General Explanations 

of the 

Adn___nistration's Revenue Proposals 

Department of the Treasury 

March 1996 

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Jcff TABLE OF CONTENTS 

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MIDDLE CLASS TA X RELIEF 

A. TAX CREDIT FOR DEPENDENT CHILDREN 1 

B. EDUCATION AND JOB TRAINING TAX DEDUCTION 3 

C. EXPANDED INDIVIDUAL RETIREMENT ACCOUNTS 6 

SMALL BUSINESS TAX RELIEF 

A. INCREASE IN SELF-EMPLOYED INDIVIDUALS' DEDUCTION FOR HEALTH 

INSURANCE COSTS 10 

B. INCREASED EXPENSING FOR SMALL BUSINESSES 12 

C. EXPANSION OF ESTATE TAX EXTENSION FOR CLOSELY HEL D BUSINESSES 14 

PENSION SIMPLIFICATION 

A. THE NEST ~ A SIMPLE RETIREMENT PLAN FOR SMALL BUSINESS 16 

B. OTHER PENSION SIMPLIFICATION MEASURES 24 

EXPAND EMPOWERMENT ZONES AND ENTERPRISE COMMUNITIES 52 

CURRENT DEDUCTION FOR CERTAIN ENVIRONMENTAL CLEANUP EXPENSES 54 

TAX RELIEF FOR CERTAIN ARMED FORCES PERSONNEL 56 

CORPORATE REFORMS AND OTHER REVENUE PROVISIONS 

A. PROVISIONS RELATING TO FINANCIAL PRODUCTS 

• Disallow interest deduction for corporate-owned life insurance polic

• Deny interest deduction on certain debt instruments 61 

• Defer deduction for accrued but unpaid interest on convertible debt 64 

• Reduce dividends-received deduction to fifty percent 66 

• Modify holding period for dividends-received deduction 67 

• Extend pro-rata disallowance of tax-exempt interest expense 

to all corporations 68 

• Require average cost-basis for securities 70 

• Require recognition of gain on certain appreciated positions in 

personal property 72 

• Eliminate the extinguishment doctrine 75 

• Require reasonable payment assumptions for interest accruals on 

certain debt instruments 76 
B. CORPORATE PROVISIONS 

• Require gain recognition for certain extraordinary dividends 78 

• Repeal percentage depletion for non-fuel minerals mined on Federal lands . 80 

• Modify net operating loss carry-back and carry-forward rules . 81 

• Treat certain preferred stock as "boot" 82 

• Repeal section 1374 for large corporations 84 

• Require gain recognition on certain distributions of controlled 

corporation stock 86 

• Reform the treatment of certain corporate stock transfers 88 

C. FOREIGN PROVISIONS 

• Deter expatriation tax avoidance 90 

• Reform the tax treatment of foreign trusts 91 

• Reformulate Puerto Rico and possessions tax credit 

(section 936) 93 

• Expand subpart F provisions regarding income from notional principal 

contracts and stock lending transactions 94 

• Provide rules regarding treatment of "captive" insurance arrangements ... 95 

• Reform foreign tax credit rules 98 

• Reform the treatment of foreign oil and gas income and 

dual-capacity taxpayers 100 

D. ACCOUNTING PROVISIONS 

• Require thrifts to account for bad debts in the same manner as banks . . . 102 

• Reform depreciation under the income forecast method 105 

• Phase out the preferential tax deferral for certain large farm corporations 

that are required to use accrual accounting 107 

• Repeal lower of cost or market inventory accounting method 108 

• Repeal components of cost inventory accounting method 109 

E. GAIN DEFERRAL PROVISIONS 

• Modify basis adjustment rules in certain involuntary conversions 110 

• Expand requirement that involuntarily converted property be 

replaced with property acquired from an unrelated person Ill 

• Further restrict like-land exchanges involving personal property 112 

• Deny rollover or exclusion of gain on sale of principal residence 

which is attributable to depreciation deductions 114 

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F. ADMINISTRATIVE PROVISIONS 

• Require registration of certain confidential corporate tax shelters 116 

• Require reporting of payments to corporations rendering 

services to federal agencies 117 

• Increase penalties for failure to file correct information returns 118 

• Extend disclosure of return information for administration of certain 

veterans' programs 119 

• Extend Internal Revenue Service user fees 120 

• Apply failure-to-pay penalty to substitute returns 121 

• Extend withholding to certain gambling winnings 122 

• Require tax reporting for payments to attorneys 123 

• Repeal advance refunds of diesel fuel tax for diesel cars and trucks .... 124 

• Permit disclosure of form 8300 information 125 

• Extend authority for undercover operations 126 

G. EXCISE AND EMPLOYMENT TAX PROVISIONS 

• Provide intermediate sanctions on amounts of private excess benefits . . . 127 

• Reimpose Superfund corporate environmental income tax 135 

• Reimpose Oil Spill Liability Trust Fund excise tax 136 

• Tax kerosene in the same manner as diesel fuel 137 

• Permanently extend the luxury passenger automobile tax 139 

• Extend the FUT A surcharge and require monthly deposits 140 

H. EITC REFORMS 

• Modifications to the Earned Income Tax Credit 142 

VIII. EXTENSIONS OF EXCISE TAXES PREVIOUSLY REFLECTED IN THE BASELINE 

A. REIMPOSE AIRPORT AND AIRWAY TRUST FUND EXCISE TAXES 147 

B. REIMPOSE LEAKING UNDERGROUND STORAGE TANK TRUST FUND TAX 148 

C. REIMPOSE SUPERFUND EXCISE TAXES 149 

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TAX CREDIT FOR DEPENDENT CHILDREN 

Current Law 

A tax exemption, in the form of a deduction, is allowed for each taxpayer and for 

each dependent of a taxpayer. A dependent includes a child of the taxpayer wh o is supported 

by the taxpayer and is under age 19 at the close of the calendar year or is a student under 

age 24. The deduction amount is $2,500 for tax year 1995. This amount is indexed 

annually for inflation. 

In addition to an exemption for each child, three other tax benefits may accrue to 

taxpayers with dependent or otherwise qualifying children: 

• the credit for child and dependent care expenses, 

• the exclusion for employer-provided child and dependent care benefits, and 

• the earned income tax credit (EITC). 

The EITC is a refundable tax credit based on the earnings of the taxpayer. The EITC 

is restricted to lower-income taxpayers and is phased out when earnings exceed specified 

levels. Although the EIT C is available for taxpayers without dependents or otherwise 

qualifying children, the credit rate and income range of the credit are far greater when the 

taxpayer has one or more qualifying children. In addition, the rate and income range are 

higher for taxpayers with two or more qualifying children than for taxpayers with only one 

qualifying child. 

Reasons for Change 

Tax relief for middle-class families has been and continues to be an important goal of 

this Administration. In 1993, the Administration faced a projection of ever-increasing 

deficits. Bringing the deficit under control and providing tax relief for low-income workers 

through an expansion of the EITC were the first priorities. Having achieved more favorable 

than projected results from the deficit reduction program introduced in 1993; the 

Administration can no w turn to providing tax relief to middle-income families. 

Tax relief to taxpayers with children is needed to adjust the relative tax burdens of 

smaller and larger families to reflect more accurately their relative abilities to pay taxes. 

Available resources should be targeted to those in greatest need and at greatest risk. 

Proposal 

A nonrefundable tax credit would be allowed for each dependent child under age 13. 

It would be phased in, at $300 per child for tax years 1996, 1997, and 1998, and $500 per 

child for 1999 and thereafter. The credit would not reduce any alternative minimum tax 

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liability. The credit would be phased out for taxpayers with adjusted gross income between 

$60,000 and $75,000. Beginning in the year 2000, both the amount of the credit and the 

phase-out range would be indexed for the effects of inflation. The EIT C would be applied 

after the dependent child credit. 

Taxpayers claiming the dependent child credit would be required to provide valid 

taxpayer identification numbers for themselves, their spouses, and their children wh o qualify 

for the credit. The procedures that would apply for determining the validity of taxpayer 

identification numbers under a separate proposal regarding the EIT C (discussed below) would 

apply for purposes of the dependent child credit. This proposal is similar to a provision 

contained in the Revenue Reconciliation Act of 1995 as passed by Congress. 

To ensure that the budget reaches balance in 2002, the child credit would be allowed 

to sunset on January 1, 2001, if the fiscal dividend for the year 2000 is not at least $20 

billion. 

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EDUCATION AND JOB TRAINING TAX DEDUCTION 

Current Law 

Taxpayers generally may not deduct the expenses of higher education and training. 

There are, however, special circumstances in which deductions for educational expenses are 

allowed, or in which the payment of educational expenses by others is excluded from 

income. 

Educational expenses may be deductible, but, in the case of an employee, only if the 

taxpayer itemizes, and only to the extent that the expenses, along with other miscellaneous 

itemized deductions, exceed two percent of adjusted gross income (AGI). A deduction for 

educational purposes is allowed only if the education maintains or improves a skill required 

in the individual's employment or other trade or business, or is required by the individual's 

employer, or by law or regulation for the individual to retain his or her current job. 

The interest from qualified U.S. savings bonds is excluded from a taxpayer's gross 

income to the extent the interest is used to pay qualified educational expenses. T o be 

qualified, the savings bonds must be purchased after December 31, 1989 by a person wh o 

has attained age 24. Qualified educational expenses consist of tuition and fees for enrollment 

of the taxpayer, the taxpayer's spouse, or the taxpayer's dependent at a public or non-profit 

institution of higher education, including two-year colleges and vocational schools. The 

interest exclusion is phased out for taxpayers with higher incomes. 

Reasons for Change 

Deductions for educational expenses combine needed tax relief with preparation for 

n ew economic imperatives. The expenses of higher education place a significant burden on 

many middle-class families. Grants and subsidized loans are available to students from 

lower-income families; high-income families can afford the costs of higher education. 

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

and facing global competition. The Administration believes that reducing the after-tax cost 

of education for individuals and families encourages investment in education and training 

while lowering tax burdens for middle-income taxpayers. 

Proposal 

A taxpayer would be allowed to deduct qualified educational expenses paid during the 

taxable year for the education or training of the taxpayer, the taxpayer's spouse, or the 

taxpayer's dependent. The deduction would be allowed in determining AGI . Therefore, 

taxpayers could claim the deduction even if they do not itemize and even if they do not meet 

the two-percent of AG I floor on itemized deductions. 

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Qualified educational expenses would be defined as tuition and fees charged by 

educational institutions that are directly related to an eligible student's course of study (e.g., 

registration fees, laboratory fees, and extra charges for particular courses). Charges and 

expenses associated with meals, lodging, books, student activities, athletics, health care, 

transportation, and similar personal, living or family expenses would not be included. The 

expenses of education involving sports, games, or hobbies would not be qualified educational 

expenses unless the education is required as part of a degree program or related to the 

student's current profession. 

Qualified educational expenses would be deductible in the year the expenses are paid, 

subject to the requirement that the education commence or continue during that year or 

during the first three months of the next year. Qualified educational expenses paid with the 

proceeds of a loan generally would be deductible (rather than repayment of the loan itself). 

Normal tax benefit rules would apply to refunds (and reimbursements through insurance) of 

previously deducted tuition and fees. 

In 1996, 1997, and 1998, the maximum deduction would be $5,000. In 1999 and 

thereafter, this maximu m would increase to $10,000. The deduction would be phased out 

ratably for taxpayers with modified AG I between $70,000 and $90,000 ($100,000 and 

$120,000 for joint returns). Modified AG I would include taxable Social Security benefits 

and amounts otherwise excluded with respect to income earned abroad (or income from 

Puerto Rico or U.S. possessions). Beginning in 2000, the income phase-out range would be 

indexed for inflation. 

Any amount taken into account as a qualified educational expense would be reduced 

by educational assistance or any other payment made on the student's behalf that is not 

required to be included in the gross income of either the student or the taxpayer claiming the 

deduction. Thus, qualified educational expenses would be reduced by scholarship or 

fellowship grants excludable from gross income under section 117 of the Internal Revenue 

Code (even if the grants are used to pay expenses other than qualified educational expenses) 

and any educational assistance received as veterans' benefits. However, no reduction would 

be required for a gift, bequest, devise or inheritance within the meaning of section 102(a). 

An eligible student would be one who is enrolled or accepted for enrollment in a 

degree, certificate, or other program (including a program of study abroad approved for 

credit by the institution at which such student is enrolled) leading to a recognized educational 

credential at an eligible institution. The student must pursue a course of study on at least a 

half-time basis unless the student is enrolled in a course that enables the student to improve 

or acquire job skills. The student ma y not be enrolled in an elementary or secondary school, 

and cannot be a nonresident alien. 

An eligible institution generally would be an accredited postsecondary educational 

institution offering credit toward a bachelor's degree, associate's degree or other recognized 

postsecondary credential. It could also be a proprietary institution or postsecondary 

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vocational institution. The institution must have entered into an agreement with the 

Department of Education to participate in the student loan program. 

This proposal would not affect deductions claimed under any other section of the 

Code, except that any amount deducted under another section of the Code could not also be 

deducted under this provision. A n eligible student would not be eligible to claim a deduction 

under this provision if that student could be claimed as a dependent of another taxpayer. 

The proposal would be effective for taxable years beginning after 1995. To ensure 

that the budget reaches balance in 2002, the educational expense deduction would be allowed 

to sunset on January 1, 2001, if the fiscal dividend for the year 2000 is not at least $20 

billion. 

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EXPANDED INDIVIDUAL RETIREMENT ACCOUNTS 

Current Law 

Under current law, an individual may make deductible contributions to an individual 

retirement account or individual retirement annuity (IRA) up to the lesser of $2,000 or 

compensation (wages and self-employment income). (The dollar limit is $2,250 if the 

individual's spouse has no compensation.) If the individual (or the individual's spouse) is an 

active participant in an employer-sponsored retirement plan, the $2,000 limit on deductible 

contributions is phased out for couples filing a joint return with adjusted gross income (AGI) 

between $40,000 and $50,000, and for single taxpayers with AG I between $25,000 and 

$35,000. T o the extent that an individual is not eligible for deductible IR A contributions, he 

or she ma y make nondeductible IRA contributions (up to the contribution limit). 

The earnings on IRA account balances are not includable in gross income until they 

are withdrawn. Withdrawals from an IRA (other than withdrawals of nondeductible 

contributions) are includable in income, and must begin by age 701/2. Amounts withdrawn 

before age 59V6 are generally subject to an additional 10-percent tax. This 10-percent early 

withdrawal tax does not apply to distributions upon the death or disability of the taxpayer or 

to substantially equal periodic payments over the life (or life expectancy) of the IRA owner 

or over the joint lives (or life expectancies) of the IRA owner and his or her beneficiary. In 

general, an excess distribution tax of 15 percent applies to the extent that an individual 

receives an aggregate amount of retirement distributions in excess of $155,000 in any year. 

Reasons for Change 

The Administration believes that individuals should be encouraged to save, both in 

order to provide for long-term needs, such as retirement and education, and in order to 

sustain a sufficient level of private investment to continue the healthy growth of the 

economy. Targeted tax policies can provide an important incentive for savings. Under 

current law, however, savings incentives in the form of deductible IRAs are not available to 

all middle-income taxpayers. Furthermore, the present-law income thresholds for deductible 

IRAs and the maximu m contribution amount are not indexed for inflation, so that fewer 

Americans are eligible to make a deductible IRA contribution each year, and the amount of 

the maximu m contribution is declining in real terms over time. The Administration also 

believes that providing taxpayers with the option of making IRA contributions that are 

nondeductible but can be withdrawn tax free will provide an alternative savings vehicle that 

some middle-income taxpayers may find more suitable for their savings needs. 

Individuals save for many purposes besides retirement. Broadening the tax incentives 

for non-retirement saving can help increase the nation's savings rate. IRAs that are flexible 

enough to meet a variety of essential savings needs, such as first-time hom e purchases, 

higher education expenditures, unemployment, and catastrophic medical and nursing hom e 

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expenses, should prove to be more attractive to many taxpayers than accounts that are limited 

to retirement savings. 

Proposal 

Expand Deductible IRAs 

Under the proposal, the income thresholds and phase-out ranges for deductible IRAs 

would be doubled, in two stages. Beginning in 1996, eligibility would be phased out for 

couples filing joint returns with AG I between $70,000 and $90,000 and for single individuals 

with AG I between $45,000 and $65,000. Beginning in 1999, eligibility would be phased out 

for couples filing joint returns with AG I between $80,000 and $100,000 and for single 

individuals with AG I between $50,000 and $70,000. The income thresholds and the presentlaw annual contribution limit of $2,000 would be indexed for inflation. A s under current 

law, any individual wh o is not an active participant in an employer-sponsored plan and 

whose spouse is also not an active participant would be eligible for deductible IRAs 

regardless of income. 

Under the proposal, the IRA contribution limit would be coordinated with the currentlaw limits on elective deferrals under qualified cash or deferred arrangements (section 401(k) 

plans), tax-sheltered annuities (section 403(b) annuities), and similar plans. The proposal 

also would provide that the current-law exclusion from the 10-percent early withdrawal tax 

for IRA withdrawals after an individual reaches age 59 V_. does not apply in the case of 

amounts attributable to contributions (excluding rollovers from tax-qualified plans or taxsheltered annuities) made during the previous five years. 

Special IRAs 

Each individual eligible for a traditional deductible IRA would have the option of contributing an amount up to the contribution limit either to a deductible IRA or to a new "Special IRA." Contributions to this Special IRA would not be tax deductible, but distributions 

of the contributions would be tax-free. If the contributions remained in the account for at 

least five years, distributions of the earnings on the contributions also would be tax-free. 

Withdrawals of earnings from Special IRAs during the five-year period after contribution 

would be subject to ordinary income tax. In addition, such withdrawals would be subject to 

the 10-percent early withdrawal tax unless used for one of the four purposes described 

below. 

The proposal would permit individuals whose AGI for a taxable year does not exceed 

the upper end of the new income eligibility limits ($100,000 for couples filing joint returns 

and $70,000 for single individuals) to convert balances in deductible IRAs into Special IRAs 

without being subject to the early withdrawal tax. The amount converted from the deductible 

I R A to the Special IR A generally would be includable in the individual's income in the year 

of the conversion. However, if a conversion was made before January 1, 1998, the 

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converted amount included in the individual's income (and taken into account in applying the 

15-percent excess distribution tax) would be spread evenly over four taxable years. 

Distributions Not Subject to Early Withdrawal Tax 

Amounts withdrawn from deductible IRAs and Special IRAs within the five-year 

period after contribution would not be subject to the early withdrawal tax, if the taxpayer 

used the amounts to pay post-secondary education costs, to buy or build a first home, to 

cover living costs if unemployed, or to pay catastrophic medical expenses (including certain 

nursing hom e costs). 

Education expenses. The early withdrawal tax would not apply to the extent the 

amount withdrawn is used to pay qualified higher education expenses of the taxpayer, the 

taxpayer's spouse, the taxpayer's dependent, or the taxpayer's child or grandchild (even if 

not a dependent). In general, a withdrawal for qualified higher education expenses would be 

subject to the same requirements as the deduction for qualified educational expenses (e.g., 

the expenses are tuition and fees that are charged by educational institutions and are directly 

related to an eligible student's course of study). 

In addition, to further assist taxpayers who are saving to pay these qualified higher 

education expenses, deductible IRAs and Special IRAs would be expressly permitted to invest 

in qualified State prepaid tuition program instruments to the extent provided by the Secretary. 

In general, a qualified State prepaid tuition program instrument is one issued under a 

program established or maintained by a State, that can be converted into a percentage of 

tuition expenses for an individual if the funds are used to pay tuition expenses, or can be 

redeemed for an amount not less than the purchase price (less any reasonable administrative 

fees), if the funds are not used for education. T o the extent a qualified instrument held by an 

I RA is converted into tuition and fees, the IRA owner will be treated as having received a 

distribution from the IR A to pay qualified higher education expenses. N o inference is 

intended as to the tax treatment of prepaid tuition programs under current law or for other 

purposes of the Code. 

First-time home purchasers. The early withdrawal tax would not apply to the extent 

the amount withdrawn is used to pay qualified acquisition, construction, or reconstruction 

costs with respect to a principal residence of a first-time hom e buyer wh o is the taxpayer, the 

taxpayer's spouse, or the taxpayer's child or grandchild. 

Unemployment. Withdrawals would not be subject to the early withdrawal tax if (1) 

the individual has separated from employment, (2) the individual has received unemployment 

compensation for 12 consecutive weeks, and (3) the withdrawal is made during the taxable 

year in which the unemployment compensation is received or the succeeding taxable year. 

Medical care expenses and nursing home costs. The proposal would extend to IRAs 

the present-law exception to the early withdrawal tax for distributions from qualified plans 

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and tax-sheltered annuities for certain medical care expenses (deductible medical expenses 

that are subject to a floor of 7.5 percent of AGI ) and would expand the exception for IRAs to 

allow withdrawal for medical care expenses (in excess of 7.5 percent of AGI ) of the 

taxpayer's child, grandchild, parent or grandparent, whether or not that person otherwise 

qualifies as the taxpayer's dependent. 

In addition, for purposes of the exclusion from the early withdrawal tax for 

distributions from IRAs, the definition of medical care would include expenses for qualified 

long-term care services for incapacitated individuals. 

The proposal would be effective January 1, 1996. To ensure that the budget reaches 

balance in 2002, the proposal would be allowed to sunset on January 1, 2001, if the fiscal 

dividend for the year 2000 is not at least $20 billion. 

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INCREASE IN SELF-EMPLOYED INDIVIDUALS' 

DEDUCTION FOR HEALTH INSURANCE COSTS 

Current Law 

Under present law, the tax treatment of health insurance expenses depends on whether 

the taxpayer is an employee and whether the taxpayer is covered under a health plan paid for 

by his or her employer. A n employer's contribution to a plan providing accident or health 

coverage for the employee (and the employee's spouse and dependents) is excludable from an 

employee's income. The exclusion is generally available for owners of a business wh o are 

also employees. 

In the case of self-employed individuals (i.e., sole proprietors or partners in a 

partnership), a deduction is allowed for 30 percent of the amount paid for health insurance 

for the self-employed individual and the individual's spouse and dependents. The 30-percent 

deduction is not available for any month in which the taxpayer is eligible to participate in a 

subsidized health plan maintained by the employer of the taxpayer or the taxpayer's spouse. 

T he amount of the deduction may not exceed the taxpayer's earned income, although health 

insurance payments in excess of the deductible amount can be taken into account in 

determining whether the individual is entitled to an itemized deduction for medical expenses. 

For purposes of these rules, more than 2-percent shareholders of S corporations are 

treated the same as self-employed individuals. 

Other individuals who purchase their own health insurance (e.g., an individual whose 

employer does not provide health insurance) can deduct their insurance premiums only to the 

extent that the premiums, when combined with other unreimbursed medical expenses, exceed 

7.5 percent of adjusted gross income. 

Reasons for Change 

The deduction for health insurance costs of self-employed individuals should be 

increased to provide greater equity between employees and self-employed individuals and to 

encourage broader health care coverage. 

Proposal 

The percentage of a self-employed individual's deduction would increase to 35 percent 

for 1996 and 1997, 40 percent for 1998, 45 percent for 1999, and 50 percent for 2000 and 

thereafter. This proposal is similar to a provision contained in the Revenue Reconciliation 

Act of 1995 as passed by Congress. 

To ensure that the budget reaches balance in 2002, the deductible percentage would 

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be allowed to revert to 30 percent after 2000 if the fiscal dividend for the year 2000 is not at 

least $20 billion. 

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INCREASED EXPENSING FOR SMALL BUSINESSES 

Current Law 

In lieu of depreciation, a taxpayer with a sufficiently small amount of annual 

investment may elect under section 179 to deduct up to $17,500 of the cost of qualifying 

property placed in service for the taxable year. In general, qualifying property is defined as 

depreciable tangible property that is purchased for use in the active conduct of a trade or 

business. The $17,500 amount is reduced (but not below zero) by the amount by which the 

cost of qualifying property placed in service during the taxable year exceeds $200,000. In 

addition, the amount eligible to be expensed for a taxable year may not exceed the taxable 

income of the taxpayer for the year that is derived from the active conduct of a trade or 

business (determined without regard to this provision). Any amount that is not allowed as a 

deduction because of the taxable income limitation may be carried forward to succeeding 

taxable years (subject to similar limitations). 

Reasons for Change 

Increasing the maximum investment that may be expensed for small businesses would 

provide an incentive for small businesses to increase their investment in capital assets. In 

addition, the proposal would simplify tax reporting for eligible small businesses. 

Proposal 

The proposal would increase the amount allowed to be expensed under Code section 

179 from $17,500 to $25,000. The increase would be phased in as follows: 

Taxable year Maximum expensing 

1996 19,000 

1997 20,000 

1998 21,000 

1999 22,000 

2000 23,000 

2001 24,000 

2002 and thereafter 25,000 

This proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

The provision is effective for property placed in service in taxable years beginning 

after December 31, 1995. To ensure that the budget reaches balance in 2002, the expensing 

level would be allowed to revert to $17,500 for property placed in service in taxable years 

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beginning after December 31, 2000, if the fiscal dividend for the year 2000 is not at least 

$20 billion. 

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EXPANSION OF ESTATE TAX EXTENSION 

PROVISIONS FOR CLOSELY HELD BUSINESSES 

Current Law 

Estate tax attributable to certain interests in closely held businesses may be paid in 

installments over up to 14 years (interest only for four years followed by up to ten annual 

installments of principal and interest). A special four-percent interest rate is provided for the 

tax deferred on the first $1 million of value. The regular IRS rate on tax underpayments 

applies to values over $1 million. A n estate is eligible for the installment payment provision 

if the value of the business interest included in the estate equals at least 35 percent of the 

value of the adjusted gross estate. Eligible business interests include those operated as 

proprietorships, partnerships or corporations, but partnerships and corporations qualify only 

if they have 15 or fewer owners, or the estate owns 20 percent or more of the value of the 

entity. 

In general, an executor can only take advantage of the installment payment provision 

if the entity is owned directly by the estate operates a trade or business. Under a special rule 

added in 1984, an executor can elect to look through certain non-publicly traded holding 

companies to determine whether an estate includes an interest in an active business eligible 

for the installment treatment, but if the election is made, neither the five-year deferral nor 

the four percent interest rate applies. 

A special estate tax lien applies to property on which the tax is deferred during the 

installment payment period. Interest paid on the deferred estate tax is allowed as a deduction 

against either the estate tax or the estate's income tax obligation. Claiming the estate tax 

deduction requires an annual filing of a supplemental estate tax return which is complicated 

due to iterative computations. 

Reasons for Change 

The installment payment provisions need to be expanded in order to better address the 

liquidity problems of estates holding farms and closely held businesses. The $1 million cap 

on the four percent interest rate has been in effect since 1976. A n increase is necessary in 

order to adjust for inflation. Furthermore, the annual computations involved in claiming an 

estate tax deduction for interest paid are complex and result in numerous disputes. 

The holding company rule should be expanded to include partnerships so that the 

choice of entity does not affect the availability of the installment payment plan. 

Furthermore, the estate should not be forced to forego the benefits of the five-year deferral 

and lower interest rate simply because of the structure of the business entity. 

Some businesses find it difficult to obtain the credit needed for day-to-day operations 

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when business property is subject to an IRS tax lien. 

Proposal 

The proposal would increase the cap on the special low interest rate so that it applies 

to the tax deferred on the first $2.5 million of value of the closely held business. The 4 

percent rate would be reduced to 2 percent, and the rate on values over $2.5 million would 

be reduced to 45 percent of the usual IRS rate on tax underpayments. The interest paid on 

deferred estate tax would not be deductible for estate or income tax purposes. 

The proposal also would expand the availability and benefits of the holding company 

exception to include partnerships that function as holding companies. In addition, an estate 

using the holding company exception (as modified by this proposal) would also be able to 

take advantage of the five-year deferral and the 2 percent interest rate, thus providing the 

same relief to closely held businesses whether owned directly or through holding companies. 

Finally, the non-readily-tradable stock requirement under the holding company rule would be 

clarified and expanded to include publicly traded partnerships. 

The proposal would authorize the Secretary to accept security arrangements in lieu of 

the special estate tax lien. 

The proposal would be effective for decedents dying after December 31, 1996. 

However, estates deferring estate tax under current law may make a one-time election to use 

lower interest rates and forego the interest deduction. 

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THE NEST - A SIMPLE RETIREMENT PLAN FOR SMALL BUSINESS 

Current Law 

Under current law, an individual may make deductible contributions to an individual 

retirement account or individual retirement annuity (TRA) up to the lesser of $2,000 or 

compensation (wages and self-employment income). (The dollar limit is $2,250 if the 

individual's spouse has no compensation.) If the individual (or the individual's spouse) is an 

active participant in an employer-sponsored retirement plan, the $2,000 limit on deductible 

contributions is phased out for couples filing a joint return with adjusted gross income (AGI) 

between $40,000 and $50,000, and for single taxpayers with AG I between $25,000 and 

$35,000. T o the extent that an individual is not eligible for deductible IR A contributions, he 

or she may make nondeductible IRA contributions (up to the contribution limit). 

The earnings on IRA account balances are not included in income until they are 

withdrawn. Withdrawals from an IRA (other than withdrawals of nondeductible 

contributions) are includible in income, and must begin by age 70 1/2. Amounts withdrawn 

before age 59 1/2 are generally subject to an additional 10 percent tax. The additional tax 

does not apply to distributions upon the death or disability of the taxpayer or to substantially 

equal periodic payments over the life (or life expectancy) of the IR A owner or over the joint 

lives (or life expectancies) of the IRA owner and his or her beneficiary. 

Simplified employee pensions (SEPs) and, for employers with 25 or fewer employees, 

salary reduction SEPs (SARSEPs), are employer-sponsored plans under which employer 

contributions and, in the case of SARSEPs, employee-elected salary reduction contributions 

are made to IRAs established by employees. A n employer that adopts a SE P must contribute 

to the SE P for every employee wh o has attained age 21, has worked for the employer during 

at least three of the immediately preceding five years, and is paid at least $400 (for 1996, as 

adjusted for cost of living) by the employer for the year. Thus, for example, an employer 

would have to make a SEP contribution for an employee wh o worked for the employer one 

hour per year in the preceding three years and worked 40 hours (and earned $400) in the 

current year, if the employer was making contributions for any other employee for the year. 

SEPs do not allow employees to make elective contributions through salary reduction. 

SARSEPs allow employees to make elective contributions, but cannot provide for 

employer matching contributions. SARSEP s are available only to for-profit employers that 

had 25 or fewer employees at all times during the preceding year. In addition, special 

eligibility and nondiscrimination rules apply to SARSEPs. If at least 50 percent of the 

eligible employees do not choose to make elective contributions to a SARSE P in a year, then 

no employee can make elective contributions. A n employer with 25 or fewer employees may 

fall below the 50 percent threshold (and out of SARSE P eligibility) from year to year. 

SARSEPs are subject to the top-heavy rules. A SARSEP is considered top-heavy if 

-16-
the aggregate accounts of key employees in the plan exceed 60 percent of the aggregate 

accounts of all employees in the plan. If a SARSE P is top-heavy and any key employee of 

the employer makes elective contributions of at least 3 percent of pay, then the employer 

must make minimum contributions of 3 percent of pay for all non-key employees - even if 

those non-key employees also make elective contributions of 3 percent of pay. 

Reasons for Change 

The tax-favored employer retirement plans currently available under the Internal 

Revenue Code have not been sufficiently successful in attracting small employers. In 1993, 

for example, only 24 percent of full-time workers in private firms with fewer than 100 

employees were covered by employer retirement plans. In contrast, 73 percent of full-time 

workers in firms with 1,000 or more workers were covered. 

The administrative cost and complexity associated with traditional qualified retirement 

plans often discourage small employers from sponsoring these plans. For employers with 

few employees, the cost of maintaining the plan may be large relative to the benefits 

provided to employees. A s a result, pension coverage of employees of small employers is 

significantly lower than the pension coverage of employees of larger employers. 

