAL TAXATION 383 

15.01 Reform Foreign Tax Credit .................... 385 

15.02 Modify Sourcing Rules for Income and 

Deductions ................................... 397 

15.03 Replace Second Dividend and Interest Taxes with 

Branch-Level Tax ............................. 406 

15.04 Revise Taxation of Foreign Exchange

Gains and Losses ............................. 409 

15.05 Reform the Mirror System of Taxation for the 

United States Possessions .................... 423 

APPENDIX A: Expiring Provisions ............................... 433 

APPENDIX B: Effective Dates and Transition Rules .............. 435 

APPENDIX C: Change in Receipts by Source ...................... 453 

vii 
LIST OF TABLES 

1.01-1 1986 Current Law and Proposed Tax Rate Schedules ........ 3 

2.01-1 Comparison of Personal Exemption and ZBA foz 1986 

Under Current Law and the President's Proposal .......... 9 

2.01-2 Comparison of the Poverty Threshold and the Tax-Free 

Income Level for 1986 Under Current Law and the 

President's Proposal .................................... 10 

2.02-1 1986 Tax-Free Levels of Income for the Elderly and Blind 

(And Those With Employer-Provided Disability Income) .... 14 

3.01-1 Tax Benefits Arising From the Exclusion of 

Employer-Provided Health Insurance ...................... 25 

3.01-2 Distribution of Employer Contributions for Health 

Insurance (1983), and Estimated Impact of the Proposal .. 29 

3.06-1. 1987 Tax-Free Levels of Income for Those with Workers' 

Compensation and Black Lung Disability Payments ......... 54 

3.06-2 Distribution of Workers' Compensation Payments

by Economic Income ...................................... 55 

3.09-1 Distribution of Deductions for Taxes Paid 

by Economic Income--1983 ................................ 67 

3.09-2 States Ranked by Per Capita Tax Savings from Tax 

Deductibility Under Current Law, 1982 ................... 68 

3.09-3 Percentage Reliance on Different Deductible Taxes 

by States in 1982 ....................................... 69 

4.02-1 IJse of Political Contributions Tax Credit--1982 ......... 107 

7.01-1 Effective Corporate Tax Rates on Income from Equity

Financed Investments with Various Rates of Inflation 

for 46 Percent Taxpayer Under Current Law ............... 136 

7.01-2 Capital Cost Recovery System Depreciation Schedule 

(as a Percent of Inflation-Adjusted Basis) .............. 140 

7.01-3 Capital Cost Recovery System Depreciation Schedule 

(as a Percent of Inflation-Adjusted Original Cost) ...... 141 

7.01-4 CCRS Asset Classes ...................................... 145 

ix 
1 

2 

3 

4 

5 

6 

7.01-5 

7.01-6 

7.01-7 

7.01-8 

7.01-9 

7.01-10 

7.01-11 

7.01-12 

7.01-13 

7.02-1 

7.04-1 

8.02-1 

8.04-1 

8.04-2 

10.02-1 

10.06-1 

Effective Tax Rates 011 Equity Financed Investments 

in Equipment and Structures ............................. 147 

Depreciation Allowances Under Alternative 

Depreciation Methods for a Class Asset ................ 152 

Depreciation Allowances Under Alternative 

Depreciation Methods for a Class Asset ................ 153 

Depreciation Allowances Under Alternative 

Depreciation Methods for a Class Asset ................ 354 

Depreciation Allowances Under Alternative 

Depreciation Methods for a Class Asset ................ 155 

Depreciation Allowances Under Alternative 

Depreciation Methods for a Class Asset ................ 156 

Depreciation Allowances Under Alternative 

DepKeCiatiOII Methods for a Class Asset ................ 157 

Effective Corporate and Personal Income Tax Rates on 

Equity Financed II'IVeStmentS--RetUKnS to Capital Distributed Equally Between Dividends and Capital Gains .... 158 

Effective Corporate Income Tax Rates on Income from 

Equity Financed Investments--Returns to Capital Distributed Equally Between Dividends and Capital Gains .... 159 

Utilization of Investment Tax Credits in 1981 ........... 162 

Percentage of Ending Inventory Valued by the 

FIFO Method by Industry ................................. 178 

Effective Tax Rate Per Dollar of Income Deferred 

by a 50 Percent Taxpayer for Different Deferral 

Periods and Interest Rates .............................. 211 

Hypothetical Example of Excess Deductions with 

Reserve Method .......................................... 218 

Discrepancy Between Reserve Deductions and 

Actual Bad Debt Losses by Change in Total Loans 

and Loss Experience ..................................... 219 

Distribution of Tax-Exempt Securities and Loans--1983 ... 246 

Distribution of Ownership of Cash-Value 

Life Insurance Policies and the Annual 'Inside 

Build-up by Economic Income--1983 ....................... 258 

X 
10.10-1 Time Pattern of boss Payments by Major Lines of 

Business of Property and Casualty Insurance 

Companies-1975 to 1983 Experience ...................... 272 

11.01-1 volume of Long-Term Tax-Exempt Bonds 

by Type of Activity, 1975-1983 .......................... 284 

14.06-1 Current and Proposed Nondiscrimination Limits for 

CODAS and for Other Employer Matching Contributions ..... 370 

B-1 proposed Changes, Effective Dates, and Transition Rules . 437 

xi 
-- 

I. INDIVIDUAL INCOME TAXES 

CHAPTER 1 

REDUCE MARGINAL TAX RATES 

REDUCE MARGINAL TAX RATES 

General Explanation 

Chapter 1.01 

Current Law 

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

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

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

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

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

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

individuals filing separately (14 tax rates). The progression of the 

rates for each class of taxpayers is adjusted annually for inflation 

as measured by the Consumer Price Index for all-urban consumers 

(CPIU). 

Reasons for Change 

The accumulation of tax exclusions and deductions over the years

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

income that is subject to tax. High marginal tax rates create 

disincentives for saving, investing, and working. These in turn 

constrict economic growth and productivity. 

The Administration proposals would expand the base of income by

eliminating many current deductions and exclusions unrelated to the 

proper measurement of taxable income. This expanded base permits a 

significant reduction in marginal tax rates without impairing Federal 

income tax revenues. 

Proposal 

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

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

The applicable tax rate brackets would be indexed as under current 

law. 

-1-
Effective Date 

The proposed individual tax rates would be effective July 1, 1986. 

Thus, the rate schedule for taxable years beginning on or after 

January 1, 1986, would reflect blended rates based on the new rates 

effective on July 1. Withholding to reflect the rate reduction would 

change on July 1, 1986. 

Analysis 

The proposal would reduce individual tax liabilities an average of 

7 percent; marginal tax rates on economic income would be 

approximately 19 percent lower than under current law. The percentage

reduction in taxes is greater at the bottom of the income scale than 

for middle-income families, due to the increase in the tax threshold. 

Tax liabilities of families with incomes below $10,000 would fall by 

an average of 35.5 percent, and the reduction in taxes for families 

with incomes below $20,000 would be 18.3 percent. 

-2-
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-3-
CEAPTER 2 

INCREASE FAIRNESS FOR FAMILIES 

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

of the Administration proposals. The proposals would accomplish these 

goals by redefining the tax threshold and by simplifying and 

rationalizing the provisions affected by the composition of the family

unit. 

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

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

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

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

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

and doubling the personal. exemption compared with its 1984 level. 

These proposed changes are designed to reflect differences in ability 

to pay taxes that result from differences in family size and 

composition. The working poor also would be protected by increasing

the earned income credit and indexing it for inflation. 

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

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

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

of the flatter rate schedule, which increases work incentives for 

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

-5-
INCREASE ZEA AND PERSONAL EXEMPTIONS 

General Explanation 

Chapter 2.01 

Current Law 

Individual income tax rates begin at 11 percent and p ogress to a 

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

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

also known as the "standard deduction"), which is $2,390 for unmarried 

individuals and heads of households, $3,540 for married couples filing

joint returns and certain surviving spouses, and $1,770 for married 

individuals filing separately. Generally, a taxpayer may elect to 

itemize deductions only if the total amount of deductions exceeds the 

applicable ZBA. 

In computing taxable income, each taxpayer is entitled to a personal exemption of $1,040 and to a dependency exemption of $1,040 for 

each of the taxpayer's dependents. if the taxpayer is blind or 65 

years of age or older, an additional personal exemption of $1,040 is 

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

applicable number of personal exemptions. 

The ZBA and the amount deducted from income for each personal and 

dependency exemption are adjusted for inflation. The percentage

increase in each amount equals the percentage increase in prices

during the previous fiscal year, as measured by the consumer price

index for all urban consumers. 

Reasons for Change 

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

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

dependency exemptions do not exempt from tax an amount necessary to 

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

increases, the cost of maintaining a minimum living standard increases 

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

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

income exceeds $9,575, which is approximately $1,025 below the poverty

threshold for such families. By burdening poor families, the tax 

system makes their transition to prosperity more difficult. The tax 

system thus discourages family creation and weakens and limits those 

that are formed. 

Because the current tax thresholds have not kept up with increases 

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

along with the percentage of taxpayers forced to itemize deductions. 

The increase in the number of returns and of itemizers has placed 

-6-
additional recordkeeping burdens on taxpayers and also has drained the 

resources of the Internal Revenue Service. These increased costs are 

frequently out of proportion to the amounts of tax involved. 

The additional personal exemptions provided to the blind and the 

elderly provide the greatest tax benefit to those elderly and blind 

taxpayers with the highest incomes. Thus, they are not the most 

effective way of reducing the tax burden for the blind and elderly who 

are in need. 

Proposal 

The ZBA would be increased to $2,900 for single returns, $4,000

for joint and certain surviving spouse returns, $2,000 for returns for 

married persons filing separately, and $3,600 for head of household 

returns. The amount deductible for each personal and dependency

exemption would be increased to $2,000 for taxable years beginning on 

or after January 1, 1986, and would be indexed for inflation 

thereafter. 

The additional exemptions for the blind and the elderly would be 

repealed, but special tax treatment for the elderly, blind, and 

disabled would be combined into a single tax credit. See Ch. 2.02. 

Effective Date 

The proposal would apply for taxable years beginning on or after 

January 1, 1986. 

Analysis 

Table 1 compares the proposed personal exemptions and ZBA amounts 

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

compared to $L,O80 under current law (after indexing for inflation 

expected to occur in 1985). The zero bracket amounts for single 

returns, head of household returns, and joint returns also would 

increase, as shown on Table 1. 

Although the additional exemptions for the blind and the elderly

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

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

When the proposed increase in the personal exemption is combined with 

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

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

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

from tax. 

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

and the Administration proposals with poverty thresholds for 

households of different sizes and compositions. Under the 

Administration proposals, the tax-free income levels would be 

-1-
increased for single persons and families of all sizes. For example,

for 1986 the tax-free income level for a one-earner married couple

with no dependents would increase from $5,830 to $8,000. A one-earner 

married couple with two children would pay no income tax unless its 

income exceeded $12,798, assuming full use of the earned income 

credit. Under current law, the same family would pay tax on income 

above $9,575. 

Table 2 shows that the proposed increase in the personal exemption

and zero bracket amounts would exempt from tax families in poverty.

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

threshold would be narrowed for single persons without dependents, the 

tax-free income level for such taxpayers would still be $900 less than 

the poverty level in 1986. If the tax-free income level for single 

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

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

penalty." Moreover, since single persons frequently live with 

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

level with the poverty threshold for such persons often is misleading.

when the tax-free income level for single persons is combined with the 

tax-free income levels of parents or other household members, the 

combined tax-free income level may exceed the poverty level. 

-8-
Table 2.01-1 

Comparison of Personal Exemption and ZBA for 1986 

under Current Law and the President's Proposal 

I Current Proposed 

Single persons 2,480 2,900

Heads of households 2,480 3,600 

Married couples 3,670 4,000 

Office of the Secretary of the Treasury May 28, 1985 

-I/ Includes indexation for expected inflation. 

-2/ Replaced with expanded credit. 

-9-
-- 

Table 2.01-2 

Comparison of the Poverty Threshold and the Tax-Free Income 

Level for 1986 Under Current Law and the President's Proposal 

I I Tax-Free Income Levels I Poverty I Current I Proposed

status I Threshold I Law 1/ I Law 

Single persons without 

dependents $ 5,800 $ 3,560 $ 4,900 

Heads of households with 

one dependent -2/ 7,700 7,945 10,158 

Married couples -3/ 7,500 5,830 8,000 

Married couples with two 

dependents 2/ 3/ 11,400 9,575 12,798 

Office of the Secretary of the Treasury May 28, 2985 

-1/ Includes expected indexation for inflation. 

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

-3/ Assumes one earner. 

- 10 -

I 
COMBINE TAX BENEFITS FOR ELDERLY, BLIND 

AND DISABLED INTO EXPANDED CREDIT 

General Explanation 

Chapter 2.02 

Current Law 

Individuals aged 65 or over and certain disabled persons are 

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

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

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

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

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

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

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

return and live apart at all times during the year. 

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

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

and annuity income (principally social security benefits) and most 

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

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

$10,000 (for married couples filing joint returns), or $5,000 (for

married individuals filing separate returns). When applied to the 

elderly, the credit provides a compensating tax benefit to those 

individuals who receive little or no social security benefits and 

hence derive little or no advantage from the exemption of such 

benefits from tax. 

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

they receive employer-provided disability income or other taxable 

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

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

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

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

cases, the credit provides individuals receiving taxable disability 

payments with treatment comparable to that provided for recipients of 

tax-free workers' compensation and veterans' disability payments. 

Elderly, blind, and disabled taxpayers also receive preferential 

treatment in other sections of the Internal Revenue Code. A taxpayer

is allowed an additional personal exemption upon attaining age 65, and 

an additional exemption if he or she is blind. Each exemption reduces 

taxable income by $1,080 for 1986. In addition, most disability

income is untaxed, including workers' compensation, black lung 

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

Finally, social security benefits (including social security 

- :1.l -
disability income) are excluded from income unless the taxpayer's

adjusted gross income (with certain modifications) exceeds $25,000 

($32,000 in the case of a joint return); in no event are more than 

one-half of such benefits included in income. 

Reasons for Change 

The preferential treatment applicable to elderly, blind, and 

disabled taxpayers recognizes the special hardships and costs such 

individuals encounter. Certain of the preferences available to such 

taxpayers under current law, however, provide the greatest benefit to 

those least in need. Thus, the additional personal exemptions for the 

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

and blind with the highest incomes. A $1,080 exemption is worth $540 

to an individual in the 50 percent tax bracket, but only $216 to an 

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

for this disparity. 

In contrast, the current credit for the elderly targets its 

assistance to those with the greatest need. Because of the 

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

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

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

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

taxpayers. The credit for taxable disability payments operates in the 

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

taxpayers. 

Finally, the current credit for employer-provided disability

income encourages the recharacterization of retirement income as 

disability income (for those retiring before age 65), since the latter 

is eligible for the credit. 

Proposal 

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

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

credit for the elderly and disabled. All newly taxable disability

income (workers' compensation and black lung) would be made eligible

for the credit. To restrict recharacterization of normal retirement 

income as disability income, employer-provided disability income would 

be eligible for the credit only if provided under a qualified plan. 

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

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

over 65 would be $7,000 (in the case of single taxpayers or taxpayers

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

$11,500 (in the case of joint returns where both spouses are blind 01 

over 65), $8,750 (in the case of heads of households who are either 

blind or over 65), or $5,750 (in the case of a married individual 

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

- 12 -
apart from his or her spouse for the entire year). Limits on the 

amount of employer-provided disability income eligible for the credit 

would be increased to identical levels. 

The income level at which the credit begins to phase out would be 

increased to $11,000 (for single taxpayers), $14,000 (for joint

returns), $12,500 (for heads of household), OK $7,000 (for married 

individuals filing separate returns). 

Both the initial base amounts and the income levels at which the 

credit begins to phase out would be indexed for inflation, beginning

in 1987. 

Effective Date 

The proposal would apply to taxable years beginning on or after 

Januarv 1. 1986. Onlv taxah e isability income would be eligible for 

the credit. The Administration proposals would require taxation of 

most workers' compensation and black lung payments received on or 

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

proposal generally would be effective on or after January 1, 1987. 

Analysis 

Table 1 compares the tax-exempt thresholds for the elderly and 

blind under current law and the Administration proposal. When 

combined with the proposed increase in their personal exemptions (to

$2,000 in 1986), the expansion of the credit for the elderly, blind,

and disabled would increase their tax-exempt thresholds, despite the 

elimination of their additional exemptions. The tax-exempt levels 

shown in the table are far in excess of those for taxpayers generally. 

The proposal would provide more equitable treatment for the 

elderly and blind and would also reduce artificial distinctions 

between sources of disability income. The effect of extending the 

credit to other forms of disability income is discussed more fully in 

Ch. 3.07, relating to proposed changes in the taxation of workers' 

compensation and black lung benefits. 

- 13 -
Table 2.02-1 

1986 Tax-Free Levels of Income for the Elderly and Blind 

(And Those With Employer-Provided Disability Income) 

Single Joint (Couple) 1I 

Current I Proposed I

I 

Current I Proposed

I Law I Law I Law 1 Law 

Ordinary Taxpayer $ 3,560 $ 4,900 $ 5,830 $ 8,000 

Age 65 or More 1/

NO Social Seciirity 9,383 11,600 14,450 17,667

Average Social Security -2/ 10,640 11,900 18,990 19,500 

Blind 1/

NO social. Securit.y 4,640 11,600 7,990 17,667 

Average Social Security -2/ 10,640 11,900 18,990 19,500 

under Aqe 65, with Employer­ - - Proviaed Disability Income 

($6,000 single/$9,000 joint) 9,383 10,400 14,450 15,333 

Office of the Secretary of the Treasury May 28, 1985 

-1/ For joint returns, assumes both are elderly/blind. 

-2/ Benefits of $6,000 (single) or $11,000 (joint). 

- 14 -
REPEAL TWO-EARNER DEDUCTION 

General Explanation 

Chapter 2.03 

Current Law 

The progressive tax rate structure of current law often results in 

higher tax rates for couples whose incomes are combined as a 

consequence of marriage. This result contributes to the so-called 

"marriage penalty," i.e., the increase in a couple's aggregate tax 

liability that may occur due to their marriage. The marriage penalty

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

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

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

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

couples. Whether marriage actually results in a tax penalty or 

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

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

To limit the marriage penalty, current law provides a special

deduction for married couples in which both spouses earn personal

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

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

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

qualified earned income for the taxable year. 

Reasons for Change 

The current deduction for two-earner married couples is poorly

designed to offset the increased tax liabilities that some couples

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

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

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

still others, the deduction merely increases an existing marriage

bonus. Moreover, because the deduction applies only to earned income,

it has no effect when the marriage penalty arises from investment 

income. 

The marriage penalty under current law is attributable primarily 

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

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

Abandonment of the joint return system would eliminate the marriage

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

couple's income and deductions are to be allocated between spouses.

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

persons with equivalent combined income ignores that married couples

frequently pool their incomes and may benefit from shared living 

expenses. An equally direct but better conceived response to the 

- 15 -
marriage penalty is to reduce marginal tax rates, which at current 

high levels may discourage labor force participation or reduce the 

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

Proposal 

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

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

The Administration proposals include flatter tax rate schedules 

and lower marginal tax rates. In general, these changes would reduce 

the significance of tax consequences in individual decisions and 

improve incentives for taxpayers to work and invest. Since the tax 

structure would retain a degree of progressivity, as well as joint 

return treatment for married couples, the Administration proposals

would not eliminate the possibility of a marriage penalty, nor, for 

that matter, of a marriage bonus. They represent, however, a more 

direct and consistent attempt to minimize the impact of marriage on 

tax liabilities than the current two-earner deduction. 

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

one line from Form 1040 and seven lines from Form 1040A. 

- 16 -
INCREASE AND INDEX EARNED INCONE TAX CREDIT 

General Explanation 

Chapter 2.04 

Current Law 

An eligible individual is allowed a refundable credit against

income tax equal to 11 percent of the first $5,000 of earned income. 

The maximum credit of $550 is reduced by an amount equal to 12 2/9

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

income (whichever is greater) over $6,500. Thus, the credit is 

eliminated when AGI or earned income reaches $11,000. Earned income 

eligible for the credit includes wages, salaries, tips, and other 

employee compensation, plus the amount of the taxpayer's net earnings

from self-employment. 

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

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

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

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

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

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

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

not indexed for inflation. 

Reasons for Change 

The earned income credit serves as an offset to social security

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

families with dependents. However, inflation has reduced the value of 

the credit. Moreover, increases in income attributable to inflation 

have reduced the number of families eligible for the credit and the 

amount of the credit for many of those who remain eligible. 

The Tax Reform Act of 1984 reduced the inflation-caused decrease 

in the value of the credit and in the credit's availability by

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

the credit. The new amounts, however, are not indexed and will. remain 

fixed until changed by legislation. 

In order to provide some compensation for the effect of inflation 

on the value of credit and on the number of families eligible for the 

credit, the credit percentage should be increased, and the credit 

should phase out at a higher income level. To eliminate the need for 

periodic legislative adjustments in the credit, the maximum earned 

income credit amount and the AGI or earned income limit should be 

indexed to the rate of inflation. 

- 17 -

476-698 0 - 85 - 3 
Proposal 

The earned income credit would be increased to 14 percent of the 

first $5,000 of earned income. The maximum credit of $700 would be 

reduced by 10 percent of the excess of AGI or earned income (whichever

is greater) over $6,500. Thus, the credit would be eliminated when 

AGI or earned income reaches $13,500. Beginning in 1986, the maximum 

earned income credit and the AGI or earned income limit would be 

adjusted for inflation. The amount of the adjustment in a given

calendar year would depend 0x1 the percentage increase in consumer 

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

index for all-urban consumers ( "CPIU") . 

Effective Date 

The proposal would apply for taxable years beginning on OK after 

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

changes in the CPIU for the 1985 fiscal year. 

Analysis 

In 1983, earned income tax credits totalling $1.8 billion were 

claimed on individual income tax returns. The increase in the credit 

percentage and extension of the credit would provide an additional 

offset for social security and income taxes and a work incentive for 

many low-income families with dependents. Indexation of the earned 

income credit would ensure that inflation-induced increases in incomes 

would not reduce the credit for some low-income families and exclude 

other low-income families from eligibility. For example, assume that 

an eligible taxpayer earning $6,500 in 1985 receives a four percent

increase in income in 1986 and that inflation also equals four percent

during the same period. Although the taxpayer's nominal income has 

increased, his or her "real" income (i.e., income adjusted for 

inflation) has stayed the same. Under current law, however, the 

taxpayer's earned income credit would fall from $550 in 1985 to $518 

in 1986, because nominal income has increased. The real value of the 

credit, in 1985 dollars, would be only $497. Under the proposal, the 

credit percentage would be increased to 14 percent and, assuming that 

inflation was four percent during fiscal year 1985, the earned income 

limit and maximum credit would be increased by four percent for 1986. 

Thus, the taxpayer would be eligible for a credit of $728, the 

inflation-adjusted value of the maximum credit. 

- 18 -
REPLACE CEILD AND DEPENDENT CARE CREDIT WITB DEDUCTION 

General Explanation 

Chapter 2.05 

Current Law 

A nonrefundable credit is allowed to an individual who pays

employment-related child and dependent care expenses provided the 

individual maintains a household for one or more "qualifying

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

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

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

is physically or mentally incapable of taking care of himself or 

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

or mentally incapable of taking care of himself or herself. 

Dependent care expenses are considered to be employmentrelated only if they are incurred to enable the taxpayer to work and 

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

individuals. Expenses for household services include the performance

of ordinary and usual maintenance in the household, provided the 

expenses are attributable in part to the care of a qualifying

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

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

for a qualifying individual. 

The amount of employment-related expenses that is eligible for the 

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

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

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

Further, employment-related expenses generally cannot exceed the 

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

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

must file a joint return to claim the credit. 

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

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

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

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

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

percent of employment-related child and dependent care expenses for 

taxpayers with adjusted gross incomes above $28,000. 

Reasons for Change 

Child and dependent care expenses incurred in order to obtain or 

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

same manner as other ordinary business expenses. A family with 

- 19 -

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

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

income and no such expenses. 

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

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

individuals. No practical standards exist, however, for allocating

child and dependent care expenses based upon the personal and business 

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

substantially higher than other mixed business/personal expenses for 

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

most business clothing. Disallowance of all dependent care costs in 

the computation of taxable income thus could generate a significant

work disincentive. 

Allowance of a deduction rather than a credit is the appropriate 

treatment of costs incurred in producing income. The current credit 

for dependent care expenses is targeted for the benefit of low-income 

taxpayers, although these expenses reduce the ability to pay tax at 

all income levels. Tax relief for low-income taxpayers is provided

best through adjustments in tax rates or in the threshold level of 

income for imposition of tax. Such changes benefit all similarly

situated taxpayers. 

Computation of the limits on the dependent care credit, which vary

with the taxpayer's adjusted gross income, also adds to the complexity

of the tax law. 

Proposa1 

A deduction from gross income would be provided for qualifying

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

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

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

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

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

earnings. 

Effective Date 

The proposal would apply to taxable years beginning on or after 

January 1, 1986. 

Analysis 

The proposal recognizes that child and dependent care expenses

constitute legitimate costs of earning income. The extent to which 

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

situation. As with certain other expenditures that provide mixed 

business and personal benefits to taxpayers, such as business meal 

expenses, the proposal sets a dollar limitation on the amount allowed 

as a deduction. 

- 20 -
Under the proposal, approximately six million families 6.5 

percent of all families) would claim deductions for dependent care 

expenses totalling approximately $8 billion. Approximately 60 percent

of these deductions would be claimed by families with economic incomes 

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

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

deduction reflects the view that progressivity should be provided

directly through the personal exemptions and the rate structure. 

- 21 -
CHAPTER 3 

MAKE THE SYSTEM MORE NEUTRAL AND FAIR 

Part A. Excluded Sources of Income-Fringe Benefits 

An employee is generally required to include in gross income all 

compensation received during the year from his or her employer,

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

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

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

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

accident and health insurance, group legal services, and dependent 

care assistance. These and certain other fringe benefits are 

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

qualified employer-sponsored plans. 

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

in principle from compensation paid directly in cash. The employee

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

position than the employee who receives cash compensation and uses it 

to purchase the same benefits. The exclusion of certain fringe

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

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

cost of certain goods or services and thereby to subsidize consumption

of such items by eligible taxpayers. 

The exclusion of fringe benefits from income has economic and 

social costs that have not always been reflected in political debate 

over fringe benefit tax policy or in individuals' expressed judgments

about the desirability of maintaining existing tax preferences for 

fringe benefits. The incentive for consumption of fringe benefits 

created by their exemption from tax may overstimulate demand,

producing losses in efficiency and artificially high prices.

Nontaxation of fringe benefits also raises significant fairness 

concerns, since nontaxable benefits are not available to all taxpayers

and are of greater value to high-bracket taxpayers. Finally, and most 

importantly, the exclusion of fringe benefits from income loses 

significant tax revenue, thus causing tax rates to be higher than they

would be if fringe benefits were taxable. 

The costs entailed in excluding fringe benefits from the tax base 

may be justified to the extent employer provision of fringe benefits 

serves significant social policy objectives that might otherwise fall 

to government and government-funded programs. This rationale for the 

nontaxation of fringe benefits requires, however, that the 

availability of an income exclusion be conditioned on the provision of 

fringe benefits on a broad, nondiscriminatory basis. It suggests as 

well that fringe benefits be excluded from income only where they

directly and significantly enhance employee health and security. 

- 23 -
INCLUDE IN INCOME A LIMITED AHOUNT OF 

EMPLOYER-PROVIDED - HEALTH INSURANCE

General Explanation 

Chapter 3.01 

Current Law 

All employer contributions to health insurance plans on behalf of 

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

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

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

under a self-insured medical plan. 

Although medical expense reimbursements under a self-insured 

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

similar benefits provided through an outside insurer are not subject 

to nondiscrimination rules. 

Reasons for Change 

The exclusion of employer-provided health insurance from income 

subsidizes the cost of such insurance for eligible taxpayers.

Although this tax-based incentive for employee health insurance is an 

appropriate part of the national policy to encourage essential health 

care services, in its present form, the exclusion contributes 

substantially to horizontal inequity and to higher than necessary

marginal tax rates. 

The exclusion from income of employer-provided health insurance is 

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

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

Table 1 illustrates the impact of the exclusion on two employees

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

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

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

compensation in cash. As shown in the table, A's after-tax income is 

$809 higher than B's simply because some of his compensation is in the 

form of health insurance. B must pay for any medical expenses or 

privately purchased insurance out of his lower after-tax earnings. 

The exclusion for employer-provided health care has also 

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

marginal tax rates, especially as employer-provided health care has 

become increasingly widespread, Imposing a limited tax on 

employer-provided health care would help broaden the base of taxable 

income and thus reduce marginal tax rates without jeopardizing the 

national policy of encouraging essential health care services. 

- 24 -
Table 3.01-1 

Tax Benefits Arising from the Exclusion 

of Employer-Provided Heal.th Insurance -1/ 

I 

Total Employer Cost 

Non-Taxable Employer-Provided

Health Insurance 

Employer Social Security Tax 

Cash Wages 

Employee Income Tax 

Employee Social Security Tax 

After-Tax Income Plus Value of 

Health Insurance 

Cost of $2,400 of Health 

Insurance 

Individual I Individual 

$35,000 $35,000 

2,400 -_-

2,141 2,305 

30,453 32,695 

2,996 3,489 

2,141 2,305 

27,710 26,901 

1,591 2,400 

Office of the Secretary of the Treasury May 28, 1985 

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

itemized deductions equal to 23 percent of adjusted gross income. 

- 25 -
In addition, the tax benefits provided for employee health care should 

not be available on a basis that permits discrimination in favor of 

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

apply to employer-provided health benefits regardless of whether such 

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

Proposal 

Employer contributions to a health plan would be included in the 

employee's gross income up to $10 per month ($120 per year) for 

individual coverage of an employee, or $25 per month ($300 per year)

for family coverage (i.e., coverage that includes the spouse or a 

dependent of the employee). 

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

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

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

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

would be calculated by determining the aggregate annual cost of 

providing coverage for all employees with the same type of coverage

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

amount by the number of such employees. 

In most cases, determination of the precise cost of coverage would 

be unnecessary, because the floor amounts would clearly be exceeded. 

In those cases where the floor amounts would not necessarily be 

exceeded, the following method of determining cost would be used. 

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

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

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

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

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

including administrative costs. In lieu of using actual administrative 

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

liability for benefit payments as the administrative costs of the 

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

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

The cost of coverage would be determined separately for each 

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

be considered a separate plan if such coverage differs in a 

significant manner from the coverage of another group of employees. 

The proposal would require that the cost of coverage under the 

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

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

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

the group of covered employees. 

- 26 -
If the actual cost of coverage cannot be determined in advance,

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

estimated cost were determined not to be reasonable, the employer

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

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

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

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

multiemployer plan, the multiemployer plan would be treated as the 

employer for purposes of determining the cost of coverage and the 

liability for errors in estimates. 

If the cost of coverage fluctuates each year depending on the 

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

coverage could be used, based, in appropriate circumstances, on the 

average cost for the past three years (adjusted to reflect increases 

in health insurance costs). 

Appropriate nondiscrimination rules would be applied to 

employer-provided health benefits, regardless of whether employer

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

See Ch. 3.04 for a description of the proposed nondiscrimination rule. 

Effective Date 

The proposal would apply to employer contributions received in 

taxable years beginning on or after January 1, 1986. 

Analysis 

The proposal would reduce the unfair distinction between those 

with employer-provided health insurance and those who must pay for 

health insurance with after-tax dollars. In the case illustrated in 

Table 1, under current law the employee with $2,400 of 

employer-provided health insurance paid $809 less in taxes than a 

similar family that purchased $2,400 of health insurance with 

after-tax dollars. Under the Administration proposal, the difference 

would fall from $809 to $611. The cost of $2,400 of employer-provided

health insurance would rise from $1,591 to $1,789, due partly to the 

inclusion of $300 of employer contributions in income and partly to 

the reduction in the marginal tax rate for this family (from 22% to 

15%). 

The higher amount included in income for family coverage reflects 

the fact that such coverage is approximately two-and-one-half times as 

costly as individual coverage. 

The proposal would be administratively simple, since almost all 

those with employer contributions will have such contributions in 

excess of the proposed includable amounts. Only in those rare cases 

where the employer's contribution is less than $10 (individual) or $25 

(family coverage) per month would estimates of the average cost of 

- 21 -
health plan coverage be necessary. Moreover, the proposal's

implementation need not be delayed, since it should have no major

impact on the nature of negotiated contracts. 

The distributional impact of this proposal is summarized in 

Table 2. Less than 20 percent of all employer contributions would be 

included in income, resulting in additions to taxable income for r approximately half of all families. Families with incomes above 

$30,000 would pay three-quarters of the taxes imposed on employer

contributions. Less than 5 percent of the additional tax liability

would fall on those with under $15,000 of income. The additional tax 

liability is concentrated among higher income taxpayers for two 

reasons. First, as illustrated in the first two columns of Table 2,

employer contributions for health insurance are much more common (and

larger) for higher income families. Less than 15 percent of families 

with incomes below $15,000 receive such contributions, compared to 

over 80 percent of families with incomes over $50,000. Second, the 

tax rate on the included portion of employer contributions is higher

for those with higher incomes. Given the proposed increases in the 

personal exemption and zero bracket amounts, no families with incomes 

below the poverty line would pay tax on employer contributions. 

- 28 -
Table 3.01-2 

Distribution of Employer Contributions 

for Health Insurance (1983),

and Estimated Impact of the Proposal 

I Percent of I I Percent of i 

I Families i 1 Contributions I 

Family I Receiving I Average I Included in I Distribution 

Economic \ Employer \ Employer \ Income Under \ of Additional 

Income I Contribution I Contribution I the Proposal I Tax Liability 

$ 0 

to 14 % $ 60 19 % *% 

9,999 

10,000 

to 34 80 19 4 

14,999 

15,000 

to 46 90 18 6 

19,999 

20,000 

to 60 100 18 16 

29,999 

30,000 

to 76 130 I8 34 

49,999 

50,000 

to 86 170 16 34 

99,999 

100,000 

to 81 190 15 6 

199,999 

200,000 

or 76 200 14 

more 

A11 

Families 56 % $125 17 % 100 % 

Office of the Secretary of the Treasury May 28, 1985 

* Less than 0.5 percent. 

- 29 -
REPEAL $5,000 EXCLUSION FOR 

EMPLOYERZPROVIDED DEATE BENEFITS 

General Explanation 

Chapter 3.02 

Current Law 

Death benefits paid by an employer to the estate or beneficiaries 

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

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

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

required if multiple beneficiaries receive, in the aggregate, more 

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

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

individuals. 

In addition to the statutory exclusion, some courts have permitted 

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

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

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

a gift rather than compensation. Such "gifts" are excludable without 

regard to the $5,000 limitation. 

Reasons for Change 

The exclusion of certain death benefits from income creates an 

artificial preference for what is, in effect, an alternative form of 

employee compensation. The exclusion of such benefits from the tax 

base causes the tax rates on other compensation to increase. 

Moreover, the exclusion is unfair because it is not available to all 

taxpayers (such as self-employed individuals). 

Death benefits are similar to group-term life insurance, the 

exclusion for which is retained. The exclusion for group-term life 

insurance premiums, however, is conditioned on satisfaction of certain 

requirements, including a nondiscrimination test. Because of the 

nature of death benefits, it would be very difficult administratively 

to place the same conditions on their availability (or on imputed

premiums for death benefits, which are also excluded). In the absence 

of such restrictions, death benefits may become more of a vehicle to 

provide tax-free compensation for highly paid employees, than a means 

to enhance the security of employees generally. 

Finally, confusion exists under present law as to whether a 

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

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

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

economic reality and leads to different tax treatment on similar 

facts. 

- 30 -
Proposa1 

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

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

family member or other beneficiary of the decedent would be 

characterized as a taxable death benefit rather than as an excludable 

gift. 

Effective Date 

The repeal would be effective for benefits paid due to deaths 

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

however, for amounts paid under a collective bargaining agreement

entered into before January 1, 1986, until the earlier of January 1,

1989, or the date such agreement terminates. 

Analysis 

Approximately $400 million of employer-provided death benefits are 

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

tax benefit per dollar of the death benefit exclusion increases with 

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

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

to receive such benefits than low-income taxpayers. 

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

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

simplify current law and also reduce the unfairness created by current 

law where similar facts may lead to different tax results. 

- 31 -
REPEAL EXCLUSION FOR ENPLOYER-PROVIDED 

COMMUTING SERVICES 

General Explanation 

Chapter 3.03 

Current Law 

The value of employer-provided commuting transportation is 

excluded from the income of employees if the transportation services 

are provided under a nondiscriminatory plan using vehicles that meet 

size and usage requirements (generally vans). The exclusion is not 

available to self-employed individuals and is scheduled to expire for 

taxable years beginning after December 31, 1985. 

Reasons for Change 

The exclusion of qualified transportation services from employee

income is poorly designed to promote its intended purpose of energy

conservation. The exclusion targets only one form of group

transportation, employer-provided van pools. This may cause taxpayers 

to reject possibly more efficient but non-subsidized transportation

alternatives. Moreover, the qualified transportation exclusion is not 

aimed at ensuring security for individual employees, but rather at 

achieving the general goal of energy conservation. This goal can be 

achieved more effectively and equitably through non-tax measures. 

Proposal 

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

commuting transportation would be allowed to expire. 

Effective Date 

Taxpayers have had notice of the scheduled expiration of the 

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

1985. It would be allowed to expire as scheduled. 

Analysis 

Expiration of the van-pooling exclusion will eliminate an 

unnecessary distortion in employee and employer choices over 

cost-effective transportation. 

- 32 -
ESTABLISH A UNIFORM NONDISCRIMINATION RULE 

General Explanation 

Chapter 3.04 

Current Law 

Overview. A variety of fringe benefits are excluded from the 

income of employees if provided by employers under certain statutorily

prescribed conditions. Among those conditions is the general

requirement that fringe benefits be provided on a nondiscriminatory

basis. Thus, with the exception of the exclusion for 

employer-provided health insurance, each fringe benefit exclusion is 

subject to nondiscrimination rules that require that the benefit not 

be provided on a basis that favors certain categories of employees

(the prohibited group members). Failure to satisfy the applicable

nondiscrimination test results in a denial of the tax exclusion, and 

thus inclusion of the benefit in income, either for all employees

receiving the benefit or only for prohibited group members. 

Separate nondiscrimination rules apply with respect to each 

benefit. Thus, a prohibited group member for one benefit may or may

not be a prohibited group member for another benefit. Also, what 

constitutes impermissible discrimination and the consequences of such 

discrimination differ with respect to different benefits. 

Group-Term Life Insurance Plans. If a group-term life insurance 

plan is determined to be discriminatory, the $50,000 exclusion of the 

cost of insurance does not apply with respect to key employees. A 

discriminatory plan is one which favors key employees as to 

eligibility to participate or as to the type or amount of benefits 

available under the plan. For purposes of these rules, related 

employers are treated as a single employer. 

With respect to eligibility, a group-term life insurance plan must 

satisfy one of the following tests: (1) the plan benefits at least 70 

percent of all employees; (2) at least 85 percent of all participants 

are not key employees; (3) the class of employees receiving benefits 

is not discriminatory in favor of key employees; or (4) in the case of 

a plan which is part of a cafeteria plan, the cafeteria plan

requirements are met. In determining whether a plan satisfies this 

eligibility test, employees who have not completed three years of 

service, part-time and seasonal employees, employees covered by a 

collective bargaining agreement, and nonresident aliens who receive no 

U.S. earned income may be disregarded. 

For purposes of determining whether the type or amount of benefits 

under the plan discriminates in favor of key employees, all benefits 

available to key employees must be available to all other employees,

and benefits proportionate to compensation are consi,dered

nondiscriminatory. 

- 33 -
The term "key employee" is generally defined as it is under the 

top-heavy rules applicable to qualified retirement plans: officers,

the top ten employee-owners, five percent owners, and one percent 

owners receiving at least $150,000 in annual compensation. Employees 

are key employees with respect to a year if they fall within one of 

the above categories at any time during the five preceding years. 

Health Benefits Plans. The exclusion of health benefits provided

by an employer through an insurance company, and the exclusion of 

medical benefits and reimbursements provided under such insurance, are 

not conditioned on the satisfaction of a nondiscrimination test. 

However, if an employer provides its employees with health benefits 

under a self-insured plan, the exclusion of a medical reimbursement 

under such plan is available to a highly compensated individual only

to the extent the reimbursement is not an "excess reimbursement,"

which generally is a reimbursement provided to a highly compensated

individual under a discriminatory plan. 

A self-insured health plan is discriminatory if it favors highly

compensated individuals as to eligibility to participate or as to 

benefits. For purposes of this nondiscrimination rule, related 

employers are treated as a single employer. 

Under the eligiblity test, a health plan must benefit (1) at least 

70 percent of all employees, (2) at least 80 percent of all eligible

employees, but only if at least 70 percent are eligible, or (3) a 

class of employees that does not discriminate in favor of highly

compensated individuals. In determining whether a plan satisfies any

of these tests, employees who have not completed three years of 

service, employees who have not attained age 25, part-time and 

seasonal employees, employees covered by a collective bargaining 

agreement, and nonresident aliens with no U.S. earned income may be 

disregarded. 

The benefits provided under a self-insured health plan will be 

treated as discriminatory unless all benefits provided for 

participants who are highly compensated individuals are provided for 

all other participants. 

For purposes of these rules, highly compensated individuals are 

(1) the five highest paid officers, (2) shareholders owning more than 

ten percent of the stock of the employer, and (3) employees who are 

among the highest paid 25 percent of employees (excluding

non-participants who may be disregarded for purposes of the 

eligibility test). 

Group Legal Services Plans. The exclusion for contributions to or 

services provided under an employer-maintained group leqal services 

plan is acailable to employees only if (1) the plan-benefits a class 

of employees that does not discriminate in favor of employees who are 

- 34 -
officers, shareholders, self-employed individuals, or highly

compensated, and (2) the contributions or benefits provided under the 

plan do not discriminate in favor of such employees. In determining

whether a plan benefits a nondiscriminatory classification of 

employees, employees covered by a collective bargaining agreement may

be disregarded. In addition, the availability of the exclusion is 

subject to a concentration test under which no more than 25 percent of 

the amounts contributed during a year may be provided for five percent 

owners (or their spouses or dependents). 

Educational Assistance Programs. The exclusion for amounts paid 

or expenses incurred by the employer for educational assistance to an 

employee under an educational assistance program is not available if 

the program benefits a class of employees that is discriminatory in 

favor or employees who are officers, owners, or highly compensated (or

their dependents). Under this test, employees covered by a collective 

bargaining agreement may be disregarded. Also, the exclusion is 

subject to a concentration test under which no more than five percent

of the amounts paid or incurred by the employer for educational 

assistance may be provided for five percent owners (or their spouses 

or dependents). 

Dependent Care Assistance Programs. The exclusion for amounts 

paid or incurred bv the employer - ­ for dependent care assistance under a

hependent care assistance program is no2 available unless (1) the 

program benefits a class of employees that does not discriminate in 

favor of employees who are officers, owners, or highly compensated (or

their dependents), and (2) the contributions or benefits provided

under the plan do not discriminate in favor of such employees. In 

determining whether a program benefits a nondiscriminatory

classification of employees, employees covered by a collective 

bargaining agreement may be disregarded. In addition, under the 

applicable concentration test, the exclusion is not available if more 

than 25 percent of the amounts paid or incurred by the employer for 

dependent care assistance is provided for five percent owners (or

their spouses or dependents). 

Cafeteria Plans. The cafeteria plan exception to the constructive 

receipt rules does not apply to any benefit provided under the plan if 

the plan discriminates in favor of highly compensated individuals as 

to eligibility to participate or as to contributions and benefits. 

For purposes of these rules, related employers are treated as a single

employer. 

A cafeteria plan does not discriminate as to eligibility to 

participate if (1) the plan benefits a class of employees that does 

not discriminate in favor of employees who are officers, shareholders, 

or highly compensated, and (2) there is a uniform year of service 

requirement of no more than three years. 

- 35 -
A cafeteria plan will not be considered to discriminate as to 

contributions and benefits if statutory nontaxable benefits and total 

benefits (or employer contributions allocable to statutory nontaxable 

benefits and employer contributions for total benefits) do not 

discriminate in favor of highly compensated participants. If a 

cafeteria plan provides health benefits, the plan will not be treated 

as discriminatory if the following tests are met: (1) contributions 

on behalf of each participant include either 100 percent of the cost 

of health benefit coverage of the majority of highly compensated

participants who are similarly situated or 75 percent of the cost of 

health benefit coverage of the similarly situated participant with the 

highest cost health benefit coverage under the plan; and (2)

contributions or benefits with respect to other benefits under the 

plan bear a uniform relationship to compensation. If a cafeteria plan

is maintained pursuant to a collective bargaining agreement, the plan

is deemed to be nondiscriminatory. 

A participant or individual is considered highly compensated for 

purposes of the cafeteria plan rules if he or she is an officer, a 

five percent shareholder, highly compensated, or a spouse or dependent

of any of the above. 

In addition, the availability of the cafeteria plan treatment for 

to key employees is subject to a concentration test, which provides

that no more than 25 percent of the aggregate of the statutory

nontaxable benefits provided to all employees under the plan may be 

provided to key employees. Related employers are treated as a single

employer for purposes of this rule. The term "key employee" has the 

meaning given to such term for purposes of the top-heavy rules 

applicable to qualified retirement plans: officers, the top ten 

employee-owners, five percent owners, and one percent owners with at 

least $150,000 in compensation. 

Certain Fringe Benefits (Sec. 132). The exclusion of a 

no-additional-cost service or a qualified employee discount applies to 

a fringe benefit provided to an officer, owner, or highly compensated

employee only if such fringe benefit is available on substantially the 

same terms to each member of a class of employees which does not 

discriminate in favor of such owners, officers or highly compensated

employees. Meals provided at a company cafeteria that covers its 

direct operating costs are generally excluded from income, except that 

this general exclusion does not apply to employees who are officers, 

owners, or highly compensated if access to the cafeteria is provided 

on a basis which discriminates in favor of such employees. For 

purposes of these rules, related employers are treated as a single

employer. 

Qualified Tuition Reductions. The exclusion of a qualified

tuition reduction applies to an officer, owner, or highly compensated

employee only if such reduction is available on substantially the same 

terms to each member of a class of employees that does not 

discriminate in favor of employees who are officers, owners, or highly

compensated. 

- 36 -
Welfare Benefit Funds. A voluntary employees' beneficiary

association or a group legal services fund which is part of an 

employer plan is not exempt from taxation unless the plan of which the 

association or fund is a part meets certain nondiscrimination rules. 

Under these rules, no class of benefits may be provided to a class of 

employees that is discriminatory in favor of highly compensated

employees. In addition, with respect to each class of benefits, the 

benefits may not discriminate in favor of highly compensated

employees. A life insurance, disability, severance pay, or 

supplemental unemployment compensation benefit will not fail the 

benefit test merely because benefits are proportional to compensation.

For purposes of these rules, related employers are treated as a single

employer. 

For purposes of the above rules, the following employees may be 

disregarded: (1) employees with less than three years of service; (2)

employees who have not attained age 21; (3) seasonal or less than 

half-time employees; (4) employees covered by a collective bargaining 

agreement; and (5) nonresident aliens with no U.S. earned income. 

Under a special rule, if a benefit, such as group legal services, is 

covered by a separate nondiscrimination rule, that separate rule wil.1 

apply in lieu of the rules described above. 

The term "highly compensated individual" includes any individual 

who is one of the five highest paid officers, a ten percent

shareholder, or among the highest paid ten percent of all employees.

For purposes of determining the highest paid ten percent of all 

employees, employees that have not completed three years of service,

employees who have not attained age 25, part-time and seasonal 

employees, employees covered by a collective bargaining agreement, and 

nonresident aliens with no U.S. earned income may be disregarded. 

These nondiscrimination rules also apply for certain other 

purposes. For example, they must be satisfied in order for an 

employer to be able to deduct contributions to a welfare benefit fund 

to provide post-retirement life insurance or health benefits. Also,

post-retirement life insurance or a post-retirement health benefit 

provided through a welfare benefit fund will be subject to a 100 

percent excise tax if the plan of which the fund is a part does not 

satisfy these nondiscrimination rules. 

Reasons for Change 

Nondiscrimination requirements are an integral part of the current 

provisions under which certain employer-provided fringe benefits are 

excluded from the income of employees. The tax-favored treatment of 

such fringe benefits significantly reduces the Federal income tax base 

and thus forces significantly higher marginal tax rates on wages,

dividends, rents, and all other income not exempt from tax. These 

costs may be justified only if employer-provided fringe benefits 

fulfill important social policy objectives, and in this respect meet 

responsibilities that would otherwise fall to government and 

- 31 -
government-funded programs. Strict nondiscrimination rules are a 

necessary adjunct to this public policy rationale since they require

that fringe benefits be nontaxable only where provided to a broad 

cross-section of employees. Nontaxable fringe benefits that favor key 

or highly compensated employees do not serve public policy objectives,

but are instead a form of tax-preferred compensation for a limited 

class of employees. 

The nondiscrimination rules that currently apply to fringe

benefits are marred by inconsistency and by their failure to establish 

clear and administrable standards. The separate nondiscrimination 

rules applicable to each fringe benefit employ different definitions 

of the prohibited group members and establish different standards for 

nondiscriminatory coverage. These differences have no policy

justification, and thus create unnecessary complexity for taxpayers

and for the Internal Revenue Service. In addition, although

employer-provided health insurance is among the most significant

fringe benefits both in terms of its importance to employees and its 

revenue cost, it is not subject to nondiscrimination rules. As with 

other fringe benefits, the exclusion of such insurance from employees'

income should be conditioned on its nondiscriminatory provision to a 

broad cross-section of employees. 

The current nondiscrimination rules also provide inadequate

guidance to taxpayers and to the Internal Revenue Service. Thus, the 

definition of prohibited group members is generally vague, leaving

unclear, for example, who qualifies as an "officer," "owner," or 

"highly compensated employee." Similarly, little specific guidance is 

provided as to whether a particular pattern of coverage discriminates 

in favor of prohibited group members. 

The uncertainty with respect to the current nondiscrimination 

requirements has resulted in significantly different patterns of 

coverage for different employee groups. Cautious employers may adopt

conservative plans, covering a broad cross-section of their employees.

Other employers, however, may conclude that uncertainty in the law 

permits an agressive approach, and set up plans that focus benefits on 

management or highly compensated employees. The Internal Revenue 

Service's ability to monitor employer practice is limited under 

current law, since the facts and circumstances approach of the 

existing standards requires that compliance be tested through detailed 

examination of individual cases. 

The uncertainty and gaps in coverage that are attributable to the 

current nondiscrimination rules outweigh the arguable benefits of 

those rules. A facts and circumstances approach does offer 

flexibility to employers, but similar benefits can be achieved without 

wholly abandoning workable, objective standards. Objective

nondiscrimination tests, if combined with a procedure under which 

plans involving special circumstances could be reviewed by the 

Internal Revenue Service, would provide workable guidelines while 

retaining appropriate employer flexibility. 

- 38 -
Proposals 

Sco e. The nondiscrimination rules described in the following

paragrap -55 would apply to employer-maintained group-term life insurance 

plans, health benefit plans (whether self-insured or through an 

insurance company), qualified group legal services plans (whether

self-insured or through an insurance company), educational assistance 

programs, dependent care assistance programs, cafeteria plans, certain 

fringe benefits (sec. 1321, qualified tuition reduction arrangements,

and welfare benefit funds. 

Prohibited Group Members. A uniform definition of prohibited 

group members would apply to the nondiscrimination test for each 

fringe benefit. Thus, in determining whether a fringe benefit is 

provided on a nondiscriminatory basis in a particular year, the 

prohibited group members would be defined to include any employee who, 

at any time during the three-year period ending on the last day of the 

plan year, met any one of the following descriptions: (1) an owner of 

one percent or more of the employer (under appropriate attribution 

rules); (2) an employee receiving at least $50,000 in annual 

compensation; (3) an employee who is among the top ten percent of 

employees by compensation or is among the highest three employees

(this number would be adjusted for small employers) by compensation,

but not if he or she receives less than $20,000 in annual compensation

(former employees would be disregarded for this purpose); and (4) a 

family member of another prohibited group member for the year. The 

$50,000 and $20,000 figures would be indexed for inflation. 

The appropriateness of the top ten percent and highest three 

employees portions of the prohibited group definition in identifying

the prohibited group members will depend, in part, on an employer's

salary structure. Thus, a mechanical rule would be provided to 

identify those situations where the ten percent and high three classes 

of employees are inappropriate and to expand or contract these classes 

accordingly. Also, adjustments to the three year lookback rule may be 

appropriate where the number of employees employed by the employer

changes significantly during that three year period. 

In the case of a benefit plan that covers former employees, an 

employee who was a prohibited group member for either the plan year in 

which he separated from service or the previous plan year would 

continue to be treated as a prohibited group member. Thus, if an 

employee falls within one of the descriptions set forth above at any

time within the year of separation or any of the preceding three 

years, he or she would continue to be a prohibited group member in the 

year of separation from service and thereafter. Appropriate rules 

would be designed to address the situation where an employee returns 

to service after separation. 

Nondiscriminatory Coverage. The exclusion from income of each 

employer-provided benefit would be subject to a nondiscriminatory 

coverage test requiring that the percentage of prohibited group

members actually benefiting under a benefit plan not exceed 125 

- 39 -
percent of the percentage of the other employees actually benefiting

under the plan. In applying this test to contributory plans, only

employees making the required contribution would be treated as 

actually benefiting under the plan. 

In certain very limited situations, where compelling business 

reasons indicate that application of the 125 percent test would not be 

appropriate, such test would not be applied if a timely ruling is 

obtained from the Internal Revenue Service. For example, an employer 

may acquire another company during a plan year. The acquired company 

may not have provided its employees with a health plan or it may have 

provided a plan substantially different from that provided by the 

acquiring employer. It may thus be appropriate to treat both the 

acquiring employer's health plan and the acquired company's health 

plan, if they each satisfied the coverage test prior to the 

acquisition, as satisfying the coverage test for a limited period

after the acquisition, in order to permit the post-acquisition

employer to redesign the plans to satisfy the test. Of course, during

the limited period, the acquiring company's plan would be required to 

satisfy any reasonable conditions that the Internal Revenue Service 

may impose as part of the timely ruling, such as that the plan satisfy

the nondiscriminatory coverage test by reference to the entire 

post-acquisition company with a more liberal percentage (e.g., 150 

percent) substituted for 125 percent. Relief from the 125 percent

test may also be appropriate where a substantial number of an 

employer's employees do not elect health coverage under the employer's

plan because they are receiving health benefits through, for example,

their spouses' employers. The Internal Revenue Service would apply

reasonable conditions on the continued validity of such rulings. 

In addition, any classification of employees used by a plan for 

participation purposes would be required to be nondiscriminatory on 

its face. Thus, for example, if a plan provided that the bottom 20 

percent of the non-prohibited group members by compensation were 

ineligible, the plan would not pass the coverage test even if the plan

otherwise satisfied the 125 percent coverage test. A contributory

plan or a plan that excludes a class of employees based on a bona fide 

job category would not be discriminatory on its face under this 

provision. 

In addition, the coverage test is not satisfied if a requirement

for benefiting under the plan is discriminatory. For example, even if 

the 125 percent test is satisfied, the nondiscrimination coverage test 

is not satisfied if any non-prohibited group participant was required, 

as a condition of plan participation, to have completed a longer

period of service than the prohibited group participant with the 

shortest required service period. Another example would be where any

non-prohibited group participant had to make a larger employee

contribution than the prohibited group participant with the smallest 

required contribution. 

- 40 -
Certain classes of employees would be disregarded in applying the 

125 percent coverage test to an employer's benefit plan so long as the 

plan did not benefit any employee in such class. The classes of 

excludable employees would be as follows: (1) employees with less 

than one year of service (except in the case of an employer's health 

plan); (2) part-time and seasonal employees; (3) employees covered by 

a collective bargaining agreement; and (4) nonresident aliens who 

receive no U.S. earned income. Part-time employees would generally be 

defined as employees who in a week work less than the lesser of (i) 20 

hours or (ii) one-half of the customary hours worked by full-time 

employees. Seasonal employees would generally be defined as employees

who in a year work less than the lesser of (i) 1,000 hours or (ii)

one-half of the customary hours worked by full-time employees. In the 

case of an employer-maintained health plan, in lieu of the one year of 

service rule, employees with less than 30 days of service would be 

disregarded. However, employees with less than 90 days of service 

would be disregarded in applying the 125 percent test to a health plan

if the plan also provided the option of post-separation health 

coverage of at least 90 days under the same terms available to other 

plan participants. 

Nondiscriminatory Availability. All types and levels of benefits 

available to any prohibited group participant in a plan must also be 

available to all hon-prohibifed grbup participants.- Similarly, if the 

plan applies a condition on the receipt of any type or level of 

benefit by any non-prohibited group participant, the same condition 

must apply to all prohibited group participants. For example, if a 

non-prohibited group participant was required to spend $1,000 on 

dependent care before the participant was eligible to receive 

reimbursements for dependent care expenses and not every prohibited 

group participant was subject to the same condition, the plan would 

discriminate in availability. 

Nondiscriminatory Benefits: Insurance-Type Benefits. Group-term

life insurance, health benefits, and group legal benefits provided

under employer-maintained plans would-each be-subject to anondiscriminatory benefits test. Health benefits and group legal

benefits would both be treated as insurance-type benefits, regardless

of whether they are provided under an arrangement with an insurance 

company or on a self-insured basis. The definition of an 

employer-maintained plan would be modified to require a permanent,

enforceable plan to qualify for a benefit exclusion. 

For group-term life insurance, benefits would be treated as 

nondiscriminatory if the amount of insurance coverage provided to 

participants varies uniformly by compensation. Thus, no prohibited 

group participant would be permitted to receive coverage which is a 

higher multiple of compensation than the lowest such multiple for any

non-prohibited group participant. Appropriate rules would establish 

how former employees would be treated under this test. 

- 41 -
For employer-maintained health benefit plans, including

self-insured reimbursement plans, benefits would be treated as 

nondiscriminatory if, in all respects, the health benefit coverage

provided to any prohibited group participant is also provided to all 

non-prohibited group participants. For this purpose, two employees

actually receiving different types of health benefit coverage would be 

considered to have received the same type of health benefit coverage

if each had the choice of electing, without charge, either type of 

coverage or if each had the choice of electing either type of coverage

for the same charge (or for a charge which is proportional to 

compensation or more than proportional to compensation). Also, if two 

employees receive the same type of individual health coverage and only 

one receives family health coverage in addition, the two employees

will be deemed to receive the same health coverage if the family 

coverage was available to both employees without charge. 

In the case of health plans under which there are different levels 

or types of health benefit coverage, each separate level or type of 

health coverage must be tested as a separate plan under both the 

nondiscriminatory coverage test and this nondiscriminatory benefits 

requirement. This rule would have special application to health plans

offering both individual coverage and family coverage. These two 

types of coverage could be considered separate benefits and thus could 

be tested separately under the nondiscriminatory coverage and the 

nondiscriminatory benefits test. However, in determining whether a 

separate "family coverage health plan" is nondiscriminatory under the 

coverage test, only employees with spouses or dependents would be 

conside red. 

Appropriate integration rules would be applied where benefits 

provided under Medicare or other Federal, State, or foreign law, are 

properly taken into account under the employer's health benefit plan.

In addition, health benefits provided under a plan to an employee may

be coordinated with those provided under a plan maintained by the 

employer of an employee's spouse. 

Disability coverage would be tested under the same 

nondiscriminatory benefit rules applicable to other health benefit 

coverage, except that the amount of the coverage would be permitted to 

vary with compensation in accordance with the rules applicable to 

group-term life insurance. Also, appropriate rules would be applied

for disability plans that integrate with disability benefits provided

under Social Security or other Federal, State, or foreign law. If a 

disability plan is integrated with disability benefits under Social 

Security or any other law, appropriate adjustments would also be 

required to the extent a qualified plan maintained by the same 

employer may be integrated with Social Security or such other law. 

An employer's group legal plan would generally have to meet the 

nondiscriminatory benefits test applicable to health benefit plans.

Thus, a group legal plan could not discriminate with respect to legal 

- 42 -
services coverage. However, family coverage and individual coverage 

may not be considered the same coverage as under the health plan

rules. In addition, in determining whether a separate "family 

coverage plan" is nondiscriminatory under the coverage test, all 

nonexcludable employees would be considered, regardless of family 

status. As with health plans, the nondiscriminatory benefits test 

would be applied on a per capita basis. Also, if the legal services 

plan provides different types or levels of legal services coverage,

each type or level of benefits must be tested as a separate plan under 

both the nondiscriminatory coverage test and this nondiscriminatory

benefits test. 

As noted above, a plan would not qualify for an exclusion unless 

it is permanent. This means that an employer must establish the plan

with the intention of maintaining it for an indefinite period of time. 

An early termination without a bona fide and unforeseeable business 

reason may indicate that the plan was not intended to be permanent,

especially if the duration of certain life, health, or legal coverage

coincides with the period during which one or more prohibited group

participants have a need for such coverage. 

Nondiscriminatory Benefits: Noninsurance-Type Benefits. An 

educational assistance proqram and a dependent care assistance 

program, as well as ceriain other fring; benefits (sec. 132) and 

qualified tuition reductions, would each be required to satisfy a 

nondiscriminatory benefits test under which the average amount 

provided for a prohibited group participant under the program may not 

exceed 125 percent of the average amount expended for a non-prohibited 

group participant. 

In the case of educational assistance, only educational assistance 

expenditures for degree programs, whether they be post-graduate,

college, high school, or a lower level, would be considered under the 

usage test. With respect to no-additional-cost services, qualified

employee discounts, and qualified tuition reductions, a similar 125 

percent test would be applied under which use of a service, discount, 

or reduction would be valued under appropriate rules. 

Concentration Test. The current law concentration tests for group

Legal services, cafeteria plans, educational assistance, and dependent 

care would be retained with certain modifications. Instead of 

prohibiting concentration in favor of five percent owners or key

employees, the rule would apply to the top twenty prohibited group

members by compensation. (Appropriate rules would be provided for 

determining the top twenty prohibited group members by compensation.)

Also, the contributions provided for prohibited group participants

with respect to each of these benefits may not exceed 25 percent of 

the total contributions provided with respect to such benefit. In 

addition, the concentration test would apply to each fringe benefit 

excluded from income. Finally, as applied to educational assistance,

the rule would be modified to apply only to education leading to a 

degree. 

- 43 -
Former Employees. The nondiscriminatory coverage and benefit 

requirements and the concentration test would apply to former 

employees. However, former employees must be treated separately for 

purposes of these requirements. For example, if an employer provides

health insurance to active and retired employees, the discrimination 

rules must be applied separately to the two groups. 

Less Than Full-Time Employees. If an employee covered under a 

benefit plan works in a plan year less than the lesser of (i) 1,500

hours or (ii) 75 percent of the hours considered full-time,

appropriate adjustments may be made in applying the nondiscriminatory

availability and benefits tests. For example, if an employer

maintains a contributory health plan, it may not be inappropriate to 

treat as nondiscriminatory under the availability and benefits tests a 

requirement that employees working less than 1,500 hours contribute a 

higher amount than the full-time employees. 

Aggregation of Plans. For purposes of the nondiscriminatory

availability and the nondiscriminatory benefits tests, employer plans

covering a common prohibited group participant shall be treated as one 

plan unless each of the plans would satisfy the nondiscriminatory 

coverage test if 100 percent were substituted for 125 percent. Also, 

at the election of the employer, two or more plans of such employer 

may be treated as one plan. 

Effect of a Finding of Discrimination. If a plan is 

discriminatory in coverage or benefits, or fails to satisfy the 

concentration test, the exclusion would not apply to prohibited group

participants. In the case of group-term life insurance, health 

benefits, and group legal services, the exclusion of the value of the 

coverage under the plan would not apply. If the coverage under the 

plan were taxable to the prohibited group participants, however, any

reimbursement of expenses under the plan would remain nontaxable. A 

finding of discrimination would not affect the exclusion of the 

coverage for non-prohibited group participants. 

In the case where a prohibited group member participates in a 

discriminatory health benefit plan and a nondiscriminatory health 

benefit plan, the amounts taxable under the discriminatory plan would 

not reduce the amounts taxable under the nondiscriminatory plan. See 

Ch. 3.01 for a discussion of the amounts taxable under a 

nondiscriminatory plan. 

Cafeteria Plans. The nondiscrimination tests applicable to a 

particular benefit, as described above, would continue to apply to 

such benefit even if it is offered under a cafeteria plan. 

In addition, the cafeteria plan must satisfy the nondiscriminatory 

coverage test treating each employee eligible to make elections under 

the plan as benefiting under the plan. Also, the nondiscriminatory

availability test would apply to a cafeteria plan. Thus, all types 

- 44 -
and levels of benefits available to any prohibited group participant

must also be available to all non-prohibited group participants, and 

if the plan applies a condition on the receipt of any type or level of 

benefit by any non-prohibited group participant, the same condition 

must apply to all prohibited group participants. 

In applying the nondiscriminatory coverage and benefits tests to 

each separate benefit offered under a cafeteria plan, a special rule 

would apply to reimbursements of medical, legal, or dependent care 

expenses under a reimbursement account. A reimbursement account for 

either medical, legal, or dependent care expenses would be deemed to 

satisfy the nondiscriminatory coverage and benefits tests if the 

average reimbursement for prohibited group participants in the 

cafeteria plan does not exceed 125 percent of the average

reimbursement for non-prohibited group participants in the cafeteria 

plan. In applying this test, reimbursements for medical, legal, and 

dependent care expenses would be aggregated. A reimbursement account 

would generally be defined as an arrangement maintained by the 

employer which is funded in whole out of elective contributions by

participants. Reimbursements of insurance premiums would not be 

permitted under reimbursement accounts. The current law rules 

otherwise applicable to reimbursement accounts (e.g., forfeitability)

would continue to apply. 

For purposes of testing each individual benefit under the 

nondiscriminatory coverage and benefits tests, each level or type of 

benefit elected under the cafeteria plan would be treated as a 

separate plan. 

Welfare Benefit Funds. The nondiscrimination rules applicable to 

welfare benefit funds would be modified to conform to the proposed

nondiscrimination rules. Thus, for example, a voluntary employees'

beneficiary association would be precluded from discriminating in 

favor of those employees who are prohibited group members under the 

proposed definition. In addition, the 125 percent coverage test would 

apply. 

Aggregation of Employers. The rules treating related employers as 

a single employer for purposes of the rules described in this proposal

would be extended to each fringe benefit. Also, the leasing rules 

currently applicable to qualified plans would apply without regard to 

the safe hatbor plan provisions of such rules. 

Effective Date 

The proposal would generally apply to fringe benefit plan years

beginning on or after January 1, 1986. However, this general

effective date would be January 1, 1987 with respect to 

employer-provided health care coverage. In addition, an exception

would be made for fringe benefit plans maintained pursuant to a 

- 45 -
collective bargaining agreement entered into prior to January 1, 1986,

until the first plan year beginning on or after the earlier of 

January 1, 1989 or the date such agreement terminates. 

Analysis 

The extension and strengthening of the nondiscrimination rules 

would help direct more of the benefits to those for whom the 

exclusions were designed. The coverage test, for instance, would 

assure that in most situations, non-prohibited group members would be 

covered in proportions close to that of the prohibited group members. 

For example, assume an employer has 20 prohibited group members and 80 

non-prohibited group members and none of these employees may be 

excluded from the nondiscriminatory coverage test. Assume further 

that all of the prohibited group members are covered. In order to 

satisfy the 125 percent coverage test, at least 80 percent of the 

non-prohibited group members, i.e., 64 of the non-prohibited group

members, must be covered. 

- 46 -
REPEAL EXCLUSION FOR EMPLOYEE AWARDS 

General Explanation 

Chapter 3.05 

Current Law 

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

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

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

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

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

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

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

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

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

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

up to $1,600 may be deducted, provided that the average cost of all 

items awarded under all such plans of the employer does not exceed 

$400. 

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

deductions has no bearing on whether the award constitutes taxable 

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

facts and circumstances surrounding the award. Nevertheless, many 

taxpayers take the position that if the dollar limitations are not 

exceeded, the award automatically constitutes a gift and is excludable 

from the employee's income. 

Reasons for Change 

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

attributable to detached and disinterested generosity, motivated by

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

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

purposes. Moreover, in the unusual circumstances where an employee

award truly has no business motivation, it should not be deductible as 

an ordinary and necessary expense of the employer's business. 

Current law not only allows employee awards to be characterized as 

gifts but provides a tax incentive for such characterization. The 

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

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

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

the extent an award exceeds those limits, gift characterization 

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

exceeds that of the employer. 

- 41 -
Current law also generates substantial administrative costs and 

complexity by requiring the characterization of employee awards to 

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

dedication of Internal Revenue Service and taxpayer resources to this 

issue is inappropriate, since relatively few employee awards represent 

true gifts and since the amounts involved are frequently not 

substantial. 

Proposal 

Gift treatment would generally be denied for all employee awards. 

Such awards would ordinarily be treated as taxable compensation, but 

in appropriate circumstances would also be subject to dividend or 

other non-gift characterization. De minimis awards of tangible

personal property would be excludable by the employee under rules of 

current law concerning de minimis fringe benefits. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

Available data concerning employee awards of tangible personal 

property is incomplete. Surveys indicate that businesses made gifts 

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

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

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

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

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

few employees and would promote horizontal equity. 

- 48 -
Part B. Excluded Sources of Income--Wage Replacement Payments 

REPEAL EXCLUSION FOR UNEMPLOYMENT AND DISABILITY PAYMENTS 

General Explanation 

Chapter 3.06 

Current Law 

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

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

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

wages lost due to unemployment or disability are fully or partially 

exempt from tax. 

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

gross income (determined without regard to certain social security and 

railroad retirement benefits and the deduction for two-earner married 

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

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

unemployment compensation is tota1l.y excluded from gross income. If 

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

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

taxpayer's unemployment compensation. 

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

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

the unemployment compensation will be totally excluded from gross

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

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

gross income. As income other than unemployment compensation

increases, a greater percentage of unemployment compensation wil.1 be 

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

$26,000). 

Disability Compensation. Workers' compensation payments as well 

as black lunq- benefits to disabled coal miners are fully - excluded from

income. 

Reasons for Change 

Net Replacement Rates. Most wage replacement programs pay

benefits eaual to a flat percentaqe of qross earninqs, subiect to 

minimum and maximum dolla; limits; Although this percentage is . 

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

replacement program can be determined only by analyzing its "net 

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

that the program replaces. Exclusion of wage replacement payments 

- 49 -

4'76-698 O - 85 - 4 
from income causes a program's net replacement rate to exceed its 

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

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

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

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

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

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

$20,000. 

Fairness. The fairness of a wage replacement system must be 

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

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

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

current exclusion of wage replacement benefits from income typically 

causes net replacement rates to exceed gross replacement rates. 

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

family . 

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

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

both suffer a loss of all wages, and each receives tax-free payments

of $80 per week. Although each has a gross replacement rate of 50 

percent, their net replacement rates may differ greatly. If A has 

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

no income tax on his $160 per week; thus his net replacement rate 

equals his gross replacement rate of 50 percent. On the other hand,

if B's spouse has substantial earnings so that the family is in the 30 

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

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

$112. 

As illustrated by a comparison of net replacement rates, the 

exclusion of wage replacement payments from income under current law 

provides the greatest benefit to single taxpayers with no dependents

and to taxpayers with other sources of income. Correspondingly,

current law provides the least benefit to taxpayers with several 

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

generally results in higher net replacement rates for those unemployed 

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

unemployment or disability. 

The current disparity in net replacement rates could be redressed 

by redesigning wage replacement programs to take total family income 

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

administrative complexity. A more efficient approach would be to tax 

wage replacement payments, recognizing that payment schedules could 

also be adjusted to maintain average net replacement rates. This 

would ensure comparable net replacement rates for individuals 

receiving benefits under the same programs. 

work Incentives. Any wage replacement program will reduce work 

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

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

- 50 -
replacement rates then increase with family income. For example, if a 

66 percent net replacement rate is desired for families with income 

below the tax-free threshold, it will be necessary to provide a 66 

percent gross replacement rate for low-wage workers. Unless benefit 

payments are based on need, however, a 66 percent gross replacement

rate will result in net replacement rates in excess of 100 percent for 

low-wage workers from high-income families. Such high replacement 

rates are clearly undesirable. However, as long as payments are 

nontaxable and are not based on need, adequate net replacement rates 

for low-income families will create extremely high net replacement 

rates for low-wage workers from wealthier families. 

With respect to unemployment compensation, taxing an increasing 

percentage of unemployment compensation as the recipient's income 

increases above his "base amount" creates peculiar work disincentives. 

For example, if a married individual receives $5,000 in unemployment

compensation, each additional dollar that the individual or his or her 

spouse earns between $13,000 and $23,000 will require inclusion in 

their gross income of another $0.50 of the unemployment compensation.

In effect, each additional dollar of earned income within that range

increases their taxable income by $1.50, and thereby multiplies their 

marginal tax rate by 1.5 for each dollar of earned income within that 

range. Such perverse results are inevitable if such a phased-out

threshold is used. 

The conflict between minimum replacement rates and work incentives 

is greatly reduced if benefits are taxed, even if the average net 

replacement rate is maintained through higher payments. 

Neutralit . Wage replacement payments are presumably reduced in 

recognition 4 t at they are nontaxable, thereby reducing the cost of

funding such programs. If the programs are paid for by employers

(either through insurance or taxes), exclusion provides an indirect 

subsidy to industries with high injury or layoff rates, and indirectly

raises tax rates on other income. Since the cost of job-related

injuries and anticipated layoffs is a real cost of production, this 

subsidy distorts market prices and resource allocation. Although

neutrality could also be achieved by treating wage replacement 

programs as insurance and taxing employees on the "premiums" paid by

employers, this would be administratively difficult and would do 

nothing to reduce the problems of fairness or work disincentives 

discussed above. 

The exclusion from taxation may also hide the true cost of 

government-mandated programs from the policymakers who determine their 

scope and size. Taxing wage replacement payments would enable 

policymakers to make more informed decisions. 

- 51 -
Proposal 

All unemployment compensation would be included in income. 

In addition, all cash payments for disability from workers' 

compensation and black lung would be included in income, except for 

payments for medical services (unless previously deducted), payments

for physical and vocational rehabilitation, and payments for burial 

expenses. Includable payments would all be eligible for an expanded

credit for the elderly, blind, and disabled. See Ch. 2.02. In order 

to protect low- and moderate--incomedisabled taxpayers, the proposal

would make taxable disability payments eligible for a 15 percent tax 

credit. The amount eligible for the credit would be reduced by any

Title I1 social security benefits and tier 1 railroad retirement 

benefits and by one-half of the excess of adjusted gross income over 

$11,000 ($14,000 for joint returns). 

Effective Dates 

The proposal would apply to all unemployment compensation received 

in taxable years beginning on or after January 1, 1987. 

With respect to workers' compensation payments, the proposal

would apply to all payments received by employees or their survivors 

for disabilities occurring on or after January 1, 1987. Payments

received for a disability occurring before such date would remain 

nontaxable. 

The proposal would apply to all black lung disability payments

received in taxable years beginning on or after January 1, 1987,

regardless of the date on which the disability occurred. 

Analysis 

In General. Taxing wage replacement payments would eliminate the 

disparities in net replacement rates under current law. It would thus 

be possible to replace a given percentage of lost wages for workers in 

low-income families without providing net replacement rates far above 

that rate for workers from families with substantial income from other 

sources. This would enable wage replacement programs to target the 

benefits to those who need them rost. 

Unemployment Compensation. Most unemployment compensation is now 

excluded from gross income. Xn 1982, only one-third of such payments 

were taxed. Of $20.6 billion in payments, only $7 billion were 

included in gross income. Over $3.8 billion was received by taxpayers

with adjusted gross incomes between $18,000 and $30,000, more than 30 

percent of which was excluded from gross income. 

Most unemployment compensation is received by families with other 

sources of income. Unemployment compensation provided less than half 

of family income for more than 67 percent of those receiving benefits 

in 1983. Most unemployed individuals remain unemployed for less than 

.- 52 -
15 weeks, so their unemployment compensation supplements income from 

employment during the rest of the year. Under such circumstances, the 

exclusion of unemployment compensation from income provides an 

unnecessary and unfair tax advantage. For example, someone earning

$15,000 during the year and receiving $3,000 in unemployment

compensation now pays substantially less tax than another person who 

works all year and earns $18,000. 

Any unemployment compensation program will necessarily create 

some work disincentives. The proposal, however, would eliminate the 

peculiar disincentives created by the threshold for taxing such 

benefits under the current system. 

States may wish to adjust their unemployment compensation 

programs if all such compensation is included in gross income. A State 

that pays benefits equal to 50 percent of gross wages will provide net 

replacement rates of less than 50 percent to most unemployed workers. 

The Administration proposals include increased personal exemptions and 

zero bracket amounts, along with lower tax rates. As a consequence,

most workers who are unemployed for a long time and have little access 

to other sources of income would pay little or no tax on their 

benefits. The proposed effective date would provide time, however, for 

States to adjust benefits to protect even more workers. 

Disability Payments. By combining most of the special treatment 

for the disabled in a single tax credit, the proposal would ensure 

that preferential treatment for the disabled is provided in a fair and 

consistent manner. Workers receiving workers' compensation and black 

lung disability payments would be treated similarly to persons who are 

disabled and receive disability pay from their employer. 

Workers' compensation rarely provides the primary source of income 

for a family. Most of those receiving workers' compensation are off 

work for less than three weeks, and less than one percent are 

permanently and totally disabled. Families receiving more than half 

of their income from workers' compensation are rare (less than 7 

percent of all cases), and the majority of recipient families obtain 

less than 10 percent of their income from workers' compensation. Very

few families (approximately 4 percent) received more than $7,000 in 

benefits in 1983. 

Table 1 compares the 1987 tax-free levels of income under current 

law and the Administration proposals for selected families receiving

workers' compensation. Due to the preferential treatment for 

disability income, their tax-free levels of income would continue to 

exceed those for non-disabled taxpayers, which are shown in the first 

row of the table. As a result of the increased personal exemptions

and zero bracket amounts, combined with the expanded tax credit for 

disability income, the tax-exempt level of income would increase for 

the vast majority of those disabled for less than the full year.

Moreover, workers disabled all year with no other source of income 

would pay no tax unless their benefits exceeded $21,176 (single), 

- 53 -
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$31,211 (couple), or $38,947 (family of 4). The maximum benefit 

payable in 1987 (estimated by adjusting 1984 benefits for expected

increases in wages) would be less than these amounts in all but 5, 2 ,

and 1 State respectively. 

The tax-exempt level of income would also increase for those 

receiving black lung disability payments (who are all permanently

disabled), as shown in Table 1. 

As illustrated in Table 2, workers' compensation benefits are 

received primarily by middle- and high-income taxpayers. This is 

largely attributable to the fact that most of those receiving workers' 

compensation are off work for less than three weeks (with less than 

one percent permanently and totally disabled), and that such benefits 

are related to wage levels. Moreover, since each dollar of excluded 

income is worth more to those in higher tax brackets, the tax benefits 

from current law are concentrated among higher income families. 

Table 3.06-2 

Distribution of Workers' Compensation Payments

by Economic Income 

I Percentage of I Percentage of 

I All Families I Cash Payments from 

Family Economic Income I (Total Population) I Workers' Compensation 

$ 0 - 9,999 15.0 % 4.1 % 

10,000 - 14,999 12.7 7.4 

15,000 - 19,999 11.7 8.3 

20,000 - 29,999 19.3 22.2 

30,000 - 49,999 23.3 33.7 

50,000 - 99,999 15.4 22.4 

100,000 - 199,999 2.1 1.3 

200,000 or more -

0.5 0.4 ____ 

Total 100.0 % 100.0 % 

Office of the Secretary of The Treasury May 28, 1985 

Despite the extensive protection the proposal provides for the 

low- and moderate-income disabled, the taxation of these forms of 

disability income generates substantial revenue which can be used to 

reduce tax rates on other income. Moreover, the higher personal

exemption and zero bracket amount would ensure that no families below 

the poverty line are taxed on income from any source. 

The repeal of the exclusion is delayed until 1987 to allow the 

State and the Federal governments to make any desired compensatory

changes in their benefit schedules. Moreover, in the case of workers' 

compensation, the repeal would apply only to those receiving workers' 

compensation for disabilities occurring on or after January 1, 1987. 

- 55 -
.. , 

2

Since most workers' compensation payments are made by private

insurance companies, payments for past injuries are funded from 

premiums paid in the past. As a result, there is no easy way to adjust

such payments for the change in tax status. No such grandfathering is 

proposed for the Federal black lung program because those payments can 

be adjusted, if desired, for all beneficiaries. 

- 56 -
Part C. Excluded Sources of Income--Other I 

LIMIT SCHOLARSHIP AND FELLOWSHIP EXCLUSION 

General Explanation 

Chapter 3.07 

Current Law 

Current law provides an exclusion from income for the amount of 

certain scholarships or fellowship grants. In the case of candidates 

for a degree at an educational organization with a regular faculty,

curriculum and enrolled body of students, any scholarship or 

fellowship grant is excludable unless it represents compensation for 

services. If teaching, research, or other services are required of 

all such degree candidates, a scholarship or fellowship grant is not 

regarded as compensation for such services. 

Nondegree candidates may exclude scholarships or fellowship grants

only if the grantor is a charitable organization, a foreign government 

or an international organization, or an agency of the IJnited States or 

a State. The amount that may be excluded is limited to $300 per

month, with a lifetime maximum of 36 months. This limit does not 

apply, however, to amounts received to cover expenses for travel,

research, clerical hel.p, or equipment, which are incident to the 

scholarship or the fellowship grant ("incidental expenses"). 

Compensation for past, present, or future services is generally

not treated as a scholarship or as a fellowship grant. However, in 

addition to the special rule for degree candidates, there is an 

exception for certain amounts received under a Federal program. These 

amounts are treated as scholarships even though the recipient must 

agree to perform future services as a Federal empl.oyee as a condition 

of obtaining the scholarship. 

-Reasons for Change 

Scholarships and fellowship grants confer a benefit on the 

recipient that should be taxed as income. The full exclusion of these 

benefits from income under current law is unfair to the ordinary 

taxpayer who must pay for education with earnings that are subject to 

tax. 

In theory, it might be appropriate to include the full amount of 

any scholarship in income. In practice, this would create real 

hardships for many scholarship recipients. Scholarship awards are 

often made on the basis of need, and if students were taxed on such 

amounts, they would often not have the resources to pay the tax. 

Moreoverl unlike most cases in which in-kind benefits are subject to 

tax, a scholarship is typically not provided in lieu of a cash amount 

and is not otherwise convertible to cash. The definition of income 

- 57 -
for tax purposes is appropriately limited by considerations of ability 

to pay. Accordingly, income from a scholarship for tax purposes

should, in general, be limited to amounts that represent out-of-pocket

savings for regular living expenses. 

An exception for incidental expenses of nondegree candidates is 

also appropriate. Such expenses would typically be deductible as 

ordinary and necessary business expenses, and thus in most cases an 

exclusion simply provides an equivalent tax result. 

Proposal 

Scholarships and fellowship grants generally would be includable 

in gross income. In the case of degree candidates, scholarships would 

be excludable to the extent that they were required to be, and in fact 

were, spent on tuition and equipment required for courses of 

instruction, but not for room and board or other personal living 

expenses. In the case of noridegree candidates, reimbursements for 

incidental expenses (as defined in current law) would be excludable. 

The special rules concerning performance of future services as a 

Federal employee and compensation for services required of all degree

candidates would be repealed. Thus, the amount of any scholarship or 

fellowship grant representing compensation for services would be 

included in income, regardless of the employer for whom the services 

were performed or whether other degree candidates were required to 

perform similar services. 

Effective Date 

The proposal generally would be effective with respect to 

scholarships and fellowships received in taxable years beginning on or 

after January 1, 1986. However, if a binding commitment to grant a 

scholarship in the case of a degree candidate was made before January

1, 1986, amounts received pursuant to such commitment would be 

excludable under the current-law rules through the end of 1990. 

Analysis 

Degree candidates receiving scholarships that were used for 

tuition and fees would not be liable for tax by reason of the award. 

Moreover, even students receiving scholarships for expenses other than 

tuition and fees would not pay tax as a result of the award unless the 

student's total income exceeded the sum of the zero bracket amount and 

the personal exemption ($4,900 if single, and $8,000 for a married 

couple filing jointly, at 1986 levels). 

- 58 -
REPEAL EXCLUSION FOR PRIZES AND AWARDS 

General Explanation 

Chapter 3.08 

Current Law 

In general, the amount of a prize or award is includable in income 

on the same basis as other receipts of cash or valuable property.

Current law provides an exception to this general rule, however, for 

prizes and awards made primarily in recognition of religious,

charitable, scientific, educational, artistic, literary, or civic 

achievement. To qualify for this exclusion, the recipient of the 

prize or award must be selected without any action on his or her part

to enter the contest or proceeding, and must not be required to render 

substantial future services as a condition of receiving the prize or 

award . 

Reasons for Change 

Prizes or awards increase an individual's ability to pay tax the 

same as any other receipt that adds to an individual's economic 

wealth. In effect, the failure to tax all prizes and awards creates a 

program of matching grants under which certain prizes or awards also 

bestow the government-funded benefit of tax relief. Basing this 

program in the tax code permits it to escape public and legislative

scrutiny and causes benefits to be distributed not according to merit 

but to the amount of the tax the individual would otherwise owe. 

Proposal 

The amount of any prize or award received by a taxpayer would be 

fully includable in income, regardless of whether for religious,

charitable, scientific, educational, artistic, literary, or civic 

achievement. The rule of current law excluding certain prizes and 

awards from income would continue to apply, however, to the extent 

that the individual recipient of a prize or award designates that such 

prize or award go to a tax-exempt charitable organization. 

Effective Date 

The proposal would be effective for prizes and awards received in 

taxable years beginning on or after January 1, 1986. 

Analysis 

Repeal of the exclusion for certain prizes and awards would affect 

the tax liability of only a few taxpayers, but it would increase the 

perceived and actual fairness of the tax system by subjecting these 

persons to tax on the same basis as others. 

- 59 -
Part D. preferred uses of Income 

The Administration proposals would curtail itemized deductions 

for certain personal expenditures, in order to broaden the tax base,

simplify compliance and administration, and allow rates to be reduced. 

The deduction for State and local taxes would be repealed, and the 

charitable contribution deduction would be eliminated for 

nonitemizers. The itemized deductions for charitable contributions,

medical expenses, casualty losses, and principal-residence mortgage

interest would be left unchanged. Changes to the itemized deduction 

for interest expense are described in Chapter 13.01 (limit on interest 

deduction). The deduction for miscellaneous expenses would be 

replaced with an adjustment to income. (See Chapter 4.01). 

- 61 -
REPEAL DEDUCTION OF STATE AND LOCAL TAXES 

General Explanation 

Chapter 3.09 

Current Law 

Individuals who itemize deductions are permitted to deduct certain 

State and local taxes without regard to whether they were incurred in 

carrying on a trade or business or an income-producing activity. The 

following such taxes are deductible: 

State and local real property taxes. 

O State and local personal property taxes. (In some States, 

payments for registration and licensing of an automobile are 

wholly or partially deductible as a personal property tax.) 

State and local income taxes. 

O State and local general sales taxes. 

Other State and local taxes are deductible by individuals only if 

they are incurred in carrying on a trade or business or 

income-producing activity. This category includes taxes on gasoline,

cigarettes, tobacco, alcoholic beverages, admission taxes, occupancy 

taxes and other miscellaneous taxes. Taxes incurred in carrying on a 

trade or business or which are attributable to property held for the 

production of rents or royalties (but not other income-producing

property) are deductible in determining adjusted gross income. Thus,

these taxes are deductible by both itemizing and nonitemizing

taxpayers. Taxes incurred in carrying on other income-producing

activities are deductible only by individuals who itemize deductions. 

Examples of these taxes include real property taxes on vacant land 

held for investment and intangible personal property taxes on stocks 

and bonds. State and local income taxes are not treated as incurred 

in carrying on a trade or business or as attributable to property held 

for the production of rents or royalties, and therefore are deductible 

only by individuals who itemize deductions. 

Reasons for Change 

Fairness. The current deduction for State and local taxes 

disproportionately benefits high-income taxpayers residing in high-tax

States. The two-thirds of taxpayers who do not itemize deductions are 

not entitled to deduct State and local taxes, and even itemizing

taxpayers receive relatively little benefit from the deduction unless 

they reside in high-tax States. Although the deduction for State and 

local taxes thus benefits a small minority of U.S. taxpayers, the cost 

of the deduction is borne by all taxpayers in the form of 

significantly higher marginal tax rates. 

- 62 -
The unfair distribution of benefits from the deduction for State 

and local taxes is illustrated by recent tax return data. For 

example, in 1982 itemizing taxpayers in New York received an average 

tax savings of $1292 from the deduction, whereas itemizers in Wyoming 

on average saved only $257. In effect, the deduction requires

taxpayers in certain communities to subsidize taxpayers in other 

communities. Moreover, the deduction effectively skews the burden of 

State and local taxes within particular communities. Consider the 

variation in effective sales tax rates for three persons facing a 6 

percent State sales tax: a nonitemizer, an itemizer in the 50 percent 

tax bracket, and an itemizer in the 20 percent bracket. The 

nonitemizer pays the full 6 percent sales tax rate, whereas the two 

itemizers pay effective rates of 3 and 4.8 percent, respectively. The 

deduction thus causes effective sales tax rates to vary with a 

taxpayer's marginal income tax rate and with whether a taxpayer

itemizes, and produces the lowest effective rate for high-bracket/high

income taxpayers. 

Erosion of the Tax Base. The deduction for State and local taxes 

is one of the most serious omissions from the Federal income tax base. 

Repeal of the deduction is projected to generate $33.8 billion in 

revenues for 1988. Recovery of those revenues will permit a 

substantial reduction in marginal tax rates. Indeed, unless those 

revenues are recovered, tax rates will almost certainly remain at the 

current unnecessarily high levels. 

The Fallacy of the "Tax on a Tax" Argument. Some argue that the 

deductibility of State and local taxes is appropriate ._ because

individuals should not be "taxed on a tax." The argument is deficient 

for a number of reasons. First, it ignores the effect of State and 

local tax deductibility on the Federal income tax base. Deductibility 

not only reduces aggregate Federal income tax revenues, it shifts the 

burden of collecting those revenues from high-tax to low-tax States. 

High-tax States effectively shield a disproportionate share of their 

income from Federal taxation, leaving a relatively greater share of 

revenues to be collected from low-tax States. Absent the ability to 

impose Federal income tax on amounts paid in State and local taxes,

the Federal government loses the ability to control its own tax base 

and to insist that the burden of Federal income taxes be distributed 

evenly among the States. 

Second, the "tax on a tax" argument suggests that amounts paid in 

State or local taxes should be exempt from Federal taxation because 

they are involuntary and State or local taxpayers receive nothing in 

return for their payments. Neither suggestion is correct. State and 

local taxpayers have ultimate control over the taxes they pay through

the electoral process and through their ability to locate in 

jurisdictions with amenable tax and fiscal policies. Moreover, State 

and local taxpayers receive important personal benefits in return for 

their taxes, such as public education, water and sewer services and 

municipal garbage removal. In this respect, the determination by

State and local taxpayers of their levels of taxation and public

service benefits is analogous to their individual decisions over how 

much to spend for the purchase of private goods. 

- 63 -
It is, of course, true that not all benefits provided by State and 

local governments are directly analogous to privately purchased goods 

or services. Examples include police and fire protection, judicial

and administrative services and public welfare. These services 

nevertheless provide substantial personal benefits to State and local 

taxpayers, whether directly or by enhancing the general quality of 

life in State and local communities. 

Finally, the "tax on a tax" argument is contradicted by the 

practice of most States with respect to their own tax systems,

including many of those with high tax rates. Federal income taxes are 

allowable as a deduction from State individual income taxes in only 16 

States and from State corporate income taxes in only seven States. 

New York and California, States with very high tax rates, are among

the States that deny a deduction for Federal income taxes. 

Inefficient Subsidy. The deduction for State and local taxes may

also be regarded as providing a subsidy to State and local 

governments, which are likely to find it somewhat easier to raise 

revenue because of the deduction. A general subsidy for spending by

State and local governments can be justified only if the services 

which State and local governments provide have important spillover

benefits to individuals in other communities. The existence of such 

benefits has not been documented. 

Even if a subsidy for State and local. government spending were 

desired, provision of the subsidy through a deduction for State and 

local taxes is neither cost effective nor fair. On average, State and 

local governments gain less than fifty cents for every dollar of 

Federal revenue lost because of the deduction. Moreover, a deduction 

for State and local taxes provides a greater level of subsidy to 

high-income States and communities than to low-income States and 

communities. In addition, a deduction for taxes does not distinguish

between categories of State and local spending on the basis of their 

spillover effects, but is as much a subsidy for spending on 

recreational facilities as for public welfare spending. Finally, the 

deduction distorts the revenue mix of State and local governments by

creating a bias against the imposition of user charges in favor of 

more general taxes. 

Proposal 

The itemized deduction for State and local income taxes and for 

other State and local taxes that are not incurred in carrying on a 

trade or business or income-producing activity would be repealed.

State and local taxes (other than income taxes) which currently are 

deductible only by itemizers, but which are incurred in carrying on an 

income-producing activity, would be aggregated with employee business 

expenses and other miscellaneous deductions and would be deductible 

subject to a threshold. See Ch. 4.01. 

- 64 -
Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

While only one-third of all families itemized deductions in 1983,

this group included most high-income families (more than 95 percent of 

families with income over $100,000 itemized tax deductions) and very

few low-income families (2 percent of families with income of $10,000 

or less itemized tax deductions). (Table 1.) Two-thirds of the total 

deductions for State and local tax payments were claimed by families 

with economic income of $50,000 or more. The benefits are even 

further skewed toward high-income families because deductions are 

worth more to families which face higher marginal tax rates. 

The tax savings from deductibility vary widely among the States 

and, as shown in Table 2, provide the greatest benefits to individuals 

in high-income States. Because this tax expenditure requires tax 

rates for all individuals to be higher than they otherwise would be,

those in the 15 States with above-average tax savings per capita

currently gain at the expense of taxpayers in the other 35 States. 

Even within the high-tax States, less than one-half of all taxpayers

itemize deductions. 

Recent estimates indicate that the effect of tax deductibility on 

the level of State and local government spending is not large. A 

National League of Cities study found that total State and local 

spending is about 2% higher because of the existence of tax 

deductibility. This estimated effect is low in part because less than 

one-third of total State and local spending is financed by taxes 

potentially deductible from the Federal individual income tax. 