SEPs and SARSEPs, which were designed for small employers, are perceived by 

many employers as overly complicated and impractical. The nondiscrimination and 

eligibility rules applicable to SARSEP s make it difficult for an eligible employer to maintain 

a SARSE P on an ongoing basis. A n eligible employer cannot encourage employees to make 

elective contributions through the incentive of offering to match employee contributions 

dollar-for-dollar or otherwise. 

The inability to offer matching contributions makes it difficult for the employer to 

satisfy the SARSE P nondiscrimination test. Under this test, elective contributions for any 

highly compensated employee are limited to 125 percent of the average elective contributions 

for all nonhighly compensated employees for the year. Thus, highly compensated employees 

are limited to very low levels of elective contributions unless other employees make 

significant elective contributions ~ which they are less likely to make without the incentive 

of a matching contribution. Concerns have also been raised that, where SEPs and SARSEP s 

are used, there ma y be significant noncompliance with the statutory requirements. 

Proposal 

The proposal would allow employers with 100 or fewer employees to adopt a new 

simple retirement plan. The new plan would be known as the National Employee Savings 

Trust, or "NEST." 

The NEST would operate through individual IRA accounts for employees, and would 

incorporate design-based nondiscrimination safe harbors similar to those the Administration is 

-17-
proposing for 401 (k) plans. Like other IRA accounts, investment in NES T accounts would 

be directed by each employee. By eliminating or greatly simplifying many of the rules that 

apply to other qualified retirement plans, including 401(k) plans, the NES T would remove 

major obstacles that deter many small employers from setting up retirement plans. The 

current SE P and SARSE P rules would not be eliminated or modified, but would remain in 

place. 

Funding Through IRAs 

Use of IRAs as the funding vehicle. All employee and employer contributions to 

NEST s would be made to IRAs, and the IRA rules would govern except where otherwise 

specified. 

Initial use of specific financial institution. In order to simplify plan administration for 

employers, an employer could require that all of its participating employees use a designated 

financial institution's IRAs as the recipient of NES T contributions — but only if participants 

were notified in writing that a participant could move his or her account balance (in a 

trustee-to-trustee transfer) without charge to another IRA at any time. This notification could 

be incorporated into the annual disclosure to employees regarding the NES T (described 

below) or could be provided separately. 

Employer Eligibility 

100-employee limit. Any employer, including a tax-exempt organization or 

governmental entity, would be eligible to make a NES T program available to its employees 

in a given year if the employer had no more than 100 employees in the prior year. For this 

purpose, employees would be counted only if they had at least $5,000 of compensation (as 

reported on Form W-2 ) from the employer. The "employer" would be determined on a 

"controlled group" basis (i.e., aggregating 80 percent affiliates). 

Two-year grace period. If an eligible employer established a NEST program and, 

subsequently, the number of employees grew to exceed 100 (based on the prior year's 

employment), the employer would continue to be eligible to provide a NES T for the current 

and subsequent year. After that two-year "grace period," the employer would cease to be 

eligible unless the employee count again dropped to 100 or fewer (based on the prior year's 

employment). If an eligible employer ceased to meet the 100-employee test because of an 

acquisition, disposition or similar transaction, the NES T program could continue only if no 

significant changes in coverage occurred. 

Employee Eligibility to Participate and Vesting 

Two-year eligibility. Each employee who attained age 21 and completed two 

consecutive years of service with the employer generally would be eligible to participate in 

the NEST . A "year of service" would be defined as a calendar year during which an 

-18-
employee's W- 2 compensation from the employer was at least $5,000. A n employer could 

choose to allow all employees to participate earlier than upon attainment of age 21 and 

completion of two years of service. Nonresident aliens and employees covered under a 

collective bargaining agreement would not have to be eligible to participate in a NEST . 

Participating employees who drop below the $5.000 threshold or whose employment 

terminates mid-year. Once an employee became eligible, the employee would be entitled to 

make elective contributions and receive any employer matching contributions for a year 

without regard to the employee's compensation during the year. All eligible employees with 

at least $5,000 of compensation from the employer for the year would receive a nonelective 

employer contribution for that year. However, no nonelective employer contributions would 

be required for eligible employees with less than $5,000 of compensation for the year, unless 

the employer chose a lower compensation threshold for all eligible employees. 

Portability/100 percent vesting. All contributions would be 100 percent vested 

immediately and would be fully portable, even during the two-year holding period (described 

below). 

No Nondiscrimination Testing 

Nondiscrimination tests not applicable. NESTs would not be subject to: 

• the top-heavy rules; 

• the nondiscrimination rules that apply to elective contributions under a 

401(k) plan (the "ADP " test); 

• the nondiscrimination rules that apply to matching contributions (the 

"ACP " test); or 

• the nondiscrimination rules that apply to SEPs and SARSEPs. (Thus, 

for example there would be no 50 percent participation requirement, 

and no 125 percent test.) 

HCE determinations irrelevant. Because NESTs would not be subject to any 

nondiscrimination tests, an employer that offers a NES T would not be required to determine 

which employees are "highly compensated employees." 

Contributions 

NESTs would receive nonelective employer contributions and, depending on the 

option selected by the employer, elective contributions and employer matching contributions. 

Design-based safe harbors. In lieu of top-heavy and nondiscrimination rules, every 

-19-
NES T would be required to choose annually to satisfy one of the following two design-based 

safe harbors (generally similar to the Administration's proposed 401(k) safe harbors): 

(1) The employer makes a nonelective contribution of at least 3 percent of compensation1 

for each eligible employee. The employer may choose to allow employee elective 

contributions in addition to the employer nonelective contributions (an employer wh o 

wants to combine nonelective contributions with matching contributions ma y use the 

second safe harbor.) 

(2) The employer makes a nonelective contribution of at least 1 percent of compensation 

for each eligible employee and allows employee elective contributions. The employer 

must provide a 100 percent matching contribution on the employee's elective 

contributions up to 3 percent of compensation and a matching contribution of at least 

50 percent (and no greater than 100 percent) on the next 2 percent of employees' 

elective contributions. The employer may not provide any other matching formula, 

including a more generous formula. Although this safe harbor would require a 1 

percent nonelective employer contribution, the top-heavy rules would not apply, as 

noted above. This means that those employers that otherwise would have been 

required to make a 3 percent top-heavy minimum contribution for each non-key 

employee would have to make only a 1 percent nonelective contribution. In addition, 

employers that offer a NES T would be relieved of the requirement to test the NES T 

for top-heavy status. 

Employee elective contributions. The limit on an employee's annual elective 

contributions (i.e., salary reduction contributions) to a NES T would be $5,000. (Elective 

contributions to 401(k) plans are currently limited to $9,500.) The NES T limit would remain 

at $5,000 until the section 402(g) limit exceeded $10,000; then, the NES T limit would be 

indexed to (and remain at) one half of the section 402(g) limit for each year. 

Nonelective employer contributions. A NEST could provide for discretionary 

nonelective employer contributions in excess of the safe harbor minimums (1 percent or 3 

percent) from year to year. An y such nonelective employer contributions in excess of the 1 

percent or 3 percent minimums would have to be an equal percentage of compensation for all 

eligible employees. Total nonelective contributions (both the safe harbor minimums and 

discretionary contributions) could not exceed 5 percent of compensation. 

Section 404 deduction limit not applicable. The employer would be permitted to 

1 The $150,000 compensation limit that applies for purposes of the deduction and 

contribution limits for qualified plans, SEPs, and SARSEP s would apply for purposes of 

determining NES T contributions. However, for purposes of the NEST , a simplified 

definition of compensation would apply ~ compensation would be determined before elective 

contributions were subtracted from compensation. 

-20-
deduct the elective, matching, and nonelective contributions described above (within the 

contribution limits described) without regard to any separate percent-of-compensation 

limitation (i.e., there would be no limit comparable to that imposed by section 404(a)(3)). 

Timing of Contributions 

Elective contributions. Employee elective contributions would be required to be 

deposited in employees' accounts by the time required under Title I of ERIS A for elective 

contributions to a 401 (k) plan. 

Quarterly employer contributions. Employer matching contributions would be 

required to be deposited in employees' accounts (IRAs) no less frequently than quarterly. 

Employer nonelective contributions would also be required to be deposited no less frequently 

than quarterly ~ but only for employees wh o as of the end of the quarter were paid at least 

$5,000 (or any lower threshold adopted by the employer) for that calendar year. If an 

employee did not reach the threshold until the second, third, or fourth calendar quarter, the 

employer would be required, after the threshold had been reached, to make nonelective 

contributions for both the current and all preceding calendar quarters in the year. 

Contributions for any calendar quarter would be required to be deposited within 45 days after 

the end of that quarter. 

Distributions 

Two-year holding period. NEST contributions (and attributable earnings) would be 

subject to a two-year holding period beginning on the first day of the calendar year for which 

the contribution was made. This two-year restriction on withdrawals would apply whether or 

not the participant had incurred a termination of employment. 

Otherwise, distributions from NEST IRAs would be subject to the same rules as 

distributions from IRAs generally (as distinguished from 401(k) or other qualified plans) ~ 

no other restrictions would be imposed. The additional 10 percent tax on premature 

distributions would apply to distributions before age 59 1/2. During the two-year holding 

period, contributions and earnings could be rolled over to another IRA — but the original 

two-year holding period would continue to apply to the rolled-over amounts in the recipient 

IRA. 

Rollovers. NESTs could originate and receive transfers from other IRAs (whether 

NESTs , SEPs, SARSEPs , or other IRAs). NEST s could also receive rollovers from 

qualified plans. All movement of NES T funds to other IRAs, whether or not during the twoyear holding period, would be required to be carried out in the form of a trustee-to-trustee 

transfer. An y amounts rolled over or transferred to a NES T would not be subject to the twoyear holding period unless they were amounts transferred from a NES T for which the twoyear holding period had not yet elapsed. 

-21-
Miscellaneous 

SEPs and other plans permitted. A n employer that maintains a NES T could also 

maintain tax-qualified plans or SEPs, other than a plan that allows for elective contributions 

or matching contributions. For example, if the employer maintained a 401(k), salary 

reduction or matching 403(b), or SARSE P plan, and wished to establish a NEST , it would 

have to freeze (but not terminate) the 401(k), 403(b), or SARSE P plan. 

If an employer did maintain another plan, compliance of the NEST with the NEST 

requirements would be determined without regard to the other plan. The other plan would 

have to take the NES T into account only for purposes of the section 404 deduction limits and 

the section 415 contribution and benefits limitations. For example, the top-heavy rules and 

nondiscrimination rules would apply to the other plan without regard to the NEST . 

In the case of an employee who works for two employers, one of which sponsors a 

NES T and the other of which sponsors a 401(k), 403(b), or SARSE P plan, the section 402(g) 

elective deferral limit for that employee would be coordinated. Elective contributions to the 

NES T would have to be taken into account in determining whether the $9,500 limit had been 

exceeded under the other plan, but any elective contributions made to the other plan would 

not be taken into account in determining whether the $5,000 NES T limit had been exceeded. 

Coordination with IRA deduction rules. NESTs would be treated as qualified plans 

for purposes of the IRA deduction phase-out rules. Thus, employees wh o participated in a 

NES T would be subject to the phase-out rules for making deductible IRA contributions if 

they had AG I in excess of the applicable thresholds. 

IRS model form. The IRS would be directed to issue a model NEST document, but 

vendors and employers would have the option of using their ow n documents. 

Application of ERISA fiduciary rules. The proposal would limit a plan sponsor's 

fiduciary liability. The sponsor would not be subject to fiduciary liability for the designation 

of the NES T trustee or issuer, or the manner in which the NES T is invested, after the 

earliest of (1) an affirmative employee election with respect to the initial investment of any 

contributions, (2) a transfer to another IRA, or (3) one year after the employee's NES T is 

established, provided that the employee had been properly notified that he or she has a right 

to transfer the NES T account balance without charge. The assets held in the NES T would 

cease to be plan assets when transferred to another IRA or otherwise distributed as benefits. 

Reporting. An employer maintaining a NEST would not be subject to any reporting 

requirements (e.g., Form 5500 filing). However, the NES T trustee or issuer would be 

required to report NES T contributions on Form 5498, on which IRA contributions are 

reported. 

Disclosure. Employees would be required to be notified annually in writing of their 

-22-
rights under the plan, including, for example, the right to a matching contribution and 

information from the NES T trustee or issuer. Similarly, if an employer wanted to change its 

safe harbor formula, the employer would be required to notify eligible employees of the 

formula that would be used for a year no later than a reasonable time before the employer 

required employees to make their elections for the year. 

Plan suspension. In order to provide flexibility to an employer that faced an 

unexpected financial hardship, employers would generally be permitted to suspend all NES T 

contributions (i.e., all elective, matching, and nonelective contributions) at any time during 

the year after notifying eligible employees in writing at least 30 days before the suspension. 

Only one suspension would be allowed during any year. The Secretary ma y prescribe rules 

to prevent abuse, such as the repeated suspension of a NES T in a manner that prevents 

seasonal workers from receiving benefits. 

Calendar plan year. The calendar year would be the plan year for all NESTs and 

would have to be used in applying all NES T contribution limits, eligibility, and other NES T 

requirements. 

This proposal would be effective for years beginning after December 31, 1996. 

The proposal is similar to a simplified pension plan proposal contained in the Revenue 

Reconciliation Act of 1995 as passed by Congress. 

-23-
OTHE R PENSIO N SIMPLIFICATIO N MEASURE S 

A. 401 (K) PLAN S FO R TAX-EXEMP T ORGANIZATION S 

Current Law 

Except for certain plans established before July 2, 1986, an organization exempt from 

income tax is not allowed to maintain a section 401(k) plan. The restriction on tax-exempts, 

including state and local governments, sponsoring a 401 (k) plan does not apply to money 

purchase pension plans maintained by rural electrical cooperatives or cooperative telephone 

companies. While a section 401(k) plan can distribute amounts upon hardship or attainment 

of age 59 1/2, in accordance with the distribution restrictions generally applicable to pension 

plans, these rural cooperative plans generally cannot allow distributions prior to a 

participant's separation from service. 

Reasons for Change 

The limitation on maintaining a 401(k) plan prevents many tax-exempt organizations 

from offering their employees retirement benefits on a salary reduction basis. Although taxsheltered annuity programs can provide similar benefits, many types of tax-exempt 

organizations are also precluded from offering those programs. 

It is also appropriate to allow a 401(k) plan maintained by a rural cooperative to 

permit distributions to plan participants under the same circumstances as a 401(k) plan 

maintained by other employers. 

Proposal 

The proposal would allow organizations exempt from income tax (other than state or 

local governments) and Indian tribes to maintain a 401(k) plan. This proposal would be 

effective for plan years beginning after December 31, 1996. 

The rules governing distributions from a 401(k) plan of a rural cooperative would be 

conformed to those that apply to other 401(k) plans by allowing distributions after attainment 

of age 59 1/2 and upon financial hardships. This proposal would be effective for 

distributions after date of enactment. 

B. REPEAL FIVE-YEAR AVERAGING FOR LUMP SUM DISTRIBUTIONS 

Current Law 

A distribution that satisfies the many requirements necessary to qualify as a "lump 

-24-
s um distribution" is eligible for five-year forward averaging. Under this method, the tax that 

is owed on the lump sum distribution is separately calculated and added to the individual's 

other income tax for the year. The separate tax is approximately equal to five times the tax 

that would apply to one-fifth of the distribution, assuming the taxpayer had no other taxable 

income. Because the tax on the distribution is calculated separately from other income and 

because the distribution is taxed at the marginal rate that would apply to one-fifth of the 

distribution, a recipient wh o receives a large distribution in one taxable year ma y be able to 

benefit from a lower marginal tax rate by using five-year forward averaging. 

Prior to the Tax Reform Act of 1986 (TRA 1986), lump sum distributions were 

eligible for 10-year averaging rather than five-year averaging. In addition, the portion of a 

lump sum distribution attributable to pre-1974 services could be treated as capital gain. 

These rules ma y be used currently only if the employee attained age 50 before January 1, 

1986. 

Reasons for Change 

Both the definition of a lump sum distribution and the calculation of tax under the 

five-year averaging method are complicated. In addition, the problem that five-year 

averaging addresses (i.e., avoiding the bunching of income in one year, resulting in an 

unusually high tax rate for that year) can be achieved by rolling over a lump sum distribution 

to an IR A without tax and taking periodic payments from the IRA over five years or more. 

In 1992, the availability of tax-free rollovers was expanded and the rules for rollovers were 

simplified significantly. 

Proposal 

The five-year averaging rules would be repealed, effective for lump sum distributions 

after December 31, 1998. However, the provisions of TR A 1986 the rules that apply tenyear averaging and capital gain treatment for employees wh o attained age 50 before January 

1, 1986 would be retained. 

C . SIMPLIF Y TAXATIO N O F ANNUIT Y DISTRIBUTION S 

Current Law 

If an employee makes after-tax contributions to a qualified employer retirement plan 

or IRA, those contributions (i.e., the employee's "basis") are not taxed upon distribution. 

Whe n the plan distributions are in the form of an annuity, a portion of each payment is 

considered nontaxable return of basis. This nontaxable portion is determined by multiplying 

the distribution by an exclusion ratio. The exclusion ratio generally is the employee's total 

after-tax contributions divided by the total expected payments under the plan over the term of 

the annuity. 

-25-
Reasons for Chang e 

T he determination of the total expected payments, which is based on the type of 

annuity being paid, often involves complicated calculations that are difficult for the average 

plan participant. Because of the difficulty an individual ma y face in calculating the exclusion 

ratio, and in applying other special tax rules that ma y be applicable, the IRS in 1988 

provided a simplified alternative method for determining the nontaxable portion of an annuity 

payment. However, this alternative has effectively added to the existing complexity because 

taxpayers feel compelled to calculate the nontaxable portion of their payments under every 

possible method in order to ensure that they maximize the nontaxable portion. 

Proposal 

A simplified method for determining the nontaxable portion of an annuity payment, 

similar to the current simplified alternative, would become the required method. Taxpayers 

would no longer be compelled to do calculations under multiple methods in order to 

determine the most advantageous approach. 

Under the simplified method, the portion of an annuity payment that would be 

nontaxable is generally equal to the employee's total after-tax employee contributions, 

divided by the number of anticipated payments listed in a table (based on the employee's age 

as of the annuity starting date). 

The proposal would be effective with respect to annuity starting dates on or after 

January 1, 1997. 

D. COMMENCEMENT OF MINIMUM DISTRIBUTIONS BEFORE RETIREMENT 

Current Law 

Under current law, an employee who participates in a qualified employer retirement 

plan must begin taking distributions of his or her benefit by the April 1 following the year in 

which he or she reaches age 70 1/2. Generally, the so-called "minimum distribution" for 

any year is determined by dividing the employee's account balance or accrued benefit by the 

employee's life expectancy. 

Reasons for Change 

If the employee is still working and accruing new benefits at age 70 1/2, the new 

benefits must be taken into account to determine the minimum amount required to be 

distributed for the same year. In effect, a portion of each year's new benefit accrual is 

required to be distributed in the same year. This pattern of contemporaneous contributions 

and required distributions causes considerable complication and confusion. 

-26-
Proposal 

T he requirement to distribute benefits before retirement would be eliminated, except 

for employees wh o ow n more than 5 percent of the employer that sponsors the plan. 

Instead, distributions would have to begin by the April 1 following the later of the year in 

which the employee reaches age 70 1/2 or the year in which the employee retires from 

service with the employer maintaining the plan. If payment of an employee's benefits were 

delayed past age 70 1/2 pursuant to this rule, the benefits ultimately paid at retirement would 

have to be actuarially increased to take into account the delay in payment. Without this 

increase, the delay in payment could cause the employee to "lose" the benefit payments that 

would otherwise have been paid between age 70 1/2 and retirement. The actuarial 

adjustment rule and the 5 percent owner rule would not apply to a governmental plan or a 

church plan. 

The age-70 1/2 requirement would continue to apply to IRAs. Because an IRA is not 

maintained by an employer, the initial payment date for an IRA cannot be tied to retirement 

from the employer maintaining the plan. (Note that the proposal also includes a separate 

item that would change the age-70 1/2 rule to an age-70 rule.) 

The proposal would be effective for years beginning after December 31, 1996. 

E. SIMPLIFY DEFINITION OF HIGHLY COMPENSATED EMPLOYEE AND REPEAL THE 

FAMILY AGGREGATION RULES 

Current Law 

Definition of highly compensated employee. A qualified retirement plan must satisfy 

various nondiscrimination tests to ensure that it does not discriminate in favor of "highly 

compensated employees." In order to apply these tests, the employer must identify its 

"highly compensated employees." This term is currently defined by reference to a test with 

seven major parts. Under this definition, an employee is treated as a highly compensated 

employee for the current year, if, at any time during the current year or the preceding year, 

the employee: 

(1) owned more than 5 percent of the employer, 

(2) received more than $100,000 (as indexed for 1996) in annual compensation 

from the employer, 

(3) received more than $66,000 (as indexed for 1996) in annual compensation 

from the employer and was one of the top-paid 20 percent of employees during 

the same year, or 

-27-
(4) was an officer of the employer wh o received compensation greater than 

$60,000 (as indexed for 1996). 

These four rules are modified by three additional rules. 

(5) An employee described in any of the last three categories for the current year 

but not the preceding year is treated as a highly compensated employee for the 

current year only if he or she was among the 100 highest paid employees for 

that year. 

(6) No more than 50 employees or, if fewer, the greater of three employees or 10 

percent of employees are treated as officers. 

(7) If no officer has compensation in excess of $60,000 (for 1996) for a year, then 

the highest paid officer of the employer for the year is treated as a highly 

compensated employee. 

Family aggregation. If an employee is a family member of either a more-than-5 

percent owner of the employer or one of the employer's ten highest-paid highly compensated 

employees, then any compensation paid to the family member and any contribution or benefit 

under the plan on behalf of the family member is aggregated with the compensation paid and 

contributions or benefits on behalf of the highly compensated employee. Therefore, the 

highly compensated employee and all family members are treated as a single highly 

compensated employee. For purposes of this rule, an employee's "family member" is 

generally a spouse, parent, grandparent, child, or grandchild (or the spouse of a parent, 

grandparent, child, or grandchild). 

A similar family aggregation rule applies with respect to the $150,000 annual limit on 

the amount of compensation that may be taken into account under a qualified plan. 

(However, under these provisions, only the highly compensated employee's spouse and 

children and grandchildren under age 19 are aggregated.) 

Reasons for Change 

The definition of highly compensated employee is not only complicated, it classifies 

many middle-income workers as "highly compensated employees" wh o are then prohibited 

from receiving higher levels of benefits. 

The family aggregation rules greatly complicate the application of the 

nondiscrimination tests, particularly for family-owned or operated businesses, and ma y 

unfairly reduce retirement benefits for the family members wh o are not highly compensated 

employees. 

-28-
Proposal 

Definition of highly compensated employee. The current seven-part test would be 

replaced by a simplified two-part test: an employee would be a "highly compensated 

employee" for the current year only if the employee owned more than 5 percent of the 

employer during the current or preceding year or had compensation from the employer of 

more than $80,000 (indexed annually for changes in the cost of living after 1997) during the 

preceding year. This dollar threshold would mean that many middle-income Americans no 

longer would be subject to nondiscrimination restrictions. 

Family aggregation. The family aggregation rules would be repealed. 

The proposals would be effective for years beginning after December 31, 1996. 

F. REPEAL OF MINIMUM PARTICIPATION RULE FOR DEFINED CONTRIBUTION PLANS 

Current Law 

Under current law, every qualified defined benefit plan or defined contribution plan is 

required to cover at least 50 employees or, in smaller companies, 40 percent of all 

employees of the employer. This rule was intended primarily to prevent an employer from 

establishing individual defined benefit plans for highly compensated employees in order to 

provide those employees with more favorable benefits than those provided to lower paid 

employees under a separate plan. The rule prevents an employer from favoring one small 

group of participants over another by, for example, covering them under two separate plans 

and funding one plan better than the other. 

Reasons for Change 

As applied to defined contribution plans, the minimum participation rule adds 

complexity for employers without delivering commensurate benefits to the system, given that 

the nondiscrimination rules also prevent qualified retirement plans from unduly favoring the 

top-paid group of employees. The abuses intended to be addressed by the minimum 

participation requirement rarely arise in the context of defined contribution plans. 

Accordingly, this requirement adds unnecessary administrative burden and complexity with 

respect to these plans. 

Proposal 

The minimum participation rule would be repealed for defined contribution plans. In 

addition, if an employer had only two employees, the rule for defined benefit plans would be 

modified to require any such plan to cover both employees. 

-29-
T he proposal would be effective for plan years beginning after December 31, 1996. 

G. SIMPLIFIED NONDISCRIMINATION TESTING FOR 401 (K) PLANS 

Current Law 

The actual deferral percentage (ADP) test generally applies to the elective 

contributions (typically made by salary reduction) of all employees eligible to participate in a 

401(k) plan. The test requires the calculation of each eligible employee's elective 

contributions as a percentage of the employee's pay. The AD P test is satisfied if the plan 

passes either of the following two tests: (1) the average percentage of elective contributions 

for highly compensated employees does not exceed 125 percent of the average percentage of 

elective contributions for nonhighly compensated employees, or (2) the average percentage of 

elective contributions for highly compensated employees does not exceed 200 percent of the 

average percentage of elective contributions for nonhighly compensated employees, and does 

not exceed the percentage for nonhighly compensated employees by more than two 

percentage points. The actual contribution percentage (ACP) test is almost identical to the 

A D P test, but generally applies to employer matching contributions and after-tax employee 

contributions under any qualified employer retirement plan. 

Both the ADP test and the ACP test generally compare the average contributions for 

highly compensated employees for the year to the average contributions for nonhighly 

compensated employees for the same year. 

When the ADP or ACP test is violated, correction is made by reducing the excess 

contributions of highly compensated employees beginning with employees wh o have deferred 

the greatest percentage of pay. 

Reasons for Change 

The annual application of these tests, and correcting violations of these tests, can be 

complicated and costly. For example, because the current year average for the nonhighly 

compensated employees is not known until the end of the year, the tests commonly require 

either monitoring and adjustments of contributions over the course of the year or complicated 

correction procedures and information reporting after the end of the year. 

The current correction method often does not affect the most highly paid of the highly 

compensated employees: their contributions, as a percentage of pay, are likely to be lower 

than the percentage contributions of lower-paid highly compensated employees, even if the 

dollar amount of their contributions is higher. For example, if an employee makes $85,000 

and contributes $6,000 (7.05 percent of pay), his or her contribution would be reduced 

before that of a CE O wh o makes $150,000 and contributes $9,000 (6 percent of pay). 

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Proposal 

Design-based safe harbors. The proposal would provide two alternative "designbased" safe harbors. If a plan were properly designed, the employer would avoid all AD P 

and AC P testing. Under the first safe harbor, the employer would have to make nonelective 

contributions of at least 3 percent of compensation for each nonhighly compensated employee 

eligible to participate in the plan. Alternatively, under the second safe harbor, the employer 

would have to make a nonelective contribution of at least 1 percent of compensation for each 

eligible nonhighly compensated employee, a 100 percent matching contribution on an 

employee's elective contributions up to the first 3 percent of compensation, and a matching 

contribution of at least 50 percent on the employee's elective contributions up to the next 2 

percent of compensation. 

A more generous matching contribution formula would also be considered to satisfy 

the matching contribution safe harbor, but only if the level of matching contributions did not 

increase as employee elective contributions increased and the matching contributions at every 

level of compensation were at least as great as they would have been under the safe harbor 

formula. However, for purposes of satisfying the matching contribution safe harbor with 

respect to the AC P test (but not the AD P test), matching contributions could not be made 

with respect to employee elective contributions in excess of 6 percent of compensation. The 

safe harbors could not be used to satisfy the AC P test with respect to after-tax employee 

contributions, which would be tested separately. 

Under both safe harbors, the nonelective employer contributions and the matching 

employer contributions would be treated in a manner similar to "qualified nonelective 

contributions", including being nonforfeitable immediately and generally not distributable 

prior to the participant's death, disability, termination of employment, or attainment of age 

59 1/2. In addition, each employee eligible to participate in the plan would have to be given 

notice of his or her rights and obligations under the plan within a reasonable period before 

the beginning of any year. 

Simplification for plans that chose not to use the design-based safe harbors. The 

proposal would also simplify the nondiscrimination rules for plans that chose not to use the 

design-based safe harbors. First, the proposal would modify the AD P and AC P tests to 

provide that, unless an employer made an election to use current year data, the average 

contributions for highly compensated employees for the current year would be compared to 

the average contributions for nonhighly compensated employees for the preceding year. A n 

election to use current year data could be revoked only as provided by the Secretary. For 

the first plan year of a 401(k) plan, the average percentage for nonhighly compensated 

employees would be deemed to be 3 percent or, at the employer's election or (except to the 

extent provided by the Secretary) in the case of a successor plan, the average percentage for 

that first plan year. Second, a simplified correction method would require excess 

contributions to be distributed first to those highly compensated employees wh o deferred the 

highest dollar amount (as opposed to the highest percentage of pay) for the year. Under this 

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approach, the lower-paid highly compensated employees would no longer tend to bear the 

brunt of the correction method. 

The design-based safe harbors would be effective for years beginning after December 

31,1998. The proposal relating to prior-year data and the correction procedures would be 

effective for years beginning after December 31, 1996. 

H. SIMPLIFICATION OF RULES RELATING TO MAXIMUM CONTRIBUTIONS AND 

BENEFIT S 

Current Law 

Annual additions to a defined contribution plan for any participant are limited to the 

lesser of $30,000 (for 1996) or 25 percent of compensation. Annual benefits payable under a 

defined benefit plan are limited to the lesser of $120,000 (for 1996) or 100 percent of "threeyear-high average compensation." (Reductions in the dollar or percentage limit for defined 

benefit plans may be required if the employee has fewer than 10 years of plan participation 

or service.) 

An employee who participates in a qualified defined benefit plan and a qualified 

defined contribution plan of the same employer must also satisfy a combined plan limit. This 

limit is satisfied if the sum of the "defined benefit fraction" and the "defined contribution 

fraction" is no greater than 1.0. 

The defined benefit fraction measures the portion of the maximum permitted defined 

benefit that the employee actually uses. The numerator is the projected normal retirement 

benefit, and the denominator is generally the lesser of 125 percent of the dollar limitation for 

the year or 140 percent of the employee's percent of pay limitation. 

The defined contribution fraction measures the portion that the employee actually uses 

of the maximum permitted contributions to a defined contribution plan for the employee's 

entire career with the employer. The numerator is generally the total of the contributions 

and forfeitures allocated to the employee's account for each of the employee's years of 

service with the employer. The denominator is the sum of a calculated vaiue for each of 

those years of service. The calculated value is the lesser of 125 percent of the dollar 

limitation for that year of service, or 35 percent of the participant's compensation. Because 

of the historical nature of this fraction, its computation is extremely cumbersome and 

requires the retention of various data for an employee's entire career. 

The combined plan limit is not the only Code provision that safeguards against an 

individual accruing excessive retirement benefits on a tax-favored basis. There are maximum 

limits for both defined benefit and defined contribution plans. In addition, a 15 percent 

"excess distribution" penalty was enacted in 1986 to achieve many of the same goals as the 

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combined plan limit. A distribution is generally considered an "excess distribution" to the 

extent all distributions to an individual from all of the individual's qualified employer plans 

and IRAs exceed a specified dollar limit ($155,000 in 1996) during a calendar year. The 

limit is multiplied by five (i.e., $775,000 in 1996) for a lump sum distribution. Excess 

distributions mad e after death are subject to an additional estate tax of 15 percent. Other 

rules also protect against tax-favored excessive benefits. 

For purposes of the various compensation limits, compensation generally does not 

include employer contributions (including elective deferrals) made to section 401(k) plans, 

section 403(b) annuities, section 125 cafeteria plans, and certain other employee benefit 

plans. 

If benefits under a defined benefit plan begin before social security retirement age, the 

dollar limit must be actuarially reduced to compensate for the earlier commencement. The 

reduction to the dollar limit for commencement between age 62 and social security retirement 

age is based on the early commencement factors used for social security. Certain special 

rules apply to governmental plans. In addition, if benefits are paid in a form other than a 

straight life annuity (or a joint and survivor annuity), the benefits must be adjusted to an 

actuarially equivalent straight life annuity prior to comparison with the dollar limitation. 

The interest rate that must be used for the actuarial reductions for any commencement 

prior to age 62, and for purposes of the benefit adjustment, depends on the form of the 

benefit that is being paid. If the benefit is being paid in an annuity distribution, the interest 

rate that must be used for both of these adjustments is the greater of 5 percent or the interest 

rate used for the parallel adjustments under the plan. However, if the benefit is being paid 

in a nonannuity form (e.g., a single sum distribution), the interest rate that must be used for 

both of these adjustments is the greater of the interest rate applicable under section 417(e)(3) 

or the interest rate used for the parallel adjustments under the plan. 

Reasons for Change 

Because other provisions of the Code, such as the excise tax on excess distributions, 

go far toward ensuring that an individual cannot accrue excessive retirement benefits on a 

tax-favored basis, the complexity of the combined plan limit is not justified. 

The exclusion of elective deferrals restricts the amount that employees can accrue 

under a qualified plan. Because the dollar limit is usually the operative limit for a highly 

compensated employee, and the percent-of-compensation limit is usually the operative limit 

for nonhighly compensated employees, the exclusion of elective contributions from the 

definition of compensation is not only complicated, but it primarily limits benefits for 

nonhighly compensated employees. 

The qualified plan limitations are uniquely burdensome for governmental plans, which 

have long-established benefits structures and practices that ma y conflict with the limitations. 

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In addition, some state constitutions ma y significantly restrict the ability to mak e the changes 

needed to conform the plans to these limitations. 

These limitations also present problems for many multiemployer plans. These plans 

typically base benefits on years of credited service, not on a participant's compensation. In 

addition, the 100 percent-of-compensation limit is based on an employee's average 

compensation for the three highest consecutive years. This rule often produces an artificially 

low limit for employees in certain industries, such as building and construction, where wages 

vary significantly from year to year. 

The requirement that the interest rate used for the early commencement actuarial 

adjustment vary depending on whether or not the benefit is payable in an annuity form adds 

complexity to the calculation of the maximu m benefit limitations that is not justified. 

Proposal 

Combined limit. The combined plan limit (Code section 415(e)) would be repealed. 

This proposal would be effective for years beginning after December 31, 1998. 

Definition of compensation. Under the proposal, elective contributions would be 

considered compensation for purposes of the annual limits on contributions and benefits. 

This proposal would be effective for years beginning after December 31, 1996. 

Governmental and multiemployer plans. The rules for governmental plans and 

multiemployer plans would be modified to eliminate the 100 percent-of-compensation limit 

(but not the $120,000 limit) for such plans, and to exempt certain survivor and disability 

benefits from the adjustments for early commencement and for participation and service of 

less than 10 years. T o the extent that governmental employers have previously made 

elections that would prevent them from utilizing these simplification provisions, the proposal 

would allow those employers to revoke their elections. These proposals would be effective 

for years beginning after December 31, 1996 for multiemployer plans and December 31,1995 

for governmental plans. 

Benefit limits for early retirees. The actuarial assumptions to be used for adjusting 

the $120,000 limit for commencement prior to age 62 would be based on the greater of 5 

percent or the interest rate used for this purpose under the plan, without regard to the form 

of benefit that is being paid. This proposal would be effective as if it were included in the 

Retirement Protection Act of 1994. 

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I. PLAN S MAINTAINE D B Y SELF-EMPLOYE D INDIVIDUALS 

Current Law 

Prior to the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), numerous 

special rules applied to qualified retirement plans that covered self-employed individuals. 

Almost all of these special rules were repealed by TEFRA. However, special aggregation 

rules that do not apply to other qualified retirement plans still apply to qualified plans that 

cover an "owner-employee" (i.e., a sole proprietor of an unincorporated trade or business or 

a more-than-10 percent partner of a partnership). These aggregation rules generally require 

affected plans to be treated as a single plan and affected employers to be treated as a single 

employer. For example, if an owner-employee controls more than one trade or business, 

then any qualified plans maintained with respect to those trades or businesses must be treated 

as a single plan and all employees of those trades or business must be treated as employed by 

a single employer. 

Reasons for Change 

The special aggregation rules afford plan participants little, if any, protection becaus

they are largely duplicative of the general aggregation rules that apply to all qualified 

employer plans, including plans that cover self-employed individuals. 

Proposal 

The special aggregation rules for qualified plans that cover owner-employees would 

be repealed. As under current law, these plans would be subject to the general plan 

aggregation rules that apply to tax-qualified employer retirement plans. 

This proposal would be effective for years beginning after December 31, 1996. 

J. REPEAL OF SLOWER VESTING SCHEDULE FOR MULTIEMPLOYER PLANS 

Current Law 

Under the Code and the Employee Retirement Income Security Act of 1974, as 

amended, (ERISA) the accrued benefits of a collectively bargained employee under a 

multiemployer retirement plan are not currently required to become nonforfeitable (i.e., 

"vested") until the employee has completed 10 years of service. If the employee's 

employment terminates before then, all benefits can be lost. Accrued benefits of all other 

employees (i.e., employees under all non-multiemployer plans and any noncollectively 

bargained employees under a multiemployer plan) must vest after five years of service, or 

after seven years if partial vesting begins after three years. 

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Reasons for Change 

T he 10-year vesting schedule for multiemployer plans adds to the complexity of the 

pension law by providing different vesting schedules for different types of plans and for 

different people covered by the same plan. In addition, conforming the multiemployer plan 

vesting rules to the vesting rules for other plans would ensure that workers covered by 

multiemployer plans would become entitled to pension benefits on the same basis as workers 

covered by other plans. 

Proposal 

The special ten-year vesting rule applicable to multiemployer plans under the Code 

and ERIS A would be repealed. 

This proposal would be effective for plan years beginning on or after the earlier of (1) 

the later of January 1, 1997, or the date on which the last of the collective bargaining 

agreements pursuant to which the plan is maintained terminates, or (2) January 1, 1999, with 

respect to participants wh o have at least one hour of service after the effective date. 

K. UNIFORM RETIREMENT AGE 

Current Law 

Several of the statutory requirements for qualified employer plans involve "normal 

retirement age." Under most of these provisions, normal retirement age can be no later than 

age 65. However, under certain other provisions, normal retirement is the social security 

retirement age (currently age 65, but scheduled to increase). 

Reasons for Change 

Many retirement plans base benefits on social security age in order for the benefits to 

complement social security. Yet, under current law, the use of social security retirement age 

(which is not uniform among participants) may cause the plan to fail applicable 

nondiscrimination tests, since those tests generally require the use of a retirement age that is 

uniform among participants. 

Proposal 

Under the proposal, the social security retirement age would be a uniform retirement 

age for purposes of the nondiscrimination rules. In addition, subsidized early retirement 

benefits and joint and survivor annuities would not be treated as not being available to 

employees on the same terms merely because they were based on an employee's social 

security retirement age. 

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This proposal would be effective for years beginning after December 31, 1996. 

L. DISABLED EMPLOYEES 

Current Law 

An employer may elect to continue making deductible contributions to a d

contribution plan on behalf of permanently and totally disabled employees who are not highly 

compensated. 

Reasons for Change 

Contributions for disabled employees should be encouraged. In addition, 

contributions should be allowed for highly compensated disabled employees, as well as for 

nonhighly compensated disabled employees, if the contributions are provided on a 

nondiscriminatory basis. 

Proposal 

In order to simplify the rules for permanently and totally disabled work

encourage contributions for those disabled workers, an employer would not have to make an 

election in order to make contributions for disabled employees, and plans would generally be 

allowed to provide for contributions for disabled highly compensated employees, as well as 

for disabled nonhighly compensated employees. 

This proposal would be effective for years beginning after December 31, 

M. DEFERRED COMPENSATION PLANS OF GOVERNMENTS AND TAX-EXEMPT 

ORGANIZATIONS 

Current Law 

The amount of reasonable compensation that may be provided to an employe

nonqualified deferred compensation arrangement maintained by a for-profit organization 

generally is not subject to any limitation. Many such employers maintain a nonqualified 

"excess benefit plan" that provides benefits for certain employees in excess of the limitations 

on annual contributions and benefits imposed by section 415 of the Code. The nonqualified 

deferred compensation is not taxable to the employee until it is paid or otherwise made 

available to the employee to draw upon at any time. 

Section 457 sets forth the tax rules applicable to nonqualified deferred 

provided by a state or local governments or tax-exempt organization. Under section 457, an 

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employee wh o elects to defer the receipt of compensation under an "eligible plan" is taxed on 

the amounts deferred when the amounts are paid or made available. If a plan for the deferral 

of compensation is not an "eligible plan," the deferred compensation is taxed to the 

participant in the first taxable year in which the compensation is not subject to a substantial 

risk of forfeiture, even if the compensation is not paid or otherwise made available to the 

participant until a later date. 

A section 457 plan is not an eligible plan unless, among other requirements, annual 

deferrals for an employee are limited to the lesser of $7,500 or 33 1/3 percent of 

compensation. In contrast to other dollar limitations applicable to employee benefit plans, 

the $7,500 limit is not indexed for cost of living. In addition, amounts deferred under an 

eligible plan ma y not be mad e available to a participant before the earlier of the calendar 

year in which the participant attains age 70 1/2, the participant's separation from service, or 

an unforeseeable emergency. Benefits under an eligible plan are not considered mad e 

available if the participant ma y elect to receive a lump sum payable after separation from 

service and within 60 days of the election. However, this exception is available only if the 

total amount payable to the participant under the plan does not exceed $3,500 and no 

additional amounts ma y be deferred under the plan with respect to the participant. 

Reasons for Change 

In order to maintain the value of deferrals under an eligible section 457 plan, the 

dollar limits on deferrals should be indexed in a manner that is consistent with the wa y other 

plan dollar limits are indexed. In addition, the existing constructive receipt rules that apply 

to section 457 plans are unnecessarily restrictive. 

An excess benefit plan provides to certain employees — those whose contributions or 

benefits are reduced by the section 415 limits — contributions or benefits that are already 

provided to other employees under a qualified plan. Even though an excess benefit plan does 

not provide management employees with disproportionately higher benefits than those 

provided to lower paid employees, the restrictions of section 457 still apply to such a plan if 

it is maintained by a state and local government or tax-exempt organization. These 

employers are therefore at a disadvantage in attempting to provide all employees with 

proportionate contributions or benefits. 

Proposal 

The proposal would provide for increases in the $7,500 limit, based on changes in the 

cost of living since 1994. The indexed value would be rounded dow n to the next lower 

multiple of $500. The proposal would also permit the in-service distribution of a 

participant's account if that account did not exceed $3,500, no amount was deferred under 

the plan with respect to the participant for two years, and there was no prior distribution 

under this cash-out rule. In addition, the proposal would allow an additional election to be 

made with respect to the time distributions must begin under the plan. The amount payable 

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to a participant under an eligible plan would not be treated as made available merely because 

the participant could elect to defer commencement of distributions under the plan after 

amounts could be distributed under the plan but before the actual commencement of benefits. 

Only one such additional election would be permitted. These proposals would be effective 

for taxable years beginning after December 31, 1996. 

The proposal would exempt excess benefit plans of state and local governments and 

tax-exempt organizations from section 457. The exemption would not apply to an excess 

benefit plan that also provided benefits in excess of qualified plan limitations other than the 

section 415 limits. This proposal generally would be effective for years beginning after 

December 31, 1996. The provision permitting governments to provide excess benefit plans 

is effective at an earlier date. 

N. TRUST REQUIREMENT FOR DEFERRED COMPENSATION PLANS OF STATE AND 

LOCAL GOVERNMENTS 

Current Law 

Section 457 sets forth the tax rules applicable to nonqualified deferred compensation 

provided by a state or local governments or tax-exempt organization. Under section 457, an 

employee wh o elects to defer the receipt of compensation under an "eligible plan" is taxed on 

the amounts deferred when the amounts are paid or made available. If a plan for the deferral 

of compensation is not an "eligible plan," the deferred compensation is taxed to the 

participant in the first taxable year in which the compensation is not subject to a substantial 

risk of forfeiture, even if the compensation is not paid or otherwise made available to the 

participant until a later date. 

Amounts deferred under a section 457 plan, including all property purchased with 

such amounts and all income attributable to such amounts, must remain solely the property of 

the employer, subject only to the claims of the employer's general creditors, until made 

available to the participant or beneficiary. Thus, compensation deferred by employees under 

a section 457 plan is not protected from the employer's general creditors in the event of the 

employer's bankruptcy. B y contrast, the assets of a qualified cash or deferred arrangement 

must be held in trust for the exclusive benefit of participants and beneficiaries. 

Reasons for Change 

Employers should be encouraged to provide benefits under a qualified retirement plan, 

but a governmental employer ma y want to offer a section 457 plan. However, employees of 

a State and local government could lose all or a portion of their retirement savings in the 

event that their employer chose to provide benefits through a section 457 plan, which must 

be an unfunded plan that is subject to the claims of the employer's creditors. 

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Proposal 

Under the proposal, all amounts deferred (including amounts deferred prior to the 

effective date of the change) under a section 457 plan maintained by a State or local 

government employer would be required to be held in trust (or in a custodial account or 

annuity contract) for the exclusive benefit of employees. Consequently, the requirement that 

amounts deferred under a section 457 plan be subject to the claims of the employer's 

creditors would be repealed with respect to section 457 plans of a governmental employer. 

T he trust would be provided tax-exempt status and, as under current law, amounts would not 

be includible in income until paid or made available to the employee. 

Other present-law requirements applicable to section 457 plans, including the annual 

limit on the maximu m amount of deferral, would continue to apply. T o the extent these 

requirements, including the trust requirement, were not satisfied, amounts deferred would be 

includible in the employee's income when there is no substantial risk if forfeiture. 

The proposal would not alter the present-law rules applicable to section 457 plans of 

nongovernmental tax-exempt employers or the rules applicable to nonqualified plans of 

governmental or nongovernmental employers. 

The proposal would be effective for assets and income held under a section 457 plan 

on the date of enactment, but amounts would not be required to be held in trust until the end 

of the first calendar quarter beginning after the end of the first regular session (treating a 

two-year legislative session as two separate one-year sessions) of the State legislature of the 

State in which the governmental entity maintaining the plan is located that begins after the 

date of enactment. 

O . APPLICATIO N O F ELECTIV E DEFERRA L LIMI T T O 403(B ) ANNUITIE S 

Current Law 

Annual elective deferrals made by an employee under a section 403(b) annuity plan 

generally are limited to $9,500. Elective deferrals in excess of this limit ma y be corrected 

by distributing the excess deferrals no later than April 15 of the year following the year of 

deferral. If the excess is not timely corrected, the excess deferrals are includible in the 

employee's income in the year of deferral and again in the year of distribution. In addition, 

a 403(b) annuity plan must provide that elective deferrals made under the plan ma y not 

exceed the annual limit. Plans that do not comply with this requirement ma y lose their taxqualified status. 

Reasons for Change 

Employees participating in a 403(b) annuity plan should not be adversely affected if 

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other employees violate the annual limit on elective contributions with respect to their 

individual contracts or custodial accounts. 

Proposal 

Under the proposal, each 403(b) annuity contract, not the 403(b) plan, must provide 

that elective deferrals made under the contract may not exceed the annual limit. 

This proposal would be effective for years beginning after December 31, 1996. 

P. EXCISE TAX AND CIVIL PENALTY ON PROHIBITED TRANSACTIONS 

Current Law 

A "prohibited transaction" under section 4975 is generally any transaction between a 

plan and a person who is considered a "disqualified person" with respect to the plan. Unless 

exempt by statute or by an individual or class exemption, a prohibited transaction gives rise 

to an excise tax (imposed on the disqualified person) equal to 5 percent of the amount 

involved in the transaction. If the transaction is not corrected, an additional 100 percent 

excise tax may be imposed. ERISA includes a parallel civil penalty for any prohibited 

transactions involving a plan that is not subject to section 4975 of the Code. 

Reasons for Change 

It is appropriate to raise the initial 5 percent amounts to discourage prohibited 

transactions. 

Proposal 

The proposal would increase the initial excise tax and ERISA penalty from 5 percent 

to 10 percent, effective for transactions occurring after December 31, 1996. 

Q. DEFINITION OF LEASED EMPLOYEE 

Current Law 

Individuals who are "leased employees" of a service recipient are considered to be 

employees of that recipient for qualified retirement plan and certain other purposes. A 

"leased employee" is any person who is not a common-law employee of the recipient and 

who provides services to the recipient if (1) the services are provided pursuant to an 

agreement between the recipient and the employer of the service provider, (2) the person has 

performed the services for the recipient on a substantially full-time basis for at least one 

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year, and (3) the services are of a type historically performed, in the business field of the 

recipient, by employees. 

Reasons for Change 

The historically performed standard produces many unintended and inappropriate 

results. For example, under this standard, employees and partners of a law firm could be 

leased employees of a client of the firm if they work a sufficient number of hours for the 

client, assuming that it is not unusual for employers in the client's business to have in-house 

counsel. 

Proposal 

The "historically performed" test would be replaced by a test that considers whether 

the services performed for the recipient are performed under significant direction or control 

by the recipient. 

This proposal would generally be effective for years beginning after December 31, 

1996, but would not apply to relationships that have been previously determined by an IRS 

ruling not to involve leased employees. 

R. UNIFORM INFORMATION REPORTING PENALTIES 

Current Law 

The penalty structure for failure to provide information reports with respect to 

pension payments is currently separate and different from the penalty structure that applies to 

information reporting in other areas. The penalty for failure to file a For m 1099-R report of 

pension distributions is currently $25 per day per return, up to a maximu m of $15,000 per 

year per return. The penalty for failure to file Form 5498 IRA report is currently a flat $50 

per return, with no maximum, regardless of the number of returns. 

In contrast, the penalty for failure to file any other information return is generally $50 

per return up to $250,000 per year, with lower penalties and maximum s if the return is filed 

within specified times. (The penalty is $15 per return filed late but within 30 days and $30 

per return filed late but on or before August 1.) Lower maximum s also apply to persons 

with gross receipts of no more than $5 million. The penalty for failure to furnish a payee 

statement is $50 per payee statement up to $100,000 per year. (Under a separate proposal, 

the general penalty amount would be increased to the greater of $50 per return or five 

percent of the total amount required to be reported, unless the aggregate amount reported by 

the trustee for the calendar year is at least 97 percent of the amount required to be reported.) 

Separate penalties apply in the case of intentional disregard of the requirement to furnish a 

payee statement. 

-42-
Reasons for Change 

Conforming the information reporting penalties that apply with respect to pension 

payments to the general information reporting penalty structure would simplify the overall 

penalty structure by providing uniformity and would provide more appropriate penalties with 

respect to pension payments. 

Proposal 

The penalties for failure to provide information reports with respect to pension 

payments would be conformed to the general penalty structure. Thus, the penalty for failure 

to file For m 1099-R would generally be reduced (for any return that was late by more than 

two days). The penalty for failure to file Form 5498 would generally remain the same as 

under current law, but would no longer be unlimited. In addition, for both Form 1099-R and 

Form 5498, the penalties would be reduced if the forms were filed late but within specified 

times. 

The proposal would apply to returns and statements for which the due date 

(determined without regard to extensions) is after December 31, 1996. 

S. DEDUCTION AND ACTUARIAL VALUATION RULES FOR MULTIEMPLOYER PLANS 

Current Law 

An employer's annual deduction for contributions to a defined benefit plan is 

generally limited to the amount by which 150 percent of the plan's current liability (or, if 

less, 100 percent of the plan's accrued liability) exceeds the value of the plan's assets. The 

150 percent-of-current-liability limit restricts the extent to which an employer can deduct 

contributions for benefits that have not yet accrued. 

Defined benefit plans are required by the Code and ERISA to have an actuarial 

valuation no less frequently than annually. 

Reasons for Change 

An employer has little, if any, incentive to make "excess" contributions to a 

multiemployer plan. The amount an employer contributes to a multiemployer plan is fixed 

by the collective bargaining agreement, and a particular employer's contributions are not set 

aside to pay benefits solely to the employees of that employer. 

Proposal 

The 150 percent limit on deductible contributions would be eliminated for 

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multiemployer plans. Therefore, the annual deduction for contributions to such a plan would 

be limited to the amount by which the plan's accrued liability exceeds the value of the plan's 

assets. 

Under the proposal, actuarial valuations would be required under the Code and 

ERIS A no less frequently than every three years for multiemployer plans. 

The proposal would be effective for years beginning after December 31, 1996. 

T. ELIMINATION OF HALF-YEAR REQUIREMENTS 

Current Law 

In general, distributions from qualified employer plans and IRAs prior to age 59 1/2 

are subject to a 10 percent penalty. In addition, under certain plans (such as section 401 (k) 

plans), distributions before age 59 1/2 are generally prohibited. Minimum distributions from 

IRAs and qualified employer plans are required to begin after attainment of age 70 1/2. 

(Note that the proposal also includes a separate item that would eliminate the requirement 

that distributions from qualified employer plans begin by age 70 1/2 for employees, other 

than more-than-5 percent owners, who have not yet retired.) 

Reasons for Change 

Requirements based on half years are not as simple to apply or communicate as 

requirements based on whole years, and may lead to confusion as to when distributions to 

I RA and qualified plan participants must commence and when distributions may be subject to 

penalty. The exact date on which an individual reaches age 59 1/2 or age 70 1/2 may not be 

readily apparent, whereas an individual's date of birth is obviously known to the individual 

and is typically included in plan and employer records. 

Proposal 

To simplify these provisions, all references to age 59 1/2 would be changed to age 

59, and all references to age 70 1/2 would be changed to age 70. 

The proposal would be effective for years beginning after December 31, 1996. 

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U. PARTIAL TERMINATION RULES FOR MULTIEMPLOYER PLANS 

Current Law 

When a qualified retirement plan is terminated, all plan participants are required to 

become 100 percent vested in their accrued benefits to the extent those benefits are funded. 

In the case of certain "partial terminations" that are not actual plan terminations (e.g., a large 

reduction in the work force), all affected employees must become 100 percent vested in their 

benefits accrued to the date of the termination, to the extent the benefits are funded. 

Whether a partial termination has occurred in a particular situation is generally based 

on the specific facts and circumstances of that situation, including the exclusion from the 

plan of a group of employees wh o have previously been covered by the plan, by reason of a 

plan amendment or severance by the employer. In addition, if a defined benefit plan stops or 

reduces future benefit accruals under the plan, a partial termination is deemed to occur if, as 

a result, a potential reversion of plan assets to the employer is created or increased. 

Reasons for Change 

Over the years, court decisions have left unanswered many key questions as to how to 

apply the partial termination rules. Accordingly, applying the rules can often be difficult and 

uncertain, especially for multiemployer plans. For example, multiemployer plans experience 

frequent fluctuations in participation levels caused by the commencement and completion of 

projects that involve significant numbers of union members. Man y of these terminated 

participants are soon rehired for another project that resumes their active coverage under the 

plan. In addition, it is commo n for participants leaving one multiemployer plan's coverage 

to maintain service credit under a reciprocal agreement if they move to the coverage of 

another plan sponsored by the same union. A s a result, these participants do not suffer the 

interruption of their progress along the plan's vesting schedule that ordinarily occurs when an 

employee stops being covered by a plan. Given these factors, and the related proposal to 

require multiemployer plans to vest participants after five (instead of the current ten) years of 

service, the difficulties associated with applying the partial termination rules to 

multiemployer plans outweigh the benefits. 

Proposal 

The requirement that affected participants become 100 percent vested in their accrued 

benefits (to the extent funded) upon the partial termination of a qualified employer retirement 

plan would be repealed with respect to multiemployer plans. 

The proposal would be effective for partial terminations that begin on or after January 

1, 1997. 

-45-
V. VETERANS' REEMPLOYMENT RIGHTS 

Current Law 

Under the Uniformed Services Employment and Reemployment Rights Act of 1

("USERRA"), which revised and restated the Federal law protecting veterans' reemployment 

rights, a returning veteran generally is entitled to the restoration of certain pension, profit 

sharing and similar benefits that would have accrued but for the employee's absence due to 

the military service. USERR A generally provides that service in the uniformed services is 

considered service with the employer for retirement plan benefit accrual purposes. USERR A 

also provides that the reemployed veteran is entitled to any accrued benefits that are 

contingent on the making of, or derived from, employee contributions or elective deferrals, 

but only to the extent the reemployed veteran makes payment to the plan with respect to such 

contributions or deferrals. N o such payment may exceed the amount the reemployed veteran 

would have been permitted or required to contribute had the person remained continuously 

employed by the employer throughout the period of uniformed service. USERR A generally 

became effective with respect to reemployments initiated on or after December 12, 1994. 

However, retirement plans not in compliance with the relevant provisions of USERR A on the 

date of its enactment (October 13, 1994) have two years to come into compliance. 

Under the Code, annual limits are provided on contributions and benefits under 

certain retirement plans. For example, the maximum amount of elective deferrals that can be 

made by an individual pursuant to a qualified cash or deferred arrangement in any taxable 

year is limited to $9,500 in 1996. Certain other rules, such as rules relating to 

nondiscrimination, coverage, minimum participation, and top-heavy plans, might limit the 

amount that can be contributed to a plan on behalf of an employee. There is no special 

provision under present law that permits contributions or deferrals to exceed these limits for 

a reemployed veteran. Violations of these rules can result in plan disqualification. The 

Code also imposes certain limits on deductible contributions to retirement plans without any 

special provision for payments made on behalf of a reemployed veteran. 

Reasons for Change 

Amendments are needed to conform the Code's qualified retirement plan rules with 

USERRA . 

Proposal 

The proposal provides special rules in the case of certain contributions ("make-up 

contributions") with respect to a reemployed veteran that are made pursuant to USERRA , so 

as to conform the rules contained in the Code with the rights of reemployed veterans under 

USERRA . The proposal applies to make-up contributions made by an employer or employee 

to an individual account plan and to make-up contributions made by an employee to a defined 

benefit plan that provides for employee contributions. 

-46-
Under the proposal, a make-up contribution is subject to the generally applicable plan 

contribution limits and the limit on deductible contributions for the year to which the 

contribution relates, not for the year in which the contribution is made. The proposal also 

provides that a plan under which a make-up contribution is made will not be treated as 

failing to meet the qualified plan nondiscrimination, coverage, minimum participation, or 

top-heavy rules on account of the contribution. In addition, the proposal provides that 

certain rules that apply to plan loans will not be violated merely because a plan suspends the 

repayment of a loan during a period of uniformed service. 

The proposal would be effective as of December 12, 1994. 

W. DATE FOR ADOPTION OF PLAN AMENDMENTS 

Current Law 

Plan amendments that are made to reflect amendments to the Internal Revenue Code 

must generally be made by the employer's income tax return due date for the employer's 

taxable year in which the change in the law occurs. 

Reasons for Change 

Plan sponsors should be given adequate time to amend plan documents following the 

enactment of legislation that requires plans to be amended. 

Proposal 

In order to ensure that plan sponsors have adequate time to amend plan documents for 

the pension simplification provisions, plan amendments required by these pension 

simplification provisions would not be required to be made before the end of the first plan 

year beginning on or after January 1, 1998, if the plan were operated in accordance with the 

applicable provision and the amendment were retroactive to the effective date of the 

applicable provision. Governmental employers would have a later date. 

X. SUBSTANTIAL OWNER RULES RELATING TO PLAN TERMINATIONS 

Current Law 

ERISA contains very complicated rules for determining the benefits guaranteed by the 

Pension Benefit Guaranty Corporation (PBGC) for an individual who owns more than ten 

percent of a business (a "substantial owner") and who is a participant in the business's 

terminating plan. These rules were designed to prevent a substantial owner from establishing 

a plan, underfunding it, and terminating it in order to receive benefits from the PBGC. 

-47-
Under the rules, the PBG C guarantee with respect to a participant who is not a substantial 

owner is generally phased in over five years from the date of the plan's adoption or 

amendment. However, for a substantial owner, the guarantee is generally phased in over 30 

years from the date the substantial owner begins participation in the plan. The substantial 

owner's benefit under each amendment within the 30 years before plan termination is 

separately phased in. In addition, a substantial owner's guaranteed benefit cannot exceed 

twice the amount guaranteed under the original plan provisions. 

Reasons for Change 

The substantial owner phase-in rules are complex and difficult to apply because of the 

need to obtain plan documents going back up to 30 years. The reduced guarantee for 

employees with less than a majority ownership interest penalizes employees who may have 

little, if any, control over plan benefit levels or funding decisions. It also unfairly penalizes 

substantial owners who granted themselves low benefits when they entered the plan. 

Proposal 

The same five-year phase-in that currently applies to a participant who is not a 

substantial owner would apply to a substantial owner with less than a 50 percent ownership 

interest. For a substantial owner with a 50 percent or more ownership interest (a "majority 

owner"), the phase-in would depend on the number of years the plan has been in effect, 

rather than on the number of years the owner has been a participant. Specifically, the 

guaranteeable plan benefit for a majority owner would be 1/30 for each year the plan has 

been in effect. (Benefits under plan amendments would not be separately phased in.) Under 

this approach, the fraction would be the same for each majority owner, eliminating the need 

for separate computations based on documents that are up to 30 years old. However, a 

majority owner's guaranteed benefit would be limited so that it could not be more than the 

amount that would be guaranteed under the regular five-year phase-in applicable to other 

participants. In addition, the proposal would eliminate the restriction that limits a substantial 

owner's guaranteed benefit to twice the amount guaranteed under the original plan provisions 

and would simplify, in certain cases, the allocation of assets with respect to majority owners 

upon plan termination. 

The proposal would be effective for plan terminations for which notices of intent to 

terminate are provided on or after the date of enactment. 

Y. ERISA SUMMARY PLAN DESCRIPTION FILING REQUIREMENTS 

Current Law 

Under ERISA, administrators of employee pension and welfare benefit plans are 

required to furnish each participant and beneficiary with a summary plan description (SPD), 

-48-
summaries of material modifications (SMMs ) to the SP D and, at specified intervals, an 

updated SPD . These documents must also be filed with the Department of Labor (DOL) . 

Filed SPDs, SMMS , and updated SPDs are required to be made available for public 

disclosure. These requirements are administered by the DOL' s Pension and Welfare Benefits 

Administration (PWBA) . The SP D is intended to provide participants and beneficiaries with 

important information concerning their plan, the benefits provided by the plan, and their 

rights and obligations under the plan. A penalty of $100 per day may be imposed for failure 

to provide an SP D to a participant or beneficiary wh o has requested it. The $100 per day 

penalty only applies if there is a failure to provide the information when requested by a 

participant. 

Reasons for Change 

The primary purpose of having SPDs filed with the DOL is to have them available for 

participants and beneficiaries wh o are unable or reluctant to request them from their plan 

administrators. However, because SMM s are not required to be filed with the DO L until 

210 days after the end of the plan year, there is little, if any, certainty that the SP D 

information on file with the DO L at any given point in time is up-to-date. 

PWBA annually receives approximately 250,000 SPD and SMM filings. Although 

PWBA' s cost for maintaining a filing, storage, and retrieval system for SPD s is relatively 

small, approximately $52,000 annually, compliance with the SP D filing requirements costs 

plan administrators approximately $2.5 million annually, with the annual imposition of an 

estimated 150,000 burden hours. O n average, PWB A receives requests annually for about 2 

percent of the filed SPDs. Man y of the requests for SPDs come from researchers and others 

w h o are not plan participants and beneficiaries. While there is some limited benefit from the 

federal government receiving and storing SPDs, the costs to the public and private plan 

administrators outweigh the benefits. This conclusion is consistent with the findings of the 

National Performance Review. 

Proposal 

The proposal would amend ERISA to eliminate the requirement that all SPDs be filed 

with the DOL , and would authorize the DO L to obtain SPDs and other relevant documents 

from plan administrators, e.g., for purposes of responding to individual SP D requests or 

monitoring compliance with the SP D requirements. If a plan administrator failed to furnish 

the documents requested by the DO L within 30 days, the administrator would be subject to a 

civil penalty of no more than $100 per day ($1,000 per request), unless the failure was 

reasonably beyond the administrator's control. The elimination of the SP D filing 

requirement would substantially reduce costs and burdens for public and private plan 

administrators, while this approach would preserve the ability of the DO L to assist 

participants wh o are unable or reluctant to request SPD s from their plan administrators. 