Because State and local spending has been growing by about 7% per year

since 1980, the elimination of tax deductibility would not reduce the 

absolute level of State and local spending, but only reduce its rate 

of growth. However, because the proportion of taxpayers who itemize 

varies a great deal among the States as well as among local 

governments within a State, the effect on spending for a particular

State or local government would be larger than 2 percent for a 

high-income community and may not affect spending at all in low-income 

communities where few residents itemize deductions. 

The three most important sources of State and local tax revenue in 

the U.S. are general sales, personal income and property taxes. Some 

argue that itemized deductions should be eliminated for some of these 

taxes, but retained for others. As Table 3 shows, however,

elimination of any one tax deduction would have an uneven effect on 

taxpayers among the States. In addition, since State and local 

governments would be likely to increase reliance on the remaining

deductible taxes, disallowing deductions for particular taxes is 

likely to lead to sizeable distortions in State and local revenue 

- 65 -
mixes. For example, disallowing only the sales tax deduction might

force a State, like Washington, that relies heavily on a general sales 

tax but does not have an individual income tax, to adopt one. 

- 66 -
Table 3.09-1 

Distribution of Deductions for Taxes Paid 

by Economic Income - 1983 

I I Percentage I State and I

Family I Number of I with State I Local Taxes I Average

Economic I Families I and Local I Deducted 1/ 1 Amount 

Income I (thousands) I Deduction I (millionsr I Deducted 2/ 

$ 0 - 9,999 337 2% $ 233 $ 691 

10,000 - 14,999 516 4 465 90 1 

15,000 - 19,999 1,009 9 1,009 1,089 

20,000 - 29,999 3,894 22 5,307 1,363 

30,000 - 49,999 10,820 51 22,012 2,034 

50,000 - 99,999 11,298 80 36,408 3,223 

100,000 - 199,999 1,793 95 12,150 6,776 

200,000 or more 426 97 9,090 21,338 

All Families 30,093 33 86,762 2,883 

Office of the Secretary of the Treasury May 28, 1985 

-1/ Net of income tax refunds. 

-2/ For families that itemize deductions. 

- 67 -
Table 3.09-2 

States Ranked by Per Capita Tax Savings from 

Tax Deductibility Under Current Law, 1982 

I Tax savings 

stete 1 par capita 

NOW York $233 

District of Columbia 198 

Maryland 185 

New Jersey 167 

Delaware 162 

California 155 

Massachusetts 155 

Minnesota 150 

Michigan 144 

Wisconsin 137 

Connecticut 135 

Oregon 117 

Hawaii 116 

Rhode Island 116 

Virginia 113 

Colorado 110 

U.S. Averags 106 

Illinois 101 

Utah 91 

Georgia 87 

Nebraska 87 

Oklahoma 89 

Pennsylvania 83 

Ohio a2 

Kansas 80 

North Carolina 77 

Arizona 76 

TOWB 75 

Vermont 75 

South Carolina 73 

Maine 70 

Missouri 70 

New Hampshire 68 

Kentucky 65 

Idaho 64 

Weshington 63 

Nevada 57 

Indiana 51 

Florida 50 

Alabama 49 

Arkansas 49 

Alaska 45 

TBKBS 43 

North Dakota 42 

Montane 41 

Mississippi 39 

New Mexiso 38 

West Virginia 34 

Tennessee 33 

Wyoming 33 

Louisiana 31 

South Dakota 20 

I Income Per 

I Capita 

$12,314 

14,550 

12,238 

13,089 

11,731 

12,567 

12,088 

11,175 

10,956 

10,774 

13,748 

10,335 

11,652 

10,723 

11,095 

12,302 

11,107 

12,100 

8,875 

9,583 

10,683 

11,370 

10,955 

10,677 

11,765 

10,044 

10,173 

10,791 

9,507 

8,502 

9,042 

10,170 

10,729 

8,934 

9,029 

11,560 

11.981 

10,021 

10,978 

8,649 

8 ~ 479 

16.257 

11,419 

10,872 

9,580 

7,778 

9,190 

8,769 

8,906 

12,372 

10,231 

9,666 

I Rank of Income 

I Per Capita 

7 

2 

9 

4 

14 

5 

11 

19 

22 

26 

3 

31 

15 

28 

20 

8 

-

10 

46 

37 

29 

18 

23 

30 

13 

41 

32 

25 

39 

49 

42 

34 

27 

44 

43 

16 

12 

35 

21 

48 

50 

1 

17 

24 

38 

51 

40 

41 

45 

6 

32 

36 

Office of the Secretary of the Treasury May 28, 1985

Source: Advisory commission an Intergovernmental elations 

- 68 -' 
Table 3.09-3 

Percentage Reliance on Different Deductible 

Taxes by States in 1982 -1/ 

I Property 1 General sales 1 Individual 

state I TBXBS I Taxes I Income Taxes 

Alabama 

Alaska 

Arizona 

Arkansas 

cblifornia 

Colorado 

Connecticut 

D.C. 

Ds1aWBr.B 

Florida 

Georgia

Hawaii 

Idaho 

111inoie 

Indiana 

Iowa 

KLLnGLIS 

Kentucky 

Louisiana 

Maine 

Maryland 

Massachusetts 

Michigan 

Minnesota 

Misaiasippi 

Miesouri 

wontana 

Nebraska 

Nevada 

New Hampshire 

NOW Jersey 

New Mexico 

New York 

North Carolins 

North Dakota 

Ohio 

Oklahoma 

Oregon 

Pennsylvania 

Rhode Island 

South Carolina 

South Dakota 

Tennessee 

Texas 

Utah 

Vermont 

Virginia 

Washington 

West Virginia 

Wisconsin 

Wyoming 

V.S. Average 

19.8 % 50.7 % 29.5 % 

89.1 10.9 0 

38.7 42.4 18.9 

31.6 37.4 31.0 

33.1 37.,3 29.6 

43.0 37.3 19.7 

60.6 34.7 4.7 

34.0 24.8 41.2 

26.8 0 73.2 

53.1 46.9 0 

35.3 34.6 30.1 

22.8 51.8 25.5 

37.9 24.7 37.4 

47.2 31.1 21.7 

42.7 37.9 19.5 

50.5 20.8 28.7 

51.0 25.7 23.2 

27.0 33.5 39.5 

22.4 68.9 8.7 

48.6 27.9 23.5 

33.9 18.9 47.2 

47.4 14.8 37.8 

53.1 20.2 26,.7 

36.5 23.0 40.5 

30.5 57.1 12.4 

35.7 36.2 28.1 

76.1 0 23.9 

55.6 26.5 17.8 

33.,0 67.0 0 

97.3 0 2.7 

61..8 19.7 18.6 

25.4 72.8 1.7 

40.2 23.3 36.5 

33.0 27.4 39.6 

52.2 38.5 9.3 

45.7 26.0 28.3 

26.2 42.0 31.8 

56.8 0 43.2 

39.0 25,l 35.9 

54.,0 22.1 23.9 

32.6 33.8 33.6 

56.8 32.2 0 

37.2 60.8 1.9 

55.7 44.3 0 

33.5 39.2 27.3 

59.0 12.2 28.7 

40.6 22.7 36.7 

40.8 59.2 0 

22.2 55.8 22.0 

43.9 20.4 35.7 

60.4 39.6 0 

42.5% 31.4% 26.2% 

Office of the Secretary of the Treasury way 28, 1985 

-

I./ These figures include some general sales end property taxes with an 

initial impact on business rather then individuals. Certain other 

taxes can also be itemized deductions. Property, genersl eeles, 

and individual income taxes accounted for 94 percent of total taxes 

itemized in 1982. 

Source: Advisory Commission on Intergovernmental Relations 

- 69 -
ACCELERATE EXPIRATION OF CEARITABLE CONTRIBUTION 

DEDUCTION FOR NONITENIZERS 

General Explanation 

Chapter 3.10 

Current Law 

Contributions to or for the benefit of religious, charitable,

educational, and certain other tax-exempt organizations are 

deductible, subject to certain limitations. Prior to 1981 individuals 

who did not itemize their deductions could not deduct their charitable 

contributions. The Economic Recovery Tax Act of 1981 (ERTA) extended 

the charitable contribution deduction to nonitemizing taxpayers,

phased in over a five-year period. For contributions made in the 1984 

tax year, individuals who did not itemize deductions were permitted to 

deduct 25 percent of the first $300 of contributions made. For 1985 

and 1986, the $300 limitation is removed, and the percentage of 

contributions deductible by nonitemizers is increased to 50 percent

and 100 percent, respectively. Thus, under current law, the 

charitable contribution deduction will be allowed in full to 

nonitemizers in 1986. The charitable deduction for nonitemizers is 

scheduled to expire after 1986, however, so that after that time the 

deduction will again be unavailable to individuals who do not itemize 

their deductions. 

Reasons for Change 

Taxpayers are not subject to tax on their incomes up to the zero 

bracket amount (ZBA). This exemption generally is regarded as an 

allowance for certain personal expenses that ought not to be included 

in income and that all taxpayers are deemed to incur. In lieu of the 

ZBA, a taxpayer may itemize deductible personal expenses, such as 

certain medical expenses, interest expenses, and, prior to the ERTA 

changes, charitable contributions. Allowing a deduction for 

charitable contributions by nonitemizers in effect creates a double 

deduction for such contributions first through the ZBA, which is 

available only to nonitemizers, and second through the charitable 

contribution deduction. 

In addition, the allowance of a charitable contribution deduction 

for nonitemizers is administratively burdensome for the Internal 

Revenue Service and complicated for taxpayers. In particular, it is 

extremely difficult for the Internal Revenue Service to monitor 

deductions claimed for countless small donations to eligible

charities; the expense of verification is out of proportion to the 

amounts of tax involved. Dishonest taxpayers are thus encouraged to 

believe that they can misrepresent their charitable contributions with 

impunity. MOKeOVi?K, taxpayers who claim charitable contribution 

deductions are required to maintain records substantiating those 

- 70 -
contributions. In the case of smaller gifts, the effort required to 

comply with the necessary substantiation requirements may be out of 

proportion to the amounts involved. 

Finally, allowance of the deduction for nonitemizers would make it 

much more difficult to implement the proposed return-free system

described in Ch. 5.01 for large numbers of taxpayers. 

Proposal 

The scheduled expiration date of the charitable contribution 

deduction for nonitemizers would be accelerated. 

Effective Date 

Expiration of the charitable contribution deduction for 

nonitemizers would be effective for contributions made in taxable 

years beginning on or after January I, 1986. 

Analysis 

There is little data indicating whether the charitable 

contribution deduction for nonitemizers has significantly increased 

the level of charitable giving. Because nonitemizers generally have 

lower incomes and thus lower marginal tax rates than itemizers, their 

contributions generally are not affected significantly by tax 

considerations. Rather, contributions made by nonitemizers are 

influenced far more by non-tax considerations such as general donative 

intent. Therefore, any adverse effect of the proposal on charitable 

giving is not expected to be significant, particularly in relation to 

the proposal's effect on tax revenues. The repeal of the charitable 

contribution deduction for nonitemizers is estimated to increase 

revenues in fiscal years 1986 and 1987 by $419 million and $2,687

million, respectively. 

The proposal would simplify both the regular tax form (1040) and 

the short-form (1040A). The current deduction requires that a 

"worksheet" be included in the tax form instructions, on which the 

taxpayer makes calculations, the results of which are subsequently

transferred onto Form 1040 or 1040A. The proposal would eliminate 

these computations and would relieve nonitemizers of recordkeeping

burdens. 

- 71 -
Part E. Tax Abuses--Mixed Business/Personal Use 

Many expenses that involve significant personal consumption

currently are being deducted as business expenses. This is unfair to 

taxpayers who do not have access to business perquisites and also 

distorts consumption choices. The proposals would limit deductions 

for entertainment, business meals, and travel expenses. 

- 73 -
LIMIT DEDUCTION FOR 

ENTERTAINHENT AND BUSINESS MEAL EXPENSES 

General Explanation 

Chapter 3.11 

Current Law 

Ordinary and necessary expenses paid or incurred during a taxable 

year generally are deductible if the expenses bear a reasonable and 

proximate relation to the taxpayer's trade or business or to 

activities engaged in for profit. Although ordinary and necessary

business expenses may include entertainment expenses, business 

entertainment expenses are deductible only if they satisfy certain 

additional requirements. 

Business meals are deductible if they occur under circumstances 

that are "conducive to a business discussion." There is no 

requirement that business actually be discussed, either before,

during, or after the meal. Expenses for other entertainment 

activities are deductible only if they are "directly related to" or 

"associated with" the taxpayer's trade or business. Entertainment 

activities are considered "directly related" if the taxpayer has more 

than a general expectation of deriving income or a specific trade or 

business benefit (other than goodwill) from the activity. The 

taxpayer need not show that income actually resulted from the 

entertainment. In general, entertainment expenses satisfy the 

"associated with" standard if they are directly preceded or followed 

by a substantial and bona fide business discussion. A business 

discussion may be considered substantial and bona fide even if it 

consumes less time than the associated entertainment and does not 

occur on the same day as the entertainment activity. 

Deductions for entertainment facilities, such as yachts, hunting

lodges, or country clubs, used to entertain clients or customers also 

are subject to certain restrictions. A deduction is allowed for the 

portion of the cost of club memberships that are "directly related" to 

the taxpayer's business if the facilities are used primarily for 

business purposes. No deduction is allowed for other types of 

entertainment facilities. Tickets to sporting and theatrical events,

and the costs of skyboxes, lounges, boxes or other similar 

arrangements that provide the taxpayer a specific viewing area to a 

sporting or theatrical event, however, are not considered to be 

expenses related to an entertainment facility. Thus, such expenses 

are fully deductible if they meet the "directly related to" or 

"associated with" tests for entertainment activities. 

Business entertainment expenses also are subject to separate

substantiation requirements. Deductions for entertainment expenses 

must be supported by records showing the amount of the expense, time 

and place of entertainment, business purpose of the expense, and 

business relationship to the taxpayer of any persons entertained. 

- 74 -
Reasons for Change 

In General. The subject of business entertainment expenses has 

received repeated legislative attention since 1962, when Congress

first applied special restrictions to the deduction of such expenses

The continuing concern in this area reflects the difficulty of 

identifying the business component of expenses that have obvious 

personal benefits and are commonly incurred in nonbusiness contexts. 

Although there are special restrictions on the deduction of 

business entertainment expenses, current law has largely maintained a 

facts and circumstances approach in determining whether entertainment 

expenses were incurred for business rather than personal purposes.

The existing “directly related to“ or “associated with“ tests require

investigation of a taxpayer’s expectations and intentions. It 

frequently is possible under those tests to demonstrate an actual 

business purpose or connection for an entertainment expense that 

nevertheless has a strong, if not predominant, element of personal

consumption. Thus, under present law, the costs of country club 

memberships, football and theater tickets, parties, and lunches and 

dinners at expensive restaurants are all deductible where a reasonable 

business connection can be demonstrated. Indeed, such deductions may

be allowed even in cases where less time is devoted to business than 

to entertainment, no business is discussed, or the taxpayer is not 

even present at the entertainment activity. 

The liberality of the law in this area is in sharp contrast to the 

treatment of other kinds of expenses that provide both business and 

personal benefits. In some cases, such as work-related clothing, the 

presence of any personal benefit is deemed sufficient reason to 

disallow any deduction. In other cases, taxpayers are allowed to 

deduct only the portion of expenses allocated to business. In 

contrast, present law often allows full deductibility of entertainment 

expenses that entail substantial personal consumption. 

Fairness. The current treatment of business entertainment 

expenses encourages taxpayers to indulge personal entertainment 

desires while at work or in the company of business associates. The 

majority of taxpayers, however, do not benefit from this incentive. 

Most hold jobs that do not permit business entertainment, and many

others are scrupulous in claiming business deductions for personal

entertainment. 

Current law thus creates a preference for the limited class of 

taxpayers willing and able to satisfy personal entertainment desires 

in a setting with at least some business trappings. Lunches are 

deductible for a business person who eats with.clients at an elegant 

restaurant, but not for a plumber who eats with other workers at the 

construction site. The cost of tickets to a sporting event for 

friends of a business person is deductible if they are business 

associates, but the cost of tickets for friends of a secretary, sales 

clerk, or nurse must be paid for with after-tax dollars. 

- I5 -
Extreme abuses of these deductions are commonly cited by those who 

assail the tax system as unfair. Such abuses may be limited to a 

relatively small number of taxpayers, but they nevertheless undermine 

the public trust that is essential in a tax system based on 

self-assessment. Taxpayers are not only aware of the abuses, they

perceive an inability under current law to police them. Absent public

confidence that the rules apply on the same basis to all, disrespect

for the system and greater noncompliance are inevitable. The adoption

of workable limitations on the deductibility of entertainment expenses

would be an important step to preserve that confidence. 

Efficiency. The treatment of "business related" entertainment 

under current law also encourages excessive spending on entertainment. 

The business person in the 40 percent marginal tax bracket considering

whether to spend $20 or $50 on a "business meal" knows that the $30 

extra cost of the more expensive meal is reduced to $18 because of the 

available deduction. The taxpayer's choice of meals is more likely to 

be based on personal rather than business considerations, but the 

deductibility of the expense makes selection of the expensive meal 

more likely than in a nonbusiness context. Similarly, a business 

person in the 50 percent marginal tax bracket may conclude that it 

costs nothing extra to take a business associate to the theater even 

if it serves little or no business purpose. The attendance of the 

business associate permits a claim that the cost of both tickets is 

deductible, and thus the extra ticket may cost nothing on an after-tax 

basis. 

Present law has no effective response to these practices because 

it characterizes an entertainment expense as business or personal on 

the basis of the taxpayer's intentions and purposes. Once a business 

purpose or connection is established, it ordinarily permits the entire 

expense to be deducted, even though the total amount spent reflects 

what is in essence a choice about the level of personal consumption. 

Proposals 

1. No deduction would be allowed for entertainment activity 

expenses. Entertainment activity expenses, however, would be exempted

from the general disallowance rule if they: are paid under a 

reimbursement arrangement (in which case the deduction would be denied 

to the person making the reimbursement); are treated as compensation

by an employer and taken into account as wages by an employee;

constitute recreational expenses for employees (e.g., Christmas 

parties and summer outings); are expenses for goods, services, and 

facilities made available to the general public (e.g., samples and 

promotional activities); or are expenses includable in income of 

persons who are not employees. 

2. A deduction would be allowed for the cost of ordinary and 

necessary business meals furnished in a clear business setting (as

defined in Treasury regulations). To the extent the total cost of a 

- 76 -
business meal exceeds $25 times the number of persons participating in 

such meal, 50 percent of such excess would be nondeductible. The meal 

cost limitation would include gratuities and tax with respect to the 

meal. However, expenses for food and beverage furnished on the 

business premises of the taxpayer primarily for employees of the 

taxpayer would not be subject to the limitation. 

Effective Date 

The proposal would apply to taxable years beginning on or after 

January 1, 1986. 

Analys is 

Business Meal Limitations. Business meals provide a mixture of 

business and personal benefits. The extent to which a meal provides a 

personal benefit will vary, and it is not possible to develop rules 

that would specify the precise percentage of personal benefit in 

individual cases. The proposal, therefore, establishes a relatively

mechanical limitation on the deductibility of business meals, targeted

at meal expenses that are most likely to provide a significant level 

of personal consumption. The $25 allowance is intentionally quite 

generous and is intended to provide a full deduction for the vast 

majority of business meals. The deduction will be disallowed only for 

50 percent of the portion of the cost of a business meal that is in 

excess of $25. 

Representatives of the restaurant industry in testimony before 

Congress have provided several estimates of the average cost of 

restaurant meals. If adjusted for inflation, those estimates would 

range between $7.50 and $11.50 for 1986. In addition, Census data 

shows that only about 2.5 percent of all restaurant meals in 1977 were 

in restaurants where the average bill exceeded $10.00. Adjusted for 

inflation, this suggests that only about 2.5 percent of all meals were 

in restaurants with average bills over $19.00 in 1986. Recent surveys 

suggest that less than 15 percent of all business meals would be 

affected by the proposal in 1986. 

While the proposal will reduce the number of expensive business 

meals, it is expected that the limitations will not have a 

significant impact on more than five percent of restaurants. 

Moreover, since some high-cost meals will be replaced by moderate-cost 

meals, the effect on total employment in the restaurant industry is 

expected to be modest. 

Businesses currently are required to keep detailed records for all 

deductible meals. Therefore, the additional recordkeeping costs 

should be minimal. 

Placing a limit on the deductibility of business meals would 

eliminate the extreme cases of abuse -- those that offend the average 

- 77 -
taxpayer the most. Despite its small revenue effect, the proposal

would be of significant assistance in restoring trust in the tax 

system. 

The Elimination of other Entertainment Deductions. - The proposal

would completely eliminate deductions for entertainment expenses such 

as tickets to piofessional sporting events, tickets to the theater,

the costs of fishing trips, and country club dues. Because all such 

entertainment has a large personal component, the proper tax 

treatment, on both efficiency and equity grounds, is to disallow a 

deduction. 

Approximately one-third of a11 baseball tickets and over one-half 

of all hockey tickets are purchased by businesses. The net effect is 

often to raise the cost of tickets for those who are not subsidized 

through the tax system for their purchases. Some performing arts 

organizations also sell large proportions of their tickets to 

businesses. Some tickets bought by businesses would remain deductible 

if the tickets are made available to the general public as a promotion

under current law standards. 

- 78 -
LIHIT DEDUCTION FOR TRAVEL EXPENSES 

General Explanation 

Chapter 3.12 

Current Law 

Travel expenses incurred by a taxpayer while "away from home" are 

deductible if such expenses are reasonable and necessary in the 

taxpayer's business and are directly attributable to the taxpayer's

business. Travel expenses may include the cost of travel to and from 

the destination and the cost of meals, lodging, and other incidental 

travel costs (e.g., laundry, taxi fares) incurred while at the 

business destination. A taxpayer's "home" for purposes of the 

deduction is generally his or her business headquarters. A taxpayer

is considered to be "away" from his or her business headquarters only

if the travel involves a "temporary" rather than an "indefinite" 

assignment at another location. If a taxpayer accepts a job at a 

distant location for an indefinite period, the new job location 

becomes the taxpayer's tax home. Temporary employment generally is 

expected to last for a short or foreseeable period of time, but 

whether employment is temporary or indefinite is essentially a factual 

question. 

The costs of attending a convention or other meeting (including

the costs of meals and lodging) in the North American area are 

deductible if the taxpayer is able to show that attendance at the 

convention is directly related to his or her trade or business and 

that such attendance is advancing the interests of the taxpayer's

trade or business. The North American area includes the United 

States, the U.S. possessions, the Trust Territory of the Pacific 

Islands, Canada, Mexico, and certain Caribbean countries that have 

entered into exchange of tax information agreements with the United 

States. A stricter rule applies for conventions held outside the 

North American area. In order to claim a deduction for the costs of 

attending such a convention, a taxpayer also must show that it was "as 

reasonable" for the meeting to be held outside the North American area 

as within it. 

Deductions for conventions, seminars, or other meetings hel,d on 

cruise ships are subject to additional limitations. No deduction is 

allowed unless the cruise ship is registered in the United States and 

stops only at ports of call in the United States or in possessions of 

the United States. In any event, a taxpayer may deduct no more than 

$2,000 for such meetings per year. 

Professional education expenses, including travel as a form of 

education, are deductible if the education maintains or improves

existing employment skills or is required by an employer, or 

applicable law or regulation. To be deductible, the travel must be 

- 79 -
directly related to the duties of the taxpayer in his or her 

employment or other trade or business. The deductible educational 

travel may occur while the taxpayer is on sabbatical leave. 

Reasons for Change 

The present limitations on deductions for business travel fail to 

distinguish adequately between costs incurred for business purposes

and costs reflecting personal consumption. The deduction for expenses

for meals and lodging incurred "away from home" is premised on the 

assumption that the business traveler incurs additional costs while 

away from home. Restaurant meals are likely to be more expensive than 

the cost to the taxpayer of eating at home, and hotel accomodations 

are a duplicative expense for the taxpayer who maintains regular

living quarters elsewhere. These excess costs incurred by a taxpayer 

away from home may reasonably be treated as legitimate business 

expenses. 

Extended travel status, however, generally permits economies not 

available on shorter trips. The temporary residence of a taxpayer

expecting to be away from home for a year or more typically will have 

kitchen, laundry, and other facilities that permit the taxpayer to 

avoid excess expenses. Moreover, extended travel may permit the 

taxpayer to abate fixed costs associated with his permanent residence,

such as by renting or subletting his house or apartment. 

In addition, the current tax treatment of travel that has both 

business and personal elements creates opportunities for abuse that 

threaten public confidence in the system. Current law largely retains 

a facts and circumstances approach to the characterization of such 

mixed motive expenses, and thus requires investigation of the 

taxpayer's particular intentions and expectations. The fact that a 

plausible business purpose frequently can be established for travel 

that has a strong personal component encourages taxpayers, in a system

of self-assessment, to take aggressive reporting positions. The great

majority of taxpayers are honest, and apply current law standards in 

good faith. It is riot reasonable, however, to expect that taxpayers

deny themselves the benefit of the doubt when applying rules that are 

broad and open to interpretation. 

The issues identified above are characteristic of a system that 

emphasizes fairness of individual results, and thus avoids the rougher

justice achieved by mechanical, bright-line rules. Without 

challenging these priorities in any fundamental way, it is still 

appropriate to recognize that the integrity of the system ultimately

depends on rules that taxpayers respect and perceive that others 

respect. This is especially so with regard to deductions for 

expenses, such as travel, that most taxpayers undertake strictly for 

personal purposes and that have obvious pecsonal consumption benefits. 

Accordingly, strict limitations on deductions for travel expenses are 

appropriate where the component of personal consumption is manifest or 

where business and personal motivations are so intertwined as to be 

inseparable. 

- 80 -
Proposals 

1. For purposes of determining whether a taxpayer is away from 

home, travel assignments which extend for more than one year in one 

city would be considered indefinite, and no travel deductions would be 

allowed. 

2. No deduction would be allowed for business travel by ocean 

liner, cruise ship, or other form of luxury water transportation in 

excess of the cost of otherwise available business transportation,

unless the taxpayer provides proof of existing medical reasons for 

utilizing such transportation. 

3. No deduction would be allowed for expenses paid with respect 

to conventions, seminars, or other meetings held aboard cruise ships. 

4. No deduction would be allowed for travel as a form of 

education. 

5. The limitations set forth in 2. through 4. above would not 

apply in cases where the expenses in question are paid under a 

reimbursement arrangement (in which case the deduction would be denied 

to the person making the reimbursement); are treated as compensation

by an employer and taken into account as wages by an employee; or are 

expenses includable in income of persons who are not employees, 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

The proposed limitations on certain travel expense deductions are 

designed to restrict deductions for travel expenses where personal

consumption benefits are most evident without unduly restricting

deductions for legitimate business expenses. 

The one-year rule for defining temporary employment would 

eliminate a significant source of dispute between taxpayers and the 

Internal Revenue Service, and would provide a reasonable division 

between temporary and indefinite assignments. One year's stay at a 

single location is sufficient to indicate that regular living patterns

will be established at the new location and, thus, that food and 

lodging expenses need not be duplicative of or more expensive than 

comparable costs at the original job site. 

The disallowance of a deduction for the cost of travel by cruise 

ships, ocean liner, or other form of luxury water transportation in 

excess of the cost of otherwise available business transportation is 

intended to deny a deduction for the portion of the travel cost most 

likely to constitute personal rather than business benefit. 

- 81 -

476-698 0 - 85 - 5 
Part P. Tax Abuses--Income Shifting 

Although the proposed rate schedule for individuals is flatter 

than under current law, there would remain a substantial difference 

between the top and bottom rates. Thus, as under current law,

taxpayers subject to the top rate would have an incentive to shift 

income to their children or other family members subject to tax at 

lower rates. Current law limits income shifting through various 

rules, including the assignment-of-income doctrine and the 

interest-free loan provisions. This Part discusses proposed rules 

that would buttress current limits on income-shifting by preventing

taxpayers from reducing the tax on unearned income by transferring

income to minor children or establishing trusts. 

- 03 -
ADJUST TAX RATE ON U"ED INCOXE OF MINOR CHILDREN 

General Explanation 

Chapter 3.13 

Current Law 

Minor children generally are subject to the same Federal income 

tax rules as adults. If a child is claimed as a dependent on another 

taxpayer's return, however, the child's zero bracket amount is limited 

to the amount of the child's earned income. Accordingly, the child 

must pay tax on any unearned income in excess of the personal

exemption ($1,040 in 1985). 

Under current law, when parents or other persons transfer 

investment assets to a child, the income from such assets generally is 

taxed thereafter to the child, even if the transferor retains 

significant control over the assets. For example, under the Uniform 

Gifts to Minors Act ("UGMA"), a person may give stock, a security

(such as a bond), a life insurance policy, an annuity contract, or 

money to a custodian, who generally may be the donor, for the child. 

As a result of the gift, legal title to the property is vested in the 

child. During the child's minority, however, the custodian has the 

power to sell and reinvest the property; to pay over amounts for the 

support, maintenance, and benefit of the minor; or to accumulate 

income. Results similar to those achieved by a transfer under the 

UGMA may be obtained by transferring property to a trust or to a 

court-appointed guardian. 

Parents also may shift income-producing assets to a child, without 

relinquishing control over the assets, by contributing such assets to 

a partnership or S corporation and giving the child an interest in the 

partnership or corporation. 

Reasons for Change 

Under current law, a family may reduce its aggregate tax liability

by shifting income-producing assets among family members. Such 

"income shifting" is a common tax-planning technique, typically

accomplished by the parents transferring assets to their children so 

that a portion of the family income will be taxed at the child's lower 

marginal tax rate. 

Income shifting undermines the progressive rate structure, and 

results in unequal treatment of taxpayers with the same ability to pay

tax. A family whose income consists largely of wages earned by one or 

both parents pays tax on that income at the marginal rate of the 

parents. Even though such wage income is used in part for the living

expenses of the children, parents may not allocate any portion 

- 84 -
of their salary to their children in order that it be taxed at the 

children's lower tax rates. Families with investment income, however,

may be financially able to transfer some of it to the children,

thereby shifting the income to lower tax brackets. Typically, this 

ability is most prevalent among wealthy taxpayers. Moreover, use of a 

trust or a gift under the UGMA allows the parents to achieve this 

result without relinquishing control over the property until the 

children come of age. 

The opportunity for income shifting also complicates the financial 

affairs of persons who take advantage of it, and causes some persons

to make transfers they would not make absent tax considerations. 

Disputes with the Internal Revenue Service are created in the case of 

transfers that arguably are ineffective in shifting the incidence of 

taxation to the transferee, such as when a parent nominally transfers 

property to children but in reality retains the power to revoke the 

transfer . 

Proposal 

Unearned income of children under 14 years of age that is 

attributable to property received from their parents would be taxed at 

the marginal tax rate of their parents. This rule would apply only to 

the extent that the child's unearned income exceeded the personal

exemption ($2,000 under the Administration proposals). The child's 

tax liability on such unearned income would be equal to the additional 

tax that his or her parents would owe if such income were added to the 

parents' taxable income and reported on their return. If the parents

report a net loss on their return, the proposed rule would not apply,

and the child's unearned income would be taxed along with his or her 

earned income. If more than one child has unearned income which is 

taxable at the parents' rate, such income would be aggregated and 

added to the parents' taxable income. Each child would then be liable 

for a proportionate part of the incremental tax. 

All unearned income of a child would be treated as attributable to 

property received from a parent, unless the income is derived from a 

qualified segregated account. A child who receives money or property

from someone other than a parent, such as another relative, or who 

earns income, could place such property or earnings into a qualified

segregated account. Property received by reason of the death of a 

parent could also be placed into the account. However, other amounts 

otherwise received directly or indirectly from a parent could not be 

placed into the account. 

For purposes of this provision, an adopted child's parents would 

be the adoptive parent or parents. In the case of a foster child, the 

parents would be either the natural parents or the foster parents, at 

the child's election. If the parents are married and file a joint

return, the child's tax would be computed with reference to the 

parents' joint income. If the parents live together as of the close 

of the taxab1.e year, but do not file a joint return (i.e., if they are 

- 85 -
married and file separate returns or if they file as single

individuals), then the child's tax would be computed with reference to 

the income of the parent with the higher taxable income. If the 

parents do not file a joint return and are not living together as of 

the close of the taxable year, the child's tax would be computed with 

reference to the income of the parent having custody of the child for 

the greater portion of the taxable year. 

Expenses that are properly attributable to the child's unearned 

income would be allowed as deductions against such income. Itemized 

deductions and the personal exemption generally would be allocated 

between earned and unearned income in any manner chosen by the 

taxpayer. Interest expense, however, would be deductible against

unearned income that is taxable at the parents' tax rate only if it is 

attributable to debt that was assumed by the child in connection with 

a transfer of property from the parents, or to debt that encumbered 

such property at the time of the transfer. 

Earned income and income from a qualified segregated account would 

be taxable (after subtracting the portion of the child's itemized 

deductions and personal exemption allocated to such income) under the 

rate schedule applicable to single individuals, starting at the lowest 

rate. Moreover, unlike current law, the zero bracket amount could be 

used against both the child's earned income and unearned income from a 

segregated account, although it could not be used to offset other 

unearned income. 

The proposed taxation of income of children under 14 years of age

may be illustrated by the following example. 

Suppose Sarah, aged 13, earns $500 from a paper route in 1984. 

She has $4,000 in a bank account, attributable to savings from her 

earned income and gifts from her grandparents. She earns $360 in 

interest from the account. She also earns $1,000 from an account set 

up by her parents under the Uniform Gifts to Minors Act. Under 

current law, Sarah's unused zero bracket amount is $2,300 less $500, 

or $1,800. This amount must be added to her income. Thus, Sarah's 

income is: 

$ 500 

360 

1,000 

1,800 

$-, less $1,000 personal exemption = $2,660. 

In 1984, the tax on taxable income of $2,660 is $39.60. Sarah must 

file a return and pay this tax. 

Under the proposal (assuming 1984 levels of the zero bracket 

amount and personal exemption), Sarah would not have to file a return,

because her income taxable at her parents' rate ($1,000) is not in 

excess of her personal exemption, and her other income ($860) is not 

- 86 -
in excess of the zero bracket amount. If her parents placed more 

money in her name she would have to file a return. Even then,

however, only one rate would apply to her income, namely that of her 

parents. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

The proposal would help to ensure the integrity of the progressive

tax rate structure, which is designed to impose tax burdens in 

accordance with each taxpayer's ability to pay. Families would be 

taxed at the rate applicable to the total earned and unearned income 

of the parents, including income from property that the parents have 

transferred to the children's names. The current Federal income tax 

incentive for transferring substantial amounts of investment property

to minor children would be eliminated. 

Under the proposal, the unearned income of a minor child under 14 

years of age would be taxed at his or her parents' rate. This is the 

age at which children may work in certain employment under the Fair 

Labor Standards Act. Because most children under 14 have little or no 

earned income, maintenance of segregated accounts and preparation of 

their returns under the proposal should not be complex. 

In most cases the income tax return of a child under 14 years of 

age is prepared by or on behalf of the parent and signed by the parent

as guardian of the child. In such cases, the requirement that a 

child's income be aggregated with that of his or her parents would not 

create a problem of confidentiality with respect to the parents'

return information, since there would be no need to divulge this 

information to the child. Although the return generally would be 

filed by a parent on behalf of a child, liability for the tax would 

rest, as under current law, on the child. 

Only children required to file a return under current law would be 

required to do so under the proposal. In 1981, only 612,000 persons

who filed returns reporting unearned income were claimed as dependents

on another taxpayer's return. This represents less than one percent

of the number of children claimed as dependents in that year.

Moreover, in many instances the proposal would eliminate tax liability

for children who currently must file a return because they cannot use 

the zero bracket amount to offset unearned income that is not 

attributable to property received from their parents. 

- 81 -
REVISE GRANTOR AND NON-GRANTOR TRUST TAXATION 

General Explanation 

Chapter 3.14 

Current Law 

In General 

The manner in which the income from property held in trust is 

taxed depends upon the extent to which the grantor has retained an 

interest in the trust. A so-called "grantor trust," a trust in which 

the grantor has retained a statutorily defined interest, is treated as 

owned by the grantor and the trust's income is taxable directly to the 

grantor. Non-grantor trusts, including "Clifford trusts," on the 

other hand, are treated as separate taxpayers for Federal income tax 

purposes, with trust income subject to a separate graduated rate 

structure. 

The rules for determining whether a trust will be treated as a 

grantor trust are highly complex. In general, however, the test is 

whether the grantor has retained an interest in the trust's assets or 

income or is able to exercise certain administrative powers. For 

example, to the extent that the grantor (or a party whose interests 

are not adverse to the grantor) has the right to vest the trust's 

income or assets in the grantor, the trust will be treated as a 

grantor trust. Similarly, to the extent that the trust's assets or 

income may reasonably be expected to revert to the grantor within ten 

years of the trust's creation, the trust will generally be treated as 

a grantor trust. 

In general, the income of a non-grantor trust is subject to one 

level of tax; it is taxable either to the trust itself or to the 

beneficiaries of the trust. Under this general model, trust income is 

included as gross income of the trust, but distributions of such 

income to trust beneficiaries are deductible by the trust and 

includable in the income of the beneficiaries. 

The maximum distribution deduction permitted to a trust, and the 

maximum amount includable in the income of trust beneficiaries, is the 

trust's distributable net income ("VNI"). A trust's DNI consists of 

its taxable income computed with certain modifications, the most 

significant of which are the subtraction of most capital gains and the 

addition of any tax-exempt income earned by the trust. 

To the extent that a trust distribution carries out DNI to a 

beneficiary, the trust essentially serves as a conduit, with the 

beneficiary taking into account separately his or her share of 

each trust item included in DNI. Under a complex set of rules, the 

computation of each beneficiary's share of an item of trust income 

- 88 -
generally depends upon the amount distributed to the beneficiary and 

the "tier" to which the beneficiary belongs. A distribution that does 

not carry out DNI -- such as one in satisfaction of a gift or bequest

of specific property or a specific sum of money, or one in excess of 

DNI -- is not deductible by the trust and is not includable in the 

recipient's income. Similarly, because capital gains generally are 

excluded from the computation of DNI, a trust ordinarily is subject to 

taxation on the entire amount of its capital gain income even when it 

distributes an amount in excess of its DNI. 

Adoption of Taxable Year 

The trustee of a non-grantor trust may select a year ending on the 

last day of any month as the trust's taxable year. Although a trust 

distribution that carries out DNI is generally deductible by the trust 

in the taxable year during which it is made, the distribution is not 

taxable to the beneficiary until his or her taxable year with which or 

in which the trust's taxable year ends. Thus, for example, if an 

individual is a calendar-year taxpayer and is the beneficiary of a 

trust with a taxable year ending January 31, distributions made by the 

trust with respect to its year ending January 31, 1984, will not be 

subject to tax until the beneficiary's year ending December 31, 1984,

even if they were made as early as February 1983. 

Throwback Rules 

The so-called "throwback rules" are applicable only to trusts that 

accumulate income rather than distribute it currently to the 

beneficiaries. These rules limit the use of a trust as a device to 

accumulate income at a marginal tax rate lower than that of the 

trust's beneficiaries. DNI that is accumulated rather than 

distributed currently becomes undistributed net income ("UNI") and may

be subject to additional tax when distributed to the beneficiaries. 

The rules for determining the amount, if any, of such additional 

tax are complex. In general, however, if a trust's current 

distributions exceed its DNI and the trust has UNI from prior taxable 

years, the excess distributions (to the extent of UNI), increased by

the taxes paid by the trust on such distribution, will be taxed at the 

beneficiary's average marginal tax rate over a specified period

preceding the distribution as reduced by a credit for the tax paid by

the trust on such distribution. 

Reasons for Change 

Taxpayer Fairness 

Present law permits a grantor to shift income to family members 

through creation of a trust, even when the grantor retains significant

control over or a beneficial interest in the trust's assets. For 

example, trust income is not taxed to the grantor even though the 

trust's assets will revert to the grantor as soon as ten years after 

the trust's creation. Similarly, trust income is not taxed to the 

- 89 -
grantor even though the grantor appoints himself OK herself as trustee 

with certain discretionary powers to accumulate income or distribute 

trust assets. Significantly broader discretion over trust income and 

distributions may be vested in an independent trustee, who, although

not formally subject to the grantor's control, may be expected to 

exercise his or her discretion in a manner that minimizes the 

aggregate tax burden of the trust's grantor and beneficiaries. 

During the lifetime of the grantor, there is no persuasive

'justification for taxing a trust under its own graduated rate 

schedule. Permitting a grantor to create trusts and thereby obtain 

the benefit of multiple graduated rate schedules is inconsistent with 

the principle that all income of an individual taxpayer should be 

subject to tax under the same progressive rate structure. A trust is 

simply an arrangement established by the grantor to manage investment 

assets and to allocate the income from those assets to beneficiaries. 

Where the grantor has effectively divested himself of control and 

enjoyment of trust income is irrevocably fixed OK determined, such 

income should be taxed to the beneficial owners of the trust. Where 

this divestment has not taken place, however, the trust's income 

should be included in the grantor's income or taxed at the grantor's

marginal tax rate. 

On the other hand, after the grantor's death it may not be 

unreasonable to respect trusts as separate taxable entities. In such

instances, it is likely that non-tax factors outweigh any Federal 

income tax considerations in the grantor's decision whether to create 

a trust. For example, it is reasonable to assume that a grantor

creating an inter vivos trust with discretion in the trustee over the 

ultimate beneficiary of the property is creating the trust, at least 

in substantial part, to obtain preferential income tax treatment;

ordinarily, the grantor could accomplish most of the non-tax 

objectives for the creation of the trust by retaining the property.

At the least, the tax system should not create a preference for 

utilizing the trust vehicle. In contrast, a trust may be the only

form in which to preserve such discretion and flexibility after the 

grantor's death. Precise rules that would define when post-death

trusts would be granted the benefit of separate graduated rate 

schedules would be complex and would lead to harsh results in many

cases. 

Efficiency and Simplification 

The significant income-splitting advantages that may be gained by

placing income-producing assets in trust have resulted in greater

utilization of the trust device than would be justified by non-tax 

economic considerations. Moreover, even where there are non-tax 

reasons for a trust's creation, tax considerations heavily influence 

the trustee's determination of whether to accumulate or distribute 

trust income. No discernable zocial policy is served by this tax 

incentive for the creation of trusts and the accumulation of income 

within them. Thus, current tax policy has not only sacrificed tax 

- 90 -
revenue with respect to trust income, it also has encouraged

artificial and inefficient arrangements for the ownership and 

management of property. In addition, the fact that the tax benefits 

of the trust form can be increased through the creation of multiple

trusts has resulted in the creation of numerous trusts with 

essentially similar dispositive provisions. 

The tax advantages that current law provides to trusts also have 

spawned a complex array of anti-abuse provisions. The grantor trust 

rules and the throwback rules are highly complex and often arbitrary

in their application. Rules that attribute capital gain of certain 

non-grantor trusts to the grantor are also complex in operation and 

can have unforeseen consequences to trust grantors. 

Proposal 

Taxation of Trusts During Lifetime of Grantor 

1. OverviewDuring the lifetime of the grantor, all trusts created by the 

grantor would be divided into two categories: trusts that are treated 

as owned by the grantor for Federal income tax purposes, because the 

grantor has retained a present interest in or control over the trust 

property; and trusts that are not treated as owned by the grantor,

because the grantor does not have any present interest in or control 

over the property. As under current law, the income of a trust 

clsssified as a grantor-owned trust generally would be taxed directly

to the grantor to the extent that the grantor is treated as the owner. 

A non-grantor-owned trust generally would be respected as a separate

taxable entity. During the grantor's lifetime, however, income would 

be taxed to the trust at the grantor's marginal tax rate, unless the 

trust instrument requires the income to be distributed to or 

irrevocably set aside for specified beneficiaries. \ 

2: Grantor-owned trusts 

The grantor would be treated as the owner of a trust to the extent 

that (i) payments of property or income are required to be made 

currently to the grantor or the grantor's spouse; (ii) payments of 

property or income may be made currently to the grantor or the 

grantor's spouse under a discretionary power held in whole or in part

by either one of them; (iii) the grantor or the grantor's spouse has 

any power to amend or to revoke the trust and cause distributions of 

property to be made to either one of them; (iv) the grantor or the 

grantor's spouse has any power to cause the trustee to lend trust 

income or corpus to either of them; or (v) the grantor or the 

grantor's spouse has borrowed trust income or corpus and has not 

eompktely repaid the loan or any interest thereon before the 

beginning of the taxable year. For purposes of these rules, the fact 

that a power held by the grantor or the grantor's spouse could be 

exercised only with the consent of another person or persons would be 

irrelevant, regardless of whether such person or persons would be 

- 91. -

I 
characterized as "adverse parties" under present law. In addition, a 

United States person who transfers property to a foreign trust having

one or more U.S. beneficiaries would continue to be treated as the 

owner of the portion of the trust attributable to that property to the 

extent required under present law. 

The present law rules under which a person other than the grantor

may be treated as owner of a trust would be retained and made 

consistent with these rules. A grantor or other person who is treated 

as the owner of any portion of a trust under these rules would be 

subject to tax on the income of such portion. Transactions between 

the trust and its owner would be disregarded for Federal income tax 

purposes where appropriate. 

3. Non-grantor-owned trusts 

eneral. A trust that is not treated as owned by the 

grantor (a'or=l?---- y any other person under the rules described above would 

be subject to tax as a separate entity. Unlike present law, however,

non-grantor-owned trusts would be required to adopt the same taxable 

year as the grantor, thereby limiting the use of fiscal years by

trusts to defer the taxation of trust income. 

The trust would compute its taxable income in the same manner as 

an individual, but would not be entitled to a zero bracket amount or a 

personal exemption (or deduction in lieu of a personal exemption).

As under current law, the trust would be entitled to a deduction for 

charitable contributions made within 65 days of the close of the 

trust's taxable year. 

(b) Distribution deduction. The present rules regarding the 

deductibility of distributions made by a trust to non-charitable 

beneficiaries would be substantially changed. First, during the 

lifetime of the grantor, only mandatory distributions would be 

deductible by a trust. A distribution would qualify for this 

deduction only if a fixed or ascertainable amount of trust income or 

property is required to be distributed to a specific beneficiary or 

beneficiaries. As under present law, distributions required to be 

made would be deductible regardless of whether actually made by the 

trustee. 

The amount of a mandatory distribution would be considered fixed 

or ascertainable if expressed in the governing instrument as a portion

or percentage of trust income. The requirement that each 

beneficiary's share be fixed or ascertainable also would be satisfied 

by a requirement that distributions be made on a per capita or per

stirpital basis that does not give any person the right to vary the 

beneficiaries' proportionate interests. Thus, distributions would not 

qualify as mandatory if the governing instrument requires the 

distribution of all income among a class of beneficiaries, but gives

any person the right to vary the proportionate interests of the 

members of the class in trust income. 

- 92 -
A distribution would be considered mandatory if required upon the 

happening of an event not within the control of the grantor, the 

grantor's spouse, or the trustee, such as the marriage of a 

beneficiary or the exercise by an adult beneficiary of an unrestricted 

power of withdrawal. The requirement that the governing instrument 

specify the beneficiary or beneficiaries of a mandatory distribution 

would be satisfied if a class of beneficiaries were specified and 

particular beneficiaries could be added or removed only upon the 

happening of certain events not within the control of the grantor,

grantor's spouse, or trustee, such as the birth or adoption of a 

child, marriage, divorce, or attainment of a certain age. 

Second, unlike present law, property required to be irrevocably

set aside for a beneficiary would be treated as a mandatory

distribution, provided the amount set aside is required to be 

distributed ultimately to the beneficiary or the beneficiary's estate,

or is subject to a power exercisable by the beneficiary the possession

of which will cause the property to be included in the beneficiary's

gross estate for Federal estate tax purposes. Thus, the trustee could 

designate property as irrevocably set aside for a beneficiary and 

obtain a distribution deduction (provided that a distribution or 

set-aside is mandatory under the governing instrument) without making

an actual distribution to the beneficiary. To qualify for the 

set-aside deduction, the beneficiary would have to agree to include 

the amount in income. 

If the tax imposed on a beneficiary by reason of a set-aside 

exceeds the amount actually distributed to the beneficiary in any

year, and if the governing instrument permits the beneficiary to 

obtain a contribution from the trustee equal to the tax liability

imposed by reason of the set-aside (less any amounts p,reviously

distributed to the beneficiary during the taxable year), such 

contribution would be treated as paid out of the amount set aside, and 

therefore would not carry out additional DNI. This structure, unlike 

present law, would permit a fiduciary to obtain the benefit of a 

beneficiary's lower tax bracket through an irrevocable set-aside. 

Accordingly, tax motivations would not override non-tax factors which 

might indicate that an actual distribution is undesirable. 

Third, whether mandatory or not, distributions to non-charitable 

beneficiaries would not be deductible during the lifetime of the 

grantor under the following circumstances indicating incomplete

relinquishment of interest in or dominion and control over the trust: 

(i) If any person has the discretionary power to make 

distributions of corpus or income to the grantor or the 

grantor's spouse; 

(ii) If any portion of the trust may revert to the grantor or 

the grantor's spouse, unless the reversion cannot occur 

prior to the death of the income beneficiary of such 

- 93 -
portion and such beneficiary is younger than the grantor,

or prior to the expiration of a term of years that is 

greater than the life expectancy of the grantor at the 

creation or the funding of the trust; 

If any person has the power exercisable in a non-fiduciary

capacity to control trust investments, to deal with the 

trust for less than full and adequate consideration, or to 

exercise any general administrative powers in a 

non-fiduciary capacity without the consent of a fiduciary; 

If and to the extent that an otherwise deductible mandatory

distribution satisfies a legal obligation of the grantor or 

grantor's spouse, including a legal obligation of support

or maintenance; or 

If trust income or corpus can be used to carry premiums on 

life insurance policies on the life of the grantor or the 

grantor's spouse with respect to which the grantor or the 

grantor's spouse possesses any incident of ownership. 

(c) Computation of tax liability. Once the taxable income of a 

non-qrantor inter vivos trust has been computed under the rules 

desc2ibed above, the trust's tax liability-would be determined. This 

liability would be the excess of (i) the tax liability that would have 

been imposed on the grantor had the trust's taxable income been added 

to the greater of zero or the grantor's taxable income and reported on 

the grantor's return, over (ii) the tax liability that is actualLy

imposed on the grantor. Thus, the trust's tax liability generally

would equal the incremental amount of tax that the grantor would have 

paid had the trust been classified as a grantor trust, with two 

exceptions. First, to avoid the difficulty associated with any

recomputation of a grantor's net operating loss carryover and other 

complexities, if the grantor has incurred a loss in the taxable year

or in a prior taxable year, such loss would be disregarded and the 

grantor would be deemed to have a taxable income of zero for purposes

of computing the trust's tax liability. Second, the addition of the 

trust's taxable income to the taxable income of the grantor would not 

affect the computation of the grantor's taxable income. For example,

trust income would not be attributed to the grantor for purposes of 

determining the grantor's floor on various deductions. 

If the grantor has created more than one non-grantor trust, then 

each such trust would be liable for a proportionate share of the tax 

that would result from adding their aggregate taxable income to the 

greater of zero or the grantor's taxable income. If one or more 

trusts do not cooperate with the grantor and other trusts created by

the grantor in determining their tax liability under these rules, the 

trusts failing to cooperate would be subject to the highest marginal

rate applicable to individuals. Similarly, if the grantor does not 

provide a trustee with information sufficient to enable the trustee to 

compute the trust's tax liability under these rules, the trustee would 

be required to assume (for purposes of computing the trust's tax) that 

- 94 -
the grantor had taxable income placing him or her in the highest

marginal rate. 

(d) Taxation of beneficiaries. As under current law,

distributions to beneficiaries that are deductible by a trust would be 

taxable to the beneficiaries, with the trust's DNI representing the 

maximum amount deductible by the trust and includable in the income of 

the beneficiaries. Capital gain deemed to be distributed would be 

included in the computation of the trust's DNI. Capital gain income 

would be deemed to be distributed if the trust instrument requires

that it be distributed or if and to the extent that mandatory

distributions and set-asides exceed DNI (as computed without regard to 

such gain). Each recipient of a required distribution or set-aside 

would take into account his or her proportionate share of DNI. Thus,

the tier rules of present law would be eliminated. Each item entering

the computation of DNI, including capital gains that are deemed to be 

distributed and hence are included in DNI, would be allocated among

the beneficiaries and the trust, based on the proportionate amounts 

distributed to or set aside for each beneficiary. 

(e) Multiple grantors. For purposes of determining whether the 

grantor is the owner of any portion of a trust, and for purposes of 

determining whether a mandatory distribution is deductible, a trust 

having more than one grantor would be treated as consisting of 

separate trusts with respect to each grantor. If a husband and wife 

are both grantors with respect to a trust, however, they would be 

entitled to elect one of them to be treated as the grantor with 

respect to the entire trust for all Federal income tax purposes, such 

as determining the marginal rate of the trust and the treatment of the 

trust as a lifetime or post-death trust. The election would have to 

be made on the trust's first income tax return. Once made, such an 

election would be irrevocable and would apply to all subsequent

transfers to such trust made during the course of the marriage by

either spouse. 

Taxation of Trusts After Death of Grantor 

For all taxable years beginning after the death of an individual,

all inter vivos and testamentary trusts established by such individual 

would compute their taxable income as in the case of an individual,

but with no zero bracket amount, no personal exemption (or deduction 

in lieu of a personal exemption), and with a distribution deduction 

for all distributions, whether mandatory or discretionary, actually

made to or for non-charitable beneficiaries. As under present law,

distributions made within 65 days of the close of the taxable year

would be treated as made on the last day of the taxable year. A 

similar rule would apply to set-asides. Charitable contributions 

would be deductible as under current Law. All trusts would compute

DNI in the same manner as non-grantor inter vivos trusts. Any taxable 

income of the trust would be subject to tax under a graduated rate 

schedule which is the same as that for married individuals filing

separately. 

- 95 -
In order to prevent the use of such post-death trusts as 

income-splitting devices, the throwback rules of present law would 

continue to apply. Because the present throwback rules often do not 

fully recapture the tax savings from the accumulation of income within 

the trust, consideration would be given to provisions such as the 

imposition of an interest charge on the tax payable with respect to an 

accumulation distribution and the application of the throwback rules 

to income accumulated while the beneficiary is under 21 years of age

and to capital gain income. In addition, consideration would be given

to a more restrictive multiple trust rule to limit the tax benefits of 

the trust form where two or more trusts have any common primary

beneficiaries. 

In order to simplify the transition of inter vivos trusts to the 

post-death rules and to achieve consistent treatment with the 

decedent's estate (see Ch. 3.15), a trust created during the grantor's

lifetime would continue to be treated as an inter vivos trust through

the end of the taxable year in which the grantor's death occurs. 

Thus, for the taxable year in which the grantor's death occurs, income 

of a grantor-owned trust would be taxed to the grantor. Similarly,

during the grantor's final taxable year, a non-grantor-owned inter 

vivos trust would compute its taxable income in the same manner as 

before the death of the grantor. Accordingly, such a trust would be 

entitled to a deduction for qualifying distributions to charity and 

for all mandatory distributions or set-asides with respect to 

non-charitable beneficiaries. The trust's taxable year would not 

terminate with the death of the grantor and the trust would compute

its tax liability for the grantor's final year by reference to the 

taxable income of the grantor. 

Testamentary trusts would compute their income using the same 

taxable year as the decedent and the decedent's estate. A 

testamentary trust created before the end of the taxable year of the 

decedent's death would compute its tax liability for its first (short)

taxable year along with all other trusts created by the decedent, by

reference to the decedent's taxable income for that year. 

Effective Date 

The proposal would apply generally to irrevocable trusts created 

af,ter 1985 and to trusts that are revocable on January 1, 1986, for 

taxable years beginning on or after January 1, 1986. A trust that is 

irrevocable on January 1, 1986, would nevertheless be treated as 

created after 1985 if any amount is transferred to such trust by a 

grantor after such date. Similarly, a trust that is revocable on 

January 1, 1986, and that becomes irrevocable after such date would be 

treated as a new trust for purposes of these rules. 

. For trusts that are irrevocable on January 1, 1986, the proposal

would apply according to the following rules. Trusts that are grantor

trusts under present law would be subject to the new rules beginning

with the first taxable year of the grantor that begins on or after 

January 1, 1986. If a trust that is classified as a grantor trust 

- 96 -
under present law is classified as a non-grantor trust under the new 

rules, however, it would be entitled to elect to be treated as if the 

grantor were the owner for Federal income tax purposes (such election 

to be made jointly by the grantor and the trustee). 

With respect to trusts that are irrevocable on January 1, 1986,

and are not classified as grantor trusts under present law, the 

proposal would apply to taxable years beginning on or after January 1,

1986, with the following exceptions. First, if such a trust has 

already validly elected a fiscal year other than the grantor's taxable 

year on a return filed before January 1, 1986, the trust would be 

entitled to retain that year as its taxable year. In a case where the 

grantor and the trust have different taxable years, the trust would 

compute its tax liability by reference to the grantor's income for the 

grantor's taxable year ending within the taxable year of the trust,

Second, such trusts would be entitled to a distribution deduction for 

all distributions and set-asides, whether discretionary or mandatory,

made during the grantor's lifetime. Finally, such trusts would be 

entitled to elect to continue the tier system of present law for 

allocating DNI among trust beneficiaries. 

Analysis 

The proposal would limit the use of trusts as an income-splitting

device. In this respect, the proposal would reinforce the integrity

of the progressive rate structure and thus enhance the fairness of the 

tax system. 

The proposal would, in general, permit the use of non-grantor

inter vivos trusts to shift income among family members only if 

distributions or set-asides are mandatory and only if the grantor has 

effectively relinquished all rights in the trust property (other than 

the exercise of certain powers as trustee). With respect to such a 

trust, present law would be liberalized in that amounts irrevocably

set aside for a beneficiary would be treated as actually distributed. 

At the same time, wholly discretionary distributions would be 

ineffective to shift income to trust beneficiaries regardless of the 

identity of the trustee. 

The proposal also would result in substantial simplification of 

the rules for taxation of trust income. The tier system and the 

special rule taxing some trust capital gains to the grantor would be 

repealed. The throwback rules would no longer be applicable to any

trust income accumulated during the grantor's lifetime after 1985. 

Similarly, it would not be necessary to apply the multiple trust rules 

until after the year in which the grantor's death occurs. Requiring

virtually all new trusts to use a calendar year would eliminate the 

unwarranted tax advantage often created by the selection of fiscal 

years. The simplicity created by these rules would more than offset 

whatever complexity is created by taxing inter vivos trusts at the 

grantor's marginal rate in certain circumstances. 

- 97 -
The removal of the artificial tax advantages of trusts would cause 

decisions regarding the creation of trusts to be based on non-tax 

considerations. For example, because the income of a ten-year

"Clifford" trust would be taxed at the grantor's marginal rate with no 

distribution deduction, such trusts would be created only where 

warranted by non-tax considerations. Because many inter vivos trusts 

are created solely for tax reasons, fewer such trusts would be 

established under the proposed rules, thus simplifying the financial 

affairs of taxpayers and reducing the number of trust income tax 

returns that have to be filed. At the same time, however, the 

proposal would not impose a tax penalty on the use of a trust to hold 

and to manage a family's assets. As a general rule, during the 

grantor's lifetime, accumulated trust income would be taxed as if the 

grantor had not established the trust. After the grantor's death, a 

more liberal treatment allowing a graduated rate schedule to the trust 

would apply. This treatment reflects the substantial non-tax 

considerations that affect how an individual disposes of his or her 

estate. Moreover, after the death of the grantor, all trusts created 

by the grantor would be taxed in the same manner as the grantor's

estate; as a result, the proposal would not affect an individual's 

decision whether to use a trust to avoid probate. 

- 98 -
REVISE INCOME TAXATION OF ESTATES 

General Explanation 

Chapter 3.15 

Current Law 

Under present law, a decedent's estate is recognized as a separate

taxable entity for Federal income tax purposes. The separate

existence of the estate begins with the death of the decedent, and the 

estate computes its income without regard to the decedent's taxable 

income for the period prior to the decedent's death. Because the 

estate's separate existence begins with the decedent's death, the 

estate is entitled to adopt its own taxable year without regard :o the 

taxable year of the decedent or the taxable year of any beneficiary of 

the estate. Furthermore, any trust created by the decedent's will is 

entitled to select its own taxable year without regard to the taxable 

year selected by the estate. 

An estate generally computes its income in the same manner as an 

individual, with a $600 deduction allowed in lieu of the personal

exemption. The amount of tax on an estate's income generally is 

determined in the same manner as a trust -- with a deduction allowed 

for distributions not in excess of distributable net income ("DNI") -- except that the throwback rules applicable to trusts do not apply to 

estates. Thus, an estate can accumulate taxable income using its 

separate graduated rate structure and distribute the income in a later 

year free of any additional tax liability. 

Under present law, the decedent's final return includes all items 

properly includable by the decedent in income for the period ending

with the date of his death. The tax paid with this return is 

generally deductible as a claim against the estate for Federal estate 

tax purposes. For Federal income tax purposes, all income received or 

accrued after the date of death is taxed to the estate rather than the 

decedent. The decedent's surviving spouse may elect, however, to file 

a joint Federal income tax return for the taxable year in which the 

decedent's death occurs. 

Reasons for Change 

The availability to an estate of a taxable year other than the 

calendar year creates tax avoidance opportunities. By appropriately

timing distributions to beneficiaries of the estate, tax on income 

generated in the estate may be deferred for a full year. This 

deferral potential is exacerbated through the use of different fiscal 

years by testamentary trusts. Estates can also use "trapping

distributions" to allocate estate income among the maximum number of 

taxpayers and thereby minimize the aggregate tax burden imposed on 

estate income. 

- 99 -
The current rules for taxation of income during the taxable year

in which the decedent dies create additional distortions. There is no 

necessary correlation between the timing of items of income and 

deduction and the date of death. Thus, for example, deductible 

expenses incurred prior to the date of death are not matched against

income received after the date of death. This can result in the 

wasting of deductions on the decedent's final return or the stacking

of income in the decedent's estate. 

Proposal 

The rules governing the taxation of estates would be changed so 

that the decedent's final taxable year would continue through the end 

of the taxable year in which his death occurs. Distributions by the 

decedent's personal representative to beneficiaries of the decedent's 

estate would not give rise to a distribution deduction against the 

decedent's income. As under current law, income tax accrued through

the date of the decedent's death would be deductible for Federal 

estate tax purposes. 

The first taxable year of the estate as a separate entity would be 

the first taxable year beginning after the decedent's death. The 

estate would be subject to tax at a separate rate schedule, with no 

zero bracket amount and no personal exemption (or deduction in lieu of 

a personal exemption), but with a deduction for distributions to 

beneficiaries. Although the estate would not be entitled to any

personal exemption, an estate having gross income of less than $600 

would be exempt from Federal income tax liability and would not be 

required to file a return (as under present law). 

An estate would compute its taxable income in the same manner as 

any trust following the death of the grantor. Thus, the estate would 

be entitled to a deduction for distributions that carry out DNI, and 

such distributions would be taxable to the beneficiaries. For this 

purpose, distributions made within 65 days of the close of the taxable 

year would be treated as made on the last day of the taxable year. As 

under present law, distributions that are made in satisfaction of a 

bequest or gift of specific property or a specific sum of money would 

not carry out DNI. 

Effective Date 

The proposal would apply to estates of decedents dying on or after 

January 1, 1986. 

Analysis 

By placing estates on the same taxable year as the decedent, the 

proposal would eliminate the selection of a taxable year for an estate 

that defers the taxation of the estate's income. Continuing the 

- 100 -
decedent's final taxable year through the last day of the year in 

which the decedent's death occurs would simplify the Federal income 

tax returns of most decedents and their estates, and would also 

permit simpler rules for taxing inter vivos trusts created by the 

decedent. See Ch. 3.14. Providing the estate with a separate rate 

structure and a deduction for distributions would continue some 

income-shifting opportunities that exist under present law; however,

placing all trusts created by the decedent on the same calendar year

and applying a strict multiple trust rule would limit the use of 

trapping distributions to shift income from estates to trusts. 

- 101 -
CIIAPTER 4 

REDUCE RECORDKEEPING AND COMPLEXITY 

Simplification is advanced by a number of the Administration 

DroDosals discussed in other chaoters. This chanter is devoted to 

iroposals particularly aimed at ;educing recordkeeping and complexity

for individuals. 

The proposals would repeal the political contribution credit, the 

presidential campaign check-off, and the adoption expense deduction. 

A floor would be imposed on employee business expenses and 

miscellaneous itemized deductions. Income averaging would be repealed

in light of the flatter tax rate schedules and lower marginal tax 

rates under the Administration proposals. Finally, the penalty

provisions would be rationalized and simplified. 

- 103 -
IMPOSE FLOOR ON EMPLOYEE BUSINESS EXPENSE AND OTHER 

MISCELLANEOUS DEDUCTIONS 

General Explanation 

Chapter 4.01 

Current Law 

Four categories of employee business expenses may be deducted by

taxpayers regardless of whether they itemize deductions. These are: 

a expenses paid by the employee and reimbursed by the employer; 

a employee expenses of travel, meals, and lodging while away from 

home ; 

a employee transportation expenses; and 

business expenses of employees who are outside salesmen. 

Various miscellaneous itemized deductions are allowed for 

taxpayers who itemize deductions. These miscellaneous itemized 

deductions comprise all itemized deductions other than medical 

expenses, charitable contributions, interest, taxes, and theft and 

casualty losses. They include: 

employee business expenses other than those described above,

including educational expenses, union and professional dues,

safety equipment, small tools, supplies, uniforms, protective

clothing, professional subscriptions, and employment agency

fees; 

O gambling losses not in excess of gambling winnings; 

a expenses of producing certain income, including fees for 

investment services, safe deposit box rentals, trustee fees,

and tax return preparation and tax advice fees. 

Reasons for Change 

Allowance of the various employee business expense deductions and 

the miscellaneous itemized deductions complicates recordkeeping for 

many taxpayers. Moreover, the small amounts that are typically

involved present significant administrative and enforcement problems

for the Internal Revenue Service. These deductions are also a source 

of numerous taxpayer errors concerning what amounts and what items are 

properly deductible. 

- 104 -
Proposal 

Employee business expenses (other than those reimbursed by the 

employer) and the miscellaneous itemized deductions would be 

consolidated into a single category, together with the deduction for 

State and local taxes (other than income taxes) which are currently

required to be itemized on Schedule A but which are incurred in 

carrying on an income-producing activity. To the extent that these 

items, in the aggregate, exceed one percent of a taxpayer's adjusted

gross income ("AGI"), they would be deductible by the taxpayer,

whether or not he itemizes deductions. The amount allowed as a 

deduction would reduce the taxpayer's adjusted gross income. However,

the one percent floor would be based on AGI as computed without regard

to the deduction. In lieu of a deduction, employer reimbursements 

would be excluded from the employee's income to the extent that the 

employee would have been entitled to a deduction without regard to the 

one percent floor. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

Disallowance of a deduction for a normal level of employee

business expenses and miscellaneous itemized deductions would simplify

recordkeeping, reduce taxpayer errors and ease administrative burdens 

for the Internal Revenue Service while still providing fair treatment 

for taxpayers who incur an unusually high level of such expenses. 

In 1982, one-half of all itemizers claimed miscellaneous 

deductions of less than one-half of one percent of their AGI. 

Fifty-eight percent claimed deductions of less than one percent of 

their AGI, and 93 percent claimed deductions of less than five percent

of their AGI. Thus, introduction of a floor or threshold of one 

percent of AGI would substantially reduce the number of returns 

claiming this deduction. 

- 105 -
REPEAL POLITICAL CONTRIBUTION CREDIT 

General Explanation 

Chapter 4.02 

Current Law 

Individuals are allowed a nonrefundable tax credit for 

contributions to political candidates and political action committees. 

The credit equals one-half of the first $100 ($200 for joint returns)

of an individual’s contributions during the year. 

Reasons For Change 

The tax credit for political campaign contributions is not 

related to the proper measurement of income, but rather is intended to 

encourage individuals to contribute to the cost of the political

process. The efficacy of the political contribution credit in 

producing additional political contributions is open to question. The 

credit produces no marginal incentive for taxpayers who without regard

to the credit would make contributions of $100 or more. The credit 

also creates no incentive for low-income individuals who have no 

income tax liability. 

The political contribution credit presents administrative and 

compliance problems for the Internal Revenue Service. The subject

matter of the credit may involve the Internal Revenue Service in 

sensitive inquiries about political affiliation. Moreover, the small 

dollar amounts involved on each tax return make verification difficult 

and expensive relative to the revenue at stake. There are some 

indications that increasing numbers of taxpayers may be claiming

credits for which no contributions have been made. 

Finally, the political contribution credit creates complexity for 

taxpayers. It adds a line to income tax forms and entails an 

additional recordkeeping burden. 

Proposal 

The credit for political contributions would be repealed. 

Effective Date 

The repeal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

In 1982, the political contribution credit was claimed on about 

5.2 million returns, or about 6.6 percent of all individual returns 

with some tax liability before deducting tax credits. 

- 106 -
As shown in Table 1, the number of users of the credit is skewed 

heavily toward higher-income taxpayers. Only 2.8 percent of all 

returns with income of $10,000 or less (and with some tax liability)

used the credit whereas 38.4 percent of all returns with income of 

$100,000 or more claimed the credit. However, because the credit is 

limited to $50 ($100 on joint returns), tax benefits slightly favor 

those in lower-income brackets. In 1982, the Federal revenue loss 

from the credit was $270 million. The percentage distribution of 

those benefits is shown in the Table 1. 

Table 4.02-1 

Vse of the Political Contributions Tax Credit -- 1982 

I Percentage I I of Returns 1 Distribution 1 Distribution

I Claiming the I of Tax Benefit I of Tax 

AGI Class I Credit 1/ I from Credit I Liability 

$ 0 - 9,999 2.8 % 8.2 % 2.5 % 

10,000 - 19,999 4.5 17.1 12.5 

20,000 - 29,999 6.5 20.9 18.8 

30,000 - 49,999 10.0 29.4 30.8 

50,000 - 99,999 20.8 16.6 18.2 

100,000 or more 38.4 7.8 17.2 

All Returns 6.6 % 100.0 % 100.0 % 

Office of the Secretary of the Treasury May 28, 1985 

-1/ Percentage of all returns with some tax liability before tax 

credits. 

Even if a large portion of the tax reduction attributable to the 

credit is not simply a windfall benefit to taxpayers who would have 

made a contribution anyway, the total subsidy from the credit 

represents only a small portion of total political campaign

expenditures in the United States. 

Repeal of the credit would not cause a significant increase in tax 

liability for any group of taxpayers. 

- 107 -
REPEAL PRESIDENTIAL CAMPAIGN CHECK-OFF 

General Explanation 

Chapter 4.03 

Current Law 

The Presidential election campaign check-off permits each 

individual who has income tax liability to elect to have one dollar of 

that liability used to finance Presidential election campaigns. By

statute, the check-off information must be either on the first page of 

the income tax return or on the page that bears the taxpayer's

signature. 

Reasons For Change 

The Presidential election campaign check-off is unrelated to the 

purposes of the income tax and is a source of complexity for 

taxpayers. The check-off does not directly affect individual tax 

liabilities, but simply allows taxpayers to direct that a small 

portion of their taxes be spent in a particular way. The use of the 

tax return system for this purpose is unique to the campaign

check-off. For the many taxpayers who do not understand its purpose

or effect, the check-off is a source of confusion. In addition, the 

check-off complicates tax forms, significantly in the case of the 

shorter forms, such as the 1040EZ. 

Proposal 

The Presidential election campaign check-off would be repealed. 

Effective Date 

The repeal would be effective for tax liability in taxable years

beginning on or after January 1, 1986. 

Analysis 

Approximately one-fourth of all taxpayers (one-third of those 

taxpayers with some income tax liability) use this provision to 

earmark funds for Presidential campaigns. The percentage of taxpayers

using the provision varies somewhat between election and nonelection 

years. 

Since use of the campaign check-off does not increase any

individual's income tax liability, taxpayers would not be adversely

affected by repeal of this provision. Repeal of the check-off would 

eliminate public funds for Presidential campaigns unless direct 

appropriations were provided. 

- 108 -
REPEAL ADOPTION EXPENSE DEDUCTION 

General Explanation 

Chapter 4.04 

Current Law 

Current law permits a deduction for "qualified adoption expenses"

paid or incurred during the taxable year. In general, qualified

adoption expenses include the reasonable and necessary adoption fees,

court costs, attorney's fees, and other expenses directly related to 

the legal adoption of a "child with special needs" as defined in the 

Social Security Act. 

The maximum amount of qualified adoption expenses that may be 

deducted with respect to a child is $1,500. Moreover, no expense may

be deducted as a qualified adoption expense if a credit or deduction 

is otherwise allowable for such expense or if such expense is paid for 

by a grant from a Federal, State, or local program. 

Reasons for Change 

The allowance of a deduction for certain adoption expenses is an 

inappropriate way of providing Federal support for those who adopt

children with special needs. Federal programs supporting such 

children or the families who adopt them should be under the 

supervision and control of agencies familiar with their needs. Such 

agencies should also have budgetary responsibility for the cost of 

programs serving these purposes. Providing Federal support through

the tax system is inconsistent with each of these objectives. 

Proposal 

The deduction for qualified adoption expenses would be repealed. 

Effective Date 

The proposal would generally be effective for taxable years

beginning on or after January 1, 1987, and would generally apply to 

expenses paid or incurred after such date. Taxpayers having incurred 

quali,fiedadoption expenses with respect to a child before January I,

1986, would be entitled to deduct qualified adoption expenses paid or 

incurred after the effective date with respect to such child. 

Analysis 

It is anticipated that a direct expenditure program would be 

enacted to continue Federal support for families adopting children 

with special needs. The effective date of such program should be 

coordinated with the proposed repeal of the current deduction. 

- 109 -
REPEAL INCOME AVERAGING 

General Explanation 

Chapter 4.05 

Current Law 

Because of the progressive tax rate structure, an individual whose 

income varies widely from year to year pays more tax over a period of 

years than an individual who earns comparable income evenly over the 

same period. The income averaging provisions mitigate this effect. 

Under these provisions, if an eligible individual's income for the 

taxable year exceeds 140 percent of his average income for the three 

preceding years ("base years"), the effective tax rate applicable to 

such excess income ("averagable income") generally will be the rate 

that would apply to one-fourth of the averagable income. The 

individual's tax liability will be an amount equal to the sum of (i)

the tax on 140 percent of the three-year base period income, plus (ii)

four times the extra tax from stacking one-fourth of the averagable

income on top of 140 percent of base period income. 

Two basic eligibility requirements restrict the availability of 

income averaging. First, the individual must have been a citizen or 

resident of the United States during the current year and each of the 

base years. Second, the individual (and the individual's spouse)

generally must have provided at least 50 percent of his or her support

during each of the three base years. This support test need not be 

satisfied if: 

(1) the individual has attained the age of 25 and was not a 

full-time student during at least four years after attaining

the age of 21; 

(2) more than one-half of the individual's taxable income for the 

current year is attributable to work performed during two or 

more of the base years; or 

(3) the individual files a joint return for the current year and 

not more than 25 percent of the aggregate adjusted gross income 

on the joint return is attributable to such individual. 

Reasons for Change 

Income averaging was intended to provide taxpayers whose income 

fluctuates widely from year to year with relief from the effect of the 

progressive rate structure. The changes in the rate structure 

included in the Administration proposal would reduce the need for 

income averaging in two respects. First, with fewer but wider 

brackets, taxpayers would be able to experience greater fluctuations 

-" 110 -
in income without becoming subject to higher progressive rates. 

Second, with the overall reduction in marginal rates, the additional 

tax paid as a result of large income fluctuations would generally be 

less. 

The eligibility requirements and computations relating to income 

averaging are extremely complex. In spite of that complexity, current 

law does not succeed in restricting the benefits of income averaging

to taxpayers with widely fluctuating income. Thus, many of the 

beneficiaries of income averaging are taxpayers who experience sharp,

sustained increases in income, such as young people who complete their 

studies and enter the work force for the first time. The availability

of income averaging for such taxpayers is inconsistent with the 

principles of a progressive tax system. 

Proposal 

The income averaging provisions would be repealed. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

For taxpayers with truly fluctuating income, the need for income 

averaging would be reduced by the proposed rate structure. Repeal of 

the income averaging provisions would simplify the tax code and forms. 

- 111 -
SIMPLIFY PENALTY PROVISIONS 

General Explanation 

Chapter 4.06 

Current Law 

The Internal Revenue Code provides civil penalties for failure to 

file information returns and for failure to furnish statements to 

persons with respect to whom an information return was required to be 

filed. The amount of the penalty is $50 for each statement or return 

that is not filed or furnished. Some of the penalty provisions have a 

$50,000 per year maximum amount. The Code does not provide a penalty

(except a $5 penalty for failure to include a correct taxpayer

identification number) for including incorrect information on 

information returns or statements. 

The Code provides a penalty for failure to pay tax when due of 0.5 

percent of the overdue tax per month, not exceeding 25 percent. 

Reasons for Change 

An effective system of information reporting is essential to 

ensure even-handed enforcement of the tax laws, to broaden the tax 

base by including currently unreported income, and to facilitate a 

shift to a largely return-free system. The present penalty structure,

which is the result of piecemeal additions to the Internal Revenue 

Code, does not provide a clear, consistent set of rules covering

information reporting violations. In addition, maximum penalty

amounts undermine horizontal equity and weaken the information 

gathering system. 

The existing penalty for failure to pay taxes when due is overly

burdensome, and generally falls on taxpayers whose failure to pay is 

not willful. 

Proposal 

The penalties for failure to furnish copies of information returns 

to payees would be eliminated as a separate section of the Internal 

Revenue Code and would be incorporated into the existing provision for 

failure to file information returns. A new penalty provision also 

would be included in the same section for filing an incorrect return 

or statement. The amount of the penalties, generally the same as 

current law, would be as follows: 

(a) failure to file information return: $50 for each return; 

(b) failure to furnish statement to payee: $50 for each 

statement; and 

- 112 -
(c) furnishing incorrect information on a return or statement: $5 

for each incorrect return or statement. 

The current $50,000 maximum on certain information return 

penalties would be eliminated. Failure both to file an information 

return and to furnish a statement to a payee would result in a 

combined penalty of $100. Only one $5 penalty would be imposed for a 

return or statement that included more than one piece of incorrect 

information. 

In addition, the present penalty for failure to pay taxes would be 

eliminated and replaced with a cost of collection charge. Current 

law does not permit the charging of collection fees, which is standard 

practice in the private sector. This proposal would allow the 

Internal Revenue Service to recoup its cost of collecting delinquent

amounts and would encourage taxpayers to pay more promptly. Like 

penalties, this fee would not be deductible by taxpayers. 

Effective Date 

The proposals would apply to returns due on or after January 1,

1986 (determined without regard to extensions). 

Analysis 

The proposed restructuring of the penalty provisions should 

promote simplification in the administration of the provisions and 

provide greater fairness in their application. The proposal would 

integrate certain information reporting penalties into a single

provision which should promote compliance with the tax laws by

enabling taxpayers to understand more easily the consequences of 

noncompliance. 

Under the proposal, the existing heavier penalty for intentional 

disregard of the filing requirements would remain intact and would be 

imposed if the violation is willful rather than merely inadvertent or 

careless. The proposal does not affect existing penalties for 

information returns involving foreign persons or transactions,

employee plans, or exempt organizations. 

The elimination of the $50,000 maximum penalty amount would serve 

the interests of fairness and compliance. Maximum penalty amounts do 

not encourage compliance with the tax laws, nor do they promote

uniformity of treatment. There is no reason, for example, that an 

employer who fails to file 5,000 w-2 reports should receive relatively

more favorable treatment than an employer who fails to file 50 or 500 

such reports. Yet that is the result under current law, which imposes

a statutory maximum on the penalty paid by the larger employer. 

476-698 0 - 85 - 6 
CEAPTER 5 

SIMPLIFY THE SYSTEM OF FILING 

IMPLEMENT RETURN-FREE SYSTEM 

General Explanation 

Chapter 5.01 

Current Law 

Individuals whose income exceeds specified levels are required to 

file income tax returns each year. 

Reasons for Change 

The requirement to file income tax returns imposes a paperwork

burden on taxpayers. This burden should be reduced to the extent 

consistent with sound tax administration. 

Proposal 

As a supplement to other alternatives to the filing of proper

income tax returns that are already under study by the Internal 

Revenue Service, the Internal Revenue Service would be given authority

to implement a return-free tax system. Under; such a system,

individual taxpayers who meet requirements to be specified by the 

Internal Revenue Service would not be required to file income tax 

returns. Instead, the Internal Revenue Service would, at the election 

of each eligible taxpayer, compute the taxpayer's liability, based on 

withholding and information reports provided to the Internal Revenue 

Service currently. The taxpayer would be sent a report, which would 

set forth the taxpayer's tax liability, and the taxpayer would be free 

to challenge the Internal Revenue Service's calculation of tax. 

Analysis 

Institution of the return-free system, together with the increases 

in zero bracket amounts and the personal exemptions, would 

substantially reduce the number of returns that taxpayers need to file 

with the Internal Revenue Service each year. This, in turn, would 

eliminate burdensome recordkeeping required of taxpayers and costs 

incurred by them in preparing returns. If the return-free system were 

to be implemented, it would initially be limited to single wage

earners with uncomplicated financial transactions, roughly 21 million 

taxpayers (17 million of which would otherwise fil,ethe simplified

Form 1040EZ and 4 million of which would otherwise file the Form 1040A 

only because they had more than $400 in interest income). After a 

pilot program and further study, the system could be extended to other 

individual taxpayers and, by the early 1990rs, more than 50 percent of 

- 115 -
all taxpayers could be covered by the return-free system. It is 

estimated that at this level of participation the return-free systern

would save taxpayers annually approximately 71 million hours in actual 

return preparation and $1.6 billion in fees paid to professional tax 

preparers. 

- 116 -
11. BUSINESS AND CAPITAL INCOME TAXES 

CHAPTER 6 

REVISE THE TAXATION OF CORPORATE INCOME 

Equity investment in the corporate sector is discouraged by the 

relatively high effective rate of taxation imposed on the return from 

such investment. Current law imposes double taxation on corporate

income distributed as dividends, mitigated only by the exclusion 

available to individual shareholders for the first $100 of dividend 

income received. The Administration proposes to repeal this exclusion 

and to institute a corporate-level deduction for 10 percent of 

previously taxed corporate earnings paid out as dividends. In 

addition, the Administration proposal would reduce the marginal tax 

burden on corporate income by lowering the top corporate tax rate from 

46 percent to 33 percent. A graduated rate structure for 

corporations would be maintained, in order not to increase the burden 

on small corporations. 

- 117 -
REDUCE CORPORATE INCOME TAX RATES 

General Explanation 

Chapter 6.01 

Current Law 

In general, a tax is imposed on the taxable income of corporations 

at a maximum rate of 46 percent for all such income in excess of 

$100,000. For corporate income under $100,000, tax generally is 

imposed under the following schedule: 

(1) 15 percent on taxable income up to $25,000; 

(2) 18 percent on taxable income between $25,000 and $50,000; 

(3) 30 percent on taxable income between $50,000 and $75,000; and 

(4) 40 percent on taxable income between $75,000 and $100,000. 

The graduated rates are phased out for corporations with taxable 

income over $1,000,000, so that corporations with taxable income of 

$1,405,000 or more pay, in effect, a flat tax at the 46 percent rate. 

Reasons for Chanqe 

The current corporate income tax overtaxes some corporations and 

undertaxes others. Although corporations generally are subject to a 

uniform rate structure, the base of income subject to tax differs 

depending on the extent to which corporations are able to generate

preferred sources of income or deductions. For corporations with 

overstated deductions or losses, or deferred or exempt income, the 

effective rate of tax may be far below the prescribed statutory rate. 

A variety of the existing provisions that narrow the base of 

corporate taxable income are explicitly intended to lower the 

effective tax rate on corporate investment and income. By

establishing preferences for particular forms of investment, however,

such provisions override private decisionmaking and stimulate 

non-economic, tax-motivated activity. In contrast, tax relief 

provided in the form of lower statutory rates creates an incentive for 

investment that is neutral across assets and industries, and allows 

the choice among various investments to be based on economic rather 

than tax considerations. Although the Administration proposals retain 

certain targeted investment incentives, the general thrust of the 

proposals is to reduce the influence of the tax law on private

commercial activity. Thus, the Administration proposals would expand

the base of corporate taxable income in order that statutory rates of 

tax applicable to such income may be substantially reduced. 

- 118 -
Proposal 

Under the proposal, a tax would be imposed on taxable income of a 

corporation at a rate of 33 percent for all such income in excess of 

$75,000. For corporate income under $75,000, tax would be imposed

under the following schedule: 

(1) 15 percent on taxable income up to $25,000; 

(2) 18 percent on taxable income between $25,000 and $50,000; and 

(3) 25 percent on taxable income between $50,000 and $75,000. 

The graduated rates would be phased out for corporations with 

taxable income over $140,000, so that corporations with taxable income 

of $360,000 or more would pay, in effect, a flat tax at the 33 percent 

rate. 

Effective Date 

The proposed corporate tax rates would be effective July 1, 1986. 

Thus, the rate schedule for taxable years including July 1, 1986,

would reflect blended rates based on the new rates effective on such 

date. 

Analysis 

Lowering the maximum corporate tax rate generally would reduce the 

after-tax cost of corporate equity capital and therefore would 

encourage increased corporate equity investment. Reducing the 

after-tax cost of corporate equity relative to debt could also lessen 

upward pressures on interest rates caused by current heavy borrowing

in the corporate sector. 

The proposal retains a modified graduated rate structure for small 

corporations in recognition of the fact that compl.ete elimination of 

the graduated rate structure would dramatically increase effective tax 

rates for many smaller corporations, thus nullifying the positive

effects, for such corporations, of the proposed reduction in the 

maximum marginal rate. 

- 119 -
REDUCE DOUBLE TAXATION OF CORPORATE EARNINGS 

DISTRIBUTED TO SHAREHOLDERS 

General Explanation 

Chapter 6.02 

Current Law 

In general, corporations are treated as taxpaying entities 

separate from their shareholders for Federal income tax purposes.

Thus, a corporation separately reports and is directly taxable on its 

income. Correspondingly, the income of a corporation is not taxable 

to its shareholders until actually distributed to them. An exception 

to these rules is provided on an elective basis under Subchapter S of 

the Code. Taxable income of an S corporation is allocated among and 

taxed directly to its shareholders. This pass-through tax regime is 

limited to corporations meeting certain requirements, including that 

the corporation have only one class of stock and 35 or fewer 

shareholders. 

Dividends paid by corporations other than S corporations are taxed 

to individual shareholders as ordinary income (except for a $100 per 

year exclusion). Corporate shareholders generally are taxed on only

15 percent of dividends received from other corporations, and are not 

subject to tax on dividends received from certain affiliated domestic 

corporations, such as controlled subsidiaries. Corporations are not 

entitled to a deduction for dividends paid to shareholders. Consequently, corporate taxable income paid as dividends to individual 

shareholders generally bears two taxes, the corporate income tax and 

the individual income tax. Corporations are permitted, however, to 

deduct interest paid on corporate indebtedness, even if paid to creditors who also are shareholders. 

Corporate distributions to shareholders generally are taxable 

"dividends" to the extent of (i) the corporation's earnings and profits in the year of distribution plus (ii) earnings and profits accumulated in prior years. In concept, a corporation's earnings and 

profits represent its ability to make distributions to shareholders 

without impairing invested capital. Thus, earnings and profits, in 

general, measure economic income of the corporation available for 

distribution to shareholders. Distributions to shareholders in excess 

of current and accumulated earnings and profits first reduce the 

shareholders' basis in their stock, and, to the extent of the excess, 

are taxed as amounts received in exchange for the stock. 

If a corporation redeems its stock from a shareholder, the distribution from the corporation generally is treated as a payment in 

exchange for the stock and any resulting gain to the shareholder is 

taxed as a capital gain. Similarly, amounts received by a shareholder 

in a distribution in complete liquidation of the corporation are 

- 120 -
treated as payments in exchange for the stock. Such sale or exchange 

treatment also applies to distributions in partial liquidation to 

noncorporate shareholders. 

Reasons for Change 

The disparate tax treatment of debt and equity in the corporate 

sector distorts a variety of decisions concerning a corporation's

capitalization as well as its policies with regard to investment or 

distribution of earnings. Because interest payments are deductible by 

a corporation and dividend distributions are not, corporate earnings

distributed to shareholders are subject to both corporate and shareholder income taxes, while corporate earnings distributed as interest 

are taxable only to the creditor. The effective double taxation of 

dividends encourages corporations to finance their operations with 

debt rather than equity. This reliance on debt capital increases the 

vulnerability of corporations both to the risks of bankruptcy and to 

cyclical changes in the economy. 

The different treatment of interest and dividends under current 

law also places great significance on rules for distinguishing debt 

from equity. Historically, the distinction for tax purposes has 

rested on a series of general factors which have been given different 

weight depending on the circumstances of the taxpayer and on the 

particular court making the determination. This approach has 

increasingly generated uncertainty, especially as more sophisticated

financial instruments have merged the traditional characteristics of 

debt and equity. Although attempts have been made to formulate and 

codify more or less mechanical tests for distinguishing debt from 

equity, no consensus exists concerning the proper criteria for such 

tests. Considerable uncertainty thus remains under current law 

concerning whether instruments will be treated as debt or equity for 

tax purposes. 

The double taxation of earnings distributed as dividends to 

shareholders also affects corporate distribution policy in ways that 

detract from the efficiency of the economy. Corporations with 

shareholders in relatively high tax brackets are encouraged to retain 

earnings, in order to defer shareholder ].eve1 income tax. 

Corporations with shareholders who are tax exempt or in relatively low 

tax brackets are encouraged to distribute earnings, so that the 

shareholders may invest those earnings without bearing future 

corporate-level income tax. These incentives for or against

distribution of earnings interfere with ordinary market incentives to 

place funds in the hands of the most efficient users. 

The double taxation of corporate earnings distributed to shareholders also increases the cost of capital for corporations and 

discourages capital-intensive means of production in the corporate 

sector. Similarly, double taxation discriminates against goods and 

services that are more readily produced or provided by the corporate 

sector as well as activities customarily engaged in by corporations. 

- 121 -
Investors are thus discouraged from using the corporate form, even in 

circumstances where nontax considerations make it desirable. The 

elective provisions of Subchapter S provide only limited relief from 

these effects. 

Proposal 

Deduction for Dividends Paid. The double taxation of corporate

earnings distributed as dividends would be partially relieved under 

the Administration proposal by allowing domestic coiporations, other 

than those subject to special tax regimes (e.g., regulated investment 

companies), a deduction equal to 10 percent of dividends paid to their 

shareholders (''dividends paid deduction"). The amount of dividends 

subject to the dividends paid deduction would be limited, however, to 

ensure that the deduction is allowed only with respect to dividends 

attributable to corporate earnings that have borne the regular corporate income tax. Thus, relief from double taxation of dividends would 

be provided only when the income with respect to which the dividends 

are paid is actually taxed at the corporate level. The dividends paid

deduction, therefore, would not be available with respect to corporate

distributions from so-called tax preference income. 

The limitation on the source of deductible dividends would be provided by requiring every corporation to maintain a Qualified Dividend 

Account. The amount of dividends with respect to which a deduction 

could be claimed in any taxable year would be limited to the Qualified

Dividend Account balance as of the end of the year during which the 

dividends were paid. Dividends paid during a taxable year in excess 

of the Qualified Dividend Account balance as of the end of the year

would not be eligible for the dividends paid deduction. Moreover,

these excess dividends could not be carried forward and deducted with 

respect to amounts added to the Qualified Dividend Account in subsequent years. 

The Qualified Dividend Account would consist of all earnings that 

have borne the regular corporate tax, less any deductible dividends 

paid by the corporation. Thus, the Qualified Dividend Account would 

be increased each year by the amount of the corporation's taxable 

income (computed without regard to the dividends paid deduction).

The corporation's taxable income would be added to the Qualified

Dividend Account even if it was taxed at a rate below 33 percent. The 

amount of taxable income added to the Qualified Dividend Account each 

year, however, would be reduced by the amount of any taxable income 

that, because of any allowable credit, did not actually bear the 

corporate tax. For this purpose, foreign tax credits would be treated 

the same as any other credit. 

The Qualified Dividend Account would be decreased each year by the 

amount of any dividends paid by the corporation with respect to which 

a dividends paid deduction was allowable. Dividends paid during a 

year in excess of the Qualified Dividend Account balance as of the end 

- 122 -
of the year, however, would have no effect. Thus, the Qualified

Dividend Account balance would never be reduced below zero. As 

described below, the Qualified Dividend Account also would be reduced 

to reflect distributions in redemption or in partial or complete

liquidation. Rules would be provided to govern the transferability of 

the Qualified Dividend Account in mergers and acquisitions. 

The dividends paid deduction allowed to corporations would be 

treated similarly to other business deductions. For example, the 

deduction would enter into the determination of a corporation's net 

operating loss and thus could be carried back and forward. Similarly,

the dividends paid deduction would be taken into account for purposes

of computing a corporation's estimated tax liability, and would be 

allocated to income from foreign countries in a manner that would 

relate the deduction to the amount of earnings in the Qualified

Dividend Account from the particular country. 

Distributions in Redemption, Partial Liquidation, and Complete

Liqu'idation, and Other Corporate Distributions. A corporation would 

not be entitled to the dividends paid deduction with respect to 

distributions in redemption of stock, including distributions in 

partial or complete liquidation, that are not taxed as dividends to 

the shareholders. In addition, the Qualified Dividend Account would 

be reduced by a proportionate amount of the redemption or liquidation

proceeds. In the case of a distribution in complete liquidation, the 

liquidating corporation would simply extinguish its Qualified Dividend 

Account balance at the time of the liquidation. In the case of a 

distribution in redemption or partial liquidation, the Qualified

Dividend Account would be reduced using a computation similar to the 

one used under current law to determine the portion of a distribution 

in redemption that is properly chargeable to earnings and profits.

Accordingly, the Qualified Dividend Account generally would be reduced 

in proportion to the amount of the corporation's outstanding stock 

that is redeemed (but not in excess of the amount of proceeds distributed to shareholders). 

Under current law, certain transactions not formally denominated 

as dividends by distributing corporations are treated as dividends for 

tax purposes. These transactions include certain redemptions (section

302(d)), certain stock purchases by corporations related to the issuer 

(sections 302(d) and 3041, certain stock dividends (sections 305(b)

and (c)), certain sales and other distributions of preferred stock 

(section 306), and certain "boot" received in otherwise tax-free 

reorganizations or divisions (sections 356(a)(2), 356(b), and 356(e)).

Corporations making distributions to shareholders in such transactions 

would be permitted to treat the distributions as dividends subject to 

the dividends paid deduction, provided that the corporations treated 

the distributions as dividends for information reporting purposes. In 

the event a distributing corporation did not treat such a distribution 

as a dividend for information reporting purposes and therefore did not 

claim a dividends paid deduction, the Internal Revenue Service would 

have the authority to allow the deduction if the transaction were 

subsequently characterized as a dividend and the corporation and 

shareholder treated the transaction consistently. 