This proposal would be effective for SPDs that otherwise would be required to be 

-49-
filed with the DO L on or after the date of enactment. 

Z. PBG C MISSIN G PARTICIPAN T PROGRA M 

Current Law 

When a qualified retirement plan is terminated, there may be plan participants who 

cannot be located. If the plan is a defined benefit plan covered by the PBGC , the plan 

administrator must generally distribute plan assets by purchasing irrevocable commitments 

from an insurer to satisfy all benefit liabilities. If the plan is a defined contribution plan or 

other plan not covered by the PBGC , plan assets still must be distributed to participants 

before the plan is considered terminated. 

Because of the problems that plan administrators and participants may face under 

these rules when plan participants cannot be located, the Retirement Protection Act of 1994 

(RPA) provided special rules for the payment of benefits with respect to missing participants 

(including benefits for beneficiaries of deceased participants) under a terminating plan 

covered by the PBGC . The rules require the plan administrator to (1) transfer the missing 

participant's designated benefit to the PBG C or purchase an annuity from an insurer to 

satisfy the benefit liability, and (2) provide the PBG C with such information and 

certifications with respect to the benefits or annuity as the PBG C may specify. 

Reasons for Change 

As currently enacted, these RPA rules apply only to defined benefit plans that are 

covered by PBGC . Yet other defined benefit plans, as well as defined contribution plans, 

face similar problems when they terminate and cannot locate missing participants. 

Proposal 

The PBGC's program for missing participants would be expanded to apply to defined 

contribution plans (other than governmental and church plans) and to defined benefit plans of 

a small professional service employer, if such plans have missing participants when the plans 

terminate. These plans would be able to transfer the missing participants' benefits to the 

PBGC . If the benefit of a missing participant is not transferred to the PBG C or to another 

plan, the plan administrator would give the PBG C information with respect to the missing 

participant's benefit. This would provide plan administrators an entity (i.e., the PBGC ) that 

would accept missing participants' benefits and would provide missing participants with a 

central repository for locating their benefits after a plan has been terminated. 

This proposal would be effective with respect to distributions that occur after the 

PBG C has adopted final regulations implementing the provision. 

-50-
These pension simplification proposals are similar to a package of pension 

simplification provisions contained in the Revenue Reconciliation Act of 1995 as passed by 

Congress. 

-51-
EXPAND EMPOWERMEN T ZONES AND ENTERPRISE COMMUNITIES 

Current Law 

The Omnibus Budget Reconciliation Act of 1993 (OBRA '93) authorized a fe

demonstration project in which nine empowerment zones and 95 enterprise communities 

would be designated in a competitive application process. Of the nine empowerment zones, 

six were to be located in urban areas and three were to be located in rural areas. State and 

local governments would jointly nominate distressed areas and propose strategic plans to 

stimulate economic and social revitalization. By the June 30, 1994 application deadline, over 

500 communities had submitted applications. 

On December 21, 1994, the Secretaries of the Department of Housing and Urban 

Development and the Department of Agriculture designated the empowerment zones and 

enterprise communities authorized by Congress in OBR A '93. 

Among other benefits, businesses located in empowerment zones are eligible for three 

federal tax incentives: an employment and training credit; an additional $20,000 per year of 

section 179 expensing; and, a new category of tax-exempt private activity bonds. Businesses 

located in enterprise communities are eligible for the new category of tax-exempt bonds. 

OBR A '93 also provided that federal grants would be made to designated areas. 

Reasons for Change 

The Administration believes that the number of authorized empowerment zones should 

be expanded, subject to budgetary constraints. Extending tax incentives to economically 

distressed areas will help stimulate revitalization of these areas. 

Proposal* 

The proposal has three components. First, the designation of two additional urban 

empowerment zones would be authorized, to be made within 180 days of enactment. The 

effect of this component would be to extend the current empowerment zone tax incentives to 

two additional urban areas. 

Second, technical changes would be made to the OBRA '93 tax-exempt private 

activity bond provisions and "enterprise zone business" definition. The purpose of these 

changes is to allow a broader range of businesses in to borrow the proceeds of the taxexempt bonds and, in empowerment zones, to qualify for the additional section 179 

* This description of the proposal reflects certain modifications mad e since the printing of the OM B analytical 

materials relating to this proposal. 

-52-
expensing. Unchanged are the requirements that at least 35 percent of the business's 

employees be zone residents and the bonds be applied against the State volume caps. These 

changes would be effective for bonds issued after the date of enactment and, with respect to 

expensing, for taxable years beginning on or after the date of enactment. 

Third, the designation of 20 additional empowerment zones and 80 additional 

enterprise communities would be authorized. Amon g the 20 zones, 15 would be in urban 

areas and 5 would be in rural areas or Indian reservations. The 80 communities would be 

divided between 50 urban areas and 30 rural areas or Indian reservations. 

The eligibility criteria for these new zones and communities would be expanded 

slightly. First, the square mileage limitations would be modified to allow the nominated 

areas to include an additional 2,000 acres for zones and 1,000 acres for communities. This 

additional acreage would not be subject to the poverty criteria and could be divided among 

up to three noncontiguous parcels. In addition, rather than applying the three-tiered poverty 

rate criteria applicable to the current zones and communities, the new zones and communities 

would be limited to census tracts that have poverty rates of 25 percent or more (in lieu of the 

poverty criteria, outmigration may be taken into account in designating a limited number of 

n ew rural communities). For this purpose, tracts with populations under 2,000 would be 

treated as if they had a 25 percent poverty rate if 75 percent or more of the tract was zoned 

for commercial or industrial use and the tract was contiguous to one or more other tracts that 

actually had a 25 percent or greater poverty rate. 

The additional zones would have available a different combination of tax incentives 

than those available to existing zones. The current-law wage credit would not be available in 

the new zones. However, the additional section 179 expensing, as modified above, and the 

proposal to provide tax incentives for remediation of "brownfields" to zones and communities 

(described below) would be available in the new zones. In addition, the new zones would 

qualify for private-activity bonds (with the modifications proposed for the existing zones, 

described above), subject to separate per-zone caps that would be outside of the current-law 

State volume caps. An y new zones in rural areas or Indian reservations would be authorized 

to issue up to $30 million of bonds, urban zones with populations under 100,000 would be 

subject to a bond cap of $140 million, and urban zones with populations of 100,000 or more 

would be subject to a bond cap of $240 million. 

The additional communities would have available the same tax incentives that apply to 

the existing communities (including the private-activity bond modifications and "brownfields" 

tax incentives included in these proposals). 

These new zones and communities would be required to be designated before 1998, 

and the designations would generally be effective for 10 years. 

-53-
CURRENT DEDUCTION FOR CERTAIN 

ENVIRONMENTAL CLEANUP EXPENSES 

Current Law 

Generally, costs incurred for new buildings or for permanent improvements made to 

increase the value of any property (including amounts incurred to prolong the useful life of 

property or to adapt property to a new or different use) are not currently deductible, but must 

be capitalized. This general capitalization requirement covers both purchases and 

improvements to currently owned assets, but does not apply to repairs (which are generally 

deductible when incurred with respect to business and investment property). 

In a ruling issued in 1994 (Revenue Ruling 94-38), the IRS concluded that certain 

costs incurred to clean up land and groundwater are currently deductible as business 

expenses. That ruling only addressed cleanup costs incurred by the same taxpayer that 

contaminated the land, rather than someone wh o acquired previously contaminated property. 

Also, the cleanup was not done in anticipation of putting the land to a new use. 

Additionally, the ruling concluded that the cost of monitoring equipment with a useful life 

beyond the year of acquisition had to be capitalized. While this ruling resolved some issues, 

it is still unsettled whether other remediation costs not addressed in that ruling are currently 

deductible or must be capitalized. 

Reasons for Change 

Thousands of sites across the country have been neglected or underutilized because of 

concerns over potential legal liabilities for pollution and contamination. Man y of these areas 

are located in distressed communities that would derive significant economic benefits if the 

sites were cleaned up and made available for use. 

Proposal* 

Certain remediation costs would be currently deductible if incurred with respect to a 

qualified site. Generally, these expenses would be limited to those paid or incurred in 

connection with the abatement or control of environmental contaminants. For example, 

expenses incurred with respect to the demolition of existing buildings and their structural 

components would not qualify for this treatment except in the unusual circumstance where 

the demolition is required as part of ongoing remediation. This deduction will apply for 

alternative minimum tax purposes as well as for regular tax purposes. 

* This description of the proposal reflects certain modifications mad e since the printing of the OM B analytical 

materials relating to this proposal. 

-54-
Qualified sites would be limited to those properties that satisfy use, geographic, and 

contamination requirements. The use requirement would be satisfied if the property is held 

by the taxpayer incurring the eligible expenses for use in a trade or business or for the 

production of income, or the property is of a kind properly included in the inventory of the 

taxpayer. 

The geographic requirement would be satisfied if the property is located in (i) any 

census tract that has a poverty rate of 20 percent or more, (ii) any other census tract (a) that 

has a population under 2,000, (b) 75 percent or more of which is zoned for industrial or 

commercial use, and (c) that is contiguous to one or more census tracts with a poverty rate 

of 20 percent or more, (iii) an area designated as a federal Empowerment Zone or Enterprise 

Community, or (iv) an area subject to one of the 40 Environmental Protection Agency 

(EPA) Brownfields Pilots announced prior to February 1996. Both urban and rural sites ma y 

qualify. Superfund National Priority listed sites would be excluded. 

The contamination requirement would be satisfied if hazardous substances are present 

or potentially present on the property. Typically, the property will be an abandoned or 

underused commercial or industrial property, the expansion or redevelopment of which is 

complicated by the presence or potential presence of the hazardous substance. Hazardous 

substances would be defined generally by reference to sections 101(14) and 102 of the 

Comprehensive Environmental Response Compensation and Liability Act (CERCLA) , subject 

to additional limitations applicable to asbestos and similar substances within buildings, certain 

naturally occurring substances such as radon, and certain other substances released into 

drinking water supplies due to deterioration through ordinary use. 

To claim this deduction, the taxpayer must obtain a statement that the site satisfies the 

geographic and contamination requirements from a State environmental agency designated by 

the EP A for such purposes. It is anticipated that in States with voluntary cleanup or similar 

programs, this process will be handled by the State or local agency overseeing that program. 

With respect to other States, it is anticipated that EP A will provide the necessary statements 

until appropriate State agencies are designated to take over that task. 

This deduction would be subject to recapture under current-law section 1245. Thus, 

any gain realized on disposition generally would be treated as ordinary income, rather than 

capital gain, up to the amount of deductions taken with respect to the property. This rule 

would be limited to deductions claimed under this provision. Environmental cleanup 

expenses that are deductible under current law would not be subject to this recapture regime. 

The proposal would be effective for eligible expenses incurred after the date of 

enactment. T o ensure that the budget reaches balance in 2002, the provision would be 

allowed to sunset on January 1, 2001, if the fiscal dividend for the year 2000 is not at least 

$20 billion. 

-55-
TAX RELIEF FOR CERTAIN ARMED FORCES PERSONNEL 

Current La w 

The Internal Revenue Code contains eight sections that provide special tax benefits for 

members of the Armed Forces serving in Presidentially designated "combat zones." A 

combat zone is any area which the President designates as an area in which the Armed 

Forces are or have engaged in combat. These provisions are (i) section 112, which excludes 

from income the compensation earned by enlisted personnel and warrant officers, and up to 

$500 per month of the compensation earned by commissioned officers, during any month in 

which the individual is engaged in active service in a combat zone or in which the individual 

is hospitalized (for up to two years) as a result of service in a combat zone, (ii) section 

7508(a), which extends a number of federal income tax deadlines while a member of the 

Armed Forces is serving in a combat zone, is hospitalized as a result of service in a combat 

zone, or in a missing status, and for at least 180 days thereafter, (iii) section 692, which 

exempts from federal income tax all income earned during any year in which a member of 

the Armed Forces serves in a combat zone if the individual dies as a result of such service 

(in addition, federal income taxes attributable to prior years that are unpaid as of the date of 

death are not subject to collection), (iv) section 2(a)(3), which allows the surviving spouse of 

an individual wh o dies while in missing status an additional period during which the 

surviving spouse tax rates are applicable, (v) section 2201(a), which provides partial estate 

tax relief to the estates of individuals wh o die as a result of service in a combat zone, (vi) 

section 3401(a), which provides an exemption from federal income tax withholding for all 

compensation for service in a combat zone, (vii) section 4253(d), which provides an 

exemption from telecommunications excise taxes for telephone calls by Armed Forces 

personnel that originate from combat zones, and (viii) section 6013(f), which allows the 

spouse of a member of the Armed Forces wh o is in missing status to file a joint return 

during the entire period in which the area is designated as a combat zone and for two years 

after the termination of that designation. 

Reasons for Change 

While the nature of the Operation Joint Endeavor mission is not consistent with a 

designation of this area as a combat zone, the risk of harm and the arduous nature of that 

military operation justifies an extension of these special tax provisions to members of the 

U.S. Armed Forces serving in the operation. 

Proposal 

The combat zone provisions of current law would be extended to Armed Forces 

personnel serving in the former republic of Yugoslavia for the period during which members 

of the Armed Forces are entitled to imminent danger pay for services performed in that area. 

In addition, support personnel wh o are performing services outside of the former republic of 

-56-
Yugoslavia as part of Operation Joint Endeavor and wh o are deployed away from their 

permanent duty stations qualify for the extended period of time to file tax returns, pay taxes, 

etc. The monthly exclusion under section 112 is also increased from $500 to approximately 

$4,100 (determined by reference to the maximu m rate of pay for enlisted personnel, 

including imminent danger pay where applicable). The proposal also includes a technical 

amendment to section 3401 that would conform income tax withholding rules to the 

compensation exclusion. The proposal generally would be effective November 21, 1995, 

except for the change to the withholding rules, which would be effective for payments after 

the date of enactment. 

The proposal is identical to the provisions of HR 2778. 

-57-
DISALLOW INTEREST DEDUCTION FOR CORPORATE-OWNED 

LIFE INSURANCE (COLD POLICY LOANS 

Current Law 

No federal income tax generally is imposed on a policyholder with respect to the 

undistributed earnings under a life insurance contract (inside buildup), provided the life 

insurance contract meets certain requirements (section 7702). Further, an exclusion from 

Federal income tax is provided for death benefits received under a life insurance contract 

(section 101(a)). The policyholder ma y generally borrow with respect to a life insurance 

contract (other than a modified endowment contract) without affecting these exclusions. 

The present law limits the allowance of a deduction for interest paid or accrued on 

any borrowings with respect to a life insurance, endowment or annuity contract. These 

limitations include specific disallowance provisions of section 264 and other statutory and 

judicial rules which ma y apply to preclude an interest deduction. 

One of the section 264 rules disallows any deduction for interest paid or accrued on 

indebtedness with respect to one or more life insurance contracts covering the life of any 

individual wh o is (1) an officer or employee of, or (2) financially interested in, any trade or 

business carried on by the taxpayer to the extent that the aggregate amount of the 

indebtedness with respect to contracts covering the individual exceeds $50,000. This $50,000 

limitation was added by the Tax Reform Act of 1986 and applies to contracts purchased after 

June 20, 1986. 

Reasons for Change 

A company that sets up a COLI program typically purchases life insurance contracts 

on the lives of its employees, in many cases thousands or tens of thousands of employees, 

including former employees. The company, not the employee's family, receives all or most 

of the proceeds on the employee's death. The company typically borrows against the cash 

value of the life insurance contracts at an interest rate just above the rate at which inside 

buildup is credited under the contract. The interest that the company pays on policy loans is 

credited under the contract and increases the tax-free inside buildup. If the interest on the 

policy loans is in fact deductible under present law, the after-tax interest expense is less than 

the interest income being credited under the policy (the inside build-up). In addition, taxfree death benefits that the company receives on the death of insured employees subsidize the 

payment of premiums in future years. 

Large COLI programs may be viewed as the economic equivalent of a tax-free 

savings account owned by the company into which it pays itself interest. The taxpayer is 

indirectly paying interest to itself through an increase in the value of the life insurance 

contract of which the taxpayer is the beneficiary. A general principle of accurate income 

-58-
measurement provides that expenses such as interest are not deductible if they are costs of 

accretions of wealth that are not included in income. For example, interest incurred to 

purchase or cany tax-exempt bonds is not deductible under section 265 of the Code. 

COLI programs represent an attempt to inappropriately use the tax rules to achieve a 

result that was never contemplated by Congress. Whe n the $50,000 limit was enacted in 

1986, it was not anticipated that it would lead to the purchase of life insurance products 

covering hundreds and thousands of employees of a business organization in an attempt to 

maximize the tax arbitrage of deducting interest that is credited, tax-free, to the organizations 

that ow n the insurance contract. 

A 1990 Treasury Report to Congress found that the increases in COLI programs since 

1986 demonstrate that the Congressional intent was not accomplished and further that 

"borrowing against corporate owned life insurance does not provide family protection, 

subverts other Congressional limitations on tax-preferred retirement and health plans, and 

loses revenue." Department of Treasury, Report to The Congress on The Taxation of Life 

Insurance Company Products, 3 (March 1990). 

Proposal 

Section 264 would be amended to provide that no deduction is allowed for interest 

paid or accrued on any indebtedness with respect to one or more life insurance, endowment 

or annuity contracts covering any individual wh o is (1) an officer or employee of, or (2) 

financially interested in, any trade or business carried on by the taxpayer, regardless of the 

aggregate amount of debt with respect to policies or contracts covering the individual. 

The proposal is not intended to affect (and no inference is intended regarding) the tax 

treatment of any interest paid or accrued under present law (including whether interest paid 

or accrued during the phase-in is otherwise deductible); the IRS would not be precluded from 

challenging COL I plans under current law. 

The provision would be effective generally with respect to interest paid or accrued 

after December 31, 1995. However, subject to the limitations described below, the provision 

would be phased in by allowing the taxpayer to deduct 50 percent of the otherwise deductible 

interest incurred during 1996 on debt incurred before September 18, 1995, with respect to a 

life insurance contract that was in effect on that date and that covers only the individual wh o 

w as insured under the contract on that date. Only interest that would have been deductible 

but for this proposal is allowed under this phase-in. In addition, no deduction is allowed 

under this phase-in with respect to interest on borrowings by a taxpayer with respect to 

contracts on the lives of more than 20,000 insured individuals (for this purpose, all persons 

treated as a single employer are treated as one taxpayer). Finally, no deduction is allowed to 

the extent the rate of interest exceeds the lesser of (1) the borrowing rate specified in the 

contract as of September 18, 1995, or (2) the Moody's Corporate Bond Yield Average -

Monthly Average Corporates for each month the interest is paid or accrued. 

-59-
A n y amount included in income during 1996 or 1997 that is received under a contract 

described in the proposal on the complete surrender, redemption, or maturity of the contract 

or in full discharge of the obligation under the contract that is in the nature of a refund of the 

consideration paid for the contract is includible ratably over the first four taxable years 

beginning with the taxable year the amount would otherwise have been includible. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

-60-
DENY INTEREST DEDUCTION ON CERTAIN DEBT INSTRUMENTS 

Current Law 

Whether an instrument qualifies for tax purposes as debt or equity is determined 

under all the facts and circumstances based on principles developed in case law. If an 

instrument qualifies as equity, the issuer generally does not receive a deduction for dividends 

paid. If an instrument qualifies as debt, the issuer ma y receive a deduction for accrued 

interest and the holder generally includes interest in income, subject to certain limitations. 

Original issue discount ("OID") on a debt instrument is the excess of the stated 

redemption price at maturity over the issue price of the instrument. A n issuer of a debt 

instrument with OI D generally accrues and deducts the discount as interest over the life of 

the instrument even though interest ma y not be paid until the instrument matures. The 

holder of such a debt instrument also generally includes the OI D in income on an accrual 

basis. 

Section 385(c) provides rules for when an issuer's characterization of an interest in a 

corporation shall be binding on the issuer and the holders. 

Reasons for Change 

The line between debt and equity is uncertain, and it has proven difficult to formulate 

general rules to classify an instrument as debt or equity for all purposes or to bifurcate an 

instrument into its debt and equity components. While the IRS has taken the position that 

some purportedly debt instruments with substantial equity features should be treated as 

equity, other instruments have not been specifically addressed. Taxpayers have exploited this 

lack of guidance by, among other things, issuing instruments that have substantial equity 

features (including many non-tax benefits of equity), but as to which they claim interest 

deductions. In many cases, these instruments have been issued in exchange for outstanding 

preferred stock. 

Proposal 

Under the proposal no deduction would be allowed for interest or OID on an 

instrument issued by a corporation (or issued by a partnership to the extent of its corporate 

partners) that (i) has a maximu m weighted average maturity of more than 40 years, or (ii) is 

payable in stock of the issuer or a related party (within the meaning of sections 267(b) and 

707(b)), including an instrument a substantial portion of which is mandatorily convertible or 

convertible at the issuer's option into the stock of the issuer or a related party. In addition, 

an instrument would be treated as payable in stock if a substantial portion of the principal or 

interest is required to be determined, or ma y be determined at the option of the issuer or 

related party, by reference to the value of stock of the issuer or related party. A n instrument 

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would also be treated as payable in stock if it is part of an arrangement designed to result in 

the payment of the instrument with such stock, such as in the case of certain issuances of a 

forward contract in connection with the issuance of debt, nonrecourse debt that is secured 

principally by such stock, or certain debt instruments that are convertible at the holder's 

option when it is substantially certain that the right will be exercised. The proposal would 

not affect typical convertible debt. 

For purposes of determining the weighted average maturity of an instrument or the 

term of an instrument, any right to extend, renew, or relend would be treated as exercised, 

and any right to accelerate payment would be ignored. 

The proposal would also clarify that for purposes of section 385(c), an issuer will be 

treated as having characterized an instrument as equity if the instrument (i) has a maximu m 

term of more than 20 years, and (ii) is not shown as indebtedness on the separate balance 

sheet of the issuer. For this purpose, in the case of an instrument with a maximu m term of 

more than 20 years issued to a related party (other than a corporation) that is eliminated in 

the consolidated balance sheet that includes the issuer and holder, the issuer will be treated as 

having characterized the instrument as equity if the holder or some other related party issues 

a related instrument that is not shown as indebtedness on the consolidated balance sheet. For 

this purpose, an instrument would not be treated as shown as indebtedness on a balance sheet 

because it is described as such in footnotes or other narrative disclosures. This proposal 

would apply only to corporations that file annual financial statements with the Securities and 

Exchange Commission (SEC), and the relevant balance sheet is the balance sheet filed with 

the SEC . In addition, this proposal would not apply to leveraged leases. 

The proposal generally would not apply to demand loans, redeemable ground rents or 

any other indebtedness specified by regulation. 

The proposal is not intended to affect the tax characterization of instruments described 

in this proposal as debt or equity under current law. 

The proposal would be effective generally for instruments issued on or after 

December 7, 1995. The proposal would not, however, apply to instruments issued under a 

commitment that was binding as of December 6, 1995, and until the instrument is issued; 

instruments issued pursuant to any exchange offer outstanding on December 6, 1995; 

instruments that were priced for purposes of issuance on or before December 6, 1995; 

instruments issued pursuant to a registration statement filed with the SE C on or before 

December 7, 1995, (other than a statement that contemplates a delayed or continuous 

offering of instruments) to the extent the instruments are described in, and the aggregate 

amount of the instruments does not exceed the amount stated in, the registration statement; 

instruments issued pursuant to a registration statement that contemplates delayed or 

continuous offering filed with the SE C on or before December 7, 1995, to the extent the 

instruments are described in, and the aggregate amount of the instruments does not exceed 

the amount stated in, a prospectus supplement (including a preliminary prospectus 

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supplement) filed on or before December 7, 1995, or, if the preliminary prospectus does not 

state a maximu m amount to be issued, the aggregate amount expected to be offered as 

established by contemporaneous, written evidence; instruments issued pursuant to a private 

placement under SE C rule 144A if on or before December 7, 1995, the issuer had made a 

public announcement of its intention to issue the instruments and an offering circular or 

memorandum (including a preliminary offering circular or memorandum) had been 

distributed to prospective investors, but only to the extent the instruments were described in, 

and the aggregate amount of the instruments does not exceed the amount stated in, the 

offering circular or memorandum; and any instruments issued before the 30th day after the 

enactment of this proposal as part of an issue that is substantially identical (other than yield) 

to an issue which was publicly announced as having been sold on December 7, 1995, but 

which was terminated on or after such date. 

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DEFER DEDUCTION FOR ACCRUED BUT UNPAID 

INTEREST ON CONVERTIBLE DEBT 

Current Law 

If a financial instrument qualifies as debt, the issuer of the instrument may receive a 

deduction for accrued interest and the holder generally includes interest in income. Original 

issue discount ("OID") is the excess of the stated redemption price at maturity over the issue 

price of a debt instrument. A n issuer of a debt instrument with OI D generally accrues and 

deducts the discount as interest over the life of the instrument even though interest ma y not 

be paid until the instrument matures. The holder of such a debt instrument also generally 

includes the OI D in income on an accrual basis. 

If a debt obligation is convertible into stock and provides no payment of, or 

adjustment for, accrued interest on conversion, no deduction is allowed for accrued but 

unpaid stated interest. 

In contrast to the rules that apply to convertible debt instruments with stated interest, 

accrued but unpaid discount on a convertible debt instrument with OI D generally is 

deductible, even if the instrument is converted before the issuer pays any OID. 

Reasons for Change 

In many cases, the issuance of convertible debt with OID is viewed by market 

participants as a de facto purchase of equity. OI D and accrued interest on convertible debt 

should be treated in the same manner. 

Proposal 

The proposal would defer the deduction for OID and interest on convertible debt until 

payment. Conversion into the stock of the issuer or a related party (within the meaning of 

sections 267(b) and 707(b)) would not be treated as a payment of accrued OID. Payments in 

equity of the issuer or a related person, and payments in cash the amount of which is 

determined by reference to the value of such equity would also be disregarded for this 

purpose. For purposes of this proposal, convertible debt would include debt (i) exchangeable 

for the stock of a party related to the issuer, (ii) with cash-settlement conversion features, or 

(iii) issued with warrants (or similar instruments) as part of an investment unit in which the 

debt instrument ma y be used to satisfy the exercise price for the warrant. This proposal 

would not apply to any debt that would be convertible solely because a fixed payment of 

principal or interest is payable, at the election of the holder, in an amount of the issuer or 

related party's equity that has a value equal to the amount of the principal or interest. The 

proposal would not affect the treatment of holders. 

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T he proposal would be effective generally for convertible debt issued on or after 

December 7, 1995. The proposal would not, however, apply to instruments issued under a 

commitment that was binding as of December 6, 1995, and until the instrument is issued; 

instruments issued pursuant to any exchange offer outstanding on December 6, 1995; 

instruments that were priced for purposes of issuance on or before December 6, 1995; 

instruments issued pursuant to a registration statement filed with the SE C on or before 

December 7, 1995, (other than a statement that contemplates a delayed or continuous 

offering of instruments) to the extent the instruments are described in, and the aggregate 

amount of the instruments does not exceed the amount stated in, the registration statement; 

instruments issued pursuant to a registration statement that contemplates delayed or 

continuous offering filed with the SE C on or before December 7, 1995, to the extent the 

instruments are described in, and the aggregate amount of the instruments does not exceed 

the amount stated in, a prospectus supplement (including a preliminary prospectus 

supplement) filed on or before December 7, 1995, or, if the preliminary prospectus does not 

state a maximu m amount to be issued, the aggregate amount expected to be offered as 

established by contemporaneous, written evidence; instruments issued pursuant to a private 

placement under SE C rule 144A if on or before December 7, 1995, the issuer had made a 

public announcement of its intention to issue the instruments and an offering circular or 

memorandum (including a preliminary offering circular or memorandum) had been 

distributed to prospective investors, but only to the extent the instruments were described in, 

and the aggregate amount of the instruments does not exceed the amount stated in, the 

offering circular or memorandum; and any instruments issued before the 30th day after the 

enactment of this proposal as part of an issue that is substantially identical (other than yield) 

to an issue that was publicly announced as having been sold on December 7, 1995, but that 

was subsequently cancelled. 

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REDUCE DIVIDENDS-RECEIVED DEDUCTION TO 50 PERCENT 

Current Law 

If an instrument issued by a U.S. corporation is classified for tax purposes as equity, 

a corporate holder of that instrument generally is entitled to a deduction for dividends 

received on that instrument. This deduction is 70 percent of dividends received if the 

recipient owns less than 20 percent (by vote and value) of the stock of the payor. If the 

recipient owns more than 20 percent of the stock the deduction is increased to 80 percent. If 

the recipient owns more than 80 percent of the payor's stock, the deduction is further 

increased to 100 percent for qualifying dividends. 

Reasons for Change 

The 70-percent dividends-received deduction is too generous for corporations that 

cannot be considered an alter ego of the distributing corporation because they do not have a 

sufficient ownership interest in that corporation. 

Proposal 

Under the proposal, the dividends-received deduction available to corporations owning 

less than 20 percent (by vote and value) of the stock of a U.S. corporation would be reduced 

to 50 percent of the dividends received. The proposal would be effective for dividends paid 

or accrued more than 30 days after the date of enactment. 

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MODIFY HOLDING PERIOD FOR DIVIDENDS-RECEIVED DEDUCTION 

Current Law 

If an instrument issued by a U.S. corporation is classified for tax purposes as equity, 

a corporate holder of that instrument generally is entitled to a deduction for dividends 

received on that instrument. This deduction is 70 percent of dividends received if the 

recipient owns less than 20 percent (by vote and value) of the stock of the payor. If the 

recipient owns more than 20 percent of the stock the deduction is increased to 80 percent. If 

the recipient owns more than 80 percent of the payor's stock, the deduction is further 

increased to 100 percent for qualifying dividends. 

The dividends-received deduction is allowed to a corporate shareholder only if the 

shareholder satisfies a 46-day holding period for the dividend-paying stock (or a 91-day 

period for certain dividends on preferred stock). The 46- or 91-day holding period generally 

does not include any time in which the shareholder is protected from the risk of loss 

otherwise inherent in the ownership of an equity interest. 

Reasons for Change 

No deduction for a distribution on stock should be allowed when the owner of stock 

does not bear the risk of loss otherwise inherent in the ownership of an equity interest at a 

time proximate to the time the distribution is made. 

Proposal 

The proposal would provide that a taxpayer is not entitled to a dividends-received 

deduction if the taxpayer's holding period for the dividend-paying stock is not satisfied over 

a period immediately before or immediately after the taxpayer becomes entitled to receive the 

dividend. The proposal would be effective for dividends paid or accrued more than 30 days 

after the date of enactment. 

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EXTEND PRO RATA DISALLOWANCE OF TAX-EXEMPT 

INTEREST EXPENSE TO ALL CORPORATIONS 

Current Law 

No income tax deduction is allowed for interest on debt used directly or indirectly to 

acquire or hold investments the income on which is tax-exempt. The determination of 

whether debt is used to acquire or hold tax-exempt investments differs depending on the 

holder of the instrument. For financial institutions and dealers in tax-exempt investments, 

debt generally is treated as financing all of the taxpayer's assets proportionately. For 

corporations, other than financial institutions and dealers, and for individuals, however, a 

tracing rule is employed. Under this approach, deductions are disallowed only when 

indebtedness is incurred or continued for the purpose of purchasing or carrying tax-exempt 

investments. On e court has applied the tracing rule across members of the same consolidated 

group, but no statutory related-party rule specifically applies. 

Reasons for Change 

The current rules applicable to corporations other than financial institutions and 

dealers in tax-exempt investments permit those corporations to reduce their tax liabilities 

inappropriately through double Federal tax benefits of interest expense deductions and taxexempt interest income. The treatment of financial institutions and dealers therefore should 

be applicable to all corporations, without regard to the type of business activity the 

corporation conducts. This approach recognizes that money is fungible, and that, therefore, 

borrowing for one purpose frees the taxpayer's remaining assets for other purposes. 

Proposal 

Under the proposal, all corporations would be treated the same as financial 

institutions are treated under current law (without regard to the small issuer exception of 

section 265(b)(3)). Thus, corporations investing in tax-exempt obligations would be 

disallowed deductions for a portion of their interest expense equal to the portion of their total 

assets that is comprised of tax-exempt investments. The rule would not apply to certain 

nonsaleable tax-exempt bonds acquired by a corporation in the ordinary course of business in 

payment for goods or services sold to a State or local government. Under the proposal, 

insurance companies would not be subject to the pro rata rule. 

In addition, the proposal would apply section 265 to all related parties within the 

meaning of section 267(f) (with appropriate adjustments to reflect any inter-company 

arrangements.) For members of the same consolidated group, the pro rata rule would apply 

as if the group were a single entity, except that any member that is an insurance company 

would be excluded. For related parties that are not members of the same consolidated group, 

-68-
the current tracing rules would apply treating all the related parties as a single entity for 

purposes of this tracing rule. 

The proposal is not intended to affect the application of section 265 to related parties 

under current law. 

The proposal would be effective for taxable years beginning after the date of 

enactment with respect to obligations acquired after December 7, 1995. 

-69-
REQUIRE AVERAGE COST BASIS FOR SECURITIES 

Current Law 

Under current law, a taxpayer who sells stock or other securities is allowed to 

account for the transaction any one of a number of ways: by specifically identifying the stock 

or securities sold or by using an accounting system such as first-in-first-out or last-in-firstout. Holders of mutual funds are also permitted to account for sales using an average cost 

basis for their shares. 

Reasons for Change 

Allowing taxpayers to account for gains or losses on the sale of fungible assets 

through specific identification is artificial and complex. For example, allowing taxpayers to 

specifically identify which shares of stock are treated as sold permits taxpayers to plan and 

control the amount of gain or loss they will recognize. Income is more clearly reflected if 

gain or loss is measured by the amount of gain or loss with respect to all substantially 

identical assets. 

Proposal 

Taxpayers generally would be required to determine their basis in substantially 

identical securities using the average of all of their holdings in the securities. Thus, for 

example, if a taxpayer holds 100 shares of stock in Corporation A , 50 of which were 

purchased for $50 and 50 of which were purchased for $100, the taxpayer's total basis in 

each share will be $75. For purposes of determining whether gain or loss on the sale of 

securities is short- or long-term, and any other time it is relevant, a taxpayer generally would 

be treated as selling or disposing of substantially identical securities on a first-in, first-out 

basis. 

This method of determining basis and holding period would apply to securities as that 

term is defined by section 475(c)(2), other than subparagraph (F) thereof. Thus, average 

cost basis would be required for stock, debt instruments, options, certain futures contracts, 

and certain other derivative financial instruments (not including those based on commodities). 

T he average cost basis rules generally would not apply to contractual financial products, such 

as over-the-counter options, notional principal contracts or forward contracts, because 

taxpayers are unlikely to have multiple fungible contractual financial products of these types 

that were purchased or entered into at different prices. 

A special rule would allow the Treasury to treat securities that are substantially 

identical as not subject to the average cost basis rule if they have a special status under a 

provision of the Code. For example, the Treasury would be permitted to treat shares of the 

same stock as not substantially identical if some are contributed to a partnership with built-in 

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gain (and are therefore subject to section 704(c)) and others are purchased by the partnership 

(and, therefore, are not subject to section 704(c)). Securities not having an average cost 

basis under this regulatory authority would still be subject to the ordering rule for 

substantially identical securities (i.e., first-in, first-out) and would not be subject to specific 

identification. 

This proposal would, by itself, eliminate taxpayers' ability to avoid immediate 

recognition of gain through short sales against the box transactions (even in the absence of 

the constructive sale proposal, described below.) This is because this proposal would govern 

the basis and holding period of all securities sold, and taxpayers would no longer be able to 

specifically identify borrowed securities as the ones delivered on a sale. For example, 

assume a taxpayer owns 20 shares of stock with an average cost basis of $20, and borrows 

10 shares of the stock immediately prior to selling 10 shares. The taxpayer would have a 

$20 tax basis in each of the shares sold, and would determine the shares sold using the firstin first-out method. Th e 10 shares the taxpayer is obligated to deliver under the borrowing 

would have no effect on the taxpayer's calculation of its average basis. 

The proposal would be effective 30 days after the date of enactment. 

-71-
REQUIRE RECOGNITION OF GAIN ON CERTAIN 

APPRECIATED POSITIONS IN PERSONAL PROPERTY 

Current Law 

Under current law gain and loss are generally taken into account for tax purposes 

when realized. Gain or loss is usually realized with respect to a capital asset at the time the 

asset is sold, exchanged or otherwise disposed of. Special rules under the Code can defer 

recognition of loss until after realization, and occasionally can accelerate recognition of gain. 

The recognition of gain or loss is postponed for open transactions. For example, in 

the case of a "short sale" (i.e., when a taxpayer sells borrowed property such as stock and 

closes the sale by returning identical property to the lender) no gain or loss on the transaction 

is recognized until the closing of the borrowing. 

Transactions designed to reduce or eliminate risk of loss on financial assets generally 

do not cause realization. For example, taxpayers ma y lock in gain on securities by entering 

into a "short sale against the box," i.e., when the taxpayer owns securities that are the same 

as, or substantially identical to, the securities borrowed and sold short. Pursuant to rules that 

allow specific identification of securities delivered on a sale, the taxpayer can obtain open 

transaction treatment by identifying the borrowed securities as the securities delivered. 

Whe n it is time to close out the borrowing, the taxpayer can choose to deliver either the 

securities held or newly purchased securities. The Code provides rules only to prevent 

taxpayers from using short sales against the box to accelerate loss or to convert short-term 

capital gain into long-term capital gain or long-term capital loss into short-term capital loss. 

Taxpayers can also lock in gain on certain property by entering into straddles without 

recognizing gain for tax purposes. A straddle consists of offsetting positions with respect to 

personal property. A taxpayer can take losses on positions in straddles into account only to 

the extent the losses exceed the unrecognized gain in the other positions in the straddle. In 

addition, rules similar to the short sale rules prevent taxpayers from changing the tax 

character of gains and losses recognized on straddles. 

The Code accelerates the recognition of gains and losses in certain cases. For 

example, taxpayers are required each year to mark to market certain regulated futures 

contracts, foreign currency contracts, non-equity options, and dealer equity options, and to 

take any capital gain or loss thereon into account as 40 percent short-term and 60 percent 

long-term. Securities dealers are also required to mark their securities to market. 

Reasons for Change 

It is inappropriate for taxpayers to be able to dispose of the economic risks and 

rewards of owning appreciated property without realizing income for tax purposes. For 

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example, in a short sale against the box the taxpayer has no risk of loss and no opportunity 

for gain on the stock sold short, but for tax purposes is not treated as having disposed of the 

stock. 

Recent innovations in the financial markets, such as swaps, have increased taxpayers' 

ability to tailor investments to lock-in gain without gain realization. It is possible no w for a 

taxpayer with appreciated property to swap the returns on the property for the returns on 

almost any other property, without recognizing built-in gain for tax purposes. Thus, 

investors with sufficient capital or access to modern financial transactions seek to avoid 

recognizing gain indefinitely. 

Proposal 

The proposal would require a taxpayer to recognize gain (but not loss) upon entering 

into a constructive sale of any appreciated position in either stock, a debt instrument, or a 

partnership interest. A taxpayer would be treated as making a constructive sale of an 

appreciated position whe n the taxpayer (or, in certain limited circumstances, a person related 

to the taxpayer) substantially eliminates risk of loss and opportunity for gain by entering into 

one or more positions with respect to the same or substantially identical property. For 

example, a taxpayer that holds appreciated stock and enters into a short position with respect 

to that stock or an equity swap with regard to the stock would recognize any gain on the 

stock. Similarly, a taxpayer that holds appreciated stock and grants a call option or enters 

into a put option on the stock would generally recognize gain on the stock if there is a 

substantial certainty that the option will be exercised. In addition, a taxpayer would 

recognize gain on an appreciated position in stock, debt or partnership interests if the 

taxpayer enters into a transaction that is marketed or sold as substantially eliminating the risk 

of loss and opportunity for gain, regardless of whether the transaction involves the same or 

substantially identical property. 

The taxpayer would recognize gain in a constructive sale as if the position were sold 

and immediately repurchased. A n appropriate adjustment (such as an increase in the basis of 

the position) would be mad e for gain recognized on the constructive sale, and a ne w holding 

period would begin as if the taxpayer had acquired the position on the date of the 

constructive sale. 

If the taxpayer makes a constructive sale of less than all of his or her appreciated 

positions in a particular property, the proposal would trigger gain recognition in the order the 

positions were acquired or entered into. If the taxpayer actually disposed of a position 

previously constructively sold, the offsetting positions creating the constructive sale still held 

by the taxpayer would be treated as causing a new constructive sale of appreciated positions 

in substantially identical property, if any, the taxpayer holds at that time. 

The proposal would not apply to any contract for the sale of any stock, debt 

instrument or partnership interest that is not a marketable security (as defined under the rules 

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that apply to installment sales) if the sale is reasonably expected to occur within one year of 

the date the contract is entered into. In addition, the proposal would not treat a transaction 

as a constructive sale if the taxpayer is required to mark to market the appreciated financial 

position under section 475 (mark to market for securities dealers) or section 1256 (mark to 

market for futures contracts, options and currency contracts). 

The proposal would be effective for constructive sales entered into after the date of 

enactment. In addition, the proposal would apply to constructive sales entered into after 

January 12, 1996, and before the date of enactment if the transaction resulting in the 

constructive sale remains open 30 days after the date of enactment. The proposal would 

apply to those pre-enactment transactions as if the constructive sales occurred on the date that 

is 30 days after the date of enactment. 

A special rule would be included for constructive sales entered into on or before the 

date of enactment by decedents dying after the date of enactment. If the constructive sale 

remains open on the day before the date of death and gain has not been recognized under this 

provision, the appreciated financial position would be treated as property constituting rights 

to receive income in respect of a decedent under section 691. 

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ELIMINATE THE EXTINGUISHMENT DOCTRINE 

Current Law 

Tax law distinguishes between a sale of a right or obligation to a third party and the 

extinguishment or retirement of the right or obligation. A sale to a third party can give rise 

to capital treatment whereas an extinguishment will be ordinary. 

Extinguishment treatment has been eliminated statutorily for all debt instruments 

except those issued by natural persons and for most options and other positions in actively 

traded property. The application of extinguishment doctrine in other contexts is unclear. 

Reasons for Change 

The distinction between sale and extinguishment allows taxpayers to choose whether 

they want capital or ordinary treatment for transactions in certain property. For example, if 

a taxpayer wants capital treatment for appreciation in the value of a non-actively traded 

contract, the taxpayer can sell the contract to a third party. If the taxpayer wants ordinary 

treatment, the taxpayer can arrange to have the contract extinguished. Thus, taxpayers can 

plan for ordinary losses and capital gains on a contract. This ability to select the treatment 

of the disposition is inappropriate. 

Proposal 

Gain or loss attributable to the cancellation, lapse, expiration, or other termination of 

any right or obligation with respect to property that is or would be a capital asset in the 

hands of the taxpayer would be treated as gain or loss from the sale or exchange of a capital 

asset. In addition, the proposal would repeal the current exemption of instruments issued by 

a natural person from the general rule that any amounts received on retirement of a debt are 

treated as received in exchange for the debt. 

The proposal is not intended to affect the treatment of any transaction under current 

law. 

The proposal would be effective 30 days after the date of enactment. 

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REQUIRE REASONABLE PAYMENT ASSUMPTIONS FOR 

INTEREST ACCRUALS ON CERTAIN DEBT INSTRUMENTS 

Current Law 

An accrual method taxpayer generally must include interest in income as it accrues 

rather than when it is paid. Original issue discount ("OID") is includable in income on an 

accrual basis, even if the holder is a cash-method taxpayer. 

If the principal amount of indebtedness may be paid by the borrower by a specified 

date without interest (as is the case with certain credit card balances), the accrual method of 

accounting does not require the lender to accrue interest until the specified date has passed. 

In addition, if a borrower can reduce the yield on a debt by exercising the option to prepay 

the debt, the accrual of OI D is calculated assuming the issuer will exercise the option. 

A special rule for determining interest accrual applies to instruments issued by real 

estate mortgage investment conduits (REMICs), mortgages held by REMIC s and other debt 

instruments if payment on the instruments can be accelerated based on prepayments of 

obligations securing the instruments. Section 1272(a)(6) requires that for purposes of 

calculating the amount of OI D accrued on these instruments, a reasonable prepayment 

assumption must be used and OI D is calculated using the "catch-up" method. Because the 

timing of principal payments, and therefore the yield, on a mortgage acquired at a discount is 

uncertain, a special rule is necessary to provide for an approximation of the economic 

accrual of interest on the instrument. This provision requires taxpayers to accrue OI D at a 

higher, but more accurate, rate than they would if they made no prepayment assumption. 

Reasons for Change 

The prepayment, catch-up method applied to REMIC interests and mortgages held by 

REMIC s should be extended to pools of debt instruments that have similarly uncertain 

payment schedules. For example, in the case of credit cards receivables an assumption about 

payment patterns must be used to accurately accrue interest income when the receivables are 

outstanding over the end of a taxable year. Applying the catch-up method with a prepayment 

assumption rule broadly to pools of receivables and other debt instruments would prevent 

taxpayers from accruing interest or OI D at artificially low rates and would equalize the 

treatment of these instruments and REMI C interests and REMI C mortgages. 

Proposal 

The proposal would require taxpayers to use the catch-up method with a reasonable 

prepayment assumption for purposes of determining the amount of interest or OI D income 

that accrues on a pool of debt instruments. Changes in accounting required by the proposal 

-76-
would be treated as a change in a method of accounting subject to section 481, with 

adjustments taken into account over a four-year period. 

This proposal is not intended to apply to pools of receivables for which interest 

charges are incidental. For example, if a merchant permits customers to pay their bills 

within a reasonable period, and does not routinely receive interest from a substantial porion 

of its customers, the proposal would not apply. In addition, Treasury would be authorized to 

provide appropriate exemptions from this proposal, including, for example, for taxpayers that 

hold a limited amount of debt instruments. 

The proposal would be effective for taxable years beginning after the date of 

enactment. 

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REQUIR E GAI N RECOGNITIO N FO R CERTAI N EXTRAORDINAR Y DIVIDENDS 

Current Law 

A corporate shareholder is generally allowed to deduct a certain percentage of 

dividends received from another domestic corporation. A corporate shareholder who 

receives an "extraordinary" dividend is required to reduce the basis of the stock with respect 

to which the dividend was received by the non-taxed portion of the dividend (section 1059). 

Whether a dividend is "extraordinary" is determined by reference to, among other things, the 

size of the dividend in relation to the adjusted basis of the shareholder's stock. Also, a 

dividend resulting from a non prorata redemption or partial liquidation is an extraordinary 

dividend. If the reduction in basis of stock exceeds the basis in the stock with respect to 

which an extraordinary dividend is received, the excess is taxed as gain at the time of a sale 

or disposition of such stock. 

In general, a distribution in redemption of stock is treated as a dividend, rather t

as a sale of the stock, if it is essentially equivalent to a dividend. A redemption of the stock 

of a shareholder generally is essentially equivalent to a dividend if it does not result in a 

meaningful reduction in the shareholder's proportionate interest in the distributing 

corporation. The determination whether a redemption is essentially equivalent to a dividend 

includes reference to the constructive ownership rules of section 318, including the option 

attribution rules of section 318(a)(4). The rules relating to treatment of other property 

received in a reorganization contain a similar reference (section 356(a)(2)). 

Reasons for Change 

Some corporate taxpayers are attempting to dispose of stock of other corporations in 

transactions structured as redemptions, where the redeemed corporate shareholder apparently 

expects to take the position that the transaction qualifies for the dividends-received deduction. 

Thus, the redeemed corporate shareholder attempts to exclude from income a substantial 

portion of the amount received. In some cases, it appears that the taxpayers' interpretations 

of the option attribution rules of section 318(a)(4) are important to the taxpayers' contentions 

that their interests in the distributing corporation are not meaningfully reduced. 

Also, the present rules may be permitting inappropriate deferral of gain recognition 

when the portion of the distribution that is excluded due to the dividends-received deduction 

exceeds the basis of the stock with respect to which the extraordinary dividend is received. 

Proposal 

The extraordinary dividend rules of section 1059 would be amended to provide that a 

corporate shareholder will recognize gain immediately with respect to any redemption treated 

as a dividend (in whole or in part) when the nontaxed portion of the dividend exceeds the 

-78-
basis of the shares surrendered, if the redemption is treated as a dividend due to options 

being counted as stock ownership. In addition, immediate gain recognition is required 

whenever the basis of stock with respect to which any extraordinary dividend was received is 

reduced below zero. Reorganizations or other exchanges involving amounts that are treated 

as dividends under section 356(a)(2) of the Code are treated as redemptions for purposes of 

applying the rules relating to redemptions under section 1059(e). 

The proposal would be effective for distributions after May 3, 1995 if the redemption 

is treated as a dividend due to options being counted as stock ownership unless the 

distribution is: (i) made pursuant to the terms of a written binding contract in effect on Ma y 

3, 1995, and at all times thereafter before such distribution, or (ii) made pursuant to the 

terms of a tender offer outstanding on Ma y 3, 1995. For distributions which are treated as 

extraordinary dividends other than due to options being counted as stock ownership, this 

proposal applies to any of these distributions after September 13, 1995. The proposal is not 

intended to affect the treatment of transactions structured as redemptions under current law. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

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REPEAL PERCENTAGE DEPLETION FOR 

NON-FUEL MINERALS MINED ON FEDERAL LANDS 

Current Law 

Taxpayers are allowed to deduct a reasonable allowance for depletion relating to 

certain hard mineral deposits. The depletion deduction for any taxable year is calculated 

under either the cost depletion method or the percentage depletion method, whichever results 

in the greater allowance for depletion for the year. 

Under the cost depletion method, the taxpayer deducts that portion of the adjusted 

basis of the property which is equal to the ratio of the units sold from that property during 

the taxable year, to the estimated total units remaining at the beginning of that year. 

Under the percentage depletion method, a deduction is allowed in each taxable year 

for a statutory percentage of the taxpayer's gross income from the property. The percentage 

depletion deduction for these minerals may not exceed 50 percent of the net income from the 

property for the taxable year (computed without allowance for depletion). Percentage 

depletion is not limited to the taxpayer's basis in the property; thus, the aggregate amount of 

percentage depletion deductions claimed may exceed the amount expended by the taxpayer to 

acquire and develop the property. 

The 1872 mining act has allowed investors to acquire mining rights on Federal lands 

at the cost of $5.00 per acre or less. 

Reasons for Change 

The percentage depletion provisions under present law generally are viewed as an 

incentive for mineral production rather than as a normative rule for recovering the taxpayer's 

investment in the property. This incentive, however, is excessive with respect to minerals 

acquired under the 1872 mining act, in light of the minimal costs of acquiring these mining 

rights. In addition, the measurement of income in the affected industries will be improved 

by the repeal of these percentage depletion provisions. 

Proposal 

The proposal would repeal percentage depletion provisions under present law for nonfuel minerals mined on lands where the mining rights were originally acquired under the 

1872 law. The proposal would be effective for taxable years beginning after the date of 

enactment. 

-80-
MODIFY NET OPERATING LOSS CARRY-BACK AND CARRY-FORWARD RULES 

Current Law 

Net operating losses ("NOLs") generally can be used to offset taxable income from 

the prior three taxable years ("carry-backs") and the succeeding 15 taxable years ("carryforwards"). 

Reasons for Change 

NOL carry-backs and carry-forwards may correct for income distortions that result 

when the end of a taxable year separates income from related losses. However, because of 

the increased complexity and administrative burden associated with carry-backs, the period of 

carry-back should be shortened. O n the other hand, the carry-forward period under current 

law can be lengthened to allow taxpayers more time to utilize their NOL s without 

substantially increasing either complexity or administrative burdens. 

Proposal 

The proposal would limit carry-backs of NOLs to one year and extend carry-forwards 

to 20 years. The proposal would be effective for taxable years beginning after the date of 

enactment. 

-81-
TREAT CERTAIN PREFERRED STOCK AS "BOOT" 

Current Law 

In reorganization transactions within the meaning of section 368, no gain or loss is 

recognized except to the extent "other property" is received, that is, property other than 

certain stock, including preferred stock. Thus, preferred stock can be received tax-free in a 

reorganization, notwithstanding that many preferred stocks are functionally equivalent to debt 

securities. Upo n the receipt of other property, gain but not loss can be recognized. A special 

rule permits debt securities to be received tax-free, but only to the extent debt securities of 

no lesser principal amount are surrendered in the exchange. Other than this debt-for-debt 

rule, similar rules generally apply to transactions described in section 351. 

Reasons for Change 

Tax-free treatment in a reorganization or section 351 transaction is inappropriate for 

preferred stock that has an enhanced likelihood of recovery of principal or of maintaining a 

dividend or both, or that otherwise has certain non-stock characteristics. 

Proposal 

The proposal would amend the relevant provisions (sections 351, 354, 355, 356 and 

1036) to treat certain preferred stock as "other property" (boot), subject to certain 

exceptions. Thus, when a taxpayer exchanges property for this preferred stock in a 

transaction that qualifies under either section 351 or section 368, gain but not loss would be 

recognized. 

The proposal would apply to preferred stock (i.e., stock which is limited and 

preferred as to dividends and does not participate, including through a conversion privilege, 

in corporate growth to any significant extent), where (i) the holder has the right to require 

the issuer or a related person (within the meaning of sections 267(b) and 707(b)) to redeem 

or purchase the stock, (ii) the issuer or a related person is required to redeem or purchase the 

stock, (iii) the issuer (or a related person) has the right to redeem or purchase the stock and, 

as of the issue date, it is more likely than not that such right will be exercised, or (iv) the 

dividend rate on the stock varies in whole or in part (directly or indirectly) with reference to 

interest rates, commodity prices, or other similar indices, regardless of whether such varying 

rate is provided as an express term of the stock (for example, in the case of an adjustable 

rate stock) or as a practical result of other aspects of the stock (for example, in the case of 

auction rate stock). For this purpose, clauses (i), (ii) and (iii) apply if the right or obligation 

m a y be exercised within 20 years of the date the instrument is issued and such right or 

obligation is not subject to a contingency which, as of the issue date, makes remote the 

likelihood of the redemption or purchase. In addition, a right or obligation would be 

disregarded if it ma y be exercised only upon the death, disability or mental incompetency of 

-82-
the holder, or in the case of stock transferred in connection with the performance of services, 

upon the holder's retirement. 

The following exchanges would be excluded from this gain recognition: (1) an 

exchange of preferred stock for comparable preferred stock of the same or lesser value; (2) 

an exchange of preferred stock for commo n stock; (3) an exchange of debt securities for 

preferred stock of the same or lesser value; and (4) exchanges of stock in certain 

recapitalizations of family-owned corporations. For this purpose, a family-owned 

corporation would be defined as any corporation if at least 50 percent of the total voting 

power and value of the stock of such corporation is owned by members of the same family 

for five years preceding the recapitalization. In addition, a recapitalization does not qualify 

for the exception if the same family does not ow n 50 percent of the total voting power and 

value of the stock throughout the three-year period following the recapitalization. Members 

of the same family would be defined by reference to the definition in section 447(e). Thus, a 

family would include children, parents, brothers, sisters, and spouses, with limited attribution 

for directly and indirectly owned stock of the corporation. Shares held by a family member 

would be treated as not held by a family member to the extent a non-family membe r had a 

right, option or agreement to acquire the shares (directly or indirectly, for example, through 

redemptions by the issuer), or with respect to shares as to which a family member has 

reduced its risk of loss with respect to the share, for example, through an equity swap. Even 

though the provision excepts certain family recapitalizations, the special valuation rules of 

section 2701 for estate and gift tax consequences still apply. 

An exchange of nonqualified preferred stock for nonqualified preferred stock in an 

acquiring corporation ma y qualify for tax-free treatment under section 354 but not section 

351. In cases in which both sections 354 and 351 may apply to a transaction, section 354 

will generally apply for purposes of this proposal. Thus, in that situation, the exchange 

would be tax free. 

The Treasury Secretary would have regulatory authority to (i) apply installment-sale 

type rules to preferred stock that is subject to this proposal in appropriate cases, and (ii) 

prescribe treatment of preferred stock subject to this provision under other provisions of the 

Code (e.g., sections 304, 306, 318 and 368(c)). 

The proposal would be effective for transactions after December 7, 1995, unless the 

stock: (1) is issued pursuant to a written agreement which was (subject to customary 

conditions) binding on such date and at all times thereafter before the stock was issued, (2) is 

issued pursuant to an exchange offer which was outstanding on such date, or (3) was priced 

for purposes of issuance on or before such date. 

-83-
REPEAL SECTION 1374 FOR LARGE CORPORATIONS 

Current Law 

C corporations are generally subject to a two-tier tax. A corporation can avoid this 

two-tier tax by electing to be treated as an S corporation or by converting to a partnership. 

Converting to a partnership is a taxable event that generally requires the corporation to 

recognize any built-in gain on its assets and requires the shareholders of the corporation to 

recognize any built-in gain in their corporate stock. The conversion of a C corporation to an 

S corporation, however, is generally tax-free for both corporations and its shareholders, 

except that the S corporation must recognize the built-in gain on assets held at the time of 

conversion if the assets are sold within ten years under section 1374. 

A corporation generally can also avoid the two-tier tax if it can qualify as a regulated 

investment company (RIC) or a real estate investment trust (REIT) (by deducting dividends 

paid to its shareholders). The conversion of a C corporation to a RI C or REIT, however, is 

treated as if the corporation had sold all of its assets at their fair market value and 

immediately liquidated, thereby requiring the corporation to recognize any built-in gain in its 

assets at the time of the conversion. Notice 88-19, 1988-1 C.B. 486. The IRS, however, 

permits the corporation to avoid the immediate recognition of its built-in gain if the 

corporation elects to be subject to rules similar to section 1374. Id. 

Reasons for Change 

The tax treatment of the conversion of a C corporation to an S corporation generally 

should be consistent with the treatment of its conversion to a partnership. In particular, any 

appreciation in corporate assets that occurred during the time the corporation is a C 

corporation should be subject to the corporate-level tax. 

Proposal 

The proposal would repeal section 1374 for large corporations. A C-to-S corporation 

conversion (whether by a C corporation electing S corporation status or by a C corporation 

merging into an S corporation) would be treated as a liquidation of the C corporation 

followed by a contribution of the assets to an S corporation by the recipient shareholders. 

Thus, the proposal would require immediate gain recognition by both the corporation (with 

respect to its appreciated assets) and its shareholders (with respect to their stock) upon the 

conversion to S corporation status. 

For this purpose, a large S corporation is one with a value of more than $5 million at 

the time of conversion. The value of the corporation would be the fair market value of all 

the stock of the corporation on the date of conversion. 

-84-
T he proposal would be effective for subchapter S elections that are first effective for a 

taxable year beginning after January 1, 1997. The proposal also would apply to acquisitions 

(e.g., the merger of a C corporation into an S corporation) after December 31, 1996. Thus, 

C corporations would continue to be permitted to elect S corporation status effective for 

taxable years beginning in 1996 or on January 1, 1997. 

In addition, the Internal Revenue Service would revise Notice 88-19 to conform to the 

proposed amendment to section 1374, with an effective date similar to the statutory proposal. 

A s a result, the conversion of a large C corporation to a RI C or a REI T after the revisions 

would result in immediate recognition by the C corporation of the net built-in gain in its 

assets. 

-85-
REQUIRE GAIN RECOGNITION ON CERTAIN DISTRIBUTIONS 

OF CONTROLLED CORPORATION STOCK 

Current Law 

A corporation is generally required to recognize gain on the distribution of property 

(including stock of a subsidiary) as if such property had been sold for its fair market value. 

T h e shareholders generally treat the receipt of property as a taxable event as well. Section 

355 provides an exception to this rule for certain distributions of stock in a controlled 

corporation, provided that various requirements are met, including certain restrictions 

relating to acquisitions and dispositions of stock of the distributing corporation 

("distributing") or the controlled corporation ("controlled") prior and subsequent to a 

distribution. 

Reasons for Change 

Corporate nonrecognition under section 355 should not apply to distributions that are 

effectively dispositions of a business. 

Proposal 

The proposal would adopt additional restrictions under section 355 on acquisitions and 

dispositions of the stock of distributing and controlled. Specifically, section 355 tax-free 

treatment would not apply, and distributing (but not its shareholders) would recognize gain, 

on the distribution of the stock of controlled unless the direct and indirect shareholders of 

distributing, as a group, control both distributing and controlled at all times during the four 

year period commencing two years prior to the distribution. Control for this purpose means 

ownership of stock possessing at least 50 percent of the total combined voting power of all 

classes of stock and at least 50 percent of the total value of shares of all classes of stock. 

In determining whether shareholders retain control in both corporations throughout the 

four-year time period, any acquisitions or dispositions of stock that are unrelated to the 

distribution will be disregarded. A transaction is unrelated to the distribution if it is not 

pursuant to a commo n plan or arrangement that includes the distribution. For example, 

public trading of the stock of either distributing or controlled is disregarded, even if that 

trading occurs in contemplation of the distribution. Similarly, an acquisition of distributing 

or controlled in a merger or otherwise that is not pursuant to a commo n plan or arrangement 

existing at the time of the distribution is not related to the distribution. For example, a 

hostile acquisition of distributing or controlled commencing after the distribution will be 

disregarded. O n the other hand, a friendly acquisition will generally be considered related to 

the distribution if it is pursuant to an arrangement negotiated (in whole or in part) prior to 

the distribution, even if at the time of distribution it is subject to various conditions, such as 

the approval of shareholders or a regulatory body. 

-86-
T he proposal would be effective for distributions after March 19, 1996 unless the 

distribution is: (i) made pursuant to a written agreement which was (subject to customary 

conditions) binding on or before March 19, 1996, and at all times thereafter before the 

distribution; (ii) described in a ruling request submitted to the IRS on or before March 19, 

1996; or (iii) described in a public announcement or SE C filing made on or before March 

19, 1996. 

-87-
REFORM THE TREATMENT OF CERTAIN CORPORATE STOCK TRANSFERS 

Current Law 

Under section 304, if one corporation purchases stock of a related corporation, the 

transaction is generally recharacterized as a redemption and ma y result in a dividend to the 

selling shareholder under section 302(d). A transaction is treated as a sale or a dividend 

depending on the change in the selling corporation's ownership of stock in the issuing 

corporation (applying the constructive ownership rules of sections 318(a) and 304(c)). Sales 

proceeds received by a corporate transferor that are treated as a dividend under section 304 

m a y qualify for a dividends-received deduction ("DRD") under section 243 if all of the 

parties are domestic corporations. Section 304 does not apply to transfers of stock between 

members of a consolidated group. 

Section 1059 applies to "extraordinary dividends," including certain redemption 

transactions treated as dividends qualifying for the DRD . If a redemption results in an 

extraordinary dividend, section 1059 generally requires the shareholder to reduce its basis in 

the stock of the redeeming corporation. Under a separate proposal (described above), section 

1059 would be amended to provide that for certain redemptions only the basis of the shares 

redeemed would be taken into account for purposes of section 1059. Accordingly, gain 

would be realized to the extent that the nontaxed portion of the dividend (generally, the 

amount of the DRD ) exceeds the shareholder's basis in the shares redeemed. 

Reasons for Change 

Section 304 is directed primarily at preventing a controlling shareholder from 

claiming basis recovery and capital gain treatment on transactions that result in a withdrawal 

of earnings from corporate solution. These concerns are most relevant where the shareholder 

is an individual. Different concerns ma y be present if the shareholder is a corporation, due 

in part to the presence of the DRD . In fact, a corporation will often prefer a transaction to 

be characterized as a dividend, as opposed to a sale or exchange. Accordingly, a corporation 

m a y intentionally seek to apply section 304 to a transaction which is in substance a sale or 

exchange. For example, in certain related party sales the selling corporation ma y take the 

position that its basis in any shares of stock it ma y have retained need not be reduced by the 

amount of the DRD . 