- 123 .-
Intercorporate Investment. The treatment under the proposal of 

dividends paid to corporate shareholders would ensure that the partial

relief from double taxation of corporate earnings would not be 

available until the earnings were distributed outside the corporate

sector. In addition, current law applicable to the receipt of 

dividends by corporate shareholders would be changed under the 

Administration proposal to eliminate the small portion of certain 

dividends (generally 15 percent) that is currently subject to more 

than two levels of tax. 

Under the proposal, a corporation paying dividends would compute

its dividends paid deduction without regard to whether the recipient

shareholders were corporations. A payor corporation, however, would 

be required to report to its corporate shareholders the amount of 

dividends paid to such shareholders with respect to which a deduction 

was allowed to the payor corporation. 

Corporate shareholders would be required to include in their taxable income the portion of dividends for which the payor corporation

received the dividends paid deduction. Accordingly, the dividends 

received deduction would be reduced to 90 percent of any dividends 

with respect to which the payor corporation claimed the dividends paid

deduction. A 100 percent dividends received deduction would be 

allowed, however, with respect to dividends that were not deducted by

the payor corporation. Thus, a corporate shareholder would be 

entitled to a 100 percent dividends received deduction with respect to 

dividends paid in excess of the payor corporation's Qualified Dividend 

Account balance. 

Although a corporate shareholder generally would be taxed on only

10 percent of the dividends it receives, the full amount of such dividends would increase the corporate shareholder's own Qualified

Dividend Account balance. This full increase would ensure that the 

partial relief from double taxation is not diminished simply because 

of the existence of multiple layers of corporate shareholders. 

A foreign corporation would not be eligible for the dividends paid

deduction. However, the dividends received deduction allowable under 

current law with respect to dividends received by a domestic corporate

shareholder from a foreign corporation's earnings subject to United 

States corporate tax would be increased to 100 percent of such dividends received. 

The current law rules that fully tax certain dividends received by 

corporate shareholders would not be changed by the proposal. If,

therefore, a corporate shareholder would not be entitled to a dedution 

under current law with respect to the receipt of a particular

dividend, the dividend would not be subject to the special

intercorporate tules of the proposal. Accordingly, the payor

corporation would be eligible for the 10 percent deduction with 

respect to the dividend paid, the full amount of the dividend would be 

taken into account in computing the corporate shareholder's taxable 

- 124 -
income, no dividends received deduction would be allowed to the 

shareholder, and no special rules would be used to compute the 

shareholder's Qualified Dividend Account. 

The application of these intercorporate rules may be illustrated 

by assuming that a wholly owned subsidiary corporation with a Qualified Dividend Account balance of $1,500 paid a $500 dividend to its 

parent corporation. The entire $500 dividend would be eligible for 

deduction by the subsidiary, which would thus be entitled to a 

dividends paid deduction of $50 and would be required to reduce its 

Qualified Dividend Account by the amount of the dividend to $1,000.

The subsidiary also would be required to inform its parent that it was 

allowed a $50 dividends paid deduction with respect to the $500 dividend. The parent would thus include $500 in its gross income and 

would be entitled to a $450 dividends received deduction. The parent

would thus be taxed on 10 percent of the dividends received from its 

subsidiary. The parent's Qualified Dividend Account, however, would 

be increased by $500 with respect to the dividend received. 

In summary, the subsidiary corporation would be subject to tax on 

$450 with respect to the earnings from which the dividend is treated 

as having been paid. In addition, if the parent corporation made no 

distributions to its shareholders, it would be subject to tax on $50 

of income with respect to the intercorporate dividend. Under current 

law, an equivalent $500 of income would be taxed to the two corporations, although the entire amount would be taxed to the subsidiary.

The proposal thus imposes the full measure of the corporate tax, but 

no more than that, in the case of intercorporate dividends that are 

not distributed outside the corporate sector. 

If, however, the parent paid $500 in dividends to its 

shareholders it would be entitled to a $50 dividends paid deduction. 

Accordingly, the parent would not be subject to any tax with respect

to the earnings attributable to the intercorporate dividend and, while 

its shareholders, assuming they were not corporations, would have been 

fully taxed on the distribution, 10 percent of the double taxation 

would be relieved. Finally, the parent's Qualified Dividend Account 

would be reduced by $500 with respect to the dividends paid to its 

shareholders. 

Treatment of foreign shareholders. A compensatory withholding tax 

would be imposed on dividends paid to foreign shareholders who are not 

entitled to the benefits of a bilateral tax treaty. The compensatory

withholding tax rate would equal the corporate income tax rate times 

the percentage of qualified dividends allowable as a deduction. Thus,

the compensatory withholding tax rate would be 3.3 percent (10 percent

of the maximum corporate income tax rate). Dividends that were not 

eligible for the dividends paid deduction, because they exceeded the 

balance in the corporation's Qualified Dividend Account, would not 

bear the compensatory withholding tax. The compensatory withholding 

tax would be imposed in addition to the basic 30 percent withholding 

tax on dividends paid to foreign shareholders who are not entitled to 

- 125 -
treaty benefits. In addition, subject to the reservations expressed

in the Analysis section of this chapter, the compensatory withholding 

tax would not initially be imposed on dividends paid to foreign

shareholders entitiled to treaty benefits. 

Earnings and Profits. The measurement of the extent to which 

corporate distributions to shareholders constitute dividends would 

continue to be based on the payor corporation's current and 

accumulated earnings and profits. Earnings and profits would continue 

to be a measure of the economic income of the corporation. The 

precise definition of earnings and profits, however, would be modified 

as necessary to reflect other proposed changes. 

Effective Date 

The proposal generally would be effective on January 1, 1987. The 

Qualified Dividend Account would include taxable income only for 

taxable years beginning after December 31, 1986. In addition,

dividends paid after December 31, 1986, in taxable years beginning

before January 1, 1987, would be treated for purposes of the dividends 

paid deduction as having been paid during the first taxable year

beginning after December 31, 1986. 

Analysis 

In General. Although the proposal provides only limited relief 

from the double taxation of corporate earnings distributed as 

dividends, a 10 percent dividends paid deduction represents a 

meaningful first step toward reducing the tax burden on corporate

equity. The proposal would thus somewhat reduce the existing

incentive for corporations to raise capital by issuing debt and would 

make equity securities more competitive with debt. Because dividend 

relief also would reduce the incentive to retain earnings,

corporations would be likely to pay greater dividends and to seek new 

capital, both equity and debt, in the financial markets. Corporations

would thus be subject to greater discipline in deciding whether to 

retain or how to invest their earnings. The increased level of 

corporate distributions would expand the pool of capital available to 

new firms. This should, in turn, enhance productivity and efficiency 

across the economy. 

Effect of Reduction in Tax Rates. Under current law, corporate

earnings paid out as dividends to an individual shareholder in the 

highest tax bracket may be subject to an overall tax rate of 73 

percent (46 percent on the earnings at the corporate level and 50 

percent on the after-tax amount of the dividend at the individual 

shareholder level). Because interest payments are deductible by the 

corporation, earnings paid out as interest to an individual creditor 

are taxed at a maximum rate of only 50 percent. Consequently,

earnings distributed as dividends are relatively overtaxed by 23 

percentage points. Without other changes, lowering the maximum 

- 126 -
corporate rate to 33 percent and the maximum individual rate to 35 

percent would reduce the relative overtaxation only by a small amount,

from 23 points to approximately 21 points. Under the proposal for 

partial dividend relief, the maximum overall tax rate on corporate

earnings distributed as dividends to individual shareholders would 

generally be approximately 54 percent. This rate exceeds the maximum 

rate on corporate earnings paid out as interest by approximately 19 

percentage points. 

Effects on Specific Industries. Industries and firms that 

distribute a large fraction of their earnings as dividends are more 

seriously affected by the current double taxation of dividends. The 

proposal, therefore, may increase the flow of resources to these 

industries. Prime examples of industries that may derive relatively 

greater benefit from the dividends paid deduction are the 

communication industry and public utilities, such as electric, natural 

gas, and sanitary utilities. These industries each distributed nearly

100 percent of their after-tax profits as dividends during the period

from 1980 through 1983. 

Foreign Experience. The United Kingdom, France, West Germany,

Japan, Canada, and other countries have adopted tax regimes that 

partially relieve the double taxation of dividends. Many of these 

countries enacted relief for policy reasons that do not apply equally 

to the United States, and have chosen different systems than the one 

proposed by the Administration. The extent of dividend relief 

provided by these countries ranges from 38 percent to 100 percent.

The Administration proposal for a 10 percent dividends paid deduction 

would provide less relief than these countries. Nevertheless, the 

proposal represents a first step toward reducing the double taxation 

of dividends. 

Treatment of Foreign Shareholders. Most of the countries that 

have adopted some form of relief from the classical system of double 

taxation-of corporate earnings distributed to sharehorders have denied 

part or all of the benefits of that relief to foreign shareholders,

although some countries have granted dividend relief to foreign

shareholders through bilateral tax treaties. The United States has 

been only partially successful in obtaining the benefits of other 

countries' dividend relief provisions for its citizens and residents. 

The most common method of dividend relief that has been adopted by

these countries is the so-called "imputation" system. Under such a 

system, shareholders include in income and are entitled to claim a 

credit for a portion of corporate taxes paid on distributed earnings.

The benefits of such a system usually are denied to foreign shareholders simply by allowing only domestic shareholders to obtain the 

credit for taxes paid by the corporation. 

In contrast to the imputation system adopted in many countries,

the proposal would allow domestic corporations a deduction equal to 

10 percent of certain dividends paid to their shareholders. The benefits of this dividend deduction system could be denied to foreign 

- 127 -
shareholders by imposing a compensatory withholding tax on deductible 

dividends paid to foreign shareholders. The amount of the compensatory withholding tax would exactly offset the deduction allowable to 

the payor corporation. 

Virtually all United States bilateral tax treaties, however, establish a maximum rate at which withholding taxes may be assessed on 

dividends. Those treaty provisions would be directly violated if the 

benefits of the dividends paid deduction were denied to foreign shareholders by imposing a compensatory withholding tax on dividends paid 

to residents of treaty countries. 

Countries using the imputation system have avoided this treaty

difficulty, while denying the benefits of dividend relief to foreign

shareholders, because, as a purely formalistic matter, no increased 

withholding tax is imposed when the ability to obtain the credit is 

limited to domestic shareholders. Accordingly, the denial of the benefit to foreign shareholders technically does not result in a direct 

treaty violation. 

As a matter of economic substance, there is no difference between 

denying foreign shareholders a credit for corporate taxes paid under 

an imputation system of dividend relief and imposing a compensatory

withholding tax on distributions to foreign shareholders under a 

dividends paid deduction system. Because the two schemes are 

economically equivalent, it would be unwarranted to adopt an imputation system, rather than a dividend deduction system, merely to avoid 

technical treaty violations. Moreover, in the context of the United 

States economy and tax system, an imputation approach to dividend relief would be extremely cumbersome. A dividend deduction system,

therefore, has been proposed. 

The United States benefits significantly from its bilateral income 

tax treaties and takes seriously its obligations under those treaties. 

It is therefore reluctant unilaterally to violate the treaties. 

Accordingly, subject to the limitation expressed below, the proposed 

compensatory withholding tax initially would not be imposed generally

with respect to dividends paid to shareholders resident in treaty

countries, and the benefits of dividend relief thus would be extended 

unilaterally to such shareholders. 

This unilateral extension of dividend relief to certain foreign

shareholders is troubling in two respects. The first concern involves 

"treaty shopping," which is the use, through conduit corporations, of 

tax treaties by residents of non-treaty countries. Only a limited 

number of treaties presently lend themselves to abuse in this way, and 

negotiations aimed at resolving this problem with these countries are 

continuing. The incentives to engage in treaty shopping, however, may

be increased under the proposal. Therefore, efforts to eliminate 

treaty shopping would be intensified. If it is not possible to resolve this problem in the very near future, then the United States 

should, at a minimum, refuse to allow the benefits of the dividends 

paid deduction to persons claiming benefits under treaties that lend 

themselves to treaty shopping. 

- 128 -
Second, as already noted, countries with imputation systems generally have not unilaterally extended the benefits of dividend relief 

to United States residents, although several have extended some or all 

of the benefits through treaty negotiations. The United States would 

expect that countries that have not previously done so would extend 

the benefits of their dividend relief rules to United States residents. Treaty negotiations would thus be undertaken with that view. 

Unwillingness of treaty partners to negotiate meaningfully on this 

issue should cause a reversal in the decision unilaterally to extend 

benefits to foreign shareholders in treaty countries. The 

Administration would therefore propose to retain the authority,

through certification by the Secretary of the Treasury, to impose a 

compensatory withholding tax on the residents of those treaty partners

with which it is not possible to resolve issues concerning treaty

shopping or the granting of reciprocal benefits under the foreign

imputation system. 

- 129 -
REPEAL $100/$200 DIVIDEND INCOHE EXCLUSION 

General Explanation 

Chapter 6.03 

Current Law 

Dividend income received by an individual generally is subject to 

Federal income taxation. There is, however, an exclusion from gross

income for the first $100 of dividend income received by an individual 

from domestic corporations. In the case of a husband and wife filing 

a joint return, the first $200 of dividend income is excluded 

regardless of whether the dividend income is received by one or both 

spouses. 

Reasons for Change 

The $100 dividend exclusion narrows the base of income subject to 

tax without creating a proportionate incentive for investment in 

domestic corporations. The exclusion provides no marginal investment 

incentive for individuals with dividend income in excess of $100, and 

only a minor incentive for other individual taxpayers. In addition,

the partial dividends-received exclusion contributes to complexity in 

the tax system by adding an extra line (and two entries) on the 

individual tax Form 1040 and two lines on the Form 1040A. 

Proposal 

The partial exclusion for dividends received by individuals would 

be repealed. 

Effective Date 

The provision would apply to taxable years beginning on or after 

January 1, 1986.. 

Analysis 

Repeal of the dividend exclusion is not likely to have a 

significant effect on aggregate economic behavior. The great majority

(76 percent) of taxpayers who receive dividends claim the full amount 

of the dividend exclusion. For these taxpayers, repeal of the 

exclusion would have no effect on marginal tax rates and thus should 

not affect investment decisions. Even for those taxpayers who do not 

receive sufficient dividends to claim the full amount of the 

exclusion, repeal should not have a significant impact. Although the 

current marginal rate of tax for such persons on additional dividends 

(up to the amount of the exclusion) is zero, the relatively small tax 

savings available from the exclusion (up to $50 for individuals and 

$100 for joint returns, assuming a maximum tax rate of 50 percent) is 

not a substantial investment incentive. 

- 130 -
CHAPTER 7 

REVISE TAXATION OF BUSINESS PROPERTY AND CAPITAL ASSETS 

This Chapter presents the Administration proposals on taxation of 

investment in business property and capital assets. The proposals

would preserve certain investment incentives for businesses and 

individuals, but would provide such incentives in a relatively neutral 

manner in order to limit investment distortions created under current 

law. The proposals would also adjust the tax system for inflation on 

a relatively comprehensive basis. 

The centerpieces of the Administration proposals on capital

formation are the proposed Capital Cost Recovery System, retention of 

favorable tax treatment for capital gains, and the proposal to allow 

businesses to index inventories. These proposals would stimulate 

private sector saving and investment and produce a more efficient 

allocation of capital. These proposals also would facilitate repeal

of provisions such as the investment tax credit and selective rapid

amortization rules that bias investment toward particular assets. 

- 131 -
ADOPT NEW CAPITAL COST RECOVERY SYSTEM (CCRS) 

General Explanation 

Chapter 7.01 

Current Law 

The Accelerated Cost Recovery System ("ACRS")was established by

the Economic Recovery Tax Act of 1981 and generally governs

depreciation allowances for tangible property placed in service after 

1980. ACRS assigns all "recovery property" to a class with a 

specified recovery period and depreciation schedule. In general, 

recovery property is defined to include all depreciable property

placed in service after 1980, except intangible property, property

subject to amortization, and property for which the taxpayer properly

elects a method of depreciation, such as the units of production

method, that is not expressed in terms of years. 

The pre-ACRS depreciation rules remain in effect for property

placed in service by a taxpayer prior to 1981. In general, these 

rules require taxpayers to recover an asset's original cost less 

salvage value over its estimated useful life. Taxpayers can elect 

among several rates of recovery ranging from straight line to methods 

that are substantially accelerated. Certain taxpayers can elect to 

depreciate assets under a system employing prescribed industry-wide

class lives, with additional rules for salvage values, retirement,

repair deductions, and other matters (the ADR system). 

ACRS differs from prior depreciation rules in many important

respects. ACRS recovery periods are not based on the useful economic 

lives of assets, and for most assets are significantly shorter than 

under prior law. ACRS employs accelerated depreciation schedules and 

also allows recovery of full original cost without reduction for 

salvage value. Thus, for most assets, ACRS allows much faster cost 

recovery and greater present value depreciation deductions than were 

obtainable under prior law. 

ACRS classifies all personal property (other than public utility

property) as three-year or five-year property. Automobiles, light

trucks and research and experimentation property are the principal

three-year property items, while most other personal property,

including machinery and equipment, is recovered over five years. Most 

real property is classified as 18-year property, although some real 

property, including real property placed in service prior to March 16,

1984, qualifies as 10-year or 15-year property. Low-income housing is 

classified as 15-year property. Public utility property may be 

five-year, 10-year or 15-year property depending upon the class life 

of such property under prior law. 

- 132 -
Under ACRS, foreign property (property used predominantly outside 

the United States during the taxable year) is generally subject to 

longer recovery periods than comparable domestic property. Generally,

foreign personal property is recovered over the pre-ACRS class life of 

an asset or 12 years and foreign real property is recovered over 35 

years. 

The ACRS depreciation schedules for three-year, five-year and 

ten-year property are based on the 150 percent declining-balance

method switching to the straight-line method. The schedules reflect a 

half-year convention which halves the first year's depreciation rate 

regardless of when during the year the property is placed in service. 

No depreciation deduction is allowed in the year of disposition of 

personal property. 

The depreciation schedule for 18-year real property, except for 

special transition rules, is based on the 175 percent decliningbalapce method switching to the straight-line method. The 

depreciation schedule for 15-year low-income housing is based on the 

200 percent declining balance method switching to the straight-line

method. First-year depreciation rates for 15-year and 18-year real 

property are reduced to reflect the number of months during the first 

year in which property is held in service. Depreciation deductions 

for real property are allowed for the year of disposition, based on 

the number of months during which the property was in service for that 

year. 

Under ACRS, the cost of building components, such as airconditioning and electrical systems, is not recoverable over periods

shorter than the building's recovery period. The recovery period for 

a component generally begins at the later of the time the component or 

the building is placed in service. The cost recovery for the 

component is accounted for separately from the building. Substantial 

improvements to a building are treated as a separate property item 

entitled to a separate recovery period and depreciation rate. 

A lessee who makes capital improvements to leased ACRS property 

may recover the cost of such improvements over the remaining lease 

term, if such term is less than the ACRS recovery period. If the 

lessor and lessee are related parties, however, leasehold improvements 

must be recovered over the ACRS recovery period, even if the remaining

lease term is shorter. 

A taxpayer may elect longer recovery periods than the prescribed 

ACRS recovery period, but in doing so must use the straight-line

nethod for determining the depreciation allowance. A taxpayer may

also elect to use the straight-line method over the ACRS recovery

period. 

Taxpayers may elect to establish mass asset accounts for assets 

where separate identification is impractical. Only assets of the same 

recovery class which are placed in service in the same year may be 

included in a single mass asset account. Gain or loss is not computed 

- 133 -
upon dispositions of items from a mass asset account, and instead all 

proceeds from sales of items from a mass asset account are treated as 

ordinary income. Correspondingly, dispositions do not reduce the 

unadjusted basis of the mass asset account, so that original cost 

basis can be fully recovered over the class recovery period. 

A special exception to ACRS allows taxpayers to expense a small 

amount of property used in a trade or business. For taxable years

beginning before 1988, a taxpayer may elect to expense a maximum of 

$5,000 per year. The limit on expensing increases to $7,500 for 

taxable years beginning in 1988 and 1989 and to $10,000 thereafter. 

No investment tax credit may be taken on expensed property. 

Generally, ACRS depreciation schedules apply to the unadjusted 

cost basis of an asset. However, if an investment tax credit is 

taken, the cost basis of an asset must be reduced by 50 percent of the 

amount of the credit before applying the depreciation rate. Gain or 

loss is generally recognized on the disposition (including retirement)

of ACRS property. Gain or loss is computed with respect to the 

adjusted basis of property which reflects previously taken 

depreciation. 

ACRS deductions are subject to recapture upon an asset's 

disposition. For all personal and most real property, gain recognized 

upon sale is recharacterized as ordinary income to the extent of 

previously allowable depreciation. There is no depreciation recapture 

on property for which a straight-line method has been elected. Only

the excess of ACRS deductions over the straight-line method is 

recaptured on residential rental property, low-income housing and 

property used predominantly outside the United States. 

ACRS does not apply to intangible assets. Amortization allowances 

are available under current law for intangible assets of limited 

useful life that are used in a business or held for the production of 

income. Generally, amortization allowances are computed using a 

straight-line method. Certain income-producing properties, such as 

motion picture and television films, may be amortized under the income 

forecast method which allocates costs proportionately to income 

expected to be produced. 

Reasons for Change 

Disre ard of Economic Depreciation. Depreciation allowances 

shou+ect the economic fact that, on average, the values of 

assets decline over time due to a variety of factors, including

declining productivity, wear and tear, and obsolescence. If 

depreciation allowances understate real economic depreciation of a 

particular asset, income from the investment is overtaxed and a tax 

disincentive is created which impairs capital formation and retards 

the economy's productive capacity. Similarly, if depreciation

allowances exceed real economic depreciation, incentives are created 

for investment in depreciable property. 

- 134 -
The pre-ACRS depreciation system required capital costs to be 

recovered over the useful economic life of particular property.

Generally, useful lives for particular types of property were 

significantly longer than the recovery periods introduced with ACRS. 

The rate of recovery over the useful life was often determined by

election of the taxpayer. The pre-ACRS depreciation system did not 

take account of inflation. Thus, pre-ACRS depreciation deductions for 

many assets understated real economic depreciation and thus resulted 

in overtaxation of the income from such assets. 

The cost recovery system introduced with ACRS addressed the prior

overtaxation of capital investment by providing for more rapid

acceleration of depreciation deductions. However, at low inflation 

rates, ACRS reverses the general overtaxation of capital investment. 

Moreover, ACRS does not differentiate between assets with varying

experienced economic depreciation rates. Thus, under the broadly

defined class of 5-year ACRS property, the same depreciation

allowances are provided for assets with significantly different rates 

of economic depreciation. In addition, ACRS continues to base 

depreciation allowances on historic costs rather than current 

replacement costs; thus, the present value of fixed depreciation

deductions varies with the rate of inflation. At recently experienced

levels of inflation, ACRS, in combination with investment tax credits,

reduces effective tax rates on investment in depreciable assets 

substantially below statutory tax rates. Under certain assumptions,

for certain assets, ACRS, in combination with investment tax credits,

is equal to or more favorable than current expensing, which is 

tantamount to tax exemption of the income from such depreciable 

assets. 

Table 1 displays Treasury Department estimates, based on certain 

stated assumptions, of average effective tax rates for income derived 

from assets in the various ACRS classes. Table 1 demonstrates (1) the 

substantial extent to which ACRS and investment tax credits reduce 

effective tax rates below statutory tax rates, (2) the variance among

ACRS classes in the extent to which ACRS and investment tax credits 

reduce effective tax rates, and (3) the volatility of effective tax 

rates in response to different inflation rates. 

Non-neutrality of ACRS Investment Incentives. The low effective 

tax rates on ACRS property at current rates of inflation urovide 

incentives for investment-in depreciable property. However, these 

incentives are not distributed among depreciable assets in a neutral 

or systematic manner. As Table 1 demonstrates, effective tax rates on 

machinery and equipment are substantially lower than effective tax 

rates on structures for all rates of inflation. This substantial 

variance in effective tax rates is due in part to the application of a 

one-time, up-front investment tax credit for machinery and equipment

and, in part, to the accelerated depreciation schedules for three-year

and five-year ACRS property. A more neutral cost recovery system

would preserve investment incentives while equalizing effective tax 

rates across assets. 

'- 135 -
Table 7.01-1 

Effective Corporate Tax Rates on Income from 

Equity Financed Investments 

with Various Rates of Inflation 

for 46 Percent Taxpayer Under Current Law -1/ 

Asset Class I Inflation Rate (Percent)

(Years) I 0 I 5 I 10 

3 -75 -9 18 

5 -47 -4 16 

10 -6 19 31 

15 8 33 43 

18 27 39 45 

Office of the Secretary of the Treasury May 28, 1985 

-1/ Assumptions: Real return after tax is four 

percent. The investment tax credit selected is the 

maximum allowable for new equipment (six percent on 

three-year equipment and ten percent on five-, 

ten-, and 15-year equipment). Effective tax rates 

are the difference between the real before-tax rate 

of return and the real after-tax rate of return 

divided by the real before-tax rate of return. 

- 136 -
Apart from the operation of the investment tax credit, significant

distortions are inherent in the ACRS classification of machinery and 

equipment. With the limited exceptions of the assets assigned to the 

three-year ACRS class and assets of regulated public utilities, all 

types of machinery and equipment are classified as five-year ACRS 

property and depreciated according to the same schedule. Thus, ships

and heavy machinery used in manufacturing receive the same 

depreciation allowances as computers and trucks. Plainly, these 

disparate assets experience significantly different rates of real. 

economic depreciation. The effect of a uniform depreciation allowance 

is that slower depreciating assets, such as ships and heavy machinery,

receive a substantially greater investment incentive than do faster 

depreciating assets. Thus, ACRS, by the very nature of its 

all-inclusive classification of machinery and equipment in the 

five-year class, distorts investment decisions across assets and 

industries. 

Investment distortions created by ACRS, investment tax credits and 

other capital cost recovery provisions hamper economic efficiency.

The tax code guides the allocation of capital, overriding private

market forces and the individually expressed consumer preferences they

represent. Paradoxically, these distortions do not reflect stated 

government policy to favor particular assets or industries. As a 

result, ACRS operates as an undeclared government industrial policy

which largely escapes public scrutiny and systematic review. 

ACRS also fails to provide a systematic level of investment 

incentives. Since ACRS does not take inflation or real replacement 

costs into account, the benefits of accelerated depreciation diminish 

as inflation increases. The variability of inflation over time 

precludes certainty as to the incentive actually provided for an 

investment in depreciable property. Such uncertainty acts as a 

depressant on economic activity. Increasing the certainty of 

obtaining inflation-proof cost recovery would stimulate risk taking

and lead to more efficient allocation of investment funds. 

Finally, ACRS has fueled the growth of tax shelters. The low or 

negative effective tax rates on ACRS property, especially in the early 

years of acquisition, make possible the sheltering of an investor's 

unrelated income and the accompanying deferral of tax liability. This 

encourages taxpayers to make otherwise uneconomic investments in order 

to obtain tax benefits. Also, the prospect of substantial up-front

deductions encourages excessive leveraging and churning of assets. 

The resulting tax-motivated transactions and divergence from market 

determined patterns of investment impair economic productivity. 

AS tax shelter activity has increased due to ACRS and other 

provisions that mismeasure income, abuses have proliferated, the need 

for anti-abuse rules has grown, and the Internal Revenue Service has 

been required to devote additional resources to policing tax shelter 

investments. Moreover, whether or not abusive, tax shelters invite 

disrespect for the tax laws from those who perceive, correctly or not,

that the laws are unfair and, hence, not worthy of compliance. 

- 137 -
Proposal 

New capital cost recovery rules would be established that preserve

investment incentives while explicitly accounting for inflation and 

different rates of economic depreciation. The new Capital Cost 

Recovery System ("CCRS") would modify ACRS in several important 

respects. First, CCRS would allow cost recovery of the real or 

inflation-adjusted cost of depreciable assets, rather than only the 

original, nominal cost. Second, CCRS would assign property among new 

recovery classes based upon economic depreciation rates. Third, CCRS 

would prescribe depreciation schedules and recovery periods which 

produce systematic investment incentives that are neutral across 

recovery classes. 

Under CCRS, all depreciable tangible assets would be assigned to 

one of six classes, which would replace the present five ACRS recovery

classes. Each CCRS class would be assigned a declining-balance

depreciation rate, ranging from 55 percent to four percent. The 

depreciation rate would be applied to an asset's inflation-adjusted

basis in a manner described below. Applying a fixed declining-balance

depreciation rate of less than 100 percent to the adjusted basis of an 

asset would never fully recover such basis. To ensure that 

depreciation accounts close out in a reasonable number of years, each 

CCRS class would be assigned a recovery period of between four and 28 

years. The recovery period is not an estimate of the economic useful 

life of an asset and hence, is not comparable to recovery periods

under pre-ACRS depreciation rules based on economic useful lives. 

To avoid bunching of the depreciation allowance in the last year

of the recovery period, CCRS depreciation schedules for each class 

would switch from the declining-balance rate to the straight-line

depreciation method in the year in which, assuming a half-year

convention, the straight-line method yields a higher allowance than 

the declining-balance rate. The half-year convention means that, for 

the CCRS class with a four year recovery period, the straight-line

method is applied assuming placement in service on July 1 of the first 

year and retirement 011 July 1 of the fifth year. Since a half-year

convention is assumed for purposes of determining the year in which 

the depreciation schedule switches from the declining-balance rate to 

the straight-line method, depreciation schedules cover one year more 

than the assigned recovery period. 

Under CCRS, the first-year depreciation rate would be prorated

based upon the number of months an asset was placed in service. A 

mid-month convention would be assumed for the month an asset is placed

in service. For example, an asset placed in service by a calendar 

year taxpayer during any part of April would obtain a depreciation 

rate equal to the full first-year rate multiplied by a percentage

equal to (12-3.5)/12. 

- 138 -
Table 2 lists the CCRS depreciation schedules for each of the six 

recovery classes. The schedules for each class prescribe the 

depreciation rate which would be applied to the adjusted basis of an 

asset in each year. Table 2 identifies the year in which the 

depreciation schedule switches from the declining-balance rate to the 

straight-line method. The apparent increase in depreciation rates 

after the switch-over to the straight-line method does not mean that 

CCRS would be a back-loaded depreciation system. Relative to 

inflation-adjusted original cost, the straight-line method produces 

constant depreciation rates. It is only with respect to adjusted

basis that straight-line method depreciation rates increase over time. 

Thus, under the straight-line method, in the close-out year, the 

applicable depreciation rate is always 100 percent and the remaining

adjusted basis of an asset is fully recovered. 

Table 3 converts the CCRS depreciation schedules from Table 2 to a 

different format. Table 3 presents CCRS depreciation rates as a 

percentage of inflation-adjusted original cost for each recovery class 

over the term of its recovery period. Table 3 demonstrates that CCRS 

would not be a back-loaded depreciation system. For each recovery

class, 100 percent of the inflation-adjusted original cost would be 

recovered over the recovery period. For each recovery class, a 

greater proportion of inflation-adjusted original cost would be 

recovered in early years than in later years. The percentages of cost 

recovery in each year that are given in Table 3 reflect assumptions

that property is placed in service on July 1 and that the mid-month 

convention is ignored. If actual depreciation allowances in the first 

year differ from those computed under the assumptions in Table 3, the 

percentage of cost recovery in subsequent years would differ 

accordingly. 

CCRS would adjust depreciation allowances for inflation by means 

of a basis adjustment. under ACRS, only the unadjusted original cost 

basis of an asset is recovered over the class recovery period. IJnder 

CCRS, after adjustment for allowable depreciation in the prior year, 

an asset's unrecovered basis would be adjusted for inflation during

the current year using an appropriate government price index. The 

applicable depreciation rate would be applied to the resulting

adjusted basis. There would be no inflation adjustment in the year in 

which an asset is placed in service; inflation adjustments would begin

with the second year in which the asset is in service. Thus, the 

scheduled depreciation rate in Table 2 would be applied as of the end 

of a taxable year to an asset's basis which had been adjusted first 

for the prior year's depreciation and then for the current year's

inflation. An asset's unrecovered basis would continue to be indexed 

for inflation after the switch-over to the straight-line method. The 

year in which the switch-over occurs would be dependent only on the 

class depreciation rate and recovery period, and not on the inflation 

rate. 

- 139 -
1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

12 

13 

14 

15 

16 

17 

18 

19 

20 

21 

22 

23 

24 

25 

26 

27 

28 

29 

Table 7.01-2 

Capital Cost Recovery System Depreciation Schedule 

(as a Percent of Inflation-Adjusted Basis) I1/ 

I 

Year 1 I 2 I 

Class 

3 I 4 I 5 I 6 

2/ 27.5 

55 

22 

44 

16.5 11 

33 22 

8.5 

17 

2.00 

4.00 

55 44 33 22 17 4.00 

67 44 33 22 17 4.00 

100 67 40 29 17 4.08 

100 67 40 18 4.26 

100 67 22 4.44 

100 29 4.65 

40 4.88 

67 5.13 

100 5.41 

5.71 

6.06 

6.45 

6.90 

7.41 

8.00 

8.70 

9.53 

10.53 

11.76 

13.33 

15.38 

18.18 

22.22 

28.57 

40.00 

66.67 

100.00 

mice of the Secretary of the Treasury May 28, 1985 

-1/ A half-year convention is assumed for purposes of determining the 

year in which the depreciation schedule switches from the 

declining-balance rate to the straight-line method. Consequently,

the depreciation schedules cover one year more than the recovery

period for each class. 

-2/ First-year allowance shown assumes an asset is placed in service 

by a calendar year taxpayer on July 1, without regard to the 

mid-month convention. Actual allowance in first year would vary

depending on when asset is placed in service. 

- 140 -
1 

2 

5 

6 

7 

8 

9 

10 

11 

12 

13 

14 

15 

16 

17 

18 

3 

4 

19 

20 

21 

22 

23 

24 

25 

26 

27 

28 

29 

Table 7.01-3 

Capital. Cost Recovery System Depreciation Schedule 

I 

(as a Percent of Inflation-Adjusted Original Cost) -

1/ 

Year I 2 I 3 

Class 

I 4 I 5 I 6 

27.5 22.0 16.5 11.0 8.5 2.0 

39.9 34.3 27.6 19.6 15.6 3.9 

17.9 19.2 18.5 15.3 12.9 3.8 

8.1 10.8 12.4 12.0 10.7 3.6 

6.6 9.1 10.0 12.0 8.9 3.5 

4.6 10.0 12.0 7.9 3.5 

5.0 12.0 7.9 3.5 

6.0 7.9 3.5 

7.9 3.5 

7.9 3.5 

3.9 3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

3.5 

1.8 

Office of the Secretary of the Treasury May 28, 1985 

-1/ Depreciation allowances are computed assuming an asset is placed

in service by a calendar year taxpayer on July 1, without regard 

to the mid-month convention. 

- 141 -
Although there would be no inflation adjustment to basis for 

purposes of determining depreciation in the year in which an asset is 

placed in service, there would be a full year's inflation adjustment

in the close-out year if property is retained in service to the end of 

the close-out year. Retirement of an asset prior to the end of the 

close-out year would be treated as a disposition, upon which a 

taxpayer would obtain full recovery of an asset's remaining adjusted

basis and recognize gain or loss. For retirements and other taxable 

dispositions, such as sales, there would be a pro-rata inflation 

adjustment to basis in the year of disposition for purposes of 

computing gain or loss. Such pro-rata adjustment would be based on 

the number of full months the asset was held during the year of 

disposition. 

An asset's adjusted basis for depreciation purposes would be used 

for purposes of computing gain or loss upon disposition of a 

depreciable asset. The Administration is proposing to tax all real 

gains on sales or dispositions of depreciable property as ordinary

income. There would be no preferential tax rate applied to long-term

gains on depreciable assets. Losses from sales or dispositions of 

depreciable property would not offset capital gains but would be fully

deductible against ordinary income. See Ch. 7.03. 

Intangible assets would not be subject to CCRS and would be 

amortized generally under current law rules. For example, assets that 

are depreciable under the income forecast method or other method not 

measured in terms of years, such as motion pictures, would continue to 

be depreciable under rules similar to current law. The basis of 

depreciable property not subject to CCRS would be indexed for 

inflation beginning with the second year of amortization. Similarly,

gains from sales or dispositions of amortized property which is 

indexed for inflation would be taxed at ordinary income rates. 

Assets that are eligible for cost depletion, such as timber, oil 

and coal, would not be subject to CCRS. Depletable assets would be 

indexed for inflation, by means of an inflation adjustment to an 

asset's cost depletion basis used for purposes of determining ordinary

income realized upon sale of the asset. 

Foreign property would be recovered under a system of real 

economic depreciation that would not contain the investment incentives 

available to domestic property under CCRS. That is, for foreign 

property, the CCRS depreciation rates and recovery periods would be 

adjusted alonq the lines of the real economic depreciation system

contained in fhe Treasury Department's Report to-the President, Tax 

Reform For Fairness, Simplicity and Economic Growth, published i n 

November 1984. The classification of foreign property would be on the 

same basis as the CCRS recovery classes. Indexing of foreign property

would use the inflation rate of the taxpayer's functional currency. 

- 142 -
Earnings and profits of domestic and foreign corporations would be 

computed on the same basis as depreciation deductions are allowed for 

foreign property. 

The current law provision permitting taxpayers to elect to expense

the aggregate cost of personal property not in excess of $5,000 would 

be retained. The scheduled increases in the ceiling to $lO,OOO would 

be repealed. See Ch. 7.05. Vintaged mass asset accounts would also 

be retained for property qualifying for such treatment under current 

law. CCRS would retain the current law distinction between deductible 

repairs and expenditures that appreciably prolong an asset's useful 

life or materially add to its value, and thus, must be capitalized.

Capitalized costs would generally be added to the adjusted basis of 

the underlying asset or, in some cases, depreciated separately. Each 

CCRS class would be assigned a safe-harbor repair allowance factor. 

The safe-harbor would permit expenses incurred after the asset is 

placed in service to be deducted without challenge, if such expenses 

are allocable to the asset and do not exceed the product of the 

asset's remaining inflation-adjusted basis and the repair allowance 

factor. 

Under CCRS, the cost of leasehold improvements that may be 

deducted by a lessee would be recovered under the general rules 

applicable to such property, regardless of the term of the lease. 

However, in the event leasehold improvements are reasonably expected 

to have no residual value upon expiration of the lease term, special

rules would be provided to permit different depreciation rates to be 

applied to such improvements, taking into account the term of the 

lease (including any renewal options and reasonably expected renewal 

periods). In the case of leasehold improvements depreciated by a 

lessee under the general rules, a lessee would treat the termination 

of a lease as a disposition of the leasehold improvements and would 

compute gain or loss upon the adjusted basis in such improvements. 

The scope of each CCRS class would be defined by reference to 

existing ACRS classes in the following manner. All three-year ACRS 

property would be classified in CCRS Class 1. All 18-year ACRS 

property and low-income housing, which is 15-year ACRS property, would 

be classified in CCRS Class 6. 

ACRS five-year, 10-year, and 15-year public utility property would 

be classified in CCRS Classes 2 through 5. Class 2 would encompass

trucks (other than light purpose trucks which are three-year ACRS 

property), buses, and office, computing and accounting equipment.

Class 3 would cover construction machinery, tractors, aircraft, mining

and oil field machinery, service industry machinery and equipment and 

instruments. Class 5 would include railroad structures, ships and 

boats, engines and turbines, plant and equipment for the generation,

transmission and distribution of electricity, gas and other power, and 

distribution plant for communications services. All other ACRS 

- 143 -
five-year, 10-year and 15-year public utility property would be 

grouped in Class 4. If an item of machinery, equipment or other 

property is not described by the asset-types listed in Classes 2, 3 

and 5, and is not reclassified specifically under the procedure

described below, such item would be assigned to Class 4. 

Table 4 summarizes the classification of ACRS assets among the six 

CCRS classes. 

CCRS would not prescribe a special class exclusively for property

of regulated public utilities. Thus, unregulated companies generating

their own electricity or providing communications services would 

depreciate assets on the same basis as regulated companies. For 

example, computers of regulated utilities would be in Class 2, while 

co-generation electric power plants of unregulated companies would be 

in Class 5. Furthermore, in recognition of the historic practice of 

requiring normalization of investment incentives for regulated public

utilities, CCRS would contain normalization rules for regulated

utilities comparable to those under ACRS. 

The principle underlying CCRS classification of assets among the 

six CCRS recovery classes is that assets should be grouped on the 

basis of equivalent economic depreciation rates. Treasury Department

empirical studies show that a geometric pattern of constant-dollar 

depreciation is generally an appropriate method to apply to all 

classes of business assets, even though the geometric pattern may not 

accurately characterize economic depreciation for all items within a 

class. Each of the six CCRS classes that resulted from the Treasury

Department studies is comprised of a group of asset-types that, on 

average, have approximately the same present value of economic 

depreciation. The six CCRS classes are organized so as to minimize 

the variance in observed economic depreciation rates for assets within 

a class. (For a published account of Treasury Department commissioned 

studies, see "The Measurement of Economic Depreciation," by Charles R. 

Hulten and Frank C. Wykoff in Depreciation, inflation, and-the 

Taxation of Income from Capital (ed. C. Hulten, 1981.) 

- 144 -
Table 7.01-4 

CCRS Asset Classes 

CCRS I Classification I Depreciation 1 Recovery

Class I of ACRS Property 1/ 1 Rate 2/ I Period 3/ 

Class 1 3-year property 55 % 4 

Class 2 Trucks, Buses, and Trailers 44 % 5 

Office, Computing, and 

Accounting Equipment 

Class 3 Construction Machinery, Tractors, 33 % 6 

Aircraft, Mining and Oil Field 

Machinery, Service Industry

Machinery, and Instruments 

Class 4 5-year, 10-year, and 15-year public 22 % 7 

utility property not assigned to 

Class 2, 3, or 5 -- E.g., Metal 

Working Machinery, Furniture and 

Fixtures, General Industrial 

Machinery, Other Electrical 

Equipment, Communications Equipment,

Fabricated Metal Products, and 

Railroad Track and Equipment 

Class 5 Railroad Structures, Ships and Boats, 17 % 10 

Engines and Turbines, Plant and 

Equipment for Generation, Transmission 

and Distribution of Electricity, Gas 

and Other Power, and Distribution Plant 

for Communications Services 

Class 6 18-year property; 15-year low-income 4% 28 

housing 

Office of the Secretary of the Treasury May 28,1985 

-1/ Items of property are assigned to CCRS classes under rules 

described in the text of the General Explanation. 

-2/ The depreciation method switches from a constant declining-balance

rate to the straight-line method in the year of service in which 

the straight-line method produces greater depreciation allowances 

than the declining-balance rate would, assuming a half-year

convention for computation of the straight-line method. 

-3/ The recovery period is the number of years over which cost recovery is computed under the straight-line method. A consequence of 

assuming a half-year convention for purposes of computing depreciation rates under the straight-line method is that depreciation

schedules cover one year more than the recovery periods. 

- 145 -

476-698 0 - 05 - '7 
The CCRS depreciation schedules assigned to each CCRS class in 

Table 2 build in incentives in excess of the economic depreciation 

rates used to classify property. The incentive depreciation schedules 

would reduce the effective tax rates on all CCRS classes. Table 5 

contains the effective tax rates on property in each CCRS class,

calculated on the basis of specified assumptions. 

The proposed CCRS system contemplates that the Treasury Department

would establish permanent facilities to conduct empirical studies of 

economic depreciation. Such studies would gather evidence for all 

types of assets of changing economic depreciation rates due to such 

factors as technological obsolescence, changing market conditions or 

changing utilization rates. In addition, the Treasury Department

would develop data that would enable economic depreciation rates to be 

measured more precisely for specific asset-types within each CCRS 

class. The Treasury Department would review data on economic 

depreciation and would promulgate regulations to reclassify

asset-types upon evidence that economic depreciation for an asset-type

deviates significantly from its class norm. Pending development of an 

institutionalized process for reviewing economic depreciation rates, 

ACRS property would be classified among CCRS classes in the manner 

described above. 

- 146 -
1 

2 

3 

4 

5 

6 

Table 7.01-5 

Effective Tax Rates on Equity Financed Investments 

in Equipment and Structures -1/ 

Class I Paid 2/ I Held 3/ 

16 -4/ 18 

16 18 

17 18 

17 18 

17 18 

23 25 

Office of the Secretary of the Treasury May 28,1985 

Assumes 33 percent statutory tax rate and 4 percent required return after tax and inflation. 

The effective tax rate at the entity level may be 

lower than reported here on leveraged investments, depending on the degree of debt-finance 

and the relation between the interest rate on 

debt and the rate of return on the investment. 

Effective tax rates on different .property within 

a recovery class may vary somewhat depending on 

experienced economic depreciation rates. 

Assumes application of a 10 percent dividend paid

deduction to a corporation which distributes 100 

percent of its earnings derived from depreciable 

assets. 

Assumes no distribution of corporate earnings

derived from depreciable assets. 

The differences between the 16 percent effective 

tax rate for Classes 1 and 2 and the 17 percent

effective tax rate for Classes 3 through 5 are 

due to rounding and are not significant. 

- 147 -
Effective Date 

CCRS would be effective for property placed in service on or after 

January 1, 1986. Anti-churning rules, similar to those enacted as 

part of ACRS, would be provided to prevent a taxpayer from treating 

property owned prior to January 1, 1986, as being subject to CCRS on 

or after such date. An asset acquired in a transaction in which the 

basis of such asset carries over from the transferor to the transferee 

would not be subject to CCRS if placed in service by the transferor 

prior to January 1, 1986. 

Analysis 

Improvements in Capital Cost Recovery System. The proposed CCRS 

depreciation system, in conjunction with repeal of the investment tax 

credit and other capital and business taxation proposals, makes 

possible a substantial lowering of statutory tax rates for individuals 

and corporations. This reduction in statutory tax rates is 

accomplished without sacrificing investment incentives necessary to 

stimulate continued economic growth for the economy as a whole. The 

CCRS depreciation rates and recovery periods produce effective tax 

rates which would stimulate new investment in depreciable assets. The 

indexing of depreciation allowances for inflation and the 

classification of assets on the basis of economic depreciation would 

ensure that the CCRS system provides neutral investment incentives. 

Thus, CCRS, in conjunction with repeal of the investment tax credit,

would correct three principal defects of the capital cost recovery 

system of current law -- the variance in effective tax rates among

different assets and industries; the volatility of effective tax rates 

in response to fluctuating inflation; and the excessive acceleration 

or front-loading of capital cost recovery which make possible negative

effective tax rates exploited by tax shelters. 

CCRS would be less distortive of economic choices among new 

investments in equipment and structures in different industries. 

Since CCRS incentive depreciation rates are derived separately for 

each CCRS class based upon economic depreciation rates, the variance 

of effective tax rates across different industries and assets would be 

minor compared to the unsystematic distortions created under current 

law. Some differences would remain, however, in the effective tax 

rates on income from depreciable and non-depreciable assets. 

CCRS would contribute further to economic neutrality by accounting

for the effects of inflation. For each recovery class, CCRS would 

produce the same real present value of depreciation deductions 

regardless of inflation rates, while ACRS and unindexed straight-line

methods, which recover original cost only, yield real present value 

deductions which decrease as inflation increases. Moreover, for all 

six CCRS classes, at an assumed inflation rate of five percent and an 

- 148 -
assumed real discount rate of four percent, the incentive depreciation 

rates under CCRS produce greater present value depreciation benefits 

than does ACRS without the investment tax credit. At higher assumed 

inflation rates, the CCRS incentives are even greater relative to 

ACRS. The CCRS incentives are provided without the front-loaded 

acceleration of depreciation deductions available under ACRS. 

Investment Incentives. CCRS would provide depreciation rates in 

excess of estimated economic depreciation rates. CCRS recovery

periods would be shorter than the recovery periods under a system of 

real economic depreciation. CCRS depreciation rates and recovery

periods would combine to produce approximately equivalent effective 

tax rates of 18 percent on all types of equipment and machinery,

regardless of the inflation rate. The effective tax rate on 

structures would be higher, although the recovery period would be 

significantly shorter than under a system with real economic 

depreciation rates. Moreover, the disparity under current law in 

effective tax rates for machinery and equipment compared to structures 

would be substantially narrowed tinder CCRS. When the effects of debt 

finance are taken into account, the difference in effective tax rates 

would likely be reduced further. 

For all six CCRS classes, CCRS depreciation allowances would be 

more valuable than accelerated ACRS depreciation allowances (without

regard to the repealed investment tax credit) under most inflation 

conditions. Tables 6 through 11 illustrate the present values of 

depreciation deductions available over the entire life of an asset 

under CCRS, ACRS and unindexed straight-line methods. These tables 

demonstrate both the incentive advantages of CCRS and the protection

afforded from fluctuating and unpredictable inflation. 

Comparisons of CCRS with current law should also consider the 

effects of CCRS in combination with other Administration proposals for 

taxing capital and business income. Table 12 compares the combined 

effective tax rates at the corporate and individual levels on equity

financed investments under different cost recovery systems. Table 13 

similarly compares effective tax rates at the corporate level only

under different cost recovery systems. Tables 12 and 13 demonstrate 

that, under the stated assumptions, CCRS would produce generally lower 

and more uniform effective tax rates than current law or the system of 

real economic depreciation proposed by the Treasury Department report

in 1984. However, the effective tax rate on equipment would be 

increased somewhat relative to current law, resulting in more nearly

equal effective tax rates on different types of capital. 

Neutrality of CCRS Asset Classification. CCRS is designed to 

provide neutral investment incentives while at the same time 

preserving the simplicity of a depreciation system based on relatively

few classes of property, each of which would have a single

depreciation rate to be applied to inflation-adjusted basis. In 

modifying the ACRS class-based system, CCRS does not revert to prior

flawed methods of depreciation which depended upon determining each 

- 149 -
asset's useful life, without regard to the pattern of economic 

depreciation over such life. Rather, CCRS is premised on the theory

that a neutral depreciation system is one which produces the same 

effective tax rate for all depreciable assets. The equivalence of 

effective tax rates can be accomplished by classifying property on the 

basis of economic depreciation. Even though CCRS depreciation rates 

contain incentives in excess of economic depreciation rates,

classification of assets on the basis of economic depreciation permits

the investment incentives to be of approximately equal effect for all 

depreciable assets, regardless of inflation. 

The asset types classified in Table 4 are obviously broad 

categorizations of the myriad of depreciable assets. These asset 

types are much broader than the categorization of assets under the ADR 

depreciation system which preceded ACRS. The six CCRS classes 

however, ate more differentiated and hence, fairer depreciation rates 

than are obtained under ACRS. ACRS has a single depreciation rate for 

assets as diverse as computers and ships. The single ACRS depreciation 

rate applicable to these diverse assets may be simple in application,

but it is neither fair nor conducive of efficient resource allocation. 

The classification of assets under CCRS is not more complex than 

under ACRS. CCRS would be a relatively simple system for taxpayers to 

comply with and for the Internal Revenue Service to administer. 

Recordkeeping would be no more involved than under ACRS. Although

there would undoubtedly be a need for regulations to refine technical 

classification of certain items of property, such regulations would 

not be more complex than existing regulations under ACRS. 

CCRS Class 4 would initially serve as a residual class for 

five-year ACRS property not specifically classified in Classes 2, 3, 

or 5. Further refinement of property classification would be expected 

as the Treasury Department conducts ongoing studies of economic 

depreciation for different assets and industries. These studies would 

take into account not only inflationary changes in replacement costs 

but also dynamic factors, such as technological change, capacity

utilization and changing market conditions, which determine rates of 

economic depreciation. For example, economic depreciation of 

telecommunications equipment and plant may be affected by technical 

change and deregulation of markets. These factors would have to be 

studied in reclassifying such property. 

Reclassification of assets would also take into account the fact 

that certain equipment used to manufacture other depreciable property

might depreciate at nearly the same rate as the end product. For 

example, equipment used to produce computer components might be so 

specialized that it depreciates at the same rate as the computers

produced. Further consideration of actual evidence of rates of 

economic depreciation for types of assets included in the categories

of assets listed in Table 4 would be conducted by an institutionalized 

office of the Treasury Department operating under administrative 

procedures affording the public an opportunity to participate. 

- 150 -
It can be expected that additional items of five-year ACRS 

property which are classified in CCRS Class 4 could be reclassified 

among CCRS Classes 2, 3, or 5. Future studies might also justify

reclassifying assets in CCRS Classes 1 or 6. For example, long-lived

electric power plants initially classified in Class 5 might experience

economic depreciation more nearly equivalent to real property in Class 

6 than to the other types of property in Class 5. The initial 

overinclusiveness of Class 4 would be mitigated by the fact that the 

present value of depreciation deductions for an asset in CCRS Class 4 

would exceed the present value of depreciation deductions for 5-year

ACRS property for all but de minimus rates of inflation. 

Simplification of Other Tax Provisions. CCRS and other proposed

reforms of the capital cost recovery system of current law would 

permit a further simplification of the tax system. Even where 

existing complex rules are retained, their significance to taxpayers

and the Internal Revenue Service would be lessened with a more neutral 

measure of taxable income. For example, recapture rules could be 

simplified considerably under CCRS, since all gain upon sale or 

disposition of depreciable property would be taxed as ordinary income. 

Consideration would be given to simplifying taxpayer accounting by

permitting an election to maintain open accounts for certain classes 

of CCRS property. 

CCRS would apply to mixed-use property which is partially used for 

personal use and partially for business purposes. For taxpayers whose 

portion of business use varies over time, indexing of depreciable

basis may require more complicated recordkeeping than is customary

under current law. 

CCRS should reduce the proliferation of tax shelters based on the 

accelerated capital cost recovery rules of current law. As a 

consequence, the significance of many anti-tax shelter rules would be 

lessened, enabling Internal Revenue Service enforcement resources to 

be committed elsewhere. 

- 151 -
Table 7.01-6 

Depreciation Allowances Under Alternative Depreciation methods 

for a Class 1 Asset I1/ 

(In Current Dollars Per $1,000 Investment) 

1 CCRS Depreciation Rate - 55 Percent I I StraightYear I 0 Percent 15 Percent 1 10 Percent I ACRS I Line I Inflation I Inflation I Inflation I 3 Years I 3 Years 

3 179 198 

Nominal total -2/ 

$1,000 $1,065 $1,135 $1,000 $1,000 

Inflation adjusted total -3/ 

$1,000 $1,000 $1,000 $948 $930 

4/ 

0% inflation $953 NA NA $957 $944 

5% inflation NA 954 NA 908 879 

10% inflation NA NA 955 865 824 

mice of the Secretary of the Treasury May 28, 1985 

Present value _. 

-1/ Depreciation is computed on an asset placed in service by a 

calendar year taxpayer on July 1 of year 1 without regard to the 

mid-month convention. 

-2/ Current dollars. 

-3/ Assumes 5 percent inflation rate. 

-4/ Assumes a 4 percent real rate of return. 

- 152 -
Table 7.01-7 

Depreciation Allowances Under Alternative Depreciation Methods 

for a Class 2 Asset -1/ 

(In Current Dollars Per $1,000 Investment) 

I CCRS Depreciation Rate - 44 Percent I I Straightr

Year I 0 Percent I 5 Percent I 10 Percent I ACRS I Line 

1 Inflation I Inflation I Inflation j 5 Years I 5 Years 

1 $220 $220 $220 $150 $100 

2 343 360 378 220 200 

3 192 212 233 210 200 

4 108 125 143 210 200 

5 91 111 134 210 200 

6 46 58 74 0 100 

Nominal total -2/ 

$1,000 $1,086 $1,181 $1,000 $1,000 

Inflation adjusted total -3/ 

$1,000 $1,000 $1,000 $904 $888 

Present value -4/ 

0% inflation $939 NA NA $922 $908 

5% inflation NA 940 NA 837 810 

10% inflation NA NA 940 766 729 

Office of the Secretary of the Treasury May 287"VRi 

See footnotes for Table 7.01-6 

- 153 -
Table 7.01-8 

Depreciation Allowances Under Alternative Depreciation Nethods 

for a Class 3 Asset -1/ 

(1x1 Current Dollars Per $1,000 Investment) 

I CCRS Depreciation Rate - 33 Percent I I StraightYear I 0 Percent I 5 Percent I 10 Percent I ACRS I Line 

I Inflation I Inflation I Inflation I 5 Years I 5 Years 

1 $165 $165 $165 $150 $100 

2 

3 

4 

5 

6 

7 

Nominal total -2/ 

276 289 303 220 200 

185 204 223 210 200 

124 143 165 210 200 

100 122 147 210 200 

100 128 162 0 100 

50 67 89 0 0 

$1,000 $1,119 $1,254 $1,000 $1,000 

Inflation adjusted total -3/ 

$1,000 $1,000 $1,000 $904 $888 

Present value -4/ 

0% inflation $919 NA NA $922 $908 

5% inflation NA 920 NA 837 810 

10% inflation NA NA 920 766 729 

Office of the Secretary of the Treasury May 28, 1985 

See footnotes for Table 7.01-6 

- 154 -
Table 7.01-9 

Depreciation Allowances Under Alternative Depreciation Methods 

for a Class 4 Asset -1/ 

(In Current Dollars Per $1,000 Investment) 

----TCCRS Depreciation Rate - 22 Percent I -7-S trai ght.-

Year I 0 Percent 15 Percent I 10 Percent I ACRS I Line t -~- I

I Inflation I Inflation I Inflation I 5 Years I 5 Years 

$110 $110 $110 $150 $100 

196 206 215 220 200 

153 168 185 210 200 

120 139 160 210 200 

120 146 176 210 200 

120 154 194 0 1.00 

120 161 213 0 0 

60 85 117 0 0 

Nominal total -2/ 

$1,000 $1,169 $1,371 $1,000 $1,000 

Inflation adjusted total -3/ 

$1,000 $1,000 $1,000 $904 $888 

Present value -4/ 

0% inflation $889 NA NA $922 $908 

5% inflation NA 890 NA 837 810 

10% inflation NA NA 891 766 729 

Office of the Secretary of the Treasury May 28, 1985 

See footnotes for Table 7.01-6 

- 155 -
Table 7.01-10 

Depreciation Allowances Under Alternative Depreciation methods 

for a Class 5 Asset -1/ 

(In current Dollars Per $1,000 Investment) 

/ CCRS Depreciation Rate - 17 Percent / 1 straightYear I 0 Percent I 5 Percent I 10 Percent [ ACRS 1 Line 

I Inflation I Inflation I Inflation I 10 Years I 10 Years 

1 $ 85 $ 85 $ 85 $ 80 $ 50 

2 156 163 171 140 100 

3 129 142 156 120 100 

4 107 124 143 100 100 

5 

6 

7 

8 

9 

10 

11 

Nominal total -2/ 

89 108 130 100 100 

79 101 127 100 100 

79 106 140 90 100 

79 111 154 90 100 

79 117 169 90 100 

79 122 186 90 100 

39 64 102 0 50 

$1,000 $1,244 $1,564 $1,000 $1,000 

Inflation adjusted total -3/ 

$1,000 $1,000 $1,000 $819 $791 

Present value -4/ 

0% inflation $853 NA NA $851 $827 

5% inflation NA 853 NA 707 665 

10% inflation NA NA 853 603 551 

Office of the Secretary of the Treasury May 28, 1985 

See footnotes for Table 7.01-6 

- 156 -
Table 7.01-11 

Depreciation Allowances Under Alternative Depreciation Methods 

for a Class 6 Asset -1/ 

(In Current Dollars Per $1,000 Investment) 

I I CCRS Depreciation Rate - 4 Percent I I Straight---

Year I 0 Percent I 5 Percent I 10 Percent I ACRS I Line 

I Inflation I 

1 $20 

2 39 

3 38 

4 36 

5 35 

6 35 

7 35 

8 35 

9 35 

10 35 

Nominal total -2/ 

$1,000 

Inflation I Inflation I 18 Years I 18 Years 

$ 20 $ 20 $50 $28 

41 43 90 56 

41 46 80 56 

42 48 80 56 

43 52 70 56 

45 57 60 56 

41 63 60 56 

50 69 50 56 

52 76 50 56 

55 83 50 56 

58 92 50 56 

61 101 50 56 

64 111 40 56 

67 122 40 56 

70 134 40 56 

74 148 40 56 

77 163 40 56 

81 179 40 56 

85 197 20 28 

89 216 0 0 

94 238 0 0 

99 262 0 0 

104 288 0 0 

109 317 0 0 

114 349 0 0 

120 383 0 0 

126 422 0 0 

132 464 0 0 

69 255 0 0 

$2,128 $4,997 $1,000 $1,000 

Inflation adjusted total -3/ 

$1,000 $1,000 $1,000 $715 $666 

Present value -4/ 

0% inflation $610 NA NA $760 $723 

5% inflation NA 610 NA 570 502 

10% inflation NA NA 610 454 377 

Office of the Secretary of the Treasury May 28, 1985 

See footnotes for Table 7.01-6 

- 157 -
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- 1,59-
REPEAL INVESTKENT TAX CREDIT 

General Explanation 

Chapter 7.02 

Current Law 

A credit against income tax liability is provided for a taxpayer's

investment in certain depreciable property. Subject to a long list of 

exceptions, the following classes of property qualify for the 

investment credit: (1) tangible personal property (other than air 

conditioning or heating units); (2) certain other tangible property

(not including buildings and their structural components); (3)

elevators and escalators; (4) single purpose agricultural or 

horticultural structures; (5) rehabilitated buildings; (6) certain 

timber property; and (7) storage facilities (not including buildings

and their structural components) used in connection with the 

distribution of petroleum or certain petroleum products. 

In general, the credit is equal to ten percent of qualified

investment in property that is placed in service during the taxable 

year. In the case of ACRS three-year property, the applicable credit 

rate is generally six percent. ~llqualifying costs for new property 

are eligible for the credit; in the case of used property, the 

qualifying costs that may be taken into account are generally limited 

to $125,000 for each taxable year. The investment tax credit is not 

available for property which is expensed. 

The basis of depreciable property for which an investment tax 

credit is taken is reduced by 50 percent of the amount of such credit. 

A taxpayer may elect a two percent reduction in the investment tax 

credit in lieu of a basis reduction. A similar basis reduction is 

required of regulated utilities under normalization rules. If 

property for which an investment tax credit was taken is disposed of 

prior to the end of its recapture period, a portion of the credit 

previously allowed may be recaptured and added to the tax due in the 

year of disposition. 

The amount of tax liability that may be offset by investment tax 

credits in any year may not exceed $25,000 plus 85 percent of the tax 

liability in excess of $25,000. Credits in excess of this limitation 

may be carried back three years and forward 15 years. 

Reasons for Change 

The investment tax credit was originally introduced and has been 

periodically modified to serve two principal purposes -- to prevent

capital consumption allowances based on historical cost from being

eroded by inflation and to stimulate increased levels of investment. 

Under current law, the investment tax credit, in combination with the 

- 160 -
Accelerated Cost Recovery System ("ACRS") provides investment 

incentives that are neither systematically protected from inflation 

nor allocated in a neutral or efficient manner. For example, a ten 

percent investment tax credit without full basis adjustment results in 

a greater reduction in the effective tax rate for assets with faster 

economic depreciation rates. In addition, a ten percent investment 

tax credit reduces effective tax rates more during periods of low 

inflation than in periods of high inflation. 

The investment tax credit is, in addition, excessively

"front-loaded.'' The one-time, up-front credit makes possible the 

sheltering of an investor's unrelated income. Thus, the investment 

tax credit is a standard element of numerous tax shelter offerings

that depend upon up-front deductions and credits for their viability.

To the extent taxpayer energy and resources are consumed in pursuing 

tax rather than economic advantage, the growth and productivity of the 

economy as a whole are weakened. 

The front-loading of the credit also limits its incentive effect 

for start-up, fast-growing or currently unprofitable businesses. 

There are substantial variations in tax rates among firms and 

industries that are caused by differences in their capacity to utilize 

credits currently. Table 1 shows the industry variations in the 

capacity to use the investment credit. 

The capital formation objectives for which the investment credit 

was adopted would be better served under the Administration proposal

for a new Capital Cost Recovery System ("CCRS"). See Ch. 7.01. 

Investment incentives would be built into depreciation allowances in a 

manner that would be inflation-proof, relatively neutral across 

assets, and distributed more evenly over the life of the investment. 

In addition, consolidation of incentives in the depreciation system

would improve public understanding and awareness of the extent to 

which the tax system is being employed to encourage investment. By

providing incentives through the investment credit and through the 

depreciation system, current law may cause taxpayers to believe that 

only the more visible credit is an incentive, and thus that 

depreciation deductions properly measure economic income. 

Finally, although the concept of the investment tax credit is 

straightforward, the applicable statutory provisions are exceedingly

complex. Repeal of the credit would substantially simplify the tax 

system by eliminating these rules. 

Proposal 

The investment tax credit would be repealed. See Ch. 12.01 for a 

discussion of repeal of the investment credit for rehabilitated 

buildings. Normalization rules would be retained for the unamortized 

portion of pre-repeal investment tax credits allowed to regulated

public utilities. 

- 161 -
Table 7.02-1 

Utilization of Investment Tax Credits in 1981 

($ millions) 

I Investment I Percent I 

I I Credit Used I of I I Investment I Against I Earned I Unused 

I Credit I 1981 Tax I Credit I Investment 

Industry I Earned I Liabilities I Allowed I Credit 

All manufacturing

Food manufacturing

Tobacco manufacturing

Textile mill products

Apparel

Lumber and wood 

Furniture and fixtures 

Paper products

Printing and publishing

Chemicals 

Petroleum and refining

Rubber and plastic

Leather products

Stone, clay and glass

Primary metals 

Fabricated metals 

Machinery

Electrical equipment

Motor vehicles 

$11,327 $ 9,116 80 $ 6,720 

1,025 831 81 403 

144 

146 

60 

309 

38 

373 

482 

1,134

2,332

132 

20 

264 

492 

447 

1,166

1,081

865 

125 86 83 

56 93 25 

48 16 392 

30 79 14 

303 81 207 

345 72 218 

872 77 653 

2,295 

111 

98 

84 

209 

120 

19 95 4 

148 56 242 

649 

326 

132 -1/

73 

981 

229 

938 80 420 

631 

739 

58 

85 

1,080

877 

123 29 501 

293 99 24 

81 79 42 

3,047

6,649 

63 

68 

7,939

8,022 

151 105 -1/ 0 

Transportation equipment 418 

Instruments 296 

Other manufacturing 103 

Utilities 4,844

Other sectors 9,831 

Total $26,002 $18,812 72 $ 22,681 

Office of the Secretary of the Treasury May 28, 1985 

-1/ Percentage greater than 100 indicates that credits were carried 

forward and used from previous years. 

- 162 -
Effective Date 

The proposal generally would be effective for property placed in 

service on or after January 1, 1986. 

Analysis 

The Administration CCRS proposal would replace both the investment 

tax credit and the ACRS depreciation system without sacrificing

investment incentives necessary to stimulate continued economic growth

for the economy as a whole. While providing investment incentives,

CCRS would permit a substantial reduction in statutory tax rates for 

both corporations and individuals. Moreover, CCRS would correct three 

principal defects in the investment tax credit and depreciation system

of current law -- the variance in effective tax rates among different 

assets and industries; the volatility of effective tax rates in 

response to fluctuating inflation; and the excessive acceleration or 

front-loading of capital cost recovery which make possible negative

effective tax rates exploited by tax shelters. 

Since repeal of the investment tax credit would eliminate the bias 

in favor of property that is eligible for the credit, investment in 

some such property may diminish. Aggregate business investment,

however, should not be diminished, given the incentive effects of 

lower overall tax rates and the CCRS proposal. 

Repeal of the investment tax credit also would eliminate 

complexity associated with existing rules (1) to distinguish qualified

from non-qualified property, (2) to determine the amount of the 

credit, (3) to adjust basis as a result of the credit, (4) to 

determine the amount of previously allowed credits subject to 

recapture in the event of early disposition of an asset, and (5) to 

carryback and carryforward unused credits. Other rules also would be 

repealed: the at-risk rules for the credit, the rules which deny the 

credit to certain noncorporate lessors, the rules governing

pass-through of the credit, the definition of qualified United States 

production costs and other special rules for films and sound 

recordings, the rules governing property used by certain tax-exempt

entities, the rules pertaining to the treatment of qualified progress

expenditures, the rules denying the credit for foreign use property

(other than property that meets one of eleven exceptions) and for 

certain property used in connection with the furnishing of lodging,

the rules governing the credit for livestock, the rules governing the 

credit for certain boilers, and the rules distinguishing used and new 

property . 

- 163 -
REVISE TAX TREATMENT OF CAPITAL GAINS 

General Explanation 

Chapter 7.03 

Current Law 

Gains or losses from the sale or exchange of capital assets held 

for more than six months (one year for assets acquired before June 23,

1984) are treated as long-term capital gains or losses. Long-term

capital gains receive preferential tax treatment. For individuals and 

other noncorporate taxpayers, 60 percent of net capital gain is 

excluded from income, with the balance of 40 percent taxable at 

ordinary rates. Thus, a taxpayer in the maximum 50 percent tax 

bracket has a marginal tax rate on net capital gain of 20 percent.

For corporations, the regular maximum tax rate of 46 percent is 

reduced to 28 percent on net capital gain if the tax computed using

that rate is lower than the corporation's regular tax. 

A taxpayer determines net capital gain by first netting long-term

capital gain against long-term capital loss and short-term capital

gain against short-term capital loss. The excess of any net long-term

capital gain over any net short-term capital loss equals net capital

gain entitled to the preferential tax rate. 

Capital losses are deductible under different rules for corporate

and noncorporate taxpayers. For corporations, any net short-term or 

long-term capital loss is offset against any net long-term or 

short-term gain. Excess capital losses are not deductible against

other income, but may generally be carried back for three taxable 

years and forward for five taxable years as a short-term capital loss 

in the carryover year. 

Individuals and other noncorporate taxpayers also deduct any net 

short-term or long-term capital loss first against any net long-term 

or short-term gain. In addition, a noncorporate taxpayer with an 

excess net capital loss may generally take up to $3,000 of such loss 

as a deduction against other income. For this purpose, only one-half 

of net long--termcapital loss is usable. Net capital loss in excess 

of the deduction limitations may be carried forward indefinitely,

retaining its character in the carryover year as either a short- or 

long-term loss. Special rules allow individuals to treat losses with 

respect to a limited amount of stock in certain samll business 

corporations as ordinary losses rather than as capital losses. 

A capital asset is defined generally as property held by a 

taxpayer other than (1) inventory, stock in trade, or property held 

primarily for sale to customers in the ordinary course of the 

taxpayer's trade or business, (2) depreciable or real property used in 

- 164 -
the taxpayer's trade or business, (3) rights to literary or artistic 

works held by the creator of such works, or acquired from the creator 

in certain tax-free transactions, (4) accounts and notes receivable,

and (5) certain publications of the government. 

Special rules apply to gains and losses with respect to "section 

1231 property," "section 1256 contracts," and certain rights to a 

patent. Section 1231 property is defined as (1) depreciable or real 

property held for more than six months and used in a taxpayer's trade 

or business, but not includable in inventory or held primarily for 

sale in the ordinary course of a trade or business, (2) property

subject to compulsory or involuntary conversion, and (3) special

property, including certain interests in timber, coal, domestic iron 

ore, certain livestock and certain unharvested crops. Gains and 

losses from all transactions involving section 1231 property are 

netted for each taxable year. Only gains that are not subject to 

recapture as ordinary income are included in the netting. If there is 

a net gain from section 1231 property, all gains and losses from 

section 1231 property are treated as long-term capital gains and 

losses and are combined with the taxpayer's other capital gains and 

losses. If there is a net loss from section 1231 property, all 

transactions in section 1231 property produce ordinary income and 

ordinary loss. However, net gain from section 1231 property is 

converted into ordinary income to the extent net losses from section 

1231 property in the previous 5 years were treated as ordinary losses. 

Depreciation recapture rules recharacterize a portion of gains 

upon dispositions of depreciable property as ordinary income. These 

rules vary with respect to the type of depreciable property. Under 

ACRS, for all personal and non-residential rental real property, all 

previously allowed depreciation, not in excess of total realized gain,

is recaptured as ordinary income. However, if taxpayers elect 

straight-line depreciation over longer recovery periods, there is no 

depreciation recapture upon disposition of the asset. With respect to 

residential rental property, only the excess of ACRS deductions over 

the straight-line method is recaptured as ordinary income. 

Depreciation recapture also is imputed to a partner who sells a 

partnership interest if recapture would have been imposed upon the 

disposition by the partnership of depreciable property. 

Section 1256 contracts are defined to include (1) any regulated

futures contract, (2) any foreign currency contract, (3) any nonequity

option, and (4) any dealer option. Gain or loss with respect to a 

section 1256 contract generally is treated as 60 percent long-term

capital gain or loss and 40 percent short-term capital gain or loss. 

Under certain circumstances, the creator of a patented invention may

transfer his or her rights to the patent and treat amounts received as 

proceeds from the sale of a capital asset, whether or not the proceeds 

are contingent on the use or productivity of the patent. 

Capital gains and losses are generally taken into account when 

"realized" upon sale, exchange, or other disposition of the property.

By contrast, section 1256 contracts generally are marked to market and 

- 165 -
treated as if sold on the last business day of the taxable year in 

which held and accrued gains or losses are realized upon such deemed 

sales. Certain hedging transactions involving section 1256 contracts 

are not marked to market. Certain dispositions of capital assets,

such as transfers by gift, are not generally realization events for 

tax purposes. Thus, usually, in the case of gifts, no gain or loss is 

realized by the donor and, in general, the donor's basis in the 

property carries over into the hands of the donee. In certain 

circumstances, such as the gift of a bond with accrued market discount 

or of property which is subject to indebtedness in excess of the 

donor's basis, the donor may recognize ordinary income upon making a 

gift. Gain or loss also is not realized on transfer at death, even 

though the transferee's basis in the property is stepped-up to fair 

market value at the time of death. 

The amount of a seller's gain or loss is equal to the difference 

between the amount realized by the seller and the seller's adjusted

basis (i.e., the cost or other original basis adjusted for items 

chargeable against basis). Under various nonrecognition provisions,

however, realized gains and losses in certain transactions are 

deferred for tax purposes. Examples of such nonrecognition

transactions include certain like-kind exchanges of property,

involuntary conversions followed by an acquisition of replacement 

property, corporate reorganizations, and the sale of a principal

residence within two years of the acquisition of a new principal

residence. Generally, nonrecognition treatment defers gain or loss 

for tax purposes by providing for a substitution of basis from the old 

property to the new or for a carryover basis from the old holder to 

the new holder. 

Reasons for Change 

Change in Exclusion Rate. The Administration proposals include a 

substantial reduction in marginal tax rates. With the reduction in 

the maximum marginal tax rate from 50 percent to 35 percent, a 

reduction in the exclusion rate applied to net capital gain is 

appropriate. The reduction in the exclusion for capital gains,

however, should substantially preserve the relative tax preference

that is available under current law for investments in capital assets. 

Effects of Inflation. During periods of inflation, nominal gains 

or losses on sales of capital assets will reflect inflationary

increases in the value of property which do not represent real changes

in economic value. Although the preferential tax rate for capital

gains is often explained as compensation for the fact that current law 

does not adjust capital gains for inflation, the preference serves 

this function only in a rough way. Because the preferential tax rate 

does not account systematically for the effects of inflation,

investors currently face substantial uncertainty regarding the 

eventual effective rate of tax on their investments, and may even be 

taxed on investments that produce an economic loss. The availability 

- 166 -
to investors of an election to index the basis of capital assets, in 

lieu of a preferential rate, would reduce uncertainty over effective 

tax rates and ensure that only real gains are subject to tax. 

Treatment of Gain on Depreciable Assets. Gains and losses from 

sal.es or other dispositions of depreciable property - - should be treated 

in the same manner-as other business income or loss and gains or 

losses from sales of other business property (e.g., inventory). The 

current asymmetrical treatment of gains and losses from depreciable

property, i.e., the availability of capital gain treatment for gains

and ordinary loss treatment for losses, is without justification as a 

matter of tax policy and should be discontinued. 

Historically, the availability of capital gain treatment for 

gains from sales of depreciable assets stems from the implementation

of excess profits taxes during World War II. Many depreciable assets,

including manufacturing plants and transportation equipment, had 

appreciated substantially in value when they became subject to 

condemnation or requisition for military use. Congress determined 

that it was unfair to tax the entire appreciation at the high rates 

applicable to wartime profits. Accordingly, gains from wartime 

involuntary conversions were taxed as capital gains. The provision 

was extended to voluntary dispositions of assets since it was not 

practical to distinguish condemnations and involuntary dispositions

from sales forced upon taxpayers by the implicit threat of 

condemnation or wartime shortages and restrictions. These historical 

circumstances offer no continuing justification for the current 

treatment of depreciable assets, given the absence of exceptional

wartime gains and the low, historically unprecedented (in the 

post-World War 11 era) statutory tax rates incorporated in the 

Administration proposals. 

In addition, capital gain treatment for depreciable assets can 

not be justified by the factors that make such treatment appropriate

for investment property qualifying as a capital asset. (See below 

"Analysis - Retention of a Preferential Rate for Capital Gains".)

IJnder current law, the capital gain preference serves in part as a 

rough adjustment for the effects of inflation, since nominal rather 

than economic gains are included in the tax base. The Administration 

proposal for a new Capital Cost Recovery System ("CCRS") would account 

explicitly for inflation with respect to depreciable property,

however, and thus a preferential rate on gain from sales of such 

property is unnecessary as an inflation adjustment. 

The capital gain preference also serves as an incentive for 

saving and investment, and to encourage the flow of capital to new and 

innovative activities that involve high risk yet offer large economic 

and social returns. Incentives for investment in depreciable 

property, however, would be provided through the proposed CCRS 

depreciation allowances. These incentives would be systematically

applied, in order to establish relative neutrality in the taxation of 

income from depreciable assets. The retention of an additional 

incentive in the form of capital gain treatment would create a 

- 167 -
-- 

preference for investment in depreciable property likely to yield

significant gains on sale. Such additional incentive is neither 

necessary nor appropriate. 

Finally, the timing of sales of depreciable business assets is 

more likely to be determined by the condition of the particular asset 

or by routine business cycles of replacement than would be true of 

capital assets held by investors. As a consequence, taxation of gains 

on sales of depreciable assets at ordinary rates is less likely to 

affect taxpayer decisions about sales and reinvestment. Conversely,

taxation of gains on sales of depreciable assets at preferential rates 

would create an unjustified bias toward certain sources of business 

income. 

Treatment of Gain on Special Section 1231 Property. Under 

current law, sains on disDositions of certain interests in timber,

coal, iron ore, livestock-and unharvested crops, are eligible forcapital gain treatment regardless of whether the property is held for 

sale in the ordinary course of the taxpayer's business. This special

treatment violates the distinction, which is inherent in the 

definition of a capital asset, between investment property and 

business property. Business income, whether derived from the sale of 

property used in a trade or business or from the sale of property to 

customers in the ordinary course of business, should be taxed as 

ordinary income. The preferential tax rate on capital gains should 

apply only to investment assets. Gains from dispositions of interests 

in certain natural and agricultural resources should be taxed in 

accordance with these generally applicable rules. 

Proposal 

The exclusion rate for net capital gain of individuals and 

noncorporate taxpayers would be reduced from 60 percent to 50 percent,

producing a maximum tax rate on capital gain under the Administration 

proposals of 17.5 percent. The current law tax rate on net capital

gain of corporations would remain at 28 percent. 

The current law definition of a capital asset would be retained. 

However, gain from the sale or disposition or the compulsory or 

involuntary conversion of depreciable or depletable property used in a 

trade or business would not be treated as gain from the sale or 

exchange of a capital asset. As under current law, recognition of 

involuntary gains could be deferred if proceeds of the conversion were 

reinvested in similar property. Land used in a trade or business 

would continue to receive capital gain and ordinary loss treatment. 

Gain or loss with respect to a section 1256 contract would be treated 

as under current law, so that 60 percent of the gain or loss would be 

treated as long-term capital gain and 40 percent of the gain or loss 

would be treated as short-term capital gain or loss. 

Depreciable property used in a trade or business and property

eligible for cost depletion which does not qualify as a capital asset 

would be indexed under rules applicable to those assets. See 

- 168 -
Ch. 7.01. Property which is held for sale in the ordinary course of 

business or as inventory would be indexed under separate rules. See 

Ch. 1.04. 

Interests in timber, coal, iron ore, livestock and unharvested 

crops which are treated as special section 1231 property under current 

law would be treated in the same manner as other assets. That is,

gains from the dispositions of such interests would be treated as 

capital gains only if such interests satisfy the definition of a 

capital asset in the hands of a particular taxpayer. 

Beginning in 1991, individual taxpayers could elect to index the 

basis of their capital assets for inflation occurring after January 1,

1991. The election would be in lieu of eligibility for the 

preferential tax rate on capital gains. An election would be 

effective for a11 capital assets disposed of in a particular year.

Indexed capital losses would remain subject to current law limitations 

on deductibility. The election would not be available to 

corporations. 

under the indexing election, a capital asset obtained prior to 

January 1, 1991 would be indexed as if acquired on that date for an 

amount equal to the taxpayer's adjusted basis in the asset. Inflation 

adjustments would be based on a Federal government price index. 

Capital assets would be required to be held more than 12 months to be 

eligible for indexing. The proposal to allow elective indexing of 

capital assets after 1991 would not alter the basic realization and 

nonrecognition rules of current law. If capital assets are held by a 

taxpayer who employs a functional currency other than the U.S. dollar,

the measure of inflation generally would be based on the inflation 

rate in the functional currency (as determined by the Internal Revenue 

Service). 

Retention of the preferential tax rate on capital gains, in 

general, would not affect nonrecognition provisions of current law 

requiring realized gains or losses to be deferred. In particular,

homeowners would be permitted, subject to existing rules, to roll over 

gain on the sale of a principal residence, if a new principal

residence is acquired within 2 years of the sale of the prior

principal residence. Moreover, subject to existing rules, homeowners 

who are age 55 or older would exclude permanently the first $125,000

of inflation adjusted gain upon the sale of a principal residence. 

Effective Date 

The proposal to reduce the exclusion rate to 50 percent would be 

effective on July 1, 1986 for all capital assets. The proposal to 

revise the treatment of gains from sales or dispositions of 

depreciable property used in a trade or business would apply to any 

property pl.aced in service by the taxpayer on or after January 1,

1986. The proposal to repeal capital gain treatment for special 

- 169 -
section 1231 property would be phased out over three years, becoming

fully effective January 1, 1989. See Ch. 9.04 for the specific

phase-out rules. 

Analysis 

Retention of a Preferential Rate for Capital Gains. The capital

gain preference serves a variety of purposes that, despite the 

inherent difficulties in a preferential rate, make its retention 

appropriate. Under current law, the capital gain preference 

compensates for the fact that nominal gains, unadjusted for inflation, 

are included in income. The inflation adjustment provided by the 

preference is, of course, imprecise, since it does not vary with the 

experienced rate of inflation OK with the period of time the asset is 

held. On the other hand, the preference is computationally easy and 

is generally familiar and understandable to taxpayers. 

Since the Administration proposals would allow elective inflation 

indexing for capital assets beginning in 1991, retention of a capital

gain preference, in the long run, must rest on grounds other than its 

function as an indirect inflation adjustment. The most significant of 

these other grounds concerns the incentive effect of the preference.

There is broad concern that elimination of the capital gain preference

would adversely affect saving and investment, and thus impair the 

capital formation necessary to continued economic growth. MOreOVeK, 

many argue that, because of risk or other factors, investment needed 

to generate new and innovative technology would not be pursued at 

optimal levels absent a favorable rate of taxation. Although it might

be possible to address these concerns through a preference limited to 

particular activities or forms of investment, the complexity entailed 

in defining and enforcing those limits would substantially offset the 

simplification benefits of a change from current law. 

Preferential treatment of capital gain may also be justified

because of the longstanding treatment of unrealized gains. Capital

gains are not subject to tax until the underlying asset is sold, and 

thus, capital gains from assets held for any significant period of 

time are accorded preferential treatment without regard to a 

preferential rate. Moreover, the deferral advantage for unrealized 

gains grows to one of total exemption if the underlying asset is held 

until death. Because the taxation of gain is deferred until 

realization, taxpayers are encouraged to retain appreciated capital

investments in circumstances where alternative investments offer a 

greater economic return. The significance of this so-called "lock-in 

effect" is a function of the rate at which realized gains are taxed. 

By reducing the rate of tax on realized gains, the preference limits 

the lock-in effect, and thus may improve the allocation of capital

within the economy. By encouraging realization of accrued gains, it 

may also offset the revenue loss attributable to a preferential rate. 

- 170 -
Finally, the preferential rate for capital gain serves to offset 

the impact of the progressive rate structure on gains that are accrued 

over a period of time but realized in a single year. In this respect, 

a capital gain preference operates as an implicit, though very rough,

averaging device. 

The purposes served by the capital gain preference are listed 

with full recognition of the difficulties the preference has created 

under current law. The capital gain preference has generated

significant complexity, reflected in the substantial body of statutory

and case law concerned solely with identifying income entitled to the 

preference. Just as clearly, preferential treatment of capital gains

stimulates artificial behavior, by encouraging taxpayers to structure 

their affairs so as to bring particular transactions or sources of 

income within the scope of the preference. Whether these costs 

outweigh the purposes served by the preference is one of the recurring

themes of tax policy debate. The conclusion reached in the 

Administration proposals is that, on balance, the preference should be 

retained. 

Effect on Saving and Investment. The proposal to retain a 

preferential tax rate on capital gain, in combination with the 

proposed substantial reduction in-tax rates, should have a stimulative 

effect on saving, investment and capital formation. 

The effect on investment of the proposal to treat all gain from 

the sale of depreciable property as ordinary income should be examined 

in light of the CCRS proposal for depreciable assets. The basis of a 

depreciable asset would be indexed for both depreciation purposes and 

for purposes of computation of gain. Thus, the inflationary component

of gain on a depreciable asset would not be subject to tax under the 

Administration proposals. Moreover, indexing of depreciable assets 

would produce more accurate measurement of real losses. In addition,

the incentives built into the depreciation allowances would be applied

in a neutral manner to all depreciable assets. Consequently, the 

treatment of gain on disposition of these assets as ordinary income 

should not impede overall capital formation or the efficient 

allocation of capital. 

Effect on risk-taking. The effect of capital gains taxation on 

private risk-taking in the economy is of critical importance. The 

venture capital and associated high-technology industries seem 

particularly sensitive to changes in effective tax rates. 

Shareholders in such ventures that are highly successful would not 

face higher effective tax rates under the Administration proposal.

Also, the increase in savings stimulated by reductions in individual 

marginal rates and expansion of IRAs, as well as the elimination of 

many industry-specific tax preferences and the enactment of measures 

to reduce the advantages of investment in unproductive tax shelters,

should increase the supply of capital available to high-risk ventures 

and high-technology industries. In addition, all investors would 

continue to benefit from the deferral of tax on accrued but unrealized 

gains. 

- 171 -
Retention of Realization Principle. The proposal would retain 

the longstanding realization principle of current law, under which 

gains and losses generally are not taxed until realized by sale,

exchange or other disposition. As discussed above, the realization 

requirement and the lock-in effect it produces impair capital resource 

allocation to the extent taxpayers are deterred from reallocating

investments by the tax costs of realizing accrued appreciation.

Repeal of the realization requirement on any broad basis, however,

would meet strong taxpayer resistance and could involve significant

administrative and economic costs. Requiring recognition of gain on 

an annual or other current basis would necessitate a system for 

valuing unsold assets, which could be burdensomely complex for 

taxpayers as well as for the Internal Revenue Service. Moreover, a 

current realization requirement could in certain situations force 

taxpayers to liquidate investments in order to satisfy accrued tax 

liabilities. 

The proposal retains the mark-to-market accounting concept

currently applicable to section 1256 contracts. The primary advantage

of the mark-to-market concept in this limited context is that it 

negates the need to identify offsetting positions for purposes of the 

loss deferral rules applicable to straddles. Straddle transactions 

utilizing section 1256 contracts would provide numerous opportunities

for abuse for taxpayers with large volumes of trades in such contracts 

absent retention of mark-to-market accounting for these assets. 

Scope of Loss Limitation Rules. In general, the proposal would 

retain the capital loss limitation rules of current law for assets 

held for investment and not for use in a trade or business. Such 

limitations are appropriately applied to investors who may selectively

realize gains and losses on investment assets. Were capital losses 

deductible without limit, taxpayers would dispose of capital assets 

selectively to produce a net loss with which to shelter noninvestment 

income. 

Simplification of Recapture Provisions. Depreciation recapture

has been necessary under ACRS and prior depreciation rules to prevent

excessive depreciation deductions from being converted into capital

gain. Indexing depreciation allowances and treating gains from 

dispositions of depreciable property as ordinary income obviates the 

need for the complicated depreciation recapture provisions of current 

law. Although a taxpayer would receive an investment incentive from 

depreciation allowances in excess of economic depreciation, taxing all 

gain from depreciable property as ordinary income would permit repeal

of many of the recapture provisions for depreciable property acquired

after January 1, 1986. Existing recapture rules would remain in 

effect for depreciable property placed in service prior to January 1,

1986. / 

The recapture rules of current law also serve to limit 

nonrecognition rules applying to gains realized in certain 

transactions (e.g., gains realized on corporate liquidations or 

- 172 -
pre-liquidation sales and gains realized on sades under the 

installment method). In general, such nonrecognition rules would be 

limited in a similar fashion under the Administration proposals.

Consideration would be given to applying such limits on a parallel

basis for realized gains with respect to personal and real property. 

Treatment of Sp-. Denial of special

capital gain treatment for timber, coal, iron ore, livestock and 

unharvested crops would result in a consistent limitation of the 

capital gain preference to investment property qualifying as a capital

asset. Thus, if special section 1231 property were used in a trade or 

business, it would be subject to cost recovery rules and ordinary

income treatment applicable to trade or business property. See Ch. 

7.01. If special section 1231 property were held for sale to 

customers or as inventory, it would be subject to rules applicable to 

all inventory property. See Ch. 7.04. If special section 1231 

property were held as a capital asset, it would be eligible for the 

capital gain preference. 

In addition, consideration would be given to treating land held 

for use in a trade or business as ordinary income property. If so 

treated, land used in a trade or business would be eligible for 

inflation indexing on the same basis as depletable property. 

Collateral Issues. Denial of capital gain treatment to 

depreciable assets would expand the scope of current law rules 

treating gain recognized on sale or disposition of a partnership

interest as ordinary income to the extent attributable to the selling

partner's interest in certain assets of the partnership that would 

produce ordinary income if sold by the partnership. Consideration 

would be given to extending similar rules to dispositions of interests 

in S corporations and stock in subsidiaries which are included in an 

affiliated group filing a consolidated return. 

Finally, consideration would be given to treating gain realized 

upon the disposition of rights to a patent as ordinary income to the 

extent that the creator of the patented invention or a holder of 

rights to the patent claimed deductions from ordinary income for the 

costs of developing the invention. 

- 173 -
INDEX INVENTORIES 

General Explanation 

Chapter 7.04 

Current Law 

In general, current law requires the use of inventory accounting

methods where necessary to determine clearly a taxpayer's income. 

Treasury regulations implementing this rule generally require

inventories to be maintained where the production, purchase or sale of 

merchandise is an income-producing factor. A taxpayer that keeps

inventories for tax purposes must use the accrual method of accounting

with respect to purchases and sales of inventory items. 

Inventory accounting assists in accurately measuring income from 

the sale of goods: this measurement, in turn, depends on the value for 

tax accounting purposes of the goods on hand at the close of the 

taxable year. The cost of goods sold during the year is generally

equal to the dollar value of beginning inventory, plus purchases and 

other inventoriable costs incurred during the year, minus the dollar 

value of ending inventory. Thus, for example, a taxpayer with 

beginning inventory of $100, purchases and other inventoriable costs 

of $500, and ending inventory of $150, has a cost of goods sold for 

the year of $450 ($100 plus $500 minus $150 = $450). The measurement 

of income from the sale of goods changes with any change in the 

valuation of ending inventory. Thus, if ending inventory, in the 

preceding example, had a higher value, the cost of goods sold would 

have been lower, and gross income from sales would have been 

correspondingly higher. Conversely, a lower figure for ending

inventory would have increased the cost of goods sold and reduced 

gross income. 

Under Treasury regulations, inventories generally are valued at 

cost, although in certain cases the lower of cost or market value is 

permitted. In order to determine the cost of ending inventory, a 

taxpayer may identify each specific item of inventory and ascertain 

its actual cost or value. In most cases, however, this "specific

identification" method is impractical because of the number and 

fungible nature of the goods on hand. The Internal Revenue Code and 

regulations therefore permit alternative methods which employ

simplifying assumptions regarding the flow of goods from inventory. 

The first-in, first-out (FIFO) method assumes that the first goods

purchased or produced are the first goods sold. Under FIFO the most 

recently purchased or produced goods are deemed on hand at year-end,

and ending inventories are thus valued at the most recent purchase or 

production costs. The last in, first-out (LIFO) method assumes that 

the last goods purchased or produced are the first goods sold. Since 

LIFO accounting values ending inventory at the oldest purchase or 

- 174 -
production costs, in periods of increasing purchase or production 

costs its use results in a higher cost of goods sold and lower taxable 

income than FIFO. 

Since 1939, taxpayers who use the LIFO method for tax purposes

have been required to use LIFO in preparing annual financial 

statements for credit purposes and for reports to stockholders, 

partners, proprietors OK beneficiaries (the "LIFO conformity

requirement"). 

Reasons for Change 

Taxes should be imposed on real economic income, not on increases 

that are attributable to inflation. Cutrent inventory accounting

methods used for tax purposes depart from this principle by failing to 

reflect inflation in a consistent manner. 

Because the LXFO method treats the most recently acquired goods as 

the first goods sold, LIFO accounting reflects income from inventory

sales more accurately during periods of inflation than does FIFO. 

Notwithstanding the advantages of LIFO accounting in an inflationary 

economy, many businesses continue to use the FIFO method. Although 

many small firms are reluctant to use LIFO accounting because of the 

perceived complexity, some businesses are simply unwilling to use LIFO 

for financial accounting purposes -- as required by the LIFO 

conformity requirement. The disincentive for LIFO accounting that is 

created by the conformity requirement is inappropriate in a tax system

designed to neutralize the effects of inflation. 

Although LIFO measures the effects of inflation better than FIFO,

it does not fully account for these effects. LIFO takes account only

of price changes in the inventoried goods, which may or may not 

correspond to the effects of inflation on prices generally. Moreover,

since LIFO represents only a flow of goods assumption rather than an 

adjustment of inventory costs in line with inflation, it results in 

only the deferral rather than the elimination of inflationary gains.

When a firm that uses the LIFO method either liquidates or reduces 

inventories, it is taxed on previously deferred inflationary gains.

This factor distorts business decisions concerning inventory levels 

and creates an incentive for transactions, such as a merger or 

reorganization, which permit continued deferral of the inflationary

gain. 