In international cases, a U.S. corporation owned by a foreign corporation may 

inappropriately claim foreign tax credits from a section 304 transaction. For example, if a 

foreign-controlled domestic corporation sells the stock of a subsidiary to a foreign sister 

corporation, the domestic corporation ma y take the position that it is entitled to credit foreign 

taxes that were paid by the foreign sister corporation. See Rev. Rul. 92-86, 1992-2 C.B. 

199; Rev. Rul. 91-5, 1991-1 C.B. 114. However, if the foreign sister corporation had 

actually distributed its earnings and profits to the commo n foreign parent, no foreign tax 

-88-
credits would have been available to the domestic corporation. 

Proposal 

The proposal would clarify that a transaction described in section 304(a)(1) is treated 

as if (1) the seller transferred the stock of the issuing corporation in exchange for stock of 

the acquiring corporation in a transaction to which section 351(a) applies, and (2) the 

acquiring corporation then redeemed the shares it was treated as issuing. Thus, even though 

the characterization of the transaction as a sale or exchange or a dividend is made by 

reference to the stock of the issuing corporation, the acquiring corporation is treated for all 

purposes (including, for example, basis determinations and the application of section 1059) as 

redeeming the stock issued to the selling corporation. Furthermore, section 1059 would be 

amended so that, if the deemed redemption is treated as a dividend and the transferor claims 

a DRD , the dividend would be treated as an extraordinary dividend in which only the basis 

of the transferred shares would be taken into account for purposes of section 1059. 

Accordingly, gain would be realized to the extent that the nontaxed portion of the dividend 

exceeds the seller's basis in the shares transferred. These rules would apply without regard 

to the seller's holding period in the stock of the issuing corporation. 

The proposal would also modify the results of international section 304 transactions. 

Under the proposal, the earnings and profits taken into account from a foreign acquiring 

corporation in a section 304 transaction would not exceed the amount of earnings and profits 

attributable to stock of the acquiring corporation owned directly or indirectly by a ten-percent 

U.S. shareholder wh o is either the transferor or a related person. In determining the amount 

of earnings and profits attributable to the U.S. shareholder's ownership, only the earnings 

and profits accrued during the period of such ownership would be taken into account. Thus, 

under the proposal, a section 304 transaction would generate foreign tax credits only to the 

extent that the foreign tax credits would have been available during the holding period if the 

acquiring corporation had actually distributed the sales proceeds to the commo n parent. 

The proposal would be effective for transactions after March 19, 1996, unless the 

transaction is: (i) undertaken pursuant to a written agreement which was (subject to 

customary conditions) binding on that date and at all times thereafter; (ii) described in a 

ruling request submitted to the IRS on or before that date; or (iii) described in a public 

announcement or SE C filing made on or before that date. The proposal is not intended to 

affect the treatment of any transaction under current law. 

-89-
DETER EXPATRIATION TAX AVOIDANCE 

Current Law 

Under current law, worldwide gains realized by U.S. citizens and resident aliens are 

subject to U.S. tax. However, if a U.S. citizen renounces or abandons citizenship or an 

alien ceases to be a resident, no tax is imposed on accrued but unrealized gains. Existing 

rules continue to tax former U.S. citizens on U.S. source income for ten years following 

expatriation if one of the principal purposes of the expatriation was to avoid U.S. income 

tax. A similar rule applies to expatriating aliens. 

Reasons for Change 

Wealthy U.S. citizens and long-term residents sometimes abandon their U.S. 

citizenship or status as residents. Existing rules to prevent tax avoidance through 

expatriation have proven largely ineffective because they apply only to U.S. source income, 

and departing taxpayers can restructure their assets to resource their income. Enforcement of 

the existing rules is difficult because the Internal Revenue Service ("IRS") ma y have only 

limited access to information about a taxpayer's transactions after the taxpayer expatriates. 

N e w measures are needed to ensure that gains generally accruing during the time that a 

taxpayer was a citizen or long-term permanent resident should be subject to U.S. tax without 

regard to the tax motivation of the expatriation. 

Proposal 

If a U.S. citizen or resident alien expatriates on or after February 6, 1995, that 

person would be treated as having sold his or her assets at fair market value immediately 

prior to expatriation. A s a result of this deemed sale, gain or loss would be recognized and 

subject to tax. A U.S. citizen would be considered to expatriate if the citizen relinquishes 

U.S. citizenship. A resident alien individual would be taxed under this proposal if the alien 

has been subject to U.S. tax as a lawful permanent resident of the United States in at least 

eight of the prior fifteen taxable years and then abandons that status. 

Exceptions to the tax on expatriation apply for U.S. real property interests (because 

they remain subject to U.S. taxing jurisdiction) and interests in qualified retirement plans. 

A n expatriating individual also would be entitled to exclude $600,000 of gain as determined 

under the proposal. A taxpayer may defer payment of the tax on expatriation until the asset 

is sold. Alternatively, a taxpayer may elect to continue to be taxed as a U.S. person. The 

taxpayer would be required to provide collateral satisfactory to the IRS. 

-90-
REFORM THE TAX TREATMENT OF FOREIGN TRUSTS 

U.S. tax rules applicable to foreign trusts have not been revised for nearly two 

decades. Ne w rules are needed to accommodate changes in the use and incidence of foreign 

trusts and to limit the avoidance and evasion of U.S. taxes. The foreign trust proposal would 

reform the taxation of trusts in several respects. This document summarizes the two most 

important changes. 

A. INFORMATION REPORTING AND FOREIGN TRUSTS 

Current Law 

Under current law, most foreign trusts established by U.S. persons are grantor trusts, 

the income of which is taxed to the grantor. U.S. persons wh o create or transfer property to 

foreign trusts are required to report transactions with the foreign trust. 

Reasons for Change 

The existing information reporting statute predates the significant expansion of the 

foreign grantor trust rules in 1976. In general, penalties for noncompliance are minimal. 

U.S. grantors of foreign trusts often do not report the income earned by foreign trusts and 

often do not comply with required information reporting. These foreign trusts are frequently 

established in tax haven jurisdictions with stringent secrecy rules. Attempts by the IRS to 

verify income earned by foreign trusts are often met with silence or a representation that 

foreign secrecy laws prevent the U.S. taxpayer from obtaining required information. 

Existing penalties have not proven adequate to encourage some U.S. taxpayers to comply 

with existing rules. 

Proposal 

The proposal would require trustees of foreign trusts created by U.S. persons to (1) 

appoint a U.S. agent wh o would provide the IRS with access to trust information, and (2) file 

an annual information return. If the trustees did not comply, creators of foreign trusts would 

be subject to substantial penalties. In addition, if required information is not provided, the 

appropriate tax treatment of any trust transactions or operations could be determined by the 

IRS. (This is similar to a rule that currently applies to certain foreign corporations.) The 

proposal would generally be effective for taxable years beginning after the date of enactment. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

-91-
B. INBOUND FOREIGN GRANTOR TRUSTS 

Current Law 

The United States disregards certain "grantor" trusts for income tax purposes. The 

grantor of such a trust is taxed as if he owned the trust assets directly. Trusts generally are 

considered grantor trusts if (1) the grantor has a reversionary interest in trust income or 

corpus, (2) the grantor or a nonadverse party holds certain powers over the beneficial 

enjoyment of trust income or corpus, (3) certain administrative powers are exercisable for the 

grantor's benefit (e.g., the grantor can reacquire trust assets by substituting assets of 

equivalent value), (4) the grantor or a nonadverse party has the power to revest trust assets in 

the grantor, or (5) trust income ma y be paid or accumulated for the benefit of the grantor or 

the grantor's spouse in the discretion of the grantor or a nonadverse party. A person other 

than the grantor is treated as owning trust assets if that person has the sole power to 

withdraw trust income or corpus. 

The grantor trust rules are intended to prevent wealthy U.S. settlors from shifting 

taxable income to beneficiaries wh o are likely to be paying taxes at lower marginal tax rates. 

These grantor trust antiabuse rules therefore treat the settlor as the owner of the underlying 

trust assets even where he retains no beneficial interest in the trust. 

In Revenue Ruling 69-70, 1969-1 C.B. 182, a foreign person funded a foreign grantor 

trust for U.S. beneficiaries. The ruling holds that since the foreign person is treated as the 

owner of the grantor trust, a U.S. beneficiary is not taxable on trust income distributed to 

him. 

Reasons for Change 

Existing law inappropriately permits foreign taxpayers to affirmatively use the 

domestic antiabuse rules concerning grantor trusts. These rules permit U.S. beneficiaries, 

w h o enjoy the benefits of residing in the United States, to avoid their U.S. tax obligations. 

U.S. beneficiaries receiving distributions of income from a trust should be taxed in the 

United States in accordance with the terms of the trust instrument. 

Proposal 

Under the proposal, a person generally would be treated as owning trust assets under 

the grantor trust rules only if the trust income is taxed to a U.S. person. Thus, U.S. 

beneficiaries of foreign trusts created by foreign persons would be taxed on distributions of 

trust income. The proposal would generally be effective on the date of enactment. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

-92-
REFORMULATE PUERTO RICO AND POSSESSIONS 

TAX CREDIT (SECTION 936) 

Current Law 

Domestic corporations with business operations in U.S. possessions (including, for 

this purpose, Puerto Rico and the U.S. Virgin Islands) ma y elect under Code section 936 

generally to eliminate the U.S. tax on certain income which is related to their 

possession-based operations. The section 936 credit ma y offset the U.S. tax on the following 

types of income: (1) foreign source income arising from the active conduct of a trade or 

business within a U.S. possession or from the sale or exchange of substantially all of the 

assets used by the taxpayer in the active conduct of such trade or business, or (2) income 

from certain investments in the possessions or in certain Caribbean Basin countries 

("qualified possession source investment income", or "QPSII"). The credit spares the 

electing corporation U.S. tax whether or not it pays income tax to the possession. 

Limitations on the active-business element of the credit were enacted in 1993. 

Section 936 companies may elect either a reduced percentage of the profits-based credit as 

allowed under prior law (60 percent in 1994, phasing down to 40 percent beginning in 1998), 

or a limitation based on the company's economic activity in the possessions (measured by 

wages and other compensation, depreciation, and certain taxes paid). 

Reasons for Change 

The Administration proposed to reformulate the credit in 1993 to make it a more 

efficient incentive for job creation and economic activity in Puerto Rico; the amendments 

enacted in 1993 moved part way toward the Administration's proposals. The Administration 

continues to believe that any credit should provide an incentive for increased economic 

activity in the possessions rather than merely an incentive to attribute profits there. 

Proposal 

To provide a more efficient tax incentive for the economic development of Puerto 

Rico and other U.S. possessions, and to continue the effort toward this goal that was begun 

in the 1993 Act, the proposal would modify current law to (1) phase-out the profits-based 

branch of the active-business portion of the credit over five years, beginning in 1997, and (2) 

allow excess amounts of economic-activity limitation to be carried forward for up to 5 years, 

effective for taxable years beginning after the date of enactment. The proposal would retain 

the economic-activity limitation on the active-business portion of the credit, as well as the 

passive-income portion of the credit for taxes otherwise payable on QPSII, as under present 

law. 

-93-
EXPAND SUBPART F PROVISIONS REGARDING INCOME FROM NOTIONAL 

PRINCIPAL CONTRACTS AND STOCK LENDING TRANSACTIONS 

Current Law 

Subpart F income includes, in various subcategories, income from notional principal 

contracts referenced to foreign currency, commodities, or interest rates, or to indices based 

thereon. It also includes income with respect to the lending of debt securities. Subpart F 

income does not include income from equity swaps or other types of notional principal 

contracts or income from transfers of equities subject to section 1058. Subpart F provides 

piecemeal exceptions for dealers in foreign currency, commodities, inventory, or certain 

other property. However, it does not provide an exception for dealers in financial 

instruments referenced to commodities. 

Reasons for Change 

Subpart F income should include income from all types of notional principal 

contracts and from stock-lending transactions, subject to a limited dealer exception. Such 

income is indistinguishable on policy grounds from other types of highly mobile income 

already targeted by subpart F. 

Proposal 

The proposal would amend section 954 to create a new category of subpart F income-

-income from notional principal contracts—and to include in subpart F income the income 

with respect to the transfer of equities subject to section 1058. This would have the effect of 

including in subpart F income the net income from equity swaps and certain categories of 

notional principal contracts that are not reached by current law, as well as income from stock 

lending transactions. 

Any income, gain, deduction, or loss from a notional principal contract entered into 

to hedge an item of income in a category of foreign personal holding company income would 

be included in that category. 

In addition, section 954 would be amended to provide an ordinary-course-of-business 

exception for regular dealers in forwards, options, notional principal contracts, and similar 

financial instruments (including instruments referenced to commodities). 

The proposal would be effective for taxable years beginning after the date of 

enactment. 

-94-
REFORM TREATMENT OF CAPTIVE "INSURANCE" ARRANGEMENTS 

Current Law 

Insurance premiums incurred in connection with a taxpayer's trade or business 

generally are deductible. In contrast, amounts set aside by a taxpayer to fund future losses 

are not deductible. 

The Code does not define the term "insurance." Case law has long defined the term 

to require "risk shifting" and "risk distribution." However, this definition has not been 

applied consistently to arrangements that are structured to minimize the amount of insurance 

risk that is shifted or distributed. 

In the case of a corporation that provides insurance to its shareholders, known as a 

"captive" insurance company, one recent court decision has held that the risk-shifting and 

risk-distribution requirements may be satisfied if the captive's unrelated business accounts for 

at least 30 percent of its total business. However, standards applied by the courts have 

varied considerably from case to case. 

A taxpayer qualifies as an insurance company for tax purposes if its primary and 

predominant business activity is the issuance of insurance or annuity contracts or the 

reinsuring of risks underwritten by insurance companies. Section 953(c) contains special 

provisions regarding the inclusion of "related person insurance income" of foreign companies 

in their U.S. shareholders' subpart F income. In addition, an excise tax is imposed on 

certain premiums paid to a foreign insurer or reinsurer on insurance policies that cover U.S. 

risks, unless the excise tax is waived by a tax treaty. 

Reasons for Change 

The uncertainty under current law as to when transactions with captives are 

considered insurance for federal income and excise tax purposes has encouraged aggressive 

planning and resulted in excessive controversy. The IRS also has experienced difficulty 

enforcing section 953(c), in part due to difficulty in obtaining information about foreign 

captives' operations. 

Proposal 

The proposal would treat certain "insurance" transactions between domestic and 

foreign captive insurance companies and their large shareholders as other than insurance for 

certain purposes. In applying the primary and predominant business activity test to 

determine whether the captive is an insurance company for tax purposes, premiums or 

similar amounts paid by large shareholders would not be considered insurance premiums. 

Thus, a captive would not qualify as an insurance company if more than 50 percent of its net 

-95-
written premiums were derived from insuring or reinsuring risks of its large shareholders. In 

determining whether a captive was an insurance company, net written premiums could be 

determined based on a multi-year rolling average, which would exclude premiums written in 

taxable years beginning on or before the date of enactment. If a captive engaged in both an 

insurance business and a financing or other noninsurance business, the captive might not 

qualify as an insurance company even if less than 50 percent of its net written premiums 

were derived from insuring or reinsuring risks of its large shareholders. 

If a captive qualified as an insurance company under the primary and predominant 

business activity test, premiums paid to the captive by its shareholders (including its large 

shareholders) for bona fide insurance would be deductible to the extent that such amounts 

would be deductible under current law, provided that the shareholder claiming a deduction 

complied with reporting and recordkeeping requirements to be prescribed. Similarly, the 

captive would compute its taxable income or the U.S. shareholders would compute their 

subpart F inclusions under the rules of subchapter L and section 953, as applicable. 

If a foreign or domestic captive failed to qualify as an insurance company under the 

primary and predominant business activity test, premiums paid directly or indirectly to such 

captive by its large shareholders would not be deductible and would be excluded from the 

captive's gross income. However, premiums paid by small shareholders or unrelated 

policyholders would continue to be deductible and would continue to be included in the 

captive's gross income. In addition, the captive would not be subject to subchapter L. The 

subpart F inclusions for a foreign captive that failed to qualify as an insurance company 

generally would be computed as under current law, except that the captive would not be 

entitled to claim reserve deductions for any of its policies or to use any other subchapter L 

rules. A captive that failed to qualify as an insurance company also would not be eligible for 

a tax exemption under section 501(c)(15). 

For captives that failed to qualify as insurance companies, claims paid to a large 

shareholder of a domestic captive would be deductible by the captive and includible in the 

large shareholder's income to the extent such claims exceeded the "premiums" paid by such 

large shareholder on the "insurance" policy. Claims payments to large shareholders of 

foreign captives would be taxable to such shareholders and deductible by the captive to the 

extent they exceeded the shareholders' "premium" payments. Large shareholders wh o 

incurred losses that gave rise to such payments would deduct those losses under sections 162 

or 165, subject to the current law all events test and economic performance rules. 

For purposes of this proposal, large shareholders would include any 10 percent 

shareholders of the captive and any person that would be a related person with respect to the 

shareholder under rules similar to those of section 953(c)(6). For this purpose, the 

attribution rules of section 958(a) and the constructive ownership rules of section 958(b) 

would apply, except for section 958(b)(4). Policyholders of mutual captives would be treated 

as shareholders for this purpose. In addition, Treasury would be authorized to promulgate 

regulations that defined related parties to include otherwise unrelated parties. For example, 

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persons that purchased insurance from the captive of a client could be considered related to 

the client that owned stock in the captive. 

If an unrelated insurance company issued an insurance policy to a taxpayer, and some 

or all of the taxpayer's risks were ceded to a corporation in which the taxpayer was a large 

shareholder, the premium paid by the taxpayer to the unrelated insurance company (the 

"fronting company") would be bifurcated between a premium payment to the fronting 

company and a deemed payment to the captive, which would be subject to the rules contained 

in this proposal. These same principles would apply if a large shareholder's risks were 

ceded and/or retroceded to one or more unrelated insurance companies, and ultimately 

retroceded to the captive. Similarly, the premium payment to a captive that reinsured or 

retroceded some of its shareholder's risks to an unrelated insurance company would be 

bifurcated between a payment to the captive, which would be subject to the rules contained in 

this proposal, and a deemed payment to the reinsurer. 

The insurance excise tax would not apply to amounts paid by a large shareholder to 

its foreign captive that failed to qualify as an insurance company, provided that certain 

procedural requirements were met. 

The proposal would not apply to reinsurance transactions between affiliated insurance 

companies, if the insured risks were not related party risks with respect to the ceding or the 

assuming insurance companies. 

The proposal is not intended to affect the treatment of putative insurance 

arrangements with captives under current law. 

The proposal would be effective for taxable years beginning after the date of 

enactment. 

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REFORM FOREIGN TAX CREDIT RULES 

A. REPEAL FINANCIAL INSTITUTION TRANSITION RULE TO IJNTEREST ALLOCATION 

RULES 

Current Law 

For foreign tax credit purposes, taxpayers generally are required to allocate and 

apportion interest expense between U.S. and foreign source income based on the proportion 

of the taxpayer's total assets in each location. Such allocation and apportionment is required 

to be made for affiliated groups (as defined in sec. 864(e)(5)) as a whole rather than on a 

subsidiary-by-subsidiary basis. However, certain types of financial institutions that are 

members of an affiliated group are treated as members of a separate affiliated group for 

purposes of the allocation and apportionment of interest expense (sec. 864(e)(5)(B)). Section 

1215(c) of the Tax Reform Act of 1986 (P L 99-514, 100 Stat 2548) includes a targeted rule 

which treats a certain corporation as a financial institution for this purpose. 

Reasons for Change 

The 1986 provision grants a single company a special exception to the basic 

fungibility principle underlying the interest allocation rules. This type of relief is 

inappropriate. 

Proposal 

The proposal would repeal the targeted exception provided by section 1215(c)(5) of 

the Tax Reform Act of 1986. The proposal would be effective for taxable years beginning 

after the date of enactment. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

B. MODIFY FOREIGN TAX CREDIT CARRYOVER RULES 

Current Law 

U.S. persons, including domestic corporations and U.S. citizens and residents, are 

subject to U.S. tax on their worldwide income. Income from sources outside the United 

States ma y also be taxed by the country in which such income originates. T o avoid double 

taxation of the same income, the United States permits taxpayers to credit income taxes paid 

to a foreign government against U.S. tax on foreign source income. Through the foreign tax 

credit limitations, the Code prevents the use of foreign tax credits to reduce U.S. tax on U.S. 

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source income. These limitations, in effect, preserve the primary right of the United States 

to tax U.S. source income. 

Under the foreign tax credit mechanism, current foreign income taxes in excess of the 

relevant current-year foreign tax credit limitation are not creditable against current U.S. tax 

liabilities. However, such excess foreign tax credits generally may be carried back for two 

years and carried forward for five years, and used as a credit to the extent there is excess 

foreign tax credit limitation (i.e., an excess of the foreign tax credit limitation over creditable 

foreign taxes) in any of those years. The unused credit is applied first against any excess 

limitation of the second preceding year, then against any excess limitation of the first 

preceding year, and is then carried forward to the first, second, and succeeding carryover 

years until it is fully used or until the expiration of the five-year period. 

Reasons for Change 

Experience over the years has shown that carrybacks are associated with increased 

complexity and administrative burdens as compared to carryforwards. Therefore, to reduce 

such complexity and burdens, the carryback period for foreign tax credits should be 

shortened. O n the other hand, the carryforward period under current law can be lengthened 

in order to allow taxpayers more time to utilize their foreign tax credits without increasing 

either complexity or administrative burdens. 

Proposal 

The proposal would limit foreign tax credit carrybacks to one year and extend foreign 

tax credit carryforwards to seven years. The proposal would be effective for foreign taxes 

paid or accrued or deemed paid or accrued in taxable years beginning after December 31, 

1996. 

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REFORM TREATMENT OF FOREIGN OIL AND GAS INCOME 

AND DUAL-CAPACITY TAXPAYERS 

Current Law 

The United States taxes U.S. persons on their worldwide income. A credit against 

U.S. tax on foreign income is allowed for foreign income taxes paid by the U.S. person. In 

addition, a credit is allowed to a U.S. corporation for foreign taxes paid by certain foreign 

subsidiary corporations upon payment of an actual or deemed dividend by the subsidiary (the 

"deemed paid" or "indirect" foreign tax credit). 

To be a creditable income tax, a foreign levy must be the substantial equivalent of an 

income tax in the U.S. sense, regardless of the label the foreign government attaches to it. 

Under regulations, a foreign levy is a tax if it is a compulsory payment under the authority 

of a foreign government to levy taxes and is not compensation for a specific economic 

benefit provided by the foreign country. Taxpayers that are subject to a foreign levy and that 

also receive (directly or indirectly) a specific economic benefit from the levying country are 

referred to as "dual capacity" taxpayers and may not claim a credit for that portion of the 

foreign levy paid as compensation for the specific economic benefit received. Under a 

regulatory safe-harbor test, if a country has a generally imposed income tax, the dualcapacity taxpayer ma y treat as a creditable tax the portion of the levy that application of the 

generally imposed income tax would yield (to the extent the levy otherwise constitutes an 

income tax or an "in lieu o f tax); the balance is treated as compensation for the specific 

economic benefit. If there is no generally imposed income tax, the regulation treats as a 

creditable tax that portion of the payment that does not exceed the applicable U.S. tax rate 

applied to net income. A foreign tax is treated as "generally imposed" even if it applies only 

to persons wh o are not residents or nationals of that country. 

Foreign oil and gas extraction income (FOGEI) generally is not included in subpart F 

income, but foreign oil related income (FORI) generally is so included. There is no separate 

section 904 foreign tax credit "basket" for oil and gas income. However, under section 907, 

the amount of creditable foreign taxes imposed on FOGE I is limited in any year to the 

applicable U.S. tax on that income. 

Reasons for Change 

The purpose of the foreign tax credit is to avoid double taxation of income by both 

the United States and a foreign jurisdiction. Whe n a payment to a foreign government is 

made as compensation for a specific economic benefit, there is no incidence of double 

taxation. Current law recognizes the distinction between creditable taxes and non-creditable 

payments for a specific economic benefit but fail to achieve the appropriate split between the 

two in a case where a foreign country imposes a levy on, for example, oil and gas income 

only, but has no generally imposed income tax. 

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Proposal 

T he proposal would treat payments by a dual-capacity taxpayer to a foreign country 

that would otherwise qualify as income taxes or "in lieu o f taxes as taxes only if there is a 

"generally applicable income tax" in that country. For this purpose, a generally applicable 

income tax is an income tax (or a series of income taxes) that applies to trade or business 

income from sources in that country, so long as the levy has substantial application both to 

non-dual-capacity taxpayers and to persons wh o are citizens or residents of that country. The 

proposal thus would replace that part of the regulatory safe harbor that treats a foreign levy 

as a tax up to the amount of the U.S. tax where the foreign country has no generally 

applicable income tax. The proposal generally would retain the rule of present law where 

the foreign country does generally impose an income tax. In that case, credits would be 

allowed up to the level of taxation that would be imposed under that general tax, so long as 

the tax satisfies the statutory definition of a "generally applicable income tax." 

The proposal would treat foreign oil and gas income (including both FOGEI and 

FORI) as subpart F income. It also would convert the special foreign tax credit limitation 

rules of present-law section 907 into a new foreign tax credit basket within section 904 for 

foreign oil and gas income. 

The proposal would be effective for taxable years beginning after the date of 

enactment. The proposal would yield to U.S. treaty obligations that allow a credit for taxes 

paid or accrued on certain oil or gas income. 

-101-
REQUIRE THRIFTS TO ACCOUNT FOR BAD DEBTS 

IN THE SAME MANNER AS BANKS 

Current Law 

A thrift institution that holds at least 60 percent of its portfolio in home mortgages 

(and certain similar loans), cash, and government obligations is permitted to maintain a 

reserve for bad debts under section 593 of the Internal Revenue Code. Under section 593, a 

thrift institution generally ma y calculate the annual addition to its bad debt reserve under 

either the "percentage of taxable income" method or the "experience" method. Under the 

percentage of taxable income method, a thrift may deduct 8 percent of its taxable income 

(determined without regard to the deduction and with certain other adjustments) as an 

addition to its bad debt reserve. Under the experience method, a thrift ma y deduct the 

greater of (1) the percentage of its loans outstanding equal to its average bad debt experience 

(i.e., bad debt losses as a percentage of loans outstanding) in the current and five preceding 

years, or (2) the amount necessary to restore its reserve to its balance at the close of the last 

taxable year beginning before 1988 (adjusted downward to reflect any post-1987 decline in 

loans outstanding). 

The reserve methods of section 593 are more generous than the rules applicable to 

commercial banks. Under section 585 of the Code, small banks are permitted to use the 

experience method, but not the percentage of taxable income method. If the adjusted basis of 

a bank's assets exceeds $500 million, section 585 does not apply and only the specific 

charge-off method can be used to compute the bad debt deduction. 

Under current law, a thrift that is no longer permitted to compute its reserve under 

section 593, either because it changes its charter to become a bank or because it fails the 60-

percent test described above, must account for bad debts as if it were a bank. In addition, it 

must recapture, through a section 481(a) adjustment, the amount by which the reserve 

computed under section 593 exceeds the reserve (if any) computed under section 585. In 

general, the amount recaptured is included in income ratably over a 6-year period. A former 

thrift that becomes a large bank, however, may use the rules that apply when a small bank 

becomes a large bank to recapture an amount equal to its reserve computed under the 

experience method. 

Reasons for Change 

As a result of the increasing convergence of the banking and thrift industries, the 

special rules applicable to thrifts, such as the subsidy provided through the reduction in 

effective marginal tax rates for thrifts using the percentage-of-taxable-income method, are no 

longer warranted. Som e relief from recapture is appropriate, however, because deferred tax 

liabilities have not been recorded with respect to pre-1988 additions to thrift bad debt 

reserves. T o require recapture with respect to these amounts, even on a deferred basis, 

-102-
would have a significant effect on the capital of some thrifts. In addition, it is appropriate to 

provide some incentive for thrifts to continue in the mortgage lending business. 

Proposal 

The bad debt reserve methods of section 593 would be repealed. (Other provisions 

that apply only to thrift institutions to which section 593 currently applies (e.g., sections 595 

and 596) would also be repealed.) Small thrifts (those with no more than $500 million of 

adjusted basis in their assets) would be permitted to use either the experience method of 

section 585 or the specific charge-off method. Large thrifts would be required to use the 

specific charge-off method. The percentage-of-taxable-income method of computing bad debt 

reserves would no longer be available. 

Any change in the method a thrift uses to compute reserves for bad debts would be 

treated as a change in method of accounting and the section 481(a) adjustment with respect to 

the change generally would be taken into account ratably (recaptured) over a 6-year period 

beginning with the year of change. However, the balance of the bad debt reserve as of the 

close of the last taxable year beginning before 1988 adjusted, except to the extent attributable 

to the supplemental reserve, to reflect any subsequent reduction in the amount of loans 

outstanding (the pre-1988 balance) would not be recaptured. In the case of a thrift that 

becomes a small bank, the opening balance of its bad debt reserve for its first taxable year 

beginning after the date of enactment would be the greater of its pre-1988 balance or its 

reserve computed under the experience method at the close of its last taxable year beginning 

on or before the date of enactment. The pre-1988 balance included in the former thrift's bad 

debt reserve under this rule would not be recaptured (or taken into account in applying the 

cut-off method) if the former thrift later becomes a large bank. 

Section 593(e) of current law (requiring recapture in the case of certain excess 

distributions to shareholders) would be modified to apply to the entire pre-1988 balance. In 

addition, the pre-1988 balance would be recaptured if the taxpayer ceases to be a bank (for 

this purpose, the taxpayer ceases to be a bank (and any amount recaptured is treated as 

income from an unrelated trade or business) if it becomes a credit union). 

Recapture of reserves in excess of the pre-1988 balance would be suspended for the 

first taxable year beginning after the date of enactment and for the succeeding taxable year if 

the taxpayer meets a residential loan requirement. The residential loan requirement is met 

for a taxable year if the principal amount of residential loans made by the taxpayer during 

the year is not less than the average of the principal amount of such loans during the six 

most recent taxable years beginning on or before the date of enactment. At the election of 

the taxpayer, the average ma y be computed by disregarding the high and low years in the 

six-year period. A residential loan is any loan described in section 7701(a)(19)(C)(v) 

(generally, loans secured by residential real property, real property used by churches, and 

mobile homes), but only to the extent the loan is made to acquire, construct, or improve the 

property. The test would be applied on a controlled group basis. 

-103-
T he pre-1988 balance would be treated as a tax attribute to which section 381 applies. 

In addition, regulations would provide rules for the application of the statutory provisions in 

the case of acquisitions, mergers, spin-offs, and other reorganizations. The proposal would 

be effective for taxable years beginning after the date of enactment. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

-104-
REFORM DEPRECIATION UNDER THE INCOME FORECAST METHOD 

Current Law 

Pursuant to several administrative pronouncements, the IRS has ruled that the cost of 

motion picture films, video tapes, sound recordings, and other similar property ma y be 

depreciated under the "income forecast" method, pursuant to which depreciation for any 

taxable year is determined by dividing the income realized for that year by the total estimated 

income from the property. The IRS has also ruled that the estimated income to be included 

in the denominator does not include income from television exhibition in the case of motion 

pictures released for theatrical exhibition, or income from syndication in the case of a 

television series or movie. In addition, estimated income does not include revenue from the 

exploitation of film characters. Such property is not eligible for depreciation under the 

modified accelerated cost recovery system. 

Reasons for Change 

While the income forecast method may be an appropriate method for matching income 

and expenses in certain cases, the exclusion of income from certain sources results in an 

inappropriate acceleration of depreciation deductions. In addition, the use of estimates in the 

income forecast method necessarily results in a mismatch between income and depreciation 

deductions when the estimate of future income is either too high or too low. A look-back 

method, i.e., a procedure to compensate for errors in estimates in prior taxable years, would 

eliminate any benefit that taxpayers may obtain from understating the estimated income from 

property, thereby overstating their depreciation deductions. 