Proposal 

Taxpayers would be permitted the option of using an Indexed FIFO 

method in addition to the current LIFO and FIFO methods of accounting.

Under the Indexed FIFO method, inventories would be indexed using

inflation adjustment factors based on a Federal government price

index. Indexing would be based on relatively simple computational 

- 175 -
methods, such as applying the percentage increase in the price index 

(such as the Consumer Price Index) to the FIFO cost of the number of 

units in beginning inventory which does not exceed the number of units 

in ending inventory. Indexing would also be permitted for inventory 

assets for which the specific identification method is used, as well 

as for property held primarily for sale in the ordinary course of 

business that may not constitute inventory (e.g., certain real estate 

held for sale by a dealer in such property). 

Indexing would be allowed only with respect to inflation occurring

after the effective date of the proposal. The requirement under 

current law that the Internal Revenue Service consent to changes in 

accounting methods would be waived for taxpayers changing to LIFO or 

to Indexed FIFO accounting methods during an appropriate transition 

period. In addition, the LIFO conformity requirement would be 

repealed. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1987. 

Analysis 

About two-thirds of inventories in the United States are owned by

firms which continue to use FIFO accounting, despite the resulting

overstatement of income tax liability during inflationary times. 

Table 1 provides data on the use of FIFO by industry group. The 

proposal would permit such firms to switch to either Indexed FIFO or 

LIFO inventory tax accounting, while continuing to use the unindexed 

FIFO method for financial accounting purposes. It is expected that 

taxpayers that currently use the unindexed FIFO method would switch to 

the Indexed FIFO method or the LIFO method. An immediate switch by

all firms that currently use FIFO to either Indexed FIFO or LIFO would 

result in a maximum aggregate annual tax saving to those firms of 

approximately $6 billion. 

Firms that currently use LIFO, however, would be unlikely to 

change to Indexed FIFO, unless the economic advantages were sufficient 

to offset the associated administrative costs as well as the tax costs 

resulting from recapture of LIFO reserves. LIFO inventories would not 

be eligible for an inflation adjustment. Such an adjustment would 

generally be inappropriate since LIFO accounting permits indefinite 

deferral of inflationary gains. Moreover, LIFO accounting, unlike the 

Indexed FIFO method, permits deferral of real inventory gains; thus, 

to combine LIFO with indexation would be a form of double benefit. 

For LIFO firms that do switch to Indexed FIFO, inventory stocks would 

thereafter be valued more accurately. Moreover, the influence of tax 

considerations over decisions as to liquidation of a business or 

levels of inventory would be reduced. 

- 176 -
The proposal to index the FIFO method would improve the 

measurement of income for tax purposes since inflationary gains would 

be permanently removed from the tax base. The Indexed FIFO method 

would also be analogous to the proposed treatment for depreciable 

assets, where depreciation allowances would be indexed for general

inflation. In this respect, the Indexed FIFO method will provide 

greater neutrality between investment in inventory and in depreciable 

property during periods of inflation. 

Finally, the current disincentive to entry into industries that 

have historically used the FIFO accounting system and thus borne an 

artificially high tax burden would be removed. 

- 171 -

476-698 0 - 85 - 0 
Table 7.04-1 

Percentage of Ending Inventory Valued 

by the FIFO method by Industry 

1 Value of Ending I Percentage

Industry I Inventory (Billions) I FIFO 

Agriculture $ 4.6 97 9;

Mining 8.2 81 

Construction 

Food 

Tobacco 

Textiles 

Apparel

Lumber 

Furniture 

Pulp and Paper

Printing and Publishing

Chemicals 

Petroleum 

Rubber 

Leather 

Stone, Clay and Glass Products 

Primary Metals 

Fabricated Metals 

Machinery

Electrical Equipment

Motor Vehicles 

Instruments 

Transportation Equipment

Transportation Public Utilities 

Communications 

Wholesale Trade 

Retail Trade 

Finance, Insurance,

and Real Estate 

Services 

23.1 97 

24.0 66 

6.7 15 

5.8 50 

8.3 82 

6.0 77 

6.0 7'7 

6.5 60 

5.4 70 

26.4 50 

23.9 41 

5.1 63 

2.1 74 

5.9 58 

20.7 39 

20.7 39 

38.9 67 

30.1 68 

16.1 47 

8.2 5'7 

18.3 78 

31.9 92 

6.5 99 

108.8 80 

102.2 69 

12.8 89 

11.0 95 

Total All Industries $ 594.2 70 % 

Office of the Secretary of the Treasury May 28, 1985 

Source: 1981 Corporation Income Tax Returns, computed by the 

Bureau of Economic Analysis 

- 178 -
RETAIN $5,000 LIMIT ON EXPENSING 

DEPRECIABLE BUSINESS PROPERTY 

General Explanation 

Chapter 7.05 

Current Law 

Under current law, taxpayers may elect to expense the cost of 

a limited amount of qualifying property rather than to recover such 

cost over time through deductions for depreciation. In general, 

property qualifying for this expensing election must be purchased for 

use in a trade or business and must otherwise be eligible for the 

investment tax credit. No investment credit is allowable with respect 

to amounts expensed under this rule. 

For taxable years beginning before 1988, the dollar limitation on 

the amount that may be expensed is $5,000 per year. This limitation 

is scheduled to increase to $7,500 for taxable years beginning in 1988 

and 1989, and to $lO,OOO for taxable years beginning after 1989. In 

each case, the limitation that applies to a married individual who 

files a separate return is one-half of the dollar limitation described 

above. 

Reasons for Change 

Expensing the cost of an asset that produces income for more than 

one year overstates the taxpayer's cost of producing income for the 

year. The overstatement of current deductions shelters other income 

from tax and thus results in a deferral of tax liability. This 

deferral advantage creates some incentive for investment in assets 

eligible for expensing, but only for taxpayers who would not otherwise 

have acquired qualifying property up to the amount eligible for 

expensing. For other taxpayers, the limited expensing election 

creates no marginal investment incentive. 

In addition, permitting taxpayers to expense the cost of an asset 

creates compliance problems. After the year in which the asset is 

expensed, the asset is removed from the tax form. As a result, it is 

relatively easy to convert the asset to personal use or to sell the 

asset without complying with the rules requiring recapture of the 

deduction. 

A limited expensing election does, however, have certain 

simplification advantages. For smaller businesses, expensing

eliminates or reduces the recordkeeping and computational burdens of 

recovering an asset's cost over a number of years. 

- 179 -
Proposal 

The scheduled increases of the dollar limitation on expensing of 

depreciable business property would be eliminated, leaving in place

the current limit of $5,000. 

Analysis 

The proposal would not change the current treatment of any 

taxpayer. Elimination of the increase in the limitation should have 

little effect on investment in depreciable assets. The proposal would 

simply retain a de minimis alternative to the more complicated

depreciation rules. 

- 180 -
REPEAL RAPID AHORTIZATION RULES 

General Explanation 

Chapter 7.06 

Introduction 

Current law contains a number of special amortization and 

expensing rules that allow taxpayers to elect premature deductions for 

certain capital expenditures. The deferral of income tax that these 

provisions permit is intended to create incentives or subsidies for 

investment in certain assets or activities. 

Some of these provisions were originally intended to be effective 

only for brief periods, but were later extended. Others have expired

in whole or in part since they do not apply to expenditures made in 

the current year or in future years. Although these provisions target

various industries and various assets, they have similar effects on 

the efficiency and fairness of the tax system and present related 

questions of tax and economic policy. 

Current Law 

1. Five-year amortization of trademark and trade name 

expenditures. Current law permits taxpavers to amortize over a Deriod 

of-at least 60 months any expenditure bald or incurred in the takab1.e 

year for the acquisition, protection, expansion, registration, or 

defense of a trademark or trade name, other than an expenditure which 

is part of the consideration for an existing trademark or trade name. 

(Section 177.) A separate election may be made by the taxpayer with 

respect to each separate trademark or trade name expenditure. 

2. Five-year amortization of pollution control facilities. 

Current Paw permits taxpayers to amortize the cost of a certified 

pollution control facility over a 60-month period. (Section 169.) To 

the extent, however, that-a pollution control facility has a useful 

life in excess of 15 years, a portion of the facility's cost is not 

eligible for 60-month amortization, but must be recovered through

depreciation or through the Accelerated Cost Recovery System (ACRS). 

A certified pollution control facility is a treatment facility

used in connection with a plant or other property to abate or control 

water or air pollution, if (1) the plant or other property was in 

operation before January 1, 1976, (2) the facility is certified by the 

appropriate State and Federal authorities as meeting certain pollution

control standards, and (3) the facility does not significantly

increase the output, extend the life, or reduce the operating costs of 

the plant or other property. In general, a profitable or "break even" 

facility is not eligible for certification. 

- 181 -
-- 

If an election is not made with respect to a certified pollution

control facility, its cost may be recovered through depreciation or,

in the case of recovery property, through ACRS. 

3. Five-year amortization of certain expenditures for qualified

child care facilities. Current law permitted employers to amortize 

over a 60--monthperiod capital costs incurred before Januarv 1. 1982. 

to acquire, construct, or-rehabilitate child care facilitie; for their 

employees. (Section 188.) 

4. Five-year amortization of expenditures to rehabilitate 

low-income housing. Current law permits taxpayers to amortize over a 

60-month period expenditures to rehabilitate low-income rental housins.. (other than hotels or other similar facilities primarily serving

transients). (Section 167(k).) Expenditures qualify for 60-month 

amortization only if they are incurred for additions or improvements 

to property with a useful life of at least five years. Expenditures

for a taxable year with respect to a dwelling unit are eligible for 

60-month amortization only if the aggregate of such expenditures over 

two consecutive taxable years including the taxable year exceeds 

$3,000. In general, a taxpayer's rehabilitation expenditures with 

respect to a dwelling unit are not eligible for five-year amortization 

to the extent that the aggregate of such expenditures exceeds $20,000.

In certain cases, this limitation is increased to $40,000. 

The election to amortize expenditures to rehabilitate low-income 

housing will not be available for expenditures incurred afer December 

31, 1986 (except in cases where rehabilitation began, or a binding

contract for such expenditures was entered into, before January 1,

1987). 

5. Five-year amortization of certain railroad rolling stock. At 

the election of the taxDaver. current law uermitted .... taxnavers -..

c-il--­ to 

amortize over a 60-month period the adjustid basis of railroad rolling

stock placed in service after 1968 and before 1976. (Section 184.) 

6. Fifty-year amortization of qualified railroad grading and 

tunnel bores. Current law Dermits domestic railroad common carriers ..- - --- - to amortize the cost of quaiified railroad grading and tunnel bores 

over a 50-year period. (Section 185.) "Qualified railroad grading

and tunnel bores" include all land improvements (including tunneling) 

necessary to provide, construct, reconstruct, alter, protect, improve,

replace, or restore a roadbed or right-of-way for railroad track. 

Amortizable basis is not reduced upon the retirement of qualified

railroad grading or tunnel bores, but no additional deduction is 

allowed on account of such retirement. 

- 182 -
I. Expensing of soil and water conservation expenditures,

fertilizer and soil conditioning expenditures, and field clearing

expenditures. Current law permits taxpayers enqaqed in the business 

of-farming ("farmers") to deduct a variety of cosfs that would 

otherwise be capitalized or inventoried, as follows: 

a. Farmers may deduct currently soil and water conservation 

expenditures that do not increase the basis of depreciable assets. 

(Section 175.) The deduction is limited annually to 25 percent of the 

taxpayer's gross income from farming. Deductible expenditures include 

costs of the following: leveling, grading, and terracing; contour 

furrowing; the construction, control, and protection of diversion 

channels, drainage ditches, earthen dams, watercourses, outlets, and 

ponds; the eradication of brush; and the planting of windbreaks. 

Expenditures with respect to land held by the taxpayer for less than 

ten years are subject to recapture as ordinary income. 

b. Farmers may deduct currently expenditures for fertilizer or 

other material used to enrich, neutralize, or condition farmland. 

(Section 180.) 

c. Farmers may deduct currently expenditures incurred to clear 

land and make the land suitable for farming. (Section 182.) The 

deduction is limited in any taxable year to the lesser of $5,000 or 25 

percent of the farmer's taxable income from farming. Expenditures

with respect to land held by the taxpayer for less than ten years are 

subject to recapture as ordinary income. 

8. Seven-year amortization of and ten percent credit for 

reforestation expenditures. Current law permits taxpayers to amortize 

over an 84-month period up to $10,000 of reforestation expenditures

incurred in each taxable year. (Section 194.) A ten percent

investment tax credit is also allowable for such expenditures.

Reforestation expenditures include amounts spent on site preparation,

seed or seedlings, labor, and tools. Amortized expenditures are 

subject to recapture if the underlying property is disposed of within 

ten years from the year of the expenditure. The credit is subject to 

the normal investment tax credit recapture rules. 

Reasons For Change 

Summary 

Targeted government subsidies for particular industries and assets 

override market-based resource allocations and the consumer 

preferences on which they are based. In circumstances where private

markets fail to reflect the social value of particular goods or 

services, government intervention in the form of a subsidy may be 

appropriate. However, many narrowly targeted tax incentives for 

business do not address problems of market failure, but instead 

subsidize specific business activities at some cost in overall 

economic efficiency. 

- 183 -
1. Trademark and trade name expenditures. A trademark or trade 

name distinguishes a firm and/or its products from other firms and/or

their products. The costs of acquiring a trademark are capital

outlays for an intangible asset, similar to expenditures to organize a 

business. Investors are willing to make such expenditures because in 

doing so they acquire an asset that will, over the course of time,

yield a rate of return at least as high as could be earned by other 

investments. Although a trademark or trade name may prove to be 

unprofitable, or even worthless, there can be no presumption that it 

will decline in value. To the contrary, the ordinary investor 

acquiring a trademark or trade name expects the value of the asset to 

appreciate along with the development of the products that it 

represents. Thus, where normal product development, including

advertising, occurs on an ongoing basis, there is no ground for 

imputing deductions for "capital cost recovery" for investments in 

trademarks or trade names. 

There is no evidence that investment in a trademark or trade name 

yields a greater benefit to society than is reflected in the expected

market return to the investor. Allocation of resources to such 

investment should thus be determined by general market principles.

There is correspondingly no basis for a tax incentive through 

premature recovery of the costs of such investment. 

2. Certified pollution control facilities. The special

amortization rules for pollution control facilities were enacted in 

1969, shortly after the enactment of Federal legislation which imposed

phased-in restrictions on industrial plant emissions. The thrust-of 

the environmental protection laws was to require producers and their 

customers to pay the costs of avoiding environmental damage in excess 

of the standards imposed. At the same time, concern was expressed

that existing plants would be subject to burdensome retrofitting 

costs, which would place them at a competitive disadvantage compared 

to newer plants that were designed after pollution control 

requirements were imposed. The special amortization rules were 

adopted to mitigate the cost of retrofitting older facilities. 

Consistent with the transitional objective, the special rules were 

scheduled to expire after seven years (December 31, 1975), a period

presumably long enough to bring pre-1969 plants into compliance with 

emission standards. 

The special amortization rules for pollution control facilities 

are poorly designed to offset the burden, if any, that revised 

environmental standards imposed on operators of existing plants.

Ordinarily, plants in industries where emissions are a major concern 

are continuously "replaced" and their capacity altered in an orderly 

process of maintenance, repair, and modernization. Thus, at the 

margin, revised emission standards raised investment and operating 

costs for "old" and "new" plants alike. The only cost disadvantage to 

"old" plants was the difference between (a) the total additional cost 

of incorporating emission control features into 'modernization" 

programs, and (b) the total additional cost of incorporating emission 

- 184 -
control features into the construction of new plants. This 

difference, which reflected differences in operating costs as well as 

capital costs, presumably varied from industry to industry, and from 

plant to plant. Thus, the extra burden imposed on taxpayers operating

old plants, if any, was not related in some simple way to the cost of 

a depreciable retrofit facility, nor was it approximately equal to the 

interest savings on deferred taxes provided by five-year amortization. 

The five-year amortization rules are also poorly targeted to 

encourage pollution control activities. The subsidy is available only

with respect to depreciable assets, and thus provides no incentive for 

numerous other ways of reducing pollution from existing plants, such 

as using cleaner but more expensive grades of fuel and other raw 

material inputs. Favoring capital intensive pollution control 

measures wastes scarce resources to accomplish the program objective. 

Finally, although the special. amortization rule for pollution

control facilities was originally a temporary measure, it was extended 

indefinitely in 1976. Even if some justification existed for 

transitional relief to operators of old plants, there is no basis for 

an ongoing subsidy of pollution control costs. 

3. Qualified child care facilities. The special rule permitting

five-year amortization of expenditures to construct or rehabilitate 

child care facilities applies only to expenditures made before January

1, 1982, and, thereforel-has effectively expired. 

4. Rehabilitation of low-income housing. Historically,

low-income housing has benefited from a variety of direct and indirect 

government subsidies, including rental subsidies, grants, loans, and 

credit supports and guarantees. A number of Federal programs,

including the housing voucher program initiated in 1983, have provided

direct or indirect assistance to low-income families unable to afford 

market rents. Also initiated in 1983 were two programs providing 

grants to assist rehabilitation and new construction of low-income 

housing by the private sector. Direct low-interest loans are made 

available to assist low-income individuals in rural areas to obtain 

adequate housing. Finally, a number of mortgage insurance and 

guarantee programs make credit available to many families who could 

not afford to purchase homes in the absence of such measures. 

In addition to these targeted direct subsidies, the current 

income tax laws contain numerous provisions which encourage investment 

in real estate, including housing. These provisions include (1)

accelerated depreciation of real property, (2) full deductibility of 

interest, including the portion of interest intended to compensate the 

lender for the effects of inflation, (3) reduced tax rates for capital

gains realized on disposition of real property, (4) relaxed recapture

rules for dispositions of real property, (5) exemption of real estate 

investments from the limitation of losses to amounts at risk, and (6) 

tax-exempt status for bonds issued to finance low-income rental 

property. In addition, several special provisions apply only to 

- 185 '-
low-income housing, including (1) immediate deductibility of 

construction-period interest and taxes, (2) the 15-year ACRS recovery

period, and (3) five-year amortization of rehabilitation expenditures. 

The tax benefits associated with real estate investment attract 

capital from high-income taxpayers who are willing to trade negative

cash flows or below-market returns for substantial tax savings, and 

therefore appear to cause increased investment in real estate,

including low-income housing. However, in a 1977 report entitled 

"Real Estate Tax Shelter Subsidies and Direct Subsidy Alternatives,"

the Congressional Budget Office estimated that, because of the costs 

of packaging tax shelters and the high after-tax returns enjoyed by

tax shelter investors, less than one-half of government revenue losses 

attributable to real estate tax shelters ever reach builders and 

developers. Thus, to the extent that the current tax laws encourage

investment in low-income housing, the incentive is unnecessarily

costly to the government. 

If additional measures are needed to stimulate investment in 

low-income housing, existing targeted spending programs should be 

expanded. 

5. Railroad rolling stock. The special rule permitting

five-year amortization of the adjusted basis of railroad rollins stock 

applies only to rolling stock placed in service before 1976, ana,

therefore, has effectively expired. 

6. Qualified railroad grading and tunnel bores. For much of its 

history, the U.S. railroad industry was subject to rate and service 

regulation designed to favor shipments of bulk raw materials over 

shipments of finished and semi-finished products. As a consequence,

the industry's capacity to haul bulk commodities, demand for which is 

highly seasonal in volume, depended heavily on cross-subsidization 

from rates that were charged for "high value" manufactured goods. 

In general, such cross-subsidization was possible so long as the 

railroad industry held a virtual monopoly on long distance overland 

haulage. Competition from trucking progressively eroded this 

monopoly, however, shifting the railroads' mix of transported goods to 

the low-value markets. Railroad rate schedules failed to keep pace

with the shift in markets, depressing industry earnings and causing

investment in right of way and rolling stock to decline. 

In 1969, Congress responded to the railroad industry's financial 

plight by allowing 50-year amortization for the cost of railroad 

grading (the basic roadway, but not the track, ties, and ballast) and 

tunnel bores, which, as assets in the nature of land improvements, had 

previously been considered nondepreciable. This special amortization 

rule, after its expansion in 1976, applied regardless of when the 

assets were placed in service, effectively granting railroad companies 

a 50-year stream of tax deferrals. 

- 186 -
The special amortization rule for railroad grading and tunnel 

bores is a poorly conceived subsidy. The value of the subsidy depends 

on a railroad's historical investment in grading and tunnel bores. In 

many cases, these costs were incurred prior to imposition of the 

income tax, and, in any event, are not correlated with regulatory

mispricing. 

In addition, the subsidy targets its benefits to railroads least 

in need of or entitled to relief. Those railroads most affected by

regulatory mispricing may not have significant taxable income, and 

thus may realize no benefit from the subsidy. Only profitable

railroads can take full advantage of the special amortization rules, 

yet they may have escaped the burdens that the subsidy is intended to 

offset. 

7. Soil and water conservation expenditures, fertilizer and soil 

conditioning expenditures, and land clearing expenditures. In 

recosnition of various economic conditions which disfavor small unit 

farming, often called family farming, Federal programs to mitigate

farm price and income instability have been in place since 1926. In 

addition to price support programs, farmers have access to Federal 

credit on a subsidized basis. The Department of Agriculture also 

administers programs for agricultural conservation and rural water 

supply, as well as providing farmers broad scale technical and 

management assistance. 

The extensive Federal involvement in agricultural input and 

output markets makes additional tax-based subsidies unnecessary and 

inefficient. Outlays to drain marshy soil, create ponds, install 

irrigation ditches, and condition soil all have the objective of 

yielding greater farm output in the future. Under ordinary accounting

principles they should be capitalized or inventoried -- treated as the 

purchase of an asset -- rather than treated as a cost of the current 

year's output. If the land-improving investments are rationally made,

the farmer has merely exchanged cash for an asset of equal value -- improved land -- the expected market value of which will accrue to him 

as output occurs. 

Finally, as with many other tax-based subsidies, the special

expensing rules for farmers are of full value only to those with 

significant income. This effectively denies the benefits of the 

subsidy to the small, new, or unprofitable farmer, who is thus given a 

relative disincentive for farm improvements. As a result, such 

farmers operate at a competitive disadvantage, since market prices for 

farm products will tend to reflect the tax advantages from which such 

farmers do not benefit. 

8. Reforestation expenditures. It has been argued that the 

market price of timber understates the social value of forested land 

because-some important benefits are not expressed in the market price. 
National security, flood control, arresting land erosion that degrades

the quality of streams, and opportunities for outdoor recreation are 

claimed to be among the additional benefits derived from forested 

land. 

In view of these "externalities," government invervention to 

increase the volume of forest output may be justified. Thus, $1.8 

billion was spent in fiscal year 1984 for management of more than 100 

million acres of national forests and for cooperative forestry and 

forestry research. 

In addition to these direct budget expenditures, present law 

contains tax subsidies intended to encourage forestry by small-scale 

landowners. All taxpayers investing in timberland are entitled to an 

investment tax credit equal to ten percent of up to $10,000 of 

reforestation expenditures each year. In addition, the total amount 

eligible for the credit may be amortized over seven years,

notwithstanding the fact that the taxpayer has expended only 90 

percent of that amount and the trees planted are likely to appreciate

in value. 

Even if one agrees that there are "externalities" in forestry in 

excess of the direct expenditures presently provided in the Federal 

budget, the reforestation credit and amortization provisions are so 

poorly designed that their continuation is difficult to justify. Any

reforestation expenditure qualifies for the investment credit and 

amortization, whether or not it yields recreational, flood control, or 

erosion control benefits, or relates to a tree species with national 

security significance. Moreover, the provisions are so structured 

that they cannot appreciably affect marginal industry investment. Due 

to economies of scale, most commercial forestry (i.e., that type which 

is likely to produce external benefits of the kind that justify a 

subsidy) requires reforestation expenditures far in excess of $10,000 

per year. For most commercial forestry, therefore, these tax 

provisions are the equivalent of a fixed grant plus assured tax 

deferral each year, and are independent of the taxpayer's decision to 

increase marginal qualified expenditures. Repeal of the reforestation 

credit and amortization provisions would increase revenue collection 

without measurably increasing soil erosion and flood damage, or 

reducing recreational opportunities and national security. 

Proposals and Effective Dates 

1. Trademark and trade name expenditures. The current election 

to amortize trademark and trade name expenditures would be repealed.

Repeal would be effective for expenditures paid or incurred on or 

after January 1, 1986. 

2. Certified pollution control facilities. The election to 

amortize the cost of certified pollution control facilities would be 

repealed. Repeal would be effective for expenditures paid or incurred 

on or after January 1, 1986. 

- 188 -
-- 

3. Qualified child care facilities. This provision would be 

deleted from the Code as deadwood, since it applies onlv - to costs

incurred prior to January 1, 1982. 

4. Rehabilitation of low-income housing. The election to 

amortize expenditures to rehabilitate low-income housinq would be 

repealed. kepeal would be effective for expenditures paid or incurred 

on or after January 1, 1986. 

5. Railroad rolling stock. This provision would be deleted from 

the Code as deadwood, since it applies __ only - to rolling. stock placed in

service prior to 1976. 

6. Qualified railroad grading and tunnel bores. The election to 

amortize the cost of qualified railroad grading and tunnel bores would 

be repealed. Repeal would be effective for expenditures paid or 

incurred on or after January 1, 1986. 

7. Soil and water conservation expenditures, fertilizer and soil 

conditioning expenditures, and land clearing expenditures. The 

elections to deduct currently expenditures for soil and water 

conservation, fertilizer and soil conditioning, and land clearing,

would be repealed. Repeal would be effective for expenditures paid or 

incurred on or after January 1, 1986. 

8. ReEorestation expenditures. The election to amortize 

reforestation expenditures and the investment tax credit for such 

expenditures would be repealed. Repeal would be effective for 

expenditures paid or incurred on or after January 1, 1986. 

Analysis 

In general, costs that currently qualify for the special

expensing and amortization rules discussed in this section create 

wasting or non-wasting long-lived assets. Thus, repeal of the special

rules would cause those costs to be capitalized or inventoried, and 

recovered under the normal cost recovery rules or at the time of 

disposition. The effect on taxpayer behavior of such repeal would 

generally depend on (1) the extent to which marginal investment 

choices are influenced by the special rules provided by current law 

and (2) the degree of neutrality achieved by the cost recovery rules 

replacing the special provisions. 

1. Trademark and trade name expenditures. An investment in a 

trademark or trade name creates an intangible asset for which there is 

no reason to impute deductions for a decline in value over time. 

Accordingly, if such an investment were capitalized it would be 

recovered only upon disposition of the asset. Thus, the interest-free 

tax deferral which currently results from the tax treatment of 

trademark and trade name expenditures would be eliminated. 

- 189 -

improvements and additions of track and rolling stock, repeal of 

50-year amortization should not have an appreciable effect on the 

volume of railroad investment or on after-tax rates of return on such 

investment. 

5. Soil and water conservation expenditures, fertilizer and soil 

conditioning expenditures, and land clearing expenditures. In the 

absence of special expensing rules for farmers' expenditures for 

clearing, conditioning, and conserving farmland, some of these 

expenditures would be capitalized as a cost of improving the land to 

make it suitable for farming and, as such, would be recovered under 

normal cost recovery rules (to the extent treated as the costs of 

land, such costs could be recovered only upon disposition of the 

land). To the extent that farmers who make such investments have 

significant marginal tax rates (generally large-scale operators and 

corporations), the loss of tax deferral would reduce the 

attractiveness of investments in land improvement relative to 

alternative investments, such as investments in farm machinery or in 

other industries. In addition to the resulting social gain from a 

better allocation of scarce private capital, eliminating this subsidy

could result in a reduced level of Federal expenditures for 

price-support programs, since expansion of farm acreage would no 

longer be encouraged by the tax laws. Repeal of the expensing

provisions should also improve the competitive position of those 

farmers, typically operating small or family farms, who do not receive 

full benefit from tax subsidies. 

6. Reforestation expenditures. Repeal of seven-year

amortization of qualified reforestation expenditures and the 

associated ten percent investment credit would have no measureable 

effect on the rate of investment in private forest lands. These 

incentives are structured so that they do not affect forest investment 

decisions; they apply only to the first $10,000 of reforestation 

investment, an amount far below the annual expenditures of a viable 

commercial forestry operation. The existing tax subsidies, however,

also benefit farmers and other landowners who use tree planting to 

control wind-related soil damage or otherwise improve the value of 

their land. Since reforestation expenditures by such owners are much 

more likely to be $10,000 or less, repeal of the credit and 

amortization provisions could affect marginal investment decisions and 

decrease the total amount of reforestation expenditures by such 

owners. Absent the current subsidy, this type of tree planting

probably would decline as investors selected other investment projects

with higher market yields. 

- 19.1 -
DENY RATE REDUCTION BENEFIT ATTRIBUTABLE 

TO EXCESS DEPRECIATION 

General Explanation 

Chapter 7.07 

Current Law 

Accelerated depreciation deductions are allowed under both the 

Accelerated Cost Recovery System ("ACRS") and pre-ACRS depreciation

schedules based on useful lives. With respect to property placed in 

service before 1981, a taxpayer could generally elect to use either 

the straight-line method or an accelerated method such as the 

declining-balance method or the sum-of-the-years-digits method applied 

over the useful life of the property or over the class life of the 

property under the Class Life Asset Depreciation Range system. For 

purposes of computing their earnings and profits, corporations are 

required to use the straight-line method over the same useful life or 

class life used to compute depreciation deductions. Generally, for 

property placed in service after 1980, ACRS prescribes accelerated 

depreciation deductions over specified recovery periods. However, for 

purposes of computing earnings and profits, corporate taxpayers must 

use the straight-line method over longer recovery periods. Thus, in 

the early years of an asset's life, accelerated depreciation

deductions under both ACRS and pre-ACRS law exceed straight-line

depreciation deductions used to calculate a corporation's earnings and 

profits for tax purposes (E&P depreciation). Conversely, in the later 

years of an asset's life, accelerated depreciation deductions are less 

than E&P depreciation deductions; the year in which this first occurs 

may be referred to as the asset's "crossover point." 

The top marginal rate for corporations was 48 percent for 1980 and 

1981 and 46 percent for taxable years beginning after 1981. The top

marginal tax rate for individuals was 70 percent for 1980 and 1981 and 

50 percent for taxable years beginning after 1981. 

Reasons for Change 

The effect of using an accelerated depreciation method is that,

relative to a calculation based on the straight-line method, taxable 

income is reduced in the years in which accelerated depreciation

exceeds straight-line depreciation (i.e., years before the crossover 

point) and taxable income is increased in later years in which 

straight-line depreciation exceeds accelerated depreciation (i.e., in 

years after the crossover point). Thus, accelerated depreciation

methods produce a deferral of tax liability relative to the time 

profile of tax liability that would result from the straight-line

depreciation method. 

- 192 -
As long as tax rates remain constant over the life of an asset,

the amount of tax that is deferred as a result of accelerated 

depreciation is equal to the amount of tax that is repaid in later 

years. However, a reduction in tax rates for the later years produces 

an unexpected benefit for the taxpayer by reducing the tax that must 

be repaid relative to the tax that was deferred. This unexpected

benefit is in addition to the intended benefit of interest-free 

deferral of the tax liability inherent in the acceleration of 

deductions. 

The Administration proposals include a substantial reduction in 

tax rates effective on July 1, 1986. The top marginal rate would be 

reduced from 46 percent to 33 percent for corporations (a 13 

percentage point reduction) and from 50 percent to 35 percent for 

individuals (a 15 percentage point reduction). Compared with the 

48-percent and 70-percent rates in effect for corporations and 

individuals, respectively, prior to 1982, the rate reduction is even 

more substantial. Most taxpayers with substantial accelerated cost 

recovery deductions taken over the period 1980-85 will have been able 

to reduce tax at rates of 46 or 50 percent (48 or 70 percent for 

1980-81). These taxpayers generally expected to repay their deferred 

tax liabilities attributable to accelerated depreciation at the 

currently applicable 46 or 50 percent rate. However, because of the 

proposed reduction in tax rates after July I, 1986, the deferred tax 

liabilities of such taxpayers would generally be repaid at a 

33-percent rate instead of a 46-percent rate for corporations (at a 

35-percent rate instead of a 50-percent rate for top--bracket

individuals). In the absence of a rule designed to recapture this 

unexpected benefit of the reduction in rates, part of the deferred tax 

liabilities attributable to accelerated depreciation deductions would 

effectively be forgiven. Taxpayers with deferred tax liabilities on 

July 1, 1986, would obtain an unintended windfall benefit, which had 

not been anticipated when investment decisions were made. 

Proposal 

In order to prevent taxpayers from obtaining the unexpected

windfall benefit described above, 40 percent of a taxpayer's "excess 

depreciation" taken between January 1, 1980, and July I, 1986, would 

be included in income over a three-year period. The excess 

depreciation over such period would be the excess of cumulative 

depreciation OK amortization deductions over cumulative depreciation

deductions that would have been allowed during such period using the 

straight-line method specified under current law for E&P depreciation

(Code section 312(k)). For calendar-year taxpayers, 12 percent of the 

excess depreciation would be included in income for the 1986 taxable 

year, 12 percent in 1987, and 16 percent in 1988. Appropriate

adjustments would be made to this schedule for fiscal-year taxpayers 

to put them on the same basis as calendar-year taxpayers. 

- 193 -
Taxpayers whose total depreciation deductions taken between 

January 1, 1980, and December 31, 1985, are less than $400,000 would 

not be subject to the rate-reduction recapture rule. Such taxpayers

would accordingly not have to make the excess depreciation calculation 

described above. Moreover, for those taxpayers who are subject to the 

rule, the first $300,000 of excess depreciation would be exempt from 

the rate-reduction recapture rule. If the taxpayer were in existence 

for only part of the 1980-85 period, the $400,000 threshold and 

$300,000 exemption would be adjusted accordingly. 

For purposes of the rate-reduction recapture rule, any excess 

depreciation would be reduced by any net operating losses carried 

forward by the taxpayer from a year before 1986 to a taxable year

beginning after 1985. The reduction of excess depreciation by such 

net operating losses would not reduce the amount of such losses that 

could be offset against taxable income. The proposed rate-reduction 

recapture rule would be applied at the level of individual partners,

shareholders in an S corporation, or beneficiaries, not at the level 

of a partnership, S corporation, or trust. Amounts included in income 

under the rule that are attributable to foreign property would be 

treated as foreign-source income. 

Effective Date 

For calendar-year taxpayers, 12 percent of the excess depreciation

would be included in income for the 1986 taxable year, 12 percent in 

1987, and 16 percent in 1988. Appropriate adjustments would be made 

to this schedule for fiscal-year taxpayers to put them on the same 

basis as calendar-year taxpayers. 

Property subject to the rate-reduction recapture rule would 

include all property placed in service on or after January 1, 1980,

and before January 1, 1986, for which depreciation or amortization 

deductions were allowable under current law for any part of the period

January 1, 1980, through June 30, 1986. 

Transfers of property before July 1, 1986, in transactions where 

gain was not recognized would be disregarded in computing the 

transferor's liability under the rate-reduction recapture rule. 

Similar rules would be provided for transfers to related parties, with 

an appropriate adjustment for income recognized on the transfer. It 

is anticipated that the tax writing committees will provide any other 

transition rules necessary to prevent avoidance of the rate-reduction 

recapture. For example, the committees may wish to develop special

rules for dispositions of real property in transactions where the gain

attributable to excess depreciation is not fully subject to recapture

under current law. No dispositions of property after June 30, 1986,

would relieve the taxpayer of liability under the recapture rule,

since such liability would be calculated as of that date. 

- 194 -
Analysis 

The proposal would prevent an unexpected windfall that would 

otherwise accrue to taxpayers who deferred tax liability by taking

accelerated depreciation deductions at relatively high pre-reform tax 

rates, but would repay this deferred tax liability at lower 

post-reform tax rates. To reduce administrative complexity, the 

Administration proposal only approximates the rules that would be 

needed to eliminate the windfall precisely. 

Ideally, the amount of the recapture tax on depreciable assets 

would be calculated as follows. The amount of excess depreciation on 

each asset placed in service prior to January 1, 1986, would be 

defined as the cumulative difference between accelerated and economic 

depreciation between the time the asset was placed in service and 

June 30, 1986. The tax would be equal to excess depreciation times 

the difference between the pre-reform and post-reform tax rates for 

the particular taxpayer, say, 13 percent. This tax would be assessed 

when the tax deferral associated with the accelerated deductions was 

repaid. That is, once the asset passed its crossover point, the 

taxpayer's annual tax burden would be increased by 13 percent of the 

amount of "deficient depreciation" in that year -- the amount by which 

economic depreciation exceeds accelerated depreciation -- until the 

full amount of the recapture tax was paid. Such a rule would ensure 

that tax deferrals that reduced income under the high pre-reform rate 

structure would be repaid at the expected time and at the expected tax 

rate, rather than at significantly lower post-reform rates. 

The proposal contains a number of simplifying assumptions. E&P 

depreciation is used as a proxy for economic depreciation. This 

choice is made primarily for convenience, since most of the taxpayers

subject to the proposal would be corporations that are currently

required to compute E&P depreciation. In addition, no attempt is made 

to determine the appropriate tax differential for each taxpayer.

Instead, the tax is assessed by including in income 40 percent of the 

cumulative excess depreciation taken prior to June 30, 1986, on assets 

placed in service between January 1, 1980, and December 31, 1985. 

This implies an effective recapture tax rate of 13.2 percent for large

corporations that will experience a rate reduction from 46 to 33 

percent; this rate is slightly below the 15 percent rate which should 

apply to corporate deductions taken at a 48 percent rate. 

For top-bracket individuals, inclusion of excess depreciation in 

income at a 40 percent rate results in an effective recapture tax rate 

of 14 percent. This is slightly lower than the 15 percentage point

reduction that would be appropriate for a top-bracket taxpayer who 

will experience a rate reduction from 50 to 35 percent; it is 

considerably below the 35 percent rate that should apply to individual 

deductions taken at a 70 percent rate. Virtually all individuals 

subject to the tax will be top-bracket taxpayers. 

- 195 -
Similarly, no attempt is made to allocate the recapture liability 

across the years beyond the asset's crossover point as described 

above. Such a procedure would be exceedingly complex, as it would 

involve the calculation of the difference between accelerated and E&P 

depreciation for many years into the future for all assets subject to 

the rule. For certain assets, particularly long-lived property,

determination of the amount of recapture liability with reference to 

the amount of excess depreciation taken prior to June 30, 1986,

although correct in dollar terms, would overstate the liability in 

present value terms, since the additional tax liability would 

appropriately be assessed in later years. The proposed three year

spread of the inclusion in income associated with the recapture rule 

would mitigate this problem, since it would reduce the present value 

of the rate-reduction recapture liability. 

The recapture rule could be applied to all existing assets that 

would benefit from deferring tax liability at high pre-reform rates 

and repaying the deferred liability at lower rates. The limited scope

of the provision is intended to reduce complexity, recognizing, for 

example, that most or all of deferred tax liability with respect to 

older depreciable assets will have been repaid by June 30, 1986. 

The de minimis rule which exempts corporate and individual 

taxpayers with cumulative depreciation deductions over the 1980-1985 

period of less than $400,000 from the rate reduction recapture rule 

would ensure that most taxpayers would not be subject to the rule and 

would not have to calculate their excess depreciation. Furthermore, 

taxpayers who may fall just above the $400,000 threshold would benefit 

from the exemption of $300,000 of excess depreciation from the ratereduction recapture rule. Only about 150,000 individuals and 10 

percent of corporations would be subject to the rule. 

The recapture rule applies only to old capital and thus it has no 

effect on the cost of capital for new equipment. 

- 196 -
CEIAPTER 8 

MEASURE INCOME PROPERLY 

Significant strides were made in the Deficit Reduction Act of 1984 

toward accurately reflecting the "time value of money" in measuring

taxable income. This Chapter discusses proposals that would continue 

these improvements. Areas addressed in the 1984 legislation were 

generally not reevaluated. 

The Administration proposals would require production costs to be 

capitalized on a more comprehensive basis, providing a more accurate 

matching of income and expenses. Accounting methods that mismeasure 

income, such as the cash method of accounting and the installment 

method, would be limited. Finally, the deductions for additions to 

bad debt reserves and to reserves for mining and solid waste 

reclamation and closing costs would be repealed. 

- 1.97 -
REVISE ACCOUNTING RULES FOR PRODUCTION COSTS 

General Explanation 

Chapter 8.01 

Current Law 

In General 

Where a taxpayer produces inventory or property that is not sold 

during the current year, the costs of production generally may not be 

currently deducted. Rather, these costs must be added to the 

taxpayer's basis in the property to which they relate. If the product

is sold, the capitalized costs are recovered against the selling

price. If the product is a durable good that is used in the 

taxpayer's business, the costs are recoverable as depreciation,

amortization, or depletion deductions. 

The general principle that production costs must be capitalized is 

not uniformly applied in all contexts. In some cases, production

costs may be currently deducted. In others, where current tax 

accounting rules require production costs to be capitalized, the costs 

included within the definition of 'production costs" vary

substantially depending on the type of property produced and the 

method of production. 

-Production Costs Other than Interest 

IInventories. In accounting for inventories of manufacturers OK 

producers, costs must be collected according to the full absorption

method of inventory accounting. All direct costs and certain indirect 

costs must be capitalized. Indirect costs that are not required to be 

included in inventoriable costs include, for example: depreciation

and amortization reported for Federal income tax purposes in excess of 

depreciation reported in the taxpayer's financial reports, and general

and administrative expenses incident to and necessary for the 

taxpayer's activities as a whole. 

The treatment of certain other indirect costs varies depending on 

how such costs are treated in the taxpayer's financial reports

("financial-conformity indirect costs"). These costs must be 

capitalized only if the taxpayer capitalizes them in its financial 

reports. Included in this category of indirect costs are: taxes,

depreciation and cost depletion attributable to assets incident to and 

necessary for production; pension and profit-sharing contributions and 

other employee benefits; costs attributable to rework labor, scrap and 

spoilage; factory administrative expenses; salaries paid to officers 

attributable to services performed incident to and necessary for 

production; and insurance costs incident to and necessary for 

production. 

- 198 -
Long-term contracts. Long-term contracts are building,

installation, construction, or manufacturing contracts that are not 

completed within the taxable year in which they are entered into. 

Taxpayers using the completed-contract method of accounting for 

long-term contracts may not deduct contract costs until the contract 

is completed and income is reported. The rules for determining which 

costs must be treated as contract costs differ from the full 

absorption costing rules applicable to inventory. In addition,

different rules apply depending on the duration of the contract. 

For many long-term contracts the costs that must be capitalized

generally track the full absorption regulations as they apply to a 

manufacturer that capitalizes in its financial reports the 

financial-conformity indirect costs. Differences are as follows: 

pension contributions and other employee benefits need not be 

capitalized; costs attributable to strikes, rework labor, scrap, and 

spoilage need not be capitalized; and research and experimental

expenses directly attributable to particular contracts must be 

capitalized. 

In the case of “extended-period long-term contracts,” proposed

regulations provide that taxpayers must capitalize certain additional 

long-term contract costs. With certain exceptions, extended-period

long-term contracts are contracts that take more than two years to 

complete. The additional costs that must be capitalized include: 

all depreciation, amortization, and cost recovery allowances on 

equipment and facilities used in the performance of particular

extended-period long-term contracts (tax depreciation in excess 

of depreciation reported on financial statements need not be 

capitalized in the case of non-extended-period contracts); 

depletion (whether or not in excess of cost) incurred in the 

performance of particular extended-period contracts; 

pension contributions and other employee benefits; 

rework labor, scrap, and spoilage incurred in the performance

of particular extended-period contracts; 

expenses of successful bids; and 

certain direct and indirect costs incurred by any

administrative, service, or support function or department to 

the extent allocable to particular extended-period contracts. 

Proposed regulations set forth detailed rules for allocating

administrative, service, and support costs to particular

extended-period long-term contracts. The general test is whether a 

particular function or department of the taxpayer provides benefits to 

the extended-period long-term contracts, or merely benefits the 

overall management or policy guidance functions of the taxpayer. 

- 199 -
Self-constructed assets. The costs of constructing or improving

property having a useful life substantially beyond the taxable year

must be capitalized and added to the basis of the property

constructed. Existing regulations do not spell out which costs are to 

be capitalized when the taxpayer constructs property for its own use. 

The Supreme Court has held that depreciation on equipment used in such 

construction must be capitalized, and other courts have required

certain indirect expenses, such as vacation pay, payroll taxes,

certain fringe benefits, and certain overhead costs to be capitalized.

Although administrative and judicial interpretations provide some 

guidelines, it is not clear in many self-construction cases whether 

particular costs may be deducted or must be capitalized. 

Farming. Most farmers are not required to keep inventories for 

tax purposes, and thus do not capitalize the costs of producing crops.

All of these costs may be deducted in the year when paid. The same is 

generally true of the costs of raising long-lived plants and animals,

such as fruit and nut trees or breeding livestock. The costs of 

acquiring the seedlings or immature animals generally may not be 

deducted, however. The rule allowing a current deduction for most 

production costs originated from a concern that undue recordkeeping

burdens not be imposed on farmers. 

Some farmers are required to capitalize certain production costs. 

Under section 447, certain farming corporations must use an accrual 

method and inventory accounting in computing income, and accordingly

are effectively denied a current deduction for production costs to the 

extent reflected in increased inventory. Section 447 does not apply

to S corporations, corporations that are 50-percent owned by one 

family, or corporations with gross receipts of $1,000,000 or less. 

The provision is also inapplicable to certain corporations that were 

closely held to a requisite extent on October 4, 1976, and were 

engaged in farming on that date. In addition to requiring use of the 

accrual method and inventory accounting for tax purposes, section 441 

requires the preproductive period expenses of raising long-lived

plants and livestock to be capitalized. Preproductive period expenses

are defined as any amount (other than interest and taxes) which is 

attributable to the preproductive period of crops, animals, or any

other property having a crop or yield. In the case of property having

a useful life of more than one year that will have more than one crop

or yield, the preproductive period is the period before the 

disposition of the first marketable crop or yield. In the case of any

other property having a crop or yield, the preproductive period is the 

period before the property is disposed of. 

Farming syndicates engaged in developing a grove, orchard, or 

vineyard in which fruit or nuts are grown must capitalize the expenses

of these activities under section 278(b). Instead of including the 

entire period before the disposition of the first marketable crop, the 

period during which expenses must be capitalized includes only the 

period before the first taxable year in which the grove, orchard, or 

- 200 -
vineyard bears a crop or yield in commercial quantities. Under 

proposed regulations, farming syndicates need not capitalize the 

following expenses: real estate taxes, interest, soil and water 

conservation expenditures that are deductible under section 175, and 

expenditures for clearing land allowable as a deduction under section 

182. 

Under section 278(a), expenses attributable to the development of 

any citrus or almond grove incurred before the close of the fourth 

taxable year beginning with the taxable year in which the trees were 

planted must be capitalized. This provision is not restricted to 

farming syndicates. As under section 278(b), interest, taxes, soil 

and water conservation expenditures, and expenditures for clearing

land need not be capitalized. 

-

Timber. Some costs of producing timber are not deductible when

paid or incurred, but may be recovered only when the timber is sold. 

These include planting costs (site preparation, seed or seedlings,

labor and tool expenses, and depreciation on equipment) and costs of 

silvicultural practices incurred before the seedlings are established. 

All other production costs may be currently deducted, including

carrying costs (such as property taxes), costs of silvicultural 

practices after establishment of the seedlings, costs of disease and 

pest control., fire protection expenses, insurance, and management

costs (including labor and professional costs, costs of materials and 

supplies, and costs of timber cruises for management purposes, but not 

timber cruises in connection with the purchase of timber). 

Capitalization of Construction-Period Interest 

Real property construction-period interest and taxes may not be 

currently deducted, but must be amortized over ten years. If the 

property is sold before all the expenses are recovered, the 

unrecovered expenses are added to basis in determining gain on the 

sale. The provision does not apply to low-income housing, or to 

property that cannot reasonably be expected to be held in a trade or 

business or in an activity condiicted for profit. Construction-period

interest includes any interest expense that could have been avoided if 

construction expenditures had instead been used to repay indebtedness. 

Construction-period interest relating to personal property may be 

deducted currently. 

Reasons for Change 

Current tax rules do not always match taxable receipts and 

deductions relating to production activities. This failure to match 

is of particular concern in the case of production that extends beyond

one taxable year (“multiperiod production”), and becomes more 

significant with longer production periods. The mismatching of 

- 201 -
receipts and expenses permits deductions from these activities to 

offset income from other activities. A large number of tax shelters 

involve the so-called "natural deferral" industries, such as timber,

extractive industries and vineyards. 

Production expenses that relate to income to be produced in future 

periods should be matched with that income by capitalizing the 

production costs. Current tax accounting rules do not require

comprehensive capitalization of costs, Most importantly, the current 

rules do not require the capitalization of interest paid with respect

to the cost of carrying multiperiod production investments to 

completion. When these costs are not capitalized, the producer is 

able to shelter other income by deducting these costs, thus enjoying

tax deferral. 

Different rules regarding which production expenses must be 

capitalized apply to different types of activities. Long-term

contracts, self-constructed assets, and inventories all have different 

capitalization rules. Replacement of the several different income tax 

accounting rules by uniform rules would make the income tax system

more neutral and fairer. 

uniform capitalization rules would also eliminate tax distortions 

across activities. The current rules encourage a business to 

construct its own assets rather than to purchase them even when it is 

not the most efficient producer. The advantage given self-constructed 

assets is evidenced by comparing the basis of property in the hands of 

one who purchases with that of one who self-constructs. A seller 

prices goods by reference to all costs, including those deducted for 

tax purposes, plus a reasonable profit. The tax basis of a purchased

asset, therefore, includes all costs of production, both direct and 

indirect, and these costs are recoverable by the purchaser only when 

sold or through depreciation, amortization, or depletion allowances. 

In contrast, the tax basis of a self-constructed asset includes only

certain direct costs and perhaps a few indirect costs, while all other 

costs are deducted currently. 

In addition to distorting investment decisions, the present rules 

cause serious unfairness. The benefits of tax deferral tend to be 

reflected in the prices of the products produced by multiperiod

processes. Because the value of the tax deferral is related to the 

marginal tax rate of the investor, the attractiveness of these 

activities as tax shelters crowds out low-bracket individuals, as 

"shelter investors' bid-up the costs. Low tax rate individuals find 

they cannot earn a market after-tax rate of return at the price

e stab1ished by 'I she1te r irivesto rs. 

In sum, present law applies incomplete capitalization rules 

nonuniformly to different types of multiperiod production and applies

rules that vary according to whether the output is sold or used in the 

producer's own business. These rules violate the principle of tax 

neutrality and should be modified. 

- 202 -
Proposal 

Capitalization of production costs other than interest. Uniform 

rules for caDitalizins Droduction costs would aDDlV " - - in all cases where

the costs of-producing br constructing real or personal property must 

be capitalized. The following types of production activities would be 

subject to the uniform capitalization rules: 

O the production or manufacture of goods to be held in inventory

or for sale to customers in the ordinary course of business; 

production under a long-term contract; 

the construction or other production of real or tangible

personal property (including improvements to property) having a 

useful life beyond the taxable year, whether such property is 

to be used in the taxpayer's business or held for investment 

("self-constructed assets"); and 

O the growing of timber. 

Special rules, described below, would apply to Federal government and 

cost-plus contracts and to farming. Current-law rules allowing

expensing of certain development costs of oil and gas and other 

mineral property would remain unchanged; indirect costs would,

however, be allocated to such development costs according to the rules 

set forth below. 

The expenses of a particular production activity that would have 

to be capitalized would generally include all direct and indirect 

costs of production, as set forth in the rules applicable to 

extended-period long-term contracts, described in detail above. Major

expenses that would not have to be capitalized as production costs 

include: 

marketing, selling, and advertising expenses; 

research and development expenses unrelated to particular

production activities; 

expenses of unsuccessful bids and proposals; and 

general and administrative expenses other than those properly

allocable to particular production activities. 

General and administrative expenses attributable to certain 

cost-plus and Federal government contracts would have to be 

capitalized. This requirement would apply to all cost-plus contracts 

(i.e. not just contracts with Federal agencies) and to contracts with 

Federal agencies where the contractor is required by statute or 

regulation to submit certified cost data in connection with the award 

- 203 -
of the contract. Federal statutes generally require certified cost 

data to be submitted in connection with contracts the price of which 

is expected to exceed $100,000. This rule does not apply where the 

contract is awarded on the basis of sealed bids; where there is 

adequate price competition; or where the price is an established 

catalog or market price or is set by law. In the case of cost-plus

contracts, only those types of general and administrative expenses

that are reimbursed under the contract would have to be capitalized.

General and administrative expenses required to be capitalized would 

not include marketing, selling, and advertising expenses, research and 

development expenses unrelated to particular contracts, or expenses of 

unsuccessful bids and proposals. 

Special rules would apply to farmers. Except as provided below 

and in Ch. 8.03 (relating to cash accounting), farmers would not be 

required to keep inventories for tax purposes if not currently

required to do so. With respect to preproductive period expenses, the 

rules of section 447 would continue to apply to the taxpayers

currently covered by that provision (except in the case of property

subject to section 278, revised as described below). Section 278,

which deals with the capitalization of the development costs of fruit 

and nut orchards and vineyards, would be revised and extended to apply

generally to any plant or animal, other than animals held for 

slaughter, whose preproductive period was two years or longer. The 

new provision would apply to all taxpayers, not just farming

syndicates. In the case of plants, the preproductive period would 

begin with the time the plant or seed was first planted or acquired by

the taxpayer, and would end with the time that the plant became 

productive or was disposed of. For example, in the case of a taxpayer

developing an orchard, the preproductive period would begin with the 

time the seedlings or saplings were purchased by the taxpayer, and 

would end with the time the tree first bore fruit. In the case of 

animals, the preproductive period would begin at the time of breeding

or embryo implantation (or at the time the taxpayer first acquired the 

animal), and would end when the animal became productive or was 

disposed of. An animal would be treated as productive when ready to 

perform its intended function, for example, when ready to be bred or 

to produce marketable quantities of milk. Animals held for slaughter

would not be subject to these rules. If the preproductive period were 

two or more years long, the preproductive period expenses would have 

to be capitalized. The types of expenses that must be capitalized

would be defined comprehensively as above. However, in lieu of 

capitalizing such expenses, taxpayers would be permitted to use 

inventory valuation methods such as the farm-price or 

unit-livestock-price method. 

Capitalization of construction-period interest. Constructionperiod interest would have to be capitalized in the case of 

self-constructed property with a long useful life, and in the case of 

any property with-a production period of two years or longer. With 

respect to self-constructed property, construction-period interest 

would have to be capitalized if it relates to property included in 

- 204 -
CCRS Class 5, 6, or 7. In determining whether the production period

is two years or longer, the period would generally begin with the 

commencement of construction or production and end with the time when 

the property is ready to be placed in service or held for sale. ~n 

the case of property produced under a long-term contract, the 

production period would end with contract completion. Interest 

attributable to the raising of plants or animals with a preproductive

period of two years or longer would also have to be capitalized. The 

interest capitalization rule, however, would not apply to 

self-constructed assets to be used by the taxpayer for personal

purposes (such as residential real estate). 

Construction-period interest would be defined as any interest 

expense of the taxpayer that would have been avoided if production or 

construction expenditures had been used to repay indebtedness. 

Production or construction expenditures would be defined as equal to 

the cumulative production costs required to be capitalized. In 

effect, as under current-law rules defining construction-period

interest, the taxpayer's interest cost would be deemed first allocable 

to production or construction activities. Indebtedness incurred 

specifically to finance construction would first be allocated to such 

construction. If construction-period expenditures exceed the amount 

of debt so allocated, interest on other debt of the taxpayer in the 

amount of such excess would be treated as construction-period

interest. Where the taxpayer has outstanding debt with different 

rates of interest, the construction-period interest (other than 

interest specifically allocated to construction) would be computed

according to the average interest rate on the taxpayer's debt. 

Appropriate related-party rules would be provided. 

A customer of a contractor making progress payments or advance 

payments would be treated as, self-constructing the property tinder 

construction by the contractor to the extent of such payments. Thus,

payments and other advances by a customer would be treated as the 

customer's construction or production expenditures, and the 

contractor's construction or production expenditures would be reduced 

to this extent. The customer would have to capitalize interest 

attributable to such payments if the constructed property were in CCRS 

Class 5, 6, or 7, or if the construction period were two years or 

longer. To the extent of such advances by the customer, the 

contractor would not be treated as having incurred construction 

expenses, and would accordingly not have to capitalize

construction-period interest. The contractor would have to capitalize

construction-period interest on only the excess, if any, of its 

accumulated contract costs over the accumulated advances or progress

payments it received. 

In cases where interest is required to be capitalized, the 

interest would be added to the basis of the property being

constructed. The basis of such property would be eligible for 

indexing, under rules similar to those set forth in Chapter 7.01,

during the production period and thereafter. In the case of a 

- 205 -
contractor, contract costs up to the amount of advance payments made 

by the customer would not be eligible for indexing as far as the 

contractor is concerned, but would be treated as self-construction by

the customer and eligible for indexing in the customer's hands. 

Effective Date 

Except as provided below, the proposed rules concerning production

cost accounting and the capitalization of interest would be effective 

generally for costs and interest expense paid or incurred on or after 

January 1, 1986. The new rules would not apply to long-term contracts 

entered into before 1986. Production costs (including interest)

attributable to timber that was planted before 1986 that are not 

required to be capitalized under present law would have to be 

capitalized under a ten-year phase-in. Thus, 10 percent of such costs 

paid or incurred in 1986 and 20 percent of such costs paid or incurred 

in 1987, etc., would have to be capitalized, until 100 percent was 

capitalized in 1995. 

With respect to inventories, the new rules would apply for the 

taxpayer's first taxable year beginning on or after January 1, 1986. 

In Order to minimize large distortions in taxable income, taxpayers

subject to the new inventory cost accounting rules would be allowed to 

spread the adjustment that results from changing to the new method of 

accounting for production costs ratably over a period not to exceed 

six taxable years. This spread is in accordance with the usual rules 

for a change in method of accounting initiated by the taxpayer and 

approved by the Internal Revenue Service. 

Finally, the new rules would not apply to self-constructed assets 

where substantial construction had begun before 1986. 

Analysis 

Capitalization of production costs means that instead of being

currently deductible, the costs are recovered when the produced

property is sold or through depreciation, amortization or depletion

deductions as the property is used in the taxpayer's business. When 

capital costs are not capitalized, deductible expenses are accelerated 

instead of being matched with the receipt of the taxable income they

serve to produce. The acceleration of expenses allows other income to 

be sheltered by the deductions, and taxable income is correspondingly

deferred until later years. The deferral of tax liability in this 

manner is the equivalent of the taxpayer receiving a subsidy, in the 

form of an interest-free loan from the Federal government. 

Interest expense is a significant component of long-term

production costs that generally is not required to be capitalized

under current law. Because interest expense is a small portion of the 

total expenses incurred in short-term production activity, the 

- 206 -
proposal would generally require capitalization of interest only where 

production takes several years. Interest incurred in relatively

short-term production of long-lived self-constructed assets would have 

to be capitalized, however, since a current deduction for such costs 

significantly accelerates deductions in comparison with 

capitalization. Because money is fungible, it is necessary to make 

certain assumptions as to the amount of interest attributable to 

production activities. Under the proposal, any debt outstanding would 

be attributed first to construction costs associated with the 

long-term production activity. The same rule applies in defining

construction-period interest under current law. 

Uniform rules for the capitalization of production costs would 

make the tax code more neutral in its application to various business 

activities. Uniform rules would also place all long-term production

activities on a consistent tax accounting basis, and reduce 

tax-induced distortions in constructing and acquiring capital assets. 

Special rules would recognize the special circumstances of certain 

industries. Thus, the current rules that do not require farmers to 

use inventories in computing income with respect to most CKOPS would 

be retained, except as provided in Ch. 6.03, so as not to impose an 

undue recordkeeping burden. In the case of certain plants and animals 

that take a long time to mature, however, production costs would have 

to be capitalized, to avoid a significant deferral of tax liability. 

The special rule requiring certain Federal contractors and 

cost-plus contractors to capitalize general and administrative 

expenses is appropriate because these contractors are paid for such 

overhead costs as part of the contract price. While it is generally

not an easy matter to determine what portion of business overhead is 

properly allocable to a contract, the determination is not difficult 

where a contractor directly bills the customer for the overhead or 

relies on the allocated overhead in setting the contract price.

Current law allows such contractors to be paid for overhead costs 

under the contract, but to treat such costs for tax purposes as period

costs unrelated to the contract. Allowance of a current deduction for 

such costs defers tax by allowing a deduction in advance of 

recognition of the income to which it relates. The proposal would put

Federal tax accounting on a consistent basis with contract cost 

accounting. The generosity of current accounting rules effectively

subsidizes Federal government contracts, causing the actual cost of 

such contracts to the government to be understated. The budgetary

process would be improved if this subsidy were removed and the full 

costs reflected in government outlays. 

- 207 -
RECOGNIZE GAIN ON PLEDGES OF INSTALLHENT OBLIGATIONS 

General Explanation 

Chapter 8.02 

Current Law 

Income from an installment sale is reported as payments are 

received, rather than in the year of sale, unless the taxpayer elects 

otherwise. In general, an installment sale is a disposition of 

property where at least one payment is to be received after the close 

of the taxable year in which the disposition occurs. The gain

recognized for any taxable year is the proportion of the installment 

payments received in that year which the gross profit to be realized 

when payment is completed bears to the total contract price ("gross

profit ratio"). In general, the total contract price is the principal

amount that will be paid to the seller. Treasury regulations provide

analogous rules for installment method reporting by dealers in 

personal property. 

Any indebtedness assumed by the buyer which is not "qualifying

indebtedness" is treated as a payment in the year of sale or 

disposition. Qualifying indebtedness is treated as a payment in the 

year of sale only to the extent that it exceeds the seller's basis in 

the property. The term qualifying indebtedness means (1) a mortgage

or other indebtedness encumbering the property, and (2) indebtedness 

incurred or assumed by the seller incident to the seller's 

akuisition, holding, or operation of the property in the ordinary

course of business or investment. 

If the seller disposes of an installment obligation, the tax that 

has been deferred on the installment sale generally becomes due. 

However, if a taxpayer pledges an installment obligation as collateral 

for a loan, he may, under some circumstances, continue to defer his 

tax on the sale. 

Reasons for Change 

The installment method was intended to alleviate liquidity

problems that might arise if a taxpayer was required to pay tax on a 

sale when he had not received all or a portion of the sales proceeds.

Nevertheless, under certain circumstances current law permits a 

taxpayer to defer his tax liability on an installment sale even though

he has obtained cash by using the installment note as collateral for a 

loan. Ffr example, assume that a taxpayer sells property for 

$100,000, payable in ten years with market-rate interest payable

annually, and pledges the note as collateral for a loan of $90,000

from a bank. The interest payments received from the buyer on the 

installment obligation provide the taxpayer with funds to make 

- 208 -
interest payments on the $90,000 loan from the bank. Although the 

taxpayer has the use of $90,000 for ten years, current law permits him 

to defer tax on his gain from the sale until receipt of payment from 

the buyer in ten years. Moreover, such deferral may be permitted even 

if the buyer's note is secured by a bank letter of credit, so that the 

transaction is essentially riskless for the seller. In such 

circumstances, the taxpayer obtains the benefit of the profit element 

on the sale and has sufficient cash to pay the tax liability. There 

is no reason to permit such a taxpayer to continue to defer tax 

liability on the sale. 

If instead of pledging the installment note after the sale of the 

property, the taxpayer had pledged the property for a loan prior to 

the sale and the buyer had assumed the taxpayer's indebtedness, the 

amount of the indebtedness (in the case of qualifying indebtedness,

the excess over basis) would have been treated as a payment in the 

year of sale. Similar rules should apply regardless of whether the 

indebtedness is incurred before or after the sale. 

Proposal 

In general, the pledge of an installment obligation as security

for a loan would cause recognition of all or a portion of the gain

remaining to be recognized by the taxpayer with respect to the 

recognition of such gain: 

installment obligation. The following rules would control the

In the case of an amount borrowed in the 

ordinary course of business and secured by an installment obligation

received for the sale of property held by the taxpayer primarily for 

sale to customers within the ordinary course of business, gain on the 

installment obligation would be recognized to the extent of the excess 

of the amount borrowed over the basis of the obligation. In all other 

cases, gain on the installment obligation would be recognized to the 

extent of the amount borrowed (and secured by the installment 

obligation) multiplied by the gross profit ratio. Gain from an 

installment obligation which, but for this rule, would be recognized

on subsequent payments on the obligation would be offset against the 

gain generated by the use of the installment obligation as security

for indebtedness. Thus, in no case would the aggregate gain

recognized by the taxpayer with respect to the installment obligation

exceed the taxpayer's gross profit with respect to the installment 

obligation. 

Exceptions would be provided for: an installment obligation which 

by its terms requires payment in full within a period not exceeding

one year and which is received for the sale of property held by the 

taxpayer primarily for sale to customers in the ordinary course of 

business; a revolving credit plan which, by its terms and conditions,

contemplates that all charges for each sale will be paid within a 

period not exceeding one year from the date of purchase; any

indebtedness which by its terms requires payment in full within a 

period not exceeding 90 days from the date of issue, and which is not 

renewed or continued; and certain indebtedness owed to a financial 

institution and secured by a general lien on all of the borrower's 

- 209 -

476-698 0 - 85 - 9 
trade or business assets. The general lien exception would not apply

to a case, such as a financing subsidiary, where substantially all the 

borrower's assets are installment obligations. 

Effective Date 

The proposal would be effective for installment obligations

pledged as security on or after January 1, 1986. In addition, any

indebtedness outstanding on January 1, 1991 which is secured by an 

installment obligation which was pledged as collateral prior to 

January 1, 1986 would be treated as if the installment obligation was 

pledged on January 1, 1991. 

Analysis 

As shown in Table 1, the deferral of tax liability under the 

installment method can substantially reduce a taxpayer's effective tax 

rate. For example, when interest rates are eight percent, the 

deferral of tax for ten years by a taxpayer with a marginal tax rate 

of 50 percent reduces the effective tax rate to 23 percent. 111 

effect, under the installment method, the Federal government makes an 

interest-free loan to the taxpayer of the tax that otherwise would be 

due in the year of sale. The benefit of tax deferral under the 

installment method would be denied to taxpayers who have obtained cash 

by pledging an installment obligation. 

In recent years, builders of commercial and residential real 

estate and sellers of equipment have issued bonds and debentures 

secured by their installment receivables. The volume of such 

borrowing by home builders alone has grown rapidly and is estimated to 

have exceeded $5 billion in 1984. The proposal would somewhat reduce 

the tax benefits of such transactions. To the extent that the 

proceeds from the bond or debenture exceed the taxpayer's basis in the 

installment obligations used as security, the taxpayer would recognize

deferred gain from the installment sales. In such cases, the 

borrowing represents enjoyment of the profit element from the 

installment sales and should trigger recognition of income. 

Certain dealers in personal property also have taken advantage of 

the ability to borrow against installment receivables by employing a 

single-purpose financing subsidiary, which has few assets other than 

installment obligations and incurs debt secured by a general lien on 

its assets. These transactions would be affected by the proposal

unless they are within the exception for installment obligations with 

a term of one year or less, or the exception for certain revolving

credit plans. 

Finally, individual taxpayers have used installment obligations as 

security for indebtedness incurred for personal expenses. The 

proposal would eliminate the tax benefits of such transactions. 

- 210 -
Table 8.02-1 

Effective Tax Rate Per Dollar of Income Deferred by a 

50 Percent Taxpayer

-

for Different Deferral Periods and Interest Rates 

Deferral Period (in years)

Interest Rate I 1 3 I 5 I 10 I 20 I 30 

4 percent 48.1 44.4 41.1 33.8 22.8 15.4 

6 percent 41.2 41.0 37.4 27.9 15.6 8.7 

8 percent 46.3 39.7 34.0 23.2 10.7 5.0 

10 percent 45.4 31.6 31.0 19.3 7.4 2.9 

12 percent 44.6 35.6 28.4 16.1 5.2 1.7 

Office of the Secretary of the Treasury May 28, 1985 

- 211 -
-- 

LIHIT USE OF CASE HETEOD OF ACCOUNTING 

General Explanation 

Chapter 8.03 

Current Law 

The Internal Revenue Code provides for the following permissible

methods of accounting: (1) the cash receipts and disbursements method 

("cash method"), (2) an accrual method, or (3) any other method or 

combination of methods permitted under Treasury regulations. A 

taxpayer is entitled to adopt any one of the permissible methods for 

each separate trade or business of the taxpayer, provided that the 

method selected clearly reflects the taxpayer's income from such trade 

or business. A method of accounting that reflects the consistent 

application of generally accepted accounting principles ordinarily is 

considered to clearly reflect income. 

The cash method of accounting generally requires an item to be 

included in income when actually or constructively received and 

permits a deduction for an expense when paid. In contrast, the 

principles of the accrual method of accounting generally require that 

an item be included in income when a11 the events have occurred which 

fix the right to its receipt and its amount can be determined with 

reasonable accuracy. Similarly, a deduction is allowed to an accrual 

basis taxpayer when all events have occurred which determine the fact 

of liability for payment, the amount of the liability can be 

determined with reasonable accuracy, and the economic performance that 

establishes the liability has occurred. 

In general, taxpayers that are required to use inventories for a 

particular trade or business (other than farming) must use an accrual 

method of accounting for their purchases and sales. A taxpayer is 

required to use inventories in all cases in which the production,

purchase, or sale of merchandise is an income-producing factor. Any

other permissible method of accounting (including the cash method) may

be used for other purposes in that trade or business or for other 

trades OK businesses of the taxpayer. 

A person engaged in the trade or business of farming generally may

use the cash method of accounting for such business even though the 

farming business may involve the production and sale of goods. Use of 

the accrual method is required, however, for a corporation (other than 

S corporations and certain family-owned corporations) engaged in the 

trade or business of farming (or a partnership engaged in the trade or 

business of farming that has a corporation as a partner) that has 

gross receipts of more than $1 million in any taxable year beginning

after December 31, 1975. 

212 -
Reason for Change 

The cash method of accounting frequently fails to reflect the 

economic results of a taxpayer's business over a taxable year. The 

cash method simply reflects actual cash receipts and disbursements,

which need not be related to economic income. Obligations to pay and 

rights to receive payment are disregarded under the cash method, even 

though they directly bear on whether the business has generated an 

economic profit or a loss. Because of its inadequacies, the cash 

method of accounting is not considered to be in accord with generally

accepted accounting principles and, therefore, is not permissible for 

financial accounting purposes. 

The relative simplicity of the cash method justifies its use for 

tax purposes by smaller, less sophisticated businesses, for which 

accrual accounting may be burdensome. Current law, however, permits

many taxpayers that already use an accrual method for financial 

accounting purposes to use the cash method for tax purposes. 

The cash method also produces a mismatching of income and 

deductions where the taxpayer engages in transactions with parties

that employ a different method of accounting. For example, an accrual 

method taxpayer may deduct certain liabilities as incurred (even

though not yet billed), such as liabilities for certain services 

rendered, even though the service provider on the cash method may

defer reporting income until the amount is billed and cash payment

thereon is made. 

Proposal 

A taxpayer would not be permitted to use the cash method of 

accounting for a trade or business unless it satisfied both of the 

following conditions: (1) the business has average (determined on a 

3-year moving average basis) annual gross receipts of $5 million or 

less (taking into account appropriate aggregation rules); and (2) with 

respect to a trade or business other than farming, no other method of 

accounting has been used regularly to ascertain the income, profit, or 

loss of the business for the purpose of reports or statements to 

shareholders, partners, other proprietors, beneficiaries or for credit 

purposes. Consideration will also be given to taking into account the 

billing of clients for services in the use of the accrual method. 

The above conditions would apply in addition to the current law 

limitation on use of the cash method with respect to a trade or 

business in which inventory accounting is required. The current rules 

requiring certain corporations to use accrual accounting for the trade 

or business of farming would also remain in effect in addition to the 

above rules. 

"_ 213 -
Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. In order to minimize large distortions in the 

taxable income of taxpayers who are required to change from the cash 

to the accrual method, the administrative rules generally applicable

to changes in methods of accounting initiated by the taxpayer and 

approved by the Internal Revenue Service would be applied.

Accordingly, taxpayers affected by the proposal would be allowed to 

spread the adjustment that results from the difference between the use 

of the cash and accrual methods of accounting ratably over a period

not to exceed six taxable years. 

Analysis 

The proposed restriction on the use of the cash method of 

accounting would affect only a small percentage of firms. In 981,

approximately 103,000 corporations (eight percent of all 

corporations), 4,000 partnerships (one percent of all partnerships),

and 1,800 sole proprietorships (including about 300 farmers) (less

than one percent of all sole proprietorships) had receipts greater

than the proposed $5 million limitation. Some of these businesses 

already use the accrual method of accounting for tax purposes.

Accurate measurement of the income of these large firms is important

to the integrity of the tax system, since they account for a 

significant share of business receipts. 

The proposal would affect only businesses that are already using

an accrual method of accounting in some part of their business 01 are 

sufficiently large to have access to professional accounting

expertise. The primary industries that would be affected by the 

proposal would be banks that use an accrual method of accounting for 

financial reporting and large service organizations, such as 

accounting, law and advertising firms. 

The virtue of the cash method's simplicity would be retained for 

those businesses, such as small farmers, that might be unduly burdened 

by a requirement that they use accrual accounting. 

- 214 -
he IIP 

REPEAL RESERVE METHOD FOR 

BAD DEBT DEDUCTIONS 

General Explanation 

Chapter 8.04 

Current Law 

Taxpavers - _ may deduct a business bad debt in ..- 1 - r in which it 

becomes worthless or, in the case of partially worthless debts, in the 

year in which part of the debt is charged off. In lieu of deducting

specific bad debts, both cash and accrual method taxpayers may create 

a bad debt reserve for the obligations created or acquired in the 

course of a trade or business and held by the taxpayer at the close of 

the taxable year. In any year, the taxpayer may deduct an addition to 

the reserve sufficient to bring it to a reasonable level. The purpose

of the reasonable reserve is to estimate the portion of the 

obligations held by the taxpayer at year-end that will become 

uncollectible in the future. Debts that become worthless during the 

year are charged against the reserve. This charge reduces the reserve 

and hence increases the amount that must be added to the reserve to 

restore it to an appropriate level. The deduction for additions to a 

bad debt reserve effectively allows a deduction for debts that become 

worthless during the year plus a deduction for future bad debts 

(attributable to the increase in the amount of receivables held at 

year-end). 

A dealer in property may deduct a reasonable addition to a reserve 

for bad debts relating to its liability as a guarantor of debt 

obligations arising out of the sale by the taxpayer of property in the 

ordinary course of its trade or business. In the case of certain 

taxpayers who were in existence in ,1965, a suspense account 

arrangement prevents allowance of a double deduction by reason of a 

change in law which took place at that time. 

Special rules govern the tax treatment of bad debts of depository

institutions; these rules are dealt with in Ch. 10.01. 

Reasons for Change 

The reserve method for bad debt deductions allows taxpayers to 

deduct the bad debt losses in the current year and to deduct any net 

increase in the reserve. The deduction for the increase in the 

reserve represents a deduction for estimated future loan losses 

arising from an increase in the level of receivables on hand, without 

any discount for the present value of such losses. Moreover, the 

formula used to estimate such losses bears no necessary relationship

to the future losses. The accelerated deduction for future losses 

defers taxable income and thereby reduces the effective tax rate of a 

business which experiences an increasing bad debt reserve. 

- 215 -
In addition to distorting the timing of taxable income, the 

reserve method of accounting for bad debt deductions discriminates in 

favor of firms with growing accounts receivable or worsening loss 

experiences. In contrast, firms that have improved loss experiences

or declining loan portfolios will be taxed on the deferred taxable 

income. 

Finally, the preferential tax treatment of bad debt reserves 

reduces the effective tax rate on the compensation earned by lenders 

for bearing the risk of loan default and enables lenders to lower the 

risk premium charged. Thus, the tax system encourages lenders to make 

risky loans. By lowering the interest rate charged on risky loans,

the preferential tax treatment also distorts the choice between debt 

and equity financing for projects involving some risk of default. 

Proposal 

The deduction for a reasonable addition to a reserve for bad debts 

would be repealed, although taxpayers would continue to be entitled to 

a deduction for debts that become worthless or are partially charged

off. This proposal would also apply to the bad debts of financial 

institutions governed by Subchapter H. 

The deduction for bad debts that become worthless would be 

conformed to the deduction for partially worthless debts. Thus, a 

deduction would not be allowed until a debt is charged off in whole or 

in part. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 111 order to prevent a double deduction for 

debts that become partially or wholly worthless after the effective 

date, a taxpayer's outstanding bad debt reserve at the close of the 

taxable year prior to the effective date would be includable in income 

ratably over a 10-year period. 

Analysis 

Taxpayers are generally not allowed to deduct future liabilities 

or losses until they occur. Because no market transaction occurs to 

fix the amount and timing of the loss for worthless or partially

worthless debts, the most accurate method to determine the appropriate

deduction for bad debts in a taxable year is to judge the loss that 

has occurred by examining the loan portfolio at the close of the year,

based on all the facts known at that time. 

In the contrast, any reserve system, even one based on generally

accepted accounting principles, is based to some degree on 

expectations as to future losses. Such an ex ante approach would be 

inconsistent with the general principle that only realized losses are 

deductible. If reserves for future losses were allowed, a neutral tax 

- 216 -
-- 

-- 

reserve system would limit the deduction to the estimated present

value of the future loss. Such a system would also require any

divergences from the assumptions used in the present value calculation 

to be corrected. An accurate reserve system is not proposed because 

of the extreme administrative complexity that it would entail. 

To illustrate the deferral allowed by the current reserve system,

suppose a new firm, shown in Table 1, begins with $1,000 of accounts 

receivable and in the first year has $10 of bad debts (an experience

rate of one percent). Under a reserve system where the allowable 

reserve equals the current year losses, the firm establishes a 

year-end reserve of $10. The allowable first year bad debt deduction 

is $20 $10 of actual losses plus $10 for the increase in the 

allowable reserve. As long as the firm’s loss experience does not 

improve and its level of receivables does not decrease, the excess 

deduction is deferred indefinitely. If the firm prospers and accounts 

receivable increase in year two to $1,500 with the same loss 

experience rate of one percent, the allowable reserve increases to $15 

and the company deducts $20 $5 more than the actual loan losses. 

In year three, if loans remain the same but the loss experience

worsens to two percent, the company can deduct $45. Finally, if in 

the fourth year the company experiences a decrease in accounts 

receivable, its bad debt deduction is less than the loan losses that 

actually occurred. A net decrease in the bad debt reserve effectively

brings excess deductions back into taxable income, thereby ending tax 

deferral on that amount. Table 1 in Ch. 8.02 shows the reduction in 

effective tax rate due to tax deferral for given deferral periods and 

interest rates. 

Table 2 shows the discrepancy between bad debt deductions and 

actual loan losses due to the reserve method. The overstatement of 

losses and the amount of tax deferral depends on the growth rate of 

loans and the change in the loss experience rate. Credit growth over 

the past 10 years for domestic non-financial corporations was in 

excess of 20 percent annually. The change in the loss experience rate 

is not known, and is probably cyclical. Yet even with a constant loss 

rate, bad debt deductions overstated aggregate actual loan losses by

10 percent annually. 

The modification of the rule governing when a worthless bad debt 

may be deducted would give taxpayers flexibility and would avoid 

penalizing them for failing to deduct a bad debt in the year in which 

it became worthless. 

- 211 -
Table 8.04-1 

Hypothetical Example of Excess Deductions with Reserve Hethod 

I 

1 I 2 

YearI 3 I 4 

LOSS experience rate (percent) 1.0 1.0 2.0 2.0 

Total loans or receivables $1,000 $1,500 $1,500 $1,000 

Actual Losses 10 - 15 30 20 

Beginning reserve 0 10 15 30 

End reserve 10 15 30 20 

Change in reserve 10 5 15 -10 

Bad debt deduction [Losses 

plus change in reserve] 20 20 45 10

Excess deduction [Deduction 

minus actual losses] 10 5 15 -1 0

Accumulated excess deductions 10 15 30 20 

o p May , s 

- 218 -
Table 8.04-2 

Discrepancy Between Reserve Deductions 1/ and Actual Bad

Debt Losses By Change in Total Loans ana boss Experience 

(In Percent) 

Annual 

Experience 

-5 -11.2 -4.9 -0.2 3.3 6.0 8.0 

0 -4.9 0.0 3.6 6.3 0.4 10.0 

+5 -0.2 3.6 6.4 8.6 10.2 11.4 

+10 3.3 6.3 8.6 10.2 11.5 12.5 

+15 6.0 8.4 10.2 11.5 12.5 13.3 

Percentage I 

I 

Annual Percentage Change in Total Loans 

Change in Loss I -5 I 

0 

I

I +5 I

I 

+10 I

I 

+15 

I

I +20 

-1/ Assumes a six-year moving average experience method reserve.

Shorter periods increase the discrepancy. 

- 219 -
REPEAL HIIQING PLWlD SOLID WASTE RECLAHATION 

AND CLOSING COST DEDUCTION 

General Explanation 

Chapter 8.05 

Current Law 

Expenses that will be incurred in the future cannot generally be 

deducted currently, even if the existence of the liability can be 

established with certainty. As a general rule, taxpayers using the 

cash method of accounting may deduct future expenses only when payment

is made. Taxpayers using the accrual method of accounting generally 

may deduct future expenses only when the economic performance OK 

activity giving rise to the expense has occurred. However, pursuant

to a statutory exception to the economic performance requirement,

taxpayers may take current deductions associated with certain mining

and solid waste disposal site reclamation and closing costs. The 

amount that may be deducted in any year generally is the estimated 

future reclamation or closing costs attributable to production or 

mining activity during the taxable year. The estimate must be made on 

the basis of reclamation and closing cost prices prevailing in the 

taxable year. To obtain the deduction, no amount need be placed into 

a fund, but deducted amounts are added to a bookkeeping reserve 

maintained for tax purposes. In addition, interest on the additions 

to the reserve must be added to the reserve each year at a rate 

specified in the statute. When reclamation or closing occurs, the 

balance in the reserve is compared to the actual cost of closing or 

reclamation. If the total amount in the reserve, including interest,

exceeds the reclamation or closing costs, further deductions are not 

allowed and the excess must be included in income. Amounts spent on 

reclamation or closing costs are charged against the reserve, and are 

deductible only to the extent the reserve is exhausted. 

Expenses subject to the above rules include generally any 

expenses for land reclamation OK closing activity pursuant to a 

reclamation plan under the Surface Mining Control and Reclamation Act 

of 1977 or similar law. Also included are expenses incurred for any

land reclamation or closing activity in connection with any solid 

waste disposal site conducted in accordance with the Solid Waste 

Disposal Act or other similar law. Expenses attributable to property

which is disturbed after being listed in the national contingency plan

established under the Comprehensive EnViKOnIWntal, Compensation, and 

Liability Act of 1980 are not, however, included. 

Reasons for Change 

The special rules for strip mining and waste disposal closing and 

reclamation costs allow a current deduction for future costs without 

recognition of the fact that economic performance will occur, and the 

- 229 -
cost will be paid, in the future. The requirements to increase the 

reserve by an interest charge and to recapture reserves limit the 

extent to which the present value of the reserve is overstated. 

Nevertheless, the deduction generally is overstated in real terms and 

results in a reduced effective tax rate for those companies that find 

the special tax treatment to be advantageous for them. 

The preferential, tax treatment reduces the production costs of 

companies engaged in surface mining and companies generating solid 

waste. By reducing the costs of the products of these companies, the 

tax system encourages production processes that cause environmental 

damage. Regulations already in place require the environmental damage

to be corrected. The tax system should not be employed to subsidize 

the costs of compliance. Such costs generally should be borne 

(through higher product prices) by the users of the products whose 

production damages the environment, rather than by a1.1 taxpayers. If 

it is determined that certain of these costs are of such societal 

importance as to justify a Federal subsidy, that subsidy should be 

provided through the appropriations process, not the tax system. 

The current reserve system is substantially more complicated than 

a system requiring deduction of the future expenses when they occur. 

Future expenses must be estimated; records must be kept of previously

deducted amounts; interest must be imputed on this amount on a 

cumulative basis; and excess amounts in the account must be 

recaptured, requiring a re-estimate of future costs each year.

Further, as reclamation or closing costs are incurred, the costs must 

be allocated to particular properties, since reclamation and closing 

can be taking place on several sites at the same time. 

Proposal 

The special rules for mining and solid waste disposal reclamation 

and closing costs would be repealed. Accordingly, such costs would 

generally be deductible only as the sites were closed or the land 

reclaimed. 

Effective Date 

The proposal would be effective for mining or production activity

occurring on or after January 1, 1986. 

- 221 -
Analysis 

The proposal would eliminate the indirect Federal subsidy for 

mining and solid waste reclamation and disposal costs. Under existing

law, companies are allowed to accelerate deductions for future 

expenses, thus reducing their effective tax rates through tax 

deferral. This preferential tax treatment reduces the costs of 

companies incurring such expenses. The elimination of the tax 

preference can be expected to raise by a small amount the price of the 

affected products, which for the most part involve production 

processes that cause environmental damage. A small shift in 

consumption away from such products would result. 

- 222 -
CHAPTER 9 

REVISE TAXATION OF ENERGY AND NATURAL RESOURCES 

The tax law has long been used to subsidize the exploration,

development and production of natural resources. Whil,e subsidies for 

particular activities generally lead to inefficiencies and misdirect 

investment capital, the subsidies applied to national resource 

development have also been important in maintaining a viable domestic 

energy industry. Accordingly, these subsidies would be modified under 

the Administration proposals in order to establish greater neutrality

in the taxation of various commercial activities, while retaining

those incentives believed necessary to maintain exploration and 

development of domestic mineral resources. 

- 223 -
REPEAL ENERGY TAX CREDITS 

General Explanation 

Chapter 9-01 

Current Law 

A. Business Energy Tax Incentives 

Special tax credits are available for business firms to encourage

investments in conservation and renewable energy technologies and to 

encourage production of alternative fuels. These incentives can be 

grouped into three major categories: 

1. Energy Investment Tax Credits. Solar, wind, geothermal

property and ocean thermal property qualify for a 15 percent energy

investment tax credit. Certain hydroelectric generating property

qualifies for an 11 percent credit. Qualified intercity buses and 

biomass property are eligible for a ten percent energy credit. These 

energy credits terminate on December 31, 1985. 

A ten percent energy investment tax credit was available for 

certain other types of energy property but this credit generally

expired on December 31, 1982. However, if such energy property

qualifies under "affirmative commitment" rules, the credit continues 

to be available until December 31, 1990. Under these rules, projects

requiring two or more years for completion will continue to be 

eligible if (a) all engineering studies were completed and all 

necessary permits filed before January 1, 1983, (b) binding contracts 

for 50 percent of specially designed equipment are entered into before 

1986, and (c) the project is completed and placed in service before 

1991. In addition, in the case of hydroelectric generating property,

the credit is available through December 31, 1988, if an application

has been filed with the Federal Energy Regulatory Commission before 

January 1, 1986. 

2. Production Tax Credits. A credit of up to $3 per barrel of oil 

equivalent is available for certain qualifying fuels. In general,

the credit is available for qualifying fuels produced from facilities 

placed in service after December 31, 1979, and before January 1, 1990,

and sold after December 31, 1979, and before January 1, 2001. The 

credit phases out as the average wellhead price of domestic crude oil 

rises from $23.50 to $29.50 per barrel. The maximum credit and the 

phaseout range are adjusted for inflation. Qualifying fuels include 

(a) oil produced from shale and tar sands, (b) gas produced from 

geopressured brine, Devonian shale, coal seams, a tight formation, or 

biomass, (c) synthetic fuels produced from coal, (d) fuel from 

qualified processed wood, and (e) steam from solid agricultural

byproducts. 

- 224 -
3. Alcohol Fuels Credit and Excise Tax Exemptions. 

a) Alcohol fuels mixtures. Present law provides a six cents 

per gallon exemption from the nine cents excise tax on gasoline and a 

similar six cents per gallon exemption from the 15 cents diesel fuel 

excise tax if the taxable products are blended in a mixture with at 

least ten percent alcohol ("gasohol"). The term alcohol is defined to 

include only alcohol derived from a source other than petroleum,

natural gas, or coal (including lignite). The provision terminates 

after December 31, 1992. 

b) Alcohol fuels. Present law provides a nine cents per

gallon exemption from the excise tax on special motor fuels for a fuel 

consisting of at least 85 percent alcohol derived from a source other 

than petroleum or natural gas and a four and one-half cents per gallon

exemption if the source is natural gas. The provision terminates 

after December 31, 1992. 

c) Alcohol production credit. A 60 cents per gallon income 

tax credit is provided for alcohol used in gasohol mixtures with 

gasoline, diesel fuel, and special motor fuels. A like credit is 

allowed for alcohol used as a fuel other than in a qualified fuels 

mixture. A lesser credit of 45 cents per gallon is provided for 

alcohol of at least 150 proof but less than 190 proof. The term 

alcohol is defined to include only alcohol derived from a source other 

than petroleum, natural gas, or coal (including lignite). This credit 

terminates on December 31, 1992, and may be carried forward for 15 

years, but not to a tax year beginning after December 31, 1994. If a 

production credit is claimed with respect to alcohol, the exemption

from the gasoline and special fuels excise taxes is not allowed. 

d) Taxicabs refund. A four cents per gallon exemption from 

the excise tax on gasoline, diesel fuel and special motor fuels is 

provided if used in certain taxicabs that are rated at above-average

fuel economy. The exemption expires on September 30, 1985. 

B. Residential Energy Tax Credits 

Under current law there are two categories of residential energy

tax credits: 

1. Conservation credits. A 15 percent credit is available to 

individuals for the first $2,000 of expenditures for certain energy

conservation equipment, such as insulation or storm windows and doors,

for a maximum credit of $300. 

2. Renewable energy credits. A 40 percent credit is available to 

individuals for the first $lO,OO0 of expenditures for solar, wind or 

geothermal energy property, for a maximum credit of $4,000. 

To be eligible for the residential energy tax credits,

expenditures must be with respect to the taxpayer's principal

residence. In the case of the residential conservation credits the 

- 225 -
residence must have been in use before April 20, 1978. The credits 

expire on December 31, 1985. unused credits may be carried over 

through 1987. 

Reasons for Change 

Congress enacted the energy credits because oil and gas price

controls understated the replacement cost of energy. Because of price

controls, consumers did not have the incentive to invest in energy

conservation and alternative fuels. The absence of free-market prices

created an economic rationale for energy tax incentives. Since these 

incentives were enacted, however, crude oil prices have been 

decontrolled and natural gas prices are being decontrolled. As a 

result, these tax credits are no longer needed. 

Proposal 

The energy tax incentives would be allowed to expire or would be 

terminated on December 31, 1985. 

Effective Dates 

A. Business Energy Tax Incentives 

1. Renewable Energy Investment Tax Credits. All renewable energy

investment tax credits would be allowed to terminate on December 31,

1985. Unused credits may be carried forward or backward. However,

for hydroelectric generating property the present law affirmative 

commitment rules will continue to apply. 

2. Energy Investment Tax Credits. All conservation and other 

alternative source energy investment tax credits would terminate on 

December 31, 1985. However, present law affirmative commitment rules 

would continue to apply. 

3. Production Tax Credits. All production tax credits would 

terminate on December 31, 1985. However, elisible fuel produced from 

a well drilled, or from facilities completed,-before JanGary 1, 1986,

and sold before January 1, 1990, would continue to be eligible for the 

credit. 

4. Alcohol Fuels Credit and Excise Tax Exemptions. The credit for 

alcohol fuels would be available for eligible alcohol fuels produced

from facilities completed before JanUaKV 1, 1986, and sold before 

January 1, 1993. Ail excise tax exemptions would terminate on 

December 31, 1985. The qualified taxicab refund that is scheduled to 

terminate on September 30, 1985, would not be renewed. 

B. Residential Energy Tax Credits. 

The residential energy tax credits would be allowed to expire on 

December 31, 1985, and would not be renewed. Carryovers of unused 

credits would continue to be available through 1987 as under current 

law. 

- 226 -
Analysis 

The energy tax credits implement questionable energy policies.

Subsidies provided for alternative fuels, for example, are 

significantly in excess of the price that should be paid for 

replacement of crude oil. With an alcohol fuel production credit at 

60 cents per gallon, the Federal government is paying a subsidy of 

$25.20 (in addition to the price paid by the consumer in order to 

save a barrel of oil currently valued at under $30. 

The energy tax .credits also add to the complexity of OUK tax laws 

and impose additional administrative burdens upon the Internal Revenue 

Service. A taxpayer compliance study with respect to individual 

income tax returns for taxable year 1979 disclosed that of $473 

million of taxpayer claims for energy tax credits, $126 million in 

claims would have had to be disallowed had the Internal Revenue 

Service been able to fully audit all returns. Taxpayers failed to 

claim only $26 million in credits that they were otherwise entitled to 

claim. Thus, by Internal Revenue Service estimates, more than 

one-quarter of the amount of energy credits claimed by taxpayers for 

1979 should not have been allowed. The high error rate resulted from 

confusion over dollar limitations, qualification of equipment for 

credit, as well as improper carryovers. According to another study,

in the case of the geothermal credit, nearly 95 percent of claimed 

credits were invalid because of an apparent massive misunderstanding

of the applicable rules. 

The residential energy credits, particularly the renewable energy

credits, tend to favor middle- and upper/middle-income households, and 

cannot be justified on the ground that they are necessary to help

low-income persons adjust to higher energy prices. For example, in 

1982, households with adjusted gross income in excess of $30,000

accounted for about 60 percent of all renewable energy expenditures

eligible for tax credits, but accounted for only 51 percent of total 

adjusted gross income. 

Finally, many of the conservation improvements subsidized by the 

residential energy credits would have been made without the tax 

credits because of decontrol and the increase in world oil prices in 

1979. Thus, in many cases, tax credits have served merely to reduce 

the tax burden o� middle- and upper-income households, rather than to 

encourage additional energy conservation efforts. 

- 227 -
REPEAL PERCENTAGE DEPLETION 

General Explanation 

Chapter 9.02 

Current Law 

The design of cost recovery rules for the extractive industries is 

complicated by the fact that the quantity of reserves and the rate of 

production vary widely for different deposits. Moreover, production 

may be prolonged through the application of various enhanced recovery

techniques. Thus, unlike ordinary depreciation methods, which may

reasonably be applied to generic categories of investment in plant and 

equipment, the rate of cost recovery for mineral properties is 

appropriately determined on a property by property basis. 

Under current law, recovery of capital investment in mineral 

properties is generally determined under the cost depletion or the 

percentage depletion method. Under cost depletion, a deduction is 

allowed each year equal to the product of the unrecovered costs and 

the ratio of the quantity of minerals sold during the year to the 

quantity of minerals estimated to be available as of the beginning of 

the year. By taking into account a property's cumulative production

record, cost depletion permits a more accurate allocation of costs 

incurred to individual time periods than methods employing a fixed 

service life OK rate of recovery. 

Under percentage depletion, a deduction is allowed based on a 

statutory percentage of the gross income from the property. The 

percentage of gross income that may be claimed is generally 15 percent

for oil, gas and geothermal, and ranges from 5 to 22 percent for other 

minerals. The allowance is limited to 50 percent of the net income 

from the property, and certain additional limitations apply in the 

case of oil and gas. Unlike all other cost recovery systems, a 

taxpayer may continue to claim percentage depletion after all the 

expenditures incurred to acquire or develop the property have been 

recovered. 

Taxpayers with an economic interest in a mineral property must 

claim the greater of percentage depletion or cost depletion.

Percentage depletion generally is not allowed in the case of oil and 

gas production. However, natural gas producers with long-term

contracts and certain independent producers and royalty owners (i.e.,

taxpayers that do not refine or market more than specified quantities

of product) are allowed to claim percentage depletion. Independent

producers and royalty owners may claim percentage depletion only on 

production up to 1,000 barrels of crude oil (or, in the case of 

natural gas, crude oil equivalents) per day. This quantity limitation 

must be allocated between different properties, and, at the taxpayer's

election, between oil and gas production. In the case of coal and 
iron ore, corporate taxpayers must reduce such deductions by 15 

percent of the amount in excess of the basis of the property.

Taxpayers denied percentage depletion, such as integrated oil 

companies, may only use cost depletion. 

The excess of percentage depletion over the adjusted basis of the 

property is a tax preference item for the corporate minimum tax and 

the noncorporate alternative minimum tax. 

Reasons for Change 

Percentage depletion allows deductions to be claimed in excess of 

a taxpayer's investment, and thus is more accurately viewed as a 

general production subsidy than as a method of cost recovery. The 

subsidy provided by percentage depletion, however, does not provide an 

efficient incentive for resource production. Because of the 

relatively lengthy interval between the acquisition of a property and 

initial production (if, in fact, the property is ever productive),

percentage depletion encourages development of existing properties

rather than exploration for new deposits. Moreover, because the 

allowance is limited to 50 percent of the property's net income, the 

subsidy is cut back for developers of marginally profitable

properties. Thus, the greatest benefits are provided where a subsidy

is least needed, i.e., to the developers of the most prolific or 

highly concentrated deposits. 

Even if percentage depletion allowances were limited to a 

taxpayer's investment, percentage depletion would not be an 

appropriate cost recovery method. The rate of cost recovery would 

depend on the volume of production, and thus would favor owners of 

deposits that can be produced more rapidly over owners of less 

productive properties (even if such production might represent a 

smaller fraction of total reserves). Percentage depletion also 

provides faster cost recovery when mineral prices rise, and less rapid 

recovery when prices fall. These factors are unrelated to the 

appropriate rate of cost recovery. 

Although percentage depletion is inappropriate as a general method 

of cost recovery, its total repeal could have a significant adverse 

effect on a segment of the domestic oil and gas industry. Recent 

sharp declines in oil and gas prices have strained the profitability

of certain marginal producing gtoperties. These so-called "stripper

wells" (i.e., wells producing less than 10 barrels per day) comprise

about 15 percent of domestic oil production. A change in existing law 

to deny percentage depletion could make many stripper wells 

unprofitable on an after-tax basis and result in their early

abandonment. A significant decline in stripper well production could,

in turn, increase the country's dependence on foreign energy,

exacerbate the problem of the trade deficit, and again make the U.S. 

vulnerable to concerted political or market action by foreign

producers. The clear national security interest in maintaining energy

independence supports current retention of percentage depletion for 

oil and gas stripper well production. 

- 229 -
The rationale for retaining percentage depletion with respect to 

stripper well production does not extend to owners of royalty

interests in stripper wells. The treatment of the stripper well 

royalty owner has no direct bearing on the operator's decision to 

maintain production, and thus such owners should be subject to the 

generally applicable cost recovery rule, i.e., cost depletion.

Royalty owners would, of course, benefit from royalties earned from 

continued stripper production as well as from the lower marginal tax 

rates that would be provided under the Administration proposals. 

Proposal 

Percentage depletion would generally be repealed for all minerals. 

Percentage depletion would be phased out over a five year period

beginning on January 1, 1986, by reducing the applicable percentage

depletion rates by 20 percent each year. In the case of oil and gas

stripper wells, however, percentage depletion would continue to be 

available for independent producers (but not royalty owners). For 

this purpose, stripper well status is to be determined on a well by

well basis. 

Taxpayers unable to claim percentage depletion would use cost 

depletion to recover their adjusted basis in the property, if any,

indexed for inflation. To the extent that percentage depletion is 

available, the excess of percentage depletion over the deduction 

allowable for cost depletion would be treated as a tax preference item 

for purposes of the corporate and noncorporate alternative minimum 

taxes. See Chs. 13.03, 13.04. 

Effective Date 

The phase out of percentage depletion would be effective for 

production beginning on or after January 1, 1986. 

Analysis 

In general, the subsidy provided by percentage depletion is 

inefficient and should be terminated. Given the decline in mineral 

prices over recent years, however, immediate termination of percentage

depletion could create significant dislocation. A phase-out of 

percentage depletion over several years should permit producers to 

continue in production until the industry adjusts. 

In addition, percentage depletion has had the effect of 

maintaining production from many marginal oil and gas wells. In order 

that domestic energy production not be significantly impaired,

percentage depletion for stripper well production by independent

producers should be retained. 

- 230 -
REVISE HINIHUH TAX ON INTANGIBLE DRILLING COSTS 

General Explanation 

Chapter 9.03 

Current Law 

Intangible drilling costs ("IDCS") are those costs of drilling and 

preparing oil, gas, and geothermal wells that generally are not 

incurred for the purchase of tangible property. These intangible

costs include not only amounts paid for labor, fuel, materials, and 

technical services necessary for the actual drilling, but also site 

preparation costs (which may require the construction of man-made 

islands from which to drill or the digging of canals to move drilling

rigs and other equipment) and costs incurred in the transportation and 

installation of drilling rigs, production casing, and wellhead 

equipment (but generally not the cost of the rigs, casing, or 

equipment). 

Under current law, taxpayers have the right to elect to expense

IDCs as incurred or to capitalize them. They may also elect to 

expense only the IDCs on unsuccessful wells ("dry holes") and to 

capitalize the IDCs on productive wells. If capitalized, the costs 

are recovered through depletion or depreciation. IDCs are subject to 

recapture upon disposition of the property with respect to which they 

are deducted. Corporate taxpayers are allowed to expense only 80 

percent of their IDCs; the balance must be capitalized and amortized 

over 36 months. 

The amount of "excess" IDCs is an item of tax preference for the 

alternative minimum tax for noncorporate taxpayers. The "excess" is 

calculated by subtracting from IDCs paid or incurred (other than costs 

of dry holes) (1) the IDCs that would have been allowable had such 

IDCs been capitalized and amortized over 10 years, and (2) the 

taxpayer's net income from oil, gas, and geothermal properties during

the taxable year. IDCs are not subject to the corporate minimum tax 

(except for personal holding companies). 

Reasons for Change 

Intangible drilling costs are a major portion of the costs 

necessary to locate and develop oil and gas reserves. IDCs associated 

with successful wells contribute to an asset that has productive value 

over more than a single year; from a tax accounting perspective,

conventional matching of income and expense would require that they be 

recovered over their full productive period. Expensing of IDCs, as 

permitted under current law, thus departs from ordinary accounting

principles and is appropriately viewed as an implicit incentive for 

domestic energy production. 

- 231 -
A change in the treatment of IDCs, however, from the expensing

allowed under current law to recovery over their full productive life 

would dramatically alter the taxation of oil and gas production.

Moreover, the change in tax burden would be concentrated on 

exploratory and developmental activities, leaving the tax treatment of 

existing producing properties largely unaffected. The downturn in oil 

prices in recent years has already caused a substantial decline in oil 

drilling activity. In this climate, a lengthening of the period over 

which IDCs are recovered could cause a significant further decline and 

thus reduce domestic oil production. Any such reduction would 

increase the country's dependence on foreign energy, exacerbate the 

problem of the trade deficit, and again make the U.S. vulnerable to 

concerted political OK market action by foreign energy producers. The 

clear national security interest in maintaining energy independence

thus supports retaining cost recovery rules for IDCs that provide an 

incentive for domestic energy production. 

At the same time, taxpayers should not be able to eliminate their 

tax liabilities through excessive use of the option to expense IDCs. 

Accordingly, it is appropriate that a portion of IDCs be treated as a 

minimum tax preference item for both corporate and noncorporate

taxpayers. The portion of IDCs so treated should reflect the extent 

to which the present value of the taxpayer's deduction for IDCs 

exceeds the present value of the deductions for such costs that would 

be allowed under generally applicable accounting rules. Furthermore,

for purposes of the minimum tax, no distinction should be made between 

taxpayers who are engaged in the oil and gas business and other 

taxpayers incurring IDCs. Accordingly, the current law rule under 

which net oil and gas income reduces the amount of IDCs treated as a 

minimum tax preference item should be repealed. 

Proposal 

The current law option to expense IDCs would be retained. 

However, eight percent of the IDCs paid or incurred on successful 

wells in a taxable year would constitute a tax preference for purposes

of the proposed corporate and noncorporate minimum taxes. See Chs. 

13.03 and 13.04. The percentage of IDCs included as a preference item 

would not be reduced by the taxpayerls net oil. and gas income. 

Effective Date 

The inclusion of IDCs in the individual and corporate minimum tax 

would be effective for costs paid or incurred on or after January I.,

1986. 

Analysis 

The Administration proposal would reduce the potential for 

corporate and noncorporate taxpayers engaged in the production of oil 

and gas to escape income taxation as a result of the election to 

- 232 -
expense IDCs. Eight percent of TDCs represents the difference between 

the present value of expensing and the present value of the deductions 

that wou1.d be allowed if the taxpayer capitalized the IDCs and 

depreciated them as CCRS class 3 property (the same as tangible

drilling costs; see Ch. 7.01). The additional tax liabilities 

incurred because of this proposal should not significantly affect 

continued development of the nation's energy resources. 

- 233 -
REVISE ROYALTY TAXATION 

GENERAL EXPLANATION 

Chapter 9.04 

Current Law 

Royalty income received by the owner of a retained economic 

interest in coal or iron ore production is eligible for treatment as 

long-term capital gain under section 1231 of the Internal Revenue 

Code. In order to receive capital gain treatment, the taxpayer must 

have been an owner of an interest in the coal or iron ore in place for 

at least six months, and must dispose of the ore under a contract by

which he retains an economic interest therein. Under such contract,

the taxpayer treats the difference between amounts received and the 

adjusted cost depletion basis of the coal or iron ore disposed of as 

long-term capital gain or ordinary loss under section 1231. No 

percentage depletion allowance may be claimed with respect to such 

income. In order to prevent operating owners from benefiting from 

these provisions, related party rules limit the availability of 

capital gain treatment. 

Royalty income received by the owner of a royalty interest in 

timber qualifies for long-term capital gain treatment under rules 

similar to those applicable to coal and iron ore royalties. In 

addition, an owner of timber or a contract right to cut timber may

elect to treat the cutting of timber (for sale or for use in the 

taxpayer's trade or business) as a sale or exchange of timber eligible

for long-term capital gain or ordinary loss treatment under section 

1231. 

Reasons for Change 

The special tax treatment of income from certain interests in 

timber, coal and iron ore is unjustified. Royalty income from these 

natural resources should be subject to tax on the same basis as 

royalty income from other investments. In addition, if items of a 

resource are held for sale to customers in the ordinary course of 

business or for use in a trade or business, income from disposition of 

such items should be treated on the same basis as income from other 

property held for the same purposes. 

Proposal 

The provisions establishing special tax treatment for timber, coal 

and iron ore royalty income would be repealed, along with the 

provisions permitting elective sale or exchange treatment for owners 

-, 234 -
of timber or contract rights to cut timber. In addition, timber, coal 

and iron ore held for sale in the ordinary course of business or for 

use in a trade or business would not be eligible for long-term capital

gain treatment. See Ch. 7.03. 

Effective Date 

Capital gain treatment for royalty income from timber, coal and 

iron ore and capital gain treatment for cut timber eligible for 

elective sale or exchange treatment would be repealed effective 

January I, 1989. However, between January 1, 1986, and January 1,

1989, capital gain treatment would be phased out. For corporations,

capital gains from timber, coal and iron ore would be taxed at a 30 

percent rate in 1986 and the rate would increase by one percent in 

1987 and 1988. For individuals, the exclusion rate on capital gains

from timber, coal and iron ore would be reduced to 30 percent in 1986, 

20 percent in 1987 and 10 percent in 1988. 

Analysis 

The Administration proposal to repeal the special treatment of 

timber, coal and iron ore royalty income would cause all royalty

income, from whatever source, to be taxed on the same basis as 

ordinary income. 

The Administration proposal to repeal the elective sale or 

exchange treatment for owners of timber tracts or of contract rights

to cut timber would defer the realization of gain or loss on those 

assets under generally applicable realization rules for property held 

for sale or use in a trade or business or held for investment. The 

character of such gain or loss would depend upon whether the interest 

in timber constitutes ordinary income property or a capital asset in 

the hands of a particular taxpayer. To provide a reasonable 

transition period for the timber industry, capital gain treatment for 

timber would be phased out over a five-year period. 

- 235 -
CHAPTER 10 

REFORN TAXATION OF FINANCIAL INSTITUTIONS 

Part A. Commercial Banks and Thrift Institutions 

This Part discusses proposals to conform special rules relating to 

the taxation of banks and thrift institutions to the general rules for 

the taxation of corporate income. The special. bad debt reserve 

deduction for banks and thrift institutions would be repealed.

Interest allocable to tax-exempt obligations held by banks, savings

and loans, and certain other thrift institutions would be 

nondeductible. The tax exemption of credit unions wou1.d be repealed

in the case of large credit unions. Finally, special rules concerning

reorganizations of certain thrift institutions and net operating

losses of depository institutions would be repealed. 

- 237 -
REPEAL SPECIAL RULES FOR DEPOSfTORY INSTITUTION BAD DEBT DEDUCTIONS 

General Explanation 

Chapter 10.01 

Current Law 

In general, taxpayers may deduct bad debts in the year in which 

they become wholly or partially worthless or may create a bad debt 

reserve and deduct a reasonable addition to the reserve each year.

Although subject to this general rule, commercial banks and thrift 

institutions are also permitted to deduct additions to reserves for 

bad debts using methods unrelated to their actual loan loss 

experience. These methods for computing additions to reserves for tax 

purposes bear no relationship to regulatory requirements for bad debt 

reserves or to the present value of the expected future loan losses. 

Commercial banks may utilize either the percentage method OK a 

modified version of the experience method for determining their bad 

debt deductions. The percentage method allows a current deduction for 

additions to reserves sufficient to maintain a tax reserve of up to 

0.6 percent of eligible loans outstanding. The experience method for 

banks generally is based on average loan losses over the most recent 

six-year period. Banks need not be consistent in their choice of 

method from one taxable year to another. The provision permitting use 

of the percentage method is scheduled to expire at the end of 1987, at 

which time all commercial banks must use the experience method. 

Thrift institutions may use modified versions of the percentage

method or experience method available to banks. Alternatively, thrift 

institutions, if they hold sufficient amounts of their assets in 

certain eligible investments (primarily residential mortgages), may

elect the percentage of taxable income method for purposes of 

establishing their bad debt reserves for qualifying real property

loans. Savings and loan associations and stock savings banks must 

hold at least 82 percent of their total assets in eligible investments 

to receive the maximum deduction, which is equal to 40 percent of 

taxable income (computed with certain modifications). A lower 

percentage of taxable income is deductible if less than 82 percent of 

total assets constitute eligible investments. Mutual savings banks 

must hold at least 72 percent of their total assets in eligible

investments to receive the maximum deduction, which is also subject to 

reduction if the percentage of eligible investments is less than 72 

percent. 

Loans which become wholly OK partially worthless during a taxable 

year are charged against the reserve. This charge reduces the reserve 

and, under the percentage of eligible loans or experience methods,

increases the amount that must be added to the reserve to restore it 

to an appropriate level. 

- 238 -
Thrift institutions that utilize the percentage of taxable income 

method are limited in the amounts of certain other tax benefits they 

may claim. For example, they may claim only one-half of the 

otherwise-allowable investment tax credit and their dividends-received 

deduction is reduced from that available to other corporations. 

The corporate preference item reduction provisions reduce the 

amount of bad debt reserve deductions that a depository institution 

not on the experience method may claim. No deduction is allowed for 

an amount equal to 20 percent of the excess of a depository

institution's addition to its bad debt reserves over the additions 

that would have been deductible had the institution used the 

experience method. In addition, an amount equal to 59-5/6 percent of 

such excess constitutes a tax preference item for purposes of the 

corporate minimum tax. 

Reasons for Change 

The deduction for additions to a bad debt reserve essentially

allows a deduction for debts that become worthless during the taxable 

year and a deduction for any net increase in the tax reserve. The 

deduction for the increase in the tax reserve represents a deduction 

for future loan losses, without any discount for the present value of 

such losses. A deduction for future losses defers taxable income,

which either increases depository institutions' after-tax income or 

enables then to offer lower loan rates. 

Current law provides more favorable tax treatment of bad debt 

losses to depository institutions than to lenders in other industries. 

The experience reserve method favors fast-growing banks and banks with 

worsening loss experiences. The percentage of eligible loans method 

favors fast-growing banks and banks with low loan loss experience.

Moreover, the methods permitted depository institutions for computing

additions to tax reserves bear no necessary relationship to actual 

loan losses. 

This tax preference distorts the investment decisions of some 

depository institutions. A thrift institution may utilize the 

favorable percentage of taxable income method only if it specializes

in residential mortgage lending. The maximum deduction is available 

only if 82 percent of the thrift's assets (72 percent for mutual 

savings banks) are invested in loans on residential real estate,

liquid assets, or certain other assets. The linkage between a lower 

effective tax rate and residential mortgage lending provides a 

disincentive to diversification by thrift institutions and thereby

subjects thrifts to increased portfolio risk. 

Finally, the special percentage of taxable income deduction 

benefits only profitable thrift institutions. Thrifts with no taxable 

income must elect the percentage of eligible loans method to maximize 

- 239 -
their net operating losses. Thus, the special bad debt deduction tied 

to residential mortgage lending benefits only a fraction of all 

mortgage lenders. 

Proposal 

The special rules for commercial banks and thrift institutions for 

computing additions to a bad debt reserve would be repealed.

Depository institutions would be subject to the general rule 

applicable to all taxpayers. The Administration proposals would 

require generally that bad debt losses be deducted only as they occur. 

See Ch. 8.04. This requirement would apply equally to commercial 

banks and thrift institutions. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. To prevent a double deduction for debts that 

become partially or wholly worthless after the effective date,

depository institutions would generally be required to include 

existing tax reserves in income ratably over ten years, starting with 

the first taxable year beginning on or after January 1, 1986. 

Alternatively, a depository institution could elect to include 

existing tax reserves in income in the first taxable year beginning on 

or after January 1, 1986. A special transition rule would be provided

for thrifts with existing tax reserves determined in whole or in part

under the percentage of taxable income method. Thrifts would 

recapture only the greater of the tax reserve computed under the 

experience or percentage of eligible loans methods. Any existing 

excess tax reserves would not be recaptured. 

Analysis 

Taxpayers are generally not allowed to deduct future liabilities 

or losses until they occur. Any reserve method for computing bad debt 

deductions is based on expectations as to future losses to some 

degree. If tax reserves for future losses were allowed, a neutral tax 

reserve system would limit the deduction to the estimated present

value of the future loss. Thus, it is proposed that for all taxpayers

the deduction for a reasonable addition to a reserve for bad debts 

would be repealed. Additional analysis of the proposed repeal of the 

reserve method for all bad debt deductions is provided in Chapter

8.04. 

Under current law, deductiogs for additions to reserves for bad . debts are overstated for depository institutions compared to 

deductions for bad debts for other businesses. Because a bad debt 

reserve for tax purposes involves only bookkeeping entries with no 

set-aside of assets, the only practical effect of present law is 

either to increase the after-tax income of depository institutions or 

to enable depository institutions to offer loans at artificially low 

rates. The proposal would eliminate these distortive effects. 

- 240 -
The proposal would reduce the amount of bad debt deductions 

reported by depository institutions. Present law permits depository

institutions to select from a variety of methods the one providing the 

largest deductions. For example, the percentage of eligible loans 

reserve method permits a bank to maintain a tax reserve equal to 0.6 

percent of its outstanding loans without regard to actual loss 

experience. Thus, it only benefits banks with bad debt experience

rates below that level; banks with higher bad debt rates will utilize 

the experience reserve method. In 1983, an estimated 73 percent of 

commercial banks found the percentage method to be more beneficial 

(actually, more used it because of special transition rules), while 

only 27 percent found the experience method to be more advantageous. 

Excess deductions for additions to bad debt reserves by thrift 

institutions under the percentage of taxable income method reduce 

their effective marginal tax rates. Most thrift institutions were 

unable to take advantage of the percentage of taxable income method in 

1981 and 1982 because they did not have taxable income. Only

profitable thrift institutions derive any bene-fit from the percentage

of taxable income method permitted under current law. For example,

the total bad debt deductions claimed by savings and loan associations 

fell from $1.41 billion in 1979 to $0.14 billion in 1981, because the 

preferential tax treatment is tied to profits, not actual. loan losses. 

In 1983, an estimated 60 percent of savings and loans found the 

percentage of taxable income method to be beneficial (actually, fewer 

did because of net operating loss carry forwards), while the remaining

40 percent found the percentage of outstanding loans method to be more 

beneficial.. 

Ninety-seven percent of all savings and loan associations and 64 

percent of all commercial banks had loss-to-loan ratios below the 

percentage method's allowable 0.6 percent. Also in 1983, 99 percent

of all savings and loan associations and 58 percent of all commercial 

banks wrote off for financial reporting purposes less than 0.6 percent

of their outstanding loans. The special bad debt reserve rules are 

a significant subsidy for depository institutions and substantially

distort the measurement of their income. 

Depository institutions must establish reserves to meet regulatory

requirements. Regulatory agencies properly seek to preserve the 

safety and soundness of depository institutions by requiring

conservative levels of actual reserves. Historically, the tax rules 

for computing deductions for additions to tax reserves have been 

unrelated to reserve requirements imposed by regulatory agencies.

Under current law, deductions for additions to a bad debt reserve do 

not reflect additions to actual reserves, only a reduction in tax 

liability. The tax accounting rules for bad debts should be designed

to measure income accurately. Thus, depository institutions, as with 

other taxpayers, should be restricted to deducting losses when they 

occur. 

- 241 -

476-698 0 - 85 - 10 
Existing tax reserves reflect previous deductions for future 

losses. If the reserves are not brought back into income and 

deductions are allowed, then some loan losses would be deducted twice. 

The portion of the thrifts' tax reserves in excess of what they would 

have taken under the commercial bank method is not brought back into 

income because it was a special subsidy for investments in residential 

mortgages. The proposed transition rule draws down existing tax 

reserves over a 10-year period. This rule is substantially more 

favorable than requiring future loan losses to be charged against the 

reserve until the reserve is exhausted. 

Finally, in response to the ociginal Treasury Department proposal, 

some commentators suggested that the deduction for bad debts be based 

on the additions to the reserve maintained for financial accounting

and regulatory purposes. Such a reserve, based on generally accepted

accounting principles ("GAAP"), is said to reflect economic income 

mote accurately than the specific chargeoff method because, it is 

argued, additions to a reserve based on GAAP reflect current 

diminutions in the value of the loan portfolio while the specific

chargeoff method delays the deduction until a time after the loss has 

actually occurred. The suggestion to recognize reserves based on GAAP 

was not adopted because any reserve system is inevitably based to some 

extent on expectations as to future losses. The more accurate method 

to determine the amount and timing of the appropriate deduction for 

bad debts in a taxable year is to judge the loss which has occurred by

examining the loan portfolio at the close of the taxable year based on 

the facts and circumstances known at that time. It is also important

to note that, if a deduction were permitted based on additions to a 

GAAP reserve, an interest charge on recoveries attributable to loans 

for which an addition to the reserve was made might be appropriate. 

- 242 -
DENY DEDUCTION FOR INTEREST TO 

CARRY TAX-EXEHPT BONDS 

General Explanation 

Chapter 10.02 

Current Law 

Current law generally denies a deduction to any taxpayer for 

interest on indebtedness incurred or continued to purchase or carry

tax-exempt obligations. Whether indebtedness is incurred or continued 

to purchase or carry tax-exempt obligations is based on the taxpayer's 

purpose in incurring indebtedness while holding tax-exempt

obligations, as indicated by the facts and circumstances of the 

particular case. 

Until 1982, banks, thrifts, and certain other financial 

institutions could invest their depository funds in tax-exempt

obligations without losing the deduction for interest paid on their 

deposits or short-term obligations. Under current law, however, such 

financial institutions are denied 20 percent of their interest 

deduction allocable to indebtedness (including deposits and other 

short-term obligations) incurred or continued in order to purchase or 

to carry tax-exempt obligations acquired after 1982. For this 

purpose, a statutory presumption treats a portion of a bank's or other 

financial institution's indebtedness as allocable to tax-exempt

obligations in an amount equal to the ratio of (i) the average

adjusted basis over the year of all tax-exempt obligations (acquired

after 1982) held by the bank or financial institution to (ii) the 

average adjusted basis over the year of all assets held by the bank or 

financial institution. 

Reasons for Change 

Basic measurement of income principles require that income be 

matched with the costs of its production. In line with these 

principles, the costs of producing tax-exempt income, including

interest expense incurred to carry tax-exempt bonds, are properly

nondeductible. Since the income to which such costs are attributable 

is exempt from tax, disallowance of a deduction is necessary to 

prevent the taxpayer from offsetting other nonexempt income. 

The exception from the above principles for interest paid or 

incurred by commercial banks and thrifts has enabled these 

institutions to hold a substantial portion of their investment 

portfolios in tax-exempt obligations, substantially reducing their 

Federal tax liability. The full allowance of interest deductions to 

banks holding tax-exempt obligations contributes to the relatively low 

effective tax rates of banks. In 1981, prior to the changes reflected 

in current law, commercial banks paid only $926 million of Federal 

income tax on approximately $15 billion of net income. 

- 243 -
In addition, the special rule for commercial banks and thrifts 

provides them with a competitive advantage over other financial 

institutions that are disallowed interest deductions for carrying

tax-exempt obligations. Brokers and dealers currently are not allowed 

to deduct any portion of the interest paid to purchase or to carry

tax-exempt securities. Similarly, life insurance companies must 

prorate their tax-exempt investment income between policyholders and 

the company, which is comparable to denying a deduction for interest 

incurred to carry tax-exempt obligations. 

Proposal 

Banks, thrifts and the other financial institutions favored under 

current law would be denied a deduction for 100 percent of their 

interest payments allocable to the purchase or carrying of tax-exempt

obligations. The portion of a financial institution's interest 

payments that would be deemed allocable to the purchase or carrying of 

tax-exempt obligations would be the same as under current law. Thus,

such portion would be equal to the ratio of (i) the average adjusted

basis over the year of all tax-exempt obligations (acquired on or 

after January 1, 1986) held by the financial instktution to (ii) the 

average adjusted basis over the year of all assets held by the 

financial institution. For example, if a bank holds $1,000,000 of 

tax-exempt bonds acquired after January 1, 1986, (measured by their 

average adjusted basis over the year) and $3,000,000 of other assets 

(similarly measured), its otherwise allowable interest deduction would 

be reduced by 25 percent without regard to whether paid to depositors,

short-term obligors, or long-term obligors. As under current law, the 

prorata presumption would be irrebuttable. 

Effective Date 

The proposal would be effective for interest allocable to 

tax-exempt obligations acquired on or after January 1, 1986. The 

current disallowance rule of 20 percent would continue to apply after 

December 31, 1985 to tax-exempt obligations acquired between January

1, 1983 and December 31, 1985. 

Analysis 

The deductibility of interest paid to purchase or to carry

tax-exempt bonds increases the attractiveness of tax-exempt

obligations because of the attendant opportunity to shelter other 

taxable income. Moreover, present law encourages banks to make 

investments that are not economically attractive except for the tax 

benefits. For example, a bank may borrow at a nine percent interest 

rate and invest in tax-exempt obligations yielding only seven percent

interest. Economically, the bank would lose two percent on the 

transaction; however, because the bank can deduct 80 percent of the 

- 244 -
interest paid, it pays an after-tax interest rate of only 5.7 percent

(9 x [l - (.46 x .8)l) and makes an after-tax profit of 1.3 percent.

Denying banks a deduction for interest allocable to the purchase or 

carrying of tax-exempt obligations would eliminate a tax incentive to 

make an otherwise unattractive economic investment. 

Commercial banks hold one-third of outstanding tax-exempt

securities and loans, as shown in Table 1. Commercial banks are the 

largest institutional investors, and are second only to households in 

total holdings of tax-exempt obligations. Commercial. banks are the 

major institutional investors because of their ability to borrow funds 

and deduct interest to carry investments that earn tax-exempt income. 

The transitional rule would continue to allow banks to deduct interest 

attributable to bonds acquired prior to the effective date, so that 

there would be no incentive to sell existing holdings. Banks would 

continue to buy some tax-exempt bonds after the effective date as 

evidenced by the current holdings of life insurance companies and 

brokers and dealers, who are already subject to the proposed rule. 

Together with the reduction in marginal tax rates, this proposal

would tend to reduce demand for tax-exempt bonds and exert upward 

pressure on tax-exempt interest rates, particularly short-term yields.

Several of the Administration proposals, however, would have the 

opposite effect on the interest rates of tax-exempt obligations. The 

aggregate impact on tax-exempt interest rates is uncertain because the 

elimination of nongovernmental tax-exempt bonds, bonds issued for 

arbitrage purposes, and other tax shelters would tend to increase 

demand for the remaining governmental bonds and exert downward 

pressure on the interest costs paid by State and local governments. 

- 245 -
-- 

Table 10.02-1 

Distribution of Tax-Exempt Securities and Loans 1983 

I Outstanding Tax-Exempt Bonds 

I Amount I

I (In Billions) I Percent 

Households $ 173.8 35.9 % 

Nonfinancial Corporate Businesses 

State and Local Government 

General Funds 

Commercial Banks 

Savings and Loan Associations 

Mutual Savings Banks 

Mutual Funds 

Life Insurance Companies

State and Local Retirement Funds 

Other Insurance Companies

Brokers and Dealers 

4.2 0.9 

9.7 2.0 

162.4 33.5 

0.9 0.2 

2.2 0.4 

31.5 6.4 

10.0 2.1 

1.8 0.4 

86.7 17.9 

-

1.4 0.3

Total $ 484.6 100.0 % 

Office of the Secretary of the Treasury may 28, 1985 

Source: Board of Governors of the Federal Reserve System, Flow of 

Funds Accounts, Assets and Liabilities Outstanding, 1960-83. 

- 246 -
REPEAL TAX EXEWPTION FOR LARGE CREDIT UNIONS 

General Explanation 

Chapter 10.03 

Current Law 

Credit unions are exempt from tax on their income, whether such 

income is retained or distributed to depositors. 

Reasons for Change 

Because of their tax exemption, credit unions enjoy a competitive

advantage over other financial institutions such as commercial banks 

and savings and loan associations. The tax-exempt status of credit 

unions has enabled them to grow rapidly since 1951., when savings and 

loan associations and mutual savings banks became subject to the 

corporate income tax. Since 1962, credit unions have enjoyed a 13 

percent annual growth rate in financial assets, compared with an 11.1 

percent rate for savings and loan associations, 9.4 percent for 

commercial banks, and 7 percent for mutual savings banks. Due to 

expanded powers and faster growth, credit unions accounted for 10.8 

percent of total consumer credit (not including mortgages) in 1983 

compared with 6.6 percent in 1962. 

In an economy based on free market principles, the tax system

should not provide a competitive advantage for particular commercial 

enterprises. Credit unions thus shou1.d generally be subject to tax on 

the same basis as other financial institutions. 

These arguments apply with particular force to large credit 

unions, which are substantially equivalent to commercial banks and 

thrifts. Most credit unions, however, are relatively small. Over 

80 percent of all credit unions have less than $5 million of gross

assets. Revoking the tax-exempt status of small credit unions would 

impose a significant administrative burden for a relatively small 

revenue increase. 

Proposal 

The tax exemption for credit unions with assets of at least 

$5 million would be repealed. Such large credit unions would be 

subject to tax under the same rules that apply to other thrift 

institutions. Credit unions with assets less than $5 million would 

continue to be exempt from tax. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

- 241 -
Analysis 

Tax exemption at the company level allows customer/owners in 

credit unions to defer tax liability on earnings retained by the 

credit union. By retaining their earnings tax-free, credit unions can 

offer their customer/owners higher rates of return than other 

financial institutions. Repealing the tax exemption of credit unions 

would eliminate the incentive for such credit unions to retain, rather 

than distribute, current earnings. 

In 1983, Federal credit unions earned $4.0 billion in net income 

and distributed $3.6 billion in dividends or interest refunds to 

customer/owners. Retained earnings, which are tax-exempt and accrue 

tax-free interest income, were 10.6 percent of current net earnings.

The proposal is limited to credit unions with assets of at least $5 

million because, while approximately 82 percent of all credit unions 

(13,020 out of a total of 15,877 credit unions) in 1983 had assets 

less than $5 million, the credit unions above this threshold accounted 

for approximately 80 percent of retained earnings for all credit 

unions. 

The proposal would subject large credit unions to tax on their 

retained earnings. To the extent that retained earnings are necessary

for growth, large credit unions would have to increase the spread

between their "dividend" rates and loan rates to cover the Federal tax 

liability in the same manner as stock companies. As with other mutual 

depository institutions, however, large credit unions could reduce the 

amount of Federal income tax paid at the corporate level by

distributing more "dividends" to depositors or by providing lower loan 

rates to borrowers. Distributions of earnings would be included in 

taxable income currently at the individual level. 

- 248 -
-- 

REPEAL REORGANIZATION RULES FOR FINANCIALLY 

TROUBLED TERIFT INSTITUTIONS 

General Explanation 

Chapter 10.04 

Current Law 

Certain acquisitions of the stock or assets of one corporation by

another qualify as tax-free reorganizations under current law. In 

general, the shareholders of a corporation that is acquired in a 

reorganization may exchange their stock for stock of the acquiring

corporation on a tax-free basis. In addition, a corporation acquired

in a reorganization may exchange its assets on a tax-free basis for 

stock of the acquiring corporation. 

Corporate acquisitions generally do not qualify as tax-free 

reorganizations unless they satisfy the "continuity of interest" 

requirement. Stated generally, an acquisition will satisfy the 

continuity of interest requirement only if the shareholders of the 

acquired corporation receive a significant, continuing equity interest 

in the acquiring corporation. 

Special rules enacted in 1981 permit the acquisition of a 

"financially troubled" thrift institution to qualify as a tax-free 

reorganization without regard to the continuity of interest 

requirement. The continuity of interest requirement would generally 

pose an obstacle in such an acquisition because depositors are the 

only persons holding interests in the financially troubled thrift who 

would receive an interest in the acquiring corporation. Because of 

their insured position, however, the depositors in the failing thrift 

generally will. not accept an equity interest in the acquiring

corporation with its attendant risk of loss. For this reason, the 

acquiring corporation ordinarily will assume the failing thrift's 

liabilities to its depositors. In the absence of the special waiver, 

an interest as a depositor would not satisfy the continuity of 

interest requirement. 

For the special rule to apply, the Federal Savings and Loan 

Insurance Corporation ("FSLIC"), Federal Home Loan Bank Board 

("FHLBB"), or, where neither has supervisory authority, an equivalent

State authority, must certify that the transferor thrift is insolvent,

that it cannot meet its obligations currently, or that it will be 

unable to meet its obligations in the immediate future. In addition,

the transferee must acquire substantially all of the transferor's 

assets and must assume substantially all of its liabilities. If an 

acquisition of a failing thrift institution satisfies these rules, the 

acquiring corporation succeeds to the tax attributes of the failing

thrift, including its net operating losses and a carryover basis in 

its assets. 

249 -
In addition to the special reorganization rule, present law 

provides an exclusion from income for payments by the FSLIC to a 

thrift institution in connection with a reorganization. Such payments 

are not included in the thrift's gross income and do not reduce the 

thrift's basis in any of its assets. 

Reasons for Change 

The special rules governing reorganizations of financially

troubled thrift institutions were enacted in 1981 to facilitate 

mergers and reorganizations of the ailing thrift industry. In such 

acquisitions, a profitable financial institution typically agrees to 

assume a failing thrift's obligations in consideration for payments

from a regulatory body, such as the FSLIC, and the right to utilize 

the failing thrift's tax losses and assume the thrift's basis in its 

assets, which typically consist primarily of mortgage loans with a 

book value substantially in excess of market value. 

Thrift institutions and their shareholders should be subject to 

tax on the same basis as other business enterprises. The special

rules for reorganizations of financially troubled thrift institutions 

are essentially in lieu of increased assessments by the FSLIC on all 

thrifts for deposit insurance and effectively shift some of the burden 

of thrift losses to the Federal government. If such subsidization of 

thrifts is necessary, it should be effected through direct 

appropriations. This would permit the appropriate regulatory agency

to determine the need for and amount of a subsidy on a case-by-case

basis. 

Proposal 

The special reorganization rules for acquisitions of financially

troubled thrifts and the exclusion from income of FSLIC payments to 

thrift institutions in connection with a reorganization would be 

repealed. 

Effective Date 

The repeal of the special reorganization rules would be effective 

for acquisitions occurring on or after January 1, 1991. The repeal of 

the exclusion for certain FSLIC payments would apply to taxable years

beginning on or after January 1, 1991; payments made on or after 

January 1, 1991, pursuant to an agreement entered into before that 

date would be exempt. 

Analysis 

The special reorganization rules are in lieu of-increased 

assessments of the thrift industry for deposit insurance and, thus, 

are an inappropriate subsidy for a particular industry. In addition, 

- 250 -
Federal assistance provided through special tax rules hides the total 

subsidy cost and is likely to exceed the amount of assistance that 

would otherwise be provided through direct appropriations. 

Nevertheless, the Administration recognizes that the thrift 

industry has not fully recovered from the economic conditions which 

prompted Congress to enact the special reorganization rules in 1981. 

Moreover, the FSLIC will require a transition period within which to 

seek authorization to charge sufficient premiums for deposit

insurance. Therefore, repeal of the special rules is not proposed to 

be effective until January 1, 1991. In the interim period, most of 

the below market loans currently jeopardizing the financial stability

of many thrifts will be repaid and the FSLIC may seek authority to 

assess more realistic deposit insurance premiums. Increased 

assessments will place the burden of thrift losses on the industry,

rather than on taxpayers generally. 

- 251 -
REPEAL SPECIAL RULES FOR NET OPERATING LOSSES 

OF DEPOSITORY INSTITUTIONS 

General Explanation 

Chapter 10.05 

Current Law 

Taxpayers may generally carry net operating losses ("NOLs") back 

to the three taxable years preceding the loss year and forward to the 

succeeding fifteen taxable years. Commercial banks and thrift 

institutions, however, may carry NOLs baclc ten taxable years and 

forward to the five succeeding taxable years. The extended carryback

period makes it more likely that a NOL of a depository institution 

will result in a current refund. 

Reason for Change 

The underlying premise of allowing a corporation to offset a NOL 

incurred in one year against taxable income earned in another year is 

to provide an averaging device to ameliorate the unduly harsh 

consequences of a strict annual accounting system. No justification

exists, however, for distinguishing between NOLs of depository

institutions and NOLs of other businesses. 

Proposal 

The special carryback and carryover rules for banks and thrifts 

would be repealed. 

Effective Date 

The proposal would be effective for NOLs incurred in taxable 

years beginning on or after January 1, 1986. Losses incurred in 

taxable years before the effective date would be subject to the rules 

of current law. 

Analysis 

Losses incurred by depository institutions should be treated in 

the same manner as losses of other taxpayers. Under current law, a 

depository institution is more likely to obtain a current benefit from 

a NOL than other taxpayers. There is no reason of tax or economic 

policy for granting favorable treatment in this regard to depository

institutions. 

- 252 -
Part B. Life Insurance Companies and Products 

The current Federal income tax treatment of life insurance 

companies and their products allows investors in such products to 

obtain a substantially higher after-tax return on the investment 

portion of such products than is available on investments whose income 

is fully taxed on a current basis. The Administration proposals would 

do away with this special treatment. Deferral of tax on the 

investment income earned on a life insurance policy (other than a term 

insurance policy) would be ended by taxing to the policyholder the 

annual increase in the cash surrender value of the policy. The same 

treatment would apply to annuity contracts. 

Special rules that reduce the income tax paid by life insurance 

companies would also be modified. The life insurance reserve for any

contract would be limited to the contract's net surrender value. The 

special 20-percent life insurance company deduction and 60-percent

small life insurance company deduction would be repealed. 

- 253 -
IMPOSE CURRENT TAXATION ON LIFE 

INSURANCE INSIDE BUILD-UP 

Genera1 Explanation 

Chapter 10.06 

Current Law 

The premium paid on any life insurance policy (other than a term 

insurance policy) can be divided into three components: a pure

insurance component, a loading component, and an investment or savings

component. During any period, the pure insurance component of a 

policy serves to redistribute funds from policyholders who pay charges

for insurance protection to beneficiaries of policyholders who die 

during the period. The loading component serves to cover the 

insurance company's expenses and to provide it with a measure of 

profit. The investment component of a policy arises from the fact 

that the company can invest funds paid by policyholders between the 

time the funds are received by the company and the time they are paid

out to beneficiaries. The company in turn credits fixed or variable 

amounts to the policy, thereby increasing the cash value of the policy

and providing a return to the policyholder on his investment in the 

policy. 

Thus, a policyholder who pays a premium in excess of the cost of 

insurance and loading charges for the year in which the premium is 

paid is, in effect, making a deposit into a savings account that earns 

income for the benefit of the policyholder. 

Current law permits life insurance policyholders to earn this 

income on amounts invested in the policy free of current tax. This 

untaxed investment income is commonly referred to as "inside 

build-up.'' The company issuing the policy is allowed a deduction for 

increases in its insurance reserves. Because the level of reserves 

relating to a policy increases as investment income is credited to the 

policy, the reserve deduction effectively shields the investment 

income from tax at the company level. 

If a policy fails at any time to satisfy a Federal tax statutory

definition of life insurance, which requires that the policy have a 

significant insurance component, the policy is treated as a 

combination of term life insurance and an investment fund, with the 

income generated by the fund being currently taxable to the 

policyholder. 

Any amount paid under a life insurance policy by reason of the 

death of the insured is excluded from the gross income of the 

beneficiary. Thus, if a policyholder holds a life insurance policy

until his death, the investment income on the policy, which was not 

taxed when credited to the policy, escapes tax permanently. If a 

policyholder surrenders his life insurance policy before death in 

- 254 -
exchange for the policy's cash surrender value or receives 

distributions in the form of policyholder dividends, the policyholder

recognizes ordinary income equal to the excess of the cash received 

over his net investment in the policy. The policyholder's investment 

in the policy includes the portion of his premiums that has been used 

to pay the cost of life insurance for past periods. Consequently, any

investment income taxed to the policyholder is reduced by the cost of 

his life insurance, even though this cost is a personal expense of the 

policyholder and would not be deductible if paid directly. 

Reasons for Change 

The deregulation of financial institutions and various economic 

factors have resulted in an increase in the rate of interest paid on 

traditional investment products (e.g., bank accounts and whole life 

insurance policies) and a proliferation of competing investment 

products offered by different types of financial institutions. The 

effect of these changes has been to increase the already substantial 

investment orientation of cash value life insurance products.

Although the definition of life insurance places some broad limits on 

the use of life insurance as a tax-favored investment product, it is 

still possible "to design an insurance policy meeting this definition 

under which the cumulative investment earnings at currently prevailing

interest rates are projected to be as much as eight times as large as 

the cumulative insurance costs. Thus, the favorable tax treatment of 

inside build-up on life insurance policies can be obtained through a 

contract that provides a relatively small amount of pure insurance 

coverage. 

Earnings on comparable investment products generally are not tax 

free or tax deferred. Instead, income credited on such investments 

generally is subject to tax whether or not the income is currently

received by the taxpayer. For example, taxpayers generally are 

subject to current tax on interest credited on certificates of deposit

although the interest is not received until the certificate of deposit

matures, and on investment income from mutual funds even if the income 

is credited in the form of additional fund shares. 

Moreover, life insurance is not subject to the significant

limitations on the timing and amount of contributions, withdrawals,

and loans that apply to other tax-favored investments, such as 

qualified pension plans and individual retirement accounts (IRAs). 

The benefit of deferring or avoiding tax on the inside build-up on 

life insurance policies goes only to individuals with excess 

disposable income that enables them to save, and particularly to 

individuals in high tax brackets. This benefit is not available to 

individuals buying term insurance since it derives solely from the 

investment component of a policy (which is not present in a term 

insurance policy). 

The tax-favored treatment of inside build-up encourages

individuals to save through life insurance companies rather than other 

- 255 -
financial institutions and perhaps to purchase life insurance that 

they would not buy except to gain access to the favorable tax 

treatment of the investment income. This distorts the flow of savings

and investment in the economy. 

Proposal 

Owners of life insurance policies (other than variable life 

insurance policies) would be treated as being in constructive receipt

of the cash surrender value (taking into account any surrender charge 

or penalty) of their policies. Thus, a policyholder would include in 

interest income for a taxable year any increase during the taxable 

year in the amount by which the policy's cash surrender value exceeds 

the policyholder's investment in the contract. A policyholder's

investment in the contract would be equal to the aggregate of his 

gross premiums, reduced by the aggregate policyholder dividends and 

other distributions under the policy and by the aggregate cost of 

renewable term insurance under the policy. In the case of variable 

life insurance policies, the policyholder would be treated as owning a 

pro rata share of the assets and income of the separate account 

underlying the variable policy. The policyholder thus yould not be 

taxed on the unrealized appreciation of assets underlying a variable 

policy. Any explicitly stated surrender charges would be an offset to 

realized gains and other income. 

Effective Date 

The proposal would be effective for all inside build-up credited 

on or after January 1, 1986 to policies issued on or after the date of 

adoption by the House Ways and Means Committee or the Senate Finance 

Committee of this proposal. Inside build-up would continue to be free 

from tax in the case of policies issued before the date of Committee 

action to the extent that the death benefit of the policy does not 

exceed the death benefit on the date of Committee action plus any

additional death benefit required for the policy to continue to 

satisfy the definition of life insurance under current law. 

Analysis 

Taxing the inside build-up on life insurance policies would 

eliminate the largest tax distortion in the financial services area 

and would place competing financial products and institutions on more 

equal footing. This would promote the efficient flow of long-term

savings. 

Taxation of inside build-up also would eliminate the need under 

current law for complex rules and restrictions in several areas,

including the determination of tax liability when a policy matures or 

is surrendered and the definition of contracts that qualify as life 

insurance. 

- 256 -
Table 1 shows the distribution of cash value life insurance 

policies by family economic income. High-income families are more 

likely to have cash value policies as well as larger policies. The 

average annual tax-deferred income earned on life insurance and 

annuity policies in 1983 is estimated at $3,050 for families with 

income greater than $200,000 and less than $200 for families with 

income less than $30,000. Because the purchase of life insurance 

policies for predominantly investment purposes is a recent 

development, the difference between the amount of inside build-up

earned by wealthier individuals and that earned by less wealthy

individuals is expected to grow in the future. 

- 257 -
Table 10.06-1 

Distribution of Ownership of Cash-Value Life 

Insurance Policies and the Annual Inside 

Interest Build-up 1/

By Economic Income --1983 

I Percentage of I Average

Family I Families with I Annual 

Economic 1 Cash-Value Life I Inside 

Income 1 Insurance Policies I Buildup 2,’ 

$ 0 - 9,999 13 % $ 85 

10,000 - 14,999 25 110 

15,000 - 19,999 33 135 

20,000 - 29,999 41 190 

30,000 - 49,999 53 310 

50,000 - 99,999 68 520 

100,000 - 199,999 78 1,240 

200,000 or more 70 3,050 

All Families 42 % $ 355 

Office of the Secretary of the Treasury May 28, 1985 

-1/ Includes annuities. 

-2/ For those with policies. 

- 258 -
IMPOSE CURRENT TAXATION ON DEFERRED 

ANNUITY INVESTMENT INCOME 

General Explanation 

Chapter 10.07 

Current Law 

Income credited to a deferred annuity contract is not taxed 

currently to the owner of the contract or to the insurance company

issuing the contract. In general, amounts received by the owner of an 

annuity contract before the annuity starting date (including loans 

under the contract) are taxed as ordinary income to the extent that 

the cash value of the contract exceeds the owner's investment in the 

contract. A portion of each distribution received after the annuity

starting date is taxed as ordinary income based on the ratio of the 

investment in the contract to the total distributions expected to be 

received. Penalties are imposed on certain premature distributions 

under an annuity contract. 

Reasons for Change 

Investment income earned on deferred annuities is similar to 

investment income earned on other savings instruments with other 

financial institutions. Interest on savings accounts and certificates 

of deposit and investment income from mutual funds is taxed currently,

however, while investment income earned on annuities is not taxed 

until withdrawal. Moreover, deferred annuities are not subject to the 

significant limitations on the timing and amount of investments that 

apply to other tax-favored investments, such as pension plans and 

individual retirement accounts ("IRAs"). Yet deferred annuity savings 

are more likely than other tax-favored investments to be withdrawn 

before retirement because of the smaller and more easily avoided 

withdrawal penalty. 

Since tax-favored annuities can be purchased only from life 

insurance companies, this tax deferral directs the flow of savings

toward life insurance companies and away from other financial 

institutions. There is no reason to favor savings through insurance 

companies over savings through competing financial institutions. 

The deferral of tax on investment income credited to deferred 

annuities is available only to persons with disposable income 

available for savings and is of greatest benefit to persons in the 

highest tax brackets. The tax deferral thus favors wealthier 

individuals. 

- 259 -
Proposal 

Owners of deferred annuity contracts (other than variable 

contracts) would be treated as being in constructive receipt of the 

cash value (taking into account any surrender charge or penalty) of 

their contracts. Thus, the owner would include in income for a 

taxable year any increase during the taxable year in the amount by

which the contract's cash value exceeds the owner's investment in the 

contract. In the case of variable deferred annuity contracts, the 

contract owner would be treated as owning a pro rata share of the 

assets and income of the separate account underlying the variable 

contract. The owner thus would not be taxed on the unrealized 

appreciation of assets underlying a variable contract. Any explicitly

stated surrender charges would be an offset to realized gains and 

other income. 

Effective Date 

The proposal would be effective for all investment income credited 

on or after January 1, 1986 to contracts issued on or after the date 

of adoption by the House Ways and Means Committee or the Senate 

Finance Committee of this proposal. In the case of contracts 

outstanding before the date of Committee action, investment income 

credited to the contracts would continue to be untaxed until 

withdrawal or distribution of funds from the policy. The penalty

imposed on premature distributions under a deferred annuity contract 

would be repealed for distributions from contracts issued on or after 

the date of Committee action. All of the other provisions prescribing

special treatment of distributions under annuity contracts before the 

annuity starting date would become obsolete as annuities containing

untaxed investment income are surrendered or mature. 

Analysis 

Taxing the investment income credited to deferred annuity

contracts would eliminate a major distortion in the financial services 

area and would place competing financial. products and institutions on 

more equal footing. This would encourage the efficient flow of 

long-term savings. 

- 260 -
-- 

LIMIT LIFE INSURANCE COMPANY RESERVE DEDUCTION 

General Explanation 

Chapter 10.08 

Current Law 

The gross amount of premiums received by a life insurance company

is included in the taxable income of the company. As described in 

Ch. 10.06, the premium paid on any life insurance policy (other than a 

term insurance policy) can be divided into a loading component, a term 

insurance component, and a savings component. The savings component

of a premium is held, in effect, for the benefit of the policyholder

in an account yielding an investment return. The savi.ngs component is 

needed to help fund the higher cost of insurance protection in later 

years and is currently available to the policyholder in the form of 

the policy's cash surrender value. 

Life insurance companies are allowed a deduction from taxable 

income for any net increase in life insurance and other reserves and 

must include in income any net decrease in reserves. The life 

insurance reserve for any contract is the greater of the net cash 

value of the contract (taking into account any surrender penalty or 

charge) or the reserve for policy claims determined under a prescribed 

set of rules (based on prevailing State regulatory requirements)

relating to the reserve method, assumed interest rate, and assumed 

mortality or morbidity rate. These latter rules attempt to measure 

the amount needed to fund the anticipated excess of the present value 

of future claims and benefits to be paid under the policy over the 

present value of future premiums (if any) to be received under the 

policy. The reserve deduction thus serves to adjust the company's

income to account for its liability to pay, in the event of a 

surrender of the policy, the cash value or, in the event of a claim 

under the policy, the face amount of the policy. 

Reasons for Change 

Like the receipt of savings deposits by a bank, the receipt of the 

savings component of life insurance premiums should not be taxed to 

the company. However, the remaining portions of the gross premiums -- the loading component and the term insurance component should be 

taxed to the company, with corresponding deductions for sales and 

administrative costs and the payment of claims. Thus, if gross

premiums are included in the gross income of the company, an 

offsetting deduction for the savings component of the premiums is 

appropriate. 

The allowance of a reserve deduction for the increase during the 

taxable year in the greater of the policy's cash surrender value or 

the reserve for policy claims often will overstate the company's 

reserve deduction, especially in the initial years of the policy. 

- 261 
This is because the reserve for policy claims, i.e., the estimate of 

the excess of the present value of future claims and benefits over the 

present value of future premiums, is calculated using conservative 

assumptions required for State regulatory purposes. 

A reserve deduction equal to the increase in the cash surrender 

value of a policy generally would be sufficient to exclude the savings 

component of gross premiums from the company's taxable income and 

allow a deduction for the exact amount of interest credited to the 

policyholder's savings account. Moreover, the policy's cash surrender 

value is an objective measure of the reserve for policy claims needed 

by the company. This is because the cash surrender value is, in 

effect, the amount the company is willing to pay to the policyholder

if he gives up his right to claims and benefits under the policy. 

The initial overstatement of reserves allowed under current law 

results in tax deferral and a reduced effective tax rate for life 

insurance companies. This enables life insurance companies to offer 

policyholders higher rates of return on savings or lower costs of 

insurance, thereby attracting investment dollars from other financial 

institutions. 

Proposal 

For tax purposes, the life insurance reserve for any contract 

generally would be limited to the net cash surrender value of the 

contract (taking into account any surrender penalty or charge). A 

special rule would be provided for current annuity contracts that may 

not be surrendered for cash. 

Effective Date 

The proposal would be effective for policies sold on or after 

January 1, 1986. 

Analysis -

Restricting life insurance companies' deductions for additions to 

reserves to the increase in the cash surrender value of policies

issued by the company would be consistent with the separation of 

income and liabilities of other financial institutions. The actual 

amount of the savings deposits included in life insurance premiums

effectively would be excluded from taxable income. Similarly, the 

actual amount of interest credited to policyholders would be deducted 

by the company and, as proposed in Ch. 10.06, included in the income 

of the policyholders. This would eliminate the different tax 

treatment of savings at the company level between life insurance 

companies and depository institutions. 

Life insurance companies would increase their premiums (or earn 

lower profits) as a result of any increased tax liability resulting

from the more accurate measurement of their taxable income. 

- 262 -
REPEAL SPECIAL LIFE INSURANCE COMPANY DEDUCTIONS 

General Explanation 

Chapter 10.09 

Current Law 

All life insurance companies are allowed a deduction equal to 20 

percent of their otherwise taxable income. In addition, a small life 

insurance company is allowed a deduction equal to 60 percent of the 

first $3 million of its otherwise taxable income. This deduction 

phases out as otherwise taxable income increases from $3 million to 

$15 million. The small company deduction is allowed only to companies

with gross assets of less than $500 million. Consolidated group tests 

generally are used in applying the taxab1,e income and gross asset 

standards. 

Reasons for Change 

The special deduction for all life insurance companies was enacted 

to reduce the competitive impact of the Tax Reform Act of 1984, which 

broadened the tax base of life insurance companies without similarly

broadening the tax base of competing financial institutions. Enactment of comprehensive tax reform affecting all financial institutions 

and reducing the maximum marginal tax rate would eliminate the 

justification for the special deduction for life insurance companies.

Retention of the special deduction for life insurance companies would 

be unfair to their competitors and would cause tax-induced economic 

distortions. 

Similarly, the special deduction for small life insurance 

companies was a deviation from the proper measurement of economic 

income to prevent a dramatic increase in the tax burden of small life 

insurance companies as a result of the 1984 Act. After comprehensive

tax reform, special rules for small life insurance companies would no 

longer be appropriate. 

PI:oposal 

The special life insurance company deduction and small life 

insurance company deduction would be repealed. 

Effective Date 

The proposal would be effective for taxable years beginning on or 

after January I., 1986. 

- 263 -
Analysis 

The revision of the tax rules governing life insurance companies

in 1984 essentially broadened their tax bases and reduced their 

effective marginal tax rates. The 20 percent deduction of otherwise 

taxable income lowers life insurance companies' effective maximum 

marginal tax rate to 36.8 percent. The Administration proposals would 

lower the top corporate rate to 33 percent. Repeal of the special 20 

percent deduction provision would be more than offset by the reduction 

in the maximum corporate tax rate. 

Small life insurance companies would be placed on a par with all 

other small corporations. Elimination of preferential tax rates based 

011 the size of the firm (other than the graduated rates made available 

to small corporations generally) would reduce tax-induced distortions 

that favor sales of life insurance through small firms. 

- 264 -
Part C. Property and Casualty Insurance Companies 

This Part discusses proposals to curtail favorable tax rules for 

property and casualty ("P&C") insurance companies. The system of 

reserves for unpaid losses would be revised to assure correct 

treatment of the underwriting and investment income earned by P&C 

companies. Special provisions that reduce the effective tax rate on 

P&C companies would be eliminated. Specifically, the deduction for 

contributions to a protection against loss account would be repealed.

Special tax exemptions, rate reductions, and deductions of small 

mutual P&C companies would be repealed. The deduction for 

policyholder dividends by mutual P&C companies would be limited in 

conformity with the deduction allowed mutual life insurance companies. 

- 265 -
REVISE TREATMENT OF LOSSES BY PROPERTY AND CASUALTY INSURANCE 

COMPANIES AND ALLOW DEDUCTION TO CERTAIN OF THEIR POLICYHOLDERS 

General Explanation 

Chapter 10.10 

Current Law 

Property and casualty ("P&C") insurance companies are allowed a 

reserve deduction for "losses incurred" during a taxable year. The 

deduction includes the company's estimate of "unpaid losses," whether 

or not unpaid losses have accrued under normal tax accounting rules. 

Unpaid losses include amounts that will be paid in connection with 

claims filed with the company during the taxable year as well as 

amounts that relate to claims expected to arise from events occurring

during the taxable year that have not been reported to the company.

The deduction for these claims generally is not discounted to reflect 

the fact that they will not be paid until some time in the future. 

Moreover, the reserve does not grow over time to reflect the 

investment income earned on the reserve. A company is also permitted 

to set up an unearned premium reserve for premiums received during one 

taxable year that relate to coverage to be provided in subsequent 

years. 

In the case of taxpayers who sustain losses, the tax treatment of 

the losses depends upon a number of factors, including whether the 

loss is a business or a personal loss, whether the loss is to the 

person or property of the taxpayer or is a tort or other liability to 

a third party, and whether the loss is covered by insurance. First, 

most personal losses are nondeductible. For example, individual 

taxpayers can claim a deduction for casualty losses to personal 

property only to the extent the losses exceed ten percent of the 

individual's adjusted gross income; deductions for medical expenses 

are limited to those in excess of five percent of adjusted gross

income. Second, otherwise deductible tort arid similar liabilities to 

a third party generally are not treated as incurred (and hence are not 

deductible) until payment is made to the third party. Third, although

certain uninsured losses sustained by a taxpayer are deductible at the 

time the loss is incurred, no deduction is allowed at this time if the 

loss is insured. In general, no account is taken of the taxpayer's

loss of the time value of money resulting from any delay between the 

time the loss is incurred and the time the insurance claim is paid. 

Often, as part of the settlement of a liability to make payments

for personal injury damages, a property and casualty company or an 

uninsured defendant will agree with the injured party to assign the 

liability to make periodic settlement payments to another person, such 

as an affiliate of a life insurance company, who will fund the 

"structured settlement" by purchasing an annuity contract. 

Third-party assignees who assume other persons' liabilities to make 

periodic payments as personal injury damages or settlements may

exclude from gross income amounts received in consideration for such 
assumptions, to the extent such amounts are invested in annuity 

contracts to fund the liabilities. The third-party assignees' basis 

in the annuity contracts is reduced by the amount of excluded income. 

Third-party assignees recognize income as they receive payments on the 

annuity contracts but may deduct periodic payments to the injured 

parties. 

Reasons �or Change 

The deduction by P&C companies of reserves for claims to be paid

in the future, unadjusted for the investment income that will be 

earned on those reserves, results in deferral of P&C companies' tax 

liability and reduces their effective tax rates. In other cases where 

tax deductions for reserves are allowed, either the allowable reserves 

are discounted for the expected future investment earnings on the 

reserve funds (as is the case with life insurance reserves) or the 

investment income earned on the reserve is added to the reserve (as is 

the case with nuclear decommissioning trust funds). 

The current tax treatment of P&C insurance reserves distorts the 

choice between self-insurance and third-party insurance. P&C 

companies deduct currently the full amount of the future liability for 

many casualty losses that would not be deductible currently by a 

self-insurer. Because a current tax deduction is more valuable than a 

future deduction, individuals and businesses are encouraged to insure 

against risks with a P&C company in order to take advantage of this 

favorable tax treatment. 

With respect to persons sustaining losses covered by insurance, 

current law is inaccurate in failing to recognize the effect of a 

delay between the time a loss is incurred and the time an insurance 

claim for such loss is paid. Even a taxpayer who suffers a loss of 

property that is fully insured for its current fair market value 

suffers an uninsured loss measured by the loss of the value of the 

property during the period the incurred loss remains unreimbursed. If 

the current system of taxing P&C companies were changed without 

correcting this defect, the tax system would discourage the purchase

of insurance with respect to losses that would otherwise be deductible 

(primarily business property losses and large personal casualty

losses). 

Finally, in the case of third-party assignees, the current tax 

treatment of amounts received from assignors and amounts paid to 

injured parties effectively exempts from tax the investment income on 

the amount assigned. This exemption is not warranted nor is it 

required by the exclusion from injured parties' income of periodic 

payments received as personal injury damages pursuant to structured 

settlements. That is, the rationale for the tax treatment of injured

parties is not to allow them tax-free investment of damage awards, but 

rather to remove a tax disincentive to injured parties who accept 

payment in the form of a structured settlement as an alternative to a 

lump sum. Just as injured parties are taxed on income from the 

- 261 -
investment of damage awards once received, third-party assignees

should be taxed on income from the investment of funds prior to 

payment to injured parties. 

Proposal 

The deduction by P&C companies for unpaid losses during a taxable 

year would be computed under the "qualified reserve account" ("QRA")

method. Under this method, the company would establish reserve 

accounts for claims to be paid in an amount estimated by the company

to be sufficient to fund payment of the claims, taking into account 

the company's estimates of the amount of the claims, the time of 

payment of the claims, and the company's after-tax rate of return on 

its investment assets. Separate reserve accounts would be established 

by line of business and year of policy issuance. In other words, one 

account would be established for all claims under all policies in a 

particular line of business issued in a particular taxable year. This 

account would take the place of the current separate reserve accounts 

for unearned premiums, incurred but not reported ("XBNR") losses, and 

reported claims. 

The initial amount deductible with respect to a given reserve 

account could not exceed the combined statutory unearned premium 

reserve, IBNR reserve, and claims reserves on policies covered by that 

account. Beyond this, the company would not be subject to federally

prescribed rules in establishing the reserve account. 

Each reserve established by the company would be increased 

annually by a percentage equal to the after-tax rate of return 

actually earned by the company on its investments during that year.

To prevent the company's investment income from being sheltered from 

tax, no additional reserve deduction would be allowed for the annual 

increase in the reserve accounts attributable to the allocation of 

investment income. 

The after-tax rate of return for a company during a given taxable 

year would be equal to the total net investment income of the company

(including tax-exempt income) for that year, reduced by taxes 

attributable to that income, divided by the average total surplus and 

reserves of the company for the year. Thus, in effect, the QRA

proposal would prorate the taxable and tax-exempt income among all the 

reserves and surplus of the company. To the extent a P&C company is 

able to increase its after-tax income through investment in tax-exempt

securities, its reserves would grow more quickly. This would require

the company either to take smaller initial reserve d.eductions or 

realize greater income from the release of reserves when claims are 

paid. 

The company would be allowed a deduction each year for the full 

amount paid to satisfy claims, but would be required to include in 

taxable income an offsetting amount released from the appropriate 

reserve account. If the reserve was insufficient to cover all claims, 

- 260 -
the excess claims would be deductible when paid. Conversely, if any 

amount remained in a reserve account after payment of the last claim 

in that account, that amount would be included in taxable income. 

A company would be permitted to strengthen a reserve it determined 

was insufficient to cover future claims and a deduction would be given

for additional amounts placed into a reserve. However, the company

would be required to establish the need for reserve strengthening by a 

showing of objective factors affecting the amount needed to fund the 

payment of claims. Such factors would include a strengthening of the 

company's reserves on its annual statement or a decline in prevailing

interest rates. Companies also would be free to release into income 

additional amounts from reserves it felt to be excessive. This would 

allow companies to avoid a bunching of income in a single year from 

the release of an excessive reserve. 

A company would not be able to maintain a reserve indefinitely.

Rules would be established limiting the maximum life of a reserve,

depending on the line of business. Any reserve balance at the end of 

the maximum life would be released into income. Any subsequent claims 

under policies covered by that reserve would be deductible when paid. 

This proposal would also apply to reserves for unpaid losses not 

included in life insurance reserves held by life insurance companies.

Thus, a life insurance company issuing accident and health policies

would be required to use the QRA method to account for unpaid losses 

on such policies. 

Taxpayers suffering losses covered by insurance would be permitted

to elect to claim a deduction with respect to those losses without 

regard to the prospect of recovery from the insurance company. In 

other words, electing taxpayers would be allowed to deduct the loss in 

the taxable year the loss is incurred as if the loss were uninsured. 

Insurance proceeds would be taxable income when received, but an 

exclusion would be given equal to the amount of any portion of the 

loss that was not deductible. Current law would continue to apply to 

nonelecting taxpayers. 

Third-party assignees of liabilities to make personal injury

damage payments would include the full amount of consideration 

received from the assignor in gross income. An assignee purchasing an 

annuity contract to fund its liabilities to an injured party would be 

treated as the owner of the annuity and would be taxed on the income 

component thereof. The assignee would be permitted to elect either to 

treat the purchase of an annuity used to fund its liabilities to an 

injured party as a deductible expense at the time of the purchase or 

to treat each payment to the injured party as deductible at the time 

the payment is made. 

Effective Date 

The proposal would be effective �or all losses incurred in taxable 

years beginning on or after January 1, 1986 that are insured under 

policies issued on or after January 1, 1986. The proposal on 

- 269 -
third-party assignments of personal injury liability would be 

effective for all assignments entered into on or after January 1,

1986. 

Analysis 

Under the proposal, P&C companies would still be permitted to use 

the reserve method to match income and losses occurring in different 

taxable years. The QRA method, however, would take into account the 

time value of money. A current deduction of $1,000 is worth 

considerably more than a future deduction of $1,000 because investment 

income will be earned on the tax saving produced by the deduction. 

For the same reasons, less than $1,000 needs to be held in reserve to 

fund a future liability of $1,000. For example, if interest income 

accumulates at an after-tax rate of six percent, a reserve of only

$792.09 is needed to provide sufficient funds to satisfy a liability

four years in the future of $1,000. If a fund of $1,000 is set aside 

and deducted, it is appropriate to recognize the growth of that fund 

to $1,262.48 and to include the excess amount of $262.48 in income 

when the claim is paid. 

The system of qualified reserve accounts does not require the 

discounting of reserves. This feature of the proposal avoids the 

difficult problem of choosing a mandatory discount rate in an 

environment where investment returns vary widely from company to 

company and from year to year. Companies are free to discount 

reserves using any set of assumptions as to future interest rates 

(e.g., the assumptions used in pricing the policies) or even to 

establish undiscounted reserves. This flexibility is possible because 

the QRA method assures that the ultimate after-tax return that a 

company realizes on a group of policies does not depend on the amount 

the company places into the reserve for those policies, assuming that 

the company's tax rate is constant over time. The company would not 

have a tax incentive to overreserve since any excess tax deduction 

would be recaptured when the claims are ultimately paid with an 

interest factor equal to the company's actual after-tax rate of 

return on investment assets. Conversely, companies that underreserve 

would receive additional deductions at the time they pay their claims 

to ensure that they will not be penalized for underreserving. 

This feature of the QRA method is not present in a system that 

requires re-tax discounting of reserves and grants additional 

deductions+or investment income earned on reserves. Such a system,

while clearly an improvement over present law, would penalize a 

company for underestimating the amount of a claim or overestimating

the length of time until payment of the claim. Conversely, a company

would receive a windfall on any claim that was overestimated or whose 

payment was delayed. More significantly, such a system would continue 

to undertax P&C companies since investment income on reserves held by

P&C companies would not be taxed. Such a system thus fails to tax the 

entire income of P&C companies and continues the distortionary effect 

of current tax law that favors third-party insurance over 

self-insurance. 

- 270 -
A substantial portion of the claims paid by P&C companies are 

paid in years subsequent to the year in which premium income is 

received and a deduction for losses paid or incurred is claimed. 

Table 1 shows the average period of loss payment for all insurance 

written by P&C companies and for several major lines of business. As 

shown on the table, over 60 percent of all losses of P&C companies are 

paid after the year of deduction. The actual discounted value of 

these losses at the time the premium income is received, assuming a 

six percent discount rate, is approximately 91 percent of their 

undiscounted value. In the case of medical malpractice insurance, a 

line of business where long delays in the payment of claims are 

common, more than one-half of all losses are paid beyond the fourth 

year after the year of deduction and the discounted value of the 

losses at the time the premium is received is only approximately 76 

percent of their undiscounted value. 

It has been argued by some that the present system of 

undiscounted claims reserves results in "rough justice" since it 

allows a deduction to some taxpayer in the full amount of an economic 

loss (of either the policyholder or a third party to whom the 

policyholder is liable) when the loss is incurred. Arguably, it is 

proper to match the time of the P&C company's deduction to the time 

the underlying economic loss is sustained. However, except in the 

case of business property losses, a large portion of property and 

casualty liabilities would not be deductible losses to the party

suffering the underlying economic loss. To the extent losses would be 

deductible by the person suffering the loss if uninsured, the proposal

would allow a deduction for insured losses and insurance proceeds

would be included in income when received. This would achieve a far 

more accurate result than the "rough justice" arguably afforded by

present law, since the taxpayer actual1.y suffering the loss is made 

whole. Under the current system, a taxpayer suffering the loss is 

penalized while the policyholders not suffering losses have a windfall 

to the extent the P&C company passes through its tax benefits in the 

form of lower premiums. The P&C company also has a windfall to the 

extent it does not pass through the tax benefits. 

The combination of the QRA reserve proposal and the proposed

change in the tax treatment of third-party assignees assures that the 

investment income on amounts set aside to fund structured settlements 

would be subject to tax. This change would make the tax system a 

neutral consideration in the choice between structured settlements and 

lump-sum payments while preserving the current rule that plaintiffs

should not have to pay tax on any personal injury damage awards. 

The P&C industry may argue that the QRA proposal is not 

appropriate for an industry with large underwriting losses (-$11.0

billion in 1983). However, the large underwriting losses occur 

primarily because P&C companies lower premiums (discount) for the 

future investment income expected to be earned prior to the payment of 

claims, while the statutory reserves used in calculating underwriting

income are not discounted. Total net income is the appropriate 

- 211. -
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- 212 -
measure of company profitability, not underwriting income. Moreover, 

even in times of overall net losses, the tax system should limit tax 

losses to properly measured economic losses and should tax profitable

enterprises on their properly measured economic income. 

The QRA would be only a bookkeeping entry. The QRA reserve system

would increase the tax liabilities of P&C companies and affiliated 

companies but, as described above, the proposal would simply eliminate 

the deferral of tax liability allowed under current law or impose an 

appropriate interest charge on the deferral. P&C companies could be 

expected to increase their premiums to cover any increased tax 

liability resulting from the more accurate measurement of their 

taxable income. 

The QRA system would not affect State law requirements for 

reserves to protect policyholders against company insolvency. The 

amount of tax reserves would be different than the amount of statutory 

reserves but, because the QRA method does not require the discounting

of reserves, tax reserves would not necessarily be lower than 

statutory reserves. State law presumably would continue to require

adequate funding of statutory reserves. 

- 213 -

476-693 0 - 85 - 11 
REPEAL HUTUAL PROPERTY AND CASUALTY INSURANCE COMPANY 

PROTECTION AGAINST LOSS ACCOUNT 

General Explanation 

Chapter 10.11 

Current Law 

Most mutual property and casualty ("P&C") insurance companies are 

allowed deductions for net contributions to a protection against loss 

("PAL") account. A deduction is generally allowed for contributions 

to the account in an amount equal to one percent of the losses (both

known and estimated) incurred during the taxable year plus 25 percent

of the underwriting gain for the taxable year. Companies that have a 

high percentage of risks relating to windstorms, hail, flood,

earthquakes, or similar hazards may defer a larger percentage of their 

underwriting income. 

The portion of the deferred income representing one percent of 

losses incurred and one-half of the deduction for 25 percent of 

underwriting income is brought back into income after, at most, a 

five-year deferral period. The remaining amount, 12.5 percent of 

underwriting income, continues to be deferred indefinitely, until the 

company has underwriting losses. 

Reasons for Change 

The special PAL deduction is unrelated to the measurement of 

economic income. The PAL deduction is allowed in addition to the full 

deduction that mutual P&C companies receive for estimates of losses to 

be paid in the future. Furthermore, the PAL account is simply a 

bookkeeping entry made for tax purposes; a corresponding reserve 

account is not required by State regulatory authorities to provide for 

the financial solvency of the companies. 

The tax deferral resulting from the deductibility of contributions 

to a PAL account reduces the effective tax rate on mutual P&C 

companies with underwriting income. The lower effective tax rate 

provides a competitive advantage to mutual P&C companies vis-a-vis 

stock P&C companies and life insurance companies that offer similar 

insurance products. 

The calculation of the PAL account requires an arbitrary

distinction between underwriting and investment income. This 

distinction increases the complexity of the tax code and increases the 

possibility that companies will undertake uneconomic transactions 

solely to minimize tax liability. 

- 274 -
Proposal 

The deduction for contributions to a PAL account would be 

repealed. Amounts currently held in the account would be included in 

income no later than ratably over a five-year period. 

Effective Date 

The proposal would apply to taxable years beginning on or after 

January I, 1986. 

Analysis 

The benefits of the special PAL deduction accrue largely to 

profitable companies that do not have underwriting losses and 

therefore obtain the maximum tax deferral. The special deduction 

provides little benefit to companies with periodic underwriting

losses. Repeal of the special PAL deduction should have minimal 

impact on premium rates. 

- 275 -
REPEAL SPECIAL TAX EXEMPTIONS, RATE REDUCTIONS,

AND DEDUCTIONS OF SMALL MUTUAL PROPERTY 

AND CASUALTY INSURANCE COMPANIES 

General Explanation 

Chapter 10.12 

Current Law 

Numerous special rules reduce or eliminate the tax liability of 

certain small mutual property and casualty ( “P&C”) insurance 

companies. Mutual P&C companies with taxable investment and 

underwriting income of not more than $6,000 are exempt from tax; a 

limitation on the rate of tax on income in excess of $6,000 phases out 

between $6,000 and $12,000. Mutual P&C companies that during the 

taxable year receive a gross amount of not more than $150,000 from 

premiums and certain investment income are also exempt from tax,

regardless of the amount of their taxable income. Unless they elect 

to the contrary, companies that receive a gross amount from premiums

and certain investment income of more than $150,000 but not more than 

$500,000 are taxed only on their investment income (and are not taxed 

at all if their investment income is not more than $3,000); their 

underwriting income is exempt from tax. A limitation on the rate of 

tax on the investment income of such companies in excess of $3,000

phases out between $3,000 and $6,000. A further reduction of the rate 

of tax on the investment income of such companies phases out as the 

gross amount from premiums and certain investment income increases 

from $150,000 to $250,000. Finally, mutual P&C companies that receive 

a gross amount from premiums and certain investment income of less 

than $1,100,000 are allowed a special deduction against their 

underwriting income (if it is subject to tax). The maximum amount of 

the deduction is $6,000, and the deduction phases out as the gross 

amount increases from $500,000 to $1,100,000. 

Reasons for Change 

The special tax rules that reduce or eliminate the tax liability

of certain small mutual P&C companies provide competitive advantages 

to those companies vis-a-vis stock companies and larger mutual 

companies. The application of these rules requires arbitrary

distinctions between underwriting and investment income, thereby

increasing the complexity of the tax code. 

Proposal 

The special tax exemptions, rate reductions, and deductions of 

small mutual P&C companies would be repealed. 

- 276 -
Effective Date 

The proposal would be phased in over a five-year period, starting

with the first taxable year beginning on or after January 1, 1986. 

Analysis 

small mutual P&C companies would be placed on a par with all other 

small corporations. Elimination of preferential rates based on the 

size of the firm (other than the graduated rates made available to 

small corporations generally) would reduce tax-induced distortions 

that favor the sale of insurance through small firms. 

- 277 -
LIMIT MUTUAL PROPERTY AND CASUALTY INSURANCE 

COMPANY DEDUCTION FOR POLICYBOLDER DIVIDENDS 

General Explanation 

Chapter 10.13 

Current Law 

In general, stock and mutual property and casualty ("P&C")

insurance companies are allowed to deduct dividends and similar 

distributions paid or declared to policyholders in their capacity as 

such. These distributions are treated by policyholders as price

rebates rather than as taxable distributions. Dividends paid by stock 

P&C companies to their shareholders are not deductible by the company

and are includable in the gross income of the recipient. 

In the case of life insurance companies, the amount of the 

deduction allowed mutual companies for policyholder dividends is 

subject to certain limitations. The deductibility constraint stems 

from a recognition that policyholder dividends paid by mutual 

companies are, to some extent, distributions of the companies'

earnings to policyholders in their capacity as owners of the company.

Consequently, the deduction for policyholder dividends is reduced by 

an amount determined to be the owner/policyholder's share of the 

distributed earnings of the company. 

Reasons for Change 

The different tax treatment of income distributed in the form of 

policyholder dividends by mutual P&C companies and shareholder 

dividends paid by stock P&C companies provides a competitive advantage 

to mutual P&C companies vis-a-vis stock P&C companies and other 

corporations. This competitive advantage of mutual companies was 

recognized in the 1984 overhaul of the life insurance company tax 

rules, which imposed a limitation on the deductibility of policyholder

dividends by mutual life insurance companies. A similar limitation on 

the deductibility of mutual P&C company policyholder dividends would 

reduce the distortion caused by the deduction and by the 

policyholders' treatment of the dividends as price rebates. 

Proposal 

The deduction for policyholder dividends allowed mutual P&C 

companies would be reduced in a manner similar to the way in which the 

deduction for policyholder dividends allowed mutual life insurance 

companies is reduced under current law. Additional study is needed to 

determine the size of the competitive advantage that the current 

treatment of policyholder dividends provides to mutual P&C companies

and to set the appropriate deduction limitation. 

- 218 -
Effective Date 

The proposal would be effective for taxable years beginning on or 

after January 1, 1986. 

Analysis 

The proposal would subject all income of mutual PLC companies,

including profits distributed to policyholders, to tax at the company

level. Mutual companies may distribute a lesser amount of 

policyholder dividends and charge slightly higher premiums as a result 

of the tax on equity income, similar to the effect of corporate taxes 

on other companies. The advantage of mutual companies over stock 

companies would be reduced, as would the advantage of mutual P&C 

companies selling insurance products in competition with life 

insurance companies. 

- 219 -
CHAPTER 11 

REFORM TREATMENT OF STATE AND LOCAL GOVERNMENT DEBT AND INVESTMENTS 

This Chapter discusses proposals to limit the tax exemption of 

interest on State and local obligations to its proper scope -- the 

financing of governmental activities, such as schools and roads for 

State and local governments. Future issues of nongovernmental bonds 

would not be exempt from Federal income tax. Restrictions on 

arbitrage with respect to tax-exempt obligations would be tightened,

and advance refundings would be prohibited. Finally, the general

stock ownership corporation provisions would be repealed as 

deadwood. 

- 201 -
REPEAL TAX EXEHPTION FOR NONGOVERNMENTAL BONDS 

General Explanation 

Chapter 11.01 

Current Law 

Interest on State and local obligations generally is exempt from 

Federal income tax. In many cases, proceeds from the issuance of 

tax-exempt bonds are made available for use by private businesses,

certain tax-exempt organizations, homeowners and students, as well as 

for use by State and local governments. 

Industrial development bonds. State and local government

obliqations are classified as industrial development bonds ("1~~s~') if 

the 6ond proceeds are to be used in any trade 0; business carried on 

by a nonexempt person and the payment of principal OK interest on the 

bonds is derived from or secured by money or property used in a trade 

or business. Interest on IDBs as a general rule is taxable, but 

interest on two categories of IDBS is tax exempt: (1) IDBS that 

qualify as exempt small issues, and (2) IDBs issued to finance certain 

exempt activities. 

Exempt small issue IDBs can be issued in amounts of $1 million or 

less to assist any principal user in the acquisition, construction OK 

improvement of land or depreciable property located in any one city or 

county. The $1 million limitation may be increased to $10 million if 

the aggregate amount of capital expenditures of the principal users in 

the particular jurisdiction do not exceed $10 million over a six-year

period. Current law also provides an exemption for interest on IDBs 

used to finance certain specific exempt activities. Any land,

buildings or other property that is functionally related and 

subordinate to the exempt facility also may be financed through 

tax-exempt bonds. 

Kortgage subsidy bonds. State and local governments may issue 

mortgage subsidy bonds to finance mortgages on owner-occupied

residences. There are two categories of mortgage subsidy bonds that 

are tax-exempt: (1) qualified mortgage bonds, and (2) qualified

veterans' mortgage bonds. Qualified mortgage bonds provide mortgage

financing for qualified homebuyers. Qualified veterans' mortgage

bonds provide mortgage financing for certain veterans, but may be 

issued only by States with programs in place before June 22, 1984. 

Other nongovernmental bonds. Tax-exempt obligations may be 

issued for certain tax-exempt organizations such as nonprofit

hospitals and educational institutions. Tax-exempt student loan bonds 

- 282 -
may be issued to finance educational and related expenses by nonprofit

corporations or public agencies or instrumentalities of a State. 

Finally, other tax-exempt bonds that are not IDBs may be used to 

provide financing to nongovernmental entities, businesses and 

individuals. 

Reasons for Change 

The exemption from Federal income tax of interest on State and 

local government obligations exists as a matter of comity between the 

Federal government and State and local governments. This tax 

exemption lowers the cost to State and local governments of financing

public facilities, such as schools, roads and sewers. Increasingly,

however, State and local governments have used their tax-exempt

financing privilege to obtain funds for use by nongovernmental 

persons. Thus, State and local tax-exempt obligations are now 

commonly used to provide financing for private businesses, residential 

mortgages, nonprofit corporations and student loans. Table 1 shows 

the volume of long-term tax-exempt bond issues from 1975 to 1983 by 

type of activity. A total of $58 billion of such nongovernmental

bonds was issued in 1983, accounting for 61 percent of all long-term 

tax-exempt bonds issued that year. 

Tax-exempt nongovernmental bonds have caused serious erosion in 

the Federal income tax base, lowering tax receipts and forcing

increases in the tax rates on nonexempt income. The revenues lost as 

a result of tax-exempt nongovernmental bonds represent an indirect 

Federal subsidy program, based in the tax code, and thus significantly

free of the scrutiny that attaches to direct Federal expenditures. In 

many cases, the issuer of nongovernmental bonds would not spend its 

own revenues to support the activities that are Federally subsidized 

through tax-exempt nongovernmental bonds. 

The Federal subsidy provided through tax-exempt bonds is 

inefficient because the subsidy is filtered through high-income

investors. Because part of the subsidy is captured by these 

investors, the revenue loss to the Federal. government is approximately

33-50 percent higher than the benefits received by the borrower. 

Tax-exempt nongovernmental bonds also have anti-competitive and 

distortive effects on the economy. Activities receiving tax-exempt

financing have a significant advantage over their competitors, which 

must raise capital with higher-cost taxable obligations. Yet, the 

availability of tax-exempt financing for nongovernmental persons

depends upon which jurisdictions have the necessary programs in place

and upon the ability of persons to negotiate through obstacles of 

State and local law and procedure. These factors have little relation 

to the value or efficiency of particular activities, and ought not to 

influence the allocation of capital among sectors of the economy. 

- 283 -
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- 284 -
Finally, the volume of tax-exempt nongovernmental bonds has 

worked to the detriment of bonds issued to provide financing for State 

and local governments. As a result of the issuance of these 

additional securities, tax-exempt interest rates must rise in order to 

attract additional capital. This increases costs for State and local 

governments, with no corresponding increase in the level of government

services provided. Moreover, these increased costs are borne by all 

State and local governments, not simply those issuing nongovernmental

bonds. 

Proposal 

Interest on obligations issued by a State or local government

would be taxable if more than one percent of the proceeds were used 

directly or indirectly by any person other than a State or local 

government. Generally, use of a facility financed with proceeds of 

tax-exempt obligations would be considered to be use of those 

proceeds. The proposal would preserve the tax exemption for 

obligations issued to finance ordinary government operations, such as 

tax anticipation notes, as well as those issued to finance the 

acquisition or construction of government buildings. 

Under an exception to the general rule, use of tax-exempt

financed facilities by a nongovernmental person would be permissible

if the facilities were available for use by the general public on the 

same basis. Use of or access to a facility by a nongovernmental 

person on a basis other than that available to the general public

could be shown by a formal or informal agreement with the 

nongovernmental person or by locating a facility at a site to which 

the general public does not have ready access. For example, extension 

of a road, sewer or other system serving the general public to a newly

constructed house or business could be financed on a tax-exempt basis. 

On the other hand, construction of an airstrip adjacent to a business 

that would be its primary user could not be financed through the 

issuance of tax-exempt bonds. Use of a facility by a nongovernmental 

person would not qualify for the exception simply because there was 

also some use of the facility by the general public. Thus, an airport

terminal leased to an airline that ultimately provides service to the 

public could not be financed on a tax-exempt basis, since the 

airline’s use of the terminal is on a basis different than that 

available to the general public. 

In addition, a de minimis exception would allow use of tax-exempt

financed facilities by a nongovernmental person pursuant to a 

short-term (one year or less) management contract. Thus, for example, 

a solid waste disposal facility serving the general public could be 

financed with tax-exempt obligations if it were owned by a city and 

operated by the city or by a private manager under a short-term 

management contract. If the proceeds of the financing were made 

- 285 -
available to a nongovernmental person to construct a privately-owned

solid waste disposal facility, however, the bonds would not be 

tax-exempt. 

In general, the lease of all or part of a government-owned

facility to a nongovernmental person would disqualify the portion so 

leased for tax-exempt financing. This rule would not apply to leases 

for a brief interim period, i.e., leases of one year or less for the 

period immediately after the facility was substantially completed. 

Allocation rules would permit tax-exempt financing for a 

proportionate share of the cost of a facility used in part for 

governmental and in part for nongovernmental purposes. For example, a 

government-owned and operated electric generating facility which by 

contract sold 10 percent of its output over its entire life to an 

investor-owned utility, and supplied its remaining power directly to 

the general public, could have 90 percent of its costs financed on a 

tax-exempt basis. 

Finally, an exception to the nongovernmental use rule would 

permit bond proceeds to be (a) used to fund a reasonably required 

reserve fund, (b) invested for the initial temporary period before use 

for the governmental purpose of the borrowing, or (c) deposited in a 

bona fide debt service fund. 

The proposal would extend to all tax-exempt bonds the IDB 

reporting requirements, and would retain certain other existing

restrictions, including the prohibition against Federal guarantees,

arbitrage restrictions, registration requirements and limitations on 

bonds granted tax-exemption by Federal law other than the Internal 

Revenue Code. Most other provisions of Internal Revenue Code section 

103 would be repealed. Since State and local governments would no 

longer be entitled to issue mortgage subsidy bonds under the proposal,

the mortgage credit certificate program would be terminated. 

Effective Date 

The proposal would be effective for obligations issued on or 

after January 1, 1986. A transition rule would be provided for 

current refundings of outstanding obligations if the refunding does 

not extend the weighted average maturity date of the obligations

outstanding at the time of the refunding or exceed the outstanding 

amount of the refunded obligation. 

Analysis 

The proposal would replace the standard for tax-exemption in 

current law, which grants tax-exempt status to obligations on the 

basis of their qualifying as student loan bonds, mortgage subsidy 

- 286 -
bonds, veterans' mortgage bonds, small issue IDBs, exempt activity

IDBs or other tax-exempt non-IDBs, with a new standard for determining

the tax-exempt status of obligations. The proposal would virtually

eliminate (rather than limit through a volume ceiling) the Federal 

subsidy currently made available to nongovernmental persons through 

tax-exempt financing. State and local governments would, however,

retain the ability to finance projects with tax-exempt obligations if 

the proceeds are not used by nongovernmental persons. 

Under any given set of tax rates, elimination of nongovernmental 

tax-exempt bonds would cause the spread between tax-exempt and taxable 

interest rates to increase, due to a lower volume of tax-exempt

obligations. Thus, the value of the Federal subsidy provided to 

governmental activities financed with tax-exempt bonds would increase. 

The proposal would, of course, increase financing costs for 

nongovernmental persons currently receiving tax-exempt financing.

Such increase, however, would simply restore parity among all 

nongovernmental persons in the competition for capital. 

- 287 -
LIMIT TAX ARBITRAGE AND ADVANCE 

REFUNDING FOR TAX-EXEMPT BONDS 

General Explanation 

Chapter 11.02 

Current Law 

Interest on State and local obligations generally is exempt from 

Federal income tax. An issuer of tax-exempt bonds may borrow at 

tax-exempt rates and earn "arbitrage" by investing the borrowed 

amounts in obligations that pay higher returns. Current law denies 

tax-exempt status to interest on bonds issued with the expectation

that the proceeds will be used to earn arbitrage in excess of 

specified amounts. 

Restrictions on Arbitrage. Treasury regulations apply different 

arbitrage restrictions to different types of obligations acquired with 

bond proceeds. "Acquired purpose obligations" are obligations

acquired to carry out the purpose of the bond issue. Permissible 

arbitrage on acquired purpose obligations generally is limited to a 

spread between the yield on the bonds and the yield on the acquired 

purpose obligations of 0.125 percent plus reasonable administrative 

costs. Administrative costs basically are the costs of issuing,

carrying and repaying the bonds, the underwriter's discount, and the 

costs of acquiring, carrying, redeeming or selling the obligation of 

the bond user. All obligations other than acquired purpose

obligations acquired with bond proceeds are "acquired nonpurpose

obligations." The arbitrage spread for investments of bond proceeds

in acquired nonpurpose obligations is restricted to 0.125 percent plus

certain costs. There are two principal exceptions to these rules. 

First, unlimited arbitrage is permitted on bond proceeds invested for 

a temporary period prior to use, without regard to whether such 

proceeds are held by the user or the issuer. The temporary period is 

generally three years for new money financings and up to two years for 

a refunding transaction. An issuer may waive the temporary period and 

receive an arbitrage spread of 0.5 percent plus allowable costs with 

respect to obligations subject to yield restrictions. Second,

unlimited arbitrage is permitted on investments held in a reasonably

required reserve or replacement fund ("4R fund"). Additional 

arbitrage restrictions apply to other types of tax-exempt obligations, 

as discussed below. 

Calculation of Yield. The limitations on permissible arbitrage

earnings under current law require a comparison of the yield on the 

bonds and the yield on the acquired obligations. In computing yield, 

current law permits various costs to be taken into account that either 

increase bond yield or decrease acquired obligation yield. The result 

is to increase the amount of permissible arbitrage that issuers may 

earn. One court has held that bond yield is the discount rate at 

which the present value of all payments of principal and interest on 

- 200 -
the bonds equals the net proceeds of the issue after deducting the 

costs of issuing the bonds. Permitting issuance costs to reduce net 

proceeds results in a corresponding increase in the bond yield. The 

effect of calculating bond yield in this fashion is that the bond 

issuer is permitted to earn an amount equal to issuance costs out of 

arbitrage. This method of calculating bond yield does not apply for 

mortgage subsidy bond rebate purposes, where bond yield is based on 

the initial offering price to the public (excluding bond houses and 

brokers). In addition, premiums paid to insure a bond issue are 

treated as additional interest on the issue (to the extent that the 

present value of the premiums does not exceed the present value of the 

interest savings) with a resulting increase in the yield on the bond 

issue. Similarly, the yield on acquired purpose obligations is 

calculated by excluding from the payments to be received with respect 

to such obligations a portion of the payments having a present value 

equal to the costs of issuing, carrying or repaying the bonds, the 

underwriter's spread and the costs of purchasing, carrying, redeeming 

or selling acquired purpose obligations. The bond issuer cannot use 

the same cost to both increase bond yield and decrease yield on 

acquired obligations. 

Advance Refundings. Current law permits the advance refunding of 

certain tax-exempt bonds. For this purpose, an advance refunding

generally is defined as the issuance of bonds to retire another bond 

issue on a date after the issuance date of the refunding bonds. 

Advance refundings of industrial development bonds and mortgage

subsidy bonds are generally prohibited. For industrial development

bonds and mortgage subsidy bonds, however, an advance refunding is 

defined as the issuance of bonds to retire another bond issue more 

than 180 days after the issuance date of the refunding bonds. 

Permissible arbitrage on advance refunding issues, in addition to that 

earned during any applicable temporary period, basically is limited to 

interest on $25,000 at the bond rate, plus an amount sufficient to 

recover reasonable administrative costs. 

Special Arbitrage Rules for Certain Bonds. Current law applies

special arbitrage rules to certain types of tax-exempt bonds. 

Mortgage subsidy bonds are permitted-to earn an arbitrage spread of 

1.125 percent on acquired purpose obligations (the mortgages).

Arbitrage earned on nonpurpose obligations must be paid to the 

mortgagors or to the United States. The amount of bond proceeds that 

can be invested in nonpurpose obligations at a yield above the bond 

yield is limited to 150 percent of annual debt service for the bond 

year. Certain industrial development bonds issued after December 31,

1984, are subject to an arbitrage rebate requirement and a limitation 

on investment in nonpurpose obligations similar to those imposed on 

mortgage subsidy bonds. Student loan bonds and other obligations

issued in connection with certain governmental programs are generally

permitted an arbitrage spread of 1.5 percent plus reasonable 

administrative costs on the acquired purpose obligations. Interest 

subsidies paid by the Department of Education can be excluded in 

determining yield on the acquired purpose obligations (student loans)

for student loan bond issues. 