Proposal 

Several changes to the income forecast method of determining depreciation deductions 

would be made. All estimated income from the use of the property or the sale of 

merchandise would be taken into account in the denominator, other than income expected to 

be generated more than ten taxable years after the year in which the property was placed in 

service. For purposes of this rule, income realized by the taxpayer from related party 

transactions would be ignored, but income realized by the related party from the ultimate 

transaction with unrelated third parties would be taken into account. The basis for 

depreciation for any taxable year may only include amounts that satisfy the economic 

performance requirements of section 461(h) as of the end of the year (including the recurring 

item exception). The adjusted basis remaining at the beginning of the tenth taxable year after 

the year in which the property is placed in service may be recovered in full in that year. 

Finally, a look-back method would be imposed and applied in a manner similar to the longterm contract provisions of section 460 (together with de minimis exceptions). The changes 

would apply to property placed in service after September 13, 1995, unless subject to a 

written agreement which was binding as of that date and at all times thereafter. 

-105-
This proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

-106-
PHASE OUT PREFERENTIAL TAX DEFERRAL FOR CERTAIN LARGE 

FARM CORPORATIONS REQUIRED TO USE ACCRUAL ACCOUNTING 

Current Law 

The Revenue Act of 1987 required certain closely held farm corporations (and 

partnerships with corporate partners) to change to the accrual method of accounting if their 

gross receipts exceed $25 million in any taxable year beginning after 1985. However, in lieu 

of making a section 481(a) adjustment for the year of change, such taxpayers were permitted 

by section 447(i) to establish a "suspense account" for the lesser of the section 481(a) 

adjustment for the year of change or the adjustment that would have been applicable for the 

preceding taxable year. This suspense account is not required to be taken into account unless 

the corporation ceases to meet the closely held test or except to the extent that the gross 

receipts of the entity are reduced in any taxable year below the amount applicable to the last 

year prior to the year of change. A s a result, the suspense account provision represents a 

potentially indefinite deferral of the section 481(a) adjustment. 

Reasons for Change 

Section 447(i) is a substantial and inappropriate departure from the policy underlying 

section 481(a) and the administrative practices of the Service, in which the cumulative 

adjustments resulting from accounting method changes are taken into account generally over 

periods not exceeding six years. 

Proposal 

The proposal would provide that no suspense accounts may be established under 

section 447(i). An y taxpayer required to change to the accrual method after the effective 

date would be required to take its section 481(a) adjustment into account generally over a 

ten-year period. An y existing suspense accounts must be restored to income ratably over a 

ten-year period (or sooner to the extent provided by existing law). This provision would be 

effective for taxable years ending after September 13, 1995, except that the 10-year period 

for restoring existing suspense accounts would begin with the first taxable year that begins 

after September 13, 1995. 

This proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

-107-
REPEAL LOWER OF COST OR MARKET INVENTORY ACCOUNTING METHOD 

Current Law 

Taxpayers required to maintain inventories are permitted to use a variety of methods 

to determine the cost of their ending inventories, including the last-in, first-out ("LIFO") 

method, the first-in, first-out ("FIFO") method, and the retail method. Taxpayers not using 

a LIF O method may determine the carrying values of their inventories by applying the lower 

of cost or market ("LCM") method and by writing down the cost of goods that are unsalable 

at normal prices or unusable in the normal way because of damage, imperfection or other 

causes (the "subnormal goods" method). 

Reasons for Change 

The allowance of write-downs under the LCM and subnormal goods methods is an 

inappropriate exception from the realization principle and is essentially a one-way mark-tomarket method that understates taxable income. 

Proposal 

The proposal would repeal the LCM and subnormal goods methods. Appropriate 

wash-sale rules would also be included. The proposal would be treated as a change in the 

method of accounting for inventories, and any resulting section 481(a) adjustment would be 

included in income ratably over a four-year period beginning with the year of change. These 

changes would not apply to taxpayers with average annual gross receipts over a three-year 

period of $5 million or less, with appropriate aggregation rules. 

The proposal would be effective for taxable years beginning after the date of 

enactment. 

-108-
REPEAL COMPONENTS OF COST INVENTORY ACCOUNTING METHOD 

Current Law 

Taxpayers required to maintain inventories are permitted to use a variety of methods 

to determine the cost of their ending inventories, including the last-in, first-out ("LIFO") 

method, the first-in, first-out ("FIFO") method, and the retail method. Under the 

regulations, a variety of dollar-value LIFO methods may be used, including double 

extension, link-chain and other index methods, in order to determine whether an increment 

has occurred and the cost of that increment. Certain taxpayers are permitted to use 

simplified LIF O methods based on externally developed price indexes. Som e LIF O 

taxpayers that use a dollar-value, double-extension method make their computations with 

respect to the three components of cost (materials, labor and overhead) of their finished 

goods and work-in-process inventories (the "COC " method) rather than the aggregate cost of 

the physical items comprising these inventories (the "total product cost" method). 

Reasons for Change 

The COC method, in many cases, does not adequately account for technological 

efficiencies in which skilled labor is substituted for less-skilled labor or where overhead costs 

(such as factory automation) replace direct labor costs. The costs of inventories determined 

by using the total product cost method generally are not affected by such factors. 

Proposal 

The proposal would repeal the COC method on a prospective, or cut-off, basis. 

Thus, no section 481(a) adjustments would be necessary. 

The proposal is not intended to affect the determination of whether the COC method 

is an appropriate method and the IRS would not be precluded from challenging its use in 

taxable years that began on or before the date of enactment. 

The proposal would be effective for taxable years beginning after the date of 

enactment. 

-109-
MODIFY BASIS ADJUSTMENT RULES 

IN CERTAIN INVOLUNTARY CONVERSIONS 

Current Law 

Section 1033 provides generally that gain realized from certain involuntary 

conversions is deferred to the extent the taxpayer purchases property similar or related in 

service or use to the converted property within a specified period of time. The replacement 

property ma y be acquired directly or, alternatively, indirectly by acquiring control of a 

corporation that owns replacement property. The taxpayer's basis in the replacement 

property generally is the same as the taxpayer's basis in the converted property, decreased by 

the amount of money received or loss recognized on the conversion, and increased by the 

amount of any gain recognized on the conversion. The IRS has taken the position that, if the 

replacement property is stock in a corporation, the basis adjustment rules do not affect 

depreciation deductions claimed by the corporation with respect to the assets it owns. 

Reasons for Change 

Where the replacement property in an involuntary conversion is stock in a 

corporation, it is necessary to adjust the basis in the assets of the corporation in order to 

properly reflect the purpose of the involuntary conversion rollover rules to allow deferral of 

gain recognition (but not avoidance of that gain). 

Proposal 

Under the proposal, where a taxpayer acquires a controlling interest in the stock of a 

corporation as replacement property after an involuntary conversion, the corporation will 

generally be required to reduce its adjusted bases in its assets by the same amount as the 

taxpayer is required to reduce its basis in the acquired stock. The corporation's adjusted 

bases in its assets would not be reduced, in the aggregate, below the taxpayer's basis in its 

stock. In addition, the basis of any individual asset would not be reduced below zero. The 

basis reduction would be applied first to property that is similar or related in service or use 

to the converted property, then to other depreciable property, and finally to any other 

property. 

The proposal would be effective for involuntary conversions occurring after 

September 13, 1995. 

This proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

-110-
EXPAND REQUIREMENT THAT INVOLUNTARILY CONVERTED PROPERTY BE 

REPLACED WITH PROPERTY ACQUIRED FROM AN UNRELATED PERSON 

Current Law 

Under section 1033, gain realized by a taxpayer from certain involuntary conversions 

of property is deferred to the extent the taxpayer purchases property similar or related in 

service or use to the converted property within a specified period of time. C corporations 

(and partnerships with one or more corporate partners that ow n more than 50 percent of the 

capital or profits interest in the partnership) generally are not entitled to defer gain under 

section 1033 if the replacement property (including stock) is purchased from a related 

person. For this purpose, whether persons are related is determined by reference to sections 

267(b) and 707(b)(1). This limitation does not apply to the extent the related person acquired 

the replacement property from an unrelated third party during the replacement period 

(generally, the end of the second full taxable year after the taxable year in which gain is first 

realized as a result of the conversion). 

Reasons for Change 

The concerns regarding the acquisition of replacement property from a related party 

generally apply to non-corporate taxpayers as well as to corporate taxpayers. 

Proposal 

The proposal would extend the rule denying gain deferral to any other taxpayer, 

including an individual, that acquires replacement property from a related person (within the 

meaning of sections 267(b) and 707(b)(1)) unless the taxpayer has aggregate realized gain of 

$100,000 or less during the year as a result of involuntary conversions. In the case of a 

partnership or S corporation, the annual $100,000 limitation would apply to the entity and 

each partner or shareholder. The proposal would be effective for involuntary conversions 

occurring after September 13, 1995. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

-Ill-
FURTHER RESTRICT LIKE-KIND EXCHANGES 

INVOLVING PERSONAL PROPERTY 

Current Law 

An exchange of property, like a sale, is generally a taxable transaction. However, 

under section 1031 of the Internal Revenue Code, no gain or loss is recognized if property 

held for productive use in a trade or business or for investment is exchanged for property of 

a "like kind" which is to be held for productive use in a trade or business or for investment. 

In general, any kind of real estate is treated as of a like kind with other real property. By 

contrast, different kinds of personal property are not treated as of a like kind. Regulations 

under section 1031 provide that property that is of a "like class" is treated as being of a like 

kind. Certain types of personal property, such as inventory, stocks and bonds, and 

partnership interests, are not eligible for nonrecognition treatment under section 1031. In 

addition, in 1989 Congress amended section 1031 to provide that real property located in the 

United States and real property located outside the United States are not of a like kind. 

In order to preserve the gain not recognized in a like-kind exchange, the basis of the 

property acquired is equal to the basis of the property transferred, decreased in the amount of 

any money received by the taxpayer and increased in the amount of gain (or decreased in the 

amount of loss) recognized by the taxpayer on the exchange. 

Reasons for Change 

The limitations on exchanges of personal property should more closely conform to the 

limitations on exchanges of real property. 

Proposal 

Under the proposal, personal property used predominantly within the United States 

and personal property used predominantly outside the United States would be treated as not 

of a like kind. Generally, the predominant use of the property relinquished in the exchange 

would be determined according to its use during the 2-year period ending on the date of 

relinquishment and the predominant use of the property acquired in the exchange would be 

determined according to its use during the 2-year period beginning on the date of acquisition. 

In addition, certain property that is used outside the United States but is not subject to the 

current-law alternative depreciation system applicable to property used predominantly outside 

the United States would be treated as used predominantly in the United States for purposes of 

this proposal. 

In general, this proposal would be effective for transfers after December 6, 1995, in 

taxable years ending after such date. However, the proposal would not apply to any transfer 

made pursuant to a written binding contract in effect on December 6, 1995, and at all times 

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thereafter before the transfer. For purposes of this rule, a written contract ma y be treated as 

binding even if it provides for a sale in lieu of an exchange, or the replacement property to 

be received was not identified before December 7, 1995. 

-113-
DENY ROLLOVER OR EXCLUSION OF GAIN ON SALE OF PRINCIPAL 

RESIDENCE WHICH IS ATTRIBUTABLE TO DEPRECIATION DEDUCTIONS 

Current Law 

Generally, under section 1034 no gain is recognized on the sale or exchange of a 

principal residence to the extent that the amount of sales price of the old residence is 

reinvested in a new residence within a specified period. This period generally begins two 

years before the sale of the old residence and ends two years after that sale. 

In addition, section 121 generally provides that a taxpayer may exclude from gross 

income up to $125,000 of gain from the sale or exchange of a principal residence if the 

taxpayer (i) has attained age 55 before the sale, and (ii) has used the residence as a principal 

residence for three or more years of the five years preceding the sale. This election is 

allowed only once in a lifetime unless all previous elections are revoked. For these 

purposes, sales on or before July 26, 1978, are not counted against the once-in-a-lifetime 

limit. 

In the case of a mixed use of a residence ("i.e.. part principal residence, part rental 

property or hom e office), the section 121 exclusion is limited to that portion of the residence 

that is used by the individual as his principal residence for at least 3 of the 5 years preceding 

the sale. Similarly, the portion of gain attributable to business or rental use during the year 

of sale is not eligible for deferral under section 1034. 

Depreciation deductions allowable with respect to an individual's residence reduce the 

individual's basis the residence. 

Reasons for Change 

Depreciation is allowed with respect to a portion of a residence when that portion is 

used for business or production of income purposes. Thus, the portion of any gain realized 

on the sale of a residence that is attributable to allowable depreciation should not be eligible 

for deferral under section 1034 or the exclusion provided by section 121, as those provisions 

are intended to mollify certain tax implications of the personal use of a residence. Thus, the 

amount of realized gain attributable to depreciation should be subject to immediate 

recognition. 

Proposal 

Gain would be recognized on the sale of a principal residence to the extent of any 

depreciation allowable with respect to the residence for periods after December 31, 1996. In 

addition, the amount of otherwise allowable one-time exclusion would be reduced to the 

extent of depreciation allowable with respect to the principal residence for periods after 

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December 31, 1996. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

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REQUIRE REGISTRATION OF CERTAIN CONFIDENTIAL 

CORPORATE TAX SHELTERS 

Current Law 

A tax-shelter organizer must register the shelter with the IRS if the tax shelter meets 

the following two requirements. First, any investment in the tax shelter must be (1) pursuant 

to an offering that is required to be registered under a Federal or state law regulating 

securities, (2) pursuant to an offering that is exempt from registration under such laws but 

with respect to which a notice must be filed with a Federal or state agency regulating the 

offering or sale of securities, or (3) a substantial investment. Second, any person must be 

able reasonably to infer from the representations made or to be made in connection with the 

offering for sale of interests in the investment that the ratio of deductions and 350 percent of 

credits to the investment for any investor (the "tax shelter ratio") ma y be greater than two to 

one as of the close of any of the first five years ending after the date on which the 

investment is offered for sale. 

Reasons for Change 

Many corporate tax shelters are not registered with the IRS. Requiring registration of 

corporate tax shelters would result in the IRS receiving useful information at an early date 

regarding various forms of tax shelter transactions engaged in by corporate participants. 

This will allow the IRS to make better informed judgments regarding the audit of corporate 

tax returns and to monitor whether legislation or administrative action is necessary regarding 

the type of transactions being registered. 

Proposal 

The proposal would require registration with the IRS of any investment, plan, 

arrangement or transaction (1) a significant purpose of the structure of which is tax 

avoidance or evasion by a corporate participant, (2) that is offered to any potential participant 

under conditions of confidentiality (for example confidentiality agreements entered with or 

for the benefit of the promoter), and (3) for which the tax shelter promoter (or promoters) 

m a y receive total fees in excess of $100,000. Registration materials will be protected 

taxpayer information, and there will be substantial penalties for non-compliance. The 

proposal would be effective for any tax shelter offered to potential participants after the date 

the Secretary of the Treasury prescribes guidance regarding the filing requirements. 

This proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

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REQUIRE REPORTING OF PAYMENTS TO CORPORATIONS 

RENDERING SERVICES TO FEDERAL AGENCIES 

Current Law 

All persons engaged in a trade or business and making payments of $600 or more to 

another person in remuneration for services generally must report those payments to the IRS 

and to the recipient. N o reporting is required if the recipient is a corporation. 

Reasons for Change 

The lack of reporting of payments made to corporations permits significant amounts 

of income to escape the tax system. Corporations that do business with the Federal 

Government should appropriately report as income their payments from the Federal 

Government. 

Proposal 

The proposal would generally require reporting of payments of $600 or more made to 

corporations for services rendered to Federal executive agencies. However, the Treasury 

Secretary would be authorized to prescribe regulations to except reporting in appropriate 

circumstances. The proposal would be effective for returns the due date for which (without 

regard to extensions) is more than 90 days after the date of enactment of the proposal. 

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INCREASE PENALTIES FOR FAILURE TO FILE 

CORRECT INFORMATION RETURNS 

Current Law 

Any person required to report payments of $600 or more for services that fails to 

report those amounts timely or reports amounts incorrectly is subject to penalties. The 

amount of the penalty is generally $50 for each return with respect to which a penalty is 

incurred, not to exceed $250,000 during any calendar year. If any failure or error is 

corrected within 30 days after the required filing date, the penalty imposed is $15 per return, 

not to exceed $75,000. Failures corrected more than 30 days after the required filing date 

but before August 1 are subject to a $30 per return penalty, not to exceed $150,000 in any 

calendar year. 

Reasons for Change 

For taxpayers filing large volumes of information returns or reporting significant 

payments, the general penalty provisions ma y not be sufficient to encourage timely and 

accurate reporting. B y basing the penalty amount on either the number or amounts, the 

proposal encourages taxpayers to assure both the accuracy and timeliness of information on 

each return and in the aggregate. 

Proposal 

The proposal would increase the general penalty amount for any failure to the greater 

of $50 per return or 5 percent of the total amount required to be reported. The increased 

penalty would not apply if the aggregate amount actually reported by the taxpayer on all 

returns filed for that calender year was at least 97 percent of the amount required to be 

reported. The proposal would be effective for returns the due date for which (without regard 

to extensions) is more than 90 days after the date of enactment of the proposal. 

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EXTEND DISCLOSURE OF RETURN INFORMATION FOR 

ADMINISTRATION OF CERTAIN VETERANS' PROGRAMS 

Current Law 

The Department of Veterans Affairs (DVA) is permitted to obtain gross income 

information from the Social Security Administration and the IRS for the purpose of meanstesting veterans' benefits. This authority expires on September 30, 1998. 

Reasons for Change 

The Department of Veterans Affairs (DVA) effectively uses this information for the 

purpose of means-testing veterans' benefits. 

Proposal 

The proposal would extend the authority to disclose return information to the DVA 

through September 30, 2002. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

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EXTEN D IRS USE R FEES 

Current Law 

The IRS generally charges fees for private rulings, such as a letter ruling, 

determination letter, opinion letter, or similar administrative determination. This authority is 

scheduled to expire on September 30, 2000. 

Reasons for Change 

Rather than requiring the costs of special rulings to be paid by all taxpayers, t

the general appropriations process, it is appropriate for the IRS to recover some of those 

costs through user fees from the specific taxpayers to whom the rulings are provided. 

Proposal 

The proposal would extend the IRS's authority to impose user fees for private rul

through September 30, 2002. 

The proposal is similar to a provision contained in the Revenue Reconciliation Ac

1995 and in H R 2778 as passed by Congress. 

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APPLY FAILURE-TO-PAY PENALTY TO SUBSTITUTE RETURNS 

Current Law 

The failure to pay penalty, which is a percentage of the tax due, generally runs from 

the due date of a return until the tax is paid. If, however, a taxpayer fails to file a return, 

and the Commissioner prepares a substitute return for the taxpayer, then the tax on which the 

penalty is measured is considered a deficiency and the penalty begins to run only ten days 

after the IRS sends the taxpayer notice and demand for payment of the tax. 

Reasons for Change 

Taxpayers for whom the Commissioner prepares substitute returns should not be 

treated better than taxpayers wh o pay late but nevertheless file their own returns. 

Proposal 

The proposal would require that the failure to pay penalty apply to taxpayers for 

who m the Commissioner prepares substitute returns in the same manner as it applies to 

delinquent taxpayers, Le^, that it commence running from the due date of the return. The 

proposal would be effective for returns the due date for which (without regard to extensions) 

is after the date of enactment of the proposal. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

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EXTEND WITHHOLDING TO CERTAIN GAMBLING WINNINGS 

Current Law 

Proceeds of most wagers with odds of less than 300 to 1 are exempt from 

withholding, as are all bingo and keno winnings. 

Reasons for Change 

Withholding on gambling winnings would improve compliance and enforcement. 

Proposal 

The proposal would impose withholding on proceeds of bingo or keno in excess of 

$5,000 at a rate of 28 percent, regardless of the odds of the wager. The proposal would be 

effective for payments made after the date of enactment. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

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REQUIRE TAX REPORTING FOR PAYMENTS TO ATTORNEYS 

Current Law 

Tax information reporting is required for persons engaged in a trade or business 

making payments in the course of the trade or business of rent, salaries, wages, or other 

fixed or determinable income. Treasury regulations require a payor to report payments of 

attorney's fees if the payments are made in the course of a trade or business. If, however, a 

payment to an attorney is a gross amount and it cannot be determined what portion is the 

attorney's fee (as is the case with payments of lump-sum judgments or settlements made 

payable to a lawyer and plaintiff jointly), no reporting is required. In general, a payor is not 

required to report payments made to corporations. 

Reasons for Change 

Payments of judgments and settlements made by insurance companies to attorneys and 

their clients jointly can yield large legal fees that are not now reported by any payor and are 

often under-reported by the recipients. 

Proposal 

The proposal would require any person making a payment in the course of a trade or 

business to a lawyer (as sole or joint payee) to report the payment to the IRS. A payment to 

a law firm would be a payment to a lawyer for this purpose. Whe n the portion that 

constitutes fees cannot be determined, the amount paid would be reported as gross proceeds. 

These reporting requirements would not apply to the extent provided in regulations if their 

application would result in double reporting (e.g., if the payor knows a payment does not 

include attorneys fees because the payor has made, and reports, a separate payment of fees to 

the attorney). In addition, the exception from reporting for payments made to corporations 

would not apply to payments of legal fees under the proposal. A lawyer receiving a payment 

would be required to provide his or her taxpayer identification number to the payor or be 

subject to applicable penalties and backup withholding. The proposal would be effective for 

payments made after December 31, 1996. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

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REPEAL ADVANCE REFUNDS OF DIESEL FUEL TAX 

FOR DIESEL CARS AND TRUCKS 

Current Law 

A Federal excise tax is imposed on highway motor fuels at a rate of 18.3 cents per 

gallon in the case of gasoline and 24.3 cents per gallon in the case of diesel fuel. The first 

purchaser of a diesel-powered highway vehicle with a gross vehicle weight of not more than 

10,000 pounds is entitled to a payment in the nature of an advance refund of the difference 

between the diesel fuel excise tax and the gasoline excise tax. The amount of the payment is 

$102 in the case of automobiles and $198 in the case of a light truck or van. 

Reasons for Change 

The tax code provides a refund to the purchasers of diesel-powered automobiles, light 

trucks, and vans because those vehicles contribute no more to highway maintenance costs 

than similar gasoline-powered vehicles but their owners pay a higher share of those costs 

unless the higher tax on diesel fuel they purchase is partially offset. However, changes in 

driving patterns and vehicles currently being marketed have resulted in fewer diesel-powered 

automobiles, vans, and light trucks today than was the case when the advance refund was 

enacted. In addition, each individual refund is very small and results in processing and other 

administrative costs disproportionate to its size. Thus, repeal of the advance refund is 

justifiable because it will reduce administrative costs and simplify the tax code. 

Proposal 

The provision allowing payments to purchasers of diesel-powered automobiles and 

light trucks would be repealed for vehicles purchased after the date of enactment. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

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PERMIT DISCLOSURE OF FORM 8300 INFORMATION 

Current Law 

Any person who receives more than $10,000 in cash in one transaction (or two or 

more related transactions) in the course of a trade or business generally must file an 

information return (Form 8300) giving the name and identifying information of the payor and 

the amount received. The IRS was temporarily permitted to disclose this information to 

other Federal agencies for Federal law enforcement purposes, but this authority expired in 

1992. 

Reasons for Change 

Information filed on Form 8300 is very similar to information filed on Currency 

Transaction Reports. Tax information should be accessible to the same agencies as Currency 

Transaction Reports for similar non-tax administration purposes. 

Proposal 

The proposal would: (1) permanently extend the IRS's authority to disclose Form 

8300 information; (2) expand that authority to permit disclosures not only to Federal agencies 

for Federal law enforcement purposes, but also to state, local, and foreign agencies for civil, 

criminal, and regulatory purposes (other than tax administration); and (3) make such 

disclosures subject to other information safeguards in the Code. 

The proposal would be effective after the date of enactment. 

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EXTEND AUTHORITY FOR UNDERCOVER OPERATIONS 

Current Law 

An exemption in the Anti-Drug Abuse Act of 1988 permitted the IRS to us

income earned in undercover operations to pay additional expenses incurred in such 

operations. This authority was subject to detailed reporting requirements. The exemption, 

which originally expired December 31, 1989, was previously extended through December 

31, 1991, but the IRS has not had the authority to use funds from undercover operations 

since that date. 

Reasons for Change 

Other law enforcement agencies have similar authority, and it is appropriate for the 

IRS to have the same ability to fund ongoing operations. 

Proposal 

The proposal would reinstate the IRS's authority to use funds from undercover 

operations from the date of enactment through January 1, 2001, subject to enhanced 

oversight and reporting obligations. 

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PROVIDE INTERMEDIATE SANCTIONS ON AMOUNTS 

OF PRIVATE EXCESS BENEFITS 

Current Law 

Private Inurement 

In order to be recognized as a tax-exempt organization described in section 501(c)(3), 

a charity must not allow any of its net earnings to inure to the benefit of any private 

shareholder or individual. Several other types of organizations, such as labor and 

agricultural organizations described in section 501(c)(5) and trade associations described in 

section 501(c)(6), are also subject to this prohibition against "private inurement." However, 

the private inurement restriction does not apply to social welfare organizations described in 

section 501(c)(4). 

Sanctions for private inurement and other violations of exemption standards 

Section 509 divides section 501(c)(3) organizations into two categories, public 

charities and private foundations. Public charities are generally organizations with a broad 

base of public support. Private foundations are generally organizations with a limited 

number of contributors. 

If a public charity engages in activities resulting in any amount of private inurement, 

it will have violated the requirements for tax-exempt status. In such cases, the only sanction 

that is specifically authorized under the Code is revocation of the organization's tax-exempt 

status. B y contrast, private foundations are subject to penalty excise taxes under section 

4945 on any expenditures they mak e that do not serve charitable purposes. In addition, 

certain disqualified persons wh o have close relationships with private foundations as well as 

the foundation's managers are subject to penalty excise taxes under section 4941 if they 

participate in "self-dealing" transactions with the private foundation. 

Sanctions in addition to revocation of tax-exempt status are also available when either 

public charities or private foundations violate requirements of section 501(c)(3) other than the 

private inurement prohibition. For example, if a public charity or a private foundation 

makes a political expenditure, violating the section 501(c)(3) prohibition against political 

activities, it will be subject to a penalty excise tax under section 4955. Similarly, if a public 

charity makes excessive lobbying expenditures, violating the section 501(c)(3) prohibition 

against substantial activities seeking to influence legislation, it will be subject to a penalty 

excise tax under section 4911 or section 4912. 

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Filing and Public Disclosure Rules 

Tax-exempt organizations (other than churches and certain small organizations) are 

required to file an annual information return (Form 990) with the Internal Revenue Service 

("IRS") setting forth information about the organization's income, expenses, disbursements, 

personnel and activities. Private foundations are required to allow public inspection at the 

foundation's principal office of their current annual information return. Other tax-exempt 

organizations, including public charities, are required to allow public inspection at the 

organization's principal office (and certain regional or district offices) of their annual 

information returns for the three most recent taxable years (section 6104(e)). The Code also 

requires that tax-exempt organizations allow public inspection of the organization's 

application to the IRS for recognition of tax-exempt status, the IRS determination letter, and 

certain related documents. In addition, upon written request to the IRS, members of the 

general public are permitted to inspect annual information returns of tax-exempt 

organizations and applications for recognition of tax-exempt status (and related documents) at 

the National Office of the IRS. Whe n viewing these document at the IRS National Office, 

notes and photographs ma y be taken and copies made for a fee. (Treas. Reg. §§ 

301.6104(a)-6 and 301.6104(g)-l). 

Section 6652(c)(1)(A) provides that a tax-exempt organization that fails to file a 

complete and accurate Form 990 is subject to a penalty of $10 for each day during which 

such failure continues (with a maximu m penalty with respect to any one return of the lesser 

of $5,000 or five percent of the organization's gross receipts for the year). Section 

6652(c)(1)(C) provides that tax-exempt organizations that fail to make certain annual returns 

and applications for exemption available for public inspection are subject to a penalty of $10 

for each day the failure continues (with a maximu m penalty with respect to any one return 

not to exceed $5,000 and without limitation with respect to applications). In addition, 

section 6685 provides a penalty for willfully failing to make an annual return or application 

available for public inspection of $1,000 per return or application. 

Organizations that have tax-exempt status but that are not eligible to receive tax 

deductible charitable contributions are required expressly to state in certain fundraising 

solicitations that contributions or gifts to the organization are not deductible as charitable 

contributions for Federal income tax purposes (section 6113). Penalties ma y be imposed on 

such organizations for failure to comply with this requirement (section 6710). 

Reasons for Change 

Sanctions on section 501(c)(3) organizations other than revocation of tax-exempt status 

are needed to improve enforcement of the private inurement prohibition. In particular, a 

sanction is needed that reaches the private parties to who m benefits are inuring, muc h as 

section 4941 does with respect to private foundation disqualified persons. In addition, to 

prevent organizations from using exemption under section 501(c)(4) as a wa y to avoid the 

private inurement prohibition, the private inurement prohibition and new intermediate 

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sanctions need to be extended to organizations described in section 501(c)(4). 

Proposal 

Extend private inurement prohibition to social welfare organizations 

The proposal would amend section 501(c)(4) to provide explicitly that a social welfare 

organization or other organization described in that section would be eligible for tax-exempt 

status only if no part of its net earnings inures to the benefit of any private shareholder or 

individual. 

This proposal generally would be effective on September 14, 1995. However, under 

a special transition rule, the provision would not apply to inurement occurring up to one year 

after the date of enactment of the statutory change, if such inurement results from a written 

contract that was binding on September 13, 1995, and at all times thereafter before such 

inurement occurred, and the terms of which have not materially changed. 

Intermediate sanctions for excess benefit transactions 

The proposal would impose penalty excise taxes as an intermediate sanction in cases 

where an organization exempt from tax under section 501(c)(3) or 501(c)(4) (other than 

private foundations) engages in an "excess benefit transaction." In such cases, intermediate 

sanctions could be imposed on certain disqualified persons (i.e. insiders) wh o improperly 

benefit from an excess benefit transaction and on organization managers wh o participate in 

such a transaction knowing that it is improper. 

In general, the intermediate sanction is expected to be the sole sanction imposed in 

those cases in which the excess benefit does not rise to a level where it calls into question 

whether, on the whole, the organization functions as a charitable or other tax-exempt 

organization. In practice, revocation of tax-exempt status with or without the imposition of 

excise taxes would occur only when the organization no longer operates as a charitable 

organization. 

An "excess benefit transaction" would be defined as (1) any transaction in which an 

economic benefit is provided to or for the use of any disqualified person if the value of the 

economic benefit provided directly by the organization (or indirectly through a controlled 

entity) to such person exceeds the value of consideration (including performance of services) 

received by the organization for providing such benefit, and (2) to the extent provided in 

regulations, any transaction in which the amount of any economic benefit provided to, or for 

the use of, any disqualified person is determined in whole or in part by the revenues of the 

organization, provided that the transaction constitutes prohibited inurement under present-law 

section 501(c)(3) or under section 501(c)(4), as amended. Thus, "excess benefit 

transactions" subject to excise taxes would include transactions in which a disqualified person 

engages in a non-fair-market-value transaction with an organization or receives unreasonable 

-129-
compensation, as well as financial arrangements (to the extent provided in Treasury 

regulations) under which a disqualified person receives payment based on the organization's 

income in a transaction that violates the present-law private inurement prohibition. 

Existing standards (see section 162) would apply in determining reasonableness of 

compensation and fair market value. In accordance with these standards, an individual need 

not necessarily accept reduced compensation merely because he or she renders services to a 

tax-exempt, as opposed to a taxable, organization. Cf. Treas. Reg. sec. 53.4941(d)-3(c)(l). 

In applying such standards, it is intended that the parties to a transaction would be entitled to 

rely on a rebuttable presumption of reasonableness with respect to a compensation 

arrangement with a disqualified person if such arrangement was approved by an independent 

board (or an independent committee authorized by the board) that (1) was composed entirely 

of individuals unrelated to and not subject to the control of the disqualified person(s) 

involved in the arrangement,1 (2) obtained and relied upon appropriate data as to 

comparability (e.g. compensation levels paid by similarly situated organizations, both taxable 

and tax-exempt, for functionally comparable positions, the location of the organization, 

including the availability of similar specialties in the geographic area, independent 

compensation surveys by nationally recognized independent firms, or actual written offers 

from similar institutions competing for the services of the disqualified person), and (3) 

adequately documented the basis for its determination (e.g. the record includes an evaluation 

of the individual whose compensation was being established and the basis for determining 

that the individual's compensation was reasonable in light of that evaluation and data).2 A 

similar rebuttable presumption would arise with respect to the reasonableness of the valuation 

of the property sold or otherwise transferred (or purchased) by an organization to (or from) a 

disqualified person if the sale or transfer (or purchase) is approved by an independent board 

that uses appropriate comparability data and adequately documents its determination. It is 

expected that any guidance addressing the reasonableness standard would incorporate this 

presumption. 

The proposal would specifically provide that the payment of personal expenses and 

benefits to or for the benefit of disqualified persons, and non-fair-market-value transactions 

benefiting such persons would be treated as compensation only if it is clear at the time of the 

1 A n individual would not be considered independent if, for example, his or her 

compensation were subject to review by the disqualified person whose compensation he or 

she was evaluating. 

2 The fact that a state or local legislative or agency body may have authorized or 

approved of a particular compensation package paid to a disqualified person would not be 

determinative of the reasonableness of compensation paid for purposes of the excise tax 

penalties provided for by the proposal. Similarly such authorization or approval would not 

be determinative of whether a revenue sharing arrangement violates the private inurement 

proscription. 

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payment that the organization intended and made the payment as compensation for services. 

In determining whether such payments or transactions are, in fact, compensation, the relevant 

factors would include whether the appropriate decision-making body approved the transfer as 

compensation in accordance with established procedures and whether the organization and the 

recipient reported the transfer (except in the case of nontaxable fringe benefits) as 

compensation on the relevant forms (i.e. the organization's For m 990, the Form W- 2 or 

Form 1099 provided by the organization to the recipient, the recipient's Form 1040, and 

other required returns). 

Any reimbursements by the organization of excise tax liability would be treated as an 

excess benefit unless they are included in the disqualified person's compensation during the 

year the reimbursement is made. The total compensation package, including the amount of 

any reimbursement, would be subject to the reasonableness requirement. Similarly, the 

payment by an applicable tax-exempt organization of premiums for an insurance policy 

providing liability insurance to a disqualified person for excess benefit taxes would be an 

excess benefit transaction unless such premiums are treated as part of the compensation paid 

to such disqualified person. 

"Disqualified person" would mean any individual who is in a position to exercise 

substantial influence over the affairs of the organization, whether by virtue of being an 

organization manager or otherwise.3 In addition, "disqualified persons" include certain family 

members and 35-percent owned entities of a disqualified person, as well as any person wh o 

was a disqualified person at any time during the five-year period prior to the transaction at 

issue. A person having the title of "officer, director, or trustee" would not automatically 

have the status of a disqualified person, nor would all highly valued professionals, such as 

members of a hospital's medical staff, be deemed to have substantial influence over the 

organizations for which they work. 

A disqualified person who benefits from an excess benefit transaction would be 

subject to a first-tier penalty tax equal to 25 percent of the amount of the excess benefit (i.e. 

the amount by which a transaction differs from fair market value or the amount of 

compensation exceeding reasonable compensation). Organization managers wh o participate 

in an excess benefit transaction knowing that it is an improper transaction would be subject 

to a first-tier penalty tax of ten percent of the amount of the excess benefit (up to a maximu m 

3 Under the proposal, a person could be in a position to exercise substantial influence 

over a tax-exempt organization despite the fact that such person is not an employee of (and 

receives no compensation directly from) a tax-exempt organization, but is formally an 

employee of (and is directly compensated by) a subsidiary - even a taxable subsidiary -

controlled by the parent tax-exempt organization. 

-131-
penalty of $10,000).4 

Additional second-tier taxes could be imposed on a disqualified person if there were 

no correction of the excess benefit transaction within a specific time period. In such cases, 

the disqualified person would be subject to a penalty tax equal to 200 percent of the amount 

of excess benefit. Th e definition and timing of satisfactory correction would track those used 

for the private foundation self-dealing excise tax. 

The intermediate sanctions for "excess benefit transactions" could be imposed by the 

I RS in lieu of (or in addition to) revocation of an organization's tax-exempt status. If more 

than one disqualified person or manager is liable for a penalty excise tax, then all such 

persons would be jointly and severally liable for such tax. A s under current law, a three-year 

statute of limitations would apply, except in the case of fraud (section 6501). Under the 

proposal, the IRS would have authority to abate the excise tax penalty (under present-law 

section 4962) if it is established that the violation was due to reasonable cause and not due to 

willful neglect and the transaction at issue was corrected within the specified period. 

To prevent avoidance of the penalty excise taxes in cases of private inurement of 

assets of a previously tax-exempt organization, the proposal would provide that an 

organization will be treated as an applicable tax-exempt organization subject to the excise 

taxes on excess benefit transactions if, at any time during the ten-year period preceding the 

transaction, it was a tax-exempt organization described in section 501(c)(3) or 501(c)(4), or a 

successor to such an organization. 

This proposal generally would apply to excess benefit transactions occurring on or 

after September 14, 1995. The provision would not apply, however, to any benefits arising 

out of a transaction pursuant to a written contract which was binding on September 13, 1995 

and at all times thereafter before such benefits arose, and the terms of which have not 

materially changed. In addition, parties to transactions entered into after September 13, 1995 

and within one year of the date of enactment of this proposal, would be entitled to rely on 

the rebuttable presumption of reasonableness if, within a reasonable period (e.g. 90 days) 

after entering into the compensation package, the parties satisfy the three criteria that give 

rise to the presumption. After this period, the rebuttable presumption should arise only if the 

three criteria are satisfied prior to payment of the compensation (or, to the extent provided 

by the Secretary of the Treasury, within a reasonable period thereafter). 

4 In determining wh o is an organization manager, it is intended that principles similar 

to those set forth in regulations issued under sections 4946 and 4955 with respect to final 

authority or responsibility for an expenditure be applied. (See Treas. Reg. sees. 53.4946-

l(f)(l)(ii), 53.4946-l(f)(2), 53.4955-l(b)(2)(ii)(B) and 53.4955-l(b)(2)(iii)). 

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Additional filing and public disclosure rules 

Reporting with respect to disqualified persons, excise tax penalties and excess benefit 

transactions. Tax-exempt organizations would be required to disclose on their Forms 990 

such information with respect to disqualified persons as the Secretary of the Treasury ma y 

prescribe. In addition, exempt organizations would be required to disclose on their returns 

information with respect to excess benefit transactions and any other excise tax penalties paid 

during the year under present-law sections 4911, 4912, and 4955, including the amount of 

the excise tax penalties paid with respect to such transactions, the nature of the activity, and 

the parties involved. The penalties applicable to failure to file a timely, complete and 

accurate return would apply for failure to comply with these requirements. In addition, it 

would be intended that the IRS implement its plan to require additional Form 990 reporting 

regarding (1) changes to the governing board or the certified accounting firm, (2) such 

information as the Secretary of the Treasury ma y require with respect to professional 

fundraising fees and (3) aggregate payments by related entities in excess of $100,000 to 

highly paid employees. 

Organizations required to provide copies of returns. Organizations described in 

sections 501(c) or (d) (other than private foundations) would be required to provide copies of 

their three most recent annual returns and any application for tax-exempt status they have 

filed to any individual requesting these documents. The organization, ma y charge a 

reasonable fee to cover reproduction and mailing costs. If the request is made in person, it 

must be filled immediately. If it is made in writing, it must be filled within 30 days. 

Organizations that willfully fail to make these documents available would be subject to a 

penalty of $5,000 with respect to each return or application requested. A n organization 

would be relieved of the requirement that it supply these documents if it made the documents 

widely available in accordance with standards established by the Secretary or if the Secretary 

determined, upon application, that the organization was subject to a harassment campaign. 

Penalties for failure to file timely or complete return. The section 6652(c)(1)(A) 

penalty imposed on a tax-exempt organization that either fails to file a Form 990 in a timely 

manner or fails to include all required information on a Form 990 would be increased from 

the present-law level of $10 for each day the failure continues (with a maximu m penalty with 

respect to any one return of the lesser of $5,000 or five percent of the organization's gross 

receipts) to $20 for each day the failure continues (with a maximu m penalty with respect to 

any one return of the lesser of $10,000 or five percent of the organization's gross receipts). 

Under the proposal, organizations with annual gross receipts exceeding $1 million would be 

subject to a penalty under section 6652(c)(1)(A) of $100 for each day the failure continues 

(with a maximu m penalty with respect to any one return of $50,000). A s under present law, 

no penalty would be imposed under section 6652(c)(1)(A) if it were shown that the failure to 

file a complete return was due to reasonable cause (sec. 6652(c)(3)). 

Effective dates. The filing and disclosure provisions governing tax-exempt 

organizations generally would be effective ninety days after the date of enactment. However, 

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the provisions regarding the reporting on annual returns of excise tax penalties and excess 

benefit transactions would be effective for returns with respect to taxable years beginning on 

or after January 1, 1996, and the requirement that organizations provide copies of their 

returns would be effective for requests made no earlier than 60 days after regulations had 

been promulgated providing standards for ho w returns could be made widely available. 

The proposal is substantially similar to a provision contained in the Revenue 

Reconciliation Act of 1995 as passed by Congress. 

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REIMPOSE SUPERFUND CORPORATE ENVIRONMENTAL INCOME TAX 

Current Law 

Before January 1, 1996, a corporate environmental income tax was imposed at a rate 

of 0.12 percent on the amount by which the modified alternative minimum taxable income of 

a corporation exceeded $2 million. Modified alternative minimum taxable income was 

defined as a corporation's alternative minimum taxable income, determined without regard to 

the alternative tax net operating loss deduction and the deduction for the corporate 

environmental tax. 

The tax was dedicated to the Hazardous Substance Superfund Trust Fund (the 

"Superfund Trust Fund"). Amounts in the Superfund Trust Fund are available for 

expenditures incurred in connection with releases or threats of releases of hazardous 

substances into the environment under specified provisions of the Comprehensive 

Environmental Response, Compensation, and Liability Act of 1980 (as amended). Spending 

from the Superfund Trust Fund is classified as discretionary domestic spending for Federal 

budget purposes. 

Reasons for Change 

The corporate environmental income tax should be reinstated because of the 

continuing need for funds to remedy damages caused by releases of hazardous substances. 

Proposal 

The corporate environmental income tax would be reinstated for taxable years 

beginning after December 31, 1995, and before January 1, 2007. 

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REIMPOSE OIL SPILL LIABILITY TRUST FUND EXCISE TAX 

Current Law 

Before January 1, 1995, a five-cents-per-barrel excise tax was imposed on domestic 

crude oil and imported petroleum products. The tax was dedicated to the Oil Spill Liability 

Trust Fund to finance the cleanup of oil spills and pay other costs associated with oil 

pollution. The tax was not imposed for a calendar quarter if the unobligated balance in the 

Trust Fund exceeded $1 billion at the close of the preceding quarter. 

Reasons for Change 

It is essential that the Oil Spill Liability Trust Fund remain funded because of the 

continuing potential for oil spills and the magnitude of damages such spills can cause. 

Moreover, the full funding level was last changed by the Omnibus Budget Reconciliation Act 

of 1989 and is no longer adequate. After the enactment of the current $1 billion limitation, 

the Oil Pollution Act of 1990 permitted the use of amounts in the Trust Fund for additional 

expenditure purposes and doubled the limits on Trust Fund expenditures with respect to a 

single incident (increasing the overall limit from $500 million to $1 billion and the limit for 

natural resource damages payments from $250 million to $500 million). In addition, the 

Treasury Department's authority to advance up to $1 billion to the Trust Fund expired in 

1994. 

Proposal 

The Oil Spill Liability Trust Fund excise tax would be reinstated for the period after 

the date of enactment and before October 1, 2006. In addition, the full funding limitation 

would be increased from $1 billion to $2.5 billion. The proposal would be effective on the 

date of enactment. 

The proposal is similar to a provision contained in the Revenue Reconciliation Act of 

1995 as passed by Congress. 

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TAX KEROSENE IN THE SAME MANNER AS DIESEL FUEL 

Current Law 

A 24.3-cents-per-gallon excise tax is imposed on diesel fuel upon removal from a 

registered terminal facility unless the fuel is indelibly dyed and is destined for a nontaxable 

use. Treasury regulations provide that kerosene is not treated as diesel fuel for this purpose. 

Thus, undyed kerosene is not subject to the diesel fuel excise tax when it is removed from a 

terminal. 

Kerosene is a petroleum distillate that is frequently blended with diesel fuel during 

cold weather in order to prevent formation of wax crystals in fuel lines. In some parts of the 

country, diesel fuel/kerosene blends containing 30-percent kerosene are common . Whe n 

kerosene is blended with previously taxed diesel fuel for highway use, the untaxed portion of 

the mixture is taxable when the mixture is removed or sold by the blender. If kerosene is 

mixed with dyed diesel fuel for a nontaxable use, the dye concentration of the mixture must 

be adjusted to ensure that it meets regulatory requirements for untaxed, dyed diesel fuel. 

Kerosene is also used as jet fuel in aircraft engines. Kerosene used as aviation fuel is 

currently taxed at a rate of 4.3 cents per gallon. Aviation fuel is taxed when it is sold or 

used by a producer, which is defined to include registered refiners, compounders, blenders, 

wholesale distributors, and dealers selling aviation fuel solely to other producers. However, 

sales between these persons are not taxed. Thus, tax is generally imposed when the fuel is 

sold to a retail dealer or used by a commercial airline that is registered as a producer. 

Clear, low-sulfur kerosene (1-K) may also be used in space heaters, and is often 

available for this purpose at service station pumps. Kerosene used in space heaters is not 

subject to a Federal excise tax. Kerosene is also not subject to tax when it is added to diesel 

fuel that is used as heating oil. Although kerosene is commonly blended with heating oil 

before removal from the terminal, it ma y be necessary during periods of extreme or 

unseasonable cold to add pure kerosene directly to furnace supply tanks. Other nontaxable 

uses of kerosene include feedstock use in the petrochemical industry. 

Reasons for Change 

Some wholesale distributors of diesel fuel have suggested that their competitors have 

not been paying the tax on kerosene that they blend with diesel fuel for highway use. A s a 

result, the government is losing tax revenues and complying taxpayers are at a competitive 

disadvantage. However, any change to the current system should accommodate uses for 

which clear kerosene is necessary to comply with Federal or State rules or product safety 

certifications, and should not impose increased burdens on those wh o use kerosene in space 

heaters. The change should also accommodate cases in which unexpectedly severe weather 

conditions mak e it necessary to add clear kerosene to heating oil after removal from the 

-137-
terminal and should not impose unnecessary burdens on feedstock uses of kerosene. 

Proposal 

Kerosene would be subject to the same rules as diesel fuel. Thus, kerosene would be 

taxed when it is removed from a registered terminal unless it is indelibly dyed and destined 

for a nontaxable use. However, aviation-grade kerosene that is removed from the terminal 

by a registered producer of aviation fuel would not be subject to the dyeing requirement and 

would be taxed under the current law rules applicable to aviation fuel. Feedstock kerosene 

that a registered industrial user receives by pipeline or vessel would also be exempt from the 

dyeing requirement. Other feedstock kerosene would be exempt from the dyeing requirement 

to the extent and under conditions (including satisfaction of registration and certification 

requirements) prescribed by regulation. T o accommodate State safety regulations that require 

the use of clear (1-K) kerosene in certain space heaters, a new refund procedure would be 

provided under which registered ultimate vendors could claim refunds of the tax paid on 

kerosene sold for that use. In addition, the Commissioner would be given discretion to 

refund to a registered ultimate vendor the tax paid on kerosene that is blended with heating 

oil for use during periods of extreme or unseasonable cold. 

The changes would be effective on July 1, 1997, with appropriate floor stocks taxes 

imposed on kerosene held on that date. 

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PERMANENTLY EXTEND THE LUXURY PASSENGER AUTOMOBILE TAX 

Current Law 

An excise tax is imposed on the first retail sale of luxury automobiles. The tax is 

equal to 10 percent of the amount by which the retail sales price exceeds an inflation-adjusted 

$30,000 base. The inflation-adjusted base currently is $34,000. The tax is scheduled to 

expire on December 31, 1999. 

Reasons for Change 

In the Omnibus Budget Reconciliation Act of 1990, Congress and the prior 

Administration agreed that a tax on luxury automobiles was an appropriate deficit reduction 

measure. Concerns have been expressed, however, that the scheduled expiration of the tax 

will substantially depress sales of automobiles subject to the tax for several months prior to 

its expiration. 

Proposal 

The luxury tax on automobiles would be extended permanently. 

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EXTEND THE FUTA SURCHARGE AND REQUIRE MONTHLY DEPOSITS 

Current Law 

The Federal Unemployment Tax Act (FUTA) currently imposes a Federal payroll tax 

on employers of 6.2 percent of the first $7,000 paid annually to each employee. The tax 

funds a portion of the Federal/State unemployment benefits system. This 6.2 percent rate 

includes a temporary surtax of 0.2 percent. States also impose an unemployment tax on 

employers. Employers in States that meet certain Federal requirements are allowed a credit 

for State unemployment taxes of up to 5.4 percent, making the minimum net Federal tax rate 

0.8 percent. Generally, Federal and State unemployment taxes are collected quarterly and 

deposited in Federal trust fund accounts. 

In 1976, Congress passed a temporary surtax of 0.2 percent of taxable wages to be 

added to the permanent FUT A tax rate. Thus, the current 0.8 percent FUT A tax rate has 

two components: a permanent tax rate of 0.6 percent, and a temporary surtax rate of 0.2 

percent. The surtax has been extended several times, the most recently through 1998, to 

build up reserves in the Federal trust accounts and thus to help avoid future funding problems 

in these accounts. 

Reasons for Change 

Extending the surtax will support the continued solvency of the Federal 

unemployment trust funds and maintain the ability of the unemployment system to adjust to 

any economic downturns. 

Accelerating collections may reduce losses to the Federal unemployment trust funds 

caused by employer delinquencies and provide a regular inflow of money to State funds to 

offset the regular payment of benefits. Limiting the application of acceleration to larger 

employers would avoid imposing additional requirements on small businesses. 

Proposal 

The proposal would extend the 0.2 percent surtax through December 31, 2006. 

The proposal would also require an employer to pay Federal and State unemployment 

taxes on a monthly basis in a given year if the employer's FUT A tax liability in the prior 

year was $1,100 or more (reflecting approximately 20 employees earning at least $7,000.) A 

safe harbor would be provided for the required deposits for the first two months of each 

calendar quarter. For the first month in each quarter, the payment would be required to be 

the lesser of 30 percent of the actual FUT A liability for the quarter or 90 percent of the 

actual FUT A liability for the month. The cumulative deposits paid in the first two months of 

each quarter would be required to be the lesser of 60 percent of the actual FUT A liability for 

-140-
the quarter or 90 percent of the actual FUT A liability for the two months. The employer 

must pay the balance of the actual FUT A liability for each quarter by the last day of the 

month following the quarter. States would be permitted to adopt a similar mechanism for 

paying State unemployment taxes. This proposal would be effective for months beginning 

after December 31, 2001. 

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MODIFICATIONS TO EARNED INCOME TAX CREDIT 

Current Law 

Structure of and eligibility for the credit generally 

Certain eligible low-income workers are entitled to claim a refundable earned income 

tax credit (EITC) on their income tax return. The amount of the credit an eligible individual 

m ay claim depends upon whether the individual has one, more than one, or no qualifying 

children and is determined by multiplying the credit rate by the taxpayer's earned income (up 

to a maximum earned income amount). The maximum amount of the credit is the product of 

the credit rate and this earned income amount. For taxpayers with earned income (or 

adjusted gross income (AGI), if greater) in excess of the beginning of a phase-out range of 

income, the maximum credit is reduced by the phaseout rate multiplied by the amount of 

earned income (or AGI , if greater) in excess of the beginning of the phaseout range of 

income. For taxpayers with earned income (or AGI, if greater) in excess of the phaseout 

range of income, no credit is allowed. 

The parameters of the credit depend upon the number of qualifying children the 

individual claims. For 1996, the parameters are as follows: 

Two or more One qualifying No qualifying 

qualifying children child children 

Credit rate 40.00% 34.00% 7.65% 

Earnings at which 

maximum credit is $8,890 $6,330 $4,220 

reached 

Maximum credit $3,556 $2,152 $323 

Phaseout begins 

Phaseout rate 

Phaseout ends 

For years after 1996, the credit rate and phaseout rates do not change. The earned 

income amount and the beginning of the phaseout range of income are indexed for inflation, 

and because the end of the phaseout range depends on those amounts (as well as the credit 

and phaseout rates), the end of the phaseout range will also increase if there is inflation. 

$11,610 

21.06% 

$28,495 

$11,610 

15.98% 

$25,078 

$5,280 

7.65% 

$9,500 

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For taxable years beginning after December 31, 1995, an individual is not eligible for 

the EIT C if the aggregate amount of "disqualified income" of the taxpayer for the taxable 

year exceeds $2,350. Disqualified income is the sum of interest income (both taxable and 

tax-exempt), dividends, and positive net rent and royalty income. 

In order to claim the EITC, an individual must either have a qualifying child or be 

older than 24 and younger than 65 and not be a dependent. A qualifying child must meet a 

relationship test, an age test, an identification test, and a residence test. T o satisfy the 

identification test, individuals must include on their tax return the name and age of each 

qualifying child claimed. For 1996 returns filed in 1997, individuals must provide a 

taxpayer identification number (TIN) for all qualifying children born on or before November 

30, 1996. For returns filed with respect to tax year 1997 and subsequent years, individuals 

must provide TINs for all qualifying children, regardless of age. A n individual's TI N is 

generally that individual's social security number (SSN). 

Assessment procedures relating to mathematical and clerical errors 

The IRS may summarily assess additional tax due as a result of a mathematical or 

clerical error without sending the taxpayer a notice of deficiency and giving the taxpayer an 

opportunity to petition the Tax Court. Where the IRS uses the summary assessment 

procedure for mathematical or clerical errors, the taxpayer must be given an explanation of 

the asserted error and a period of 60 days to request that the IRS abate the assessment. The 

IRS may not proceed to collect the amount of the assessment until the taxpayer has agreed to 

it or has allowed the 60-day period for objecting to expire. If the taxpayer files a request for 

abatement of the assessment specified in the notice, the IRS must abate the assessment. An y 

reassessment of the abated amount is subject to the ordinary deficiency procedures. The 

request for abatement of the assessment is the only procedure a taxpayer may use prior to 

paying the assessed amount in order to contest an assessment arising out of a mathematical or 

clerical error. Once the assessed amount is paid or otherwise satisfied, however, the 

taxpayer ma y file a claim for refund if he or she believes the assessment was made in error. 

Advance EITC 

An eligible individual with a qualifying child may elect to receive a portion of the 

EITC on an advance basis simply by furnishing an advance payment certificate (IRS Form 

W-5 ) to his or her employer. For such an employee, the employer makes an advance 

payment of the EIT C at the time wages are paid. The amount of advance payment allowable 

for the year is limited to 60 percent of the maximu m credit available to an individual with 

one qualifying child. Advance payments by an employer during any payroll period are not 

treated as a payment of compensation, but rather are treated as made out of the employer's 

share of FIC A taxes and amounts required to be withheld by the employer for income and 

the employee's share of FIC A taxes. The balance of any EITC still due the individual is 

claimed on the individual's tax return. 

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Reasons for Chang e 

Since 1993 the Administration and Congress have taken a number of steps to improve 

the administration of the EITC. Further steps are desirable to ensure that only the intended 

beneficiaries receive the EITC. 

Most EITC recipients do not have significant resources and must rely on earnings to 

meet their day-to-day living expenses. Taxpayers with significant capital gains or passive 

income, in contrast, are able to draw upon the resources that produce these kinds of income 

to meet family needs. Taxpayers should also be limited in their ability to claim the EIT C 

because their adjusted gross income is reduced by certain kinds of losses. 

In addition, the Administration believes the EITC should not be available to 

individuals wh o are not authorized to work in the United States. In this regard, only 

taxpayers with valid TINs should receive the EIT C and certain other tax benefits. 

Finally, receiving the EITC through advance payments may help recipients' cash flow 

and reinforce the message that "work pays," particularly among those wh o are trying to take 

the step from welfare to work. In the past, few EIT C recipients have chosen to receive any 

portion of their EIT C on an advance basis. The reasons for the low utilization rate are not 

fully known. The IRS has undertaken an intensive effort to educate both employers and 

eligible employees about the advance payment option, but participation still remains relatively 

low. The Administration is interested in learning whether participation would improve if 

State agencies were given the authority to provide advance payments on a limited basis. 

Proposal 

Individuals would not be eligible for the EITC if they do not include their TIN (and, 

if married, their spouse's TIN) on their tax return. For this purpose, as well as for purposes 

of the present-law identification requirement for a qualifying child, the required TI N would 

be an SS N issued to an individual by the Social Security Administration other than a number 

issued under section 205(c)(2)(B)(i)(II) (or that portion of section 205(c)(2)(B)(i)(III) relating 

to section 205(c)(2)(B)(i)(II)) of the Social Security Act (regarding the issuance of a number 

to an individual applying for or receiving federally funded benefits). 

If an individual fails to provide a correct TIN, the omission would be treated as a 

mathematical or clerical error. Similarly, if an individual wh o claims the credit with respect 

to net earnings from self-employment fails to pay the proper amount of self-employment tax 

on those net earnings, the failure would be treated as a mathematical or clerical error for 

purposes of the amount of EIT C allowed. Finally, taxpayers would be required to provide a 

correct TI N for any dependent claimed on the return, and the failure to do so would be 

treated as a mathematical or clerical error. In such a case, the IRS would be authorized to 

deny the dependency exemption (subject to the taxpayer's ability to file a request for an 

abatement of the resulting assessment). The denial would also have indirect consequences 

-144-
for other tax benefits conditioned on being able to claim a dependency exemption (e.g.. head 

of household filing status and the dependent care credit). 

The definition of disqualified income would be expanded to include net passive 

income that is not self-employment income and net capital gain (only to the extent such net 

amounts are positive). In addition, the disqualified income threshold would be lowered to 

$2,200 in 1996 and indexed for inflation thereafter (subject to a $50 round-down rule). 

The definition of AGI for purposes of applying the phaseout rules would be modified 

by disregarding net capital losses, net losses from nonbusiness rents and royalties, net losses 

from trusts and estates, and 50 percent of the business losses from sole proprietorships (both 

farming and nonfarming) and from partnerships and S corporations. 

Lastly, a demonstration program would be authorized pursuant to which an eligible 

individual would be able to receive the EIT C on an advance basis from a designated State 

agency instead of receiving it on an advance basis from his or her employer. States 

interested in participating in the program would submit proposals to the Secretary of the 

Treasury who, in consultation with the Secretary of Health and Huma n Services, would 

select projects in up to 4 States. Advance EIT C payments would be made for 3 years under 

the demonstration programs. 

EITC recipients participating in the programs would receive up to 75 percent of the 

maximum credit available to an EIT C claimant with the corresponding number of qualifying 

children. The advance payments, which would be made no less frequently than quarterly, 

would not be treated as compensation and would not be includible in the recipient's income. 

The State agency would be allowed to make such payments out of amounts withheld by the 

State from its employees' pay for income and employee FIC A taxes as well as out of its ow n 

employer FIC A liability. 

The proposals submitted by States would include an explanation of how the advance 

EITC payments would be administered by the appropriate State agency and of how the 

payments would be coordinated with other benefits. A detailed explanation would also be 

required of ho w eligibility for the credit would be determined and verified. States would 

have to agree to provide to the IRS and participating recipients by January 31 annual 

information reports showing the participant's name, TIN, and the amount of advance 

payments made during the previous year. States would also be required to submit to the IRS 

by December 1 the name and TI N of each participant. States would be responsible for a 

portion of the erroneous advance EIT C payments made as part of the demonstration 

program. 

Genrally these proposed changes to the EITC would be applicable for taxable years 

beginning after December 31, 1995. The provisions treating certain omissions as 

mathematical or clerical errors would be effective for returns the due date for which (without 

regard to extensions) is more than 30 days after the date of enactment of the proposal. The 

-145-
demonstration project provisions would be effective for taxable years beginning after 

December 31, 1996. 

-146-
REIMPOSE AIRPORT AND AIRWAY TRUST FUND EXCISE TAXES 

Current Law 

Before January 1, 1996, the Airport and Airway Trust Fund was supported 

on air passenger transportation, domestic air freight transportation, and noncommercial 

aviation fuel. The tax on domestic air passenger transportation was 10 percent of the amount 

paid for the transportation, the tax on international departures was $6 per person, the tax on 

domestic air freight transportation was 6.25 percent of the amount paid for the transportation, 

and the tax on noncommercial aviation fuel, to the extent dedicated to the Trust Fund, was 

17.5 cents per gallon (15 cents per gallon in the case of gasoline). The taxes on air 

passenger and air freight transportation, the dedicated tax on noncommercial jet fuel, and a 

1-cent-per-gallon dedicated tax on noncommercial aviation gasoline expired on December 31, 

1995. The authority to transfer tax revenues to the Trust Fund also expired on December 

31, 1995. 

Reason for Change 

To provide for necessary Federal airport and airway expenditures, the aviation excise 

taxes should be reinstated and revenues from the reinstated taxes should be transferred to the 

Airport and Airway Trust Fund. 

Proposal 

The aviation excise taxes would be reinstated for the period after the date of 

enactment and before October 1, 2006. (The Administration understands that these taxes 

m ay be replaced by a fee-based structure before the proposed expiration date.) The 

reinstated taxes on air passenger and air freight transportation would not apply to amounts 

paid on or before the date of enactment. The authority to transfer revenues to the Airport 

and Airway Trust Fund would be reinstated for the period after December 31, 1995, and 

before October 1, 2006. 

-147-
REIMPOSE LEAKING UNDERGROUND STORAGE 

TANK TRUST FUND TAX 

Current Law 

Before January 1, 1996, a tax of 0.1 cent per gallon was imposed on gasoline, diesel 

fuel, special motor fuels, aviation fuel, and fuels used on inland waterways. Revenues from 

the tax were dedicated to the Leaking Underground Storage Tank (LUST) Trust Fund. 

Reason for Change 

The LUST Trust Fund taxes should be reinstated to ensure the availability of funds to 

pay clean-up costs associated with leaks from underground storage tanks. 

Proposal 

The LUST Trust Fund tax would be reinstated for the period after the date of 

enactment and before October 1, 2006. 

-148-
REIMPOSE SUPERFUND EXCISE TAXES 

Current Law 

The following Superfund excise taxes were imposed before January 1, 1996: 

(1) An excise tax on domestic crude oil and on imported petroleum products at a rate 

of 9.7 cents per barrel; 

(2) An excise tax on listed hazardous chemicals at a rate that varied from $0.22 to 

$4.87 per ton; and 

(3) An excise tax on imported substances that use as materials in their manufacture or 

production one or more of the hazardous chemicals subject to the excise tax described in (2) 

above. 

Amounts equivalent to the revenues from these taxes were dedicated to the Hazardous 

Substance Superfund Trust Fund (the "Superfund Trust Fund"). Amounts in the Superfund 

Trust Fund are available for expenditures incurred in connection with releases or threats of 

releases of hazardous substances into the environment under specified provisions of the 

Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (as 

amended). Spending from the Superfund Trust Fund is classified as discretionary domestic 

spending for Federal budget purposes. 

Reason for Change 

The Superfund excise taxes should be reinstated because of the continuing need for 

funds to remedy damages caused by releases of hazardous substances. 

Proposal 

The three Superfund excise taxes would be reinstated for the period after the date of 

enactment and before October 1, 2006. 

-149-


Department of the Treasury 

Washington, D.C. 20220 

Official Business 

Penalty for Private Use, $300