- 289 -
Reasons for Change 

Under current law, the exclusion from Federal income tax of 

interest on State and local government obligations provides two 

separate benefits to State and local issuers. The basic benefit is 

the reduction in interest cost for the financing. The additional 

benefit, however, is the ability of the issuer to invest bond proceeds

to earn arbitrage. Arbitrage consists of the amounts directly

permitted as arbitrage spread and amounts earned when yield

restrictions do not apply. By virtue of the definition of yield, the 

spread includes issuance costs and bond insurance premiums. 

Current law is overly generous in that it allows issuers or bond 

users to retain the economic benefit of all permissible arbitrage, 

even though many of the rules permitting arbitrage (those for 

temporary periods and 4R funds, for example) are intended only to 

reduce the complexity of the arbitrage restrictions. Moreover,

because the current rules generally prevent only the issuance of bonds 

that are expected to earn arbitrage and do not prohibit the retention 

of arbitrage ultimately earned, issuers and bond users often are 

rewarded with substantial amounts of "unexpected" arbitrage. 

Arbitrage has two undesirable results. First, it may be used for 

activities ineligible for tax-exempt bond financing, since arbitrage

is not subject to the use limitations applicable to proceeds of 

tax-exempt bonds. Second, arbitrage also increases the volume of 

tax-exempt bonds. This increase in volume occurs for several reasons. 

First, the availability of arbitrage makes feasible bond issues that 

otherwise would be uneconomical. For example, since issuance costs 

for advance refundings can be recovered out of arbitrage, such bonds 

may be issued even though issuance costs dwarf the economic benefit to 

the issuer or the bond user. Bond counsel and underwriters benefit 

from the resulting lack of motivation on the part of the issuer to 

restrain costs. Second, the arbitrage encourages issuers to sell more 

bonds than are necessary in order to invest-the excess proceeds in 

higher yielding investments. Finally, theErbitrage encourages

issuers to sell bonds earlier or keep them outstanding longer than is 

necessardin order to invest the proceeds to earn the arbitrage. For 

example, it was recently reported that New York City will earn $3 

million in legal arbitrage simply by extending the maturity of its tax 

anticipation notes five months beyond the date on which the taxes will 

be collected. 

Advance refundings of tax-exempt bonds also have the undesirable 

effect of increasing the volume of tax-exempt bonds. Advance 

refundings result in twice as many bonds being outstanding as are 

required for a given project. 

Increased bond volume brought about by arbitrage and advance 

refundings increases the Federal revenue loss associated with 

tax-exempt bonds, thereby causing taxpayers all over the country to 

pay additional taxes to support this subsidy of selected governmental

issuers. Furthermore, additional volume in the tax-exempt bond market 

- 290 -
raises the interest rates that must be paid to finance State and local 

government projects. This expansion also results in pressure for 

additional Federal aid for those projects from more jurisdictions

because of the increased cost of providing the governmental services. 

Proposal 

Issuers of tax-exempt bonds would be required to rebate to the 

United States all arbitrage on acquired nonpurpose obligations

(adjusted for gains and losses on the obligations and earnings on the 

gains and on the arbitrage). Investments in acquired nonpurpose

obligations would be limited to 150 percent of annual debt service 

with exceptions for the initial temporary period and for bona fide 

debt service funds. 

Yield on the bond issue would be determined without regard to 

the underwriter's discount, costs of issuance, credit enhancement fees 

or other costs. Calculation of yield on acquired obligations also 

would be changed to prevent any reduction for costs. 

The reasonable expectations test would be clarified to provide

explicitly that it only protects inadvertent errors and not 

intentional acts to create arbitrage. For example, any fund that will 

be used to pay debt service on an issue will be subject to the rebate 

requirement regardless of whether its creation or its arbitrage was 

anticipated at the time of the tax-exempt bond issuance. 

Temporary period rules permitting unlimited arbitrage until bond 

proceeds are used would be made more strict than the current rules. 

There would be no temporary period for bond issues to finance 

acquisitions. The temporary period for construction projects would 

terminate when the project is substantially completed or when an 

amount equal to bond proceeds has been expended on the project and 

would in all cases be limited to three years. The right to waive the 

temporary period and earn a yield exceeding the bond yield by 0.5 

percent would be repealed. 

(Early issuance of bonds for a project would be prohibited. The 

issuer would be required to spend a significant part of the bond 

proceeds within one month and spend all bond proceeds excluding

proceeds in a 4R fund) within three years of issuance.3 

Advance refundings would be prohibited for all tax-exempt bonds. 

Refundings would be permitted only if the proceeds of the refunding

bonds are used immediately to retire the prior bond issue. 

Effective Date 

The proposal would be effective for obligations issued on or 

after January 1, 1986. 

- 291 -
Analysis 

The proposal's rebate requirement would eliminate most of the 

economic motivation to issue tax-exempt bonds to earn arbitrage. In 

addition, arbitrage earned on obligations that are issued for 

governmental functions would not result in a windfall profit for the 

issuer. Proposed changes in the method of calculating yield and in 

the reasonable expectations test are necessary to implement the rebate 

requirement properly. 

The prohibition of advance refundings would result in a reduction 

in the aggregate volume of tax-exempt obligations being issued. 

Individual bond issues would be limited in size by the proposal's

restriction on the amount of investments in acquired nonpurpose

obligations. In addition, the period during which bonds may be 

outstanding would be limite5by the proposal's restrictions on 

temporary periods and early issuance. The reductions in both the 

overall volume and individual size of bond issues would reduce the 

Federal revenue cost of tax-exempt bonds and would also reduce the 

interest costs to issuers of obtaining financing for governmental

functions3 

State and local governments would continue to fulfill necessary

governmental functions. Governmental facilities and services could 

still be financed on a tax-exempt basis. Issuers, however, would not 

obtain the unnecessary "double dipping" provided by arbitrage in 

addition to the basic benefit of reduced interest cost. 

The proposal would eliminate many complex provisions in the Code 

and in the Treasury regulations interpreting the Code. The rules on 

advance refundings would be unnecessary and those dealing with yield

computation would be simplified. The special arbitrage rules for 

certain bonds under current law also would be unnecessary because 

these bonds would not be exempt under the proposal for repeal of tax 

exemption for nongovernmental bonds. 

- 292 -
REPEAL GENERAL STOCK OWNERSHIP CORPORATION PROVISIONS 

General Explanation 

Chapter 11.03 

Current Law 

Current law authorizes a State to establish a General Stock 

Ownership Corporation ("GSOC") for the benefit of its citizens. A 

GSOC meeting certain statutory requirements and making an appropriate

election is exempt from Federal income tax. Instead, the shareholders 

of the GSOC are taxable on their daily pro rata share of the GSOC's 

taxable income. The GSOC computes its taxable income in the same 

manner as a regular corporation, but is not eligible for the 

dividends-received deduction. Losses of a GSOC do not flow through to 

its shareholders, but the GSOC is allowed a 10-year net operating loss 

carryforward. 

Current law permits such corporations to be chartered after 

December 31, 1978, and before January 1, 1984. 

Reasons for Change 

No GSOC has been organized under this law and the period during

which they may be formed has expired. 

Proposal 

The proposal would repeal the law permitting creation of GSOCs. 

Effective Date 

The proposal would be effective as of January 1, 1984, the sunset 

date for creation of GSOCs. 

Analysis 

The complex provisions governing organization and operation of 

GSOCs have never been utilized. Repeal of these provisions would 

simplify the Code and have no economic effect. There would be no 

impact on revenues or expenditures as a result of implementing this 

proposal. 

- 293-
CHAPTER 12 

MODIFY OTHER SPECIFIC SUBSIDIES 

The Administration proposals would repeal various tax subsidies 

for particular businesses, including the rehabilitation tax credit,

the merchant marine capital construction fund provisions, and special

rules for book, magazine, and discount coupon income. The research 

and experimentation credit would be retained, but modified to improve

its efficiency. The possessions tax credit would be replaced with a 

wage credit. Various tax incentives designed to encourage employee

stock ownership would be revised to better carry out their purposes. 

- 295 -
REPEAL TAX CREDIT FOR QUALIFIED

REHABILITATION 

General Explanation 

Chapter 12.01 

Current Law 

A special investment tax credit (the "rehabilitation credit") is 

provided for qualified expenditures incurred in connection with the 

rehabilitation (but not enlargement) of certain old or historic 

buildings. The credit rate is equal to (a) 15 percent for qualified

expenditures incurred in connection with buildings at least 30 years

old but less than 40 years old, (b) 20 percent for qualified

expenditures incurred in connection with buildings at least 40 years

old, and (c) 25 percent for qualified expenditures incurred in 

connection with certified historic structures of any aye. The regular

investment tax credit and the energy investment tax credit do not 

apply to any portion of an expenditure which qualifies for the 

rehabilitation credit. 

The rehabilitation credit is limited to expenditures incurred in 

connection with buildings that will not be used for lodging (except in 

the case of certified historic structures), and is available only if 

the taxpayer elects to use the straight-line recovery method with 

respect to the expenditures. A rehabilitation must be substantial to 

qualify for the credit. In general, this requirement is met if 

rehabilitation expenditures incurred over a 24-month period exceed the 

adjusted basis of the property at the beginning of that period. In 

addition, at least 75 percent of the building's external walls must be 

retained in place. 

The 25 percent credit for rehabilitations of certified historic 

structures is subject to certain additional requirements. In general,

the 25 percent credit is not available unless the rehabilitation is 

certified by the Secretary of the Interior as being consistent with 

the historic character of the building or the district in which the 

building is located. Certified historic structures include only (a)

buildings listed in the National Register and (b) buildings located in 

a registered historic district and certified by the Secretary of the 

Interior as being of historic significance to the district. 

In the case of a qualified rehabilitation of a certified historic 

structure, the basis of the rehabilitated building is reduced by 50 

percent of the amount of the credit. The reduction is 100 percent of 

the credit in the case of other qualified rehabilitations. If a 

rehabilitation credit is subsequently recaptured, corrective basis 

adjustments are made (and treated as occurring immediately before the 

recapture event). 

- 296 -
Reasons For Change 

As enacted in 1962, the investment tax credit was unavailable for 

buildings and their structural components. In limiting the credit to 

tangible personal property, Congress was primarily concerned about the 

greater average age and lower efficiency of domestic machinery and 

equipment in comparison with the facilities of major foreign

producers. 

In 1978, Congress observed a decline in the usefulness of 

existing, older buildings, primarily in central cities and older 

neighborhoods, and extended the regular investment tax credit to older 

buildings for the purpose of promoting stability and economic vitality

in deteriorating areas. No special credit was provided for certified 

historic structures, although the credit was made available for 

rehabilitation of such structures only if the Secretary of the 

Interior certified the rehabilitation as appropriate. 

In 1981, Congress enacted the Accelerated Cost Recovery System

(tq~~~~"), and noted that ACRS had the unintended effect of reducing

the relative attractiveness of the original (ten percent) credit for 

rehabilitating older buildings. Accordingly, Congress replaced the 

original rehabilitation credit with the three-tier credit contained in 

current law. The three-tier system had the effect of (1) increasing

the amount of the credit available for all qualified buildings, (2)

further increasing the credit for buildings more than 30 years old,

and (3) providing a special increased credit for certified historic 

structures. 

The current rehabilitation tax credit is flawed in several 

respects. First, the credits are embedded in a complicated matrix of 

tax rules which, taken as a whole, result in widely varying after-tax 

returns for investments in different types of assets. There is no 

evidence that the combined tax benefits granted to rehabilitators of 

older buildings, when compared to the tax benefits available to 

constructors or rehabilitators of newer buildings, are an appropriate

incentive for investment in older buildings. Moreover, since the 

amount of the credit for any qualified rehabilitation is generally a 

function only of (1) the age of the existing structure, and (2) the 

cost of the rehabilitation, the incentive effects of the credit are 

not limited to investment in deteriorating areas, as opposed to 

modernization of older structures in stable areas. 

In addition, the 25 percent credit for certified historic 

structures is effectively administered by an agency without budgetary

responsibility for the revenue cost. The Secretary of the Interior is 

given sole authority to determine whether a structure meets the 

requirements for the credit, but the subsidy is not included in the 

Interior Department's budget. Thus, in determining the availability

of the credit, the sole reviewing agency has no direct incentive to 

compare probable costs and benefits. 

- 297 -
Proposal 

The rehabilitation credit would be repealed 

Effective Date 

Repeal would be effective for expenditures incurred on or after 

January 1, 1986. Expenditures incurred on or after the effective date 

would be aggregated with expenditures incurred prior to the effective 

date for purposes of determining whether the earlier expenditures were 

incurred in connection with a "substantial" rehabilitation. 

Analysis 

In the absence of investment tax credits for rehabilitation 

expenditures, the full amount of such expenditures would be recovered 

through normal cost recovery rules. 

- 298 -
REPEAL SPECIAL RULES FOR BOOK, MAGAZINE, AND 

DISCOUNT COUPON INCOME 

General Explanation 

Chapter 12.02 

Current Law 

Magazine, Paperback, and Record Returns. An accrual basis 

taxpayer that distributes magazines, paperbacks, or sound recordings

for resale may elect (irrevocably) to exclude from gross income for 

the taxable year certain amounts attributable to the sale of such 

items if the purchaser fails to resell the items and returns them 

within a specified period after the end of the taxab1.e year (2-1/2

months in the case of magazines, and 4-1/2 months in the case of 

paperbacks and recordings). The exclusion applies only if, at the 

time of sale, the taxpayer has a legal obligation to adjust the sales 

price if the items are not resold, and the exclusion is limited to the 

amount of price reductions for returns that are actually made within 

the prescribe6 periods. 

An election to take advantage of this exclusion triggers the 

application of special transitional adjustment rules designed to 

prevent the "bunching" of deductions in the first year of the 

election. In the case of an election relating to magazines, the 

decrease in income resulting from the bunching of deductions in the 

first year is spread over a five-year period. In the case of an 

election relating to paperbacks or records, however, the decrease is 

placed in a suspense account. Adjustments to this suspense account 

permit additional exclusions from income in subsequent taxable years

only to the extent the taxpayer's adjustments from post-year returns 

decline over time. In general, the effect of the suspense account is 

to defer deduction of the transitional adjustment until the taxpayer 

ceases to be engaged in the trade or business of publishing or 

distributing paperbacks or records. 

Redemptions of Qualified Discount Coupons. An accrual basis 

taxpayer that issues discount coupons with respect to merchandise 

marketed by unrelated retailers may irrevocably elect to deduct in the 

taxable year the cost of redeeming qualified coupons that are returned 

within six months after the end of the taxable year. A shorter period 

may be used at the taxpayer's election. 

In the case of an election under this provision, the decrease in 

income resulting from the "bunching" of deductions in the first year

is not allowed but is placed in a suspense account. Adjustments to 

this suspense account permit additional deductions in subsequent

taxable years only to the extent the taxpayer's qualified discount 

coupon redemptions decline over time. If such redemptions do not 

decline, the suspended amounts may be deducted only when the taxpayer 

ceases to be engaged in the business. 

- 299 -
Reasons for Change 

The primary purpose of the special provisions for magazine,

paperback, and record returns, and redemptions of qualified discount 

coupons, is to enable taxpayers to conform their tax accounting to 

their financial accounting. In both cases, the exclusion or deduction 

is designed to approximate decreases in adjusted gross income that 

would have accrued at the end of the taxable year if the amount of the 

taxpayer's price-adjustment or redemption obligation were known at 

that time. 

On the other hand, there is a general standard for accrual of 

liabilities in the taxable year -- occurrence of all events sufficient 

to establish the existence and amount of the liability. The cases 

covered by the current rules do not satisfy this standard, since the 

events establishing the taxpayer's liability for the adjustment -- return of magazines, paperbacks, or records, or presentment of 

coupons -- have not occurred as of the end of the year. 

Repeal of these rules would also simplify the tax code and would 

make it unnecessary to determine the correctness of taxpayers' claims 

that post-year price adjustments and redemptions are made pursuant to 

obligations or coupons that were outstanding prior to the end of the 

taxable year. 

Proposal 

The elections (a) to exclude from income certain adjustments

relating to magazines, paperbacks, and record returns, and (b) to 

deduct costs of redeeming qualified discount coupons, would be 

repealed. 

Effective Date 

The repeal would be effective for taxable years beginning on or 

after January 1, 1986. Affected taxpayers would be permitted to 

deduct the balances of their suspense accounts or suspended amounts in 

the first taxable year in which the proposal is effective. 

Analysis 

Taxpayers would be adversely affected by repeal of these special

accounting rules only to the extent of amounts prematurely deducted in 

prior years. Under the proposal, affected taxpayers would compute

their income on the same basis as others using the accrual method. 

Adversely affected taxpayers also would gain a compensating benefit 

from the proposed general reductions in tax rates. 

- 300 -
EXTEND AND MODIFY RESEARCH AND EXPERIMENTATION CREDIT 

General Explanation 

Chapter 12.03 

Current Law 

A 25 percent nonrefundable tax credit is allowed for the portion

of a taxpayer's qualified research expenses which is equal to the 

lesser of (1) the excess of such expenses in the current year over the 

average amount of such expenses for the prior three years or (2) 50 

percent of qualified research expenses in the current year. Special

rules apply to aggregate qualified research expenses of certain 

related persons to ensure that the credit is available only for real 

increases in qualified research expenditures. 

"Qualified research expenses" generally include only research and 

development costs in the experimental or laboratory sense. Qualified

research expenses that are eligible for the credit include (1) 

expenses paid or incurred for qualified research conducted directly by

the taxpayer, (2) 65 percent of any amounts paid or incurred to 

another person for qualified research (i.e., "contract research" 

expenses), and (3) in the case of corporate taxpayers, 65 percent of 

any amounts contributed to universities and other qualifying

organizations for the conduct of basic research. 

The credit is available only for research expenses paid or 

incurred in connection with an ongoing trade or business of the 

taxpayer. Employee wages are treated as qualified research expenses 

to the extent paid to an employee for engaging in (1) the actual 

conduct of qualified research, (2) the immediate supervision of 

qualified research activities, or (3) the direct support of such 

activities. Payments for supplies used in the conduct of qualified

research and amounts paid for the right to use personal property in 

the conduct of qualified research also constitute qualified research 

expenses. 

Expenses of (1) research conducted outside the IJnited States, (2)

research in the social sciences and humanities, and (3) funded 

research are specifically excluded from qualified research expenses

eligible for the credit. 

Credits that are not used in a taxable year may be carried back 

three years and forward 15 years. The credit will not be available 

for expenses paid or incurred after December 31, 1985. 

Reasons For Change 

The existing credit for research and experimentation activities is 

intended to create an incentive for technological innovation. The 

- 301 -
benefit to the country from such innovation is unquestioned, and there 

are reasonable grounds for believing that market rewards to those who 

take the risks of research and experimentation are not sufficient to 

support an optimal level of such activity. The credit is intended to 

reward those engaged in research and experimentation of unproven

technologies. 

Although the credit for research and experimentation is justified

in concept, the existing definition of eligible activities is overly

broad. Some taxpayers take the view that the costs of any trial and 

error procedure are eligible for the credit even though there may be 

little doubt about the outcome of the procedure. 

The definition of qualifying expenses for purposes of the credit 

should identify clearly those innovative research activities which 

merit government support. This definition also should incorporate

standards that are sufficiently objective to permit taxpayers, in 

planning their activities, to determine with reasonable certainty

whether the credit will be available. A definition that satisfies 

these two criteria would be more effective in encouraging taxpayers to 

undertake innovative research and experimental activities. 

Proposal 

The credit for increases in research and experimentation

expenditures would be extended for an additional three years (until

December 31, 1988), and the definition of qualified research would be 

revised to target those research activities likely to result in 

technological innovations. 

Effective Date 

The revised definition of qualified research would be effective 

for expenses paid or incurred after December 31, 1985. 

Analysis 

The definition of expenses qualifying for the research credit 

should target private research activities designed to lead to 

technological innovations in products and production processes. At 

the same time, the definition must be phrased in terms that permit 

taxpayers to know with reasonable certainty what research activities 

qualify for the credit. 

A useful definition incorporating both principles is found in the 

Senate amendment to H.R. 4170 (enacted as the "Tax Reform Act of 

1984"). Although the conference committee agreed to defer 

consideration of the research credit, the Senate definition targets

technological innovation and provides taxpayers with relatively

objective rules. 

- 302 -
The Senate definition focuses on new or technologically improved

products and processes and provides that research qualifies for the 

credit only if it rel.ates to a process of experimentation encompassing

the evaluation of alternatives that involve a serious degree of 

uncertainty as to whether the desired result can be achieved. This 

requirement is designed to ensure that the credit is available only

for research activities intended to lead to technological innovation. 

In addition, the Senate definition excludes a number of activities,

such as reverse engineering and debugging, that, by their nature, will 

not result in technological innovation. 

Further refinements in the Senate definition, such as identifying

additional exclusions from the scope of qualifying research, may be 

appropriate to ensure that the credit does not subsidize 

private research activities that are not innovative. In addition, the 

revenue loss resulting from the extension of the credit must be 

considered in redefining the scope of qualifying expenses. 

Other legislative proposals, such as a separate credit for 

contributions to fund basic university research or an enhanced 

charitable deduction for contributions of scientific equipment to 

universities, are typically associated with the research credit. 

Although the Administration proposal does not address these related 

issues, they would be considered in the context of legislative efforts 

to extend the research credit. 

- 303 -
REPEAL MERCHANT MARINE CAPITAL 

CONSTRUCTION FUND PROVISIONS 

General Explanation 

Chapter 12.04 

Current Law 

The Merchant Marine Act provides special tax treatment for U.S. 

citizens and domestic corporations owning or leasing certain vessels 

operated in the foreign or domestic commerce of the United States or 

in U.S. fisheries. The vessel must have been constructed or 

reconstructed in the United States and must be documented under the 

laws of the United States. 

In general, a taxpayer that qualifies for this treatment receives 

a deduction for amounts deposited in a capital construction fund 

pursuant to an agreement with the Secretary of Transportation or, in 

the case of U.S. fisheries, the Secretary of Commerce. The deductible 

amount is limited to the portion of the taxable income of the owner or 

lessee that is attributable to the qualified operation of the vessel 

covered by the agreement ("eligible agreement vessel"). In addition,

nondeductible deposits may be made up to the amount of depreciation on 

such vessel for the year. Earnings on all amounts in the fund are 

exempt from Federal income tax liability. 

The tax consequences of a withdrawal from such a fund are 

determined by reference to three accounts. The capital account 

represents deposits that were not deductible as well as the fund's 

tax-exempt income (that is, income exempt from tax without regard to 

the fund's special exemption). The capital gain account represents

accumulated net long-term capital gain income of the fund. The 

ordinary income account represents deductible deposits and accumulated 

taxable income of the fund (that is, income that would have been 

taxable if the fund were not exempt). 

The tax treatment of a withdrawal depends on whether it is 

"qualified." A withdrawal is qualified if used to acquire, construct, 

or reconstruct "qualified agreement vessels," or barges and containers 

which are part of the complement of such vessels, in accordance with 

the terms of the applicable agreement, or to repay principal on debt 

incurred with respect to such acquisition, construction, or 

reconstruction. 

A qualified withdrawal is not currently taxable, and is deemed to 

come first out of the capital account, then out of the capital gain 

account, and finally out of the ordinary income account (after the 

other accounts have been exhausted). Amounts withdrawn from the 

ordinary income or capital gain accounts reduce the taxpayer's basis 

in its investment in the qualified vessels (only in part in the case 

- 304 -
of capital gain account withdrawals). A taxpayer may, however, 

compute its investment tax credit with respect to a qualified vessel 

by including at least one-half of its qualified withdrawals in basis. 

Accordingly, the taxpayer is entitled to at least a partial investment 

tax credit on investments made with fund withdrawals, even though its 

basis attributable to withdrawals is zero for purposes of computing

depreciation. A qualified withdrawal out of the ordinary income or 

capital gain account made to retire debt requires a reduction in the 

basis of vessels, barges, and containers owned by the person

maintaining the fund. 

Nonqualified withdrawals are deemed to come first out of the 

ordinary income account, then out of the capital gain account, and 

finally out of the capital account. A nonqualified withdrawal treated 

as made out of the ordinary income account must be included in taxable 

income. To the extent the withdrawal comes out of the capital gain

account it is taxed as long-term capital gain; a withdrawal out of the 

capital account is not taxable. Interest on the tax liability

attributable to the withdrawal is payable from the time for payment of 

tax for the year in which the item was deposited into the fund. 

Reasons for Change 

The current rules for taxation of merchant marine capital

construction funds are a gross departure from generally applicable

principles of taxation. The special rules generally exempt from tax 

earnings on deposits in such funds. Moreover, they permit an eligible 

taxpayer to expense capital investments made with fund withdrawals as 

well as claim an investment tax credit on an asset in which it has a 

zero basis. 

The special tax treatment of capital construction funds 

originated, along with a direct appropriations program, to assure an 

adequate supply of shipping in the event of war. It was thus feared 

that because of comparative shipbuilding and operating cost 

disadvantages, peacetime demand for U.S.-flag vessels would not 

reflect possible wartime needs. 

A national security justification for subsidies of U.S. maritime 

construction is today unclear. U.S. citizens own or control large

numbers of ships registered in Panama, Liberia, and Honduras that 

would be available to the United States in an emergency, and most 1J.S. 

allies possess substantial fleets of oceangoing cargo ships that would 

be available in any common emergency. Largely for this reason, direct 

appropriations for maritime construction (the construction 

differential and operating differential subsidies) are being phased 

out. 

A similar fate is appropriate for the special tax rules 

applicable to capital construction funds. Even if a capital

construction fund subsidy is justified, it would more appropriately be 

provided in the form of a direct spending or regulatory program that 

- 305 -

476-698 0 - 85 - 12 
is subject to review by the congressional committees and agencies

concerned with maritime policy. Basing such a subsidy in the tax laws 

complicates tax administration and has a differential impact on 

different taxpayers depending on their other tax attributes. A direct 

subsidy would be more straightforward and would reflect the costs of 

the subsidy in the budget of the appropriate agency. Such an approach

would also avoid problems of coordination and excessive bureaucracy

due to administration of a program by two agencies (the IRS and 

MARAD ) . 

Similar considerations apply to the allowance of capital

construction funds for fishing vessels. To the extent that a subsidy

is justified for reasons relating to foreign competition, it would be 

better provided outside the tax system. 

Proposal 

The rules providing special tax treatment for capital

construction funds would be repealed. 

Effective Date 

No further tax-free contributions to capital construction funds 

could be made after 1985, except with respect to qualified agreement

vessels that the taxpayer owned on January 1, 1986, or qualified

agreement vessels with respect to which the taxpayer had performed (or

had caused to be performed) a substantial amount of construction or 

reconstruction before January 1, 1986. To the extent that fund assets 

exceeded amounts designated under the agreement to be used with 

respect to such qualified vessels, earnings on such excess 

attributable to the period after December 31, 1985, would be subject 

to tax. Any withdrawals from a fund on or after January 1, 1986,

other than with respect to such qualified vessels, would be treated as 

nonqualified withdrawals, except that no interest charge would apply

with respect to such withdrawals. Any amounts remaining in a capital

construction fund on January 1, 1996, would be treated as withdrawn at 

that time. 

Analysis 

Repeal of the special tax treatment for capital construction 

funds would promote neutrality by ensuring that capital investments 

are made only when justified by economic rather than tax 

considerations. 

- 306 -
REPLACE POSSESSIONS TAX CREDIT WITH A WAGE CREDIT 

General Explanation 

Chapter 12.05 

Current Law 

Section 936 provides a special credit for certain income of 

qualifying corporations operating in Puerto Rico and possessions of 

the United States other than the Virgin Islands. A section 936 

corporation is generally subject to tax on its worldwide income in a 

manner similar to any other U.S. corporation. However, it may claim a 

tax credit equal to the 1J.S. tax on business and qualified investment 

income from the possessions, regardless of whether any tax is paid to 

the government of the possessions. The effect of this treatment is to 

exempt from U.S. tax the income from business activities and qualified

investments in the possessions and the income from disposition of a 

possessions business. (Rules having similar effect, but through a 

different mechanism, apply for the Virgin Islands.) All other income 

of section 936 corporations is taxed currently, subject to the usual 

credit for foreign taxes paid on foreign source income. To avoid a 

double credit against U.S. taxes, no credit is allowed under section 

901 for foreign taxes paid on income subject to the section 936 

credit, and no deduction is allowed for such taxes. 

Any domestic corporation which elects to be a section 936 

corporation may receive the section 936 credit if it satisfies two 

conditions. First, 80 percent or more of its gross income for the 

three-year period immediately preceding the close of the taxable year 

must be from sources within a possession (or possessions). Second,

for tax years beginning after 1984 at least 65 percent of its income 

for that period must be from the active conduct of a trade or business 

within a possession (or possessions). 

Puerto Rico has complemented the section 936 credit with 

incentives of its own. Puerto Rico grants tax exemptions of up to 90 

percent for income of certain approved enterprises for specified

periods of time (generally 10 to 25 years). In addition, Puerto Rico 

exempts from tax certain passive income. The combination of the 

section 936 credit and the Puerto Rican incentives means that 

qualifying corporations pay little tax on their Puerto Rican-source 

income. 

The Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA")

made two changes designed to reduce the revenue cost of section 936 

due to (a) the attempted allocation of intangible income to 

possessions in order to claim exemption for such income, and (b) the 

exemption of passive income. The problem of intangible income was 

addressed by adding a very complex set of allocation rules to section 

936 for tax years beginning after 1982. The revenue cost of exempting 

- 307 -
passive income was addressed by increasing the active trade or 

business percentage requirement from 50 percent in 1982 to 65 percent

in 1985. 

As a rough corollary to section 936 (and to section 934(b) for 

Virgin Islands operations), section 957(c) provides that a corporation

organized in a possession (including Puerto Rico, Guam, American 

Samoa, the Commonwealth of the Northern Mariana Islands, and the 

Virgin Islands) shall not be considered a controlled foreign

corporation (the Subpart F income of which would otherwise be taxed 

currently to its controlling U.S. shareholders) if 80 percent of its 

gross income is derived from sources in the possession and 50 percent

of its gross income is derived from the active conduct within the 

possession of certain specified trades or businesses. 

Reasons for Change 

The stated purpose of section 936 is to "assist the U.S. 

possessions in obtaining employment-producing investments by U.S. 

corporations." However, despite the fact that inflation-adjusted

tax-exempt income of corporations which have elected the benefits of 

section 936 has more than doubled since 1972, employment levels (both

overall and in the manufacturing sector) have been flat. The credit 

rewards generating income in the possessions; it provides no direct 

incentive to generating employment. Even after TEFRA, much of the 

benefit of the existing credit accrues to income of intangible assets 

which have been developed in the United States and attributed to a 

possessions corporation for purposes of determining possession-source

income. As an example, for pharmaceutical companies operating in 

Puerto Rico, profits are frequently 60 percent of their sales. 

The existing credit is very costly and inefficient. The average 

tax benefit per employee for all section 936 corporations was more 

than $22,000 in 1982, more than 50 percent more than the average wage

of possessions corporations' employees of $14,210. Fourteen corporations received tax benefits in excess of $100,000 per employee. Those 

fourteen companies accounted for 4 percent of the section 936 

corporations for which employment data was available and derived 29 

percent of the combined tax benefits. (The fourteen companies

accounted for 3 percent of all section 936 corporations and 26 percent

of the total tax benefits of all such corporations.) 

The TEFRA changes were designed to reduce the revenue cost and 

income distortions associated with this program. However, an 

examination of available 1983 returns (post-TEFRA), representing

companies which claimed 25 percent of the possessions tax credits in 

1982, indicates that the credit claimed in 1983 actually increased 

slightly, rather than declining sharply as had been expected, even 

though the previously predicted decline in cost had taken expected

growth into account. This increase in the possessions credits is 

particularly disturbing because it took place when there appears to 

have been a substantial decline in qualified interest income, due to 

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the decline in average interest rates in 1983 and to repatriation of 

earnings by the companies. In the absence of the decline in interest 

income, the credits would have increased much more. 

Moreover, the TEFRA changes are exceedingly complex. As a result,

they will be very difficult for the IRS to administer. 

In addition, there remains no direct incentive under current law 

to increase employment in the possessions; the incentive continues to 

be to attribute income to the possessions. Even with the TEFRA rules,

section 936 fails to provide any incentive to increase employment or 

economic activity in the possessions beyond the minimum business 

presence required to qualify for the special income allocation rules 

introduced by TEFRA. 

The exemption from controlled foreign corporation status available 

to possession-chartered corporations under section 957(c) is similarly

poorly targeted to the creation of employment-producing investments in 

the possessions. That provision permits the exemption of tax-haven 

income from the Subpart F classification without any significant

justification. 

Proposal 

The current income-based credit would be repealed and replaced by 

a permanent wage credit. A U.S. corporation could elect a wage credit 

equal to 60 percent of wages, up to the Federal minimum wage amount,

paid to persons employed in the possessions by an establishment 

engaged in manufacturing, plus 20 percent of such wages paid above the 

Federal minimum wage amount, subject to an overall wage cap per

employee of four times the Federal minimum wage amount. Corporations

electing the wage credit would be required to reduce their otherwise 

allowable deduction for wages paid by the amount of the wage credit 

claimed. At the present annual minimum wage amount of $6,968, and 

with a 33 percent corporate tax, the maximum net credit would be 

$5,602 per employee (67 percent of the maximum gross credit of 

$8,362). 

The wage credit could be used to offset the U.S. tax on any

income, without regard to whether such income may have arisen from 

sources in a possession. The credit would not be refundable, but 

could be carried forward for 15 years. United States corporations

with manufacturing operations in the Virgin Islands would be entitled 

to elect the wage credit on the same basis as U.S. corporations with 

operations in any other eligible possession. Thus, the parity that 

exists under current law between U.S. corporations doing business in 

the Virgin Islands and those doing business in other possessions would 

continue. 

Corporations electing the wage credit would not be entitled to 

claim a foreign tax credit for taxes paid to the possessions, but they

would be allowed a deduction for such taxes, regardless of whether 

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they otherwise claim a credit for taxes paid to other countries. This 

rule allowing a deduction for possessions taxes and a foreign tax 

credit for other foreign taxes compensates for the denial of the 

foreign tax credit for possessions taxes and is consistent with the 

approach taken under the proposed per-country limitation on the 

foreign tax credit. Also, for possessions corporations that elect the 

wage credit rather than the foreign tax ctedit for possessions taxes,

the introduction of the per-country limitation eliminates any need 

that might otherwise arise to adopt special rules for possessionssource income to prevent such corporations from using that low-tax 

income to increase their foreign tax credit limitation on other 

categories of income. 

Dividends paid by corporations electing the wage credit would be 

subject to the general rules with respect to dividends-received 

deductions for dividends from U.S. corporations. The electing

corporations would be required to be included in the consolidated tax 

returns filed by affiliated corporations, thereby effectively

achieving the equivalent of a 100 percent dividends-received 

deduction. 

Section 957(c) would be repealed, thereby eliminating the deferral 

of U.S. tax on the Subpart F income of possessions-chartered

corporations that fall into the category of controlled foreign

corporations. 

For purposes of applying the rules of the proposed Capital Cost 

Recovery System ("CCRS") to property purchased by a domestic 

corporation on or after January 1, 1986 and used predominantly in a 

U.S. possession, such property would be treated as foreign property

only to the extent such corporation elects to claim the benefits of 

the income-based credit under section 936, as that section currently

applies, during the grandfather period described below. 

Effective Date 

The proposals would generally be effective for taxable years

beginning on or after January 1, 1986. However, corporations which 

have validly elected possessions corporation status for a taxable year

beginning before January 1, 1986 would be entitled to grandfather

protection. Such corporations would be allowed to continue to use the 

existing income-based credit for their first five taxable years

beginning on or after January 1, 1986, but only with respect to 

products which they had validly designated as possessions products for 

their last taxable year beginning before January 1, 1986. (If they

had validly elected possessions corporation status but had not 

designated a possessions product, they would be allowed to use the 

income-based credit during the grandfather period only with respect to 

products which they were "manufacturing" in the same possession during

their last taxable year beginning before January 1, 1986, as 

determined in a manner similar to the significant business presence

test transition rules in the proposed section 936(h) regulations 

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issued after TEFRA.) In addition, such corporations could continue to 

use the income-based credit during the grandfather period with respect

to qualified possessions-source investment income from such 

grandfathered activities and from their existing qualifying passive

investments. Existing possessions corporations could elect to claim 

either the wage credit or the current section 936 credit during the 

grandfather period, but once they have elected the wage credit they

could not return to use of the income-based credit. Related corporations operating in the possessions would not be permitted to make 

different elections. 

Domestic corporations doing business in the Virgin Islands which 

have validly qualified for the benefits of section 934(b) for their 

last taxable year beginning before January 1, 1986 would be entitled 

to elect to use the income-based credit during the five-year grandfather period to achieve exemption of their qualifying Virgin Islandssource income from U.S. taxation under rules similar to those applying 

to existing possessions corporations. 

The repeal of section 957(c) would apply to taxable years of 

possessions-chartered corporations beginning on or after January 1,

1986 and to taxable years of U.S. shareholders within or with which 

these taxable years of the possessions-chartered corporations end. 

For purposes of applying the controlled foreign corporation rules to 

such corporations, earnings and profits for taxable years beginning

before January 1, 1986 and property acquired before January 1, 1986 

would be excluded from the operation of the controlled foreign

corporation provisions. 

Analysis 

The current system is complicated, expensive, and inefficient. 

The rules for determining possessions source income are among the most 

complex in the tax law. Because section 936 is not targeted toward 

increasing employment, the average revenue cost per job has exceeded 

150 percent of the average total compensation per employee of section 

936 corporations, without producing any clearly identifiable and 

readily measurable improvement in employment levels. Furthermore, the 

TEFRA changes do not appear to have limited the level of credits 

claimed to any significant extent. 

The Administration recognizes its special obligations toward, and 

supports the goal of encouraging increased employment and economic 

growth in, the possessions. The Administration also recognizes a 

special interest in the economic health of the Caribbean region.

Thus, notwithstanding the inefficiency of the present system, a 

subsidy is maintained for operations in the possessions. The subsidy

for the possessions would be restructured as a wage credit, however,

for the reasons discussed herein. The Administration is aware of the 

proposals being developed by interested parties that seek better to 

benefit Puerto Rico and countries participating in the Caribbean Basin 

Initiative. It is recognized that there may be other ways to 

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encourage employment in the possessions in a cost-effective way, or 

that there may be ways to restructure the wage credit to make it more 

efficient. The Administration looks forward to receiving further 

comments and suggestions in this regard from the governments of the 

possessions and other interested persons. 

The objective of the proposal is to encourage employment in the 

possessions in a cost-effective way. The simplest and most direct and 

efficient way to do so is through a wage subsidy. The proposed credit 

is permanent, to provide an ongoing incentive to investors. 

The proposed wage credit is more generous than it may at first 

appear. The amount of the credit is 60 percent of the annual Federal 

minimum wage plus 20 percent of wages above that level up to the 

ceiling amount of four times the annual Federal minimum wage. The 

proposed formula for the wage credit primarily offsets the costs of 

employing a worker at the Federal minimum wage level, but it also 

gives corporations an incentive to employ more highly skilled, highly

paid workers, thereby encouraging the development of a technologyoriented labor force in the possessions. Linking the credit to the 

minimum wage also provides an element of automatic indexing when that 

amount is adjusted for inflation. At the current minimum wage level 

and with a 33 percent corporate rate, the maximum net credit per

employee (after reducing the deduction for wages paid by the amount of 

the credit) is $5,602, that credit would eliminate the tax on $16,975

of taxable income per employee. In 1983 the pre-tax corporate profit 

per employee in U.S. manufacturing was about $3,600. Even assuming a 

substantial increase since then as a result of the economic recovery,

the availability of a wage credit of the type proposed would have 

meant a very large increase in the after-tax return on capital. For 

example, after-tax profits would have much more than doubled in the 

electronics, instruments, fabricated metals and food industries and 

would have significantly increased even in the chemical and allied 

products industries. This result is not surprising, considering the 

importance of labor costs in manufacturing. For U.S. manufacturing,

labor compensation accounts for 70 percent of the value-added on 

average, somewhat less (about 60 percent) in the manufacture of 

nondurable goods and somewhat more (nearly 80 percent) in the 

manufacture of durables. Thus, the proposal should be attractive to a 

broad class of industries. At the same time, the grandfather

protection and the wage credit's extra incentive for highly paid

workers should make it attractive to existing companies as well. 

Another way in which the proposed credit is generous is that it 

may be used to offset u.S. tax on any income (including income of 

affiliated companies filing as a consolidated group). Thus, the 

benefit is not limited to companies able to generate large profits in 

the possessions. Even an operation in a possession with a relatively

low profit margin would provide tax benefits to a company with other 

taxable income. This aspect of the proposal will also simplify 

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present law. Any U.S. corporation may elect the credit and may use it 

to offset U.S. tax on any income; the excessively complex eligibility 

tests and income allocation rules will no longer be necessary. 

Despite the problems inherent in the existing law, the Administration recognizes that the proposed wage credit may be less 

attractive than the existing income-based credit for certain 

corporations, primarily those in industries such as pharmaceuticals

and electronics which have lower than average employment levels and 

higher intangible income, and that immediate repeal of the existing

credit could cause undesirable short-term economic dislocation in the 

possessions. The proposed grandfather protection is designed to allow 

existing firms a generous transitional period to recover their 

existing investments and restructure their operations. Available data 

indicate that possessions corporations are able to recover their 

investments quickly under existing law. For example, in 1982 the 

ratio of pre-tax operating income to operating assets (including

inventories and net accounts receivable as well as property, plant and 

equipment) was 57 percent for all possessions corporations, this 

implies that that investments can be fully recovered in about 1 3/4 

years. For pharmaceuticals and the electrical and electronic 

industries, the ratios were 79 and 68 percent, respectively, which 

imply a recovery periods of about 1 1/4 years for pharmaceuticals and 

about 1 1/2 years for the electrical and electronic firms. Accordingly, the five-year period should be more than adequate to allow 

tax-free recovery of investment in existing assets. In addition, a 

grandfather period of any longer than five years would heighten the 

need for a re-examination and amendment of the income allocation rules 

of the existing section 936 to reduce existing abuses during the 

transition period. 

The banking sector of the possessions' economies currently

benefits from that aspect of the income-based credit which exempts

qualifying possessions-source investment income from tax. Available 

data indicate, however, that the accumulation of section 936 funds has 

had little positive impact on real investment in the possessions. The 

proposal would have little adverse impact on the Puerto Rican banking 

system, even in the absence of the grandfathering provision, due to 

the system's high liquidity. 

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REVISE RULES FOR LEVERAGED ESOPS 

General Explanation 

Chapter 12.06 

Current Law 

An employee stock ownership plan ("ESOP") is a qualified

retirement plan designed to invest primarily in employer securities. 

Such plans generally are either "tax credit ESOPs" or "leveraged

ESOPs." Both types of plans receive significant tax subsidies. 

A corporate employer is entitled to a tax credit for contributions 

to a tax credit ESOP of cash or employer secur-itiesnot in excess of 

0.5 percent of the compensation paid or accrued with respect to 

employees participating in the ESOP. The employer also receives a tax 

credit for the costs of establishing and administering the plan,

within certain limits. 

In a leveraged ESOP, the plan borrows to purchase employer

securities and the corporation obligates itself to contribute amounts 

sufficient for the ESOP to make payments on the debt. The employer

generally may deduct these contributions to the ESOP currently without 

regard to the limits on employer contributions to other types of 

qualified plans. A special exception to the prohibited transaction 

rules applicable to qualified plans permits a sponsoring corporation

and its ESOP to engage in this transaction if the loan is primarily

for the benefit of participants and certain other requirements are 

satisfied. 

Employees are not taxed on employer contributions to an ESOP or 

accumulated income of the trust until securities are distributed. A 

tax credit ESOP must hold employer securities for at least seven years

before the securities can be distributed to employees; a leveraged

ESOP generally must hold employer securities for at least two years

before they can be distributed to employees. Typically, however, in 

both types of plans, participants do not receive a distribution of 

securities until they separate from service. When a distribution is 

made, the participant may "put" the securities to the employer and 

receive cash, unless the securities are traded on an established 

exchange. 

An ESOP must pass through voting rights on employer securities 

allocated to the accounts of participants; this requirement, however,

is substantially limited if the employer has no registration-required

class of securities. An ESOP may pass dividends through to 

participants on shares allocated to participants' accounts; dividends 

on unallocated shares ate retained by the trust. 

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Congress provided certain additional incentives for employee

ownership through qualified plans in the Tax Reform Act of 1984: (1)

banks, insurance companies and other commercial lenders may exclude 

half of the interest paid or accrued on a loan used by a leveraged

ESOP to purchase qualified securities; (2) corporations may deduct 

dividends actually paid to employees with respect to employer stock 

held in an ESOP and allocated to participants' accounts; (3) taxpayers 

are permitted to sell securities in a corporation to an ESOP or 

eligible worker-owned cooperative, purchase securities in a second 

corporation and defer recognition of gain on the sale; and (4) an ESOP 

may assume the estate tax liability of a decedent if the decedent's 

securities are transferred to the ESOP. 

Reasons for Change 

many argue that employees who own stock in their employer are more 

productive because, as part owners of the business, they have a stake 

in seeing the enterprise become more profitable. Current law has in 

many respects embraced this argument, since it contains a variety of 

provisions aimed at encouraging employee ownership. Despite the 

intentions behind such provisions, they represent a confused mix of 

incentives and requirements which fails to encourage direct employee

ownership. 

Employee ownership of employer securities through a qualified plan

defers significant incidents of ownership for employees until 

distribution of the securities. In most ESOPs, employees must wait 

until they separate from service before they receive a distribution. 

Furthermore, since employees are entitled to put nontraded securities 

to the employer following distribution, employees may never directly 

own any employer securities despite years of participation in an ESOP. 

ESOP participants receive only a small portion of the dividends 

paid on the employer securities that are eventually distributed to 

them. This results from the fact that an ESOP may pass through

dividends only with respect to shares actually allocated to the 

participants' accounts. Similarly, voting rights with respect to 

employer securities are passed through to participants only in limited 

circumstances and only with respect to shares allocated to 

participants' accounts. 

To the extent the full benefits of owning employer securities are 

deferred for ESOP participants, the intended incentive for employee

ownership is diminished. Indeed, if participation in the ESOP is in 

lieu of current compensation, such deferral may actually lessen 

employees' overall incentive to increase productivity. 

Finally, ESOPs should be recognized and treated as vehicles to 

encourage employee ownership rather than as an alternative form of 

quaiified retirement plan. Relying on ESOPs to provide retirement 

- 315 -
benefits is poor retirement policy. Qualified retirement plans are 

generally required to invest in a diversified portfolio to insure that 

anticipated benefits will be available when a participant retires. A 

retirement benefit entirely dependent on market fluctuations in a 

single, often unmarketable asset provides an employee little certainty

that adequate retirement security will be provided. This concern is 

particularly acute where employers reduce or eliminate contributions 

to pension or profit sharing plans because of required contributions 

to an ESOP. In addition, applying to ESOPs the rules for qualified

retirement plans, such as vesting requirements and contribution and 

distribution limits, unnecessarily restricts the ability of an 

employer to provide the benefits of owning employer securities to its 

employees. 

Proposal 

The tax credit for contributions to an ESOP would be permitted to 

expire as scheduled and the special deduction limits for contributions 

to leveraged ESOPs would be repealed. Also, the special exception to 

the prohibited transaction rules for leveraged ESOPs would be 

repealed. 

An employer with 15 or more employees that borrows funds from an 

unrelated lender to purchase outstanding "employer securities" with a 

fair market value equal to the principal amount of the loan would be 

permitted to deduct principal payments made each year with respect to 

the indebtedness provided that (1) the employer contributes the 

securities to an "employee stock ownership trust" and (2) the loan 

agreement requires either (i) annual principal payments not greater

than 20 percent or less than 8.3 percent of the original principal

balance or (ii) equal annual payments and a term of ten years or less. 

In addition, an employer would be precluded from deducting principal 

payments for any year in excess of 25 percent of eligible employees'

aggregate compensation for such year. Nondeductible payments would be 

deductible in a subsequent year, subject to the same 25 percent limit. 

For this purpose, "employer securities" would constitute either the 

stock of the employer or of any related corporation which is traded on 

an established securities exchange or, if no stock of the employer or 

of any related corporation is so traded, the securities of the 

employer or of any related corporation having the greatest voting and 

dividend rights. The employer would be required to employ an 

independent fiduciary to value nontraded employer securities. 

The employee stock ownership trust generally would be required to 

distribute annually a portion of the securities held by the trust (in

proportion to the scheduled principal repayments for the year) as well 

as dividends paid during the year on securities held by the trust. 

Alternatively, the trust agreement could provide that the trust would 

retain nominal ownership of the employer securities allocated to 

employees; a trust agreement so providing, would be required to 

provide employees with all rights of direct ownership in the 

- 316 -
securities, including the right to dividends paid with respect to the 

securities, the right to vote and the right to transfer the 

securities. 

In addition, the trust agreement for an employee stock ownership 

trust would be required to provide that the securities distributed or 

allocated during a year and dividends on undistributed securities be 

apportioned among employees on the basis of each employee's

compensation for the year not in excess of $50,000. The trust 

agreement could provide that only employees with at least 1,000 hours 

of service during the year would receive a distribution or allocation 

of securities or dividends on unallocated securities. The trust 

agreement would also be required to provide that employees be able to 

vote unallocated securities with respect to a corporate matter 

requiring more than a majority vote of outstanding employer

securities; the trustee could grant the right to vote unallocated 

securities in such cases to employees eligible to receive 

distributions from the trust in any reasonable manner. In addition,

the trustee of the trust holding the employer securities would be 

subject to the fiduciary responsibility provisions of Title I of 

ERISA. 

Employees would realize no income on the distribution or 

allocation of securities from an employee stock ownership trust. 

Employees could freely enter into voting trust arrangements or 

buy-sell agreements with respect to such securities, but the employer

could not impose any restrictions on the exercise of voting rights or 

transferability of the securities. The employer would be required to 

grant employees the right to put distributed or allocated securities 

to the employer at their fair market value three years after receipt 

or allocation of the securities; the put right would be required to be 

available during a specified period every year thereafter (through the 

year following separation from service). Upon sale or disposition of 

securities, employees would recognize income equal to the full amount 

of the proceeds from the sale or disposition; the portion of such 

proceeds not in excess of the employer's principal payments with 

respect to the stock would be characterized as ordinary income, and 

the excess would be capital gain. 

The current rule allowing deferral of gain on a sale of employer

securities to an ESOP or eligible worker-owned cooperative would be 

retained, but would be revised to permit deferral of gain only on 

sales of employer securities to an employee stock ownership trust. 

The exclusion of one-half of the interest paid on a loan used by a 

leveraged ESOP to purchase employer securities would be retained, but 

revised to apply to loans to employers in connection with an employee

stock ownership trust. The current rule permitting a deduction for 

dividends paid on stock held in an ESOP would be retained, but revised 

to require an employer to make an additional nondeductible payment to 

any employee who receives a dividend with respect to employer

securities distributed or allocated to the employee. This additional 

- 317 -
payment would be an amount equal to the tax saving available to the 

employer for the taxable year on account of the deductible dividend. 

The provision permitting an ESOP to assume certain decedents' estate 

tax liabilities would be repealed. 

Effective Date 

An employer's deduction for ESOP contributions with respect to 

securities acquisition loans outstanding on December 31, 1985, and the 

status of such loans under the prohibited transaction rules would 

continue to be governed by current law. See Ch. 14.03. The repeal of 

the rule relating to the assumption of estate tax liability would 

apply beginning January 1, 1986. 

The proposal for an employee stock ownership trust would apply to 

securities acquisition loans made on or after January 1, 1986. The 

amendment to the dividends paid deduction would apply to dividends 

paid on or after January 1, 1986. The amendment of the interest 

exclusion would apply to loans made on or after January 1, 1986. 

Analysis 

The proposal is designed to provide a subsidy equivalent to that 

provided under current law for leveraged ESOPs, but in a manner that 

will encourage direct ownership by employees. under current law, an 

employer is entitled essentially to a current deduction for principal 

payments on a loan used to acquire employer securities, while an 

employee is generally not required to include such amounts in income 

until he or she receives a distribution from the ESOP, usually upon

retirement or other separation from service. under the proposal, the 

employer would be entitled to claim current deductions for principal 

payments, but employees, while receiving the employer securities as 

the loan is repaid, would recognize no income until the securities are 

sold. 

Tax subsidies for employee ownership should encourage direct 

ownership of employer stock. Direct ownership of employer securities,

with the attendant rights and benefits, is far more likely to be an 

incentive for employee productivity than a speculative benefit to be 

realized only upon separation from service. Moreover, employees are 

fully capable of exercising all of the rights of direct stock 

ownership, including the right to vote and to determine whether to 

dispose of or hold employer securities. 

The tax law should not foster arrangements, such as those existing

under current law, which purportedly vest the incidents of ownership

of employer securities in employees, but which actually defer and, in 

certain respects, deprive employees of the rights and responsibilities

of stock ownership. For example, if one of the goals of tax 

incentives for employee ownership is to give employees some voice in 

the affairs of the employer corporation, employees must be entitled to 

vote the shares which have been allocated to them. To vest this right 

- 318 -
in a third party, such as the trustee of an ESOP (who may be an 

officer of the employer), deprives employees of a valuable right of 

stock ownership. 

Similarly, if an employer chooses to compensate employees by

giving employees shares of its stock, employees should receive the 

benefits of owning the stock currently, including the right to decide 

whether the employer securities are an appropriate investment, rather 

than being required, as under current law, to maintain an investment 

in the employer through the ESOP. If ownership of employer securities 

is a sound investment, the employees will readily agree to continue 

that tax deferred investment and work to enhance its value. On the 

other hand, if the employer stock is a bad investment, employees

should enjoy the same freedom to dispose of it as any other rational 

investor. Employees are poorly served where the tax law overrides 

their own judgments. 

The proposal is also designed to remove the subsidy for employee

ownership from the requirements applicable to qualified retirement 

plans. These requirements are needlessly restrictive in the context 

of an incentive for employee ownership. Moreover, benefits provided

in the form of employer securities should not be viewed as a 

substitute for plans established to provide a more secure retirement 

benefit. 

- 319 -
CHAPTER 13 

CURTAIL TAX SHELTERS 

Current rules limiting the deduction of investment interest are 

inadequate to curtail tax shelter abuses. This Chapter proposes a 

comprehensive limitation on the deduction of nonbusiness interest. In 

addition, the special exceptions to the at-risk limitations for real 

estate would be repealed, so that the at-risk rules would apply more 

uniformly to all activities. Finally, the individual and corporate

minimum taxes would be revised and expanded. 

- 321 -
LIPIIT INTEREST DEDUCTIONS 

General Explanation 

Chapter 13.01 

Current Law 

In general, interest paid or incurred on indebtedness is fully

deductible from income. This general rule is subject to exceptions

for interest on indebtedness incurred to generate certain taxpreferred income. Thus, for taxpayers other than certain financial 

institutions, no deduction is allowed for interest on indebtedness 

incurred to purchase or carry obligations that generate tax-exempt

income. In addition, for noncorporate taxpayers, interest on debt 

incurred to acquire or carry investment property ("investment

interest") is deductible only to the extent of the sum of (i) $10,000 

($5,000 for married persons filing separately), (ii) "net investment 

income," and (iii) certain deductions attributable to net-leased 

property, Amounts disallowed under this limitation for a taxable year 

are carried forward and treated as investment interest in the 

succeeding taxable year. 

Interest on debt incurred to acquire or carry personal-use 

property or business property is ordinarily deductible currently, even 

if that property does not produce taxable income or is likely to 

appreciate substantially (resulting in deferred capital gains). (See

Ch. 8.01 for a discussion of circumstances in which interest costs 

must be capitalized when incurred in connection with certain 

production or manufacturing activities.) 

Reasons for Change 

Clear reflection of income for tax purposes requires that the 

costs of generating income be matched with the income actually earned. 

If a current deduction is allowed for the cost of producing income 

that is exempt from tax or includable in income on a deferred basis,

the current deduction will offset other taxable income and thus 

eliminate or defer tax. Such "tax arbitrage" occurs, for example,

when an investor deducts interest on indebtedness incurred to acquire 

OK carry assets that yield tax-exempt income such as personal-use 

property or assets held in an Individual Retirement Account. It also 

occurs, though with less predictability, where indebtedness is 

incurred to acquire or carry interests in business property that 

experiences real appreciation over time. 

Current law permits taxpayers to deduct the interest costs of 

generating certain tax-exempt or tax-deferred income. Although

interest incurred to acquire or carry tax-exempt bonds is 

nondeductible, interest incurred to produce analogous forms of 

tax-preferred income is deductible without limitation. Thus,

"consumer interest," i.e., interest incurred to acquire personal 

- 322 -
assets, such as a car or vacation home, is fully deductible, even 

though such assets do not generate taxable income. Similarly, current 

law limits the deductibility of “investment interest,” but interest 

incurred in a trade or business is fully deductible, even if the 

investor is not actively engaged in the management of the business and 

much of the return from the business is expected to be deferred. The 

current deductibility of interest is an important feature of real 

estate tax shelter investments structured as limited partnerships. 

The unlimited deduction for consumer and “passive” business 

interest also undermines existing limitations on investment interest 

and interest incurred to acquire tax-exempt bonds. Since money is 

fungible, the identification required under current law of the purpose

for which indebtedness is incurred is difficult at best. The general

deductibility of all consumer and business interest complicates the 

task of determining whether debt was incurred for a nondeductible 

purpose. 

Proposal 

Interest subject to the current investment interest limitation 

would be expanded to include: (a) all interest not incurred in 

connection with a trade or business (other than interest on debt 

secured by the taxpayer’s principal residence, to the extent such debt 

does not exceed the fair market value of the residence), (b) the 

taxpayer’s share of all interest expense of S corporations (other than 

S corporations in which the taxpayer actively participates in 

management), and (c) the taxpayer’s distributive share of all interest 

expense of limited partnerships in which the taxpayer is a limited 

partner. Interest on indebtedness incurred to carry or acquire

business rental property used by the taxpayer for personal purposes

for part of a taxable year would generally be treated as business 

interest (and thus not subject to limitation) in the same proportion

that the number of days the property is rented at a fair rental bears 

to the number of days in the taxable year. 

Interest subject to the limitation would be deductible only to the 

extent of the sum of (a) $5,000 ($2,500 in the case of a married 

person filing a separate return), and (b) the taxpayer‘s net 

investment income. In general, net investment income for this purpose

would have the same meaning as under current law, except that it would 

include the taxpayer’s share of all income of S corporations not 

managed by the taxpayer and the taxpayer’s distributive share of all 

income of limited partnerships in which the taxpayer is a limited 

partner. Any interest deduction disallowed for the taxable year under 

this limitation would be treated as interest expense subject to the 

limitation for the succeeding taxable year. 

Effective Date 

Subject to two phase-in rules, the proposal would be effective for 

interest expense paid or incurred in taxable years beginning on or 

after January 1, 1986. Under the first phase-in rule, for taxable 

- 323 -
years beginning before January 1, 1988, interest subject to limitation 

would continue to be deductible to the extent of $10,000 plus net 

investment income (determined under the new rules). Thereafter, the 

proposed limitation of $5,000 plus net investment income would apply.

Under the second phase-in rule, for taxable years beginning on or 

after January 1, 1986, an increasing percentage of interest expense

that is treated as investment interest under the expanded definition 

but that is not subject to the investment interest limitation of 

current law would become subject to the proposed expanded investment 

interest limitation. That is, in taxable years beginning in 1986, 10 

percent of newly limited investment interest (e.g., consumer interest,

interest passed through a limited partnership or a passive subchapter 

S corporation) would be subject to the limitation; in taxable years

beginning in 1987, 20 percent of newly limited investment interest 

would be subject to the limitation; and in each subsequent taxable 

year, the percentage would be increased by 10 percentage points until 

fully phased in. For purposes of the proposed limitation, the 

expanded definition of net investment income would be phased in on a 

similar basis. 

Analysis 

Because the expanded limitation on interest deductions would not 

apply to mortgage interest deductions on the taxpayer's principal

residence or to the first $5,000 of any additional interest expense,

the vast majority of taxpayers would not be affected by the proposal.

Interest expenses attributable to a trade or business in which the 

taxpayer actively participates also would not be subject to the 

limitation. Thus, sole proprietors, owner-operators of farms, general

partners, and shareholder-managers of S corporations would continue to 

treat their business interest expenses in the same manner as under 

current law. However, taxpayers with substantial tax shelter interest 

expense would be prevented, in many cases, from using that interest 

expense to offset business and employment income. 

- 324 -
EXTEND AT-RISK LIfiITATION TO REAL ESTATE 

General Explanation 

Chapter 13.02 

Current Law 

In general, in the case of individuals and certain closely held 

corporations, current law limits the loss a taxpayer may deduct from 

an investment to the amount the taxpayer has at risk with respect to 

such investment. This "at-risk" limitation on deductible losses is 

applied on an "activity-by-activity'' basis. The at-risk rules extend 

to all activities conducted by taxpayers to whom the rules apply,

other than (1) real estate activities and (2) most business activities 

actively conducted by closely held corporations. Accordingly, an 

investor in real estate, a closely held corporation actively

conducting a business activity, or a widely held corporation investing

in any activity, may generally deduct for tax purposes losses from the 

investment that exceed the investor's maximum possible economic loss 

from the investment. 

For purposes of the at-risk rules, a taxpayer is generally at risk 

in an activity to the extent that the taxpayer has contributed money 

or property (to the extent of its basis) to the activity, or is 

personally liable to repay borrowed funds used in the activity. A 

taxpayer is not considered to be at risk with respect to amounts 

protected against loss through nonrecourse financing, guarantees and 

stop loss or similar arrangements. Losses which are disallowed for a 

taxable year under the at risk rules are carried forward indefinitely

and are allowed in a succeeding taxable year to the extent that the 

taxpayer increases the amount at risk in the activity giving rise to 

the losses. 

Reasons for Change 

The at-risk rules of current law reflect the fact that, as an 

economic matter, an investor cannot lose more than the amount that he 

or she has directly invested plus any additional amount for which the 

investor is liable. This principle is no less true for investments in 

real estate or corporate activities than it is for the activities to 

which the current at-risk rules apply. 

However, the purpose of the at-risk rules is generally to restrict 

the use by individual taxpayers of limited-risk transactions to 

shelter artificially their income from other sources. The use of 

limited-risk financing in the public corporate sector has not 

generally been viewed as abusive. Similarly, the use of limited-risk 

financing in the closely-held corporate sector has not been viewed as 

- 325 -
abusive where loss activities are conducted as substantial active 

businesses; in such situations, the likelihood that loss activities 

are utilized for the purpose of sheltering other income of the 

corporate owners is diminished. 

On the other hand, the exclusion of real estate activities from 

the at-risk rules is not similarly justified. Due to this exclusion,

individuals investing in real estate may offset current taxable income 

from other activities (e.g., wages) with tax losses that will never be 

matched by economic losses. 

The allowance of such noneconomic losses for tax purposes is a 

necessary basis for many tax-sheltered real estate investments. 

Front-loaded tax losses that have no economic basis permit the 

investor to reduce or eliminate tax on his other income. The 

resulting deferral of tax liability guarantees a return to the 

investor that may make an otherwise noneconomic investment plausible.

Tax-driven noneconomic investment activity diverts capital from more 

productive uses, causes overinvestment in the tax-preferred activities 

and thus distorts prices and capital costs throughout the economy. 

Tax shelter activity also invites disrespect for the tax law. 

Whether legally justified or not, the use of tax shelters by

high-income, well advised individuals is viewed with confusion and 

skepticism by ordinary taxpayers. These perceptions undermine the 

voluntary compliance that is crucial to the income tax system. 

Proposal 

The at-risk rules would be extended to real estate activities. 

The at-risk rules would continue to be applicable only to individuals 

and certain activities of closely held corporations. 

Effective Date 

The proposal would be effective for losses attributable to 

property acquired on or after January 1, 1986. 

Analysis 

Extending the at-risk rules to real estate activities would not 

inhibit the leveraged acquisition of properties expected to yield a 

market rate of return. The proposal, however, would require that 

investors in real estate activities evaluate the economic risk of loss 

associated with investments in those activities as well as their tax 

benefits and income potential. The proposal thus would leave real 

estate investments subject to the same market discipline as currently

applies to investments generally. The enhanced neutrality among

investment alternatives would improve resource allocation and reduce 

overinvestment in currently tax-preferred real estate activities. 

This, in turn, should lead to overall productivity gains. 

- 326 -
It is possible that the laws of some States that preclude the use 

of recourse debt in connection with the acquisition of certain real 

estate could prevent certain investors in those States from receiving

full tax benefits from leveraged real estate investments. It is 

anticipated that any such States would act quickly to permit business 

investments in real estate to employ recourse indebtedness. 

Some have argued that the proper goal of the at-risk rules is 

not, as indicated above, to prevent taxpayers from sheltering income 

with artificial losses, but to police the use of limited-risk 

financing to inflate artifically value and thus recoverable basis in 

property acquired by purchase. Under this view, the at-risk rules 

should be restructured to limit a taxpayer's basis in property

financed with limited risk debt. Since the focus of such a rule would 

be on artificially inflated values, limited-risk financing from 

unrelated institutional lenders would presumably be free of the basis 

restriction. Such rule generally would not disturb limited-risk 

transactions lacking the indicia of abuse, but would limit cost 

recovery deductions from abusive transactions to a greater extent than 

current law. Under the Administration proposal, the at-risk rules 

would continue to serve the broader function of loss limitation that 

their current structure implies. At the appropriate time, Congress 

may wish to consider whether the at-risk rules place sensible 

limitations on artificial losses, or could be targeted instead to 

restrict abusive transactions. 

. 

- 321 -
REVISE ALTERNATIVE MINIMUM TAX FOR NONCORPORATE TAXPAYERS 

General Explanation 

Chapter 13.03 

Current Law 

Taxpayers whose taxable incomes are substantially reduced by

specified "items of tax preference" are subject to "minimum taxes" 

that may increase their overall tax liabilities. For noncorporate 

taxpayers, such minimum taxes are imposed in the form of an 

"alternative minimum tax" ( "AMT"). 

Noncorporate taxpayers whose regular tax liabilities are 

substantially reduced by tax preferences are, in effect, subject to 

the AMT in lieu of the regular income tax. The AMT is equal to 20 

percent of the excess of the taxpayer's "alternative minimum taxable 

income" ("AMTI") over an exemption amount.*/ A taxpayer's AMTI is 

computed by (a) adding tax preferences bacE to adjusted gross income,

(b) subtracting the "alternative tax itemized deductions," and (c)

malting adjustments for net operating loss carryovers and certain trust 

distributions included in income under the so-called "throwback 

rules." The alternative tax itemized deductions include (a) casualty

losses and certain wagering losses, (b) charitable contributions, (c)

deductible medical expenses, (d) certain interest expenses (including

interest on debt incurred to acquire the taxpayer's principal

residence), and (e) estate taxes attributable to income in respect of 

a decedent. The exemption amount for the AMT is (a) $40,000 for a 

joint return or a surviving spouse, (b) $30,000 for a single taxpayer 

or head of household, and (c) $20,000 for other noncorporate 

taxpayers. 

Items of tax preference generally include: 

(a) Dividends excluded from gross income. 

(b) The excess of accelerated over straight-line depreciation for 

each item of real property and leased personal property (other

than recovery property). 

*/ The statutory term "alternative minimum tax" actually refers to the -. excess of (1) 20% of AMTI less the exemption amount over (2) the 

regular income tax. This excess is imposed in addition to the 

regular tax. For convenience, however, the terms "alternative 

minimum tax" and "AMT", as used herein, will refer to the sum of 

the true alternative minimum tax and the regular income tax. 

- 328 -
In the case of an item of recovery property (but only if it is 

leased property, 18-year real property, or low-income housing),

the excess of ACRS deductions over depreciation deductions that 

would have been allowed had the property been depreciated under 

the straight-line method over prescribed recovery periods. 

The net capital gain deduction. 

The excess of amortization deductions for each pollution control 

facility over depreciation deductions that would otherwise be 

allowable for the facility in the absence of special

amortization. 

In the case of mining exploration and development costs with 

respect to a mine or other natural deposit, the excess of the 

amount allowable as a deduction over the amount that would have 

been allowable had such costs been amortized over a ten-year

period. 

In the case of intangible drilling and development costs of oil, 

gas, and geothermal properties, the amount by which (i) the 

excess of the amount allowable as a deduction over the amount 

that would have been allowable had such costs been amortized over 

a ten-year period, exceeds (ii) the taxpayer's net income from 

oil, gas, and geothermal properties. 

The excess of the deduction for the taxable year for research and 

experimental expenditures over the amount that would have been 

allowed had such expenditures been amortized over a three-year

period. 

In the case of circulation expenditures, the excess of the amount 

allowable as a deduction over the amount that would have been 

allowable had such expenditures been amortized over a three-year

period. 

With respect to each depletable property, the excess of the 

deduction for depletion for the taxable year over the adjusted

basis of the property. 

In the case of stock transferred pursuant to the exercise of an 

incentive stock option, the excess of the fair market value of 

the stock over the option price. 

Reasons For Change 

The alternative and corporate minimum taxes were originally

enacted as part of the Tax Reform Act of 1969 to ensure that "all 

taxpayers are required to pay significant amounts of tax on their 

economic income." The measures (originally a single minimum tax for 

all taxpayers) were considered necessary because, as concluded by 

- 329 -
Congress, "many individuals and corporations did not pay tax on a 

substantial part of their economic income as a result of the receipt

of various kinds of tax-favored income or special deductions." 

Since the Administration proposals contain incentive provisions

that depart from the measurement of economic income, some high-income

individuals would be able to eliminate their tax liabilities or 

substantially reduce their effective tax rates by heavy utilization of 

such provisions. As under current law, the prospect of high-income

individuals paying little or no tax threatens public confidence in the 

system. Consequently, a minimum tax designed to limit the number of 

high-income low-tax returns should be retained. 

Proposa1 

Under the proposal, the minimum tax for noncorporate taxpayers

would continue to be structured as an alternative tax, with a rate of 

20 percent. Alternative minimum taxable income would be computed by

adding to adjusted gross income the excess of preference items over 

$10,000 ($5,000 for married persons filing separately), and 

subtracting (a) allowable itemized deductions, (b) personal

exemptions, and (c) a threshold exemption amount. The threshold 

exemption amount would be $15,000 for joint returns ($7,500 for 

married persons filing separately), $12,000 for heads of households,

and $10,000 for single persons. 

Allowable itemized deductions generally would include all 

itemized deductions, with the exception of the deduction for 

non-business interest (other than mortgage interest with respect to 

the taxpayer's principal residence) in excess of net investment 

income. 

Items of tax preference subject to the alternative minimum tax 

would include the following: 

(a) The tax preference, as defined under current law, with respect to 

each item or real property placed in service before 1981 and each 

item of recovery property which is 15-year real property, 18-year

real property, or low-income housing. 

(b) For each item of real property placed in service on or after 

January 1, 1986, the amount (if any) by which the deduction 

allowed under CCRS for the taxable year exceeds the deduction 

which would have been allowable for the taxable year had the 

property been depreciated along the lines of the real economic 

depreciation svstem Drooosed in the Treasurv UeDartment's ReDOrt - to-the Presideit, Tax Reform for Fairness, ;impiicity, -and 

Economic Growth, p z 

- 330 -
The tax preference, as defined under current law, with respect to 

each item of leased personal property placed in service before 

1981 and each item of leased recovery property which is not 

15-year real property, 18-year real property, or low-income 

housing. 

For each item of leased personal property placed in service on or 

after January 1, 1986, the amount (if any) by which the deduction 

allowed under CCRS for the taxable year exceeds the deduction 

which would have been allowable for the taxable year had the 

property been depreciated along the lines of the real economic 

deoreciation svstem DroDosed in the Treasurv DeDartment'S Reuort 

to*the PresideGt, Tai RGform for Fairness, Bimpiicity, and A 

Economic Growth, published in November 1984. 

The excess of the allowable amortization deduction for each 

pollution control facility over the depreciation deduction that 

would otherwise be allowable in the absence of special

amortization. 

The net capital gain deduction. 

In the case of mining exploration and development costs with 

respect to a mine or other natural deposit, the excess of the 

amount allowable as a deduction over the amount that would have 

been allowable had such costs been amortized over a ten-year

period. 

In the case of intangible drilling and development costs of oil, 

gas, and geothermal properties (other than dry holes), eight 

percent of the amount of such costs paid or incurred in the 

taxable year. 

With respect to each depletable property placed in service before 

January 1, 1986, the excess of the deduction for depletion for the 

taxable year over the adjusted basis of the property. 

With respect to each depletable property placed in service on or 

after January 1, 1986, the excess of the deduction allowable for 

the taxable year for percentage depletion over the amount that 

would have been allowable for the taxable year had capitalized 

costs been recovered through cost depletion. 

With respect to each item of contributed property for which a 

charitable contribution deduction is allowed, the excess of the 

deduction allowed over the donor's basis in the property. 

- 331 -
(1) The excess of the deduction for the taxable year for research and 

experimental expenditures over the amount that would have been 

allowed had such expenditures been amortized over a ten-year

period. 

(m) In the case of stock transferred pursuant to the exercise of an 

incentive stock option, the excess of the fair market value of the 

stock over the option price. 

The deduction for circulation expenditures would not be treated as 

an item of tax preference under the proposal. 

Effective Date 

The revised alternative minimum tax would be effective for taxable 

years beginning on or after January 1, 1986. 

Analysis 

The proposal would minimize the number of high-income individuals 

who pay little or no tax as a result of heavy utilization of the tax 

preferences included in the alternative minimum tax base, and would 

thus improve the fairness of the tax system. Due to the exclusion of 

a taxpayer’s first $10,000 of preferences from alternative minimum 

taxable income, only individuals using substantial amounts of tax 

preferences would need to compute the minimum tax. The threshold 

amounts would ensure that no individual would be subject to a minimum 

tax liability greater than the regular tax liability computed by

adding preferences to the regular tax base. For analysis of the 

treatment of IDCs as an item of tax preference, see Ch. 9.03. 

- 332 -
REVISE CORPORATE MINIMUM TAX 

General Explanation 

Chapter 13.04 

Current Law 

Taxpayers whose taxable incomes are substantially reduced by

specified "items of tax preference" are subject to "minimum taxes" 

which may increase their overall tax liabilities. For corporations, 

a minimum tax is imposed in the form of an "add-on" minimum tax. 

In general, the corporate minimum tax is equal to 15 percent of 

the amount by which the taxpayer's items of tax preference exceed the 

greater of (a) $10,000 or (b) the regular corporate income tax for the 

taxable year (without regard to the accumulated earnings tax or 

personal holding company tax, if any, and reduced by most allowable 

tax credits). 

Items of tax preference generally include: 

(a) The excess of accelerated over straight-line depreciation for each 

item of real property (other than recovery property) and, for 

personal holding companies, each item of leased personal property

(other than recovery property). 

(b) In the case of each item of recovery property that is 18-year real 

property or low-income housing (and, for personal holding

companies, each item of leased recovery property other than 

18-year real property or low-income housing), the excess of ACRS 

deductions over depreciation deductions that wou1.d have been 

allowed had the property been depreciated under the straight-line

method over prescribed recovery periods. 

(c) The amount of income effectively untaxed due to the preferential 

rate of tax applied to capital gains. 

(d) The excess of the allowable amortization deduction for each 

pollution control facility over the depreciation deduction that 

would otherwise be allowable in the absence of special

amortization. 

(e) In the case of mining exploration and development costs with 

respect to a mine or other natural deposit of a personal holding 

company, the excess of the amount allowable as a deduction over 

the amount that would have been allowable had such costs been 

amortized over a ten-year period. 

(f) In the case of intangible drilling and development costs of oil, 

gas, and geothermal properties of personal holding companies, the 
amount by which (i) the excess of the amount allowable as a 

deduction over the amount that would have been allowable had such 

costs been amortized over a ten-year period, exceeds (ii) the 

taxpayer's net income from oil, gas, and geothermal properties. 

(g) In the case of circulation expenditures of personal holding

companies, the excess of the amount allowable as a deduction over 

the amount that would have been allowable had such expenditures

been amortized over a three-year period. 

(h) In the case of research and experimental expenditures of personal

holding companies, the excess of the amount allowable as a 

deduction over the amount that would have been allowable had such 

expenditures been amortized over a ten-year period. 

(i) The excess of a financial institution's allowable deduction for 

bad debt reserves over the deduction that would have been 

allowable had the institution maintained its reserves on the basis 

of actual experience. 

(j) With respect to each depletable property, the excess of the 

deduction for depletion for the taxable year over the adjusted

basis of the property. 

Reasons For Change 

Since the Administration's tax reform proposals contain incentive 

provisions that depart from the measurement of economic income, some 

high-income corporations would be able to eliminate their tax 

liabilities or substantially reduce their effective tax rates by heavy

utilization of such provisions. As under current law, the prospect of 

high-income corporations paying little or no tax threatens public

confidence in the tax system. Consequently, a minimum tax designed to 

limit the number of high-income, low-tax returns should be retained. 

The add-on corporate minimum tax under current law is poorly

designed for this purpose. The add-on tax may be imposed on 

preferences used by a corporate taxpayer even though the taxpayer is 

taxed at an effective rate higher than the minimum tax rate. An 

"alternative" minimum tax, imposed only to the extent a taxpayer's

regular effective tax rate falls below a minimum acceptable level, is 

better designed to achieve the purposes of a minimum tax. 

However, an alternative minimum tax limited to the tax preferences

applicable to corporations under current law would be insufficient to 

prevent many corporations from eliminating their regular tax on 

economic income. Additional preferences should thus be taken into 

account. Although the Administration proposals generally would allow 

accelerated depreciation as an incentive for capital formation, a 

debt-financed acquisition of depreciable assets may reduce the 

effective tax rate on such investment substantially below the 

effective tax rate on similar investments that are equity financed. 

- 334 -
The full deductibility of interest, without adjustment for the extent 

to which interest payments are compensation for the effects of 

inflation rather than a cost of borrowing money, results in 

significant mismeasurement of income. This mismeasurement is more 

serious where the investment itself receives preferential treatment. 

Since the low effective tax rates for debt-financed investment in 

depreciable property are unnecessary to encourage capital formation,

the minimum tax should apply to corporations that substantially reduce 

their regular tax liabilities through such debt-financed investments. 

In addition, corporations engaged in oil and gas activities may

eliminate or substantially reduce tax liabilities through excessive 

use of the election to expense intangible drilling costs ("IDCs").

Although the election to expense IDCs is provided as an incentive for 

domestic energy production, the value of the incentive is 

appropriately an item of tax preference for purposes of the corporate

minimum tax. 

Proposa1 

Under the proposal, the minimum tax for corporations would be 

repealed and replaced with an alternative minimum tax, similar in 

structure to the alternative minimum tax for noncorporate taxpayers.

The alternative minimum tax rate would be 20 percent. Alternative 

minimum taxable income would generally be computed by adding to 

taxable income (or loss) the excess of preference items over $10,000,

subtracting a threshold exemption amount of $15,000, and making

adjustments for net operating loss carryovers attributable to 

preference items. The foreign tax credit generally would be allowed 

to offset minimum tax liability. 

Items of tax preference subject to the alternative minimum tax 

would include the following: 

(a) The tax preferences, as defined under current law, with respect to 

each item of real property placed in service before 1981 and each 

item of recovery property which is 15-year real property, 18-year

real property, or low-income housing. 

(b) For each item of real property placed in service on or after 

January 1, 1986, the amount (if any) by which the deduction 

allowed under CCRS for the taxable year exceeds the deduction 

which would have been allowable for the taxable year had the 

property been depreciated along the lines of the real economic 

depreciation system proposed in the Treasury Department's Report

to the President, Tax Reform for Fairness, Simplicity, and 

Economic Growth, published in November 1984. 

(c) In the case of personal holding companies, the tax preference, as 

defined under current law, with respect to each item of leased 

- 335 -
personal property placed in service before 1981 and each item of 

leased recovery property which is not 15-year real property,

18-year real property, or low-income housing. 

(d) In the case of personal holding companies, for each item of leased 

personal property placed in service on or after January 1, 1986,

the amount (if any) by which the deduction allowed under CCRS for 

the taxable year exceeds the deduction which would have been 

allowable for the taxable year had the property been depreciated

along the lines of the real economic depreciation system proposed

in the Treasury Department's Report to the President, Tax Reform 

for Fairness, Simplicity, and Economic Growth, published in 

November 1984. 

The excess of the allowable amortization deduction for each 

pollution control facility over the depreciation deduction for 

that facility that would otherwise be allowable in the absence of 

special amortization. 

The amount of income effectively untaxed due to the preferential 

rate of tax applied to capital gains. 

In the case of mining exploration and development costs with 

respect to a mine or other natural deposit, the excess of the 

amount allowable as a deduction over the amount that would have 

been allowable had such costs been amortized over a ten-year

period. 

In the case of intangible drilling and development costs of oil, 

gas, and geothermal properties (other than dry holes), eight 

percent of the amount of such costs paid or incurred in the 

taxable year. 

With respect to each depletable property placed in service before 

January 1, 1986, the excess of the deduction for depletion for the 

taxable year over the adjusted basis of the property. 

With respect to each depletable property placed in service on or 

after January 1, 1986, the excess of the deduction allowable for 

the taxable year for percentage depletion over the amount that 

would have been allowable for the taxable year had capitalized 

costs been recovered through cost depletion. 

With respect to each item of contributed property for which a 

charitable contribution deduction is allowed, the excess of the 

deduction allowed over the donor's basis in the property. 

Twenty-five percent of the deduction for interest expense for the 

taxable year (reduced by taxable interest income for such year),

but not in excess of the amount (if any) by which the deduction 

allowed under CCRS for the taxable year for each item of personal 

property placed in service on or after January 1, 1986 (but, in 

- 336 -
the case of personal holding companies, only if such property is 

not subject to a lease), exceeds the deduction which would have 

been allowable for the taxable year had the property been 

depreciated along the lines of the real economic depreciation

system proposed in the Treasury Department's Report to the 

President, Tax Reform for Fairness, Simplicity, and Economic 

Growth, published in November 1984. 

(m) In the case of personal holding companies, the excess of the 

deduction for the taxable year for research and experimental

expenditures over the amount that would have been allowed had such 

expenditures been amortized over a ten-year period, 

The deduction for circulation expenditures would not be treated as 

an item of tax preference under the proposal. 

Effective Date 

The proposed alternative minimum tax would be effective for 

taxable years beginning on or after January 1, 1986. 

Analysis 

The proposal would minimize the number of high-income corporations

paying little or no tax as a result of heavy utilization of the tax 

preferences included in the alternative minimum tax base, and would 

thus improve the fairness of the tax system. Due to the exclusion of 

a corporation's first $10,000 of preferences from alternative minimum 

taxable income, corporations using only small amounts of tax 

preferences would not need to compute the minimum tax. The $15,000

threshold amount would ensure that no corporation would be subject to 

a minimum tax liability greater than the regular tax liability

computed by adding preferences to the regular tax base. 

The inclusion of 25 percent of net interest expense as an item of 

tax preference (to the extent of the excess of CCRS deductions for 

personal property over economic depreciation) effectively treats the 

taxpayer's first investments in CCRS property as being financed by

indebtedness of the taxpayer. The 25 percent fraction is intended to 

identify, on the basis of very conservative assumptions, the portion

of such interest representing an inflation premium rather than a cost 

of borrowing money. For analysis of the treatment of IDCs as an item 

of tax preference, see Ch. 9.03. 

- 331 -

476-698 0 - 85 - 13 
CHAPTER 14 

REVISE TREATMENT OF RETIREMENT SAVINGS 

Current law provides tax-favored treatment to funds set aside in 

any of several employer-sponsored or individual plans providing for 

deferred compensation or retirement savings. Such "tax-favored plans"

include qualified profit-sharing, stock bonus, and pension plans

(section 401(a)); qualified annuity plans (section 403(a)); certain 

annuity contracts, custodial accounts, and retirement income accounts 

(tax-sheltered annuities) (section 403(b)); individual retirement 

accounts and annuities (IRAs) (section 408(a)&(b)); and simplified

employee pensions (SEPs) (section 408(k)). 

The Administration proposals generally would maintain the current 

treatment of tax-favored plans. The proposals, however, would 

simplify existing rules and provide more uniform treatment of the 

various plans. In addition, the proposals would target the favorable 

tax treatment more directly at reasonable accumulations of retirement 

savings by applying excise taxes designed to recapture unintended tax 

advantages where plan benefits are diverted from retirement savings or 

are in excess of reasonable levels. 

Uniform rules, including an excise tax on early distributions,

would govern distributions from the various types of plans, and more 

uniform contribution limits would be established. The overall limit 

on non-top-heavy defined benefit and defined contribution plans would 

be eliminated, and an excise tax would be imposed on annual 

distributions from tax-favored plans in excess of specified limits. 

The current rules governing IRA contributions by married couples would 

be made more equitable. Cash or deferred arrangements would be made 

more comparable to IRAs by the application of a special annual dollar 

limit. In addition, the related nondiscrimination rules for elective 

contributions and employer matching contributions under these and 

similar elective arrangements would be modified to assure that broad 

cross-sections of employees actually benefit. A special

nondiscriminatory coverage rule also would be applied to 

employer-maintained plans to assure that such plans achieve the same 

fundamental goal. 

Certain adjustments would be made to the current rules governing

the tax treatment of loans to participants from qualified plans to 

assure that tax-favored funds are not available for permanent use 

before retirement. An excise tax would be applied to qualified plan

funds reverting to an employer upon plan termination. Qualified

pension plans would be permitted to use benefits forfeited by

separated employees to increase the benefits of other employees.

Finally, the existing limits on unfunded deferred compensation for 

employees of States, with certain modifications, would be extended to 

unfunded deferred compensation arrangements for employees of 

tax-exempt employers. 

- 339 -
INCREASE SPOUSAL INDIVIDUAL RETIREMENT ACCOUNT LIMIT 

General Explanation 

Chapter 14.01 

Current Law 

An individual generally is permitted to deduct annual 

contributions to an individual retirement account or annuity (IRA) up

to the lesser of $2,000 or 100 percent of the individual's annual 

compensation. Thus, if a married individual and his or her spouse

each receive compensation during a year, each may make separate

deductible contributions to his or her own IRA up to the lesser of 

$2,000 or 100 percent of compensation. 

If an individual receives no compensation during a year, the 

individual generally is not allowed to make a deductible IRA 

contribution for such year. Special "spousal IRA" limits, however,

provide that if a married individual's spouse earns no compensation

during a year for which the married couple files a joint return, the 

individual may deduct annual IRA contributions up to the lesser of 

$2,250 or 100 percent of the individual's annual compensation. The 

contributions may be allocated in any fashion between the individual's 

IRA and the nonearning spouse's IRA, except that no more than $2,000 

may be contributed to either IRA. 

The special spousal IRA maximum limit of $2,250 is not available 

if the married individual's spouse has compensation income during the 

year. Thus, if a husband and wife each has compensation income, each 

is separately subject to the $2,000 and 100 percent of compensation

limits on deductible contributions. As a consequence of this rule, a 

married couple with a nonearning spouse is permitted to make larger

total deductible IRA contributions than a married couple with a spouse

who has compensation income of less than $250. 

Reasons for Change 

The tax benefits applicable to IRAs are intended to encourage

individuals to save for retirement. Savings for this purpose also 

contribute to the formation of investment capital needed for economic 

growth. For many individuals, including individuals who are covered 

by employer-maintained retirement plans, IRAs may play an important 

part in an overall strategy to provide for retirement security. The 

use of IRAs for retirement saving should thus not only be encouraged,

but made available on a broad and consistent basis. 

The existing limitations on IRA contributions are illogical and 

inequitable as applied to married couples. The relatively minor 

allowances for a spousal IRA fail to recognize the important economic 

contributions made by nonearning spouses. Moreover, they are 

inconsistent with other rules of current law under which married 

- 340 -
couples are treated as an economic and taxpaying unit. Thus, a 

husband and wife that each earn $10,000 can make aggregate IRA 

contributions of $4,000 under current law. A couple with the same 

joint income of $20,000, all of it earned by one spouse, may make 

aggregate IRA contributions of only $2,250. A third couple, also with 

$20,000 of joint income, but with one spouse earning only $200, is 

limited even further to a $2,200 aggregate IRA contribution. These 

disparate results are inconsistent with both retirement savings policy

and general tax principles requiring similar treatment of similarly

situated taxpayers. 

Proposal 

A married individual filing a joint return, including an 

individual with no annual compensation, would be permitted to take 

into account his or her spouse's compensation (less the deductible IRA 

contribution made by such spouse) in determining the deduction limit 

for such individual. Thus, married couples with aggregate

compensation of $4,000 or more ultimately would be entitled to a 

$4,000 aggregate IRA contribution ($2,000 apiece) regardless of how 

much of the aggregate compensation was generated by either spouse. 

Deductible IRA contributions would be coordinated with the dollar 

limit on elective contributions under a cash or deferred arrangement.

See Ch. 14.06. 

Consideration would be given to the adoption of rules preventing

in appropriate instances the deduction of interest attributable to 

indebtedness incurred to make deductible IRA contributions. If 

adopted, such rules would conform to current law principles barring

the deduction of interest on indebtedness incurred or carried to 

generate tax-exempt income. 

Effective Date 

The spousal compensation rule for married individuals would apply 

to taxable years beginning on or after January 1, 1986. 

Analysis 

The proposed spousal compensation rule would permit certain 

married couples to set aside additional amounts in IRAs for long-term

savings. This would enhance retirement security for such couples, and 

should also contribute to increased capital formation and 

productivity. 

- 341 -
UNIFY RULES FOR DISTRIBUTIONS 

FROM TAX-FAVORED RETIREMENT PLANS 

General Explanation 

Chapter 14.02 

Current Law 

Current law provides tax-favored treatment with respect to a 

variety of employer-sponsored and individual plans. Although these 

tax-favored plans are related in concept and purpose, distributions 

from the plans are subject to differing requirements and may result in 

significantly different tax consequences to individual recipients. 

Minimum Distribution Requirements. Tax-favored retirement plans 

are subject to certain minimum requirements concerning the timing and 

amount of distributions. Qualified profit-sharing, stock bonus,.

pension, and annuity plans must generally commence distributions no 

later than the April 1 following the year in which the employee

attains age 70-1/2 or, if later, the year in which the employee

retires. (Distributions to five percent owners must commence no later 

than the April 1 following the year in which the individual attains 

age 70-1/2.) Benefits thereafter must be distributed under a minimum 

distribution schedule. Additional rules require minimum annual 

distributions where the employee dies before benefit distributions 

have commenced or have been completed. A qualified plan failing to 

satisfy the minimum distribution rules with respect to a participant 

may lose its tax-favored status. 

Individual retirement accounts (IRAs) and simplified employee

pensions (SEPs) must commence distributions no later than the April 1 

following the year in which the IRA or SEP owner attains age 70-1/2,

without regard to whether such owner has retired. Thereafter,

benefits must be distributed under lifetime and after-death 

distribution schedules similar to those for qualified plans. An IRA 

or SEP that fails to satisfy the minimum distribution rules does not 

lose its tax-favored status. Instead, the payee is subject to an 

excise tax of 50 percent of the amount by which the required

distribution exceeds the amount actually distributed. 

Benefits provided through tax-sheltered annuities are not subject

to minimum distribution rules for the period during which the original

holder of the annuity remains alive. If, however, the holder dies 

before the entire interest in the annuity is distributed, distribution 

rules based on the after-death rules for qualified plans must be 

satisfied. (A technical correction bill has been introduced in 

Congress that would subject tax-sheltered annuities to lifetime and 

after-death distribution rules similar to those for qualified plans.) 

Tax Treatment of Distributions. In general, amounts distributed 

from tax-favored plans are fully taxable to the recipient at the time 

- 342 -
of distribution. There are a variety of exceptions to this general

rule under which certain distributions incur additional taxes and 

certain others receive more favorable tax treatment than ordinary

distributions. 

Early Distributions. Distributions from an IRA or SEP before the 

IRA or SEP owner dies, becomes disabled, or attains age 59-1/2

generally are subject to a ten percent additional tax. Similar 

distributions from a qualified profit-sharing, stock bonus, pension, 

or annuity plan are subject to an additional tax only in the case of 

employees owning more than five percent of the employer. Early

distributions from tax-sheltered annuities are not subject to an 

additional tax. However, distributions from tax-sheltered custodial 

accounts are generally prohibited absent financial hardship,

separation from service, the attainment of age 59-1/2, death, or 

disability. 

Lump Sum Distributions. Preferential tax treatment is currently

available for certain lump sum distributions from qualified

profit-sharing, stock bonus, pension, and annuity plans. Under a 

special forward averaging rule, the tax liability on a lump sum 

distribution is generally determined as though the individual received 

the distribution ratably over ten years and as though the individual 

received no other taxable income during such period. In addition, the 

portion of a lump sum distribution attributable to plan participation

before 1974 may be taxed at capital gain rather than ordinary income 

rates. Whether a lump sum distribution qualifies for favorable 

treatment is determined under an extensive set of rules, based in part 

on the employee's age, employment status and years of participation in 

the plan. Favorable lump sum treatment is not available for 

distributions from IRAs, SEPs, or tax-sheltered annuities. 

Employer Securities. Current law also provides preferential tax 

treatment for unrealized appreciation on employer securities included 

in a lump sum distribution from a qualified profit-sharing, stock 

bonus, or pension plan. Such appreciation is not included in income 

at the time of distribution, but instead is taxable upon subsequent

disposition of the securities, ordinarily at capital gain rates. If 

the distribution is not a lump sum distribution, only the unrealized 

appreciation on employer securities purchased with employee

contributions qualifies for the special treatment. Unrealized 

appreciation on plan distributions of securities other than employer

securities is fully taxable upon distribution. 

Basis Recovery. Tax-favored plans are subject to special rules 

for the recovery of employee contributions previously subject to tax. 

Outside the area of tax-favored plans, an amount not received as an 

annuity before the annuity starting date is generally treated, first, 

as a taxable distribution and, second, as a tax-free recovery of 

employee contributions. This basis recovery rule is reversed,

however, for a non-annuity distribution from a qualified

profit-sharing, stock bonus, pension, or annuity plan or a 

tax-sheltered annuity, so that such distribution is treated, first, as 

a tax-free recovery of employee contributions. 

- 343 -
Tax-favored plans are also granted special treatment for amounts 

received as annuities after the annuity starting date. Under the 

general basis recovery rules, employee contributions are recovered 

tax-free on a pro rata basis, in accordance with an exclusion ratio 

based on the employee's life expectancy at the time distributions 

commence. An employee's after-tax investment in a tax-favored plan,

however, is recovered prior to any taxable distributions, provided

that the aggregate amount to be distributed during the first three 

years exceeds such after-tax investment. 

Ro~~overs.Distributions from a tax-favored plan (including

distributions of property, such as employer securities) are not 

subject to taxation to the extent rolled over to another tax-favored 

plan. Generally, a plan distribution may be rolled over to another 

plan if it qualifies as a lump sum distribution, and may be rolled 

over to an IRA if it is at least 50 percent of the employee's total 

benefit in the plan. A complex series of rules governs the extent to 

which distributions from particular plans may be rolled over as well 

as the type of plans to which rollovers may be made. In general,

these rules are designed to prevent individuals from avoiding

restrictions applicable to certain plans by shifting benefits to a 

plan that is free of the restrictions. 

Constructive Receipt. In general, benefits under tax-favored 

plans are taxable when received. For most plans, receipt occurs for 

tax purposes only when benefits are actually distributed. The 

doctrine of constructive receipt is applied, however, to benefits 

under tax-sheltered annuities, which may be treated as received either 

when actually distributed or when made available to the individual. 

As a consequence, benefits in such annuities may be taxable prior to 

their actual distribution. 

Reasons for Change 

The current rules for distributions from tax-favored plans are 

burdensomely complex for taxpayers and inconsistent in their treatment 

of similarly situated individuals. The current rules also undercut 

the basic rationale for tax-favored plans, which is the encouragement

of retirement savings, and in certain instances provide excessively

favorable treatment. 

Uniform Treatment of Distributions. The various tax-favored 

olans are imoortant comoonents of a qeneral policy to enhance 

'Individual rktirement ihcome security. The current absence of 

uniformity in the treatment of such plans creates significant

disparities among individuals based on the type of plans to which the 

individuals happen to have access. Uniform rules would eliminate such 

disparities and also reduce the complexity of the existing rules 

governing plan distributions. Existing differences in the tax 

treatment of plan distributions give tax considerations undue 

influence over an individual's choice of retirement plans. Moreover,

they require individuals either to master a complex set of rules or to 

- 344 -
-- 

seek professional advice. In too many cases they may result in a loss 

of possible benefits. Uniform rules would have the additional 

advantage of making unnecessary most of the current restrictions on 

the shifting of benefits from one plan to another. 

The tax-favored status of retirement plans is intended to enable 

individuals to replace, after retirement, compensation that terminates 

with retirement. Minimum distribution rules support this rationale by

limiting the extent to which tax-deferral on retirement savings can be 

extended beyond the individual's retirement. Given the purpose of 

minimum distribution rules, they should apply to all retirement plans

receiving tax-favored treatment. 

Uniform sanctions should also apply to violations of minimum 

distribution rules. The sanction of disqualification, however, is too 

onerous for a plan's failure to satisfy the highly technical 

requirements. Disqualification may result in adverse tax consequences 

to all plan participants, even though plan administration generally is 

outside the control of the participants and the failure may have 

occurred with respect to only a single participant. Plan 

disqualification procedures also impose a significant administrative 

burden on the Internal Revenue Service. 

Encourage Retirement Savings. The current favorable treatment of 

certain plan distributions undercuts retirement saving by encouraging

early and lump sum withdrawals. The ability of individuals to gain 

access to the tax advantages provided to tax-favored funds before 

retirement permits employees to use tax-favored plans as short-term 

savings accounts rather than as retirement savings vehicles. Also, 

the special basis recovery rules for early distributions permit the 

accelerated tax-free recovery of employee contributions and thus 

further encourage the use of tax-favored plans for nonretirement 

purposes. 

The special ten-year averaging and capital gain provisions for 

lump sum distributions (including lump sum distributions before 

retirement) encourage individuals to withdraw tax-favored funds from 

the retirement income stream and thus are inconsistent with the policy 

to provide individuals with income throughout the entire period of 

retirement. The original purpose of the capital gain and ten-year

averaging provisions was to mitigate the effect of the progressive tax 

structure on individuals receiving all. of their benefits in a single 

year. The same purpose is now served, however, by permitting

individuals to roll over distributions into an IRA. This results in 

the individual being taxed only as amounts are subsequently withdrawn 

from the IRA. 

Finally, the rules permitting the deferral of tax on unrealized 

appreciation in employer securities encourage the investment and 

receipt of tax-favored funds in the form of such securities. The 

opportunity to defer tax even after distribution (and to escape tax 

altogether if the securities are unsold at death) permits the use of 

tax-favored plans for nonretirement purposes, such as the accumulation 

345 -
of funds to pass on to beneficiaries on a tax-favored basis. In 

addition, individuals are able to avoid having to sell employer

securities upon distribution in order to pay the tax due by rolling

the securities ovet into an IRA. 

Proposals 

Uniform Minimum Distribution Rules. All tax-favored plans,

including tax-sheltered annuities, would be subject to uniform minimum 

distribution rules governing both lifetime and after-death 

distributions. Thus, distributions from all employer-maintained plans

would be required to commence no later than the April 1 following the 

year in which the individual attains age 70-1/2 or, if later and the 

individual is not a five percent owner, the year in which the 

individual retires. Distributions from IRAs would be required to 

commence no later than April 1 following the year in which the 

individual attains age 70-1/2. Thereafter, both lifetime and 

after-death distributions would have to conform with minimum payout

schedules. Certain simplifying modifications would be made to the 

existing rules to ease the calculation and improve the predictability

of required annual distributions. 

The uniform sanction for failure to satisfy the minimum 

distribution rules would be a nondeductible excise tax equal to 50 

percent of the amount by which the minimum amount required to be 

distributed exceeds the amount actually distributed. The recipient of 

the distribution would be primarily liable for payment of the tax,

with a right, in appropriate cases, to recover the tax from the plan.

The current sanction of disqualification would be eliminated. 

Distribution Restrictions. Tax-sheltered annuities, including

annuity contracts and retirement income accounts, would be subject to 

the distribution restrictions currently applicable only to custodial 

accounts. Financial hardship would be eliminated as an event 

permitting distributions. Thus, early distributions from all 

tax-sheltered annuities would generally be prohibited absent 

separation from service, the attainment of age 59-1/2, death, or 

disability. 

Uniform Tax Treatment of Distributions, Including Lump Sum 

Distributions. ~~ Uniform rules would qovern the tax consequences of

plan distributions to individual recipients. Thus, distributions 

would be subject to tax only upon actual receipt. Current application

of the constructive receipt doctrine to tax-sheltered annuities would 

be eliminated. In addition, the taxable portion of any distribution 

from a tax-favored plan would be taxed fully as ordinary income. The 

special capital gain and ten-year averaging treatment for lump sum 

distributions and the deferred inclusion of unrealized appreciation on 

distributions of employer securities would be eliminated. 

In calculating the taxable portion of a plan distribution, the 

generally applicable basis recovery rules, with certain modifications,

would apply. Thus, an amount received before the annuity starting 

- 346 -
date would be treated, first, as a taxable distribution and, second, 

as a nontaxable return of basis. Annuity distributions after the 

annuity starting date would be taxed in accordance with the exclusion 

ratio established when such distributions commenced; the three-year 

recovery rule would be eliminated. In establishing the exclusion 

ratio for an individual, standardized recovery periods of multiples of 

five years would be used in lieu of the individual's actual life 

expectancy; the recovery period for a particular individual would be 

the period closest to the individual's life expectancy at the time 

distributions commence. If distributions cease before the individual 

recovers his entire basis tax-free, the individual, his estate, or his 

heirs would be entitled to deduct the unrecovered basis. If the 

individual receives benefits for longer than his recovery period, all 

additional distributions would be fully taxable. 

Reca ture Tax on Early Distributions. Early distributions from 

tax-f-9avored plans would be subject to uniform treatment. The taxable 

portion of an early distribution from any tax-favored plan would be 

subject to an excise tax of 20 percent designed to recapture some 

portion of the tax advantages provided with respect to the distributed 

funds. However, if the early distribution is used to pay for college 

expenses incurred by a dependent, for the purchase of the individual's 

first principal residence, or to replace unemployment benefits during 

a period of unemployment following the cessation of such benefits, the 

rate of the recapture tax would be reduced to ten percent. In any 

case, the tax would be nondeductible and could not be offset by any

deductions or credits otherwise available to the individual. A 

distribution would be treated as an early distribution if it is made 

before the individual's death, disability, or attainment of age

59-1/2. However, a distribution before the attainment of age 59-1/2

(but not before the attainment of age 50) would not be treated as an 

early distribution if it is one of a scheduled series of substantially

level payments under a single or joint life annuity or under a term 

certain of at least 180 months commencing upon retirement under the 

plan. 

Rollovers. Individuals generally would be permitted to make 

tax-free rollovers of funds, within 60 days, between tax-favored 

plans. Rollovers and transfers would be limited, however, to prevent

individuals from thereby avoiding the minimum distribution rules. 

Effective Date 

The proposed rules governing distributions generally wou1.d apply

to distributions from tax-favored plans on or after January 1, 1986,

in years beginning on or after such date. The following transition 

rules, however, are proposed with respect to certain of the rules. 

The extension of uniform minimum distribution rules and early

distribution restrictions to all tax-sheltered annuities would not 

apply to annuities with respect to which no additional contributions 

are made on or after January 1, 1986. 

- 347 -
The repeal of capital gain and ten-year averaging treatment of 

lump sum distributions for individuals who, as of January 1, 1987,

will have attained age 55 would be phased in over a six-year period.

Under this transition rule, five percent of a lump sum distribution 

received in 1987 would not qualify for capital gain or ten-year

averaging treatment; 25 percent would not qualify in 1988; 50 percent

in 1989; 75 percent in 1990; and 100 percent in 1991. For all other 

individuals, the repeal of capital gain and ten year averaging 

treatment would be fully effective for distributions on or after 

January 1, 1986. 

The repeal of the deferred inclusion of unrealized appreciation on 

employer securities would be phased in under the same rule. Thus, for 

individuals who will have attained age 55 by January 1, 1987, five 

percent of the unrealized appreciation on each employer security

received in 1987 would not qualify for nonrecognition; 25 percent in 

1988; 50 percent in 1989; 75 percent in 1990; and 100 percent in 1991. 

Again, for all other individuals, repeal of the deferred inclusion 

rule would be fully effective for distributions on or after January 1,

1986. 

The proposed modification to the basis recovery rule for 

distributions before the annuity starting date would not apply to 

benefits accrued under a plan as of January I, 1986. Also,

distributions after such date will be treated, first, as distributions 

of benefits accrued as of January 1, 1986 and, thereafter, as 

distributions of benefits accrued after January 1, 1986. Thus, for 

example, if an employee's accrued benefit as of January 1, 1986 

includes employee contributions, non-annuity distributions after 

January 1, 1986 would be treated, first, as distributions of employee

contributions made before January 1, 1986; second, as distributions of 

taxable benefits; and, third, as distributions of employee

contributions made after January 1, 1986. 

The proposed modification to the three-year basis recovery rule 

and the exclusion ratio would not be effective with respect to amounts 

received as an annuity after the annuity starting date if such 

annuity was in pay status as of January 1, 1986. The recovery rules 

of current law would continue to apply to such amounts. 

Analysis 

The recapture tax on early distributions and the minimum 

distribution rules are intended to target the tax-favored treatment of 

plans at retirement savings. The tax is not designed as a penalty,

but rather to recoup some portion of the unintended tax advantages

that can be obtained by using tax-favored funds for nonretirement 

purposes, including colleges expenses and the purchase of a residence. 

AS funds are permitted to accumulate for longer periods of time, the 

advantages of saving in a tax-favored vehicle increase relative to 

saving in a taxable vehicle. Thus, after funds have accumulated for a 

certain number of years, the recapture tax will recoup only a portion

of the tax advantages provided with respect to the funds, and as the 

- 348 -
accumulation period increases, the recouped portion decreases. 

Concomitantly, the minimum distribution rules limit the ability of 

individuals to defer the receipt of retirement savings beyond

retirement or to transfer such tax-favored accumulations to succeeding

generations. 

The elimination of capital gain and ten-year averaging treatment 

for lump sum distributions would not subject individuals using their 

tax-favored benefits for retirement purposes to significant adverse 

tax effects. Except to the extent precluded under the minimum 

distribution rules, an individual receiving a large distribution from 

a tax-favored plan could still avoid a large tax liability by rolling 

over some or all of such benefits to an IRA or other qualified plan.

This would be consistent with the basic objective of promoting

tax-favored distributions over an individual's entire retirement 

period. Also, even though the relative advantages of ten-year

averaging treatment may be greater for smaller lump sum distributions,

it is important that the tax rules not create incentives for 

individuals, particularly lower-paid individuals, to divert 

tax-favored funds from the retirement income stream before retirement. 

The proposed modifications to the calculation of the exclusion 

ratio applicable to distributions after the annuity starting date 

would assure that an individual (or his estate or heirs) would receive 

the individual's after-tax investment in the plan without additional 

tax. Also, the modifications would assure that an individual who 

outlives his life expectancy would not receive significant amounts in 

excess of his after-tax investment without tax. Finally, the use of 

standardized recovery periods would simplify the calculation and 

application of the exclusion ratio by taxpayers and would facilitate 

the administration and enforcement of such rules by the Internal 

Revenue Service. 

- 349 -
MODIFY DEDUCTION RULES 

FOR TAX-FAVORED RETIREHENT PLANS 

General Explanation 

Chapter 14.03 

Current Law 

In general, amounts paid as deferred compensation are deductible 

by an employer only as they are included in the income of employees.

Moreover, income on amounts set aside by an employer to fund deferred 

compensation is generally taxable to the employer as earned. 

Exceptions to these general rules are provided for deferred 

compensation provided under the various types of tax-favored plans.

Thus, within certain limits, employer contributions to such plans are 

currently deductible by the employer even though employees will not be 

taxable until they receive distributions from the plans. In addition,

the income earned on assets held in a tax-favored plan is not subject 

to tax while it remains in the plan. 

An employer's deduction for contributions to a tax-favored plan is 

subject to two separate limitations. The first applies on an 

individual-by-individual basis and covers contributions to defined 

contribution plans (i.e., profit-sharing, stock bonus, and money

purchase pension plans), defined benefit plans, and combinations of 

the two. The second limitation applies plan by plan and is based on 

the total contributions for the group of employees covered by the 

particular plan. This group-based limitation applies to pension plans

(i.e., money purchase pension plans and defined benefit pension

plans), profit-sharing and stock bonus plans, and combinations 

thereof. 

The individual-by-individual limitation is as follows: (i) the 

contributions and other additions on behalf of an individual under a 

defined contribution plan for a year may not exceed the lesser of 

$30,000 (indexed beginning in 1988) or 25 percent of the individual's 

compensation for the year; (ii) the contribution to a defined benefit 

plan to fund an individual's annual retirement benefit may not exceed 

the contribution necessary, under reasonable actuarial methods, to 

fund an annual retirement benefit of $90,000 (indexed beginning in 

1988); and (iii) the total contributions with respect to an individual 

covered by both a defined contribution plan and a defined benefit plan 

may not exceed a particular percentage (less than 100 percent, and 

dependent on the individual's compensation) of the sum of the two 

preceding limits. In addition to being nondeductible, contributions 

in excess of these limits may also trigger disqualification of the 

plan. 

The group-based limitation applies different limits to pension

plans and to profit-sharing and stock bonus plans. An employer's

deduction for contributions to a pension plan is subject to 

- 350 -
limitations based on the minimum funding standards applicable to 

pension plans and on certain other actuarial determinations. An 

employer's deduction for contributions to a profit-sharing or stock 

bonus plan is limited to 15 percent of the aggregate compensation paid

during the taxable year to all employees in the plan. A carryforward

of the unused portion of the 15 percent limit to a succeeding year is 

permitted, subject to an overall 25 percent of aggregate compensation

limit for the succeeding year. Excess contributions may be carried 

forward and deducted in a succeeding year, subject to the 15 percent

of compensation limit for such year. 

If an employer contributes to both a pension plan and a 

profit-sharing or stock bonus plan, the total deduction for a year is 

limited to the greater of (i) 25 percent of the aggregate compensation

paid during the year to the employees covered by the plans, or (ii)

the amount of contribution to the pension plan necessary to satisfy

the minimum funding standards for such year. An employer may carry

forward excess contributions to a succeeding year, but the deduction 

of current and carryforward contributions for any year is limited to 

25 percent of compensation paid for such year. 

The group-based deduction limitation also provides special rules 

with respect to the deductibility of contributions to employee stock 

ownership plans ("ESOPs"), which in general are profit-sharing, stock 

bonus, or money purchase pension plans that invest primarily in 

employer securities. Contributions to an ESOP to repay principal and 

interest on a loan incurred by the ESOP for the purpose of buying

employer securities may be deductible even though they are in excess 

of the generally applicable limits. In addition, an employer may be 

allowed a tax credit in lieu of a deduction for contributions to an 

ESOP for up to 0.5 percent of the aggregate compensation paid during

the year to employees under the ESOP. This tax credit is scheduled to 

expire at the end of 1987. 

Reasons for Change 

The limitations on an employer's deduction for qualified plan

contributions are intended to restrict the tax-favored treatment 

associated with such plans for individual employees to amounts 

necessary to provide a reasonable ].eve1 of retirement income security.

Amounts in excess of these limitations are presumptively in excess of 

the amounts necessary to provide reasonable benefits and should not be 

eligible for tax advantages. 

The current group-based limitation on deductible plan

contributions is intended to be more restrictive for contributions to 

plans that may be used to finance current consumption or otherwise 

serve nonretirement purposes. Thus, employer deductions for 

contributions to profit-sharing and stock bonus plans have been 

subject to greater restrictions, since, unlike pension plans,

profit-sharing and stock bonus pl.ans are not subject to minimum 

funding requirements and generally are more liberal in permitting

pre-retirement distributions. 

- 351 -
Although profit-sharing and stock bonus plans are thus 

appropriately subject to greater limitations than pension plans, the 

current 15 percent of aggregate compensation limit on the 

deductibility of contributions to profit-sharing and stock bonus plans

is not fully effective in restricting the use of these plans. The 

effectiveness of the 15 percent limit is undermined by the 

carryforward rules and, in certain situations, the ability of 

employers to contribute more than 15 percent of compensation for 

highly paid individuals and less than 15 percent for lower-paid

individuals. 

In addition, the 25 percent of aggregate compensation deduction 

limit applies only to combinations of profit-sharing or stock bonus 

plans and pension plans, rather than to combinations of defined 

contribution plans and defined benefit pension plans. As a result, an 

employer may make contributions to a money purchase pension plan and a 

defined benefit pension plan without regard to the 25 percent of 

aggregate compensation limit, even though money purchase pension plans 

are essentially equivalent to profit-sharing and stock bonus plans in 

that the benefit provided under each is based entirely on the 

individual's account balance at the time of retirement. 

The special tax treatment of ESOPs cannot be justified on 

retirement policy grounds. ESOPs are not primarily retirement plans,

but rather are aimed at promoting employee ownership of employer stock 

and at facilitating employers in raising capital. 

Proposals 

The 15 percent of aggregate compensation limit on deductions for 

contributions to profit-sharing and stock bonus plans would be 

eliminated. The current annual limit on the deductibility of the 

contributions for any individual in a defined contribution plan would 

be modified so that the contributions to a profit-sharing or stock 

bonus plan for any individual could not exceed 15 percent of such 

individual's compensation for the year. Contributions in excess of 

this limit would be deductible in a succeeding year subject to the 15 

percent of compensation limit for that year. 

Under the 15 percent of individual compensation deduction limit, 

a carryforward of an unused limit to a succeeding year would generally

be prohibited. There would be an exception to this general rule,

however, for employer contributions with respect to a 

"retirement-type" profit-sharing plan. Under the exception, there 

would be a carryforward of any unused portion of the 15 percent

deduction limit with respect to a participant from one year to a 

subsequent year only if the profit-sharing plan is a "retirement-type"

plan with respect to such participant for each year during the period

beginning ten years before the year in which the unused limit arose 

through the year to which the unused limit is to be carried forward. 

In any case, the deduction limit with respect to a participant for any 

year, i.e., the sum of the new deduction limit plus the unused limit 

- 352 -
carried forward from any prior year, could not exceed 25 percent of 

the individual's compensation for such year. 

For purposes of this rule, a profit-sharing plan would be treated 

as a "retirement-type'' plan with respect to an individual for a year

only if the following conditions are satisfied for such year: (1) the 

individual is an active participant under the plan; (2) the individual 

is not a participant in any other qualified profit-sharing or stock 

bonus plan maintained by the employer; (3) contributions on behalf of 

the individual are based on a contribution or allocation formula using 

a reasonable year-of-service factor; (4) employer-derived benefits 

attributable to the year and to any other year for which the plan was 

a "retirement-type'' plan are not available, either by distribution or 

loan, before separation from service, death, or disability; and (5)

the plan is not top-heavy. 

The 25 percent of aggregate compensation limit on deductions for 

total contributions to combinations of pension plans and profitsharing or stock bonus plans would be modified by applying the limit 

to combinations of defined contribution plans and defined benefit 

plans. Thus, if an employer maintains a money purchase pension plan

and a defined benefit pension plan, the employer's deduction for total 

contributions to both plans would be limited to the greater of (1) 25 

percent of the aggregate compensation paid to the employees covered by

the plans, or (2) the amount necessary to satisfy the minimum funding

standard for the defined benefit plan. 

An excess contribution to a tax-favored plan would generally not 

trigger plan disqualification, but rather would be subject to an 

annual tax of ten percent for the year of contribution and for as long 

as the excess contribution both remained in the plan and was 

nondeductible. 

The special rules for ESOPs--the tax credit and the special

deduction limits for ESOP contributions to repay principal and 

interest on securities acquisition loans--would be eliminated. Thus,

the deductibility of contributions to a tax-favored plan designed to 

invest primarily in employer securities would be governed by the 

generally applicable deduction limits. See Ch. 12.06. 

Effective Date 

The proposals generally would be effective for years beginning on 

or after January 1, 1986. A special rule would permit an employer to 

deduct contributions to a retirement-type profit-sharing or stock 

bonus plan for the benefit of an individual in excess of the 15 

percent of individual compensation limit where annual contributions of 

less than 15 percent had been made on behalf of such individual before 

the effective date. In addition, a special rule would permit the 

deduction of excess contributions carried forward from years before 

the effective date. 

- 353 -
The repeal of the special deduction limits for ESOP contributions 

to repay securities acquisition loans would not be effective with 

respect to ESOP contributions to repay principal and pay interest on 

securities acquisition loans outstanding on December 31, 1985. 

Securities acquisition loans outstanding on December 31, 1985 that are 

renegotiated, extended, renewed, or revised on or after that date 

generally would be treated as new loans made on the date of 

modification. In addition, the tax credit for contributions to ESOPs 

would be permitted to expire as scheduled at the end of 1987. 

Analysis 

The annual ten percent tax on accumulated excess contributions is 

intended to offset the advantage of tax-free accumulation to which 

excess contributions are currently entitled. The tax would parallel

the tax currently applicable to excess contributions to a 

tax-sheltered annuity contract or custodial account, individual 

retirement account or simplified employee pension, except that it 

would apply to the year of contribution without regard to whether the 

excess contributions were distributed within any specified period. 

The 15 percent of individual compensation deduction limit on 

contributions to profit-sharing and stock bonus plans is intended to 

be a more effective limitation on such plans where they ate not 

designed as retirement plans, which is generally the case. However,

the special carryforward rule recognizes that profit-sharing and stock 

bonus plans may be designed to function as retirement plans and, where 

this is the case, a 15 percent lifetime limit is more appropriate than 

a 15 percent annual limit. 

- 354 -
MODIFY ANNUAL LIMITS ON 

CONTRIBUTIONS AND BENEFITS 

UNDER TAX-FAVORED PLANS 

General Explanation 

Chapter 14.04 

Current Law 

Current law provides favorable tax treatment to funds set aside in 

employer-maintained plans that satisfy certain qualification

requirements. Among the qualification requirements applicable to such 

plans are restrictions on the annual contributions and benefits that 

may be provided with respect to any individual under the defined 

contribution plans and defined benefit plans of an employer. For this 

purpose, defined contribution plans generally include profit-sharing,

stock bonus, money purchase pension, and annuity plans, tax-sheltered 

annuities, and simplified employee pensions. Defined benefit plans

for this purpose are limited to defined benefit pension plans.

Separate annual limits apply to each individual in a defined 

contribution plan and to each individual in a defined benefit plan

("separate plan limits"). An "overall limit" also applies to each 

individual covered by both a defined contribution plan and a defined 

benefit plan. 

The separate plan limit for a defined contribution plan provides

generally that the annual contributions, forfeitures, and other 

additions for any individual may not exceed the lesser of $30,000

(indexed for inflation beginning in l988) or 25 percent of the 

individual's compensation for such year. In determining whether the 

applicable limit is satisfied with respect to an individual for a 

year, the lesser of (i) one-half of the employee contributions for the 

year or (ii) the excess of the employee contributions for the year 

over six percent of the individual's compensation for the year are 

treated as annual additions. 

Special rules permit the employees of certain tax-exempt

organizations, such as educational institutions, hospitals, and 

churches, to benefit from contributions and other additions to 

tax-sheltered annuities in excess of the general defined contribution 

plan limits. Similarly, special limits applicable to employee stock 

ownership plans (ESOPs) permit contributions to exceed the general

limits for defined contribution plans. 

The separate plan limit for a defined benefit plan provides that 

the benefit payable with respect to an individual for a year, when 

expressed as an annual retirement benefit, may not exceed the lesser 

of $90,000 (indexed for inflation beginning in 1988) or 100 percent of 

the average of the individual's highest three years of compensation.

The defined benefit limit is not violated if the annual benefit 

payable to an individual who has never participated in a defined 

- 355 -
contribution plan is not in excess of $10,000. If an individual has , less than ten years o� service with an employer, the $90,000, the 100 

percent of compensation, and the $10,000 annual benefit limits are 

reduced on a pro rata basis. 

The overall limit coordinates the contributions and benefits that 

may be provided to an individual covered by both a defined 

contribution plan and a defined benefit plan. Calculation of the 

overall limit is complex, requiring that the sum of the defined 

contribution fraction and the defined benefit fraction for any

individual subject to the separate plan dollar limits for any year not 

exceed 1.25. For an individual who is subject to the separate plan

percentage-of-compensation limits, rather than the dollar limits, the 

sum of the fractions may not exceed 1.4. The numerator of an 

individual's defined contribution fraction is the aggregate additions 

made on behalf of the individual under the plan during all years of 

the individual's participation, and the denominator is the sum of each 

of the separate defined contribution plan limits that applied, or 

would have applied, for each of the individual's years of service with 

the employer. The defined benefit fraction is the individual's 

accrued annual retirement benefit over the applicable separate defined 

benefit plan limit for the year. 

In the case of a "top-heavy" plan, i.e., a plan under which more 

than 60 percent of the total accrued benefits are for key employees

(five percent owners, one percent owners with $150,000 in 

compensation, the ten employees with the largest ownership interests,

and officers), the 1.25 limit on the sum of the defined contribution 

and defined benefit fractions for key employees subject to the 

separate plan dollar limits is reduced to 1.0. If, however, accrued 

benefits for the key employees are not greater than 90 percent of the 

total accrued benefits under the plan and if the non-key employees are 

provided with the required additional minimum contributions or 

benefits, the overall limit for key employees subject to the dollar 

limits is increased from 1.0 to 1.25. 

Reasons for Change 

The separate plan and overall limits on annual contributions and 

benefits reflect a policy that favorable tax treatment should be 

available only up to levels needed for reasonable retirement savings.

The limits under current law, however, are unnecessarily complex

and fail to limit the use of tax-favored plans in a consistent or 

equitable manner. 

Calculation of the overall limit imposes a significant burden on 

employers and plans, and indeed may be the primary source of 

complexity in the retirement plan area. It requires an employer to 

maintain significant records for many employees and to coordinate the 

contributions and benefits under all of its tax-favored plans. 

The overall limit also creates a disincentive for employers to 

establish both defined contribution and defined benefit plans, since 

- 356 -
the aggregate contributions and benefits for an individual may not 

exceed a particular percentage (less than 100 percent, and dependent 

on the individual's compensation) of the sum of the separate plan

limits. In most situations, the maintenance of both a defined 

contribution plan and a defined benefit plan would better serve the 

interests of employees generally; younger, more mobile employees tend 

to be favored by defined contribution plans, while older employees,

particularly those close to retirement, generally are favored by

defined benefit plans. 

The effectiveness of the current limits is undermined by the 

inconsistency in their application. The separate and overall limits 

fail to take into account benefits under such tax-favored plans as 

individual retirement accounts (IRAs). In addition, certain 

individuals (e.g., participants in tax-sheltered annuities and ESOP 

participants) are permitted to receive annual contributions and 

benefits in excess of the generally applicable limits. Moreover, the 

limits consider only the contributions and benefits provided to an 

individual by a single employer; individuals who have accrued 

tax-favored benefits with more than one employer may receive total 

contributions and benefits far in excess of the existing limits. 

Finally, the limits do not effectively restrict the tax-favored 

benefits (as compared to the tax-favored contributions) that may be 

provided to an individual under a defined contribution plan. 

In addition, the current limits fail to count all employee

contributions and thus disregard the tax advantages such contributions 

receive. Although not deductible, employee contributions to a 

tax-favored plan may accumulate income on a tax-deferred basis. Also,

highly-paid individuals generally are in a better position to take 

disproportionate advantage of the tax benefits for employee

contributions . 

Finally, the phase-in of the annual defined benefit limits over an 

individual's first ten years of service with an employer fails to 

preclude the key empl.oyee of an employer, typically a small employer,

from delaying the establishment of a defined benefit plan until such 

employee is close to retirement. Because such a key employee

generally will have in excess of ten years of service with the 

employer, the employee may be provided with a benefit under the 

defined benefit plan up to the full, unreduced annual limit. By

delaying the establishment of the plan, however, the employer is able 

to avoid providing benefits to non-key employees who may have worked 

for the employer in earlier years. 

Proposals 

The overall limit on the annual contributions and benefits that 

may be provided to an individual under a defined contribution plan and 

a defined benefit plan of an employer would be eliminated. For 

top-heavy plans, however, the existing overall limits would continue 

to apply. 

- 351 -
An additional tax would be applied to taxable, tax-favored 

benefits distributed to or with respect to a participant from all 

plans, including IRAs and tax-sheltered annuities, to recapture some 

portion of the tax advantages provided with respect to annual benefits 

in excess of reasonable levels. The recapture tax would be ten 

percent of the amount by which such annual benefits exceed 1.25 times 

the defined benefit dollar limit in effect for the year. The tax 

would be nondeductible for income tax purposes, and losses,

deductions, and credits would not be applicable against the tax. 

Finally, the ten percent tax on excess annual distributions would be 

coordinated with the 20 percent recapture tax on early distributions 

(see Ch. 14.02) so that the same amounts are not subject to both 

recapture taxes. 

In determining whether the separate plan limit for an employee in 

a defined contribution plan is satisfied, one-half of all employee

contributions would be treated as annual additions on behalf of the 

employee. In addition, the special limits for employees of certain 

tax-exempt organizations participating in tax-sheltered annuities 

and for employees participating in ESOPs would be eliminated. 

Finally, the phase-in of the separate defined benefit plan limit 

over ten years of service with the employer would be modified by

providing for a phase-in of the $90,000 annual defined benefit dollar 

limit over the first ten years of plan participation. A minimum 

annual benefit would be permitted, however, for low-paid employees 

near retirement with significant years of service at the time plan

participation commences. 

Effective Dates 

The modifications to the annual limits on contributions and 

benefits would apply to plan limitation years beginning on or after 

January 1, 1986. For collectively bargained plans, these 

modifications would apply to limitation years beginning after 

termination of the collective bargaining contract. The ten percent 

recapture tax on annual distributions in excess of the applicable

dollar amount would apply to tax-favored distributions made on or 

after January 1, 1986, in taxable years of individual recipients

beginning on or after such date. 

The phase-in of the defined benefit dollar limit over an 

employee's first ten years of plan participation would itself be 

phased in according to the following schedule: for limitation years

beginning in calendar year 1986, the applicable limit would be 

determined by applying a two years of participation phase-in rule; for 

years beginning in 1987, a three years of participation phase-in would 

apply; and so forth until for years beginning on or after January 1,

1994, the applicable dollar limit would be determined under a ten 

years of participation rule. 

- 350 -
Analysis 

Eliminating the overall limit for non-top-heavy plans would 

eliminate a significant source of complexity and thus should promote

the adoption of tax-favored plans. It should also provide employers

with a significant incentive to maintain both defined contribution 

plans and defined benefit plans. 

The ten percent tax on annual tax-favored distributions in excess 

of 1.25 times the applicable defined benefit dollar limit for the year

is an appropriate limit on an individual's annual tax-favored 

retirement benefits. This tax is not designed as a penalty, but 

rather to recapture a portion of the tax advantages provided to excess 

benefits, without requiring significant employer involvement and 

without encouraging employers to maintain only one type of plan. By

applying at the individual level, rather than on an 

employer-by-employer basis, the recapture tax also would apply to 

individuals who accrue excess benefits from multiple employers,

without imposing significant administrative burden; the current limits 

fail to prevent a doubling up of benefits through multiple employers.

For example, if in 1986 an individual receives total tax-favored 

retirement benefits of $200,000 from any number of employers, the 

excess of the $200,000 over $112,500, or $87,500, would be subject to 

the ten percent tax. 

Of course, unless required to take a distribution into income by

the minimum distribution rules, an individual may avoid the ten 

percent recaptuce tax on an excess distribution by rolling over some 

or all of such distribution to an IRA OK qualified plan. 

- 359 -
APPLY TEN PERCENT RECAPTURE TAX TO QUALIFIED PLAN 

ASSETS REVERTING TO EMPLOYER 

General Explanation 

Chapter 14.05 

Current Law 

As a general rule, amounts paid as deferred compensation are 

deductible by an employer only as they are included in the income of 

the employee. Moreover, income from amounts set aside to fund 

deferred compensation is fully taxable to the employer as it is 

earned. Current law provides exceptions to these general rules for 

employer contributions to defined benefit plans. Thus, within certain 

limits, employer contributions to defined benefit plans are currently

deductible, even though employees are not taxable until they receive 

distributions from the plan. In addition, income generated from plan

assets is exempt from tax until distributed by the plan. These tax 

advantages are intended to encourage the creation of qualified plans

and thus to improve the retirement income security of employees. 

Current law requires employers to fund defined benefit plans on a 

"going concern," rather than a "termination," basis; i.e., employers 

must fund not merely benefits already accrued, but also some portion

of the plan's projected benefits. Current minimum funding standards 

also provide that experience gains (e.g., better-than-expected claims 

or earnings experience) may not be taken into account in a single year

for purposes of determining required contributions, but rather must be 

amortized over a fifteen-year period. As a result of these funding

standards, and because employers may also receive a deduction for 

certain plan contributions in excess of minimum funding requirements,

the funds in a defined benefit plan at any particular time may exceed 

the amount necessary to fund benefits accrued as of such time. 

Although current law generally prohibits the use of plan assets by

the employer, upon termination of a plan the employer may receive plan

assets in excess of those necessary to fund fixed and contingent

benefits as of the date of termination. Plan assets that revert to 

the employer upon termination generally are included in the employer's 

gross income. 

Reasons for Change 

Current law permits employers to gain unintended tax advantages by

receiving tax-favored assets on plan termination. Although plan 

assets reverting to the employer are includable in its income, the 

employer retains the benefit of an initial deduction and of 

tax-deferral on the plan's income. As assets accumulate over longer

periods of time in tax-favored plans, the value of these tax 

advantages becomes quite substantial. Such tax-favored treatment is 

inappropriate where plan assets are not used to provide retirement 

benefits to employees. 

- 360 -
The problem is not limited to the situation where an employer

intentionally overfunds and later terminates a defined benefit plan to 

gain the tax-favored funds. It also includes the situation where an 

employer, for independent business reasons, terminates a defined 

benefit plan that has become overfunded solely due to the performance

of the plan's investments. In both situations, the employer is 

receiving the benefit of tax advantages that should be available only

for retirement purposes. 

The use of defined benefit plans for nonretirement purposes is 

evidenced in a number of recent cases in which employers have 

undertaken transactions that effectively permit the employer to 

receive assets from a defined benefit plan while continuing to 

maintain a defined benefit plan for its employees. These transactions 

are inconsistent with the minimum funding standards for qualified

defined benefit plans and may undermine the security of the promised

benefits in the continuing plans. The Treasury Department, along with 

the Labor Department and the Pension Benefit Guaranty Corporation, has 

issued current law guidelines regarding these transactions; these 

guidelines should effectively guard against many of the potential

abuses related to plan terminations. However, because the guidelines 

are issued within the confines of existing administrative authority,

they do nothing to recapture any portion of the tax advantages

provided to defined benefit plan funds when such funds revert to the 

employer. 

Proposal 

An excise tax of ten percent of the plan funds reverting to the 

employer upon plan termination would be imposed on such employer to 

recapture some portion of the tax advantages provided with respect to 

such funds. This tax would be nondeductible for income tax purposes,

and could not be offset by losses or other deductions or credits. 

Effective Date 

The ten percent recapture tax would apply to qualified plan assets 

reverting to an employer pursuant to a plan termination occurring on 

or after January 1, 1986. 

Analysis 

The recapture tax on plan assets reverting to an employer would 

parallel the tax on early distributions to individuals from 

tax-favored plans. Thus, it is designed not as a penalty on asset 

reversions, but rather to recapture a portion of the substantial tax 

advantages provided with respect to a terminating plan's assets when 

such assets are not used to provide benefits under the plan. Under 

the minimum funding rules currently applicable to defined benefit 

plans, an employer is effectively able to gain the benefit of excess 

plan assets by reducing its plan contributions over a five to ten year

period. This approach, however, does not enable the employer to gain 

- 361 -
currently the benefit of the tax advantages provided with respect to 

plan assets, is fully consistent with the "going concern" approach of 

the funding standards, and does not create special risks about the 

security of employees' future retirement benefits. 

- 362 -
REVISE CASH OR DEFERRED ARRANGEMENT (SECTION 401(K)) AND 

EMPLOYER MATCHING CONTRIBUTION RULES 

General Explanation 

Chapter 14.06 

Current Law 

Cash or Deferred Arrangements. In general, employees are subject 

to tax not only on compensation actually received, but also on amounts 

the receipt of which is, at the employee's election, deferred until a 

later year. An exception to this rule of constructive receipt is 

provided for so-called cash or deferred arrangements ("CODAS"), under 

which an employee may elect to defer the receipt of cash compensation

and have the deferred amount contributed as an "elective contribution" 

to a qualified profit-sharing or stock bonus plan. If the CODA meets 

certain qualification requirements, the employee is not currently

taxable on his or her elective contributions. 

A taxable employer may maintain a qualified profit-sharing plan

and thus may maintain a CODA. Congress has not directly addressed 

these questions, however, with respect to either tax-exempt employers 

or public sector employers, such as states or local governments. 

A CODA is qualified if (1) the elective contributions are wholly

nonforfeitable immediately upon contribution; (2) the elective 

contributions may not be distributable before the earlier of aye

59-1/2, hardship, separation from service, disability, or death; (3)

the employees eligible to make elective contributions under the CODA 

satisfy the coverage requirements generally applicable to qualified

plans; and (4) the elective contributions satisfy the "actual deferral 

percentage test" (the "ADP test"). 

IJnder the coverage requirements generally applicable to qualified

plans, the maximum year-of-service condition for eligibility to make 

elective contributions under a CODA is three years of service. Also,

such coverage rules require that the employees eligible to make 

elective contributions under a CODA constitute either (1) at least 70 

percent of all nonexcluded employees who have satisfied the applicable 

age and service conditions, or (2) a classification of nonexcluded 

employees that does not discriminate in favor of employees who are 

officers, shareholders, or highly compensated. Excluded employees are 

those employees who are included in a unit of employees covered by a 

collective bargaining agreement and employees who are nonresident 

aliens without U.S. earned income. 

The ADP test is satisfied for a year if either (1) the ADP for the 

"highly compensated employees" for the year is not more than 150 

percent of the ADP for all other eligible employees, or (2) the ADP 

for the "highly compensated employees" is not more than 250 percent of 

the ADP for all other eligible employees and is not more than 3 

- 363 -
percentage points greater than the ADP for all other eligible

employees. The ADP for a group of employees for a year is the average

of the separate deferral ratios for each employee in the group; an 

employee's deferral ratio for a year is the ratio of the employee's

elective contributions for the year to the employee's compensation for 

the year. For purposes of the ADP test, "highly compensated

employees" are those employees who are more highly compensated than 

two-thirds of all employees eligible to make elective contributions 

under the CODA. 

Elective contributions to CODAS are treated as employer

contributions for purposes of applying the annual contribution and 

benefit limits that apply generally to tax-favored defined 

contribution plans. Thus, if allowed under the ADP test, the maximum 

elective contribution to a CODA on behalf of any employee who does not 

participate in another tax-favored plan is the lesser of $30,000

(indexed beginning in 1988) or 25 percent of the individual's 

compensation. 

Employer Hatching Contributions. An employer may coordinate its 

own contributions to a tax-favored plan with either after-tax employee

contributions to such plan or with elective contributions under a C~DA 

that is part of such plan. Employee contributions that are a 

condition of an employer-provided contribution or benefit are labeled 

"mandatory contributions," and employer contributions that are geared

to either mandatory employee contributions or mandatory elective 

contributions are "employer matching contributions." 

Employer contributions to a tax-favored plan must satisfy the 

general nondiscrimination rule, which generally requires that 

contributions or benefits under the plan not discriminate in favor of 

employees who are officers, shareholders, or highly compensated (the

prohibited group members). This rule is normally satisfied if the 

employer contributions on behalf of employees are a uniform percentage

of the employees' compensation. Under certain circumstances, employer

contributions may satisfy this general rule, even though they are not 

a uniform percentage of compensation, because the plan takes the 

employer's social security contributions into account or because such 

contributions actuarially produce nondiscriminatory benefits. There 

is significant uncertainty, however, regarding the application of the 

general nondiscrimination rules to employer matching contributions. 

Nonelective employer contributioris ( including employer matching

contributions) on behalf of an employee under a plan containing a CODA 

may be treated as elective contributions for purposes of determining

the deferral ratio for such employee if the nonelective contributions 

are wholly nonforfeitable upon contribution and are subject to the 

distribution rules applicable to elective contributions. Thus, such 

nonelective contributions may be combined with elective contributions 

under a CODA to determine whether the elective contributions satisfy

the ADP test. Such nonelective contributions, however, still must 

separately satisfy the general nondiscrimination rule. 

- ,364-
Reasons for Change 

The tax-favored treatment made available to employermaintained and individual plans should be directed primarily at 

enhancing retirement income security. Consistent with this policy,

the ability to make elective contributions to tax-favored plans should 

be available to individuals on a broad and consistent basis. 

An elective contribution under a CODA has the same economic and 

tax effect for the employee as a deductible contribution by the 

employee to an individual retirement account ("IRA"). Despite this 

equivalence, the limits on elective contributions under a CODA are far 

more liberal than the IRA contribution limits. Current law thus 

provides tax advantages to employees of employers maintaining CODAs 

that substantially exceed those available to other individuals. 

Some greater liberality in the limitations on CODA contributions 

is appropriate because of the effectiveness of CODAs in encouraging

employees to save for retirement. The most important CODA feature is 

flexibility: employees need not make elective contributions unless 

their own financial circumstances permit. A higher annual limit on 

elective contributions facilitates this flexibility by enabling

employees to catch up in a subsequent year for not having made 

elective contributions in an earlier year. Many employers make 

employer matching contributions with respect to elective 

contributions, thereby further enhancing employee participation.

The availability of plan loans, distributions upon hardship or 

separation from service, and numerous investment options also add to 

the relative attractiveness of CODAs. Finally, some claim that 

employers that would not otherwise adopt tax-favored plans are 

adopting CODAs. 

If liberal CODA contribution limits are to be justified because of 

the effectiveness of CODAs in encouraging employee retirement saving,

such limits should be applicable only to the extent elective 

contributions actually are made by broad cross-sections of employees 

on a nondiscriminatory basis; nondiscriminatory availability alone is 

insufficient to justify more favorable treatment. The existing CODA 

rules, however, permit employers to exclude many employees from 

eligibility, and permit excessive disparity between the elective 

contributions by highly compensated employees and the elective 

contributions by other eligible employees. 

In addition, because the ADP test applies on an average basis and 

treats a broad category of employees as "highly compensated" (e.?., 

surveys indicate that the compensation breakpoint between the "highly

compensated employees" and other eligible employees often is less than 

$30,000), it is not uncommon for certain very highly paid employees to 

make elective contributions far in excess of the maximum ADP permitted

for highly compensated employees generally. Although employee

participation at the lower and middle income levels may be greater in 

CODAs than in IRAs, the disparity in contributions and benefits in 

favor of the highly paid employees generally is greater in CODAs than 

- 365 -
in other defined contribution plans. This disparity can be reduced 

without affecting the most important feature of CODAs, i.e., employee

flexibility. 

Tax-exempt employers and public sector employers each have access 

to their own tax-favored elective contribution plans for retirement 

savings. Tax-exempt employers may offer their employees tax-sheltered 

annuities and public sector employers may permit employees to make 

elective deferrals under eligible State deferred compensaton plans

(see Ch. 14.10) and, in some cases, to tax-sheltered annuities;

coordination rules are provided for public sector employees who 

participate in both types of tax-favored elective deferral 

arrangements. Thus, the extension of CODAs to tax-exempt and public

employers would be inappropriately duplicative. 

Employers should be encouraged to make employer matching

contributions for employees on a fully nonforfeitable basis and 

subject to the CODA distribution restrictions. In addition, the 

application of the general nondiscrimination rules to employer

matching contributions should be clarified. Uncertainty about the 

applicable rules hinders some employers in fully utilizing plans with 

employer matching contributions and permits other employers to provide

excessive contributions and benefits for highly paid employees. As is 

the case with other tax-favored contributions to and benefits in 

employer-maintained plans, it is important to assure that employer

matching contributions are actually being provided to broad 

cross-sections of employees on a nondiscriminatory basis. Employers

should not be permitted to design plans using employer matching

contributions as mechanisms to deliver disproportionate tax-favored 

benefits to highly paid employees. Accordingly, appropriate

nondiscrimination rules should be applied to employer matching

contributions. 

Proposals 

CODA (401(k)) Rules. The rules governing CODAs would be modified 

so that an employee's elective contributions for a year would be 

limited to $8,000. Elective contributions would continue to count as 

employer contributions against the annual contribution and benefit 

limits for tax-favored plans. 

Deductible IRA contributions by an individual for a year would 

count against the dollar limit on elective contributions under a CODA 

by such individual for the plan year beginning in the calendar year to 

which the IRA contributions relate. Thus, if an individual with 

$20,000 in compensation makes a $2,000 IRA contribution for 1987, the 

dollar limit on the CODA contributions by such individual for the plan 

year beginning in 1987 would be reduced by $2,000. 

The ADP test for CODAs would be modified in a number of ways.

First, the prohibited group members in applying the ADP test for a 

year would not be the "highly compensated employees" of current law,

but rather those employees who, at any time during the three year 

- 366 -
period ending on the last day of the year in question, meet any one of 

the following descriptions: (1) owners of one percent or more of the 

employer (under appropriate attribution rules); (2) employees

receiving at least $50,000 in annual compensation; (3) employees who 

were among the top ten percent of employees by compensation or who 

were among the highest three employees by compensation, but not if 

they received less than $20,000 in annual compensation; or (4) family

members of a prohibited group member with respect to such year. It 

would be appropriate to provide for the automatic expansion or 

contraction of the ten percent and highest three classes in category

(3) based on certain objective characteristics, such as the salary 

structure of an employer's workforce, and to contract the highest

three class for very small employers. It may also be appropriate to 

adjust the three year lookback period where there has been a 

significant change in the size of an employer's workforce. Finally,

the $50,000 and $20,000 dollar amounts would be indexed for inflation. 

Second, the ADP test would be satisfied only if no prohibited 

group member had a deferral ratio in excess of the greater of the 

following two amounts: (1) 125 percent of the ADP for the 

non-prohibited group eligible employees, or (2) the lesser of 200 

percent of the ADP for the other eligible employees or the ADP for the 

other eligible employees plus two percentage points. In calculating

the deferral ratio for a prohibited group member, only the first 

$200,000 of compensation would be considered. 

Third, if the deferral ratio for any prohibited group member for a 

year exceeded the applicable limit for such year, the excess elective 

contributions would be treated as nondeductible employer contributions 

subject to the ten percent tax on contributions in excess of the 

applicable deduction limits. Thus, excess elective contributions 

would not be deductible by the employer in the year paid and would be 

subject to an annual tax of ten percent for the year of contribution. 

See Ch. 14.03. Also, excess elective contributions (and any earnings

attributable thereto) would have to be distributed by the end of the 

plan year following the plan year to which the contributions related. 

Such a required distribution would not be treated as violating the 

distribution restrictions applicable to elective contributions or to 

qualified plans generally. Also, a required distribution would be 

exempt from the early distribution recapture tax applicable to 

tax-favored plan. See Ch. 14.02. If excess elective contributions 

and related earnings are not distributed by the end of the applicable

plan year, the CODA would cease to be qualified as of the plan year to 

which the excess contributions related. 

A special nondiscriminatory eligibility test would be applied to 

CODAS. Under this test, the ratio of prohibited group members 

eligible to make elective contributions under the CODA to the total 

prohibited group members could not exceed 125 percent of the analogous

ratio for the other employees. In applying this test, employees with 

less than one year of service, employees who have not attained age 21,

employees covered by a collective bargaining agreement, and 

nonresident aliens with no U.S. earned income would be disregarded. 

See Ch. 14.09. 

- 367 -
For purposes of applying the ADP test, CODAS covering a common 

prohibited group member would be treated as a single CODA. 

A CODA would be precluded from requiring, as a condition of 

eligibility, employees to complete more than one year of service. 

The CODA distribution restrictions would be modified to preclude

distributions of amounts attributable to elective contributions before 

the employee's death, disability, or separation from service, or plan

termination. 

An employer would be prohibited from conditioning, either directly 

or indirectly, contributions and benefits (other than employer

matching contributions) to employees' elective contributions under a 

CODA. 

Finally, CODAS would be available only to taxable employers.

Tax-exempt and public sector employers would be precluded from 

maintaining CODAS. 

Employer Matching Contributions. Special nondiscrimination rules 

would be applied to employer matching contributions in lieu of the 

general nondiscrimination rules. Employer matching contributions that 

(1) are wholly nonforfeitable upon contribution, (2) may not be 

distributed from the plan prior to the employee's death, disability, 

or separation from service, or plan termination, and (3) are not in 

excess of 100 percent of the employees' mandatory contributions would 

be required to satisfy the ADP test as if such contributions were 

elective contributions. If the employer matching contributions were 

tied to elective contributions under a CODA, the matching

contributions would be combined with the elective contributions for 

purposes of determining whether both the elective contributions and 

the matching contributions satisfied the ADP test. 

If the employer matching contributions were (1) not wholly

nonforfeitable upon contribution, (2) distributable before the 

employee's death, disability, or separation from service, or plan

termination, or (3) in excess of 100 percent of the employees'

mandatory contributions, the matching contributions would be required 

to satisfy the ADP test as though they were elective contributions. 

For this purpose, however, the deferral ratio for each prohibited 

group member would be limited to the greater of the following two 

amounts: (1) 110 percent of the ADP for the non-prohibited group

members, or (2) the lesser of 150 percent of the ADP for the 

non-prohibited group members or the ADP for the non-prohibited group

members plus one percentage point. 

If employer matching contributions under a plan for any individual 

for a year were in excess of the applicable limit for such year, the 

excess matching contributions would be treated in the same fashion as 

excess elective contributions to a CODA. Thus, such excess matching

contributions would not be deductible by the employer for the year of 

- 368 -
contribution and would be subject to a ten percent tax for the year of 

contribution. See Ch. 14.03. Also, excess matching contributions 

(and any earnings attributable thereto) would have to be distributed 

by the end of the plan year following the plan year to which the 

contributions related. This is the case without regard to whether the 

excess matching contributions were vested upon contribution. A 

required distribution of excess matching contributions and related 

earnings would not be treated as violating any applicable distribution 

restrictions. Also, such a required distribution would be exempt from 

the early distribution recapture tax applicable to tax-favored plans.

See Ch. 14.02. If excess matching contributions and related earnings 

are not distributed by the required date, the plan will cease to be 

qualified as of the plan year to which the contributions related. 

Effective Dates 

The proposals relating to CODAs and employer matching

contributions would apply to plan years beginning on or after January

1, 1986. For collectively bargained plans, the proposals would apply

to plan years beginning after the termination of the collective 

bargaining agreement. 

However, an employee's accrued benefit under a CODA as of the last 

day of the first plan year ending on or after December 31, 1985 would 

continue to be subject to the current law distribution limits on 

elective contributions. 

Analysis 

The following table illustrates the proposed modifications to the 

nondiscrimination rules for CODAs (i.e., fully vested and 

nondistributable elective contributions and employer matching

contributions) and for other employer matching contributions. Note 

that the percentage limits set forth below under current law and under 

the proposals refer to the employees' compensation, and that the 

current law CODA limits apply to the average of the elective deferrals 

by the highly compensated employees, whereas the proposed limits apply 

to each prohibited group member's deferral ratio. 

- 369 -

476-698 0 - 85 - 14 
1 

2 

3 

4 

5 

6 

7 

8 

9 

10 

11 

12 

Table 14.06-1 

Current and Proposed Nondiscrimination Limits 

for CODAS and Other Employer Hatching Contributions 

Base ADP for 

Non-Prohibited 

Group 

(In Percent) 

/ Proposed Maximum 

Current I CODA Deferral 

Maximum CODA I Ratio for Each 

ADP for High- I Prohibited 

Paid Group I Group Member 

2.5 2.00 

5.0 4.00 

6.0 5.00 

7.0 6.00 

8.0 7.00 

9.0 8.00 

10.5 9.00 

12.0 10.00 

13.5 11.25 

15.0 12.50 

16.5 13.75 

18.0 15.00 

Office of the Secretary of the Treasury 

Proposed Maximum 

Non-CODA Matching

Contribution for 

Each Prohibited 

Group Member 

1.5 

3.0 

4.0 

5.0 

6.0 

7.0 

8.0 

9.0 

10.0 

11.0 

12.1 

13.2 

May 28, 1985 

The proposals would reduce the currently excessive disparity

permitted between the elective contributions of the prohibited group

members and the elective contributions of the other employees.

However, the proposals would still authorize some disparity, which is 

appropriate to permit prohibited group members near retirement to make 

larger contributions. Also, by more narrowly defining the "prohibited

group," the proposals would generally enhance employee flexibility in 

CODAS. 

As the table reflects, under the proposals, there would be a 

significant difference between the maximum elective and matching

deferrals permitted under a CODA for prohibited group members and the 

maximum employer matching contributions that may be provided to 

prohibited group members without satisfying the vesting and 

distribution rules for CODAS. This difference in maximums is 

necessary to encourage employers to make employer matching

contributions that comply with the CODA vesting and distribution 

requirements. 

- 370 -
MODIFY RULES FOR BENEFIT FORFEITURES 

General Explanation 

Chapter 14.07 

Current Law 

Tax-favo ed tr atment is provided with respect to funds set aside 

in employer-mainta ned plans that satisfy certain qualification

requikements. Among these requirements is one providing that benefits 

under a money purchase pension plan that are forfeited upon the 

employee's separation from service for the employer maintaining the 

plan may not be used to increase the benefits any other employee would 

receive under the plan. The forfeited amounts must be used to reduce 

future employer contributions to the plan or to offset plan

administrative expenses. Forfeited benefits under a profit-sharing or 

stock bonus plan may be reallocated to the remaining participants and 

thus may be used to increase the benefits that the participants would 

otherwise receive. 

Reasons for Change 

Uniform rules governing the treatment of forfeitures should be 

applied to all qualified plans. Also, because forfeitures are treated 

as contributions and other additions for purposes of the annual limits 

on contributions, permitting pension plans to reallocate forfeitures 

among plan parti,cipantsgenerally will benefit rank-and-file 

employees, and not merely highly compensated employees. 

Proposal 

Qualified money purchase pension plans would be permitted to use 

benefits forfeited by a separated employee to increase the benefits 

that other employees would otherwise receive under the plan. 

Effective Date 

The proposal would apply to plan years ending on or after 

January 1, 1986. 

Analysis 

Under the proposal, a qualified money purchase pension plan could 

provide that forfeited benefits will be used to reduce future employer

contributions or to offset administrative expenses, OK that 

forfeitures will be reallocated among the remaining participants. 

- 371 -
MODIFY LOAN RULES FOR 

TAX-FAVORED RETIREMENT PLANS 

General Explanation 

Chapter 14.08 

Current Law 

Generally, if an employee or beneficiary in a qualified

profit-sharing, pension, stock bonus, or annuity plan or a 

tax-sheltered annuity receives any amount as a loan, such amount is 

treated as having been received as a taxable distribution. An 

exception to this general rule provides that a loan shall not be 

treated as a taxable distribution to the extent that the loan (when

added to the outstanding balance of all other loans from such plan)

does not exceed the lesser of two amounts: (1) $50,000, or (2) the 

greater of $10,000 or one-half of the employee's accrued benefit under 

the,plan. This exception is available, however, only for a loan that 

is required to be repaid within five years or, if the loan proceeds 

are used to acquire or improve the principal residence of the employee 

or a member of the employee's family, is required to be repaid within 

q reasonable time. 

Reasons for Change 

The rules governing the tax treatment of loans from certain 

tax-favored plans are aimed at limiting the extent to which an 

employee may currently use assets held by a plan for nonretirement 

purposes and at assuring that loans are actually repaid within a 

reasonable period. However, there is concern that the current rules 

nut prevent an employee from effectively maintaining a permanent

outstanding $50,000 loan balance through the use of balloon repayment

obligations and bridge loans from third-parties. 

In addition, the current rule permitting home loans with repayment

periods extending beyond five years for family members of the employee

and for 'certain improvements on existing principal residences is 

overly broad and difficult to apply. The rule's breadth effectively

eliminates the application of the five year limit in many situations 

for which a five-year rule is appropriate. The favorable tax 

treatment for amounts set aside in qualified plans should be targeted 

at providing employees with retirement income security, and any

exceptions to this general policy should be narrowly limited. 

- groposals -. 

- The exception to the general rule for loans less than a specified

%mount would be modified so that the $50,000 limit is reduced by the 

highest outstanding loan balance owed by the employee to the plan

during the prior twelve months. Thus, the exception as modified would 

provide that a loan would be treated as a taxable distribution only to 

- 372 -
the extent that the loan (when added to the outstanding balance of all 

other loans from the plan) does not exceed the lesser of the following

two amounts: (1) $50,000, reduced by the highest outstanding loan 

balance owed by the employee to the plan during the prior twelve 

months, or (2) the greater of $10,000 or one-half of the employee's

accrued benefit under the plan. 

The special rule for home loans would be available only for the 

first-time purchase of a principal residence by and for the employee.

Plan loans to improve an existing principal residence, to purchase a 

second home, and to finance the purchase of a home or home 

improvements for other members of the employee's family would be 

subject to the five year repayment rule. 

Effective Date 

The modifications to the rules governing the tax treatment of 

loans from certain tax-favored plans would apply with respect to all 

amounts received as a loan on or after January 1, 1986. Loans 

outstanding on January I, 1986 that are renegotiated, extended,

renewed, or revised on or after that date generally would be treated 

as loans made on the date of modification. 

Analysis 

Under the proposed limit on plan loans, an employee who borrowed 

$50,000 from a qualified plan on January 1, 1986, and repaid the full 

principal, with interest, on December 31, 1990, would be precluded

from borrowing additional amounts from the plan on a nontaxable basis 

until 1992. Thus, employees wou1.d generally not be able to maintain 

permanent $50,000 outstanding loans from plans through the use of 

balloon payments and short-term bridge loans. 

Most employees, however, repay plan loans on a regular basis,

often by payroll deduction. These employees generally would not be 

affected by the proposed modification. For example, assume an 

employee borrows $50,000 from a qualified plan on January 1, 1986, and 

commits to repaying the principal in equal monthly installments over a 

five-year period ($833.33 per month, plus interest). During the first 

year of repayment, the employee would not be able to make a second,

nontaxable loan. However, at the end of the second year, $10,000

would be available for loan on a nontaxable basis. At the end of the 

fifth year of repayment, $40,000 would be available. And in 1992, the 

full $50,000 would again be available as a nontaxable loan. 

- 373 -
MODIFY NONDISCRIMINATORY COVERAGE 

TEST FOR TAX-FAVORED RETIREMENT PLANS 

General Explanation 

Chapter 14.09 

Current Law 

A profit-r aring, stock bonus, pension, or annuity p sn must be 

nondiscriminatory in coverage in order to qualify for favorable 

treatment. More specifically, such qualified plans must provide

benefits to a group meeting one of the following descriptions: (1) at 

least 70 percent of all the nonexcludable employees who have satisfied 

the maximum age and service conditions; (2) at least 80 percent of all 

eligible employees, but only if at least 70 percent of the 

nonexcludable employees who have satisfied the maximum age and service 

conditions are eligible; or (3) a classification of nonexcludable 

employees that is not discriminatory in favor of employees who are 

officers, shareholders, or highly compensated. For purposes of this 

rule, excludable employees are those employees who are covered by a 

collective bargaining agreement and nonresident aliens without U.S. 

earned income. The maximum service condition for a plan is one year

of service for the employer (or, if employees are fully vested on 

employer-derived benefits immediately upon accrual, three years of 

service), and the maximum age condition is age 21. 

Neither the Congress nor the Internal Revenue Service has 

attempted to define in a detailed way the classes of 

individuals--i.e., officers, shareholders, and highly compensated

employees-in whose favor discrimination is prohibited (the

"prohibited group"). Moreover, no objective standards have been 

established for determining whether coverage is based on a 

nondiscriminatory classification. Instead, these issues, i.e.,

whether an employee is a shareholder, an officer, or highly

compensated, and whether any particular classification of covered 

employees is nondiscriminatory, have been left for resolution on the 

basis of the facts and circumstances in each particular case. 

The existing facts and circumstances approach to the 

classification test requires that the class of covered employees be 

nondiscriminatory both on its face and in actual operation. In 

determining whether a classification discriminates in operation, there 

may be a "reasonable difference" between (1) the ratio of the 

prohibited group members covered under a plan to the total prohibited 

group members employed by the employer and (2) the ratio of the other 

employees covered under the plan to the total non-prohibited group

employees of the employer. The comparison of these ratios, however,

is only one of the factors to be considered in testing whether a 

classification is nondiscriminatory. 

- 374 -
Reasons for Change 

The basic rationale for the tax-favored treatment afforded 

qualified plans is that such plans, in providing for the retirement 

security of individual employees or groups of employees, contribute to 

the national goal of providing security for all retired workers. 

Thus, tax incentives for qualified plans harness the initiative and 

energy of the private sector to meet responsibilities that might

otherwise fall upon government and government-funded programs. ~f 

this use of the tax system is to be justified, however, coverage under 

qualified plans must be made available on the broadest possible basis. 

Absent such broad coverage, qualified plans are less an instrument of 

national retirement policy than a form of tax-preferred investment for 

a limited class of taxpayers. 

The nondiscriminatory coverage test of current law fails 

adequately to assure that the tax advantages of qualified plans are 

available only where coverage is provided on a broad,

nondiscriminatory basis. Under the current facts and circumstances 

approach, employers are left with substantial uncertainty concerning

whether their plans qualify. As a consequence, some employers will 

apply relatively strict standards to ensure qualification. Others,

however, take the lack of certainty as permitting an agressive

approach to coverage issues. The result is a patchwork of empl.oyee 

coverage patterns, ranging from plans that cover a broad cross-section 

of employees at all income levels to plans that focus benefits on the 

highly compensated. Such inconsistent coverage is unfair to 

individual employees and fails to condition tax-favored treatment on 

broad, nondiscriminatory coverage. 

In order that qualified plan coverage be provided on the broadest 

possible basis, it is important not only that nondiscrimination tests 

provide greater certainty, but also that such tests prevent coverage

that disproportionately favors the highly compensated. Current 

administrative rulings have made possible arguments that, for example, 

a plan may satisfy the nondiscriminatory classification test so long 

as a high percentage of an employer's employees is in the middle- and 

lower-income groups and a meaningful percentage (e.g., 40 percent) of 

these employee groups is covered, even though the plan may cover 100 

percent of the employer's prohibited group members. To prevent

discriminatory coverage, it is appropriate that the coverage ratios 

for prohibited and for non-prohibited group members not vary by a 

substantial margin. Such requirement, if combined with a procedure

for case by case review of plans presenting special circumstances,

would ensure that tax-favored treatment be limited to plans that serve 

the national policy of providing retirement security on a broad,

nondiscriminatory basis. 

Proposals 

A profit-sharing, stock bonus, pension, or anniiity plan would be 

required to satisfy a nondiscriminatory coverage test as a condition 

of tax qualification. Under this test, the percentage of the 

- 315 -
employer's prohibited group members benefiting under the plan would 

not be permitted to exceed 125 percent of the percentage of the 

employer's other employees benefiting under the plan. Employees in a 

class of excludable employees would be disregarded in applying this 

125 percent test if the plan does not benefit any employee in such 

class. 

An employee would be treated as a prohibited group member with 

respect to a plan year if, at any time during the three year period

ending on the last day of the plan year, the employee met any one of 

the following descriptions: (1) an owner of one percent or more of 

the employer (under appropriate attribution rules); (2) an employee

receiving at least $50,000 in annual compensation; (3) an employee who 

is among the top ten percent of employees by compensation or who is 

among the highest three employees by compensation, but not if he or 

she received less than $20,000 in annual compensation; or (4) a family

member of another prohibited group member with respect to such year.

It would be appropriate to provide for the automatic expansion or 

contraction of the ten percent and highest three classes in category 

(3) based on certain objective characteristics, such as the salary 

structure of an employer's workforce, and to contract the highest

three class for very small employers. It may also be appropriate to 

adjust the three year lookback period where there has been a 

significant change in the size of an employer's workforce. Finally,

the $50,000 and $20,000 dollar amounts would be indexed for inflation. 

In applying the 125 percent coverage test, the following classes 

of employees would be treated as excludable: (1) employees with less 

than one year of service (or, if benefits are vested immediately on 

accrual and the plan does not contain a cash or deferred arrangement 

(see Ch. 14.06), two years of service); (2) employees who have not 

attained age 21; (3) employees covered by a collective bargaining 

agreement; and (4) nonresident aliens with no U.S. earned income. 

In very limited situations where compelling business reasons 

indicate that application of the 125 percent test would not be 

appropriate (e.g., for a limited period following a merger or 

acquisition of businesses), an employer would be permitted to obtain a 

timely ruling from the Internal Revenue Service that the employer's

plan satisfies the nondiscriminatory coverage test even though it 

fails to satisfy the 125 percent test. The Internal Revenue Service 

would be permitted to apply any reasonable conditions on the continued 

validity of such a ruling. 

In addition, any classification of employees used by a plan for 

participation purposes would be required to be nondiscriminatory on 

its face. For example, except to the extent permitted under the rules 

permitting integration with social security, it would be impermissible

for a plan to provide that only employees earning more than $45,000 in 

compensation will be covered, even if the plan otherwise satisfies the 

125 percent coverage test. A plan requiring an employee contribution 

as a condition of participation or excluding employees in a bona fide 

job category from participation would generally not be deemed to be 

discriminatory on its face. - 316 -
For purposes of applying this nondiscriminatory coverage test,

plans covering a common prohibited group member would be treated as a 

single plan. 

Effective Date 

The proposed nondiscriminatory coverage test would apply to plan 

years beginning on or after January I, 1987. For collectively

bargained plans, the test would not apply to plan years beginning

before the termination of the collective bargaining agreement. 

analysis 

The proposed 125 percent coverage test would assure that a plan

claiming favorable tax treatment actually provides benefits to a 

nondiscriminatory classification of employees. The test would require 

some qualified plans to provide benefits to additional numbers of 

non-prohibited group employees. Without changes to the plans' benefit 

formulas, this would tend to increase the costs of these plans.

However, because these increased costs would be attributable to 

expanded plan coverage, the costs would be justified as furthering the 

fundamental objective of providing benefits to broad cross-sections of 

employees on a nondiscriminatory basis. In addition, a plan could 

offset any resulting increased costs by reducing the benefits provided 

to all employees for future years of service or by reducing the 

coverage of prohibited group members. 

Application of the 125 percent coverage test is illustrated by the 

following example. Assume that an employer has 100 nonexcludable 

employees, 20 of whom are prohibited group members with respect to a 

plan year. Assume further that 60 of the 80 non-prohibited group

employees are covered under the plan (i.e., 75 percent), and that 12 

of the covered non-prohibited group employees do not actually receive 

benefits under the plan because the plan is properly integrated with 

social security. Under the proposed test, the percentage of the 20 

prohibited group members who benefit under the plan would not be 

permitted to exceed 125 percent of the percentage of the 

non-prohibited group employees who benefit under the plan; sixty

non-prohibited group employees benefit under the plan for this 

purpose. Thus, if more than L8 of the prohibited group members (1.25 

x (60/80) x 20, or 18.75) benefitted under the plan, it would not 

satisfy the test. 

The 125 percent test would not be an appropriate test in certain 

limited situations. For example, assume that an employer maintaining 

a qualified plan acquires another company during a plan year and the 

acquired company did not maintain a qualified plan for its employees.

It thus may be appropriate to treat the acquiring company's qualified

plan, if it satisfied the 125 percent test before the acquisition, as 

satisfying the nondiscriminatory coverage test for a limited period

after the acquisition to permit the post-acquisition employer to 

redesign the qualified plan or to establish a new plan to satisfy the 

- 377 -
125 percent test. Of course, during the limited period, the acquiring

company's plan would be required to satisfy any reasonable conditions 

that the Internal Revenue Service may impose as part of the timely

ruling, such as that the plan satisfy the nondiscriminatory coverage 

test by reference to the entire post-acquisition company with a more 

liberal percentage (e.g., 150 percent) substituted for 125 percent. 

Finally, consideration would be given to adoption of a rule 

precluding the exclusion of employees or any group of employees in the 

absence of a bona fide business purpose, in order to prevent an 

employer from excluding, by design, the maximum number of 

non-prohibited group members that can be excluded without failing the 

125 percent test. 

- 378 -
UNIFY RULES FOR UNFUNDED DEFERRED COMPENSATION 

ARRANGEMENTS OF _. STATES AND TAX-EXEMPT EMPLOYERS

General Explanation 

Chapter 14.10 

Current Law 

In general, employees are subject to tax not only on compensation

actually received but also on amounts the receipt of which is, at the 

employee's election, deferred until a later year. The application of 

this general rule of constructive receipt to nonqualified and unfunded 

deferred compensation arrangements is modified for amounts deferred 

under either a "private deferred compensation plan" or an "eligible

State deferred compensation plan." Neither of these plans is 

available to tax-exempt employers. 

A "private deferred compensation plan" is a plan or arrangement

maintained by a taxable employer under which the receipt of cash 

compensation is deferred, at an employee's election, on an unfunded 

basis. The taxable year of inclusion under these plans is to be 

determined in accordance with the applicable rules and judicial

decisions in effect on February 1, 1978. 

Under an "eligible State deferred compensation plan," an employee

of a State who elects to defer the receipt of current compensation

will be taxable on the deferred amounts (and on any income 

attributable thereto) when such amounts are paid or otherwise made 

available. In order to qualify as an eligible State plan, deferred 

amounts must remain, at all times until subsequently paid or made 

available, solely the property of the State, subject only to the 

claims of the State's general creditors. The maximum annual deferral 

under an eligible State plan is the lesser of (1) $7,500 OK (2) 33-1/3

percent of the employee's compensation. The rules provide a special

catch-up limit permitting higher deferrals for the three years

immediately preceding an employee's normal retirement age. Amounts 

deferred by employees under tax-sheltered annuities are taken into 

account in applying these limits. 

Amounts deferred by an employee under an eligible State plan may

be automatically transferred to the eligible plan of another employer

in which the empl.oyeebecomes a participant if (1) the entities 

sponsoring the plans are located within the same State, (2) the 

transferee plan provides for the acceptance of the amounts, and (3)

the transferor plan provides that if an employee separates from 

service in order to accept employment with another such entity,

deferred amounts will be automatically transferred. 

A deferral under an eligible State plan may not be made available 

to an employee before separation from service with the State or an 

unforeseeable emergency. In addition, distributions of amounts under 

- 379 -
an eligible plan must commence within 60 days after the later of two 

dates: (1) the close of the year in which the employee or former 

employee attains the normal retirement age, or (2) the close of the 

plan year in which the employee separates from service for the State. 

Distributions over the employee's lifetime must be projected to exceed 

50 percent of the total benefits payable with respect to the employee

and any beneficiaries. Finally, if the employee dies before his or 

her entire benefit is distributed, the remaining portion of the 

benefit must be distributed to the employee's beneficiary over (1) the 

life of the beneficiary (or shorter period), if the beneficiary is the 

employee's surviving spouse, or (2) a period not in excess of fifteen 

years. 

If an unfunded State plan does not qualify as an eligible plan, a 

deferral is included in the employee's gross income when there is no 

longer a substantial risk of forfeiture of such amount (e.g., the 

employee's right to the deferred amount is no longer conditioned upon

the future performance of substantial services). 

Reasons for Change 

Employees of tax-exempt employers should have access to 

nonqualified, unfunded deferred compensation arrangements on 

essentially the same basis as other employees. Current law denies 

such equal access by applying constructive receipt principles to 

employees of tax-exempt entities, while permitting deferral of tax for 

State employees and employees of taxable employers until actual 

receipt. As a consequence, employees of tax-exempt employers are at a 

relative disadvantage in providing for their retirement income 

security. Moreover, under current law, some employees of tax-exempt

employers are deferring compensation on a nonqualified and unfunded 

basis without regard to either the general constructive receipt rule 

or the rules governing eligible plans. Application of specifically

defined rules would ensure that employees of tax-exempt employers who 

do defer compensation on a nonqualified, unfunded basis receive 

comparable tax treatment. 

Although employees of tax-exempt employers should have comparable 

access to nonqualified, unfunded deferred compensation arrangements,

there are practical constraints on the use of such arrangements by

taxable employers that would not similarly affect tax-exempt

employers. A taxable employer's deduction for deferred amounts in a 

nonqualified arrangement is postponed until the employee includes the 

amounts in income. There is thus a tension between the tax treatment 

of a taxable employer and that of an employee which limits the amount 

of compensation the employer will permit an employee to defer. 

However, as is the case with States, tax-exempt employers are 

indifferent about the timing of the tax deduction for deferred 

compensation. Thus, in order that nonqualified, unfunded deferred 

compensation arrangements be available to all employees on roughly the 

same basis, it is appropriate to limit the amount of deferral for 

employees of tax-exempt employers as well as for public Sector 

employees. 

- 380 -
In addition, nonqualified and unfunded deferred compensation plans

should not enable employees to defer the receipt of income 

indefinitely or to transfer deferred amounts to subsequent

generations. Thus, certain modifications to the existing distribution 

rules applicable to eligible State plans should be made to assure that 

the employee, rather than the employee's beneficiaries, will receive a 

substantial portion of the deferred benefits over the employee's

lifetime. Finally, certain of the existing restrictions on deferred 

compensation arrangements impose burdens that do not further the 

retirement security of employees. 

Thus, the existing rules prohibit an employee from electing to 

receive deferred amounts before separation from service or an 

unforeseeable emergency even though the employee has decided to cease 

participation in the eligible plan and the deferred amounts are de 

minimis. In addition, the existing restrictions on transfers between 

eligible plans have the practical effect of forcing employees to 

receive their deferred amounts even though they are participating in 

an eligible plan maintained by another State. 

Proposals 

The rules permitting the elective deferral of compensation by

employees of States on a nonqualified and unfunded basis would be 

expanded to apply to the employees of employers exempt from tax under 

the Internal Revenue Code. Thus, an employee of a tax-exempt employer

would be permitted to defer, on an elective basis and subject to the 

same limitations currently applicable to State employees, a portion of 

his or her current compensation under a nonqualified and unfunded 

arrangement maintained by the employer (an "eligible deferred 

compensation plan"). Compensation deferred by an employee of a State 

or a tax-exempt employer under an ineligible deferred compensation

plan would be includable in the employee's gross income when there is 

no longer a substantial risk of forfeiture. 

The expanded rules governing eligible deferred compensation plans

generally would be consistent with the current rules applicable to 

States. However, certain modifications would be made to these rules 

in expanding them to cover both categories of employees. 

The required distribution rules for benefits under eligible

deferred compensation plans would be modified to require that 

(5) the benefits projected to be payable over the lifetime of the 

employee exceed 66-2/3 percent of the total benefits projected to be 

payable with respect to the employee; (2) if payments are to be made 

over a period extending beyond one year, payments be made on at least 

an annual and substantially nonincreasing basis; and (3) distributions 

of benefits to a beneficiary of an employee commence within one year

following the employee's death. 

A deferred compensation arrangement would not fail to be an 

eligible deferred compensation plan and amounts would not be treated 

- 381 -
as made available to an employee merely because, under the 

arrangement, an employee may at any time elect to receive, in a single 

sum within 60 days of the election, all amounts deferred for his OK 

her benefit. However, this rule would apply with respect to an 

employee only if such employee’s total deferred benefit is not in 

excess of $3,500 and the employee is no longer eligible to defer 

compensation with respect to the State or tax-exempt employer. 

Finally, the applicable rules would be modified to permit the 

automatic transfer of deferred amounts between any two eligible plans,

whether or not maintained within the same State, only if the following 

are satisfied with respect to both the transferor and transferee 

plans: (1) the plans provide for the acceptance of such automatic 

transfers with respect to all individuals who become employees of the 

employers maintaining the plans; and (2) the plans provide for the 

automatic transfer of deferred amounts with respect to all employees

who separate from service and become employed for employers

maintaining eligible plans that accept such transfers. Transfers not 

conforming to these conditions would be prohibited. 

Effective Date 

The application of the rules governing eligible State plans to the 

nonqualified and unfunded deferred compensation arrangements of 

tax-exempt employers, and the modifications to these rules for both 

States and tax-exempt employers, would apply to taxable years of 

individuals beginning on or after January 1, 1986. 

Analysis 

The expansion to tax-exempt employers of nonqualified, unfunded 

deferred compensation arrangements will permit their employees to 

provide for retirement security on the same basis as other employees,

and would ensure uniform treatment of those employees of tax-exempt

employers that may now be deferring compensation, without regard to 

constructive receipt principles or to the limits applicable to 

eligible State plans. The proposal would not, however, affect the 

treatment of a nonqualified deferred compensation plan under the labor 

provisions of the Employees Retirement Income Security Act of 1974. 

The modifications to the rules currently applicable to eligible

State plans are designed to target the permitted arrangements more 

specifically at retirement savings. Thus, the minimum distribution 

modifications would limit the ability of employees to defer benefits 

beyond retirement. Also, the modification to permit automatic benefit 

transfers between eligible plans in different States would enhance the 

portability of these deferred amounts and thus the likelihood that 

they will be received as retirement income. 

- 382 -
CHAPTER 15 

REFORIVI INTERNATIONAL TAXATION 

The Administration proposals would retain the basic structure for 

taxing foreign income of U.S. taxpayers that has evolved since 1913. 

This structure is intended to cause foreign income to bear a fair 

share of U.S. tax in a manner that does not distort investment 

decisions; at the same time, special measures reflect concern for the 

international competitiveness of U.S. business. Thus, the general

rule is that U.S. taxpayers are subject to U.S. tax on their worldwide 

income. A credit is allowed against U.S. tax for foreign income taxes 

paid in order to avoid double taxation of foreign income which has 

been taxed by the country where the income is earned. The special

measures include the deferral of 1J.S. tax on income earned by

U.S.-controlled foreign corporations until that income is remitted to 

U.S. shareholders. (Certain tax haven income is, however, taxed to 

the U.S. currently even though not repatriated.) In addition, the 

first $80,000 of foreign earned income of a qualifying IJ.S. citizen or 

resident whose tax home is in a foreign country is excluded from 

income subject to U.S. tax. 

In reaching the decision to continue the worldwide taxation of 

u.S. taxpayers with allowance for foreign tax credits, the 

Administration considered and rejected the alternatives of exempting

foreign source income from U.S. tax, or taxing foreign source income 

but only allowing a deduction for foreign taxes. While an exemption

approach would in some circumstances facilitate overseas competition

by U.S. business with competitors from countries that tax foreign

income on a favored basis, such an approach also would favor foreign

over U.S. investment in any case where the foreign country's effective 

tax rate was less than that of the United States. Moreover there 

would be a strong incentive to engage in offshore tax haven activity.

The longstanding position of the United States that, as the country of 

residence, it has the right to tax worldwide income is considered 

appropriate to promote tax neutrality in investment decisions. 

Exempting foreign income from tax would favor foreign investment at 

the expense of U.S. investment. The other alternative, to allow only

a deduction for foreign taxes, would not satisfy the objective of 

avoiding double taxation. Nor would it promote tax neutrality; it 

would be a serious disincentive to make foreign investments in 

countries where there is any foreign income tax. 

The Administration proposals therefore would correct certain 

problems in the existing system of U.S. taxation of international 

transactions. When combined with the proposed reductions in tax 

rates, the net effect of the Administration proposals would be to 

reduce the U.S. tax burden on foreign income. By 1990, after the rate 

reductions are fully phased-in, the U.S. tax collections on foreign

income would be $9.4 billion, compared with $11.4 billion if current 

- 383 -
law continued to apply. This 18 percent net reduction in U.S. tax on 

foreign income would enhance the overall competitiveness of U.S. 

business abroad. 

The Administration strongly supports a foreign tax credit as the 

appropriate measure to avoid international double taxation. However,

the existing overall foreign tax credit limitation allows high foreign

taxes to be credited against U.S. tax on other low-taxed foreign

income. This allows a high tax country's tax to be utilized to offset 

the residual U.S. tax that otherwise would be imposed with respect to 

low-taxed foreign income, and as a consequence favors foreign over 

U.S. investment. The Administration proposal to adopt a per-country

limitation on the foreign tax credit would limit the foreign tax 

credit to its function of eliminating international double taxation of 

foreign income by restricting the ability to average foreign income 

subject to high and low foreign effective tax rates. 

The other Administration proposals are intended to rationalize and 

improve existing law relating to the taxation of international transactions. Certain income source rules and expense allocation rules 

would be modified to associate income more appropriately with the 

source of the underlying economic activity and associate interest 

expense with assets supported by the borrowing. The proposals

relating to taxation of U.S. branches of foreign corporations, tax 

relationships with U.S. possessions and taxation of foreign exchange

gains and losses represent important technical improvements to 

existing law. While a number of these changes could be made administratively under current law, it is appropriate to describe such 

proposals in conjunction with tax reform proposals requiring

legislative amendments. 

- 384 -
REFORM FOREIGN TAX CREDIT 

General Explanation 

Chapter 15.01 

Current Law 

Foreign Tax Credit Limitation 

The United States taxes its citizens and residents, including

U.S. corporations, on their worldwide income. To avoid international 

double taxation when the foreign income of a U.S. citizen, resident or 

corporation is taxed by a foreign country, the United States permits a 

taxpayer to elect to credit the foreign income taxes paid against his 

U.S. tax liability. The amount of foreign tax credit which may be 

claimed in any taxable year is limited to the U.S. tax otherwise 

imposed on foreign source income for that year. This limit is 

measured as the portion of U.S. tax, before credit, corresponding to 

the portion that foreign taxable income is of worldwide taxable 

income. The limitation is calculated on an overall basis; that is,

the amount of credit potentially allowable is the aggregate of income 

taxes paid to all foreign countries, and foreign source taxable income 

is the aggregate of all taxable income from sources outside the United 

States. In effect, each taxpayer is allowed to average foreign

effective tax rates above and below the U.S. rate. Only if the 

average foreign tax rate exceeds the U.S. tax rate are any potential

credits denied. Potential credits that exceed the limitation in a 

particular year may be carried back two years and forward five years. 

The foreign tax credit limitation is calculated separately for 

several different categories or baskets of income, including a passive

interest income basket. The separate basket rules prevent taxpayers

from averaging for foreign tax credit limitation purposes foreign tax 

rates on different classes of income that may be easily moved from one 

source to another or that are typically subject to lower aggregate

foreign tax. Special limitations also apply in determining the amount 

of credit that can be claimed with respect to income derived from oil 

and gas related activities. 

Indirect Credit for Foreign Taxes Paid by Foreign Subsidiaries 

All taxpayers are allowed to credit foreign income taxes that they

pay directly. In addition, U.S. corporations are allowed to credit a 

share of taxes paid by foreign subsidiary corporations when the 

earnings of the subsidiary become subject to U.S. tax. This is called 

the "indirect" or "deemed paid" foreign tax credit. The share of 

foreiSn taxes paid by the foreign corporation for a taxable year that 

is eligible for the indirect credit is related to the share of that 

corporation's "accumulated profits" that is repatriated as a dividend 

- 385 -
purpose 

to the U.S. parent corporation. Shareholders that are currently

taxable under the provisions of subpart F on income of a controlled 

foreign corporation are also entitled to an indirect credit for the 

foreign taxes paid by that corporation. The share of taxes eligible

for the indirect credit under subpart F is related to the share of 

"earnings and profits" of the controlled foreign corporation for the 

taxable year included in the shareholder's income. These taxes are 

subject to the limitation described above. 

For purposes of computing the indirect credit with respect to an 

actual dividend distribution, distributions are treated as made out of 

the most recently accumulated profits of the distributing corporation.

Distributions made during the first 60 days of a taxable year are 

generally treated as paid out of the prior year's accumulated profits.

Foreign taxes paid are required to be associated with the accumulated 

profits to which they relate on a year by year basis. For purposes of 

computing the indirect credit with respect to a subpart F inclusion,

taxpayers are required to associate foreign taxes with earnings and 

profits of the current year. 

Accumulated profits as calculated for purposes of the indirect 

credit with respect to actual distributions and earnings and profits

as calculated for purposes of the indirect credit with respect to 

subpart F inclusions may differ in several respects. For example, the 

subpart F rules require adjustment to U.S. financial and tax accounting principles to be made only if the adjustment is material. 

Differing foreign currency translation rules also apply as discussed 

in more detail in Ch. 15.04. Existing regulations permit, but do not 

require, a corporation to calculate accumulated profits and earnings

and profits on the basis of the same accounting and tax adjustments

although different currency translation rules are mandatory. 

In calculating the indirect credit, dividends received are 

generally characterized as from foreign or domestic sources on the 

basis of the place of incorporation and other tax attributes of the 

corporation paying the dividend. Existing law also contains rules 

preventing the conversion of u.S. source income into foreign source 

income and interest income into non-interest income by routing that 

income through foreign affiliates. 

Reasons for Change 

Foreign Tax Credit Limitation 

The of the foreign tax credit is to relieve international 

double taxation of foreign income. Double taxation would be fully

relieved if income derived from each separate transaction were treated 

separately for credit purposes and the U.S. tax were offset by a 

credit for the foreign tax paid with respect to that income. Any

departure from a transactional approach to crediting foreign tax will 

permit some averaging of foreign taxes and will therefore involve some 

- 386 -
surrender of the residual tax imposed by the United States on foreign

income that is taxed by foreign countries at rates below the U.S. 

rate. 

The existing law prohibits averaging of foreign taxes on passive

interest income, which is often exempt from foreign tax under foreign

law or treaties or subject only to withholding tax at modest rates,

with foreign taxes on other foreign income. Foreign tax on other 

types of passive income, including portfolio dividends, is permitted

to be averaged with tax on active business income, even though this 

passive income may also be subject to foreign tax at low rates. The 

existing overall limitation also permits high foreign taxes in one 

country and low foreign taxes in a second country to be averaged in 

computing the available foreign tax credit. The deferral of U.S. tax 

on foreign subsidiary earnings until those earnings are repatriated

allows taxpayers to control this averaging process by controlling the 

timing of foreign subsidiary dividend distributions. 

The averaging of effective rates permitted under current law is 

undesirable for at least two reasons. First, the averaging permitted

by an overall limitation gives taxpayers with operations in a high tax 

country an incentive to invest in low tax countries. For a taxpayer

with excess foreign tax credits, low tax country investments may be 

more attractive than investments in the United States that generate a 

higher pre-tax economic return simply because of the possibility of 

using the excess credits to offset a portion of the U.S. tax otherwise 

due. In that way the effective rate of overall tax on the foreign

investments can be reduced below the effective rate that would apply

if the investment in the low tax country had been made in the United 

States. The overall limitation under current law thus causes economic 

decisions to be distorted purely for tax advantage. 

This potential for distortion of economic decision making that 

results from the overall limitation exists at the U.S. tax rates 

prevailing under existing law. However, the incentives to invest in 

low tax countries may be more pronounced when U.S. corporate tax rates 

are greatly reduced under the tax reform proposal. The substantial 

proposed tax rate reduction will cause many more taxpayers to operate

in an excess foreign tax credit position. The additional excess 

credits created by the proposed rate reduction will result in a 

significant opportunity for reducing a corporation’s overall tax 

burden by making investments in low tax countries instead of the 

United States. A similar strong incentive will be created to generate

averageable low tax passive income that is not subject to the existing

separate basket rules and definitions. 

A second problem is that the overall limitation permits some 

foreign countries to maintain high tax rates without reducing their 

ability to attract U.S. investment. Under an overall limitation 

system, a company with operations in a low tax country is able to 

invest in a high tax country without bearing the full burden of the 

high foreign tax. The overall limitation inappropriately requires the 

- 387 -
U.S. Treasury to bear the cost of high foreign tax rates on U.S. 

businesses to the extent of its claim to a residual tax on low tax 

foreign income. A neutral U.S. tax system would require U.S. 

corporations to bear the full burden of high foreign taxes rather than 

allowing these costs to be passed on to the U.S. Treasury and other 

taxpayers through the foreign tax credit mechanism. As a result of 

adopting a per country limitation, high tax countries may find it 

appropriate to reevaluate their rules for taxing U.S. capital. Such 

countries would have a stronger incentive to adopt lower taxes either 

unilaterally or through the treaty process. 

It is impossible as a practical matter to eliminate all tax rate 

averaging by calculating the foreign tax credit on a transactional 

basis. Taxes are not ordinarily levied on such a basis and the 

technical complexity of such a system would make it unworkable. The 

question therefore becomes how much tax rate averaging to permit in 

the system and at what cost in terms of the complexities of compliance

and enforcement. 

At a minimum, passive and active income should be separated for 

credit purposes in order to prevent averaging of easily movable types

of income that are generally taxed in different ways by most foreign

countries. Calculating the foreign tax credit limitation on a per

country basis would go further and prevent averaging between income 

from high tax and low tax countries. A separate basket, per country

limitation would therefore provide as close a proxy as practically

possible for a separate transaction type limitation calculation. Such

a limitation would effectively restrict the foreign tax credit to its 

purpose of eliminating double taxation. 

Indirect Credit 

The requirement that accumulated profits and earnings and profits

be associated with foreign taxes on an annual basis for purposes of 

the indirect credit can lead to seriously defective results. Where a 

subsidiary incurs a foreign loss under U.S. tax principles in a year

in which it is required to pay foreign tax under foreign tax 

principles, an indirect foreign tax credit may not be available for 

the foreign tax paid. See Rev. Rul. 74-550, 1974-2 C.B. 209. On the 

other hand, taxpayers are sometimes able to accelerate or increase 

artificially the available credit simply by appropriately controlling

the timing of receipt of income, payment of foreign tax, arid 

distribution of earnings. 

The different methods of computing accumulated profits and 

earnings and profits in calculating the indirect credit with respect

to actual distributions and subpart F deemed distributions can cause 

very different foreign tax credit results to follow from a current 

distribution of non-subpart F earnings and a subpart F inclusion, even 

though the transactions may be economically equivalent. Taxpayers are 

free to accelerate credits by intentionally generating subpart F 

income (for example, by making a loan to a controlling U.S. share-

- 388 -
holder) if the earnings and profits calculation results in a larger

credit than would the accumulated profits calculation applicable to an 

actual distribution. 

proposal 

Per Country Foreign Tax Credit Limitation 

The amount of income tax paid to a foreign country which may be 

claimed as a foreign tax credit in any year will be limited to the 

U.S. tax on income from that country. The limitation with respect to 

each country will be a fraction of the total pre-credit U.S. tax equal

to the ratio of taxable income from that country to worldwide taxable 

income. United States tax principles and rules for determining the 

source of income will apply for purposes of calculating the taxable 

income from individual countries. 

The separate baskets of income defined under current law will be 

retained. The separate passive income basket, currently limited to 

passive interest income, will be broadened to include dividends 

received from companies in which the taxpayer owns less than a 10 

percent interest and gains derived from the disposition of assets that 

generate passive income (other than Corn Products type assets). The 

Administration will continue to cons- whether other types of easily

movable income that are generally taxed abroad on a gross withholding

basis should also be included in the passive income basket. Interest,

rents and royalties received from subsidiaries or other affiliated 

corporations will be treated as active business income, however, and 

will not be included in the passive income basket. 

Special Issues Under the Direct Credit 

Sourcing of Income and Related Issues. Taxpayers will be required

to calculate their income from sources within individual countries for 

purposes of computing the foreign tax credit. The source rule changes

proposed in Ch. 15.02 are designed in part to facilitate such separate

country sourcing. 

Situations will arise, as they do under current law, in which the 

United States and the foreign country characterize income as being

derived from different sources. For example, income received for 

architectural and engineering services performed in the United States 

but relating to foreign construction projects may be treated as 

taxable local source income by the foreign country, but will be 

treated as U.S. source income in the United States. Similarly,

because of differing tax accounting rules, depreciation allowances,

and other reasons, income may be taxable in a foreign country in 

taxable years either before or after the year in which income would be 

includible under U.S. tax principles. Without rules to minimize the 

effect of temporal mismatching of income and conflicting source rules,

timing and sourcing differences could result in a permanent loss of 

credits. 

- 389 -
Two changes in the operation of the credit will be made to help

alleviate mismatching problems that arise or are made potentially more 

severe under a per country limitation. First, to reduce the 

consequences of temporal mismatching, the carryforward period for 

excess credi s will be extended to ten years. A longer carryback

period would arguably also be appropriate. However, because the 

carryback of excess credits creates serious administrative 

difficulties by requiring recomputation of past years' taxes, it is 

not practica to extend the carryback period beyond two years. 

Second, to alleviate severe mismatching of income by source,

taxpayers will be permitted to elect whether to deduct or to credit 

foreign taxes on a country by country basis. This will permit

taxpayers to obtain a deduction for foreign taxes paid to a particular

country even if they have no income, or a taxable loss, in that 

country under U.S. tax principles, without losing their ability to 

obtain a foreign tax credit for taxes paid to other countries. Such 

changes would not be necessary or acceptable under an overall 

limitation. 

Allocation of Expenses. The expense allocation rules of existing

law require only that expenses be divided between U.S. and foreign

source income and do not require a separate country by country

subdivision of the expenses allocated to foreign income. Under the 

proposal, expenses will be required to be allocated and apportioned to 

separate countries. Consideration will be given to applying

simplified rules for allocating and apportioning expenses which 

otherwise would require asset based allocation. 

Losses. Three alternative treatments of losses would be possible

under a per country limitation. First, losses could be permitted to 

offset only other subsequent income from the loss country. Such a 

rule would lead to excessively harsh results if a loss operation in a 

foreign country were abandoned without recouping the losses. Second,

losses could be permitted to offset only U.S. income, which would tend 

to transfer much of the economic risk of a foreign loss to the U.S. 

Treasury. There is, however, no reason to conclude that foreign

losses should be more closely associated with U.S. income than with 

other income. Third, losses could offset a pro rata portion of all 

income, irrespective of source. The proposal adopts this third option

by requiring that losses be spread to all income rather than simply

reducing the tax on U.S. income. In the year a loss occurs, it would 

be prorated against income earned in all other countries (including

the United States) and separate baskets in proportion to each separate

country and separate basket share in that year's worldwide taxable 

income. The proration of losses in this manner would be required

whether the taxpayer elected to deduct or credit the foreign taxes 

paid to the loss country for the year in question. 

If the taxpayer earns income in the loss country in a subsequent

year it will be re-sourced in proportion to the previous loss 

allocation. 1f the loss had the effect of increasing or creating 

- 3 90 .-
excess foreign tax credits in a country the subsequent resourcing of 

income in that country will make additional credits available. If the 

loss proration had the effect of reducing the U.S. tax on either 

domestic or low taxed foreign income, resourcing the subsequent income 

should recapture the previously foregone tax. 

As noted above, in applying these loss rules, the United States 

will be treated as any other country except that U.S. income will be 

treated as in a single basket. A share of any loss in a foreign

country will be allocated to U.S. income and result in the reduction 

of U.S. tax liability. Similarly, a U.S. loss will be allocated to 

foreign income and prorated over all countries and baskets. 

Subsequently earned U.S. source income will be resourced in proportion

to the initial loss proration. 

Rules Relating to Oil and Gas Income. The limitations contained 

in existing section 907(a) on the creditable foreign tax imposed on 

oil and gas extraction income will be retained and applied on a 

separate country basis. After reducing the creditable tax in 

accordance with these rules, the ordinary rules for computing the 

foreign tax credit limitation, including the loss allocation rules,

will be applied to taxpayers in the oil and gas industry.

Accordingly, an extraction loss in one country would not reduce the 

creditable foreign extraction taxes paid to another country. However,

a foreign oil and gas extraction loss in any country will be prorated

against other income from that and other countries, including income 

from non-extraction activities, and be fully recaptured when income 

ultimately is earned in the loss country. 

Rules for Applying a Per Country Limitation to the 

Indirect Credit 

Under the proposal, foreign taxes would be matched as closely as 

possible with the foreign income to which they relate. Tracing income 

and taxes to the proper country and basket of income for purposes of 

the indirect credit under a multi-tiered corporate structure raises 

several issues. 

Source of Dividend Distributions. The ordinary U.S. source rule 

for dividend income sources the dividend at the place of incorporation

of the payor. Application of such a rule in calculating the indirect 

credit on a separate country basis would permit a taxpayer to use a 

foreign holding company to average high and low tax foreign source 

income from lower tier corporations, thereby avoiding the purpose of 

the per country limitation. Such averaging would not be permitted if 

the same income were earned either through a branch or as subpart F 

income. In order to preserve the integrity of the per country

limitation, dividends from subsidiaries earning income in more than 

one country will ordinarily be required to be resourced for purposes

of calculating the foreign tax credit limitation. 

- 391 -
-- 

Dividends will be sourced for foreign tax credit purposes pro rata 

to the country or countries from which the payor corporation has 

derived the accumulated profits out of which the dividend is paid.

Thus, if a subsidiary has derived 40 percent of its accumulated 

profits from country x and 60 percent of its accumulated profits from 

country Y, 40 percent of a dividend it pays will be sourced in country

x and 60 percent of the dividend will be sourced in country Y. 

Taxpayers receiving dividends from subsidiaries which derive less than 

10 percent of their accumulated profits from countries outside their 

country of incorporation may elect not to have a portion of those 

dividends resourced under these rules, provided no election is made to 

use the tax reallocation rules described below. Dividends paid out 

of profits accumulated prior to the effective date will be sourced in 

the distributing corporation's country of incorporation. The rules of 

existing section 904(g) for maintaining U.S. source will be retained. 

maintaining Separate Basket Character of Dividend Income. 

Dividends will also be required to be traced to separate baskets in 

proportion to the distributing corporation's accumulated profits

derived from separate basket income under rules similar to those of 

current section 904(d). For example, if ten percent of a foreign

subsidiary's accumulated profits are derived from passive basket 

income, ten percent of a dividend paid by that subsidiary will be 

treated as passive basket income in the hands of the shareholder. 

These rules will prevent taxpayers from using a multi-tiered structure 

to blend income in the various separate baskets. The rules will 

require corporations at each level of the corporate structure to 

maintain separate basket accounts in each country from which they

derive income. Similar rules for maintaining the separate basket 

character of other payments to related parties attributable to 

separate basket income of the payor will be considered. 

Interaction of the Indirect Credit with Subpart F. Under the 

F

nrovisions of subDart F. certain income of foreian corDorations

contiolled by U.S: shareholders is taxed currentiy to those U.S. 

shareholders. A credit for the foreign taxes paid with respect to 

that income is allowed to the shareholder. When income that has been 

previously taxed under subpart F is subsequently distributed, it is 

not taxed a second time. These rules will be maintained under the 

proposal. Dividend distributions from foreign subsidiaries will be 

treated as having been paid first out of previously taxed subpart F 

income and will be excluded from the shareholder's gross income. Only

the portion of any dividend that exceeds previously taxed income will 

be subject to the dividend resourcing and recharacterization rules 

described above. Rules of existing law allowing credits for 

withholding taxes on distributions of previously taxed income will be 

retained . Allocation of Foreign Taxes to Income from Lower Corporate Tiers. 

Subject to the exceptions described below, taxes on net income paid to 

a foreign country will be treated for foreign tax credit limitation 

purposes as taxes of the country to which they are paid. GLOSS basis 

392 -
withholding taxes on dividends will be treated as if they had been 

paid to the country or countries in which the dividend income is 

resourced under the rules described above. Gross basis withholding

taxes on non-dividend income such as interest, rents and royalties

will be treated as paid to the country that imposes the tax. 

Where a foreign subsidiary of a U.S. company is taxed on a 

worldwide net income basis in its country of residence and derives 

more than 10 percent of its income from sources outside of its country

of residence, its dividend payments will be at least partially

resourced under the rules described above. If taxes paid in the 

country of residence were not also resourced, mismatching of tax and 

income could occur in some circumstances. Accordingly, such taxpayers

will be permitted to elect to treat a portion of a subsidiary's

residence country tax as if it were paid to other countries in which 

the subsidiary derived income. The amount of foreign tax that may be 

reallocated in this manner will be calculated by (i) computing the 

ratio of total foreign income tax (excluding gross basis withholding

tax) paid to all countries with respect to the distribution to the 

total distributed accumulated profits; (ii) multiplying the 

distributing subsidiary's distributed accumulated profits from sources 

in the residence country by that ratio; and (iii) subtracting the 

resulting amount from the total income tax (excluding withholding tax)

paid to the residence country with respect to the distributed accumulated profits. The resulting amount will be reallocated to other 

countries in proportion to the subsidiary's accumulated profits from 

sources in those countries. However, no amount of residence country

tax need be allocated to countries in which the effective tax rate on 

the distributed accumulated profits (calculated under U.S. principles)

equals or exceeds the ratio computed in step (i) above. 

Allocation of Foreign Subsidiary Expenses. Current law requires

that expenses incurred by U.S. companies be allocated among separate

baskets of income and between domestic and foreign source income in 

determining net foreign source taxable income for purposes of the 

foreign tax credit limitation calculation. The proposal would retain 

this requirement, modified as described above, to enable expenses to 

be allocated to specific foreign sources. Expenses incurred by

foreign subsidiaries would also be required to be allocated among

separate baskets of income and individual foreign countries. 

Consideration will be given to applying simplified rules for purposes

of allocating foreign subsidiary expenses. 

Other Changes to the Indirect Credit 

For purposes of computing the indirect foreign tax credit,

dividend distributions and subpart F inclusions will be deemed to be 

made from the pool of all of the distributing corporation's

accumulated profits (or earnings and profits in the case of subpart F 

inclusions) rather than being related to accumulated profits (or

earnings and profits) from any particular year. Earnings of the 

current year would be included in the relevant pool. The rule 

- 393 -
treating distributions made in the first 60 days of a taxable year as 

made from the prior year's accumulated profits would be repealed. A 

dividend or subpart F inclusion will similarly be deemed to bring with 

it a pro rata share of the accumulated foreign taxes paid by the 

subsidiary. 

Accumulated profits will be required to be calculated in the same 

manner as earnings and profits. In general, the earnings and profits

and accumulated profits computations will be required to be made under 

rules similar to those contained in the existing regulations under 

section 964. The rules for translating foreign currency contained in 

the existing section 964 regulations, however, will be modified as 

described in Ch. 15.04. 

Effective Date 

The proposals would be effective for taxable years beginning on or 

after January 1, 1986. A five year carryforward of excess foreign tax 

credits existing on the effective date would be permitted subject to 

an overall limitation. The ten year carryforward period contained in 

the proposal would apply only to excess credits generated after the 

effective date. Excess credits generated after the effective date 

would not be permitted to be carried back to pre-effective date years. 

Pre-effective date overall losses would be required to be 

recaptured out of post-reform income. Each year until such losses are 

exhausted, taxpayers will determine the amount they would have been 

required to recapture under pre-effective date law. This amount of 

foreign income would be recharacterized as U.S. source. Rules would 

be prescribed to determine the countries from which this income would 

be deemed to have been taken. 

The proposal to treat dividends as paid out of a pool of 

accumulated profits would apply only prospectively. Future dividends 

would be treated as paid first out of the pool of all accumulated 

profits derived by the payor after the effective date. Dividends in 

excess of that accumulated pool of post-effective date earnings would 

be treated as paid out of pre-effective date accumulated profits under 

the ordering principles of existing law. 

Analysis 

The adoption of a per country foreign tax credit limitation will 

limit the ability of taxpayers to average low foreign taxes imposed in 

one country with high foreign taxes imposed in a second country in 

calculating the foreign tax credit. The broadening of the passive

income basket will limit the ability of taxpayers to average foreign

taxes on types of income typically taxed abroad at low or zero tax 

rates with foreign taxes on other types of income that are typically

subject to higher aggregate foreign taxes, Rules for tracing source 

and character of income will preserve neutrality in the application of 

a per country limitation between foreign branches and foreign 

- 394 -
subsidiaries by preventing use of creative corporate structures to 

avoid the effect of the per country and separate basket rules. 

By restricting the ability of taxpayers to average high and low 

foreign taxes, the proposed changes will limit the foreign tax credit 

to its function of eliminating international double taxation of 

foreign income. The changes will preserve the residual U.S. tax on 

lightly taxed foreign income while causing other countries to bear the 

full investment disincentive effects of their own high tax rates. The 

proposed changes would help to counteract the incentives otherwise 

created by the proposed reduction in 1J.S. tax rates for U.S. taxpayers

to invest in low tax countries or foreign assets generating lightly

taxed passive income. The proposed changes will not violate the provisions of existing United States tax treaties. 

It is recognized that these appropriate results will be achieved 

only through imposition of significant new burdens on both taxpayers

and the Internal Revenue Service. Computation of a per country

limitation with expanded separate baskets will introduce additional 

complexity into the already complicated limitation calculation. The 

per country limitation will make determinations regarding the source 

of subsidiary income, correct intercompany transfer pricing, and 

expense allocation involving exclusively foreign operations relevant 

to the foreign tax credit computation. The recordkeeping burdens on 

taxpayers and auditing burdens on the IRS will be correspondingly

increased. 

The proposal attempts to minimize these burdens to the extent that 

can be done consistent with the purpose of the per country limitation. 

It contains a de minimis rule for resourcing dividends. Simplified

expense allocation rules will be considered. The proposal also 

suggests extending the carryover period, permitting a separate country

deduction election, and permitting tax reallocations on an elective 

basis to limit the potential harshness of the proposal. The 

Administration will continue to consider other methods of simplifying

the credit calculation that are consistent with the objective of 

limiting the averaging of high and low foreign tax rates. In 

particular, the Administration will consider workable options for 

calculating the credit on a regional or integrated operation basis if 

that can be done in a manner consistent with the underlying rationale 

of the per country limitation. The Administration has not, however,

yet been able to devise an integrated operation approach that both 

prevents inappropriate averaging and is significantly simpler than a 

per country approach. In the absence of a workable regional or 

integrated group proposal, the advantages of the per country

limitation are believed to be important enough to warrant the 

additional complexity and recordkeeping burdens. 

The proposed changes to the foreign tax credit other than the per

country limitation proposal, i.e. the broadening of the passive income 

basket, making earnings and profits calculations consistent for all 

indirect credit purposes, and adopting a pooling approach to making 

- 395 -
the relevant earnings calculations under the indirect credit, all have 

independent merit. They would each make the foreign tax credit 

mechanism operate more consistently and without unintended harshness 

to taxpayers or unintended incentives for economically unjustified

activities that serve only to increase or accelerate the available 

credits. Each of these proposals would be beneficial regardless of 

the method used to calculate the foreign tax credit. 

- 396 -
MODIFY SOURCING RULES FOR INCOHE AND DEDUCTIONS 

General Explanation 

Chapter 15.02 

Current Law 

Rules for defining the source of particula items of incom serve 

two principal purposes. First, those rules de .ne the scope o t7.s. 

taxation of non-resident aliens and foreign corporations, part xlarly

those that do not engage in a U.S. trade or business. Second, :hrough

the operation of the foreign tax credit mechanism, the source S 

income rules define the circumstances under which the United S ttes is 

willing to concede primary jurisdiction to a foreign country to tax 

I7.S. citizens and residents on income because that income is deemed to 

be earned in that foreign country. In the respects relevant to the 

proposals set forth below, existing rules for determining the source 

of income and the allocation and apportionment of related expenses are 

as follows: 

Income Derived from Purchase and Resale of Property. Income 

derived from the purchase and resale of personal property, both 

tangible and intangible, is ordinarily sourced at the location where 

the sale occurs. The place of sale is generally deemed to be the 

place where title to the property passes to the purchaser. 

Income Derived from manufacture and Sale of Property. Income 

derived from the manufacture of products in one country and their sale 

in a second country is treated as having a divided source. Under 

existing regulations, half of such income generally is sourced on the 

basis of the location of the taxpayer's property, reflecting the place

of manufacture, and half of the income is sourced on the basis of the 

place of sale (determined under the title passage test). The division 

of the income between manufacturing and selling components may be made 

on the basis of an independent factory price rather than on an 

arbitrary 50/50 basis if such a price exists. 

Income Derived from License of Intangible Property. Royalty

income derived from the license of intangible property generally is 

sourced by reference to the place where the licensed intangible

property is used. For certain limited purposes income derived from 

the sale of intangible property for an amount contingent on the use of 

the intangible is also sourced as if it were royalty income. 

Dividend Income. Dividend income is generally sourced at the 

place of incorporation of the payor. However, if a U.S. corporation

earns more than 80 percent of its income from foreign sources,

dividends paid by that corporation are treated as foreign source 

income. 

- 397 -
Interest Income. Interest income is generally sourced on the 

basis of the residence of the payor. Under one exception to this 

rule, interest income received from a U.S. corporation which earns 

more than EO percent of its income from foreign sources is treated as 

foreign source income. Certain other exceptions to the source rules 

applicable to interest income are designed as tax exemptions for 

limited classes of income earned by foreign persons. 

Transportation Income. Under existing regulations income derived 

from providing transportation services generally is allocated between 

U.S. and foreign sources in proportion to the expenses incurred in 

providing the services. Expenses incurred outside the three-mile 

limit to the territorial waters of the United States are treated as 

foreign expenses for purposes of this allocation. Special rules apply

to income derived from coast-wise shipping and from transportation

between the United States and its possessions. Income derived from 

the lease or disposition of vessels and aircraft that are constructed 

in the United States and leased to United States persons is treated as 

U.S. source income. Expenses, losses and deductions incurred in 

leasing such vessels and aircraft are also attributable to U.S. source 

income. These rules apply regardless of where the vessel or aircraft 

may be used. 

Allocation and Apportionment of Interest Expense. The determination of taxable income (qross income less expenses) by source or 

activity requires that expenses be matched with the category of income 

in question. Under existing regulations, the allocation and apportionment of interest expense to income is based on the principle that 

money is fungible and that interest expense is attributable to all 

property of a taxpayer regardless of the specific purpose for 

incurring the obligation on which interest is paid. When money is 

borrowed for a specific purpose, such borrowing will generally free 

other funds for other purposes and it is reasonable to attribute part

of the cost of borrowing to such other purposes. 

Under existing regulations, tax exempt income and assets generating tax exempt income are permitted to be taken into account in 

allocating deductible interest expense. Interest expense incurred by

a related group of corporations that file a consolidated tax return is 

required to be allocated between domestic and foreign source income in 

computing foreign source taxable income and the foreign tax credit 

limitation. Under existing regulations, this allocation is made on a 

separate company basis, rather than on a consolidated group basis. 

Thus, a company within the consolidated group that incurs interest 

expense takes only its own assets and gross income into account in 

allocating the expense, rather than those of the entire consolidated 

group. 

- 398 -
Reasons for Change 

Source of Income 

The following basic principles should be applied in formulating

rules for determining the source of income. First, appropriate source 

of income rules should reflect the location of the economic activity

generating the income and the source of legal protections facilitating

the earning of that income. Income derived from the use of property

or capital ordinarily should be sourced where the property or capital

is used. Second, the rules should be neutral in the sense that the 

United States would have no ground for objection if its source of 

income rules were applied by other countries. Unless there are 

sufficient reasons to the contrary, international norms for source of 

income determinations should be followed to the extent such norms 

exist. Third, the rules should not allow erosion of the legitimate

U.S. tax base through taxpayer manipulation of the source rules or of 

the foreign tax credit limitation. The rules should generally

preserve the residence country's taxing right in cases where other 

countries typically do not assert a source basis claim to tax the 

income. Fourth, to the extent possible the rules should operate

clearly and not require difficult factual determinations on a transaction by transaction basis. Clarity and ease of application would be 

even more important under the Administration proposal to calculate the 

foreign tax credit limitation on a per country basis because of the 

requirement that income be sourced to specific foreign countries. 

Plainly, it will not be possible to fully satisfy each of these 

objectives in every case. Some balancing of the objectives is 

therefore necessary in reaching appropriate source rules. Existing

rules for determining source of income are deficient in the following

respects: 

Sales Income. Under the existing title passage test, the source 

of income derived from the sale of goods bears no necessary

relationship to the economic activity generating that income. 

Particularly where property manufactured in the United States is sold 

to a sales subsidiary abroad, half or more of the income from the sale 

may be treated as foreign source income even though only a negligible

portion of the seller's relevant economic activity may occur outside 

the United States. 

Because the place of title passage may be arbitrarily determined 

by affected taxpayers, the existing rule permits artificial 

manipulation of the foreign tax credit limitation and the U.S. tax 

base. Most foreign countries do not tax sales income merely because 

title passes in that country. (The united States would not tax such 

income in the reverse case solely because of 1J.S. title passage.) The 

existing U.S. source rule therefore surrenders 1J.S. primary taxing

jurisdiction over sales in many situations where the income is not 

taxed abroad. IJnder the foreign tax credit limitation provisions, the 

zero foreign tax on such income may be averaged with foreign source 

- 399 -
income that is highly taxed by a foreign country. This averaging

artificially increases the amount of the foreign taxes imposed by a 

high tax country that may be credited against U.S. tax liability and 

thereby permits the credit for the foreign tax to reduce U.S. tax 

otherwise due on income derived from what is essentially domestic 

economic activity. 

Sales of Intangible Property. Income derived from the sale of 

intangible property generally is determined under a title passage test 

while income derived from the license of such property is determined 

by reference to the place where the property is used. Existing rules 

that treat sales and licenses similarly are limited in their scope.

The economic distinction between a sale and a license of intangible

property often is elusive. Clarity and uniformity of treatment would 

be served by applying the same source of income rules to all transactions involving intangible property. The title passage rule is no 

more satisfactory when applied to sales of intangible property than 

when it is applied to sales of tangible property. Moreover, the 

principal factor giving intangible property value is the legal

protection afforded that property in the country where it is used, a 

factor arguing for a source rule based on the place of use in all 

transactions involving intangible property. 

Dividend Income. The existing source rule applicable to dividend 

income focuses on the place of incorporation of the corporation

distributing the dividend income. This rule, or a close variant of it 

focusing on the corporation's place of management, is followed in the 

tax systems of most countries. The rule is clear and easily applied

and otherwise generally satisfies the characteristics of appropriate

source rules. 

The exception to this general rule for so-called 80-20 companies

alters a sound, well accepted rule under circumstances where most 

foreign countries do not assert a competing source based claim to tax 

the income. Because foreign countries normally do not tax such 

dividends, the treatment of the 80-20 company dividend as foreign

source may have the effect of making what would otherwise be excess 

foreign tax credits usable. This occurs despite the fact that a full 

foreign tax credit is available with respect to the foreign tax on the 

80-20 corporation's operating income. Very often the result will be 

the total exemption of the 80-20 dividend from shareholder level tax 

either in the United States or in the country where the earnings were 

derived. Moreover, foreign taxpayers may be able to use an 80-20 

holding company to convert distributions by U.S. operating subsidiaries into foreign source income and thereby avoid U.S. withholding

tax on those distributions. 

Interest Income. Just as with dividends, the 80-20 exception to 

the general source rule applicable to interest income alters an 

accepted rule in the absence of competing source based claims of 

foreign countries. The 80-20 rule for interest therefore gives rise 

to the same type of U.S. withholding tax avoidance and total U.S. and 

- 400 -
foreign tax exemption as does the dividend rule. Where it is 

desirable to provide a U.S. tax exemption for specific classes of 

interest income, that should be done directly rather than through

modifications to the source rules. 

Transportation Income. Under current rules, large portions of 

transportation services income are treated as earned in international 

waters or skies and outside the generally asserted source taxing

jurisdiction of any country. Such income may therefore go totally

untaxed as a result of the foreign tax credit mechanism. Section

861(e) modifies the general source rule for income and related 

expenses derived from U.S. produced vessels and aircraft leased to 

U.S. persons. The general source rule is abandoned solely to provide

a very indirect subsidy for user,s of U.S. produced ships and aircraft 

by allocating losses on the lease of such ships and aircraft to the 

United States, so as to avoid a reduction in the foreign tax credit 

limitation. This subsidy is inappropriate in a system of neutral 

source rules. An appropriate source rule would reflect the economic 

activity generating the income. 

Allocation and Apportionment of Interest Expense 

The current regulation's treatment of a single taxpayer's interest 

expense under the fungibility approach generally apportions interest 

expense to income based on the relative value of assets used to 

generate the income. It also permits allocation on the basis of gross

income provided the result does not depart too significantly from the 

result of an asset based allocation. It is inappropriate, however, to 

apply the fungibility concept on a separate company basis when a 

taxpayer is a member of an affiliated group and is included in a 

consolidated return. The separate company method of allocation 

enables taxpayers to limit artificially the interest expense allocated 

to foreign source income by simply manipulating the location of 

borrowing within the consolidated group. This may result in an 

unwarranted increase in the amount of foreign tax credit available to 

a consolidated group of corporations. 

The inclusion of tax-exempt interest and assets generating tax 

exempt interest in the allocation formula has similarly provided

opportunities for artificial inflation of the foreign tax credit 

limitation. The inclusion of exempt U.S. source income and assets in 

the expense allocation increases the amount of expense allocated to 

U.S. source income even though the income generated is not subject to 

[J.S. tax. The proposed change complements the Administration proposal

to deny deductions to all taxpayers for interest incurred to carry

tax-exempt obligations. The change in expense allocation rules would 

be justified, however, in the absence of a change in the rules 

relating to deductibility of the expense. 

- 401 -

476-698 0 - 85 - 15 
Proposal 

Source of Income 

Source Rules Relating to Sales Income. Income derived from the 

sale of personal property is divided into three broad categories for 

purposes-of determining kource: (i) income from sales of 

inventory-type property in the ordinary course of business; (ii)

income from sales of non-inventory property used in a trade or 

business; and (iii) income from sales of other personal property

including personal financial property such as stocks, bonds and 

commodities contracts. Income derived from the purchase and resale of 

inventory-type goods will be sourced in the country of the taxpayer's

residence. An exception to this general rule will apply if the seller 

maintains a fixed place of business located outside of its country of 

residence and that fixed place of business participates materially in 

the sale generating the income. In such a case, the income would be 

sourced in the country where the fixed place of business is located. 

However, all sales to a taxpayer's foreign subsidiaries and affiliates 

would be sourced at the seller's residence even if the seller 

maintains a fixed place of business in another country. A fixed place

of business maintained by an independent distributor would not be 

attributed to the seller for purposes of this source rule. The place

where title to the goods passes to the buyer, the place where 

purchasing activity is carried out and the place of ultimate 

destination of the goods all would be irrelevant for purposes of 

determining the source of sales income. The proposal modifies the 

original Treasury Department proposal by requiring only that a foreign

fixed place of business participate materially in a sale, rather than 

conduct the predominant portion of the selling activity, in order to 

qualify for the exception to the residence based source rule. This 

change will make the source rule correspond to the principles of 

existing section 864(c)(4)(B)(iii) and will avoid disputes over the 

relative contribution to a sale of sales activity conducted in two 

places of business. It is believed that the Administration proposal

will correlate the source of sales income with the location of the 

underlying selling activity much more closely than does existing law. 

Similar changes would also be made in the rules for determining

the source of income derived from the manufacture and sale of 

inventory-type products. The existing practice of sourcing an 

arbitrary percentage of such income on the basis of the place of 

manufacture would continue. The remaining portion of the income would 

be attributed to sales activity and would be sourced on the basis of 

the rules described in the preceding paragraph. The title passage

test would be eliminated. Accordingly, no portion of the income 

derived from the manufacture of products in the United States and the 

sale of such products abroad would be sourced in a foreign country

unless the seller maintains a fixed place of business in that foreign

country and that place of business participates materially in the 

sale. Similarly, the sale of property manufactured by the taxpayer in 

the United States to a foreign sales subsidiary or affiliate would 

- 402 -
generate no foreign source income. (The sales subsidiary's income 

would itself be foreign source and, assuming appropriate pricing,

would represent the full return to selling activity.) 

Current law arbitrarily divides income between manufacturing and 

sales activities on a 50/50 basis. It is probable that this division 

overallocates income to selling activity in many cases. The 

Administration will consider whether a fixed percentage allocation 

apportioning greater income to manufacturing activity would more 

appropriately be applied as a general rule to divide the income. The 

option of applying an independent factory price in allocating divided 

source income would be retained, however. The special manufacturesale rules in the existing regulations relating to U.S. possessions

would be eliminated and the rule described above would be applied to 

such sales. 

Income derived from sales of personal property used by the 

taxpayer in its business (including Corn Products type property that 

would otherwise be passive investment property) would be sourced in 

the place where the property is used. Income derived from the sale of 

personal property not described above, including in particular gains

derived from the sale of passive investment property such as stock,

securities and commodity futures contracts, would be sourced on the 

basis of the taxpayer's residence. 

Income Derived from Sales of Intangible Property. The rules 

relatinq to rovaltv income derived from licenses of intanaible 

property will he retained in their present form. Source ;ules

relating to sales of intangible property will be modified to 

correspond to the rules relating to licenses. Accordingly, income 

derived from the sale of intangible property, other than passive

investment property, will be sourced on the basis of where the 

underlying property is to be used. 

80-20 Corporation Rules Relating to Interest and Dividends. The

80-20 corporation exceptions to the general source rules auulicable to 

dividend and interest income will be-repealed. Thus, diviaends 

received from a domestic corporation earning most of its income 

outside the United States will be sourced on the basis of the place of 

incorporation of the corporation paying the dividend. (See Ch. 15.03 

for a proposal to repeal the interest and dividend source rules 

relating to foreign corporations that earn more than half of their 

income from U.S. sources and to replace those rules with a branch 

profits tax.) Interest income received from all U.S. residents and 

domestic corporations will be sourced on the basis of the residence of 

the payor without looking to the underlying source of the payor's

income. Other provisions of the existing source rules relating to 

interest income that are designed to provide tax exemptions for 

particular activities will not be repealed but will be restructured as 

overt exemption provisions in the interest of establishing neutral 

source rules. Thus, for example, interest paid on deposits in U.S. 

banks will be treated as 1J.S. source income but will be exempt from 

- 403 -
tax if the interest is paid to a non-resident alien individual or 

foreign corporation and is not effectively connected with the conduct 

of a trade or business in the United States. 

Transportation Income. Consideration will be given to 

modifications in the rules relating to transportation income in order 

to cause those rules to reflect mo;e accurately the underlying

economic activity, to more fully exercise U.S. taxing jurisdiction

over income not taxed abroad, and to make those rules operate in a 

manner consistent with a per country foreign tax credit limitation. 

Specifically, more general application of the 50 percent convention 

applied to possessions related transportation income will be 

considered. The special source rule of section 861(e) relating to 

income derived from the lease or disposition of vessels and aircraft 

manufactured in the United States will be repealed. 

Allocation of Interest Expense 

Interest expense incurred by a corporation joining in filing a 

U.S. consolidated return will be required to be allocated to income 

from various sources on a consolidated group basis. The assets or 

gross income of all members of the consolidated group shall be 

aggregated for purposes of determining the percentage of interest 

expense to be allocated to foreign income. That percentage will then 

be applied to the interest expense of each member of the group in 

calculating the foreign tax credit under the consolidated return 

regulations. The separate company basis of allocation will be 

retained for taxpayers not filing a consolidated return. 

Only deductible expenses are required to be allocated between 

foreign and domestic sources in calculating net taxable income from 

of a taxpayer's 

foreign sources. In order to reach the proper result when a portion

interest expense is not deductible because it is 

incurred to carry tax exempt obligations, tax exempt interest income 

and assets generating tax exemp't interest income will not be 

considered in allocating interest expense to foreign source income for 

purposes of the foreign tax credit calculation. 

Effective Dates 

The proposals would generally be effective for taxable years

beginning on or after January 1, 1986. The modification of the source 

rule for interest income received from 80-20 corporations would be 

effective only with respect to interest paid on debt obligations

incurred after January 1, 1986. The repeal of the section 861(e)

source rule would not affect income derived by the taxpayer owning the 

asset on January 1, 1986, from the lease or disposition of ships or 

aircraft first leased by the taxpayer prior to January 1, 1986. 

Transitional rules applicable to the sales income source rules would 

be provided for sales made under unrelated party contracts entered 

into prior to January 1, 1986. The rules relating to the 

consideration for expense allocation purposes of tax-exempt interest 

- 404 -
and tax exempt obligations would not apply to obligations or income 

derived from obligations held by the taxpayer prior to January 1,

1986. 

Analysis 

The proposals would create a set of rules for determining the 

source of income that more clearly reflects the situs of relevant 

economic activity than do the existing rules. The proposals regarding

the source of sales income and the source of interest and dividends 

paid by 80/20 companies would also limit the circumstances in which 

the United States cedes its primary tax jurisdiction by treating

income that is not ordinarily taxed by foreign countries as foreign

source income for U.S. tax purposes. These rules will therefore 

appropriately restrict the ability of U.S. taxpayers to average down 

high foreign tax rate income and to use foreign tax credits to offset 

U.S. tax on income derived from domestic economic activity. The 

source rule proposals are meritorious without reference to the 

Administration proposals regarding the foreign tax credit limitation. 

However, they also complement the proposed modifications of the 

foreign tax credit limitation and provide rules more suitab1,eto 

separate country sourcing of income and to the computation of the 

foreign tax credit limitation on a per country basis. 

It can be anticipated that under these proposals somewhat greater

amounts of income of U.S. taxpayers derived from sales of products to 

destinations located outside the United States would be treated in the 

future as domestic source income. As a result some U.S. export

activities would lose collateral foreign tax credit benefits if the 

exporting companies have excess foreign tax credits from their purely

foreign activities. However, the United States should retain the 

primary taxing right over export income when the activities giving

rise to the income are carried out in the United States and should not 

be granting foreign tax credits with respect to broad classes of 

income not generally taxed abroad. To the extent export subsidies are 

included in the tax law they should be overt and evenly applied. 

- 405 -
REPLACE SECOND DIVIDEND AND INTEREST TAXES 

WITH BRANCH-LEVEL TAX 

General Explanation 

Chapter 15.03 

Current Law 

The effectively connected income of a U.S. branch of a foreign

corporation is subject to U.S. income tax, but there is no additional 

tax, comparable to the withholding tax imposed on dividends paid by a 

U.S. subsidiary of a foreign corporation, on the branch's remittances 

to the home office. Instead, the United States imposes a withholding

tax, known as the "second dividend tax," on a proportionate part of 

the dividends paid by the foreign corporation, if more than 50 percent

of the corporation's gross income is effectively connected with a U.S. 

trade or business. 

There is also no tax, comparable to the withholding tax on 

interest paid to foreign persons by a U.S. subsidiary of a foreign

corporation, on the interest paid to foreign persons on debt allocable 

to the branch. Instead, the United States imposes a withholding tax,

known as the "second interest tax," on a proportionate part of the 

interest paid by the foreign corporation to foreign persons, if more 

than 50 percent of the corporation's gross income is effectively

connected with a U.S. trade or business. 

Reasons for Change 

A U.S. corporation owned by nonresidents is subject to income tax 

on its profits, and, in addition, its foreign shareholders are subject

to a withholding tax on the dividends which they receive (30 percent

by statute, reduced to as little as five percent by treaty). No comparable tax, beyond the corporate tax, is imposed on the distributed 

profits of a U.S. branch of a foreign corporation. The "second 

dividend tax" is intended as the analogue to the dividend withholding

tax, but it fails to equalize the tax treatment of branches and 

subsidiaries in many cases. The "second dividend tax" applies only

when a majority of the income of the foreign corporation is derived 

from its U.S. branches, while the dividend withholding tax applies to 

all distributions of subsidiary profits. Moreover, the enforcement of 

this tax is very difficult. It is difficult to know when the tax is 

due and difficult to enforce its collection by a foreign corporation. 

Foreign holders of debt of a U.S. corporation owned by nonresidents are subject to a tax on the interest which they receive (30

percent by statute, unless reduced or eliminated by treaty), although

for debt issued after July 18, 1984 this tax applies to a limited 

class of interest. No comparable tax is imposed on the interest paid

on debt allocable to the branch. The "second interest tax" is 

- 406 -
intended as the analogue to the interest withholding tax, but it also 

fails to equalize the treatment of branches and subsidiaries in many

cases. Like the "second dividend tax," the "second interest tax" 

applies only when a majority of the income of the foreign corporation

is derived from its U.S. branches, while the interest withholding tax 

applies generally to all interest paid by the subsidiary (except where 

the interest is exempt by statute or treaty). The "second interest 

tax" suffers from the same enforcement problems as the "second 

dividend tax." 

Proposal 

The "second dividend tax" and "second interest tax" would be 

repealed and replaced by an additional tax on the profits of U.S. 

branches of foreign corporations and on interest on (i) debt issued by

a foreign corporation to an affiliate which is allocable to a U.S. 

branch of the corporation and (ii) extensions of credit by a foreign

bank to a foreign corporation which is allocable to a U.S. branch of 

the corporation. The branch-level tax would place the branch of a 

foreign corporation on a more comparable footing with a U.S. 

subsidiary of a foreign corporation. 

The profits subject to the tax would be defined so as to 

approximate the distributed profits of a U.S. subsidiary. The taxable 

income of the branch as shown on its lJ.S. corporate tax return would 

be reduced by the 1J.S. corporate tax before foreign tax credits and by

further adjustment to reflect reinvestment of profits in the branch. 

To adjust for such reinvestment, increases in net investment in the 

branch, for both fixed and working capital, would be deducted from the 

after-corporate tax branch profits and increases in net liabilities 

incurred for such reinvestment would be added to such profits. The 

addition of increases in net liabilities to taxable profits would 

ensure that branches could not decrease their branch-level tax through

the purchase of assets with debt rather than reinvested earnings. A 

deficit in taxable profits could not be carried forward or back to 

other taxable years. 

Since the branch-level tax would in part replace the "second 

interest tax," which is a withholding tax on gross amounts of 

interest, the interest subject to the branch-level tax would be the 

gross amount of interest on (i) debt issued by a foreign corporation

to an affiliate which is allocable to its U.S. branch and (ii)

extensions of credit by a foreign bank to a foreign corporation which 

are allocable to a U.S. branch of the corporation. 

The rate of the branch-level tax would be the same as the dividend 

and interest withholding tax rates, currently 30 percent. Where the 

foreign corporation is resident in a treaty country, the treaty rate 

applicable to direct investment dividends would apply to the taxable 

profits and taxable interest (if such rate would otherwise be available to the foreign corporation under the treaty). 

- 407 -
The same rule for determining what debt of a foreign corporation

is allocable to its U.S. branch would apply for purposes of the 

branch-level tax as for determining allowable interest deductions for 

purposes of the corporate income tax. 

~llforeign corporations with a branch in the United States (a

trade or business under the tax code or a permanent establishment 

under tax treaties) would be subject to the branch-level tax, unless 

it is prohibited by an existing U.S. tax treaty. The tax would not 

override existing treaties, but the Treasury Department would seek to 

amend those treaties which now prohibit the tax to permit its 

imposition. (Many treaties do not prohibit the imposition of such a 

tax. ) 

Effective Date 

The proposal would take effect for taxable years beginning on or 

after January 1, 1986. 

Analysis 

Under the proposal, U.S. tax would apply more evenly to foreign

corporations doing business in the United States than under present

law. Thus, the tax rules would have less of an influence on a foreign

investor's decision whether to operate in the United States through a 

branch or a subsidiary. (Under current law a branch operation is 

generally subject to lower U.S. taxes than a subsidiary, if the 

subsidiary pays dividends.) The branch-level tax is also more easily

administrable and enforceable than the "second dividend tax" and 

"second interest tax." It can be reported on the regular corporate

income tax form of the branch. Many foreign countries, including

Canada, France, and Australia, impose a branch Frofits or remittance 

tax. 

There may be situations under bilateral income tax treaties with 

other countries where the availability of a dividends-paid deduction 

to a U.S. subsidiary of a company resident in the treaty country will 

result in heavier U.S. taxation of income earned through a U.S. branch 

of such company than through a subsidiary. In that event, consideration might be given to granting comparable corporate tax relief to 

branches of companies resident in the other country in the context of 

bilateral treaty negotiations. 

The proposed changes are not likely to have a significant effect 

on flows of capital into the United States. The latest available data 

indicate that most foreign corporations operating in the United States 

through branches are in the finance, insurance and real estate 

industries, with most of the income attributable to branch banks. 

- 408 -
nEVISE TAXATION OF FOREIGN 

EXCHANGE GAINS AND LOSSES 

General Explanation 

Chapter 15.04 

Current Law 

Foreign Currency Transactions 

Recognition of Income. Foreign currency is treated as property

for Federal income tax purposes. Generally, exchange gain or loss is 

recognized when payment is made on a foreign-currency-denominated

obligation. However, the recognition of loss on a forward exchange

contract or other foreign-currency-denominated position in actively

traded personal property that substantially diminishes a taxpayer's

risk of loss with respect to another such position is subject to the 

taxing regime for straddles. Further, certain foreign currency

forward contracts are marked-to-market on the last day of a taxpayer's

taxable year. 

It is uncertain how the original issue discount rules (providing

for the accrual of discount income) are to apply to foreign-currencydenominated obligations issued for foreign currency. If foreign

currency is treated as property, the recently enacted imputed interest 

rules applicable to debt instruments issued for property would apply

(unless the obligation is traded on an established securities market).

Generally, these rules would impute interest on foreign currency loans 

at 120 percent of the "applicable Federal rate" whenever the stated 

interest rate was equal to or less than 110 percent of the applicable

Federal rate. This would have the effect of treating the loan as 

though it were translated to U.S. dollars on the date made and 

recharacterizing payments as interest based on dollar interest rates. 

The General Explanation of the Revenue Provisions of the Deficit 

Reduction Act of 1984, prepared by the Staff of the Joint Committee on 

Taxation, states that Congress did not intend for the imputed interest 

rules to apply to foreign currency loans where the value of the 

currency is readily ascertainable by reason of active trading in an 

established market. If the issue price were determined with reference 

to the current value of an actively traded foreign currency, however,

original issue discount generally would only be found where the stated 

interest rate in the foreign currency is less than the arm's length

interest rate in the foreign currency. 

The Secretary is granted broad regulatory authority to modify the 

original issue discount rules as necessary to carry out the purposes

of the original issue discount provisions. The General Explanation

provides that such regulations should deal with treatment of foreigncurrency-denominated obligations issued for property. 

- 409 -
Character and Source. Because foreign currency is treated as 

property, the full panoply of rules pertaining to characterization of 

gain and loss as capital or ordinary applies. There is great

uncertainty under the relevant judicial decisions as to the proper

characterization of exchange gain or loss. Moreover, foreign currency

forward contracts held as capital assets are marked-to-market and gain

or loss is treated as 60 percent long-term and 40 percent short-term 

capital gain or loss. Straddles consisting of such contracts and 

foreign-currency-denominated positions are subject to the mixed 

straddle rules. 

Furthermore, there is little authority under current law regarding

the source of foreign exchange gain and the proper allocation of 

foreign exchange loss. Because foreign currency is treated as 

property, the source of exchange gain has been determined under the 

passage of title test applied to source gain from the sale of personal

property. This test is extremely difficult to apply to international 

transactions involving foreign currency. 

Foreign Currency Translation 

Income and loss of a taxpayer for Federal income tax purposes is 

determined in U.S. dollars. (References herein to dollars are to the 

U.S. dollar.) While taxpayers are permitted to keep books and records 

in a foreign currency under current law, there are no clear standards 

for when this is appropriate. Taxpayers that maintain books and 

records in a currency other than the dollar have been permitted to use 

a variety of methods to translate results recorded in a foreign

currency into dollars. 

Foreign Branch of a Domestic Corporation. A domestic taxpayer

that maintains books and records of a foreign branch in a foreign

currency may report income or loss of the branch using either the "net 

worth" or the "profit and loss" method of currency translation. Under 

the net worth method, the dollar value of the income or loss of the 

branch is measured by adding the increase (or decrease) in the dollar 

value of the branch net worth and the dollar value of any remittances 

from the branch to the home office. For purposes of determining the 

dollar value of the branch net worth at the beginning and end of each 

period, current assets and liabilities are translated at the year-end

exchange rates, and non-current assets and liabilities are translated 

at the exchange rate for the date acquired or incurred. Remittances 

are translated at the exchange rate on the date remitted. No specific

rules govern the source or character of income of a net worth branch. 

The net worth method causes exchange gain or loss on unrealized income 

or loss to be taken into account currently. 

Under the profit and loss method, only the profit or loss of the 

branch, determined in the foreign currency, is translated into 

dollars. Unremitted profits are translated at the year-end exchange

rate and remittances are translated at the exchange rate on the date 

made. There are no clear rules for translating losses, or for 

- 410 -
determining the Character or source of remittances from a profit and 

loss branch. The profit and loss method results in the recognition of 

exchange gain or loss only with respect to income or loss that has 

been realized in the foreign currency. 

Foreign Corporations. A domestic taxpayer that conducts foreign

operations through a foreign corporation is subject to U.S. tax on 

actual distributions of earnings of the foreign corporation or on 

deemed distributions from a controlled foreign corporation that are 

included in a U.S. shareholder's income under subpart F of the Code. 

In addition, gain realized by a domestic taxpayer on the sale of stock 

of a controlled foreign corporation may be recharacterized as a 

dividend to the extent of the untaxed earnings of the foreign

corporation. A domestic corporate shareholder that owns 10 percent or 

more of the voting stock of a foreign corporation generally will be 

allowed a foreign tax credit for taxes paid by the foreign corporation

with respect to earnings distributed as a dividend, or as a deemed 

distribution under subpart F or in connection w'ith a sale of stock in 

the corporation (the indirect credit). 

The rules for translating into dollars earnings of a foreign

corporation that maintains its books and records in a foreign currency

depend on how the earnings are subjected to 0.S. tax. An actual 

distribution is translated into dollars at the exchange rate for the 

date received. In determining the indirect credit with respect to an 

actual distribution that is a dividend, the dividend, accumulated 

profits and foreign tax deemed paid with respect to the dividend are 

translated at the exchange rate for the date the distribution is 

received by the taxpayer. (The translation of distributions for 

dividend and indirect credit purposes at a current exchange rate was 

endorsed in Bon Ami Company, 39 B.T.A. 825 (1939), a decision of the 

predecessor to the Tax Court, and is referred to herein as the -__ Bon Ami

approach.) 

If a domestic corporation is considered to receive a deemed 

distribution of earnings of a foreign subsidiary under subpart F, the 

amount of the distribution and the earnings to which the distribution 

is attributable are translated to dollars under rules which (i)

translate the profit and loss to dollars at an average exchange rate 

for the period, and (ii) increase or decrease the dollar profit or 

loss amount by an additional exchange gain or loss reflecting a 

translation of the balance sheet of the corporation (the subpart F 

method). Transactions in dollars are reflected at their dollar 

amount. The foreign tax deemed paid is translated at an average

exchange rate for the period in which the income is earned. 

Income Taxes Available for the Foreign Tax Credit. For purposes

of the direct credit, cash basis taxpayers translate the amount of 

foreign income taxes paid into dollars at the exchange rate for the 

date of payment. Accrual basis taxpayers use the year-end rate for 

the year of accrual or, if paid during the year, the exchange rate for 

the date of payment. Accrued taxes paid in a later year must be 

restated to the value on the date of payment. 

- 411 -
For purposes of the indirect credit, foreign taxes deemed paid

with respect to an actual distribution are translated to dollars at 

the exchange rate for the date the distribution is received. Foreign

taxes deemed paid with respect to income inclusions under subpart F 

are translated at an average rate for the period in which the income 

is earned by the foreign corporation. 

Reasons for Change 

The various rules for taxing foreign currency transactions of a 

dollar taxpayer and for translating into dollars the income and loss 

of a foreign branch or corporation that maintains its books and 

records in a foreign currency have never been rationalized. In 1980 

the Treasury Department conducted a comprehensive review of the law 

pertaining to taxation of foreign currency. That review resulted in a 

discussion draft presenting a system for taxing foreign exchange gains

and losses (the Discussion Draft) that reflected the "functional 

currency" foreign currency translation principles proposed in an 

exDosure draft bv the Financial Accountinq Standards Board (later

published as FAS6, Statement No. 52: Foreign Currency Translation 

(1981)). The functional currencv concept is based on the proposition

that the most meaningful measurement unit for assets, liabilities and 

operations of an entity is the currency in which it primarily conducts 

its business. 

The Administration proposals generally follow the Discussion Draft 

and adopt the functional currency concept for determining when an 

entity must subject transactions in a foreign currency to the tax 

rules for foreign currency transactions. Conversely, the functional 

currency concept would be used to determine when an entity would be 

allowed to maintain its books and records in a foreign currency, for 

Federal income tax purposes, and account for transactions in the 

foreign currency as though that currency were the dollar (and the 

dollar were a foreign currency). 

Foreign Currency Transactions 

The Internal Revenue Code and Treasury regulations provide little 

direct guidance regarding the taxation of gain or loss from transactions in a foreign currency. The administrative and judicial

decisions have failed to enunciate a clear or consistent set of rules;

moreover, they do not take account of changes in the law relating to 

the time value of money, straddles and mark-to-market taxation of 

certain property. Finally, innovations in the financial markets have 

rendered even existing tax rules anachronistic. The result is 

uncertainty of tax treatment for many legitimate business transactions 

and opportunities for abuse and whipsawing of the fisc. 

A significant defect of the current tax treatment of foreign

currency transactions is its failure to reflect the underlying

economic relationship of exchange rate fluctuations to interest. 

- 412 -
General,ly,exchange rate fluctuations will tend to offset interest 

rate differences between two currencies. The relationship between 

interest rates for a particular currency tind expected movements in 

exchange rates is not perfect, because of different risk factors 

associated with different currencies. In addition, international 

currency markets are not perfectly efficient, particularly for less 

actively traded currencies. However, the relationship between 

interest rates in two currencies and expected exchange rates is quite

close for those traded currencies in which the preponderant amount of 

international commercial transactions are conducted. The failure of 

current law to reflect this underlying economic reality gives rise to 

the same kinds of mismatching of income and deductions and 

manipulation of the principal amount of indebtedness that caused 

enactment of the original issue discount provisions of current 1,aw. 

For example, assume that a dollar taxpayer sells property in 

exchange for an obligation denominated in Swiss francs bearing

interest at a market rate for francs of 5 percent when the dollar 

interest rate on an obligation of the same maturity for a comparable

borrower would be 10 percent. While the lender will earn interest 

income at a 5 percent rate in francs, he will generally expect the 

franc to appreciate in value over the term of the obligation so that 

he can buy sufficient additional dollars to bring his overall yield on 

the obligation up to a return equivalent to that which he could have 

earned by purchasing a comparable dollar obligation. In this 

circumstance the true interest element of the transaction generally

would be understated and the principal component overstated. This may

occur without regard to whether there is original issue discount in 

terms of the market interest rate for the foreign currency. 

Alternatively, assume that a dollar taxpayer issues an obligation

denominated in Brazilian cruzeiros bearing interest at a market 

interest rate for cruzeiros of 32 percent when the comparable dollar 

rate is 10 percent. While the borrower will accrue interest expense

based on the 32 percent rate in cruzeiros, he will expect the cruzeiro 

to depreciate in value over the term of the obligation so that his 

true cost of borrowing will not exceed the rate at which he could 

borrow in dollars. If the anticipated exchange loss is not accrued,

his true interest expense will be overstated. While recently enacted 

time value of money legislation authorizes regulations that would 

provide for correct timing of recognition of anticipated exchange gain

or loss, it would be preferable to establish a coherent set of tax 

rules for foreign currency transactions. 

A second defect of current law is the extreme uncertainty of 

application of rules to determine the character and source of income. 

At least one U.S. Court of Appeals has held that foreign exchange gain

on the repayment of a taxpayer's foreign-currency-denominated

obligation is the equivalent of cancellation of indebtedness income. 

(Some taxpayers argue that such gain is eligible for deferral from 

current tax if the taxpayer elects to decrease basis in certain 

depreciable assets.) Other case law suggests that exchange gain with 

- 413 -
respect to a foreign-currency-denominated obligation that is a capital

asset in the hands of a taxpayer would be capital gain. The 

inconsistent authority has created uncertainty. The same U.S. Court 

of Appeals referred to above also affirmed a divided Tax Court 

decision holding that an exchange loss on repayment of a foreigncurrency-denominated loan is ordinary in character because the 

repayment of a loan does not constitute a sale or exchange. Treatment 

of exchange gain as cancellation of indebtedness income and exchange

loss as ordinary loss affords opportunity for tax avoidance. 

Foreign Currency Translation 

Under current law, there are no clear standards for determining

when books and records for a branch (or a controlled foreign corporation) may be maintained for Federal income tax purposes in a foreign

currency. This is significant because if transactions are accounted 

for in the local currency, exchange gain and loss (in relation to the 

dollar) will not be recognized with respect to individual transactions 

at the time income or loss is realized. Instead, under the net worth,

profit and loss or subpart F methods, exchange gain or loss is 

determined in different ways for the aggregate results of the 

reporting entity for the taxable year. The distinction in treatment 

that results from use of one of the net translation methods instead of 

translating separate transactions requires that standards be provided

to ensure that income in dollars is clearly reflected. 

Foreign Branch of a Domestic Corporation. The use of the net 

worth method for foreign branches under current law generally allows 

exchange gain or loss on net current assets to be taken into-income 

currently even though income from the disposition of the assets has 

not been realized. The subpart F method produces a similar result for 

controlled foreign corporations. Therefore, in the case of a 

controlled foreign corporation a taxpayer may in effect elect to 

recognize foreign exchange loss (or gain) currently by realizing

subpart F income in a corporation operating in a weak (or strong)

currency. The recognition of exchange loss (or gain) on unrealized 

income may have the effect of overstating (or understating) the 

indirect foreign tax credit. 

In a world of flexible exchange rates, it is inappropriate for a 

taxpayer operating primarily in a foreign currency to accelerate 

recognition of foreign exchange gain or loss if the underlying income 

or loss is not realized or property is not taken out of use in the 

foreign currency environment. In this regard, the profit and loss 

method is more consistent with the functional currency concept than is 

the net worth or subpart F method. 

Foreign Corporations. The virtues of the Bon Ami approach are its 

relative simplicity and that it maintains the XaGnship between the 

dollar value of a dividend grossed-up for foreign taxes and the 

foreign taxes deemed paid with respect to the earnings. The Bon Ami 

approach, however, has significant defects. First, even if there= a 

- 414 -
distribution of the current year's earnings, the date of distribution 

translation rate under --Bon Ami generally will differ from the average

exchange rate used under the subpart F method. A taxpayer therefore 

may "trigger" a deemed distribution of those earnings under subpart F 

and obtain a different result. The inconsistency in translation of 

income and foreign tax paid between an actual distribution and a 

subpart F distribution (and the results if the income is earned 

through a branch) is more dramatic if earnings are not distributed 

currently. 

For example, assume that a foreign corporation earns 100 Swiss 

francs and pays Swiss tax of 40 francs when the exchange rate is four 

Swiss francs to the dollar. (In dollars, pre-tax earnings would be 

$25 and the Swiss tax $10.) If these earnings are distributed in a 

later year when the swiss franc has appreciated to two francs to the 

dollar, the dividend (grossed-up for foreign taxes paid) would be $50 

and the deemed paid taxes would be $20. Similarly, if the franc 

declined to eight francs to the dollar, the grossed-up dividend would 

be $12.50 and the deemed paid Swiss tax $5. 

As may be seen from the example, the exchange rate gain or loss 

between the date the income is earned and the date it is paid is in 

effect characterized as an increase or decrease in the earnings of the 

foreign corporation. In addition, the deemed paid foreign tax is 

increased or decreased by subsequent exchange fluctuations even though

the tax may actually have been paid in an earlier year. Treating the 

exchange gain or loss as part of the distribution and translating the 

deemed paid foreign tax at the current rate distorts the amount of 

allowable foreign tax credits. Moreover, it gives rise to a different 

result than would occur if the same income were subpart F income or 

were earned through a branch and remitted to the head office at a 

later date. 

Proposal 

Functional Currency of an Entity 

Each business entity of the taxpayer would have a single

functional currency. For this purpose, a business entity would be any

separate and distinct business operation of the taxpayer, the 

activities of which constitute an active trade or business and are 

accounted for by a complete and separate set of books and records. 

Each taxpayer always will be a business entity separate from any

affiliated taxpayer, though a single taxpayer may include more than 

one business entity. (A business entity is hereinafter referred to as 

an entity.) 

The functional currency of an entity generally would be the 

primary currency of the economic environment in which the entity

operates. Thus, most U.S. taxpayers operating in the United States 

would use the dollar as their functional currency. A taxpayer always

would be allowed to elect to treat the dollar as the functional 

- 415 -
currency of an entity. (An entity whose functional currency is the 

dollar is referred to herein as a dollar taxpayer.) The 

Administration is considering whether special rules should be applied

with respect to taxpayers operating in a highly inflationary economy. 

If a taxpayer does not elect to use the dollar as the functional 

currency for an entity, the entity's functional currency generally

would be the currency of the country in which the entity is located 

and the books and records maintained. However, the identification of 

a foreign functional currency of an entity would be a question of fact 

to be determined on the basis of the relevant facts and circumstances. 

Factors to be taken into account would include: 

(i) the currency in which the books of account of the entity

are maintained; 

(ii) the currency in which the revenues and expenses of the 

entity are primarily generated; 

(iii) the currency in which the entity primarily borrows and 

lends; and 

(iv) the functional currency of related entities and the 

extent of integration of the operations of related entities. 

These factors generally correspond to the factors relevant for determination of a functional currency required for financial accounting

purposes under FASB Statement No. 52. While the functional currency

of an entity generally would correspond to that for financial accounting purposes, it is not necessary that it do so. (Moreover, a 

"business entity" for tax purposes will not necessarily comprise the 

same activities as a reporting enterprise for financial accounting

purposes. ) 

Although identification of a functional currency would depend on 

the facts and circumstances relevant to each entity, consistent 

criteria for identifying the functional currency of entities conducting similar trades or businesses in different countries would be 

required. If in a particular case the facts and circumstances did not 

indicate choice of a particular currency, taxpayers would have 

discretion in choosing a functional currency from among the possible

alternatives. A consistent choice would have to be made for similarly

situated entities. The choice of a functional currency for an entity,

including an election to use the dollar as the functional currency,

would be treated as a method of accounting which may be changed only

with the consent of the Secretary. 

The choice of a functional currency is significant because it will 

determine the circumstances in which exchange gain or loss will be 

recognized. If an entity adopts a functional currency other than the 

dollar, the entity would be required to maintain books and records for 

Federal income tax purposes in the functional currency. Transactions 

- 416 -
in the functional currency would not be subject to the taxing rules 

for foreign currency transactions. However, if the entity conducts 

transactions in a currency other than its functional currency,

exchange gain or loss (in relation to the functional currency) would 

be recognized under the rules for foreign currency transactions. 

For example, if an entity that uses the French franc as its 

functional currency promises to pay francs in six months in exchange

for property, exchange gain or loss would not be realized upon payment

(without regard to whether the value of the franc had changed in 

relation to the dollar). Instead, the income or loss from the 

transaction would be included as part of the entity's profit or loss 

for the period. The entity's profit and loss (in francs) would be 

translated under the proposals for foreign currency translation. 

However, the entity's exchange gain or loss from transactions in 

currencies other than the franc (including the dollar) would be taxed 

under the proposals for foreign currency transactions. 

Foreign Currency Transactions 

This section describes rules for the taxation of transactions in a 

currency other than the entity's functional currency. For ease of 

exposition, it is assumed that the entity's functional currency is the 

dollar and that the transaction is denominated in a foreign currency. 

Recognition of Income. Exchange gain or loss would not be 

realized with respect to a foreign-currency-denominated item of income 

or expense that is received and translated on the same date as it is 

recognized as income or allowed as a deduction for Federal income tax 

purposes. For example, if an entity sells property for Swiss francs 

and receives the francs on the date the sales income is taken into 

account for tax purposes, no exchange gain or loss will arise since 

the item of income is translated on the same date as the income is 

recognized for tax purposes. Thus, exchange gain or loss does not 

arise in a broad range of everyday transactions. Moreover, if in the 

foregoing example the entity's functional currency is the Swiss franc,

the entity would not be required to recognize exchange gain or loss on 

a transaction in francs but would translate the results of its 

operations for the period under the profit and loss method. 

Foreign exchange gain or loss may arise with respect to a foreigncurrency-denominated financial asset or liability. A foreigncurrency-denominated financial asset or liability is any financial 

asset or liability (e.9. trade receivables or payables, preferred

stock and debt instruments) the principal amount of which is determined in one or more foreign currencies. If there is a change in the 

exchange rate between the date on which a foreign-currency-denominated

asset is taken into account for tax purposes (i.e. recorded as an item 

of income or expense, treated as a liability or assigned an asset 

basis) and the date it is paid, foreign exchange gain or loss will 

exist. 

- 411 -
currency 

Exchange gain or loss with respect to financial assets or 

liabilities denominated in a currency other than the functional 

currency of an entity may properly be thought of as an economic 

equivalent to interest. In most transactions the parties anticipate

that exchange gain or loss with respect to a foreign-currencydenominated financial asset generally will offset the difference 

between the yield in the foreign currency and the yield for a 

comparable dollar asset over the life of the asset. It is therefore 

appropriate to treat foreign exchange gain or loss as the equivalent

of interest for tax purposes. 

In order to prevent the mismatching of income and deductions that 

can arise if foreign exchange gain or loss is not taken into account 

until it is realized, “anticipated exchange gain or loss“ would be 

recognized on an accrual basis with respect to a foreign-currencydenominated financial asset or liability that provides �or a fixed or 

determinable payment in the future (e.g., an accrued item of income or 

expense, or an obligation). Anticipated exchange gain or loss would 

be determined under rules comparable to those which apply to impute

interest with respect to obligations issued for property.

Unanticipated exchange gains and losses would be recognized when 

realized. 

Anticipated currency gain or loss would be based on the difference 

between the nominal dollar yield on the asset or liability and the 

applicable Federal rate with respect to an equivalent dollardenominated asset or liability. The nominal dollar yield of the asset 

may be measured by translating the principal amount and future 

payments on the asset into dollars at the exchange rate on the date 

incurred and calculating the yield using those amounts. The 

anticipated exchange gain or loss would equal that amount which would 

increase or decrease the nominal dollar yield to the market dollar 

yield. (If the functional currency is not the dollar, the anticipated

exchange gain or loss with respect to a transaction in a 

other than the functional currency would be based on the difference 

between the nominal yield and the market yield in the functional 

currency.) The accrual of anticipated exchange gain would increase 

the holder’s basis in the obligation; the accrual of anticipated

exchange loss would decrease basis in the obligation. 

It is recognized that the proposed treatment of foreign exchange

gains and losses would raise the complexities similar to those 

existing today in connection with the rules applicable to dollar 

obligations issued for property. The Administration will consider 

whether it is possible to establish safe harbors for circumstances 

where the mismatching of income and expense would not be material. 

Character and Source. Anticipated and unanticipated exchange gain

or loss generally would be treated as an increase or decrease in 

interest income or expense with respect to the foreign-currencydenominated asset or liability. However, if exchange gains exceed 

interest expense, such gains would be treated as additional interest 

- 418 -
income. If exchange losses exceed interest income, such losses will 

be treated as additional interest expense. Exchange gains will be 

sourced under the same rules as apply to interest income. Exchange

losses would be allocated and apportioned under the same rules as 

apply to interest expense. 

Forward Exchange Contracts. This subsection describes rules for 

the taxation of gain or loss on a forward sale or purchase contract,

or a contract to receive or pay dollars or a foreign currency, that 

hedges a specific foreign-currency-denominated asset or liability

(including an item of income or expense). For this purpose, a forward 

sale contract is any contract to sell or exchange foreign currency at 

a future date under terms fixed in the contract. A forward purchase

contract is any contract to purchase foreign currency with dollars at 

a future date under terms fixed in the contract. A contract to 

exchange foreign currency for another foreign currency at a future 

date under terms fixed in the contract would be considered a forward 

sale contract. 

A contract will be considered to hedge a foreign-currencydenominated item if (i) the item hedged would constitute ordinary

income or expense to the taxpayer, (ii) the primary purpose of the 

contract (either alone or in combination with other contracts) is to 

offset the effect of a change in the exchange rate on the dollar value 

of the foreign-currency-denominated item, and (iii) either the 

taxpayer identifies the contract(s) as hedging a particular item or 

the Commissioner determines that, under the facts and circumstances,

the contract hedges a particular item. For this purpose, a contract 

offsetting risk of exchange fluctuations on the value of stock in a 

non-consolidated subsidiary or of assets held by, or liabilities of, a 

non-consolidated subsidiary would not be considered a hedge. 

The exchange gain or loss on a forward sale contract hedging the 

principal amount of a foreign-currency-denominated financial asset 

would be recognized on an accrual basis and would be treated as in 

increase or decrease in the interest received with respect to the 

asset. The exchange gain or loss on a forward purchase contract 

hedging the principal amount of a foreign-currency-denominated

financial liability would be characterized and sourced in the same 

manner as interest paid with respect to that liability. The gain or 

loss on a forward sale or purchase contract hedging, respectively, an 

item of income or expense would be characterized and sourced in the 

same manner as an increase or decrease in the item of income or 

expense. Comparable rules would also apply to contracts for payments

made to offset foreign exchange fluctuations. 

Foreign Currency Translation 

Foreign Branches. An entity that uses a functional currency other 

than the dollar wouZd be required to use a profit and loss method to 

translate income or loss into dollars at the average exchange rate for 

the period. For example, if an entity using the Swiss franc as its 

- 419 -
functional currency earned 10,000 Swiss francs and made no remittances 

to the home office during the period, and if the average exchange rate 

for the period was 4 francs to the dollar, the profit of the entity

would be $2,500. 

It is necessary to establish rules for translation of losses and 

to account for exchange gain or loss with respect to property that is 

transferred to and from an entity of the taxpayer having a different 

functional currency, in order to ensure that the cumulative gain or 

loss recognized over the life of the entity is the same without regard

to its functional currency. If translation rules are not provided for 

losses and remittances, exchange gain or loss with respect to assets 

acquired with income or capital of the entity might never be 

recognized. 

A taxpayer using the dollar as its functional currency would be 

considered to have a dollar (i.e. functional currency) "basis" in an 

entity solely for purposes of recognition of exchange gain or Loss. 

The taxpayer's dollar basis in the entity would be analogous to a 

partner's basis in a partnership interest; it would identify when 

exchange gain or loss should be recognized with respect to 

distributions and losses. The basis in the entity would be increased 

by contributed property translated on the date of contribution and by

unremitted earnings translated at the average exchange rate for the 

year. Losses translated at the average rate for the year and 

remittances translated at the exchange rate for the date remitted 

would reduce entity basis. Exchange gain and loss 011 remittances 

would be recognized once entity basis is recovered. Exchange gain or 

loss realized on remittances of property would be treated as ordinary

and domestic source income. 

For example, assume that a dollar taxpayer's head office 

contributes 200 Swiss francs to an entity using the Swiss franc as its 

functional currency when the exchange rate is four francs to the 

dollar. The entity earns 100 francs during a period in which the 

exchange rate does not change. At the end of the period, the entity's

profit would be $25 and the taxpayer's dollar basis in the entity

would be $75 ($50 + $25 = $75). If the entity loses 40 francs the 

following year when the exchange rate is two francs to the dollar, the 

loss would be $20 and the entity basis would be $55 ($75 - $20 = $55).

No exchange gain or loss would be required to be recognized during

that year. If the entity were liquidated after the end of the second 

year and the remaining 260 francs were remitted when the exchange rate 

remained at two francs to the dollar, the difference between the value 

of the francs on the date of remittance and the branch basis would be 

treated as exchange gain or loss. In this case there would be 

exchange gain of $75 ($130 - $55 = $75). The exchange gain would be 

treated as ordinary and domestic source income. 

Foreign Corporations. As described in Ch. 15.01, the 

Administration proposes that the indirect tax credit be computed usinq

a "pooling" concept. That is, dividend distributions and s;bpart F 

- 420 -
income inclusions will be considered made from the pool of all of the 

distributing corporation's earnings and profits. For translation 

purposes, it is tentatively proposed that the --Bon Ami approach be 

followed. Accordingly, an actual distribution, the pool of earnings

and profits from which the distribution derives and the foreign taxes 

deemed paid with respect to such earnings would be translated at the 

exchange rate for the date of distribution. Amounts deemed distributed under subpart F, the pool of earnings from which the deemed 

distribution derives and the deemed paid taxes would be translated at 

the average exchange rate for the year in which the subpart F income 

is earned. Earnings previously taxed under subpart F would be 

segregated in a separate pool. When such earnings are later actually

distributed, any further exchange gain or loss on the distribution 

would be treated as ordinary and domestic source income or loss. The

exchange gain or loss would be measured by multiplying the foreign

currency distribution by the difference between the exchange rate for 

the date of the deemed distribution and the exchange rate on the date 

of actual distribution. 

Because of the concerns described above with respect to the -Bon 

Ami approach, the Administration is continuing to consider an 

nernative approach which would separate the exchange gain or loss 

from the value of an actual distribution at the time it was earned. 

Under this approach, the grossed-up dividend distribution would be 

translated at the historic exchange rates applicable to the earnings

from which the distribution is derived. Any subsequent exchange gain

or loss with respect to the actual distribution (which would not 

include the gross-up for the foreign taxes deemed paid) would be 

recognized at the time of the distribution. Such an approach would 

reduce the disparity in treatment of exchange gain and loss between 

actual and deemed distributions and between income earned by foreign

branches of domestic corporations and foreign corporations. 

Other Translation Matters. The average exchange rate for a period

is a rate which, if used to translate total qross receipts of an 

entity during the period, would produce approximately the same dollar 

amount as would have been obtained had each gross receipt of the 

entity been translated at the exchange rate for the date the receipt

was recorded for tax purposes. A taxpayer would be permitted to use 

any reasonable procedure, consistently applied, to determine an 

appropriately weighted exchange rate for the period. 

If an entity or foreign corporation uses one currency as its 

functional currency and maintains hooks or records in another currency

or conducts transactions in another currency, results in the other 

currency would be translated into the functional currency before 

translation into dollars. 

The amount of foreign income taxes claimed as a credit would be 

restated to take account of any refund or difference between the 

amount accrued and the amount paid. The restated foreign tax, 

- 421 -
-- 

however, would be translated at the same rate as applied to the tax 

which was originally taken into account for Federal income tax 

purposes. 

Effective Dates 

The proposals would be effective for taxable years beginning on or 

after January 1, 1986. The proposals governing taxation of foreign

currency transactions would be effective for foreign-currencydenominated assets acquired or liabilities incurred after January 1,

1986. 

Analysis 

The proposals would rationalize the taxation of foreign exchange

transactions by (i) providing rules to identify a taxpayer’s

functional currency, (ii) treating exchange gain or loss on assets or 

liabilities not denominated in a functional currency as the equivalent

of interest, (iii) taxing anticipated exchange gain or loss on an 

accrual basis, and (iv) providing clear and unambiguous character and 

source rules for anticipated and unanticipated exchange gain and loss. 

The treatment of exchange gain or loss as interest and subjecting

anticipated exchange gain or loss to tax on an accrual basis takes 

account of the economic relationship between exchange rate fluctuations and interest rates. Accrual taxation would prevent overstatement of deductions for borrowings in weak currencies and understatement of income with respect to loans in strong currencies. The 

former, in particular, has been the basis for a number of tax 

shelters. The proposed source rule for anticipated and unanticipated

exchange gain corresponds to the source rule for interest. 

The proposals for translating books and records maintained in a 

foreign currency generally would rationalize the translation rules for 

income earned by foreign branches and subpart F income of a foreign

corporation. The Bon Ami rule for translating actual distributions 

from a foreign corKa5n and associated deemed paid taxes at the 

current exchange rate follows current law and maintains a consistent 

relationship between the amount of the distribution and foreign taxes 

deemed paid. However, the Administration will continue to consider 

alternatives to Bon Ami. 

- 422 -
REFORM MIRROR SYSTEM OF T-TION 

FOR UNITED STATES POSSESSIONS 

General Explanation 

Chapter 15.05 

Current Law 

In General 

The income tax laws of the United States are in effect in Guam,

the Commonwealth of the Northern Mariana Islands (“CNMI”),the U.S. 

Virgin Islands, and American Samoa as their local income tax systems.

These jurisdictions are “possessions“ of the United States for tax 

purposes. To transform the Internal Revenue Code of 1954, as amended 

(the “Code”), into a local tax code, each possession, in effect,

substitutes its name for the name “United States” where appropriate in 

the Code. The possessions generally are treated as foreign countries 

for U.S. tax purposes. Similarly, the United States generally is 

treated as a foreign country for purposes of possessions taxation. 

Although this word-substitution system, known as the “mirror system“,

applies to Guam, the CNMI, the Virgin Islands, and American Samoa, the

U.S. tax relationship with each possession is governed by somewhat 

different rules, as described below. 

-

Guam

Under the Organic Act of 1950, Guam currently employs the mirror 

system of taxation. Under Code section 935, an individual resident of 

the United States or Guam is required to file, with respect to income 

tax liability to those jurisdictions, only one tax return -- with Guam 

if he is a Guamanian resident on the last day of the taxable year, or 

with the United States if he is a U.S. resident on the last day of the 

year (the “single filing rule”). Income taxes withheld by the 

jurisdiction in which a return is not filed may be claimed as a credit 

against tax imposed by the jurisdiction of filing. In addition, with 

respect to taxation of U.S. and Guamanian citizens and resident 

individuals (but not corporations), the U.S. is treated as part of 

Guam for purposes of Guamanian taxation, and Guam is treated as part

of the United States for purposes of t7.S. taxation. 

A corporation chartered in Guam that receives 1J.S. source income 

(other than certain passive income) must file a U.S. return and pay

1J.S. tax on that income. Under Code section 881(b), a Guamanian 

corporation is not treated as a foreign corporation for purposes of 

the 30% withholding tax on certain passive income paid to foreign

corporations if (a) less than 25% in value of its stock is owned by

foreign persons, and (b) at least 20% of its gross income is derived 

from sources within Guam. 

- 423 -
Under U.S. law, Guam is authorized to impose up to a 10% surtax on 

income tax collected under the mirror system and may provide for 

rebates of mirror system taxes in certain circumstances. 

Code section 936, which provides an incentive for U.S. corporations to invest in certain possessions, applies to Guam. In effect, a 

section 936 corporation operating in a possession such as Guam enjoys

an exemption from all U.S. tax on the income from its business 

activities and qualified investments in that possession. To qualify

for this treatment, the section 936 corporation must meet two 

conditions: (a) at least 80% of its gross income for the three-year

period immediately preceding the close of the taxable year must be 

from sources within the possession; and (b) at least 65% of its gross

income for that period must be from the active conduct of a trade or 

business in the possession. 

Federal statutes do not permit Federal employers to withhold 

territorial income taxes. However, under code section 7654, the 

United States generally covers into (i.e., transfers to) the treasury

of Guam certain tax collected from individuals on Guamanian source 

income and withholding tax on U.S. military personnel stationed in 

Guam. Similarly, Guam covers into the treasury of the United States 

certain tax collected from individuals on U.S. source income. 

CNMI 

As of January 1, 1985, the CNMI is required to implement the 

mirror system in substantially the same manner as the mirror system is 

in effect in Guam. Code references to Guam are deemed to include the 

CNMI. Thus, the single filing rule for individuals under Code section 

935 and the special withholding tax rule for interest and other 

passive income earned by corporations under section 881(b) also apply

to the CNMI. In addition, U.S. law provides that the CNMI may by

local law impose additional taxes and permit tax rebates, but only

with respect to taxes on local source income. 

Virgin Islands 

under the Naval Appropriations Act of 1922, the income tax laws of 

the United States, as amended, are held to be "likewise in force in 

the Virgin Islands", except that the proceeds of the income tax are 

paid into the treasury of the Virgin Islands, The courts have 

interpreted this provision to establish a mirror system of taxation in 

the Virgin Islands. 

under the Revised Organic Act of the Virgin Islands, as 

interpreted by the courts, an "inhabitant" of the Virgin Islands is 

exempt from U.S. tax as long as it pays tax to the Virgin Islands on 

its worldwide income. The term "inhabitant", for these purposes, has 

generally been interpreted to include individual residents of the 

Virgin Islands, corporations organized under the laws of the Virgin

Islands, and corporations not organized under the laws of the Virgin

Islands if such corporations have contacts with the Virgin Islands 

sufficient to establish "residence" in the Virgin Islands. 

- 424 -
Notwithstanding section 28(a) of the Revised Organic Act, Virgin

Islands corporations, which are generally treated as foreign

corporations, are liable for the U.S. 30% withholding tax on certain 

payments to foreign corporations. However, under Code section 881(b),

a Virgin Islands corporation is not treated as a foreign corporation

for purposes of this tax if (a) less than 25% in value of its stock is 

owned by foreign persons, and (b) at least 20% of its income is 

derived from sources within the Virgin Islands. 

Under Code section 934, the Virgin Islands is generally prohibited

from reducing or rebating taxes imposed under the mirror system, with 

the following exceptions: (a) the prohibition does not apply (with

respect to taxes on income derived from Virgin Islands sources) in the 

case of a full-year Virgin Islands resident individual; and (b) the 

prohibition does not apply (with respect to taxes on non-U.S. source 

income) in the case of a Virgin Islands or I1.S. corporation which 

derives at least 80% of its income from Virgin Islands sources and at 

least 65% of its income from a Virgin Islands trade or business. 

(Code section 936, which provides an incentive for U.S. corporations

to invest in certain possessions, does not apply to investment in the 

Virgin Islands. However, Code section 934(b), in conjunction with 

section 28(a) of the Revised Organic Act, provides similar results.)

under Code section 934A, the 30% withholding tax on certain payments

to foreign persons (including U.S. persons), as imposed under the 

Virgin Islands mirror system, applies to payments to IJ.S. persons at a 

reduced 10% rate (which may be further reduced by the Virgin Islands). 

The Virgin Islands is authorized to impose up to a 10% surtax on 

the mirror system tax. Otherwise, the Virgin Islands does not have 

the power to impose local taxes on income. 

American Samoa 

Unlike the possessions described above, (J.S. law permits American 

Samoa to assume autonomy over its own income tax system. In 1963,

however, American Samoa adopted the U.S. Internal Revenue Code as its 

local income tax, thereby also adopting the mirror system of income 

taxation. While American Samoa has the power to modify the Code in 

its capacity as American Samoa's territorial tax, this authority has 

been exercised on few occasions, generally to simplify the Code and 

adapt it to the needs of American Samoa. 

Under section 931, U.S. citizens who receive 80% or more of their 

gross income from sources within American Samoa and 50% or more of 

their gross income from the conduct of a trade or business in American 

Samoa are exempt from 1I.S. tax on income derived from sources without 

the United States. In addition, Code section 936 applies to 

qualifying U.S. corporations doing business in American Samoa. 

Reasons for Change 

The Internal Revenue Code, with all its complexities, is designed

primarily to tax income in the highly developed U.S. economy. The 

- 425 -
mirror system, which entails imposing the Code in its entirety as 

local law, may be wholly inappropriate for the island economies of the 

U.S. possessions. The possessions need tax systems that help them to 

pursue development policies independently and to exercise greater

control over their own economic welfare. 

The frequency and extent of revisions to the Code in recent years

have highlighted the problems inherent in the mirror system. For 

example, in the possessions generally, a large portion of the Levenue 

is collected from individuals in the lower tax brackets. Generally,

the portion of local revenues collected from corporations and higherincome individuals is very small. Thus, any revisions to the Code 

that lower the tax rates on individuals (such as the rate reductions 

enacted by the Economic Recovery Tax Act of 1981 and those proposed in 

this report) could have a potentially harsh revenue effect on the 

possessions. In addition, revenue-neutral proposals that compensate

for lowering tax rates by broadening the tax base may well not be 

revenue neutral in a possession where very little tax is collected 

from corporations or higher-income individuals. 

The present mirror systems are very complex and the possessions

often lack the resources to enforce these mirror systems effectively.

Because of the difficulties of enforcement and the ambiguities and 

inconsistencies inherent in the mirror system, U.S. taxpayers are 

known to abuse the mirror systems without making real economic 

contributions to the possessions. 

To promote fiscal autonomy of the possessions, therefore, it is 

important to permit each to develop a tax system that is suited to its 

own revenue needs and administrative resources. It is also important

to coordinate the possessions' tax systems with the U.S. tax system in 

a rational manner in order to provide certainty and minimize the 

potential for abuse. 

The deficiencies in the current mirror systems of taxation afflict 

each possession, though in differing respects. The close economic 

relationship between Guam and the CNMI has given rise to mirror system

problems for which there is no clear solution, resulting, in some 

cases, in harsh consequences for residents of Guam. With respect to 

the CNMI, the mirror system of taxation went into force for the first 

time in 1985. The CNMI has repeatedly voiced its concern that it will 

have difficulty administering and enforcing the complex mirror system

because of its lack of resources. In addition, American Samoa has had 

difficulty collecting tax from U.S. Government employees because of 

the United States' lack of authority to withhold Samoan tax from 

wages. 

With respect to the Virgin Islands, the interaction of the 

Internal Revenue Code with the Virgin Islands Revised Organic Act and 

the mirror system gives rise to numerous areas of ambiguity and problems of interpretation. These technical difficulties have made administration of the law problematic, created a climate of uncertainty for 

investors, and raised the possibility of unintended tax benefits for 

- 426 -
some and harsh consequences for others. In addition to fostering tax 

avoidance and tax evasion, the "inhabitant" rule of the Revised 

Organic Act, in conjunction with tax reductions authorized by the 

Virgin Islands, effectively permits United States corporations meeting

certain requirements to derive income from a Virgin Islands business 

free of any U.S. tax and subject to reduced Virgin Islands tax rates. 

(Such corporations, generally described in Rev. Rul. 80-40, are known 

as "80-40" companies.) However, due to substantial uncertainty as to 

the operational requirements of the so-called "80-40" mechanism, it 

does not appear to have encouraged U.S. investment in the Virgin

Islands to any appreciable extent. Moreover, where the mechanism is 

used, the resulting U.S. tax benefit (i.e., exemption from U.S. tax of 

the "80-40" corporation's income from all sources) bears no necessary

relation to the corporation's investment in the Virgin Islands or 

employment of Virgin Islands residents. 

Proposal 

In General 

The proposal outlined below is divided into two parts. The first 

part deals with reform of the mirror system in the Virgin Islands. 

This part of the proposal is based in large part on extended 

discussions with the Virgin Islands in recent years regarding mirror 

system reform. It differs from the proposals for the other 

possessions because of the unique history of the relationship between 

the Virgin Islands and the United States. The second part relates to 

reforming the mirror system of taxation in Guam, the CNMI, and 

American Samoa. 

Virgin Islands 

Changes relating to all taxpayers. Under the proposal, certain 

tax provisions not contained in the Internal Revenue Code would be 

repealed or amended. First, the "inhabitant" rule contained in the 

Revised Organic Act would be repealed, and provisions in the Act 

relating to the covering of taxes would be revised to reflect such 

repeal. Second, the provision in the Naval Appropriations Act 

establishing the mirror system would be clarified to ensure that, in 

"mirroring" the Internal Revenue Code, (a) the Virgin Islands is not 

treated as having any possessions, (b) provisions in the Code 

referring to the Virgin Islands or to other possessions are not 

themselves mirrored, (c) possessions other than the Virgin Islands are 

treated as foreign countries for purposes of the Virgin Islands mirror 

system, and (d) certain provisions not intended to be included in the 

Virgin Islands mirror code are not mirrored. Third, the Revised 

Organic Act would be amended to provide the Virgin Islands with 

authority to enact nondiscriminatory local income taxes in addition to 

those imposed under the mirror system. Fourth, measures coordinating

the tax administration and collection functions of the Internal 

Revenue Service and the Virgin Islands Bureau of Internal Revenue, as 

well as procedures for exchanging tax information, would be 

implemented. 

- 421 -
Additionally, the EO percent and 65 percent requirements contained 

in Code section 934(b) would be eliminated with respect to U.S. 

corporations (other than corporations validly electing to be covered 

by the five-year grandfather protection for existing section 934(b)

corporations, as described in Ch. 12.05). Moreover, consideration 

would be given to authorizing the Virgin Islands to reduce or rebate 

the tax liability of certain foreign persons with respect to income 

derived from Virgin Islands sources. 

Changes relatirig only to individuals. The tax treatment of 

individuals who are citizens or residents of the United States or the 

Virgin Islands would be modified through amendments to the Code. 

Under the proposal, for purposes of determining the tax liability of 

such individuals, the United States would be treated as including the 

Virgin Islands (for purposes of determining U.S. tax liability), and 

the Virgin Islands would be treated as including the United States 

(for purposes of determining liability for the Virgin Islands tax).

However, a corporation organized in one jurisdiction would continue to 

be treated, where relevant, as a foreign corporation for purposes of 

individual income taxation in the other jurisdiction. 

An individual qualifying as a bona fide Virgin Islands resident as 

of the last day of the taxable year (determined under general

principles of Federal income tax law in effect prior to the enactment 

of section 7701(b)) would pay tax to the Virgin Islands under the 

mirror system on his worldwide income, and would have no final tax 

liability for such year to the United States. Any taxes withheld in 

the United States from payments to such an individual, and any

estimated tax payments properly made by such an individual to the 

United States, would be covered into the Virgin Islands treasury and 

would be credited against the individual‘s Virgin Islands tax 

liability. A Virgin Islands resident deriving gross income from 

sources outside the Virgin Islands would list all items of such income 

on an attachment to his Virgin Islands return. Information contained 

on these attachments would be compiled by the Virgin Islands Bureau of 

Internal Revenue and transmitted to the Internal Revenue Service to 

facilitate enforcement assistance. 

In the case of a citizen or resident of the United States (other

than a bona fide Virgin Islands resident) deriving income from the 

Virgin Islands, tax liability to the Virgin Islands would be a 

fraction of the individual’s U.S. tax liability, based on the ratio of 

adjusted gross income derived from Virgin Islands sources to worldwide 

adjusted gross income. Such an individual would file identical 

returns with the United States and the Virgin Islands. The 

individual’s Virgin Islands tax liability (if paid) would be credited 

against his United States tax liability. Taxes paid to the Virgin

Islands by the individual other than the tax paid pursuant to the 

mirror code would be treated, for U.S. tax purposes, in the same 

manner as State and local taxes. 

- 428 -
In the case of a joint return filed by a couple of which only one 

spouse qualified as a resident of the Virgin Islands, resident status 

of both spouses would be determined by reference to the status of the 

spouse with the greater adjusted gross income for the taxable year.

Rules for the payment to the Virgin Islands of estimated taxes by a 

U.S. resident would also be provided. 

Changes relating only to corporations. Under the proposal, Code 

section 881(b) would be amended by deletinq the 20% source-of-income 

requirement and adding, in its place, a requirement that 65% of the 

corporation's income be effectively connected with a trade or business 

in a possession or in the United States. In addition, the exemption

from the withholding tax would not be available for a corporation used 

as a conduit for payments to persons not resident in the Virgin

Islands. Generally, the branch profits tax described in Ch. 15.03 

would not apply to a corporation qualifying under Code section 881(b). 

For purposes of the wage credit described in Ch. 12.05, the Virgin

Islands would be treated as an eligible possession. Moreover, U.S. 

corporations that have validly qualified for the benefits of section 

934(b) for their last taxable year beginning on or before December 31,

1985 would be allowed to elect to be covered by the five-year grandfather protection extended to existing section 936 corporations, as 

described in Ch. 12.05. 

Guam, the CNMI, and American Samoa 

Guam and the CNMI would each be granted full authority over its 

own local income tax system, subject to certain qualifications

discussed below. Thus, as is currently the case with respect to 

American Samoa, either possession could adopt a mirror system as its 

local law if desired. The tax systems implemented by Guam and the 

CNMI would raise at least as much revenue as the mirror systems

currently implemented in those possessions. 

American Samoa already has autonomy with respect to its local tax 

system, but certain anti-abuse provisions described below would apply

to American Samoa as well as Guam and the CNMI. 

A resident of Guam or the CNMI would be required to file a U.S. 

return if he received U.S. or foreign source income. However, he 

would be required to pay U.S. tax only if he received more than a 

threshold amount of income, including U.S. source income, from sources 

outside these possessions. The threshold amount would approximate the 

tax exempt threshold for U.S. individual taxpayers (i.e., the zero 

- 429 -
bracket amount plus one or two personal exemptions, depending on 

filing status). The United States would cover into the treasury of 

Guam or the CNMI all U.S. income tax paid by a Guamanian or CNMI 

resident. 

Code section 881(b) would be modified to provide that a Guamanian 

or CNMI corporation would not be exempt from the 30% withholding tax 

unless (a) less than 25% in value of the corporation's stock were 

owned by foreign persons; and (b) 65% of the corporation's income were 

effectively connected with the conduct of a trade or business in a 

U.S. possession or in the United States. In addition, the exemption

from the withholding tax would not be available for a corporation used 

as a conduit for payments to persons not resident in the possession.

A similar exemption provision would be enacted with respect to the 

branch profits tax described in Ch. 15.03 imposed on a U.S. branch of 

a Guamanian or CNMI corporation. 

Qualifying U.S. corporations doing business in Guam, CNMI, or 

American Samoa would be eligible for the wage credit and the five-year

grandfather protection for existing section 936 corporations, as 

described in Ch. 12.05. 

For purposes of determining the U.S. tax liability of a Guamanian 

or CNMI resident, a dividend paid by a Guam or CNMI corporation would 

be deemed to be income derived from sources within Guam or the CNMI 

only if 50% or more of the corporation's gross income were derived 

from sources within those possessions. 

Anti-abuse provisions would be implemented to coordinate the 

source rules, subpart F, and foreign personal holding company

provisions to prevent the use of holding companies incorporated in 

Guam, CNMI, or American Samoa by U.S. or foreign persons to avoid U.S. 

tax, and to avoid application of those provisions in a non-abusive 

situation. Additional provisions would be enacted to eliminate 

certain reporting requirements with respect to Guamanian or CNMI 

residents who are not subject to U.S. tax. Local taxes of Guam, the 

CNMI, and American Samoa would be creditable for U.S. tax purposes if 

such taxes qualified as creditable taxes under the applicable foreign

tax credit regulations. 

Guam, the CNRI, and American Samoa would be prohibited from 

imposing discriminatory taxation on citizens and residents of the 

United States. These possessions would be required to exchange tax 

information with the United States under a mutually agreed upon

procedure. Each would be authorized to enter into mutual agreement

procedures and agreements to coordinate tax administration and 

withholding. Withholding on the compensation of U.S. Government 

personnel stationed in Guam, including military personnel, would be 

covered into the Guamanian, CNMI, and American Samoan treasuries, as 

appropriate. Finally, taxation by Guam, the CNMI, and American Samoa 

of the same individual or entity would be coordinated. This 

cootdination is necessary because of the close economic relationships

among these possessions. 

- 430 -
Effective Dates 

Virgin Islands 

The Virgin Islands proposal would be effective for taxable years

beginning on or after January 1, 1986. 

Guam, the CNMI, and American Samoa 

The proposed grants of authority to Guam and the CNMI, as well as 

the conforming changes to U.S. law, anti-abuse provisions, and 

administrative provisions, would be effective as of January 1, ,1986.

However, the mirror codes currently administered by Guam and the CNMI 

would continue to operate mutatis mutandis as their respective local 

income tax laws until and except to the extent that each possession

took action to amend its tax laws. The anti-abuse and administrative 

provisions with respect to American Samoa also would be effective as 

of January 1, 1986. 

Analysis 

The proposals would promote the important goal of fiscal autonomy

in the possessions and would permit those jurisdictions to enact and 

enforce tax laws that suit their revenue needs and administrative 

capabilities. The proposals are designed to resolve the technical 

flaws in current law and to permit the possessions to rationalize 

their tax systems. 

The proposal relating to Guam, the CNMI, and American Samoa would 

clarify and promote the ability of these possessions to pursue

economic development unhindered by a complex tax code designed for an 

entirely different type of economy. The major elements of these 

proposals have been discussed over the past several years with 

representatives of Guam, the CNMI, and American Samoa in general

terms. The governments of these possessions generally favor changes

to the current mirror systems that would free them from the frequent

(and often detrimental) revisions to the Internal Revenue Code. 

Rationalizing the tax provisions relating to the Virgin Islands 

would accomplish the following: (a) simplify the tax treatment of 

individuals moving between the Virgin Islands and the United States,

(b) rectify the inequitable treatment of U.S. individuals deriving

income from the Virgin Islands, (c) enhance the ability of the Virgin

Islands to attract foreign capital, and (d) eliminate known and 

unknown opportunities for avoidance and evasion of United States and 

Virgin Islands taxes through inappropriate but untested interpretations of the mirror system and the Revised Organic Act. 

- 431 -
APPENDIX A 

__EXPIRING PROVISIONS 

The following provisions of the Internal Revenue Code are 

scheduled to expire under current law: 

Administration Proposal 

1. Residential and business See Ch. 9.01 

energy tax credits. 

2. Targeted jobs credit. Allow to expi.re as 

scheduled. 

3. Expensing of expenditures to 

remove architectural barriers 

Allow to expire as 

scheduled. 

to the elderly and handicapped. 

4. Credit for testing orphan drugs. Allow to expire as 

scheduled. 

5. Special treatment for dividend 

reinvestment in public utility

stock. 

Allow to expire as 

scheduled. 

6. Exclusion of employer-provided

legal services. 

Make permanent, but 

require a qualified 

group legal services 

plan to require the 

irrevocable establishment of the employee's

annual contributions 

prior to the beginning

of the plan year. 

7. Exclusion of employer-provided

education assistance. 

Make permanent, and drop

the $5,000 annual limit 

of current law on the 

amount of educational 

assistance benefits that 

can be excluded. 

0. Exclusion of employer-provided

vanpooling. 

See Ch. 3.03. 

- 433 -

476-698 0 - 85 - 16 
APPENDIX B 

EFFECTIVE DATES AND TRANSITION RULES 

The Administration proposals are designed to provide for fair and 

orderly transition to a new tax system. In general, prompt

implementation of the proposals is desirable in order to capture their 

benefits as quickly as possible. Immediate implementation of some 

proposals, however, would be unfair and disruptive to taxpayers who 

have made economic commitments based on the current tax structure. 

Moreover, certain of the proposals would generate substantial windfall 

gains or losses if implemented immediately. These concerns mandate 

transition rules that reflect the differing effects of the various 

proposals. 

In those areas where immediate implementation of the proposals

would be unfair or disruptive, transition rules are provided to 

minimize unanticipated effects. These rules include delayed and 

phased in implementation of reform, as well as a wide variety of 

grandfather provisions that insulate existing investments. The 

proposed changes and transition rules for each element of the 

Administration proposals are summarized in Table 8-1. More complete

statements are found in each General Explanation. 

In general, consistent with Secretary of the Treasury James A. 

Baker, 111's February 27, 1985, testimony before the House Ways and 

Means Committee, no Administration proposal contains an effective date 

before January I, 1986. Even though not effective until 1986, many of 

the proposals would affect the tax treatment of investments 

contemplated before 1986. Thus, for example, the new rules for 

capital cost recovery and repeal of the investment tax credit are 

proposed to be effective for all property placed in service after 

1985, without regard to contractual commitments to acquire such 

property entered into before 1986. Xn recognition of the prerogative

of the congressional tax-writing committees to design appropriate

transition rules, grandfather rules were not specified in this and 

similar instances. Announcement of a binding contract exception

effective as of the date of announcement of the Administration 

proposals would have encroached on this congressional prerogative; 

announcement of a binding contract exception to take effect at a 

future date was considered inappropriate because it would tend to 

accelerate investments solely for tax reasons. 

With respect to life insurance inside build-up and the taxation of 

deferred annuity investment income, the Administration proposals

adopt the rule suggested in the March 15, 1985, statement by House 

Ways and Means Committee Chairman Dan Rostenkowski and Senate Finance 

Committee Chairman Bob Packwood. That is, such income would be taxed, 

- 435 -
beginning January 1, 1986, only on policies issued after the date of 

committee action. This rule again defers to the tax-writing

committees with respect to the termination date of the grandfather

period. 

The Treasury Department looks forward to working with the 

congressional committees to develop any additional transition rules 

that the committees determine are necessary to implement the 

Administration proposals in a fair and orderly manner. 

- 436 ~ 
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